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dividends it paid does not sit well for petitioner in light of
the other factors that support a conflict of interest.
Rather than focusing on the payment of dividends, the Court
of Appeals for the Ninth Circuit evaluated the reasonableness of
compensation from the viewpoint of a hypothetical independent
investor. A return on shareholder equity, after paying officer
compensation, that would satisfy an independent investor is a
strong indication that the compensation is reasonable and that
the company is not siphoning off profits disguised as salary.
Elliotts, Inc. v. Commissioner, supra at 1247.
Petitioner argued that it provided a sufficient return
measured by the dividend paid in each year in issue as a
percentage of Kleindienst's initial capital contribution. Such
a percentage is not a correct measure of a shareholder's return
on investment because it ignores the past earnings retained and
reinvested by the corporation which, in this case, constitute a
large percentage of shareholder equity. During taxable years
ended July 31, 1989 and July 31, 1990, petitioner reported
shareholder equity5 of $341,708 and $338,458, respectively.
During these years, net income after Kleindienst's compensation
and taxes was $72,681 and $0, respectively--a return of 21
5 To calculate shareholder equity, we added together the
listed amounts for capital stock and unappropriated retained
earning from Schedule L on Form 1120, U.S. Corporation Income Tax
Return.
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