t c memo united_states tax_court alpha medical inc f k a alpha medical management inc petitioner v commissioner of internal revenue respondent docket no filed date john p konvalinka and thomas e smith for petitioner bonnie l cameron for respondent memorandum findings_of_fact and opinion parr judge respondent determined a deficiency in petitioner's federal_income_tax of dollar_figure and a penalty under section of dollar_figure all section references are to the internal_revenue_code as in effect during the year in issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated all dollar amounts are rounded to the nearest dollar unless otherwise indicated the issues for decision are whether an amount_paid by petitioner to william t rogers rogers as compensation during taxable_year is reasonable within the meaning of sec_162 we find the amount_paid was not reasonable to the extent set out below whether petitioner is liable for the accuracy-related_penalty under sec_6662 for substantially understating its income for the year in issue we find it is in its petition to this court petitioner raised the issue of whether a second inspection of petitioner's records within the meaning of sec_7605 was conducted by respondent's agent for the taxable_year on date petitioner received a notice of audit for upon receipt of the notice of audit for petitioner objected to the audit on the basis that the audit was repetitive and that the internal_revenue_service irs already had in its possession information relating to revenue_agent arthur w horton caused a summons to be issued for information relating to by letter dated date petitioner informed the irs that petitioner was not going to produce the records a summons enforcement proceeding was initiated in the u s district_court for the eastern district of tennessee on date and a hearing was held on date petitioner's representative appeared at the hearing and objected to the summons on the ground inter alia that the irs's request to examine its books of account for was a second inspection in violation of sec_7605 the district_court ruled in favor of the irs and petitioner appealed to the court_of_appeals for the sixth circuit in united_states v alpha med management inc 116_f3d_1481 6th cir the court_of_appeals for the sixth circuit by an unpublished opinion remanded the case to the district_court for a determination of which documents sought by the summons were already in the possession of or accessible to the irs in other respects the district court's order enforcing the summons was affirmed in its ruling the court_of_appeals found that the irs complied with the statutory requirements of sec_7605 we conclude that there was no second inspection of petitioner's books of account in violation of sec_7605 findings_of_fact some of the facts have been stipulated the stipulated facts and attached exhibits are incorporated herein by this reference a petitioner's background alpha medical management inc also known as alpha medical inc hereinafter petitioner is a medical management_corporation duly formed and organized under the laws of tennessee at the time the petition was filed its principal_place_of_business was in chattanooga tennessee rogers incorporated petitioner in with an initial capital_contribution of dollar_figure he has not made any additional capital contributions to petitioner petitioner began operations on date by petitioner had employees petitioner provides medical management services to home health care agencies and hospitals with home health care departments home health care agencies are subject_to state licensing requirements and requirements known as certificate of need the services petitioner provides to its clients are tailored to meet each client's individual needs and to assist each client in complying with the various licensing requirements certificate of need requirements and the various medicare and medicaid regulations in most instances petitioner's services include the management of four categories of operations i reimbursement ii accounting iii accounts_receivable billing and computer operation and iv clinical operational consulting petitioner's entire operation is located in one office in chattanooga tennessee petitioner's clients' locations grew from in to in in tennessee kentucky arkansas and florida in petitioner managed locations b william t rogers' background and duties since petitioner began operations in rogers has been its president sole director and sole shareholder rogers worked hours a day and was available at all times of the day by telephone or pager during and prior to rogers made all decisions that affected petitioner's mid- and long-range plans and rogers handled any problems that arose with petitioner's clients or employees rogers did not routinely deal with petitioner's day-to-day operations or with the day-to-day care of patients until sometime in or rogers negotiated each contract petitioner made with its clients rogers has a bachelor of science in biology from tennessee technological university and a doctorate in pharmacy from the university of tennessee he has more than years of experience in the health care field rogers was the founder of a successful local drugstore chain with seven stores which he sold in rogers also began a durable medical equipment business which he sold to a publicly traded company in when rogers sold the durable medical equipment business he was offered a million-dollar-plus salary to manage national medical equipment california home health care division rogers turned down that job offer because he did not want to move to california c petitioner's divisions and management team the financial division petitioner is divided into two divisions the financial division and the clinical and operations division the financial division provides a complete array of accounting services for petitioner's clients including the review of each client's expenditures to insure that they are reimbursable by medicare rayburn h tankersly tankersly a certified_public_accountant has been petitioner's senior vice president of finance and chief financial officer in charge of the financial division since date when he began working for petitioner tankersly has been in the medical accounting field since tankersly was hired in part to help rogers make technical decisions dealing with medicare regulations tankersly provides strategic focus for petitioner's financial division he assists in strategic planning for clients develops and maintains client relationships provides financial guidelines to clients and ensures proper staffing for the financial division tankersly worked to hours a day in tim stees stees a certified_public_accountant has been petitioner's vice president of finance since late stees coordinates tax_return preparation participates in strategic planning for petitioner and its clients and develops and maintains client relationships during stees was the controller in addition to being responsible for supervising various functions of the payroll and accounts_payable departments petitioner's reimbursement and information systems departments are part of petitioner's financial division from to libby walker walker was petitioner's director of reimbursement walker dealt with the commerce clearing house cch guides the health insurance manual-11 him-11 all the government rules and medicare regulations the clinical and operations division the operations division provides surveys advice and evaluations for petitioner's clients and develops the operational and clinical products that are delivered to clients rebecca worley worley a registered nurse has been petitioner's senior vice president of operations and chief operations officer since petitioner's inception in worley provides strategic focus for petitioner's operations division she decides the direction and timing of client selection and development translates rogers' management vision into operational plans is responsible for marketing services and petitioner's development ensures proper staffing levels and training programs guides clients regarding the direction and actions of their companies and at one time oversaw and assisted in the development of petitioner's clinical information system from through worley worked to hours a day for petitioner worley directs the nurses petitioner employs donna stapleton stapleton a registered nurse is petitioner's vice president of operations stapleton earned a certification in nursing administration in from the american nursing association she is responsible for the operational and clinical oversight of the field staff acts as a liaison with state and federal fiscal intermediaries regarding regulatory issues provides evaluations and advice to clients and handles personnel management development and recruitment currently petitioner has three senior consultants with nursing backgrounds in its operations division each senior consultant along with stapleton supervises a team of two to four nurses before the senior consultants were hired sometime after these duties were performed under rogers' guidance petitioner's management team--general from to petitioner's management tasks were performed by rogers and worley in late tankersly joined and in late stees joined petitioner's management team rogers tankersly and worley knew petitioner's business rogers had the reputation that brought the clients in and finalized the contracts sometime in or a salesman began working for petitioner out of nashville rogers recruited petitioner's executive and management staff rogers tankersly and worley attended state and national home care association meetings entertained and recruited clients visited exhibit halls to see what vendors were offering and shared the information they obtained with each other in petitioner's board_of directors included rogers president ceo tankersly vice president cfo and worley executive vice president secretary d petitioner's services petitioner provides its clients with a team of employees who have advanced skills and knowledge in dealing with medicare and medicaid regulations the team conducts a mock survey to determine whether the clients are in compliance with state licensing federal conditions of participation and the rules of other accrediting bodies and recommends ways to comply or improve rogers developed the parameters for the mock survey team and together with worley developed the product line for the mock survey the mock survey replicates the annual inspection required by state and federal regulatory authorities and as a result of the mock survey petitioner's clients have exceptional records with respect to their inspections petitioner has policy manuals that discuss petitioner's products and explain how services are to be provided to its clients the policy manuals are periodically revised by petitioner had policy manuals and by petitioner had policy manuals rogers helped develop most if not all of petitioner's policy manuals during and there was a nursing shortage rogers worked with an advertising firm to develop a recruitment plan to help petitioner's clients recruit adequate staffs rogers developed the per-visit method of compensation_for nurses and recommended its use to petitioner's clients which increased the availability of nurses rogers also suggested developing the alpha information system a clinical system that provides documentation and assistance to the clinician providing the services and reduces paperwork the use of the alpha information system enhances the quality of patient care by allowing the nurse to spend more time on patient care and less time on documentation and ensures accuracy there were no other computer systems like it in the home health care industry in rogers drew the schematics about how home health care works for petitioner's computer programmers who then developed the system petitioner's clients have to attend medicare preexit and exit conferences to determine whether medicare agrees with the amounts the clients were reimbursed for at preexit conferences medicare informs the client of proposed adjustments and items that may be disallowed at exit conferences the clients present explanations for the items medicare proposed to adjust if an item is disallowed the client has to reimburse medicare what medicare paid the client during the years through rogers attended all of petitioner's clients' medicare preexit and exit conferences and vigorously defended their positions usually a second employee of petitioner attended the conferences with rogers e petitioner's key employees' compensation petitioner awards bonuses to almost all of its employees both management and nonmanagement bonuses are based upon contributions to petitioner's overall profit and employee performance for the years and petitioner paid its key employees other than rogers the following compensation amounts employee salary bonus total salary bonus total salary bonus total worley dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure tankersly big_number big_number big_number big_number big_number big_number big_number big_number big_number walker big_number big_number big_number big_number big_number big_number big_number big_number big_number frazier big_number big_number big_number big_number big_number big_number big_number big_number big_number goodwin --- --- --- big_number big_number big_number big_number big_number big_number stees --- --- --- big_number big_number big_number big_number big_number big_number in rogers determined the amounts of the bonuses f rogers' compensation during the years through rogers determined how much petitioner paid him for those years rogers gave himself a base salary plus a bonus based on a percentage of petitioner's pretax profit as follows year base salary bonus dollar_figure big_number big_number big_number of pre-tax profit of pre-tax profit of pre-tax profit of pre-tax profit rogers' salary and bonus percentage were reflected in petitioner's corporate minutes at the beginning of each year for rogers gave himself a large base salary increase dollar_figure to dollar_figure million to compensate himself for turning down the california job offer for through rogers' compensation compared to the total paid to other employees petitioner's taxable_income petitioner's gross_receipts and the percentage of gross_receipts which his compensation made up was as follows rogers' other year compensation employees taxable_income gross_receipts of gross_receipts dollar_figure dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number during the years through petitioner did not have pension plans or other forms of deferred_compensation for rogers or other key employees petitioner paid dividends to rogers its sole shareholder of dollar_figure in dollar_figure in and dollar_figure in rogers is the only person who had authority to declare dividends for petitioner for the years through petitioner's retained earnings were as follows year retained earnings dollar_figure big_number big_number big_number big_number g petitioner's audits on date petitioner received a notice of audit for the audit the audit continued until date during the audit of petitioner the internal_revenue_service irs analyzed the issue of the deductibility of compensation paid to rogers and obtained information relating to the calculation of compensation in both and including the amount of compensation petitioner paid rogers and petitioner's tax_return petitioner paid rogers dollar_figure of compensation in and dollar_figure in respondent allowed dollar_figure as a deduction for reasonable_compensation opinion issue whether the amount_paid by petitioner to rogers as compensation during taxable_year is reasonable within the meaning of sec_162 sec_162 allows a corporation to deduct as a business_expense a reasonable allowance for salaries or other compensation_for_personal_services actually rendered to come within the ambit of sec_162 the compensation must be both reasonable in amount and paid purely for services rendered to the corporation 500_f2d_148 8th cir affg tcmemo_1973_130 sec_1_162-7 income_tax regs it is clear that bonuses may be part of the allowable deductions as long as the sum of the base pay and the bonuses does not exceed a reasonable_compensation 399_f2d_603 9th cir affg tcmemo_1967_7 sec_1_162-9 income_tax regs neither party has suggested that rogers did not render valuable services to petitioner accordingly we will focus on the first element of the deductibility test--whether the amounts of the payments were reasonable whether the compensation is reasonable is a question to be resolved on the basis of an examination of all the facts and circumstances of the case 178_f2d_115 6th cir revg a memorandum opinion of this court 95_tc_525 affd 965_f2d_1038 11th cir respondent's determination is presumed correct and sec_1_162-9 income_tax regs provides in part bonuses to employees will constitute allowable deductions from gross_income when such amounts are made in good_faith and as additional compensation_for the services actually rendered by the employees provided such payments when added to the stipulated salaries do not exceed reasonable_compensation for the services rendered petitioner bears the burden of proving the reasonableness of the compensation rule a 290_us_111 if petitioner proves respondent's determination to be wrong the court must then decide the amount of compensation that was reasonable 61_tc_564 affd 528_f2d_176 10th cir in addressing the reasonableness of compensation the court_of_appeals for the sixth circuit the court to which an appeal in this case lies has adopted a set of basic factors that should be considered by the court in reaching its decision the employee's qualifications the nature extent and scope of the employee's work the size and complexities of the employer's business a comparison of salaries paid with the employer's gross and net_income the prevailing general economic conditions a comparison of salaries paid with distributions of retained earnings the prevailing rates of compensation_for comparable positions in comparable concerns the salary policy of the employer as to all employees and in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years mayson manufacturing co v commissioner supra see also 73_tc_1142 the situation must be considered as a whole with no single factor decisive mayson manufacturing co v commissioner supra in analyzing these factors the court must carefully scrutinize the facts of a case in which the paying corporation is controlled by an employee to whom the compensation is paid for example sec_1_162-7 income_tax regs cautions that in the case of a corporation having few shareholders an ostensible salary paid_by a corporation may be a distribution of a dividend on stock see estate of wallace v commissioner supra pincite in such a situation we must be convinced that the purported compensation was paid for services rendered by the employee as opposed to a distribution of earnings to him that the employer could not deduct 877_f2d_647 8th cir affg per curiam tcmemo_1987_ 332_f2d_899 2d cir remanding tcmemo_1962_307 rogers' qualifications an employee's superior qualifications for his or her position with the business may justify high compensation see eg home interiors gifts inc v commissioner supra pincite 59_tc_338 although rogers had no formal training in business management he has more than years of practical business experience in the health care industry furthermore rogers developed a single drugstore into a chain of stores that he sold in and a hospital supply business that he sold to a publicly traded company in rogers was instrumental in developing petitioner's computer_software programs mock surveys and policy manuals solving its staffing problems and developing cost-efficient operating procedures petitioner's success is mainly attributable to rogers' ambition creativity vision and energy not to its investment in capital see home interiors gifts inc v commissioner supra pincite dave fischbein manufacturing co v commissioner supra this factor favors petitioner nature extent and scope of rogers' work an employee's position hours worked duties performed and general importance to the success of a business may justify high compensation home interiors gifts inc v commissioner supra pincite in this case the history of rogers' contributions to petitioner must be considered rather than just his contributions during the year at issue because the compensation petitioner paid to him during the year at issue represents in part an attempt to rectify prior undercompensation see our discussion under factor infra at one time or another since its inception rogers has held most of the management positions at petitioner he has consistently worked hours each day in the office and is on call hours a day rogers' responsibilities have covered a wide range of activities including sales personnel operations finance planning and flying the corporate airplane the record shows that no other officer of petitioner has the breadth of experience with the company which rogers has however his experience has not been a solitary one he has been assisted by a hard-working and well-qualified management team and in particular by worley by any reasonable measure rogers' efforts on behalf of petitioner have been highly successful petitioner's profitability is attributable to sales of its services and effective cost containment getting and keeping customers is of course the lifeblood of any business 671_f2d_167 6th cir revg 72_tc_793 rogers is petitioner's primary salesman and deal closer he personally obtained each of petitioner's clients and negotiated each contract petitioner made with its clients since petitioner's gross_receipts have increased almost times taxable_income has increased almost times and net_worth has shown an increase of over times see home we note however that tankersly and worley also entertained and recruited clients and since stees' responsibilities have included developing and maintaining client relationships interiors gifts inc v commissioner supra pincite8 extraordinary corporate performance is evidence that officer's compensation is not excessive see also kennedy v commissioner supra cf 76_f2d_839 6th cir poor performance did not justify compensation paid affg in part and revg in part 28_bta_67 furthermore the gross_receipts were percent greater than the receipts yet expenses increased by only percent petitioner's successful cost containment is attributable in part to innovative management programs which were developed by rogers and worley significantly petitioner increased its business and revenues during a time of a nursing shortage petitioner's ability to increase its business while presented with a restricted labor force was due in part to petitioner's use of an innovative compensation plan for the nurses and the use of the drug interaction system the compensation plan and the drug interaction system were both developed in part by rogers this factor favors petitioner size and complexities of petitioner's business petitioner's gross receipts--an indicator of its size--were dollar_figure in from to the number of employees at petitioner increased from rogers and his wife to and the number of client locations increased from to which included locations in the states of tennessee kentucky arkansas and mississippi moreover approximately percent of the increase in client locations occurred from to finally the home health care visits managed by petitioner in almost doubled from the big_number managed in thus petitioner's business dramatically increased in compared to petitioner is in a complex business the management of the home health care business requires special expertise with regard to medicare medicaid insurance requirements and state health care licensing regulations in addition to technical expertise compliance with the various insurance programs requires accurate documentation of each home visit petitioner managed the documentation and reporting of almost a million home health care visits in the documentation and reporting of these visits included both clinical information and claims information which were processed through the alpha information system that was designed in part by rogers and worley and implemented by rogers this factor favors petitioner comparison of salaries paid to gross and net_income in rogers' compensation wa sec_44 percent of petitioner's gross_receipts and percent of its net taxable_income before deduction of rogers' compensation although it is often helpful to consider compensation as a percentage of both gross_receipts and net_income the latter is in most cases more probative because it more accurately gauges whether a corporation is disguising the distribution of dividends as compensation 819_f2d_1315 5th cir affg tcmemo_1985_267 however as noted previously each case turns on its own facts and circumstances and no particular ratio between compensation and gross or net taxable_income is a prerequisite for a finding of reasonableness petitioner cites several cases in which this court found that the compensation paid was reasonable notwithstanding the fact that the compensation was a large portion of the taxpayer's gross and net_income see eg pulsar components intl inc v commissioner tcmemo_1996_129 reasonable_compensation wa sec_27 percent of gross_receipts of dollar_figure and percent of dollar_figure taxable net_income before deduction of the compensation at issue in mad auto wrecking inc v commissioner tcmemo_1995_153 reasonable_compensation wa sec_34 sec_28 and sec_38 percent of gross_receipts of dollar_figure in rogers' compensation was dollar_figure petitioner's net taxable_income after deducting rogers' compensation was dollar_figure thus petitioner's net taxable_income before deducting rogers' compensation was dollar_figure dollar_figure and dollar_figure and and percent of net taxable_income of dollar_figure dollar_figure and dollar_figure before deducting officer's compensation at issue for and respectively acme constr co v commissioner tcmemo_1995_6 reasonable_compensation was percent of gross_income of dollar_figure and dollar_figure percent of net taxable_income of dollar_figure before deduction of compensation at issue in boca constr inc v commissioner tcmemo_1995_5 reasonable_compensation wa sec_27 and percent of gross_receipts of dollar_figure and dollar_figure for and respectively and approximately percent of net_income of dollar_figure and dollar_figure not including the compensation at issue in each year in these cases cited by petitioner this court found that the compensation paid_by the taxpayer was reasonable even though it was a large portion of the taxpayer's gross_receipts and net_income however petitioner fails to recognize that unlike the instant case where the compensation being challenged was paid to only one employee rogers in pulsar components intl inc mad auto wrecking inc and boca constr inc the compensation at issue was paid to two officer shareholders thus the facts of those cases and the case at hand are clearly distinguishable petitioner contends that a portion of the compensation paid rogers in is for services he provided petitioner in prior years similarly in acme constr co the compensation was paid in part to the officer shareholder for services he performed in prior years in that case we found that the compensation was reasonable notwithstanding the fact that it was dollar_figure percent of net taxable_income before deduction of compensation at issue however as noted in owensby kritikos inc v commissioner supra pincite n the absolute probative value of compensation as a percentage of net_income as an isolated factor is often minimal the main reason for this is that this factor is dependent upon a variable--the company's income-- that at least in the short run may be unrelated to the value of an individual's services for example a company with a high income might pay unreasonable salaries to its shareholder-employees yet that compensation as a percentage of net_income would be low because of the company's high income on the other hand a company with low net_income might pay virtually all of that income to its shareholder-employees in salaries that are unquestionably reasonable in acme constr co the net taxable_income was dollar_figure in the case at bar the net taxable_income is dollar_figure before deduction of the compensation at issue the difference in magnitude of the respective companies' net incomes makes the comparison of the relevant percentages of limited probative value we find that in this case the large portion of net_income paid in compensation to rogers is a factor that points to the conclusion that the compensation paid was in part unreasonable general economic conditions this factor helps to determine whether the success of a business is attributable to general economic conditions as opposed to the efforts and business acumen of the employees general economic conditions may affect a business' performance and indicate the extent if any of the employees' effect on the company mayson manufacturing co v commissioner f 2d pincite adverse economic conditions for example tend to show that an employee's skill was important to a company that grew during the bad years at trial petitioner presented expert witness testimony as to the reasonableness of rogers' compensation expert witness testimony is appropriate to help the court understand an area requiring specialized training knowledge or judgment fed r evid 93_tc_529 the court however is not bound by an expert's opinion we weigh an expert's testimony in light of his or her qualifications and with respect to all credible_evidence in the record depending on what we believe is appropriate under the facts and circumstances of the case we may either reject an expert's opinion in its entirety accept it in its entirety or accept selective portions of it 304_us_282 102_tc_149 petitioner's expert mr james v hughes hughes is an expert on compensation with arthur anderson co hughes testified at trial and submitted a report that he coauthored with bruce k benesh benesh benesh did not testify at trial petitioner's experts concluded that the compensation paid rogers was reasonable hughes based his conclusion on various sources one of which was relevant industry and compensation data this data according to hughes and benesh describes the economic conditions in which petitioner operated from through in their report hughes and benesh provided data they gathered from the tennessee board_of licensing health care facilities and the national association for home care washington d c the data shows that there were fewer licensed health care agencies in the state of tennessee in each year after for instance there were licensed health care agencies in the state of tennessee in in and in hughes interpreted this data to indicate that the health care industry was slowing down hughes and benesh attributed this slowing down to the increasing medicare paperwork and unreliable payment policies petitioner's gross_receipts net_income and retained earnings have increased every year since it is evident that petitioner was able to take advantage of the business opportunities that arose in the consolidating industry hughes and benesh attributed this ability to rogers' business acumen and knowledge of the industry although we agree that the data supports a finding that there were fewer health care agencies in the state of tennessee in each year after we note that more than percent of the consolidation occurred between and and less than percent of the consolidation occurred after furthermore hughes and benesh have provided no data on the status of the home health care industry in any of the other states in which petitioner does business significantly although hughes and benesh characterized the home care industry as contracting they provided no data that shows that the health care business actually was contracting instead of consolidating the data shows only that there were fewer home health care agencies not that there were fewer dollars spent on home health care in fact due to the changes in the regulations governing reimbursements to home health care agencies by medicare payment for a greater number of services was allowed which provided potential for increased revenue thus the data actually shows that each year there were fewer agencies operating in a business that had expanding at trial rogers gave the following testimony in response to petitioner's lawyer's questions and as a result of the number of home health industries q in the state of tennessee would you say that it was-- a q a it was a free-for-all --a competitive market it was a free-for-all thus rogers did not characterize the business conditions as competitive he chose instead to use a description that would not be unfamiliar to a 49'er participating in the california gold rush opportunities for greater revenues under these facts and circumstances we do not assume that a consolidation phase is a per se adverse economic condition for a business thus petitioner's evidence does not support a finding that the home health care business suffered from adverse economic conditions or that the home health care business was significantly more competitive in than it was in this factor points to the conclusion that the compensation paid rogers in was in part unreasonable comparison of salaries paid with distributions of retained earnings the failure to pay more than minimal dividends may suggest that reported compensation actually is in whole or in part a dividend owensby kritikos inc v commissioner f 2d pincite3 charles schneider co v commissioner f 2d pincite corporations however are not required to pay dividends shareholders may be equally content with the appreciation of their stock caused for example by the retention of earnings owensby kritikos inc v commissioner supra home interiors gifts inc v commissioner t c pincite in reviewing the reasonableness of an employee's compensation we often apply a hypothetical independent investor standard to determine whether a shareholder has received a fair return on investment after payment of the compensation in question owensby kritikos inc v commissioner supra pincite7 pulsar components intl inc v commissioner tcmemo_1996_129 rogers had sole discretion of whether to pay a dividend and the amount thereof petitioner paid dollar_figure in dividends in the year at issue although the amount of this dividend is a 150-percent return on the capital invested it is insignificant in comparison to petitioner's earnings a corporation's dividend policies should not however be viewed in a vacuum owensby kritikos inc v commissioner supra pincite7 the court should look at the total return the corporation is earning for its shareholders the prime indicator of which is the return on shareholders' equity id if the company's earnings on equity remain at a level that would satisfy an independent investor there is a strong indication that management is providing compensable services and that profits are not being siphoned out of the company disguised as salary 716_f2d_1241 9th cir revg tcmemo_1980_282 fn ref omitted petitioner's shareholder's equity grew from dollar_figure at yearend to dollar_figure at yearend to dollar_figure at yearend petitioner's total return on equity for the year at issue was dollar_figure percent this return is impressive and an in this case shareholder's equity is the sum of rogers' original capital_investment dollar_figure plus retained earnings return on equity is calculated after deducting all amounts paid as compensation thus total return on equity is the sum of the increase in shareholder's equity from yearend to yearend plus dividends_paid in divided by shareholder's equity at yearend independent investor would undoubtedly be satisfied with such a return this factor favors petitioner prevailing rates of compensation_for comparable positions in comparable concerns respondent's regulations provide that it is in general just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances sec_1_162-7 income_tax regs petitioner relied on its expert witnesses' testimony and reports for evidence on this factor petitioner submitted a report written by joe t fisher fisher in addition to the one coauthored by hughes and benesh petitioner's experts' reports although fisher does not specialize in executive compensation he is a member of the american college of health care executives and has held various executive positions in the health care industry since in his professional capacity fisher has become familiar with the various incentive plans that have been administered through various health care companies he has conducted studies and surveys of executive compensation and he has participated in the design of executive compensation plans in his report fisher concluded that the amount of compensation paid rogers in was reasonable fisher's report however contains several inaccuracies that cause this court to discount his opinion for instance in his report fisher stated that rogers personally designed and implemented a computer system for petitioner and that rogers was personally involved in the day-to-day operations of petitioner from the period of through rogers however testified to the contrary furthermore although fisher testified that he compared rogers' compensation to that paid to others in comparable positions he did not cite the sources for those comparisons in either his testimony or his report fisher's opinion does not appear to be based on verified factual data thus we accord fisher's opinion little weight see diverse indus inc v commissioner tcmemo_1986_84 petitioner's other experts hughes and benesh also submitted a written report the report coauthored by hughes and benesh states however that they were unable to locate any comparable survey data on home health care agency managers similar to petitioner hughes and benesh therefore were unable to perform a direct comparison nor were they able to identify individuals in a similar employment position with similar experience qualifications knowledge and responsibilities to those of rogers despite these obstacles hughes and benesh were able to create in their opinion a reasonable comparison by examining the specific functions performed by rogers and then comparing the compensation paid to rogers with that paid to the person performing functions similar to those performed by rogers thus hughes and benesh first compared rogers to a physician in comparing the compensation paid to rogers to the compensation paid to a physician hughes and benesh determined that rogers' average_annual_compensation was approximately percent of petitioner's total revenue whereas for a physician the average median compensation-to-production ratio i sec_40 percent and the compensation_for a physician in the 90th percentile i sec_59 percent which exceeds the percentage paid to rogers in in the alternative hughes and benesh compared rogers' position and compensation to that of a real_estate sales agent for this comparison hughes and benesh relied upon data provided in a report entitled real_estate profitability which was published by the national association of realtors hughes and benesh found that the median compensation_for real_estate agents who are paid on a sliding scale starts pincite percent of the commission paid_by the sellers to the real_estate broker and increases to percent on the basis of these comparisons compensation on a sliding scale is based upon the notion that a salesperson will receive a larger portion of the commission as her total dollar volume of sales increases hughes and benesh determined that rogers' compensation as a percentage of gross revenue was low we do not find hughes and benesh's opinion persuasive for the evidence of comparable salaries to be accorded any weight it must be shown that the salaried positions are actually comparable work responsibility nature of operations years in which the salary is paid and even the local cost of living may be taken into account see eg thomas a curtis m d inc v commissioner tcmemo_1994_15 diverse indus inc v commissioner tcmemo_1986_84 snyder bros co v commissioner tcmemo_1980_275 townsend v commissioner tcmemo_1980_264 the similarity hughes and benesh found between a physician and rogers was that both are in the health care business and that rogers performed his duties well with the support of several office professionals and nurses thus they concluded that just as a medical practice cannot exist without a physician without rogers petitioner's supporting staff would not perform their duties and petitioner would not exist this superficial comparison is specious and is accorded no weight hughes' and benesh's comparison of rogers' compensation to that of a real_estate agent is equally unpersuasive in their report hughes and benesh state that although real_estate agents and rogers perform similar functions in their jobs eg research the market for prospective buyers and sellers solicit business provide consulting expertise negotiate agreements with prospective clients and assist with paperwork rogers' compensation as a percentage of petitioner's gross revenue is much lower than the real_estate agents' median commission which i sec_55 to percent of the commission paid_by the seller to the real_estate broker petitioner's experts however ignore the fact that the industry publication that they relied upon for their data reports that the median amount of the net compensation paid to real_estate sales agents in the south in who are compensated on a sliding scale is approximately dollar_figure the amount of rogers' compensation in was dollar_figure thus although the amount of rogers' compensation is more than times greater than the median amount_paid to persons who according to hughes and benesh perform comparable functions hughes and benesh conclude that rogers' level of compensation is comparatively low previously we stated that the absolute probative value of measuring compensation as a percentage of income is often minimal when used as an isolated factor we do not find that the data the report also states that the typical established real_estate salesperson is a 49-year-old female who derive sec_67 percent of her household_income from the practice of residential real_estate brokerage we have not given any weight to these differences between the typical real_estate salesperson and rogers relied upon by hughes' and benesh's report supports their conclusion hughes' and benesh's total disregard of the actual amounts paid to those who in their opinion perform jobs requiring functions comparable to those required of rogers is suspect thus we find petitioner's experts' opinions of dubious value respondent's witness respondent chose not to rely upon an expert witness for an opinion and chose instead to rely upon revenue_agent horton to explain how he determined dollar_figure was the reasonable amount of compensation_for petitioner to pay rogers horton is not an expert on compensation horton based his determination of the compensation that would be reasonable upon his experience as an irs agent and some general statistics on the average compensation paid to an officer of a business of approximately the same size as petitioner there is no evidence that horton based his determination on the prevailing rates of compensation_for comparable positions in comparable concerns therefore we accord horton's testimony regarding this factor no weight this factor favors neither party we consider it neutral salary policy of petitioner as to all employees courts have considered salaries paid to other employees of a business in deciding whether compensation is reasonable kennedy v commissioner f 2d pincite home interiors gifts inc v commissioner t c pincite we look to this factor to determine whether rogers was compensated differently than petitioner's other employees solely because of his status as a shareholder petitioner deducted total compensation of dollar_figure in as a percentage of total compensation paid rogers received percent even though he constituted less than percent of petitioner's employeesdollar_figure furthermore of the total compensation paid to petitioner's seven key employees including rogers dollar_figure or dollar_figure percent was paid to rogersdollar_figure moreover the compensation of the highest paid nonshareholder worley wa sec_5 percent of the amount_paid to rogers the disparity between the compensation paid to the nonshareholders and that paid to the shareholder--rogers--is patent further exploration of this situation is required contingent_compensation paid under a longstanding arm's- length agreement will usually be upheld even if an incentive formula results in greater compensation than the parties anticipated at the time they entered into the contract owensby kritikos inc v commissioner f 2d pincite thus rogers' compensation was almost three times greater than the total compensation paid to all of the other employees thus rogers' compensation was more than six times the total amount_paid the other key employees elliotts inc v commissioner f 2d pincite kennedy v commissioner supra pincite rogers' bonus formula was established in the corporate minutes at the beginning of dollar_figure thus the bonus formula was not longstanding cf mayson manufacturing co v commissioner f 2d pincite bonus contracts basically unchanged since they were negotiated in held reasonable for taxable_year rogers is the percent shareholder of petitioner its director and its president rogers alone determined the salary and bonus compensation of every employee including himself thus rogers and petitioner were not dealing at arm's length see estate of wallace v commissioner t c pincite cf mayson manufacturing co v commissioner supra pincite bonus plan established by board_of directors for minority shareholders was an arm's-length_transaction where an employer and employee are not dealing at arm's length the amount of compensation may be unreasonable owensby kritikos inc v commissioner supra pincite elliotts inc v commissioner supra pincite petitioner notes on brief that respondent previously reviewed the bonus formula in the examination of petitioner's return the result of that examination was a dollar_figure refund and no adjustment was proposed to the deduction for compensation in rogers' base salary was dollar_figure in it was dollar_figure million in both years the bonus formula wa sec_50 percent of pretax profit by petitioner petitioner contends this fact is of particular importance in this case contrary to the position of petitioner we do not find that the fact respondent chose not to assert deficiencies in the prior examination is necessarily important or that it indicates that the irs accepted the manner in which compensation was determined see owensby kritikos inc v commissioner supra pincite cf mayson manufacturing co v commissioner supra pincite commission contract approved and accepted by the commissioner over a period of a number of years we note that rogers was paid total compensation of dollar_figure in compared to dollar_figure in the dramatic increase raised the stakes involved and thereby increased respondent's incentive to challenge the payments owensby kritikos inc v commissioner supra pincite n the great disparity between the amounts paid to the nonshareholders and the sole shareholder--rogers--and the fact that rogers' compensation plan was not the result of a longstanding arm's-length agreement point to the conclusion that the compensation paid rogers in was in part unreasonable amount of compensation paid to rogers in previous years we note at the outset that respondent concedes on brief that the maximum reasonable_compensation for rogers in is dollar_figure respondent arrived at this amount by calculating the percentage of gross_receipts that rogers received as compensation in percent--and applying that percentage to petitioner's gross_receipts petitioner contends that although rogers' compensation in wa sec_44 percent of that year's gross_receipts it is reasonable because when the percentage is averaged with the prior years' percentages the average percentage is dollar_figure percent which is almost the same percentage as the compensation respondent allowed in dollar_figure thus petitioner argues that the compensation paid rogers in was in part paid to compensate him for undercompensation in earlier years respondent counters that in making this argument petitioner in effect is seeking to deduct in compensation_for services performed by rogers in prior years rogers' compensation in and measured as a percentage of petitioner's gross_receipts in each of those years is and percent respectively the average of the percentages is dollar_figure percent we find however that petitioner's argument on this point is flawed from through petitioner paid rogers dollar_figure and petitioner's total gross_receipts for the same period were dollar_figure thus the total compensation paid to rogers as a percentage of petitioner's total gross revenue is dollar_figure percent if it was actually petitioner's intent to compensate rogers in for his service in the prior years by paying him percent of the gross_receipts it earned in those years petitioner would have paid rogers dollar_figure this amount is the total of percent of each prior year's gross_receipts less the amounts petitioner actually paid to him for each of those years plus percent of petitioner's gross_receipts x dollar_figure - dollar_figure x dollar_figure - dollar_figure x dollar_figure - dollar_figure x dollar_figure - dollar_figure x dollar_figure respondent correctly acknowledges that it is well settled that under some circumstances reasonable additional compensation of officers for services rendered in prior years is deductible from the corporation's income for the year in which paid 281_us_115 however a taxpayer claiming that part of the payment to an officer in the current_year is for services rendered for prior periods must show the insufficiency of the officer's compensation in the previous year and the amount of the current year's compensation that was intended as compensation_for that underpayment pacific grains inc v commissioner f 2d pincite estate of wallace v commissioner supra pincite pulsar components intl inc v commissioner tcmemo_1996_129 we have found as a fact that the dollar_figure increase in rogers' base salary was intended to compensate him for service in prior years therefore it is only the first prong that is at issue respondent denies that rogers was undercompensated in prior years in support of his position respondent notes that in rogers' compensation was very nearly one-half of petitioner's taxable_income and that in and it was more than one-half moreover respondent argues that as petitioner paid rogers more than dollar_figure million over those years rogers could not have been undercompensated in rogers rejected a job that offered to pay him in excess of dollar_figure million a year to manage a home health care division instead rogers went to work for petitioner in managing its home health care business petitioner paid rogers dollar_figure dollar_figure dollar_figure and dollar_figure in and respectively it is evident therefore that rogers was underpaid in each of those years thus we find that petitioner has met its burden of proving that part of the compensation paid rogers in was intended to compensate him for services he performed prior to conclusion we come to the point where we must use our best judgment after weighing the evidence to reconcile and integrate the factors discussed above and reach our ultimate conclusion because of all the factors and circumstances here present we have given the issue herein a close scrutiny with the result that we agree with neither petitioner nor respondent on the basis of our examination of the entire record we hold that dollar_figure million constituted reasonable_compensation to rogers for personal services rendered to petitioner in and prior years issue accuracy-related_penalty under sec_6662 respondent determined an accuracy-related_penalty under sec_6662 against petitioner for equal to percent of the tax_deficiency sec_6662 provides that if any portion of an underpayment_of_tax is attributable to any one of the factors listed in sec_6662 then there shall be added to the tax an amount equal to percent of the amount of the underpayment to which it is so attributable petitioner has the burden of proving that respondent's determination of the penalty is erroneous rule a welch v helvering u s pincite petitioner did not address the sec_6662 penalty issue at trial or on brief therefore it failed to carry its burden_of_proof and we sustain respondent's determination of the penalty for to reflect the foregoing decision will be entered under rule


t c summary opinion united_states tax_court fletcher h hyler petitioner v commissioner of internal revenue respondent docket no 11078-13s filed date fletcher h hyler pro_se sarah e sexton for respondent summary opinion panuthos chief special_trial_judge this case was heard pursuant to the provisions of sec_7463 of the internal_revenue_code in effect when the petition was filed pursuant to sec_7463 the decision to be entered is not unless otherwise indicated subsequent section references are to the continued reviewable by any other court and this opinion shall not be treated as precedent for any other case respondent determined a deficiency of dollar_figure in petitioner’ sec_2010 federal_income_tax and an accuracy-related_penalty under sec_6662 of dollar_figure after concessions by petitioner the only issue in dispute is a new issue that he raised as to whether he is entitled to a claimed casualty_loss deduction for destruction of personal_property in a fire background some of the facts have been stipulated and they are so found we incorporate by reference the parties’ stipulations of fact and the accompanying exhibits petitioner resided in california when the petition was filed before petitioner and his wife resided in a single-family three-bedroom house in woodside california petitioner and his wife were tenants and paid monthly rent on date while petitioner and his wife were away visiting friends a fire continued internal_revenue_code in effect for the year in issue and all rule references are to the tax_court rules_of_practice and procedure at the commencement of trial petitioner conceded all the adjustments in the notice_of_deficiency destroyed the house and its contents the woodside fire protection district reported that the fire likely started in the kitchen but did not state a specific cause petitioner believes that the fire may have started because of rodents and or faulty electrical wiring immediately after the fire petitioner and his wife stayed at a motel but they later moved into another rental property petitioner’s personal_property was insured through a policy with state farm insurance co the insurance policy’s limit on recovery was dollar_figure petitioner and his wife received a dollar_figure payment from the insurance_company a few weeks after the fire before petitioner worked as a self-employed consultant creating and consulting in marketing processes petitioner also taught a marketing course at stanford university in approximately petitioner declared bankruptcy as a result of a downturn in the economy petitioner received a discharge_in_bankruptcy a few years later in date piers n p mackenzie an appraiser and auctioneer prepared an appraisal report authorized by the bankruptcy trustee the report reflected a total value for artwork of dollar_figure and furniture and decorative arts of dollar_figure totaling dollar_figure petitioner presented other documents to respondent in which petitioner valued artwork furnishings and other personal_property at approximately dollar_figure million after the fire petitioner and his wife made a claim against the landlord’s insurance_company the claim was denied and at some point petitioner and his wife filed a lawsuit with the superior court of california county of san mateo in the case against the landlord was set for trial in date petitioner indicated that meetings had been scheduled for the purpose of conducting mediation of the claim against the landlord and the landlord’s insurer petitioner filed a married filing separate tax_return for the taxable_year as indicated earlier petitioner has conceded all the adjustments set forth in respondent’s notice_of_deficiency petitioner submitted to respondent a form 1040x amended u s individual_income_tax_return for the return reflects a signature and date of date also part of the record is a copy of petitioner’s form_1040 u s individual_income_tax_return for reflecting a signature and date of date petitioner claimed a casualty_loss of there is some discussion in the record about ownership of the personal_property petitioner asserted that under california community_property law one- half of the personal_property was owned by his wife given our conclusions infra we need not make any findings with respect to ownership of the personal_property as between petitioner and his wife dollar_figure on the return and seeks to carry back some portion of the loss to the year in issue discussion in general the commissioner’s determination set forth in a notice_of_deficiency is presumed correct and the taxpayer bears the burden of proving that the determination is in error rule a 290_us_111 pursuant to sec_7491 the burden_of_proof as to factual matters shifts to the commissioner under certain circumstances petitioner did not allege or otherwise show that sec_7491 applies see sec_7491 and b therefore petitioner bears the burden_of_proof see rule a the court may consider facts relating to tax for years that are not otherwise within the court’s jurisdiction where necessary to correctly redetermine the amount of the tax_deficiency for any year properly before the court see sec_6214 in particular in redetermining the amount of a deficiency for a taxable the record is somewhat incomplete in that respondent refers to a second form 1040x which is not made part of the record further petitioner does not make clear the extent to which he seeks to carry back the claimed casualty_loss to or any other year for reasons discussed infra we need not make any findings with respect to these matters to the extent respondent determined omitted income the presumption of correctness does not play any role in our decision year before the court we may decide the correct amount of a net_operating_loss_carryover or carryback claimed with respect to the year in issue notwithstanding that the loss arose in a year that is not within the court’s jurisdiction 95_tc_257 as a general_rule sec_165 allows as a deduction any loss sustained during the taxable_year and not_compensated_for_by_insurance_or_otherwise in the case of an individual however sec_165 limits the deduction to losses_incurred in a trade_or_business losses_incurred in any transaction entered into for profit and losses of property not connected with a trade_or_business or with a transaction entered into for profit if such losses arise from fire storm shipwreck or other_casualty or from theft a loss is treated as sustained during the taxable_year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable_year sec_1_165-1 income_tax regs see also sec_1_165-1 income_tax regs however if there exists a claim for reimbursement with respect to which there is a reasonable_prospect_of_recovery no portion of a loss with respect to which reimbursement may be received is sustained until it can be ascertained with reasonable certainty whether such reimbursement will be received sec_1_165-1 income_tax regs for eligible losses an individual may carry back a net_operating_loss to each of the three taxable years preceding the taxable_year of such loss sec_172 f i an eligible_loss includes a loss arising from fire sec_172 the parties stipulated to the authenticity of various documents relating to the personal_property destroyed by the fire and the purported value of each item petitioner also testified as to the values of certain items and asserted that the appraiser’s valuations were inaccurate and did not represent the fair market values we need not delve into the issues of whether petitioner substantiated the amount of the loss or whether he made a proper carryback claim since we conclude that he is not otherwise entitled to the claimed casualty_loss deduction petitioner made clear during the trial of this case in that legal proceedings were being pursued against the landlord and the landlord’s insurance_company thus in the year of the fire and at the time of trial there existed a claim for reimbursement which petitioner was actively pursuing the statute and the regulations are clear that a loss is not considered sustained until it can be ascertained with reasonable certainty whether such reimbursement will be received sec_1_165-1 income_tax regs a casualty_loss is not recognized in the year of actual occurrence if there exists at that time a reasonable_prospect_of_recovery on a claim for reimbursement the settlement the adjudication or the abandonment of the claim ordinarily constitutes the event sufficient to render the loss sustained with the meaning of sec_165 65_tc_351 petitioner’s claim for reimbursement from the fire was not resolved in in fact at the time of trial in early petitioner was involved in the litigation seeking reimbursement for the claimed loss from the fire we conclude that petitioner sustained no lo sec_2012 evidenced by a closed and completed transaction on the basis of the foregoing we conclude that petitioner is not entitled to the claimed casualty_loss deduction and cannot carry back the claimed loss to respondent’s determination in the notice_of_deficiency which petitioner conceded is sustained and petitioner’s claim for a carryback loss deduction is denied in full we have considered the parties’ arguments and to the extent not discussed herein we conclude the arguments to be irrelevant moot or without merit to reflect the foregoing decision will be entered for respondent


internal_revenue_service national_office technical_advice_memorandum date number release date index uil no case mis no tam-115287-01 cc ita b5 director field operations taxpayer's name taxpayer's address taxpayer's identification no year involved date of conference legend taxpayer district_court patentholder unit year year year year year year year amount dollar_figure tam-115287-01 amount dollar_figure amount dollar_figure amount dollar_figure amount dollar_figure amount dollar_figure amount dollar_figure amount dollar_figure month issue whether taxpayer is eligible for the benefits of sec_1341 for the payment of damages in a patent infringement lawsuit facts from year to year taxpayer produced and sold over units amounting to sales in excess of amount dollar_figure in year patentholder filed a patent infringement lawsuit in district_court in its lawsuit against taxpayer patentholder alleged that taxpayer’s manufacture and sale of the units infringed certain patents of patentholder and therefore violated u s c sec_271 under u s c whoever without authority makes uses offers to sell sells or imports any patented invention infringes the patent under u s c damages for patent infringement are an amount adequate to compensate for the infringement but in no event less than a reasonable royalty for the use made of the invention by the infringer the district_court determined that taxpayer did not infringe upon patentholder’s patents on appeal the district court’s ruling was reversed ultimately taxpayer was ordered to pay patentholder the sum of amount dollar_figure constituting damages and pre- judgment interest in the respective amounts of amount dollar_figure and amount dollar_figure the district_court further ordered that the court files be sealed in the fiscal_year ending month year fye year taxpayer paid the amount awarded to patentholder taxpayer claims that the damages paid to patentholder are based upon a reasonable royalty tam-115287-01 for fye year taxpayer allocated the damages on an annual basis to tax years year through year and computed its income_tax_liability by applying sec_1341 for the tax years year through year the years of the infringement for which the rate applicable for fye year was different from the rates applicable for those years in applying sec_1341 taxpayer determined its tax_liability for fye year to be amount dollar_figure without the benefit of sec_1341 taxpayer’s liability for fye year would have been amount dollar_figure law sec_1341 of the code provides that if an item was included in gross_income for a prior taxable_year or years because it appeared that the taxpayer had an unrestricted right to such item a deduction is allowable for the taxable_year because it was established after the close of such prior taxable_year or years that the taxpayer did not have an unrestricted right to such item or to a portion of such item and the amount of such deduction exceeds dollar_figure then the tax imposed by this chapter for the taxable_year shall be the lesser_of the tax for the taxable_year computed with such deduction or the tax for the taxable_year computed without such deduction minus the decrease in tax under this chapter for the prior taxable_year or years which would result solely from the exclusion of such item or portion thereof from gross_income for such prior taxable_year or years sec_1_1341-1 of the income_tax regulations provides that a taxpayer is entitled to the benefits of sec_1341 of the code if the taxpayer is entitled to a deduction of more than dollar_figure because of the restoration to another of an item which was included in the taxpayer’s gross_income for a prior taxable_year or years under a claim of right sec_1_1341-1 of the regulations provides that income included under a claim of right means an item included in gross_income because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to such item also this section provides that the phrase restoration to another means a restoration resulting because it was established after the close of the prior taxable_year or years that the taxpayer did not have an unrestricted right to all or a portion of the item included in gross_income analysi sec_1 whether taxpayer is entitled to a deduction with respect to the damages payment sec_162 provides that a taxpayer may deduct all ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying_on_a_trade_or_business amounts a taxpayer pays as civil damages arising out of the ordinary conduct of its business are generally deductible under sec_162 79_f2d_358 9th cir in the context of patent infringement litigation the sixth tam-115287-01 circuit observed that when an infringer is required to pay damages to a design patentee the amount so paid is deductible from his income_tax 620_f2d_1166 6th cir in the present case taxpayer’s damage payment for patent infringement satisfies the general requirements of sec_162 because taxpayer is in the business of manufacturing and selling units the acts of patent infringement arose directly out of the conduct of its business and the damage payment was both an ordinary_and_necessary_expense taxpayer alleges that the payment of patent infringement damages is deductible under sec_165 as losses rather than as ordinary and necessary business_expenses under sec_162 sec_165 allows a deduction for any loss sustained during the taxable_year and not_compensated_for_by_insurance_or_otherwise there is no specific test to distinguish a loss under sec_165 from an ordinary or necessary business_expense under sec_162 however in the present case taxpayer’s damage payment satisfies the ordinary and necessary requirement of sec_162 also case law does not support the taxpayer’s argument that the damage payment constitutes a loss under sec_165 7_f2d_3 2nd cir cited by taxpayer is contrary to the weight of authority and consequently unpersuasive taxpayer’s situation is factually distinguishable from becker brothers for two reasons the question of whether the damages were properly characterized as an inventory cost was not at issue in becker brothers the case involved the question of whether the damages could even be taken into account in computing taxable_income and the damages paid_by taxpayer were not based on taxpayer’s profits but a reasonable royalty sec_162 business deductions are subject_to the exceptions provided in part ix sec_261 and following relating to items not deductible under sec_261 no deduction is allowed for costs described in sec_263a sec_263a requires a taxpayer to include in inventory costs all direct and indirect_costs associated with the production of property that is inventory in the hands of the taxpayer direct and indirect_costs must be included in inventory costs under sec_263a even though these costs would otherwise be deductible under some other section of the code eg sec_162 for ordinary and necessary business_expenses sec_1_263a-1 provides that c osts that are capitalized under sec_263a are recovered through depreciation amortization cost_of_goods_sold or by an adjustment to basis at the time the property is used sold placed_in_service or otherwise_disposed_of by the taxpayer emphasis added direct and indirect_costs for which a deduction would be allowed absent the applicability of sec_263a are not deducted but recovered through cost_of_goods_sold sec_1_263a-1 provides that the indirect_costs required to be included in inventory costs under sec_263a include royalties incurred in securing and maintaining the right to use a manufacturing procedure associated with property produced in plastic engineering v commissioner tcmemo_2001_324 the taxpayer tam-115287-01 failed to allocate any payments made under a royalty agreement to inventory costs instead the taxpayer deducted the entire amount the tax_court held that royalty payments incurred for_the_use_of a patent are indirect_costs of the goods manufactured using the patent and therefore subject_to the uniform_capitalization_rules under sec_263a according to taxpayer’s factual assertion the patent infringement damages in this case are based upon a reasonable royalty since the amount of the damages are based upon a reasonable royalty without regard to the infringer’s profits the damages are analogous to a royalty for_the_use_of a manufacturing procedure royalties for_the_use_of a manufacturing procedure associated with property produced must be included in inventory costs see sec_1_263a-1 plastic engineering supra because the patent infringement damages incurred by taxpayer are analogous to a royalty payment for_the_use_of a manufacturing procedure associated with property produced by taxpayer the damages must be included in inventory costs under sec_263a in order for sec_1341 to apply to the payment of an item a deduction must be allowable for the item sec_1341 since these damages must be included in inventory costs under sec_263a they are not deducted but instead are recovered through cost_of_goods_sold see sec_1_263a-1 as a result sec_1341 does not apply to the patent infringement damages paid_by taxpayer taxpayer argues that the patent infringement damages are deductions for purposes of applying sec_1341 because cost_of_goods_sold is a deduction from gross_income and to retroactively capitalize inventory costs would be inconsistent with the matching principles underlying sec_263a in support of its position taxpayer quotes from plastic engineering according to the tax court’s summation of the service’s argument the service contends that the royalty payments incurred by petitioner are subject_to the capitalization_rules of sec_263a and that the payments must be deducted over time through cost_of_goods_sold plastic engineering tcmemo_2001_324 emphasis added however the service did not argue in plastic engineering and we do not interpret the court’s statement as holding that cost_of_goods_sold is a deduction as stated above costs included in inventory under sec_263a are not deducted but are recovered through costs of goods sold sec_1341 inventory exception even if taxpayer was entitled to a deduction with respect to the patent infringement damages payment taxpayer would be precluded from obtaining the benefits of sec_1341 by the inventory exception of sec_1341 tam-115287-01 sec_1341 provides that sec_1341 does not apply to any deduction allowable with respect to an item which was included in gross_income by reason of the sale_or_other_disposition of stock_in_trade of the taxpayer or other_property of a kind which would properly have been included in the inventory of the taxpayer if on hand at the close of the prior taxable_year or property held by the taxpayer primarily_for_sale_to_customers in the ordinary_course_of_his_trade_or_business sec_1_1341-1 of the regulations provides sec_1341 and this section do not apply to deductions attributable to items which were included in gross_income by reason of the sale_or_other_disposition of stock_in_trade of the taxpayer or other_property of a kind which would properly have been included in the inventory of the taxpayer if on hand at the close of the prior taxable_year or property held by the taxpayer primarily_for_sale_to_customers in the ordinary course of the taxpayer’s trade_or_business this section is therefore not applicable to sales returns and allowances and similar items taxpayer interprets sec_1_1341-1 of the regulations to mean that sec_1341 is limited to sales returns and allowances and similar items and therefore does not disallow it from claiming sec_1341 treatment with respect to the sales proceeds of the infringing products the plain language of the statute and the regulations does not support taxpayer’s conclusion the statutory language of sec_1341 is very broad and in no way limits the application of the inventory exception to sales returns and allowances and similar items further we interpret the first sentence of sec_1_1341-1 as equally broad the second sentence of the regulation merely provides examples of the inventory exception and does not constitute the entire rule thus even if the patent infringement damages otherwise met the requirements of sec_1341 the application of sec_1341 to the taxpayer’s patent infringement damages payment would be disallowed under the sec_1341 inventory exception because the profits from the infringing products were included in the gross_income of taxpayer by reason of the sale_or_other_disposition of stock_in_trade or property held by taxpayer primarily_for_sale_to_customers in the ordinary course of taxpayer’s business conclusion taxpayer is not eligible for the benefits of sec_1341 for the payment of patent infringement damages because taxpayer is not entitled to a deduction with respect to that payment even if taxpayer were not otherwise precluded from using sec_1341 the sec_1341 inventory exception would prohibit its use for taxpayer’s patent infringement damages a copy of this technical_advice_memorandum is to be given to the taxpayer sec_6110 of the code provides that it may not be used or cited by others as precedent