                         T.C. Memo. 2006-133



                       UNITED STATES TAX COURT



            E.J. HARRISON & SONS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5316-01.               Filed June 26, 2006.



     Philip Garrett Panitz, for petitioner.

     Jonathan H. Sloat, for respondent.



                 SUPPLEMENTAL MEMORANDUM OPINION

     HALPERN, Judge:    This case is before us on remand from the

U.S. Court of Appeals for the Ninth Circuit for reconsideration

of a question of reasonable compensation.      See E.J. Harrison &

Sons, Inc. v. Commissioner, 138 Fed. Appx. 994 (9th Cir. 2005),

affg. part, revg. part, and remanding T.C. Memo. 2003-239.
                                - 2 -

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                              Background

     The single question before us is how much of the salary paid

by petitioner to Myra I. Harrison (Mrs. Harrison) and deducted by

petitioner on its Federal income tax returns for its 1995, 1996,

and 1997 taxable years (the audit years) was not reasonable in

amount and, therefore, not deductible as an ordinary and

necessary business expense.    See sec. 162(a)(1); sec. 1.162-7(a),

Income Tax Regs.   Petitioner, a California corporation, is in the

business of waste pickup and disposal.     During the audit years,

Mrs. Harrison was a member of petitioner’s board of directors

(indeed, its chairman), an officer of petitioner (president), and

petitioner’s principal shareholder.      Mrs. Harrison’s three sons

(Myron, James, and Ralph Harrison) were the remaining members of

the board and the only other officers of petitioner.     For the

audit years, petitioner’s officers received, and petitioner

deducted, compensation in the following amounts:

                 Mrs.
     Year      Harrison        Myron         James       Ralph

     1995      $860,682       $479,773      $473,973    $459,673
     1996       818,059        442,882       475,183     468,188
     1997       600,059        338,436       377,849     360,391
                              - 3 -

When this case was before us originally, respondent argued that

petitioner’s deductions for compensation paid to Mrs. Harrison

during the audit years should be reduced on account of the

unreasonableness of her salary as follows:

                Amount       Amount          Amount
     Year      Deducted      Allowed       Disallowed

     1995      $860,682      $54,215         $806,467
     1996       818,059       56,040          762,019
     1997       600,059       58,734          541,325

Petitioner argued that all amounts paid to her during the audit

years were reasonable and, therefore, were deductible in full.

We concluded that petitioner may deduct the following amounts as

compensation for services performed by Mrs. Harrison during the

audit years:

                Year                       Amount

                1995                       $98,000
                1996                       101,000
                1997                       106,000

We were persuaded that, during the audit years, petitioner was a

company run by Mrs. Harrison’s sons, her role in the operations

of the company had always been “secondary”, and her titles of

president and chairman of the board were titular and not

reflective of her status in the company.   We found that her role

as an essentially compliant member of petitioner’s board of

directors justified her receipt of only a small fraction of the

compensation paid to her during the audit years.     We considered

apposite respondent’s analogy of Mrs. Harrison’s activities on
                                 - 4 -

petitioner’s behalf to the duties performed by an outside board

chair, and we used that model to determine reasonable

compensation for her services.

     The Court of Appeals affirmed our application of the five-

factor test articulated in Elliotts, Inc. v. Commissioner, 716

F.2d 1241 (9th Cir. 1983), revg. T.C. Memo. 1980-282, to

determine reasonable compensation.       E.J. Harrison & Sons, Inc. v.

Commissioner, supra at 995.    Although it reversed our finding of

what was reasonable compensation for Mrs. Harrison, id. at 996,

it affirmed our determination that some portion of Mrs.

Harrison’s salary should be disallowed as unreasonable

compensation, id. at 995.     With respect to Mrs. Harrison’s role

in the company, the Court of Appeals reversed our finding that

Mrs. Harrison’s role was “secondary” and equivalent to that of a

typical outside board chair.     Id. at 996.   It found that her role

was equal to or greater than the roles of other officers.       Id.

It instructed us that the reasonableness of her compensation

should have been evaluated based on her actual role as president

of the corporation.   Id.   It further instructed us:    “At the very

least, Mrs. Harrison’s reasonable compensation should not have

dropped below that of her sons during the audit years.”       Id.   The

Court of Appeals remanded the case to us for a redetermination of

reasonable compensation in a manner consistent with its

discussion.
                                 - 5 -

                              Discussion

     Since the Court of Appeals affirmed our determination that a

portion of Mrs. Harrison’s salary should be disallowed as

unreasonable and instructed us that it was not unreasonable for

petitioner to have paid her at least as much as it paid her sons

during the audit years, we would not be amiss to find that she

was reasonably compensated at some level between her actual

compensation and the compensation paid her sons.

     In its original brief, petitioner states its position as

follows:     “It is E.J. Harrison & Sons [sic] position that the

services rendered by Myra Harrison, including her guaranty of

company notes, merited the compensation she received and was

reasonable under the independent investor analysis set forth in

Elliotts, Inc. v. Commissioner of Internal Revenue, * * *

[supra].”    In Elliotts, Inc. v. Commissioner, supra at 1245, the

United States Court of Appeals for the Ninth Circuit identified

the factors that identify what is “reasonable compensation” under

section 162(a)(1).     Among those factors is a comparison of the

employee’s salary with those paid by similar companies for

similar services: viz, an “External Comparison”.     Id. at 1246.

On brief, under the heading “External Comparison”, petitioner

states:     “The unique nature of the services provided by Myra

Harrison makes an external comparison extremely difficult.     * * *

As the public face of a company dependent on public contracts,
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Myra Harrison could not be replaced at any price.”     Following the

remand of this case to us by the United States Court of Appeals

for the Ninth Circuit, petitioner moved the Court to hold an

evidentiary hearing limited to “the external comparison factor of

the Elliotts test”, so that the Court could properly evaluate

that factor.   Respondent objected to the motion, and we denied

it.   In our order disposing of the motion, we agreed with

respondent that, having eschewed such testimony at trial,

petitioner would not be prejudiced by being denied the

opportunity to supplement the record with additional expert

testimony addressed at external comparisons.     We added that

granting the motion would undermine principles of judicial

economy and the need for finality.     Finally, we stated that we

were convinced by respondent that he would be prejudiced if

forced to expend additional resources to rebut any additional

testimony.

      Petitioner bears the burden of proof, and we have little, if

anything, in the way of guidance from petitioner to aid us in

fixing a number for the reasonable amount of compensation paid to

Mrs. Harrison for the audit years.     In its supplemental brief on

remand, petitioner suggests that we adopt the perspective of a

hypothetical independent investor to determine whether such an

investor would be satisfied with his return on equity after the

compensation in issue was paid.   See Elliotts, Inc. v.
                               - 7 -

Commissioner, supra at 1245; Labelgraphics, Inc. v. Commissioner,

T.C. Memo. 1998-343, affd. 221 F.3d 1091 (9th Cir. 2000).

Petitioner argues that its return on equity “was a very solid

12.33%” during the audit years, and that return “is consistent

with the 14.9% average rate of return of comparably sized

companies testified to by the IRS’s expert”.1     Accordingly, it

continues:   “[A]n independent investor would have been very

satisfied with the return on equity yielded by * * * [petitioner]

during the 1995, 1996 and 1997 fiscal years.”     While all of that

may be true, it does not necessarily support petitioner’s

conclusion that reasonable compensation for Mrs. Harrison for the

audit years is as follows:2

                  Year                   Amount

                  1995                  $860,682
                  1996                   772,000
                  1997                   378,000

Certainly, the corporation's rate of return on equity would be

relevant to a hypothetical independent investor in assessing the

reasonableness of compensation in a small corporation where


     1
        Petitioner calculates returns on equity of 41, 13, and
(17) percent for petitioner’s 1995, 1996 and 1997 fiscal years,
respectively, and a mean return on equity for those years of
12.33 percent.
     2
        Computed by reducing Mrs. Harrison’s compensation for
petitioner’s 1996 fiscal year to an amount that would make
petitioner’s return on equity for that year 14.9 percent, and
computed for 1997 (a loss year) by reducing her compensation to
$378,000, an amount approximately equal to the amount paid her
son, James.
                                 - 8 -

excessive compensation would noticeably decrease the rate of

return.   Elliotts, Inc. v. Commissioner, 716 F.2d at 1245.    It

would aid in the investor’s assessment of whether the total

compensation package paid by the corporation to all of its

employees is reasonable.   If, like petitioner, however, the

corporation has more than one employee, its rate of return on

equity tells us nothing precise about the reasonableness of the

distribution of compensation among those employees.    Moreover,

petitioner ignores the following caveat, in Elliotts, to the

application of the independent investor test:

     A relevant inquiry is whether an inactive, independent
     investor would be willing to compensate the employee as
     he was compensated. The nature and quality of the
     services should be considered, as well as the effect of
     those services on the return the investor is seeing on
     his investment. * * * [Id.]

By agreeing that a portion of Mrs. Harrison’s salary should be

disallowed as unreasonable compensation, the Court of Appeals for

the Ninth Circuit implicitly agrees with our finding that “an

independent investor in petitioner would object to the size of

Mrs. Harrison’s compensation”.     E.J. Harrison & Sons, Inc. v.

Commissioner, T.C. Memo. 2003-239.

     Considering the rulings and instructions of the Court of

Appeals, we find that the amounts of reasonable compensation paid

to Mrs. Harrison for the audit years are as follows:
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           Year                        Amount

           1995                        $500,000
           1996                         500,000
           1997                         400,000


                      Conclusion

Based on the foregoing,


                                       Decision will be entered

                                  under Rule 155.
