Beiner, Inc. v. Comm'r

T.C. Memo. 2004-219

UNITED STATES TAX COURT

BEINER, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14697-03. Filed September 28, 2004.

Philip Garrett Panitz and Ryan D. Schaap, for petitioner.

Jonathan H. Sloat and Leslie Vanderwalt, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Petitioner petitioned the Court to redetermine

the following deficiencies in Federal income taxes and related

section 6662(a) accuracy-related penalties:1

1
Section references, unless otherwise indicated, are to the
applicable versions of the Internal Revenue Code (Code). Rule
references are to the Tax Court Rules of Practice and Procedure.
 - 2 -

Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)

1999 $294,389 $55,165.20
2000 405,286 81,057.20

Following petitioner’s concessions, we decide whether petitioner

may deduct the officer compensation of $1,087,000 and $1,350,000

that it claimed on its 1999 and 2000 Federal income tax returns,

respectively. Respondent determined in the notice of deficiency

that petitioner may deduct only $303,020 and $157,982 of the

respective claimed amounts because petitioner had not shown that

any greater amount was reasonable and paid for services. We hold

that petitioner may deduct all of the claimed amounts but for

$180,260 in 1999.2 We also decide whether petitioner is liable

for the portion of the accuracy-related penalty attributable to

the $180,260. We hold it is not.

FINDINGS OF FACT

Some facts were stipulated and are so found. The

stipulation of facts and the accompanying exhibits are

incorporated herein by this reference. Petitioner is a C

corporation doing business as B & B Electric Sales. Its

2
On the basis of this holding, we also hold without further
discussion that petitioner is not liable for the portion of the
accuracy-related penalty attributable to respondent’s disallowed
compensation for 2000 or the portion of the accuracy-related
penalty attributable to respondent’s disallowed compensation
greater than $180,260 for 1999.
 - 3 -

principal place of business was in Ventura, California, when its

petition was filed in this Court.

A. Petitioner’s Business

Petitioner is a wholesale distributor of motor controls

(parts) manufactured by Allen-Bradley. It was incorporated in

1991 by Robert Lance Beiner (Beiner) and his brother. Beiner and

his brother owned petitioner’s stock equally until 1992 when

Beiner became (and remains today) petitioner’s sole shareholder.

Since December 2, 1991, Beiner has been petitioner’s sole

director and its president, secretary, and treasurer. Since at

least December 3, 1995, Beiner has also been petitioner’s chief

executive officer and its chief financial officer.

Petitioner began its business selling a wide range of

materials made by various manufacturers. Shortly after starting

the business, Beiner concluded that no distributor in the United

States stocked a wide range of parts made by Allen-Bradley, and

he caused petitioner to limit its business to the sale of those

parts. Beiner surmised on the basis of his longtime experience

as an electrical designer that petitioner’s sale of only

Allen-Bradley parts would be most profitable to it in that it

could stock a wide range of those parts and immediately deliver

them to customers upon request. Other distributors of

Allen-Bradley parts, and Allen-Bradley itself, were usually

unable to deliver those parts until many days after a request.
 - 4 -

Beiner’s brother, who was Beiner’s mentor in petitioner’s

business at the start of that business, disagreed with the change

and as a result of the change disaffiliated himself entirely from

any ownership or continued participation in petitioner. Numerous

other individuals also believed that petitioner’s new business

would be a failure.

During the relevant years, Allen-Bradley sold its parts only

to its authorized distributors and to original equipment

manufacturers (OEMs). The authorized distributors sold the parts

which they purchased from Allen-Bradley directly to end users.

Allen-Bradley sold its parts to OEMs not for resale but to

incorporate the parts into equipment that they manufactured and

sold as finished products.

Petitioner is neither an OEM nor an authorized distributor

of Allen-Bradley parts. Petitioner bought and sold Allen-Bradley

parts in a bootleg market for those parts. During the subject

years, petitioner purchased Allen-Bradley parts primarily from

three OEMs. These OEMs purchased large quantities of

Allen-Bradley parts either (1) directly from Allen-Bradley at

prices which were deeply discounted from those of the retail

market or (2) from one or more of Allen-Bradley’s authorized

distributors at prices which were commensurate with the retail

market but which were subsidized by Allen-Bradley so as to reduce

significantly the prices paid by the OEMs for those parts. These
 - 5 -

OEMs intentionally purchased more parts than needed for their

manufacturing process and resold the extra (surplus) parts to

petitioner at prices far less than the prices which the

authorized distributors paid Allen-Bradley for the same parts.

During the relevant years, petitioner also purchased

Allen-Bradley parts at fire sale prices from distressed companies

which had either overbought the parts for their own needs or gone

out of business.

Petitioner’s inventory during the relevant years included

approximately 50,000 different types of parts made by

Allen-Bradley, including many parts that Allen-Bradley no longer

manufactured but which were still used as replacement parts in

some older equipment. Petitioner sold its inventory throughout

the continental United States to approximately 1,100 customers at

prices that approximated the prices at which the authorized

distributors purchased those parts from Allen-Bradley.

Petitioner’s typical customers were (1) large plants, such as

General Motors Corp., that had a nonperforming part that had to

be replaced immediately rather than in the 2 or more days that it

took to receive a replacement part from an authorized

distributor, and (2) the authorized distributors of Allen-Bradley

parts who also needed a part immediately rather than in the 2 or

more weeks that it took to receive the part directly from

Allen-Bradley.
 - 6 -

The three OEMs sold their surplus parts to petitioner in

violation of an understanding that they had with Allen-Bradley to

not sell those parts other than as part of their finished

products or, in some cases, as replacement parts for those

products. Over the years, Beiner had developed a relationship

with the three OEMs such that they sold their surplus parts to

petitioner at the risk of Allen-Bradley’s declaring that it would

no longer sell parts to them or that it would do so only at

inflated prices. Allen-Bradley learned during the subject years

that one of the three OEMs, petitioner’s then-largest supplier,

was selling its surplus parts to petitioner. In 2000,

Allen-Bradley charged this OEM more for the parts, and petitioner

was unable to continue purchasing Allen-Bradley parts from that

OEM at favorable prices. Petitioner’s purchases from this OEM

dropped from $1,199,628.53 in 1999 (approximately 64 percent of

petitioner’s purchases during that year) to $28,505.36 in 2000.

To make up for this reduction, Beiner had petitioner purchase

more Allen-Bradley parts from the other two OEMs and take steps

to establish a relationship with a fourth OEM.

The three OEMs benefited from purchasing surplus parts and

selling them to petitioner in that they paid less per unit when

they purchased a greater quantity of parts which, in turn,

increased their profit margins on their sale of the finished

products. At least one of these OEMs also benefited from an
 - 7 -

improved cashflow in that petitioner typically paid for its

purchases within 10 days while the OEM usually had to wait at

least 45 days to be paid on its sale of a finished product. The

three OEMs were regularly asked by other persons to sell surplus

parts to them, but the OEMs always turned these requests down.

The three OEMs would have stopped selling their surplus parts to

petitioner had Beiner become disaffiliated with it.

B. Related Business

In 1997, Beiner and his brother incorporated California

Controls, Inc. (California Controls), whose business is the same

as petitioner’s except that the parts that each sells are made by

a different manufacturer. Beiner and his brother own California

Controls equally, and they share equally in making its business

decisions. During the subject years, Beiner worked for

California Controls approximately 19 hours a week, and it

compensated him for that work.

C. Beiner’s Background and His Management of Petitioner

Beiner was an electrical designer for 27 years before he and

his brother incorporated petitioner. In that capacity, Beiner,

either solely or with others, designed electrical systems for

high-rise office buildings, large hotels, shopping centers, and

numerous residential and commercial projects. Beiner’s salary at

the end of his career as an electrical designer was $90,000 to

$100,000 a year.
 - 8 -

During the subject years, Beiner’s knowledge, experience,

and relationships with the three OEMs were critical to

petitioner’s business and were indispensable to petitioner’s

operation and existence. He also negotiated prices and other

terms for petitioner, decided the price at which petitioner

bought and sold its inventory, and knew the uses for each part in

petitioner’s inventory. He established inventory controls,

purchased inventory, resolved with the three OEMs problems

concerning the shipment of parts to petitioner, and ascertained

the quantity of each part that petitioner had to maintain in its

inventory so that petitioner had a part when needed but did not

have too many parts that sat idly on the shelf. Petitioner had a

computerized accounting system that monitored its inventory and

allowed Beiner to set minimum and maximum amounts of each part

that should be in inventory at any one time. Generally once

during each subject year, Beiner reviewed the prior year’s sales

of each part, including whether anything unusual occurred during

the prior year that would have skewed those sales, and

established each part’s minimum and maximum amounts for each

month of the current year. Beiner’s system of inventory

generally allowed petitioner to turn over its inventory four

times a year.

Beiner also set petitioner’s corporate, accounting, and

financial policies, which petitioner’s other employees were not
 - 9 -

authorized to change, and reviewed petitioner’s financial

statements and other records. He decided the credit limit that

petitioner gave to each of its customers, and he was responsible

for petitioner’s exceptionally low number of uncollectible

receivables. He also directed and evaluated employee performance

and was responsible for hiring and firing all of petitioner’s

employees.

Petitioner conducted its business out of a warehouse with

small offices in front, and it dealt with its customers by

telephone rather than face to face. During the subject years,

Beiner worked directly for petitioner approximately 38 hours per

week, in addition to the approximately 19 hours per week which he

worked for California Controls, and he generally was at

petitioner’s warehouse approximately 85 percent of the hours in

its workweek. When he was away from the warehouse, he remained

accessible to his staff by cell phone, facsimile, and overnight

mail, and he continued to make all of petitioner’s managerial and

policy decisions and to direct and control petitioner’s business.

In January 2000, Beiner suffered a heart attack, and he

stayed away from petitioner’s warehouse for approximately 60

days. Petitioner’s business did not grow during that 60-day

period.
 - 10 -

D. Petitioner’s Other Employees

In addition to Beiner, petitioner employed five individuals

during the subject years. Each of these other employees reported

to Beiner. These other employees and their positions or the

departments in which they worked were as follows:

Name Position or Department

Adam Caldwell (Caldwell) Vice president and sales manager
Jennifer Shows (Shows)1 Purchasing manager
Becky Gonzalez (Gonzalez) Office manager
Frankki R. Andrade (Andrade) Receiving and sales
James T. Loftus (Loftus) Shipping
1
Shows is now named Jennifer Caldwell. We refer to her by
her former name, which was her name during the subject years.

Petitioner paid salaries to Caldwell, Shows, and Gonzalez in a

capacity that it designated during the subject years as

“clerical”. Petitioner paid salaries to Andrade and Loftus in a

capacity that it designated during the subject years as

“warehouse work”. Petitioner paid a salary to Beiner in a

capacity that it designated during the subject years as

“officer”.

Caldwell began working for petitioner in 1991, and he has

served as its vice president since 1992.3 During the subject

3
During the relevant years, petitioner’s officers were
Beiner, Caldwell, and Donna Marie Beiner. (The record does not
disclose the relationship, if any, between this woman and
Beiner.) In 1993, Caldwell was petitioner’s second vice
president, and Donna Marie Beiner was petitioner’s first vice
president. Since at least Dec. 3, 1995, Caldwell and Donna Marie
Beiner have both been vice presidents of petitioner, without any
(continued...)
 - 11 -

years, he oversaw the ministerial aspects of petitioner’s daily

operations. He also took orders for parts placed by petitioner’s

customers, informed petitioner’s customers about the pricing and

availability of those parts, and gave petitioner’s customers

technical support as to the use of those parts. He did not

solicit any business for petitioner, and he did not perform any

managerial duties. He regularly consulted with Beiner on matters

pertaining to petitioner’s business, including all matters which

required a managerial decision.

Shows also took orders for parts placed by petitioner’s

customers, in a capacity very similar to Caldwell’s. She spoke

with petitioner’s customers by telephone, and she entered those

orders into petitioner’s computer. She also helped enter other

information into the computer.

Gonzalez worked with petitioner’s finances, including its

payroll, accounts receivable, accounts payable, billing, and

invoicing. She also prepared certain monthly and weekly

financial reports for Beiner’s review. The weekly reports showed

the balances of petitioner’s bank accounts, accounts receivable,

open purchase orders, accounts that were 45 days or older, and a

6-week cash report. The monthly reports included profit and loss

statements, bank reconciliations, and sales information listed by

3
(...continued)
distinction in title.
 - 12 -

product and profit percentages. The sales information also

included the frequency and amount of each customer’s sales and

showed whether that customer was paying as required. Gonzalez

regularly discussed each of these weekly and monthly reports with

Beiner.

Gonzalez also was responsible for setting up petitioner’s

new sales accounts. She spoke to each new customer, performed a

credit check on the customer, and relayed the substance of her

conversation and the result of her credit check to Beiner along

with the customer’s request for credit. Beiner then decided the

amount of credit that petitioner would allow the new customer,

and Beiner relayed this decision back to Gonzalez. Gonzalez also

was responsible for ordering office supplies.

Andrade worked in the warehouse. She generally received the

parts which were purchased by and shipped to petitioner, verified

that the underlying orders were correct, and stocked those parts

in the warehouse. She also took orders for parts placed by

petitioner’s customers, verified that the requested parts were in

stock, processed the orders (including shipping the parts from

petitioner to its customers), and verified that the correct part

was shipped to the correct location. She also helped enter

information into petitioner’s computer.

Loftus was a shipping clerk. He assisted Andrade in the

warehouse.
 - 13 -

E. Petitioner’s Employee Compensation

In 1999, petitioner paid its employees the following

salaries (exclusive of bonuses), bonuses, and total compensation

(inclusive of bonuses):

Name Salary Bonus Total Compensation

Beiner $600,000.00 $487,000 $1,087,000.00
Caldwell 45,759.92 12,500 58,259.92
Shows 38,133.28 12,500 50,633.28
Gonzalez 37,440.08 5,000 42,440.08
Andrade 29,466.64 2,000 31,466.64
Loftus 24,266.64 2,000 26,266.64
Total 775,066.56 521,000 1,296,066.56

Petitioner deducted the $1,087,000 paid to Beiner as officer

compensation. Petitioner deducted the $209,067 paid to the other

employees as salaries and wages paid to nonofficers.

In 2000, petitioner paid its employees the following

salaries (exclusive of bonuses), bonuses, and total compensation

(inclusive of bonuses):

Name Salary Bonus Total Compensation

Beiner $600,000.00 $750,000 $1,350,000.00
Caldwell 53,806.72 17,500 71,306.72
Shows 44,433.32 15,000 59,433.32
Gonzalez 44,086.68 7,500 51,586.68
Andrade 34,366.60 3,000 37,366.60
Loftus 29,160.00 2,500 31,660.00
Total 805,853.32 795,500 1,601,353.32

Petitioner deducted the $1,350,000 paid to Beiner as officer

compensation. Petitioner deducted the $251,353 paid to the other

employees as salaries and wages paid to nonofficers.
 - 14 -

Petitioner did not have a formal compensation plan, and it

did not have a written employment agreement with Beiner. During

each subject year, petitioner generally paid its employees other

than Beiner one twenty-fourth of their annual salary on the 1st

and the 15th of each month, and it paid them bonuses on December

31. During both years, Beiner generally was entitled to a fixed

salary of $50,000 per month and a bonus in December. Beiner did

not always receive the monthly salary to which he was entitled

when he was entitled to it because of problems that petitioner

experienced with its cashflow. During 1999, petitioner paid

$25,000 in salary to Beiner on January 1, September 1, September

15, October 1, October 15, November 1, November 15, December 1,

and December 15, and it paid $862,000 (inclusive of the $487,000

bonus) to Beiner on December 31. During 2000, petitioner paid

$25,000 in salary to Beiner on January 1, January 15, February 1,

February 15, June 1, June 15, July 1, July 15, August 1, August

15, September 1, September 15, October 1, October 15, November 1,

November 15, December 1, and December 15, and it credited him

with two payments of $450,000 (inclusive of the $750,000 bonus)

on December 31.

In December of each subject year, petitioner’s accountant,

Thomas Gallardo (Gallardo), met with Beiner to ascertain the

bonus that petitioner paid to Beiner during that year.

Petitioner generally ascertained each bonus by using a formula
 - 15 -

that took into account its sales and profit for that year,

Beiner’s work during that year, and the amount of its profit that

it needed to retain at the end of that year for its operation

after that year.

F. Petitioner’s Financial Condition

Petitioner was established with a capital contribution of

$7,000. As of December 31, 1999 and 2000, petitioner reported

that its shareholder equity consisted of the following:

1999 2000

Common stock $7,000 $7,000
Retained earnings 365,513 747,857
372,513 754,857

For 1999 and 2000, petitioner’s gross and net sales

(collectively, sales), costs of goods sold, gross profits,

taxable income, total taxes, and net income, each as reported,

and the ratios of its gross profits to its sales, expressed as

percentages, were as follows:

1999 2000

Sales $3,473,802 $3,485,568
Cost of goods sold 1,760,084 1,064,976
Gross profit 1,713,718 2,420,592

Taxable income 143,926 579,984
Total tax 39,381 197,195
Net income 104,545 382,789

Ratio of gross profits to sales 49.3 69.4

In petitioner’s first taxable year of operation, a period of

32 weeks that ended on December 31, 1991, its sales totaled
 - 16 -

$184,449. Petitioner reported a small loss for that 32-week

period and reported profits in each year since through 2000.

Petitioner has never paid a dividend. Its return on equity

using average annual shareholder equity was as follows for 1991

through 2000:

Year Return on Equity

1991 -102.2%
1992 113.6
1993 70.0
1994 82.0
1995 23.7
1996 39.1
1997 28.9
1998 20.0
1999 32.6
2000 67.9

G. Martin Wertlieb (Wertlieb)

Wertlieb testified at trial as petitioner’s witness. The

parties stipulated that Wertlieb was an expert on executive

compensation, and the Court recognized him as such.4 Wertlieb

has worked for over 30 years in the compensation and personnel

field, and he currently heads his own compensation consulting

firm. He has advised a wide range of clients on the subject of

executive compensation, and he has testified before both Congress

and the courts as an expert on executive compensation. He opined

in this case that

4
Respondent also called an individual (James F. Carey) to
testify as an expert on compensation but withdrew that individual
before he was recognized as an expert.
 - 17 -

Based on the facts and circumstances of this case; our
understanding of the importance of Mr. Beiner’s
contribution to the very existence and success of the
business; our analysis of compensation paid to chief
executives in other comparable companies; the financial
performance of Beiner, Inc., during the years in
question as compared to the financial performance of
other similar wholesaler distributors; and our
knowledge, judgment and experience in executive
compensation, it is my opinion that Mr. Beiner’s
reasonable compensation for the year ending
December 31, 1999 was $906,740 and that his reasonable
compensation for the year ending December 31, 2000 was
$1,533,093.

The relevant standard industrial classification (SIC) codes

5063 and 5065 include every (34 in total) publicly held wholesale

distributor of electrical or electronic parts and components that

filed reports with the Securities and Exchange Commission (SEC)

during 1999 and 2000. In reaching his opinion, Wertlieb reviewed

the financial statements of each of these companies and noted

their sales, pretax income, and chief executive officer

compensation. He broke that compensation into two parts. The

first part, “fixed compensation”, included annual salary and the

value of any special benefits reported as “other compensation” in

the company*s SEC filings. The second part, “variable

compensation”, included annual bonuses contingent on company

profits and the value of any stock awards or longterm incentive

payouts made during the year. The fixed compensation paid by the

34 companies ranged from $70,123 to $1,439,676 and averaged

$399,426. The variable compensation paid by the 34 companies

ranged from zero to approximately $3.4 million. The relationship
 - 18 -

between variable compensation and company profits ranged from 0

to 64.4 percent.

Wertlieb testified that the fixed compensation paid to a

chief executive officer typically correlates with the sales of

his or her company and that this correlation may be expressed in

a mathematical formula that may be used to calculate the

“average” fixed compensation for the chief executive officer of

any size company near and within the range of the data. Wertlieb

testified that variable compensation of a chief executive officer

also correlates with his or her company’s sales. Wertlieb

concluded that Beiner’s reasonable compensation for each subject

year equaled the sum of: (1) Petitioner*s gross profit less the

gross profit that petitioner would have realized had it performed

at the ratio of gross profit to sales corresponding to the 90th

percentile of the 34 companies (31.49 percent for 1999 and 34.47

for 2000) (excess gross profits), (2) fixed compensation

consistent with the nature and size of petitioner and the amounts

paid at the 90th percentile of the 34 companies, as ascertained

using the referenced correlation for fixed compensation, and

(3) variable compensation consistent with prevailing executive

incentive practices and contingent on the level of sales and

profit performance, as ascertained using the referenced

correlation for variable compensation. Wertlieb calculated these

amounts as follows:
 - 19 -

1999 2000

Excess gross profits $619,740 $1,219,270
Reasonable salary 166,000 166,000
Reasonable incentive 121,000 147,823
Total 906,740 1,533,093

As further support for his opinion, Wertlieb also calculated

and compared for petitioner and each of the 34 companies (1) the

percentage return on equity and (2) the ratio (expressed as a

percentage) of gross profit to sales. As to the former, Wertlieb

calculated petitioner’s pretax return on equity (taxable income

as ascertained by Wertlieb divided by ending shareholder equity)

as follows:

1999 2000

Sales $3,473,802 $3,485,568
Cost of goods sold 1,760 084 1,064,976
Gross profit 1,713,718 2,420,592
Gross profit at 90th percentile 1,093,978 1,201,322
Excess gross profit 619,740 1,219,270
Reasonable salary 166,000 166,000
Reasonable incentive 121,000 147,823
Total reasonable compensation 906,740 1,533,093
Officer compensation deducted 1,087,000 1,350,000
Over (under) reasonable 180,260 (183,093)
Taxable income, as reported 143,926 579,984
Adjusted taxable income 324,186 396,891
1
Shareholder equity at end of year 372,857 754,857
Pretax return on equity 86.9% 52.6%
1
This amount was actually $372,513. We consider
the difference in figures immaterial to our analysis.

He compared these returns to the 34 companies as follows:
 - 20 -

Taxable Income As
a Percentage of
Shareholder Equity

1999 2000

Petitioner 86.9% 52.6%
SIC code 5063 and 5065
companies:
High 49.9 49.5
90th Percentile 29.1 34.9
3d Quartile 21.6 23.6
Median 12.8 12.6
Mean 1.6 -46.7

He concluded from this calculation that approximately one-third

of the 34 companies lost money for their shareholders in each of

the analyzed years and that the return on equity produced by

petitioner in both subject years exceeded the maximum return of

any of the 34 companies.

As to the latter calculation, the ratio of gross profit to

sales (expressed as a percentage), Wertlieb calculated for

petitioner and each of the 34 companies the following

percentages:

Gross Profit As A
Percentage of Sales

1999 2000

Petitioner 49.3% 69.4%
SIC code 5063 and 5065
companies:
High 50.6 48.2
90th Percentile 31.5 34.5
Median 20.4 22.5
Mean 20.4 22.1
10th Percentile 8.6 9.0
 - 21 -

Wertlieb concluded that petitioner outperformed the 34 companies

in terms of that calculation with one exception in 1999.

OPINION

A. Deduction of Compensation Paid to Beiner

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

deduct as reasonable compensation the portion of the officer

compensation claimed paid to Beiner and disallowed by respondent

in the notice of deficiency.5 A payment of compensation is

deductible under section 162(a)(1) only if it is both (1)

reasonable in amount and (2) paid 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); LabelGraphics, Inc. v.

Commissioner, 221 F.3d 1091, 1095 (9th Cir. 2000), affg. T.C.

Memo. 1998-343; O.S.C. & Associates, Inc. v. Commissioner,

187 F.3d 1116, 1119-1120 (9th Cir. 1999), affg. T.C. Memo.

1997-300; Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243

(9th Cir. 1983), revg. and remanding T.C. Memo. 1980-282;

Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 362 (9th Cir.

5
Sec. 162(a)(1) 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;
 - 22 -

1974), affg. T.C. Memo. 1971-200; Pac. Grains, Inc. v.

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

1967-7; Haffner’s Serv. Stations, Inc. v. Commissioner, T.C.

Memo. 2002-38, affd. 326 F.3d 1 (1st Cir. 2003); sec. 1.162-7(a),

Income Tax Regs. Petitioner conceded at trial that it must prove

that section 162(a)(1) allows it to deduct compensation in an

amount greater than that determined by respondent.6 See Rule

142(a)(1); see also LabelGraphics, Inc. v. Commissioner, supra at

1095. Careful scrutiny of the facts is appropriate in a case

such as this where the payor is controlled by a payee/employee.

Elliotts, Inc. v. Commissioner, supra at 1243; Paul E. Kummer

Realty Co. v. Commissioner, 511 F.2d 313, 315-316 (8th Cir.

1975), affg. T.C. Memo. 1974-44; Haffner’s Serv. Stations, Inc.

v. Commissioner, supra. We must be persuaded that the purported

compensation was paid for services rendered by the employee, as

opposed to a distribution of earnings to him that the payor could

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

1995-153 (and the cases cited therein).

Respondent argues in his brief that the disallowed

compensation was neither reasonable nor paid for Beiner’s

services. Respondent asserts that the disallowed compensation

represented funds that petitioner did not need for its operation

6
Given this concession, we conclude that sec. 7491(a),
which in certain circumstances places the burden of proof upon
the Commissioner, is not applicable here.
 - 23 -

and had to expend to avoid the accumulated earnings tax of

section 531. Respondent asserts that Beiner performed minimal,

nonspecialized services for petitioner during each subject year

and that those services did not entitle petitioner to deduct the

disputed payments as compensation. Petitioner argues in its

brief that the disallowed compensation was reasonably paid to

Beiner for his services. Petitioner asserts that Beiner was

skilled in and deeply involved with petitioner’s business and

that his services resulted in petitioner’s realizing a superior

return on equity in each subject year. Petitioner asserts that

these rates of return would have caused a hypothetical inactive

independent investor to pay Beiner the same amount of

compensation that petitioner paid him during those years.

In support of their arguments, both parties rely upon the

opinion of the Court of Appeals for the Ninth Circuit in

Elliotts, Inc. v. Commissioner, supra at 1245-1248. Because this

case is most likely appealable to that court, see sec.

7482(b)(1)(B), we do the same, see Golsen v. Commissioner,

54 T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

Pursuant to that opinion, we generally determine the

deductibility of the compensation paid to Beiner by focusing on

its reasonableness, and we decide that reasonableness by

considering five factors from the perspective of a hypothetical

inactive independent investor. Elliotts, Inc. v. Commissioner,
 - 24 -

supra at 1243-1245. The five factors are: (1) The employee’s

role in the company; (2) a comparison of the compensation paid to

the employee with the compensation paid to similarly situated

employees in similar companies (external comparison); (3) the

character and condition of the company; (4) whether a conflict of

interest existed that might have permitted the company to

disguise dividend payments as deductible compensation; and (5)

whether the company’s payments of compensation to all of its

employees were internally consistent (internal consistency). Id.

at 1245-1248. As to each factor, we ask ourselves the following

question: “Would a hypothetical inactive independent investor

consider the factor favorably to require the payment of the

disputed compensation to Beiner in order to retain his services

during each of the subject years?” See Haffner’s Serv. Stations,

Inc. v. Commissioner, supra; cf. Elliotts, Inc. v. Commissioner,

supra at 1245. An answer in the negative indicates that the

payment of the compensation was not sufficiently tied to Beiner’s

services to constitute personal service income but was more

likely a distribution of earnings. An answer in the affirmative

supports deducting the disputed compensation as personal service

compensation. A relevant consideration in answering our question

is whether the hypothetical inactive independent investor, after

taking into account the amount of the compensation paid to

Beiner, would receive at least the minimum return anticipated on
 - 25 -

an investment in petitioner. See Elliotts, Inc. v. Commissioner,

716 F.2d at 1245; Haffner’s Serv. Stations, Inc. v. Commissioner,

supra.

We are assisted in this case by Wertlieb. In light of his

qualifications and with due regard to all other credible evidence

in the record, we consider Wertlieb’s training, knowledge, and

judgment to be most helpful to our understanding of the executive

compensation issue at hand. See Fed. R. Evid. 702; Snyder v.

Commissioner, 93 T.C. 529, 534 (1989). Wertlieb testified at

trial through his expert report (report). See Rule 143(f). The

Court accepted that report into evidence without any objection

from respondent. Respondent also declined to cross-examine

Wertlieb as to its contents.

We turn to the five factors and analyze them seriatim. None

of these factors is decisive in and of itself. LabelGraphics,

Inc. v. Commissioner, 221 F.3d at 1095.

1. Employee’s Role in the Company

We analyze Beiner’s role in petitioner’s business. A

relevant consideration is his general importance to petitioner’s

success. See Elliotts, Inc. v. Commissioner, supra at 1245.

Other considerations include his position, hours worked, and

duties performed. See id.

Beiner is an experienced electrical designer who had the

devotion, dedication, intelligence, foresight, and skill to
 - 26 -

tailor petitioner’s business to the exclusive sale of

Allen-Bradley parts and to manage petitioner’s business

profitably throughout the subject years. At all relevant times,

he was petitioner’s chief executive officer, chief financial

officer, president, secretary, and treasurer, and, in those

capacities, he performed duties the nature, extent, and scope of

which were fundamental, substantial, and encompassing. He was

primarily responsible for petitioner’s extraordinary growth, he

was irreplaceable in petitioner’s business operation and

important to its success, and his services performed for

petitioner were directly and inextricably related to the volume

of its sales. In fact, when Beiner was unable to frequent

petitioner’s warehouse for the 60-day period in 2000, its sales

ceased to grow.

Although Beiner did not work exceptionally long hours in

petitioner’s business during the subject years (he worked for

petitioner an average of approximately 38 hours per week), nor

devote 100 percent of his time to that business (he additionally

worked approximately 19 hours a week for California Controls), he

cofounded petitioner’s business and has worked there continuously

since its inception in a managerial capacity as its primary

officer and its most valuable employee. In addition, his role

was distinguishable from the role of each of petitioner’s other

employees, all of whom he directed and supervised, in that they,
 - 27 -

unlike he, performed clerical, nonmanagerial work. Petitioner’s

business would have suffered dramatically, if not ceased

altogether, had Beiner disaffiliated himself from petitioner

during the subject years; any void created by his loss could not

have been filled by one or more other employees. Moreover, as

noted by Wertlieb, employees such as Beiner are not paid on an

hourly basis but are paid for their leadership, knowledge, and

experience and for their ultimate accountability in achieving

company goals. In this regard, Wertlieb noted, Beiner was the

locomotive of petitioner’s business, and, but for him, petitioner

would not have been able to obtain its inventory at the discount

prices that allowed it to function as profitably as it did. In

fact, Wertlieb noted, the special relationships which Beiner

developed with the three OEMs allowed petitioner to report

greater gross profit margins and returns on sales and investment

than virtually any other similar public company for which data

was available for 1999 and 2000.

Respondent concedes that Beiner played an “important” role

in petitioner’s business. However, respondent asserts, Beiner’s

services were nonspecialized, Beiner spent little time in

petitioner’s business, Beiner devoted a significant amount of his

time to working for California Controls, and Beiner’s brother was

a primary income-producing factor in petitioner’s business.
 - 28 -

Respondent concludes that Beiner’s services for petitioner did

not entitle it to pay to him the compensation that it did.

We disagree with respondent’s assertions and conclusion. As

we see it, the most important element of petitioner’s business

was its purchase of Allen-Bradley parts at prices less than those

paid by the authorized distributors, and those purchases at those

prices were the direct product of one employee; i.e., Beiner.

But for petitioner’s employment of Beiner, petitioner would not

have been able to obtain its Allen-Bradley inventory and to

operate as profitably as it did, let alone to even operate at

all. Given the double-digit rates of return on petitioner’s

equity during the subject years, we believe that a hypothetical

inactive independent investor who was knowledgeable of Beiner’s

role in petitioner’s operation and the significant effect that he

had upon its profitability would have paid the disputed

compensation to Beiner in order to retain his services.

Moreover, contrary to respondent’s assertion, Beiner did not

spend little time in petitioner’s business during each subject

year. While respondent asks the Court to find as a fact that

Beiner worked in petitioner’s business approximately 6 to 10

hours per week during the subject years and that Caldwell was at

that time the business’s spearhead, the credible evidence in the

record supports a contrary finding, which we make, that Beiner

during the subject years worked in petitioner’s business
 - 29 -

approximately 38 hours a week as its most valuable employee. Nor

does the record support respondent’s second assertion that

Beiner’s brother was a primary income-producing factor in

petitioner’s business. When Beiner caused petitioner in 1992 to

limit its business to Allen-Bradley parts, Beiner’s brother

disaffiliated himself entirely from any continued participation

in the business. Although respondent notes correctly in his

third assertion that Beiner spent approximately one-third of his

time during the subject years working for California Controls,

respondent ignores in this regard that Beiner spent the other

two-thirds of his time working for petitioner in a role that was

most significant to its existence and profitability.

We conclude that a hypothetical inactive independent

investor would consider this factor favorably to require the

payment of the disputed compensation to Beiner in order to retain

his services during each of the subject years.

2. External Comparison

This factor compares the employee’s salary with the salaries

paid by similar companies for similar services. Elliotts, Inc.

v. Commissioner, 716 F.2d at 1246.

Wertlieb’s testimony is the only evidence in the record as

to this factor. Wertlieb reviewed the financial statements of

the 34 referenced companies and the compensation paid to their

chief executive officers. Wertlieb opined that petitioner was
 - 30 -

substantially more profitable than virtually all of the 34

companies in terms of the ratio of gross profit to sales.

Wertlieb opined that petitioner returned more as a percentage of

equity to its investor than any of the 34 companies returned to

their investors. Wertlieb concluded that Beiner’s reasonable

compensation for the respective subject years was $906,740 and

$1,533,093 and that these amounts were consistent with the

salaries paid by similar companies for similar services.

Wertlieb noted that Beiner was performing the functions of a wide

range of employees.

Respondent argues that we should ignore the “Excess Gross

Profits” portion of Wertlieb’s report as to Beiner’s reasonable

compensation because, respondent states: “Wertlieb provided no

evidence that any of the companies he surveyed employed such a

compensation plan.” We decline to do so. First, experts, but

for their testimony, are not the source of evidence; the parties

are. See United States v. Scheffer, 523 U.S. 303, 317 n. 13

(1998). Second, Wertlieb’s testimony, all of which was credible

and without contradiction, was that an employer such as

petitioner may pay an employee such as Beiner reasonable

compensation inclusive of all gross profit in excess of the gross

profit that the employer would have realized had it performed at

the 90th percentile of similar public companies. In a case such

as this, where Beiner’s services were directly, if not solely,
 - 31 -

related to petitioner’s realization of those excess gross

profits, we agree with Wertlieb that petitioner is entitled to

pay those profits to Beiner as compensation for his work. See

Elliotts, Inc. v. Commissioner, supra at 1248.

We conclude that a hypothetical inactive independent

investor would consider this factor favorably to require the

payment of up to $906,740 and $1,533,093 in compensation to

Beiner in the respective years in order to retain his services

during each of those years.

3. Character and Condition of the Company

This factor concerns petitioner’s character and condition.

The focus of this factor may be on petitioner’s size as indicated

by its sales, net income, or capital value. The complexities of

petitioner’s business and the general economic conditions are

also relevant. Id. at 1246.

Petitioner was established in 1991 with a $7,000 capital

contribution. In each year after its first short taxable year,

petitioner was an extremely well-managed, profitable company in

that it experienced extraordinary growth in sales and shareholder

equity. During the respective subject years, its sales totaled

$3,473,802 and $3,485,568, and its gross profit totaled

$1,713,718 and $2,420,592. At the end of the respective years,

its shareholder equity totaled $372,513 and $754,837. During the

subject years, its customers were located throughout the United
 - 32 -

States and totaled approximately 1,100. In short, petitioner had

during the subject years a strong character and a strong

financial condition.

Respondent argues that petitioner was a simple (as opposed

to complex) business that required few personal skills. We

disagree. During the respective subject years, neither

petitioner’s sales nor its gross profits could have been attained

but for the personal skill of Beiner in obtaining Allen-Bradley

parts at prices less than those at which the same types of parts

were sold to the authorized distributors.7 Although petitioner’s

business may not be the most complex business in operation, we do

not consider it to have been a simple task for petitioner to have

purchased its Allen-Bradley inventory from the three OEMs at

deeply discounted prices given their agreement with Allen-Bradley

not to sell those parts at all except in a very limited situation

that did not apply here.

We conclude that a hypothetical inactive independent

investor would consider this factor favorably to require the

payment of the disputed compensation to Beiner in order to retain

his services during each of the subject years.

7
We find nothing in the record to indicate that these sales
were attributable to the general economic conditions.
 - 33 -

4. Conflict of Interest

This factor focuses on whether a relationship exists between

the corporation and its employee which might allow the

corporation to disguise nondeductible dividends as deductible

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

an exploitation of a relationship may exist where, as here, the

employee is the corporate employer’s sole shareholder. Id.

The mere existence of such a relationship, however,
when coupled with the absence of dividend payments,
does not necessarily lead to the conclusion that the
amount of compensation is unreasonably high. * * *

In such a situation, * * * it is appropriate to
evaluate the compensation payments from the perspective
of a hypothetical independent investor. If the bulk of
the corporation’s earnings are being paid out in the
form of compensation, so that the corporate profits,
after payment of the compensation, do not represent a
reasonable return on the shareholder’s equity in the
corporation, then an independent shareholder would
probably not approve of the compensation arrangement.
If, however, that is not the case and the company’s
earnings on equity remain at a level that would satisfy
an independent investor, there is a strong indication
that management is providing compensable services and
that profits are not being siphoned out of the company
disguised as salary. [Id. at 1246-1247.]

Accord LabelGraphics, Inc. v. Commissioner, 221 F.3d at 1099. In

Elliotts, Inc. v. Commissioner, supra at 1247, the Court of

Appeals for the Ninth Circuit concluded that the 20-percent

average rate of return on equity for the 2 years at issue there

would satisfy a hypothetical inactive independent investor and

indicate that the corporate employer and its shareholder/employee

were not exploiting their relationship.
 - 34 -

Petitioner’s return on equity (net income/shareholder equity

at the end of the year) during the subject years was 28.1 percent

and 50.1 percent, respectively (104,545/372,513;

382,789/754,857). Petitioner’s consistently high return on

equity resulted in an increase in shareholder equity from $7,000

to over $754,000 during petitioner’s short existence through

2000. We believe that returns of this magnitude would satisfy an

independent investor.

Respondent asserts that petitioner during the respective

subject years paid Beiner 31.3 and 38.7 percent of its gross

receipts and 88.3 and 69.9 percent of its net income (adding back

compensation). Respondent points the Court to Alpha Med. Inc. v.

Commissioner, 172 F.3d 942, 948 (6th Cir. 1999), revg. T.C. Memo.

1997-464, where the Court of Appeals for the Sixth Circuit held

that payments to a sole shareholder of 44.9 percent of gross

receipts and 64.6 percent of net income were unreasonable.

Respondent concludes that the compensation payments to Beiner

also were unreasonable.

We disagree with respondent that the mere fact that a

corporation pays its most valuable employee compensation in an

amount exceeding a certain percentage of gross receipts or net

income means that part or all of the compensation is

unreasonable. The amount of reasonable compensation that may be

paid to a corporate officer such as Beiner is a question of fact
 - 35 -

that must be resolved on the basis of all credible evidence in

the record. See Pac. Grains, Inc. v. Commissioner, 399 F.2d at

605. Here, Beiner was vital and indispensable to petitioner’s

success and performed for petitioner services which were directly

and inextricably tied to petitioner’s profitability. In

addition, from the view of a hypothetical inactive independent

investor, the returns on equity after taking into account the

disputed compensation payments were meaningful.

We conclude that a hypothetical inactive independent

investor would consider this factor favorably to require the

payment of the disputed compensation to Beiner in order to retain

his services during each of the subject years.

5. Internal Comparison

Evidence of internal inconsistency in a company’s treatment

of payments to its employees may indicate the presence of

unreasonable compensation. Elliotts, Inc. v. Commissioner, supra

at 1247.

Respondent argues that the compensation that petitioner paid

to Beiner vis-a-vis its nonowner/officer Caldwell and to Beiner

vis-a-vis all of its employees shows that Beiner’s compensation

was unreasonable. We disagree. As previously stated, we believe

that a hypothetical inactive independent investor would view

Beiner’s compensation during 1999 and 2000 as reasonable. The

fact that petitioner paid Beiner compensation that was much
 - 36 -

greater than the separate or collective compensation that it paid

to its employees who worked under Beiner is explained by noting

that petitioner’s profits were derived almost exclusively through

the all-encompassing, far-reaching efforts of Beiner and that

petitioner’s other employees had limited roles in that

profitability.

We conclude that a hypothetical inactive independent

investor would consider this factor favorably to require the

payment of the disputed compensation to Beiner in order to retain

his services during each of the subject years.

6. Compensatory Intent

In addition to our decision on the five factors just

discussed, respondent invites the Court to decide petitioner’s

intent in making the disputed payments to Beiner. Specifically,

respondent argues, the compensation paid to Beiner was not paid

with the requisite compensatory intent but represented the

earnings that petitioner did not need to retain in its operation

and had to expend to avoid the accumulated earnings tax of

section 531. Respondent supports this argument by asserting that

petitioner has never paid a dividend, that petitioner paid Beiner

compensation in 1999 and 2000 equal to 88.3 and 69.9 percent of

those respective years’ net income, and that Beiner’s

compensation increased during those years from $970,000 to

$1,350,000 although, respondent states, Beiner reduced his hours
 - 37 -

during those years almost fourfold to approximately 6 to 10 hours

per week.

We decline respondent’s invitation to decide petitioner’s

intent in making the disputed payments to Beiner. This case is

not one of those “rare [cases] where there is evidence that an

otherwise reasonable compensation payment contains a disguised

dividend * * * [so that our] inquiry may expand into compensatory

intent apart from reasonableness”. Elliotts, Inc. v.

Commissioner, 716 F.2d at 1244-1245; cf. O.S.C. & Associates,

Inc. v. Commissioner, 187 F.3d 1116 (9th Cir. 1999). Contrary to

respondent’s assertion, petitioner did not ascertain Beiner’s

compensation simply by ascertaining the earnings that it needed

to retain in its operation and the earnings that it had to expend

to avoid the accumulated earnings tax of section 531. Petitioner

set Beiner’s salary at $50,000 per month at or before the

beginning of the subject years, and it ascertained Beiner’s bonus

for each of those years by taking into account petitioner’s sales

and profit for that year, Beiner’s work during that year, and the

amount of petitioner’s profits that petitioner needed to retain

for its future operation. Indeed, after the bonuses were paid

for the subject years, petitioner even retained a meaningful

amount of its earnings upon which it paid significant Federal

income taxes.
 - 38 -

In addition, the fact that petitioner has never paid a

dividend does not control our analysis. As the Court of Appeals

for the Ninth Circuit stated in a similar setting, the court will

“not presume an element of disguised dividend from the bare fact

that a profitable corporation does not pay dividends.” Elliotts,

Inc. v. Commissioner, supra at 1244. Nor is it decisive that

petitioner may have paid Beiner compensation in 1999 and 2000

equal to 88.3 and 69.9 percent of those respective years’ net

income. As we stated supra in rejecting the same argument, the

amount of reasonable compensation that may be paid to a corporate

officer such as Beiner is a question of fact that must be

resolved on the basis of all credible evidence in the record.

Finally, from a factual point of view, we have already noted our

disagreement with respondent’s proposed finding that Beiner

reduced the number of hours that he worked in petitioner’s

business during the subject years.

7. Conclusion

We have concluded as to four of the five factors that a

hypothetical inactive independent investor would pay the disputed

compensation to Beiner in order to retain his services during

each of the subject years. We have concluded as to the remaining

factor, namely, an external comparison, that a hypothetical

inactive independent investor would limit Beiner’s compensation

in the subject years to $906,740 and $1,533,093, respectively.
 - 39 -

On the balance, we believe that Beiner’s reasonable

compensation for 1999 should be capped at $906,740, as testified

by Wertlieb. That testimony takes into account the comparative

salaries in the industry which we believe is most relevant to our

decision herein. See Metro Leasing & Dev. Corp. v. Commissioner,

376 F.3d 1015, 1119 (9th Cir. 2004) (the fact that a hypothetical

inactive independent investor would pay an employee compensation

equal to an amount in dispute is not decisive in and of itself),

affg. T.C. Memo. 2001-119; see also Menard, Inc. v. Commissioner,

T.C. Memo. 2004-207 (although compensation paid to an employee

may satisfy the independent investor test of Exacto Spring Corp.

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

Commissioner, T.C. Memo. 1998-220, the compensation may be

unreasonable within the context of section 162(a)(1) to the

extent that it exceeds the compensation paid by a comparable

company to a similarly situated employee). Although Wertlieb

also testified that Beiner’s compensation for both subject years

was really only overstated by $2,833; i.e., the amount by which

the $2,437,000 paid to him during both years ($1,087,000 +

$1,350,000) exceeded the $2,439,833 of reasonable compensation

ascertained by Wertlieb for those years ($906,740 + $1,533,093),

we believe it appropriate to view each year separately rather

than collectively and hold that petitioner correctly reported

Beiner’s compensation for 2000 but overreported his compensation
 - 40 -

for 1999 by $180,260 ($1,087,000 - $906,740). While there is

firm authority for the proposition that compensation paid in one

year may be deductible in that year if paid to make up for

undercompensation of services rendered to the payor in or before

the year of payment, e.g., Lucas v. Ox Fibre Brush Co., 281 U.S.

at 119, the same is not true in the case of a payment for

services to be performed in the future, e.g., Maple v.

Commissioner, T.C. Memo. 1968-194, affd. 440 F.2d 1055 (9th Cir.

1971). Moreover, from a factual point of view, petitioner makes

no claim that the $180,260 was paid in 1999 for services that

Beiner would render in 2000. We hold that Beiner’s reasonable

compensation for the subject years was $906,740 and $1,533,093,

respectively.

B. Accuracy-Related Penalty for 2000

Respondent also determined that petitioner was liable for an

accuracy-related penalty under section 6662(a) and (b)(1). That

section in relevant part 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.
 - 41 -

Petitioner, in order to prevail, must prove respondent’s

determination wrong. See Rule 142(a).8 Petitioner argues in

part that it is not liable for the accuracy-related penalty

because it did not exploit its relationship with Beiner in paying

him the compensation that it did. Respondent rebuts that

petitioner is liable for the accuracy-related penalty because it

distributed money to Beiner as compensation without any regard to

the value of his services and without any formal compensation

plan.

We agree with petitioner that it is not liable for the

accuracy-related penalty. That penalty does not apply to an

underpayment to the extent that the taxpayer exercised ordinary

business care and prudence as to the underpayment. Sec. 6664(c);

secs. 1.6662-3(a), 1.6664-4(a), Income Tax Regs.; see also United

States v. Boyle, 469 U.S. 241 (1985). The record persuades us

that petitioner exercised ordinary business care and prudence as

to its deduction of the unreasonable compensation of $180,260.

Beiner, on behalf of petitioner, met with Gallardo each December

to set the bonus that petitioner paid to Beiner during that year,

and petitioner generally ascertained that bonus by taking into

account certain factors including Beiner’s work during the year.

8
Pursuant to sec. 7491(c), the Commissioner bears the
burden of production in this Court “with respect to the liability
of any individual for any [accuracy-related] penalty” under sec.
6662(a). Because petitioner is not an individual, that section
has no applicability here.
 - 42 -

The compensation paid to Beiner also left enough of petitioner’s

profits for that year in petitioner’s equity so as to constitute

a meaningful return to a hypothetical inactive independent

investor. We hold that petitioner is not liable for the

accuracy-related penalty determined by respondent as to the

$180,260 of disallowed compensation for 1999.

All arguments have been considered, and those arguments not

discussed herein are without merit.

Decision will be entered

under Rule 155.