t c memo united_states tax_court brewer quality homes inc petitioner v commissioner of internal revenue respondent docket no filed date r disallowed deductions for portions of amounts p paid to a shareholder-officer held maximum amounts of reasonable_compensation less than amounts p deducted but greater than amounts r determined are redetermined the amounts so redetermined were paid as compensation_for_personal_services actually rendered and are deductible the amounts p paid in excess of the amounts so redetermined are not deductible sec_162 i r c r cody mayo jr for petitioner mary beth calkins and joseph ineich for respondent memorandum findings_of_fact and opinion chabot judge respondent determined deficiencies in federal corporate_income_tax against petitioner as follows year deficiency dollar_figure big_number after concessions by respondent the issue for decision is the extent to which amounts that petitioner paid to jack are deductible as reasonable_compensation under sec_162 in the notice_of_deficiency respondent disallowed dollar_figure of the dollar_figure of officer compensation that petitioner paid to jack r brewer sr hereinafter sometimes referred to as jack and mary l brewer hereinafter sometimes referred to as mary in and dollar_figure of the dollar_figure of officer compensation that petitioner paid to jack and mary in respondent concedes that all payments of officer compensation to mary are deductible and additional portions of the payments to jack are deductible after respondent’s concessions there remain in dispute only dollar_figure of the original dollar_figure disallowance for and only dollar_figure of the original dollar_figure disallowance for unless indicated otherwise all section references are to sections of the internal_revenue_code_of_1986 as in effect for the taxable years in issue findings of fact3 some of the facts have been stipulated the stipulations and the stipulated exhibits are incorporated herein by this reference petitioner was incorporated in louisiana on date when its petition in the instant case was filed petitioner’s principal_place_of_business was in bossier city louisiana bossier city is in northwest louisiana on the east side of the red river across from shreveport petitioner is located on rte u sec_80 respondent’s counsel complied with the detailed requirements of rule e as to proposed findings_of_fact in opening briefs petitioner’s counsel did not as a result respondent was deprived of the opportunity to explain why petitioner’s views of the facts were incorrect in our determinations we have taken the foregoing into account and have resolved many otherwise uncertain matters in favor of respondent’s view of the facts petitioner’s counsel is put on notice that the rule is designed both to facilitate the work of the court and also to provide a level playing field to the parties and the court will be inclined to impose formal sanctions in the event of future similar violations sec_7491 which shifts the burden_of_proof to the commissioner if the taxpayer meets certain conditions is effective for court proceedings arising in connection with examinations beginning after date internal_revenue_service restructuring and reform act of publaw_105_206 sec a 112_stat_726 respondent began examining petitioner’s and federal corporate_income_tax returns sometime in early accordingly sec_7491 does not apply in the instant case unless indicated otherwise all rule references are to the tax_court rules_of_practice and procedure petitioner is engaged in the business of retail selling of manufactured homes also known as mobile homes trailers or trailer homes hereinafter sometimes collectively referred to as mobile homes at all relevant times jack and mary each owned percent of petitioner’s stock petitioner’s stock was not publicly traded a jack’s background jack served in the u s marine corps for years in he left the marine corps and moved to dallas texas where he began a career in the automobile business jack served as the sales finance and insurance manager for several general motors dealerships in he left the automobile business to pursue a career in the mobile home business b petitioner’s origin and economic development jack began his mobile home retailing business with capital raised from the dollar_figure of equity that he had in his home and a dollar_figure bank loan he used this capital to establish an inventory of about six mobile homes jack increased his inventory by buying distressed merchandise at a discount--new mobile homes that lenders had repurchased from retailers who were going out of business he attributed the failures of other retailers’ businesses to an economic downturn that began in jack did not employ anyone in his mobile home retailing business during its first year during the 1980s the mobile home retailing business in petitioner’s region of the country texas louisiana and oklahoma endured another economic downturn because of the oil industry more than big_number mobile homes were repossessed in texas alone in petitioner’s basic trade area mobile home retailers either went out of business or filed for bankruptcy petitioner was one of only two mobile home retailers located within mile of petitioner that survived the 1980s’ economic downturn during and the mobile home retailing business in petitioner’s basic trade area endured another economic downturn although petitioner survived this downturn many other mobile home retailers did not nine of the mobile home retailers that did not survive this downturn were located within mile of petitioner on the u sec_80 corridor petitioner again took advantage of the situation by buying at distress sale prices mobile homes that lenders had repossessed and selling these mobile homes at regular retail prices petitioner had about employees during the early 1990s in petitioner had employees of whom were in sales petitioner’s business was operated as a sole_proprietorship from until petitioner’s incorporation in petitioner elected s_corporation status as of date petitioner was a c_corporation for petitioner elected s_corporation status as of date and remained in that status through petitioner was a c_corporation for through petitioner reported gross_sales total income and taxable_income for through as shown in table year table gross_sales total income1 taxable_income loss dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number total income includes gross_profit interest_income and other income jack and mary personally guaranteed all loans by banks to petitioner c jack’s duties jack exercised complete control_over petitioner’s business since it was founded and over petitioner since it was incorporated including the years in issue he served as petitioner’s president chief financial officer chief_executive_officer general manager sales manager loan officer credit manager purchasing officer personnel manager advertising manager insurance agent real_estate manager and corporate legal affairs liaison with the exception of sales manager--jack promoted a sales administrator to sales manager in mid-1996-- jack has always held these positions in his capacity as general sales manager jack oversaw petitioner’s daily sales operations worked with salespeople on all transactions appraised trade-ins negotiated with buyers and approved all closings in his capacity as advertising manager jack directed petitioner’s advertising efforts he met with all media wrote ad copies for television radio and newspaper advertisements prepared the advertising budgets and approved all advertising costs in his capacity as loan officer jack approved the underwriting for all in-house loans and personally worked delinquent accounts in his capacity as licensed general insurance agent jack was responsible for petitioner’s book of insurance petitioner had more than insurance customers petitioner insured percent of its sales the commissions earned for jack’s work as the licensed general insurance agent went to petitioner and were reported on petitioner’s tax_return as the personnel manager jack was responsible for hiring firing supervising training and evaluating all of petitioner’s employees in his capacity as purchasing officer jack ordered all of petitioner’s inventory lot supplies and office supplies he also bought all company vehicles and approved all invoices for payment in his capacity as corporate legal affairs liaison jack reviewed legal contracts between petitioner and third parties in addition to the foregoing jack supervised the in-house bookkeeper reviewed vendor invoices maintained inventory records gathered the necessary information to prepare petitioner’s financial statements and tax returns planned and monitored petitioner’s cashflow signed checks negotiated lines of credit advances and loans and directed the investment of petitioner’s cash reserve jack extensively reviewed petitioner’s quarterly financial reports jack brought enthusiasm dedication and energy to petitioner he made a point of being willing to meet every customer at some point in the sales process he worked to days per week and often worked long into the night he opened and closed the business each day if there were delinquent accounts then jack went out at night and collected on them in petitioner’s early years jack worked about hours per week during the years in issue jack worked about hours per week his duties also involved frequent travel at all times relevant to the instant case mary has been either petitioner’s vice president secretary or secretary- treasurer d compensation practice sec_1 general petitioner did not maintain a written salary policy or bonus plan for its employees to attract top-notch people it paid compensation that was equivalent to or greater than the compensation paid_by other mobile home retailers since its incorporation petitioner has paid all the cost of health insurance for all its employees it has also provided paid sick and vacation_leave for all its employees except jack and presumably mary although petitioner established a profit- sharing plan with commercial national bank in january of the plan was terminated in late in addition petitioner’s resolution on date to adopt a k retirement_plan was aborted on date because of excessive administrative costs table sets forth the compensation petitioner paid to its key employees other than jack for and table name position john atkinson sales person dollar_figure dollar_figure dollar_figure garry hood sales person na big_number big_number kurt ley sales manager na big_number big_number patsy k watson bus manager big_number big_number big_number larry gill service manager big_number big_number big_number dale hughes sales person big_number big_number big_number tony lewis sales person big_number big_number big_number mary brewer bookkeeper decorator big_number big_number big_number jack’s compensation during the years in issue petitioner never had a compensation defined benefit or profit-sharing_plan for jack jack analogized petitioner’s compensation policy for him to that of a farmer’s if petitioner had a good year then jack had a good year if petitioner had a bad year then jack took minimum wages table shows for each of the years through petitioner’s claimed compensation payment to jack that claimed compensation as a percentage of gross_sales supra table and that claimed compensation as a percentage of taxable_income before deduction of that claimed compensation supra table as adjusted by adding back the claimed compensation to jack table claimed as of taxable_income claimed compensation as before deduction of year compensation of gross_sales jack’s compensation claimed compensation dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number in petitioner paid dollar_figure in salary to jack over the course of the year on date petitioner paid an additional dollar_figure to him as a bonus in petitioner paid dollar_figure in salary to jack over the course of the year on date petitioner paid an additional dollar_figure to him as a bonus jack determined the amount of his bonus each year after he and j michael sledge hereinafter sometimes referred to as sledge examined petitioner’s financial situation sledge a certified_public_accountant has been petitioner’s accountant since its incorporation and jack’s accountant since sledge prepared petitioner’s tax returns for both of the years in issue and signed those tax returns as paid preparer he represented petitioner and jack during the audit stage that led to the instant case he met with jack at least quarterly every year to review the financial performance of the company and another times a year on an ad hoc basis he has attended most of the meetings of petitioner’s board_of directors since in determining the amount of a bonus for jack jack and sledge considered petitioner’s profit situation and the amount of retained earnings necessary to satisfy an investor in petitioner jack discussed with sledge the possibility that the amounts of the and bonuses might be viewed as unreasonable_compensation in eyes of the commissioner of internal revenue jack was aware that there were risks involved with petitioner’s payment of the bonuses on the last day of the year petitioner’s corporate board minutes for and do not reflect any intent to increase jack’s compensation in those years to make up for jack’s earlier years’ undercompensated services e distribution and dividend history petitioner distributed dollar_figure in as an s_corporation petitioner distributed dollar_figure dividends in as a c_corporation this was done in accordance with sledge’s recommendation the and distributions are the only ones petitioner ever made through the end of petitioner did not have any agreements with any banks or financial institutions with which it dealt that prohibited it from declaring dividends for the years in issue f business practice sec_1 products over the years petitioner has been a dealer of about different brands of mobile homes in and petitioner carried the fleetwood line of mobile homes as its primary product offering fleetwood manufactures price-competitive high quality mobile homes fleetwood dealerships generally are very successful during the years in issue petitioner did not have a franchise agreement with fleetwood nor did petitioner receive any market protection from it indeed there was another fleetwood retailer located almost next door to petitioner for petitioner was ranked number of fleetwood retailers in the nation for petitioner was ranked the top fleetwood retailer in louisiana and number in the nation financing since petitioner has offered financing to customers who jack describes as people that do not conform to the average lending institution jack managed this loan portfolio for petitioner and also served as the underwriter for each of the loans petitioner has extended more than loans as part of its financing endeavors of this number only three failed and only one resulted in a loss to petitioner petitioner’s mobile home loan portfolio produced dollar_figure interest for and dollar_figure interest for insurance underwriting before petitioner could install a mobile home on a buyer’s location the buyer had to insure the mobile home as a licensed fire and casualty insurance agent jack wrote insurance policies for percent of petitioner’s sales these policies were then attached to their corresponding notes which were sold to banks the commissions earned from the insurance sales went to petitioner petitioner reported part insurance_income of dollar_figure and dollar_figure respectively on its and tax returns g conclusions table sets forth the parties’ and the court’s positions with respect to claimed compensation payments by petitioner to jack for the years in issue petitioner contends that all of the amounts paid meet the requirements for deductibility and that greater payments unspecified in amount also would be deductible respondent’s determinations and contentions and the court’s redeterminations are in terms of the maximum amounts that meet the requirements for deductibility table petitioner paid deducted and dollar_figure dollar_figure stands by tax returns respondent allows notice_of_deficiency big_number 2big_number after concessions big_number big_number court finds big_number big_number in the notice_of_deficiency respondent allowed a deduction of dollar_figure of the amount petitioner paid to both jack and mary because respondent concedes that the entire dollar_figure paid to mary is deductible this leaves dollar_figure as the amount petitioner paid to jack that respondent determined to be deductible in the notice_of_deficiency respondent allowed a deduction of dollar_figure of the amount petitioner paid to both jack and mary because respondent concedes that the entire dollar_figure paid to mary is deductible this leaves dollar_figure as the amount petitioner paid to jack that respondent determined to be deductible this is the sum of dollar_figure derived by hakala’s formulaic approach plus additional compensation of dollar_figure to mr brewer for providing his personal guarantee to secure a short-term working_capital line of credit in infra opinion c analysis reasonableness d amount of reasonable_compensation loan guarantee petitioner did not intend in and did not intend in to compensate jack for his earlier services to petitioner a parties’ positions opinion petitioner maintains that the amounts it paid to jack as compensation were reasonable in amount within the meaning of sec_162 and so these amounts are fully deductible respondent agrees that mr brewer brought enthusiasm dedication and energy to the petitioner and that the company experienced great growth during the mid 1990s however respondent contends that any amounts paid to jack in excess of dollar_figure for and dollar_figure for were not intended as payments purely for personal services and even if they were so on answering brief petitioner contends as follows the respondent contends that a portion of the payments are disguised dividends the issue as to whether the payment of compensation was purely for services is not before the court the notice_of_deficiency did not raise the issue of disguised dividends or the compensatory nature of the services or assert that any portion of the payment was a disguised_dividend it is unfair to the petitioner after close of the trial to raise a new issue that being that the payment received by mr brewer was for something other than the services he rendered the petitioner contends that only the amount of compensation the court may find is in excess of a reasonable amount if any be declared to be a dividend and that the respondent not be allowed to dispute the compensatory nature of the payments to mr brewer for the following reasons we conclude that the issue of whether any part of petitioner’s payments to jack was disguised dividends rather than intended compensation_for_personal_services is properly before the court firstly the notice_of_deficiency explanation includes the alternative that disallowed amounts were not expended for the purposes designated secondly the first sentence of respondent’s opening statement before the trial is as follows continued intended they were unreasonable in amount for the services he rendered respondent argues that these excess amounts are not deductible under sec_162 b summary conclusions in determining the maximum reasonable_compensation for jack’s services for the years in issue we have considered the relevant factors listed in 819_f2d_1315 5th cir affg tcmemo_1985_267 both parties presented expert witness reports and testimony on the applicability of the relevant factors to the instant case while we do not find the experts’ conclusion sec_4 continued opening statement by counsel on behalf of the respondent ms calkins your honor this case presents two questions whether a portion of payments made to mr brewer in and and deducted as officer’s compensation by the petitioner are actually disguised dividends the second question respondent stated was whether the deducted amounts are reasonable in amount the final sentence of respondent’s opening statement is as follows it is respondent’s position that in spite of mr brewer’s contributions to petitioner during the years at issue the payments to him over and above what respondent has allowed in the trial memorandum should be disallowed as disguised dividends thirdly our search of the transcript shows that notwithstanding respondent’s clear statements at the start of the trial petitioner did not object or otherwise comment on this matter at that time or at any other time during the 3-day trial particularly helpful we do use some of the data and analyses they provide in reaching our decision we first consider the robert morris associates hereinafter sometimes referred to as rma report for the industry on financial ratios which provides data on among other things executive compensation as a percentage of sales for companies comparable to petitioner based on petitioner’s and the mobile home retail industry’s financial performances in and we conclude that jack’s compensation as a percentage of sales should be compared to those of executives in comparable companies at around the 90th percentile by multiplying petitioner’s sales by the appropriate rma factor for each year we determine that payments to jack as compensation_for the services he performed for petitioner would have been about dollar_figure in and dollar_figure in we add dollar_figure to the amount on account of jack’s guaranty of a bank loan to petitioner we also consider the fact that petitioner did not provide jack with retirement benefits based on comments by respondent’s expert we conclude that an amount of about percent of jack’s compensation would be sufficient to compensate him for the absence of retirement benefits this brings reasonable_compensation to about dollar_figure in and dollar_figure in in light of respondent’s willingness to allow what hakala recommends for plus correction of hakala’s mathematical errors we round the amount to dollar_figure we conclude that all of the amounts that would have been reasonable_compensation to jack were intended by petitioner to be compensation and not dividends c analysis sec_162 allows a deduction for the payment of compensation but only if the compensation is both reasonable in amount and paid for personal services rendered 58_tc_1055 affd without published opinion 474_f2d_1345 5th cir sec_1_162-7 income_tax regs the question of reasonableness is one of fact which must be resolved on the basis of all the facts and circumstances in the case owensby kritikos inc v commissioner f 2d pincite 528_f2d_176 10th cir affg 61_tc_564 estate of wallace v commissioner sec_162 trade_or_business_expenses a in general --there shall be allowed as a deduction all the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business including-- a reasonable allowance for salaries or other compensation_for_personal_services actually rendered 95_tc_525 affd 965_f2d_1038 11th cir 73_tc_1142 in addition to multifactor tests see owensby kritikos inc v commissioner f 2d pincite courts have also used independent investor tests to determine whether payments to an employee-shareholder exceeded reasonable_compensation see eg 147_f3d_96 2d cir vacating and remanding tcmemo_1995_135 on remand tcmemo_1999_155 generally courts have described independent investor tests as a lens through which the entire analysis should be viewed dexsil corp v commissioner id pincite in owensby kritikos inc v commissioner f 2d pincite the court_of_appeals for the fifth circuit stated the so-called independent_investor_test is simply one of the factors a court should consider and in certain cases it may be a substantial factor in discussing the significance of a corporation’s dividend practices that court also stated the prime indicator of the return a corporation is earning for its investors is its return on equity id pincite7 discerning the intent behind the payments also presents a factual question to be resolved within the bounds of the individual case 503_f2d_359 9th cir affg tcmemo_1971_200 paula construction co v commissioner t c pincite where officer-shareholders who are in control of a corporation set their own compensation careful scrutiny is required to determine whether the alleged compensation is in fact a distribution of profits 853_f2d_1267 5th cir affg tcmemo_1986_407 owensby kritikos inc v commissioner f 2d pincite estate of wallace v commissioner t c pincite sec_1 b income_tax regs we will consider first whether and if so then to what extent the payments to jack exceeded reasonable_compensation and then whether and if so then to what extent any part of the payments that survive the first test should nevertheless be nondeductible because they were not intended to be compensation compare owensby kritikos inc v commissioner f 2d pincite payments made in the form of compensation with paula construction co v commissioner t c pincite payments made in the form of distributions and 98_tc_511 corporation’s unreported income diverted to shareholder reasonableness many factors are relevant in determining whether amounts paid to a person were reasonable_compensation including the following the person’s qualifications the nature extent and scope of the person’s work the size and complexities of the business a comparison of salaries paid with gross_income and net_income the prevailing general economic conditions a comparison of salaries with distributions to stockholders the prevailing rates of compensation_for comparable positions in comparable concerns the salary policy of the taxpayer as to all persons in the case of small corporations with a limited number of officers the amount of compensation paid to the particular person in previous years and whether the corporation provided the person with a pension or profit-sharing_plan owensby kritikos inc v commissioner f 2d pincite and cases there cited no single factor is decisive rather we must consider and weigh the totality of the facts and circumstances in arriving at our decision idem before we apply the relevant factors to the instant case we note that petitioner presented evidence of three offers to buy petitioner the parties devoted substantial efforts to analyze the direct and indirect ie regarding return on investment significance of these offers indeed respondent’s expert opined the single best evidence of reasonable_compensation can be found in the three subsequent offers to acquire the assets and business of petitioner however none of the offers is sufficiently detailed to enable us to determine what jack’s services would be worth under that offer petitioner contends that one offer would justify a compensation level higher than petitioner paid while respondent contends that using the same methodology that petitioner used one of the other offers would lead to a conclusion that the maximum reasonable_compensation would be only dollar_figure also the parties do not assist us in deciding how to adjust for the difference in time between the offers’ presentations and the years in issue finally we do not even know when one of the offers was made under these circumstances we conclude that the offers are not to be given any weight in determining the amounts of reasonable_compensation for jack’s services for the years in issue the following indicia of relatively high reasonable_compensation are present in the instant case jack has been involved in every aspect of petitioner since its inception through his enthusiasm hard work and dedication he built petitioner into a successful enterprise he served as its president chairman chief_executive_officer general manager chief financial officer credit manager purchasing officer personnel manager advertising manager insurance agent real_estate manager and corporate legal affairs liaison he worked hours per week to days per week petitioner grew rapidly between and in it was ranked number of fleetwood mobile home retailers in the nation in it climbed to number in the nation jack personally guaranteed the working_capital lines of credit of petitioner petitioner did not provide a defined benefit or profit- sharing plan to jack the only nonsalary benefit that petitioner provided to jack was health insurance jack and presumably mary was the only employee who did not receive paid sick and vacation_leave under jack’s control petitioner survived several economic downturns when many other mobile home retailers went out of business the following indicia of relatively low reasonable_compensation are present in the instant case the claimed compensation petitioner paid to jack in and constituted percent and percent respectively of petitioner’s gross_sales and percent and percent respectively of petitioner’s taxable_income these percentages exceed those of most similar companies petitioner did not maintain a compensation policy for jack because jack controlled the corporation he was able to set his own compensation the bonus amounts were not set in accordance with any formula or other detailed arrangement agreed upon in advance rather they were determined and paid at the end of the year when petitioner knew its profitability for that year thus jack’s compensation was set on an ad hoc basis petitioner did not pay dividends in or even though it had made a distribution in and paid dividends in and profitability before officer’s compensation was greater in and than it was in the two earlier years petitioner’s average return on equity which measures the percent of profit before taxes as a percentage of tangible net_worth was below that of comparable companies for the years in issue at trial both parties presented the reports and testimony of expert witnesses petitioner’s experts were sledge and mae lon ding hereinafter sometimes referred to as ding respondent’s expert was scott d hakala hereinafter sometimes referred to as hakala before admitting expert testimony into evidence the trial judge is charged with the gatekeeping obligation of ensuring that the testimony is both relevant and reliable 526_us_137 509_us_579 118_tc_379 on appeal 5th cir date this gatekeeping obligation applies to all expert testimony including testimony based on technical and other specialized knowledge kumho tire co v carmichael u s pincite see fed r evid 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 945_f2d_92 5th cir and cases there cited affg tcmemo_1990_87 the three experts agree on some aspects of elements that should be taken into account in determining what would be reasonable_compensation for jack’s services to petitioner but even there they do not agree on what numbers those aspects should lead us to each expert does a much better job of explaining why the other side is wrong than why his or her analysis is correct to that extent each expert has been helpful to put it another way the experts have provided substantial assistance to the trier of fact fed r evid in identifying and winnowing out the chaff they have provided far less assistance in identifying and keeping the wheat see 685_f2d_776 2d cir a hakala hakala is a principal in business valuation services inc he had academic training in compensation theory and was awarded the degree of ph d in economics by the university of minnesota he has testified as an expert witness in reasonable_compensation cases table shows the amounts that hakala concluded were maximum reasonable_compensation for jack’s services to petitioner in and per hakala’s expert witness report ex r and hakala’s rebuttal expert witness report ex 61-r table ex 60-r ex 61-r dollar_figure dollar_figure big_number big_number big_number big_number the task of calculating a maximum amount of reasonable_compensation ordinarily and in the instant case involves judgment calls generalizations and very rough approximations we are mindful of judge tannenwald’s observation that in valuation disputes and reasonable_compensation disputes are essentially a subset of valuation disputes there is often an overzealous effort during the course of the ensuing litigation to infuse a talismanic precision into an issue which should frankly be recognized as inherently imprecise 48_tc_502 see 101_tc_412 hakala acknowledges that the correction of but one set of inconsistencies in his expert witness report assumptions results in changes of to percent in his conclusions ex 61-r pp iv-3 we are struck by the fact that hakala has so much confidence in the combination of accuracy and precision of his numbers and analysis that even after the humbling exercise of making the gross corrections he describes he claims to be able to come to conclusions to six significant figures supra table respondent urges us to follow in hakala’s footsteps--to six significant figures we respond that neither hakala’s nor respondent’s continued presentation of six-significant-figure conclusions causes us to have any confidence that the precision of those conclusions is an indication that those conclusions are accurate indeed hakala’s efforts to persuade us to walk that road serve only to cause us to doubt his judgment when we doubt the judgment of an expert witness on one point we become reluctant to accept that expert’s conclusions on other points a quotation from shakespeare is perhaps apt glendower i can call spirits from the vasty deep hotspur why so can i or so can any man but will they come when you do call for them henry iv part i act sc for completeness it should be noted that when the court asked hakala why it is that you believe it is appropriate to come up with a result to six significant figures he responded that-- no one in a real compensation would round to six significant figures that normally i would round to the nearest thousand continued when the court asked hakala if he was confident in his conclusion that reasonable_compensation for should be substantially below reasonable_compensation for see supra table sec_4 and he responded as follows the witness no and i think they have a valid point that there was more income and what i missed was that in the other income was the rebate from fleetwood when you factor the rebate from fleetwood in the compensation_for ‘96 should go up if you do that then you have to adjust the compensation_for ‘95 downward so you know i would agree that i think intuitively ‘96 should probably be higher than ‘95 notwithstanding this testimony hakala did not change his report recommendations and respondent’s posttrial briefs still urge us to adopt hakala’s report recommendations with substantially lower reasonable_compensation for as compared to continued or the nearest big_number in effect if i was pincite i’d round up to big_number if it was pincite i might round to however notwithstanding hakala’s concession that no one in a real situation would determine reasonable_compensation to six significant figures hakala did not change his report recommendation and respondent’s posttrial briefs still urge us to adopt hakala’s six-significant-figure recommendations at trial hakala explained that if he adjusted upward the maximum reasonable_compensation for jack for then he would have to make a corresponding downward adjustment for neither hakala at trial nor respondent on brief has explained why an upward adjustment for on account of the fleetwood rebate would require a downward adjustment for except that at trial hakala invoked the imagery of squeezing on a balloon b sledge sledge is a c p a in private practice in his own firm he was awarded the degree of b s in industrial psychology by louisiana state university and took postgraduate work to prepare himself for the c p a examination he has testified as an expert witness in business valuation cases and other matters involving officer compensation issues sledge did not determine what was maximum reasonable_compensation for jack’s services to petitioner in the years in issue but concluded that it is my opinion that the salary paid to mr brewer during and is reasonable as a result we can agree with much of what sledge says and still have little or no guidance from his expert witness report as to what numbers to set for reasonable_compensation before the trial respondent moved in limine to exclude sledge’s expert witness report and to not allow sledge to testify as an expert witness respondent pointed to sledge’s obvious conflict of interest and contended that sledge is unable to provide the degree of objectivity required of an expert witness we concluded that in the instant case it was better to take sledge’s conflict of interest into account in weighing his expert witness report and expert testimony and not exclude sledge and his report in retrospect we conclude that we made the right decision on this matter ie we conclude that sledge’s expert witness report his rebuttal report and his expert witness testimony did assist us as trier of fact in understanding concepts involved in determining reasonable_compensation and in understanding matters raised by hakala see 85_f3d_1178 5th cir c ding ding is president of personnel systems associates she was awarded the degree of m b a by the university of southern california and the degree of b a in industrial psychology from ucla she has testified as an expert witness in reasonable_compensation cases ding did not conclude what was maximum reasonable_compensation for jack’s services to petitioner in the years in issue but she concluded that mr brewer was compensated at a rate in and which we believe an investor in an arm’s- length transaction would have thought to be reasonable nevertheless ding’s presentation of the data from rma enables us to make our own evaluation and to start the process of redetermining reasonable_compensation numbers for jack’s services d amount of maximum reasonable_compensation rma ratios both hakala and ding direct our attention to rma surveys of companies that specialize in mobile home retailing none of the expert witnesses was able to identify any published surveys of the amounts of executive compensation_for the mobile home retailing industry however it was noted that the rma’s surveys provided financial ratios including a ratio for executive compensation to company sales in her analysis of the rma data ding stated that petitioner’s-- average compensation total executive compensation including what petitioner paid to mary to sales ratio for the period wa sec_4 which was slightly above the rma 75th percentile of and considerably below our ie ding’s projection of the 90th percentile average of exhibit f ding regarded the following considerations as being among those leading to her conclusion that jack achieved exceptional financial performance at petitioner justifying a comparison of compensation above the 75th percentile and as high as the 90th percentile petitioner’s sales grew at an average annual rate of percent while the industry grew at an average annual rate of only percent petitioner’s inventory turnover rate a key measure of efficient use of capital and inventory management was more than one-third higher than the mobile home retail industry as a whole petitioner has very high capitalization relative to industry norms which reduce risk to the shareholder in the event of a downturn in business saves interest costs on loans enables faster growth and causes roe returns on equity ratios to understate true profit performance from the foregoing and other matters ding concluded as follows when all the above factors are taken into consideration it is apparent that brewer quality homes’ performance is among the best in the industry ceos who achieve top performance in their industry receive top pay therefore it is reasonable to expect that jack brewer would receive compensation above the 75th percentile and as high as the 90th percentile hakala on the other hand stated that for and jack’s compensation level as a percentage of sales was significantly higher than the third quartile levels of the rma comparable firms he stated that this high compensation level resulted in a drop in profitability which together with an elimination of dividends provided low returns to its petitioner’s shareholder in his rebuttal report hakala presented several criticisms of ding’s use of rma data we consider these criticisms seriatim ding used average percentages over time while hakala focused on year-by-year figures for through table compares petitioner’s total officer compensation jack’s plus mary’s in the case of petitioner as a percentage of mobile home sales on the one hand to ding’s and hakala’s different approaches as to the rma 75th percentile data table petitioner rma--ding rma--hakala averages ding -- ding -- hakala -- ding’s focus on 11-year averages led her to conclude that petitioner’s 11-year average payment ratios are only a little higher than the rma 75th percentile ratios percent to percent and much lower than the estimated rma 90th percentile ratios9 percent to percent hakala on the other hand concluded that petitioner’s 1-year payment ratios are much higher than the rma 75th percentile ratios percent to percent supra table hakala also criticized ding’s analysis as follows in the tax_year through bqh petitioner elected s_corporation status the owner-officer of an s_corporation has an incentive to minimize personal salary and bonus compensation and to recognize greater taxable corporate hakala ignores ding’s estimates of rma 90th percentile ratios he neither disputes nor accepts the correctness of ding’s estimates however on brief respondent accepts the correctness of ding’s estimates of rma 90th percentile ratios at least for the purpose of pointing out that petitioner’s and ratios are far higher than the ratios that ding applies income due to payroll_taxes on reported compensation this calls into question the appropriateness of an undercompensation analysis in the years through firstly for of the years hakala refers to and petitioner was a c_corporation not an s_corporation it is not clear whether these mistakes were merely harmless error or whether this affected hakala’s conclusions secondly if hakala’s thesis is correct that this incentive affected petitioner’s actions during the c_corporation years then it becomes relevant to determine whether and to what extent it also affected the similar-sized businesses that provided the underlying data for the rma ratios in general an s_corporation shareholder is taxed on the shareholder’s pro_rata share of the corporation’s income regardless of whether the shareholder actually receives a distribution sec_1366 where the shareholder is also an employee of the corporation there is an incentive both for the corporation and for the employee-shareholder to characterize a payment to the employee-shareholder as a distribution rather than as compensation because only payments for compensation are subject_to federal employment_taxes see sec_3111 sec_3301 in such instances the commissioner may recharacterize a distribution as compensation in order to reflect the true nature of the payment see revrul_74_44 1974_1_cb_287 dividends_paid to s_corporation shareholders treated as reasonable_compensation for services rendered and subjected to federal employment_taxes see also 117_tc_141 affd sub nom 54_fedappx_100 3d cir although hakala argued that petitioner may have practiced tax gamesmanship in one or more of the years before the record does not disclose that respondent made a determination on this matter nor can we tell from the record whether petitioner did distort the situation until we know that we do not know how to deal with the concern that hakala has described thirdly hakala does not a point to any evidence that would enable us to quantify the amount if any by which this potential gamesmanship actually diminished the compensation that petitioner paid to jack in any year b suggest any way of adjusting the ratio for petitioner to compensate for this potential gamesmanship or c explain why petitioner and jack would shift payments from compensation in but not use that device for and when presumably the same incentives were in play and when petitioner and jack had the same tax adviser that they had in thus hakala’s speculation is interesting but we do not find it helpful in analyzing the instant issue see infra previous underpayment hakala also presents the following double-barreled attack on ding’s reliance on the rma data the robert morris associates rma data requires more analysis than was provided by ms ding first we don’t know exactly how many officers directors and affiliates are represented in the total officers’ compensation in the rma figures for larger dealerships our experience is that more than one officer is included and sometimes three or more persons may be represented in the total figures second we don’t know the extent to which the officers’ compensation is consistent with arm’s length practices the bvs report summarized in exhibits ii-2 and ii-3 attachments to exh 60-r hakala’s expert witness report represents an attempt to address these issues the suggested total compensation at the 75th percentile level is at most dollar_figure in and dollar_figure in for a single officer and dollar_figure in and dollar_figure in for two officers or more executive officers of bqh based on this information as to the multiple-officer concern we are satisfied that ding’s approach is useful in the absence of anything better ding determined appropriate total officer compensation subtracted the agreed-upon compensation to mary and concluded that the remainder is appropriate compensation to jack in the material that hakala cites he assumed that in a two-officer arrangement the second officer was compensated at half the rate of the first officer and concluded that the ceo’s compensation wa sec_67 percent of the total officer compensation we agree that hakala’s conclusions follow arithmetically from his assumptions however hakala does not give us any reason to conclude that hakala’s attempt to address these issues is any better than ding’s approach in the absence of any hard information as to businesses of petitioner’s size other than the evidence of petitioner’s own history we are willing to follow ding’s approach hakala’s concern that the underlying rma data may not be consistent with arm’s length practices is the more serious attack however hakala does not provide anything to back up the suspicion that he voices also the material to which hakala directs our attention does not appear to address this issue at all finally the numbers that hakala finally commends to us dollar_figure for dollar_figure for supra table sec_4 are substantially greater than the numbers that hakala tells us would result from the rma 75th percentile data that hakala suggest are too great hakala does not direct our attention to any other data that focus on the mobile homes retail sales industrydollar_figure on this record the rma ratios leave much to be desired as a foundation for decision-making we nevertheless use those ratios as a starting point because they are the only statistical information we have that deals with mobile home retailers in other words the rma ratios are the only game in town see eg 584_f2d_424 d c cir mackinnon j dissenting the years in issue and were good years for the mobile home retailing industry and even better years for petitionerdollar_figure in his rebuttal report hakala states as follows the single best evidence of reasonable_compensation can be found in the three subsequent offers to acquire the assets and business of bqh petitioner found in the exhibits to ms ding’s report however hakala relies on these offers only to the extent of contending that in reality the offers amount to less compensation_for jack than the approach that hakala uses in effect then hakala rejects the lessons of the evidence that he describes as the single best evidence petitioner’s sales increased proportionately more than continued jack guided petitioner through the hard times when many of petitioner’s competitors went out of business and into the breakout years of and dollar_figure we are satisfied that jack’s long-term efforts leading up to and and jack’s spectacularly successful work in and justify ranking jack with the leaders of his field for the latter years to us this means that reasonable_compensation for and is to be determined by reference to the 90th percentile of officer compensation payments continued the industry’s sales as shown by the following table petitioner’s sales see supra table industry sales petitioner’s sales as a of industry sales dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number year hakala stated in his rebuttal report bqh petitioner was a well run and successful dealership with an established franchise and presence mr brewer clearly deserves substantial credit for this success in and we note that the rma ratios fluctuate greatly from year to year and even the relative ratios ie comparisons of the ratios for smaller companies with the ratios for larger companies fluctuate greatly none of the experts discusses the factors that led to the rma ratio fluctuations ding attempted to smoothen the relevant ratios see supra table for 75th percentile numbers for 90th percentile numbers ding used for and for hakala did not discuss whether there should be a different approach to the smoothening process or whether the rma ratio amounts should be used without any smoothening in the absence of criticism by hakala we are willing to follow ding’s smoothening approach we apply the rma 90th percentile ratios to petitioner’s and sales to obtain total shareholder-employee reasonable_compensation from the totals thus obtained we subtract the amounts petitioner paid to mary which have been agreed to be reasonable_compensation for mary’s services however our willingness to follow ding’s analysis regarding jack’ sec_90th-percentile status at least for and does not lead us to ding’s conclusions that all of jack’s compensation is reasonable for each of these years as ding acknowledged at trial the compensation that petitioner paid to jack for each of these years as a percentage of petitioner’s sales was significantly higher than the 90th-percentile level shown by the rma data for the same years our acceptance of ding’s thesis then leads us to apply the rma 90th-percentile ratios to petitioner’s sales which results in reasonable_compensation amounts significantly less than petitioner’s actual payments to jack this process leads us to initial calculations of dollar_figure for and dollar_figure for as reasonable_compensation amounts for jack’s services loan guaranty hakala opined in his expert witness report that jack was entitled to an additional dollar_figure reasonable_compensation for providing his personal guarantee to secure a short-term working_capital line of credit in respondent has conceded the allowability of this additional_amount petitioner does not dispute this item we accept it owensby kritikos inc v commissioner f 2d pincite n accordingly we increase our reasonable_compensation determination to dollar_figure previous underpayment petitioner contends that jack was underpaid in previous years particularly and see supra table petitioner argues as follows while there are no corporate minuets sic declaring any part of mr brewer’s compensation_for and as make up salary a good_faith argument for extension of existing law can be made where it is apparent from the facts because of the extreme disparity between mr brewer’s compensation in and and his compensation in both previous and following years that the fact that he was being compensated for past performance is plainly apparent respondent’s rejoinder is twofold there is no indication of an intent to compensate jack in or in on account of past undercompensation and hakala concluded that jack was adequately compensated for jack’s services to petitioner for through amounts paid in a later year for earlier years’ services may be deducted when paid if the services were undercompensated in the earlier years 281_us_115 estate of wallace v commissioner t c pincite 75_tc_288 affd without published opinion 665_f2d_1050 7th cir r j nicoll co v commissione59_tc_37 in order to be allowed the deduction the taxpayer must establish the amount of the undercompensation for the earlier years’ services and that the payment in the later year is intended as compensation_for the earlier years’ services 399_f2d_603 9th cir affg tcmemo_1967_7 373_f2d_45 10th cir affg 44_tc_382 estate of wallace v commissioner t c pincite in the instant case petitioner has presented us with little more than the claim and general conclusory testimony that some amount was intended as compensation_for jack’s earlier years’ services we are not told how much of the payments or the payments was so intended how the intent was arrived at or formulated or what earlier years’ services were being compensated for in or in for all we can tell petitioner’s theory of compensation_for prior services was only an afterthought developed at a time when the reasonableness of the compensation was already under attack pacific grains inc v commissioner f 2d pincite petitioner’s plea that we overlook the absence of corporate minutes runs into the concern that it is precisely in situations such as the instant case where one person’s controlling presence was on all sides of the negotiating table 91_tc_575 that we must carefully scrutinize the payments to ensure that they are not disguised dividends owensby kritikos inc v commissioner f 2d pincite on the basis of jack’s and sledge’s testimony as well as petitioner’s failure to produce any relevant corporate minutes or any other contemporaneous paper trail see 6_tc_1158 affd 162_f2d_513 10th cir we conclude that it is more_likely_than_not that petitioner did not intend in and did not intend in to compensate jack for his earlier services to petitioner we have so found under these circumstances we need not and we do not determine whether jack was undercompensated for his earlier services to petitioner nonsalary benefits ding stated that petitioner’s failure to provide nonsalary benefits other than health insurance to its executives should be taken into account in determining the maximum reasonable_compensation for jack she regarded as particularly important the lack of a defined_benefit_plan or deferred_compensation plan she relied on studies showing that companies typically provide their executives with benefits representing of compensation and sixty-one percent of retail and wholesale trade industries provide long-term incentive programs for their top managers in his rebuttal expert witness report hakala responded as follows compensation_for poor benefits this is an interesting issue it is difficult to quantify bqh is not a large public company benefits are typically more limited for officers of manufactured_home dealerships it is our understanding that mr brewer’s benefits were consistent with the benefits realized by his top sales personnel the data relied upon by ms ding is not applicable for a company of the size and type of bqh however some elements for benefits might be considered appropriate in a market compensation analysis but not in the independent investor returns analysis on opening brief petitioner contends as follows additionally mr brewer’s compensation lacked the typical benefits package mr brewer’s compensation package did not include a retirement_plan a sep a k a profit-sharing_plan a defined benefits plan a plan a plan sick leave or paid vacation trial trans vol page these types of benefits were customary in the industry and represent a substantial amount of money this lack of customary benefits package justifies a larger salary trial trans vol pages typically companies provide their executives with benefits representing of compensation exhibit 56-p page and exhibit x therein if mr brewer would have had a typical benefits package his cash compensation could have been less and he still had the same total compensation on answering brief respondent replies as follows petitioner’s argument that jack brewer’s compensation in and made up for the lack of company provided fringe_benefits is unfounded it was not necessary for jack brewer to participate in a company sponsored profit sharing plan because in fact jack brewer determined and allocated substantially_all company profits to himself on december of each year we analyze this matter as follows firstly if petitioner means to say that courts apply the reasonable_compensation test to only cash compensation then petitioner is wrong it has long been settled law that-- the sum of all compensation deferred as well as direct must meet the requirement of sec_162 that it be reasonable in amount 501_f2d_675 7th cir to the same effect see 72_tc_377 66_tc_324 affd without published opinion 553_f2d_93 2d cir secondly the question of what courts do in fact requires an understanding of the effect of the limits of what is in the record before us for example if we knew that the underlying data for the rma ratios came from only those mobile home retailers who provided nonsalary benefits to their executives but this underlying data included only the cash compensation paid to the executives and not the value of or current cost to buy the nonsalary benefits and the value of or current cost to buy these benefits was as ding stated percent of total compensation ie cash compensation plus nonsalary benefits then we would adjust the cash compensation amount upward by about percent to arrive at total equivalent compensationdollar_figure however the record before us does not include any of the needed information as to the data underlying the rma ratios also the percent in ding’s analysis comes from a report of a study of employers the record does not give us any characteristics of the participating employers that would enable us to make a useful judgment as to how that sample if nonsalary benefits are percent of total compensation then cash compensation constitutes the remaining percent of the total compensation thus total compensation is percent percent of cash compensation or l32 percent of cash compensation related to the rma samples for and petitioner’s brief makes assumptions that are not stated in the brief and that appear to be neither supported by nor contradicted by the record respondent’s brief on this issue seems to be totally irrelevant to a reasonable_compensation analysis even though it may be significant to an analysis of petitioner’s intent we are left with hakala’s observation that some adjustment for nonsalary benefits might be considered appropriate in a market compensation analysis because of hakala’s observation and in light of the lack of foundation for_the_use_of percent for mobile home retailers of petitioner’s size we conclude that we should adjust upward by some amount the estimates derived from the rma ratios see 671_f2d_167 6th cir revg 72_tc_793 doing the best we can with the record in the instant case we increase our reasonable_compensation determination to dollar_figure and our reasonable_compensation determination to dollar_figure independent investor returns in reaching his reasonable_compensation figures hakala relied primarily our on investor return analysis as an indication of the upper bound on executive compensation such that an arm’s-length investor in the company is able to realize a fair return on equity a fair_market_value analysis in the first part of his analysis hakala valued petitioner based on two rules of thumb three times owners’ discretionary cash_flow and five times earnings before interest the net of interest_income and interest_expense and taxes only federal income taxes or ebit owners’ discretionary cashflow is the sum of ebit jack’s compensation and mary’s compensation hakala states that because only the owners’ discretionary cashflow measure is calculated before deduction of officers’ compensation the difference in value between the two measures provides an implied amount of excess compensation_for and hakala calculated implied excess compensation of dollar_figure and dollar_figure respectively by subtracting the amounts of implied excess compensation from the amounts that petitioner paid to jack hakala determined an implied amount of reasonable_compensation of dollar_figure for and dollar_figure for in his expert witness reports hakala included tables showing how his fair_market_value analysis would apply if petitioner had paid to jack only the amounts that hakala concluded would be reasonable_compensation in his original report in which he concluded that maximum reasonable_compensation to jack would be dollar_figure for and dollar_figure for hakala’s fair_market_value analysis shows that what hakala referred to as the implied amount of reasonable_compensation would be only dollar_figure for but would be dollar_figure for in his rebuttal report in which he concluded that maximum reasonable_compensation to jack would be dollar_figure for see supra note and dollar_figure for hakala’s fair market analysis shows that what hakala refers to as the implied amount of reasonable_compensation still would be only dollar_figure for and dollar_figure for hakala’s analysis seems to not make any further use of the implied amounts of reasonable_compensation that he thus calculated as far as we can tell hakala uses the three times owners’ discretionary cashflow only in calculating operating return operating income on fmv operating_assets which hakala apparently equates to three times owners’ discretionary cashflow both in terms of what the ratios actually were and what the ratios would have been under the method described infra b estimate of petitioner’s discount rate as far as we can tell hakala uses the five times ebit only in one table which appears twice in hakala’s original report for these calculations hakala ignored without explanation the additional dollar_figure discussed supra loan guaranty in that table hakala uses interchangeably times ebit and fmv of bqh petitioner hakala does not appear to use the five times ebit amount to derive anything hakala has not explained and we have not been able to discern any role that hakala’s fair_market_value analysis played in producing hakala’s bottom-line reasonable_compensation conclusions under these circumstances we do not pause to consider the appropriateness of hakala’s choices of the three and five multipliers why not 2½ and 5½ or some other sets of numbers of hakala’s choices of things to multiply owners’ discretionary cashflow and ebit of hakala’s choices of equivalents three times owners’ discretionary cashflow is equivalent to the fair_market_value of petitioner’s operating_assets five times ebit is equivalent to the fair_market_value of petitioner and of hakala’s method of deriving implied reasonable_compensation from these multiplier rules of thumb we have thought it appropriate to consider hakala’s fair_market_value analysis only because hakala presented it at the head of his independent investor returns analysis and it helps us in evaluating the complexities of the remaining portions of hakala’s independent investor returns analysisdollar_figure however we in gilbert and sullivan’s patience the character bunthorne extols obscurity and complexity as the route to creation of an impressive persona as follows continued conclude that this fair_market_value analysis in hakala’s expert witness report does not lead us to any answer in our quest for the maximum amount of reasonable_compensation from petitioner to jack b estimate of petitioner’s discount rate hakala’s next step in his investor returns analysis was to estimate the discount rate or cost of capital as hakala uses the term petitioner’s cost of capital is the rate of return that an investor would expect to realize from an investment in a continued if you’re anxious for to shine in the high aesthetic line as a man of culture rare you must get up all the germs of the transcendental terms and plant them everywhere you must lie upon the daisies and discourse in novel phrases of your complicated state of mind the meaning doesn’t matter if it’s only idle chatter of a transcendental kind and every one will say as you walk your mystic way if this young man expresses himself in terms too deep for me why what a very singularly deep young man this deep young man must be patience the complete plays of gilbert and sullivan pp new york modern library under fed r evid the justification for the expert witness is that the expert witness will assist the trier of fact to understand the evidence or to determine a fact in issue it is not enough that the expert can communicate with other experts the expert should be enough of a teacher or explainer so that the nonexpert trier of fact can understand the steps in the expert’s analysis the nonexpert trier of fact should not have to be a detective discovering clues in odd places in the expert’s report in order to understand how the expert proceeded from one step to the next company such as petitioner taking into account the appropriate risk and performance characteristics of petitioner from his pretax operating return on net operating_assets percentages hakala determined an adjusted average required rate of return of dollar_figure percent in so doing he assumed inflation plus real growth will average approximately per annum and grossed up for taxes hakala then calculated reasonable_compensation numbers for jack such that the average required rate of return was dollar_figure percent the values of the variables operating_profit and three times owners’ discretionary cashflow that hakala used to conclude that the average required rate of return equaled dollar_figure percent are pretax values the dollar_figure percent however contemplates that the values will be after-tax values hakala chose to use the capital_asset pricing model hereinafter sometimes referred to as capm to estimate petitioner’s cost of capital he states that capm is a standard method of estimating the cost of capital petitioner contends that capm has no application to closely held companies citing furman v commissioner tcmemo_1998_ neither hakala nor respondent seeks to rebut petitioner’s furman contention hakala did not tell us whether there are other standard methods whether capm has advantages over other standard methods nor why hakala chose to use capm in this instance in estate of heck v commissioner tcmemo_2002_34 we commented as follows in recent cases we have criticized the use of both the capital_asset pricing model capm and wacc as analytical tools in valuing the stock of closely held corporations see furman v commissioner tcmemo_1998_157 see also estate of maggos v commissioner tcmemo_2000_129 and estate of hendrickson v commissioner tcmemo_1999_278 which reaffirm that view citing furman and estate of klauss v commissioner tcmemo_2000_191 where we rejected an expert valuation utilizing capm in favor of one utilizing the buildup method in other recent cases however we have adopted expert reports which valued closely held corporations utilizing capm to derive an appropriate cost of equity_capital see btr dunlop holdings inc v commissioner tcmemo_1999_377 gross v commissioner tcmemo_1999_254 affd 272_f3d_333 6th cir because the parties have not developed this dispute and we conclude infra that hakala’s application of capm to petitioner in the instant case has significant flaws we do not determine in the instant case the conceptual suitability of applying capm to the valuation of closely held companies such as petitioner the first step in capm involves calculating the cost of equity_capital which hakala defined as the expected or required rate of return on the firm’s common_stock that an investor would expect to realize from an investment in a company with the risk and performance characteristics of petitioner hakala estimated the cost of equity_capital to be dollar_figure percent in and dollar_figure percent in dollar_figure hakala then estimated the cost of debt which he based on the prevailing prime lending rate plu sec_1 for and the costs of debt were dollar_figure percent and dollar_figure percent respectively next hakala applied the values determined in the preceding two steps to calculating the weighted average cost of capital sometimes hereinafter referred to as wacc hakala determined that the wacc was dollar_figure percent for and dollar_figure percent for in his expert witness report hakala described this process as using weights reflecting the relative importance of debt and equity in the typical firm’s capital structure he multiplied the cost of equity_capital by a fraction derived from the relative portion of total capital that consisted of equity he hakala’s report shows the arithmetic as follows plus time sec_1 plu sec_1 plus time sec_1 plu sec_1 sledge’s supplemental report adds the same components for as follows long-term risk less sic rate dollar_figure market risk x beta x dollar_figure dollar_figure non-systematic risk dollar_figure required return on equity dollar_figure rounded sledge then uses the dollar_figure percent in his calculations when we perform the indicated arithmetic we get rounded to dollar_figure percent for and rounded to dollar_figure percent for multiplied the cost of debt capital by a fraction derived from the ratio_of_debt_to_equity instead of the ratio of debt to total capital and he added the two products together to produce his wacc amounts sledge in his rebuttal report points out correctly that hakala’s debt multiplier should have been the ratio of debt to total capital that the sum of the debt multiplier and the equity multiplier should be while hakala’s sum wa sec_1 and that this error by hakala resulted in hakala’s overstating the wacc and thereby understating the amount of reasonable_compensation sledge also has errors discussed infra hakala has chosen to use dollar_figure percent as the basic debt- equity ratio from this he derives the equity multiplier of this is one divided by it follows that the debt multiplier should be minus or and not the that hakala used if we correct this error and the above- noted error of dollar_figure percent rather than dollar_figure percent for the cost of equity_capital then hakala’s capm approach should yield a wacc of instead of hakala’s similar corrections would apply to the wacc because a lower wacc leads to higher reasonable_compensation under hakala’s approach these corrections in hakala’s numbers would result in an increase in the reasonable_compensation numbers that hakala recommends hakala testified that correcting the wacc caused the numbers in both years to go up and stated in his rebuttal report that the calculation of the weights for debt and equity in the bvs report hakala’s expert witness report was inconsistent with the assumed weights in the original exhibit iv-2 however we are unable to determine exactly what corrections hakala made in his wacc calculations that led to the substantial increases in his recommendations as to reasonable_compensation as a result we do not know whether hakala has already corrected for the above-noted errors in sledge’s rebuttal report he pointed out that the combined debt and equity multipliers that hakala used to determine the cost of debt and the cost of equity exceeded he then proposed debt and equity multipliers that total and he demonstrated the effect of the change by calculating the wacc for which he determined was dollar_figure percent sledge presented this as follows this is the weighed sic average cost of capital wacc and is calculated as shown below cost of debt dollar_figure x - dollar_figure this is the cost of debt after taxes weighed sic cost of debt dollar_figure x dollar_figure weighed sic cost of equity dollar_figure x or dollar_figure x dollar_figure wacc dollar_figure rounded dr hakala has made an error in the calculations of wacc refer to exhibit rebut-19 an attachment in sledge’s rebuttal report and you will see the correct formula for wacc while dr hakala has correctly written the formula on his p he does not compute it correctly correct calculations for wacc cost of debt dollar_figure x - dollar_figure this is the cost of debt after taxes weighed sic cost of debt dollar_figure x dollar_figure weighed sic cost of equity dollar_figure x dollar_figure wacc dollar_figure as this excerpt shows sledge failed to add together the weighted cost of debt and the weighted cost of equity in his calculation the corrected wacc according to the values sledge proposed is dollar_figure percent for and dollar_figure percent for amounts greater than what hakala had determined thus while sledge correctly noted one of hakala’s mathematical errors sledge’s proposed solution leads to or would have led to if sledge had carried the analysis out reasonable_compensation conclusions that are less than hakala’s conclusions as we noted supra hakala used dollar_figure percent as the debt- equity ratio in calculating the relative weights to be given to debt capital and equity_capital he did not give us any source for his statement that this is the relative importance of debt and equity in the typical firm’s capital structure emphasis added however elsewhere in his report he indicated that dollar_figure percent is the average debt-equity_ratio of four named firms these four firms had debt-equity ratios ranging from percent to as of date we are not given any information that would lead us to conclude that the average of four firms’ widely disparate capital structures happens to be precisely equal to the typical firm’s capital structure all four firms are publicly traded while petitioner is not we do not find any information suggesting that this makes a difference or does not make a difference in what a reasonable independent investor would do with a firm like petitioner hakala told us that each of the four firms is a large manufacturer of mobile homes with a large retail organization petitioner is entirely a retailer hakala told us that the four firms had sales of dollar_figure million to dollar_figure million a year for and while petitioner’s sales were only dollar_figure-10 million hakala described the four firms as billion dollar companies while he regarded petitioner as worth only a few million dollars hakala did not present to us any explanation much less evidence supporting any explanation as to whether or not adjustments should be made to this particular four-firm average debt-equity_ratio to arrive at a typical debt-equity_ratio that would be meaningful with regard to firms that are similar to petitioner because hakala’s capm analysis makes reasonable_compensation vary directly with the debt-equity_ratio and hakala contends that his capm analysis enables him to determine jack’s maximum reasonable_compensation to the dollar it becomes important for us to have confidence in the correctness of hakala’s determination of dollar_figure percent as the debt-equity_ratio to use because of the above-noted omissions we have no idea what debt-equity_ratio is appropriate to use in a capm analysis this makes us reluctant to rely on a capm analysis based on the record in the instant case whether or not capm analyses are viewed as conceptually appropriate for firms such as petitioner finally we note that in his expert witness report hakala’s arithmetic was inconsistent with his narrative description of the process of moving from wacc to pretax operating return on net operating_assets the arithmetic was consistent with an assumed combined state and federal tax_rate of about percent while the narrative states that hakala used percent in his rebuttal report sledge pointed out the error under hakala’s approach the cost of debt capital is substantially less than the cost of equity_capital thus a greater debt-equity_ratio leads to a lesser weighted average cost of capital wacc this means that under the capm the greater the debt-equity_ratio the less the net profit that an independent investor would require and so the independent investor could afford to pay more compensation and stated that correction of this error in math will raise the allowable compensation to jack brewer by about dollar_figure in his rebuttal report hakala appears to have corrected this error19 and has increased his recommended reasonable_compensation amounts by a total of dollar_figure for and we note that hakala did not make any change to his original wacc amounts in correcting his expert witness report and that his bottom-line determinations changed by almost the same amount that sledge stated would be the case if hakala were to make the corrections yet when asked about this matter at trial hakala testified that his error was in the weighting of the two components of wacc and not in the assumed tax_rate we have described supra some mathematical errors that hakala made in his wacc calculations hakala did not correct these errors it appears that if these were corrected then hakala’s bottom-line numbers would be greater but we cannot tell by what amounts c determination of compensation formula after hakala determined a net required rate of return of dollar_figure percent he conducted an analysis to determine a compensation formula to arrive at a reasonable range for we say appears to because hakala’s final numbers are not precisely the same as sledge’s numbers we suspect that the differences are due to rounding at earlier stages of the computation but we cannot be sure because hakala does not present a clear explanation of what he did officer’s compensation such that an arm’s-length investor could realize market rates of return on invested capital in petitioner dollar_figure hakala calculated the theoretically appropriate officers’ compensation by starting with a base salary of dollar_figure he determined this amount by multiplying by the median base salary shown in a survey for by panel publications of aspen publishing hereinafter sometimes referred to as panel aspen hakala did not explain why he multiplied the median base salary by or why he used as a base_year when he provided the data for and 1996--but not for 1994--in his report also the data hakala used was from both the fabricated metal and wood products industry group and the business services industry group we are unclear as to how these industry groups are similar to petitioner hakala admitted that the comparability is somewhat limited and not a very good fit nevertheless he claimed that the data provided information dollar_figure this dollar_figure percent dollar_figure percent in hakala’s first expert witness report is determined as an average of the information for and for hakala has not explained how there could be a plausible scenario in which an arm’s-length investor would take into account information including interest rates in agreeing to compensation payments in hakala’s justification at trial for use of the panel aspen data from the fabricated metal and wood products industry group and the business services industry group to determine a base salary for jack was as follows continued continued q by calkins on direct now dr hakala we’re going to exhibit 57-p which is ms ding’s rebuttal to your report a okay q ms ding assigns a number of errors in her report and we’ll briefly go through each of these errors at page error number one she addresses the use of the penell panel aspen publishing survey criticizing the data and the size of the company could you comment on that a there’s some validity to the limitations on the use of the penell since i used fabricated metal wood products and business services i did pick the right types of industries but the survey is too broad to probably be as applicable as i would like it’s informative but it’s certainly not determinative of my ultimate opinion in the case q so when she says this data is not valid-- a it’s valid it’s used all the time in the real world to sort of condition what you’d make in a small closely-held company but the issue is that you have to sort of condition the data for what industry and sector you’re in and that element of her criticism i think has some validity a lot of validity q by mayo on cross okay the first thing you did was you went to a survey called pennell panel aspen publishing survey a yes q and that was a survey of compensation of ceo’s continued continued a yes q and the first industry you looked at was wood products manufacturing a fabricated metal and wood products q yeah fabricated metal that’s not really very closely related to mr brewer’s business though is it a it’s not a very good fit it -- he’s selling products that might -- q small low tech components you know pegs and brackets and that kind of stuff a not always exacto spring fell in there but anyway q how about business services what was business services a it’s so broad it’s also not a very good fit i think some are -- yeah on page i say thus the comparability is somewhat limited q yeah but that was what you used a it provided information q i want to point out to the court that there are some weaknesses in this analysis a i agree q you agree that there are some weaknesses a agree and it provides some information but the analysis is limited q right and there are some weak -- because it’s wood products and business services neither one are kind of directly related to mr brewer continued to determine the base salary for and hakala increased the theoretical base salary of dollar_figure by percent per year thus the base salary for and would have been dollar_figure big_number x and dollar_figure big_number x respectively hakala then determined the bonus amounts based on a percentage of the operating income before officers’ compensation in his expert witness report hakala explains as follows the bonus percentage is solved based on the projected per annum rate of growth the expected operating_expenses before officers’ compensation in each future year and a required average net operating return on operating_assets of based on our analysis we calculate that the reasonable_compensation for mr brewer to achieve a investor return is dollar_figure in and dollar_figure in this corresponds to a bonus of dollar_figure in which would be of theoretical operating income and a bonus of dollar_figure in which would be of theoretical operating income in his rebuttal report hakala noted that his revised adjusted average required operating return on net operating_assets dollar_figure percent rather than dollar_figure percent resulted in his increasing the recommended compensation level for each year as described supra however he attributed this change entirely to recalculation of the weights for debt and equity hakala’s discussion of the panel aspen data described supra does not seem to affect his conclusions at all except as to how continued a correct much of jack’s maximum reasonable_compensation should be labeled base pay and how much should be labeled bonus he apparently regarded this as so inconsequential that in his rebuttal report he did not bother to correct the bonus components when he revised the total compensation amounts we cannot tell what function hakala’s discussion of base pay serves in hakala’s reaching or explaining his bottom-line conclusions hakala’s discussions of other comparisons although eventually discarded serve the appropriate function of demonstrating that those comparisons would have resulted in lower permissible amounts of reasonable_compensation they thereby make the capm approach appear to be more generous to petitioner than would be the case if the other methods had not been presented when push came to shove hakala’s conclusions rested entirely on capm and respondent followed hakala’s conclusions to the dollar conclusion hakala has not presented us with a description of how his various analyses fit together to lead to the final numbers he reaches he has not specified what points in his analyses are being corrected and how these corrections result in the changed numbers between his original expert witness report and his rebuttal report as to the many different variables in capm hakala has not indicated why we should accept his choices in values rather than other choices such as sledge’s sledge however has not shown us how the changes in values result in his conclusions rather he simply concludes that changing one of the variables to a value that is more favorable to petitioner results in a specified amount of greater maximum compensation without a thorough explanation or demonstration of why his changes result in the numbers that he reaches we do not accept sledge’s conclusions further we cannot tell from the information included in the expert reports whether a variation in any particular value is likely to cause a great or only slight change in the bottom line and often it is not apparent whether a change is likely to increase the maximum amount of reasonable_compensation or decrease the maximum amount of reasonable_compensation in fact sledge conceded that it would be highly improbable for all of his suggested revisions to hakala’s capm numbers to be operable together adoption of some of his suggested revisions very likely would require that some other suggested revisions would have to be rejected or might have to be revised in such a way as to result in the latter revisions undoing the effect of the former revisions we also note the paradox in hakala’s approach that the more successful jack was in building up petitioner the less the amount hakala would say would be reasonable_compensation we find it difficult to justify an analysis that leads to such a counterintuitive result under these circumstances we conclude that hakala’s application of capm on the record herein presents too many difficulties to justify using capm in the calculation of reasonable_compensation for jack and neither hakala nor sledge has explained capm sufficiently for us to be able to determine what would be the bottom-line effect of even correcting the arithmetic errors we have described except that we perceive it is more_likely_than_not that those corrections would produce reasonable_compensation numbers somewhat greater than those that hakala recommended however it appears from respondent’s reactions on brief that respondent is willing to accept hakala’s recommendations even when the amounts exceed what had been determined in the notice_of_deficiency accordingly we conclude based on the foregoing analysis of hakala’s independent investor approach and the correction of hakala’s arithmetic errors plus the allowance for jack’s loan guaranty reasonable_compensation for jack’s services is dollar_figure and based on the foregoing analysis of the rma data plus an amount for nonsalary benefits reasonable_compensation for jack’s services is dollar_figure intent because of the comparatively subjective nature of the determination of a taxpayer’s intent in making a payment to a shareholder-employee courts have generally concentrated on the reasonableness prong rather than the intent prong in sec_162 cases see eg 716_f2d_1241 9th cir revg tcmemo_1980_282 however it is clear that if a payment was not intended to be compensation_for_personal_services then it will not be deductible under sec_162 even if the payment did not exceed reasonable_compensation see king’s court mobile home park v commissioner t c pincite paula construction co v commissioner t c pincite having made determinations as to the maximum amounts of petitioner’s payments to jack that would be reasonable_compensation for jack’s services we now proceed to the second prong--whether any portions of those reasonable amounts are nevertheless not deductible by petitioner because they were not intended as compensation respondent contends that part of the payments to jack deducted by petitioner are disguised dividends in support of this contention respondent directs our attention to the following jack’s testimony that if petitioner had a good year then jack had a good year the yearend ad hoc determination of jack’s bonuses and absence of any compensation plan for jack are indicia of an intent to distribute earnings rather than pay compensation_for services and the incentive to avoid one of the two layers of income_taxation of dividends petitioner contends that the issue is not properly before the court in the instant case see supra note and devotes its efforts to the reasonable_compensation prong we agree with respondent that the issue is properly before us and the evidence to which respondent draws our attention points toward an intent to distribute earnings however in the instant case this agreement with respondent’s position does not result in any disallowance of otherwise reasonable_compensation in each year before us substantially_all of petitioner’s payments to jack were made by way of a bonus at the end of the year there is no testimony or other evidence that indicates that the participants in the discussions--jack and sledge--had one intention with regard to a portion of each bonus and a different intention with regard to the remaining portion of each bonus thus one might contend that a contaminating intention should result in disallowance of deductions for the entirety of each bonus or alternatively that the contamination was not great enough to require disallowance of deductions for any part of each bonus yet from the notice_of_deficiency onward respondent clearly has not taken the all-or-nothing approach rather even though respondent seems to regard the intent prong as more important than the reasonable amount prong at each stage respondent has applied the intent argument only to so much of petitioner’s payments to jack as exceeds reasonable compensationdollar_figure on the basis of the record in the instant case consistent with the foregoing we conclude that part of the amounts petitioner paid to jack in each of the years in issue was not intended as compensation the part that was not intended as compensation in each year is the amount by which the payments exceeded the amounts that we have held to be reasonable_compensation see supra table for example in the opening statement at trial respondent’s counsel described respondent’s position as follows it is respondent’s position that in spite of mr brewer’s contributions to petitioner during the years at issue the payments to him over and above what respondent has allowed in the trial memorandum should be disallowed as disguised dividends the trial memorandum reference is as follows respondent’s expert witness opinion as modified by revised exhibit iv-3 in the rebuttal report provides for reasonable_compensation for services rendered to petitioner by mr brewer of dollar_figure for and dollar_figure for further the report allows additional compensation of dollar_figure to mr brewer for providing his personal guarantee to secure a short-term working_capital line of credit in it is respondent’s position that the stated amounts represent the reasonable_compensation to mr brewer and will be sustained by the court as such thus we hold for petitioner that all of the amounts petitioner paid to jack that would not exceed reasonable_compensation for jack’s services were in fact paid as compensation_for jack’s services to take account of the foregoing decision will be entered under rule