                         T.C. Memo. 2001-119



                       UNITED STATES TAX COURT



         METRO LEASING AND DEVELOPMENT CORPORATION, EAST BAY
           CHEVROLET COMPANY, A CORPORATION, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 8054-99, 8055-99.        Filed May 18, 2001.



     William L. Raby, for petitioners.

     Kathryn K. Vetter, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:    In these consolidated cases, respondent

determined the following deficiencies and penalties in

petitioners’1 1995 and 1996 taxable years:



     1
       Petitioner, Metro Leasing and Development Corp. is a
successor in interest to petitioner, East Bay Chevrolet Co., a
corporation. Accordingly, there is no need to distinguish
between them for purposes of this opinion, and petitioners will
be collectively referred to as petitioner.
                                - 2 -

                       Deficiencies
                 Income      Accumulated         Penalty
         Year      tax       earnings tax      sec. 6662(a)

         1995   $307,699      $108,714          $61,540
         1996    142,559         ---             28,512

The parties have reached agreement with respect to several

issues, and the following issues remain for our consideration:

(1) Whether for its 1995 or 1996 tax year petitioner is entitled

to deduct officer’s compensation in any amount exceeding $76,800,

the amount determined by respondent; (2) whether for its 1995 tax

year petitioner permitted its earnings to accumulate beyond the

reasonable needs of the business so as to be subject to the

accumulated earnings tax; and (3) whether petitioner is liable

for an accuracy-related penalty under section 6662(a)2 for 1995

and/or 1996.

                           FINDINGS OF FACT

     Metro Leasing and Development Corp., petitioner, had its

principal place of business in El Macero, California, at the time

the petitions were filed in these cases.      During the years in

issue, George Valente, who was approximately 70 years old, was

director and owned 100 percent of the common stock of petitioner.

Mr. Valente became ill in 1992 and suffered from prostate cancer

during 1995 and 1996.   Mr. Valente was somewhat disabled by and


     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.
                                - 3 -

concerned about his condition, so he appointed his wife, Lena

Valente, to be petitioner’s president during the years under

consideration.    During 1995 and 1996, Mrs. Valente was 66 and 67

years of age, respectively.    Even though he was ill, Mr. Valente

remained active in petitioner’s business by means of a

cooperative effort with Mrs. Valente.    Under that arrangement,

Mr. Valente was the decision-maker, and Mrs. Valente executed his

decisions.   Mr. Valente determined the amount of compensation to

be paid to officers based on the profitability of the business.

Because of their joint efforts, Mr. and Mrs. Valente’s

compensation was treated as an undivided amount for their

combined efforts.    Mrs. Valente became ill during 1996, retiring

at the end of that year, and she died during 1998.

     Mr. Valente became involved in the automobile business in

1959 and at one point owned seven automobile dealerships and an

automobile leasing company.    Mr. Valente sold the last of his

automobile dealerships, Green Valley Ford, in 1990.    In

connection with the last sale, Mr. Valente agreed to provide

business consultation to the new owners and to “run” the profit-

sharing plan.    The new owners agreed to provide the Valentes with

a new car each year. In 1991, Mr. Valente received $20,444 of

compensation from Green Valley Ford and for 1992, 1993, 1995, and

1996 he received $1,690, $2,851, $3,289, and $2,049,

respectively.    For 1995 and 1996, Mr. Valente received

distributions of $55,307 and $76,076, respectively, from Green

Valley Ford’s profit-sharing plan.
                                - 4 -

     During the years in issue, petitioner had three employees,

Mr. and Mrs. Valente and Jo Ann Michaels, who was the corporate

secretary and bookkeeper.   As bookkeeper, Ms. Michaels deposited

receipts, prepared checks, reconciled bank statements and

maintained the books of account, including the general ledger and

the cash receipts and disbursement journals. Petitioner’s place

of business was in the Valentes’ residence.

     Petitioner’s business during 1995 and 1996 included the

ownership of land and buildings leased to Green Valley Ford,

under which the lessee paid the expenses associated with the

property.    Petitioner was also engaged in the business of leasing

automobiles and the purchase and sale of real property.

Petitioner had approximately 10 automobile leases during the

years in question, all of which had been entered into prior to

1995.   Petitioner’s assets included land and a building in El

Cerrito, and mortgages receivable in excess of $2.5 million,

secured by real property located on Airport Boulevard, South San

Francisco.   Petitioner had sold this property, on the installment

basis, on January 19, 1995.

     Mr. Valente was qualified to be involved in any aspect of

the automobile business, including petitioner’s activities of

leasing realty to an automobile dealer and leasing automobiles.

Mr. Valente was, in general, successful and experienced in

business operations.   For the 12-year period 1985 through 1996,

his highest annual wages exeeded $1 million, and his average

wages for that period exceeded one-half million dollars. After
                                - 5 -

1990 and before 1995, however, Mr. Valente’s reported wages did

not exceed $320,000 and were as low as $151,690 and averaged

$209,462.   Mr. Valente consulted for and was compensated by Green

Valley Ford.   He also consulted with the dealership executives in

connection with petitioner’s business operations.    Mr. Valente

spent as much as 15 hours per week consulting.    His expertise was

also used in connection with the South San Francisco property,

which also involved an automobile dealership.    He consulted with

that dealership’s executives to help ensure their continued

ability to make mortgage payments on petitioner’s self-financed

sale of the property to the new dealer.     Mr. Valente also spent a

limited amount of time working on petitioner’s accounts

collectible.

     For 1995, petitioner deducted $240,435 as compensation to

officers, which included a yearend bonus of $180,435.    For 1996,

petitioner deducted $460,000 as compensation to officers,

including yearend bonuses of $150,000 to Mrs. Valente and

$250,000 to Mr. Valente.    For years prior to 1995, the Valentes

reported wages as follows:

                     Year               Amount

                     1985            $498,647
                     1986             493,485
                     1987           1,053,801
                     1988           1,075,075
                     1989             941,407
                     1990           1,072,362
                     1991             320,000
                     1992             151,690
                     1993             152,851
                     1994             213,305
                                - 6 -

     For 1995 and 1996, petitioner’s gross receipts consisted of

the following amounts:

     Type of income             1995              1996

     Interest income          $259,652          $240,427
     Gross rents               353,376           388,676
     Net capital gains          35,884           267,657
     Form 4797 gain            246,346             8,141
     Late fees                   2,931             1,170
       Total income            898,189           906,071

     Petitioner’s total income before expenses, officer’s

compensation, and ratio of compensation to total income for 1987

through 1996 were as follows:

                                                Compensation as
              Total             Officer          percentage of
     Year     income          compensation       total income

     1987    $626,991           $425,000                 67.8
     1988     583,949            310,000                 53.1
     1989     503,859            260,000                 51.6
     1990     569,530            260,000                 45.7
     1991     946,396            360,000                 38.0
     1992     604,344            150,000                 24.8
     1993     633,688            150,000                 23.7
     1994     640,602            210,000                 32.8
     1995     898,479            240,435                 26.7
     1996     806,071            460,000                 57.1



Petitioner acquired and sold shares of stock as follows:

     Company name          Date acquired     Date sold

     Data Med                 9/20/88        5/9/95
     Mylex Corp.              pre-‘95          ---
     Cyrix Corp.              ‘95 & ‘96      ‘96
     Focus Enhancement        5/23/96        12/9/96
     IMP, Inc.                12/16/94       5/9/96
     Interactive Medical
          Tech.               6/30/95         10/21/96
     Oryx                     ‘96               ---
                              - 7 -

     Respondent determined the amount of petitioner’s allowable

deductions for reasonable compensation by use of statistics

reflecting compensation for corporate officers in the equipment-

leasing and real estate-rental business.   Based on those

statistics, respondent determined that petitioner was entitled to

a deduction of $76,800 for each of the years 1995 and 1996 as

reasonable compensation for the Valentes’ services to petitioner.

     The following schedule reflects respondent’s comparison

between petitioner’s taxable income; adjusted taxable income

(adjusted to not include net operating loss deductions, special

deductions, and deductions for officer’s compensation); officer’s

compensation; and the percentage of adjusted taxable income

represented by officer compensation:
                                    - 8 -

                             Adjusted
            Taxable          taxable
Year        income           income         Compensation   Percentage
                                                            1
1987       ($171,253)        $285,636        $425,000         100.0
1988          33,406          343,406         310,000          90.3
                                                            1
1989         (19,237)         240,763         260,000         100.0
1990          (5,402)         273,871         260,000          94.9
1991         327,543          692,945         360,000          52.0
1992         244,323          394,376         150,000          38.0
1993          26,348          176,348         150,000          85.1
                                                            1
1994         (36,327)         173,673         210,000         100.0
1995          17,825          294,587         240,435          81.6
1996          58,755          518,755         460,000          88.7
       1
           Greater than 100 percent.

       The following schedule reflects the dividends received by

the Valentes from petitioner:

                          Year              Amount

                          1985             -0-
                          1986             -0-
                          1987             -0-
                          1988          $17,600
                          1989           10,560
                          1990           11,241
                          1991           60,000
                          1992           10,000
                          1993           10,800
                          1994             -0-
                          1995             -0-
                          1996             -0-

       Petitioner owned property in El Cerrito, which had been used

as a parking lot, and Mr. Valente envisioned future development

of the property.        Although Mr. Valente envisioned future

development at a cost ranging from $7 million to $10 million, as

of the years in question, no plans had been made for development

nor action commenced to initiate a formal plan to develop the

property.       Petitioner, through its bookkeeper and the Valentes,
                                - 9 -

provided all relevant information to their accountant and relied

upon his expertise and judgment in the preparation and reporting

of Federal income.

                               OPINION

I.   Reasonable Compensation

      The parties disagree about the methodology to be used for

measuring or determining the amount of reasonable compensation.

They also rely on differing facts in applying the standards.

Section 162 provides for deductions for ordinary and necessary

expenses incurred in carrying on a trade or business, including a

reasonable allowance for salaries or compensation for services

performed.

      Respondent, emphasizing case law from opinions of the Court

of Appeals for the Ninth Circuit,3 argues that when payments are

made to a corporate employee who is also a principal shareholder,

the compensation must be reasonable in amount and have a purely

compensatory purpose.   See O.S.C. & Associates, Inc. v.

Commissioner, 187 F.3d 1116, 1119-1120 (9th Cir. 1999) (and cases

cited therein), affg. T.C. Memo. 1997-300.

      Respondent also points out that the Court of Appeals for the

Ninth Circuit traditionally has looked to five factors, none of

which is decisive, to evaluate whether compensation is

reasonable, to wit:   (1) The employee’s role in the company; (2)


      3
       Barring a stipulation to the contrary, any appeal from
this Court’s decision would be to the Court of Appeals for the
Ninth Circuit. See sec. 7482(b).
                              - 10 -

an external comparison of the employee’s salary with salaries

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

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

between the company and the employee; and (5) the internal

consistency in the company’s treatment of payments to employees.

See, e.g., Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-

1248 (9th Cir. 1983), revg. T.C. Memo. 1980-282.

     Petitioner, in a similar fashion, points out that there are

five traditional factors that the courts have used to decide

whether compensation is reasonable, to wit:   (1) The type of

services and their extent; (2) the scarcity of qualified

employees; (3) qualifications and prior earning capacity; (4) the

net earnings of the corporate taxpayer; and (5) the peculiar

characteristics of the taxpayer’s business.   Petitioner’s

suggested traditional factors are, in essence, the same ones the

Court of Appeals for the Ninth Circuit has utilized.

     Each party reviews the facts of these cases under the

traditional factors and concludes that their position is fully

supported--i.e., respondent contends that his determination is

correct, and petitioner contends that its compensation claims are

reasonable.   Petitioner, however, contends that the traditional

tests are not adequate in the circumstances of these cases.

Petitioner urges us to use exclusively the “independent investor

test” in the same manner as used by the Court of Appeals for the

Seventh Circuit in Exacto Spring Corp. v. Commissioner, 196 F.3d
                               - 11 -

833, 835 (7th Cir. 1999), revg. Heitz v. Commissioner, T.C. Memo.

1998-220.

     We begin our reasonable compensation analysis by evaluating

the facts of these cases in the context of the traditional

factors, in the format used by the Court of Appeals for the Ninth

Circuit.

     A.    The Employee’s Role in the Company

     We consider the Valentes as a single unit in the setting of

this case because Mr. Valente was ill, and, although he was able

to make decisions, it was Mrs. Valente who executed his

decisions.    Although a large portion of the compensation was paid

to Mrs. Valente, the total compensation was based on the

Valentes’ joint efforts or performance, and we refer to that

performance collectively and in the singular.    The Valentes

(initially Mr. Valente and then Mrs. Valente) were taken ill and

became unable to fully function in petitioner’s business.

Petitioner’s sources of income are of a passive or investment

nature, in that income was generally received from established

capital investment rather than from personal services.    Prior to

the years under consideration, Mr. Valente sold his active

operating interests in automobile dealerships and a leasing

operation.    Thereafter, operating out of the Valentes’ home,

petitioner’s sources of income were mainly from investment type

activity--collection of rent and interest and the purchase and

sale of securities and realty.    Except for the ownership of a
                               - 12 -

couple of parcels of land and some stock, petitioner’s source of

income was from the remnants of Mr. Valente’s former ownership of

automobile dealerships.    Until the beginning of 1995, they owned

realty that was leased to two different Ford dealerships.    In the

beginning of 1995, they sold one of the properties to the lessee

and their income therefrom became income from seller-financing

rather than from rental.

     Due to their age and physical condition, the Valentes were

essentially semiretired.    During 1995 and 1996, Mr. Valente was

recuperating from surgery necessitated by prostrate cancer, so

that his ability to participate in petitioner’s business activity

was more limited than it had been in prior years.    For the 4

years immediately prior to 1995 and 1996, the Valentes’ wages or

salary, including amounts received other than from petitioner,

averaged just over $200,000.    For 1995 and 1996, the years under

consideration, petitioner compensated the Valentes in the amounts

of $240,435 and $460,000, respectively.    We note that for 1995

and 1996, the Valentes were more hindered by health and age than

in prior years and unable to devote their full efforts to the

business.

     Mr. Valente’s consultation to automobile dealerships which

either leased from petitioner or for whom petitioner was

mortgagor is thought by petitioner to be critical to the success

of the automobile companies.    We are not able to find that Mr.

Valente’s role was critical, especially because the financial
                              - 13 -

condition of the dealerships was not made a part of the record.

There is no indication that the dealerships that leased or

purchased from petitioner were in financial difficulty or that

petitioner’s income stream was in jeopardy.    Mr. Valente did, in

any event, play a role in obtaining and maintaining the source of

rental and interest income.   We must note, however, that Mr.

Valente received each year the use of a new automobile, monetary

compensation, and relatively large profit-sharing distributions

from the Green Valley Ford dealership.

     For the years 1995 and 1996, approximately 68 percent and 78

percent, respectively, of petitioner’s income was from interest

and rents derived from sources that were established prior to or

at the beginning of the 1995 year.     The majority of the remainder

of petitioner’s income was derived from the sale of property,

both real and personal.   Other than the Valentes, petitioner had

only one employee, who was a clerical/bookkeeper.    Accordingly,

petitioner’s financial success and the job of ensuring a

continued income stream fell upon the Valentes.    Although it was

not shown that the automobile dealerships to whom land had been

sold on installment contract or leased were in financial

difficulty, petitioner has shown that, to some extent, Mr.

Valente’s efforts helped to ensure or maintain the income stream.

Those same efforts also enhanced the capital structure of

petitioner.   In these circumstances, it is difficult to decide
                              - 14 -

whether the Valentes’ efforts were designed to generate income

and/or to protect Mr. Valente’s capital investment.

     B.   An External Comparison of the Employee’s Salary With
          Salaries Paid by Similar Companies for Similar Services

     On this point, respondent contends that Mrs. Valente would

not be entitled to earn the amount petitioner paid her during

1995 and 1996.   Conversely, petitioner argues that the

compensation paid to Mr. and/or Mrs. Valente was for their joint

effort.   Admittedly, Mrs. Valente acted in the nature of an

amanuensis for Mr. Valente; however, petitioner has shown that

its payments were to the Valentes for their joint efforts.     Our

focus here is not on the question of who should report the income

but on the amount deductible as reasonable compensation for the

efforts of the operative officers of petitioner.   See, e.g.,

Lewisville Inv. Co. v. Commissioner, 56 T.C. 770 (1971).

Accordingly, we must evaluate whether the Valentes, acting

together as petitioner’s operative officers, earned the amount of

compensation paid by petitioner.   Neither party introduced

evidence about compensation paid by similar companies for similar

services.

     C.   The Character and Condition of the Company

     Respondent characterizes petitioner as a small business with

activities that are not complex.   As noted, petitioner’s income

during the years in issue was from passive sources (rents,

interest, and dividends), and respondent emphasizes that those

sources did not require much effort by the Valentes.   Respondent,
                               - 15 -

however, acknowledges that the increases to petitioner’s 1995 and

1996 income were attributable to gain on the sale of real

property and stocks.    Those increases, compared to the average of

the prior 3 years, amounted to $25,922 and $171,719 for 1995 and

1996, respectively.4   Considered as a percentage increase over

the 3 years prior to 1995, the increases were 4 percent and 27

percent, respectively.

     Petitioner contends that its assets were “interwoven with

the retail automobile business” and that it was Mr. Valente’s

knowledge, expertise, and involvement that made petitioner

financially successful.    Petitioner acknowledges that the

Valentes did not devote their full time to petitioner but argues

that petitioner’s success was nevertheless dependent upon the

Valentes.


     D.    The Conflict of Interest Between the Company and the
           Employee

     The question posed here is whether the Valentes used their

control of petitioner to pay deductible salary, as opposed to

nondeductible dividends.    As contended by respondent,

substantially all of petitioner’s income was paid out in the form

of compensation to the Valentes.    In that regard, respondent

references Elliotts, Inc. v. Commissioner, 716 F.2d at 1243, for

the proposition that there is a




     4
         For computation of these increases see infra note 6.
                              - 16 -

     general problem [in] * * * distinguishing between
     dividends and compensation for services received by a
     shareholder-employee of a closely held corporation.
     What makes this situation troublesome is that the
     shareholder-employee and the corporation are not
     dealing with each other at arm’s length. It is likely
     to be in the interests of both the corporation and the
     shareholder-employee to characterize any payments to
     the shareholder-employee as compensation rather than
     dividends. For this reason, a taxpayer’s
     characterization of such payments may warrant close
     scrutiny to ensure that a portion of the purported
     compensation payments is not a disguised dividend. See
     Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361
     (9th Cir. 1974).

     In that regard, respondent points out that petitioner paid

out 26.7 percent and 57.1 percent of its gross income as

compensation for 1995 and 1996, respectively.   In addition,

petitioner paid out in compensation to the Valentes’ 81.6 percent

and 88.7 percent of its taxable income before considering the

compensation deduction for 1995 and 1996, respectively.


     E.   The Internal Consistency in the Company’s Treatment of
          Payments to Employees

     Under this test, a company’s formal compensation program is

considered, and a comparative analysis is made of compensation to

shareholder/employees in relation to compensation of

nonshareholder employees.   Petitioner had no such formal program;

instead, Mr. Valente would decide the amount of compensation on a

year-by-year basis.   Moreover, the only other employee of

petitioner was a bookkeeper who did not have comparable

qualifications, responsibilities, etc.
                                 - 17 -

     F.   Independent Investor

     In addition to and in conjunction with the above-considered

traditional tests, the Court of Appeals for the Ninth Circuit has

also used an independent investor test.   In Elliotts, Inc. v.

Commissioner, supra at 1245, that test was described as follows:

     A relevant inquiry is whether an inactive, independent
     investor would be willing to compensate the employee as
     he was compensated. The nature and quality of the
     services should be considered, as well as the effect of
     those services on the return the investor is seeing on
     his investment. The corporation’s rate of return on
     equity would be relevant to the independent investor in
     assessing the reasonableness of compensation in a small
     corporation where excessive compensation would
     noticeably decrease the rate of return.

The Court of Appeals for the Ninth Circuit has employed the

independent investor test in conjunction with the other above-

discussed tests as another means of measuring the reasonableness

of officer compensation.

     Petitioner contends that we should disregard the traditional

tests and focus solely upon the independent investor test, in the

same manner as the Court of Appeals for the Seventh Circuit did

in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.

1999).    Petitioner contends that the traditional tests do not fit

petitioner’s situation, and use of the traditional tests “invites

arbitrary decisions”.   Before we decide whether it would be

appropriate to focus solely on the independent investor test, we

will first consider it in light of facts of this case.
                                  - 18 -

     Respondent, based on petitioner’s tax returns, contends

that, after subtracting the compensation deducted by petitioner,

the return on petitioner’s equity is as follows:

                Pretax      After-tax                Return on
     Year       income        income       Equity1    equity(%)

     19952      $17,825       $15,151   $2,013,692       .75
     1996        58,755        49,066    2,028,715      2.42
     1
       The amount of equity reflected consists of the total of
the yearend balances in the capital stock, paid-in surplus, and
retained earning accounts.
     2
       The $17,825 amount is after a deduction for a net
operating loss carryforward from another year. Without
considering the net operating loss deduction, the return on
equity would be 1.67 percent for 1995.

Petitioner does not dispute the returns on equity computed by

respondent based upon the information reported in petitioner’s

income tax returns.       Petitioner contends that we should focus on

the return on equity in the form of appreciation of petitioner’s

assets.     Based on petitioner’s calculation of the increases

(appreciation) in the value of realty and securities, its return

on equity for 1995 and 1996 would have been 34.5 percent and 36.5

percent, respectively.      Petitioner, on the same basis, contends

that it had a 29-percent average return on equity for the years

1993 through 1996.

     Respondent argues that petitioner’s approach to measuring

the return on equity is speculative and overstated and does not

match the amount shown on petitioner’s tax returns.       In other

words, respondent contends that the return on equity should be
                              - 19 -

measured based on realized income and not on unrealized

appreciation of the business assets.   Respondent points out that

petitioner’s percentage return is due to unrealized appreciation

on marketable securities and estimated average appreciation on

the leased Green Valley Ford property.   In addition, respondent

notes that petitioner did not factually establish that the real

property had appreciated to the extent claimed.   Significantly,

there has been no showing that any portion of the claimed asset

appreciation was due to the Valentes’ efforts rather than general

market conditions.

     We cannot accept the inherent premise of petitioner’s

approach; i.e., that an independent investor would be satisfied

with little or no return on petitioner’s current income stream

that was being generated with little effort on the part of

petitioner’s officers.   Petitioner’s approach also assumes that

an independent investor would forgo an established stream of

income cash-flow return on equity for the possibility that

unrealized asset appreciation will be available in the future.

To some extent, an independent investor might invest in an entity

for the possibility of asset appreciation.   That investor,

however, would not, without some compelling reason, forgo the

income stream from those assets.   That is especially true where,

as here, the Valentes’ efforts were, in great part, directed at

the maintenance, as opposed to the creation of the income stream.
                               - 20 -

In fact, there is no evidence that the income stream (rental

income and mortgage installment payments) was in jeopardy.     While

it is clear that the Valentes played some role in producing the

1995 and 1996 income increases over prior years, the increases

were limited to the acquisition and sale of realty and marketable

securities.

     During 1995 and 1996, petitioner’s adjusted taxable income

(pretax and without considering net operating loss deductions

from other years) was $294,587 and $518,755, respectively.

Assuming an independent investor would have been satisfied with a

20-percent return, then as much as $235,670 and $415,004, for

1995 and 1996, respectively, would have been available for

compensation of petitioner’s officers.   However, reasonable

compensation cannot be based solely on allowing an amount that

represented what was left after computing what was thought to be

a fair return for an investor.   Under any measure of reasonable

compensation, the amount must be for “personal services actually

rendered”.    Sec. 162(a)(1); Elliotts, Inc. v. Commissioner, supra

at 1245; Exacto Spring Corp. v. Commissioner, supra at 835.

     The facts in these cases reflect that a majority of

petitioner’s income stream would have existed regardless of the

Valentes’ services or efforts during 1995 and 1996.   The passive

portion of petitioner’s income was well established and would

continue with a minimum amount of effort.   We also note that Mr.
                              - 21 -

Valente had been well compensated in prior years, reflecting that

he had already been compensated for petitioner’s financial

success prior to 1995.   Significantly, the Valentes were

physically less able to devote their time and efforts to

petitioner’s business during 1995 and 1996, yet petitioner seeks

to justify substantial increases in the Valentes’ compensation

over the average of the prior 3 years.    The increases over the

$209,462 average for the 4 prior years was approximately $30,000

in 1995 and $250,000 for 1996.   Although, as discussed infra,

there appears to be some justification for compensation in excess

of the amount determined by respondent, the amounts sought by

petitioner are unreasonable and unjustified on this record.    The

profit from the acquisition and sale of realty and securities, on

the other hand, was more directly attributable to the Valentes’

efforts.

     The compensation paid to the Valentes represented 81.6

percent and 88.7 percent, respectively, of petitioner’s 1995 and

1996 adjusted5 taxable income.   That would leave an independent

investor with less than 20 percent and 10 percent of petitioner’s

income for 1995 and 1996, respectively.    An independent investor

might or might not be willing to accept a division of “operating”

profits that is not based on the extent to which the efforts,


     5
       The income was adjusted so as not to include net operating
loss deductions from other years, special deductions, and the
deductions for officers’ salaries.
                              - 22 -

talents, or services of the officers were necessary for the

generation of the profit.   Those are the same aspects that we

have considered to decide the amount of compensation that is

reasonable.   Accordingly, petitioner must show here that the

Valentes were compensated for services and that the compensation

was reasonable; i.e., that the officers in these cases were

responsible for 81.6 percent and 88.7 percent of the profit.

     Petitioner has not shown that the Valentes’ efforts in the

collection of petitioner’s established stream of income would

warrant any amount in excess of the annual $76,800 in

compensation that respondent determined was reasonable.

Petitioner, however, has shown that the increases to its income

for 1995 and 1996 due to the sale of assets during the 1995 and

1996 years were attributable to the Valentes’ efforts.    Those

efforts produced additional income in the amounts of $25,922 and

$171,719 for 1995 and 1996, respectively.6   Unfortunately the

parties did not provide the Court with appropriate expert

testimony or some methodology by which to decide the quantum of

compensation (bonus) to be attributed to the results obtained by


     6
       The total income for 1992, 1993, and 1994 was $604,344,
$633,688, and $640,602 for an average total income of $626,211
($1,878,634 ÷ 3). The total income for 1995 and 1996 was
$898,479 and $806,071 for increases of $272,268 and $179,860,
respectively. The $272,268 for 1995, however, includes $246,346
of income from recapture of depreciation, so that the increase in
earned income was actually $25,922 ($272,268 - $246,346). The
1996 income figure contained recapture of $8,141 so that the
adjusted income was $171,719.
                               - 23 -

the Valentes’ efforts.    Starting with respondent’s $76,800

determination as a base amount attributable to the Valentes’

collection of petitioner’s established income, we have

approximated an additional amount of compensation attributable to

the increase in income generated by the Valentes during 1995 and

1996.    We conclude and hold that reasonable compensation for the

Valentes’ services for 1995 and 1996 is $89,750 and $162,650,

respectively.    We calculated those amounts by dividing the

increased amount of income earned by the Valentes’ efforts

between the officer/employee and equity holder, which when added

to respondent’s $76,800 determination resulted in an annual

reasonable compensation of $89,750 and $162,650 for 1995 and

1996, respectively.7

     Petitioner argues that the independent investor test should

be the sole method of deciding whether the officer compensation

claimed by petitioner was reasonable.    Respondent counters that

the independent investor test should be only one of the factors

considered, citing the Court of Appeals for the Ninth Circuit

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

Cir. 1983).    In addition, respondent contends that the facts of




     7
       The amount of compensation in excess of the $76,800, the
amount determined by respondent, was calculated by dividing in
half the 1995 and 1996 increases in income over the average of
the 3 prior years, $25,922 and $171,719 and arriving at bonuses
of $12,950 and $85,850.
                               - 24 -

these cases are distinguishable from those in Exacto Spring Corp.

v. Commissioner 196 F.3d 333 (7th Cir. 1999).

      Respondent points out that the compensated officer of Exacto

Spring Corp. (Exacto), a fine wire and spring manufacturer, was a

technical expert who was integrally involved in development of

the automated machinery that was one of the reasons for Exacto’s

financial success.   In addition, the compensated officer in

Exacto was responsible for the solicitation of 60 percent to 70

percent of Exacto’s sales.    By contrast, the Valentes’ services

to petitioner were, with the exception of the purchase and sale

of assets during the years under consideration, essentially to

maintain and collect petitioner’s established and passive sources

of revenue.   Considering the fact that venue for any appeal of

this case would be the Court of Appeals for the Ninth Circuit,

see Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d

985 (10th Cir. (1971), and the fact that petitioner failed to

meet the independent investor test, we do not find it appropriate

to rely solely on the independent investor test to reach our

findings and/or holding.

II.   Whether Petitioner Permitted Its 1995 Earnings To Accumulate
      Beyond the Reasonable Needs of the Business--Section 531

      Section 531 imposes an additional 39.6-percent tax on

accumulated taxable income.   Under section 535, accumulated

taxable income is adjusted taxable income less a dividends paid

deduction and the accumulated earnings credit.   For corporations,
                               - 25 -

other than holding or investment companies, the credit is

generally an amount equal to the part of earnings and profits

that is retained for the reasonable needs of the business.      See

sec. 535(c)(1).   The term “reasonable needs of the business”

includes the reasonably anticipated needs of the business.      Sec.

537(a)(1).   The accumulated earnings tax is imposed on

corporations “formed or availed of for the purpose of avoiding

the income tax * * * by permitting earnings and profits to

accumulate instead of being divided or distributed.”     Sec.

532(a).

     The controversy here focuses on two questions:    (1) Whether

petitioner was a “mere holding or investment company” so as to

not be entitled to accumulate income for reasonable needs beyond

$250,000, and, if not, (2) whether petitioner accumulated income

beyond its reasonable needs.    Respondent argues that petitioner

meets the definition of a holding company as set forth in the

statute and the regulations.    A corporation is a “holding

company” if it has “practically no activities except holding

property and collecting the income therefrom or investing

therein”.    Sec. 1.533-1(c), Income Tax Regs.   A corporation is

also considered an    investment company if, in addition to holding

properties and collecting income, it actively trades stocks,

securities, real estate, or other investments.     See id.
                               - 26 -

     Petitioner held real property and stocks and received income

from rent, interest, and the sale of stocks and realty.    Although

some of the income was from rent, the leases were net leases, and

petitioner was not involved in operating or managing the rental

properties.   Petitioner’s situation here is not, in any

distinguishable aspect, different from that in H.C. Cockrell

Warehouse Corp. v. Commissioner, 71 T.C. 1036 (1979), where the

taxpayer’s income was derived from the rental of real property to

operating companies.

     Petitioner argues that its circumstances are more similar to

those of the taxpayer in Dahlem Found., Inc. v. Commissioner, 54

T.C. 1566 (1970).    In that case, the Court explained that the

word “mere” was designed to draw a distinction between holding or

investment corporations that are strictly passive and those that

engage in some measure of business activity.    See id. at 1576.

In H.C. Cockrell Warehouse Corp. v. Commissioner, supra at 1046,

we described the activities that were sufficient to avoid “mere

holding company” status in Dahlem Found., Inc. v. Commissioner,

supra, as follows:

     (1) Locating an undeveloped parcel of real estate for a
     shopping center; (2) negotiating and paying the
     purchase price of such undeveloped land; (3) securing
     leases for occupancy of the buildings to be situated in
     the shopping center; (4) arranging for a loan for
     construction of the shopping center; (5) various
     management functions with respect to the center; and
     (6) maintaining and repairing various portions of the
     center. The taxpayer also actively managed other
     properties.
                              - 27 -


     We do not find petitioner’s activities to approach those

that this Court found sufficient to distinguish between a

corporation that is primarily a “holding company” and one that is

a “mere holding company” in Dahlem Found., Inc. v. Commissioner,

supra.   Accordingly, we hold that petitioner is a “mere holding

company” within the meaning of section 533(b) and prima facie had

a purpose of avoiding the income tax on shareholders.      In

addition, petitioner has not shown evidence of any purpose for

its accumulation other than testimony about possible expansion

and legal theories about possible needs.8   Accordingly,

     8
       We note that the burden of proof is on petitioner and has
not been shifted to respondent under sec. 534(c). See also Rule
142(e). Although it is unnecessary for us to consider whether
petitioner had reasonable needs of its business in excess of
$250,000, we must note that under traditional standards
petitioner has not shown that its needs exceeded the $250,000
amount. Petitioner’s needs were based on the speculation that
Mr. Valente’s future inability to provide such consultation to
the auto dealerships could result in defaults on obligations to
petitioner and that there would be a need for capital. The
financial status of the automobile dealerships, however, is not
available in this record, nor is there any indication that such
event was a need, without even considering whether it was
“reasonable”. Petitioner also anticipated the death of the
Valentes and the possibility of stock redemption to pay estate
taxes. To this respondent aptly points out that there would
likely be no estate tax burden when the first of the Valentes
died. Finally, although no formal plans had been made or action
taken, Mr. Valente described a desire to develop a parcel of
property which had been held by petitioner for an extended amount
of time. Although Mr. Valente testified about some of these
                                                   (continued...)
                                  - 28 -

petitioner was availed of for the purpose of evading the income

tax on shareholders and is limited to accumulating, without

imposition of accumulated earnings tax, no more than $250,000.

III.       Whether Petitioner Is Liable for Accuracy-Related Penalties
           Under Section 6662(a) for 1995 and/or 1996

       Section 6662(a) imposes an accuracy-related penalty if any

portion of an underpayment is attributable to negligence or

disregard of rules or regulations or any substantial

understatement of tax.      A substantial understatement for a

corporation is an understatement that exceeds the greater of 10

percent of the tax required to be shown on the return or $10,000.

For 1995 and 1996, petitioner’s understatement may exceed the 10-

percent or $10,000 threshold.      The penalty will not apply to any

portion of an underpayment for which there was reasonable cause

for the position taken and the taxpayer acted in good faith.      See

sec. 6664(c).

       Respondent, focusing on the reasonable compensation

question, contends that the Valentes did little or nothing to

earn the $240,435 and $460,000 salaries they were paid.      Although

we have concluded that the value of their services was less than


       8
      (...continued)
matters, no steps had been taken or evidence presented that
corroborated these matters as established or reasonable needs.
                                - 29 -

the amounts paid, we have found that the Valentes did play a

meaningful role in the success of petitioner.     That is in

contrast to respondent’s contention that the Valentes performed

no services and/or did not play a meaningful role in the

financial success of petitioner.

     Petitioner contends that no penalty should apply here

because of its full disclosure to and reliance upon a competent

professional.    See sec. 1.6664-4, Income Tax Regs.   The

adjustments we have considered in these cases are quite technical

in nature (whether petitioner was a “mere holding company” within

the meaning of section 533 and whether the Valentes’ compensation

was reasonable).    Although our holdings are generally unfavorable

to petitioner, we are convinced that petitioner relied on its

accountant and that reliance was reasonable.     See United States

v. Boyle, 469 U.S. 241, 251 (1985).      Petitioner’s accountant, who

testified at trial, was competent, and he was fully informed of

the factual predicate for deducting the compensation in dispute.

His testimony regarding the compensation reflected that he was

well informed.     He relied, however, on factors that the Court

ultimately found insufficient to carry the day.     Petitioner, vis-

a-vis the Valentes, had no tax expertise, and it was reasonable

to rely on a fully informed and competent professional in the
                               - 30 -

matters under consideration.   Accordingly, we hold that

petitioner is not liable for penalties under section 6662.

     To reflect the foregoing and the agreement of the parties,


                                    Decisions will be entered

                               under Rule 155.
