Choate Constr. Co. v. Commissioner

T.C. Memo. 1997-495

UNITED STATES TAX COURT

CHOATE CONSTRUCTION CO., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 20781-95. Filed November 4, 1997.

Matthew J. Howard, for petitioner.

Larry D. Anderson, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge: Respondent determined a $212,580 deficiency

in petitioner's income tax for 1992.

William Millard Choate (Choate) is petitioner's founder and

chief executive officer (CEO). After concessions, the sole issue

for decision is whether petitioner may deduct $1,010,000 in
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compensation for Choate in 1992, as petitioner contends;

$265,550, as respondent contends; or some other amount. We hold

that petitioner may deduct $1,010,000.

Section references are to the Internal Revenue Code as in

effect for the relevant periods. Rule references are to the Tax

Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

A. Petitioner

Petitioner's principal place of business was in Marietta,

Georgia, when it filed the petition in this case.

Petitioner is a construction company that specializes in

building medical facilities (e.g., operating rooms), biomedical

and "clean rooms" for laboratories, highly sophisticated

industrial and robotics facilities, and plants that manufacture

glass. Businesses use "clean rooms" to manufacture computer

chips and pharmaceuticals and for activities that require a

sterile environment of up to 100 times cleaner than a hospital

operating room.

Petitioner's 1992 tax year started on July 1, 1991, and

ended on June 30, 1992. Petitioner became an S corporation on

July 1, 1993.
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B. William Millard Choate

1. College and Early Work Experience

Choate graduated from Vanderbilt University around 1973 with

a bachelor of arts degree. After graduation, he worked for about

a year for Boyce Steel Co., a structural steel fabrication

company, where he estimated bids and fabricated structural steel.

Choate worked for Gray Construction Co. in Glasgow,

Kentucky, approximately from 1974 to 1977. He worked as an

estimator, a project manager, an assistant superintendent, and a

superintendent. He returned to Nashville around 1977 and worked

for about a year at Foster & Crayton Co. in a management training

program and as an estimator and project manager. He also worked

as a concrete form worker and carpenter.

2. Toon Construction Co.

Choate was a manager at Toon Construction Co. (Toon) in

Atlanta, Georgia, from 1978 to 1986. Choate was Toon's chief of

operations beginning in 1979 or 1980.

Choate hired David Barrett (Barrett) in 1981, assigned him

to a construction project, and trained him. Choate hired Patrick

Freese (Freese) to serve as an estimator around 1985. Choate

hired Jeff Dudley (Dudley) in 1986. Dudley had no background in

construction. Choate believed that Dudley would be good at
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developing business. Choate taught Dudley about construction and

how to find construction job leads.

After 1986, Choate became Toon's president, the third

highest person in the company. Choate wrote a procedural manual

for Toon. Choate left Toon for about 6 months to serve as

operations manager of the Southeast Division of the Carlson

Construction Co. After 6 months he returned to Toon. Toon grew

dramatically and its financial condition improved substantially

while it employed Choate.

C. Incorporation of Petitioner

Choate left Toon to incorporate petitioner in June 1989.

Economic conditions in the construction industry were poor at

that time.

Petitioner initially operated in Choate's basement.

Petitioner did not pay Choate to use his home. Choate initially

owned all of petitioner's stock. Choate has been petitioner's

president, CEO, chairman of the board, and the only member of

petitioner's board of directors since he incorporated it.

In 1989, Choate designed petitioner's logo, which petitioner

still used at the time of trial.

Petitioner grew very quickly. After 6 months, petitioner

had four or five employees in its office and some field
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superintendents. Petitioner then moved into a 784-square-foot

office. In 1990, petitioner moved into a 10,000-square-foot

office. At that time, petitioner had about 39 employees. In

1992, petitioner had 84 employees. In 1994, petitioner moved

into a 15,000-square-foot office.

D. Choate's Role in Petitioner's Operations

1. Personal Investment of Time and Money

Choate worked only for petitioner after he incorporated it.

He worked 16 hours a day, 7 days a week for the first 3 years,

including the year in issue. Choate took one vacation, lasting 4

days, in the first 3 years after he incorporated petitioner.

Choate lent all of his personal savings (about $450,000) to

petitioner to help petitioner get surety bonds required to bid

large jobs. Choate reported $19,500 in interest income from

petitioner for 1991, $19,500 for 1992, and $44,846 for 1993.

Choate had contributed $402,475 in capital to petitioner by June

30, 1992. Choate lent petitioner $50,000 on June 27, 1992,

$100,000 on August 9, 1992, and $350,000 on September 10, 1992,

at an interest rate of 13 percent; and $493,868.78 on December

31, 1992, at an interest rate of 5 percent.
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2. Petitioner's Manuals, Documents, and Procedures

Choate wrote petitioner's business plans for 1991, 1992, and

1993. He wrote petitioner's training and procedural manuals and

manuals for project superintendents and managers, fast track

projects, program scheduling, preliminary cost reports, project

controls, site analyses, and estimating procedures. He also

wrote petitioner's employees' handbook for 1990 and 1991. Choate

wrote petitioner's internal control documents, procedures for job

site meetings, subcontractor safety, checklists for estimating

bids for office buildings, check voucher forms, credit reports,

daily reports, expense reports, and employment applications. The

procedures Choate developed worked in concert with petitioner's

computer, scheduling, and accounting systems.

Petitioner rarely hired an attorney. Choate negotiated

contracts for petitioner. He drafted and reviewed contracts,

purchase orders, corporate resolutions, stock sale agreements,

shareholders' agreements, promissory notes, profit-sharing plans,

and deferred compensation agreements. Choate handled claims from

subcontractors. No subcontractor claims against petitioner

reached arbitration until 1995.

Choate authorized petitioner to issue section 1244 stock on

July 27, 1989.
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3. Computer Technology

Choate used computer technology to digitize site plans for

three-dimensional topography and site analysis. He also

digitized blueprints for buildings. This let estimators do in 30

minutes what formerly took several days. Choate kept current

with computer-assisted design technology, and he integrated

computer technology systems with petitioner's procedures.

4. Personnel and Training

Choate hired and trained petitioner's key employees the

first 5 years and trained them in general construction and in the

systems and procedures that he had developed for petitioner.

5. Business Development

Choate was principally responsible for developing

petitioner's highly technical biomedical construction business.

Other employees of petitioner often found leads for contracts.

However, Choate was principally responsible for obtaining

contracts for petitioner.

6. Awards

Entrepreneur of the Year Institute nominated Choate in 1992

and named him in 1993 as Entrepreneur of the Year in the

southeast construction division. Selection of the Entrepreneur

of the Year is based on financial statements, clients' opinions
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about the firms' performance, and a personal interview relating

to the business growth and performance of the nominee's firm in

recent years.

E. Choate's Assistants

1. Dudley, Freese, and Barrett

In 1989 and 1990, Choate hired Freese to estimate bids,

Barrett to do interior work, and Dudley to pursue job leads.

Choate trained Dudley, Freese, and Barrett. Choate's training

and education of Dudley regarding the construction industry was

vital to Dudley. Choate was Dudley's primary mentor in the

construction business.

On June 30, 1990, Choate sold 500 shares of petitioner's

stock to: (a) Freese for $20,000, which Freese sold back around

December 31, 1993, for $95,219; and (b) Barrett and Dudley for

$27,518, which they each sold back around January 1, 1995, for

$128,382. Choate owned 85 percent of petitioner's stock when

Dudley, Freese, and Barrett each owned 5 percent. Dudley pledged

his home as collateral to Choate to secure the loan from Choate

that Dudley used to buy the 500 shares from Choate.

In 1992, Dudley, Freese, and Barrett asked Choate to split

petitioner's profits based on stock ownership until a certain
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target was achieved and to split profits above the target equally

four ways. Choate rejected this plan.

At the time of trial, Dudley and Barrett jointly owned a

construction company and Freese worked for another construction

company.

2. Bunyard

In June 1990, Choate hired Ben Bunyard (Bunyard) to be a

project manager. Bunyard had previously worked in the

construction business, but he learned more about project

management from Choate than from anyone else. Bunyard received a

bonus in 1990.

3. Page

On June 3, 1991, Choate hired David A. Page (Page) to be

petitioner's chief financial officer, comptroller, and chief of

computers. Page had an accounting degree and had worked for a

contractor. He spent 15 to 25 hours each week with Choate during

the first 3 months that he worked at petitioner, learning about

computers, construction, and Choate's detailed cost accounting

controls. He and Choate usually reviewed checks from 4 p.m. to

11 p.m. on Thursdays. They made notes and sent them to project

managers. They reviewed the reports project managers returned to

accounting.
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F. Compensation Paid by Petitioner

Petitioner did not pay Choate for work he performed during

its first 6 months. For its fiscal year ending June 30, 1990,

petitioner paid $202,000 to Choate and paid salary, wages, and

other labor costs of $240,938.

Petitioner paid salaries and bonuses to its officers as

follows:

Fiscal year Choate Dudley Freese Barrett

June 30, 1990 $202,000 -- -- --
June 30, 1991 156,250 $72,200 $46,042 $63,000
June 30, 1992 1,010,000 134,250 121,000 121,000

The record does not show how much petitioner paid Dudley, Freese,

and Barrett during petitioner's fiscal year ending June 30, 1990.

Petitioner has always had a policy of paying bonuses to its

employees. The bonuses petitioner pays to its project managers

and superintendents often exceed their salaries. Petitioner paid

bonuses based on the amount of work or revenues the employees

produced.

Choate authorized bonuses for petitioner's officers and

shareholders (himself, Dudley, Freese, and Barrett) on June 26,

1992. Petitioner paid those bonuses in the fiscal year ending

June 30, 1992, as follows:
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Percent Bonus as Officers' Percent of
of stock percent of total officers'
Officer ownership Bonus bonus pool pay total pay
Choate 85 $935,000 82.75 $1,010,000 72
Dudley 5 65,000 5.75 134,250 10
Freese 5 65,000 5.75 121,000 9
Barrett 5 65,000 5.75 121,000 9
$1,130,000 100.00 $1,386,250 100

Choate set these bonuses based on performance, but he did not use

a formula to compute them.

Choate required Dudley, Freese, and Barrett to lend their

1992 bonuses to petitioner.

G. Petitioner's Gross Sales, Taxable Income, and Retained
Earnings

Petitioner grew dramatically during its first 3 years.

Petitioner reported income on its audited financial

statements under the percentage of completion method of

accounting and reported income on its income tax returns under

the completed contract method of accounting. Petitioner's gross

sales, taxable income, and retained earnings under those two

accounting methods are as follows:

Gross sales Taxable income
Completed Percentage Completed Percentage
Year contract completion contract completion
1990 $1,484,188 $4,809,514 ($218,807) $228,317
1991 15,599,142 16,984,287 37,840 675,849
1992 26,066,541 30,042,011 1,101,512 381,409
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Retained earnings
Completed Percentage
Year contract completion
1990 ($271,603) $147,885
1991 (366,386) 559,711
1992 585,554 786,282

The value of petitioner's stock increased as its retained

earnings increased.

H. Return on Equity

Using the percentage of completion method, petitioner's

return on equity (net profits; i.e., profits less taxes and

compensation of the CEO, divided by equity) was about 37 percent

for 1990, 75 percent for 1991, and 25 percent for 1992.

Under the completed contract method, petitioner's return on

equity was about 2,665 percent for 1992. Petitioner's average

return on equity for 1990, 1991, and 1992 was 45.4 percent under

the percentage of completion method of accounting and 842 percent

under the completed contract method. Petitioner paid $10,000 in

dividends ($1 per share) on June 30, 1992.

I. Reynolds

Construction businesses are generally required to have a

surety bond for the amount of the contract as a condition for

submitting a bid and entering a contract. Robert N. Reynolds
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(Reynolds), a surety bond agent, worked with Choate for

petitioner, and with Barrett, Freese, and Dudley for their own

companies. Reynolds used the following criteria to evaluate the

companies owned by Barrett, Freese, Dudley, and Choate when they

sought surety bonds: (1) The character and integrity of the key

individual, (2) the capacity and experience of the company to

perform projects they want to undertake, and (3) the amount of

cash in or the financial ability of the company to perform the

contracts.

OPINION

A. Contentions of the Parties

Petitioner deducted the $1,010,000 which it paid to Choate

in 1992. Respondent determined and contends that it was

unreasonable to pay Choate more than $265,550, and that part of

the $1,010,000 was not for services that Choate rendered to

petitioner in 1992. Respondent's determination is presumed to be

correct. Rule 142(a).

B. Background

A taxpayer may deduct a reasonable allowance for salaries or

other compensation for services actually rendered. Sec.
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162(a)(1). A taxpayer may deduct compensation if it is: (1)

Reasonable in amount, and (2) purely for services. Sec.

162(a)(1); Rutter v. Commissioner, 853 F.2d 1267, 1271 (5th Cir.

1988), affg. T.C. Memo. 1986-407; Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1322-1323 (5th Cir. 1987), affg.

T.C. Memo. 1985-267. Thus, we must decide whether petitioner has

shown that the compensation petitioner paid to Choate in 1992 was

reasonable in amount and whether it was purely for services.

1. Factors Considered in Deciding If Compensation Is
Reasonable in Amount

Courts have considered many factors in deciding whether

compensation is reasonable in amount, such as: (1) The

employee's qualifications; (2) the nature and scope of the

employee's work; (3) the size and complexity of the business; (4)

general economic conditions; (5) the employer's financial

condition; (6) a comparison of salaries paid with sales and net

income; (7) distributions to shareholders and retained earnings;

(8) whether the employee and employer dealt at arm's length, and

if not, whether an independent investor would have approved the

compensation; (9) the employer's compensation policy for all

employees; (10) the prevailing rates of compensation for
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comparable positions in comparable companies; (11) compensation

paid in prior years; and (12) whether the employee guaranteed the

employer's debt. Rutter v. Commissioner, supra; Owensby &

Kritikos, Inc. v. Commissioner, supra; Mayson Manufacturing Co.

v. Commissioner, 178 F.2d 115, 119 (6th Cir. 1949), revg. and

remanding a Memorandum Opinion of this Court dated Nov. 16, 1948;

R.J. Nicoll Co. v. Commissioner, 59 T.C. 37, 51 (1972). No

single factor controls. Mayson Manufacturing Co. v.

Commissioner, supra.

2. Post-June 30, 1992, Facts

The last day of the tax year at issue was June 30, 1992.

Respondent objected to the admission of evidence relating to some

post-June 30, 1992, events as irrelevant.1 Petitioner relies on

events occurring after June 30, 1992, to show Choate's value to

petitioner in the year ending June 30, 1992, and to rebut

1
Respondent does not argue on brief that we should not
consider events occurring after June 30, 1992. On brief,
respondent points out that Choate lent money to petitioner from
June 2, 1992, to June 29, 1993, when he was receiving large
bonuses from petitioner. Respondent's expert testified that he
would consider petitioner's 1994, 1995, and 1996 financial
success in estimating Choate's reasonable compensation for 1992
because the performance of an officer in a construction company
affects the firm in later years.
 - 16 -

Dudley's and Freese's testimony that they were important to

petitioner and Dudley's testimony that Choate was not.

We do not consider events occurring after June 30, 1992, in

deciding the value of Choate's services in petitioner's fiscal

year ending on that date, see Estate of Gilford v. Commissioner,

88 T.C. 38, 52-55 (1987), except as stated next. We consider

Choate's 1993 Entrepreneur of the Year award as evidence that his

1992 compensation was reasonable because the selection process

for the 1993 award had begun in 1992, and we believe that

petitioner knew before June 30, 1992, about most or all of

Choate's accomplishments that led to his receipt of the 1993

award. We do not consider petitioner's growth from 1993 to 1995

in deciding Choate's value to petitioner in 1992 because

petitioner did not show that it knew in 1992 that the growth

would occur.

C. Reasonableness of Choate's Compensation

We next apply the factors listed above at paragraph B-1 in

deciding whether the compensation petitioner paid to Choate was

reasonable.
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1. Employee's Qualifications

An employee's superior qualifications for his or her

position with the business may justify high compensation. Home

Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1158

(1980). Respondent concedes that Choate was highly qualified for

his position with petitioner. This factor favors petitioner.

2. Nature and Scope of Employee's Work

The duties performed by the employee, the hours worked, and

the importance of the employee to the success of the company may

justify high compensation. Rutter v. Commissioner, supra; Mayson

Manufacturing Co. v. Commissioner, supra.

Respondent concedes that Choate contributed significantly to

petitioner's success but contends that Dudley, Freese, and

Barrett contributed as much as Choate to petitioner's success.

We disagree. Choate was clearly more important to petitioner

than anyone else. Reynolds, a surety bond agent, knew Choate,

Barrett, Freese, and Dudley professionally. He testified that

Choate had a much greater ability than Barrett, Freese, or Dudley

to develop petitioner.
 - 18 -

Respondent speculates that Choate did not work as many hours

as he claimed. However, no witness contradicted Choate's

testimony about his own efforts, and Page, petitioner's chief

financial officer, testified that he had never known anyone that

worked as hard as Choate.

Respondent contends that it is common for a CEO to work long

hours, suggesting that Choate's schedule was nothing out of the

ordinary. However, respondent produced no evidence that CEO's

commonly work as hard as Choate did.

Respondent points out that Choate was quoted in a magazine

article giving Barrett, Freese, and Dudley credit for helping

petitioner become successful. This fact is not contrary to the

conclusion that Choate was more important to petitioner than his

assistants.

This factor favors petitioner.

3. Size and Complexity of the Business

The size and complexity of a taxpayer's business are factors

in deciding whether compensation is reasonable. Rutter v.

Commissioner, supra; Pepsi-Cola Bottling Co. v. Commissioner, 528
 - 19 -

F.2d 176, 179 (10th Cir. 1975), affg. 61 T.C. 564 (1974); Mayson

Manufacturing Co. v. Commissioner, supra.

Respondent concedes that the construction industry is

generally complex but contends that petitioner had not developed

a niche in medical construction by June 30, 1992. Respondent's

argument overlooks the fact that petitioner specialized in

complex projects from its inception, such as hospital operating

rooms, robotics facilities, high-quality glass-making plants, and

"clean" industrial rooms, all built to exacting specifications.

This factor favors petitioner.

4. General Economic Conditions

General economic conditions may affect a company's

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

the company. Rutter v. Commissioner, 853 F.2d 1267 (5th Cir.

1988); Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115

(6th Cir. 1949). Respondent concedes that the construction

industry was weak in 1992. Despite this, petitioner had become

extremely successful by June 30, 1992. This factor favors

petitioner.
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5. Petitioner's Financial Condition

The past and present financial condition of a company is

relevant to deciding whether compensation was reasonable. Home

Interiors & Gifts, Inc. v. Commissioner, supra at 1157-1158.

Respondent concedes that petitioner had become financially

successful by 1992. Respondent points out that petitioner's

gross and net profit margins for the fiscal year ending June 30,

1992, were 8.6 percent and 1.3 percent, which is less than the

average of 9.8 and 1.6 percent for commercial construction

contractors with receipts of $10 to $50 million, according to

Robert Morris Associates (RMA) data. We give this RMA data

little weight because we doubt that the companies on which it is

based were in only their third year of operation.

This factor favors petitioner.

6. Comparison of Salaries Paid With Sales and Net Income

Courts have compared sales and net income to amounts of

compensation in deciding whether compensation is reasonable.

Mayson Manufacturing Co. v. Commissioner, supra. Respondent

concedes that Choate's compensation was a small percentage of
 - 21 -

petitioner's gross sales. For 1992, petitioner had gross sales

of $26,066,541 under the completed contract method of accounting

and $30,042,011 under the percentage of completion method. This

factor favors petitioner.

7. Distributions to Shareholders and Retained Earnings

Courts consider the amount of distributions to shareholders

in deciding if compensation is reasonable. Mayson Manufacturing

Co. v. Commissioner, supra. The failure to pay more than a

minimal amount of dividends may suggest that some of the amounts

paid as compensation to a shareholder-employee are dividends,

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d at 1322-1323,

and warrant further scrutiny by the court, Edwin's, Inc. v.

United States, 501 F.2d 675, 677 n.5 (7th Cir. 1974). However,

corporations are not required to pay dividends; shareholders may

be equally content with the appreciation of their stock if the

company retains earnings. Owensby & Kritikos, Inc. v.

Commissioner, supra; Home Interiors & Gifts, Inc. v.

Commissioner, supra at 1161.
 - 22 -

Petitioner retained its earnings and did not pay dividends

before 1992, when it paid dividends of $10,000. Petitioner

needed to retain earnings to be able to obtain surety bonds which

allowed it to bid on large contracts. Petitioner's retained

earnings grew from negative $271,603 in 1990 to $585,554 under

the completed contract method of accounting and from $147,885 to

$786,282 under the percentage of completion method at the end of

the year in issue. We believe a shareholder of petitioner's

would be satisfied with these results.

Respondent points out that Choate wanted petitioner to elect

S corporation status earlier than July 1, 1993, and that he

thought that this case would have been unnecessary if petitioner

had made the election earlier. Respondent contends that this

shows that Choate's bonus was a disguised dividend. Respondent

cites no case in which a court considered the fact that a

business owner preferred S corporation status in deciding if

compensation was reasonable. We disagree that Choate's wanting

to elect S corporation status has any bearing here.

This factor favors petitioner.
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8. Whether an Independent Investor Would Have Approved
Petitioner's Pay to Choate

If the employee and employer did not deal at arm's length,

for example, if the employee is the employer's sole or

controlling shareholder, the amount of compensation paid may be

unreasonable. Owensby & Kritikos, Inc. v. Commissioner, supra at

1324. Choate has been petitioner's majority shareholder at all

times since Choate founded petitioner. Thus, we must decide

whether an independent investor would have approved petitioner's

pay to Choate. Id. at 1326-1327. We believe that an independent

investor would have approved Choate's compensation because his

efforts led to its rapid growth and financial success.

The prime indicator of the return a corporation is earning

for its investors is its return on equity. Id. In Elliotts,

Inc. v. Commissioner, 716 F.2d 1241, 1247 (9th Cir. 1983), revg.

and remanding T.C. Memo. 1980-282, the U.S. Court of Appeals for

the Ninth Circuit concluded that a rate of return on equity of 20

percent would satisfy an independent investor and would show that

the employee was not exploiting his position with the taxpayer.
 - 24 -

In this case, the return on equity for 1992 was about 25 percent

under the percentage of completion method.

Respondent points out that we have calculated return on

investment by dividing taxable income (before net operating

losses) by shareholder's equity for each fiscal year. Wy'East

Color, Inc. v. Commissioner, T.C. Memo. 1996-136. Respondent

contends that, since petitioner was capitalized with $402,475,

and petitioner's taxable income was ($218,807) and $37,840 in its

fiscal years 1990 and 1991 under the completed contract method of

accounting, its return on investment was negative for those 2

years.

We are not convinced by respondent's argument. The year in

issue is 1992, not 1990 or 1991. Petitioner showed a substantial

net profit and return on investment under the percentage of

completion method for 1990 and 1991 and under either method in

1992. Dudley, Freese, and Barrett clearly received a good return

on their investment in the stock of petitioner over a period that

included the year in issue.

This factor favors petitioner.
 - 25 -

9. Petitioner's Compensation Policy for All Employees

Courts have considered the taxpayer's compensation policy

for other employees of the business in deciding whether

compensation is reasonable. Mayson Manufacturing Co. v.

Commissioner, 178 F.2d at 119; Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. at 1159. This factor focuses on whether

the entity pays top dollar to all of its employees, including

both shareholders and nonshareholders. Owensby & Kritikos, Inc.

v. Commissioner, supra at 1329-1330.

Petitioner paid Choate at the high end of the compensation

range. Petitioner points out that its project managers and

superintendents often make more from bonuses (which are based on

performance) than they do from salaries, but petitioner presented

no evidence that its other employees were paid at or near the

high end of the compensation range. Cf. Home Interiors & Gifts,

Inc. v. Commissioner, supra at 1159-1160.

This factor favors respondent.
 - 26 -

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

In deciding whether pay is reasonable, we compare it to

compensation paid to persons holding comparable positions in

comparable companies. Rutter v. Commissioner, 853 F.2d 1267 (5th

Cir. 1988); Mayson Manufacturing Co. v. Commissioner, supra at

119.

Both parties produced expert testimony regarding this

factor. Petitioner's expert was Stephen D. Kirkland (Kirkland),

and respondent's was Emmet James Brennan III (Brennan).

Brennan testified that Choate's compensation was 4.5 percent

of petitioner's revenues while "top performing companies" paid

their officers 2.6 percent of revenues. Brennan stated that

"high average" compensation to CEO's of similar-sized

construction companies was $265,550. Brennan stated that no

Atlanta construction company similar in size to petitioner that

answered his survey paid its CEO more than $500,000 in 1992.

Brennan did not show that the performance of the CEO's of

the companies he considered was comparable to Choate's
 - 27 -

performance or that the other companies were as successful as

quickly as petitioner. Brennan's analysis is not helpful because

he has not shown that he considered comparable firms and

executives. We have said this about Brennan's testimony in other

cases. E.g., Lumber City Corp. v. Commissioner, T.C. Memo. 1996-

171; Pulsar Components Intl., Inc. v. Commissioner, T.C. Memo.

1996-129; Alondra Indus., Ltd. v. Commissioner, T.C. Memo. 1996-

32; Guy Schoenecker, Inc. v. Commissioner, T.C. Memo. 1995-539;

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

Kirkland's opinion is that reasonable compensation to Choate

for 1990, 1991, and 1992 would have been an average of $539,416

per year. Kirkland based this amount in part on Choate's pay

from Toon, his prior service to petitioner, the absence of

benefits from petitioner, petitioner's return on equity, and

Choate's success with petitioner.2 Choate's pay from petitioner

from 1990 to 1992 averaged $456,000. Kirkland said this was

2
Kirkland noted that he found no boats or lakehouses, or
relatives on petitioner's payroll, leading him to observe that
petitioner is a very "clean" organization.
 - 28 -

reasonable in amount, considering that Toon paid Choate $250,693

in 1983, $312,134 in 1984, $434,148 in 1985, and $460,000 in

1986. Choate's average pay from Toon for 1985 and 1986 was

$447,074, slightly more than his 1990-92 average pay from

petitioner. This fact tends to show that Choate's pay in 1992

was reasonable.

This factor favors petitioner.

11. Compensation Paid in Prior Years

An employer may deduct compensation paid in a year for

services rendered in prior years. Lucas v. Ox Fibre Brush Co.,

281 U.S. 115, 119 (1930); R.J. Nicoll Co. v. Commissioner, 59

T.C. at 50-51. Respondent contends that petitioner's pay to

Choate in 1992 did not include catch-up pay for 1990 and 1991.

We disagree. Choate testified that his compensation for 1992

included catch-up pay for his services to petitioner before 1992.

Choate received no pay in his first 6 months working for

petitioner. Petitioner underpaid Choate in 1990 and 1991 to keep

more cash in the company so that it could obtain surety bonds.
 - 29 -

Choate awarded himself a large amount of catchup pay in 1992,

when petitioner had become successful.

Respondent contends that we should disregard Choate's

testimony because it was self-serving. We disagree. Choate's

testimony was plausible and consistent with the objective

evidence. Respondent offered no evidence to contradict Choate's

testimony that petitioner intended to pay him catchup pay.

Reynolds corroborated Choate's testimony.

Respondent points out that cases permitting catchup pay

because of past undercompensation usually involve a substantial

base period. See Lucas v. Ox Fibre Brush Co., supra (14 years);

R.J. Nicoll Co. v. Commissioner, supra (13 years); Acme Constr.

Co. v. Commissioner, T.C. Memo. 1995-6 (7 years); Comtec Systems,

Inc. v. Commissioner, T.C. Memo. 1995-4 (12 years). Respondent

concludes from this that a deduction for catchup pay is not

available in a company's third year. We disagree. If a taxpayer

otherwise qualifies, it may deduct catchup pay. The fact that

petitioner could provide catchup pay quickly is another measure

of Choate's success.
 - 30 -

This factor favors petitioner.

12. Employee's Guaranty of the Employer's Debt

In deciding whether compensation is reasonable, courts have

considered whether the employee personally guaranteed the

employer's debt. See R.J. Nicoll Co. v. Commissioner, supra at

51. Choate personally guaranteed petitioner's debt in the early

years.

Respondent points out that in petitioner's fiscal year

ending June 30, 1991, petitioner had a $250,000 line of credit at

the prime rate guaranteed by a shareholder (presumably Choate),

which there is no evidence petitioner used. Respondent also

contends that Choate profited by lending substantial amounts of

money to petitioner in calendar year 1992 at an interest rate of

13 percent. Despite this, there is no doubt that Choate

personally guaranteed petitioner's debt.

Respondent contends that Dudley assumed financial risk for

petitioner. Respondent bases this on the fact that Dudley

pledged his home as collateral to Choate when Dudley bought 5

percent of petitioner's stock. Dudley did not assume financial
 - 31 -

risk for petitioner; he simply assumed risk to buy stock for

himself.

This factor favors petitioner.

13. Respondent's Other Contentions

Respondent cites Guy Schoenecker, Inc. v. Commissioner, T.C.

Memo. 1995-539. In that case, we were not convinced that the

taxpayer's CEO was exceptional or irreplaceable because an

assistant or the CEO's son could do the CEO's job. The

taxpayer's growth was similar to that of its competitors. The

taxpayer had been in business for 10 years before the years in

issue and had not had the rapid growth and success that

petitioner did. Choate's performance was exceptional. There is

no evidence that anyone else could have done what Choate did for

petitioner.

In Tricon Metals & Servs., Inc. v. Commissioner, T.C. Memo.

1997-360 (decided after the parties filed their briefs in this

case), we found that the compensation paid by the taxpayer

exceeded a reasonable amount. However, in Tricon Metals, unlike

this case, the taxpayer did not show that its operations were
 - 32 -

highly technical or complex, that it paid compensation for

services provided in prior years, and that its CEO had managerial

skills unique to its industry, had founded a firm that became

very successful in 3 years, or worked an inordinate number of

hours.

14. Conclusion

We conclude that the amount of compensation that petitioner

paid to Choate in 1992 was reasonable.

D. Whether Payments to Choate Were for Services

To be deductible, compensation must be purely for services.

Sec. 162(a)(1); Rutter v. Commissioner, 853 F.2d at 1271; Owensby

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

There is no question that Choate rendered services to

petitioner. However, respondent contends that petitioner's

payments to Choate were disguised dividends and were not purely

for services. Respondent points out that Dudley and Freese

testified that they believed their bonuses for 1992 were based on

stock ownership; that Dudley, Freese, and Barrett each received

$65,000 bonuses and Choate received a $935,000 bonus; and that
 - 33 -

5.75 percent of the bonuses was paid to Dudley, Freese, and

Barrett and 82.75 percent was paid to Choate, which is about in

proportion to their stock ownership.

We disagree. We think a more likely view of this is that

Choate's sale of his stock in petitioner to Dudley, Freese, and

Barrett reflects Choate's assessment of their contribution to

petitioner. Likewise, petitioner probably paid them about that

portion of the bonuses because Choate continued to have the same

assessment of them. We believe Choate set their bonuses based on

his assessment of their work, not based on their stock ownership.

Choate credibly testified that the bonuses were for services

rendered and were not based on stock ownership.3 He rejected a

plan which Dudley, Freese, and Barrett suggested to him to split

profits based on stock ownership and split the excess equally

four ways after a certain target was achieved.

Although Dudley and Freese testified that they believed that

the bonuses were based on stock ownership, they also testified

3
Choate decided how much stock he would allow Dudley,
Freese, and Barrett to buy from him.
 - 34 -

that their own bonuses were based on their work, not on their

stock ownership. Dudley and Freese were inconsistent on this

point. Choate, who made the decision, was not.

Respondent contends that the facts here are like those in

Nor-Cal Adjusters v. Commissioner, T.C. Memo. 1971-200, affd. 503

F.2d 359 (9th Cir. 1974). We disagree. In Nor-Cal Adjusters,

unlike in this case: (1) Bonuses were paid only to officer-

shareholders and not to nonshareholder employees who did work

similar to that done by officer-shareholders; (2) bonuses were

exactly proportionate to stock ownership; and (3) the taxpayer's

compensation plan was not based on a percentage of billings as

were those of other independent insurance adjusting firms.

Respondent contends that this case is similar to Pacific

Grains, Inc. v. Commissioner, 399 F.2d 603, 607 (9th Cir. 1968),

affg. T.C. Memo. 1967-7. We disagree. In Pacific Grains, Inc.

v. Commissioner, supra at 606-607, unlike this case: (1) The pay

at issue did not include catchup pay for prior services, and (2)

the taxpayer did not pay dividends and had no reason to

accumulate earnings and not to pay dividends.
 - 35 -

We conclude that petitioner paid the bonuses for services

Choate rendered to petitioner.

E. Conclusion

Based on the factors outlined above, we conclude that

petitioner's compensation to Choate for petitioner's fiscal year

ending 1992 was reasonable in amount and was paid purely for

services Choate rendered to petitioner.

To reflect the foregoing and concessions,

Decision will be entered

under Rule 155.