                  T.C. Memo. 2001-81



                UNITED STATES TAX COURT



  PEDIATRIC SURGICAL ASSOCIATES, P.C., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 12743-98.                      Filed April 2, 2001.



     P is a personal service corporation in the
business of providing pediatric surgical services. It
employs both shareholder surgeons and nonshareholder
surgeons to perform such services. For the years in
issue, the shareholder surgeons received a fixed
monthly salary plus monthly bonuses consisting of
available cash less amounts needed to pay P’s near-term
expenses. The nonshareholder surgeons received only a
fixed monthly salary. P deducted the amounts paid to
the shareholder surgeons as “officers compensation”.

     R disallowed a portion of such deductions on the
ground that a portion of the amounts paid to the
shareholder surgeons was a dividend rather than
officers’ compensation. R also determined that P was
subject to a sec. 6662, I.R.C., accuracy-related
penalty for each of the years in question. Ultimately,
R sharply reduced his proposed deficiencies to amounts
determined to represent P’s profits attributable to
services rendered by the nonshareholder surgeons. P
                                 - 2 -

     claims that R’s revised deficiency determinations
     constitute the raising of “new matters” with respect to
     which R bears the burden of proof.
          1. Held: R has not raised new matters, and,
     therefore, the burden of proof remains with P.
          2. Held, further, R’s disallowance of a portion
     of P’s deductions for shareholder compensation is
     sustained in part.
          3. Held, further, the penalties are sustained.



     Robyn A. Frohlin, for petitioner.

     James R. Turton, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     HALPERN, Judge:     By notice of deficiency dated June 25, 1998

(the notice), respondent determined deficiencies in petitioner’s

Federal income tax and accuracy-related penalties as follows:

       Tax Year Ending                      Sec. 6662(a)
         December 31        Deficiency        Penalty
            1994             $206,455         $41,291
            1995              287,606          57,521

     The principal adjustments giving rise to those deficiencies

(the principal adjustments) are respondent’s disallowance for

each year of a portion of the deduction claimed by petitioner for

compensation paid for services.    The amounts disallowed

(disallowed amounts) are $598,710 and $805,469, for 1994 and
                                - 3 -

1995, respectively (the audit years).1   On brief, respondent

concedes the deductibility of all but $140,776 and $19,450 of the

disallowed amounts.    We accept such concession, and, thus, with

respect to the principal adjustments, we need decide only the

deductibility of such remaining amounts for the audit years.

     Petitioner also argues that, because respondent’s rationale

with respect to the principal adjustments changed subsequent to

the notice, respondent has raised a “new matter” with respect to

the principal adjustments, with respect to which respondent bears

the burden of proof.

     Finally, we must also decide whether petitioner is liable

for the accuracy-related penalties determined under section

6662(a).

     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.

                          FINDINGS OF FACT

     Some facts have been stipulated and are so found.   The

stipulation of facts, with attached exhibits, is incorporated

herein by this reference.


     1
        The deficiencies also reflect adjustments to petitioner’s
deductions for FICA taxes and charitable contributions, which are
derivative of the principal adjustments and are not directly
disputed by petitioner. We do not further discuss those
adjustments.
                                 - 4 -

Petitioner

     Petitioner, a Texas corporation, was organized in 1976 by

Drs. Richard Ellis and Charles M. Mann, Jr.    It is a personal

service corporation.    It provides pediatric surgical services in

the area of Fort Worth, Texas.    Pediatric surgery is a surgical

subspecialty limited to surgical procedures on infants and

children.    During the audit years, petitioner employed

approximately 20 individuals, including six pediatric surgeons.

During those years, it maintained three offices.

     Petitioner’s patient base consists, primarily, of patients

referred to petitioner by pediatricians.   Petitioner’s employee

surgeons perform almost all of their surgery at Cook Children’s

Medical Center (the hospital), in Fort Worth, Texas.    Petitioner

also has an arrangement with the hospital to provide on-call

surgical services in the hospital’s emergency room.

     Petitioner’s business is the only pediatric surgical

business in the Fort Worth, Texas, area.

     Petitioner computes taxable income under the cash receipts

and disbursements method of accounting.

     Petitioner has never declared a dividend.

Shareholder Surgeons

     During the audit years, the shares of stock of petitioner

were owned exclusively by individuals who were also employed by

petitioner as surgeons.    From January 1, 1994, through June 30,
                                - 5 -

1995, those individuals were:   Drs. Ellis, Mann, James P. Miller,

and Timothy L. Black (collectively, the shareholder surgeons).

On June 30, 1995, Dr. Ellis ceased to be a shareholder, and, from

July 1, 1995, to December 31, 1995, petitioner was owned equally

by the three remaining shareholder surgeons.

     Drs. Mann, Miller, and Black were employees of petitioner

for all of 1994 and 1995.   Dr. Ellis was an employee of

petitioner for all of 1994 and until June 30, 1995.

Shareholder Surgeon Employment Contracts

     With respect to their relative periods of employment during

the audit years, the shareholder surgeons were all employed by

petitioner pursuant to agreements containing similar terms

(sometimes, the shareholder employment agreements).   Among other

things, the shareholder employment agreements provide:     The

relationship between petitioner and the shareholder surgeon

“shall be that of an employer and an employee”.   The agreement is

to continue from year to year if such is mutually agreeable to

the shareholder surgeon and the board of directors of petitioner

(the board).   The shareholder surgeon “is employed to engage

exclusively, and actively in the practice of medicine on behalf

of the Association.”   The shareholder surgeon “shall devote full

time and attention to rendering professional services on behalf

of the Association and in furtherance of its best interests”.

The shareholder surgeon has, however, the option of working less
                                 - 6 -

than full time, but not less than 6 months a year.    Without

permission, he is prohibited from practicing medicine except as

an employee of the corporation.    Petitioner has the power to

determine both the specific duties performed by the shareholder

surgeon and the means and manner of performing those duties.

Petitioner has the power to determine the assignment of patients

to the shareholder surgeon.   “All fees, compensation, and other

things of value, charged by the Association and received or

realized as a result of the rendition of services by * * * [the

shareholder surgeon] shall belong to and be paid and delivered

forthwith to the Association.”    Base compensation is $16,500 a

month.   The shareholder surgeon “may be paid cash bonuses in such

amounts and at such times and on such basis as the Board of

Directors may from time to time, in its absolute discretion,

determine.”   For less than full-time shareholder employees, base

compensation and bonuses “shall be reduced to equal a percent,

the numerator being the minimum number of months per twelve-month

period set forth in such notice [of intent to work less than full

time] and the denominator being twelve months.”

     The shareholder employment agreements with respect to

Drs. Miller and Black (but not Drs. Ellis and Mann) provide that,

if the shareholder surgeon’s employment terminates prior to July

1, 1996, and he continues either the practice of medicine, or to
                               - 7 -

have hospital privileges, in Tarrant County, Texas, he must pay

petitioner $5,000 a month until 96 months have passed.

Cash Bonuses

     In the middle of each month, petitioner would determine the

amount remaining in its bank account and the amount of cash

necessary to meet anticipated cash-flow needs for the immediate

and near future.   The balance in the account, if any, was paid

out, in equal amounts, as bonuses to the shareholder surgeons,

pursuant to the shareholder employment agreements.

Audit Year Compensation of Shareholder Surgeons

     On petitioner’s U.S. Corporation Income Tax Returns,

Forms 1120 (Forms 1120), for the audit years, petitioner deducted

compensation paid to shareholder surgeons under the heading

“Compensation of officers”, in the following amounts:

                               1994             1995
          Dr.   Ellis        $239,866         $172,896
          Dr.   Mann          347,968          452,969
          Dr.   Miller        355,391          450,485
          Dr.   Black         357,006          451,775
                 Total      1,300,231        1,528,125

     All such payments were subjected to appropriate wage

withholding and were reported on Forms W-2, Wage and Tax

Statements, issued by petitioner to the shareholder surgeons.

Nature of Petitioner’s Income From Shareholder Surgeons

     All of the income received by petitioner on account of the

employment of the shareholder surgeons was received on account of

the provision of medical services by those shareholder surgeons.
                                - 8 -

Nonshareholder Surgeons

     Petitioner also employs nonshareholder surgeons.    Typically,

a nonshareholder surgeon is hired for a period of 2 years.

During that 2-year period, a nonshareholder surgeon is expected

to obtain his certification as a pediatric surgeon, meet members

of the medical community, and become part of the established

referral network.   At the end of the 2-year period, a

nonshareholder surgeon may purchase from the existing shareholder

surgeons an equal interest in the shares of petitioner and, thus,

become a shareholder surgeon.   Both Drs. Miller and Black

followed that path to becoming shareholder surgeons.

     During the audit years, petitioner employed two surgeons who

were not shareholders:    Dr. Charles Snyder, from July 15, 1992,

until July 14, 1994, and Dr. Glaze Vaughan, from July 1, 1995,

until June 30, 1997 (collectively, the nonshareholder surgeons).

Dr. Vaughan, but not Dr. Snyder, became a shareholder surgeon at

the end of the period described.

     The employment of the nonshareholder surgeons was governed

by employment agreements with similar terms (the nonshareholder

employment agreements).   Among those terms are the following:

The term of the agreement is 2 years, but shall continue on a

year-to-year basis if the board agrees to accept the

nonshareholder surgeon as a partner.    The monthly salary of each

(for the term) is fixed, $12,000 for Dr. Snyder and $12,500 for
                                - 9 -

Dr. Vaughan.   No bonuses are payable.   Each is to engage in the

practice of medicine on behalf of, and exclusively for,

petitioner, in furtherance of its best interests.   Petitioner is

to furnish each with an office, stenographic help, supplies,

equipment and other facilities and services adequate for the

performance of duty.   At the conclusion of the 2-year employment

period, each has the option to purchase shares in the corporation

at a price based on accounts receivables and the fair market

value of petitioner’s assets.

     Each of the nonshareholder employment agreements has a

noncompete clause:   With respect to Dr. Snyder, for an 8-year

period beginning on the effective date of his employment, if his

employment terminated for any reason other than death or

disability, and if he continues either the practice of medicine,

or to have hospital privileges, in Tarrant County, Texas, he is

obligated to pay petitioner $6,000 a month until 96 months have

passed.   Dr. Vaughan is similarly restricted, except the term of

his restriction is 3 years, and the monthly penalty is $8,000.

     For 1994, Dr. Snyder received a salary of $72,000, and, for

1995, Dr. Vaughan received a salary of $76,061.   Petitioner

incurred expenses in connection with the employment of the

nonshareholder surgeons during the audit year.

     The nonshareholder surgeons had no significant duties with

respect to the administration of petitioner.
                              - 10 -

Other Staff

     Petitioner employs individuals who are not surgeons.

During the audit years, petitioner had 12 to 14 employees on its

office staff.

Fee Schedule

     Petitioner established a schedule of fees for the services

provided by its surgeon employees (the fee schedule).   The term

“gross billing” refers to the practice of billing for services

according to the fee schedule.   Normally, petitioner did not

engage in gross billing.   The term “net billing” refers to the

practice, generally engaged in by petitioner, of billing only a

negotiated percentage of the amount found on the fee schedule.

Such negotiations were carried out, for instance, with third-

party payers, such as health maintenance organizations.   The term

“collections” refers to the amount, less than 100 percent,

actually collected by petitioner with respect to billings.

Collections

     For 1994, there are no reliable records of collections

attributable to specific surgeon employees of petitioner’s.     For

1995, collections attributable to each of petitioner’s surgeon

employees were as follows:2




     2
        Even though Dr. Snyder left petitioner in July 1994,
petitioner’s records indicate that there were collections
attributable to his services through 1997.
                                 - 11 -

                 Dr.   Ellis      $351,120.98
                 Dr.   Mann        519,396.47
                 Dr.   Black       592,821.01
                 Dr.   Miller      772,752.38
                 Dr.   Vaughan     125,467.35
                 Dr.   Snyder        4,338.96

Taxable Income

       For 1994, on gross receipts of $2,080,008, petitioner

reported taxable income of $29,255.        For 1995, on gross receipts

of $2,405,718, petitioner reported taxable income of $49,323.

       On its Forms 1120 for the audit years, petitioner reported

the following deductions (other than compensation of officers):

                                            1994          1995
       Salaries and wages                 $233,403      $273,524
       Repairs and maintenance               3,329         8,930
       Rents                                62,353        57,954
       Taxes and licenses                   52,013        64,176
       Interest                              2,278           174
       Contributions                         3,251         5,480
       Depreciation                         33,398        27,592
       Pension, etc.                       138,207       134,917
       Other deductions*                   238,032       268,867
   *
    The largest items were insurance, $135,770 and $113,889, for
1994 and 1995, respectively.

Assets

       Balance sheets prepared for petitioner for the audit years

show the following assets:

                                   1994                  1995
       Current assets
         Cash in banks            $30,797               $6,894

       Property and equipment
         Office equipment         139,110              148,451
         Accum. depr.            (108,215)            (124,609)
         Leasehold improv.         39,820               41,073
         Accum. amort.            (28,658)             (29,064)
                                 - 12 -

          Med. & surg. equip.      14,766             14,766
          Accum. depr.            (14,766)           (14,766)
          Automobiles             143,767            115,751
          Accum. depr.            (76,690)           (29,455)

      Other assets
        Accrued int. exp.                                348
        Prepaid rent                1,274              1,274

      Total assets                141,206            130,662


                                 OPINION

I.   Burden of Proof

      A.    Introduction

      Petitioner claims that, with respect to the principal

adjustments, respondent has raised a new matter, and, therefore,

with respect to that matter, respondent bears the burden of

proof.     We disagree that respondent has raised a new matter.

      B.    Rule 142(a)

      Rule 142 governs the burden of proof.3    In pertinent part,

Rule 142(a) provides:      “The burden of proof shall be upon the

petitioner, * * * except that, in respect of any new matter,

* * * it shall be upon the respondent.”



      3
        The Internal Revenue Service Restructuring and Reform Act
of 1998 (RRA 1998), Pub. L. 105-206, sec. 3001, 112 Stat. 685,
727, added sec. 7491, which shifts the burden of proof to the
Secretary in certain circumstances. Sec. 7491 is applicable to
“court proceedings arising in connection with examinations
commencing after the date of the enactment of this Act.” RRA
1998, sec. 3001(c). RRA 1998 was enacted on July 22, 1998, which
date is after the date (June 25, 1998) of respondent’s notice of
deficiency in this case. Accordingly, sec. 7491 is inapplicable
to this case.
                                 - 13 -

     With respect to what constitutes a new matter, we have

stated:   “A new theory that is presented to sustain a deficiency

is treated as a new matter when it either alters the original

deficiency or requires the presentation of different evidence.”

Shea v. Commissioner, 112 T.C. 183, 191 (1999) (quoting Wayne

Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989)).

     C.   Notice and Pleadings

           1.   Notice

     The notice contains the following explanation of the

principal adjustments:

     It is determined that the deductions of $1,300,231.00
     in 1994 and $1,528,125.00 in 1995 for officers
     compensation are decreased $598,710.00 and $805,469.00,
     respectively, because it has not been established that
     any amounts greater than $701,521.00 in 1994 and
     $722,656.00 in 1995, * * * were for officers
     compensation. It has been established that the
     unallowed amounts were a distribution of earnings and
     profits to stockholder doctors. Accordingly, your
     taxable income is increased $598,710.00 in 1994 and
     $805,469.00 in 1995.

           2.   Petition

     By the petition, petitioner sets forth the following

disagreement with respondent’s adjustments:

     Taxpayer disagrees with all changes and resulting tax
     * * * for years 1994 and 1995. Auditor limited
     deductible officers’ salaries based on his theory that
     reasonable doctors’ salaries were established by the
     salary paid to the new, less experienced non-officer
     doctor. There is no tax law to validate auditor’s
     theory and none was presented to taxpayer during the
     audit. * * *
                               - 14 -

            3.   Answer

     In the answer, with respect to the quoted language from the

petition, respondent admits the first sentence and denies the

remainder of the paragraph.

     D.   Petitioner’s Claim

     With respect to the notice, petitioner makes reference to

section 162(a), which, in pertinent part, states:

     SEC. 162.    TRADE OR BUSINESS EXPENSES.

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

              (1) a reasonable allowance for salaries or
            other compensation for personal services
            actually rendered;

Petitioner claims:    “The only issue reasonably inferred from the

wording of * * * [the notice] is one of reasonable compensation.

That is, whether the money paid to the shareholder surgeons as

salary was reasonable such that Petitioner’s deductions of these

payments was [sic] proper under I.R.C. § 162(a).”    Petitioner

argues that respondent has raised a new issue because he has

changed his theory of the case:    “Respondent’s new theory * * *

is that Petitioner paid a dividend to the shareholder surgeons

equal to the actual collections of the non-shareholder doctors

minus the costs and overhead allocable to the non-shareholder

doctors.”
                             - 15 -

     E.   Discussion

     By the notice, respondent explains the principal adjustments

on the grounds that petitioner has failed to establish that the

disallowed amounts “were for officers compensation.”   Further,

respondent avers that the disallowed amounts “were a distribution

of earnings and profits to * * * [the shareholder surgeons]”.

Although section 162(a) is not mentioned in the notice, its

provisions are implicit in respondent’s explanation that

petitioner has failed to establish that the disallowed amounts

were for officers’ compensation.   It is not implicit in the

notice, however, that respondent has denied a deduction for

officers’ compensation exclusively because petitioner has failed

to establish that such compensation was reasonable in amount.

     Section 162(a)(1) establishes a two-pronged test for the

deductibility of payments purportedly paid as salaries or other

compensation for personal services actually rendered (without

distinction, compensation for services).   To be deductible as

compensation for services, the payments must be (1) “reasonable”

and (2) “in fact payments purely for services.”   Sec. 1.162-7(a),

Income Tax Regs.; see also Nor-Cal Adjusters v. Commissioner,

T.C. Memo. 1971-200, affd. 503 F.2d 359 (9th Cir. 1974).     If

anything, the notice indicates that it is the second prong–-that

the disallowed amounts were not, in fact, payments purely for

services--that concerned respondent.   The notice explains
                               - 16 -

respondent’s adjustment on the grounds that the disallowed

amounts were a distribution of earnings and profits.    By the

petition, petitioner avers that respondent’s theory is

exclusively a “reasonable compensation” theory.    By the answer,

respondent denies that averment.    Petitioner has failed to prove

that respondent’s notice theory is exclusively a reasonable

compensation theory and is not premised on a failure by

petitioner to establish that the disallowed amounts were paid

purely for services.

     Respondent’s position on brief is that a portion of what

petitioner has treated as compensation to the shareholder

surgeons is profit attributable to services performed by the

nonshareholder surgeons, which should be treated as a

nondeductible, disguised dividend rather than as deductible

compensation.    Respondent has not raised a new matter.   The

notice fairly puts petitioner on notice that respondent is

challenging the bona fides of the disallowed amounts as “officers

compensation”.    Petitioner clearly understood that section

162(a)(1) was involved.    Respondent’s concession dramatically

decreases the proposed deficiencies and, together with

respondent’s position on brief, delimits petitioner’s obligation

to prove compliance with the second prong of the section

162(a)(1) test.
                               - 17 -

      Finally, petitioner invokes section 7522, which, among other

things, states that deficiency notices in income tax cases “shall

describe the basis for, and identify the amounts (if any) of, the

tax due”.    The notice sets forth deficiencies in tax and, as

noted in the preceding paragraph, describes the basis for that

portion of the proposed deficiencies attributable to the

principal adjustments as petitioner’s failure to establish that

the disallowed amounts were for officers’ compensation.

Respondent has complied with section 7522.

      F.   Conclusion

      Respondent has not raised a new matter.   Petitioner bears

the burden of proof.

II.   Deductibility of Payments to Shareholder Surgeons

      A.    Introduction

      Petitioner, a cash method taxpayer, paid its four

shareholder surgeons $1,300,231 and $1,528,125 during 1994 and

1995, respectively, and deducted such amounts (the return

amounts) as officers’ compensation on its Federal income tax

returns for such years.    After initially disallowing $598,710 and

$805,469 of such deductions, respondent now agrees that

petitioner may deduct $1,159,455 and $1,508,675 for 1994 and

1995, respectively, as compensation for services.    That leaves

for our decision respondent’s disallowance of deductions for
                                  - 18 -

officers’ compensation in the amounts of $140,776 and $19,450,

for 1994 and 1995, respectively (the remaining amounts).

     Section 162(a)(1) (set forth supra in section I.D.) allows a

deduction for payments of “a reasonable allowance for salaries or

other compensation for personal services actually rendered”.

Respondent’s ground for disallowing petitioner’s deduction for

the remaining amounts is that such amounts are disguised

dividends rather than compensation for services.

     B.   Question Before Us

             1.   Introduction

     As discussed supra in section I.D., section 162(a)(1)

establishes a two-pronged test for determining whether a payment

is deductible as compensation for services.      The payment must be

both reasonable and, in fact, purely for services.      In part, the

parties have directed their arguments to the reasonableness

aspect of that test.     We do not believe, however, that whether

the return amounts were reasonable in amount is actually in

question.4    The question framed by the parties’ briefs is whether

the remaining amounts were paid to the shareholder surgeons

purely for their services.       In respondent’s opening brief,

respondent relies on the following point:      “The respondent


     4
        For 1995, petitioner deducted $1,508,675 as officers’
compensation, and, after concessions, respondent would disallow
$19,450, which is 1.29 percent of the amount deducted. We
hesitate to conclude that respondent would ask us to find that
compensation was unreasonable based on such a small variance.
                                - 19 -

contends that in 1994 and 1995, the petitioner is entitled to

deduct as wages the actual collections of the shareholder-

employees, less their share of the petitioner’s expenses.”      In

petitioner’s opening brief, petitioner argues for a “per se”

rule, that the payments to the shareholder surgeons were

reasonable in amount because they did not exceed petitioner’s

profits, calculated by subtracting from petitioner’s gross

receipts (which were exclusively from providing services) all

corporate expenses except officers’ compensation.     Petitioner

makes the same argument in different terms in its answering

brief:   “Petitioner’s shareholder surgeons were paid compensation

in an amount less than their gross collections, which proves that

they were reasonably compensated.”       The disagreement between the

parties is over how much the shareholder surgeons received for

their services, not whether that amount, when finally determined,

is reasonable.

     To prevail, petitioner must show that the remaining amounts

were paid to the shareholder surgeons purely for their services.

As a preliminary matter, petitioner’s principal arguments raise

questions of law.

          2.     Questions of Law

           a.    Bianchi v. Commissioner

     Petitioner argues:

     [T]he best evidence of value of services provided in a
     professional personal service corporation is the profit
                               - 20 -

     made by the corporation. Thomas A. Curtis, M.D., Inc.
     v. Commissioner, 67 T.C.M. (CCH) 1958, 1963 (1994)
     [T.C. Memo. 1994-15]; LaMastro v. Commissioner, 72 T.C.
     337, 384 (1979). The Tax Court in LaMastro, relying on
     Bianchi v. Commissioner, 66 T.C. 324 (1976), aff’d. per
     curium [sic], 553 F.2d 93 (2nd Cir. 1977), held that
     the best evidence of the value of a dentist’s personal
     services is the profit derived from the practice. Id.
     at 383.

     In Bianchi v. Commissioner, supra at 333, we held that it is

proper to examine the prior self-employment earnings of a

corporate employee to determine whether compensation currently

paid to such employee by the corporation is reasonable.

In Bianchi, the corporate employee, a dentist, had incorporated

his individual proprietorship, transferring to the corporation

(which elected status as an S corporation) the equipment

previously used in the proprietorship, accounts receivable, and

good will.   See id. at 325.   In determining what would be

reasonable compensation for his services provided to the

corporation, we said:   “It cannot be questioned that the clearest

evidence of the worth of petitioner’s services is petitioner’s

earnings from his dentistry practice as an individual

proprietor.”   Id. at 333.   It is clear that, in referring to

“petitioner’s earnings”, we were referring to the profit earned

by the dentist as an individual proprietor.   Indeed, we restated

our point as follows:   “[T]he best evidence of the value of his

personal services is profit he derived from his own practice.”

Id. at 335 (emphasis added).   Undoubtedly, we were using the term
                               - 21 -

“profit” to refer to the excess of the dentist’s receipts from

his practice of dentistry over the costs of earning those

receipts but without any reduction for the value of the dentist’s

own services.    The case, thus, reflects the unremarkable

proposition that the return to an individual proprietor equals

the receipts of the proprietorship less the expenses of the

proprietorship, viz, the “profit” of the proprietorship.

     That proposition was useful to us in Bianchi because we

assumed that (1) the proprietorship in question provided a

service, (2) all of the proprietorship’s income resulted from the

provision of that service, and (3) the proprietor was the sole

service provider employed by the proprietorship.    We were, thus,

able to determine the value of the services provided by the

individual proprietor to his proprietorship, and to use the

result to test the reasonableness of the compensation paid to him

by his wholly owned corporation.

     We cannot analogize petitioner to an individual

proprietorship and employ the stated proposition to find that the

value of the services provided by the shareholder surgeons to

petitioner is equal to the profit made by petitioner (determined

without any deduction for the compensation of the shareholder

surgeons).   One reason why we cannot do so is that the

shareholder surgeons were not the only service providers employed

by petitioner.    There were also the nonshareholder surgeons,
                                 - 22 -

whose contribution to petitioner’s profit we cannot assume to be

zero.

     Petitioner does not prevail, as a matter of law, based on

Bianchi v. Commissioner, supra.

             b.   Richlands Med. Association v. Commissioner

        Petitioner refers us to one of our memorandum opinions,

Richlands Med. Association v. Commissioner, T.C. Memo. 1990-660,

affd. without published opinion 953 F.2d 639 (4th Cir. 1992), for

the following proposition:     Specifically, the Tax Court held

“petitioner’s associates were entitled to receive, as

compensation for their services to patients, 100 percent of the

collections recorded by petitioner as attributable to such

services.”     In Richlands Med. Association, we did so find.     We

did that, however, after finding that respondent, in his notice

of deficiency, had allowed such amounts as a deduction for

compensation.

     In Richlands Med. Association, the taxpayer not only

provided physician’s services but also owned a hospital that

provided medical services ancillary to physician’s services.

With respect to the taxpayer’s system of compensation, under

which all funds left after the payment of expenses and the

establishment of reserves were distributed to its associates

(owner employees), we observed that the taxpayer’s expert, an

accountant, was unable to explain how the taxpayer could ever
                                - 23 -

earn a profit.    Nevertheless, we allowed a deduction for

compensation to associates in excess of the amounts recorded as

attributable to patient services to reflect additional services

provided by the associates to the association.     Because a portion

of the taxpayer’s profit was attributable to “ancillary hospital

service charges” that were not shown to be allocable to the

associates, we held that a portion of what the taxpayer treated

as compensation to the associates was, in fact, a nondeductible

distribution of profits.     Richlands Med. Association does not

establish a rule of law that, in all circumstances, an employer

may deduct as compensation paid to an employee amounts collected

for services performed by such employee.

          3.     Relevant Inquiry

     Section 1.162-7(b)(1), Income Tax Regs., states:     “Any

amount paid in the form of compensation, but not in fact as the

purchase price of services, is not deductible.”     The regulations

further provide that an ostensible salary may, if paid by a

corporation, be a distribution of a dividend on stock, or may be

in part a payment for property.     See id.   Petitioner must prove

its intent (i.e., the intent of the members of the board) to pay

compensation.    See, e.g., Paula Constr. Co. v. Commissioner, 58

T.C. 1055, 1058 (1972), affd. per curiam 474 F.2d 1345 (5th Cir.

1973); Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324, 1340

(1971), affd. without published opinion 496 F.2d 876 (5th Cir.
                                - 24 -

1974).    Whether such intent has been demonstrated is a factual

question to be decided on the basis of the particular facts and

circumstances of the case.     Electric & Neon, Inc. v.

Commissioner, supra at 1059.

     We turn now to that factual question.

     C.    Discussion

            1.   Petitioner’s Principal Argument

     Petitioner’s principal argument is:

          In the instant case, the payments made to the
     shareholder surgeons were clearly compensation for
     services rendered and not disguised dividends.
     Petitioner issued W-2 forms to its shareholder surgeons
     and that income was duly reported on the surgeons’
     personal tax returns. * * * Moreover, the salary
     payments were properly deducted as such on Petitioner’s
     tax returns.

Petitioner’s treatment of the reported amounts is consistent with

the board’s intending such amounts to constitute payments purely

for services.    Nevertheless, since the shareholder surgeons owned

petitioner, the board was not necessarily concerned that

shareholder surgeon compensation not be overstated.       See, e.g.,

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1156

(1980) (“Where officers-shareholders, who are in control of a

corporation, set their own compensation, careful scrutiny is

required to determine whether the alleged compensation is in fact

a distribution of profits.”)    Petitioner also argues that the

shareholder employment agreements pegged base compensation and

bonuses to the number of months worked during the year, which,
                               - 25 -

petitioner argues, signifies compensation for services.        A

payment pegged to time worked may be nothing more than a payment

for services.   It may, however, include a distribution of

profits, if the only recipients of such payments are the owners

of the enterprise.   Cf. Klamath Med. Serv. Bureau v.

Commissioner, 29 T.C. 339, 348-349 (1957) (payments in proportion

to billings, but in excess of billings, were held to be, in part,

disguised dividends), affd. 261 F.2d 842 (9th Cir. 1958).          Here,

all of the recipients of such payments were shareholders of

petitioner (shareholder surgeons).      Three were full-time

employees, entitled to equal payments, while the fourth was a

part-time employee, entitled to a proportionate payment.        That

disparity does not eliminate the possibility of a disguised

distribution of profit, but may reflect only an implicit

redistribution of ownership upon the decision of a shareholder

surgeon partially to retire.

     We must determine whether there was a disguised distribution

of profit by petitioner to the shareholder surgeons.

          2.    Profit Attributable to Nonshareholder Employment
                Agreements

     Petitioner’s gross receipts in each of the audit years

exceeded $2 million.   Balance sheets prepared for petitioner for

those years list as assets only cash, office equipment, leasehold

improvements, medical and surgical equipment, automobiles,

prepaid rent, and accrued interest (the balance-sheet assets),
                               - 26 -

with an unrecovered cost of $141,206 and $130,622, for 1994 and

1995, respectively.   It is unlikely that, by themselves, the

balance-sheet assets account for $2 million in gross receipts.

In addition to the balance-sheet assets, however, petitioner had

assets not shown on its balance sheets (the nonbalance-sheet

assets), viz, both the shareholder and nonshareholder employment

contracts, petitioner’s arrangement with the hospital to provide

on-call services in the hospital’s emergency room, and the

goodwill that petitioner undoubtedly built up during its almost

20 years of business in the Fort Worth area.     Together, the

balance-sheet and nonbalance-sheet assets account for the in-

excess-of $2 million in gross receipts that petitioner reported

for each of the audit years.   Respondent concedes (and petitioner

does not disagree) that petitioner made no profit on the

shareholder employment agreements.      As stated supra, in section

II.B.1, respondent is willing to allow petitioner to deduct, as

compensation for services, collections attributable to the

shareholder surgeons less their allocable share of petitioner’s

expenses.   Respondent believes, however, that petitioner has

understated its profit on the nonshareholder employment

agreements by both understating its collections with respect to

such agreements and overstating its overhead allocable to such

agreements.   For 1994, respondent would reallocate collections

from the shareholder employment agreements to the nonshareholder
                                - 27 -

employment agreements and, for both 1994 and 1995, overhead from

the nonshareholder employment agreements to the shareholder

employment agreements.    That would have the effect of reducing

petitioner’s deduction for compensation paid to officers (and

increasing its taxable income for each of the audit years).

Respondent’s position is:

     [P]etitioner can deduct as wages the actual net
     collections of the shareholder-doctors in 1994 and
     1995. The way to arrive at the allowable deductions,
     since petitioner’s records were unreliable, was to
     subtract from the total compensation paid to the share-
     holder doctors the net collections of the non-
     shareholder doctors. * * *

           3.    Determination of Profits Attributable to
                 Nonshareholder Surgeons

           a.    Introduction

     Petitioner is contradictory in its calculation of any profit

attributable to the nonshareholder surgeons.    In one exhibit,

petitioner calculates the profit attributable to Dr. Snyder in

1994 as $20,174 and to Dr. Vaughan in 1995 as $12,579.      In

another exhibit, petitioner claims that, for those years, it lost

money by employing Drs. Snyder and Vaughan.    Respondent computes

the profit attributable to Drs. Snyder and Vaughan as the

remaining amounts ($140,776 and $19,450, for 1994 and 1995,

respectively).    Neither party’s position is persuasive on its

face.   The Court must make its own calculation.

     During the pretrial conference and, again, at the conclusion

of the trial, the Court elicited from respondent’s counsel that
                              - 28 -

respondent’s proposed deduction disallowance, for both 1994 and

1995, is limited to collections attributable to the

nonshareholder surgeons less applicable direct costs and

allocable overhead.   On both occasions, the Court suggested that

it would be helpful if the parties were able to stipulate as to

the proper allocation of overhead attributable to collections

generated by Drs. Snyder and Vaughan.     To that end the Court

agreed to leave the record open for 30 days for such stipulations

by the parties.   The parties failed to stipulate agreed

allocations of overhead.   It is therefore left to the Court to

make the required overhead allocations, on the basis of the

evidence in the record.

     In his proposed findings of fact, respondent attempts to

compute the portion of petitioner’s total expenses attributable

to Dr. Snyder for 1994 and to Dr. Vaughan for 1995.     Respondent

subtracts those allocated expenses, for 1994, from Dr. Snyder’s

deemed collections (considered by respondent to equal his net

billings for that year) and, for 1995, from actual collections

attributed to both Dr. Snyder and Dr. Vaughan, in order to derive

the deemed dividend for each year.     Petitioner objects to

respondent’s computation of Dr. Snyder’s collections for 1994 and

to respondent’s allocations of expenses for both years.     The

expenses subject to allocation are those deducted on petitioner’s
                               - 29 -

Forms 1120 for the audit years (other than compensation of

officers).

            b.   Collections

     The record does not contain reliable records of collections

for 1994.    At trial, respondent argued that, because Dr. Snyder’s

billings for 1994 “were paid, to an extremely large percent, by

Blue Cross-Blue Shield or Medicare” it was appropriate to treat

his collections as equal to his net billings for the year:

$245,597.    Exhibit 8-J, prepared by petitioner’s accountant,

alleges Dr. Snyder’s 1994 collections to be $146,837.    Neither of

those conclusions is supported by the evidence, which consists

mainly of Dr. Mann’s testimony that petitioner’s collections are

“probably between 60 to 70 percent of * * * net billings”.

Because petitioner has not presented any evidence to the

contrary, we shall assume that Dr. Snyder’s collections for 1994

were at the high end of petitioner’s estimated range, i.e.,

70 percent of net billings, or $171,918.    The parties have

stipulated that collections attributable to Dr. Vaughan for 1995

were $125,467.    We also find, based upon an attachment to

petitioner’s expert report, that collections attributable to

Dr. Snyder for 1995 (to which no expenses are allocable because

Dr. Snyder was not an employee during 1995) were $4,338.96.
                              - 30 -

          c.   Expenses

     Both parties’ allocations of expenses to Dr. Snyder’s

collections for 1994 and Dr. Vaughan’s collections for 1995

consist of the salary paid to each plus one-tenth (one-fifth for

the one-half of the audit year during which each was employed) of

other expenses considered equally apportionable to the five

surgeons employed during each year.5   The parties differ,

however, as to whether certain of petitioner’s expenses were at

all allocable to Drs. Snyder and Vaughan.   We accept respondent’s

proposed allocation of expenses as reasonable with the following

additional allocations:   There should be a pro rata (one-tenth)

allocation of rent, repair and maintenance expense, depreciation

of office equipment (other than shareholder automobiles),

telephone expenses, and equipment lease expenses to the

nonshareholder surgeons’ collections.6   Thus, for the audit




     5
        Although respondent attempted to elicit testimony from
Dr. Mann that the nonshareholder surgeons might not have utilized
office space and staff to the same degree as the shareholder
surgeons, there is no evidence in the record that would enable
the Court to make a specific finding in that regard. We also
ignore as immaterial the fact that Dr. Ellis was employed for
only 6 months during 1995.
     6
        As noted, supra in our findings of fact, the
nonshareholder surgeons’ employment contracts obligated
petitioner to furnish its nonshareholder surgeons with “an
office, stenographic help, supplies, equipment, and such other
facilities and services * * * adequate for the performance of
* * * [their] duties.”
                                  - 31 -

years, we find that the proper expense allocations are as

follows:

                                          1994             1995
  Respondent’s allocation               $100,482         $110,356
  1/10 of rent expenses                    6,235            5,795
  1/10 of repair and maintenance             333              893
  1/10 of office equipment depreciation    2,397            2,158
  1/10 of telephone expenses               1,237            1,168
  1/10 of equipment lease expenses           –-               399
                    Total                110,684          120,769

             d.   Profit

       For the audit years, we find that the net profit

attributable to the nonshareholder surgeons was as follows:

                                     1994            1995
             Collections           $171,918        $129,806
             Expenses              (110,684)       (120,769)
             Profit                  61,234           9,037

       D.   Conclusion

       We hold that the deductions claimed by petitioner for 1994

and 1995 for salaries paid to the shareholder surgeons exceed

reasonable allowances for services actually rendered by them by

the amounts of $61,234 and $9,037, respectively, and that such

amounts, therefore, are not deductible by petitioner under

section 162(a)(1).       We sustain respondent’s determination of a

deficiency to the extent attributable to such disallowances.

III.    Accuracy-Related Penalty

       Section 6662 provides for an accuracy-related penalty (the

accuracy-related penalty) in the amount of 20 percent of the

portion of any underpayment attributable to, among other things,
                              - 32 -

negligence or intentional disregard of rules or regulations

(without distinction, negligence), any substantial understatement

of income tax, or any substantial valuation misstatement.

Respondent determined the accuracy-related penalty against

petitioner.   Although the notice indicates that respondent

determined such penalty upon “one or more” of the three grounds

described for such penalty, the issue presented by this case and

our resolution thereof demonstrate that the only possible ground

for imposition of the penalty is negligence.     Negligence has been

defined as lack of due care or failure to do what a reasonable

and prudent person would do under like circumstances.     See, e.g.,

Hofstetter v. Commissioner, 98 T.C. 695, 704 (1992).     Section

6664(c)(1) provides that the accuracy-related penalty shall not

be imposed with respect to any portion of an underpayment if it

is shown that the taxpayer acted in good faith and that there was

reasonable cause for the underpayment.     The determination of

whether a taxpayer acted in good faith and with reasonable cause

is made on a case-by-case basis, taking into account all

pertinent facts and circumstances.     “Circumstances that may

indicate reasonable cause and good faith include an honest

misunderstanding of * * * law that is reasonable in light of all

the facts and circumstances, including the experience, knowledge

and education of the taxpayer.”   Sec. 1.6664-4(b)(1), Income Tax
                               - 33 -

Regs.   Petitioner bears the burden of proving facts showing good

faith and reasonable cause.    See Rule 142(a).

     The same circumstances that led to our finding that a

portion of the bonuses paid to the shareholder surgeons

constituted a disguised dividend rather than a payment purely for

services rendered by them also lead us to sustain respondent’s

imposition of the section 6662(a) penalty.    When asked during the

trial why petitioner had never paid a dividend, Dr. Mann

responded:   “Well, we are not a very big organization and all of

our income comes from just the work we did.    And we just treated

everything as salary.”   But Dr. Mann’s professed good faith

belief that the monthly bonus payments of all available earnings

reasonably represented payments for services rendered by the

shareholder surgeons is belied by his later testimony that,

within a short time after they arrive (and, certainly, within the

2-year employment period), the nonshareholder     surgeons also

“made money” for petitioner.    Given that Dr. Mann and, by

implication, the other shareholder surgeons were aware that at

least a portion of petitioner’s profits were attributable to

services performed by the nonshareholder surgeons, we are not

persuaded that petitioner’s treatment of its distribution of
                                - 34 -

essentially all profits7 to the shareholder surgeons as salary

for services performed by them was based upon a good faith belief

that such was the case.   Cf. Comenout v. Commissioner, T.C. Memo.

1982-40, affd. 746 F.2d 1484 (9th Cir. 1984).

     Although it happened that, for the audit years, profits

attributable to the nonshareholder surgeons were small (and, for

1995, practically nil), such need not have been the case.       For

example, in 1996, collections attributable to Dr. Vaughan (still

a nonshareholder surgeon), totaled just under $460,000 as

compared to $491,000 for Dr. Mann.       Under such circumstances,

the shareholder surgeons could not reasonably conclude that all

pre-distribution profits were solely attributable to services

performed by them and, therefore, available for bonus payments to

them.    It is the shareholder surgeons’ utter indifference to the

possibility that a portion of the annual prebonus profits might

have been derived from collections generated by nonshareholder

surgeons that justifies respondent’s imposition of the accuracy-

related penalty in this case.




     7
        Based upon Dr. Mann’s testimony that the bonuses to the
shareholder surgeons consisted of all available cash less the
amount necessary to meet anticipated expenses, we find that the
small amount of taxable income reported for each of the audit
years ($29,255 for 1994 and $49,323 for 1995) was no more than
the yearend set-aside needed to meet anticipated immediate and
near-term expenses for the following year.
                             - 35 -

     Accordingly, we find petitioner liable for the section

6662(a) penalty.


                                        Decision will be entered

                                   under Rule 155.
