                        T.C. Memo. 2011-74



                      UNITED STATES TAX COURT



    MULCAHY, PAURITSCH, SALVADOR & CO., LTD. f.k.a. MULCAHY,
            PAURITSCH & COMPANY, LTD., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4901-08.              Filed March 31, 2011.



     Albert L. Grasso and David B. Shiner, for petitioner.

     Naseem J. Khan, James Cascino, and Judah Fish (student), for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     MORRISON, Judge:   In a notice dated December 5, 2007,

respondent (whom we refer to here as the IRS) determined

deficiencies in the federal income tax of petitioner (whom we
                                 - 2 -

refer to here as the firm).1    The IRS determined the following

deficiencies in tax:    $317,729 for 2001, $284,505 for 2002, and

$377,247 for 2003.    The IRS also determined that the firm was

liable for accuracy-related penalties under section 6662 in the

following amounts:    $63,546 for 2001, $56,901 for 2002, and

$73,238 for 2003.2    The firm disputes these determinations.

                           FINDINGS OF FACT

The Firm, Shareholders, and Related Entities

     The firm is an accounting and consulting firm with its

principal place of business in Orland Park, Illinois.    The firm

was founded in 1979 by Edward W. Mulcahy, Michael F. Pauritsch,

and Philip A. Salvador.    We refer to the three men collectively

as the founders.     Throughout the years in issue--2001, 2002, and

2003--the founders served as the firm’s board of directors and

sole officers.   The founders also served as the only members of

the firm’s compensation committee, which determined what the firm

paid its employees, officers, and board members.    The firm was a

C corporation and a cash-basis taxpayer; it used a calendar year

for its taxable year.




     1
      Petitioner’s full name is “Mulcahy, Pauritsch, Salvador &
Co., Ltd.” This case also involves a related entity named MPS
Limited. To avoid confusion, we refer to petitioner as “the
firm” and the related entity as “MPS Ltd.”
     2
      All section references are to the Internal Revenue Code, as
amended and effective during the years at issue. All Rule
references are to the Tax Court Rules of Practice and Procedure.
                                  - 3 -

     From October 1, 2002 through the end of 2003,3 the firm was

owned by six shareholders, and their ownership percentages4 were

as follows:

                Edward W. Mulcahy                     26%
                Michael F. Pauritsch                  26%
                Philip A. Salvador                    26%
                Edward T. McCormick                   11%
                Glenn E. Byline                        5%
                David Kobza                            5%

We refer to McCormick, Byline, and Kobza as the minority

shareholders.   Kobza became a shareholder in 2002.    No

shareholders were related by blood or marriage.

     At issue is the deductibility of payments the firm made to

three related entities:   Financial Alternatives, Inc. (Financial

Alternatives), PEM & Associates (PEM), and MPS Limited (MPS

Ltd.).   We refer to the three entities collectively as the

related entities.

     The sole shareholders of Financial Alternatives were the

founders (Mulcahy, Pauritsch, and Salvador).   The founders owned

Financial Alternatives in equal shares.   Financial Alternatives

was a C corporation that used a taxable year ending June 30.    It



     3
      The record is incomplete regarding the ownership
percentages before October 1, 2002.
     4
      The shareholding percentages listed are rounded to the
nearest percentage point.
                                - 4 -

filed Forms 1120, U.S. Corporation Income Tax Return, for taxable

years ending June 30, 2002, 2003, and 2004.

     The founders also owned PEM in equal shares.      PEM was a

general partnership.    It filed Forms 1065, U.S. Return of

Partnership Income, for taxable years 2001, 2002, and 2003.

     Mulcahy and Salvador owned MPS Ltd. in equal shares, but

Pauritsch was not an owner.    MPS Ltd. was a limited liability

company filing as a C corporation.      It filed Forms 1120 for

taxable years 2002 and 2003.

     The related entities did not perform any services for the

firm in the years at issue.    The founders performed various

services for the firm, including accounting, consulting, and

management services.    The firm’s other employees (there were

approximately 40 throughout the years at issue) performed both

accounting and consulting services for the firm.

Payments by the Firm:    “Consulting fees”, Compensation, and
Interest Expense

     The firm paid the founders the following amounts, which it

designated as compensation:

       Year    Mulcahy     Pauritsch      Salvador     Total
       2001    $106,175     $99,074       $117,824   $323,073
       2002     103,156       96,376       106,376    305,908
       2003     102,662       95,048       112,086    309,796

     The firm made a number of payments to the related entities

that it designated as “consulting fees”.      It now claims that
                               - 5 -

these payments were compensation for the services of the

founders.5   It paid PEM, as “consulting fees”, $136,570 in 2001,

$147,837 in 2002, and $81,467 in 2003.6   It paid Financial

Alternatives, as “consulting fees”, $755,0007 in 2001, $468,306


     5
      Note that if the firm had made payments to the founders
that were profit distributions (besides the “consulting fee”
payments, which the IRS contends were profit distributions), this
would plausibly point in favor of characterizing the “consulting
fee” payments as compensation for services. The firm does not
contend that there were any profit distributions.

     Note also that if the firm had made other payments to the
founders for their services, besides the amounts paid directly to
the founders as compensation and the amounts paid as “consulting
fees” to the related entities (fees the firm contends were
payments in exchange for the founders’ services), this would
plausibly point in favor of characterizing the “consulting fee”
payments as profit distributions. The IRS does not contend that
there were any other payments for the founders’ services.
     6
      The firm also made payments it designated as rent to PEM in
the following amounts: $127,750 in 2001, $153,300 in 2002, and
$127,750 in 2003. It paid the amounts in installments of
$12,750. The firm paid PEM each month during 2001 through 2003,
except the following months: January 2001, December 2001,
January 2003, and April 2003. Neither party argued that any part
of the amounts designated as rent was a distribution to the
founders or compensation for the founders’ services. As
discussed below, the firm also paid $46,541.95 that it designated
as an interest expense to PEM in 2003. As discussed below, the
firm claimed a deduction of $34,421--which is the sum of two of
the three payments it designated as interest expenses in 2003.
The firm now argues that the $34,421 is additional compensation
for the founders’ services.
     7
      In its petition the firm asserted that it paid “consulting
fees” of $775,000 to Financial Alternatives in 2001. We find
that it paid only $755,000 because (i) the canceled check
evidencing the payment to Financial Alternatives was for
$755,000, not $775,000; (ii) the firm did not object to the IRS’
proposed finding of fact that it paid Financial Alternatives
$755,000, not $775,000; and (iii) Financial Alternatives reported
                                                   (continued...)
                                 - 6 -
in 2002, and $610,524 in 2003.      And it paid MPS Ltd., as

“consulting fees”, zero in 2001, $250,000 in 2002, and $301,537

in 2003.8   To summarize, we find the firm paid the following

amounts to the related entities, which it designated as

“consulting fees”:

     Year     Financial       PEM         MPS Ltd.       Total
            Alternatives
     2001      $755,000    $136,570          -0-       $891,570
     2002       468,306     147,837       $250,000      866,143
     2003       610,524      81,467        301,537      993,528

     The firm paid PEM throughout the year and paid Financial

Alternatives and MPS Ltd. at the end of each year.      Salvador

determined the amounts of the payments to Financial Alternatives

and MPS Ltd. by setting the total amounts of these payments equal

to the cash the firm had on hand at the end of the year.       He did

this for tax planning reasons.      The result of removing all the

cash on hand was to reduce the taxable income that the firm

reported to zero (or near zero).




     7
      (...continued)
only $755,000 in gross receipts on its tax year ending June 30,
2002.
     8
      For the amounts paid to Financial Alternatives and PEM, the
firm provided canceled checks as evidence of the payment. It did
not offer canceled checks for the payments to MPS Ltd., but it
offered testimony that the payments were made and a copy of its
general ledger showing the payments. We find this evidence
credible.
                                - 7 -
       The compensation committee allocated the firm’s payments to

the related entities among the founders according to the hours

each founder worked for the year.    The related entities in turn

paid the founders according roughly to the committee’s

allocation.    The payments to each founder by the related entities

were thus proportionate to his hours worked in relation to the

other founders and not to his shareholdings.    The allocations

were as follows:

  Year        Mulcahy    Pauritsch      Salvador           Total
                                                       1
  2001      $286,954      $285,240      $339,376        $911,570
  2002        360,698      132,373       373,072           866,143
  2003        451,723       93,457       448,348           993,528
   1
    The firm included in the amounts that it allocated to its
founders the $20,000 that it claims to have paid to Financial
Alternatives but that we find it did not in fact pay. See
supra note 7. Hence the total allocation for 2001 is $20,000
more than the amount we find the firm paid to the related
entities.


       Besides the amounts paid to PEM as “consulting fees”, in

2003 the firm paid PEM $34,421, which it designated as an

“interest expense”.9




       9
      The $34,421 is in issue because, as discussed below, the
IRS disallowed the firm’s deduction of that amount. The firm
paid another $12,300.73 on June 25, 2003, which it designated as
an “interest expense”. Neither party, however, has asserted that
this payment was either additional compensation for the founders’
services or a distribution of profits. See also supra notes 5
and 6.
                                 - 8 -
     Finally, in its petition the firm asserted that in 2003 it

paid $500 to a company named Sure Prep for consulting services.

As we explain below, we find that the firm did not make this

payment.   See infra part I.D.

Deductions

     The firm filed Forms 1120 for 2001, 2002, and 2003,

reporting gross receipts of $5,496,028, $5,742,420, and

$6,338,482, respectively.    It reported taxable income of $11,249

for 2001 and zero in 2003.   It reported a loss of $53,271 for

2002.

     Among the deductions claimed on the returns, the firm

claimed “consulting fees” of $911,570 for 2001, $866,143 for

2002, and $994,028 for 2003.     Of the $994,028 of “consulting

fees” deducted in 2003, $500 was for the alleged payment to Sure

Prep.   The firm claimed on its 2003 return (i) a credit for

prior-year minimum tax of $9,141, (ii) a net operating loss

carryforward deduction of $49,579, and (iii) a deduction for the

$34,421 that it paid PEM as an interest expense.

Notice of Deficiency

     In a notice dated December 5, 2007, the IRS determined the

following deficiencies in tax:     $317,729 for 2001, $284,505 for

2002, and $377,247 for 2003.     The deficiencies primarily resulted

from disallowance of the deductions for “consulting fees”.        The

IRS also determined that the firm was not entitled to the $34,421
                                 - 9 -
interest expense deduction in 2003.       And, as a result of its

disallowance of the “consulting fee” deductions for 2001 and

2003, the IRS determined that for 2003 the firm was entitled to

neither the credit for prior-year minimum tax nor the deduction

for the net operating loss carry forward.

     The IRS also determined that the firm was liable for

accuracy-related penalties under section 6662 in the following

amounts:   $63,546 in 2001, $56,901 in 2002, and $73,238 in 2003.

                                OPINION

     At issue is whether the IRS properly disallowed deductions

for (i) “consulting fees” paid to the related entities, (ii) an

interest expense paid to PEM, and (iii) “consulting fees” paid to

Sure Prep.   Also at issue is whether the IRS properly imposed

penalties under section 6662.    As we explain below, we find that

the IRS properly disallowed the deductions and properly imposed

penalties.

I.   Deductions and Credits

     A.    Burden of Proof

     Generally, the taxpayer has the burden of proving that the

determinations in the notice of deficiency are wrong.       Rule

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

7491(a)(1) shifts the burden of proof to the IRS if (i) the

taxpayer satisfies the conditions set forth in section 7491(a)(2)

and (ii) the taxpayer introduces credible evidence on factual
                               - 10 -
issues relevant to the taxpayer’s liability for a tax under

subtitle A or B.    To satisfy section 7491(a)(2), the taxpayer

must comply with the substantiation and recordkeeping

requirements of the Internal Revenue Code.     Sec. 7491(a)(2)(A).

The taxpayer must also cooperate with reasonable requests by the

IRS for “witnesses, information, documents, meetings, and

interviews”.   Sec. 7491(a)(2)(B).   And, if the taxpayer is a

corporation, it must meet the net-worth requirements of section

7430(c)(4)(A)(ii).   See sec. 7491(a)(2)(C).   A taxpayer bears the

burden of proving it satisfied these conditions.    See Higbee v.

Commissioner, 116 T.C. 438, 440–441 (2001).     The firm has neither

contended nor adduced evidence that it satisfied these

conditions; thus section 7491(a)(1) does not shift the burden of

proof to the IRS.

     The firm therefore has the burden of proof regarding its

entitlement to the deductions at issue.
                              - 11 -
     B.   Payments to the Related Entities--“Consulting Fee”
          Deductions10

     Section 162(a)(1) allows taxpayers to deduct “ordinary and

necessary expenses”, including a “reasonable allowance for

salaries or other compensation for personal services actually

rendered”.   The IRS argues that the firm is not entitled to

deductions for the “consulting fee” payments because the related

entities rendered no services to the firm.   Citing Commissioner

v. Natl. Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149

(1974), the IRS argues that the firm is bound to the form it

chose for the transactions with the related entities.11


     10
      As we explain below, we find that the firm is not entitled
to deductions for the “consulting fee” payments to the related
entities. There is an additional reason the “consulting fees”
paid to PEM in particular are not deductible. The firm’s counsel
conceded--and Salvador testified--that some of the payments to
PEM that were reported as “consulting fees” were properly
characterized as “return[s] on capital”. The firm offered
neither evidence nor a legal theory as to why such a return of
capital is deductible. Even if some part of the “consulting fee”
payments to PEM were deductible, the firm has not demonstrated
what part of the “consulting fee” payments were nondeductible
returns of capital. We have no way of reasonably allocating the
“consulting fee” payments between returns of capital and
nonreturns of capital. Thus the “consulting fee” payments to PEM
are not deductible because the firm has conceded that at least
part of the payments was a return of capital.
     11
      The firm structured the form of its transactions with the
related entities as if it was paying the related entities for
services rendered by the related entities. The payments were
made to the related entities, not the founders. The firm
recorded the payments in its general ledger as “consulting fees”
paid to the related entities. The checks issued by the firm did
not designate the payments as payments for the founders’
services. And the way the firm filed tax forms and paid taxes
                                                   (continued...)
                               - 12 -
Therefore, the IRS argues, the “consulting fee” payments should

be tested for deductibility as payments for the related entities’

services--as opposed to payments for the founders’ services.   We

need not reach this issue because, even if the payments are

tested for deductibility as payments for the founders’ services,

the firm failed to show that the payments are deductible.

     Section 1.162-7(a), Income Tax Regs., provides that “There

may be included among the ordinary and necessary expenses paid or

incurred in carrying on any trade or business a reasonable

allowance for salaries or other compensation for personal

services actually rendered.”   (Emphasis added.)   The firm

concedes that no services were rendered by the related entities.

Therefore the firm is not entitled to deduct the “consulting fee”

payments as payments for services rendered by the related

entities.




     11
      (...continued)
was consistent with payments made for the services of the related
entities. The firm did not withhold payroll taxes on the
“consulting fee” payments, as it would have been required to do
with respect to employee compensation payments to the founders.
It did not include the “consulting fee” payments on the founders’
Forms W-2, Wage and Tax Statement, as it would have been required
to do with respect to employee-compensation payments to the
founders. It did not issue the founders Forms 1099-MISC,
Miscellaneous Income, as it would have been required to do with
respect to payments of nonemployee compensation to the founders.
Finally, it did not report the “consulting fee” payments on its
income tax returns as officers’ compensation.
                                 - 13 -
     Evaluating the payments as if they were payments for the

founders’ services, we find that the firm has failed to show that

it is entitled to the deductions.

           1.   Reasonableness

     A deduction for compensation “may not exceed what is

reasonable under all the circumstances.”     Sec. 1.162-7(b)(3),

Income Tax Regs.   The Court of Appeals for the Seventh Circuit,

in Exacto Spring Corp. v. Commissioner, 196 F.3d 833, 839 (7th

Cir. 1999), revg. Heitz v. Commissioner, T.C. Memo. 1998-220, has

held that to determine if payments of compensation are

reasonable, an “independent investor test” should be applied.

See also Menard, Inc. v. Commissioner, 560 F.3d 620, 623 (7th

Cir. 2009), revg. T.C. Memo. 2004-207.     Appeal of this case will

be to the Seventh Circuit, unless the parties otherwise agree.

See sec. 7482(b)(1) and (2).     We follow the law of the Court of

Appeals to which an appeal will lie.      Golsen v. Commissioner, 54

T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

Therefore, the independent investor test must be applied in

determining whether the “consulting fee” payments are deductible.

     The independent investor test creates a rebuttable

presumption that an owner-employee’s salary is reasonable if

investors obtain a “far higher return than they had any reason to

expect”.   Exacto Spring Corp. v. Commissioner, supra at 839.      The

test’s rationale is that investors pay managers salaries to
                               - 14 -
“[work] to increase the value of the assets * * * entrusted to

[their] management”.    Id. at 838.   A high rate of return

indicates that the assets’ value increased and that the manager

therefore provided valuable services.     Id.   Thus, if investors

obtain returns above what they should reasonably expect, a

manager’s salary is presumptively reasonable.      Id. at 839.   The

presumption is rebutted if the high rate of return is

attributable to an extraneous event rather than the manager’s

efforts.    See Menard, Inc. v. Commissioner, supra at 623 (giving

examples).

     The parties disagree on how to calculate the rate of return

on investment, which is also known as the rate of return on

equity.    The firm contends that the rate of return on equity is

equal to its gross revenue for one year minus its gross revenue

for the prior year, divided by the gross revenue for the prior

year.   This definition is based on the theory that the value of

the firm’s equity is equal to the firm’s gross revenue for one

year.   The firm claims that annual gross revenue is an

appropriate measure of the firm’s equity because someone once

offered to buy the firm for a purchase price equal to one year’s

gross revenue.    Gross revenues were $5,496,028 for 2001,

$5,742,420 for 2002, and $6,338,482 for 2003, and the firm claims
                               - 15 -
that gross revenues for 2000 were $5,405,102.12    So the firm

calculates that from 2000 to 2003 the cumulative rate of return

for the shareholders was 17.27 percent.

     The IRS does not propose an exact formula for rate of return

on equity.   It argues only that rate of return on equity should

depend on annual net income.   Any formula for rate of return on

equity using annual net income would--in this case--result in a

rate of return on equity near zero.     For example, if the rate of

return on equity is defined as annual net income divided by the

value of equity, the rate of return on equity would be near zero

because (i) the firm’s annual net income was near zero and (ii)

the value of equity was substantial relative to that annual net

income.

     We agree with the IRS that the rate of return on the firm’s

equity should be calculated by reference to annual net income,

not the year-to-year change in gross revenue.     It is

inappropriate to look to gross revenue (or to changes in gross

revenue) to determine if equity investors are receiving good

returns on their investment.   A corporation’s shareholders do not

seek to maximize gross revenue.   They seek to maximize profit.



     12
      The firm attached documents supporting this contention to
its reply brief, but did not offer them into evidence.
Statements in a party’s brief and documents attached to a party’s
brief are not evidence. Rule 143(c). And we will not consider
them. See Godwin v. Commissioner, T.C. Memo. 2003-289, affd. 132
Fed. Appx. 785 (11th Cir. 2005).
                                - 16 -
See Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 793

(7th Cir. 2009).    Profit equals revenues minus cost.13    It is

therefore different from revenues.       See Wash. Natl. Ins. Co. v.

Administrators, 2 F.3d 192, 194 (7th Cir. 1993) (“Hoefer’s desire

to maximize gross revenues, contrasted with WNIC’s desire to

maximize net profits, put them on a collision course * * * .”

(emphasis added)).    A company with high revenues does not

necessarily have high profits.    Suppose, for example, that a

company receives $1 million per year from its clients, pays $1

million to its employees in wages, and has no other revenues or

costs.    The gross revenues of such a company would be $1 million,

but its profit would be zero.    Such a company would not be

earning a good rate of return for its equity investors.

     Using annual net income comports with the approach taken by

the Seventh Circuit in Exacto Spring Corp. v. Commissioner,

supra.    In evaluating the rate of return on Exacto’s equity, the

Seventh Circuit relied on the Tax Court’s finding that the rate

of return on the equity of the Exacto Spring Corp. was 20

percent.    Id. at 838-839.   That 20 percent figure was based on

the posttax profit of the company.       See Heitz v. Commissioner,

supra (“An investor return analysis compares a company’s after-

tax profit to its equity to determine whether an independent



     13
      Profit is roughly equivalent to annual net income for
these purposes.
                                - 17 -
investor would be satisfied with the level of return.” (emphasis

added)).    Thus the Seventh Circuit in Exacto Spring looked to

profit, not gross income.    Again, the Seventh Circuit is where an

appeal of this case will lie, and we are required to follow its

caselaw.

     Having addressed the question of how to define the rate of

return on equity, we find that the rate of return on the firm’s

equity is too low to create a presumption that the amounts

claimed as “consulting fees” were reasonable compensation for the

founders’ services.   In Menard, Inc. v. Commissioner, 560 F.3d at

624, the rate of return on equity was 18.8 percent, and in Exacto

Spring Corp. v. Commissioner, 196 F.3d at 838-839, the rate of

return was 20 percent.     Both rates of return were high enough to

create a presumption that the compensation received by the

respective shareholders for their services was reasonable.    But

in this case, the firm reported taxable income of $11,249 for

2001, a tax loss of $53,271 for 2002, and taxable income of zero

for 2003.    This makes the rate of return on equity either near

zero, below zero, or zero, in each respective year.    Thus the

independent investor test does not create a presumption that the

amounts were reasonable.

     Without the aid of the presumption of reasonability, the

firm has not otherwise shown that the amounts it seeks to deduct

as compensation were reasonable.    Generally, “reasonable and true
                              - 18 -
compensation is only such amount as would ordinarily be paid for

like services by like enterprises under like circumstances.”

Sec. 1.162-7(b)(3), Income Tax Regs.14   The firm has not satisfied

this standard because, as we explain below:   (i) the firm’s

expert relied on irrelevant statistics regarding the amounts paid

to the shareholder-employees at other companies and (ii) the firm

has not shown that the other benchmarks it offered--the amounts

it paid the minority shareholders and other employees--are

appropriate for comparison.

     Using statistics gathered from other firms, the firm’s

expert witness, Marc Rosenberg, opined on the reasonableness of

amounts paid to each founder, which included (i) amounts

designated as compensation and (ii) amounts designated as

“consulting fees”.   The first problem with his analysis is that

the statistics he gathered from other firms were irrelevant.    He

appears to have relied on the following statistic he gathered

from each firm:   (i) the sum of (a) the salaries the other firm

ostensibly paid its owners for its owners’ services and (b) the


     14
      In considering evidence of what would be paid for services
similar to the services provided by the founders, we bear in mind
the Seventh Circuit’s admonition in Exacto Spring Corp. v.
Commissioner, 196 F.3d 833, 835 (7th Cir. 1999), revg. Heitz v.
Commissioner, T.C. Memo. 1998-220, that courts should not invite
themselves to “decide what the taxpayer’s employees should be
paid on the basis of the judges’ own ideas of what jobs are
comparable”. We consider evidence of what would be paid for
similar services because we have first addressed the question of
whether the taxpayer in this case had a high rate of return on
equity.
                                - 19 -
other firm’s net income, divided by (ii) the other firm’s total

number of owners.   This statistic does not necessarily correspond

to what owners of other firms received for their services.    For

example, suppose that another company paid its sole owner

$300,000 per year in “salary” payments that were ostensibly for

services.   This does not mean that the owner’s services to the

company were worth $300,000.    Even though the $300,000 in

payments were nominally labeled by the company as “salary”, the

payments could in reality be a return on the owner’s investment

in the company (or a repayment of the investment).    Similarly,

suppose that a company with a sole owner has $200,000 in net

income.   This does not mean that its sole owner’s services were

worth $200,000.   The $200,000 in income could have resulted from

the owner’s investment in the company as opposed to the owner’s

services.   The second problem with Rosenberg’s analysis is that

he opined on the wrong thing.    He concluded that the payments to

the founders were reasonable, not that they were reasonable

compensation for services.     For example, the total payments to

Mulcahy in 2001 were $393,129, which is the sum of $106,175 in

wages and $286,954 in “consulting fees” paid through the related

entities.   It does not help us to know, as Rosenberg informs us,

that it was reasonable for the firm to pay Mulcahy $393,129.

What we need to know is whether $393,129 was a reasonable amount
                              - 20 -
to compensate Mulcahy for his services.   Rosenberg’s report does

not support the firm’s position.

     The firm also argues that, because the amounts it reported

as compensation for each minority shareholder were more than the

amounts it reported as compensation for each founder, the

“consulting fees” it paid to the founders through the related

entities must have been reasonable.    This argument fails for two

reasons.   First, the firm did not establish that the amounts it

paid the minority shareholders as compensation were actually

compensation for services.   The minority shareholders were

shareholders, not merely employees.    The payments they received

could have been partially composed of profit distributions.

Second, the firm has not established that the services performed

by the minority shareholders were like the services performed by

the founders.

     Similarly, the firm argues that the founders’ pay is

reasonable because the founders should be paid substantially more

than nonshareholder employees whose salaries were similar to the

amounts the firm paid the founders directly.   Although the

compensation of nonshareholder employees would not include profit

distributions, as could the payments to the minority

shareholders, the firm has not shown how the services performed

by these nonshareholder employees compare to the services

performed by the founders.   The firm has offered only general
                                - 21 -
testimony about the importance of the founders to the firm and

has not offered specific evidence about the services performed by

the founders or any of the employees.    The firm--which has the

burden of proof--simply has not offered enough evidence to allow

us to compare the relative value of the founders’ services and

the services of the nonshareholder employees.

     Because the firm did not meet its burden of proof, we find

that the “consulting fee” payments were not reasonable

compensation to the founders.

          2.   Intent To Compensate

     Besides being reasonable, to be deductible as compensation,

a payment must be intended by the payor--at the time of

payment--to compensate for services.     See Paula Constr. Co. v.

Commissioner, 58 T.C. 1055, 1058-1060 (1972), affd. without

published opinion 474 F.2d 1345 (5th Cir. 1973); see also Exacto

Spring Corp. v. Commissioner, 196 F.3d at 839 (stating that even

where the taxpayer was entitled to the presumption of

reasonability, “The government could * * * have prevailed by

showing that while * * * [the owner employee’s] salary may have

been no greater than would be reasonable in the circumstances,

the company did not in fact intend to pay * * * [the] amount as

salary * * * .”).   Where shareholders set their own pay, we must

apply careful scrutiny because payments labeled as compensation

may be profit distributions.    Home Interiors & Gifts, Inc. v.
                              - 22 -
Commissioner, 73 T.C. 1142, 1156 (1980); cf. Menard, Inc. v.

Commissioner, 560 F.3d at 622 (“treating a dividend as salary

[is] less likely to be attempted in a publicly held

corporation”).

    One characteristic of the “consulting fee” payments was that

the amounts eventually paid to the founders were proportionate to

the hours worked by the founders, rather than to the founders’

ownership shares.   Because of this, the firm argues that section

1.162-7(b)(1), Income Tax Regs., compels the conclusion that the

firm did not intend for the payments to be profit distributions.

That regulation provides that payments to shareholder-employees

are likely to be profit distributions if:    (i) the payments are

proportionate to ownership shares and (ii) the payments are more

than what employers normally pay for similar services.   The

regulation does not say that only payments that meet these two

conditions can be considered profit distributions.    Payments that

fail the two conditions could qualify as profit distributions.

For example, payments that are not proportionate to ownership

shares can be profit distributions.    See, e.g., Baird v.

Commissioner, 25 T.C. 387, 395-396 (1955).    Thus the “consulting

fee” payments to the firm’s founders can be considered profit

distributions even though the payments are not proportionate to

ownership shares.
                                - 23 -
    We find that the firm intended for the payments to the

related entities to distribute profits, not to compensate for

services.    As discussed above, Salvador chose the amount to pay

each year so that the payments distributed all (or nearly all)

accumulated profit for the year.    He did this for tax planning

purposes.    Each founder’s percentage of the payments to the

related entities was tied to hours worked, but the firm’s intent

in making the payments was to eliminate all taxable income.     The

firm did not intend to compensate for services.

    C.      Payments to PEM--Interest Expense Deduction

    The firm claims it paid PEM $34,421, an amount that it

deducted as an interest expense for 2003.    The firm now concedes

that the $34,421 was not deductible as an interest expense.     But

the firm asserts that it was deductible as compensation to the

founders, paid through PEM.    As discussed above, for a payment to

be deductible as compensation for services under section

162(a)(1), the payor must intend to compensate for services.     See

supra part I.B.2.    As with the payments designated as “consulting

fee” payments, the firm has failed to show that this amount was

intended as compensation, as opposed to a distribution of profits

or payment of nondeductible interest.    The firm has the burden of

proof, and we therefore find that it was not entitled to the

deduction.
                               - 24 -
    D.   Payment to Sure Prep--“Consulting Fee” Deduction

    A portion of the $994,028 deducted by the firm in 2003 in

“consulting fees” was for an alleged $500 payment to Sure Prep.

In its petition the firm asserted that in 2003 it paid $500 to

Sure Prep for consulting services.      The IRS denied that the firm

made the payment.    The parties’ briefs did not address the

deductibility of the purported payment.     Although there is an

entry in the firm’s general ledger that may correspond to this

amount, see Ex. 46-R at 43, the firm provided no other evidence

that it in fact paid the $500 or that the ledger entry

corresponds to this purported payment.     Even if the firm paid the

$500, no evidence shows that such a payment would have been

deductible.    We therefore find that the $500 the firm claimed on

the return was not paid, and alternatively, even if paid, that it

is not deductible.

    E.   The Net Operating Loss Deduction and the Credit for
         Prior-Year Minimum Tax

    For tax year 2003, the IRS disallowed the firm’s net

operating loss deduction and the firm’s credit for prior-year

minimum tax.   Because the IRS properly disallowed the “consulting

fee” and interest expense deductions, the IRS properly disallowed

the net operating loss deduction and the credit for prior-year

minimum tax.
                               - 25 -
II.    Penalties

      The IRS determined that the firm was liable for accuracy-

related penalties under section 6662.   Section 6662 imposes a 20%

penalty on an underpayment of tax that results either from

negligence or disregard of rules and regulations or from a

substantial understatement of income tax.   The IRS determined

that there were underpayments of tax for the years at issue and

that the underpayments were attributable to substantial

understatements of income tax or, alternatively, negligence.      As

we explain below, we find that the firm is liable for the

accuracy-related penalty due to substantial understatements of

income tax.   We therefore do not reach whether the underpayments

are also attributable to negligence.

      Generally, an understatement is the excess of tax required

to be shown on the return over the tax shown on the return.    Sec.

6662(d)(2)(A); sec. 1.6662-4(b)(2), Income Tax Regs.   For

corporations other than S corporations and personal holding

companies, an understatement is considered substantial if it

exceeds $10,000 and exceeds 10 percent of the tax required to be

shown on the return.   Sec. 6662(d)(1); sec. 1.6662-4(b)(1),

Income Tax Regs.

      No penalty is imposed on a portion of the underpayment if

the taxpayer both (i) had reasonable cause for that portion and
                                 - 26 -
(ii) acted in good faith regarding that portion.     See sec.

6664(c); sec. 1.6664-4(a), Income Tax Regs.

     A.   Burden of Proof

    Section 7491(c) provides that the IRS has the burden of

production regarding the liability “of any individual for any

penalty, addition to tax, or additional amount imposed by * * *

[the Internal Revenue Code].”    To meet this burden, the IRS must

“come forward with sufficient evidence indicating that it is

appropriate to impose the relevant penalty.”     Higbee v.

Commissioner, 116 T.C. at 446.    The taxpayer, not the IRS, bears

the burden of proof.   Thus, if the IRS meets the burden of

production, the taxpayer bears the burden of proving that it is

not liable for penalties.    Id. at 446-447.   The taxpayer bears

the burdens of both production and proof on reasonable cause and

good faith.    See id. at 446 (“the * * * [IRS] need not introduce

evidence regarding reasonable cause”).

    B.    Substantial Understatement

    The IRS met its burden of production for substantial

understatement because it has shown that in each year in issue

(i) the firm understated its tax and (ii) the understatement was

substantial.   As discussed above, the IRS has shown that the firm

understated its tax by $317,729 in 2001, $284,505 in 2002, and

$377,247 in 2003.   The firm’s returns show tax of $1,687 in 2001,

zero in 2002, and zero in 2003.    Because each year’s
                              - 27 -
understatement exceeds $10,000 and exceeds 10 percent of the

total tax required to be shown on the return, the understatements

were substantial.   Thus the IRS has come forward with sufficient

evidence that it is appropriate to impose the substantial

understatement penalty for each year.

    The firm failed to prove that it is not liable for the

penalty.   And, as explained below, the firm has not shown that it

had reasonable cause for and acted in good faith regarding any

part of any underpayment.

    C.     Reasonable Cause and Good Faith

    The firm argues that penalties should be abated because it

had reasonable cause for and acted in good faith regarding the

underpayments.

    The firm has not met its burden of proof for reasonable

cause and good faith.   As to the “consulting fee” deductions paid

to the related entities, the firm did not show that it had

reasonable cause to believe it could deduct, as compensation,

payments to entities that performed no services.   The firm

asserted that it “evaluated the applicable tax laws, reviewed

relevant statistical information of like enterprises and

determined that the compensation for the Founders paid as

‘consulting fees’ through the Affiliated Entities was

deductible”.   Petrs. Posttrial Br. at 52.   But the firm did not

point to specific evidence that it had reasonable cause for the
                                - 28 -
underpayments.   And the statistics on which Salvador relied were

the same irrelevant statistics on which Rosenberg based his

expert testimony.   Besides, Salvador testified that when actually

determining how much to pay through the related entities (at the

end of each year) he looked to cash on hand, not to Rosenberg’s

statistics.    Finally, the firm offered no reasonable cause for

the underpayments attributable to the interest expense deductions

and the deductions for “consulting fees” paid to Sure Prep.

    Generally, one of the most important factors in

demonstrating reasonable cause and good faith is the extent of

the taxpayer’s effort to determine its proper tax liability.

Sec. 1.6664-4(b)(1), Income Tax Regs.    The firm provided little

evidence of such efforts.    Other factors include the taxpayer’s

experience, knowledge, and education.    Id.   These factors weigh

heavily against the firm, which specialized in accounting and

consulting.    Thus the firm has not proven that it had reasonable

cause for and acted in good faith regarding any part of any

underpayment.

    We therefore find that the IRS correctly determined that the

firm is liable for the penalty under section 6662 for substantial

understatement of income tax.

III. Summary

    The firm has not shown that it was entitled to the

“consulting fee” deductions for payments to the related entities.
                              - 29 -
The firm has not shown that it is entitled to deduct the $34,421

for which it claimed a deduction as an interest expense.   And the

firm has not shown that it was entitled to deduct the $500 it

claims to have paid to Sure Prep as “consulting fees”.

    We therefore sustain the IRS’ determinations disallowing (i)

the “consulting fee” deductions for 2001, 2002, and 2003; (ii)

the interest expense deduction for 2003; (iii) the net operating

loss deduction for 2003; and (iv) the credit for prior-year

minimum tax for 2003.

    Finally, the IRS has shown that it was appropriate to impose

penalties under section 6662 for substantial understatement of

income tax.   The firm has failed to show that it had reasonable

cause for and acted in good faith regarding any part of any

underpayment.   We therefore sustain the IRS’ determinations on

penalties.

     To reflect the foregoing,

                                       Decision will be entered

                                   for respondent.
