                         T.C. Memo. 1999-155



                       UNITED STATES TAX COURT



                DEXSIL CORPORATION, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 1349-93.                         Filed May 5, 1999.



     William J. Doyle, Charles P. Reed, and Mark R. Kravitz,

for petitioner.

     Robert E. Marum, for respondent.


                  SUPPLEMENTAL MEMORANDUM OPINION

     COHEN, Chief Judge:    This case is before us on remand from

the Court of Appeals for the Second Circuit in Dexsil Corp. v.

Commissioner, 147 F.3d 96 (2d Cir. 1998), vacating and remanding

T.C. Memo. 1995-135.   The Court of Appeals directed us:

     to make specific findings regarding the following
     questions: (1) whether a hypothetical investor would
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     accept the compensation paid to [Theodore R.] Lynn;
     (2) whether Lynn was paid according to a long-standing
     and consistently applied contingent compensation
     formula, and if so, whether his salary was reasonable
     in light of this formula; (3) whether Lynn's
     compensation compared favorably with the compensation
     paid by similar companies for comparable services,
     given the many roles Lynn played at Dexsil; and
     (4) whether, after reconsideration of these factors,
     the balance of factors has shifted in favor of Dexsil
     such that it has met its burden of proving that Lynn's
     compensation was reasonable. [147 F.3d at 103.]

By agreement of the parties, supplemental briefs were filed in

which they argue their respective positions on the above issues.

Background

     In our prior Memorandum Findings of Fact and Opinion, T.C.

Memo. 1995-135, we concluded that $300,000 and $320,000 for the

fiscal years 1989 and 1990, respectively, was reasonable

compensation for Theodore R. Lynn (Lynn), the majority

shareholder, president, and a director of petitioner.    We

disallowed petitioner's deductions, to the extent of $76,540 in

1989 and $168,000 in 1990, in excess of the amounts that we

determined to be reasonable.   We agreed with petitioner that the

amount paid to Lynn's son, Timothy D. Lynn (T.D. Lynn), a

shareholder, vice president, and director, was reasonable.    We

also disallowed in part a deduction claimed for compensation to

another son, Theodore B. Lynn (T.B. Lynn), and a deduction for

director's fees.
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Hypothetical or Independent Investor Test

     Petitioner argues that Lynn's compensation passes the

hypothetical investor test, asserting that "there is overwhelming

evidence in the record that Dexsil's financial performance would

have overjoyed a hypothetical investor."    The data on which

petitioner relies, however, is ambiguous.    As set forth in the

tables in the Court of Appeals' opinion, Dexsil Corp. v.

Commissioner, 147 F.3d at 99, petitioner's return on equity

varied substantially from year to year and declined for the years

in issue.   By another calculation, the return on equity over the

time that the company was controlled by Lynn averaged an annual

rate of 15 percent.   The increase was almost entirely in retained

earnings; dividends were an insignificant percentage of the

calculation.   Lynn's salary and bonus, on the other hand,

increased substantially over the same years.

     The only evidence at trial relating to the rate of return

acceptable to a hypothetical investor was petitioner's expert's

compilation of data on New York Stock Exchange companies.    There

was no evidence, however, that those companies were comparable to

petitioner or that the average return of those companies would be

satisfactory to a hypothetical investor in a company with the

degree of risk associated with petitioner's business.    There was

no analysis of the significance of dividends paid as contrasted

to unrealized appreciation.   Thus, we could not determine that
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petitioner's rate of return, standing alone, would have satisfied

a hypothetical independent investor.   Cf. Rapco, Inc. v.

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

1995-128.

     Petitioner now seeks to compare the rate of return in this

case to that in other cases in which the reasonableness of

compensation paid to shareholder-officers of closely held

companies was determined.   Each case, however, must be decided on

the evidence in that case and on the specific characteristics of

the company and the employee involved.   Cases relied on by

petitioner, such as Donald Palmer Co. v. Commissioner, T.C. Memo.

1995-65, affd. without published opinion 84 F.3d 431 (5th Cir.

1996), involved companies that are totally different in

operation, in sharing of managerial responsibility, and in risks

associated with the business of the company.   The deficiencies in

the expert evidence in this case cannot be overcome by surveys of

results in different cases decided on different evidence.

Petitioner's proposed method of surveying cases suggests that we

decide the issue as "what the traffic will bear", excluding

consideration of all nonlitigated compensation arrangements and

other relevant market data.

     Petitioner also argues that the testimony of actual

shareholders, who were pleased with the return on their minimal

investments and small percentage holdings in petitioner, supports
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the conclusion that hypothetical independent investors would have

been satisfied with the compensation paid to Lynn.   We were not

and are not persuaded, however, that the witnesses called by

petitioner in that regard were independent.   They were long-

standing friends and admirers of Lynn.    In any event, they were

not aware of how the compensation was established and,

apparently, were only consulted about Lynn's compensation in

relation to trial preparation, at which time they had an indirect

interest in the outcome of the case.

     The Court of Appeals stated in part: "in this circuit the

independent investor test is not a separate autonomous factor;

rather, it provides a lens through which the entire analysis

should be viewed.   See Rapco, Inc., 85 F.3d at 954-55."     Dexsil

Corp. v. Commissioner, 147 F.3d at 101.    As suggested by

petitioner's expert, an independent investor deciding on the

value of the company would look to what it would take to replace

the current management in terms of comparable salaries.      The

hypothetical or independent investor standard does not look

solely to the rate of return but looks to other factors as part

of "the entire tableau."   See Rapco, Inc. v. Commissioner, supra

at 954-955, where the Court stated:

          We find that the Elliotts' [Elliotts, Inc. v.
     Commissioner, 716 F.2d 1241 (9th Cir. 1983)] factors,
     examined from the perspective of an independent
     investor, are an appropriate standard to evaluate the
     reasonableness of employee compensation. These factors
                              - 6 -


     adequately balance the company's financial fitness and
     role in the market, and the employee's responsibility
     for that role. They also require a suitable comparison
     of the employee's compensation to other employees in
     the same company, and similar employees in analogous
     companies--sturdy benchmarks for determining the
     reasonableness of an employee's reward. And, these
     considerations properly patrol a company's ability to
     substitute salary for dividends by recognizing, in the
     first place, a shareholder-officer's temptation to do
     so, and, then, by focusing on the disinterested
     investor's perspective.

Petitioner's position is that an investor in a closely held

company such as petitioner, dominated by family members, should

be satisfied with a return equal to or even less than the return

paid by a company listed on a major exchange.    If that were the

law, any amount of compensation would be regarded as reasonable

as long as a minimal average return, computed by adding

appreciation as well as actual payments to shareholders, was

reflected on the company's balance sheets.    We believe that

petitioner's premise is erroneous.    We conclude that a

hypothetical independent investor would not accept Lynn's

compensation as reasonable where consideration is given to all

relevant factors.

"Contingent Compensation Formula"

     Petitioner contends that the $302,340 and $410,000 bonuses

paid to Lynn during the respective years in issue were pursuant

to a formula adopted in 1982 by which Lynn's annual bonus would

be equal to approximately 11 percent of sales.    That argument is
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based on a history that shows that Lynn's compensation for fiscal

years ended from 1982 through 1990 equaled 10, 11, or 12 percent

of sales.    There was no testimony, however, indicating when and

how the alleged formula was established.     In response to leading

questions, Lynn testified as follows:

          Q And over the years has your compensation, and
     in particular in '89 and '90, borne any relationship to
     the sales and, if so, approximately what?

          A Approximately about 11 or 12 percent, something
     like that.

            Q   Has that been fairly consistent over the years?

            A   Very consistent.

          Q And in terms of salary -- your total
     compensation, in terms of salary and bonus, how is that
     broken down and why do you do it that way?

          A We met with the -- at the end of every year,
     after the financial statement was audited and prepared,
     we would sit down and determine a compensation. It was
     kind of an informal thing. We would set a compensation
     plan for the next year based on the sales.

          My salary didn't increase very much, but it was
     mostly on performance, how we performed, how the sales
     came in and whether we needed cash or what our cash
     needs were, but the actual paying of the bonus at the
     time was determined by the cash flow.

Petitioner's certified public accountant testified as follows:

          Q Okay, during these years, could you tell the
     Court what participation, if any, you had in setting
     the compensation for Ted Lynn?

          A Well, during the audit and after audit, Ted and
     I would get together and we would discuss what salaries
     were and we would try to project what salaries should
     be in the coming year.
                                 - 8 -


          During '89 we looked at past salary history.
     Actually prior to '89 we had set up a performance-based
     type salary. We were salarying based on a percentage
     of sales. We came up with a percentage of around
     11 percent back in the earlier years when the
     corporation started to become profitable and we just
     kept it going.

     This testimony was vague and had the earmarks of

retrospective argument.    During the first year that the relevant

comparison can be made between Lynn's compensation and sales, the

company suffered a loss and Lynn was paid $10,000.    There is no

evidence from which we can determine whether that compensation

was reasonable at that time.    There is no explanation of why the

alleged 11 percent formula would have been 10 percent in 5 years,

11 percent in 2 years, and 12 percent in 2 years out of the 9

years over which the relationship between Lynn's compensation and

gross sales is observable.    No other witness corroborated this

alleged formula.    We were not persuaded and are not persuaded

that the formula existed or was consistently applied.

Lynn's Many Roles

     On remand, petitioner contends that we should add the

compensation paid by Daedalus Enterprises, Inc. (Daedalus), to

its chief executive officer (CEO) ($158,962) and to its chief

financial officer ($78,375), and then double it ($474,674), as we

doubled in our prior opinion the compensation paid to the CEO of

Daedalus. This computation, according to petitioner, supports the

$488,000 paid to Lynn in 1990.
                                - 9 -


     At trial Lynn testified:

          A Obviously, I'm the president and the chief
     financial officer. I also attend every sales meeting,
     every research meeting. I worked nights on installing
     the equipment and moving into the new facility. I keep
     up with the literature.

          I don't run the day-to-day operation but I have
     meetings with the vice president, the sales manager
     when he's in town and not on the road. I'm involved
     with the research and development of all the new
     products.

          Q   And who deals with the banks and the lawyers?

          A   I do.

          Q   Who deals with the shareholders?

          A   I deal with the shareholders.

          Q And do you have an estimate of how many hours a
     week in '89 and '90 you devoted to the interests of
     Dexsil?

          A In those years I probably put about 50 hours a
     week at work, at the plant, and to some of the shows.
     I take reports home that are prepared by the
     consultants and the research director and go over lab
     results and I do that at home.

          I also meet with shareholders and consultants at
     night and that type of thing.

          Q Taking the time at the plant and at home that
     you spend on Dexsil matters, approximately what would
     that come to a week during -- in your best judgment --
     during the years 1989 and 1990?

          A   Maybe 60 to 65 hours a week.

The day-to-day operations of the company were overseen by

T.D. Lynn, the vice president and general manager.   According to

petitioner, all employees reported to T.D. Lynn, before they
                                - 10 -


reported to his father, Lynn.    We concluded that T.D. Lynn's

compensation was reasonable, and we took his duties into account

when we determined the amount of reasonable compensation for the

other officers.   Respondent's expert, David J. Bowering, also

took those factors into account in multiplying the compensation

paid to the Daedalus CEO by 150 percent, and we took the multiple

roles into account in determining reasonable compensation for

Lynn.   We do not agree with petitioner that the salaries of two

separate officers should be both combined and doubled, because to

do so would be to duplicate the adjustment that we previously

made.

     Petitioner refers to losses sustained by Daedalus in earlier

years in support of its argument.    Petitioner, however, also had

meager and loss years.   We recognized in our prior opinion and

recognize now the contributions that Lynn made to the success of

petitioner.   As the court stated in Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1325 (5th Cir. 1987), affg. T.C.

Memo. 1985-869, "limits to reasonable compensation exist even for

the most valuable employees."    Upon our review of the entire

record and with careful consideration of the opinion of the Court

of Appeals, we believe that we made the appropriate allowances on

the evidence in this case.
                               - 11 -


Burden of Proof

     Petitioner on remand relies almost exclusively on the

alleged compensation formula in arguing that, on reconsideration,

Dexsil has satisfied its burden of proving that Lynn's

compensation was reasonable.   For the reasons set forth above, we

do not believe that the formula was established as alleged by

petitioner in 1982 or was consistently applied.   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; and we do not believe that the evidence

supports a determination that reasonable compensation to Lynn in

petitioner's fiscal years ended 1989 and 1990 exceeded $300,000

and $320,000, respectively.

     As we indicated in our prior memorandum opinion, the data

compiled by respondent's expert showed that Lynn's compensation

was more than four times the median CEO compensation for seven

comparable companies during the years in issue.   There was no

evidence that Lynn's compensation for the years in issue was

intended to compensate him for any past undercompensation.

Petitioner's return on equity was declining during the years in

issue, and the dividends paid were negligible in comparison to
                               - 12 -


increased sales.    We do not believe that the hypothetical

independent investor, under these circumstances, would have

approved hikes in Lynn's compensation of 32 percent ($98,660) and

30 percent ($111,460) during those years.

     On careful reconsideration pursuant to the mandate of the

Court of Appeals,

                                     Decision will be entered

                                for the same years in the

                                same amounts as previously

                                entered in this case.
