                        T.C. Memo. 1996-32



                      UNITED STATES TAX COURT



                  ALONDRA INDUSTRIES, LIMITED,
                d.b.a. ACCENT INSULATION COMPANY
            AND SUBSIDIARIES, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 10849-91, 10851-91,     Filed January 29, 1996.
                 24777-92.



     Mark D. Pastor and Larry S. Dushkes, for petitioners.

     Ursula P. Gee, William A. McCarthy, and Linette B.

Angelastro, for respondent.

             MEMORANDUM FINDINGS OF FACT AND OPINION


     BEGHE, Judge:   By statutory notices dated March 8, 1991,

respondent determined deficiencies in and additions to the



     1
      Cases of the following petitioners are consolidated
herewith: Edco Leasing Corporation, docket No. 10851-91; and
Pertinax, Limited, docket No. 24777-92.
                                      2

    Federal corporation income tax of petitioner Alondra Industries,

    Limited, d.b.a. Accent Insulation Company (Alondra), for its

    fiscal year ended June 30, 1987 (Alondra's fiscal 1987), and of

    petitioner Edco Leasing Corporation (Edco) for its fiscal year

    ended September 30, 1987 (Edco's fiscal 1987).    By notice of

    final partnership administrative adjustment (FPAA) dated July 13,

    1992, respondent increased the income reported on the U.S.

    Partnership Return of Income of petitioner Pertinax, Limited

    (Pertinax), a partnership whose partners include Alondra and

    Edco, for the calendar year 1987.     The deficiencies, additions,

    and adjustment in dispute are as follows:



ket No. 10849-91 (Alondra)

Fiscal                              Additions to tax
Year Deficiency        Sec. 6653(a)(1)(A) Sec. 6653(a)(1)(B) Sec. 6661(a)
1987   $836,238             $41,812       50% of the           $209,060
                                          interest due
                                          on $836,238

Docket No. 10851-91 (Edco)

Fiscal                               Additions to tax
Year Deficiency        Sec. 6653(a)(1)(A) Sec. 6653(a)(1)(B)
1987   $21,814                $1,091      50% of the
                                          interest due
                                          on $21,814

Docket No. 24777-92 (Pertinax)

Calendar
Year                              Adjustment to Income
1987                                   $860,425

           Petitioners' cases were consolidated for trial, briefing,

    and opinion.
                                3

     The issues for decision are (1) whether the burden of proof

should be shifted from corporate petitioners to respondent with

respect to the issues of substantiation of claimed expenses for

rent and management fees; (2) whether disputed amounts of

$26,881, $3,721, and $3,136 allegedly paid respectively by

Alondra, Edco, and Pertinax to Joel Munro (Mr. Munro) for rent

are deductible by petitioners as ordinary and necessary business

expenses; (3) whether and to what extent $1,000,112 paid to Mr.

Munro is deductible by Pertinax as reasonable compensation; (4)

whether disputed amounts of $906,879 and $9,922 allegedly paid

respectively by Alondra and Edco to Pertinax as management fees

are deductible by Alondra and Edco as reasonable compensation;

(5) whether disputed amounts of $884,148 and $35,671 paid

respectively by Alondra and Edco to Pertinax for wages paid to

employees of Pertinax, some of whom also served as officers of

Alondra and Edco, are deductible by Alondra and Edco as ordinary

and necessary business expenses; (6) the proper tax treatment of

unreasonable compensation routed to Mr. Munro by Alondra and Edco

through Pertinax; and (7) whether Alondra and Edco are liable for

additions to tax for negligence under section 6653(a)(1)(A) and

(B)2 and Alondra is liable to the addition to tax for substantial

understatement under section 6661(a).

     2
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue. All
Rule references are to the Tax Court Rules of Practice and
Procedure.
                                 4

     We hold that:   (1) Corporate petitioners' motion to shift

the burden of proof is denied as moot; (2) the disputed amounts

allegedly paid for rent are not deductible; (3) the disputed

amounts paid to Mr. Munro as compensation are deductible by

Pertinax only to the extent stated below; (4) the disputed

amounts allegedly paid by Alondra and Edco to Pertinax as

management fees are not deductible; (5) the disputed amounts paid

by Alondra and Edco to Pertinax for wages of its employees are

deductible to the extent stated below; (6) the unreasonable

compensation routed to Mr. Munro by Alondra and Edco through

Pertinax should be treated as unreasonable compensation directly

provided to Mr. Munro by Alondra and Edco; and (7) the additions

to tax for negligence and for substantial understatement are both

sustained to the extent stated below.

                         FINDINGS OF FACT

     The stipulations of fact, the supplemental stipulations of

fact, and the exhibits attached thereto are incorporated in our

findings by this reference.   Unless we state otherwise, these

findings concern facts occurring during the relevant taxable

period.

Parties and Affiliates

     Alondra is a California corporation.   Alondra keeps its

books and reports its income using the accrual method of

accounting on a fiscal year ending June 30.   J.B. Ross, a.k.a. Jo

Anne Munro (Ms. Ross), is Alondra's sole shareholder and
                                   5

secretary.   At the time of filing of Alondra's petition, its

principal place of business was at 1001 El Centro Street, South

Pasadena, California (the El Centro property).

     Edco is a California corporation.      Edco keeps its books and

reports its income using the accrual method of accounting on a

fiscal year ending September 30.       Mr. Munro, Ms. Ross's father,

is Edco's sole shareholder.   At the time of filing of Edco's

petition, its principal place of business was at the El Centro

property.

     United California Insulation Company (UCIC) is a wholly

owned subsidiary of United California Industries, Inc. (UCII);

both of them are California corporations, and their income,

deductions, and credits are reported on consolidated corporation

income tax returns.3   The principal place of business of both

UCIC and UCII is at the El Centro property.      Mr. Munro is UCII's

sole shareholder.   UCII keeps its books and reports its income

using the accrual method of accounting and a calendar year.

Neither UCIC nor UCII is a petitioner in this Court.4

     3
      According to UCII's consolidated return for 1987, UCIC was
one of three subsidiaries of UCII, but was by far the dominant
member, accounting for some 77 percent of the UCII affiliated
group's total gross receipts.
     4
      Respondent determined a deficiency and additions against
UCII for 1987, employing adjustments to the income of UCII
similar to those against Alondra and Edco for their fiscal 1987,
but the deficiency and additions are not in dispute, having been
settled administratively. At some undetermined time after 1987
and before trial of the cases at hand, UCII and/or UCIC filed for
                                                   (continued...)
                                  6

     Pertinax was formed as a California general partnership in

January 1978.    Pertinax keeps its books and records and reports

its income using the accrual method of accounting and a calendar

year.    At the time of filing of Pertinax's petition, its

principal place of business was at the El Centro property.     From

the time of its formation through 1987, Pertinax always had three

general partners that shared equally in income and made equal

capital contributions, and those partners are Edco, Alondra, and

UCIC.

     All three petitioners--Alondra, Edco, and Pertinax--as well

as UCIC and UCII, are controlled by Mr. Munro and his family.

Mr. Munro's daughter Ms. Ross is the sole shareholder of Alondra.

Mr. Munro is the sole shareholder of Edco and UCII.    Thus,

members of Mr. Munro's family directly or indirectly own all of

Pertinax's partners.    Pertinax manages Alondra, Edco, and UCIC,

and Mr. Munro controls Pertinax's policies.

Business Background

     Alondra and UCIC are insulation contractors, engaged

primarily in the sale and installation of insulation material in

buildings.    Edco is engaged in leasing automobiles and trucks.

Pertinax provides marketing, management, and administrative

services to its partners.



     4
      (...continued)
bankruptcy.
                                 7

     Alondra employs between 175 and 200 persons.   Edco has three

employees.   Pertinax employs approximately 6 executives

(including Mr. Munro and Ms. Ross), 2 to 3 managers, a sales

employee, and 20-plus clerical personnel as support staff.

     In 1970, when Mr. Munro was in his midsixties, he had

approximately 30 years of business experience in banking and

finance that included employment with Security Bank, Security

Pacific Bank, the Bank of Pasadena, and Wells Fargo Bank.     He

first became acquainted with UCIC while he was employed at Wells

Fargo, when the then owner of UCIC asked him for advice.     In

September 1970, when Mr. Munro retired from Wells Fargo, UCIC

hired him as an adviser.   Later, about 1972, Mr. Munro acquired

ownership of UCIC5 and was its sole shareholder from about 1972

through 1987.   In 1972, Alondra was a newly organized but

inactive corporation, and UCIC did all the insulation work of the

complex later made up of Alondra, UCIC, Edco, and Pertinax.

     David Lee Clearman (Mr. Clearman) joined UCIC at Mr. Munro's

invitation in spring 1975, working as assistant to the president.

After some 2 years at UCIC, Mr. Clearman became president of

Alondra, which was just then beginning active operations.

     Prior to beginning employment with UCIC and its affiliates

in 1975, Mr. Clearman worked for Wells Fargo Bank, where he had


     5
      The record does not indicate whether UCII existed at that
time or how and when UCIC became a wholly owned subsidiary of
UCII.
                                 8

started in 1957 and risen to the rank of vice president and

branch manager.   In March 1968, while he was assistant manager of

the South Pasadena branch, Mr. Clearman first met Mr. Munro, who

was manager of that branch.   Mr. Clearman and Mr. Munro worked

together at the South Pasadena branch for about a year and a

half.

     By about 1975, UCIC's trade debt with its primary insulation

supplier, Owens-Corning Fiberglass, was delinquent.   Because of

Owens-Corning's importance to UCIC, UCIC could not remain in

business unless it avoided default on this debt.   Mr. Munro

persuaded Owens-Corning to restructure the payment terms on the

debt.   Then, by reducing overhead, returning some leased

equipment, and closing unprofitable branch locations, he cut

UCIC's expenses and increased its cash-flow.   In this and other

ways, Mr. Munro succeeded in having the Owens-Corning trade debt

repaid in full and in putting UCIC on a sound operating footing.

     Mr. Munro was UCIC's and Alondra's primary spokesman for

purchasing fiberglass insulation material and for negotiating

prices and terms with Owens-Corning.   This was because the

president of Owens-Corning personally held him in high esteem.

Whereas the industry payment term was generally 30 days, and 60

days for a large contractor, Owens-Corning's terms with Alondra

and UCIC were 90 days with a 2-percent discount.   Mr. Munro's

good relations with Owens-Corning were a critical reason for

Owens-Corning's granting such favorable terms.   The 90-day-
                                 9

payment terms allowed Alondra and UCIC to buy and warehouse the

insulation, sell and install the product, and collect the sale

price before being required to pay Owens-Corning.   Alondra and

UCIC always took advantage of the discounts offered by Owens-

Corning.   The Alondra-UCIC combination was Owens-Corning's

largest customer, and Alondra and UCIC were given Owens-Corning's

best prices and terms.

     As a result of the policies set by Mr. Munro, UCIC--and

later Alondra--came to have excellent reputations with suppliers

like Owens-Corning and with their customers, the general building

contractors.   Alondra and UCIC could sell at competitive prices,

and general contractors could depend on the two companies to

deliver and install the product in good time, pass the necessary

inspections, and relieve the general contractors' concerns about

the insulation work on their projects.   Alondra and UCIC did not

require any outside borrowings through 1987.

     In the late 1970's, building activity was increasing in

California, but insulation contractors were restricted to limited

amounts of fiberglass insulation material from the primary

supplier of this material, Owens-Corning.    In response, Mr. Munro

decided to supplement fiberglass insulation, which is in bat

form, with blowing wool made of cellulose.   He acquired eight

blowing trucks for UCIC and Alondra, as he correctly anticipated

that the shortage of fiberglass insulation would last several

years.   With the eight trucks, at first primarily UCIC, and later
                                10

Alondra, could and did take advantage of the housing boom just

then starting.   As a result, UCIC and Alondra were able to

increase their sales.   In its 1978 corporate income tax return,

UCII reported gross receipts of $10,938,143.51, whereas the

relevant returns for UCII, Alondra, and Edco for their 1987

taxable years reported combined gross receipts of $25,115,417.6

     6
      The figures are not strictly comparable. The figures for
Alondra and Edco are not available for the earlier year. While
Alondra presumably had few or no sales in that year, Edco is
known to have been in existence and to have had employees.
Subtracting Edco's gross receipts of $670,771 from the total for
1986-87 reduces the total to $24,444,646.

     These figures should be adjusted to account for inflation.
The Consumer Price Index published by the Department of Labor is
the measure of inflation that is used in several sections of the
Code. Secs. 1(f)(3)-(5), 32(j), 41(e)(5)(C), 42(h)(6)(G),
63(c)(4), 68(b)(2), 132(f)(6), 135(b)(2)(B), 151(d)(4),
513(h)(2)(C), 4001(e)(2). In addition, it is the measure of
inflation that courts often use where the measure is not
specified by statute, e.g., for the purpose of computing legal
costs awarded under the Equal Access to Justice Act or sec. 7430.
Jones v. Espy, 10 F.3d 690, 692 (9th Cir. 1993); Harris v.
Sullivan, 968 F.2d 263, 265 (2d Cir. 1992); Bode v. United
States, 919 F.2d 1044, 1053 n.8 (5th Cir. 1991).

     If we use the Consumer Price Index, $10,938,143.51 in 1978
amounts to $19,042,313.47 in 1987 dollars. The 1986-87 total of
$24,444,646 represents only 28.37 percent growth over that
figure. If we take compounding into account, this corresponds to
annual growth of 2.8 percent if we consider the time until
1986-87 to be 9 years (3.2 percent if we use 8 years). If we use
the Producer Price Index, we get similar figures: $16,516,711.96
in 1987 dollars; total growth of 48.00 percent, representing 4.45
percent annual growth over 9 years.

     For comparison, Mr. Munro's compensation received from
Pertinax rose from $216,955 in 1978 to $596,316 in 1986 and
$1,000,112 in 1987. If we use the Consumer Price Index, $216,955
in 1978 amounts to $377,698.93 in 1987 dollars. The 1987 amount
of $1,000,112 represents 164.79 percent growth over that figure.
                                                   (continued...)
                                11

Role of Alondra

     Until the late 1970's, UCIC was the dominant member of this

complex of organizations.   However, UCIC's installation workers

were unionized, competitive pressures increased, and a trend

toward employment of nonunion workers developed in the Southern

California construction industry.    In 1978, Alondra, which had

previously been an inactive corporation, began to conduct

insulation sales and installation business using nonunion

installation workers, while UCIC continued its insulation sales

and installation business using union installation workers.    By

operating Alondra and UCIC in this fashion, Mr. Munro implemented

the business operating concept of "double-breasting", under

which, out of a total business operation, one entity is subject

to union contracts, while the other entity is not.    During the

middle and late 1980's, Alondra, with its lower labor costs, grew

in size, while UCIC experienced a decline in business because of

its higher labor costs.7

     6
      (...continued)
This corresponds to annualized growth of 11.43 percent if we take
the time until 1986-87 as being 9 years (and 12.94 percent if we
take it as being 8 years). Using the Producer Price Index
instead, we get similar figures: $327,604.34 in 1987 dollars;
total growth of 205.28 percent, representing 13.20 percent annual
growth over 9 years.
     7
      The Carpenters' Union, at a date unspecified in the record,
filed a lawsuit challenging the structuring of Alondra as a
nonunion shop, on the grounds that UCIC and Alondra were one and
the same business entity for labor union contract purposes.
Eventually, around 1986 or 1987, a settlement was reached with
                                                   (continued...)
                                12

Role of Pertinax

     Mr. Munro, at about the same time that Alondra was activated

and as an integral part of the "double-breasting" operating

concept, decided to establish Pertinax as a separate entity to

provide management, marketing, and administrative services for

UCIC and Alondra.   On January 4, 1978, Pertinax was organized as

an equal partnership of UCIC, Alondra, and Edco.    Mr. Clearman

became Pertinax's general administrative manager and was so

employed continuously through December 1987.    Alondra and UCIC

used their own separate work forces to carry out their contracts

to install insulation.   However, Pertinax supplied overall

management, marketing, administrative, and financial services for

each of the three corporate partners.

     Pertinax provided its corporate partners with numerous

important advantages, including economies of scale and

utilization of the same talents in providing similar services to

both UCIC and Alondra, while at the same time preserving their

separateness for installation labor purposes.    Thus, Pertinax

could avoid staff duplications and provide the same services to


     7
      (...continued)
the Carpenters' Union whereby Alondra became a union shop but
could remain competitive with nonunion shops. Alondra signed a
contract with the Carpenters' Union that allowed piecework pay
(which nonunion contractors used), rather than the hourly rate
that the union had traditionally demanded. Even after the
settlement, management continued to emphasize growth in Alondra,
which, as a union shop that could compete with nonunion
contractors, had the best of both worlds.
                                 13

the two insulation businesses whose needs were virtually

identical, including the making and implementation of executive

policy, accounting, marketing, clerical assistance, personnel

work, administration, purchasing (insulation product, supplies,

and equipment), insurance, data processing, tax return

preparation, and so on.   In effect, Pertinax provided, with the

exceptions of vehicles and insulation installers and their

supervisors, virtually all the services that UCIC, Alondra, and

Edco required, including executive personnel.   Pertinax's

executives, Mr. Munro, James Brewer (Mr. Brewer), and Mr.

Clearman, set overall business policies and, together with other

managers employed by Pertinax, implemented these business

policies.

     Another major advantage was that, by using Pertinax as a

central purchasing agent, Alondra and UCIC received the benefit

of lower prices for insulation materials and other supplies and

services through leveraging their purchasing power.

     Throughout 1986 and 1987, Alondra required the most services

of the three partners.    Thus, during this period, Mr. Clearman,

as the general administrative manager of Pertinax, spent 75 to 90

percent of his time on Alondra matters, because Alondra's size

and growth were continuing to increase in relation to UCIC's.

     At the end of each month, Pertinax would add up the costs

incurred by each of the three partners for Pertinax services and

charge them for those costs, plus a 10-to-11-percent markup.
                                14

Pertinax's service revenue thus consisted of reimbursement of its

out-of-pocket expenses, plus a markup.   To determine the

allocation of its charges, Pertinax would survey its employees

every 3 or 4 months, asking each of them to allocate his time

spent in servicing the three partners.   Most of Pertinax's 25 to

30 employees at the El Centro property received the periodic

questionnaires.   The percentages derived from this survey were

used to allocate Pertinax's costs among the three corporate

partners.   These surveys were conducted regularly, and, if an

employee's activities changed from a prior survey, that change

was taken into account, and the costs attributable to that

employee were reallocated appropriately.   Pertinax generated

invoices for the charges allocated to each partner, and all of

the partners paid Pertinax's invoices on a timely basis.    All

four entities--UCIC, Alondra, Edco, and Pertinax--maintained

separate general ledgers.

     During 1987, 41 employees of Pertinax--apart from Mr.

Munro--were listed on Pertinax's Payroll Year to Date Report.

They performed the following services and/or occupied the

following positions:   Computer person, accounting, invoicer,

executive administrator, receptionist, administrator, accounting

in sales department, clerical, invoicing, handling of claims,

data processing, supervision of Alondra's production, accounts

receivable/collections, sales training, controller, and in-house

attorney.   Together, they received $982,740 of wages and salaries
                                 15

from Pertinax in 1987.   When we include Mr. Munro's salary of

$500,112, Pertinax's total payroll in 1987 was $1,482,852.

     Pertinax's payroll reports record two monthly payments of

$41,676 to Mr. Munro during the first half of 1987.    They also

indicate that Mr. Clearman and Mr. Brewer received substantial

deferred compensation at the beginning of January 1987.

     During all of 1987, Pertinax was engaged in the business of

providing management services.    No records were kept by Pertinax

or any of its general corporate partners that show how many hours

per week Mr. Munro or any of its other executives and managers

worked for Pertinax.

Uses and Rentals of Real Property

     In addition to its headquarters at the El Centro property,

Alondra uses four to six other locations as warehouses, including

a warehouse on Lilac Avenue, in Rialto, California (the Lilac

Avenue property), and UCIC has its own separate warehouse.

     The El Centro property, the headquarters of all four

entities, consists of an 11,000-square-foot office building

situated on about one-half acre of land.    The improvements are

owned by Mr. Munro, and the land is owned by his family trust.

Mr. Munro has a ground lease with his family trust, so that

petitioners and UCIC pay rent only to him and make no separate

rent payments to the trust.

     The Lilac Avenue property is a 15,000-square-foot warehouse,

situated on about 5 acres.    Alondra owns the improvements, and
                                16

Mr. Munro's family trust owns the land.   Alondra has a written

ground lease for the Lilac Avenue property.   Every year or two,

Mr. Clearman, as Pertinax's general administrative manager, would

adjust the amount of rent paid by Alondra for the Lilac Avenue

property after calling local realtors for going rental rates on

similar properties

     UCIC, Alondra, Edco, and Pertinax each have leases with Mr.

Munro for their use and occupancy of the El Centro property.

These leases are all for terms of 20 years.   The lease with Edco

is dated November 1, 1978.   The lease with Alondra, although

undated, also appears to have commenced on November 1, 1978.     The

lease with Pertinax is dated November 1, 1979.    These leases

state as initial rental figures $1,000 per month for Alondra,

$500 per month for Edco, and $500 per month for Pertinax.    Each

lease provides for periodic rent adjustments in accordance with

the Consumer Price Index, and Mr. Clearman would follow the same

procedure in adjusting the rental rate from time to time as he

did for the Lilac Avenue property.   The rent for the El Centro

property would be allocated among UCIC, Alondra, Edco, and

Pertinax in accordance with the amount of space each of them

used.   Mr. Clearman would review and adjust the rent allocations

on an annual basis.   In general, Alondra's space usage, and thus

its share of the rent, increased over the years, whereas UCIC's

decreased, and Edco's remained fairly constant.    There were no

defaults in rental payments by any of the four entities during
                                17

any relevant period.   Pertinax's rent expense was not charged

separately to its three corporate partners, but was absorbed in

the 10 to 11 percent markup added to the costs that Pertinax

invoiced to the partners.   Mr. Munro reported $128,160 in rental

income from the El Centro property on his 1987 U.S. Individual

Income Tax Return.

Mr. Munro's Working Conditions and Responsibilities

     In 1986 and 1987, Mr. Munro had a house in San Marino,

California, about 5 miles from the El Centro property.   However,

he generally lived at another house in Santa Barbara, California,

about 75 miles from the El Centro property.

     If Mr. Munro was not in the office on a particular business

day, a designated executive of Pertinax called him at the end of

the day to report on the day's business activities and to obtain

operating instructions for the following day or days.    Mr. Munro

would give specific directions about what should be done

regarding current sales, cash management, sales with interesting

indications about the current market, and sometimes employee

matters.   A typical conversation would last between 10 and 30

minutes.   In 1986 and 1987, Mr. Brewer coordinated sales

activities, carried out Mr. Munro's policy directives governing

marketing practices, gross profit margins, how competitive to get

with a particular contractor, and so on, and conducted the daily

telephone conversations with Mr. Munro.   Mr. Munro made the final

policy decisions for Pertinax and the other entities, including
                                 18

cash management, overall marketing, hiring of sales personnel,

capital improvements, and equipment purchases, and monitored

their overhead costs.   Thus, he had ultimate responsibility for

them.

Mr. Munro's Compensation Arrangements

     Since the 1970's, Attorney William Malis (Mr. Malis) has

known Mr. Munro and acted as a business adviser and general legal

counsel to UCIC, Alondra, and Edco.   At some undisclosed time,8

Mr. Munro asked Mr. Malis to propose a fair and reasonable

compensation package.   Mr. Malis looked at the last 4 years'

income tax returns for all the corporations and concluded that

average gross sales were something less than $5 million.   He

therefore suggested that Mr. Munro should not be compensated

unless sales exceeded that base line and suggested

step-percentages above that amount.   Further, because of Mr.

Munro's alleged expertise and negotiating skills in obtaining

price concessions and favorable payment terms from suppliers, Mr.

Malis thought that Mr. Munro should receive apparently modest

percentages of gross profits, again according to a scale of step-

percentages.   Based on that reasoning, Mr. Malis drafted the

Business Consultant and Management Agreement (the Management

Agreement).    The original Management Agreement included Alondra


     8
      This time appears to be close to Jan. 2, 1978, when the
agreement about to be described was by its terms to commence.
This agreement is undated.
                                19

and Edco as signatories and referred to UCIC "and its

affiliates".   Although the Management Agreement by its terms made

Mr. Munro's compensation as consultant depend on the gross sales

and profits of UCIC alone, it was intended that Alondra's and

Edco's gross sales and profits should also be taken into account.

     Later, about 1983 or 1984, Mr. Malis revised the Management

Agreement to address Mr. Munro's concerns about asbestos

liability and to make the language of the agreement conform to

the previous practice of using the gross sales and profits of all

three companies--UCIC, Alondra, and Edco--in computing Mr.

Munro's compensation.   Either at the relevant time or thereafter,

Mr. Malis calculated what Mr. Munro's compensation should be

under the revised Management Agreement by aggregating the gross

sales and gross profits of UCIC, Alondra, and Edco.   On that

basis, Mr. Munro would have been entitled to $956,905 for 1986

and $1,276,427 for 1987, but he actually received only $596,316

during 1986 and $1,000,112 during 1987.

     Mr. Malis observed Mr. Munro's skills in negotiating useful

price concessions and payment terms from the primary supplier of

insulation materials.   At some time, Mr. Malis calculated that

from 1975 through 1993 Mr. Munro had saved UCIC and Alondra a

combined amount of at least $6 million in materials costs, and

finance charges of approximately $2 million.9

     9
      However, in 1987 alone the savings were no more than
                                                   (continued...)
                                  20

Payments in Issue

     In 1987, Pertinax paid Mr. Munro $500,112 in salary and

$500,000 as a management fee, and he reported both amounts as

income on his Form 1040, U.S. Individual Income Tax Return, for

1987.    Pertinax paid rent of $12,834 to Mr. Munro, and he

reported that amount on his 1987 individual income tax return.

     Alondra paid $900,000 to Pertinax on June 26, 1987.      The

payment was originally recorded in Account No. 1920, a suspense

and clearing account, but a substitute invoice reclassified this

expense under Account No. 6395, for management services to the El

Centro headquarters for Alondra.       The following account numbers

were used by Pertinax, Alondra, UCIC, and Edco to classify

expenditures in certain expense categories that were paid to

Pertinax by Alondra, UCIC, and Edco and deducted as ordinary and

necessary business expenses for income tax purposes:      Account No.

6395 for management services for the El Centro headquarters

office for Alondra; Account No. 5395 for branch management

services; and Account No. 6055 for general administration wages

for the El Centro headquarters.

     In addition to the $900,000 payment to Pertinax, Alondra has

documented further payments to Pertinax during Alondra's fiscal

     9
      (...continued)
slightly in excess of $714,246 in      materials costs and $226,178 in
finance charges. Moreover, if we       subtract the figures for 1988
and subsequent years, the savings      allegedly achieved by Mr. Munro
over the period from 1975 through      1987 do not exceed $3,683,409
in materials costs and $1,166,412      in finance charges.
                                 21

1987 for wages and management services amounting to $1,231,127.10

Because we do not know how much of the $225,203 claimed by

Alondra as a rent deduction is supposed to have been paid to

third parties, we cannot determine the exact relationship of this

amount to the rental income that Mr. Munro reported as such in

his 1987 individual income tax return.   However, Mr. Munro's

reporting of rental income appears consistent with the rental

payments that petitioners claimed as deductions.

     Edco has documented payments of $37,658 to Pertinax during

Edco's fiscal 1987 for wages and management services.   Mr. Munro

appears to have included the $7,200 claimed by Edco as a rent

deduction in the rental income that he reported in his 1987

individual income tax return as rental income.

     Pertinax, in its U.S. Partnership Return of Income for 1987,

reported as gross income $2,649,859 in management fees.   It

deducted $1,655,942 for salaries and wages and $500,000 for

"management".   Respondent, having determined that reasonable

compensation for Mr. Munro was $142,823, disallowed the $500,000

management deduction and $357,289 of the deduction for salaries

and wages claimed by Pertinax.



     10
      Respondent concedes that petitioners have documented
$1,198,407 through one exhibit and an additional $32,450 through
another pair of exhibits. In fact, however, the first of these
exhibits, by our calculation, documents $1,198,677. As a result,
the total documented is $1,231,127, not $1,230,857, as respondent
calculates.
                                 22

                               OPINION

       The disputes in these consolidated cases primarily concern

the deductibility of:    (1) Payments by corporate petitioners

Alondra and Edco, which generally went to partnership petitioner

Pertinax and which it included in gross income on its Form

1065;11 and (2) payments by Pertinax, most notably of

compensation and rent to Mr. Munro.

       This state of affairs creates a danger of double taxation to

corporate petitioners to the extent that they are disallowed

deductions for payments to Pertinax at level (1).    This is

because disallowing deductions to Pertinax at level (2) for

payments that originated in receipts from corporate petitioners

that are also disallowed as deductions to them at level (1) will

cause amounts disallowed to Pertinax to come back to corporate

petitioners as distributive shares of partnership income at level

(1).

       In what follows, we will avoid double taxation by treating

Pertinax as a conduit so that the unreasonable compensation

routed from the corporate partners to Mr. Munro through Pertinax

will be regarded for tax purposes as received by Mr. Munro from

the corporate partners.    We leave the calculations of the amounts

of the necessary adjustments to the Rule 155 computations.     See

discussion infra Issue 6.

       11
      However, rental payments by Alondra, Edco, and Pertinax
went directly to Mr. Munro.
                                23

Issue 1.   Motion To Shift Burden of Proof

     Just before trial, corporate petitioners, invoking Rule

142(a), filed a Motion to Shift the Burden of Proof Upon

Respondent with regard to substantiation of the following

categories of disallowed amounts paid by Alondra and Edco:     Those

paid as rent to Mr. Munro (discussed infra Issue 2); those paid

to Pertinax under the rubric of Management Services--Other

(discussed infra Issue 4); and those paid to Pertinax under the

rubric of Management Services--Wages (discussed infra Issue 5).

We postponed acting on the motion and left it for disposition as

part of our opinion on the merits.

     Petitioners argue and respondent denies that the language of

the deficiency notices implies that the payments now questioned

by respondent were in fact made.     As an example, we quote the

language of the notice sent to Alondra on March 8, 1991.     With

respect to the rental expenses, this notice states:

     It is determined that you incurred rental expense in
     the amount of $198,322.00 in lieu of the $225,203.00
     reported on your return for the taxable year ended June
     30, 1987. The adjustment of $26,881.00, as shown
     below, results from the partial disallowance of rental
     expenses paid to Joel Munro, * * * claimed on your
     return for two properties owned by him * * * because
     you have not established that the amounts paid were the
     fair market rental values of the properties at the time
     of payment, or that the amounts paid were incurred or,
     if incurred, paid by you during the taxable year for
     ordinary and necessary business purposes or that these
     expenses were deductible under the provisions of the
     Internal Revenue Code. [Emphasis added.]

With respect to management service fees, the notice states:
                                24

     It is determined that you incurred management service
     fees of $332,717.00 in lieu of the $1,239,596.00
     reported on your return for the tax year ended June 30,
     1987. The adjustment of $906,879.00 results from the
     disallowance of amounts paid by you to Pertinax,
     Limited * * *, for management services provided to the
     taxpayer by Pertinax. This adjustment is made because
     you have failed to establish that the amounts paid were
     incurred, or if incurred, were paid by you during the
     taxable year for ordinary and necessary business
     purposes; or that actual management services were
     provided for the fees paid. [Emphasis added.]

Finally, with respect to wage expenses, the notice states:

     It is determined that you incurred wage expense on your
     tax return of $687,167.00 in lieu of the $1,571,315.00
     reported on your return for the tax year ended June 30,
     1987. The adjustment of $884,148.00 results from the
     disallowance of amounts paid by you to Pertinax,
     Limited * * *, and deducted by you as reimbursement for
     the wages paid to the officers of this corporation who
     were classified as employees of Pertinax, Limited.
     This adjustment is made because you have failed to
     establish that the amounts paid were incurred, or if
     incurred, were paid by you during the taxable year for
     ordinary and necessary business purposes, or that the
     individuals classified as employees of Pertinax were
     not, in fact, employees of this taxpayer corporation
     under the provisions of the Internal Revenue Code.
     [Emphasis added.]

The notice to Edco contains substantially identical language.

     Respondent's answers, filed on July 11 and July 26, 1991,

implicitly not only deny that these three categories of payment

were fair and reasonable, but also that they were even incurred.

Respondent's trial memoranda for the Alondra and Edco cases made

clear that respondent was going to require petitioners to

establish that the three categories of expenditures had been paid

or incurred.   Corporate petitioners' motion argues that

substantiation of the payments was a new matter not mentioned in
                                  25

the statutory notices.   Corporate petitioners have always seen

the substantiation issue as concerning substantiation of payment.

At trial, documents were stipulated that substantiate the

challenged management payments.    Indeed, respondent, except for

some small matters of detail, essentially failed at trial to

dispute the substantiation issue.      However, respondent on brief

not only continues to deny that the payments to Pertinax for

management services and to Mr. Munro for rent have been

substantiated, but now argues that Alondra and Edco were required

to and failed to substantiate their total deductions for wages

and management services.

     Insofar as the issue is substantiation of payment, corporate

petitioners' motion is moot.   Respondent's belated demand for

substantiation of Alondra's total deductions for wages is

unacceptable.   In the period in question, Alondra had between 175

and 200 employees.12   Before briefing, respondent had challenged

only payments to Pertinax and Mr. Munro.      There was no reason for

Alondra to anticipate that it would have to substantiate wages

paid to its own employees.   Inasmuch as this matter was not even

argued until briefing, we consider it not to be before the Court.

Generally, we will not consider issues that are raised for the

first time at trial or on brief.       Foil v. Commissioner, 92 T.C.


     12
      We do not discuss here Edco's three employees, because
respondent's notice disallowed all of Edco's $35,671 deduction
for wages and salaries.
                                26

376, 418 (1989), affd. 920 F.2d 1196 (5th Cir. 1990); Markwardt

v. Commissioner, 64 T.C. 989, 997 (1975).   In what follows, we

consider Alondra and Edco wage expense deductions only insofar as

they were either actually or allegedly paid to Pertinax as

reimbursement for wages paid by Pertinax to its employees.

     The record suggests but does not state that corporate

petitioners paid fees for management services only to Pertinax.

If any such fees were paid to other parties, substantiation of

such payments would also be a matter not before the Court.     In

any event, insofar as payments by Alondra to Pertinax for

management services, and to Mr. Munro for rent, require

substantiation, we find that they have been substantiated in the

record, regardless of which party is deemed to have the burden of

proof.   Accordingly, we deny as moot corporate petitioners'

motion to shift the burden to respondent with respect to wage and

salary payments by Alondra.

     For Edco, respondent disallowed all deductions for wages and

management services in her statutory notice.   Respondent admits

that, of the total claimed deductions for management services and

management wages of $45,593, petitioner Edco has substantiated

payments of $37,657.64.   We need only consider who has the burden

of substantiating payment of the remaining $7,935.36 if we decide

infra that reasonable payment by Edco to Pertinax exceeded

$37,657.64.   Inasmuch as we do not so find, there is no need for

further substantiation of payment of any of Edco's claimed
                                27

deduction for management services and management wages, and the

only remaining payment by Edco for which we must consider

substantiation is the entire $7,200 paid in rent to Mr. Munro,

for which respondent now demands substantiation.   The record

supports the conclusion that this amount was paid.13

     For Alondra, the record similarly supports the conclusion

that as much of the entire rental expense of $225,203 for which

Alondra claimed a deduction as was supposed to have been paid to

Mr. Munro was indeed paid to him.14   Moreover, the substantiated

amount that Alondra paid Pertinax during Alondra's fiscal 1987,

namely, $2,131,127 ($900,000 + $1,231,127) exceeds $2,123,744,

the sum of the originally challenged $884,148 representing

reimbursement of wages paid by Pertinax, plus the total of

$1,239,596 deducted by Alondra as ordinary and necessary expenses

for management services.

     Inasmuch as payment of the challenged amounts is either

adequately supported by the record or need not be considered by

us for other reasons, corporate petitioners' motion is moot, and

we therefore deny it.15

     13
      Mr. Munro appears to have reported as rental income in his
1987 individual income tax return amounts comparable to those
allegedly paid by the entities and claimed by them as deductions.
Mr. Clearman's testimony at trial supports the conclusion that
the rent payments were made.
     14
          See supra p. 21.
     15
       However, in our view the language of the statutory notices
                                                    (continued...)
                                 28

     Having disposed of the parties' dispute over the burden of

proof with respect to the substantiation of payments, we preface

the following discussion with the observation that petitioners

have the burden of showing that their payments for rent and

management services were ordinary and necessary business expenses

deductible under section 162.    Rule 142(a).

Issue 2.   Rental Payments

     Section 162 provides, in pertinent part:

          SEC. 162(a). In General.--There shall be allowed
     as a deduction all the ordinary and necessary expenses
     paid or incurred during the taxable year in carrying on
     any trade or business, including--

               *     *       *    *     *       *   *

                (3) rentals or other payments required to be
           made as a condition to the continued use or
           possession, for purposes of the trade or business,
           of property to which the taxpayer has not taken or
           is not taking title or in which he has no equity.

     Excessive rental payments do not constitute ordinary and

necessary business expenses and are therefore not deductible.

Foyt v. United States, 561 F.2d 599, 603 (5th Cir. 1977).

Payments in excess of reasonable rent pursuant to an agreement

between closely related parties that is not the product of

arm's-length negotiation are not "required" within the meaning of


     15
      (...continued)
does reflect the assumption that the challenged amounts were
paid, and Fleming v. Commissioner, T.C. Memo. 1985-165, would
provide adequate support for granting corporate petitioners'
motion (to the extent that it concerns substantiation of payment)
if it had not been mooted.
                                 29

section 162(a)(3) and may therefore be rendered nondeductible.

Sparks Nugget, Inc. v. Commissioner, 458 F.2d 631, 634 (9th Cir.

1972), affg. T.C. Memo. 1970-74; Hyde v. Commissioner, T.C. Memo.

1974-103.    In the absence of arm's-length negotiations,

determination of what is a reasonable rental requires an inquiry

into whether the amount paid exceeds what a lessee dealing at

arm's length with a stranger would have been required to pay.

Peck v. Commissioner, 904 F.2d 525, 528 (9th Cir. 1990), affg. 90

T.C. 162 (1988); Sparks Nugget, Inc. v. Commissioner, supra at

635.    The taxpayer has the burden of rebutting the Commissioner's

determination, initially entitled to a presumption of

correctness, that rental payments are unreasonable, even when the

Commissioner has disallowed them in their entirety.     Audano v.

United States, 428 F.2d 251, 257 (5th Cir. 1970).

       Here, petitioners have not carried that burden, particularly

since respondent has disallowed only a relatively small part of

their rental payments:    $33,738 out of a total of $245,237

claimed as deductions by all three petitioners, leaving a total

deduction of $211,499 not in dispute.    Mr. Clearman testified

that the rent for both the Lilac Avenue and the El Centro

properties was determined every 1 to 2 years by calling a local

realtor and inquiring into the prevailing rents for similar

properties.    However, this was the only evidence offered by

petitioners to support the conclusion that the rents were fair

and reasonable.    We are not satisfied that the rents were
                                 30

established by arm's-length negotiations among these closely

related parties.    The leases for the El Centro property make

adjustments in rent dependent on the Consumer Price Index.    The

total in monthly rents paid by Alondra, Edco, and Pertinax,

according to the 1978-79 leases, of $2,000 per month in 1978,

adjusted for the Consumer Price Index, corresponds to $41,782 per

annum in 1987, but in that year Mr. Munro received $128,160 in

rental income from that property.     A variation in the rents paid

by UCIC and/or UCII between those years cannot explain the

discrepancy.   In any case, petitioners have not established that

the initial lease terms for the El Centro property were

reasonable.    The lease for the Lilac Avenue property is not in

the record.

     Under these circumstances, we will not overturn respondent's

determinations with respect to rental payments.

Issue 3.   Mr. Munro's Compensation From Pertinax

     Section 162(a)(1) allows a partnership, like any other

business, to deduct "a reasonable allowance for salaries or other

compensation for personal services actually rendered" as an

ordinary and necessary business expense.    Salary arrangements

between closely held corporations and their shareholders warrant

close scrutiny, Spicer Accounting, Inc. v. United States, 918

F.2d 90, 92 (9th Cir. 1990); Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1324 (5th Cir. 1987), affg. T.C.

Memo. 1985-267, and the same holds true for payments among
                                  31

related entities that include a partnership, Velvet Horn, Inc. v.

Commissioner, T.C. Memo. 1981-227 (rental payments from

controlled corporation to controlled partnership).    To be

deductible under section 162(a)(1), compensation must be both:

(1) Reasonable and (2) paid "purely for services" rendered to the

business.   Sec. 1.162-7(a), Income Tax Regs.

     According to section 1.162-7(a), Income Tax Regs., any

amount paid in the form of compensation, but not in fact as the

purchase price of services, is not deductible.    Sec. 1.162-

7(b)(1), Income Tax Regs.    In addition, contingent compensation

invites close scrutiny as a possible distribution of earnings of

the enterprise.    Sec. 1.162-7(b)(2), Income Tax Regs.   If a

contingent compensation arrangement turns out to generate

payments greater than the amounts that would ordinarily be paid

as compensation, those payments are generally deductible only if

they are paid pursuant to a free bargain between the employer and

the individual made before the services are rendered and not

influenced by any consideration on the part of the employer other

than that of securing the services of the individual on fair and

advantageous terms.    Id.   Finally, the allowance for the

compensation may not exceed what is reasonable under all the

circumstances.    Sec. 1.162-7(b)(3), Income Tax Regs.

     Bonuses paid to employees are deductible only when made in

good faith and as additional compensation for services actually

rendered by the employees, provided that when added to the
                                32

salaries, they do not exceed reasonable compensation for the

services rendered.   Rapco, Inc. v. Commissioner, T.C. Memo. 1995-

128; sec. 1.162-9, Income Tax Regs.

     Extraordinary, unusual, and extravagant amounts paid by a

corporation to its officers as purported compensation for their

services, but having no substantial relation to the measure of

their services and being disproportionate to their value, are not

in reality payments for services; they are not regarded as

"ordinary and necessary expenses" within the meaning of section

162(a)(1) merely because the payments are made in accordance with

an agreement between the corporation and its officers.     Botany

Worsted Mills v. United States, 278 U.S. 282, 292 (1929).

     Contingent compensation agreements can be upheld and

compensation paid under them held to be deductible under

appropriate circumstances.   Automotive Inv. Dev., Inc. v.

Commissioner, T.C. Memo. 1993-298; North Carolina Equip. Co. v.

Commissioner, a Memorandum Opinion of this Court dated June 4,

1945.   However, we expressly stated in Automotive Inv. Dev., Inc.

v. Commissioner, supra, that even the contingent compensation

formula there approved might in other circumstances result in

compensation that is unreasonable under section 162(a)(1).

Compensation, even under a contingent compensation formula, is in

any case limited to what is reasonable under all the

circumstances, which is in general such amount as would

ordinarily be paid for like services by like enterprises under
                                  33

like circumstances.   Sec. 1.162-7(b)(3), Income Tax Regs.    Where

there is no free bargain between the parties as contemplated by

section 1.162-7(b)(2), Income Tax Regs., a contingent

compensation agreement will not be dispositive of what is

deductible under section 162(a)(1).    Pepsi-Cola Bottling Co. v.

Commissioner, 528 F.2d 176, 181-183 (10th Cir. 1975), affg. 61

T.C. 564 (1974); Hammond Lead Prods., Inc. v. Commissioner, 425

F.2d 31, 33 (7th Cir. 1970), affg. T.C. Memo. 1969-14.    The court

in such a case is free to make its own determination of what is

reasonable compensation.

     Whether an expenditure that is claimed as a deduction under

section 162(a)(1) is reasonable compensation for services

rendered is a question of fact that must be decided on the basis

of the facts and circumstances.    Estate of Wallace v.

Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th

Cir. 1992); Paula Constr. Co. v. Commissioner, 58 T.C. 1055,

1058-1059 (1972), affd. without published opinion 474 F.2d 1345

(5th Cir. 1973).   The burden is on petitioners to show that they

are entitled to a compensation deduction larger than that allowed

by respondent.   Rule 142(a); Owensby & Kritikos, Inc. v.

Commissioner, supra at 1324; Nor-Cal Adjusters v. Commissioner,

503 F.2d 359, 361 (9th Cir. 1974), affg. T.C. Memo. 1971-200.

Partnerships bear this burden as much as corporations.      Huber v.

Commissioner, T.C. Memo. 1984-593.
                                34

     The cases contain lengthy lists of factors that bear on the

determination of reasonableness.     The Court of Appeals for the

Ninth Circuit, to which appeal in these cases would lie, uses the

five-factor test of Elliotts, Inc. v. Commissioner, 716 F.2d

1241, 1245-1248 (9th Cir. 1983), revg. and remanding T.C. Memo.

1980-282.   These five factors are:    (a) Role in company; (b)

external comparison; (c) character and condition of company; (d)

conflict of interest; and (e) internal consistency.     Id.; L & B

Pipe & Supply Co. v. Commissioner, T.C. Memo. 1994-187; Curtis v.

Commissioner, T.C. Memo. 1994-15.     No single factor is

controlling.   Pacific Grains, Inc. v. Commissioner, 399 F.2d 603,

606 (9th Cir. 1968), affg. T.C. Memo. 1967-7.

     (a) Role in Company

     Relevant considerations include the position held by the

employee, hours worked, duties performed, and the general

importance of the employee to the success of the enterprise.      If

the employee has received a large salary increase, it may be

helpful to compare past and present duties and salary payments.

Elliotts, Inc. v. Commissioner, supra at 1245.     Even though

respondent now disputes that Mr. Munro was chief executive

officer of petitioners, including Pertinax, both parties have

treated him as such, and the record is replete with evidence that

he was ultimately responsible for petitioners' policy decisions.

Although Mr. Munro had been responsible for obtaining favorable

terms with suppliers in prior years, nothing in the record
                                35

indicates that he actually did so in 1986-87.    The record does

not indicate that Mr. Munro devoted any more than minimal time to

petitioners' affairs during the years in question.    Moreover, the

record indicates a sharp rise in Mr. Munro's compensation for

1987 without any concomitant growth of the associated

enterprises.

     This factor supports allowing a deduction for payments to

Mr. Munro of no more than the normal pay of a chief executive

officer in the industry.

     (b) External Comparison

     This factor requires a comparison of the employee's

compensation with that paid by similar companies for similar

services.   Elliotts, Inc. v. Commissioner, supra at 1246.    Courts

often regard this as the most important factor and receive

testimony on the subject from competing experts.    In these cases,

however, we have only the testimony of respondent's expert, E.

James Brennan III (Mr. Brennan).     As we have previously noted,

Mr. Brennan is no stranger to this Court in that capacity.     Mad

Auto Wrecking, Inc. v. Commissioner, T.C. Memo. 1995-153.     The

method that Mr. Brennan has used to try to determine reasonable

compensation for Mr. Munro is similar to Mr. Brennan's method in

other recent cases.   Mr. Brennan uses data published in executive

compensation surveys to derive equations relating total revenues

of a business to the compensation paid to    its officers.
                                36

     Mr. Brennan concluded in his report that the highest maximum

amount of total compensation that the top executive of Pertinax

should have received was $213,470.     This figure was derived from

the data reported by Executive Compensation Service for Industry

Sector:   Services (Bonus Paying Companies) for 1988 and took into

account Pertinax's reported revenues.    Since the value of Mr.

Munro's and Pertinax's services depended on the extent to which

they helped corporate petitioners' businesses, and not on the

gross revenues of Pertinax from the corporate partners, it was a

clear error for Mr. Brennan to use Pertinax's revenues.    In his

testimony at trial Mr. Brennan used the revenues of Alondra,

UCIC, and Edco to reach the conclusion that maximum reasonable

compensation for Mr. Munro should have been $400,000 if he was

"the best of the best" among chief executive officers and

$300,00016 if he was merely average.

     As in previous cases, we have difficulty accepting

Mr. Brennan's methods and conclusions.     Guy Schoenecker, Inc. v.

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

Commissioner, supra; BOCA Constr., Inc. v. Commissioner, T.C.

Memo. 1995-5; L & B Pipe & Supply, Inc. v. Commissioner, supra;

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

110; Curtis v. Commissioner, supra; Automotive Inv. Dev., Inc. v.


     16
      Mr. Brennan spoke of one standard deviation's distance
from the mean, but respondent rightly uses Mr. Brennan's
equations and data to interpret this to mean $300,000.
                                37

Commissioner, T.C. Memo. 1993-298; Diverse Indus., Inc. v.

Commissioner, T.C. Memo. 1986-84; Owensby & Kritikos, Inc. v.

Commissioner, T.C. Memo. 1985-267.   Probably the greatest flaw in

his methods, as we have often stated, is that he does not base

his conclusions on comparable businesses:   perhaps it would have

been too difficult to get information about insulation

contractors in particular, but industry services--as opposed to,

say, building contractors--is far too broad.   In addition, we

note that the method presents a serious risk of bias:    the data

come from 643 out of 2,737 U.S. companies that chose to reply to

questionnaires.   Mr. Brennan's method purports to depend on the

highest compensation actually paid by other businesses, but

Executive Compensation Service, in producing its reports,

excludes "outliers" that cannot be explained by its equations.17

     Despite our difficulties with Mr. Brennan's methods, we note

that respondent continues to rely on Mr. Brennan to argue that

Mr. Munro was not entitled to compensation exceeding $300,000,

or, if we conclude that he rendered exceptional service as a

chief executive officer, $400,000.   We agree with respondent that

Mr. Munro was not a truly superlative chief executive officer in


     17
      We have trouble understanding the significance of Mr.
Brennan's use of "standard deviations" in this context. He
admitted that his data are asymmetrical and do not display the
percentage of outliers at distances of more than one or two
standard deviations from the mean that one would expect from a
bell-shaped curve; i.e., that the distribution of the population
is not normal.
                                  38

1986-87.   However, we will use Mr. Brennan's conclusions only

against respondent, as a tacit concession that Mr. Munro was

entitled to be paid $300,000.   Cf. Guy Schoenecker, Inc. v.

Commissioner, supra.

     Thus, this factor favors petitioners, but only to the extent

described above.

     (c) Character and Condition of Company

     The focus here is on the company's size as indicated by its

sales, net income, or capital value, and on the complexities of

the business and general economic conditions.    Elliotts, Inc. v.

Commissioner, 716 F.2d at 1246.

     The parties agree that Alondra and UCIC were operating at a

profit in 1987 but showed no particularly great growth.    However,

petitioners argue that Mr. Munro should have been credited with

and compensated for petitioners' allegedly great growth in

previous years and point to Allison Corp. v. Commissioner, T.C.

Memo. 1977-166, where deferred compensation for earlier years'

work was allowed.

     Under certain circumstances, prior services may be

compensated in a later year.    Lucas v. Ox Fibre Brush Co., 281

U.S. 115, 119-120 (1930); American Foundry v. Commissioner, 59

T.C. 231, 239 (1972), affd. in part and revd. in part on other

grounds 536 F.2d 289 (9th Cir. 1976).   However, the taxpayer must

establish that compensation in the prior periods was insufficient

and that the current year's compensation was intended to
                                39

compensate for the prior underpayments.     Estate of Wallace v.

Commissioner, 95 T.C. 525, 553-554 (1990), affd. on another

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

     As we have seen supra note 6, earlier growth was not so

extraordinary.   In any case, Mr. Munro was highly compensated in

earlier years,18 so no reason was shown to reward him in

1986-1987 for what he had done earlier.   Moreover, there is

nothing in the record to indicate that any of the compensation

paid to Mr. Munro in 1987 was earmarked as being for prior

services; the absence of any earmarking supports the view that

petitioners' argument in this regard is a mere afterthought.

Pacific Grains, Inc. v. Commissioner, 399 F.2d at 606.

     On balance, this factor supports upholding normal chief

executive officer compensation for the current year for Mr.

Munro.

     (d) Conflict of Interest

     This fourth factor focuses on whether a relationship exists

between petitioners and the employee (here Mr. Munro) that might

permit them to disguise nondeductible corporate distributions of

income as deductible salary expenditures.    Such a relationship

may exist where the employee is a business's sole or controlling


     18
      In 1986, the salary income reported on Mr. and Mrs.
Munro's joint income tax return was $596,316. We have no
evidence for 1984 and 1985. In 1983, Mr. Munro's salary was
$309,504. In 1982, it was $231,500. In 1979, 1980, and 1981, it
was $240,000.
                                  40

shareholder, or where the existence of a family relationship

indicates that the terms of the compensation arrangement may not

have been the result of a free bargain.     Elliotts, Inc. v.

Commissioner, supra at 1246-1247.

     The record clearly discloses a family relationship.

Alondra's sole shareholder was Mr. Munro's daughter Ms. Ross.

The sole shareholder of UCII (the sole owner of UCIC) and of Edco

was Mr. Munro himself.    Thus, Mr. Munro was the sole owner of two

out of the three equal partners of Pertinax, and the third

partner was wholly owned by his daughter.    Petitioners themselves

argue strenuously, in support of their claim that Mr. Munro did

important work deserving generous compensation, that he

effectively controlled all the entities.    There is nothing in the

record besides Mr. Malis' less than credible testimony to

indicate that anything like arm's-length negotiations took place.

     The cases at hand bear a striking resemblance to Pepsi-Cola

Bottling Co. v. Commissioner, 61 T.C. at 568-569.     In that case,

the contingent compensation agreement under review had been

struck years before.     During its earlier years, the arrangement

resulted in far less compensation to the executive in question

than he later received.    Moreover, he long had been the sole

executive officer of the corporation that paid the compensation.

We concluded that the contingent compensation agreement was not

the result of a free bargain, so that it did not have to be
                                41

honored under section 1.162-7(b)(2), Income Tax Regs.    Here too,

there was no such free bargain.19

     As petitioners concede, this factor favors respondent.

     (e) Internal Consistency

     This factor requires comparison with how other employees in

the business were paid compared to the employee in question and

with how the employee himself was paid in other years.    Elliotts,

Inc. v. Commissioner, supra at 1247-1248.

     In these cases, for purposes of comparing salaries of other

employees with Mr. Munro's compensation, we have information only

for 1987.   In that year, $500,112 out of Mr. Munro's total

compensation of $1,000,112 was wages and salary, whereas the

wages and salary of petitioners' other two primary executives,

Mr. Brewer and Mr. Clearman, were $191,748 and $78,000,

respectively.

     Although Mr. Munro's compensation in previous years had been

substantial, the management fee or bonus of $500,000 for 1987

was, as far as we know, unprecedented in the history of Pertinax

and its partners.

     Petitioners concede that this factor also favors respondent.



     19
      We need not take into account either version of the
Management Agreement, both because there was no free bargain and
because the record indicates that neither version was actually
given effect by the parties. Thus, we need not discuss the
parties' arguments about whether the Management Agreements were
enforceable under California contract law.
                                  42

      We conclude that on balance all the factors favor allowing

only as much deductible compensation for Mr. Munro as Mr. Brennan

and respondent have conceded is reasonable.    We therefore hold

that Pertinax was entitled to deduct $300,000 for compensation

paid to Mr. Munro, but no more.    Cf. Guy Schoenecker, Inc. v.

Commissioner, T.C. Memo. 1995-539.     We thus sustain a

disallowance of $700,112 in the deduction claimed by Pertinax for

compensation payments to Mr. Munro.

Issue 4.    Management Service Fees Paid by Alondra and Edco

      We have held that businesses can deduct management and

consulting fees under section 162(a)(1) only to the extent that

they were paid for services actually rendered.     Huber v.

Commissioner, T.C. Memo. 1984-593.     What matters is the nature of

the services performed, and not the label put on them by the

payor and the payee.    Id.   Petitioners bear the burden of proving

what portion of the fees is allocable to deductible expenses.

Id.

      In these cases, petitioners have established that Pertinax

performed management services for the corporate partners.

However, they have not carried their burden of establishing the

extent to which the total of $1,249,518 alleged to have been paid

to Pertinax by corporate petitioners was in payment for such

services.    The bulk of the $906,879 disallowed to Alondra by

respondent might well be presumed to consist of the $900,000

challenged by respondent.     Aside from a bare statement that the
                                43

$900,000 was "reimbursement of salaries and compensation paid by

and/or incurred for Pertinax to its employees, including James

Brewer, David Clearman, Joel Munro, and others", petitioners have

pointed to no evidence establishing the purpose of the payment.

Certainly, the circumstances surrounding the substitute invoice

create suspicion.   Moreover, petitioners have not provided the

information that would enable us to determine the value of the

services provided by Pertinax--particularly Mr. Munro's

services--to the corporate partners.

     Respondent, in her trial memorandum in the Alondra case,

docket No. 10849-91, states that $900,000 of the $906,879

disallowed to Alondra was used for "mgmt. fees (bonuses)".20

This statement strongly suggests that this amount includes the

$500,000 paid as a management fee to Mr. Munro.   Even though

petitioners, who bear the burden of disproving respondent's

determination, Rule 142(a), have not even moved to have the trial

memorandum entered into the record,21 we admit respondent's

     20
       The remaining $6,879 is said in that memorandum to have
been paid for "mgmt. services (wages) for Mirror Products".
Mirror Products is not identified in the record, but respondent's
treatment of the amount suggests it is controlled somehow by Mr.
Munro.
     21
      The relevant information in the trial memorandum was
available to both parties. As we stated in Sisson v.
Commissioner, T.C. Memo. 1994-545, the evidentiary rule of
Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165
(1946), affd. on other grounds 162 F.2d 513 (10th Cir. 1947)
(failure of a party to produce evidence in his possession that
might favor his case leads to the presumption that the evidence
                                                   (continued...)
                                44

statement sua sponte as an admission, Fed. R. Evid. 801(d)(2).

We conclude from this evidence that upholding respondent's

disallowances at both the Pertinax and corporate petitioner

levels would, absent some offsetting adjustment, result in

substantial double taxation of corporate petitioner Alondra.    See

introductory discussion supra pp. 21-22.   Nevertheless,

petitioners have failed to refute respondent's disallowances of

deductions of $906,879 by Alondra and of $9,922 by Edco under

this heading.   We therefore sustain respondent's disallowances of

all of Edco's $9,922 deduction and $906,879 of Alondra's

$1,239,596 deduction.   However, we deal infra Issue 6 with the

double taxation issue generated by respondent's determinations

and our rulings on Issues 3, 4, and 5.

Issue 5.   Management Wages

     Respondent's statutory notice appears to have disallowed as

much of Alondra's total deduction of $1,571,315 for wages and

salaries as went to Pertinax--$884,148--and all of Edco's


     21
       (...continued)
is in fact unfavorable), therefore cannot be used against either
party.

     Respondent urges us to use Wichita Terminal against
petitioners because of Mr. Munro's failure to testify at trial.
Petitioners' counsel's assertion of Mr. Munro's bad health was,
however, an adequate explanation of his absence, particularly in
view of his advanced age at the time of trial. In any event,
respondent was just as free as or even more free than petitioners
to call Mr. Munro as a witness. We therefore consider Mr.
Munro's absence to be a neutral factor.
                                  45

deduction of $35,671 for wages and salaries.    However, the record

shows that Pertinax paid wages and salaries amounting to $982,740

to 41 employees other than Mr. Munro, and the numbers for those

employees are reasonable.22   In addition, we have just held that

reasonable compensation for Pertinax to pay Mr. Munro was

$300,000.   These figures add up to $1,282,740.

     We do not know the relative shares of this total paid by

Alondra, UCIC, and Edco.23    However, we conclude, using the rule

of Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930), and

the sales figures available for 1987, that of this $1,282,740,

UCIC paid $412,016, Alondra $838,448, and Edco $32,276.

     With respect to Edco, we note that respondent has disallowed

all of Edco's $35,671 deduction for salaries and wages, even

though the parties have stipulated that Edco had three employees.

Even though the stipulation does not say whether or not they were

full time, or represented an allocation between Edco and the

other corporate partners, this determination is obviously wrong.

We uphold Edco's $35,671 deduction in full.

     Of the $884,148 that Alondra apparently paid to Pertinax for

wages, we uphold $838,448 and disallow the remaining $45,700.


     22
      If we divide this figure of $982,740 by 41, the number of
Pertinax's employees other than Mr. Munro, we reach an average
annual compensation of $23,969. When we take into account that
this figure includes the executive salaries for Messrs. Clearman
and Brewer, this average looks eminently reasonable.
     23
      The statutory notice sent to UCII disallowed $294,408,
apparently UCII's total deduction for management fees--wages for
1987.
                                      46

     This means that of the total $1,571,315 that Alondra deducted for

     wages, we uphold respondent's disallowance to the extent of

     $45,700 and uphold Alondra's deduction of the remaining

     $1,525,615.    This $1,525,615 includes both the $838,448 that we

     have just calculated, and the initially unchallenged figure of

     $687,167, which was presumably paid to Alondra's own employees.

     The $45,700 we disallow represents the part of Alondra's claimed

     deduction for wages and salaries that we are not satisfied was

     used by either Alondra or Pertinax to pay reasonable

     compensation.

          Our results to this point may be tabulated as follows:

                                  Deductions

                                   Allowed       Allowed    Disallowed
                     Claimed     Stat. Notice    Tax Ct.      Tax Ct.

Rents (Issue 2)

     Alondra        $225,203      $198,322       $198,322     $26,881
     Edco              7,200         3,479          3,479       3,721
     Pertinax         12,834         9,698          9,698       3,136

Management Services/Other (Issues 4, 3)

     Alondra       1,239,596       332,717        332,717     906,879
     Edco              9,922             0              0       9,922
     Pertinax      2,603,623     2,103,623      2,103,623     500,000

Wages & Salaries (Issues 5, 3)

     Alondra       1,571,315       687,167      1,525,615      45,700
     Edco             35,671             0         35,671           0
     Pertinax      1,655,942     1,298,653      1,455,830     200,112

          It should be noted that, although we have disallowed

     $700,112 in deductions claimed by Pertinax in the last two

     categories as representing the unreasonable part of Mr. Munro's
                                  47

compensation, we have disallowed deductions in these categories

of $954,879 for Alondra and $9,922 for Edco.    There is no reason

why the figures should be identical at both levels.     The

disallowances to Alondra and Edco at the corporate partner level

result partly from a failure of proof by petitioners.     Because we

have used our determination of Mr. Munro's reasonable level of

compensation to reach our results on Issue 5, we must consider

it, as well as Issues 3 and 4, when we consider the proper

adjustments needed.

Issue 6.   Tax Treatment of Disallowed Payments at Two Levels

      The strongest reason for upholding respondent's

disallowances of the deductions by Alondra and Edco in the

management services and wages categories (Issues (4) and (5)) to

the extent that we have is that the bulk of those unreasonable

payments ended up in Mr. Munro's hands as unreasonable

compensation.   Our conclusion that the amounts that Pertinax

claimed as deductions exceeded what we have determined was Mr.

Munro's reasonable level of compensation is of course why we have

upheld respondent's disallowance of Pertinax's deductions in

these categories to the substantial extent that we have (Issue

3).

      The record in its present state makes it difficult to trace

precisely how Pertinax used payments coming from the corporate

partners, including the payments for which we have disallowed

deductions by Alondra and Edco.    However, the record, once we
                                 48

include respondent's trial memorandum, which we have admitted sua

sponte, permits us to conclude that the bulk of the disallowed

payments made by the corporate partners to Pertinax was used by

Pertinax to make payments to Mr. Munro that exceeded reasonable

compensation.   The record also discloses considerable payments by

Alondra and Edco to Pertinax during their taxable years in

question.

     Unless we treat Pertinax as a mere conduit, our upholding of

respondent's disallowances of deductions for the same

unreasonable compensation at both the partnership and the

corporate partner levels will give respondent two bites of the

apple.    If we disallow the deductions at the partnership level,

having also disallowed deductions for the same payments at the

corporate level, then under the rules of TEFRA (Tax Equity and

Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. 97-248, sec.

402(a), 96 Stat. 648) and section 6226 respondent will be able--

and indeed obliged--to treat as income to the partners the

payments by them, Munro v. Commissioner, 92 T.C. 71, 74 (1989),

that had also been disallowed as deductions to them at the

corporate level.

     At trial, we asked the parties to address in their briefs

the consequence of denying the deductions claimed by Pertinax for

compensation paid to Mr. Munro that had, in effect, been received

by Pertinax from its partners and reported by Pertinax as gross

income.    It appeared to us then, as it does now, that disallowing
                                      49

deductions to the corporate partners for amounts included in

distributable income of the partnership would result in doubly

taxed income.        To the extent that the funds were merely

transferred through Pertinax to Mr. Munro, Pertinax did not

actually receive gross income that should properly increase

partnership income distributable to its partners.

        Neither party complied with our request.       Because of the

difficulty in tracing that we have mentioned, it is possible that

some of those amounts may have been reported in years not before

us.24        Nevertheless, we believe that the bulk of the disallowed

payments made by the corporate partners to Pertinax was used by

Pertinax to make payments to Mr. Munro that exceeded reasonable

compensation during the years before us.          We will give

petitioners a last opportunity, during the Rule 155 computation,

to establish the mathematical computations and corrections

necessary to avoid this problem.           See The Home Group, Inc. v.

        24
      We realize that the double taxation we are concerned about
would occur in two different taxable years of the corporate
petitioners. The disallowance of the payments made to Pertinax
by Alondra and Edco occurs during their fiscal years ending June
30 and Sept. 30, 1987, respectively. The Pertinax income on
which they would be taxed as a result of the Pertinax
disallowance of deductions would be taxed to them in their
immediately following fiscal years ending June 30 and Sept. 30,
1988, respectively. This is because Pertinax is on a calendar
year, consistently with the limitations of sec. 706(b), and its
partners include within their income for a taxable year of theirs
any sec. 702 distributive share taxable income with respect to a
partnership for any taxable year of the partnership ending within
or with the taxable year of the partner. Sec. 706(a). However,
the fact that the corporate petitioners would not be taxed on
their distributive shares of the phantom income before us here
until their following tax year, which is not before us, would not
obviate the double taxation danger we see here.
                                   50

Commissioner, 91 T.C. 265, 268-271 (1988), affd. on other issues

875 F.2d 377 (2d Cir. 1989).

     We will not perform a similar adjustment for petitioners'

rental payments because Pertinax actually used the space that it

rented, even if it paid slightly more than respondent determined

was reasonable.   The evidence does not suggest to us, as it does

for the unreasonable compensation, that the parties' intent and

the economic substance was for funds to be transferred from the

corporate partners to Mr. Munro through the partnership.    We are

not overly troubled by the small amount of double taxation that

may result to the corporate partners from their having to pay tax

on their distributive shares of Pertinax's $3,136 rental

deduction disallowance.

Issue 7.   Additions to Tax

     (a) Negligence

     Respondent determined that petitioners Alondra and Edco are

liable for the additions to tax for negligence pursuant to former

section 6653(a)(1)(A) and (B).25    Section 6653(a)(1)(A) provides

an addition to tax for negligence or intentional disregard of

rules and regulations in the amount of 5 percent of the

underpayment if any part thereof is attributable to negligence.

Section 6653(a)(1)(B) imposes an addition to tax in the amount of

     25
      Repealed effective for returns whose due date (determined
without regard to extensions) is after Dec. 31, 1989. Omnibus
Budget Reconciliation Act of 1989 (OBRA 89), Pub. L. 101-239,
sec. 7721(c), 103 Stat. 2399. The current provisions for returns
due after that date are to be found in current secs. 6662(a),
(b)(1), and (c).
                                51

50 percent of the interest due on the portion of the underpayment

attributable to negligence.

     Negligence is defined as the lack of due care or the failure

to do what a reasonable and ordinarily prudent person would do

under similar circumstances.   Anderson v. Commissioner, 62 F.3d

1266, 1271 (10th Cir. 1995), affg. T.C. Memo. 1993-607; Norgaard

v. Commissioner, 939 F.2d 874, 880 (9th Cir. 1991), affg. in part

and revg. in part on other grounds T.C. Memo. 1989-390; Allen v.

Commissioner, 925 F.2d 348, 353 (9th Cir. 1991), affg. 92 T.C. 1

(1989); Neely v. Commissioner, 85 T.C. 934, 947 (1985).

Petitioners bear the burden of proving that respondent's

determination of negligence is erroneous.   Rule 142(a); Allen v.

Commissioner, supra at 353; Bixby v. Commissioner, 58 T.C. 757,

791-792 (1972).

     The taxpayer can avoid liability for the addition to tax for

negligence by showing that he reasonably relied on competent

professional advice.   Collins v. Commissioner, 857 F.2d 1383,

1386 (9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo.

1987-217; Weis v. Commissioner, 94 T.C. 473, 487 (1990); Freytag

v. Commissioner, 89 T.C. 849, 887-888 (1987), affd. 904 F.2d 1011

(5th Cir. 1990), affd. 501 U.S. 868 (1991).   However, "Reliance

on professional advice, standing alone, is not an absolute

defense to negligence, but rather a factor to be considered."

Freytag v. Commissioner, supra at 888.   To succeed in this

defense, the taxpayer must show that he supplied all necessary
                                52

information to the professional adviser.     Weis v. Commissioner,

supra at 487; Pessin v. Commissioner, 59 T.C. 473, 489 (1972).

When considering the negligence addition, we must evaluate the

particular facts of each case, considering the relative

sophistication of the taxpayers, as well as the way in which they

approached their decisions.   Vorsheck v. Commissioner, 933 F.2d

757, 759 (9th Cir. 1991); Levine v. Commissioner, T.C. Memo.

1995-362; Lucas v. Commissioner, T.C. Memo. 1995-341.

     In these cases, petitioners contend that their actions were

reasonable because they relied upon Mr. Malis, a tax attorney and

certified public accountant, in using Pertinax and because the

corporate income tax returns were prepared by certified public

accountants.

     Petitioners have not established that they fully informed

the preparers of all information that should have been taken into

account in preparing their returns.    Mr. Malis did testify that

he drafted and revised the Management Agreement, but not that he

gave advice on tax matters.   Although it must be regarded as

highly probable that, as general counsel of the various entities,

he offered such advice, the record does not so indicate, and we

do not know what his advice was.     See Allen v. Commissioner,

supra at 354.   In any case, and most importantly for our

purposes, petitioners cannot be regarded as lacking

sophistication, in view of the extensive business experience of
                                  53

Mr. Munro and Mr. Clearman and the presence of an in-house

attorney.

     Evaluation of whether, in this setting, petitioners Alondra

and Edco were negligent, or intentionally disregarded the rules

and regulations, is a factual inquiry.      C.T.I. Inc. v.

Commissioner, T.C. Memo. 1994-82.      Here, Alondra and Edco have

not given any credible explanation of what the payments for

management services were in fact compensation for.     We are

particularly struck by the absence of explanation by petitioners

for Alondra's $900,000 payment.    Under the circumstances,

petitioners have not met their burden of showing that they acted

reasonably in claiming the deductions whose disallowance we have

sustained.   Indeed, they have not made such a showing with

respect to any such deductions.    Consequently, all such

underpayments as we find for the corporate petitioners we treat

as being attributable to negligence, and the section

6653(a)(1)(A) and (B) additions to tax are imposed on them in

their entirety.

     (b) Substantial Understatement

     Respondent also determined that petitioner Alondra is liable

for the addition to tax for substantial understatement of income

tax liability pursuant to section 6661(a).26


     26
      Also repealed effective for returns the due date for which
(determined without regard to extensions) is after Dec. 31, 1989.
OBRA 89 sec. 7721(c), 103 Stat. 2399. The current provisions for
returns due after that date are to be found in current secs.
6662(a), (b)(2), and (d).
                                 54

     Former section 6661(a) provides for an addition to tax equal

to 25 percent of the amount attributable to a substantial

understatement of income tax.   An understatement is substantial

if it exceeds the greater of 10 percent of the tax required to be

shown on the return or $10,000 in the case of a corporation.

Sec. 6661(b)(1)(A) and (B).   An understatement of income tax

occurs if the tax actually shown on the return is less than the

amount required to be shown on the return.   Sec. 6661(b)(2);

Woods v. Commissioner, 91 T.C. 88, 95 (1988).    Petitioners bear

the burden of proving that respondent's determination is

erroneous.   Rule 142(a); Conti v. Commissioner, 39 F.3d 658, 664

(6th Cir. 1994), affg. and remanding 99 T.C. 370 (1992).

     Alondra reported total tax due for Alondra's fiscal 1987 of

$222,879.    In computing this tax, Alondra claimed deductions for

rent, management fees, and wages that respondent disallowed.    In

light of our findings on these issues, Alondra's understatement

of tax exceeds the threshold established by section 6661.    Thus,

Alondra made a substantial understatement within the meaning of

section 6661(b).

     Petitioners argue, as they do for the negligence additions

to tax, that they reasonably relied on competent professional

advice.   We reject this argument here as well, just as we do for

the negligence additions to tax, and for the same reasons.

     An understatement will be reduced to the extent that it is:

(1) Based on substantial authority or (2) adequately disclosed in
                                55

the return or in a statement attached to the return.    Sec.

6661(b)(2)(B).   In these cases, Alondra's understatement for

Alondra's fiscal 1987 was not adequately disclosed.    We cannot

say that there was substantial authority for petitioners' tax

treatment of the disputed items, even under the liberal standards

just enunciated by the Court of Appeals for the Eleventh Circuit

in Osteen v. Commissioner, 62 F.3d 356, 359-360 (11th Cir. 1995),

affg. in part and revg. in part T.C. Memo. 1993-519.    Osteen can

be distinguished from Alondra's case, primarily because the issue

here is purely factual.   Nor do we have here the all-or-nothing

situation that troubled the Court of Appeals for the Eleventh

Circuit in Osteen.

     Section 6661(c) provides that the Secretary may waive all or

any part of the addition to tax for substantial understatement on

a showing by the taxpayer that there was reasonable cause for the

understatement (or part thereof) and that the taxpayer acted in

good faith.   While the authority to waive the section 6661

addition to tax rests with the Commissioner, not with this Court,

we review the denial of a waiver by the Commissioner under the

abuse of discretion standard.   Mailman v. Commissioner, 91 T.C.

1079, 1084 (1988).27


     27
      Under sec. 6664(c) of current law, OBRA 89 sec. 7721(a),
103 Stat. 2398, effective for returns the due date for which is
after Dec. 31, 1989, the Commissioner no longer has this
discretion, and no penalty can be imposed for underpayments if it
is shown that there was a reasonable cause for them and that the
taxpayer acted in good faith, but this is new law, not in effect
for the cases before us.
                                56

     Having found that Alondra has not sustained its burden for

the purpose of avoiding the negligence penalty, we would have no

difficulty in sustaining the imposition of the substantial

understatement penalty, even if Alondra had ever requested a

waiver.

     In any event, there is no evidence that Alondra has ever

requested a waiver.   Accordingly, as we noted in Brown v.

Commissioner, T.C. Memo. 1992-15, "we cannot find that respondent

abused * * * [her] discretion when petitioner never requested

respondent to exercise it."   See also McCoy Enters., Inc. v.

Commissioner, 58 F.3d 557, 563 (10th Cir. 1995), affg. T.C. Memo.

1992-693; Reinke v. Commissioner, 46 F.3d 760, 765-766 (8th Cir.

1995), affg. T.C. Memo. 1993-197; Mailman v. Commissioner, supra

at 1082-1084; Dugow v. Commissioner, T.C. Memo. 1993-401, affd.

without published opinion 64 F.3d 666 (9th Cir. 1995); Klieger v.

Commissioner, T.C. Memo. 1992-734; sec. 1.6661-6, Income Tax

Regs.

     Respondent's determination of the section 6661 addition to

tax is sustained, to the extent of 25 percent of Alondra's

understatement of tax.

     To reflect the foregoing and the parties' concessions,



                                     Decisions will be entered

                               under Rule 155.
