T.C. Memo. 2007-272



                       UNITED STATES TAX COURT



                VITAMIN VILLAGE, INC., Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8745-02.                Filed September 12, 2007.



     Daniel L. Reeves (officer), for petitioner.

     Wesley F. McNamara, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     HAINES, Judge:    Respondent determined deficiencies in

petitioner’s Federal corporate income tax for the fiscal years

ending (FYE) June 30, 1995 and 1996 (fiscal years at issue), of

$562,967 and $502,786, respectively.1


     1
         Unless otherwise indicated, all section references are to
                                                     (continued...)
                                - 2 -

     After concessions,2 the issues for decision are:   (1)

Whether the amounts paid to petitioner’s sole executive and

shareholder during the fiscal years at issue constituted

reasonable compensation under section 162(a)(1); (2) whether

petitioner is entitled to deduct advertising expenses under

section 162(a) of $1,105,276 for FYE June 30, 1996; and (3)

whether petitioner is entitled to depreciate costs incurred in

constructing a houseboat, a floating garage, and a dock under

section 167(a)(1) during the fiscal years at issue.

                           FINDINGS OF FACT

     The parties’ stipulation of facts and the attached exhibits

are incorporated herein by this reference, and the facts

stipulated are so found.    At the time the petition was filed,

petitioner maintained its business office in Wilsonville, Oregon.

A.   Petitioner’s Business History

     Petitioner was incorporated by Daniel L. Reeves in the State

of Oregon in 1979.3   Petitioner, an accrual basis taxpayer with


     1
      (...continued)
the Internal Revenue Code, as amended, and Rule references are to
the Tax Court Rules of Practice and Procedure. Amounts are
rounded to the nearest dollar.
     2
       At trial, respondent conceded that petitioner was entitled
to deduct a net operating loss of $320,845 in FYE June 30, 1996,
carried back from its FYE June 30, 1998. On brief, petitioner
conceded it failed to report interest income of $11,516 in FYE
June 30, 1996.
     3
         Mr. Reeves originally founded petitioner with two other
                                                     (continued...)
                               - 3 -

an FYE June 30, was in the business of producing, distributing,

and selling skin care products, tanning lotions, diet aids,

sports performance products, nutritional supplements, health food

products, and apparel at both the retail and wholesale levels.

Petitioner also provided indoor tanning salon services and its

own printing, advertising, and marketing services.    Petitioner

used the business names of Vitamin Village for the production and

sales of nutritional supplements, health food, skin care

products, and tanning lotions; Club Tan for its tanning salon

services; and Universal Graphics for its advertising, marketing,

and printing activities.

     Mr. Reeves was petitioner’s president from 1979 and its

secretary, treasurer, and sole shareholder from 1986 through the

fiscal years at issue, and he controlled all aspects of

petitioner’s corporate operations.     From 1979 through the fiscal

years at issue, Mr. Reeves also performed all of petitioner’s

managerial duties.   He worked more than 80 hours per week

managing petitioner’s research, development, production, sales,

marketing, and advertising and supervised petitioner’s employees,

including making all hiring and firing decisions.



     3
      (...continued)
individuals, Jeff O’Brien and R. Gail Reeves. Mr. O’Brien left
petitioner shortly after its incorporation. R. Gail Reeves
terminated her positions as petitioner’s secretary and treasurer,
and all stock she owned in petitioner was redeemed in FYE June
30, 1986.
                               - 4 -

B.   Spinoff Corporations

     To reduce petitioner’s potential liability and to increase

efficiency and growth, Mr. Reeves organized two new corporations

out of petitioner, Club Tan Centers of Oregon, Inc. (CTC), and

Universal Marketing, Inc. (UMI).   In December 1994, petitioner

transferred the assets used by Club Tan to CTC, and on June 1,

1995, petitioner transferred the assets used by Universal

Graphics to UMI.   All of the stock issued by CTC and UMI was

transferred to Mr. Reeves in a section 355 reorganization

(spinoff) resulting in petitioner, CTC, and UMI becoming brother-

sister corporations.

     Mr. Reeves was the president, secretary, treasurer, and sole

shareholder of CTC and UMI.   Although his obligations to

petitioner decreased as a result of the spinoffs, as the sole

officer and manager of three corporations, Mr. Reeves had

significantly increased responsibilities.
                                - 5 -

C.     Petitioner’s Financial Condition

       For FYE June 30, 1985 through 1996, petitioner’s gross

receipts, net income, and net margin were as follows:4

 FY        Gross receipts      Net income     Net margin (percent)
1985         $471,720            $21,938             4.7
1986          496,367              2,614             0.5
1987          628,333            (26,344)           -4.2
1988          749,595              3,363             0.4
1989        1,044,449            (49,205)           -4.7
1990          752,702             (5,281)           -0.7
1991          661,928            (46,254)           -7.0
1992        1,011,083              7,078             0.7
1993        2,074,682             43,360             2.1
1994        1,936,476             49,545             2.6
1995       12,501,980          1,087,759             8.7
1996        5,709,686            398,585             7.0
1997        2,170,205             31,985             1.5

       During the fiscal years at issue, petitioner’s sales, costs

of goods sold, gross profits, net income, total taxes, net income

per books, and ratios of gross profit to gross receipts,

expressed as percentages, were as follows:5




       4
       The stated gross receipts and net income (taxable income)
for FYE June 30, 1985 through 1997, were obtained from
petitioner’s Forms 1120, U.S. Corporation Income Tax Return, for
the respective fiscal years.
       5
       The amounts listed in this table were reported in
petitioner’s Forms 1120 for the respective fiscal years at issue.
Net income per books was reported on Forms 1120, Schedule M-1.
                              - 6 -

                              FY 1995             FY 1996
Gross receipts             $12,501,980          $5,709,686
Cost of goods sold           6,128,126           1,473,083
Gross profits                6,373,854           4,236,603
Net income                   1,087,759             398,858
Total tax                      300,374             123,769
Net income per books           742,910             268,326
Ratio of gross profits
  to gross receipts                   51%               74%

     Petitioner reported the following shareholder equity during

the years at issue:6

                              FY 1995             FY 1996
Common stock                   $2,770               $2,770
Retained earnings             793,574            1,061,900
Equity                        796,344            1,064,670
Net income per books          742,910              268,326
Return on equity                   93%                  25%




     6
       Petitioner’s common stock value and retained earnings were
reported on its Forms 1120, Schedules L for the fiscal years at
issue.

     Because of the spinoffs, the value of petitioner’s common
stock was reduced from $3,000 to $2,770.

     Petitioner’s equity was computed by adding petitioner’s end-
of-year common stock value to its end-of-year retained earnings.
Rate of return on equity is computed by dividing petitioner’s net
income per books by its equity for the respective fiscal years at
issue.
                                 - 7 -

D.   Petitioner’s Employee Compensation

     The compensation petitioner paid Mr. Reeves each year from

1982 through 1996 was:7

  FYE June 30             Compensation

     1982                   $15,707
     1983                    16,100
     1984                    26,000
     1985                    42,000
     1986                    47,000 (includes $18,240 bonus)
     1987                    11,000
     1988                        -0-
     1989                    22,444
     1990                     4,000
     1991                        -0-
     1992                        -0-
     1993                   310,000
     1994                   182,300
     1995                 2,278,000 (includes $2 million bonus)
     1996                 1,012,000 (includes $1 million bonus)

     From FY 1982 through FY 1992, Mr. Reeves’s salary remained

low or he was unpaid so that profits could be invested to expand

petitioner’s business.    Beginning in FYE June 30, 1993,

petitioner’s business improved, and profits substantially

increased.   Petitioner deducted the compensation paid to Mr.

Reeves as officer compensation on its Forms 1120, U.S.

Corporation Income Tax Return, in the fiscal years at issue.

     In FYE June 30, 1995, petitioner paid $374,884 in salary and

wages to its employees including $95,000 in bonuses, and in FYE

June 30, 1996, petitioner paid $348,837 in salary and wages to



     7
       The table does not include amounts UMI or CTC paid to Mr.
Reeves.
                               - 8 -

its employees including $125,000 in bonuses.   Petitioner deducted

these amounts as salaries and wages paid to its employees on its

Forms 1120 in the fiscal years at issue.

     Petitioner did not maintain a compensation policy for its

officers and employees.   However, all 12 of petitioner’s

memorandums of consent to corporate action from FYE June 30, 1985

through 1996, indicated Mr. Reeves received less than full and

adequate compensation for his role as petitioner’s president and

that petitioner would give future consideration to increasing Mr.

Reeves’s salary and/or award future discretionary bonuses to

reimburse him for his past and present service.

     The bonuses Mr. Reeves and petitioner’s other employees

received were not based upon a formula or previously set forth in

writing.   Each bonus was determined and paid at the end of the

fiscal year when petitioner could ascertain its cash availability

and determine what would be a reasonable bonus, taking into

consideration previous underpayments.

E.   Advertising Agreement With UMI

     In the fiscal year previous to UMI’s formation, petitioner’s

gross skin care and tanning products sales totaled $600,000 with

$124,000 profit.   In an effort to increase sales, in June 1995

(in petitioner’s FYE June 30, 1995), petitioner entered into an

agreement with UMI by which, in exchange for $1 million, UMI

agreed to brand, market, and advertise the skin care and tanning
                               - 9 -

products petitioner sold in UMI’s FYE May 31, 1996.     Pursuant to

a similar agreement petitioner paid $1,105,276 (in petitioner’s

FYE June 30, 1996) for the same services in UMI’s FYE May 31,

1997.

     As a result of UMI’s services, within UMI’s first fiscal

year (FYE May 31, 1996), petitioner’s gross receipts exceeded $1

million with $800,000 in gross profits from the sale of the

products UMI branded, marketed, and advertised.8   Furthermore, in

petitioner’s 1997 fiscal year, UMI’s services caused petitioner’s

gross receipts to double, exceeding $2 million and earning over

$1 million in gross profits.   Petitioner deducted the amounts

paid to UMI as advertising expenses in the fiscal years at issue.

F.   Mr. Reeves’s Home and the Floating Structures

     On September 24, 1993, Mr. Reeves purchased 1.2 acres along

the Willamette River in Newberg, Oregon, which included Mr.

Reeves’s family residence and a dilapidated houseboat and a

floating dock on the river behind and down a hill from the

residence.   The residence was a two-story house with

approximately 2,200 square feet per floor.   The first floor was a

daylight basement used by the previous owner to store

automobiles.   The houseboat and the dock were connected to Mr.




     8
        The record does not indicate CTC’s earnings or the amount
of time Mr. Reeves spent conducting its activities. The record
indicates Mr. Reeves sold CTC in 1997.
                               - 10 -

Reeves’s property by a rundown gangway.   The houseboat, the dock,

and the gangway were in a poor and dangerous condition.

     In petitioner’s FYE June 30, 1995, Mr. Reeves and petitioner

entered into a lease agreement for $1,000 a month to provide

petitioner with access from Mr. Reeves’s residence to the

houseboat and the dock, the use of his utilities, and the use of

his parking lot, boat, and jet skis for advertising and

promotional purposes.9   In the fiscal years at issue, petitioner

also rented the first floor of Mr. Reeves’s residence for $700 a

month to store goods.

     In 1995, Mr. Reeves and petitioner removed the dilapidated

houseboat and the dock and hired a contractor to build a new

houseboat, a 100-foot dock, and a floating garage (floating

structures).   Construction of the floating structures was

completed in the spring of 1996, and they were placed into

service on May 28, 1996.10   The Oregon State Marine Board listed

petitioner as the owner and Mr. Reeves as the coowner.11




     9
       The $1,000 a month also allowed access to Mr. Reeves’s
tennis court and an enclosed area where corporate guests could
place their children so they would be safe from falling into the
Willamette River.
     10
       Petitioner’s Form 4562, Depreciation and Amortization,
reported the property was placed into service on May 28, 1996.
     11
       Mr. Reeves claimed that only petitioner owned the
floating structures and he was listed as a coowner because the
State required an individual contact.
                               - 11 -

     The new houseboat was approximately 43 feet long and 28 feet

wide.   It had one floor with three rooms including a living area,

a photo studio, and office space, and an open-air deck on top

which included an outdoor cafe.   Adjacent to the new house boat

was the floating garage where Mr. Reeves’s boat and jet skis and

petitioner’s tables and chairs were stored.    The garage was

covered and securely locked.

     Petitioner and Mr. Reeves shared the costs of the floating

structures’ construction.   Mr. Reeves paid $80,717 in 1995 and

petitioner paid a total of $185,327:    $95,046 in FYE June 30,

1995, and $90,281 in FYE June 30, 1996.    Petitioner capitalized

the $185,327 and depreciated the costs over a 39-year period.

Petitioner reported these expenditures on its Forms 4562,

Depreciation and Amortization, as leasehold improvements

involving nonresidential real property and claimed depreciation

deductions of $721 and $2,726 in the fiscal years at issue,

respectively.

     Petitioner and UMI used the floating structures for

promotional events, meetings, and advertising photo shoots.

Beginning in 1996, Mr. Reeves used the floating structures for

personal purposes approximately 10 times a year.    Neither

petitioner nor Mr. Reeves kept a log of the use of the floating

structures.
                                - 12 -

     In 2002, Mr. Reeves sold his residence in Newberg, Oregon,

as part of a bankruptcy sale.    As part of the sale, petitioner

sold the floating structures to Mr. Reeves’s wife’s company,

Royal Sun Properties, L.L.C., for $100,000 with $55,000 paid as a

downpayment.12

     Respondent issued the notice of deficiency on March 8, 2002.

Petitioner timely filed its amended petition on August 19, 2002.

                                OPINION

I.   Reasonable Compensation

     Petitioner contends the amounts paid to its sole executive

and shareholder, Mr. Reeves, in the fiscal years at issue

constituted reasonable compensation under section 162(a)(1).

Conversely, respondent contends Mr. Reeves’s compensation for the

fiscal years at issue was unreasonable but, on the basis of

respondent’s expert’s opinion, concedes deductions of $1 million

and $750,000,13 respectively.




     12
       Royal Sun Properties, L.L.C., still owes petitioner
$45,000.
     13
       The $750,000 includes reasonable compensation paid to Mr.
Reeves by petitioner and UMI together. Respondent argued on
brief that if the Court accepted $750,000 as reasonable
compensation for FYE June 30, 1996, it would be appropriate to
divide this amount between petitioner and UMI and allow
petitioner to deduct $499,012. Respondent alternatively argued
that it would be appropriate to allow UMI its full claimed
deduction of $509,000 if petitioner were allowed only $250,000 as
reasonable compensation for its FYE June 30, 1996.
                                - 13 -

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

allowance for salaries or other compensation for personal

services actually rendered”.    A taxpayer is entitled to a

deduction for compensation only if the payments were reasonable

in amount and in fact paid purely for services.    Sec. 1.162-7(a),

Income Tax Regs.14   Although framed as a two-prong test, the

inquiry under section 162(a)(1) generally turns on whether the

amounts of the purported compensation payments were reasonable.

Elliotts, Inc. v. Commissioner, 

, 1245 (9th Cir.

1983), revg. T.C. Memo. 1980-282.     Petitioner has the burden of

proving the payments to Mr. Reeves were reasonable.    See Rule

142(a).

     Because petitioner’s place of business is in the State of

Oregon, absent stipulation otherwise, an appeal of this case

would go to the Court of Appeals for the Ninth Circuit.    See sec.

7482(b)(1)(B).    That Court of Appeals uses five factors to

determine the reasonableness of compensation, with no single

factor being determinative.     Elliotts, Inc. v. 

.    The factors are:   (1) The employee’s role in the company;

(2) comparison with other companies; (3) the character and

condition of the company; (4) potential conflicts of interest;

and (5) internal consistency in compensation.

       Respondent argues only that the amount of compensation
was unreasonable.
                                   - 14 -

When shareholder-officers who control the corporation set their

own compensation, careful scrutiny is necessary to determine

whether the alleged compensation is in fact a distribution of

profits and a constructive dividend.        Home Interiors & Gifts,

Inc. v. Commissioner, 

, 1156 (1980).

II.   The Elliotts Factors Applied to Petitioner’s Compensation of
      Mr. Reeves

      A.     Role in the Company

      The role the employee plays in the company focuses on the

employee’s importance to the success of the business.       Pertinent

considerations include the employee’s position, hours worked, and

duties performed.     Elliotts, Inc. v. 

at 1245.

      From petitioner’s incorporation in 1979, Mr. Reeves’s hard

work and vision were critical and indispensable to petitioner’s

business and the primary reason for its overall success.       He

served as petitioner’s president from its incorporation in 1979

and its secretary and treasurer from 1986.       Mr. Reeves also

handled all of petitioner’s managerial duties.       On a daily basis

he managed petitioner’s research, development, production, sales,

and marketing and advertising (until UMI was spun off on June 1,

1995).     Mr. Reeves also supervised petitioner’s employees15 and

was responsible for all hiring and firing.



      15
       Mr. Reeves testified that petitioner had approximately 25
employees during the fiscal years at issue.
                                  - 15 -

     Although Mr. Reeves did not devote 100 percent of his time

to petitioner’s business during the fiscal years at issue, as the

only executive and manager he was the driving force behind

petitioner’s success.16   Mr. Reeves was a highly motivated

employee who worked over 80 hours per week for petitioner during

the first 6 months of its FY 1995 and a substantial amount of

time during the second half of its FY 1995.       Despite managing two

other companies during petitioner’s FY 1996, Mr. Reeves continued

to devote a substantial amount of time to petitioner’s

operations, which led to its further success.

     B.     External Comparison

     This factor compares the employee’s compensation with that

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

v. 

at 1246; see sec. 1.162-7(b)(3), Income

Tax Regs.    Courts often use expert witness opinions to evaluate

the reasonableness of compensation.        Nonetheless, this Court is

not bound by the opinion of any expert witness and may accept or

reject expert testimony in the exercise of sound judgment.

     16
       The record indicated the incorporation of UMI and CTC
resulted in Mr. Reeves’s performing fewer services and spending
less time operating petitioner without delineating the number of
hours per week Mr. Reeves spent operating petitioner. However,
the record did indicate that: CTC was a separate corporation for
one-half of petitioner’s FYE June 30, 1995, and UMI was a
separate corporation for 1 month of petitioner’s FYE June 30,
1995; Mr. Reeves spent over 80 hours a week operating petitioner
before CTC and UMI were spun off; and shortly after CTC and UMI
were spun off Mr. Reeves’s overall time spent working increased
significantly.
                                - 16 -

Helvering v. Natl. Grocery Co., 

, 295 (1938);

Silverman v. Commissioner, 

, 933 (2d Cir. 1976),

affg. T.C. Memo. 1974-285.     Furthermore, the Court may be

selective in determining what portions of an expert’s opinion, if

any, to accept.     Parker v. Commissioner, 

, 562 (1986).

     Only respondent offered expert testimony comparing Mr.

Reeves’s compensation with that paid by similar companies for

similar services.     Respondent’s proffered expert, Scott D.

Hakala, was a principal and director of CBIZ Valuation Group,

Inc., an appraisal, financial advisory, and litigation support

firm.     Mr. Hakala has a doctorate in economics, has worked as an

economist and financial analyst, and has testified on numerous

occasions as an expert in cases involving compensation disputes.

     Mr. Hakala compared Mr. Reeves’s compensation to chief

executive officer (CEO) compensation in five publicly traded

companies (guideline companies).17    He used four methods to make

the comparison:    (1) The average compensation paid to the CEOs

from the guideline companies; (2) a regression analysis based

upon the guideline companies’ relationship between CEO

compensation and their respective sales;18 (3) a guideline

     17
       Mr. Hakala stated in his report and testified at trial
that he used the guideline companies because some or most of
their operations were based in the development and marketing of
nutritional products.
     18
          The regression equation for 1995 was Y = 315653.0283 +
                                                      (continued...)
                             - 17 -

company’s compensation-to-sales ratio of 7.1 percent;19 and (4)

the guideline companies’ net margins.   The financial information

used in the four methods was obtained from the guideline

companies’ financial statements.   The table below reflects Mr.

Hakala’s range of reasonable compensation for Mr. Reeves,

computed by applying the four methods to the guideline companies’

financial information:




     18
      (...continued)
0.002365149(X). The regression equation for 1996 was Y =
325357.1548 + 0.002408813(X). Y equals CEO compensation and X
equals revenue. Mr. Hakala’s report did not explain how he
configured the variables used in the regression analysis.
     19
       The sales ratio is CEO compensation divided by company
sales, expressed as a percent. Mr. Hakala’s report stated that
he used the sales ratio from only one of the five guideline
companies, Natural Health Trends Corp (Natural Health), because
it was the highest of the five companies’ ratios. Natural
Health’s sales ratios for its FY 1995 and FY 1996 were 9.4
percent and 7.1 percent, respectively. Without indicating his
reasoning, Mr. Hakala applied Natural Health’s sales ratio of 7.1
percent to petitioner’s sales for both FY 1995 and FY 1996.
However, he should have computed the guideline company’s sales
ratio for FY 1995 by multiplying Natural Health’s sales ratio of
9.4 percent by petitioner’s sales for FY 1995, not the sales
ratio of 7.1 percent. This computation would make the FY 1995
guideline company percent of sales $1,175,186, instead of
$887,641.

     Because the Court does not consider petitioner and UMI as a
single company, i.e., combine their income, reasonable
compensation under the “percent of sales” method for petitioner
for FY 1996 is $405,388 instead of $409,323.
                               - 18 -

          Method                             FYE 1995    FYE 1996
Guideline cos. CEO compensation              $659,849    $755,309
Guideline cos. regression analysis            345,222     339,111
Guideline co. percent of sales                887,641     409,323
Guideline cos. net margins                  2,150,000   1,500,000
Average of the methods                      1,010,678     750,936

     The notice of deficiency allowed petitioner to deduct

$1,044,809 and $367,382 as compensation to Mr. Reeves in the

fiscal years at issue, respectively.    Mr. Hakala’s report

concluded the maximum reasonable compensation payable to Mr.

Reeves in the years at issue was $1 million and $750,000,20

respectively.21

     On cross-examination, Mr. Hakala conceded he was unable to

consider all the facts and circumstances needed to conduct a

comprehensive analysis because his financial review was limited

to petitioner’s revenue and net income from FY 1985 through FY

1994 and petitioner’s tax returns for the years at issue.     He

testified that additional information could have made a material

impact on his conclusions.22




     20
          See supra note 13.
     21
       Mr. Hakala’s reasonable compensation determinations for
the years at issue were the rounded averages of figures computed
by applying the four methods to the guideline companies’
financial information. See table supra p. 18.
     22
       In Mr. Hakala’s report and at trial, he stated that he
reserved the right to amend the report to reflect consideration
of additional information.
                               - 19 -

     Mr. Hakala admitted that there were six circumstances not

considered in his report that could affect his findings in

petitioner’s favor.   First, he stated that an employee who serves

in multiple positions within a company may be compensated at a

higher level to reflect the additional duties and

responsibilities.   He recognized that unlike the CEOs of the

guideline companies, Mr. Reeves served in all of petitioner’s

executive and managerial roles.   Consequently, his compensation

should reflect the combined salaries of the positions he held.

See Elliotts, Inc. v. 

.23

     Second, Mr. Hakala testified that typically an employee of a

company like petitioner that has variable performance years and

who is underpaid during those years is compensated at a higher

amount in profitable years to make up for the lower income

years.24   In addition, when the employee is reimbursed at a later

date, the time value of money is often considered in increasing

compensation.   Mr. Hakala’s report did not take into account that

in some of the years before the fiscal years at issue petitioner

either underpaid Mr. Reeves or did not pay him at all.



     23
       The average combined executive salaries for the five
guideline companies during the fiscal years at issue were
$1,019,418 and $1,124,167, respectively.
     24
       Mr. Hakala stated that the common way to compensate
employees in businesses with volatile performance is through a
compensation plan that pays a fixed salary, with a bonus during
good years and no bonus during years in which performance is
poor.
                                - 20 -

     Mr. Reeves testified that one of the reasons petitioner paid

him a large bonus in its FY 1995 was to compensate for the years

he was underpaid.     Multiplying the sales ratio of 8.25 percent by

petitioner’s total sales in FY 1985 through FY 1994, the Court

finds that Mr. Reeves was underpaid for 6 years:25

                 FY               Amount underpaid

                1987                  $40,837
                1988                   61,842
                1989                   63,723
                1990                   58,098
                1991                   54,609
                1992                   83,414

     The future values of the amounts underpaid as of December

31, 1995, were $81,102, $111,647, $101,436, $87,373, 71,771, and

$94,021, totaling $547,350.26

     Third, Mr. Hakala stated that a company experiencing losses

may significantly decrease compensation to its CEO, and using the

company as a guideline can result in understatement of executive

income.   Of the five guideline companies, in FY 1995 one

experienced significant losses, and in FY 1996, three experienced

substantial losses.27    The five guideline companies’ financial



     25
       8.25 percent was computed by averaging the sales ratios
(9.4 percent and 7.1 percent) used to determine reasonable
compensation under the “percent of sales” method.
     26
       The future values were determined using the applicable
Federal rate compounded semiannually under sec. 1274(d).
     27
        Mr. Hakala testified that he chose the guideline
companies because they developed and sold nutritional products
and not because they sustained profits or losses.
                               - 21 -

characteristics during the fiscal years at issue are set out

below:

                    Ratio of                   Net
                      gross       Net        income/
                     profits    income/    loss as a    Return on
  Guideline co.     to sales      loss     percentage    equity
     and year      (percent)   (million)    of sales    (percent)
NBTY, Inc.
           1995        40         $5.4         3.2         6.6
           1996        49          9.5         5.0        10.4
National Health
           1995        53        (0.5)       -15.7       -17.5
           1996         9        (2.9)       -66.5       -86.6
Natural
           1995        29         2.0          5.4        15.3
           1996        28         3.2          6.8        18.18
Nutritional 21
           1995        73         0.5          4.1         4.5
           1996        61        (4.4)       -27.7       -25.9
Reliv’
           1995        78          1           3.4        18.5
           1996        38        (10)        -31.2      -188.1
Average    1995        55          1.68        0.08        5.9
Average    1996        37         (0.92)     -22.72      -54.4

     Fourth, Mr. Hakala stated a CEO may be entitled to increased

compensation during a year when his or her company earns higher

profits.   He opined that petitioner was more profitable than all

five companies in terms of the ratio of net income to sales (net

margin).   Petitioner’s net margins for the fiscal years at issue
                              - 22 -

were 8.7 percent and 7.0 percent, respectively,28 exceeding the

guideline companies’ average net margins of 1.68 and -0.92,

respectively.

     Fifth, Mr. Hakala did not evaluate companies like

petitioner, whose operations during FYE June 30, 1995, included

advertising, indoor tanning services, and the sale of tanning

products.

     Sixth, Mr. Hakala stated that publicly held companies have

additional costs of up to 5 percent as compared to privately held

companies.   As a result, petitioner would have fewer expenses and

more income available to compensate its employees.29

     In conclusion, the Court adopts three of the four methods30

Mr. Hakala used to compute reasonable compensation.    After taking

into consideration the six circumstances not considered in his

report, the Court finds that the table below sets out the ranges

for reasonable compensation more accurately:




     28
        In his report, Mr. Hakala indicated that in FYE 1996 the
guideline companies exhibited increased sales, whereas
petitioner’s sales decreased by over 50 percent during the same
period.
     29
       In Mr. Hakala’s report and trial testimony he stated that
he reserved the right to amend the report to reflect
consideration of additional information.
     30
       Because the Court could not determine how Mr. Hakala
computed reasonable compensation under the regression analysis,
the Court did not consider the regression analysis method to
determine petitioner’s compensation of Mr. Reeves.
                             - 23 -

          Method                             FYE 1995     FYE 1996
Guideline cos. CEO compensation            $1,019,418   $1,124,167
Guideline cos. percent of sales             1,175,186      405,388
Guideline cos. net margins                  2,150,000   1,500,000
Average of the methods                      1,448,201   1,009,852

     In addition, taking into consideration the $547,350 Mr.

Reeves was underpaid as of December 31, 1995, the reasonable

compensation for petitioner’s FY 1995 is increased to $1,995,551.

     C.   Character and Condition of the Company

     This factor requires the Court to focus on petitioner’s

size as measured by its sales, net income, or capital value; the

complexities of the business; and general economic conditions.

See Elliotts, Inc. v. 

.

     Petitioner was a relatively small company that had secured

itself a market niche enabling it to earn high profit margins on

its product sales and services.

     Petitioner’s income was modest until 1993 when it began to

experience a substantial increase.    Gross sales grew from

$661,928 in FYE June 30, 1991, to $2,074,682 and $1,936,476 in

FYE June 30, 1993 and 1994, respectively, and continued to

increase in the fiscal years at issue to $12,501,980 and

$5,709,686, with net margins of 8.7 and 7 percent, respectively.

Petitioner’s net income was substantially higher than the

guideline companies’ average and each guideline company’s

individually, except for NBTY, Inc.’s FY 1996.    Moreover,
                                - 24 -

petitioner’s shareholders return on equity increased to 93

percent and 25 percent in the fiscal years at issue,

respectively.    These percentages were also substantially higher

than the guideline companies’ average, as discussed below.

     Although petitioner’s business may not have been a complex

operation, this Court does not consider it to have been a simple

task for Mr. Reeves to operate petitioner as its sole executive

and manager.    Neither petitioner’s sales nor its gross profits

could have been attained but for the personal skills of Mr.

Reeves.

     D.   Conflict of Interest

     This factor examines whether a relationship exists between

the company and the employee which may permit the company to

disguise nondeductible corporate distributions as section

162(a)(1) compensation payments.     Close scrutiny may be used when

the paying corporation is controlled by the compensated employee,

as in the instant case.     Elliotts, Inc. v. 

at

1246-1247.     However, the mere fact that the individual whose

compensation is under scrutiny is the sole shareholder of the

company, even when coupled with an absence of dividend payments,

“does not necessarily lead to the conclusion that the amount of

compensation is unreasonably high.”

     The Court of Appeals for the Ninth Circuit formulated the

inquiry by evaluating the compensation payments from the
                             - 25 -

perspective of a hypothetical independent investor.    The prime

indicator is the return on the investor’s equity.

If the company’s earnings on equity after payment of the

compensation remain at a level that would satisfy an independent

investor, there is a strong indication that the employee is

providing compensable services and that profits are not being

siphoned out of the company disguised as salary.31

Appeals in Elliotts calculated the return on equity

using the yearend shareholders equity.

income book value by the yearend shareholders

equity results in the following:

          FYE June 30         Percent return on equity

             1995                     93 percent
             1996                     25 percent

     Petitioner’s return on equity substantially exceeded the

guideline companies’ average return on equity of 5.9 percent and

-54.4 percent during the fiscal years at issue, respectively, and

exceeded each specific company’s return on equity.32      Mr. Reeves

was solely responsible for petitioner’s success and performed the


     31
       The Court of Appeals for the Ninth Circuit found that a
20-percent average rate of return on equity would satisfy a
hypothetical inactive independent investor and indicated the
corporate employer and its shareholder/employee were not
exploiting their relationship. Elliotts, Inc. v. Commissioner,

, 1247 (9th Cir. 1983), revg. T.C. Memo. 1980-282.
     32
       See the table showing each guideline company’s return on
equity supra p. 21.
                               - 26 -

services which were directly responsible for petitioner’s

profitability.

     E.    Internal Consistency in Compensation

     This factor focuses on whether the compensation was paid

pursuant to a structured, formal, and consistently applied

program.   Elliotts, Inc. v. 

at 1247.     Bonuses

not paid pursuant to such plans are suspect.   Salaries paid to

controlling shareholders are also suspect if, when compared to

salaries paid to nonowner management, they indicate that the

amount of compensation is a function of ownership, not corporate

management responsibility.

employees are deductible “when * * * made in

good faith and as additional compensation for 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.”   Sec. 1.162-9, Income Tax Regs.     No

internal discrepancy exists when a company pays and deducts

compensation for services performed in prior years.   Elliotts,

Inc. v. 

at 1248.

     Financial stability was the crucial element in petitioner’s

growth strategy.   To foster petitioner’s growth, from 1979

through 1992 petitioner either underpaid Mr. Reeves, petitioner’s

sole executive officer and manager, or did not pay him at all.

Petitioner retained Mr. Reeves’s compensation and used it to
                               - 27 -

further develop and expand its business.   Petitioner stated in

its memoranda of consent to corporate action that it would

reimburse Mr. Reeves for past underpayment and pay bonuses for

the extraordinary services he provided when petitioner became

more profitable.

     Petitioner was a very profitable company in the fiscal years

at issue and paid Mr. Reeves and its other employees bonuses.

The bonuses paid were not awarded under a structured, formal, or

consistently applied program but were paid under petitioner’s

plan to award a bonus for present hard work and prior years’ lack

of compensation when it became more profitable.

     F.    Conclusion

     Mr. Reeves, petitioner’s sole executive officer and manager,

was the driving force behind petitioner’s success.   His vision

and hard work resulted in petitioner’s realizing sales of

$12,501,980, and $5,709,686, with a shareholders return on equity

of 93 percent and 25 percent in the respective fiscal years at

issue.    The averages of the methods used to determine reasonable

compensation were $1,448,201 and $1,009,852 in the respective

fiscal years at issue, and taking into consideration the $547,350

Mr. Reeves was underpaid as of December 31, 1995, the Court finds
                                - 28 -

that $2 million and $1,012,000 in the respective fiscal years at

issue are deductible under section 162(a)(1).33

III. Advertising Expenses

     Petitioner argues it is entitled to deduct advertising

expenses under section 162(a) of $1,105,276 for its FYE June 30,

1996.

     Advertising expenses are a type of ordinary and necessary

expense for which a current deduction is allowed to an active

trade or business.     Sec. 162(a); sec. 1.162-1(a), Income Tax

Regs.     Advertising expenses are allowed as a deduction under

section 162 if the taxpayer can demonstrate a sufficient

connection between the expenditure and the taxpayer’s business.

See RJR Nabisco Inc. & Consol. Subs. v. Commissioner, T.C. Memo.

1998-252.

     Petitioner is an active trade or business that entered into

an exclusive contract with UMI to conduct all of petitioner’s

marketing, advertising, and branding in the fiscal years at

issue.     In its FYE June 30, 1996, petitioner paid UMI $1,105,276

and deducted this amount as advertising expenses.

     Respondent argues that $831,137 of the advertising expenses

was not for ordinary and necessary advertising expenses because

it was a distribution to Mr. Reeves from UMI and not paid as

     33
       Conversely, the Court finds $278,000 of the $2,278,000
claimed by petitioner as a deduction for FYE June 30, 1995, to be
nondeductible.
                              - 29 -

advertising expenses.   As a result, respondent reduced

petitioner’s allowable advertising expenses to $274,139.

     UMI received the $1,105,276 during its FYE May 30, 1997.

UMI did not receive a notice of deficiency for this year, and its

FY 1997 is not at issue in this case.   Respondent did not produce

UMI’s tax return for the FY 1997, evidence showing Mr. Reeves

received a $831,137 distribution from UMI, or evidence indicating

how UMI used the amounts petitioner paid for advertising.

     Respondent’s revenue agent Steve Rans, who conducted the

audit of petitioner’s returns, testified that in determining

ordinary and necessary advertising expenses he did not take into

consideration wages paid by UMI, UMI’s costs of creating and

developing ideas, nor all the activities UMI performed to market,

advertise, and brand petitioner’s suntan lotion products.

     Mr. Reeves testified that UMI had a substantial marketing

and advertising plan to create a lifestyle image for petitioner’s

products by:   (1) Developing product catalogs; (2) designing

packaging and logos; (3) developing trade show display booths;

(4) attending trade shows; (5) meeting with salespersons to

educate them on petitioner’s products and how to sell them; and

(6) producing radio advertisements and promoting sporting events

to advertise petitioner’s products.

     Steve Rans also testified that because of UMI’s marketing

and advertising in the FY 1996 and FY 1997, petitioner’s gross
                                - 30 -

receipts from the sale of suntan products grew to $2,999,000,

with $1,800,000 profit.

      The Court finds that petitioner showed a sufficient

connection between the $1,105,276 paid in advertising expenses

and its business of producing and selling suntan lotion products.

Therefore, this Court finds petitioner is entitled to deduct the

$1,105,276 in advertising expenses under section 162(a) for FYE

June 30, 1996.

IV.   Floating Structures

      Petitioner contends that it may depreciate its cost of

building the floating structures because the structures were used

primarily for business purposes.

      Respondent does not dispute petitioner’s costs incurred

building the floating structures.    Rather, respondent contends

that petitioner failed to establish the floating structures were

used in petitioner’s business during the fiscal years at issue.

      Section 167(a)(1) allows as a depreciation deduction a

reasonable allowance for the exhaustion, wear and tear, and

obsolescence of property used in a trade or business.34     The

taxpayer bears the burden of proving the Commissioner’s

determinations are incorrect.    Rule 142(a).   Furthermore, each

deduction must be carefully scrutinized when the taxpayer is a


      34
       Petitioner did not argue that the floating structures
were property held for the production of income under sec.
167(a)(2) or that the floating structures qualify for
depreciation as entertainment facilities under sec. 274(a)(1).
                               - 31 -

closely held corporation.    Intl. Artists, Ltd. v. Commissioner,

, 108 (1970).

     The floating structures were placed in service on May 28,

1996, approximately 1 month before the end of petitioner’s FYE

June 30, 1996.   The structures were under construction in 1995.

Thus, they were not used in petitioner’s trade or business during

its FY 1995.   See sec. 167(a)(1).    Therefore, this Court finds

petitioner is not entitled to a depreciation deduction pursuant

to section 167(a)(1) in FYE June 30, 1995.

     Mr. Reeves testified that after the floating structures were

placed into service, they were used primarily by petitioner and

UMI to develop advertising for the purpose of promoting

petitioner’s skin care and suntan lotion products, nutritional

supplements, and health food products.     He testified the

advertising work included photo shoots that involved people

around water; i.e., riding jet skis, skiing, or lying out in the

sun next to the river.    Petitioner also indicated the property

was used for promotional events.

     Neither petitioner nor Mr. Reeves kept logs of petitioner’s

or UMI’s business use of the floating structures from May 28,

1996, through FYE June 30, 1996.     The only evidence petitioner

offered to establish that the floating structures were used for a

business purpose was Mr. Reeves’s testimony and several undated
                                - 32 -

photographs or photographs used in petitioner’s advertising dated

before the floating structures were completed.

        Petitioner did not provide any evidence showing that the

floating structures were used primarily or at all for business

purposes during the last month of FYE June 30, 1996.35    See

Hobson Motor Co. v. Commissioner, T.C. Memo. 1990-297.

Therefore, this Court also finds petitioner is not entitled to a

depreciation deduction pursuant to section 167(a)(1) for FYE June

1996.

     The Court, in reaching its holdings, has considered all

arguments made and concludes that any arguments not mentioned

above are moot, irrelevant, or without merit.

     To reflect the foregoing,


                                      Decision will be entered

                                 under Rule 155.




        35
       The lack of adequate documentation also precludes any
deductions for entertainment, amusement, or recreation with
respect to a facility used in connection with such activities.
Sec. 274(d)(2); see Finney v. Commissioner, T.C. Memo. 1980-23.