Miller & Sons Drywall, Inc. v. Comm'r

T.C. Memo. 2005-114

UNITED STATES TAX COURT

MILLER & SONS DRYWALL, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 1241-03. Filed May 19, 2005.

Rodger G. Mohagen, for petitioner.

David W. Sorensen, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GOEKE, Judge: On January 6, 2003, respondent issued a

notice of deficiency determining Federal income tax deficiencies

for petitioner’s tax years ended June 30, 1998, 1999, and 2000,

of $82,686, $83,016, and $103,855, respectively. Among other

things, respondent partially disallowed petitioner’s deductions

for compensation paid to its shareholder-employees of $204,577 in
 - 2 -

1998, $242,227 in 1999, and $292,474 in 2000. Respondent

disallowed these deductions because he determined that the

compensation petitioner paid to its shareholder-employees was

unreasonable under section 162(a).1 Petitioner timely petitioned

this Court. After concessions, the remaining issue for decision

is whether petitioner’s payments to its shareholder-employees

were reasonable for the years in issue. We hold that they were.

FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference. When petitioner

petitioned this Court, its principal place of business was in

Fargo, North Dakota.

A. General Background

Darle Miller (Darle) and his father entered the drywall

construction business in the mid-1970s. Darle acquired the

drywall construction business from his father before 1980 and

initially operated it as a sole proprietorship. Darle

incorporated the business on July 1, 1980, as a C corporation.

Darle paid $2,000 for 200 shares of petitioner’s stock, and

Darle’s brother Dean Miller (Dean) paid $2,500 for 50 shares of

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect during the years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
 - 3 -

petitioner’s stock.2 On June 30, 1982, Dean paid $2,150 to

petitioner for 43 additional shares of its stock, and Darle’s

other brother Rocky Miller (Rocky) paid $4,650 to petitioner for

93 shares of stock. From June 30, 1982, until June 30, 2000,

petitioner was owned by the three brothers as follows:

Shareholder Percent Ownership

Darle Miller 51.8%
Dean Miller 24.1
Rocky Miller 24.1

Since its inception, petitioner’s tax year has ended June 30.

B. Petitioner’s Business

Petitioner’s primary business was interior wall

construction. Wall construction includes the placing of studs,

insulating the walls, hanging drywall and other wall materials as

required, and drywall taping (collectively, the drywall

construction business). Since the early 1990s, petitioner has

limited its geographic business area to Fargo, North Dakota, and

Moorhead, Minnesota.

Petitioner was a subcontractor. It was awarded construction

jobs from general contractors by submitting the lowest bid to

complete a specific job (a lowest bid commodity business).

Petitioner primarily bid on commercial construction projects.

After being awarded a job, petitioner purchased the supplies

2
The record is devoid of an explanation why Darle paid less
than Dean for each share of petitioner’s stock.
 - 4 -

Darle anticipated it needed to complete the job and arranged for

them to be delivered to the job site. Petitioner maintained a

small inventory of drywall, studs, and mud at its warehouse.

C. Competition in the Drywall Business

The drywall construction business is a competitive industry

because jobs are generally awarded to the lowest bidder, and

because a minimal capital investment allows a competitor to enter

the drywall construction industry. A drywall construction

business is established with a capital investment of about $300,

which is used to purchase a tool belt, a screw gun and cord, and

a T-square. There are no proficiency exam requirements, but

petitioner is required to have a contractor’s license to place

its bids with general contractors.

D. Petitioner’s Shareholder-Employees

1. Darle Miller

Darle was the chief executive officer (CEO) and president of

petitioner. He performed many duties as CEO, including preparing

and submitting job bids, scheduling projects and jobs, hiring and

coordinating employees, coordinating activities between

petitioner and the general contractors, ordering supplies,

dealing with payroll issues, and confronting any problems that

arose. Darle usually arrived at the office by 7 a.m., opened it

for business, checked messages, and returned phone calls. It was

common for Darle to deliver supplies and equipment to the
 - 5 -

different job sites when Rocky and Dean were unavailable. Darle

occasionally even performed labor-intensive tasks including, but

not limited to, hanging sheet rock, drywall taping, and unloading

materials at different job sites. Darle regularly brought job

plans home with him at night to estimate the cost of completing a

job.

The success of petitioner’s business depended on accurately

estimating the cost of completing a job. After Darle estimated

the cost of completing a potential job, he determined the amount

petitioner would bid to maximize profits and, at the same time,

remain competitive in the bidding process.

On average, Darle worked 55 hours per week during the years

in issue, but worked 60 to 65 hours per week when petitioner was

establishing itself in the drywall construction industry.

2. Rocky Miller

Rocky was petitioner’s vice president. His primary duty was

job-site supervisor, which required him to supervise the workers

on a job site, determine what materials were needed on a job

site, hire and fire employees on petitioner’s behalf, coordinate

the progress of each job with Darle, and perform other day-to-day

operations. Rocky performed additional duties including, inter

alia, delivering materials to the job sites and performing

physical labor, such as hanging sheetrock, drywall taping,

repairing equipment, and removing snow at the sites.
 - 6 -

A usual workday for Rocky began around 5:30 a.m. with

loading the materials needed at a specific job site into

petitioner’s work trucks. Rocky then delivered those materials

to the job site. When petitioner was engaged in many small jobs,

Rocky went to multiple sites during a single workday. Rocky’s

workday ended around 5:30 p.m. During the years in issue, Rocky

worked an average of 55 to 60 hours per week.

3. Dean Miller

Dean was petitioner’s secretary/treasurer. However, Dean

primarily functioned as a job-site supervisor, which required him

to perform the same duties as Rocky. Dean’s typical workday and

workweek were similar to Rocky’s.

E. Compensation Paid by Petitioner to Its Shareholder-
Employees

For tax years ended after June 30, 1996, Darle’s base salary

was $300,000, except for the taxable year ended June 30, 1999,

when his base salary was $282,501. Darle was paid a bonus for

the tax years ended June 30, 1984 through 1997, and 2000.

Darle’s total compensation was as follows:
 - 7 -

TYE Base Total
June 30 Salary Bonus Compensation
1983 $36,000 $22,000 $58,000
1985 36,000 133,000 169,000
1987 36,000 40,000 76,000
1988 36,000 60,000 96,000
1989 36,000 60,000 96,000
1990 36,000 119,057 155,057
1991 88,000 120,000 208,000
1992 41,000 167,208 208,208
1993 60,000 181,248 241,248
1994 72,000 270,160 342,160
1995 72,000 258,480 330,480
1996 300,000 86,000 386,000
1997 300,000 -0- 300,000
1998 300,000 -0- 300,000
1999 282,501 -0- 282,501
2000 300,000 140,000 440,000

Dean and Rocky each received base annual salaries of $90,000

for each tax year after 1996. Dean and Rocky were both paid

bonuses during all 3 tax years in issue. Petitioner paid Dean

and Rocky the same amount of total annual compensation (salary

plus bonus), but the total amounts varied from year to year. The

following table represents Rocky’s and Dean’s individual

compensation:
 - 8 -

TYE Base Total
June 30 Salary Bonus Compensation
1983 $36,000 $15,000 $51,000
1985 36,000 104,700 140,700
1987 36,000 30,000 66,000
1988 36,000 40,000 76,000
1989 36,000 30,000 66,000
1990 36,000 40,471 76,471
1991 56,404 40,000 96,404
1992 34,900 61,196 96,096
1993 43,200 69,376 112,576
1994 48,000 109,920 157,920
1995 48,000 105,760 153,760
1996 90,000 109,000 199,000
1997 90,000 60,000 150,000
1998 90,000 60,000 150,000
1999 90,000 60,000 150,000
2000 90,000 160,000 250,000

F. Petitioner’s Financial Condition

From 1980 through 1982, the shareholder-employees

capitalized petitioner with contributions of property totaling

$11,300. No additional capital contributions were made. As of

June 30, 2000, petitioner had retained earnings of $781,702 and

total shareholder equity of $793,002. Petitioner never declared

a dividend.
 - 9 -

OPINION

Section 162(a)(1) permits a taxpayer to deduct “a reasonable

allowance for salaries or other compensation for personal

services actually rendered”. A taxpayer can take a deduction for

compensation only if: (1) The payments were reasonable in

amount, and (2) the payments were for services actually rendered.

Sec. 1.162-7(a), Income Tax Regs.

Petitioner argues that the total compensation it paid to its

shareholder-employees was deductible because it was reasonable

under section 162(a). Respondent avers that the amounts of

compensation for petitioner’s tax years ended June 30, 1998

through 2000, were unreasonable and were, instead, disguised

dividends. In this case, the parties agree that the sole issue

is whether the payments petitioner made to its shareholder-

employees were reasonable.

I. Applicable Caselaw

Because this case appears to be appealable to the Court of

Appeals for the Eighth Circuit, see sec. 7482(b)(1)(B), we shall

follow the relevant decisions of that circuit, see Golsen v.

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

1971).

Whether the compensation paid by a corporate taxpayer to a

shareholder-employee was reasonable is a question of fact.

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323
 - 10 -

(5th Cir. 1987), affg. T.C. Memo. 1985-267; Elliotts, Inc. v.

Commissioner, 716 F.2d 1241, 1245 (9th Cir. 1983), revg. T.C.

Memo. 1980-282; Charles Schneider & Co. v. Commissioner, 500 F.2d

148, 151 (8th Cir. 1974), affg. T.C. Memo. 1973-130. Situations

indicating that shareholder-employees were not dealing with the

corporation at arm’s length warrant close scrutiny. This ensures

that no part of the purported compensation was a disguised

dividend. Owensby & Kritikos, Inc. v. Commissioner, supra; Heil

Beauty Supplies, Inc. v. Commissioner, 199 F.2d 193, 194 (8th

Cir. 1952), affg. a Memorandum Opinion of this Court dated Dec.

13, 1950. Numerous factors have been used in determining the

reasonableness of compensation, with no single factor being

dispositive. See Rapco, Inc. v. Commissioner, 85 F.3d 950, 954

(2d Cir. 1996) (applying the factor analysis from the perspective

of an independent investor), affg. T.C. Memo. 1995-128; Owensby &

Kritikos, Inc. v. Commissioner, supra at 1323; Pepsi–Cola

Bottling Co. v. Commissioner, 528 F.2d 176, 178 (10th Cir. 1975),

affg. 61 T.C. 564 (1974); Charles Schneider & Co. v.

Commissioner, supra at 152 (identifying nine factors); RTS Inv.

Corp. v. Commissioner, T.C. Memo. 1987-98 (identifying eight

factors), affd. 877 F.2d 647 (8th Cir. 1989). But cf. Exacto

Spring Corp. v. Commissioner, 196 F.3d 833, 838 (7th Cir. 1999)

(applying the “independent investor test” rather than the

multiple-factor approach used by the majority of circuits), revg.
 - 11 -

Heitz v. Commissioner, T.C. Memo. 1998-220. These factors

include, but are not limited to: (1) Employee qualifications;

(2) the nature, extent, and scope of the employee’s work; (3) the

size and complexity of the business; (4) prevailing general

economic conditions; (5) the employee’s compensation as a

percentage of gross and net income; (6) the employee-

shareholders’ compensation compared with distributions to

shareholders; (7) the employee-shareholders’ compensation

compared with that paid to non-shareholder-employees or paid in

prior years; (8) prevailing rates of compensation for comparable

positions in comparable concerns; and (9) comparison of

compensation paid to a particular shareholder-employee in

previous years where the corporation has a limited number of

officers.

The Court of Appeals for the Eighth Circuit has not applied

the independent investor test, but in Wagner Constr., Inc. v.

Commissioner, T.C. Memo. 2001-160, which would have been

appealable to the Court of Appeals for the Eighth Circuit, we

applied the independent investor test as a lens through which we

view each factor. See also Haffner’s Serv. Stations, Inc. v.

Commissioner, T.C. Memo. 2002-38, affd. 326 F.3d 1 (1st Cir.

2003). In general, this test questions whether an inactive,

independent investor would have been willing to pay the amount of

disputed compensation on the basis of the facts of each
 - 12 -

particular case. See Elliotts, Inc. v. Commissioner, supra at

1246; Haffner’s Serv. Stations, Inc. v. Commissioner, supra.

This test allows us to decide whether the amount of compensation

paid to petitioner’s shareholder-employees would have been the

same had they engaged in an arm’s-length negotiation. See also

Heil Beauty Supplies, Inc. v. Commissioner, supra at 194. One

important inquiry in applying this test is whether the

corporation’s shareholders received a fair return on their

investments. See Rapco, Inc. v. Commissioner, supra at 955.

In performing our analysis, we generally review each

shareholder-employee’s compensation separately because whether

his salary was reasonable depends on the services he performed.

See RTS Inv. Corp. v. Commissioner, supra. In this case, we

shall review Dean’s and Rocky’s salaries concurrently because

they performed similar services for petitioner.

II. Burden of Proof

Under Rule 142(a), petitioner has the burden of proving that

the compensation paid to its shareholder-employees was reasonable

for deduction purposes. See Welch v. Helvering, 290 U.S. 111,

115 (1933). Section 7491(a) provides a taxpayer with the

opportunity to shift the burden of proof to the Commissioner

under specific circumstances. To shift the burden of proof, a

taxpayer must have complied with all the requirements in section

7491(a). See Higbee v. Commissioner, 116 T.C. 438 (2001); E.J.
 - 13 -

Harrison & Sons, Inc. v. Commissioner, T.C. Memo. 2003-239.

Here, petitioner has not argued the application of section 7491

nor established that it satisfied the requirements in section

7491. Nevertheless, we decide this case on the preponderance of

the evidence, and therefore it is unaffected by section 7491.

See Blodgett v. Commissioner, 394 F.3d 1030, 1035 (8th Cir.

2005), affg. T.C. Memo. 2003-212.

III. Expert Testimony

Leonard J. Sliwoski, C.P.A., Ph.D, testified at trial as an

expert witness on petitioner’s behalf. William C. Herber,

C.B.A., testified at trial as an expert witness on respondent’s

behalf. At trial, the parties orally stipulated the

qualifications of both Dr. Sliwoski and Mr. Herber. Opinion

testimony of an expert is admissible if it assists the trier of

fact in understanding evidence that will determine a fact in

issue. See Fed. R. Evid. 702. We decide, as the trier of fact,

the weight afforded a witness’s testimony, and we are not

compelled to accept any testimony even when it is uncontradicted.

See McGraw v. Commissioner, 384 F.3d 965, 972 (8th Cir. 2004),

affg. Butler v. Commissioner, T.C. Memo. 2002-314; Paul E. Kummer

Realty Co. v. Commissioner, 511 F.2d 313, 315 (8th Cir. 1975),

affg. T.C. Memo. 1974-44.

IV. Evidentiary Issue

Petitioner requests that judicial notice be taken of the
 - 14 -

Risk Management Association (RMA) Annual Statement Studies 1998-

1999, 1999-2000, and 2000-2001, and the Methodology/Disclaimer

from the October 1, 2001, Database of the Executive Compensation

Assessor software and database published by the Economic Research

Institute (ERI). Respondent objects to petitioner’s request

because petitioner did not indicate which RMA studies it wanted

the Court to take judicial notice of, and the information

contained in both the RMA and ERI materials does not meet the

criteria under rule 201 of the Federal Rules of Evidence and this

Court’s jurisprudence.

Rule 201(b) of the Federal Rules of Evidence provides:

Kinds of facts. A judicially noticed fact must be one not
subject to reasonable dispute in that it is either (1)
generally known within the territorial jurisdiction of the
trial court or (2) capable of accurate and ready
determination by resort to sources whose accuracy cannot
reasonably be questioned.

See also Estate of Reis v. Commissioner, 87 T.C. 1016, 1026-1027

(1986).

These materials were relied on by both parties’ experts to

form their respective opinions. We have heard the testimony of

both experts and have reviewed their respective reports,

including the materials in issue, which were attached to the

expert reports. The experts relied on these materials, but they

bolstered their opinions with facts other than those considered

in producing these materials. Each expert testified, and his

respective opinion was subject to cross-examination. While an
 - 15 -

expert can rely on data that is not admissible to form his

opinion, such reliance does not elevate the evidence to be

admissible for the truth of the matter asserted. Fed. R. Evid.

703.

Petitioner contends that even though the ERI data considers

businesses similar to it, “exceptional business data is not

available”. Petitioner’s statement identifies the issues related

to the application of this data to the instant case. The ERI and

RMA materials are compilations of data that we do not believe

rise to the level required by rule 201(b) of the Federal Rules of

Evidence. For these reasons, we do not find these materials

subject to judicial notice. However, since we analyzed the data

contained therein in the context of the experts’ reports and

testimony, whether these materials are admissible does not change

our analysis.

V. Compensation Paid for Prior Year’s Services

Petitioner claims that a portion of the total compensation

paid to its shareholder-employees during the tax years in issue

was to remedy past undercompensation. Under some circumstances,

a taxpayer may deduct compensation paid in one year for services

rendered in prior years. Lucas v. Ox Fibre Brush Co., 281 U.S.

115, 119 (1930). But to deduct amounts paid as compensation for

past undercompensation, a taxpayer must show: (a) Its intention

that part of the current payments compensate employees for past
 - 16 -

services, and (b) the amount of the past undercompensation. See

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 (1990), affd. 965 F.2d 1038 (11th

Cir. 1992); Haffner’s Serv. Stations, Inc. v. Commissioner, T.C.

Memo. 2002-38; Wagner Constr., Inc. v. Commissioner, T.C. Memo.

2001-160.

The parties stipulated that petitioner’s board of directors

meeting minutes indicate that in the tax year ended June 30,

1985, petitioner intended to compensate its shareholder-employees

for past services. The record shows that the amount of

compensation paid in that tax year was much larger than it had

been in 19833 and the 4 subsequent years. This indicates that

the payments were intended to rectify past undercompensation for

services rendered. No such stipulation exists for the years in

issue, and no board of directors meeting minutes for the years in

issue are in the record.

Additionally, in each tax year ending June 30, 1992 through

1996, the total compensation for a shareholder-employee of

petitioner generally increased or remained consistent. During

each tax year ending June 30, 1997 through 1999, each of

petitioner’s shareholder-employees received less total

3
These figures are taken from the expert reports. There are
no compensation figures for 1984 in either report.
 - 17 -

compensation than he had during the June 30, 1996, tax year.

These facts do not support a conclusion that during the years in

issue, petitioner was making catchup payments for the years prior

to 1997. Of the years in issue, only for the tax year ended June

30, 2000, did petitioner’s shareholder-employees receive

compensation over that paid in 1996. The record establishes that

this increase resulted from petitioner’s obtaining its most

profitable job ever, not from petitioner’s intention to remedy

past undercompensation. Even if petitioner intended some of the

payments in issue to remedy past undercompensation, petitioner

failed to establish the amount of the past undercompensation or

how much catchup compensation was allegedly paid during each year

in issue. Therefore, we hold that none of the compensation

petitioner paid for the years in issue was to remedy past

undercompensation.

We do not include this as a factor in our reasonableness-of-

the-compensation analysis because such a finding would not

necessarily indicate the shareholder-employees were

overcompensated. Instead, that analysis is based on the factors

discussed below.

VI. Application of Reasonable Compensation Factors

A. Employee Qualifications

An employee’s superior qualifications may justify high

compensation for his services. See Charles Schneider & Co. v.
 - 18 -

Commissioner, 500 F.2d at 152; Wagner Constr., Inc. v.

Commissioner, supra.

Petitioner claims that through Darle’s, Rocky’s, and Dean’s

exceptional qualifications it was able to maintain fairly

consistent yearly sales and remain profitable in a highly

competitive industry. Respondent agrees that Darle, Rocky, and

Dean did “contribute superior qualifications to the successful

operation of the petitioner[’]s business”.

A factor that contributed to petitioner’s success was

petitioner’s ability to obtain profitable construction jobs.

Petitioner obtained jobs primarily by submitting the lowest bid

to a general contractor, and Darle was solely responsible for

preparing each bid. Darle’s estimate of the cost to complete a

job was the most significant aspect of preparing a bid. If

Darle’s estimate was inaccurate, petitioner would neither receive

the job, because its bid was too high, nor make a profit. Darle

therefore deserved high compensation because of his knowledge and

experience.

Although Rocky was petitioner’s vice president and Dean was

petitioner’s treasurer during the years in issue, the facts

indicate that they primarily performed the duties of job-site

supervisors, not executives. Each has been working for

petitioner since the early 1980s and worked between 55 and 60

hours per week during the 1990s and 2000. Petitioner’s financial
 - 19 -

success was directly correlated with completing jobs within

budget. As supervisors with about 20 years of experience each,

Rocky and Dean made sure each job was completed in an efficient,

cost-effective manner. Their knowledge and experience warranted

high compensation for their services for each year in issue.

This factor favors petitioner.

B. Nature, Extent, and Scope of an Employee’s Work

An employee’s position, duties performed, hours worked, and

general importance to the corporation’s success may justify high

compensation. See Charles Schneider & Co. v. Commissioner, supra

at 152.

1. Darle

Petitioner argues that Darle was a key employee. Mr.

Herber, respondent’s expert, similarly opined that Darle was the

key employee of petitioner. Petitioner’s business model was to

maintain consistent yearly sales. Petitioner’s success depended

on two things: (1) Accurately estimating the cost of completing

a job, and (2) completing the job within budget. Darle was the

sole individual responsible for preparing these bids. In

addition to performing his duties as petitioner’s CEO, Darle

performed many other tasks. Darle also testified that he worked

about 50 hours per week during the years in issue. We believe

that Darle’s 20 years of experience were irreplaceable to

petitioner. Therefore, we find that the nature, extent, and
 - 20 -

scope of Darle’s work justify high compensation. This factor

weighs in favor of petitioner with respect to Darle’s

compensation.

2. Rocky and Dean

Petitioner has not offered any evidence detailing Rocky’s or

Dean’s duties as officers, but the record makes it clear that

Rocky and Dean primarily worked as job-site supervisors.

Petitioner’s position appears to be that job-site

supervisors are important to its success. We agree. Because

petitioner’s jobs are awarded in a low-bid process, it was

necessary for petitioner to remain within its budget. This was

confirmed by Darle’s testimony that employee productivity was one

of the keys to petitioner’s profitability. Rocky and Dean made

this happen. According to the Minnesota Work Force Center 1999

Salary Survey, relied on by both experts, Rocky’s and Dean’s

duties appeared to be similar to those of a construction manager

who has numerous responsibilities. One specific duty of a

construction manager was to make sure a job was completed within

budget. Both Rocky and Dean had about 20 years of supervisory

experience, and this experience added to petitioner’s success.

Respondent argues that the nature, extent, and scope of

Rocky’s and Dean’s services are not “in any way unique to the

petitioner.” We do not believe that the uniqueness of their

services is dispositive of this factor. Rocky and Dean were both
 - 21 -

integral to petitioner’s success, and each averaged between 55

and 60 work hours per week during the years in issue. Rocky and

Dean arrived at petitioner’s place of business at about 5:30 a.m.

to load the work trucks and deliver the materials to specific job

sites. Rocky and Dean hung drywall and performed any other

physical task that needed to be done. Petitioner’s consistent

sales and substantial pretax profit margins before shareholder-

employees compensation were due in part to the skills,

dedication, and efforts of Rocky and Dean. We find the extent

and scope of Rocky’s and Dean’s duties warrant high compensation.

This factor favors petitioner with respect to Rocky’s and Dean’s

compensation.

C. Size and Complexity of Petitioner’s Business

Courts consider the size and complexity of a taxpayer’s

business when deciding the reasonableness of compensation paid to

its shareholder-employees. See RTS Inv. Corp. v. Commissioner,

877 F.2d at 651; Charles Schneider & Co. v. Commissioner, 500

F.2d at 152. A company’s size is determined by its sales, net

income, gross receipts, or capital value. See Beiner, Inc. v.

Commissioner, T.C. Memo. 2004-219; Wagner Constr., Inc. v.

Commissioner, T.C. Memo. 2001-160.

During the tax years in issue, petitioner was a small

business, as measured by its annual gross sales, and its business

model indicates it was not interested in growth. After reviewing
 - 22 -

petitioner’s financial documents, both experts concluded that

petitioner’s annual sales were fairly constant during the 1990s.

Petitioner argues that these facts tip the scale in its favor.

Respondent conversely contends that this factor supports the

position that the shareholder-employees were unreasonably

compensated because petitioner’s business was small and simple.

As we understand this argument, respondent believes petitioner’s

business was simple because a competitor could establish a

drywall construction business for a mere $300 investment, and

because the drywall business did not require substantial

scientific and highly technical knowledge. See B & D

Foundations, Inc. v. Commissioner, T.C. Memo. 2001-262.

We do not agree with either party’s analysis. Petitioner’s

consistent sales and net income do not show that its business was

large or complex. Nothing in the record supports a finding that

petitioner’s business was different from any other drywall

construction business, except that its business model was to

maintain consistent yearly sales. An independent investor would

have been unwilling to increase an employee’s compensation where

the corporation is not expected to increase sales because that

could have decreased the investor’s return (assuming costs

remained the same). Similarly, an independent investor might have

been hesitant to increase an employee’s compensation where the

employee had no substantial or specified training.
 - 23 -

On the other hand, although the drywall business did not

require highly technical knowledge, petitioner’s shareholder-

employees developed the skills and methods to accurately bid on

and complete projects within budget. An individual could have

entered the drywall construction business with a mere $300

investment, but there was no guarantee of success. Darle

credibly testified that a number of competitors emerged and

failed since petitioner has been in existence. Petitioner has

been engaged in the drywall business for more than 20 years, and

its success depends on the time-tested skills and judgment of its

key employees. In a competitive industry such as this,

petitioner’s development of business methods and techniques

directly related to its success. The successful execution of

these methods was complex or, at a minimum, difficult. We also

believe that the leanness of petitioner’s management and the

multiple duties each shareholder-employee performed further weigh

against respondent. Consequently, we find this factor to favor

petitioner.

D. General Economic Conditions

Another factor we take into consideration is the employee’s

impact on the corporation’s success compared to the impact of the

general economic conditions. See RTS Inv. Corp. v. Commissioner,

supra at 651. This comparison helps indicate whether the
 - 24 -

business’s success is attributable to the employee’s prowess and

acumen or to other economic factors.

Petitioner argues its business was insulated from the

existing economic conditions. Dr. Sliwoski’s report states that

petitioner was shielded from economic fluctuations when compared

to other similar businesses because of its exceptional management

and business model that focused on consistent sales rather than

growth. Dr. Sliwoski did acknowledge in his report that the

economic conditions were favorable for the entire construction

industry during much of the 1990s. Given the favorable economic

conditions, respondent urges us to hold that the compensation

petitioner paid Darle, Rocky, and Dean was unreasonable. We

agree that the economic conditions were favorable, but whether

this factor supports either party depends on how these conditions

affected petitioner’s business.

Petitioner’s gross yearly sales in the 1990s remained fairly

consistent. Only during the tax year ended June 30, 2000, did

petitioner have a significant spike in sales. This spike was

mostly attributable to one large job petitioner had obtained.

Given petitioner’s business model and its consistent annual gross

sales, we believe the economic conditions had, at most, a minimal

impact on its success. In addition, nothing in the record

indicates that any of petitioner’s shareholder-employees worked

fewer hours because the economic conditions were favorable. No
 - 25 -

matter how favorable the economic conditions were, petitioner’s

success depended on obtaining jobs through the bidding process

and completing each job within budget. In other words,

petitioner’s success depended on how well Darle, Dean, and Rocky

performed their respective jobs, not on the economy’s health. We

hold that this factor weighs in petitioner’s favor because its

success was not a function of economic circumstances.

E. Comparison of Salaries With Distributions to
Stockholders and Retained Earnings

The Court of Appeals for the Eighth Circuit has stated that

the “absence of dividends to stockholders out of available

profits justifies an inference that some of the purported

compensation really represented a distribution of profits as

dividends.” Paul E. Kummer Realty Co. v. Commissioner, 511 F.2d

at 315; Charles Schneider & Co. v. Commissioner, 500 F.2d at 153;

see also RTS Inv. Corp. v. Commissioner, 877 F.2d at 651.

Petitioner never declared a dividend.

However, corporations generally are not required to pay

dividends. In addition, Darle testified that petitioner did not

pay dividends because it wanted a financial cushion in case it

had difficulty obtaining jobs. Petitioner had retained earnings

of $781,702 as of June 30, 2000. Respondent would argue that

petitioner’s retained earnings exceeded the amount needed to

sustain its business. We do not find these amounts so excessive

as to warrant us to second-guess Darle’s business judgment.
 - 26 -

As we have mentioned, the independent investor test measures

whether a corporation’s shareholders received a fair return on

their investment. Return on equity measures the appreciation of

the stockholders’ investments through the corporation’s

retainment of earnings. See Owensby & Kritikos, Inc. v.

Commissioner, 819 F.2d at 1326-1327; Home Interiors & Gifts, Inc.

v. Commissioner, 73 T.C. 1142, 1161 (1980); see also Rev. Rul.

79-8, 1979-1 C.B. 92 (stating compensation may be reasonable even

when the corporation never paid a substantial portion of its

earnings and profits as a dividend).

Each party’s expert analyzed whether an independent investor

would consider the amount of compensation paid by petitioner

reasonable in light of the return on equity (ROE) petitioner’s

shareholders received. To do this, the experts first determined

the appropriate assumed rate of return on equity that an

independent investor would find acceptable for each year in

issue. The parties do not agree on the assumed equity rate of

return. The second step is to determine the appropriate period

in which to compare the ROE received by petitioner’s shareholders

with the assumed rates. The parties do not agree on the

appropriate period.
 - 27 -

1. Assumed Rate of Return

Both experts used the build-up approach to calculate the

assumed rate of return for the tax years in issue. The build-up

approach starts with the risk-free rate of return for the year in

issue, and three adjustments are made: An equity risk

adjustment, a size adjustment, and a company-specific risk

adjustment. The only adjustment the parties do not agree on is

the company-specific risk adjustment. This adjustment cannot be

found in reference materials; rather, it requires a factual

determination.

Dr. Sliwoski, petitioner’s expert, found a company-specific

risk adjustment of negative 2.5 percent because he determined

that petitioner was subject to minimal business risks and

extremely minimal financial risk. By contrast, Mr. Herber,

respondent’s expert, concluded that the company-specific risk

adjustment should be positive 5 percent for each tax year in

issue. Mr. Herber considered petitioner’s size (as measured by

annual sales), industry risks, lack of management depth, and the

competitive nature of the drywall construction business as

factors in making the company-specific adjustment.

Having reviewed the parties’ respective positions, we

disagree in part with each expert’s company-specific risk

adjustment analysis. We find the total company-specific risk

adjustment to be negative 2 percent for each year in issue. We
 - 28 -

make the negative-2-percent adjustment on the basis of

petitioner’s conservative capital structure as reflected in its

ample cash reserves and borrowing capacity as defined by Dr.

Sliwoski, low debt-to-equity ratio, and business model to

maintain consistent yearly sales.

Therefore, we hold that an independent investor would find

the following assumed rates of return acceptable:

TYE TYE TYE
Factor June 30, June 30, June 30, 2000
1998 1999
Risk-free rate 6.0% 5.4% 6.8%
Equity risk premium 8.2 8.4 8.5

Size premium 3.3 2.6 4.3
Company specific (2.0) (2.0) (2.0)
risk premium
Assumed rate of 15.5 14.4 17.6
return

The average assumed rate of return for the years in issue was

15.8 percent.

2. Time Period and Calculation

The parties computed the compound growth rates of

petitioner’s shareholders’ equity for 20-year and 10-year

periods. Instead of using compound growth rates to determine

whether an independent investor would be satisfied with the

return on its investment, this Court has generally calculated a

corporation’s ROE by dividing its net income after tax for a

specific year by its shareholders equity. See B & D Foundations,

Inc. v. Commissioner, T.C. Memo. 2001-262 (discussing the ROE
 - 29 -

calculation in greater detail); Labelgraphics, Inc. v.

Commissioner, T.C. Memo. 1998-343, affd. 221 F.3d 1091 (9th Cir.

2000). Shareholder equity is either the corporation’s

shareholders’ equity at the beginning of that year, e.g., Alpha

Med., Inc. v. Commissioner, T.C. Memo. 1997-464 at n.8, revd. on

other grounds 172 F.3d 942 (6th Cir. 1999), the shareholders’

equity at the end of the year, e.g., Labelgraphics, Inc. v.

Commissioner, supra, or the year’s average shareholder equity,

e.g., Dexsil Corp. v. Commissioner, 147 F.3d 96, 99 (2d Cir.

1998), affg. T.C. Memo. 1995-135; see B & D Foundations, Inc. v.

Commissioner, supra. We shall apply the general ROE approach in

this case using petitioner’s shareholders’ equity at the

beginning of each tax year in issue.

Moreover, the parties do not agree on the appropriate time

period to determine whether petitioner’s shareholders’ ROE would

satisfy an independent investor. Petitioner argues that we

should review the entire period it has been incorporated.

Respondent argues that an independent investor would find the 10-

year period ending with 2000, the last year in issue, to be a

more accurate representation of its investment. If we were to

consider petitioner’s tax years outside of the 3 years in issue,

we would be inclined to review the entire period it has been

incorporated. However, given the facts of this case, an analysis

focused on the years in issue is more appropriate.
 - 30 -

Respondent also relies on Alpha Med., Inc. v. Commissioner,

supra, and Eberl’s Claim Serv., Inc. v. Commissioner, T.C. Memo.

1999-211, affd. 249 F.3d 994 (10th Cir. 2001), for the

proposition that the ROE should be analyzed only for each tax

year in issue separately. Petitioner argues that respondent’s

analysis should not be relied on because he incorrectly

interpreted this Court’s jurisprudence.

We agree that the independent investor would initially focus

on each of the 3 years in issue separately. However,

respondent’s reliance on Alpha Med., Inc. and Eberl’s Claim

Serv., Inc. is partially misplaced. Unlike those cases, the

total capital investment of $11,300, as of 1982, made by the

shareholder-employees in this case was not de minimis considering

a competitor could establish a drywall construction business with

only $300. Also, in this case, there are three shareholder-

employees, compared to a single shareholder-employee in each of

those cases. These differences sufficiently distinguish this

case from the reasoning used in Alpha Med., Inc. and Eberl’s

Claim Serv., Inc. to view the years in issue only separately.

Thus, we shall consider the years in issue collectively and

separately.

Petitioner’s ROE for the tax year ended June 30, 1998, was

7.8 percent, for the tax year ended June 30, 1999, negative 4.1
 - 31 -

percent, and for the tax year ended June 30, 2000, 41.3 percent.4

The average ROE for the 3 years in issue was 15 percent, which is

very close to our average assumed rate of return. The average

ROE is slightly less because in the tax year ended June 30, 1999,

petitioner had a negative ROE. However, the fact that

petitioner’s CEO received less compensation in that year than in

any of the previous 5 years and did not receive a bonus in that

year nullifies any negative inference we would have drawn.

Instead, these facts support the conclusion that Darle’s

compensation was in accord with performance, which was reasonable

for a CEO. Furthermore, petitioner’s ROE for the tax year ended

June 30, 2000, was substantial. Analyzing the ROE of the years

in issue together in this case eliminates anomalies created by

fluctuations in a given year. Therefore, looking at the years

before us together, we hold that this factor favors petitioner.

F. Comparison of Compensation to Gross and Net Income

Compensation as a percentage of a taxpayer’s gross and net

income has been considered in deciding whether compensation was

reasonable. See RTS Inv. Corp. v. Commissioner, 877 F.2d at 650.

The comparison of salaries to net income is more important

because it “more accurately gauges whether a corporation is

4
We calculated ROE by dividing the year’s net income by the
year’s beginning total shareholder equity. We used the figures
in the financial documents included in the expert reports to
determine ROE.
 - 32 -

disguising the distribution of dividends as compensation.”

Wagner Constr., Inc. v. Commissioner, T.C. Memo. 2001-160 (citing

Owensby & Kritkos, Inc. v. Commissioner, 819 F.2d at 1325-1326).

Respondent provided a chart that expressed the shareholder-

employees’ compensation as a percentage of gross receipts and net

pretax income for tax years ended June 30, 1990 through 2000.

With respect to the years in issue, respondent determined that

the shareholder-employees’ compensation was as follows:

Net income
Compensation before taxes
paid to and
TYE petitioner’s Gross shareholder
June 30 shareholders receipts Percent compensation Percent
1998 $600,000 $1,857,221 32% $673,651 89%
1999 592,727 1,688,437 35 548,980 108
2000 940,000 2,905,034 32 1,277,316 74

Petitioner argues that this factor should not be afforded much

weight because Darle, Rocky, and Dean each wore “three hats”--

directors, officers, and key employees–-which required them to

perform duties above and beyond their respective titles.

While we disagree with both parties’ analyses, we find this

factor favors respondent. The shareholder-employees’

compensation expressed as a percent of gross income was fairly

consistent in the years in issue and was a significant portion of

the net income. In some cases, the percentages may be less

indicative because the qualifications of the shareholder-

employees and the nature, extent, and scope of their work support
 - 33 -

petitioner’s paying them high compensation. See, e.g., Mad Auto

Wrecking, Inc. v. Commissioner, T.C. Memo. 1995-153 (deciding

this factor to be neutral where the officers’ qualifications and

the nature, extent, and scope of their work supported high

compensation, but where their compensation represented a

significant percent of gross income and book net income (before

deducting the officers’ compensation) and even exceeded the

amount of net income in a tax year). However, in this case we

think the percentages favor respondent because petitioner’s

shareholder-employees’ compensation was a substantial portion of

its net income and even exceeded its net income in the tax year

ended June 30, 1999.

G. External Comparison

This factor compares the shareholder-employees’ salaries to

the salaries that similar companies pay for similar employee

services. See Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.

In this case, salary surveys were used by both parties’ experts.

1. Darle--Petitioner’s CEO

With respect to Darle’s compensation, Dr. Sliwoski relied on

ERI’s compensation tables for the comparison. He testified that

the proper standard industry code (SIC) for petitioner’s drywall

construction business was SIC 1742, “Plastering, Drywall, and

Insulation”. His report included a table which was titled “Table

3: SIC 1742: Chief Executive Officer Compensation: Years Ended
 - 34 -

June 30, 1998 through June 30, 2000”. After reviewing the

attachments to the report, it is clear that Dr. Sliwoski included

data from SIC 1799, “Special Trade Contractors”, not SIC 1742.

Dr. Sliwoski testified that he used the SIC 1799 data because it

includes a broader pool of construction industries than SIC 1742

and provides maximum compensation figures.

Respondent exhorts us to disregard petitioner’s expert’s

report and testimony with respect to the external comparison

analyses because they both relied on the incorrect SIC. In this

case, we agree such action is warranted because both experts

agreed that SIC 1742 was the most relevant, not SIC 1799. See

Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938) (holding

that the trier of fact is not bound by any expert witness’s

opinion and may accept or reject expert testimony, in whole or in

part, in the exercise of sound judgment).

Mr. Herber correctly used SIC 1742 to compare Darle’s

compensation. The ERI data indicates the total compensation for

CEOs in the 90th percentile5 was $183,805, $184,499, and $235,270

for 1998, 1999, and 2000, respectively.6 According to the ERI

data, Darle was compensated substantially above similarly

situated CEOs whose compensation was in the 90th percentile. On

5
Ninetieth percentile means that only 10 percent of the
year’s data lies above this figure.
6
The ERI date was based on calendar years, but the tax years
in issue were fiscal years ending on June 30.
 - 35 -

the basis of this data, Darle’s experience, and petitioner’s

strong profitability before taxes and shareholder-employee

compensation, Mr. Herber estimated a high and low total

compensation range.

At first glance, the ERI data from SIC 1742 appears relevant

because it is based on the proper SIC and is limited to

businesses in the Fargo, North Dakota, area, and it accounts for

petitioner’s size as measured by revenues. However, the ERI data

does not take into account the number of hours the similarly

situated CEOs worked or the duties they performed. Darle was

solely responsible for determining the amount petitioner would

bid on each job. However, the ERI data does not indicate that

the CEOs in similar companies also had this responsibility. In

addition, Darle performed many tasks that may not be

traditionally performed by a CEO. The ERI materials included in

the record fail to indicate whether other CEOs performed similar

tasks. The ERI data also does not state the business model of

the corporations included in its data. It is plausible that CEOs

working under different business models may expect to be

compensated differently. Considering these facts, we place

little weight on these materials and are unwilling to conclude

that the ERI data is sufficient for us to find that Darle’s

compensation was unreasonable.
 - 36 -

Mr. Herber relied on the National Institute for Business

Management (NIBM) Executive Compensation Survey and the RMA

studies in addition to the ERI data to compare Darle’s

compensation. The NIBM data Mr. Herber relied on was for

companies most similar to petitioner on the basis of overall size

in terms of revenues, having sales volume of less than $5

million, and businesses classified as construction, contracting,

or extraction. However, at trial, Mr. Herber testified that

NIBM’s survey group included industries that were not comparable

to petitioner’s, including mineral extraction, and we shall not

rely on the information contained therein.

Mr. Herber also used the RMA data to compare Darle’s

compensation, represented as a percentage of income, to a subject

group composed of companies in the SIC 1742 category and having

revenues similar to petitioner’s. Officer-shareholder

compensation is expressed as a percentage of total revenue. For

1997 through 1999, officer-shareholder compensation represented

as a percentage of revenues was as follows:

25th 75th
Calendar year percentile Median percentile
1997 2.8% 4.4% 7.7%
1998 3.2 5.1 7.5
1999 3.7 5.0 7.4

Darle’s compensation as a percentage of total revenues for

the tax years ended June 30, 1998 through 2000, was 16.2 percent,
 - 37 -

16.7 percent, and 15.1 percent, respectively. These figures

indicate that Darle’s compensation expressed as a percentage of

total revenue exceeded the 75th percentile.

Mr. Herber then attempted to calculate Darle’s reasonable

compensation using these percentages. We do not believe that

such a computation is possible because the RMA data is provided

only up to the 75th percentile. Nor do we believe that

estimating the percentage for petitioner’s CEO is appropriate or

accurate.

This factor is neutral, with respect to Darle, because the

parties failed to provide comparable compensation data that was

persuasive.

2. Petitioner’s Other Officers/Job-Site Supervisors

Rocky and Dean both had officer titles but primarily

performed duties as job-site supervisors. Both parties’ experts

relied on information from the Web site of the Minnesota Work

Force Center (MWFC) of the Minnesota Department of Economic

Security and determined that Rocky’s and Dean’s job

responsibilities are analogous to those of “construction

managers”. The MWFC 1999 salary survey that estimated

construction managers’ salaries for the fourth quarter 2000 is

summarized below.
 - 38 -

50th
10th 25th percentil 75th 90th
Average percentil percentil e percentil percentil
e e (median) e e

Hourly $26.47 $15.27 $20.04 $24.62 $28.88 $42.39
wage
Annual 55,073 31,771 41,670 51,196 60,070 88,171
salary

For each year in issue, Rocky and Dean were each compensated

above the 90th percentile annual salary amount. Mr. Herber used

the 90th percentile as the starting point to determine the amount

of reasonable compensation for their services.

Mr. Herber determined that four additional factors should be

taken into consideration when determining whether the

shareholder-employees were overcompensated. The first factor

considers whether a shareholder-employee’s expertise enhanced the

corporation’s profitability. Mr. Herber determined, and we

agree, that Rocky’s and Dean’s prowess contributed to

petitioner’s profitability. The second factor considers a

shareholder-employee’s experience. We have already concluded

that both Dean and Rocky had significant and valuable experience.

The third factor considers the number of hours the shareholder-

employee dedicated to the taxpayer’s business. We have also

found that Rocky and Dean have both dedicated between 55 and 60

hours per week to petitioner’s business. This factor is

particularly significant because it appears that the average

hourly rate of $26.47 was simply calculated by dividing the

average annual wage of $55,073 by 52 weeks and then by 40 hours
 - 39 -

per week. This simple calculation indicates that Rocky and Dean

were deserving of compensation beyond that contained in the MWFC

tables. The final factor considered was the level of management

required for the drywall installation business versus overseeing

the construction of an entire building. Clearly, the level of

supervision is less in the drywall business as it is merely an

aspect of constructing an entire building. Considering these

factors, we hold that Dean and Rocky deserved to be compensated

above the 90th percentile as found in the MWFC data.

Annualizing the 90th percentile hourly wage on the basis of

a 55-hour work week reveals that Rocky and Dean would have

received about $121,235 in compensation per year. Rocky and Dean

would have then received compensation that exceeded the 90th

percentile annual income adjusted for the number of hours worked

by 23.7 percent for tax years ended June 30, 1998 and 1999, and

100.6 percent for the tax year ended June 30, 2000. Taking into

consideration the four factors that Mr. Herber identified, we

believe that Rocky and Dean deserved to be compensated above this

adjusted amount. Their experience and the nature, extent, and

scope of their work support this conclusion. After weighing all

the facts, we find this factor to be neutral.
 - 40 -

H. Petitioner’s Salary Policy as to All Employees

Courts have considered the salary policy of the taxpayers as

to all employees (sometimes referred to as internal consistency)

in determining whether its shareholder-employees received

reasonable compensation. See Charles Schneider & Co. v.

Commissioner, 500 F.2d at 152; Home Interiors & Gifts, Inc. v.

Commissioner, 73 T.C. at 1159. This factor is probative because

it questions whether the shareholder-employees, because of their

status as such, were compensated differently from petitioner’s

other employees. See Owensby & Kritikos, Inc. v. Commissioner,

819 F.2d at 1329. For example, a reasonable, longstanding, and

consistently applied compensation plan is evidence of reasonable

compensation. See Elliotts, Inc. v. Commissioner, 716 F.2d at

1247.

In this case, petitioner paid bonuses to its non-

shareholder-employees and shareholder-employees. The bonuses

that the nonshareholders received were not paid annually,

appeared never to exceed their respective annual compensation,

were relatively insignificant in amount, and were not part of a

longstanding, consistently applied compensation plan.

Conversely, the bonuses paid by petitioner to its

shareholder-employees were paid annually (except that Darle did

not receive a bonus in 1997, 1998, or 1999), and they often

exceeded each shareholder-employee’s base annual salary. More
 - 41 -

importantly petitioner paid its shareholder-employees annual

bonuses regularly, unlike its non-shareholder-employees. On the

basis of these facts, this factor favors respondent.

I. Petitioner’s Pretax Profit Margin

Petitioner claims that its pretax profit margin before

shareholder-employee compensation indicates that it was

exceptionally well managed. The pretax profit margin before

shareholder-employee compensation was calculated by dividing the

pretax net income before shareholder-employee compensation

expense by annual sales. Conversely, respondent argues that

petitioner’s mean pretax profit margins after shareholder

compensation for the years at issue and over a 10-year period

were virtually identical to the industry average.

After comparing petitioner’s pretax profit margin before

shareholder-employee compensation to RMA’s annual statement

studies, which were for SIC 1742, we find that petitioner had an

exceptional pretax profit margin before shareholder-employee

compensation for each tax year in issue. This indicates

petitioner’s shareholder-employees were deserving of high

compensation. However, we are mindful that petitioner’s pretax

profit margin after shareholder compensation was not exceptional,

and the compensation paid to petitioner’s shareholder-employees

depleted its earnings significantly. Nevertheless, we find this

factor to be neutral for each year in issue because the profit
 - 42 -

margin after shareholder compensation was near the industry

average, and we see no compelling reason to require an above-

average return.

VII. Conclusion

A preponderance of the evidence shows that petitioner’s

shareholder-employees were reasonably compensated for each year

in issue. Therefore, petitioner may deduct in full the

compensation it paid to Darle, Dean, and Rocky for each year in

issue.

To reflect the foregoing and give effect to the parties’

concessions,

Decision will be entered

under Rule 155.