                          T.C. Memo. 1997-17



                        UNITED STATES TAX COURT



   THE ESCROW CONNECTION, INC., A.K.A. THE ESCROW CONNECTION,
   Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15867-94.                      Filed January 8, 1997.



     David Roth, for petitioner.

     Patrick W. Lucas, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:     Respondent determined deficiencies in

petitioner's Federal income tax for taxable years ended July 31,

1989 and July 31, 1990, in the amounts of $160,381 and $140,849,

respectively.    Respondent also determined an addition to tax of

$40,349 under section 66611 for taxable year ended July 31, 1989,


     1
         All section references are to the Internal Revenue Code in
                                                      (continued...)
                                - 2 -


and an accuracy-related penalty of $28,170 under section 6662(a)

for taxable year ended July 31, 1990.

     The issues for decision are: (1) The amount that petitioner

is entitled to deduct as reasonable compensation to Kathryn

Kleindienst; (2) whether petitioner is liable for an addition to

tax for 1989; and (3) whether petitioner is liable for an

accuracy-related penalty for 1990.

                          FINDINGS OF FACT2

     The Escrow Connection, Inc. (petitioner), is an independent

escrow firm, organized in California, with its principal place of

business in Palm Springs, California.    Kathryn Kleindienst

(Kleindienst) formed petitioner in 1983 and began business during

1984.    Since incorporation, Kleindienst has been petitioner's

sole shareholder and sole officer.

     Kleindienst obtained an associate of arts degree in business

administration from The College of The Desert.    She acquired the

skills necessary to be an escrow officer by working as a

secretary to an escrow officer for a few years.    An escrow

officer must be good with numbers and attending to details.

     After working as an escrow secretary, Kleindienst was

promoted to an escrow officer in 1977, and 2 years later, First


     1
      (...continued)
effect for taxable years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
     2
       The parties' stipulation of facts, along with attached
exhibits, is incorporated by this reference.
                               - 3 -


Centennial Title hired her to open an escrow office in Palm

Springs.   First Centennial Title hired Kleindienst based on

excellent recommendations from past employers and her ability to

attract clients.   Kleindienst worked for First Centennial Title

and its successors until 1984, when she began petitioner's

operations.   At that time, petitioner took over the office space

and telephone number of Kleindienst's former employer, which went

out of business.   Kleindienst also taught two escrow officer

courses at The College of The Desert.

     During the years in issue, Kleindienst served as

petitioner's president, secretary, and chief financial officer

and worked as an escrow officer and manager.   In her

administrative capacity, Kleindienst oversaw business operations,

controlled finances, and provided financial planning.   She

supervised personnel, reviewed employee performance, and

determined compensation.   In addition, she kept up-to-date with

State regulation of the escrow industry and determined when to

obtain legal advice in handling escrow transactions.    Kleindienst

dealt with client complaints and determined when petitioner

should not accept an escrow because of potential problems the

escrow may create.   As an escrow officer, Kleindienst handled all

types of escrow transactions, including most of petitioner's

complex escrows.   She also advised other escrow officers in

handling their accounts.   Although Kleindienst could not estimate

the hours she spent at each function, she spent the majority of
                                - 4 -


her time working as an escrow officer.    In total, Kleindienst

worked about 70 hours per week.

     In addition to her work as an executive and escrow officer,

Kleindienst held seminars and met with realty boards, realtors,

real estate developers, attorneys, and accountants to promote

petitioner's business.    Kleindienst estimated that she solicited

escrows that generated approximately $1.2 million of petitioner's

$1.46 million in gross receipts during each of the years in

issue.   Both Lynne West (West), petitioner's accountant, and

Kleindienst believed that Kleindienst's services were essential

to petitioner's business success.    Without the large number of

escrows she solicited, petitioner would not be a viable business.

Kleindienst's clients have generally followed her when she

changed firms.    This factor makes Kleindienst more valuable.

     Petitioner's gross receipts consisted solely of fees

generated from closing escrow transactions.    To close an escrow,

an escrow officer must collect the purchase price and transfer

ownership of the property to the transferee.    Not all escrows

that are originated are closed; about 75 percent of escrow

accounts close.    Petitioner did not receive any fee when a client

opened an escrow.    The average escrow closing generated an $800

fee, but petitioner has received fees as large as $20,000 for

closing an escrow.

     During the years in issue, petitioner employed three to four

escrow officers, including Kleindienst.    Escrow officers, except
                                - 5 -


for Kleindienst, received a commission of 10 percent of the

escrow fee generated (closing commission) in addition to a base

salary.   Petitioner reassigned some of the escrows that

Kleindienst solicited.    The officer handling the reassigned

escrow received the 10-percent closing commission.    Escrow

officers, not including Kleindienst, closed escrows generating

gross receipts of $877,795 and $778,144 during the years in

issue, respectively.    Kleindienst closed escrows generating gross

receipts of $588,523 and $684,099, respectively.

     During its first year in business, taxable year ended July

31, 1985, petitioner employed three people and generated gross

receipts of $318,963.    By 1989 and 1990, petitioner's gross

receipts had increased to $1,466,318 and $1,462,243,

respectively, and petitioner employed 22 and 24 people,

respectively, including Kleindienst, the other escrow officers,

and support staff.   In part, petitioner's success resulted from a

favorable economy during the late 1980's.    Economic conditions

may have a profound effect on the performance of the escrow

industry.   From the 1984 beginning of petitioner's escrow

business, there were six escrow firms in the Palm Springs area.

     Despite the substantial increase in gross receipts, net

income before taxes was $100,212 and $10,867, for 1989 and 1990,

respectively.   During the years in issue, petitioner's profit

margin, measured as ratio of net income before taxes over gross

receipts, was 6.8 percent and .7 percent, respectively.
                                   - 6 -


Petitioner's witness, Larri E. Jones (Jones), an executive vice

president of a title insurance company with an escrow practice,

would be satisfied with a 10-percent profit margin.

     Petitioner did not pay dividends from 1984 through 1988, and

in 1989 and 1990, it paid $3,000 and $3,250 in dividends,

respectively.   Petitioner did not pay dividends before 1989 to

build up retained earnings.       Petitioner allowed retained earnings

to accumulate to guard against possible slowdowns in the escrow

industry and to satisfy government liquidity requirements.

Accumulating retained earnings is a normal practice in the escrow

industry, especially for startup firms.          Shareholder equity

increased from $20,000 (Kleindienst's initial capital investment)

to $341,708 by 1989.     Shareholder equity decreased in 1990 to

$338,458, and petitioner's net income after taxes was $0.

Kleindienst received compensation in the following amounts:

     Year          Total                                      Percent of
     Ended       Compensa-     Base               Gross       Gross Receipts
    July 31        tion       Salary    Bonus     Receipts         (%)
     1984           0           0         0           0            N/A
     1985       $109,250     $39,250   $70,000     $318,963       34.25
     1986        189,346      53,250   136,096      496,169       38.16
     1987        364,755      94,250   270,505      830,557       43.92
     1988        390,000     155,000   235,000    1,101,072       35.42
     1989        584,710     240,000   344,710    1,466,318       39.88
     1990        564,800     300,000   264,800    1,462,243       38.63

In 1989 and 1990, Kleindienst's compensation as a percentage of

taxable income before deducting her compensation was 85 percent

and 98 percent, respectively.

     Petitioner did not have a written employment agreement with

Kleindienst or a stated formula for determining her compensation.
                                 - 7 -


She did not receive the 10-percent escrow closing commission for

escrows she personally closed.    Nor did she receive a stated

percentage of the fees generated from escrows that she solicited.

Kleindienst determined the amount of her own compensation, as

well as the compensation for petitioner's other employees, with

the assistance of West and Kleindienst's husband.    They based

Kleindienst's salary and bonuses on current and anticipated

revenue, the percentage increase in gross revenue, Kleindienst's

compensation as a percentage of gross revenue, and the amount of

earnings petitioner desired to retain, as well as Kleindienst's

skill, hours, and the number of escrows she solicited and closed.

Petitioner set Kleindienst's base salary at the beginning of each

fiscal year and paid her bonuses throughout the year.     Petitioner

did not have a pension or profit-sharing plan for any of its

employees.

     Kleindienst set compensation for petitioner's other

employees in the same manner that she determined her own

compensation.    Petitioner paid each employee, besides

Kleindienst, a salary and a bonus at the end of the calendar

year.    The amount of the bonus depended on the employee's

position and length of employment and ranged from about $110 to

$1,200.3   In addition, it paid the escrow officers the 10-percent

closing commission on escrows they closed.    For the year ended


     3
       One employee received unexplained bonuses throughout
taxable year 1989 totaling about $8,600.
                               - 8 -


July 31, 1989, petitioner paid its 21 employees, other than

Kleindienst, a total of $457,291 in salary, commission, and

bonuses; for the year ended July 31, 1990, petitioner paid its 23

employees, other than Kleindienst, a total of $485,306.    Thus,

Kleindienst's compensation exceeded the combined compensation of

petitioner's other employees by $127,419 and $79,494,

respectively.

     Respondent determined $142,852 and $156,610 as reasonable

compensation for Kleindienst for taxable years ended July 31,

1989 and July 31, 1990, respectively, and disallowed petitioner's

claimed deductions for the excess.     At trial, respondent conceded

that compensation of approximately $300,000 per year would be

reasonable.

                              OPINION

     Before addressing the reasonableness of Kleindienst's

compensation, we consider the admissibility of two stipulated

exhibits offered by respondent.   The first exhibit is a published

survey of owners' compensation; the second is a published survey

of executive compensation.   Petitioner raised two objections to

the exhibits.   In the stipulation of facts, petitioner reserved

hearsay objections.   No testimony at trial involved the exhibits,

but respondent relied on the exhibits in its brief.    Petitioner

did not renew the hearsay objections or discuss them in its

initial or reply briefs.   Therefore, we consider the hearsay

objections reserved in the stipulation of facts abandoned.
                               - 9 -


Midkiff v. Commissioner, 96 T.C. 724, 734 (1991), affd. sub nom.

Noguchi v. Commissioner, 992 F.2d 226 (9th Cir. 1993); Van Heemst

v. Commissioner, T.C. Memo. 1996-305.

     In its reply brief, petitioner objected to the relevancy of

the exhibits.   Petitioner contends that the exhibits are

irrelevant because respondent conceded to compensation for

Kleindienst in an amount greater than the average surveyed

compensation from both exhibits.    Petitioner did not reserve

these relevancy objections in the stipulation of facts as

required by Rule 91.   Foster v. Commissioner, 80 T.C. 34, 135

(1983), affd. in part and vacated in part 756 F.2d 1430 (9th Cir.

1985).   In addition, petitioner's previous hearsay objections do

not reserve the relevancy objections to the stipulated exhibits

because objections must be specific.    United States v. Ruffin,

575 F.2d 346, 355 (2d Cir. 1978).    As the relevancy objections

raised by petitioner in its reply brief are untimely, we decline

to consider them.   Pan Am. Acceptance Corp. v. Commissioner, T.C.

Memo. 1989-440.4

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

necessary business expenses including "a reasonable allowance for


     4
      Despite our holding that petitioner abandoned its
objections, we note that we did not rely on the exhibits. The
exhibits did not provide any information specifically about owner
or executive compensation in the escrow industry. In addition,
the exhibits did not identify whether the owners and executives
surveyed performed functions similar to those Kleindienst
performed. Thus, the exhibits provide little, if any, guidance
as to the value of Kleindienst's services.
                                - 10 -


salaries or other compensation for personal services actually

rendered".    A two-prong test determines deductibility: (1)

Whether the amount of compensation is reasonable in relation to

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

for services rendered.     Elliotts, Inc. v. Commissioner, 716 F.2d

1241, 1243 (9th Cir. 1983), revg. T.C. Memo. 1980-282; Nor-Cal

Adjusters v. Commissioner, 503 F.2d 359, 362 (9th Cir. 1974),

affg. T.C. Memo. 1971-200; sec. 1.162-7(a), Income Tax Regs.          The

decision as to the deductibility of compensation generally

focuses on the reasonableness of the compensation.        Elliotts,

Inc. v. Commissioner, supra at 1245.     Petitioner bears the burden

of proving the reasonableness of the compensation.       Rule 142(a);

Botany Worsted Mills v. United States, 278 U.S. 282 (1929).

     The reasonableness of compensation is a question of fact to

be answered by considering and weighing all facts and

circumstances of the particular case.        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

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

a lengthy list of factors that bear on the determination of

reasonableness.     Mayson Manufacturing Co. v. Commissioner, 178

F.2d 115, 119 (6th Cir. 1949); Foos v. Commissioner, T.C. Memo.

1981-61.     No single factor is decisive.     Pacific Grains, Inc. v.

Commissioner, supra at 606.     In Elliotts, Inc. v. Commissioner,

supra, the Court of Appeals for the Ninth Circuit, to which this
                              - 11 -


case is appealable, has divided these factors into five

categories:   (1) The employee's role in the company; (2) an

external comparison of the employee's salary with salaries paid

by similar companies for similar services; (3) the character and

condition of the company; (4) the conflict of interest between

the company and the employee; and (5) the internal consistency in

the company's treatment of payments to employees.   Elliotts, Inc.

v. Commissioner, supra at 1245-1248.

A.   Role in the Company

      The first category of factors identified by the Court of

Appeals concerns the employee's role in the company.   Relevant

factors include the employee's qualifications, position and

duties, hours worked, and the general importance of the employee

to the success of the company.   Elliotts, Inc. v. Commissioner,

supra at 1245; 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).   An employee's superior qualifications and

substantial contribution to the employer's extraordinary success

may justify a high level of compensation.   Home Interiors &

Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1146 (1980).

Petitioner maintains that Kleindienst is the primary reason for

petitioner's success while respondent contends that, although she

had the skill and experience to successfully manage petitioner,

neither her academic achievements nor experience was
                               - 12 -


extraordinary.    We find respondent's stance to be correct but not

entitled to much weight.

     Kleindienst was highly motivated, productive, and

indispensable to petitioner's business.    She worked long hours,

performed the functions of corporate officer and manager, and

spent the majority of the hours as an escrow officer.

Kleindienst was a well-qualified escrow officer with 12 years of

experience.    She handled most of petitioner's complex escrows.

Some controversy surrounded the number of escrows that

Kleindienst closed, and she believed she closed 850 escrows in

1989.    Based on the closing commission they received, the escrow

officers other than Kleindienst closed escrows that generated

fees of approximately $877,795 and $778,144 during the years in

issue.    This leaves a possible $588,523 and $684,099 in escrow

fees generated from Kleindienst's closings.    On average, an

escrow transaction generated an $800 fee.    This confirms

Kleindienst's belief as she would have closed about 735 and 855

escrows, respectively.    Although respondents' experts doubted

that Kleindienst could close this number of escrows given her

administrative responsibilities, Kleindienst's testimony was

credible.

     Perhaps the most valuable service that Kleindienst provided

to petitioner was marketing.    She personally solicited escrows

that generated $1.2 million of petitioner's approximately $1.46

million gross receipts during each year in issue.    Respondent
                                - 13 -


argues that Kleindienst could not have generated $1.2 million in

gross receipts because that would attribute too little fees to

the other escrow officers as determined by the amount of

commission they received.    Kleindienst, however, did not close

escrows generating $1.2 million in fees; she solicited escrows

that generated $1.2 million in fees when closed.    Kleindienst

created a continuing source of referrals by developing contacts

with realty boards, realtors, real estate developers, attorneys,

and accountants.    Petitioner assigned some of the escrows that

Kleindienst solicited to other escrow officers who, in turn,

closed the escrow, generated the fee, and received the 10-percent

closing commission.

     Kleindienst's efforts to solicit clients played a key role

in petitioner's success, and petitioner was substantially

dependent on her.    Respondent's expert, Dave Brooks (Brooks),

admitted that Kleindienst's role in petitioner's success would

justify paying her more.    Nevertheless, limits on reasonable

compensation exist even for the most valuable employee.     Owensby

& Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1325 (5th Cir.

1987), affg. T.C. Memo. 1985-267; Rutter v. Commissioner, 853

F.2d 1267, 1272 (5th Cir. 1988), affg. T.C. Memo. 1986-407.

B.   External Comparison

      The second category of factors involves a comparison of the

employee's salary with salaries paid by similar companies for

similar services.     Industry standards for compensation have been
                              - 14 -


significant in determining reasonable compensation.     Owensby &

Kritikos, Inc. v. Commissioner, supra at 1330; Charles Schneider

& Co. v. Commissioner, 500 F.2d 148, 154-155 (8th Cir. 1974),

affg. T.C. Memo. 1973-130; sec. 1.162- 7(b)(3), Income Tax Regs.

As Kleindienst performed numerous functions, the relevant

comparison is to the salaries of each position she filled.

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

     At trial, both parties presented expert testimony as to what

a similar escrow firm would pay for Kleindienst's services.

Petitioner called Larri Jones as an expert witness.   Jones

supervises escrow operations at Chicago Title and determines

compensation for escrow officers.   Chicago Title pays its escrow

officers a base salary of $36,000 to $60,000 plus commission.

Jones described three types of commission.   The first commission

is paid to escrow officers based on escrow fees they generate by

closing escrows (closing commission).   To earn this commission,

an escrow officer must generate fees over a predetermined

threshold.   Once over the threshold, an officer earns a

commission of 25 to 31 percent of the closing fees generated; the

exact percentage depends on the officer's responsibilities, such

as hiring, overseeing escrow accounts, and marketing.    The second

commission is earned by an escrow officer who manages escrow

operations (management commission).    An escrow manager receives

an additional 2 to 4 percent of revenue generated by officers

under her supervision.   The third commission is paid to
                               - 15 -


salespersons who solicit escrows and equals 10 to 20 percent of

revenues generated from escrows they solicited (sales

commission).   Chicago Title did not pay the sales commission to

its escrow officers who solicited and closed their own escrows.

Rather, Chicago Title would increase the officers' percentage for

the closing commission within the 25- to 31-percent range.    Jones

also stated that Chicago Title has employee benefits, including

retirement and health insurance, of about one-third of an

employee's pay.

     Jones applied this compensation formula to the revenue

figures that petitioner provided.   Jones set a base salary for

Kleindienst at $60,000 and a threshold for the closing commission

of $200,000.   Jones determined $310,0000 as Kleindienst's closing

commissions based on her having closed escrows which generated

$1.2 million in fees and applying a 31-percent commission--the

highest possible percentage.   Next, Jones stated that he would

have to pay the sales commission to the salesperson who solicited

the $1.2 million of escrow revenues, so he would be willing to

pay Kleindienst an equivalent amount for her marketing efforts.

According to this calculation, he would pay Kleindienst more than

$500,000 not including the 2- to 4-percent management commission.

     Although Jones' opinion provides some insight into the

compensation structure of the escrow industry, we decline to

accept his methodology in its entirety.   Jones' formula would pay

Kleindienst a closing commission of 25 to 31 percent.   However,
                               - 16 -


petitioner paid its escrow officers a commission of only 10

percent of the closing fee.    Petitioner did not offer any

explanation for why its compensation system varied from the one

its expert advanced to opine on the reasonable compensation for

Kleindienst.

     We can accept the general methodology of an expert and

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

support that conclusion.   Rutter v. Commissioner, supra at 1274;

Barry v. United States, 501 F.2d 578, 581-583 (6th Cir. 1974).

In addition, we can decline to follow the opinion of an expert

witness if the opinion is contrary to our own judgment.       Barry v.

United States, supra at 583.

     Not only is Jones's formula inappropriate in this case, his

conclusion that he would pay Kleindienst more than $500,000 is

suspect for two reasons.   First, Jones calculated the closing

commission based on the revenues produced from escrows that

Kleindienst solicited and not from fees generated from escrows

that she closed.   Second, Jones stated that he did not pay the

sales commission to escrow officers who solicited and closed

their own escrows.   Yet, Jones stated that he would be willing

to pay Kleindienst both the closing and sales commissions.       A

more appropriate manner of compensation would be to pay

Kleindienst the sales commission only on those escrows that she

solicited but petitioner reassigned to other escrow officers to

close.
                             - 17 -


     Respondent argues that we should not apply Jones' formula

because Chicago Title is not an independent escrow firm like

petitioner.   We find no reason to believe that the compensation

structure for an escrow officer in an independent firm would be

significantly different from one used in a title insurance

company.   In addition, respondent concedes that its experts'

compensation formulas for independent firms are similar to that

described by Jones.

     Respondent called as its expert witnesses Dave Brooks and

Michael Haas, who collaborated on a report that provided five

formulas to determine Kleindienst's compensation.   Dave Brooks

is president, chief executive officer, and majority shareholder

of a multibranch, independent escrow firm that generates an

average of $3 million in gross receipts.   Michael Haas is an

accountant who performed accounting services for 42 independent

escrow firms during the years in issue.    The five formulas are

based on their experience and represent compensation plans

common in the independent escrow industry.   Each formula

assigned an arbitrary amount of $12,000 as compensation for

Kleindienst's duties as a corporate officer.   The average

compensation from the five formulas was $300,000.   Respondent

conceded this amount as reasonable compensation for Kleindienst.

     While two formulas provided by respondent resemble Jones'

formula, we are not satisfied that respondent's proffered

formulas accurately reflect the value of Kleindienst's marketing
                             - 18 -


services to petitioner.   These two formulas advanced by

respondent's experts awarded Kleindienst a 5-percent marketing

commission on escrows she solicited but petitioner reassigned.

Brooks stated that he may pay an employee more if she solicited

a substantial portion of escrow revenues as Kleindienst did.

Without Kleindienst, petitioner would have far fewer clients and

would most likely be unsuccessful.    However, Brooks did not take

this into account when determining Kleindienst's compensation.

Brooks explained that the nature of the escrow industry means

that an employer loses clients when any employee leaves.

Brooks' explanation does not justify ignoring or diminishing the

value of the significant contribution that Kleindienst made to

petitioner by soliciting the large majority of its escrow

clients.

     In addition to providing the compensation formulas, Haas

also provided corporate officer compensation as a percentage of

gross receipts for 28 independent escrow firms.   The average

percentage was 22 percent during the years in issue.   Haas

stated that most of these corporate officers also worked as

escrow officers, and Haas used the total compensation received

for both the executive and escrow duties to calculate the

percentage.   Haas also provided specific examples of the

compensation paid to shareholder-employees of two independent

escrow firms.   In both firms, the shareholder worked as a

corporate officer and escrow officer.   Although we can compare
                              - 19 -


the officer compensation and gross revenue of these firms with

that of petitioner, we do not know how much the officers of

these other firms contributed to the success of their

businesses, the percentage of escrows they solicited and

handled, or the hours they worked.     Thus, any comparison would

be of limited assistance in our evaluation of the value of

Kleindienst's services.

     Petitioner argued that we should assign $220,000 as

compensation for Kleindienst's administrative services, rather

than the arbitrary $12,000 assigned by Brooks and Haas because

Brooks' firm paid $220,000 to its corporate officers.    We agree

that Brooks and Haas arbitrarily allocated $12,000 for

Kleindienst's compensation as an executive and manager.

However, $220,000 compensation would be too high.    Brooks' firm

generated more than two times the gross revenues of petitioner.

Also, the officers' compensation at Brooks' firm included

payment for soliciting about 25 percent of the firm's escrow

clients, which generated over $750,000 in revenue.    Petitioner,

however, argues that Kleindienst should receive compensation for

soliciting clients in addition to her compensation for her

administrative duties.    Because of these differences, we find

that the amount of officer compensation paid by Brooks' firm

does not support equivalent compensation for Kleindienst's

executive responsibilities.
                             - 20 -


C.   Character and Condition of the Company

      The third category of factors provided by Elliotts, Inc. v.

Commissioner, 716 F.2d 1241 (9th Cir. 1983), concerns the

character and condition of the company.   Important

considerations are the size of the company, as indicated by

gross sales, net income, or capital value, general economic

conditions, and the complexities of the business.      Elliotts,

Inc. v. Commissioner, supra at 1246.   The success of the

business provides a basis for increases in compensation.     Summit

Publishing Co. v. Commissioner, T.C. Memo. 1990-288.

      Petitioner's gross receipts grew from $318,963 in 1984, its

first year in operation, to over $1.46 million in 1989 and 1990.

Petitioner's shareholder equity increased from an initial

investment of $20,000 to $341,708 in taxable year 1989.     The

growth in gross receipts and shareholder equity provides clear

evidence that Kleindienst was dynamic and effective.    However,

we find it somewhat telling that petitioner's net income after

taxes remained low.   For the years in issue, net income after

taxes was $72,000 and $0, respectively, while it was $40,169

after 1 year in business and reached a peak of $93,546 in

taxable year ended July 31, 1988.

      In addition, Kleindienst is not the sole reason for

petitioner's substantial increase in gross receipts.    Favorable

economic conditions during the years in issue also played a role
                              - 21 -


in petitioner's growth and lessened the credit due to

Kleindienst for petitioner's success.   Although the economy

positively influenced petitioner's success, the record does not

permit us to quantify the extent it affected petitioner's

success.

D.   Conflict of Interest

      The fourth category identified by the Court of Appeals for

the Ninth Circuit concerns the relationship between the company

and the shareholder-employee possibly permitting nondeductible

corporate distributions of profits to be paid as deductible

compensation.   Elliotts, Inc. v. Commissioner, supra at 1246.     A

potential for such abuse exists when the employee whose

compensation is in issue is the company's sole or controlling

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

at 152; sec. 1.162-7(b)(1), Income Tax Regs.   Respondent

correctly contends that Kleindienst controlled the amount of her

own compensation as she was the sole shareholder and sole

corporate officer.   In such a situation, we must carefully

scrutinize the reasonableness of the compensation.   Owensby &

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

Schneider & Co. v. Commissioner, supra at 152.   Other factors

that point to a conflict of interest include compensation that

equals a disproportionately large percentage of gross income or

pretax net income, large bonuses to shareholder-employees but
                               - 22 -


not to nonshareholder-employees, and the absence of dividends.

Elliotts, Inc. v. Commissioner, supra at 1246; Nor-Cal Adjusters

v. Commissioner, 503 F.2d at 362.

        Respondent argues that petitioner's dividends of $3,000 and

$3,250 were "de minimis" in comparison to Kleindienst's bonuses

of $344,710 and $264,800 during the years in issue,

respectively.     The negligible amount of dividends here is

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

1324.     However, this alone is not determinative, and valid

business reasons could exist for not paying dividends.         Id.;

Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694, 714 (1977).

At least one court has relied on the absence of dividends to

find compensation unreasonable despite the taxpayer's assertion

that there were legitimate business reasons for not paying them.

Rutter v. Commissioner, 853 F.2d at 1273.       The court reasoned

that the corporation's failure to pay dividends could not be

justified in light of the large bonuses the corporation paid its

shareholder-employee.

     In this case, petitioner presented legitimate business

reasons for not paying dividends.       Yet, petitioner paid

substantial bonuses to Kleindienst despite the purported need to

retain earnings.     Although we do not second-guess petitioner's

reasons for not paying dividends, the trivial amount of
                             - 23 -


dividends it paid does not sit well for petitioner in light of

the other factors that support a conflict of interest.

     Rather than focusing on the payment of dividends, the Court

of Appeals for the Ninth Circuit evaluated the reasonableness of

compensation from the viewpoint of a hypothetical independent

investor.   A return on shareholder equity, after paying officer

compensation, that would satisfy an independent investor is a

strong indication that the compensation is reasonable and that

the company is not siphoning off profits disguised as salary.

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

     Petitioner argued that it provided a sufficient return

measured by the dividend paid in each year in issue as a

percentage of Kleindienst's initial capital contribution.     Such

a percentage is not a correct measure of a shareholder's return

on investment because it ignores the past earnings retained and

reinvested by the corporation which, in this case, constitute a

large percentage of shareholder equity.   During taxable years

ended July 31, 1989 and July 31, 1990, petitioner reported

shareholder equity5 of $341,708 and $338,458, respectively.

During these years, net income after Kleindienst's compensation

and taxes was $72,681 and $0, respectively--a return of 21



     5
      To calculate shareholder equity, we added together the
listed amounts for capital stock and unappropriated retained
earning from Schedule L on Form 1120, U.S. Corporation Income Tax
Return.
                              - 24 -


percent and no return, respectively.   Although a rate of return

on equity of 21 percent could satisfy an independent investor,

no return would not.   In addition, Jones stated that, as an

investor, he would be satisfied with a 10-percent profit margin,

measured as a ratio of net income before taxes over gross

receipts.   During the years in issue, petitioner's profit margin

was 6.8 percent and .7 percent, respectively.   We find

respondent's contention of an inadequate return to be probative

here.

     Respondent points out that petitioner paid Kleindienst

nearly all of its net income before deducting officer

compensation and taxes.   Respondent asks us to focus on the time

of year that petitioner declared and paid Kleindienst's bonuses.

Payment of bonuses at the end of the year when the corporation

knows its revenue for the year may enable it to disguise

dividends as compensation.    Owensby & Kritikos, Inc. v.

Commissioner, supra at 1329; Estate of Wallace v. Commissioner,

95 T.C. at 556.    Here, however, petitioner paid Kleindienst the

bonuses throughout the year and only declared the amount at the

end of the year.   Thus, the timing of the bonuses does not

indicate unreasonableness.   On the other hand, the fact that

petitioner paid nearly all of its pretax earnings as

compensation to Kleindienst is detrimental to petitioner here.

Estate of Wallace v. Commissioner, supra at 556.
                             - 25 -


      The escrow industry is service-oriented and relies heavily

on commission as compensation.   Kleindienst was the primary

source of solicited escrows and also generated a significant

percentage of closing fees as compared to petitioner's other

escrow officers combined.   As a result, her compensation as a

percentage of net income would logically be high.    However, we

are apprehensive about the fact that Kleindienst's compensation

is an extremely high percentage of net income before deducting

her compensation and taxes, 85 percent and 98 percent,

respectively.   In addition, Kleindienst admitted that she based

the amount of her bonuses, in part, on the amount of earnings

she wanted petitioner to retain.   Thus, we conclude that

Kleindienst's compensation was based on factors other than the

value of her services to petitioner.

E.   Internal Consistency

      The fifth category of factors provided by the Court of

Appeals in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th

Cir. 1983), is the internal consistency of the company's

treatment of payments to employees.    Compensation to

shareholder-employees can prove to be unreasonable when compared

to compensation paid to nonshareholder-employees of the same

company with similar responsibilities.    Home Interior & Gifts,

Inc. v. Commissioner, 73 T.C. at 1159.    On the other hand, if a

corporation pays salaries at the top of its industry to all of
                               - 26 -


its employees, both shareholders and nonshareholders, it may be

able to justify a higher compensation level to its shareholder-

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

at 1324.     In addition, a longstanding, consistently applied

compensation plan indicates that compensation is reasonable.

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

     Petitioner paid bonuses to all employees, but petitioner

did not pay bonuses to its nonshareholder escrow officers in a

manner consistent with which it paid Kleindienst.     Petitioner

paid its escrow officers a closing commission of 10 percent of

fees from escrows that they closed.     Expert witnesses from both

parties stated that escrow officers commonly make about one-

third of the closing fees as commission.    Petitioner never

explained why its compensation plan for its escrow officers

differed from the industry norm.     These officers also solicited

escrows without additional commission.     In total, petitioner's

other escrow officers received salary, commission, and bonuses

of $218,763 and $248,091, while Kleindienst made $584,710 and

$564,800 during the years in issue, respectively.     In addition,

Kleindienst's compensation exceeded the combined compensation of

all of petitioner's other 21 employees by $127,419 in taxable

year 1989 and its other 23 employees by $79,494 in taxable year

1990.   The disparity between Kleindienst's compensation and that

of the nonshareholder escrow officers is patently glaring
                             - 27 -


regardless of Kleindienst's additional functions as a corporate

officer and manager.

     Petitioner contends that it had a longstanding and

consistently applied compensation plan.    Compensation as a

percentage of gross receipts that is within the range of

percentages from previous years indicates an informal,

consistently applied compensation plan.     L&B Pipe & Supply Co.

v. Commissioner, T.C. Memo. 1994-187; Mortex Manufacturing. Co.

v. Commissioner, T.C. Memo. 1994-110.     Petitioner did not use a

predetermined formula to calculate Kleindienst's base salary or

bonus.   Rather, each year Kleindienst met with petitioner's

accountant to determine her salary from a stated list of

subjective criteria.   Kleindienst's compensation rested

completely within her own discretion.     Thus, we attach little

weight to the fact that Kleindienst's compensation as a

percentage of gross revenue during the years in issue fell

within the range of percentages from prior years.

     Based on these considerations, we find that reasonable

compensation for Kleindienst for taxable years ended July 31,

1989 and July 31, 1990, is $450,000 and $460,000, respectively.

To the extent that arguments of each party were not addressed

herein, we find them to be without merit.

                Addition to Tax Under Section 6661
                             - 28 -


     Respondent determined an addition to tax of $40,349 under

section 6661 for taxable year ended July 31, 1989.     Section

6661(a) imposes an addition to tax of 25 percent of the amount

of any underpayment attributable to a substantial understatement

of tax.   An understatement is the difference between the amount

required to be shown on the return and the amount actually shown

on the return and is substantial if it exceeds the greater of

(1) 10 percent of the tax required to be shown on the return for

a taxable year, or (2) $10,000.   Sec. 6661(b)(1) and (2)(A);

Tweeddale v. Commissioner, 92 T.C. 501, 505 (1989).     The amount

of the understatement can be reduced if substantial authority

existed for the taxpayer's tax treatment of the item in dispute

or if the taxpayer adequately disclosed relevant facts regarding

the taxpayer's treatment of the item in the return or in a

statement attached to the return.     Sec. 6661(b)(2)(B).   The

taxpayer has the burden of proving it is not liable for the

addition to tax.   Rule 142(a).   Petitioner does not contend that

substantial authority existed for its position or that it

adequately disclosed the relevant facts.

     Rather, petitioner maintains that it had reasonable cause

for the understatement.   Section 6661(c) provides that the

Commissioner may waive the addition to tax if the taxpayer

proves that reasonable cause existed for the understatement and

the taxpayer acted in good faith.     The most important factor in
                             - 29 -


determining whether reasonable cause exists is the extent of the

taxpayer's efforts to ascertain its proper tax liability.    Sec.

1.6661-6(b), Income Tax Regs.

     Our role with regard to a waiver of the addition is only to

determine whether respondent abused her discretion for failing

to waive the addition.   Cramer v. Commissioner, 101 T.C. 225,

256 (1993), affd. 64 F.3d 1406 (9th Cir. 1995); Mailman v.

Commissioner, 91 T.C. 1079, 1082-1083 (1988); Sisson v.

Commissioner, T.C. Memo. 1994-545, affd. without published

opinion ___ F.3d ___ (9th Cir., Dec. 17, 1996).    Petitioner must

show that respondent's refusal to waive the addition is

arbitrary, capricious, or without sound basis in fact.     Cramer

v. Commissioner, supra at 256.   Taxpayers should make a specific

request for a waiver to later challenge the failure to waive as

an abuse of discretion because without this request the

Commissioner did not exercise any discretion.     McCoy Enters.,

Inc. v. Commissioner, 58 F.3d 557, 563 (10th Cir. 1995), affg.

T.C. Memo. 1992-693; Chin v. Commissioner, T.C. Memo. 1994-54;

Dugow v. Commissioner, T.C. Memo. 1993-401, affd. without

published opinion 64 F.3d 666 (9th Cir. 1995); Estate of Reinke

v. Commissioner, T.C. Memo. 1993-197, affd. 46 F.3d 760 (8th

Cir. 1995); Klieger v. Commissioner, T.C. Memo. 1992-734.    If a

taxpayer never asks the Commissioner to waive the addition, it

is difficult to fault the Commissioner for failing to waive it.
                               - 30 -


Estate of Reinke v. Commissioner, 46 F.3d at 765.     In this case,

the record contains no indication that petitioner specifically

requested that respondent waive the addition prior to trial.

     Even if it had requested a waiver, petitioner did not prove

reasonable cause existed for its compensation deduction.

Petitioner asserts that it reasonably relied on the no-change

result from an audit regarding Kleindienst's compensation for

taxable year 1987 in determining Kleindienst's compensation for

taxable year 1989.   In taxable year ended July 31, 1987,

Kleindienst earned $364,755.    In a letter to the Internal

Revenue Service (IRS) in response to the audit, West justified

Kleindienst's compensation as a percentage of petitioner's gross

receipts.   During taxable years 1985-87, the percentage ranged

from 34 percent to 44 percent.    West stated that she believed

that the no-change result of the audit meant that the IRS

approved of compensation to Kleindienst as a percentage of gross

receipts within this range.

     The no-change result of a prior audit does not mean that

respondent approved the manner in which petitioner determined

Kleindienst's compensation or that her compensation in taxable

year 1987 was reasonable.     Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d at 1329.    In Owensby, the court held that

the prior audit result is not decisive in determining the

reasonableness of compensation for a subsequent year.       However,
                              - 31 -


the court stated that reliance on the compensation practice

previously allowed by the Commissioner may show good faith.        Id.

at 1329.   The prior audit may, in some circumstances, provide

reasonable cause for an understatement and support a waiver of

an addition to tax.   See Matthews v. Commissioner, 92 T.C. 351,

362-363 (1989), affd. 907 F.2d 1173 (D.C. Cir. 1990).

     We find that petitioner's reliance on the prior audit in

this case does not provide reasonable cause for its excessive

officer's compensation deduction.      Petitioner should have been

aware, especially with the involvement of an accountant, that

the IRS could have decided not to pursue a deficiency for the

prior year for a number of reasons, in addition to the possible

weakness of its case.   The prior audit could have served as a

warning to petitioner as to the legality of characterizing the

entire amount of payments to Kleindienst as compensation.     See

Burke v. Commissioner, 929 F.2d 110, 113 (2d Cir. 1991), affg.

in part and revg. in part T.C. Memo. 1989-671.      In addition,

Kleindienst's compensation increased by 60 percent after the

year audited.   This significant change in the amount of

Kleindienst's compensation made it unreasonable for petitioner

to rely on the result of the prior audit.      Also, petitioner did

not prove the extent to which it relied on the no-change result

as it considered a number of other factors in determining

Kleindienst's compensation.   Thus, petitioner did not prove
                               - 32 -


reasonable cause for its deduction of the excessive

compensation.

       To avoid liability for the addition to tax, petitioner

further argues that it relied on the advice of its accountant,

West.     Reliance upon the advice of an attorney or accountant

constitutes a showing of reasonable cause and good faith only if

it was reasonable to rely on the advice under the circumstances.

Vorsheck v. Commissioner, 933 F.2d 757, 759 (9th Cir. 1991);

sec. 1.6661-6(b), Income Tax Regs.      For reliance on professional

advice to be reasonable, the taxpayer must supply the accountant

with accurate information and the error in the return must be

due to the accountant's mistake.     Metra Chem Corp. v.

Commissioner, 88 T.C. 654, 662 (1987); Ma-Tran Corp. v.

Commissioner, 70 T.C. 158, 173 (1978).      The experience and

sophistication of the taxpayer affect the reasonableness of its

reliance on a professional.     Vorsheck v. Commissioner, supra at

759.

        In this case, Kleindienst, petitioner's representative, is

a sophisticated and experienced businesswoman well aware of the

prior audit and the uncertainty of the legality of the

compensation deduction for taxable year ended July 31, 1987.

Kleindienst not only participated in the compensation

determination but also had the final authority to set her own

compensation.     Petitioner did not prove that the deficiency
                              - 33 -


resulted from the accountant's mistake.     Therefore, we find that

petitioner's reliance on West does not protect it from an

addition to tax under section 6661.

     Given these considerations, we find that respondent did not

abuse her discretion by not waiving the addition to tax.     No

reasonable cause existed for the understatement despite West's

purported reliance on the prior audit and petitioner's purported

reliance on West.   Regardless, petitioner failed to request that

respondent waive the addition to tax.     We hold petitioner liable

for an addition to tax under section 6661 for taxable year ended

July 31, 1989.

           Accuracy-related Penalty Under Section 6662

     Respondent determined an accuracy-related penalty of

$28,170 under section 6662(a) for taxable year ended July 31,

1990.   Section 6662(a) imposes a penalty in an amount equal to

20 percent of the portion of the underpayment of tax

attributable to (1) negligence or disregard of the rules or

regulations or (2) any substantial understatement of income tax.

Sec. 6662(b)(1) and (2).   The definition and the calculation of

a substantial understatement under section 6662(d) are similar

in most respects to section 6661.      The section 6662(a) penalty

does not apply to any portion of an underpayment for which

reasonable cause exists and the taxpayer acted in good faith.

Sec. 6664(c)(1).    The taxpayer bears the burden of proving that
                             - 34 -


it is not liable for the accuracy-related penalty.     Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933); Neely v.

Commissioner, 85 T.C. 934, 947 (1985).

     As petitioner substantially understated its income for

taxable year ended July 31, 1990, it is liable for the accuracy-

related penalty.   For the reasons stated above, reasonable cause

for petitioner's excessive compensation does not exist.     In

addition, petitioner did not act in good faith in taxable year

1990.   Petitioner paid Kleindienst excessive compensation,

including large discretionary bonuses, and left no net income

after taxes.   Also, Kleindienst improperly considered the amount

of earnings she wanted petitioner to retain as a factor in

determining her own compensation.     Thus, we find petitioner

liable for an accuracy-related penalty under section 6662(a).

                                      Decision will be entered

                               under Rule 155.
