t c memo united_states tax_court labelgraphics inc petitioner v commissioner of internal revenue respondent docket no filed date gersham goldstein gregory r mowe jaime m w sanders and peter r jarvis for petitioner shirley m francis for respondent memorandum findings_of_fact and opinion parr judge respondent in a notice_of_deficiency determined against petitioner the following federal_income_tax deficiencies an addition_to_tax and a penalty year addition_to_tax penalty ended deficiency sec_6661 sec_6662 dollar_figure dollar_figure -- big_number -- dollar_figure all section references are to the internal_revenue_code in effect for the years in issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated after concessions the issues for decision are the amount petitioner is entitled to deduct under sec_162 as reasonable_compensation to its president lon martin for its year ended date we find it is entitled to deduct dollar_figure whether petitioner is liable for an accuracy-related_penalty under sec_6662 and b for the year ended date with respect to its claimed deduction for the compensation to lon martin we hold that it is not liable for the penalty findings_of_fact some of the facts and certain documents have been stipulated for trial pursuant to rule and are found accordingly we incorporate the parties' stipulations in this opinion by reference petitioner is an oregon corporation when its petition herein was filed petitioner maintained its principal office in portland oregon 1among other things respondent concedes that petitioner is not liable for an addition_to_tax under sec_6661 for its year ended date petitioner manufactures pressure-sensitive identification materials such as product labels and graphic overlays in addition it offers typesetting services to retail customers lon martin who was petitioner's president and sole shareholder during its fiscal_year ended date completed about years of college and then began working in the printing business as of mr martin had approximately years of experience working in the label and printing industry during those years he performed tasks ranging from running presses to managing his own label and printing business before mr martin in partnership with other individuals had owned and operated for a number of years a label and printing business in southern california following his first wife's death and his remarriage he sold his interest in the southern california business and moved to portland oregon about from until petitioner's incorporation in mr martin operated a sole_proprietorship label and printing business in portland initially this label and printing business was a one-man operation that he conducted with the help of his second wife and his junior-high-school-age son mike martin mike mr martin called upon potential customers during the day and often printed at night the labels that were ordered mrs martin helped him by serving as a secretary and shipping clerk mike helped him with the printing of the labels in date petitioner was incorporated to conduct the sole_proprietorship label and printing business that mr martin had operated upon petitioner's incorporation shares of petitioner's outstanding shares of stock were issued to mr martin and the remaining shares of petitioner's outstanding_stock were issued to another individual in date this other individual' sec_50 shares were redeemed and mr martin became petitioner's sole shareholder mr martin continued to be petitioner's sole shareholder until when he sold all of his shares in petitioner to mike during its fiscal_year ended date petitioner's board_of directors consisted of mr martin mrs martin mr martin's wife and jerry crispe who was then petitioner's executive vice president in conducting his and later petitioner's label and printing business mr martin concentrated on selling to companies in the electronics industry a number of which are located in the pacific northwest since its incorporation in all of petitioner's products have been custom designed and produced for particular customers most of petitioner's sales are to electronics companies like compaq and hewlett-packard who demand high quality products from their suppliers over the years mr martin has been extremely successful in operating petitioner profitably and in expanding its business and sales petitioner has enjoyed high profit margins in selling its custom-designed products to a number of high-technology companies petitioner mastered early the ability to produce polycarbonate overlays with little loss of material it has also been very innovative in developing scratch-resistant coatings for its products by its fiscal_year ended date petitioner employed persons its plant is perhaps one of the most modern in the united_states in addition petitioner is very highly regarded in the label and printing industry its principal competitors in the country are much larger companies over its first fiscal years from date through date petitioner's annual gross_receipts increased dramatically its gross_receipts for each fiscal_year during this period were higher than the preceding year for its fiscal_year ended date petitioner had dollar_figure in gross_receipts over its next fiscal years from date through date however petitioner's annual gross_receipts slightly declined this decline in petitioner's business was not unexpected earlier in petitioner's management had anticipated such a possible future decline in business at that time its management recognized that it would be difficult to expand sales further in the portland market and to maintain high profit margins as petitioner had already saturated that market and was likely to encounter increasing competition for that market's remaining new business also by petitioner's management was concerned about some customers' relocating their manufacturing facilities to puerto rico as management believed this relocation overseas might cause a reduction in petitioner's sales around or intel corp a customer of petitioner that had recently relocated certain of its manufacturing facilities to puerto rico asked whether mr martin could establish a plant in puerto rico to supply its puerto rican facilities as a result during mr martin incorporated lasergraphics caribe inc caribe to conduct a label and printing business in puerto rico mr martin was caribe's sole shareholder petitioner had no interest in caribe as the latter corporation was a personal business venture of mr martin that was totally separate and distinct from petitioner from through mr martin devoted some of his time to caribe's business operations caribe established a plant in puerto rico mr martin operated caribe for about years then sold the business after concluding that he could not operate it profitably during and petitioner successfully developed its micro clean proprietary process for producing labels meeting the clean room production facility standards of its electronics industry customers the process represented a significant technological innovation in the label industry before its development there were no contaminant-free labels comparable to petitioner's clean room labels although electronics companies could use normal labels to identify and package sensitive electronic components they manufactured in their clean rooms the normal labels themselves would contain contaminants the materials used in and the processing for petitioner's clean room labels are quite different from that of normal labels clean room label production requires a special cleaning machine that petitioner devised to clean labels after their manufacture and before their packaging in addition the labels employ a special adhesive that petitioner developed with the assistance of outside adhesive consultants and chemists mr martin was instrumental in developing the micro clean process in it was he who envisioned a process to produce labels to clean room standards initiated the engineering program for its development and saw the program through to a successful conclusion in early he and petitioner's staff engineer worked on the label-cleaning machine petitioner devised he and certain other of petitioner's employees refined the process for producing clean room labels and worked with outside consultants and chemists to develop the special adhesive the labels required petitioner sold its first clean room labels during the first half of for its fiscal_year ended date its sales of clean room labels totaled dollar_figure in date petitioner's directors anticipated that clean room labels would produce significant sales and profits in future years and would strengthen petitioner's competitive advantage in the industry their assumption proved to be correct as by the labels accounted for approximately percent of petitioner's sales and were the fastest growing and most profitable segment of its business from through petitioner's annual sales and gross margins from clean room labels were as follows year sales gross margin dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number during its fiscal_year ended date petitioner's three officers were mr martin president jerry crispe executive vice president and mrs martin secretary of petitioner's officers only mr martin had substantial experience in the label and printing industry before working for petitioner he designed petitioner's physical plant and layout he also hired and trained the other members of petitioner's management team including mr crispe and mike when he began working part time for petitioner around or mr crispe had no experience in the label and printing business he previously had been in the real_estate development business and had some familiarity with general business matters he became a full-time_employee in after he began working full time for petitioner mr crispe eventually performed substantial administrative and general business tasks that mr martin previously handled as indicated previously mike had helped mr martin while in junior high school following his graduation from high school he worked for petitioner full time he became petitioner's production manager in the late 1980's and was promoted to vice president for manufacturing in in addition to mike during its fiscal_year ended date petitioner employed a staff engineer as well as two production managers or team leaders petitioner also had four salesmen each of whom worked on a commission basis during mr martin's duties included setting corporate policy establishing and monitoring quality policy and authorizing resources to ensure compliance maintaining relationships with customers professionals and the community as needed directing the investment of funds directing employee policies establishing 1-year and 5-year mission statements coordinating relationships with competitors suppliers and consultants to accomplish corporate goals chairing all board meetings approving departmental strategy and reviewing and approving all capital expenditures from through mr martin's total annual compensation consisting of a salary and bonus from petitioner was as follows year salary bonus total compensation dollar_figure big_number big_number big_number dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number -- big_number 1no breakdown between salary and bonus is available petitioner had no fixed formula for determining mr martin's annual bonuses rather its directors generally considered petitioner's financial performance for the recent fiscal_year for instance concerning the dollar_figure bonus paid to him for minutes of petitioner's board_of directors' meeting on date state in pertinent part bonus to lon d martin the directors reported that the past fiscal_year had been particularly successful and that it was appropriate to raise mr martin's annual bonus in light of such success additionally mr martin's regular base salary has not been increased for several years on the theory that his total annual compensation would be tied significantly to the performance of the corporation in light of all of the above circumstances the directors ratified and approved a bonus to mr martin of dollar_figure with respect to the dollar_figure bonus paid to him for the deductibility of which is in issue minutes of petitioner's board_of directors' meeting on date state in pertinent part bonus to lon d martin once again the corporation has enjoyed a successful and profitable fiscal_year the directors recognize that this success continues to be due in large part to the efforts and expertise of president lon d martin in light of this recognition and the fact that mr martin's base salary has been continued at the same level for several years the directors unanimously agreed to pay mr martin a total bonus of dollar_figure this bonus is to be paid_by the corporation's forgiving a debt of dollar_figure due from mr martin to the corporation and by paying the balance of dollar_figure in cash to mr martin from through jerry crispe's mrs martin's and mike's respective total annual compensation from petitioner was as follows mr crispe year salary bonus total compensation dollar_figure big_number dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number -- big_number 1no breakdown between salary and bonus is available mrs martin year salary bonus total compensation dollar_figure -- dollar_figure -- -- -- -- -- -- big_number -- big_number big_number -- big_number big_number dollar_figure big_number big_number -- big_number mike year salary bonus total compensation dollar_figure big_number big_number dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number -- big_number 1no breakdown between salary and bonus is available on date petitioner's directors adopted two separate formulas for determining the respective annual bonuses to be paid to mr crispe and mike minutes of the date board_of directors meeting state in pertinent part bonus to gerald a crispe the directors ratified and approved a bonus formula for gerald a crispe for his services as executive vice president of the corporation effective as of date mr crispe is to receive a bonus equal to of the net_income of the corporation net_income for purposes of calculating mr crispe's bonus is the income the corporation would have after deducting all taxes that would be incurred on the corporation's income before paying any executive bonuses mr crispe's bonus is payable annually although advances against the bonus may be made more frequently bonus to mike martin the directors ratified and approved a bonus formula for mike martin for his services as production manager effective date his annual bonus shall be equal to 10th of of the company's annual gross_profits times the factor obtained by dividing the corporation's costs of goods sold by total sales mike's bonus is payable annually although advances against the bonus may be paid more frequently mr crispe and mike received annual bonuses for through based on the above bonus formulas in petitioner further paid to mike an additional special bonus of dollar_figure thus giving him for that year a total bonus of dollar_figure as indicated previously mrs martin received a dollar_figure bonus for this bonus was not determined pursuant to any fixed bonus formula petitioner's annual financial statements for its fiscal years from date through date reflect the following annual gross_receipts and net profit or net_loss after taxes net profit 0r net_loss fye june gross_receipts after taxes dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number its annual financial statements for this period further reflect the following total assets and net assets 2mike's dollar_figure total bonus consisted of the dollar_figure regular bonus he earned under the bonus formula petitioner had adopted for him in and the dollar_figure special bonus he received in recognition of his contribution to the manufacturing operations of the corporation neither the regular nor the special bonus to mike was challenged by respondent 3in the notice_of_deficiency issued to petitioner respondent originally determined that no portion of petitioner's dollar_figure of purported total compensation to mrs martin for its fiscal_year ended date was deductible as reasonable_compensation as a result of a settlement concluded between the parties they now agree that half of this dollar_figure which includes the dollar_figure bonus to her is deductible by petitioner fye june total asset sec_1 net asset sec_2 dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number 1petitioner's cost for the assets less accumulated depreciation 2total assets less current and long-term liabilities its annual financial statements for this period also reflect the following equity annual return on equity and cumulative average annual return on equity return on cum average ret fye june equity1 equity2 on equity3 dollar_figure dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number dollar_figure percent dollar_figure percent big_number percent dollar_figure percent 1invested capital plus retained earnings less treasury_stock 2net profit after taxes see second preceding paragraph above divided by equity 3sum of current year's return on equity and each prior year's return on equity divided by petitioner's number of years of operation through current_year in petitioner retained a business valuation company to appraise mr martin's 100-percent stock interest in petitioner in its appraisal report this valuation company concluded that mr martin's stock interest had a fair_market_value of dollar_figure as of date on date mr martin sold all of his stock in petitioner to mike from its incorporation in date through date petitioner declared and paid no formal dividends in the notice_of_deficiency issued to petitioner respondent among other things disallowed petitioner's deduction of a dollar_figure portion of its total compensation to mr martin for its year ended date the notice_of_deficiency stated in pertinent part the compensation of officer shareholder lon martin claimed in the amount of dollar_figure is overstated dollar_figure it has not been established that an amount greater than dollar_figure is reasonable_compensation for services provided by lon martin during the taxable_year further it has not been established that any amount represents payments for prior years in which lon martin may have been undercompensated accordingly taxable_income is increased dollar_figure for the taxable_year ended respondent further determined that petitioner was liable for a penalty under sec_6662 and b with respect to the underpayment from the disallowed compensation deduction to mr martin issue reasonable_compensation opinion sec_162 allows as a business deduction a reasonable allowance for salaries or other compensation_for_personal_services actually rendered a two-prong test determines deductibility whether the amount of compensation is reasonable in relation to services performed and whether the payment is in fact purely for services rendered sec_1 a income_tax regs more specifically bonuses paid to employees are deductible when made in good_faith and as additional compensation_for the services actually rendered by the employees provided such payments when added to the stipulated salaries do not exceed a reasonable_compensation for the services rendered sec_1_162-9 income_tax regs generally courts have focused on the reasonableness requirement in determining the deductibility of purported compensation 716_f2d_1241 9th cir revg and remanding tcmemo_1980_282 the reasonableness of compensation is a question of fact to be answered by considering and weighing all facts and circumstances of the particular case 399_f2d_603 9th cir affg tcmemo_1967_7 95_tc_525 affd 965_f2d_1038 11th cir petitioner has the burden of showing that it is entitled to a compensation deduction larger than that allowed by respondent rule a 503_f2d_359 9th cir affg tcmemo_1971_200 case law has provided an extensive list of factors that are relevant in determining the reasonableness of compensation 178_f2d_115 6th cir revg and remanding a memorandum opinion of this court no single factor is dispositive pacific grains inc v commissioner f 2d pincite 73_tc_1142 in elliotts inc v commissioner supra pincite8 the court_of_appeals for the ninth circuit to which this case is appealable used a five- factor test the employee's role in the company a comparison of the compensation paid to the employee with the compensation paid to similarly situated employees in similar companies the character and condition of the company whether a conflict of interest exists that might permit the company to disguise dividend payments as deductible compensation and whether the compensation was paid pursuant to a structured formal and consistently applied program the parties recognize the applicability of the elliotts inc test however they disagree concerning the amount of purported compensation to mr martin that qualifies as reasonable_compensation under that test petitioner contends that the entire dollar_figure mr martin received is reasonable_compensation although it acknowledges that mr martin was given an unusually high bonus of dollar_figure petitioner maintains this bonus represented reasonable_compensation for his unique services respondent on the other hand contends that only dollar_figure is reasonable respondent argues that there was no compensatory purpose for the remaining balance and that mr martin arranged this large disguised_dividend in preparation for selling petitioner to his son mike accordingly we shall analyze and apply the factors enunciated by the court_of_appeals for the ninth circuit in elliotts inc v commissioner supra in order to determine reasonable_compensation for mr martin petitioner and respondent offered the testimony of three expert witnesses petitioner's two experts john culbertson culbertson and pamela jones jones each own management consulting firms and have advised their respective corporate clients on executive compensation respondent's expert paul t clausen clausen owns his own business valuation company and has testified as an expert witness on the valuation of business_assets business interests and reasonable executive compensation in numerous court cases as trier of fact we are not bound by the opinion of any expert witness and will accept or reject expert testimony in whole or in part in the exercise of sound judgment 304_us_282 538_f2d_927 2d cir and cases thereat affg tcmemo_1974_285 a role in the company the first factor focuses on the compensated employee's importance to the success of the business pertinent considerations include the employee's position hours worked duties performed and the general importance of the employee to the company 536_f2d_289 9th cir affg in part and revg in part 59_tc_231 where a large salary increase is at issue similar to the instant case it is further useful to compare past and present duties and salary payments elliotts inc v commissioner supra pincite mr martin was petitioner's key_employee and the primary reason for its success over the years as president he was the driving force behind petitioner's success from its inception and his personal services were essential to that success he managed and built up petitioner's business designed its physical plant and layout and trained other later members of its management team although he had delegated some administrative duties and general business responsibilities to mr crispe by the fiscal_year in issue mr martin remained the driving force behind petitioner further while he was also devoting some time and attention to caribe in puerto rico being petitioner's president remained his full-time job thus any reduction in the hours he worked per week for petitioner must be balanced against his knowledge and experience in the industry and the valuable services he continued to render to petitioner during its fiscal_year in and mr martin was instrumental in developing petitioner's micro clean process for producing clean room labels the resulting clean room labels were a technologically innovative commercially promising and potentially significantly profitable new product over the short_period from early when development work on the labels' production process was completed through date petitioner had dollar_figure in sales of the new labels in date its directors anticipated the labels would contribute significantly to petitioner's profitability and financial success in future years however mr martin's bonus of dollar_figure is almost three times the size of his prior largest annual bonus of dollar_figure for indeed on brief petitioner acknowledges the bonus to be an unusually high extraordinary one time bonus the record further fails to reflect that part of this fiscal_year compensation was to remedy petitioner's alleged prior undercompensation of mr martin 4the parties stipulated that his being petitioner's president was a full-time job although petitioner's expert culbertson opined that the fiscal_year compensation was justified because mr martin had been undercompensated in prior years he offered no analysis or explanation in support of his claim in light of his failure to do so we give his conclusion little weight except for perhaps and covering petitioner's first year and a half of operations mr martin appears to have been very well compensated in prior years his total compensation of dollar_figure was almost as much as his total compensation of dollar_figure despite petitioner's enjoying a substantially better financial performance for its fiscal_year than for its fiscal_year petitioner's fiscal_year gross_receipts were more than twice its fiscal_year gross_receipts similarly its fiscal_year net profit after taxes was over times its fiscal_year net profit after taxes thus any possible earlier undercompensation by petitioner of mr martin was likely remedied long before further pertinent minutes of the date board meeting authorizing petitioner's payment of the bonus in issue make no mention that any part of this dollar_figure was to compensate mr martin for his services in prior years accordingly we conclude that petitioner has failed to establish that some of the fiscal_year compensation in issue was to remedy its alleged prior undercompensation of mr martin see pacific grains inc v commissioner f 2d pincite see also estate of wallace v commissioner t c pincite b external comparison this second factor compares the employee's compensation with that paid_by similar companies for similar services elliotts inc v commissioner f 2d pincite see sec_1_162-7 income_tax regs based on their claimed knowledge of the compensation certain high-technology companies furnished their executives petitioner's experts culbertson and jones were each of the opinion that the dollar_figure bonus petitioner paid to mr martin was reasonable they noted that top executives at many high- technology companies typically receive stock_options as part of their compensation package and that these stock_options can produce substantial compensation in the event the company's stock price rises greatly however as jones noted stock_options could not be used by petitioner to compensate mr martin because mr martin already owned a 100-percent stock interest in petitioner jones was also of the opinion that mr martin was actually entitled to even more compensation than he received because according to her he performed multiple executive roles including being petitioner's chief_executive_officer vice president of marketing vice president of sales and chief technical officer she further asserted that he would have been entitled to royalties on petitioner's clean room labels as chief technical officers of hi-tech companies typically will receive a royalty on the sales of any products they help develop culbertson and jones failed to offer any details concerning the specific high-technology companies upon which they based their opinions they also offered no specifics on the particular executives involved nor pertinent information on their particular qualifications and skills and the exact compensation they received we thus are unable to determine how similar these other unidentified companies and their businesses are to petitioner and how similar the services their executives rendered are to the services mr martin performed moreover even if he were not petitioner's sole shareholder we are skeptical that mr martin prior to and during the fiscal_year in addition to the salary and bonus he had already received would also have been compensated by petitioner with stock_options we do not doubt that certain top executives of various high-technology companies typically will receive stock_options as part of their compensation and that the stock_option sec_5both the parties and their experts argue at considerable length over whether or not petitioner is a high-technology company petitioner contends that it is a high-technology company whereas respondent contends that petitioner is not in our view this dispute is neither helpful nor productive to our resolving the instant case granted them can often prove highly remunerative however as discussed previously mr martin generally does not appear to have been undercompensated in prior years also we have no way of knowing the specific stock_options petitioner's experts believed mr martin hypothetically should otherwise have received as they provided no further elaboration in connection with this point the same is true of jones' contentions about royalties with respect to petitioner's expert jones' claim that mr martin could have taken even more compensation from petitioner we find questionable her suggestion that he performed the work of four full-time executives serving as petitioner's chief_executive_officer vice president for marketing vice president for sales and chief technical officer although mr martin may have performed some of the duties and functions of four such executives he did not perform work equal to the full-time services of four such executives indeed by the fiscal_year in issue he was devoting some of his time and attention to his other company caribe in sum petitioner's experts have failed meaningfully to 6to be sure this court and other courts in numerous reasonable_compensation cases have considered the fact that the recipient performed more than one function for his employer even though that individual's reasonable_compensation may not be the sum of the amounts paid to a full-time_employee in each such position see pmt inc v commissioner tcmemo_1996_303 compare the executive compensation provided by other companies they selected to the situation presented in the instant case consequently we give petitioner's experts' above opinions little weight respondent's expert clausen examined other companies in the printing industry clausen selected three public companies to compare to petitioner two of these companies were much larger than petitioner particularly in terms of their respective annual sales and number of employees the third company whose annual sales were somewhat closer to petitioner's was far less profitable than petitioner and was acknowledged by clausen as not being reasonably comparable to petitioner in determining mr martin's reasonable_compensation clausen further considered two surveys of executive compensation in the printing industry however he acknowledged these surveys to be only of limited use in determining what might be reasonable_compensation in a particular company's case clausen opined that reasonable_compensation to mr martin for the fiscal_year would be dollar_figure consisting of a dollar_figure salary and a dollar_figure bonus he noted that mr martin's dollar_figure in salary and bonus exceeded the total cash compensation of each chief_executive_officer of the two large public printing companies he examined none of the three public printing companies clausen selected was reasonably comparable to petitioner the largest company had sales for of dollar_figure million and a pretax profit of dollar_figure million and employed a total of big_number employees the next largest company had sales for of dollar_figure million and a pretax profit of dollar_figure million and employed a total of employees respondent argues that mr martin's reasonable_compensation cannot exceed the cash compensation received by these two chief executive officers of much larger printing companies however as petitioner points out clausen failed to take into account the stock_options the chief executive officers of the two larger printing companies previously were granted the compensation they earned from these stock_options appears to have been substantial in any event the two larger printing companies clausen chose are not reasonably comparable to petitioner moreover as clausen acknowledged the two industry surveys he consulted are of only limited use in determining mr martin's reasonable_compensation accordingly the court does not accept clausen's opinion concerning mr martin's reasonable_compensation for the fiscal_year c character and condition of company this third factor considers the company's character and condition relevant considerations are the company's size as measured by its sales net_income or capital value the complexities of the business and general economic conditions elliotts inc v commissioner f 2d pincite see 93_f2d_816 9th cir petitioner was a relatively small label and printing company that grossed more than dollar_figure million annually for its through fiscal years it had secured itself a nice market niche in supplying certain custom-designed products to a number of high- technology companies thus enabling it to earn high profit margins on its product sales moreover as petitioner's directors correctly anticipated in date its recently developed clean room labels would produce significant profits and give petitioner a competitive advantage in future years from through the new clean room labels helped reverse the slight decline in business petitioner experienced during its and fiscal years also mr martin's 100-percent stock interest in petitioner was subsequently appraised by a business valuation company to have a fair_market_value of dollar_figure million as of date in years after and the labels were probably the single most important factor in spurring petitioner to even greater sales and profitability all in all from its inception through the fiscal_year petitioner has been an extremely well managed and profitable company it had a very lean management team and by the fiscal_year enjoyed an excellent reputation in the label and printing industry d conflict of interest this fourth factor examines whether a relationship exists between the company and employee that might permit the company to disguise nondeductible corporate_distributions as sec_162 deductible compensation thus close scrutiny must be given where the paying corporation is controlled by the compensated employee as in the instant case elliotts inc v commissioner supra pincite7 however the mere existence of such a relationship when coupled with an absence of dividend payments does not necessarily lead to the conclusion that the amount of compensation is unreasonably high id pincite instead the fact finder is further to adopt the perspective of an independent investor in determining whether the investor would be satisfied with the company's return on equity after the compensation in issue was paid id pincite as a result of its payment of the dollar_figure bonus to mr martin petitioner had a dollar_figure loss and a negative dollar_figure percent return on equity for the fiscal_year we do not think an independent investor would be happy with such a negative return on equity especially where the unusually high bonus payment producing the loss for the fiscal_year is equal to approximately dollar_figure percent of the investor's equity in the company dollar_figure divided by dollar_figure net assets petitioner nevertheless asserts that an independent investor would still be satisfied with the corporation's dollar_figure percent cumulative average annual return on equity through the fiscal_year we disagree in our opinion the cumulative average annual return on equity petitioner experienced over the period from date through date would not be as significant to an independent investor as the corporation's return on equity for the current fiscal_year in issue indeed the record reflects that petitioner's directors' usual practice had been to tie mr martin's annual bonus to the corporation's financial performance during the recent fiscal_year also the higher dollar_figure percent cumulative average annual return is somewhat skewed by the much higher annual returns on equity petitioner enjoyed during its earlier years of operation when its equity was much lower e internal consistency the fifth factor focuses on whether the compensation was paid pursuant to a structured formal and consistently applied program bonuses not paid pursuant to such plans are suspect similarly bonuses paid to controlling shareholders are also suspect if when compared to salaries paid non-owner management they indicate that the level of compensation is a function of ownership not corporate management responsibility elliotts inc v commissioner supra pincite petitioner's unusually high extraordinary one time bonus of dollar_figure to mr martin represented a departure from its normal annual bonus practice for him as reflected by minutes of the date board meeting petitioner's directors' usual practice had been to tie mr martin's annual bonus in large part to petitioner's financial performance during the recent fiscal_year yet mr martin's bonus was almost three times the size of his bonus of dollar_figure even though petitioner enjoyed significantly higher gross_receipts as well as a substantially higher net profit after taxes for its fiscal_year than for its fiscal_year we do not accept petitioner's and its expert's arguments that the bonus of dollar_figure was justified because of mr martin's instrumental efforts in developing the micro clean process although petitioner's directors anticipated the resulting clean room labels would be significantly profitable in future years petitioner's later financial success with the new labels was by no means certain as of the end of the fiscal_year most importantly we do not believe that an independent investor would approve of paying mr martin this large dollar_figure bonus when the new labels' profit prospects were still uncertain and yet to be confirmed while mr martin is entitled to some bonus for his efforts in developing petitioner's clean room labels in our opinion the dollar_figure bonus payment to him far exceeds a reasonable bonus see pmt inc v commissioner tcmemo_1996_303 shareholder-employee entitled to additional compensation of dollar_figure for his prior invention of corporation's new fabric product new fabric accounted for a dollar_figure million increase in the corporation's sales during the year in issue and corporation also enjoyed a high return on equity for that year f amount of reasonable_compensation we consider the dollar_figure salary mr martin received to be reasonable as president he managed a business that grossed more than dollar_figure million annually for its through fiscal years he had also received approximately the same annual salary since at least in addition mr martin should receive a bonus as it had been petitioner's practice to provide him a substantial portion of his compensation in the form of an annual bonus tied to petitioner's financial performance during the recent fiscal_year we consider a bonus of dollar_figure to him to be reasonable although petitioner's business slightly declined for the fiscal_year the decline had been expected and was attributable to factors beyond mr martin's control moreover petitioner still grossed over more than dollar_figure million for the fiscal_year also as indicated previously mr martin is entitled to some bonus for his efforts in successfully developing the micro clean process this dollar_figure of reasonable_compensation we estimate results in a revised return on equity for petitioner of approximately dollar_figure percent for the fiscal_year we think an independent investor would be satisfied with this return on equity and with petitioner's fiscal_year financial performance despite the slight decline in business experienced for that year mr martin still had done an excellent job in managing petitioner as previously discussed petitioner was encountering increased competition in the portland market and was experiencing some loss of sales due to its customers' relocating their manufacturing facilities overseas moreover petitioner 7petitioner's organizational minutes provide that if the internal_revenue_service or a court of competent jurisdiction determines any salary to any stockholder officer to be a dividend the payment shall immediately be treated as a loan to the officer with interest payable at the legal rate from the date of payment thereof due and payable within year from the date of determination if mr martin's total compensation was dollar_figure rather than dollar_figure petitioner's fiscal_year income would be increased dollar_figure giving it a revised net_income before taxes of dollar_figure the dollar_figure net_loss reflected on the fiscal_year financial statement plus dollar_figure assuming combined federal and state income taxes are imposed equal to percent of this revised net_income before taxes petitioner's revised net taxable_income after taxes would be dollar_figure dollar_figure multiplied by percent and its revised equity would be dollar_figure revised retained earnings plus invested capital less treasury_stock per fiscal_year financial statement this would represent a revised return on equity of approximately dollar_figure percent dollar_figure divided by dollar_figure had just finished successfully developing its commercially promising and potentially significantly profitable new clean room labels we hold that petitioner is entitled to a dollar_figure deduction under sec_162 as reasonable_compensation to mr martin for its year ended date issue accuracy-related_penalty respondent determined that petitioner was liable for a penalty under sec_6662 and b for substantial_understatement of its income_tax for the year ended date an understatement of income_tax is substantial if it exceeds the greater of percent of the tax required to be shown on the return or for a corporation dollar_figure sec_6662 as relevant to the instant case any understatement is reduced by the portion of the understatement attributable to an item for which the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return sec_6662 for 8in the notice_of_deficiency respondent determined that the entire underpayment for the year ended date was attributable to non-tax-shelter items 9the omnibus_budget_reconciliation_act_of_1993 obra_1993 publaw_103_66 sec a 107_stat_531 amended sec_6662 to also require a reasonable basis for the tax continued the year under consideration respondent provided guidance totaxpayers by means of notice_90_20 1990_1_cb_328 and revproc_90_16 c b dollar_figure revproc_90_16 sec_4 c b pincite provides that for purposes of reducing any understatement of income_tax under sec_6662 additional disclosure of facts with respect to an issue involving the reasonableness of officers' compensation is unnecessary where the schedule e compensation of officers to the form_1120 is completed in a clear manner and in accordance with its instructions sec_4 of revproc_90_16 further requires that the time devoted by the officer to the business be expressed as a specific percentage in addition sec_6664 provides that a penalty under sec_6662 shall not be imposed on any portion of an underpayment if the taxpayer shows reasonable_cause for such continued treatment of the item however this amendment is effective only for returns the due dates for which determined without regard to extensions are after date and is not applicable to the instant case obra_1993 sec b 107_stat_531 petitioner's return for the year ended date was due on or before date sec_6072 sec_1_6662-4 and f income_tax regs is not applicable because they were issued to apply prospectively with respect to income_tax returns due after date see t d 1992_1_cb_374 however absent further guidance taxpayers may rely on the rules set forth in notice_90_20 1990_1_cb_328 and revproc_90_16 1990_1_cb_477 portion of the underpayment and that the taxpayer acted in good_faith with respect to such portion reliance on the advice of a professional such as an accountant may constitute a showing of reasonable_cause if under all the facts and circumstances such reliance is reasonable and the taxpayer acted in good_faith sec_1_6664-4 income_tax regs petitioner asserts that no penalty under sec_6662 and b should be imposed it maintains that pursuant to revproc_90_16 supra its return for the year ended date adequately disclosed the relevant facts concerning its claimed compensation deduction to mr martin alternatively petitioner argues that it qualifies under the sec_6664 reasonable- cause-and-good-faith exception to the penalty we agree with petitioner that there was adequate_disclosure in its return since a properly completed schedule e concerning its officers' compensation was included in petitioner's return we hold that petitioner is not liable for a penalty under sec_6662 and b for the year ended date notice_90_20 supra revproc_90_16 supra to reflect the foregoing and the parties' concessions decision will be entered under rule


internal_revenue_service department of the treasury number release date index number washington dc person to contact telephone number refer reply to cc fip plr-164335-02 date date fund a fund b fund c fund d fund e date date date date firm plr-164335-02 dear this is in reply to a letter dated date requesting on behalf of funds a through e funds extensions of time to file elections under sec_855 of the internal_revenue_code sec_855 elections facts funds are corporations registered under the investment_company act of as amended as open-end management investment companies funds have elected to be treated as regulated_investment_companies rics in accordance with subchapter_m of the code the taxable_year of all the funds is the calendar_year firm prepares funds’ federal_income_tax returns for the taxable_year ending date firm intended to file forms on funds’ behalf for extensions for filing the returns in which elections had to be made under sec_855 of the internal_revenue_code the forms should have been mailed by date on date three days after date firm discovered that by oversight the forms had not been mailed and promptly mailed them on date funds filed their income_tax returns for the year ending on date because the returns were filed late the filing_date is the date on which they were received at the appropriate service_center rather than the date on which they were mailed the returns were not mailed by registered mail return receipt requested so funds are not certain precisely when the returns were received by the service_center funds make the following representations the request for relief was filed by funds before the failure to make the regulatory election was discovered by the service granting the relief will not result in funds having a lower tax_liability in the aggregate for all years to which the regulatory election applies than funds would have had if the elections had been timely made taking into account the time_value_of_money funds do not seek to alter a return position for which an accuracy-related_penalty has been or could have been imposed under sec_6662 of the code at the time funds requested relief and the new position requires or permits a regulatory election for which relief is requested being fully informed of the required regulatory election and related tax consequences funds did not choose to not file the election plr-164335-02 applicable law sec_301_9100-1 of the regulations provides in part that the commissioner has discretion to grant a reasonable extension of time to make a regulatory election defined in sec_301_9100-1 as an election whose deadline is prescribed by regulations or by a revenue_ruling a revenue_procedure a notice or an announcement published in the internal_revenue_bulletin or a statutory election but no more than months except in the case of a taxpayer who is abroad under all subtitles of the internal_revenue_code except subtitles e g h and i sec_301_9100-3 through c i of the regulations sets forth rules that the internal_revenue_service generally will use to determine whether under the facts and circumstances of each situation the commissioner will grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 sec_301_9100-3 provides that subject_to paragraphs b i through iii of sec_301_9100-3 when a taxpayer applies for relief under this section before the failure to make the regulatory election is discovered by the service the taxpayer will be deemed to have acted reasonably and in good_faith and sec_301_9100-3 provides that the interests of the government are prejudiced if granting relief would result in the taxpayer having a lower tax_liability in the aggregate for all years to which the regulatory election applies than the taxpayer would have had if the election had been timely made taking into account the time_value_of_money conclusion based upon the facts and representations submitted it is held that funds have shown good cause for granting a reasonable extension of time to make a sec_855 election accordingly the time for filing the election is extended to the date on which the returns mailed on date were received in the service_center no opinion is expressed as to whether funds’ tax_liability is not lower in the aggregate for all years to which the regulatory election applies than the tax_liability would have been if the elections had been timely made taking into account the time_value_of_money upon audit of the federal_income_tax returns involved the director's office will determine the taxpayers’ tax_liability for the years involved if the director's office determines the taxpayers’ liability is lower that office will determine the federal_income_tax effect this ruling is limited to the timeliness of funds’ elections this ruling does not relieve funds from any penalties they may owe as a result of the failures to file federal_income_tax returns on time this ruling's application is limited to the facts code sections and regulations cited herein no opinion is expressed as to whether funds qualify as rics under subchapter_m part i of the code plr-164335-02 a copy of this letter is being forwarded to the service_center where funds file their returns with instructions that although returns were not timely filed funds are to be treated as having made timely sec_855 elections except as specifically provided otherwise no opinion is expressed on the federal_income_tax consequences of the transaction described above this ruling is directed only to the taxpayers that requested it sec_6110 of the code provides that it may not be used or cited as precedent in accordance with the terms of a power_of_attorney on file in this office a copy of this letter is being sent to your authorized representative sincerely yours william e coppersmith william e coppersmith chief branch office of associate chief_counsel financial institutions products


significant index number department of the treasury internal_revenue_service washington d c tax_exempt_and_government_entities_division feb l se't ep ralald re taxpayer dear this letter constitutes notice that approval has been granted for your request for a 5-year automatic_extension for amortizing the unfunded liabilities as of date for the above-named plan which are described in sec_431 and sec_431 of the intemal revenue code code and sec_304 and sec_304 of the employee_retirement_income_security_act_of_1974 erisa this extension is effective with the plan_year beginning date this extension applies to the amortization charge bases as identified in your application submission established as of date with a total outstanding balance of dollar_figure as of that date the extension of the amortization periods of the unfunded liabilities of the plan was granted in accordance with sec_431 of the code sec_431 of the code requires the secretary to extend the period of time required to amortize any unfunded_liability of a plan for a period of time not in excess of years if the plan submits an application meeting the criteria stated in sec_431 the plan has submitted the required information to meet the criteria in sec_431 including a certification from the plan’s actuary that i absent the extension under subparagraph a the plan would have an accumulated_funding_deficiency in the current plan_year or any of the succeeding plan years ii the plan_sponsor has adopted a plan to improve the plan's funding status iii the plan is projected to have sufficient assets to timely pay expected benefits and anticipated expenditures over the amortization period as extended and iv the notice required under paragraph a has been provided we have sent a copy of this letter to the and to the this ruling is directed only to the taxpayer that requested it sec_6110 of the internal_revenue_code provides that it may not be used or cited by others as precedent if you require further assistance in this matter please contact sincerely yours david m ziegler manager ep actuarial group


department of the treasury washington dc third party communication none date of communication not applicable_person to contact ----------------- id no ------------- telephone number refer reply to cc ita b03 plr-132734-05 date date internal_revenue_service number release date index number ------------------------------------------------------ ------------------------------------- --------------------------------------------- ------------------------------- attn --------------------- ------------------------------- in re --------------------------------------- ------------------------------ ------------------------------- ---------------------------- legend taxpayer taxpayer corp x business a state a investment investment banking firm investment banking firm accounting firm date date date date date date date date date --- plr-132734-05 dear -------------- this ruling is in reply to a letter dated date submitted by corp x as successor to taxpayer and taxpayer requesting an extension of time under sec_301_9100-3 of the procedure and administrative regulations for taxpayer and taxpayer collectively referred to as taxpayers to complete the documentation of success-based fees required under sec_1_263_a_-5 of the income_tax regulations in order to be excepted from the requirement to capitalize such fees under sec_263 of the internal_revenue_code facts prior to the termination of their corporate existence both taxpayer and taxpayer were business a holding_companies incorporated in state a and owned all of the outstanding capital stock of one or more operating subsidiaries on date taxpayer acquired taxpayer in a transaction qualifying as a reorganization under sec_368 and sec_368 of the internal_revenue_code wherein taxpayer survived a merger with a merger subsidiary controlled by taxpayer subsequently taxpayer merged with and into taxpayer in a statutory merger described in sec_368 and ceased to exist taxpayer 2’s operating subsidiary was also merged with and into one of taxpayer 1’s subsidiaries in conjunction with the acquisition of taxpayer acquisition taxpayer engaged investment banking firm on date and incurred fees for investment banking services including a success- based fee in conjunction with acquisition taxpayer engaged investment banking firm and also incurred fees for investment banking services including a success- based fee in a separate subsequent transaction qualifying as a reorganization under sec_368 taxpayer merged with and into corp x on date and ceased to exist acquisition taxpayer 1’s operating subsidiaries were also merged with and into corp x’s operating subsidiary in anticipation of acquisition taxpayer engaged investment banking firm on date and incurred fees for investment banking services including a success-based_fee on date taxpayer engaged accounting firm to provide tax consulting and analyze the transaction costs incurred by both taxpayer and taxpayer with regard to acquisition and acquisition accounting firm determined that certain amounts of taxpayer 1’s and taxpayer 2’s success-based fees incurred in conjunction with acquisition and acquisition were allocable to activities that did not facilitate the transactions plr-132734-05 taxpayers relied on accounting firm to advise them about the treatment and the documentation requirements for success-based fees that were allocable to non- facilitative activities under sec_1_263_a_-5 under this provision the taxpayers were required to complete documentation of these amounts on or before the due_date of the taxpayers’ timely filed original federal_income_tax returns including extensions for the taxable years during which the transactions closed the original due_date for taxpayer 1’s final tax_return for the short_period ended date was date and the extended due_date for its final tax_return would have been date in the case of taxpayer the original due_date for its final tax_return for the short_period ended date was date and the extended due_date for its final return would have been date however accounting firm miscalculated the original due dates of taxpayers’ tax returns and failed to advise taxpayers to file an extension of time to file their returns as a result accounting firm failed to complete the documentation requirement for taxpayers’ success-based fees incurred with regard to acquisition and acquisition before the due dates of taxpayers’ timely filed original tax returns including extensions accounting firm completed the documentation required under sec_1_263_a_-5 for taxpayer by date and for taxpayer by date but after the returns were due thus corp x as successor to taxpayers filed a request under sec_301_9100-3 to ask for an extension of the time provided in sec_1_263_a_-5 for documenting that certain success-based fees were non-facilitative law and analysis sec_263 provides that no deduction shall be allowed for any amounts paid out for new buildings or permanent improvements or betterments made to increase the value of any property or estate sec_1_263_a_-5 provides in part that a taxpayer must capitalize an amount_paid to facilitate certain transactions including reorganizations described in sec_368 sec_1_263_a_-5 provides as follows an amount_paid that is contingent on the successful closing of a transaction described in paragraph a of this section is an amount_paid to facilitate the transaction except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction this documentation must be completed on or before the due_date of the taxpayer's timely filed original federal_income_tax return including extensions for the taxable_year during which the transaction closes for purposes of this paragraph f documentation must consist of more than merely an allocation between activities that facilitate the transaction and activities that do not facilitate the transaction and must consist of supporting records for example time records itemized invoices or other records that identify-- plr-132734-05 the various activities performed by the service provider the amount of the fee or percentage of time that is allocable to each of the various activities performed where the date the activity was performed is relevant to understanding whether the activity facilitated the transaction the amount of the fee or percentage of time that is allocable to the performance of that activity before and after the relevant date and the name business address and business telephone number of the service provider emphasis added sec_301_9100-1 through set forth the standards the commissioner will use in determining whether to grant an extension of time to make an election sec_301_9100-1 provides in part that an election includes an application_for relief in respect of tax a request to adopt change or retain an accounting_method or accounting_period but does not include an application_for an extension of time for filing a return under sec_6081 of the code sec_301_9100-1 generally provides that the commissioner has discretion to grant a taxpayer a reasonable extension of time under the rules set forth in sec_301_9100-2 and sec_301_9100-3 to make a regulatory election under all subtitles of the code except subtitles e g h and i sec_301_9100-3 generally provides that requests for relief subject_to this section ie requests for extensions of time for regulatory elections that do not meet the requirements of sec_301_9100-2 for automatic 12-month extension will be granted when the taxpayer provides the evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and the grant of relief will not prejudice the interests of the government we do not believe that the timely documentation requirement for success-based fees in sec_1_263_a_-5 constitutes an election to which the provisions of sec_301 apply specifically we do not believe that the documentation provision constitutes an application_for relief in respect of tax or a request to adopt change or retain an accounting_method or accounting_period as described in sec_301_9100-1 for which an extension of time under sec_301_9100-3 is available first the documentation requirement in sec_1_263_a_-5 does not fall within the meaning of the term an application_for relief in respect of tax described in sec_301_9100-1 because the phrase is not well-defined it should be interpreted and applied based on its ordinary and usual meaning see 380_us_563 in the ordinary sense the term application means a request or petition see black’s law dictionary 8th ed an application_for relief in respect of tax for plr-132734-05 which sec_301 relief has been available and granted has generally required the filing of a request notice form or other information with the internal_revenue_service these filings can be made by means such as providing a separate notice filing a relevant document with a tax_return or by taking an affirmative position on a tax_return see eg sec_1_195-1 sec_1_508-1 sec_1_612-4 however the timely documentation requirement of sec_1_263_a_-5 does not require any filing with the service under the regulation a taxpayer must complete the appropriate documentation by the due_date of the return including extensions in order to establish that certain amounts are exempt from capitalization under this provision the timely documentation requirement is more like a record-keeping requirement to substantiate the taxpayer’s characterization rather than a request for relief from the imposition of tax additionally the explicit language of sec_1_263_a_-5 suggests that it was not intended to be treated as an election under sec_301_9100-1 the provision does not require the filing of information with the service but does require that the taxpayer complete detailed documentation in close proximity to the taxable_year in which the acquisition transaction closes this information must include supporting records identifying the precise activities performed the amounts allocable to those activities and the service provider that performed them thus the emphasis of this regulation is on the maintenance of contemporaneous and accurate records that clearly demonstrate that a portion of the success-based_fee is allocable to activities that do not facilitate the acquisition the application of sec_301 to allow an extension of the time to complete this information would seem to undermine the clear intent of underlying regulation for these reasons we believe that sec_1_263_a_-5 does not constitute an application_for relief in respect of tax and an election for which relief under sec_301 is available to taxpayers furthermore we believe that the documentation requirement for success-based fees in sec_1_263_a_-5 is not i a request to adopt an accounting_method ii a request to change an accounting_method or iii a request to retain an accounting_method these three conclusions all implicate the same threshold issue namely whether the timely documentation of non-facilitative success-based fees under sec_1_263_a_-5 constitutes a method_of_accounting under sec_446 and sec_481 and the regulations thereunder we do not believe it does rather the method_of_accounting is the timing principle articulated by sec_1_263_a_-5 in its entirety success-based fees are capitalized except to the extent they are timely documented as non-facilitative the existence or absence of timely prepared documentation is an objective and verifiable fact external to the accounting_method that determines the application of the accounting_method the method of deducting non-facilitative success-based fees does not apply to fees that are not timely documented any more than it applies to fees that are not in fact success-based or facilitative in summary the documentation of non-facilitative success-based fees under sec_1 a - f is not in itself a method_of_accounting rather documentation is an extrinsic fact that affects the operation of the method_of_accounting established by sec_1_263_a_-5 for plr-132734-05 this reason and for other reasons previously stated the completion of documentation under sec_1_263_a_-5 does not constitute a request to adopt change or retain a method_of_accounting as described in sec_301_9100-1 conclusion based on the discussion above we conclude that the provision of sec_1_263_a_-5 which requires a taxpayer to complete the documentation of success-based fees allocable to non-facilitative activities on or before the due_date of its timely filed return including extensions for the taxable_year in which the transaction closes does not constitute an election as defined in sec_301_9100-1 for which relief is available to taxpayers under sec_301_9100-3 accordingly taxpayers’ request for an extension of time under sec_301_9100-3 to satisfy the documentation requirement relating to success-based fees under sec_1_263_a_-5 is hereby denied except as expressly provided herein no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter this ruling is directed only to the taxpayer requesting it sec_6110 of the code provides that it may not be used or cited as precedent pursuant to a power_of_attorney on file in this office a copy of this letter is being furnished to your authorized representatives christopher f kane branch chief branch income_tax accounting sincerely


internal_revenue_service department of the treasury number release date index number washington dc person to contact telephone number refer reply to cc psi 2-plr-123687-02 date date legend x a b c d e f g h i j date date date date x y plr-123687-02 this responds to a letter dated date together with subsequent correspondence submitted on behalf of x requesting relief under sec_1362 of the internal_revenue_code facts the information submitted states that x was formed on date and timely filed an s election effective on date a was the sole shareholder of x from date to date on date a sold x shares of stock in x to b a nonresident_alien on date at a meeting with a’s accountant a and b learned that the transfer of stock to b terminated x’s s election on date b transferred y shares of x stock to each of b’s children c d e f g h i and j all of whom are u s citizens x represents that there was no intent to knowingly terminate x’s s election and that the events that resulted in the termination were not motivated by tax_avoidance or retroactive tax planning x and x’s shareholders have agreed to make any adjustments that the secretary may require consistent with the treatment of x as an s_corporation law and analysis sec_1361 provides that the term s_corporation means with respect to any taxable_year a small_business_corporation for which an election under sec_1362 is in effect for such year sec_1361 provides that the term small_business_corporation means a domestic_corporation which is not an ineligible_corporation and which does not have a nonresident_alien as a shareholder sec_1362 provides that an election under sec_1362 shall be terminated whenever at any time on or after the 1st day of the 1st taxable_year for which the corporation is an s_corporation such corporation ceases to be a small_business_corporation sec_1362 provides that if an election under sec_1362 by any corporation a was not effective for the taxable_year for which made determined without regard to sec_1362 by reason of a failure to meet the requirements of sec_1361 or to obtain shareholder consents or b was terminated under paragraph or of sec_1362 the secretary determines that the circumstances resulting in such ineffectiveness were inadvertent no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness steps were taken so that the corporation is a small_business_corporation and the corporation and plr-123687-02 each person who was a shareholder in the corporation at any time during the period specified pursuant to this subsection agrees to make such adjustments consistent with the treatment of the corporation as an s_corporation as may be required by the secretary with respect to such period then notwithstanding the circumstances resulting in such ineffectiveness such corporation shall be treated as an s_corporation during the period specified by the secretary conclusion based solely on the facts and the representations submitted we conclude that x’s s election terminated on date when the x stock was sold to b we further conclude that the termination was inadvertent within the meaning of sec_1362 accordingly we hold that under the provisions of sec_1362 x will be treated as an s_corporation from date and thereafter provided that x’s election was otherwise valid and was not terminated under sec_1362 in determining their respective income_tax liabilities the shareholders of x must include their pro_rata share of the separately and nonseparately computed items of x as provided in sec_1366 make adjustments to stock basis as provided in sec_1367 and take into account any distributions made by x as provided by sec_1368 for purposes of the preceding sentence c d e f g h i and j each will be treated as owning y shares of x stock during the period from date through date except as expressly provided herein no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter this ruling is directed only to the taxpayer s requesting it sec_6110 of the code provides that it may not be used or cited as precedent in accordance with the power_of_attorney on file with this office a copy of this letter is being sent to x’s authorized representative sincerely matthew lay acting chief branch associate chief_counsel passthroughs and special industries enclosures copy of this letter copy for sec_6110 purposes


t c memo united_states tax_court ralph e and mildred e galyen petitioners v commissioner of internal revenue respondent docket no filed date the telecommunication relay service trs enables a hearing-impaired individual to communicate with a hearing individual over the telephone through the use of a relay operator ps subscribed to the adacom program which provided an alternative to the trs through the use of a computer rather than a relay operator on their and federal_income_tax returns ps claimed a disabled_access_credit see sec_44 i r c ps also claimed a sec_162 i r c trade_or_business expense deduction r disallowed the credit and deduction held because the adacom program was not acquired by ps in order for them to comply with the applicable_requirements of the americans with disabilities act of publaw_101_336 104_stat_327 the adacom program is not an eligible_access_expenditure for purposes of sec_44 i r c taye-channell v commissioner tcmemo_2006_8 svoboda v commissioner tcmemo_2006_1 held further ps are not entitled to claim a deduction under sec_162 i r c with respect to the adacom program scott m estill and stephanie f long for petitioners richard d d’estrada for respondent memorandum findings_of_fact and opinion vasquez judge respondent determined deficiencies of dollar_figure dollar_figure and dollar_figure in petitioners’ federal_income_tax for and respectively the issues for decision are whether petitioners are entitled to claim a tax_credit pursuant to sec_381 and sec_44 for their subscription to the adacom program program whether petitioners are entitled to claim a trade_or_business expense deduction under sec_162 with respect to the program and if petitioners are entitled to a credit and or deduction for their investment in the program the proper valuation of the program unless otherwise indicated all section references are to the internal_revenue_code in effect for the years in issue and all rule references are to the tax_court rules_of_practice and procedure findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts and the attached exhibits are incorporated herein by this reference at the time they filed the petition petitioners resided in colorado springs colorado during the years at issue petitioners subscribed to the program which was sold sponsored and administered by adacon advantage co inc adacom2 adacom is a colorado corporation headquartered in colorado springs colorado adacom developed a program to enable deaf or hearing-impaired individuals to communicate with hearing individuals and or businesses current technology a text telephone tty is an electronic device that allows a person to type conversations over telephone lines ttys do not amplify sound or convert speech to text a tty user can use the telecommunications relay services trs to call a person using a standard telephone and vice versa trs is a system by which a hearing person and a deaf person can communicate over the telephone trs employs a relay operator who receives the text from the deaf person the relay operator then reads the text to the hearing party when a hearing party provides a voice response the relay operator types the text of as the parties refer to the company as adacom for clarity we shall do the same the spoken message and transmits the text to the tty trs is available in all states in the united_states and as required_by_law is provided free of charge by the local telephone company normal charges do apply to long distance telephone calls trs is available days per week hours per day adacom technology during the years at issue adacom maintained a computer with tty software to allow a hearing-impaired person to use a tty to call the adacom computer the computer then sent the text to a program subscriber who was required to have a computer with a standard modem a program subscriber could also use his computer equipped with a modem to contact the adacom computer to initiate calls to a tty user the adacom computer was available days per week hours per day if a program subscriber was unavailable when an attempt was made by the adacom computer to contact him a message was transmitted that could be retrieved at a later time once a communication was completed the text of the communication was deleted from the adacom computer_program subscribers were listed in the adacom yellow pages directory the adacom yellow pages directory listed only the subscribers to the program and contained information on how to communicate with the subscriber by listing a number code to access the adacom computer adacom also maintained a web site directory of its program subscribers adacom listed only program subscribers on the web site in addition to receiving a listing in the adacom yellow pages directory and on the web site the program entitled each program subscriber to hours of interpretative services of a sign language interpreter additionally the program entitled each program subscriber to hours of audit defense which consisted of representation before the internal_revenue_service irs to defend the claiming of the sec_44 credit and associated deductions of the program the audit defense services did not cover representation at the irs appeals level or the cost of litigation the subscription the subscription price of the program was dollar_figure annually the program subscribers were entitled to pay dollar_figure in cash and provide dollar_figure in promotional services to be performed by the program subscribers the promotional service programs which adacom valued at dollar_figure were as follows program a-11 referrals by the program subscribers program b-7 referrals by the program subscribers and the program subscribers were to display and distribute adacom brochures and program c-4 referrals by the program subscribers and the program subscribers were to display and distribute adacom brochures and display an adacom window decal adacom advised program subscribers to include dollar_figure in income deduct dollar_figure as an ordinary and necessary business_expense pursuant to sec_162 and claim a credit equal to dollar_figure pursuant to sec_38 and sec_44 the deduction of dollar_figure comprised the dollar_figure cash paid plus the excess of the promotional services income over the claimed credit amount--dollar_figure minus dollar_figure which equals dollar_figure adacom issued a form 1099-misc miscellaneous income in the amount of dollar_figure to each program subscriber none of the people referred by the program subscribers were required to subscribe to the program in order for the referring program subscriber to obtain credit towards the purchase_price of the program petitioners’ tax_return during the taxable years and petitioner mildred e galyen was a retired teacher and petitioner ralph e galyen was employed as an insurance salesman for the ralph galyen agency inc galyen agency a colorado subchapter_s_corporation petitioner ralph e galyen was sole shareholder and president of the galyen agency during this period the galyen agency provided insurance services to the general_public during the years at issue the galyen agency had less than dollar_figure million in annual sales and fewer than employees the galyen agency subscribed to the program for the taxable years and on the subscription for each year the galyen agency chose promotional service program c the subscription contracts do not include the names of the referrals made by the galyen agency the galyen agency paid adacom dollar_figure and was credited with dollar_figure in promotional services the gross_income of the galyen agency for the taxable years and was dollar_figure dollar_figure and dollar_figure respectively these amounts included dollar_figure each year as bartering income for promotional services from adacom on the basis of the subscriptions to the program the galyen agency claimed a dollar_figure business_expense deduction and a dollar_figure sec_44 credit on form_1120s u s income_tax return for an s_corporation for each of the years and on their form_1040 u s individual_income_tax_return for taxable years and petitioners reported schedule_k-1 shareholder’s share of income credits deductions etc distributive shares of dollar_figure dollar_figure and dollar_figure of nonpassive_income from the galyen agency respectively respondent determined deficiencies in petitioners’ federal_income_tax for and in the amounts of dollar_figure dollar_figure and dollar_figure respectively after decreasing petitioners’ income by the amount of bartering services income reported and disallowing a sec_44 credit and a sec_162 deduction burden_of_proof opinion as a general_rule the notice_of_deficiency is entitled to a presumption of correctness and the taxpayer bears the burden of proving the commissioner’s deficiency determinations incorrect rule a 290_us_111 sec_7491 however provides that if a taxpayer introduces credible_evidence and meets certain other prerequisites the commissioner shall bear the burden_of_proof with respect to factual issues relating to the liability of the taxpayer for a tax imposed under subtitle a or b of the internal_revenue_code code for the burden to shift however the taxpayer must comply with the substantiation and recordkeeping requirements as provided in the code and cooperate with the commissioner see sec_7491 although petitioners claimed that sec_7491 applies petitioners failed to introduce sufficient evidence to shift the burden to respondent nonetheless our findings in this case are based on a preponderance_of_the_evidence see 124_tc_244 ada tax_credit sec_44 is included in calculating the general_business_credit pursuant to sec_38 sec_38 and b sec_44 provides a disabled_access_credit for an eligible_small_business the amount of this credit is equal to percent of the eligible_access_expenditures of an eligible_small_business that exceed dollar_figure but that do not exceed dollar_figure for the year sec_44 therefore in order to claim the disabled_access_credit a taxpayer must demonstrate that the taxpayer is an eligible_small_business for the year in which the credit is claimed and the taxpayer has made an eligible_access_expenditure during that year if the taxpayer cannot fulfill both of these requirements the taxpayer is not eligible to claim the sec_44 credit for that year eligible_small_business is defined as any person that had gross_receipts of not more than dollar_figure million for the preceding_taxable_year or not more than employees during the preceding year and elects the application of sec_44 for the year sec_44 eligible_access_expenditure is defined as an amount_paid or incurred by eligible small businesses for the purpose of complying with the americans with disabilities act of ada publaw_101_336 104_stat_327 sec_44 such expenditures include amounts paid_or_incurred for the purpose of removing architectural communication physical or transportation barriers that prevent a business from being accessible to or usable by individuals with disabilities to provide qualified interpreters or other effective methods of making aurally delivered materials available to individuals with hearing impairments to acquire or modify equipment or devices for individuals with disabilities or to provide other similar services modifications materials or equipment see sec_44 eligible_access_expenditures however do not include expenditures that are unnecessary to accomplish such purposes see sec_44 additionally eligible_access_expenditures do not include amounts that are paid_or_incurred for the purpose of removing architectural communication physical or transportation barriers that prevent a business from being accessible to or usable by individuals with disabilities with respect to any facility first placed_in_service after date see sec_44 petitioners contend that they are eligible to claim the disabled_access_credit under sec_44 because they had an eligible_small_business and their investment in the program was an eligible_access_expenditure respondent contends among other things that a subscription to the program is not necessary to comply with the ada and thus is not an eligible_access_expenditure pursuant to sec_44 in order for an expenditure to qualify as an eligible_access_expenditure within the meaning given that term by sec_44 the expenditure must have been made to enable an eligible_small_business to comply with the applicable_requirements under the ada arevalo v commissioner supra 117_tc_32 title iv of the ada requires each common carrier providing telephone voice transmission services to provide throughout the area in which it offers service telecommunications relay services u s c sec c telecommunications relay services is defined as telephone transmission services that provide the ability for an individual who has a hearing impairment or speech impairment to engage in communication by wire or radio with a hearing individual in a manner that is functionally equivalent to the ability of an individual who does not have a hearing impairment or speech impairment to communicate using voice communication services by wire or radio such term includes services that enable two-way communication between an individual who uses a tdd or other nonvoice terminal device and an individual who does not use such a device u s c sec a tty supersedes the term tdd c f_r sec_64 congress further directed the federal communications commission fcc to enforce these provisions and to a establish functional requirements guidelines and operations procedures for trs b establish minimum standards that shall be met c require that trs operate every day for hours per day d require that users of trs pay rates no greater than the rates paid for functionally equivalent voice communication services with respect to such factors as the duration of the call the time of day and the distance from point of origin to point of termination e prohibit relay operators from failing to fulfill the obligations of common carriers by refusing calls or limiting the length of calls that use trs f prohibit relay operators from disclosing the content of any relayed conversation and from keeping records of the content of any such conversation beyond the duration of the call and g prohibit relay operators from intentionally altering a relayed conversation u s c sec d and e as mentioned supra all states utilize trs and follow the aforementioned requirements since congress mandated the adoption of trs by common carriers any place with a telephone is currently in compliance with the ada petitioners argue that the program is an alternative to trs and provides improvements to trs however petitioners’ subscription to the program did not enable them to comply with the ada--they already were in compliance with the ada through the use of trs taye-channell v commissioner tcmemo_2006_8 svoboda v commissioner tcmemo_2006_1 therefore the cost of the program is not an eligible_access_expenditure within the meaning of sec_44 and consequently they do not qualify for the disabled_access_credit respondent’s determination disallowing the credit is sustained sec_162 trade_or_business activity deductions are a matter of legislative grace and taxpayers bear the burden of proving that they are entitled to any deductions claimed rule a 503_us_79 taxpayers are allowed a deduction for ordinary and necessary expenses paid_or_incurred in carrying_on_a_trade_or_business sec_162 whether an expenditure is ordinary and necessary is generally a question of fact 320_us_467 generally for an expenditure to be an ordinary and necessary business_expense the taxpayer must show a bona_fide business_purpose for the expenditure there must be a proximate relationship between the expenditure and the business_of_the_taxpayer 37_tc_650 36_tc_879 to be necessary within the meaning of sec_162 an expense need be appropriate and helpful to the taxpayer's business 290_us_111 the requirement that an expense be ordinary connotes that the transaction which gives rise to it must be of common or frequent occurrence in the type of business involved 308_us_488 citing welch v helvering supra pincite petitioners are not entitled to a sec_162 deduction for their investment in the program the program was not ordinary necessary or helpful because petitioners were already in compliance with the ada through the use of trs additionally the program did not serve a valid business_purpose respondent’s determination disallowing the deduction is sustained conclusion we sustain respondent’s determination in the notice_of_deficiency decreasing petitioners’ income by the amount of bartering services income reported and disallowing a sec_44 credit and a sec_162 deduction as we conclude that petitioners are not entitled to a sec_44 credit or a sec_162 deduction it is unnecessary for us to decide the proper valuation of the program to reflect the foregoing decision will be entered for respondent