MEMORANDUM FINDINGS OF FACT AND OPINION

SHIELDS, Judge: In these consolidated cases, respondent determined deficiencies in petitioner's income tax for its fiscal years ending on March 31, 1987, 1988, and 1989, in the respective amounts of $ 5,698, $ 262,617, and $ 129,252.

After concessions, ¹ the only issue for decision is whether petitioner, Mortex Manufacturing Co., Inc. (Mortex), is entitled to claim deductions, for fiscal years 1988 and 1989, under section 162(a)(1) ²1994 Tax Ct. Memo LEXIS 111">*112 for the full amounts paid to its officers as compensation. ³ Petitioner argues in the alternative that, if a portion of the payments made to the officers is found to be unreasonable compensation for services rendered, then the disallowed amounts are properly deductible for the use by petitioner of certain patents and a trade secret owned by one or more of the officers.

FINDINGS OF FACT

Petitioner, an Arizona corporation with its principal place of business at Tucson, was organized in 1976 by Max W. Deason (Max), his wife, Jo Elsie Deason (Jo), and their children Ted Deason (Ted), Ann Deason (Ann), and Bart Deason (Bart) to carry on a business which Max with Jo's help had founded and developed over a period of years as a sole proprietorship. The business consists of the manufacture and distribution of products used in the construction of swimming pools.

Max, an inventor and entrepreneur, was the moving force behind the business both before and after its incorporation until his death in 1987. However, all other members of the family were closely involved in the business from its inception. Jo was responsible for its finances, and all of the children worked in the business1994 Tax Ct. Memo LEXIS 111">*113 when they were students and later when they were shareholders of the corporation. Ann subsequently married Donald Poyas (Don), who began to work for the business in 1970. Ted's wife Carlene Deason (Carlene) became a vice president of the corporation in 1988. ⁴

Upon its incorporation, 200,000 shares of Mortex's common stock were issued at $ 1 per share as follows:

By March 31, 1981, the stock ownership was as follows:

1994 Tax Ct. Memo LEXIS 111">*114 In April 1981, Ted and Ann purchased their father's shares in petitioner, and thereafter through the fiscal years in question petitioner's stock was held as follows:

The total payments made to its officers ⁵ as compensation by petitioner for fiscal years 1988 and 1989 were as follows:

Of the total of $ 920,760 paid by petitioner to its officers in fiscal year 1988, $ 505,760 was paid during the year as salaries and deducted as such on petitioner's return for 1988. The balance of $ 415,000 was paid by petitioner at the end of the year and deducted as commissions. Of the $ 752,760 paid by petitioner1994 Tax Ct. Memo LEXIS 111">*115 to its officers in fiscal year 1989, $ 572,760 was paid during the year as salaries and deducted as such on petitioner's return for 1989. The balance of $ 180,000 was paid by petitioner at the end of the year and deducted as commissions. In the deficiency notice respondent did not make a separate determination with respect to the reasonableness of the compensation paid to each officer. Instead respondent determined that total reasonable compensation for the officers in 1988 and 1989 was $ 272,440 and $ 335,000, respectively, and disallowed the balance of the salaries and all of the commissions deducted by petitioner. Under petitioner's bylaws, each officer is required to reimburse petitioner for any amount paid to such officer as compensation but ultimately disallowed as a deduction by respondent.

In the years prior to the incorporation of Mortex, Max, assisted by Jo and Ted, developed a formula for a product used in finishing concrete structures. The product, known as Keystone Kool Deck (Kool Deck), is a chemical additive which creates a colorful nonskid surface when mixed with cement and certain other chemicals including dyes and applied to the wet surface of concrete structures1994 Tax Ct. Memo LEXIS 111">*116 such as swimming pool decks. The use of the Kool Deck additive also reduces the temperature of a concrete surface to which it is applied by up to as much as 35 percent compared to a concrete surface that has not been similarly treated.

When Mortex was incorporated in 1976, the formula for Kool Deck was not transferred to the corporation. Instead, knowledge of the formula was retained at that time by Max, Jo, and Ted. During the years under consideration the formula was known only to Ted, Jo, Ann, and Don. Since its development the formula, as well as the manner and order in which its components are added to the mixture, have been zealously guarded by the family, whose knowledgeable members regard it as a trade secret which they provide as part of their services to petitioner. The formula for Kool Deck has never been patented because of the disclosures which would have to be made in a patent application and the certainty that the trade secret would enter the public domain when the patent expires. ⁶

1994 Tax Ct. Memo LEXIS 111">*117 A family member who knows the secret of Kool Deck must be present when the product is prepared. Usually, Ted mixes the chemical constituents of Kool Deck, but Don and Ann are capable of doing so. Even though she knows the formula, Jo is probably not capable of mixing the necessary chemicals because of her age and physical limitations. One trusted employee mixes the colors and does some mixing of chemicals, but the employee does not know the trade secret of Kool Deck. This trusted employee as well as all other nonofficer employees of Mortex are required to sign an Employee Confidentiality Agreement in which they agree to not reveal any knowledge of petitioner's operation or its products acquired in the course of their employment.

Kool Deck and other products of Mortex are sold throughout the United States and in 25 or 26 foreign countries. No one else manufactures a product similar to Kool Deck although over the years a number of people have attempted to do so without success. Their failure is apparently due to the fact that, while a chemical analysis of Kool Deck will reveal its chemical ingredients, it will not disclose the form or condition of the ingredients when they are1994 Tax Ct. Memo LEXIS 111">*118 added to the mixture or the order in which they are added.

Max acquired during his life and held at his death a patent covering forms for use in the construction of free-form pools, a patent for forms for use in the construction of concrete expansion and contraction joints, a patent for the construction of an apparatus for forming pool deckings and copings, and a patent for a pool deck drain. Max died intestate on May 5, 1987, and under Arizona law his wife Jo was the sole beneficiary of his estate. There is no formal documentation of a transfer of his patents to Jo. However, at the time of the trial, the products protected by the patents were being manufactured by petitioner with Jo's permission and the Kool Deck formula was still being provided to petitioner by Ted, Don, Ann, and Jo.

While Ted, the president of petitioner, was still in high school, he began to assist his father in the family business and continued to do so while attending the University of Arizona, where he earned in 1969 a bachelor of science degree in metallurgical engineering. During the fiscal years in question, Ted developed for petitioner two new products, Marquee, a commercial grade of Kool Deck for1994 Tax Ct. Memo LEXIS 111">*119 use on walkways and driveways of commercial buildings, and the Ad-Tex Sprayer, a device which simplifies the application of some of petitioner's products. With his engineering background, Ted has been able to personally modify almost all of the equipment used by petitioner in the production of the products sold by petitioner.

Ted regularly works 80 hours each week of which 5 percent or less is devoted to Tucson Foam and Equipment, Inc. (Tucson Foam), a related entity described hereinafter. Petitioner's plant operates around the clock Monday through Saturday. Ted is at the plant for startup at 4:30 on each Monday morning and is always on call throughout the week including Sunday. Because of his broad knowledge of the business and of the contribution made by each of the individuals involved, Ted is primarily responsible for setting the levels of compensation for each officer of petitioner. However, the compensation of each officer is considered at a meeting of petitioner's officers, who are also its directors, which is usually held at or near the end of each fiscal year. During each of these meetings, petitioner's net sales are estimated for the year and 30 percent of the estimated1994 Tax Ct. Memo LEXIS 111">*120 net sales is considered the total of all compensation to be paid by petitioner to its officers for the year. After a discussion during which each officer has an opportunity to state his or her opinion of the value of each officer's contribution to the corporation during the preceding year, an agreement is reached with regard to the share of each officer in the total compensation for the year. The excess of such agreed amount for each officer over the total amount of his or her salary for the year is then paid to the officer as a yearend bonus or commission.

Ted, with assistance from Don, is also responsible for the compensation of each of petitioner's 8 to 11 plant workers; and with assistance from Jo, he is responsible for the compensation paid to petitioner's 3 or 4 office employees. ⁷

1994 Tax Ct. Memo LEXIS 111">*121 Don, a vice president of petitioner, is a professional photographer. In addition, he has received professional training in computers and business administration. He established and is responsible for petitioner's computer system. However, purchasing is his primary responsibility for petitioner. He is also responsible for having established a cost-reducing system whereby trucks delivering products for petitioner are loaded upon return with petitioner's supplies. He too is on call for petitioner 24 hours a day and fills in for absent employees, as well as for Ted when Ted is not available. Don usually works 80 hours in a week which includes his supervision of the plant operations at Tucson Foam. Ten percent or less of his time is devoted to Tucson Foam and the balance to petitioner.

Ann, the secretary of petitioner, is primarily in charge of its sales and marketing. Like her brother Ted, she is thoroughly familiar with petitioner's business since she began working with her father while she was still in high school. She negotiates prices with major customers and has established an "early buy" program whereby customers place orders in the fall for products they will need the1994 Tax Ct. Memo LEXIS 111">*122 following summer. With Ann's excellent planning, petitioner is able to ship orders on the day they are placed. Her marketing efforts include attendance at all national and regional conventions where petitioner's products are exhibited. With her knowledge of all aspects of petitioner's business, she is able at such conventions to explain petitioner's products, handle technical questions, and advise contractors and other interested parties in the use of petitioner's products.

Ann is also an experienced artist, and her husband, as stated above, is a professional photographer. Working together after regular hours and often into the mornings in an office ⁸ in their home, they frequently develop for petitioner advertising brochures and instructional videotapes.

Ann also helps Jo supervise petitioner's bookkeeping and insurance coverage. In addition during the1994 Tax Ct. Memo LEXIS 111">*123 years in question she was training Carlene in bookkeeping, foreign sales, and export documentation.

Jo, petitioner's treasurer, is also thoroughly familiar with petitioner's operation because she helped Max start the business and has been closely associated with it from the beginning. She is primarily responsible for petitioner's banking and other financial affairs including the negotiation of certain letters of credit and sales negotiations with established customers. Together with Ann, she also supervises petitioner's bookkeeping and its insurance coverage. As indicated hereinbefore, she assists Ted in determining the levels of compensation paid to petitioner's three or four office employees. At the trial Jo, who is 70 years old, did not testify because she was recovering from a back operation, and the level of her involvement with petitioner appeared to be somewhat less than full time. ⁹

1994 Tax Ct. Memo LEXIS 111">*124 As indicated hereinbefore, Carlene, the wife of Ted, has been a vice president of petitioner since 1988. The record, however, fails to establish what her duties for petitioner were prior to becoming a vice president of petitioner in 1988 or the specific duties she performed or was responsible for during fiscal years 1988 and 1989 other than the fact that she was being trained by Ann in bookkeeping, foreign sales, and export documentation.

Petitioner uses polystyrene foam board in its manufacture of pool deck forms. Over the years petitioner has had difficulty in finding a dependable source for such board which satisfies petitioner's specifications. Consequently in 1979, Bart Deason formed Tucson Foam Board to manufacture such board for petitioner. The business operated by Bart as Tucson Foam Board was sold in 1986 to Tucson Foam & Equipment, Inc., a separate corporation. One-half of the stock of Tucson Foam is owned by Ted and his wife and the other one-half is owned by Ann and her husband. Its officers are also Ted, Carlene, Ann, and Don, who during the years in question received salaries from Tucson Foam in the following amounts:

1994 Tax Ct. Memo LEXIS 111">*125 On July 13, 1988, Ted, Carlene, Don, and Ann organized Deck Directors, Inc., and with it attempted to launch a business to sell to pool contractors a franchise to construct pool decks. The franchise included the use of, but not the formula for, an enhanced version of Kool Deck as well as certain other products manufactured by Mortex and covered by the patents obtained by Max.

The venture known as Deck Directors was primarily the responsibility of Ann but it was not successful, since no franchises were sold. Deck Directors was dissolved after filing two nonprofitable income tax returns, one for the period from July 13, 1988, to March 31, 1989, and the other for the period from April 1, 1989, to December 31, 1989. During its short existence, Ann spent less than 5 percent of her time tending to Deck Directors' affairs.

During 1988 and 1989 Ann and Don owned some show horses which were held for breeding purposes. The horses were not stabled at or near the residence of Ann and Don but at the Star B Farm where they were being trained by Star Bennett. Neither Ann, Don, nor any other member of their family ever rode the horses or participated in their training or spent any appreciable1994 Tax Ct. Memo LEXIS 111">*126 amount of time during the period in question in the training or upkeep of the horses.

After Christmas in 1988, Ann initiated a business called Signed, Sealed, and Remembered. The business which had one employee was begun in Ann's home, but about a month later in late January of 1989 the business and its one employee moved to a small office on Oracle Road in Tucson, Arizona. The business consisted of the sale or lease of a computer program designed in a few hours by Ann for the purpose of helping people to organize their time in order to attend to important matters which are often neglected, such as business and personal appointments and the recognition of birthdays, anniversaries, and holidays. During 1989 Ann devoted about 1 or 2 hours each month to the affairs of Signed, Sealed, and Remembered. For 1988 she reported on her joint return with Don no income and a loss of $ 9,677 from Signed, Sealed, and Remembered. On their joint return for 1989, she reported gross receipts of $ 33,146 and a net loss of $ 56,775. The record does not reflect the amount of time, if any, which Don devoted to the business.

During 1989 Jo was responsible for an outlet for Signed, Sealed, and Remembered1994 Tax Ct. Memo LEXIS 111">*127 located in Las Vegas, from which she reported gross receipts of $ 10,235 and a net loss of $ 30,938. The record does not disclose the amount of time which Jo devoted to this operation.

From its incorporation petitioner has been in excellent financial condition. It has a high rating with Dunn and Bradstreet, and its bad debt ratio is less than 1 percent. Petitioner's liquidity as measured by standard ratios is excellent. Its officers and directors have a longstanding policy against outside borrowing. Over the years, expansion and other capital needs of petitioner have been financed with retained earnings or advances from stockholders. In the years in question, $ 400,000 was invested by petitioner in its plant and equipment. In March shortly before the end of its fiscal year 1989 petitioner borrowed $ 210,000 from its shareholders because of a cash shortage. The loan was repaid within 6 months.

Petitioner does not have a pension or a deferred compensation plan. It did not pay any dividends between April 1, 1985, and March 31, 1989. Its initial capitalization in 1976 was $ 200,000 or $ 1 per share of its stock. By the end of its fiscal year 1989, petitioner's book value 1994 Tax Ct. Memo LEXIS 111">*128 was $ 704,000, and its appraised value was conservatively estimated at $ 1,851,166.

For the years 1985 through 1989, petitioner's income and deductions can be summarized as follows:

Comparable figures are not in the record for years prior to 1985. However, net sales and officers' compensation are in the record for the years 1978 through 1989. They are as follows:

As a percentage of net sales, total compensation paid by petitioner to its stockholder-officers for each of the years 1978 through 1989 was 35 percent, 31 percent, 28 percent, 30 percent 28 percent, 35 percent, 31 percent, 38 percent, 38 percent, 36 percent, 31 percent, ¹⁰ and 27 percent, respectively, for an average annual percentage during this period of 32 percent. ¹¹

1994 Tax Ct. Memo LEXIS 111">*130 Expert witnesses for the parties offered contradictory testimony concerning the reasonableness of the total compensation paid to petitioner's officers. However, respondent's expert, Emmett J. Brennan III, a compensation consultant, did not question the valuation of $ 1,851,166 placed on Mortex as of March 31, 1989, by petitioner's expert, Walter Pocock, a business valuation specialist. Mr. Pocock summarized his valuation of Mortex as follows:

The adjusted net worth used by Mr. Pocock included petitioner's machinery and equipment at $ 775,450, its cost less depreciation. Mr. Pocock noted that this was a conservative valuation, because it made no upward adjustment for the substantial modifications made to the equipment by Ted or for its excellent condition due to its careful maintenance under Ted's supervision.

Mr. Pocock also found that on the basis of book value before any adjustment petitioner's net worth had increased over 800 percent between 1977 and 1989; i.e., from $ 67,000 to $ 704,000. He also noted that between petitioner's incorporation in 1976 with an initial capitalization of $ 200,0001994 Tax Ct. Memo LEXIS 111">*131 and the end of its fiscal year 1989, its net worth increased by 350 percent; that during the same period its value increased from $ 200,000 to $ 1,851,166 or by over 900 percent; and that during the 2 years in issue, its net worth as reflected on its balance sheet increased by 4.8 percent as follows:

Mr. Pocock also noted, that of petitioner's $ 316,501 in debt at the end of fiscal year 1989, $ 210,000 was represented by a loan from its shareholder-officers. The note was repaid by petitioner within 6 months.

Petitioner's expert testified that he had chosen the highest salaries he could find as appropriate for its officers, in view of its excellent performance. He noted that its officers work together as an effective team and have a substantial amount of cross-training which permits them to do each other's jobs. As a result, petitioner has been able to consistently generate sales in the range of $ 3 million per year with only 8 to 11 plant employees and only 3 or 4 office employees. He also noted that such an accomplishment can be attained1994 Tax Ct. Memo LEXIS 111">*132 with only 11 to 15 nonofficer employees by very few manufacturing companies. He was unable to find an appropriate ceiling for the compensation paid by petitioner to its officers because in his opinion "the company would disintegrate without them." His conclusions, which are not restricted to companies with comparable sales or number of nonstockholder-employees, are based generally on the PAS Executive Compensation Survey of contractors and the National Institute of Business Management survey of companies manufacturing concrete products.

Respondent's expert concluded that petitioner's officers received compensation which was "extraordinarily higher" than officers of firms that he concluded were comparable. In reaching his conclusion, he surveyed published data from various sources ¹² on companies manufacturing concrete products with the same level of sales as petitioner's 1988 sales of $ 3.15 million and 1989 sales of $ 2.82 million. ¹³ The following table summarizes his conclusions with respect to salaries paid by corporations which he found to be comparable to petitioner; i.e., companies manufacturing concrete products with sales similar in amount to those of petitioner. For1994 Tax Ct. Memo LEXIS 111">*133 the position held by each of petitioner's officers the table lists the maximum average compensation and maximum compensation.

1994 Tax Ct. Memo LEXIS 111">*134 In arriving at his conclusion, respondent's expert incorrectly assumed that Carlene devoted only 50 percent of her time and Ann only 80 percent of her time to Mortex. Furthermore, when he compiled his data, respondent's expert did not know or take into consideration the exact nature and extent of the duties of petitioner's officers or the value of the Kool Deck formula which was made available to petitioner through the services of Ted, Ann, Don, and Jo or the value of the patents originally obtained by Max and made available to petitioner by Jo after Max's death. Furthermore, he did not know whether the occupants of similar corporate positions with companies which he found to be comparable to petitioner made any such formulas, patents, or other items of value available to their employers.

OPINION

The resolution of the dispute involved in this case depends upon whether the amounts paid by petitioner to its officers constitute reasonable compensation within the meaning of section 162(a)(1), which provides:

SEC. 162(a) In General. -- There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade1994 Tax Ct. Memo LEXIS 111">*135 or business, including --