Haffner's Serv. Stations, Inc. v. Comm'r

T.C. Memo. 2002-38

UNITED STATES TAX COURT

HAFFNER’S SERVICE STATIONS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 16408-97. Filed February 11, 2002.

Joseph G. Aronson and Rufino Fernandez, Jr., for

petitioner.

William F. Halley and Richard E. Buchbinder, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Petitioner petitioned the Court to redetermine

respondent’s determination of deficiencies in its 1990, 1991, and

1992 Federal income taxes and negligence accuracy-related
 - 2 -

penalties under section 6662(a).1 For the respective years,

respondent determined deficiencies of $877,861, $495,884, and

$300,438 and accuracy-related penalties of $138,952, $69,965, and

$33,423.

Following concessions,2 we must decide the following three

issues:

1. Whether the bonuses petitioner paid during the subject

years to two of its officers, Emile and Louise, were “reasonable”

within the meaning of section 162(a)(1). We hold they were not.

2. Whether petitioner is liable for the accumulated

earnings tax of $490,924, $240,902, and $130,438 determined by

respondent for the respective years. We hold it is.

3. Whether petitioner is liable for the accuracy-related

penalties determined by respondent. We hold it is not.

1
Unless otherwise indicated, section references are to the
Internal Revenue Code applicable to the subject years. Rule
references are to the Tax Court Rules of Practice and Procedure.
Percentages are rounded.
2
Among other things, petitioner has conceded that it paid
$85,414 in legal fees during 1990 as a nondeductible personal
expense of its controlling shareholder, Louise Haffner Fournier
(Louise), and her husband, Emile Fournier (Emile).
 - 3 -

FINDINGS OF FACT3

Some facts were stipulated. We incorporate herein by this

reference the parties’ stipulation of facts and the exhibits

submitted therewith. We find the stipulated facts accordingly.

Petitioner is a C corporation that timely filed Federal income

tax returns for the subject years.

Background

Petitioner retails gasoline and related products

(collectively, gasoline) and home heating oil in Massachusetts

and New Hampshire. Petitioner sells its gasoline and home

heating oil only for cash, and its service stations (stations)

only sell gasoline. Petitioner’s stations all display the name

“Haffner’s” and operate under the name Haffner’s Service

Stations, Inc.

3
During trial, petitioner elicited testimony from its
accountants (Seymour Rubin (Rubin) and George Goertz (Goertz))
and some of its faithful (to the Haffner/Fournier family),
longtime employees (Peggy Willett (Willett), Mary Osgood
(Osgood), Roland Beauchesne (Beauchesne), and E. Haffner Fournier
(Haff)). We find unreliable much of the testimony of Rubin,
Willett, Osgood, and Haff. We find much of their testimony to be
vague and uncorroborated. We also find some of the testimony of
Haff to be inconsistent with and/or contrary to the documentary
evidence. Under the circumstances, we are not required to, and
we do not, rely on the unreliable testimony of Rubin, Willett,
Osgood, and Haff to support petitioner’s positions herein. See
Brookfield Wire Co. v. Commissioner, 667 F.2d 551, 552 (1st Cir.
1981), affg. T.C. Memo. 1980-321; Tokarski v. Commissioner, 87
T.C. 74, 77 (1986). See also Kenney v. Commissioner, T.C. Memo.
1995-431, where the Court declined to rely upon most of the
testimony of the taxpayer and a long list of relatives and close
friends who testified in support of her claim of innocent spouse
relief.
 - 4 -

Petitioner operates independently and competes directly with

major oil companies by selling gasoline at a price lower than

that of the stations of those companies. For the respective

subject years, petitioner’s tax returns reported that its gross

receipts were $61,359,783, $61,406,193, and $56,265,955, that its

total income was $6,574,351, $5,203,710, and $3,704,259, and that

its taxable income was $2,126,645, $1,283,987, and $985,747.

Petitioner reported that its balance sheet at the end of those

years and 1989 was as follows:
1989 1990 1991 1992

Current Assets:
Cash $2,508,283 $3,526,942 $3,495,498 $4,245,727
Accounts receivable 1,596,322 495,332 456,686 433,204
Inventory 266,588 353,990 288,883 271,350
Prepaid expenses 671,566 1,061,716 1,019,877 748,286
5,042,759 5,437,980 5,260,944 5,698,567
Long-term assets:
Property and equipment 900,982 979,368 1,245,184 1,245,184
Less: accumulated depreciation (567,330) (719,855) (822,012) (913,557)
Officers’ life insurance: C.S.V. 445,385 525,904 660,344 752,034
Notes receivable 35,155 1,126,777 1,575,929 1,643,343
Investments 189,589 304,915 327,579 367,158
1,003,781 2,217,109 2,987,024 3,094,162

Total assets 6,046,540 7,655,089 8,247,968 8,792,729

Current liabilities:
Accounts payable 91,420 146,040 98,985 114,959
Other current liabilities 687,682 850,341 572,962 442,175
779,102 996,381 671,947 557,134

Long-term liabilities:
Mortgages and other debt 210,560 210,560 233,735 210,560

Equity:
Capital stock 125,000 125,000 125,000 125,000
Unappropriated retained earnings 4,931,878 6,323,148 7,217,286 7,900,035
5,056,878 6,458,148 7,342,286 8,025,035

Total liabilities and equity 6,046,540 7,655,089 8,247,968 8,792,729

John F. Haffner (John) and his wife, Emma (Emma), started

petitioner’s business in or about 1940 as a single station, and

the business has grown to include 13 stations (most of which are

self-service and are staffed with relatively unskilled employees)
 - 5 -

and the home heating oil business. John and Emma’s family

(Haffner/Fournier family) also owns other entities in addition to

petitioner. The operating entities include petitioner, Haffner’s

Car Care (HCC), and Parker Fuel Corp. (Parker). HCC operates the

car washes and vacuum cleaners located at some of petitioner’s

stations. Parker sells to petitioner, its only customer, all of

the gasoline and home heating oil for resale to consumers. All

three of these operating entities share employees. These labor

cost are paid by petitioner and apportioned among these three

operating entities by way of bookkeeping entries posted in

intercompany accounts.

John and Emma’s family also owns certain nonoperating

entities. The nonoperating entities include Haffner Realty Trust

(Haffner Realty), Fournier Realty Trust (Fournier Realty), and

EMLO Realty Trust (EMLO Realty). Each of these three

nonoperating entities was formed to hold properties transferred

to it by the principals of the three operating entities mentioned

above.

In its early years, petitioner had one class of stock. Four

hundred and fifty shares of that stock were outstanding, and

those shares were owned one-third each by John, Emma, and Louise,

their only child. In 1949, John transferred 76 of his shares to

Louise. Afterwards, Louise owned 226 shares, John owned 74

shares, and Emma owned the remaining 150 shares.
 - 6 -

John died on March 10, 1955, and his 74 shares passed

through his residuary estate to the John F. Haffner Trust (John’s

Trust). John’s Trust benefited his and Emma’s five grandchildren

(the grandchildren); namely (in order from oldest to youngest),

Haff, Jolyne H. Boyle (Jolyne), John Haffner Fournier (JH), Susan

H. Baker-Spruce (Susan), and Richard Haffner Fournier (Richard).

John’s Trust provided that its principal and accumulated income

would be distributed in equal amounts to each living grandchild

when the youngest grandchild turned 21. Richard, the youngest

grandchild, turned 21 on February 20, 1965. John’s will provided

that he had “purposely omitted a direct bequest to my daughter,

Louise H. Fournier, because of provisions made for her during my

lifetime” (e.g., his transfer to her of a majority of

petitioner’s shares). John intended through his testamentary

scheme that Louise would be petitioner’s majority shareholder and

that each grandchild would be a minority shareholder.

Louise and her husband, Emile, were named in John’s will as

executors of John’s estate, and they were formally appointed to

that position by the Probate and Family Court Department of the

Commonwealth of Massachusetts (probate court). Louise and Emile

also were named trustees of John’s Trust.

On December 20, 1956, petitioner recapitalized, doubling the

number of voting shares held by each shareholder and issuing to

each shareholder an additional 4 nonvoting shares for each voting
 - 7 -

share then owned. Later in 1956 and in 1957, Emma transferred 75

voting shares to Louise, 150 nonvoting shares to Emile, and 150

nonvoting shares to each grandchild. Louise also transferred

during that time 150 shares of nonvoting stock to Emile and 150

nonvoting shares to each grandchild.

Upon Emma’s death in 1958, her remaining shares were placed

in the Emma Haffner Trust (Emma’s Trust).4 Louise was the

executrix of Emma’s estate and the named trustee of Emma’s Trust.

On February 4, 1959, Emma’s Trust transferred 75 of its voting

shares to Louise, and Louise transferred 150 of her nonvoting

shares to Emile and 150 nonvoting shares to each grandchild. The

voting shares were then owned 148 by John’s Trust, 150 by Emma’s

Trust, and 602 by Louise. The nonvoting shares were owned 592 by

John’s Trust, 300 by Emma’s Trust, 8 by Louise, 450 by Emile, and

450 by each grandchild.

On August 1, 1959, Emma’s Trust transferred its 150 voting

shares to Louise. On February 14, 1961, Louise transferred from

John’s Trust to herself the remaining 148 voting shares and 592

nonvoting shares (the 1961 transfer) as reimbursement for estate

taxes which she had paid personally on behalf of John’s estate.

After the 1961 transfer, Louise owned all 900 voting shares and

600 of the 3,600 nonvoting shares. Emma’s Trust owned 300 of the

4
The stipulation of facts incorrectly lists this trust as
the Emma Fournier Trust.
 - 8 -

nonvoting shares, and Emile and each grandchild owned 450 of the

nonvoting shares.

Family Lawsuit

On or about November 21, 1989, Richard and Susan filed a

complaint with the probate court against Emile and Louise, each

individually and as executors of John’s estate. The complaint

alleged that Emile and Louise had breached their fiduciary duty

as executors by failing to list properly the assets of John’s

estate (e.g., the shares underlying the 1961 transfer (disputed

shares)) and by failing to distribute those assets in accordance

with John’s will. The complaint primarily sought rescission of

the 1961 transfer, any costs (including attorney’s fees) incurred

by Richard and Susan in prosecuting the family lawsuit, and the

return (with interest) of all unnecessary expenses incurred by

John’s estate (e.g., for income taxes, accountant’s and

attorney’s fees, and filing fees).5 Petitioner was not named as

a defendant in the family lawsuit. Jolyne later joined the

family lawsuit on or about June 6, 1995.6

5
On or about Nov. 13, 1990, Richard and Susan amended the
complaint primarily to allege further that Emile and Louise were
also liable to them for self-dealing as executors of John’s
estate. The first amended complaint generally sought further
damages in the form of a complete accounting of expenditures and
financial information relating to the estate and to many of the
Haffner/Fournier family entities.
6
Haff never joined the family lawsuit, which he viewed as a
family falling-out that rested on the plaintiffs’ attempt to get
(continued...)
 - 9 -

On June 7, 1996, the probate court ruled in favor of the

plaintiffs, finding that Louise and Emile had breached their

fiduciary duty by failing to carry out the terms of John’s will,

and rescinded the 1961 transfer. By virtue of this ruling,

petitioner’s stock was thereafter owned as follows:

Voting Stock Nonvoting Stock
Shareholder Shares Percentage Shares Percentage

Louise 752 83.56 8 .22
Emile -0- -0- 450 12.50
Haff -0- -0- 450 12.50
Jolyne -0- -0- 450 12.50
JH -0- -0- 450 12.50
Susan -0- -0- 450 12.50
Richard -0- -0- 450 12.50
Emma’s Trust -0- -0- 300 8.33
John’s Trust 148 16.44 592 16.44
900 100.00 3,600 100.00

The probate court’s judgment also authorized John’s estate:

(1) To hire a certified public accountant (C.P.A.), at the

expense of Emile and Louise, to ascertain the “present value” of

the disputed shares, and (2) to distribute the disputed shares

directly to the grandchildren. The judgment also stated that

Emile and Louise were responsible for the attorney’s fees and

costs incurred by the plaintiffs.

In 1997, Robert Minasian (Minasian), the then administrator

of John’s estate,7 filed on behalf of the estate a separate

6
(...continued)
back at their parents for imposing strict standards on the
plaintiffs’ upbringing.
7
On or about June 7, 1996, the probate court had removed
Emile as executor of John’s estate because he was unsuitable to
act in that capacity. His coexecutor, Louise, having died, the
(continued...)
 - 10 -

lawsuit in the probate court against Emile, Haff, HCC, Parker,

Haffner Realty, Fournier Realty, and EMLO Realty. Upon motion by

the plaintiffs in the family lawsuit, the probate court

consolidated that action with the family lawsuit and with another

action that the plaintiffs had filed in that court against Louise

and Emile, individually and as executors of Emma’s will.8 Each

of the three separate lawsuits involved common questions of law

and fact concerning the 1961 transfer.

Jerrold Katz (Katz) was the individual selected to value the

shares of petitioner and certain of its related entities. Katz

issued his report on October 16, 2000. The report concludes that

the fair market value of petitioner, HCC, Parker, and a fourth

operating entity organized after the subject years totaled $67.8

million as of December 31, 1998, and that the fair market values

of the respective entities were approximately $29.3 million,

$22.1 million, $10 million, and $6.87 million. The report

expresses no conclusion as to the specific value of the disputed

shares. To date, the parties to the family lawsuit have not

formally indicated their positions on Katz’s report, and the

family lawsuit is still pending.

7
(...continued)
probate court appointed Minasian as the administrator of John’s
estate.
8
On the same date that John had signed his will, Emma had
signed a reciprocal will disposing of her estate in trust to the
grandchildren.
 - 11 -

Petitioner’s Directors, Officers, and Other Noteworthy Employees

During each subject year, petitioner employed approximately

150 individuals, including Haff, Emile, and Louise. It did not

have a written employment agreement with any of these

individuals. Many of the employees, including Haff, Emile, and

Louise, spent a significant amount of their time working on the

business of HCC and Parker. Haff, Emile, and Louise also devoted

a significant amount of their time to the business of the

nonoperating entities owned by the Haffner/Fournier family.

Petitioners’ directors during each subject year were Haff,

Emile, and Louise. The directors did not hold formal board

meetings but generally spoke with each other daily without

memorializing their discussions. Haff, upon discussions with

Emile and Louise in their capacity as board members, established

petitioner’s business plan and its employees’ compensation.

Haff, upon discussions with Emile and Louise in their capacity as

board members, decided matters contributing to petitioner’s

growth in the industry (e.g., finding new locations at which to

sell its products).

Petitioner’s officers during the subject years were Haff,

Richard, Emile, and Louise. Haff was president and CEO. Richard

was vice president. Louise was treasurer. Emile was assistant

treasurer and secretary. Emile and Louise were each about 80

years old at that time and receiving Social Security.
 - 12 -

Haff began working for petitioner part time in 1951. During

the subject years, he was its general manager, working

approximately 13 hours a day. In that capacity, he set the price

at which petitioner would sell its gasoline and home heating oil

to its customers and made most of petitioner’s other business

decisions. Haff received from petitioner compensation of

approximately $742,400, $592,000, and $469,250 in the respective

subject years. Part of each year’s compensation was apportioned

to at least HCC and Parker, and petitioner claimed a deduction

for the rest.

During the subject years, Emile opened petitioner’s office

each morning sometime between 4:30 a.m. and 5 a.m. He also made

bank deposits for some of the stations, collected items from all

of the stations, and discussed many of the business decisions

with Haff before Haff decided upon and implemented them. Emile

also helped answer the telephones and discussed home heating oil

matters by telephone with various individuals. Emile received

from petitioner a weekly salary of $425. Part of the salary was

apportioned to at least HCC and Parker, and petitioner claimed a

deduction for the rest.

During the subject years, Louise helped answer the

telephones, took customer orders, drafted and signed checks, made

bank deposits, conversed with customers and employees, and

performed minor tasks around the office. She also communicated
 - 13 -

with petitioner’s drivers delivering home heating oil, signed the

subject Federal income tax returns in her capacity as an officer,

and discussed some of the business decisions with Haff before he

decided upon and implemented them. Louise received from

petitioner a weekly salary of $450. Part of the salary was

apportioned to at least HCC and Parker, and petitioner claimed a

deduction for the rest.

Richard has worked for petitioner for approximately the last

40 years, with a 2-year absence to serve in the Army and another

brief absence to earn a master’s in business administration. He

worked 5 days a week in the office, and he was responsible for

monitoring each station’s condition and collecting money from

three of the stations. Richard received from petitioner a salary

of approximately $50,000 in each of the last 10 years, and he has

not received from petitioner a bonus since 1986 or 1987.

Richard’s bonus at that time was $5,000.

Willett began working for petitioner on January 6, 1978.

She became the office manager in 1979 and remained with the

company in that position throughout the subject years. She

supervised the office personnel, hired and fired station

employees and drivers, maintained the driver’s reports, took

orders, and handled service calls. She wrote deposit slips that

Louise or Emile took to the bank, took customer complaints, and

was responsible for maintaining the general ledger. She
 - 14 -

completed much of the daily paperwork for petitioner’s

accountant’s monthly visit and calculated each station’s daily

and monthly inventory. She received from petitioner a salary of

approximately $50,000 in 1990.

Osgood has been petitioner’s payroll bookkeeper since 1976.

She reported directly to Haff but usually talked first to Willett

before consulting him.

Beauchesne has worked for petitioner since 1973. During the

subject years, he met Emile each morning to open the office.

Beauchesne also supervised the truck drivers, did light

maintenance at the stations, and supervised some of the employees

at the stations.

Petitioner’s Accountants

Rubin and Goertz are C.P.A.s who are, and for many years

have been, petitioner’s accountants. Goertz oversaw the

preparation of petitioner’s books and records, and he prepared

petitioner’s financial statements and income tax returns. For

these purposes, Goertz traveled to petitioner’s principal place

of business in Lawrence, Massachusetts (Lawrence), once a month.

While there, he met with Haff but never with Emile or Louise.

Rubin is responsible for petitioner’s tax and business

planning. Rubin usually met with petitioner’s board members in

Lawrence 1 day per month, and he usually conferred with them by

telephone three to four times per week. Rubin never recommended
 - 15 -

to petitioner that it pay a dividend, nor has petitioner ever

paid a dividend.

Bonuses

Petitioner paid to Haff a $625,000 bonus in late 1990. On

December 17, 1990, December 15, 1991, and December 17, 1992,

petitioner paid identical bonuses of $625,000, $475,000, and

$250,000, respectively, to Emile and Louise. Petitioner did not

use a formula to decide the amount of any of these bonuses.

Instead, Haff met with Rubin in December of each year to set the

amounts of the bonuses primarily on the basis of petitioner’s

profit for the corresponding year. Haff, upon discussions with

Emile and Louise in their capacity as board members, set the

amounts of the bonuses at the amounts suggested by Rubin. Haff

never discussed the payment of a dividend when he discussed the

subject bonuses with Rubin, Emile, or Louise.

Petitioner apportioned to Parker and HCC $100,000 of each

bonus paid to Louise and Emile in 1990 and 1991, and petitioner

deducted as “Officers’ Compensation” the remaining amounts paid

to Louise and Emile. Petitioner deducted Haff’s bonus as “Cost

of Goods Sold”. For the respective subject years, petitioner

deducted the following types and amounts of compensation paid to

Emile and Louise:
 - 16 -

Year Payment Type Emile Louise Total

1990 Salary $17,950 $17,950 $35,900
Bonus 525,000 525,000 1,050,000
542,950 542,950 1,085,900

1991 Salary 18,000 17,900 35,900
Bonus 375,000 375,000 750,000
393,000 392,900 785,900

1992 Salary 17,725 19,050 36,775
Bonus 250,000 250,000 500,000
267,725 269,050 536,775

Respondent determined that the bonuses which petitioner paid

to Louise and Emile were unreasonable. Respondent did not adjust

Haff’s bonus because he worked long hours for the company as its

general manager in charge of its operation.

Accumulated Earnings

On November 26, 1996, respondent mailed by certified mail to

Goertz, petitioner’s authorized representative, a notification

under section 534(b) for 1990 through 1992.9 On December 16,

1996, petitioner responded to the notification with a two-page

letter. The letter referenced the family lawsuit and the probate

court’s ruling rescinding the 1961 transfer. Enclosed with the

letter was a copy of the probate court’s order rescinding the

transfer and several cases which petitioner believed supported

its position that the accumulation of earnings was not subject to

the accumulated earnings tax determined by respondent. Also

9
Respondent’s notification erroneously lists 1989 through
1991 instead of 1990 through 1992. Respondent concedes that he
has the burden of proof on excess accumulated earnings for 1992.
 - 17 -

enclosed with the letter was Haff’s signed statement declaring

that the facts mentioned in the letter were true.

Rubin spoke with Haff regarding the accumulation of earnings

during the subject years. Rubin advised Haff in 1989 that

petitioner should not pay a dividend but should accumulate its

funds possibly to redeem the disputed shares in the event that

the plaintiffs prevailed in the family lawsuit. Petitioner’s

articles of incorporation provide with respect to the sale of

petitioner’s stock that

Any stockholder, including the heirs, assigns,
executors or administrators of a deceased stockholder,
desiring to sell such stock owned by him or them, shall
first offer it to the corporation through the board of
directors in the manner following:

He shall notify the directors of his desire to
sell by notice in writing which notice shall contain
the price at which he is willing to sell and the name
of one arbitrator. The directors shall within thirty
days thereafter either accept the offer, or by notice
to him in writing name a second arbitrator, and those
two shall name a third. It shall then be the duty of
the arbitrators to ascertain the fair market value of
the stock and if any arbitrator shall neglect or refuse
to appear at any meeting appointed by the arbitrators,
a majority may act in the absence of such arbitrator.

After the acceptance of the offer, or the report
of the arbitrators of the value of the stock, the
directors shall have thirty days within which to
purchase the same at such valuation, but if after the
expiration of thirty days, the owner of the stock shall
be at liberty to dispense of the same as he sees fit.

No shares of stock shall be sold or transferred on
the books of the corporation until these provisions
have been complied with.
 - 18 -

The Board of Directors may, however, waive these
provisions in any particular instance.

During petitioner’s audit, respondent issued an information

document request (IDR) to Goertz, in his capacity as petitioner’s

authorized representative, asking him to state petitioner’s

reason for accumulating earnings. Goertz responded that the

accumulation related to the family lawsuit.

OPINION

1. Compensation

We decide first whether section 162(a)(1) allows petitioner

to deduct as reasonable compensation the bonuses paid to Emile

and Louise. Respondent determined that petitioner was not

entitled to deduct those bonuses under section 162(a)(1) because

they were not “reasonable”. Petitioner argues that the bonuses

were reasonable under the independent investor test set forth by

the Court of Appeals for the Seventh Circuit in Exacto Spring

Corp. v. Commissioner, 196 F.3d 833, 835 (7th Cir. 1999), revg.

Heitz v. Commissioner, T.C. Memo. 1998-220. Petitioner argues

that the bonuses also were reasonable under the multifactor test

set forth by the Court of Appeals for the Ninth Circuit in

Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1248 (9th

Cir. 1983), revg. and remanding T.C. Memo. 1980-282. Petitioner

argues it paid the bonuses to Emile and Louise also intending to

compensate them for past services.
 - 19 -

Absent the parties’ stipulation to the contrary, this case

is appealable to the Court of Appeals for the First Circuit.

Sec. 7482(b)(1) and (2). Thus, we shall apply that court’s

jurisprudence to the extent it is squarely in point. Golsen v.

Commissioner, 54 T.C. 742, 757 (1970) (“better judicial

administration requires us to follow a Court of Appeals decision

which is squarely in point where appeal from our decision lies to

that Court of Appeals and to that court alone”), affd. 445 F.2d

985 (10th Cir. 1971); see also Lardas v. Commissioner, 99 T.C.

490, 494-495 (1992) (Golsen rule should be construed narrowly and

applied only if “a reversal would appear inevitable, due to the

clearly established position of the Court of Appeals to which an

appeal would lie”). We have found no case of the Court of

Appeals for the First Circuit that squarely addresses the

disputed compensation issue; nor have the parties referenced one.

Accordingly, as a national court, we analyze this issue on the

basis of our view of the law.
 - 20 -

The compensation issue focuses on section 162(a)(1).10 A

payment of compensation is deductible under that section if it is

reasonable in amount and for services actually rendered to the

payor in or before the year of payment. Lucas v. Ox Fibre Brush

Co., 281 U.S. 115, 119 (1930); Charles Schneider & Co. v.

Commissioner, 500 F.2d 148, 151 (8th Cir. 1974), affg. T.C. Memo.

1973-130; Pac. Grains, Inc. v. Commissioner, 399 F.2d 603, 606

(9th Cir. 1968), affg. T.C. Memo. 1967-7; Estate of Wallace v.

Commissioner, 95 T.C. 525, 553-554 (1990), affd. 965 F.2d 1038

(11th Cir. 1992); sec. 1.162-7(a), Income Tax Regs. Petitioner

must prove that section 162(a)(1) allows it to deduct

compensation in an amount greater than that determined by

respondent. Rule 142(a)(1). Careful scrutiny of the facts is

appropriate in a case such as this where the payor is controlled

by a payee/employee. Paul E. Kummer Realty Co. v. Commissioner,

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

Charles Schneider & Co. v. Commissioner, supra at 152-153;

Law Offices-Richard Ashare, P.C. v. Commissioner, T.C. Memo.

10
That section provides:

SEC. 162(a). In General.--There shall be allowed
as a deduction all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on
any trade or business, including--

(1) a reasonable allowance for salaries
or other compensation for personal services
actually rendered;
 - 21 -

1999-282. We must be persuaded that the purported compensation

was paid for services rendered by the employees/shareholders, as

opposed to a distribution of earnings to them that the payor

could not deduct. Mad Auto Wrecking, Inc. v. Commissioner, T.C.

Memo. 1995-153 (and the cases cited therein).

Reasonable compensation is determined by comparing the

compensation paid to an employee with the value of the services

performed in return. Such a determination is a question of fact

that is made as to each employee individually, rather than as to

the compensation paid to a group of employees collectively.

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

1996-129; Mad Auto Wrecking, Inc. v. Commissioner, supra. The

cases concerning reasonable compensation are numerous and usually

list many factors to be considered in making this factual

determination. As relevant herein, the factors include: (a) The

employee’s qualifications; (b) the nature, extent, and scope of

the employee’s work; (c) the size and complexity of the

employer’s business; (d) a comparison of salaries paid with the

employer’s gross and net income; (e) the prevailing general

economic conditions; (f) a comparison of salaries with

distributions to shareholders and retained earnings; (g) the

prevailing rates of compensation for comparable positions in

comparable companies; (h) the salary policy of the employer as to

all employees; (i) the amount of compensation paid to the
 - 22 -

particular employee in previous years; and (j) whether the

employer offers a pension plan or profit-sharing plan to its

employees. See Mad Auto Wrecking, Inc. v. Commissioner, supra

(and the cases cited therein). Recently, the Court of Appeals

for the Seventh Circuit has expressed its disagreement with a

multifactor test, opting instead to rest its analysis of the

reasonableness of compensation primarily on whether an

independent investor would have approved of the amount of

compensation paid to the employee. Exacto Spring Corp. v.

Commissioner, 196 F.3d at 838-839. The court observed that the

Courts of Appeals for the Second and Ninth Circuits have

concluded somewhat differently by requiring that the various

factors of the traditional test be analyzed from the perspective

of an independent investor. Id. at 838; accord Eberl’s Claim

Serv., Inc. v. Commissioner, 249 F.3d 994, 1003-1004 (10th Cir.

2001) (court rejected independent investor test in lieu of a

multifactor approach), affg. T.C. Memo. 1999-211. Our

jurisprudence has also applied a multifactor test through the

lens of an independent investor, in the setting of a case that

was not appealable to a circuit that had already recognized such

an application. Wagner Constr., Inc. v. Commissioner, T.C. Memo.

2001-160 (venue was the Eighth Circuit); see also Tricon Metals &

Servs., Inc. v. Commissioner, T.C. Memo. 1997-360. We follow
 - 23 -

that jurisprudence here and apply the multi factor test through

the lens of an independent investor.11

At the trial of this case, Jay Fishman, ASA, CBA (Fishman),

was called by petitioner as a witness, and the Court, with no

objection from respondent, recognized him as an expert on

reasonable compensation. Petitioner introduced into evidence

Fishman’s expert report (written under the name of his employer,

Financial Research, Inc.) as to the reasonableness of the total

compensation paid to Haff, Emile, and Louise. The report

concludes on the basis of the aggregate compensation paid to the

three individuals that “the deductions claimed by Haffner’s

Service Stations, Inc. for compensation paid to Emile and Louise

Fournier for the years ended December 31, 1990, 1991, and 1992

are reasonable deductions for compensation and not distributions

of profits.” As discussed infra, the report is premised on

Fishman’s belief that the specific compensation paid to each

officer of a corporation is reasonable when the total

compensation paid to all of the corporation’s officers is

reasonable.

Expert testimony is appropriate to help the Court understand

an area requiring specialized training, knowledge, or judgment.

11
As discussed herein, we decide this test adversely to
petitioner. Even if we had applied one of the tests argued for
by petitioner, petitioner would still not have prevailed.
Neither Emile nor Louise made a significant contribution during
the subject years to the success of petitioner’s business.
 - 24 -

Fed. R. Evid. 702; Snyder v. Commissioner, 93 T.C. 529, 534

(1989). The Court, however, is not bound by an expert’s opinion.

We weigh an expert’s testimony in light of his or her

qualifications and with respect to all credible evidence in the

record. Depending on what we believe is appropriate under the

facts and circumstances of the case, we may either reject an

expert’s opinion in its entirety, accept it in its entirety, or

accept selected portions of it. Helvering v. Natl. Grocery Co.,

304 U.S. 282, 294-295 (1938); Seagate Tech., Inc., & Consol.

Subs. v. Commissioner, 102 T.C. 149, 186 (1994); Parker v.

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

We reject most of Fishman’s testimony. For the three

reasons set forth below, we are unimpressed with his conclusion

and its underlying rationale. First, he reached his conclusion

relying primarily upon: (1) Specific data that he received

mainly from Haff12 and (2) general data that he derived from a

statistical compilation by Robert Morris Associates (Robert

Morris). Fishman independently verified none of this data,

relying blindly upon it. As to the specific data, Haff is

clearly an interested party given his relationship to petitioner

and his pecuniary interest in the outcome of this case. We find

disturbing that Fishman, while acknowledging to the Court that he

12
Fishman also spoke with Emile, Willett, Osgood,
Beauchesne, and petitioner’s accountants.
 - 25 -

was concerned about Haff’s conflict of interest, relied upon data

supplied by him without performing any meaningful independent

verification of it.13 Fishman acknowledged at trial that

critical “facts” that entered into his conclusion as to the

reasonableness of the total compensation were his understandings

that Louise performed “extensive duties” for petitioner during

the subject years and that Louise and Emile did not spend

extensive time working for any other entity. The facts at hand

disprove both of these “facts”. Fishman also inappropriately

ascertained his specific data for the period 1988 through 1993

and made no meaningful attempt to limit that data to the subject

years. As he testified at trial with respect to the specific

data that he received from Willett:

The Court: Why are we talking about ’88? If the
year starts with ’90, why are we doing ’88?

The Witness: I wanted a predicate when I did my
financial analysis. I looked at five years. I looked
longer, actually.

The Court: But for the purpose of determining
reasonable compensation, I think we ought to focus in
on the years at issue.

The Witness: And that encompasses that. She
[Willett] says ’89 to ’93.

13
Such an actual and glaring conflict of interest is also
held by the other employees and the accountants with whom Fishman
spoke to obtain specific data. Each of those individuals has
been connected with petitioner and its officers for many years
and stood to gain from a personal and/or business point of view
should petitioner prevail in this litigation.
 - 26 -

The Court: It encompasses it, but the concern
that I have, though, Mr. Fishman, is that it could be
that she [Louise] did a great deal during 1988 and
didn’t do anything in ’91. And there is no way to
confirm that from what you’re saying; isn’t that right?

The Witness: Other than speaking to her, that’s
correct.[14]

Fishman’s blind reliance on the specific data is especially

exemplified by the following colloquy between Fishman and the

Court:

The Court: When he described to you that Louise
Fournier negotiated fuel purchases, * * * did you come
to understand that she did that every day, every week,
every month, every year? How often did that happen?

The Witness: I don’t know.

The Court: * * * you indicate that she managed
the Company’s banking relationships.

The Witness: Yes.

The Court: Where did you get that information,
the same source?

The Witness: Yes.

The Court: Did you independently verify that?

The Witness: No.

The Court: What banking relationships did she
manage?

The Witness: I think they were the day-to-day
banking relationships, the signing of the checks —-

The Court: That’s more ministerial.

14
And speaking to Louise was not possible because she was
dead.
 - 27 -

The Witness: It is.

The Court: Did she negotiate any loans?

The Witness: I don’t think so.

The Court: So when you say manage the banking
relationships, what’s the relationship? I’m not
understanding what you mean by relationship. That she
made deposits; is that what you’re saying?

The Witness: Your honor, there was in 1982, ’83,
’84, where, in fact, they did--

The Court: Yes, but I’m talking about the years
in issue now, ’90, ’91, and ’92. Were there any
banking relationships that she managed?

The Witness: I guess I don’t know the answer to
that.

The Court: * * * now, then you say that another
role that she had was that she supervised employees.

The Witness: Yes.

The Court: What employees did she supervise?

The Witness: Peggy Willett, Mary Osgood--

* * * * * * *

The Court: So, how did she supervise these
employees? * * * describe it to me. When you say that
she supervised them, what did she do to supervise them?

The Witness: She made policy decisions with
regard to things that had to be done, and she made sure
that --

The Court: Give me an example of a policy
decision.

The Witness: You know what? I can’t give you a
particular one.
 - 28 -

The general data suffers from similar infirmities. In

addition to the fact that Fishman acknowledged at trial that the

general data was unreliable, he stated specifically that he knew

that Robert Morris’s publication warns readers explicitly that

the data is not statistically accurate and should not be relied

upon or used in a legal proceeding. Fishman attempted to

rationalize his reliance on the Robert Morris compilation by

stating: “Unfortunately, I had to use what was available. It

was that and the–-were the best stuff around. I have to concede

that they’re flawed.” We find this attempt unavailing.

Much of the purported data that Fishman relied upon in

reaching his conclusion also never made its way into evidence.

Although an expert need not rely upon admissible evidence in

forming his or her opinion, Fed. R. Evid. 703, we must rely upon

admitted evidence in forming our opinion and, in so doing, may

not necessarily agree with an expert whose opinion is not

supported by a sufficient factual record. The mere fact that the

Court admits an expert’s opinion into evidence does not mean that

the underlying facts upon which the expert relied are also

admitted into evidence. Anchor Co. v. Commissioner, 42 F.2d 99

(4th Cir. 1930); Rogers v. Commissioner, 31 B.T.A. 994, 1006

(1935); see United States v. Scheffer, 523 U.S. 303, 317 n.13

(1998) (whereas expert opinion is considered evidence, the facts

upon which such an expert relies in forming that opinion are not
 - 29 -

considered evidence until introduced at trial by a fact witness);

see also United States v. 0.59 Acres of Land, 109 F.3d 1493, 1496

(9th Cir. 1997). In a case such as this, where an expert witness

relies upon facts which are critical to the Court’s analysis of

an issue, we expect that the party calling the witness will enter

into evidence those critical facts. Petitioner did not.

Petitioner, in short, asks us to close our eyes to the

non-expert-opinion evidence and to adopt without adequate

verification Fishman’s conclusion and the representations upon

which he relied. We decline to do so. Whereas we may determine

the reasonableness of compensation with the assistance of experts

if we consider it helpful, we will not accept an expert’s

conclusion when it is based on premises unsupported by the

record.

Our second concern with Fishman’s conclusion is that he

inexplicably neglected to take into account properly the

“significant” flaws in the Robert Morris compilation that he

acknowledged upon cross-examination had influenced his opinion.

The compilation, for example, did not reflect the fact that the

salary of a person in one part of the country may be different

than the salary of a person performing the same services in

another part of the country. Nor did the compilation reflect the

number of corporate officers in a particular category. As to the

latter flaw, Fishman stated, he listed the responsibilities of
 - 30 -

Haff, Emil, and Louise collectively, rather than individually,

and he drew no distinction among Haff, Emile, and Louise as to

the reasonableness of each individual’s compensation. To

Fishman’s mind, each officer’s compensation is reasonable under

section 162(a)(1) if the aggregate amount of compensation is

reasonable for the services performed by all of the officers. We

disagree. In fact, even Fishman recognized the impropriety of

his approach when he answered the Court’s question as to why he

included Haff’s compensation in the analysis of the

reasonableness of Emile and Louise’s compensation. The colloquy

went as follows:

The Court: by including the third person and
including that salary in here, we’re throwing into this
mix something that is not relevant. I mean, suppose,
for instance, the third person’s salary was $10,000?
Or suppose it was $500,000? It certainly has an
impact, and it distorts the comparison?

The Witness: I understand your point, and it
would have been better if I had made an allocation by
individual. I didn’t think I could do that and sit
here and talk to you about it.

We also note that Fishman, notwithstanding his knowledge of the

fact that Emile and Louise received equal bonuses, believed that

Louise performed significantly more services for petitioner than

Emile and acknowledged that some of Louise’s duties could have

been performed by somebody else for significantly less than the

amount paid to Louise.
 - 31 -

Our third concern with Fishman’s conclusion is that he

reached it by comparing petitioner to four publicly traded

companies none of which was actually comparable to petitioner.

Each company is significantly larger than petitioner, both in

size and in revenue, and none of those companies, unlike

petitioner, is a discount operation that aims to charge less than

a typical retail oil company. The four companies also are

located in different geographical areas than petitioner, have

convenience stores, accept credit card payments, and are more

heavily debt leveraged. Their officers also have significantly

different responsibilities than petitioner’s officers. To be

sure, as Fishman acknowledged in reply to a question from the

Court:

The Court: * * * Now, let’s talk again about
your comparisons to the public companies. And I
understand that in the field of valuation, how one uses
public companies for comparison purposes. But these
companies are a stretch, don’t you think, to try to
substantiate reasonableness of compensation, based on
three top individuals in public companies?

The Witness: * * * I will tell you, are they the
best comparable that I could--they are the best
comparable that I could find. In a perfect world,
would they be the ones that I would rather use? No.

Having rejected Fishman’s conclusion in its entirety, and

having rejected much of his rationale, we now turn to the various

factors on reasonable compensation and analyze them seriatim

through the eyes of a hypothetical independent investor. As to

each factor, we ask ourselves the following question (the
 - 32 -

question): “Would a hypothetical independent investor consider

the factor favorably to require the payment of the bonuses to the

employee in order to retain the services which the employee

performed during the subject years?” An answer in the negative

indicates that the payment of a bonus was not sufficiently tied

to the employee’s services to constitute personal service income

but was more likely a distribution of earnings. An answer in the

affirmative supports deducting the bonuses as personal service

compensation. The reasonableness of the amount of the employee’s

compensation (inclusive of the bonuses) then hinges on whether

the hypothetical independent investor, after taking into account

the amount of the compensation, would receive at least the

minimum return anticipated on an investment in the employer.

a. Employee’s Qualifications

We analyze the qualifications of Emile and Louise. Each has

worked in petitioner’s business since its inception, and each

understands petitioner’s operation well. Petitioner’s

profitability during the subject years, however, did not rest

upon the personal qualifications of Emile or Louise but rested

more appropriately upon the volume of its sales, which, in turn,

hinged on the price at which petitioner sold its gasoline and

home heating oil. In the particular industry of which petitioner

was a part, the marginal skills of Emile and Louise were not

critical to petitioner’s profitability. Neither Emile’s nor
 - 33 -

Louise’s personal services were vital to petitioner’s operation

during the subject years, and neither of them was irreplaceable

in petitioner’s operation or in the maximization of its profit.

Nor was the level of petitioner’s sales sufficiently connected

with the presence of either of them. A significant number of

petitioner’s customers did not frequent its stations or purchase

its home heating oil on account of Emile or Louise. Although we

assume that Emile’s and Louise’s personal efforts had a

meaningful impact on petitioner’s growth during its early years,

the record simply does not persuade us that either of them

contributed significantly during the subject years to any

additional growth. As to both Emile and Louise, we answer the

question in the negative.

b. Nature, Extent, and Scope of Employee’s Work

We analyze the nature, extent, and scope of Emile and

Louise’s work in petitioner’s business. Neither the nature,

extent, nor scope of that work was fundamental, substantial, or

all encompassing. Haff was the locomotive of the business, and

he was petitioner’s most valuable employee in that, among other

things, he set the price at which petitioner would sell its

gasoline and home heating oil and made most of the other

important everyday business decisions. Although Emile and Louise

discussed many of the business decisions with Haff before he

passed on those decisions, we are unable to find that either
 - 34 -

Emile or Louise rendered any significant advice to Haff in the

capacity as an employee (as opposed to a director) that was

necessary or significant enough to distinguish Emile and Louise

from petitioner’s other employees. In fact, the record reveals

that Emile and Louise performed during the subject years mainly

the type of clerical, nonmanagerial work that could be performed

by the staff employees of an office. The record also reveals

that both Emile and Louise devoted significantly less than 100

percent of their time to petitioner, given the fact that each of

them worked significant hours on the business of the related

entities of the Haffner/Fournier family.

Nor do we believe that petitioner’s business would have

suffered had Emile or Louise severed his or her affiliation with

the company. Any void created by the loss of Emile and/or

Louise could have been filled by one or more other employees.

Emile’s and Louise’s circumstances in this case are fairly common

in the world of closely held business. Presumably, they were

vibrant, energetic, and highly productive individuals in

petitioner’s earlier years, when its business grew and became

successful. In order to manage that growth, however, they

developed an organizational structure that included the next

generation of managers and support staff. Throughout the years,

Emile’s and Louise delegated many of their managerial

responsibilities to the new organization so that Emile’s and
 - 35 -

Louise’s responsibilities diminished over time to almost nothing.

During the subject years, the new organization and next

generation of management capably managed the business so that

Emile and Louise had little to do but to sit back and observe.

Their roles, once as active managers, now were more passive and

less critical with respect to the business’s daily affairs. For

example, Haff was the only one who regularly met with the

accountants during the subject years in a capacity other than as

a board member. As to both Emile and Louise, we answer the

question in the negative.

c. Size and Complexity of Employer’s Business

We analyze the size and complexity of petitioner’ business.

We conclude that petitioner’s business is neither complex nor

relatively large. Petitioner retails commodities (gasoline and

home heating oil), and its retail operation demands only routine

managerial skills. In fact, petitioner’s business was somewhat

rudimentary in that it only sold gasoline and home heating oil,

that it purchased all of its inventory from a single supplier,

and that it sold its gasoline only for cash.

Petitioner’s success and survival hinged on its ability to

maintain enough supply to meet consumer demand and its ability to

sell that supply at a price that would appeal to consumers while

allowing petitioner to reap a meaningful profit. The most

important aspects of petitioner’s business involved, first, the
 - 36 -

cost and quantity of the gasoline and home heating oil which it

would purchase from Parker and, second, the price at which it

would sell those products to consumers. Whereas petitioner

(through Haff) set the price at which it would sell its products

to its customers, the record establishes that petitioner had few

negotiations with Parker as to petitioner’s cost of those

products. Petitioner also played no part in the negotiations of

the cost and quantity of those products purchased by Parker for

resale to petitioner. The negotiations, obviously, occurred

between Parker and the third party from which it purchased the

products. Although petitioner’s business could be viewed as

somewhat large in the sense that it employed approximately 150

individuals and generated approximately $60 million of gross

receipts, the fact of the matter is that petitioner’s business

was relatively small when compared to the industry’s “comparable”

businesses. As to both Emile and Louise, we answer the question

in the negative.

d. Comparison of Salaries Paid With Net and Gross Income

For each of the subject years, we compare Emile’s and

Louise’s compensation, including bonuses, first to petitioner’s

gross income and then to its taxable income (before any deduction

for the relevant employee’s compensation). As to Emile, the

first comparison yields percentages of 8.26, 7.55, and 7.23,

respectively, and the second comparison yields percentages of
 - 37 -

20.34, 23.44, and 21.36, respectively. In the case of Louise,

the first comparison yields percentages of 8.26, 7.55, and 7.26,

respectively, and the second comparison yields percentages of

20.34, 23.43, and 21.44, respectively.

We believe all four sets of percentages are rather high

seeing that petitioner employed approximately 150 individuals and

given our findings as to the qualifications of Emile and Louise

and the nature, extent, and scope of their work. We also bear in

mind our finding that petitioner did not ascertain Emile’s and

Louise’s bonuses on the basis of their contribution to it, but

rather on the size of its profits for the related years. We note

further that the percentages for both sets of comparisons are

relatively the same for Emile and Louise.

We are not unmindful that petitioner reported large amounts

of taxable income for each subject year, notwithstanding its

payment of large amounts of compensation to Emile and Louise.

The mere fact that a corporation has substantial taxable income

in a given year, however, does not necessarily mean that a

hypothetical independent investor would approve of what an

employee received as compensation. Such is especially true as to

Emile and Louise who, as mentioned above, were not indispensable

to the business and whose efforts during the subject years did

not result significantly in the generation of that income. As to

both Emile and Louise, we answer the question in the negative.
 - 38 -

e. General Economic Conditions

We analyze the general economic conditions related to the

relevant business. General economic conditions may affect a

business’s performance and indicate the extent (if any) of the

employee’s effect on the company. Mayson Manufacturing Co. v.

Commissioner, 178 F.2d 115, 119-120 (6th Cir. 1949), revg. and

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

Adverse economic conditions, for example, tend to show that an

employee’s skill was important to a company that grew during the

bad years.

The record does not indicate whether petitioner’s success

during the subject years was attributable to the work of one or

more employees or to the general economic conditions. The record

indicates, however, that the economic conditions related to

petitioner’s business were not adverse. As to both Emile and

Louise, we are unable to answer the question affirmatively.

f. Comparison of Salaries with Distributions to
Shareholders and Retained Earnings

We compare Emile’s and Louise’s compensation first to

petitioner’s distributions and then to its retained earnings.

The fact that petitioner has never paid a dividend is a factor

that may suggest that some portion of the amounts paid as

compensation to a shareholder/employee is really a dividend.

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315,

1322-1323 (5th Cir. 1987), affg. T.C. Memo. 1985-267; see also
 - 39 -

O.S.C. & Associates, Inc. v. Commissioner, 187 F.3d 1116, 1121

(9th Cir. 1999), affg. T.C. Memo. 1997-300. Such an absence may

raise a red flag that invites special scrutiny by the Court and

justify an inference that some of the purported compensation was

actually a distribution of profits. Charles Schneider & Co. v.

Commissioner, 500 F.2d at 153.

Such an absence and inference, however, does not

automatically convert compensation that would otherwise be

reasonable into a dividend. Corporations are not required to pay

dividends. Instead, an individual shareholder may participate in

the success of a corporation through the appreciation in the

value of his or her stock brought on by retained earnings and the

possibility of a future return. Thus, a corporate employer with

little or no dividend history may be able to pay and deduct large

amounts of compensation if the Court is convinced that a

reasonable person would still have invested in the corporation.

Critical to this test is whether the shareholders of the

corporation received a fair rate of return (without taking into

account any compensation paid to them) from the total of their

initial and subsequent investments. Owensby & Kritikos, Inc. v.

Commissioner, supra at 1326-1327; Medina v. Commissioner, T.C.

Memo. 1983-253; see also Rev. Rul. 79-8, 1979-1 C.B. 92

(compensation is not unreasonable merely because a corporation

pays an insubstantial portion of its earnings as dividends).
 - 40 -

The record does not contain enough information for us to

conclude that a reasonable person would have invested in

petitioner, given the payments of the large amounts of

compensation to Emile and Louise. Nor does the record allow us

to determine with any meaningful precision the rate of return

that a hypothetical investor would have received during the

subject years on his or her investment in petitioner.15 As to

both Emile and Louise, we are unable to answer the question

affirmatively.

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

The record does not disclose the prevailing rates of

compensation for comparable positions in comparable companies.

As to both Emile and Louise, we are unable to answer the question

affirmatively.

15
Even if we could make a fair approximation of the rate of
return that a hypothetical investor would have received during
the subject years on his or her investment in petitioner, the
record contains no evidence as to what an investor would expect
as a rate of return in light of the risks of the business.
Moreover, even if the return on capital actually achieved by
petitioner were high enough to satisfy an independent investor,
this would not carry the day, in the absence of proof, which is
lacking here, that the profits are attributable to the efforts of
Emile and Louise. Cf. B & D Foundations, Inc. v. Commissioner,
T.C. Memo. 2001-262 (citing Exacto Spring Corp. v. Commissioner,
196 F.3d 833, 839 (7th Cir. 1999), revg. Heitz v. Commissioner,
T.C. Memo. 1998-220).
 - 41 -

h. Employer’s Salary Policy as to All Employees

We analyze petitioner’s salary policy as to all of its

employees. The record establishes that both Emile and Louise

were compensated differently than the other employees, most

likely because of Louise’s status as the controlling shareholder.

Apart from Emile, Louise, and, in 1990, Haff, none of

petitioner’s employees received a large bonus for any subject

year. Nor does the record indicate that any of petitioner’s

other employees, except for Haff, the president, CEO, and general

manager of the company, received six-figure compensation in any

one year. We also note that Emile and Louise, by virtue of their

positions as corporate officers and directors, and by virtue of

Louise’s relationship to the company as its controlling

shareholder, were not dealing with petitioner at arm’s length.

As to both Emile and Louise, we answer the question in the

negative.

i. Compensation Paid in Prior Years

We analyze the compensation that petitioner paid to Emile

and Louise in years prior to the subject years. An employer may

deduct compensation paid to an employee in a year although the

employee performed the services in a previous year. Lucas v. Ox

Fibre Brush Co., 281 U.S. at 119; see also R. J. Nicoll Co. v.

Commissioner, 59 T.C. 37, 50-51 (1972) (and the cases cited

thereat). In order to do so, the employer must show: (1) That
 - 42 -

the employer intended to compensate the employee for past

undercompensation, and (2) the amount of the undercompensation.

Pac. Grains, Inc. v. Commissioner, 399 F.2d at 606; Estate of

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

We conclude that none of the payments in issue were intended

to compensate either Emile or Louise for past undercompensation.

In addition to the fact that petitioner alleged in its petition

that the compensation was all attributable to the efforts of

Emile and Louise during the subject years, the payment of the

extremely large bonuses to them began in 1990, around the time

that the family lawsuit was initiated. Petitioner’s payment of

these large amounts of cash obviously reduced its value and,

correspondingly, the amount of petitioner’s value that was

attributable to the disputed shares. In their capacity as

defendants in the family lawsuit, Emile and Louise, the

recipients of the bonuses, also were most likely incurring large

expenses in defending against the lawsuit and were facing the

possibility of a large damage award by virtue of an adverse

ruling against them. We also observe that petitioner had

sufficient resources in 1989 and in each of the subject years to

pay Emile and Louise any additional amount that it purportedly

believed was due to them for their services, that the bonuses

were ascertained arbitrarily at the end of each year, and that
 - 43 -

the same amounts were paid as bonuses to Louise and Emile. As to

both Emile and Louise, we answer the question in the negative.

j. Absence of Pension Plan/Profit-Sharing Plan

We analyze whether petitioner had a pension plan or

profit-sharing plan. The absence of a pension plan or profit-

sharing plan may allow an employer to pay an employee more

compensation than the employer would have paid had the employer

offered the employee either of those plans. Rutter v.

Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988), affg. T.C.

Memo. 1986-407.

Petitioner had a pension plan, but we do not know who its

participants were. As to both Emile and Louise, we are unable to

answer the question affirmatively.

k. Conclusion

We conclude that the bonuses paid to Emile and Louise in the

subject years were unreasonable in that they were not actually

paid for personal services rendered. Accordingly, we sustain

respondent’s determination as to this issue.

2. Accumulated Earnings Tax

We turn next to the applicability of the accumulated

earnings tax. Respondent determined that the tax applies to each

year in issue. Petitioner contends that the tax applies to none

of those years. Petitioner asserts that it accumulated earnings

during those years to redeem the disputed shares. Petitioner
 - 44 -

argues that an accumulation for that purpose was a reasonable

business need. Respondent rejoins that an accumulation for that

purpose is not a reasonable need of petitioner’s business.

Petitioner takes no exception to respondent’s calculation of the

accumulated earnings tax but for its dispute as to the reasonable

needs of its business.

Section 531 imposes a penalty tax on the accumulated taxable

income of a corporation that is availed of for the purpose of

avoiding tax with respect to its shareholders by permitting

earnings and profits (earnings) to accumulate instead of

distributing them. Secs. 531 and 532(a). The purpose of the

penalty tax is to compel the corporation to distribute any

earnings not needed for its business so that its shareholders

will pay income taxes on the dividends received. See Ivan Allen

Co. v. United States, 422 U.S. 617, 626 (1975); United States v.

Donruss Co., 393 U.S. 297, 303 (1969); Helvering v. Chicago Stock

Yards Co., 318 U.S. 693, 699 (1943). The fact that earnings have

accumulated beyond the reasonable needs of a business establishes

a presumption that the accumulation was motivated by tax

avoidance. Sec. 533(a).

The reasonable needs of the business include reasonably

anticipated future needs. Sec. 1.537-1(a), Income Tax Regs. In

order to meet the reasonable needs of the business test, a need

to retain earnings must be directly connected with the needs of
 - 45 -

the corporation itself and must be for bona fide business

purposes. Id. The regulations provide a “prudent businessman”

test to determine whether earnings have been accumulated beyond

the business’s present and reasonably anticipated future needs.

Under this test, “An accumulation of the earnings and profits * *

* is in excess of the reasonable needs of the business if it

exceeds the amount that a prudent businessman would consider

appropriate for the present business purposes and for the

reasonable anticipated future needs of the business.” Id.

The determination of the reasonable needs of a business is

in the first instance a question for the corporation’s officers

and directors, and courts should only reject the officers’ and

directors’ judgment to accumulate earnings where the facts and

circumstances warrant the conclusion that an earnings

accumulation is unreasonable and for tax-motivated purposes.

Snow Manufacturing Co. v. Commissioner, 86 T.C. 260, 269 (1986);

Atl. Props., Inc. v. Commissioner, 62 T.C. 644, 656 (1974), affd.

519 F.2d 1233 (1st Cir. 1975). The mere fact that a

corporation’s officers and/or directors have consciously decided

to retain earnings for a stated anticipated future need, however,

does not necessarily mean that an accumulation for that need

satisfies the reasonable needs of the business test. A

corporation must justify an accumulation for reasonably

anticipated future needs by demonstrating, as of the end of each

relevant year, a specific, definite, and feasible plan to use the

accumulation to meet the stated need within a reasonable time.
 - 46 -

Sec. 1.537-1(b), Income Tax Regs. In recognition of the

informality which commonly characterizes planning within a

closely held corporation, however, neither the regulations nor

the cases require meticulously drawn formal blueprints for

action. Faber Cement Block Co. v. Commissioner, 50 T.C. 317, 332

(1968); Bremerton Sun Publg. Co. v. Commissioner, 44 T.C. 566,

584-585 (1965). But where documentation is lacking, the

intention to dedicate corporate resources to identified business

needs must be unambiguously evidenced by some contemporaneous

course of action toward this end. Cheyenne Newspapers, Inc. v.

Commissioner, 494 F.2d 429, 433-434 (10th Cir. 1974), affg. T.C.

Memo. 1973-52; Snow Manufacturing Co. v. Commissioner, supra at

273-277; Ellwest Stereo Theatres, Inc. v. Commissioner, T.C.

Memo. 1995-610.

Section 534 lists two situations in which the Commissioner

bears the burden of proving that earnings have accumulated beyond

the reasonable needs of the business. First, the Commissioner

bears the burden of proof when the Commissioner fails to notify

the corporation before issuing a notice of deficiency to it that

the notice of deficiency includes an amount for the accumulated

earnings tax. Second, the Commissioner bears the burden of proof

when the corporation responds timely to the Commissioner’s

notification with a statement that explains the grounds, with

facts sufficient to show the basis thereof, on which it relies to

establish that the accumulation was for the reasonable needs of
 - 47 -

the business. See Myco Indus., Inc. v. Commissioner, T.C. Memo.

1992-147.

Petitioner argues that respondent bears the burden of proof

in all years by virtue of the December 16, 1996, letter.

Respondent concedes that he bears the burden of proof for 1992,

with respect to whether petitioner allowed its earnings to

accumulate beyond the reasonable needs of the business, but

argues that petitioner bears the burden of proof for the

remaining years. We agree with neither side in full. We hold

that respondent bears the burden of proof as to the grounds set

forth in the December 16, 1996, letter on which petitioner relies

to establish that its accumulation of earnings did not exceed the

reasonable needs of its business. We hold that petitioner

continues to bear the burden of proof with respect to any

additional grounds that it alleges were the reason for the

accumulation, as well as with respect to the ultimate question of

whether petitioner was availed of for a tax-motivated purpose.16

Pelton Steel Casting Co. v. Commissioner, 28 T.C. 153, 183-184

(1957), affd. 251 F.2d 278 (7th Cir. 1958); see also Wellman

Operating Corp. v. Commissioner, 33 T.C. 162, 182 (1959).

We read the December 16, 1996, letter to have alerted

respondent that petitioner was asserting that it had accumulated

earnings during the subject years for a planned stock redemption

16
Notwithstanding our holdings as to which party bears the
burden of proof on this issue, none of our holdings as to the
related substantive issue hinges on the burden of proof.
 - 48 -

connected to the family lawsuit. The letter characterized the

family lawsuit plaintiffs as “dissident and hostile minority”

shareholders and asserted that they “cannot function as part of a

unified team”. The letter indicated that petitioner planned to

redeem the shares of those shareholders “to promote harmony in

the business”. The letter was accompanied by the probate court’s

order rescinding the 1961 transfer. The letter was accompanied

by a few cases that petitioner asserted supported the

permissibility of its earnings accumulation.

Petitioner asserts in brief that it also accumulated

earnings during the subject years for reasons other than a stock

redemption. Neither petitioner’s December 16, 1996, letter nor

its pleadings in this case set forth any reason for the earnings

accumulation other than a stock redemption. Nor did petitioner’s

authorized representative state any other reason when, during

petitioner’s audit, he responded to the IDR. In fact, the first

time that petitioner asserted that it was also accumulating

earnings to meet certain business contingencies and to provide

working capital was at or about the time of trial. Such an after

the fact rationalization to support the accumulation of earnings

is unavailing.17

17
We also find unavailing petitioner’s assertion in brief
that it was unable to declare dividends during the subject years
by virtue of the fact that the family lawsuit placed in doubt the
true identity of its shareholders. The mere fact that the
identity of some of the shareholders was being disputed during
the subject years does not, to our minds, mean that petitioner
was prevented from declaring a dividend.
 - 49 -

We focus solely on petitioner’s assertion that it was

accumulating earnings for a stock redemption and analyze whether

this need was: (1) A bona fide reason for the accumulation and

(2) a reasonable business need. We decide both prongs of this

analysis adversely to petitioner. As to the first prong,

petitioner lacked as of the end of each subject year a specific,

definite, and feasible plan to use a set portion of its

accumulated earnings to redeem part of its stock. The record

indicates that: (1) Neither petitioner’s officers nor its

directors ever discussed in earnest Rubin’s suggestion in 1989

that petitioner begin accumulating funds for a possible

redemption of the disputed shares, (2) petitioner never

considered meaningfully the amount of funds that would be

necessary to effect such a redemption,18 or whether the family

lawsuit plaintiffs, given John’s testamentary intent, were

receptive to a redemption of their shares, and (3) petitioner

never undertook a meaningful study of the value of the disputed

shares or the likelihood that Emile and Louise would lose the

18
We find incredible Haff’s testimony that petitioner
needed to retain $10 million as a contingency for the family
lawsuit. In this regard, we give no weight to Richard’s offer to
settle for $20 million his lawsuits against Emile and Louise,
individually, and as executors of the wills of John and Emma, or
Emile and Louise’s counteroffer on July 27, 1990, proposing, in
part, to settle Richard’s lawsuits by redeeming his shares in
petitioner, Haffner Realty, and Fournier Realty for a total
payment of $300,000. The counteroffer stated that Richard owned
10 percent of petitioner’s nonvoting stock, approximately 10
percent of the nonvoting stock of Haffner Realty, and
approximately 6 percent of the nonvoting stock of Fournier
Realty.
 - 50 -

family lawsuit. Contrary to petitioner’s suggestion, the mere

fact that petitioner retained earnings contemporaneously with its

controlling shareholder’s defense of a lawsuit challenging her

right to ownership of ceratin shares constituting a minority

interest is not enough to establish the requisite plan under

section 1.537-1(b), Income Tax Regs. Such is especially true

here where petitioner’s board never formally exercised its

judgment to accumulate funds for a planned redemption and where

neither petitioner’s board nor its officers ever performed an

action signifying that petitioner had a specific plan to redeem

any of its shares.

As to the second prong, the presence of a reasonable

business need, the redemption of the stock of dissenting,

minority stockholders is a reasonable business need where the

redemption appears necessary to preserve the corporation’s

existence or to promote harmony in the conduct of the

corporation’s business. Wilcox Manufacturing Co. v.

Commissioner, T.C. Memo. 1979-92; Farmers & Merchants Inv. Co. v.

Commissioner, T.C. Memo. 1970-161. The dispositive factual

consideration in such a situation is whether competing demands

among shareholders imperil the very existence of the corporation

or the manner in which up to then it has been successfully

conducting its business. Mountain State Steel Foundries, Inc. v.

Commissioner, 284 F.2d 737 (4th Cir. 1960).

We decide this factual consideration adversely to

petitioner. Any redemption by petitioner of the family lawsuit
 - 51 -

plaintiffs’ stock would not have been necessary to prevent

competing demands among shareholders from imperiling petitioner’s

existence or to safeguard the manner in which petitioner had been

successfully conducting its business. Instead, the redemption,

had it occurred, would have been related to the family lawsuit,

an action that was filed against Emile and Louise and in which

the plaintiffs never made a claim for damages against

petitioner.19 The mere fact that the family lawsuit centered on

ownership of a minority interest in petitioner’s stock does not,

in and of itself, mean that petitioner’s redemption of that stock

would be a reasonable business need.20 Lambert & Associates v.
United States, 212 Ct. Cl. 71 (1976). Such is particularly true

here where a redemption of those shares would have satisfied the

personal obligations of Emile and Louise and where petitioner’s

operations were never disrupted or compromised during the

relevant years as a result of the family lawsuit. In this

regard, we distinguish factually the cases of Knight Furniture

Co. v. Commissioner, T.C. Memo. 2001-19, Oman Constr. Co., Inc.

v. Commissioner, T.C. Memo. 1965-325, and C.E. Hooper, Inc. v.

United States, 210 Ct. Cl. 615, 539 F.2d 1276 (1976), relied upon

19
We note that petitioner has acknowledged by virtue of its
concession, see supra note 2, that its directors had previously
used corporate funds to satisfy a personal liability of Emile and
Louise stemming from the family lawsuit. Haff considered the
lawsuit to be a personal matter between Richard and Susan, on the
one hand, and Emile and Louise, on the other.
20
Nor do we think that this proposition would be different
even if one or more of the plaintiffs were attempting to obtain
that minority interest in order to sell it.
 - 52 -

by petitioner for a contrary holding as to this issue. We also

disagree with petitioner’s reading of the above quoted provision

of its articles of incorporation to impose upon its board a short

time to redeem a shareholder’s stock should the board desire to

do so. We read nothing in the quoted provision that sets a time

limitation on the board’s ability to redeem stock.

3. Accuracy-Related Penalties

Respondent determined that petitioner was liable for

accuracy-related penalties under section 6662(a) and (b)(1) for

negligence or intentional disregard of rules and regulations.

Petitioner argues that it is not liable for these penalties

because it relied reasonably on its accountants’ advice in

preparing its returns. We agree with petitioner.

As relevant herein, section 6662(a) and (b)(1) imposes a

20-percent accuracy-related penalty on the portion of an

underpayment that is due to negligence or intentional disregard

of rules or regulations. Negligence includes a failure to

attempt reasonably to comply with the Code. Sec. 6662(c).

Disregard includes a careless, reckless, or intentional

disregard. Id.

A section 6662(a) accuracy-related penalty shall not be

imposed to the extent that the taxpayer shows that an

underpayment is due to the taxpayer’s having reasonable cause and

acting in good faith. Sec. 6664(c); secs. 1.6662-3(a),

1.6664-4(a), Income Tax Regs. Reasonable cause requires that the

taxpayer have exercised ordinary business care and prudence as to
 - 53 -

the disputed item. United States v. Boyle, 469 U.S. 241 (1985).

A good faith, reasonable reliance on the advice of an

independent, competent professional as to the tax treatment of an

item may meet this requirement. Id.; sec. 1.6664-4(b), Income

Tax Regs.

Whether a taxpayer relies on professional advice and whether

such reliance is reasonable hinge on the facts and circumstances

of the case and the law that applies to those facts and

circumstances. Sec. 1.6664-4(c)(i), Income Tax Regs. For a

taxpayer to rely reasonably upon professional advice so as

possibly to negate a section 6662(a) accuracy-related penalty,

the taxpayer must prove by a preponderance of the evidence that

the taxpayer meets each requirement of the following three-prong

test: (1) The adviser was a competent professional who had

sufficient expertise to justify reliance, (2) the taxpayer

provided necessary and accurate information to the adviser, and

(3) the taxpayer actually relied in good faith on the adviser’s

judgment. Ellwest Stereo Theatres, Inc. v. Commissioner, T.C.

Memo. 1995-610; see also Rule 142(a)(1). The record persuades us

that petitioner has met each of these requirements. Because

petitioner (through its officers) actually relied in good faith

on its accountants’ advice as to the matters at hand, and the

reliance was reasonable, we decline to sustain respondent’s

determination as to the accuracy-related penalties.
 - 54 -

All arguments in this case have been considered and, to the

extent not discussed above, are without merit. Accordingly,

Decision will be entered

under Rule 155.