                         T.C. Memo. 2006-173



                       UNITED STATES TAX COURT



               WECHSLER & CO., INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 9667-04.                Filed August 17, 2006.



          Edward I. Foster, Jessica S. Powers, Harold N.

     Pappas, and Leonard D. Steinman, for petitioner.

          Carmen M. Baerga, Joseph W. Fogelson, and Marvis

     A. Knospe, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     HALPERN, Judge:    By notice of deficiency dated March 11,

2004, respondent determined deficiencies in petitioner’s Federal

income taxes as follows:
                               - 2 -

                Taxable (Fiscal)
                Year Ended May 31         Deficiency

                     1992                  $898,237
                     1993                 1,182,805
                     1994                 1,165,619
                     1995                 1,152,613
                     1996                 1,048,539
                     1997                    66,710
                     1998                 1,251,760
                     1999                   270,594

     The deficiencies result principally from respondent’s

adjustments disallowing (1) a portion of the deductions that

petitioner claimed for the foregoing taxable years for amounts

paid as compensation to Norman Wechsler (Mr. Wechsler),

petitioner’s president and controlling shareholder and an owner

of a majority of its common stock; (2) a portion of the deduction

that petitioner claimed for its 1999 taxable year for an amount

paid as compensation to Sharon Wechsler (Mrs. Wechsler),

petitioner’s employee and corporate secretary and Mr. Wechsler’s

wife; and (3) all of the deductions that petitioner claimed for

its 1992 and 1993 taxable years for compensation paid to Gilbert

Wechsler (Gilbert), an alleged consultant to petitioner during

those years and Mr. Wechsler’s brother.

     Unless otherwise indicated, 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.   Many dollar amounts have been rounded to the nearest

dollar, and the term “fiscal year” will be used to refer to both
                               - 3 -

petitioner’s annual accounting period and its taxable year.

Petitioner bears the burden of proof.   See Rule 142(a)(1).1

                         FINDINGS OF FACT

     Some facts have been stipulated and so found.   The

stipulation of facts, with attached exhibits, is incorporated

herein by this reference.

Background

     At the time the petition was filed, petitioner maintained

its business office in Mt. Kisco, New York.   From 1962 until

November 1992, petitioner’s office was in New York City.

Thereafter, petitioner’s office was in Mt. Kisco, New York.

     Petitioner is a successor to Ogden, Wechsler, & Co., a

partnership formed in 1947 by Charles Ogden and Mr. Wechsler’s

father (the partnership).   The partnership was a broker-dealer

specializing in trading as a market maker or specialist and

retailing obscure and limited-float real estate securities.

Those securities traded sporadically in the over-the-counter

market.   In January 1947, the partnership registered with the

Securities & Exchange Commission (SEC) to act in the capacity of

a broker-dealer.   From 1947 through 1957, the partnership (1)


     1
        Sec. 7491, which, under certain circumstances, shifts the
burden of proof to the Commissioner, is inapplicable because the
examination in this case began before July 22, 1998, the
effective date of that section. See Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, sec.
3001(c), 112 Stat. 727.
                               - 4 -

expanded its trading activities to include trading a few

additional over-the-counter stocks, convertible bonds, and

preferred stocks, and (2) began to act as a “broker’s broker”

(i.e., trading with other broker-dealers on an undisclosed basis

on behalf of another broker-dealer, typically the investment

banker for the securities traded).

     In 1962, the partnership’s then partners incorporated their

firm under the name of Ogden, Wechsler, and Krumholz, Inc., the

corporation that is petitioner in this case.    Upon the retirement

of Charles Ogden in 1965, petitioner changed its name to Wechsler

& Krumholz, Inc.   In 1992, petitioner changed its name to

Wechsler & Co., Inc.

     Mr. Wechsler became an employee of petitioner’s in July

1963, an officer of petitioner’s in June 1967, a member of

petitioner’s board of directors in May 1969, and a shareholder in

petitioner in June 1969.   By 1965, the focus of petitioner’s

business was trading convertible securities and acting as a

broker’s broker.   From 1963 through 1966, Mr. Wechsler worked for

petitioner as a trader’s assistant and clerk.    From 1966 through

1970, he became a senior trader for petitioner.    In 1970, he

became petitioner’s head trader, a position he held until 1978,

when he became petitioner’s president.   In 1986, he became

chairman of petitioner’s board of directors.    He has been both

petitioner’s president and chairman of its board since 1986.
                                 - 5 -

     During most of the 1980s, Mr. Wechsler and Elroy Krumholz

(Mr. Krumholz) were involved in the management of petitioner.

Mr. Krumholz was the son of a partner in the partnership

(petitioner’s predecessor).   Mr. Krumholz joined petitioner as an

employee in June 1967 and became an officer of petitioner in June

1967 and a shareholder in petitioner in 1969.    As of August 1972,

Mr. Wechsler’s father, Mr. Krumholz’s father, Mr. Wechsler, and

Mr. Krumholz each owned 80 shares, or 25 percent, of petitioner’s

then-outstanding common stock.    Mr. Krumholz’s father died in

September 1978, at which time petitioner redeemed all of the

common and preferred stock that Mr. Krumholz’s father had owned

in petitioner.   Mr. Wechsler’s father died in June 1986 and

bequeathed his 80 shares of common stock in petitioner to Mr.

Wechsler, making Mr. Wechsler the owner of 160 of petitioner’s

then 255 outstanding shares of common stock.    After Mr. Krumholz

died in 1988, petitioner redeemed all of Mr. Krumholz’s common

and preferred stock in petitioner.

Petitioner’s Business From 1991 Through 1999

     By 1991, petitioner functioned primarily as a market maker,

or “specialist”, in convertible bonds, as a broker-dealer in

convertible bonds, and as an investor for its own account in

convertible bonds, with a portion of its portfolio in hedged

positions.   A specialist serves to “make a market”, particularly

for thinly traded securities, standing ready to buy or sell the
                               - 6 -

securities as demanded to provide increased liquidity, especially

where there is a temporary imbalance between buy and sell orders

from investors.

     Convertible bonds are hybrid instruments; typically they are

subordinated debentures with a fixed interest rate, a fixed

maturity, and an ability to be converted into the issuer’s stock

at the holder’s option.   Bonds generally have been and remain

thinly traded.

     A hedge in convertible bonds typically consists of a long

position in the bonds and a short position in the underlying

common stock into which the bonds can be converted, which is

intended to be market neutral (i.e., to have the combined bond

and stock positions not generate major additional profits or

losses even with large moves in the overall markets).

     Before moving to Mt. Kisco in December 1992, petitioner had

as many as 53 employees in its New York City office.    Until

December 1992, petitioner had its own “back office” operation in

which petitioner’s staff “cleared” securities (i.e., moved the

actual certificates in sales transactions), kept records and

accounts of trades, sent and received confirmations, and

maintained records otherwise required by the SEC, securities

exchanges, and the National Association of Securities Dealers

(NASD).
                               - 7 -

     Upon moving to Mt. Kisco, petitioner eliminated most of its

back office operation and outsourced most of those functions to

Bear Stearns & Co.   Shortly after its move to Mt. Kisco in

December 1992, petitioner had approximately 20 employees.     By

1999, the number of petitioner’s employees decreased to 12.

     Petitioner produced profits for itself in various ways:       (1)

As a market maker, petitioner profited from the spread between

bid and ask prices; (2) as a principal rather than an agent,

petitioner earned income from executing trades on behalf of its

institutional clients and, to a smaller extent, from executing

trades on behalf of other broker-dealers;2 (3) petitioner

profited from short-term opportunities created by imbalances in

convertible bond prices and underlying stock prices; (4)

petitioner earned trading profits from long-term investments that

were entered into after significant analysis and research; (5)

petitioner profited from its hedge portfolio; (6) petitioner

profited on new issues of convertibles, for which it acted as a

primary market maker and influenced the pricing and distribution

of those securities, profiting from redistribution of those

securities from short-term buyers to long-term buyers; and (7)



     2
        Acting as principal rather than an agent, petitioner was
the counterparty for the sale or purchase by its client (or
another broker-dealer). The transaction was in effect free of
market risk to petitioner if it had contracted an offsetting
purchase or sale. Petitioner assumed a market risk if it had not
done so.
                                 - 8 -

petitioner’s large stock investments in microcap companies, after

the market crash in 1987 and extending through the 1990s,

resulted in gains for petitioner.

     Although petitioner was a relatively small company, during

the 1990s it acted as a market maker for several hundred

convertible securities.    It listed and traded a much greater

number of those securities than its competitors.    Because

petitioner was a boutique dealer in convertible securities, Mr.

Wechsler himself often would deal with and advise some of

petitioner’s better customers.    During the 1980s, he developed

and improved a computer software program for petitioner to keep

track of the convertible securities that it listed and traded.

     In the spring of 1997, petitioner formally adopted a plan to

reduce its institutional and convertible bond business and

concentrate on its own proprietary trading and short-term and

long-term investments.    Even before its formal adoption of this

plan, Mr. Wechsler had begun to change the focus of petitioner’s

business in this manner.   By 1997, Mr. Wechsler realized that the

prior advantages petitioner enjoyed as a market maker in the

convertible securities market no longer applied and that

petitioner faced increasing competition from a number of much

larger securities investment and trading companies.   Among other

things, by the 1990s some major investment and trading companies

expanded into the convertible securities market as market makers.
                                 - 9 -

     By that time, computerized convertible bond trading programs

were readily available, and trading in convertible securities

came to be conducted in great measure electronically.    That

diminished petitioner’s prior competitive advantage from Mr.

Wechsler’s expertise and reputation as a market maker in hundreds

of convertible securities and the longstanding business

relationships that Mr. Wechsler had with various individuals in

the financial sector.     Price competition in a number of

convertible securities increased among various market makers, and

typically how good a price a market maker quoted for those

securities became the controlling factor for potential customers

in selecting a particular market maker for a transaction.     Also,

generally, trades came to involve larger dollar amounts,

resulting in larger capital requirements for market makers in

convertible securities.    From 1990 through about 1997, petitioner

listed and traded approximately 350 convertible securities.

Thereafter, petitioner sharply reduced its participation and role

as a market maker in the convertible securities market while

continuing to act as a market maker in 30 to 50 convertible

securities and perhaps a half-dozen stocks.

Duties and Work Performed by Certain Officers and Individuals

     Mr. Wechsler

     Since 1988, Mr. Wechsler has been petitioner’s principal

manager and has made all major financial decisions concerning
                              - 10 -

petitioner.   As previously discussed, he was petitioner’s

president and chairman of its board.     He was intimately involved

in managing petitioner’s business, closely supervised all of

petitioner’s trading and investment activities in debt and equity

securities, and worked long hours.     Among other things, he:   (1)

Conducted all of petitioner’s marketing, (2) determined the

securities for which petitioner would be a market maker, and (3)

managed petitioner’s investment portfolio.     Besides Mr. Wechsler,

from 1992 through 1997 petitioner had two salesmen, three to five

traders, and one to five assistants working at its trading desk.

Mr. Wechsler spent most of his time at work either in

petitioner’s trading room or in his office adjoining the trading

room, which was only 4 to 5 feet away from the trading desk.

Petitioner’s trading room was a large room that contained a large

trading desk that had four seats on each side and two seats at

each end, with a telephone at each seat position.     All of the

traders, institutional sales representatives, and certain support

staff sat together in the trading room.     The traders sat at the

central seats of the trading desk, with each trader generally

having five computers.   When Mr. Wechsler was in his office, his

office door into the trading room was open 99 percent of the

time.

     In managing petitioner, Mr. Wechsler was assisted by three

individuals who had worked for petitioner for a number of years:
                              - 11 -

(1) Philip Glickman (Mr. Glickman), (2) Richard Zeeman (Mr.

Zeeman), and (3) Ricky Solomon (Mr. Solomon).   In the next lower

level of petitioner’s senior employees were Jay Mittentag (Mr.

Mittentag) and Evan Lobel (Mr. Lobel).

     In addition, petitioner paid Gilbert (Mr. Wechsler’s

brother) $80,359 and $108,097 during its 1992 and 1993 fiscal

years, respectively.   Petitioner deducted those payments on its

1992 and 1993 Federal income tax returns as compensation paid for

services.   Those deductions are at issue.

     Mrs. Wechsler began working for petitioner during its 1999

fiscal year.   A portion of the $486,154 that petitioner paid to

her and deducted as compensation paid for her services during

that year is at issue.

     Mr. Glickman

     Mr. Glickman started working for the partnership

(petitioner’s predecessor) in 1959 as a clerk/trainee, primarily

assisting Mr. Wechsler’s father.   Mr. Glickman later worked as a

senior trader for petitioner, until the mid-1980s, when he became

an institutional salesman for convertible bonds.   He served as

petitioner’s vice president from 1967 until June 2, 1988, when he

was appointed its executive vice president.   He served on

petitioner’s board from 1986 until his retirement from petitioner

on May 31, 1997.
                                - 12 -

     Mr. Zeeman

     Mr. Zeeman started working for the partnership in 1963 as a

clerk/trainee assisting Charles Ogden (a partner) and then Mr.

Krumholz’s father (another partner).     Mr. Zeeman later became a

senior trader for petitioner and was registered with the NASD as

a registered representative, a principal, and a financial

operations principal (FINOP).    From the mid-1980s until 1992, he

was in charge of petitioner’s back office operation.    From June

1, 1991, through May 1997, when he was terminated, Mr. Zeeman’s

duties were primarily administrative, and he largely functioned

as petitioner’s chief financial officer.    At various periods

during the years at issue, he served as petitioner’s secretary,

treasurer, vice president, or executive vice president.

Following petitioner’s outsourcing of its back office operation

in December 1992, until his termination from petitioner in May

1997, he was responsible for ensuring that petitioner’s books and

records (including its monthly Financial and Operational Combined

Uniform Single (FOCUS) reports) were prepared and that petitioner

was in compliance with other financial and reporting requirements

imposed by the NASD and the SEC.

     Mr. Solomon

     Mr. Solomon joined petitioner in 1983.    He was a registered

representative with the NASD and rose relatively quickly working

for petitioner.    He was given significant authority to trade and
                                - 13 -

maintain large trading and investment positions.       Nevertheless,

he consulted closely with Mr. Wechsler while performing those

trading and investment activities.       He became petitioner’s vice

president in 1988 and became a member of petitioner’s board in

1992.

     Mr. Mittentag

     Mr. Mittentag began working for petitioner in the 1960s as a

back office clerk.     He became an assistant cashier for petitioner

and later its cashier.    He became petitioner’s chief financial

officer in October 1998.     He is registered with the NASD as a

FINOP.

     Mr. Lobel

     Mr. Lobel began working for petitioner in 1987 as a clerk/

trainee.   He became a senior trader and then a trader/analyst.

He had limited discretion to trade and make investments for

petitioner.    He also made recommendations as to investments to

Mr. Wechsler and recommendations as to trading to Mr. Wechsler

and Mr. Solomon.     He became a FINOP in June 1997.    He resigned

from petitioner on August 24, 1998.

     Gilbert

     During petitioner’s 1992 and 1993 fiscal years, Gilbert

worked as a lighting designer at the Metropolitan Opera.       He had

been a lighting designer there for 19 years.       He did not spend

time in petitioner’s office every day.       Petitioner did not
                                - 14 -

provide him with access to its computer system, nor did it

provide him its computer program allowing him to access the

system from outside petitioner’s office.

     Mrs. Wechsler

     Mrs. Wechsler previously worked for a broker-dealer in

Dallas, Texas, where Mr. Wechsler met her.     She moved to New York

City in 1971 and then married Mr. Wechsler.     Until petitioner

hired her on July 14, 1998, she had not worked outside her home

since the late 1970s.    Petitioner agreed to pay her compensation

of at least $500,000 a year.     On July 14, 1998, she became

petitioner’s secretary and a member and vice chairman of

petitioner’s board of directors.    During petitioner’s 1999 fiscal

year, she devoted 70 percent of her time to office management and

30 percent to portfolio research.    She became a full

registration/general securities representative in February 1999

and a general securities principal in June 1999.

Common and Preferred Stock Ownership in Petitioner

     Petitioner has had outstanding both common and preferred

shares of stock.     Since 1986, Mr. Wechsler has owned a majority

of the outstanding common shares of petitioner and has held

sufficient shares to elect a majority of petitioner’s directors.

From May 31, 1997, through May 31, 1999, the holders of

petitioner’s preferred stock have had the authority to elect one

of petitioner’s directors but have never exercised that
                               - 15 -

authority.

     From its incorporation in 1962 through May 31, 1999,

petitioner has never paid cash dividends with respect to its

common stock.    On July 6, 1984, petitioner distributed 14 shares

of its preferred stock with respect to each share of its common

stock.    It has not since then distributed preferred shares with

respect to its common stock.    Petitioner paid cash dividends on

its preferred stock in 1979, 1980, 1981, 1982, 1983, 1984, and

1985.    From 1986 through May 31, 1999, petitioner did not pay

dividends on its preferred stock.

     As previously discussed, Mr. Wechsler’s father died in June

1986 and bequeathed his 80 common shares in petitioner to Mr.

Wechsler, making Mr. Wechsler owner of 160 of petitioner’s then-

outstanding 255 common shares.    The father left his preferred

shares in petitioner to two trusts primarily for the benefit of

his wife, Mr. Wechsler’s mother, with Mr. Wechsler and Gilbert

(the two sons of the father and mother) as remaindermen.    The

father’s estate elected to pay the Federal estate tax it owed

under the installment provisions of section 6166.    Mr. Wechsler’s

mother died on May 3, 1989, and her estate also elected to pay

the Federal estate tax it owed under the installment provisions

of section 6166.    Mr. Wechsler and Gilbert were cofiduciaries of

the father’s estate, the mother’s estate, and the trusts that

their father and mother established.
                                - 16 -

     As of June 1, 1990, the father’s estate, the mother’s

estate, and the trusts collectively owned 3,188.55 preferred

shares in petitioner.    Over the period covering its 1991 through

1999 fiscal years, petitioner redeemed 878.55 of these 3,188.55

shares as follows:

                     Number of                             Price
FYE May 31        Shares Redeemed       Total Payment    Per Share

    1991               58.55              $104,512       $1,785.00
    1992               45.00                83,026        1,845.02
    1993              347.00               649,230        1,870.98
    1994              112.00               218,354        1,949.59
    1995              157.00               316,575        2,016.40
    1996              125.00               258,420        2,067.36
    1997                --                   --              --
    1998               19.00                41,325        2,175.00
    1999               15.00                33,975        2,265.00

     As of June 30, 1990, and May 31, 1999, legal title to

petitioner’s outstanding preferred shares was held as follows:

     Holder                         June 30, 1990       May 31, 1999

Mr. Wechsler’s father’s                3,188.55          2,310.00
 and mother’s estates
Mr. Wechsler                           1,549.75          1,549.75
Mr. Glickman                             140.00            140.00
Mr. Zeeman or his estate1                 70.00             70.00
  Total                                4,948.30          4,069.75
     1
         Mr. Zeeman died on Apr. 27, 1999.


     From September 3, 1999, through December 6, 2000, petitioner

redeemed another 200 of the 3,185.55 preferred shares that Mr.

Wechsler’s father previously had owned as follows:
                                - 17 -

                                         Number of
                                         Preferred
                   Date               Shares Redeemed

            Sept. 3, 1999                     5
            Mar. 9, 2000                     42
            Sept. 14, 2000                   11
            Dec. 6, 2000                    142
              Total                         200

     After petitioner’s redemption of the above 200 shares, 2,110

of the 3,188.55 preferred shares that the father had owned

remained outstanding.     Mr. Wechsler and Gilbert (as co-

fiduciaries of both their father’s and mother’s estates)

determined that the two estates had satisfied the Federal estate

taxes they owed.    Mr. Wechsler and Gilbert further determined

they were each entitled to 1,055 of the remaining 2,110 preferred

shares that their father had owned in petitioner.       On December 7,

2000, petitioner redeemed Gilbert’s 1,055 preferred shares for

$2,299,099.25, or $2,179.24 a share.     Mr. Wechsler’s 1,055

preferred shares were not formally transferred to him or

redeemed.    As of the time of the trial, the certificates

representing these 1,055 preferred shares that Mr. Wechsler

inherited remained in the name of the father’s estate, the

mother’s estate, or the trusts.

     From June 1, 1991, through August 7, 1997, petitioner’s then

180 outstanding shares of common stock were owned as follows:
                              - 18 -

                                         Number of
          Shareholder               Common Shares Owned

          Mr. Wechsler                     160
          Mr. Glickman                      10
          Mr. Zeeman                         8
          Mr. Solomon                        2
            Total                          180

     Mr. Glickman and Mr. Zeeman ceased to be employed by

petitioner on May 31, 1997.   On August 1, 1997, petitioner

exercised its rights to purchase their common shares under stock

purchase agreements that it had negotiated with them, and it

offered them $97,286.59 a share for that stock.3    It further

offered to purchase their preferred shares for a price equal to

those shares’ stated redemption value of $1,000 a share, plus

accumulated accrued dividends.   On August 1, 1997, petitioner

also offered to purchase Mr. Solomon’s common shares for

$97,286.59 a share.   Mr. Solomon accepted petitioner’s offer and

petitioner redeemed his shares on August 7, 1997.    Mr. Glickman

and Mr. Zeeman (and Mr. Zeeman’s estate after Mr. Zeeman’s death

on April 27, 1999) litigated in a New York State court

petitioner’s determination of a price for their common stock

under the stock purchase agreements.   That litigation was settled



     3
        The stock purchase agreements between petitioner and Mr.
Glickman, Mr. Zeeman, and Mr. Solomon each generally provided
that petitioner would repurchase all of the individual’s common
shares upon his death or termination of employment with
petitioner at a price equal to the book value of those shares as
of the last day of the month preceding the holder’s death or
termination of employment.
                              - 19 -

in November 1999, and petitioner redeemed the common shares owned

by Mr. Glickman and Mr. Zeeman’s estate on November 30, 1999,

paying him and the estate $97,286.59 a share for the stock, plus

accrued interest from May 31, 1997.    On November 30, 1999,

petitioner purchased the preferred shares that previously had

been owned by Mr. Glickman and Mr. Zeeman at a price equal to the

sum of those shares’ redemption value of $1,000 a share, plus

accumulated accrued dividends as of May 31, 1997, plus accrued

interest from May 31, 1997.

     After November 30, 1999, Mr. Wechsler owned all 160

outstanding common shares of stock in petitioner.    Following

petitioner’s redemption of Gilbert’s 1,055 preferred shares on

December 7, 2000, discussed supra, Mr. Wechsler owned all the

outstanding preferred shares of stock in petitioner.

Compensation Paid to Upper Level Managers and Employees in the
Financial Industry and Petitioner’s Payments of Compensation to
Mr. Wechsler, Mrs. Wechsler, Gilbert, and Others During Years in
Issue

     In the financial industry, upper level managers and

employees at investment and trading companies typically receive a

substantial part of their annual compensation from bonuses that

are based upon their company’s earnings or profits for that year.

In particular, principal managers of companies that enjoy highly

profitable years often may be paid bonuses that are a number of

times the amounts of their annual salaries.
                             - 20 -

     During its 1992 through 1999 fiscal years, petitioner did

not have a written compensation policy as to the payment of

either base compensation or bonuses to its employees.

     In each fiscal year, petitioner generally paid Mr. Wechsler

and its other officers (1) a base salary, (2) a December or

holidays bonus and (3) a May or fiscal-yearend bonus.    The

December bonuses typically were based on petitioner’s year-to-

date earnings and the assumption of petitioner’s continuing

profitability for the remainder of that fiscal year.    Generally,

the December bonuses were smaller than the May bonuses.

     Toward the middle of May, Mr. Wechsler prepared a

spreadsheet listing all of petitioner’s employees and the

proposed bonuses and salary adjustments for them.   Mr. Wechsler’s

proposed total May bonuses were based on his estimate of

petitioner’s realized and unrealized profits for the fiscal year,

which he determined primarily by using petitioner’s most recent

monthly FOCUS reports, though he gave more weight to realized

profits because unrealized profits had not been reduced to cash

and petitioner wished not to liquidate investment assets.      In

addition, in determining the proposed May bonuses, Mr. Wechsler

took into account, to a small degree, his current expectations

and outlooks for the securities industry, petitioner, and

petitioner’s portfolio.
                               - 21 -

     Generally, petitioner’s officers other than Mr. Wechsler did

not make bonus recommendations for themselves or petitioner’s

other employees.    While the proposed bonuses would be discussed

at a meeting of petitioner’s board of directors, Mr. Wechsler

made the final decisions regarding the salary and bonuses that

petitioner paid to each of its employees and officers, including

himself.   At no time did petitioner’s board of directors reject

the compensation that Mr. Wechsler proposed for himself, nor did

the board ever authorize him to receive more or less than the

amount of compensation that he proposed for himself.

     During its 1992 through 1999 fiscal years, petitioner paid

Mr. Wechsler a base salary, a December bonus, and a May bonus as

follows:

                                December                   Total
FYE May 31      Base Salary       Bonus    May Bonus    Annual Comp.

    1992           $390,000     $750,000   $3,250,000   $4,390,000
    1993            390,000    2,000,000    2,500,000    4,890,000
    1994            390,000    3,000,000    3,700,000    7,090,000
    1995            405,000       30,000    5,425,000    5,860,000
    1996            390,000        --       5,000,000    5,390,000
    1997            390,000        --       1,000,000    1,390,000
    1998            415,000       32,000    7,040,000    7,487,000
    1999            571,694       23,076      900,000    1,494,770

     Petitioner paid and deducted $80,359 as compensation to

Gilbert for its 1992 fiscal year.   It paid and deducted $108,097

as compensation to him for its 1993 fiscal year.
                             - 22 -

     Petitioner paid and deducted $486,154 as compensation to

Mrs. Wechsler for its 1999 fiscal year.   Of that amount, $178,154

was salary, $8,000 was a December bonus, and $300,000 was a May

bonus.

     During its 1992 through 1997 fiscal years, petitioner paid

its then executive vice president, Mr. Glickman, a base salary, a

December bonus, and a May bonus as follows:

                              December                     Total
FYE May 31     Base Salary      Bonus     May Bonus     Annual Comp.

    1992        $166,400      $100,000    $550,000       $816,400
    1993         166,400       250,000     400,000        816,400
    1994         166,400       300,000     450,000        916,400
    1995         172,800        12,800     600,000        785,600
    1996         166,400         --        600,000        766,400
    1997         169,600         --        160,000        329,600

     During its 1992 through 1997 fiscal years, petitioner paid

Mr. Zeeman (who largely functioned as its chief financial officer

and until 1992 headed its back office operation) a base salary, a

December bonus, and a May bonus as follows:

                              December                     Total
FYE May 31     Base Salary      Bonus     May Bonus     Annual Comp.

    1992        $156,000      $100,000    $550,000       $806,000
    1993         146,000        50,000     100,000        296,000
    1994         104,000        50,000     100,000        254,000
    1995         108,000         8,000     115,000        231,000
    1996         114,000         --        115,000        229,000
    1997         106,000         --         48,000        154,000

     During its 1992 through 1999 fiscal years, petitioner paid

its vice president/executive vice president, Mr. Solomon, a base

salary, a December bonus, and a May bonus as follows:
                             - 23 -

                              December                     Total
FYE May 31     Base Salary      Bonus    May Bonus      Annual Comp.

    1992        $104,000      $50,000    $400,000        $554,000
    1993         104,000      200,000     350,000         654,000
    1994         104,000      300,000     400,000         804,000
    1995         108,000        8,000     560,000         676,000
    1996         104,000         --       560,000         664,000
    1997         130,000         --       300,000         430,000
    1998         293,500       23,080     700,000       1,016,580
    1999          46,160         --          --            46,160

     During its 1992 through 1999 fiscal years, petitioner paid

Mr. Mittentag (who was its cashier and became its chief financial

officer in October 1998) a base salary, a December bonus, and a

May bonus as follows:

                              December                     Total
FYE May 31     Base Salary      Bonus    May Bonus      Annual Comp.

    1992         $52,300       $2,000     $35,000        $89,300
    1993          55,620        8,240      37,000        100,860
    1994          53,560       10,000      40,000        103,560
    1995          55,820        4,120      55,000        114,940
    1996          58,760        4,520      55,000        118,280
    1997          58,760        2,260      40,000        101,020
    1998          62,260        4,800      60,000        127,060
    1999          79,385        3,461      40,000        122,846

     During its 1992 through 1999 fiscal years, petitioner paid

Mr. Lobel (a senior trader and later a trader/analyst) a base

salary, a December bonus, and a May bonus as follows:
                                - 24 -

                                December                    Total
FYE May 31     Base Salary        Bonus      May Bonus   Annual Comp.

    1992           $51,385       $3,800      $100,000     $155,185
    1993            55,350        6,150       120,000      181,500
    1994            53,300       15,000       150,000      218,300
    1995            55,000        4,100       160,000      219,100
    1996            59,800        4,600       160,000      224,400
    1997            65,000        2,500       120,000      187,500
    1998           168,000       16,000       250,000      434,000
    1999            48,000         --           --          48,000

1999 Fiscal Year Loans Mr. Wechsler Made to Petitioner

     During petitioner’s 1999 fiscal year, Mr. Wechsler made

several short-term loans to petitioner.      He made four cash loans

totaling $2,562,400 to petitioner on the dates and in the amounts

specified below:

                     Date                  Amount

               Sept. 1, 1998              $797,000
               Sept. 2, 1998               807,000
               Sept. 11, 1998               57,100
               Oct. 7, 1998                901,300
                 Total                   2,562,400

Petitioner repaid these cash loans on the dates and in the

amounts specified below:

                     Date                   Amount

               Sept. 24, 1998             $797,000.00
               Oct. 8, 1998                291,376.54
               Oct. 21, 1998             1,474,023.46
                 Total                   2,562,400.00

     On October 8, 1998, Mr. Wechsler lent petitioner securities

with a market value of $1,479,453 (the securities loan).      On

October 14, 1998, petitioner returned those securities to Mr.

Wechsler.
                                - 25 -

        Petitioner did not pay any interest to Mr. Wechsler with

respect to either the above cash loans or the securities loan.

Petitioner’s 1992 Through 1999 Tax Returns and FOCUS Reports

        For its 1992 through 1999 fiscal years, petitioner prepared

its Federal income tax returns using an accrual method of

accounting.     Under that method, securities petitioner held in

investment accounts were reflected on the tax return balance

sheet at cost and not at fair market value.     Up until its 1994

return, petitioner for tax purposes generally carried its

securities positions in trading accounts at the lower of cost or

market.     In 1993, the mark-to-market rules of section 475 were

added to the Internal Revenue Code by the Omnibus Budget

Reconciliation Act of 1993, Pub. L. 103-66, sec. 13223, 107 Stat.

481, effective for taxable years ending on or after December 30,

1993.     Beginning with its 1994 return, petitioner marked to

market all securities held in trading accounts daily, so that

immediate realization and recognition of gain or loss resulted.

     Petitioner’s annual FOCUS reports for its 1992 through 1999

fiscal years incorporate petitioner’s audited financial

statements, which were required to be prepared in accordance with

generally accepted accounting principles (GAAP).     Those audited

financial statements were prepared in accordance with GAAP except

to the extent the balance sheets failed to list as a liability

petitioner’s deferred taxes computed in accordance with GAAP.
                                       - 26 -

Petitioner’s annual FOCUS reports differed from its tax returns

in that petitioner’s revenue and earnings for purposes of the

former were computed by marking to market all securities

petitioner then held, including those held for investment.                  Cf.

sec. 475(b)(1)(A).

     On its 1992 through 1999 Federal income tax returns,

petitioner reported gross income, total deductions, taxable

income or loss, retained earnings, and retained earnings and

capital stock as follows:

                                                                       Retained
                                          Taxable                      Earnings
 FYE        Gross          Total          Income        Retained      and Capital
May 31      Income       Deductions       (Loss)        Earnings         Stock

 1992      $13,507,518   $11,776,469     $1,731,049     $10,097,005   $11,570,519
 1993       11,708,935    11,740,630        (31,695)      9,130,437    10,512,068
 1994       14,124,390    13,738,343        386,048       8,943,389    10,295,362
 1995       13,733,608    13,607,047        126,560       9,479,267    10,789,667
 1996       13,894,468    13,880,601         13,867       8,991,933    10,269,234
 1997        9,044,532     9,161,872       (117,340)      8,871,568    10,148,869
 1998       14,232,286    14,003,689        228,597       8,744,865    10,001,047
 1999        7,673,379     7,264,787        406,592       8,392,760     9,633,942

     On its annual FOCUS reports for its 1992 through 1999 fiscal

years, petitioner reported revenue, expenses, earnings before

Federal income tax (EBFIT), retained earnings, and retained

earnings and capital stock as follows:

                                                                        Retained
                                                                        Earnings
   FYE                                                     Retained    and Capital
  May 31       Revenue       Expenses           EBFIT      Earnings       Stock

   1992      $15,466,673    $11,544,567     $3,922,106 $21,336,807     $22,810,321
   1993       17,834,269     11,660,585      6,173,684  26,923,441      28,305,072
   1994       11,738,296     13,649,167     (1,910,871) 24,821,032      26,173,006
   1995       20,028,281     13,623,510      6,404,771  31,870,981      33,181,381
   1996       26,768,427     13,840,558     12,927,869  44,546,634      45,823,935
   1997        4,730,016      9,025,627     (4,295,611) 40,248,943      41,526,244
   1998       16,843,524     13,931,893      2,911,631  42,859,076      44,115,258
   1999       (8,513,310)     7,255,075    (15,768,385) 26,949,031      28,190,213
                                - 27 -

Adjustments

       For the fiscal years in issue, the following table shows the

amounts petitioner claimed as deductions for compensation paid to

Mr. Wechsler, Mrs. Wechsler, and Gilbert and the amounts

respondent allowed:

Mr. Wechsler

Year          Amount claimed    Amount allowed   Amount disallowed

1992           $4,390,000        $1,834,000        $2,556,000
1993            4,890,000         1,486,000          3,404,000
1994            7,090,000         3,665,927          3,424,073
                                                    1
1995            5,860,000         2,414,067           3,445,933
1996            5,390,000         2,316,344          3,073,656
1997            1,390,000         1,176,000             214,000
1998            7,487,000         3,821,000          3,666,000
1999            1,494,771         1,035,000             459,771
       1
        In the stipulation of facts, the amount of Mr. Wechsler’s
compensation that was disallowed as a deduction for the 1995
fiscal year is stated to be $3,445,993. In the notice of
deficiency, that amount is stated to be $3,445,933. We assume
that the $60 difference is due to the parties’ error in drafting
the stipulation. We accept the amount disallowed in the notice
of deficiency as correct.

Mrs. Wechsler

Year        Amount claimed     Amount allowed    Amount disallowed

1999            $486,154         $150,000           $336,154

Gilbert

Year        Amount claimed     Amount allowed    Amount disallowed

1992             $80,359            -0-              $80,359
1993             108,097            -0-              108,097
                                 - 28 -

Respondent determined that the amounts disallowed with respect to

Mr. Wechsler and Mrs. Wechsler exceeded a reasonable allowance

for services rendered within the meaning of section 162.        With

respect to Gilbert, respondent determined that no amounts were

allowable because no information was provided showing any service

Gilbert rendered to petitioner.


                                 OPINION

I.    Introduction

       This case is what is conventionally known as a “reasonable

compensation” case.      We must determine the deductibility of

amounts petitioner claims it paid to three individuals as

compensation for personal services rendered to petitioner.         There

is no dispute as to the fact of the payments; there is a dispute

only as to the character of portions of those payments.

II.    Applicable Law

       Section 162(a)(1) permits a taxpayer to deduct “a reasonable

allowance for salaries or other compensation for personal

services actually rendered”.      A taxpayer is entitled to a

deduction for compensation only if:        (1) The payments were

reasonable in amount, and (2) the payments were for services

actually rendered.      Sec. 1.162-7(a), Income Tax Regs.    Bonuses

paid to employees are deductible “when * * * made in good faith

and as additional compensation for services actually rendered by

the employees, provided such payments, when added to the
                              - 29 -

stipulated salaries, do not exceed a reasonable compensation for

the services rendered.”   Sec. 1.162-9, Income Tax Regs.

     Because petitioner’s place of business is in the State of

New York, and barring a stipulation to the contrary, any appeal

of this case would be to the Court of Appeals for the Second

Circuit.   See sec. 7482(b)(1)(B).   Therefore, under the doctrine

of Golsen v. Commissioner, 54 T.C. 742, 756-758 (1970), affd. 445

F.2d 985 (10th Cir. 1971), we must apply that court’s precedents

governing issues of reasonable compensation to the extent that

they contradict our precedents.

     The question of whether compensation is reasonable is to be

resolved upon a consideration of all of the facts and

circumstances of the case.   E.g., Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. 1142, 1155 (1980).    Numerous factors have

been used in determining the reasonableness of compensation, with

no single factor being determinative.    See Rapco, Inc. v.

Commissioner, 85 F.3d 950, 954 (2d Cir. 1996), affg. T.C. Memo.

1995-128; Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d

1315, 1323 (5th Cir. 1987), affg. T.C. Memo. 1985-267.     Those

factors considered include, but are not limited to: (1) the

employee’s role in the company, (2) comparison with other

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

potential conflicts of interest, and (5) internal consistency in

compensation.   Rapco, Inc. v. Commissioner, supra at 954-955;
                               - 30 -

Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1248 (9th

Cir. 1983), revg. T.C. Memo. 1980-282.   Where shareholder-

officers who are in control of a corporation set their own

compensation, careful scrutiny is required to determine whether

the alleged compensation is in fact a distribution of profits and

a constructive dividend.   Home Interiors & Gifts, Inc. v.

Commissioner, supra at 1156.

     The Court of Appeals for the Second Circuit has adopted an

independent investor test whereby the fact-finder must apply the

above multifactor test from the perspective of an independent

investor.   In general, this test questions whether, given the

dividends and return on equity enjoyed by a disinterested

stockholder, that stockholder would approve the amount of

disputed compensation paid to the employee on the basis of the

facts of each particular case.   See Rapco, Inc. v. Commissioner,

supra at 954-955; see also Elliotts, Inc. v. Commissioner, supra

at 1247; Haffner’s Serv. Stations, Inc. v. Commissioner, T.C.

Memo. 2002-38, affd. 326 F.3d 1 (1st Cir. 2003).   That test

allows us to decide whether the amount of compensation paid to a

taxpayer-corporation’s shareholder-employees by the corporation

would have been the same had they engaged in arm’s-length

negotiation.   See Miller & Sons Drywall, Inc. v. Commissioner,

T.C. Memo. 2005-114.   One important inquiry is whether this

hypothetical independent investor received a fair return on his
                                - 31 -

or her investment.    See Rapco, Inc. v. Commissioner, supra at

954-955.

       In performing our analysis, we review Mr. Wechsler’s, Mrs.

Wechsler’s, and Gilbert’s compensation separately because whether

the compensation that petitioner paid to each is reasonable

depends on the services he or she performed.    See Miller & Sons

Drywall, Inc. v. Commissioner, supra.

III.    Expert Reports

       A.   Introduction

       Both parties offered expert testimony in support of their

respective positions concerning reasonable compensation for Mr.

Wechsler.     No expert testimony was offered concerning reasonable

compensation for either Mrs. Wechsler or Gilbert.

       In deciding the reasonableness of compensation, courts often

look to the opinions of expert witnesses.    Nonetheless, we are

not bound by the opinion of any expert witness, and we may accept

or reject expert testimony in the exercise of sound judgment.

Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938);

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

cases cited thereat), affg. T.C. Memo. 1974-285.    Although we may

accept the testimony of an expert in its entirety, see Buffalo

Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452

(1980), we may be selective in determining what portions of an
                              - 32 -

expert’s opinion, if any, to accept, Parker v. Commissioner, 86

T.C. 547, 562 (1986).

     Petitioner and one of its experts, Gilbert E. Matthews, on

the one hand, argue that reasonable compensation for Mr. Wechsler

should be determined by considering data with respect to 27

broker-dealers that Mr. Matthews surveyed, particularly the

averages of the ratios of (1) aggregate compensation to net

revenues and (2) aggregate compensation to pretax income before

compensation for each broker-dealer.   Mr. Matthews compared those

averages to ratios similarly computed for petitioner to support

his conclusion that, in general, Mr. Wechsler’s compensation was

reasonable.   Respondent and respondent’s expert, Scott D. Hakala,

on the other hand, maintain that reasonable compensation for Mr.

Wechsler should be based upon a typical compensation arrangement

given to an asset manager, with Mr. Wechsler receiving 40 percent

of the bonus pool.

     As will be discussed more fully infra, neither of the

foregoing proposed approaches for determining reasonable

compensation for Mr. Wechsler (nor that of petitioner’s second

expert, Paul R. Dorf) is entirely appropriate.   In particular,

petitioner is not reasonably comparable to the broker-dealers

selected by petitioner’s expert Mr. Matthews.    Also, Mr. Hakala’s

allocation of 40 percent of the incentive compensation to Mr.
                                  - 33 -

Wechsler substantially undercompensates him for his contributions

to petitioner.

     We now consider in more detail the testimony of the parties’

experts.

     B.    Petitioners’ Experts

     Petitioner offered Gilbert E. Matthews and Paul R. Dorf as

experts in compensation practices in the securities industry, and

they were accepted as such by the Court.

            1.   Gilbert E. Matthews

     Mr. Matthews is chairman of the board and senior managing

director of Sutter Securities, Inc.        He has more than 40 years of

experience working in investment banking.       He was asked to

testify with respect to compensation practices in the securities

industry and the return on petitioner’s common stock.

     In attempting to determine customary compensation in the

securities industry, Mr. Matthews examined 27 broker-dealers

whose stock was publicly traded and their financial statements

covering all or a significant portion of the years in issue.        He

obtained their financial information from either their annual

reports or their registration statements filed with the SEC.

Those 27 broker-dealers had average annual net revenues for the

periods being examined ranging from $21 million to approximately

$3.79 billion.    Of the 27 broker-dealers, the four largest--

Lehman Brothers, Paine Webber, Bear Stearns & Co., and A.G.
                              - 34 -

Edwards--were extremely large companies having, respectively,

average annual revenues of $3.79 billion, $3.43 billion, $2.79

billion, and $1.63 billion.   The 21st-largest broker-dealer,

First of Michigan, had average annual revenues of $109.5 million,

and the 22d-largest broker-dealer, Rodman & Renshaw, had average

annual revenues of $68.0 million.    In contrast, petitioner had

average annual net revenues of $13.7 million from June 1, 1991,

through May 31, 1998.

     Mr. Matthews proceeded by first listing the net revenues,

aggregate compensation paid to all employees (aggregate

compensation), and pretax income for each of the 27 broker-

dealers for each period examined.    He then calculated the ratios

of (1) aggregate compensation to net revenues and (2) aggregate

compensation to pretax income before aggregate compensation for

each of those broker-dealers for each of those periods.    Next, he

calculated average ratios for each of the broker-dealers and

averages for the group as a whole.     For the group as a whole, the

averages of (1) aggregate compensation to net revenues and (2)

aggregate compensation to pretax income before compensation were

60.1 percent and 84.1 percent, respectively.    He compared those

averages to averages similarly computed for petitioner for its

1992 through 1998 fiscal years, which were 60.2 percent

(aggregate compensation to net revenues) and 68.9 percent

(aggregate compensation to pretax income before compensation).
                              - 35 -

Mr. Matthews concluded that the average 60.2 percent of its net

revenues that petitioner paid in aggregate compensation from 1992

through 1998 was reasonable, since it was virtually equal to the

average of 60.1 percent of net revenues paid in aggregate

compensation computed for the 27 broker-dealers he examined.   He

further observed that the average 68.9 percent of its pretax

income before aggregate compensation that petitioner paid in

compensation from 1992 through 1998 was well below the mean or

group average of 84.1 percent of pretax income before aggregate

compensation paid in compensation computed for those 27 broker-

dealers.   He stated that those results indicate that petitioner

(1) retained a higher portion of its “discretionary income”

(i.e., pretax income before compensation) and (2) paid a lower

portion of its “discretionary income” as compensation than did

most of the publicly traded broker-dealers.   Mr. Matthews added

that, in his experience, smaller broker-dealers with a limited

range of activities, like petitioner, would pay a larger

percentage of their revenues to senior management employees than

would larger, more diversified broker-dealers.

     Mr. Matthews noted that, for petitioner’s 1992 through 1999

fiscal years, Mr. Wechsler’s annual compensation represented the

following percentages of the aggregate annual compensation

petitioner paid to all its employees:
                                       - 36 -

                                     Mr. Wechsler’s Comp. as
       FYE May 31                      % of Aggregate Comp.

             1992                               53.6%
             1993                               60.3
             1994                               67.3
             1995                               64.0
             1996                               63.5
             1997                               41.2
             1998                               75.5
             1999                               43.5

Mr. Matthews concluded that Mr. Wechsler was entitled to a major

share of the aggregate compensation petitioner paid because Mr.

Wechsler was the driving force of petitioner’s business and was

instrumental in producing most of petitioner’s revenue.

      Mr. Matthews also testified that petitioner’s 1992 through

1999 aggregate compensation amounts represent the following

percentages of petitioner’s 1992 through 1999 annual net revenues

and pretax income before payment of compensation:
                                                                       Aggregate
                                Pretax                    Aggregate   Comp. as %
                                Income       Aggregate     Comp. as    of Pretax
               Net Revenue    Before Comp.      Comp.      % of Net     Income
FYE May 31     (millions)     (millions)     (millions)    Revenue    Before Comp.

    1992            $13.97      $12.1           $8.18         58.6%        67.6%
    1993             16.18       14.3            8.13         50.3         56.9
    1994             10.48        8.62          10.53        100.5        122.2
    1995             17.17       15.58           9.18         53.5         58.9
    1996             23.40       21.42           8.49         36.3         39.6
    1997              0.94        (.93)          3.37        358.5          n/a
    1998             13.81       12.82           9.91         71.8         77.3
    1999            (10.68)     (12.45)          3.44         n/a           n/a


      Mr. Matthews opined that the annual compensation petitioner

paid to Mr. Wechsler for its 1992, 1993, 1995, and 1996 fiscal

years was “clearly reasonable”, since the percentages of net

revenue and pretax net income before payment of aggregate
                              - 37 -

compensation that petitioner paid in compensation for those years

fell within “industry standards”.4   By “industry standards”, Mr.

Matthews was referring to the group average percentages that

aggregate compensation represented of net revenues and pretax

income before payment of compensation (which, as discussed supra,

were 60.2 percent and 84.1 percent, respectively) that he

computed for the 27 broker-dealers he examined.   He further

opined that petitioner’s 1996 fiscal year compensation

percentages of 36.3 percent and 39.6 percent were quite low by

industry standards.

     Mr. Matthews also opined that the annual compensation

petitioner paid Mr. Wechsler for its 1997 and 1998 fiscal years

was reasonable.   He explained that the higher compensation

percentage of 358.5 percent for 1997 was caused by that year’s

lower net revenue from lower market prices for petitioner’s

portfolio securities.   He maintained that the compensation

percentage for 1997 should be analyzed by combining the financial

data for 1996 and 1997.   He computed that the combined aggregate

compensation petitioner paid for those 2 years was 48.7 percent

of its combined 1996 and 1997 net revenues and 57.9 percent of

its combined 1996 and 1997 pretax income before payment of



     4
        We read this conclusion (and the similar conclusions for
1997 and 1998) in conjunction with Mr. Matthews’s conclusion that
Mr. Wechsler was entitled to a major share of the aggregate
compensation petitioner paid.
                               - 38 -

compensation.5   He concluded that those aggregate percentages of

48.7 percent and 57.9 percent for 1996 and 1997 were extremely

reasonable by industry standards.   Similarly, he claimed that the

compensation percentage for 1998 should be analyzed by combining

the financial data for 1996, 1997, and 1998, given what he felt

was the low aggregate compensation paid for 1996 and 1997.    He

computed that, on his suggested aggregate basis, the combined

aggregate compensation petitioner paid for those 3 years was 57.1

percent of its combined 1996, 1997, and 1998 net revenues and

65.4 percent of its combined 1996, 1997, and 1998 pretax income

before payment of aggregate compensation.6   He concluded that

those aggregate percentages of 57.1 percent and 65.4 percent for

1996, 1997, and 1998 were reasonable by industry standards.

     Mr. Matthews used a somewhat different analysis in opining

that the compensation petitioner paid to Mr. Wechsler for fiscal

year 1999 was reasonable.   He said that, because petitioner had a

negative $10.68 million in net revenue for 1999, the same


     5
        Combined 1996 and 1997 aggregate compensation paid of
$11.86 million, divided by combined 1996 and 1997 net revenues of
$24.34 million, equals approximately 48.7 percent; and $11.86
million, divided by combined 1996 and 1997 pretax income before
aggregate compensation of $20.49 million, equals approximately
57.9 percent.
     6
        Combined 1996, 1997, and 1998 aggregate compensation paid
of $21.77 million, divided by combined 1996, 1997, and 1998 net
revenues of $38.15 million, equals approximately 57.1 percent;
and $21.77 million, divided by combined 1996, 1997, and 1998
pretax income before aggregate compensation of $33.31 million,
equals approximately 65.4 percent.
                              - 39 -

percentages method he employed for its other fiscal years could

not be used for 1999, and that it was necessary to consider the

“absolute numbers”.   He noted that Mr. Wechsler was paid

$1,494,771 in 1999, which represented 28.6 percent of his average

compensation for the prior 7 years, and that his 1999 yearend

bonus of $900,000 was 22.6 percent of his average bonus for the

prior 7 years.   He further noted that Mr. Wechsler made several

large interest-free loans to petitioner during its 1999 fiscal

year.   He reasoned that those loans justified a substantial

portion of the $900,000 bonus Mr. Wechsler received for that

year.   Mr. Matthews concluded that the 1999 compensation

petitioner paid Mr. Wechsler was reasonable because of those

loans and Mr. Wechsler’s services in managing petitioner.

     Lastly, Mr. Matthews opined that the 1994 fiscal year

compensation of $7.09 million petitioner paid Mr. Wechsler was

unreasonable and that reasonable compensation for 1994 would have

been $4 million.   He noted the aggregate compensation of $10.53

million petitioner paid for 1994 represents 100.5 percent of its

net revenue for that year and 122.2 percent of its pretax income

before payment of compensation for that year.   He further noted

that, if Mr. Wechsler’s 1994 compensation had been $4 million,

rather than $7.09 million, petitioner’s adjusted aggregate

compensation of $7.44 million ($10.53 million, less $3.09

million) would represent 71.0 percent of its net revenue for that
                                        - 40 -

year and 86.3 percent of its pretax income before payment of

compensation for that year.7

      Additionally, Mr. Matthews determined that petitioner, from

its 1992 through 1998 fiscal years, enjoyed a 10.4-percent

compounded annual rate of return on its common stock equity,

adjusted for deferred taxes.8           His computation was as follows:

             Common Stock    Deferred      Adj. Common                   Compounded
               Equity          Taxes       Stock Equity   Annual Rate    Annual Rate
FYE May 31    (millions)      (millions)     (millions)     of Return     of Return1

    1991        $18.234        $3.701         $14.533          --            --
    1992        21.527          4.603          16.924         16.5          16.5
    1993        27.114          7.286          19.828         17.2          16.8
    1994        25.012          6.912          18.100         (8.7)          7.6
    1995        32.062          9.169          22.893         26.5          12.0
    1996        44.737         14.560          30.177         31.8          15.7
    1997        40.440         12.849          27.591         (8.6)         11.3
    1998        43.049         13.970          29.079          5.4          10.4
    1999        27.138          7.599          19.539        (32.8)          3.8

       1
         Computed using a present-value-future-value formula where: Present value
equals $14.533 million (petitioner’s adjusted common stock equity at the beginning of
its 1992 fiscal year); future value equals adjusted common stock equity at the end of
the period in question; and n equals the number of years from June 1, 1991, through
the end of that period.

Mr. Matthews opined that an independent investor would be

satisfied with this 10.4-percent compounded annual rate of




       7
        Adjusted aggregate compensation of $7.44 million, divided
by net revenue of $10.48 million, equals approximately 71.0
percent; and $7.44 million, divided by pretax income before
payment of aggregate compensation of $8.62 million, equals
approximately 86.3 percent.
       8
        Petitioner’s 1991 fiscal year annual FOCUS report
reflects preferred stock equity of $1,294,782 as of May 31, 1991.
Petitioner’s 1998 fiscal year annual FOCUS report reflects
preferred stock equity of $1,067,652 as of May 31, 1998. Its
1999 fiscal year annual FOCUS report reflects preferred stock
equity of $1,052,652 as of May 31, 1999.
                               - 41 -

return, maintaining:   “This rate of return would be highly

satisfactory to most equity investors.”9

          2.   Paul R. Dorf

     Mr. Dorf is managing director of Compensation Resources,

Inc., which he describes as a human resources consulting firm

specializing in compensation consulting.    He has 40 years of

human resources and compensation experience, including 10 years

in various positions as an executive with a number of

corporations and 25 years heading the executive compensation

consulting businesses of several major accounting and

actuarial/benefit consulting firms.

     Mr. Dorf could not find any broker-dealers that were

reasonably comparable to petitioner.    Mr. Dorf testified that, in

his research, he found no published surveys or publicly available

data with respect to companies similarly situated and of similar

size to petitioner.    He testified that, although, private

companies similar to petitioner might exist, generally data on

such private companies is not available.    He stated that, in the

absence of data on companies reasonably comparable to petitioner,

he would analyze the reasonableness of Mr. Wechsler’s

compensation on the basis of other factors in the multifactor

test used by the courts, the financial and other available


     9
        Mr. Matthews concedes that the compound growth rate fell
in fiscal 1999, but he states that it “recovered dramatically” in
2000.
                                            - 42 -

information concerning petitioner and Mr. Wechsler, and the facts

and circumstances of the situation presented.

         Mr. Dorf examined the sources of petitioner’s income for the

years at issue and included the following chart in his expert

report:
 FYE                          Principal       Dividends/
May 31      Commissions      Transactions      Interest            Other             Total

 1992         $24,567        $11,118,059     $3,203,830         $1,120,217        $15,466,673
 1993          27,071         12,288,119      4,017,604          1,501,475         17,834,269
 1994          67,964          8,356,715      3,042,308            271,309         11,738,296
 1995          64,729         15,628,125      3,421,921            913,506         20,028,281
 1996          70,912         21,843,852      3,641,947          1,211,716         26,768,427
 1997         106,213            135,729      3,011,003          1,477,071          4,730,016
 1998          24,066         14,243,962      1,111,818          1,463,678         16,843,524
 1999          13,124         (8,942,848)       254,813            161,601        (8,513,310)
  Total       398,646         74,671,713     21,705,244          8,120,573        104,896,176

         Mr. Dorf examined and analyzed petitioner’s annual revenues

and retained earnings from 1991 through 2000 and Mr. Wechsler’s

compensation for the 1992 through 1999 years in issue, as

follows:
 FYE       Retained       Percentage                  Percentage      Mr. Wechsler’s Percentage
May 31     Earnings         Change       Revenue        Change         Total Comp.      Change


 1991     $18,043,103         --       $14,763,269        --                   No data           --
 1992      21,336,807         18%       15,466,673         5%              $4,390,000            --
                                                                           1
 1993      26,923,441         16        17,834,269        15                 4,905,000           12%
 1994      24,821,032         -8        11,738,296       -34                 7,090,000           45
                                                                            1
 1995      31,870,981         28        20,028,281        71                  5,875,000         -17
 1996      44,546,634         40        26,768,427        34                 5,390,000           -8
 1997      40,248,943        -10         4,730,016       -82                 1,390,000         -74
 1998      42,859,076          6        16,843,524       256                 7,487,000         439
 1999      26,949,031        -37        (8,513,310)      n/a                1,494,771          -80
 2000      50,887,981         88        15,693,799       n/a                  No data        No data
       1
         As determined in our findings, Mr. Wechsler’s actual total annual
compensation for 1993 was $4,890,000 and his actual total annual compensation for
1995 was $5,860,000.

         Mr. Dorf concludes:

              There appears to be a relationship between * * *
         [petitioner’s] performance and Mr. Wechsler’s
         compensation levels. While compensation levels in 1994
         and 1998 were higher than expected in light of the
         decrease in Fiscal Year End performance of * * *
                              - 43 -

     [petitioner], I believe that the average compensation
     received by Mr. Wechsler over the eight-year period,
     $4,752,721, is justified and reasonable based on
     industry standards and taking into consideration the
     full scope of Mr. Wechsler’s responsibilities, and his
     integral involvement in the financial profitability of
     the Company.

     Mr. Dorf did not perform an analysis of whether a

hypothetical independent investor would have been satisfied with

the rate of return on that investor’s investment in petitioner.

He did, however, testify that, while petitioner’s other officer-

shareholders Mr. Glickman, Mr. Zeeman (and Mr. Zeeman’s estate),

and Mr. Solomon were not independent investors as such, they had

done well on their respective investments in petitioner’s common

stock when they sold their shares back to petitioner in August

1997 or November 1999.   He acknowledged that their shares were

not valued at market prices but essentially had been valued under

a formula prescribed by an agreement between each of them and

petitioner.   See further discussion of this point infra note 11.

     With respect to the approach of petitioner’s first expert,

Mr. Matthews, Mr. Dorf testified that Mr. Matthews’s approach in

drawing an analogy between petitioner and 27 larger (some

substantially larger) companies was unreliable because of the

disparity in size between the subject company (petitioner) and

the comparables selected by Mr. Matthews.   Mr. Dorf explained

that, in selecting comparable companies, he seeks companies that

range from 50 percent to 200 percent the size of the subject
                                - 44 -

company in terms of assets, revenues, and net equity.    He stated

that, when comparable companies in that range are found, a direct

comparison of the subject company to those companies may be made

and reliable conclusions may be drawn concerning the

reasonableness of the compensation paid by the subject company.

He testified that, when companies disproportionately greater in

size (beyond that range) are used and compared to the subject

company, any conclusions drawn with respect to the reasonableness

of the compensation paid by the subject company are likely to be

inaccurate and unreliable.

     C.   Respondent’s Expert, Scott D. Hakala

     Scott D. Hakala is a principal and director of CBIZ

Valuation Group, Inc., an appraisal, financial advisory, and

litigation support firm.     Mr. Hakala has a doctorate in

economics, has worked as an economist and financial analyst, and

has testified on numerous occasions as an expert witness on

valuation and other business matters.     The Court accepted him as

a compensation expert.

     Mr. Hakala opined that petitioner substantially

overcompensated Mr. Wechsler during the years in issue.      He

believed that Mr. Wechsler not only was handsomely compensated in

petitioner’s very profitable years but also received high bonuses

even in petitioner’s down years, including its loss years.        He

reasoned that an independent investor would object to such
                               - 45 -

compensation practices because they would place that investor in

the position of absorbing all of the downside in petitioner’s bad

years while not adequately allowing that investor to benefit from

and share in the upside in petitioner’s good years.

     Mr. Hakala suggested a method for reasonably compensating

Mr. Wechsler and petitioner’s other top managers under which Mr.

Wechsler and those managers, in addition to their salaries, would

receive annual bonuses totaling 20 percent of petitioner’s

profits for that year before payment of bonuses.    Mr. Hakala

explained that his approach would allow an independent investor

to obtain most of the profits from petitioner’s good years, yet

require that investor to absorb all of the downside from

petitioner’s bad years.    He added that incentive compensation for

hedge fund managers is commonly set at 20 percent of the fund’s

annual trading profits.    Mr. Hakala further determined that his

prescribed annual “bonus pool” money for petitioner’s managers

would then be allocated 40 percent to Mr. Wechsler and 60 percent

to the other managers.    He based that allocation on certain

surveys of other finance industry companies in which the highest

paid officer in a surveyed company typically received around 30

percent to 40 percent of total officer compensation.    Many of the

companies covered in those surveys were much larger than

petitioner.
                                  - 46 -

      Mr. Hakala opined that reasonable compensation for Mr.

Wechsler for petitioner’s 1992 through 1999 fiscal years would be

as follows:

                                                       Total
FYE May 31          Base Salary            Bonus   Compensation

   1992              $390,000           $776,768     $1,166,768
   1993               405,000            961,895      1,366,895
   1994               390,000            511,130        901,130
   1995               420,000          1,053,086      1,473,086
   1996               390,000          1,536,230      1,926,230
   1997               390,000              --           390,000
   1998               415,000            877,817      1,292,817
   1999               571,694              --           571,694

IV.   Application of Reasonable Compensation Factors

      A.   Role in the Company

      This factor focuses on the employee’s importance to the

success of the business.    Pertinent considerations include the

employee’s position, hours worked, and duties performed and the

general importance of the employee to the company.     Rapco, Inc.

v. Commissioner, 85 F.3d at 954-955; Elliotts, Inc. v.

Commissioner, 716 F.2d at 1245.

      Since at least as early as 1988, Mr. Wechsler has been

petitioner’s key employee and the primary reason for its overall

success.    He has worked long hours, been intimately involved in

managing petitioner’s business, and closely supervised all of

petitioner’s investment and trading activities.

      In contrast to the evidence concerning Mr. Wechsler, the

evidence is sketchy concerning the work performed by Mrs.
                              - 47 -

Wechsler and Gilbert, the hours they worked, and their importance

to petitioner’s business.   Petitioner offered no testimony from

either Mrs. Wechsler or Gilbert.   Although Mrs. Wechsler had

previously worked in the financial industry, she had not worked

outside her home from the late 1970s until July 14, 1998, when

petitioner hired her and agreed to pay her minimum annual

compensation of about $500,000.    Upon being hired by petitioner,

she became petitioner’s secretary and a director.    She became a

full registration/general securities representative in February

1999 and a general securities principal in June 1999.     Mr.

Wechsler estimated that during petitioner's 1999 fiscal year she

devoted 70 percent of her time to office management and 30

percent to portfolio research.

     The credible evidence of record is even more vague

concerning what, if any, “consulting work” Gilbert performed for

petitioner during petitioner’s 1992 and 1993 fiscal years.

Gilbert already worked full time as a lighting designer at the

Metropolitan Opera.   In his testimony, Mr. Wechsler essentially

claimed that Gilbert spent an unspecified amount of time in

petitioner’s office, consulted with Mr. Wechsler on scientific

and technical matters, and was also going to help introduce Mr.

Wechsler to potential investors (ostensibly people whom Gilbert

knew from working at the Metropolitan Opera over the years) in

the hedge fund Mr. Wechsler was then contemplating establishing.
                              - 48 -

We find Mr. Wechsler’s testimony self-serving and unconvincing.10

We note that petitioner offered no other evidence (e.g.,

testimony from Gilbert, petitioner’s other employees, or

potential investors) that Gilbert performed any services for

petitioner.   We infer that petitioner’s failure to offer such

evidence means such evidence would have been unfavorable to

petitioner’s case.   See Wichita Terminal Elevator Co. v.

Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th

Cir. 1947).

     This factor supports petitioner with respect to the

compensation paid to Mr. Wechsler and respondent with respect to

the compensation paid to Mrs. Wechsler and Gilbert.



     10
        Mr. Wechsler acknowledged that petitioner’s 1992 and
1993 payments to Gilbert were, in unspecified part, for Gilbert’s
agreeing to the estate tax installment payment elections made by
their father’s and mother’s estates. Mr. Wechsler explained that
Gilbert (as either cofiduciary or cobeneficiary of their parents’
respective estates and the trusts established by their father)
greatly helped petitioner and Mr. Wechsler by agreeing to elect
to pay the estate taxes owed by the two estates on the
installment basis. He said that the installment tax payment
elections allowed petitioner to keep more of its capital to use
in its business, because petitioner then did not have to redeem
immediately substantially more preferred shares in order to pay
the estate taxes owed. Gilbert’s actions as a cofiduciary of the
estates in making the elections, however, do not constitute work
performed for petitioner. Petitioner does not argue that its
payments to Gilbert for his agreeing to the installment payment
elections are otherwise deductible under sec. 162 as ordinary
and necessary business expenses (other than compensation)
directly connected with or proximately resulting from
petitioner’s business. See secs. 161, 162(k), 261, 263;
Kornhauser v. United States, 276 U.S. 145, 153 (1928).
                               - 49 -

     B.   Comparison With Other Companies

     This factor compares the employee’s compensation with that

paid by similar companies for similar services.    Rapco, Inc. v.

Commissioner, supra at 954-955; Elliotts, Inc. v. Commissioner,

supra at 1246; see sec. 1.162-7(b)(3), Income Tax Regs.

     The record reflects that petitioner functioned as a broker-

dealer during all the years in issue, that it had substantial

investments in micro-cap stocks as well as other securities

during those years, and that it sharply reduced its activities as

a broker-dealer in 1997 to concentrate on its own trading and

investments.   We find that the parties’ experts failed to show

that their surveys identified any securities investment and

trading companies similar to petitioner whose chief executive

officers or principal managers rendered services similar to Mr.

Wechsler’s.    Indeed, petitioner’s second expert, Mr. Dorf,

acknowledged that petitioner is very different from other broker-

dealers and that he could not find any broker-dealers reasonably

comparable to petitioner against whom petitioner could directly

be compared or measured.   Consequently, with respect to the

reasonableness of the compensation paid by petitioner to Mr.

Wechsler, this factor is neutral.    Labelgraphics, Inc. v.

Commissioner, 221 F.3d 1091, 1098 (9th Cir. 2000), affg. T.C.

Memo. 1998-343.
                              - 50 -

     Also, no expert testimony was given concerning the

reasonableness of the compensation paid by petitioner to either

Mrs. Wechsler or Gilbert.   No attempt was made to compare the

compensation paid to Mrs. Wechsler or Gilbert with the

compensation paid to employees rendering similar services in

similar companies, nor is the Court convinced that their services

were unique, making any attempt at comparisons fruitless.     As

with petitioner’s failure to offer evidence with respect to the

services Gilbert performed for petitioner, we infer that

petitioner’s failure to offer comparative evidence means such

evidence would have been unfavorable to petitioner.     See Wichita

Terminal Elevator Co. v. Commissioner, supra.      Consequently, with

respect to the compensation petitioner paid to Mrs. Wechsler and

Gilbert, this factor is negative.

     C.   Character and Condition of the Company

     This 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.   Rapco, Inc. v.

Commissioner, 85 F.3d at 954-955; Elliotts, Inc. v. Commissioner,

716 F.2d at 1246.

     Petitioner was a relatively small broker-dealer that had

secured a prominent market niche as a specialist in convertible

securities.   It enjoyed an excellent, longstanding reputation for
                                 - 51 -

its expertise as a market maker in convertible securities.    From

1992 until 1997, petitioner listed and traded as a market maker

approximately 350 convertible securities, a far greater number of

securities than its competitors.

     In 1992, petitioner moved its office from New York City to

Mt. Kisco, New York.   Shortly thereafter, it outsourced its back-

office operation, resulting in a substantial reduction in the

number of its employees.   Even before 1997, petitioner and Mr.

Wechsler had started to change the focus of petitioner’s business

on account of changed business conditions for market makers in

convertible securities.    In 1997, petitioner sharply reduced the

number of convertible securities and stocks it listed and traded

as a market maker and decided to emphasize trading and investing

for its own account.   That resulted in a further decrease in

petitioner’s employees and management team members.

     In sum, both before and during the years in issue,

petitioner was a successful, well-managed, but relatively small,

investment and trading company with a very lean management team.

This factor supports petitioner.

     D.   Conflict of Interest

     This factor examines whether a relationship exists between

the company and the employee that might permit the company to

disguise nondeductible corporate distributions as section

162(a)(1) compensation payments.     Thus, close scrutiny must be
                               - 52 -

given where the paying corporation is controlled by the

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

Commissioner, supra at 954-955; Elliotts, Inc. v. Commissioner,

supra at 1246-1247.   Also, the existence of a family relationship

may indicate that the terms of a compensation arrangement may not

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

Commissioner, supra at 1246.   However, the mere fact that the

individual whose compensation is under scrutiny is the sole

shareholder of the company, even when coupled with an absence of

dividend payments, “does not necessarily lead to the conclusion

that the amount of compensation is unreasonably high.”     Id.

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.

     Clearly, Mr. Wechsler’s relationship to petitioner

influenced petitioner’s payments of compensation to Mrs. Wechsler

and Gilbert, some or all of which were not reasonable

compensation for services rendered to petitioner and, we suspect,

were disguised dividends to Mr. Wechsler.     We thus carefully

examine petitioner’s corporate motives in making the payments in

question to Mr. Wechsler.

     As set forth in our findings, principal managers of

financial industry investment and trading companies typically
                              - 53 -

receive a substantial portion of their annual compensation from

incentive compensation or bonuses tied to their company’s

earnings and profitability for that year.   Yet, contrary to

petitioner’s experts’ (Messrs. Matthews’s and Dorf’s) claims, no

strong linkage existed between petitioner’s financial performance

in a given year and Mr. Wechsler’s bonuses and total compensation

for that year.   We agree with respondent’s expert, Mr. Hakala,

that petitioner’s compensation practice as to Mr. Wechsler would

put an independent investor in the highly disadvantageous

position of absorbing all the downside in petitioner’s bad years

while causing that investor to share inadequately in the upside

in petitioner’s good years.   In our opinion, all of the foregoing

strongly indicates that the $37.992 million petitioner paid Mr.

Wechsler from 1992 through 1998 was not reasonable compensation,

and he was overcompensated during the 1992 through 1999 years in

issue.   See Rapco, Inc. v. Commissioner, supra at 955 (sustaining

Tax Court’s determination as to unreasonableness of controlling

shareholder’s compensation because, among other things, (1)

taxpayer-corporation’s compensation scheme was bonus-heavy and

salary-light, suggesting masked dividends, (2) taxpayer could

point to no consistent method for bonus calculation, and (3) as

ultimate decision-maker as to his own pay, controlling
                                - 54 -

shareholder had a definite conflict of interest).11    This factor

strongly supports respondent.

     E.    Internal Consistency in Compensation

     This 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,

Inc. v. Commissioner, 716 F.2d at 1247; see also Rapco, Inc. v.

Commissioner, 85 F.3d at 954.


     11
        On brief, petitioner argues that Mr. Wechsler’s
compensation for most of the years in issue should be considered
reasonable because three other unrelated shareholders in
petitioner--Mr. Glickman, Mr. Zeeman, and Mr. Solomon--
purportedly approved that compensation. Petitioner’s reliance
upon Mr. Glickman’s, Mr. Zeeman’s and Mr. Solomon’s alleged
approval of the compensation petitioner paid Mr. Wechsler,
however, is misplaced. Mr. Wechsler was petitioner’s controlling
shareholder and owned a majority of its common shares sufficient
to elect a majority of petitioner’s directors. In contrast, Mr.
Glickman, Mr. Zeeman, and Mr. Solomon (who were also full-time
employees and officers of petitioner) owned small minority stock
interests in petitioner. Their continued employment was subject
to Mr. Wechsler’s authority. Mr. Glickman, Mr. Zeeman, and Mr.
Solomon thus cannot substitute for the inactive, hypothetical
independent investor under the independent investor test adopted
by the Court of Appeals for the Second Circuit and other courts.
See Rapco, Inc. v. Commissioner, 85 F.3d 950, 954-955 (2d Cir.
1996), affg. T.C. Memo. 1995-128; Elliotts, Inc. v. Commissioner,
716 F.2d 1241, 1245, 1247 (9th Cir. 1983), revg. T.C. Memo. 1980-
282; Haffner’s Serv. Stations, Inc. v. Commissioner, T.C. Memo.
2002-38, affd. 326 F.3d 1 (1st Cir. 2003).
                                - 55 -

     As previously discussed, Mr. Wechsler was paid large bonuses

even in petitioner’s down and loss years.    Contrary to the claims

of petitioner’s experts, no strong linkage existed between the

bonuses and total compensation paid to Mr. Wechsler for a given

year and petitioner’s financial performance for that year.

Neither petitioner nor its experts established any consistent

method for calculating Mr. Wechsler’s bonuses for the years in

issue.12   See Rapco, Inc. v. Commissioner, supra at 955.

     With respect to Mrs. Wechsler’s compensation for

petitioner’s 1999 fiscal year, she started working for petitioner

that year and also served as petitioner’s secretary and a member

of its board.   Petitioner paid her a $178,154 salary and a

$308,000 bonus for that year.    Petitioner’s 1999 fiscal year

FOCUS report reflects negative earnings before Federal income tax

(EBFIT) of $15,768,385 and substantial declines in retained



      12
        As discussed infra, some of petitioner’s other employees
received bonuses for petitioner’s 1999 fiscal year--a bad year
for petitioner. We have no reason to question the arm’s-length
nature and reasonableness of the 1999 bonuses paid to those
employees who (unlike Mrs. Wechsler) were unrelated to Mr.
Wechsler. We believe, however, that the method used to
compensate Mr. Wechsler should differ materially from the method
used to compensate petitioner’s other employees, in light of the
crucial importance of Mr. Wechsler’s services to petitioner and
petitioner’s business. We think an independent investor, to
secure Mr. Wechsler’s services in an arm’s-length arrangement, on
the one hand, would have to provide a method whereby Mr. Wechsler
potentially could earn much higher annual pay from petitioner
than petitioner’s other employees. Such a method for reasonably
compensating Mr. Wechsler, on the other hand, would also closely
tie his annual bonuses to petitioner’s earnings and profitability
in a given year.
                               - 56 -

earnings and capital stock.    Notwithstanding petitioner’s poor

performance for its 1999 fiscal year, Mrs. Wechsler received a

substantial 1999 bonus of $308,000.     The record reflects that

(except for Mr. Wechsler) petitioner’s other employees received

far lower bonuses for the 1999 fiscal year than Mrs. Wechsler

received.   For example, petitioner paid Matt Dickinson (its vice

president and a principal, who had worked for petitioner since

January 1989) a 1999 salary of $149,969 and a 1999 bonus of

$115,768; petitioner paid Michael Revy (its vice president and a

principal, who had worked for petitioner since August 1998) a

1999 salary of $208,000 and a 1999 bonus of $188,000; it paid Mr.

Mittentag (its chief financial officer) a 1999 salary of $179,385

and a 1999 bonus of $43,461.

     Mr. Wechsler set the amounts of petitioner’s 1999 payments

to Mrs. Wechsler.   According to Mr. Wechsler, Mrs. Wechsler

agreed to work for petitioner only if she were paid at least

about $500,000 annually.   That $500,000 minimum annual pay to

her, however, is substantially higher than the 1999 annual

salaries of the aforementioned officers who were unrelated to Mr.

Wechsler and is also significantly higher than Mr. Wechsler’s

1992 through 1998 annual salaries.13    We are unpersuaded that


     13
        On brief, petitioner argues that Mrs. Wechsler’s
compensation and Gilbert’s compensation were reasonable when
compared to the compensation paid certain other employees of
petitioner, such as Mr. Lobel, who was paid $434,000 for fiscal
year 1998. Petitioner notes that respondent did not challenge
                                                   (continued...)
                              - 57 -

there was internal consistency in salary payments throughout

petitioner’s ranks.   This factor also strongly favors respondent.

     F.   Mr. Wechsler’s Loans to Petitioner

     In some circumstances, a key employee-shareholder’s

interest-free loans to the corporation may weigh in favor of

higher compensation to that employee.   See Owensby & Kritikos,

Inc. v. Commissioner, 819 F.2d at 1325 n.33 (noting that key

employee-shareholders’ personal guaranties of loans to the

corporation also weighed in favor of munificent compensation, but

stating that the record was unclear as to the riskiness of the

loans); R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 51 (1972)

(similar).

     Mr. Wechsler made short-term cash loans to petitioner during

September and October 1998.   During those months, beginning on

September 1, Mr. Wechsler made loans to petitioner totaling

$2,562,400 which petitioner repaid between September 24 and



     13
      (...continued)
petitioner’s deduction of the compensation paid to those
employees. Petitioner, however, has made no meaningful attempt
to compare the qualifications of and services rendered by those
employees to the qualifications of and services rendered by Mrs.
Wechsler and Gilbert. As a result, we have no way of knowing how
similar the services performed by those other employees were to
the services performed by Mrs. Wechsler and Gilbert. Moreover,
those other employees (unlike Mrs. Wechsler and Gilbert) were
unrelated to Mr. Wechsler. Presumably, Mr. Wechsler determined
and set the compensation that petitioner paid to those other
employees (who were not close family members of Mr. Wechsler) in
an arm’s-length manner. The same cannot be said of the
compensation Mr. Wechsler had petitioner pay to his wife and to
his brother.
                                   - 58 -

October 21.        On October 8, 1998, Mr. Wechsler lent petitioner

securities with a market value of $1,479,453.         Six days later, on

October 14, 1998, petitioner returned those securities to Mr.

Wechsler.        Petitioner fails to suggest an appropriate interest

rate by which to measure any implicit interest payment to Mr.

Wechsler on account of those loans.         For simplicity, we shall

assume an annual interest rate of 10.4 percent (0.0285 percent a

day, based on a 365-day year),14 no compounding, the total of the

cash loans, $2,562,400, to be outstanding for 51 days, and the

securities loan, value of $1,479,453, to be outstanding for 7

days.        Interest forgone on the cash loans and the security loan

would be $37,245 and $2,952, respectively, for a total of

$40,197.        We shall take that amount into account in determining

reasonable compensation to Mr. Wechsler for fiscal year 1999.

V.   Reasonable Compensation Determinations

      A.       Reasonable Compensation to Mrs. Wechsler

      In the light of the preceding discussion, we conclude that

the $486,154 in total compensation petitioner paid Mrs. Wechsler

for its 1999 fiscal year is not reasonable compensation and that

petitioner overcompensated her for that year.         We think, however,

that reasonable compensation to her for that year exceeds the

$150,000 respondent allowed in the notice of deficiency.         Bearing



        14
        The interest rate of 10.4 percent is the annual rate of
return that Mr. Matthews determined would be satisfactory to an
independent equity investor.
                              - 59 -

heavily against petitioner since the inexactitude in this case is

of its own making, and using our best judgment, we conclude that

reasonable compensation to Mrs. Wechsler for petitioner’s 1999

fiscal year is $253,154.   This $253,154 in reasonable

compensation includes the $178,154 in annual salary that

petitioner paid her and a $75,000 bonus to her for that year.

See Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930).     We

hold that petitioner can deduct this $253,154 in reasonable

compensation under section 162(a)(1) for that year.      We further

hold that petitioner cannot deduct the remaining $233,000 in

compensation (above the $253,154 we have determined to be

reasonable) that it paid Mrs. Wechsler for that year.      See secs.

1.162-7(a), 1.162-9, Income Tax Regs.

     B.   Reasonable Compensation to Gilbert

     Petitioner has failed to establish that any portion of the

amounts in issue paid by petitioner to Gilbert for its 1992 and

1993 fiscal years is reasonable compensation.   Petitioner has not

persuaded us that Gilbert performed any services of value for

petitioner during the years in issue.   Consequently, we sustain

respondent’s determinations that the $80,359 and $108,097 paid by

petitioner to Gilbert for its 1992 and 1993 fiscal years,

respectively, are not deductible by petitioner under section

162(a)(1).
                                - 60 -

     C.   Reasonable Compensation to Mr. Wechsler

            1.   Introduction

     We believe that an appropriate method for reasonably

compensating Mr. Wechsler for each of the years in issue should

be based upon his receiving (1) an annual salary and (2) an

annual bonus that is closely tied to petitioner’s earnings and

profitability for that year.     We reach that conclusion because we

are persuaded by respondent’s expert (Mr. Hakala) of the

appropriateness of that method.     We are not persuaded by the

approach of either of petitioner’s experts.     Our reasons follow.

            2.   Expert Testimony

            a.   Petitioner’s Experts

            i.   Mr. Matthews

     We give little if any weight to Mr. Matthews’s opinion

concerning the reasonableness of the compensation petitioner paid

Mr. Wechsler for the years in issue to the extent it is based on

his comparisons between petitioner and the 27 broker-dealers he

examined.    We are persuaded by Mr. Dorf that Mr. Matthews’s

approach in drawing an analogy between petitioner and the 27

broker-dealers is unreliable because of the disparity in size

between petitioner and those companies.     See B & D Founds., Inc.

v. Commissioner, T.C. Memo. 2001-262 n.25 (rejecting expert’s

assumption that same mathematical relationship, calculated

through regression analysis, between various surveyed companies’
                              - 61 -

sales or net income and those companies’ compensation to their

executives, should hold equally true for taxpayer-corporation;

surveyed companies were many times the size of taxpayer and were

not reasonably comparable to taxpayer).

     Nor has Mr. Matthews convinced us that an independent

investor would be satisfied with the 10.4-percent compounded

annual rate of return on petitioner’s common stock that Mr.

Matthews computed for petitioner’s 1992 through 1998 fiscal

years.   Mr. Matthews’s written testimony is contained in two

reports, an initial report and a report made in rebuttal to the

testimony of respondent’s expert, Mr. Hakala (the rebuttal

report).   The initial report contains no support for Mr.

Matthews’s conclusion beyond his claim that the 10.4-percent rate

of return “would be highly satisfactory to most equity

investors.”   In the rebuttal report, Mr. Matthews compares

petitioner’s return on equity with 17 publicly traded broker-

dealers and finds the returns provided by petitioner to be

satisfactory to a hypothetical investor.   He also uses a

financial tool, the capital asset pricing model, to determine the

return an investor would expect for an investment in petitioner’s

common stock.   He determines that the expected return on

petitioner’s common stock is satisfactory by comparing that

return to the cost of equity determined under the capital asset

pricing model using data with respect to “beta” (a measure of the
                              - 62 -

risk that compares the volatility of a specific stock to the

market as whole) representing the median beta for six “smaller”

publicly traded broker-dealers.

     Mr. Matthews has failed to persuade us of the reliability of

his return-on-equity comparison between the 17 broker-dealers and

petitioner because he has failed to convince us that the 17

broker-dealers are comparable to petitioner, whose business

interests were varied, as described in our findings of fact, and

include an increasing concentration on its own proprietary

trading and short-term and long-term investments.   He has

likewise failed to persuade us that his capital asset pricing

model analysis is reliable because he has failed to persuade us

of the comparability to petitioner of the six publicly traded

“smaller” companies that he used to determine beta.

     We also question whether a 10.4-percent compounded annual

rate of return would be “highly satisfactory” to an independent

investor in petitioner when compared to the compensation paid to

petitioner over the 1992 through 1998 period.   Mr. Matthews’s

calculations show that petitioner’s adjusted common stock equity

increased by $14.546 million, from $14.533 million to $29.079

million during that period.   For that same period, petitioner

compensated Mr. Wechsler $37.992 million.    That $37.992 million

is more than 2.5 times the $14.546 million increase in

petitioner’s adjusted common stock equity.   Thus, for each dollar
                                - 63 -

of increase in equity over 1992 through 1998, petitioner paid Mr.

Wechsler $2.50.    While that may be an appropriate fee for

wringing profits out of some dubious investment, it seems

unreasonable for producing a compound rate of return of only 10.4

percent over 7 years when, according to Mr. Matthews’s rebuttal

report, the average risk-free rate of return during each May of

1992 through 1998 was approximately 7 percent.    Moreover, the

$37.992 million paid to Mr. Wechsler is substantially more than

even petitioner’s own adjusted common stock equity of $29.079

million and total adjusted (common and preferred) stock equity of

$30.147 million at the end of petitioner’s 1998 fiscal year.      Mr.

Matthews has failed to convince us that, for the 10.4-percent

compound rate of return Mr. Wechsler produced for petitioner’s

1992 through 1998 fiscal years, an independent investor would

approve of paying him $36.497 million in total compensation.

          ii.     Mr. Dorf

     Mr. Dorf, while recognizing that Mr. Wechsler’s compensation

in 1994 and 1998 was “higher than expected” (and, presumably,

therefore, more than reasonable), was of the opinion that the

average ($4,752,721) of the amounts of compensation paid Mr.

Wechsler for the 8 years in question was “justified and

reasonable”.15    Mr. Dorf based his conclusions on a number of


     15
        During the 8 years in question, the range of Mr.
Wechsler’s annual compensation was $6,097,000, from a low of
$1,390,000 (for 1997) to a high of $7,487,000 (for 1998). Mr.
                                                   (continued...)
                                    - 64 -

considerations, including petitioner's performance, Mr.

Wechsler’s responsibilities to, and the services he provided for,

petitioner, as well as general economic conditions and the nature

of petitioner’s business.         However, Mr. Dorf did not give weight

to these factors.      Nor did he provide a method of analysis that

an independent investor could use to determine whether Mr.

Wechsler’s compensation was reasonable or unreasonable in a given

year.     He merely concluded without explanation that, in the light

of the factors he considered, Mr. Wechsler’s average compensation

was reasonable.      Mr. Dorf’s “trust-me” approach does not aid us

substantially in determining whether an independent investor

would be satisfied in any given year with the compensation paid

Mr. Wechsler or whether that payment was reasonable, within the

meaning of section 162(a)(1).

            iii.     Conclusion

     Neither of petitioner’s experts’ approaches provides a

reliable method for determining whether the amounts of

compensation paid to Mr. Wechsler during the years in issue were

reasonable.

            b.     Respondent’s Expert

     Mr. Hakala opined that the base salaries paid Mr. Wechsler

throughout the relevant period were reasonable but that the



     15
      (...continued)
Dorf’s average differs from the average ($4,748,971) we calculate
from the annual compensation amounts stipulated by the parties.
                              - 65 -

bonuses paid were unreasonable.   Mr. Hakala based his opinion on

compensation practices in the investment industry.   He opined

that, in the investment industry, management is typically paid 20

percent of pretax profits as incentive compensation.   Mr. Hakala

opined that 20 percent of petitioner’s pretax profits would have

been reasonable as incentive compensation for all of petitioner’s

employees.   Mr. Hakala split the resulting pool of incentive

compensation 60/40, with Mr. Wechsler receiving 40 percent as a

reasonable bonus.   Thus, in Mr. Hakala’s view, a reasonable bonus

for Mr. Wechsler during the years at issue would have been equal

to 40 percent of 20 percent of petitioner’s profits (8 percent of

petitioner’s profits).   While we agree with Mr. Hakala’s

percentage-of-profits approach to determining incentive

compensation, we think his allocation to Mr. Wechsler is

unreasonably low.

     That allocation aside, we agree with Mr. Hakala’s

percentage-of-profits approach for the following reasons.   During

the years at issue, petitioner engaged in a range of activities.

The company acted as a broker earning commission income, as a

market maker earning income through the spread between its bid

and ask prices, as a selling agent for underwriters, and as a

proprietary trader exploiting sophisticated investment strategies

in the convertible bond market.   As Mr. Hakala has shown, the

concentration of petitioner’s operations make it distinguishable
                              - 66 -

from the broker-dealers Mr. Matthews identified.   Though

petitioner’s endeavors covered a range of activities during the

relevant period, proprietary trading was responsible for most of

its revenue, and commissions generated only a small percentage.

(According to the report of petitioner’s expert, Mr. Dorf, during

the audit period petitioner reaped only 0.4 percent of its income

from commissions, whereas most of its income came from its

investments.)

     Because petitioner carried on a unique mix of investment

services and trading operations, it would be difficult, if not

impossible, to neatly classify its business.   Rather, at best,

petitioner could be described only as a business offering a

unique combination of financial services and investments.    Thus,

in determining reasonable incentive compensation for Mr.

Wechsler, we are unable to look to the compensation practices of

any single business or any single type of business for guidance.

Rather, we must look more generally to compensation practices in

the investment industry.

     As a basis for determining reasonable incentive compensation

for Mr. Wechsler, we therefore adopt Mr. Hakala’s percentage-of-

profits approach, which he argues is customary in the investment

industry.   According to Mr. Hakala’s calculations, an independent

investor in petitioner would have received a reasonable return on

equity had petitioner’s incentive compensation been limited to 20
                              - 67 -

percent of petitioner’s profits.    Mr. Hakala compared his

calculated return for petitioner with the returns an independent

investor would have received by investing in other investments

consisting of similar securities.

     While we adopt Mr. Hakala’s percentage-of-profits approach,

we believe that a 20-percent-of-profits bonus pool divided 40/60

between Mr. Wechsler and other bonus-paid employees would under-

compensate Mr. Wechsler, rewarding him with only 8 percent of

petitioner’s annual pre-bonus profits.    In comparison to the

other financial industry companies that Mr. Hakala examined,

petitioner is a small company that had a much smaller workforce

and an extremely lean management team.    Following its move to Mt.

Kisco, New York, and the outsourcing of its back-office

operations, petitioner in late 1992 had approximately 20

employees.   By 1999, the number of petitioner’s employees

decreased to 12.   Consideration of petitioner’s relatively small

size and workforce, we believe, demonstrates Mr. Wechsler’s

indispensable role in the success of petitioner’s business.      We

have no basis for concluding that the chief executives of the

companies Mr. Hakala surveyed provided similar services and

shouldered responsibilities comparable to the services Mr.

Wechsler provided and the responsibilities he shouldered.     Mr.

Wechsler organized petitioner, served as its principal manager,

worked long hours, ensured its compliance with all relevant
                               - 68 -

regulations, and closely supervised all of its investment and

trading activities.   In essence, Mr. Wechsler single-handedly

managed the business during the years at issue, and an

independent investor holding equity in petitioner would have been

investing predominantly, if not exclusively, in the trading and

business judgment of Mr. Wechsler.

          3.   Reasonable Compensation

     We believe that the foregoing analysis justifies more

compensation to Mr. Wechsler than that determined by Mr. Hakala,

and an appropriate method for reasonably compensating Mr.

Wechsler for each of the years in issue should be based upon his

receiving (1) an annual salary and (2) an annual bonus that (A)

reflects his virtually exclusive responsibility for petitioner’s

achievements and (B) is closely tied to petitioner’s earnings and

profitability for each year.

     In evaluating petitioner’s annual financial performance

during the years in issue, all three experts (Messrs. Dorf,

Hakala, and Matthews) used the earnings reported in petitioner’s

annual FOCUS reports, recognizing that those earnings were

computed by marking to market all securities petitioner then

held, including those held for investment.   Messrs. Dorf, Hakala,

and Matthews each considered petitioner’s annual FOCUS report

earnings to be a more accurate indicator of petitioner’s

financial performance in a given year than the earnings reported
                                       - 69 -

on petitioner’s tax returns, and we accept that aspect of their

opinions.

      We conclude that reasonable compensation to Mr. Wechsler for

the years in issue would include petitioner’s payment to him of

(1) the annual salaries he received, (2) for 1999, a payment of

$40,917 to reflect interest, and (3) a yearly bonus equal to 20

percent of petitioner’s adjusted EBFIT before petitioner’s

payment of any bonus to Mr. Wechsler for that year.16

      Using the above method for determining Mr. Wechsler’s

compensation, we calculate that reasonable compensation to Mr.

Wechsler for petitioner’s 1992 through 1999 fiscal years in issue

is as follows:
                              Annual         Adj. EBFIT   Annual Bonus3
  FYE May 31     Salary       Adj. EBFIT1   Before Bonus2 and Interest    Total Comp.

    1992        $390,000      $4,002,465      $8,002,465     $1,600,493    $1,990,493
    1993         390,000       6,281,781      10,781,781      2,156,356     2,546,356
    1994         390,000      (1,910,871)      4,789,129        957,826     1,347,826
    1995         405,000       6,404,771      11,859,771      2,371,954     2,776,954
    1996         390,000      12,927,869      17,927,869      3,585,574     3,975,574
    1997         390,000      (4,295,611)     (3,295,611)        -0-          390,000
    1998         415,000       2,911,631       9,983,631      1,996,726     2,411,726
    1999         571,694     (15,535,385)    (14,612,309)        40,197       611,891
       1
         EBFIT for that year, plus (if any) disallowed, nondeductible compensation for
that year paid by petitioner to Mrs. Wechsler or Gilbert.
       2
         Adjusted EBFIT for that year, plus December and May bonuses for that year
actually paid by petitioner to Mr. Wechsler.
       3
         Equal to 20 percent of adjusted EBFIT before bonus for that year (rounded to
nearest dollar) plus, for 1999, $40,197, as a payment of interest.




       16
        Petitioner’s adjusted EBFIT is the EBFIT reported on its
FOCUS report for that year, increased by any disallowed,
nondeductible compensation petitioner paid for that year to Mrs.
Wechsler or Gilbert.
                                - 70 -

For petitioner’s 1992 through 1999 fiscal years in issue, this

results in reasonable compensation to Mr. Wechsler totaling

$16,050,820.

     We estimate that this results in petitioner’s having a

compounded annual return on its revised common stock equity,

adjusted for deferred taxes, of approximately 16.3 percent for

its 1992 through 1998 fiscal years.      That calculation is as

follows:

                               Revised Adj.                Compounded
                Adj. Common    Common Stock      Annual      Annual
                Stock Equity     Equity          Rate of     Rate of
  FYE May 31    (millions)1    (millions)2       Return3     Return4

     1991         $14.533       $14.533           --           --
     1992          16.924        18.412           26.7%      26.7%
     1993          19.828        22.768           23.7       25.2
     1994          18.100        24.485            7.5       19.0
     1995          22.893        31.128           27.1       21.0
     1996          30.177        39.261           26.1       22.0
     1997          27.591        37.205           (5.2)      17.0
     1998          29.079        41.738           12.2       16.3
     1999          19.539        32.868          (21.2)      10.7
     1
         Common stock equity per annual FOCUS report, less deferred
taxes.
     2
       Adjusted common stock equity, plus cumulative estimated
additional after-tax earnings attributable to petitioner’s
increased positive taxable income for prior years and current
year from disallowed, nondeductible compensation paid to Mr.
Wechsler, Mrs. Wechsler, and Gilbert, assuming those increases in
positive taxable income were subject to combined Federal and
State income taxes equal to 40 percent.
     3
       Increase or decrease for that year in revised adjusted
common stock equity, divided by revised adjusted common stock
equity at beginning of that year.
     4
       Computed using a present-value-future-value formula where:
Present value equals revised adjusted common stock equity of
                               - 71 -

$14.533 million   on June 1, 1991; future value equals revised
adjusted common   stock equity at the end of the period in
question; and n   equals the number of years from June 1, 1991,
through the end   of that period.

     We think an independent investor would be satisfied with a

16.3-percent compounded annual return on petitioner’s revised

adjusted common stock equity from June 1, 1991, through May 31,

 1998.

     We find that $16,050,820 is reasonable compensation to Mr.

Wechsler for the 1992 through 1999 fiscal years in issue, and is,

therefore, deductible by petitioner under section 162(a)(1) for

those years in the amounts shown.    For some of the years in

issue, however, we have found that reasonable compensation paid

to Mr. Wechsler is less than allowed by respondent.    On March 23,

2005, shortly after the trial began, respondent moved for leave

to amend his answer in order to assert increased deficiencies for

the years in issue above those determined in the notice of

deficiency, in the light of the expected testimony of

respondent’s expert, Mr. Hakala.    The time for respondent to

amend his answer without leave had expired on September 1, 2004.

See Rule 41(a).    On March 23, 2005, we denied respondent’s motion

because of the lateness of its filing on the day of trial and

refused to allow respondent to seek such increased deficiencies.

We shall, therefore, not redetermine a deficiency for any year in

issue greater than respondent determined in the notice for that

year.
                              - 72 -

VI.   Conclusion

      To reflect the foregoing,


                                        Decision will be entered

                                   under Rule 155.
