                  T.C. Memo. 1996-129



                UNITED STATES TAX COURT



 PULSAR COMPONENTS INTERNATIONAL, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 15172-92.             Filed March 14, 1996.



     Held: Compensation paid by P to two of its
officers/shareholders is reasonable. Both officers had
the appropriate education and employment background for
their positions with P, worked long hours for the
company and its predecessor, and helped increase its
gross sales in a volatile market. The success of the
business required great expertise in trading computer
chips and microprocessors. These qualities were
especially exemplified during the taxable year at issue
when P proved profitable even though it faced adverse
economic conditions. Moreover, P's retained earnings
grew, and P paid regular dividends. Although P paid
the officers more compensation than provided for in
their employment agreements, all of their compensation
was reasonable in light of the significant appreciation
in the value of P's stock and other facts and
circumstances.


Charles R. Goulding and Michael S. Press, for petitioner.
                                 - 2 -


     Halvor N. Adams III and Thomas J Kerrigan, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:     Pulsar Components International, Inc.,

petitioned the Court to redetermine respondent's determination of

a $382,771 deficiency in its income tax for its taxable year

ended July 31, 1985.    Respondent determined that $822,000 of the

$2,922,000 claimed by petitioner as officers' compensation was

unreasonable.    In an amendment to her answer, respondent asserted

that $2,324,170 of the claimed compensation was unreasonable,

increasing the claimed deficiency to $1,089,369.     Respondent also

asserted in the amendment that petitioner was liable for an

addition to tax under section 6661.

     We must decide the amount of compensation paid by petitioner

that is reasonable and thus deductible as a business expense

under section 162.    We hold all of it is.1   Unless otherwise

stated, section references are to the Internal Revenue Code in

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

Court Rules of Practice and Procedure.    We separately refer to

Thomas F. Laviano and Peter T. Woll as Mr. Laviano and Mr. Woll,

respectively.    We collectively refer to them as the Officers.

                           FINDINGS OF FACT

     1
       Accordingly, we also hold that petitioner is not liable
for the addition to tax asserted by respondent.
                               - 3 -


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

The stipulations and attached exhibits are incorporated herein by

this reference.   Petitioner's principal office was in Hicksville,

New York, when it petitioned the Court.   Petitioner filed its

Federal income tax return based on a fiscal year ending July 31,

1985, and it used the cash receipts and disbursements method.

1.   Petitioner

     Petitioner is a "third-tier chip broker” that locates,

purchases, and sells computer chips, electronic components, and

integrated circuits.2   Petitioner and its predecessor, Pulsar

Components, Inc. (Components), developed a niche in their field

that enabled them to take advantage of supply and demand

imbalances caused by the production capacities of microchip

manufacturers and the production needs of computer manufacturers.

Petitioner located scarce parts during periods of low supply and

high demand by using a network of brokers, surplus houses,

distributors, and manufacturers, of which it had a working

     2
       Computer manufacturers obtain electronic components and
microchips from three sources (tiers) of supply. The first tier,
the primary source of supply of electronic components, is a chip
manufacturer such as Intel, Micron, or Fujitsu. Approximately
90 percent of the parts purchased by equipment manufacturers are
purchased directly from chip manufacturers. The second tier,
franchise distributors such as Arrow Electronics, Hamilton-Avnet,
and Schweber, are typically large corporations that warehouse
substantial inventories of parts. Franchised distributors have
franchise agreements to represent product lines of certain
manufacturers, and they sell parts out of inventory for a set
markup that is usually 15 to 20 percent. The third tier consists
of chip brokers and traders like petitioner.
                                - 4 -


knowledge, and by using the sources of supply that were developed

therefrom.

     Unlike its competitors, petitioner derived economies by

copying the trading operations of some of the large securities

firms on Wall Street in New York, New York.   Petitioner’s traders

worked out of a trading pit where purchasing and selling

transactions were brokered in a matter of seconds.    Petitioner’s

traders did not have a set markup on parts sold; instead, they

worked off market prices; i.e., petitioner profited on the spread

between the purchase and selling price when it was able to match

a customer's need with the integrated circuits that petitioner

could locate.    Petitioner carried minimal inventory, had a high

inventory turnover rate, and had no written agreements with

manufacturers.   Petitioner generally did not order goods for

which it did not have a buyer, and in the rare cases that it did,

it always had the option of selling the goods before they were

delivered or canceling the order.

2.   Petitioner's Owners

     The Officers were longtime friends who met in grade school.

They organized Components in October 1979 by contributing a total

of $2,000 in cash in return for all of its stock.    Mr. Laviano

received 75 percent of the stock, and Mr. Woll received the other

25 percent.   The business of Components was headquartered in the

basement of the home of Mr. Laviano's parents.   The Officers used
                                    - 5 -


card tables and folding chairs as furniture, and they rented

telephones.

        With the Officers at the helm, Components prospered and

became a successful entity.        Although its gross receipts varied

greatly from year to year, based on the volatility of the

industry, Components reported the following results for the

taxable years ended November 30, 1979, through November 30, 1982:

                 Nov. 30, 1979   Nov. 30, 1980     Nov. 30, 1981   Nov. 30, 1982

Sales               $251,588     $5,061,159         $1,876,555     $2,061,989

Gross profit
 on sales            $5,349      $1,499,411           $779,655       $832,036

Gross profit
 on sales as
 a percentage
 of sales               2.1%           29.6%             41.5%           40.4%

Taxable income
 (loss)               ($110)         ($4,592)           $4,136         $32,967

Retained earnings
 (deficit)             ($110)       ($14,691)         ($11,562)        $23,806


        In the fall of 1982, the Officers agreed to transfer

Components to petitioner so that Mr. Woll could increase his

ownership percentage and John Laviano, Mr. Laviano's younger

brother, could become a shareholder.             Petitioner was organized on

August 3, 1982.       From petitioner's organization through July 31,

1985, Mr. Laviano owned 55 percent of its stock, Mr. Woll owned

40 percent, and John Laviano owned the remaining 5 percent.

Petitioner's board of directors consisted of Mr. Laviano,
                                  - 6 -


Mr. Woll, and John Laviano.     Petitioner commenced business on

December 1, 1982.

     Petitioner conducted the same business as Components; the

only changes were the addition of the word “International” to the

name and the change in ownership percentages.     All of Components'

accounts and sources of supply that were developed prior to

petitioner's organization, and all employees who were trained

prior to the organization of petitioner, were transferred to

petitioner.

     a.    Mr. Laviano

     Mr. Laviano was petitioner's president.     He received a

bachelor of science degree in accounting from St. John's

University in 1977.      After graduating from college, Mr. Laviano

worked for Semi-Specialists of America, Inc. (SAI), one of the

largest and most profitable semiconductor brokerages in the

nation.     SAI was an electronics business that functioned as a

middleman for computer chips and other electronic components,

much as petitioner did.     Mr. Laviano worked for SAI for

approximately 1 year.     While he was employed there, Mr. Laviano

learned SAI's business well enough to go into the business for

himself.     During the year in issue, Mr. Laviano worked for

petitioner approximately 60 to 80 hours per week, 52 weeks per

year.     Mr. Laviano was a devoted workaholic who was committed to

petitioner's business and success.
                                 - 7 -


     b.   Mr. Woll

     Mr. Woll was petitioner's secretary and treasurer.      He

graduated from Yale University, cum laude, in 1977, receiving his

bachelor of arts degree in economics and political science. After

graduating from college, Mr. Woll worked on Wall Street as a

trader in U.S. Treasury securities, first for A.G. Becker, Inc.,

for about 1 year, and then for First International Money Markets.

At A.G. Becker, Inc., he placed third on its list of top salesmen

for the month in which he left.     Mr. Woll also did very well at

First International Money Markets.       He left First International

Money Markets in September 1979 to organize Components with

Mr. Laviano.   During the year in issue, Mr. Woll worked for

petitioner approximately 50 to 80 hours per week.      Like Mr.

Laviano, Mr. Woll was a devoted employee who was totally

dedicated and committed to petitioner's business and its success.

     c.   The Officers' Duties

     The Officers were involved in every aspect of petitioner’s

business.   They performed all of its executive and managerial

functions, oversaw all of its employees, and were directly

responsible for its success.     The Officers served as co-chief

traders, overseeing all of petitioner’s purchases and sales and

approving all of its deals.    The Officers bought and sold parts

for petitioner, quoted all of its prices, and supervised all of
                                        - 8 -


its traders.     The Officers recruited, interviewed, hired, and

trained petitioner’s employees.

        The Officers also were petitioner’s executive officers and

managers.     They were directly responsible for profit

maximization, long-term business planning, office automation,

cash management, physical plant expansion, marketing, and all

other management functions.           When not trading, Mr. Woll focused

on administrative functions and was in charge of cash

disbursements, cash receipts, billing, receivables, and

investigating credit.         Mr. Woll also dealt with petitioner’s

accountants, lawyers, and bankers, and he supervised petitioner's

bookkeeping staff.        The Officers supervised the shipping staff,

and they personally inspected every part received by petitioner

in order to ensure that the parts were not counterfeit or

defective.

3.   Petitioner's Operations

        For the 3-year period ended with the year in issue,

petitioner's gross receipts (net of returns and allowances),

gross income, book income, taxable income, Officers'

compensation, Officers' compensation percentages, and Officers'

equity were (rounded to the nearest dollar):

Taxable
Year        Gross
Ended      Receipts    Net Income    Taxable       Officers'     Gross
July 31     (Net)      Per Books    Net Income1   Compensation    Income

19832     $2,671,061     $88,903       $88,903        $26,000     $279,158
1984      29,763,657   1,796,032     1,823,904      1,449,000    5,415,936
                                          - 9 -


 1985        10,693,635   3,546,647    3,546,647       2,922,000    4,830,348
        1
        Before deduction of officers compensation.
        2
        This year, petitioner's first, represents approximately 8 months of
operation.


                                      Officer Compensation
                                           Percentages

Taxable                       Officer Compensation Divided by:
Year                Gross
Ended              Receipts          Gross        Net Income         Taxable
July 31             (Net)            Income       Per Books        Net Income

 1983                1.0%              0.9%         29.2%            29.2%
 1984                4.9              26.8          80.7             79.4
 1985               27.3              60.5          82.4             82.4


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

total assets, liabilities, and equity:

Taxable
Year Ended
July 31              Total Assets             Total Liabilities          Equity

  1983                    $116,298                 $52,395               $63,903
  1984                     900,935                 500,000               400,935
  1985                     961,032                     450               960,582
4.   The Officers' Compensation From Petitioner

        a.    Overview

        The Officers each signed an employment agreement with

petitioner that entitled each of them to $650,000 of compensation

per year.

        b.    Mr. Woll's Efforts

        Mr. Woll recognized that he was a minority shareholder and

he believed that, in the absence of an employment agreement,

Mr. Laviano could set Mr. Woll's compensation at any amount.

One of the Officers' first efforts to address the concerns of
                               - 10 -


Mr. Woll was to form petitioner, giving Mr. Woll a larger

ownership interest.    Mr. Woll continued to try to negotiate a

higher salary after petitioner's formation.    Mr. Laviano, on the

other hand, wanted to limit the amount Mr. Woll was paid.

Mr. Woll never threatened to leave the employment of petitioner

if his compensation was not increased, but he constantly tried to

convince Mr. Laviano to increase his compensation.    One of the

ways Mr. Woll attempted to convince Mr. Laviano to increase his

compensation was to report to Mr. Laviano his estimate of what

executives in other firms in petitioner's industry were making.

Most of the information upon which Mr. Woll based his estimate

was obtained from the owners of companies that competed with

petitioner.

     After much discussion among themselves, the Officers agreed

to set their salaries at $650,000 a year for 3 years, beginning

on November 5, 1982.    In doing so, the Officers considered what

they understood other people in petitioner's industry were

making.   They considered that they would be acting as chief

traders, as well as managers and executives.    They discussed

whether they should receive commissions, but decided to work

strictly on a salary basis.    In agreeing to set their

compensation at a fixed annual rate, the Officers did so with the

understanding that it might not be possible for petitioner to pay

them $650,000 each year due to the cyclical nature of its
                             - 11 -


industry, and that any underpayment in a year would be made up

when petitioner had the available resources.3

     On November 1, 1982, petitioner's board of directors met and

resolved that the "compensation for the next three (3) years for

Mr. Peter Woll and Mr. Thomas Laviano, should be set at $650,000

per year."4

     c. Amounts Claimed by Petitioner as Officers' Compensation

     The Officers served as officers of petitioner during each of

its taxable years ended July 31, 1983, through July 31, 1985.


     3
       Par. 4(e) of the principal officer employment agreements
states:

     during some fiscal years of the Corporation, available
     cash may not allow compensation of the Employee to the
     extent of immediate and long term effects of his
     efforts upon the profitability of the Corporation.

     *        *        *      *         *        *       *

     it is acknowledged between the Employee and the
     Corporation that full compensation for all Employee’s
     services may not be possible, from a cash standpoint
     during years in which there has been a downturn or
     recession in the semiconductor market. Therefore, the
     Corporation shall, in setting compensation for the
     Employee in later more profitable fiscal periods, take
     into account previously uncompensated services arising
     at former, less profitable years. * * *
     4
       Petitioner's contracts with the Officers also entitled
them to benefits including: (1) Automobiles (2) financial
counseling, (3) disability benefits, (4) any benefits (including
pension, retirement, profit sharing, insurance, and medical
benefits) provided by petitioner to its employees in general,
(5) apartments and vacation condominiums, (6) reimbursement for
expenses incurred on behalf of petitioner, and (7) reimbursement
for club dues and expenses.
                                   - 12 -


Petitioner deducted the following Officers' compensation on its

Federal corporate income tax returns for those years as follows:

     Taxable
     Year Ended                 Deduction Claimed
     July 31          Mr. Laviano    Mr. Woll               Total

       1983              $11,000         $15,000            $26,000
       1984              729,000         720,000          1,449,000
       1985            1,461,000       1,461,000          2,922,000
         Total         2,201,000       2,196,000          4,397,000


A comparison of the Officers' compensation and their stock

ownership interests is as follows:

     Taxable
     Year Ended
     July 31           Mr. Laviano (55%)             Mr. Woll (40%)

       1983                42.3%                            57.7%
       1984                50.3                             49.7
       1985                50.0                             50.0

     d.   Board Resolution Concerning Undercompensation

     Petitioner's board met on August 6, 1984, and reported that

each of the Officers was actually paid less than the amounts that

were fixed in their employment agreements.         Specifically, the

board found, the Officers were entitled to receive $650,000 per

year, but were actually paid the following amounts:

                                     1983          1984

     Thomas Laviano                $11,000   $729,000
     Peter Woll                     15,000    720,000

The board decided that petitioner owed Mr. Laviano $560,000 and

that petitioner owed Mr. Woll $565,000.      The board unanimously
                               - 13 -


decided that petitioner would pay these debts in the taxable year

ended July 31, 1985.

5.   Petitioner's Employees

      Petitioner employed many individuals to buy and sell

electronic components.    Most of petitioner's employees did not

have prior experience in the electronics industry before they

commenced their employment with petitioner.    The Officers taught

petitioner's new employees to be traders by sitting next to them,

having the new employees watch them, and answering the new

employees' questions.    After a while, the new employees were

given simple tasks to do on their own, and if they performed

those tasks correctly, the new employees were given a few

well-established accounts to manage in order to develop their

trading skills.    From 1980 through 1984, approximately eight

individuals terminated their employment with petitioner (or

Components) in order to start a competing businesses.

      Petitioner also employed several individuals to support its

sales and purchasing operations.    Petitioner's support staff

ranged from one to three employees in the shipping and receiving

department, one to two secretaries, a bookkeeper, and an

individual to perform administrative functions.

      a.   Compensation of Petitioner's Employees

      Petitioner generally paid its employees a rate of

compensation which the Officers thought was commensurate with
                               - 14 -


each employee's skill and experience and, particularly due to the

fierce competition in petitioner's industry, what the Officers

believed it would take to hire and retain the employee.

Petitioner's compensation package differed depending upon whether

the employee was a member of petitioner's sales and purchasing

staff or its administrative or support staff.    Petitioner, unlike

Components, did not have a pension plan.    The only benefits that

petitioner provided to its employees were paid vacations and,

beginning in the year in issue, medical insurance.

     Petitioner's sales and purchasing staff received a base

salary plus commissions for sales greater than monthly sales

quotas.    They did not receive any other bonuses.   Their

commissions ranged from 2 to 15 percent, and the average

commission was 10 percent of the gross profits from the

transactions consummated by the employee.    Commissions were the

bulk of the annual compensation received by sales or purchasing

agents.5   During the 1984 and 1985 calendar years, petitioner

paid its sales and purchasing employees the following amounts:




     5
       Consequently, such employees' annual compensation varied
greatly depending on the economic conditions in petitioner's
industry. In periods of high profitability, many of petitioner's
sales personnel were highly compensated, earning in excess of
$100,000. In more fallow periods, petitioner's sales personnel
earned only a fraction of that amount.
                                 - 15 -


     Employee           1984          1985         Total

John Laviano1         $515,397      $196,000     $711,397
Michael Lavelle        263,764       148,000      411,764
Kenneth Forster        172,004        34,695      206,699
Ginny Neitzel          105,139        38,199      143,338
Lee Ackerly2           138,319         -0-        138,319
       1
       John Laviano, received commissions based on 15 percent of
the gross profits from the transactions in which he was involved.
     2
       Lee Ackerley left the petitioner during 1984 to start a
competing business.

       Petitioner paid its support staff a salary and occasional

monthly bonuses depending on petitioner's profitability.      No

bonuses were paid during periods of low profitability.      During

periods of high profitability, bonuses were mediocre and were

paid with an intent to permit petitioner's support personnel to

participate in its profits.

6.    Petitioner's Retained Earnings and Dividend Policy

       Petitioner retained earnings for the 3-year period ended

July 31, 1985, were as follows:

                      Taxable
                      Year Ended      Retained
                      July 31         Earnings

                       1983           $62,903
                       1984           399,935
                       1985           959,582
                                - 16 -


During these years, petitioner paid the following dividends:6

     Taxable
     Year Ended                      Dividends
     July 31          Mr. Laviano    Mr. Woll    John Laviano

         1983           -0-            -0-         -0-
         1984          $5,500         $4,000        $500
         1985          35,750         26,000       3,250
           Total       41,250         30,000       3,750

     Petitioner’s retained earnings increased by approximately

1,525 percent from $62,903 on July 31, 1983, to $959,582 on

July 31, 1985.     Its shareholder’s equity increased by 1,503

percent from $63,903 on July 31, 1983, to $960,582 on July 31,

1985.    Even though petitioner had a cash surplus on July 31,

1985, petitioner was retaining these funds for business reasons.

7.   The Officers' Other Entities

     The Officers, jointly or individually, were engaged in other

activities aside from their interest in petitioner.     They were

equal partners in a partnership that was formed to increase their

market share in petitioner's industry, and to allow for volume

discounts on purchases.

     Petitioner used the services of the other entities that were

entirely owned by the Officers.     Services performed by these

other entities included financial, marketing, and management

consulting.    Petitioner, through the Officers, devoted some of


     6
       Components paid dividends of $12,500 in its taxable year
ended Nov. 30, 1980, and $8,000 in its taxable year ended
Nov. 30, 1981.
                                - 17 -


its time to (and performed services on behalf of) the operations

of these other entities.

                               OPINION

       Once again, we are faced with perhaps one of the most

litigated issues in Federal income taxation, the deductibility of

compensation paid to shareholders/employees in the setting of a

closely held corporation.    In order for employee compensation to

be deductible by a cash method taxpayer, the compensation must

be:    (1) Paid in the taxable year for services rendered to the

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

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

162(a)(1); Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243

(9th Cir. 1983), revg. and remanding T.C. Memo. 1980-282; 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 the Officers' compensation

was an ordinary and necessary expense of petitioner.       Thus, we
                                - 18 -


assume it was, and we limit our discussion to the other two

prongs, and we pass on these prongs seriatim.

1.   Whether the Compensation Paid by Petitioner Was Reasonable

     a. Overview

     Reasonable compensation is determined by comparing the

compensation paid to an employee with the value of the services

that he or she performed in return.      Such a determination is made

with respect to each employee individually, rather than with

respect to the compensation paid to all employees collectively.

Such a determination is a question of fact.      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;

Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115, 119

(6th Cir. 1949), revg. and remanding a Memorandum Opinion of this

Court; Estate of Wallace v. Commissioner, 95 T.C. 525, 553

(1990), affd. 965 F.2d 1038 (11th Cir. 1992).     Respondent's

determination is presumed correct, and petitioner must prove it

wrong.   Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

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

     The cases concerning reasonable compensation are legion and

list many factors to be considered in making this factual

determination.     The factors which may be considered, none of

which is controlling in itself, include:     (a) The employee's
                              - 19 -


qualifications; (b) the nature, extent, and scope of the

employee's work; (c) the size and complexities of the employer's

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

gross and net income; (e) the prevailing general economic

conditions; (f) a comparison of salaries with distributions to

Officers and retained earnings; (g) the prevailing rates of

compensation for comparable positions in comparable concerns;

(h) the salary policy of the employer as to all employees;

(i) the amount of compensation paid to the particular employee in

previous years; (j) the employer's financial condition;

(k) whether the employer and employee dealt at arm's length;

(l) whether the employee guaranteed the employer's debt;

(m) whether the employer offered a pension plan or profit-sharing

plan to its employees; and (n) 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; Elliotts,

Inc. v. Commissioner, supra at 1245-1248; Kennedy v.

Commissioner, 671 F.2d 167, 174 (6th Cir. 1982), revg. and

remanding 72 T.C. 793 (1979); Charles Schneider & Co. v.

Commissioner, supra at 151-152; Mayson Manufacturing Co. v.

Commissioner, supra at 119; 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.
                               - 20 -


v. Commissioner, supra.    In analyzing these factors, the Court

must carefully scrutinize the facts of a case in which the paying

corporation is controlled by the employees to whom the

compensation is paid.   In such a situation, we must be convinced

that the purported compensation was paid for services rendered by

the employees as opposed to a distribution of earnings to them

that the payor could not 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; Seven Canal

Place Corp. v. Commissioner, 332 F.2d 899 (2d Cir. 1964),

remanding T.C. Memo. 1962-307.

   b.   Employee's Qualifications

   An employee's superior qualifications for his or her position

with the business may 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).

   The Officers are exceptionally qualified for petitioner's

business, by virtue of their education, training, experience, and

dedication.   They understand and control every aspect of

petitioner's operations.   They are highly motivated and extremely

productive employees.   They are the primary reason for

petitioner's success.   The Officers’ outstanding qualifications
                              - 21 -


justify high compensation.   Petitioner's profitability, which

rests upon its sales, and the Officers' 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.   This factor favors petitioner.

   c.   Nature, Extent, and Scope of the Employee's Work

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

general importance to the success of a business may justify high

compensation.   Elliotts, Inc. v. Commissioner, 716 F.2d at

1245-1246; American Foundry v. Commissioner, 536 F.2d 289,

291-292 (9th Cir. 1976), affg. in part and revg. in part 59 T.C.

231 (1972); Mayson Manufacturing Co. v. Commissioner, supra; Home

Interiors & Gifts, Inc. v. Commissioner, supra at 1158.

   The Officers performed all of petitioner's executive and

managerial functions.   They performed or oversaw virtually all of

its trading activities.   They supervised its daily operations,

including supervising and directing its employees, and they made

its business decisions.   Given the vital role played by the

Officers in petitioner's operations and success, and the long

hours that they each dedicated thereto, we view the Officers as

indispensable to petitioner's business.     Petitioner's growth and

prosperity are due directly to their skills, dedication, and
                               - 22 -


creativity.   This factor favors petitioner.   See Elliotts, Inc.

v. Commissioner, supra at 1245-1246; Kennedy v. Commissioner,

supra at 176; Home Interiors & Gifts, Inc. v. Commissioner, supra

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

at 352-353.

   d.   Size and Complexities of the Employer's Business

   Courts have considered the size and complexity of a

taxpayer’s business in deciding whether compensation is

reasonable.    Elliotts, Inc. v. Commissioner, supra at 1246;

Pepsi-Cola Bottling Co. v. Commissioner, 528 F.2d 176, 179

(10th Cir. 1975), affg. 61 T.C. 564 (1974); Mayson Manufacturing

Co. v. Commissioner, 178 F.2d at 119.

   Petitioner is a highly specialized semiconductor trading

company, and its split-second trading operations demand

expertise.    Petitioner's business is highly competitive, with

thousands of competitors trying to locate and sell the same parts

as petitioner.   Petitioner's unique trading method introduced by

the Officers enabled it to survive and become extremely

profitable in a highly competitive industry.    Petitioner's gross

receipts during the year in issue totaled more than $10 million.

This factor favors petitioner.    See Elliotts, Inc. v.

Commissioner, supra at 1246.

   e.   Comparison of Salaries Paid to Net and Gross Income
                                - 23 -


   Courts have compared sales, net income, and capital value to

amounts of compensation in deciding whether compensation is

reasonable.    Elliotts, Inc. v. Commissioner, supra at 1241;

Mayson Manufacturing v. Commissioner, supra.

   For the year in issue, Officers' salaries were 27.3 percent

of gross receipts and 60.5 percent of gross income.   Officers’

salaries were 82.4 of book net income (before deducting Officers'

compensation) and 82.4 percent of taxable net income (before

deducting Officers' compensation).

   These percentages are reasonable in light of the

qualifications of the Officers and the nature, extent, and scope

of their work, and the years of prior undercompensation.    During

1983, petitioner paid the Officers less compensation than they

were entitled to, while they helped petitioner increase its gross

sales from $2,671,061 in 1983 to $10,693,635 in 1985.   We also

find relevant the fact that petitioner reported more than

$995,460 in taxable income during the subject year,

notwithstanding its payment of large compensation to the

Officers.     This factor favors petitioner.

   f.   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 employees.

General economic conditions may affect a business' performance
                               - 24 -


and indicate the extent (if any) of the employees effect on the

company.    Mayson Manufacturing Co. v. Commissioner, supra at

119-120.    Adverse economic conditions, for example, tend to show

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

during the bad years.

   Because petitioner's industry seeks to take advantage of

supply imbalances present in the computer chip/semiconductor

market, it is characterized by periods of rapid growth and

profitability followed by periods of sharp decline.   Petitioner

faced declining sales during the subject year as market

imbalances in supply began to correct themselves, and petitioner

was forced to compete with an increasing number of competitors.

Although petitioner's gross receipts declined significantly,

petitioner experienced an increase in its taxable income,

retained earnings, and shareholder’s equity.   The adverse

economic conditions tend to show that the Officers' skill and

diligence were important to petitioner's success.   This factor

favors petitioner.

   g. 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.
                               - 25 -


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; Elliotts, Inc.

v. Commissioner, supra; Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. at 1162 (1980).

   Petitioner has a history of regularly declaring and paying

dividends.   In reviewing the reasonableness of an employee's

compensation, we often apply a hypothetical independent investor

standard to determine whether a shareholder has received a fair

return on investment after the payment of the compensation in

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

1326-1327; Elliotts, Inc. v. Commissioner, 716 F.2d at 1244;

Medina v. Commissioner, T.C. Memo. 1983-253; 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).   Whether to pay a dividend, and the

amount thereof, were business decisions made by petitioner's

board taking into account that petitioner had accumulated

sufficient earnings during profitable years and that petitioner

might need to retain some (or all) of those earnings in order to

weather less profitable periods that were likely ahead.   We

refuse to second-guess the board's business judgment under the

facts of this case; we view its decisions concerning the payment
                               - 26 -


of dividends and the amounts thereof as reasonable business

decisions.7   Petitioner paid $65,000 in dividends in the year at

issue.    Its shareholder’s equity grew from $63,903 on July 31,

1983, to $960,582 on July 31, 1985.     Its retained earnings grew

from $62,902 on July 31, 1983, to $959,582 on July 31, 1985.

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 $959,582 in

retained earnings to have been a worthy performance for the

3-year period.    Moreover, the Officers received dividends from

petitioner's earnings.    The dividends per share increased from

$95 per share on July 31, 1984, to $617.50 per share on July 31,

1985.    On this record, it is clear that an investment in

petitioner's stock was very attractive and that the Officers

received an adequate share of petitioner's profits through

dividends.    This factor favors petitioner.

   h. Prevailing Rates of Compensation for Comparable
   Positions in Comparable Companies

   Both petitioner and respondent rely on expert testimony with

respect to this factor.    Expert testimony is appropriate to help


     7
       Bearing in mind that respondent has not determined that
petitioner is liable for the accumulated earnings tax of sec.
531, it is possible that she would agree that the large increase
in petitioner's retained earnings was necessary for the
reasonable needs of petitioner's business.
                              - 27 -


the Court understand an area requiring specialized training,

knowledge, or judgment.   Fed. R. Evid. 702; Snyder v.

Commissioner, 93 T.C. 529, 534 (1989).    The Court, however, is

not bound by an expert's opinion.   We weigh an expert's testimony

in light of his or her qualifications, and with respect to all

credible evidence in the record.    Depending on what we believe is

appropriate under the facts and circumstances of the case, we may

either reject an expert's opinion in its entirety, accept it in

its entirety, or accept selective portions of it.    Helvering v.

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

Technology, Inc. & consol. Subs. v. Commissioner, 102 T.C. 149,

186 (1994); Parker v. Commissioner, 86 T.C. 547, 562 (1986).

   Petitioner's expert is Paul R. Dorf, managing director of

Compensation Resources, Inc., of Upper Saddle River, New Jersey.

Respondent's expert is E. James Brennan III, president of

Brennan, Thomsen Associates, Inc., of Chesterfield, Missouri.

Mr. Brennan is no stranger to this Court, having testified before

us on no fewer than 13 prior occasions.   See Alondra Indus. Ltd.

v. Commissioner, T.C. Memo. 1996-32; Guy Schoenecker, Inc. v.

Commissioner, T.C. Memo. 1995-539; Mad Auto Wrecking, Inc. v.

Commissioner, T.C. Memo. 1995-153, and the cases cited therein.

   We are not persuaded by either of the experts.    Mr. Dorf's

testimony was unconvincing because it did not directly address

the factor at hand; i.e., the prevailing rates of compensation
                              - 28 -


for comparable positions in comparable concerns.   Considering his

testimony in its entirety, we find that Mr. Dorf was retained by

petitioner to advocate its position herein.   See Laureys v.

Commissioner, 92 T.C. 101, 129 (1989).   We are no more convinced

by Mr. Brennan.   We have had difficulty accepting Mr. Brennan's

"expert" opinions in previous cases.   As in the past, we have

trouble accepting his conclusions as they are not based on data

from businesses that are akin to the business at hand; i.e.,

third-tier supply firms in the computer chip and semiconductor

industry.   Restating what we have previously stated with respect

to Mr. Brennan's "expert" testimony:   "We are not satisfied that

a reasonable level of compensation for an executive like * * *

[the Officers] can be accurately determined by reference to the

industries Brennan surveyed because of the absence of significant

information on other businesses similar to petitioner's."

Mad Auto Wrecking, Inc. v. Commissioner, supra (quoting

Thomas A. Curtis, M.D., Inc. v. Commissioner, T.C. Memo.

1994-15).   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.   This factor favors neither party.   We consider

it neutral.
                               - 29 -


   i.    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 the Officers were

compensated differently than petitioner's other employees merely

because of the Officers' status as shareholders.      Owensby &

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

reasonable, longstanding, and consistently applied compensation

plan, for example, is evidence that compensation is reasonable.

Elliotts, Inc. v. Commissioner, supra at 1247.

   Petitioner generally offered its employees an amount that, in

its board's judgment, was a competitive level of compensation

designed to secure and retain employees.      Petitioner paid its

sales and purchasing staff a base salary, commissions, and

benefits.   Petitioner paid its other employees a salary, some

benefits, and an occasional bonus.      This factor favors neither

party.   We consider it neutral.

   j.    Compensation Paid in Prior 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),

and the cases cited therein.   In order to do so, the employer
                              - 30 -


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. 525, 553-554 (1990),

affd. 965 F.2d 1038 (11th Cir. 1992).

   Petitioner has met both of these requirements.     Its board

found that, during the 2-year period ended July 31, 1984, the

Officers had not received $1,125,000 of the compensation provided

in their employment agreements.   Its board decided that

petitioner would pay this liability during the year in issue.

During the 2 years prior to the year in issue petitioner

experienced cash-flow problems, particularly during its first

year of operation, and sought to preserve its cash.    Petitioner

deferred the payment of some of the Officers' compensation until

the year in issue.   This factor favors petitioner.

   k.   Employer's Past and Present Financial Condition

   Petitioner grew and became very profitable.   Its equity grew

from $63,903 on July 31, 1983, to $960,582 on July 31, 1985, an

increase of 1,403 percent.   This factor favors petitioner.

   l.   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; Elliotts
                              - 31 -


Inc. v. Commissioner, 716 F.2d at 1246; see Gilman Paper Co. v.

Commissioner, 284 F.2d 697 (2d Cir. 1960), affg. T.C. Memo.

1960-13.

   Respondent argues that some of the compensation that

petitioner paid to the Officers was unreasonable by virtue of the

fact that some portion of their compensation exceeded the amounts

fixed in their employment agreements.   We disagree.   While it may

have been good corporate form for petitioner to have amended the

employment agreements to provide for the extra compensation, such

a formality is not dispositive of the realities here.    Surely the

compensation paid was agreed to by the Officers, and certainly

the Officers were in control of petitioner and could have had

petitioner approve the increase in compensation.   It is not

dispositive that petitioner failed to adhere to corporate

formalities in setting the amount of compensation to the

Officers.   As the Court observed in Levenson & Klein, Inc. v.

Commissioner, 67 T.C. 694, 714 (1977) (quoting Reub Issacs & Co.

v. Commissioner, 1 B.T.A. 45, 48 (1924)): “Closely held

corporations, as is well known, often act informally, 'their

decisions being made in conversations, and oftentimes recorded

not in minutes, but by action.'"   See id. at 713-714 (courts may

give little or no weight to the lack of corporate formality in

closely held corporations); Mad Auto Wrecking, Inc. v.

Commissioner, T.C. Memo. 1995-153.
                                - 32 -


   We find most relevant the percent of stock owned by each of

the Officers in determining whether their compensation is

attributable to arm's-length bargaining.    Mr. Woll was a minority

shareholder, and he was constantly trying to increase his

ownership interest and salary.    Mr. Laviano, on the other hand,

was the majority shareholder.    He wanted petitioner to keep cash

reserves in the business for working capital.   We believe that

Mr. Woll bargained at arm's length with petitioner.

   Given Mr. Laviano's relationship to petitioner as its

controlling shareholder, we must inquire whether an independent

investor would have paid Mr. Laviano the amount of compensation

that he received during the subject year.   See Owensby &

Kritikos, Inc. v. Commissioner, supra at 1326-1327; see also

Elliotts, Inc. v. Commissioner, supra at 1246-1247.    We conclude

that an independent investor would have approved of the

compensation paid to Mr. Laviano, in view of the nature and

quality of the services that he performed for petitioner and the

effect of his services on a hypothetical investor's return on

investment.   This factor favors petitioner.

   m.   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
                              - 33 -


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

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

Inc. v. Commissioner, 819 F.2d 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.

   The Officers guaranteed the repayment of $500,000 that

petitioner borrowed from the First National Bank of Long Island

on June 20, 1984.   Thus, at first blush, this factor would appear

to favor petitioner.   We bear in mind, however, that the $500,000

proceeds were lent to the Officers by petitioner interest free,

immediately after petitioner received these funds from the bank.

The fact that the Officers received an interest-free loan from

petitioner negates the fact that the Officers guaranteed the

debt.   This factor favors neither party.   We consider it neutral.

   n.   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

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.
                                - 34 -


   Petitioner did not have a pension plan; thus, the Officers

did not receive the benefit of any pension contributions.      This

factor favors petitioner.

   o.   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.

   The Officers were reimbursed for their out-of-pocket expenses
incurred on behalf of petitioner. The record, however, does not
disclose the exact amount of these expenses. Moreover, it does
not appear that any of those expenses were incurred with other
than a corporate benefit in mind. This factor favors neither
party. We consider it neutral.


   p.   Conclusion on Reasonableness

   Most of the factors described above favor petitioner, and

none of them favor respondent.       We conclude that the $1,461,000

paid to Mr. Laviano in 1985 was reasonable compensation for that

year.   We conclude likewise with respect to the $1,461,000 paid

to Mr. Woll in 1985.

2. Whether Compensation Was Paid for Services Rendered to
Petitioner

   According to respondent, petitioner is not entitled to deduct

all of the compensation paid to the Officers because it paid part

of this compensation for services that they performed on account

of other, related companies.    We disagree.    Although the Officers
                                 - 35 -


provided some services to other related entities, we are unable

to find that these services were performed on behalf of anyone

other than petitioner.   We hold that petitioner paid the Officers

the subject compensation for services that they rendered to it.

3.   Conclusion

     Based on the above, we conclude that petitioner may deduct

the $1,461,000 that it paid to Mr. Laviano, and it may deduct the

$1,461,000 that it paid to Mr. Woll.      In so concluding, we have

considered all arguments made by respondent for a contrary

holding and, to the extent not discussed above, we find them to

be without merit.

     To reflect the foregoing,

                                      Decision will be entered

                                 for petitioner.
