                               T.C. Memo. 2017-203


                         UNITED STATES TAX COURT



    JEFFREY WYCOFF AND MERRIE PISANNO-WYCOFF, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 24158-09.                          Filed October 16, 2017.



      Steven R. Toscher and Lacey E. Strachan, for petitioners.

      Halvor R. Melom, Debra Ann Bowe, and Michael E. Washburn, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      MARVEL, Chief Judge: Respondent determined deficiencies in petitioners’

Federal income tax and section 6662(a)1 accuracy-related penalties as follows:


      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code), as amended and in effect for the years at issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure. All monetary
                                                                        (continued...)
                                        -2-

                      [*2]                       Penalty
                      Year       Deficiency    sec. 6662(a)

                      2001      $4,511,398       $902,280
                      2002         518,138        103,628

After concessions,2 the issues for decision are (1) whether two subchapter S

corporations petitioners owned, Sirius Products, Inc. (Sirius), and Restore 4, Inc.

(Restore 4),3 are entitled to deduct management fees they paid to Albion

Management, Inc. (Albion), in 2001-034 (years at issue), and (2) whether

petitioners are liable for accuracy-related penalties pursuant to section 6662(a) for

the 2001 and 2002 taxable years.




      1
      (...continued)
amounts have been rounded to the nearest dollar.
      2
        Respondent concedes that petitioners did not receive a deemed distribution
of their vested account balances in an employee stock ownership plan (ESOP)
trust under sec. 409(p)(2) in 2002. Petitioners concede that they were not entitled
to apply a net operating loss (NOL) generated in 2004 against their 2005 tax
liability, and they agree that the NOL should be applied against petitioners’ 2002
tax liability. All other issues are computational.
      3
     We will refer to Sirius and Restore 4 collectively as the operating
companies.
      4
        Although respondent did not determine a deficiency in petitioners’ 2003
Federal income tax, our determination of whether the operating companies are
able to deduct management fees paid to Albion in 2003 will affect the amount of
an NOL carryback that petitioners’ claimed on their 2001 return.
                                        -3-

[*3]                           FINDINGS OF FACT

       Some of the facts have been stipulated. The stipulations of facts are

incorporated herein by this reference. Petitioners resided in Colorado when they

petitioned this Court. The parties have stipulated that an appeal in this case would

lie to the U.S. Court of Appeals for the Tenth Circuit.

I.     Background

       Jeffrey Wycoff earned a bachelor of arts degree from Ryder College in

1975. Mr. Wycoff previously had two California State licenses: a B1 contractor’s

license and a C54 tile contractor sublicense. In 1981 he sold life insurance. At

some point between 1981 and 1985 he managed a Domino’s Pizza franchise.

From 1985 to 1991 he sold cars. From 1991 to 1995 he managed the Better Bath

of L.A. (later named Tile Pros), a construction company.

       Merrie Pisanno-Wycoff earned her bachelor of arts degree in public

relations from California State University, Chico, in 1980 and her doctor of

philosophy degree in comparative religion from the University of Sedona.

II.    Zap

       In the early 1990s petitioners asked a chemist, Dr. Marantz, to create a

chemical formula for a product that would clean tile. Dr. Marantz developed the

formula, and petitioners named the product “Zap”. Petitioners filed a trademark
                                        -4-

[*4] application for the name “Zap”. They also attempted to patent the formula

but were advised by legal counsel that it was too simple to patent. They

subsequently decided to sell Zap using a direct response marketing model,

specifically infomercials. They had previously used direct response marketing for

other products, but the marketing for many of those products was not successful.

In their experience, whether the consumer liked the product was the most

important factor in determining success. They generally expected their products to

at best have an 18-month life cycle.

III.   The Operating Companies

       A.    Sirius

       Petitioners incorporated Sirius on January 11, 1995. They initially

capitalized Sirius with funds from Tile Pros and personal credit cards. They were

the only members of Sirius’ board of directors and its only officers.

       Sirius formulated, manufactured, and marketed household chemical

products. In particular, Sirius sold Zap directly to consumers using infomercials

and to various retailers, including Wal-Mart, Costco, Bed Bath & Beyond, Linens

‘N Things, Walgreens, Target, Kroger, BJ’s, Sam’s Club, and several grocery

stores in Salt Lake City, Utah. Sirius also sold products that it developed, which

were unrelated to Zap. Sirius used direct response marketing, specifically “short
                                        -5-

[*5] form” television advertisements (approximately two minutes long), to market

its products.

      B.        Restore 4

      Petitioners incorporated Restore 4 on January 30, 1997. They initially

capitalized Restore 4 with funds from Sirius. Restore 4 sold the same products as

Sirius. They incorporated Restore 4 because Sirius could not market its products

using the various direct response companies, such as the Home Shopping Network

and QVC. The operating companies operated out of the same facility, and they

shared a common labor force.

      Restore 4 sold Zap under the name “Restore 4” (Restore 4 product).

Restore 4 owned the rights to the Restore 4 product name. Restore 4 sold the

Restore 4 product directly to consumers and through Home Depot. Restore 4

marketed its products via “long form” television advertisements (approximately 30

minutes long) and on QVC.

      C.        The Operating Companies’ Operations

      On January 1, 2001, Sirius and Restore 4 elected to be subchapter S

corporations, and they were subchapter S corporations at all times during 2001-03.

Petitioners were at all relevant times the sole officers and board members of the

operating companies. After the years at issue Restore 4 merged with Sirius.
                                        -6-

[*6] Mr. Wycoff was primarily responsible for all operations of the operating

companies. His principal duties included: negotiating contracts, overseeing

advertising purchases and content, managing the operating companies’ finances,

selling the products to retailers, and overseeing other employees’ work. In short,

Mr. Wycoff performed all managerial tasks for the operating companies. He also

referred to himself as the national sales manager and product spokesman because

of his duties in selling the products and overseeing advertisements.

IV.   The Marshall & Stevens Transaction

      On August 18, 2000, Robert Boespflug of Marshall & Stevens ESOP5

Capital Strategies Group (Marshall & Stevens) gave a presentation to Barry

Marlin, petitioners’ attorney at the time. The presentation outlined how the

operating companies and petitioners could purportedly reduce their income tax

liabilities by way of a series of transactions (collectively, Marshall & Stevens

transaction) using a subchapter S corporation, a deferred compensation plan, and

an ESOP. Petitioners did not attend this presentation. During the presentation Mr.

Boespflug’s PowerPoint slides represented that the objectives of the Marshall &

Stevens transaction were to: (1) “reduce corporate income tax liability”; (2) “defer

income/reduce personal income tax liability of owners”; (3) “get equity

      5
          ESOP is an abbreviation for employee stock ownership plan.
                                       -7-

[*7] ownership/special benefits in the hands of key people”; (4) “provide

broad-based incentives to rank & file”; and (5) “create tax advantaged structure in

preparation of future asset sale”. Marshall & Stevens’ PowerPoint slides also

represented that the proposed steps of the transaction were as follows:

      Step One: Form a new subchapter S Corporation (SMC);

      Step Two: Create deferred compensation benefits for key employees
      of operating entities;

      Step Three: Adopt ESOP/401(k) plan;

      Step Four: Sell new SMC stock to ESOP/401(k) for $1000
      promissory note;

      Step Five: Pay management fee from each operating entity to SMC.
      Adopt mgt. contracts;

      Step Six: Manage the new assets in the SMC, fund the deferred
      compensation benefits and ESOP/401(k) Plans.
                                        -8-

[*8] After the presentation Mr. Marlin and Roland Attenborough,6 an attorney

with Reish & Luftman hired by Marshall & Stevens to develop the portion of the

Marshall & Stevens transaction with respect to the ESOP, met with Mr. Wycoff to

discuss the transaction. After the meeting Mr. Wycoff instructed Mr. Marlin to

review the transaction. Mr. Marlin’s review consisted solely of discussions with

two accounting firms. Mr. Marlin did not provide petitioners with a written legal

opinion. On the basis of Mr. Marlin’s limited review petitioners decided to

implement the transaction, and on August 28, 2000, petitioners, on behalf of

Sirius, executed a contract with Marshall & Stevens to implement the Marshall &




      6
        Trial was held in this case on August 13 and 14, 2012. During the course
of posttrial proceedings the Court became aware of a potential conflict of interest
involving petitioners’ then counsel, Jeffrey D. Davine, an attorney associated with
Mitchell Silberberg & Knupp, LLP. At the time of trial Mr. Attenborough was
and had been, since before the filing of the petition, an attorney also associated
with Mitchell Silberberg & Knupp, LLP. After discussing the matter with the
parties the Court gave petitioners’ counsel time to resolve the potential conflict of
interest by obtaining the informed consent of petitioners to counsel’s continuing
representation. After consultation with independent counsel petitioners advised
their counsel and the Court that they would not provide the requested waiver.
Consequently, petitioners’ former counsel withdrew his representation and new
counsel entered an appearance for petitioners. In an order dated January 4, 2014,
we concluded that petitioners’ former counsel had an imputed conflict of interest,
and we reopened the record for petitioners to, inter alia, present evidence as to the
reasonableness under sec. 162 of the management fee and the arm’s-length value
of the management services that Albion purportedly provided to the operating
companies.
                                         -9-

[*9] Stevens transaction for a fee of $50,000. The contract contained the

following disclaimer:

      The parties acknowledge that the S Management corporation and
      KSOP strategy is an aggressive tax planning program and that the
      CLIENT has been advised of this fact, has been advised to and has
      had the opportunity to seek independent legal and tax counsel with
      respect thereto, and does hereby accept the risk that the IRS may
      challenge and/or disqualify any aspect of the program * * * .[7]

V.    Implemention of the Marshall & Stevens Transaction

      A.       Step 1: Albion Management

      On October 19, 2000, Mr. Attenborough incorporated Albion Management,

Inc. (Albion), and appointed petitioners as Albion’s directors. Albion then

designated Mr. Wycoff as its president, Dr. Pisanno-Wycoff as its secretary, and

Janie Emaus as its chief financial officer. Petitioners have held their positions

with Albion ever since. Albion then issued 10,000 shares of stock and sold 2,500

of those shares to Mr. Wycoff for $250 and 7,500 of those shares to Dr. Pisanno-

Wycoff for $750. Albion also elected to be taxed as a subchapter S corporation.

      B.       Step 2: Deferred Compensation Benefits

      On November 1, 2000, Albion hired Mr. Marlin as its in-house counsel and

Mr. Wycoff as a full-time manager for Albion’s clients. Mr. Wycoff’s contract


      7
          An ESOP that is combined with a sec. 401(k) plan is referred to as a KSOP.
                                        - 10 -

[*10] with Albion provided that Albion would compensate him with an annual

salary, a deferred compensation plan, a life insurance policy, and an option to

purchase 100 shares of Albion’s stock at any time.

      On November 1, 2000, Albion also established a “Supplemental Retirement

Plan and Rabbi Trust” (Rabbi Trust).8 The Rabbi Trust was an unfunded deferred

compensation plan for the sole benefit of Mr. Wycoff. Mr. Wycoff is, and always

was, the sole beneficiary of the Rabbi Trust. Mr. Marlin was appointed as the

trustee of the Rabbi Trust. The Rabbi Trust agreement specified that it was

effective from November 1, 2000, either until Mr. Wycoff left the company or

until petitioners lost control of the company.

      Under the Rabbi Trust agreement and Mr. Wycoff’s employment contract

all contributions to the Rabbi Trust were at Albion’s discretion and were to be

capped at 80% of Albion’s management fees. The Rabbi Trust agreement forbade

the assignment, alienation, pledge, or encumbrance of funds in the Rabbi Trust.

      8
        A rabbi trust is an unfunded deferred compensation plan. Funds deposited
into the trust remain subject to the claims of the employer’s creditors. See In re IT
Group, Inc., 448 F.3d 661, 664-665 (3d Cir. 2006). The employee beneficiary of
the rabbi trust is not taxed on the funds deposited into the account until the funds
are actually distributed to him. See id. Likewise, the employer is not entitled to a
deduction for the funds deposited into the rabbi trust until the rabbi trust actually
distributes the contributions. See id. at 665. Because Albion was an ESOP, a tax-
exempt entity, it had no need for a current deduction because its income was tax-
exempt. See secs. 401(a), 501(a).
                                       - 11 -

[*11] The Rabbi Trust agreement provided that distribution of benefits was to

occur upon Mr. Wycoff’s separation from service.

      C.     Step 3: KSOP and ESOP Trust

      On November 8, 2000, Albion established a combined employee stock

ownership and section 401(k) plan (KSOP) and an employee stock ownership plan

trust (ESOP trust). Albion appointed petitioners as trustees of the KSOP and the

ESOP trust. The operating companies then agreed to participate in the KSOP and

the ESOP trust. Petitioners did not participate in the KSOP or the ESOP trust.

      D.     Step 4: Sell Albion to the ESOP Trust

      On November 8, 2000, Albion contributed $1,000 to the ESOP trust.

Petitioners then sold all 10,000 shares of Albion’s stock to the ESOP trust for

$1,000. On December 19, 2000, Marshall & Stevens determined that the book

value of Albion as of November 1, 2000, was $1,000.

      E.     Step 5: Adopt Management Contracts

      On October 30, 2000, the operating companies entered into management

agreements with Albion.9 The agreements did not specify the particular services


      9
       Albion entered into two other management agreements with Soapworks
and Safety Tubs, two companies that petitioners incorporated in 2003. However,
because respondent does not challenge the management fees that Soapworks and
Safety Tubs paid to Albion, we do not discuss them.
                                          - 12 -

[*12] that Albion employees would provide. Under these agreements the

operating companies agreed to purchase management services from Albion for

20% of their respective gross receipts.

      To determine the management fee, Mr. Marlin, Mr. Attenborough, Mr.

Boespflug, and Mr. Wycoff held a meeting where Mr. Wycoff described the

services that Albion would provide to the operating companies. Petitioners did

not hire an adviser familiar with petitioners’ business model to assist with

determining the amount of the management fee or to advise with respect to

reasonable compensation. Mr. Marlin, Mr. Attenborough, Mr. Boespflug, and Mr.

Wycoff had no experience determining reasonable compensation. On the basis of

Mr. Wycoff’s information, however, Mr. Marlin, Mr. Attenborough, and Mr.

Boespflug calculated that an appropriate management fee was 20% of the

operating companies’ gross receipts.10

      On November 1, 2000, Albion hired Mr. Wycoff to “provide management

services to the client companies of * * * [Albion] so as to fulfill the obligations of

      10
        Mr. Attenborough testified that the management fee was supported by
caselaw because courts had upheld similar management fees. Petitioners did not
introduce documentary evidence to show exactly how the management fee was
calculated, and the record does not reveal the cases Mr. Attenborough allegedly
reviewed or relied on. According to Mr. Wycoff the management fees were
calculated partially on the basis of the profitability of the operating companies and
not on the hours worked or services Albion provided.
                                        - 13 -

[*13] * * * [Albion] under its various management agreements”. The contract

between Albion and Mr. Wycoff did not specify the particular “management

services” that Mr. Wycoff was to provide. However, Mr. Wycoff provided the

same services to the operating companies that he had provided to them before

incorporating Albion.

      The operating companies’ functions did not change after they had hired

Albion except that the employees of the operating companies began providing

services via Albion. Employees were not aware of this change until they began

receiving their salaries from Albion. For all practical purposes, the operating

companies’ employees’ work did not change when they began working for Albion.

      On January 1, 2002, the operating companies and Albion amended their

respective management agreements to provide that the operating companies would

pay Albion 10% of their respective gross receipts for Albion’s services because

the operating companies’ revenues had declined. On September 1, 2003, the

operating companies and Albion further amended their respective management

agreements to provide that the operating companies would pay Albion 3% of their

respective gross receipts for Albion’s services. Regardless of the size of the fee,

Albion purportedly provided the same services to the operating companies for the

years at issue.
                                        - 14 -

[*14] On their applicable Federal income tax returns the operating companies

reported the following gross receipts, total income or loss, management fees, and

ordinary or taxable income or loss:

                                        Sirius

 Year Gross receipts      Total income     Management fees      Income or loss

 1998      $7,004,350      $4,944,211                ---            ($42,608)
 1999       8,068,096       2,227,397                ---              -0-
 2000      23,268,263      16,164,535            $1,094,393           60,029
 2001      46,475,388      30,974,978             8,413,486        1,491,607
 2002      18,648,288       7,831,765             1,236,198         (482,847)
 2003       4,336,682       1,535,736               328,075         (298,568)

                                      Restore 4

 Year Gross receipts      Total income     Management fees      Income or loss

 1998       $360,660        $234,107                 ---             $25,398
 1999       6,898,330       5,608,958                ---              48,965
 2000      19,038,397      16,022,402             $762,925           426,274
 2001      12,858,998      10,540,527             2,536,815             (455)
 2002       9,522,677       6,619,430               322,449          139,054
 2003       5,453,891       3,642,867               332,531         (108,230)
                                         - 15 -

[*15] F.        Step 6: Fund Deferred Compensation

      Albion’s financial statements for financial year ending (FYE) December 31,

2001, FYE December 31, 2002, nine months ending September 30, 2003, and

three months ending (3ME) December 31, 2003, show the following Rabbi Trust

assets, accrued deferred compensation liability, and deferred compensation

expense:
                                                  Accrued deferred     Deferred
                                                   compensation      compensation
           FYE           Rabbi Trust assets           liability        expense

    Dec. 31, 2001 Not separately stated             $11,045,932       $8,760,242
    Dec. 31, 2002       $4,651,269                    11,500,262         774,954
    Sept. 30, 2003       9,317,751                    11,381,215         548,740
                      1                             2
    Dec. 31, 2003       10,739,301                    12,136,356          87,355
           1
               This amount was listed on Albion’s balance sheet as follows:

                    Rabbi Trust                       $1,032,883
                    UBS-Rabbi Trust (f.k.a.)
                     Paine Web)                        9,706,418
           2
           Albion accrued deferred compensation liability in its short, 3ME
    Dec. 31, 2003, year even though its employment agreement with Mr.
    Wycoff, as amended on Mar. 5, 2004, stated that such accruals would
    cease on Sept. 1, 2003.

      The Rabbi Trust’s ledger does not reflect any contributions by Albion to the

Rabbi Trust. Instead, the Rabbi Trust’s ledger reflects a series of contributions

from the operating companies on September 29, 2003.
                                        - 16 -

[*16] On its Forms 1120S, U.S. Income Tax Return for an S Corporation, for

2001-03 and on the attached Schedules L, Balance Sheets per Books, Albion

reported the following gross receipts, investments in the Rabbi Trust, total assets,

and total liabilities and shareholders’ equity:

                                     Assets                        Total liabilities
                      Gross        invested in                    and shareholders’
      TYE            receipts      Rabbi Trust     Total assets        equity

 Dec. 31, 2001     $10,283,449     $10,787,657     $10,891,076      $10,891,076
 Dec. 31, 2002       1,803,671      11,294,169      12,073,165       12,073,165
 Sept. 30, 2003        685,925              (1 )    12,140,641       12,140,641
 Dec. 31, 2003         109,193              (1 )    12,801,680       12,801,680
             1
            For its taxable years ending Sept. 30 and Dec. 31, 2003,
      Albion did not separately report its investments in the Rabbi Trust.

VI.   Windup of the Marshall & Stevens Transaction

      On September 29, 2003, Albion revoked its subchapter S election and

terminated the ESOP portion of the KSOP plan. On January 23, 2004, Marshall &

Stevens determined that the book value of Albion as of September 30, 2003, was

$112,390. On March 5, 2004, Albion and Mr. Wycoff amended Mr. Wycoff’s

employment agreement with Albion. Mr. Wycoff agreed to provide the same

services as before, in exchange for a $60,000 annual salary, the accrued benefits in

the Rabbi Trust, and a commitment that Albion would amend the Rabbi Trust

agreement to provide that the Rabbi Trust would begin distributing its assets
                                        - 17 -

[*17] quarterly. Albion amended the Rabbi Trust agreement to provide that the

Rabbi Trust would begin distributing its assets at Mr. Wycoff’s discretion.

      On April 12, 2004, the ESOP trust sold all of its Albion stock to Sirius for

$112,390. On March 25, 2005, Marshall & Stevens determined that the book

value of Albion as of April 12, 2004, was zero. In its March 25, 2005, appraisal,

Marshall & Stevens opined that Albion’s stock was worthless as of April 12, 2004,

because Albion’s total liabilities (most of the liabilities consisted of accrued

deferred compensation) exceeded the value of its assets. On March 29, 2005,

Albion distributed $105,163.16 to various employees as a final distribution from

the ESOP.

VII. Wages Paid to Mr. Wycoff and Other Employees

      From 1998 to 2000 the operating companies issued Mr. Wycoff Forms W-2,

Wage and Tax Statement, showing the following wages:
                                      - 18 -

                [*18] Year             Sirius         Restore 4

                     1998             $355,000            -0-
                     1999              320,000        $137,500
                                                      1
                     2000              620,000          500,000

                 1
                   Restore 4 issued Mr. Wycoff a Form W-2 stating
           that his wages were $500,000. However, Restore 4
           reported on its Form 1120S for 2000 that Mr. Wycoff’s
           wages were $642,500. Mr. Wycoff reported his wage
           income from Restore 4 as $142,500 on petitioners’
           Federal income tax return for 2000. Consequently, we
           use the Form W-2 amount.

      From 2000 to 2003 Mr. Wycoff’s total compensation from Albion was as

follows:

                                        Deferred
                                      compensation
                Year         Wages      expense1         Total

                2000        $53,125        -0-          $53,125
                2001        744,983    $8,760,242     9,505,225
                2002        479,500       744,954     1,224,454
                2003         51,000       636,095       687,095

                 1
                  Petitioners’ records vary as to the exact deferred
           compensation expenses. The Court uses the figures
           reported on Albion’s financial statements as deferred
           compensation expenses.
                                        - 19 -

[*19] From 2001 to 2003 Albion reported11 the following wage expenses for its

employees:12
                   Wages Albion
                   paid, excluding   Wages Albion
                    wages paid to      paid to                              Total wage
       Year          Mr. Wycoff       Mr. Wycoff        Payroll taxes        expenses


       2001         $143,866          $744,983            $29,870           $918,719
       2002          353,205           479,500      Not separately stated    832,705
       2003          419,792            51,000             38,745            509,537

      Chet Millard was the most highly paid employee of the operating companies

from 2001 to 2003 other than petitioners. Mr. Millard was paid total wages of

$169,280, $141,779, and $78,762 by Albion and the operating companies for

2001, 2002, and 2003, respectively.

VIII. Potential Sale of Operating Companies

      In 2001 petitioners hired Barrington & Associates, an investment banking

firm, to solicit offers to buy the stock or assets of the operating companies. In

drafting a memorandum for potential buyers, Barrington & Associates reviewed

the operating companies’ financial performance. To calculate the profitability of



      11
        Some of the amounts reported on Forms W-2 issued to employees are
different from the wage expenses Albion deducted on its tax returns. For
consistency, we rely on the amounts on the Forms W-2.
      12
       The operating companies also paid wages, exclusive of wages paid to Mr.
Wycoff, of $574,905, $450,218, and $97,363 for the years at issue, respectively.
                                        - 20 -

[*20] the operating companies, Barrington & Associates excluded the

management fees paid to Albion because the management fees exceeded market

rate salaries. Barrington & Associates estimated that a market rate salary for all

shareholder compensation was $300,000 per year.

IX.   Expert Witnesses

      A.     Respondent’s Expert

      Respondent submitted the expert report of Kenneth Nunes, a chartered

financial analyst. Mr. Nunes earned a master of science degree in mechanical

engineering from the University of California, Davis, in 1981, and he earned a

master’s in business administration from the University of California, Los

Angeles, in 1985. He has over 25 years of experience advising companies on

financial, valuation, and dispute resolution issues. Since 1990 Mr. Nunes has

testified as a valuation expert in various Federal and State courts.

      Mr. Nunes’s report addressed two issues: (1) whether Mr. Wycoff’s

compensation from Albion was reasonable and (2) whether the management fees

that Sirius, Restore 4, Safety Tubs, and Soapworks paid to Albion were arm’s-

length fees within the meaning of section 482.
                                        - 21 -

[*21]         1.    Mr. Wycoff’s Compensation

        Mr. Nunes examined the condition of the operating companies, the market

for executive compensation in the industry and in the business community

generally, and Mr. Wycoff’s relevant qualifications and attributes.

        Mr. Nunes found that compensation is typically determined by industry,

firm size measured either by company value or revenue, and position. He

determined that Mr. Wycoff was acting as the chief executive officer (CEO) of the

operating companies. Therefore, to calculate the reasonable total value of

compensation for Mr. Wycoff, Mr. Nunes examined compensation paid to

individuals acting as the CEO of comparable companies.

        Petitioners had identified the operating companies’ primary business

activity as the production and sale of household chemicals. Therefore Mr. Nunes

determined that the operating companies’ peer group was companies that had

reported financial information from 1999-2003 in the following Standard

Industrial Classification (SIC) codes: 2841 (soap, detergents, cleaning

preparations, perfumes, cosmetics); 2842 (speciality cleaning, polishing and

sanitation preparations), and 2844 (perfumes, cosmetics, and other toilet

preparations). After reviewing the financial data of the peer group companies he

excluded companies with less than $5 million and more than $200 million in
                                      - 22 -

[*22] annual revenue because the total revenue of the operating companies ranged

between $10 million and $60 million. Mr. Nunes included companies with annual

revenue of $60 million to $200 million because doing so increased the number of

companies to which he could compare the operating companies and the additional

information helped him determine the upper limits of reasonable compensation.

He excluded companies that conducted unrelated activities such as software

companies and pharmaceutical drug companies. He ultimately identified seven

companies that he concluded were comparable to the operating companies (peer

group).

      Mr. Nunes then compared the data for the peer group with data from a

broader group of 24 different companies to ensure that the peer group did not set

executive compensation at unreasonably low levels. All 24 companies had annual

revenue below $200 million and were not pharmaceutical companies. In

comparing executive compensation between the peer group and the broader group

of 24 companies, Mr. Nunes used only cash compensation. He did not include

stock option compensation because he determined that stock option compensation

was not used in the industry and was “a meaningful source of CEO compensation

only at larger companies.” Mr. Nunes found that the peer group did not omit

highly compensated individuals but rather included some of the most highly
                                      - 23 -

[*23] compensated executives of the broader group of 24 companies. He therefore

concluded that the peer group represented compensation in the industry.

      Mr. Nunes then performed a regression analysis on the peer group data to

create an equation for the relationship between annual CEO compensation and a

company’s annual revenue. The equation allowed him to input a particular annual

revenue and determine what a company would pay its CEO. He calculated that

companies of similar size in terms of annual revenue and in the operating

companies’ industry would have paid a CEO baseline compensation of $929,000

in 2001 and $606,000 in 2002.

      In 2003 the operating companies’ revenues were lower than those of the

peer group, and therefore Mr. Nunes decided that using the equation for 2003 was

not appropriate. Instead he calculated that the operating companies would pay a

CEO baseline compensation of $109,000, which was the lowest salary a CEO in

the peer group received for 2003.13

      After calculating baseline compensation, Mr. Nunes considered whether

baseline compensation should be increased to account for unique characteristics of


      13
        The company that had the lowest CEO salary for 2003 also had the lowest
revenue of the peer group. The operating companies had revenue of less than $10
million in 2003. In 2003 the company with the lowest revenue had revenue of
approximately $20 million.
                                       - 24 -

[*24] the operating companies and Mr. Wycoff. Mr. Nunes decided that a 20%

cost of living adjustment was appropriate because of the location of the operating

companies. He then determined that a 10% decrease in baseline salary for 2002

and 2003 was appropriate14 because of revenue declines and a 20% increase in

2001 was appropriate because the operating companies had performed well.15 He

found that Mr. Wycoff’s tenure, experience, and education were typical of other

CEOs in the peer group and no adjustment for individual characteristics was

necessary. Mr. Nunes therefore concluded that the reasonable total compensation

for Mr. Wycoff’s services was $1,338,000, $654,000, and $118,000 for 2001,

2002, and 2003, respectively.

             2.    Arm’s-Length Management Fee

      Mr. Nunes next determined what an arm’s-length management fee would be

for the years at issue. He reached his arm’s-length calculation by first determining

whether the services Albion provided the operating companies were nonintegral or



      14
        Petitioners have cited the events of September 11, 2001, as a reason for the
decline in sales during 2002 and 2003. Mr. Nunes’ report concludes that the
economy was relatively stable for the years at issue with the exception of a brief
shock after September 11, 2001.
      15
        Mr. Nunes cites academic literature indicating that executive
compensation is positively correlated with relative profitability and changes in
share value.
                                          - 25 -

[*25] integral services for the purposes of the applicable regulations. See sec.

1.482-2(b)(3), (b)(7)(ii), Income Tax Regs. Mr. Nunes determined that Albion’s

services were integral, and the applicable regulations required that operating

companies pay a management fee that unrelated parties would pay for similar

services. See sec. 1.482-2(b)(3), Income Tax Regs.16

      To determine an arm’s-length charge for Albion’s services, Mr. Nunes

researched companies comparable to Albion. He used companies that had annual

revenue between $5 million and $500 million and reported themselves as

“employment agencies”, “help supply services”, and “all other professional

services”. He determined that these companies were similar to Albion because

Albion provided routine management services to the operating companies.17 Mr.

Nunes then excluded companies that did not have a retail focus, which led to the

exclusion of healthcare and IT services companies. He therefore determined that

eight public companies engaged in management and administrative services with

financial information reported during the years at issue were comparable to

Albion.



      16
       Mr. Nunes’ report states that for nonintegral services an arm’s-length price
is deemed equal to all costs incurred. See sec. 1.482-2(b)(3), Income Tax Regs.
      17
           Albion reported itself under “all other professional services”.
                                        - 26 -

[*26] Mr. Nunes used a cost markup method to determine the arm’s-length

management fee. His approach required him to determine the operating profit

earned by comparable companies as a percentage of their total costs.18 Mr. Nunes

chose this method because Albion’s costs were “readily observable and services

provided are of a routine nature.” After analyzing the costs of the eight public

companies similar to Albion, he determined that the median cost markup was

4.6%, -0.5%, and -0.4%, respectively, for the years at issue.19

      Mr. Nunes then calculated Albion’s total expenses for each of the years at

issue by adding the amount of Mr. Wycoff’s reasonable compensation that he had

determined, see supra part IX.A.1., and Albion’s other reported expenses. After

applying the median cost markup of comparable companies to Albion’s total

expenses, he determined that Albion was entitled to aggregate management fees of



      18
         The regulations refer to this method as the comparable profits method
(CPM). See sec. 1.482-5, Income Tax Regs. Petitioners contend that Mr. Nunes
used the “cost of services plus method” described in sec. 1.482-9(e), Income Tax
Regs. However, we find that the record supports a finding that Mr. Nunes used
the comparable profits method because Mr. Nunes compared Albion’s operating
profit to that of similar companies. See sec. 1.482-5, Income Tax Regs. The “cost
of services plus method” compares profit markup of the uncontrolled transaction
with the controlled transaction. See sec. 1.482-9(e)(1), Income Tax Regs.
      19
       The median cost markup was negative for 2002 and 2003 because the
comparable group of companies that Mr. Nunes used had losses during those
years.
                                        - 27 -

[*27] $1.725 million, $1.417 million, and $705,000, respectively, for the years at

issue. Albion provided services during the years at issue to Sirius, Restore 4,

Safety Tubs, and Soapworks. Because Albion did not maintain time logs for its

services to each of the companies,20 Mr. Nunes allocated the management fees on

the basis of relative costs incurred by the entities and determined the following

allocations:

            Company            2001                2002           2003

           Sirius          $1,346,000             $939,000     $266,000
           Restore 4          379,000              478,000      324,000
           Safety Tubs          ---                  ---         35,000
           Soapworks            ---                  ---         80,000
            Total           1,725,000            1,417,000      705,000

      Mr. Nunes next considered the combined results of the reasonable

compensation and the arm’s-length management fee analysis. After allowing for a

deduction for an arm’s-length management fee, he calculated that the operating

companies had a three-year average operating income margin of 4.9%. Because

the operating income margin was within the three-year average for the operating

companies’ peer group, he considered his results reasonable.

      20
       Albion started providing services to Safety Tubs and Soapworks only in
2003. As Mr. Nunes noted in his report, emerging companies often require more
management time. However, without logs of the services Albion provided, Mr.
Nunes was unable to allocate the management fee on the basis of services
provided to each company.
                                       - 28 -

[*28] B.     Petitioners’ Experts

             1.    Mr. Dupler

      Petitioners submitted the expert report of Timothy Dupler. Mr. Dupler has

experience working with companies using direct response marketing. He does not

have any experience, training, or education in financial analysis or with the

valuation of management contracts or executive compensation.

      Mr. Dupler determined that the 20% of gross receipts that Albion charged

the operating companies as a management fee was reasonable and customary for a

company using direct response marketing. He based his opinion on his previous

experience with companies using direct response marketing, and he did not cite

any corroborating sources, documents, or authorities in his report.

             2.    Mr. Burns

      Petitioner also submitted the expert report of Francis X. Burns, who is an

accredited senior appraiser in business valuation from the American Society of

Appraisers and who is certified as accredited in business appraisal review by the

Institute of Business Appraisers. Mr. Burns graduated from Stanford University in

1982 and earned a master of management degree in finance and economics from

Northwestern University in 1986. He has over 25 years of experience as an

economic consultant, including experience evaluating executive compensation in
                                       - 29 -

[*29] the valuation of businesses, in commercial damages litigation, and in

determining the reasonableness of compensation under the Code. Mr. Burns has

testified previously as an expert witness for both the Government and taxpayers.

      Mr. Burns first considered the management contract Albion entered into

with the operating companies. He noted that, on the basis of information available

in October 2000 when the contract was signed, scaling management fees to sales

was reasonable because all parties assumed some risk of the operating companies’

success. However, he did not find the fact that petitioners controlled the operating

companies and Albion relevant when concluding that the contract was reasonable.

      Mr. Burns next looked at the services Albion provided with a focus on the

services Mr. Wycoff provided. He noted that Mr. Wycoff served in a variety of

roles for the operating companies, including: (1) CEO, (2) chief financial officer,

(3) chief operating officer, (4) national sales manager, and (5) spokesman for the

operating companies.

      To determine a reasonable management fee for the services Albion provided

the operating companies, Mr. Burns used four methods. First, he looked to

companies he had determined were comparable to petitioners’ operating

companies. His consideration of companies that classified themselves as cleaning

product companies and direct response industry companies with revenues similar
                                       - 30 -

[*30] to those of the operating companies resulted in one company. Because he

found only one, he expanded the criteria to include companies that classified

themselves as “Chemical and Allied Products” companies, which included

pharmaceutical companies. The new criteria resulted in 17 companies that he

considered sufficiently similar to the operating companies. Of the 17 companies,

16 were pharmaceutical companies. None of the companies manufactured

cleaning products, and only two sold cleaning products. On the basis of the

salaries paid to the CEOs of this group and Mr. Wycoff’s other work for the

operating companies, Mr. Burns determined that a management fee of 15.1%

would be reasonable.

      Mr. Burns’ next method of calculating a reasonable management fee was to

compare Albion’s CEO compensation with that of consulting firms. He

considered hourly rates of CEO compensation of six consulting firms and found

that the average rate was $740 per hour. He then determined, on the basis of Mr.

Wycoff’s statements, that Mr. Wycoff worked 13.5 hours per day, and therefore

determined that Mr. Wycoff was entitled to $3.5 million per year, or

approximately 15.9% of expected net sales.

      Mr. Burns’ third method for determining the management fee was to review

an executive compensation survey. He used survey data from companies in the
                                       - 31 -

[*31] cleaning, polishing, and sanitary preparations field with annual revenue of

$22.5 million.21 After combing the “maximum reasonable [cash] compensation”

from the survey and the median figures for equity based compensation, he

determined that an appropriate management fee was 15.3% of revenue.

      The final method Mr. Burns used to calculate the management fee was an

independent investor test. Mr. Burns’ independent investor test required him to

calculate the median return on tangible net worth for companies purportedly

operating in the same industry as the operating companies. Using data from a

survey, he determined that the median return on tangible net worth for similar

companies was 8.3% to 14.4% over the years 1996 to 2001. The independent

investor test led him to conclude that the operating companies should pay a

management fee of 14%.22

      Mr. Burns concluded on the basis of his four methods that it would have

been reasonable to pay Albion 15% to 16% of the operating companies’ sales for

the years at issue. He also noted that Mr. Wycoff should be entitled to additional


      21
         The survey data is not from the years at issue. The oldest data available
for cash compensation was 2004, and data for equity compensation was available
starting in 2007.
      22
       Mr. Burns’ report also notes that on the basis of projections from
Barrington Associates, a management fee between 17% and 20% would be
acceptable for 2001 and 2002.
                                        - 32 -

[*32] compensation for his roles as national sales manager and product

spokesperson.

X.    Notice of Deficiency

      Respondent issued a notice of deficiency to petitioners on July 15, 2009.

Respondent disallowed the following deductions for management fees that the

operating companies reported paying to Albion:

           Company           2001            2002           2003

           Sirius        $8,413,486     $1,214,003         $35,069
           Restore 4      2,536,815        321,564         226,317

Petitioners timely petitioned this Court.

                                      OPINION

I.    Burden of Proof

      Generally, the Commissioner’s determination of a deficiency is presumed

correct, and the taxpayer bears the burden of proving that the determination is

improper. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).

However, if a taxpayer produces credible evidence23 with respect to any factual


      23
        “Credible evidence is the quality of evidence which, after critical analysis,
the court would find sufficient upon which to base a decision on the issue if no
contrary evidence were submitted (without regard to the judicial presumption of
IRS correctness).” Higbee v. Commissioner, 116 T.C. 438, 442 (2001) (quoting
H.R. Conf. Rept. No. 105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-995).
                                       - 33 -

[*33] issue relevant to ascertaining the taxpayer’s liability for any tax imposed by

subtitle A or B of the Code and satisfies the requirements of section 7491(a)(2),

the burden of proof on any such issue shifts to the Commissioner. Sec.

7491(a)(1). Section 7491(a)(2) requires a taxpayer to demonstrate that he or she

(1) complied with the requirements under the Code to substantiate any item,

(2) maintained all records required under the Code, and (3) cooperated with

reasonable requests by the Secretary24 for witnesses, information, documents,

meetings, and interviews. See Higbee v. Commissioner, 116 T.C. 438, 440-441

(2001).

      Petitioners contend that the notice of deficiency should no longer be

presumed correct. Petitioners contend that the expert reports by Mr. Dupler and

Mr. Burns are credible evidence or that respondent has through his own

concessions and expert reports established that his determination in the notice of

deficiency was erroneous because respondent’s primary position entitles

petitioners to deduct some management fees, while the notice of deficiency

disallowed the deduction for all management fees.




      24
       The term “Secretary” means the Secretary of the Treasury or his delegate.
Sec. 7701(a)(11)(B).
                                        - 34 -

[*34] Petitioners rely on a series of cases from the U.S. Court of Appeals for the

Ninth Circuit holding that the Commissioner’s adoption of a litigation position

that substantially deviates from the position in the notice of deficiency results in a

forfeiture of any presumption of correctness in the notice and places the burden of

proof as to factual matters on the Commissioner. See Estate of Mitchell v.

Commissioner, 250 F.3d 696 (9th Cir. 2001), aff’g in part, vacating in part and

remanding T.C. Memo. 1997-461; Estate of Simplot v. Commissioner, 249 F.3d

1191 (9th Cir. 2001), rev’g and remanding 112 T.C. 130 (1999); Morrissey v.

Commissioner, 243 F.3d 1145 (9th Cir. 2001), rev’g and remanding Estate of

Kaufman v. Commissioner, T.C. Memo. 1999-119. The parties have stipulated

that appeal in this case would lie to the U.S. Court of Appeals for the Tenth

Circuit, and therefore we are not bound by caselaw from the U.S. Court of Appeals

for the Ninth Circuit. See Golsen v. Commissioner, 54 T.C. 742, 757 (1970),

aff’d, 445 F.2d 985 (10th Cir. 1971).

      Even if we were to follow the precedent of the U.S. Court of Appeals for the

Ninth Circuit, the notice of deficiency would not lose the presumption of

correctness. Although in the notice of deficiency respondent disallowed

petitioners’ claimed deductions for management fees, on brief he allowed the

deductions to the extent petitioners proved that Albion had paid wages or payroll
                                        - 35 -

[*35] taxes. When the Commissioner concedes certain facts or issues, the notice

of deficiency is still presumed correct. See U.S. Holding Co. v. Commissioner, 44

T.C. 323, 328 (1965). In any event, we reach our decision on the basis of the

preponderance of the evidence. See Knudsen v. Commissioner, 131 T.C. 185, 189

(2008).

II.   Management Fee Deductions

      A.     The Parties’ Positions

      Respondent advances four arguments as to why petitioners’ claimed

deductions for management fees that the operating companies paid to Albion

under the compensation agreement should be reduced. Respondent’s primary

argument is that the operating companies did not substantiate the management fees

beyond the amounts that Albion reported paying for wages and for payroll taxes.

Alternatively respondent contends petitioners are entitled to deduct only the

portions of the management fees that are considered reasonable compensation.

See sec. 162(a)(1). Respondent also argues that the management fees should be

reallocated under section 482 or, to the extent the management fees constitute

unreasonable compensation, the transaction should be recharacterized as

distributions to petitioners. Petitioners contend that the inquiries under section
                                       - 36 -

[*36] 162 and section 482 are substantially the same and that under either Code

provision they are entitled to deduct the management fees.

      On brief respondent concedes that Albion is not a sham entity and should

not be disregarded.25 Respondent asks us to determine Mr. Wycoff’s reasonable

compensation under section 162. However, the management fees that the

operating companies paid to Albion are before the Court and not Mr. Wycoff’s

reasonable compensation. Because respondent concedes that Albion is not a sham

entity, we will focus our analysis on section 482 and the proper arm’s-length

amounts of the management fees. Although a section 482 analysis may require us

to determine Albion’s costs, including Mr. Wycoff’s reasonable compensation,26

Albion is entitled to charge the operating companies an arm’s-length price for its

services that may be higher than the salaries Albion paid.27


      25
        In the notice of deficiency respondent determined as an alternative
position that Albion should be disregarded because it lacked a legitimate business
purpose and had no economic substance.
      26
        We also find that the record provides an adequate basis to determine Mr.
Wycoff’s reasonable compensation, and therefore we reject respondent’s
substantiation argument. See Cohan v. Commissioner, 39 F.2d 540, 542-544 (2d
Cir. 1930).
      27
        Additionally, the regulations under sec. 482 provide that an arm’s-length
charge shall not be deemed equal to costs or deductions with respect to integral
services. See sec. 1.482-2(b)(7)(ii)(A), Income Tax Regs. Respondent concedes
                                                                       (continued...)
                                        - 37 -

[*37] B.     Section 482

      “Section 482 was enacted to prevent tax evasion and ensure that taxpayers

clearly reflect income relating to transactions between controlled entities.” Veritas

Software Corp. & Subs. v. Commissioner, 133 T.C. 297, 316 (2009). This section

gives the Commissioner broad authority to allocate gross income, deductions,

credits, or allowances between two related corporations if the allocations are

necessary either to prevent evasion of tax or to clearly reflect the income of the

corporations. See Seagate Tech., Inc. & Consol. Subs. v. Commissioner, 102 T.C.

149, 163 (1994).

      To determine true taxable income, the standard to be applied in every case is

that of a taxpayer dealing at arm’s-length with an uncontrolled taxpayer. Sec.

1.482-1(b)(1), Income Tax Regs. The arm’s-length result of a controlled

transaction must be determined under the method that, under the facts and

circumstances, provides the most reliable measure of an arm’s-length result. Id.

para. (c)(1). In determining which of two or more available methods provides the

most reliable measure of an arm’s-length result, the two primary factors to take

into account are the degree of comparability between the controlled taxpayer and


      27
         (...continued)
that the services Albion provided the operating companies were integral.
                                       - 38 -

[*38] any uncontrolled comparable and the quality of data and assumptions used

in the analysis. See sec. 1.482-1(c)(2), Income Tax Regs.

      The parties dispute the best method for determining an arm’s-length result.

Petitioners contend that we should accept Mr. Burns’ analysis, which applies four

different methods that all reach a result of 15% to 16% of the operating

companies’ revenues as a management fee. Respondent contends that the CPM

that Mr. Nunes applied is best method for reaching an arm’s-length result because

data of comparable transactions was unavailable and Mr. Nunes’ determination

ensured that Albion would receive the same profit or loss as companies providing

similar services. Accordingly, we must determine the most reliable method for

calculating an arm’s-length management fee.28 We do so by analyzing the expert

reports.

            1.     Expert Reports

      Both parties introduced expert witness reports and additional testimony to

assist the Court in determining the management fee. Expert witnesses are


      28
        For sec. 482 to apply, the operating companies and Albion must be
“owned or controlled directly or indirectly by the same interests”. See sec. 482.
During the years at issue petitioners owned and controlled the operating
companies. Petitioners served as directors of Albion and as trustees of the KSOP
plan and the ESOP trust. Petitioners therefore controlled Albion. Accordingly
sec. 482 applies.
                                       - 39 -

[*39] appropriate to help the Court understand an area requiring specialized

training, knowledge, or judgment. See Fed. R. Evid. 702; Snyder v.

Commissioner, 93 T.C. 529, 534 (1989). Nonetheless, the Court is not bound by

an expert’s opinion, and we may either accept or reject expert testimony in the

exercise of sound judgment. Helvering v. Nat’l Grocery Co., 304 U.S. 282, 295

(1938); Parker v. Commissioner, 86 T.C. 547, 561-562 (1986). Furthermore, the

Court may be selective in determining what portions of an expert’s opinion, if any,

to accept. Parker v. Commissioner, 86 T.C. at 562.

                   a.    Petitioners’ Experts

      Petitioners first submitted the expert report of Mr. Dupler. Mr. Dupler has

previously worked with companies that use direct response marketing, and, on the

basis of that experience he concluded that a management fee of 20% was

reasonable for Albion to charge. Mr. Dupler did not provide any support for his

opinion other than his experience, and he did not cite any academic literature or

trade publications. He cited fee arrangements by a company that he had worked

for as support for his conclusion, but he did not have access to the fee arrangement

contracts. Additionally, the contracts were not from the years at issue, and we are

not convinced that these contracts represent current trends. Mr. Dupler also

admitted that the contracts had been modified several times. Accordingly, we
                                       - 40 -

[*40] decline to accept Mr. Dupler’s conclusions in his expert report because they

cannot be verified. See sec. 1.482-1(c)(2), Income Tax Regs.

      Petitioners also submitted the expert report of Mr. Burns. Mr. Burns

calculated that the “market-based compensation for management serviced

provided by Mr. Wycoff through Albion would have been in the range of 15% to

16%”. Mr. Burns also found that Mr. Wycoff may be entitled to additional

compensation for his role as national sales manager and products spokesman. To

support his conclusion, Mr. Burns used four different methods.

      Mr. Burns’ first method was to look at comparable companies and compare

the salaries of the CEOs. He selected 16 pharmaceutical companies as comparable

corporations. We disagree that pharmaceutical companies are comparable to the

operating companies. See id. subdiv. (i) (stating that as comparability increases,

inaccuracy is reduced). As Mr. Nunes stated in his rebuttal report, the

development cost of a drug is substantially more than the cost of developing a

household cleaner. Most drugs also have a longer life span and are generally

protected through a patent. In contrast, the product at issue here, Zap, was not

eligible for a patent. Also, as petitioners conceded, most products that are

marketed using direct response have an 18-month product life cycle. Further, the

development of drugs requires particular skills and expertise that were not
                                        - 41 -

[*41] required for petitioners’ business. There is no evidence to support the claim

that pharmaceutical companies are comparable to the operating companies other

than Mr. Burns’ opinion, and we do not find that opinion to be credible. Mr.

Burns did not select any company that manufactures cleaning products, and he

included only two companies that distributed cleaning products as comparable to

the operating companies. Accordingly, we find this method unreliable.

      Mr. Burns’ next method for determining the management fee was to

calculate the fee as if Albion were a consulting firm. He considered the hourly

rate of CEO compensation of six consulting firms, and after calculating the

number of hours Mr. Wycoff worked, Mr. Burns determined that Albion was

entitled to 15.9% of net sales for a management fee. However, Mr. Burns’ report

is devoid of any analysis of how these six consulting companies compare to

Albion and the services it provided. Additionally, Mr. Wycoff did not maintain

time logs of the work he performed and for which entity. Other than his

testimony, which we find exaggerated and not credible, there is no evidence in the

record to support Mr. Wycoff’s hours.

      Mr. Burns’ third method for determining the management fee was to review

an executive compensation survey. Although the survey includes companies that

considered themselves cleaning, polishing, and sanitary preparations companies
                                       - 42 -

[*42] with revenue of $22.5 million, Mr. Burns’ report does not identify which

companies he included.29 Mr. Burns’ fourth method for calculating the

management fee was an independent investor test, which included companies from

the same company classification as the executive survey. He determined that these

companies earned a median return on tangible net worth ranged from 8.3% to

14.4%. For the operating companies to earn a similar return, Mr. Burns’

determined that a management fee of 14% was reasonable.

      We find both Mr. Burns’ executive survey compensation method and

independent investor method unreliable. Under both methods, Mr. Burns did not

identify the companies he used for these tests. We note that respondent’s expert

also used data from various company classifications and found that some of the

companies in particular classifications were not comparable to the operating

companies. Petitioners have objected to the use of a company in this category that

Mr. Nunes included in his report, yet petitioners’ expert report does not state what

companies were included in the survey or independent investor method. In short,

we decline to accept Mr. Burns’ determination because the underlying data is not


      29
       Additionally, in calculating an acceptable management fee under the
survey method, Mr. Burns used the “maximum reasonable [cash] compensation”
from the survey. However, Mr. Burns’ report is devoid of any analysis as to why
Albion would be entitled to the maximum figure.
                                        - 43 -

[*43] available, and we are unable to conclude that the companies on which Mr.

Burns relied are comparable to the operating companies.

                   b.     Respondent’s Expert

      Respondent submitted the report of Mr. Nunes. Mr. Nunes determined that

an appropriate method for calculating an arm’s-length management fee was a

markup of Albion’s expenses, referred to as CPM. See sec. 1.482-5, Income Tax

Regs. Mr. Nunes’ method required that, after determining Albion’s costs, Mr.

Nunes multiply the costs by the median profit margin of a comparable group of

companies for the particular year at issue.

      Mr. Nunes looked to the cost markup of companies that provided

management services to other companies. His research found eight public

companies that were comparable to Albion. After analyzing the eight comparable

companies, Mr. Nunes determined that the cost markups should be 4.6%, -0.5%,

and -0.4% for the years at issue, respectively. He next determined Albion’s costs

by using Albion’s reported expenses, subtracting that portion of the expenses Mr.

Nunes considered to be unreasonable compensation to Mr. Wycoff.

      Petitioners contend that Mr. Nunes’ analysis is unreliable because the

analysis relies on his determination that Mr. Wycoff was overcompensated.

Because Mr. Nunes determined that Mr. Wycoff’s compensation was unreasonable
                                        - 44 -

[*44] for the years at issue, he adjusted Albion’s reported expenses before

conducting his cost markup analysis. Accordingly, we will address Mr. Nunes’

reasonable compensation analysis.

      Section 162(a)(1) allows a taxpayer to deduct “a reasonable allowance for

salaries or other compensation for personal services actually rendered” as an

ordinary and necessary business expense. A taxpayer is entitled to a deduction for

compensation payments if the payments are reasonable in amount and in fact paid

purely for services. Sec. 1.162-7(a), Income Tax Regs. The question of whether

amounts paid to employees represent reasonable compensation for services

rendered is a question of fact that must be determined in the light of all the

evidence. Botany Worsted Mills v. United States, 278 U.S. 282, 289-290 (1929);

Perlmutter v. Commissioner, 373 F.2d 45, 47 (10th Cir. 1967), aff’g 44 T.C. 382

(1965); Estate of Wallace v. Commissioner, 95 T.C. 525, 553 (1990), aff’d, 965

F.2d 1038 (11th Cir. 1992). Special scrutiny is given in situations where a

corporation is controlled by the employees to whom the compensation is paid

because there is a lack of arm’s- length bargaining. Pepsi-Cola Bottling Co. v.

Commissioner, 528 F.2d 176, 179 (10th Cir. 1975), aff’g 61 T.C. 564 (1974); K &

K Veterinary Supply, Inc. v. Commissioner, T.C. Memo. 2013-84, at *10.
                                        - 45 -

[*45] Section 1.162-7(b)(2), Income Tax Regs., provides that “the form or method

of fixing compensation is not decisive as to deductibility.” Contingent

compensation agreements generally invite scrutiny as a possible distribution of

earnings, but this Court has upheld such agreements under appropriate

circumstances. See Auto. Inv. Dev., Inc. v. Commissioner, T.C. Memo. 1993-298.

If a contingent compensation agreement generates payments greater than the

amounts that would otherwise be reasonable, those payments are generally

deductible only if: (1) they are paid pursuant to a free bargain between the

employer and the individual; (2) the agreement is made before the services are

rendered; and (3) the payments are not influenced by any consideration on the part

of the employer other than that of securing the services of the individual on fair

and advantageous terms. Sec. 1.162-7(b)(2), Income Tax Regs. Where there is no

free bargain between the parties, the contingent compensation agreement is not

dispositive as to what is deductible under section 162. Rather the Court is free to

make its own determination of what is reasonable compensation. Pepsi-Cola

Bottling Co. v. Commissioner, 528 F.2d at 181-183; Hammond Lead Prods., Inc.

v. Commissioner, 425 F.2d 31, 33 (7th Cir. 1970), aff’g T.C. Memo. 1969-14.

      The U.S. Court of Appeals for the Tenth Circuit, to which an appeal in this

case would lie, applies nine factors to determine the reasonableness of
                                        - 46 -

[*46] compensation, with no factor being determinative: (1) the employee’s

qualifications; (2) the nature, extent and scope of the employee’s work; (3) the size

and complexities of the business; (4) a comparison of salaries paid with the gross

income and net income; (5) the prevailing economic conditions; (6) a comparison

of salaries with distributions to shareholders; (7) the prevailing rates of

compensation for comparable positions in comparable concerns; (8) the salary

policy of the taxpayer as to all employees; and (9) in the case of small corporations

with a limited number of officers, the amount of compensation paid to the

particular employee in previous years. Pepsi-Cola Bottling Co. v. Commissioner,

528 F.2d at 179.

      We do not undertake an exhaustive review of each factor to determine that

Mr. Wycoff’s compensation was unreasonable. Mr. Wycoff had not previously

worked in retail or with companies that use direct response marketing. In fact, Mr.

Wycoff testified that he had to learn how direct response marketing worked, which

is why Mr. Nunes determined that no increase to baseline compensation was

warranted to account for Mr. Wycoff’s characteristics.

      The record also does not convince us that Mr. Wycoff’s work was any more

complex or extensive than that of a typical executive. Mr. Wycoff did work

diligently for the operating companies and his other startups; however, he did not
                                       - 47 -

[*47] maintain any records reflecting what he did and for which company.30

Petitioners also appear to argue that multiple salaries should be aggregated to

account for Mr. Wycoff’s multiple roles. This Court has consistently rejected that

argument. See Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C. at 569;

Richlands Med. Ass’n v. Commissioner, T.C. Memo. 1990-660, aff’d without

published opinion, 953 F.2d 639 (4th Cir. 1992); Ken Miller Supply, Inc. v.

Commissioner, T.C. Memo. 1978-228.

      Petitioners owned the operating companies. Shareholder executive

compensation in a closely held corporation that depletes most of a corporation’s

value is generally unreasonable when the deductible salary expenses are a disguise

for nondeductible profit distributions. See Eberl’s Claim Serv. v. Commissioner,

249 F.3d 994, 1000 (10th Cir. 2001), aff’g T.C. Memo. 1999-211. In this case, the

management fee depleted most, if not all, of the operating companies’ profits. The

management fee in turn was used primarily to pay Mr. Wycoff. For example,

approximately 87% of the management fee went to pay Mr. Wycoff’s

compensation in 2001.

      30
        Petitioners’ expert Mr. Burns noted that Mr. Wycoff claimed to work 15
hours a day, seven days a week, and 52 weeks a year with no vacation. Mr.
Wycoff did not maintain logs of his hours, and his testimony with respect to his
hours was vague. We do not find Mr. Wycoff’s testimony credible with respect to
his hours.
                                        - 48 -

[*48] Our conclusion that Mr. Wycoff’s compensation was unreasonable for each

year at issue is bolstered by the fact that the investment bank that petitioners had

hired to advise them with respect to the potential sale of the operating companies

found that Mr. Wycoff was compensated in excess of market rates and his annual

compensation should be approximately $300,000. Mr. Wycoff’s compensation,

including deferred compensation, was $9,505,225, $1,224,454, and $687,095 in

2001, 2002, and 2003, respectively. While Mr. Wycoff’s duties remained constant

from prior years to the years at issue, Mr. Wycoff received a substantial increase in

compensation during the years at issue. Petitioners contend that a portion of Mr.

Wycoff’s compensation was compensation for work completed before the years at

issue. See Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930) (holding that a

taxpayer may deduct compensation paid in the current year but for services

provided in prior years). However, the record is completely devoid of any

evidence proving that Mr. Wycoff was underpaid before the years at issue or what

would have constituted reasonable compensation for those years. Even if Mr.

Wycoff had been underpaid for years before the years at issue, the operating

companies should have paid Mr. Wycoff directly and not Albion. Albion was not

in existence before the years at issue and could not have provided services.
                                      - 49 -

[*49] In summary, Mr. Wycoff’s compensation was unreasonable and Mr. Nunes

correctly adjusted Mr. Wycoff’s compensation before calculating an arm’s-length

management fee. In calculating Mr. Wycoff’s reasonable compensation, Mr.

Nunes analyzed executive compensation of companies engaged in selling cleaning

products and found that Mr. Wycoff’s compensation was substantially more. Mr.

Nunes provided a list of companies and excluded companies that were dissimilar

either by product or revenue. We are not convinced that the operating companies’

activities were more complex than the companies that Mr. Nunes relied on because

the operating companies also sold cleaning products. Therefore, we find Mr.

Nunes’ conclusions regarding Mr. Wycoff’s reasonable compensation reliable.

      Petitioners contend that, even if Mr. Nunes computed Albion’s expenses

including Mr. Wycoff’s compensation correctly, Mr. Nunes did not use

comparable companies. However, according to the management contract, Albion

was providing standard management services similar to those provided by the

companies that Mr. Nunes used in his analysis. Mr. Nunes’ report lists the

comparable companies and describes the work each comparable company

performed. Similarly to Albion, these companies provided management and

consulting services to other companies. While the record is vague as to exactly
                                        - 50 -

[*50] what Albion did and for whom, we accept Mr. Nunes’ determination that

Albion provided routine management services.

      Petitioners further contend that Mr. Nunes’ determination is not reliable

because the cost markup was negative for 2002 and 2003. However, product sales

fell during 2002 and 2003. Petitioners claim that this decline was due to the

events of September 11, 2001. Petitioners also testified that a typical direct

response marketing is usually profitable for only 18 months. Assuming without

deciding that these statements are true, Albion should have expected to recognize

losses in 2002 and 2003. Albion signed a long-term management contract.

Petitioners’ expert, Mr. Burns, stated that the contract was rational from an

economic perspective and that if Albion oversaw a decline in sales, its

compensation would be reduced. This ensured Albion was incentivized to grow

sales and that Albion would share the risks with the product companies. Further,

even after the management fees are adjusted to an arm’s-length result for 2002 and

2003, the operating companies collectively recognized losses. Accordingly we

find it rational that Mr. Nunes concluded that after substantial declines in sales

Albion would recognize losses during 2002 and 2003.

      Petitioners additionally contend that Mr. Nunes’ reasonableness test, which

averaged the three-year operating margin to determine whether his analysis was
                                       - 51 -

[*51] consistent with an arm’s-length result, was flawed because the test

minimized the operating margin from 2001, petitioners’ most successful year. The

applicable regulations under section 482, however, provide that using multiyear

data depends on the method being applied and the issue being addressed. In

various circumstances multiyear data may be considered in determining an arm’s-

length result. See sec. 1.482-1(f)(2)(iii)(B), Income Tax Regs. These

circumstances include situations where complete and accurate data is available for

the taxable year under review, the taxpayer’s industry is affected by business

cycles, or the product being examined is affected by a life cycle. See id. Data

from one or more years before or after the taxable year under review must

ordinarily be considered for purposes of applying the CPM. Id.

      Mr. Nunes applied the CPM, which generally requires the use of data from

one or more years. Mr. Nunes had complete and accurate data available from the

operating companies’ and Albion’s records. Additionally, Mr. Nunes determined

and petitioners admitted that the operating companies were affected by

macroeconomic recession and the products sold had a defined life cycle.

Therefore, the use of multiyear data was appropriate.
                                          - 52 -

[*52]          2.    Conclusion

        Petitioners and their experts31 have other criticisms of Mr. Nunes’ report.

We do not find merit in these arguments and do not discuss them. We conclude

that Mr. Nunes’ determination was reasonable and produced the most reliable

measure of an arm’s-length result under the facts and circumstances. See sec.

1.482-1(c)(2), Income Tax Regs. (determining the best method depends on the

comparability of the transaction (or taxpayer) and the quality of the data).

Accordingly, petitioners’ operating companies are entitled to the following

deductions for management fees:

             Company              2001                2002         2003

             Sirius          $1,346,000            $939,000     $266,000
             Restore 4          379,000              478,000     324,000
              Total           1,725,000            1,417,000     590,000

III.    Section 6662(a) Penalties

        Section 6662(a) and (b)(1) and (2) authorizes the Commissioner to impose a

20% penalty on an underpayment of tax that is attributable to (1) negligence or

disregard of rules or regulations or (2) any substantial understatement of income

tax. Only one section 6662 accuracy-related penalty may be imposed with respect


        31
      This includes the rebuttal report of Mr. Wertlieb. However, we do not find
Mr. Wertlieb’s report persuasive, and therefore we do not discuss it.
                                        - 53 -

[*53] to any given portion of an underpayment. New Phoenix Sunrise Corp. v.

Commissioner, 132 T.C. 161, 187 (2009), aff’d, 408 F. App’x 908 (6th Cir. 2010);

sec. 1.6662-2(c), Income Tax Regs.

      The term “negligence” includes any failure to make a reasonable attempt to

comply with the provisions of the internal revenue laws, and the term “disregard”

includes any careless, reckless, or intentional disregard. Sec. 6662(c); sec. 1.6662-

3(b)(1) and (2), Income Tax Regs. “‘Negligence’ also includes any failure by the

taxpayer to keep adequate books and records or to substantiate items properly.”

Sec. 1.6662-3(b)(1), Income Tax Regs. Disregard of rules or regulations “is

‘careless’ if the taxpayer does not exercise reasonable diligence to determine the

correctness of a return position” and “is ‘reckless’ if the taxpayer makes little or

no effort to determine whether a rule or regulation exists, under circumstances

which demonstrate a substantial deviation from the standard of conduct that a

reasonable person would observe.” Id. subpara. (2); see also Neely v.

Commissioner, 85 T.C. 934, 947 (1985). An understatement means the excess of

the amount of the tax required to be shown on the return over the amount of the

tax imposed which is shown on the return, reduced by any rebate. Sec.

6662(d)(2)(A). An understatement is substantial in the case of an individual if the
                                        - 54 -

[*54] amount of the understatement for the taxable year exceeds the greater of

10% of the tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A).

      The accuracy-related penalty does not apply with respect to any portion of

the underpayment for which the taxpayer shows that there was reasonable cause

and that he or she acted in good faith. Sec. 6664(c)(1). The decision as to whether

a taxpayer acted with reasonable cause and in good faith is made on a case-by-case

basis, taking into account all of the pertinent facts and circumstances, including

the experience, knowledge, and education of the taxpayer. See sec. 1.6664-

4(b)(1), Income Tax Regs. “Circumstances that may indicate reasonable cause and

good faith include an honest misunderstanding of fact or law that is reasonable in

light of all of the facts and circumstances, including the experience, knowledge,

and education of the taxpayer.” Id. Reliance on the advice of a tax professional

may, but does not necessarily, establish reasonable cause and good faith for the

purpose of avoiding a section 6662(a) penalty. United States v. Boyle, 469 U.S.

241, 251 (1985). A taxpayer’s reliance on a competent tax professional may

establish reasonable cause and good faith when the taxpayer provides necessary

and accurate information to the adviser and the taxpayer reasonably relies in good

faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner,

115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
                                       - 55 -

[*55] The Commissioner bears the burden of production with respect to the

taxpayer’s liability for the section 6662(a) penalty and must produce sufficient

evidence indicating that it is appropriate to impose the penalty. See sec. 7491(c);

Higbee v. Commissioner, 116 T.C. at 446-447. Once the Commissioner meets his

burden of production, the taxpayer must come forward with persuasive evidence

that the Commissioner’s determination is incorrect or that the taxpayer had

reasonable cause or substantial authority for the position. See Higbee v.

Commissioner, 116 T.C. at 446-447.

      Although the parties made concessions before the start of trial and on brief,

and the Court allowed the operating companies to partially deduct the management

fees paid to Albion, the computations under Rule 155 will establish that there is a

substantial understatement of income tax. Respondent has, therefore, satisfied his

burden of production to the extent that the accuracy-related penalty relates to a

substantial understatement of income tax.

      Petitioners contend that they had reasonable cause and acted in good faith

because they reasonably relied on the advice of tax professionals with respect to

setting the management fee. Petitioners did not contend that they had reasonable

cause or acted in good faith with respect to the NOL. Therefore, with respect to
                                       - 56 -

[*56] that portion of the underpayment, petitioners are liable for accuracy-related

penalties under section 6662(a).

      We next address whether petitioners reasonably relied on the advice of tax

professionals with respect to setting the management fees paid to Albion.

Petitioners sought the advice of Marshall & Stevens ESOP Capital Strategies

Group, Barry Marlin, and Roland Attenborough to determine the proper

management fees that the operating companies should pay Albion. To determine

the management fees, petitioners’ tax advisers met with Mr. Wycoff to understand

the services Albion would provide to the operating companies and researched

caselaw with respect to reasonable compensation. Petitioners were subsequently

advised to set the rate of the management fees at 20% of each operating

company’s gross receipts.

      Mr. Wycoff testified in great detail that companies using direct response

marketing compensate differently from other companies; however, petitioners still

relied on the advice of Marshall & Stevens, Mr. Marlin, and Mr. Attenborough to

determine the management fee. Both Mr. Attenborough and Marshall & Stevens

were experienced in forming ESOPs but were not experienced in determining an

arm’s-length management fee. Petitioners also knew that Mr. Attenborough was

hired by Marshall & Stevens to complete the transaction and that Marshall &
                                       - 57 -

[*57] Stevens had an economic interest in petitioners’ going forward with the

transaction. Mr. Attenborough had an obvious conflict of interest that petitioners

and Mr. Marlin knew or should have known about. See Neonatology Assocs.,

P.A. v. Commissioner, 115 T.C. at 98-99. Additionally, aside from the work that

Mr. Marlin completed for petitioners, none of the advisers had experience with

companies using direct response marketing. Mr. Marlin’s law practice focused on

international tax, and petitioners knew or should have known the planning at issue

here did not involve any international tax issue. Petitioners did not consult an

economist or any adviser with experience in determining an arm’s-length

management fee to calculate the management fees the operating companies paid

Albion. Assuming that petitioners’ claims are true regarding direct response

marketing, a prudent business person in Mr. Wycoff’s situation with similar

experience, knowledge, and education would have sought the advice of an adviser

with experience in direct response marketing and/or calculating a reasonable

management fee. See sec. 1.6664-4(b)(1), Income Tax Regs. We are not

convinced petitioners reasonably relied on independent advisers who were

competent in calculating a reasonable management fee and/or executive

compensation. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99.
                                       - 58 -

[*58] Neither did petitioners introduce any documentary evidence with respect

how the management fees were determined. Petitioners claim a document existed,

but they claimed they did not have it. See Wichita Terminal Elevator Co. v.

Commissioner, 6 T.C. 1158, 1165 (1946) (stating that a taxpayer’s choosing not to

present evidence within his or her possession gives rise to a presumption that it

would have been unfavorable if it had). Petitioners’ advisers testified only

vaguely regarding the determination of the management fees. The advisers

testified that the management fees were originally set at 20% of gross receipts

because, in caselaw they purportedly reviewed, unidentified courts had held that

percentage to be reasonable.32 The advisers also met with Mr. Wycoff to

understand the services he provides, but the record does not indicate whether Mr.

Wycoff provided all necessary and accurate information to petitioners’ advisers.

Petitioners presented no credible evidence that their advisers considered what


      32
        On brief petitioners contend that the Court erred in excluding testimony
from Frederick Thomas, president of Marshall & Stevens. Petitioners contend that
Mr. Thomas could offer testimony of Marshall & Stevens’ general business
practices to prove that an analysis of a reasonable management fee would have
been completed as part of the Marshall & Stevens transaction. Petitioners’ tax
advisers testified that an analysis was completed. Although petitioners’ tax
advisers’ description of the analysis is vague, we conclude that the testimony of
Mr. Thomas would not have been helpful to the Court. He has no personal
knowledge of this particular transaction, and other advisers with personal
knowledge did testify.
                                       - 59 -

[*59] comparable companies would pay for comparable services when calculating

the management fees. Because the record is so vague as to how petitioners’

advisers calculated the management fees, we cannot find that it was reasonable to

rely on such an analysis.

      Petitioners also knew that the Marshall & Stevens transaction was an

aggressive tax planning program. Petitioners were warned that there were risks

and were encouraged to seek independent counsel. Petitioners did not seek advice

from independent counsel and from advisers with the requisite experience. In

short, petitioners’ reliance on their tax advisers, who were part of the promoter

group, was not reasonable. Accordingly, we sustain accuracy-related penalties

under section 6662(a).

      We have considered the parties’ remaining arguments, and to the extent not

discussed above, conclude those arguments are irrelevant, moot, or without merit.

      To reflect the foregoing,


                                                     Decision will be entered

                                                under Rule 155.
