                       T.C. Memo. 1996-303



                     UNITED STATES TAX COURT




                    PMT, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4458-94.                       Filed July 2, 1996.



     Mitchell R. Miller, for petitioner.1

     1
        After the trial of this case in Los Angeles, Cal., on
Mar. 22, 23, and 24, 1995, was concluded, petitioner on June 14,
1995, filed a petition in the U.S. Bankruptcy Court for the
Central District of California. This Court was notified of the
filing of the petition in bankruptcy and was furnished a
certified copy of the petition on June 28, 1995.

     On June 29, 1995, we issued an order staying all proceedings
in this case.

     On Oct. 31, 1995, respondent filed a status report in this
case, to which was attached a certified copy of an order of the
U.S. Bankruptcy Court for the Central District of California,
dated Oct. 20, 1995, in which the bankruptcy court stated that
the automatic stay is terminated for the purpose of allowing the
                                                   (continued...)
                               -2 -

     Donna F. Herbert, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     SCOTT, Judge:   Respondent determined a deficiency in

petitioner's Federal income tax in the amount of $426,707, and an

accuracy-related penalty under section 6662(a)2 in the amount of

$85,341 for petitioner's taxable year ended July 31, 1990.   Some


     1
      (...continued)
U.S. Tax Court to continue its proceedings involving the debtor
in the bankruptcy case, and allowing the IRS to assess any tax
liability determined by the U.S. Tax Court in the case before it.

     On Nov. 6, 1995, this Court issued an order that the stay of
proceedings in this case was lifted and allowed petitioner to and
including Dec. 20, 1995, within which to file a brief in this
case. In a further order dated Nov. 22, 1995, granting Mitchell
R. Miller's motion to withdraw as counsel for petitioner, which
order was served on petitioner, the Court specifically stated
that petitioner was not relieved of the obligation of filing a
brief in this case by Dec. 20, 1995, because of withdrawal of its
counsel.

     No brief was received by the Court as required by order of
the Court. By order dated Mar. 18, 1996, we granted petitioner
to and including Apr. 15, 1996, to file a reply to respondent's
brief filed June 21, 1995 (which had been served on petitioner
Jan. 16, 1996), and stated that if no brief were received from
petitioner on or before Apr. 15, 1996, the Court would proceed
with consideration of this case. The Court has received no brief
from petitioner, and, therefore, it has been necessary to
determine the issues in this case without a statement of
petitioner's position with respect to the evidence in the case or
petitioner's position with respect to respondent's requested
findings of fact and arguments in her brief.

     2
        All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
of the issues raised by the pleadings have been disposed of by

agreement of the parties, leaving for decision:    (1) The proper

amount to be allowed as a deduction to petitioner for reasonable

compensation of officers; (2) to what extent, if any, the amount

allowable to petitioner as a deduction for officers' compensation

for the year at issue should be allocated to mixed service costs

and capitalized pursuant to section 263A; and (3) whether

petitioner is liable for an accuracy-related penalty under

section 6662(a) for the year at issue.

                        FINDINGS OF FACT

     Some of the facts have been stipulated and are found

accordingly.

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

filing of the petition in this case was Vernon, California.

During the year at issue, petitioner was engaged in the business

of converting yarn to fabric.   PST, Inc. (PST), was the

predecessor company to petitioner and was formed by Patti Penalba

(Mrs. Penalba) and Marcos Penalba (Mr. Penalba).   PST was a

textile converting operation, which is an operation that

purchases raw textile materials, known as gray goods, commissions

out the materials to operators that produce the fabric, and then

has the fabric finished at dye houses, after which the fabric is

sold to clothing manufacturers.

     Petitioner was incorporated in 1984.   Mr. and Mrs. Penalba

were married prior to and during the year at issue, but had been
                                -4 -

divorced prior to the trial of this case.   Each of the Penalbas

held 50 percent of petitioner's stock during the years 1988

through 1990.   The initial investment of the Penalbas in

petitioner's stock was a total of approximately $15,000.    When

petitioner first began its operations, its conversion was all

done through commissioned knitting, dyeing, and finishing plants.

After 1987, petitioner stopped selling woven fabrics and started

selling only knitted fabrics.   In 1990, petitioner was involved

in some resales of both gray goods and finished goods.

     Mrs. Penalba was the chief financial officer and secretary

of petitioner during its fiscal years 1987 through 1990, and Mr.

Penalba was its president during those years.   Petitioner hired a

bookkeeper in 1985.   Sometime after the bookkeeper was hired,

petitioner hired a receptionist who was trained in production.

In 1987 or 1988, petitioner began to hire outside salespeople.

     Petitioner designed its own fabrics, and most of the fabrics

it sold to customers were of petitioner's own designs.   Both Mr.

or Mrs. Penalba would discuss development of a fabric which was

being designed, but Mr. Penalba actually designed the fabric.

Mr. Penalba would determine such aspects of the fabric as the

type of thread to be used, the construction needed for the

fabric, whether the fabric needed stretchability on the width or

length, or whether the fabric was to be top or bottom weighted.

Mr. Penalba was responsible for selecting the proper yarns, the

proper equipment, the knitting weights, and the work requirements
                                -5 -

for production efficiency in the manufacture of the fabric.     Mr.

Penalba shared the responsibility for ensuring that the

manufacture of the fabric was cost efficient.     Since petitioner

was a converter that contracted out its operations, selecting

efficient and capable factories to produce the fabrics was

essential to petitioner's success.     Mr. Penalba was responsible

for selecting the fabrics to be contracted out to the various

manufacturers of its fabrics.

     Jorge Rubino (Mr. Rubino) began working for petitioner in

1989 as its production manager.    Mr. Rubino's duties as

production manager included purchasing yarn, taking the orders to

the knitting plants, controlling the production of the fabrics,

and delivering the fabrics to the finishing plants to be

finished.    Mr. Penalba supervised and worked directly with Mr.

Rubino.

     Mr. Penalba's duties as the top person in charge of

production included deciding which fabric designs petitioner

would produce.   Mr. Penalba's duties included researching and

developing fabrics, meeting with customers in designing fabrics,

and negotiating with the commissioned knitting and dyeing plants.

Mr. Penalba held meetings with the production staff at least once

a week.   Mr. Penalba worked very closely with Mr. Rubino.

     Mr. Penalba was also responsible for petitioner's sales

operation.   Mr. Penalba would recruit and train salespeople to

work with petitioner's customers.      As petitioner's sales manager,
                                 -6 -

Mr. Penalba's duties included supervising the sales staff,

meeting with both salespeople and purchasers, and handling

product service.

     Mr. Penalba frequently worked 15 to 18 hours a day, and Mr.

Penalba often worked weekends.    Mr. Penalba worked approximately

80 to 100 hours per week during the year at issue.    Mr. Penalba's

duties and responsibilities did not change dramatically from year

to year.

     Mrs. Penalba was responsible for the daily operations of

petitioner.   Mrs. Penalba secured credit to finance material

purchases and operations.   Mrs. Penalba was also responsible for

recordkeeping and customer services.    Mrs. Penalba was

responsible for confirming orders and seeing that purchase orders

were properly filled.   In general, Mrs. Penalba was second in

authority in making policy decisions for petitioner, including

decisions with respect to production.

     Although Mrs. Penalba's workload increased steadily from

1985 through 1991, the nature of her duties remained

substantially the same.   Mrs. Penalba worked approximately 60 to

80 hours per week during the year at issue.

     In 1987, Mr. Penalba developed several fabrics that became

very desirable in the industry.    The most popular fabric that Mr.

Penalba developed was a cotton fabric with a Spandex polyurethane

or Lycra synthetic filament (the cotton/Lycra fabric).     The

cotton/Lycra fabric was desirable because it gave an elastic
                                 -7 -

quality to the cotton fabric, which cotton did not have

naturally.   Mr. Penalba developed the cotton/Lycra fabric by

wrapping the synthetic filament completely around the cotton

fibers.   The cotton/Lycra fabric was used by clothing

manufacturers for such products as athletic jerseys, leotards,

dresses, bicycling shorts, ski shorts, and leggings.      Sales for

the cotton/Lycra fabric caused petitioner's gross receipts for

its fiscal year 1990 to increase dramatically.

     The cause of petitioner's decrease in sales after 1990 was

primarily market conditions.     After its fiscal year 1990, other

operators became able to manufacture fabrics similar to the

cotton/Lycra fabric, causing increased competition for petitioner

in this product.

     On its Federal income tax returns for its years ending July

31, 1987 through July 31, 1990, petitioner reported the following

gross receipts:

           Year ending July 31             Gross receipts

                  1987                       $9,244,122
                  1988                        7,764,587
                  1989                       11,514,777
                  1990                       22,203,363


     On its Federal income tax returns for its years ending July

31, 1987 through July 31, 1990, petitioner reported the following

taxable income:
                                   -8 -

            Year ending July 31             Taxable income

                 1987                         $193,594
                 1988                          109,261
                 1989                          134,120
                 1990                          823,886


     After its fiscal year 1990, petitioner became an S

corporation, and thereafter for each year filed a Form 1120S,

U.S. Income Tax Return for an S Corporation.      On its Federal

income tax returns for its taxable years 1990 (short year of

August 1, 1990 through December 31, 1990), 1991, and 1992,

petitioner reported gross receipts and ordinary income as

follows:


     Year               Gross receipts      Ordinary income

     1990                 $7,643,457           $61,223
     1991                 16,664,152           525,687
     1992                 11,493,635           173,169


     Petitioner paid no dividends from the date of its inception

to the time of the trial in this case.      Petitioner's return on

equity for its fiscal years 1988 through 1990 and calendar years

1990 through 1992, computed by using as net income after taxes

amounts computed from petitioner's Federal income tax returns and

dividing that amount by shareholder equity at the beginning of

the year, is as follows:

     Tax year ended               Formula        Return on equity

     July 31, 1988              $83,399
                               $210,654                  40%
                                      -9 -

      July 31, 1989                  98,563
                                    277,762                    35

      July 31, 1990                 543,765
                                    361,229                  150

      Dec. 31, 19901                 61,2232
                                    682,819                     9

      Dec. 31, 1991                 525,6872
                                  1,241,915                    42

      Dec. 31, 1992                 173,1692
                                  1,736,516                    10

      1
          The year ended Dec. 31, 1990, was a short taxable year.
      2
         For these years, the ordinary income figures that were reported on the
Forms 1120S were used, since no tax was paid by the corporation.




      On its Federal income tax returns for its years ending July

31, 1987 through July 31, 1990, petitioner deducted officers'

compensation as follows:


Year ending         Mr. Penalba's          Mrs. Penalba's              Total
July 31             compensation           compensation             compensation

   1987               $296,500               $296,500                $593,000
   1988                220,000                105,000                 325,000
   1989                445,000                215,000                 660,000
   1990              1,342,400                407,600               1,750,000


      For its fiscal year 1990, petitioner adopted an incentive

bonus plan (the bonus plan), under which petitioner's officers

were to be paid an incentive bonus equal to 10 percent of the

gross increase in petitioner's sales for its fiscal year 1990
                                -10 -

over its gross sales for its fiscal year 1989.   The bonus plan

provided as follows:

          RESOLVED FURTHER, that the Board of Directors have
     evaluated various incentive compensation programs and have
     determined that the most appropriate method for determining
     and measuring the performance and contribution of its
     officers to this Corporation during a fiscal year is through
     the application of a fixed formula which calculates the
     incentive amount by multiplying a fixed percentage times the
     net * * * increase in gross sales volume of the Corporation
     for its current fiscal year over the immediately preceding
     fiscal year.

           RESOLVED FURTHER, that the Board of Directors of the
     Corporation have determined that the standard percentage
     within the industry in which the Corporation engages is ten
     percent (10%) and that this amount represents a fair
     incentive. As such, the Corporation shall make available
     for distribution to its officers a gross bonus pool amount
     equal to ten percent (10%) of the gross increase in sales of
     this Corporation for its fiscal year ending July 31, 1990
     over its gross sales for its fiscal year ending July 31,
     1989.

          RESOLVED FURTHER, that the gross bonus amount available
     for distribution shall be distributed to its officers not
     later than ninety (90) days following the close of its
     fiscal year. Each officer shall be entitled to receive a
     distribution from the bonus pool in an amount which equals
     the ratio of an officer's annual compensation (without
     regard to the bonus) to all officers' compensation
     multiplied against the gross bonus pool.


     Isaac Blumberg (Mr. Blumberg) was the outside accountant for

petitioner during the year at issue and for some years prior and

subsequent thereto.    Mr. Blumberg performed a number of services

for petitioner during the year at issue, including preparing

financial statements, consulting on tax issues, and performing

other tax work.   Mr. Blumberg also participated in designing the

bonus plan for the fiscal year 1990 for petitioner.   For the
                                   -11 -

calendar years 1989 and 1990, petitioner paid Mr. Blumberg fees

for his services in the amounts of $68,553.50 and $89,594.59,

respectively.

     The bonus plan was not offered to employees other than Mr.

and Mrs. Penalba.   The bonus plan was terminated in March 1991,

because it was no longer needed after petitioner became an S

corporation.

     For its fiscal year 1990, petitioner's production personnel

earned the following compensation:

Employee                   Title               Salary

Mr. Rubino            Converting supervisor-
                        yarn purchasing        $58,175
Elena Cabrera         Production supervisor-
                        dyeing and finishing
                        coordinator             26,000
Gonzalo Campos        Production clerk-
                        knitting                18,900
Juan Isidro           Production clerk-
                        yarn                    14,880
Beverly Dominguez     Production clerk-
                        data entry              15,715

     In addition to the above listed compensation, Mr. Rubino

received a company car and health insurance benefits for himself

and his family.

     Mr. Blumberg also prepared a pension plan for petitioner's

employees sometime before the fiscal year at issue (the employee

pension plan).    The plan was funded for approximately 2 years and

covered five employees.   At the request of some of the employees

covered by the plan, the employee pension plan was terminated in

1990.
                                -12 -

     Mr. and Mrs. Penalba, along with Mike Macias (Mr. Macias),

owned a knitting plant, U.S. Fabrics Corp. (U.S. Fabrics), in

1990.   Mr. and Mrs. Penalba together owned 65 percent of U.S.

Fabric.   U.S. Fabrics was an S corporation during 1990.

Approximately 40 to 50 percent of U.S. Fabrics' business was

production for petitioner.    Mrs. Penalba was involved in setting

up U.S. Fabrics in 1990, and provided some management to U.S.

Fabrics in that year.    Mrs. Penalba spent approximately 5 percent

of her time working for U.S. Fabrics.    Mr. Penalba met with Mr.

Macias at least 2 to 3 times per week and sometimes once a day.

Mrs. Penalba earned $79,938 from U.S. Fabrics during the calendar

year 1990, and Mr. Penalba earned $79,939 from U.S. Fabrics

during that year.    U.S. Fabrics had its offices in the same

building as petitioner.

     Long Beach Dyeing and Finishing (Long Beach) was a dyeing

and finishing plant owned by the Penalbas, with Rodolfo Saldias

(Mr. Saldias), who was a salesman for petitioner.

     The Penalbas owned the building in which petitioner and U.S.

Fabrics had offices, and the Penalbas leased building space to

these companies.    Petitioner paid $129,775 in rent to the

Penalbas during the calendar year 1990.    The Penalbas, along with

Mr. Blumberg, determined a fair rental for petitioner to pay the

Penalbas.

     Petitioner paid sales commissions of $578,947 during its

fiscal year 1990.    The rate of commission that petitioner paid
                               -13 -

its salespeople was between 1.5 and 4 percent of sales.    In 1990,

the top salesperson for petitioner was Mr. Saldias, who earned

$337,182.59 in commissions for the calendar year 1990.

     On July 31, 1990, Mr. Penalba loaned $689,454.42 to

petitioner, and Mrs. Penalba loaned $172,363.61 to petitioner.

Petitioner's income tax return for its fiscal year 1990 shows

that at the beginning of the year its loans from stockholders

were $822,941 and at the end of the year were $1,233,246.    Mrs.

Penalba loaned substantial sums of money to petitioner over the

years in order to establish more working capital to enable

petitioner to receive further credit from suppliers and vendors.

     On its income tax return for its fiscal year 1990,

petitioner claimed a deduction for compensation paid to Mr.

Penalba of $1,342,400 and for compensation paid to Mrs. Penalba

of $407,600.   Respondent in her notice of deficiency determined

that reasonable compensation for petitioner's officers during its

fiscal year 1990 was $875,000 and disallowed as a deduction

$875,000 of the $1,750,000 claimed by petitioner on its income

tax return for officers' compensation for that year.   Respondent

determined that reasonable compensation for Mr. Penalba for

petitioner's fiscal year 1990 was $671,200 and that reasonable

compensation for Mrs. Penalba was $203,800.   Respondent also

determined that petitioner's closing inventory for its fiscal

year 1990 was undervalued by $379,819.   At the trial, counsel for

respondent explained that part of the undervaluing of inventory
                               -14 -

was due to an increase in inventory value because of capitalizing

a portion of officers' compensation for petitioner's fiscal year

1990.   Respondent further determined that petitioner was liable

for an accuracy-related penalty pursuant to section 6662(a).

                              OPINION

     Section 162(a)(1) provides for the deduction of all the

ordinary and necessary expenses paid or incurred in the carrying

on of a trade or business, including a reasonable allowance for

compensation for personal services actually rendered.   Whether

the compensation is reasonable compensation is a question of

fact.   Estate of Wallace v. Commissioner, 95 T.C. 525, 553

(1990), affd. 965 F.2d 1038 (11th Cir. 1992).   Some of the

factors to be considered in determining the reasonableness of

compensation of an employee are:   (1) The employee's role in the

company; (2) a comparison of the employee's salary with salaries

paid by similar companies for similar services; (3) the character

and condition of the company; (4) whether the relationship

between the employee and the company is such as to permit the

company to disguise nondeductible corporate distributions of

profits as deductible compensation; and (5) the internal

inconsistency of a company's treatment of payments to employees.

Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1247 (9th

Cir. 1983), revg. and remanding T.C. Memo. 1980-282.

     The employee's role in the company requires a consideration

of the position held by the employee, the number of hours worked
                                 -15 -

by the employee, the duties that the employee performed, and the

general importance of the employee to the success of the company.

American Foundry v. Commissioner, 536 F.2d 289, 291-292 (9th Cir.

1976), affg. in part and revg. in part 59 T.C. 231 (1972).

     It is clear from the testimony in this case that both Mr.

and Mrs. Penalba worked long hours for petitioner.     The evidence

indicates that Mr. Penalba frequently worked 15- to 18-hour days,

while Mrs. Penalba worked 60 to 80 hours per week.     It is also

evident that petitioner would not have been in existence, or have

continued in existence, without the efforts of employees or

officers comparable to the Penalbas.     The Penalbas were both

extremely dedicated to their work.

     Respondent contends that the dramatic increase in gross

receipts was not solely caused by the efforts of the Penalbas,

but rather the fashion trends that had a great impact on

petitioner's business in 1990.    Respondent argues that the

increase in sales was, for the most part, a fortuitous

circumstance.

     We find that the dramatic increase in sales in 1990, while

partly due to fortuitous market circumstances, was due primarily

to the insight of Mr. Penalba in seeing the need for a

cotton/Lycra fabric and developing such a material.     Mr. Penalba

saw the need in the manufacture of leggings and other garments of

an expandable fabric and developed such a fabric before

petitioner's competitors had such a fabric available.     This to an
                                 -16 -

appreciable extent caused the increase in petitioner's sales in

1990.   Such a fabric was desirable, not simply because of

fortuitous fashion trends, but because such a fabric was useful

in a wide variety of garments.

     Respondent makes the argument that the large amount of

commissions paid by petitioner to its salespeople in 1990 creates

an inference that the efforts of the salespeople had a direct

influence on the increase in gross receipts that year.    However,

the evidence indicates that petitioner's salesmen received no

greater percentage commission that year than in previous years.

Therefore, this evidence does not indicate that the efforts of

the salespeople were entirely responsible for the dramatic

increase in sales.   The evidence indicates that the sales staff

earned large commissions at least in part because of the

desirability of the product petitioner produced during the year

at issue.

     The second factor listed above is salaries paid by similar

companies for similar services.     Each party offered testimony of

an expert with respect to this factor.

     Respondent's witness, E. James Brennan III (Mr. Brennan),

the president of a personnel and pay practice consulting firm,

testified that the salaries of the Penalbas were unreasonable.

He relied on information from other firms the same size in sales

as petitioner.   Mr. Brennan concluded that the CEO function

should be used to compare to Mr. Penalba's salary, while the top
                               -17 -

financial executive should be used to compare with Mrs. Penalba's

salary.   Mr. Brennan described the CEO as "the highest paid

position found among survey data", while the top financial

executive was the officer "responsible for the organization's

overall financial plans and policies, along with its accounting

activities and the conduct of its relationship with lending

institutions, shareholders, and the financial community".

     Mr. Brennan's calculations were based primarily on data from

the Executive Compensation Service (ECS).   Mr. Brennan's report

stated that the total compensation figures were based on the

highest amounts from the non-manufacturing and wholesale

categories, and included both salary and bonus amounts.    If the

survey for non-manufacturing companies yielded a higher pay

amount than the survey for the wholesale industry, Mr. Brennan

used the higher number.   Mr. Brennan determined what the average

compensation for each job was from the ECS survey and then took

two standard deviations to arrive at his highest maximum amounts.

     We find no evidence that Mr. Brennan's conclusions are based

on companies comparable to petitioner.   Mr. Brennan's figures,

taken from ECS statistics, are based on broad, general categories

of industries, and not on businesses that are similar to the

business of petitioner in this case.   Mr. Brennan based his

calculations on the wholesale industry and used the ECS

statistics for companies with a Standard Industrial

Classification (SIC) code for a trader in "nondurables, apparel,
                                -18 -

piece goods, and notions".    However, Mr. Brennan testified that

he was unable to state the industry petitioner was in, and was

unsure whether petitioner was, in fact, in either the wholesale

or the non-manufacturing industry.      Mr. Brennan stated that he

had little, if any, knowledge of petitioner's operations, and

that there was no evidence that his statistics included any other

converting operations comparable to petitioner's.      In fact,

petitioner in this case was not a wholesale operation, but rather

a manufacturing operation with its work contracted out to other

companies.    Petitioner produced knitted fabric for garment

manufacturers, and was not included in the SIC code that Mr.

Brennan relied on, which specifically excluded knitted goods

operations.    Petitioner was properly included in the SIC code for

manufacturers.    The statistics that Mr. Brennan used from the

Conference Board data, another survey he relied on in his report,

are based on companies, all of which had annual sales of at least

$60 million, while petitioner had sales of approximately $22

million in the year here in issue.      The median average company in

the ECS survey had sales of $1.7 billion, while only four

companies in the survey had sales of less than $199 million.

     Even though Mr. Brennan categorized Mr. Penalba as the chief

executive officer and Mrs. Penalba as the top financial

executive, he had no information as to what duties each of the

Penalbas actually performed for petitioner.      From the job

descriptions in Mr. Brennan's report, it is clear that Mr.
                                 -19 -

Brennan's comparables are based on occupations for much larger

companies that have more specialized officers.    The Penalbas'

duties were not accurately described by Mr. Brennan's

descriptions of chief executive officer and top financial

executive.    In effect, Mr. Brennan's statistics merely determined

who were the highest paid individuals for the wholesale trade

industry for the top executive officer and the top financial

officer nationwide without regard to the particular aspects of

petitioner's industry.   We find no evidence that Mr. Brennan's

report includes any businesses comparable to petitioner.

     Petitioner had two witnesses testify as to reasonable

compensation for the Penalbas.    Edward Dubner (Mr. Dubner)

testified on behalf of petitioner with regard to the Penalbas'

compensation.   Mr. Dubner was a credit manager for two factoring

companies during 1989 and 1990, that did business with

petitioner.   In the garment industry, a factoring company

purchases receivables or lends money against those receivables.

A factor's interest in reviewing officers' compensation is to

determine if the business is capable of functioning on a day-to-

day basis and paying its bills on time.    In August 1990, Mr.

Blumberg consulted with Mr. Dubner about the amount petitioner

was proposing to pay as officers' compensation.    Mr. Dubner did

not object to the 1990 compensation because the Penalbas loaned

back a substantial portion of their 1990 compensation to

petitioner, and subordinated those loans to the loans of other
                                -20 -

creditors.   Mr. Dubner's interest was not in the reasonableness

of salaries paid to officers, but rather the capital of the

company.   Mr. Dubner's testimony, therefore, is of little, if

any, value on the issue of reasonable compensation.    His interest

was solely whether the 1990 officers' compensation paid by

petitioner would adversely affect petitioner's ability to pay its

bills.

     Petitioner's accountant, Mr. Blumberg, was called as a

witness by petitioner to testify as to the reasonableness of the

Penalbas' compensation.   The Court ruled that consideration of

Mr. Blumberg's testimony would be limited to the financial data

he had prepared.   Mr. Blumberg utilized the Robert Morris

Associates 1990 Annual Statement Studies (RMA).    The RMA is

heavily relied on by credit managers and officers at banks,

factors, and trade creditors.   The RMA lists comparables by their

Standard Industrial Classification (SIC) code.    Mr. Blumberg

utilized the SIC code 2257, which includes operations that are

"establishments primarily engaged in knitting weft (circular)

fabrics or in dyeing, or finishing weft (circular) knit fabrics."

This definition includes converting operations.    Mr. Blumberg

determined that it was inappropriate to classify petitioner as an

apparel maker, fabric producer, or distributor, because these

operations produce woven fabrics that are rarely produced in the

U.S. and are generally produced on a much greater scale than knit

fabrics.   In comparison with woven fabric operations, operations
                                -21 -

that manufacture knitted fabric require less capital investment,

yet the personal vision and talent of management is more

important.   Mr. Blumberg concluded that the knit goods industry

is dominated by small-scale entrepreneurs who are successful if

they are able to anticipate fashion trends and quickly produce

goods to meet emerging demands.

     In comparison with the data provided by the RMA, Mr.

Blumberg determined that petitioner had greater gross profit,

return on owner's equity based on profit before taxes (by a

factor of 1,300 percent), and return on total assets (by a factor

of 562 percent) than the RMA reported data.

     Mr. Blumberg also provided two comparables from clients from

his accounting practice in the southern California area.

However, when Mr. Blumberg refused to supply the names or any

information about the business of these clients, the Court stated

that this evidence would not be considered, since respondent had

no way of verifying the data.   Mr. Blumberg had few

qualifications as an expert on reasonable salaries.    Mr. Blumberg

has had a close association with petitioner for a number of

years.   Mr. Blumberg served as petitioner's accountant during the

year at issue and for a number of other years.   While Mr.

Blumberg had a few college courses that dealt with reasonable

salaries for corporate officers, he had no history of recognized

expertise in compensation matters.
                               -22 -

     The RMA study that Mr. Blumberg relied on was a collection

from lending institutions that came from bank and creditor loan

records.   It was not designed to be used as a survey of

compensation.   An important weakness of the RMA study is that it

supplies the amount of total officers' compensation, but does not

supply information regarding the number of officers or their

duties.

     The testimony of none of the witnesses in this case offered

as experts is helpful in resolving the issue of the

reasonableness of salaries paid by petitioner.

     While the record contains some evidence of the character and

condition of petitioner during the year here in issue, there is

little in the record to show the complexities of petitioner's

business as compared to other companies.   There is evidence that

in the year here in issue petitioner's sales and profits

increased dramatically, but that this situation did not carry

over to later years.

     Finally, it is clear that petitioner's sole shareholders

were in a position to determine the amount of their compensation

without reference to the amount which would be paid for similar

work in an arm's-length transaction.   See Spicer Accounting, Inc.

v. United States, 918 F.2d 90, 92 (9th Cir. 1990); Nor-Cal

Adjusters v. Commissioner, 503 F.2d 359 (9th Cir. 1974), affg.

T.C. Memo. 1971-200.
                               -23 -

     Petitioner never paid dividends from the date of its

inception through the years at issue.   Mr. Blumberg testified

that petitioner did not pay dividends because petitioner was a

growth company.   According to Mr. Blumberg, growth companies

generally do not pay dividends because they are not attempting to

strengthen their stock values or attract new stockholders but

rather growth companies are desirous of retaining capital.    In

Elliotts, Inc. v. Commissioner, 716 F.2d at 1247, the Court of

Appeals stated:

     If the bulk of the corporation's earnings are being
     paid out in the form of compensation, so that the
     corporate profits, after payment of the compensation,
     do not represent a reasonable return on the
     shareholder's equity in the corporation, then an
     independent shareholder would probably not approve of
     the compensation arrangement. If, however, that is not
     the case and the company's earnings on equity remain at
     a level that would satisfy an independent investor,
     there is a strong indication that management is
     providing compensable services and that profits are not
     being siphoned out of the company disguised as salary.
     [Fn. ref. omitted.]

     Petitioner's return on equity, calculated as net income

after taxes per petitioner's Federal income tax returns, divided

by shareholder equity at the beginning of the year, was 150

percent for the year at issue, while for the 2 previous fiscal

years, petitioner's return on equity was 45 and 50 percent,

respectively.   Respondent does not dispute that the return on

equity for 1990 was "excellent", but argues that the return on

equity from the taxable year ended July 31, 1988, to the taxable

year ended December 31, 1992, was not as impressive.   While the
                               -24 -

return on equity for years not at issue in this case is less

relevant than the return on equity for the year that is before

us, the evidence in the record indicates that except for the

short taxable year 1990, where the return on equity would be

skewed in favor of a low return, the return on equity for the

years shortly after the year at issue were very good as well.    We

find that petitioner maintained a high return on equity.

However, petitioner's capital also included borrowed capital.

This borrowed capital was from loans made to petitioner by the

Penalbas, apparently from the large salaries they were paid.    In

this situation, the return on equity is of limited importance.

     Also, the high return on equity does not mean that an

unrelated stockholder would be willing to have nearly twice the

amount paid by petitioner as officers' salaries as its remaining

total income, if equally competent officers were available for

more reasonable amounts of compensation.

     One factor to be considered is whether the compensation at

issue was paid pursuant to a structured, formal, and consistently

applied program.

     The record indicates that the bonuses paid to the Penalbas

were not based on the bonus plan entered for its fiscal year

1990.   Since petitioner did not file a brief in this case, we are

not privy to its position on this issue.   Petitioner's accountant

testified that the bonuses that petitioner paid to the Penalbas

complied with the terms of the bonus plan.   This is contradictory
                               -25 -

to the direct terms of the bonus plan.   The bonus plan provided

that the officers were to be paid a bonus equal to 10 percent of

the gross increase in sales of petitioner for the fiscal year

1990 over its gross sales for its fiscal year 1989.   Under the

bonus plan, the total bonuses paid to all officers from the bonus

pool would have been $1,068,858.   The bonus plan clearly provided

that the bonuses were to be paid in an amount equal to the ratio

of an officer's annual compensation to that of all officers

applied to the gross bonus pool.   The record is unclear as to the

amount the Penalbas received in base salary for petitioner's

fiscal year 1990.   However, the evidence indicates that the

Penalbas' base salaries were approximately equal if not

identical.   Mrs. Penalba testified that her salary, which was the

same as Mr. Penalba's for the year here in issue, was

approximately $125,000.   Mr. Blumberg implied that the Penalbas'

base compensation in petitioner's fiscal year 1990 was $682,000.

Since under the bonus plan Mr. and Mrs. Penalba were to have been

paid in the same proportion as their base salary, we conclude

that the bonuses paid for the year at issue were not paid

pursuant to a structured, formal, and consistently applied

program.   Also, the total amount of the bonuses appears to have

been improperly computed.

     Respondent contends that neither Mr. nor Mrs. Penalba needed

an incentive to work harder since they owned the business.     Both

Mr. and Mrs. Penalba testified that they gave their full efforts
                               -26 -

to the business, and that they did not need an incentive plan to

perform well.

     Mr. Penalba testified that he assisted in development of the

plan and thought that it was adequate to maintain the performance

of the company.   Mr. Penalba did not know how it was calculated,

nor did he know the specifics of the plan.   Based on the record

in this case, it is clear that the plan was not the major

incentive for the work output of either Mr. or Mrs. Penalba

during the year at issue.

     It is also clear from the record that petitioner paid its

other employees at least on par with, if not slightly better

than, other companies in the industry.   Mr. Rubino, the

production manager for petitioner during the year at issue, and a

salesman for petitioner at the time of trial, and the only

employee of petitioner other than the Penalbas to testify in this

case, received a salary of $58,175, along with a company car,

certain other bonuses, and health care for his family.     Mr.

Rubino testified that he was better paid than others at the same

level in the industry.   The record also indicates that petitioner

paid its salesmen, who served as either independent contractors

or employees, well, during the year at issue.   The only evidence

as to the compensation of the other employees of petitioner is

their respective salaries.   Petitioner did not provide a pension

plan for its employees during the year at issue, but the evidence

indicates that it was other employees of petitioner and not the
                               -27 -

Penalbas who requested that the pension plan be terminated,

because the employees desired control over how to invest the

proceeds.   Although petitioner paid its employees other than the

Penalbas well, the divergence in their pay and the pay of the

Penalbas is striking.   Petitioner's highest paid salesman earned

$337,182.59 in petitioner's fiscal year 1990, as compared to

$1,342,400 paid to Mr. Penalba.   It should also be noted that

each of the Penalbas devoted some time to another corporation in

which they were stockholders and were compensated for that work

as employees.

     Based on all of these factors, we conclude that, although

there has been no showing that the compensation allowed by

respondent for Mr. Penalba is not reasonable for Mr. Penalba's

normal duties as petitioner's CEO, Mr. Penalba, in addition, is

entitled to substantial compensation during the year at issue for

his development of the cotton/Lycra fabric that was largely

responsible for petitioner's increased sales in that year.

     Respondent argues on brief that it is not appropriate to

determine a reasonable salary for Mr. Penalba's services to

petitioner by separately considering all the various "jobs" he

did and determining a reasonable amount for each.   However, this

Court and other courts have in numerous cases considered the

reasonableness of compensation based on the fact that the

recipient performed more than one function for his employer, even

though it may not be the sum of the amounts which would be paid
                                 -28 -

to a full-time employee in each such position that determines a

reasonable salary for one employee performing many functions.

     Mr. Penalba's duties as production manager and sales manager

were comparable to the CEO position in other operations.    We find

no information in this record as to companies comparable to

petitioner, and, based on this record, hold a reasonable salary

for Mr. Penalba as petitioner's CEO is $671,200 as determined in

the notice of deficiency.   This amount is comparable to the

maximum amounts paid to CEOs of other companies for which

statistics are in this record.    We consider the $671,200 as

reasonable compensation for Mr. Penalba, solely for his work as

CEO of petitioner in its fiscal year 1990.

     This record shows that Mr. Penalba, in addition to being

petitioner's CEO, was also the developer of the process for

manufacturing the cotton/Lycra fabric, which development was

responsible in large part for petitioner's increase in sales for

the year here in issue.   In our view, in an arm's-length

arrangement, Mr. Penalba would have been compensated for his work

in the development of the cotton/Lycra fabric with a percent of

the sales of the cotton/Lycra fabric, in addition to his

compensation as petitioner's CEO.

     Since the sales of cotton/Lycra fabric are not shown

separately in the record, we shall assume that the increase in

petitioner's sales in its fiscal year 1990, over its fiscal year

1989, were due primarily to sales of cotton/Lycra fabric.    There
                                -29 -

is nothing in this record to show directly    the percent of sales

of the cotton/Lycra fabric that Mr. Penalba would have received

in an arm's-length transaction because he was the developer of

the fabric.   However, some of petitioner's salesmen were paid a

commission of 4 percent for their selling activities.    Based on

this fact, we conclude that in an arm's-length transaction

petitioner would have paid Mr. Penalba approximately 4 percent of

the sales of cotton/Lycra fabric in its fiscal year 1990, and

hold that this amount would be $400,000.    We, therefore, hold

that total reasonable compensation to Mr. Penalba by petitioner

in its fiscal year 1990 is $1,071,200.

     The record shows that Mrs. Penalba worked 60 to 80 hours a

week, but does not show any other extraordinary contribution she

made to petitioner.   In fact, from her testimony it appears that

she was not knowledgeable with respect to some of petitioner's

activities about which a chief financial officer would be

expected to be knowledgeable.    There is nothing in this record to

indicate that reasonable compensation for Mrs. Penalba would be

in excess of the amount determined by respondent, except the

testimony of respondent's expert witness that reasonable

compensation for Mrs. Penalba was $209,520 for petitioner's

fiscal year 1990.   For reasons heretofore stated, we do not

accept the opinion of respondent's expert because of its being

based on noncomparable data.    However, we shall accept the

$209,520 as reasonable compensation for Mrs. Penalba's services
                               -30 -

to petitioner in petitioner's fiscal year 1990, as in effect a

concession by respondent of this amount, which is a little over

$6,000 in excess of the amount determined by respondent in the

notice of deficiency.

     The next issue is to what extent, if any, the officers'

compensation paid by petitioner for its fiscal year 1990 should

be allocated to mixed service costs and capitalized pursuant to

section 263A.   Although the deficiency notice merely determined

an increase in petitioner's ending inventory, respondent at trial

explained that this was due in part to capitalization under

section 263A of officers' salaries paid for production

activities.3




     3
        In Hamilton Indus., Inc. v. Commissioner, 97 T.C. 120,
143 n.10 (1991), which involved an inventory valuation issue, we
pointed out that:

          For tax years beginning after Dec. 31, 1986, the full
     absorption rules were replaced by the uniform capitalization
     rules of sec. 263A, added to the Code by The Tax Reform Act
     of 1986, supra, which expanded the types of indirect costs
     required to be treated as inventory costs. See S. Rept.
     99-313, 1986-3 C.B. (Vol. 3) 1, 133-152.
                            -31 -

Section 263A4 generally requires the capitalization of


4
    SEC. 263A.   CAPITALIZATION AND INCLUSION OF INVENTORY
                 COSTS OF CERTAIN EXPENSES.

      (a) Nondeductibility of Certain Direct and Indirect
           Costs.--

          (1) In general.--In the case of any property to
which this section applies, any costs described in paragraph
(2)--

                 (A)   in the case of property which is   inven
                                                          tory
                                                          in
                                                          the
                                                          hands
                                                          of
                                                          the
                                                          taxpa
                                                          yer,
                                                          shall
                                                          be
                                                          inclu
                                                          ded
                                                          in
                                                          inven
                                                          tory
                                                          costs
                                                          , and

                (B) in the case of any other property, shall
           be capitalized.

           (2) Allocable costs.--The costs described in this
      paragraph with respect to any property are--

                 (A) the direct costs of such property, and

                (B) such property's proper share of those
      indirect costs (including taxes) part or all of which
      are allocable to such property.

      Any cost which (but for this subsection) could not be
      taken into account in computing taxable income for any
      taxable year shall not be treated as a cost described
      in this paragraph.
                                -32 -

direct and indirect costs (including taxes) properly allocable to

real and tangible property produced by a taxpayer.     "Produced

property" includes both property that is sold to customers

(inventory) and property that is used in a taxpayer's trade or

business (self-constructed assets).     Sec. 263A(g)(1).   Section

1.263A-1T(b), Temporary Income Tax Regs., 52 Fed. Reg. 10061-

10062 (Mar. 30, 1987), provides that direct material and labor

costs must be capitalized with respect to production activities.

Further, all indirect costs that directly benefit or are incurred

by reason of the performance of a production activity must be

capitalized.    Sec. 1.263A-1T(b)(2)(ii), Temporary Income Tax

Regs., 52 Fed. Reg. 10062 (Mar. 30, 1987).     Property produced for

the taxpayer under a contract with another is treated as property

produced by the taxpayer to the extent that the taxpayer makes

payments or otherwise incurs costs with respect to such property.

Sec. 1.263A-1T(a)(5)(ii), Temporary Income Tax Regs., 52 Fed.

Reg. 10061 (Mar. 30, 1987).

     "Direct material costs" include the cost of those materials

that become an integral part of the subject matter and the cost

of those materials that are consumed in the ordinary course of

the activity.    "Direct labor costs" include the cost of labor

which can be identified or associated with a particular activity.

Sec. 1.263A-1T(b)(2), Temporary Income Tax Regs., 52 Fed. Reg.

10062 (Mar. 30, 1987).    "Indirect costs" include those costs that

directly benefit or are incurred by reason of the performance of
                               -33 -

a production activity.   Sec. 1.263A-1T(b)(2)(ii), Temporary

Income Tax Regs., 52 Fed. Reg. 10062 (Mar. 30, 1987).

Compensation paid to officers attributable to services performed

in connection with particular production activities is an example

of an indirect cost that must be capitalized.   Sec. 1.263A-

1T(b)(2)(iii)(N), Temporary Income Tax Regs., 52 Fed. Reg. 10062

(Mar. 30, 1987).   Marketing, selling, advertising, and

distribution expenses, including compensation of officers

attributable to services performed in connection with the cost of

selling, are not required to be capitalized under section 263A.

Sec. 1.263A-1T(b)(2)(iii)(N), supra; sec. 1.263A-1T(b)(2)(v)(A),

Temporary Income Tax Regs., 52 Fed. Reg. 10066 (Mar. 30, 1987).

     The record is unclear as to Mrs. Penalba's role in the

production aspect of petitioner's operations.   However, under

section 263A(g) development of a product is included in the

definition of production.   Mrs. Penalba testified that both she

and Mr. Penalba were involved in purchasing raw materials for

petitioner.   Mrs. Penalba also testified that she worked a great

deal with Mr. Penalba in product development.   This testimony was

somewhat inconsistent with the testimony of Mr. Rubino,

petitioner's production manager during the year at issue, who

testified that he did not work with Mrs. Penalba in production,

and that her role in the company was strictly dealing with

finances.   While Mrs. Penalba may have had authority over
                                -34 -

production in Mr. Penalba's absence, she was seldom involved in

the day-to-day production operations.

     It is clear from the record that Mr. Penalba was very

involved in production, and that production was vital to

petitioner's business.   Mr. Penalba was responsible for both

production and sales of the fabric.     Mr. Penalba not only

developed the fabrics petitioner produced, but also supervised

the production of the fabrics from the factories with which

petitioner had contracts.    While Mr. Penalba was intimately

involved in production, he was also responsible for sales,

including recruiting and training salesmen, customer service, and

frequently meeting with customers and the salesmen.

     Respondent has submitted that 75 percent of Mr. Penalba's

compensation is subject to the capitalization requirement of

section 263A, while 50 percent of Mrs. Penalba's compensation is

subject to section 263A.    It appears from the record that Mr.

Penalba's compensation was due substantially to his production

services for petitioner.    We have concluded that $400,000 was

reasonable compensation to Mr. Penalba in petitioner's fiscal

year 1990 for development of the cotton/Lycra fabric, which is

part of production.   Sec. 263A(g)(1).    Certainly, petitioner has

not shown that the compensation of Mr. Penalba was not primarily

for his production duties.    We hold that 75 percent of Mr.

Penalba's compensation was for his production duties.
                                -35 -

     Based on the record, we find that the amount of Mrs.

Penalba's compensation attributable to production was de minimis.

We, therefore, conclude that 75 percent of the amount of

reasonable compensation we have determined for Mr. Penalba is

subject to the provisions of section 263A, but that none of Mrs.

Penalba's compensation is subject to the provisions of section

263A.

     The final issue is whether petitioner is liable for an

accuracy-related penalty pursuant to section 6662(a).   Section

6662(a) imposes an accuracy-related penalty of 20 percent on any

portion of an underpayment of tax which is attributable to items

set forth in section 6662(b).   Respondent contends that either

negligence or substantial understatement of tax applies in the

instant case under section 6662(b)(1) and (2).

     Negligence includes any careless, reckless, or intentional

disregard of rules and regulations, any failure to make a

reasonable attempt to comply with the provisions of the law, and

any failure to exercise ordinary and reasonable care in the

preparation of a tax return.    Zmuda v. Commissioner, 731 F.2d

1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982).

     Section 6662(b)(2) specifies as one of those items "Any

substantial understatement of income tax".   An understatement is

substantial if it exceeds the greater of 10 percent of the tax

required to be shown on the return, or, for a corporation,

$10,000.
                                 -36 -

     Section 6662(d)(2)(B) states that the amount of the

understatement shall be reduced by the portion of the

understatement which is attributable to the tax treatment of any

item if there is or was substantial authority for such treatment

or if the relevant facts affecting the item's tax treatment are

adequately disclosed on the return or in a statement attached to

the return and there is a reasonable basis for the tax treatment

of such item.    To determine whether the treatment of any portion

of an understatement is supported by substantial authority, the

weight of authorities in support of the taxpayer's position must

be substantial in relation to the weight of authorities

supporting contrary positions.     Antonides v. Commissioner, 91

T.C. 686, 702-703 (1988), affd. 893 F.2d 656 (4th Cir. 1990).

     Section 6664(c)(1) provides that the penalty should not be

imposed on any portion of an underpayment if the taxpayer shows

reasonable cause for such portion of the underpayment and that

the taxpayer acted in good faith with respect to such portion.

Reliance on the advice of a professional, such as an accountant,

may constitute a showing of reasonable cause if, under all the

circumstances, such reliance is reasonable and the taxpayer acted

in good faith.   Sec. 1.6661-6(b), Income Tax Regs.

     We hold that petitioner acted with reasonable cause.     Mr.

and Mrs. Penalba relied on the advice of their accountant, Mr.

Blumberg, both in determining the salaries for the year at issue

and establishing the bonus plan.     Mr. Blumberg was under the
                              -37 -

impression that the salaries conformed with the bonus plan, as

evidenced by his testimony in this case.    Petitioner,

undoubtedly, reasonably relied on Mr. Blumberg's advice when it

determined the appropriate compensation for the Penalbas, and,

therefore, acted with reasonable cause and with good faith.



                                           Decision will be entered

                                      under Rule 155.
