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e. Internal Inconsistency
Evidence of an internal inconsistency in the determination
of employee compensation may indicate the presence of
unreasonable compensation to employee-shareholders. Elliotts,
Inc. v. Commissioner, 716 F.2d at 1247. Such evidence may also
be “probative of a presence or absence of compensatory intent.”
Id. at n.7. In addition, “salaries paid to controlling
shareholders are open to question if, when compared to salaries
paid nonowner management, they indicate that the level of
compensation is a function of ownership, not corporate management
6(...continued)
attached to the copy of the return in evidence.
Moreover, because petitioner’s equity remained essentially
constant while its sales and assets increased, ROE does not
appear to be an appropriate measure of shareholder return in this
case. For example, comparing 1988-90 with the audit years (1995-
97), average yearend equity increased only 4 percent whereas
average sales increased 129 percent and average yearend assets
increased 215 percent. Under such circumstances, it would appear
that either ROA or ROS would be superior to ROE as a measure of
performance. For the audit years, both ROA and ROS were quite
low (average ROA was .9 percent and average ROS was .27 percent).
Alternatively, ROE might be an appropriate measure of
performance if petitioner’s fair market value were substituted
for “book” equity. In that connection, we note that book equity
has not always been used in computing return on equity. See
Lumber City Corp. v. Commissioner, T.C. Memo. 1996-171 (holding
that the amount paid by the employee-shareholder for a stock
interest in his employer, rather than book shareholder equity,
was appropriate for use in determining whether return on
investment was sufficient to satisfy an independent investor).
That alternative approach is not available in this case because,
aside from Mr. Carey’s admitted speculation that petitioner was
worth between $12 million and $20 million, there is no evidence
as to petitioner’s fair market value during the audit years.
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