# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A406431f8878abcc8 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text T.C. Memo. 2006-36 UNITED STATES TAX COURT PK VENTURES, INC. AND SUBSIDIARIES, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent* Docket Nos. 5836-99, 6395-99, 10154-99. Filed March 7, 2006. B. Gray Gibbs, Daniel C. Johnson, and Philip Alan Diamond, for petitioners (at trial). Sheldon M. Kay and Thomas Cullinan, for petitioners (on reconsideration). Kirk S. Chaberski and Benjamin A. de Luna, for respondent. 1 Cases of the following petitioners are consolidated herewith: P.K. Ventures I Limited Partnership, Robert L. Rose, Tax Matters Partner, docket No. 6395-99; Robert L. and Alice N. Rose, docket No. 10154-99. *This opinion supersedes T.C. Memo. 2005-56, which is withdrawn by order served this date, as a result of a motion for reconsideration filed subsequent to the release of T.C. Memo. 2005-56. - 2 MEMORANDUM FINDINGS OF FACT AND OPINION Table of Contents FINDINGS OF FACT .......................................... 7 Background ........................................... A. Rose ....................................... B. Printon Kane and Co. and the Printon Kane Group, Inc. ................................ C. PK Ventures ................................ D. PKVI LP .................................... 7 7 8 9 11 PK Ventures’ Purchase of the Stock of SLPC, TBPC, TPC, and TPTC ............................................. 15 Rose’s Initial Receipt of an Equity Interest in PK Ventures .......................................... 25 The Purchase of Zephyr 26 ............................... Transfers From PK Ventures, TBPC, and TPTC to Zephyr and Zephyr’s Bankruptcy .............................. A. As Described in the Business’s Financial Statements and Income Tax Returns .......... 1. 1987 .................................. 2. 1988 .................................. 3. 1989 .................................. 4. 1990 .................................. B. Internal Revenue Service (IRS) Determinations ............................. Rose’s Acquisition of Control of PK Ventures and PKVI LP .............................................. 29 30 30 31 32 33 34 35 Transfers From PK Ventures to the Zephyr Purchasers .. A. As Described in the Financial Statements and Income Tax Returns for PK Ventures and PKV&S ...................................... B. As Described in the Roses’ Income Tax Returns .................................... C. IRS Determinations ......................... 42 Transfers to PKVI LP ................................. A. Transfers From Unrelated Parties to PKVI LP .................................... 47 43 46 47 47 - 3 B. Transfers From PK Ventures and/or Its Subsidiaries to PKVI LP .................... 1. As Described in the Business’s Financial Statements and Income Tax Returns ............................... a. 1986 ............................. b. 1987 ............................. c. 1988 ............................. d. 1989 ............................. e. 1990 ............................. f. 1991 ............................. g. 1992 ............................. h. 1993 ............................. 2. IRS Determinations .................... Other Circumstances Surrounding PK Ventures’ Operations and Financial Arrangements ................ A. Going Concern Notes in the Business’s Financial Statements ....................... 1. PK Ventures, SLPC, TBPC, and TPTC ..... 2. PKVI LP ............................... B. Litigation Involving SLPC, TBPC, and TPTC .. C. Transfers From Rose to PK Ventures ......... Rose’s Wages for 1986 Through 1993 ................... A. Wages Received From Printon Kane and the Printon Kane Group ......................... B. Wages Recorded on PK Ventures’ Books and Records .................................... C. Wages Reported on Income Tax Returns ....... D. IRS Determinations ......................... PK Ventures’ Share of PKVI LP’s Items of Income and Loss ................................................. A. As Reported on PK Ventures’ Schedules K-1 .. B. As Reported on the Income Tax Returns for PK Ventures and PKV&S ...................... C. IRS Determinations ......................... The Roses’ Share of PKVI LP’s Items of Income and Loss ................................................. A. As Reported on Rose’s Schedules K-1 ........ B. As Reported on the Roses’ Income Tax Returns .................................... C. IRS Determinations ......................... 55 58 58 59 60 61 63 64 66 67 67 70 70 70 70 72 73 74 76 76 79 82 85 85 86 87 88 88 89 92 - 4 The Roses’ Share of Zephyr’s Items of Income and Loss ................................................. A. As Reported on Rose’s Schedules K-1 ........ B. As Reported on the Roses’ Income Tax Returns .................................... C. IRS Determinations ......................... 94 94 95 96 Transactions Involving SLPC, TPC, and the Roses During 1994 and 1995 ................................. A. As Described in SLPC and the Roses’ Income Tax Returns ................................ B. IRS Determinations ......................... 99 100 Imposition of Accuracy-Related Penalties by the IRS .. 101 ................................................... 102 OPINION Procedural Matters 97 ................................... 102 Issue #1--Transfers From PK Ventures to the Zephyr Purchasers ................................. 104 Issue #2--Transfers From PK Ventures, TBPC, and TPTC to PKVI LP ................................. 111 Issue #3--Transfers From PK Ventures, TBPC, and TPTC to Zephyr .................................. 118 Issues #4 and #5--Partners’ Basis in PKVI LP 119 ......... Issue #6--The Roses’ Basis in Their Zephyr Interest .. 123 .... 132 .................... 138 .................................. 151 Issue #7--The Roses’ Basis in Their SLPC Interest Issue #8--Reasonable Compensation Issue #9--Penalties COHEN, Judge: Respondent determined deficiencies and penalties with respect to the Federal income taxes for petitioner PK Ventures, Inc. and Subsidiaries (PKV&S), for 1990, 1991, 1992, and 1993 as follows: - 5 Year Deficiency Penalty Sec. 6662(a) 1990 1991 1992 1993 $211,278 791,480 649,700 750,743 $2,269 9,517 1,316 –- By Notice of Final Partnership Administrative Adjustment (FPAA) dated January 11, 1999, respondent determined an upward adjustment of $100,661 with respect to the ordinary income of P.K. Ventures I Limited Partnership (PKVI LP) for 1991. Robert L. Rose (Rose), the designated tax matters partner for PKVI LP, filed a Petition for Readjustment of Partnership Items Under Code Section 6226. Respondent determined deficiencies, an addition to tax, and penalties with respect to the Federal income taxes for petitioners Robert L. and Alice N. Rose (the Roses) for 1990, 1991, 1992, 1993, 1994, and 1995 as follows: Year Deficiency Addition to Tax Sec. 6651(a)(1) 1990 1991 1992 1993 1994 1995 $11,729 90,133 503,928 177,286 248,981 397,096 –----$8,446 Penalty Sec. 6662(a) $2,346 18,027 100,786 35,457 –-- The principal issues tried and briefed in these consolidated cases were: (1) Whether a transfer of $1 million from PK Ventures, Inc. (PK Ventures), to 10 individuals, 9 of whom were shareholders of - 6 PK Ventures, in 1987 to enable them to purchase Zephyr Rock & Lime, Inc. (Zephyr), was a bona fide loan and, if so, whether that debt ever became worthless (Issue #1); (2) whether transfers of funds from PK Ventures and/or its subsidiaries to PKVI LP prior to and during 1990 and during 1991 were bona fide loans and, if so, whether such debts ever became worthless (Issue #2); (3) whether transfers of funds from PK Ventures and two of its subsidiaries to Zephyr prior to 1990 were bona fide loans and, if so, whether such debts ever became worthless (Issue #3); (4) whether PK Ventures had sufficient basis in its PKVI LP interest during 1990, 1991, 1992, and 1993 to deduct the losses that it claimed from PKVI LP on PKV&S’s consolidated Federal income tax returns for those years (Issue #4); (5) whether the Roses had sufficient basis in their PKVI LP interest during 1990, 1991, 1992, 1993, 1994, and 1995 to deduct the losses that they claimed from PKVI LP on their joint Federal income tax returns for those years (Issue #5); (6) whether the Roses had sufficient basis in their Zephyr interest during 1990, 1991, and 1992 to deduct the losses that they claimed from that S corporation on their joint Federal income tax returns for those years (Issue #6); (7) whether the Roses had sufficient basis in their St. Louis Pipeline Corp. interest during 1994 and 1995 to deduct - 7 the losses that they claimed from that S corporation on their joint Federal income tax returns for those years (Issue #7); (8) whether the compensation that Rose received from PKV&S during 1992 and 1993 was reasonable (Issue #8); and (9) whether the Roses are liable for accuracy-related penalties under section 6662(a) for 1990, 1991, 1992, and 1993 (Issue #9). Unless otherwise indicated, 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. Most amounts have been rounded to the nearest dollar. FINDINGS OF FACT Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. The principal place of business of PKV&S was in Sarasota, Florida, at the time that the petition was filed at docket No. 5836-99. The principal place of business of PKVI LP was in Tampa, Florida, at the time that the petition was filed at docket No. 6395-99. The Roses resided in Florida at the time that the petition was filed at docket No. 10154-99. Background A. Rose Rose obtained a bachelor’s degree in physics from Lancaster University in England, an M.B.A. and a master’s degree in - 8 education from Lehigh University, and a master’s degree from the University of Pennsylvania. Prior to 1985, Rose was employed by Evantash Associates, Chemical Bank, Soloman Bros., Thompson McKenan, Kidder Peabody, J.J. Lowry & Co., and Community College of Philadelphia, among others. Through his employment, Rose gained experience in budgeting, financial futures, hedging transactions, foreign currencies, and loan transactions. B. Printon Kane and Co. and the Printon Kane Group, Inc. Printon Kane and Co. (Printon Kane), a Delaware limited partnership, was, at all relevant times, in the business of dealing in bonds and other investment opportunities. Printon Kane’s business was eventually transferred to the Printon Kane Group, Inc. (Printon Kane Group), a Delaware corporation, during 1989. Rose began working for Printon Kane in 1985 and was a full-time employee of Printon Kane through 1988. Rose remained employed by Printon Kane during 1989 and by the Printon Kane Group during 1989 and 1990. Rose worked in the area of corporate finance at Printon Kane and the Printon Kane Group. In that capacity, Rose acted as a loan broker and would attempt to find lenders to fund small hydroelectric projects, cogeneration projects, and coal mining projects. In addition, Rose’s duties at Printon Kane and the Printon Kane Group included seeking out and developing investment opportunities for the firm. - 9 C. PK Ventures On or about September 12, 1986, PK Ventures was organized as a Delaware corporation for the purposes of acquiring, owning, leasing, holding, operating, maintaining, and disposing of assets such as pipelines and alternate energy facilities and engaging in any and all activities related or incidental thereto. Rose was responsible for organizing PK Ventures as part of his duties to develop investment opportunities for Printon Kane. Sometime before Rose organized PK Ventures, Rose and Printon Kane’s management had agreed that he would receive an equity interest in PK Ventures as part of his compensation for arranging this investment opportunity for the firm. PK Ventures was initially authorized to issue 1,000 shares of stock. As of September 16, 1986, PK Ventures had issued all of those authorized shares to 11 individuals. These initial owners of PK Ventures included G. Clifford McCarthy, Jr. (McCarthy), and 10 individuals who were either partners in or employees of Printon Kane--Amos Beason (Beason), Francis Cerosky (Cerosky), Robert Grimmig (Grimmig), Thomas Kane (Kane), Thomas Kane, Jr. (Kane Jr.), Eugene Kirkwood (Kirkwood), Louis Krutoy (Krutoy), Joseph Mannello (Mannello), Joel Marshall (Marshall), and John Parker (Parker). As of that date, PK Ventures’ stock was owned in the following proportions: - 10 Shareholder Number of Shares Owned Percentage of Shares Owned McCarthy Beason Cerosky Grimmig Kane Kane Jr. Kirkwood Krutoy Mannello Marshall Parker 3 6 36 156 407 21 16 160 24 21 150 .3% .6 3.6 15.6 40.7 2.1 1.6 16.0 2.4 2.1 15.0 The purchase price for these shares was $0.50 per share. On September 15, 1986, Rose was elected by the shareholders of PK Ventures as its sole director. Rose then elected himself as the president, treasurer, and secretary of the corporation. Rose held the positions of sole director, president, treasurer, and secretary of PK Ventures and operated PK Ventures out of his office at Printon Kane until he resigned from those positions in November 1988. Krutoy replaced Rose as president of PK Ventures from November 1988 through March 1990. Although he resigned the position of president of PK Ventures, Rose continued to run the day-to-day operations of PK Ventures from his office at Printon Kane or the Printon Kane Group from November 1988 through March 1990. He then regained the positions of sole director and president of PK Ventures and held those positions through 1993. Rose’s duties for PK Ventures and later for PK Ventures and its wholly owned subsidiaries--St. Louis Pipeline Corp. (SLPC), Tampa Bay Pipeline Co. (TBPC), Tampa Pipeline Corp. (TPC), and Tampa - 11 Pipeline Transport Co. (TPTC)–-included handling cash management functions, payroll, insurance and risk management functions, customer relations, and marketing. During 1990, 1991, 1992, and 1993, PK Ventures operated as a C corporation, used the accrual method of accounting, and was the holding company for SLPC, TBPC, TPC, and TPTC. During 1991, 1992, and 1993, PK Ventures and its subsidiaries employed approximately 20 people. Neither PK Ventures nor any of its subsidiaries paid any dividends to their shareholders from 1986 through 1993. D. PKVI LP On September 15, 1986, Rose, as sole director of PK Ventures, adopted a resolution that PK Ventures, Rose, and Herbert Patrick (Patrick), as general partners, would form PKVI LP for the purposes of acquiring, owning, leasing, holding, operating, maintaining, mortgaging, and disposing of hydroelectric, cogeneration, and other energy projects. PKVI LP was subsequently organized as a Delaware limited partnership. Rose was responsible for organizing PKVI LP as part of his duties to develop investment opportunities for Printon Kane. Sometime before Rose organized PKVI LP, Rose and Printon Kane’s management had agreed that he would receive an equity interest in PKVI LP as part of his compensation for arranging this investment opportunity for the firm. - 12 The initial partners in PKVI LP included PK Ventures, Patrick, Rose, McCarthy, and 10 other individuals who were associated with Printon Kane--Beason, Cerosky, Grimmig, Kane, Kane Jr., Kirkwood, Krutoy, Mannello, Marshall, and Parker. Under the terms of the Agreement of Limited Partnership of PK Ventures I Limited Partnership (agreement of limited partnership), these partners made initial capital contributions to PKVI LP in the following amounts and held the following interests in PKVI LP as of September 15, 1986: Partner Initial Capital Contribution Participating Percentage Limited or General PK Ventures Patrick Rose McCarthy Beason Cerosky Grimmig Kane Kane Jr. Kirkwood Krutoy Mannello Marshall Parker $500 0 0 148 297 1,782 7,722 20,146 1,040 792 7,920 1,188 1,040 7,425 1.000% 40.000 30.000 .087 .174 1.044 4.524 11.803 .609 .464 4.640 .696 .609 4.350 General General General Limited Limited Limited Limited Limited Limited Limited Limited Limited Limited Limited The initial capital contributions to PKVI LP totaled $50,000. No other amounts transferred to PKVI LP were identified as capital contributions on its books. The terms of the agreement of limited partnership required that, as of the end of each fiscal year of the partnership, PKVI LP pay to each of its partners interest on their capital contributions (as adjusted for - 13 any subsequent contributions and withdrawals) at a rate equal to the greater of (1) the prime rate as published in the Wall Street Journal on the last business day of the fiscal year plus 2 percent or (2) such other floating or fixed rate authorized by PK Ventures, the corporate general partner of PKVI LP. In their roles as general partners of PKVI LP, Patrick was responsible for the management of the partnership’s daily operations, and Rose was responsible for the partnership’s ongoing financial activities. The terms of the agreement of limited partnership provided that neither Rose nor Patrick would be compensated for their services to the partnership. As corporate general partner of PKVI LP, PK Ventures had, inter alia, the exclusive right, power, and authority to authorize distributions of cash on behalf of PKVI LP. PK Ventures also had the exclusive right, power, and authority, subject to written approval of the partnership’s limited partners holding at least 67 percent of the aggregate voting percentages of the limited partners, to do the following: (1) Make calls for additional capital contributions on behalf of PKVI LP; (2) permit a withdrawal of capital by any partner; (3) admit an additional partner to the partnership; (4) permit the withdrawal of any partner from the partnership; (5) designate any additional investments for the partnership and determine the participating percentages of the partners in such additional investments; - 14 (6) sell or otherwise dispose of all or substantially all of the partnership’s property attributable to any investment; (7) permit any agreement between the partnership and any general partner or any person controlled by or controlling or under common control with a general partner; and (8) permit the transfer or assignment, in whole or in part, by a partner of his interest in the partnership. The terms of the agreement of limited partnership provided that the general partners of PKVI LP were under no obligation to make any additional capital contributions to the partnership in response to any capital calls made on behalf of the partnership by PK Ventures. A general partner’s participating percentage could not be decreased as a result of not making any additional capital contributions to PKVI LP, but it could be increased as a result of making such a contribution. A limited partner’s participating percentage could be adjusted upward or remain the same if that partner did make an additional capital contribution to PKVI LP in response to a capital call, or it could be adjusted downward if that partner did not make an additional capital contribution in response to a capital call. Patrick, Rose, and PK Ventures were the general partners of PKVI LP from September 15, 1986, until sometime in 1989. During that time, PK Ventures owned a 1-percent interest, Rose owned a 30-percent interest, and Patrick owned a 40-percent interest. - 15 Sometime during 1989, Patrick relinquished his interest in PKVI LP. As a result of Patrick’s withdrawal from PKVI LP, Rose and PK Ventures became the partnership’s only general partners. At that time, Rose held a 70-percent general partnership interest in PKVI LP. From May 1988 through January 1990, PK Ventures was both a 1-percent general partner and a 4.35-percent limited partner of PKVI LP. PK Ventures’ Purchase of the Stock of SLPC, TBPC, TPC, and TPTC On December 10, 1986, PK Ventures entered into separate Stock Purchase Agreements for the purchase of 100 percent of the outstanding stock of SLPC, TBPC, TPC, and TPTC. At the time that PK Ventures entered into these agreements, SLPC, TBPC, and TPC were owned by Joyce Western Corp. (Joyce Western), and TPTC was owned by Joyce Western, Kathleen Biondo, Christine Joyce, Helma Joyce, and James Joyce (the TPTC sellers). At all relevant times, these corporations were engaged in the following operations: (1) SLPC owned a pipeline that transported aviation fuel from Illinois to the Lambert Airport in St. Louis, Missouri; (2) TBPC and TPTC owned pipelines that transported anhydrous ammonia from the port of Tampa Bay, Florida, to Hillsborough County, Florida, and Polk County, Florida; and (3) TPC held a general partnership interest and/or a limited partnership interest in Tampa Pipeline Limited Partnership, a business that operated an aviation fuel pipeline that serviced the Tampa - 16 International Airport. As of December 10, 1986, TBPC and TPTC owned two of the four existing anhydrous ammonia pipelines in the United States. Also as of that date, TBPC had leased the use of its pipeline to W.R. Grace & Co. and Royster Co. (Royster), and TPTC had leased the use of its pipeline to International Minerals & Chemical Corp. Under the terms of the Stock Purchase Agreements, PK Ventures agreed to pay the following base purchase prices for the stock of SLPC, TBPC, TPC, and TPTC: Corporation Base Purchase Price SLPC TBPC TPC TPTC $150,000 1,000,000 50,000 1,300,000 The parties agreed that these base purchase prices would be adjusted to reflect the amount by which each corporation’s current assets differed from its current liabilities as of the closing date. On December 30, 1986, PK Ventures agreed to pay to Joyce Western the following portions of the base purchase prices for the stock of SLPC, TBPC, and TPC on the transaction’s closing date: Corporation Amount Paid SLPC TBPC TPC $40,000 350,000 10,000 - 17 In addition, PK Ventures agreed to deliver to Joyce Western nonnegotiable promissory notes in the following principal amounts for the balances of the base purchase prices: Corporation Promissory Note Amount SLPC TBPC TPC $110,000 650,000 40,000 Also on December 30, 1986, PK Ventures entered into an Interim Loan Agreement (ILA) with Norstar Bank (Norstar) in connection with its purchase of the stock of SLPC, TBPC, TPC, and TPTC. The ILA was a precursor to the permanent financing arrangement that PK Ventures was to enter into with Norstar in connection with this transaction. The ILA required Norstar, inter alia, to make a loan to PK Ventures in the form of a revolving line of credit in the maximum principal amount of $1.6 million. This loan was secured by an irrevocable letter of credit that the Summit Trust Co. (Summit Trust) issued in favor of PK Ventures on December 31, 1986. The terms of the loan required that all outstanding principal amounts bear interest at a rate equal to three-fourths of 1 percent above Norstar’s stated prime rate, that payments of accrued interest and outstanding principal amounts be made monthly, and that the entire outstanding principal balance plus accrued interest become due and payable at the time that the permanent financing was finalized. Advances under this loan were to be made, inter alia, - 18 to pay to James Joyce or Joyce Western a total of $600,000 in two installments--$400,000 was due to be paid at the closing of the loan, and the balance was due to be paid at the earlier of the closing of the permanent financing or February 1, 1987. The ILA also set forth the details of the permanent financing arrangement that was being negotiated between PK Ventures and Norstar. As set forth in the ILA, Norstar had agreed to make one term loan to SLPC in the amount of $1.1 million and one or more term loans to TBPC, TPC, and/or TPTC in the total amount of $10.5 million. The purpose of these term loans was, inter alia, to refinance the indebtedness that SLPC, TBPC, TPC, and TPTC owed to Norstar. In addition to these term loans, Norstar agreed to establish a 5-year revolving line of credit in the maximum principal amount of $2.5 million for PK Ventures ($2.5 million revolving line of credit). Under the terms of the permanent financing arrangement, the term loans to SLPC, TBPC, TPC, and TPTC and the first $1.3 million of outstanding principal on the $2.5 million revolving line of credit were to be secured by a pledge of all of the stock of SLPC, TBPC, TPC, and TPTC as well as a first mortgage on and security interest in all of the assets of those corporations. On December 31, 1986, PK Ventures closed on the purchase of the stock of SLPC, TBPC, and TPC from Joyce Western. On that date, PK Ventures executed documents entitled “Non-Negotiable - 19 Promissory Note” in favor of Joyce Western for the balances of the base purchase prices for the stock of SLPC, TBPC, and TPC. The terms of the Non-Negotiable Promissory Note for the balance of the base purchase price for the stock of SLPC required that the principal amount bear interest at a rate of 9 percent, that a $10,000 principal installment payment be made on January 31, 1987, and that the remaining principal balance plus accrued interest become due and payable no later than February 15, 1987. The terms of the Non-Negotiable Promissory Note for the balance of the base purchase price for the stock of TBPC required that the principal amount bear interest at a rate of 9 percent, that a $185,000 principal installment payment be made on January 31, 1987, and that the remaining principal balance plus accrued interest become due and payable no later than February 15, 1987. The terms of the Non-Negotiable Promissory Note for the balance of the base purchase price for the stock of TPC required that the principal amount bear interest at a rate of 9 percent, that a $5,000 principal installment payment be made on January 31, 1987, and that the remaining principal balance plus accrued interest become due and payable no later than February 15, 1987. These promissory notes were subordinate to the indebtedness incurred by PK Ventures, SLPC, TBPC, TPC, and TPTC to Norstar in connection with PK Ventures’ acquisition of SLPC, TBPC, TPC, and TPTC. - 20 Also on December 31, 1986, PK Ventures executed documents entitled “Subordinated Note” in favor of the TPTC sellers in exchange for the stock of TPTC. The Subordinated Notes were issued in the following amounts and were, in the aggregate, equal to the base purchase price for the stock of TPTC: TPTC Seller Subordinated Note Amount Joyce Western Kathleen Biondo Christine Joyce Helma Joyce James Joyce $780,000 130,000 130,000 130,000 130,000 The terms of the Subordinated Notes required that the principal balances bear interest at a rate of 7.6923 percent, that payments of accrued interest be made monthly beginning on February 1, 1987, and that the principal balances become due and payable on January 1, 1992. The Subordinated Notes were subordinate to the indebtedness incurred by PK Ventures, SLPC, TBPC, TPC, and TPTC to Norstar in connection with PK Ventures’ acquisition of SLPC, TBPC, TPC, and TPTC. On or about February 3, 1987, SLPC, TBPC, and TPTC executed documents entitled “Promissory Note” in favor of Norstar in which they promised to pay to Norstar the principal amounts of $1.1 million, $6.5 million, and $4 million, respectively. The terms of SLPC’s Promissory Note to Norstar required that the outstanding principal balance bear interest at a rate of 10.25 percent, that the interest on the outstanding principal - 21 amount be calculated on the basis of a 360-day year, that payments of principal and accrued interest be made in equal quarterly installments of $55,532 beginning on February 15, 1987, and that any remaining balance of principal and accrued interest become due and payable on February 3, 1994. The terms of TBPC’s Promissory Note to Norstar required that the outstanding principal balance bear interest at a rate of 10.40 percent, that the interest on the outstanding principal amount be calculated on the basis of a 360-day year, that payments of principal and accrued interest be made in equal monthly installments of $87,345 beginning on March 15, 1987, and that any remaining balance of principal and accrued interest become due and payable on February 3, 1997. The terms of TPTC’s Promissory Note to Norstar required that the outstanding principal balance bear interest at a rate of 10.40 percent, that the interest on the outstanding principal amount be calculated on the basis of a 360-day year, that payments of principal and accrued interest be made in equal monthly installments of $53,751 beginning on February 15, 1987, and that any remaining balance of principal and accrued interest become due and payable on February 3, 1997. Also on or about February 3, 1987, PK Ventures executed a document entitled “Master Note” in favor of Norstar in which it promised to pay to Norstar the principal amount of $2.5 million or, if less, the aggregate unpaid principal amount of all - 22 advances made by Norstar to PK Ventures under the $2.5 million revolving line of credit. The terms of this Master Note required that all outstanding principal amounts bear interest at a rate equal to three-fourths of 1 percent above Norstar’s stated prime rate, that the interest on the outstanding principal amounts be calculated on the basis of a 360-day year, that PK Ventures make payments of all accrued interest on the outstanding principal amounts on a monthly basis, and that the line of credit expire on January 1, 1992, with all amounts thereunder becoming immediately due and payable. On February 9, 1987, Norstar sent a letter to Rose to inform him that it had transferred a total of $12.5 million in loan proceeds to PK Ventures’ Norstar account. This letter indicated that, effective February 3, 1987, Norstar had advanced the following loans: Borrower Loan Amount SLPC TBPC TPTC PK Ventures $1,100,000 6,500,000 4,000,000 900,000 Norstar made the $900,000 advance to PK Ventures under the $2.5 million revolving line of credit. In addition, the letter indicated that Norstar had “closed-out” previously outstanding notes of SLPC, TBPC, TPC, and TPTC totaling $12,493,009. Pursuant to Rose’s instructions, Norstar debited PK Ventures’ account for this amount. - 23 On or about June 23, 1987, TBPC executed a document entitled “Restated Promissory Note” in favor of Contel Credit Corp. (Contel) in which it promised to pay to Contel the principal amount of $5.3 million. This Restated Promissory Note restated and superseded the Promissory Note that TBPC had executed in favor of Norstar on February 3, 1987, in the original principal amount of $6.5 million. The terms of the Restated Promissory Note required that the outstanding principal balance bear interest at a rate of 9.9 percent through June 14, 1992, and 10.25 percent thereafter, that the interest on the outstanding principal amount be calculated on the basis of a 360-day year, that payments of principal and accrued interest be made monthly beginning on July 15, 1987, and that any remaining balance of principal and accrued interest become due and payable on December 15, 1995. Also on or about June 23, 1987, TPTC executed a document entitled “Consolidation Note” in favor of Contel in which it promised to pay to Contel the principal amount of $6.5 million. The principal amount of this Consolidation Note included and consolidated the principal balance of the Promissory Note that TPTC had executed in favor of Norstar on February 3, 1987, in the original principal amount of $4 million as well as the principal balance of an Additional Advance Note that TPTC had executed in favor of Contel in the original principal amount of $2.5 million. - 24 The terms of the Consolidation Note required that the outstanding principal balance bear interest at a rate of 9.9 percent through June 14, 1992, and 10.25 percent thereafter, that the interest on the outstanding principal amount be calculated on the basis of a 360-day year, that payments of principal and accrued interest be made monthly beginning on July 15, 1987, and that any remaining balance of principal and accrued interest become due and payable on December 15, 1996. Also on or about June 23, 1987, PK Ventures agreed to guarantee the loans between TBPC and Contel and between TPTC and Contel (collectively, the Contel debt) and to pledge all of the stock of TBPC, TPC, and TPTC to secure the Contel debt. In addition, TBPC, TPC, and TPTC agreed to encumber all of their assets to secure the Contel debt, and PK Ventures decided that TBPC, TPC, and TPTC no longer had to guarantee or to secure the first $1.3 million of outstanding principal on the $2.5 million revolving line of credit or any other indebtedness owed by SLPC, TBPC, TPC, or TPTC to Norstar. PK Ventures also decided that SLPC no longer had to guarantee or to secure the first $1.3 million of outstanding principal on the revolving line of credit. PK Ventures, SLPC, TBPC, TPC, and TPTC (jointly referred to as petitioner PKV&S) filed consolidated Federal income tax returns for 1987 through 1993. Prior to 1990, PK Ventures, SLPC, - 25 TBPC, TPC, and TPTC each prepared separate financial statements. Beginning in 1990 and continuing through 1993, PK Ventures, SLPC, TBPC, TPC, and TPTC prepared consolidated financial statements. These consolidated financial statements will be referred to as PKV&S’s consolidated financial statements. Any references to PK Ventures in this Opinion should not be construed to include its subsidiaries. Rose’s Initial Receipt of an Equity Interest in PK Ventures On or about August 19, 1987, PK Ventures adopted a resolution to amend its Certificate of Incorporation to increase the number of shares of stock that it was authorized to issue from 1,000 to 20,000. In connection with this amendment, the 150 shares of PK Ventures stock owned by Parker and the 36 shares of PK Ventures stock owned by Cerosky were redeemed by PK Ventures at a price of $0.50 per share. Also in connection with this amendment, Rose and the PK Ventures shareholders were given the opportunity to purchase 9,186 shares of PK Ventures stock at a price of $0.05 per share. As a result of these transactions, the stock of PK Ventures was owned in the following proportions as of August 19, 1987: - 26 Additional Shareholder Shares Acquired McCarthy Beason Grimmig Kane Kane Jr. Kirkwood Krutoy Mannello Marshall Rose Total 7 14 1,073 2,802 48 37 1,101 56 48 4,000 9,186 Total Shares Owned After Acquisition Percentage of Shares Owned After Acquisition 10 20 1,229 3,209 69 53 1,261 80 69 4,000 10,000 .10% .20 12.29 32.09 .69 .53 12.61 .80 .69 40.00 100.00 The Purchase of Zephyr Zephyr, a Florida corporation, operated as an S corporation during 1987. Zephyr’s primary business was mining, processing, and selling limestone from a quarry that it owned in Pasco County, Florida. As of August 19, 1987, Zephyr’s balance sheets showed that its current liabilities exceeded its current assets by $6,030,986. Sometime before August 20, 1987, PK Ventures entered into a stock purchase agreement with Elli M.A. Mills (Mills) to purchase all of Zephyr’s issued and outstanding stock. Prior to closing this agreement, it was decided that, for certain business and tax reasons, PK Ventures would assign its rights under the stock purchase agreement to 10 individuals--Beason, Cerosky, Grimmig, Kane, Kane Jr., Krutoy, Mannello, Marshall, McCarthy, and Rose (collectively, the Zephyr purchasers)–-9 of whom were shareholders of PK Ventures (i.e., Cerosky was no longer a - 27 shareholder of PK Ventures) and 9 of whom were associated with Printon Kane. McCarthy was neither a partner in nor an employee of Printon Kane. On or about August 20, 1987, PK Ventures transferred $1 million to the Zephyr purchasers. received $400,000. Of this $1 million, Rose Rose and the other Zephyr purchasers used this $1 million to purchase Zephyr’s stock from Mills, to cure delinquent payments to Zephyr’s creditors, and to provide Zephyr with working capital. As of August 20, 1987, the Zephyr purchasers owned interests in Zephyr and in PK Ventures as follows: Shareholder Zephyr Shares Owned Percentage of Zephyr Owned Percentage of PK Ventures Owned Beason Cerosky Grimmig Kane Kane Jr. Krutoy Mannello Marshall McCarthy Rose Total 36 18 708 1,451 177 708 177 177 88 2,360 5,900 .610% .305 12.000 24.593 3.000 12.000 3.000 3.000 1.492 40.000 100.000 .20% 0 12.29 32.09 .69 12.61 .80 .69 .10 40.00 99.47 PK Ventures obtained the $1 million that it transferred to the Zephyr purchasers from Summit Trust (Summit Trust loan). An entity named Printon Kane Government Securities pledged a $1 million certificate of deposit as collateral for the Summit Trust loan. PK Ventures accounted for the Summit Trust loan by - 28 crediting a liability account, “Due to Summit Trust”, and debiting an asset account, “Due from Shareholders”. Also on or about August 20, 1987, PK Ventures and Zephyr agreed to enter into a Management and Guaranty Inducement Agreement. Under the terms of the Management and Guaranty Inducement Agreement, PK Ventures and Zephyr agreed that PK Ventures would provide certain management services to Zephyr, guarantee certain debts of Zephyr and the Zephyr purchasers, and indemnify Mills with respect to his existing guarantees of Zephyr’s debt. In connection with the Management and Guaranty Inducement Agreement, PK Ventures agreed to guarantee the following: (1) $500,000 of the purchase price to be paid by the Zephyr purchasers for Zephyr’s stock; (2) payment of the amounts due under Zephyr’s promissory note to NCNB National Bank of Florida in the original principal amount of $2,615,000; (3) payment of the amounts due under Zephyr’s promissory note to Southeast Bank, N.A., in the principal amount $950,000; and (4) liabilities that Zephyr incurred in the ordinary course of its business. On or about November 23, 1987, Summit Trust approved a 6-month renewal of the Summit Trust loan. The terms of the renewal required that the principal balance of the Summit Trust loan bear interest at a rate of 1.5 percent over the rate of the $1 million certificate of deposit being held as collateral, that - 29 payments of accrued interest be made monthly beginning on December 20, 1987, and that the principal balance and accrued interest become due and payable on May 20, 1988. On or about June 6, 1988, the Summit Trust loan was renewed until May 20, 1989, under terms similar to those contained in the renewal of November 23, 1987. Transfers From PK Ventures, TBPC, and TPTC to Zephyr and Zephyr’s Bankruptcy After its acquisition by the Zephyr purchasers in 1987, Zephyr continued to operate as a limestone mining business. During 1987 and 1988, Zephyr received transfers totaling $2,281,818 from the following sources: Source Amount Printon Kane PK Ventures TBPC TPTC $1,450,000 446,215 263,296 122,307 During 1988, Zephyr unsuccessfully attempted to obtain financing from ITT Commercial Finance Corp. and Tarmac Florida, Inc. On December 6, 1988, Zephyr filed for bankruptcy under Chapter 11 of the Bankruptcy Code. Among the creditors listed in its bankruptcy documents were Printon Kane, PK Ventures, TBPC, and TPTC. The bankruptcy documents indicated that PK Ventures, TBPC, and TPTC had transferred $831,818 to Zephyr, as set forth above. PK Ventures, TBPC, and TPTC each filed claims in Zephyr’s bankruptcy proceeding on September 12, 1989. Copies of canceled - 30 checks and promissory notes were attached to each of these claims as substantiation of the amounts owed. Zephyr’s bankruptcy was finalized in late 1989. Sometime between the time that the bankruptcy was finalized and the end of March 1990, a third party purchased Zephyr’s assets, and the proceeds of that sale were distributed to specific secured and unsecured creditors of Zephyr. Neither Printon Kane, PK Ventures, TBPC, nor TPTC received any of those proceeds. As of December 31, 1990, the general ledger account used by PK Ventures to account for certain transfers that it had made to Zephyr had a net or remaining balance of $64,888. A. As Described in the Business’s Financial Statements and Income Tax Returns 1. 1987 No direct references were made and no explanations were provided in Zephyr’s Form 1120S, U.S. Income Tax Return for an S Corporation, for 1987 as to the amounts that Zephyr received from Printon Kane, PK Ventures, TBPC, or TPTC during that year. On the Schedule L, Balance Sheets, attached to that return, Zephyr reported $6,961,306 of “Mortgages, notes, bonds payable in less than 1 year” and $902,669 of “Mortgages, notes, bonds payable in 1 year or more” as of the end of 1987. There were no amounts separately identified as interest payments made and/or imputed by Zephyr to PK Ventures, TBPC, or TPTC on Zephyr’s Form 1120S for 1987. - 31 No direct references were made and no explanations were provided in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1987, as to the amounts that PK Ventures, TBPC, and TPTC transferred to Zephyr during that year. No direct references were made and no explanations were provided in PKV&S’s consolidated income tax return for 1987 as to the amounts that PK Ventures, TBPC, and TPTC transferred to Zephyr during that year. There were also no amounts separately identified as interest payments received and/or imputed by PK Ventures, TBPC, or TPTC from Zephyr on PKV&S’s consolidated income tax return for 1987. 2. 1988 No direct references were made and no explanations were provided in Zephyr’s Form 1120S for 1988 as to the amounts that Zephyr received from Printon Kane, PK Ventures, TBPC, or TPTC during that year. On the Schedule L attached to that return, Zephyr reported $7,318,462 of “Mortgages, notes, bonds payable in less than 1 year”, $677,132 of “Other current liabilities”, and $730,189 of “Mortgages, notes, bonds payable in 1 year or more” as of the end of 1988. There were no amounts separately identified as interest payments made and/or imputed by Zephyr to PK Ventures, TBPC, or TPTC on Zephyr’s Form 1120S for 1988. - 32 No direct references were made and no explanations were provided in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1988, as to the amounts that PK Ventures, TBPC, and TPTC transferred to Zephyr during that year. Furthermore, no mention of Zephyr’s bankruptcy was made in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1988. On the Schedule L attached to PKV&S’s consolidated income tax return for 1988, TBPC and TPTC reported a total of $385,603 due from Zephyr under “Other assets” as of the end of that year. Of this amount, $263,296 was attributable to TBPC and $122,307 was attributable to TPTC. These amounts were described as “DUE FROM UNCONSOLIDATED SUBSIDIARIES”. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures, TBPC, or TPTC from Zephyr on PKV&S’s consolidated income tax return for 1988. 3. 1989 No direct references were made and no explanations were provided in Zephyr’s Form 1120S for 1989 as to the amounts that Zephyr received from Printon Kane, PK Ventures, TBPC, or TPTC during that year. this return. Furthermore, no Schedule L was attached to There were no amounts separately identified as interest payments made and/or imputed by Zephyr to PK Ventures, TBPC, or TPTC on Zephyr’s Form 1120S for 1989. - 33 No direct references were made and no explanations were provided in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1989, as to the amounts that PK Ventures, TBPC, and TPTC transferred to Zephyr during that year. Furthermore, no mention of Zephyr’s bankruptcy was made in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1989. PKV&S claimed a $953,652 bad debt deduction on its consolidated income tax return for 1989 for cash transfers that PK Ventures, TBPC, and TPTC had made to Zephyr. PKV&S did not attach to this return an explanation for claiming this bad debt deduction. On the Schedule L attached to PKV&S’s consolidated income tax return for 1989, PK Ventures and its subsidiaries reported a total of $90,000 due from Zephyr under “Other assets” as of the end of that year. This amount was described as “DUE FROM UNCONSOLIDATED SUBSIDIARIES”. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures, TBPC, or TPTC from Zephyr on PKV&S’s consolidated income tax return for 1989. 4. 1990 On its Form 1120S for 1990, Zephyr represented that “No income or expense items where [sic] reported on the tax return due to the fact that the corporation was not solvent after the completion of the bankruptcy.” - 34 PKV&S claimed a $664,888 bad debt deduction on its consolidated income tax return for 1990 for cash transfers that PK Ventures, TBPC, and TPTC had made to Zephyr and for the cash transfers that PK Ventures had made to the nine Zephyr purchasers other than Rose. With respect to this bad debt deduction, $64,888 was attributable to the cash transfers that PK Ventures and/or its subsidiaries had made to Zephyr in prior years. PKV&S did not attach to this return an explanation for claiming this bad debt deduction. B. Internal Revenue Service (IRS) Determinations The IRS determined that PKV&S was not allowed to claim a bad debt deduction of $953,652 on its consolidated income tax return for 1989 for cash transfers that PK Ventures and/or its subsidiaries had made to Zephyr because it had not established that a true debtor-creditor relationship was intended by these transfers. Furthermore, the IRS determined that, if a debt had been intended, PKV&S had not established that such debt had become worthless during 1989. The effect of this determination was to reduce the net operating loss carryover that PKV&S could report on its consolidated income tax return for 1990 (as amended) from $1,023,245 to $69,593. Accordingly, the IRS increased PKV&S’s taxable income by $953,652 for 1990. The IRS also determined that PKV&S was not allowed to claim a bad debt deduction of $64,888 on its consolidated income tax - 35 return for 1990 for cash transfers that PK Ventures and/or its subsidiaries had made to Zephyr because it had not established that a true debtor-creditor relationship was intended by these transfers. Furthermore, the IRS determined that, if a debt had been intended, PKV&S had not established that such debt had become worthless during 1990. Accordingly, the IRS increased PKV&S’s taxable income by $64,888 for 1990. The IRS determined that, with respect to the $64,888 of transfers from PK Ventures and/or its subsidiaries to Zephyr for which PKV&S had claimed a bad debt deduction on its consolidated income tax return for 1990, 40 percent of that amount constituted a constructive dividend to the Roses in 1990. Consequently, the IRS increased the Roses’ taxable income by $25,955 for 1990. Rose’s Acquisition of Control of PK Ventures and PKVI LP At the beginning of 1990, PK Ventures was experiencing difficulty servicing its debt. On February 16, 1990, Kane, Kane Jr., Krutoy, Mannello, Rose, and PK Ventures executed a document entitled “Agreement” (debt service agreement) whereby PK Ventures agreed to repay the loans that it had outstanding with Norstar and Summit Trust according to the schedule set forth in that agreement. As of that date, PK Ventures had an $800,000 outstanding principal balance with respect to its $2.5 million revolving line of credit with Norstar and had not repaid the Summit Trust loan. - 36 According to the schedule set forth in the debt service agreement, PK Ventures agreed to pay the outstanding principal balance of the $2.5 million revolving line of credit plus any accrued interest within 5 days from the date of the debt service agreement. Furthermore, PK Ventures agreed to make a $400,000 payment on the Summit Trust loan at the earlier of September 30, 1990, or the date that Rose acquired a majority interest in PK Ventures. PK Ventures was to repay the remaining $600,000 of the Summit Trust loan at the loan’s maturity date, 12 months from the date of the debt service agreement or as extended by Summit Trust. The debt service agreement also contained the following provision: 3.3 Compensation. Until October 1, 1990, Robert Rose’s salary, as Chief Executive Officer, will be fixed at $80,000 per annum, payable bi-weekly. The debt service agreement provided that PK Ventures was to borrow funds from Rose if it did not have sufficient funds to make the scheduled payments to Norstar and Summit Trust. If PK Ventures borrowed any funds from Rose, it was required to execute a promissory note in Rose’s favor and to secure repayment of the loan by placing a priority lien (as permitted) on all of its assets. In addition, any such loans between Rose and PK Ventures were to be secured by an escalating pledge of the shares of PK Ventures’ stock owned by Kane, Kane Jr., Krutoy, and Mannello in an amount identified in a Pledge Agreement. - 37 Certificates of deposit had been pledged as security for the loans that PK Ventures had taken out with Norstar and Summit Trust. Specifically, an $800,000 certificate of deposit secured the outstanding principal balance of the $2.5 million revolving line of credit and a $1 million certificate of deposit from Printon Kane Government Securities secured the Summit Trust loan. Under the terms of the debt service agreement, PK Ventures was to instruct Norstar and Summit Trust to release a like amount of the certificates of deposit that they had been holding as collateral to the receiving agent for Kane, Kane Jr., Krutoy, and Mannello as it made the scheduled payments to these institutions. As contemplated by the debt service agreement, PK Ventures borrowed $800,000 from Rose on February 16, 1990, in order to make its scheduled payment to Norstar. Rose obtained a portion of the funds for this loan by placing a $675,000 mortgage on his New Jersey residence with First Fidelity Bank (First Fidelity). Rose gathered the remaining $125,000 for this loan from other sources. In exchange for this $800,000 loan, PK Ventures executed documents entitled “Promissory Note” and “Security Agreement” in favor of Rose. The terms of the Promissory Note required that the principal amount bear interest at a rate equal to 3 percent above First Fidelity’s stated prime rate, that PK Ventures make payments of accrued interest on a monthly basis beginning March 1, 1990, and that the principal balance become - 38 due and payable on September 30, 1990. In addition, Kane, Kane Jr., Krutoy, and Mannello executed a document entitled “Pledge Agreement” in favor of Rose. Under the terms of the Pledge Agreement, Kane, Kane Jr., Krutoy, and Mannello agreed to pledge 44 percent of their total shares of PK Ventures’ stock to Rose in order to secure repayment of Rose’s $800,000 loan to PK Ventures. As a result of entering into the Pledge Agreement, Kane, Kane. Jr., Krutoy, and Mannello pledged a combined total of 2,032.36 shares of PK Ventures’ stock to Rose. Also on February 16, 1990, Kane, Kane Jr., Krutoy, and Mannello executed a document entitled “Voting Trust Agreement” whereby they agreed to place all of their shares of PK Ventures’ stock into a voting trust in exchange for voting trust certificates. The voting trust certificates indicated their ownership rights in the shares of stock held by the trustee. Rose was designated as trustee of this voting trust and was given sole authority to vote the shares. As trustee of the voting trust, Rose had voting rights to 86.19 percent of the shares of PK Ventures’ stock. (The Voting Trust Agreement granted Rose voting rights to 46.19 percent of PK Ventures’ stock; he already held voting rights to 40 percent of the shares of PK Ventures’ stock prior to becoming trustee of the voting trust.) The shares of PK Ventures’ stock placed into the voting trust included the shares that had been pledged to Rose under the Pledge Agreement. - 39 The voting trust was to last for 21 years from February 16, 1990, unless terminated earlier by the death, resignation, or incapacity of Rose. Also on February 16, 1990, Kane, Kane Jr., Krutoy, and Mannello executed documents entitled “Assignment” whereby they agreed to transfer all of their respective interests in PKVI LP to PK Ventures. In sum, they transferred a 17.748-percent limited partnership interest in PKVI LP to PK Ventures. With that transfer, PK Ventures held a 22.098-percent limited partnership interest and a 1-percent general partnership interest in PKVI LP. PK Ventures satisfied its obligation to Norstar with the $800,000 loan that it received from Rose. PK Ventures repaid this loan by making various cash payments to Rose and to First Fidelity. On December 7, 1990, a document entitled “Stock Redemption Agreement” was executed by Cerosky (as a holder of an interest in PKVI LP), the shareholders of PK Ventures (i.e., Beason, Grimmig, Kane, Kane Jr., Kirkwood, Krutoy, Mannello, Marshall, McCarthy, and Rose), and PK Ventures. Under the terms of the Stock Redemption Agreement, (1) PK Ventures agreed to redeem a total of 5,295 shares of its stock from the shareholders of PK Ventures other than Rose (the withdrawing shareholders); (2) the withdrawing shareholders agreed to sell, assign, and transfer - 40 their ownership interests in all of PK Ventures’ subsidiaries (i.e., SLPC, TBPC, TPC, and TPTC) to PK Ventures; and (3) Beason, Cerosky, Grimmig, Kirkwood, Marshall, and McCarthy agreed to transfer their ownership interests in PKVI LP to PK Ventures. At the completion of the stock redemption on December 7, 1990, Kane and Rose were the only shareholders of PK Ventures, with Rose owning 85.016 percent of PK Ventures’ outstanding shares. Rose and PK Ventures also became the only owners of PKVI LP. In sum, Beason, Cerosky, Grimmig, Kirkwood, Marshall, and McCarthy transferred a 6.902-percent limited partnership interest in PKVI LP to PK Ventures. Consequently, as of December 7, 1990, PK Ventures owned a 1-percent general partnership interest and the entire 29-percent limited partnership interest in PKVI LP, and Rose owned a 70-percent general partnership interest in PKVI LP. As consideration for the stock redemption and purchases described above, PK Ventures agreed to repay the Summit Trust loan based on the following schedule: $400,000 on December 7, 1990, $50,000 within 9 months of December 7, 1990, and $550,000 within 1 year of December 7, 1990. In addition, PK Ventures agreed to instruct Summit Trust to release a like amount of the $1 million certificate of deposit that it held as collateral for the Summit Trust loan to the receiving agent for the withdrawing - 41 shareholders with each scheduled payment that it made. The parties to the Stock Redemption Agreement also agreed as follows: 7.1 Release. The Company, Rose, and the Shareholders acknowledge that there are certain obligations and indebtedness existing between Rose and the Company on the one hand and the Shareholders on the other hand. It is the intent of the parties in executing this Agreement that all such debts and obligations, except as otherwise provided herein, be hereby expressly extinguished. Accordingly, the Shareholders hereby release Rose and the Company and the Company and Rose, jointly and severally, release the Shareholders with respect to any and all claims which the Shareholders on the one hand may have against Rose and/or the Company (including obligations of the Company to repay the indebtedness to Summit as set forth in the Agreement among Rose, the Certificate Holders and the Company dated February 16, 1990) or, respecting claims which Rose and/or the company may have against the Shareholders excepting, as to all parties, claims and obligations arising pursuant to this Agreement, the * * * Pledge Agreement, the Voting Trust Agreement, and any agreement executed in conjunction with this Agreement * * * In accordance with the Stock Redemption Agreement, Rose loaned $400,000 to PK Ventures on December 7, 1990. the $400,000 directly to Summit Trust. Rose paid Rose refinanced his New Jersey home in order to obtain the funds for this loan. In exchange for the $400,000 loan, PK Ventures gave Rose a promissory note. PK Ventures accounted for the promissory note by debiting the liability account to Summit Trust and crediting the account “Due To/From PKV/RLR”. PK Ventures repaid the $400,000 directly to Rose’s mortgagee. The series of agreements executed on February 16, 1990, were amended, but not voided, by the Stock Redemption Agreement. - 42 Under the terms of the Stock Redemption Agreement, the 705 shares of PK Ventures’ stock that were not redeemed from Kane remained subject to both the Voting Trust Agreement and the Pledge Agreement. Also on December 7, 1990, Rose, PK Ventures, and the Printon Kane Group executed a document entitled “Agreement” (litigation agreement) whereby they agreed to share the litigation costs incurred to sue Raymond James & Associates. The litigation subject to the litigation agreement involved the business and activities of Zephyr. As a result of Zephyr’s bankruptcy, the Zephyr purchasers had lost all of the cash that they had contributed to Zephyr. Transfers From PK Ventures to the Zephyr Purchasers PK Ventures did not receive promissory notes from the Zephyr purchasers in exchange for the $1 million that it transferred to them. No accrued interest attributable to this transfer was posted to PK Ventures’ general ledger or reported in its audited financial statements. The Zephyr purchasers did not repay any portion of the $1 million that had been transferred to them from PK Ventures. PK Ventures neither took legal action against the Zephyr purchasers to force repayment of the $1 million transfer nor did it attempt to negotiate a partial collection of this amount with any of the Zephyr purchasers. PK Ventures issued Forms 1099 to - 43 each of the Zephyr purchasers reflecting cancellation of indebtedness income. On August 5, 1991, the Roses sold their home in New Jersey for $422,500. The Roses purchased a home in Florida for $481,555 sometime between August 5, 1991, and March 16, 1992. The Roses paid the entire $481,555 purchase price with cash from their savings. On December 31, 1991, PK Ventures’ financial books and records indicated that Rose owed $437,469 to PK Ventures. This balance was reduced to zero by “reclassifying” $400,000 as a bad debt attributable to Rose’s portion of the $1 million that PK Ventures had transferred to the Zephyr purchasers and by “reclassifying” the remaining $37,469 as compensation expense attributable to Rose. A. As Described in the Financial Statements and Income Tax Returns for PK Ventures and PKV&S Note 3 to PK Ventures’ audited financial statements for the year ended December 31, 1987, stated: $1,000,000 to the stockholders. “The company has advanced This money was advanced for the sole purpose to acquire a company that would be compatible with the business objectives of the Company.” The same statement was included in the notes to PK Ventures’ financial statements for the years ended December 31, 1988, and December 31, 1989. A $1 million amount “Due from stockholders” was listed as an asset on PK Ventures’ audited financial statements for the years ended - 44 December 31, 1987, December 31, 1988, and December 31, 1989, respectively. A $1 million “Loans to stockholders” amount was listed as an asset on the Schedules L attached to PKV&S’s consolidated income tax returns for 1987, 1988, and 1989. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures from the Zephyr purchasers on PKV&S’s consolidated income tax returns for 1987 through 1989. On its audited consolidated financial statements for the year ended December 31, 1990, PKV&S claimed a bad debt expense of $664,888, $600,000 of which was attributable to the transfers that PK Ventures had made to the nine Zephyr purchasers other than Rose. Note B to these financial statements offered the following explanation for PKV&S asserting a bad debt expense with respect to this $600,000 transfer: The Company advanced $1,000,000 interest free to the shareholders of the Company in 1987 which was invested in Zephyr Rock & Lime, Inc. (“Zephyr”). In March 1990, Zephyr sold all its assets and there were no funds left to distribute to shareholders after paying liabilities. Thereupon the Company ascertained that $600,000 of the advances to shareholders was uncollectible and, accordingly, charged $600,000 to 1990 operations. The remaining balance of $400,000 at December 31, 1990 is due from the Company’s majority shareholder and has been netted against other advances from the shareholder. There is no explanation in these financial statements as to what the balance of the $664,888 bad debt expense was attributable. - 45 PKV&S claimed a $664,888 bad debt deduction on its consolidated income tax return for 1990 for cash transfers that PK Ventures, TBPC, and TPTC had made to Zephyr and for the cash transfers that PK Ventures had made to the nine Zephyr purchasers other than Rose. With respect to this bad debt deduction, $600,000 was attributable to the cash transfers that PK Ventures had made to the nine Zephyr purchasers other than Rose. PKV&S did not attach to this return an explanation for claiming this bad debt deduction. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures from the Zephyr purchasers on PKV&S’s consolidated income tax return for 1990. PKV&S claimed a bad debt expense of $1,712,151 on its audited consolidated financial statements for the year ended December 31, 1991. Of this amount, $400,000 was attributable to the transfer that PK Ventures had made to Rose in connection with the Zephyr purchase. Note 2 to these financial statements offered the following explanation for PKV&S asserting a bad debt expense with respect to this $400,000 transfer: The Company advanced $1,000,000 interest free to the shareholders of the Company in 1987 which was invested in Zephyr Rock & Lime, Inc. (Zephyr). In March 1990, Zephyr sold all its assets and there were no funds left to distribute to shareholders after paying liabilities. Thereupon the Company ascertained that $600,000 of the advances to shareholders was uncollectible and, accordingly, charged $600,000 to 1990 operations. The remaining balance of $400,000 at December 31, 1990 was due from the Company’s majority shareholder and netted - 46 against other advances due to the shareholder. During 1991, the remaining $400,000 was determined to be uncollectible and charged to 1991 operations. PKV&S claimed a $1,916,246 bad debt deduction on its consolidated income tax return for 1991 for the cash transfers that PK Ventures, TBPC, and TPTC had made to PKVI LP and for the cash transfer that PK Ventures had made to Rose in connection with the Zephyr purchase. With respect to this bad debt deduction, $400,000 was attributable to the transfer that PK Ventures had made to Rose in connection with the Zephyr purchase. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures from the Zephyr purchasers on PKV&S’s consolidated income tax return for 1991. B. As Described in the Roses’ Income Tax Returns There were no amounts separately identified as interest payments made and/or imputed by the Roses to PK Ventures on their joint income tax returns for 1990 or 1991. On their joint income tax return for 1991, the Roses reported $1,461,372 of cancellation of indebtedness income. The Roses reported that $400,000 of this amount was attributable to the transfer that PK Ventures had made to Rose in connection with the Zephyr purchase. - 47 C. IRS Determinations The IRS determined that PKV&S was not allowed to claim bad debt deductions of $600,000 and $400,000 on its consolidated income tax returns for 1990 and 1991, respectively, for the cash transfers that PK Ventures had made to the Zephyr purchasers because it had not established that a true debtor-creditor relationship was intended by these transfers. Furthermore, the IRS determined that, if a debt had been intended, PKV&S had not established that such debt had become worthless during either 1990 or 1991. Accordingly, the IRS increased PKV&S’s taxable income by $600,000 for 1990 and by $400,000 for 1991. The IRS determined that PK Ventures’ transfer of $400,000 to Rose in connection with the Zephyr purchase constituted a constructive dividend to him in 1990. Consequently, the IRS increased the Roses’ taxable income by $400,000 for 1990 and determined that the Roses should not have reported $400,000 of cancellation of indebtedness income on their joint income tax return for 1991. Transfers to PKVI LP A. Transfers From Unrelated Parties to PKVI LP At the time of its organization, PKVI LP was engaged in the acquisition of three hydroelectric projects that were located in or near Bynum, North Carolina; Henrietta, North Carolina; and Columbus, Georgia, respectively. A small portion of the - 48 acquisition of these three hydroelectric projects was financed by the initial capital contributions that were made to PKVI LP. During the years in issue, the bulk of PKVI LP’s assets consisted of hydroelectric powerplant projects in North Carolina and Georgia. PKVI LP’s debts to unrelated parties were generally nonrecourse in nature and were secured by these hydroelectric properties. As of December 31, 1986, PKVI LP had loan agreements outstanding with First Fidelity, Liberty Life Insurance Co. (Liberty Life), and Middle Georgia Fuel Products, Inc. (MGFP), as follows: Lender Maturity Date Interest Rate First Fidelity Liberty Life MGFP Jan. 27, 1987 Dec. 1, 1998 July 1, 1988 9.00% 10.50 10.00 Outstanding Principal Balance as of 12/31/86 $200,000 672,644 328,500 As of that date, the outstanding principal balances of the transfers associated with these agreements totaled $1,201,144. Of this $1,201,144, $227,326 was listed as a current liability on the Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1986, and as “Mortgages, notes, and bonds payable in less than 1 year” on the Schedule L attached to PKVI LP’s Form 1065, U.S. Partnership Return of Income, for 1986. The balance of this amount was listed as a long-term liability on the - 49 Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1986, and as “Mortgages, notes, and bonds payable in 1 year or more” on the Schedule L attached to PKVI LP’s Form 1065 for 1986. As of December 31, 1987, PKVI LP had loan agreements outstanding with First Fidelity, Liberty Life, MGFP, and Trio Manufacturing Co. (Trio) as follows: Lender Maturity Date Interest Rate First Fidelity First Fidelity Liberty Life MGFP Trio Feb. 1, 1988 Feb. 1, 1988 Dec. 1, 1998 July 1, 1988 Mar. 12, 1988 10.50% 10.25 10.50 10.00 10.00 Outstanding Principal Balance as of 12/31/87 $320,000 15,000 645,318 328,500 517,500 As of that date, the outstanding principal balances of the transfers associated with these agreements totaled $1,826,318. Of this $1,826,318, $1,213,953 was listed as a current liability on the Balance Sheet included in PKVI LP’s audited financial statements for the year ended December 31, 1987, and as “Mortgages, notes, and bonds payable in less than 1 year” on the Schedule L attached to PKVI LP’s Form 1065 for 1987. The balance of this amount was listed as a long-term liability on the Balance Sheet included in PKVI LP’s audited financial statements for the year ended December 31, 1987, and as “Mortgages, notes, and bonds payable in 1 year or more” on the Schedule L attached to PKVI LP’s Form 1065 for 1987. - 50 As of December 31, 1988, PKVI LP had the following loan agreements outstanding: Lender Maturity Date Interest Rate Daley Corp. First Fidelity First Fidelity Liberty Life Liberty Life Liberty Life MGFP July 1, 1989 Jan. 18, 1989 Jan. 18, 1989 Dec. 1, 1998 Apr. 1, 2001 Aug. 20, 2001 Mar. 31, 1990 -11.50% 12.00 10.50 10.70 11.35 10.00 Outstanding Principal Balance as of 12/31/88 $3,416 75,000 50,000 612,365 800,000 400,000 328,500 As of that date, the outstanding principal balances of the transfers associated with these agreements totaled $2,269,281. Of this $2,269,281, $193,060 was listed as a current liability on the Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1988, and as “Mortgages, notes, and bonds payable in less than 1 year” on the Schedule L attached to PKVI LP’s Form 1065 for 1988. The balance of this amount was listed as a long-term liability on the Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1988, and as “Mortgages, notes, and bonds payable in 1 year or more” on the Schedule L attached to PKVI LP’s Form 1065 for 1988. As of December 31, 1989, PKVI LP had the following loan agreements outstanding: - 51 - Lender Maturity Date Interest Rate First Fidelity MGFP Jan. 16, 1990 Mar. 31, 1990 12.00% 10.00 Outstanding Principal Balance as of 12/31/89 $125,000 328,500 PKVI LP entered into the $125,000 loan agreement with First Fidelity on or before October 16, 1989. PKVI LP also had the same loan agreements outstanding with Liberty Life on December 31, 1989, as it did on December 31, 1988. The outstanding principal balances of PKVI LP’s loan agreements with Liberty Life totaled $1,778,241 as of December 31, 1989; $1,652,584 of this amount was treated as long-term debt on PKVI LP’s audited financial statements for the year ended December 31, 1989, and the balance was treated as a current liability. The outstanding principal balances of the transfers associated with the agreements described in the preceding two paragraphs totaled $2,231,741 as of December 31, 1989. Of this amount, $579,157 was listed as a current liability on the Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1989, and as “Mortgages, notes, and bonds payable in less than 1 year” on the Schedule L attached to PKVI LP’s Form 1065 for 1989. The balance of this amount was listed as a long-term liability on the Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1989, and as - 52 “Mortgages, notes, and bonds payable in 1 year or more” on the Schedule L attached to PKVI LP’s Form 1065 for 1989. PKVI LP renegotiated its loan agreement with MGFP during 1990. The renegotiated loan agreement between PKVI LP and MGFP was for the principal balance of $401,284, an amount that included the $328,500 principal balance from their original loan agreement plus $72,784 of accrued interest. As of December 31, 1990, PKVI LP had the following loan agreements outstanding: Lender Maturity Date Interest Rate Liberty Life Liberty Life Liberty Life MGFP Dec. 1, 1998 Apr. 1, 2001 Aug. 20, 2001 Dec. 31, 1991 10.50% 10.70 11.35 10.00 Outstanding Principal Balance as of 12/31/90 $559,372 762,224 387,716 401,284 As of that date, the outstanding principal balances of the transfers associated with these agreements totaled $2,110,596. On the Balance Sheet included in PKVI LP’s audited financial statements for the year ended December 31, 1990, PKVI LP’s “Current portion of long-term debt” was listed as $403,473, and its “LONG-TERM DEBT DUE AFTER ONE YEAR” was listed as $1,829,201. On the Schedule L attached to PKVI LP’s Form 1065 for 1990, “Mortgages, notes, and bonds payable in less than 1 year” was listed as $425,000 as of the end of that year, and “Mortgages, notes, and bonds payable in 1 year or more” was listed as $1,685,596. - 53 On February 15, 1991, PKVI LP and Liberty Life agreed to consolidate their three outstanding loan agreements into one agreement. The principal balance of this consolidated loan agreement was $1,854,939, an amount that included the $1,709,312 of outstanding principal balances from the three original loan agreements between PKVI LP and Liberty Life plus $145,628 of accrued interest. The interest rate for this consolidated loan agreement was 10.78 percent, i.e., the weighted average of the interest rates from the original loan agreements. PKVI LP experienced difficulties with its Georgia hydroelectric facilities, City Mills and Juliette, during 1991. As a result, PKVI LP defaulted on the loan agreement it had entered with MGFP to finance the Juliette facility. As noted above, PKVI LP and MGFP had renegotiated this loan agreement during 1990. In addition, PKVI LP failed to make the required payments of principal on its consolidated loan agreement with Liberty Life. These payments were scheduled to begin on August 15, 1991. As of December 31, 1991, PKVI LP had the following loan agreements outstanding: Lender Maturity Date Interest Rate Liberty Life MGFP Aug. 15, 2003 Dec. 31, 1991 10.78% 10.00 Outstanding Principal Balance as of 12/31/91 $1,854,939 401,284 - 54 As of that date, the outstanding principal balances of the transfers associated with these agreements totaled $2,256,223. PKVI LP’s financial statements for the year ended December 31, 1991, are not part of the record in these cases. On the Balance Sheets included in PKVI LP’s reviewed financial statements for the year ended December 31, 1992, PKVI LP’s total and current liabilities were listed as $2,334,551 as of December 31, 1991. The $2,334,551 included $2,256,223 for long-term debt in default, $76,058 for accrued expenses, and $2,270 for accounts payable. On the Schedule L attached to PKVI LP’s Form 1065 for 1991, $2,256,223 was listed under “Mortgages, notes, and bonds payable in less than 1 year” as of the end of that year. As of December 31, 1992, PKVI LP had loan agreements outstanding with Liberty Life and MGFP. As of that date, the outstanding principal balances of the transfers associated with these agreements remained $2,256,223. This entire amount was listed as a current liability on the Balance Sheets included in PKVI LP’s reviewed financial statements for the year ended December 31, 1992. On the Schedule L attached to PKVI LP’s Form 1065 for 1991, $335,448 was listed under “Mortgages, notes, and bonds payable in less than 1 year” as of the end of that year, and $2,528,779 was listed under “All nonrecourse loans”. - 55 As of December 31, 1993, the loan agreement that PKVI LP had with Liberty Life remained outstanding. As of that date, the outstanding principal balance of this loan agreement remained $1,854,939. This entire amount was listed as a current liability on the Balance Sheets included in PKVI LP’s reviewed financial statements for the year ended December 31, 1993. There was no Schedule L attached to PKVI LP’s Form 1065 for 1993. B. Transfers From PK Ventures and/or Its Subsidiaries to PKVI LP Between 1986 and the end of 1991, PK Ventures, TBPC, and TPTC made cash transfers to PKVI LP. On PK Ventures’ general ledger, these transfers were treated as loans. Rose executed one-page documents entitled “Promissory Note” (PKVI LP promissory note) with respect to some, but not all, of these transfers. The terms of the PKVI LP promissory notes required that (1) the transfers be repaid on demand with an interest rate of either 8.75 or 9 percent; (2) payment of interest was due only with the payment of principal; and (3) payment of principal was not to be made if payment to PK Ventures would have caused PKVI LP to default or breach any other note or agreement to which PKVI LP was a party. This last provision subordinated PK Ventures’ right to demand payment of the transfers to the rights of PKVI LP’s creditors. Unlike the basic structure of PKVI LP’s debt to unrelated parties, the PKVI LP promissory notes were not secured by the hydroelectric properties owned by PKVI LP. The PKVI LP - 56 promissory notes were signed by Rose alone; they were neither attested to by a witness nor notarized. On December 31, 1989, Rose executed a PKVI LP promissory note in favor of PK Ventures in which PKVI LP promised to pay PK Ventures the principal amount of $448,646 ($448,646 promissory note). The $448,646 promissory note reflected the aggregate amount of cash that had been transferred from PK Ventures, TBPC, and TPTC to PKVI LP from 1986 through 1989. PK Ventures, TBPC, and TPTC made cash transfers to PKVI LP totaling $647,605 during 1990. On December 31, 1990, Rose executed a PKVI LP promissory note in favor of PK Ventures in which PKVI LP promised to pay PK Ventures the principal amount of $1,096,250 ($1,096,250 promissory note). The $1,096,250 promissory note reflected the aggregate amount of cash that had been transferred from PK Ventures, TBPC, and TPTC to PKVI LP from 1986 through 1990. PK Ventures, TBPC, and TPTC made transfers to PKVI LP totaling $419,995 during 1991. On December 31, 1991, Rose executed a PKVI LP promissory note in favor of PK Ventures in which PKVI LP promised to pay PK Ventures the principal amount of $1,516,246 ($1,516,246 promissory note). The $1,516,246 promissory note reflected the aggregate amount of cash that had been transferred from PK Ventures, TBPC, and TPTC to PKVI LP from 1986 through 1991. At the time that Rose signed the $1,516,246 - 57 promissory note, he did not intend to have PKVI LP repay any of this amount to PK Ventures. In addition, Rose, as a general partner with a 70-percent interest in PKVI LP, did not intend to repay any of this amount to PK Ventures at the time that he signed the $1,516,246 promissory note. No legal action was taken by PK Ventures against Rose to force repayment of the $1,516,246 promissory note. Rose owned approximately 85 percent of the stock of PK Ventures during 1991. In a letter dated July 6, 1992, to Douglas W. Kroske, C.F.A., senior vice president of Liberty Capital Advisors, Inc., Rose made the following statements concerning the transfers from PK Ventures, TBPC, and TPTC to PKVI LP: Since 1986, PK Ventures Inc has invested over $1.5 million in these hydroelectric projects, and is willing to continue but needs some help from Liberty Life. * * * * * * * * * * There has been a delay on the financial statements for the year ending 12/31/91. During the year based on Ernst & Young’s review, $419,996 cash was provided to the Partnership from PK Ventures, Inc. Since inception to 12/31/91 a total amount of $1,516,246 has been injected, and our auditors are now going to make PK Ventures Inc write this off as it is an uncollectible claim against the Partnership. The $419,996 cash of 1991, was used approximately for equipment and Bynum canal repairs of $225,661, and the balance used in payments to Liberty Life. - 58 1. As Described in the Business’s Financial Statements and Income Tax Returns a. 1986 No direct references were made and no explanations were provided in PKVI LP’s audited financial statements for the year ended December 31, 1986, as to the amounts that PKVI LP received from PK Ventures during that year. On PK Ventures’ Schedule K-1, Partner’s Share of Income, Credits, Deductions, etc., attached to PKVI LP’s Form 1065 for 1986, PK Ventures was reported to have made a $500 capital contribution to PKVI LP during that year and to have a capital account with a balance of $242 as of the end of that year. No other direct references were made and no other explanations were provided in PKVI LP’s Form 1065 for 1986 as to the amounts that PKVI LP received from PK Ventures during that year. There were also no amounts separately identified as interest payments made and/or imputed by PKVI LP to PK Ventures on its Form 1065 for 1986. On the Statement of Financial Condition included in PK Ventures’ audited financial statements for the year ended December 31, 1986, a $242 “Investment in affiliated partnership” was listed as an asset. This entry referred to PK Ventures’ investment in PKVI LP. The $242 was listed under “Other investments” on the Schedule L attached to PK Ventures’ income tax return for 1986. No other direct references were made and no - 59 other explanations were provided in PK Ventures’ financial statements for 1986 as to the amounts that it transferred to PKVI LP during that year. No direct references were made and no explanations were provided in PK Ventures’ income tax return for 1986 as to the amounts that it transferred to PKVI LP during that year. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures from PKVI LP on PK Ventures’ income tax return for 1986. b. 1987 No direct references were made and no explanations were provided in PKVI LP’s financial statements for 1987 as to the amounts that PKVI LP received from PK Ventures, TBPC, or TPTC during that year. On the Balance Sheet included in PKVI LP’s audited financial statements for the year ended December 31, 1987, $48,300 “Due to affiliated company” was listed as a current liability. No direct references were made and no explanations were provided in PKVI LP’s Form 1065 for 1987 as to the amounts that PKVI LP received from PK Ventures, TBPC, or TPTC during that year. On the Schedule L attached to PKVI LP’s Form 1065 for 1987, $48,300 was listed under “Other liabilities” as of the end of that year. There were no amounts separately identified as - 60 interest payments made and/or imputed by PKVI LP to PK Ventures, TBPC, or TPTC on its Form 1065 for 1987. No direct references were made and no explanations were provided in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1987, as to the amounts that PK Ventures, TBPC, and TPTC transferred to PKVI LP during that year. No direct references were made and no explanations were provided in PKV&S’s consolidated income tax return for 1987 as to the amounts that PK Ventures, TBPC, and TPTC transferred to PKVI LP during that year. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures, TBPC, or TPTC from PKVI LP on PKV&S’s consolidated income tax return for 1987. c. 1988 Note 4 to PKVI LP’s audited financial statements for the year ended December 31, 1988, stated, in pertinent part: “At December 31, 1988, the Partnership owed $20,580 to P.K. Ventures, Inc. and $105,978 to affiliated entities which are respectively owned by the Partnerships’ general partners.” On the Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1988, $126,558 “Due to affiliated company” was listed as a current liability. - 61 On the Schedule L attached to PKVI LP’s Form 1065 for 1988, $126,558 “Due to Affiliated Company” was listed under “Other current liabilities” as of the end of that year. There were no amounts separately identified as interest payments made and/or imputed by PKVI LP to PK Ventures, TBPC, or TPTC on its Form 1065 for 1988. No direct references were made and no explanations were provided in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1988, as to the amounts that PK Ventures, TBPC, and TPTC transferred to PKVI LP during that year. On the Schedule L attached to PKV&S’s consolidated income tax return for 1988, PK Ventures, TBPC, and TPTC reported $118,558 due from PKVI LP under “Other assets” as of the end of that year. Of this amount, $20,580 was attributable to PK Ventures, $48,000 was attributable to TBPC, and $49,978 was attributable to TPTC. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures, TBPC, or TPTC from PKVI LP on PKV&S’s consolidated income tax return for 1988. d. 1989 Note 4 to PKVI LP’s audited financial statements for the year ended December 31, 1989, stated, in pertinent part: December 31, 1989, the Partnership owed $448,646 to “At - 62 P.K. Ventures, Inc. and $107,978 to companies affiliated with P.K. Ventures, Inc.” On the Statement of Financial Condition included in PKVI LP’s audited financial statements for the year ended December 31, 1989, $556,624 “Due to affiliated company” was listed as a liability. No direct references were made and no explanations were provided in PKVI LP’s Form 1065 for 1989 as to the amounts that PKVI LP received from PK Ventures, TBPC, or TPTC during that year. On the Schedule L attached to PKVI LP’s Form 1065 for 1989, $556,624 “Due to Affiliated Company” was listed under “Other current liabilities” as of the end of that year. There were no amounts separately identified as interest payments made and/or imputed by PKVI LP to PK Ventures, TBPC, or TPTC on its Form 1065 for 1989. No direct references were made and no explanations were provided in PK Ventures, TBPC, or TPTC’s financial statements for the year ended December 31, 1989, as to the amounts that PK Ventures, TBPC, and TPTC transferred to PKVI LP during that year. On the Schedule L attached to PKV&S’s consolidated income tax return for 1989, PK Ventures and its subsidiaries reported $556,624 due from PKVI LP under “Other assets” as of the end of that year. There were no amounts separately identified as interest payments received and/or imputed by PK Ventures, TBPC, - 63 or TPTC from PKVI LP on PKV&S’s consolidated income tax return for 1989. e. 1990 Contrary to the terms of the PKVI LP promissory notes, Note D to PKVI LP’s audited financial statements for the year ended December 31, 1990, stated that the transfers that had been received by PKVI LP from PK Ventures (totaling $1,096,250) did not bear interest. Note D also stated that there was no stated maturity date with respect to these transfers and that PKVI LP anticipated that it would repay PK Ventures when cash was available. On the Balance Sheets included in these financial statements, $1,096,250 “DUE TO AFFILIATED COMPANY” was listed as a liability. On the Schedule L attached to PKVI LP’s Form 1065 for 1990, $1,096,250 “DUE TO AFFILIATED COMPANIES” was listed under “Other liabilities” as of the end of that year. On its Form 1065 for 1990, PKVI LP reported imputed interest payments totaling $67,772. There were no amounts separately identified as interest payments made and/or imputed by PKVI LP to PK Ventures, TBPC, or TPTC on its Form 1065 for 1990. Note C to the audited consolidated financial statements of PKV&S for the year ended December 31, 1990, stated the following: The Company has a receivable of $1,096,250 from PK Ventures I Limited Partnership (“LTD”) in which it has a 1% general partnership interest and a 29% limited partnership interest. The Company’s investment in and - 64 advances to LTD have been reduced by $75,000 under the equity method of accounting. At December 31, 1990, LTD has a deficit of $667,000 and incurred a net loss of $262,000 in 1990. The management of LTD is completing construction of certain operating facilities and believes that LTD will become profitable in the future and be able to repay the advances from the Company. The collectibility of the receivable is dependent upon future events which cannot be predicted at this time. On the Consolidated Balance Sheets included in these financial statements, $1,027,577 for “INVESTMENT IN AND ADVANCES TO LIMITED PARTNERSHIPS” was listed as an asset. Of the $1,027,577, $1,021,250 was attributable to an amount “Due from Limited Partnership” for PK Ventures and $6,327 was attributable to an “Investment in limited partnerships” by TPC. On the Consolidated Statements of Cash Flows included in these financial statements, $539,626 for “Advances to limited partnership” was listed under investing activities. On the Schedule L attached to PKV&S’s consolidated income tax return for 1990, PK Ventures reported $1,116,250 due from PKVI LP under “Other current assets” as of the end of that year. On its consolidated income tax return for 1990, PKV&S reported that PK Ventures had imputed interest payments from PKVI LP under section 7872 totaling $67,772. f. 1991 PKVI LP’s financial statements for the year ended December 31, 1991, are not part of the record in these cases. - 65 On the Schedule L attached to PKVI LP’s Form 1065 for 1990, no amount “DUE TO AFFILIATED COMPANIES” was listed under “Other liabilities” as of the end of that year. On its Form 1065 for 1991, PKVI LP reported imputed interest payments totaling $100,661. There were no amounts separately identified as interest payments made and/or imputed by PKVI LP to PK Ventures, TBPC, or TPTC on its Form 1065 for 1991. PKV&S claimed a bad debt expense of $1,712,151 on its audited consolidated financial statements for the year ended December 31, 1991. Of this amount, $1,312,151 was attributable to the transfers that PK Ventures had made to PKVI LP in 1991 and prior years. Note 3 to these financial statements offered the following explanation for PKV&S’ claiming a bad debt expense with respect to these transfers: At December 31, 1990, the Company had made $1,096,250 of noninterest-bearing advances to PK Ventures I Limited Partnership (LTD) in which it has a 1% general partnership interest and a 29% limited partnership interest. The Company made additional advances to LTD in 1991 of $419,996, principally to fund operating losses. Management of the Company believes that recovery of its advances to and investment in LTD is unlikely and, accordingly, has forgiven advances amounting to $1,312,151 in 1991 and charged bad debts expense. The Company also recorded losses under the equity method of $129,095 in 1991 and $75,000 in 1990. PKV&S claimed a $1,916,246 bad debt deduction on its consolidated income tax return for 1991 for the cash transfers that PK Ventures, TBPC, and TPTC had made to PKVI LP and for the cash transfer that PK Ventures had made to Rose in connection - 66 with the Zephyr purchase. With respect to this bad debt deduction, PKV&S reported that $1,516,246 was attributable to the $1,516,246 promissory note’s being uncollectible. On its consolidated income tax return for 1991, PKV&S reported that PK Ventures had imputed interest payments from PKVI LP under section 7872 totaling $100,661. g. 1992 The reviewed financial statements of PKVI LP for the year ended December 31, 1992, indicate that PK Ventures, as PKVI LP’s sole limited partner, continued to transfer funds to PKVI LP during 1992. Note 4 to these financial statements stated the following: At December 31, 1991, the general partner, P K Ventures, Inc. forgave advances totaling $1,516,246. At December 31, 1992, the Partnership owed the limited partner $335,448 in the form of demand notes at 9% interest. These notes cannot be repaid if such payment causes defaults with regard to other debt agreements. Interest of $10,645 was incurred but not paid during 1992 related to these notes. On the Balance Sheets included in these financial statements, $335,448 for “Notes payable to limited partner” was listed as a current liability. On the Consolidated Statements of Cash Flows included in PKV&S’s audited consolidated financial statements for the year ended December 31, 1992, there was no amount listed for “Advances to limited partnership” under the “Investing activities” section. Note 3, “Due From Limited Partnership”, to these financial - 67 statements does not mention that any transfers had been made from PK Ventures to PKVI LP during 1992. h. 1993 PKVI LP’s reviewed financial statements for the year ended December 31, 1993, indicate that PKVI LP received transfers from PK Ventures totaling $242,073 during 1993. Note 4 to PKVI LP’s reviewed financial statements for the year ended December 31, 1993, stated: “At December 31, 1993, the Partnership owed one limited partner $577,521 in the form of demand notes at interest rates ranging from 8% to 9%. Interest of $31,201 and $10,645 was incurred but not paid during 1993 and 1992, respectively.” On the Balance Sheets included in these financial statements, $577,521 for “Notes payable to limited partner” was listed as a current liability. On the Consolidating Balance Sheet included in PKV&S’s audited consolidated financial statements for the year ended December 31, 1993, there were no amounts listed as “Due from affiliated partnership” or as “Investments in limited partnerships” with respect to PK Ventures. 2. IRS Determinations The IRS determined that PKV&S should not have imputed $67,772 of interest income from PKVI LP on its consolidated income tax return for 1990 or $100,661 of interest income from PKVI LP on its consolidated income tax return for 1991 because - 68 the cash transfers that PK Ventures had made to PKVI LP were contributions to capital instead of loans. Accordingly, the IRS decreased PKV&S’s interest income by $67,772 for 1990 and by $100,661 for 1991. The IRS also determined that PKV&S was not allowed to claim a bad debt deduction of $1,516,246 on its consolidated income tax return for 1991 for cash transfers that PK Ventures and/or its subsidiaries had made to PKVI LP because these transfers were contributions to capital instead of loans. Alternatively, the IRS determined that, if these transfers were not contributions to capital, they were made for the benefit of the partners of PKVI LP and, thus, were distributions to the partners. As a further alternative, the IRS determined that, if these transfers were bona fide loans, the bad debt deduction should not be allowed because PKV&S had not established that the debt had become worthless during 1991. Accordingly, the IRS increased PKV&S’s taxable income by $1,516,246 for 1991. The IRS determined that PKVI LP should not have imputed $100,661 of interest expense to PK Ventures on its Form 1065 for 1991 because it had not been established that the interest expense was attributable to a bona fide debt. Rather, the IRS determined that the funds that had been transferred from PK Ventures and/or its subsidiaries to PKVI LP were capital - 69 contributions. Accordingly, the IRS increased PKVI LP’s ordinary income by $100,661 for 1991. The IRS determined that the cash transfers that had been made by PK Ventures and/or its subsidiaries to PKVI LP were made on behalf of the Roses and that the transfers constituted constructive dividends to them. After making certain concessions, the IRS determined that the Roses should have reported a constructive dividend of $411,338 on their joint income tax return for 1990 and a constructive dividend of $293,997 on their joint income tax return for 1991. Accordingly, the IRS increased the Roses’ taxable income by $411,338 for 1990 and by $293,997 for 1991. The IRS notified the Roses that, with respect to 1991, PKVI LP was subject to partnership-level proceedings pursuant to the partnership audit and litigation procedures of sections 6221 through 6233. Consequently, the IRS removed the amount that the Roses had reported as their distributive share of PKVI LP’s cancellation of indebtedness income from their income for that year. The IRS made these adjustments pursuant to Munro v. Commissioner, 92 T.C. 71 (1989). - 70 Other Circumstances Surrounding PK Ventures’ Operations and Financial Arrangements A. Going Concern Notes in the Business’s Financial Statements 1. PK Ventures, SLPC, TBPC, and TPTC Note 10 to PK Ventures’ audited financial statements for the year ended December 31, 1989, set forth the going concern position of the corporation. Note 10 stated, in pertinent part, the following with respect to the corporation’s financial status: “Management’s plans include several steps which may mitigate the current adverse financial condition. * * * The Company’s management extended payment terms related to certain accrued payables such as officer’s salaries, indefinitely, subject to cash availability.” The notes to SLPC, TBPC, and TPTC’s audited financial statements for the year ended December 31, 1989, also include “going concern” notes that state that each corporation’s management had “extended payment terms related to certain accrued payables such as officer’s salary, indefinitely, subject to cash availability.” No corporate resolutions and/or other agreements by PK Ventures, SLPC, TBPC, or TPTC set forth the terms of these extended payment arrangements. 2. PKVI LP Note 8 to PKVI LP’s audited financial statements for the year ended December 31, 1989, set forth the going concern position of the partnership. Note 8 stated the following with - 71 respect to the partnership’s financial status: “Management’s plans include several steps which may mitigate the current adverse financial condition. These steps include renegotiation and reduction of short term debt * * * and reduction of certain operating costs.” Note E to PKVI LP’s audited financial statements for the year ended December 31, 1990, set forth the going concern position of the partnership. Note E stated, in pertinent part, the following with respect to the partnership’s financial status: The Partnership’s financial statements have been presented on a going concern basis which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. At December 31, 1990, partners’ capital is in a deficit position of $667,182. Management plans to mitigate the current adverse financial position by restoring one of its plants to operating condition during 1991 and completing construction projects on two hydroelectric plants which are not yet operational to generate revenues. In addition, P.K. Ventures, Inc., the general and a limited partner, will continue to advance cash to the Partnership as needed. * * * Note 6 to PKVI LP’s reviewed financial statements for the year ended December 31, 1992, set forth the going concern position of the partnership. Note 6 stated, in pertinent part, the following with respect to the partnership’s financial status: The Partnership’s financial statements have been presented on a going-concern basis which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Cash flow deficits and capital needs were supplied and funded in 1991 by P K Ventures, Inc. In 1992, cash flow deficits and capital needs were funded by a loan from the limited partner. Management is exploring the - 72 possibility of renegotiating higher rates on the sales of power and intends to maintain tight expense control at all three of its operational plants. The Partnership may be able to obtain additional funding from the limited partner. Management is also exploring a possible reorganization or merger. The outcome of these matters cannot be predicted at this time. Note 6 to PKVI LP’s reviewed financial statements for the year ended December 31, 1993, set forth the going concern position of the partnership. Note 6 stated, in pertinent part, the following with respect to the partnership’s financial status: The Partnership’s financial statements have been presented on a going-concern basis which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. Cash flow deficits and capital needs were funded in 1993 and 1992 by loans from the limited partner. Management is also exploring a possible reorganization or merger. The outcome of these matters cannot be predicted at this time. B. Litigation Involving SLPC, TBPC, and TPTC A majority of PK Ventures’ income was generated by the operations of its pipeline subsidiaries (i.e., SLPC, TBPC, TPC, and TPTC). PK Ventures’ largest investments were in TBPC and TPTC. As of December 31, 1991, SLPC, TBPC, and TPTC were all litigating separate matters. The matters being litigated affected the corporations’ revenue streams. In particular, TBPC did not receive any of the $483,000 of lease payments that it was owed by Royster between April 1991 and June 1992. In addition, - 73 SLPC’s pipeline was taken out of service sometime prior to January 1, 1992, for environmental reasons. There were no direct references made to this litigation in PKV&S’s audited consolidated financial statements for the year ended December 31, 1991. Note 5 of these financial statements, however, stated, in pertinent part, that: “The Company has not repaid $1,300,000 of subordinated notes payable to the former shareholders of its subsidiaries pending the resolution of various claims against the former shareholders.” C. Transfers From Rose to PK Ventures As of the beginning of October 1992, PK Ventures owed $1.3 million to the TPTC sellers. paid by January 1, 1992. This amount was to have been This debt was settled in October 1992 when PK Ventures agreed to pay the TPTC sellers $590,000. Rose transferred the $590,000 to PK Ventures in October 1992 so that it could pay the TPTC sellers. PK Ventures was relieved of the remaining balance of this $1.3 million debt. In sum, Rose made cash transfers to PK Ventures totaling $990,000 during 1992. Of this $990,000, Rose transferred $940,000 during the last quarter of 1992. PK Ventures executed documents that were identical to the PKVI LP promissory notes described above in favor of Rose with respect to these transfers. These documents were signed by Rose alone; they were neither attested to by a witness nor notarized. - 74 During 1993, Rose made cash transfers to PK Ventures and its subsidiaries totaling $2,863,500. Note 3 to PKV&S’s audited consolidated financial statements for the year ended December 31, 1993, stated the following with respect to these transfers: Notes payable to shareholder represent cash advances contributed to the Company by the major shareholder for operations. The notes bear interest at 12% and are due on demand. The shareholder advanced $2,863,500 and $990,000 to the Company during 1993 and 1992, respectively. Interest expense on notes payable to shareholder was $292,350 and $19,313 during 1993 and 1992, respectively. Rose’s Wages for 1986 Through 1993 The following table breaks down the percentage of time that Rose devoted to his duties for Printon Kane and/or the Printon Kane Group, PK Ventures and its subsidiaries, PKVI LP, and Zephyr during 1986 through 1993: Printon Kane/ PK Ventures and Year Printon Kane Group Subsidiaries PKVI LP Zephyr 1986 1987 1988 1989 1990 1991 1992 1993 40% 20 15 15 ––––- 50% 40 40 50 78 85 85 85 10% 10 15 15 15 15 15 15 –30% 30 20 7 –––- During these years, Rose routinely worked long hours and rarely took vacations. PK Ventures reported the following amounts from its operations on its income tax return for 1986, and PKV&S reported - 75 the following amounts from its operations on its consolidated income tax returns for 1987 through 1993: Year Gross Receipts or Sales Gross Profit Total Income (Loss) Net Income (Loss) 1986 1987 1988 1989 1990 1991 1992 1993 -$3,054,478 4,026,675 4,457,954 5,300,792 5,002,606 4,777,238 4,638,025 -$3,054,478 2,805,981 3,368,325 4,620,576 4,490,177 4,193,245 3,884,120 ($1,307) 3,569,218 3,217,948 3,700,349 4,815,805 5,783,636 4,775,526 4,591,313 ($9,318) (228,055) 579,061 (43,069) 650,781 1,037,967 802,979 230,435 PKVI LP reported the following amounts from its operations on its Forms 1065 for 1986 through 1993: Year 1986 1987 1988 1989 1990 1991 1992 1993 Gross Receipts or Sales Gross Profit $11,093 158,501 151,381 227,616 144,153 61,071 100,250 101,703 Total Income (Loss) Ordinary Income (Loss) From Business Activities $12,488 61,358 28,755 35,120 (260,619) (181,635) 100,250 101,703 ($132,332) (203,653) (346,069) (495,274) (603,756) (604,235) (839,738) (627,306) $11,093 61,358 28,755 35,120 (260,619) (183,635) 100,250 101,703 Zephyr reported the following amounts from its operations on its Forms 1120S for 1987 through 1989: Year 1987 1988 1989 Gross Receipts or Sales Gross Profit $1,623,593 2,022,492 516,969 ($211,807) (569,839) (1,117,281) Total Income (Loss) Ordinary Income (Loss) From Business Activities ($85,237) (563,666) (1,117,281) ($964,830) (1,993,131) (1,628,388) - 76 In addition to the wages discussed below, PK Ventures provided health insurance to Rose and his family during the years in issue. Sometime in 1991, PK Ventures purchased a Honda Civic and provided that car to Rose. PK Ventures replaced the Honda Civic with a Mercedes Benz in 1993 and provided the Mercedes Benz to Rose throughout that year and the remaining years in issue. Rose determined that PK Ventures would not provide him with any retirement benefits. A. Wages Received From Printon Kane and the Printon Kane Group Rose’s salaries from Printon Kane during 1986, 1987, and 1988 were $65,000, $67,500, and $65,000, respectively. In 1989, Rose received salaries from Printon Kane and the Printon Kane Group totaling $34,423 and $12,115, respectively. In 1990, Rose received a salary from the Printon Kane Group totaling $6,923. Rose did not receive any compensation from either Printon Kane or the Printon Kane Group after 1990. B. Wages Recorded on PK Ventures’ Books and Records PK Ventures’ general ledger for 1990 indicated that, during 1990, PK Ventures paid Rose compensation totaling $350,000. PK Ventures’ general ledger for 1990 also indicated that, of this $350,000, PK Ventures had accrued $65,000 prior to 1990 and that SLPC, TBPC, and TPTC had accrued the balance prior to and during 1990 in the following proportions: - 77 - Year Total Compensation Accrued 1987 1988 1989 1990 Total $75,000 75,000 75,000 60,000 285,000 Portion Attributable To: SLPC TBPC TPTC $15,000 15,000 15,000 –45,000 $30,000 30,000 30,000 30,000 120,000 $30,000 30,000 30,000 30,000 120,000 As of December 31, 1991, PK Ventures’ books indicated that, during 1991, PK Ventures had accrued $90,000 of “Salary” and an additional $37,469 of “Compensation & Benefits” with respect to Rose, that TBPC had accrued $30,000 of “Compensation & Benefits” with respect to Rose, and that TPTC had accrued $30,000 of “Mgt Salaries” with respect to Rose. During March 1992, Rose made journal entries to PK Ventures’ general ledger to reflect “deferred compensation” payable to him for 1986 through 1991 in the following amounts: Year Amount 1986 1987 1988 1989 1990 1991 $500,000 600,000 720,000 840,000 900,000 900,000 According to this “Deferred Compensation” account, PK Ventures owed Rose $4,460,000 as of March 30, 1992. Prior to Rose’s making these journal entries, there had never been a written agreement between Rose and PK Ventures as to deferred compensation, and Rose had never discussed deferred compensation - 78 with anyone who had an equity interest or financial interest in PK Ventures. PK Ventures’ general ledger for 1992 indicated that, during 1992, PK Ventures paid Rose $500,000 for 1986 and $246,948 for 1987. As of December 31, 1992, the “Deferred Compensation” account included in PK Ventures’ general ledger showed a current balance of $3,713,052. At the advice of the auditors of PKV&S’s consolidated financial statements, this balance was “reversed” off of PK Ventures’ general ledger. Consequently, there was no liability for deferred compensation reported on PKV&S’s audited consolidated financial statements for the year ended December 31, 1992, or on PKV&S’s audited consolidated financial statements for the year ended December 31, 1993. Moreover, there was no liability for deferred compensation reported on the Schedules L attached to PKV&S’s consolidated income tax returns for 1992 and 1993. PK Ventures’ general ledger for 1992 also indicated that, during 1992, PK Ventures paid Rose $900,000 for his services to it and its subsidiaries. Of this $900,000, $32,500 was attributable to “MGT SAL TPTC” and $32,500 was attributable to “MGT SAL TBPC”. PK Ventures’ general ledger for 1993 indicated that, during 1993, PK Ventures paid Rose compensation totaling $2,031,993. The general ledger did not clearly indicate what portion of this - 79 $2,031,993 was attributable to current compensation and what part (if any) was attributable to deferred compensation. Rose, as sole director of PK Ventures, determined the amounts of compensation that PK Ventures paid to him during the years in issue. With respect to the $4,460,000 of “deferred compensation” that was recorded in PK Ventures’ general ledger for 1992, Rose first determined this amount sometime between the beginning of 1992 and March 30, 1992. Included in the determination of the $4,460,000 was the amount of compensation that Rose believed that he should have received from Zephyr during a 16-month period in 1987 and 1988. There had never been an amount accrued as a salary for Rose on Zephyr’s books and records, and PK Ventures had never been a shareholder of Zephyr. Furthermore, the total compensation that Rose determined that PK Ventures should pay him for 1992 and 1993 related to his providing services over an “8.3-year” period that included a portion of 1985 and the entirety of 1986 through 1993. C. Wages Reported on Income Tax Returns PK Ventures deducted the following amounts as compensation paid to officers and salaries and wages paid on its income tax return for 1986, and PKV&S deducted the following amounts as compensation paid to officers and salaries and wages paid on its consolidated income tax returns for 1987 through 1993: - 80 Year Compensation Paid to Officers Salaries and Wages Paid 1986 1987 1988 1989 1990 1991 1992 1993 --– -– $170,000 80,068 103,000 1,646,948 2,031,993 -$173,844 192,211 -– 276,190 396,247 306,718 352,974 All of the amounts that PKV&S reported as compensation paid to officers on these returns were attributable to Rose. On the Roses’ joint income tax returns for 1990 through 1995, Rose reported that he received the following amounts of compensation: Year Wages and Salaries Gross Income Reported on Schedule C Miscellaneous Income from Form 1099 1990 1991 1992 1993 1994 1995 $6,923 –––606,250 250,000 $17,000 ––-– -– -– -– $103,000 1,646,948 2,031,993 -– -– Rose did not report any compensation from PK Ventures or its subsidiaries in 1987 or 1988. On its consolidated income tax return for 1990, PKV&S claimed a $50,068 deduction for officer compensation paid to Rose and a $30,000 deduction for a “salary transfer to Tampa Bay Pipeline Co.” from PK Ventures. PKV&S reported that $17,000 of the $50,068 was paid by TPTC and that the balance was paid by PK Ventures. Neither the $30,000 attributable to TBPC nor the - 81 $50,068 attributable to PK Ventures and TPTC appears on the Roses’ joint income tax return for 1990 as wages received. Rose did, however, report $33,068 of imputed interest from PK Ventures on that return as well as $17,000 of gross income from his involvement in an “investment company” on a Schedule C, Profit or Loss From Business, that was attached to the return. On its consolidated income tax return for 1991, PKV&S claimed a $103,000 deduction for officer compensation paid to Rose. PKV&S reported that $30,000 of this amount was paid by TBPC, that $30,000 was paid by TPTC, and that the balance was paid by PK Ventures. In addition, PKV&S claimed a $37,469 deduction for other salaries and wages paid to Rose. This latter deduction was attributable to the “reclassification” of an account showing that Rose owed PK Ventures $437,469 as of December 31, 1991. As discussed above, this “reclassification” resulted in PKV&S’s claiming a $400,000 bad debt deduction as well as the $37,469 deduction for other salaries and wages paid to Rose. The Roses reported the $103,000 of officer compensation on their joint income tax return for 1991, but they failed to report the $37,469 of other salaries and wages. On its consolidated income tax return for 1992, PKV&S claimed a $1,646,948 deduction for officer compensation paid to Rose. PKV&S reported that $32,500 of this amount was paid by TBPC, that $32,500 was paid by TPTC, and that the balance was - 82 paid by PK Ventures. The Roses reported the $1,646,948 of officer compensation on their joint income tax return for 1992. On its consolidated income tax return for 1993, PKV&S claimed a $2,031,993 deduction for officer compensation paid to Rose. PKV&S reported that $32,500 of this amount was paid by TBPC, that $32,500 was paid by TPTC, and that the balance was paid by PK Ventures. The Roses reported the $2,031,993 of officer compensation on their joint income tax return for 1993. In addition to this amount, the Roses reported interest from PK Ventures of $292,350. Rose received the amounts of wages and salaries that he reported on the Roses’ joint income tax returns for 1994 and 1995 from TPC. TPC issued Forms W-2, Wage and Tax Statement, to Rose with respect to these amounts. D. IRS Determinations With respect to 1990, the IRS determined that Rose should have reported a total of $350,000 of compensation from PK Ventures and its subsidiaries. The IRS determined that this amount included $285,000 of compensation that had been accrued by SLPC, TBPC, and TPTC during 1987, 1988, 1989, and 1990 and paid to Rose in 1990 and included $65,000 of compensation that had been accrued by PK Ventures prior to 1990 and paid to Rose in 1990. After taking into account the $17,000 of gross income that Rose had reported on a Schedule C that was attached to the Roses’ - 83 joint income tax return for 1990 and shifting $13,000 of the compensation that Rose reported in 1991 to 1990, the IRS increased the Roses’ taxable income for 1990 by $320,000. With respect to 1991, the IRS determined that Rose should have reported an additional $97,469 of compensation from PK Ventures and its subsidiaries. The IRS determined that this amount included $60,000 of compensation that had been accrued by TBPC and TPTC during 1991 and included $37,469 of compensation that had been accrued by PK Ventures during that year. Accordingly, the IRS increased the Roses’ taxable income for 1991 by $97,469. The Roses conceded these adjustments for 1990 and 1991. Taking into account these concessions, Rose received the following amounts of compensation for his services to PK Ventures and its subsidiaries during 1986 through 1991: - 84 Entity 1986-89 PK Ventures $170,000 SLPC -TBPC –TPTC -Total 170,000 1990 1991 $98,068 45,000 120,000 120,000 383,068 $67,469 -60,000 60,000 187,469 In sum, Rose received $740,537 for his services to PK Ventures and its subsidiaries during these years. With respect to 1992, the IRS determined that the deduction that PKV&S claimed for compensation paid to Rose should be reduced by $1,208,893. The IRS determined this reduction by subtracting (1) reasonable salary for 1992 totaling $143,317 and (2) deferred compensation totaling $294,738 from the $1,646,948 that PKV&S deducted in that year. The IRS determined the reasonable salary for 1992 by multiplying PKV&S’s gross receipts for that year by 3 percent. The IRS determined deferred compensation as follows: Year Salary Deducted on Return Reasonable Salary Difference Deferred Compensation 1987 1988 1989 1990 1991 Total -– -– $170,000 50,068 140,469 360,537 $91,634 120,800 133,739 159,024 150,078 655,275 ($91,634) (120,800) 36,261 (108,956) (9,609) (294,738) $91,634 120,800 (36,261) 108,956 9,609 294,738 As it did in 1992, the IRS determined reasonable salary for 1987 through 1991 by multiplying PKV&S’s gross receipts for each of those years by 3 percent. Accordingly, the IRS increased PKV&S’s taxable income by $1,208,893 for 1992. - 85 With respect to 1993, the IRS determined that the deduction that PKV&S claimed for compensation paid to Rose should be reduced by $1,892,852. The IRS determined this reduction by subtracting reasonable salary for 1993 totaling $139,141 from the officer compensation that PKV&S deducted in that year. As it did in 1992, the IRS determined reasonable salary for 1993 by multiplying PKV&S’s gross receipts for that year by 3 percent. Accordingly, the IRS increased PKV&S’s taxable income by $1,892,852 for 1993. PK Ventures’ Share of PKVI LP’s Items of Income and Loss A. As Reported on PK Ventures’ Schedules K-1 The following items were listed on PK Ventures’ Schedules K-1 that were attached to PKVI LP’s Forms 1065 for 1986 through 1993: - 86 Amount General Limited Interest Interest Year Item 1986 Capital contributed during year Net long-term capital gain Withdrawals and distributions Ordinary loss from business activities Net short-term capital loss $500 29 -(1,323) (13) --– -– -– -– 1987 Capital contributed during year Interest income Withdrawals and distributions Ordinary loss from business activities -69 -(2,036) --– -– -– 1988 Capital contributed during year 3,540 Withdrawals and distributions -– Ordinary loss from business activities (18,515) ---– 1989 Capital contributed during year -Withdrawals and distributions -– Ordinary loss from business activities (26,497) ---– 1990 Capital contributed during year -($95,640) Net gain under section 1231 708 2,105 Withdrawals and distributions -– -Ordinary loss from business activities (32,301) (96,097) 1991 Capital contributed during year --Cancellation of indebtedness income 81,119 373,755 Withdrawals and distributions -– -Ordinary loss from business activities (32,327) (148,944) 1992 Capital contributed during year --Withdrawals and distributions -– -Ordinary loss from business activities (44,925) (206,996) 1993 Capital contributed during year --Withdrawals and distributions -– -Ordinary loss from business activities (33,561) (154,631) Net loss under section 1231 (4,405) (20,296) B. As Reported on the Income Tax Returns for PK Ventures and PKV&S PK Ventures reported the following amount with respect to its interest in PKVI LP on its income tax return for 1986, and - 87 PKV&S reported the following amounts with respect to PK Ventures’ and/or its subsidiaries’ interests in PKVI LP on its consolidated income tax returns for 1987 through 1993: Year 1986 1987 1988 1989 1990 1991 1992 1993 C. Income (Loss) Cancellation of from PKVI LP Bad Debts Indebtedness Income ($1,323) (2,036) (18,515) (26,497) (124,687) (181,271) (251,921) (212,893) -– -– -– -– -$1,516,246 -– -– -– --– —-$454,874 --- IRS Determinations The IRS determined that PKV&S could deduct PK Ventures’ distributive share of PKVI LP’s losses for 1990, 1991, 1992, and 1993 to the extent of PK Ventures’ basis in its PKVI LP interest. Before taking into account any of PKVI LP’s losses, the IRS determined that PK Ventures’ basis in its PKVI LP interest was $114,936 as of December 31, 1990. The IRS determined this amount by subtracting the amount of PKVI LP’s losses that PKV&S deducted in 1986, 1987, 1988, and 1989 from the cash advances that it determined that PK Ventures had made to PKVI LP in 1990 and prior years and the capital contribution that it determined that PK Ventures had made to PKVI LP in 1988. The IRS allowed as a deduction against this basis $114,936 of PK Ventures’ distributive share of PKVI LP’s losses for 1990. Accordingly, the IRS increased PKV&S’s taxable income by $9,751 for 1990. - 88 Before taki [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3A406431f8878abcc8. Public record. Not legal advice.