                          T.C. Memo. 1997-467



                      UNITED STATES TAX COURT



        H & A INTERNATIONAL JEWELRY, LTD., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent


     Docket No. 156-95.                Filed October 14, 1997.



     David D. Aughtry and Lisa M. Lawson, for petitioner.

     Eric Jorgensen, for respondent.



                          MEMORANDUM OPINION

     PARR, Judge:   Respondent determined the following

deficiencies in petitioner's Federal income tax:

          Year                        Deficiency
          1989                           $5,107
          1990                            4,632
          1991                          159,932
          1992                           79,454

     All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise
                               - 2 -

indicated.   All dollar amounts are rounded to the nearest dollar,

unless otherwise indicated.   After concessions, the sole issue

before the Court is whether the amount of executive compensation

paid to Mr. Haim Haviv for 1991 and 1992 is unreasonable, and if

so, what reasonable compensation is.   We find the amounts paid to

be unreasonable under section 162(a)(1).

     Some of the facts have been stipulated and are so found.

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference.

     Petitioner, an international jeweler, is a Georgia

corporation with its principal place of business in Dunwoody,

Georgia, an unincorporated suburb of Atlanta.

General Background

     H&A International Jewelry, Ltd.

     Mr. and Mrs. Haviv are the sole shareholders of petitioner.

Each owns 50 percent.   Mr. and Mrs. Haviv contributed $500 to

capital upon petitioner's incorporation.   Since petitioner's

incorporation, Mr. Haviv has served as its president and chairman

of the board of directors, and Mrs. Haviv has served as its

secretary.   Petitioner has never paid any dividends.

     Petitioner (1) conducts wholesale and retail sales of

jewelry and precious stones, (2) appraises and insures precious

stones, and (3) custom designs and repairs jewelry.     Petitioner

became a company unique in specialty, reputation, location, and

purchasing power.
                                    - 3 -

           Petitioner has paid Mr. Haviv the following amounts in

compensation:

Year            Salary    Bonus/Commission          Total Compensation1

1984              $0          $10,000                   $10,000
1985               0           25,000                    25,000
1986               0           25,000                    25,000
1987            12,000         35,000                    47,000
1988            26,000        125,000                   151,000
1989            28,000         95,000                   123,000
1990            30,000        105,000                   135,000
1991            40,000        562,000                   601,077
1992            68,000        535,000                   603,269

Petitioner's board of directors (the board), consists solely of

Mr. and Mrs. Haviv.        The board approved Mr. Haviv's

bonuses/commissions for 1991 and 1992 at the end of each

respective year.2

           Petitioner is located in a secluded office building "quite

distant" from any major highway, retail district, or mall.

Petitioner does not advertise.          Rather,   petitioner's reputation

enables it to operate by word of mouth. Petitioner purchases its

jewels from diamond exchanges, mostly in Antwerp, Belgium, and

Tel Aviv, Israel, as well as from side holders and wholesalers



       1
          The parties have stipulated that Mr. Haviv's total
compensation for 1991 and 1992 is $601,077 and $603,269,
respectively. We note, however, that Mr. Haviv's salary and
bonus/commission for 1991 and 1992 actually total $602,000 and
$603,000, respectively. We find that the $923 difference for
1991 is a concession by respondent, and the $269 difference for
1992 is a concession by petitioner.
       2
          Mr. and Mrs. Haviv's bonuses/commissions for 1984
through 1990 were also approved at the end of each respective
year.
                                 - 4 -

within the United States.3     The stones are then transported to

petitioner's Dunwoody store and held for sale.4        Petitioner also

accepts customer orders for desired stones and seeks them out.

In 1991, petitioner had 10 employees in addition to Mr. and Mrs.

Haviv:   3 salespersons, 1 jewelry repairman, 4 office staff, and

2 employees in the newly opened Oklahoma City store.       In 1992,

petitioner employed an additional salesperson in its newly opened

Augusta, Georgia, store.     Petitioner's employees received salary

and commissions, but only Mr. and Mrs. Haviv received bonuses.

Employees were compensated the following amounts for 1991:

Name of           Total
Employee          Comp.       Salary     Comm./Bonus   Position
Haim Haviv      $601,077     $39,077     $562,000
Amy Haviv         21,885      20,885        1,000
Robert Wade       30,500      25,150        5,350      Atlanta Sales
R. Lingerfelt     17,645      17,501          144      Oklahoma Sales
T.S. New          24,384      24,046          338      Jewelry Repairs
Beth Leamon       37,305      21,200       16,105      Atlanta Sales
M. Stevens         3,691       3,641           50      Part Time
Ann Hardy         22,240      22,135          105      Office Staff
Venita Smith      19,997      19,960           37      Bookkeeper
Bill Frank        71,409      55,923       15,486      Atlanta Sales
Matt Kaye          8,110       8,077           33      Oklahoma Sales
J.M. McKnight      9,651       9,623           28      Office Staff

Total            867,894     267,218      600,676



In 1992, petitioner's employees were compensated the following

amounts:



    3
          A side holder is an individual who obtains diamonds
directly from the owner of a diamond mine.
    4
          Petitioner opened stores in Oklahoma City, Oklahoma, in
1991 and Augusta, Georgia, in 1992.
                               - 5 -

Name of        Total
Employee       Comp.      Salary       Comm./Bonus   Position
Haim Haviv    $603,269   $68,269        $535,000
Amy Haviv       24,731    24,231             500
Robert Wade     33,980    33,100             880     Atlanta Sales
R. Lingerfelt   19,757    19,423             334     Oklahoma Sales
T.S. New         2,085     1,157             928     Jewelry Repairs
Beth Leamon     28,903    25,250           3,653     Atlanta Sales
Ann Hardy       24,942    24,292             650     Office Staff
Venita Smith    22,860    22,231             629     Bookkeeper
Bill Frank      76,572    69,250           7,322     Atlanta Sales
Matt Kaye       34,890    34,731             159     Oklahoma Sales
J.M. McKnight   20,502    20,252             250     Office Staff
D. Alexander     8,329                     8,329     Augusta Sales.
R. Cockrom       5,381     5,381                     Office Staff

Total          906,201   347,567         558,634


     Mr. Haviv's Skills and Qualifications

     Haim Haviv was introduced to the jewelry industry at a young

age by his uncle, a small collector.     Mr. Haviv attended the

Israeli Naval Academy and served in the Israeli Special Forces.

His military background earned him trust and respect from those

in the Tel Aviv diamond market.    Mr. Haviv obtained a bachelor of

science degree from the University of California and graduated

from the Gemology Institute of America.     Mr. Haviv started his

career at Alman's in Atlanta as a jewelry salesman.      He then

became a manager in training at Citizens Jewelry Co. before he

and his wife formed petitioner in 1983.

     Mr. Haviv has a photographic memory with precious stones.

This ability is a major asset when he makes purchases and sales.

His memory enables him to keep a mental record of the identity

and location of the thousands of stones in petitioner's
                                 - 6 -

inventory.   In addition, Mr. Haviv speaks six languages:    Hebrew,

French, English, Flemish, Arabic, and Italian.

     Mr. Haviv's Role in the Company

     Mr. Haviv makes all of petitioner's purchases.     He also

approves vendor invoices for payment, signs all checks, extends

customer credit, and prices inventory.     William L. Frank (Mr.

Frank), petitioner's top salesman, also has the power to set

prices for his personal sales.    When Mr. Haviv is traveling,

office manager Ann Hardy runs the store, although major decisions

are reserved for Mr. Haviv.

     Mr. Haviv's workday often extends late into the night

conducting meetings, employee seminars, and strategy sessions.

Except during the Christmas season he usually does not work on

the weekends.

     Mr. Haviv makes about eight purchasing trips abroad per year

to diamond exchanges in Antwerp and Tel Aviv.     He also traveled

to the Orient in 1992.    His linguistic ability helps him obtain

low prices in foreign cities.     Mrs. Haviv accompanies him about

once a year.    Mr. Frank traveled with Mr. Haviv two or three

times between 1991 and 1992.    Salesman Robert Wade has also been

to the diamond exchanges.

     Mr. Haviv's purchases are transported back to the Georgia

store by secured delivery services.      On occasion, Mr. Haviv
                                - 7 -

brings them back himself. Regardless of the means of

transportation, all stones are insured during travel.

     Mr. Frank joined the jewelry industry in 1973, working for

Citizens Jewelry Company and D. Geller & Sons before operating

his own partnership, Diamond Industries, from 1979 to 1985.        He

has worked for petitioner for over 5 years.

     About 45 percent of petitioner's purchases are made within

the United States.   Domestic purchases are often made by

telephone and are delivered by armored division, registered mail,

or commercial carriers, depending upon the size of the order.

     The $600,000 Red Diamond Transaction

     In 1991 petitioner took an order from a customer for an

extremely rare .70 carat red diamond.      Mr. Haviv located and

purchased the diamond for $56,000. After Mr. Haviv transported

the diamond into the United States, petitioner's salesperson,

Beth Leamon, sold it for $600,000.      Her bonus that year was

$16,105.

     Dangers of the Business

     Mr. Haviv has encountered increased dangers by working

overseas.   For instance, an individual was killed at the Tel Aviv

diamond exchange, and Mr. Haviv was near an airport bombing in

France.    Mr. Haviv carries a gun in countries where it is legal,

including the United States.   Even when Mr. Haviv travels in

nearby Atlanta, his work places him at a special risk.

Petitioner asserts that part of Mr. Haviv's compensation is for
                                 - 8 -

this added risk, which it likens to "combat-pay."        Although

petitioner's other employees also travel abroad and transport

jewels throughout the city of Atlanta, they are not given

"combat-pay."     Petitioner does not employ a security guard on its

premises.

        Petitioner's Salary Policy

        During 1991 and 1992, Mr. Haviv determined the salaries,

commissions, and bonuses for all of petitioner's employees.

Salaries were fixed for the entire year.       Salespersons earned

commissions of 50 percent of gross profits on all sales made to

their personal customers.     When a sale was made to a "house

customer" salespersons would typically earn commissions of 5

percent of the gross sale.5    All "house customers" were

considered to be customers of Mr. Haviv, although he was not

bound by the commission structure.       Petitioner had no written

policy for bonuses.

        A Comparison of Salaries Paid to Mr. Haviv with Gross
        Income and Net Income

        In 1991, Mr. Haviv's compensation was four times larger than

his average compensation from the prior 3 years.       In 1992, his

total compensation exceeded that of 1991.       For 1988-92 petitioner

paid Mr. Haviv the following percentages of gross revenues:



    5
          "House customers" are those customers who do not seek
an individual salesperson. Since Ms. Leamon did not receive 5
percent of the red diamond sale price, we are at a loss to
understand how this rule was applied.
                                - 9 -

                            Mr. Haviv's        Percentage of
          Gross Revenue     Compensation       Gross Revenue

1988       $3,914,409         $151,000            3.9%
1989        4,684,286          123,000            2.6%
1990        4,740,731          135,000            2.9%
1991        6,495,378          601,077            9.3%
1992        7,009,772          603,269            8.6%


In 1992, the compensation paid to Mr. Haviv was greater than

petitioner's net income (before deduction for Mr. Haviv's

compensation).    Mr. Haviv's compensation as a percentage of

petitioner's taxable income for 1988-92 before the deduction for

Mr. Haviv's compensation amounted to:

        Net Income                         Percentage of Net Income
     (before deduction                         (before deduction
      for Mr. Haviv's      Mr. Haviv's          for Mr. Haviv's
       Compensation)       Compensation          Compensation)
1988     $186,208            $151,000                81%
1989      157,044             123,000                78%
1990      165,883             135,000                81%
1991      685,988             601,077                88%
1992      470,991             603,269               128%



       The Prevailing Rates of Compensation for Comparable
       Positions in Comparable Concerns

       Respondent used Robert Morris Associates (RMA) Annual

Statement Studies to determine Mr. Haviv's reasonable

compensation for 1991 and 1992 to be $207,852 and $224,313

respectively.    The RMA Study was based upon the financial

statements of 10 wholesale jewelers with $5 to $10 million in

annual sales.    The RMA survey for 1991 divided the officer
                                 - 10 -

compensation for the 10 companies by percentage of sales:        Upper

quartile, 3.2 percent; median, 2.1 percent; and lower quartile,

1.0 percent.6    Respondent allowed compensation of 3.2 percent of

net sales.

        Petitioner contends that due to Mr. Haviv's talents and

market positioning, petitioner has no true competitors in the

United States.     Therefore, petitioner presents what it considers

"the only person remotely qualified within 100 miles of Atlanta"

as a "competitor."     He has been designated as Mr. W for this

trial.     Mr. W owns 100 percent of the stock of what have been

designated as B Co. and C Co., each a retail jewelry store in a

city in the southeast region of the United States.         At the end of

the companies' fiscal year 1991, C Co was merged into B Co.

        Mr. W has been in the jewelry business for 57 years and has

operated C Co. and B Co. for 52 and 36 years respectively.        B Co.

and C Co. have customers in Atlanta and have competed against

petitioner on a few occasions in the sale of large diamonds and

precious stones.

        In 1991, there was an industrywide recession induced by the

10 percent luxury tax on jewelry.         See Omnibus Budget

Reconciliation Act of 1990, Pub. L. 101-508, sec. 11221(a), 104

Stat. 1388, 1388-441 to 1388-442.



    6
          For example, 25 percent (in this survey 2) of the
companies compensated their officers greater than 3.2 percent of
annual sales.
                               - 11 -

     Petitioner deducted Mr. Haviv's salary for 1991 and 1992 as

a business expense.   This produced a loss of $132,278 for 1992

which was carried back to offset income from 1989, 1990, and

1991.



Discussion

     The sole issue for determination is whether the salary and

bonus paid by petitioner to its president, Haim Haviv, in 1991

and 1992 represents reasonable compensation deductible as a

business expense.   Petitioner contends that the entire

compensation paid, $601,077 in 1991 and $603,269 in 1992, was

reasonable and paid for his present and past services.

Respondent, on the other hand, determined that reasonable

compensation for Mr. Haviv was $207,852 and $224,313 for 1991 and

1992, respectively.

     Section 162(a)(1) allows a deduction for ordinary and

necessary business expenses including "a reasonable allowance for

salaries or other compensation for personal services actually

rendered".   Compensation which is a guise for the distribution of

dividends to employee-stockholders is not deductible.     Sec.

1.162-7(b)(1), Income Tax Regs.   Respondent's determination is

presumed correct, and petitioner has the burden of proving that

the amount it paid to Mr. Haviv was reasonable.    Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933).     If petitioner
                                 - 12 -

proves respondent's determination erroneous, the Court must then

decide the amount of compensation that was reasonable.    Pepsi-

Cola Bottling Co. v. Commissioner, 61 T.C. 564, 568 (1974), affd.

528 F.2d 176 (10th Cir. 1975).

     The reasonableness of compensation is a question of fact to

be determined from the record in each case.   Estate of Wallace v.

Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th

Cir. 1992).   In Estate of Wallace v. Commissioner, we used the

following nine factors to determine reasonableness:   (1) the

employee's qualifications; (2) the nature, extent, and scope of

the employee's work; (3) the size and complexities of the

business; (4) a comparison of salaries paid with the gross income

and the net income; (5) the prevailing general economic

conditions; (6) comparison of salaries with distributions to

stockholders; (7) the prevailing rates of compensation for

comparable positions in comparable concerns; (8) the salary

policy of the corporation as to all employees; and (9) in the

case of small corporations with a limited number of officers, the

amount of compensation paid to the particular employee in

previous years.   Estate of Wallace v. Commissioner, supra at 553;

see also Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115,

119 (6th Cir. 1949).   All the facts must be considered; no one

factor is determinative.   Rutter v. Commissioner, 853 F.2d 1267,

1274 (5th Cir. 1988), affg. T.C. Memo. 1986-407; Pacific Grains,
                                 - 13 -

Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), affg.

T.C. Memo. 1967-7; Home Interiors & Gifts, Inc. v. Commissioner,

73 T.C. 1142, 1156 (1980).   In analyzing these factors, the Court

must carefully scrutinize the facts of a case in which the paying

corporation is controlled by the employees to whom the

compensation is paid.   In such a situation, we must be convinced

that the purported compensation was paid for services rendered by

the employees as opposed to a distribution of earnings to them

that the payor could not deduct.      RTS Inv. Corp v. Commissioner,

877 F.2d 647, 650 (8th Cir. 1989), affg. per curiam T.C. Memo.

1987-98; Paul E. Kummer Realty Co. v. Commissioner, 511 F.2d 313,

315-316 (8th Cir. 1975), affg. T.C. Memo. 1974-44; Charles

Schneider & Co. v. Commissioner, 500 F.2d 148, 152-153 (8th Cir.

1974), affg. T.C. Memo 1973-130; Seven Canal Place Corp. v.

Commissioner, 332 F.2d 899 (2d Cir. 1964), remanding T.C. Memo.

1962-307.

     Employee's Qualifications

     An employee's superior qualifications for his or her

position with the business may justify high compensation.     See,

e.g., Home Interiors & Gifts, Inc. v. Commissioner, supra at

1158; Dave Fischbein Manufacturing Co. v. Commissioner, 59 T.C.

338, 352-353 (1972).

     Mr. Haviv is highly qualified to run petitioner's business

as a result of his education, training, experience, and mental
                                 - 14 -

attributes.    When petitioner is successful, he is the primary

reason for its success.    While this factor favors petitioner, we

note that there are limits to reasonable compensation "even for

the most valuable employees."     Owensby   & Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1325 (5th Cir. 1987), affg. T.C.

Memo. 1985-267.

       Nature, Extent, and Scope of the Employee's Work

       An employee's position, hours worked, duties performed, and

general importance to the success of a business may justify high

compensation.     Home Interiors & Gifts, Inc. v. Commissioner,

supra at 1158.

       Mr. Haviv essentially runs the entire business.    Among other

roles, Mr. Haviv is petitioner's president, sole purchaser, and

supervisor of most sales.    When Mr. Haviv is able to utilize all

of his skills to purchase jewels at low prices, petitioner can

generate profits.    This factor favors petitioner.

       Size and Complexities of the Business

       Courts have considered the size and complexity of a

taxpayer's business in deciding whether compensation is

reasonable.     Pepsi-Cola Bottling Co. v. Commissioner, supra at

179.    In evaluating the size of petitioner we examine its sales

and net income.    See E. Wagner & Son v. Commissioner, 93 F.2d

816, 819 (9th Cir. 1937).    In considering the complexities of

petitioner's business we note that petitioner does not own its

own building, has only 13 employees, has retained earnings of
                                 - 15 -

$115,726, and has fixed assets under $75,000.     However, we also

note the specialized skills required for making money in the

jewelry industry and recognize that petitioner increased its

sales while opening new offices in Oklahoma City, Oklahoma, in

1991 and Augusta, Georgia, in 1992.

        Comparison of Salaries Paid to Gross and Net Income

        Courts have compared sales, net income, and capital value to

amounts of compensation in deciding whether compensation is

reasonable.     Owensby & Kritikos, Inc. v. Commissioner, supra at

1325-1326; Home Interiors & Gifts, Inc. v. Commissioner, supra

1155-1156.

        For 1991 and 1992, Mr. Haviv's compensation was 9.3 percent

and 8.6 percent of gross revenue, respectively.     However, Mr.

Haviv's compensation was 88 percent and 128 percent of net income

before deductions for his compensation.     While considering

compensation as a percentage of both gross revenue and net income

is often helpful, the latter may be more probative because "it

more accurately gauges whether a corporation is disguising the

distribution of dividends as compensation."     Owensby & Kritikos,

Inc. v. Commissioner, supra at 1325-1326.7




    7
          While compensation as a percentage of net income is
often of minimal significance if viewed alone, it can be an
appropriate factor pointing toward a conclusion that compensation
paid is unreasonable. Owensby & Kritikos, Inc. v. Commissioner,
819 F.2d 1315, 1326 n.34 (5th Cir. 1987), affg. T.C. Memo. 1985-
267.
                                - 16 -

       In 1991, Mr. Haviv's $601,077 compensation caused

petitioner's net income to plummet to one-eighth of its pre-

compensation amount.    In 1992, petitioner had net income of

$470,991 before compensating Mr. Haviv.    Payment of his $603,269

compensation (including his $535,000 yearend bonus) caused

petitioner to suffer a net operating loss of $132,278.     We give

special attention to the fact that the loss in 1992, which was

caused by Mr. Haviv's bonus, was carried back to offset income

from 1989, 1990, and 1991.    While this factor alone does not

control the result in this case, it weighs heavily against

petitioner's claim that Mr. Haviv's compensation was reasonable.

       Prevailing Economic Conditions

       Courts will examine whether the success of a business is

attributable to prevailing economic conditions, as opposed to the

efforts and business acumen of the employees.    Prevailing

economic conditions may affect a business' performance and

indicate the extent, if any, of the employees' effect on the

company.    Mayson Manufacturing Co. v. Commissioner, supra at 119-

120.    Adverse economic conditions, for example, tend to show that

an employee's skill was important to a company that grew during

hard times.

       Petitioner asserts that both a general recession and an

industry-specific recession induced by the luxury tax forced Mr.

Haviv to work harder to increase gross sales by approximately
                                - 17 -

$2,200,000 and $500,000 in 1991 and 1992, respectively.      We agree.

     Comparison of Salaries Paid With Dividends to
     Shareholders

     The failure to pay more than minimal dividends may suggest

that reported compensation actually is (in whole or in part) a

dividend.    Owensby & Kritikos, Inc. v. Commissioner, supra at

1323-1324; Charles Schneider & Co. v. Commissioner, 500 F.2d at

151-152.    Corporations, however, are not required to pay

dividends.    Indeed, shareholders may be equally content with the

appreciation of their stock caused, for example, by the retention

of earnings.    Owensby & Kritikos, Inc. v. Commissioner, supra;

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1162.

Nevertheless, a corporation's failure to pay dividends may be a

factor in determining the reasonableness of officer compensation.

     Since its incorporation in 1983, petitioner has never paid a

dividend to shareholders.    The board of directors, which has the

authority to pay dividends and award bonuses, has always

consisted solely of Mr. and Mrs. Haviv, who are also the only

employees ever to receive yearend bonuses.

     Prevailing Rates of Compensation for Comparable
     Positions in Comparable Companies

     Respondent's regulations provide that:

     It is, in general, just to assume that reasonable and
     true compensation is only such amount as would
     ordinarily be paid for like services by like
     enterprises under like circumstances.   ***[Sec. 1.162-
     7(b)(3), Income Tax Regs.]

Both parties testified to the difficulty of finding a business

comparable to petitioner.    In determining that $207,852 and
                                 - 18 -

$224,313 constituted reasonable compensation for 1991 and 1992,

respectively, respondent relied solely upon statistics from the

RMA survey.8    Respondent accepts the 10 jewelers used in the

survey as petitioner's competitors.       However, in an introduction

to its studies, RMA cautions that its data should be used "only

as general guidelines and not as absolute industry norms."       The

RMA guidelines explain that companies used are not selected "by

any random or statistically reliable method" and that a

relatively small industry sample (such as the 10 companies used

for wholesale jewelers) may increase the chances that such data

do not fully represent an industry.

        We have other reservations about the manner in which

respondent applied the survey statistics.9      Respondent used the

3.2-percent figure (derived from the 1991 survey) for 1992 also,

despite the fact that the 1992 RMA survey did not release such

figures for 1992, while the 1993 survey provided a much higher

corresponding percentage of 6.0.      In addition, the RMA wholesale

jewelry survey does not account for all aspects of petitioner's


    8
          According to the RMA survey, respondent's
determinations would place petitioner just below the upper
quartile of wholesale jewelry companies as distinguished by
levels of officer compensation. While data from RMA surveys have
been accepted by this Court in some instances, on other occasions
its reliability in determining reasonable compensation has been
questioned. See PMT, Inc. v. Commissioner, T.C. Memo. 1996-303;
Lumber City Corp. v. Commissioner, T.C. Memo. 1996-171; Hendricks
Furniture, Inc. v. Commissioner, T.C. Memo. 1988-133.
    9
          Respondent's capping reasonable compensation at 3.2
percent of petitioner's net sales ignores RMA figures from 1992
and 1993.
                               - 19 -

business such as jewelry sold at retail, yet that is the only RMA

survey respondent elected to use.       Despite the inherent flaws in

the RMA survey, respondent relied solely upon the RMA statistics

without presenting any witnesses, expert or otherwise, to bolster

respondent's figures.   Respondent has offered no evidence to show

that the 10 companies used in the survey to determine a

"reasonable" compensation for Mr. Haviv are even comparable to

petitioner.   Thus, we find respondent's figures to be arbitrary.

     We also find petitioner's figures lack credibility.

Admitting that a true competitor does not exist, petitioner

compares itself to Mr. W's company (which we will refer to as

simply B Co. despite the fact that it was actually two companies,

B Co. and C Co., before 1991) by virtue of the fact that they are

both involved in selling wholesale and retail jewelry and

precious stones, appraisal and insurance of precious stones, as

well as custom design and jewelry repairs.      However, the

percentage of business allocated to each aspect of its operations

varied greatly between companies.       For example, wholesale trade

accounted for over 50 percent of petitioner's business, but for

only 10 percent of B Co.'s total profits.

      However there are many similarities that weigh in

petitioner's favor.   B Co.'s net sales figure for 1991 was

$5,523,835 compared to petitioner's $6,495,378, and for 1992 was

$6,792,055 compared to petitioner's $7,009,772.      B Co.'s net

income was $22,211 for 1991 and negative $220,395 for 1992.        Mr.
                                - 20 -

W was compensated $751,000 for 1991 compared to Mr. Haviv's

$601,077 and $1,016,000 for 1992 compared to Mr. Haviv's

$603,269.   Like Mr. Haviv, Mr. W was also the primary shareholder

of his company.   But, unlike Mr. Haviv, he operated the company

as an S corporation.   B Co.'s sales were slightly lower for 1991

and 1992, but its gross profit percentage was approximately

double that of petitioner.

     While Mr. W's compensation statistics indicate that

respondent's compensation allocations may be less than the value

of Mr. Haviv's services, we decline to accept the compensation of

one employee from one company in the industry as a benchmark for

reasonableness.

     Petitioner presented two certified public accountants as

witnesses who each testified that Mr. Haviv's compensation was

reasonable for the services rendered.     Mr. Randy Galanti

concluded that Mr. Haviv's "compensation was in the range of

reasonable based upon the compensation that could have been

reasonably paid for just the first four functions [performed by

Mr. Haviv]:"

                                 1991             1992
Purchasing function            $106,598        $151,270
Sales function                  451,027         393,791
Chief executive officer         413,553         446,367
Chief financial officer         406,454         433,337

Reasonable Compensation
for above functions          $1,377,632      $1,424,765
                               - 21 -

Mr. Galanti's reasoning is flawed.10      The "reasonable" salary

used for each title is based upon a full-time position.      It is

most unlikely that Mr. Haviv could have worked 160 hours per

week.

     In addition, in considering whether a reasonable investor

would have approved of compensation to Mr. Haviv of over $600,000

per year, Mr. Galanti focused on Mr. and Mrs. Haviv's return on

their $500 investment since 1983.       That calculation resulted in

an annualized growth rate of 72 percent.      We recognize the

caution with which such a ratio must be examined.11      Return on

equity is a much more accurate indicator of company performance.

(See our discussion, infra.)   As opposed to the 72 percent

figure, petitioner's return on equity year by year from 1988 to

1992 was 35 percent, 21 percent, 16 percent, 36 percent, and -51

percent respectively.   Since a board makes its bonus decisions

from year to year, return on equity may also be examined from

year to year.   Thus, a strong return in 1 year does not guarantee

board approval of bonuses in the next year, especially if there

are financial reverses the second year.




    10
          Mr. Galanti believes that it would have been reasonable
to pay Mr. Haviv $1,377,632 in 1991 for a company that earned
$84,911 and $1,424,765 in 1992 for a company that lost $132,278.
    11
          For example, if Mr. and Mrs. Haviv had invested $1,000
in 1983 their annualized return on investment would have been 36
percent whereas a smaller $250 investment would have given them
an annualized return of 144 percent.
                                - 22 -

     Petitioner's other witness, Mr. Stephen Gross, similarly

examined the "reasonableness" of petitioner's figures by adding

up the salaries of full-time positions for each of the different

roles Mr. Haviv performed.   Finding no actual competitors of

petitioner, Mr. Gross also placed improper reliance upon the RMA

survey used by respondent.

     Employer's Salary Policy as to All Employees

     Courts have considered salaries paid to other employees of a

business in deciding whether compensation is reasonable.      Home

Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1159.     We

look to this factor to determine if Mr. Haviv was compensated

differently than petitioner's other employees solely because of

his status as a shareholder.

     Mr. Haviv earned $601,077 in 1991 and $603,269 in 1992

compared to petitioner's second highest paid employee who made

$71,409 and $76,572, respectively.       In 1991, the total

compensation for petitioner's nonstockholder employees totaled

$244,933.    Mr. Haviv's total compensation was 2.4 times the total

compensation for all of petitioner's nonshareholder employees

combined.    In 1992, Mr. Haviv's total compensation was 2.1 times

the total compensation of all of petitioner's nonshareholder

employees.

     A reasonable, longstanding, and consistently applied

compensation plan negotiated at arm's length, often provides

evidence that compensation paid pursuant to that plan is
                                 - 23 -

reasonable.     Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d

at 1327-1328.    In 1991 and 1992, Mr. Haviv determined the

compensation amounts for all of petitioner's employees.      There

were no written policies for making such determinations.

Salaries for Mr. and Mrs. Haviv were approved by the board of

directors at the annual meeting preceding each year.      Yearend

bonuses were also approved at the annual meeting.       Mr. and Mrs.

Haviv were the only employees ever to receive yearend bonuses.

Mr. Haviv received yearend bonuses of $95,000, $105,000,

$562,000, and $535,000 for 1989, 1990, 1991, and 1992,

respectively.    Such substantial bonuses, declared at yearend when

corporate earnings are determinable, may indicate the existence

of disguised dividends.     Id. at 1329.   Disguised dividends are

even more probable when, as is the case with petitioner, the

"corporation has a history of distributing as compensation to its

shareholder-employees the bulk of its profits." Id.; Estate of

Wallace v. Commissioner, 95 T.C. at 557.12

     Petitioner asserted that it paid Mr. Haviv less compensation

for his sales than it would have under petitioner's fixed

commission rate of 50 percent of profits.     Petitioner asserted

that under its commission policy, Mr. Haviv would have been

entitled to a commission of $272,000 on the sale of the red

diamond in 1991.    We consider the commission that a


    12
          As noted, in 1991 and 1992, petitioner paid 88 percent
and 128 percent of net income to Mr. Haviv in the form of
compensation.
                               - 24 -

nonshareholder-employee would have earned on this sale to be an

appropriate factor in measuring Mr. Haviv's compensation for

1991.   However, petitioner did not establish the total amount of

sales for which Mr. Haviv was directly responsible.      Since Mr.

Haviv was an employee of petitioner, it was improper to credit

him with all of the "house sales" as if they were his own.      Thus,

we disagree with petitioner's assertion that an arm's-length

value for Mr. Haviv's selling position was 50 percent of profits

from all sales to "house customers".       As petitioner admits, the

sale of the red diamond was an extraordinary transaction, as

there were only five in the world.      Mr. Haviv took a specific

order for a red diamond and then was able to purchase one at the

Antwerp exchange.   This diamond was then sold by one of

petitioner's salespersons and petitioner made $546,000 profit.

Unlike traditional "house sales", where customers purchase from

petitioner's salespersons after hearing of petitioner's

reputation, Mr. Haviv played an unusually active role in the sale

of the red diamond.   In sales where Mr. Haviv lacked such

involvement, we find it was improper for petitioner to have

credited him with a "house sale".       Therefore, since 1992 did not

contain such an extraordinary sale as the red diamond, Mr.

Haviv's total compensation for 1992 might have been significantly

less than what it was for 1991 if based upon commissions.
                               - 25 -

     Petitioner asserted that an arm's-length rate for purchasing

commissions was 3 percent.   That is, were it not for Mr. Haviv's

services, it would have had to pay an outsider 3 percent of all

stones purchased.   During the deposition, Mr. W, petitioner's

"nearest competitor", made no mention of paying a 3-percent

commission on his purchases.   Regardless of what the "outside

rate" might have been, Mr. Haviv was an employee of petitioner,

and petitioner made the business decision to employ a chief

executive officer who could also perform the purchasing function.

We are not persuaded that Mr. Haviv's reasonable compensation may

properly be determined based upon what it would cost to employ a

full-time chief executive officer, a full-time chief operating

officer, a full-time purchaser, and a full-time salesman.

     Moreover, because Mr. and Mrs. Haviv were the sole

shareholders, Mr. Haviv's compensation was not bargained for at

arm's length.   We therefore must inquire whether an independent

investor would have approved of the compensation levels paid to

Mr. Haviv during the subject years.     See Owensby & Kritikos, Inc.

v. Commissioner, supra at 1326-1327.

     As the taxpayer's experts testified, a corporation may

choose to retain its earnings to fuel future growth.    An investor

may obtain a return on his investment through either dividends or

appreciation in the value of his stock. Id. at 1326.     Thus, the

Court looks not only at a corporation's dividend practices, but
                                       - 26 -

also at the total return the corporation is earning for its

investors.     Id.     A prime indicator of the return a corporation is

earning for its investors is its return on equity.13                  See also

id. at 1327.    Petitioner's return on equity for the years 1988 to

1992 was as follows:

                             Return on Equity        1988-1992
Taxable Year
Ended                12/31/88     12/31/89      12/31/90   12/31/91    12/31/92

Shareholder
 Equity
 Beg. of Yr.    $113,753         $136,289       $165,333   $172,363    $235,066

net income            40,317        29,045        26,521     62,703    -119,340

Return on
 Equity                35%           21%           16%        36%        -51%

An independent investor would not be satisfied with the awarding

of a yearend bonus worth over seven times an employee's salary, a

return on equity of negative 51 percent.

     Another benchmark for reasonableness is the value of an

employee to his company.          We find it hard to believe that Mr.

Haviv could be worth, in 1 year, more than petitioner has

cumulatively earned under Mr. Haviv's 8 years of stewardship.

     Based upon all of the facts, it is reasonable to conclude

that Mr. Haviv's compensation was neither bargained for nor

reached at arm's length.          Together with other facts and

circumstances, this is a strong indication that the bonuses paid

to Mr. Haviv were a disguised dividend.               See id. at 1326 n.34.


    13
          Return on equity is calculated after deducting all
amounts paid as compensation.
                               - 27 -

     The Amount of Compensation Paid to Mr. Haviv in the
     Previous Years.

     Petitioner contends that part of Mr. Haviv's payment for

1991 and 1992 was for services rendered in prior years.       Under

some circumstances prior services may be compensated for in a

later year.   Lucas v. Ox Fibre Brush Co, 281 U.S. 115 (1930);

Estate of Wallace v. Commissioner, 95 T.C. at 553.      However, it

is incumbent on a taxpayer claiming that part of the payment to

an officer in the current year is for services rendered for prior

periods to show that the officer was not sufficiently compensated

in the prior year and that in fact the current year's

compensation was to compensate for that underpayment.        Pacific

Grains, Inc. v. Commissioner, 399 F.2d at 606; Home Interiors &

Gifts, Inc. v. Commissioner, 73 T.C. at 1156.

     There is evidence in the record to show that Mr. Haviv may

not have been paid in full for the services he rendered to

petitioner in the years 1983 to 1987.      Before creating

petitioner, Mr. Haviv had worked for several years for other

employers in the jewelry industry.      Mr. Haviv was the sole

purchaser, supervised most sales, and traveled overseas for

petitioner.   The record shows that petitioner paid Mr. Haviv

$10,000, $25,000, $25,000, and $47,000, in 1984, 1985, 1986, and

1987, respectively.   However, we do not find any evidence, with

the exception of Mr. Haviv's unsupported testimony, that Mr.

Haviv's compensation in 1991 and 1992 was to compensate for his

underpayment of prior years.   The minutes from the shareholder
                               - 28 -

meetings of December 26, 1991, and December 30, 1992, make no

reference to Mr. Haviv's efforts outside of the respective year

at issue.   The minutes from the 1991 meeting authorize a $562,000

bonus to Mr. Haviv "for performance rendered during 1991 and for

the superior efforts associated with the `red' diamond and for

the day to day management of the Company."     The minutes for the

1992 meeting also demonstrate that the board of directors did not

intend to compensate Mr. Haviv for prior years' underpayment:

     The President presented tentative operating statistics
     for the year which reflected 10% increase in sales (20%
     if the prior year extraordinary sales were eliminated),
     a strengthening of the gross profit percentage and a
     moderate increase in operating costs. This all
     occurred in a recessionary economy. The Board stated
     the President was performing beyond their expectations
     and congratulated him for his extraordinary efforts.
     Resolved, that for performance rendered during 1992 for
     the above stated reasons, the Board authorizes the
     following bonuses: Haim Haviv $535,000, Amy Haviv $500.

We find that petitioner did not intend Mr. Haviv's compensation

for 1991 and 1992 to include compensation for prior years.



     Upon scrutinizing all of the facts and circumstances

presented here before us, we find petitioner's compensation

deduction unreasonable.   We also find that respondent's absolute

reliance on the RMA survey was erroneous.    On the basis of the

entire record, we hold that $429,000 for 1991 and $305,000 for

1992 constituted reasonable compensation to Mr. Haviv for

services rendered.

                                                 Decision will be

                                             entered under Rule 155.
