                       T.C. Memo. 1998-220



                     UNITED STATES TAX COURT



         WILLIAM J. AND SANDRA D. HEITZ, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

               EXACTO SPRING CORP., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket Nos. 27151-96, 27152-96.            Filed June 24, 1998.



    Robert E. Dallman, Vincent J. Beres, Michael G. Goller,

Joseph M. Maier, and Joseph E. Bender, for petitioners.

    George W. Bezold, Frederic J. Fernandez, Mark J. Miller,

Michael F. O’Donnell, and Christa A. Gruber, for respondent.
                                     - 2 -


                  MEMORANDUM FINDINGS OF FACT AND OPINION

       GERBER, Judge:       Respondent, by means of a statutory notice

of deficiency, determined the following income tax deficiencies

and section 6662(a)1 penalties with respect to petitioners:

                         William J. and Sandra D. Heitz
                                                      Penalty
               Year              Deficiency          Sec. 6662
               1992               $31,592             $6,318
               1993                43,283              8,657

                              Exacto Spring Corp.
                Year                                 Penalty
                Ended           Deficiency          Sec. 6662
               5/31/93          $868,886            $173,777
               5/31/94           686,940             137,388

       These two cases were consolidated for trial, briefing, and

opinion.2      After concessions, the issues for our consideration

are:       (1) The amount that Exacto Spring Corp. (Exacto) is

entitled to deduct as reasonable compensation to William Heitz

for its taxable years ending May 31, 1993 and 1994; (2) whether

Exacto is liable for accuracy-related penalties with respect to

the claimed deductions for the compensation to William Heitz; (3)

whether William and Sandra Heitz constructively received interest

income of $87,056 and $106,903 for the taxable years 1992 and




       1
       Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years under
consideration, and all Rule references are to this Court's Rules
of Practice and Procedure.
       2
       Unless otherwise indicated, all references to petitioner
are to Exacto Spring Corp.
                                 - 3 -


1993, respectively; and (4) whether William and Sandra Heitz are

liable for accuracy-related penalties.

                         FINDINGS OF FACT3

1.   Reasonable Compensation

     Exacto was founded in 1960 by petitioner William Heitz (Mr.

Heitz), Kenneth Quillen (Mr. Quillen), and William Greene (Mr.

Greene) in Rockford, Illinois.    In 1964, Exacto was moved from

Rockford, Illinois, to the present site in Grafton, Wisconsin.

     Exacto was initially operated as a partnership and was owned

60 percent by Mr. Heitz, 20 percent by Mr. Greene, and 20 percent

by Mr. Quillen.   Mr. Quillen and Mr. Greene each contributed

$1,000 to the partnership, and Mr. Heitz contributed $7,000.

Exacto was incorporated in 1962.    From incorporation through

1993, Exacto's common stock was owned by Mr. Heitz (60 percent),

Mr. Quillen (20 percent), and Mr. Greene (20 percent).    In 1993

and again in 1994, Mr. Heitz gave some of his Exacto stock to

each of his two children, reducing his ownership in Exacto to 55

percent.

     Mr. Heitz obtained a bachelor of science degree in

mechanical engineering from Purdue University in 1952.    In 1955,

Mr. Heitz was hired by Midwest Spring Co. as an engineer.    Mr.

Heitz left Midwest Spring Co. after 4 years and went to work at


     3
       The stipulation of facts and the attached exhibits are
incorporated by this reference.
                               - 4 -


Rockford Spring Co., where he met Mr. Greene and Mr. Quillen.     In

1960, Mr. Heitz, Mr. Greene, and Mr. Quillen left Rockford Spring

Co. to form Exacto.

     Exacto manufactures fine-wire precision springs for various

applications.   Typically, Exacto will act as a consultant for its

customers in designing and engineering springs for a specific

function.   In addition, Exacto designs and manufactures spring

measuring and spring gauge equipment, and designs and develops

spring packaging equipment.   Exacto manufactures springs that are

used in highly sensitive equipment including:   Automobile

airbags, fuel injection systems, and computer keyboards.

     Mr. Heitz is a technical expert in the area of spring design

and was personally involved in the development of a completely

automated line of spring-making machines.    Exacto was the first

spring maker in the country to develop a completely automated

spring-making plant.   Mr. Heitz is constantly improving Exacto's

production process by making adjustments to the automated line.

There are very few engineers who specialize in spring design;

therefore Mr. Heitz also served as a teacher for Exacto's sales

and engineering department.

     Mr. Heitz has contributed significantly to improving the

efficiency of Exacto's production process.   In 1960, Mr. Heitz

introduced Exacto to statistical process control, which is a

quality control technique that operates by taking random samples.
                                - 5 -


Statistical process control insures that approximately 99.9-

percent of Exacto's springs will be within specifications.

     Mr. Heitz has also worked extensively in the area of spring

packaging.    In 1992, Mr. Heitz developed magnetic boards designed

to have springs adhere to the board during shipment.    This

technique helped reduce spring tangling and damage during

shipment and eased customer product assembly.    Mr. Heitz also

helped develop the idea of using tubes to ship and disburse

springs.    The development and improvement of Exacto's spring

packaging is an ongoing process.

     Mr. Heitz has been the president of Exacto since 1976.      As

president, Mr. Heitz was responsible for overall company

finances, management, and direction.    Since Exacto's inception,

Mr. Heitz’ greatest contribution to Exacto has been in the areas

of spring development and sales.    Mr. Heitz has the unique

ability to target a client, identify a way the client could

benefit from a specific spring application, and then design the

spring that could perform that application.    During the years at

issue, Mr. Heitz was responsible for soliciting 65 to 70 percent

of Exacto's sales.

     Hickory Sales Corp. (Hickory) was established during 1985.

Until June 15, 1994, all of Hickory's shares were owned equally

by Dennis Backhaus and Daniel Linsley, who were employees of

Exacto.    Hickory acted as a sales representative for Exacto.    For
                                 - 6 -


the years at issue, Hickory had no income other than commissions

and consulting fees paid by Exacto.      Hickory's only employee

during the years at issue was Mr. Heitz.      Mr. Heitz spent 10 to

20 percent of his time working for Hickory.      Mr. Heitz received

the following salary from Hickory:

             Fiscal Year                     Salary
            Jan. 31, 1992                   $100,000
            Jan. 31, 1993                    200,000
            Jan. 31, 1994                    100,000

     Exacto's executive management team consisted of only five

individuals:   Daniel Linsley, chief financial officer; Dennis

Backhaus, director of the Sales and Engineering Department;

Mr. Quillen; Mr. Greene; and Mr. Heitz.      Mr. Quillen was the

secretary and treasurer of the company until his retirement in

1988.   Mr. Quillen was also in charge of shipping, receiving, and

warehousing for Exacto.     Mr. Greene was the plant manager for

Exacto and also assisted Mr. Heitz in research and development.

After Mr. Quillen's retirement in 1988, Mr. Greene became the

secretary and treasurer of Exacto and assumed the position of

director of shipping, receiving, and warehousing until his

retirement in 1991.

     Before the retirements of Mr. Greene and Mr. Quillen, Mr.

Heitz worked approximately 60 to 70 hours per week.      In addition,

he often worked at home on Sundays.      After the retirements of

both Mr. Greene and Mr. Quillen, Mr. Heitz assumed more of the
                               - 7 -


management responsibilities at Exacto, and, as a result, his

hours increased from 1991 through early 1994.

     From its inception in 1960 through 1994, Exacto experienced

significant growth.   The original building occupied by Exacto in

Grafton, Wisconsin, was approximately 4,000 square feet when it

was initially built in 1964.   By the end of fiscal year (FY)

1994, Exacto's facility was approximately 52,000 square feet.

The additions were made to the facility to accommodate the growth

of Exacto's sales and operations.   Exacto continued to grow

following the retirements of Mr. Quillen and Mr. Greene.     In

1987, Exacto employed an average of 90 individuals.   During FY

1993 and FY 1994, Exacto employed an average of 102 and 122

employees, respectively.   Exacto also experienced a sharp

increase in gross sales during the period when Mr. Heitz assumed

sole responsibility for the administration and operation of the

company.   From FY 1991 to FY 1994, Exacto's gross sales increased

from $8,923,374 to $16,162,119.

     Exacto did not pay dividends from FY 1989 to FY 1994.     From

FY 1973 to FY 1988, Exacto paid $145,000 in dividends.

Shareholder equity increased from $9,000 (Mr. Heitz’, Mr.

Greene's, and Mr. Quillen's initial capital investment) to

$7,550,000 in 1989 (the date of Exacto's last appraisal).     From

FY 1988 to FY 1994, Exacto paid compensation to its shareholder

executives in the following amounts:
                                - 8 -


                         Heitz             Greene        Quillen
       FY Ended       Compensation      Compensation   Compensation
     May 31, 1988       $300,000          $300,000       $300,000
     May 31, 1989        350,000           450,000        100,000
     May 31, 1990      1,300,000           300,000          ---
     May 31, 1991      1,200,000             ---            ---
     May 31, 1992      1,400,000             ---            ---
     May 31, 1993      1,300,000             ---            ---
     May 31, 1994      1,000,000             ---            ---

In FY’s 1993 and 1994, Mr. Heitz’ compensation as a percentage of

Exacto's gross receipts was approximately 11 percent and 6

percent, respectively.

     Exacto did not have a written employment contract with Mr.

Heitz or a stated formula for determining his compensation.

During the years in issue, Exacto's board of directors comprised

Mr. Heitz, Mr. Quillen, Mr. Greene, and Mr. Linsley.      The board

of directors approved the level of compensation paid to Mr. Heitz

on the basis of his performance.     Exacto determined and paid

Mr. Heitz' compensation in December, just over halfway through

its fiscal year.    Mr. Heitz' compensation was reduced in FY 1994

from $1,300,000 to $1 million to reflect the fact that he would

be taking time off recuperating from surgery, which took place in

December 1993.   Respondent determined $380,952 and $400,000 as

reasonable compensation for Mr. Heitz for taxable years ended

May 31, 1993 and 1994, respectively, and disallowed Exacto's

claimed deductions for the excess.
                                - 9 -


2.   Interest Income

     During the calendar years 1992 and 1993, Exacto was indebted

to Mr. and Mrs. Heitz in the approximate amount of $2 million.4

In 1992 and 1993, Exacto made monthly accruals of the interest

due to Mr. and Mrs. Heitz in the amounts of $217,056 and

$268,955, respectively.   These monthly accruals were deducted by

Exacto in the appropriate fiscal years.

      Exacto made payments in varying amounts and at irregular

intervals on the loans from Mr. and Mrs. Heitz.    Payments

designated as interest were made in lump sums and only in May

and/or December of each year.   Mr. and Mrs. Heitz reported

$130,000 and $162,000 as the amount of interest paid to them by

Exacto during the years 1992 and 1993, respectively.    However,

because the interest was not paid until several months after it

was accrued by Exacto, Mr. and Mrs. Heitz did not report $87,056

($217,056 - $130,000) and $106,903 ($268,955 - $162,052) accrued

and deducted by Exacto for those calendar years.

      Mr. Heitz, as president and chief executive officer of

Exacto, was responsible for overall company finances.    On


     4
        On May 1, 1993, Mr. Heitz transferred the note receivable
to the name of Mrs. Heitz. The amount of Exacto's indebtedness
to Mr. and Mrs. Heitz fluctuated in 1992 and 1993 as Exacto made
principal payments or borrowed additional funds from Mr. and Mrs.
Heitz.
                                - 10 -


December 31, 1992 and 1993, Exacto held cash, cash equivalents,

and marketable securities in the amounts of $2,792,123 and

$3,129,900, respectively.   Respondent determined that Mr. and

Mrs. Heitz had constructively received interest income in the

amounts of $87,056 and $106,903 for 1992 and 1993, respectively.

                                OPINION

Issue 1.   Reasonable Compensation

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

necessary business expenses including a “reasonable allowance for

salaries or other compensation for personal services actually

rendered”.   A two-prong test determines deductibility:

(1) Whether the amount of compensation is reasonable in relation

to services performed, and (2) whether the payment is in fact

purely for services rendered.      Summit Publg. Co. v. Commissioner,

T.C. Memo. 1990-288; sec. 1.162-7(a), Income Tax Regs.     The

inquiry into reasonableness is a broad one and generally subsumes

the inquiry into compensatory intent.     Summit Publg. Co. v.

Commissioner, supra.   Petitioner must show the reasonableness of

the compensation.   Rule 142(a).

     The reasonableness of compensation is a question of fact to

be answered by considering and weighing all facts and

circumstances of the particular case.      Estate of Wallace v.
                                 - 11 -


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

Cir. 1992).   Case law has provided an extensive list of factors

that bear on the determination of reasonableness.     Mayson

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

1949), affg. a Memorandum Opinion of this Court.     No single

factor is determinative.   Id.    In Edwin's, Inc. v. United States,

501 F.2d 675, 677 (7th Cir. 1974), the Court of Appeals for the

Seventh Circuit, to which this case is appealable, divided these

factors into seven categories:     (1) The type and extent of the

services rendered; (2) the scarcity of qualified employees; (3)

the qualifications and prior earning capacity of the employee;

(4) the contributions of the employee to the business venture;

(5) the net earnings of the employer; (6) the prevailing

compensation paid to employees with comparable jobs; and (7) the

peculiar characteristics of the employer's business.    For any

given position, there will be a range, not unduly narrow, of

compensation that could properly be considered “reasonable”.        Id.

     A.   Type and Extent of Services

     The first category of factors identified by the Court of

Appeals concerns the type and extent of the employee's services

for the company.   Relevant factors include the employee's

position, hours worked, and duties performed.     Home Interiors &
                              - 12 -


Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1158 (1980).

Petitioner maintains that Mr. Heitz is involved in every facet of

Exacto's business and that he discharged his responsibility

through long hours and significant effort.    Respondent

acknowledges that Mr. Heitz is a valuable employee, but

respondent maintains that this fact was taken into account in his

determination of reasonable compensation.

     Mr. Heitz was indispensable to Exacto's business.     He worked

60 to 70 hours per week, performing several functions.     Mr. Heitz

served as president and chief executive officer, and he

supervised sales, marketing, and research and development.       In

addition, Mr. Heitz assisted in the development of an automated

line of spring-making machines and in inventing technical and

practical advances in spring packaging.     Mr. Heitz was essential

to Exacto's success.

     B.   Scarcity of Qualified Employees

     The second factor considered in determining whether

compensation is reasonable is the ability of the employer to find

a qualified replacement for the employee.     Home Interiors &

Gifts, Inc. v. Commissioner, supra at 1158.     Mr. Heitz is a

technical expert in the area of spring design.    Spring design is

an extremely specialized branch of mechanical engineering, and
                               - 13 -


there are very few engineers who have made careers specializing

in this area.    Mr. Heitz combines his technical expertise with

the ability to identify and attract clients and to develop

springs to perform a specific function for that client.     As of

the years in question, he had established a stable and highly

successful pattern of applied expertise in product innovation and

development and packaging technology.   It would have been very

difficult to replace Mr. Heitz.    See id.

     C.   Qualifications of the Employee

     An employee's superior qualifications for his or her

position with the business may justify high compensation.

Edwin's, Inc. v. United States, supra at 677; Dave Fischbein

Manufacturing Co. v. Commissioner, 59 T.C. 338, 352-353 (1972).

Mr. Heitz is highly qualified to run Exacto as a result of his

education, training, experience, and motivation.    Mr. Heitz has

over 40 years of highly successful experience in the field of

spring design.

     D.   Contribution of the Employee to the Business

     The fourth factor identified by the Court of Appeals

concerns the employee's contribution to the success of the

business.   An employee's substantial contribution to the

employer's success may justify a high level of compensation.
                              - 14 -


Home Interiors & Gifts, Inc. v. Commissioner, supra at 1146.

Exacto maintains that Mr. Heitz’ efforts were of great value to

the corporation, and we agree.

     Mr. Heitz has contributed to the success of Exacto in

several ways.   First, he was instrumental in improving the

overall efficiency and quality of Exacto's production process.

Mr. Heitz regularly makes adjustments to Exacto's automated line

of spring-making machines to improve the efficiency of the line

and to reduce the percentage of rejected springs.     Mr. Heitz also

contributes significantly in the area of shipping and product

assembly, having invented several new types of spring packaging.

     Perhaps the most valuable service that Mr. Heitz provided to

Exacto was in sales and marketing.     He was very successful at

targeting clients and marketing Exacto's services.     He was

personally responsible for 65 to 70 percent of Exacto's sales

during the years at issue.   From FY 1991 to FY 1994, the period

when Mr. Heitz had assumed sole responsibility for the

administration and operation of the company, Exacto's gross sales

increased from $8,923,374 to $16,162,119.     Mr. Heitz’ efforts to

solicit clients played a key role in Exacto's success, and Exacto

was substantially dependent on him.     However, Mr. Heitz was also

being compensated for his sales efforts, in part, by Hickory.      He
                              - 15 -


received compensation from Hickory of $100,000, $200,000, and

$100,000 during Hickory's 1992, 1993, and 1994 fiscal years,

respectively.   Mr. Heitz’ salary from Hickory should be

considered in deciding whether his overall compensation was

reasonable.

     E.   Net Earnings of the Employer

     A fifth factor to be considered concerns the net earnings of

the employer.   The success of the business provides a basis for

increased compensation.   Summit Publg. Co. v. Commissioner, T.C.

Memo. 1990-288.   Exacto reported a $193,667 loss in FY 1993 and

$73,897 in taxable income in FY 1994.    Respondent argues that

Exacto's performance, as indicated on its tax returns, does not

warrant the compensation that was paid to Mr. Heitz.    We agree

that the financial success of a corporation is an important

factor in determining reasonable compensation.    If we measure

that success on an after-tax basis in this case, we must consider

Exacto's concessions that increase taxable income and enhance its

financial performance.

     Exacto conceded over $1 million in adjustments in each of

the taxable years at issue.   The adjustments concern Exacto's

classification of capital expenditures as operating expenses,

inappropriate or erroneous inventory calculations, and
                                - 16 -


inappropriate or erroneous deduction of certain bonuses.     After

these concessions, Exacto's income was over $1 million in each of

the taxable years at issue.     That level of income in each year

would have been after taking into account Mr. Heitz’

compensation, no part of which was conceded by petitioner.

     F.   External Comparison

     The sixth factor involves a comparison of the employee's

salary with salaries paid by similar companies for similar

services.   Industry standards for compensation are important in

determining reasonable compensation.     Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1330 (5th Cir. 1987), affg. T.C.

Memo. 1985-267; sec. 1.162-7(b)(3), Income Tax Regs.

     Both respondent and petitioner offered expert testimony and

written opinions on the level of reasonable compensation for an

executive in a position comparable to Mr. Heitz’.     Both experts

reached conclusions favorable to the party that had engaged their

services, and their reports were designed to support their

conclusions.   Respondent's expert used inappropriate or

unsuitable data to reach a result that understates reasonable

compensation, while petitioner's expert applied an inappropriate

or unsuitable technique to reach a result that overstates

reasonable compensation.
                              - 17 -


     Petitioner's expert was the supervisor of a major accounting

firm's compensation consulting department for an 18-State region

in the vicinity of petitioner's corporate business location.

Petitioner's expert was unable to obtain representative data or

other publicly available information on the compensation of

executives in the spring industry.     He reported that most spring

manufacturing companies are privately held.    Petitioner's expert

relied on published sources from general manufacturing companies

for representative data.   His survey reflected data from

manufacturing companies with gross sales approximating those of

Exacto.

     Petitioner's expert assumed:    (1) That Mr. Heitz performed

the following functions for Exacto:    President and chief

executive officer, top manufacturing executive, top research and

development executive, and top sales and marketing executive, and

that the estimated market value of these four positions was

aggregated in determining reasonable compensation for Mr. Heitz;

and (2) that executive compensation was made up of three

components:   Base salary, bonus, and long-term incentives.

Petitioner's expert concluded that the present value of long-term

incentives is typically 1.2 times the executive's base salary and

that Mr. Heitz’ market-based compensation should be within the

following parameters:
                                 - 18 -


                                 FY 1993                  FY 1994
                             75th        90th         75th       90th
                          Percentile Percentile   Percentile Percentile
1. Base salary             $457,700    $735,600    $476,400    $765,700
2. Total annual comp.       554,500     866,300     577,200     901,700
3. Annual bonus comp.        96,800     130,700     100,800     136,000
  (line 2-line 1)
4. Long-term incentive     549,240     882,720     571,680     918,840
   comp. (line 1 x 1.2)
5. Total market-based     1,103,740   1,749,020   1,148,880   1,820,540
   comp. (lines 2+4)

Finally, petitioner's expert concluded that compensation between

the 75th and 90th percentiles is appropriate for an executive of

Mr. Heitz’ accomplishments, success, and leadership.

     We do not accept certain aspects of petitioner's expert's

approach.    His aggregation approach would result in compensation

equal to that of four full-time corporate executives.         We have

not approved of aggregating salaries for an officer performing

multiple roles where each of the four salaries represents full-

time performance.     Pepsi-Cola Bottling Co., Inc. v. Commissioner,

61 T.C. 564, 569 (1974), affd. 528 F.2d 176 (10th Cir. 1975);

Richlands Med. Association v. Commissioner, T.C. Memo. 1990-660,

affd. without published opinion 953 F.2d 639 (4th Cir. 1992); Ken

Miller Supply, Inc. v. Commissioner, T.C. Memo. 1978-228.

Although Mr. Heitz may have performed some of the functions of

those four executives, he most assuredly did not perform full-

time services in each of the four disciplines.       Mr. Heitz’

inability to perform the services of four executives is
                              - 19 -


emphasized by the fact that he spent 10 to 20 percent of his time

working for Hickory.

     We can accept the general methodology of an expert and

reject the expert's ultimate conclusion if the record does not

support the conclusion.   Rutter v. Commissioner, 853 F.2d 1267,

1274 (5th Cir. 1988), affg. T.C. Memo. 1986-407; Barry v. United

States, 501 F.2d 578, 581-583 (6th Cir. 1974).   In addition, we

can decline to follow the opinion of an expert witness if the

opinion is contrary to our own judgment.   Barry v. United States,

supra at 583.

     Respondent relied on an expert in the field of compensation

and business valuation.   In his opinion of the reasonable

compensation for services rendered by Mr. Heitz to Exacto, he

relied on representative data and an investor return analysis

approach.   Respondent's expert placed more emphasis on the

investor return analysis tailored to the financial statements of

Exacto.   An investor return analysis compares a company's after-

tax profit to its equity to determine whether an independent

investor would be satisfied with the level of return.

Respondent's expert indicated that the minimum required return

for an investor in Exacto, given the risks associated with the

industry, would be about 13 percent.   Respondent's expert

concluded that Exacto's after-tax profit was insufficient to
                              - 20 -


support the level of compensation that was paid to Mr. Heitz and

still provide the minimum required return and that reasonable

compensation should, at most, be $592,500 and $621,400 for the

fiscal years 1993 and 1994, respectively.   Respondent, however,

maintains that reasonable compensation does not exceed the

amounts allowed in the notice of deficiency ($380,952 and

$400,000 for the fiscal years 1993 and 1994, respectively).

     Although we have approved of the use of an investor return

analysis in evaluating the reasonableness of compensation,

Diverse Indus., Inc. v. Commissioner, T.C. Memo. 1986-84, the

analysis here is flawed.   Exacto's concession of over $1 million

in adjustments in each of the tax years was not taken into

account by respondent's expert in determining Exacto's after-tax

profit for purposes of the investor return analysis.   In

calculating an investor's return, a company's actual performance,

not necessarily its reported underperformance, should be

considered.   If Exacto's concessions are taken into account,

Exacto's after-tax return on equity would have been over 20

percent for each of the years at issue.

     G.   Characteristics of the Employer's Business

     The final category identified by the Court of Appeals for

the Seventh Circuit concerns the peculiar characteristics of the

employer's business.   Edwin’s, Inc. v. United States, 501 F.2d at
                               - 21 -


677.    Respondent argues that several characteristics of Exacto

support the conclusion that the level of compensation paid to Mr.

Heitz was unreasonable.    First, respondent argues that Exacto's

low level of dividends is an indication that part of Mr. Heitz’

compensation was really disguised dividends.    Exacto did not pay

dividends from FY 1989 through FY 1994.

       A corporation's failure to pay dividends may be a factor in

determining the reasonableness of officer compensation.     Owensby

& Kritikos, Inc. v. Commissioner, 819 F.2d at 1324.

Corporations, however, are not required to pay dividends.

Indeed, shareholders may be equally content with the appreciation

of their stock caused, for example, by the retention of earnings.

Id. at 1323-1324; Home Interiors & Gifts, Inc. v. Commissioner,

73 T.C. at 1162.    Shareholder equity increased from $9,000 (Mr.

Heitz’, Mr. Greene's, and Mr. Quillen's initial capital

investment in 1960) to $7,550,000 in 1989.    The appreciation in

the value of Exacto's stock weakens respondent's argument that

the earnings of Exacto were being siphoned out in the form of

disguised dividends.

       Second, respondent correctly contends that Mr. Heitz was

able to influence the amount of his own compensation as he was

the majority shareholder and president of Exacto.    In such a

situation, we must carefully scrutinize the reasonableness of the
                               - 22 -


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

1324.   Mr. Heitz owned approximately 55 percent of Exacto's

common stock, and Mr. Quillen and Mr. Green each owned 20

percent.   During the years in issue, Mr. Heitz’ compensation was

approved by Mr. Green and Mr. Quillen.   It is more unlikely that

Mr. Greene and Mr. Quillen would have approved a substantial

"disguised dividend" to Mr. Heitz where they did not receive a

substantial dividend or some other benefit as well.   When there

is no close relationship between the share of compensation and

the share of stock holdings, it may be a persuasive indication

that the company is receiving compensable services and that

profits are not being siphoned out of the company disguised as

salary.    See Mayson Manufacturing Co. v. Commissioner, 178 F.2d

at 119-120.

     We have considered the factors relevant in deciding

reasonable compensation for Mr. Heitz.   On the basis of all the

evidence, we hold that reasonable compensation for Mr. Heitz for

taxable years ended May 31, 1993 and 1994, is $900,000 and

$700,000, respectively.   These amounts are in addition to the

salary Mr. Heitz received from Hickory, which we have considered

in determining his overall reasonable compensation.

     In deciding the above-stated amounts to be reasonable

compensation, we have balanced Mr. Heitz’ unique selling and
                               - 23 -


technical ability, his years of experience, and the difficulty of

replacing Mr. Heitz with the fact that the corporate entity would

have shown a reasonable return for the equity holders, after

considering petitioners' concessions.

Issue 2.   Accuracy-Related Penalty:    Exacto

     The next issue is whether petitioner is liable for accuracy-

related penalties pursuant to section 6662(a).   Section 6662(a)

imposes an accuracy-related penalty of 20 percent on any portion

of an underpayment of tax that is attributable to items set forth

in section 6662(b).   Respondent contends that either negligence

or substantial understatement of tax under section 6662(b)(1) and

(2) applies in the instant case.

     Negligence includes any careless, reckless, or intentional

disregard of rules or regulations, any failure to make a

reasonable attempt to comply with the provisions of the law, and

any failure to exercise ordinary and reasonable care in

preparation of a tax return.   Zmuda v. Commissioner, 731 F.2d

1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982).

     Section 6662(b)(2) specifies that a penalty shall be imposed

on “Any substantial understatement of income tax.”   An

understatement is substantial if it exceeds the greater of 10

percent of the tax required to be shown on the return, or $10,000

for a corporation.
                              - 24 -


     Section 6662(d)(2)(B) provides that the amount of the

understatement shall be reduced by the portion of the

understatement that is attributable to the tax treatment of any

item if:   (1) There is or was substantial authority for such

treatment; or (2) if the relevant facts affecting the item's tax

treatment are adequately disclosed in the return or in a

statement attached to the return.

     Section 1.6662-4(f)(2), Income Tax Regs., provides that the

Commissioner may prescribe by revenue procedure the circumstances

under which information provided on the return will constitute

adequate disclosure for purposes of section 6662.   The

Commissioner issued Rev. Proc. 93-33, 1993-2 C.B. 470, and Rev.

Proc. 94-36, 1994-1 C.B. 682, which describe the requirements for

adequate disclosure for purposes of the reasonableness of officer

compensation for tax years using 1992 and 1993 tax forms.

Petitioner complied with these requirements by providing Mr.

Heitz’ name, Social Security number, stock ownership, percentage

of time devoted to Exacto, and the amount of the compensation on

Schedule E of its return for each of the years in issue.5

Accordingly, petitioner's understatement for FY 1993 was

adequately disclosed and will be evaluated only to determine

whether there was negligence under section 6662(b)(1).

     5
       Petitioner used 1992 and 1993 tax forms for FY 1993 and FY
1994, respectively.
                              - 25 -


     For returns with a due date after December 31, 1993, the

item must be adequately disclosed and there must be a reasonable

basis for the tax treatment of such item.   The test to determine

whether there was a reasonable basis for the taxpayer's position

is the same standard used to determine whether the taxpayer was

negligent under section 6662(b)(1).    Sec. 1.6661-3(a)(2), Income

Tax Regs.   Accordingly, petitioner's understatement for FY 1994

will be evaluated using the negligence standard under section

6662(b)(1).

     Respondent determined accuracy-related penalties against all

the adjustments made in the notice of deficiency.   Petitioner has

conceded the penalties as to all adjustments with the exception

of the adjustment to the compensation to Mr. Heitz.   Considering

the facts of this case, we find that petitioner has shown that

approximately 70 percent of the amounts claimed for salary and

bonuses paid to Mr. Heitz was reasonable.   Evaluation of whether

petitioner had a reasonable basis in the claimed deductions is a

factual pursuit.   The range of reasonableness for Mr. Heitz’

compensation was particularly difficult to determine in this case

given his unique skills and ability.   Considering the

circumstances of this case, we find that petitioner is not liable

for the accuracy-related penalties under section 6662(a) with
                              - 26 -


respect to the reasonable compensation issue for its 1993 and

1994 fiscal years.

Issue 3.   Interest Income

     The next issue for our consideration is whether Mr. and Mrs.

Heitz constructively received interest income of $87,056 and

$106,903 for the taxable years 1992 and 1993, respectively.    In

the notice of deficiency, respondent determined that Mr. and Mrs.

Heitz constructively received interest income.    This interest

income represents amounts that were accrued and deducted by

Exacto during calendar years 1992 or 1993 but were not actually

paid to Mr. and Mrs. Heitz until the following year.    Respondent

argues that because Mr. Heitz was in control of Exacto, he had

the power to compel payment of the interest, and therefore he and

his wife constructively received the interest income.    Mr. and

Mrs. Heitz argue that the doctrine of constructive receipt is

inapplicable because Exacto had no funds to make the interest

payments, and Mr. Heitz had no discretion to order Exacto to make

the interest payments because corporate checks required two

signatures.   We agree with respondent.   To the extent the

arguments of petitioners are not addressed herein, we find them

to be without merit.

     Cash basis taxpayers such as Mr. and Mrs. Heitz must include

in their income amounts which they have received, actually or
                                - 27 -


constructively.     Sec. 1.451-1(a), Income Tax Regs.   It is well

established that income is constructively received by a taxpayer

when “it is credited to his account, set apart for him, or

otherwise made available so that he may draw upon it at any time,

or so that he could have drawn upon it * * * if notice of

intention to withdraw had been given.”     Sec. 1.451-2(a), Income

Tax Regs.     Whether the taxpayer has the necessary control over

the income to constitute constructive receipt is a question of

fact.     Willits v. Commissioner, 50 T.C. 602, 612-613 (1968).

        We have described in our findings of fact the authority that

Exacto vested in Mr. Heitz.     Mr. Heitz was the president and

chief executive officer of Exacto and was responsible for overall

company finances.     He had the power to cause the interest in

question to be paid timely.     As this Court has stated with

respect to the doctrine of constructive receipt:

             Respondent contends * * * that no evidence was
        presented here that petitioner's board of directors had
        taken any action that would bind the corporation to pay
        the interest. To the contrary, we feel that no further
        corporate action was necessary here. On the record
        herein, to require petitioner's board to authorize
        payment of the interest income at issue as a condition
        to our finding constructive receipt in this case would
        be a meaningless requirement on our part and an
        unnecessary gesture on its part since the corporation
        had already vested * * * [the employee] with the
        authority to pay the interest whenever requested by the
        debenture holders or whenever she determined to credit
        it to their personal accounts. * * * [F.D. Bisset &
                              - 28 -


     Son, Inc. v. Commissioner, 56 T.C. 453, 462-463 (1971);
     citation omitted.6]

     It is the right rather than the power to receive income that

determines whether such income is constructively received.     Id.

at 463.   However, Mr. and Mrs. Heitz had the right to receive the

interest income at the time that it was accrued.   Nothing in the

record indicates that the interest in question was not subject to

their unqualified demands thereafter.   Mr. and Mrs. Heitz argue

that Mr. Heitz had no discretion to order payment because two

signatures were required to validly issue an Exacto check.     We

find this argument unpersuasive.   Mr. and Mrs. Heitz presented no

evidence that Mr. Heitz ever requested that a check be issued for

the interest payments or that such a request would have been

denied.   Mr. Heitz had the right and authority to order the

payment of interest that had accrued.   See Fountain v.

Commissioner, 59 T.C. 696, 705-706 (1973).

     Mr. and Mrs. Heitz contend that Exacto did not have the

funds available to pay the interest in question.   On December 31,

1992 and 1993, Exacto held cash, cash equivalents, and marketable

securities in the amounts of $2,792,123 and $3,129,900,

respectively.   Mr. and Mrs. Heitz contend that these liquid

     6
       Most of the cases discussing the doctrine of constructive
receipt with respect to interest income apply to sec. 267. In
the cited case, the Commissioner was arguing that there was no
constructive receipt of interest income by the employee in order
to deny the employer-corporation the corresponding deduction.
                               - 29 -


assets were needed for an upcoming plant expansion.     We recognize

that there is no constructive receipt where the payor lacks the

funds to make the payments.    Estate of Noel v. Commissioner, 50

T.C. 702, 706-707 (1968).    However, no evidence was presented

that Exacto was indebted to any creditors or was financially

impaired during the period in question.     General statements

concerning future expansions are insufficient to justify not

applying the constructive receipt doctrine.     Accordingly, there

was constructive receipt, and we find for respondent on this

issue.

Issue 4.    Accuracy-Related Penalty:   Mr. and Mrs. Heitz

     Respondent determined that Mr. and Mrs. Heitz were liable

for penalties under section 6662(a) and (b)(1) for each of the

years in issue because they were negligent in failing to include

the interest income on their returns.     We sustain respondent's

determination.

     In determining whether Mr. and Mrs. Heitz were negligent in

the preparation of their returns, we take into account Mr. Heitz’

business experience.    Wise v. Commissioner, T.C. Memo. 1997-135.

Mr. Heitz, a sophisticated taxpayer, manipulated the timing of

the interest payments in order to defer the recognition of

income.    Accordingly, petitioners Mr. and Mrs. Heitz are liable

for the section 6662(a) penalties.
                        - 30 -


To reflect the foregoing,

                                  Decisions will be entered

                             under Rule 155.
