T.C. Mem o. 2 01 6- 95

UNITED STAT ES TAX COURT

H. W . JOHNSON, INC., Pet it io ne r v. COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt

Doc ke t No . 31 10 -0 7. Fi le d M ay 11 , 20 16 . Greg ory A. Rob in so n, fo r pe ti ti on er. Jo hn W . Dun can , forres po nd en t.

MEMORANDUM FINDINGS OF FACT AND OPINION GALE, Ju dg e: Res po nd en t d et erm in edde fic ie nc ie s i n p et it io ne r’s Fed eral in co m e ta x fo r th e ta xabl e y ears en de d J un e 3 0, 2 00 3 a nd20 04 (y ears at i ss ue ), of 1 $8 77 ,44 0 a nd$2 ,08 7,6 78 , res pe ct iv el y . The i ss ue s fo r de ci si on are: (1) whet he r Unl es s o th erwi se in di cat ed , refer en ces to a y ear are t o t he fis cal y ear 1 en di ng inth atcal en da r y ear.- 2 -

[* 2] th e am ou nt s p ai d t o B ru ce A. Jo hn so n andDon al d J . Jo hn so n dur in g t he y ears atis su e co ns ti tu te d re as on ab le co m pe ns at io n d educ ti bl e und er s ect io n 1 62 ; an d 2 (2 ) whe th er p et it io ne r is en ti tl edto de du cta $5 00 ,00 0 p aym en t t o DBJ Ent erp ris es , LLC, an en ti ty con tro ll edby Bruce an d Do na ld , as an o rd in ary an d ne ces sa ry bu si ne ss expe ns e und er s ect io n 1 62 for20 04 .

FINDINGS OF FACT So m e o f th e fac ts ha ve be enst ip ul at edan d a re s o fo un d. We in co rp or at e b y th is refe ren ce the st ip ul at io n o f fac ts an d t he acco m pa nyin g e xh ib it s. Pet it io ne r m ai nt ai ne d i ts pri nc ip al off ic e in Ariz on a atth e ti m e th e p et it io n was fil ed . I. Pet it io ne r’s in cep ti on , m an ag em en t, an d o rg an iz at io n Dur in g the y ears at i ss ue pe ti ti on er o pe rat eda co nc ret e co nt ract in g b us in es s. At tha t t im e p et it io ne r was on e o f th e la rg es t cu rb , gu tt er, an d s id ewal k c on tra ct or s in th e St at e o f Ariz on a, with o ve r 20 0 e m pl oyees andco ntractrev enue s o f $2 3,7 54 ,18 2 a nd$3 8,0 22 ,61 2 i n 2 00 3 a nd20 04 , res pe ct iv el y . Pet it io ne r was in co rp or at edin19 74 by H .W . Jo hn so n a ndMarg aret Jo hn so n. H.W . andMarg aretha d o pe rat eda pr ed eces so r so le pro pr ie to rs hi p o ut
All sec ti on refe ren ces are t o t he Int ern al Rev enue Co de of 1 98 6, as in 2 effe ctforth e y ears at i ss ue , andall Ru le refe ren ces are t o the Tax C ou rt Rul es of Prac ti ce an d P ro cedur e. All do ll ar am ount s h av e b eenrou nd edto th e n eare st do ll ar.- 3 -

[* 3] of t he ir h om e si nc e 1 96 8. H.W . han dl edpe ti ti on er’s o pe rat io ns , and Mar garetha nd le d fi na nc ia l an d a dm in is tra ti ve m at te rs . Two o f H.W . andMarg aret ’s so ns , Bru ce an d Do na ld , beg anwork in g p art ti m e fo r pe ti ti on er as tee na ge rs inth e 1 97 0s , andth enful l t im e whe n t he y co m pl et edth ei r educ at io n i n 1 97 7 a nd19 82 , res pe ct iv el y . Bru ce an d Do na ld gr adua ll y ass um edin crea si ng res po ns ib il it ie s an d t oo k o ve r pe ti ti on er’s d ai ly op erat io ns in19 93 . H.W . andMarg aretm ad e g ift s o f sh ares of p et it io ne r’s st oc k to Bru ce an d Do na ld ; an d b y 19 96 , when H.W . ret ire d fr om pe ti ti on er, Bru ce an d Don al d h adeach acqui red24 .5% o f th e sh ares , with M arg aretret ai ni ng th e rem ai ni ng 51 %. Upo n H.W.’ s re ti rem en t the bro th ers be cam e co -v ic e p res id en ts an d m em be rs of p et it io ne r’s bo ardof d ire ct or s, al on g wi th Marg aret . II. Pet it io ne r’s gr owth a ndfin an ci al co nd it io n u nd er Bruc e an d Do na ld ’s m an ag em en t Pet it io ne r’s co nt ractrev enue s g rew rap id ly after B ru ce an d Do na ldass um ed co nt ro l o f pe ti ti on er’s d ai ly ope rat io ns in19 93 . In tha t year pe ti ti on er h ad co nt ractrev enue s o f ap pr ox im at el y $4 mil li on ; co nt ractrev enue s i nc reas edto ov er $1 1 m il li on an d $ 13 m il li on in19 94 an d 1 99 5, re sp ect iv el y . Peti ti on er’s co nt ract rev enue s re m ai ne d s te ady at abo ut$1 7 m il li on be twee n 1 99 6 a nd19 99 an d- 4 -

[* 4] cli m be d s te ad il y

ev ery y ear t he reaf

te r in cl ud in g t he y ears at i ss ue , when rev enue s i nc reas eddra m at ic al ly between20 03 an d 2 00 4. Pet it io ne r was pro fit ab le an d e xp eri en cedsi gn ifi can t re ve nu e an d a ss et gr owt h dur in g 2 00 3 a nd20 04 , with g ro ss pro fitm arg in s b efo re p aym en t o f of fic er bo nu se s o f 38 .3% an d 3 8.2 %, res pe ct iv el y . Peti ti on er’s as se ts , li ab il it ie s, equi ty, rev enue , netin co m e b efo re t ax es , andne t i nc om e aft er t ax es du rin g 2 00 2 t hr ou gh 20 04 were as fol lo ws: 20 02 20 03 20 04 Ass et s $6 ,81 4,3 99 $8 ,84 4,7 69 $1 3,4 24 ,70 5 Liab il it ie s 3,2 28 ,64 9 5,0 58 ,55 1 9,5 36 ,12 1 Equ ity 3,5 85 ,75 0 3,7 86 ,21 8 3,8 88 ,58 4 Co nt ract rev enue 23 ,23 9,2 07 23 ,75 4,1 82 38 ,02 2,6 12 Net i nc om e bef or e ta xe s 21 0,9 67 38 7,7 06 348 ,57 9 Net i nc om e aft er t ax es 13 2,5 45 25 0,4 68 202 ,36 6 Dur in g the y ears at i ss ue Bru ce an d Do na ldpe rs on al ly gua ran te edlo an s who se pro ceed s p et it io ne r us edto pu rch as e m at eri al s an d s up pl ie s.- 5 -

[* 5] III. Pet it io ne r’s op erat io ns an d i ndus try repu ta ti onin20 03 an d 2 00 4 Dur in g the y ears at i ss ue Marg aretserve d a s p et it io ne r’s pr es id en t an d ch ai rm anof t he bo ard . She ha nd le d t he co m pa ny’ s p ayro ll an d fi na nc es , acco un ts rece iv ab le an d d el in qu en t ac co un t co ll ect io ns , em pl oyee hi rin g a ndterm in at io ns , an d v ari ou s o th er ad min is tra ti ve fun ct io ns , work in g a ro un d 4 0 h ou rs a week . Bru ce an d Do na ldto ge th er m an ag edall op erat io na l as pe ct s o f pe ti ti on er’s bu si ne ss . Opera ti on s wer e sp li t i nt o t wo g eo gr ap hi cal di vi si on s, ea st ernan d wes te rn , with e ach bro th er m an ag in g adi vi si on ’s op erat io ns , in cl ud in g c on tra ct bi dd in g a ndne go ti at io n, p ro ject s ch edul in g a ndm an ag em en t, equi pm en t p ur ch as e an d m od ifi cat io n, p ers on ne l m an ag em en t, an d c us to m er re la ti on s. Bru ce an d Don al d e ach supe rv is edov er 1 00 em pl oyees i n t he ir r es pe ct iv e d iv is io ns , in cl ud in g s up eri nt en de nt s an d fo rem en , andwork ed10 to 12 ho ur s a d ay , fiv e to si x d ay s a we ek . They were atth e job si te s d ai ly andreg ul arl y op erat edequi pm en t whi le th ere. Th e b ro th ers were re ad il y av ai labl e if

pro bl em s ata job si te aro se an d were kno wn i n the lo cal in du st ry forth ei r res po ns iv e an d h an ds -o n m an ag em en t st y le . App ro xi m at el y

95 % of p et it io ne r’s bu si ne ss du rin g t he y ears at i ss ue was fo r res id en ti al subd iv is io n c on st ru ct io n. Th e co nc ret e work B ru ce an d Do na ld supe rv is edrequi redco ns id erab le tec hn ic al sk il l an d c oo rd in at io n, as fres h- 6 -

[* 6] co nc ret e is hi gh ly peri sh ab le . Con cret e “ se ts ”--a ndbe co m es un us ab le --ei th er 90 m in ut es aft er i t i s m ix edan d l oa de d o nt o atru ckor i f itreac he s 9 0 d eg rees . (Keep in g the co nc ret e fro m reac hi ng 90 de gr ees inPh oe ni x’s ty pi cal 10 0- de gr eepl us tem pe ratur es was apa rti cu lar ch al le ng e inpe ti ti on er’s o pe rat io ns .) The co nc ret e fo r si de walk s an d c urbs ha d t o b e p ouredpre ci se ly to p rev en t s ur face area s wh ere wat er co ul d c ol le ct ; i f wat er s to odm or e th anha lf a n i nc h d eep at a ny po in t o n afin is he d c urb o r si de walk , th e are a h adto be rip pe d o utan d re po ur edor gr ou nddo wn t o c orrectth e fl aw. Add it io na ll y , pet it io ne r ha d t o m eetth e v arying sp eci fic at io ns of d iff

eren t co nt ract or s, en gi ne ers , cit ie s, t own s, an d c ou nt ie s o n an y gi ve n jo b. Pe ti ti on er’s equi pm en t was oft enm od ifi edor s pe ci al ly fabri cat ed to m eetth e requi rem en ts of agi ve n jo b. Mo stsu chworkwas d on e in -h ou se -- th ereb y reduc in g c os ts an d i m

pr ov in g e ffi ci en cy --wi th Bru ce o r Don al d o fte n supp lying th e id ea fo r a d es ig n tha t was th enrefi ne d a ndim pl em en te d b y pe ti ti on er’s fab ric at io n fo rem an . Pet it io ne r ha d a n e xc el le ntrep ut at io n wi thde ve lo pe rs , in sp ect or s, an d o th er co nt ract or s an d was kn own forit s t im el y pe rfo rm an ce an d qua li ty pro du ct . As a res ul t, p et it io ne r was rou ti ne ly awarde d c on tra ct s ev enwher e itwas n otth e lo wes t bi dd er, an d the co m

pa ny need edli tt le m ark et in g b ey on d i ts rep ut at io n i n t he in du st ry .- 7 -

[* 7] IV. Cem en t s ho rta ge an d fo rm at io n o f Ariz on a Ma te ria ls A rel iabl e supp ly of co nc ret e was cri ti cal to pe ti ti on er’s b us in es s. Pet it io ne r, ho wev er, d idno t p ro du ce i ts ownco nc ret e, rel y in g i ns te adon lo cal supp li ers . Starti ng inlat e 2 00 2 a ndth ro ug ho utth e y ears at i ss ue th ere wer e sh orta ge s o f co nc ret e in pe ti ti on er’s m ark etdu e to a ho us in g b oo m inAriz on a. In ad di ti on , lar ge m

ul ti na ti on al an d n at io na l fi rm s wer e acqui rin g s up pl ie rs of co nc ret e in Ariz on a, di srup ti ng pe ti ti on er’s the ret of or e lo cal ly bas edne two rk . Face d wi th th e p os si bi li ty of di srup ti on s i n p et it io ne r’s supp ly of co nc ret e, Bru ce an d Do na ldsu gg es te d t o M arg aretth atpe ti ti on er i nv es t i n aco nc ret e supp li er s o as to ha ve a rel iabl e supp ly. Marg aret , ho ld in g aco nt ro ll in g s ha re i n p et it io ne r, refu se d t o i nv ol ve th e co m pany in s uc h ave ntur e b ecau se sh e jud ge d i t t oo ris ky. On M arch 21 , 20 03 , Bru ce an d Do na ld , act in g t hr ou gh D.B.J. Ent erp ris es , LLC (DBJ ), pa rtn eredwith o th er i nv es to rs , in cl ud in g aform er ex ecu ti ve of a

3 lo cal co nc ret e supp li er tha t h adbe enacqui redby a larg e m ul ti na ti on al firm , to fo rm Ariz on a Ma te ria ls , LLC (Arizo naMat eri al s) , to co nduc t a c on cret e supp ly bu si ne ss . DBJ o wne d a52 % in te res t i n Ari zo naMat eri al s. Bru ce an d Do na ld ,

Bru ce an d Do na ldha d fo rm edDBJ o n Au gu st10 , 19 95 , to ho ld 3 in ve st m en ts ; dur in g the y ears at i ss ue Bru ce an d Do na ldeachown ed50 % of DB J th ro ug h fa m il y

tru st s.- 8 -

[* 8] th ro ug h DBJ , in ve st edsubs tant ia l s um s i n, an d g ua ran te edth e in de bt edne ss of , Arizo naMat eri al s. The re were als o o ccas io na l m ark etsh orta ge s o f cem en t-- aness en ti al in gr ed ie ntof c on cret e--dur in g the y ears at i ss ue , bu t Ari zo naMat eri al s was ab le to ob ta in acce ss to cem en t o ve r th atpe rio d b ecau se of t he rel at io ns hi ps it s o th er in ve st or s h adwith c em en t s up pl ie rs . Tho ug h s om et im es un ab le to pro cu re co nc ret e fro m

it s o th er s up pl ie rs , pet it io ne r ob ta in eda subs tant ia l am ou ntof co nc ret e fro m

Ariz on a Ma te ria ls du rin g 2 00 4 a ndwas abl e to pro cure co nc ret e ev enwhenothe r co nt ract or s co ul d n ot(an d wer e th eref or e fo rcedto tem

po rari ly su sp en d o pe rat io ns ). Pet it io ne r rec ei ve d b ul k d is co un ts forlar ge co nc ret e pu rch as es fro m

Ariz on a Ma te ria ls , ob ta in in g c on cret e ata pr ic e lo wer tha n i t p ai d ot he r supp li ers . DBJ ex erci se d i ts in flu en ce as m ajor ity sh areh ol de r of

Ariz on a Mat eri al s t o e ns ur e th atpe ti ti on er re cei ve d ast eady supp ly of co nc ret e, as at t ha t ti m e Ari zo naMat eri al s h adothe r cu st om ers wil li ng to pa y a hi gh er p ric e fo r th e co nc ret e. At the en d o f 20 04 pe ti ti on er p ai d DBJ $5 00 ,00 0. Pe ti ti on er’s b oa rd
m eet in g m in ut es st at e th atth e p aym en t was fora “ gu aran te edsupp ly of co nc ret e at m ark etpri ces forth e y ear e nd edJu ne 30 , 20 04 . DBJ En te rp ris es , L.L. C. ha s ne go ti at edwith Ari zo naMat eri al s L.L.C. on be ha lf o f H.W . Jo hn so n, In c. to- 9 -

[* 9] pro vi de a co nt in uo us supp ly of co nc ret e.” Pet it io ne r an d DBJ ha d n o wri tt en ag reem en t re ga rd in g the $5 00 ,00 0 p aym en t. V. Pet it io ne r’s of

fic er co m pe ns at io n anddi vi de ndpl an s Dur in g the y ears at i ss ue pe ti ti on er’s b oa rdhe ldan nu al m eet in gs inMay to de te rm in e o ffi cer c om

pe ns at io n, d ire ct or ’s fees , anddi vi de nd s. Pet it io ne r co m pe ns at edBru ce an d Do na ldas f ol lo ws: 4 Offi cer 20 03 20 04 Bru ce $2 ,01 3,2 50 $3 ,65 1,1 77 Don al d 2,0 11 ,78 9 3,6 49 ,73 9 Tot al 4,0 25 ,03 9 7,3 00 ,91 6 Und er p et it io ne r’s of

fic er b on us form

ul a, ad op te d b y

pe ti ti on er’s b oa rdin 19 91 an d a m en de d i n 1 99 9, t ot al po te nt ia l b on us es were ca lc ul at edinpro po rti on to th e co m

pa ny’ s an nu al co nt ractrev enue an d a dd edto a “bo nu s p oo l” . The b on us po ol was c al cu la te d u nd er the 19 91 bo nu s fo rm ul a as fol lo ws: 12 % of c on tra ct rev enue up to $1 0 m il li on ; 1 0% o f co nt ractrev enue be twee n $ 10 mil li on an d $ 20
m il li on ; an d 8 % of c on tra ctrev enue inex ces s o f $2 0 m il li on . The b on us po ol was cal cu la te d u nd er the am en de d 1 99 9 b on us form ul a as fol lo ws: 20 % of c on tra ct rev enue up to $1 5 m il li on ; 1 8% o f co nt ractrev enue be twee n $ 15 mil li on an d $ 30
The se am ou nt s i nc lu de off ic er s al ari es , bo nu se s, an d d ire ct or ’s fees . 4- 10 -

[* 10 ] m il li on ; an d 1 6% o f co nt ractrev enue be twee n $ 30 m il li on an d $ 45 m il li on . At y eare ndan d upo n the advi ce o f pe ti ti on er’s acc ou nt an t, the bo ardof d ire ct or s is su edbo nu se s o utof the bo nu s p oo l b as edonoff ic er p erfo rm an ce an d pe ti ti on er’s ab il ity

to pa y . Any

unpa idam ou nt s re m ai ne d i n t he bo nu s p oo l fo r la te r paym en t p en di ng bo ardap pr ov al . Peti ti on er’s b oa rdaward edbo nu se s be twee n 1 99 2 a nd20 04 as f ol lo ws:

Year Contra ctre venue Bonus poo l Bonus es awar ded 1 Am ountoverpa id or (un derpai d) fr om curre nt bonu s po ol 1992 $2,6 37,8 77 Accu m ula te d: n/ a Curr ent : $ 316, 545 M: $ 20,0 00 B: 5 0,00 0 D: 5 0,00 0 T ota l: 1 20,0 00 ($1 96,5 45) 1993 3,92 4,80 3 Accu m ula te d: 196, 545 Curr ent : 4 70,9 76
- 0- (47 0,97 6) 1994 11,1 48,8 77 Accu m ula te d: 667, 521 Curr ent : 1 ,314 ,888
- 0- (1, 314, 888) 1995 13,0 50,2 53 Accu m ula te d: 1,98 2,40 9 Curr ent : 1 ,505 ,025
- 0- ( 1,50 5,02 5) 1996 17,2 97,5 73 Accu m ula te d: 3,48 7,43 4 Curr ent : 1 ,929 ,757 M: 8 33,0 00 B: 83 3,00 0 D: 83 3,00 0 T ota l: 2,4 99,0 00 56 9,24 3 1997 16,4 30,4 80 Accu m ula te d: 2,91 8,19 1 Curr ent : 1 ,843 ,048 M: 8 33,3 33 B: 83 3,33 3 D: 83 3,33 3 T ota l: 2,4 99,0 00 656 ,951 1998 18,1 12,9 35 Accu m ula te d: 2,26 1,24 0 Curr ent : 2 ,011 ,294 M: 6 50,0 00 B: 77 5,00 0 D: 77 5,00 0 T ota l: 2,2 00,0 00 188, 706- 11 -

[* 11 ] 1999 17,9 24,8 93 Accu m ula te d: 2,07 2,53 4 Curr ent : 3 ,529 ,721 M: 2 50,0 00 B: 87 5,00 0 D: 87 5,00 0 T ota l: 2,0 00,0 00 (1, 529, 721) 2000 19,4 09,4 57 Accu m ula te d: 3,60 2,25 5 Curr ent : 3 ,793 ,702 M: 2 50,0 00 B: 1,25 0,00 0 D: 1,25 0,00 0 T ota l: 2,7 50,0 00 (1, 043, 702) 2001 20,0 62,2 13 Accu m ula te d: 4,64 5,95 7 Curr ent : 3 ,911 ,198 M: 2 50,0 00 B: 1,55 0,00 0 D: 1,55 0,00 0 T ota l: 3,3 50,0 00 (56 1,19 8) 2002 23,2 39,2 07 Accu m ula te d: 5,20 7,15 5 Curr ent : 4 ,483 ,057 M: 2 50,0 00 B: 1,75 0,00 0 D: 1,75 0,00 0 T ota l: 3,7 50,0 00 (73 3,05 7) 2003 23,7 54,1 82 Accu m ula te d: 5,94 0,21 2 Curr ent : 4 ,575 ,753 M: 2 50,0 00 B: 1,75 0,00 0 D: 1,75 0,00 0 T ota l: 3,7 50,0 00 (82 5,75 3) 2004 38,0 22,6 12 Accu m ula te d: 6,76 5,96 5 Curr ent : 6 ,983 ,618 M: 5 00,0 00 B: 3,40 0,00 0 D: 3,40 0,00 0 T ota l: 7,3 00,0 00 316, 382 M = Ma rgare t; B = Bruce ; D = Dona ld 1 Dur in g the y ears at i ss ue pe ti ti on er al so ha d adi vi de ndpl an , ado pt edin 19 91 an d a m en de d i n 1 99 9. Th atpl ancal le d fo r di vi de ndpa ym en ts when th e co m pa ny’ s re ta in edearn in gs ex ceed ed$2 m il li on . The b oa rdde te rm in edth e am ountof t he di vi de ndon th e b as is of p et it io ne r’s fin an ci al po si ti on , pro fit ab il ity , an d c ap it al iz at io n, fo ll owi ng th e advi ce o f pe ti ti on er’s acc ou nt an t. Pet it io ne r pa id
m od es t an nu al di vi de nd s t o i ts sh areh ol de rs be twee n 1 99 6 a nd20 04 . For m os t o f- 12 -

[* 12 ] th os e y ears , th e d iv id en d a m ou ntwas $ 25 ,00 0. In20 02 an d 2 00 3 t he
am ountros e to $5 0,0 00 , andin20 04 , itwas $ 10 0,0 00 . VI. Pet it io ne r’s 20 03 an d 2 00 4 re tu rn s an d t he de fic ie nc y de te rm in at io ns On i ts ti m el y

fil edFo rm s 1 12 0, U.S. Co rp or at io n In co m e Tax Return, fo r 20 03 an d 2 00 4 p et it io ne r cl ai m edde du ct io ns forth e sa larie s, b on us es , and di rect or ’s fees itpa idto Marg aret , Bru ce, an d Do na ld . Peti ti on er al so cla im eda de du ct io n fo r 20 04 for

th e $ 50 0,0 00 itpa idto DBJ, re po rti ng th e p aym en t as an

“ adm in is tra ti on fees ” ex pe ns e. Res po nd en t i ss ue d ano ti ce o f de fic ie nc y to pe ti ti on er d et erm in in g t ha t $2 ,60 7,5 17 an d $ 5,6 16 ,77 1 o f th e am ou nt s p et it io ne r de du ct edfor20 03 an d 2 00 4, res pe ct iv el y , as o ffi cer c om pe ns at io n e xc eed edreas on ab le co m pe ns at io n a nd di sa ll owi ng init s en ti rety th e $ 50 0,0 00 de du ct io n p et it io ne r cl ai m edfor 20 04 as adm in is tra ti on fees . Peti ti on er t im el y pe ti ti on edth is Co urt fo r red et erm in at io n o f th e d efi ci en ci es . OPINION I. Rea so nabl e co m

pe ns at io n Pet it io ne r co nt en ds th atth e $ 4,0 25 ,03 9 a nd$7 ,30 0,9 16 itpa idto Bru ce an d Don al d a ndde du ct edas c om pe ns at io n fo r 20 03 an d 2 00 4, re sp ect iv el y , con st itut e reas on ab le co m

pe ns at io n u nd er s ect io n 1 62 (a)( 1) . Res po nd en t d is ag rees . The- 13 -

[* 13 ] no ti ce o f de fic ie nc y di sa ll owe d $ 2,6 07 ,51 7 and$5 ,58 9,0 74 of t he cla im ed 5 de du ct io ns for20 03 an d 2 00 4, re sp ect iv el y , as e xc eed in g re as on ab le co m pe ns at io n, treat in g the reas on ab le am ou nt s as li m it edto $1 ,41 7,5 22 an d $1 ,71 1,8 42 , res pe ct iv el y , foreach y ear. Re sp on de ntno w con ced es th at de du ct io ns of $ 3,2 14 ,00 0 a nd$6 ,53 2,0 00 for co m pe ns at io n are re as on ab le , le av in g $ 81 1,0 39 an d $ 76 8,9 16 indi sp ut e fo r 20 03 an d 2 00 4, re sp ect iv el y . Sect io n 1 62 (a)( 1) pe rm it s a t ax pa y er t o d educ t “ a rea so nabl e al lo wan ce fo r sa larie s o r ot he r co m

pe ns at io n fo r pe rs on al servi ces actua ll y ren de red ” as an or di na ry an d n eces sa ry

bu si ne ss ex pe ns e. A tax pa y er i s en ti tl edto a de du ct io n fo r co m pe ns at io n p aym en ts if the paym en ts are re as on ab le inam ou ntan d i n fa ctpa id pu rel y forservi ces . Sec. 1 .16 2- 7( a), In co m e Tax Reg s. Th ou gh fram edas atwo pr on ge d t es t, co urts co ns id eri ng th e d educ ti bi li ty of co m pe ns at io n u nd er s ect io n 16 2( a)(1 ) ge ne ral ly focu s o n wh ethe r th e am ou ntof p ur po rte d c om

pe ns at io n i s reas on ab le . Elli ot ts , Inc . v. Co m m is si on er, 7 16 F.2d12 41 , 12 44 (9t h C ir. 1 98 3) , rev ’g T.C. Mem o. 1 98 0- 28 2. Pe ti ti on er h as th e b ur de n o f pr ov in g t ha t the

The no ti ce o f de fic ie nc y

als o i ni ti al ly dis al lo wed$2 7,6 97 of d ire ct or ’s fees 5 pe ti ti on er p ai d t o M arg aretan d d educ te d fo r 20 04 . Res po nd en t h as no t ad dr es se d Mar garet ’s fees onbri ef (p res um ab ly becau se hi s o wn ex pe rt c on cl ud edth at Mar garetwas u nd erco m

pe ns at edin20 04 ), an d we t he refo re d eem res po nd en t t o ha ve co nc ed edth is is su e.- 14 -

[* 14 ] am ou nt s p ai d t o B ru ce an d Do na ldin20 03 an d 2 00 4 wer e rea so nabl e. See 6 Ru le 14 2( a). The Co urt o f App eal s fo r th e Nin th Cir cu it , to whi chanap pe al inth is cas e wou ldno rm al ly lie, ap pl ie s fi ve fact or s t o d et erm in e th e rea so nabl en es s o f co m pe ns at io n, wi th no fact or be in g d et erm in at iv e: (1) th e em pl oyee’s rol e in th e
At the ou ts etof t ria l p et it io ne r co nt en de d t ha t the no ti ce o f de fic ie nc y ha d 6 lo stit s p res um

pt iv e co rrec tn es s i n v ie w of the factth atres po nd en t h adab an do ne d th e p os it io n i n the no ti ce tha t re as on ab le co m pe ns at io n fo r Bru ce an d Do na ldwas li mit edto $1 ,41 7,5 22 an d $ 1,7 11 ,84 2 fo r 20 03 an d 2 00 4, re sp ect iv el y , andha d in st eadtak enth e p os it io n- -inli ne with h is ex pe rt’s re po rt- -th atreas on ab le co m pe ns at io n fo r th em

was am uc h h ig he r fi gu re fo r eac h year; n am el y , $3 ,21 4,0 00 an d $ 6,5 32 ,00 0 fo r 20 03 an d 2 00 4, re sp ect iv el y . Pet it io ne r was pre su m ab ly rely in g o n ali ne of c as es fro m th e Co urt o f App eal s fo r th e Nin th Cir cu it , wher e anap pe al inth is cas e wou ldno rm al ly lie, ho ld in g tha t the Co m

m is si on er’s ad op ti on of ali ti ga ti on po si ti on th atsubs tant ia ll y de vi at es fro m

th e p os it io n i n the no ti ce o f de fic ie nc y res ul ts ina fo rfei tu re o f an y pr es um pt io n o f co rrec tn es s i n the no ti ce an d p la ces th e b ur de n o f pr oo f onth e Co m m is si on er. See Est at e o f Mi tc he ll v. Co m mis si on er, 2 50 F.3d69 6 (9 th Cir . 20 01 ), aff’g i n p art , vac at in g i n p artan d re m an di ng T.C. Mem o. 1 99 7- 46 1; Est at e of Sim pl otv. Co m

m is si on er, 2 49 F.3d11 91 (9t h C ir. 2 00 1) , rev ’g an d re m an di ng 11 2 T.C. 1 30 (19 99 ); M orris se y v. Co m m is si on er, 2 43 F.3d11 45 (9t h C ir. 2 00 1) , rev ’g an d re m an di ng Est at e o f Kau fm anv. Co m m is si on er, T.C. Mem o. 1 99 9- 11 9. On b rie f, ho wev er, p et it io ne r do es no t ad dr es s s uc h a n a rg um en t o r ci te an y of th e fo reg oi ng cas es . Ins te ad , pet it io ne r st at es th atit“ ha s m etit s b ur de n o f pr oo f inest ab li sh in g tha t the co m pe ns at io n p ai d t o Do n a ndBru ce J oh ns on for 20 03 an d 2 00 4 was reas on ab le .” W e co ns eque nt ly deem pe ti ti on er t o h av e ab an do ne d a ny argu m en t tha t the bu rd enof p ro of res ts with re sp on de nt . In an y ev en t, we re ach our de ci si on on th e b as is th atth e p rep on de ran ce o f th e ev id en ce es tabl is he s tha t the di sp ut edam ou nt s tha t p et it io ne r de du ct edforth e y ears at i ss ue co ns ti tu te d re as on ab le co m pe ns at io n a ndth eref

or e fi nditun ne ces sary

to co ns id er furth er an y

im pa ctof t he afo rem en ti on edcas es .- 15 -

[* 15 ] co m

pany; (2 ) a co m

pa ris on of c om

pe ns at io n p ai d b y

si m il ar co m

pa ni es for si mil ar s erv ic es ; (3 ) th e ch arac te r an d c on di ti on of the co m pany; (4 ) po te nt ia l co nf li ct s o f in te res t; an d (5 ) th e in te rn al co ns is te nc y of c om pe ns at io n arra ng em en ts . Elli ot ts v. Co m m is si on er, 7 16 F.2dat 1 24 5- 12 47 . In an al yzi ng th e fo urth fact or , th e Co urt o f App eal s empha si zes ev al ua ti ng th e rea so nabl en es s o f co m pe ns at io n p aym en ts fro m th e p ers pe ct iv e o f a h y

po th et ic al in de pe nd en t in ve st or , foc us in g o n wh ethe r th e in ve st orwou ldrece iv e a rea so nabl e return o n equi ty after p aym en t o f th e co m pe ns at io n. Id . at 1 24 7; see als o M etro Leas in g Dev . Cor p. v . Commis si on er, 3 76 F.3d10 15 , 10 19 (9t h C ir. 2 00 4) , aff’g T.C. Mem o. 2 00 1- 11 9. Bo th pa rti es in tro du cedex pe rt wi tn es s re po rts an d t es ti m on y to supp ort the pa rti es ’ po si ti on s. Ex pe rt wi tn es s t es ti m on y is ap pr op ria te to he lp th e Co urt un de rs tandanarearequi rin g s pe ci al iz edtra in in g, kno wled ge , or ju dg m en t. See Fed . R. Evi d. 7 02 ; Sn y de r v. C ommis si on er, 9 3 T.C. 5 29 , 53 4 (1 98 9) . Non ethe le ss , th e Co urt i s n otbo un d b y anex pe rt’s o pi ni on , andwe m ay eit he r acce ptor r ejectex pe rt t es ti m on y inth e ex erci se of s oundjud gm en t. Hel ve rin g v . Nat’l Gro cery Co., 30 4 U.S. 2 82 , 29 5 (1 93 8) ; Pa rk er v . Comm is si on er, 8 6 T.C. 54 7, 5 61 -5 62 (19 86 ). Furth erm or e, th e Co urt m ay be sel ect iv e in de te rm in in g- 16 -

[* 16 ] whatpo rti on s o f anex pe rt’s o pi ni on , if an y , to acce pt . Park er v . Co m m is si on er, 8 6 T.C. at56 2. On b rie f res po nd en t ef

fect iv el y co nc ed es fou r of

th e fi ve Ell io tt s fa ct or s tha t te ndto supp ort, o r are at l eas t n eu tra l wi th res pe ctto , th e rea so nabl en es s o f th e co m pe ns at io n p et it io ne r pa id . As to th e em pl oyees’ rol es an d t he co nd it io n o f th e co m pa ny, resp on de ntco nc ed es th e “ si gn ifi can t ro le s” Bru ce an d Do na ldpl ay edin pe ti ti on er’s “ subs tant ia l s uc ces s” du rin g t he y ears at i ss ue . Sim il arl y , res po nd en t co nc ed es th atth e le ve l o f pe ti ti on er’s s uc ces s was so gre atth atco m pa ris on s t o the co m pe ns at io n p ai d b y

si m il ar co m

pa ni es were d iff

ic ul t t o m ak e an d t ha t the bo nu se s p ai d t o B ru ce an d Do na ld --wh il e unr eas on ab le co m pe ns at io n i n res po nd en t’s v ie w--were no ne th el es s the res ul t o f a co ns is te nt ly app li edbo nu s fo rm ul a. Notwiths tand in g the for eg oi ng , res po nd en t ar gu es th atth is cas e h in ge s on th e fo urth Ell io tt s fa ct or ; n am el y , whet he r a h y po th et ic al in de pe nd en t i nv es to r wou ldrece iv e anad equa te return o n e qu ity aft er ac co un ti ng for

Bru ce’s an d Don al d’s co m

pe ns at io n. Nev erthe le ss , we con si de r eac h o f th e Ell io tt s fa ct or s, in as m uc h a s the Co urt o f App eal s fo r th e Nin th Cir cu itha s i nd ic at edth atno on e fact or is di sp os it iv e. See M etro Leas in g Dev . Cor p. v . Commis si on er, 3 76 F.3dat 10 19 ; Lab el Grap hi cs , Inc . v. Co m m is si on er, 2 21 F.3d10 91 , 10 95 (9t h C ir. 2 00 0) , aff’g T.C. Me m o. 1 99 8- 34 3; Ell io tt s, In c. v. Co m m is si on er, 7 16 F.2dat 1 24 5.- 17 -

[* 17 ] A. Ro le inth e co m pa ny Thi s fa ct orfoc us es onth e em pl oyee’s im

po rta nc e to th e su cces s o f th e bu si ne ss . Elli ot ts , Inc . v. Co m m is si on er, 7 16 F.2dat 1 24 5. Pe rti ne nt co ns id erat io ns in cl ud e th e em pl oyee’s po si ti on , du ti es pe rfo rm ed , andho ur s worke d. Id . As o urfin di ng s d em on st rat e (an d re sp on de ntco nc ed es ), Bru ce an d Do na ld were i nt eg ral to pe ti ti on er’s s uc ces s dur in g t he y ears at i ss ue . They were res po ns ib le forco nt ractbi ll in g, o ns it e m an ag em en t an d p ers on ne l s up erv is io n, an d e qu ip m en t m od ifi cat io ns to m eetsp eci fic pro ject r equi rem en ts . They were kn own to lo cal de ve lo pe rs as h av in g aha nd s- onm an ag em en t s tyle th at co ns is te nt ly pro du ceda qu al ity pro du cton sch edul e. Furth erm or e, un de r Bru ce an d Do na ld ’s m an ag em en t, p et it io ne r’s an nu al co ntractrev enue s i nc reas ed dr am at ic al ly, fro m

ap pr ox im at el y

$4 m il li on in19 93 to ov er $ 38 mil li on in20 04 . Whi le so m e o f th is gro wth was u nd oubt ed ly due to th e h ou si ng bo om inAriz on a atth atti m e, pe ti ti on er’s rep ut at io n fo r qu al ity an d t im el y

pe rfo rm an ce u nd er Bruc e an d Do na ld ’s m an ag em en t al lo weditto sec ur e co nt ract s ev enwhen itwas n otth e lo wes t b id de r. Bru ce an d Do na ldals o p ers on al ly gua ran te edin de bt edne ss th atpe ti ti on er in cu rredto pu rch as e m at eri al s an d s up pl ie s, ad di ng to th ei r ro le inen su rin g i ts- 18 -

[* 18 ] su cces sf

ul op erat io ns . See Leo na rdPip el in e Co nt ract or s, Lt d. v . Co m m is si on er, T.C. Mem o. 1 99 8- 31 5, af f’d witho utpubl is he d o pi ni on , 21 0 F .3d 38 4 (9 thCir . 20 00 ); Owen sb y & Krit ik os , Inc . v. Co m

mis si on er, T.C. Mem o. 19 85 -2 67 , aff’d, 8 19 F.2d13 15 (5t h C ir. 1 98 7) . Thi s fa ct orweig hs inpe ti ti on er’s fav or . B. Ext ern al co m

pa ris on Thi s fa ct orco m

pa res th e em

pl oyee’s compen sa ti on with t ha t p ai d b y si m il ar co m pa ni es forsi m il ar s erv ic es . Elli ot ts , Inc . v. Co m m is si on er, 7 16 F.2dat 1 24 6; se c. 1.1 62 -7 (b )(3 ), In co m e Tax Reg s. Re sp on de ntco nc ed es th atpe ti ti on er’s pe rfo rm an ce s o e xc eed edth atof a ny of th e co m pa ni es id en ti fie d b y

th e p art ie s’ ex pe rts as c om

pa rab le th atco m

pe ns at io n c om

pa ris on s ar e n otm ean in gf ul . Pet it io ne r’s ex pe rt c al cu la te d tha t p et it io ne r’s of fic ers ’ co m

pe ns at io n a s a pe rcen ta ge of g ro ss rev enue was 1 8.4 % an d 2 0.9 % for20 03 an d 2 00 4, res pe ct iv el y , wher eas th e in du stry av erag e fo r th os e y ears was 2 .2%. Pet it io ne r co nt en ds th atit s p erfo rm an ce s o e xc eed edth e in du st ry av erag e th atth e d iv erg en ce of it s co m pe ns at io n fr om

th e av erag e is jus ti fie d. Onth is reco rdwe lac k a ny rel iabl e b en ch m ark s fr om whi chto ass es s p et it io ne r’s cl ai m an d t he refo re fi ndit unpe rs ua si ve . In v ie w of thi s an d re sp on de nt ’s con ces si on , we con cl ud e th atth is- 19 -

[* 19 ] fact oris ess en ti al ly neu tra l. See Mu lt i-P akCo rp . v. Co m m is si on er, T.C. Mem o. 2 01 0- 13 9. C. Ch arac te r an d c on di ti on of the co m pa ny Thi s fa ct orco ns id ers th e co m pa ny’ s ch arac te r an d c on di ti on , foc us in g o n si ze as m eas ur edby sale s, n etin co m e, orcap it al va lu e. Ell io tt s, In c. v. Co m m is si on er, 7 16 F.2dat 1 24 6. Th e co m pl ex it ie s o f th e b us in es s an d g en eral eco no m ic co nd it io ns are al so rel ev an t. Id . As re fle ct edinou r fi nd in gs , pet it io ne r expe rie nc edrem ark ab le rev enue , pr of itm arg in s (b efo re o ffi cer c om pe ns at io n) , andass etgro wth du rin g t he y ears at is su e. Res po nd en t co nc ed es pe ti ti on er’s “ subs tant ia l s uc ces s” du rin g t he y ears at is su e. Thi s fa ct orweig hs inpe ti ti on er’s fav or . D. Co nf

li ctof i nt eres t The pri m ary fo cu s o f th is fact oris whet he r a rel at io ns hi p e xi st s b etweenth e co m pa ny andth e em

pl oyee whi chm ay

pe rm itth e co m

pa ny to d is gu is e no nd educ ti bl e co rp or at e d is tri bu ti on s as de du ct ib le sec ti on 16 2( a)(1 ) co m pe ns at io n p aym en ts . Id. A po te nt ia ll y ex pl oi tabl e rel at io ns hi p m ay ex is t whe re the em

pl oyee is th e co m

pa ny’ s s ol e o r co nt ro ll in g s hareh ol de r orwher e a sp eci al fam il y

rel at io ns hi p i nd ic at es th atth e te rm s o f a co m pe ns at io n a rran ge m en t are n otth e res ul t o f a fre e b arg ai n. Id . Becau se pe ti ti on er’s m ajor ity sh areh ol de r- 20 -

[* 20 ] du rin g the y ears at i ss ue was M arg aret --Bruc e an d Do na ld ’s m ot he r--a nd to ge th er the th ree o f th em own edall pe ti ti on er’s s to ck , th is fact or warran ts sc ru ti ny. 7 The Co urt o f App eal s fo r th e Nin th Cir cu itap pr oa ch es th is in qu iry by ev al ua ti ng th e co m

pe ns at io n p aym en ts fro m th e p ers pe ct iv e o f a h y

po th et ic al in de pe nd en t i nv es to r, fo cu si ng on th e in ve st or ’s return o n e qu ity . Id. at12 47 . If th e co m pany’ s ea rn in gs on equi ty after p aym en t o f co m pe ns at io n re m ai n a t a l ev el th atwou ldsat is fy

anin de pe nd en t i nv es to r, th ere i s a s tro ng in di cat io n t ha t the em pl oyee is pro vi di ng co m

pe ns ab le servi ces an d tha t p ro fit s ar e n otbe in g si ph on edou t o f th e co m

pa ny dis gu is edas s al ary. Id. The pa rti es an d the ir e xp ert s ag ree t ha t p et it io ne r ha d p ret ax returns on equi ty of 10 .2% an d 9 % for 20 03 an d 2 00 4, re sp ect iv el y . They diff er, h owe ve r, 8 W e fu rth er n ot e in th is reg ardth atpe ti ti on er p ai d d iv id en ds to ta li ng on ly 7 $5 0,0 00 an d $ 10 0,0 00 for 20 03 an d 2 00 4, re sp ect iv el y , no twi th st an di ng gro ss pr of itm arg in s (b efo re o ffi cer c om pe ns at io n) foreach y ear e xc eed in g 3 8%. Altho ug h El li ot ts co m

pu te s re tu rnonequi ty on an a fte rta x b as is --b y 8 di vi di ng ne t i nc om e (i .e., in co m e aft er t ax es ) by y eare ndsh areh ol de r equi ty, Ell io tt s, In c. v. Co m

m is si on er, 7 16 F.2d12 41 , 12 47 (9t h C ir. 1 98 3) , rev ’g T.C. Mem o. 1 98 0- 28 2- -b ot h p art ie s’ exp ert s g en eral ly com pu te d p et it io ne r’s return o n equi ty usi ng pre ta x i nc om e fi gu res . They di d s o b ecau se , as re sp on de nt ’s exp ert ex pl ai ne d, m os t o f th e av ai labl e d at a fro m th e co m pa ni es th ey

co ns id ered co m pa rab le pro vi de s p ret ax return o n e qu ity fig ur es . Neithe r th e p art ie s n orth ei r ex pe rts off

er an y in si gh t co nc ern in g t he po ss ib le im pa ctof u si ng pre ta x v ers us

(co nt in ue d...)- 21 -

[* 21 ] on whatanex pe ct edreturn o n e qu ity sh ou ldha ve be enforpe ti ti on er. Res po nd en t’s ex pe rt u se d re tu rnon equi ty figu res fro m fou r so ur ces th atpro du ced return o n e qu ity

fig ur es ran gi ng fro m

13 .8% t o 1 8.3 %. W e fi ndth atth e d at a o n whi chhe rel ie d i s n otas r el iabl e as th atus edby pet it io ne r’s ex pe rt. Re sp on de nt ’s ex pe rt’s fi rs t re tu rnon equi ty figu re was de riv edfro m sev en“ gu id el in e co m pa ni es ”. Bu t the se gu id el in e co m pa ni es are n otco m

pa rab le to pe ti ti on er as th ey were p ub li cl y

tra de d, o pe rat edinin du strie s d iff eren t fr om

pe ti ti on er’s, an d ha d g ro ss sal es subs tant ia ll y lar ge r th anpe ti ti on er’s. His sec on d fi gu re was de riv edfro m

co m pa ny dat a in anan nu al st at em en t p ub li sh edby the Ris k Man ag em en t As so ci at io n, yet th e p ub li cat io n i ts el f st at es th atit s d at a sh ou ldbe us ed“ on ly as ge ne ral gu id el in es an d n otas abs ol ut e in du st ry no rm s” be cau se th e da ta“ m ay

no t b e fu ll y

rep res en ta ti ve of agi ve n i ndus try” forsev eral reas on s, in cl ud in g tha t i t i s n otran do m ly sele ct edan d m ay in cl ud e small s am

pl e si zes for cert ai n i ndus tri es . His t hi rdfig ur e is de riv edfro m th e Co ns tru ct io n F in an ci al Man ag em en t As so ci at io n’s an nu al fin an ci al surv ey , bu t m an y of t he co m

pa ni es in th atda tasample o pe rat edinin du st rie s d is si m il ar fro m pe ti ti on er’s. Fin al ly, (...co nt inue d) 8 aft ert ax fig ur es , th ou ghpre su m ab ly pret ax returns onequi ty w ou ldalwa y s b e hi gh er. Inth es e ci rcu m st an ces , we are co ns tra in edto ev al ua te th is fact oron th e ba si s o f pr et ax fig ur es .- 22 -

[* 22 ] res po nd en t’s ex pe rt d eri ve d a“ m ark etrequi redreturn o n e qu ity ” fro m da ta publ is he d b y

Ibb ot so n As so ci at es . Butth atdatais fro m co m pa ni es en ga ge d i n the co ns tru ct io n i ndus try gen eral ly, no t the co nc ret e co nt ract in g s ect orof wh ic h pe ti ti on er i s a p art . By co nt ras t, p et it io ne r’s ex pe rt u se d re tu rnon equi ty figu res de riv edfro m In te gr a In fo rm at io n (I nt eg ra) d at a. In te gr a is a da taservi ce wh ic h c om pi le s fin an ci al in fo rm at io n o f pr iv at el y he ldco m pa ni es fro m

go ve rn m en t an d o th er so ur ces . Peti ti on er’s expe rt u se d In te gr a d at a fro m 33 co m pa ni es fal li ng un de r SIC c od e 1 77 1, Co ns tru ct io n- -Sp eci al Trad e Co nt ract or s- -Co nc ret e Work , with sa le s ra ng in g fr om

$2 5 m il li on to $4 9,9 99 ,99 9. We fin d t he co m pa ni es th at pe ti ti on er’s ex pe rt u se d t o b e m or e co m pa rab le to pe ti ti on er fo r pu rp os es of a return o n e qu ity

an al y si s tha n tho se us edby resp on de nt ’s exp ert . Pet it io ne r’s 9
ex pe rt c al cu late d a n a ve rag e p ret ax return o n e qu ity fro m th es e 3 3 c om

pa ni es of 10 .5% an d 1 0.9 % forcal en da r y ears 20 03 an d 2 00 4, re sp ect iv el y . Thu s,
Res po nd en t faul ts th e In te gr a co m pa ny sam pl e b ecau se itha s n otbe en 9 sh own whet he r an y

of t he se co m

pa ni es actua ll y

ha d i nd ep en de ntin ve st or s (wh o wou ldpre su m ab ly serv e as a ch eckon ex ces si ve off ic er co m pe ns at io n) . Howev er, th e sa m e co ul d b e sa idof a ny pri va te ly hel d c om pany in the vario us da taba se s tha t res po nd en t’s ex pe rt u se d. Onba lanc e, we are p ers ua de d t ha t co m pa ni es whi chare cl os es t t o p et it io ne r with re sp ectto th e n atur e o f th e b us in es s ac ti vi ty andth e si ze of an nu al sal es pro vi de th e b es t i nd ex of areas on ab le return o n e qu ity . Pet it io ne r’s ex pe rt’s c om pa ni es were cl os er t o p et it io ne r in th es e res pe ct s.- 23 -

[* 23 ] pe ti ti on er’s p ret ax return o n e qu ity fel l 0 .3 p erce nt ag e p oi nt s b el ow the In te gr a co m

pa ni es ’ av erag e in 20 03 an d 1 .9 p erce nt ag e p oi nt s b el ow i t i n 2 00 4. The pa rti es di sa gr ee o ve r th e im pl ic at io ns of t he se fig ur es . Res po nd en t arg ue s tha t b ecau se pe ti ti on er’s return o n e qu ity fel l b el ow the in du st ry

av erag e in 20 03 an d 2 00 4, Bruc e an d Do na ldwere u nr eas on ab ly com pe ns at edinth os e y ears . An i nd ep en de ntin ve st orwou ldha ve de m an de d areturn m or e co m m en surat e wit h pe ti ti on er’s s up eri orpe rfo rm an ce, res po nd en t cl ai m s. Pet it io ne r co nt en ds th atit s return o n e qu ity

was i n l in e wit h t he in du stry av erag e an d t he refo re wo ul d h av e sa ti sf ie d a n i nd ep en de ntin ve st or . W e ag ree wi th pe ti ti on er. Res po nd en t ci te s n o autho rit y forth e p ro po si ti on th atth e requi redreturn o n e qu ity forpu rp os es of t he in de pe nd en t i nv es to r te st m us t s ig ni fic an tl y

ex ceedth e in du st ry

av erag e whe n t he subjec t co m pany has be en es pe ci al ly suc ces sf

ul , andwe ha ve fou ndno ne inth e cas el aw. Ins te ad , inap pl y in g th e in de pe nd en t i nv es to r te stth e co urts ha ve typic al ly foundth ata return o n e qu ity of at l eas t 1 0% t en ds to in di cat e th atanin de pe nd en t i nv es to r wou ldbe sat is fie d an d thu s p aym en t o f co m pe ns at io n t ha t l eav es th atrat e o f return fo r th e in ve st oris reas on ab le . See, e.g ., Tho us an d Oak s R es id en ti al Care Hom e I, In c. v. Co m m is si on er, T.C. Mem o. 2 01 3- 10 ; M ul ti -PakCo rp . v. Co m m is si on er, T.C. Mem o. 2 01 0- 13 9. In de ed , com pe ns at io n p aym en ts th atres ul te d i n areturn o n- 24 -

[* 24 ] equi ty of 2.9 % ha ve be enfou ndreas on ab le . Mul ti -PakCo rp . v. Co m m is si on er, T.C. Mem o. 2 01 0- 13 9. Itis co m pe ns at io n t ha t re su lt s i n re tu rn s on equi ty of zero or l es s tha n z ero th atha s b eenfou ndto be un reas on ab le . See, e.g ., Mul cah y , Paurit sc h, Sa lv ad or& Co ., Ltd. v . Commis si on er, 6 80 F.3d86 7 (7 th Cir . 20 12 ), aff’g T.C. Me m o. 2 01 1- 74 ; M ul ti -PakCo rp . v. Co m m is si on er, T.C. Mem o. 2 01 0- 13 9. We con se qu en tl y fin d t ha t p et it io ne r’s returns on equi ty of 10 .2% an d 9 % for20 03 an d 2 00 4, re sp ect iv el y , ten d t o s ho w th atth e co m pe ns at io n p ai d t o Do na ldan d B ru ce fo r th os e y ears was re as on ab le . As pe ti ti on er’s ex pe rt p oi nt s o ut , m ere r educ ti on s i n t he ir c ol le ct iv e co m pe ns at io n o f $9 ,84 7 a nd$7 5,2 77 in20 03 an d 2 00 4, re sp ect iv el y --d iff eren ces of app ro xi m at el y 1%- -wo ul d h av e p la cedpe ti ti on er’s return o n e qu ity at e xa ct ly the av erag e fo r co m pa rab le co m

pa ni es inth e co nc ret e b us in es s. Co ns eque nt ly, th is fact orfav or s a fin di ng th atth e co m

pe ns at io n a t i ss ue was re as on ab le . E. In te rn al co ns is te nc y of c om pe ns at io n Thi s fa ct orfoc us es onwhet he r th e co m pe ns at io n was pa idpu rs ua ntto a st ru ctur ed , form al , andco ns is te nt ly app li edpro gr am ; b on us es no t awa rd edun de r su chpl an s ar e su sp ect . Elli ot ts , Inc . v. Co m m is si on er, 7 16 F.2dat 1 24 7. Pet it io ne r co ns is te nt ly adh eredto th e o ffi cer b on us form ul a fro m it s in cep ti on in19 91 . Res po nd en t co nc ed es as m uc h a ltho ug h h e arg ue s tha t the- 25 -

[* 25 ] form

ul a y ie ld edun reas on ab le co m pe ns at io n dur in g t he y ears at i ss ue . W e co nc lu de th atth is fact orweig hs inpe ti ti on er’s fav or . 1 0 F. Co nc lu si on As a wh ol e, th e Ell io tt s fa ct or s s up po rt t he co nc lu si on th atth e co m pe ns at io n p et it io ne r pa idto Bru ce an d Do na ldin20 03 an d 2 00 4 was reas on ab le . The b ro th ers were ab so lu te ly int eg ral to pe ti ti on er’s s uc ces sf ul pe rfo rm an ce, a p erfo rm an ce tha t i nc lu de d re m ark ab le gro wth inrev enue s, as se ts , an d g ro ss pro fitm arg in s dur in g t ho se y ears , as re sp on de ntco nc ed es . The return on equi ty pet it io ne r ge ne rat edfor each y ear a fte r pa y

m en t o f Bru ce’s an d Do na ld ’s co m pe ns at io n was inli ne with- -in de edclo se ly app ro xi m at ed --the return g en erat ed by the co m

pa ni es m os t co m

pa rab le to it . W e acc or di ng ly con cl ud e th atan in de pe nd en t i nv es to r wou ldha ve be ensat is fie d wi thth e return. Fo r th es e rea so ns , we ho ldth atth e $ 4,0 25 ,03 9 a nd$7 ,30 0,9 16 pe ti ti on er p ai d a s o ffi cer co m pe ns at io n i n 2 00 3 a nd20 04 , res pe ct iv el y , were rea so nabl e an d t he refo re de du ct ib le un de r se ct io n 1 62 (a)( 1) .

At tria l p et it io ne r so ug htto in tro du ce ev id en ce p ert ai ni ng to res po nd en t’s 1 0 ex am in at io n o f pe ti ti on er’s return fo r 19 96 to sh ow tha t re sp on de ntdi d n ot qu es ti on th e b on us form

ul a (an d t he refo re, i n p et it io ne r’s vi ew, ap pr ov edit ). W e ha ve ex cl ud edth atev id en ce b ecau se itis irr el ev an t. See , e.g., Pek ar v . Co m m is si on er, 1 13 T.C. 15 8, 1 65 -1 66 (19 99 ).- 26 -

[* 26 ] II. DBJpa ym en t W e n ow ad dr es s wh ethe r pe ti ti on er i s en ti tl edto de du ctth e $ 50 0,0 00

“ adm in is tra ti on fees ” ex pe ns e p ai d t o DBJ an d re po rte d o n i ts 20 04 return a s a bu si ne ss ex pe ns e. Gen eral ly, a ta xp ay er m ay de du ctord in ary an d n eces sa ry ex pe ns es pa idor in cu rreddu rin g the tax ab le y ear i n c arrying on a tr ad e o r bu si ne ss , in cl ud in g reas on ab le co m

pe ns at io n fo r pe rs on al servi ces actua ll y ren de red . Sec. 1 62 (a)( 1) . Ord in ary ex pe ns es are “ no rm al , us ua l, o r cu st om ary” in the tax pay er’s trad e o r bu si ne ss . Depu ty v. duPo nt , 30 8 U.S. 4 88 , 49 5 (1 94 0) . In o rd er fo r anexpe ns e to be ord in ary th ere m

us t b e ev id en ce tha t the tra ns act io n i n que st io n h as so m e de gr ee o f no rm al ity

inth e type o f bu si ne ss un de r sc ru ti ny. Id . at 4 95 -4 96 . Abs en t su chev id en ce, the re m

us t b e a b as is foranass um pt io n, i n e xp eri en ce o r co m m on kn owl ed ge , th atpaym en ts so ug htto be de du ct edare t o b e p la cedinth e sa m e cat eg ory as o rd in ary ex pe ns es . Id. at49 6- 49 7. Nece ss ary ex pe ns es are ex pe ns es th atare “ ap pr op ria te an d h el pf ul ” to a ta xp ay er’s trad e o r bu si ne ss . W el chv. Helv eri ng , 29 0 U.S. 1 11 , 11 3 (1 93 3) . Whe th er an expe ns e is ord in ary an d ne ces sa ry is a qu es ti on of f

act . Id. at11 5. Tax de du ct io ns are a m at te r of leg is la ti ve gra ce, an d atax pa y er h as th e bu rd enof p ro vi ng th athe is en ti tl edto th e d educ ti on s cl ai m ed . Rul e 1 42 (a);- 27 -

[* 27 ] INDOPCO, In c. v. Co m m is si on er, 5 03 U.S. 79 , 84 (19 92 ); Ne w Col on ia l Ic e Co . v. Hel ve rin g, 2 92 U.S. 43 5, 4 40 (19 34 ). 1 1 Pet it io ne r arg ue s tha t the $5 00 ,00 0 “ adm in is tra ti on fees ” ex pe ns e is an or di na ry an d n eces sa ry

bu si ne ss ex pe ns e b ecau se itco ns ti tu te s a p aym en t i t m ad e to DBJ t o c om

pe ns at e itforsec ur in g agu aran te edsupp ly of co nc ret e, di sc ou nt ed fo r bu lkpu rch as es , fro m

Ariz on a Ma te ria ls du rin g 2 00 4. Re sp on de ntco nt en ds on se ve ral gro un ds th atth e $ 50 0,0 00 paym en t was no t an ord in ary an d n eces sa ry bu si ne ss ex pe ns e, in cl ud in g: (1) th atth ere was no writte n a gr eem en t o r ev id en ce of an y ora l ag reem en t o bl ig at in g p et it io ne r to co m pe ns at e DBJ , andth eref

or e th e $5 00 ,00 0 p aym en t was vo lu nt ary; (2) th atDBJ p erfo rm edno co m pe ns ab le se rv ic es onbe ha lf o f pe ti ti on er; an d (3 ) th atth e $ 50 0,0 00 paym en t was m ad e n ot fo r se rv ic es th atDBJ p ro vi de d, b utforservi ces Bru ce an d Do na ldpe rfo rm edin th ei r cap aci ti es as o ffi cers of p et it io ne r. Res po nd en t’s ar gu m en ts are u np ers ua si ve . W e are sat is fie d o n thi s re co rd th atBru ce an d Do na ld , act in g thr ou gh DBJ, u se d DBJ ’s con tro ll in g p os it io n i n Ariz on a Mate ria ls to cau se Ariz on a Ma te ria ls to supp ly con cret e to pe ti ti on er du rin g t im es of s ho rta ge at f av or ab le pri ces . Thir d- party tes ti m on y --t o t he effe ct Pet it io ne r di d n otcla im , or s ho w ent it le m en t t o, an y sh iftinth e b ur de n o f 1 1 pr oo f un de r se c. 74 91 (a) wi th res pe ctto th e fac tu al is su es rel ev an t t o thi s de du ct io n.- 28 -

[* 28 ] th atpe ti ti on er was ab le to ob ta in co nc ret e in 20 04 at t im es when ot he r co nc ret e co nt ract or s co ul d n ot --co rro bo rat es th e b ro th ers ’ acco un t. Mo reo ve r, Bru ce an d Do na ld , act in g i n the ir i nd iv idua l capa ci ti es when th ei r m or e ri sk
av ers e, co nt ro ll in g- sh areh ol de r m ot he r wou ldno t al lo w pet it io ne r to do so , m ad e arra ng em en ts to form

Ariz on a Ma te ria ls to en su re p et it io ne r’s co nc ret e supp ly in th e fac e o f lo om in g s ho rta ge s. Th ey bro ug htinot he r in ve st or s wi thin du st ry co nt act s, i nc lu di ng ex is ti ng rel at io ns hi ps with c em en t s up pl ie rs , cem en t b ei ng a cri ti cal in gr ed ie ntof c on cret e an d a ls o e xh ib it in g s ho rta ge s. Th e b ro th ers , aga in act in g i n the ir i nd iv idua l capa ci ti es an d u si ng DBJ a s the ir v eh ic le , in ve st ed subs tant ia ll y

inan d g ua ran te edth e in de bt edne ss of Ari zo naMat eri al s. Hav in g as su m edth e ri sk s as so ci at edwith Ari zo naMat eri al s’ form at io n a ndop erat io n i n th ei r in di vi du al cap aci ti es , Bru ce an d Do na ldco ul d re as on ab ly exp ectto be co m pe ns at edby pet it io ne r fo r do in g s o wh enitsubs tant ia ll y be ne fit edfro m

th e fru it s o f th ei r effo rts . Pet it io ne r al so be ne fit edfro m Bru ce’s an d Do na ld ’s 1 2 Not withs tand in g s ub st an ti al cred ib le tes ti m on y to th e eff ectth atth ere was 1 2 a co nc ret e sh orta ge inAriz on a in 20 04 an d t ha t Ari zo naMat eri al s s up pl ie d co nc ret e to pe ti ti on er wh enothe r co nc ret e co nt ract or s h adex pe rie nc edsupp ly di srup ti on s, re sp on de ntsu gg es ts th atAriz on a Ma te ria ls di d n otpl ay a si gn ifi can t ro le insupp lying pe ti ti on er co nc ret e b ecau se pe ti ti on er p ur ch as edon ly $3.5 m il li on inco nc ret e fro m

Ariz on a Ma te ria ls ou t o f a t ot al of $ 13 m il li on inco nc ret e pu rch as es du rin g 2 00 4. We di sa gr ee. Tha t p et it io ne r m ay ha ve pu rch as edon ly a li tt le ov er a qua rte r of

it s co nc ret e supp ly from Ariz on a Ma te ria ls do es no t

(co nt in ue d...)- 29 -

[* 29 ] for es ig htan d b us in es s ac um eninfin di ng a so lu ti on to th e co nc ret e sh orta ge , ev enwhenpe ti ti on er’s co nt ro ll in g s ha reh ol de r was un wil li ng to co m m it pe ti ti on er’s res ou rces to do so . Invi ew of

th e fo reg oi ng , res po nd en t’s co nt en ti on th atpe ti ti on er’s p aym en t to DBJ was vo lu nt ary, gi ve n the ab se nc e o f a wri tt enag reem en t o r ev id en ce o f an or al ag reem en t t o c om

pe ns at e DBJ , is un av ai li ng . “ Cl os el y he ldco rp or at io ns , as is well kn own , oft enactin fo rm al ly, ‘the ir d eci si on s b ei ng m ad e in co nv ers at io ns , an d o fte nt im es reco rd edno t i n the m in ut es , bu t b y act io n.’” Leve ns on & Kle in , In c. v. Co m

m is si on er, 6 7 T.C. 6 94 , 71 4 (1 97 7) (qu ot in g R eub Is aacs & Co . v. Co m m is si on er, 1 B.T.A. 45 , 48 (19 24 )). W e are sat is fie d t ha t p et it io ne r’s bo ard , in cl ud in g m ajor ity

sh areh ol de r Mar ga ret , con cl ud edat t he clo se of 2 00 4 tha t the $5 00 ,00 0 p aym en t t o DBJ was app ro pr ia te to co m pe ns at e Bru ce an d Do na ldfor th e subs tant ia l b en efi t the y co nf erre d o n p et it io ne r in th ei r in di vi du al cap aci ti es . Insh ort, the act io n i n m ak in g the pa ym en t u nd oubt ed ly reflec te d a n i nf orm al un de rs tand in g a m on g p et it io ne r’s sh areh ol de rs , Marg aret , Bru ce, an d Do na ld , th at th e la tt er two o ug htto be co m pe ns at edforth ei r in di vi du al effo rts an d t he ir
(...co nt in ue d) 1 2 di m in is h the im

po rta nc e o f ha vi ng th atco nc ret e av ai labl e whe n s ho rta ge s oc cu rred .- 30 -

[* 30 ] ass um

pt io n o f th e ri sk s en ta il edinav ert in g t he co ns eque nc es of aco nc ret e sh orta ge forpe ti ti on er dur in g 2 00 4. Inth e sa m e v ei n, we d o n otag ree wi th res po nd en t tha t DBJ pro vi de d n o co m pe ns ab le servi ces to pe ti ti on er. As B ru ce’s an d Do na ld ’s who ll y own ed li mit edli ab il ity

co m pa ny, D BJwas m erel y

th e en ti ty thro ug h wh ic h t he bro th ers im pl em en te d the ir p lan t o fo rm an d fi na nc e Ari zo naMat eri al s. Th ro ug h DBJ , th en , pet it io ne r rec ei ve d two d is ti nc t b en efi ts : (1 ) Bru ce’s an d Do na ld ’s
m an ag em en t ac um enbe hi nda su cces sf ul strat eg y

to av erta po te nt ia ll y

cri pp li ng co nc ret e sh orta ge , an d (2 ) Bru ce’s an d Do na ld ’s ass um pt io n i n t he ir i nd iv idua l 1 3 cap aci ti es of t he ris ks ass oc ia te d wi th Ariz on a Ma te ria l’s fo rm at io n a ndop erat io n, be cau se Bru ce an d Do na ldin ve st edth ei r own fun ds in , andgu aran te edth e d eb t o f, Ariz on a Mate ria ls . Becau se Bru ce an d Do na ldeach own ed50 % of DB J, the pa ym en t t o DBJ co m

pe ns at edth em

forth e fo reg oi ng servi ces rece iv edby pe ti ti on er.

Whi le on e wou ldno rm al ly exp ectth atBru ce an d Do na ld , as o ffi cers of 1 3 pe ti ti on er re sp on si bl e fo r m an ag in g i ts op erat io ns , were al read y ob li ga te d t o pr ov id e th ei r m an ag em en t ac um enwitho utad di ti on al co m pe ns at io n, i n t he un us ua l ci rcu m st an ces pre se nt edhe re the ir m an ag em en t s tra te gy hadbe enreject ed by pet it io ne r be cau se itwas o pp os edby its m ajor ity sh areh ol de r. As a co ns eque nc e, Bru ce an d Do na ldeffe ct iv el y pro vi de d t he ir m an ag em en t s ki ll s t o av erta co nc ret e sh orta ge as o ut si de , th ird -p arty co ns ul tant s.- 31 -

[* 31 ] Fo r es se nt ia ll y

th e sam e rea so ns , we rejectres po nd en t’s ar gu m en t, p rem is ed on Ste wartv. Co m

mis si on er, T.C. Mem o. 2 00 2- 19 9, tha t the $5 00 ,00 0 p aym en t t o DBJwas a ctua ll y

a paym en t t o B ru ce an d Do na ldinth ei r cap aci ti es as o ffi cers of pe ti ti on er. InSte wart , th e ta xp ay er s ou gh t t o d educ t p aym en ts m ad e to hi s wh ol ly own edco rp or at io n o n the gro un ds th atth ey were fo r th e ta xp ay er’s m an ag em en t se rv ic es pro vi de d thr ou gh th e co rp or at io n t o h is so le pro pr ie to rs hi p. We rejecte d th atcla im , fin di ng th atth e ta xp ay er h adpro vi de d t he servi ces inhi s i nd iv idua l cap aci ty dire ct ly to the so le pro pr ie to rs hi p andno t as anem pl oyee of th e co rp or at io n. St ewartis read il y di st in gu is habl e, be cau se he re Bruc e an d Do na ld were cl earl y

act in g i n the ir i nd iv idua l, ra th er tha n c or po rat e o ffi cer, capa ci ti es in fo rm in g a ndfin an ci ng Ariz on a Ma te ria ls . Peti ti on er’s co nt ro ll in g s ha reh ol de r ha d ex pr es sl y reject edth e b ro th ers ’ pr op os al th atitacqui re a co nc ret e supp li er. The br ot he rs th ereupo n p utth ei r own fun ds an d c red itworth in es s i nt o Ari zo na Mat eri al s as in di vi du al s. Th e $ 50 0,0 00 pa ym en t p et it io ne r m ad e inco ns id erat io n of th e res ul ti ng be ne fit s was th eref or e earne d a ndrece iv edby Bruce an d Do na ld (th ro ug h DBJ ) in th ei r in di vi du al cap aci ti es . The $5 00 ,00 0 p aym en t was anord in ary an d n eces sa ry ex pe ns e wit hi n t he
m ean in g o f se ct io n 1 62 (a) b ecau se itwas n orm al fora co nc ret e co nt ract orto ex pe ndfun ds inco nn ect io n wi th en su rin g arel iabl e supp ly of co nc ret e inth e fac e- 32 -

[* 32 ] of s ho rta ge s, an d the expe nd itur e was he lp fu l t o p et it io ne r’s bu si ne ss , al lo win g i t t o m eetcu st om er d em an d wh enot he r co m pa ni es en ga ge d i n t he same bu si ne ss were h am

pe redby the sh orta ge . Peti ti on er i s the refo re en ti tl edto de du ct it . III. Co nc lu si on W e co nc lu de , andho ld , th atth e $ 4,0 25 ,03 9 a nd$7 ,30 0,9 16 pe ti ti on er p ai d to Bru ce an d Do na ldas c om pe ns at io n i n 2 00 3 a nd20 04 , res pe ct iv el y , are de du ct ib le un de r se ct io n 1 62 (a)( 1) . W e fu rth er h ol d t ha t p et it io ne r is en ti tl edto de du ctth e $ 50 0,0 00 pa ym en t i t m ad e to DBJ i n 2 00 4 a s anord in ary an d n eces sa ry bu si ne ss ex pe ns e und er s ect io n 1 62 (a). To re fle ctth e fo reg oi ng , Deci si on wil l b e en te redfor pe ti ti on er.