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T.C. Memo. 1997-467

UNITED STATES TAX COURT

H & A INTERNATIONAL JEWELRY, LTD., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 156-95.

Filed October 14, 1997.

David D. Aughtry and Lisa M. Lawson, for petitioner.

Eric Jorgensen, for respondent.

MEMORANDUM OPINION

PARR, Judge:

Respondent determined the following

deficiencies in petitioner's Federal income tax:

Year

1989

1990

1991

1992

Deficiency

$5,107

4,632

159,932

79,454

All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise

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indicated.

All dollar amounts are rounded to the nearest dollar,

unless otherwise indicated.

After concessions, the sole issue

before the Court is whether the amount of executive compensation

paid to Mr. Haim Haviv for 1991 and 1992 is unreasonable, and if

so, what reasonable compensation is.

We find the amounts paid to

be unreasonable under section 162(a)(1).

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

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference.

Petitioner, an international jeweler, is a Georgia

corporation with its principal place of business in Dunwoody,

Georgia, an unincorporated suburb of Atlanta.

General Background

H&A International Jewelry, Ltd.

Mr. and Mrs. Haviv are the sole shareholders of petitioner.

Each owns 50 percent.

Mr. and Mrs. Haviv contributed $500 to

capital upon petitioner's incorporation.

Since petitioner's

incorporation, Mr. Haviv has served as its president and chairman

of the board of directors, and Mrs. Haviv has served as its

secretary.

Petitioner has never paid any dividends.

Petitioner (1) conducts wholesale and retail sales of

jewelry and precious stones, (2) appraises and insures precious

stones, and (3) custom designs and repairs jewelry.

Petitioner

became a company unique in specialty, reputation, location, and

purchasing power.

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Petitioner has paid Mr. Haviv the following amounts in

compensation:

Year

Salary

Bonus/Commission

1984

1985

1986

1987

1988

1989

1990

1991

1992

12,000

26,000

28,000

30,000

40,000

68,000

$10,000

25,000

35,000

125,000

95,000

105,000

562,000

535,000

Total Compensation1

$10,000

25,000

47,000

151,000

123,000

135,000

601,077

603,269

Petitioner's board of directors (the board), consists solely of

Mr. and Mrs. Haviv.

The board approved Mr. Haviv's

bonuses/commissions for 1991 and 1992 at the end of each

respective year.2

Petitioner is located in a secluded office building "quite

distant" from any major highway, retail district, or mall.

Petitioner does not advertise.

Rather,

petitioner's reputation

enables it to operate by word of mouth. Petitioner purchases its

jewels from diamond exchanges, mostly in Antwerp, Belgium, and

Tel Aviv, Israel, as well as from side holders and wholesalers

The parties have stipulated that Mr. Haviv's total

compensation for 1991 and 1992 is $601,077 and $603,269,

respectively. We note, however, that Mr. Haviv's salary and

bonus/commission for 1991 and 1992 actually total $602,000 and

$603,000, respectively. We find that the $923 difference for

1991 is a concession by respondent, and the $269 difference for

1992 is a concession by petitioner.

Mr. and Mrs. Haviv's bonuses/commissions for 1984

through 1990 were also approved at the end of each respective

year.

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within the United States.3

The stones are then transported to

petitioner's Dunwoody store and held for sale.4

Petitioner also

accepts customer orders for desired stones and seeks them out.

In 1991, petitioner had 10 employees in addition to Mr. and Mrs.

Haviv:

3 salespersons, 1 jewelry repairman, 4 office staff, and

2 employees in the newly opened Oklahoma City store.

In 1992,

petitioner employed an additional salesperson in its newly opened

Augusta, Georgia, store.

Petitioner's employees received salary

and commissions, but only Mr. and Mrs. Haviv received bonuses.

Employees were compensated the following amounts for 1991:

Name of

Employee

Haim Haviv

Amy Haviv

Robert Wade

R. Lingerfelt

T.S. New

Beth Leamon

M. Stevens

Ann Hardy

Venita Smith

Bill Frank

Matt Kaye

J.M. McKnight

Total

Comp.

$601,077

21,885

30,500

17,645

24,384

37,305

3,691

22,240

19,997

71,409

8,110

9,651

Salary

$39,077

20,885

25,150

17,501

24,046

21,200

3,641

22,135

19,960

55,923

8,077

9,623

Comm./Bonus

$562,000

1,000

5,350

144

338

16,105

105

15,486

Total

867,894

267,218

600,676

Position

Atlanta Sales

Oklahoma Sales

Jewelry Repairs

Atlanta Sales

Part Time

Office Staff

Bookkeeper

Atlanta Sales

Oklahoma Sales

Office Staff

In 1992, petitioner's employees were compensated the following

amounts:

A side holder is an individual who obtains diamonds

directly from the owner of a diamond mine.

Petitioner opened stores in Oklahoma City, Oklahoma, in

1991 and Augusta, Georgia, in 1992.

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Name of

Total

Employee

Comp.

Haim Haviv

$603,269

Amy Haviv

24,731

Robert Wade

33,980

R. Lingerfelt

19,757

T.S. New

2,085

Beth Leamon

28,903

Ann Hardy

24,942

Venita Smith

22,860

Bill Frank

76,572

Matt Kaye

34,890

J.M. McKnight

20,502

D. Alexander

8,329

R. Cockrom

5,381

Total

906,201

Salary

$68,269

24,231

33,100

19,423

1,157

25,250

24,292

22,231

69,250

34,731

20,252

Comm./Bonus

$535,000

500

880

334

928

3,653

650

629

7,322

159

250

8,329

5,381

347,567

Position

Atlanta Sales

Oklahoma Sales

Jewelry Repairs

Atlanta Sales

Office Staff

Bookkeeper

Atlanta Sales

Oklahoma Sales

Office Staff

Augusta Sales.

Office Staff

558,634

Mr. Haviv's Skills and Qualifications

Haim Haviv was introduced to the jewelry industry at a young

age by his uncle, a small collector.

Mr. Haviv attended the

Israeli Naval Academy and served in the Israeli Special Forces.

His military background earned him trust and respect from those

in the Tel Aviv diamond market.

Mr. Haviv obtained a bachelor of

science degree from the University of California and graduated

from the Gemology Institute of America.

Mr. Haviv started his

career at Alman's in Atlanta as a jewelry salesman.

He then

became a manager in training at Citizens Jewelry Co. before he

and his wife formed petitioner in 1983.

Mr. Haviv has a photographic memory with precious stones.

This ability is a major asset when he makes purchases and sales.

His memory enables him to keep a mental record of the identity

and location of the thousands of stones in petitioner's

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inventory.

In addition, Mr. Haviv speaks six languages:

Hebrew,

French, English, Flemish, Arabic, and Italian.

Mr. Haviv's Role in the Company

Mr. Haviv makes all of petitioner's purchases.

He also

approves vendor invoices for payment, signs all checks, extends

customer credit, and prices inventory.

William L. Frank (Mr.

Frank), petitioner's top salesman, also has the power to set

prices for his personal sales.

When Mr. Haviv is traveling,

office manager Ann Hardy runs the store, although major decisions

are reserved for Mr. Haviv.

Mr. Haviv's workday often extends late into the night

conducting meetings, employee seminars, and strategy sessions.

Except during the Christmas season he usually does not work on

the weekends.

Mr. Haviv makes about eight purchasing trips abroad per year

to diamond exchanges in Antwerp and Tel Aviv.

to the Orient in 1992.

His linguistic ability helps him obtain

low prices in foreign cities.

once a year.

He also traveled

Mrs. Haviv accompanies him about

Mr. Frank traveled with Mr. Haviv two or three

times between 1991 and 1992.

Salesman Robert Wade has also been

to the diamond exchanges.

Mr. Haviv's purchases are transported back to the Georgia

store by secured delivery services.

On occasion, Mr. Haviv

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brings them back himself. Regardless of the means of

transportation, all stones are insured during travel.

Mr. Frank joined the jewelry industry in 1973, working for

Citizens Jewelry Company and D. Geller & Sons before operating

his own partnership, Diamond Industries, from 1979 to 1985.

has worked for petitioner for over 5 years.

About 45 percent of petitioner's purchases are made within

the United States.

Domestic purchases are often made by

telephone and are delivered by armored division, registered mail,

or commercial carriers, depending upon the size of the order.

The $600,000 Red Diamond Transaction

In 1991 petitioner took an order from a customer for an

extremely rare .70 carat red diamond.

Mr. Haviv located and

purchased the diamond for $56,000. After Mr. Haviv transported

the diamond into the United States, petitioner's salesperson,

Beth Leamon, sold it for $600,000.

Her bonus that year was

$16,105.

Dangers of the Business

Mr. Haviv has encountered increased dangers by working

overseas.

For instance, an individual was killed at the Tel Aviv

diamond exchange, and Mr. Haviv was near an airport bombing in

France.

Mr. Haviv carries a gun in countries where it is legal,

including the United States.

Even when Mr. Haviv travels in

nearby Atlanta, his work places him at a special risk.

Petitioner asserts that part of Mr. Haviv's compensation is for

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this added risk, which it likens to "combat-pay."

Although

petitioner's other employees also travel abroad and transport

jewels throughout the city of Atlanta, they are not given

"combat-pay."

Petitioner does not employ a security guard on its

premises.

Petitioner's Salary Policy

During 1991 and 1992, Mr. Haviv determined the salaries,

commissions, and bonuses for all of petitioner's employees.

Salaries were fixed for the entire year.

Salespersons earned

commissions of 50 percent of gross profits on all sales made to

their personal customers.

When a sale was made to a "house

customer" salespersons would typically earn commissions of 5

percent of the gross sale.5

All "house customers" were

considered to be customers of Mr. Haviv, although he was not

bound by the commission structure.

Petitioner had no written

policy for bonuses.

A Comparison of Salaries Paid to Mr. Haviv with Gross

Income and Net Income

In 1991, Mr. Haviv's compensation was four times larger than

his average compensation from the prior 3 years.

total compensation exceeded that of 1991.

In 1992, his

For 1988-92 petitioner

paid Mr. Haviv the following percentages of gross revenues:

"House customers" are those customers who do not seek

an individual salesperson. Since Ms. Leamon did not receive 5

percent of the red diamond sale price, we are at a loss to

understand how this rule was applied.

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1988

1989

1990

1991

1992

Gross Revenue

Mr. Haviv's

Compensation

$3,914,409

4,684,286

4,740,731

6,495,378

7,009,772

$151,000

123,000

135,000

601,077

603,269

Percentage of

Gross Revenue

3.9%

2.6%

2.9%

9.3%

8.6%

In 1992, the compensation paid to Mr. Haviv was greater than

petitioner's net income (before deduction for Mr. Haviv's

compensation).

Mr. Haviv's compensation as a percentage of

petitioner's taxable income for 1988-92 before the deduction for

Mr. Haviv's compensation amounted to:

Net Income

(before deduction

for Mr. Haviv's

Compensation)

1988

$186,208

1989

157,044

1990

165,883

1991

685,988

1992

470,991

Mr. Haviv's

Compensation

$151,000

123,000

135,000

601,077

603,269

Percentage of Net Income

(before deduction

for Mr. Haviv's

Compensation)

81%

78%

81%

88%

128%

The Prevailing Rates of Compensation for Comparable

Positions in Comparable Concerns

Respondent used Robert Morris Associates (RMA) Annual

Statement Studies to determine Mr. Haviv's reasonable

compensation for 1991 and 1992 to be $207,852 and $224,313

respectively.

The RMA Study was based upon the financial

statements of 10 wholesale jewelers with $5 to $10 million in

annual sales.

The RMA survey for 1991 divided the officer

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compensation for the 10 companies by percentage of sales:

Upper

quartile, 3.2 percent; median, 2.1 percent; and lower quartile,

1.0 percent.6

Respondent allowed compensation of 3.2 percent of

net sales.

Petitioner contends that due to Mr. Haviv's talents and

market positioning, petitioner has no true competitors in the

United States.

Therefore, petitioner presents what it considers

"the only person remotely qualified within 100 miles of Atlanta"

as a "competitor."

trial.

He has been designated as Mr. W for this

Mr. W owns 100 percent of the stock of what have been

designated as B Co. and C Co., each a retail jewelry store in a

city in the southeast region of the United States.

At the end of

the companies' fiscal year 1991, C Co was merged into B Co.

Mr. W has been in the jewelry business for 57 years and has

operated C Co. and B Co. for 52 and 36 years respectively.

B Co.

and C Co. have customers in Atlanta and have competed against

petitioner on a few occasions in the sale of large diamonds and

precious stones.

In 1991, there was an industrywide recession induced by the

10 percent luxury tax on jewelry.

See Omnibus Budget

Reconciliation Act of 1990, Pub. L. 101-508, sec. 11221(a), 104

Stat. 1388, 1388-441 to 1388-442.

For example, 25 percent (in this survey 2) of the

companies compensated their officers greater than 3.2 percent of

annual sales.

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Petitioner deducted Mr. Haviv's salary for 1991 and 1992 as

a business expense.

This produced a loss of $132,278 for 1992

which was carried back to offset income from 1989, 1990, and

1991.

Discussion

The sole issue for determination is whether the salary and

bonus paid by petitioner to its president, Haim Haviv, in 1991

and 1992 represents reasonable compensation deductible as a

business expense.

Petitioner contends that the entire

compensation paid, $601,077 in 1991 and $603,269 in 1992, was

reasonable and paid for his present and past services.

Respondent, on the other hand, determined that reasonable

compensation for Mr. Haviv was $207,852 and $224,313 for 1991 and

1992, respectively.

Section 162(a)(1) allows a deduction for ordinary and

necessary business expenses including "a reasonable allowance for

salaries or other compensation for personal services actually

rendered".

Compensation which is a guise for the distribution of

dividends to employee-stockholders is not deductible.

1.162-7(b)(1), Income Tax Regs.

Sec.

Respondent's determination is

presumed correct, and petitioner has the burden of proving that

the amount it paid to Mr. Haviv was reasonable.

Welch v. Helvering, 290 U.S. 111, 115 (1933).

Rule 142(a);

If petitioner

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proves respondent's determination erroneous, the Court must then

decide the amount of compensation that was reasonable.

Pepsi-

Cola Bottling Co. v. Commissioner, 61 T.C. 564, 568 (1974), affd.

528 F.2d 176 (10th Cir. 1975).

The reasonableness of compensation is a question of fact to

be determined from the record in each case.

Estate of Wallace v.

Commissioner, 95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th

Cir. 1992).

In Estate of Wallace v. Commissioner, we used the

following nine factors to determine reasonableness:

(1) the

employee's qualifications; (2) the nature, extent, and scope of

the employee's work; (3) the size and complexities of the

business; (4) a comparison of salaries paid with the gross income

and the net income; (5) the prevailing general economic

conditions; (6) comparison of salaries with distributions to

stockholders; (7) the prevailing rates of compensation for

comparable positions in comparable concerns; (8) the salary

policy of the corporation as to all employees; and (9) in the

case of small corporations with a limited number of officers, the

amount of compensation paid to the particular employee in

previous years.

Estate of Wallace v. Commissioner, supra at 553;

see also Mayson Manufacturing Co. v. Commissioner, 178 F.2d 115,

119 (6th Cir. 1949).

All the facts must be considered; no one

factor is determinative.

Rutter v. Commissioner, 853 F.2d 1267,

1274 (5th Cir. 1988), affg. T.C. Memo. 1986-407; Pacific Grains,

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Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), affg.

T.C. Memo. 1967-7; Home Interiors & Gifts, Inc. v. Commissioner,

73 T.C. 1142, 1156 (1980).

In analyzing these factors, the Court

must carefully scrutinize the facts of a case in which the paying

corporation is controlled by the employees to whom the

compensation is paid.

In such a situation, we must be convinced

that the purported compensation was paid for services rendered by

the employees as opposed to a distribution of earnings to them

that the payor could not deduct.

RTS Inv. Corp v. Commissioner,

877 F.2d 647, 650 (8th Cir. 1989), affg. per curiam T.C. Memo.

1987-98; Paul E. Kummer Realty Co. v. Commissioner, 511 F.2d 313,

315-316 (8th Cir. 1975), affg. T.C. Memo. 1974-44; Charles

Schneider & Co. v. Commissioner, 500 F.2d 148, 152-153 (8th Cir.

1974), affg. T.C. Memo 1973-130; Seven Canal Place Corp. v.

Commissioner, 332 F.2d 899 (2d Cir. 1964), remanding T.C. Memo.

1962-307.

Employee's Qualifications

An employee's superior qualifications for his or her

position with the business may justify high compensation.

See,

e.g., Home Interiors & Gifts, Inc. v. Commissioner, supra at

1158; Dave Fischbein Manufacturing Co. v. Commissioner, 59 T.C.

338, 352-353 (1972).

Mr. Haviv is highly qualified to run petitioner's business

as a result of his education, training, experience, and mental

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attributes.

When petitioner is successful, he is the primary

reason for its success.

While this factor favors petitioner, we

note that there are limits to reasonable compensation "even for

the most valuable employees."

Owensby

& Kritikos, Inc. v.

Commissioner, 819 F.2d 1315, 1325 (5th Cir. 1987), affg. T.C.

Memo. 1985-267.

Nature, Extent, and Scope of the Employee's 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 at 1158.

Mr. Haviv essentially runs the entire business.

Among other

roles, Mr. Haviv is petitioner's president, sole purchaser, and

supervisor of most sales.

When Mr. Haviv is able to utilize all

of his skills to purchase jewels at low prices, petitioner can

generate profits.

This factor favors petitioner.

Size and Complexities of the Business

Courts have considered the size and complexity of a

taxpayer's business in deciding whether compensation is

reasonable.

179.

Pepsi-Cola Bottling Co. v. Commissioner, supra at

In evaluating the size of petitioner we examine its sales

and net income.

See E. Wagner & Son v. Commissioner, 93 F.2d

816, 819 (9th Cir. 1937).

In considering the complexities of

petitioner's business we note that petitioner does not own its

own building, has only 13 employees, has retained earnings of

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$115,726, and has fixed assets under $75,000.

However, we also

note the specialized skills required for making money in the

jewelry industry and recognize that petitioner increased its

sales while opening new offices in Oklahoma City, Oklahoma, in

1991 and Augusta, Georgia, in 1992.

Comparison of Salaries Paid to Gross and Net Income

Courts have compared sales, net income, and capital value to

amounts of compensation in deciding whether compensation is

reasonable.

Owensby & Kritikos, Inc. v. Commissioner, supra at

1325-1326; Home Interiors & Gifts, Inc. v. Commissioner, supra

1155-1156.

For 1991 and 1992, Mr. Haviv's compensation was 9.3 percent

and 8.6 percent of gross revenue, respectively.

However, Mr.

Haviv's compensation was 88 percent and 128 percent of net income

before deductions for his compensation.

While considering

compensation as a percentage of both gross revenue and net income

is often helpful, the latter may be more probative because "it

more accurately gauges whether a corporation is disguising the

distribution of dividends as compensation."

Owensby & Kritikos,

Inc. v. Commissioner, supra at 1325-1326.7

While compensation as a percentage of net income is

often of minimal significance if viewed alone, it can be an

appropriate factor pointing toward a conclusion that compensation

paid is unreasonable. Owensby & Kritikos, Inc. v. Commissioner,

819 F.2d 1315, 1326 n.34 (5th Cir. 1987), affg. T.C. Memo. 1985267.

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In 1991, Mr. Haviv's $601,077 compensation caused

petitioner's net income to plummet to one-eighth of its precompensation amount.

In 1992, petitioner had net income of

$470,991 before compensating Mr. Haviv.

Payment of his $603,269

compensation (including his $535,000 yearend bonus) caused

petitioner to suffer a net operating loss of $132,278.

We give

special attention to the fact that the loss in 1992, which was

caused by Mr. Haviv's bonus, was carried back to offset income

from 1989, 1990, and 1991.

While this factor alone does not

control the result in this case, it weighs heavily against

petitioner's claim that Mr. Haviv's compensation was reasonable.

Prevailing Economic Conditions

Courts will examine whether the success of a business is

attributable to prevailing economic conditions, as opposed to the

efforts and business acumen of the employees.

Prevailing

economic conditions may affect a business' performance and

indicate the extent, if any, of the employees' effect on the

company.

120.

Mayson Manufacturing Co. v. Commissioner, supra at 119-

Adverse economic conditions, for example, tend to show that

an employee's skill was important to a company that grew during

hard times.

Petitioner asserts that both a general recession and an

industry-specific recession induced by the luxury tax forced Mr.

Haviv to work harder to increase gross sales by approximately

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$2,200,000 and $500,000 in 1991 and 1992, respectively.

We agree.

Comparison of Salaries Paid With Dividends to

Shareholders

The failure to pay more than minimal dividends may suggest

that reported compensation actually is (in whole or in part) a

Owensby & Kritikos, Inc. v. Commissioner, supra at

dividend.

1323-1324; Charles Schneider & Co. v. Commissioner, 500 F.2d at

151-152.

Corporations, however, are not required to pay

dividends.

Indeed, 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, 73 T.C. at 1162.

Nevertheless, a corporation's failure to pay dividends may be a

factor in determining the reasonableness of officer compensation.

Since its incorporation in 1983, petitioner has never paid a

dividend to shareholders.

The board of directors, which has the

authority to pay dividends and award bonuses, has always

consisted solely of Mr. and Mrs. Haviv, who are also the only

employees ever to receive yearend bonuses.

Prevailing Rates of Compensation for Comparable

Positions in Comparable Companies

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. 1.1627(b)(3), Income Tax Regs.]

Both parties testified to the difficulty of finding a business

comparable to petitioner.

In determining that $207,852 and

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$224,313 constituted reasonable compensation for 1991 and 1992,

respectively, respondent relied solely upon statistics from the

RMA survey.8

Respondent accepts the 10 jewelers used in the

survey as petitioner's competitors.

However, in an introduction

to its studies, RMA cautions that its data should be used "only

as general guidelines and not as absolute industry norms."

The

RMA guidelines explain that companies used are not selected "by

any random or statistically reliable method" and that a

relatively small industry sample (such as the 10 companies used

for wholesale jewelers) may increase the chances that such data

do not fully represent an industry.

We have other reservations about the manner in which

respondent applied the survey statistics.9

Respondent used the

3.2-percent figure (derived from the 1991 survey) for 1992 also,

despite the fact that the 1992 RMA survey did not release such

figures for 1992, while the 1993 survey provided a much higher

corresponding percentage of 6.0.

In addition, the RMA wholesale

jewelry survey does not account for all aspects of petitioner's

According to the RMA survey, respondent's

determinations would place petitioner just below the upper

quartile of wholesale jewelry companies as distinguished by

levels of officer compensation. While data from RMA surveys have

been accepted by this Court in some instances, on other occasions

its reliability in determining reasonable compensation has been

questioned. See PMT, Inc. v. Commissioner, T.C. Memo. 1996-303;

Lumber City Corp. v. Commissioner, T.C. Memo. 1996-171; Hendricks

Furniture, Inc. v. Commissioner, T.C. Memo. 1988-133.

Respondent's capping reasonable compensation at 3.2

percent of petitioner's net sales ignores RMA figures from 1992

and 1993.

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business such as jewelry sold at retail, yet that is the only RMA

survey respondent elected to use.

Despite the inherent flaws in

the RMA survey, respondent relied solely upon the RMA statistics

without presenting any witnesses, expert or otherwise, to bolster

respondent's figures.

Respondent has offered no evidence to show

that the 10 companies used in the survey to determine a

"reasonable" compensation for Mr. Haviv are even comparable to

petitioner.

Thus, we find respondent's figures to be arbitrary.

We also find petitioner's figures lack credibility.

Admitting that a true competitor does not exist, petitioner

compares itself to Mr. W's company (which we will refer to as

simply B Co. despite the fact that it was actually two companies,

B Co. and C Co., before 1991) by virtue of the fact that they are

both involved in selling wholesale and retail jewelry and

precious stones, appraisal and insurance of precious stones, as

well as custom design and jewelry repairs.

However, the

percentage of business allocated to each aspect of its operations

varied greatly between companies.

For example, wholesale trade

accounted for over 50 percent of petitioner's business, but for

only 10 percent of B Co.'s total profits.

However there are many similarities that weigh in

petitioner's favor.

B Co.'s net sales figure for 1991 was

$5,523,835 compared to petitioner's $6,495,378, and for 1992 was

$6,792,055 compared to petitioner's $7,009,772.

B Co.'s net

income was $22,211 for 1991 and negative $220,395 for 1992.

Mr.

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W was compensated $751,000 for 1991 compared to Mr. Haviv's

$601,077 and $1,016,000 for 1992 compared to Mr. Haviv's

$603,269.

Like Mr. Haviv, Mr. W was also the primary shareholder

of his company.

But, unlike Mr. Haviv, he operated the company

as an S corporation.

B Co.'s sales were slightly lower for 1991

and 1992, but its gross profit percentage was approximately

double that of petitioner.

While Mr. W's compensation statistics indicate that

respondent's compensation allocations may be less than the value

of Mr. Haviv's services, we decline to accept the compensation of

one employee from one company in the industry as a benchmark for

reasonableness.

Petitioner presented two certified public accountants as

witnesses who each testified that Mr. Haviv's compensation was

reasonable for the services rendered.

Mr. Randy Galanti

concluded that Mr. Haviv's "compensation was in the range of

reasonable based upon the compensation that could have been

reasonably paid for just the first four functions [performed by

Mr. Haviv]:"

Purchasing function

Sales function

Chief executive officer

Chief financial officer

1991

$106,598

451,027

413,553

406,454

1992

$151,270

393,791

446,367

433,337

Reasonable Compensation

for above functions

$1,377,632

$1,424,765

- 21 -

Mr. Galanti's reasoning is flawed.10

The "reasonable" salary

used for each title is based upon a full-time position.

It is

most unlikely that Mr. Haviv could have worked 160 hours per

week.

In addition, in considering whether a reasonable investor

would have approved of compensation to Mr. Haviv of over $600,000

per year, Mr. Galanti focused on Mr. and Mrs. Haviv's return on

their $500 investment since 1983.

That calculation resulted in

an annualized growth rate of 72 percent.

We recognize the

caution with which such a ratio must be examined.11

Return on

equity is a much more accurate indicator of company performance.

(See our discussion, infra.)

As opposed to the 72 percent

figure, petitioner's return on equity year by year from 1988 to

1992 was 35 percent, 21 percent, 16 percent, 36 percent, and -51

percent respectively.

Since a board makes its bonus decisions

from year to year, return on equity may also be examined from

year to year.

Thus, a strong return in 1 year does not guarantee

board approval of bonuses in the next year, especially if there

are financial reverses the second year.

Mr. Galanti believes that it would have been reasonable

to pay Mr. Haviv $1,377,632 in 1991 for a company that earned

$84,911 and $1,424,765 in 1992 for a company that lost $132,278.

For example, if Mr. and Mrs. Haviv had invested $1,000

in 1983 their annualized return on investment would have been 36

percent whereas a smaller $250 investment would have given them

an annualized return of 144 percent.

- 22 -

Petitioner's other witness, Mr. Stephen Gross, similarly

examined the "reasonableness" of petitioner's figures by adding

up the salaries of full-time positions for each of the different

roles Mr. Haviv performed.

Finding no actual competitors of

petitioner, Mr. Gross also placed improper reliance upon the RMA

survey used by respondent.

Employer's Salary Policy as to All Employees

Courts have considered salaries paid to other employees of a

business in deciding whether compensation is reasonable.

Home

Interiors & Gifts, Inc. v. Commissioner, 73 T.C. at 1159.

look to this factor to determine if Mr. Haviv was compensated

differently than petitioner's other employees solely because of

his status as a shareholder.

Mr. Haviv earned $601,077 in 1991 and $603,269 in 1992

compared to petitioner's second highest paid employee who made

$71,409 and $76,572, respectively.

In 1991, the total

compensation for petitioner's nonstockholder employees totaled

$244,933.

Mr. Haviv's total compensation was 2.4 times the total

compensation for all of petitioner's nonshareholder employees

combined.

In 1992, Mr. Haviv's total compensation was 2.1 times

the total compensation of all of petitioner's nonshareholder

employees.

A reasonable, longstanding, and consistently applied

compensation plan negotiated at arm's length, often provides

evidence that compensation paid pursuant to that plan is

- 23 -

reasonable.

at 1327-1328.

Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d

In 1991 and 1992, Mr. Haviv determined the

compensation amounts for all of petitioner's employees.

There

were no written policies for making such determinations.

Salaries for Mr. and Mrs. Haviv were approved by the board of

directors at the annual meeting preceding each year.

bonuses were also approved at the annual meeting.

Yearend

Mr. and Mrs.

Haviv were the only employees ever to receive yearend bonuses.

Mr. Haviv received yearend bonuses of $95,000, $105,000,

$562,000, and $535,000 for 1989, 1990, 1991, and 1992,

respectively.

Such substantial bonuses, declared at yearend when

corporate earnings are determinable, may indicate the existence

of disguised dividends.

Id. at 1329.

Disguised dividends are

even more probable when, as is the case with petitioner, the

"corporation has a history of distributing as compensation to its

shareholder-employees the bulk of its profits." Id.; Estate of

Wallace v. Commissioner, 95 T.C. at 557.12

Petitioner asserted that it paid Mr. Haviv less compensation

for his sales than it would have under petitioner's fixed

commission rate of 50 percent of profits.

Petitioner asserted

that under its commission policy, Mr. Haviv would have been

entitled to a commission of $272,000 on the sale of the red

diamond in 1991.

We consider the commission that a

As noted, in 1991 and 1992, petitioner paid 88 percent

and 128 percent of net income to Mr. Haviv in the form of

compensation.

- 24 -

nonshareholder-employee would have earned on this sale to be an

appropriate factor in measuring Mr. Haviv's compensation for

1991.

However, petitioner did not establish the total amount of

sales for which Mr. Haviv was directly responsible.

Since Mr.

Haviv was an employee of petitioner, it was improper to credit

him with all of the "house sales" as if they were his own.

Thus,

we disagree with petitioner's assertion that an arm's-length

value for Mr. Haviv's selling position was 50 percent of profits

from all sales to "house customers".

As petitioner admits, the

sale of the red diamond was an extraordinary transaction, as

there were only five in the world.

Mr. Haviv took a specific

order for a red diamond and then was able to purchase one at the

Antwerp exchange.

This diamond was then sold by one of

petitioner's salespersons and petitioner made $546,000 profit.

Unlike traditional "house sales", where customers purchase from

petitioner's salespersons after hearing of petitioner's

reputation, Mr. Haviv played an unusually active role in the sale

of the red diamond.

In sales where Mr. Haviv lacked such

involvement, we find it was improper for petitioner to have

credited him with a "house sale".

Therefore, since 1992 did not

contain such an extraordinary sale as the red diamond, Mr.

Haviv's total compensation for 1992 might have been significantly

less than what it was for 1991 if based upon commissions.

- 25 -

Petitioner asserted that an arm's-length rate for purchasing

commissions was 3 percent.

That is, were it not for Mr. Haviv's

services, it would have had to pay an outsider 3 percent of all

stones purchased.

During the deposition, Mr. W, petitioner's

"nearest competitor", made no mention of paying a 3-percent

commission on his purchases.

Regardless of what the "outside

rate" might have been, Mr. Haviv was an employee of petitioner,

and petitioner made the business decision to employ a chief

executive officer who could also perform the purchasing function.

We are not persuaded that Mr. Haviv's reasonable compensation may

properly be determined based upon what it would cost to employ a

full-time chief executive officer, a full-time chief operating

officer, a full-time purchaser, and a full-time salesman.

Moreover, because Mr. and Mrs. Haviv were the sole

shareholders, Mr. Haviv's compensation was not bargained for at

arm's length.

We therefore must inquire whether an independent

investor would have approved of the compensation levels paid to

Mr. Haviv during the subject years.

See Owensby & Kritikos, Inc.

v. Commissioner, supra at 1326-1327.

As the taxpayer's experts testified, a corporation may

choose to retain its earnings to fuel future growth.

An investor

may obtain a return on his investment through either dividends or

appreciation in the value of his stock. Id. at 1326.

Thus, the

Court looks not only at a corporation's dividend practices, but

- 26 -

also at the total return the corporation is earning for its

investors.

Id.

A prime indicator of the return a corporation is

earning for its investors is its return on equity.13

id. at 1327.