Elliotts, Inc. v. Commissioner

1980 T.C. Memo. 282, 40 T.C.M. 802, 1980 Tax Ct. Memo LEXIS 302

• Court: United States Tax Court
• Decided: July 30, 1980
• Docket: Docket No. 10576-78.
• Status: Unpublished

Opinion

ELLIOTTS, INC. Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Elliotts, Inc. v. Commissioner

Docket No. 10576-78.

United States Tax Court

T.C. Memo 1980-282; 1980 Tax Ct. Memo LEXIS 302; 40 T.C.M. (CCH) 802; T.C.M. (RIA) 80282;

July 30, 1980, Filed; Reversed and Remanded September 26, 1983

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William H. Adams and Glen E. Clark, for the petitioner.

Dan A. Lisonbee, for the respondent.

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SCOTT

MEMORANDUM FINDINGS OF FACT AND OPINION

SCOTT, Judge: Respondent determined deficiencies in petitioner's income tax for its fiscal years ending February 28, 1975, and February 28, 1976, in the amounts of $58,159.91 and $62,507.38, respectively. Some of the issues raised by the pleadings have been disposed of by the parties, leaving for our decision whether petitioner is entitled to deduct any amount in excess of $65,000 in each of its fiscal years 1975 and 1976 for compensation paid to its sole stockholder, chief executive officer, Mr. Edward G. Elliott.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Elliotts, Inc. (petitioner), an Idaho corporation formed in 1952, had its principal place of business in Burley, Idaho at the time of the filing of its petition in this case. Petitioner filed corporate Federal income tax returns for its fiscal years ending February 28, 1975, and February 28, 1976.

Petitioner's principal business is selling equipment manufactured by John Deere Company and servicing the equipment it sells as well as other equipment. During the years here in issue petitioner had the following contracts with John Deere Company:

(a) John Deere Agricultural Dealer Agreement.

(b) John Deere Agricultural Security Agreement.

(c) John Deere Consumer Products Agreement.

(d) John Deere Agricultural D.R.V. Leasing Agreement.

(e) John Deere Industrial Construction Equipment Agreement.

(f) John Deere Industrial Utility Equipment Agreement.

(g) John Deere Forestry Equipment Agreement.

Petitioner had two business locations during the years here in issue, one in Burley, Idaho and one in Idaho Falls, Idaho. The business located in Burley, Idaho dealt in both agricultural and industrial equipment, while the business located in Idaho Falls dealt only in industrial equipment. Of the approximately 168 John Deere agricultural dealers in Zone 11, which includes the states of California, Nevada, Arizona, Utah, Oregon, Washington and Idaho, only three, including petitioner, were dealers in both agricultural equipment and industrial equipment. On March 1, 1975, petitioner sold its business located in Idaho Falls, Idaho to the Elliott Industrial Company and thereafter maintained only the business location in Burley, Idaho.

When petitioner was initially incorporated in 1952, Mr. Elliott was not the sole stockholder. However, in 1954 he bought the interest of the other stockholder in petitioner and has since that time been petitioner's sole stockholder. Mr. Elliott has been petitioner's chief executive officer since its incorporation.

For the first year after its incorporation petitioner sold only agricultural equipment in the Burley, Idaho area and had annual gross sales of approximately $500,000. At that time petitioner employed approximately 8 people. In its fiscal year ending February 28, 1975, petitioner was employing approximately 40 people, selling several lines of equipment, both agricultural and industrial, throughout southeast Idaho and had gross annual sales of over $5 million.

Mr. Elliott was born and reared in Boise, Idaho. He graduated from the University of Idaho in 1938 with a degree in Political Science. Shortly after finishing college he was employed by the Water Resource Branch of the Geological Survey and thereafter was a junior officer in a Civilian Conservation Corps camp in Idaho. Later he became a company commander in the Civilian Conservation Corps and remained in this position until he entered the military service during World War II. Following his releases from active duty in World War II, Mr. Elliott worked for approximately 5 years for the Veterans' Administration in Twin Falls, Idaho. When he resigned from the Veterans' Administration he, together with another person, purchased the John Deere dealership in Burley, Idaho and incorporated the business which is now Elliotts, Inc. In addition to being the president and general manager of petitioner since 1952, Mr. Elliott has participated in a number of civic and other activities including being chairman of the Small Business Advisory Committee for the State of Idaho and president of the Burley Chamber of Commerce and the South Idaho Chamber of Commerce.

Until 1959, petitioner dealt solely in agricultural equipment, but in 1959 began to handle industrial equipment manufactured by John Deere Company. During the years here in issue, as well as the years prior thereto, Mr. Elliott had the total final managerial responsibility for the business of petitioner. During these years petitioner had the following employees, in addition to Mr. Elliott, at its location in Burley, Idaho:

1 Office Supervisor

2-3 Agricultural Salesmen

2-3 Office Employees

1 Parts Manager

2 Parts Employees

1 Industrial Salesman

10-12 Agricultural Mechanics

6-7 Industrial Mechanics

Approximately 28 employees

For its fiscal year ending February 28, 1975, petitioner had the following employees, in addition to Mr. Elliott, at its location in Idaho Falls, Idaho:

1 Division Manager

2 Salesmen

2 Office Employees

1 Service Manager

7-9 Mechanics

Approximately 15 employees

For the years in issue and for several years prior thereto Mr. Elliott was paid a base salary of $2,000 a month and in addition received a bonus at the end of each fiscal year. The bonus was based on a predetermined formula which had been in use since the incorporation of petitioner and represented 50 percent of net profits because deductions for income taxes and management bonuses. Mr. Elliott's employment contract was not in writing and the provision for the bonus was not in writing and had no time period or other limitations as to the amount of the bonus. The following schedule shows the amounts which Mr. Elliott has been paid by petitioner as president and general manager of petitioner for its fiscal years ending February 28, 1968, through February 28, 1978:

Fiscal Year Ending	Total Compensation
February 28	Paid to Mr. Elliott
1968	$ 42,800
1969	19,600
1970	34,035
1971	84,450
1972	68,323
1973	66,401
1974	136,536
1975	181,074
1976	193,663
1977	153,696
1978	83,052

During each of the years here in issue and for many years prior thereto, Mr. Elliott worked for petitioner from approximately 8 a.m. to 6 p.m., 6 days a week. Generally he worked approximately 80 hours a week. Mr. Elliott, as chief executive officer of petitioner, not only performed the functions of general manager but also most of the functions of sales manager and credit manager, and he made all policy decisions with respect to the parts and service department.

For each of its fiscal years ending February 28, 1968 through 1978, petitioner's net profits have been as follows:

Fiscal Year Ending		After Tax
February 28	Net Profits *	Profits
1968	$ 25,090	$19,715
1969	5,635	4,206
1970	27,042	19,190
1971	77,569	43,934
1972	59,873	36,713
1973	57,951	37,268
1974	112,536	63,674
1975	157,074	88,969
1976	169,663	98,297
1977	129,696	78,250
1978	59,052	42,860

The annual return realized by petitioner for each of its fiscal years ending February 28, 1968, through February 28, 1978, on its equity based on total pre-tax income and on after tax profits separately for its agricultural operations and industrial operations, with invested capital allocated between the two on the basis of sales, was as follows:

		Percent of	Percent of	Percent of
Fiscal Year		Annual Return	Annual Return	Annual Return
Ending		on After Tax	on Agricultural	on Industrial
February 28	Equity *	Profits	Pre-Tax Income	Pre-Tax Income
1968	$130,387	15	20.47	Not shown
1969	131,518	3	4.28	Not shown
1970	149,442	13	18.10	Not shown
1971	192,708	23	40.25	Not shown
1972	226,629	16	26.42	Not shown
1973	263,030	14	24.51	19.31
1974 **	326,441	20	34.47	34.47
1975	415,133	21	120.43	(49.88)
1976	513,429	19	35.61	24.23
1977	590,597	13	13.42	12.66
1978	633,496	7	(6.96)	39.50

For its fiscal year 1975 petitioner's industrial equipment as contrasted with its agricultural equipment operations in Burley, Idaho and Idaho Falls, Idaho incurred losses. The following schedule shows the income, costs and expenses of the industrial equipment operation of petitioner at Burley and Idaho Falls:

	Burley	Idaho Falls
Total Sales	$1,049,235.98	$1,191,166.01
Cost of Sales	950,287.86	1,086,563.20
Gross Margin	98,948.12	104,602.81
Other Income	53,945.85	47,328.57
	152,893.97	151,931.38
Operating Expenses	230,656.24	161,987.22
Net Loss	($ 77,762.27)	($ 10,055.84)

In its fiscal years 1975 and 1976, petitioner paid bonuses to employees other than Mr. Elliott totaling $20,000 and $25,000 respectively. All of the employees of petitioner participated to some extent in these bonuses, the amount being determined by a vote of the board of directors and not by a preset formula as was the case of the bonus to Mr. Elliott. The following schedule shows the salaries paid to petitioner's key employes, other than Mr. Elliott, during its fiscal years 1975 and 1976:

Position	Annual Salary
Industrial Salesman	$36,471
Office Supervisor	20,666
Shop Foreman (Agricultural)	24,702
Parts Manager	13,362

During its fiscal year 1975, petitioner paid a salary of $15,253 to the division manager at Idaho Falls.

Since its incorporation in 1952, petitioner has never paid a dividend to its shareholder, Mr. Elliott.

For its fiscal years ending February 28, 1968 through 1972, petitioner did not account separately for its industrial sales and agricultural sales and related expenses. For this period petitioner's sales, compensation paid to Mr. Elliott, the percentage of compensation paid to Mr. Elliott of total sales, compensation paid to all employees, other than service labor, and the percentage of compensation paid to all employees of total sales were as follows:

Fiscal Year		Compensation	Percent
Ending		Paid to	of
February 28	Sales	Officer	Sales
1968	$1,779,989	$42,800	2.40
1969	1,603,661	19,600	1.22
1970	2,760,991	34,035	1.23
1971	2,797,767	84,450	3.02
1972	3,637,614	68,323	1.88

	Total
Fiscal Year	Compensation	Percent
Ending	Paid to All	of
February 28	Employees	Sales
1968	$ 97,317	5.47
1969	79.443	4.95
1970	114,261	4.14
1971	186,178	6.65
1972	194,914	5.36

Beginning with its fiscal year ending February 28, 1973, and for all years thereafter, petitioner accounted for industrial sales and agricultural sales separately.

For its fiscal years ending February 28, 1973, through February 28, 1978, petitioner's sales of agricultural equipment, the compensation paid to Mr. Elliott allocated to agricultural sales based on the percentage of agricultural sales to total sales, the percentage of compensation so computed paid to Mr. Elliott to agricultural sales, the compensation paid to all employees, other than service labor, allocated to agricultural sales, and the percentage of such total compensation paid to all employees to agricultural sales, were as follows:

Fiscal Year		Compensation	Percent
Ending		Paid to	of
February 28	Sales	Officer	Sales
1973	$2,127,471	$ 34,727	1.63
1974	3,486,313	107,099	3.07
1975	3,042,791	104,286	3.43
1976	3,467,758	150,001	4.33
1977	3,558,513	119,149	3.35
1978	3,052,209	58,518	1.92

	Total
Fiscal Year	Compensation	Percent
Ending	Paid to All	of
February 28	Employees	Sales
1973	$117,889	5.54
1974	244,377	7.01
1975	219,089	7.20
1976	280,269	8.08
1977	262,849	7.39
1978	185,661	6.08

For its fiscal years ending February 28, 1973, through February 28, 1978, petitioner's sales of industrial equipment, the compensation paid to Mr. Elliott allocated to industrial sales based on the percentage of industrial sales to total sales, the percentage of compensation so computed paid to Mr. Elliott to industrial sales, the compensation paid to all employees, other than service labor, allocated to industrial sales, and the percentage of total compensation paid to all employees to industrial sales were as follows:

Fiscal Year		Compensation	Percent
Ending		Paid to	of
February 28	Sales	Officer	Sales
1973	$1,940,440	$31,674	1.63
1974	958,241	29,437	3.07
1975	2,240,401	76,786	3.43
1976	1,009,378	43,661	4.33
1977	1,031,789	34,547	3.35
1978	1,279,659	24,533	1.92

	Total
Fiscal Year	Compensation	Percent
Ending	Paid to All	of
February 28	Employees	Sales
1973	$107,525	5.54
1974	67,169	7.01
1975	161,315	7.20
1976	81,579	8.08
1977	76,212	7.39
1978	77,839	6.08

Since 1967, John Deere Company has published an annual Dealer Comparative Management Review. From 1967 through 1971, John Deere Company did not separate industrial and agricultural dealers in this review, but after 1971 a separate review was published for agricultural and industrial dealers. Included in these reviews were statistical summaries of the operations of the dealers covered by the report, including profitability, return on equity, compensation paid to all employees, compensation paid to officers, owners and managers, and sales. The agricultural dealers are separated by regions and then further separated based on the sales volume of the dealer. In this review industrial dealers are separated by region and also separated by sales volume. However, the dealers by region are not further separated based on the sales volume of the dealers. These statistics are compiled from reports submitted by the dealers to John Deere Company. Not all dealers are included in the survey, but over one-half of the dealers are included. All dealers are required to submit these reports. The statistics from the "operation analysis" are based on tax-adjusted information which is submitted during the first 3 or 4 months of the following year. The statistics from the "employee analysis" are gathered in November and December and are based on a different sample than the "operation analysis" statistics. The information for the "employee analysis" is obtained by John Deere Company by surveys sent to all John Deere dealers. The response to these surveys is voluntary by the various dealers. Because the information is compiled in November and December, the salary information may or may not reflect bonuses paid to employees. The dealers included in the sample used for the "operation analysis" are dealers who have adopted the John Deere accounting system. Also, an attempt is made to exclude from the sample those dealers which handle both agricultural and industrial equipment. Because petitioner did not adopt the John Deere accounting system until its fiscal year ending February 28, 1975, it would not have been included in the "operation analysis" sample for the calendar years through 1975. Also, because petitioner handled both agricultural and industrial equipment it was probably excluded from the sample for subsequent years.

The classification contained in the "operation analysis" headed "Salary and Compensation Paid to Officers, Owners and Managers" generally includes the compensation to owners, corporate officers, general managers, sales managers, parts managers, service managers and possibly other management personnel. However, some reporting dealers do not include all of these employees within the classification. John Deere Company imposes no guidelines in this regard.

Based on statistics compiled and published by John Deere Company in its "operation analysis," the following schedule shows the average total sales, average compensation paid to officers, owners and managers, the percentage of compensation paid to such officers of sales, the average total compensation paid to employees, other than service labor, and the percentage of such compensation to sales for John Deere agricultural dealers located in Zone 11 which had total sales of $800,000 or above for the calendar years 1967 through 1973:

		Average
		Compensation
		Paid to
		Officers,	Percent
Calendar	Average	Owners and	of
Year	Sales	Managers	Sales
1967	$1,155,308	$20,889	1.81
1968	1,318,883	32,134	2.44
1969	1,106,663	27,090	2.45
1970	1,237,612	47,797	3.86
1971	1,499,603	48,524	3.24
1972	1,403,268	43,749	3.12
1973	2,273,230	75,127	3.30

	Average Total
	Compensation	Percent
Calendar	Paid to All	of
Year	Employees	Sales
1967	$ 56,818	4.92
1968	79,902	6.06
1969	64,310	5.81
1970	100,245	8.10
1971	107,263	7.15 *
1972	96,613	6.88
1973	153,312	6.74

The following schedule shows the information compiled by John Deere Company in its "operation analysis" for the years 1974 through 1977 for agricultural dealers located in Zone 11 with sales comparable to petitioner's, for total compensation paid to officers with the percentage of such compensation to sales, and total compensation paid to all employees with the percentage of such compensation to sales:

		Average
		Compensation
		Paid to
		Officers,	Percent
Calendar	Average	Owners and	of
Year	Sales	Managers	Sales
1974	$3,073,860	$117,899	3.84
1975	3,817,313	130,067	3.41
1976	4,660,968	138,988	2.98
1977	4,177,737	149,512	3.58

	Average Total
	Compensation	Percent
Calendar	Paid to All	of
Year	Employees	Sales
1974	$213,377	6.95 *
1975	241,352	6.32
1976	283,407	6.08
1977	281,780	6.74

The above information was compiled from agricultural dealers with sales in excess of $1,367,000 for 1974, $1,871,000 for 1975, $2,358,600 for 1976, and $2,568,800 for 1977.

The following schedule lists the indicated information compiled by John Deere Company in its "operation analysis" for the years 1972 through 1977 for all North American industrial dealers with sales in excess of or under the amounts shown:

			Average
			Compensation
			Paid to
	Sales		Officers,
Calendar	In Excess Of	Average	Owners and
Year	Or Under	Sales	Managers
1972	In excess of
	$1,500,000	$2,241,806	$ 74,830
1973	Under
	1,317,000	944,773	34,343
1974	In excess of
	2,196,000	3,594,992	136,717
1975	Under
	1,107,000	755,929	37,490
1976	Under
	1,377,700	967,430	39,330
1977	Under
	1,652,000	1,214,040	42,581

		Average Total
	Percent	Compensation	Percent
Calendar	of	Paid to All	of
Year	Sales	Employees	Sales
1972
	3.34	$156,606	6.99
1973
	3.64	66,154	7.00
1974
	3.80	276,496	7.69
1975
	4.96	69,182	9.15
1976
	4.07	81,551	8.43
1977
	3.51	91,771	7.56

The following schedule shows on the basis of the "employee analysis" published by John Deere Company the average salary paid to managerial personnel, the average number of such personnel reported per dealership, the number of dealers reporting in each category, and the average hours worked per week for John Deere agricultural dealers located in Zone 11 which had total sales of $1,367,000 or above for the calendar year 1974, total sales of $1,871,000 or above for 1975, total sales of $2,358,600 or above for 1976, and total sales of $2,568,800 or above for 1977:

		No. Per
Calendar		Dealership
Year	Position	Reporting
1974	Owners/General Manager	1
	Sales Manager	1
	Parts Manager	1
	Service Manager	1
1975	Owners/General Manager	1.7
	Sales Manager	1.2
	Parts Manager	1.2
	Service Manager	1.1
1976	Owners/General Manager	1.47
	Sales Manager	1
	Parts Manager	1.20
	Service Manager	1.07
1977	Owners/General Manager	1.24
	Sales Manager	1
	Parts Manager	1.13
	Service Manager	1.06

	No. of
	Dealers
	Reporting		Average Hours
Calendar	in Each	Average	Worked
Year	Category	Salary	Per Week
1974	Not shown	$22,636	Not available
	Not Shown	18,813	Not available
	Not shown	12,814	Not available
	Not shown	13,892	Not available
1975	48	25,505	46
	17	21,578	45
	44	14,117	44
	48	14,791	44
1976	72	40,122	44
	25	27,760	44
	53	14,232	44
	49	16,044	43
1977	38	41,476	44
	22	32,557	45
	38	17,301	44
	35	18,012	43

The following schedule shows on the basis of the "employee analysis" published by John Deere Company the average salary paid to managerial personnel, the average number of such personnel reported per dealership, the number of dealers reporting in each category, and the average hours worked per week for North American John Deere industrial dealers which had total sales of $1,317,000 or below for the calendar year 1973, total sales of $2,196,000 or above for the calendar year 1974, total sales of $1,107,000 or below for the calendar year 1975, total sales of $1,377,700 or below for the calendar year 1976, and total sales of $1,652,700 or below for the calendar year 1977:

		No. Per
Calendar		Dealership
Year	Position	Reporting
1973	Owners/General Manager	Not available
	Sales Manager	Not available
	Parts Manager	Not available
	Service Manager	Not available
1974	Owners/General Manager	1
	Sales Manager	None
		reported
	Parts Manager	1
	Service Manager	1
1975	Owners/General Manager	1.3
	Sales Manager	1.1
	Parts Manager	1.0
	Service Manager	1.3
1976	Owners/General Manager	1.3
	Sales Manager	1
	Parts Manager	1
	Service Manager	1.2
1977	Owners/General Manager	1.2
	Sales Manager	1.1
	Parts Manager	1
	Service Manager	1.2

	No. of
	Dealers
	Reporting		Average Hours
Calendar	in Each	Average	Worked
Year	Category	Salary	Per Week
1973	Not shown	$16,175	Not available
	Not shown	16,526	Not available
	Not shown	9,559	Not available
	Not shown	10,440	Not available
1974	Not shown	23,384	Not available
	Not shown	None	None
		reported	reported
	Not shown	13,371	Not available
	Not shown	15,799	Not available
1975	63	19,099	46
	9	15,112	43
	29	11,433	45
	43	11,908	45
1976	89	22,061	44
	16	17,334	44
	42	12,607	44
	54	20,886	45
1977	78	24,940	49
	17	20,088	51
	35	16,980	45
	57	25,441	44

The statistics compiled by John Deere Company as its "operation analysis" show the following average return on equity (based on pre-tax income) for John Deere agricultural dealers located in Zone 11 in the same sales volume classification as petitioner, and for John Deere industrial dealers in the same sales volume classification as petitioner:

	Percent of	Percent of
Calendar	Average Return	Average Return
Year	For Agricultural	For Industrial
1967	28.61
1968	18.79
1969	13.10
1970	13.32
1971	19.71
1972	19.36	41.31
1973	31.53	29.56
1974	50.51	24.66
1975	48.77	5.20
1976	38.90	13.60
1977	36.10	16.00

The average net profits before taxes for John Deere dealers with sales comparable to petitioner's for the calendar years 1974 and 1975 and petitioner's total net profits before taxes (not segregated between agricultural and industrial operations) for its fiscal years 1975 and 1976 were as follows:

	John Deere Dealers
Calendar	Average Net Profits
Year	Agri.	Indus.	Total
1974	$198,159	$192,956	$391,115
1975	258,592	8,076	266,668

	Fiscal
	Year	Petitioner's
Calendar	Ending	Total
Year	Feb. 28	Net Profits
1974	1975	$157,074
1975	1976	169,663

Petitioner on its Federal income tax returns for its fiscal years ending February 28, 1975, and February 28, 1976, deducted $181,073.71 and $193,662.71, respectively, as compensation of officer, representing payments by petitioner to Mr. Elliott in each of these years. Respondent in his notice of deficiency disallowed $116,073.71 and $128,662.91 of the claimed deductions for compensation of officer for petitioner's fiscal years ending February 28, 1975, and February 28, 1976, respectively, with the following explanation:

It is determined that compensation paid to Edward G. Elliott during the taxable years ended 2/28/75 and 2/28/76 is excessive in the amounts of $116,073.71 and $128,662.91, respectively. Such amounts exceed a reasonable allowance for salaries and other compensation for personal services rendered within the ambit of section 162 of the Internal Revenue Code. Compensation has been allowed in the amount of $65,000.00 for each year.

OPINION

Section 162, I.R.C. 1954, ¹ provides for the allowance of deductions for all ordinary and necessary expenses paid during the taxable year in carrying on a trade or business, including "a reasonable allowance for salaries or other compensations for personal services actually rendered." The issue here is whether the amounts paid by petitioner to Mr. Elliott in petitioner's fiscal years 1975 and 1976 were reasonable compensation for personal services actually rendered and, if not, to what extent these payments exceeded such reasonable compensation.

It is petitioner's position that the entire amounts paid to Mr. Elliott represent reasonable compensation for personal services actually rendered by Mr. Elliott to petitioner. Petitioner contends that because it had a predetermined formula which had been in use since its incorporation for the bonus paid to Mr. Elliott, the amounts paid in the years here in issue, though high, were reasonable. Petitioner argues that its formula of paying Mr. Elliott 50 percent of the net profits of petitioner before deductions for income taxes and management bonuses was a reasonable formula for determining Mr. Elliott's compensation and did not represent a disguised distribution of profits. Petitioner further argues that in some prior years Mr. Elliott's salary had been too low for the services he rendered to petitioner and for this reason the higher salaries in the years here in issue resulted in average reasonable compensation during the 10-year period covering petitioner's fiscal years 1968 through 1978. Petitioner contends that the stipulated evidence of the amounts paid by other John Deere dealers to officers when compared to the average sales of such businesses supports its position that Mr. Elliott's salary was reasonable.

Respondent takes the position that, since Mr. Elliott was the sole shareholder of petitioner, any agreement between Mr. Elliott and petitioner concerning Mr. Elliott's receiving a percentage of petitioner's profits as a bonus was not an arm's-length agreement and therefore should be given no weight in determining the reasonableness of the amounts paid to Mr. Elliott. Respondent further argues that the arrangement between petitioner and Mr. Elliott, considered in light of the fact that petitioner had not paid a dividend to Mr. Elliott, its sole shareholder, during its entire history is strong evidence that a part of the profits of petitioner paid to Mr. Elliott in the guise of compensation was in reality a dividend to Mr. Elliott. Relying on Charles McCandless Tile Service v. United States,191 Ct. Cl. 108, 422 F.2d 1336 (1970), respondent contends that at least 15 percent of the earnings and profits of petitioner before income taxes and payments to Mr. Elliott were dividends and not compensation for services rendered by Mr. Elliott. Respondent further contends that, properly interpreted, the statistical information stipulated into the record with respect to the earnings, profits and salaries paid by other John Deere dealers supports his position that any amount in excess of $65,000 each year paid by petitioner to Mr. Elliott is excessive and not reasonable compensation for services rendered by Mr. Elliott. Respondent points out that the record shows that the services rendered by Mr. Elliott to petitioner did not change in the years here in issue from the services he rendered in prior years, although the amounts paid to Mr. Elliott during the years here in issue were greatly in excess of the amounts paid to him in prior years.

It is well settled that whether compensation paid by a taxpayer to an officer or employee is deductible as reasonable compensation for the services rendered is a question of fact to be determined from all the evidence in the case. Charles Schneider & Co. v. Commissioner,500 F.2d 148 (8th Cir. 1974), affirming a Memorandum Opinion of this Court. It is equally well settled that respondent's determination carries a presumption of correctness and the burden is on petitioner to show that it is entitled to deductions for compensation paid to officers in excess of the amounts allowed by respondent. Laure v. Commissioner,70 T.C. 1087, 1097 (1978).

Some of the factors to be considered in making the determination of whether amounts paid to an officerstockholder represent reasonable compensation for services rendered are set forth in section 1.162-7(b), Income Tax Regs.² Further guidelines have been listed in a number of cases. A summary of some of the factors to be considered are set forth in Charles Schneider & Co. v. Commissioner,supra at 152, as follows:

Such factors include the employee's qualifications; the nature, extent and scope of the employee's work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the prevailing general economic conditions; 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 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 Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir. 1949).

It is also clear that in determining the reasonableness of the amount paid, the criteria is whether the amount paid to the individual whose compensation is questioned is reasonable and not the overall reasonableness of the total wages paid by the taxpayer. Commissioner v. R. J. Reynolds Tobacco Company,260 F.2d 9, 13 (4th Cir. 1958), affirming a Memorandum Opinion of this Court. Where, as here, there is only one stockholder of a corporation which had no history of dividend payment, the courts have closely scrutinized the arrangements made for his compensation to ascertain whether a part of the amount claimed to be deductible is in reality a distribution of corporate profits. Charles Schneider & Co. v. Commissioner,supra;Pacific Grains, Inc. v. Commissioner,399 F.2d 603 (9th Cir. 1968), affirming a Memorandum Opinion of this Court; Logan Lumber Co. v. Commissioner,365 F.2d 846 (5th Cir. 1966), affirming on this issue a Memorandum Opinion of this Court. The fact that a longstanding formula is used in determining compensation of a sole shareholder is of little weight. No special incentive is necessary to insure his best efforts since he would "receive the fruits of success through his status as the majority shareholder." Charles Schneider & Co. v. Commissioner, supra at 153.

Petitioner in its argument relies primarily on the testimony of an expert witness who gave as his opinion that the amount paid by petitioner to Mr. Elliott in each of the years here in issue was reasonable compensation for the services rendered by Mr. Elliott. This witness stated that the bases of his opinion were (1) the amount of officer's compensation as a percentage of sales paid by other John Deere dealers based on the "operation analysis" published by John Deere Company, (2) the fact that the absolute amount of salary paid by petitioner to Mr. Elliott was less than half the average salary paid to the chief executive officer by 500 leading publicly-held companies in the United States as listed in Forbes Magazine, (3) the relatively low salary paid to Mr. Elliott in some prior years, (4) the fact that Mr. Elliott's bonus had been consistently determined for a number of years, and (5) the absolute amount of Mr. Elliott's salary adjusted for inflation. ³ This witness further relied on the return on equity of petitioner after deduction of Mr. Elliott's salary. The witness considered it immaterial that the total compensation paid to officers, managers, and owners by other John Deere dealers may have been an amount paid to more than one individual. He also considered the profitability of the business not to be relevant in determining the amount of reasonable compensation ⁴ since that figure would not take into consideration the level of capitalization of the company. However, this witness did not know the amount of borrowed capital which might have been used by either petitioner or other John Deere dealers. The witness did not consider it necessary to adjust the amounts paid to officers by other John Deere dealers for the fact that in many instances the payments were made to more than one individual. This expert did not know the duties of Mr. Elliott as compared to the duties of the officers of other John Deere dealers. The expert gave no basis for his assumption that Mr. Elliott may have been underpaid in prior years. In any event, nothing in this record shows that any portions of the payments made to Mr. Elliott in the years here in issue were intended to be or were for services in prior years. The witness did not explain why he considered, after an adjustment for inflation, reasonable compensation for Mr. Elliott in the years here in issue should be more than in any prior or subsequent year. In our view petitioner's expert did not consider all pertinent factors and considered some irrelevant factors in arriving at his conclusions. For this reason we give little weight to his opinion.

Considering the evidence here as a whole, we conclude that in fact the system used by petitioner to determine Mr. Elliott's salary was partially, and was intended to be partially, a distribution of profits to Mr. Elliott. As pointed out in Laure v. Commissioner, supra at 1097-1098, an amount which is in fact a distribution of profit and not intended as compensation for personal services actually rendered is not deductible as compensation even though otherwise compensation might be considered reasonable. In the instant case we have no basis for determining the amount of the payment to Mr. Elliott which was in fact, and was intended to be a distribution of profits as distinguished from compensation.However, on the basis of this record we do not consider the entire amounts paid to Mr. Elliott to be reasonable compensation for the services he rendered to petitioner. Under these circumstances, the best method of determining the amounts paid to Mr. Elliott which were distributions of profits is to determine, on the basis of the other evidence in the record, the amount of reasonable compensation for Mr. Elliott in each of the years here in issue. See Commissioner v. R.J. Reynolds Tobacco Company, 260 F.2d 9 (4th Cir. 1958), affirming a Memorandum Opinion of this Court. As was there pointed out (at 12):

If there is a reasonable basis in the record for isolating that part of the payment which is reasonable compensation for services, we think that a deduction for that part should be allowed. This is true whether the excess is classified as unreasonable compensation or as dividends.* * *

We have reviewed all the facts in this record with special consideration to the statistics stipulated with respect to salaries paid by other John Deere dealers which had sales comparable to petitioner's. We have used the calendar years 1974 and 1975 as being roughly comparable to petitioner's fiscal years ending February 28, 1975, and February 28, 1976. We have also taken into consideration the number of persons to whom the salaries were paid and the profitability of the operations. We do not consider the amount of salaries paid by 500 unidentified leading publicly-held corporations partially relied on by petitioner's expert witness to be in any way indicative of reasonable compensation for Mr. Elliott.

The record shows that petitioner's profit from agricultural sales for its fiscal year ending February 28, 1975, was phenomenally high as cmpared to other John Deere dealers. However, for its fiscal year 1975 petitioner had a substantial loss on its industrial sales whereas other John Deere dealers had a substantial profit on such sales. Also, we have noted that, compared with other years, all John Deere agricultural dealers in the area in which petitioner operated with sales volume comparable to petitioner's had higher profits than in any other year for which we have statistics, indicating that economic conditions substantially contributed to the profitability of sales of agricultural equipment in that year. We have also noted that the average return of John Deere agricultural dealers in 1975 on sales was substantially higher than petitioner's return on agricultural sales, although in this year petitioner's return on industrial sales was higher than the average return of John Deere dealers on industrial sales.

In our view, the breakdown of statistics between industrial and agricultural sales for a comparison of the reasonableness of the salary petitioner paid to Mr. Elliott has less meaning than it would have if the salary paid to Mr. Elliott had not been allocated on the basis of sales in making the comparison. We are aware that no separate bookkeeping system was maintained to show what portion of Mr. Elliott's compensation was for his work for the part of the business dealing in agricultural equipment and what part was for his work for the part dealing in industrial equipment. However, Mr. Elliott's compensation as computed by petitioner was based on profits and not on sales. Therefore, any comparisons based on sales broken down between the two operations has less meaning than it might have under other circumstances.

While Mr. Elliott's management of petitioner in a manner to return a profit indicates that he was a capable executive, there is nothing in this record to show that he had any special expertise. Compare Laurie v. Commissioner, supra. In fact, this record shows that for the two years here in issue petitioner's operation was overall less profitable than the operations of other John Deere dealers.

However, we do consider the salaries paid by other John Deere dealers to their officers and managers with reference to the volume of sales and profitability of the operation and the number of officers of the business to whom the amounts were paid to be indicative of a reasonable salary for Mr. Elliott. We have examined both the "operation analysis" and the "employee analysis," bearing in mind that the "employee analysis" may well reflect salaries of officers before bonuses.

Based on the record as a whole, and considering (1) the nature of the work done by Mr. Elliott, (2) the hours he worked, (3) the lack of difference in his work in the years here in issue and prior years, (4) the fact that in many instances salaries paid by other John Deere dealers were paid to more than one individual, and (5) the level of salaries paid by petitioner to executive employees other than Mr. Elliott, we conclude that reasonable compensation for Mr. Elliott for petitioner's fiscal years ending February 28, 1975, and February 28, 1976, was $120,000 and $125,000, respectively. We therefore sustain respondent's disallowance of petitioner's claimed deduction for compensation paid to Mr. Elliott which is in excess of these amounts.

Decision will be entered under Rule 155.

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Footnotes

• *. After salary to Mr. Elliott and before State and Federal income taxes.

• *. Invested capital plus retained earnings.

  ** Information to allocate is not available and therefore this year is based on total return on total equity for each category.

• *. This figure is taken from the stipulation although mathematically this figure would come out to 7.18.

• *. This figure is taken from the stipulation although mathematically this figure would come out to 6.94.

• 1. All section references are to the Internal Revenue Code of 1954, as amended, unless otherwise stated.

• 2. Section 1.162-7(b)(1), (2) and (3), Income Tax Regs., provide as follows:

  SEC. 1.162-7 Compensation for personal services.

  * * *

  (b) The test set forth in paragraph (a) of this section and its practical application may be further stated and illustrated as follows:

  (1) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock. An ostensible salary may be in part payment for property. This may occur, for example, where a partnership sells out to a corporation, the former partners agreeing to continue in the service of the corporation. In such a case it may be found that the salaries of the former partners are not merely for services, but in part constitute payment for the transfer of their business.

  (2) The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.

  (3) In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. 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. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.

• 3. As his analysis of the absolute amounts of compensation paid to Mr. Elliott based on adjustments for inflation, the witness relied on the following stipulated fact:

  Fiscal	Compensation	Federal
  Year	Paid to	Income
  Ending	Edward Elliott	Taxes *	Net
  1968	$ 42,800	$ 9,844	$ 32,956
  1969	19,600	3,136	16,464
  1970	34,035	5,446	28,589
  1971	84,450	23,646	60,804
  1972	68,323	19,130	49,193
  1973	66,401	22,576	43,825
  1974	136,536	54,614	81,922
  1975	181,074	86,915	9,158 **
  1976	193,663	83,275	110,388
  1977	153,696	66,089	87,607
  1978	83,052	32,390	50,662

  		Net
  Fiscal	Consumer	Compensation
  Year	Price Index	Adjusted for
  Ending	(1967=100.0)	Inflation
  1968	104.2	$31,628
  1969	109.8$14,995
  1970	116.3	24,582
  1971	121.3	50,127
  1972$125.3	39,260
  1973	133.1	32,926
  1974	147.7	55,465
  1975	161.2	58,411
  1976	170.5	64,744
  1977	185.0	47,355
  1978	200.0	25,331

  * Based on an average rate for all income for Edward Elliott after taking into account deductions from adjusted gross income.

  ** This figure is taken from the stipulation although mathematically this figure would come out to 94,159.

• 4. This witness testified as follows:

  Q * * * In arriving at your conclusion in this case, did you take into consideration the fact that in some occasions, the profits of Elliotts, Inc. are lower than the profits of other dealers, average?

  A The absolute profits?

  Q Yes.

  A Yes, I did.Again, my opinion. But in my opinion, the level of absolute profits is a relatively meaningless number. And the reason I say that is because comparing Elliotts' profits to another dealer's profits is like comparing General Motors' profits to John Deere's profits. One has much more capital. One obviously ought to have more profits. And absolute profit, that does not take -- and absolute profit number that doesn't take into consideration the level of capitalization doesn't mean a whole lot. And to make it meaningful, you've got to normalize it using something like earnings per share or return on equity. Those numbers are much more meaningful.