                        T.C. Memo. 2003-15



                      UNITED STATES TAX COURT



              DEVINE BROTHERS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8135-01.              Filed January 16, 2003.



     Lowell F. Raeder and David R. White, Jr., for petitioner.

     Gerald A. Thorpe, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent determined a deficiency of $25,086

in petitioner’s Federal income tax for the fiscal year ended

February 28, 1995.   After concessions, the issue for decision is

whether deductions claimed by petitioner for salary and bonuses

paid to one of its officers, who was also a shareholder, exceeded

reasonable compensation.   Unless otherwise indicated, all section
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references are to the Internal Revenue Code in effect for the

year in issue, and all Rule references are to the Tax Court Rules

of Practice and Procedure.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

     Petitioner is a Pennsylvania corporation with its principal

place of business in Havertown, Pennsylvania.     Petitioner has

been operating as a family-run mechanical contractor business,

performing heating, air conditioning, and plumbing services since

1918.   The business was started by Michael F. Devine and his

brother James Devine.    In the mid-1950s, Michael F. Devine’s son,

Richard E. Devine, Sr. (Richard, Sr.), began working for

petitioner.    Petitioner incorporated in 1954.

     Richard, Sr. held a bachelor of science degree in

engineering.    Richard, Sr. began working for petitioner when he

was about 25 years old.    Richard, Sr. continued the business

started by his father and his uncle and by 1961 had acquired

100 percent of petitioner’s outstanding common stock.     After

becoming the sole shareholder of petitioner, Richard, Sr. had

responsibility for human resources, finances, sales and

marketing, training and supervising employees, and accounting and

legal matters.
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     In the late 1970s, petitioner experienced problems with the

business due to delayed projects and the bankruptcy of a general

contractor.   Petitioner released all of its employees and scaled

back operations, and Richard, Sr. became the sole employee of

petitioner.   Richard, Sr. changed the direction of the company in

the 1980s.    Petitioner began to increase its retained earnings to

increase its bonding capacity in order to compete in the direct

bid market.   To meet bonding requirements, petitioner needed to

have 10 percent of its revenue in liquid assets.   To accomplish

this result, petitioner underpaid Richard, Sr. in order to keep

liquid assets in the company.    Petitioner incrementally increased

its bonding capacity each year.

     From April 30, 1986, until April 30, 1989, Richard, Sr.

transferred 220 of his 550 shares of common stock to his son,

Richard E. Devine, Jr. (Richard, Jr.).   Discussion began before

December 27, 1993, regarding the sale of Richard, Sr.’s remaining

shares of common stock to Richard, Jr.   On January 15, 1996,

Richard, Jr. purchased the remaining shares of petitioner for

$305,000.    Richard, Jr. paid the purchase price to Richard, Sr.

with a note payable in monthly installments over 10 years at an

8-percent interest rate.

     During the year in issue and continuing until January 1997,

Richard, Sr. was petitioner’s president and chairman of the board

of directors.   Likewise, Richard, Jr. was petitioner’s vice
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president and a member of the board of directors.    In January

1997, Richard, Jr. became president of petitioner.

     For the taxable year ended February 28, 1994, Richard Sr.’s

salary was $51,663 and Richard, Jr.’s salary was $66,897.    For

the year in issue, Richard, Sr.’s salary was $260,378 and

Richard, Jr.’s salary was $112,599.

     Richard, Sr. determined the compensation that petitioner

paid.    Petitioner never paid dividends to any of its shareholders

from its inception to the tax year in issue. Petitioner provided

to Richard, Sr. a retirement plan, health insurance, life

insurance, disability insurance, and use of a vehicle.

Petitioner paid $50,000 into Richard, Sr.’s retirement plan each

year for 5 years from 1989 until 1993.

     Petitioner filed a Form 1120, U.S. Corporation Income Tax

Return, for the taxable year ended February 28, 1995.    Petitioner

claimed a deduction of $260,378 for compensation of Richard, Sr.

Respondent allowed $195,378 and disallowed the remaining $65,000.

The parties stipulated that “Richard Sr.’s annual salary for the

taxable year ended February 28, 1995 falls in the range of

salaries paid to presidents/chief executive officers of

comparable companies in the same industry during the taxable

year.”
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                               OPINION

     Section 162(a)(1) allows as a deduction “a reasonable

allowance for salaries or other compensation for personal

services actually rendered”.   Section 1.162-7(a), Income Tax

Regs., provides a two-part test for deductibility of

compensation:   (1) Whether the payment was purely for services

rendered and (2) whether the amount paid was reasonable.        See

Estate of Wallace v. Commissioner, 95 T.C. 525, 552 (1990), affd.

965 F.2d 1038 (11th Cir. 1992).   Section 1.162-9, Income Tax

Regs., provides that bonuses paid to employees are deductible

“when such payments are made in good faith and as additional

compensation for the services actually rendered by the employees,

provided such payments, when added to the stipulated

salaries, do not exceed a reasonable compensation for the

services rendered.”

     Whether an expense that is claimed pursuant to section

162(a)(1) is reasonable compensation for services rendered is a

question of fact that must be decided on the basis of the

particular facts and circumstances.      Estate of Wallace v.

Commissioner, supra at 553; Paula Constr. Co. v. Commissioner, 58

T.C. 1055, 1058-1059 (1972), affd. without published opinion 474

F.2d 1345 (5th Cir. 1973).   The burden is on petitioner to show

that it is entitled to a compensation deduction larger than that

allowed by respondent.   Welch v. Helvering, 290 U.S. 111, 115
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(1933); Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315,

1324 (5th Cir. 1987), affg. T.C. Memo. 1985-267.   Section 7491

does not apply to shift the burden in this case because the

examination of petitioner’s return commenced before July 22,

1998.

     Cases traditionally set forth a lengthy list of factors that

are relevant in the determination of reasonableness, including:

(1) The employee’s qualifications; (2) the nature, extent, and

scope of the employee’s work; (3) the size and complexities of

the business; (4) a comparison of salaries paid with gross income

and net income; (5) the prevailing general economic conditions;

(6) comparison of salaries with distributions to stockholders;

(7) the prevailing rates of compensation for comparable positions

in comparable concerns; (8) the salary policy of the taxpayer as

to all employees; and (9) the amount of compensation paid to the

particular employee in previous years.    Mayson Manufacturing Co.

v. Commissioner, 178 F.2d 115 (6th Cir. 1949), affg. a Memorandum

Opinion of this Court.   No single factor is determinative.    See

id.; Estate of Wallace v. Commissioner, supra at 553; Home

Interiors & Gifts, Inc. v. Commissioner, 73 T.C. 1142, 1156

(1980).   When the case involves a closely held corporation with

the controlling shareholders setting their own level of

compensation as employees, the reasonableness of the compensation

is subject to close scrutiny.    Owensby & Kritikos, Inc. v.
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Commissioner, supra at 1324; Estate of Wallace v. Commissioner,

supra at 556.

     Recent cases in some Courts of Appeals have adopted a

somewhat different view of this analysis, substituting instead an

independent investor test.    See, e.g., Exacto Spring Corp. v.

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

Commissioner, T.C. Memo. 1998-220.       This case is appealable to

the Court of Appeals for the Third Circuit, which has not adopted

the independent investor test but has endorsed the traditional

multifactor test.   See B.B. Rider Corp. v. Commissioner, 725 F.2d

945 (3d Cir. 1984), affg. in part and vacating in part on other

grounds T.C. Memo. 1982-98.   We have applied the multifactor test

for reasonableness, viewed through the lens of an independent

investor, when a case is not appealable to a circuit that has

addressed this issue.   See Haffner’s Serv. Stations, Inc. v.

Commissioner, T.C. Memo. 2002-38.

     Whatever analysis is applied, petitioner has made a prima

facie case for reasonableness.    Respondent has provided no

evidence to the contrary.    Respondent conceded in the stipulation

that Richard, Sr.’s salary was within the range of salaries paid

to similarly situated executives.    Respondent allowed all but

$65,000 of Richard, Sr.’s compensation.      Respondent gives no

reasoning for his calculation of the “excessive” compensation.
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       Under certain circumstances, prior services may be

compensated in a later year.    Lucas v. Ox Fibre Brush Co., 281

U.S. 115, 119 (1930); Estate of Wallace v. Commissioner, supra at

553.    However, in such instances, the taxpayer must establish

that there was not sufficient compensation in the prior periods

and that, in fact, the current year’s compensation was to

compensate for that underpayment.       Estate of Wallace v.

Commissioner, supra at 553-554.     In the year in issue, Richard,

Sr.’s salary was within the range of those of similarly situated

executives, and witnesses testified that Richard, Sr. had been

paid significantly less than similarly situated executives in

other years.    Petitioner has established that Richard, Sr. was

undercompensated in prior years in order to meet specified

bonding requirements, a business necessity.      The testimony also

supports an inference, and we conclude, that the bonus paid in

the year in issue was intended to compensate for the established

undercompensation in the earlier years.      The entire deduction for

compensation was therefore reasonable.

       To reflect the foregoing and the concessions of the parties,


                                             Decision will be entered

                                        under Rule 155.
