                        T.C. Memo. 2001-160



                      UNITED STATES TAX COURT



            WAGNER CONSTRUCTION, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3819-99.                        Filed June 29, 2001.


     John K. Steffen, Walter A. Pickhardt, and Myron L. Frans,

for petitioner.

     Jack Forsberg and Eric W. Johnson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     PARR, Judge:   Respondent determined deficiencies in

petitioner's Federal income tax of $370,158 for the taxable year

ending October 31, 1995, and $317,261 for the taxable year ending

October 31, 1996.
                                 - 2 -

     The issue for decision is whether petitioner may deduct as

officer compensation paid to Dennis Wagner (Dennis) and Curtis

Wagner (Curtis) for taxable years ending October 31, 1995 and

1996, the amounts shown below as the parties contend, or some

other amounts:

                               Petitioner
        Year             Dennis           Curtis        Total
     10/31/95          $1,048,200        $246,688    $1,294,888
     10/31/96             699,192         400,573     1,099,765

                               Respondent
        Year             Dennis           Curtis        Total
     10/31/95           $243,000         $192,450      $435,450
     10/31/96            258,600          202,350       460,950


     Unless otherwise indicated, all section references are to

the Internal Revenue Code, as amended and 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 of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.

A. General Background

     Petitioner is a Minnesota corporation that was incorporated

on November 1, 1985.     When the petition in this case was filed,

petitioner maintained its principal place of business in

International Falls, Minnesota.
                               - 3 -

     During the years in issue, Dennis and Curtis were

petitioner's sole stockholders.   Dennis and Curtis are the sons

of Clifford Wagner (Clifford) and Evelyn Wagner (Evelyn).

Dennis was born in 1952, and graduated from high school in 1971.

Curtis was born in 1954, and graduated from high school in 1973.

Neither Dennis nor Curtis attended college.    Both began working

with their father when they were young boys.

     Petitioner is the successor to a partnership called Clifford

Wagner & Dennis Wagner Construction (Wagner & Wagner).    Clifford

and Dennis formed Wagner & Wagner in 1974 to conduct a logging

business.   In 1976, Wagner & Wagner acquired a construction

business that previously had been owned by Clifford and a third

individual.   Clifford and Dennis each owned a 50-percent interest

in Wagner & Wagner.

     On November 1, 1985, Clifford and Dennis incorporated

petitioner.   At that time, the construction business of Wagner &

Wagner was well established; the partnership had approximately 30

employees1 and normally operated four construction crews during

the construction season.

     Wagner & Wagner transferred assets of $638,916 and

liabilities of $127,543 to petitioner.   The transfer was treated

as a contribution to capital on petitioner's books.   The amount



     1
      Wagner & Wagner had seven or eight full-time employees; the
other employees were seasonal.
                              - 4 -

of additional paid-in capital reflected on petitioner's balance

sheet dated November 1, 1985, was $332,373.    The $332,373 net

equity on the books included a charge of $179,000 for deferred

income taxes attributable to Wagner & Wagner's being an accrual

basis taxpayer and petitioner's being a cash basis taxpayer.

Additionally, the financial statements show a capital

contribution of $2,000 for the common stock.

     Initially, Clifford and Dennis each owned 1,000 shares (50

percent) of petitioner's stock.   Clifford died on April 15, 1986.

In August 1986, petitioner redeemed 1,000 shares of its stock for

$157,883 payable to Evelyn in monthly installments of $2,000 with

interest at a rate of 9 percent per annum.    At the same time,

Dennis transferred 250 of his 1,000 shares of petitioner's stock

(25 percent of the outstanding stock) to Curtis, and Evelyn gave

each son a 25-percent interest in Wagner & Wagner.    From August

1986 through the years at issue, Dennis owned 75 percent of

petitioner and Wagner & Wagner, and Curtis owned 25 percent.

     On January 1, 1988, Wagner & Wagner transferred a

substantial portion of its net assets (assets of $703,257 and

liabilities of $207,106) to petitioner, and petitioner issued to

Wagner & Wagner a debenture of $496,151 due January 1, 1993.      The

debenture bore interest at an annual rate of 8 percent and was

recorded as long-term debt on petitioner's books.
                               - 5 -

B.   Petitioner's Business Activity

     From 1985 through the years at issue, petitioner's primary

business activity was sewer, water, and road construction

(highway and heavy construction).     Because of the seasonal nature

of the construction work performed by the company, petitioner

also performed contract logging in the winter months.    The

logging operation complimented petitioner's construction business

because petitioner could use its trucks and equipment during the

winter months.   This seasonal operation kept many of petitioner's

construction employees working throughout the winter months.

Petitioner also owned and operated property for storage of logs

and construction materials and owned and operated sand and gravel

pits.

     Petitioner was required to submit competitive bids for

highway and heavy construction contracts.    Petitioner submitted

detailed information in the bids that included fixed costs for

materials and subcontractors in addition to petitioner's

projected costs for its labor, supplies, and bond costs.    After

the bids were submitted, the requesting agency selected the

lowest bid and awarded the contract.

     In order to submit a bid for construction projects,

petitioner was required by law to show that it had obtained the

required performance and payment bonds issued by an approved

bonding company.   Performance and payment bonds protect the owner
                              - 6 -

of the construction project by guaranteeing that the contractor

will build the project according to the specifications and make

all required payments to its subcontractors on the project.

Dennis, Curtis, and their wives personally guaranteed all

performance and payment bonds issued on behalf of petitioner.

     In addition to Dennis and Curtis, petitioner employed 35

persons during 1995 and 41 persons during 1996.   Petitioner's

office staff consisted of Rodney Olson (Mr. Olson), who was the

office manager, and Jane Wagner (Jane), who was Curtis' wife.

Other than Dennis, Curtis, Jane, and Mr. Olson, petitioner's

remaining employees worked an average of 28.9 weeks in 1995 and

27.3 weeks in 1996.

     Petitioner's major construction jobs for 1995 and 1996 were

performed throughout northern Minnesota and included jobs located

in International Falls, Littlefork, Warroad, Roseau, Greenbush,

Crookston, Chisholm, and Ash River.   During the construction

season, which is generally from May through November in northern

Minnesota, petitioner maintained four construction crews.

     The Associated General Contractors of Minnesota Highway,

Railroad and Heavy Construction Contractors entered into separate

agreements with the International Union of Operating Engineers

Local No. 49 and the Laborer's District Council of Minnesota and

North Dakota on behalf of its affiliated local unions.   During

the years in issue, petitioner operated under those contracts
                               - 7 -

with its laborers and operating engineers.    Petitioner paid its

laborers and operating engineers the highest wage scale in the

State of Minnesota.

C.   Dennis' Responsibilities and Qualifications

     By 1995, Dennis had more than 30 years of experience in the

construction and logging industries and had been petitioner's

president for 10 years.

     Dennis prepared, approved, and submitted bids for contract

work.   He was responsible for securing contracts at a profit

sufficient to keep petitioner's four construction crews active

throughout the construction season in northern Minnesota.     He

selected bonding companies, consulting engineers, investment

firms, attorneys, and accountants.     Dennis negotiated the union

contracts and the employee fringe benefit plans.    He was

responsible for addressing all complaints and concerns about the

daily operations of the company.

     Dennis was also responsible for the final decisions on the

purchase of major assets.   Dennis approved all subcontract

payments and verified that all subcontractor deficiencies were

corrected.   He was responsible for negotiating all financing

arrangements and equipment rental rates.    Dennis made the final

decision on when to purchase and select stocks, securities, and

investments.   He negotiated all private business contracts and

made the final decision on billings and collections.
                               - 8 -

     Dennis attended bid lettings, prebid showings, job meetings,

and inspections, prepared job schedules, and worked with project

engineers on payment schedules, job problems, and change orders.

He was the primary contact person between petitioner and all

regulatory or governmental agencies.

     Further, Dennis was responsible for dispatching equipment

with the operators.   He managed construction projects by

supervising all projects on a regular basis.    He also supervised

the company's maintenance shop and the maintenance, repair, and

certification of petitioner's large fleet of machinery and

equipment.   Dennis supervised all sand and gravel operations,

wood storage, and dump-site operators employed by the company.

He hired personnel, scheduled layoffs, and determined pay raises

and bonuses.   Dennis negotiated all subcontract arrangements and

supervised the subcontractor's performance.    He made change

orders and approved all extra work or deductions on projects.

Dennis secured all permits and licenses necessary for the company

to conduct its businesses.   He could operate all equipment owned

by the company and would fill in as needed to operate equipment,

drive trucks, or work as a laborer.

     Dennis devoted all his work activity to petitioner and

worked long hours, 6 or 7 days a week.
                                 - 9 -

     Dennis diversified petitioner's operations in order to

provide year-round employment for employees, to use equipment

more efficiently, and to increase earnings.

     Dennis bought or leased property to store and dispose of

waste construction materials generated in connection with

petitioner's construction contracts.     He began recycling

construction waste materials for use in its sand and gravel pit

operations, for use as materials in other construction projects,

and for sale to third parties.

     Dennis negotiated petitioner's logging contracts and

purchase rights directly with property owners.     He began using

real estate, originally purchased to store and dispose of

construction waste, as a storage yard in petitioner's logging

operations and also for log storage for third parties.

D.   Curtis' Responsibilities and Qualifications

     After graduating from high school in 1973, Curtis began

working for his father in the construction and logging

businesses.   By 1995, he had more than 20 years of experience in

the construction and logging businesses and had been petitioner's

vice president for 10 years.

     Curtis supervised petitioner's major construction projects

in and around International Falls, Minnesota.     In addition, he

regularly consulted with the other construction foremen via the

radio or mobile telephone, giving technical assistance with other
                              - 10 -

construction projects.   Curtis was petitioner's most skilled

equipment operator.   He operated the largest heavy equipment

daily and recommended maintenance policies.   He recommended and

assisted with petitioner's equipment purchase decisions.

Curtis supervised petitioner's winter logging operations.   Since

1985, Boise Cascade Corp. has awarded numerous logging contracts

to petitioner.   These contracts were the direct result of Curtis'

effective management and supervision of the logging operation.

      Curtis devoted all his work activity to petitioner and

worked long hours, 6 or 7 days a week.

E.   Salaries, Bonuses, and Profit-Sharing Contributions Paid by
     Petitioner to Dennis and Curtis

      From 1986 to 1996, petitioner paid annual salaries, bonuses,

and profit-sharing contributions to Dennis and Curtis as

follows:2




      2
      These amounts were stipulated by the parties as being paid
during the "taxable" year. Petitioner reported all amounts paid
to Dennis and Curtis as compensation during the calendar years
1985 through 1996 on Forms W-2, Wage and Tax Statement. The
stipulated amounts vary slightly from the amounts reported on the
Forms W-2 as paid during the calendar year but vary in much
greater amounts than reported on petitioner's Federal income tax
returns as compensation paid to officers during the taxable
(fiscal) year.
                             - 11 -

                          Dennis Wagner
                                   Profit-Sharing
    Year    Salary        Bonus     Contribution       Total

    1986    $51,810      $82,500      $20,146        $154,456
    1987     40,456        -0-          6,096          46,552
    1988     40,456       33,750       11,131          85,337
    1989     40,456      120,000       24,068         184,524
    1990     42,239      165,000       30,000         237,239
    1991     45,050      700,000       30,000         775,050
    1992     43,350      550,000       30,000         623,350
    1993     44,720      740,000       30,000         814,720
    1994     44,720      800,000       30,000         874,720
    1995     47,528    1,000,000       22,500       1,070,028
    1996     49,088      650,000       22,500         721,588

                         Curtis Wagner
                                   Profit-Sharing
    Year    Salary        Bonus     Contribution       Total

    1986    $33,190      $27,500       $9,103         $69,793
    1987     40,456        -0-          6,096          46,552
    1988     40,456       11,250        7,756          59,462
    1989     40,456       40,000       12,068          92,524
    1990     42,239       55,000       14,673         111,912
    1991     45,050      300,000       30,000         375,050
    1992     43,350      150,000       29,477         222,827
    1993     44,720      160,000       30,000         234,720
    1994     44,720      353,333       30,000         428,053
    1995     47,528      200,000       22,500         270,028
    1996     49,088      350,000       22,500         421,588

     Petitioner paid to Dennis and Curtis weekly salaries equal

to the highest wage that petitioner paid to its operators.

     At the end of each fiscal year from 1986 to 1996, Dennis

reviewed financial information with petitioner's accountants.

Dennis limited the amount of the bonuses he and Curtis received

to ensure that petitioner had sufficient funds to expand its

business, purchase needed equipment, pay subcontractors on time,

satisfy business creditors and bonding companies, pay top wages
                              - 12 -

to its employees, and remain profitable.   Dennis and Curtis

agreed that bonuses would be paid on a ratio of 3 to 1 with

Dennis receiving three times the bonus amount paid to Curtis.3

      Petitioner generally paid bonuses to Dennis and Curtis in

October of the fiscal year to which they related.    No bonuses

were paid for the year ending October 31, 1987.    Beginning with

the year ending October 31, 1993, a portion of the bonuses, with

interest, was paid to Dennis and/or Curtis in the following

January.

F.   Petitioner's Officers and Directors

      From 1986 to 1996, Dennis, Curtis, and Dennis' wife Wendy

served as petitioner's officers and directors.    Dennis was

president, Curtis was vice president, and Wendy was

secretary/treasurer.

G.   Petitioner's Financial Statements and Federal Income Tax
     Returns

      At all times since its incorporation, petitioner has had a

fiscal year and taxable year ending October 31 and has used the

accrual method of accounting for financial reporting purposes.

Before November 1, 1991, however, petitioner used the cash method

of accounting for tax purposes.



      3
      The stipulated bonus amounts do not reflect the 3-to-1
ratio, in part, because (1) there were differences in the
calendar year reporting for Dennis and Curtis and the fiscal year
used by petitioner, and (2) in some years, a portion of the
bonuses was paid in the following January.
                              - 13 -

     Effective November 1, 1991, petitioner changed its method of

accounting for tax purposes from the cash method to the accrual

method.   Petitioner realized a section 481(a) adjustment of

$1,637,156 on account of the change in accounting methods.

Petitioner included $409,289 of the adjustment in income in each

of the 4 taxable years ending October 31, 1992 through 1995.

Since November 1, 1991, petitioner has used the accrual method of

accounting for tax purposes and for financial purposes.

     Petitioner engaged accountants to prepare financial

statements and reports for its operations.   For the taxable years

ending October 31, 1986 and 1987, the accountant prepared

combined financial statements for petitioner and Wagner & Wagner.

Those statements show the following balance sheets:
                                                  - 14 -
Separate
Partnership/corporation                  10/31/86                                  10/31/87
Assets                     Partnership   Corporation    Combined     Partnership   Corporation     Combined
  Current assets            $122,128     $1,060,510    $1,112,860     $126,739     $1,406,116    $1,571,777
  Property and equipment     315,179         19,600       334,779      437,683         18,300       455,983
  Other assets                80,918            602        81,520         -–              451           451
    Total assets             518,225      1,080,712     1,529,159      564,422      1,424,867     2,028,211
Liabilities
    Current liabilities       224,378       581,694        736,294     220,998        848,505     1,027,507
    Long-term debt             13,631       244,000        257,631      63,676        133,566       197,242
       Total liabilities      238,009       825,694        993,925     284,674        982,071     1,224,749
Stockholders Equity
    Common stock                 -–           2,000           --           -–           2,000          --
    Paid-in capital              –-         332,373           --           –-         332,373          --
    Retained earnings            –-          78,529           --           –-         266,307          --
    Treasury stock               --        (157,884)          --           --        (157,884)         --
       Total                     –-         255,018        255,018         –-         442,796       442,796
Partners Equity               280,216          –-          280,216      360,666          –-         360,666
                                                           535,234                                  803,462
  Total liabilities and
    equity                    518,225     1,080,712     1,529,159       645,340     1,424,867     2,028,211
                                 - 15 -

     For each of the taxable years ending October 31, 1988 to

1996, the accountants prepared a separate financial statement for

petitioner.    The financial statements show balance sheets for

petitioner for those years as follows:

                                 10/31/88     10/31/89     10/31/90
Assets
  Current assets                 $2,060,231   $2,483,018   $3,862,379
  Property and equipment            672,050      545,040      958,851
  Other assets                          300        -0-        223,437
    Total assets                  2,732,581    3,028,058    5,044,667
Liabilities
    Current liabilities          1,496,368    1,321,926    2,101,079
    Long-term debt                 692,428      871,633    1,036,257
      Total liabilities          2,188,796    2,193,559    3,137,336
Stockholders Equity
    Common stock                     2,000        2,000        2,000
    Paid-in capital                332,372      332,372      332,372
    Retained earnings              367,297      658,011    1,730,843
    Treasury stock               (157,884)     (157,884)    (157,884)
      Total equity                 543,785      834,499    1,907,331
  Total liabilities and equity   2,732,581    3,028,058    5,044,667

                                 10/31/91     10/31/92     10/31/93
Assets
  Current assets                 $3,314,652   $3,928,507   $3,471,251
  Property and equipment            982,165    1,292,130      973,986
  Other assets                      223,972      221,522      193,843
    Total assets                  4,520,789    5,442,159    4,639,080
Liabilities
    Current liabilities          1,309,273    2,080,527    1,373,010
    Long-term debt                 969,136      396,568      223,440
      Total liabilities          2,278,409    2,477,095    1,596,450
Stockholders Equity
    Common stock                     2,000        2,000        2,000
    Paid-in capital                332,372      332,372      332,372
    Retained earnings            2,065,892    2,788,576    2,866,142
    Treasury stock                (157,884)    (157,884)    (157,884)
      Total equity               2,242,380    2,965,064    3,042,630
  Total liabilities and equity   4,520,789    5,442,159    4,639,080
                                 - 16 -

                                 10/31/94         10/31/95     10/31/96
Assets
  Current assets                 $2,898,541       $3,584,901   $3,295,219
  Property and equipment            877,553        1,032,037    1,118,592
  Other assets                      106,309          101,710       92,286
    Total assets                  3,882,403        4,718,648    4,506,097
Liabilities
    Current liabilities            827,931        1,584,793    1,114,378
    Long-term debt                 149,780          243,107      257,842
      Total liabilities            977,711        1,827,900    1,372,220
Stockholders Equity
    Common stock                     2,000            2,000        2,000
    Paid-in capital                332,372          332,372      332,372
    Retained earnings            2,728,204        2,714,260    2,957,389
    Treasury stock                (157,884)        (157,884)    (157,884)
      Total equity               2,904,692        2,890,748    3,133,877
  Total liabilities and equity   3,882,403        4,718,648    4,506,097

     From 1986 to 1993, Dennis and Curtis made loans to

petitioner, which were unsecured.      The outstanding loan amounts

petitioner owed to Dennis and Curtis on the last day of fiscal

years ending October 31, as reflected on petitioner's financial

statements, were as follows:

                  Fiscal Year             Loan Amounts

                      1986                    $198,982
                      1987                     131,574
                      1988                     153,484
                      1989                     351,424
                      1990                     547,621
                      1991                     496,838
                      1992                      51,729
                      1993                       -0-
                                      - 17 -

      Petitioner's financial statements and Forms 1120, U.S.

Corporation Income Tax Return (Forms 1120 or returns), for the

years ending October 31, 1986 through 1996, show the following

income:

                                      10/31/86                     10/31/87
                              Financial                    Financial
                              Statement      Return        Statement      Return
General & contract revenue   $2,135,832    $2,108,148     $3,666,642    $3,359,825
Operating expenses           (2,009,634)   (2,005,650)    (3,409,657)   (3,327,492)
  Income from operations        126,198        102,498       256,985         32,333
Other income/(loss)              20,805          1,239        57,384         37,038
  Net income before taxes       147,003        103,737       314,369         69,371
  Taxes                         (37,689)       (27,469)      (46,141)       (13,481)
  Net income                    109,314         76,268       268,228         55,890
                                      10/31/88                     10/31/89
                              Financial                    Financial
                              Statement      Return        Statement      Return
General & contract revenue   $4,416,990    $3,910,680     $4,423,002    $4,489,886
Operating expenses           (4,318,785)   (3,847,599)    (3,986,317)   (4,351,131)
  Income from operations         98,205         63,081       436,685        138,755
Other income/(loss)              45,745         21,225        50,024         21,629
  Net income before taxes       143,950         84,306       486,709        160,384
Provision for taxes             (42,960)       (16,914)     (195,995)       (54,825)
  Net income                    100,990         67,392       290,714        105,559
                                      10/31/90                     10/31/91
                              Financial                    Financial
                              Statement      Return        Statement      Return
General & contract revenue   $6,746,331    $6,014,515     $5,156,266    $5,581,672
Operating expenses           (5,008,338)   (5,269,014)    (4,812,253)   (5,141,657)
  Income from operations      1,737,993        745,501       344,013        440,015
Other income/(loss)              58,139         59,876       203,106        149,527
  Net income before taxes     1,796,132        805,377       547,119        589,542
Provision for taxes            (723,300)     (272,170)      (212,070)     (193,077)
  Net income                  1,072,832        533,207       335,049        396,465
                                      10/31/92                     10/31/93
                              Financial                    Financial
                              Statement      Return        Statement      Return
General & contract revenue   $7,442,762    $7,388,353     $5,090,933    $5,088,511
Operating expenses           (6,503,283)   (6,809,208)    (4,983,762)   (5,174,854)
  Income from operations        939,479        579,145       107,171        (86,343)
Other income/(loss)             176,050        524,359       130,396        593,430
  Net income before taxes     1,115,529     1,103,504        237,567        507,087
Provision for taxes            (392,845)     (375,191)      (160,001)     (172,410)
  Net income                    722,684        728,313        77,566        334,677
                                       - 18 -


                                       10/31/94                      10/31/95
                               Financial                     Financial
                               Statement      Return         Statement      Return
General & contract revenue    $4,615,746    $4,633,752      $5,312,291    $5,443,976
Operating expenses            (4,737,810)   (4,876,375)     (5,504,288)   (5,640,193)
  Income from operations        (122,064)     (242,623)       (191,997)     (196,217)
Other income/(loss)             (119,795)       491,262        123,346        504,140
  Net income before taxes       (241,859)       248,639        (68,651)       307,923
Provision for taxes              103,921        (80,219)        54,707      (103,340)
  Net income                    (137,938)       168,420        (13,944)       204,583
                                       10/31/96
                               Financial
                               Statement      Return
General & contract revenue    $6,141,479    $6,069,677
Operating expenses            (5,907,484)   (6,063,715)
  Income from operations         233,995          5,962
Other income/(loss)              137,722         79,668
  Net income before taxes        371,717         85,630
Provision for taxes             (128,588)       (17,364)
  Net income                     243,129         68,266


      Petitioner's gross receipts/sales, net earnings, and profit

before interest and taxes as reflected on its Forms 1120 and

financial statements for the years ending October 31, 1986 to

1996, were as follows:
                  Gross                       Net                  Profit
              Receipts/Sales             Income/(Loss)      Before Interest & Taxes
                         Financial             Financial                    Financial
   Year     Return       Statement   Return    Statement         Return     Statement
   1986   $2,108,148    $2,135,832   $76,268    $109,314        $107,882     $170,099
   1987    3,359,825     3,666,642    55,890     268,228          91,505      355,062
   1988    3,910,680     4,416,990    67,392     100,990         128,110      219,691
   1989    4,489,866     4,423,002   105,559     290,714         274,428      564,877
   1990    6,014,515     6,746,331   533,207   1,072,832         891,514    1,881,196
   1991    5,581,672     5,156,266   396,465     335,049         686,366      643,943
   1992    7,388,353     7,442,762   728,313     722,684       1,155,251    1,187,754
   1993    5,088,511     5,090,933   334,677      77,566         558,886      289,650
   1994    4,633,752     4,615,746   168,420    (137,938)        255,090    (229,787)
   1995    5,443,976     5,312,291   204,583     (13,944)        340,176     (32,698)
   1996    6,069,677     6,141,479    68,266     243,129         126,942      417,147

      Petitioner's financial statements and the Schedules E,

Compensation of Officers, of Forms 1120 for the years ending

October 31, 1986 through 1996, reported compensation of officers

as follows:
                                    - 19 -
                          Return                    Financial Statement
                                    Total Officer      Total Officer
  Year      Dennis        Curtis    Compensation       Compensation

  1986      $134,310      $60,690     $195,000            $195,000
  1987        40,641       40,641       81,282              81,282
  1988        74,206       51,706      125,912             285,912
  1989       160,456       80,456      240,912             243,090
  1990       207,239       97,239      304,478             304,478
  1991       745,050      345,050    1,090,100             930,100
  1992       593,350      193,350      786,700             788,400
  1993       784,470      204,450      988,920             988,920
  1994       847,109      399,260    1,246,369           1,246,437
  1995     1,048,200      246,688    1,294,888           1,293,948
  1996       699,192      400,573    1,099,765           1,099,825

     Since its incorporation in 1985, petitioner has neither paid

nor declared any dividends.

     Petitioner timely filed its Forms 1120 for the taxable years

1995 and 1996 with the Internal Revenue Service Center at Kansas

City, Missouri.        On November 25, 1998, respondent issued a notice

of deficiency to petitioner for the taxable years ending October

31, 1995 and 1996.       Respondent's proposed adjustments concerned

only the reasonableness of petitioner's total officer

compensation payments made to Dennis and Curtis.

                                    OPINION

A. Positions of the Parties

     On its Forms 1120, petitioner deducted officer compensation

of $1,294,888 ($1,048,200 for Dennis and $246,688 for Curtis) in

1995 and $1,099,765 ($699,192 for Dennis and $400,573 for Curtis)

in 1996.   Petitioner contends that the amounts paid to Dennis and

Curtis were reasonable and were for services they provided to

petitioner.
                                - 20 -

     In the notice of deficiency, respondent disallowed

$1,084,719 of the officer compensation deducted in 1995 (allowing

$210,169) and disallowed $898,560 deducted in 1996 (allowing

$201,205).    On brief, respondent now contends that officer

compensation in excess of $435,450 ($243,000 paid to Dennis and

$192,450 to Curtis) in 1995 and in excess of $460,950 ($258,600

paid to Dennis and $202,350 to Curtis) in 1996 was unreasonable,

was disguised dividends, and was not compensation for services

Dennis and Curtis rendered to petitioner.

B. Controlling Factors

     A taxpayer may deduct payments for compensation if the

amount paid is reasonable and for services actually rendered.

See sec. 162(a)(1).    The reasonableness of compensation is a

question of fact that must be answered by comparing each

employee's compensation with the value of services that he or she

performed in return.     See RTS Inv. Corp. v. Commissioner, 877

F.2d 647, 650 (8th Cir. 1989), affg. per curiam T.C. Memo. 1987-

98; Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 151

(8th Cir. 1974), affg. T.C. Memo. 1973-130; Estate of Wallace v.

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

Cir. 1992).    Where, as in this case, the corporation is

controlled by the same employees to whom the compensation is

paid, there is a lack of arm's-length bargaining.    Special

scrutiny must be given to bonus payments paid under such
                               - 21 -

circumstances, because such payments "may be distributions of

earnings rather than payments of compensation for services

rendered; even if they are reasonable, they would not be

deductible."    Charles Schneider & Co. v. Commissioner, supra at

153 (emphasis supplied).    Nevertheless, the existence of a

compensatory purpose can often be inferred if the amount of the

compensation is determined to be reasonable.    See O.S.C. &

Associates, Inc. v. Commissioner, 187 F.3d 1116, 1120 (9th Cir.

1999), affg. T.C. Memo. 1997-300.    For that reason, courts

generally focus on the reasonableness of the amount of the

purported compensation.    See id.   Courts generally do not delve

into whether a compensatory purpose exists unless there is

evidence that purported compensation payments, although

reasonable in amount, were in fact disguised dividends.      See id.

"[I]f there is evidence that the payments contain disguised

dividends, the corporation must separately satisfy both the

reasonableness and the compensatory intent prongs of the test.

Reasonableness alone will not suffice."     Id. at 1121.

C.   Expert Witness Reports

     Both parties submitted expert witness reports to establish

the amount of compensation paid to Dennis and Curtis that was

reasonable.    Expert witness reports may help the Court understand

an area requiring specialized training, knowledge, or judgment.

See Snyder v. Commissioner, 93 T.C. 529, 534 (1989).       We may be
                              - 22 -

selective in deciding what part of an expert witness' report we

will accept.   See Helvering v. National Grocery Co., 304 U.S.

282, 295 (1938); Silverman v. Commissioner, 538 F.2d 927, 933 (2d

Cir. 1976), affg. T.C. Memo. 1974-285; Parker v. Commissioner, 86

T.C. 547, 561 (1986).

     1.   Robert F. Reilly

     Petitioner presented the report and testimony of Robert F.

Reilly (Mr. Reilly), a compensation expert and a business

valuation expert from the firm of Willamette Management

Associates.

     In order to prepare his report, Mr. Reilly reviewed

petitioner's Forms 1120 and financial statements covering periods

from 1986 to 1996.   He interviewed Dennis and reviewed various

documents produced by petitioner, respondent, and third parties

to obtain information regarding petitioner and the services

provided by Dennis and Curtis.   Mr. Reilly researched the

published proxy data of public companies in 1995 and 1996 in an

effort to find companies comparable to petitioner but found no

specific public companies comparable to petitioner for

compensation purposes.   Additionally, he used various surveys to

evaluate the compensation paid to Dennis and Curtis in 1995 and

1996.

     Mr. Reilly considered developments of petitioner's business

from 1986 through 1996, including the following:
                                - 23 -

     (a)   Petitioner won and held onto logging contracts with

Boise Cascade Corp.;

     (b)   petitioner purchased land (or rented land from Wagner &

Wagner) to store construction wastes from its construction

operations and for others;

     (c)   petitioner converted portions of land from construction

waste storage to log storage for its logging operations and those

of Boise Cascade Corp.;

     (d)   petitioner purchased land and developed sand and gravel

pits for use in its construction business and for sale to others;

     (e)   petitioner entered into advantageous agreements to

extract gravel from other properties for use in its construction

business and its sand and gravel operations;

     (f)   petitioner's revenues increased from $2.1 million in

1986 to $6.1 million in 1996;

     (g)   from 1985 to 1996, both Dennis and Curtis devoted

themselves exclusively to petitioner's construction and related

businesses, and they worked up to 90 hours per week;

     (h)   by 1995, Dennis had more than 30 years of experience

and Curtis had more than 20 years of experience in the

construction and logging industries; and

     (i)   Dennis and Curtis were petitioner's only officers from

1985 to 1996; they performed all the executive and administrative
                              - 24 -

duties and assumed all the responsibilities for petitioner's

operations.

     Mr. Reilly based his analysis of compensation paid to Dennis

on the duties performed as president and chief executive officer

(CEO), chief financial officer, vice president of marketing and

sales, and chief operating officer (COO).   Mr. Reilly based his

analysis of compensation paid to Curtis on the duties performed

as vice president and chief engineering executive, COO (in

Dennis' absence), and supervisor of petitioner's logging

operations.

     Mr. Reilly found that, in his efforts to compare petitioner

to other highway and heavy construction companies, petitioner was

unique because it had a management team of only two people,

Dennis and Curtis, who operated a business with annual revenues

between $5 and $6 million.   Petitioner's management structure was

comparable to that of highway and heavy construction companies

with annual revenues between $1 and $3 million.   Furthermore, in

Mr. Reilly's opinion, it would take four people to replace

Dennis.   Mr. Reilly also noted, in comparing petitioner to other

highway and heavy construction companies of comparable size, that

petitioner operates in northern Minnesota where the construction

season is very short.   In comparing petitioner's financial

information to the published survey data, Mr. Reilly used
                             - 25 -

petitioner's Forms 1120 for sales figures of $5.4 million in 1995

and $6.1 million in 1996.

     Mr. Reilly reviewed the "Almanac of Business and Industrial

Financial Ratios" for the period from July 1995 to June 1996,

which uses data from the Federal income tax returns of businesses

included in the various categories.    Mr. Reilly determined that

of the nearly 21,000 businesses included in the highway and heavy

construction contractor category, 71 percent had total assets of

less than $1 million, fewer than 10 percent had total assets in

excess of $5 million, 62 percent had a positive net income, and

38 percent of the companies showed a loss in 1995 and 1996.

     Mr. Reilly concluded that petitioner's Forms 1120 showed a

profit every year from 1986 to 1996.   Mr. Reilly viewed

petitioner's financial record over 10 years because, in his

opinion, examining only 2 years would not take into account prior

undercompensation of executives.   Further, in his opinion, a

company's historical record is the best way to determine whether

a company has provided a fair return to its stockholders.

     Mr. Reilly, using the "CFMA's 1996 Construction Industry

Annual Financial Survey" (the CFMA survey), calculated that

highway and heavy construction contractors with revenue under $10

million reported a net income (or after-tax profit margin)

percentage of 2.3 percent for 1995 and 0.3 percent for 1996.    The

record does not indicate whether the CFMA survey used data from
                              - 26 -

financial statements or tax returns.   On the basis of the income

reported on petitioner's Forms 1120, Mr. Reilly calculated that

petitioner had a net income percentage (or after-tax profit

margin) of 3.8 percent for 1995 and 1.1 percent for 1996.

     Mr. Reilly did not compare compensation paid to Dennis and

Curtis to that paid to petitioner's other employees because no

other employee held an administrative or executive position.     Mr.

Reilly observed that petitioner maintained a profit-sharing plan

that included other employees, and the union employees were paid

top scale wages for the State of Minnesota rather than the

specific region governed by petitioner's union contracts.

     Mr. Reilly performed two separate analyses of petitioner's

executive compensation for purposes of determining a range of

reasonable compensation.

     Mr. Reilly first compared the executive compensation of

Dennis and Curtis to published executive compensation study

figures for positions in companies that, in his opinion, were of

comparable size and in comparable industries.   He used annual

compensation surveys from the National Institute of Business

Management (the NIBM survey) and Aspen Publishers, Inc. (the

Aspen survey).   The NIBM survey covers companies in the

construction, contracting, and extraction industries with annual

sales exceeding $5 million.   There is no upper limit on the sales

volume of companies included in the survey segment and,
                               - 27 -

accordingly, the survey segment could include companies with

sales of as much as $500 million.

     Mr. Reilly also used Watson Wyatt Data Services (Watson

Wyatt), which publishes an annual regression analysis report on

top management compensation.   The Watson Wyatt data includes data

for the general services sector; this sector includes all service

industries except banking, insurance, and financial services and

is not limited to the construction industry.   For each position

reported, Watson Wyatt provides equations used to calculate a

predicted mean total compensation as a function of sales or

stockholders equity.   In addition, the log of the standard

deviation provided with each equation allows for the calculation

of predicted total compensation at different percentiles.

     The median and high compensation of executives reported for

1995 and 1996 by the NIBM survey, the Aspen survey, and the

Watson Wyatt computation (calculated on the basis of shareholder

equity of $2,904,691 at the beginning of 1995 and $2,890,745 at

the beginning of 1996) is as follows:
                                      - 28 -

                            NIBM Survey           Aspen Survey       Watson Wyatt Data



                                     75th                    3rd               84th
Year/Position            Median    Percentil    Median    Quartile   Median Percentile
                                       e
1995
  CEO/president          $203,000 $300,000     $215,000 $386,000     $220,190 $378,180
  Marketing                95,000 134,000        73,000 120,000       110,659  164,319
  Finance                  97,000 150,000        73,000 110,000       108,194  170,766
  COO/manufacturing        94,000 147,500       194,000 222,000       176,470  248,296
                           81,450 125,000        74,000 111,000        93,513  127,666

Engineering/production


1996
  CEO/president          160,787    239,000     140,000   299,000    224,427   385,456
  Marketing               80,600    122,190      69,000    74,000    112,162   166,550
  Finance                 97,392    125,000      64,000    72,000    109,955   173,547
  COO/manufacturing      106,000    150,000     115,000   870,000    179,169   252,095
                         140,200    157,000      79,000    98,000     94,218   128,628

Engineering/production

      Using the NIBM survey, the Aspen survey, and the Watson

Wyatt data and not taking into account any undercompensation in

prior years, Mr. Reilly computed the upper range of reasonable

compensation for Dennis and Curtis in 1995 and 1996.                     In

computing the compensation for Dennis, Mr. Reilly added the

compensation for the CEO, highest marketing position, highest

financial position, and the COO, and then subtracted 25 percent

of the COO position (which he allocated to Curtis).                     In computing

the compensation for Curtis, Mr. Reilly added to the compensation

for the top engineering position 25 percent of the compensation

for the COO.      On the basis of those computations, Mr. Reilly's

opinion is that the upper range of reasonable compensation for

Dennis was between $694,625 and $899,487 for 1995 and between

$598,690 and $1,097,500 for 1996.              The reasonable compensation

for Curtis was between $161,875 and $189,740 for 1995 and between
                              - 29 -

$191,652 and $315,500 for 1996.

     We do not accept certain aspects of Mr. Reilly's analysis.

Mr. Reilly's aggregation approach would result in compensation

equal to that of four full-time corporate executives.   We reject

Mr. Reilly's suggestion that Dennis performed the work of four

full-time executives serving as petitioner's president and CEO,

chief financial officer, vice president of marketing and sales,

and COO.   Although Dennis may have performed some of the duties

and functions of four such executives, he did not perform work

equal to the full-time services of four such executives.

Although the more roles or functions an employee performs the

more valuable his services are likely to be, an employee who

performs four jobs, each on a part-time basis, is not necessarily

worth as much to a company as four employees each working full

time at one of those jobs.

     Dennis testified that he worked 80 to 90 hours per week.

Four full-time employees would have worked at least 160 combined

hours each week.   It is therefore inappropriate to aggregate the

normal full-time salary for four jobs to compute the reasonable

compensation of the employee who fills all four of them.   See

Pepsi-Cola Bottling Co. v. Commissioner, 61 T.C. 564, 569 (1974),

affd. 528 F.2d 176 (10th Cir. 1975); Richlands Med. Association

v. Commissioner, T.C. Memo. 1990-660, affd. without published

opinion 953 F.2d 639 (4th Cir. 1992); Ken Miller Supply, Inc. v.

Commissioner, T.C. Memo. 1978-228.
                                - 30 -

     We also find questionable some of the data from the surveys

Mr. Reilly used in forming his opinion.     For example, Mr. Reilly

opined that reasonable compensation for Dennis was between

$598,690 and $1,097,500 for 1996.     The $1,097,500 results in

large part from the use of data from the Aspen survey.

Specifically, Mr. Reilly used annual compensation for a COO of

$870,000 reported in the Aspen survey for the third quartile

amount.     The third quartile compensation was computed on the

basis of information reported by only three incumbents for the

COO category.4    The average amount was $132,000 and the median

was $115,000.    It is clear therefore that the $870,000 of the

third quartile was reported by one incumbent.     One company

reporting in the $2 to $5 million of sales category also reported

$870,000.    The $870,000 reported by the two companies is

substantially out of line with all other companies reporting COO

compensation in all categories.     Therefore, we do not find the

$870,000 to be reliable.

     We also find that Mr. Reilly's use of the income data from

petitioner's Forms 1120 for the 2 years at issue in his analysis

was inherently flawed because of the distortion caused by the

section 481(a) adjustment.     The adjustment resulted from

petitioner's change in accounting methods in 1991.     Before



     4
      The survey notes that where fewer than three incumbents
report in a given category, median, first quartile, and third
quartile information is not statistically relevant.
                                - 31 -

November 1, 1991, petitioner used the cash method of accounting

for tax purposes.   Effective November 1, 1991, petitioner changed

its method of accounting for tax purposes from the cash method to

the accrual method.   As a result of the change in accounting

method, petitioner realized a section 481(a) adjustment of

$1,637,156 and included $409,289 of the adjustment in income for

each of the 4 taxable years ending October 31, 1992 through 1995.

Thus, the section 481(a) adjustment affected the taxable year

1995 and artificially increased petitioner's income by $409,289

for that year.

     Mr. Reilly's second analysis estimated the reasonableness of

petitioner's executive compensation by calculating petitioner's

residual economic income after a fair return on the total fair

market value of the stockholders' invested capital.   In order to

assess the reasonableness of executive compensation under this

method, Mr. Reilly allocated to management all the profits in

excess of a fair return on the total fair market value of the

stockholders' invested capital.

     Mr. Reilly estimated that, over the period from 1987 to

1996, a fair before-tax annual rate of return on petitioner's

common stock would vary year to year from 26.0 percent to 32.7

percent.   Mr. Reilly's estimated fair return was 28.2 percent for

1995 and 26 percent for 1996.    Mr. Reilly calculated an estimated

value of invested capital in each year and increased the value by
                               - 32 -

the fair after-tax return from year to year, representing the

increase in theoretical retained earnings from October 31, 1985

through 1996, if a fair return was earned in each year through

1996 but no dividends were paid.

     Mr. Reilly then added the actual executive compensation paid

to income before taxes in order to calculate the amount available

to pay a fair return on invested capital and compensation to

officers.   Mr. Reilly used the income and executive compensation

reported on petitioner's Forms 1120.    He then subtracted from

this subtotal a fair return on the stockholders' invested

capital.    Under Mr. Reilly's analysis, the remainder (residual)

represents the amount available to pay the company's officers as

compensation for the results of their managerial efforts.    Mr.

Reilly then calculated the difference between the amount

available to pay petitioner's officers and the actual officers'

compensation, which, in his opinion, represented the

undercompensation or overcompensation in each year.

     Mr. Reilly calculated the amount of undercompensation or

overcompensation for the taxable years ending October 31, 1987

through 1996, as follows:
                                                        - 33 -
                                                10/31/1987    10/31/1988     10/31/1989    10/31/1990    10/31/1991
After-tax rate of return                             17.5%          19.57%        21.61%        20.29%        20.72%
Taxable income plus officers'                     $150,653       $210,218      $401,296    $1,109,855    $1,679,642
compensation
Fair return on capital
  Value begin year                                 315,766        370,993       443,716       539,478       648,787
  Pretax rate of return1                             26.5%          29.7%         32.7%         30.7%        31.4%
  Fair pretax return                                83,678        110,185       145,095       165,620       203,719
Available for officers' compensation                66,975        100,033       256,201       944,235     1,475,923
Actual compensation                                 81,282        125,912       240,912       304,478     1,090,100
Under/(over) compensation                          (14,307)       (25,879)       15,289       639,757       385,823
Cumulative under/(over) compensation               (14,307)       (40,186)      (24,897)      614,860     1,000,683

                                                10/31/1992    10/31/1993     10/31/1994    10/31/1995    10/31/1996
After-tax rate of return                             19.76%        19.67%         17.59%        18.60%        17.18%
Taxable income plus officers'                    1,890,204     1,496,007      1,495,008     1,602,811     1,185,395
compensation
Fair return on capital
  Value begin year                                 783,242        937,807     1,122,255     1,320,019     1,565,701
  Pretax rate of return1                             29.9%          29.8%         26.7%         28.2%         26.0%
  Fair pretax return                               234,189       279,467        299,642       372,245       407,082
Available for officers' compensation             1,656,015     1,216,540      1,195,366     1,230,566       778,313
Actual compensation                                786,700       988,920      1,246,369     1,294,888     1,099,765
Under/(over) compensation                          869,315       227,620        (51,003)      (64,322)     (321,452)
Cumulative under/(over) compensation             1,869,997     2,097,618      2,046,615     1,982,293     1,660,840

     1
         Pretax rate of return divided by 34 percent Federal tax rate.
                              - 34 -

     Mr. Reilly concluded that the total amount available as

reasonable compensation for Dennis and Curtis, as indicated by

the residual from a fair return of invested capital analysis, was

$1,230,566 for 1995 and $778,313 for 1996.

     Mr. Reilly combined the results of his two analyses and

found that the upper end of the range of reasonable combined

compensation for Dennis and Curtis was approximately $1.2 million

for 1995 and $1.1 million for 1996, without any adjustment for

undercompensation in prior years.    Mr. Reilly concluded that

Dennis and Curtis were undercompensated by more than $2 million

for the period from 1986 to 1994.

      We question Mr. Reilly's use of his fair return on invested

capital analysis to show that Dennis and Curtis were

undercompensated in prior years.    An executive has not been

undercompensated simply because the stockholders received an

excellent return on invested capital that greatly exceeds a

"fair" return.   As Mr. Reilly acknowledged, a fair return on

invested capital is the minimum a stockholder would expect and

demand; a stockholder who has not received such a return will

either replace management or sell the stock.

     Mr. Reilly's use of the cumulative excess amounts over a 10-

year period created a distortion that was merely an attempt to

justify payments in excess of the maximum Mr. Reilly could

compute using his other methods.    The Court notes that Mr. Reilly
                               - 35 -

used a hypothetical investment in capital for purposes of

computing a fair return on the capital.    Use of the hypothetical

investment in capital resulted in a smaller fair return for most

years.   The smaller fair return resulted in a larger excess,

which Mr. Reilly accumulated and used as the amount of

undercompensation.    Mr. Reilly used the more realistic

stockholders equity shown on petitioner's Forms 1120, however, to

compute compensation using the Watson Wyatt formula.    We reject

this inconsistency.

     As an additional analysis, Mr. Reilly calculated the average

compound annual returns to petitioner's stockholders.      He used

$315,766 (approximately twice the price petitioner paid for

Clifford's 1,000 shares of stock) as the value of the

stockholders' initial investment on October 31, 1986, and three

different measures of petitioner's stockholders equity.      Using

his fair return of invested capital analysis and the estimated

value of $1,834,375 as of October 31, 1996, Mr. Reilly calculated

that the average annual after-tax return over the 10-year period

from 1986 to 1996 was 19.24 percent.    Using the $3,133,877 book

value of stockholders equity as of October 31, 1996, Mr. Reilly

calculated that the average annual after-tax return over the 10-

year period was 25.80 percent.    Finally, using the $1,150,000

purchase price Dennis paid to Curtis for his 25 percent of

petitioner's stock in November 1997 to determine an estimated
                              - 36 -

value of $4.6 million for all of petitioner's stock as of that

date, Mr. Reilly calculated that the average annual after-tax

return over the 11-year period was 27.57 percent.

     We question Mr. Reilly's use of $315,766 as the value of the

stockholders' initial capital investment on October 31, 1986.

The purchase of Clifford's shares of stock was not the result of

an arm's-length negotiation and was made in conjunction with

Dennis' transfer of 25 percent of his stock to Curtis and with

the gratuitous transfer of Clifford's interest in Wagner & Wagner

to Dennis and Curtis.

     We also give little weight to the use of the purchase price

Dennis paid to Curtis for his 25 percent of petitioner's stock in

November 1997.   The sale occurred after the years in issue, and

the full terms of the purchase are not in evidence.5

     2.   John M. Lacey

     Respondent offered the report and testimony of John M.

Lacey, Ph.D. (Dr. Lacey), to establish that petitioner's return

on equity for 1995 and 1996 was not comparable to that of the

industry and would not meet a reasonable investor's expectations,

and to establish that petitioner did not fairly distribute its

earnings between management and stockholders.




     5
      At trial, petitioner objected in another context to the
admission of facts related to events occurring after the years
before the Court.
                               - 37 -

     To determine the reasonableness of the return on equity, Dr.

Lacey compared petitioner's returns on equity for 1995 and 1996

with those of publicly traded companies in the construction

industry for the same years.   Dr. Lacey found 19 publicly traded

companies in the highway and heavy construction industry.     He

excluded seven companies for one or more of the following

reasons:

     (1)   The company's annual sales exceeded $5 billion;

     (2)   a large portion of the company's operations were

conducted outside the United States;

     (3)   the company made large acquisitions during the relevant

period;

     (4)   the company reported negative equity, indicating

insolvency;

     (5)   construction was not the company's primary business;

     (6)   the company had material expense for settlement of

contract claims and unapproved change orders.

     The 12 remaining companies that Dr. Lacey used to compare to

petitioner included Amerilink Corp. (AmC), Atkinson, G.F. Co.

(AtC), Dycom Industries, Inc. (DII), Foster Wheeler (FW),

Goldfield Corp. (GoC), Granite Construction (GrC), Insituform

Technologies (IT), Jacobs Engineering (JE), Mastec Inc. (MI),

Meadow Valley Corp. (MV), MYR Group (MG), and Utilx Corp. (UC).
                             - 38 -

In making his comparisons, Dr. Lacey used the following data for

petitioner and the publicly traded companies:
                                                      - 39 -
                                                               Recalculated                               Return on
                        Sales               Gross Profit        Net Income            Equity               Equity

                                                     Dollar Amounts in Millions
                 1995           1996      1995      1996       1995      1996      1995         1996     1995     1996
Comparables:
 AmC             $47.54       $56.06     $15.68    $17.11    $1.45      $0.46      $8.75        $9.21   16.6%     5.0%
 AtC             417.00       468.47      39.17     44.25     3.61       5.02      83.46        89.28    4.3      5.6
 DII             143.91       143.93      26.17     28.20     4.43       6.39      11.19        17.78   39.6     35.9
 FW            3,042.18     4,005.50     399.89    494.53    83.14     111.42     625.87       688.96   13.3     16.2
 GoC              12.77        13.16       0.70      1.29    (0.68)     (0.34)     12.47        12.10   -5.4     -2.8
 GrC             894.80       928.80     111.96    110.66    28.54      27.35     209.91       233.61   13.6     11.7
 IT              272.20       289.93      89.92     88.71    14.85      11.37     116.81       123.20   12.7      9.2
 JE            1,723.06     1,798.97     189.23    208.06    32.24      40.36     238.76       283.39   13.5     14.2
 MI              174.58       472.80      43.82    120.47    19.79      30.08      50.50       103.50   39.2     29.1
 MV               90.05       133.72       4.35      2.81     1.23      (0.09)     11.76        11.68   10.5     -0.7
 MG              266.97       310.58      29.55     31.64     3.43       3.97      26.62        29.57   12.9     13.4
 UC               49.72        48.99       6.74      6.41    (2.02)     (4.49)     28.07        23.46   -7.2    -19.1

Average          594.56         722.58    79.76     96.18    15.83      19.29     118.68       135.48   13.6      9.8
Median           220.77         300.26    34.36     37.95     4.02       5.70      39.29        59.43   13.1     10.5
Petitioner         5.31           6.14     1.20      1.44    (0.01)      0.24       2.89         3.13   -0.5      7.8
                              - 40 -

     Dr. Lacey computed the return on equity for 1995 and 1996

for each of the 12 publicly traded companies by dividing

"recalculated net income" by common equity.   Recalculated net

income is net income excluding income from discontinued

operations, minority interests, the writeoff of offering costs,

and special charges.   Dr. Lacey calculated that the median return

on equity of the publicly traded companies was a gain of 13.1

percent in 1995 and a gain of 10.5 percent in 1996.   In addition,

he calculated that the average return was a gain of 13.6 percent

in 1995 and 9.8 percent in 1996.   He calculated that petitioner's

return on equity was a loss of 0.5 percent in 1995 and a gain of

7.8 percent in 1996.   Dr. Lacey concluded that petitioner's

return on equity would not satisfy the expectation of reasonable

investors because it was below the median and average returns for

the industry.

     In order to assess the fairness of petitioner's division of

earnings, Dr. Lacey examined petitioner's distribution among debt

holders (in the form of interest expense), executive officers (in

the form of bonuses and other compensation), stockholders (in the

form of net income, some of which may be paid out currently as

dividends), and the Government (in the form of taxes).    Dr. Lacey

compared petitioner's distribution of its earnings among the four

groups to those made by the 12 publicly traded companies.
                              - 41 -

     Using data from the 12 publicly traded companies, Dr. Lacey

calculated that the total pool of funds available for

distribution among the four groups was equal to operating income

plus other income/expense plus management compensation.     In

calculating management compensation paid by the publicly traded

companies, Dr. Lacey included only salaries and bonuses paid to

executive officers.   He did not include stock options or any

other perquisite compensation paid to executive officers of the

publicly traded companies or compensation to managers such as

supervisors who were not officers.

     Dr. Lacey calculated distributable funds, net income

distributable to equity holders, and management compensation for

the 12 publicly traded companies and petitioner as follows:
                                                     - 42 -
             Distributable Funds            Net Income/Equity Holders                 Management Compensation
                                                  Dollar Amounts in Thousands
                1995        1996           1995                  1996                 1995                 1996
Comparables:
 AmC          $3,399.84  $1,750.56    $1,449.77   42.6%      $457.04   26.1%     $612.19     18.0%    $552.31      31.6%
 AtC           7,460.96  10,241.00     3,609.00   48.4      5,019.00   49.0     1,806.96     24.2    1,744.00      17.0
 DII           8,510.67  10,633.17     4,433.20   52.1      6,390.14   60.1       994.57     11.7    1,513.45      14.2
 FW          176,540.16 214,251.74    83,144.00   47.1    111,416.00   52.0     3,256.16      1.8    3,269.74       1.5
 GoC            (105.10)    340.18      (677.56) 644.7       (337.84) -99.3       510.46   -485.7      678.02     199.3
 GrC          50,336.00  49,365.00    28,542.00   56.7     27,348.00   55.4     1,589.00      3.2    1,589.00       3.2
 IT           26,960.10  24,333.89    14,850.00   55.1     11,367.00   46.7     1,730.10      6.4    1,758.89       7.2
 JE           59,281.82  73,718.78    32,242.00   54.4     40,360.00   54.7     3,684.82      6.2    4,120.38       5.6
 MI           24,087.00  60,111.00    19,785.00   82.1     30,083.00   50.0     1,183.00      4.9    2,933.00       4.9
 MV            3,240.70   1,058.73     1,232.35   38.0        (85.23) -8.1        342.24     10.6      553.77      52.3
 MG            8,798.35   9,657.00     3,429.00   39.0      3,968.00   41.1     1,311.35     14.9    1,431.00      14.8
 UC           (2,173.66) (1,513.00)   (2,022.00) 93.0      (4,489.00) 296.7       748.34    -34.4      985.00     -65.1
Average                                                                                      10.2                  11.1
Median                                                                                        8.5                   7.2
Petitioner
               1,262.99    1,516.94     (13.94)   -1.1        243.13   16.0     1,293.95     102.5   1,099.83      72.5
                               - 43 -

     For comparison purposes, Dr. Lacey excluded two companies in

1995 (GoC and UC) and three companies in 1996 (GoC, MV, and UC)

because the companies reported losses.    Dr. Lacey calculated that

petitioner distributed more than 100 percent of its available

funds to management (Dennis and Curtis) in 1995 and 72.5 percent

in 1996 compared with the remaining publicly traded companies

that ranged from 1.8 to 24.2 percent in 1995 and 1.5 to 31.6

percent in 1996.    Generally, equity holders received twice as

much as management.

     Dr. Lacey also reviewed the annual proxy statements filed by

the 12 publicly traded companies with the Securities and Exchange

Commission.    The proxy statements indicate that four of the

companies do not have a formal bonus policy.    The other eight

companies limit the size of the bonuses.    For example, five

companies limit the bonus to a percentage of the base salary

(ranging from 50 to 150 percent).    Other companies create a bonus

pool determined on the basis of the company's financial

performance.    Individual officers then receive a portion of the

total pool as recommended by top management or the board of

directors.    One company gives its CEO a bonus equal to 5 percent

of the company's operating income above a target level.

     Dr. Lacey also used two studies compiled from data submitted

for 1995 to compare the bonuses petitioner paid to those paid by

other businesses.    Dr. Lacey's report does not disclose the range
                               - 44 -

of the bonuses paid by the other companies.    According to one

survey, CEO's in the construction industry earned median bonuses

equal to 100 percent of their base salaries, and COO's in the

construction industry earned median bonuses equal to 53 percent

of their base salaries.   According to the other survey, CEO's

from all industries earned a median bonus equal to 90 percent of

their base salaries.

     Dr. Lacey compared petitioner to the industry as a whole

using two financial ratios derived from the Robert Morris

Associates "RMA Annual Statement Studies".    He calculated

officers', directors', and owners' compensation as a percentage

of sales for petitioner and compared the results with the median

for highway and heavy construction companies for which data was

available.    Dr. Lacey calculated that petitioner's percentage of

sales ratio (on the basis of compensation paid to Dennis and

Curtis) was 24.4 percent in 1995 and 17.9 percent in 1996.    He

calculated the median ratio for companies in each of the four

subcategories in the highway and heavy construction industry and

reported that the median ratio for companies doing highway and

heavy construction did not exceed 4 percent.    The report does not

show the range of ratios for companies included in his

evaluation.

     Dr. Lacey also calculated petitioner's pretax profit as a

percentage of tangible net worth and compared the results with
                               - 45 -

the medians for highway and heavy construction companies.     A

larger percentage indicates that equity holders receive a higher

return, in relation to the book value of their investment in the

company.    Petitioner's ratio was -2.4 percent in 1995 and 11.9

percent in 1996.    The medians for companies in the four

subcategories with sales between $1 and $10 million were between

11.2 and 20.4 percent in 1995 and between 11.1 and 19.1 percent

in 1996.

     Dr. Lacey's analysis has a fatal flaw; none of the 12

publicly traded companies he selected was reasonably comparable

to petitioner.    All of them were much larger than petitioner,

particularly in terms of their respective annual sales.     The

largest company, FW, had sales of $3.04 billion in 1995 and $4

billion in 1996.    The smallest company, GoC, had sales of $12.77

million in 1995 and $13.16 million in 1996.    Eight of the

companies had gross receipts in excess of $100 million in 1995

and 1996.    Another had gross receipts in excess of $90 million in

1995 and $133 million in 1996.    Of the three remaining smaller

companies (gross receipts between $12 and $50 million), Dr. Lacey

eliminated two companies (GoC and UC) from many of his

calculations because they showed losses in both 1995 and 1996.

     Dr. Lacey concluded that petitioner's return on equity would

not satisfy the expectation of a reasonable investor because the

return was below the median and average returns of the publicly
                               - 46 -

traded companies.   The returns on equity of the publicly traded

companies, however, ranged from a loss of 7.2 percent to a gain

of 39.6 percent for 1995 and from a loss of 19.1 percent to a

gain of 35.9 percent for 1996.   Petitioner's equity showed a loss

of 0.5 percent for 1995 and a gain of 7.8 percent for 1996.     Of

the 12 publicly traded companies, 2 had returns on equity lower

than petitioner's in 1995, and 5 had returns lower than

petitioner's in 1996.    Petitioner's returns on equity were within

the range of the returns realized by the publicly traded

companies.   Thus, without more,6 comparison to those companies

does not show that petitioner's returns on equity would not

satisfy the expectation of reasonable investors.

     Dr. Lacey opined that the compensation paid to Dennis and

Curtis in salaries and bonuses exceeded the 1995 and 1996 total

cash compensation of management for the large publicly traded

companies he examined.   However, as petitioner points out, Dr.

Lacey failed to take into account the stock options granted to

the executive officers of the publicly traded companies.   Top

executives at many publicly traded companies typically receive

stock options as part of their compensation packages.   These

stock options can produce substantial compensation in the event



     6
      Dr. Lacey offered no evidence that stockholders sold their
stock in the corporations reporting losses, that the prices of
stock of the companies were lower, or that the corporations
replaced management.
                               - 47 -

that the company's stock price rises greatly.    In at least one

other case, the Commissioner conceded that the value of stock

options granted to employees in public companies should be

considered in determining what like enterprises paid for like

services.   See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d

1315, 1330 n.60 (5th Cir. 1987) (experts calculated the average

amounts the top three executives could expect to earn in cash and

stock options for an outstanding performance), affg. T.C. Memo.

1985-267.    When the compensation paid to Dennis and Curtis is

compared with that of other CEO's who did receive options, the

options must be considered as part of the compensation packages

being used for comparison.    See Labelgraphics, Inc. v.

Commissioner, T.C. Memo. 1998-343, affd. 221 F.3d 1091 (9th Cir.

2000).    Accordingly, we reject Dr. Lacey's opinion.

     3.   Paul A. Katz

     Respondent offered the report and testimony of Paul A. Katz

(Mr. Katz) for purposes of establishing whether the compensation

petitioner paid to Dennis and Curtis in 1995 and 1996 was

comparable to that paid for similar positions in the industry.

Mr. Katz is a compensation consultant certified by the American

Compensation Association.

     Mr. Katz compared the compensation paid to Dennis and Curtis

in 1995 and 1996 to the median compensation paid in those years

to CEO's, and COO's, respectively, as reported by the Economic
                                - 48 -

Research Institute (ERI).   ERI compiles data from 2,400 surveys

taken by associations, governmental organization, and reports

submitted to the Government.    Mr. Katz analyzed the data for

CEO's7 and COO's8 of construction companies with revenues of

approximately $6 million and doing business within 200 miles of

International Falls, Minnesota (but excluding the Minneapolis

area).

     Using the ERI data, Mr. Katz calculated that the median

comparable compensation (including bonuses but excluding

benefits) for CEO's and COO's for 1995 and 1996 was as follows:

     Position                    1995               1996
       CEO
        Base                   $142,800           $152,400
        Bonus                    19,200              20,100
                                                  1
         Total                  162,000             172,500
       COO
        Base                    99,700             106,400
        Bonus                   28,600              28,500
           Total               128,300             134,900
     1
      Mr. Katz incorrectly indicated a total of $172,400 in his
report.

     Mr. Katz opined that compensation for comparable positions

can vary as much as 50 percent above or below the median and that

variances greater than 50 percent are generally not considered


     7
      The ERI survey defines the CEO as the highest ranking and
paid officer in the company with overall responsibility for
directing the running and planning of the company's business
activities.
     8
      The ERI survey defines the COO as the second highest
ranking and paid officer in the company with subordinate
responsibility to manage costs and achieve goals.
                               - 49 -

good compensation practice.   On that basis, Mr. Katz opined that

Dennis and Curtis were overpaid by an almost unprecedented

amount.   On the basis of Mr. Katz' opinion, respondent contends

on brief that compensation petitioner paid to Dennis and Curtis

in excess of the following amounts for 1995 and 1996 was

unreasonable:

       Position                 1995                1996
     Dennis (CEO)             $243,000            $258,600
     Curtis (COO)              192,450             202,350

     Mr. Katz based his analysis of compensation paid to Dennis

on the duties performed as the CEO and his analysis of

compensation paid to Curtis on the duties performed as the COO.

Mr. Katz did not consider any other functions performed by Dennis

and Curtis or the number of hours they worked.

     We find the report of Mr. Katz to be unreliable.    The report

contains several typographical and mathematical errors.      Although

some errors were corrected by Mr. Katz' testimony at trial,

others were not.    Except for a statement in his report that the

median salaries were based on ERI data, the report does not

include the ERI data used by Mr. Katz to determine the median

salaries and does not indicate the number of corporations, CEO's,

or COO's included in the data.   Additionally, although Mr. Katz

testified that he looked at the range of compensation to evaluate

the quality of the data, the report does not provide a range of

compensation amounts from the ERI data.
                              - 50 -

     Finally, Mr. Katz opined that salaries and bonuses paid to

Dennis and Curtis were excessive because the compensation

exceeded the 1995 and 1996 median cash compensation for CEO's and

COO's included in the ERI data.    However, Mr. Katz, like Dr.

Lacey, failed to take into account the stock options granted to

the CEO's and COO's of the publicly traded companies.    See

Labelgraphics, Inc. v. Commissioner, supra.

     Accordingly, we reject Mr. Katz' opinion concerning

reasonable compensation paid to Dennis and Curtis for the years

at issue.

D.   Rejection of Expert Witness Opinions

     Because of fundamental differences in approach among the

experts engaged by both parties, the values arrived at in the

reports are extremely far apart.    Although it is not unusual in

valuation cases that two experts reach significantly different

conclusions, the reports and testimony of the experts in this

case are so dissimilar that the reliability of the experts is

brought into question.   In this case, the experts reached

conclusions that patently favored their respective clients, and

their reports were designed to support their conclusions.

     The purpose of expert testimony is to assist the trier of

fact to understand evidence that will determine the fact in

issue.   See Laureys v. Commissioner, 92 T.C. 101, 127-129 (1989).

That purpose is jeopardized when an expert assumes the position
                               - 51 -

of an advocate.   See id.   An expert has a duty to the Court that

exceeds his duty to his client; the expert is obligated to

present data, analysis, and opinion with detached neutrality and

without bias, regardless of the effect of such unbiased

presentation on his client's case.      See, e.g., Estate of Halas v.

Commissioner, 94 T.C. 570, 577-578 (1990).      When an expert

displays an unyielding allegiance to the party who is paying his

or her bill, we generally will disregard that testimony as

untrustworthy.    See id.; Laureys v. Commissioner, supra; see also

Jacobson v. Commissioner, T.C. Memo. 1989-606 (when experts act

as advocates, "the experts can be viewed only as hired guns of

the side that retained them, and this not only disparages their

professional status but precludes their assistance to the Court

in reaching a proper and reasonably accurate conclusion").       The

experts' lack of impartiality has caused a disservice to the

Court and the system of tax administration.

E.   Reasonableness of Compensation

     We first determine the amount of compensation that was

reasonable for petitioner to pay to Dennis and Curtis for their

services.   In Charles Schneider & Co. v. Commissioner, 500 F.2d

at 151-152, the Court of Appeals for the Eight Circuit, to which

an appeal in this case would lie, listed the following factors

courts consider in assessing the reasonableness of an employee's

compensation:
                              - 52 -

     (1) The employee's qualifications;

     (2) the nature, extent, and scope of the employee's work;

     (3) the size and complexities of the business;

     (4) the prevailing general economic conditions;

     (5) the prevailing rates of compensation for comparable

positions in comparable concerns;

     (6) the salary policy of the taxpayer as to all employees;

     (7) in the case of small corporations with a limited number

of officers the amount of compensation paid to the particular

employee in previous years;

     (8) a comparison of salaries paid with the gross income and

the net income; and

     (9) comparison of salaries with distributions to

stockholders.

      We carefully scrutinize the facts at hand because Dennis

and Curtis, the employees to whom the compensation was paid,

control petitioner, the paying corporation.   We must be sure that

any amounts purportedly paid as compensation were actually paid

for services rendered by Dennis and Curtis, rather than

distributions to them of earnings that petitioner could not

otherwise deduct.   See Paul E. Kummer Realty Co. v. Commissioner,

511 F.2d 313, 315-316 (8th Cir. 1975), affg. T.C. Memo. 1974-44;

Charles Schneider & Co. v. Commissioner, supra at 152-153.     No

single factor controls.   We examine these factors from the
                              - 53 -

perspective of an independent investor.    See RAPCO, Inc. v.

Commissioner, 85 F.3d 950, 954-955 (2d Cir. 1996), affg. T.C.

Memo. 1995-128.

     1. Employee's Qualifications

     An employee's superior qualifications for his or her

position with the business may justify high compensation.   See

Charles Schneider & Co. v. Commissioner, supra at 152; Mayson

Manufacturing Co. v. Commissioner, 178 F.2d 115, 121 (6th Cir.

1949); Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C.

1142, 1158 (1980).

     By 1995, Dennis and Curtis had many years of experience in

the construction and logging industries.   During the years at

issue, both Dennis and Curtis devoted themselves exclusively to

petitioner's business, and they worked up to 90 hours per week.

Dennis and Curtis performed all the executive and administrative

duties and assumed all the responsibilities for petitioner's

operations.   Their experience and knowledge of petitioner's

construction, logging, and other diverse business activities made

them uniquely qualified for their positions with the business and

warrant high compensation.

     2. Nature, Extent, and Scope of Employee's Work

     An employee's position, duties performed, hours worked, and

general importance to the success of the company may justify high

compensation.   See Charles Schneider & Co. v. Commissioner,
                               - 54 -

supra; see also Rutter v. Commissioner, 853 F.2d 1267 (5th Cir.

1988), affg. T.C. Memo. 1986-407; Mayson Manufacturing Co. v.

Commissioner, supra at 121.    Dennis and Curtis worked long hours,

6 or 7 days a week.    They were petitioner's only officers.

Dennis performed all the duties of a CEO, and Curtis performed

all duties of a COO.    We view Dennis and Curtis as indispensable

to petitioner's various business activities, including highway

and heavy construction, logging, construction waste storage, and

sand and gravel operations.    Petitioner's growth and prosperity

are due directly to the skills, dedication, and efforts of Dennis

and Curtis.

     We find the nature and scope of the work performed by Dennis

and Curtis warrant high compensation.

     3. Size and Complexity of Business

     We consider the size and complexity of a taxpayer's business

in deciding whether compensation is reasonable.    See Owensby &

Kritikos, Inc. v. Commissioner, 819 F.2d at 1322-1323; Mayson

Manufacturing Co. v. Commissioner, supra.    A company's size is

measured by its sales, net income, gross receipts, or capital

value.   See E. Wagner & Son, Inc. v. Commissioner, 93 F.2d 816,

819 (9th Cir. 1937).

     Petitioner's business is more complex than that of many

highway and heavy construction companies; petitioner's business

also includes logging, construction, waste storage, and sand and
                               - 55 -

gravel operations.   In 1995, petitioner had gross receipts of

$5.31 million and capital value of $2.89 million (on the basis of

shareholder equity).   In 1996, petitioner had gross receipts of

$6.14 million and capital value of $3.13 million (on the basis

shareholder equity).

     We find that the size and complexity of petitioner's

business warrants high compensation for its officers.

     4. General Economic Conditions

     General economic conditions may affect a company's

performance and thus show the extent of the employee's effect on

the company.   See Rutter v. Commissioner, supra at 1271; Mayson

Manufacturing Co. v. Commissioner, supra at 119.   This factor

helps to determine whether the success of a business is

attributable to general economic conditions, as opposed to the

efforts and business acumen of the employee.   Adverse economic

conditions, for example, tend to show that an employee's skill

was important to a company that grew during the bad years.   See

Mad Auto Wrecking, Inc. v. Commissioner, T.C. Memo. 1995-153.

     Petitioner's sales increased from $4.62 to $6.14 million

during the 2 years at issue.   There is no evidence that

petitioner's success resulted from general economic conditions.

The record shows that petitioner's success resulted in large part

from the expertise of Dennis and Curtis and their long hours of

hard work.
                              - 56 -

     5.   Prevailing Rates of Compensation for Comparable
          Positions in Comparable Companies

     In deciding whether compensation is reasonable, we compare

it to compensation paid to persons holding comparable positions

in comparable companies.   See Rutter v. Commissioner, supra at

1271; Mayson Manufacturing Co. v. Commissioner, supra at 119.

     Petitioner and respondent rely on their experts' reports and

testimony with respect to this factor.   We are not persuaded by

any of the experts.

     Dr. Lacey's report does not provide any data or opinion as

to the amount of compensation that would be reasonable for

petitioner to pay to Dennis or Curtis.   Respondent uses the

compensation amounts Mr. Katz concluded were reasonable.    Those

amounts, however, do not take into account the valuable stock

options received by executives of the publicly traded companies.

We think that those amounts are less than the amounts that Dennis

or Curtis would expect to be paid or that an independent investor

would agree to pay for their services.

     By contrast, the amounts calculated by Mr. Reilly for Dennis

exceed the amounts paid by other companies for four full-time

executives, and they are excessive.

     On the basis of their value to petitioner's business, we

find that an independent investor would agree to pay Dennis, as

CEO, the highest amount of reasonable compensation for a CEO and

Curtis, as COO, the highest amount of reasonable compensation for
                               - 57 -

a COO.    Therefore, on the basis of the data that we have found

reliable for other companies in the industry contained in Mr.

Reilly's report, we find that for both years in issue at least

$385,000 is reasonable compensation for Dennis as CEO and at

least $250,000 is reasonable for Curtis as COO.

     6.   Petitioner's Compensation Policy for All Employees

     Courts have considered the taxpayer's compensation policy

for its other employees in deciding whether compensation is

reasonable.    See Mayson Manufacturing Co. v. Commissioner, 178

F.2d at 119; Home Interiors & Gifts, Inc. v. Commissioner, 73

T.C. at 1159.    This factor focuses on whether the entity pays top

dollar to all employees, including both stockholders and

nonstockholders.    See Owensby & Kritikos, Inc. v. Commissioner,

supra at 1329-1330.    We look to this factor to determine whether

Dennis and Curtis were compensated differently than petitioner's

other employees merely because of their status as stockholders.

See id.

     Petitioner paid its employees the highest wages under the

union contracts.    That fact, along with petitioner's success,

supports paying Dennis and Curtis the highest salaries for

officers.    The salaries paid to Dennis and Curtis were

substantially lower than the compensation paid to top executives

of other companies.    This supports a finding that part of the

bonus was compensation for services rendered during the year.
                              - 58 -

     None of petitioner's employees other than Dennis and Curtis,

however, shared in the large distribution of profits petitioner

made at yearend.   Cf. Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. at 1159-1160 (compensation paid to the

taxpayer's shareholder-employees was reasonable in part because

the taxpayer had a longstanding practice of paying all its key

employees on the basis of commissions).   Thus, petitioner's bonus

policy for its nonshareholder employees is not similar to the

bonus policy for Dennis and Curtis.    Cf. id.   Furthermore, the

bonuses were paid to Dennis and Curtis in the same proportion as

their stockholdings.

     This factor indicates that the bonus was in part

compensation for services and in part a distribution of profits.

     7.   Compensation Paid in Prior Years

     An employer may deduct compensation paid in a year for

services rendered in prior years.   See Lucas v. Ox Fibre Brush

Co., 281 U.S. 115, 119 (1930); R.J. Nicoll Co. v. Commissioner,

59 T.C. 37, 50-51 (1972).   To currently deduct amounts paid as

compensation for past undercompensation, a taxpayer must show

that it intended to compensate employees for past services from

current payments and must establish the amount of past

undercompensation.   See Pacific Grains, Inc. v. Commissioner, 399

F.2d 603, 606 (9th Cir. 1968), affg. T.C. Memo. 1967-7; Estate of

Wallace v. Commissioner, 95 T.C. at 553-554.
                              - 59 -

     Petitioner contends that parts of the payments to Dennis and

Curtis were for services rendered in prior years.   Petitioner

relies on its expert to establish the amount of past

undercompensation.   We have rejected Mr. Reilly's calculation of

undercompensation paid to Dennis and Curtis from 1986 to 1996.

We find that any undercompensation that may have occurred in

earlier years was rectified prior to the years at issue.    The

record does not indicate that the compensation paid to Dennis and

Curtis in 1995 and 1996 was attributable to services performed

for petitioner in earlier years.

     This fact further indicates that part of the bonus was a

distribution of profits and not compensation for services.

     8. Comparison of Salaries Paid With Gross Income and Net
        Income

     Courts have compared compensation to gross and net income in

deciding whether compensation is reasonable.   See Owensby &

Kritikos, Inc. v. Commissioner, 819 F.2d at 1322-1323; Mayson

Manufacturing Co. v. Commissioner, 178 F.2d 115 (6th Cir. 1949).

In most cases, considering compensation as a percentage of net

income is more probative than considering compensation as a

percentage of gross receipts because compensation as a percentage

of net income more accurately gauges whether a corporation is

disguising the distribution of dividends as compensation.    See

Owensby & Kritikos, Inc. v. Commissioner, supra at 1325-1326.
                              - 60 -

     According to its financial statements, petitioner had gross

receipts of $5,312,291 in 1995 and $6,141,479 in 1996.    After

payment of compensation, petitioner had a net loss of $13,944 in

1995 and net income of $243,129 in 1996.   In 1995, petitioner

paid $1,292,888 in officer compensation (or more than 100 percent

of petitioner's net income before payment of officer

compensation) and 24.4 percent of gross receipts.   In 1996,

petitioner paid $1,099,765 in officer compensation (or 81.9

percent of petitioner's net income before payment of officer

compensation) and 17.9 percent of gross receipts.   Although

petitioner reported net income of $204,583 on its 1995 Form 1120,

the positive net income is attributable in large part to the

section 481(a) adjustment that artificially increased

petitioner's income by $409,289 for that year.

     We think this factor favors respondent for 1995 and is

neutral for 1996.

     9.   Comparison of Salary to Distributions to Stockholders
          and Retained Earnings

     The failure to pay more than a minimal amount of dividends

may suggest that some of the amounts paid as compensation to the

shareholder-employee are dividends.    See id. at 1322-1323;

Edwin's, Inc. v. United States, 501 F.2d 675, 677 n.5 (7th Cir.

1974); Charles Schneider & Co. v. Commissioner, 500 F.2d 148 (8th

Cir. 1974).   Corporations, however, are not required to pay

dividends; stockholders may be equally content with the
                               - 61 -

appreciation of their stock if the company retains earnings.     See

Owensby & Kritikos, Inc. v. Commissioner, supra at 1326-1327;

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1161.

       In reviewing the reasonableness of an employee's

compensation, a hypothetical independent investor standard may be

used to determine whether a shareholder has received a fair

return on investment after the payment of the compensation in

question.    That leads us to consider whether an independent

investor would have approved the compensation in view of the

nature and quality of the services performed and the effect of

those services on the investor's return on his or her investment.

See Owensby & Kritikos, Inc. v. Commissioner, supra at 1326-1327;

see also Summit Sheet Metal Co. v. Commissioner, T.C. Memo. 1996-

563.

       The prime indicator of the return a corporation is earning

for its investors is the return on equity.    See Owensby &

Kritikos, Inc. v. Commissioner, supra at 1324.    In his report,

Mr. Reilly provides rates of return that an independent investor

would expect to earn on his investment.    From 1986 to 1996, the

following table shows:    (1) The equity shown on petitioner's

financial statements; (2) Mr. Reilly's fair after-tax rate of

returns on equity that an independent investor would expect to

earn; (3) the fair after-tax returns on equity using Mr. Reilly's

rates; (4) petitioner's actual after-tax returns on equity; (5)
                                     - 62 -

petitioner's actual after-tax rate of return; and (6) the

officers' compensation.

        Year-End        Fair       Fair       Actual        Actual     Officers'
Year     Equity     Return Rate   Return      Return     Return Rate Compensation
1985     $176,489
1986      255,018       NA           NA        $78,529      44.5%      $195,000
1987      442,796     17.50%      $44,628     187,778       73.6         81,282
1988      543,785     19.57        86,655     100,990       22.8        285,912
1989      834,499     21.61       117,512     290,714       53.5        243,090
1990    1,907,331     20.29       169,320   1,072,832      128.6        304,478
1991    2,242,380     20.72       395,199     335,049       17.6        930,100
1992    2,965,064     19.76       443,094     722,684       32.2        788,400
1993    3,042,630     19.67       583,228      77,566        2.6        988,920
1994    2,904,692     17.59       535,199    (137,938)      -4.5      1,246,437
1995    2,890,748     18.60       569,320     (13,944)      -0.5      1,293,948
1996    3,133,877     17.18       496,631     243,129        8.4      1,099,825

       From 1986 to 1992, petitioner's actual after-tax return on

equity greatly exceeded the expected fair return on equity, and

the increase in petitioner's retained earnings increased the

value of its stock.        During that period, Dennis and Curtis, in

effect, treated the company as a "growth stock", reinvesting

earnings to increase the value of their shares in the company.                    A

hypothetical investor would have considered $2,788,575 growth in

equity to have been an exceptional performance for the 7-year

period from 1986 to 1992 ($176,489 beginning year equity in 1986

to $2,965,064 end of year equity in 1992).

       As Mr. Reilly points out in his opinion, Dennis and Curtis

kept large amounts of cash in the company in order to build the

business.    Rather than having the profits distributed to them,

they caused petitioner to retain the earnings, in effect,
                              - 63 -

reinvesting the money in the business.    By the end of the 1992

fiscal year, they had invested $2,965,064 in the business.

     From 1993 to 1996, however, the bonuses paid to Dennis and

Curtis left petitioner with either an operating loss or a nominal

profit.   During the 4-year period from 1993 to 1996, shareholder

equity increased by only $168,813 (to $3,133,877 ending year

equity in 1996).   Having reinvested profits from earlier years, a

hypothetical investor would have considered a return of $168,813

on the $2,965,064 investment to have been an unacceptable

performance.

     An absence of profits paid to the stockholders as dividends

or reinvested in the business as retained profits justifies an

inference that some of the purported compensation really

represents a distribution of profits.    Paying most of

petitioner's taxable income as compensation to its officers from

1993 to 1996 suggests that the distributions to Dennis and Curtis

were in part disguised dividends.    See Owensby & Kritikos, Inc.

v. Commissioner, 819 F.2d at 1325.     Although an independent

investor might have approved of the very large payments made to

Dennis and Curtis in 1993 and 1994 because of the exceptional

returns in prior years, we do not think such an investor would

forgo profits beyond that period.    We think that an independent

investor would not have been satisfied with the large bonuses

petitioner paid to Dennis and Curtis in 1995 and 1996, since it
                                - 64 -

appears that profits were being siphoned out of the company

disguised as salary.   See id. at 1327.

     The ability to disguise dividends as salary, particularly if

the employee is the sole or majority shareholder, or if a large

percentage of the compensation is paid as a bonus, may suggest

that compensation is not reasonable.     See RAPCO, Inc. v.

Commissioner, 85 F.3d at 954.    Payment of bonuses at the end of a

tax year when a corporation knows its revenue for the year may

enable it to disguise dividends as compensation.    See Owensby &

Kritikos, Inc. v. Commissioner, supra at 1329; Estate of Wallace

v. Commissioner, 95 T.C. at 555-556.     The large yearend payments

made to Dennis and Curtis suggest that part of their compensation

was disguised dividends.   See Petro-Chem Mktg. Co. v. United

States, 221 Ct. Cl. 211, 602 F.2d 959, 968 (1979); Builders Steel

Co. v. Commissioner, 197 F.2d 263, 264 (8th Cir. 1952); Owensby &

Kritikos, Inc. v. Commissioner, T.C. Memo. 1985-267; Rich Plan,

Inc. v. Commissioner, T.C. Memo. 1978-514.

     Whether petitioner in fact intended to pay Dennis and Curtis

those amounts as salaries is material because to be deductible

under section 162(a)(1) they must be paid for services actually

rendered as well as be reasonable in amount.

     The following factors indicate that payments to shareholder

officers may be disguised dividend distributions rather than

payment for services rendered:
                              - 65 -

     (1)   The bonuses were in exact proportion to the officers'

stockholdings;

     (2)   payments were in lump sums rather than as the services

were rendered;

     (3)   there was a complete absence of formal dividend

distributions by an expanding corporation;

     (4)   the system of bonuses was completely unstructured,

having no relation to services performed;

     (5)   the company's negligible taxable income for 4

consecutive years was an indication that the bonus system was

based on funds available rather than on services rendered; and

     (6)   bonus payments were made only to the officer-

stockholders in proportion to their stockholdings, and not to

other employees.

See, e.g., O.S.C. & Associates, Inc. v. Commissioner, 187 F.3d at

1120; Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361-362

(9th Cir. 1974), affg. T.C. Memo. 1971-200.

     In this case, all the factors indicate that portions of the

bonuses were disguised dividends.

F.   Conclusion

     We do not think that petitioner intended the relatively

small salaries paid to Dennis and Curtis during the year to fully

compensate them for their services.    Thus, portions of the

bonuses paid to Dennis and Curtis at the end of the year were
                              - 66 -

intended as compensation for services.   We have found that for

both years in issue at least $385,000 is reasonable compensation

for Dennis as CEO and at least $250,000 is reasonable for Curtis

as COO.   We think another corporation would pay those amounts to

Dennis and Curtis for their services.

     We do not think, however, that an independent investor would

approve salaries in excess of $635,000, unless the investor were

receiving at least a fair return on his investment.

     Mr. Reilly, petitioner's expert, determined that 28.2

percent would be a fair pre-tax return (18.6 percent after-tax

return) on equity in 1995.   For 1995, an independent investor

would expect a pre-tax return of $819,123 ($2,904,692 beginning

year equity times fair pre-tax return of 28.2 percent).   In 1995,

petitioner deducted $1,294,888 as officer compensation and

reported a net loss of $13,946.   The $659,888 excess reported as

compensation ($1,294,888 less $635,000) is less than the fair

return and is, therefore, a nondeductible dividend.

     Mr. Reilly determined that 26 percent would be a fair pre-

tax return (17.18 percent after-tax return) on equity in 1996.

For 1996, an independent investor would expect a pre-tax return

of $751,594 ($2,890,748 beginning year equity times fair pre-tax

return 26 percent).   In 1996, petitioner deducted $1,099,765 as

officer compensation and had retained earnings of $243,132.   The

$464,765 excess reported as compensation ($1,099,765 less
                             - 67 -

$635,000) plus the $243,132 retained earnings equals $707,897.

That amount is less than the fair return and is a nondeductible

dividend.

     We hold that petitioner may deduct $635,000 ($385,000 paid

to Dennis plus $250,000 paid to Curtis) as officer compensation

in each of the taxable years ending October 31, 1995 and 1996.



                                        Decision will be entered

                                   under Rule 155.
