                          T.C. Memo. 1998-128



                        UNITED STATES TAX COURT



          RANDY L. AND JULIE J. WYSONG, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 22527-96.                         Filed April 1, 1998.



     Jess A. Bahs and Frank M. Polasky, for petitioners.

     Elizabeth Patino, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION

     LARO, Judge:     In a notice of deficiency dated July 19, 1996,

respondent determined deficiencies in petitioners' Federal income

tax for 1992 and 1993 in the amounts of $28,507 and $13,643,

respectively.    The deficiencies stem from the disallowance of

rent paid by Wysong Medical Corp. (Wysong Medical), a subchapter

S corporation, to Wysong Corp., a subchapter C corporation, and a
                                 - 2 -


corresponding increase in the amount of flow-through income from

Wysong Medical to petitioners.

     We must decide whether petitioners' share of ordinary income

from Wysong Medical should be increased by the amounts of $85,587

and $42,750 in 1992 and 1993, respectively.    Our answer to this

question rests on whether amounts paid as rent by Wysong Medical

to Wysong Corp. represented ordinary and necessary expenditures

under section 162(a)(3).    We answer this question in the negative

and thereby hold that petitioners' share of ordinary income

should be increased by the stated amounts.    Unless otherwise

stated, section references are to the Internal Revenue Code in

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

Court Rules of Practice and Procedure.

                           FINDINGS OF FACT

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

The stipulated facts and exhibits submitted therewith are

incorporated herein by this reference.    Petitioners, husband and

wife, resided in Midland, Michigan, when they petitioned the

Court.   They filed timely joint 1992 and 1993 Federal income tax

returns.

     Petitioners own a commercial building (the Eastman Building)

located in Midland, Michigan.    The Eastman Building currently

contains a total of 25,196 square feet, consisting of 15,400

square feet of warehouse space, 3,500 square feet of office area,
                               - 3 -


and 6,296 square feet of office-work area.   The 25,196 square

feet includes an addition which was made after the years in issue

and which increased the warehouse section of the building by

approximately twofold.   On petitioners' 1992 and 1993 tax

returns, the Eastman Building's total asset cost was identified

at $403,400.

     Randy L. Wysong (Dr. Wysong) is a doctor of veterinary

medicine.   In the early 1980's, he purchased all the stock of

Vet-Med Health Products, a company in the business of nutritional

products designed for veterinary clinical use.   Dr. Wysong

subsequently changed the name of the company to Wysong Medical.

Prior to 1992, Wysong Medical conducted research and development

activities and manufacturing and marketing activities.    Also

prior to 1992, Wysong Medical leased the Eastman Building from

petitioners for an amount and under terms not disclosed by the

record, and it owned all the personal property in the Eastman

Building.

     Due, in part, to liability concerns, Dr. Wysong decided to

separate research and development activities from manufacturing

and marketing activities.   To accomplish this end, Dr. Wysong, in

or around 1991, founded Wysong Corp. to market products developed

by Wysong Medical.1   Dr. Wysong is Wysong Corp.'s sole


     1
        Wysong Corp. also manufactures a limited amount of these
products.
                                - 4 -


shareholder.    Following Wysong Corp.'s incorporation, Wysong

Medical was dedicated to research and development activities

consisting of developing food supplements for animals and people,

designing medical and surgical equipment, and designing athletic

and fitness equipment.    Except for filling a few invoice orders

carried over from 1991, beginning in January 1992, Wysong Medical

performed strictly research and development activities during the

years in issue.    Its sole client was Wysong Corp.

     Petitioners instigated a series of transactions in order to

shift liabilities and assets away from Wysong Medical to Wysong

Corp.    On January 1, 1992, petitioners leased the Eastman

Building and the underlying property to Wysong Corp. for a period

of 10 years.    Both petitioners signed the lease agreement as

lessors, and Dr. Wysong signed as lessee in his capacity as

president of Wysong Corp.    Under the terms of the lease

agreement, Wysong Corp. was obligated to pay petitioners monthly

rent of $9,085, $4,800 per month to Dr. Wysong, and $4,285 per

month to Julie Wysong, for an annual total of $109,020.     During

1992 and 1993, Wysong Corp. paid petitioners rent in the amounts

of $132,842 and $131,520, respectively.2

     On December 31, 1991, prior to Wysong Corp.'s finalizing its

lease agreement with petitioners, Wysong Corp. leased space in

     2
        The record does not disclose the reason for the disparity
in the rent provided by the lease agreement and the rent actually
paid by Wysong Corp.
                                - 5 -


the Eastman Building to Wysong Medical for the 1992 calendar

year. In pertinent part, the 1992 lease agreement provides:

     Wysong Corporation party of the first part and Wysong
     Medical Corporation party of the second part, [hereby
     agree that] * * * The said party of the first part, in
     consideration of the rents and covenants herein
     specified hereby Let and Lease to the said party of the
     second part the following described premises, situated
     and being in the township of Larkin, County of Midland,
     and State of Michigan, to-wit: 1880 N. Eastman Road,
     Midland, Michigan * * * 500 square foot annual fee -
     $92,087 for the term of one year from and after the 1st
     day of January, 1992 * * *.

Wysong Corp. and Wysong Medical executed a second lease agreement

on December 31, 1992, for the 1993 calendar year.     The 1993 lease

agreement contains identical terms except that it limits the

square footage leased by Wysong Medical to 250 square feet and

reduces Wysong Medical's rent to $46,000.     Dr. Wysong signed the

1992 and 1993 lease agreements as both the lessor and the lessee.

     On January 1, 1992, Wysong Medical sold all its assets to

Wysong Corp. for $89,293.   Wysong Medical received Wysong Corp.'s

promissory note in the amount of $89,293 with interest at 8

percent per annum.   Out of the $89,293 purchase price, $33,138

was allocated to equipment sold; the remainder to stock in trade

and all other unidentified assets.      The price breakdown for the

equipment sold is as follows:

    Equipment                                  Sales Price

1986 Dodge Caravan                                $1,875
Mita copier                                        4,251
IBM computer system                               17,506
Furniture & fixtures                               9,506
                               - 6 -


   Total                                       33,138

After this sale, Wysong Corp. owned and operated all the

equipment, furniture, and fixtures in the Eastman Building.     Both

corporations operated out of the Eastman Building under the

following arrangement: Wysong Corp. paid Wysong Medical for its

research and development activities conducted on behalf of Wysong

Corp., and pursuant to the lease agreements, Wysong Medical paid

Wysong Corp. for the use of the latter's facilities.    Also, all

employees of Wysong Medical became employees of Wysong Corp.

     On Wysong Medical's 1992 and 1993 tax returns, it deducted

rent paid to Wysong Corp. in the amounts of $92,087 and $46,000,

respectively.   Wysong Medical also deducted on these returns

"other deductions" of $91,502 and $52,207: in 1992, "other

deductions" include $1,000 for legal and accounting costs,

$70,000 in commissions, $9,000 for equipment rental, $43 in fees,

$3,386 for auto/travel, $7,913 for utilities, and $160 for

refunds; in 1993, "other deductions" include $218 in fees,

$48,309 in contract work, and $3,680 for utilities.

     In the notice of deficiency, respondent determined that the

amounts claimed as rent deductions by Wysong Medical exceeded

reasonable amounts for rent within the meaning of section

162(a)(3).   Using the square footage identified in the lease

agreements, respondent computed Wysong Medical's allowable rent

deduction at $13 per square foot (500 times $13; 250 times $13).
                              - 7 -


Based on these amounts, respondent determined that reasonable

amounts for Wysong Medical to pay for the use and occupancy of

the leased property were $6,500 and $3,250 in 1992 and 1993,

respectively.

                             OPINION

     We must decide whether amounts paid as rent by Wysong

Medical to Wysong Corp. represented ordinary and necessary

expenditures under section 162(a)(3).   Deductions are a matter of

legislative grace, and petitioners bear the burden of showing

that they are entitled to the deductions claimed.   Rule 142(a);

New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934).

     Section 162(a)(3) allows a deduction for all ordinary and

necessary business expenses, including rent required to be paid

as a condition for the use of property.3   Inherent in the phrase

"ordinary and necessary" is an element of reasonableness, and,

where the lessor and lessee are closely related and there is no

arm's-length dealing between them, an inquiry into what

constitutes reasonable rent is necessary to determine whether the

sums paid exceed what the lessee would have paid in an arm's-


     3
        Sec. 162(a)(3) provides that "There shall be allowed as a
deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or
business, including * * * rentals or other payments required to
be made as a condition to the continued use or possession, for
purposes of the trade or business, of property to which the
taxpayer has not taken or is not taking title or in which he has
no equity."
                                - 8 -


length transaction with an unrelated party.    See Southeastern

Canteen Co. v. Commissioner, 410 F.2d 615, 619 (6th Cir. 1969),

affg. in part and revg. in part T.C. Memo. 1967-183; Place v.

Commissioner, 17 T.C. 199, 203 (1951), affd. per curiam 199 F.2d

373 (6th Cir. 1952); see also Maschmeyer's Nursery, Inc. v.

Commissioner, T.C. Memo. 1996-78.   The close relationship in the

present case is evident.   Dr. Wysong was the sole shareholder of

both corporations, and whatever negotiations took place were

between Dr. Wysong and himself.   Furthermore, Dr. Wysong signed

the lease agreements on behalf of both the lessor and the lessee.

The entire record supports the fact that there were no

arm's-length negotiations between the two entities.    We closely

scrutinize related party transactions, and to the extent that

rent paid by a lessee to a related lessor is excessive, a rental

deduction will be disallowed.   The question of whether rental

payments are reasonable is one of fact.    Many factors may be

considered, such as the terms and conditions of the lease and the

facts and circumstances surrounding the signing of the lease.

See Audano v. United States, 428 F.2d 251, 256 (5th Cir. 1970);

Commissioner v. Lincoln Elec. Co., 176 F.2d 815, 817 (6th Cir.

1949); see also Alondra Indus., Ltd. v. Commissioner, T.C. Memo.

1996-32.   No one factor is dispositive.

     Petitioners argue that the claimed rent was reasonable

because the parties to the lease agreements intended to convey
                                - 9 -


additional property and services to Wysong Medical that were not

explicitly mentioned in the lease agreements.   First, petitioners

argue that there was a mistake in the 1992 and 1993 lease

agreements; that the parties did not intend to limit Wysong

Medical's use of the Eastman Building to the square footage

identified in the agreements and that in fact Wysong Medical's

use of the Eastman Building was not so limited.   Petitioners

contend that during 1992 Wysong Medical used approximately one-

half of the Eastman Building for its research and development

activities, and, given the Eastman Building's square footage

subsequent to the warehouse expansion (approximately 25,000

square feet) and respondent's determination that $13 a square

foot was reasonable rent, the rent paid by Wysong Medical was

significantly less than the $162,500 fair rental value (25,000

divided by 2, times $13).    Petitioners argue alternatively that

one-half of the original building size, approximately 13,500

square feet divided by 2, still establishes that the rent paid by

Wysong Medical during 1992 was reasonable to the extent of

$87,750 (6,750 times $13).   Petitioners reduce the aforementioned

calculations by half for 1993 to reflect a claimed 50-percent

decrease in Wysong Medical's research and development activities

for that year.

     Second, petitioners argue that the amount of rent was

reasonable in light of the fact that Wysong Corp. furnished
                              - 10 -


Wysong Medical with additional equipment and services not

specified in the lease agreements.     According to petitioners, the

lease agreements do not embody the entire agreement between the

two entities.   In addition to the physical space, petitioners

contend that Wysong Medical's rent payments included a premium

for: access to or use of Wysong Corp.'s equipment and employees;

and costs incurred on behalf of Wysong Medical by Wysong Corp.

for phone systems, computer systems, freight expenses, printing

expenses, fitness equipment, kitchen facilities, and inventory

used by Wysong Medical in its research and development

activities.

     Respondent argues that the lease agreements speak for

themselves.   Alternatively, respondent argues that even if Wysong

Medical used additional space not reflected in the lease

agreements petitioners failed to establish that the rental rate

was reasonable.   For example, petitioners failed to adduce

evidence which establishes when the Eastman Building's addition

was completed and hence the square footage of the Eastman

Building during the years in issue.

     Respondent also attacks petitioners' second argument that

the parties to the lease agreements intended for the lease to

cover additional equipment and services.    Among other things,

respondent argues that Wysong Medical had no business purpose for

the sale and leaseback of its equipment and that the transaction
                               - 11 -


lacked economic reality.    According to respondent, because there

was no business purpose behind the asset sale, the transaction

should be ignored for tax purposes and Wysong Medical retains an

equity interest in the assets.    Hence, respondent contends that

no deduction is allowed under section 162 for any part of the

rent payment earmarked for Wysong Medical's use of the

aforementioned equipment.    See sec. 162(a)(3).

     We sustain respondent's position as to the amounts allowable

as deductions for rent.    We entertained, at great length,

petitioners' evidence of Wysong Medical's and Wysong Corp.'s

intent to convey to Wysong Medical the right to use more than the

square footage identified in the lease agreements.    We remain

unconvinced, however, that petitioners or the two corporations

intended to enter into an agreement other than the one evidenced

by the leases.   The leases are clear and unambiguous.   Dr. Wysong

had unfettered control over the final terms embodied in the

leases, and he signed both agreements in his capacity as the sole

shareholder of both the lessor and lessee corporations.    We are

also unpersuaded that Wysong Medical used more of the Eastman

Building than it was allowed under the terms of the leases, or

that the addition to the Eastman Building's warehouse was

completed during the years in issue.    Petitioners' 1992 and 1993

tax returns identify the Eastman Building's total asset cost as

$403,400.   If petitioners had incurred construction expenses in
                               - 12 -


1992 or 1993, it would have increased the Eastman Building's

total asset cost in 1993.

     We also reject petitioners' second argument that the rent

was reasonable because the parties intended for Wysong Medical to

reimburse Wysong Corp. for additional equipment and services

provided by the latter.    Assuming that there was in fact a

legitimate business purpose for the sale of Wysong Medical's

assets to Wysong Corp., and that the transaction may be

recognized for tax purposes, Southeastern Canteen Co. v.

Commissioner, 410 F.2d 619; Carroll v. Commissioner, T.C. Memo.

1978-173, Wysong Medical's other deductions are inconsistent with

petitioners' argument.    If the rent established by the 1992 and

1993 lease agreements included a premium for the use of

equipment, then why did Wysong Medical take a $9,000 deduction in

1992 for equipment rental?    Petitioners offered no explanation.

Also, in 1992 and 1993, Wysong Medical deducted $7,913 and

$3,680, respectively, for utilities expenses paid.    Jill Hubbard

(Ms. Hubbard), who began working for Wysong Medical in 1986 and

continued on with Wysong Corp. in the capacity of office manager

and bookkeeper, testified that Wysong Medical paid $7,913 to

Wysong Corp. to reimburse the latter for a percentage of the

utilities bills it paid.    Again, petitioners failed to explain

why Wysong Medical made separate payments to reimburse Wysong

Corp. for utilities payments made on Wysong Medical's behalf if
                              - 13 -


Wysong Medical's share of the utilities was factored into its

rent payment.   And finally, in 1992 and 1993, Wysong Medical

deducted $70,000 and $48,309, respectively, for "commissions" and

"contract work" expenses.   Ms. Hubbard testified that the $70,000

deduction for "commissions" was for contract labor performed by

employees of Wysong Corp.   This undercuts petitioners' argument

that Wysong Medical's rent payments included a premium for the

use of Wysong Corp.'s employees.    Petitioners further argue that

the rent payment included a premium for access to, and not the

use of, Wysong Corp.'s employees.   This argument lacks merit.     It

is well-settled law that a deduction claimed for rent is only

allowable where the payment is actually made for rent and not for

something else in the guise of rent.    Mackinac Island Carriage

Tours, Inc. v. Commissioner, 419 F.2d 1103, 1105 (6th Cir. 1970);

Place v. Commissioner, 17 T.C. at 203; American Metal Prods.

Corp. v. Commissioner, 34 T.C. 89, 105 (1960), affd. 287 F.2d 860

(8th Cir. 1961) ("To the extent * * * [payments were not made for

rent], such payments would not be ordinary and necessary and

therefore would not be deductible as rental expenses").

     Rejecting petitioners' arguments as to square footage,

property, and services not identified in the lease agreements, we

now turn to the parties' remaining arguments for and against the

reasonableness of the rent.   Neither party presented expert

testimony to establish the fair rental value of the leased
                              - 14 -


property.   Among other things, petitioners argue that the

reasonableness of Wysong Medical's rent is evidenced by the

proportionally similar income and losses reported by both the

lessor and the lessee.   For example, in 1992, Wysong Medical's

total deductions represented approximately 101 percent of its

gross income, whereas Wysong Corp.'s total deductions represented

approximately 99 percent of its gross income.    Petitioners

contend that this balancing of income and losses was done by

design, and that this proportionality establishes that there was

no improper shifting of income.

     Respondent argues that Wysong Medical's payments were not

reasonable in light of all the facts and circumstances.    First,

and using the square footage identified in the lease agreements,

respondent argues that parties in an arm's-length transaction

would not have agreed to rent office space at $184 per square

foot when the prevailing rate in the area was $13 per square

foot.   Second, respondent argues that the amount of rent paid by

Wysong Medical was not reasonable in relation to the business

activities of the two corporations.    In 1992 and 1993, Wysong

Medical's gross receipts were $147,341 and $100,537,

respectively; whereas Wysong Corp.'s gross receipts were

$2,436,888 and $2,666,759 in 1992 and 1993, respectively.      Yet,

the amount of rent paid by Wysong Medical represented 69 percent

and 35 percent of the total rent paid by Wysong Corp. in 1992 and
                              - 15 -


1993, respectively.   According to respondent, it was not

reasonable for Wysong Medical to pay such portions of the rent.

Third, respondent argues that Wysong Medical's payments to Wysong

Corp. were made as a means of shifting income with the end effect

being a decrease in the amount of flow-through income from Wysong

Medical, an S corporation, to its sole shareholder Dr. Wysong.

     We are not satisfied that the amount of rent paid by Wysong

Medical was reasonable, in other words, that a lessee in an

arm's-length transaction with an unrelated party would have paid

the amount of rent that Wysong Medical was required to pay under

the lease agreements.   We reject petitioners' argument that the

corporations' proportionally similar income and losses for the

years in issue demonstrates that there was no improper shifting

of income and that the amount of rent paid by Wysong Medical was

reasonable.   We believe that the relevant inquiry focuses not

only on the effect that these deductions had on the two

corporations but also on the effect that the deductions had on

the S corporation's sole shareholder, Dr. Wysong.

     Furthermore, we find that Wysong Medical's rent payments

were not reasonable in relation to the corporations' business

activities.   In 1992 and 1993, Wysong Corp. had gross income in

the amounts of $2,436,888 and $2,666,759, respectively, and made

rent payments to petitioners in the amounts of $132,842 and

$131,520.   The rent payments were approximately 5.5 percent and
                              - 16 -


4.9 percent of Wysong Corp.'s gross income.    In comparison, in

1992 and 1993, Wysong Medical had gross income in the amounts of

$147,341 and $100,537, respectively, and paid rent to Wysong

Corp. in the amounts of $92,087 and $46,000.    Wysong Medical's

rent payments were approximately 49.7 percent and 45.8 percent of

its gross income.   We also note that petitioners made no attempt

to determine the fair rental value of the property prior to

Wysong Medical and Wysong Corp.'s entering into the lease

agreements; petitioners did not consult with a real estate

appraiser to determine fair rental rates in the area, and they

did not investigate the rental rates of comparable properties.

          In conclusion, we find that Wysong Medical's rent

payments were excessive for purposes of section 162(a)(3).

Accordingly, we sustain respondent's determination on this issue.

The excess rent payments do not constitute rent that Wysong

Medical was required to pay for the continued use and possession

of the property in question, for purposes of its trade or

business, and are therefore not deductible.

     We have considered all other arguments made by the parties

and found them to be either irrelevant or without merit.

                          To reflect the foregoing,

                                         Decision will be entered

                                    for respondent.
