Normandie Metal Fabricators, Inc. v. Commissioner

T.C. Memo. 2000-102

UNITED STATES TAX COURT

NORMANDIE METAL FABRICATORS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2526-98. Filed March 27, 2000.

Louis F. Brush, for petitioner.

Halvor N. Adams III, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge: Respondent determined deficiencies in

petitioner’s Federal income tax and a penalty under section 6662

as follows:
 - 2 -

Penalty
Year Deficiency Sec. 6662
1993 $130,822 $26,164
1994 135,336 27,067
1995 120,550 24,110

In an amendment to answer filed January 7, 1999, respondent

contends that petitioner’s deficiencies are $163,173 for 1993,

$155,139 for 1994, and $141,328 for 1995, and that petitioner is

liable for penalties of $32,635 for 1993, $31,028 for 1994, and

$28,266 for 1995.1

After concessions, the issues for decision are:

1. Whether petitioner may deduct as compensation for

Isidore Klein and Steven Klein for 1993, 1994, and 1995, the

amounts shown below as the parties contend, or some other amount:

Year Isidore Klein Steven Klein Total

Petitioner
1993 $352,000 $500,400 $852,400
1994 368,000 450,400 818,400
1
1995 5,000 820,400 825,400

Respondent
1993 $405,250
1994 392,157
1995 444,284
1
Respondent does not dispute this amount.

We hold that petitioner may deduct $500,000 in 1993, $500,000 in

1
Petitioner bears the burden of proving the reasonableness
of compensation it paid in excess of what respondent determined
was reasonable. See Rule 142(a). Respondent bears the burden of
proving the increases in deficiency and sec. 6662 penalty
asserted in the amended answer. See id. However, our decision
does not depend on which party bears the burden of proof.
 - 3 -

1994, and $445,000 in 1995, based on the following amounts of

reasonable compensation:

Year Isidore Klein Steven Klein Total
1993 $200,000 $300,000 $500,000
1994 200,000 300,000 500,000
1995 5,000 440,000 445,000

2. Whether petitioner is liable for the accuracy-related

penalty under section 6662 for substantial understatement of tax

for 1993, 1994, and 1995. We hold that it is for 1993 and 1994,

but not for 1995.

Section references are to the Internal Revenue Code in

effect during the years in issue. Rule references are to the Tax

Court Rules of Practice and Procedure.

I. FINDINGS OF FACT

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

Petitioner is a corporation the principal office of which

was in Port Washington, New York, when it filed the petition.

A. The Kleins

Isidore Klein was born in 1913. He is married to Gertrude

Klein. He was a baker and taught baking at a vocational high

school in New York. He also manufactured small metal products

that he used in his baking business.

Steven Klein was born in 1942. He is the son of Isidore and

Gertrude Klein.

B. Formation of Petitioner

Petitioner manufactures and sells small implements and metal
 - 4 -

food handling equipment primarily for the bakery industry.

Isidore Klein and Victor Lampeh (Lampeh) incorporated petitioner

in 1949 in New York, after Isidore Klein developed white lung

disease (similar to emphysema) and had to retire from baking.

Isidore Klein initially invested only $119 in petitioner.

Petitioner issued 4 shares of common stock in 1949. In

1954, Lampeh left the company. From March 1954 to January 1995,

Isidore Klein owned 3 shares and Gertrude Klein owned 1 share of

petitioner’s stock. Before and during the years in issue (until

January 1995), the members of petitioner’s board of directors

were Isidore and Gertrude Klein, and Isidore Klein was chairman

of the board of directors.

C. Isidore Klein’s and Steven Klein’s Work for Petitioner
Before 1980

1. Isidore Klein

Isidore Klein created, developed, and built petitioner into

a profitable business. His background in the baking industry

helped him to understand what bakers needed and to develop

products to meet those needs. Isidore Klein worked 12 to 18

hours a day, 6 days a week. He manufactured baking implements

during the day and often sold his products to bakers at night

while they worked.

Petitioner grew during the 1950's because Isidore Klein

invented and manufactured several successful products. For

example, he invented a hanging cord dispenser, aluminum anodized
 - 5 -

cookie display trays in different colors, a line of plastic

window display stands, and a motorized carousel tray. Petitioner

began producing racks, cabinets, and covers in the 1960's.

Isidore Klein continued to invent products in the 1960's and

1970's that petitioner manufactured and sold.

Isidore Klein designed most of the products in petitioner’s

catalog. He developed many products that became widely accepted

in the baking industry in the New York metropolitan area.

Baker’s Aid, a national seller of baking equipment with annual

sales of about $40 million during the years in issue, has been an

important customer of petitioner’s since the 1950's. Baker’s Aid

became petitioner’s biggest customer largely due to Isidore

Klein’s innovative products.

2. Steven Klein

Steven Klein worked for petitioner part time and during the

summer beginning in the late 1950's when he was in high school.

He began working full time for petitioner in September 1963,

after he had finished 2 years of college. From 1963 to 1980, he

performed most of the jobs in petitioner's business. For

example, he worked in the factory, welded, made purchases, and

prepared sketches for special orders.

D. Petitioner’s Move to Port Washington and the 1984 Guaranty
Agreement

On November 1, 1984, petitioner guaranteed a $995,000

industrial development loan to Steven Klein to buy a building in
 - 6 -

Port Washington to house petitioner. Petitioner moved from New

York to Port Washington in 1984. Petitioner’s Port Washington

building has an office and a factory. Petitioner rented the

building from Steven Klein for 15 years under a triple net lease.

Under the 1984 guaranty, petitioner promised not to pay cash

dividends or to redeem shares of stock for cash except for stock

owned by Isidore Klein. However, the bank waived the covenant

and consented to petitioner’s redemption of Gertrude Klein's

stock for cash in 1995.

E. Isidore and Steven Klein’s Work for Petitioner From 1980
Through the Years in Issue

As discussed next, from 1980 to 1994, Isidore Klein was

semiretired, and Steven Klein ran petitioner, subject to Isidore

Klein’s overall approval.

1. Isidore Klein

Isidore and Gertrude Klein have lived in Florida since 1980.

Isidore Klein had the title of chief executive officer and

president of petitioner until he sold his stock in January 1995.

Isidore Klein oversaw petitioner’s operations in 1993 and 1994.

He called Steven Klein at least twice a week in 1993 and 1994 to

discuss the business, to monitor the cost of raw materials,

labor, and office personnel, and to approve Steven Klein’s major

business decisions. Steven Klein and Isidore Klein often

disagreed about how Steven Klein should run petitioner, which

caused a strain in their relationship.
 - 7 -

In 1993 and 1994, petitioner’s comptroller, Jeffrey

Schwaeber, or petitioner’s bookkeeper, Karen Macken, sent Isidore

Klein weekly financial reports about petitioner. During those

years, Isidore Klein called Jeffrey Schwaeber to ask questions

about the weekly financial reports. Isidore Klein also

corresponded with Richard Schwaeber, petitioner’s accountant, in

1993 and 1994 to monitor petitioner’s financial position.

Isidore Klein visited petitioner's facility four to eight

times a year in 1993 and 1994. He stayed at least a week each

time he visited petitioner. In 1993 and 1994, Isidore Klein did

not supervise petitioner’s salespeople, warehouses, or day-to-day

operations. However, Isidore Klein occasionally provided product

support to, or consulted on technical or design questions with,

Baker’s Aid during those years. He also attended trade shows to

look for ideas for new products petitioner could manufacture.

In 1993 and 1994, Isidore Klein designed a portable housing

system for use by the military or as emergency housing. He

attempted unsuccessfully in 1993 and 1994 to market the housing

system to the U.S. military. Petitioner did not pursue the

portable housing system after 1994.

2. Steven Klein

Steven Klein was petitioner’s vice president and chief

operating officer from 1991 to 1994. Steven Klein reported to

his father during those years. He was responsible for
 - 8 -

petitioner’s day-to-day management, which he found to be

difficult because he was under the constant scrutiny of his

father. He managed petitioner’s office staff of four people,

designed petitioner’s marketing catalogues, handled special

orders for customers, and designed custom-made items for

customers. He managed petitioner’s sales activities and was the

primary contact for petitioner’s biggest customer, Baker’s Aid,

in 1993, 1994, and 1995. Baker’s Aid accounted for about one-

third of petitioner’s sales in those years. Steven Klein was

very familiar with petitioner's customers and operations and had

good technical knowledge of its products. In 1993 and 1994,

Steven Klein worked long hours. Steven Klein became president

and chief executive officer (CEO) in January 1995, when Isidore

and Gertrude Klein sold their stock in petitioner. In 1995,

Steven Klein assumed more responsibility for petitioner. He

often received business telephone calls at home during 1993,

1994, and 1995.

3. Petitioner’s Redemption of Gertrude and Isidore Klein’s
Stock and Steven Klein’s Purchase of Petitioner

Around 1988, Steven Klein proposed buying Isidore and

Gertrude Klein’s stock in petitioner because he wanted to control

petitioner and to ensure that he and his children would own the

business. Steven Klein negotiated intermittently with Isidore

Klein from 1988 to 1994 to buy the stock. Isidore Klein

initially asked Steven Klein to pay $3 million for the stock.
 - 9 -

On January 30, 1995, petitioner redeemed its stock owned by

Gertrude Klein for $468,528 and by Isidore Klein for $1,405,584,

for a total of $1,874,112. Petitioner paid Isidore Klein

$31,472, and gave him a $1,374,112 note bearing interest at 8

percent for the balance. Also on that day, petitioner issued 100

shares of its stock to Steven Klein for $1,376. Since then,

Steven Klein has owned all of petitioner’s stock. Petitioner’s

net worth declined from $2,001,654 in 1994 to $194,130 in 1995

after the redemption.

F. Petitioner’s Employees and Compensation Policies

1. Petitioner’s Employees

Petitioner had three employees during the 1950's: Isidore

Klein and two other people. By 1963, petitioner had nine

employees: Steven Klein and three others in the office, and five

employees in the factory. By 1993, 1994, and 1995 petitioner had

about 13 or 14 employees.

In 1994 and 1995, petitioner had four employees in the

office: Steven Klein, Jeffrey Schwaeber, Karin Paterson

(Paterson), and Karen Macken (Macken). Jeffrey Schwaeber has an

accounting degree and worked at his father’s accounting firm from

June 1981 to September 1991. His father is Richard Schwaeber,

who was petitioner’s accountant from 1972 through the years at

issue, except for a short time in the late 1970's. Jeffrey

Schwaeber worked for petitioner from 1991 to 1997. He was
 - 10 -

petitioner’s vice president for operations, comptroller, and

purchasing agent. He set priorities for jobs to be performed in

the factory and supervised petitioner’s bookkeeper. He signed

some of petitioner’s quarterly Federal income tax returns and

information statements.

Macken was petitioner's bookkeeper from May 1993 through

1995. Paterson worked at petitioner from April 1994 until the

end of 1995. Her work included answering phones, taking orders,

and printing and mailing invoices.

In 1993, 1994, and 1995, Reinaldo (Ray) Cruz was

petitioner's factory foreman, and Felix Ortega received incoming

raw material and shipped finished products. Ray Cruz began

working for petitioner in 1973, and Felix Ortega in 1985.

2. Compensation Paid by Petitioner

a. Isidore Klein

From 1980 through 1994, Isidore Klein set his own salary

based on a percentage of petitioner’s gross sales. In 1980, the

board of directors (i.e., Isidore and Gertrude Klein) agreed that

petitioner would pay Isidore Klein a salary of 8 percent of gross

sales but would not reimburse him for his expenses. In 1993 and

1994, Isidore Klein set his salary at 10 percent of petitioner’s

gross sales. In 1993 and 1994, petitioner paid Isidore Klein

$1,000 per week plus $70,000, $80,000, and $80,000, respectively,

for the first three quarters, and payments just before yearend of
 - 11 -

$70,000 in 1993 and $86,000 in 1994. Petitioner made these

quarterly payments after Richard Schwaeber had prepared

petitioner's quarterly financial statements.

Petitioner compensated Isidore Klein from 1986 to 1995 as

follows:

Percentage of
Year Amount gross sales
1986 $226,752 8.0%
1987 238,298 8.0
1988 405,400 12.4
1989 426,068 12.6
1990 304,100 8.3
1991 251,100 7.7
1992 367,400 10.2
1993 352,000 9.9
1994 368,000 10.0
1995 5,000 –-

b. Steven Klein

From sometime in the 1980's until January 1995, Steven Klein

and Isidore Klein disagreed about how much petitioner would pay

Steven Klein, but Isidore Klein ultimately paid Steven Klein what

he requested. Steven Klein set his own pay in 1995. Petitioner

compensated Steven Klein from 1991 to 1995 as follows:

Year Amount
1991 $393,800
1992 476,800
1993 500,400
1994 450,400
1995 820,400

In 1995, petitioner paid Steven Klein: $7,700 per week,

$220,000 on December 26, 1995, and $200,000 on December 28, 1995.

Steven Klein discussed with Richard Schwaeber how much
 - 12 -

petitioner could reasonably pay him in 1995. Richard Schwaeber

advised him around the time petitioner redeemed Isidore Klein’s

stock in January 1995 that, since he was taking on the

responsibilities of two jobs (his and Isidore Klein’s), a salary

of about $800,000 in 1995 would be reasonable.

c. Other Employees

Petitioner paid Jeffrey Schwaeber $164,900 in 1992, $173,500

in 1993, $146,900 in 1994, and $148,500 in 1995. In 1993, 1994,

and 1995, petitioner had sales representatives to sell its

products. Petitioner paid its sales representatives commissions

of 5 percent.

In 1980, petitioner’s board of directors (i.e., Isidore and

Gertrude Klein) authorized Isidore Klein to conduct business on

its behalf in Florida. From 1990 to 1996, Howard Appell (Appell)

was petitioner's exclusive sales representative in Florida. In

1993, Appell talked to Jeffrey Schwaeber three to five times a

week. Appell dealt with Steven Klein several times in 1993,

1994, and 1995, but not with Isidore Klein.

G. Petitioner’s Financial History

1. Petitioner’s Sales and Taxable Income

Petitioner's sales increased in nominal dollars from 1983 to

1995. Petitioner’s net income before taxes declined sharply as

follows:
 - 13 -

Net income
before officers’
compensation Net income
Year Sales and taxes before taxes
1
1983 $2,723,342 $279,705
1
1984 2,911,934 446,738
1
1985 2,988,876 325,267
1
1986 2,856,060 303,649
1
1987 2,982,447 240,456
1988 3,280,793 $526,466 121,066
1989 3,379,488 547,980 121,912
1990 3,648,605 643,168 339,068
1991 3,247,094 741,359 96,459
1992 3,617,493 916,256 72,056
1993 3,549,669 920,277 67,877
1994 3,687,715 878,621 60,221
1995 4,057,464 914,715 89,315
1
Not in record.

In 1995, $4,057,464 equaled $2,649,524 in 1983 dollars. See

Statistical Abstract of the United States 1998, at 487 (chart

771). Thus, petitioner’s sales did not increase from 1983 to

1995 in real dollars.

Petitioner's annual and cumulative retained earnings were as

follows:

Year Annual Cumulative
1983 $157,853 $677,686
1984 227,686 905,372
1985 180,807 1,086,179
1986 169,566 1,255,745
1987 145,848 1,401,593
1988 87,068 1,488,661
1989 84,567 1,573,227
1990 205,415 1,778,642
1991 69,412 1,848,054
1992 55,353 1,903,407
1993 51,889 1,955,296
1994 46,239 2,001,535
1995 65,212 2,066,747

Petitioner has never paid dividends.
 - 14 -

Petitioner’s return on the fair market value of its

operating assets was 0.97 percent in 1993, 0.70 percent in 1994,

and 5.26 percent in 1995.

2. Petitioner’s Federal Income Tax Returns

Richard Schwaeber prepared and signed petitioner’s tax

returns from 1988 through the years at issue. Petitioner

attached Schedules E, Compensation of Officers, to its 1993,

1994, and 1995 returns. However, petitioner did not report the

percentage of time that its officers devoted to the business.

II. OPINION

A. Positions of the Parties

A taxpayer may deduct payments for compensation if the

amount paid is reasonable in amount and for services actually

rendered. See sec. 162(a)(1); Rutter v. Commissioner, 853 F.2d

1267, 1270-1271 (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.

Petitioner paid Isidore Klein $352,000 in 1993 and $368,000

in 1994, and paid Steven Klein $500,400 in 1993, $450,400 in

1994, and $820,400 in 1995. Petitioner contends that those

amounts were reasonable and were for services they provided to

petitioner. Respondent contends that compensation petitioner

paid in excess of $405,250 for 1993, $392,157 for 1994, and

$451,284 for 1995 was unreasonable, was disguised dividends, and

was not for services to petitioner.
 - 15 -

B. Controlling Factors

In Rapco, Inc. v. Commissioner, 85 F.3d 950, 954 (2d Cir.

1996), affg. T.C. Memo. 1995-128, the U.S. Court of Appeals for

the Second Circuit, the court to which an appeal in this case

would lie, stated five factors to be considered in assessing the

reasonableness of an employee's compensation: (1) The employee's

role in the taxpaying company, including the employee's position,

hours worked, and duties performed; (2) potential conflicts of

interest, such as the ability to “disguise” dividends as salary;

(3) the employer’s compensation policy for all employees; (4) the

character and financial condition of the company; and (5)

comparison of the employee's salary with those paid by similar

companies for similar services. No single factor controls.

These factors should be examined from the perspective of an

independent investor. See id. at 954-955; Dexsil Corp. v.

Commissioner, 147 F.3d 96, 100 (2d Cir. 1998), vacating and

remanding T.C. Memo. 1995-135.

Both parties called experts to testify about whether the

amount of compensation paid to the Kleins was reasonable.

Petitioner's expert was Paul Dorf (Dorf), and respondent's expert

was Scott D. Hakala (Hakala).

We next apply the factors listed above in deciding whether

the amount of compensation petitioner paid to the Kleins was

reasonable.
 - 16 -

1. The Employee's Role in the Company: The Employee's
Position, Hours Worked, and Duties Performed, Plus Any
Special Duties or Role

From the perspective of an independent investor, we consider

whether the employee's role in the taxpaying company, including

the employee's position, hours worked, and duties performed, plus

any special duties or role (such as personally guaranteeing

corporate loans), justify the compensation paid. See Rapco, Inc.

v. Commissioner, supra at 954.

a. Isidore Klein’s Role

Isidore Klein founded petitioner, built it into a profitable

business, and was a prolific inventor. However, Isidore Klein

was less actively involved in petitioner’s operations in 1993 and

1994 than he had been in earlier years. Isidore Klein had no

dealings with petitioner’s exclusive sales representative in

Florida in 1993 and 1994. Isidore Klein did not manage

petitioner day to day after 1980 as he had before he moved to

Florida. Isidore Klein spoke frequently on the phone to Steven

Klein and approved the major decisions, but day-to-day

responsibility had shifted to Steven Klein. We think an

independent investor would have objected to an increase in

Isidore Klein’s salary from 8 percent of gross sales in 1992 to

10 percent of gross sales in 1993 and 1994.

Petitioner contends that part of Isidore Klein’s

compensation in 1993 and 1994 was catchup pay for years in which
 - 17 -

he was underpaid. We disagree. Petitioner relies on Dorf’s

testimony that Isidore Klein’s salary in 1993 and 1994 was

reasonable because Isidore Klein was somewhat underpaid in

earlier years and had no long-term financial incentives and

benefits. Dorf’s conclusion that Isidore Klein was underpaid in

earlier years is unconvincing because he disregarded large

bonuses that petitioner paid Isidore Klein in 1984, 1988, and

1989. Dorf’s testimony does not establish and there is no

evidence that petitioner intended any of Isidore Klein’s pay in

1993 and 1994 to be catchup pay. See Pacific Grains, Inc. v.

Commissioner, 399 F.2d 603, 606 (9th Cir. 1968) (court found that

corporate president was not underpaid in part because taxpayer's

board did not state that some part of the payments were for his

prior services), affg. T.C. Memo. 1967-7; H&A Intl. Jewelry, Ltd.

v. Commissioner, T.C. Memo. 1997-467 (pay was not catchup pay

where minutes from shareholder meetings showed that the

compensation for the current year was not intended to reward the

employee's efforts for prior years).

Petitioner points out that Isidore Klein was trying to

develop a portable housing system in 1993 and 1994 and contends

that it could have increased petitioner’s annual revenue from $4

million to $50 million. However, there is no credible evidence

that the portable housing system could have generated $50 million

of revenue. The fact that Steven Klein abandoned work on the
 - 18 -

portable housing system as soon as he became owner of petitioner

in 1995 suggests that it did not have the profit potential

petitioner now claims.

b. Steven Klein’s Role

Petitioner contends that the amount of compensation it paid

to Steven Klein during the years in issue was reasonable because

of his superior skills and because he was the driving force

behind petitioner and solely responsible for its success in 1995.

We disagree in part.

Steven Klein ran petitioner with at best moderate success as

evidenced by petitioner’s modest increase in the real value of

sales, below average performance after officers’ compensation

(according to Hakala), and sharp decrease in profits from 1983 to

1995. We agree with Hakala that these results would not satisfy

an independent investor.

We also disagree that Steven Klein’s added duties or longer

hours in 1995 merit the large raise in his salary in 1995. We do

not believe that an independent investor would have been

satisfied with Steven Klein’s operation of petitioner in light of

Steven Klein’s assessment that petitioner was not very valuable

and that petitioner might not survive the loss of Isidore Klein

in 1995. Richard Schwaeber testified that petitioner had a cash-

flow problem and that its net worth essentially “disappeared”

when it redeemed Isidore Klein’s stock in 1995. We do not
 - 19 -

believe that an independent investor would have approved doubling

Steven Klein’s salary in 1995.

Citing Dexsil Corp. v. Commissioner, 147 F.3d at 102-103,

petitioner contends that Steven Klein’s salary increase from

$450,400 in 1994 to $820,400 in 1995 was reasonable because he

was performing his and Isidore Klein’s jobs. Petitioner’s

reliance on Dexsil is misplaced. In Dexsil, the U.S. Court of

Appeals for the Second Circuit directed the Tax Court to consider

whether compensation paid to a corporate president was reasonable

in light of the fact that he performed multiple roles and

compared to compensation paid by similar companies for comparable

services. See id. at 103. Steven Klein’s compensation in 1995

exceeded the total compensation paid to Isidore and Steven Klein

in 1994 by $7,000. Steven Klein admitted that he could not

perform Isidore Klein’s research and development activities as

well as Isidore Klein. Steven Klein testified that petitioner

would have had to pay someone $150,000-$250,000 to fill the

research and development position held by Isidore Klein. Dorf

provided market data showing that the annual compensation of a

research and development executive was $187,578 for 1993 and

$153,712 for 1994. We conclude that an independent investor

would not approve paying Steven Klein $150,000 in 1995 for

research and development activities that he admitted that he

could not perform as well as Isidore Klein.
 - 20 -

c. Petitioner’s Other Contentions

Petitioner argues that the compensation paid to Isidore and

Steven Klein is justified by the fact that they both guaranteed

the 1984 industrial development bond and remained liable on it in

1993 and 1994. We disagree. First, Steven Klein, not

petitioner, held title to the building purchased with the

proceeds of the industrial development bond. Second, there is

nothing about the financing of petitioner’s building to justify

higher compensation for Steven or Isidore Klein in 1993 and 1994.

Petitioner contends that we should treat it as a personal

service company because its success depends on the skill and

efforts of its officers, Isidore and Steven Klein, rather than on

capital. Petitioner contends that courts are more deferential in

deciding whether payments for services to officers of personal

service companies are reasonable, citing C.T.I. Inc. v.

Commissioner, T.C. Memo. 1994-82, affd. without published opinion

54 F.3d 767 (3d Cir. 1995); Kay, Inc. v. Commissioner, a

Memorandum Opinion of this Court dated Oct. 10, 1949; J. Brodie &

Son, Inc. v. Commissioner, a Memorandum Opinion of this Court

dated Mar. 30, 1949; and Firefoam Sales Co. v. Commissioner, a

Memorandum Opinion of this Court dated Apr. 22, 1947.

Petitioner’s reliance on these cases is misplaced because

petitioner was not a personal service company; it manufactures

and sells products.
 - 21 -

This factor favors respondent.

2. Potential Conflicts of Interest: Ability To Disguise
Dividends as Salary, Particularly If the Employee Is
the Sole or Majority Shareholder, or If a Large
Percentage of the Compensation Is Paid as a Bonus

The ability to disguise dividends as salary, particularly if

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

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

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

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

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

enable it to disguise dividends as compensation. See Owensby &

Kritikos, Inc. v. Commissioner, 819 F.2d at 1329; Estate of

Wallace v. Commissioner, 95 T.C. 525, 555-556 (1990), affd. 965

F.2d 1038 (11th Cir. 1992).

a. Ability To Disguise Dividends Paid to Isidore
Klein as Compensation

Isidore Klein set his own salary in 1993 and 1994. Isidore

Klein and petitioner did not deal at arm's length in those years

because he was the controlling shareholder and chairman of the

board of directors. See Estate of Wallace v. Commissioner, supra

at 556; cf. Mayson Manufacturing Co. v. Commissioner, 178 F.2d

115, 121 (6th Cir. 1949) (bonus plan established by board of

directors for minority shareholders was an arm's-length

transaction).
 - 22 -

b. Ability To Disguise Dividends Paid to Steven Klein
as Compensation

Petitioner contends that Steven Klein’s salary was

reasonable in amount in 1993 and 1994 because he had an arm’s-

length relationship with his father, Isidore Klein, in those

years.

We closely scrutinize intrafamily transactions. See Seven

Canal Place Corp. v. Commissioner, 332 F.2d 899, 900 (2d Cir.

1964), remanding T.C. Memo. 1962-307; Estate of Van Anda v.

Commissioner, 12 T.C. 1158, 1162 (1949), affd. per curiam 192

F.2d 391 (2d Cir. 1951). Richard Schwaeber testified that,

although Isidore and Steven Klein negotiated Steven Klein’s

salary, Isidore Klein ultimately paid Steven Klein what Steven

wanted. There is no evidence that Isidore Klein tried to hire

someone to replace Steven Klein or to sell petitioner to a third

party or that Steven Klein ever sought another job. Steven

Klein’s impressive salary in 1993 and 1994 despite petitioner’s

unimpressive performance suggests that his compensation did not

result from arm’s-length negotiations and was not handled as an

independent investor would have handled it. These facts suggest

that the salary negotiations were not at arm’s length.

c. Yearend Bonuses

The large yearend payments to Isidore and Steven Klein

suggest that part of their compensation was disguised dividends.
 - 23 -

See Petro-Chem Mktg. Co. v. United States, 221 Ct. Cl. 211, 602

F.2d 959, 968 (1979) (Court inferred that bonuses paid to

shareholder-employees near the end of the year which absorbed

nearly all of the taxpayer's earnings were at least in part a

distribution of profits); Builders Steel Co. v. Commissioner, 197

F.2d 263, 264 (8th Cir. 1952); Owensby & Kritikos, Inc. v.

Commissioner, T.C. Memo. 1985-267, affd. 819 F.2d 1315 (5th Cir.

1987); see, e.g., Rich Plan of Northern New England, Inc. v.

Commissioner, T.C. Memo. 1978-514. Petitioner paid $230,000 to

Isidore Klein in both 1993 and 1994 after the end of the first

three quarters, and $70,000 in 1993 and $86,000 in 1994 just

before the end of the year. Steven Klein had petitioner pay him

$420,000 in the final week of 1995. The yearend payments to

Isidore and Steven Klein were made after petitioner’s accounting

firm had prepared petitioner’s quarterly financial statements and

computed petitioner’s earnings for the first three periods.

The payments to Isidore and Steven Klein left petitioner

with a nominal amount of operating profits in 1993 and 1994.

Petitioner paid Isidore and Steven Klein 93 percent of its

taxable income before officers’ compensation in 1993 and 1994,

and Steven Klein 90 percent of its taxable income before

officers’ compensation in 1995. Paying most of petitioner’s

taxable income as compensation to its officers suggests that its
 - 24 -

distributions to Isidore and Steven Klein were in part disguised

dividends. See Owensby & Kritikos, Inc. v. Commissioner, 819

F.2d at 1325. We believe Isidore Klein decided the amount of his

compensation late in 1993 and 1994, and Steven Klein late in

1995, so that they could receive a greater part of petitioner's

net profits as compensation.

Petitioner contends that petitioner did not pay Steven Klein

bonuses in 1995; petitioner contends that the amount of the

yearend payments to Steven Klein were determined shortly after

the redemption of Isidore Klein’s stock in consultation with the

outside accountants and that petitioner did not pay it until

yearend to protect its cash-flow. We disagree. Unlike the

payments to Isidore Klein, petitioner did not compensate Steven

Klein based on a compensation formula. Steven Klein owned all of

petitioner’s stock in 1995 and set his own compensation that

year. The large yearend payments to Steven Klein in 1995 suggest

that part of his payments were disguised dividends.

We believe that an independent investor would not have been

satisfied with the large amount petitioner paid to Steven Klein

the last week of 1995 since it appears that profits were being

“siphoned out of the company disguised as salary.” See Dexsil

Corp. v. Commissioner, 147 F.3d at 101; Elliotts, Inc. v.

Commissioner, 716 F.2d 1241, 1247 (9th Cir. 1983), revg. and
 - 25 -

remanding on other grounds T.C. Memo. 1980-282; see also Owensby

& Kritikos, Inc. v. Commissioner, 819 F.2d at 1327.

This factor favors respondent.

3. Internal Consistency in Compensation: Consistency of
the Compensation System Throughout the Company

Inconsistency of the compensation system throughout the

ranks of the company may suggest that the employee’s compensation

is not reasonable. See Rapco, Inc. v. Commissioner, 85 F.3d at

954.

Isidore and Steven Klein paid themselves and Jeffrey

Schwaeber generously.

Petitioner contends that it paid all of its employees at or

above market rate salaries. We disagree. Petitioner presented

no persuasive evidence that it paid all of its employees at or

above market rate salaries. On brief, petitioner concedes that

it did not have a bonus program during the years in issue. There

is no evidence that any of petitioner’s employees other than

Isidore and Steven Klein shared in the large distribution of

profits petitioner made at yearend in 1993, 1994, and 1995. Cf.

Home Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1159-

1160 (1980) (compensation paid to the taxpayer's shareholder-

employees was reasonable in part because the taxpayer had

longstanding practice of paying all of its key employees on the

basis of commissions). This factor favors respondent.
 - 26 -

4. Character and Condition of the Company: Including
Sales, Net Income, Capital Value, and General Economic
Fitness of the Company

From the perspective of an independent investor, the

character and condition of the company, including its sales, net

income, capital value, and general economic fitness are important

in deciding how much compensation to pay to a corporation’s top

officers. See Rapco, Inc. v. Commissioner, supra. Petitioner

contends that the fact that its sales increased from $2,723,342

in 1983 to $3,549,669 in 1993, $3,687,715 in 1994, and $4,057,464

in 1995 shows that its financial condition was good.

We disagree. Petitioner’s retained earnings were lower each

year from 1991 to 1995 than they were for any year from 1983 to

1990. Petitioner’s sales did not increase from 1983 to 1995 in

real dollars. Petitioner’s net income before taxes declined from

$279,705 in 1983 to $67,877 in 1993, $60,220 in 1994, and $89,315

in 1995. Petitioner’s income declined from 1990 to 1994.

Petitioner’s sales and income increased from 1994 to 1995, but

were still well below the 1983 to 1990 amounts.

We believe petitioner’s financial condition in the years in

issue would give an independent investor doubts about the

performance of petitioner’s top management. See B.B. Rider Corp.

v. Commissioner, 725 F.2d 945, 953 (3d Cir. 1984) (taxpayer’s

deduction for large increases in an employee’s salary disallowed
 - 27 -

absent evidence that the company’s financial condition improved

sufficiently to warrant the increases), affg. in part and

vacating in part on other grounds T.C. Memo. 1982-98. The

instant case is distinguishable from Exacto Spring Corp. v.

Commissioner, 196 F.3d 833 (7th Cir. 1999) (compensation of $1.3

and $1.0 million paid to taxpayer’s chief executive and principal

owner was reasonable; corporation had substantial earnings,

sales, and shareholder equity, and CEO’s salary was approved by

corporation’s two other unrelated, 20-percent shareholders),

revg. Heitz v. Commissioner, T.C. Memo. 1998-220; Alpha Med.,

Inc. v. Commissioner, 172 F.3d 942 (6th Cir. 1999) (Court held

that compensation of $4,439,180 paid to the president and sole

shareholder of a medical management corporation was reasonable

because the taxpayer was financially successful), revg. T.C.

Memo. 1997-464; Mayson Manufacturing Co. v. Commissioner, 178

F.2d at 120 (larger compensation paid in a particularly

successful year was reasonable).

The prime indicator of the return a corporation is earning

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

Kritikos, Inc. v. Commissioner, supra at 1324. Petitioner

contends that it had an annual return on equity of 23.38 percent

and that this return on equity would satisfy an independent

investor. Petitioner contends that its return on equity should
 - 28 -

be based on Isidore Klein's original $119 investment.

We disagree. First, petitioner cites no case in which a

court gave significant weight to a high return on equity computed

based on a founding shareholder's small initial investment.

Courts have relied on other financial factors when a

shareholder's capital contribution is small. See, e.g., Alpha

Med., Inc. v. Commissioner, T.C. Memo. 1997-464 (Court derived

return on equity by using as shareholder’s equity retained

earnings for the year at issue plus the shareholder's capital

investment, and then comparing the increase in shareholder’s

equity from prior year to the year at issue), revd. on other

grounds 172 F.3d 942 (6th Cir. 1999); Labelgraphics, Inc. v.

Commissioner, T.C. Memo. 1998-343 (annual return on equity may be

skewed in years in which the taxpayer's equity is low); H&A Intl.

Jewelry, Ltd. v. Commissioner, T.C. Memo. 1997-467. Using the

approach in Alpha Medical, Inc. v. Commissioner, supra,

petitioner’s return on equity was 2.7 percent in 1993, 2.4

percent in 1994, and 3.3 percent in 1995.

Second, Hakala testified that it is misleading to measure

return on equity based on a shareholder’s nominal investment in

the company because the shareholder may have invested capital or

sweat equity and the company may have contributed patents,

intellectual property, or other intangibles that do not appear on
 - 29 -

the balance sheet. He testified that the rate of return on

equity is best measured by comparing the company’s operating

return to the fair market value of its operating assets.

Petitioner did not respond to Hakala’s analysis on this point.

Hakala stated that an independent investor would have expected an

average net operating return on assets of about 20 percent in the

years in issue, and that petitioner’s operating returns, which

ranged from 0.7 percent to 5.26 percent in the years in issue,

were far below the returns that would have satisfied an

independent investor. Thus, we give little weight to

petitioner’s use of Isidore Klein’s $119 initial capital

contribution to calculate return on equity for 1993, 1994, and

1995.

Petitioner also contends that it did not need to pay

dividends because a hypothetical shareholder would be satisfied

with the appreciation in value of his or her stock due to

petitioner's retention of earnings and the growth in petitioner's

annual sales. We disagree. Although Hakala testified that an

investor would be happy with a return of $1,874,112 (the

redemption price of Isidore and Gertrude Klein’s stock) on $119

(Isidore Klein’s capital investment), he also stated that it is

inappropriate in this case to analyze rate of return based on

Isidore Klein’s $119 investment.
 - 30 -

This factor favors respondent.

5. Comparison With Other Companies: Salaries Paid to
Comparable Employees in Similar Companies

In deciding whether compensation is reasonable, we compare

it to compensation paid to persons holding comparable positions

in comparable companies. See Rapco, Inc. v. Commissioner, 85

F.3d at 954; Rutter v. Commissioner, 853 F.2d 1267, 1271 (5th

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

v. Commissioner, supra at 119.

Respondent’s expert, Hakala, and petitioner’s expert, Dorf,

submitted reports in which they analyzed compensation paid to

persons holding comparable positions in other companies. Each of

their reports provides some basis for us to apply this factor;

however, we give less weight to Dorf’s opinion because we believe

his analysis contains major flaws.

a. Dorf

Dorf concluded that the compensation petitioner paid to

Isidore Klein in 1993 ($352,000) and 1994 ($368,000) and Steven

Klein in 1993 ($500,400), 1994 ($450,400), and 1995 ($820,400)

“could be deemed reasonable”. We believe he overstated the

amount of compensation that “could be deemed reasonable” because

he: (1) Did not consider petitioner’s financial performance from

the standpoint of an independent investor, (2) incorrectly

assumed that Isidore Klein had been undercompensated in prior
 - 31 -

years, (3) overstated Isidore Klein’s contributions to petitioner

in 1993 and 1994, (4) gave too little weight to data from surveys

he cited in his report which suggest that Isidore and Steven

Klein were overpaid, (5) used as comparables corporations that

were more than four times larger than petitioner, (6) analyzed

the reasonableness of Steven Klein’s compensation based in part

on data for which he provided no source and using a method that

in effect assumed that Steven Klein’s compensation was

reasonable, and (7) incorrectly assumed that petitioner’s

compensation practices were similarly generous to all of

petitioner’s employees.

The companies which Dorf compared to petitioner had annual

revenues averaging $17 million, more than four times those of

petitioner. He estimated that Isidore Klein was paid about

$66,000 more in 1993 and about $82,000 more in 1994 than the

average compensation paid to the CEO’s of those companies.

Isidore Klein was paid $116,000 to $178,000 more in 1993 and

$68,000 to $244,000 more in 1994 than CEO’s whose compensation

ranked in the third quartile of companies that responded to 1993

and 1994 National Executive Compensation and Panel Publication

surveys (i.e., CEO’s whose pay ranked from the 50th percentile to

the 75th percentile). Despite the data from these surveys, Dorf

concluded that Isidore Klein was not overpaid.
 - 32 -

Dorf estimated how much it would have been reasonable for

petitioner to pay Isidore Klein from 1975 to 1994. Dorf added

what he estimated was the compensation of a full-time chief

executive officer without Isidore Klein’s research and

development capabilities ($211,324 in 1993 and $231,538 in 1994),

to 50 percent of what he said was the compensation of a full-time

research and development professional ($187,578 in 1993 and

$153,712 in 1994). He concluded that petitioner overpaid Isidore

Klein by $46,887 in 1993 and $59,606 in 1994, but he concluded

that Isidore Klein’s compensation was reasonable in those years

in part because it was catchup pay for prior years. We rejected

Dorf’s suggestion that Isidore Klein was paid catchup pay at

paragraph II-B-1-a, above. Dorf's data suggests that

compensation paid to Isidore Klein up to $305,113 in 1993 and

$308,394 in 1994 might have been reasonable if he had worked full

time. There is no convincing evidence of how much time he

worked. We think two-thirds (or somewhat less) time would be a

reasonable estimate based on how often he called and visited

employees, the fact that he attended some trade shows and worked

on the portable housing project, and because he reviewed various

records of petitioner’s. Dorf’s data (which is based on full-

time service) suggests that compensation for Isidore Klein of

about $200,000 per year for 1993 and 1994 would be reasonable.
 - 33 -

We start with Dorf’s data for the average CEO (i.e.,

$211,324 in 1993 and $231,538 in 1994) to decide the

reasonableness of Steven Klein’s compensation, but we do not

increase it based on compensation paid to a person with research

and development skills because he lacked Isidore Klein’s skills

in that area. However, due to Steven Klein’s long hours worked,

we think Dorf’s data suggests the maximum amount of reasonable

compensation for Steven Klein would be $300,000 for 1993 and

$300,000 for 1994.

b. Hakala

Hakala testified that the most a similar company would have

reasonably paid for the combined services of Isidore and Steven

Klein was $405,250 in 1993 and $392,157 in 1994. He also

testified that the most a similar company would have reasonably

paid Steven Klein in 1995 was $439,284. We believe that he

underestimated the total amount Isidore and Steven Klein could

reasonably be paid in 1993 and 1994 but that his estimate of

Steven Klein’s reasonable compensation for 1995 was correct.

Petitioner argues that Hakala relied on companies that were

not comparable to petitioner. We disagree. Although Hakala

considered Conference Board surveys of larger, public companies,

he primarily focused on data from companies that specialized in

fabricating metal products and that had annual sales comparable
 - 34 -

in size to petitioner’s (that is, between $2 and $5 million).

Petitioner contends that Hakala failed to consider that

petitioner and the services of Isidore Klein and Steven Klein are

unique. Although all companies and corporate officers are in one

sense unique, we believe that survey data cited by Hakala (as

well as Dorf) is helpful in deciding the amount of Isidore and

Steven Klein’s reasonable compensation.

Hakala concluded that, from the standpoint of a hypothetical

independent investor, the compensation petitioner paid to Isidore

and Steven Klein in 1993 and 1994, and to Steven Klein in 1995,

was unreasonable. Hakala pointed out that, although petitioner

was very profitable before paying officers’ compensation, its

performance after paying officers’ compensation was well below

what would satisfy an independent investor. Hakala estimated the

maximum amount petitioner could pay Isidore and Steven Klein

while paying a reasonable return to an independent investor and

concluded that the compensation paid to Isidore and Steven Klein

was about twice the maximum reasonable compensation.

Petitioner criticizes Hakala for not separately valuing the

services of Steven and Isidore Klein. We agree that having a

separate opinion for their reasonable compensation would have

been more helpful, but despite that we still find Hakala’s

analysis to be helpful.
 - 35 -

c. Baker’s Aid

Petitioner argues that the best evidence of how much

comparable firms pay officers’ holding comparable positions was

the testimony that the two owners/officers of Baker’s Aid (a

father and son) each earned $1-$2 million per year in 1993 and

1994. We disagree because there is no evidence of their duties

or accomplishments and because Baker’s Aid had annual sales of

about $40 million in 1993 and 1994, which is more than 10 times

petitioner’s sales in those years.

d. Conclusion

This factor suggests that it would have been reasonable to

pay Isidore Klein up to $200,000 in 1993 and $200,000 in 1994 and

to pay Steven Klein up to $300,000 in 1993, $300,000 in 1994, and

$439,284, or for simplicity, $440,000, in 1995.

C. Applying the Factors From the Perspective of the
Hypothetical Independent Investor

We apply each of these five factors from the standpoint of

whether a hypothetical independent investor would approve the

compensation petitioner paid to Isidore and Steven Klein in the

years in issue. See Dexsil Corp. v. Commissioner, 147 F.3d at

100; Rapco, Inc. v. Commissioner, 85 F.3d at 954-955; Elliotts,

Inc. v. Commissioner, 716 F.2d at 1247.

1. Isidore Klein

We believe that an independent investor would not have

approved the increase in Isidore Klein’s longstanding
 - 36 -

compensation formula from 8 percent to 10 percent of sales in

view of his lessened contribution to petitioner in 1993 and 1994

and petitioner’s financial performance compared to earlier years.

We conclude that an independent investor would consider

compensation paid to Isidore Klein of $200,000 in 1993 and

$200,000 in 1994 to be reasonable. These amounts are based in

part on Dorf’s data. However, they are less than the amounts

Dorf said might be reasonable, for reasons stated above where we

discussed Dorf’s analysis. As discussed at paragraph II-B-3-a,

above, we estimate that Isidore Klein worked at most two-thirds

of the time in 1993 and 1994. Under the circumstances, we think

paying Isidore Klein more than $200,000, which equaled 5 to 6

percent of sales (about two-thirds of his customary 8 percent of

sales) was unreasonable.

2. Steven Klein

We conclude that an independent investor would not have

approved Steven Klein’s compensation based on petitioner’s

performance in those years. We do not think an independent

investor would believe that Steven Klein should be paid, in 1

year (1995), more than the cumulative amount petitioner earned in

the previous 10 years (1986-95). See H&A Intl. Jewelry, Ltd. v.

Commissioner, T.C. Memo. 1997-467 (compensation paid to president

of corporation was held unreasonable because he was paid more in

1 year than the company earned in the prior 8 years).

We conclude that compensation paid to Steven Klein in excess
 - 37 -

of $300,000 in 1993 and $300,000 in 1994 was unreasonable. Due

to Steven Klein’s assumption of more responsibilities when he

became CEO in 1995 and based on Hakala’s estimate of reasonable

compensation to Steven Klein for 1995, we conclude that

compensation up to $440,000 in 1995 was reasonable. These

amounts for Steven Klein for 1993 and 1994 are based on Dorf’s

data but without any additional amounts added for research and

development work previously done by Isidore Klein, and with an

adjustment for hours worked. Our amount for Steven Klein for

1995 ($440,000) is essentially the same as believed reasonable by

Hakala ($439,284). Dorf did not provide data for 1995; Hakala’s

data is a suitable substitute.

D. Whether Petitioner Is Liable for the Penalty Under Section
6662 for Substantial Understatement

Respondent determined that petitioner is liable for the

accuracy-related penalty for substantial understatement for 1993,

1994, and 1995 under section 6662.

Taxpayers are liable for a penalty equal to 20 percent of

the part of the underpayment attributable to negligence or

substantial understatement of tax. See sec. 6662(a), (b)(1) and

(2). A substantial understatement of income tax occurs when the

amount of the understatement for a taxable year exceeds the

greater of 10 percent of the tax required to be shown on the

return or $10,000 in the case of a corporation. See sec.

6662(d)(1)(A).
 - 38 -

The accuracy-related penalty does not apply to any part of

an underpayment if the taxpayer shows that there was reasonable

cause for the underpayment and that the taxpayer acted in good

faith. See sec. 6664(c)(1). Reliance on the advice of a

professional, such as an accountant, may constitute reasonable

cause if, under all the facts and circumstances, that reliance is

reasonable and the taxpayer acted in good faith. See sec.

1.6664-4(c), Income Tax Regs.

Petitioner argues that it is not liable for the accuracy-

related penalty for the years in issue because the issues in this

case are highly technical; petitioner disclosed the deductions on

its tax returns for 1993, 1994, and 1995; and Steven Klein

reasonably relied on petitioner’s accountant to advise petitioner

about what would constitute reasonable compensation to pay Steven

Klein in 1995.

1. 1993 and 1994

Petitioner is not liable for the substantial understatement

penalty if it had a reasonable basis for, and adequately

disclosed the facts relating to, the Kleins’ compensation on its

1993, 1994, and 1995 returns. See sec. 6662(d)(2)(B)(ii); Rev.

Proc. 94-36, 1994-1 C.B. 682; Rev. Proc. 94-74, 1994-2 C.B. 823;

Rev. Proc. 95-55, 1995-2 C.B. 457. Section 4.01(2)(d) of each of

those revenue procedures provides that, for purposes of reducing

the understatement of income tax under section 6662(d),

additional disclosure of facts relating to an issue involving
 - 39 -

reasonable compensation is unnecessary if the taxpayer properly

completes Form 1120, Schedule E, Compensation of Officers,

including the percent of time each officer devoted to the

business. Petitioner did not adequately disclose the facts

relating to the Kleins’ compensation on its 1993, 1994, and 1995

returns because it left blank the "percent of time devoted to

business" section of its 1993, 1994, and 1995 Schedules E.

Petitioner contends that its failure to list the percentage

of time petitioner’s officers devoted to the business is not

significant because the Kleins each devoted a substantial amount

of time to the business. We disagree. See C.T.I. Inc. v.

Commissioner, T.C. Memo. 1994-82 (taxpayer’s disclosure was

inadequate because it did not state the percentage of time its

officers devoted to the business).

We do not believe that the issues in this case were highly

technical. Petitioner does not contend that it relied on its

accountant to advise it on the reasonable compensation issue for

1993 and 1994. Thus, we conclude that petitioner is liable for

the accuracy-related penalty under section 6662 for 1993 and

1994.

2. 1995

Respondent argues that petitioner did not have reasonable

cause for deducting the compensation it paid to Steven Klein in

1995 because it made no attempt to determine whether the amount

it deducted as compensation in 1995 was reasonable. We disagree.
 - 40 -

Steven Klein relied on Richard Schwaeber to advise

petitioner about the amount of compensation it could reasonably

pay him in 1995. Richard Schwaeber told Steven Klein that a

salary of about $800,000 in 1995 would be reasonable. We hold

that petitioner’s reliance on Richard Schwaeber was reasonable

cause for deducting the compensation it paid to Steven Klein in

1995.

We conclude that petitioner is liable for the accuracy-

related penalty under section 6662 for 1993 and 1994, but it is

not liable for 1995.

To reflect the foregoing and concessions,

Decision will be entered

under Rule 155.