                           T.C. Memo. 1998-343



                       UNITED STATES TAX COURT



                  LABELGRAPHICS, INC., Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 13673-95.                 Filed September 28, 1998.



     Gersham Goldstein, Gregory R. Mowe, Jaime M.W. Sanders, and

Peter R. Jarvis, for petitioner.

     Shirley M. Francis, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION

     PARR, Judge:    Respondent, in a notice of deficiency,

determined against petitioner the following Federal income tax

deficiencies, an addition to tax, and a penalty:

     Year                      Addition to Tax     Penalty
     Ended      Deficiency        Sec. 6661       Sec. 6662

    6/30/87      $48,610           $12,153            --
    6/30/90      210,354              --           $42,071
                               - 2 -


All section references are to the Internal Revenue Code in effect

for the years in issue, and all Rule references are to the Tax

Court Rules of Practice and Procedure, unless otherwise

indicated.

     After concessions,1 the issues for decision are:

     (1) The amount petitioner is entitled to deduct under

section 162 as reasonable compensation to its president Lon

Martin for its year ended June 30, 1990.    We find it is entitled

to deduct $406,000.

     (2) Whether petitioner is liable for an accuracy-related

penalty under section 6662(a) and (b)(2) for the year ended June

30, 1990, with respect to its claimed deduction for the

compensation to Lon Martin.   We hold that it is not liable for

the penalty.

                        FINDINGS OF FACT

     Some of the facts and certain documents have been stipulated

for trial pursuant to Rule 91 and are found accordingly.     We

incorporate the parties' stipulations in this opinion by

reference.

     Petitioner is an Oregon corporation.   When its petition

herein was filed, petitioner maintained its principal office in

Portland, Oregon.



     1
      Among other things, respondent concedes that petitioner is
not liable for an addition to tax under sec. 6661 for its year
ended June 30, 1987.
                               - 3 -


     Petitioner manufactures pressure-sensitive identification

materials, such as product labels and graphic overlays.    In

addition, it offers typesetting services to retail customers.

     Lon Martin (who was petitioner's president and sole

shareholder during its fiscal year ended June 30, 1990) completed

about 2 years of college and then began working in the printing

business.   As of 1978, Mr. Martin had approximately 20 years of

experience working in the label and printing industry.    During

those 20 years, he performed tasks ranging from running presses

to managing his own label and printing business.

     Before 1978, Mr. Martin, in partnership with other

individuals, had owned and operated for a number of years a label

and printing business in southern California.    Following his

first wife's death and his remarriage, he sold his interest in

the southern California business and moved to Portland, Oregon,

about 1978.

     From 1978 until petitioner's incorporation in 1980, Mr.

Martin operated a sole proprietorship label and printing business

in Portland.   Initially, this label and printing business was a

one-man operation that he conducted with the help of his second

wife and his junior-high-school-age son, Mike Martin (Mike).     Mr.

Martin called upon potential customers during the day and often

printed at night the labels that were ordered.    Mrs. Martin

helped him by serving as a secretary and shipping clerk; Mike

helped him with the printing of the labels.
                                 - 4 -


     In June 1980, petitioner was incorporated to conduct the

sole proprietorship label and printing business that Mr. Martin

had operated.   Upon petitioner's incorporation, 450 shares of

petitioner's outstanding shares of stock were issued to Mr.

Martin and the remaining 50 shares of petitioner's outstanding

stock were issued to another individual.    In January 1986, this

other individual's 50 shares were redeemed, and Mr. Martin became

petitioner's sole shareholder.    Mr. Martin continued to be

petitioner's sole shareholder until 1992, when he sold all of his

shares in petitioner to Mike.    During its fiscal year ended June

30, 1990, petitioner's board of directors consisted of Mr.

Martin, Mrs. Martin (Mr. Martin's wife), and Jerry Crispe (who

was then petitioner's executive vice president).

     In conducting his and later petitioner's label and printing

business, Mr. Martin concentrated on selling to companies in the

electronics industry, a number of which are located in the

Pacific Northwest.   Since its incorporation in 1980, all of

petitioner's products have been custom designed and produced for

particular customers.   Most of petitioner's sales are to

electronics companies, like Compaq and Hewlett-Packard, who

demand high quality products from their suppliers.

     Over the years, Mr. Martin has been extremely successful in

operating petitioner profitably and in expanding its business and

sales.   Petitioner has enjoyed high profit margins in selling its

custom-designed products to a number of high-technology
                                - 5 -


companies.    Petitioner mastered early the ability to produce

polycarbonate overlays with little loss of material.    It has also

been very innovative in developing scratch-resistant coatings for

its products.    By its fiscal year ended June 30, 1990, petitioner

employed 58 persons.    Its plant is perhaps one of the most modern

in the United States.    In addition, petitioner is very highly

regarded in the label and printing industry.    Its principal

competitors in the country are much larger companies.

     Over its first 8 fiscal years from July 1, 1980, through

June 30, 1988, petitioner's annual gross receipts increased

dramatically.    Its gross receipts for each fiscal year during

this period were higher than the preceding year.    For its fiscal

year ended June 30, 1988, petitioner had $4,821,650 in gross

receipts.

     Over its next 2 fiscal years from July 1, 1988, through June

30, 1990, however, petitioner's annual gross receipts slightly

declined.    This decline in petitioner's business was not

unexpected.    Earlier, in 1987, petitioner's management had

anticipated such a possible future decline in business.      At that

time, its management recognized that it would be difficult to

expand sales further in the Portland market and to maintain high

profit margins, as petitioner had already saturated that market

and was likely to encounter increasing competition for that

market's remaining new business.    Also, by 1987, petitioner's

management was concerned about some customers' relocating their
                                - 6 -


manufacturing facilities to Puerto Rico, as management believed

this relocation overseas might cause a reduction in petitioner's

sales.

     Around 1987 or 1988, Intel Corp. (a customer of petitioner

that had recently relocated certain of its manufacturing

facilities to Puerto Rico) asked whether Mr. Martin could

establish a plant in Puerto Rico to supply its Puerto Rican

facilities.    As a result, during 1988, Mr. Martin incorporated

LaserGraphics Caribe, Inc. (Caribe), to conduct a label and

printing business in Puerto Rico.

     Mr. Martin was Caribe's sole shareholder.    Petitioner had no

interest in Caribe, as the latter corporation was a personal

business venture of Mr. Martin that was totally separate and

distinct from petitioner.

      From 1988 through 1990, Mr. Martin devoted some of his time

to Caribe's business operations.    Caribe established a plant in

Puerto Rico.   Mr. Martin operated Caribe for about 2 years, then

sold the business after concluding that he could not operate it

profitably.

     During 1989 and 1990, petitioner successfully developed its

Micro Clean 100 proprietary process for producing labels meeting

the "clean room" production facility standards of its electronics

industry customers.   The process represented a significant

technological innovation in the label industry.    Before its

development, there were no contaminant-free labels comparable to
                                - 7 -


petitioner's clean room labels.    Although electronics companies

could use normal labels to identify and package sensitive

electronic components they manufactured in their clean rooms, the

normal labels themselves would contain contaminants.

     The materials used in and the processing for petitioner's

clean room labels are quite different from that of normal labels.

Clean room label production requires a special cleaning machine

that petitioner devised to clean labels after their manufacture

and before their packaging.    In addition, the labels employ a

special adhesive that petitioner developed with the assistance of

outside adhesive consultants and chemists.

     Mr. Martin was instrumental in developing the Micro Clean

100 process.    In 1989, it was he who envisioned a process to

produce labels to clean room standards, initiated the engineering

program for its development, and saw the program through to a

successful conclusion in early 1990.    He and petitioner's staff

engineer worked on the label-cleaning machine petitioner devised.

He and certain other of petitioner's employees refined the

process for producing clean room labels and worked with outside

consultants and chemists to develop the special adhesive the

labels required.

     Petitioner sold its first clean room labels during the first

half of 1990.    For its fiscal year ended June 30, 1990, its sales

of clean room labels totaled $32,639.    In June 1990, petitioner's

directors anticipated that clean room labels would produce
                                - 8 -


significant sales and profits in future years and would

strengthen petitioner's competitive advantage in the industry.

Their assumption proved to be correct, as by 1995 the labels

accounted for approximately 30 percent of petitioner's sales and

were the fastest growing and most profitable segment of its

business.

     From 1990 through 1996, petitioner's annual sales and gross

margins from clean room labels were as follows:

            Year       Sales       Gross Margin

            1990     $174,099        $102,196
            1991      331,601         255,333
            1992      450,856         360,685
            1993    1,398,683       1,049,012
            1994    1,828,637       1,371,478
            1995    3,954,393       2,965,794
            1996    5,116,026       3,990,500

     During its fiscal year ended June 30, 1990, petitioner's

three officers were Mr. Martin, president; Jerry Crispe,

executive vice president; and Mrs. Martin, secretary.   Of

petitioner's officers, only Mr. Martin had substantial experience

in the label and printing industry before working for petitioner.

He designed petitioner's physical plant and layout.   He also

hired and trained the other members of petitioner's management

team, including Mr. Crispe and Mike.

     When he began working part time for petitioner around 1982

or 1983, Mr. Crispe had no experience in the label and printing

business.   He previously had been in the real estate development

business and had some familiarity with general business matters.
                               - 9 -


He became a full-time employee in 1985.

     After he began working full time for petitioner, Mr. Crispe

eventually performed substantial administrative and general

business tasks that Mr. Martin previously handled.

     As indicated previously, Mike had helped Mr. Martin while in

junior high school.   Following his graduation from high school,

he worked for petitioner full time.    He became petitioner's

production manager in the late 1980's and was promoted to vice

president for manufacturing in 1990.

     In addition to Mike, during its fiscal year ended June 30,

1990, petitioner employed a staff engineer, as well as two

production managers or team leaders.    Petitioner also had four

salesmen, each of whom worked on a commission basis.

     During 1990, Mr. Martin's duties included:    (1) Setting

corporate policy; (2) establishing and monitoring quality policy

and authorizing resources to ensure compliance; (3) maintaining

relationships with customers, professionals, and the community,

as needed; (4) directing the investment of funds; (5) directing

employee policies; (6) establishing 1-year and 5-year mission

statements; (7) coordinating relationships with competitors,

suppliers, and consultants to accomplish corporate goals; (8)

chairing all board meetings; (9) approving departmental strategy;

and (10) reviewing and approving all capital expenditures.

     From 1981 through 1991, Mr. Martin's total annual

compensation, consisting of a salary and bonus, from petitioner
                              - 10 -


was as follows:

     Year     Salary        Bonus      Total Compensation
                  1           1
     1981                                   $27,750
                  1           1
     1982                                   164,000
                  1           1
     1983                                   162,900
                  1           1
     1984                                   352,200
     1985    $154,000     $150,000          304,000
     1986     156,600      125,000          281,600
     1987     156,600      125,000          281,600
     1988     185,000      250,000          435,000
     1989     158,200      200,000          358,200
     1990     156,000      722,913          878,913
     1991     156,000        --             156,000
     1
      No breakdown between salary and bonus is available.

     Petitioner had no fixed formula for determining Mr. Martin's

annual bonuses.   Rather, its directors generally considered

petitioner's financial performance for the recent fiscal year.

For instance, concerning the $250,000 bonus paid to him for 1988,

minutes of petitioner's board of directors' meeting on June 17,

1988, state, in pertinent part:

          4. Bonus to Lon D. Martin. The directors reported
     that the past fiscal year had been particularly
     successful and that it was appropriate to raise Mr.
     Martin's annual bonus in light of such success.
     Additionally, Mr. Martin's regular base salary has not
     been increased for several years on the theory that his
     total annual compensation would be tied significantly
     to the performance of the corporation. In light of all
     of the above circumstances, the directors ratified and
     approved a bonus to Mr. Martin of $250,000.00.

     With respect to the $722,913 bonus paid to him for 1990, the

deductibility of which is in issue, minutes of petitioner's board

of directors' meeting on June 27, 1990, state, in pertinent part:

          5. Bonus to Lon D. Martin. Once again, the
     corporation has enjoyed a successful and profitable
                               - 11 -


     fiscal year. The Directors recognize that this success
     continues to be due in large part to the efforts and
     expertise of President, Lon D. Martin. In light of
     this recognition and the fact that Mr. Martin's base
     salary has been continued at the same level for several
     years, the Directors unanimously agreed to pay Mr.
     Martin a total bonus of $722,913.00. This bonus is to
     be paid by the corporation's forgiving a debt of
     $82,566.00 due from Mr. Martin to the corporation and
     by paying the balance of $640,347.00 in cash to Mr.
     Martin.

     From 1985 through 1991, Jerry Crispe's, Mrs. Martin's, and

Mike's respective total annual compensation from petitioner was

as follows:

                             Mr. Crispe

          Year     Salary         Bonus    Total Compensation
                      1             1
          1985                                   $4,300
                      1             1
          1986                                   17,000
          1987     $42,564      $14,917          57,481
          1988      50,000       48,195          98,195
          1989      50,000       58,650         108,650
          1990      50,000       67,277         117,277
          1991     157,073         --           157,073
          1
           No breakdown between salary and bonus is available.

                             Mrs. Martin

          Year     Salary         Bonus    Total Compensation

          1985      $8,000         --            $8,000
          1986        --           --               --
          1987        --           --               --
          1988       1,200         --             1,200
          1989      13,800         --            13,800
          1990      24,000      $33,060          57,060
          1991      23,790         --            23,790

                                Mike

          Year     Salary         Bonus    Total Compensation
                      1                1
          1985                                  $25,230
                             - 12 -

                      1              1
          1986                                       29,923
                      1              1
          1987                                       37,409
          1988     $40,249     $21,694               61,944
          1989      41,937      21,897               63,835
          1990      50,000      54,027              104,027
          1991      72,529        --                 72,529
          1
           No breakdown between salary and bonus is available.

     On June 17, 1988, petitioner's directors adopted two

separate formulas for determining the respective annual bonuses

to be paid to Mr. Crispe and Mike.       Minutes of the June 17, 1988,

board of directors meeting state, in pertinent part:

          5. Bonus to Gerald A. Crispe. The directors
     ratified and approved a bonus formula for Gerald A.
     Crispe for his services as Executive Vice President of
     the corporation, effective as of September 1, 1987.
     Mr. Crispe is to receive a bonus equal to 10% of the
     "net income" of the corporation. Net income for
     purposes of calculating Mr. Crispe's bonus is the
     income the corporation would have after deducting all
     taxes that would be incurred on the corporation's
     income before paying any executive bonuses. Mr.
     Crispe's bonus is payable annually, although advances
     against the bonus may be made more frequently.

          6. Bonus to Mike Martin. The directors ratified
     and approved a bonus formula for Mike Martin for his
     services as Production Manager, effective January 1,
     1988. His annual bonus shall be equal to 1/10th of 1%
     of the company's annual gross profits times the factor
     obtained by dividing the corporation's costs of goods
     sold by total sales. Mike's bonus is payable annually,
     although advances against the bonus may be paid more
     frequently.

     Mr. Crispe and Mike received annual bonuses for 1988 through

1990 based on the above bonus formulas.       In 1990, petitioner

further paid to Mike an additional special bonus of $44,027, thus
                               - 13 -


giving him for that year a total bonus of $54,027.2

     As indicated previously, Mrs. Martin received a $33,060

"bonus" for 1990.   This "bonus" was not determined pursuant to

any fixed bonus formula.3

     Petitioner's annual financial statements for its fiscal

years from July 1, 1980, through June 30, 1990, reflect the

following annual gross receipts and net profit or net loss after

taxes:

                                        Net Profit 0r (Net Loss)
    FYE JUNE 30     Gross Receipts           After Taxes
       1981            $313,131                 $38,482
       1982             688,887                  77,435
       1983             954,902                  66,425
       1984           2,178,100                 264,330
       1985           2,692,567                 184,821
       1986           3,049,560                 148,154
       1987           3,545,513                 179,645
       1988           4,821,650                 376,062
       1989           4,581,509                 382,755
       1990           4,346,972                 (98,639)

     Its annual financial statements for this period further

reflect the following total assets and net assets:



     2
      Mike's $54,027 total bonus consisted of (1) the $10,000
regular bonus he earned under the bonus formula petitioner had
adopted for him in 1988, and (2) the $44,027 special bonus he
received "in recognition of his contribution to the manufacturing
operations of the corporation." Neither the regular nor the
special bonus to Mike was challenged by respondent.
     3
      In the notice of deficiency issued to petitioner,
respondent originally determined that no portion of petitioner's
$53,660 of purported total compensation to Mrs. Martin for its
fiscal year ended June 30, 1990, was deductible as reasonable
compensation. As a result of a settlement concluded between the
parties, they now agree that half of this $53,660 (which includes
the $33,060 "bonus" to her) is deductible by petitioner.
                                  - 14 -


            FYE JUNE 30     Total Assets1     Net Assets2
               1981          $147,158         $43,482
               1982           387,985         120,921
               1983           432,667         187,346
               1984         1,084,463         451,676
               1985         1,104,384         636,497
               1986         1,306,450         741,564
               1987         1,516,691         921,209
               1988         2,348,268       1,297,271
               1989         2,527,392       1,691,979
               1990         2,473,200       1,593,340
            1
              Petitioner's cost for the assets, less accumulated
            depreciation.
            2
              Total assets, less current and long-term liabilities.

       Its annual financial statements for this period also reflect

the following equity, annual return on equity, and cumulative

average annual return on equity:

                               Return on       Cum. Average Ret.
 FYE JUNE 30      Equity1        Equity2           on Equity3

     1981         $43,482     88.50 percent     88.50   percent
     1982         120,921     64.04 percent     76.27   percent
     1983         187,346     35.46 percent     62.66   percent
     1984         451,676     58.52 percent     61.63   percent
     1985         636,497     29.04 percent     55.11   percent
     1986         741,564     19.98 percent     49.25   percent
     1987         921,209     19.50 percent     45.01   percent
     1988       1,297,271     28.99 percent     43.00   percent
     1989       1,691,979     22.62 percent     40.73   percent
     1990       1,593,340     (6.19) percent    36.05   percent
 1
  Invested capital, plus retained earnings, less treasury
stock.
 2
  Net profit after taxes (see second preceding paragraph
above), divided by equity.
 3
  Sum of current year's return on equity and each prior
year's return on equity, divided by petitioner's number of years
of operation through current year.

       In 1991, petitioner retained a business valuation company to

appraise Mr. Martin's 100-percent stock interest in petitioner.

In its appraisal report, this valuation company concluded that
                                - 15 -


Mr. Martin's stock interest had a fair market value of $9,250,000

as of October 25, 1991.

     On January 1, 1992, Mr. Martin sold all of his stock in

petitioner to Mike.

     From its incorporation in June 1980 through January 1, 1992,

petitioner declared and paid no formal dividends.

     In the notice of deficiency issued to petitioner,

respondent, among other things, disallowed petitioner's deduction

of a $633,313 portion of its total compensation to Mr. Martin for

its year ended June 30, 1990.    The notice of deficiency stated,

in pertinent part:

     the compensation of officer/shareholder Lon Martin
     claimed in the amount of $878,913.00 is overstated
     $633,313.00. It has not been established that an
     amount greater * * * [than] $245,600 is reasonable
     compensation for services provided by Lon Martin during
     the taxable year. Further, it has not been established
     that any amount represents payments for prior years in
     which Lon Martin may have been undercompensated.
     Accordingly, taxable income is increased $613,313.00
     for the taxable year ended 6-30-90.

Respondent further determined that petitioner was liable for a

penalty under section 6662(a) and (b)(2) with respect to the

underpayment from the disallowed compensation deduction to Mr.

Martin.


                                OPINION

Issue 1.   Reasonable Compensation

     Section 162(a)(1) allows as a business deduction "a

reasonable allowance for salaries or other compensation for
                               - 16 -


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.    Sec. 1.162-

7(a), Income Tax Regs.   More specifically, bonuses paid to

employees are deductible "when * * * made in good faith and as

additional compensation for the services actually rendered by the

employees, provided such payments, when added to the stipulated

salaries, do not exceed a reasonable compensation for the

services rendered."   Sec. 1.162-9, Income Tax Regs.   Generally,

courts have focused on the reasonableness requirement in

determining the deductibility of purported compensation.

Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243-1244 (9th

Cir. 1983), revg. and remanding T.C. Memo. 1980-282.

     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, 605 (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).    Petitioner has the

burden of showing that it is entitled to a compensation deduction

larger than that allowed by respondent.    Rule 142(a); Nor-Cal

Adjusters v. Commissioner, 503 F.2d 359, 361 (9th Cir. 1974),

affg. T.C. Memo. 1971-200.

     Case law has provided an extensive list of factors that are
                                - 17 -


relevant in determining the reasonableness of compensation.

Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115, 119 (6th

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

Court.   No single factor is dispositive.    Pacific Grains, Inc. v.

Commissioner, 399 F.2d at 606; Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. 1142, 1156 (1980).     In Elliotts, Inc. v.

Commissioner, supra at 1245-1248, the Court of Appeals for the

Ninth Circuit, to which this case is appealable, used a five-

factor test:   (1) The employee's role in the company; (2) a

comparison of the compensation paid to the employee with the

compensation paid to similarly situated employees in similar

companies; (3) the character and condition of the company; (4)

whether a conflict of interest exists that might permit the

company to disguise dividend payments as deductible compensation;

and (5) whether the compensation was paid pursuant to a

structured, formal, and consistently applied program.

     The parties recognize the applicability of the Elliotts,

Inc. test.   However, they disagree concerning the amount of

purported compensation to Mr. Martin that qualifies as reasonable

compensation under that test.

     Petitioner contends that the entire $878,913 Mr. Martin

received is reasonable compensation.     Although it acknowledges

that Mr. Martin was given an "unusually high" bonus of $722,913,

petitioner maintains this bonus represented reasonable

compensation for his unique services.
                              - 18 -


     Respondent, on the other hand, contends that only $245,600

is reasonable.   Respondent argues that there was no compensatory

purpose for the remaining balance, and that Mr. Martin arranged

this large disguised dividend in preparation for selling

petitioner to his son Mike.

     Accordingly, we shall analyze and apply the factors

enunciated by the Court of Appeals for the Ninth Circuit in

Elliotts, Inc. v. Commissioner, supra, in order to determine

reasonable compensation for Mr. Martin.

     Petitioner and respondent offered the testimony of three

expert witnesses.   Petitioner's two experts, John Culbertson

(Culbertson) and Pamela Jones (Jones), each own management

consulting firms and have advised their respective corporate

clients on executive compensation.     Respondent's expert, Paul T.

Clausen (Clausen), owns his own business valuation company and

has testified as an expert witness on the valuation of business

assets, business interests, and reasonable executive compensation

in numerous court cases.

     As trier of fact, we are not bound by the opinion of any

expert witness and will accept or reject expert testimony, in

whole or in part, in the exercise of sound judgment.     Helvering

v. National Grocery Co., 304 U.S. 282, 295 (1938); Silverman v.

Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), and cases

thereat, affg. T.C. Memo. 1974-285.
                                - 19 -


     A.   Role in the Company

     The first factor focuses on the compensated employee's

importance to the success of the business.     Pertinent

considerations include the employee's position, hours worked,

duties performed, and the general importance of the employee to

the company.    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).    Where a large salary increase is at issue (similar

to the instant case), it is further useful to compare past and

present duties and salary payments.      Elliotts, Inc. v.

Commissioner, supra at 1245.

     Mr. Martin was petitioner's key employee and the primary

reason for its success over the years.     As president, he was the

driving force behind petitioner's success from its inception, and

his personal services were essential to that success.        He managed

and built up petitioner's business, designed its physical plant

and layout, and trained other later members of its management

team.

     Although he had delegated some administrative duties and

general business responsibilities to Mr. Crispe by the 1990

fiscal year in issue, Mr. Martin remained the driving force

behind petitioner.   Further, while he was also devoting some time

and attention to Caribe in Puerto Rico, being petitioner's
                               - 20 -


president remained his full-time job.4   Thus, any reduction in

the hours he worked per week for petitioner must be balanced

against his knowledge and experience in the industry and the

valuable services he continued to render to petitioner during its

1990 fiscal year.

     In 1989 and 1990, Mr. Martin was instrumental in developing

petitioner's Micro Clean 100 process for producing clean room

labels.    The resulting clean room labels were a technologically

innovative, commercially promising, and potentially significantly

profitable new product.    Over the short period from early 1990,

when development work on the labels' production process was

completed, through June 30, 1990, petitioner had $32,639 in sales

of the new labels.    In June 1990, its directors anticipated the

labels would contribute significantly to petitioner's

profitability and financial success in future years.

     However, Mr. Martin's 1990 bonus of $722,913 is almost three

times the size of his prior largest annual bonus of $250,000 for

1988.    Indeed, on brief, petitioner acknowledges the 1990 bonus

to be an "unusually high", "extraordinary one time" bonus.    The

record further fails to reflect that part of this 1990 fiscal

year compensation was to remedy petitioner's alleged prior

undercompensation of Mr. Martin.



     4
      The parties stipulated that his being petitioner's
president was a "full-time job".
                              - 21 -


     Although petitioner's expert Culbertson opined that the 1990

fiscal year compensation was justified because Mr. Martin had

been undercompensated in prior years, he offered no analysis or

explanation in support of his claim.    In light of his failure to

do so, we give his conclusion little weight.

     Except for perhaps 1980 and 1981 (covering petitioner's

first year and a half of operations), Mr. Martin appears to have

been very well compensated in prior years.    His 1984 total

compensation of $352,200 was almost as much as his 1989 total

compensation of $358,200, despite petitioner's enjoying a

substantially better financial performance for its 1989 fiscal

year than for its 1984 fiscal year.    Petitioner's 1989 fiscal

year gross receipts were more than twice its 1984 fiscal year

gross receipts.   Similarly, its 1989 fiscal year net profit after

taxes was over 1.4 times its 1984 fiscal year net profit after

taxes.   Thus, any possible earlier undercompensation by

petitioner of Mr. Martin was likely remedied long before 1990.

     Further, pertinent minutes of the June 27, 1990, board

meeting authorizing petitioner's payment of the 1990 bonus in

issue make no mention that any part of this $722,913 was to

compensate Mr. Martin for his services in prior years.

Accordingly, we conclude that petitioner has failed to establish

that some of the 1990 fiscal year compensation in issue was to

remedy its alleged prior undercompensation of Mr. Martin.      See
                              - 22 -


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

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

     B. External Comparison

     This second factor compares the employee's compensation with

that paid by similar companies for similar services.     Elliotts,

Inc. v. Commissioner, 716 F.2d at 1246; see sec. 1.162-7(b)(3),

Income Tax Regs.

     Based on their claimed knowledge of the compensation certain

high-technology companies furnished their executives,

petitioner's experts Culbertson and Jones were each of the

opinion that the $722,913 bonus petitioner paid to Mr. Martin was

reasonable.   They noted that top executives at many high-

technology companies typically receive stock options as part of

their compensation package, and that these stock options can

produce substantial compensation in the event the company's stock

price rises greatly.   However, as Jones noted, stock options

could not be used by petitioner to compensate Mr. Martin, because

Mr. Martin already owned a 100-percent stock interest in

petitioner.

     Jones was also of the opinion that Mr. Martin was actually

entitled to even more compensation than he received, because,

according to her, he performed multiple executive roles,

including being petitioner's chief executive officer, vice

president of marketing, vice president of sales, and chief
                               - 23 -


technical officer.    She further asserted that he would have been

entitled to royalties on petitioner's clean room labels, as chief

technical officers of hi-tech companies typically will receive a

royalty on the sales of any products they help develop.

     Culbertson and Jones failed to offer any details concerning

the specific high-technology companies upon which they based

their opinions.    They also offered no specifics on the particular

executives involved, nor pertinent information on their

particular qualifications and skills and the exact compensation

they received.    We thus are unable to determine:   (1) How similar

these other unidentified companies and their businesses are to

petitioner; and (2) how similar the services their executives

rendered are to the services Mr. Martin performed.5

     Moreover, even if he were not petitioner's sole shareholder,

we are skeptical that Mr. Martin, prior to and during the 1990

fiscal year, in addition to the salary and bonus he had already

received, would also have been compensated by petitioner with

stock options.    We do not doubt that certain top executives of

various high-technology companies typically will receive stock

options as part of their compensation and that the stock options



     5
      Both the parties and their experts argue at considerable
length over whether or not petitioner is a high-technology
company. Petitioner contends that it is a high-technology
company, whereas respondent contends that petitioner is not. In
our view, this dispute is neither helpful nor productive to our
resolving the instant case.
                               - 24 -


granted them can often prove highly remunerative.   However, as

discussed previously, Mr. Martin generally does not appear to

have been undercompensated in prior years.   Also, we have no way

of knowing the specific stock options petitioner's experts

believed Mr. Martin, hypothetically, should otherwise have

received, as they provided no further elaboration in connection

with this point.   The same is true of Jones' contentions about

royalties.

     With respect to petitioner's expert Jones' claim that Mr.

Martin could have taken even more compensation from petitioner,

we find questionable her suggestion that he performed the work of

four full-time executives serving as petitioner's chief executive

officer, vice president for marketing, vice president for sales,

and chief technical officer.   Although Mr. Martin may have

performed some of the duties and functions of four such

executives, he did not perform work equal to the full-time

services of four such executives.   Indeed, by the 1990 fiscal

year in issue, he was devoting some of his time and attention to

his other company, Caribe.6

     In sum, petitioner's experts have failed meaningfully to



     6
      To be sure, this Court and other courts in numerous
reasonable compensation cases have considered the fact that the
recipient performed more than one function for his employer, even
though that individual's reasonable compensation may not be the
sum of the amounts paid to a full-time employee in each such
position. See PMT, Inc. v. Commissioner, T.C. Memo. 1996-303.
                              - 25 -


compare the executive compensation provided by other companies

they selected to the situation presented in the instant case.

Consequently, we give petitioner's experts' above opinions little

weight.

     Respondent's expert Clausen examined other companies in the

printing industry.   Clausen selected three public companies to

compare to petitioner.   Two of these companies were much larger

than petitioner, particularly in terms of their respective 1990

annual sales and number of employees.    The third company (whose

1990 annual sales were somewhat closer to petitioner's) was far

less profitable than petitioner, and was acknowledged by Clausen

as not being reasonably comparable to petitioner.   In determining

Mr. Martin's reasonable compensation, Clausen further considered

two 1990 surveys of executive compensation in the printing

industry.   However, he acknowledged these surveys to be only of

limited use in determining what might be reasonable compensation

in a particular company's case.

     Clausen opined that reasonable compensation to Mr. Martin

for the 1990 fiscal year would be $230,000, consisting of a

$120,000 salary and a $110,000 bonus.    He noted that Mr. Martin's

$878,913 in salary and bonus exceeded the 1990 total cash

compensation of each chief executive officer of the two large

public printing companies he examined.

     None of the three public printing companies Clausen selected
                               - 26 -


was reasonably comparable to petitioner.     The largest company had

sales for 1990 of $191 million and a pretax profit of $26

million, and employed a total of 1,884 employees.    The next

largest company had sales for 1990 of $65 million and a pretax

profit of $3 million, and employed a total of 450 employees.

Respondent argues that Mr. Martin's reasonable compensation

cannot exceed the cash compensation received by these two chief

executive officers of much larger printing companies.

     However, as petitioner points out, Clausen failed to take

into account the stock options the chief executive officers of

the two larger printing companies previously were granted.      The

compensation they earned from these stock options appears to have

been substantial.   In any event, the two larger printing

companies Clausen chose are not reasonably comparable to

petitioner.   Moreover, as Clausen acknowledged, the two industry

surveys he consulted are of only limited use in determining Mr.

Martin's reasonable compensation.    Accordingly, the Court does

not accept Clausen's opinion concerning Mr. Martin's reasonable

compensation for the 1990 fiscal year.

     C. Character and Condition of Company

     This third factor considers the company's character and

condition.    Relevant considerations are the company's size as

measured by its sales, net income, or capital value; the

complexities of the business; and general economic conditions.
                                - 27 -


Elliotts, Inc. v. Commissioner, 716 F.2d at 1246; see E. Wagner &

Son, Inc. v. Commissioner, 93 F.2d 816, 819 (9th Cir. 1937).

     Petitioner was a relatively small label and printing company

that grossed more than $4 million annually for its 1988 through

1990 fiscal years.    It had secured itself a nice market niche in

supplying certain custom-designed products to a number of high-

technology companies, thus enabling it to earn high profit

margins on its product sales.

     Moreover, as petitioner's directors correctly anticipated in

June 1990, its recently developed clean room labels would produce

significant profits and give petitioner a competitive advantage

in future years.   From 1991 through 1996, the new clean room

labels helped reverse the slight decline in business petitioner

experienced during its 1989 and 1990 fiscal years.   Also, Mr.

Martin's 100-percent stock interest in petitioner was

subsequently appraised by a business valuation company to have a

fair market value of $9.25 million, as of October 25, 1991.     In

years after 1990 and 1991, the labels were probably the single

most important factor in spurring petitioner to even greater

sales and profitability.

      All in all, from its inception through the 1990 fiscal

year, petitioner has been an extremely well managed and

profitable company.   It had a very lean management team and by

the 1990 fiscal year enjoyed an excellent reputation in the label
                                  - 28 -


and printing industry.

     D.    Conflict of Interest

     This fourth factor examines whether a relationship exists

between the company and employee that might permit the company to

disguise nondeductible corporate distributions as section

162(a)(1) deductible compensation.         Thus, close scrutiny must be

given where the paying corporation is controlled by the

compensated employee, as in the instant case.         Elliotts, Inc. v.

Commissioner, supra at 1246-1247.      However, "The mere existence

of such a relationship, * * * when coupled with an absence of

dividend payments, does not necessarily lead to the conclusion

that the amount of compensation is unreasonably high."           Id. at

1246.     Instead, the fact finder is further to adopt the

perspective of an independent investor in determining whether the

investor would be satisfied with the company's return on equity

after the compensation in issue was paid.         Id. at 1247.

     As a result of its payment of the $722,913 bonus to Mr.

Martin, petitioner had a $98,639 loss and a negative 6.19 percent

return on equity for the 1990 fiscal year.        We do not think an

independent investor would be happy with such a negative return

on equity, especially where the "unusually high" bonus payment

producing the loss for the fiscal year is equal to approximately

45.37 percent of the investor's equity in the company ($722,913

divided by $1,593,340 net assets).
                               - 29 -


     Petitioner, nevertheless, asserts that an independent

investor would still be satisfied with the corporation's 36.05

percent cumulative average annual return on equity through the

1990 fiscal year.   We disagree.

     In our opinion, the cumulative average annual return on

equity petitioner experienced over the period from July 1, 1980

through June 30, 1990, would not be as significant to an

independent investor as the corporation's return on equity for

the current 1990 fiscal year in issue.   Indeed, the record

reflects that petitioner's directors' usual practice had been to

tie Mr. Martin's annual bonus to the corporation's financial

performance during the recent fiscal year.   Also, the higher

36.05 percent cumulative average annual return is somewhat skewed

by the much higher annual returns on equity petitioner enjoyed

during its earlier years of operation, when its equity was much

lower.

     E. Internal Consistency

     The fifth factor focuses on whether the compensation was

paid pursuant to a structured, formal, and consistently applied

program.   Bonuses not paid pursuant to such plans are suspect.

Similarly, bonuses paid to controlling shareholders are also

suspect "if, when compared to salaries paid non-owner management,

they indicate that the level of compensation is a function of

ownership, not corporate management responsibility."   Elliotts,
                              - 30 -


Inc. v. Commissioner, supra at 1247.

     Petitioner's "unusually high", "extraordinary one time" 1990

bonus of $722,913 to Mr. Martin represented a departure from its

normal annual bonus practice for him.    As reflected by minutes of

the June 17, 1988, board meeting, petitioner's directors' usual

practice had been to tie Mr. Martin's annual bonus, in large

part, to petitioner's financial performance during the recent

fiscal year.   Yet, Mr. Martin's 1990 bonus was almost three times

the size of his 1988 bonus of $250,000, even though petitioner

enjoyed significantly higher gross receipts (as well as a

substantially higher net profit after taxes) for its 1988 fiscal

year than for its 1990 fiscal year.

     We do not accept petitioner's and its expert's arguments

that the 1990 bonus of $722,913 was justified because of Mr.

Martin's instrumental efforts in developing the Micro Clean 100

process.   Although petitioner's directors anticipated the

resulting clean room labels would be significantly profitable in

future years, petitioner's later financial success with the new

labels was by no means certain as of the end of the 1990 fiscal

year.   Most importantly, we do not believe that an independent

investor would approve of paying Mr. Martin this large $722,913

"bonus", when the new labels' profit prospects were still

uncertain and yet to be confirmed.     While Mr. Martin is entitled

to some 1990 bonus for his efforts in developing petitioner's
                              - 31 -


clean room labels, in our opinion the $722,913 bonus payment to

him far exceeds a reasonable bonus.    See, PMT, Inc. v.

Commissioner, T.C. Memo. 1996-303 (shareholder-employee entitled

to additional compensation of $400,000 for his prior invention of

corporation's new fabric product; new fabric accounted for a $10

million increase in the corporation's sales during the year in

issue and corporation also enjoyed a high return on equity for

that year).

     F. Amount of Reasonable Compensation.

     We consider the $156,000 salary Mr. Martin received to be

reasonable.   As president, he managed a business that grossed

more than $4 million annually for its 1988 through 1990 fiscal

years.   He had also received approximately the same annual salary

since at least 1985.

     In addition, Mr. Martin should receive a bonus, as it had

been petitioner's practice to provide him a substantial portion

of his compensation in the form of an annual bonus tied to

petitioner's financial performance during the recent fiscal year.

We consider a 1990 bonus of $250,000 to him to be reasonable.

Although petitioner's business slightly declined for the 1990

fiscal year, the decline had been expected and was attributable

to factors beyond Mr. Martin's control.   Moreover, petitioner

still grossed over more than $4.34 million for the fiscal year.

Also, as indicated previously, Mr. Martin is entitled to some
                              - 32 -


bonus for his efforts in successfully developing the Micro Clean

100 process.

     This $406,000 of reasonable compensation, we estimate,

results in a revised return on equity for petitioner of

approximately 10.20 percent for the 1990 fiscal year.7    We think

an independent investor would be satisfied with this return on

equity and with petitioner's 1990 fiscal year financial

performance. Despite the slight decline in business experienced

for that year, Mr. Martin still had done an excellent job in

managing petitioner.   As previously discussed, petitioner was

encountering increased competition in the Portland market and was

experiencing some loss of sales due to its customers' relocating

their manufacturing facilities overseas.   Moreover, petitioner


     7
      Petitioner's organizational minutes provide that if the
Internal Revenue Service or a court of competent jurisdiction
determines any "salary to any stockholder officer" to be a
dividend, the payment shall immediately be treated as a loan to
the officer (with interest payable at the legal rate from the
date of payment thereof), due and payable within 1 year from the
date of determination. If Mr. Martin's total compensation was
$406,000, rather than $878,913, petitioner's 1990 fiscal year
income would be increased $472,913, giving it a revised net
income before taxes of $320,274 (the ($152,639) net loss
reflected on the 1990 fiscal year financial statement, plus
$472,913). Assuming combined Federal and State income taxes are
imposed equal to 40 percent of this revised net income before
taxes, petitioner's revised net taxable income after taxes would
be $192,164 ($320,274 multiplied by 60 percent) and its revised
equity would be $1,884,143 (revised retained earnings, plus
invested capital, less treasury stock, per 1990 fiscal year
financial statement). This would represent a revised return on
equity of approximately 10.20 percent ($192,164 divided by
$1,884,143).
                                - 33 -


had just finished successfully developing its commercially

promising and potentially significantly profitable new clean room

labels.

     We hold that petitioner is entitled to a $406,000 deduction

under section 162 as reasonable compensation to Mr. Martin for

its year ended June 30, 1990.

Issue 2.   Accuracy-Related Penalty

     Respondent determined that petitioner was liable for a

penalty under section 6662(a) and (b)(2) for substantial

understatement of its income tax for the year ended June 30,

1990.

     An understatement of income tax is substantial if it exceeds

the greater of:   (1) 10 percent of the tax required to be shown

on the return, or (2) for a corporation, $10,000.     Sec.

6662(d)(1).   As relevant to the instant case,8 any understatement

is reduced by the portion of the understatement attributable to

an item for which the relevant facts affecting the item's tax

treatment are adequately disclosed in the return or in a

statement attached to the return.     Sec. 6662(d)(2)(B)(ii).9   For


     8
      In the notice of deficiency, respondent determined that the
entire underpayment for the year ended June 30, 1990, was
attributable to non-tax-shelter items.
     9
      The Omnibus Budget Reconciliation Act of 1993 (OBRA 1993),
Pub. L. 103-66, sec. 13251(a), 107 Stat. 531, amended sec.
6662(d)(2)(B)(ii), to also require a reasonable basis for the tax
                                                   (continued...)
                              - 34 -


the year under consideration, respondent provided guidance

totaxpayers by means of Notice 90-20, 1990-1 C.B. 328, and Rev.

Proc. 90-16, 1990-1 C.B. 477.10

     Rev. Proc. 90-16, section 4(b)(4), 1990-1 C.B. at 478,

provides that, for purposes of reducing any understatement of

income tax under section 6662(d), additional disclosure of facts

with respect to an issue involving the reasonableness of

officers' compensation is unnecessary, where the Schedule E

(Compensation of Officers) to the Form 1120 is completed in a

clear manner and in accordance with its instructions.   Section

4(b)(4) of Rev. Proc. 90-16 further requires that the time

devoted by the officer to the business be expressed as a specific

percentage.

     In addition, section 6664(c)(1) provides that a penalty

under section 6662 shall not be imposed on any portion of an

underpayment if the taxpayer shows reasonable cause for such


     9
      (...continued)
treatment of the item. However, this amendment is effective only
for returns the due dates for which (determined without regard to
extensions) are after Dec. 31, 1993, and is not applicable to the
instant case. OBRA 1993, sec. 13251(b), 107 Stat. 531.
Petitioner's return for the year ended June 30, 1990, was due on
or before Sept. 15, 1990. Sec. 6072(b).
     10
      Sec. 1.6662-4(e) and (f), Income Tax Regs., is not
applicable because they were issued to apply prospectively with
respect to income tax returns due after Dec. 31, 1991. See T.D.
8381, 1992-1 C.B. 374, 375. However, absent further guidance,
taxpayers may rely on the rules set forth in Notice 90-20, 1990-1
C.B. 328, 330, and Rev. Proc. 90-16, 1990-1 C.B. 477.
                              - 35 -


portion of the underpayment and that the taxpayer acted in good

faith with respect to such portion.    Reliance on the advice of a

professional, such as an accountant, may constitute a showing of

reasonable cause if, under all the facts and circumstances, such

reliance is reasonable and the taxpayer acted in good faith.

Sec. 1.6664-4(c), Income Tax Regs.

     Petitioner asserts that no penalty under section 6662(a) and

(b)(2) should be imposed.   It maintains that, pursuant to Rev.

Proc. 90-16, supra, its return for the year ended June 30, 1990,

adequately disclosed the relevant facts concerning its claimed

compensation deduction to Mr. Martin.    Alternatively, petitioner

argues that it qualifies under the section 6664(c)(1) reasonable-

cause-and-good-faith exception to the penalty.    We agree with

petitioner that there was adequate disclosure in its return,

since a properly completed Schedule E concerning its officers'

compensation was included in petitioner's return.       We hold that

petitioner is not liable for a penalty under section 6662(a) and

(b)(2) for the year ended June 30, 1990.    Notice 90-20, supra;

Rev. Proc. 90-16, supra.

     To reflect the foregoing and the parties' concessions,

                                           Decision will be entered

                                      under Rule 155.
