                  T.C. Memo. 2003-239



                UNITED STATES TAX COURT



     E.J. HARRISON AND SONS, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 5316-01.              Filed August 13, 2003.



     P was engaged in the waste pickup and disposal
business, servicing several California communities.
During the years in question, H was one of four
officers of P, the other three being her sons, who were
responsible for all of the key management functions on
P’s behalf. R disallowed a portion of P’s deduction
for compensation paid to H on the ground that it was
unreasonable and excessive.

     Held: Reasonable compensation for H determined.
See sec. 162(a), I.R.C.



Philip Garrett Panitz, for petitioner.

Ryan D. Schaap (specially recognized), for petitioner.

Jonathan H. Sloat and Linette B. Angelastro, for respondent.
                                - 2 -

              MEMORANDUM FINDINGS OF FACT AND OPINION


     HALPERN, Judge:    By notice of deficiency dated February 2,

2001 (the notice), respondent determined deficiencies in

petitioner’s Federal income tax as follows:

             TYE 6/30               Deficiency

              1995                  $161,680
              1996                   152,933
              1997                    61,628

     The adjustments giving rise to those deficiencies are

respondent’s disallowance of a portion of the deduction

petitioner claimed in each of the foregoing taxable years (the

audit years) for amounts paid to Myra I. Harrison (Mrs.

Harrison), one of petitioner’s officer-shareholders, as

compensation for services.   The amounts disallowed (disallowed

amounts) are $808,041, $764,664, and $541,325 for petitioner’s

1995, 1996, and 1997 audit years, respectively.   On brief,

respondent concedes a small portion of each of the disallowed

amounts for petitioner’s 1995 and 1996 audit years, so that they

are reduced to $806,467 and $762,019, respectively.     We accept

those concessions.

     Unless otherwise indicated, all section references are to

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

all Rule references are to the Tax Court Rules of Practice and

Procedure.   All dollar amounts have been rounded to the nearest

dollar.
                                - 3 -

                          FINDINGS OF FACT


     Some facts have been stipulated and are so found.    The

stipulation of facts, with attached exhibits, is incorporated

herein by this reference.

Petitioner’s Business Operations

     Elmo J. Harrison (Mr. Harrison) and Mrs. Harrison entered

into the trash or waste pickup and disposal (trash hauling)

business (sometimes, the business) in 1932.    They incorporated

the business (i.e., petitioner) in the State of California in

1967.   At the time it filed its petition, petitioner’s principal

place of business was in the State of California.    During the

audit years, petitioner performed its trash hauling services

pursuant to contracts with various municipalities in Ventura and

Santa Barbara Counties in the State of California.    Those

contracts provided to petitioner the exclusive right or franchise

to pick up and dispose of residential and commercial waste.

Under the contracts, petitioner was permitted to charge a per-

barrel or per-bin trash hauling rate as set by the municipality

from time to time.    Some contracts also provided a “management

fee” based upon petitioner’s cost of performance.    In

consideration of the grant of the franchise, petitioner was

typically charged a “franchise fee” by the customer equal to a

specified percentage (e.g., 5 percent) of its gross receipts

under the contract.    The municipalities with which petitioner had
                                - 4 -

contracts during the audit years included the cities of

Carpenteria, Ventura, Camarillo, and Ojai.    Petitioner also

contracted with Ventura County, covering the unincorporated

portions of that county.

Board of Directors Meetings

     On July 15, 1991, shortly after Mr. Harrison’s death on

April 5, 1991, petitioner’s board of directors (the board)

elected Mrs. Harrison president of petitioner, a title she held

continuously through the audit years.    Petitioner’s other

officers during the 1991-97 period were the Harrisons’ three

sons, Ralph E. Harrison (Ralph), James E. Harrison (James), and

Myron G. Harrison (Myron), each of whom held the title “vice

president”.    Ralph also held the title “secretary and treasurer”.

After Mr. Harrison’s death, those four individuals constituted

the board.    The formal board meetings (for which typewritten

minutes were kept) were held annually on July 15 during the 1991-

97 period.    Mrs. Harrison acted as or was designated “chairman”

of the meeting and Ralph acted as or was designated “secretary”.

During the 1995-97 annual meetings, the board determined “the

annual compensation, including bonuses, of each of the * * *

[officers]” for the fiscal year ending the previous June 30;
                               - 5 -

i.e., for each of the audit years.1    The members of the board

also met informally each week to discuss company business.

     Under petitioner’s bylaws, each director has an equal vote;

no director has veto power over a decision by a majority of the

board.   Nevertheless, in practice, with respect to major

decisions (e.g., approval of trash hauling contracts, major

equipment purchases, or large borrowings), the board acted by

consensus; i.e., unanimous agreement.

Duties of Officers

     Mrs. Harrison

     In the early years of the business, Mrs. Harrison kept

petitioner’s financial books and maintained the “route books”,

which determined the routes for the trash pickup trucks.    Her

duties consisted primarily of keeping track of customers,

collecting payments, and depositing collections.    After her three

sons joined the business in the early 1960s, Mrs. Harrison

continued to keep “the books”, basically keeping track of

payments and collections.   She also paid certain of the bills and

attended contract negotiation meetings with Mr. Harrison.




     1
        We note that petitioner, an accrual basis taxpayer, would
appear to be prohibited from deducting, in any taxable year,
compensation that is not fixed or determinable until after the
close of that taxable year. See sec. 1.461-1(a)(2), Income Tax
Regs. Because respondent has not raised, as an issue, the proper
accrual of officer compensation, we do not address it.
                               - 6 -

     During the audit years, Mrs. Harrison’s principal activities

consisted of (1) attending board meetings and voting on major

proposals put forward by her sons, who were responsible for the

day to day operations of petitioner, (2) engaging in extensive

public relations activities on behalf of petitioner, and (3)

acting as a coguarantor (together with her sons) of bank loans to

petitioner for major capital equipment purchases.

     At board meetings during the audit years, Mrs. Harrison

uniformly concurred in the proposals put forward by her sons,

e.g., proposed trash hauling contracts or equipment purchases.

On only one occasion before those years (in the mid-1960s) did

Mrs. Harrison “veto” a decision (to purchase new trucks) that had

been agreed to by the other directors.

     For the most part, her public relations activities consisted

of representing petitioner at civic events, such as meetings of

seven chambers of commerce for municipalities where petitioner

did business, Boy Scout functions, Ventura County Boys and Girls

Club functions, and the Ventura Chamber Music Festival.

Typically, the Harrison family would purchase one or two tables

at community events.   They would attend en masse with

Mrs. Harrison always at the head table.

     Although she approved petitioner’s trash hauling contracts

as a member of the board of directors, she did not take part in

the negotiation of those contracts, nor did she communicate with
                                - 7 -

employees of the cities with regard to the implementation of

those contracts.

     During the audit years, Mrs. Harrison was in her office at

one of petitioner’s facilities (and, after April 1997, at the

facilities of a related corporation) an average of two to three

times per week.    On occasion, she also took work home.   Her work

consisted in part of filing and maintaining historic company

records.   She also looked over proposed trash hauling contracts

before signature, and she reviewed bills and signed checks

prepared by others in payment of those bills.    She was the only

officer with authority to sign checks without a countersignature.

On occasion, she attended meetings arranged by one or more of her

sons with drivers or other employees where her fluency in Spanish

was of use.   In addition, she met with bankers in connection with

her loan guaranties.    Her attendance at those meetings usually

occurred after the loan terms had been negotiated but before the

final decision to go ahead with the loan.    Including her public

relations activities, Mrs. Harrison worked 40 or more hours per

week on petitioner’s behalf.

     Mrs. Harrison was 79, 80, and 81 years old during the audit

years.

     Myron Harrison

     Myron joined the business in 1959 and has been employed

continuously by petitioner since its incorporation.    Before and
                                - 8 -

during the audit years, Myron was in charge of financing

petitioner’s operations, including vehicle financing.    He was

also in charge of billings and collections.    Myron exercised sole

responsibility for the purchase of office equipment, although

Mrs. Harrison would be consulted regarding major purchases, such

as a new computer system for the office.    The company controller

reported to Myron.    In addition, during the audit years, Myron

was involved in the negotiation of trash hauling contracts with

petitioner’s customers.

     Myron was also involved in community affairs.    He was on the

board of directors of the Boys and Girls Club of Ventura and of a

local theater company.

     James Harrison

     James joined the business in 1962 and, like Myron, has been

employed continuously by petitioner since its incorporation.

Before and during the audit years he was responsible for

operations and contracts.    In that capacity, he was in charge of

negotiating the trash hauling contracts with the various cities,

and he represented petitioner at city council meetings.    He also

had primary responsibility for the design and planning of trash

pickup routes and for trash barrel and bin management.    He often

worked as many as 70 hours per week.
                                - 9 -

     Ralph Harrison

     Ralph also joined the business in 1962 and, like his

brothers, has been employed continuously by petitioner since its

incorporation.    Before and during the audit years his principal

responsibility was to manage, maintain, and refurbish

petitioner’s fleet of trash pickup trucks.    He was also

responsible for all major equipment purchases, including trucks,

containers, and heavy equipment such as tractors and bulldozers.

Related Entities

     During the audit years, Mrs. Harrison and her sons were

involved in the trash hauling business through entities other

than petitioner.    They were the sole partners in three

partnerships:    E.J. Harrison & Sons Rentals (Rentals), Newbury

Disposal Co. (Newbury), and Santa Clara Valley Disposal (Valley).

Mrs. Harrison was employed by Newbury and Valley, but she

received no compensation other than by means of partnership

distributions.    In addition, Myron, James, and Ralph were the

sole shareholders in Gold Coast Recycling, Inc., which was formed

in 1990 to operate a recycling facility in Ventura County.    Mr.

and Mrs. Harrison declined to take any interest in Gold Coast

Recycling, Inc., as they did not want to be involved in the

recycling business.    Mrs. Harrison had no involvement with Gold

Coast Recycling, Inc., during the audit years.
                              - 10 -

     Well before the audit years, the family formed Rentals,

which purchased trucks from petitioner.     Since that time,

petitioner has leased most of its trash hauling trucks from

Rentals.   During the audit years, Rentals was owned 55 percent by

Mrs. Harrison and 15 percent each by Myron, James, and Ralph.

Loan Guaranties

     Before the audit years, the California legislature passed a

recycling law (known as AB 939) that required California cities

to recycle 50 percent of their waste, all of which had previously

been dumped into landfills.   In order to comply with AB 939,

petitioner was required to supply each of its individual

customers with three barrels instead of one:     A trash barrel, a

recycle barrel, and a green waste container for lawn or grass

trimmings.   In order to raise the cash needed to purchase the

additional barrels and related equipment, petitioner and Rentals

arranged for loans from Bank of America.     On June 1, 1992, and on

May 3, 1996, Bank of America, as lender, and petitioner and

Rentals, as borrowers, entered into business loan agreements

(loan 1 and loan 2, respectively).     Loan 1 provided a $1.5

million line of credit secured by the personal property financed

by the loan and was conditioned, in part, on the execution of

guaranties by Mrs. Harrison, Myron, James, and Ralph, each in the

sum of $1.5 million.   Pursuant to amendments to loan 1 dated

August 14, 1992, and June 13, 1994, the line of credit was
                               - 11 -

increased to $5,350,000.    On June 13, 1994, Mrs. Harrison, Myron,

and Ralph, and, on June 14, 1994, James separately executed

continuing guaranties of “any and all indebtedness” of petitioner

and Rentals to Bank of America up to the sum of $7.5 million.

Loan 2 increased the overall line of credit from Bank of America

to petitioner and Rentals to approximately $7 million.

     On August 25, 1995, Mrs. Harrison, Myron, Ralph, and James

jointly and severally guaranteed the obligations of petitioner

and Rentals as lessees under a truck lease with an independent

third party, BA Leasing & Capital Corp., as lessor.   A corporate

resolution executed on the same date by Myron and Ralph on behalf

of petitioner limited the aggregate cost of the trucks subject to

the lease to $1 million.

     After the audit years, on April 14, 1998, Mrs. Harrison, as

trustee of the Survivor’s Trust, created under the E.J. Harrison

Family Trust, and James and Mary Harrison, as trustees of the

James E. Harrison Family Trust, executed a continuing guaranty in

favor of Bank of America securing a line of credit to petitioner

and Rentals in the sum of $16 million.   That guaranty replaced

the earlier, lesser guaranties executed during the audit years.

     During the audit years, petitioner used the line of credit

from Bank of America to place in service equipment costing in

excess of $3.6 million.    Petitioner has never defaulted on any of
                                                - 12 -

     the loans made to it by Bank of America, nor has there ever been

     any threat of default.

     Compensation of Officers by Petitioner

           Petitioner’s officers received compensation in the following

     amounts for petitioner’s taxable years ending June 30, 1979

     through 1997:

                                                                                    Total Officer
TYE 6/30       Mr. Harrison     Mrs. Harrison     Myron      James       Ralph      Compensation

 1979          (no breakdown – data not in evidence)                                   $353,850
 1980           $87,109           $74,990     $61,335       $61,360     $61,360         346,154
 1981           120,358           100,955      94,466        93,584      88,481         497,844
 1982           164,075           151,335     108,310       108,310     108,310         640,340
 1983           224,025           211,285     141,010       141,010     141,010         858,340
 1984           182,900           169,915     118,940       118,940     118,940         709,635
 1985           243,367           230,626     151,560       151,560     151,560         928,673
 1986           297,450           284,710     181,060       181,060     181,060       1,125,340
 1987           384,846           372,106     239,840       239,840     239,840       1,476,472
 1988           279,383           265,721     184,379       184,379     184,379       1,098,241
 1989          (no breakdown – data not in evidence)                                  1,161,150
 1990           421,951           354,305     240,498       240,498     240,498       1,497,750
 1991           125,697           351,084     154,792       154,792     154,792         941,157
 1992              -              419,394     165,371       166,218     166,217         917,200
 1993              -              174,585     132,425       132,425     132,425         571,860
 1994              -              431,482     262,607       262,607     262,607       1,219,303
 1995              -              860,682     479,773       473,973     459,673       2,274,101
 1996              -              818,059     442,882       475,183     468,188       2,204,312
 1997              -              600,059     338,436       377,849     360,391       1,676,735


     Petitioner’s Financial Results

           For the same taxable years, according to its returns as

     filed, petitioner’s sales, after-tax income (net income), yearend

     stockholder equity (equity), yearend assets (assets), return on

     sales (ROS), return on yearend equity (ROE), and return on

     yearend assets (ROA) were as follows:

                               Net
                   Sales      income    Equity     Assets     ROS       ROE         ROA
     TYE 6/30      $000        $000      $000       $000    percent   percent     percent

        1979      $3,200      $106       $348      $1,010    3.3       30.5       10.4
                                  - 13 -
 1980    3,819       82         433         955     2.1      18.9     8.6
 1981    4,502      124         556       1,058     2.8      22.3    11.7
 1982    5,372      197         753       1,167     3.7      26.2    16.9
 1983    5,522       25         778       1,214      .5       3.2     2.1
 1984    6,234      (95)        683       1,082    (1.5)    (13.9)   (8.8)
 1985    6,070      (92)    (data not     1,085    (1.5)      --     (8.5)
                           in evidence)
 1986     7,666      35         757       1,217      .5       4.6     2.9
 1987     8,884     (38)        769       1,130     (.4)     (4.9)   (3.4)
 1988     9,760     106       1,276       2,049     1.1       8.3     5.2
 1989    11,328      89       1,229       2,503      .8       7.2     3.6
 1990    14,011      82       1,183       2,805      .6       6.9     2.9
 1991    15,662     (59)        827       3,743     (.4)     (7.1)   (1.6)
 1992    16,817    (217)        256       3,672    (1.3)    (84.8)   (5.9)
 1993    18,366     (16)        251       4,490     (.1)     (6.4)    (.4)
 1994    23,604     356         450       6,444     1.5      79.1     5.5
 1995    27,409     302       1,027       7,505     1.1      29.4     4.0
 1996    26,826     155       1,451       8,279      .6      10.7     1.9
 1997    26,288    (233)      1,296       7,326     (.9)    (18.0)   (3.2)

     Pursuant to the foregoing figures, the average ROS, ROE and

ROA for the audit years were as follows:

                   ROS                    .27%
                   ROE                    7.4%
                   ROA                     .9%

Officers’ Ownership of Petitioner’s Stock

     During the 1980-97 taxable years, Mr. and Mrs. Harrison,

Myron, James, and Ralph owned all of petitioner’s stock in the

following percentage amounts:

                                     TYE June 30
                     1980-90           1991-94             1995-97

   Mr. Harrison            28                 –               --
                                             1
   Mrs. Harrison           27                 55              46
   Myron                   15                 15              18
   James                   15                 15              18
   Ralph                   15                 15              18
     1
        The return for the taxable year ending June 30, 1991,
lists Mrs. Harrison as owning a 54-percent interest. We assume
that that entry is mistaken and that she actually owned a 55-
percent interest in petitioner.
                               - 14 -

Dividend History

      Petitioner has never paid a dividend.


                               OPINION

I.   Burden of Proof

      A.   Rule 142(a)

      In pertinent part, Rule 142(a)(1) provides the general rule

that “[t]he burden of proof shall be upon the petitioner”.    Rule

142(a)(2) references the applicability of section 7491, which

shifts the burden of proof to the Secretary under certain

specified circumstances.

      B.   Section 7491

      Section 7491, enacted as part of the Internal Revenue

Service Restructuring and Reform Act of 1998 (RRA 1998), Pub. L.

105-206, sec. 3001, 112 Stat. 727, is applicable to “court

proceedings arising in connection with examinations commencing

after the date of the enactment of this Act.”    RRA 1998 sec.

3001(c).    RRA 1998 was enacted on July 22, 1998, well before

respondent’s issuance of the notice on February 2, 2001.    The

record fails to indicate, however, the commencement date of

respondent’s examination of petitioner.    Moreover, petitioner has

neither argued that section 7491 is applicable to shift the

burden of proof to respondent nor established compliance with the

requirements of section 7491(a)(2)(C) (the net worth limitation).

Petitioner has the burden to prove that it satisfies the
                                - 15 -

requirements of that provision as one of the      prerequisites to

establishing that the burden of proof is on respondent.       See

Edwards v. Commissioner, T.C. Memo. 2002-169; Cipriano v.

Commissioner, T.C. Memo. 2001-157, affd. 55 Fed. Appx. 104 (3d

Cir. 2003).

      C.   Conclusion

      Because petitioner has failed to establish that it meets the

conditions for the applicability of section 7491, petitioner

bears the burden of proof.     Rule 142(a).

II.   Deductibility of Payments to Mrs. Harrison

      A.   Section 162(a)(1)

      This case requires that we decide whether pursuant to

section 162(a)(1) petitioner can deduct amounts it paid to Mrs.

Harrison during the audit years.     That section provides:

      SEC. 162.   TRADE OR BUSINESS EXPENSES

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

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

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

deductibility of amounts purportedly paid as salaries or other

compensation for personal services actually rendered (without

distinction, compensation for services):      The payments must be

(1) “reasonable”, and (2) “in fact payments purely for services”.
                                   - 16 -

Sec. 1.162-7(a), Income Tax Regs.; see also Nor-Cal Adjusters v.

Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), affg. T.C. Memo.

1971-200.

     B.     Positions of the Parties

     Respondent argues that petitioner’s deductions for

compensation paid to Mrs. Harrison during the audit years should

be reduced as follows:

                         Amount              Amount         Amount
         TYE 6/30       deducted            allowed       disallowed

           1995         $860,682            $54,215       $806,467
           1996          818,059             56,040        762,019
           1997          600,059             58,734        541,325

Respondent argues that the disallowed amounts are “unreasonable

and excessive compensation”.       Respondent considers Mrs.

Harrison’s services equivalent to those provided by an outsider

serving as chair of a corporation’s board of directors, and the

amounts respondent allowed as reasonable compensation for the

audit years reflect respondent’s concession as to the amounts

properly attributable to those services.         Respondent also argues

that the disallowed amounts were intended to be disguised

dividends to Mrs. Harrison rather than payments for services

rendered.2

     2
        Respondent’s “disguised dividend” argument is raised for
the first time on brief. Petitioner has not argued that the
introduction of that argument on brief constitutes the raising of
a “new matter” requiring respondent to bear the burden of proof
with respect to that matter. See Rule 142(a). Had petitioner
made that argument, we would have rejected it for the reasons set
                                                   (continued...)
                               - 17 -

     Petitioner argues that, during the audit years, Mrs.

Harrison provided significant services to petitioner consisting

principally of (1) her services as a member of petitioner’s board

of directors, (2) her public relations activities, i.e., her

activities as petitioner’s primary representative at numerous

charitable and civic events in the communities served by

petitioner, and (3) her personal guaranty of the line of credit

to petitioner from Bank of America.     Petitioner also argues that

its return on equity during the audit years would have satisfied

an independent investor in petitioner.    On that basis, petitioner

argues that it is entitled to deduct the entire amount paid to

Mrs. Harrison during the audit years as reasonable compensation

for services rendered.

     C.   Analysis

          1.   Applicable Caselaw

     Because petitioner’s principal place of business is in

California, it is likely that any appeal of this case would be to

the Court of Appeals for the Ninth Circuit.    See sec.

7482(b)(1)(B).    Therefore, we must apply that court’s

jurisprudence governing issues of reasonable compensation in

accordance with the doctrine of Golsen v. Commissioner, 54 T.C.

742 (1970), affd. 445 F.2d 985 (10th Cir. 1971).


     2
      (...continued)
forth in Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 361-362
(9th Cir. 1974), affg. T.C. Memo. 1971-200.
                              - 18 -

     The jurisprudence of the Court of Appeals for the Ninth

Circuit is set forth in Elliotts, Inc. v. Commissioner, 716 F.2d

1241, 1244-1245 (9th Cir. 1983), revg. T.C. Memo. 1980-282,

wherein it adopts and applies the two-pronged test set forth in

the regulations as follows:

         In determining the deductibility of compensation
     payments paid to shareholder-employees, we will
     continue to concentrate on the reasonableness of those
     payments. In the rare case where there is evidence
     that an otherwise reasonable compensation payment
     contains a disguised dividend, the inquiry may expand
     into compensatory intent apart from reasonableness.
     * * * The inquiry into reasonableness is a broad one
     and will, in effect, subsume the inquiry into
     compensatory intent in most cases.

         In evaluating the reasonableness of compensation
     paid to a shareholder-employee * * * it is helpful to
     consider the matter from the perspective of a
     hypothetical independent investor. A relevant inquiry
     is whether an inactive, independent investor would be
     willing to compensate the employee as he was
     compensated. The nature and quality of the services
     should be considered, as well as the effect of those
     services on the return the investor is seeing on his
     investment. * * *

     In considering the reasonableness of compensation “from the

perspective of a hypothetical independent investor”, the Court of

Appeals for the Ninth Circuit in Elliotts, Inc. applies a five-

factor test:   (1) The employee’s role in the company; (2) a

comparison of the compensation paid to the employee with the

compensation paid to similarly situated employees in similar

companies (external comparison); (3) the character and condition

of the company; (4) whether a conflict of interest exists that

might permit the company to disguise dividend payments as
                                   - 19 -

deductible compensation; and (5) whether the compensation was

paid pursuant to a structured, formal and consistently applied

program.    Id. at 1245-1248; see also LabelGraphics, Inc. v.

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

2000) (the Elliotts, Inc. factors).

           2.   Need To Apply the Elliotts, Inc. Factors

     In this case, respondent’s conclusion that petitioner’s

purported compensation payments to Mrs. Harrison constituted

disguised dividends to the extent of the disallowed amounts is

based, in large part, upon his conclusion that total payments

were well in excess of the amounts that may be considered

reasonable compensation for the services Mrs. Harrison performed

on petitioner’s behalf.        Therefore, we must determine

reasonableness in terms of the Elliotts, Inc. factors.

           3.   Expert Reports

           a.   Introduction

     Both parties offered expert testimony in support of their

respective positions.

     In deciding the reasonableness of compensation, courts often

look to the opinions of expert witnesses.        Nonetheless, we are

not bound by the opinion of any expert witness, and we may accept

or reject expert testimony in the exercise of sound judgment.

Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938); Estate

of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990).         Although

we may accept the opinion of an expert in its entirety, see
                                - 20 -

Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C.

441, 452 (1980), we may be selective in determining what portions

of an expert’s opinion, if any, to accept, Parker v.

Commissioner, 86 T.C. 547, 562 (1986).

           b.   Petitioner’s Expert

     Petitioner’s expert, David Ostrove (Mr. Ostrove), is an

attorney and C.P.A.     He has been engaged as an expert witness on

numerous occasions, including cases involving reasonable

compensation issues.     Approximately one-third of Mr. Ostrove’s

report was voluntarily redacted by petitioner’s counsel because

it comprised legal analysis and argument, including citations and

discussion of caselaw and of a published revenue ruling.      The

balance of the report consists of Mr. Ostrove’s analysis of (1)

petitioner’s return on equity (ROE) for the 1979-84, 1986-90, and

1994-97 tax years and (2) the reasonableness of Mrs. Harrison’s

compensation in terms of his application of the Elliotts, Inc.

factors.

     Mr. Ostrove acknowledged during the voir dire that he had no

formal training in conducting compensation surveys; comparing or

evaluating types or components of compensation; corporate

finance; or valuation appraisal.      Moreover, in response to a

hypothetical question by the Court, he admitted that he lacked

the expertise necessary to advise a corporate client as to the

appropriate salary to offer candidates for director of a new

division.
                               - 21 -

     Respondent objects to the admissibility of Mr. Ostrove’s

report on the ground that Mr. Ostrove is not an expert with

respect to compensation matters.    Alternatively, respondent

argues that, if admitted into evidence, Mr. Ostrove’s report

should be given no weight.    In light of Mr. Ostrove’s obvious

lack of training or experience in the field of executive

compensation, we are inclined to agree with respondent that Mr.

Ostrove’s report is inadmissible because it is not the testimony

of an “expert” within the meaning of rule 702 of the Federal

Rules of Evidence.3    We find it unnecessary, however, to so rule

because we find the report to be inadmissible on the ground that

it was not “based upon sufficient facts or data”, and on the

further ground that Mr. Ostrove did not apply “principles and

methods [for determining the reasonableness of Mrs. Harrison’s

compensation] reliably to the facts of the case” as required by

rule 702 of the Federal Rules of Evidence.



     3
         Fed. R. Evid. 702 provides:

           Rule 702.   Testimony by Experts

                If scientific, technical, or other specialized
           knowledge will assist the trier of fact to understand
           the evidence or to determine a fact in issue, a witness
           qualified as an expert by knowledge, skill, experience,
           training, or education, may testify thereto in the form
           of an opinion or otherwise, if (1) the testimony is
           based upon sufficient facts or data, (2) the testimony
           is the product of reliable principles and methods, and
           (3) the witness has applied the principles and methods
           reliably to the facts of the case.
                               - 22 -

     Virtually all of Mr. Ostrove’s factual conclusions upon

which he bases his opinion are either unsupported or in error, as

follows.

     Mr. Ostrove’s computation of petitioner’s ROE for the 1979-

84, 1986-90, and 1994-97 taxable years is based upon the ratio of

taxable (pretax) income to equity, which contradicts principles

of corporate finance that require the use of after-tax income in

such computations.   See Adams et al., Fundamentals of Business

Valuation (Part I) 4-21 (2000); Brealey & Myers, Principles of

Corporate Finance 828, 830 (7th ed. 2003).   We have used after-

tax income in computing ROE.   See B & D Founds., Inc. v.

Commissioner, T.C. Memo. 2001-262 (n.2 to table listing annual

ROE); LabelGraphics, Inc. v. Commissioner, supra (n.2 to table

listing annual ROE).

     Mr. Ostrove observes that “it cannot be denied that [Mrs.

Harrison] is a highly qualified business person and is largely

responsible for the noteworthy success of her company.”     As

discussed infra section II.C.4., it is clear from the trial

testimony that Mrs. Harrison has always played a secondary role

in the operation of petitioner’s trash hauling business and that

the primary roles were played, first, by Mr. Harrison and, later,

by Myron, James, and Ralph.

     Mr. Ostrove also states that “Mrs. Harrison (and her

deceased husband) assumed not only the plethora of risks

associated with founding and developing a successful business
                              - 23 -

concern, but she also incurred a substantial economic opportunity

cost, by sticking with this business for all of these years.”

That statement appears in the portion of Mr. Ostrove’s report

dealing with the independent investor test, and we assume that he

is referring to the investment return from some alternative

investment that Mrs. Harrison gave up (her “opportunity cost”)

when she decided to invest in (and stick with) petitioner.    In

corporate finance, the term “opportunity cost” is generally used

to refer to financial investments (and not employment status).

See, e.g., Brealey & Myers, supra at 15 (defining “opportunity

cost” as “the return foregone by investing in * * * [a] project

rather than investing in securities”).

     Mr. Ostrove states that “Mrs. Harrison’s compensation for *

* * [the audit years] did not exceed the amount needed to remedy

prior years of undercompensation, and was therefore reasonable.”

The only evidence of undercompensation is Mrs. Harrison’s

testimony that, for a year or so, when James and Ralph joined the

business in 1962, nobody received wages “because we needed that

money to grow.”   Assuming arguendo that petitioner absorbed the

entire preincorporation business and took title to all of the

assets of that business, thereby becoming eligible to deduct

payments intended to compensate Mrs. Harrison for services

performed in a preincorporation taxable year, see Young v.

Commissioner, 650 F.2d 1083, 1085 (9th Cir. 1981), affg. T.C.

Memo. 1979-242; R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 50-
                               - 24 -

52 (1972), Mr. Ostrove has failed to offer any evidence of intent

on the part of petitioner’s officers and directors to compensate

Mrs. Harrison for such prior services, see Pac. Grains, Inc. v.

Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), affg. T.C. Memo.

1967-7; R.J. Nicoll Co. v. Commissioner, supra at 52.    Nor has he

offered evidence as to the amount of any prior years’

undercompensation or shown that it has not been more than offset

by payments to Mrs. Harrison for taxable years before the audit

years.    At least since 1979, Mrs. Harrison’s compensation has

annually exceeded that of her sons, each of whom has exercised

greater management responsibility on petitioner’s behalf than

she.    Thus, any earlier undercompensation of Mrs. Harrison was

most likely remedied before the audit years.    See LabelGraphics,

Inc. v. Commissioner, 221 F.3d at 1096-1097; B & D Founds., Inc.

v. Commissioner, supra.    It is also noteworthy that the briefs

filed on petitioner’s behalf make no attempt to defend the

reasonableness of Mrs. Harrison’s compensation during the audit

years on the basis of prior years’ undercompensation.

       Mr. Ostrove states that “Mrs. Harrison negotiates and brings

in the contracts.”    That conclusion is directly contrary to the

parties’ stipulation at trial that “[f]rom 1989 through the years

in issue, Mrs. Harrison did not represent the petitioner in

negotiation of any contracts between petitioner and the cities,

nor did she communicate with employees of the cities with regard

to the implementation of the contracts.”
                                - 25 -

     In short, Mr. Ostrove’s report at times fails to set forth

“the facts or data on which * * * [his] opinion is based”, in

violation of Rule 143(f), and, at other times, his factual

conclusions are either belied by the record or not germane to the

issue of reasonable compensation.     Thus, the report fails to

satisfy the requirements of rule 702 of the Federal Rules of

Evidence and is, therefore, inadmissible.

           c.   Respondent’s Expert

     Respondent’s expert, James F. Carey (Mr. Carey), is a self-

employed certified management consultant specializing in

compensation planning.     He has been an expert witness in State

and Federal courts, and he has testified on compensation-related

matters.    The Court accepted Mr. Carey as an expert in

compensation planning, which, for purposes of this case, includes

the setting of compensation for a particular individual.

Mr. Carey’s written report was received into evidence as his

direct and rebuttal testimony.

     We will consider the merits of Mr. Carey’s analysis and

conclusions, largely relied upon by respondent, in connection

with our application of the Elliotts, Inc. factors.

           4.   Application of the Elliotts, Inc. Factors

           a.   Mrs. Harrison’s Role in the Company

     The relevant considerations in applying this factor include

the employee’s position, hours worked, and duties performed.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1245.     Mrs. Harrison
                               - 26 -

testified that, during the audit years, she worked more than 40

hours per week on behalf of petitioner.   Her principal

involvement with petitioner consisted of:   (1) Attending weekly

board meetings; (2) attending, as a representative of petitioner,

chamber of commerce meetings and various community functions and

events in the cities served by petitioner; and (3) executing her

personal guaranty relating to the line of credit extended to

petitioner by Bank of America.    Mrs. Harrison’s other activities,

such as filing and maintaining historic company records, signing

checks presented to her for the payment of bills, and attending

occasional meetings with drivers or other rank and file

employees, were either ministerial in nature or so sporadic as to

justify no more than a small fraction of the payments to her

during the audit years.   We will consider each of her three

principal functions in turn.

        (1)   Weekly Board Meetings

     The weekly board meeting discussions covered matters of

importance in the conduct of petitioner’s business, and they

often culminated in a board vote on whether to go ahead with a

proposed transaction.   Although Mrs. Harrison, her three sons,

and other witnesses all characterized Mrs. Harrison as the final

arbiter of all major business decisions, it is clear that, under

petitioner’s bylaws, she was one of four members of the board,

each of whom had an equal vote.   Thus, Mrs. Harrison possessed no

power to veto a decision agreed to by her sons.   What the
                             - 27 -

seemingly contradictory testimony indicates, however, is that

Mrs. Harrison’s sons, whether out of filial respect for their

mother, respect for her many years of involvement with

petitioner, or both, voluntarily chose to operate petitioner by

consensus.

     We suspect that the decision to operate the board by

consensus was reached principally out of respect for Mrs.

Harrison’s conservative approach to proposals for major

expenditures, which, to some extent, carried over to her sons.

For example, Myron testified as follows:

         Q. What type of purchasing decisions would she
     disapprove of?

         A. Buying too many new trucks, or too many trucks
     period. She didn’t like to spend a whole lot of money;
     she was very tight with the money, so she didn’t like
     to purchase new trucks. We have the ability to
     refurbish old equipment, and that’s what she would
     prefer to see us do.

         Q. And so sometimes you wouldn’t purchase these
     trucks, and just go the refurbishing route?

        A.   Exactly; more often than not.

     James also testified as to the continuing influence of his

mother’s conservative approach to purchasing new trucks:

         Q. * * * were you the one responsible for deciding
     what trucks to purchase for the company?

         A. Yeah. Usually we’re a very conservative
     company, so usually we would get pretty tight on our
     trucking before we would consider buying some
     additional trucks * * *.
                             - 28 -

     Whatever lingering effect Mrs. Harrison’s conservative

business philosophy may have had on the decisionmaking process,

it appears that her responsibility for and influence over the

actual decisions of the board were sharply limited in practice.

Mrs. Harrison acknowledged that, shortly after her sons joined

the business, they became the “supervisors of the company”, and

she and Mr. Harrison became primarily responsible for paying

bills, keeping track of collections, and keeping the books.     She

further acknowledged that major decisions requiring board

approval (such as approval of trash hauling contracts or truck or

other equipment purchases) had been “pretty well thought out” by

her sons so that, with the exception of one proposed purchase of

trucks in the mid-1960s, she never dissented.   Even when she

initially had doubts concerning a proposal of one of her sons,

her sons were able to win her over to their position.   Myron

testified that, in connection with the guaranteed loans, Mrs.

Harrison attended meetings with the Bank of America that were

held “after most of the decisions were made, for the final

decision”.

     The overall picture that emerges is of a company run during

the audit years (and for many prior years) by Mrs. Harrison’s

sons, each of whom was responsible for managing a key operational

function (Myron, finance; James, general operations and

contracts; Ralph, equipment purchasing, maintenance, and

refurbishment) and for the development of all major business
                                - 29 -

proposals in his management area.     During that same period, Mrs.

Harrison’s role as a member of the board was limited to the

review and, in all cases, approval of proposals developed by her

sons.     She had neither the power (under petitioner’s bylaws) nor

the inclination to challenge their decisions.      Under the

circumstances, we believe that her titles of president and

chairman of the board were titular and not reflective of her

actual status within the company.     We find that her role as an

essentially compliant member of petitioner’s board justified her

receipt of only a small fraction of the compensation paid to her

during the audit years.

           (2)   Public Relations Activities

        The benefit to petitioner of Mrs. Harrison’s public

relations activities depends upon the contribution of those

activities to petitioner’s ability to secure trash hauling

contracts.

        Two of Mrs. Harrison’s sons testified as to the importance

to petitioner of those activities.       Myron referred to his mother

as petitioner’s “ambassador of good will”, known and appreciated

by “everybody” including city councilors, mayors, and county

supervisors for the jurisdictions in which petitioner conducted

business.     James speculated that her lifetime spent in Ventura

County and her involvement in that community led to business.

Stan Whisenhunt, the owner of a Ventura County public relations

and marketing company who had published newsletters for
                             - 30 -

petitioner and was in the process of publishing Mrs. Harrison’s

biography, also stressed the importance of petitioner’s excellent

reputation to its ability to win contracts.

     In contrast, a member of the Ventura City Council, part of

whose job it was to approve trash hauling contracts, testified

that petitioner was awarded contracts because of its “excellent

record”, the honesty of its “operating people”, and its

performance on behalf of the city and because “they have the

equipment and the personnel to do the work.”   He noted that trash

hauling contracts are awarded to “the most qualified bidder”, not

necessarily the lowest bidder, as both price and profit rates are

set by the City Council in advance.   For that reason, eligible

bidders are prequalified, and the one considered best able to do

the work is selected by the City Council.   He testified that, in

years past, at least two trash hauling contracts had been awarded

to companies other than petitioner.   Similarly, a member of the

Camarillo City Council, involved for many years in the

negotiation and approval of trash hauling contracts on behalf of

the city, testified that such contracts had been awarded to

petitioner “[b]ecause they’ve provided good service for us ever

since the city was incorporated, and they provide it at a very

good price for our residents.”   In addition, Nan Drake,

petitioner’s public relations director and a member of

petitioner’s contract negotiating team, having testified that

Mrs. Harrison is “the one who people like to see at the chamber
                               - 31 -

functions * * * [and at] the different sponsorship events that we

do”, acknowledged that petitioner’s success derived from its

ability to provide good service at a reasonable price.

     The testimony of those public officials responsible for

awarding the trash hauling contracts demonstrates that

petitioner’s success in obtaining those contracts was based upon

its ability to carry out those contracts in a satisfactory manner

and at a reasonable price; i.e., the awards were based upon

performance, not reputation for community involvement.    Thus,

although petitioner has shown that Mrs. Harrison was instrumental

in helping petitioner project a positive corporate image in the

communities it served, petitioner has not shown that Mrs.

Harrison’s public relations activities contributed directly to

its sales and profits.

        (3)   Personal Guaranties

     Courts, including this Court, have developed a series of

factors for deciding the deductibility of guaranty fees paid to a

shareholder employee:    (1) Whether, given the financial risks,

the fees are reasonable in amount; (2) whether businesses of the

same type and size as the payor must customarily pay guarantor

fees to shareholders; (3) whether the shareholder demanded

compensation for the guaranty; (4) whether the payor had

sufficient profits to pay a dividend, but failed to do so; and

(5) whether the purported guaranty fees were proportional to

stock ownership.   See Olton Feed Yard, Inc. v. United States, 592
                              - 32 -

F.2d 272, 275-276 (5th Cir. 1979); Tulia Feedlot, Inc. v. United

States, 513 F.2d 800, 803-806 (5th Cir. 1975); Fong v.

Commissioner, T.C. Memo. 1984-402, affd. without published

opinion 816 F.2d 684 (9th Cir. 1987); Seminole Thriftway, Inc. v.

United States, 42 Fed. Cl. 584, 589-590 (1998) (the guaranty fee

cases).

     We find no meaningful distinction between the guaranty fee

cases and this case where, instead of defending the deductibility

of amounts labeled by the payor as guaranty fees, petitioner, in

effect, seeks to treat, as guaranty fees, an unspecified portion

of an amount originally labeled by the board as “annual

compensation, including bonuses”.   The same deductibility factors

should apply under either set of circumstances, with the possible

exception of the fifth factor (fees proportional to stock

ownership), which would be difficult to apply in the absence of

some way to identify the guaranty-fee portion of the payments

labeled compensation.

     In this case, the shareholder-guarantors did not demand

compensation, and there is no evidence in the minutes of the

annual board meetings or elsewhere of an intent to compensate

them for the guaranties.4   It is also clear that petitioner had

     4
        When Mrs. Harrison executed her $7.5 million personal
guaranty of bank loans to petitioner in 1994, she neither
requested, received, nor was promised additional compensation as
consideration therefor. Moreover, her total compensation as
determined by the board of directors for 1994-97 (when her
                                                   (continued...)
                                - 33 -

sufficient retained earnings to pay a dividend.       Thus,

application of factors (3) and (4) militates against the

deductibility of any portion of the amounts paid to Mrs. Harrison

during the audit years as compensation for guaranteeing loans to

petitioner.   Moreover, there is no evidence that businesses of

the same type and size as petitioner customarily were required to

pay guaranty fees to shareholders (factor (2)).

     Petitioner has also failed to establish what amount, if any,

would have constituted a reasonable fee for Mrs. Harrison’s

personal guaranties (factor (1)).    There is no evidence of any

significant financial risk to her.       She was one of four

guarantors, each jointly and severally liable for the guaranteed

amounts.   None of her property was encumbered under the terms of

the guaranties, and there was never any threat of default by

petitioner as primary debtor.    Nor has petitioner shown that

there was a disproportionate reliance by the bank on Mrs.

Harrison’s personal assets to satisfy the potential obligations

of the guarantors.   Mr. Summers, when asked why the bank required

     4
      (...continued)
continuing guaranty was in effect) was not significantly
different as a percentage of total officer compensation from what
it had been for the years immediately preceding her guaranty. In
fact, her average compensation as a percentage of total officer
compensation for 1992 and 1993 (38.5 percent) was actually higher
than for 1994-97 (36.5 percent). Thus, there is no evidence to
indicate that the board awarded any additional compensation to
Mrs. Harrison for the audit years in consideration of her
personal guaranty of bank loans to petitioner.
                               - 34 -

Mrs. Harrison to sign the guaranties, responded that the bank

“wanted additional strength or support behind * * * [the

collateral], and with her liquidity base, it was important to

have her involvement.”    But it is entirely possible that Mr.

Summers would have provided a similar response had he been asked

why the bank had required guaranties from Myron, James, and

Ralph.    Moreover, it appears that much of Mrs. Harrison’s wealth

may have actually been attributable to the estate of her late

husband in the form of the Survivor’s Trust that acted as the

coguarantor of the $16 million replacement guaranty executed in

1998.    There is no evidence as to the relative values of the

interests of Mrs. Harrison, Myron, James, and Ralph in the assets

of that trust.

     Finally, the financial risk to Mrs. Harrison from

guaranteeing loans to petitioner was further reduced to the

extent that the Bank of America line of credit resulted in loans

to Rentals.    Petitioner is not entitled to deduct any amount as

compensation for Mrs. Harrison’s guaranty of loans to Rentals.

See Cropland Chem. Corp. v. Commissioner, 75 T.C. 288, 292-295

(1980), affd. without published opinion 665 F.2d 1050 (7th Cir.

1981); Columbian Rope Co. v. Commissioner, 42 T.C. 800, 815-816

(1964); E.B. & A.C. Whiting Co. v. Commissioner, 10 T.C. 102, 116

(1948).    Although the overall line of credit from Bank of America

to petitioner and Rentals reached approximately $7 million during

the audit years, the fact that petitioner’s total long-term debt
                              - 35 -

never exceeded $3.43 million during those years suggests that

more than half of the potential benefit may have been derived by

Rentals.

     Petitioner cites Owensby & Kritikos, Inc. v. Commissioner,

819 F.2d 1315, 1325 n.33 (5th Cir. 1987), affg. T.C. Memo. 1985-

267, and R.J. Nicoll Co. v. Commissioner, 59 T.C. at 51, in

support of its view that Mrs. Harrison’s personal guaranties were

an important factor in demonstrating the reasonableness of the

compensation paid to her during the audit years.   Those cases are

representative of a line of cases (the no-fee cases) in which

courts, including this Court, have cited employee-shareholder

loan guaranties in support of findings that all or a portion of

amounts paid to such individuals constituted deductible

compensation.   See, e.g., Owensby & Kritikos, Inc. v.

Commissioner, supra at 1325 n.33 (stating that loan guaranties by

key employee-shareholders weigh “in favor of munificent

compensation”); Leonard Pipeline Contractors, Ltd. v.

Commissioner, T.C. Memo. 1998-315 (noting that an “indispensable”

employee-shareholder’s personal guaranty of a $1.5 million bank

loan was “crucial” to a large project), affd. 210 F.3d 384 (9th

Cir. 2000); Ledford Constr. Co. v. Commissioner, T.C. Memo. 1977-

204 (giving “some consideration” to the chief executive’s

personal guaranty of company debt in deciding the reasonableness

of his compensation); see also Shotmeyer v. Commissioner, T.C.

Memo. 1980-238; Adolph Hanslik Cotton Co. v. Commissioner, T.C.
                                  - 36 -

Memo. 1978-394; Allison Corp. v. Commissioner, T.C. Memo. 1977-

166.       In each of those cases, and in R.J. Nicoll Co. v.

Commissioner, 59 T.C. 37 (1972), cited by petitioner, the Court

simply listed a key employee-shareholder’s personal guaranty of

corporate employer debt as one of several positive contributions

by the employee to the corporate employer.      All of those no-fee

cases involve a key employee, usually the person (or one of the

persons) most responsible for the success of the corporate

employer.       No specific compensatory amount is attributed to the

guaranty, and in none of the cases is it certain that the Court

would have reached a different result in the absence of the

guaranty.5      Moreover, in Owensby & Kritikos, Inc. v.

Commissioner, supra, the Court of Appeals for the Fifth Circuit

hedged its comment regarding the relevance of the loan guaranties

by noting that “[t]he record is unclear * * * as to the amount or

riskiness of these loans”, an allusion to factor (1) in the

guaranty fee cases.

       Mrs. Harrison’s loan guaranties represented one of her

principal contributions to petitioner.      They did not, as in the


       5
        In Adolph Hanslik Cotton Co. v. Commissioner, T.C. Memo.
1978-394, the Commissioner argued that an amount paid for the
guaranty of a line of credit is not “compensation for personal
services actually rendered” within the meaning of sec. 162(a)(1)
and, therefore, may not be considered in finding the amount that
constitutes “reasonable” compensation. We declined to address
that argument on the ground that “[o]ur finding would be the same
regardless of whether guarantying such obligations may properly
be considered.” Id. at n.14.
                                - 37 -

no-fee cases, merely supplement her performance of substantial

managerial activities on petitioner’s behalf.    Therefore, we find

those cases to be inapposite.    Rather, we find that the factors

utilized in the guaranty fee cases are properly suited to the

task of determining what amount, if any, may be considered

reasonable compensation for Mrs. Harrison’s personal guaranties.

Because (1) Mrs. Harrison was willing to issue the guaranties

without compensation, (2) there is no evidence that businesses of

the same type and size as petitioner customarily paid guarantor

fees to shareholders, (3) petitioner had sufficient profits to

pay dividends, but failed to do so, and (4) the evidence does not

establish what amount, if any, would constitute reasonable

compensation for her guaranties, we find that Mrs. Harrison’s

guaranties do not support the characterization of any amount she

received from petitioner as reasonable compensation.   Instead, we

view the shareholder guaranties in this case as a means of

protecting the shareholders’ ownership interests in petitioner,

not as a function of their employment by petitioner.   See Olton

Feed Yard, Inc. v. United States, 592 F.2d at 275-276 (stating

that employee-shareholders’ willingness to guaranty, without

charge, the corporate employer’s debt is evidence that such

individuals “signed the guaranties in order to protect and

enhance their investment in the corporation”).

        b.   External Comparison
                               - 38 -

     This factor invokes a comparison between the employee’s

salary and salaries paid by similar companies for similar

services.    Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.

     The only evidence relating to this factor is that contained

in the report submitted by respondent’s expert, Mr. Carey, who

likens Mrs. Harrison’s activities to those of an outside board

chair.   He cites, as appropriate compensation for Mrs. Harrison’s

services, the median compensation paid to board chairs during the

audit years by other companies with comparable sales revenues as

derived from surveys conducted by Economic Research Institute

(ERI).   Except for a small ($696) discrepancy for the 1997

taxable year, the compensation amounts derived by Mr. Carey from

the ERI data are allowed, by respondent, as reasonable

compensation to Mrs. Harrison.

     Petitioner objects to Mr. Carey’s (and respondent’s)

characterization of Mrs. Harrison’s duties as equivalent to the

duties of a board chair and, in particular, to the duties of an

outside board chair.   Petitioner also questions the relevance of

the ERI survey because of its failure to identify the number of

responding companies, whether they were public or private, and

whether the chairs were from inside or outside the responding

companies.

     We find that petitioner’s objections are unfounded.    A

general description of the duties of a board chair submitted by

Mr. Carey (to which petitioner raises no objection) confirms the
                             - 39 -

similarity of such duties (which, in pertinent part, include

participation “in outside activities which will enhance corporate

prestige and fulfill the corporation’s public obligations as a

member of industry and the community”, conducting regular and

special board meetings, and carrying out “special assignments”)

to the principal duties discharged by Mrs. Harrison:    Her

community activities as a representative of petitioner and her

presiding over (1) petitioner’s weekly and annual board meetings

and (2) the ad hoc meetings with employees arranged by her sons.

Moreover, because very few companies pay fees to inside directors

and board chairs, but almost all companies pay fees to outside

directors and board chairs, the vast majority of the survey data

must relate to outside directors.   Lastly, although it is true

that the survey data do not identify the number of responding

companies, Mr. Carey describes the ERI surveys as “broadly

based”, and he bases his conclusions as to board chair

compensation on what he describes as a “large-sample survey”.

Moreover, he specifically declines to rely upon the results of a

narrower survey involving only five board chairs.    We give Mr.

Carey the benefit of the doubt and assume that, as an

acknowledged expert in the area of executive compensation, he has

relied upon survey data that are representative of a critical

mass of respondents.

     Mrs. Harrison’s personal guaranties of petitioner’s debt

were not typical of an outside board chair.   But, for the reasons
                              - 40 -

discussed in section II.C.4.a.(3), supra, we find that no

compensation is properly attributable to those guaranties.

Therefore, on the basis of our finding that the rest of Mrs.

Harrison’s duties were substantially similar to those of an

outside board chair who does not otherwise perform the tasks of a

chief executive or chief operating officer, we find that Mrs.

Harrison’s compensation was grossly in excess of what companies

of a comparable size pay for such services.

         c.   Character and Condition of the Company

     “The focus under this category may be on the company’s size

as indicated by its sales, net income, or capital value.     * * *

Also relevant are the complexities of the business and general

economic conditions.”   Elliotts, Inc. v. Commissioner, supra at

1246.   In general, petitioner appears to have been a successful,

growing company during the 1979-97 period.    The problem from

petitioner’s standpoint is that Mrs. Harrison’s very limited

management role during the audit years renders this factor

(although generally favorable to petitioner) of little or no

relevance to our decision.

         d.   Conflict of Interest

     This factor focuses on “whether some relationship exists

between the taxpaying company and its employee which might permit

the company to disguise nondeductible * * * [dividends] as salary

* * * deductible under section 162(a)(1).”    Id. at 1246.

Elliotts, Inc. instructs that such a relationship “may also be
                              - 41 -

probative of a presence or absence of compensatory intent.”     Id.

at 1246 n.4.   In this case, Mrs. Harrison’s 46-percent stock

ownership interest (with the other 54 percent in the hands of

nonadverse family members) indicates the existence of a potential

conflict of interest.   Moreover, there are several indications of

an intent to disguise profit distributions to Mrs. Harrison as

deductible salary payments:   (1) Petitioner has never declared or

paid a dividend, see O.S.C. & Associates, Inc. v. Commissioner,

187 F.3d 1116, 1121 (9th Cir. 1999), affg. T.C. Memo. 1997-300;

(2) during the audit years, petitioner’s total deduction for

officer compensation, on average, equaled 92 percent of pretax

income before that deduction, and Mrs. Harrison’s compensation

alone averaged 35 percent of pretax income for that period, see

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d at 1325-1326;

Pac. Grains, Inc. v. Commissioner, 399 F.2d at 607; O.S.C. &

Associates, Inc. v. Commissioner, T.C. Memo. 1997-300; (3)

officer compensation was determined after the close of the

taxable year, when profits for the year were either known or

could be estimated with reasonable accuracy, see Owensby &

Kritikos, Inc. v. Commissioner, supra at 1329; Ecco High

Frequency Corp. v. Commissioner, 167 F.2d 583, 585 (2d Cir.

1948), affg. a Memorandum Opinion of this Court; Rich Plan of N.

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

     Petitioner attempts to discount the potential impact of any

circumstances indicative of disguised dividends or profit
                              - 42 -

distributions to Mrs. Harrison by stressing that, despite the

large payments to her, petitioner’s ROE during the audit years

would have been more than satisfactory in the eyes of an

independent investor in petitioner.    Indeed, the Court of Appeals

for the Ninth Circuit in Elliotts, Inc. v. Commissioner, 716 F.2d

at 1247, states that, in any potential conflict of interest

situation, “it is appropriate to evaluate the compensation

payments from the perspective of a hypothetical independent

shareholder.”   The test suggested in Elliotts, Inc. is whether

retained earnings “represent a reasonable return on the

shareholder’s equity in the corporation”.    Id.   Petitioner argues

that its ROE during the audit years was more than adequate to

satisfy a hypothetical independent investor; and it further

argues that that fact alone should make Mrs. Harrison’s

compensation during those years “presumptively reasonable”,

consistent with the holding of the Court of Appeals for the

Seventh Circuit in Exacto Spring Corp. v. Commissioner, 196 F.3d

833, 839 (7th Cir. 1999), revg. Heitz v. Commissioner, T.C. Memo.

1998-220.   Petitioner would restrict the application of the

Elliotts, Inc. factors to years in which the corporate employer

suffers a loss so that ROE is negative.

     Petitioner’s approach is not the law in the Ninth Circuit;

and the Court of Appeals for the Seventh Circuit, in Exacto

Spring (a case involving the reasonableness of compensation paid

to an employee-shareholder “indispensable to Exacto’s business”
                              - 43 -

and “essential to Exacto’s success”), specifically acknowledges

that the independent investor test would not be appropriate in a

case in which ROE, “though very high, is not due to the * * *

[employee’s] exertions”, or in a case in which the purported

salary payment “really did include a concealed dividend”.   Id.;

accord Haffner’s Serv. Stations, Inc. v. Commissioner, 326 F.3d

1, 5 (1st Cir. 2003) (“Even if the company performed well in the

subject period and even if executives at comparable companies got

large packages * * * a neutral owner would not pay * * *

[employee-shareholders] handsomely for producing results for

which others * * * were responsible”), affg. T.C. Memo. 2002-38.

To the same effect, in Dexsil Corp. v. Commissioner, T.C. Memo.

1999-155, the Court stated:

     We do not believe that the hypothetical investor would
     have looked solely at rate of return and ignored the
     availability of other executives at less compensation
     than that paid Lynn; we do not believe that Lynn was
     the sole reason for Dexsil’s success to the extent that
     other officer-shareholders were in the cases relied on
     by petitioner * * *.

     Similarly, in Elliotts, Inc. v. Commissioner, supra at 1247

n.6, the Court of Appeals for the Ninth Circuit states that an

ROE satisfactory to an independent investor is “probative [not

conclusive] of * * * [the employee-shareholder’s] management

contributions to * * * [the employer].”

     Because petitioner’s overall profit for the audit years was

primarily attributable to the efforts of Myron, James, and Ralph,

not to those of Mrs. Harrison, see supra section II.C.4.a., and
                              - 44 -

because (as discussed in this section) the evidence strongly

suggests an intent to distribute profits to Mrs. Harrison in the

guise of compensation, we find that an independent investor in

petitioner would object to the size of Mrs. Harrison’s

compensation, even assuming arguendo that petitioner’s retained

earnings for the audit years represented a reasonable return on

shareholder equity when viewed in relation to the ROE at

comparable companies.   Thus, application of this factor furnishes

additional evidence that Mrs. Harrison was greatly

overcompensated during the audit years.6

     6
        Even assuming petitioner’s ROE were relevant to our
decision in this case, petitioner’s computation of ROE during the
audit years is open to question.

     Petitioner argues that ROE represents net profit (after
taxes) divided by equity (defined as invested capital plus
retained earnings less treasury stock), and that petitioner’s ROE
for the audit years was either 22 percent (using beginning year
equity) or 12.3 percent (using the average of beginning year and
yearend equity). Petitioner stresses that either result compares
favorably with the 14.9 percent ROE for comparably sized
companies during the same period as compiled by Mr. Carey.
Petitioner ignores ROE derived from using yearend equity,
presumably because, under that approach, average ROE for the
audit years is 7.4 percent, substantially below the 14.9 percent
average ROE for comparably sized companies. In fact, it is
unclear which of the three approaches is proper in this case
because it is not known which approach was used in the
computation of ROE for the comparably sized companies reflected
in Mr. Carey’s report.

     Another reason to question the use of petitioner’s annual
ROE in evaluating shareholder return is the inability to follow,
on the basis of the returns as filed, all of the year-to-year
changes in equity. For several years, those changes cannot be
explained by the income (or loss) for the year, and the
description of the reconciling item is either unclear or not
                                                   (continued...)
                              - 45 -

         e.   Internal Inconsistency

     Evidence of an internal inconsistency in the determination

of employee compensation may indicate the presence of

unreasonable compensation to employee-shareholders.     Elliotts,

Inc. v. Commissioner, 716 F.2d at 1247.   Such evidence may also

be “probative of a presence or absence of compensatory intent.”

Id. at n.7.   In addition, “salaries paid to controlling

shareholders are open to question if, when compared to salaries

paid nonowner management, they indicate that the level of

compensation is a function of ownership, not corporate management


     6
      (...continued)
attached to the copy of the return in evidence.

     Moreover, because petitioner’s equity remained essentially
constant while its sales and assets increased, ROE does not
appear to be an appropriate measure of shareholder return in this
case. For example, comparing 1988-90 with the audit years (1995-
97), average yearend equity increased only 4 percent whereas
average sales increased 129 percent and average yearend assets
increased 215 percent. Under such circumstances, it would appear
that either ROA or ROS would be superior to ROE as a measure of
performance. For the audit years, both ROA and ROS were quite
low (average ROA was .9 percent and average ROS was .27 percent).

     Alternatively, ROE might be an appropriate measure of
performance if petitioner’s fair market value were substituted
for “book” equity. In that connection, we note that book equity
has not always been used in computing return on equity. See
Lumber City Corp. v. Commissioner, T.C. Memo. 1996-171 (holding
that the amount paid by the employee-shareholder for a stock
interest in his employer, rather than book shareholder equity,
was appropriate for use in determining whether return on
investment was sufficient to satisfy an independent investor).
That alternative approach is not available in this case because,
aside from Mr. Carey’s admitted speculation that petitioner was
worth between $12 million and $20 million, there is no evidence
as to petitioner’s fair market value during the audit years.
                              - 46 -

responsibility.”   Id. at 1247.   In this case, it is clear from

the minutes of the annual board meetings that officer

compensation was determined after the close of the taxable year

when earnings availability was either known or could be estimated

with reasonable accuracy.   There is nothing in the board minutes,

nor is there any other evidence, to indicate that compensation

for nonofficer employees was set in the same manner.    The sole

exception pertained to modest ($4,000) bonuses for a single

employee for the 1994 and 1995 tax years, which were also awarded

after the close of the taxable year.

     There is also evidence that the salaries paid to

petitioner’s controlling shareholders greatly exceeded the

salaries paid to nonowner management.   In 1995 (the only year for

which the record contains nonshareholder employee salary

information), the highest salary for a nonshareholder employee

was $79,639, paid to the company controller who reported to

Myron.   That is less than 10 percent of the amount paid to Mrs.

Harrison and approximately 17 percent of the compensation paid to

Myron, James, and Ralph individually.   Petitioner has failed to

introduce any evidence that might justify such large differences

in compensation.

     The evidence pertaining to this factor also indicates that

Mrs. Harrison’s compensation during the audit years was more a

function of her stock ownership than of the value of the

services.
                                   - 47 -

III.   Conclusion

       We consider respondent’s analogy of Mrs. Harrison’s

activities on petitioner’s behalf to the duties performed by an

outside board chair to be apposite.         Moreover, Mr. Carey’s focus

on the median compensation paid to outside board chairs at

comparably sized companies appears reasonable in the absence of

evidence that Mrs. Harrison’s services should place her in either

a higher or lower percentile.       We find, however, that Mrs.

Harrison’s lifetime devotion to petitioner’s business, the

respect for her judgment accorded by her sons who actually ran

the business on a day to day basis, and her dedication in the

performance of her public relations function, even at an advanced

age, afforded benefits to petitioner (whether tangible or

intangible) that were unlikely to have been afforded by an

outside board chair.     We find that the value of those additional

benefits is adequately reflected by an 80-percent premium over

and above the median compensation paid to an outside board chair

during the audit years.        Therefore, we hold that petitioner may

deduct the following amounts (rounded to the nearest $1000) as

compensation for services performed by Mrs. Harrison during each

of the audit years:



                    TYE 6/30            Amount

                      1995              $98,000
                      1996              101,000
                      1997              106,000
- 48 -




         Decision will be entered

   under Rule 155.
