                      T.C. Memo. 2008-217



                     UNITED STATES TAX COURT



      YEAROUT MECHANICAL & ENGINEERING, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8130-01.              Filed September 24, 2008.



     Clinton W. Marrs and Pamela A. Rice, for petitioner.

     Kelly M. Davidson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GALE, Judge: Respondent determined deficiencies in

petitioner's Federal income tax as follows:

          Taxable Year Ended              Deficiency

             Aug. 31, 1996                  $42,836
             Aug. 31, 1997                  129,727
                              - 2 -

By amendment to answer respondent asserted increased deficiencies

of $115,940 for petitioner's taxable year ended (TYE) August 31,

1996, and $177,520 for petitioner's TYE August 31, 1997.   The

issue for decision is what portions of petitioner's claimed

rental expenses, incurred by leasing construction equipment from

its shareholders during the taxable years in issue, are

deductible under section 162(a)(3).1

                        FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.    We

incorporate by this reference the stipulation of facts, the

supplemental stipulation of facts, and the accompanying exhibits.

Introduction

     Petitioner is a mechanical contractor, incorporated in New

Mexico in 1964, and licensed to construct, install, repair, and

maintain plumbing and heating systems and their components.

Petitioner's principal place of business at the time the petition

was filed was in Albuquerque, New Mexico.   Petitioner reports its

income using the percentage completion method of accounting with

a fiscal yearend (FYE) of August 31.   During the taxable years in

issue petitioner's shareholders and officers, as well as their

ownership percentages, were as follows:



     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code of 1986, as amended and in effect for
the taxable years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
                                 - 3 -

                                              1996        1997
         Shareholder            Office      Ownership   Ownership
Robert (Kim) Yearout1     CEO                  48%         51%
Kevin Yearout             President            24          25
Bryan Yearout             Vice president,      12          13
                            secretary,
                            and treasurer
Other family members                           16          11

     1
      Kim Yearout is the father of Kevin and Bryan Yearout.

Petitioner's Business Expansion

     For the first 25 years of its existence petitioner was a

conventional mechanical contractor with annual gross revenues

between $7 and $10 million in the late 1980s and early 1990s.    In

the late 1980s semiconductor manufacturers Intel Corp. (Intel),

Motorola, Inc. (Motorola), Sumitomo Electric Industries, Ltd.

(Sumitomo), and others began building computer chip manufacturing

facilities in Albuquerque triggering an unprecedented

construction boom in that area of New Mexico (Bernalillo County).

Petitioner responded to these developments by attempting to

transform its business to serve the needs of Albuquerque's new

high-tech construction market.

     Petitioner performed its first project at Intel in late 1992

and successfully completed several other, larger projects for

Intel in 1993 and 1994.    By working on these early projects
                                 - 4 -

petitioner began acquiring expertise in "process piping"2 systems

in "clean room"3 environments.    In 1995 petitioner successfully

bid on its first contract for construction of an entire

semiconductor manufacturing facility for Silmax, Inc. (Silmax), a

division of Sumitomo.   As petitioner gained experience with

process piping its gross revenues began to grow reaching $14

million in 1994, over $24 million in 1995 and 1996, and over $31

million in 1997.

     Given the substantial costs the high-tech projects entailed,

petitioner found itself facing competition from national rather

than local contracting firms for this new line of business.     To

compete effectively petitioner had to become responsive to the

unusual demands of its high-tech construction clients.    For

example, because of the complexity of the projects and the tight

construction timetables those clients demanded, petitioner had to

have all of its equipment, personnel, and materials available on




     2
      Process piping describes the specialized plumbing systems
used for semiconductor computer chip manufacturing. These
systems differ from conventional plumbing systems in that the
piping is constructed from stainless steel or passivated copper
and carries either very high purity or dangerous gas or liquid
instead of water.
     3
      Clean rooms are specially designed manufacturing
environments that meet the purity conditions required for
semiconductor chip manufacture. When working within them,
workers must wear protective clothing to avoid contamination of
the worksite. Equipment used within the clean room must be
treated with isopropyl alcohol and covered with special taping so
it leaves no residue.
                               - 5 -

demand in order to ensure timely performance.4   To meet project

deadlines petitioner's personnel often worked more than 5 days

per week, at times working double shifts.

     Petitioner's new high-tech clients' construction needs were

also unpredictable.   Twice one of petitioner's clients suspended

or "mothballed" projects when the client's own financial outlook

turned bleak.   On other occasions projects that had been awarded

to petitioner were canceled by clients who lost financing for the

projects they had planned.   One client found its construction

needs so unpredictable, and its requirements for rapid completion

of an identified need so compelling, that it entered into an

annual "retainer" contract with petitioner under which petitioner

would maintain a construction management team at the client's

disposal and certain equipment on the client's site for rapid

deployment when needed.

     Because petitioner worked primarily on a competitive bid

basis, the nature of its business was such that the company

experienced significant changes in the timing, size, number, and

types of jobs it performed from year to year.    The volatility in



     4
      When construction of one of Intel's facilities was at its
height, semi trucks were backed up on the freeway outside the
Intel site waiting to unload. If a contractor was not at the
dock to unload its materials when the truck arrived, either the
truck went to the back of the line or the contractor had to pay
someone else to unload.
                                - 6 -

petitioner's work backlog was a function of many variables only

some of which petitioner was able to influence or control.

Consequences of Expansion

     Petitioner's early efforts in process piping were

successfully completed but costly.      Lacking experience at working

with the new form of piping in clean rooms, petitioner's

management5 significantly underestimated project costs because

they did not fully appreciate the different job skills and the

specialized equipment required to install process piping

correctly.   As a result petitioner incurred a substantial loss on

the Silmax project and was, uncharacteristically, unable to

complete the project on time.

     Petitioner's expansion into process piping also required

significant capital investment.   To meet its new project

management demands petitioner increased the size of its

administrative staff from 6 employees in the early 1990s to

nearly 20 by the end of August 1997.     Petitioner also expanded

its facilities, both the offices and the prefabrication shop, to

accommodate its new personnel and project work.




     5
      Used interchangeably herein, the terms "petitioner's
management", "petitioner's controlling shareholders", and
"petitioner's officers" all refer to petitioner's principals:
Kim, Kevin, and Bryan Yearout.
                              - 7 -

     Petitioner financed the purchase of most of its new

materials inventory and the new small tools required for work in

clean rooms6 out of working capital or cashflow.    Between

September 1, 1994, and August 31, 1997, petitioner's capital

expenditures from cashflow totaled $1,730,454.     To acquire some

of the specialized and more costly equipment it required (e.g.,

orbital robotic welders, facing tools, and trucks),7 petitioner

relied on bank financing.8

Petitioner's Financial Condition

     By FYE August 31, 1995, petitioner had exhausted its three

lines of credit (totaling $1.6 million).   In late 1995 petitioner

incurred such large losses9 that its surety company demanded that

it reorganize its debt as a condition for maintaining its bonding

capacity, and Dun & Bradstreet downgraded petitioner's credit



     6
      Petitioner had to purchase new small tools because many of
its existing tools were not adaptable for use in clean room
construction environments.
     7
      New trucks were also required in order for petitioner to
haul the supplies and materials inventory that would be taken
into the clean rooms. These trucks had to undergo specialized
cleaning and detailing.
     8
      Petitioner had access to both revolving lines of credit and
term loan facilities that it used in full to finance these
acquisitions.
     9
      Petitioner's losses were due, in large part, to the Silmax
project and to accounting errors that surfaced following the
retirement of the company's longtime chief financial officer.
                                - 8 -

rating from "fair" to "unbalanced".10   Because of concerns about

petitioner's ability to successfully manage the rapid growth it

was experiencing, petitioner was notified by Sunwest, its bank of

long standing, that the bank was no longer willing to extend

petitioner short-term, job-specific lines of credit.

     In 1996 petitioner received notice that its surety was no

longer willing to serve as its bonding agent.11   On learning this

Sunwest sought reassurances from petitioner's management

regarding the steps it was taking to improve its financial

condition; for the first time, Sunwest also required that

petitioner's officers personally guarantee some of the company's

loans.    Throughout 1996 and 1997 petitioner's financing

difficulties continued; petitioner's "cash on hand" balance at

FYE August 31, 1997, was negative $511,375.    Sunwest agreed to

refinance a portion of petitioner's line of credit into long-term

debt;12 but when petitioner twice failed to repay the note when

due, Sunwest severed its relationship with petitioner.


     10
      Before petitioner's business expansion efforts, its credit
rating was "good". As expansion began, spending increased, and
bills were paid less promptly, its credit rating was lowered to
"fair".
     11
      Petitioner was able to find another bonding agent, but
whereas petitioner had previously paid $9 per thousand on a
declining scale for its bonds, it had to pay a flat $25 per
thousand to the new surety in order to secure performance bonds.
     12
      As a condition of refinancing, Sunwest also required that
petitioner secure the bank's approval before acquiring any
additional debt.
                               - 9 -

Satisfying Petitioner's Equipment Needs Through Rental

     Despite its extensive expenditures for materials inventory,

new tools, equipment, and facilities expansion, petitioner had

additional equipment needs arising from its entry into high-tech

construction that could not be met with cashflow or credit.

Petitioner's management decided against entering into long-term

leases or financing acquisition of the equipment for two reasons:

(1) They considered it imprudent to bind petitioner to any new

long-term obligations in view of the risks the company faced with

respect to its business expansion plans; and (2) they believed

petitioner lacked the financial wherewithal to assume additional

long-term debt.   At the same time, however, management knew that

some sort of dedicated access to the necessary equipment would be

required for petitioner's business expansion plan to succeed.

     Some of petitioner's work was done on a guaranteed maximum

price (GMP) basis.   On a GMP project petitioner was paid its

actual costs (on a time-and-materials basis) plus an agreed

markup, not to exceed the maximum price petitioner bid for the

project.   Thus, petitioner bore the full risk of cost overruns on

a GMP project, while the client received the benefit in the event

that a project was completed for less than the bid price.

     When petitioner worked on GMP projects, its clients

permitted a markup of 17.5 percent on rented equipment charges.

Petitioner could also charge for the use of all tools and
                                - 10 -

equipment it owned, but it was not allowed to charge the 17.5-

percent markup that was available for rented equipment.      Thus,

management determined that renting equipment as needed was

petitioner's best option.    However, conditions in Albuquerque's

third-party rental market for construction equipment generally

made renting equipment through this means infeasible for

petitioner.

Third-Party Rental Market Conditions

     The 1990s construction boom in Albuquerque was fueled in

large part by the decisions of major semiconductor chip

manufacturers to build new facilities in Albuquerque, but there

were also major road, military base, and commercial laboratory

construction projects in the area.       As a consequence the demand

for construction equipment exceeded the supply thereof in the

third-party rental market from the early 1990s through the

taxable years in issue.     It was not uncommon, for example, for

companies to rent construction equipment at short-term rental

rates for periods of 10 to 12 months or longer.

     This excess demand drove rental rates up, and equipment was

not reliably available in the third-party rental market,

especially on short notice.    Making availability more precarious,

some rental companies began to exercise their contractual rights

to terminate existing rental agreements when higher rates could

be obtained from another customer.
                                - 11 -

     Under the standard third-party rental agreement used in

Albuquerque, lessees were charged strictly on a "time-out, time-

in" basis.    Consequently, lessees incurred charges both for

actual use of the equipment and for periods when it was in

transit to or between project sites or being prepared for use in

a clean room.    Third-party rental companies typically offered

hourly, daily, weekly, or monthly rates for rental equipment.     In

many cases rates for longer rental periods reflected a discount

from the hourly or daily rates.

     In the third-party rental market premium rates were charged

for "overtime" equipment use that exceeded 8 hours per day, 5

days per week, or 160 hours per month.     Overtime rates were 1.5

times the base rate for double-shift operations, and twice the

base rate for triple-shift operations.    By contrast, rate

concessions were generally not given when equipment was returned

before the rental term expired.

Petitioner's Equipment Rentals From Its Shareholders

     Cognizant of the excess demand for construction equipment in

Albuquerque's third-party rental market, petitioner's controlling

shareholders decided to satisfy petitioner's equipment needs by

acquiring the necessary equipment themselves and renting it to

petitioner.     During the taxable years in issue petitioner leased

or, in two instances, subleased equipment from its shareholders

on primarily an hourly or monthly basis.    The rent was generally
                                - 12 -

paid pursuant to written 5-year agreements originally entered

into on or about the dates indicated for the following equipment:

                         HOURLY RENTALS
                                                           Date
    Lessor       Equipment                 Make/Model     Entered

     Kim       Crane               Grove 22-ton           Apr. 93
               Backhoe #1          John Deere 410C        June 91
               Backhoe #2          John Deere 410C        Apr. 93
               Manlift #1N         Grove SM 2632E         Apr. 94
               Manlift #1          Grove SM 2633E         June 92
               Manlift #2          Grove SM 2632E         July 94
               Manlift #3          Grove 3158E            May 93
               Manlift #4          Grove 3158E            July 93
               Manlift #5          Grove SM 4688          Aug. 92
               Manlift #6          JLG CM2033             Aug. 95
               Manlift #7          JLG CM2033             Aug. 95
               Boomlift #6         Grove MX48B            Aug. 92
     Kevin     Cybermation Machine CFC700A                Dec. 96
     Bryan     Bobcat #943         Melrose 943            May 88
               Bobcat #743         Melrose 743B           Oct. 94

                         MONTHLY RENTALS
                                                           Date
    Lessor       Equipment                 Make/Model     Entered

     Kevin     Brake Press1          LVD 150-ton          Dec. 94
                                       150JS13
               Clean Room            Intel office site2   Sept. 95
     Bryan     Lift #1               Genie 27/48          June 93
               Lift #2               Genie IWP-24         June 93
               Lift #3               Genie IWP-24         Mar. 95
               Forklift              Baraga SS-624        July 95
               Fusion Machine        IR-63 machine/       Apr. 96
                                       converter

                              SUBLEASES
                                                           Date
   SubLessor     Equipment                Make/Model      Entered

     Kevin     LVD Shear             LVD 25/10 HST-C      Feb. 96
     Bryan     QuickPen Computer     CAD hardware/        May 96
                                       software3
                                - 13 -
     1
       While described herein as a single item of equipment, Brake
Press was in fact three separate pieces of equipment used to (1)
roll, (2) seam, and (3) bend duct.
     2
       The record contains a purchase order from Servicor, Inc.,
to construct a portable modular clean room for Kevin Yearout;
other evidence indicates this portable modular clean room was
located at the Intel worksite.
     3
       CAD denotes computer-aided design.

     As noted above, two items of equipment were subleased by

petitioner from its shareholders; i.e., the shareholders leased

the equipment from third parties (with petitioner as a colessee)

and then subleased it to petitioner.     LVD Shear was leased by

petitioner and Kevin Yearout from Commercial Equipment Leasing

Services, Inc., for 4 years, commencing February 27, 1996, at a

rate of $1,050 per month with an option to purchase for $1 at the

expiration of the lease term.    Kevin Yearout subleased LVD Shear

to petitioner, commencing February 27, 1996, at a rate of $1,600

per month.   QuickPen Computer was leased by petitioner and Bryan

Yearout from LINC Anthem Corp. for 5 years, commencing May 30,

1996, at a rate of $2,340 per month with an option to purchase

for $1 at the end of the lease term.13    Bryan Yearout subleased


     13
      On brief, respondent contends that Bryan Yearout subleased
both QuickPen Computer and Fusion Machine to petitioner. In
support thereof, respondent points out that the equipment
description on the LINC Anthem master lease agreement indicates
Bryan Yearout was leasing QuickPen Computer and IR-63 Fusion
Machine. The total equipment cost, however, is listed as
$106,000, which other evidence in the record indicates is the
cost of QuickPen Computer alone. According to respondent's
expert's report, the Fusion Machine at issue was purchased on
April 12, 1996, from Plastic Services Southwest, Inc., for
$27,062.68, and was simultaneously rented to petitioner at a
                                                   (continued...)
                                - 14 -

QuickPen Computer to petitioner, commencing July 1, 1996, at an

initial rate of $2,715 per month.    See infra p. 18.   As the

foregoing table indicates, the contract date for each piece of

equipment varied, ranging from May 1988 for Bobcat #943 to

December 1996 for Cybermation Machine.   Most of the contracts in

issue, however, were entered between 1992 and 1994.14

     Petitioner's contractual rights and obligations with respect

to the use of this equipment were memorialized by written

agreements in the case of shareholders Kim and Kevin Yearout.

Except for Bobcat #943 and QuickPen Computer, there were no

written agreements covering petitioner's rentals from shareholder

Bryan Yearout; i.e., Bobcat #743, Lift #1, Lift #2, Lift #3,

Forklift, and Fusion Machine.

     The written rental agreements between petitioner and its

shareholders were drafted by Kevin Yearout, a nonlawyer, without

legal assistance.   Most of the written agreements had similar

terms, to wit:



     13
      (...continued)
monthly rate of $1,900 by Bryan Yearout. On the record before
us, we conclude that the equipment description on the LINC Anthem
master lease agreement is incorrect; the lease covered QuickPen
Computer only.
     14
      The leases for Backhoe #1, Backhoe #2, Manlift #1, Manlift
#3, Manlift #4, and Cybermation Machine were renewals of prior
rental agreements between petitioner and the respective
shareholder lessor. As illustrated in app. A, these six items of
equipment were placed in service either 5 or 10 years before the
effective dates of the leases in issue.
                              - 15 -

     (A) The contract term was 5 years;15

     (B) the rent was generally set at hourly rates;16

     (C) petitioner had exclusive use of the equipment throughout
         the term but was generally obligated to pay only for
         "actual usage";17

     (D) at the end of the term the equipment reverted to the
         shareholder lessor;



     15
      Some of the lease agreements expired before or during the
years in issue. The contracting parties' course of dealing, as
illustrated in petitioner's annual payment schedules by item of
equipment, indicates that these agreements remained in effect as
between petitioner and the shareholder lessor despite expiration
of the written lease agreement.
     16
      As discussed infra, two of the written agreements (for
Brake Press and Clean Room) set monthly rates, and the written
agreement covering Cybermation Machine set a monthly rate plus an
additional amount per hour of use. For five other items of
equipment (Lift #1, Lift #2, Lift #3, Forklift, and Fusion
Machine) there were no written agreements, but rents were paid on
a monthly basis.
     17
      Of the 15 items of equipment petitioner rented at hourly
rates, 14 had written agreements with "actual usage" provisions.
For the one hourly rental without a written agreement (Bobcat
#743), petitioner's annual payment records show that petitioner
paid for less than full-time use of the equipment, indicating
that petitioner was not charged for periods when the equipment
was idle. Of the remaining nine items of equipment rented at
monthly rates, four had written agreements (Brake Press, Clean
Room, LVD Shear and QuickPen Computer) that did not contain
"actual usage" provisions; and petitioner's annual payment
records show, and its shareholders admit, that petitioner paid
for essentially full-time use of this equipment. As noted, five
items of equipment were rented on a monthly basis without a
written agreement (Lift #1, Lift #2, Lift #3, Forklift, and
Fusion Machine). Petitioner's annual payment records show that
petitioner paid for less than full-time use in certain years for
two of these items (Lift #1 and Lift #2) and paid for full-time
use of the rest.
                              - 16 -

     (E) petitioner was liable for "normal" maintenance while the
         shareholder lessor was liable for "extraordinary"
         maintenance;

     (F) the rental rate was renegotiable annually.

The 5-year lease term was designed to ensure petitioner's

unrestricted access to the equipment without regard to the claims

of creditors or the shareholder lessors' former spouses.

     Brake Press, Clean Room, LVD Shear, and QuickPen Computer

were leased or subleased under written agreements at monthly,

rather than hourly, rates that were renegotiable annually on the

lease anniversary date.   Cybermation Machine was leased under a

written agreement for a flat fee of $200 per month plus $100 per

hour of actual use.

     As noted, the record contains no evidence of a written

agreement with respect to six items of equipment (Bobcat #743,

Lift #1, Lift #2, Lift #3, Forklift, and Fusion Machine) leased

to petitioner by Bryan Yearout.   However, petitioner's records of

payment indicate that all six were rented at monthly rates except

Bobcat #743, which was rented at an hourly rate.   Petitioner's

annual payment schedules by item of equipment indicate that

petitioner paid rent for less than full-time use in certain years

for three of these items of equipment (Lift #1, Lift #2, and

Bobcat #743).   See app. A.

     Petitioner and its shareholders generally established rental

rates on the basis of their industry expertise, their prior
                                - 17 -

experience with third-party rental companies, and investigation

into current rates being charged for comparable equipment by

third-party rental companies in the Albuquerque area.    Appendix B

summarizes prevailing third-party rental rates18 in Albuquerque

for listed equipment during the taxable years in issue as well as

petitioner's contract rates with its shareholders.    Appendix A

contains a summary of the rents petitioner accrued and paid to

its shareholders by item of equipment and by calendar year.

     In general the rental amounts billed to and paid by

petitioner during the taxable years in issue were consistent with

its written contract rates.19   The contract rate for Brake Press

was $3,900 per month, but petitioner was actually billed and paid

$3,686 per month.    Petitioner's initial Clean Room lease was

replaced with a new agreement at a higher rental rate, but the

parties' course of dealing indicates that the higher rate was

never implemented.


     18
      These rates are based upon the reports of each party's
expert. Petitioner also offered the testimony of a former
operator of an equipment rental business in Albuquerque during
the years in issue. However, the figures provided by that
witness, on the basis of his recollections, depart from those
provided by both experts. We consequently find the experts'
figures more reliable and accept them.
     19
      The billing schedules reveal that there were occasional de
minimis deviations from the written lease agreements with respect
to rents paid. For example, on one day during the taxable years
in issue Manlift #1 was rented for $105 per day rather than the
stated contract price of $6.25 per hour. The same occurred for
Manlift #2. Manlifts #1N and #7 were intermittently billed at
$6.50 rather than $6.25 per hour.
                             - 18 -

     The record reflects no other written contract modifications.

However, uncontroverted testimony and the parties' course of

dealing, as illustrated in petitioner's annual payment schedules

by item of equipment, reveal that the parties agreed to

modifications to some of petitioner's contracts.    From July

through September 1996, and again from November 1996 through

January 1997, owing to the demands of petitioner's project load

during that time, the parties agreed to double payments for the

three lifts petitioner leased from Bryan Yearout.    During roughly

the same time period the parties also agreed to add a temporary

$25-per-hour usage rate to the monthly $2,100 rate for Forklift.

     As petitioner's workload increased and petitioner's

management anticipated that the manlifts and Boomlift #6 would be

used on double shifts or 6 to 7 days a week, the contracting

parties agreed to switch from hourly to flat monthly rates equal

to the original hourly rate times 160 hours.   With minor

exceptions petitioner was billed at the monthly rate unless the

hourly rate produced a lower charge for that month.    Finally,

while the written lease rate for QuickPen Computer was $2,715 per

month, the amount petitioner paid increased to $2,851.20 per

month in August 1996, then to $3,421.80 per month in December

1996.

     As a result of the "actual usage" term in most of the

written rental agreements, petitioner generally incurred a rent
                              - 19 -

obligation to its shareholders only when the equipment was

actually used.   Petitioner incurred no rental expense when

equipment rented on an hourly basis sat idle because of

fluctuations in workloads due to its high-tech clients'

unanticipated changes in construction needs, petitioner's lack of

success in penetrating the high-tech construction market, or

other unforeseen circumstances.   As noted, the payment records

for the equipment petitioner leased from shareholder Bryan

Yearout without a written agreement also reflect that petitioner

paid rent for less than full-time use for some of this equipment.

     Petitioner's clients had knowledgeable purchasing agents who

reviewed petitioner's itemized billings and would have returned

bills to petitioner for adjustment if petitioner's billings for

equipment rental expense were not in line with the prevailing

market rates.

     Decisions about whether, or to what extent, any piece of

shareholder-owned equipment would be used on a particular project

were made by the project foremen without input from the

shareholders.

     During the taxable years in issue either petitioner's

employees or third parties at petitioner's direction and expense

performed maintenance on 5 of the 24 items of equipment leased
                               - 20 -

from its shareholders.20   Petitioner kept a detailed maintenance

log for each item of equipment.   Those logs indicate that the

types of maintenance performed included replacing seats, changing

filters, servicing engines, adding fluids, replacing switches,

checking tire condition and pressure, reworking harnesses, and

rebuilding cylinders.21

Respondent's Position

     Respondent determined in a notice of deficiency that

petitioner's claimed deductions for the rental of property from

its shareholders were excessive, and therefore not ordinary and

necessary expenses deductible for Federal income tax purposes, to

the extent of $125,988 and $381,551 for petitioner's TYE August

31, 1996 and 1997, respectively. This position resulted in

deficiencies of $42,836 and $129,727 for 1996 and 1997,

respectively.   Respondent's determinations were based upon the

report of an Internal Revenue Service valuation engineer

(valuation engineer), who concluded that the fair market rent was

an amount that would produce a 30-percent return on equity for

the equipment petitioner leased from shareholders Kim and Bryan



     20
      The items maintained by petitioner were Backhoe #1,
Backhoe #2, Manlift #4, Bobcat #943, and Forklift.
     21
      Nothing in the record establishes which, if any, of these
maintenance tasks were extraordinary rather than routine. We
note, however, that the maintenance logs indicate that servicing
done by petitioner's employees never took longer than a day to
complete.
                               - 21 -

Yearout and a 35-percent return on equity for the equipment it

leased from shareholder Kevin Yearout.    The rate of return

differential was appropriate, according to the valuation

engineer, because the items Kevin Yearout leased to petitioner

were "sophisticated high-tech equipment" that, unlike general

construction equipment, was not generally available in the third-

party rental market and carried a greater risk of obsolescence.

     By amendment to answer respondent asserted that petitioner's

claimed deductions were overstated by $340,998 and $522,119 for

1996 and 1997, respectively; i.e., the amounts by which the

claimed deductions exceeded what respondent's expert witness

contends was the "fair market value of petitioner's five year

leasehold interest in construction equipment leased from its

shareholders".    The position taken by respondent in the amended

answer resulted in increased deficiencies of $115,940 and

$177,520, respectively, for 1996 and 1997.

Burden of Proof

     During pretrial proceedings respondent informally sought

information concerning petitioner's operations, the lease

agreements with its shareholders, and its rental expenditures by

item of equipment.    When repeated informal requests proved

fruitless, respondent sought Court enforcement of his formal

discovery requests, which was granted.    Petitioner thereupon

provided satisfactory responses.
                                - 22 -

                                OPINION

I.   Burden of Proof

     Respondent concedes that under Rule 142(a)(1) he bears the

burden of proof with respect to the increased deficiencies

asserted in his amendment to answer.      With respect to the

original deficiencies, petitioner contends that the burden of

proof with respect to the factual issues thereunder has shifted

to respondent pursuant to section 7491(a) because it has

introduced credible evidence bearing on those issues.      We

disagree.

     To be eligible for the burden-shifting benefits set forth in

section 7491(a)(1) a taxpayer must satisfy the substantiation,

cooperation, and net worth prerequisites of section 7491(a)(2).

Allnutt v. Commissioner, T.C. Memo. 2004-239; Oatman v.

Commissioner, T.C. Memo. 2004-236; H. Conf. Rept. 105-599, at 239

(1998), 1998-3 C.B. 747, 993.    The parties agree that petitioner

satisfies the net worth prerequisite, and on the basis of the

record we conclude that the rental expense deductions at issue

have been substantiated.

     The cooperation prerequisite requires that the taxpayer have

"cooperated with reasonable requests by the Secretary for

witnesses, information, documents, meetings, and interviews".

Sec. 7491(a)(2)(B).    Petitioner contends that it cooperated

because it did so during respondent's examination for the taxable
                                - 23 -

years at issue.   However, the requirement of cooperation extends

through pretrial proceedings.    See, e.g., Connors v.

Commissioner, 277 Fed. Appx. 122 (2d Cir. 2008), affg. T.C. Memo.

2006-239; Krohn v. Commissioner, T.C. Memo. 2005-145; Lopez v.

Commissioner, T.C. Memo. 2003-142, affd. on this issue 116 Fed.

Appx. 546 (5th Cir. 2004).

     Petitioner argues that it was unable to provide the

information and documents requested during pretrial proceedings

because it did not maintain its records in the format respondent

requested; i.e., by item of equipment.   Petitioner has at no

point asserted that the material sought was confidential or

proprietary business information, see Kohler v. Commissioner,

T.C. Memo. 2006-152, and we are unpersuaded by the justification

asserted.   The material petitioner resisted producing was

necessary to substantiate its claimed rental expense deductions.

See sec. 6001; sec. 1.6001-1(a), Proced. & Admin. Regs.

Petitioner's failure to comply with informal and formal discovery

covering reasonable requests for information and documents,

resulting in Court-enforced discovery, precludes a finding that

it cooperated for purposes of section 7491(a)(2)(B).     See AMC

Trust v. Commissioner, T.C. Memo. 2005-180; Rinn v. Commissioner,

T.C. Memo. 2004-246.   Accordingly, the burden of proof does not

shift to respondent with respect to the factual issues relevant

to the originally determined deficiencies.
                              - 24 -

II.   Petitioner's Rent Deductions for Shareholder-Owned Equipment

      Deductions are a matter of legislative grace.   INDOPCO, Inc.

v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934).   Therefore, petitioner bears

the burden of proving that it is entitled to the deductions

claimed and of substantiating the amount and purpose of those

deductions.   Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975),

affd. per curiam 540 F.2d 821 (5th Cir. 1976).

      Section 162 permits a taxpayer to deduct all ordinary and

necessary expenses paid during the taxable year in carrying on

its trade or business, including "rentals or other payments

required to be made as a condition to the continued use or

possession" of property.   Sec. 162(a)(3).   In determining whether

the payments in issue are deductible under section 162, the basic

question is whether the payments were in fact rent and not

something else disguised as rent.   See Place v. Commissioner, 17

T.C. 199, 203 (1951), affd. per curiam 199 F.2d 373 (6th Cir.

1952); accord Levenson & Klein, Inc. v. Commissioner, 67 T.C.

694, 715 (1977).   This is a question of fact, and the character

of the payments in question is to be judged in view of (1) all

the terms and conditions of the agreement establishing the

obligation to pay, and (2) all the facts and circumstances

existing at the time the agreement was made.   See Audano v.

United States, 428 F.2d 251, 256 (5th Cir. 1970); Brown Printing
                                - 25 -

Co. v. Commissioner, 255 F.2d 436, 440 (5th Cir. 1958), revg.

T.C. Memo. 1957-37.    When, as here, the lessor and lessee are

related, an inquiry into what constitutes "reasonable" rent

becomes necessary to determine whether the amount paid is greater

than the lessee would have paid had he dealt with a stranger at

arm's length.     Brown Printing Co. v. Commissioner, supra at 438;

Place v. Commissioner, supra at 203.

     A.   Business Reasons for Petitioner's Equipment Rentals From
          Its Shareholders

     In the early 1990s petitioner faced a substantial new

business opportunity in the form of expansion into the field of

high-tech construction brought on by the influx of high-tech

manufacturers in the Albuquerque area.    To avail itself of that

opportunity, however, required substantial expenditures.

Petitioner made those expenditures--for additional staff, larger

offices, an expanded prefabrication shop, new small tools,

materials inventory, new trucks, and specialized equipment--

largely out of working capital and its lines of credit (up to

capacity) with its bank.    Nonetheless petitioner still had

substantial construction equipment needs to satisfy in order to

be competitively positioned to enter the high-tech construction

market.

     Given certain features of that market in the Albuquerque

area at the time, petitioner's equipment needs were to some

extent unusual.    Critical features of the construction of high-
                              - 26 -

tech manufacturing facilities were extraordinary pressure from

clients to get projects completed and "on line" quickly because

of the competitive pressures the clients faced to bring new

products to market expeditiously, and volatility in the clients'

construction needs.   In addition, because the equipment was to be

used in clean room environments, it had to be specially prepared

and maintained for this purpose.   Thus, given the time

constraints and special conditions for its use, petitioner

essentially needed guaranteed, exclusive access to the equipment

used for high-tech construction projects to meet the demands of

its clients.

     The conventional means for petitioner to obtain equipment

were purchase, long-term lease, or short-term rental.     Because

petitioner consumed its cashflow and working capital acquiring

materials, tools, trucks, certain equipment, working space, and

staff, purchasing the remaining necessary equipment would have

required petitioner to assume additional indebtedness.     To the

extent petitioner had any remaining borrowing capacity,

petitioner's management did not consider it prudent to incur

additional debt given the uncertainty of whether petitioner would

succeed in its new line of business.   For the same reasons

petitioner's management did not believe long-term leases were
                               - 27 -

feasible.22   With respect to both additional debt and long-term

leases, petitioner's management was reluctant to encumber

petitioner with substantial long-term obligations in connection

with "tooling up" for the high-tech market as petitioner's

eventual success in that market was uncertain.

     Short-term rentals of equipment from third-party rental

companies on an "as needed" basis so that petitioner could

perform under the construction contracts it obtained also

presented substantial drawbacks.   The short-term rental market

for general construction equipment in the Albuquerque area was

overheated in the early 1990s as a result of the influx of high-

tech construction and other projects; shortages were prevalent,

equipment could not be obtained on short notice, and lessors were

increasingly exercising early termination rights and reclaiming

equipment when higher rents could be secured elsewhere.

Moreover, equipment obtained on a "spot" basis through short-term

rentals required extensive preparation for clean room use.    Thus,

short-term rentals did not present a reliable or especially


     22
      According to expert testimony in the record, a long-term
capital lease is often referred to as a conditional sales
contract because the lease payments create the same kind of
obligation as interest payments on debt. A capital lease is
usually classified as a purchase by the lessee because it is
essentially a bank loan with a buyout at the end; i.e., the
lessee makes an agreed number of fixed, monthly payments over the
contract period and then acquires the asset for a nominal amount
at the conclusion of the lease term. Consequently, long-term
leases would impair petitioner's financial condition in the same
manner as purchases made with borrowed funds.
                               - 28 -

feasible means of meeting petitioner's equipment needs for

entering the high-tech construction market, in management's view.

Yet management also recognized that if a reliable supply of

rental equipment were available, the somewhat greater expense

associated with short-term rental rates versus long-term lease

rates would be mitigated by the fact that petitioner's contracts

with its high-tech construction clients entitled petitioner to

bill those clients for equipment rental at cost plus a 17.5-

percent markup.

       Against this backdrop, petitioner's management concluded

that petitioner's general construction equipment needs for the

high-tech market expansion could best be met if its shareholders

acquired the equipment and leased it to petitioner under lease or

rental agreements23 specially tailored to petitioner's

circumstances.    Specifically, the agreements had 5-year terms to

guarantee petitioner's exclusive access to the equipment and to

protect petitioner's access as against the claims of the

shareholders' former spouses or creditors.    However, petitioner

was generally obligated to pay its shareholders only for actual

use.    That is, under the "actual usage" terms employed in

petitioner's hourly rate agreements, petitioner incurred rent


       23
      Our use of the term "lease agreement" or "rental
agreement" is not intended to confirm or rebut respondent's
contention that petitioner held a "5-year leasehold interest"
pursuant to the contracts covering petitioner's compensation of
its shareholders for the use of equipment they owned.
                              - 29 -

obligations based on the number of hours the equipment was

actually in use at a job site.24   With respect to the items of

equipment rented at a monthly rate, petitioner's payments were

equal to the cost of full-time use for the equipment subject to a

written agreement (Brake Press, Clean Room, LVD Shear, and

QuickPen Computer).   However, with respect to the five items of

equipment rented at monthly rates without a written agreement,

petitioner's actual payments for two items (Lift #1 and Lift #2)

were less than the cost of full-time monthly use, indicating that

petitioner did not pay for periods when the equipment was idle.

     As a consequence, petitioner generally incurred no

obligation for rent for periods when the equipment was idle or in

transit, although under petitioner's exclusive control.   Thus,

the rental agreements between petitioner and its controlling

shareholders were hybrid arrangements, containing both features

of long-term (5-year) leases such as the "exclusive use" feature,

and features of short-term rental agreements such as the "actual

usage" provision that generally protected petitioner from the

long-term obligations of such a lease.25   In this way, most of


     24
      One item of equipment rented on an hourly basis, Bobcat
#743, did not have a written agreement covering the rental terms.
However, the payment schedule demonstrates that petitioner paid
for less than full-time hourly use, indicating that petitioner
did not pay for periods when the equipment was idle.
     25
      Two of the twenty-four items of equipment for which the
rent payments are at issue involved arrangements where petitioner
                                                   (continued...)
                               - 30 -

petitioner's agreements more closely resembled the obligation

that petitioner would have incurred under short-term rental

contracts in the third-party rental market.

     The rental payments at issue, although claimed as deductions

for petitioner's TYE August 31, 1996 and 1997, were made pursuant

to agreements that, for 19 of the 24 items of equipment, were

entered into before the taxable years in issue; i.e., between

1991 and the first 8 months of 1995.    This period encompassed

petitioner's initial efforts to penetrate the high-tech

construction market and the onset of petitioner's financial

difficulties.   The remaining five contracts were entered into or

renewed during petitioner's 1996 taxable year, when its financial

difficulties from its rapid growth and the Silmax contract were

acute.

     We are satisfied that petitioner had valid business reasons

for these arrangements.   Petitioner's management determined that

additional long-term debt or comparable commitments under long-

term leases were imprudent for purposes of entering an untested

line of business.26   Petitioner's management likewise considered


     25
      (...continued)
and a shareholder initially coleased equipment and the
shareholder then subleased the equipment to petitioner at a
premium. Those arrangements are discussed infra pp. 46-53.
     26
      Petitioner's management's conservatism regarding longer
term commitments in the early 1990s proved well founded, as
petitioner encountered financial difficulties attributable in
                                                   (continued...)
                              - 31 -

short-term rentals infeasible because of the shortages and other

uncertainties that had arisen as a result of an overheated short-

term general construction equipment rental market.   The solution

was hybrid agreements that guaranteed petitioner access to

equipment it would need if it were successful in obtaining high-

tech projects without the financial burdens of carrying the cost

of acquired or long-term leased equipment in the event its

contemplated work did not materialize or could not be performed

profitably.   The financial risk of owning equipment that was not

deployed on projects was borne by petitioner's shareholders

rather than petitioner, a reallocation of the financial risk

underlying petitioner's capital needs that is not entirely unlike

the transfer of risk to a shareholder who provides a guaranty for

his corporation's debt.   Accordingly, if the payments petitioner

made under its hybrid agreements were reasonable, they constitute

deductible rent.   See Roman Systems, Ltd. v. Commissioner, T.C.

Memo. 1981-273.




     26
      (...continued)
significant degree to its miscalculations under one of its first
large high-tech construction projects, Silmax. By 1995 the
financial difficulties associated with expansion and the Silmax
project culminated in petitioner's credit rating being
significantly downgraded, its longtime banker severing its
relationship with petitioner, and its surety refusing to write
any further performance bonds for petitioner. Had petitioner
incurred indebtedness or assumed long-term leases to obtain the
equipment at issue, its precarious financial condition would no
doubt have arisen earlier and been significantly worse.
                              - 32 -

     B.   Were Petitioner's Rental Payments "Required"?

     Having concluded petitioner had valid business reasons for

renting at short-term rates rather than purchasing or entering

long-term leases for the construction equipment it needed, we

must now decide whether the rental payments petitioner made were

"required" within the meaning of section 162(a)(3).   Since the

rental agreements at issue were between related parties, we must

determine whether, in view of the agreements' terms and the facts

and circumstances existing at the time the agreements were made,

the amounts paid as rent were reasonable; i.e., not more than

petitioner would have been required to pay as the result of an

arm's-length bargain.   Brown Printing Co. v. Commissioner, 255

F.2d at 438, 440; Place v. Commissioner, 17 T.C. at 203.

     Respondent, emphasizing the 5-year terms of the agreements,

contends that petitioner had a "5-year leasehold interest" in

each item of equipment and that arm's-length payments for that

interest would equal the approximate fair market value of

payments under a 5-year bank loan, capital lease, or true lease27

for the acquisition or use of the equipment.   Moreover,

respondent contends, rentals of general construction equipment


     27
      A capital lease is, in a economic sense, an agreement to
purchase over time whereby the lessee, after making "lease"
payments over a stated period, becomes entitled to acquire the
asset from the lessor at a nominal cost. See supra note 22.
Under a true lease, also known as an operating lease, the lessee
pays to use the asset during the lease term but has no option to
purchase at the term's expiration.
                               - 33 -

are not available in the third-party rental market for 5-year

terms; the longest rate term generally available is monthly or

quarterly.    Expert testimony in the record corroborates this

point.    Thus, respondent concludes, amounts petitioner paid as

rent that exceeded the fair market value of a 5-year leasehold

interest in the equipment do not represent an arm's-length price

for the use of the equipment, are excessive, and are accordingly

not deductible under section 162(a)(3).28

     Petitioner argues that the "actual usage" term of its

agreements resulted in the agreements' more closely resembling

"at will" or short-term rental agreements.    The "actual usage"

feature was a material term of most of its contracts, petitioner

argues, made necessary by petitioner's particular needs and

risks.    Thus, in petitioner's view, the rental payments that it

made to its shareholders, which were based on hourly or monthly

short-term rates, were required to secure the equipment on the

terms petitioner needed and are therefore fully deductible.



     28
      Respondent also argues that petitioner's rental deductions
are excessive because its employees performed "extensive
maintenance and rebuilding" on the leased equipment. As noted
supra note 21, the record establishes that none of the
maintenance performed on the rented equipment took more than a
day to complete. In any event, in view of the limited amount of
maintenance performed during the taxable years in issue as
compared to the number of items of equipment rented and the
significant number of hours the rented equipment was used by
petitioner, we find that any maintenance expense petitioner
incurred that was the contractual responsibility of the
shareholder lessors was de minimis.
                               - 34 -

Expert testimony, as summarized in appendix B, confirms that the

hourly and monthly rates petitioner paid to its shareholders were

generally consistent with or below rates in the short-term rental

market in the Albuquerque area at the time.

     After a careful review of the expert testimony and the other

evidence in the record, including the particulars of the rental

agreements and petitioner's course of dealing thereunder with its

shareholders, we agree with petitioner.

          1.   Increased Deficiencies Asserted in the Answer

     We note as a threshold matter that while respondent's

contention that petitioner had a 5-year leasehold interest in the

rented equipment has some support in the case of the equipment

that was subject to written leases with 5-year terms, the same

cannot be said for the six items of equipment for which there

were no written leases; namely Bobcat #743, Lift #1, Lift #2,

Lift #3, Forklift, and Fusion Machine.    For this equipment, where

there was merely a course of dealing between petitioner and its

shareholders reflecting rental payments at hourly or monthly

rates, respondent's claim that petitioner had a 5-year leasehold

interest is tenuous at best.

     With respect to the equipment subject to written leases, a

principal defect in respondent's contention that the arm's-length

rate for petitioner's rent was equal to the cost of a 5-year

leasehold interest is the premise that petitioner in fact could
                              - 35 -

have obtained the equipment pursuant to long-term leases.

Petitioner has adduced persuasive evidence that it lacked

financial wherewithal or creditworthiness to do so during the

relevant period.   Petitioner had already employed bank financing

for other equipment and consumed cashflow and working capital

addressing other capital needs.   During the period when the

rental agreements at issue were entered into, petitioner's

financial condition evolved from a situation (in the early 1990s)

where its management considered additional debt or long-term

lease commitments for this equipment to be merely imprudent,

given petitioner's inexperience in high-tech construction, to a

situation where petitioner's inability to borrow or obtain long-

term leases was obvious--that is, by early 1996 when its long-

time banker and surety both abandoned petitioner as a client.     In

sum, petitioner's financial condition precluded its obtaining 5-

year leases for the equipment at issue.

     Respondent suggests on brief that this problem could have

been remedied by the shareholders' giving their personal

guaranties for petitioner's indebtedness or long-term leases used

to secure the equipment.   But such arrangements would not have

been arm's length unless the shareholders were compensated for

this assumption of risk.   Here, instead of providing personal

guaranties to enable petitioner to acquire equipment,

petitioner's shareholders acquired the equipment themselves and
                              - 36 -

leased it to petitioner.   In our view, arm's-length rental rates

in these circumstances would be set at some level above what

would be paid for a 5-year leasehold interest in order to

compensate the shareholders for the risk they assumed in the

transaction; petitioner was entering an untested line of business

and, as a practical matter, the rent might not be paid.   See

Roman Systems, Ltd. v. Commissioner, T.C. Memo. 1981-273.

     Because we are not persuaded that petitioner could have

obtained the equipment at issue for payments approximating the

cost of 5-year leasehold interests, respondent has failed to meet

his burden of proof with respect to the increased deficiencies

asserted in the amendment to answer.   Consequently, those

increased deficiencies are not sustained.

          2.   Original Deficiency Determination

     The notice of deficiency determined that petitioner's

maximum allowable rent deduction was an amount that would provide

shareholders Kim and Bryan Yearout a 30-percent rate of return on

equity, and shareholder Kevin Yearout a 35-percent return, on the

items of equipment each leased to petitioner.   The valuation

engineer reached this conclusion in part by analyzing what

petitioner would have paid if it had rented the equipment from a

third-party rental company at monthly, rather than daily or

hourly, rates and in part by assuming that returns on equity of

30 to 35 percent were reasonable expectations in the Albuquerque
                               - 37 -

market.   Respondent did not support or defend this methodology at

trial or on brief, devoting his arguments instead to the "5-year

leasehold interest" methodology advanced by his expert and used

to compute the increased deficiencies asserted in the amendment

to answer.   We accordingly conclude that respondent has abandoned

the methodology and analysis underlying the notice of deficiency.

Consequently, we must decide whether the original deficiency

determinations can be sustained on the "5-year leasehold

interest" methodology advanced by respondent and his expert at

trial.

                a.   Equipment Leased at Monthly Rates

     With respect to the seven rental agreements under which

petitioner paid a monthly rate,29 appendix B lists petitioner's

rental rates and the prevailing rates in the third-party rental

market for similar equipment according to the expert witnesses.

The report and testimony of respondent's own expert establish

that the monthly rates petitioner paid for Lift #1, Lift #2, Lift

#3, and Forklift were less than the rates being charged for those

items of equipment by third-party rental companies.

     Respondent's expert failed to provide an estimate of fair

market rental value for Brake Press, Clean Room, and Fusion


     29
       The items rented at monthly rates were Brake Press, Clean
Room, Lift #1, Lift #2, Lift #3, Forklift, and Fusion Machine.
The subleased items of equipment that were rented at monthly
rates, LVD Shear and QuickPen Computer, are discussed infra pp.
46-53.
                               - 38 -

Machine.   Petitioner relies on the rates estimated by its expert

to illustrate that the rates it paid for these items of equipment

were either comparable to or below the rates available in the

third-party rental market.30   Consistent with the aforementioned

findings of respondent's expert, petitioner's expert's estimates

of the monthly third-party rental rates for this equipment were

higher than those petitioner was charged by its shareholders; in

the case of Brake Press, substantially more.   The 5-year terms of

the monthly rate agreements negotiated at arm's length might be

expected to exert some downward pressure on the amount a lessor

would charge; the fact that petitioner's shareholders generally

charged it less than prevailing third-party rental rates for

month-to-month arrangements indicates that the 5-year term did,

in fact, affect rates in the direction of an arm's-length rate.

     In addition, with respect to certain monthly rental

arrangements that did not have written agreements, petitioner's

annual payment schedules by item of equipment demonstrate that

petitioner paid for less than full-time use of Lift #1, Lift #2,



     30
      Petitioner's expert surveyed local and national third-
party rental companies to determine average monthly rental rates
for widely available construction equipment. For items of
equipment not generally available from third-party companies,
petitioner's expert contacted other local users of similar
equipment to determine average rental rates. In all instances,
the rates relied upon were for equipment that was similar, if not
identical, to petitioner's; i.e., in job-ready condition and
meeting all code and safety requirements. We find the
methodology employed by petitioner's expert to be sound.
                               - 39 -

and Forklift during some years.   We conclude that, in practice,

petitioner paid only for actual use of this equipment in a manner

similar to the arrangements under the written agreements covering

hourly rentals of equipment.   See app. A.    Since "actual usage"

terms were in practice applied in these monthly agreements, the

shareholder lessors were subjected to another element of risk for

which they were entitled to be compensated.    Rental rates that

were closer to short- rather than long-term rates did so.

     Given that (1) petitioner has shown that it was infeasible

for petitioner to obtain conventional long-term leases for this

equipment (as discussed supra pp. 34-36), (2) the expert evidence

demonstrates that the amounts petitioner paid its shareholders to

lease equipment at monthly rates were generally less than amounts

that were charged by third-party lessors for the same equipment,

and (3) in actual practice, petitioner was not required to pay

when at least some of the equipment rented at monthly rates was

idle, we conclude that petitioner has carried its burden of

proving significant error in the notice of deficiency

determination that these rental payments were excessive.

Instead, we find by a preponderance of the evidence that the

monthly rents petitioner paid were reasonable.    Accordingly, the

rental payments made pursuant to the seven monthly agreements and

claimed as deductions for the years in issue are allowable under

section 162(a)(3).
                               - 40 -

                b.   Equipment Leased at Hourly Rates

     With respect to the 15 items of equipment petitioner leased

on a hourly basis, there is an additional problem with

respondent's position that the deductible portion of petitioner's

rent payments should be limited to the value of a 5-year

leasehold interest in the equipment.    Respondent's equating of

petitioner's rental agreements with a 5-year leasehold interest

takes no account of the "actual usage" term present in those

agreements.   Respondent contends that the "actual usage" term is

properly disregarded because it had "no value".    Respondent

argues that

     because the unprecedented construction boom kept
     petitioner so busy, petitioner could not realistically
     have ceased using any of the equipment. Because
     petitioner's argument that it could stop further
     accrual of liability at any time by ceasing to use the
     equipment is contrary to the weight of evidence, this
     ["actual usage"] term is of no value.

     We disagree.    Respondent reaches the conclusion that

petitioner could not realistically have ceased using the

equipment on the basis of conditions as they existed during the

taxable years at issue.    However the rental payments in dispute

were made pursuant to agreements that were, for the most part,

entered into during the 4 years before the taxable years in

issue.   During that period petitioner was hoping to exploit the

new business opportunities presented by the advent of high-tech
                               - 41 -

construction clients, but it could not be certain that its

efforts would be successful.

     As it turned out, petitioner in fact was able to secure

substantial high-tech business and was essentially working

overtime to perform under its contracts during the years in

issue.    But this outcome could not be foreseen with any certainty

in 1992 or 1993 when the bulk of the contracts were entered into;

indeed, it occurred only after a near-ruinous start, represented

by the Silmax project, that had a significant adverse impact on

petitioner's creditworthiness during the years in issue.

     By assessing the reasonableness of petitioner's contracts as

of the taxable years in issue, when petitioner had established a

successful reputation as a high-tech manufacturing contractor and

was regularly working overtime to satisfy project commitments in

a booming market, respondent engages in the kind of hindsight

that is not permitted in determining whether rent is deductible

under section 162(a)(3); rather, the reasonableness of an

agreement's terms generally must be assessed at the time the

agreement was entered into, without the benefit of hindsight,

considering all the facts and circumstances existing at that

time.    See Audano v. United States, 428 F.2d at 256; Brown

Printing Co. v. Commissioner, 255 F.2d at 438; Stanley Imerman v.

Commissioner, 7 T.C. 1030, 1037 (1946); Estate of Sullivan v.
                              - 42 -

Commissioner, a Memorandum Opinion of this Court dated Aug. 10,

1951.

     When all the facts and circumstances that existed at the

time petitioner's agreements were entered into are considered, we

are not persuaded that the "actual usage" terms had no value.

The uncontroverted evidence is that petitioner's high-tech

clients' construction needs were difficult to predict.

Petitioner's competence in performing the new type of work was

untested at the time that many of the contracts were entered

into.   Later, when petitioner's competence was better

established, there was no certainty that demand for high-tech

construction would continue at the "boom" levels that

characterized the 2 taxable years at issue.   We are persuaded

that the "actual usage" terms were an important hedge against

petitioner's downside risks in pursuing a new line of business.

     Petitioner's actual experience under its rental agreements

corroborates the significance of the "actual usage" provisions.

Had it been the case that petitioner used the equipment

essentially full time during the 5-year terms of the contracts,

respondent's position that the "actual usage" provisions should

be disregarded might be more persuasive.   But that is not what

happened.

     As illustrated in appendix A, with respect to 13 of the 15

items of equipment rented at hourly rates with "actual usage"
                              - 43 -

provisions, petitioner used the equipment significantly less than

full time; in many years actual use was less than 50 percent of

full-time use.   Petitioner accordingly paid its shareholders

significantly less than short-term rates premised on full-time

use for these items of equipment.31    Given that the "actual

usage" provisions had a significant impact on the amounts

petitioner was required to pay its shareholders for exclusive

annual use, they cannot be disregarded as respondent contends.32

     A 5-year lease with an "actual usage" provision, such as

those between petitioner and its shareholders, is not essentially

equivalent to a conventional long-term lease with a 5-year term

as respondent contends because in the former the risk of the

equipment's nonuse has been shifted from the lessee to the

lessor.   The lessor in such an arrangement bears a risk similar

to that of the lessor in a short-term equipment rental; for the


     31
      Petitioner also achieved savings, notwithstanding paying
short-term rates, for any time that a piece of equipment was in
transit between jobs or being prepared for clean room use as
these periods did not constitute actual use. Thus, the
shareholder lessors received no rent for these periods, although
a conventional short-term lessor would have.
     32
      In examining petitioner's experience under the rental
agreements after they were executed, we do not depart from the
principle that the reasonableness of the agreements must be
assessed at the time they are entered into and in view of the
conditions then existing. Instead, the actual experience under
the agreements gives rise to reasonable inferences concerning
what the parties to the agreements anticipated when they were
entered into, including the inference that the possibility of
less than full-time use was anticipated.
                               - 44 -

periods the equipment is not in use, the lessor is not

compensated and accordingly must recoup the idle periods by way

of a premium charged for periods of actual use.   A lessor in a

long-term lease bears no such risk, and his arm's-length rate is

accordingly less.

     We are therefore not persuaded of respondent's position that

an amount equivalent to the rent that would be paid on a

conventional 5-year, long-term lease for the equipment is the

amount that would be paid under an arm's-length arrangement for

the rights that petitioner obtained under the hourly rate leases

with its shareholders.33   Instead we are persuaded that, in an

arm's-length arrangement, lessors such as petitioner's

shareholders would have demanded short-term rates to compensate

for periods of nonuse and would have been willing to assume the


     33
      There are other substantial problems with the figures that
respondent asserts are the values of petitioner's 5-year
leasehold interests in the equipment at issue. In computing
these figures, respondent's expert used interest rates prevailing
at the time his report was prepared rather than those prevailing
some 10 years earlier when the agreements were made. The record
establishes that the rates in effect at the time petitioner's
rental agreements were entered into were considerably higher than
those in effect 10 years later. Additionally, respondent
computed residual values using fair market value at the end of
the lease term. According to petitioner's rebuttal expert, a
member of the American Society of Appraisers with a specialty
certification in machinery and equipment appraisal, typical
lessors compute residual value on the basis of orderly
liquidation value, which is between 15 and 25 percent less than
fair market value, and determine residual value at the beginning
of the lease term rather than the end, thereby eliminating the
effects of inflation during the lease years.
                                - 45 -

risk of periods of nonuse so long as they could reasonably

predict that the lessee's actual use of the equipment would be

significant over the lease period.       Petitioner's shareholders

obviously possessed sufficient knowledge of petitioner's business

prospects to make an informed judgment that petitioner's actual

use of the equipment would likely be sufficient for them to earn

a reasonable return on their investment over time.

     Conversely, petitioner's side of the bargain was also arm's

length in our view; petitioner obtained exclusive use of the

equipment without assuming the downside risks posed by

indebtedness or long-term leases in the event that petitioner did

not succeed in a new venture.    Moreover, petitioner could pass

along the costs of short-term rental rates to its clients, with a

17.5-percent markup, alleviating the burden of heavy use at

short-term rates.

     In sum, we are persuaded that in petitioner's circumstances,

the payment of essentially short-term rental rates for long-term

use of the equipment was within the range of what would have been

paid in an arm's-length arrangement to secure the same rights.

Because the expert evidence demonstrates that the amounts

petitioner paid its shareholders to lease equipment at hourly

rates were generally less than amounts that would be charged by

third-party lessors for the same equipment, we conclude that

petitioner has carried its burden of proving significant error in
                                 - 46 -

the notice of deficiency determination.    Instead, we find by a

preponderance of the evidence that the hourly rents petitioner

paid were reasonable.    Accordingly, the rental payments made by

petitioner pursuant to the 15 hourly agreements and claimed as

deductions for the years in issue are allowable under section

162(a)(3).

               c.   Equipment Subleased

     Petitioner and shareholder Kevin Yearout entered into an

agreement in February 1996 to colease LVD Shear for 4 years at a

rate of $1,050 per month with an option to purchase for $1 on the

lease expiration date.   Kevin Yearout simultaneously subleased

LVD Shear to petitioner at a rate of $1,600 per month.     In the

notice of deficiency respondent determined that the maximum rent

allowable for LVD Shear was $1,470 per month.34

     Petitioner and shareholder Bryan Yearout entered an

agreement in May 1996 to lease QuickPen Computer for 5 years at a

rate of $2,430 per month, with an option to purchase for $1 at

the expiration of the lease.35    Bryan Yearout subleased QuickPen

     34
      The maximum rent allowable was computed by multiplying LVD
Shear's total acquisition cost of $50,400 by 35 percent (the rate
of return on equity attributed to Kevin Yearout) and dividing the
result by 12 to yield a monthly rental rate. (The reports of
both experts confirm that LVD Shear's total acquisition cost was
$50,400, although the initial cost specified on the master lease
agreement with the primary lessor was $41,190.)
     35
      As noted in our findings of fact, respondent's conclusion
that a single lease agreement covered both QuickPen Computer and
                                                   (continued...)
                              - 47 -

Computer to petitioner in July 1996 at rates ranging from $2,715

to $3,422 per month.   In the notice of deficiency respondent

determined that the maximum rent allowable for QuickPen Computer

was $2,650 per month.36

     Respondent, citing Connelly v. Commissioner, T.C. Memo.

1994-436, affd. without published opinion 99 F.3d 1154 (11th Cir.

1996), argues on brief that when a sublessee pays more for

equipment than the sublessor pays its own lessor (under a lease-

to-own contract), it is an indication that the rate being paid by

the sublessee is above fair market value.37   The gravamen of


     35
      (...continued)
Fusion Machine is belied by the purchase price listed on the
agreement, which represents the cost of the computer alone.
     36
      The maximum rent allowable was computed by multiplying
QuickPen Computer's initial acquisition cost of $106,000 by 30
percent (the rate of return on equity attributed to Bryan
Yearout) and dividing the result by 12 to yield a monthly rental
rate.
     37
      Respondent also argues, for the first time on brief, that
petitioner has not proved that the respective shareholders
acquired petitioner's leasehold interests in the originally
coleased equipment (i.e., LVD Shear and QuickPen Computer) before
subleasing it back to petitioner. A party may not raise an issue
for the first time on posttrial brief where surprise and
prejudice are found to exist. See Sundstrand Corp. v.
Commissioner, 96 T.C. 226, 346-347 (1991); Seligman v.
Commissioner, 84 T.C. 191, 198-199 (1985), affd. 796 F.2d 116
(5th Cir. 1986); Markwardt v. Commissioner, 64 T.C. 989 (1975).
Since respondent did not raise the issue of the transfer of
petitioner's colessee interests until after trial, petitioner had
no opportunity to address it. Allowing the issue to be raised at
this point would prejudice petitioner, and we therefore decline
to do so.
                                                   (continued...)
                              - 48 -

respondent's argument is that petitioner could have leased LVD

Shear and QuickPen Computer directly from the primary lessors; it

was therefore unnecessary for petitioner to enter into subleases

with its shareholders for the equipment at higher rates than were

paid to the primary lessor.   Therefore, respondent concludes, the

lease rates paid by the shareholders directly to the primary

lessor are the best evidence of fair market value for those

items.

     Petitioner argues that any premiums paid to the shareholders

under the subleases are justified by the risks the shareholders

assumed as colessees, relying on Roman Sys., Ltd. v.

Commissioner, T.C. Memo. 1981-273.     Petitioner contends that

amounts paid to its shareholders under the subleases that

exceeded the rents due under the primary lease were compensation

for the shareholders' assumption of risks as guarantors of the

primary lease payments and as sublessors in respect of tort

claims (for which they would not have been responsible as

shareholders).

     37
      (...continued)
     Even if we allowed the issue to be raised, we would conclude
on this record, in view of petitioner's precarious financial
condition when the leases and subleases were entered into, that
petitioner and its shareholders had informal agreements in
respect of the leased equipment under which petitioner agreed (1)
to transfer its rights as colessee to the colessee shareholders,
and (2) to sublease the equipment from the shareholders at a
premium, in consideration of the shareholders' effectively
serving as guarantors of petitioner's obligations under the
primary lease.
                               - 49 -

     We agree with petitioner.    Respondent's contention that

petitioner could have obtained LVD Shear and QuickPen Computer

directly--that is, without a shareholder serving as colessee--

finds no support in the record.    When petitioner acquired the use

of these items in 1996, its surety had ceased writing performance

bonds and its longtime banker had begun, for the first time, to

require petitioner's shareholders to provide personal guaranties

for petitioner's indebtedness.    Contrary to respondent's

argument, petitioner's financial condition in 1996 strongly

supports the inference that the primary lessors of LVD Shear and

QuickPen Computer would not have entered into leases without

Kevin and Bryan Yearout as colessees, respectively-–in substance,

the same condition being imposed by petitioner's banker for

loans.

     Given these circumstances, petitioner's position is akin to

that of the taxpayer in Roman Sys., Ltd. v. Commissioner, supra,

where we rejected an argument very similar to respondent's.      In

Roman Systems, the taxpayer was "an unproven corporation

embarking on a type of business venture which had a high failure

rate."   Id.   The taxpayer needed a building for its proposed

restaurant operation, but the building's owners were unwilling to

lease the building to the taxpayer on the basis of the

taxpayer's credit alone.    Two of the taxpayer's shareholders

therefore formed a partnership that entered into a lease with the
                               - 50 -

building's owners and then subleased the building to the taxpayer

at a higher rate.   The Commissioner argued that the taxpayer

could have leased directly from the owners and that consequently

the amounts paid under the sublease to the shareholder

partnership that exceeded what the partnership paid under the

primary lease was not rent for purposes of section 162(a)(3).

This Court concluded that the additional amounts paid under the

sublease served to compensate the shareholders for their

assumption of risk and that these amounts were deductible as rent

so long as they did not exceed what would have been paid in an

arm's-length arrangement.

     The same analysis should apply here, because petitioner's

shareholders effectively served as guarantors for the rental

payments to the primary lessor.   For the same reason, Connelly v.

Commissioner, supra, relied on by respondent, is distinguishable.

In that case, the taxpayer argued that the amounts it paid as

sublessee that exceeded what its sublessor paid to the primary

lessor were compensation for improvements made to the leased

property by the sublessor.   We denied the section 162(a)(3)

deduction for the excess payments because there was no persuasive

evidence that the sublessor had made the improvements as claimed

by the taxpayer.    Here, petitioner's claim that its shareholders

provided their creditworthiness in connection with the subleasing

arrangements is supported by the evidence.
                              - 51 -

     Regarding the fair market rental value of LVD Shear,

respondent argues that the most reliable measure of fair market

rental value is what was paid in the arm's-length arrangement

between the primary lessor and colessees petitioner and Kevin

Yearout; namely $1,050 per month.    Following Roman Sys., Ltd. v.

Commissioner, supra, we disagree, since this figure does not

reflect any compensation to Kevin Yearout for the guarantor risk

he assumed as colessee.   Respondent's valuation engineer took the

position that fair rental value for LVD Shear was the amount that

would secure a 35-percent return on equity for Kevin Yearout, or

$1,470 per month.   Petitioner's expert's estimate of the fair

rental value of LVD Shear in the Albuquerque market during the

taxable years in issue was $4,500 per month;    respondent offered

no expert testimony on this point.

     We believe some doubt necessarily attaches to petitioner's

expert's estimate, given that petitioner and Kevin Yearout were

able to lease LVD Shear for $1,050 per month.   We nonetheless

find that, in view of respondent's valuation engineer's estimate

that $1,470 per month was a reasonable rent, the $1,600 per month

petitioner paid as sublessee to Kevin Yearout was a reasonable

amount to compensate Kevin Yearout for his risk as guarantor,

given petitioner's precarious financial condition when the lease
                                - 52 -

and sublease were executed.38   We therefore conclude that

petitioner has met its burden of proving that the $1,600 per

month petitioner paid to shareholder Kevin Yearout to sublease

LVD Shear was within the range of fair market rental value and

was arm's length.   The deficiency determined with respect to this

item is therefore not sustained.

     Regarding the fair market rental value of QuickPen Computer,

respondent likewise takes the position that the best measure of

that value was the rent paid under the arm's-length arrangement

between the primary lessor and colessees petitioner and Bryan

Yearout; namely, $2,430.   For the reasons just stated with

respect to the LVD Shear sublease, we reject respondent's

contention.   Respondent's valuation engineer took the position

that fair rental value for QuickPen Computer was the amount that

would secure a 30-percent return on equity for Bryan Yearout's

investment of $106,000, or $2,650 per month.   The valuation

engineer also expressed the view, however, that a 30-percent

return was appropriate for general construction equipment but

that a 35-percent return was appropriate for high-tech equipment.

We find that QuickPen Computer more likely falls in the latter

     38
      We also note that the rents being charged petitioner by
its shareholders were subject to review by knowledgeable
purchasing agents of petitioner's clients. The undisputed
testimony was that, under the typical GMP construction contracts
petitioner had with its clients, these purchasing agents were
quick to reject any claimed expenses for equipment rental that
they considered in excess of prevailing rates.
                               - 53 -

category.    A 35-percent return on equity would suggest that fair

market rental value under the valuation engineer's methodology

would be $3,091.67 per month (($106,000 x .35) ÷ 12).

       Respondent offered no expert testimony as to the fair rental

value of QuickPen Computer.    Petitioner's expert estimated that

the fair market rental value of QuickPen Computer in Albuquerque

during the taxable years in issue was $2,850 per month; this

estimate was based on market rent comparables for QuickPen

Computer ranging between $2,200 and $3,500 per month.      Under the

valuation engineer's methodology, the fair market rental value

for QuickPen Computer was $3,091.67 per month.      The amounts

petitioner paid for QuickPen Computer ranged from $2,715 to

$3,422 per month during the years in issue.      On this record, we

conclude that petitioner has met its burden of proving that the

$2,715 to $3,422 per month it paid to shareholder Bryan Yearout

to sublease QuickPen Computer was within the range of fair market

rental value and was arm's length.      The deficiency determined

with respect to this item is therefore not sustained.

III.   Conclusion

       Petitioner had valid business reasons for entering into

specialized rental agreements with its shareholders to secure

needed construction equipment.    We find on this record that the

rates petitioner agreed to pay its shareholders for the equipment

were reasonable at the time the contracts were entered into and
                             - 54 -

reflected arm's-length arrangements.   We therefore conclude that

petitioner's rental expense deductions claimed during the years

in issue are allowed under section 162(a)(3).

     We have considered all the remaining arguments made by the

parties for results contrary to those reached herein.   To the

extent not discussed herein, we conclude those arguments are

moot, without merit, or unnecessary to reach.

     To reflect the foregoing,


                                         Decision will be entered

                                   for petitioner.
                                                                                 - 55 -
                                                             APPENDIX A - RENTAL PAYMENT ANALYSIS

                                             Annual      Annual
                                 Allowable Rent Using      5-yr     Annual Rent Amounts Amounts Amounts Amounts Amounts Amounts Amounts Amounts Amounts
                                   Annual    Hourly/    Leasehold    for Full-    Paid   Paid     Paid    Paid    Paid    Paid    Paid    Paid    Paid
                In                Rent per Monthly 3d- Interest      Time Use   Share- Share- Share- Share- Share- Share- Share- Share- Share-
  Item of    Service   Lease    Deficiency Party Rental Value(R's     per P's   holders holders holders holders holders holders holders holders holders
 Equipment     Date     Date       Notice1    Rates2     Expert)     Contracts3   1988   1989     1990    1991    1992    1993    1995    1996    1997

ITEMS RENTED HOURLY
Crane         Apr-93   Apr-93    $24,000    $42,000    $12,000       $145,600        XXX      XXX     XXX      XXX      XXX  $28,359 $35,086 $24,251 $25,565
Backhoe 1     Jun-86   Jun-91     17,668     34,800      3,600         41,600     $29,327   $7,190 $11,290   $3,900   $8,200 19,751 31,225 22,031 24,766
Backhoe 2     Apr-88   Apr-93     15,240     34,800      3,600         41,600       9,820   11,110 10,545    12,050    8,300 19,354 24,283 25,813 30,774
Manlift 1N    Apr-94   Apr-94      3,714      7,500        960         13,000        XXX      XXX     XXX      XXX      XXX     XXX     XXX    9,677 12,675
Manlift 1     Jun-87   Jun-92      5,211      7,500      3,100         13,000      12,390   10,500   7,250   12,250   11,210 12,439 12,474     9,614 12,675
Manlift 2     Jul-94   Jul-94      3,714      7,500      3,120         13,000       9,300   10,500   8,510   12,500   11,500 12,110 11,581 12,673 11,675
Manlift 3     May-88   May-93      6,457     12,960      1,020         15,600       8,730   12,450 13,405    14,100   13,200 14,390 16,507 15,204 12,674
Manlift 4     Jul-88   Jul-93      6,631     12,960      1,080         15,600       5,100   12,900   7,901   15,600   15,500 16,437 12,698 15,204 13,311
Manlift 5     Aug-92   Aug-92     12,509     16,800      6,000         23,400        XXX      XXX     XXX      XXX      XXX     XXX     XXX   19,053 13,254
Manlift 64    May-95   Aug-92      3,790      8,400      2,940         13,000        XXX      XXX     XXX      XXX      XXX     XXX    6,353   9,192 12,497
Manlift 7     May-95   Aug-95      3,790      8,400      2,940         13,000        XXX      XXX     XXX      XXX      XXX     XXX    4,235 11,185 12,375
Boomlift 6    Aug-92   Aug-92      7,967     28,800      4,800         31,200        XXX      XXX     XXX      XXX      XXX     XXX     XXX   23,783 13,063
Bobcat 943    Apr-88   May-88      8,739     28,800      1,320         41,600      10,605    9,971   2,130   10,540    8,940   8,691 10,190 28,320 15,500
Bobcat 743    Oct-94   Oct-94      8,550     18,000      5,820         31,200        XXX      XXX     XXX      XXX      XXX     XXX    8,405   7,245   6,705
Cybermation   Dec-86   Dec-96     22,925     42,000      3,000        210,400      21,938   35,999 21,565    24,961   33,288 71,151 83,383 104,698 153,420

ITEMS RENTED MONTHLY
Brake Press   Dec-94 Dec-94      $43,253    $78,000    $15,600        $44,232       XXX      XXX     XXX      XXX      XXX      XXX  $46,800 $46,800 $36,857
Clean Room    Sep-95 Sep-95       21,000     36,000      7,800         31,200       XXX      XXX     XXX      XXX      XXX      XXX    7,800 31,200 30,559
Lift 1        Jun-93 Jun-93        1,587      7,200      1,080          6,300       XXX      XXX     XXX      XXX      XXX    $5,555   5,321   9,450   6,825
Lift 2        Jun-93 Jun-93        1,587      7,200      1,080          6,300       XXX      XXX     XXX      XXX      XXX     3,333   5,775   9,450   6,825
Lift 3        Mar-95 Mar-95        1,254      7,200        840          6,300       XXX      XXX     XXX      XXX      XXX      XXX    4,439   9,450   6,825
Forklift      Jul-95 Jul-95       18,561     28,200     10,200         25,200       XXX      XXX     XXX      XXX      XXX      XXX   12,600 50,275 31,250
Fusion Mach   Apr-96 Apr-96        8,124     28,800      4,200         22,800       XXX      XXX     XXX      XXX      XXX      XXX     XXX   17,100 22,800

ITEMS SUBLEASED
LVD Shear     Feb-96 Feb-96      $17,640    $54,000     $6,000        $19,200       XXX      XXX     XXX      XXX      XXX     XXX     XXX   $19,200 $16,000
QuickPen      May-96 May-96       31,800     34,200     28,560        variable      XXX      XXX     XXX      XXX      XXX     XXX     XXX    20,394 41,062

     NOTE: Amounts in the "annual rent using monthly third-party rates", "annual 5-yr leasehold interest value", and "annual rent for full-time use
per P's contracts" columns are exclusive of State sales tax. The "amounts paid shareholders" columns (by year) are taken directly from schedules of
rate analysis by shareholder prepared by respondent during examination, are by calendar rather than fiscal year, and are inclusive of State sales tax.
     1
       This column is based on the putative methodology that respondent used to compute the maximum allowable rents in the notice of deficiency, i.e.,
maximum allowable rent was computed by taking the appropriate return on equity (30 percent for equipment owned by shareholders Kim and Bryan Yearout;
35 percent for equipment owned by shareholder Kevin Yearout) times the shareholder's investment in the item of equipment.
     2
       This rent is computed using the lowest hourly or monthly (depending on the term in petitioner's agreements) rental rate estimated by
respondent's expert, when available; otherwise using the rates estimated by petitioner's expert.
     3
       Full-time use rent is computed for the most part using the actual rates specified in petitioner's contracts, multiplied by 12 for items of
equipment rented on a monthly basis, and by 2,080 for those items rented on an hourly basis. For Brake Press, the figure reflects the actual monthly
rate paid of $3,686 per month multiplied by 12. For Cybermation Machine, the value is the sum of the monthly rental fee of $200 times 12, and the
hourly rental fee of $100 times 2,080. Where written agreements do not exist, the rent interval and rate were inferred from petitioner's annual
payment schedules by item of equipment. For QuickPen Computer, the maximum annual full-time rent for 1996 was $20,392 (1 month at $2,715, 5 months at
$2,851 and 1 month at $3,422); for 1997, the maximum annual full-time rent was $41,064.
     4
       The effective date of the written lease contract in the record for Manlift #6 is Aug. 30, 1992. However, the schedules prepared by respondent's
revenue agent during the examination and the report of respondent's expert all show that Manlift #6 was not acquired until Aug. 30, 1995. On the
weight of the evidence, we conclude there was a typographical error in the written lease agreement as petitioner, in fact, incurred no rental charges
with respect to Manlift #6 until calendar year 1995.
                                                        - 56 -
                                     APPENDIX B - SUMMARY OF EQUIPMENT RENTAL RATES

Item of Equipment       Lease Date       Contract Rate             Petitioner's Expert          Respondent's Expert1
ITEMS LEASED HOURLY
  Crane                  Apr-93             $70/hr           $76.50 to $85.50/hr              $85/hr; $3,500/mo
  Backhoe #1             Jun-91             $20/hr           $19.50 to $22.50/hr              $35/hr; $2,900/mo
  Backhoe #2             Apr-93             $20/hr           $19.50 to $22.50/hr              $35/hr; $2,900/mo
  Manlift #1N            Apr-94            $6.25/hr          $5.50 to $8.50/hr; $650/mo       $8/hr; $625 to $740/mo
  Manlift #1             Jun-92            $6.25/hr          $5.50 to $8.50/hr; $650/mo       $8/hr; $625 to $740/mo
  Manlift #2             Jul-94            $6.25/hr          $5.50 to $8.50/hr; $650/mo       $8/hr; $625 to $740/mo
  Manlift #3             May-93            $7.50/hr          $8 to $15/hr; $1,550/mo          $10/hr; $960/mo
  Manlift #4             Jul-93            $7.50/hr          $8 to $15/hr; $1,550/mo          $15/hr; $1,080/mo
  Manlift #5             Aug-92           $11.25/hr          $10.50 to $17.50/hr; $1,750/mo   $23.75/hr; $1,400/mo
  Manlift #6             Aug-92            $6.25/hr          $5.50 to $8.50/hr; $650/mo       $6.87/hr; $700/mo
  Manlift #7             Aug-95            $6.25/hr          $5.50 to $8.50/hr; $650/mo       $6.87/hr; $700/mo
  Boomlift #6            Aug-92             $15/hr           $15 to $20.50/hr; $2,050/mo      $25/hr; $2,400/mo
  Cybermation Machine    Dec-96        $200/mo + $100/hr     $70 to $80/hr or $7,000/mo       none provided
  Bobcat #943            May-88             $20/hr           $18 to $20/hr                    $25/hr; $2,400/mo
  Bobcat #743            May-88             $15/hr           $18 to $20/hr                    $16.87/hr; $1,500/mo

ITEMS LEASED MONTHLY
  Brake Press            Dec-94            $3,900/mo2        $6,500/mo                        none provided
  Clean Room             Sep-95            $2,600/mo3        $3,000/mo                        none provided
  Lift #1                Jun-93             $525/mo          $550/mo                          $600 to $660/mo
  Lift #2                Jun-93             $525/mo          $550/mo                          $600 to $660/mo
  Lift #3                Mar-95             $525/mo          $550/mo                          $600 to $660/mo
  Forklift               Jul-95            $2,100/mo         $2,200/mo                        $2,350/mo
  Fusion Machine         Apr-96            $1,900/mo         $2,400/mo                        none provided

ITEMS SUBLEASED
  LVD Shear              Feb-96             $1,600/mo        $4,500/mo                        none provided
  QuickPen Computer      Jun-96         $2,715-$3,422/mo4    $2,850/mo                        none provided
     1
       The hourly rates for Manlift #3, Manlift #4, Manlift #5, Manlift #6, Manlift #7, Bobcat #943, and Bobcat
#743 were computed by dividing the daily fair market rental rate provided by respondent's expert by 8.
     2
       Petitioner's annual payment schedules by item of equipment indicate that the monthly rental rate for Brake
Press was $3,686/mo, even though the parties' written lease agreement specifies a monthly rental rate of
$3,900/mo.
     3
       In December 1996, the parties entered a new written lease agreement increasing the monthly rental rate for
Clean Room to $3,900/mo. Petitioner's annual payment schedules by item of equipment indicate that this rate was
never implemented.
     4
       The parties' written lease agreement specifies a monthly rental rate of $2,715/mo for QuickPen Computer.
Petitioner's annual payment schedules by item of equipment indicate that in July 1996 the monthly rental rate
increased to $2,851/mo, and in December 1996 the monthly rental rate increased to $3,422/mo.
