                          T.C. Memo. 2013-97




                   UNITED STATES TAX COURT




     ARIES COMMUNICATIONS INC. & SUBS., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent




Docket No. 27483-10.                          Filed April 10, 2013.




      R determined that the compensation P paid to E, its employee
and owner, was unreasonable and disallowed its deduction for the tax
year ending Aug. 31, 2004.

       Held: E’s compensation was reasonable and deductible under
I.R.C. sec. 162 to the extent determined herein.

      Held, further, P is liable for a portion of the I.R.C. sec. 6662(a)
accuracy-related penalty as redetermined in this opinion.




Vicken Abajian, for petitioner.

Aaron T. Vaughan, for respondent.
                                         -2-

[*2]         MEMORANDUM FINDINGS OF FACT AND OPINION


       WHERRY, Judge: This case is before the Court on a petition for

redetermination of a deficiency in income tax and a penalty respondent determined

for petitioner’s tax year ended (TYE) August 31, 2004.1

       After concessions the issues remaining are:2

       (1) whether the compensation paid to N. Arthur Astor was reasonable under

section 162 for TYE August 31, 2004; and

       (2) whether petitioner is liable for a section 6662(a) accuracy-related penalty

for TYE August 31, 2004.




       1
        Unless otherwise indicated, all section references are to the Internal Revenue
Code of 1986, as amended and in effect for the taxable year at issue. All references
to a tax year are to the fiscal year ended on August 31 of that year, unless otherwise
stated. All Rule references are to the Tax Court Rules of Practice and Procedure.
       2
        The parties agree that the period of limitations on assessment was properly
extended and has not expired for TYE August 31, 2004. Petitioner concedes that it
is not entitled to deduct $550,000 of rental expenses for the year at issue. Petitioner
concedes that it failed to report $93,671 of imputed interest under sec. 7872, and
respondent concedes the remainder, $1,298,457, of the imputed interest set forth in
the notice of deficiency. Respondent concedes that the sec. 6662(a) accuracy-
related penalty does not apply to the underpayment of tax caused by petitioner’s
failure to recognize imputed interest under sec. 7872. Respondent concedes that
petitioner generated a net operating loss (NOL) of $2,677,686 during its 2005 tax
year and that, subject to computational adjustments, petitioner is entitled to carry
back this NOL and claim it as a deduction for the year at issue.
                                           -3-

[*3]                             FINDINGS OF FACT

       The parties’ stipulation of facts, with accompanying exhibits, and the

stipulation of settled issues are incorporated herein by this reference.3 At the time

petitioner filed the petition, its principal place of business was in California.

N. Arthur Astor

       N. Arthur Astor has been in radio broadcasting for over 60 years. He was

involved in several television shows, did a little film work, and worked as a talent in

radio broadcasting before he decided to become involved in broadcasting sales.

After many years of managing sales for a multitude of different radio broadcasting

companies, Mr. Astor in June 1970 was employed as general manager of KADY, a

50,000-watt radio station in Los Angeles owned by Atlanta-based Rollins

Broadcasting. In 1975 he was employed by Dratch & Knott Enterprises, which

owned three radio stations and was the number one programing company supplying

programing and special features to radio stations nationally.




       3
       Petitioner objects to stipulated paras. 6, 21, 22, 24, 57, and 61-67 and
Exhibits 4-J, 5-J, 18-J, 19-J, and 22-J through 37-J on the grounds of relevance.
Fed. R. Evid. 401 states: “Evidence is relevant if: (a) it has any tendency to make a
fact more or less probable than it would be without the evidence; and (b) the fact is
of consequence in determining the action.” We overrule petitioner’s objections and
hold that the exhibits tend to make the reasonableness of Mr. Astor’s compensation
more or less probable.
                                         -4-

[*4]   About two years later Mr. Astor was offered a position as general manager of

a small FM radio station in Canoga Park, California, with ownership potential based

on performance levels. He met those performance requirements and after two years

of work earned 10% of the station and was then able to purchase another 10% of

that station for 10%, $31,200, of its original 1976 $312,000 purchase price. In 1983

Mr. Astor arranged for a loan and bought out his other partners to became the sole

owner of that station, KIKF.

       At the same time that Mr. Astor bought out his KIKF partners, he or an entity

he controlled also purchased two other radio stations, KTIM-AM and FM, in Marin

County, California. He then purchased two more stations, KOWN-AM and FM, in

San Diego, California, in 1987. He sold the two Marin County stations in 1994, and

he purchased an additional North San Diego station, KCEO, in 1995. In 1999 or

2000 Mr. Astor purchased another station, KSPA AM 1510, in Ontario, California,

from a friend.

       Mr. Astor bought and sold certain of these stations using petitioner, Aries

Communications Inc. (Aries), and its subsidiaries Orange Broadcasting Corp. and

North County Broadcasting Corp. (Orange Broadcasting and North County
                                        -5-

[*5] Broadcasting, respectively).4 Mr. Astor was Aries’ president, chief financial

officer (CFO), and sole shareholder from its incorporation in 1983. Mr. Astor acted

as general manager of each of petitioner’s radio stations. He was a “hands-on”

manager who was actively involved in many aspects of petitioner’s day-to-day

operations. Mr. Astor’s duties included: (1) oversight of petitioner’s other

management personnel; (2) planning and overseeing the execution of programming;

(3) negotiating and communicating with petitioner’s lenders; (4) participating in

sales meetings; and (5) communicating with outside advisers (such as lawyers and

accountants).

Susan E. Burke

      Susan Burke has served as the executive vice president and corporate

secretary for both Orange Broadcasting and North County Broadcasting from 1996.

Her duties included: (1) Federal Communications Commission (FCC) issues (e.g.,

license renewals and upgrades, consultation with counsel); (2) labor and

employment issues; (3) music licensing; and (4) review of documents, leases, and

contracts. During the year at issue petitioner paid Ms. Burke $288,654, including a

$200,000 bonus from Orange Broadcasting.


      4
       The Court takes judicial notice of FCC records indicating that Aries
purchased 94.3 FM and then transferred it to Orange Broadcasting in 1983.
                                          -6-

[*6] Aries Communications Inc.

      Aries and its two operating subsidiaries, Orange Broadcasting and North

County Broadcasting, are known as the Aries Consolidated Group. The Aries

Consolidated Group operated on a fiscal year that ran from September 1 through

August 31. Petitioner was a cash basis taxpayer until it changed its method of

accounting to the accrual basis in the year at issue. Petitioner filed consolidated

Federal income tax returns from 1998 through at least 2008. Petitioner earned

revenue by selling advertising spots on its radio stations.5

      Orange Broadcasting

      Orange Broadcasting was incorporated in 1976. From 1977 until 2003

Orange Broadcasting held the FCC license for 94.3 FM in Orange County,

California. During the 1980s and 1990s Orange Broadcasting aired a country music

radio station broadcast under the call letters KIKF. In 2000 Orange Broadcasting

changed the station’s format to an adult contemporary music station under the call

letters KMXN.

      On May 15, 2003, petitioner sold 94.3 FM to LBI Media and its subsidiary,

Liberman Broadcasting, Inc. (Liberman), for $35 million. Petitioner engaged


      5
      Petitioner sold 60-, 30-, and 10-second announcements and half-hour to hour
programs.
                                         -7-

[*7] Kalil & Co. (Kalil), a broker, to help sell 94.3 FM. Upon completion of the

sale petitioner paid Kalil $790,000 in accordance with the brokerage agreement.

Mr. Astor explained at trial that petitioner engaged the broker primarily to find

prospective purchasers he might not know about. He referred the broker to

potential purchasers he was aware of personally.

      Mr. Astor was personally involved in garnering the first bid of around $18 to

$20 million for 94.3 FM from Liberman. Mr. Astor knew that Liberman already

owned 94.3 FM in the San Fernando Valley, and he explained to Liberman that the

two stations together could form a quasi-Los Angeles station which would be much

more valuable than the two stations separately. After several rounds of phone calls

with Mr. Astor over the course of a year, Liberman advised that its final offer was

$28 million. Thereafter, Kalil, at Mr. Astor’s suggestion, sought and obtained a bid

from Entravision of $33 million. With this bid in hand, Kalil and Mr. Astor held a

telephone conference with Liberman where Mr. Astor explained that he would sell

94.3 FM only for $35 million. Liberman discussed this price with Mr. Astor and

ultimately agreed to it.
                                         -8-

[*8]   Orange Broadcasting’s unaudited financial documents reflected the following

net income (loss) and “Stockholders Equity” as of December 31 of each calendar

year listed below.6


                           2002            2003            2004             2005
 Net income (loss)    ($1,771,765)     $25,891,031    ($17,043,881)     ($1,532,436)
 Stockholders           (2,099,723)     23,765,122        6,721,242       4,376,865
 equity

       North County Broadcasting

       North County Broadcasting was incorporated in 1987. North County

Broadcasting owned three radio stations at the beginning of the year at issue: AM

1000 with call letters KCEO, AM 1450 with call letters KFSD, and 92.1 FM with

call letters KFSD (these were the stations originally purchased in 1987 with call

letters KOWN). Each of the three stations owned an FCC license to broadcast on

its respective frequency across portions of San Diego County and Riverside County,

California.


       6
        All amounts have been rounded to the nearest dollar. We note that these are
unaudited financial documents and the numbers do not add up year to year. We also
note that on the balance sheets 2004 was the only year in which retained earnings
was the same amount carried over from the prior December; however, it appears to
be the wrong amount if the income or loss account was closed to retained earnings.
Because the then-current 2004 calendar year income was negative in that year, when
the loss is subtracted from the stockholders equity (assets - liabilities) the retained
earnings apparently should be $23,765,122.
                                         -9-

[*9]   In April 2004 North County Broadcasting sold certain assets of 92.1 FM,

including FCC licenses, equipment, engineering data, and selected contracts to

Jefferson-Pilot Communications (Jefferson-Pilot). This sale did not include: the

Carlsbad Studio; certain equipment located there; vehicles, receivables, cash and

cash equivalents; North County Broadcasting’s name, programing materials and

information; and North County Broadcasting’s sales and marketing materials.

       Before the sale the president of Jefferson-Pilot informally contacted Mr.

Astor and offered $12 million for the station, which Mr. Astor rejected. The

president of Jefferson-Pilot then made a further offer of $15 million. Mr. Astor also

rejected this offer and informed Jefferson-Pilot that he wanted $18 million for the

station. After these negotiations petitioner again engaged Kalil to broker the sale of

92.1 FM for $18 million. Upon the completion of the sale of 92.1 FM, petitioner

paid Kalil $459,333.34.

       North County Broadcasting’s unaudited financial documents reflected the

following net income (loss) and “Stockholders Equity” at the end of each calendar

year listed below.7

       7
       We again note that these are unaudited financial documents, and the trial
record does not contain information on distributions to or equity contributions by
shareholders; consequently, the Court is unable to verify the reported retained
earnings. The Court notes that reported retained earnings for the previous year plus
                                                                         (continued...)
                                           - 10 -

           [*10]               2002                 2003           2004          2005
 Net income (loss)         ($1,269,102)          ($436,159)    $13,988,322    ($113,102)
 Stockholders equity         (7,286,271)        (7,731,116)      6,204,662     4,430,601

      Financial Results

      Petitioner reported the following for TYE August 31, 1999 through 2006:


               Gross                            Net profit
             operating      Taxable            (loss) after   Depreciation    Retained
  TYE         receipts      income                taxes         expense       earnings
 1999       $4,829,003      ($817,104)     ($817,104)           $148,078     ($3,533,253)
 2000        4,760,169       (887,413)          (887,413)        118,273     (4,472,578)
 2001        5,400,873     (1,172,231)     (1,172,231)           123,768     (6,004,001)
 2002        4,506,958     (1,415,651)     (1,415,651)           134,142     (7,641,199)
 2003        2,922,013     14,596,284          9,587,585         147,291     12,262,495
                                           1
 2004        1,131,744      3,902,092          4,025,956         269,406     12,725,862
 2005        1,341,503     (1,742,547)     (1,742,547)           108,396      9,618,745
 2006        1,514,492    (2,688,686)      (2,688,686)            90,319      6,863,724
  Total     26,406,755     9,774,744           4,889,909       1,139,673     19,819,795
      1
          Petitioner was owed a tax refund of $123,864.




      7
       (...continued)
or minus reported net income does not always total reported retained earnings for
the subsequent year.
                                        - 11 -

[*11] Although respondent disputes the characterization of the type of

compensation, the parties stipulated that petitioner paid Mr. Astor the following

compensation for TYE:


                  Aug. 31, 2002    Aug. 31, 2003     Aug. 31, 2004     Aug. 31, 2005
 Salary             $136,800          $136,800          $136,800         $136,800
 Commissions          123,205            68,035            62,474           56,347
 Bonus                  -0-           1,870,148        6,697,700             -0-
   Total              260,005         2,074,983        6,896,974           193,147

      Petitioner’s Form 1120, U.S. Corporation Income Tax Return, page 4 balance

sheet for 1998, the earliest return in the record, shows a common stock account

balance of $280,000 at the beginning of the year and a common stock account

balance of $120,000 at the end of the year. Thereafter, all of petitioner’s tax returns

in the record report a common stock account balance of $120,000.

      Petitioner guaranteed loans from Goldman Sachs Credit Partners L.P. to

Orange Broadcasting (Goldman Sachs debt) from as early as the end of the

calendar year 2001. Mr. Astor had also personally guaranteed the Goldman Sachs

debt. The total debt was $20 million. Petitioner’s December 31, 2001, financial

documents stated that petitioner and Goldman Sachs had entered into a

forbearance agreement which required petitioner to sell some of the radio stations
                                        - 12 -

[*12] to satisfy obligations under the Goldman Sachs debt before December 20,

2002. When the assets of Orange Broadcasting were sold, $32,784,836 of the $35

million gross proceeds was used to repay the Goldman Sachs debt, including $20

million of principal and $12,784,836 of interest.

      For the year at issue Aries’ Federal income tax return was prepared by

Thoerner & Toma certified public accountants of Orange County. They have been

preparing Mr. Astor’s returns for 20 to 25 years. Aries’ Federal income tax return

for TYE August 31, 2004, claimed a deduction for compensation paid to Mr. Astor

of $6,896,974.

Procedural Background

      Respondent issued petitioner a notice of deficiency on September 15, 2010,

disallowing $6,086,752 of petitioner’s claimed $6,896,974 deduction for

compensation paid to Mr. Astor and determining a deficiency of $2,676,002 and a

section 6662(a) accuracy-related penalty of $535,200.40 for TYE 2004. Petitioner

timely petitioned the Court on December 13, 2010. A trial was held on December

9, 2011, in Los Angeles, California.

Expert Report--Martin Wertlieb

      After the petition was filed petitioner commissioned Martin Wertlieb to

prepare a report on the amount of compensation, that in his opinion, petitioner
                                       - 13 -

[*13] could have reasonably paid Mr. Astor in TYE August 31, 2004. Mr. Wertlieb

has a bachelor of arts degree from the Baruch School of Business of the City

College of New York and graduate studies in management at New York University

and the University of California, Los Angeles. He has over 40 years of experience

in the compensation and personnel field and has been an expert witness on

reasonable compensation before the U.S. Tax Court and many other courts.

      In reaching his conclusions, Mr. Wertlieb examined the financial statements

of 10 publicly traded radio broadcasting companies. He calculated the pretax

revenues of these companies and compared them to that of Aries. Mr. Wertlieb also

compared the amount paid to Mr. Astor with the compensation paid to the CEOs of

the publicly traded corporations. He believes that because the corporations are

publicly traded and the compensation they pay is subject to the approval of the

boards of directors and State and Federal regulators, that compensation represents

arm’s-length transactions.

      Mr. Wertlieb explained in his report that fixed compensation tends to

correlate to annual company sales or revenues.8 Mr. Wertlieb applied a



      8
       Mr. Wertlieb defined fixed compensation as annual salary and any special
benefits provided to the individual. He defined variable compensation as annual
bonuses and the value of any stock awards or long-term incentive payouts made
during the year.
                                         - 14 -

[*14] mathematical formula using the statistical technique of linear regression or

“line of best fit” to show the correlation.9 Mr. Wertlieb used the trend lines for the

correlation of CEOs’ fixed compensation to annual revenues at the 75th percentile

range because of Mr. Astor’s experience in the industry and his status as the

owner/operator. Mr. Wertlieb also believes that variable compensation tends to

correlate to the company’s profitability. Mr. Wertlieb again used linear regression

analysis to show the correlation. On the basis of this information Mr. Wertlieb

believes that reasonable fixed compensation and reasonable variable compensation

for Mr. Astor were as follows:


          TYE Aug. 31            Fixed compensation         Variable compensation
             2004                      $438,900                   $4,704,500
             2003                        443,400                    3,192,900
             2002                        422,100                       -0-
             2001                        360,200                       -0-
              Total                    1,664,600                    7,897,400




      9
       Regression analysis is a statistical technique designed to determine the effect
that one or more explanatory independent variables have on a single dependent
variable. This method may allow an expert to test the causal relationship, if any,
between the explanatory independent variables and the dependent variable.
                                         - 15 -

[*15] Expert Rebuttal Report--Andrew J. Caffrey, Ph.D.

      Respondent asked Dr. Caffrey to opine on the validity and usefulness of the

regression analyses presented in Mr. Wertlieb’s report. Dr. Caffrey has a bachelor

of arts degree in mathematics and economics from the California State University,

Bakersfield and a Ph.D. in economics from the University of California, San Diego.

Dr. Caffrey is a staff economist for the Internal Revenue Service who receives an

annual salary that is not dependent on the outcome of this case.

      Dr. Caffrey came to four conclusions after reviewing Mr. Wertlieb’s report:

(1) Mr. Wertlieb’s regressions are used to extrapolate rather than to interpolate;10

(2) the inclusion of Clear Channel Communications (the largest of the publicly

traded companies Mr. Wertlieb looked at) drives the results of the fixed

compensation regressions; (3) on the basis of the P-values of the coefficients in all

of the regressions, the coefficients are not useful; and (4) on the basis of the R-

squareds of the regressions, the regressions do not explain the variation in either the

fixed compensation or the variable compensation. Dr. Caffrey concluded that




      10
        Dr. Caffrey believes that because the companies used in Mr. Wertlieb’s
analysis had uniformly higher revenues than Aries, the regressions are being used to
make a prediction outside of the range of the observations (extrapolate) rather than
to make a prediction inside the range of observations used (interpolate).
                                        - 16 -

[*16] Mr. Wertlieb’s regression analysis is not useful to make a positive conclusion

about the reasonableness of Mr. Astor’s compensation.

Expert Report--Mark R. Lipis

      After the petition was filed respondent engaged Lipis Consulting, Inc., to

opine on what constituted reasonable compensation for the owner/operator of the

radio broadcast stations operated by Aries and its subsidiaries for TYE August 31,

2004. Mr. Lipis has a bachelor of science degree in economics from the Wharton

School at the University of Pennsylvania and a master of business administration

degree from the University of Chicago. He has been in the consulting field of

compensation for more than 30 years serving clients in the public, private, and

nonprofit sectors.

      Mr. Lipis considered executive officer compensation and broadcaster gross

income and profitability information from the National Association of Broadcasters

(NAB) for the position of general manager and information from the Economic

Research Institute. He then applied a 75% premium to those figures to account for

the fact that Mr. Astor was not just the general manager of one station but also the

president and CEO. The adjusted NAB figures are as follows:
                                       - 17 -

                                         Total compensation      Total compensation
 [*17] Survey section    Base-median          --median           with 75% premium
 All Stations--            $140,000             $160,000             $280,000
 nationwide
 Revenues $1-1.5            105,000              125,000              218,750
 million
 Revenues $1.5-2            132,090              144,590               253,033
 million
 Revenues $2-3              144,000              170,000               297,500
 million
 Pacific region             189,250              222,500               389,375

      Mr. Lipis averaged the total compensation with the addition of the 75%

premium to arrive at $287,732 and compared it with Mr. Astor’s 2004

compensation. Mr. Lipis then discounted the $287,732 backwards to compare it

with Mr. Astor’s compensation in 2003, 2002, and 2001. On the basis of this

analysis, Mr. Lipis concluded that for the four years Mr. Astor was underpaid by a

total of $173,114 if his bonus is not included; and if Mr. Astor’s bonus was included

then he was overpaid over four years by a total of $8,394,734.

      Mr. Lipis also compared Mr. Astor’s compensation with data from

broadcast company proxies as reported by the Kenexa.com database. That data

includes compensation amounts for several television and radio companies, all of

which were much larger than Aries when measured by revenues. Mr. Lipis used
                                        - 18 -

[*18] scattergrams and regression analysis to show the correlation between

compensation and revenue, net income, and profit margin.

      With respect to Mr. Astor’s bonus, Mr. Lipis believed that the question to be

answered was: “Assuming the owner acted as a consultant to Kalil, how much were

his services worth to improve the $12 million offer to $18 million?” Mr. Lipis

concluded that a reasonable success fee for securing the additional $6 million of

value was $210,000. Mr. Lipis then combined all of his methods and concluded that

the total reasonable compensation for Mr. Astor for 2004 was $635,447.

                                     OPINION

I.    Burden of Proof

      The Commissioner’s determination of a taxpayer’s liability for an income tax

deficiency is generally presumed correct, and the taxpayer bears the burden of

proving that the determination is improper. See Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).11




      11
       Petitioner did not argue that the burden should shift to respondent under sec.
7491(a)(2); however, we have decided this case on the preponderance of the
evidence.
                                        - 19 -

[*19] II.    Reasonable Compensation

       Respondent contends that most of the compensation paid to Mr. Astor was

not reasonable under section 162 for TYE 2004 and, in the notice of deficiency,

disallowed $6,086,752 of petitioner’s claimed salary expense of $6,896,974.

Petitioner contends that all of Mr. Astor’s compensation was reasonable, that it

included catchup payments for prior years in which Mr. Astor was

undercompensated, and that he was entitled to a bonus for the sales, which he

masterminded and facilitated, of the two radio stations.

       A.    Overview of Section 162(a)(1)

       Section 162(a)(1) provides a deduction for ordinary and necessary business

expenses, including “a reasonable allowance for salaries or other compensation for

personal services actually rendered”. Absent stipulation to the contrary, an appeal

in this case would lie to the Court of Appeals for the Ninth Circuit. See sec.

7482(b)(1). Therefore, we follow that court’s precedent. Golsen v.

Commissioner, 54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). The

Court of Appeals for the Ninth Circuit determines the deductibility of

compensation through a two-prong test: the amount of compensation must be

reasonable, and the payment must be purely for services rendered. Nor-Cal
                                        - 20 -

[*20] Adjusters v. Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), aff’g T.C.

Memo. 1971-200; sec. 1.162-7(a), Income Tax Regs.

      B.     Salary Payments

             1.    Catchup Compensation and Services Actually Rendered

      Compensation for prior years’ services is deductible in the current year as

long as the employee was actually undercompensated in prior years and the current

payments are intended as compensation for past services. R.J. Nicoll Co. v.

Commissioner, 59 T.C. 37, 50-51 (1972); see also LabelGraphics, Inc. v.

Commissioner, 221 F.3d 1091, 1096 (9th Cir. 2000) (“an intention to remedy prior

undercompensation can weigh in favor of reasonableness”), aff’g T.C. Memo. 1998-

343. To the extent total compensation includes amounts that were actually for prior

years of service, the total compensation need not be reasonable in the year it was

paid. Devine Bros., Inc. v. Commissioner, T.C. Memo. 2003-15. Petitioner

contends that the amount paid to Mr. Astor in fiscal year 2004 includes catchup

amounts for the three prior years. Therefore, we shall evaluate the reasonableness

of Mr. Astor’s compensation for TYE August 31, 2001 through 2004.
                                         - 21 -

[*21] There is no doubt that Mr. Astor was the most valuable employee of Aries

and the compensation paid to him, or at least a portion thereof, was for services

actually rendered.

             2.      Reasonableness of Payments

      We consider the reasonableness of the compensation with reference to five

broad factors set forth in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir.

1983), rev’g T.C. Memo. 1980-282. No single factor is dispositive. Id. at 1245.

The relevant factors are: (i) the employee’s role in the company; (ii) a comparison

of the employee’s salary with salaries paid by similar companies for similar

services; (iii) the character and condition of the company; (iv) potential conflicts of

interest; and (v) internal consistency. Id. at 1245-1247.

      We also consider an additional factor: whether an independent investor

would be willing to compensate the employee as the taxpayer compensated the

employee. Metro Leasing & Dev. Corp. v. Commissioner, 376 F.3d 1015, 1019

(9th Cir. 2004), aff’g 119 T.C. 8 (2002). The Court of Appeals notes that “the

perspective of an independent investor is but one of many factors that are to be

considered when assessing the reasonableness of an executive officer’s

compensation.” Id. at 1021. The reasonableness of compensation is a question of

fact to be determined on the basis of all the facts and circumstances. Pac. Grains,
                                         - 22 -

[*22] Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), aff’g T.C. Memo.

1967-7.

                    i.     Employee’s Role in the Company

      This factor looks to the overall significance of the employee to the company.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1245. “Relevant considerations include

the position held by the employee, hours worked, and duties performed, American

Foundry v. Commissioner, 536 F.2d 289, 291-292 (9th Cir. 1976), as well as the

general importance of the employee to the success of the company”, id.

      Mr. Astor was the hands-on owner-operator of Aries. Mr. Astor has been

Aries’ president, chief financial officer, and sole shareholder from its incorporation

in 1983 and has acted as general manger of each of petitioner’s radio stations. He

was actively involved in managing many aspects of petitioner’s day-to-day

operations, including: (1) overseeing management personnel; (2) planning and

overseeing programming; (3) negotiating and communicating with lenders; (4)

participating in sales meetings; and (5) communicating with outside advisers. As

the key employee, he played a pivotal role in the profitable sale of petitioner’s major

assets.
                                        - 23 -

[*23] Respondent argues that the sale of Aries subsidiaries’ assets was profitable

not because of Mr. Astor’s personal role but because of the significant appreciation

of the FCC licenses. While we agree that the FCC licenses were the principal

driving force behind the sale and the key component of the sale price of the

subsidiaries, that does not necessarily diminish Mr. Astor’s role as an employee of

the corporation.

      Mr. Astor made the decision to both acquire and maintain the FCC licenses.

However, his role does raise an interesting issue. Did Mr. Astor invest in the

licenses personally, as the passive owner/investor of Aries, or did he make the

investment choices as a money-making strategy, in his employment capacity, as the

chief executive of Aries? Respondent wants to disallow the deduction of most of

Mr. Astor’s salary and thus increase the tax of Aries. Had Mr. Astor personally

purchased the FCC licenses and then transferred them to a corporate entity such as

Aries or its subsidiaries, respondent’s position might be well taken. However, the

FCC licenses were acquired by the corporate entities, and the decisions of Mr.

Astor should therefore be treated as the decisions of the chief executive of Aries.

Aries should compensate Mr. Astor for his successful investment choices.

      In a situation similar to that of the appreciation of the FCC licenses, market

forces also helped create the cashflow enabling an employee’s significantly
                                         - 24 -

[*24] increased salary. In Shotmeyer v. Commissioner, T.C. Memo. 1980-238, we

explained that one of the reasons the employee-owner’s corporation was finally able

to pay the manager a large salary was the conditions created by the Arab oil

embargo. We noted that the “economic conditions were not the primary reason for

the increase in salary.” The primary reason was the taxpayer’s “business acumen

and experience”.

      Although petitioner did not have any substantial taxable income before the

sale of two of its major assets, Mr. Astor, who was responsible for the assets,

facilitated the sale of those assets for prices far exceeding the buyers’ original

offers. For the year before the year at issue petitioner’s taxable income was

$14,596,284, and for the year at issue its taxable income was $3,902,092. Both

respondent’s and petitioner’s experts agree that Mr. Astor was petitioner’s most

important employee. Mr. Astor also facilitated the Goldman Sachs debt by way of

his personal guarantee. See Leonard Pipeline Contractors, Ltd. v. Commissioner,

T.C. Memo. 1998-315, aff’d without published opinion, 210 F.3d 384 (9th Cir.

2000).12 We find this factor weighs in favor of petitioner.




      12
        Respondent has not asserted a thin capitalization argument, and the Court
shall not make one for him that petitioner would have no chance to rebut.
                                         - 25 -

[*25]         ii.   Comparison With Similar Companies’ Salaries

        The next relevant factor is a comparison of the employee’s salary with those

paid by similar companies providing similar services. Elliotts, Inc. v.

Commissioner, 716 F.2d at 1246; Hoffman Radio Corp. v. Commissioner, 177 F.2d

264, 266 (9th Cir. 1949). Mr. Astor explained that Aries was one of only a few

companies in the industry in which the owner was also the operator. Therefore

external comparisons are difficult, and each of the parties retained an expert to

provide an opinion regarding reasonable compensation for Mr. Astor.13

        The following table summarizes both expert opinions as to Mr. Astor’s fixed

reasonable compensation:




        13
         We evaluate expert opinions in the light of each expert’s demonstrated
qualifications and all other evidence in the record. See Parker v. Commissioner, 86
T.C. 547, 561 (1986). We are not bound by an expert’s opinions and may accept or
reject an expert opinion in full or in part in the exercise of sound judgment. See
Helvering v. Nat’l Grocery Co., 304 U.S. 282, 295 (1938); Parker v. Commissioner,
86 T.C. at 561-562. We may also reach a determination of value on the basis of our
own examination of the evidence in the record. Silverman v. Commissioner, 538
F.2d 927, 933 (2d Cir. 1976), aff’g T.C. Memo. 1974-285.
                                           - 26 -

   [*26] TYE             Respondent’s           Petitioner’s          Actual salary +
     Aug. 31                expert                expert               commission
      2001                  $287,732                $360,200             $250,351
      2002                   277,733                 422,100              260,005
      2003                   267,051                 443,400              204,835
      2004                   255,063                 438,900              199,274
           Total           1,087,579             1,664,600                914,465

      The following table summarizes both expert opinions as to Mr. Astor’s

variable reasonable compensation:


     TYE                 Respondent’s           Petitioner’s
    Aug. 31st               expert                expert               Actual bonus

      2001                     -0-                    -0-                   -0-
      2002                     -0-                    -0-                   -0-
      2003                     -0-              $3,192,900              $1,870,148
      2004                  $210,000                4,704,500            6,697,700
           Total             210,000                7,897,400            8,567,848

      The tables indicate that the experts’ opinions are very divergent. Both

experts compared the compensation of executive officers in companies similar to

Aries and then used linear regression as a tool to compare the companies’ income

with that compensation.14


      14
           As mentioned previously, linear regression is a statistical technique that can
                                                                             (continued...)
                                          - 27 -

[*27] Respondent called a rebuttal expert, Dr. Caffrey, to challenge the findings of

Mr. Wertlieb, petitioner’s expert. Dr. Caffrey came to certain conclusions regarding

Mr. Wertlieb’s report. The concerns we find relevant are: (i) Mr. Wertlieb’s report

is premised on a model analysis that employs return on sales as its principal if not

sole measure of financial performance; (ii) the regressions are used to extrapolate;

(iii) on the basis of the p-values, the coefficients are not useful, and; (iv) on the basis

of the R-squareds, the regressions do not explain the variation in either the fixed

compensation or the variable compensation. If those conclusions are true, these are

factors that would describe the mathematical imprecision of the results of these

regression models. Consequently, they constitute arguments that require the Court

to determine the proper weight to be accorded to the conclusions of the Wertlieb

report. 15

       14
         (...continued)
be used to estimate the correlation and effect between one or more independent
variable(s) and another single dependent variable. It can consequently also be
useful for prediction. In the case at hand it was used to estimate the correlation
between executive compensation and revenues.
       15
         See generally Barabin v. Asten-Johnson, Inc., 700 F.3d 428, 431 (9th Cir.
2012); Esgar Corp. v. Commissioner, T.C. Memo. 2012-35, slip op. at 30-32 (citing
Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579, 551 (1993), Fed. R. Evid. 702
and 703, and Kumho Tire Co. v. Carmichael, 526 U.S. 137, 148 (1999)), appeal
filed (10th Cir. Sept. 6, 2012). The Court has previously addressed these issues in
greater detail in our order in this case filed December 27, 2011, in response to the
                                                                         (continued...)
                                        - 28 -

[*28] Dr. Caffrey explained that the regressions are used to extrapolate rather than

interpolate because the data used for the comparison was acquired from companies

much larger than Aries. Because of the nature of the radio industry, there are not

very many companies whose financial information is public that are similar to Aries,

and the experts must use the data available. In fact, respondent’s own expert

witness, Mr. Lipis, also used data from companies much larger than Aries,

explaining that “all the companies were considerably larger than Aries

Communications when measured by revenue yet I can still learn from their

compensation practices”.

      Dr. Caffrey attempted to recreate Mr. Wertlieb’s regression analysis, and

then he listed the p-values for those re-creations.16 Dr. Caffrey explained that

      [I]f the p-value is less than 0.05, then we can state that the beta
      coefficient is statistically different from zero “at the 5% significance
      level.” The p-values generated from my replication attempts are 0.136
      (2004), 0.105 (2003), 0.051 (2002), and 0.072 (2001). None of



      15
        (...continued)
motion in limine respondent filed on November 25, 2011, in an attempt to bar Mr.
Wertlieb’s direct testimony in the form of his previously submitted report.
      16
        The “p-value” shows the “confidence intervals” or reliability of the
regression’s coefficient, that is, how wide the confidence interval around the beta
coefficient is. If the confidence interval includes zero, there is no established
ascertainable relationship between revenues and fixed compensation. The highest p-
value Dr. Caffrey finds useful is 10%, which is also represented as 0.1.
                                          - 29 -

      [*29] these beta coefficients are statistically significant at the
      standard 5% significance level. The beta coefficients from the 2003
      and 2004 regressions are not statistically significant even at the less
      rigorous 10% significance level.

Dr. Caffrey also objects to including the data from Clear Channel Communications

as, in his opinion, it is an outlier. If it is included, the values would range from as

low as 5.1% to as high as 13.6%. Although as the p-values demonstrate the

regression analysis is not strong, we will accord them the proper weight in reaching

our decision. However, we do not find the p-values make the regression analysis

completely irrelevant in this case.

      Dr. Caffrey was also concerned with Mr. Wertlieb’s regression analysis

because when he recreated the analysis, the R-squareds did not explain the variation

in either the fixed compensation or the variable compensation.17 Dr. Caffrey found

R-squareds of 0.163, 0.206, 0.321, and 0.349 for TYE August 31, of 2004, 2003,

2002, and 2001, respectively. However, regarding his own regression analysis,

respondent’s expert, Mr. Lipis, explained:

      An indicator of the robustness of the regression equation [i.e.
      explanation of variation] is called the R-squared value; the higher the
      number (between 0.00 and 1.00), the stronger the equation. The R-
      squared value for the total compensation regression using the raw
      numbers was 0.19. The R-squared values for the two logarithmic

      17
          R-squared is the measure of the explanatory power of a regression, i.e. how
well it fits the data.
                                        - 30 -

       [*30] value regressions are 0.30 for total compensation and 0.16 for
       total annual compensation. None of the R-squareds is strong but still
       useful to know.

Mr. Lipis’ R-squareds and the R-squareds Dr. Caffrey recreated from Mr.

Wertlieb’s data are similar and not very strong in describing the mathematical

precision of the results of these regression models. Consequently, the Court will

bear this in mind when determining the proper weight to attribute to these

conclusions. Mr. Lipis’ regression analysis explains the variation in either fixed

compensation or variable compensation about as well (or as poorly) as Mr.

Wertlieb’s.

      Both experts agree that with respect to Mr. Astor’s fixed compensation for

TYE August 31, 2001 through 2004, he was underpaid. Mr. Lipis determined that

for those four years a total of $1,087,579 was reasonable compensation, and Mr.

Wertlieb determined that a total of $1,664,600 was reasonable compensation. Mr.

Astor was actually paid a total of $914,465. We find that, given the R-squareds and

the p-values of both Mr. Wertlieb’s and Mr. Lipis’ regression analysis, both reports

should be given equal weight. Therefore we shall average their two conclusions and

find that for those four years a total of $1,376,090 would have been reasonable fixed

compensation. Thus, Mr. Astor was underpaid by $461,625.
                                          - 31 -

[*31] The greatest difference in opinion between the experts is with respect to Mr.

Astor’s bonus. Mr. Wertlieb found that when the receipts of a corporation increase,

so do executive bonuses; using his regression analysis he found that for the receipts

earned in TYE August 31, 2003 and 2004 Mr. Astor’s bonus would have been

reasonable at $3,192,900 and $4,704,500, respectively. Mr. Lipis took a different

approach for his analysis of Mr. Astor’s bonus and believed that the question to be

answered was: “Assuming the owner acted as a consultant to Kalil, how much were

his services worth to improve the $12 million offer to $18 million?” Mr. Lipis

concludes that a reasonable success fee for securing the additional $6 million of

value was $210,000.18

        We do not entirely agree with either Mr. Wertlieb or Mr. Lipis. Mr.

Wertlieb’s regression analysis suffered from low R-squareds and high p-values, and

Mr. Lipis undercompensated Mr. Astor for increasing the sale price by $6 million.

      We note that “[t]o determine what is ‘reasonable’ compensation in any

situation is a difficult task, given the various factors to consider, the unique

aspects of every business, and the unavoidable tension between the rules of




      18
        Mr. Lipis used the formula from the Kalil brokerage contract to determine
the $210,000 ((5% x $3,000,000) + (2% x $3,000,000) = $210,000).
                                         - 32 -

[*32] section 162 and the latitude allowed to business judgment.” Clymer v.

Commissioner, T.C. Memo. 1984-203, aff’d without published opinion sub nom.

Dension Poultry & Egg Co. v. Commissioner, 775 F.2d 299 (5th Cir. 1985). Mr.

Astor, acting in his executive capacity, was responsible for increasing the sale price

from $12 million to $18 million, or by 50%. Mr. Astor also had significant

involvement in his executive capacity, acquiring, managing, and selling the

investment. Given his dual status as shareholder and chief executive officer he

would in all events, see Univ. Chevrolet Co. v. Commissioner, 16 T.C. 1452, 1455

(1951), aff’d, 199 F.2d 629 (5th Cir. 1952), have been motivated to obtain the

highest sale price possible. Nevertheless, his efforts as an employee are still entitled

to reasonable compensation for services actually rendered. In short, his executive

efforts over a number of years permitted Aries to capitalize on this business

opportunity. Therefore “using our best judgment, based on all the evidence in the

record”, the Court finds that Mr. Astor’s appropriate bonus would be one-third of

the increase in the sale price, which is $2 million. See id. This factor weighs against

finding that Mr. Astor’s variable compensation was reasonable and that petitioner

may deduct the entire expense under section 162.
                                          - 33 -

[*33]         iii.   Character and Condition of the Company

        Under this factor we analyze the character and condition of the company,

focusing on the company’s size, complexity, net income, and general economic

condition. Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.

        Aries was a complex business holding multiple subsidiaries each with its own

radio stations. Aries had gross receipts of over $4.5 million before it sold off some

of its major assets. However, Aries was losing more and more money each year

from 1999 to 2002 and immediately after the two years of major asset sales began

losing money again. Respondent points out that Aries was deeply in debt when the

asset sales occurred. Petitioner had guaranteed the Goldman Sachs debt of $20

million. And at trial Mr. Astor explained that the forbearance agreement was behind

the sale of Orange Broadcasting. Orange Broadcasting would not have been able to

continue as a going concern if the sale had not occurred.

        One of the asset sales did occur during the year at issue, and during that year

Aries was profitable because of that sale. Mr. Astor was responsible for the

increased sale price of the assets and had managed to keep the wolves at bay

before the sale of the assets so that Aries might enjoy the financial benefit from

those asset sales. Nevertheless, as discussed infra, we note that even for the year at

issue Aries’ tax return reflects a $4,041,016 loan from Mr. Astor. The fact that
                                         - 34 -

[*34] Aries basically had to borrow the bonus back from Mr. Astor in the year it

was paid depicts a rather bleak financial condition and casts a shadow on the

substance of the transaction, suggesting that Aries was thinly capitalized.

      The economics at play here are enlightening. The value of assets such as the

FCC licenses is generally determined by the discounted value of the future income

stream the asset will produce. It is therefore curious that radio stations and FCC

licenses with a history of operating losses were valued by purchasers at $35 million

and $18 million. Apparently others believed that they could employ these assets

much more profitably than their track record would suggest. This implies that either

the stations were managed poorly or at least in the case of 94.3 FM, there was a

synergistic effect and significant value was created when the coverage area was

materially increased by combining the stations. Perhaps both these and other factors

were at work. In any case the stations’ financial performance lagged behind what

would be expected from the use of assets with such significant value.

      Because Aries was a large asset-laden complex business with a negative net

income and a bleak financial picture despite the favorable fact that it enjoyed a

successful asset sale during the year at issue, we find this factor favors respondent.
                                          - 35 -

[*35]                iv.    Potential Conflicts of Interest

        This factor focuses on any indicia that there may be a conflict of interest.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1246. Primarily we are concerned with

whether a relationship exists between the employee and the company that may

permit the disguise of nondeductible corporate distributions as salary expenditures.

Id. Mr. Astor was an owner-operator. There was no specific evidence introduced

that Aries ever paid or that he received a dividend, although the change in common

stock from $280,000 to $120,000 and the Court’s difficulties in reconciling retained

earnings imply some distributions to stockholders may have occurred. Their

character is not resolved by the record, and in the absence of accumulated or current

year’s earnings and profits it may have resulted in a tax-free return of capital. In

any event it was incumbent on petitioner, who has the burden of proof, to clarify the

facts if doing so was favorable to Aries.

        Therefore a relationship did exist between Mr. Astor and Aries that could

have permitted the disguised dividend distributions as salary expenditures. “The

mere existence of such a relationship, however, when coupled with * * * [the]

absence of dividend payments, does not necessarily lead to the conclusion that the

amount of compensation is unreasonably high.” Id. When this is the case, we
                                          - 36 -

[*36] closely scrutinize the alleged salary payments and frequently evaluate the

compensation from the perspective of a hypothetical independent investor. Id. at

1247.

        Petitioner argues that Aries’ return on equity resulted in an increase in

shareholder equity from a $280,000 initial contribution in 1983 to $12,725,862 in

TYE August 31, 2003. Respondent argues that this paints a rosier picture than

petitioner’s actual financial standing at that time. In TYE August 31, 2003

petitioner had $3,561,369 cash on hand after having paid off the Goldman Sachs

debt that precipitated the sale, and in addition petitioner no longer owned some of

its most valuable assets.

        Both parties overstate and oversimplify their cases. Because of various

interparty loans and the $20 million Goldman Sachs debt Mr. Astor personally

guaranteed it is difficult to discern the true capital structure and equity status of

the corporate entities. During the same years stated shareholder investment,

ignoring negative retained earnings, was $120,000. However, when interparty

loans are considered and unrealized asset appreciation is adjusted for, a quite

different picture emerges. The Court has previously concluded that the real source

of value here was the FCC licenses that made the Goldman Sachs loan possible.

Mr. Astor’s guarantee, we believe, added little other than its protection of the
                                         - 37 -

[*37] value by including as an obligor the sole shareholder of the corporation

holding the FCC licenses.

      The following table reflects the interparty loans between Mr. Astor and Aries.

This table suggests that other than Mr. Astor’s investment in the, as of yet,

unrealized appreciation in Aries’ and its subsidiaries’ assets, he had no capital

investment at all. They were the corporation’s assets, not his (ignoring his stock

ownership), and provided the necessary security for the loans. Further, when the

loans are scrutinized Mr. Astor had in practice already withdrawn his stated

$120,000 equity and a material portion of the appreciation in Aries and its

subsidiaries’ assets.19 Consequently, these facts must be considered in determining

an investor’s right to a reasonable return on investment.




      19
        The “loans” may have been in substance dividends or distributions (only for
years in which there was a profit) but were apparently reflected by interest-bearing
notes; and although the notes were frequently refinanced with new notes, interest
was paid and notes were paid. Respondent has, for whatever reason, chosen not to
contest the shareholder loans for tax purposes.
                                         - 38 -

     [*38] TYE Aug. 31        Aries’ loans to Mr. Astor     Loans from Mr. Astor to Aries
            1999                      $1,775,641                           -0-
            2000                       2,715,399                        $740,016
            2001                       2,741,850                         740,016
            2002                       2,739,045                         740,016
            2003                       2,727,389                         740,016
            2004                       2,727,389                       4,041,016
            2005                       2,727,389                       4,404,381

      Mr. Astor shrewdly negotiated the sales of some of Aries’ assets for prices

much higher than initially offered and by paying off the Goldman Sachs debt kept

the company a going concern and out of bankruptcy. An independent investor

would have desired the highest prices for the assets and rewarded Mr. Astor for

his work in securing those prices. However, as the owner of Aries Mr. Astor also

had a significant interest in garnering the highest price for the assets and then

receiving the reward as salary deductible by Aries instead of a nondeductible

dividend. Mr. Astor had also been receiving a significant benefit from the loans

from Aries, and we note that Mr. Astor was well compensated for his work in

investing in and maintaining the major assets of Aries in the year immediately

before the year at issue when the first major asset sale took place. Mr. Astor was
                                         - 39 -

[*39] paid $2,074,983 in TYE August 31, 2003. These are precisely the conflicts of

interest this factor seeks to avoid; therefore, we find this factor favors respondent.

                    v.     Internal Consistency

      “[E]vidence of an internal inconsistency in a company’s treatment of

payments to employees may indicate that the payments go beyond reasonable

compensation.” Elliotts, Inc. v. Commissioner, 716 F.2d at 1247. And with respect

to bonuses paid, we note that “Bonuses that have not been awarded under a

structured, formal, consistently applied program generally are suspect * * * On the

other hand, evidence of a reasonable, longstanding, consistently applied

compensation plan is evidence that the compensation paid in the years in question

was reasonable.” Id.

      In Vitamin Vill., Inc. v. Commissioner, T.C. Memo. 2007-272, the Court

found that the bonuses paid were not awarded under a structured, formal, or

consistently applied program; however, because they “were paid under the

taxpayer’s plan to award a bonus for present hard work and prior years’ lack of

compensation when the taxpayer became more profitable”, Multi-Pak Corp. v.

Commissioner, T.C. Memo. 2010-139, it found the factor to favor the taxpayer. Mr.

Astor’s bonuses were not paid under a structured or formal plan. Aries paid
                                       - 40 -

[*40] Mr. Astor large bonuses in the years that it was able to afford them. We note,

however, that the bonuses were determined at the end of the year when Mr. Astor

and petitioner could reasonably predict Aries’ profits and potential Federal income

tax liability absent a section 162 deduction for Mr. Astor’s compensation. This fact

weighs in respondent’s favor.

      Another facet of this factor is the comparison of the owner-operator’s

compensation with that of other employees of the company. Elliotts, Inc. v.

Commissioner, 716 F.2d at 1247. However, if the services provided by unrelated

nonowner employees are not comparable in scope to the responsibilities of the

owner-operator, the compensation paid such nonowner employees is not necessarily

relevant to the reasonableness of the owner-operator’s compensation. Clymer v.

Commissioner, T.C. Memo. 1984-203.

      Susan Burke served as the executive vice president and corporate secretary

for both Orange Broadcasting and North County Broadcasting from 1996. Her

duties included: FCC-related issues, labor and employment issues, music

licensing, and review of documents and contracts. During the year at issue

petitioner paid Ms. Burke $288,654, including a $200,000 bonus from Orange

Broadcasting. Ms. Burke is the only employee with duties remotely similar to Mr.

Astor’s. Mr. Astor described Ms. Burke as his “Girl Friday” at trial. She was the
                                       - 41 -

[*41] chief administrator of the business, and her duties are not comparable in scope

to Mr. Astor’s duties. Thus her compensation is not relevant to our analysis. Id.

      Because Mr. Astor’s compensation was not awarded under a structured,

formal, consistently applied program, it was suspect. However, because we found

supra that Mr. Astor’s compensation included amounts for prior years of hard work

for which he was undercompensated, we find this factor neutral.

                   vi.    Additional Factor: The Independent Investor

      While we found supra that petitioner did intend Mr. Astor’s compensation as

catchup compensation for prior services rendered, in Elliotts, Inc. v. Commissioner,

716 F.2d at 1247, the Court of Appeals for the Ninth Circuit noted that

      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.]

      Petitioner’s Form 1120, page 4 balance sheet for 1998, the earliest return in

the record, shows a common stock balance of $280,000 at the beginning of the
                                         - 42 -

[*42] year. We shall assume that the $280,000 is the investor’s (in this case Mr.

Astor’s) initial investment. As we noted above, while petitioner argues that its

return on equity resulted in an increase in shareholder equity from a $280,000 initial

contribution in 1983 to $12,725,862 in TYE August 31, 2003, there may in

substance have been no equity (other than unrealized appreciation in the corporate

assets). Apparently, in a manner not revealed by the record, petitioner paid Mr.

Astor some sort of distribution in 1998 because the common stock balance was

reduced to $120,000 at the end of the year. Thereafter, all of petitioner’s later tax

returns in the record reflect a common stock balance of $120,000.

      A reasonable investor would expect to receive a return on this initial

investment and would not approve of a salary package that depleted the

corporation’s assets without paying the investor. Id. (a 20% return on equity

“would satisfy an independent investor”); Thousand Oaks Residential Care Home I,

Inc. v. Commissioner, T.C. Memo. 2013-10 (“return on investment of between 10%

and 20% tends to indicate compensation was reasonable”); L & B Pipe & Supply

Co. v. Commissioner, T.C. Memo. 1994-187 (investor would have been happy with

either 6% dividend return plus 10% growth in retained earnings or 20% growth in

shareholders’ equity).
                                         - 43 -

[*43] As the cases above show, the Court has found that a return on investment of

10% to 20% tends to indicate compensation was reasonable.20 In Miller & Sons

Drywall, Inc. v. Commissioner, T.C. Memo. 2005-114, we explained that “this

Court has generally calculated a corporation’s ROE [return on equity] by dividing

its net income after tax for a specific year by its shareholders equity” instead of

using compound growth rates. See B & D Founds., Inc. v. Commissioner, T.C.

Memo. 2001-262 (discussing the ROE calculation in greater detail); LabelGraphics,

Inc. v. Commissioner, T.C. Memo. 1998-343. For the reasons discussed below, we

will use petitioner’s shareholder’s equity at the end of TYE August 31, 2004, the

year in issue. Because we have the specific financial information for Orange

Broadcasting and North County Broadcasting, we will analyze each subsidiary

separately.




      20
       The Court takes judicial notice that in 1983 (when Mr. Astor purchased
94.3 FM) the prime interest rate was 11% and in 1987 (when Mr. Astor purchased
92.1 FM) the prime interest rate was between 7.75% and 8.75%. A 10-year
Treasury note had a 10.46% interest rate in 1983 and a 7.08% rate in 1987.
                                           - 44 -

           [*44]          2002               2003              2004             2005
                                                 Orange Broadcasting
 Net income (loss)    ($1,771,765)        $25,891,030      ($17,043,881)    ($1,532,436)

 Stockholders           (2,099,723)        23,765,122         6,721,242        4,376,865
 equity
 ROE                      0.844              1.089            (2.536)           (0.35)
                                             North County Broadcasting
 Net income (loss)    ($1,269,102)         ($436,159)       $13,988,322       ($113,102)
 Stockholders           (7,286,270)        (7,731,116)        6,204,662        4,430,601
 equity
 ROE                      0.174              0.056            2.254            (0.026)

       We note that Aries was made up of more than just Orange Broadcasting and

North County Broadcasting and therefore analyze the ROE of Aries as a whole by

deriving the following information from Aries’ tax returns.
            TYE              Net profit (loss)
           Aug. 31             after taxes                Equity1       Return on equity
             2002             ($1,415,651)           ($7,569,904)            0.187
             2003                 9,247,098             12,333,790           0.750
                                 1
             2004                    4,025,956           12,797,157           0.315
             2005              (1,742,547)               9,690,040           (0.180)
             2006              (2,688,686)               6,935,019           (0.388)
       1
        Equity was determined by adding the common stock, additional paid in
capital, and retained earnings stated on Aries’ Form 1120 page 4 balance sheet.
                                         - 45 -

[*45] We note that this method of determining the shareholders’ return on

investment is skewed because of the interparty loans and further skewed in the years

in which the two subsidiaries sold major assets. Therefore under the specific facts

of this case as discussed supra under the heading “Potential Conflicts of Interest”,

the corporation’s ROE does not paint a very meaningful or accurate picture. In this

case, the independent investor analysis is a weak factor, and the Court of Appeals

for the Ninth Circuit explains that the independent investor test is only one of the

many factors to be considered. Metro Leasing & Dev. Corp. v. Commissioner, 376

F.3d at 1021.

      We find that using compound growth rates presents a more accurate picture.

As the table supra page 10 shows, petitioner had negative income in every year in

the record except for the two years in which petitioner had major asset sales. The

record does not apportion the capital investment represented by the common stock

of $280,000 or $120,000 among the multiple radio stations and subsidiaries of

petitioner, and it indicates only that Mr. Astor’s initial investment in 94.3 FM was

$31,200. The record does not reveal what his initial investment in 92.1 FM was.

      A 10% return on $280,000 compounded annually for 21 years (1983-2003)

is roughly $2,072,069.98, a 15% return is $5,270,025, and 20% return is

$12,881,434. We note that in 1998 $160,000 of the initial investment was
                                        - 46 -

[*46] removed from the corporate books. A 10% rate of return on $280,000

compounded annually for 16 years (1983-1998) is $1,286,592; then if we subtract

the $160,000 and compound the rest for the final 5 years, the final return is

$1,814,388. The same calculation at 15 and 20% yields $5,270,025 and

$12,881,434, respectively. Because Aries was a highly leveraged business but

possessed assets, such as the FCC licenses, likely to appreciate, a hypothetical

investor might be satisfied with a 10% return on this investment. Consequently, the

corporation should have had at least $1,814,388 left for distribution after payment of

the compensation packages.

      Petitioner had a net income of $4,025,956 after taxes and the compensation

packages were paid in the year at issue and retained earnings of $12,725,862.

Respondent argues that the large income was due to the substantial asset sales that

occurred and that this level of income was not sustained. In TYE August 31, 2005

and 2006 petitioner had a net income of ($1,742,547) and ($2,688,686),

respectively. Because petitioner had enough retained earnings to almost satisfy an

investor even at 20% compounded annually after Mr. Astor’s compensation was

paid in 2004, we conclude this factor favors petitioner.
                                         - 47 -

[*47]                vii.   Conclusion

        After review of each factor discussed above, we hold that Mr. Astor’s

compensation was not reasonable for TYE August 31, 2004, and that petitioner may

not deduct the entire amount of claimed compensation expense under section 162.

We found supra that Mr. Astor’s fixed salary was underpaid for the four years we

reviewed by $461,625. That amount, plus Mr. Astor’s actual fixed salary of

$199,274 for the year at issue, plus the $2 million bonus that we found reasonable,

or a total of $2,660,899 is deductible as reasonable compensation for TYE August

31, 2004, under section 162. We again note that the reasonableness of

compensation is a question of fact to be determined on the basis of all the facts and

circumstances. Pac. Grains, Inc. v. Commissioner, 399 F.2d at 606.

III.    Section 6662(a) Accuracy-Related Penalty

        Respondent contends that petitioner is liable for the section 6662(a) and

(b)(1) and (2) accuracy-related penalty for TYE August 31, 2004, because a

portion of petitioner’s underpayment was due to either a substantial

understatement of income tax or negligence. There is a “substantial

understatement” of income tax for any tax year where, in the case of corporations

(other than S corporations or personal holding companies), the amount of the

understatement exceeds the greater of (1) 10% of the tax required to be shown on
                                         - 48 -

[*48] the return for the tax year or (2) $10,000. Sec. 6662(d)(1)(B). Section

6662(a) and (b)(1) also imposes a penalty for negligence or disregard of rules or

regulations. Under this section “‘negligence’ includes any failure to make a

reasonable attempt to comply with the provisions of this title”. Sec. 6662(c). Under

caselaw, “‘[n]egligence is a lack of due care or the failure to do what a reasonable

and ordinarily prudent person would do under the circumstances.’” Freytag v.

Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v. Commissioner, 380

F.2d 499, 506 (5th Cir. 1967), aff’g on this issue 43 T.C. 168 (1964) and T.C.

Memo. 1964-299), aff’d, 904 F.2d 1011 (5th Cir. 1990), aff’d, 501 U.S. 868

(1991).

        There is an exception to the section 6662(a) penalty when a taxpayer can

demonstrate (1) reasonable cause for the underpayment and (2) that the taxpayer

acted in good faith with respect to the underpayment. Sec. 6664(c)(1). Regulations

promulgated under section 6664(c) further provide that the determination of

reasonable cause and good faith “is made on a case-by-case basis, taking into

account all pertinent facts and circumstances.” Sec. 1.6664-4(b)(1), Income Tax

Regs.

        Reliance on the advice of a tax professional may, but does not necessarily,

establish reasonable cause and good faith for the purpose of avoiding a section
                                         - 49 -

[*49] 6662(a) penalty. See United States v. Boyle, 469 U.S. 241, 251 (1985)

(“Reliance by a lay person on a lawyer [or accountant] is of course common; but

that reliance cannot function as a substitute for compliance with an unambiguous

statute.”).

       The caselaw sets forth the following three requirements for a taxpayer to use

reliance on a tax professional to avoid liability for a section 6662(a) penalty: “(1)

The adviser was a competent professional who had sufficient expertise to justify

reliance, (2) the taxpayer provided necessary and accurate information to the

adviser, and (3) the taxpayer actually relied in good faith on the adviser’s

judgment.” See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99

(2000), aff’d, 299 F.3d 221 (3d Cir. 2002); see also Charlotte’s Office Boutique,

Inc. v. Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005) (quoting with

approval the above three-prong test), aff’g 121 T.C. 89 (2003).

       Although at trial Mr. Astor stated that he “discussed the compensation that

they thought was acceptable” with his accountants, he never explained what kind of

information he provided to his accountants or whether he even relied on the

accountants’ judgment. While Aries’ Federal income tax returns were prepared by

his accountants, none of them testified at trial. Petitioner did not meet the three

prongs of the Neonatology test, and therefore we do not find petitioner’s reliance
                                        - 50 -

[*50] on a tax professional reasonable cause for the underpayment attributable to

Mr. Astor’s compensation.

      With respect to the $550,000 concession, petitioner presented no evidence

that it acted with reasonable cause and in good faith. Therefore petitioner is liable

for the section 6662(a) accuracy-related penalty.

      The Court has considered all of the parties’ contentions, arguments, requests,

and statements. To the extent not discussed herein, the Court concludes that they

are meritless, moot, or irrelevant.

      To reflect the foregoing,


                                                 Decision will be entered

                                        under Rule 155.
