UNITED STATES TAX COURT

T.C. Memo. 2013-97

UNITED STATES TAX COURT

ARIES COMMUNICATIONS INC. & SUBS., Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 27483-10.

Filed April 10, 2013.

R determined that the compensation P paid to E, its employee

and owner, was unreasonable and disallowed its deduction for the tax

year ending Aug. 31, 2004.

Held: E's compensation was reasonable and deductible under

I.R.C. sec. 162 to the extent determined herein.

Held, further, P is liable for a portion of the I.R.C. sec. 6662(a)

accuracy-related penalty as redetermined in this opinion.

Vicken Abajian, for petitioner.

Aaron T. Vaughan, for respondent.

SERVED APR 10 2013

-2-

[*2]

MEMORANDUM FINDINGS OF FACT AND OPINION

WHERRY, Judge: This case is before the Court on a petition for

redetermination of a deficiency in income tax and a penalty respondent determined

for petitioner's tax year ended (TYE) August 31, 2004.1

After concessions the issues remaining are:2

(1) whether the compensation paid to N. Arthur Astor was reasonable under

section 162 for TYE August 31, 2004; and

(2) whether petitioner is liable for a section 6662(a) accuracy-related

penalty for TYE August 31, 2004.

'Unless otherwise indicated, all section references are to the Internal

Revenue Code of 1986, as amended and in effect for the taxable year at issue. All

references to a tax year are to the fiscal year ended on August 31 of that year,

unless otherwise stated. All Rule references are to the Tax Court Rules of Practice

and Procedure.

2The parties agree that the period of limitations on assessment was properly

extended and has not expired for TYE August 31, 2004. Petitioner concedes that

it is not entitled to deduct $550,000 of rental expenses for the year at issue.

Petitioner concedes that it failed to report $93,671 of imputed interest under sec.

7872, and respondent concedes the remainder, $1,298,457, of the imputed interest

set forth in the notice of deficiency. Respondent concedes that the sec. 6662(a)

accuracy-related penalty does not apply to the underpayment of tax caused by

petitioner's failure to recognize imputed interest under sec. 7872. Respondent

concedes that petitioner generated a net operating loss (NOL) of $2,677,686

during its 2005 tax year and that, subject to computational adjustments, petitioner

is entitled to carry back this NOL and claim it as a deduction for the year at issue.

-3[*3]

FINDINGS OF FACT

The parties' stipulation of facts, with accompanying exhibits, and the

stipulation of settled issues are incorporated herein by this reference 3 At the time

petitioner filed the petition, its principal place of business was in California.

N. Arthur Astor

N. Arthur Astor has been in radio broadcasting for over 60 years. He was

involved in several television shows, did a little film work, and worked as a talent

in radio broadcasting before he decided to become involved in broadcasting sales.

After many years of managing sales for a multitude of different radio broadcasting

companies, Mr. Astor in June 1970 was employed as general manager of KADY, a

50,000-watt radio station in Los Angeles owned by Atlanta-based Rollins

Broadcasting. In 1975 he was employed by Dratch & Knott Enterprises, which

owned three radio stations and was the number one programing company

supplying programing and special features to radio stations nationally.

3Petitioner objects to stipulated paras. 6, 21, 22, 24, 57, and 61-67 and

Exhibits 4-J, 5-J, 18-J, 19-J, and 22-J through 37-J on the grounds of relevance.

Fed. R. Evid. 401 states: "Evidence is relevant if: (a) it has any tendency to make

a fact more or less probable than it would be without the evidence; and (b) the fact

is of consequence in determining the action." We overrule petitioner's objections

and hold that the exhibits tend to make the reasonableness of Mr. Astor's

compensation more or less probable.

[*4] About two years later Mr. Astor was offered a position as general manager

of a small FM radio station in Canoga Park, California, with ownership potential

based on performance levels. He met those performance requirements and after

two years of work earned 10% of the station and was then able to purchase another

10% of that station for 10%, $31,200, of its original 1976 $312,000 purchase

price. In 1983 Mr. Astor arranged for a loan and bought out his other partners to

became the sole owner of that station, KIKF.

At the same time that Mr. Astor bought out his KIKF partners, he or an

entity he controlled also purchased two other radio stations, KTIM-AM and FM,

in Marin County, California. He then purchased two more stations, KOWN-AM

and FM, in San Diego, California, in 1987. He sold the two Marin County stations

in 1994, and he purchased an additional North San Diego station, KCEO, in 1995.

In 1999 or 2000 Mr. Astor purchased another station, KSPA AM 1510, in Ontario,

California, from a friend.

Mr. Astor bought and sold certain of these stations using petitioner, Aries

Communications Inc. (Aries), and its subsidiaries Orange Broadcasting Corp. and

North County Broadcasting Corp. (Orange Broadcasting and North County

-5[*5] Broadcasting, respectively).4 Mr. Astor was Aries' president, chief financial

officer (CFO), and sole shareholder from its incorporation in 1983. Mr. Astor

acted as general manager of each of petitioner's radio stations. He was a "handson" manager who was actively involved in many aspects of petitioner's day-to-day

operations. Mr. Astor's duties included: (1) oversight of petitioner's other

management personnel; (2) planning and overseeing the execution of

programming; (3) negotiating and communicating with petitioner's lenders; (4)

participating in sales meetings; and (5) communicating with outside advisers (such

as lawyers and accountants).

Susan E. Burke

Susan Burke has served as the executive vice president and corporate

secretary for both Orange Broadcasting and North County Broadcasting from

1996. Her duties included: (1) Federal Communications Commission (FCC)

issues (e.g., license renewals and upgrades, consultation with counsel); (2) labor

and employment issues; (3) music licensing; and (4) review of documents, leases,

and contracts. During the year at issue petitioner paid Ms. Burke $288,654,

including a $200,000 bonus from Orange Broadcasting.

4The Court takes judicial notice of FCC records indicating that Aries

purchased 94.3 FM and then transferred it to Orange Broadcasting in 1983.

-6[*6] Aries Communications Inc.

Aries and its two operating subsidiaries, Orange Broadcasting and North

County Broadcasting, are known as the Aries Consolidated Group. The Aries

Consolidated Group operated on a fiscal year that ran from September 1 through

August 31. Petitioner was a cash basis taxpayer until it changed its method of

accounting to the accrual basis in the year at issue. Petitioner filed consolidated

Federal income tax returns from 1998 through at least 2008. Petitioner earned

revenue by selling advertising spots on its radio stations.5

Orange Broadcasting

Orange Broadcasting was incorporated in 1976. From 1977 until 2003

Orange Broadcasting held the FCC license for 94.3 FM in Orange County,

California. During the 1980s and 1990s Orange Broadcasting aired a country

music radio station broadcast under the call letters KIKF. In 2000 Orange

Broadcasting changed the station's format to an adult contemporary music station

under the call letters KMXN.

On May 15, 2003, petitioner sold 94.3 FM to LBI Media and its subsidiary,

Liberman Broadcasting, Inc. (Liberman), for $35 million. Petitioner engaged

5Petitioner sold 60-, 30-, and 10-second announcements and half-hour to

hour programs.

-7[*7] Kalil & Co. (Kalil), a broker, to help sell 94.3 FM. Upon completion of the

sale petitioner paid Kalil $790,000 in accordance with the brokerage agreement.

Mr. Astor explained at trial that petitioner engaged the broker primarily to find

prospective purchasers he might not know about. He referred the broker to

potential purchasers he was aware of personally.

Mr. Astor was personally involved in garnering the first bid of around $18

to $20 million for 94.3 FM from Liberman. Mr. Astor knew that Liberman already

owned 94.3 FM in the San Fernando Valley, and he explained to Liberman that the

two stations together could form a quasi-Los Angeles station which would be

much more valuable than the two stations separately. After several rounds of

phone calls with Mr. Astor over the course of a year, Liberman advised that its

final offer was $28 million. Thereafter, Kalil, at Mr. Astor's suggestion, sought

and obtained a bid from Entravision of $33 million. With this bid in hand, Kalil

and Mr. Astor held a telephone conference with Liberman where Mr. Astor

explained that he would sell 94.3 FM only for $35 million. Liberman discussed

this price with Mr. Astor and ultimately agreed to it.

-8[*8] Orange Broadcasting's unaudited financial documents reflected the

following net income (loss) and "Stockholders Equity" as of December 31 of each

calendar year listed below.6

2002

2003

Net income (loss)

($1,771,765) $25,891,031

Stockholders

(2,099,723)

23,765,122

2004

2005

($17,043,881) ($1,532,436)

6,721,242

4,376,865

equity

North County Broadcasting

North County Broadcasting was incorporated in 1987. North County

Broadcasting owned three radio stations at the beginning of the year at issue: AM

1000 with call letters KCEO, AM 1450 with call letters KFSD, and 92.1 FM with

call letters KFSD (these were the stations originally purchased in 1987 with call

letters KOWN). Each of the three stations owned an FCC license to broadcast on

its respective frequency across portions of San Diego County and Riverside

County, California.

6All amounts have been rounded to the nearest dollar. We note that these

are unaudited financial documents and the numbers do not add up year to year.

We also note that on the balance sheets 2004 was the only year in which retained

earnings was the same amount carried over from the prior December; however, it

appears to be the wrong amount if the income or loss account was closed to

retained earnings. Because the then-current 2004 calendar year income was

negative in that year, when the loss is subtracted from the stockholders equity

(assets - liabilities) the retained earnings apparently should be $23,765,122.

-9[*9] In April 2004 North County Broadcasting sold certain assets of 92.1 FM,

including FCC licenses, equipment, engineering data, and selected contracts to

Jefferson-Pilot Communications (Jefferson-Pilot). This sale did not include: the

Carlsbad Studio; certain equipment located there; vehicles, receivables, cash and

cash equivalents; North County Broadcasting's name, programing materials and

information; and North County Broadcasting's sales and marketing materials.

Before the sale the president of Jefferson-Pilot informally contacted Mr.

Astor and offered $12 million for the station, which Mr. Astor rejected. The

president of Jefferson-Pilot then made a further offer of $15 million. Mr. Astor

also rejected this offer and informed Jefferson-Pilot that he wanted $18 million for

the station. After these negotiations petitioner again engaged Kalil to broker the

sale of 92.1 FM for $18 million. Upon the completion of the sale of 92.1 FM,

petitioner paid Kalil $459,333.34.

North County Broadcasting's unaudited financial documents reflected the

following net income (loss) and "Stockholders Equity" at the end of each calendar

year listed below.7

7We again note that these are unaudited financial documents, and the trial

record does not contain information on distributions to or equity contributions by

shareholders; consequently, the Court is unable to verify the reported retained

earnings. The Court notes that reported retained earnings for the previous year

(continued...)

- 10 [*10]

2002

2003

Net income (loss)

($1,269,102)

($436,159)

Stockholders equity

(7,286,271)

(7,731,116)

2004

2005

$13,988,322 ($113,102)

6,204,662

4,430,601

Financial Results

Petitioner reported the following for TYE August 31, 1999 through 2006:

TYE

Gross

receipts

Taxable

income

Net profit

(loss) after

taxes

1999

$4,829,003

($817,104)

($817,104)

$148,078

($3,533,253)

2000

4,760,169

(887,413)

(887,413)

118,273

(4,472,578)

2001

5,400,873

(1,172,231)

(1,172,231)

123,768

(6,004,001)

2002

4,506,958

(1,415,651)

(1,415,651)

134,142

(7,641,199)

2003

2,922,013

14,596,284

9,587,585

147,291

12,262,495

2004

1,131,744

3,902,092

14,025,956

269,406

12,725,862

2005

1,341,503

(1,742,547)

(1,742,547)

108,396

9,618,745

2006

1,514,492

(2,688,686)

(2,688,686)

90,319

6,863,724

Total 26,406,755

9,774,744

4,889,909

1,139,673

19,819,795

Depreciation

expense

Retained

earnings

'Petitioner was owed a tax refund of $123,864.

7(...continued)

plus or minus reported net income does not always total reported retained earnings

for the subsequent year.

- 11 [*11] Although respondent disputes the characterization of the type of

compensation, the parties stipulated that petitioner paid Mr. Astor the following

compensation for TYE:

Aug. 31, 2002 Aug. 31, 2003

Aug. 31, 2004 Aug. 31, 2005

Salary

$136,800

$136,800

$136,800

$136,800

Commissions

123,205

68,035

62,474

56,347

Bonus

-0-

1,870,148

6,697,700

-0-

Total

260,005

2,074,983

6,896,974

193,147

Petitioner's Form 1120, U.S. Corporation Income Tax Return, page 4

balance sheet for 1998, the earliest return in the record, shows a common stock

account balance of $280,000 at the beginning of the year and a common stock

account balance of $120,000 at the end of the year. Thereafter, all of petitioner's

tax returns in the record report a common stock account balance of $120,000.

Petitioner guaranteed loans from Goldman Sachs Credit Partners L.P. to

Orange Broadcasting (Goldman Sachs debt) from as early as the end of the

calendar year 2001. Mr. Astor had also personally guaranteed the Goldman Sachs

debt. The total debt was $20 million. Petitioner's December 31, 2001, financial

documents stated that petitioner and Goldman Sachs had entered into a

forbearance agreement which required petitioner to sell some of the radio stations

- 12 [*12] to satisfy obligations under the Goldman Sachs debt before December 20,

2002. When the assets of Orange Broadcasting were sold, $32,784,836 of the $35

million gross proceeds was used to repay the Goldman Sachs debt, including $20

million of principal and $12,784,836 of interest.

For the year at issue Aries' Federal income tax return was prepared by

Thoerner & Toma certified public accountants of Orange County. They have been

preparing Mr. Astor's returns for 20 to 25 years. Aries' Federal income tax return

for TYE August 31, 2004, claimed a deduction for compensation paid to Mr. Astor

of $6,896,974.

Procedural Background

Respondent issued petitioner a notice of deficiency on September 15, 2010,

disallowing petitioner's deducti.on of $6,086,752 of compensation paid to Mr.

Astor and determining a deficiency of $2,676,002 and a section 6662(a) accuracyrelated penalty of $535,200.40 for TYE 2004. Petitioner timely petitioned the

Court on December 13, 2010. A trial was held on December 9, 2011, in Los

Angeles, California.

Expert Report--Martin Wertlieb

After the petition was filed petitioner commissioned Martin Wertlieb to

prepare a report on the amount of compensation, that in his opinion, petitioner

- 13 [*13] could have reasonably paid Mr. Astor in 2004. Mr. Wertlieb has a bachelor

of arts degree from the Baruch School of Business of the City College of New

York and graduate studies in management at New York University and the

University of California, Los Angeles. He has over 40 years of experience in the

compensation and personnel field and has been an expert witness on reasonable

compensation before the U.S. Tax Court and many other courts.

In reaching his conclusions, Mr. Wertlieb examined the financial statements

of 10 publicly traded radio broadcasting companies. He calculated the pretax

revenues of these companies and compared them to that of Aries. Mr. Wertlieb

also compared the amount paid to Mr. Astor with the compensation paid to the

CEOs of the publicly traded corporations. He believes that because the

corporations are publicly traded and the compensation they pay is subject to the

approval of the boards of directors and State and Federal regulators, that

compensation represents arm's-length transactions.

Mr. Wertlieb explained in his report that fixed compensation tends to

correlate to annual company sales or revenues.8 Mr. Wertlieb applied a

8Mr. Wertlieb defined fixed compensation as annual salary and any special

benefits provided to the individual. He defined variable compensation as annual

bonuses and the value of any stock awards or long-term incentive payouts made

during the year.

- 14 [*14] mathematical formula using the statistical technique of linear regression or

"line of best fit" to show the correlation.9 Mr. Wertlieb used the trend lines for the

correlation of CEOs' fixed compensation to annual revenues at the 75th percentile

range because of Mr. Astor's experience in the industry and his status as the

owner/operator. Mr. Wertlieb also believes that váriable compensation tends to

correlate to the company's profitability. Mr. Wertlieb again used linear regression

analysis to show the correlation. On the basis of this information Mr. Wertlieb

believes that reasonable fixed compensation and reasonable variable compensation

for Mr. Astor were as follows

TYE Aug. 31

Fixed compensation

Variable compensation

2004

$438,900

$4,704,500

2003

443,400

3,192,900

2002

422,100

-0-

2001

360,200

-0-

Total

1,664,600

7,897,400

9Regression analysis is a statistical technique designed to determine the

effect that one or more explanatory independent variables have on a single

dependent variable. This method may allow an expert to test the causal

relationship, if any, between the explanatory independent variables and the

dependent variable.

- 15 [*15] Expert Rebuttal Report--Andrew J. Caffrey, Ph.D.

Respondent asked Dr. Caffrey to opine on the validity and usefulness of the

regression analyses presented in Mr. Wertlieb's report. Dr. Caffrey has a bachelor

of arts degree in mathematics and economics from the California State University,

Bakersfield and a Ph.D. in economics from the University of California, San

Diego. Dr. Caffrey is a staff economist for the Internal Revenue Service who

receives an annual salary that is not dependent on the outcome of this case.

Dr. Caffrey came to four conclusions after reviewing Mr. Wertlieb's report:

(1) Mr. Wertlieb's regressions are used to extrapolate rather than to interpolate;l°

(2) the inclusion of Clear Channel Communications (the largest of the publicly

traded companies Mr. Wertlieb looked at) drives the results of the fixed

compensation regressions; (3) on the basis of the P-values of the coefficients in all

of the regressions, the coefficients are not useful; and (4) on the basis of the Rsquareds of the regressions, the regressions do not explain the variation in either

the fixed compensation or the variable compensation. Dr. Caffrey concluded that

1°Dr. Caffrey believes that because the companies used in Mr. Wertlieb s

analysis had uniformly higher revenues than Aries, the regressions are being used

to make a prediction outside of the range of the observations (extrapolate) rather

than to make a prediction inside the range of observations used (interpolate).

- 16 [*16] Mr. Wertlieb's regression analysis is not useful to make a positive

conclusion about the reasonableness of Mr. Astor's compensation.

Expert Report--Mark R. Lipis

After the petition was filed respondent engaged Lipis Consulting, Inc., to

opine on what constituted reasonable compensation for the owner/operator of the

radio broadcast stations operated by Aries and its subsidiaries for TYE August 31,

2004. Mr. Lipis has a bachelor of science degree in economics from the Wharton

School at the University of Pennsylvania and a master of business administration

degree from the University of Chicago. He has been in the consulting field of

compensation for more than 30 years serving clients in the public, private, and

nonprofit sectors.

Mr. Lipis considered executive officer compensation and broadcaster gross

income and profitability information from the National Association of

Broadcasters (NAB) for the position of general manager and information from the

Economic Research Institute. He then applied a 75% premium to those figures to

account for the fact that Mr. Astor was not just the general manager of one station

but also the president and CEO. The adjusted NAB figures are as follows:

- 17 Total compensation Total compensation

[*17] Survey section Base-median

--median

with 75% premium

All Stations--

$140,000

$160,000

$280,000

Revenues $1-1.5

million

105,000

125,000

218,750

Revenues $1.5-2

132,090

144,590

253,033

144,000

170,000

297,500

189,250

222,500

389,375

nationwide

million

Revenues $2-3

million

Pacific region

Mr. Lipis averaged the total compensation with the addition of the 75%

premium to arrive at $287,732 and compared it with Mr. Astor's 2004

compensation. Mr. Lipis then discounted the $287,732 backwards to compare it

with Mr. Astor's compensation in 2003, 2002, and 2001. On the basis of this

analysis, Mr. Lipis concluded that for the four years Mr. Astor was underpaid by a

total of $173,114 if his bonus is not included; and if Mr. Astor's bonus was

included then he was overpaid over four years by a total of $8,394,734.

Mr. Lipis also compared Mr. Astor's compensation with data from

broadcast company proxies as reported by the Kenexa.com database. That data

includes compensation amounts for several television and radio companies, all of

which were much larger than Aries when measured by revenues. Mr. Lipis used

- 18 [*18] scattergrams and regression analysis to show the correlation between

compensation and revenue, net income, and profit margin.

With respect to Mr. Astor's bonus, Mr. Lipis believed that the question to

be answered was: "Assuming the owner acted as a consultant to Kalil, how much

were his services worth to improve the $12 million offer to $18 million?" Mr.

Lipis concluded that a reasonable success fee for securing the additional $6

million of value was $210,000. Mr. Lipis then combined all of his methods and

concluded that the total reasonable compensation for Mr. Astor for 2004 was

$635,447.

OPINION

I.

Burden of Proof

The Commissioner's determination of a taxpayer's liability for an income

tax deficiency is generally presumed correct, and the taxpayer bears the burden of

proving that the determination is improper. See Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933)."

"Petitioner did not argue that the burden should shift to respondent under

sec. 7491(a)(2); however, we have decided this case on the preponderance of the

evidence.

- 19 [*19] II.

Reasonable Compensation

Respondent contends that most of the compensation paid to Mr. Astor was

not reasonable under section 162 for TYE 2004 and, in the notice of deficiency,

disallowed $6,086,752 of petitioner's claimed salary expense of $6,896,974.

Petitioner contends that all of Mr. Astor's compensation was reasonable, that it

included catchup payments for prior years in which Mr. Astor was

undercompensated, and that he was entitled to a bonus for the sales, which he

masterminded and facilitated, of the two radio stations.

A.

Overview of Section 162(a)(1)

Section 162(a)(1) provides a deduction for ordinary and necessary business

expenses, including "a reasonable allowance for salaries or other compensation for

personal services actually rendered". Absent stipulation to the contrary, an appeal

in this case would lie to the Court of Appeals for the Ninth Circuit. See sec.

7482(b)(1). Therefore, we follow that court's precedent. Golsen v.

Commissioner, 54 T.C. 742 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971). The

Court of Appeals for the Ninth Circuit determines the deductibility of

compensation through a two-prong test: the amount of compensation must be

reasonable, and the payment must be purely for services rendered. Nor-Cal

- 20 [*20] Adjusters v. Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), aff'g T.C.

Memo. 1971-200; sec. 1.162-7(a), Income Tax Regs.

B.

Salary Payments

1.

. Catchup Compensation and Services Actually Rendered

Compensation for prior years' services is deductible in the current year as

long as the employee was actually undercompensated in prior years and the current

payments are intended as compensation for past services. R.J. Nicoll Co. v.

Commissioner, 59 T.C. 37, 50-51 (1972); see also LabelGraphics, Inc. v.

Commissioner, 221 F.3d 1091, 1096 (9th Cir. 2000) ("an intention to remedy prior

undercompensation can weigh in favor of reasonableness"), af_f'g T.C. Memo.

1998-343. To the extent total compensation includes amounts that were actually

for prior years of service, the total compensation need not be reasonable in the

year it was paid. Devine Bros., Inc. v. Commissioner, T.C. Memo. 2003-15.

Petitioner contends that the amount paid to Mr. Astor in fiscal year 2004 includes

catchup amounts for the three prior years. Therefore, we shall evaluate the

reasonableness of Mr. Astor's compensation for TYE August 31, 2001 through

2004.

- 21 [*21] There is no doubt that Mr. Astor was the most valuable employee of Aries

and the compensation paid to him, or at least a portion thereof, was for services

actually rendered.

2.

Reasonableness of Payments

We consider the reasonableness of the compensation with reference to five

broad factors set forth in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir.

1983), rev'g T.C. Memo. 1980-282. No single factor is dispositive. Idlm at 1245.

The relevant factors are: (i) the employee's role in the company; (ii) a comparison

of the employee's salary with salaries paid by similar companies for similar

services; (iii) the character and condition of the company; (iv) potential conflicts

of interest; and (v) internal consistency. Id. at 1245-1247.

We also consider an additional factor: whether an independent investor

would be willing to compensate the employee as the taxpayer compensated the

employee. Metro Leasing & Dev. Corp. v. Commissioner, 376 F.3d 1015, 1019

(9th Cir. 2004), aff's 119 T.C. 8 (2002). The Court of Appeals notes that "the

perspective of an independent investor is but one of many factors that are to be

considered when assessing the reasonableness of an executive officer's

compensation." Id. at 1021. The reasonableness of compensation is a question of

fact to be determined on the basis of all the facts and circumstances. Pac. Grains,

- 22 [*22] Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), af£g T.C. Memo.

1967-7.

i.

Employee's Role in the Company

This factor looks to the overall significance of the employee to the

company. Elliotts, Inc. v. Commissioner, 716 F.2d at 1245. "Relevant

considerations include the position held by the employee, hours worked, and

duties performed, American Foundry v. Commissioner, 536 F.2d 289, 291-292

(9th Cir. 1976), as well as the general importance of the employee to the success

of the company", id.

Mr. Astor was the hands-on owner-operator of Aries. Mr. Astor has been

Aries' president, chief financial officer, and sole shareholder from its

incorporation in 1983 and has acted as general manger of each of petitioner's radio

stations. He was actively involved in managing many aspects of petitioner's dayto-day operations, including: (1) overseeing management personnel; (2) planning

and overseeing programming; (3) negotiating and communicating with lenders; (4)

participating in sales meetings; and (5) communicating with outside advisers. As

the key employee, he played a pivotal role in the profitable sale of petitioner's

major assets.

- 23 [*23] Respondent argues that the sale of Aries subsidiaries' assets was profitable

not because of Mr. Astor's personal role but because of the significant

appreciation of the FCC licenses. While we agree that the FCC licenses were the

principal driving force behind the sale and the key component of the sale price of

the subsidiaries, that does not necessarily diminish Mr. Astor's role as an

employee of the corporation.

Mr. Astor made the decision to both acquire and maintain the FCC licenses.

However, his role does raise an interesting issue. Did Mr. Astor invest in the

licenses personally, as the passive owner/investor of Aries, or did he make the

investment choices as a money-making strategy, in his employment capacity, as

the chief executive of Aries? Respondent wants to disallow the deduction of most

of Mr. Astor's salary and thus increase the tax of Aries. Had Mr. Astor personally

purchased the FCC licenses and then transferred them to a corporate entity such as

Aries or its subsidiaries, respondent's position might be well taken. However, the

FCC licenses were acquired by the corporate entities, and the decisions of Mr.

Astor should therefore be treated as the decisions of the chief executive of Aries.

Aries should compensate Mr. Astor for his successful investment choices.

In a situation similar to that of the appreciation of the FCC licenses, market

forces also helped create the cashflow enabling an employee's significantly

- 24 [*24] increased salary. In Shotmeyer v. Commissioner, T.C. Memo. 1980-238, we

explained that one of the reasons the employee-owner's corporation was finally

able to pay the manager a large salary was the conditions created by the Arab oil

embargo. We noted that the "economic conditions were not the primary reason for

the increase in salary." The primary reason was the taxpayer's "business acumen

and experience".

Although petitioner did not have any substantial taxable income before the

sale of two of its major assets, Mr. Astor, who was responsible for the assets,

facilitated the sale of those assets for prices far exceeding the buyers' original

offers. For the year before the year at issue petitioner's taxable income was

$14,596,284, and for the year at issue its taxable income was $3,902,092. Both

respondent's and petitioner's experts agree that Mr. Astor was petitioner's most

important employee. Mr. Astor also facilitated the Goldman Sachs debt by way of

his personal guarantee. See Leonard Pipeline Contractors, Ltd. v. Commissioner,

T.C. Memo. 1998-315, aff'd without published opinion, 210 F.3d 384 (9th Cir.

2000)." We find this factor weighs in favor of petitioner.

"Respondent has not asserted a thin capitalization argument, and the Court

shall not make one for him that petitioner would have no chance to rebut.

- 25 [*25]

ii.

Comparison With Similar Companies' Salaries

The next relevant factor is a comparison of the employee's salary with those

paid by similar companies providing similar services. Elliotts, Inc. v.

Commissioner, 716 F.2d at 1246; Hoffman Radio Corp. v. Commissioner, 177

F.2d 264, 266 (9th Cir. 1949). Mr. Astor explained that Aries was one of only a

few companies in the industry in which the owner was also the operator.

Therefore external comparisons are difficult, and each of the parties retained an

expert to provide an opinion regarding reasonable compensation for Mr. Astor."

The following table summarizes both expert opinions as to Mr. Astor's

fixed reasonable compensation:

"We evaluate expert opinions in the light of each expert's demonstrated

qualifications and all other evidence in the record. See Parker v. Commissioner,

86 T.C. 547, 561 (1986). We are not bound by an expert's opinions and may

accept or reject an expert opinion in full or in part in the exercise of sound

judgment. See Helvering v. Nat'l Grocery Co., 304 U.S. 282, 295 (1938); Parker

v. Commissioner, 86 T.C. at 561-562. We may also reach a determination of value

on the basis of our own examination of the evidence in the record. Silverman v.

Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), aff'g T.C. Memo. 1974-285.

- 26 [*26] TYE

Aug. 31

Respondent's

expert

Petitioner's

expert

Actual salary +

commission

2001

$287,732

$360,200

$250,351

2002

277,733

422,100

260,005

2003

267,051

443,400

204,835

2004

255,063

438,900

199,274

Total

1,087,579

1,664,600

914,465

The following table summarizes both expert opinions as to Mr. Astor's

variable reasonable compensation:

TYE

Aug. 31st

Respondent's

expert

Petitioner's

expert

Actual bonus

2001

-0-

-0-

-0-

2002

-0-

-0-

-0-

2003

-0-

$3,192,900

$1,870,148

2004

$210,000

4,704,500

6,697,700

Total

210,000

7,897,400

8,567,848

The tables indicate that the experts' opinions are very divergent. Both

experts compared the compensation of executive officers in companies similar to

Aries and then used linear regression as a tool to compare the companies' income

with that compensation.14

14As mentioned previously, linear regression is a statistical technique that

(continued...)

- 27 [*27] Respondent called a rebuttal expert, Dr. Caffrey, to challenge the findings

of Mr. Wertlieb, petitioner's expert. Dr. Caffrey came to certain conclusions

regarding Mr. Wertlieb's report. The concerns we find relevant are: (i) Mr.

Wertlieb's report is premised on a model analysis that employs return on sales as

its principal if not sole measure of financial performance; (ii) the regressions are

used to extrapolate; (iii) on the basis of the p-values, the coefficients are not

useful, and; (iv) on the basis of the R-squareds, the regressions do not explain the

variation in either the fixed compensation or the variable compensation. If those

conclusions are true, these are factors that would describe the mathematical

imprecision of the results of these regression models. Consequently, they

constitute arguments that require the Court to determine the proper weight to be

accorded to the conclusions of the Wertlieb report."

"(...continued)

can be used to estimate the correlation and effect between one or more

independent variable(s) and another single dependent variable. It can

consequently also be useful for prediction. In the case at hand it was used to

estimate the correlation between executive compensation and revenues.

"See generally Barabin v. Asten-Johnson, Inc., 700 F.3d 428, 431 (9th Cir.

2012); Esgar Corp. v. Commissioner, T.C. Memo. 2012-35, slip op. at 30-32

(citing Daubert v. Merrell Dow Pharms., Inc., 509 U.S. 579, 551 (1993), Fed. R.

Evid. 702 and 703, and Kumho Tire Co. v. Carmichael, 526 U.S. 137, 148 (1999)),

appeal filed (10th Cir. Sept. 6, 2012). The Court has previously addressed these

issues in greater detail in our order in this case filed December 27, 2011, in

(continued...)

- 28 [*28] Dr. Caffrey explained that the regressions are used to extrapolate rather than

interpolate because the data used for the comparison was acquired from companies

much larger than Aries. Because of the nature of the radio industry, there are not

very many companies whose financial information is public that are similar to

Aries, and the experts must use the data available. In fact, respondent's own

expert witness, Mr. Lipis, also used data from companies much larger than Aries,

explaining that "all the companies were considerably larger than Aries

Communications when measured by revenue yet I can still learn from their

compensation practices".

Dr. Caffrey attempted to recreate Mr. Wertlieb's regression analysis, and

then he listed the p-values for those re-creations.16 Dr. Caffrey explained that

[I]f the p-value is less than 0.05, then we can state that the beta

coefficient is statistically different from zero "at the 5% significance

level." The p-values generated from my replication attempts are

0.136 (2004), 0.105 (2003), 0.051 (2002), and 0.072 (2001). None of

is(...continued)

response to the motion in limine respondent filed on November 25, 2011, in an

attempt to bar Mr. Wertlieb's direct testimony in the form of his previously

submitted report.

1673g up-value" shows the "confidence intervals" or reliability of the

regression's coefficient, that is, how wide the confidence interval around the beta

coefficient is. If the confidence interval includes zero, there is no established

ascertainable relationship between revenues and fixed compensation. The highest

p-value Dr. Caffrey finds useful is 10%, which is also represented as 0.1.

- 29 [*29] these beta coefficients are statistically significant at the

standard 5% significance level. The beta coefficients from the 2003

and 2004 regressions are not statistically significant even at the less

rigorous 10% significance level.

Dr. Caffrey also objects to including the data from Clear Channel Communications

as, in his opinion, it is an outlier. If it is included, the values would range from as

low as 5.1% to as high as 13.6%. Although as the p-values demonstrate the

regression analysis is not strong, we will accord them the proper weight in

reaching our decision. However, we do not find the p-values make the regression

analysis completely irrelevant in this case.

Dr. Caffrey was also concerned with Mr. Wertlieb's regression analysis

because when he recreated the analysis, the R-squareds did not explain the

variation in either the fixed compensation or the variable compensation." Dr.

Caffrey found R-squareds of 0.163, 0.206, 0.321, and 0.349 for TYE August 31, of

2004, 2003, 2002, and 2001, respectively. However, regarding his own regression

analysis, respondent's expert, Mr. Lipis, explained:

An indicator of the robustness of the regression equation [i.e.

explanation of variation] is called the R-squared value; the higher the

number (between 0.00 and 1.00), the stronger the equation. The Rsquared value for the total compensation regression using the raw

numbers was 0.19. The R-squared values for the two logarithmic

"R-squared is the measure of the explanatory power of a regression, i.e.

how well it fits the data.

- 30 [*30] value regressions are 0.30 for total compensation and 0.16 for

total annual compensation. None of the R-squareds is strong but still

useful to know.

Mr. Lipis' R-squareds and the R-squareds Dr. Caffrey recreated from Mr.

Wertlieb's data are similar and not very strong in describing the mathematical

precision of the results of these regression models. Consequently, the Court will

bear this in mind when determining the proper weight to attribute to these

conclusions. Mr. Lipis' regression analysis explains the variation in either fixed

compensation or variable compensation about as well (or as poorly) as Mr.

Wertlieb's.

Both experts agree that with respect to Mr. Astor's fixed compensation for

TYE August 31, 2001 through 2004, he was underpaid. Mr. Lipis determined that

for those four years a total of $1,087,579 was reasonable compensation, and Mr.

Wertlieb determined that a total of $1,664,600 was reasonable compensation. Mr.

Astor was actually paid a total of $914,465. We find that, given the R-squareds

and the p-values of both Mr. Wertlieb's and Mr. Lipis' regression analysis, both

reports should be given equal weight. Therefore we shall average their two

conclusions and fmd that for those four years a total of $1,376,090 would have

been reasonable fixed compensation. Thus, Mr. Astor was underpaid by

$461,625.

- 31 [*31] The greatest difference in opinion between the experts is with respect to Mr.

Astor's bonus. Mr. Wertlieb found that when the receipts of a corporation

increase, so do executive bonuses; using his regression analysis he found that for

the receipts earned in TYE August 31, 2003 and 2004 Mr. Astor's bonus would

have been reasonable at $3,192,900 and $4,704,500, respectively. Mr. Lipis took

a different approach for his analysis of Mr. Astor's bonus and believed that the

question to be answered was: "Assuming the owner acted as a consultant to Kalil,

how much were his services worth to improve the $12 million offer to $18

million?" Mr. Lipis concludes that a reasonable success fee for securing the

additional $6 million of value was $210,000.18

We do not entirely agree with either Mr. Wertlieb or Mr. Lipis. Mr.

Wertlieb's regression analysis suffered from low R-squareds and high p-values,

and Mr. Lipis undercompensated Mr. Astor for increasing the sale price by $6

million.

We note that "[t]o determine what is 'reasonable' compensation in any

situation is a difficult task, given the various factors to consider, the unique

aspects of every business, and the unavoidable tension between the rules of

18Mr. Lipis used the formula from the Kalil brokerage contract to determine

the $210,000 ((5% x $3,000,000)+ (2% x $3,000,000)= $210,000).

- 32 [*32] section 162 and the latitude allowed to business judgment." Clymer v.

Commissioner, T.C. Memo. 1984-203, aff'd without published opinion sub nom.

Dension Poultry & Egg Co. v. Commissioner, 775 F.2d 299 (5th Cir. 1985). Mr.

Astor, acting in his executive capacity, was responsible for increasing the sale

price from $12 million to $18 million, or by 50%. Mr. Astor also had significant

involvement in his executive capacity, acquiring, managing, and selling the

investment. Given his dual status as shareholder and chief executive officer he

would in all events, see Univ. Chevrolet Co. v. Commissioner, 16 T.C. 1452, 1455

(1951), aff'd, 199 F.2d 629 (5th Cir. 1952), have been motivated to obtain the

highest sale price possible. Nevertheless, his efforts as an employee are still

entitled to reasonable compensation for services actually rendered. In short, his

executive efforts over a number of years permitted Aries to capitalize on this

business opportunity. Therefore "using our best judgment, based on all the

evidence in the record", the Court finds that Mr. Astor's appropriate bonus would

be one-third of the increase in the sale price, which is $2 million. See id. This

factor weighs against finding that Mr. Astor's variable compensation was

reasonable and that petitioner may deduct the entire expense under section 162.

- 33 [*33]

iii.

Character and Condition of the Company

Under this factor we analyze the character and condition of the company,

focusing on the company's size, complexity, net income, and general economic

condition. Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.

Aries was a complex business holding multiple subsidiaries each with its

own radio stations. Aries had gross receipts of over $4.5 million before it sold off

some of its major assets. However, Aries was losing more and more money each

year from 1999 to 2002 and immediately after the two years of major asset sales

began losing money again. Respondent points out that Aries was deeply in debt

when the asset sales occurred. Petitioner had guaranteed the Goldman Sachs debt

of $20 million. And at trial Mr. Astor explained that the forbearance agreement

was behind the sale of Orange Broadcasting. Orange Broadcasting would not

have been able to continue as a going concern if the sale had not occurred.

One of the asset sales did occur during the year at issue, and during that year

Aries was profitable because of that sale. Mr. Astor was responsible for the

increased sale price of the assets and had managed to keep the wolves at bay

before the sale of the assets so that Aries might enjoy the financial benefit from

those asset sales. Nevertheless, as discussed infra, we note that even for the year

at issue Aries' tax return reflects a $4,041,016 loan from Mr. Astor. The fact that

- 34 [*34] Aries basically had to borrow the bonus back from Mr. Astor in the year it

was paid depicts a rather bleak financial condition and casts a shadow on the

substance of the transaction, suggesting that Aries was thinly capitalized.

The economics at play here are enlightening. The value of assets such as

the FCC licenses is generally determined by the discounted value of the future

income stream the asset will produce. It is therefore curious that radio stations and

FCC licenses with a history of operating losses were valued by purchasers at $35

million and $18 million. Apparently others believed that they could employ these

assets much more profitably than their track record would suggest. This implies

that either the stations were managed poorly or at least in the case of 94.3 FM,

there was a synergistic effect and significant value was created when the coverage

area was materially increased by combining the stations. Perhaps both these and

other factors were at work. In any case the stations' financial performance lagged

behind what would be expected from the use of assets with such significant value.

Because Aries was a large asset-laden complex business with a negative net

income and a bleak financial picture despite the favorable fact that it enjoyed a

successful asset sale during the year at issue, we find this factor favors respondent.

- 35 [*35]

iv.

Potential Conflicts of Interest

This factor focuses on any indicia that there may be a conflict of interest.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1246. Primarily we are concerned with

whether a relationship exists between the employee and the company that may

permit the disguise of nondeductible corporate distributions as salary

expenditures. Id. Mr. Astor was an owner-operator. There was no specific

evidence introduced that Aries ever paid or that he received a dividend, although

the change in common stock from $280,000 to $120,000 and the Court's

difficulties in reconciling retained earnings imply some distributions to

stockholders may have occurred. Their character is not resolved by the record,

and in the absence of accumulated or current year's earnings and profits it may

have resulted in a tax-free return of capital. In any event it was incumbent on

petitioner, who has the burden of proof, to clarify the facts if doing so was

favorable to Aries.

Therefore a relationship did exist between Mr. Astor and Aries that could

have permitted the disguised dividend distributions as salary expenditures. "The

mere existence of such a relationship, however, when coupled with * * * [the]

absence of dividend payments, does not necessarily lead to the conclusion that the

amount of compensation is unreasonably high." Id. When this is the case, we

- 36 [*36] closely scrutinize the alleged salary payments and frequently evaluate the

compensation from the perspective of a hypothetical independent investor. Id. at

1247.

Petitioner argues that Aries' return on equity resulted in an increase in

shareholder equity from a $280,000 initial contribution in 1983 to $12,725,862 in

TYE August 31, 2003. Respondent argues that this paints a rosier picture than

petitioner's actual financial standing at that time. In TYE August 31, 2003

petitioner had $3,561,369 cash on hand after having paid off the Goldman Sachs

debt that precipitated the sale, and in addition petitioner no longer owned some of

its most valuable assets.

Both parties overstate and oversimplify their cases. Because of various

interparty loans and the $20 million Goldman Sachs debt Mr. Astor personally

guaranteed it is difficult to discern the true capital structure and equity status of

the corporate entities. During the same years stated shareholder investment,

ignoring negative retained earnings, was $120,000. However, when interparty

loans are considered and unrealized asset appreciation is adjusted for, a quite

different picture emerges. The Court has previously concluded that the real source

of value here was the FCC licenses that made the Goldman Sachs loan possible.

Mr. Astor's guarantee, we believe, added little other than.its protection of the

- 37 [*37] value by including as an obligor the sole shareholder of the corporation

holding the FCC licenses.

The following table reflects the interparty loans between Mr. Astor and

Aries. This table suggests that other than Mr. Astor's investment in the, as of yet,

unrealized appreciation in Aries' and its subsidiaries' assets, he had no capital

investment at all. They were the corporation's assets, not his (ignoring his stock

ownership), and provided the necessary security for the loans. Further, when the

loans are scrutinized Mr. Astor had in practice already withdrawn his stated

$120,000 equity and a material portion of the appreciation in Aries and its

subsidiaries' assets.19 Consequently, these facts must be considered in

determining an investor's right to a reasonable return on investment.

19The "loans" may have been in substance dividends or distributions (only

for years in which there was a profit) but were apparently reflected by interestbearing notes; and although the notes were frequently refinanced with new notes,

interest was paid and notes were paid. Respondent has, for whatever reason,

chosen not to contest the shareholder loans for tax purposes.

- 38 [*38] TYE Aug. 31

Aries' loans to Mr. Astor Loans from Mr. Astor to Aries

1999

$1,775,641 .

-0-

2000

2,715,399

$740,016

2001

2,741,850

740,016

2002

2,739,045

740,016

2003

2,727,389

740,016

2004

2,727,389

4,041,016

2005

2,727,389

4,404,381

Mr. Astor shrewdly negotiated the sales of some of Aries' assets for prices

much higher than initially offered and by paying off the Goldman Sachs debt kept

the company a going concern and out of bankruptcy. An independent investor

would have desired the highest prices for the assets and rewarded Mr. Astor for his

work in securing those prices. However, as the owner of Aries Mr. Astor also had

a significant interest in garnering the highest price for the assets and then

receiving the reward as salary deductible by Aries instead of a nondeductible

dividend. Mr. Astor had also been receiving a significant benefit from the loans

from Aries, and we note that Mr. Astor was well compensated for his work in

investing in and maintaining the major assets of Aries in the year immediately

before the year at issue when the first major asset sale took place. Mr. Astor was

- 39 [*39] paid $2,074,983 in TYE August 31, 2003. These are precisely the conflicts

of interest this factor seeks to avoid; therefore, we find this factor favors

respondent.

v.

Internal Consistency

"[E]vidence of an internal inconsistency in a company's treatment of

payments to employees may indicate that the payments go beyond reasonable

compensation." Elliotts, Inc. v. Commissioner, 716 F.2d at 1247. And with

respect to bonuses paid, we note that "Bonuses that have not been awarded under a

structured, formal, consistently applied program generally are suspect * * * On the

other hand, evidence of a reasonable, longstanding, consistently applied

compensation plan is evidence that the compensation paid in the years in question

was reasonable." Id.

In Vitamin Vill., Inc. v. Commissioner, T.C. Memo. 2007-272, the Court

found that the bonuses paid were not awarded under a structured, formal, or

consistently applied program; however, because they "were paid under the

taxpayer's plan to award a bonus for present hard work and prior years' lack of

compensation when the taxpayer became more profitable", Multi-Pak Corp. v.

Commissioner, T.C. Memo. 2010-139, it found the factor to favor the taxpayer.

Mr. Astor's bonuses were not paid under a structured or formal plan. Aries paid

- 40 [*40] Mr. Astor large bonuses in the years that it was able to afford them. We

note, however, that the bonuses were determined at the end of the year when Mr.

Astor and petitioner could reasonably predict Aries' profits and potential Federal

income tax liability absent a section 162 deduction for Mr. Astor's compensation.

This fact weighs in respondent's favor.

Another facet of this factor is the comparison of the owner-operator's

compensation with that of other employees of the company. Elliotts, Inc. v.

Commissioner, 716 F.2d at 1247. However, if the services provided by unrelated

nonowner employees are not comparable in scope to the responsibilities of the

owner-operator, the compensation paid such nonowner employees is not

necessarily relevant to the reasonableness of the owner-operator's compensation.

Clymer v. Commissioner, T.C. Memo. 1984-203.

Susan Burke served as the executive vice president and corporate secretary

for both Orange Broadcasting and North County Broadcasting from 1996. Her

duties included: FCC-related issues, labor and employment issues, music

licensing, and review of documents and contracts. During the year at issue

petitioner paid Ms. Burke $288,654, including a $200,000 bonus from Orange

Broadcasting. Ms. Burke is the only employee with duties remotely similar to Mr.

Astor's. Mr. Astor described Ms. Burke as his "Girl Friday" at trial. She was the

- 41 [*41] chief administrator of the business, and her duties are not comparable in

scope to.Mr. Astor's duties. Thus her compensation is not relevant to our analysis.

Id.

Because Mr. Astor's compensation was not awarded under a structured,

formal, consistently applied program, it was suspect. However, because we found

supra that Mr. Astor's compensation included amounts for prior years of hard

work for which he was undercompensated, we find this factor neutral.

vi.

Additional Factor: The Independent Investor

While we found supra that petitioner did intend Mr. Astor's compensation

as catchup compensation for prior services rendered, in Elliotts, Inc. v.

Commissioner, 716 F.2d at 1247, the Court of Appeals for the Ninth Circuit noted

that

If the bulk of the corporation's earnings are being paid out in the form

of compensation, so that the corporate profits, after payment of the

compensation, do not represent a reasonable return on the

shareholder's equity in the corporation, then an independent

shareholder would probably not approve of the compensation

arrangement. If, however, that is not the case and 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. [Fn. ref. omitted.]

Petitioner's Form 1120, page 4 balance sheet for 1998, the earliest return in

the record, shows a common stock balance of $280,000 at the beginning of the

- 42 [*42] year. We shall assume that the $280,000 is the investor's (in this case Mr.

Astor's) initial investment. As we noted above, while petitioner argues that its

return on equity resulted in an increase in shareholder equity from a $280,000

initial contribution in 1983 to $12,725,862 in TYE August 31, 2003, there may in

substance have been no equity (other than unrealized appreciation in the corporate

assets). Apparently, in a manner not revealed by the record, petitioner paid Mr.

Astor some sort of distribution in 1998 because the common stock balance was

reduced to $120,000 at the end of the year. Thereafter, all of petitioner's later tax

returns in the record reflect a common stock balance of $120,000.

A reasonable investor would expect to receive a return on this initial

investment and would not approve of a salary package that depleted the

corporation's assets without paying the investor. Id. (a 20% return on equity

"would satisfy an independent investor"); Thousand Oaks Residential Care Home

I, Inc. v. Commissioner, T.C. Memo. 2013-10 ("return on investment of between

10% and 20% tends to indicate compensation was reasonable"); L & B Pipe &

Supply Co. v. Commissioner, T.C. Memo. 1994-187 (investor would have been

happy with either 6% dividend return plus 10% growth in retained earnings or

20% growth in shareholders' equity).

- 43 [*43] As the cases above show, the Court has found that a return on investment of

10% to 20% tends to indicate compensation was reasonable.20 In Miller & Sons

Drywall, Inc. v. Commissioner, T.C. Memo. 2005-114, we explained that "this

Court has generally calculated a corporation's ROE [return on equity] by dividing

its net income after tax for a specific year by its shareholders equity" instead of

using compound growth rates. See B & D Founds., Inc. v. Commissioner, T.C.

Memo. 2001-262 (discussing the ROE calculation in greater detail);

LabelGraphics, Inc. v. Commissioner, T.C. Memo. 1998-343. For the reasons

discussed below, we will use petitioner's shareholder's equity at the end of TYE

August 31, 2004, the year in issue. Because we have the specific financial

information for Orange Broadcasting and North County Broadcasting, we will

analyze each subsidiary separately.

20The Court takes judicial notice that in 1983 (when Mr. Astor purchased

94.3 FM) the prime interest rate was 11% and in 1987 (when Mr. Astor purchased

92.1 FM) the prime interest rate was between 7.75% and 8.75%. A 10-year

Treasury note had a 10.46% interest rate in 1983 and a 7.08% rate in 1987.

- 44 -

[*44]

2002

2003

2004

2005

Orange Broadcasting

Net income (loss)

($1,771,765)

$25,891,030 ($17,043,881) ($1,532,436)

Stockholders

equity

(2,099,723)

23,765,122

6,721,242

4,376,865

0.844

1.089

(2.536)

(0.35)

ROE

North County Broadcasting

Net income (loss)

($1,269,102)

($436,159)

$13,988,322

($113,102)

Stockholders

equity

(7,286,270)

(7,731,116)

6,204,662

4,430,601

0.174

0.056

2.254

(0.026)

ROE

We note that Aries was made up of more than just Orange Broadcasting and

North County Broadcasting and therefore analyze the ROE of Aries as a whole by

deriving the following information from Aries' tax returns.

TYE

Aug. 31

Net profit (loss)

after taxes

Equity'

Return on equity

2002

($1,415,651)

($7,569,904)

0.187

2003

9,247,098

12,333,790

0.750

2004

14,025,956

12,797,157

0.315

2005

(1,742,547)

9,690,040

(0.180)

2006

(2,688,686)

6,935,019

(0.388)

'Equity was determined by adding the.common stock, additional paid in

capital, and retained earnings stated on Aries' Form 1120 page 4 balance sheet.

- 45 [*45] We note that this method of determining the shareholders' return on

investment is skewed because of the interparty loans and further skewed in the

years in which the two subsidiaries sold major assets. Therefore under the specific

facts of this case as discussed supra under the heading "Potential Conflicts of

Interest", the corporation's ROE does not paint a very meaningful or accurate

picture. In this case, the independent investor analysis is a weak factor, and the

Court of Appeals for the Ninth Circuit explains that the independent investor test

is only one of the many factors to be considered. Metro Leasing & Dev. Corp. v.

Commissioner, 376 F.3d at 1021.

We find that using compound growth rates presents a more accurate picture.

As the table supra page 10 shows, petitioner had negative income in every year in

the record except for the two years in which petitioner had major asset sales. The

record does not apportion the capital investment represented by the common stock

of $280,000 or $120,000 among the multiple radio stations and subsidiaries of

petitioner, and it indicates only that Mr. Astor's initial investment in 94.3 FM was

$31,200. The record does not reveal what his initial investment in 92.1 FM was.

A 10% return on $280,000 compounded annually for 21 years (1983-2003)

is roughly $2,072,069.98, a 15% return is $5,270,025, and 20% return is

$12,881,434. We note that in 1998 $160,000 of the initial investment was

- 46 [*46] removed from the corporate books. A 10% rate of return on $280,000

compounded annually for 16 years (1983-1998) is $1,286,592; then if we subtract

the $160,000 and compound the rest for the final 5 years, the final return is .

$1,814,388. The same calculation at 15 and 20% yields $5,270,025 and

$12,881,434, respectively. Because Aries was a highly leveraged business but

possessed assets, such as the FCC licenses, likely to appreciate, a hypothetical

investor might be satisfied with a 10% return on this investment. Consequently,

the corporation should have had at least $1,814,388 left for distribution after

payment of the compensation packages.

Petitioner had a net income of $4,025,956 after taxes and the compensation

packages were paid in the year at issue and retained earnings of $12,725,862.

Respondent argues that the large income was due to the substantial asset sales that

occurred and that this level of income was not sustained. In TYE August 31, 2005

and 2006 petitioner had a net income of ($1,742,547) and ($2,688,686),

respectively. Because petitioner had enough retained earnings to almost satisfy an

investor even at 20% compounded annually after Mr. Astor's compensation was

paid in 2004, we conclude this factor favors petitioner.

-47[*47]

vii.

Conclusion

After review of each factor discussed above, we hold that Mr. Astor's

compensation was not reasonable for TYE August 31, 2004, and that petitioner

may not deduct the entire amount of claimed compensation expense under section

162. We found supra that Mr. Astor's fixed salary was underpaid for the four

years we reviewed by $461,625. That amount, plus Mr. Astor's actual fixed salary

of $199,274 for the year at issue, plus the $2 million bonus that we found

reasonable, or a total of $2,660,899 is deductible as reasonable compensation for

TYE August 31, 2004, under section 162. We again note that the reasonableness

of compensation is a question of fact to be determined on the basis of all the facts

and circumstances. Pac. Grains, Inc. v. Commissioner, 399 F.2d at 606.

III.

Section 6662(a) Accuracy-Related Penalty

Respondent contends that petitioner is liable for the section 6662(a) and

(b)(1) and (2) accuracy-related penalty for TYE August 31, 2004, because a

portion of petitioner's underpayment was due to either a substantial

understatement of income tax or negligence. There is a "substantial

understatement" of income tax for any tax year where, in the case of corporations

(other than S corporations or personal holding companies), the amount of the

understatement exceeds the greater of (1) 10% of the tax required to be shown on

- 48 -

[*48] the return for the tax year or (2) $10,000. Sec. 6662(d)(1)(B). Section

6662(a) and (b)(1) also imposes a penalty for negligence or disregard of rules or

regulations. Under this section "'negligence' includes any failure to make a

reasonable attempt to comply with the provisions of this title". Sec. 6662(c).

Under caselaw, "'[n]egligence is a lack of due care or the failure to do what a

reasonable and ordinarily prudent person would do under the circumstances.'"

Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v.

Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff'g on this issue 43 T.C. 168

(1964) and T.C. Memo. 1964-299), aff'd, 904 F.2d 1011 (5th Cir. 1990), aff'd,

501 U.S. 868 (1991).

There is an exception to the section 6662(a) penalty when a taxpayer can

demonstrate (1) reasonable cause for the underpayment and (2) that the taxpayer

acted in good faith with respect to the underpayment. Sec. 6664(c)(1).

Regulations promulgated under section 6664(c) further provide that the

determination of reasonable cause and good faith "is made on a case-by-case basis,

taking into account all pertinent facts and circumstances." Sec. 1.6664-4(b)(1),

Income Tax Regs.

Reliance on the advice of a tax professional may, but does not necessarily,

establish reasonable cause and good faith for the purpose of avoiding a section

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[*49] 6662(a) penalty. See United States v. Boyle, 469 U.S. 241, 251 (1985)

("Reliance by a lay person on a lawyer [or accountant] is of course common; but

that reliance cannot function as a substitute for compliance with an unambiguous

statute.").

The caselaw sets forth the following three requirements for a taxpayer to use

reliance on a tax professional to avoid liability for a section 6662(a) penalty: "(1)

The adviser was a competent professional who had sufficient expertise to justify

reliance, (2) the taxpayer provided necessary and accurate information to the

adviser, and (3) the taxpayer actually relied in good faith on the adviser's

judgment." See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99

(2000), aff'd, 299 F.3d 221 (3d Cir. 2002); see also Charlotte's Office Boutique,

Inc. v. Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005) (quoting with

approval the above three-prong test), aff'g 121 T.C. 89 (2003).

Although at trial Mr. Astor stated that he "discussed the compensation that

they thought was acceptable" with his accountants, he never explained what kind

of information he provided to his accountants or whether he even relied on the

accountants' judgment. While Aries' Federal income tax returns were prepared by

his accountants, none of them testified at trial. Petitioner did not meet the three

prongs of the Neonatology test, and therefore we do not find petitioner's reliance

- 50 [*50] on a tax professional reasonable cause for the underpayment attributable to

Mr. Astor's compensation.

With respect to the $550,000 concession, petitioner presented no evidence

that it acted with reasonable cause and in good faith. Therefore petitioner is liable

for the section 6662(a) accuracy-related penalty.

The Court has considered all of the parties' contentions, arguments,

requests, and statements. To the extent not discussed herein, the Court concludes

that they are meritless, moot, or irrelevant.

To reflect the foregoing,

Decision will be entered

under Rule 155.