                    T.C. Memo. 2003-200



                   UNITED STATES TAX COURT



       BREWER QUALITY HOMES, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 8222-99.                Filed July 10, 2003.



     R disallowed deductions for portions of amounts P paid
to a shareholder-officer.

     Held: (1) Maximum amounts of reasonable compensation
(less than amounts P deducted, but greater than amounts R
determined) are redetermined.

      (2) The   amounts so redetermined were paid as
compensation    for personal services actually rendered and are
deductible.     The amounts P paid in excess of the amounts so
redetermined    are not deductible. Sec. 162(a)(1), I.R.C.
1986.



R. Cody Mayo, Jr., for petitioner.

Mary Beth Calkins and Joseph Ineich, for respondent.
                                - 2 -


             MEMORANDUM FINDINGS OF FACT AND OPINION

     CHABOT, Judge:    Respondent determined deficiencies in

Federal corporate income tax against petitioner as follows:

                      Year              Deficiency

                      1995               $123,602

                      1996                144,411

     After concessions by respondent,1 the issue for decision is

the extent to which amounts that petitioner paid to Jack are

deductible as reasonable compensation under section 162(a)(1).2




     1
        In the notice of deficiency, respondent disallowed (1)
$338,941 of the $783,930 of officer compensation that petitioner
paid to Jack R. Brewer, Sr. (hereinafter sometimes referred to as
Jack), and Mary L. Brewer (hereinafter sometimes referred to as
Mary) in 1995, and (2) $397,759 of the $881,559 of officer
compensation that petitioner paid to Jack and Mary in 1996.

     Respondent concedes that (1) all payments of officer
compensation to Mary are deductible, and (2) additional portions
of the payments to Jack are deductible. After respondent’s
concessions, there remain in dispute only $158,069 of the
original $338,941 disallowance for 1995, and only $337,593 of the
original $397,759 disallowance for 1996.
     2
        Unless indicated otherwise, all section references are to
sections of the Internal Revenue Code of 1986 as in effect for
the taxable years in issue.
                              - 3 -

                        FINDINGS OF FACT3

     Some of the facts have been stipulated; the stipulations and

the stipulated exhibits are incorporated herein by this

reference.

     Petitioner was incorporated in Louisiana on August 1, 1977.

When its petition in the instant case was filed, petitioner’s

principal place of business was in Bossier City, Louisiana.

Bossier City is in northwest Louisiana, on the east side of the

Red River, across from Shreveport.    Petitioner is located on Rte.

US 80.


     3
        Respondent’s counsel complied with the detailed
requirements of Rule 151(e)(3) as to proposed findings of fact in
opening briefs; petitioner’s counsel did not. As a result,
respondent was deprived of the opportunity to explain why
petitioner’s views of the facts were incorrect. In our
determinations, we have taken the foregoing into account and have
resolved many otherwise uncertain matters in favor of
respondent’s view of the facts.

     Petitioner’s counsel is put on notice that (1) the Rule is
designed both to facilitate the work of the Court and also to
provide a “level playing field” to the parties, and (2) the Court
will be inclined to impose formal sanctions in the event of
future similar violations.

     Sec. 7491, which shifts the burden of proof to the
Commissioner if the taxpayer meets certain conditions, is
effective for court proceedings arising in connection with
examinations beginning after July 22, 1998. Internal Revenue
Service Restructuring and Reform Act of 1998, Pub. L. 105-206,
sec. 3001(a), 112 Stat. 726. Respondent began examining
petitioner’s 1995 and 1996 Federal corporate income tax returns
sometime in early 1997. Accordingly, sec. 7491 does not apply in
the instant case.

     Unless indicated otherwise, all Rule references are to the
Tax Court Rules of Practice and Procedure.
                                 - 4 -

      Petitioner is engaged in the business of retail selling of

manufactured homes, also known as mobile homes, trailers, or

trailer homes, hereinafter sometimes collectively referred to as

mobile homes.   At all relevant times, Jack and Mary each owned 50

percent of petitioner’s stock.    Petitioner’s stock was not

publicly traded.

A.   Jack’s Background

      Jack served in the U.S. Marine Corps for 3 years.    In 1954,

he left the Marine Corps and moved to Dallas, Texas, where he

began a career in the automobile business.     Jack served as the

sales, finance, and insurance manager for several General Motors

dealerships.    In 1973, he left the automobile business to pursue

a career in the mobile home business.

B.   Petitioner’s Origin and Economic Development

      Jack began his mobile home retailing business with capital

raised from the $8,000 of equity that he had in his home and a

$50,000 bank loan.   He used this capital to establish an

inventory of about six mobile homes.     Jack increased his

inventory by buying distressed merchandise at a discount--new

mobile homes that lenders had repurchased from retailers who were

going out of business.   He attributed the failures of other

retailers’ businesses to an economic downturn that began in 1973.

      Jack did not employ anyone in his mobile home retailing

business during its first year.
                                - 5 -

     During the 1980s, the mobile home retailing business in

petitioner’s region of the country (Texas, Louisiana, and

Oklahoma) endured another economic downturn, because of the oil

industry.   More than 45,000 mobile homes were repossessed in

Texas alone.   In petitioner’s basic trade area, 21 mobile home

retailers either went out of business or filed for bankruptcy.

Petitioner was one of only two mobile home retailers located

within 1 mile of petitioner that survived the 1980s’ economic

downturn.

     During 1992 and 1993, the mobile home retailing business in

petitioner’s basic trade area endured another economic downturn.

Although petitioner survived this downturn, many other mobile

home retailers did not.   Nine of the mobile home retailers that

did not survive this downturn were located within 1 mile of

petitioner on the US 80 corridor.   Petitioner again took

advantage of the situation by buying at distress sale prices

mobile homes that lenders had repossessed and selling these

mobile homes at regular retail prices.

     Petitioner had about 16 employees during the early 1990s.

In 1996, petitioner had 22 employees, 7 of whom were in sales.

     Petitioner’s business was operated as a sole proprietorship

from 1973 until petitioner’s incorporation, in 1977.   Petitioner

elected S corporation status as of January 1, 1987.    Petitioner

was a C corporation for 1988.   Petitioner elected S corporation
                                  - 6 -

status as of January 1, 1989, and remained in that status through

1993.      Petitioner was a C corporation for 1994 through 1996.

       Petitioner reported gross sales, total income, and taxable

income for 1986 through 1996 as shown in table 1.

                                 Table 1

Year          Gross Sales     Total Income1    Taxable Income(Loss)

1986          $2,528,724       $530,635                $36,429
1987           3,022,585        657,051                 19,819
1988           3,569,197        843,645                 15,816
1989           3,380,615        771,252                (18,214)
1990           3,526,171        884,275                 (1,791)
1991           2,888,775        716,812                 (6,976)
1992           2,732,920        728,845                118,987
1993           4,197,494      1,015,976                337,405
1994           6,559,036      1,383,467                 97,840
1995           9,006,092      2,029,979                167,758
1996           9,920,208      2,326,709                151,566

       1
       Total income includes gross profit, interest income, and
other income.

       Jack and Mary personally guaranteed all loans by banks to

petitioner.

C.   Jack’s Duties

       Jack exercised complete control over petitioner’s business

since it was founded (1973) and over petitioner since it was

incorporated (1977), including the years in issue.      He served as

petitioner’s president, chief financial officer, chief executive

officer, general manager, sales manager, loan officer, credit

manager, purchasing officer, personnel manager, advertising

manager, insurance agent, real estate manager, and corporate

legal affairs liaison.      With the exception of sales manager--Jack
                               - 7 -

promoted a sales administrator to sales manager in     mid-1996--

Jack has always held these positions.

     In his capacity as general sales manager, Jack oversaw

petitioner’s daily sales operations, worked with salespeople on

all transactions, appraised trade-ins, negotiated with buyers,

and approved all closings.   In his capacity as advertising

manager, Jack directed petitioner’s advertising efforts:     He met

with all media, wrote ad copies for television, radio, and

newspaper advertisements, prepared the advertising budgets, and

approved all advertising costs.   In his capacity as loan officer,

Jack approved the underwriting for all in-house loans and

personally worked delinquent accounts.     In his capacity as

licensed general insurance agent, Jack was responsible for

petitioner’s book of insurance; petitioner had more than 400

insurance customers.   Petitioner insured 60 percent of its sales.

The commissions earned for Jack’s work as the licensed general

insurance agent went to petitioner and were reported on

petitioner’s tax return.   As the personnel manager, Jack was

responsible for hiring, firing, supervising, training, and

evaluating all of petitioner’s employees.     In his capacity as

purchasing officer, Jack ordered all of petitioner’s inventory,

lot supplies, and office supplies.     He also bought all company

vehicles and approved all invoices for payment.     In his capacity
                               - 8 -

as corporate legal affairs liaison, Jack reviewed legal contracts

between petitioner and third parties.

     In addition to the foregoing, Jack supervised the in-house

bookkeeper; reviewed vendor invoices; maintained inventory

records; gathered the necessary information to prepare

petitioner’s financial statements and tax returns; planned and

monitored petitioner’s cashflow; signed checks; negotiated lines

of credit, advances, and loans; and directed the investment of

petitioner’s cash reserve.   Jack extensively reviewed

petitioner’s quarterly financial reports.

     Jack brought enthusiasm, dedication, and energy to

petitioner.   He made a point of being willing to meet every

customer at some point in the sales process.   He worked 6 to 7

days per week, and often worked long into the night.     He opened

and closed the business each day.   If there were delinquent

accounts, then Jack went out at night and collected on them.    In

petitioner’s early years, Jack worked about 70 hours per week;

during the years in issue, Jack worked about 60 hours per week.

His duties also involved frequent travel.

     At all times relevant to the instant case, Mary has been

either petitioner’s vice president, secretary, or secretary-

treasurer.
                               - 9 -

D.   Compensation Practices

      1.   General

     Petitioner did not maintain a written salary policy or bonus

plan for its employees.   To attract “top-notch” people it paid

compensation that was equivalent to or greater than the

compensation paid by other mobile home retailers.   Since its

incorporation, petitioner has paid all the cost of health

insurance for all its employees.   It has also provided paid sick

and vacation leave for all its employees, except Jack (and,

presumably, Mary).   Although petitioner established a profit-

sharing plan with Commercial National Bank in January of 1985,

the plan was terminated in late 1987.   In addition, petitioner’s

resolution on February 5, 1996, to adopt a 401(k) retirement plan

was aborted on February 7, 1997, because of excessive

administrative costs.

     Table 2 sets forth the compensation petitioner paid to its

key employees, other than Jack, for 1994, 1995, and 1996.
                                  - 10 -

                                  Table 2

Name                Position                 1994      1995      1996
John Atkinson       Sales Person            $60,053   $75,407   $72,209
Garry Hood          Sales Person                NA     21,777   74,551
Kurt Ley            Sales Manager               NA     21,000   71,424
Patsy K. Watson     Bus. Manager             31,428    37,946   40,250
Larry Gill          Service Manager          51,161    56,827   62,523
Dale Hughes         Sales Person             26,823    45,210   27,635
Tony Lewis          Sales Person             42,763    55,434   41,445
Mary Brewer         Bookkeeper/Decorator     21,765    21,744   18,000

       2.   Jack’s Compensation

       During the years in issue, petitioner never had a

compensation, defined benefit, or profit-sharing plan for Jack.

Jack analogized petitioner’s compensation policy for him to that

of a farmer’s:     If petitioner had a good year, then Jack had a

good year; if petitioner had a bad year, then Jack took “minimum

wages.”

       Table 3 shows, for each of the years 1986 through 1996, (1)

petitioner’s claimed compensation payment to Jack, (2) that

claimed compensation as a percentage of gross sales (supra table

1), and (3) that claimed compensation as a percentage of taxable

income before deduction of that claimed compensation, supra table

1 as adjusted by adding back the claimed compensation to Jack.
                                 - 11 -

                                 Table 3

                                              Claimed compensation
                              Claimed         as % of taxable income
            Claimed        compensation as    before deduction of
Year      compensation    % of gross sales    Jack’s compensation

1986        $24,195            1.0                  39.9
1987         79,413            2.6                  80.0
1988        164,292            4.6                  91.2
1989         84,581            2.5                 127.5
1990        175,164            5.0                 101.0
1991        129,828            4.5                 105.7
1992         25,174            0.9                  17.5
1993         25,818            0.6                   7.1
1994        398,638            6.1                  80.3
1995        762,186            8.5                  82.0
1996        863,559            8.7                  85.1

       In 1995, petitioner paid $62,186 in salary to Jack over the

course of the year.      On December 31, 1995, petitioner paid an

additional $700,000 to him as a bonus.       In 1996, petitioner paid

$63,559 in salary to Jack over the course of the year.      On

December 31, 1996, petitioner paid an additional $800,000 to him

as a bonus.    Jack determined the amount of his bonus each year

after he and J. Michael Sledge (hereinafter sometimes referred to

as Sledge) examined petitioner’s financial situation.      Sledge, a

certified public accountant, has been petitioner’s accountant

since its incorporation and Jack’s accountant since 1975.        Sledge

prepared petitioner’s tax returns for both of the years in issue,

and signed those tax returns as paid preparer.      He represented

petitioner and Jack during the audit stage that led to the

instant case.    He met with Jack at least quarterly every year to

review the financial performance of the company and another 20-30
                              - 12 -

times a year on an ad hoc basis.   He has attended most of the

meetings of petitioner’s board of directors since 1977.

      In determining the amount of a bonus for Jack, Jack and

Sledge considered petitioner’s profit situation and the amount of

retained earnings necessary to satisfy an investor in petitioner.

Jack discussed with Sledge the possibility that the amounts of

the 1995 and 1996 bonuses might be viewed as “unreasonable

compensation in eyes of the Commissioner” of Internal Revenue.

Jack was aware that there were risks involved with petitioner’s

payment of the bonuses on the last day of the year.

      Petitioner’s corporate board minutes for 1995 and 1996 do

not reflect any intent to increase Jack’s compensation in those

years to make up for Jack’s earlier years’ undercompensated

services.

E.   Distribution and Dividend History

      Petitioner distributed $116,100 in 1993, as an S

corporation.   Petitioner distributed $320,949 dividends in 1994,

as a C corporation.   This was done in accordance with Sledge’s

recommendation.   The 1993 and 1994 distributions are the only

ones petitioner ever made, through the end of 1996.   Petitioner

did not have any agreements with any banks or financial

institutions with which it dealt that prohibited it from

declaring dividends for the years in issue.
                                - 13 -

F.   Business Practices

      1.    Products

      Over the years, petitioner has been a dealer of about 20

different brands of mobile homes.     In 1995 and 1996, petitioner

carried the Fleetwood line of mobile homes as its primary product

offering.     Fleetwood manufactures price-competitive, high quality

mobile homes.     Fleetwood dealerships generally are very

successful.

      During the years in issue, petitioner did not have a

franchise agreement with Fleetwood, nor did petitioner receive

any market protection from it.     Indeed, there was another

Fleetwood retailer located “almost next door” to petitioner.

      For 1995-1996, petitioner was ranked number 36 of Fleetwood

retailers in the nation.     For 1996-1997, petitioner was ranked

(1) the top Fleetwood retailer in Louisiana, and (2) number 13 in

the nation.

      2.    Financing

      Since 1991, petitioner has offered financing to customers

who Jack describes as “people that do not conform to the average

lending institution.”     Jack managed this loan portfolio for

petitioner and also served as the underwriter for each of the

loans.     Petitioner has extended more than 200 loans as part of

its financing endeavors.     Of this number, only three failed, and

only one resulted in a loss to petitioner.      Petitioner’s mobile
                               - 14 -

home loan portfolio produced $87,974 interest for 1995 and

$89,357 interest for 1996.

     3.    Insurance Underwriting

      Before petitioner could install a mobile home on a buyer’s

location, the buyer had to insure the mobile home.    As a licensed

fire and casualty insurance agent, Jack wrote insurance policies

for 60 percent of petitioner’s sales.    These policies were then

attached to their corresponding notes, which were sold to banks.

The commissions earned from the insurance sales went to

petitioner.    Petitioner reported “Part. & Insurance Income” of

$58,019 and $44,566, respectively, on its 1995 and 1996 tax

returns.

G.   Conclusions

      Table 4 sets forth the parties’ and the Court’s positions

with respect to claimed compensation payments by petitioner to

Jack for the years in issue.    Petitioner contends that all of the

amounts paid meet the requirements for deductibility, and that

greater payments, unspecified in amount, also would be

deductible.    Respondent’s determinations and contentions, and the

Court’s redeterminations, are in terms of the maximum amounts

that meet the requirements for deductibility.
                              - 15 -

                              Table 4

                                        1995            1996

Petitioner: Paid, deducted, and     $762,186       $863,559
     stands by tax returns

Respondent Allows:
                                    1              2
     Notice of deficiency               423,245     465,800
                                    3
     After concessions                  604,117     485,966

Court Finds:                            610,000        630,000

      1
       In the notice of deficiency, respondent allowed a
deduction of $444,989 of the amount petitioner paid to both Jack
and Mary. Because respondent concedes that the entire $21,744
paid to Mary is deductible, this leaves $423,245 as the amount
petitioner paid to Jack that respondent determined to be
deductible.
     2
        In the notice of deficiency, respondent allowed a
deduction of $483,800 of the amount petitioner paid to both Jack
and Mary. Because respondent concedes that the entire $18,000
paid to Mary is deductible, this leaves $465,800 as the amount
petitioner paid to Jack that respondent determined to be
deductible.
     3
        This is the sum of $599,117, derived by Hakala’s
formulaic approach, plus “additional compensation of $5,000.00 to
Mr. Brewer for providing his personal guarantee to secure a
short-term working capital line of credit in 1995.” Infra
OPINION, C. Analysis, 1. Reasonableness, (d) Amount of Reasonable
Compensation, (2) Loan Guarantee.

      Petitioner did not intend in 1995 and did not intend in 1996

to compensate Jack for his earlier services to petitioner.

                              OPINION

A.   Parties’ Positions

      Petitioner maintains that the amounts it paid to Jack as

compensation were reasonable in amount, within the meaning of

section 162(a)(1), and so these amounts are fully deductible.
                              - 16 -

     Respondent “agrees that Mr. Brewer brought enthusiasm,

dedication[,] and energy to the Petitioner, and that the company

experienced great growth during the mid 1990s; however,”

respondent contends that any amounts paid to Jack in excess of

$604,117 for 1995 and $485,966 for 1996 were not intended as

payments purely for personal services,4 and even if they were so

     4
         On answering brief, petitioner contends as follows:

          The Respondent contends that a portion of the payments
     are disguised dividends. * * *

          The issue as to whether the payment of compensation was
     purely for services is not before the Court.

          The Notice of Deficiency did not raise the issue of
     disguised dividends or the compensatory nature of the
     services, or assert that any portion of the payment was a
     disguised dividend. * * * It is unfair to the Petitioner
     after close of the trial to raise a new issue that being
     that the payment received by Mr. Brewer was for something
     other than the services he rendered. * * *

          The Petitioner contends that only the amount of
     compensation the Court may find is in excess of a reasonable
     amount, if any, be declared to be a dividend, and that the
     Respondent not be allowed to dispute the compensatory nature
     of the payments to Mr. Brewer.

     For the following reasons, we conclude that the issue of
whether any part of petitioner’s payments to Jack was disguised
dividends, rather than intended compensation for personal
services, is properly before the Court.

     Firstly, the notice of deficiency explanation includes the
alternative that disallowed amounts were not “expended for the
purposes designated.”

     Secondly, the first sentence of respondent’s opening
statement before the trial is as follows:

                                                    (continued...)
                              - 17 -

intended, they were unreasonable in amount for the services he

rendered.   Respondent argues that these excess amounts are not

deductible under section 162(a)(1).

B.   Summary; Conclusions

      In determining the maximum reasonable compensation for

Jack’s services for the years in issue, we have considered the

relevant factors listed in Owensby & Kritikos, Inc.   v.

Commissioner, 819 F.2d 1315, 1323 (5th Cir. 1987), affg. T.C.

Memo. 1985-267.   Both parties presented expert witness reports

and testimony on the applicability of the relevant factors to the

instant case.   While we do not find the experts’ conclusions



      4
       (...continued)
           OPENING STATEMENT BY COUNSEL ON BEHALF OF THE
      RESPONDENT

           MS. CALKINS: Your Honor, this case presents two
      questions: whether a portion of payments made to Mr. Brewer
      in 1995 and 1996 and deducted as officer’s compensation by
      the Petitioner are actually disguised dividends. * * *

The second question, respondent stated, was whether the deducted
amounts “are reasonable in amount.” The final sentence of
respondent’s opening statement is as follows:

           It is Respondent’s position that in spite of Mr.
      Brewer’s contributions to Petitioner during the years at
      issue, the payments to him over and above what Respondent
      has allowed in the trial memorandum should be disallowed as
      disguised dividends.

     Thirdly, our search of the transcript shows that,
notwithstanding respondent’s clear statements at the start of the
trial, petitioner did not object, or otherwise comment on this
matter, at that time or at any other time during the 3-day trial.
                              - 18 -

particularly helpful, we do use some of the data and analyses

they provide in reaching our decision.

     We first consider the Robert Morris Associates (hereinafter

sometimes referred to as RMA) report for the industry on

financial ratios, which provides data on, among other things,

executive compensation as a percentage of sales for companies

comparable to petitioner.   Based on petitioner’s and the mobile

home retail industry’s financial performances in 1995 and 1996,

we conclude that Jack’s compensation as a percentage of sales

should be compared to those of executives in comparable companies

at around the 90th percentile.    By multiplying petitioner’s sales

by the appropriate RMA factor for each year, we determine that

payments to Jack, as compensation for the services he performed

for petitioner, would have been about $520,000 in 1995 and

$600,000 in 1996.   We add $5,000 to the 1995 amount on account of

Jack’s guaranty of a bank loan to petitioner.

     We also consider the fact that petitioner did not provide

Jack with retirement benefits.    Based on comments by respondent’s

expert, we conclude that an amount of about 5 percent of Jack’s

compensation would be sufficient to compensate him for the

absence of retirement benefits.   This brings reasonable

compensation to about $550,000 in 1995 and $630,000 in 1996.
                                - 19 -

      In light of respondent’s willingness to allow what Hakala

recommends for 1995, plus correction of Hakala’s mathematical

errors, we round the 1995 amount to $610,000.

      We conclude that all of the amounts that would have been

reasonable compensation to Jack were intended by petitioner to be

compensation and not dividends.

C.   Analysis

      Section 162(a)(1)5 allows a deduction for the payment of

compensation, but only if the compensation is both (1) reasonable

in amount and (2) paid for personal services rendered.     Paula

Construction Co. v. Commissioner, 58 T.C. 1055, 1058 (1972),

affd. without published opinion 474 F.2d 1345 (5th Cir. 1973);

sec. 1.162-7(a), Income Tax Regs.     The question of reasonableness

is one of fact which must be resolved on the basis of all the

facts and circumstances in the case.     Owensby & Kritikos, Inc.

v. Commissioner, 819 F.2d at 1323; Pepsi-Cola Bottling Co. of

Salina, Inc. v. Commissioner, 528 F.2d 176, 179 (10th Cir. 1975),

affg. 61 T.C. 564, 567 (1974); Estate of Wallace v. Commissioner,


      5
          SEC. 162.   TRADE OR BUSINESS EXPENSES.

           (a) In General.–-There shall be allowed as a deduction
      all the ordinary and necessary expenses paid or incurred
      during the taxable year in carrying on any trade or
      business, including--

                 (1) a reasonable allowance for salaries or other
            compensation for personal services actually
            rendered * * *
                               - 20 -

95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992);

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1155

(1980).

     In addition to multifactor tests (see Owensby & Kritikos,

Inc. v. Commissioner, 819 F.2d at 1323), courts have also used

independent investor tests to determine whether payments to an

employee-shareholder exceeded reasonable compensation.     See,

e.g., Dexsil Corp. v. Commissioner, 147 F.3d 96, 100-101 (2d Cir.

1998), vacating and remanding T.C. Memo. 1995-135, on remand T.C.

Memo. 1999-155.    Generally, courts have described independent

investor tests as a lens through which the entire analysis should

be viewed.    Dexsil Corp. v. Commissioner, id. at 101.    In Owensby

& Kritikos, Inc. v. Commissioner, 819 F.2d at 1327, the Court of

Appeals for the Fifth Circuit stated:     “The so-called independent

investor test is simply one of the factors a court should

consider, and in certain cases it may be a substantial factor.”

In discussing the significance of a corporation’s dividend

practices, that Court also stated:      “The prime indicator of the

return a corporation is earning for its investors is its return

on equity.”   Id. at 1326-1327.

     Discerning the intent behind the payments also presents a

factual question to be resolved within the bounds of the

individual case.    Nor-Cal Adjusters v. Commissioner, 503 F.2d
                               - 21 -

359, 362 (9th Cir. 1974), affg. T.C. Memo. 1971-200; Paula

Construction Co. v. Commissioner, 58 T.C. at 1059.

     Where officer-shareholders who are in control of a

corporation set their own compensation, careful scrutiny is

required to determine whether the alleged compensation is in fact

a distribution of profits.    Rutter v. Commissioner, 853 F.2d

1267, 1270-1271 (5th Cir. 1988), affg. T.C. Memo. 1986-407;

Owensby & Kritikos, Inc.    v. Commissioner, 819 F.2d at 1324;

Estate of Wallace v. Commissioner, 95 T.C. at 556; sec. 1.162-

7(b)(1), Income Tax Regs.

     We will consider first whether (and, if so, then to what

extent) the payments to Jack exceeded reasonable compensation,

and then whether (and, if so, then to what extent) any part of

the payments that survive the first test should nevertheless be

nondeductible because they were not intended to be compensation.

Compare Owensby & Kritikos, Inc.   v. Commissioner, 819 F.2d at

1325 (payments made in the form of compensation), with Paula

Construction Co. v. Commissioner, 58 T.C. at 1057, 1059-1060

(payments made in the form of distributions), and King’s Court

Mobile Home Park v. Commissioner, 98 T.C. 511, 514-515 (1992)

(corporation’s unreported income diverted to shareholder).

     1.   Reasonableness

     Many factors are relevant in determining whether amounts

paid to a person were reasonable compensation, including the
                                - 22 -

following:    The person’s qualifications; the nature, extent, and

scope of the person’s work; the size and complexities of the

business; a comparison of salaries paid with gross income and net

income; the prevailing general economic conditions; a comparison

of salaries with distributions to stockholders; the prevailing

rates of compensation for comparable positions in comparable

concerns; the salary policy of the taxpayer as to all persons; in

the case of small corporations with a limited number of officers

the amount of compensation paid to the particular person in

previous years; and whether the corporation provided the person

with a pension or profit-sharing plan.    Owensby & Kritikos, Inc.

v. Commissioner, 819 F.2d at 1323, and cases there cited.      No

single factor is decisive; rather, we must consider and weigh the

totality of the facts and circumstances in arriving at our

decision.     Idem.

     Before we apply the relevant factors to the instant case, we

note that petitioner presented evidence of three offers to buy

petitioner.    The parties devoted substantial efforts to analyze

the direct and indirect (i.e., regarding return on investment)

significance of these offers.    Indeed, respondent’s expert

opined: “The single best evidence of reasonable compensation can

be found in the three subsequent offers to acquire the assets and

business of [petitioner]”.    However, none of the offers is

sufficiently detailed to enable us to determine what Jack’s
                              - 23 -

services would be worth under that offer.   (Petitioner contends

that one offer would justify a 1996 compensation level higher

than petitioner paid, while respondent contends that, using the

same methodology that petitioner used, one of the other offers,

would lead to a conclusion that the maximum 1996 reasonable

compensation would be only $79,103.)   Also, the parties do not

assist us in deciding how to adjust for the difference in time

between the offers’ presentations and the years in issue.

Finally, we do not even know when one of the offers was made.

Under these circumstances, we conclude that the offers are not to

be given any weight in determining the amounts of reasonable

compensation for Jack’s services for the years in issue.

     The following indicia of relatively high reasonable

compensation are present in the instant case:

     (1) Jack has been involved in every aspect of petitioner

since its inception.   Through his enthusiasm, hard work, and

dedication, he built petitioner into a successful enterprise.     He

served as its president, chairman, chief executive officer,

general manager, chief financial officer, credit manager,

purchasing officer, personnel manager, advertising manager,

insurance agent, real estate manager, and corporate legal affairs

liaison.   He worked 60 hours per week, 6 to 7 days per week.
                              - 24 -

     (2) Petitioner grew rapidly between 1991 and 1996.   In 1995,

it was ranked number 36 of Fleetwood mobile home retailers in the

nation; in 1996, it climbed to number 13 in the nation.

     (3) Jack personally guaranteed the working capital lines of

credit of petitioner.

     (4) Petitioner did not provide a defined benefit or profit-

sharing plan to Jack.   The only nonsalary benefit that petitioner

provided to Jack was health insurance; Jack (and, presumably,

Mary) was the only employee who did not receive paid sick and

vacation leave.

     (5) Under Jack’s control, petitioner survived several

economic downturns when many other mobile home retailers went out

of business.

     The following indicia of relatively low reasonable

compensation are present in the instant case:

     (1) The claimed compensation petitioner paid to Jack in 1995

and 1996 constituted 8.5 percent and 8.7 percent, respectively,

of petitioner’s gross sales, and 82 percent and 85 percent,

respectively, of petitioner’s taxable income.   These percentages

exceed those of most similar companies.

     (2) Petitioner did not maintain a compensation policy for

Jack.   Because Jack controlled the corporation, he was able to

set his own compensation.
                              - 25 -

     (3) The bonus amounts were not set in accordance with any

formula or other detailed arrangement agreed upon in advance.

Rather, they were determined and paid at the end of the year,

when petitioner knew its profitability for that year.    Thus,

Jack’s compensation was set on an ad hoc basis.

     (4) Petitioner did not pay dividends in 1995 or 1996, even

though it had made a distribution in 1993 and paid dividends in

1994, and profitability before officer’s compensation was greater

in 1995 and 1996 than it was in the two earlier years.

     (5) Petitioner’s average return on equity, which measures

the percent of profit before taxes as a percentage of tangible

net worth, was below that of comparable companies for the years

in issue.

     At trial, both parties presented the reports and testimony

of expert witnesses.   Petitioner’s experts were Sledge and Mae

Lon Ding, hereinafter sometimes referred to as Ding.

Respondent’s expert was Scott D. Hakala, hereinafter sometimes

referred to as Hakala.

     Before admitting expert testimony into evidence, the trial

judge is charged with the gatekeeping obligation of ensuring that

the testimony is both relevant and reliable.   Kumho Tire Co. v.

Carmichael, 526 U.S. 137, 147 (1999); Daubert v. Merrell Dow

Pharmaceuticals, Inc., 509 U.S. 579, 589 (1993); Caracci v.

Commissioner, 118 T.C. 379, 393 (2002), on appeal (5th Cir. Oct.
                                - 26 -

15, 2002).    This gatekeeping obligation applies to all expert

testimony, including testimony based on technical and other

specialized knowledge.     Kumho Tire Co. v. Carmichael, 526 U.S. at

141; see Fed. R. Evid. 702.

     As trier of fact, we are not bound by the opinion of any

expert witness and will accept or reject expert testimony, in

whole or in part, in the exercise of sound judgment.       Lukens v.

Commissioner, 945 F.2d 92, 96 (5th Cir. 1991) (and cases there

cited), affg. T.C. Memo. 1990-87.

     The three experts agree on some aspects of elements that

should be taken into account in determining what would be

reasonable compensation for Jack’s services to petitioner, but

even there they do not agree on what numbers those aspects should

lead us to.     Each expert does a much better job of explaining why

the other side is wrong than why his or her analysis is correct.

To that extent, each expert has been helpful.      To put it another

way, the experts have provided substantial assistance to the

trier of fact (Fed. R. Evid. 702) in identifying and winnowing

out the chaff; they have provided far less assistance in

identifying and keeping the wheat.       See United States v.

Mastropieri, 685 F.2d 776, 786 (2d Cir. 1982).

     (a)     Hakala

     Hakala is a principal in Business Valuation Services, Inc.

He had academic training in compensation theory and was awarded
                             - 27 -

the degree of Ph.D. in Economics by the University of Minnesota.

He has testified as an expert witness in reasonable compensation

cases.

     Table 5 shows the amounts that Hakala concluded were maximum

reasonable compensation for Jack’s services to petitioner in

1994, 1995, and 1996, per Hakala’s expert witness report (Ex. 60-

R) and Hakala’s rebuttal expert witness report (Ex. 61-R).

                             Table 5

                            Ex. 60-R          Ex. 61-R

              1994          $381,608          $410,626
              1995           544,419           599,117
              1996           448,620           485,966

     The task of calculating a maximum amount of reasonable

compensation ordinarily, and in the instant case, involves

judgment calls, generalizations, and very rough approximations.

We are mindful of Judge Tannenwald’s observation that in

valuation disputes (and reasonable compensation disputes are

essentially a subset of valuation disputes) there is often “an

overzealous effort, during the course of the ensuing litigation,

to infuse a talismanic precision into an issue which should

frankly be recognized as inherently imprecise”.   Messing v.

Commissioner, 48 T.C. 502, 512 (1967); see Estate of Jung v.

Commissioner, 101 T.C. 412, 446 (1993).

     Hakala acknowledges that the correction of but one set of

inconsistencies in his expert witness report assumptions results
                                - 28 -

in changes of 7 to 10 percent in his conclusions.    Ex. 61-R,

pp.6-7, IV-3.     We are struck by the fact that Hakala has so much

confidence in the combination of accuracy and precision of his

numbers and analysis that, even after the humbling exercise of

making the gross corrections he describes, he claims to be able

to come to conclusions to six significant figures.      Supra table

5.   Respondent urges us to follow in Hakala’s footsteps--to six

significant figures.    We respond that, neither Hakala’s nor

respondent’s continued presentation of six-significant-figure

conclusions causes us to have any confidence that the precision

of those conclusions is an indication that those conclusions are

accurate.6   Indeed, Hakala’s efforts to persuade us to walk that

road serve only to cause us to doubt his judgment.      When we doubt

the judgment of an expert witness on one point, we become

reluctant to accept that expert’s conclusions on other points.7

     6
         A quotation from Shakespeare is perhaps apt:

     Glendower:    I can call spirits from the vasty deep.

     Hotspur: Why, so can I, or so can any man;     But will they
     come when you do call for them?

Henry IV, Part I, act 3, sc. 1.
     7
        For completeness, it should be noted that, when the Court
asked Hakala “why it is that you believe it is appropriate to
come up with a result to six significant figures”, he responded
that--

     no one in a real compensation would round to six significant
     figures, that normally I would round to the nearest thousand
                                                   (continued...)
                             - 29 -

     When the Court asked Hakala if he was “confident” in his

conclusion that reasonable compensation for 1996 should be

substantially below reasonable compensation for 1995 (see supra

tables 4 and 5), he responded as follows:

          THE WITNESS: No, and I think they have a valid point
     that there was more income, and what I missed was that in
     the other income was the rebate from Fleetwood. When you
     factor the rebate from Fleetwood in, the compensation for
     ‘96 should go up. If you do that, then you have to adjust
     the compensation for ‘95 downward. So, you know, I would
     agree that I think intuitively, ‘96 should probably be
     higher than ‘95.

     Notwithstanding this testimony, Hakala did not change his

report recommendations, and respondent’s posttrial briefs still

urge us to adopt Hakala’s report recommendations, with

substantially lower reasonable compensation for 1996 as compared

to 1995.8




     7
      (...continued)
     or the nearest 5,000. In effect, if I was at 599, I’d round
     up to 600,000. If it was at 485, I might round to 485.

     However, notwithstanding Hakala’s concession that “no one”
in a real situation would determine reasonable compensation to
six significant figures, Hakala did not change his report
recommendation, and respondent’s posttrial briefs still urge us
to adopt Hakala’s six-significant-figure recommendations.
     8
        At trial, Hakala explained that, if he adjusted upward
the maximum reasonable compensation for Jack for 1996, then he
would have to make a corresponding downward adjustment for 1995.
Neither Hakala at trial nor respondent on brief has explained why
an upward adjustment for 1996 on account of the Fleetwood rebate
would require a downward adjustment for 1995, except that at
trial Hakala invoked the imagery of “squeezing on a balloon.”
                                - 30 -

     (b)   Sledge

     Sledge is a C.P.A. in private practice in his own firm.      He

was awarded the degree of B.S. in Industrial Psychology by

Louisiana State University and took postgraduate work to prepare

himself for the C.P.A. examination.      He has testified as an

expert witness in business valuation cases, and other matters

involving officer compensation issues.

     Sledge did not determine what was maximum reasonable

compensation for Jack’s services to petitioner in the years in

issue, but concluded that “it is my opinion that the salary paid

to Mr. Brewer during 1995 and 1996 is reasonable.”     As a result,

we can agree with much of what Sledge says, and still have little

or no guidance from his expert witness report as to what numbers

to set for reasonable compensation.

     Before the trial, respondent moved in limine to exclude

Sledge’s expert witness report and to not allow Sledge to testify

as an expert witness.    Respondent pointed to Sledge’s obvious

conflict of interest and contended that Sledge “is unable to

provide the degree of objectivity required of an expert witness.”

We concluded that, in the instant case, it was better to (1) take

Sledge’s conflict of interest into account in weighing his expert

witness report and expert testimony, and (2) not exclude Sledge

and his report.     In retrospect, we conclude that we made the

right decision on this matter; i.e., we conclude that Sledge’s
                              - 31 -

expert witness report, his rebuttal report, and his expert

witness testimony did assist us, as trier of fact, in

understanding concepts involved in determining reasonable

compensation, and in understanding matters raised by Hakala.   See

Koch Refining Co. v. Jennifer L. Boudreau MV, 85 F.3d 1178, 1182-

1183 (5th Cir. 1996).

     (c)    Ding

     Ding is president of Personnel Systems Associates.    She was

awarded the degree of M.B.A. by the University of Southern

California, and the degree of B.A. in Industrial Psychology from

UCLA.   She has testified as an expert witness in reasonable

compensation cases.

     Ding did not conclude what was maximum reasonable

compensation for Jack’s services to petitioner in the years in

issue, but she concluded that “Mr. Brewer was compensated at a

rate in 1995 and 1996, which we believe an investor in an arm’s-

length transaction would have thought to be reasonable”.

Nevertheless, Ding’s presentation of the data from RMA enables us

to make our own evaluation and to start the process of

redetermining reasonable compensation numbers for Jack’s

services.
                                - 32 -

     (d)   Amount of Maximum Reasonable Compensation

     (1)   RMA Ratios

     Both Hakala and Ding direct our attention to RMA surveys of

companies that specialize in mobile home retailing.    None of the

expert witnesses was able to identify any published surveys of

the amounts of executive compensation for the mobile home

retailing industry.     However, it was noted that the RMA’s surveys

provided financial ratios, including a ratio for executive

compensation to company sales.

     In her analysis of the RMA data, Ding stated that

petitioner’s--

     average compensation [total executive compensation,
     including what petitioner paid to Mary] to sales ratio for
     the period 1986-1996 was 4.6%, which was slightly above the
     RMA 75th percentile of 4.2% and considerably below our
     [i.e., Ding’s] projection of the 90th percentile average of
     5.9% (Exhibit F).

Ding regarded the following considerations as being among those

leading to her conclusion that Jack “achieved exceptional

financial performance” at petitioner, “justifying a comparison of

compensation above the 75th percentile and as high as the 90th

percentile”:

          Petitioner’s sales grew at an average annual rate of 17
     percent while the industry grew at an average annual rate of
     only 10.8 percent.

          Petitioner’s inventory turnover rate, “a key measure of
     efficient use of capital and inventory management”, was more
     than one-third higher than the mobile home retail industry
     as a whole.
                               - 33 -

          Petitioner “has very high capitalization relative to
     industry norms which reduce risk to the shareholder in the
     event of a downturn in business, saves interest costs on
     loans, enables faster growth, and causes ROE [returns on
     equity] ratios to understate true profit performance.”

     From the foregoing and other matters, Ding concluded as

follows:

     When all the above factors are taken into consideration, it
     is apparent that Brewer Quality Homes’ performance is among
     the best in the industry. CEOs who achieve top performance
     in their industry receive top pay, therefore it is
     reasonable to expect that Jack Brewer would receive
     compensation above the 75th percentile and as high as the
     90th percentile.

     Hakala, on the other hand, stated that for 1995 and 1996

Jack’s “compensation level * * * [as a percentage of sales] was

significantly higher than the third quartile levels of the RMA

comparable firms.”   He stated that this high compensation level

resulted in a drop in profitability which, together with an

elimination of dividends, provided “low returns to its

[petitioner’s] shareholder.”

     In his rebuttal report, Hakala presented several criticisms

of Ding’s use of RMA data.   We consider these criticisms

seriatim.

     Ding used average percentages over time, while Hakala

focused on year-by-year figures for 1994 through 1996.   Table 6

compares petitioner’s total officer compensation (Jack’s plus

Mary’s, in the case of petitioner) as a percentage of mobile home
                                - 34 -

sales, on the one hand, to Ding’s and Hakala’s different

approaches as to the RMA 75th percentile data.

                                Table 6

                   Petitioner      RMA--Ding       RMA--Hakala

1994                  6.4            4.2              5.4
1995                  8.7            4.2              5.4
1996                  8.9            4.4              3.4

Averages

Ding (1986-1996)      4.6            4.2               --
Ding (1994-1996)      8.0            4.3               --
Hakala (1994-1996)    8.0            --               4.7

       Ding’s focus on 11-year averages led her to conclude that

petitioner’s 11-year average payment ratios are only a little

higher than the RMA 75th percentile ratios (4.6 percent to 4.2

percent) and much lower than the estimated RMA 90th percentile

ratios9 (4.6 percent to 5.9 percent).      Hakala, on the other hand,

concluded that petitioner’s 1-year payment ratios are much higher

than the RMA 75th percentile ratios (8.0 percent to 4.7 percent).

Supra table 6.

       Hakala also criticized Ding’s analysis, as follows:

       In the tax year 1986 through 1993, BQH [petitioner] elected
       S Corporation status. The owner-officer of an S Corporation
       has an incentive to minimize personal salary and bonus
       compensation and to recognize greater taxable corporate

       9
        Hakala ignores Ding’s estimates of RMA 90th percentile
ratios; he neither disputes nor accepts the correctness of Ding’s
estimates. However, on brief, respondent accepts the correctness
of Ding’s estimates of RMA 90th percentile ratios, at least for
the purpose of pointing out that petitioner’s 1995 and 1996
ratios are far higher than the ratios that Ding applies.
                             - 35 -

     income due to payroll taxes on reported compensation.[10]
     This calls into question the appropriateness of an
     undercompensation analysis in the years 1986 through 1993.

     Firstly, for 2 of the 8 years Hakala refers to (1986 and

1988), petitioner was a C corporation, not an S corporation.    It

is not clear whether these mistakes were merely “harmless error”

or whether this affected Hakala’s conclusions.

     Secondly, if Hakala’s thesis is correct, that this

“incentive” affected petitioner’s actions during the C

corporation years, then it becomes relevant to determine whether

(and to what extent) it also affected the similar-sized

businesses that provided the underlying data for the RMA ratios.


     10
        In general, an S corporation shareholder is taxed on the
shareholder’s pro rata share of the corporation’s income,
regardless of whether the shareholder actually receives a
distribution. Sec. 1366(a)(1). Where the shareholder is also an
employee of the corporation, there is an incentive both for the
corporation and for the employee-shareholder to characterize a
payment to the employee-shareholder as a distribution rather than
as compensation because only payments for compensation are
subject to Federal employment taxes. See secs. 3111, 3301. In
such instances, the Commissioner may recharacterize a
distribution as compensation in order to reflect the true nature
of the payment. See Rev. Rul. 74-44, 1974-1 C.B. 287
(“dividends” paid to S corporation shareholders treated as
reasonable compensation for services rendered and subjected to
Federal employment taxes); see also Veterinary Surgical
Consultants, P.C. v. Commissioner, 117 T.C. 141, 145-146 (2001),
affd. sub nom. Yeagle Drywall Co. v. Commissioner, 54 Fed. Appx.
100 (3d Cir. 2002).

     Although Hakala argued that petitioner may have practiced
tax gamesmanship in one or more of the years before 1995, the
record does not disclose that respondent made a determination on
this matter, nor can we tell from the record whether petitioner
did distort the situation.
                             - 36 -

Until we know that, we do not know how to deal with the concern

that Hakala has described.

     Thirdly, Hakala does not: (a) Point to any evidence that

would enable us to quantify the amount, if any, by which this

potential gamesmanship actually diminished the compensation that

petitioner paid to Jack in any year, (b) suggest any way of

adjusting the ratio for petitioner to compensate for this

potential gamesmanship, or (c) explain why petitioner and Jack

would shift payments from compensation in 1993 but not use that

device for 1989, 1990, and 1991, when presumably the same

“incentives” were in play and when petitioner and Jack had the

same tax adviser that they had in 1993.

     Thus, Hakala’s speculation is interesting but we do not find

it helpful in analyzing the instant issue.   See infra (3)

Previous Underpayment.

     Hakala also presents the following double-barreled attack on

Ding’s reliance on the RMA data:

     The Robert Morris Associates (“RMA”) data requires more
     analysis than was provided by Ms. Ding. First, we don’t
     know exactly how many officers, directors and affiliates are
     represented in the total officers’ compensation in the RMA
     figures. For larger dealerships, our experience is that
     more than one officer is included and sometimes three or
     more persons may be represented in the total figures.
     Second, we don’t know the extent to which the officers’
     compensation is consistent with arm’s length practices. The
     BVS Report summarized in Exhibits II-2 and II-3 [attachments
     to Exh. 60-R, Hakala’s expert witness report] represents an
     attempt to address these issues. The suggested total
     compensation at the 75th percentile level is at most
     $324,219 in 1995 and $224,858 in 1996 for a single officer
                               - 37 -

       and $486,329 in 1995 and $337,287 in 1986 for two officers
       or more executive officers of BQH based on this information.

       As to the multiple-officer concern, we are satisfied that

Ding’s approach is useful, in the absence of anything better.

Ding determined appropriate total officer compensation,

subtracted the agreed-upon compensation to Mary, and concluded

that the remainder is appropriate compensation to Jack.      In the

material that Hakala cites, he assumed that, in a two-officer

arrangement, the second officer was compensated at half the rate

of the first officer, and concluded that the CEO’s compensation

was 67 percent of the total officer compensation.    We agree that

Hakala’s conclusions follow, arithmetically, from his

assumptions.    However, Hakala does not give us any reason to

conclude that Hakala’s “attempt to address these issues” is any

better than Ding’s approach.    In the absence of any hard

information as to businesses of petitioner’s size, other than the

evidence of petitioner’s own history, we are willing to follow

Ding’s approach.

       Hakala’s concern that the underlying RMA data may not be

“consistent with arm’s length practices” is the more serious

attack.

       However, Hakala does not provide anything to back up the

suspicion that he voices.    Also, the material to which Hakala

directs our attention does not appear to address this issue at

all.    Finally, the numbers that Hakala finally commends to us
                               - 38 -

($599,117 for 1995, $485,966 for 1996, supra tables 4, 5) are

substantially greater than the numbers that Hakala tells us would

result from the RMA 75th percentile data that Hakala suggest are

too great.

     Hakala does not direct our attention to any other data that

focus on the mobile homes retail sales industry.11

     On this record, the RMA ratios leave much to be desired as a

foundation for decision-making.   We nevertheless use those ratios

as a starting point, because they are the only statistical

information we have that deals with mobile home retailers.      In

other words, the RMA ratios are “the only game in town”.      See,

e.g., United States v. Borum, 584 F.2d 424, 434 (D.C. Cir. 1978)

(MacKinnon, J., dissenting).

     The years in issue, 1995 and 1996, were good years for the

mobile home retailing industry and even better years for

petitioner.12


     11
          In his rebuttal report, Hakala states as follows:

     The single best evidence of reasonable compensation can be
     found in the three subsequent offers to acquire the assets
     and business of BQH [petitioner] found in the exhibits to
     Ms. Ding’s report.

     However, Hakala relies on these offers only to the extent of
contending that, in reality, the offers amount to less
compensation for Jack than the approach that Hakala uses. In
effect, then, Hakala rejects the lessons of the evidence that he
describes as “The single best evidence”.
     12
          Petitioner’s sales increased proportionately more than
                                                     (continued...)
                                  - 39 -

     Jack guided petitioner through the hard times when many of

petitioner’s competitors went out of business and into the

breakout years of 1995 and 1996.13     We are satisfied that Jack’s

long-term efforts leading up to 1995 and 1996, and Jack’s

spectacularly successful work in 1995 and 1996, justify ranking

Jack with the leaders of his field for the latter years.       To us,

this means that reasonable compensation for 1995 and 1996 is to

be determined by reference to the 90th percentile of officer

compensation payments.


     12
      (...continued)
the industry’s sales, as shown by the following table:

                                                        Petitioner’s
             Petitioner’s Sales                       Sales as a % of
   Year       see supra Table 1     Industry Sales    Industry Sales

   1986         $2,528,724           $5,480,384,000        0.046
   1987          3,022,585            5,512,572,600        0.055
   1988          3,569,197            5,482,567,900        0.065
   1989          3,380,615            5,392,508,800        0.063
   1990          3,526,171            5,231,181,600        0.067
   1991          2,888,775            4,728,750,100        0.061
   1992          2,732,920            5,986,350,800        0.046
   1993          4,197,494            7,755,418,000        0.054
   1994          6,559,036           10,181,722,000        0.064
   1995          9,006,092           12,327,516,300        0.073
   1996          9,920,208           13,954,982,400        0.071

     13
          Hakala stated, in his rebuttal report:

     BQH [petitioner] was a well run and successful dealership
     with an established franchise and presence. Mr. Brewer
     clearly deserves substantial credit for this success in 1995
     and 1996.
                                - 40 -

     We note that the RMA ratios fluctuate greatly from year to

year, and even the relative ratios (i.e., comparisons of the

ratios for smaller companies with the ratios for larger

companies) fluctuate greatly.    None of the experts discusses the

factors that led to the RMA ratio fluctuations.      Ding attempted

to “smoothen” the relevant ratios.       See supra table 6 for 75th

percentile numbers.   For 90th percentile numbers, Ding used 6.0

for 1995 and 6.3 for 1996.   Hakala did not discuss whether there

should be a different approach to the smoothening process or

whether the RMA ratio amounts should be used without any

smoothening.   In the absence of criticism by Hakala, we are

willing to follow Ding’s smoothening approach.      We apply the RMA

90th percentile ratios to petitioner’s 1995 and 1996 sales to

obtain total shareholder-employee reasonable compensation.      From

the totals thus obtained, we subtract the amounts petitioner paid

to Mary, which have been agreed to be reasonable compensation for

Mary’s services.

     However, our willingness to follow Ding’s analysis regarding

Jack’s 90th-percentile status, at least for 1995 and 1996, does

not lead us to Ding’s conclusions that all of Jack’s compensation

is reasonable for each of these years.      As Ding acknowledged at

trial, the compensation that petitioner paid to Jack for each of

these years, as a percentage of petitioner’s sales, was
                                - 41 -

significantly higher than the 90th-percentile level shown by the

RMA data for the same years.

     Our acceptance of Ding’s thesis, then, leads us to apply the

RMA 90th-percentile ratios to petitioner’s sales, which results

in reasonable compensation amounts significantly less than

petitioner’s actual payments to Jack.      This process leads us to

initial calculations of $520,000 for 1995 and $600,000 for 1996

as reasonable compensation amounts for Jack’s services.

     (2)   Loan Guaranty

     Hakala opined, in his expert witness report, that Jack was

entitled to an additional $5,000 reasonable compensation “for

providing his personal guarantee to secure a short-term working

capital line of credit in 1995".    Respondent has conceded the

allowability of this additional amount.      Petitioner does not

dispute this item; we accept it.     Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d at 1325 n.33.

     Accordingly, we increase our 1995 reasonable compensation

determination to $525,000.

     (3)   Previous Underpayment

     Petitioner contends that Jack was underpaid in previous

years, particularly 1992 and 1993.       See supra table 3.

Petitioner argues as follows:

          While there are no corporate minuets [sic] declaring
     any part of Mr. Brewer’s compensation for 1995 and 1996 as
     make up salary, a good faith argument for extension of
     existing law can be made where it is apparent from the facts
                              - 42 -

     because of the extreme disparity between Mr. Brewer’s
     compensation in 1992 and 1993 and his compensation in both
     previous and following years that the fact that he was being
     compensated for past performance is plainly apparent.

     Respondent’s rejoinder is twofold:   (1) There is no

indication of an intent to compensate Jack in 1995 or in 1996 on

account of past undercompensation, and (2) Hakala concluded that

Jack was adequately compensated for Jack’s services to petitioner

for 1986 through 1994.

     Amounts paid in a later year for earlier years’ services may

be deducted when paid, if the services were undercompensated in

the earlier years.   Lucas v. Ox Fibre Brush Co., 281 U.S. 115,

119 (1930); Estate of Wallace v. Commissioner, 95 T.C. at 553;

Cropland Chemical Corp. v. Commissioner, 75 T.C. 288, 297-298

(1980), affd. without published opinion 665 F.2d 1050 (7th Cir.

1981); R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 50-51 (1972).

In order to be allowed the deduction, the taxpayer must establish

(1) the amount of the undercompensation for the earlier years’

services and (2) that the payment in the later year is intended

as compensation for the earlier years’ services.   Pacific Grains,

Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), affg.

T.C. Memo. 1967-7; Perlmutter v. Commissioner, 373 F.2d 45, 48

(10th Cir. 1967), affg. 44 T.C. 382, 403 (1965); Estate of

Wallace v. Commissioner, 95 T.C. at 553-554.

     In the instant case, petitioner has presented us with little

more than the claim, and general conclusory testimony, that some
                              - 43 -

amount was intended as compensation for Jack’s earlier years’

services.   We are not told (1) how much of the 1995 payments or

the 1996 payments was so intended; (2) how the intent was arrived

at or formulated; or (3) what earlier years’ services were being

compensated for in 1995 or in 1996.    For all we can tell,

petitioner’s “theory of compensation for prior services was only

an afterthought developed at a time when the reasonableness of

the compensation was already under attack.”    Pacific Grains, Inc.

v. Commissioner, 399 F.2d at 606.

     Petitioner’s plea that we overlook the absence of corporate

minutes runs into the concern that it is precisely in situations

such as the instant case, where one person’s “controlling

presence was on all sides of the negotiating table” (Kean,

Transferee v. Commissioner, 91 T.C. 575, 595 (1988)), that we

“must carefully scrutinize the payments to ensure that they are

not disguised dividends.”   Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d at 1324.

     On the basis of Jack’s and Sledge’s testimony, as well as

petitioner’s failure to produce any relevant corporate minutes or

any other contemporaneous paper trail (see Wichita Terminal

Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946), affd.

162 F.2d 513 (10th Cir. 1947)), we conclude that it is more

likely than not that petitioner did not intend in 1995 and did
                                 - 44 -

not intend in 1996 to compensate Jack for his earlier services to

petitioner.    We have so found.

     Under these circumstances we need not, and we do not,

determine whether Jack was undercompensated for his earlier

services to petitioner.

     (4)    Nonsalary Benefits

     Ding stated that petitioner’s failure to provide nonsalary

benefits (other than health insurance) to its executives should

be taken into account in determining the maximum reasonable

compensation for Jack.    She regarded as particularly important

the lack of “a defined benefit plan or deferred compensation

plan.”     She relied on studies showing that (1) “Companies

typically provide their executives with benefits representing

24.4% of compensation” and (2) “Sixty-one percent of retail and

wholesale trade industries provide long-term incentive programs

for their top managers”.

     In his rebuttal expert witness report, Hakala responded as

follows:

     Compensation for Poor Benefits: This is an interesting
     issue. It is difficult to quantify. BQH is not a large,
     public company. Benefits are typically more limited for
     officers of manufactured home dealerships. It is our
     understanding that Mr. Brewer’s benefits were consistent
     with the benefits realized by his top sales personnel. The
     data relied upon by Ms. Ding is not applicable for a company
     of the size and type of BQH. However, some elements for
     benefits might be considered appropriate in a market
     compensation analysis but not in the independent investor
     returns analysis.
                             - 45 -

     On opening brief, petitioner contends as follows:

          Additionally, Mr. Brewer’s compensation lacked the
     typical benefits package. Mr. Brewer’s compensation package
     did not include, a retirement plan, a SEP, a 401(k), a
     Profit-sharing plan, a Defined benefits plan, a 205 plan, a
     125 plan, sick leave, or paid vacation. (Trial Trans. Vol.
     1 page 38) These types of benefits were customary in the
     industry and represent a substantial amount of money. This
     lack of customary benefits package justifies a larger
     salary. (Trial Trans. Vol. 2 pages 193-196) Typically,
     companies provide their executives with benefits
     representing 24.4% of compensation. (Exhibit 56-P page 7 and
     Exhibit X therein) If Mr. Brewer would have had a typical
     benefits package his cash compensation could have been 24%
     less and he still had the same total compensation.

     On answering brief, respondent replies as follows:

          Petitioner’s argument that Jack Brewer’s compensation
     in 1995 and 1996 made up for the lack of company provided
     fringe benefits is unfounded. It was not necessary for Jack
     Brewer to participate in a company sponsored profit sharing
     plan because, in fact, Jack Brewer determined and allocated
     substantially all company profits to himself on December 31
     of each year.

     We analyze this matter as follows:

     Firstly, if petitioner means to say that courts apply the

reasonable compensation test to only “cash compensation”, then

petitioner is wrong.

     It has long been settled law that--

     The sum of all compensation, deferred as well as direct,
     must meet the requirement of §162 that it be reasonable in
     amount. [Edwin’s, Inc. v. United States, 501 F.2d 675, 679
     (7th Cir. 1974).]

To the same effect, see LaMastro v. Commissioner, 72 T.C. 377,

381-382 (1979); Bianchi v. Commissioner, 66 T.C. 324, 329-330
                               - 46 -

(1976), affd. without published opinion 553 F.2d 93 (2d Cir.

1977).

     Secondly, the question of what courts do in fact requires an

understanding of the effect of the limits of what is in the

record before us.   For example, if we knew that (1) the

underlying data for the RMA ratios came from only those mobile

home retailers who provided nonsalary benefits to their

executives, (2) but this underlying data included only the cash

compensation paid to the executives and not the value of (or

current cost to buy) the nonsalary benefits, and (3) the value of

(or current cost to buy) these benefits was, as Ding stated, 24.4

percent of total compensation (i.e., cash compensation plus

nonsalary benefits), then we would adjust the cash compensation

amount upward by about 32.3 percent to arrive at total equivalent

compensation.14   However, the record before us does not include

any of the needed information as to the data underlying the RMA

ratios.   Also, the 24.4 percent in Ding’s analysis comes from a

report of a 1992 study of 297 employers.   The record does not

give us any characteristics of the participating employers that

would enable us to make a useful judgment as to how that sample



     14
          If nonsalary benefits are 24.4 percent of total
compensation, then cash compensation constitutes the remaining
75.6 percent of the total compensation. Thus, total compensation
is
100 percent   of cash compensation, or l32.3 percent of cash
75.6 percent  compensation.
                               - 47 -

related to the RMA samples for 1995 and 1996.    Petitioner’s brief

makes assumptions that are not stated in the brief and that

appear to be neither supported by nor contradicted by the record.

Respondent’s brief on this issue seems to be totally irrelevant

to a reasonable compensation analysis, even though it may be

significant to an analysis of petitioner’s intent.

     We are left with Hakala’s observation that some adjustment

for nonsalary benefits “might be considered appropriate in a

market compensation analysis”.    Because of Hakala’s observation,

and in light of the lack of foundation for the use of 24.4

percent for mobile home retailers of petitioner’s size, we

conclude that we should adjust upward by some amount the

estimates derived from the RMA ratios.     See Kennedy v.

Commissioner, 671 F.2d 167, 175 (6th Cir. 1982), revg. 72 T.C.

793 (1979).    Doing the best we can with the record in the instant

case, we increase our 1995 reasonable compensation determination

to $550,000 and our 1996 reasonable compensation determination to

$630,000.

     (5)    Independent Investor Returns

     In reaching his reasonable compensation figures, Hakala

“relied primarily our [on ?] investor return analysis as an

indication of the upper bound on executive compensation such that

an arm’s-length investor in the Company is able to realize a fair

return on equity.”
                              - 48 -

     a.   Fair Market Value Analysis

     In the first part of his analysis, Hakala valued petitioner

based on two “rules of thumb”: (1) three times “owners’

discretionary cash flow” and (2) five times earnings before

interest (the net of interest income and interest expense) and

taxes (only Federal income taxes), or EBIT.   Owners’

discretionary cashflow is the sum of EBIT, Jack’s compensation,

and Mary’s compensation.   Hakala states that, because only the

owners’ discretionary cashflow measure is calculated before

deduction of officers’ compensation, the difference in value

between the two measures provides an implied amount of excess

compensation.   For 1995 and 1996, Hakala calculated implied

excess compensation of $356,942 and $412,625, respectively.     By

subtracting the amounts of implied excess compensation from the

amounts that petitioner paid to Jack, Hakala determined an

implied amount of reasonable compensation of $405,244 for 1995

and $450,934 for 1996.

     In his expert witness reports, Hakala included tables

showing how his fair market value analysis would apply if

petitioner had paid to Jack only the amounts that Hakala

concluded would be reasonable compensation.   In his original

report, in which he concluded that maximum reasonable
                              - 49 -

compensation to Jack would be $544,419 for 199515 and $448,620

for 1996, Hakala’s fair market value analysis shows that, what

Hakala referred to as the implied amount of reasonable

compensation would be only $418,290 for 1995, but would be

$461,734 for 1996.   In his rebuttal report, in which he concluded

that maximum reasonable compensation to Jack would be $599,117

for 1995 (see supra note 15) and $485,966 for 1996, Hakala’s fair

market analysis shows that, what Hakala refers to as the implied

amount of reasonable compensation still would be only $418,290

for 1995, and $461,734 for 1996.

      Hakala’s analysis seems to not make any further use of the

implied amounts of reasonable compensation that he thus

calculated.

      As far as we can tell, Hakala uses the three times owners’

discretionary cashflow only in calculating “Operating return

[operating income] on FMV operating assets [which Hakala

apparently equates to three times owners’ discretionary

cashflow]” both in terms of what the ratios actually were and

what the ratios would have been under the method described infra

b.   Estimate of Petitioner’s Discount Rate.

      As far as we can tell, Hakala uses the five times EBIT only

in one table, which appears twice in Hakala’s original report.


      15
        For these calculations, Hakala ignored, without
explanation, the additional $5,000 discussed supra (2) Loan
Guaranty.
                              - 50 -

In that table, Hakala uses interchangeably “5 times EBIT” and

“FMV of BQH [petitioner]”.   Hakala does not appear to use the

five times EBIT amount to derive anything.

     Hakala has not explained, and we have not been able to

discern, any role that Hakala’s fair market value analysis played

in producing Hakala’s bottom-line reasonable compensation

conclusions.   Under these circumstances, we do not pause to

consider the appropriateness of Hakala’s choices of the three and

five multipliers (why not 2½ and 5½, or some other sets of

numbers), of Hakala’s choices of things to multiply (owners’

discretionary cashflow and EBIT), of Hakala’s choices of

equivalents (three times owners’ discretionary cashflow is

equivalent to the fair market value of petitioner’s operating

assets; five times EBIT is equivalent to the fair market value of

petitioner), and of Hakala’s method of deriving implied

reasonable compensation from these multiplier rules of thumb.

     We have thought it appropriate to consider Hakala’s fair

market value analysis only because (1) Hakala presented it at the

head of his independent investor returns analysis, and (2) it

helps us in evaluating the complexities of the remaining portions

of Hakala’s independent investor returns analysis.16   However, we


     16
        In Gilbert and Sullivan’s “Patience”, the character
Bunthorne extols obscurity and complexity as the route to
creation of an impressive persona, as follows:

                                                    (continued...)
                              - 51 -

conclude that this fair market value analysis in Hakala’s expert

witness report does not lead us to any answer in our quest for

the maximum amount of reasonable compensation from petitioner to

Jack.

     b.   Estimate of Petitioner’s Discount Rate

     Hakala’s next step in his investor returns analysis was to

estimate the discount rate, or “cost of capital”.   As Hakala uses

the term, petitioner’s cost of capital is the rate of return that

an investor would expect to realize from an investment in a


     16
      (...continued)
     If you’re anxious for to shine in the high aesthetic line as
          a man of culture rare,
     You must get up all the germs of the transcendental terms,
          and plant them everywhere.
     You must lie upon the daisies and discourse in novel
          phrases of your complicated state of mind,
     The meaning doesn’t matter if it’s only idle chatter of a
          transcendental kind.
               And every one will say,
               As you walk your mystic way,
     “If this young man expresses himself in terms too deep
          for me,
     Why, what a very singularly deep young man this deep
          young man must be!”

“Patience”, The Complete Plays of Gilbert and Sullivan, pp. 199-
200 (New York: Modern Library).

     Under Fed. R. Evid. 702, the justification for the expert
witness is that the expert witness “will assist the trier of fact
to understand the evidence or to determine a fact in issue”. It
is not enough that the expert can communicate with other experts.
The expert should be enough of a teacher or explainer so that the
nonexpert trier of fact can understand the steps in the expert’s
analysis. The nonexpert trier of fact should not have to be a
detective, discovering clues in odd places in the expert’s
report, in order to understand how the expert proceeded from one
step to the next.
                                - 52 -

company such as petitioner, taking into account the appropriate

risk and performance characteristics of petitioner.

       From his pretax operating return on net operating assets

percentages, Hakala determined an adjusted average required rate

of return of 16.77 percent.    In so doing, he assumed “inflation

plus real growth will average approximately 4.0% per annum” and

grossed up for taxes.    Hakala then calculated reasonable

compensation numbers for Jack such that the average required rate

of return was 16.77 percent.    The values of the variables

(operating profit and three times owners’ discretionary cashflow)

that Hakala used to conclude that the average required rate of

return equaled 16.77 percent are pretax values.    The 16.77

percent, however, contemplates that the values will be after-tax

values.

       Hakala chose to use the Capital Asset Pricing Model

(hereinafter sometimes referred to as CAPM) to estimate

petitioner’s cost of capital.    He states that CAPM is “A standard

method of estimating the cost of capital”.

       Petitioner contends that CAPM “has no application to closely

held companies”, citing Furman v. Commissioner, T.C. Memo. 1998-

157.    Neither Hakala nor respondent seeks to rebut petitioner’s

Furman contention.    Hakala did not tell us (1) whether there are

other standard methods, (2) whether CAPM has advantages over
                             - 53 -

other standard methods, nor (3) why Hakala chose to use CAPM in

this instance.

     In Estate of Heck v. Commissioner, T.C. Memo. 2002-34, we

commented as follows:
          11
            In recent cases, we have criticized the use of both
     the capital asset pricing model (CAPM) and WACC as
     analytical tools in valuing the stock of closely held
     corporations. See Furman v. Commissioner, T.C. Memo. 1998-
     157. See also Estate of Maggos v. Commissioner, T.C. Memo.
     2000-129, and Estate of Hendrickson v. Commissioner, T.C.
     Memo. 1999-278, which reaffirm that view, citing Furman, and
     Estate of Klauss v. Commissioner, T.C. Memo. 2000-191, where
     we rejected an expert valuation utilizing CAPM in favor of
     one utilizing the buildup method. In other recent cases,
     however, we have adopted expert reports which valued closely
     held corporations utilizing CAPM to derive an appropriate
     cost of equity capital. See BTR Dunlop Holdings, Inc. v.
     Commissioner, T.C. Memo. 1999-377; Gross v. Commissioner,
     T.C. Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001).

     Because the parties have not developed this dispute and we

conclude infra that Hakala’s application of CAPM to petitioner in

the instant case has significant flaws, we do not determine in

the instant case the conceptual suitability of applying CAPM to

the valuation of closely held companies such as petitioner.

     The first step in CAPM involves calculating the cost of

equity capital, which Hakala defined as “the expected (or

required) rate of return on the firm’s common stock” that an

investor would “expect to realize from an investment in a company

with the risk and performance characteristics” of petitioner.

Hakala estimated the cost of equity capital to be 15.06 percent
                               - 54 -

in 1995 and 15.75 percent in 1996.17    Hakala then estimated the

cost of debt, which he based on “the prevailing prime lending

rate plus 1.0%.”   For 1995 and 1996, the costs of debt were 9.50

percent and 9.25 percent, respectively.

     Next, Hakala applied the values determined in the preceding

two steps to calculating the weighted average cost of capital,

sometimes hereinafter referred to as WACC.    Hakala determined

that the WACC was 14.16 percent for 1995 and 14.76 percent for

1996.

     In his expert witness report, Hakala described this process

as “using weights reflecting the relative importance of debt and

equity in the typical firm’s capital structure.”    He multiplied

the cost of equity capital by a fraction derived from the

relative portion of total capital that consisted of equity; he



     17
          Hakala’s report shows the arithmetic as follows:

     1995: “15.06% = 5.96% plus (7.40% times 1.09) plus 1.00%”
     1996: “15.75% = 6.65% plus (7.40% times 1.09) plus 1.00%”

     Sledge’s supplemental report adds the same components for
1995 as follows:

     Long-Term Risk Less [sic] Rate        5.96
   + Market Risk x Beta 7.4 x 1.09 =       8.07
   + Non-systematic risk                   1.00
   = Required return on equity            15.06 rounded

Sledge then uses the 15.06 percent in his calculations.

     When we perform the indicated arithmetic, we get 15.026,
rounded to 15.03 percent for 1995, and 15.716, rounded to 15.72
percent for 1996.
                              - 55 -

multiplied the cost of debt capital by a fraction derived from

the ratio of debt to equity (instead of the ratio of debt to

total capital); and he added the two products together to produce

his WACC amounts.

     Sledge, in his rebuttal report, points out (correctly) that

Hakala’s debt multiplier should have been the ratio of debt to

total capital; that the sum of the debt multiplier and the equity

multiplier should be 1.000, while Hakala’s sum was 1.0123; and

that this error by Hakala resulted in Hakala’s overstating the

WACC and thereby understating the amount of reasonable

compensation.   (Sledge also has errors, discussed infra.)

     Hakala has chosen to use 11.70 percent as the basic debt-

equity ratio.   From this, he derives the equity multiplier of

0.8953 (this is one, divided by 1.117).   It follows that the debt

multiplier should be 1.0 minus 0.8953, or 0.1047, and not the

0.117 that Hakala used.   If we correct this error and the above-

noted error of 15.06 percent rather than 15.03 percent for the

cost of equity capital, then Hakala’s CAPM approach should yield

a 1995 WACC of 14.08, instead of Hakala’s 14.16.   Similar

corrections would apply to the 1996 WACC.   Because a lower WACC

leads to higher reasonable compensation under Hakala’s approach,

these corrections in Hakala’s numbers would result in an increase

in the reasonable compensation numbers that Hakala recommends.
                                - 56 -

     Hakala testified that correcting the WACC “caused the

numbers in both years to go up” and stated in his rebuttal report

that “The calculation of the weights for debt and equity in the

BVS report [Hakala’s expert witness report] was inconsistent with

the assumed weights in the original Exhibit IV-2.”

     However, we are unable to determine exactly what corrections

Hakala made in his WACC calculations that led to the substantial

increases in his recommendations as to reasonable compensation.

As a result, we do not know whether Hakala has already corrected

for the above-noted errors.

     In Sledge’s rebuttal report, he pointed out that the

combined debt and equity multipliers that Hakala used to

determine the cost of debt and the cost of equity exceeded 1.0.

He then proposed debt and equity multipliers that total 1.0, and

he demonstrated the effect of the change by calculating the WACC

for 1995, which he determined was 13.66 percent.       Sledge

presented this as follows:

     3. This is the weighed [sic] average cost of capital, WACC,
     and is calculated as shown below.

         Cost of debt             9.50 x (1 -.38) =      5.89
         This is the cost of
             debt after taxes
         Weighed [sic] cost of debt     5.89 x .1170            =   0.69

    +     Weighed [sic] cost of equity   15.06 x (1/1 +.1170) =

                   or,                   15.06 x .8953          = 13.48

        = WACC                                           14.16 rounded
                                - 57 -

     DR. HAKALA HAS MADE AN ERROR IN THE CALCULATIONS OF WACC

     Refer to Exhibit Rebut-19.1 [an attachment in Sledge’s
     rebuttal report] and you will see the correct formula for
     WACC. While Dr. Hakala has correctly written the formula on
     his p. 20, he does not compute it correctly.

     CORRECT CALCULATIONS FOR WACC.

           Cost of   debt             9.50 x (1 - .38) = 5.89
           This is   the cost of
              debt   after taxes
           Weighed   [sic] cost of debt     5.89 x .0928 =    0.55

       +   Weighed [sic] cost of equity   15.06 x .9072   =   13.66

     = WACC                                                   13.66

     As this excerpt shows, Sledge failed to add together the

weighted cost of debt and the weighted cost of equity in his

calculation.   The corrected WACC, according to the values Sledge

proposed, is 14.21 percent for 1995 and 14.82 percent for 1996,

amounts greater than what Hakala had determined.    Thus, while

Sledge correctly noted one of Hakala’s mathematical errors,

Sledge’s proposed solution leads to (or would have led to, if

Sledge had carried the analysis out) reasonable compensation

conclusions that are less than Hakala’s conclusions.

     As we noted supra, Hakala used 11.70 percent as the debt-

equity ratio in calculating the relative weights to be given to

debt capital and equity capital.     He did not give us any source

for his statement that this is “the relative importance of debt

and equity in the typical firm’s capital structure.”      (Emphasis
                              - 58 -

added.)   However, elsewhere in his report he indicated that 11.70

percent is the average debt-equity ratio of four named firms.

     These four firms had debt-equity ratios ranging from 0.8

percent to 33.6 as of June 30, 1996.   We are not given any

information that would lead us to conclude that the average of

four firms’ widely disparate capital structures happens to be

precisely equal to “the typical firm’s” capital structure.

     All four firms are publicly traded, while petitioner is not.

We do not find any information suggesting that this makes a

difference or does not make a difference in what a reasonable

independent investor would do with a firm like petitioner.

     Hakala told us that “each of the four firms is a large

manufacturer of * * * [mobile] homes with a large retail

organization.”   Petitioner is entirely a retailer.

     Hakala told us that the four firms had sales of $208 million

to $862 million a year for 1995 and 1996, while petitioner’s

sales were only $9-10 million.

     Hakala described the four firms as “billion dollar

companies”, while he regarded petitioner as worth only a few

million dollars.

     Hakala did not present to us any explanation (much less

evidence supporting any explanation) as to whether or not

adjustments should be made to this particular four-firm average

debt-equity ratio to arrive at a typical debt-equity ratio that
                              - 59 -

would be meaningful with regard to firms that are similar to

petitioner.   Because (1) Hakala’s CAPM analysis makes reasonable

compensation vary directly with the debt-equity ratio,18 and (2)

Hakala contends that his CAPM analysis enables him to determine

Jack’s maximum reasonable compensation to the dollar, it becomes

important for us to have confidence in the correctness of

Hakala’s determination of 11.70 percent as the debt-equity ratio

to use.

     Because of the above-noted omissions, we have no idea what

debt-equity ratio is appropriate to use in a CAPM analysis.    This

makes us reluctant to rely on a CAPM analysis based on the record

in the instant case, whether or not CAPM analyses are viewed as

conceptually appropriate for firms such as petitioner.

     Finally, we note that, in his expert witness report,

Hakala’s arithmetic was inconsistent with his narrative

description of the process of moving from WACC to pretax

operating return on net operating assets.   The arithmetic was

consistent with an assumed combined State and Federal tax rate of

about 41 percent, while the narrative states that Hakala used 38

percent.   In his rebuttal report, Sledge pointed out the error


     18
        Under Hakala’s approach, the cost of debt capital is
substantially less than the cost of equity capital. Thus, a
greater debt-equity ratio leads to a lesser weighted average cost
of capital (WACC). This means that under the CAPM, the greater
the debt-equity ratio, the less the net profit that an
independent investor would require, and so the independent
investor could afford to pay more compensation.
                              - 60 -

and stated that “Correction of this error in math will raise the

allowable compensation to Jack Brewer by about $94,000.”   In his

rebuttal report, Hakala appears to have corrected this error19

and has increased his recommended reasonable compensation amounts

by a total of $92,044 for 1995 and 1996.

     We note that Hakala did not make any change to his original

WACC amounts, in correcting his expert witness report, and that

his “bottom-line” determinations changed by almost the same

amount that Sledge stated would be the case if Hakala were to

make the corrections.   Yet, when asked about this matter at

trial, Hakala testified that his error was in the weighting of

the two components of WACC, and not in the assumed tax rate.

     We have described supra some mathematical errors that Hakala

made in his WACC calculations.   Hakala did not correct these

errors.   It appears that if these were corrected, then Hakala’s

“bottom-line” numbers would be greater, but we cannot tell by

what amounts.

     c.   Determination of Compensation Formula

     After Hakala determined a net required rate of return of

16.77 percent, he “conducted an analysis to determine a

compensation formula to arrive at a reasonable range for


     19
        We say “appears to”, because Hakala’s final numbers are
not precisely the same as Sledge’s numbers. We suspect that the
differences are due to rounding at earlier stages of the
computation, but we cannot be sure, because Hakala does not
present a clear explanation of what he did.
                              - 61 -

officer’s compensation such that an arm’s-length investor could

realize market rates of return on invested capital in * * *

[petitioner]”.20

     Hakala calculated the “theoretically appropriate officers’

compensation” by starting with a base salary of $207,000.    He

determined this amount by multiplying by 1.5 the median base

salary shown in a survey for 1994 by Panel Publications of Aspen

Publishing, hereinafter sometimes referred to as Panel/Aspen.

Hakala did not explain why he multiplied the 1994 median base

salary by 1.5, or why he used 1994 as a base year when he

provided the data for 1995 and 1996--but not for 1994--in his

report.   Also, the data Hakala used was from both (1) the

fabricated metal and wood products industry group and (2) the

business services industry group.   We are unclear as to how these

industry groups are similar to petitioner.   Hakala admitted that

the comparability is somewhat limited and “not a very good fit”.

Nevertheless, he claimed that the data “provided information”.21


     20
        This 16.77 percent (18.18 percent in Hakala’s first
expert witness report) is determined as an average of the
information for 1995 and for 1996. Hakala has not explained how
there could be a plausible scenario in which an “arm’s-length
investor” would take into account 1996 information, including
1996 interest rates, in agreeing to compensation payments in
1995.
     21
        Hakala’s justification at trial for use of the
Panel/Aspen data from the “Fabricated Metal and Wood Products
Industry Group” and the “Business Services Industry Group” to
determine a base salary for Jack was as follows:
                                                   (continued...)
                            - 62 -



21
 (...continued)
     [Q. by Calkins, on direct] Now, Dr. Hakala, we’re
going to Exhibit 57-P, which is Ms. Ding’s rebuttal to your
report.

     A   Okay

     Q Ms. Ding assigns a number of errors in her report,
and we’ll briefly go through each of these errors.

        At page 2, error number one, she addresses the use
of the Penell [Panel/Aspen] Publishing Survey, criticizing
the data and the size of the company.

         Could you comment on that?

     A There’s some validity to the limitations on the use
of the Penell, since I used fabricated metal wood products
and business services.

        I did pick the right types of industries, but the
survey is too broad to probably be as applicable as I would
like.
        It’s informative, but it’s certainly not
determinative of my ultimate opinion in the case.

     Q   So, when she says this data is not valid--

     A It’s valid. It’s used all the time in the real
world to sort of condition what you’d make in a small,
closely-held company, but the issue is that you have to sort
of condition the data for what industry and sector you’re
in, and that element of her criticism I think has some
validity, a lot of validity.

                *   *   *     *      *   *   *

     Q [By Mayo, on cross] Okay. The first thing you did
was you went to a survey called Pennell [Panel] Aspen
Publishing Survey.

     A   Yes.

     Q   And that was a survey of compensation of CEO’s.

                                                 (continued...)
                            - 63 -



21
     (...continued)
         A Yes.

     Q And the first industry you looked at was wood
products manufacturing?

        A   Fabricated metal and wood products.

     Q Yeah, fabricated metal, that’s not really very
closely related to Mr. Brewer’s business, though, is it?

     A It’s not a very good fit.       It -- he’s selling
products that might --

     Q Small, low tech components, you know, pegs and
brackets and that kind of stuff.

     A Not always.       Exacto Spring fell in there, but
anyway.

     Q How about Business Services?       What was Business
Services?

     A It’s so broad. It’s also not a very good fit.          I
think some are -- yeah, on page 13, I say thus, the
comparability is somewhat limited.

        Q   Yeah, but that was what you used.

        A   It provided information.

     Q I want to point out to the Court that there are some
weaknesses in this analysis.

        A   I agree.

        Q   You agree that there are some weaknesses?

     A Agree, and it provides some information, but the
analysis is limited.

     Q Right, and there are some weak -- because it’s wood
products and business services, neither one are kind of
directly related to Mr. Brewer?

                                                  (continued...)
                                - 64 -

     To determine the base salary for 1995 and 1996, Hakala

increased the 1994 theoretical base salary of $207,000 by 4

percent per year.     Thus, the base salary for 1995 and 1996 would

have been $215,280 (207,000 x 1.04) and $223,891 (215,280 x

1.04), respectively.     Hakala then determined the bonus amounts

based on a percentage of the operating income before officers’

compensation.     In his expert witness report, Hakala explains as

follows:

     The bonus percentage is solved based on the projected 4% per
     annum rate of growth, the expected operating expenses before
     officers’ compensation in each future year and a required
     average net operating return on operating assets of 18.18%.

     Based on our analysis we calculate that the reasonable
     compensation for Mr. Brewer to achieve a 18.18% investor
     return is $544,419 in 1995 and $448,620 in 1996. This
     corresponds to a bonus of $329,568 in 1995, which would be
     65.8% of theoretical operating income, and a bonus of
     $225,022 in 1996, which would be 31.9% of theoretical
     operating income.

     In his rebuttal report, Hakala noted that his revised

adjusted average required operating return on net operating

assets (16.77 percent, rather than 18.18 percent) resulted in his

increasing the recommended compensation level for each year, as

described supra.     However, he attributed this change entirely to

recalculation of the weights for debt and equity.

     Hakala’s discussion of the Panel/Aspen data described supra

does not seem to affect his conclusions at all, except as to how



     21
          (...continued)
              A. Correct.
                              - 65 -

much of Jack’s maximum reasonable compensation should be labeled

base pay and how much should be labeled bonus.   He apparently

regarded this as so inconsequential that, in his rebuttal report,

he did not bother to correct the bonus components when he revised

the total compensation amounts.   We cannot tell what function

Hakala’s discussion of base pay serves in Hakala’s reaching, or

explaining, his bottom-line conclusions.

     Hakala’s discussions of other comparisons, although

eventually discarded, serve the appropriate function of

demonstrating that those comparisons would have resulted in lower

permissible amounts of reasonable compensation; they thereby make

the CAPM approach appear to be more generous to petitioner than

would be the case if the other methods had not been presented.

     When “push came to shove”, Hakala’s conclusions rested

entirely on CAPM, and respondent followed Hakala’s conclusions to

the dollar.

     (6)   Conclusion

     Hakala has not presented us with a description of how his

various analyses fit together to lead to the final numbers he

reaches.   He has not specified what points in his analyses are

being corrected and how these corrections result in the changed

numbers between his original expert witness report and his

rebuttal report.   As to the many different variables in CAPM,
                               - 66 -

Hakala has not indicated why we should accept his choices in

values rather than other choices, such as Sledge’s.

     Sledge, however, has not shown us how the changes in values

result in his conclusions.   Rather, he simply concludes that

changing one of the variables to a value that is more favorable

to petitioner results in a specified amount of greater maximum

compensation.   Without a thorough explanation or demonstration of

why his changes result in the numbers that he reaches, we do not

accept Sledge’s conclusions.   Further, we cannot tell from the

information included in the expert reports whether a variation in

any particular value is likely to cause a great or only slight

change in the bottom line, and often it is not apparent whether a

change is likely to increase the maximum amount of reasonable

compensation or decrease the maximum amount of reasonable

compensation.

     In fact, Sledge conceded that it would be highly improbable

for all of his suggested revisions to Hakala’s CAPM numbers to be

operable together.   Adoption of some of his suggested revisions

very likely would require that some other suggested revisions

would have to be rejected, or might have to be revised in such a

way as to result in the latter revisions undoing the effect of

the former revisions.

     We also note the paradox in Hakala’s approach that the more

successful Jack was in building up petitioner, the less the
                              - 67 -

amount Hakala would say would be reasonable compensation.    We

find it difficult to justify an analysis that leads to such a

counterintuitive result.

     Under these circumstances, we conclude that (1) Hakala’s

application of CAPM on the record herein presents too many

difficulties to justify using CAPM in the calculation of

reasonable compensation for Jack, and (2) neither Hakala nor

Sledge has explained CAPM sufficiently for us to be able to

determine what would be the bottom-line effect of even correcting

the arithmetic errors we have described, except that we perceive

it is more likely than not that those corrections would produce

reasonable compensation numbers somewhat greater than those that

Hakala recommended.

     However, it appears from respondent’s reactions on brief

that respondent is willing to accept Hakala’s recommendations

even when the amounts exceed what had been determined in the

notice of deficiency.   Accordingly, we conclude:   (1) Based on

the foregoing analysis of Hakala’s independent investor approach

and the correction of Hakala’s arithmetic errors (plus the

allowance for Jack’s loan guaranty), 1995 reasonable compensation

for Jack’s services is $610,000; and (2) based on the foregoing

analysis of the RMA data (plus an amount for nonsalary benefits),

1996 reasonable compensation for Jack’s services is $630,000.
                              - 68 -

     2.   Intent

     Because of the comparatively subjective nature of the

determination of a taxpayer’s intent in making a payment to a

shareholder-employee, courts have generally concentrated on the

reasonableness prong rather than the intent prong in section

162(a)(2) cases.   See, e.g., Elliotts Inc. v. Commissioner, 716

F.2d 1241, 1243 (9th Cir. 1983), revg. T.C. Memo. 1980-282.

However, it is clear that if a payment was not intended to be

compensation for personal services, then it will not be

deductible under section 162(a)(2) even if the payment did not

exceed reasonable compensation.   See King’s Court Mobile Home

Park v. Commissioner, 98 T.C. at 514-515; Paula Construction Co.

v. Commissioner, 58 T.C. at 1057, 1059-1060.

     Having made determinations as to the maximum amounts of

petitioner’s payments to Jack that would be reasonable

compensation for Jack’s services, we now proceed to the second

prong--whether any portions of those reasonable amounts are

nevertheless not deductible by petitioner because they were not

intended as compensation.

     Respondent contends “that part of the payments [to Jack]

deducted by petitioner are disguised dividends.”   In support of

this contention, respondent directs our attention to the

following:   (1) Jack’s testimony that if petitioner had a good

year, then Jack had a good year, (2) the yearend ad hoc
                               - 69 -

determination of Jack’s bonuses and absence of any compensation

plan for Jack are indicia of an intent to distribute earnings

rather than pay compensation for services, and (3) the incentive

to avoid one of the two layers of income taxation of dividends.

     Petitioner contends that the issue is not properly before

the Court in the instant case (see supra note 4), and devotes its

efforts to the reasonable compensation prong.

     We agree with respondent that (1) the issue is properly

before us and (2) the evidence to which respondent draws our

attention points toward an intent to distribute earnings.

     However, in the instant case this agreement with

respondent’s position does not result in any disallowance of

otherwise reasonable compensation.

     In each year before us, substantially all of petitioner’s

payments to Jack were made by way of a bonus at the end of the

year.    There is no testimony or other evidence that indicates

that the participants in the discussions--Jack and Sledge--had

one intention with regard to a portion of each bonus and a

different intention with regard to the remaining portion of each

bonus.    Thus, one might contend that a contaminating intention

should result in disallowance of deductions for the entirety of

each bonus, or alternatively that the contamination was not great

enough to require disallowance of deductions for any part of each

bonus.
                              - 70 -

     Yet, from the notice of deficiency onward respondent clearly

has not taken the all-or-nothing approach.   Rather, even though

respondent seems to regard the intent prong as more important

than the reasonable amount prong, at each stage respondent has

applied the intent argument only to so much of petitioner’s

payments to Jack as exceeds reasonable compensation.22

     On the basis of the record in the instant case, consistent

with the foregoing, we conclude that part of the amounts

petitioner paid to Jack in each of the years in issue was not

intended as compensation.   The part that was not intended as

compensation in each year is the amount by which the payments

exceeded the amounts that we have held to be reasonable

compensation.   See supra table 4.


     22
        For example, in the opening statement at trial,
respondent’s counsel described respondent’s position as follows:

          It is Respondent’s position that in spite of Mr.
     Brewer’s contributions to Petitioner during the years at
     issue, the payments to him over and above what Respondent
     has allowed in the trial memorandum should be disallowed as
     disguised dividends.

     The trial memorandum reference is as follows:

          Respondent’s expert witness opinion (as modified by
     revised Exhibit IV-3 in the rebuttal report) provides for
     reasonable compensation for services rendered to petitioner
     by Mr. Brewer of $599,117.00 for 1995 and $485,966 for 1996.
     Further, the report allows additional compensation of
     $5,000.00 to Mr. Brewer for providing his personal guarantee
     to secure a short-term working capital line of credit in
     1995. It is respondent’s position that the stated amounts
     represent the reasonable compensation to Mr. Brewer and will
     be sustained by the Court as such.
                             - 71 -

     Thus, we hold, for petitioner, that all of the amounts

petitioner paid to Jack that would not exceed reasonable

compensation for Jack’s services were in fact paid as

compensation for Jack’s services.

     To take account of the foregoing,



                                         Decision will be entered

                                    under Rule 155.
