                          T.C. Memo. 1996-462



                        UNITED STATES TAX COURT



     JAMES H. LESTE AND STACY LESTE, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 17310-94, 17311-94,           Filed October 15, 1996.
                 17312-94, 17420-94.



     Sebastian D'Amico, for petitioners.

     James J. Posedel and Gordon L. Gidlund, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS,   Judge:     In   these   consolidated   cases,   respondent

determined deficiencies in, an addition to, and penalties on

petitioners' Federal income taxes as follows:



     1
          Cases of the following petitioners are consolidated
herewith: Richard W. Moore and Katherine J. Moore, docket No.
17311-94; James H. Leste, docket No. 17312-94; and First
Associates Mortgage Corp., docket No. 17420-94.
                                        - 2 -

James H. and Stacy Leste
Docket No. 17310-94
                                  Accuracy-Related Penalty
Year         Deficiency                 Sec. 6662(a)
1991          $14,467                      $2,893


Richard W. and Katherine J. Moore
Docket No. 17311-94
                         Accuracy-Related Penalty
Year      Deficiency           Sec. 6662(a)
1989       $37,712                $7,542
1990        15,708                 7,469
1991        18,930                 3,786

James H. Leste
Docket No. 17312-94
                                  Accuracy-Related Penalty
Year         Deficiency                 Sec. 6662(a)
1989          $40,312                      $8,062
1990           21,954                       4,391

First Associates Mortgage Corp.
Docket No. 17420-94

  Year                       Addition to Tax        Accuracy-Related Penalty
  Ended      Deficiency      Sec. 6651(a)(1)              Sec. 6662(a)
10/31/89      $82,867              --                       $16,573
10/31/90       52,626              --                        10,525
10/31/91       92,046            $12,625                     18,409


Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule   references      are   to   the   Tax     Court   Rules   of    Practice   and

Procedure.

       After concessions, the issues for decision are:

       (1)   Whether    payments     made     by   corporate    petitioner   First

Associates     Mortgage      Corp.      (FAMC)     to   Valentine      Silbernagel

(Silbernagel),      pursuant       to   a     consulting   and       noncompetition

agreement, represent compensation deductible under section 162(a),

as petitioners contend, or additional consideration to Valentine
                                  - 3 -

Associates Ltd. Corp. for James H. Leste's and Richard W. Moore's

purchase of FAMC's stock, and thus nondeductible by FAMC and

taxable as constructive dividends to the individual petitioners, as

respondent contends;

     (2)    whether all petitioners are liable for the accuracy-

related penalty under section 6662(a) pertaining to the above

issue;

     (3)    whether the Lestes and the Moores are liable for the

accuracy-related penalty under section 6662(a) for failing to

properly report bonus income received from FAMC on their individual

income tax returns; and

     (4)    whether FAMC is liable for the accuracy-related penalty

under section 6662(a) for overstating its cost of goods sold by

$202,525 for its fiscal year ended October 31, 1991.

                           FINDINGS OF FACT

     Some   of   the   facts   have   been    stipulated   and   are   found

accordingly.     The stipulation of facts and the attached exhibits

are incorporated herein by this reference. At the time of the

filing of the petitions, the Lestes and the Moores resided, and

FAMC's principal place of business was located, in California.

     FAMC was incorporated on February 26, 1986; it was a wholly

owned subsidiary of Valentine Associates Limited Corp. (VALC).

VALC was incorporated in 1973 and was engaged in the business of

providing collection and accounting services to mortgage lenders

(loan servicing). At all relevant times, Silbernagel owned all the

stock of VALC and was its president.         From 1969 until the time VALC
                                    - 4 -

was incorporated, Silbernagel had been the president of a large

mobile home loan servicing company; prior thereto, he had worked

for about 8 to 10 years for an automobile loan servicing company.

In his prior employment, Silbernagel procured loans and marketed

them for sale in bulk to banks and savings and loan associations.

Silbernagel had developed contacts at 200 to 250 banks and savings

and loan associations with which he had worked. Utilizing his

experience and contacts in the loan servicing industry, Silbernagel

organized VALC and began providing loan procurement and marketing

services, as well as collection and foreclosure services, primarily

to mobile home mortgage lenders.

     On March 1, 1987, VALC's mobile home mortgage servicing

business, which at that time represented about 75 to 80 percent of

the company's operations, was sold to WESAV Financial Corp. (WESAV)

for approximately $2,180,000.           The sale contract between WESAV and

VALC included a covenant not to compete pursuant to which VALC

agreed to refrain from owning or operating a mobile home loan

servicing   business   for   a    period     of   18   months.    In   addition,

Silbernagel personally executed a consulting and noncompetition

agreement   with   WESAV.        That     agreement     noted     Silbernagel's

"substantial knowledge and expertise in the operation, management,

business contacts, and research and development activities of the

business" and required him to refrain from aiding any competitor or

potential competitor for a period of 18 months.                 As compensation

for services to be rendered and for his covenant not to compete,
                                   - 5 -

Silbernagel was to receive $8,000 per month during the term of the

agreement.

      Despite VALC's and Silbernagel's noncompetition agreement with

WESAV, VALC entered into a mortgage servicing agreement with

Imperial   Savings   Association    (Imperial)   on   November   4,   1987.

Pursuant to that agreement, VALC agreed to service loans purchased

by   Imperial   in   bulk   from   other   lenders;   the   agreement   was

prospective only and no loans were being serviced at the time the

agreement was entered.      The agreement required VALC to obtain all

necessary business licenses, a fidelity bond protecting against

losses caused by improper employee acts, and various insurance

policies naming Imperial as the beneficiary.

      In response to concerns raised by WESAV regarding VALC's

covenant not to compete with WESAV, the servicing rights and

obligations under the Imperial agreement were assigned to FAMC on

December 12, 1987.     At that time FAMC was not an active business

entity and had been a dormant subsidiary of VALC since it was

incorporated in 1986.

      Shortly after the assignment of the Imperial contract to FAMC,

and to further alleviate concerns over his covenant not to compete

with WESAV, Silbernagel approached petitioners James Leste (Leste)

and Richard Moore (Moore) to determine whether they would be

interested in buying the stock of FAMC and operating the company as

an independent loan servicing organization. Leste and Moore joined

VALC in 1985 and held the positions of vice president of finance

and senior vice president in charge of lending, respectively. Both
                                         - 6 -

men were aware that VALC's servicing agreement with Imperial was

causing Silbernagel to receive "a lot of flack" from WESAV.                       They

knew   that    FAMC   had    not   yet    begun     servicing     loans,    and   they

understood that FAMC would have to secure the appropriate business

licenses, a fidelity bond, and various insurance policies prior to

commencing loan service for Imperial.

       Leste and Moore agreed to acquire the stock of FAMC, and they

executed an agreement with VALC on February 25, 1988.                     Pursuant to

this agreement, Leste and Moore each paid $10,000 to acquire all

the outstanding stock of FAMC, and thereafter they became equal 50-

percent shareholders of FAMC.            In addition to the amounts paid for

FAMC's stock, Leste and Moore each contributed $10,000 to FAMC's

working capital to be used in acquiring office furniture and for

other expenses associated with getting the business started. After

purchasing the stock of FAMC, Leste and Moore served as the

company's chief financial officer and president, respectively.

       At the time Leste and Moore purchased the stock of FAMC, the

company had not yet obtained the fidelity bond and insurance

policies      required      pursuant     to   the      Imperial    loan     servicing

agreement. Although FAMC began servicing some large loan pools for

Imperial in April 1988, FAMC's failure to obtain the fidelity bond

and    insurance      policies     resulted       in    a   somewhat       precarious

relationship with Imperial. In September 1988, Stephen M. Wright

(Wright),     Imperial's      senior      vice    president,      wrote     to    Moore

requesting that the fidelity bond and insurance requirements be

satisfied within 30 days or "I will have no choice but to consider
                                    - 7 -

pulling the servicing from your company."               FAMC complied with

Wright's request in October 1988.

     Shortly after purchasing the stock of FAMC, Leste and Moore

entered    into   discussions     with   a   consultant,   Donald   G.     Shirk

(Shirk), who offered to assist FAMC in contacting banks and other

mortgage lenders and in acting as a broker in the buying and

selling of mobile home loan pools.            In a letter to Moore dated

March 10, 1988, Shirk stated that his services could assist FAMC

"in developing large, profitable servicing portfolios." In his

letter, Shirk proposed a fee for his services of $500 per day plus

office rental expenses and reimbursement for other reasonable and

verifiable expenses. An oral agreement was reached pursuant to

which Shirk was hired as a consultant to FAMC on substantially the

same terms as outlined in his letter to Moore.             Thereafter, Shirk

submitted billing statements to FAMC pursuant to the agreed per

diem consulting fee and expense reimbursement arrangement. The

record does not indicate whether Shirk entered into a covenant not

to compete with FAMC.

     Shirk provided consulting services to FAMC through March 1989,

when it was determined that he was not generating an appropriate

level of    new   business   to    replace    FAMC's   declining    loan   pool

balances. Effective April 1, 1989, Shirk's compensation under the

consulting agreement with FAMC was changed to a commission-only

arrangement, whereunder Shirk was paid only when he brought in new

business. In the final 5 months of the original per diem consulting

arrangement, FAMC paid Shirk a total of $35,542 in consulting fees
                                       - 8 -

and expense reimbursements.           There is no evidence in the record as

to the payment of any fees to Shirk under the commission-based

consulting agreement, and it appears that his consulting services

to FAMC were essentially discontinued by April 1989.

      At about that time, Leste and Moore entered into discussions

with Silbernagel, who had previously offered to provide consulting

services to FAMC.2        As the founder of VALC, and ultimately FAMC

itself, and with his numerous contacts in the loan servicing

industry, it was anticipated that Silbernagel would "add some

muscle" to FAMC's marketing effort and help restore the company's

declining loan pool balances.          On May 1, 1989, Silbernagel entered

into a consulting and noncompetition agreement with FAMC. Under

that agreement, Silbernagel's primary duty was to attract new

business through direct sales and other marketing efforts designed

to   promote    FAMC's   loan   servicing      business.         Silbernagel   was

required to refer all loan servicing opportunities made known to

him to FAMC, and he agreed not to compete with FAMC by directly or

indirectly      assisting   FAMC's      competitors.       The   consulting    and

noncompetition agreement with Silbernagel was incorporated into a

multiyear contract commencing on May 1, 1989, and extending to

April     1,   2002.   During   the    first   7   years    of    the   agreement,

Silbernagel was to be paid the lesser of $300,000 per year or 25

percent of FAMC's after-tax profits; in conjunction therewith, FAMC


      2
          A consulting agreement with Silbernagel was previously
proposed, but not executed, in August 1988. At that time, Leste
and Moore decided to give Shirk a little more time to see how
much new business he could bring in.
                                      - 9 -

was to advance to Silbernagel "a fully earned draw of $15,000 per

month against annual compensation."               Thereafter, the compensation

limits and monthly draw amounts were to be reduced by 50 percent

for the remaining years of the contract.

        During the years in issue, Silbernagel contacted between 40

and 50 banks and other mortgage lenders, many of which he had

worked with previously, in an effort to generate loan servicing

business for FAMC. Approximately 95 percent or more of those

contacts involved personal meetings with representatives of the

mortgage lenders.       Additionally, Moore and Silbernagel spoke over

the phone approximately 15 times per month. Although Silbernagel

did not submit billing statements to FAMC, through their regular

phone    conversations      Moore   was    kept    apprised     of    Silbernagel's

activities, including any leads that Silbernagel had developed and

whether any business was expected to come in.

        Despite   Silbernagel's      efforts,      FAMC   did   not    receive   the

anticipated increase in loan servicing business, and it became

increasingly difficult to support Silbernagel's consulting fees.

In February 1990, FAMC reduced its payments to Silbernagel to

$10,000 per month; in May 1991, the payments were further reduced

to $5,000 per month. Silbernagel was aware of FAMC's financial

difficulties and agreed to the reductions in his consulting fees.

        In March 1992, Leste wrote to Silbernagel to inform him that

his consulting agreement was to be terminated effective April 1,

1992. Silbernagel disagreed with the termination of the consulting

agreement    and   in   a   letter    to    Leste,    dated     April    30,   1992,
                                       - 10 -

Silbernagel stated: "I must insist that you continue with the

reduced consulting fees as called for in our agreement or I will be

required to take the necessary action to enforce the agreement."

Despite the comments in his letter to Leste, Silbernagel did not

pursue legal action to enforce the consulting agreement, nor did he

receive any additional consulting fees from FAMC.

       FAMC issued Forms 1099 to Silbernagel for the calendar years

1989, 1990,        and   1991   in   the   respective   amounts    of   $135,000,

$110,000, and $65,000. Silbernagel indicated at trial that he

reported these amounts as ordinary income from consulting services

on his Federal income tax returns for the respective years.3

       On its Federal income tax returns for its fiscal years ended

October 31, 1989, 1990, and 1991, FAMC claimed deductions of

$90,000, $130,000, and $75,000, respectively, for consulting fees

paid       to   Silbernagel.    Respondent    disallowed   these    deductions,

contending Silbernagel performed few or no consulting services for

FAMC and that the payments to Silbernagel were in fact additional

payments with regard to Leste's and Moore's purchase of FAMC's

stock from VALC.          Further, as a result of FAMC's payments to

Silbernagel, respondent determined that Leste and Moore each had




       3
          Silbernagel's tax returns were not introduced into
evidence; however, respondent did not challenge Silbernagel's
assertion that the consulting fees were reported as ordinary
income.
                                - 11 -

received   constructive   dividends   from    FAMC   in    the    amounts    of

$67,500, $55,000, and $32,500 for the calendar years 1989, 1990,

and 1991, respectively.




     During 1989 and 1990, Leste received bonuses from FAMC in the

amounts of $29,431 and $130,000, respectively.            The entire amount

of the 1989 bonus and one-half of the 1990 bonus were incorrectly

reported as self-employment income on Leste's individual income tax

returns for the respective years.     Leste concedes that this error

resulted in the overstatement of deductions for contributions to

his pension plan, and that he is liable for excise taxes on the

overstated amounts.

     During 1990 and 1991, Moore received bonuses from FAMC in the

amounts of $130,000 and $21,970, respectively.             One-half of the

1990 bonus and the entire amount of the 1991 bonus were not

reported on Moore's original income tax returns for the respective

years.   After   respondent's   examination    of    FAMC's      returns    had

commenced, Moore filed an amended income tax return for 1990

reporting the additional $65,000 in bonus income for that year.

Moore also has conceded that he is liable for the bonus income he

failed to report on his 1991 return.

     On its income tax return for the fiscal year ending October

31, 1991, FAMC claimed $202,525 for cost of goods sold. Respondent

disallowed this amount in full, and FAMC concedes the disallowance.
                                      - 12 -

                                      OPINION

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

reasonable       allowance   for     salaries     or   other   compensation       for

personal services actually rendered" as an ordinary and necessary

business expense.          Compensation payments are deductible under

section 162(a)(1) if they are reasonable and paid "purely for

services" rendered to the business.                Sec. 1.162-7(a), Income Tax

Regs.

      Petitioners contend that the payments to Silbernagel represent

compensation for services rendered and for his agreement not to

compete with FAMC.         Respondent claims that the payments were, in

substance, additional payments by Leste and Moore for the stock in

FAMC.       Respondent contends that FAMC is not entitled to deduct the

payments under section 162(a)(1) because Silbernagel performed few

or   no     consulting    services    for   FAMC,      and   that   such    payments

constitute constructive dividends to Leste and Moore to the extent

of FAMC's earnings and profits.4            Apschnikat v. United States, 421

F.2d 910, 913 (6th Cir. 1970); Smith v. Commissioner, 70 T.C. 651,

668 (1978).

        Petitioners      provided    little       documentation     of     the    work

performed by Silbernagel on behalf of FAMC.                      We are mindful,

however, that the consulting and noncompetition agreement entered

between FAMC and Silbernagel provided for fixed monthly payments to


        4
           The parties agree that FAMC had sufficient earnings and
profits in all relevant years such that all of the payments to
Silbernagel would be eligible for treatment as constructive
dividends.
                                     - 13 -

Silbernagel regardless of the number of days worked, and the

agreement did not require Silbernagel to submit billing statements

or other summaries of his consulting activities.5

       In determining the nature of FAMC's payments to Silbernagel,

we   consider       Silbernagel's    testimony,      which   we   found   highly

credible.          We are convinced that Silbernagel indeed performed

consulting services for FAMC, which included utilizing his contacts

in the mortgage lending industry in an attempt to generate business

for FAMC and regularly discussing his activities in that regard

with Moore.         Further, Silbernagel testified that he reported the

payments      received     from   FAMC   as   ordinary   income    because    he

considered them to be compensation for consulting services rendered

and for his covenant not to compete.

       Silbernagel was hired as a consultant to FAMC at a time when

the company's loan servicing business was declining.                 Leste and

Moore, whom we also regard as credible witnesses, indicated that

they expected Silbernagel's expertise and contacts in the mortgage

lending industry to add muscle to FAMC's marketing effort and

generate new loan servicing business, as well as smooth out FAMC's

somewhat precarious relationship with Imperial.              It is reasonable

that       Leste    and   Moore   considered    it    worthwhile    to    pursue

Silbernagel's offer to provide consulting services to FAMC and in




       5
          As noted above, FAMC's prior consulting agreement with
Shirk was a per diem and expense reimbursement arrangement,
whereunder Shirk was required to submit monthly billing
statements in order to get paid.
                                     - 14 -

conjunction therewith FAMC secured from him a covenant not to

compete.

     The $20,000 VALC received from Leste and Moore for the stock

of FAMC was not unduly low, and in our opinion none of the

consulting fees paid to Silbernagel was for the FAMC stock.           At the

time Leste and Moore considered purchasing the stock of FAMC, they

were aware of the speculative value of the Imperial loan servicing

agreement assigned by VALC to FAMC.           It was not clear at that time

how much loan servicing business would be generated by the Imperial

agreement. Nevertheless, Leste and Moore agreed to pay, and VALC

accepted, $20,000 for all of FAMC's stock.           Absent a showing that

this was not an arm's-length agreement or a reasonable price to pay

for the risky business opportunity FAMC provided, we will not

disturb their judgment.          We do not find, as respondent contends,

that the consulting and noncompetition agreement between FAMC and

Silbernagel more than 14 months after Leste and Moore purchased

FAMC's stock was intended to provide additional consideration to

Silbernagel in connection with that purchase.

     We also consider the amounts paid Silbernagel pursuant to his

consulting and noncompetition agreement with FAMC to be reasonable

in light of his expertise and contacts in the mortgage lending

industry.     FAMC paid Shirk a total of $35,542 during the final 5

months   of   his   per   diem    and   expense   reimbursement   consulting

agreement, or on average approximately $7,000 per month.             Shirk's

consulting agreement apparently did not contain a covenant not to

compete with FAMC.        Silbernagel's agreement with FAMC, however,
                                 - 15 -

contained both a consulting services component and a covenant not

to compete.    While the covenant not to compete did not have a

separately stated consideration, it did represent an additional

commitment on Silbernagel's part, supplemental to the consulting

commitment, and it was an added value for the consideration FAMC

was to pay Silbernagel monthly.     (Silbernagel had previously been

paid $8,000 per month for a covenant not to compete with WESAV for

a period of 18 months following WESAV's purchase of VALC's mobile

home mortgage servicing business.6) We believe the $15,000 monthly

fee paid to Silbernagel constitutes reasonable compensation for

both the consulting services component and the covenant not to

compete   in   the   agreement    between   Silbernagel   and   FAMC.7

Consequently, we hold that: (1) FAMC is entitled to deduct all of

the payments made to Silbernagel pursuant to the consulting and

noncompetition agreement entered between those parties;8 (2) there


     6
          Although the agreement with WESAV also required
Silbernagel to assist in effecting a smooth transfer of the
business, we find that the payments under the agreement were
primarily designed to compensate him for his covenant not to
compete with WESAV for a period of 18 months following the sale.
     7
          In determining that the $15,000 monthly fee was
reasonable, we recognize that there were subsequent reductions of
the monthly payment to $10,000 in February 1990, and to $5,000 in
May 1991. Those reductions were the result of arm's-length
negotiations precipitated by the decline in FAMC's loan servicing
business and the company's resulting financial difficulties.
     8
          Respondent suggests on brief that the payments under
the consulting and noncompetition agreement between Silbernagel
and FAMC were limited to the lesser of $300,000 per year or 25
percent of FAMC's after-tax profits, and therefore, FAMC's
deduction should likewise be limited to this amount. Moore
testified at trial, however, that the monthly payments to
                                                   (continued...)
                                     - 16 -

are no constructive dividends to the individual petitioners; and

(3) the accuracy-related penalties under section 6662(a) relating

to this issue are not applicable.

     The remaining issues for decision are: (1) Whether the Lestes

and the Moores are liable for accuracy-related penalties under

section 6662(a) for their failure to properly report bonus income

received from FAMC, and (2) whether FAMC is liable for the section

6662(a) accuracy-related penalty for claiming cost of goods sold of

$202,525 which the parties have agreed was improper.

     Section   6662(a)     imposes    a   penalty   on   any   portion   of   an

underpayment that is attributable to negligence or disregard of

rules and regulations.        In the instant case, petitioners have

conceded that they are liable for the underlying deficiencies

resulting from the improperly reported bonus income and cost of

goods sold amounts.

     A   taxpayer   must    establish      error    in   the   Commissioner's

determination that he or she is liable for the penalty provided by

section 6662(a).    Rule 142(a); Estate of Monroe v. Commissioner,

104 T.C. 352, 366 (1995). Petitioners offered no evidence at trial

concerning the negligence penalties and failed to address the issue



     8
      (...continued)
Silbernagel under the consulting and noncompetition agreement
were his "fully earned draw" and that he could earn more but not
less than the agreed $15,000 per month "floor". As noted
previously, respondent did not challenge Silbernagel's assertion
that he reported all of the consulting fees received from FAMC as
ordinary income on his individual income tax returns, nor is
there any evidence that Silbernagel returned any of the payments
to FAMC.
                               - 17 -

on   brief.9   Accordingly,   to   the    extent   that    respondent   has

prevailed on the underlying issues, her corresponding determination

of the applicable penalties is sustained.

      To reflect the foregoing and the concessions of the parties,


                                              Decisions will be entered

                                         under Rule 155.




      9
          Petitioners did, however, attach a document to their
posttrial reply brief purporting to be an audit notification
letter sent from an Internal Revenue Service agent to Moore on
Nov. 23, 1992. Presumably, petitioners intend this document to
exculpate Moore from the negligence penalty for 1990 by
establishing that Moore filed his amended 1990 return reporting
the additional $65,000 in bonus income prior to being informed by
respondent that his return was under audit. The document
attached to petitioner's posttrial reply brief, however, was not
introduced at trial and, therefore, is not part of the record in
this case. Rule 143(b). Additionally, we note that the parties
have stipulated that Moore filed his amended 1990 return after
respondent's examination of FAMC's returns had commenced. Based
on our review of the record in this case, and petitioners'
failure to address the negligence issue at trial or on brief, we
conclude that petitioners have not carried their burden of proof
and, accordingly, are liable for the accuracy-related penalties
under sec. 6662(a) pertaining to the conceded deficiencies.
