                        T.C. Memo. 1997-251



                      UNITED STATES TAX COURT



    JOHN L. GINGER MASONRY, INC., Petitioner v. COMMISSIONER
                 OF INTERNAL REVENUE, Respondent



     Docket No. 1695-95.               Filed June 4, 1997.



     Gary E. Reddish and Scott R. Heil, for petitioner.

     Maria D. Murphy and Margaret Kuo, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION

     CLAPP, Judge:   Respondent determined the following

deficiencies in petitioner's Federal income taxes:
                                 - 2 -


              FYE
             June 30                     Deficiency

             1990                        $227,677
             1991                          52,981
             1992                          72,081

     The issue for decision is whether the compensation paid to

petitioner's shareholder in its fiscal years ending 1990 and 1992

is deductible by petitioner as reasonable compensation under

section 162(a)(1).     We hold that it is.

     All section references are to the Internal Revenue Code in

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

Tax Court Rules of Practice and Procedure, unless otherwise

indicated.

                           FINDINGS OF FACT

     We incorporate by reference the stipulation of facts and

attached exhibits.     John L. Ginger Masonry, Inc. (petitioner), is

a California corporation whose principal place of business was in

Riverside, California, when the petition was filed.       Petitioner

operates on a fiscal year ending June 30.       The deficiency

determined by respondent for the fiscal year ended June 30, 1991,

stems solely from adjustments tied to the fiscal years ended June

30, 1990, and June 30, 1992.

A. Petitioner

     Petitioner is a masonry contractor that specializes in

brick, stone, and block masonry.     Petitioner's founder, John L.

Ginger (Ginger), has spent his entire career in the construction
                                - 3 -

business.   Ginger's father was a contractor, and Ginger worked

for him during the summers.    Ginger had no formal education past

high school.   When Ginger completed high school, he began working

full time for his father.    Ginger worked for other contractors

before starting his own masonry contracting business as a sole

proprietorship in 1978 with a capital investment of $500 and one

employee.

     In September 1984, Ginger formed petitioner with a capital

investment of $15,000.    Ginger and his wife, Toni S. Ginger (Mrs.

Ginger), owned equally all of petitioner's issued and outstanding

shares of stock.   Ginger and Mrs. Ginger serve as petitioner's

board of directors.   During the fiscal years ending 1985 through

1992, Ginger served as petitioner's president, and Mrs. Ginger

served as petitioner's corporate secretary.    Mrs. Ginger had no

role with petitioner other than being a member of the board and

the corporate secretary.

     Ginger quickly developed a reputation as an honest and

no-nonsense operator.    Immediately after forming petitioner,

Ginger negotiated with vendors and asked them to help finance

petitioner's purchases.    If petitioner was out of cash, Ginger

would call the owner of the creditor company, tell him that

petitioner could not pay the bill that month, and explain what

was being done to remedy the situation.

B. Ginger's Strategy When He Formed Petitioner
                                - 4 -

     While working for other contractors, Ginger noticed that the

masonry business was divided into contractors that worked on

commercial projects and contractors that worked on residential

projects.    The commercial masonry contractors were large

companies that handled the large commercial jobs, such as high-

rise buildings, office buildings, and shopping centers.    The

commercial masonry contractors were very professional.    They had

solid reputations and had established working relationships with

the large developers overseeing the commercial construction

projects.

     The residential masonry contractors, on the other hand,

consisted of mostly smaller companies that bid on projects in a

very limited geographic area.    These contractors did not have

working relationships with the developers.    Competition for jobs

was stiff, and the contractors would try and squeeze as much

profit from a job as possible, and often quality would suffer as

a result.

     Ginger developed a strategy that would enable petitioner to

penetrate the residential masonry market.    Ginger wanted to enter

that market with the same professionalism found in commercial

masonry.    Ginger wanted to avoid an adversarial posture between

petitioner and the customers (i.e., the developers).    Rather, he

wanted to work with the developers to make sure that they were

satisfied with petitioner's work.    Ginger reasoned that if
                               - 5 -

petitioner provided high-quality work, the developers would

continue to hire petitioner year after year.

     Ginger realized that working with the large developers was

essential to petitioner's success.     The large developers were

building entire housing tracts, and they were the most reliable

source for a steady volume of masonry projects.     Ginger also

realized that, in order to work with large developers, petitioner

would need a lot of equity to meet its operating expenses.

Ginger knew that some large developers would wait 90 to 100 days

before paying the masonry contractor.     The large developers

wanted contractors on the job that could complete the project, on

time, without problems.   As a result, the developers avoided

contractors with insufficient resources.     Ginger consulted with

petitioner's accountant, Gary Christenson (Christenson).

Christenson advised Ginger that petitioner would have to

accumulate substantial amounts of working capital and maintain

strong financial statements before it could work with the large

developers.   Thus, in the years 1985 through 1989, Ginger's first

priority was to grow petitioner to an acceptable size; to this

end, he took less compensation in order to speed the process of

reaching petitioner's capitalization goals.

     Ginger's insight proved accurate, and petitioner began to

develop a good reputation among the residential developers.

After winning the trust of the residential developer, the

developer would often contact Ginger directly to get a
                               - 6 -

preliminary cost estimate.   The developer would use the

preliminary estimate to develop a budget on a project.     In

essence, Ginger served as consultant to the residential

developer, providing information such as the type of products the

developer should use or a cost-saving approach to a problem.

     When the preliminary work was finished and the job was set

to go forward, the residential developer would want petitioner to

get the job because Ginger already was familiar with it.     As a

result, the residential developer would be more lenient with

petitioner in the bidding process than might otherwise be the

case.   This proved crucial to petitioner's success because it

gave Ginger the opportunity to negotiate a final bid with the

developer.   This was not standard practice in the industry.

Typically, the subcontractor submitting the lowest bid would get

the job, but petitioner generally was not the lowest bidder.     In

fact, Ginger did not want petitioner to be the lowest bidder.

Because of Ginger's good working relationship with the

developers, they were willing to pay petitioner a premium since

they trusted that Ginger would deliver superior quality and

service.   Ginger considered this a key to petitioner's success.

     Once petitioner began working with the large developers,

Ginger took advantage of economies of scale and negotiated

excellent terms on the purchase of materials.   Petitioner grew

and developed a backlog of pending projects equal to 3-5 months

of work.   The backlog helped petitioner retain quality workers
                                - 7 -

because they knew that a steady supply of work existed.     The

ability to maintain experienced crews enabled petitioner to

deliver the highest quality masonry work.

C. Petitioner's Operations

     Petitioner typically became involved in a job when the

developer called Ginger directly.    Ginger would go to the

developer's office, review the plans, discuss the details for the

job, and suggest cost saving alternatives.     Ginger would then

take the plans to his office and review the plans with

petitioner's estimator, Gary Sawhill (Sawhill).

     Ginger and Sawhill would work through the plans and come up

with a bid.   Ginger assisted Sawhill with matters such as profit

percentages, overhead, cost of labor, material cost, production

rates, and anything out of the ordinary.     On an annual or

semiannual basis, Ginger would set the appropriate rates that

petitioner would use to bid a job.      During the recession in 1990-

92, Ginger revised petitioner's rates every quarter.

     Sawhill used the current figures to calculate the bid, which

was then given to Ginger.    Ginger reviewed the entire bid before

it was sent to the developer.   After the bid was submitted,

Ginger contacted the developer and offered to discuss the bid

further if the developer believed it to be too high.     This often

would lead to further negotiations between the developer and

Ginger.
                                - 8 -

     When a developer accepted a bid, Ginger provided

petitioner's superintendent with the details of the job.     On a

small job, only one person would travel to the jobsite, and that

would be the job foreman.    The foreman would travel to the site

with his equipment and his materials and complete the job.     On

larger jobs, the foreman would oversee a crew on the jobsite.

     During the fiscal years 1990 through 1992, petitioner

employed approximately 80 to 100 people and had as many as 150

jobs in progress at any given time.     Ginger separated

petitioner's operations into two categories:     Brick and stone

masonry and block masonry.   Ginger employed a superintendent on

the block masonry side of the business.     The superintendent would

visit the jobsites, talk with the job foreman, see how the work

was progressing, and then report the progress to Ginger at the

end of the day.   Since 1990, Steve Adams (Adams) has been the

superintendent of petitioner's block masonry division.     Until

1992 or 1993, Ginger, himself, worked as the superintendent on

the brick and stone masonry side of the business.

     Although the superintendent or foreman supervised the job

once work began on the jobsite, Ginger resolved any significant

problems that developed on the jobsite, such as quality,

manpower, labor, etc.   When a significant problem developed,

typically the developer would contact Ginger directly, and Ginger

resolved the problem.
                                 - 9 -

      As for hiring, Ginger had sole authority over whether the

company needed a new employee.    Petitioner had very low turnover,

and Ginger discouraged hiring additional staff because he wanted

to keep overhead as low as possible.     Every applicant completed

an application and a health screening.    Ginger frequently made

the final hiring decision, but Adams also had the authority to

hire a new employee who would be working on a site that he

supervised.   Adams had the authority to fire new employees

working on the sites that he supervised.    He did not, however,

have the authority to fire an established employee.    Ginger

decided whether to fire an established employee.

     During the years in issue, Cheri Lawrence (Lawrence),

Ginger's sister, worked as petitioner's bookkeeper.    She does not

have a degree in accounting.   Lawrence entered the accounts

payable and accounts receivable, prepared quarterly reports

submitted to the Internal Revenue Service, and made entries into

the general ledger.   Lawrence reviewed the financial statements

for accuracy, but she did not set petitioner's financial policy.

Kay Peterson (Peterson), Ginger's mother, worked as an office

manager and paid minor expenses, such as utilities, phone, and

office supplies.    Peterson and Ginger were the only persons with

signatory authority on petitioner's checking account.

   Ginger made all of petitioner's financial decisions and set

financial policy.   The bookkeeper entered the numbers, and, with

Ginger's help, assembled a monthly report.    Ginger reviewed the
                               - 10 -

accounting and bookkeeping work, in addition to all of the

estimates for jobs over $1,000.    Ginger personally reviewed any

invoice over $200.   Ginger would interpret the contracts for work

in progress, verify the amount of work actually completed, and

assemble a rough draft of the invoice.    Ginger reviewed the final

draft of every invoice.   If a change order was required, Ginger

was the one who told the developer that the project was going to

cost more money.

     Ginger made all compensation decisions, and petitioner paid

its employees above the market rate in an attempt to reduce

turnover.   Ginger made all decisions regarding the use of

accountants, lawyers, and other professionals.    Ginger handled

all financial management and credit management.    Ginger

considered petitioner's cash flow crucial to survival, and he

managed the collection of past due invoices on a daily basis.

Every month Ginger would sit down with the bookkeeper and review

every job in progress.    Ginger typically worked 13 hours a day,

and, at times up to 15.5 hours a day.    Ginger served as

petitioner's only marketing person, and he often spent his

weekends and evenings building relationships with customers or

potential customers.   Ginger joined and participated in local

organizations related to the construction industry in an attempt

to generate business for petitioner.    He also joined

organizations that gave him access to executives and

entrepreneurs from other industries.
                                 - 11 -

       Petitioner's financial statements reflect the following:

FYE                         Gross             Net        Retained
June 30     Revenue         Profit          Income       Earnings

1985       $3,727,655       1,098,482      256,644        256,644
1986        4,817,376       1,037,224       66,943        323,587
1987        5,427,047       1,428,669      230,224        553,811
1988        5,162,114       1,247,098      245,153        798,964
1989        8,607,196       2,293,224      549,984      1,279,4271
1990        8,937,324       2,063,142       18,063      1,297,490
1991        5,012,347         929,136     (149,901)     1,147,589
1992        6,995,774       1,429,611       22,726      1,170,315

Petitioner has never paid dividends.       Ginger's total compensation

was as follows:



FYE               Total          Disallowed by           Allowed by
June 30           Compensation    Respondent             Respondent

1985            $249,145                --                    --
1986             383,290                --                    --
1987             390,724                --                    --
1988             280,000                --                    --
1989             516,371                --                    --
1990           1,069,001             818,756               250,245
1991             132,000                --                 132,000
1992             396,698             186,825               209,873

Petitioner's shareholders' equity, as contained in petitioner's

financial statements, is as follows:

                 FYE                    Shareholders'
                June 30                    Equity

                  1985                     $271,644
                  1986                      338,587
                  1987                      568,811
                  1988                      813,964


       1
       Due to an error in recording, the June 30, 1989, retained
earnings figure was restated on June 30, 1990, from $1,348,948 to
$1,279,427.
                               - 12 -

               1989                     1,294,4272
               1990                     1,312,490
               1991                     1,162,589
               1992                     1,185,315

     Petitioner claimed deductions for officer's compensation in

the amounts of $1,069,001 and $396,698 for the fiscal years 1990

and 1992, respectively.

D. Others Familiar With Petitioner

     Christenson, petitioner's accountant, assisted in the

formation of petitioner in 1984, and his accounting firm has

reviewed petitioner's financial statements since 1985.

Approximately 90 percent of Christenson's clients are in the

construction industry.

     Christenson considered Ginger the sole marketing person for

petitioner, and he characterized Ginger's sales and marketing

abilities as "amazing".   Christenson noticed that Ginger had an

"intuition" in matters, such as profitability, overhead

management, and the need to maintain volume to break even.

Ginger was a rare client in that he invited Christenson to

economic forecast luncheons.

     Petitioner's banker, Greg Adamson (Adamson), talked with

petitioner's vendors, customers, and competitors.    Such contacts

were common during Adamson's management of a client's portfolio.

Adamson concluded that petitioner had a very solid reputation in

     2
       We have adjusted the shareholders' equity figure for the
fiscal year ended June 30, 1989, to account for the recording
error entered supra note 1.
                               - 13 -

the industry.   With respect to profitability, petitioner ranked

near the top of Adamson's client portfolio.    Adamson considered

petitioner to be a high performer with gross profit margins often

exceeding 20 percent.

     Rick Muth (Muth), an owner of Orco Block Co., characterized

Ginger's sales and marketing expertise as "outstanding".    Muth

considered petitioner a low credit risk, and he ranked petitioner

at the top of its field in quality.

E. The Recession

     In late 1989 and early 1990, economic experts had predicted

a slowdown in the construction industry with a corresponding

"soft landing" for the Southern California residential housing

market.    There was no soft landing.   Petitioner did well through

July of 1990, and then in August 1990 petitioner's business "fell

apart".

     In August 1990, the California housing market suffered a

severe setback.    When this happened, petitioner's customers, the

large housing developers, reevaluated their positions.    Ginger

estimated that 50 to 60 percent of petitioner's substantial

contract backlog that existed in July of 1990 was canceled within

60 days.    Developers called Ginger about building contracts

already entered into by petitioner.     The developers told Ginger

that the jobs were canceled unless petitioner would lower its

bids by 8 to 10 percent.    Ginger renegotiated his material

purchases and slashed his bid prices just to stay in business.
                              - 14 -

     Petitioner's strength revealed itself during the economic

slowdown.   Ginger had aligned petitioner with the large

developers, the most likely candidates to build during the

downturn.   By this time, however, bid prices were critical in

obtaining work.   Ginger studied the jobsites of his competitors

and talked to their customers and suppliers in an attempt to

determine whether a competitor could bid a lower price than

petitioner.   These were additional duties that Ginger took on as

a result of the economic slowdown.     In addition, Ginger reviewed

an industrywide credit report that indicated whether petitioner's

competitors were experiencing credit problems.

     Many other construction-related companies lost business

during the fall of 1990 and some went out of business entirely.

John Connors (Connors), vice president of a construction

materials supply company, held an emergency meeting with the

executives of his company in September 1990 to address the

economic downturn.   Connors' stores suffered a 40-percent to 60-

percent drop in sales.   Connors' company reduced its staff from

145 to 80 and reduced salaries across the board by 10 percent.

                              OPINION

     Section 162(a)(1) allows a corporation to deduct "a

reasonable allowance for salaries or other compensation for

personal services actually rendered" as a business expense.    To

come within the ambit of section 162(a)(1), the compensation must

be both reasonable in amount and in fact paid purely for
                               - 15 -

services.   Sec. 1.162-7(a), Income Tax Regs.   Although framed as

a two-prong test, the inquiry under section 162(a)(1) has

generally turned on whether the amounts of the purported

compensation payments were reasonable.    Elliotts, Inc. v.

Commissioner, 716 F.2d 1241, 1243-1244 (9th Cir. l983), revg. and

remanding T.C. Memo. 1980-282.   What constitutes reasonable

compensation to a corporate officer is a question of fact to be

determined on the basis of all the facts and circumstances of a

case.   Pacific Grains, Inc. v. Commissioner, 399 F.2d 603, 605

(9th Cir. 1968), affg. T.C. Memo. 1967-7.   Petitioner has the

burden of proving that the payments to Ginger were reasonable.

Rule 142(a).    Respondent has conceded that petitioner is entitled

to a deduction for compensation paid to Ginger in the amounts of

$300,000 and $209,873 for the fiscal years 1990 and 1992,

respectively.

     Many factors are relevant in determining the reasonableness

of compensation, and no single factor is decisive.     Mayson

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

1949), revg. a Memorandum Opinion of this Court.     The Court of

Appeals for the Ninth Circuit has divided the factors relevant to

the reasonable compensation determination into the following five

broad categories for analytical purposes.



1. Roles in Company
                                - 16 -

     The first category of factors identified by the Court of

Appeals for the Ninth Circuit concerns the employee's role in the

company.   Relevant considerations include Ginger's

qualifications, hours worked, duties performed, as well as his

general importance to petitioner's success.    American Foundry v.

Commissioner, 536 F.2d 289, 292-293 (9th Cir. 1976), affg. in

part and revg. in part 59 T.C. 231 (1972).

     Ginger was a highly motivated employee working as much as

15.5 hours a day.    His evenings and weekends were often spent

marketing petitioner's services to existing customers and

potential customers.

     Despite his lack of formal business training, Ginger

acquired the skills necessary to manage every facet of

petitioner's operations.    He attended economic forecast

luncheons.   He joined organizations that gave him access to other

business executives and entrepreneurs, and he sought advice from

these individuals.

     Ginger handled all of petitioner's executive and managerial

duties.    Other employees assisted Ginger, but petitioner had no

other managers or executives.    Ginger received assistance in the

areas of bookkeeping, field supervision, and estimating, but that

assistance extended only to routine matters.    Ginger devised and

implemented petitioner's corporate strategy of targeting the

large residential developers.    Ginger's financial discipline and

marketing abilities brought petitioner's corporate strategy to
                               - 17 -

fruition.   Ginger reviewed all of petitioner's expenditures,

ensured low overhead, resisted adding new employees, and insisted

that petitioner grow through retained earnings.    Ginger

continually marketed petitioner's services.    Ginger's sales and

marketing abilities were described as "amazing" and

"outstanding".   Petitioner grew steadily from its inception in

1984, weathered the economic downturn in 1991, and began a

recovery in 1992.   Ginger served as the catalyst for petitioner's

growth and success.

2. External Comparison

     We also compare the employee's salary with the salaries paid

by similar companies for similar services.    Sec.1.162-7(b)(3),

Income Tax Regs.    Both parties offered expert testimony as to

what a like company would pay for like services.    Both experts

considered surveys of financial data on numerous organizations,

including developers, builders, residential building contractors,

and construction contractors in specialty trades.

     a. Respondent's Expert

     Respondent presented expert testimony from Scott D. Hakala

(Hakala).   Hakala reviewed the surveys of financial data and

concluded that it was not very "satisfying".    As a result, he

relied less on the market data than he would prefer for the final

conclusion.   Instead, Hakala derived a formula to calculate

Ginger's compensation; the formula does incorporate one aspect of

the survey data.
                              - 18 -

     Hakala's formula consists of a base salary of $90,000

increasing at a nominal rate of 2 percent for each year of the

term, plus a variable component equal to 20 percent of operating

income before officers' compensation.

     As for the base salary figure, Hakala used data on

contractor executive compensation compiled by Personnel

Administration Services (PAS survey).   Hakala felt the PAS survey

was the most accurate under the circumstances of this case.

Hakala used the median, 50th percentile, salary of $144,000, and

broke this down into a median base salary of $90,000 plus a

$54,000 bonus.   Hakala explained that $90,000 is the median base

salary for someone working in a firm with between $5 million and

$20 million in sales on the west coast.   For companies in the

75th percentile, compensation climbed to $200,000.   The top

officer also received additional benefits with a cash value of up

to $50,000.

     As for the variable component, the 2-percent figure accounts

for the slow growth in the real estate market in addition to an

inflation factor.   Hakala calculated the 20-percent bonus figure

using financial projections for 1993 and 1994 and an intended

return on equity.   Hakala concluded that 20 percent was "the most

bonus" the executive could be paid and still allow some kind of

reasonable return expectation to the shareholder.    Hakala opined

that Ginger's compensation for the fiscal years ended June 30,
                               - 19 -

1990 and 1992 should be no more than $300,000 and $200,000,

respectively.

     Hakala also opined that a median compensation for the second

highest corporate officer for companies in the building trades

was $100,000, while compensation at the 75th percentile was

$129,000.    The second highest corporate officer also received

additional benefits with a cash value slightly under $30,000.

     b. Petitioner's Expert

     Petitioner presented the testimony of Sidra Wieder (Wieder),

who specializes in employee compensation and employee benefits.

Wieder focused on the duties performed by Ginger as well as the

duties performed by petitioner's other employees.    Wieder

specifically reviewed Ginger's responsibilities and scope of

authority.    Two of the factors Wieder used to determine Ginger's

compensation were the payroll amounts that petitioner saved by

having Ginger serve many roles and the amount that Ginger should

be paid for the various duties he performed for petitioner.

Wieder concluded that Ginger served as petitioner's chief

executive officer, chief operations/administrative officer, and

marketing executive.    Wieder concluded that Ginger also served as

petitioner's chief financial officer.    She did not, however,

include the chief executive officer as a separate position

because she concluded that those duties would be subsumed within

Ginger's other executive duties.    Based on the data reviewed by

Wieder, she opined that the total compensation paid to a
                                - 20 -

comparable company's chief executive officer, chief

operations/administrative officer, and marketing executive ranged

between $476,949 and $1,910,740 in 1990 and between $555,029 and

$776,349 in 1992.    Wieder opined that the compensation petitioner

paid Ginger in 1990 and 1992 was reasonable.

     c. Discussion

     Respondent and respondent's expert have understated the

services provided by Ginger and have overstated the services

provided by Sawhill, Lawrence, Peterson, and Adams.      Respondent

contends that the latter individuals were responsible for

petitioner's day-to-day operations.      We do not agree with

respondent's characterization.    The record indicates that Ginger

played the crucial role in petitioner's operations.      Sawhill,

Lawrence, and Peterson completed relatively routine matters that

Ginger had delegated to them.    They discussed anything out of the

ordinary with Ginger.    Adams had limited authority over the

jobsites that he supervised, including the authority to hire and

terminate new employees on those sites.      Ginger made all other

personnel decisions.

     Petitioner did not have a strong managerial infrastructure

other than Ginger.    Ginger effectively performed the roles of

chief executive officer, chief financial officer, chief

operations/administrative officer, and marketing executive.

Ginger's compensation should reflect the combined salaries of the
                               - 21 -

job positions he performed.    Elliotts, Inc. v. Commissioner, 716

F.2d at 1246.

3. Character and Condition of Company

     This factor requires us to focus on petitioner's size as

indicated by its sales, or capital value, the complexities of the

business, and the general economic conditions.     Elliotts, Inc. v.

Commissioner, supra at 1246.    In a relatively short time,

petitioner became a top performer in a highly competitive market.

Petitioner maintained a high gross profit ratio.    Petitioner

penetrated the residential masonry market and won contracts with

some of the largest residential developers in the area.

Furthermore, petitioner survived the economic downturn that began

in 1990.    Petitioner's survival was due, in part, to its

financial strength and its ability to obtain work in a declining

market.    Ginger was the architect of petitioner's growth

strategy, and he provided the tools necessary to implement that

strategy.    Ginger also charted petitioner's path through the

economic decline.



4. Conflict of Interest

     The primary issue in considering factors indicating a

conflict of interest is whether some relationship exists between

the company and the employees which might permit the former to

disguise nondeductible corporate distributions of income as

salary expenditures deductible under section 162(a)(1).      "Such a
                                - 22 -

potentially exploitable relationship may exist where, as in this

case, the * * * [employees are] the taxpaying company's sole or

controlling shareholder[s]".     Elliotts, Inc. v. Commissioner,

supra at 1246.

      The relationship in this case, where Ginger and his wife

were petitioner's sole shareholders, warrants scrutiny.      Id.   The

mere existence of such a relationship, coupled with an absence of

dividend payments, however, does not necessarily lead to the

conclusion that the amount of compensation is unreasonably high.

Id.   They are relevant factors but are not to be viewed in

isolation.    Id. at 1247.   Furthermore, we shall not presume a

disguised dividend from the bare fact that a profitable

corporation does not pay dividends.      Id. at 1244; Owensby &

Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1326-1327 (5th

Cir. 1987), affg. T.C. Memo. 1985-267.

      The Court of Appeals for the Ninth Circuit formulated the

inquiry in such a situation by evaluating the compensation

payments from the perspective of a hypothetical independent

investor.    The prime indicator is the return on its investors'

equity. Owensby & Kritikos, Inc. v. Commisisoner, supra at 1326-

1327.   If the company's earnings on equity after payment of the

compensation remain at a level that would satisfy an independent

investor, there is a strong indication that management is

providing compensable services and that profits are not being

siphoned out of the company disguised as salary.      Elliotts, Inc.
                               - 23 -

v. Commissioner, supra at 1247.    The Court of Appeals for the

Ninth Circuit, in Elliotts, Inc., calculated the return on equity

using the yearend shareholder's equity.    We follow that approach.

See Golsen v. Commissioner, 54 T.C. 742 (1970), affd. on another

issue 445 F.2d 985 (10th Cir. 1971).    Dividing petitioner's net

profit (after payment of compensation and a provision for income

taxes) by the yearend shareholders' equity, as reflected in its

financial statements, yields the following:

                 FYE              Percentage Return
                 June 30              on Equity

                 1985                      94
                 1986                      20
                 1987                      40
                 1988                      30
                 1989                      42
                 1990                       1
                 1991                     (13)
                 1992                       2


       Under the circumstances of this case, we find that the

return on equity for the years at issue (1990-92) is not a

reliable indicator of the reasonableness of Ginger's

compensation.    See Elliotts, Inc. v. Commissioner, supra at 1247

n.5.    We doubt that the 1-percent return on equity for the year

ended June 30, 1990, would satisfy an independent investor;

however, there is probative evidence that Ginger had forgone

compensation in prior years in an attempt to enlarge petitioner's
                              - 24 -

capital base in order to satisfy the demands of the large

developers.   Increasing petitioner's capital base in the early

years was central to petitioner's ability to penetrate the

residential masonry market.   Indeed, the percentage return-on-

equity figures for the years 1985 through 1989 indicate that

petitioner could have paid additional officer compensation and

maintained a satisfactory return on equity.    Under these

circumstances, isolating the return-on-equity figure for the

fiscal year ended June 30, 1990, would ignore petitioner's

successful corporate strategy and the steps taken to implement

that strategy.

     The percentage return-on-equity figures for the years 1991

and 1992 must be viewed in light of the precipitous drop in the

residential housing market in late 1990.    Given the severity of

that economic decline, the return-on-equity figures are not a

good indicator of petitioner's performance or the reasonableness

of compensation that petitioner paid Ginger.

5. Internal Consistency

     Internal inconsistency in petitioner's treatment of payments

to employees may indicate that the payments to Ginger were not

reasonable.   Elliotts, Inc. v. Commissioner, 715 F.2d at 1247.

Bonuses that have not been awarded under a formal and

consistently applied program are suspect.     Nor-Cal Adjusters v.

Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), affg. T.C. Memo.
                               - 25 -

1971-200.   However, it is permissible to pay and deduct

compensation for services performed in prior years.    Lucas v. Ox

Fibre Brush Co., 281 U.S. 115, 119 (1930).

     a. Compensation for Services in Prior Years

     Financial stability was a crucial element in petitioner's

growth strategy.   Ginger knew that petitioner would need strong

financial statements and considerable equity in order to work

with the large developers.   To this end, Ginger received less

compensation in years prior to the years in issue.    Petitioner,

as a result, retained a significant portion of its earnings and

increased its equity base.   After petitioner reached its

financial goals and secured a working relationship with the large

developers, petitioner compensated Ginger for the extraordinary

services he provided petitioner from 1984 to 1989.

     b. Compensation Paid to Other Employees

     Wieder concluded that petitioner's other employees, such as

superintendent, bookkeeper, and administrative assistant, were

all paid above-average compensation from 1986 to 1992 with above-

average pay increases most of those years.   Hakala concluded that

petitioner's other employees, specifically Sawhill and Adams,

were undercompensated.   Hakala opined that an estimator,

Sawhill's position, would earn $70,000 and up to $100,000 in a

very good year.    Included in the $100,000 figure is a bonus of up
                               - 26 -

to $20,000.   Hakala opined that Adams' compensation in 1990

should have exceeded $70,000, which it did not.

     As explained above, respondent has attributed to

petitioner's other employees services actually performed by

Ginger.   Ginger filled the critical roles in petitioner's

operations.   Ginger worked closely with Sawhill.   Sawhill

performed the calculations necessary to produce a bid, but Ginger

determined the substantive financial data that was incorporated

into a bid, such as profit percentages, overhead, cost of labor,

material cost, and production rates.    The accuracy of the

substantive financial data was essential to petitioner's

profitability.   After petitioner submitted a bid, Ginger

contacted the developer and negotiated an agreement.    When

discussing hours worked by various employees, Hakala stated that

the marketing and salesperson is usually the estimator.     But this

was not the case with petitioner.   Ginger served as petitioner's

marketing and salesperson.

     Adams served as the superintendent on the block masonry side

of petitioner's business.    However, Ginger resolved significant

problems on all of the jobsites, including the sites supervised

by Adams.   Indeed, when a significant problem developed on one of

petitioner's jobsites, the developer typically would contact

Ginger directly.   Ginger, himself, worked as the superintendent

on the brick and stone masonry side of the business.
                              - 27 -

     Ginger served as the central figure in petitioner's growth

and success.   Ginger effectively discharged the responsibilities

of several corporate executives.   He did so through long hours,

consultation with others, and efficient use of petitioner's other

employees.   Petitioner's success was due to Ginger's significant

efforts and contributions, and we conclude that the compensation

paid to Ginger during the years in issue was reasonable.

     To reflect the foregoing,

                                         Decision will be entered

                                    under Rule 155.
