                        T.C. Memo. 2001-262



                      UNITED STATES TAX COURT



             B & D FOUNDATIONS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 14973-98.                     Filed October 3, 2001.


     Joseph H. Thibodeau, Matthew T. Gehrke, and

 Kandace C. Gerdes, for petitioner.

     Michael W. Lloyd, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     BEGHE, Judge:   Respondent determined the following

deficiencies in petitioner’s Federal income tax:

               Year Ended      Deficiency

                 7/31/93        $24,142
                 7/31/96         98,279
                               - 2 -

     Respondent disallowed as unreasonable compensation under

section 162(a)(1)1 $353,911 of salaries out of $1,113,800 paid

and claimed by petitioner as salaries and bonuses to its officer-

director-shareholders, William and Connie Myers, for its fiscal

year ended July 31, 1996.   We sustain respondent’s determination.

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are found

accordingly.   The stipulation of facts and accompanying exhibits

are incorporated by this reference.

     Petitioner is a Colorado corporation that pours concrete

foundations of residential houses and light commercial buildings

for real property developers, and provides other concrete “flat

work”, such as driveways, sidewalks, and basement and garage

floors.   When petitioner filed its petition, it maintained its

principal place of business in Colorado.    At all relevant times,

petitioner has been taxable as a C corporation and reported its

income and deductions, except for State income tax, on the cash

method of accounting.




     1
      All section references are to the Internal Revenue Code as
in effect during the years in issue, and all Rule references are
to the Tax Court’s Rules of Practice and Procedure. The
deficiency for the fiscal year ended July 31, 1993, is
attributable to the reduction of a net operating loss carryback
(claimed by petitioner from the fiscal year ended July 31, 1996)
by reason of respondent’s disallowance of a portion of the
compensation deduction claimed by petitioner for the later year.
                               - 3 -

     Since petitioner was incorporated in late 1986, William

Myers, petitioner’s president, and his wife Connie Myers,

petitioner’s vice president, secretary, and treasurer, have been

its only officers, directors, and shareholders.

     Mr. Myers has a high school education.   After graduating

from high school, Mr. Myers worked in the grocery business for

approximately 12 years and was the manager of a grocery store.

For the next 14 years, before petitioner’s incorporation in late

1986, Mr. Myers worked in the construction industry on a variety

of jobs related to the pouring of concrete for foundations and

flat work:   Delivering mixed concrete to construction sites as

the driver of a Redi-Mix concrete truck, pouring concrete

foundations and flat work for numerous building projects as a

construction worker, foreman, or supervisor, and, beginning in

1983, managing his own foundation and flat work business in

partnership with another individual (the B & D partnership).

     Mrs. Myers has an associate’s degree in computer science.

She worked as a computer programmer and then became a licensed

stockbroker.   After petitioner’s incorporation, she quit her job

as a stockbroker to join Mr. Myers in managing petitioner.

While working for petitioner, Mrs. Myers resumed her college

education and obtained a bachelor’s degree in business in 1990.

     Following a downturn in construction in Colorado, Mr.

Myers’s partner sold his interest in the B & D partnership to Mr.
                                - 4 -

Myers and retired.    In late 1986, petitioner was incorporated to

conduct the foundation and flat work contracting business

previously operated by the B & D partnership and by Mr. Myers.

     Upon incorporation of petitioner, Mr. and Mrs. Myers

invested $10,000 in its capital stock; Mr. Myers received 51

percent of petitioner’s outstanding shares of common stock, and

Mrs. Myers received the other 49 percent.    Mr. and Mrs. Myers

have owned these same stock interests throughout petitioner’s

existence (including the year in issue, ended July 31, 1996).

     Mr. and Mrs. Myers also made advances to petitioner of

$77,237, which were shown on petitioner’s books and income tax

returns as debt.    The record does not show how the advances were

divided between Mr. and Mrs. Myers or whether petitioner paid

interest on them.    Petitioner paid off these advances over the

first 4 years of its existence.

     Since 1987, when petitioner began operations, Mr. and Mrs.

Myers have played complementary roles as the only members of its

management team.    Mr. Myers has handled all work in the field,

and Mrs. Myers has maintained petitioner’s books and provided all

administrative support.    In 1987, petitioner employed about 10

construction workers.    Over the years, petitioner has employed up

to 35 to 40 construction workers, depending on work volume.

     Throughout petitioner’s existence, Mr. Myers, during peak

construction periods, has worked long hours to accomplish a
                                 - 5 -

variety of tasks.     Mr. Myers schedules and coordinates

petitioner’s construction activities with various builders, other

contractors, and suppliers.     Mr. Myers manages and supervises

petitioner’s construction workers and is responsible for all

construction work done by petitioner.     He exclusively solicits,

bids, and obtains jobs for petitioner.

     For each job petitioner obtains, Mr. Myers orders and

arranges for delivery of the premixed concrete to the

construction site.2    He orders and arranges for all necessary

equipment and supplies.    He often supervises the actual work by

petitioner’s workers at the site.     When Mr. Myers cannot be

present to supervise the work at a site, he assigns an

experienced and responsible construction worker of petitioner to

act as foreman of the work crew.3

     On workdays during peak periods, Mr. Myers typically spends

most of his time in the field attending to and supervising


     2
      Petitioner does not perform the excavation work needed to
lay the foundation of a building. Another contractor performs
all required excavation work. After excavation is completed, Mr.
Myers examines the excavated building site and determines the
quantity of mixed concrete to be delivered to lay the foundation.
To avoid running short of mixed concrete during pouring, he
orders more than the minimum quantity he estimates is needed to
lay the foundation. To minimize waste from ordering excess mixed
concrete, where petitioner is constructing a number of
foundations at sites in close proximity, such as the home
foundations in a subdivision, Mr. Myers tries to schedule the
pouring of several foundations per day.
     3
      During the fiscal year ended July 31, 1996, petitioner
employed three individuals who served as foremen.
                               - 6 -

petitioner’s construction activities and marketing its services

to builders.   On workday evenings after he returns home or on

weekends, he informs and discusses with Mrs. Myers, among other

things, the amounts to bill the builders for petitioner’s work on

their jobs, petitioner’s payment obligations for equipment and

supplies, and petitioner’s weekly payroll for construction

workers, and he also works on bids he intends to submit to

builders on petitioner’s behalf.

     Mr. and Mrs. Myers have always maintained petitioner’s

office in their home.   Before petitioner’s incorporation, they

resided in Greeley, Colorado, approximately 50 miles north of

Denver.4   In early 1987, shortly after petitioner’s

incorporation, Mr. Myers decided to seek contracting work for

petitioner in Highlands Ranch, Colorado, approximately 20 to 30

miles south of Denver, where a number of large residential

subdivisions were being developed.     However, it took Mr. Myers

some time to establish the reputation with the builders in

Highlands Ranch that enabled him to obtain substantial work from



     4
      Originally, the B & D partnership had been operating in the
Boulder, Longmont, and north Denver areas. After construction
work declined in those areas in the mid-1980's, Mr. Myers had
obtained contracting jobs for the B & D partnership in Colorado
Springs, approximately 120 miles from his home in Greeley. For
several years, he spent many of his nights during the workweek at
an apartment, motel or mobile home in Colorado Springs and would
often see Mrs. Myers only on weekends. However, by early 1987,
construction work in Colorado Springs had also started to decline
following the Space Shuttle disaster.
                                - 7 -

them for petitioner.   During this interim period, Mr. Myers

continued to commute from Greeley to Colorado Springs while

finishing the jobs petitioner had there.

     By 1990, Mr. Myers and petitioner began to enjoy a good

reputation among home builders and other construction industry

people in the Denver metropolitan area, particularly in Douglas

County (which includes Highlands Ranch).   Mr. Myers and

petitioner had become well known for doing high-quality

foundations and flat work efficiently, reliably, and on schedule.

This reputation enabled petitioner to obtain more business and

increase its gross receipts and profits.   Although petitioner’s

bids had to be competitive, petitioner did not always have to be

the lowest bidder to obtain work from the builders.

     In the latter part of 1990, Mr. and Mrs. Myers moved their

home (and petitioner’s office) to Castle Rock, Colorado, which is

located about 40 miles south of Denver and 20 miles from

Highlands Ranch.

     From 1986 through 1996, a substantial number of new houses

were built in Douglas County.   The rate of annual increase in new

houses built in Douglas County slightly declined from 1986

through 1990, going from 11 percent for 1986 to 6.5 percent for

1990.   This slight decline ended in 1991; according to U.S.

Census Bureau information, from 1990 through 1998 Douglas County

was the fastest growing county in the nation, in terms of
                                 - 8 -

population increases.     For 1996, the rate of increase in the

number of new houses built in Douglas County was 14.8 percent.

     In 1995, petitioner became a contractor for Kaufman & Broad,

a national home building company then building numerous houses in

Highlands Ranch.   During the fiscal year ended July 31, 1996,

petitioner laid more than 600 foundations, of which approximately

500 were for Kaufman & Broad.

     Over the period from January 1, 1987 (when petitioner began

operations), through July 31, 1996, petitioner made annual

payments as compensation to Mr. and Mrs. Myers and to

petitioner’s construction workers as set forth below.5

                                            Total       Total
       FYE      William        Connie      Officer   Construction
     July 31     Myers         Myers        Comp.    Worker Comp.

         1987   $30,000        $6,750      $36,750    $86,846
         1988    54,500        12,950       67,450    216,394
         1989    43,000        15,050       58,050    191,414
         1990    83,000        29,650      112,650    269,681
         1991   173,600        12,500      186,100    374,135
         1992   165,000        65,000      230,000    425,413
         1993   457,785       156,000      613,785    535,051
         1994   630,750       271,750      902,500    592,977
         1995   455,000       247,500      702,500    675,671
         1996   749,500       364,300    1,113,800    679,437

     The total compensation of $1,113,800 paid Mr. and Mrs. Myers

for the fiscal year in issue ended July 31, 1996, was divided

between salaries and bonuses as follows:




     5
      The allocation of officers’ compensation between salary
and bonus for each year is set forth infra in the appendix.
                                 - 9 -

                  Mr. Myers    Mrs. Myers    Totals

    Salaries      $586,500    $288,500       $875,000
    Bonuses        163,0001     75,8002       238,800
    Totals         749,500     364,300      1,113,800
    1
     Of this $163,000, $125,000 was said to be a bonus for
    fiscal year 1995 and $38,000 a bonus for fiscal year
    1996.
    2
     Of this $75,800, $58,000 was said to be a bonus for
    fiscal year 1995 and $17,800 a bonus for fiscal year
    1996.

As described infra pp. 10-11, 13, petitioner also made

contributions on behalf of Mr. and Mrs. Myers to a qualified

retirement plan and further agreed to make specified deferred

compensation payments to each of them.

        Petitioner had no fixed formula for determining the annual

salaries and bonuses paid to Mr. and Mrs. Myers.      Until the

fiscal year ended July 31, 1996, Mr. and Mrs. Myers, petitioner’s

directors, generally around the beginning of the fiscal year,

would set the respective salaries they were to receive for that

year.     At the same time, they would authorize Mr. Myers, as

petitioner’s president, to pay himself and Mrs. Myers whatever

raises, fringe benefits, and bonuses that he considered

appropriate for that year.     For example, concerning the

respective salaries and bonuses paid to Mr. and Mrs. Myers for

the fiscal year ended July 31, 1995, the minutes of petitioner’s
                                - 10 -

annual directors’ meeting of August 8, 1994, stated, in pertinent

part:

     The Corporation has experienced continued
     financial growth due almost entirely to the
     efforts of William Myers and Connie Myers.
     The Board of Director’s [sic] wishes to
     compensate the Officers for a job well done.

     Upon motion duly made, seconded and unanimously
     approved, the Corporation shall pay the following
     officers’ salaries for the fiscal year end July 31,
     1995:

          William L. Myers, President        $100,000
          Connie J. Myers, Secretary           60,000

     The President is also authorized to approve whatever
     raises, fringe benefits and bonuses he judges to be
     fair.

     For the fiscal year ended July 31, 1996, the Memorandum of

Action of the directors with respect to the compensation of Mr.

and Mrs. Myers speaks as of the end of the fiscal year.

Specifically, the Memorandum of Action states as follows

concerning the respective salaries and bonuses of Mr. and Mrs.

Myers, the contribution for that year to a qualified retirement

plan for their benefit, and the deferred compensation agreements

being entered into with them:

          We, all the Directors of B & D FOUNDATIONS, INC.,
     a Colorado corporation, pursuant to Section 7-108-202
     of the Colorado Business Corporation Act, take the
     following action(s), by consent and without a meeting,
     as if by unanimous vote, and waive all notice of such
     meeting pursuant to Section 7-108-203 of that Act:

          *     *     *     *       *    *       *
                             - 11 -


          2. Deferred Compensation Agreement. The
     Directors, after exhaustive review of the officers’
     compensation and the shareholders’ returns since the
     Company was founded, have determined that the Officers
     have been substantially undercompensated since the
     Company’s inception. Therefore, after recognition of a
     substantial return to the Shareholders on their
     investment in the Company, the Directors have
     determined to provide the Officers deferred
     compensation in consideration of their past services
     rendered. The Deferred Compensation Agreements between
     this Corporation and William Myers and between the
     Corporation and Connie Myers, copies of which are
     included in the Corporation’s minute book, are hereby
     approved. The Officers of this Corporation are
     authorized to execute and perform those Agreements on
     behalf of this Corporation.

          3. Ratification of Defined Benefit Plan. The
     Board of Directors hereby ratifies and approves of the
     actions taken by the Officers of this Corporation in
     adopting a Qualified Defined Benefit Retirement Plan,
     copies of which are included in this Corporation’s
     minute book.

          4. Contributions to Qualified Plans. The Board of
     Directors hereby ratifies and approves the contribution
     of $92,600.00 to the trustee of the B & D Foundations,
     Inc. Employee Retirement Defined Benefit Plan.

         5. Salaries. The Board of Directors hereby
    acknowledges that it reached a settlement in calendar
    year 1996 with the Internal Revenue Service respecting
    officers’ compensation for fiscal years ending 1993 and
    1994. In accordance with the guidelines established by
    the Internal Revenue Service[6] in reaching this


     6
      Pursuant to that settlement, petitioner agreed to treat as
constructive dividend income $108,830 of the total compensation
paid to Mr. and Mrs. Myers for the 1993 fiscal year and $57,533
of the total compensation paid to them for the 1994 fiscal year.
However, the record discloses no specific guidelines or
compensation formula that had been applied by the parties in
determining the amounts deductible by petitioner as reasonable
compensation to Mr. and Mrs. Myers under this settlement. The
                                                   (continued...)
                                 - 12 -

     settlement and after effecting an inflation increase
     for 1996, the following salaries, and the bonuses set
     forth in paragraph 6 below, are hereby fixed for the
     following Officers until further action of the Board.

          William L. Myers          $586,500
          Connie J. Myers           $288,500

          6. Payment of Bonus. The Board of Directors
     hereby authorize and direct the Officers of this
     Corporation to pay bonuses for the fiscal years ended
     July 31, 1995 and 1996, to the following Officers in
     the amounts set opposite their names:

                                 Total          1995       1996

          William L. Myers       $163,000      $125,000    $38,000
          Connie J. Myers        $ 75,800      $ 58,000    $17,800

          *       *   *      *       *      *          *

          This consent of the Board of Directors when signed
     by all of the Directors of this corporation shall have
     the same effect as having been unanimously adopted by
     vote of the Board of Directors of this Corporation on
     the 31st day of July, 1996.[7] The Directors of this
     Corporation are as follows:

     Approved:

     DIRECTORS:


     6
      (...continued)
Income Tax Examination report dated Apr. 18, 1998, of the
revenue agent who examined petitioner’s return for the fiscal
year ended July 31, 1996, stated that “The settlement [for the
earlier 1993 and 1994 fiscal years] is not specific as to how a
reasonable compensation amount was determined.” Indeed,
petitioner now acknowledges no formula was used in settling those
1993 and 1994 tax years.
     7
      The record does not disclose the date on which petitioner’s
directors, Mr. and Mrs. Myers, had signed the Memorandum of
Action. Respondent did not question whether the salaries and
bonuses authorized by the Memorandum, which petitioner deducted
on its return for the year ended July 31, 1996, were actually
paid to Mr. and Mrs. Myers during that year.
                                - 13 -


     /s/ William L. Myers
     William L. Myers

     /s/ Connie J. Myers
     Connie J. Myers

     Petitioner agreed, in the Deferred Compensation Agreements

referred to in paragraph 2 of the Memorandum of Action, to pay

Mr. Myers $362,000 and to pay Mrs. Myers $126,000, as deferred

compensation.   Petitioner agreed to make the deferred

compensation payments in equal monthly installments over a 60-

month period beginning 1 month after:    (1) The sale or exchange

(through merger or otherwise) of more than 50 percent of

petitioner’s outstanding shares of stock; (2) the sale or

exchange of all or substantially all of petitioner’s assets

(other than in the ordinary course of business); or (3)

termination of employment with petitioner.

     Petitioner’s income tax returns for the fiscal years ended

July 31, 1987, through 1996, disclose the following annual gross

receipts and net profit or net loss after taxes:

                                             Net Profit
                                             (Net Loss)
     FYE July 31      Gross Receipts         After Taxes

        1987                $423,897          $18,317
        1988                 856,623           60,729
        1989                 742,876           39,657
        1990                 978,152           38,632
        1991               1,407,191           53,684
        1992               2,053,999            3,274
        1993               3,247,464           61,521
        1994               3,289,189          193,624
        1995               3,638,980           59,292
        1996               4,561,878          (61,904)
                                - 14 -

        The Schedule L--Balance Sheets included in petitioner’s

income tax returns for these years further reflect the following

total assets and net assets and equity (without regard to

petitioner’s obligation to make future payments to Mr. and Mrs.

Myers or to respondent’s contention that the $77,237 of advances

should be treated as equity):

                                                Net Assets/
        FYE July 31       Total Assets1           Equity2

           1987              $131,216            $31,405
           1988               182,088            101,931
           1989               207,373            134,073
           1990               218,956            172,011
           1991               254,634            218,462
           1992               255,443            221,554
           1993               361,949            282,989
           1994               591,366            475,808
           1995               547,656            534,443
           1996               378,684            378,542
    1
      Petitioner’s cost for the assets, less accumulated
  depreciation.
    2
     Total assets, less liabilities, which equals capital
  stock of $10,000, plus retained earnings.

        From incorporation in late 1986 through July 31, 1996,

petitioner declared and paid no formal dividends.

        Around 1994, Mr. and Mrs. Myers decided they would no longer

seek to increase the size of petitioner’s business.        Shortly

thereafter, Mr. Myers helped his son, Kurt Myers (Kurt),

establish another foundation and flat work construction company,

Myers Foundations, Inc. (Myers Foundations).      Mr. Myers owned 51

percent of the outstanding shares of stock of Myers Foundations

and Kurt owned the other 49 percent.      Mr. Myers served as vice
                               - 15 -

president of Myers Foundations.    On July 31, 1996, Mr. Myers’

stock interest in Myers Foundations was redeemed, and Kurt became

its sole shareholder.

     Mr. Myers also helped Bill Collins, a former employee of

petitioner and the B & D partnership, establish Collins Concrete

Construction, Inc. (Collins Concrete), another foundation and

flat work construction company.    Mr. Collins and Mr. Myers

together owned Collins Concrete.    By 1996, Mr. Myers’ entire

stock interest in Collins Concrete had been redeemed.

     During 1996, Mr. Myers also engaged in certain cattle

breeding and feeding activities and horse breeding and showing

activities.

     In the notice of deficiency, respondent disallowed

petitioner’s deduction of $353,911 of the $875,000 of salaries

paid Mr. Myers and Mrs. Myers for its fiscal year ended July 31,

1996, but did not make any adjustment to the $238,000 of bonuses

paid for that year and the preceding year.    The notice of

deficiency stated, in pertinent part:

     Issue A: Whether the compensation paid to the
     shareholder/officers of the corporation are reasonable
     given the duties and services provided to the company.

     Reconciliation:       FYE 7/31/96
      Per Return        [$]1,113,800
      Per Exam               759,889

      Adjustment             353,911

     The total “reasonable” compensation amount was
     determined as follows:
                              - 16 -

     Chief Executive Officer       [$]186,420
     Chief Financial Officer           59,150
     Chief Operations/Administrative
      Officer                         162,095
     Marketing Executives             113,424
                                      521,089

     Bonus (no adjustment to amount
            paid by TP as bonuses)      183,000   FY 7/95
                                         55,800   FY 7/96
     Total compensation allowed         759,889


                              OPINION

     This is yet another case in which a closely held C

corporation--whose shareholders have never elected pass-through

treatment under subchapter S-–faces the burden of justifying the

deductibility for U.S. corporation income tax purposes of amounts

paid to them as compensation that respondent claims to be

unreasonable and excessive.

     Section 162(a)(1) allows as a business deduction “a

reasonable allowance for salaries or other compensation for

personal services actually rendered”.   A two-prong test

determines the deductibility of payments as compensation:   (1)

Whether the amount claimed to be deductible as compensation is

reasonable in relation to services performed, and (2) whether the

payment is in fact purely for services rendered.   Sec. 1.162-

7(a), Income Tax Regs.   Bonuses paid to employees are deductible

“when * * * made in good faith and as additional compensation for

the services actually rendered by the employees, provided such

payments, when added to the stipulated salaries, do not exceed a
                              - 17 -

reasonable compensation for the services rendered.”    Sec. 1.162-

9, Income Tax Regs.8   Generally, courts have focused on the

reasonableness requirement in determining deductibility.

Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243-1244 (9th

Cir. 1983), revg. and remanding T.C. Memo. 1980-282.

     The reasonableness of compensation is a question of fact to

be answered by considering all facts and circumstances of the

particular case.   Pepsi-Cola Bottling Co. of Salina, Inc. v.

Commissioner, 528 F.2d 176, 179 (10th Cir. 1975), affg. 61 T.C.

564 (1974); Estate of Wallace v. Commissioner, 95 T.C. 525, 553

(1990), affd. 965 F.2d 1038 (11th Cir. 1992).   Petitioner has the

burden of showing that the amount it deducted as compensation was

reasonable, and that it is entitled to a compensation deduction

larger than that allowed by respondent.   Rule 142(a); Pepsi-Cola

Bottling Co. of Salina, Inc. v. Commissioner, supra at 179; Nor-

Cal Adjusters v. Commissioner, 503 F.2d 359, 361 (9th Cir. 1974),

affg. T.C. Memo. 1971-200.9


     8
      In the notice of deficiency, respondent did not adjust the
$238,000 of bonuses paid to Mr. Myers and Mrs. Myers for the 1995
and 1996 fiscal years that petitioner deducted on its fiscal year
1996 return. However, the total compensation that was paid to
Mr. and Mrs. Myers during the 1996 fiscal year in issue included
these bonuses. Accordingly, in evaluating the reasonableness of
the salaries petitioner paid and deducted for Mr. Myers and Mrs.
Myers, we consider the total compensation they received,
including bonuses.
     9
      The Internal Revenue Service Restructuring and Reform Act
of 1998 (RRA), Pub. L. 105-206, sec. 3001(a), 112 Stat. 685, 726-
727, enacted sec. 7491 to shift the burden of proof to respondent
                                                   (continued...)
                              - 18 -

     Compensation paid by a corporation whose stock is closely

held (as in the case at hand) is to be given special scrutiny.

Elliotts, Inc. v. Commissioner, supra at 1243; Pepsi-Cola

Bottling Co. of Salina, Inc. v. Commissioner, supra at 179.       As

the Court of Appeals for the Ninth Circuit has explained, a

closely held corporation will normally have an interest to

characterize payments to a shareholder-employee as deductible

compensation, rather than as nondeductible dividends, and the

shareholder-employee and corporation are likely not to be dealing

at arm’s length.   Elliotts, Inc. v. Commissioner, supra.    The

problem of determining whether a purported compensation payment

is actually a disguised dividend, the Court of Appeals further

noted, is aggravated when a shareholder-employee is the

corporation’s sole shareholder.   An employee who is sole

shareholder not only has complete control over the corporation’s

operations but is the only eligible dividend recipient.     Id.

     Case law has provided an extensive list of factors that are

relevant in determining reasonable compensation.   Mayson

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

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


     9
      (...continued)
in court proceedings under certain circumstances. However, sec.
7491 generally applies and is effective only to court proceedings
arising in connection with examinations commencing after July 22,
1998, and is not applicable to this case. RRA sec. 3001(c)(1),
112 Stat. 727. Respondent’s examination of petitioner’s return
for the fiscal year ended July 31, 1996, began well before July
22, 1998.
                                - 19 -

No single factor is dispositive.    Pac. Grains, 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 Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner,

supra at 179, the Court of Appeals for the Tenth Circuit, to

which this case is appealable, listed nine factors to be

considered, with the situation as a whole being considered and no

single factor being decisive.    These nine factors are:   (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 economic conditions; (6) a

comparison of salaries with distributions to shareholders; (7)

the prevailing rates of compensation for comparable positions in

comparable concerns; (8) the salary policy of the taxpayer 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.

     Petitioner contends it has established the reasonableness of

the compensation it paid to Mr. Myers and Mrs. Myers and deducted

for its fiscal year ended July 31, 1996.    Respondent contends to

the contrary that petitioner has failed to establish its right to

a larger compensation deduction than respondent allowed in the

notice of deficiency.
                                - 20 -

     In their post-trial briefs, the parties have addressed in

cursory fashion the independent investor test used by the Courts

of Appeals for the Second,10 Seventh,11 and Ninth Circuits.12

     In Eberl’s Claim Serv., Inc. v. Commissioner, 249 F.3d 994,

1003-1004 (10th Cir. 2001), affg. T.C. Memo. 1999-211, the Court

of Appeals for the Tenth Circuit recently confirmed that it

continues to use the multifactor approach of Pepsi-Cola Bottling

Co. of Salina, Inc. v. Commissioner, supra.     In Eberl’s Claim

Serv., Inc., the panel rejected the taxpayer’s argument for

adoption of some form of the independent investor test (more

fully discussed infra pp. 47-57), stating that it was bound to

continue using the multifactor approach of Pepsi-Cola Bottling

Co. of Salina, Inc., absent reconsideration and adoption in an en

banc rehearing.   Id.

     In all likelihood, any appeal from our decision in the case

at hand would be to the Court of Appeals for the Tenth Circuit.

Sec. 7482(b)(1)(B).     As a result, in deciding this case, we

follow its decisions in Eberl’s Claim Serv., Inc., supra, and


     10
      E.g., Dexsil Corp. v. Commissioner, 147 F.3d 96 (2d Cir.
1998), vacating and remanding T.C. Memo. 1995-135; Rapco, Inc. v.
Commissioner, 85 F.3d 950 (2d Cir. 1996), affg. T.C. Memo. 1995-
128.
     11
      E.g., Exacto Spring Corp. v. Commissioner, 196 F.3d 833
(7th Cir. 1999), revg. T.C. Memo. 1998-220.
     12
      E.g., Labelgraphics, Inc. v. Commissioner, 221 F.3d 1091
(9th Cir. 2000), affg. T.C. Memo. 1998-343; Elliotts, Inc. v.
Commissioner, 716 F.2d 1241 (9th Cir. 1983), revg. and remanding
T.C. Memo. 1980-282.
                               - 21 -

Pepsi-Cola Bottling Co. of Salina, Inc., supra, and apply the

multifactor approach.    See Golsen v. Commissioner, 54 T.C. 742,

757 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

     Petitioner argues, among other things, that its compensation

payments to Mr. Myers and Mrs. Myers for the 1996 fiscal year

were reasonable because their efforts enabled it to enjoy

outstanding financial performance from January 1, 1987, through

July 31, 1996.    Petitioner claims, in light of its alleged

outstanding financial performance, that an independent investor

would have approved the compensation paid to Mr. Myers and Mrs.

Myers.    Not surprisingly, respondent disputes petitioner’s

claims.    In applying the multifactor approach of the Court of

Appeals for the Tenth Circuit, whether petitioner’s owners

enjoyed a high rate of return on their equity investment is a

relevant factor.    The return on equity analysis (which, as

discussed infra pp. 48-50, is central to the independent investor

test) can be especially useful in evaluating the taxpayer’s

financial performance, an additional factor this Court addressed

in Eberl’s Claim Serv., Inc., supra.13


     13
      In Eberl’s Claim Serv., Inc. v. Commissioner, 249 F.3d
994, 999 (10th Cir. 2001), affg. T.C. Memo. 1999-211, the Court
of Appeals noted that under the traditional multifactor approach
in Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner, 528
F.2d 176 (10th Cir. 1975), affg. 61 T.C. 564 (1974), the
situation must be considered as a whole, with no one factor being
decisive. It further noted that while the factors to be
considered have been stated innumerable times in past cases,
those factors have never been reduced to a definitive list. Id.
                                                    (continued...)
                              - 22 -

     Accordingly, in determining whether the amounts petitioner

paid to Mr. and Mrs. Myers and deducted on its income tax returns

were reasonable compensation, we first analyze and apply the nine

factors used by the Court of Appeals for the Tenth Circuit in

Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner, supra.

We then evaluate petitioner’s financial performance using certain

elements of the independent investor test.

     A.   Mr. Myers’ and Mrs. Myers’ Qualifications

     An employee’s superior qualifications for his or her

position may justify high compensation.   Home Interiors & Gifts,

Inc. v. Commissioner, supra at 1158.

     Mr. Myers had substantial knowledge and experience in doing

concrete work in the construction industry.   Before petitioner’s

incorporation in late 1986, Mr. Myers already had extensive

experience in pouring concrete foundations and flat work, and in

managing and operating his own foundation and flat work

contracting business.

     Mrs. Myers had almost no experience in the construction

industry before she began to work for petitioner.     She had some



     13
      (...continued)
Indeed, in reviewing and affirming our decision in Eberl’s Claim
Serv., Inc., the Court of Appeals observed that this Court, in
concluding that the taxpayer in that case had not carried its
burden of showing the entire amount of compensation deducted was
reasonable, had identified and examined 12 relevant factors,
including, where the employee and employer have failed to deal at
arm’s length, whether an independent investor would have approved
the compensation. Id.
                                - 23 -

familiarity with general business matters and with office and

administrative support functions, having previously worked as a

computer programmer and stockbroker.     After joining Mr. Myers in

managing petitioner, she obtained a bachelor’s degree in business

in 1990.

     This factor favors petitioner with respect to Mr. Myers but

is neutral with respect to Mrs. Myers.

     B.    The Nature, Extent, and Scope of Mr. and Mrs.
           Myers’s Work

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

general importance to the success of the business may justify

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

supra at 1158.

     Mr. Myers was petitioner’s key employee and driving force

from its inception, and his personal services were essential to

its success.     He managed and built up petitioner’s business,

solicited and obtained all petitioner’s jobs, and supervised and

was responsible for all work performed.

     On brief, respondent argues that, by the year ended July 31,

1996, Mr. Myers had substantially reduced the hours per week he

worked for petitioner, and was devoting a substantial percentage

of his time to the businesses of Myers Foundations and Collins

Concrete.    In doing so, respondent relies heavily on a tax return

filed for the same period by Myers Foundations, the foundation

and flat work construction company that Mr. Myers and his son
                               - 24 -

Kurt established in March 1994.    This return (signed by Mr. Myers

as vice president of Myers Foundations) reflects that Mr. Myers

that year was paid $155,200 in compensation.   The return further

specifically states that Mr. Myers devoted 50 percent of his time

to the business of Myers Foundations.14   Although that return

statement by Mr. Myers supports respondent’s contention, we are

satisfied that petitioner has adequately explained and disproved

that statement.

     Mr. Myers and Kurt testified that Kurt had previously worked

for petitioner and the B & D partnership, and had already been

trained by Mr. Myers during his prior employment with petitioner

and the partnership.   Mr. Myers testified that he did not

actually devote more than about 1 percent of his overall time to

Myers Foundations during its and petitioner’s respective 1996

fiscal years.    Similarly, Kurt testified that his father’s work

for Myers Foundations consisted of his consulting with Kurt over

the telephone.




     14
      The record further reflects that Mr. Myers received
$324,000 of reported compensation from Collins Concrete (the
other foundation and flat work construction company he owned
together with Bill Collins) during 1995.
                               - 25 -

     We found Mr. Myers’s and Kurt’s testimony credible.15   As

determined in our findings, over the years, Mr. Myers has worked

long hours to accomplish the numerous duties and tasks he

performs for petitioner.   He and other witnesses further

convincingly testified that he each year (including during

petitioner’s year ended July 31, 1996) puts in numerous workdays

of 10 hours or more.16   He also has often worked on weekends and




     15
      We questioned Mr. Myers closely about the statement in the
fiscal year ended July 31, 1996, return of Myers Foundations that
he had devoted 50 percent of his time to its business. Although
he maintained the statement was untrue, he did not recall how
that 50-percent figure had been arrived at by the accountant who
had prepared that return. We note that this accountant had also
prepared petitioner’s return for its year ended July 31, 1996,
and that return stated that Mr. Myers had devoted 100 percent of
his time to petitioner’s business.
     16
      During peak construction periods, Monday through Friday is
the normal workweek for petitioner’s construction workers.
Although petitioner does not pour concrete on Saturdays, some of
its workers may work on Saturday to prepare or finish work on a
particular building site. On a typical workday, petitioner’s
construction workers report to a staging area by 7 a.m. Mr.
Myers is usually at the staging area around 6:30 a.m., in order
to plan and direct the work to be done that day. From the
staging area, after picking up and loading any equipment and
supplies needed in the work that day (panels, i.e., rectangular
aluminum forms, form oil, anchor bolts, wall ties, etc.) Mr.
Myers and petitioner’s work crews proceed to various construction
sites. Petitioner’s work crews normally work until 4:30 p.m. or
5 p.m., although they sometimes may be required to work until 7
p.m. or 8 p.m. After petitioner’s construction workers have
stopped work, Mr. Myers usually has other tasks to perform,
including preparing petitioner’s billings, its weekly payroll,
and its bids on future jobs, and planning construction activities
for the next workday.
                               - 26 -

has not taken extended vacations, because he must see that all of

petitioner’s work is done.17

     We similarly reject respondent’s suggestion that Mr. Myers

by the 1996 fiscal year was no longer putting in long hours for

petitioner because of his cattle breeding and feeding and horse

breeding and showing activities.

     Mrs. Myers is petitioner’s only office worker.    She has

played a complementary role to Mr. Myers by handling petitioner’s

accounting, administrative, and support functions.18

     This factor favors petitioner with respect to Mr. Myers but

is neutral with respect to Mrs. Myers.

     C. The Size and Complexities of Petitioner’s Business

     The size and complexity of a taxpayer’s business is

considered in determining whether compensation is reasonable.

Pepsi-Cola Bottling Co. of Salina, Inc. v. Commissioner, 528 F.2d

at 179.



     17
      Petitioner’s volume of work generally fluctuates during
the year. In the Denver metropolitan area, the peak periods of
construction include May, June, September and October.
Notwithstanding fluctuations in petitioner’s workload, Mr. Myers
tries to schedule and have petitioner undertake some contracting
jobs throughout the year, in order to provide steady work for
some of his better workers. Because winter temperatures in the
Denver metropolitan area generally do not fall below freezing,
concrete can usually be poured throughout the year.
     18
      Although Mrs. Myers was not a shareholder or officer of
Myers Foundations, she kept its books and prepared its payroll
during its fiscal year ended July 31, 1996. During that year,
Myers Foundations maintained its office in the home of Mr. and
Mrs. Myers.
                              - 27 -

     As indicated in our findings, around 1994 Mr. and Mrs. Myers

had decided not to seek to increase the size of petitioner’s

business.   At that point, petitioner had reached the maximum size

they felt comfortable managing and operating.   If petitioner’s

contracting business had expanded substantially, Mr. Myers would

no longer have been able to manage and be personally responsible

for all of petitioner’s construction work.   Mr. and Mrs. Myers

further believed it would be difficult to find and hire qualified

additional employees to perform any of the same functions as Mr.

Myers.   At any rate, they were unwilling to make the substantial

additional financial commitment needed if petitioner were to

attempt to grow substantially, particularly since petitioner at

this time had relatively little debt.   Indeed, as respondent’s

expert suggested, petitioner’s contracting business was similar

to other small, family-owned-and-run construction contracting

businesses, distinguished from them only by its relatively

outstanding ability to generate funds to pay dividends and

compensation to its shareholders.

     Petitioner grossed more than $3.2 million annually from its

foundation and flat work construction business for its 1993

through 1995 fiscal years.   For the 1996 fiscal year in issue,

petitioner grossed more than $4.5 million and poured more than

600 foundations.   It has employed up to as many as 35 to 40

construction workers during a year.    Mr. and Mrs. Myers were the

only members of petitioner’s management team and performed
                              - 28 -

multiple roles in managing petitioner’s operations.

     Petitioner’s jobs did not require substantial scientific and

highly technical knowledge.   Miller Box, Inc. v. United States,

488 F.2d 695, 705 (5th Cir. 1974) (wooden ammunition box

manufacturing operation was simple); Tricon Metals & Servs., Inc.

v. Commissioner, T.C. Memo. 1997-360; cf. Choate Constr. Co. v.

Commissioner, T.C. Memo. 1997-495 (taxpayer   specialized in

constructing complex projects such as hospital operating rooms,

robotics facilities, high-quality glass-making plants, and

industrial “clean rooms”).

     This factor favors respondent, but the advantage to

respondent is substantially offset by the leanness of

petitioner’s management team and the multiple functions Mr. and

Mrs. Myers performed in managing petitioner’s operations.    See

PMT, Inc. v. Commissioner, T.C. Memo. 1996-303 (noting that

courts have considered the recipient-employee’s performance of

more than one function for the employer); see also Labelgraphics,

Inc. v. Commissioner, T.C. Memo. 1998-343, affd. 221 F.3d 1091

(9th Cir. 2000).

     D. Comparison of Mr. and Mrs. Myers’s Salaries and Bonuses
        With Petitioner’s Gross Receipts and Net Income or Net
        Loss After Taxes

     Although it is often helpful to consider compensation as a

percentage of both gross receipts and net income, net income is

usually more important, because it more accurately gauges whether

a corporation is disguising the distribution of dividends as
                                     - 29 -

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

1315, 1325-1326 (5th Cir. 1987), affg. T.C. Memo. 1985-267.

However, no particular ratio between compensation and gross or

net taxable income is a prerequisite for a finding of

reasonableness.       Id. at 1326.

     Over the period January 1, 1987, through July 31, 1996,

petitioner had the annual gross receipts and net income (before

taxes and officer compensation)19 set forth below.

          FYE July 31       Gross Receipts     Net Income

             1987             $423,987           $58,299
             1988              856,623           141,745
             1989              742,876           104,705
             1990              978,152           158,100
             1991            1,407,191           251,012
             1992            2,053,999           233,852
             1993            3,247,464           689,195
             1994            3,289,189         1,192,457
             1995            3,638,980           778,656
             1996            4,561,878         1,051,896

     From January 1, 1987 through July 31, 1996, the annual

compensation paid Mr. and Mrs. Myers represented the percentages

of petitioner’s gross income and net income (before taxes and

officer compensation) set forth below:



     19
      The net income figure given for the fiscal year ended July
31, 1996, is net of the $92,681 that petitioner contributed to
the qualified retirement plan it established for petitioner’s
employees that year. No breakdown is available as to the portion
of the $92,681 contribution that would benefit Mr. and Mrs. Myers
as opposed to petitioner’s other employees. The record does
reflect that Mr. and Mrs. Myers were among the employees who
would benefit under the plan. It is thus likely that most, if
not substantially all, of the contribution would benefit them.
                                 - 30 -

                 Total Officer     Percentage of     Percentage of
FYE July 31      Compensation       Gross Income       Net Income

  1987            $36,750                  8.67          63.04
  1988             67,450                  7.87          47.59
  1989             58,050                  7.81          55.44
  1990            112,650                 11.52          71.25
  1991            186,100                 13.22          74.14
  1992            230,000                 11.20          98.35
  1993            613,785                 18.90          89.05
  1994            902,500                 27.44          75.68
  1995            702,500                 19.30          90.22
  1996          1,113,800                 24.42         105.88

     For the 1996 fiscal year in issue, petitioner had a net loss

after taxes of $61,904 as a result of the $586,500 salary and

$163,000 bonus paid to Mr. Myers and the $288,500 salary and

$75,800 bonus paid to Mrs. Myers.     These payments equaled 105.88

percent of petitioner’s net income for that year (before taxes

and officer compensation).   Petitioner that year also experienced

a $155,901 reduction in its equity ($534,443 net assets and

equity at the beginning of the year, less $378,542 net assets and

equity at yearend, without regard to the obligation petitioner

took on in that year to pay an additional $488,000 of “deferred

compensation” to Mr. and Mrs. Myers).

     Respondent’s expert acknowledged that Mr. and Mrs. Myers

were undercompensated during petitioner’s early years of

operation.    However, as discussed more fully infra pp. 43-47,

respondent and petitioner disagree over whether Mr. Myers and

Mrs. Myers remained underpaid for their past services in prior
                              - 31 -

years as of the beginning of petitioner’s fiscal year ended July

31, 1996.

     This factor favors respondent.

     E. Economic Conditions

     If general economic conditions are favorable, they may

downgrade the extent of the employee’s effect on the company’s

performance.   Mayson Manufacturing Co. v. Commissioner, 178 F.2d

115, 119-120 (6th Cir. 1949), revg. and remanding a Memorandum

Opinion of this Court.

     The record reflects the construction boom in Douglas County

from 1990 through 1996.   Indeed, with some help and guidance from

Mr. Myers, Myers Foundations and Collins Concrete, two other

foundation and flat work contracting companies that he helped

establish, were able to operate successfully and obtain

substantial business during 1995 and 1996.

     Although the construction boom in Douglas County contributed

to petitioner’s profitability during these years, the record also

reflects that petitioner was a well managed company whose work

enjoyed an excellent reputation among builders and other

construction industry people in the Denver, Colorado, area.

     This factor is neutral because petitioner’s financial

success was not due merely to fortuitous economic conditions.

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1158;

Neils v. Commissioner, T.C. Memo. 1982-173.
                              - 32 -

     F. Comparison of Salaries and Bonuses Petitioner Paid
        Mr. and Mrs. Myers With Formal Dividend Distributions

     The failure to declare and pay dividends suggests that

purported compensation payments may be disguised dividends.

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

Cir. 1974), affg. T.C. Memo. 1973-130.

     Although Mr. and Mrs. Myers were extremely well compensated,

commencing with petitioner’s fiscal year ended July 31, 1993,

petitioner made no formal dividend distributions from the time of

its incorporation in late 1986 through July 31, 1996.

     This factor favors respondent.

      G. Prevailing Rates of Compensation for Comparable
         Positions in Comparable Concerns

     In deciding whether compensation to an employee is

reasonable, we compare it to compensation paid to persons holding

comparable positions in comparable companies.     Mayson

Manufacturing Co. v. Commissioner, 178 F.2d at 119; sec. 1.162-

7(b)(3), Income Tax Regs.   In assessing this factor, we consider

the testimony of the parties’ expert witnesses.    As trier of

fact, we are not bound by the opinion of any expert witness and

will accept or reject expert testimony, in whole or in part, in

the exercise of sound judgment.   Helvering v. National Grocery

Co., 304 U.S. 282, 295 (1938); Silverman v. Commissioner, 538

F.2d 927, 933 (2d Cir. 1976) (and cases cited therein), affg.

T.C. Memo. 1974-285.
                              - 33 -

Petitioner’s Expert

     Petitioner’s expert Lawrence P. Gelfond owns his own

certified public accounting and business consulting firm.    He has

extensive experience in evaluating commercial enterprises for

business decisions, and he has valued closely held businesses and

professional practices.

     Mr. Gelfond opined that the compensation petitioner paid to

Mr. Myers and Mrs. Myers for its year ended July 31, 1996, was

reasonable.   Among other things, Mr. Gelfond heavily based his

conclusion on his examination of a 1996 survey of a large number

of concrete contracting companies.     In his report, he elaborated

as follows:

     The Company [petitioner] realized net profit (before
     owner’s compensation and taxes) of 23 percent of
     revenues for the tax year ended July 31, 1996. As
     previously stated, the Company also realized an average
     annual return of 43 percent over the 10 year period
     ending July 31, 1996 (“the Operating Period”)--well
     above the annual return of a superior mutual fund.[20]

    According to Robert Morris Associates Annual Statement
    Studies - 1996 (“the Study”), Concrete Contractors
    (Standard Industrial Classification Code #1771),
    companies within the 75th percentile (implies the
    statistic ranks 25th of 100 samples) realized net
    profit (before officers’ compensation and taxes) of
    12.9 percent of revenues. As the Company realized net
    profit of 23.1 percent for the tax year ended July 31,
    1996, it is obvious that the Company realized superior
    financial performance compared to the companies in the
    Study’s data.


     20
       Mr. Gelfond’s compounded average annual return analysis
is discussed infra pp. 50-52, in connection with our discussion
of petitioner’s financial performance and the independent
investor test.
                        - 34 -

The Study’s data also reflects that companies in the
75th percentile paid officers’ compensation of 8.5
percent of revenues. Although the Company paid
officers’ compensation of 24.4 percent (including the
bonus paid for 1995 performance; 20.4 percent excluding
the 1995 bonus) of revenues in the tax year ended July
31, 1996, consideration must be given to the fact that
the Company performed far superior (as noted in the
previous paragraph) to the companies included in the
Study’s 75th percentile data.

In addition, the Study does not indicate how many
officers are included in the “officers’ compensation as
a percentage of revenues” calculation. Given that the
Myers collectively perform the duties including but not
limited to, chief executive officer; chief financial
officer; chief operating officer; bookkeeper; personnel
manager; and office manager, a percentage of the Myers’
compensation should be allocated, and compared to the
Study’s “Operating Expenses” category. This
appropriate allocation would decrease the Company’s
officers’ salaries as a percentage of revenues, and
would be a more appropriate and consistent manner of
comparing the Company’s figures to the Study’s data.
(As the Study does not offer detail with respect to
accounting and office administration salaries as a
percentage of revenues, GHP [Mr. Gelfond’s consulting
firm] is unable to make this more appropriate and
consistent comparison.)

Of additional importance for purposes of ascertaining
the relevance of the Study’s information to the case at
hand is the fact that the Study’s data is not organized
by type of entity (e.g., subchapter S or C
corporations). Officers/shareholders of subchapter S
corporations often minimize officers’ compensation in
lieu of cash distributions. As such, officers’
compensation as a percent of revenues will generally be
less for a subchapter S corporation than a C
corporation. Over 85 percent of the companies included
in the Study had annual revenues less than $10 million,
which could indicate the majority of the companies
included in the Study are subchapter S corporations.
Therefore, officers’ compensation as a percentage of
revenues, as reflected in the Study, is likely to be
artificially low.

Mr. Gelfond offered no details concerning the specific
                               - 35 -

concrete contracting companies covered in the survey upon which

he based his opinion.    He also offered no information on the

particular qualifications, skills, services, or compensation of

the executives of those companies.      We thus are unable to

determine:    (1) How similar these other unidentified companies

and their businesses are to petitioner; and (2) how similar the

services their officers performed are to the services performed

by Mr. Myers and Mrs. Myers.

     Furthermore, although Mr. Gelfond opined that the $1,113,800

in compensation paid to Mr. Myers and Mrs. Myers that year was

reasonable, he failed to address the contribution for their

benefit to petitioner’s qualified retirement plan.      This

retirement plan contribution represented significant additional

compensation to Mr. Myers and Mrs. Myers and was part of their

total compensation package during petitioner’s fiscal year ended

July 31, 1996.

     The Memorandum of Board Action authorizing petitioner’s

entry into the deferred compensation agreements, asserts that the

additional future payments of $488,000 were to remedy

petitioner’s past substantial undercompensation of Mr. Myers and

Mrs. Myers.    However, as discussed more fully infra pp. 45-47,

petitioner and Mr. Gelfond presented no further analysis or

explanation of (1) the amount of Mr. Myers’ and Mrs. Myers’ prior

undercompensation during petitioner’s earlier years of operation,

or (2) the additional compensation needed in later years to
                               - 36 -

remedy that undercompensation.   As noted by respondent’s expert,

Mr. Myers and Mrs. Myers were extremely well compensated

commencing with petitioner’s 1993 fiscal year.   We thus give

little weight to petitioner’s and Mr. Gelfond’s unsupported

contention that petitioner’s prior undercompensation of Mr. Myers

and Mrs. Myers still remained largely unremedied when the

deferred compensation agreements were entered into.21

     We also reject Mr. Gelfond’s suggestion that Mr. Myers and

Mrs. Myers are entitled to the compensation that would be

provided to six full-time executives/employees serving as

petitioner’s chief executive officer, chief financial officer,

chief operating officer, bookkeeper, personnel manager, and

office manager.   Although Mr. Myers and Mrs. Myers may have

performed some of the duties of six such executives/employees,

they did not perform work equal to the full-time services of six

such executives/employees.22

     21
      Petitioner also asserts that the amounts it treated as
constructive dividends under its settlement with respondent for
its 1993 and 1994 fiscal years, still represented reasonable
compensation to Mr. Myers and Mrs. Myers for purposes of the
case. We draw no adverse inference from petitioner’s subsequent
treatment as dividends under that settlement of part of its 1993
and 1994 fiscal year compensation to Mr. Myers and Mrs. Myers.
See also Fed. R. Evid. 408.
     22
      This Court and other courts in numerous reasonable
compensation cases have considered the employee-recipient’s
performance of more than one function for the employer but have
concluded that the recipient’s reasonable compensation should be
less than the sum of the amounts paid to full-time employees each
of whom occupied one such position. See, e.g., Labelgraphics,
                                                    (continued...)
                                - 37 -

     In sum, Mr. Gelfond failed to compare the executive

compensation provided by other companies he surveyed with the

situation presented in the case at hand.    Consequently, we give

his opinion little weight on the issue of comparability of

compensation paid by similar companies.

Respondent’s Expert

     Respondent’s expert Stuart J. Packard is employed as a

general engineer and valuation and compensation specialist with

the Internal Revenue Service.    He has a bachelor of science

degree in mechanical and civil engineering and also has been a

licensed professional builder in the State of Michigan.

     Mr. Packard opined that reasonable compensation to Mr. Myers

for petitioner’s year ended July 31, 1996, would be $300,000, and

that reasonable compensation to Mrs. Myers for that year would be

$200,000.23

     In arriving at those reasonable compensation amounts for Mr.

Myers and Mrs. Myers, Mr. Packard relied heavily on three



     22
      (...continued)
Inc. v. Commissioner, T.C. Memo. 1998-343 n.6, affd. 221 F.3d
1091 (9th Cir. 2000).
     23
      This $500,000 in total combined compensation to Mr. Myers
and Mrs. Myers for the 1996 fiscal year that respondent’s expert
Mr. Packard opined was reasonable is less than the amount
respondent determined in the notice of deficiency. However,
respondent has not sought to amend his answer to assert an
increased deficiency.
                              - 38 -

surveys:   (1) The 1996/1997 Watson Wyatt Data Services survey of

over 1,700 companies throughout the nation in various industries

(Watson Wyatt survey) (which survey according to Packard’s report

included an unspecified number of companies in the construction

industry); (2) the 1995 Conference Board, Inc., survey of over

1,000 private and public companies throughout the nation in

various industries (Conference Board survey) (which survey

covered 12 companies in the construction industry--nine of which

had 1994 sales of $200 million or more and three of which had

1994 sales of $199 million or less); and (3) his own survey of

seven residential homebuilding companies.   Mr. Packard then

applied regression analysis24 to the survey sample data (either by

the Watson Wyatt or Conference Board surveys themselves or by Mr.

Packard) to calculate the mathematically indicated relationship

between two chosen factors (e.g., annual sales of each company


     24
      As explained in an excerpt from the Watson Wyatt survey
attached to Mr. Packard’s report, regression analysis is a
statistical analytical technique that examines the relationship
between two selected variables (e.g., compensation and sales
volume). The data from each surveyed organization is plotted on
a graph. For instance, a company’s sales volume is measured
along the horizontal (x) axis, and compensation is measured along
the vertical (y) axis. Assuming sufficient data is available to
provide a realistic picture of the relationship between
compensation and sales volume, a regression formula using the
“least squares method” is used to calculate the mathematical
equation that provides the “best fit” to the data. The resulting
equation (y = bx + a) can then be used to estimate the y for any
value of x within the range of the model. The appropriate range
of the model is determined by the data on which it is estimated.
                                       - 39 -

versus its compensation to its chief executive officer).                         From

the calculated mathematical relationship between these two

selected factors among companies in each survey, Mr. Packard then

extrapolated and computed what he thought the suggested

compensation (based on each particular survey) should be for the

top two executive officers in a construction industry company

having the same annual sales or net income that petitioner had

for its 1996 fiscal year in issue.

      Mr. Packard further averaged the suggested compensation he

determined for the two top officers of a company having the same

annual sales as petitioner under (1) his own survey, (2) his

percentage of income method, (3) the Watson Wyatt survey, and (4)

the Conference Board survey.               Based on this foregoing

information, Mr. Packard concluded and opined that reasonable

compensation for Mr. Myers and Mrs. Myers for petitioner’s fiscal

year ended July 31, 1996, would be as follows:
                                 Mr.        Percentage   Watson     Conference
                               Packard’s    of Income    Wyatt        Board
                               Survey        Method      Survey       Survey
Average1

Chairman, President, and CEO   $242,663      $303,479    $154,762     $381,140
$270,511
Second In Command, Chief        169,864       212,436     119,456      277,116
194,718
  Operating Officer (COO)

Total Executive Compensation    412,527       515,915     274,218      658,256
465,229
  Two Top Officers
1
 Sum of compensation Mr. Packard determined for the officer based on each of the
three surveys and his percentage of income method, divided by 4.

      Recommended Top Executive Compensation

      William Myers, Chairman, President, and CEO          $300,000

      Connie Myers, COO, Secretary, Treasurer, and          200,000
        Chief Financial Officer

      Total Executive Compensation Allowable                500,000
                              - 40 -


     Although statistical surveys analyzing the top executive

compensation paid by other construction companies can sometimes

be useful for comparison purposes in examining the reasonableness

of compensation, such statistical surveys are not dispositive.

More importantly, the companies covered in the Watson Wyatt and

Conference Board surveys were not reasonably comparable to

petitioner.   Mr. Packard acknowledged that the Watson Wyatt

survey was “normally more appropriate for companies with [annual]

sales in excess of $100 million.”   Similarly, the Conference

Board survey also covered construction companies that were

generally many times the size of petitioner.

     With respect to his own survey of seven other residential

homebuilding companies, Mr. Packard provided few specifics

regarding these companies he selected, omitting, among other

things, their number of employees, the business conditions in the

area in which they operated, and how similar their businesses

were to petitioner’s business.   It appears that those seven

residential homebuilding companies had annual sales ranging from

$5.938 million to $55.628 million, and that their shares were

publicly traded.   Of those seven companies, the company having

the second lowest annual sales had sales of $17.678 million.    In

addition, Mr. Packard failed to elaborate on the particular

skills and qualifications of the individual executives in those

companies, and the similarities or dissimilarities of their

services to those performed by Mr. Myers and Mrs. Myers.
                               - 41 -

     The surveyed companies that Packard relied upon were

generally much larger companies that were not reasonably

comparable to petitioner.   We do not believe that reasonable

compensation to Mr. Myers and Mrs. Myers should be based upon the

compensation paid to executives of the companies surveyed by Mr.

Packard.25   Accordingly, we also give Mr. Packard’s opinion little

weight on the issue of comparability of compensation paid by

similar companies.26


     25
      Indeed, Mr. Packard essentially assumed that the same
mathematical relationship (calculated through regression
analysis) between the surveyed companies’ sales or net income and
those companies’ compensation to their executives, should hold
equally true for petitioner. However, we are not convinced that
assumption is valid. In explaining the regression analysis
technique, the Watson Wyatt survey notes that “Regression
equations are recommended for use in making direct comparisons
between management compensation in your own organization and that
paid by comparable organizations.”   Moreover, Mr. Packard failed
to explain what, if any, adjustments he had made to take into
account the substantial differences between those surveyed
companies and petitioner. For instance, with respect to the
Watson Wyatt survey, Mr. Packard merely stated: “The information
* * * [from that survey] correlated well against the salaries
paid to public executives for similarly sized large companies but
correlated less well to the compensation paid to the CEO’s of
small companies. The report did however correlate well with
compensation and salaries paid to the non-owner employees of
companies regardless of the size of the company.”
     26
      To be sure, some of the survey data does indicate that the
$1,113,800 in total compensation Mr. and Mrs. Myers were paid for
petitioner’s year ended July 31, 1996, was high. Yet, for this
data to establish persuasively that the compensation paid Mr. and
Mrs. Myers was unreasonably high, further analysis by
respondent’s expert was required. Among other things, the total
compensation packages furnished the executives working for the
much larger companies surveyed should have been evaluated and
compared against the total compensation package petitioner
                                                    (continued...)
                              - 42 -

     This factor is neutral because neither petitioner’s expert

Mr. Gelfond nor respondent’s expert Mr. Packard proffered

persuasive comparable pay data.

     H. Petitioner’s Salary Policy to All Its 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 whether Mr. and Mrs. Myers were

compensated differently from petitioner’s other employees solely

because of their status as shareholders.

     Petitioner’s other employees (its construction workers) were

compensated on a totally different basis from Mr. Myers and Mrs.

Myers (its two sole officer-director-shareholders and the only

members of its management team).    The construction workers were

compensated on an hourly basis.    Mr. Myers testified that the

construction workers (who were nonunion) received hourly wages,

including higher hourly wages for any overtime work, and were

paid weekly, and that he tried to pay them above average wages

for the area.   However, he added, petitioner had no uniform pay



     26
      (...continued)
furnished Mr. and Mrs. Myers. In this connection, we note that
top executives of large, publicly traded companies often will
receive stock options and deferred compensations as part of their
compensation package. However, the record in the case at hand
does not disclose what, if any, stock options the executives
surveyed received. See, e.g. Labelgraphics, Inc. v.
Commissioner, 221 F.3d 1091, 1097-1098 n.9 (9th Cir. 2000).
                               - 43 -

scale for its construction workers, as Mr. Myers set each

worker’s hourly wage rate on an individual basis.    The workers

further all usually received Christmas bonuses, and certain key

workers were paid additional bonuses.

     In contrast, Mr. Myers and Mrs. Myers annually have set

their own compensation.

     For obvious reasons, Mr. and Mrs. Myers, who were the only

members of petitioner’s management team, were compensated on a

different basis from petitioner’s construction workers.    No other

employees of petitioner performed services similar to those of

Mr. and Mrs. Myers.

     This factor is neutral.

     I. Compensation Paid to Mr. Myers and Mrs. Myers
        in Previous Years

     Where a large salary increase is in issue (as in the case at

hand), it may be useful to compare past and present duties and

salary payments, Elliotts, Inc. v. Commissioner, 716 F.2d at

1245, in order to determine whether and to what extent the

current payments represent compensation for services performed in

prior years, which can be currently deductible.     Lucas v. Ox

Fibre Brush Co., 281 U.S. 115, 119-120 (1930); Am. Foundry v.

Commissioner, 59 T.C. 231, 239 (1972), affd. in part and revd. in

part 536 F.2d 289 (9th Cir. 1976).

     As indicated previously, respondent’s expert Mr. Packard

acknowledged that Mr. and Mrs. Myers were undercompensated during
                                 - 44 -

petitioner’s early years of operation.       However, he also noted

that Mr. and Mrs. Myers were extremely well compensated

commencing with petitioner’s 1993 fiscal year.        Mr. Packard

opined that petitioner’s undercompensation of Mr. and Mrs. Myers

in prior years had been fully remedied by the beginning of the

1996 fiscal year in issue.

     From January 1, 1987 through July 31, 1996, petitioner

paid Mr. and Mrs. Myers the annual amounts of compensation and

had the net income (before taxes and officer compensation) set

forth below.

                                             Total
    FYE                                     Officer
  July 31      Mr. Myers   Mrs. Myers     Compensation   Net Income

    1987       $30,000      $6,750          $36,750        $58,299
    1988        54,500      12,950           67,450        141,745
    1989        43,000      15,050           58,050        104,705
    1990        83,000      29,650          112,650        158,100
    1991       173,600      12,500          186,100        251,012
    1992       165,000      65,000          230,000        233,852
    1993       457,785     156,000          613,785        689,195
    1994       630,750     271,750          902,500      1,192,457
    1995       455,000     247,500          702,500        778,656
    1996       749,500     364,300        1,113,800      1,051,896

     We agree that Mr. and Mrs. Myers received relatively modest

compensation during petitioner’s early years of operation, and

that petitioner’s business in those years was not generating

sufficient net income for it to have paid Mr. Myers and Mrs.

Myers substantially higher compensation and also to have repaid

the $77,237 of advances.      As Mr. and Mrs. Myers testified, during

those early years, they took less annual compensation in order to
                                - 45 -

build up petitioner, as they did not want petitioner to borrow

from third parties.

     However, petitioner provided insufficient evidence to

establish the amount of the undercompensation of Mr. and Mrs.

Myers during its early years.    Neither did petitioner and its

expert address whether such past undercompensation had been

recovered through its 1996 fiscal year in issue.    There are only

some vague statements in the record by Mr. Myers and Mrs. Myers

that this past undercompensation (which they and petitioner’s

expert failed to quantify) never had been made up to them.    The

fact of undercompensation in the past alone is not enough.    For a

reasonable compensation deduction for a subsequent year in issue

to be allowed to a taxpayer-employer for purportedly remedying

alleged undercompensation of an employee in earlier years, the

taxpayer-employer must, among other things, establish (1) the

amount of its undercompensation of that employee in those earlier

years, and (2) that this past undercompensation still remained

unremedied by the later year in issue.    Am. Foundry v.

Commissioner, supra at 239-240; Labelgraphics, Inc. v.

Commissioner, T.C. Memo. 1998-343.

     During the trial, the Court pointed out the need for

petitioner to provide persuasive evidence establishing what part

of the 1996 fiscal year compensation in issue to Mr. and Mrs.

Myers was catchup pay.   Also, as noted supra, the Memorandum of

Board Action covering the compensation package furnished Mr. and
                              - 46 -

Mrs. Myers during the 1996 fiscal year indicated another $488,000

in “deferred compensation” petitioner agreed to pay was to remedy

its alleged substantial undercompensation of them in prior years.

The Memorandum stated that the board, after an exhaustive review

of the compensation of Mr. and Mrs. Myers since petitioner’s

inception, determined that Mr. and Mrs. Myers had been

substantially undercompensated in prior years.    Yet, no

convincing analysis or review data was entered in evidence by

petitioner.   Neither petitioner nor its expert Mr. Gelfond

addressed what amount, if any, of catchup pay to Mr. and Mrs.

Myers was still required as of the 1996 fiscal year in issue.

     Mr. and Mrs. Myers have been extremely well compensated

since petitioner’s 1993 fiscal year.   Hence petitioner’s past

undercompensation of them might very well have been fully

recovered before its 1996 fiscal year in issue.    Moreover, the

Memorandum of Board Action is susceptible to the interpretation

that the sole remedy for any undercompensation of prior years was

to be the $488,000 of deferred compensation payments.    We

conclude that petitioner has failed to establish that any part of

the salary payments respondent disallowed for its 1996 fiscal

year in issue qualifies as reasonable compensation to Mr. Myers

and Mrs. Myers for past services in prior years.    Rule 142(a);

Am. Foundry v. Commissioner, supra; Labelgraphics, Inc. v.
                             - 47 -

Commissioner, supra.

     This factor favors respondent.

     J. Independent Investor Test and Petitioner’s Financial
        Performance

     As indicated previously, the Courts of Appeals for the

Second, Seventh, and Ninth Circuits have applied an independent

investor test in determining whether payments to an employee-

shareholder are deductible by a taxpayer-corporation as

reasonable compensation under section 162.

     In applying their respective versions of the independent

investor test, the Courts of Appeals for the Second and Ninth

Circuits have considered many of the same or similar factors in

determining reasonable compensation as examined above, and they

have used the same totality of the circumstances approach adopted

by the Court of Appeals for the Tenth Circuit in Pepsi-Cola

Bottling Co. of Salina, Inc. v. Commissioner, 528 F.2d at 179.

Dexsil Corp. v. Commissioner, 147 F.3d 96, 100-101 (2d Cir. 1998)

(noting that the independent investor test applied is not a

separate autonomous factor; rather, it provides a lens through

which the entire analysis should be viewed), vacating and

remanding T.C. Memo. 1995-135; Rapco, Inc. v. Commissioner, 85

F.3d 950, 954-955 (2d Cir. 1996) (applying a multifactor test

from perspective of an independent investor), affg. T.C. Memo.

1995-128; Elliotts, Inc. v. Commissioner, 716 F.2d at 1245

(same).
                             - 48 -

     The Court of Appeals for the Seventh Circuit, on the other

hand, treats a corporation’s enjoyment of a higher than average

return on shareholder equity as presumptively establishing the

reasonableness of a shareholder-officer’s compensation, without

regard to the multifactor analysis.   Exacto Spring Corp. v.

Commissioner, 196 F.3d 833, 838-839 (7th Cir. 1999), revg. T.C.

Memo. 1998-220.

     Central to both variants of the independent investor test is

the need to examine the return on equity of the taxpayer-

corporation (where the employee-shareholder receiving the

compensation in issue also controls that taxpayer) from the

perspective of a hypothetical independent investor.    As the Court

of Appeals for the Ninth Circuit explained in Elliotts, Inc. v.

Commissioner, supra at 1245-1247:

          In evaluating the reasonableness of compensation
     paid to a shareholder-employee, particularly a sole
     shareholder, it is helpful to consider the matter from
     the perspective of a hypothetical independent investor.
     A relevant inquiry is whether an inactive, independent
     investor would be willing to compensate the employee as
     he was compensated. The nature and quality of the
     services should be considered, as well as the effect of
     those services on the return the investor is seeing on
     his investment. The corporation’s rate of return on
     equity would be relevant to the independent investor in
     assessing the reasonableness of compensation in a small
     corporation where excessive compensation would
     noticeably decrease the rate of return.

          *       *     *      *      *      *        *

          In this case, where * * * [the employee
     receiving the compensation in issue] was the sole
     shareholder, the sort of relationship existed that
                              - 49 -

     warrants scrutiny. The mere existence of such a
     relationship, however, when coupled with an absence of
     dividend payments, does not necessarily lead to the
     conclusion that the amount of compensation is
     unreasonably high. Further exploration of the
     situation is necessary.

          In such a situation, as discussed earlier, it is
     appropriate to evaluate the compensation payments from
     the perspective of a hypothetical independent
     shareholder. If the bulk of the corporation’s earnings
     are being paid out in the form of compensation, so that
     the corporate profits, after payment of the
     compensation, do not represent a reasonable return on
     the shareholder’s equity in the corporation, then an
     independent shareholder would probably not approve of
     the compensation arrangement. If, however, that is not
     the case and the company’s earnings on equity remain at
     a level that would satisfy an independent investor,
     there is a strong indication that management is
     providing compensable services and that profits are not
     being siphoned out of the company disguised as salary.
     [Fn. ref. omitted.]

     Even under the variants of the independent investor test

applied by the Courts of Appeals for the Second, Seventh, and

Ninth Circuits, a firm’s high or low return on equity may not be

dispositive of the reasonableness of a shareholder-officer’s

compensation.   Exacto Spring Corp. v. Commissioner, supra at 839

(noting possible situations where presumption of compensation’s

reasonableness may be rebutted by showing that company’s high

return was not due to shareholder-officer’s efforts); Elliotts,

Inc. v. Commissioner, 716 F.2d at 1247 n.5 (noting a shareholder-

employee’s compensation may be reasonable even though company

suffers a loss or inadequate return on equity).

     Petitioner and its expert Mr. Gelfond contend that an

independent investor would be satisfied with the 43.82 percent
                              - 50 -

compounded annual rate of return they calculate was enjoyed

through the year ended July 31, 1996, on that investor’s initial

$10,000 investment in the corporation.   Mr. Gelfond computed this

43.82 percent compounded annual rate by using a present-value-

future-value formula where:   Present value equals $10,000 (the

shareholder initial investment); future value equals $378,542

(the company’s stated “equity” or net book asset value at the end

of the 1996 fiscal year before consideration of its deferred

payment obligation to Mr. Myers and Mrs. Myers); and N (the

number of years over which that investment is annually

compounded) equals 10.

     Under the independent investor test, a company’s annual

return on equity usually examines that company’s net income after

taxes for that year.   More importantly, the shareholders’ equity

in the company, upon which an annual return is calculated,

includes not just the shareholders’ initial invested capital but

the company’s prior accumulated earnings.   Dexsil Corp. v.

Commissioner, 147 F.3d at 99; Labelgraphics, Inc. v.

Commissioner, T.C. Memo. 1998-343; see also Exacto Spring Corp.

v. Commissioner, supra at 837 (noting, among other things, that

“What investors care about is the corporate income available to

pay dividends or be reinvested”), revg. T.C. Memo. 1998-220;

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1326-

1327 (5th Cir. 1987) (noting that the prime indicator of the
                               - 51 -

return a corporation is earning for its investor is its return on

equity).

     In Eberl’s Claim Serv., Inc. v. Commissioner, T.C. Memo.

1999-211, we rejected the taxpayer’s argument that the

corporation’s “return on equity” should be based on its founding

shareholder’s small initial investment of $500, and noted that

the taxpayer had cited no case in which a court gave significant

weight to a high return based on a founding shareholder’s small

initial investment.    We explained that the courts have instead

relied on other financial factors when a shareholder’s capital

investment is small, citing Alpha Med., Inc. v. Commissioner, 172

F.3d 942 (6th Cir. 1999) (Court derived return on equity by

taking increase in equity for the year at issue plus the

dividends paid that year, divided by shareholder’s $1,000 capital

investment plus retained earnings at the beginning of that year)

revg. T.C. Memo. 1997-464 n.8; Labelgraphics, Inc. v.

Commissioner, T.C. Memo. 1998-343 (cumulative average return on

equity may be skewed by high annual returns for earlier years in

which equity was low); H&A Intl. Jewelry, Ltd. v. Commissioner,

T.C. Memo. 1997-467.

     In contrast to petitioner, respondent, among other things,

calculated petitioner’s return on equity as equaling petitioner’s

net income for a year, divided by petitioner’s equity at the

beginning of that year.    We note that in various reasonable
                                               - 52 -

compensation cases, three different approaches generally have

been used to compute a company’s return on equity.                            The company’s

net income that year has been divided by either:                           (1) Its equity

at the beginning of that year (e.g., Alpha Med., Inc. v.

Commissioner, T.C. Memo. 1997-464 n.8, (2) its ending equity that

year (e.g., Labelgraphics, Inc. v. Commissioner, T.C. Memo. 1998-

343), or (3) the year’s average equity (e.g., Dexsil Corp. v.

Commissioner, 147 F.3d at 99.

            Over the period from January 1, 1987, through July 31, 1996,

petitioner’s annual net profit or net loss after taxes, equity

(beginning, yearend, and year’s average), and return on equity

(calculated under each of the three foregoing approaches,

before consideration of petitioner’s “deferred compensation”

obligation to Mr. and Mrs. Myers) are as set forth below:
                   Net Profit                 Equity                      Return on Equity2
        FYE        (Net Loss)    Begin.      Yearend       Year’s     Begin. Yearend    Year’s
      July 31      After Taxes   Equity       Equity      Avg. Eq.1   Equity   Equity   Avg.
Eq.

          1987      $18,317      $10,000      $31,405     $20,703     183.17%  58.33%  88.48%
          1988       60,729       31,405      101,931      66,668     193.37   59.58   91.09
          1989       46,655      101,931      134,073     117,502      45.77   34.80   39.54
            1990       38,632      134,073      172,011     153,042      28.81   22.46   25.24
          1991       53,684      172,011      218,462     195,237      31.21   24.57   27.50
          1992        3,274      218,462      221,554     220,008       1.50    1.48    1.49
          1993       61,521      221,554      282,989     252,272      27.77   21.74   24.39
          1994      193,624      282,989      475,808     379,399      68.42   40.69   51.03
          1995       59,292      475,808      534,443     505,126      12.46   11.09   11.74
          1996      (61,904)     534,443      378,542     456,493     (11.58) (16.35) (13.56)
      1
          Sum of beginning equity plus yearend equity, divided by 2.
      2
          Net profit or net loss after taxes, divided by equity.

            Regardless of which of the three approaches is used to

calculate petitioner’s return on equity, for the 1996 fiscal year

in issue petitioner suffered a negative return on equity even
                                         - 53 -

before consideration of petitioner’s “deferred compensation”

obligation to Mr. and Mrs. Myers.

      Some prior reasonable compensation cases have also examined

and considered the taxpayer’s cumulative average return on

equity.    E.g., Labelgraphics, Inc. v. Commissioner, 221 F.3d

1091, 1099 (9th Cir. 2000); Dexsil Corp. v. Commissioner, T.C.

Memo. 1999-155.          From January 1, 1987, through July 31, 1996,

petitioner’s annual return on equity (under each of the three

approaches used supra, before consideration of petitioner’s

“deferred compensation” obligation to Mr. and Mrs. Myers) and

cumulative average return on equity (without regard to the

deferred compensation obligation) are as set forth below:
                      Return on Equity            Cum. Avg. Return on Equity1
  FYE        Begin.       Yearend      Year’s     Begin.    Yearend      Year’s
July 31      Equity        Equity     Avg. Eq.    Equity     Equity      Avg. Eq.

  1987        183.17%    58.33%      88.48%       183.17%     58.33%      88.48%
  1988        193.37     59.58       91.09        188.27      58.96       89.79
  1989         45.77     34.80       39.54        140.77      50.90       73.04
  1990         28.81     22.46       25.24        112.78      43.79       61.09
  1991         31.21     24.57       27.50         96.47      39.95       54.37
  1992          1.50      1.48        1.49         80.64      33.54       45.56
  1993         27.77     21.74       24.39         73.09      31.85       42.53
  1994         68.42     40.69       51.03         72.50      32.96       43.60
  1995         12.46     11.09       11.74         65.83      30.53       40.06
  1996        (11.58)   (16.35)     (13.56)        58.09      25.84       34.69
1
  Sum of current year’s return on equity and each prior year’s return on equity,
divided by petitioner’s number of years of operation through current year.

      In our opinion, the cumulative average annual return on

equity petitioner experienced over the period from January 1,

1987 through July 31, 1996, would not be as significant to an

independent investor as petitioner’s return on equity for the
                              - 54 -

current 1996 fiscal year in issue.     This higher cumulative

average annual return is skewed by the much higher annual returns

on equity petitioner enjoyed during its early years of operation,

when its equity was much lower.   See, e.g. Labelgraphics, Inc. v.

Commissioner, 221 F.3d at 1099 (88.5-percent return on $43,482

equity enjoyed during the taxpayer’s first year of operation is

not particularly meaningful to a present investor judging return

on the current year’s equity in excess of $1 million).     In

addition, the higher cumulative average return on equity is even

less significant where, as discussed previously, petitioner’s

past undercompensation of Mr. and Mrs. Myers, during prior years

of operation, to the extent not fully recovered prior to the 1996

fiscal year in issue, was intended to be remedied by the deferred

compensation agreements adopted during that year.    See also,

e.g., Wagner Constr., Inc. v. Commissioner, T.C. Memo. 2001-160.

     At any rate, petitioner has failed to show that an

independent-investor-return-on-equity analysis establishes that

the compensation in issue paid to Mr. and Mrs. Myers for its year

ended July 31, 1996, was reasonable.27    For that year, even before


     27
      Petitioner further failed to address respondent’s argument
that the $77,237 advance Mr. and Mrs. Myers made to it in 1987
should also be included in shareholder invested capital for
purposes of calculating petitioner’s annual return on equity.
Although petitioner did repay or distribute an amount equal to
the $77,237 advance to Mr. and Mrs. Myers during its first 4
years of operation, petitioner provided neither a factual record
nor legal argument that would enable the Court properly to
determine whether the advance represented debt or equity, or
                                                    (continued...)
                              - 55 -

consideration of its future deferred payment obligation to Mr.

and Mrs. Myers, petitioner had a $61,904 net loss after taxes,

suffered a negative return on equity (ranging from a negative

11.58-percent return to a negative 16.35-percent return under the

three approaches used supra to calculate its annual return on

equity), and experienced a $155,901 reduction in its equity or

net asset value (i.e., its $534,443 of equity at the beginning of

the 1996 fiscal year, less its $378,542 yearend equity).28   We do


     27
      (...continued)
should be considered part of petitioner’s invested capital for
the purpose of determining the overall compounded rate of return
that would be deemed to have accrued to an independent investor
as of the end of the fiscal year for which we must analyze
petitioner’s financial performance. Obviously, the addition of
the $77,237 to petitioner’s equity or invested capital would
reduce the compounded rate of return regarded as having accrued
as of the end of the fiscal year in issue to an independent
investor who had purchased all of petitioner’s capital stock at
its inception. It can also be argued that the debt-equity
distinction should have no bearing on assessing the overall
return that accrued on the total amount of funds--$87,237--made
available to petitioner by its officer-shareholders. See Pratt,
“The Debt-Equity Distinction in a Second-Best World”, 53 Vand. L.
Rev. 1056 (2000).
     28
      Petitioner notes that, although it reported a $61,904 net
loss after taxes for its 1996 fiscal year, $183,000 of the
bonuses paid to Mr. and Mrs. Myers that year were belated bonuses
to them for its 1995 fiscal year. Petitioner argues that this
$183,000, in effect, should be reallocated and treated as a
fiscal year 1995 business expense for purposes of determining its
annual returns on equity for its 1995 and 1996 fiscal years,
since the $183,000 was reasonable compensation for services Mr.
and Mrs. Myers rendered during the 1995 fiscal year. In the
notice of deficiency, respondent allowed petitioner a deduction
under sec. 162 for the $238,800 in total bonuses it paid to Mr.
and Mrs. Myers during the 1996 fiscal year. We conclude that
petitioner’s reallocation argument does not help its case. If
                                                    (continued...)
                             - 56 -

not believe an independent investor would be happy with

petitioner’s financial performance for its 1996 fiscal year,

especially where the total officer compensation paid to Mr. and

Mrs. Myers for that year was almost three times the investor’s

year-end equity in the company ($1,113,800, divided by

$378,542).29

     This factor favors respondent.




     28
      (...continued)
the $183,000 bonus payment is reallocated to petitioner’s 1995
fiscal year, petitioner, would have a revised net loss after
taxes for that year of $123,708, a revised yearend equity of
$368,307, and a revised return on equity ranging from a negative
26.00 percent to a negative 33.59 percent (under the three
approaches used supra). We think petitioner’s resulting negative
return on equity for fiscal year 1995 would be equally
unsatisfactory to an independent investor.
     29
      Under an independent-investor-return-on-equity-analysis
the corporation’s greatly increased market value can also be
probative of the value of a shareholder-officer’s services.
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1326
(5th Cir. 1987), affg. T.C. Memo. 1985-267 (noting that an
investor may garner a return on investment through stock
appreciation); Elliotts, Inc. v. Commissioner, 716 F.2d 1241,
1247 n.6 (9th Cir. 1983), revg. and remanding T.C. Memo. 1980-
282. However, petitioner offered no evidence or argument
regarding appreciation in the market value of its stock.
                              - 57 -

K. Conclusion

     Petitioner has failed to show it is entitled to a larger

compensation deduction under section 162 than respondent allowed

in the statutory notice.   We therefore sustain respondent’s

determination disallowing petitioner’s deduction of $353,911 of

the salaries paid to Mr. and Mrs. Myers for the year ended July

31, 1996.   Rule 142(a); Pepsi-Cola Bottling Co. of Salina, Inc.

v. Commissioner, 528 F.2d at 179; Nor-Cal Adjusters v.

Commissioner, 503 F.2d at 361.

                                         Decision will be entered

                                    for respondent.
                                                       - 58 -




                     APPENDIX – ANNUAL COMPENSATION PAID MR. MYERS AND MRS. MYERS
                              FROM JANUARY 1, 1987, THROUGH JULY 31, 1996


                FYE       FYE       FYE       FYE        FYE       FYE        FYE        FYE        FYE        FYE
              7/31/87   7/31/88   7/31/89   7/31/90    7/31/91   7/31/92    7/31/93    7/31/94    7/31/95    7/31/96

Mr. Myers-
                 1         1         1         1
  Salary                                              $60,000    $100,000   $100,000   $100,000   $100,000   $586,500
                 1         1         1         1
  Bonus                                               113,600      65,000    357,785    530,750    355,000    163,0002
  Total       $30,000   $54,500   $43,000   $83,000   173,600     165,000    457,785    630,750    455,000    749,500

Mrs. Myers-
                 1         1         1         1
  Salary                                               $10,000    $12,000   $30,000    $30,000    $60,000    $288,500
                 1         1         1         1
  Bonus                                                  2,500     53,000   126,000    241,750    187,500      75,8003
  Total        $6,750   $12,950   $15,050   $29,650     12,500     65,000   156,000    271,750    247,500     364,300
1
  No breakdown between salary and bonus is available for the period from January 1, 1987, through July 31, 1990.
2
  Of this $163,000, $125,000 was said to be a bonus for fiscal year 1995 and $38,000 a bonus for fiscal year 1996.
3
  Of this 75,800, $58,000 was said to be a bonus for fiscal year 1995 and $17,800 a bonus for fiscal year 1996.
