                        T.C. Memo. 1999-26



                      UNITED STATES TAX COURT



        HEROLD MARKETING ASSOCIATES, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 1529-97.                     Filed January 29, 1999.



          Held: Compensation paid by P to its sole
     shareholder/CEO was reasonable.


     Daniel J. Boivin, Frank R. Berman, and Jeffrey A. Olson,

for petitioner.

     Jack M. Forsberg, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Herold Marketing Associates, Inc., petitioned

the Court to redetermine 1992 and 1993 income tax deficiencies of

$246,508 and $247,829, respectively.   The deficiencies stem from

respondent's determination that $700,000 of the $1.2 million in
                                 - 2 -


compensation that petitioner paid to its sole shareholder/chief

executive officer could not be deducted under section 162(a).

     We must decide whether petitioner may deduct the full

compensation of $1.2 million.    We hold it may.   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.    Most dollar amounts are

rounded to the nearest dollar.

                          FINDINGS OF FACT

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

The stipulations of fact and the exhibits submitted therewith are

incorporated herein by this reference.    Petitioner is an accrual

method, calendar year C corporation, the principal office of

which was in Eden Prairie, Minnesota, when it petitioned the

Court.   Stephan Herold (Herold) has been petitioner's president

and chief executive officer since it was founded.     He has been

petitioner's sole director since April 1985.

1.   Petitioner's Business History

     Petitioner was originally a division of Stan Clothier Co.

(SCC), which was primarily a manufacturer's representative for

industrial components.    The division that was to become

petitioner was a manufacturer's representative for consumer

electronics components.    When it was first spun off in 1980,

petitioner was named Clothier-Herold Co.     Stan Clothier owned

50 percent of petitioner's stock, and Herold owned the rest.       In
                                - 3 -


1984, Herold became the sole shareholder, and he changed the

company's name to Herold Marketing Associates.

     Petitioner was very successful in its early years.    Herold

recognized as early as the mid-1970's that personal computers

would become an extremely successful technology.   Later, he

identified Apple Computer (Apple) as a company that was destined

for success in this fledgling industry.   By cultivating

relationships with key personnel at Apple, Herold overcame that

company's initial resistance to marketing through sales

representatives.   In 1980, its first year of business, petitioner

became Apple's first sales representative with a territory that

covered the Dakotas, Minnesota, and western Wisconsin.

     Petitioner developed its territory for Apple from annual

sales of $1 million in 1980 to $70 million in 1984.   In 1984,

Apple stopped using sales representatives and terminated its

relationship with petitioner.   Just before the relationship

ended, Apple accounted for 80 percent of petitioner's sales

volume.

     Herold changed the focus of the company by identifying three

of Apple's four largest accounts and concentrating on selling

them other electronics products.   Petitioner ran into

difficulties in 1986, when all three of these key accounts became

insolvent.   Herold then developed a three-pronged strategy

focusing on one major product line in each of three categories:

(1) Products that were currently well recognized and in demand,

(2) products that were just beginning to become available and for
                               - 4 -


which Herold foresaw a strong demand, and (3) products that were

just beginning to be conceptualized that Herold felt would gain

strong market acceptance.   By implementing this strategy,

petitioner, which had seen its revenue drop to less than $1

million in 1985, achieved sales of over $36 million in 1992 and

nearly $44 million in 1993.   Around 1992, Herold changed the

company's fundamental mode of doing business by ceasing to

operate as a sales representative and concentrating on being a

distributor.   Herold recognized that this strategy involved

greater risks, since petitioner would have to finance customer

receivables and carry inventories of the products it was selling.

He decided these risks would be outweighed by certain benefits.

In particular, Herold personally would be able to minimize

unproductive time he had been spending at sales meetings for each

of the manufacturers whose product lines petitioner had been

representing, and petitioner would gain greater leeway to develop

its own sales and business strategies.

     Another significant event in 1992 was petitioner's loss of

its largest customer, Gateway Computers, which had accounted for

18 percent of petitioner's sales.   This occurred at a time when

the computer industry in general was in a minirecession. Despite

this setback and amid adverse conditions, petitioner achieved

sales growth of more than $12 million in 1992, a 50-percent

increase over 1991, and further growth of nearly $7.7 million in

1993, a 21.25-percent increase over 1992.
                                - 5 -


     At the time of trial, a potential buyer had offered $25

million for Herold's stake in petitioner and was engaged in due

diligence.    At that point, Herold had not accepted the offer.

2.   Petitioner's Owner

     Herold was born and raised in Iowa.    He joined the U.S. Navy

upon graduating from high school and received training in various

categories of complex electronic communications and navigation

equipment.    After his discharge from the Navy, Herold held a

series of jobs with electronics companies such as Control Data

and Univac.    In the course of these jobs, he developed computer

programming and diagnostic skills.

     In late 1960, Herold began working at Dayton-Hudson and

evolved a role in which he acted as an internal management

consultant, interviewing company executives, reviewing

operations, and recommending improvements for various business

units of Dayton-Hudson around the country.    While working full

time for Dayton-Hudson, Herold attended the University of

Minnesota and earned a bachelor's degree in 3 years.    He later

began but did not complete a master's degree in business

administration.    At that point, a number of graduates of

nationally recognized M.B.A. programs were Herold's subordinates

at Dayton-Hudson and, observing them, Herold was not convinced

that additional academic studies would be worth the investment of

his time and energy.

     Herold left Dayton-Hudson for a position as an account

executive at SCC in 1972.    This was his first sales-related
                                - 6 -


position.    He was hired to help SCC diversify into consumer

electronics.    Within 2 years, SCC had established a separate

consumer electronics division, with Herold as vice president.

This was the division that was eventually spun off with Herold

first as co-owner and eventually sole owner and that is the

petitioner in this action.

     Herold is a workaholic, sometimes working 60-70 hours a

week.   At one point, his workaholism contributed to a marital

breakup.    He is also a micromanager, involved in all aspects of

the company's operations.    For example, he personally interviews

every new employee and determines and distributes each employee's

annual bonus.    He is responsible for every business plan at the

company.    He personally reviews every major sale, does the sales

forecasting and sales reporting, and has designed petitioner's

sales report.    The success of petitioner's business derives

almost entirely from its relationships with manufacturers and

customers.    Herold is deeply involved in each of these essential

relationships.

     Petitioner occupies a unique niche in the industry in terms

of size.    Most of its competitors are either much smaller or much

larger in terms of sales volume.    The smaller firms tend to have

annual sales ranging from $5 to $15 million, and sales of the

industry giants are in the billions of dollars.    Petitioner's

sales were $35 to $45 million during the subject years.    To help

petitioner thrive in this environment, Herold devised a strategy

of identifying and aggressively pursuing large customers that
                                - 7 -


would not normally do business with a supplier as small as

petitioner.   As a result, petitioner sells to 10 of the top 20

accounts in the nation for its industry.

     During petitioner's early days, Herold undertook major

financial risks to provide funding for petitioner.   When

petitioner hit a slump in 1984, Herold withdrew funds from a

qualified retirement plan, paying income tax on the withdrawal as

well as a 10-percent penalty, to obtain funds needed to keep

petitioner going.   As part of the three-pronged strategy

described above, Herold aggressively sought a relationship with

Houston Instruments, seeking to market its Computer Aided Design

(CAD) product line.    To cement that relationship and meet Houston

Instrument's concerns as to petitioner's financial stability,

Herold mortgaged his house to secure a $75,000 letter of credit.

Herold has also lent substantial personal funds to petitioner and

personally guaranteed credit lines of $4 to $5 million with Sony

Corp. and Mitsubishi Corp.   These guaranties were still in effect

during the subject years.

     By contrast with his willingness to place his personal

assets at risk, Herold maintains a conservative financial

strategy with respect to petitioner.    He insists that petitioner

maintain substantial cash reserves, refusing his financial

adviser's suggestions that petitioner "play the float".     This

builds petitioner's credibility with suppliers and customers and

enables it to take full advantage of vendors' early payment

discounts.    By following this strategy, petitioner has incurred
                                       - 8 -


interest costs of $100,000 to maintain its cash balances in some

years, while generating savings of as much as $250,000 through

early payment discounts.

     3.    Petitioner's Operations, Financial Results, and Dividend
History

       For 1985, 1992, and 1993, petitioner's gross receipts (net

of returns and allowances), gross income, book net income (before

deducting Herold's compensation), taxable income (before

deducting Herold's compensation), Herold's compensation, and

Herold's compensation percentages (rounded to the nearest dollar)

were:1

Taxable     Gross Receipts     Gross         Book         Taxable      Herold's
 Year      (Net of Returns)   Income      Net Income      Income     Compensation

1985           $826,544        $660,564     $135,565      $135,565    $120,000
1992         37,162,286       4,336,752    1,296,512     1,356,628   1,200,000
1993         45,558,284       4,136,946    1,293,421     1,329,273   1,200,000

                    Herold's Compensation Percentages

Herold's Compensation Divided by:

                   Gross
Taxable           Receipts             Gross     Net Income           Taxable
 Year              (Net)               Income    Per Books           Net Income

 1985               14.52%             18.17%          88.51%           88.38%
 1992                3.23              27.67           92.55            88.45
 1993                2.63              29.00           92.77            90.27




       1
      We use 1985 as the base year for comparison purposes. That
was the year immediately after Herold became petitioner's sole
shareholder. At that point, petitioner had lost its sales
representation arrangement with Apple, was facing the impending
insolvency of the three major Apple accounts it had been
cultivating, and was starting over again essentially from
scratch.
                                     - 9 -


     Petitioner's retained earnings and the percentage by which

those retained earnings increased over the previous year's

amounts for 1985, 1992, and 1993 were:

            Year          Retained Earnings             Percent Increase

            1985                 $141,939                     9.2%
            1992                  504,507                    23.7
            1993                  597,928                    18.5

     As of the end of these 3 years, petitioner reported the

following total assets, liabilities, and equity:

     Year          Total Assets      Total Liabilities          Equity

     1985             $617,630               $524,691          $92,939
     1992            8,097,928              7,592,421          505,507
     1993            7,560,778              6,961,850          598,928

     Petitioner's after-tax income (after deducting Herold's

compensation), equity, and return on equity for 1985, 1992, and

1993 were:

  Year                 Income                 Equity       Return on Equity

  1985               $15,565                 $92,939            16.75%
  1992                96,512                 505,507            19.09
  1993                93,421                 598,928            15.60

     Petitioner has never paid any dividends.

4.   Herold's Compensation From Petitioner

     Herold has no written employment contract with petitioner.

Herold does have a written bonus plan (as explained below).              In
                                  - 10 -


1984 through 1993, petitioner paid Herold salary and bonuses as

follows:

     Year              Salary                Bonus          Total

     1984             $262,000             $120,000        $382,000
     1985              120,000               - 0 -          120,000
     1986              120,000               - 0 -          120,000
     1987              120,000               - 0 -          120,000
     1988              170,000              400,000         570,000
     1989              237,000              400,000         637,000
     1990              397,500              400,000         797,000
     1991              592,500              100,000         692,500
     1992              600,000              600,000       1,200,000
     1993              600,000              600,000       1,200,000

     Petitioner also provided Herold with a $15,000 life

insurance policy, health insurance, and vacation and sick leave

during the subject years.       Neither Herold nor any other employee

of petitioner received contributions to a qualified pension or

profit-sharing plan during the subject years.

     Herold is the sole member of petitioner's board of

directors, and, in that capacity, he devised formulas under which

his bonus was paid.    His practice each year was to prepare a

"bottom-up" analysis of projected sales, revenues, and profits

and then to determine sales goals, taking extraordinary events

and economic conditions into account.      His aim was to determine

goals that were attainable with hard work.      He then built a

"stretch" factor into his goals in order to challenge himself.

The resulting bonus plan was always keyed to specific sales

increase percentages.    Petitioner adopted each year's plan

through board minutes drafted during the first week of April.
                                          - 11 -


         In establishing his compensation, Herold focused on some

executives he knew personally and on some he knew by reputation,

measuring himself against his personal competitors, executives at

other companies, with whom he sought to achieve parity.                   He did

not find directly comparable companies or make a statistically

rigorous analysis.            He looked at firms in related fields and came

up with a figure that he considered an appropriate level to

aspire to for himself.               In 1992 and 1993, he considered $1.2

million the salary target compared to the executives he measured

himself against.            He set this figure as his maximum compensation

in both years.            He did not contemplate any increase in

compensation between 1992 and 1993 although he aimed for and

achieved substantial sales growth in that period.

         Herold's bonus plans for 1988 through 1993 provided as

follows:

 Sales                                     Bonus Amounts
Increase1       1988          1989         1990        1991     1992         1993

 0   -   14%     - 0 -        - 0 -      $100,000     - 0 -      - 0 -     $200,000
15   -   19      - 0 -        - 0 -         same      - 0 -    $200,000     400,000
20   -   24    $100,000     $100,000      200,000   $100,000    400,000     600,000
25   -   29      same         same          same       same     600,000       same
30   -   39      same         same        300,000      same       same        same
40   -   49     200,000      200,000      400,000    200,000      same        same
50   -   59      same         same          same       same       same        same
60   -   69     300,000      300,000        same     300,000      same        same
70   -   79      same         same          same       same       same        same
80   +          400,000      400,000        same     400,000      same        same
      1
        For the years 1988 through 1991, Herold's bonus was based on increases
in all of petitioner's revenues from its distribution and sales representative
activities. Beginning in 1992, only sales in petitioner's distribution
business under the trade name GTI were taken into account.


         Herold failed to achieve his maximum bonus percentage during

2 of these years.            The 1989 target was approximately $14 million
                                     - 12 -


for a maximum bonus of $400,000.         Petitioner paid Herold the

maximum bonus at a time when it appeared this target was met.

Later that year, merchandise returns reduced 1989 sales to

$13,265,000.      At that level of sales, Herold was entitled to a

1989 bonus of $300,000 rather than $400,000.           Herold never

reimbursed petitioner for the $100,000 excess bonus he had

received.       In 1991, petitioner's sales volume increase was less

than the maximum targeted amount.            Petitioner paid Herold a bonus

of just $100,000 rather than the $400,000 bonus he would have

received if sales had increased 80 percent or more.

5.    Petitioner's Employees

       For 1989 through 1993, petitioners' five most highly

compensated employees, their respective positions, their

respective total bonuses for the year, and their respective total

compensation for the year were as follows:

                                      1989
                                                                Total
     Employee             Position                   Bonus   Compensation

Stephan Herold           President/CEO            $427,000    $637,000
Greg Harris              Vice president &
                           account executive        25,000     123,174
Greg Appelhoff           Account executive           5,000     103,409
Dana Frederickson        Account executive           2,500      83,042
Joe Berini               Account executive           1,000      69,835

                                      1990
                                                                Total
     Employee             Position                   Bonus   Compensation

Stephan Herold           President/CEO            $430,000    $797,500
Dana Frederickson        Account executive           3,000     144,769
Greg Harris              Vice president &
                          account executive         30,000     140,930
Greg Appelhoff           Account executive          - 0 -       99,077
Scott Munson             Account executive          - 0 -       67,313
                                  - 13 -


                                   1991
                                                             Total
  Employee             Position                   Bonus   Compensation

Stephan Herold       President/CEO             $100,000     $692,500
Dana Frederickson    Account executive            5,000      190,251
Greg Appelhoff       Account executive           25,000      186,996
Greg Harris          Vice president &
                      account executive          12,500       97,703
Wayne Williams       Account executive            2,000       68,360

                                   1992
                                                             Total
  Employee             Position                   Bonus   Compensation

Stephan Herold       President/CEO             $600,000   $1,200,000
Dana Frederickson    Account executive           - 0 -       221,035
Greg Appelhoff       Account executive           20,000      182,710
Jeff Fetzer          Account executive           - 0 -       105,674
Greg Harris          Vice president &
                      account executive          - 0 -        78,347

                                   1993
                                                             Total
  Employee             Position                   Bonus   Compensation

Stephan Herold       President/CEO             $600,000   $1,200,000
Greg Appelhoff       Vice president &
                       account executive         50,000      254,200
Chris Schmidt        Account executive            2,000       92,303
Bruce Senst          Controller                  10,000       89,583
Curtis Ocepak        Account executive            4,000       85,220

     The total compensation of petitioner's four most highly

compensated employees, other than Herold, for each of the years

1989 through 1993 as a percentage of Herold's compensation was as

follows:

                                                Next Four Most
                                          Highly Compensated Employees
                   Herold's                  Total      As % of Herold's
    Year         Compensation             Compensation    Compensation

    1989          $637,000                 $379,460          59.57
    1990           797,500                  452,089          56.69
    1991           692,500                  543,310          78.46
    1992         1,200,000                  587,766          48.98
    1993         1,200,000                  521,306          43.44
                              - 14 -


     During 1989 through 1993, petitioner's account executives

earned both a salary and commissions.   The bulk of their

compensation each year was earned as commissions.   Most account

executives were paid a salary of $600 per month, although some

received a higher salary.   The account executives earned a

commission of 25 percent of the gross margin on sales they

generated.   The commission paid by petitioner was a quarter to a

third higher than generally paid in the industry.

     Petitioner employed "consultative" selling techniques

designed by Herold to differentiate itself in the marketplace and

to justify higher-than-average markups.    This strategy required

that petitioner's account executives provide services beyond

those normally provided in the industry.   Petitioner's account

executives spent more time with each customer than required of

the competitors' account executives.    Herold believed that this

justified a more generous commission structure.   Beyond that,

Herold felt it was worthwhile to pay higher compensation to

attract and retain the best people.

                              OPINION

     We are faced with perhaps one of the most litigated issues

in Federal income taxation, the deductibility of compensation

paid to shareholder/employees of a closely held corporation.     In

order for employee compensation to be deductible by an accrual

method taxpayer like petitioner, the compensation must be:

(1) Incurred in the taxable year for services rendered to the

taxpayer in the conduct of its trade or business, (2) reasonable
                             - 15 -


in amount, and (3) ordinary and necessary in character.      Sec.

162(a)(1); sec. 1.162-7(a), Income Tax Regs.    While each

criterion may be at issue from time to time, it is the

reasonableness standard that presents the most difficult issue.

As the Court has observed:

   Inherently, there is a natural tension between:
   (1) Shareholders/employees who feel that they are entitled
   to be paid from a corporation's profits, even to the
   exhaustion thereof, of an amount that reflects their
   skills and efforts, and (2) a provision in the tax law
   that conditions the deductibility of compensation on the
   concept of reasonableness. What is reasonable to the
   entrepreneur/employee often may not be to the tax
   collector. * * * The term "reasonable", however, must
   reflect the intrinsic value of employees in the broadest
   and most comprehensive sense. [Mad Auto Wrecking, Inc. v.
   Commissioner, T.C. Memo. 1995-153.]

   The parties do not dispute that Herold's compensation was an

ordinary and necessary expense of petitioner or that it was paid

for services which he rendered to petitioner.    Thus, we assume it

was and limit our discussion to the question of reasonableness.

     The reasonableness of compensation is a question of fact

that must be answered by comparing each employee's compensation

with the value of services that he or she performed in return.

RTS Inv. Corp. v. Commissioner, 877 F.2d 647, 650 (8th Cir.

1989), affg. per curiam T.C. Memo. 1987-98; Charles Schneider &

Co. v. Commissioner, 500 F.2d 148, 151 (8th Cir. 1974), affg.

T.C. Memo. 1973-130; Estate of Wallace v. Commissioner, 95 T.C.

525, 553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992).    The

Commissioner's determination as to the reasonableness of

compensation is presumed correct, and taxpayers like petitioner
                              - 16 -


must prove it wrong.   Rule 142(a); Welch v. Helvering, 290 U.S.

111, 115 (1933); RTS Inv. Corp. v. Commissioner, supra at 650.

Factors to consider in passing on the question of reasonableness,

no one factor of which is controlling in itself, include:

(1) The employee's qualifications; (2) the nature, extent, and

scope of the employee's work; (3) the size and complexities of

the employer's business; (4) a comparison of salaries paid with

the employer's gross and net income; (5) the prevailing general

economic conditions; (6) a comparison of salaries with

distributions to officers and retained earnings; (7) the

prevailing rates of compensation for comparable positions in

comparable concerns; (8) the salary policy of the employer as to

all employees; (9) the amount of compensation paid to the

particular employee in previous years; (10) the employer's

financial condition; (11) whether the employer and the employee

dealt at arm's length; (12) whether the employee guaranteed the

employer's debt; (13) whether the employer offered a pension plan

or profit-sharing plan to its employees; and (14) whether the

employee was reimbursed by the employer for business expenses

that the employee paid personally.     See Rutter v. Commissioner,

853 F.2d 1267, 1274 (5th Cir. 1988), affg. T.C. Memo. 1986-407;

Charles Schneider & Co. v. Commissioner, supra at 151-152; Estate

of Wallace v. Commissioner, supra at 553; Home Interiors & Gifts,

Inc. v. Commissioner, 73 T.C. 1142, 1155-1156 (1980); see also

Mad Auto Wrecking, Inc. v. Commissioner, supra.
                                 - 17 -


     We carefully scrutinize the facts at hand because

petitioner, the paying corporation, is controlled by Herold, the

employee to whom the compensation was paid.   We must be sure that

any amount purportedly paid as compensation was actually paid for

services rendered by Herold, rather than a distribution to him of

earnings that petitioner could not otherwise deduct.     RTS Inv.

Corp. v. Commissioner, supra at 650; Paul E. Kummer Realty Co. v.

Commissioner, 511 F.2d 313, 315-316 (8th Cir. 1975), affg.

T.C. Memo. 1974-44; Charles Schneider & Co. v. Commissioner,

supra at 152-153.   We turn to the applicable factors.

1.   Employee's Qualifications

     An employee's superior qualifications justify high

compensation.   See, e.g., Home Interiors & Gifts, Inc. v.

Commissioner, supra at 1158; Dave Fischbein Manufacturing Co. v.

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

     Herold is exceptionally qualified for petitioner's business

by virtue of his education, training, experience, and dedication.

He understands and controls every aspect of its operations.    He

is highly motivated and extremely productive.   He is the primary

reason for petitioner's success.

       The ability to conceptualize a vision and to lead an

organization to fulfill that vision is the essence of effective

business leadership.   As the record amply demonstrates, Herold's

vision and insight into his industry have enabled him to invent

and reinvent petitioner's business in response to a series of

crises that might have led others to capitulate.   In each
                               - 18 -


instance, petitioner has survived the crisis by dint of Herold's

efforts.   Petitioner's profitability, which rests upon its sales,

upon key relationships Herold has painstakingly cultivated, and

upon Herold's ambition, inventiveness, and energy (as opposed to

petitioner's investment in capital) are the primary reasons for

petitioner's sales, growth, and success.     See Home Interiors &

Gifts, Inc. v. Commissioner, supra at 1158; Dave Fischbein

Manufacturing Co. v. Commissioner, supra at 352-353.

2.   Nature, Extent, and Scope of Employee's Work

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

general importance to the success of a business may justify high

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

supra at 1158.

     Herold is a micromanager who oversees all of petitioner's

executive and managerial functions.     He performs or oversees

virtually all of its sales activities.     He supervises its daily

operations, including supervising and directing its employees,

and makes every key business decision.     Given the vital role

Herold plays in petitioner's operations and success, and the long

hours that he dedicates thereto, we view Herold as indispensable

to petitioner's business.   Petitioner's growth and prosperity are

due directly to his skills, dedication, and creativity.     See

Kennedy v. Commissioner, 671 F.2d 167, 176 (6th Cir. 1982), revg.

72 T.C. 793 (1979); Home Interiors & Gifts, Inc. v. Commissioner,

supra at 1158; Dave Fischbein Manufacturing Co. v. Commissioner,

supra at 352-353.
                               - 19 -


3.   Size and Complexities of Employer's Business

      Courts have considered the size and complexity of a

taxpayer’s business in deciding whether compensation is

reasonable.    Pepsi-Cola Bottling Co. v. Commissioner, 528 F.2d

176, 179 (10th Cir. 1975), affg. 61 T.C. 564 (1974).

      Petitioner's is a highly specialized sales operation,

occupying a unique niche in its industry.     There is no comparably

sized competitor.   Most firms in the field are much smaller; a

few are larger.   Herold's aggressive pursuit of large accounts

that can be serviced at a lower cost relative to volume, and his

development of a service-intensive, consultative selling style

have enabled petitioner to compete successfully with its

industry's giants and to develop relationships with 10 of the 20

largest national accounts in its field.

4.   Comparison of Salaries Paid With Net and Gross Income

      A comparison of sales and net income to amounts of

compensation may be important in deciding whether compensation is

reasonable.    Mad Auto Wrecking, Inc. v. Commissioner, T.C. Memo.

1995-153.

      The instant percentages are reasonable in light of Herold's

qualifications and the nature, extent, scope, and success of his

efforts.    In 1992, his salary was 3.23 percent of gross receipts

and 27.67 percent of gross income.      In 1993, his salary was 2.63

percent of gross receipts and 29 percent of gross income.

      His salary was 92.56 percent and 92.78 percent of book net

income (before deducting his compensation), respectively.     His
                               - 20 -


salary was 88.45 percent of taxable net income (before deducting

his compensation) in 1992 and 90.27 percent in 1993.

5.   General Economic Conditions

      This factor helps to determine whether the success of a

business is attributable to general economic conditions, as

opposed to the efforts and business acumen of the employee.

General economic conditions may affect a business' performance

and indicate the extent (if any) of the employee's effect on the

company.   Adverse economic conditions, for example, may tend to

show that an employee's skill was important to a company that

grew during the bad years.    Mad Auto Wrecking, Inc. v.

Commissioner, supra.

      Petitioner has faced economic ruin and been forced to

reinvent itself on at least three separate occasions.      Its sales

went from $1 million in its first year to $70 million in 1984.

Sales fell to less than $1 million in 1985 and were back up to

nearly $44 million by 1993.

      In 1984, petitioner lost its sales representation contract

with Apple.   This accounts for the precipitous sales decline in

1985.   While petitioner represented Apple, it had developed

Apple's four largest accounts nationwide.    Herold devised a

strategy of targeting these four largest accounts and selling

other electronics products to them.     He succeeded with three of

these jumbo accounts.   Just as that strategy was beginning to

take hold, all three of these accounts ran into adverse economic

conditions and became insolvent.   Again, petitioner saw its
                              - 21 -


continuing viability threatened, and, again, Herold devised a new

strategy:   a three-pronged, targeted focus on key products in

each of three different phases of market penetration.   Combined

with the consultative selling technique Herold had crafted and

his focus on selling to very large customers who would not

normally do business with a company the size of petitioner,

Herold succeeded in reinventing and revitalizing petitioner's

business each time it was threatened.

6. Comparison of Salaries With Distributions to Officers and
Retained Earnings

     The failure to pay more than minimal dividends may suggest

that reported compensation actually is (in whole or in part) a

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

1315, 1322-1323 (5th Cir. 1987), affg. T.C. Memo. 1985-267;

Charles Schneider & Co. v. Commissioner, 500 F.2d at 151.

Corporations, however, are not required to pay dividends.

Shareholders may be equally content with the appreciation of

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

Owensby & Kritikos, Inc. v. Commissioner, supra; Home Interiors &

Gifts, Inc. v. Commissioner, 73 T.C. at 1162; see also Rev. Rul.

79-8, 1979-1 C.B. 92 (compensation is not unreasonable merely

because a corporation pays an insubstantial portion of its

earnings as dividends).   In reviewing the reasonableness of an

employee's compensation, a hypothetical independent investor

standard may be used to determine whether a shareholder has

received a fair return on investment after the payment of the
                              - 22 -


compensation in question.   See Owensby & Kritikos, Inc. v.

Commissioner, supra at 1326-1327; Medina v. Commissioner, T.C.

Memo. 1983-253.

     Whether to pay a dividend, and the amount thereof, were

business decisions Herold made acting as petitioner's sole

director.   Herold treated his company, in effect, as a "growth

stock", reinvesting earnings and aiming to derive a return on his

investment in the form of capital gain at some future time by

selling his shares in the company.     At the time of trial, a

potential buyer had offered $25 million for Herold's stake in

petitioner.

     We refuse to second-guess the business judgment of

petitioner's director under the facts herein; we view its

decision not to pay dividends as a reasonable business decision.2

See Comtec Sys., Inc. v. Commissioner, T.C. Memo. 1995-4.        In

addition to the fact that the increase in petitioner's retained

earnings most likely increased the value of its stock, we believe

that a hypothetical investor would have considered over $450,000

growth in retained earnings to have been an acceptable

performance for the period from 1985 to 1993.     A growth-oriented

investor might be most concerned with the increases in annual



     2
       As noted above, petitioner's strategy is to maintain
substantial cash balances to take advantage of early payment
discounts and to present a reassuring image of financial
stability for the large customers with whom petitioner seeks to
do business. By building retained earnings to more than a half
million dollars, petitioner reduces the interest costs it would
otherwise incur to maintain these cash balances.
                                - 23 -


revenue, which a potential buyer would focus on in formulating an

offering price for petitioner's stock.      The $25 million offer

that has been made would certainly tend to validate such a

judgment.   We conclude that an investment in petitioner's stock

was very attractive and that a hypothetical investor would have

received a handsome return through appreciation in the value of

petitioner's stock.

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

     Petitioner and respondent rely on expert testimony with

respect to this factor.     We have wide discretion when it comes to

expert testimony.     Sometimes, an expert will help us decide a

case.   See, e.g., Booth v. Commissioner, 108 T.C. 524, 573

(1997); Trans City Life Ins. Co. v. Commissioner, 106 T.C. 274,

302 (1996); see also M.I.C. Ltd. v. Commissioner, T.C. Memo.

1997-96.    Other times, he or she will not.    See, e.g., Estate of

Scanlan v. Commissioner, T.C. Memo. 1996-331, affd. without

published opinion 116 F.3d 1476 (5th Cir. 1997); Mandelbaum v.

Commissioner, T.C. Memo. 1995-255, affd. without published

opinion 91 F.3d 124 (3d Cir. 1996).      We weigh an expert's

testimony in light of his or her qualifications, and with proper

regard to all other credible evidence in the record.      We may

accept or reject an expert's opinion in toto, or we may pick and

choose the portions of the opinion which we adopt.      Helvering v.

National Grocery Co., 304 U.S. 282, 294-295 (1938); Parker v.
                              - 24 -


Commissioner, 86 T.C. 547, 562 (1986); see also Pabst Brewing Co.

v. Commissioner, T.C. Memo. 1996-506.

     We are not persuaded by either expert.   Petitioner's expert

was Edwin S. Mruk, senior partner and owner of Mruk & Partners.

He candidly stated that the companies he had used for comparison

were "reasonably comparable, not totally comparable."     He chose

these companies not because they were appropriate, but because

they were cited in an engineering report respondent used in

making his determination in this matter.   Respondent's

engineering report was not offered in evidence.   Mr. Mruk also

did not make an independent evaluation, preparing a rebuttal for

a document that is not part of the record.

     Respondent's expert was James Carey, owner of a management

consulting firm, Carey Associates, Inc.    His conclusions were not

based on data from businesses that are akin to the business at

hand; i.e., medium-sized wholesalers of electronic components.

Some of the firms in his survey are, for example, software

designers, rather than hardware distributors.   Others are large,

publicly traded corporations with sales far in excess of

petitioner's.   We also question the reliability and validity of

Mr. Carey's sample size and data analysis.    He received replies

from only 40 out of nearly 1,200 persons to whom he directed his

mailing, and he pointed to no methodological guidelines that

would indicate this small number was statistically reliable.    In

fact, on many occasions, persons failed to answer questions, and

Mr. Carey interpreted these omissions as negative responses.
                              - 25 -


Nothing in the record gives us comfort that treating blank

responses as negative responses is a reasonable approach under

the circumstances.   Once again, "'We are not satisfied that a

reasonable level of compensation for an executive like * * *

[Herold] can be accurately determined by reference to the

industries * * * [Mr. Carey] surveyed because of the absence of

significant information on other businesses similar to

petitioner's.'"   Pulsar Components Intl., Inc. v. Commissioner,

T.C. Memo. 1996-129 (quoting Thomas A. Curtis, M.D., Inc. v.

Commissioner, T.C. Memo. 1994-15); see also Mad Auto Wrecking,

Inc. v. Commissioner, T.C. Memo. 1995-153.     Indeed, comparing

compensation paid to officers of companies that differ markedly

provides guidance of dubious value.    See Diverse Indus., Inc. v.

Commissioner, T.C. Memo. 1986-84; Niagara Falls Coach Lines, Inc.

v. Commissioner, T.C. Memo. 1977-269.

8.   Employer's Salary Policy As to All Employees

     Courts have considered salaries paid to other employees of a

business in deciding whether compensation is reasonable.

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1159.

We look to this factor to determine whether Herold was

compensated differently than petitioner's other employees merely

because of Herold's status as a shareholder.     Owensby & Kritikos,

Inc. v. Commissioner, 819 F.2d at 1322-1323.     A reasonable,

longstanding, and consistently applied compensation plan is

evidence that compensation is reasonable.
                               - 26 -


     Petitioner's approach to compensation leaned heavily on

commissions as a motivational tool for all of its employees.

Its commission structure for all of its employees was

considerably more generous than the industry standard.      Herold's

approach to determining his own compensation structure was

consistent with that overall approach.     We think it is

significant that Herold consistently designed his compensation

structure by the end of the first quarter each year and

memorialized the bonus structure in board minutes.     This was done

well before Herold could know what the actual outcome for the

year would be.   With one minor deviation that we do not consider

significant,3 petitioner lived by this structure.    When he failed

to "make his numbers", he did not get his maximum bonus.     He was

never paid any additional bonus beyond the maximum he had

committed petitioner to earlier in the year.

9.   Compensation Paid in Previous Years

     An employer may deduct compensation paid to an employee in a

year although the employee performed the services in a prior

year.    Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930); see

also R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 50-51 (1972),


     3
       In 1 year, after-the-fact developments caused the maximum
sales target to be missed by a relatively small amount. By then
Herold had been paid the maximum bonus, which was appropriate
according to the information available when the payment was made.
As it later turned out, he was overpaid by $100,000. Looking at
Herold's overall track record and the vital role he played in
petitioner's continuing success, we do not believe independent
investors would have pressed Herold to repay this overage. We
note, for example, that Herold was not paid a bonus during
petitioner's lean years.
                               - 27 -


and the cases cited therein.    In order to do so, the employer

must show:    (1) That the employer intended to compensate the

employee for past undercompensation and (2) the amount of the

undercompensation.    Pacific Grains, Inc. v. Commissioner,

399 F.2d 603, 606 (9th Cir. 1968), affg. T.C. Memo. 1967-7;

Estate of Wallace v. Commissioner, 95 T.C. at 553-554.

      The record does not indicate that Herold's compensation

during the subject years was attributable to services which he

performed for petitioner in earlier years.    In fact, Herold even

testified that none of his 1992 and 1993 compensation was redress

for earlier years.

10.   Employer's Past and Present Financial Condition

      Petitioner grew and became very profitable under Herold's

leadership.    Its equity grew from $92,939 at the end of 1985 to

$598,928 at the end of 1993, an increase of 644 percent.

11.   Whether Employer and Employee Dealt at Arm's Length

      Where an employer and an employee are not dealing at arm's

length, the amount of compensation paid may be unreasonable.

Owensby & Kritikos, Inc. v. Commissioner, supra at 1324; see

Gilman Paper Co. v. Commissioner, 284 F.2d 697 (2d Cir. 1960),

affg. T.C. Memo. 1960-13.

      As petitioner's sole shareholder and its only board member,

Herold controlled every detail of the process by which his

compensation was determined.    Nevertheless, we are impressed by

the lengths Herold went to in order to develop objective

underpinnings for his bonus formula each year.
                              - 28 -


12.   Whether Employee Guaranteed Employer's Debt

      Courts have considered whether an employee personally

guaranteed his or her employer's debt in determining whether the

employee's compensation is reasonable.    In certain situations, an

employee's personal guaranty of his or her employer's debt may

entitle the employer to pay a greater salary to the employee than

the employer would otherwise have paid.   See Owensby & Kritikos,

Inc. v. Commissioner, supra at 1325 n.33; R.J. Nicoll Co. v.

Commissioner, supra at 51; see also Acme Constr. Co. v.

Commissioner, T.C. Memo. 1995-6; BOCA Constr. Inc. v.

Commissioner, T.C. Memo. 1995-5.

      At a key point, when petitioner's economic outlook was grim,

Herold pledged his personal residence to secure a letter of

credit that was required by a potential supplier, Houston

Instruments.   Securing Houston Instruments as a supplier was a

linchpin of Herold's three-pronged strategy.   In addition to the

fact that Herold was willing to put his residence at risk to

ensure this strategy's success, Herold also personally guaranteed

other credit lines of $4 to $5 million, which were still in

effect during the subject years.

13.   Absence of Pension Plan/Profit-Sharing Plan

      Courts have considered the absence of a pension plan or a

profit-sharing plan in determining reasonable compensation.

Rutter v. Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988),

affg. T.C. Memo. 1986-407; Kennedy v. Commissioner, 671 F.2d at

174-175.   Such an absence may allow the employer to pay the
                              - 29 -


employee more compensation than the employer would have paid had

the employer offered the employee a pension plan or a profit-

sharing plan.   Rutter v. Commissioner, supra at 1274.

      Petitioner did not have a pension or profit-sharing plan.

Thus, Herold did not receive the benefit of any qualified

retirement plan contributions.

14.   Reimbursement of Business Expenses

      Courts have considered the reimbursement of business

expenses in determining reasonable compensation.    An employer may

pay greater compensation to an employee to reflect the fact that

the employee is not being reimbursed for expenses that he or she

paid on behalf of the employer.     Id.

      There is no evidence that Herold incurred unreimbursed

expenses on behalf of petitioner.

Conclusion

      Our analysis of the factors favors the deductibility of all

the compensation paid to Herold by petitioner.    We sustain

petitioner's deductions in 1992 and in 1993 as for reasonable

compensation.

      To reflect the foregoing,

                                           Decision will be entered

                                      for petitioner.
