                        T.C. Memo. 1996-136



                      UNITED STATES TAX COURT



    WY'EAST COLOR, INC., AN OREGON CORPORATION, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4195-93.                  Filed March 19, 1996.


     Christopher H. Kent, Kevin O'Connell, and Steve Hval

(specially recognized), for petitioner.

     Brenda M. Fitzgerald, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     COLVIN, Judge:   Respondent determined deficiencies in

petitioner's Federal income tax of $223,038, $252,490, and

$240,727 for fiscal years 1989, 1990, and 1991, respectively.

After concessions, we must decide the following issues:
                                 - 2 -


      1.   Whether petitioner may deduct as management fees

$284,300, $699,359, and $738,239 for fiscal years 1989, 1990,

and 1991, respectively, as petitioner contends; $57,159,

$149,175, and $155,559, as respondent contends; or some other

amount.    We hold that petitioner may deduct 75 percent of the

management fees it paid for those years, i.e., $213,000,

$525,000, and $554,000.

      2.   Whether (or to what extent) petitioner may deduct rent

it paid to its sole shareholder for the sublease of property in

excess of the rent its sole shareholder paid for the prime lease

of the property.    Petitioner contends it may deduct rent of

$216,000, $250,000, and $264,000 for fiscal years 1989, 1990, and

1991, respectively.    Respondent contends petitioner may deduct

rent of $97,975 for each of those years.    We hold that petitioner

may deduct rent of $120,087, $124,896, and $129,891 for fiscal

years 1989, 1990, and 1991, respectively.

      Section references are to the Internal Revenue Code in

effect for the years in issue.    Rule references are to the Tax

Court Rules of Practice and Procedure.    Unless otherwise stated,

references to years are to calendar years and references to

fiscal years are to petitioner's fiscal year, which ends on March

31.
                                - 3 -


                           FINDINGS OF FACT

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

A.   Petitioner

     1.     Petitioner’s Activities and Growth

     Petitioner is an Oregon corporation the principal place of

business of which is in Portland, Oregon.     Dwight A. Cummings

(Mr. Cummings) owned all of petitioner's stock during the years

in issue.    He and his family (the Cummings) founded petitioner

and built it into a successful business.

     Petitioner is a graphic arts prepress company.     It uses

original art, photographs, and page layouts to prepare film to

make plates for printing.    It also processes photographs for

commercial photographers and makes large display prints.

     Petitioner's workforce grew from 60-70 employees to 100-110

employees during the years in issue.    Petitioner had gross sales

of about $12 million and had about 40 percent of the Portland

market in the late 1980's.    For each year in issue, petitioner

had retained earnings of $1 to $2 million.

     Mr. and Mrs. Cummings organized petitioner into various

departments.    There were three production departments:

stripping, color, and planning.    Department managers reported to

Mr. and Mrs. Cummings.    Mrs. Cummings held weekly management

meetings.    Petitioner's managers did not have written employment

contracts.
                                  - 4 -


       2.   Petitioner’s Management Employees

            a.   Grady Preston

       Grady Preston (Preston) managed petitioner's color

department during the years in issue.       Preston is well informed

about the technical aspects of petitioner’s industry.       He keeps

current with new technology.      Preston was responsible for

electronics in his division, which was a large part of

petitioner's operation.    He tried to keep petitioner efficient

and competitive.    Petitioner paid Preston $55,874 in 1989,

$59,832 in 1990, and $60,816 in 1991.

            b.   Steve Philps

       Steve Philps (Philps) managed petitioner's color lab

division during the years in issue.       He worked 8 to 12 hours per

day.    Philps supervised film printing and processing, slide

production, display material production, and some advertising,

sales and customer relations.      He also interviewed, hired, fired,

trained, and supervised employees.        Petitioner paid Philps $8,395

in 1989, $50,917 in 1990, and $49,823 in 1991.

            c.   Rick Capatosto

       Rick Capatosto managed petitioner's planning department

during part of the years in issue.        He also handled the Payless

account.    Petitioner paid him $24,558.14 in 1989, $50,103.78 in

1990, and $51,997.67 in 1991.
                                   - 5 -


          d.      Larry Deal

     Larry Deal (Deal) managed petitioner's planning department

at some time during the years in issue.       Petitioner paid Deal

$48,563.19 in 1989, $52,317.61 in 1990, and $54,536.14 in 1991.

          e.      Jim Faust

     Jim Faust (Faust) managed petitioner's planning department

at some time during the years in issue.       Petitioner paid Faust

$55,979.29 in 1989, $57,812.14 in 1990, and $60,059.19 in 1991.

     3.   Management Fees, Sales, Assets, and Taxable Income

     Petitioner did not deduct any officer compensation for the

years in issue.    Petitioner deducted management fees of $284,300,

$699,359, and $738,239 for fiscal years 1989, 1990, and 1991,

respectively.   Petitioner deducted salaries and wages of

$905,321, $1,092,762, and $1,293,692 for fiscal years 1989, 1990,

and 1991, respectively.       Petitioner included in costs of goods

sold, labor costs of $2,559,735, $3,048,681, and $3,836,954 for

fiscal years 1989, 1990, and 1991, respectively.       Management fees

as a percent of petitioner's salaries, wages, and labor, were

8.21 percent, 16.89 percent, and 14.39 percent in fiscal years

1989, 1990, and 1991, respectively.

     Petitioner had sales, assets, and taxable income before

deducting net operating losses and management fees and before

adding to income deductions petitioner concedes are not allowable

(taxable income before certain adjustments) as follows:
                                 - 6 -


                                                 Taxable Income
     Fiscal                                      Before Certain
      Year        Gross Sales      Assets          Adjustments
      1989         $8,644,356    $4,119,578          $774,054
      1990         10,283,552     5,106,452         1,154,903
      1991         12,904,812     5,443,713         1,663,073

B.   The Cummings Family

     Mr. Cummings is married to Karen R. Cummings (Mrs.

Cummings).     Their children are Grant, Bruce, Dwight D. (Deen),

Karen Ann, and Cynthia, who is married to Jim Medding (Medding).

     1.     Mr. Cummings

     Mr. Cummings lived in Redmond, Washington, during the years

in issue.     Mr. Cummings knew the technology that affected

petitioner's business.     He was president and a director of

petitioner; Dacor, Inc. (Dacor), petitioner's management company

(see par. C-1, below); and Lasercolor, Inc. (Lasercolor), another

photographic processing business (see par. D, below).     He had

offices at petitioner's Portland facility and at Lasercolor's

Bellevue, Washington, facility, near Seattle.     Mr. Cummings did

not keep records of how much time he worked for petitioner or

Lasercolor.     He was a shareholder and officer of Kadac, Inc.

(Kadac), petitioner's management company that succeeded Dacor

(see par. C-2, below).     He reported on Kadac's income tax return

that he devoted all of his time to Kadac.     He attended some of

petitioner's weekly management meetings.      He helped decide which

equipment petitioner would buy for the color lab.     Mr. Cummings

served on the boards of the International Prepress Association
                                   - 7 -


and DuPont Crossfield Users Group and as president and vice

president of the Western States Prepress Conference.

     2.     Mrs. Cummings

     Mrs. Cummings lived in Redmond, Washington, during the years

in issue.    She resigned as associate administrator for Children’s

Hospital in Seattle in 1986 to help manage petitioner.         She was

earning about $70,000 per year at Children's Hospital.

     Mrs. Cummings performed services for petitioner in 1988 as

an employee of Dacor.       She was petitioner's general manager from

1989 to 1991.    Mrs. Cummings interviewed all job applicants who

passed petitioner's color laboratory manager's inspection.

     Mrs. Cummings had offices at petitioner's Portland facility

and at Lasercolor's facility in Bellevue, Washington.         When in

Portland, she lived at a house that petitioner owned.         The

previous occupants used the house as an office.         Petitioner paid

to remodel the house into a residence.

     3.     Deen Cummings

     Deen Cummings worked for petitioner in 1988 and in 1989

until Kadac was formed.      He then worked for Kadac.     He began to

live in Oregon in 1979.      He performed services through Kadac for

petitioner and Lasercolor during the years in issue.         He worked

60 to 70 hours a week for Kadac in 1990 and 1991.        He was on call

24 hours per day, 7 days per week.         He managed petitioner's plant

facilities and dispatch functions.         He handled sales to one of
                                    - 8 -


petitioner's major retail accounts.          In 1990 or 1991, he provided

many more hours than usual of services to Lasercolor for 14 to 16

weeks.

     4.    Grant Cummings

     Grant Cummings was president of Kadac.          He performed

services for Lasercolor and petitioner during the years in issue

at Bellevue, Washington.

     Grant Cummings worked full time for Kadac from May 1 to

December 31, 1989, and in 1990 and 1991.          He worked 60 to 80

hours per week for Kadac during the years in issue.          He spent

about 80 percent of his time working for Lasercolor and about

20 percent working for petitioner during the years in issue.

Lasercolor and Kadac paid him as follows:

           Corporation       Year             Amount
           Lasercolor        1988           $41,365.34
           Lasercolor        1989            45,795.39
           Kadac             1989            10,000.00
           Kadac             1990            55,000.04
           Kadac             1991            68,900.04

     He attended some of petitioner's management meetings during

the years in issue.      He reported earning no income from services

performed in Oregon in 1988, 1989, 1990, and 1991.

     5.    Bruce Cummings

     Bruce Cummings performed technical services for petitioner

pertaining to telephones, computers, and lithography.          By 1991,

he was project manager for a group of people who worked for

Preston.   Bruce Cummings was a system operator for petitioner at
                                 - 9 -


a time not specified in the record.      He worked full time for

Kadac in 1990 and 1991.

     6.     Karen Ann Cummings

     During the years in issue, Karen Ann Cummings worked as a

planner for petitioner's lithography department.      She provided

daily planning services (not otherwise described in the record)

to petitioner.     She attended some management meetings from 1988

to 1991.

     7.     Jim Medding

     Medding married Cynthia Cummings, daughter of Mr. and Mrs.

Cummings.     In 1989, 1990, and 1991, Medding performed research

and development for petitioner and was current with new

technology.     Kadac paid him $6,875 in 1990 and $59,387 in 1991.

C.   Dacor, Inc. and Kadac, Inc.

     Dacor and Kadac provided management services to petitioner

and Lasercolor.     Dacor and Kadac did not compare the salaries

they paid to their employees to other salaries in the Portland

area.     Dacor did not have a written contract to perform services

during the years in issue.

     1.     Dacor, Inc.

     Mr. Cummings owned all of the stock of Dacor.      Dacor did not

pay dividends during the years in issue.      Dacor provided services

only to petitioner and Lasercolor.       Dacor's fiscal year ended on

March 31.
                                - 10 -


     2.    Kadac, Inc.

     Mr. Cummings formed Kadac to replace Dacor.      He incorporated

Kadac in Nevada on April 28, 1989.       Mr. Cummings, Mrs. Cummings,

and their sons, Deen, Grant, and Bruce, each owned 200 shares of

Kadac stock.    Kadac and Lasercolor share facilities in Bellevue,

Washington.    Kadac did not pay dividends during the years in

issue.    Kadac provided management services to petitioner and

Lasercolor.    Neither Dacor nor Kadac kept time sheets or other

records of the services they or any member of the Cummings family

performed for petitioner.     Kadac's taxable year ended on December

31 during the years in issue.

     Kadac’s only employee from 1989 to 1991 who was not related

to the Cummings was Wendy Jo Goddard.

     3.    Management Fees

     Dacor received management fees of $276,266 in its fiscal

year 1989 (ending March 31, 1989) and Kadac received $317,906,

$806,658, and $881,820 in calendar years 1989, 1990, and 1991,

respectively (a total of $2,282,650 from April 1, 1988 to

December 31, 1991).1     Dacor paid officer compensation, salary,


     1
       Petitioner deducted management fees totaling $1,721,890
for fiscal years (1989, 1990, and 1991); i.e., from Apr. 1, 1988,
to Mar. 31, 1991. The record does not indicate whether
petitioner paid the $881,820 ratably throughout 1991. If
petitioner paid the $881,820 ratably throughout 1991, then Kadac
would have received one-fourth of that amount ($220,455) by
Mar. 31, 1991, and Dacor and Kadac would have received $1,621,285
from Apr. 1, 1988 to Mar. 31, 1991.
                                     - 11 -


and wages of $152,296 in its fiscal year 1989 (ending March 31,

1989).       Kadac paid $194,430, $593,450, and $413,511, in 1989,

1990, and 1991, respectively (a total of $1,347,994 from April 1,

1988, to December 31, 1991), as shown below:2

        Calendar                       Officer           Salaries
Payor     Year       Employee        Compensation        and Wages      Totals

Dacor       1988    Mr. Cummings                         $104,615
                    Mrs. Cummings                          39,635
                          1988 Total [Dacor]                           $144,250
                                                          1
            1989    Mr. Cummings                           17,308
                    Mrs. Cummings                           9,346
                          1989 Total [Dacor]                             26,654

Kadac       1989    Mr. Cummings                          144,615
                    Mrs. Cummings                          34,615
                    Grant Cummings         $10,000
                    Karen Ann Cummings                        5,200
                          1989 Total [Kadac]                            194,430
                          1989 Total [Dacor and Kadac]                  221,084

            1990    Mr. Cummings                          360,000
                    Mrs. Cummings                          45,000
                    Grant Cummings         55,000
                    Deen Cummings          54,000
                    Bruce Cummings         40,500
                    Karen Ann Cummings                        26,382
                    Jim Medding                                6,875
                    Wendy Jo Goddard                           5,693
                          1990 Total                                    593,450

            1991    Mr. Cummings           110,000
                    Mrs. Cummings            45,525
                                           2
                    Grant Cummings           70,000
                                           3
                    Deen Cummings            57,793
                    Bruce Cummings           43,500
                    Karen Ann Cummings                        27,599
                    Jim Medding                               59,387
                          1991 Total                                     413,804
                               Total for 1988 - 1991                   1,372,584




        2
       The record does not indicate whether Kadac paid the
$413,511 ratably throughout 1991. If Kadac paid the $413,511
ratably throughout 1991, then Kadac would have paid one-fourth of
that amount ($103,377.75) by Mar. 31, 1991, and Dacor and Kadac
would have paid $1,037,860.80 from Apr. 1, 1988 to Mar. 31, 1991.
                                   - 12 -

     1
       The parties agree that Dacor paid these amounts to Mr. Cummings in
1989 and that Dacor paid $72,115 to Dwight Cummings in its fiscal year 1989
(Apr. 1, 1988 to Mar. 31, 1989).
     2
       The parties stipulated that Kadac paid $70,000 to Grant Cummings in
1991 and that a Form W-2 for 1991 showed that Kadac paid him $68,900.04 in
1991. We find that Kadac paid him $70,000 in 1991. The $1,099.96 difference
does not alter our analysis.
     3
       Respondent determined that Kadac paid $57,793 to Deen Cummings.
Petitioner contends that Kadac paid $57,500. We accept respondent's
determination. The $293 difference does not alter our analysis.

D.   Lasercolor, Inc.

     Lasercolor was a Washington corporation that did business in

Washington as Wy'East Color.       Mr. Cummings acquired Lasercolor in

1988.    He owned all of Lasercolor's stock during its fiscal years

ending March 31, 1990 and 1991.        Dacor filed a consolidated tax

return with Lasercolor for its fiscal year ending March 31, 1989,

on which Dacor reported that it owned Lasercolor.            Lasercolor did

not pay dividends during its 1989 fiscal year.

     Lasercolor paid the following amounts for officer

compensation, salaries and wages, and management services:

                                                         Management
                                                          Services
         Fiscal          Officer         Salaries          Paid to
          Year         Compensation      and Wages          Kadac
         1989            $72,115         $206,002          unknown
         1990              none           113,534          $10,385
         1991              none           102,769            none

E.   Other Related Corporations

     During the years in issue, Mr. Cummings owned 30 percent of

Dynagraphics, a printing company in Portland, Oregon, that was

one of petitioner's clients.
                              - 13 -


     On its 1989 return, petitioner reported that it was a member

of a controlled group of corporations which included Dacor,

Lasercolor, and Visionworks, Inc.

     On its 1991 return, petitioner reported that it was a member

of a controlled group of corporations which included Lasercolor

and Nevada Graphics, Inc.   Mr. Cummings was president of those

corporations.   Kadac paid Mr. or Mrs. Cummings about half of

their wage and salary income for 1991.

F.   Oregon Income of the Cummings

     Mr. and Mrs. Cummings reported on their Federal and Oregon

income tax returns that they earned the following amounts from

Dacor and Kadac:

                      Reported            Reported as
                     on Federal            Earned in
         Year        Tax Returns            Oregon
         1988        $144,250.05            $30,643
         1989         188,593.84             43,961
         1990         405,000.00             20,250
         1991         155,525.00             19,069

The amounts reported as earned in Oregon in 1988 and 1991 were

Mr. and Mrs. Cummings' earnings.     The amounts reported as earned

in Oregon in 1989 and 1990 were Mrs. Cummings’ earnings.

Mr. Cummings did not file Oregon individual income tax returns

for 1989 or 1990.   Deen filed Oregon tax returns for tax years

1988 to 1991.   Grant Cummings did not file Oregon income tax

returns for tax years 1988 to 1991.    The State of Washington does

not have an income tax.
                                - 14 -


G.   Petitioner's Lease of the 4200 S.W. Corbett Street Property

     Petitioner is located at 4200 S.W. Corbett Street, Portland,

Oregon (4200 S.W. Corbett St. property).      Before moving to 4200

S.W. Corbett Street, petitioner leased buildings at 4343 and 4321

S.W. Corbett Street (old property).      Petitioner leased the old

property from Mr. Cummings, doing business as Blackstone,3 under

an oral, month-to-month lease.    The buildings on the old property

had about 15,000 square feet.    Petitioner paid rent of $10,000

per month to Mr. Cummings.

     In 1986, Mr. Cummings leased the 4200 S.W. Corbett St.

property from the American Red Cross for 12 years with an option

to buy.    The 4200 S.W. Corbett property was a three-story, wood

frame building with about 33,631 square feet, a detached shop and

storage building with 3,969 to 4,050 square feet, and an annex or

residence with about 2,400 square feet.      Mr. Cummings paid rent

of $8,164.61 per month ($97,975 per year) to the American Red

Cross.    He agreed to pay real estate taxes, maintenance, and

insurance expenses on the property.      The lease did not require

Mr. Cummings to perform major repairs.

     The 4200 S.W. Corbett St. property was zoned for high

density multifamily residences.    Before Mr. Cummings leased the

4200 S.W. Corbett St. property from the American Red Cross,


     3
       Mr. Cummings did business in the name of "The Blackstone
Co." (Blackstone) before and during the years in issue.
                             - 15 -


petitioner obtained a revocable permit to use the property as a

photo processing lab as the tenant of the American Red Cross.

Petitioner paid all the expenses required to obtain the revocable

permit.

     Mr. Cummings sublet the 4200 S.W. Corbett St. property to

petitioner before the years in issue.   Petitioner spent about

$1,000,000 to adapt the property for its use.   Petitioner paid

for insurance, maintenance, utilities, and other similar costs.4

     Petitioner paid rent of $216,000 to Mr. Cummings for fiscal

year 1989, $250,000 for 1990, and $264,000 for 1991.

     Mr. and Mrs. Cummings deducted rent of $97,975 in 1988 and

1991, and taxes of $64,378 for 1988 and $90,626 for 1991.   Mrs.

Cummings deducted rent of $97,975 for 1989 and 1990, and taxes of

$61,086 for 1989 and $101,048 for 1990.   In 1994, Mr. Cummings

paid about $100,000 to repair the roof and dry rot damage and to

remove an oil tank.




     4
       Petitioner contends that Blackstone paid real property
taxes for the 4200 S.W. Corbett St. property. Petitioner relies
on Exh. 20, which consists of copies of checks written by The
Blackstone Co. from Feb. 14, 1989 to Nov. 14, 1991, and a memo to
the file from petitioner's counsel dated Oct. 3, 1994, pertaining
to tax accounts associated with particular pieces of property.
Petitioner did not provide Exh. 20 to respondent in the time
required by the Court's standing pretrial order. The parties
stipulated that the information in the exhibit pertaining to tax
accounts for the particular pieces of property is based on
inadmissible hearsay. Thus, we do not consider Exh. 20.
                                - 16 -


                                OPINION

A.   Deductions for Management Fees

     1.   Contentions of the Parties

     A taxpayer may deduct payments for management services under

section 162 if the payments are for services actually rendered

and are reasonable in amount.     American Sav. Bank v.

Commissioner, 56 T.C. 828, 842-843 (1971).       This question is

decided based on a consideration of all of the facts and

circumstances of the case.   Id. at 843.      Petitioner bears the

burden of proving that it may deduct the management fees it paid.

Rule 142(a); Schaffer v. Commissioner, 779 F.2d 849, 857 (2d Cir.

1985), affg. in part and remanding in part Mandina v.

Commissioner, T.C. Memo. 1982-34.

     Petitioner deducted management fees it paid to Dacor and

Kadac totaling $284,300, $699,359, and $738,239 for fiscal years

1989, 1990, and 1991, respectively.       Petitioner contends that it

paid the management fees exclusively for personal services and

that the fees are reasonable, ordinary, and necessary under

section 162.

     Respondent contends that the management fees were excessive.

Respondent contends that part of the payments was for something

other than services, such as disguised dividends, a transfer of

wealth from Mr. Cummings to members of his family without gift

tax consequences, or a means of evading Oregon income tax.
                              - 17 -


Respondent contends that petitioner may deduct only $57,159,

$149,175, and $155,559 for those years.    Respondent determined

these amounts based on the amount Dacor's and Kadac's employees

reported on their Oregon income tax returns, increased by 30

percent for taxes and benefits.

     2.   Whether the Amount of Management Fees That Petitioner
          Paid Was Reasonable

     The parties agree that we should apply the legal standards

which govern whether compensation is reasonable to decide whether

the management fees at issue here were reasonable.    More

specifically, the parties agree that we should apply the factors

in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983),

revg. and remanding T.C. Memo. 1980-282.    The factors are:   The

importance of the employees who perform services to the success

of the business; the character and condition of the company; the

hypothetical investor's viewpoint; the consistency of payments

for similar services within petitioner’s business; and a

comparison of amounts paid by other similar businesses for

similar services.   We also consider petitioner's contention that

comparing the management fees to petitioner's gross receipts

shows that the management fees were reasonable.

     No single factor determines whether the fees at issue were

reasonable.   Pacific Grains, Inc. v. Commissioner, 399 F.2d 603,

606 (9th Cir. 1968), affg. T.C. Memo. 1967-7; Mayson

Manufacturing Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.
                                - 18 -


1949), revg. and remanding a Memorandum Opinion of this Court.

Whether the amount of management fees was reasonable is a

question of fact.   American Sav. Bank v. Commissioner, supra;

see Elliotts, Inc. v. Commissioner, supra.     Petitioner bears

the burden of proving that the amount of management fees was

reasonable.   Rule 142(a).   We evaluate the case by considering

the total amount of management fees petitioner seeks to deduct,

not the smaller amounts that Dacor and Kadac paid to various

members of the Cummings family.

     If the employee controls the employer, we closely scrutinize

the reasonableness of compensation to see if it was paid for

something other than the employee's services.     Owensby &

Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1322-1324 (5th

Cir. 1987), affg. T.C. Memo. 1985-267; Elliotts, Inc. v.

Commissioner, supra at 1243; Charles Schneider & Co. v.

Commissioner, 500 F.2d 148, 152-153 (8th Cir. 1974), affg. T.C.

Memo. 1973-130; see also Dielectric Matls. Co. v. Commissioner,

57 T.C. 587, 591 (1972).     An exploitable relationship may exist

if the employees are the controlling shareholders or if a family

relationship suggests that the compensation plan was not the

result of a free bargain.     Elliotts, Inc. v. Commissioner, supra

at 1246; see Pacific Grains, Inc. v. Commissioner, supra at 607;

Harolds Club v. Commissioner, 340 F.2d 861, 865 (9th Cir. 1965),

affg. T.C. Memo. 1963-198.     Petitioner and the Cummings did not
                                - 19 -


deal at arm's-length and the Cummings controlled Dacor, Kadac,

and petitioner.    Thus, we will closely scrutinize the

reasonableness of the management fees petitioner paid.

     3.     Application of the Factors

            a.    Importance of Dacor and Kadac Employees to
                  Petitioner

     The positions that Dacor and Kadac employees held with

petitioner, their hours and duties, and their importance to the

success of petitioner are relevant to deciding whether management

fees for their services are reasonable.     Elliotts, Inc. v.

Commissioner, supra at 1245; American Foundry v. Commissioner,

536 F.2d 289, 291-292 (9th Cir. 1976), affg. in part and revg. in

part 59 T.C. 231 (1972); Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. 1142, 1158 (1980).

     Mr. and Mrs. Cummings and other members of their family

built petitioner from a small prepress company to a successful

firm.     Mr. Cummings testified that petitioner is ranked in the

top 25 of 2,000 prepress companies in the nation.     Mr. and Mrs.

Cummings, Deen, and to a lesser extent other Dacor and Kadac

employees contributed to petitioner's success.     However, there

are no billing records for those services or records showing how

much time Dacor and Kadac employees spent providing services to

petitioner.

     Oregon income tax returns filed by members of the Cummings

family suggest that the Cummings did not provide services to
                               - 20 -


petitioner in Oregon to the extent they claim.    Oregon income

tax law requires nonresident taxpayers who earned income from

personal services rendered in Oregon to apportion their Oregon

income based on the ratio of the number of days worked in Oregon

for a business over the number of days worked in and out of

Oregon for that business.    Or. Rev. Stat. sec. 316.127 (1993);

Or. Admin. R. 150-316.127-(A)(3)(a)(A).

     Mr. Cummings and two employees testified that Mr. Cummings

spent a little more than 1 day a week in Portland.    However,

Mr. Cummings did not file Oregon income tax returns in 1989 and

1990.   That suggests that he did not perform services for

petitioner in Oregon during those years.

     Mrs. Cummings testified that she worked in Oregon most of

the time during the years in issue.     She reported in her Oregon

income tax returns that she earned $43,961 in 1989 and $20,250

in 1990.   Dacor or Kadac paid her $43,961 in Oregon in 1989 and

$45,000 in 1990.   This suggests that Mrs. Cummings worked full

time for Dacor or Kadac in Oregon in 1989, but only about half

time in 1990.    Petitioner did not adequately explain these

apparent inconsistencies.

     Mr. and Mrs. Cummings testified that they worked only for

Kadac in 1991.   However, Kadac paid Mr. or Mrs. Cummings only

about half of the wage and salary income they received in 1991.
                               - 21 -


Mr. and Mrs. Cummings did not explain this apparent

inconsistency.

     This factor favors petitioner somewhat.

         b.      Character and Condition of the Company

     A company's size as indicated by its sales, net income, or

capital value, the complexities of the business, and general

economic conditions is relevant in deciding whether management

fees are reasonable.    Elliotts, Inc. v. Commissioner, 716 F.2d

at 1246; see E. Wagner & Son, Inc. v. Commissioner, 93 F.2d 816,

819 (9th Cir. 1937); General Water Heater Corp. v. Commissioner,

42 F.2d 419, 420 (9th Cir. 1930), affg. 14 B.T.A. 4 (1928).

     Petitioner's performance improved during the years in issue.

Petitioner's gross sales increased 18.96 percent in fiscal year

1990 and 25.49 percent in fiscal year 1991.     Its total assets

increased 23.96 percent in fiscal year 1990 and 6.6 percent in

fiscal year 1991.   Its taxable income increased 49.20 percent in

fiscal year 1990 and 46.53 percent in fiscal year 1991.      This

factor favors petitioner.

         c.      The Hypothetical Investor's Viewpoint

     It is appropriate to consider whether the amount paid for

management service is reasonable from the perspective of a

hypothetical independent investor.      Elliotts, Inc. v.

Commissioner, supra at 1247.    To calculate the return on

investment, we divide taxable income before net operating losses
                                     - 22 -


by the shareholder's equity for each fiscal year.        See Universal

Manufacturing Co. v. Commissioner, T.C. Memo. 1994-367 (citing

Elliotts, Inc. v. Commissioner, supra at 1245).         Petitioner

reported the following:

    Fiscal          Taxable Income      Shareholder's    Return on
     Year            Before NOL’s          Equity        Investment
     1989             $357,932           $1,341,966        26.67%
     1990              435,637            1,518,957        28.68%
     1991              924,834            2,006,195        46.10%

     Petitioner's rate of return would satisfy a hypothetical

investor.    See Elliotts, Inc. v. Commissioner, supra at 1247 (an

average return on equity of 20 percent would satisfy an

independent investor).       This factor favors petitioner.

            d.      Comparison of Amounts Paid by Similar Businesses
                    for Similar Services

     Evidence that similar companies pay comparable amounts for

similar work may indicate that compensation is reasonable.

Elliotts, Inc. v. Commissioner, supra at 1246; see Hoffman Radio

Corp. v. Commissioner, 177 F.2d 264, 266 (9th Cir. 1949); E.

Wagner & Son, Inc. v. Commissioner, supra at 819.         Neither party

offered any evidence of the compensation that similar

corporations pay for services similar to those performed by Dacor

and Kadac.       Because petitioner bears the burden of proof, Rule

142(a), this factor favors respondent.
                               - 23 -


         e.     Consistency of Payments for Similar Services
                Within Petitioner

     Evidence that a company pays controlling shareholders the

same that it pays other employees for similar work may indicate

that compensation is reasonable.   Elliotts, Inc. v. Commissioner,

supra at 1247; Sunset Scavenger Co. v. Commissioner, 84 F.2d 453,

456 (9th Cir. 1936), affg. in part and revg. in part 31 B.T.A.

758 (1934).   Petitioner provided no convincing analysis whether

management fees it paid to Dacor and Kadac were reasonable in

relation to salaries it paid to its employees.

     Petitioner contends that this factor favors petitioner

because the amounts Dacor and Kadac paid to their employees were

generally less or equal to the amounts petitioner paid to its

department managers during the years in issue.   We disagree.

Petitioner's argument does not explain why the full amount of the

management fee petitioner paid to Dacor and Kadac is reasonable.

Petitioner does not adequately explain why it is reasonable for

management fees to substantially exceed Dacor's and Kadac's

payments to the individuals.   If petitioner's payments to Kadac

and Kadac's payments to its employees in 1991 occurred ratably

throughout the year, then, for the period April 1, 1988, to March

31, 1991, petitioner's management fees paid to Dacor and Kadac

totaled $1,721,890 and Dacor and Kadac's payments to their

employees totaled $1,037,860.80.
                                - 24 -


     It is difficult to compare the management fee and employee

salary data in our record because some of it is based on fiscal

years and some is based on calendar years.       See footnotes 1 and 2

and accompanying text at par. C-3.       However, it seems that the

management fees were substantially larger than the total amount

of salaries Dacor and Kadac paid to their employees.

         f.       Comparison of Management Fees to Gross Receipts

     Courts have compared gross receipts to compensation in

deciding whether compensation is reasonable.       Elliotts, Inc. v.

Commissioner, supra at 1246; Mayson Manufacturing Co. v.

Commissioner, 178 F.2d at 119.     Here, the management fees were

6.86 percent, 7.84 percent, and 17.69 percent of gross sales in

fiscal years 1989 to 1991, respectively.       Mr. Cummings'

compensation was 1.9 percent, 3.5 percent and 0.9 percent of

gross sales in fiscal years 1989 to 1991.

     Petitioner contends that compensation of the key individual

in a company is reasonable if it falls between 10 and 25 percent

of gross sales.    Petitioner cites RAPCO, Inc. v. Commissioner,

T.C. Memo. 1995-128; Donald Palmer Co. v. Commissioner, T.C.

Memo. 1995-65 (compensation was 31.4 percent of gross sales for

Palmer; we allowed 5.5 percent); Acme Constr. Co. v.

Commissioner, T.C. Memo. 1995-6 (compensation was 10.2 percent of

gross sales for Horth); BOCA Constr., Inc. v. Commissioner, T.C.

Memo. 1995-5 (compensation totaled 27.7 percent and 31.1 percent
                               - 25 -


of gross sales for 1989 and 1990); and Comtec Sys., Inc. v.

Commissioner, T.C. Memo. 1995-4 (compensation was 28.1 percent of

gross sales for Vernon Beard and 2.3 percent for Reda Beard).     We

disagree with petitioner's reliance on those cases.    We did not

calculate or consider compensation as a percent of gross sales or

gross receipts in any of these cases except for BOCA Constr.,

Inc. v. Commissioner, supra.   We calculated those percentages

based on facts found in those cases.    In those cases, we

considered compensation as a percent of net sales, net profit, or

gross profit, but not compensation as a percent of gross sales.

RAPCO, Inc. v. Commissioner, supra; Donald Palmer Co. v.

Commissioner, supra; Acme Constr. Co. v. Commissioner, supra; and

Comtec Sys., Inc. v. Commissioner, supra.

     In Donald Palmer Co. v. Commissioner, supra, we concluded

that a salary equal to 58.2 percent of gross profit was

reasonable because that percentage was similar to what the

taxpayer had paid in prior years.   Here, we have no evidence of

management fees as a percent of gross profit that petitioner paid

in prior years.   Acme Constr. Co. v. Commissioner, supra, and

Comtec Sys., Inc. v. Commissioner, supra, are unlike this case

because some pay during the years in issue in those cases was

catchup pay for prior years.   Acme Constr. Co. v. Commissioner,

supra, is unlike this case because the executive there personally

guaranteed all of the taxpayer's debt.    The taxpayers in Acme
                               - 26 -


Constr. Co. v. Commissioner, supra, and Comtec Sys., Inc. v.

Commissioner, supra, also provided evidence comparing the

compensation at issue with that paid by similar companies.     There

is no such evidence here.    In BOCA Constr., Inc. v. Commissioner,

supra, and RAPCO, Inc., v. Commissioner, supra, the taxpayer

applied a longstanding bonus formula or compensation plan.     There

is no similar formula or plan in this case.     In Comtec Sys., Inc.

v. Commissioner, supra, the taxpayer provided evidence which

compared the compensation at issue with compensation in a similar

company.   There is no similar evidence here.

     Petitioner contends that this case is similar to Mortex

Manufacturing Co. v. Commissioner, T.C. Memo. 1994-110.     In that

case, we found that it was important that the company had a

longstanding compensation plan for its officer-stockholders that

was well within industry norms.   Petitioner did not make this

showing.   The taxpayer in Mortex provided evidence comparing the

compensation at issue to various published surveys.    Petitioner

has submitted no such evidence.

     Petitioner cites Universal Manufacturing Co. v.

Commissioner, T.C. Memo. 1994-367, to show that Mr. Cummings'

compensation from Dacor and Kadac was reasonable because it was

2.35 percent of net sales.    Universal Manufacturing Co. v.

Commissioner, supra, is similar to BOCA Constr., Inc. v.
                              - 27 -


Commissioner, supra, in that it states that compensation as a

percentage of gross sales is one of the factors we may consider.

     We disagree with petitioner's reliance on Universal

Manufacturing Co. v. Commissioner, supra.    The issue here is not

whether Mr. Cummings' compensation is reasonable.   It is whether

the management fees petitioner paid to Dacor and Kadac were

reasonable.   Further, in that case, unlike here, part of the pay

during the year in issue was catchup pay for prior years.     The

taxpayer in that case introduced evidence comparing the

compensation at issue with that paid by other companies.

Petitioner did not do so here.   The executive in that case

guaranteed the taxpayer's $2.8 million debt.   There is no similar

guarantee in this case.   The cases petitioner cites do not show

that the management fees at issue in this case are reasonable.

     This factor favors petitioner.

     4.   Conclusion About Management Fees

     We conclude that petitioner is entitled to deduct more

management fees than respondent allowed for each year in issue,

but that part of the management fees that petitioner paid during

the years in issue was not reasonable.   Considering the above

discussion and the entire record, we hold that petitioner may

deduct management fees of $213,000, $525,000, and $554,000 for

fiscal years 1989, 1990, and 1991, respectively.    This amount is
                                - 28 -


75 percent of the management fee rounded to the nearest thousand

dollars.

B.   Whether Petitioner May Deduct Its Rent Payments to Mr.
     Cummings In Excess of the Rent He Paid to the American Red
     Cross

     1.     Contentions of the Parties

     Mr. Cummings paid rent of $97,975 per year ($293,925 for 3

years) to the American Red Cross for the 4200 S.W. Corbett St.

property.    Mr. Cummings sublet that property to petitioner.

Petitioner paid rent to Mr. Cummings of $216,000, $250,000, and

$264,000 for fiscal years 1989, 1990, and 1991, respectively

($730,000 for 3 years).    Respondent contends that petitioner may

not deduct more for rent than Mr. Cummings paid to the American

Red Cross.    Petitioner contends that it may deduct all the rent

it paid to Mr. Cummings in those years.

     2.     Background

     A taxpayer generally may deduct reasonable rents paid for

property used in a trade or business.      Sec. 162(a)(3); Limericks,

Inc. v. Commissioner, 165 F.2d 483, 484 (5th Cir. 1948), affg. 7

T.C. 1129 (1946).    A taxpayer who rents property from a related

person may not deduct more than he or she would have paid if the

parties had dealt at arm’s-length.       Sparks Nugget, Inc. v.

Commissioner, 458 F.2d 631, 635 (9th Cir. 1972), affg. T.C. Memo.

1970-74; Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694, 715

(1977).    A taxpayer may deduct only the fair rental value of
                               - 29 -


premises it rents from related persons.    Coe Lab., Inc. v.

Commissioner, 34 T.C. 549, 585-586 (1960).   We closely scrutinize

whether rents exceed fair rental value if the lessor and lessee

are related.   B. Forman Co. v. Commissioner, 453 F.2d 1144 (2d

Cir. 1972), affg. in part and revg. in part 54 T.C. 912 (1970);

Sparks Nugget, Inc. v. Commissioner, supra; Limericks, Inc. v.

Commissioner, supra.    Fair rental value is a question of fact.

Utter-McKinley Mortuaries v. Commissioner, 225 F.2d 870, 872-873

(9th Cir. 1955), affg. a Memorandum Opinion of this Court;5 Mark

R. Switz, Inc. v. Commissioner, T.C. Memo. 1979-162.6   Petitioner

bears the burden of proof.   Rule 142(a); Welch v. Helvering, 290

U.S. 111, 115 (1933).

     3.   Rental From American Red Cross by Mr. Cummings

     A price chosen after arm’s-length bargaining close to the

time of the valuation date is the best evidence of value.      Estate

     5
       In Utter-McKinley Mortuaries v. Commissioner, 225 F.2d 870
(9th Cir. 1955), affg. a Memorandum Opinion of this Court, the
controlling stockholder leased the premises from a third party.
The taxpayer corporation then sublet the premises and paid rent
to the controlling stockholder that was three to four times as
much as the controlling stockholder paid to the third party
lessor. We held that the taxpayer corporation may not deduct the
increased amount of rent because there was no business purpose
for paying increased rent. The U.S. Court of Appeals for the
Ninth Circuit affirmed our decision.
     6
       In Mark R. Switz, Inc. v. Commissioner, T.C. Memo. 1979-
162, Mark Switz (Switz) controlled the taxpayer-corporation. He
leased property from a third party at a reasonable rental rate.
He sublet the property to the taxpayer-corporation for more than
twice that rate. We disallowed the deduction for rent to the
extent it exceeded the rent Switz paid to the third party.
                                - 30 -


of Spruill v. Commissioner, 88 T.C. 1197, 1229, 1233 (1987);

Utter-McKinley Mortuaries v. Commissioner, supra; Mark R. Switz,

Inc. v. Commissioner, supra.    There is no indication in the

record that the lease from the American Red Cross to Mr. Cummings

was not negotiated at arm's-length.      Thus, the lease payment

($97,975) is highly probative evidence of rental value of these

premises during the years in issue.

     4.   Respondent's Expert

     Respondent's expert, Steve Pietka (Pietka), concluded that

the fair rental values of the 4200 S.W. Corbett St. property were

$120,087, $124,896, and $129,891 for fiscal years, 1989, 1990,

and 1991, respectively.

     Petitioner criticizes Pietka's comparables because they are

not located near 4200 S.W. Corbett Street.      We disagree because

there are no similar leased properties in that area.      Petitioner

points out that its experts said that the fair rental values of

Pietka’s comparables in North Portland and Beaverton are

generally lower than those in the 4200 S.W. Corbett Street area.

We disagree for reasons stated in par. 5, below.     We believe

Pietka's comparables are more like the 4200 S.W. Corbett St.

property than comparables considered by petitioner's experts.

     Petitioner contends that Pietka did not consider the fact

that petitioner could gradually move from the old property to

4200 S.W. Corbett Street.   Petitioner did not state how much
                               - 31 -


value to attribute to this fact.    We are not convinced that it

added more than a minimal amount, if any.

     Petitioner criticizes Pietka's assumption that petitioner

paid all of the expenses including real estate taxes.    However,

petitioner did not prove otherwise.     Mr. Cummings' testimony that

he paid the real estate taxes differs from his testimony in a

prior unrelated case before the Oregon Tax Court.    In the Oregon

Tax Court case, Mr. Cummings testified that petitioner paid the

real estate taxes on the 4200 S.W. Corbett St. property.     We make

no finding as to who paid those taxes.7

     Petitioner offered documents showing that Mr. Cummings spent

about $100,000 for repairs in the spring of 1994.    The documents

were not admitted because they were exchanged too late (1 week

before trial).    About 5 months before this case was calendared

for trial, we sent a copy of the Court’s standing pretrial order

to the parties.    The standing pretrial order stated in part:

“Any documents or materials which a party expects to utilize in

the event of trial (except for impeachment), but which are not

stipulated, shall be identified in writing and exchanged by the

parties at least 15 days before the first day of the trial

session.”

     Materials not provided in compliance with our pretrial

orders are not admitted into evidence.    Rule 104(c)(2); see

     7
         See supra note 7.
                               - 32 -


Freedson v. Commissioner, 565 F.2d 954 (5th Cir. 1978), affg. 65

T.C. 333 (1975) and 67 T.C. 931 (1977); McCoy v. Commissioner, 76

T.C. 1027 (1981), affd. 696 F.2d 1234 (9th Cir. 1983).     Even if

petitioner's documents had been admitted, we would give them very

little weight because they apply to periods much later than the

years in issue.

     Petitioner contends that Pietka did not consider that

Mr. Cummings made repairs.    Petitioner points out that

Mr. Cummings paid about $70,000 to repair the roof and dry rot

in 1994.   We make no findings about who paid for repairs during

the years in issue.   We would give little weight to evidence of

who paid for repairs in 1994 because it occurred so long after

the years in issue.

     Petitioner contends that Pietka considered an incorrect

amount of square footage for the 4200 S.W. Corbett St. property.

The parties agree that the 4200 S.W. Corbett St. property

included a 33,631 square-foot production facility.     They disagree

about the size of the other areas.      Petitioner contends that the

shop has 4,050 (rather than 3,969) square feet and that the annex

or residence has 2,408 (rather than 2,316) square feet.     These

differences are de minimis.

     Petitioner contends that Pietka did not consider all of the

property that was subject to the lease.     Petitioner argues that

it leased property other than the 4200 S.W. Corbett St. property,
                                 - 33 -


including a 840 square foot storage facility and 4,000 square

feet from the old property.   Petitioner bases this on

Mr. Cummings' testimony that by 1989 petitioner rented about

4,000 square feet in the old building, and an additional 800

square feet from another building that Mr. Cummings, doing

business as Blackstone, owns.     Petitioner has not convinced us

that its position about the rental area is correct.       Petitioner's

position is inconsistent with its expert's report.       Petitioner's

experts did not include a rental value for the 840 square-foot

storage space or the 4,000 square feet in the old building.        We

believe Pietka considered all of the property that was subject to

the lease.

     5.   Petitioner's Experts

     Petitioner relied on the expert testimony of John Vissotzky

(Vissotzky).   Petitioner also called Steve Zenker, George

Marandas, and Bruce Korter as expert witnesses, essentially to

corroborate Vissotzky.   We believe Vissotzky overestimated the

fair rental value.   He based his opinion on nine leases that he

said were comparable.    Most of the properties that he evaluated

were buildings with several tenants, which had offices up to

5,000 square feet.   Those spaces are considerably smaller than

the 4200 S.W. Corbett St. property.       Vissotzky’s comparable

properties were used as offices for professionals such as

lawyers, doctors, and securities brokers.       Only part of the
                              - 34 -


property leased by petitioner is used for offices.    Much of it is

used for production and storage.    It also includes a residence.

     Vissotzky only evaluated leases under which the landlord

pays for insurance, maintenance, real estate taxes, and other

similar costs.   Petitioner admits that it paid insurance,

maintenance, and utilities.   Thus, Vissotzky's comparables are

not like petitioner's facilities.

     Vissotzky’s fair rental value estimate includes the value

added to the property by the $1 million petitioner spent to

improve it.   We agree with Pietka's view that it is unreasonable

to expect a tenant to pay for the rental value of improvements

that the tenant made.

     6.   Petitioner's Claim That It Had Business Reasons for
          Paying More Rent to Mr. Cummings Than He Paid to the
          Red Cross

     Petitioner contends that it had substantial business reasons

for paying more rent to Mr. Cummings than Mr. Cummings paid to

the American Red Cross, unlike the taxpayers in Utter-McKinley

Mortuaries v. Commissioner, 225 F.2d 870 (9th Cir. 1944), and

Mark R. Switz, Inc. v. Commissioner, T.C. Memo. 1979-162.

Petitioner contends that it had a business purpose in having a

month-to-month rental instead of a 12-year lease.    Mr. Cummings

testified that a 12-year obligation on petitioner’s balance sheet

would give petitioner a poor debt to equity ratio and hurt

petitioner's banking relationships.    We are not convinced that
                               - 35 -


petitioner's banking relationships would have been hurt if

petitioner had signed a 12-year lease.    For each of the years in

issue, petitioner had retained earnings of from $1 million to $2

million.

     Petitioner contends that it paid more rent to Mr. Cummings

than Mr. Cummings paid to the Red Cross because petitioner had a

month-to-month lease instead of a 12-year lease.    Mr. Cummings

also testified that binding petitioner to one location for 12

years would hurt its ability to grow and move.    We believe that

petitioner overstates the value of having a month-to-month lease,

especially considering that petitioner had spent $1 million to

adapt the property to its own needs.

     Petitioner contends that a business reason for renting from

Mr. Cummings is that it could pay rent late if necessary.

However, petitioner had no right to pay rent late.    Petitioner in

fact paid rent on time.   Petitioner's claim that Mr. Cummings

might give it a break is entirely speculative.

     The points cited by petitioner are far outweighed by the

fact that it paid rent of $730,000 for the 3 years in issue

instead of the $293,925 Mr. Cummings paid to the American Red

Cross.

     Petitioner contends that W.H. Braum Family Partnership v.

Commissioner, T.C. Memo. 1993-434, is strikingly similar to the

instant case.   We disagree.   That case did not involve a lease
                             - 36 -


between a controlling shareholder and a third party followed by a

sublease by the controlling shareholder to the taxpayer

corporation for substantially more rent.   In W.H. Braum Family

Partnership v. Commissioner, supra, the Braum family owned the

properties that they leased to the taxpayer corporation.   We

found that the rent was not excessive.

     7.   Conclusion

     Petitioner has not shown that Mr. Cummings did not pay fair

rental value to the American Red Cross and has shown little or no

business purpose to increase the rent.   The facts of this case

are similar to those in Utter-McKinley Mortuaries v.

Commissioner, supra, and Mark R. Switz, Inc. v. Commissioner,

supra, and the reasoning of those cases applies here.

     To account for the points described above in pars. B-4, B-5,

and B-6, we accept Pietka's conclusion of the fair rental value.

We conclude that the petitioner may deduct rental payments of

$120,087, $124,896, and $129,891 for fiscal years 1989, 1990, and

1991, respectively.

     To reflect concessions and the foregoing,


                                           Decision will be entered

                                      under Rule 155.
