UNITED STATES TAX COURT
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T.C. Memo. 1996-435
UNITED STATES TAX COURT
BARRY B. BEALOR AND NANCY L. BEALOR, ET AL.,1
Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 13364-89, 14112-89,
17236-89, 26434-89,
27614-90, 14819-91,
14820-91, 22407-91,
22496-91, 25519-91,
27125-91, 3453-92,
3456-92, 3457-92,
3461-92, 3462-92,
3551-92, 9950-92,
3221-93, 10897-93,
23719-93.
1
Filed September 25, 1996.
Cases of the following petitioners are consolidated
herewith: Frank A. Pettisani and Lucille M. Pettisani, docket
No. 14112-89; James D. Cameron and Anita B. Cameron, docket No.
17236-89; Intercoastal Management Co. and Subsidiaries, docket
No. 26434-89; Donald P. Crescenzo and Kathleen Crescenzo, docket
No. 27614-90; MIT 82, Bryen & Bryen, P.A., Tax Matters Partner,
docket No. 14819-91; MIT 83, Bryen & Bryen, P.A., Tax Matters
Partner, docket No. 14820-91; MIT 83, Bryen & Bryen, P.A., Tax
Matters Partner, docket No. 22407-91; MIT 84, Bryen & Bryen,
P.A., Tax Matters Partner, docket No. 22496-91; MIT 85, Bryen &
Bryen, P.A., Tax Matters Partner, docket No. 25519-91;
Intercoastal Management Co. and Subsidiaries, docket No. 2712591; MIT 85, Bryen & Bryen, P.A., Tax Matters Partner, docket No.
3453-92; MIT 82, Bryen & Bryen, P.A., Tax Matters Partner, docket
No. 3456-92; MIT 80, Bryen & Bryen, P.A., Tax Matters Partner,
docket No. 3457-92; MIT 84, Bryen & Bryen, P.A., Tax Matters
Partner, docket No. 3461-92; MIT 86, Bryen & Bryen, P.A., Tax
Matters Partner, docket No. 3462-92; MIT 83, Bryen & Bryen, P.A.,
Tax Matters Partner, docket No. 3551-92; MIT 86, Bryen & Bryen,
P.A., Tax Matters Partner, docket No. 9950-92; W & A Payroll
Service, Bryen & Bryen, P.A., Tax Matters Partner, docket No.
3221-93; W & A Payroll Service, Bryen & Bryen, P.A., Tax Matters
Partner, docket No. 10897-93; and Frank A. Pettisani and
Lucille M. Pettisani, docket No. 23719-93.
- 2 Stephen J. Jozwiak, for petitioners in docket Nos. 13364-89,
14112-89, 17236-89, 26434-89, 27614-90, 22407-91, 22496-91,
25519-91, 27125-91, 9950-92, 10897-93, and 23719-93.
Fred Bryen (an officer), for petitioners in docket Nos.
14819-91, 14820-91, 3453-92, 3456-92, 3457-92, 3461-92, 3462-92,
3551-92, and 3221-93.
John E. Becker, Jr., James C. Fee, Jr., and Joseph M. Abele,
for respondent.
CONTENTS
Subject
Page
Issues..................................................
7
FINDINGS OF FACT........................................
8
Background..............................................
9
MIT 80..................................................
12
Formation of MIT 80................................
Investors in MIT 80................................
Organization and Management of MIT 80..............
MIT 80 Employee Leasing Arrangement................
Operation of MIT 80................................
Petitioner Crescenzo's Deduction of MIT 80
Partnership Loss.................................
Post-1980 Transactions of MIT 80...................
Illustration No. 1.................................
Purported Transactions--MIT 80.....................
Termination Agreement of MIT 80....................
Partnership Income of MIT 80.......................
12
13
13
14
17
MIT 82..................................................
31
Formation of MIT 82................................
Investors in MIT 82................................
Organization and Management of MIT 82..............
MIT 82 Employee Leasing Agreement..................
Operation of MIT 82................................
Individual Petitioners’ Deductions of
Partnership Loss.................................
31
31
33
35
36
21
21
24
25
26
28
39
- 3 Intercoastal’s Deduction of Compensation Fee.......
Post-1982 Transactions of MIT 82...................
The Pettisanis’ Deductions of Interest
Payments.........................................
Illustration No. 2.................................
Purported Transactions--MIT 82.....................
Termination Agreement of MIT 82....................
Partnership Income of MIT 82.......................
39
40
MIT 83..................................................
46
MIT 83 Investors...................................
Organization and Management of MIT 83..............
MIT 83 Employee Leasing Agreement..................
Operation of MIT 83................................
Tax Deductions.....................................
Other Developments.................................
Post-1983 Transactions of MIT 83...................
Illustration No. 3.................................
Investment Program--MIT 83.........................
Termination Agreement of MIT 83....................
MIT 83 Income......................................
46
46
50
51
54
55
56
57
57
60
60
MIT 84..................................................
61
MIT 85..................................................
68
MIT 86..................................................
75
W & A Payroll Service...................................
82
The Investors...........................................
89
OPINION.................................................
92
I.
Neither the Partners Nor the Partnerships
Are Entitled to Loss Deductions Based Upon
Payment of Machise's Payroll Costs ...........
41
42
42
43
44
93
A. The Requirement of Economic Substance...... 93
1. The Relationship of the Employees
and Independent Contractors to
Machise and to the Partnerships....... 95
2. Lack of Economic Substance of the
Employee Leasing Agreements........... 103
a. Structure of the Financing....... 104
b. Termination Agreements........... 110
c. Arm's-Length Negotiations........ 115
d. Adherence to Contractual
Terms............................ 119
e. Reasonableness of Income
- 4 Projections...................... 123
f. Insertion of Other Entities...... 128
B. Lack of Profit Objective of the
Employee Leasing Partnerships.............. 129
II.
The Pettisanis Are Not Entitled to
Deductions for Interest Claimed on Their
Long-Term Notes............................... 138
III. Intercoastal Is Not Entitled To Deduct From
Its Income the Accrued Interest, Management
Fees, or Override Payments to the Leasing
Partnerships.................................. 141
IV.
The Transactions at Issue Are Not
Recognized for Purposes of Claiming
Deductions or Reporting Income................ 145
A. In Summary................................. 145
B. No Procedural Defense to Determined
Deficiencies............................... 146
C. No Need To Address Other Issues............ 151
- 5 MEMORANDUM FINDINGS OF FACT AND OPINION
BEGHE, Judge:
In seven of these consolidated cases
respondent determined deficiencies in Federal income taxes as
follows:
Taxable
Year
Deficiency
Barry B. Bealor
and Nancy L. Bealor
1982
$23,434
14112-89
Frank A. Pettisani
and Lucille M. Pettisani
1982
12,344
17236-89
James D. Cameron
and Anita B. Cameron
1982
33,749
26434-89
Intercoastal Management Co.
and Subsidiaries
1982
1983
312,775
471,918
27614-90
Donald P. Crescenzo
and Kathleen Crescenzo
1980
23,903
27125-91
Intercoastal Management Co.
and Subsidiaries
1984
1985
1986
644,814
670,597
725,758
23719-93
Frank A. Pettisani1
and Lucille M. Pettisani
1983
1984
1985
1986
1987
270,425
606,481
1,014,702
1,304,694
293,682
Docket No.
Petitioners
13364-89
1
In this case, respondent determined substantial deficiencies
and additions to tax arising from petitioners' activities, including
investments in various partnerships and S corporations. The only
portions of the deficiencies at issue are those that arise from
petitioners' claimed interest expense deductions with respect to
their investment in MIT 82.
In certain of the cases listed above, respondent also
determined additions to tax under sections 6653(a)(1) and (2),
- 6 and 6661, and additional interest under section 6621(c).2
By
agreement of the parties, resolution of petitioners' liabilities
for the additions to tax and additional interest has been
reserved for other proceedings.
In five other cases, respondent determined administrative
adjustments to partnership returns, arising from disallowance of
claimed partnership losses, as follows:
Docket No.
Partnership
Taxable
Year
Adjustment
22407-91
22496-91
25519-91
9550-92
10897-93
MIT 83
MIT 84
MIT 85
MIT 86
W & A
1983
1984
1985
1986
1987
$3,066,626
3,035,000
2,700,000
3,850,000
3,586,269
In the nine remaining cases, petitioners have requested the
following administrative adjustments reflecting the reduction of
reported income to zero if we find that the transactions giving
rise to that income are shams:
Docket No.
Partnership
14819-91
14820-91
3453-92
MIT 82
MIT 83
MIT 85
3456-92
MIT 82
3457-92
MIT 80
2
Taxable
Year
Adjustment
1986
1986
1986
1987
1988
1987
1988
1989
1986
$428,142
519,960
412,722
1,865,187
1,419,986
840,069
275,156
1,274,633
443,415
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.
- 7 -
3461-92
MIT 84
3462-92
3551-92
MIT 86
MIT 83
3221-93
W & A
1987
1988
1989
1986
1987
1988
1989
1987
1987
1988
1989
1988
840,838
969,316
1,335,995
546,300
1,315,352
23,889
1,423,786
4,855,505
797,976
360,236
1,218,735
3,586,156
The cases in the foregoing dockets have been selected by the
parties as test cases that will resolve common issues in more
than 120 cases in a group identified by respondent as "Fred Bryen
Promotions".
Most petitioners in the nontest cases have executed
"piggyback agreements" in which they agree with respondent to be
bound by the outcomes in the test cases.
Issues
The global issue in these consolidated cases is the tax
effect of the purported employee leasing transactions of seven
partnerships.
By agreement of the parties, the questions
presented for decision are whether the transactions of the seven
partnerships had (1) economic substance and (2) a profit
objective.
Because we answer those questions in the negative, we
hold that neither the partners nor the partnerships are entitled
to loss deductions for payroll costs, that the Pettisani
petitioners are not entitled to deductions for interest on
certain long-term notes, that petitioner Intercoastal Management
- 8 Co. & Subsidiaries, the operator of the business for which worker
services were provided, is not entitled to deduct from its
income, ostensible accrued interest, management fees, or override
payments to the partnerships, that none of the transactions at
issue are recognized for the purpose of claiming deductions or
reporting income, and that respondent is not estopped from
asserting any of the deficiencies or proposed adjustments at
issue.
In view of these holdings, we need not answer any of a
series of more particularized substantive tax questions that the
parties posed:
Whether the partnerships at issue are actually
partnerships within the meaning of the Internal Revenue Code;
whether the partnerships are employers under the Internal Revenue
Code; whether the losses claimed by petitioner partners exceed
their bases in the partnerships; whether the partners were at
risk with respect to certain notes they issued; and whether the
cash method of accounting selected by the partnerships clearly
reflected their income.
FINDINGS OF FACT
The parties have stipulated some of the facts, and the eight
sets of stipulations of fact and attached exhibits are
incorporated in this opinion.
- 9 Background
The individual petitioners were residents of New Jersey
when they filed their petitions.
The principal place of business
of the partnerships known as MIT 80, MIT 82, MIT 83, MIT 84, MIT
85, MIT 86, and W & A Payroll Service was Marlton, New Jersey,
when their tax matters partner filed the petitions relating to
the administrative adjustments or requests for adjustments at
issue.
When petitioner Intercoastal Management Co. filed its
petitions, its principal place of business was Hammonton, New
Jersey.
Fred Bryen (Fred) has been a certified public accountant for
approximately 40 years.
From 1965 to 1978, he was a professor of
accounting at Rutgers University.
He is also one of the owners
and employees of the accounting firm Bryen & Bryen, P.A. (BBPA).
His son Bruce, also a certified public accountant, is also an
employee-owner of BBPA.
Marion Hunt, also a certified public
accountant, is the third owner-employee of BBPA.
BBPA provided
business and tax advice to clients and prepared tax returns, but
did not certify financial statements.
In the mid-1970's, Fred and Bruce began to structure and
promote tax shelters.
These tax shelters were structured by Fred
and primarily promoted by Bruce.
One of BBPA's accounting clients was Machise Interstate
Transportation Co., Inc. (Machise), a New Jersey corporation
- 10 engaged in hauling gasoline and fuel oil.
Machise was on the
accrual method of accounting and employed a fiscal year ending
June 30.
Anthony Bucci (Bucci) and Joseph Ingemi (Ingemi) were
clients of BBPA.
In 1975, Bucci and Ingemi each purchased 50
percent of Machise's stock.
At BBPA's suggestion, they
transferred their Machise stock to their newly formed
corporation, Intercoastal Management Co. (Intercoastal).
Bucci
and Ingemi were the only shareholders and employees of
Intercoastal.
The primary purpose for BBPA's recommending the
formation of Intercoastal was to provide a means for Bucci and
Ingemi to enjoy a generous pension plan without providing for the
rank and file employees.
During the years at issue, Intercoastal
filed consolidated Federal income tax returns with Machise.
For
purposes of these findings and opinion, Intercoastal and Machise
are essentially the same entity.
Both corporations were
dominated by Bucci and Ingemi, and, after Ingemi's death, by
Bucci alone.
Machise subsequently entered into an employee leasing
agreement with MIT Personnel Co. (MIT Personnel), a corporation
that was owned by Bruce Bryen.
Bruce, at the time a young man,
agreed to undertake the ownership of MIT Personnel as a favor to
Bucci and Ingemi and in the hopes of attaining a promised $50,000
fee from them.
Pursuant to this agreement, MIT Personnel was to
provide Machise with the employees and independent contractors
- 11 that Machise would need to carry on its business.
Following
execution of the agreement, the same employees and independent
contractors who had worked previously for Machise continued to
provide the same services for Machise.
Fred recommended that MIT Personnel be formed to enable
Bucci and Ingemi to set up a separate pension plan for the rank
and file employees.
BBPA also advised Bucci and Ingemi that the
use of MIT Personnel would minimize their union problems, help
reduce their exposure to personal liability arising from
accidents to the Machise tank trucks, and minimize their exposure
to payroll tax problems if the truck drivers were classified as
employees rather than as independent contractors.
On July 1, 1977, Bruce transferred ownership of MIT
Personnel equally to Stella Bucci and Lena Ingemi, the mothers of
Bucci and Ingemi.
In 1980, the first of the tax years at issue, Bucci and
Ingemi owned the stock of Intercoastal and were its only
employees.
Intercoastal owned the stock of Machise, the
operating company.
The employees and independent contractors who
had worked for Machise continued to work for Machise, but now
were ostensibly employed by MIT Personnel, a company owned by the
mothers of Bucci and Ingemi.
The following findings of fact describe the form of the
transactions that give rise to the tax deductions at issue.
- 12 These findings are necessary for an understanding of the issues
presented.
The descriptions of the transactions, however, are
not meant to indicate that the events described actually
happened, or that they had any economic effect.
We reserve for
the opinion below our discussion and conclusions on those
matters.
MIT 80
Formation of MIT 80
Fred decided to abandon the MIT Personnel/Machise leasing
arrangement in order to promote annual tax-shelter partnerships
that would utilize Machise.
To this end, in 1980, Fred and Bruce
organized and promoted a general partnership named MIT 80.
MIT
80's business address was Allison Drive, Cherry Hill, New Jersey,
the same address as BBPA’s.
MIT 80 moved its business address to
100A Centre Boulevard, Marlton, New Jersey, when BBPA moved
there.
MIT 80 used the calendar year as it tax year.
In order
to carry out its tax-shelter objectives, MIT 80 employed the cash
method of accounting until December 31, 1986, when it was
required to change to the accrual method in accordance with a
change in the accounting provisions of the Internal Revenue Code.
MIT 80 obtained an employer identification number from the
Internal Revenue Service and opened a payroll account at the
Guarantee Bank.
account.
Bucci and Ingemi were signatories on this
- 13 Investors in MIT 80
There were nine investors who became partners in MIT 80--six
individuals, a trust, and two partnerships that BBPA had
organized.
One of the individual partners was Donald P.
Crescenzo (Dr. Crescenzo), a dentist who practices in Hammonton,
New Jersey.
The Bryens were his accountants.
that he invest in tax shelters.
Bruce recommended
He invested in MIT 80 because of
the tax-sheltered nature of the investment.
Dr. Crescenzo had a
lot of faith in the Bryens and left the matter of his investment
entirely up to Bruce.
He was later surprised to discover that,
in the course of becoming a partner in MIT 80, he had signed a
note for $150,000.
The MIT 80 investors were provided with a three-page
document prepared by BBPA that set forth projections of income
and expenses to the end of the partnership term.
Organization and Management of MIT 80
Beginning in July 1980, the nine MIT 80 investors executed
powers of attorney in favor of BBPA.
Thereafter, at Fred's
suggestion, Bruce signed the partnership agreement of MIT 80 on
behalf of its investors, who thereby became partners in MIT 80.
During July 1980, the investors, including petitioner
Dr. Crescenzo, also executed promissory notes aggregating $2.4
million to Intercoastal.
The notes bore interest at the annual
rate of 10 percent on the unpaid principal.
The notes specified
- 14 that they would be repaid in 120 monthly installments of interest
and principal.
On July 17, 1980, Intercoastal drew checks on an
account at the Bank of New Jersey totaling $2.4 million.
The
checks were payable to the MIT 80 investors in amounts equal to
the face amounts of their notes.
checks to MIT 80.
The investors endorsed these
These endorsed checks constituted the only
capital investments in MIT 80 made by the nine investors.3
MIT 80 and BBPA also entered into a management agreement,
drafted by Fred, dated "as of" January 1, 1980, whereby BBPA
agreed to manage MIT 80.
At Fred's behest, Bruce signed the
management agreement on behalf of the MIT 80 partners pursuant to
their powers of attorney.
MIT 80 Employee Leasing Arrangement
MIT 80 and Machise entered into an employee leasing
agreement dated "as of" January 1, 1980.
The agreement provided
that MIT 80 would furnish all the employees and independent
contractors needed by Machise to conduct its business for the
1980 calendar year.
The agreement specified the duties of the partnership in
some detail.
3
Thus, under the heading "Supply of Individuals",
During 1980, the investors of MIT 80 actually made cash
payments totaling $158,580.80 to Intercoastal, as payments of
principal and interest on their notes. These payments went into
a separate set of accounts called the MIT 80 ledger. They were
deposited with the Merrill Lynch brokerage firm and with the
Empire Savings & Loan Association.
- 15 the agreement provided-(a) Within ten (10) days of the effective date of
this Agreement, the Company shall provide the
Partnership with an estimate of the job classifications
and the number of individuals within each job
classification that it will require during each month
in 1980. In any month, the Partnership shall be
obligated to provide only such number of individuals
having only the qualification designated in such notice
and estimate by the Company * * *.
(b) Ten (10) days prior to the date that the
Partnership is to provide an individual to the Company,
the Partnership shall provide the Company biographical
information of such individual, containing such
information as may be mutually agreed between the
Partnership and the Company. The amount of payroll
costs to be incurred by the Partnership with respect to
any such individual shall also be disclosed. * * *
*
*
*
*
*
*
*
(d) The Partnership shall have the exclusive
right to determine which of its employees shall perform
the job services designated by the Company according to
the terms of this agreement. * * * The Partnership
shall have the right to control and direct the
performance of the services of the individuals, and
shall instruct each individual as to his work hours and
the nature of his duties. * * *
Under the heading "Supply of Contractors" the Agreement
provided-(a) The Company shall provide the Partnership at
least three (3) days prior to the date needed, the
number of contractors required for any particular day,
the type of equipment required, the type of product to
be hauled and the destination of such product. The
Partnership shall be obligated to provide such number
of contractors with the required equipment * * *.
(b) One day prior to the date that the
Partnership is to provide a contractor to the Company,
the Partnership shall provide the Company such
information concerning the contractor and his equipment
- 16 as may be mutually agreed between the Partnership and
the Company * * *.
*
*
*
*
*
*
*
(d) The Partnership shall have the exclusive
right to determine the contractor to be used to fulfill
the Partnership's obligations under this Agreement.
Fred provided that the term of the employee leasing
agreement between MIT 80 and Machise would be for 1 year so that,
in each succeeding year, he could bring in more investors who
would be able to deduct their shares of the first-year loss of a
new and different tax shelter partnership.
Bruce signed the
employee leasing agreement on behalf of the partners in MIT 80,
writing the words "by power of attorney" below each signature.
Journal entries indicate that MIT 80 advanced 100 percent of
its $2.4 million capital to Intercoastal on July 29, 1980,
although MIT 80 was not specifically required to do so by the
employee leasing agreement.
The journal entries reflect that
these advances took the form of MIT 80's further endorsement of
$2.4 million in checks that originally had been drawn by
Intercoastal, made payable to the MIT 80 investors, and deemed to
have been used by them as their initial investment in MIT 80.
However, the journal entries are the only documents indicating
the endorsements; MIT 80 did not in fact endorse these checks to
Intercoastal.
None of the checks entered banking channels;
instead, as Fred intended, they circled back to Intercoastal,
their drawer.
- 17 Thus, at the conclusion of this series of transactions,
Intercoastal held, as an advance, the $2.4 million in checks that
it had issued to the partners in exchange for their notes, and
the partners owed Intercoastal $2.4 million on their notes.
The above transactions are depicted in Illustration No. 1,
infra p. 25.
Operation of MIT 80
Following execution of the employee leasing agreement the
same employees and independent contractors who had performed
services for Machise continued to perform the same services
for Machise.
Neither Machise nor MIT Personnel--the prior
employers--gave written notice of termination to the employees
and independent contractors.
The employees and independent
contractors did not submit formal employment applications to MIT
80.
Bucci and Ingemi were the individuals most knowledgeable
about the detailed work assignments of Machise's employees.
They actually directed and controlled the activities of those
employees.
However, there was no provision in the employee lease
with MIT 80, purportedly the new employer, or any other document,
under which Bucci and Ingemi were to provide such direction and
control.
Nor was there any provision in any agreement for
remunerating Intercoastal, Bucci, or Ingemi for undertaking to
manage the Machise personnel on behalf of MIT 80.
Machise made
- 18 weekly cash "advances" to the Guarantee Bank payroll account held
by MIT 80, although it was not required to do so by the employee
leasing agreement.4
These advances were equal to the actual
weekly worker service compensation payments to employees and
independent contractors.
The advances were reflected on the
books of MIT 80 and Machise.
During 1980, Machise paid
$2,243,495.73 into the MIT 80 payroll account so that MIT 80
could cover the weekly payroll costs for the employees and
independent contractors.
Hereafter, use of the term “payroll
costs” includes amounts paid with respect to, or on behalf of,
both employees and independent contractors.
Bucci and Ingemi retained control of the MIT 80 ledger,
although they were not partners in MIT 80.
Either Bucci or
Ingemi signed the MIT 80 checks that paid the employees and
independent contractors from the weekly advances made by Machise.
There was also a pension plan in effect for the rank and file
employees.
Bucci decided what investments were to be made for
the pension plan, and the comptroller of Machise prepared the
4
Fred testified that there was an "oral agreement" that
Machise would advance to MIT 80 the funds needed to pay Machise's
employees and independent contractors for the first 6 months of
1980, until MIT 80 obtained funds from its incoming partnerinvestors. Thereafter MIT 80 would repay Machise and deposit
with Machise the estimated amount needed by MIT 80 to pay the
payroll expenses for the second 6 months. As a result, each
week, Machise would pay into the MIT 80 account the amount
needed to meet the Machise payroll. At the end of the year, Fred
explained, "it was all washed out".
- 19 quarterly financial statements for the pension plan.5
By or on behalf of MIT 80, payroll taxes were withheld from
employees' wages and remitted to the appropriate State and
Federal Government agencies under MIT 80's employer
identification number.
The employment tax returns that were
filed showed MIT 80 as the employer.
In 1983, the State of New
Jersey made a claim against MIT 80 arising out of an alleged
underpayment of unemployment tax contributions in the amount of
$140.47.
The employee leasing agreement required Machise to pay MIT
80 a "compensation fee" of 115 percent of the payroll costs paid
by MIT 80 with respect to the erstwhile Machise employees and
independent contractors.
the "override".
The 15-percent excess of such costs was
The override was supposed to compensate MIT 80
for its services in providing and paying the employees and
independent contractors to perform the services Machise required
5
The MIT Personnel Co. pension plan was in place for the
Machise employees before and during the years in issue. The MIT
80 partnership and successor partnerships apparently were named
parties to this plan by virtue of a "participation agreement".
The evidence includes a "Valuation Report" of the "MIT 80 Money
Purchase Pension Plan" prepared by an independent pension
administration company. This report indicates that the plan had
accrued assets and vesting schedules attributable to years before
MIT 80 came into existence. Additionally, the report's
terminology speaks of the MIT 80 "Board of Directors" and
"Officers". These terms are consistent with the employer being a
corporation, not a partnership.
- 20 in order to carry on its business.6
Machise was not required to
pay the compensation fee until April 30, 1981, 4 months after MIT
80's obligation to furnish employees and independent contractors
had ceased.
Additionally, the employee leasing agreement allowed
Machise to defer payment of this fee for more than 10 years,
until December 31, 1991, if it paid a 10-percent per year late
charge on all deferred unpaid portions of the compensation fee.
Thus, Machise was not required to, and did not, make any
payment of the compensation fee to MIT 80 during 1980.
MIT 80,
under its cash method of accounting, accordingly reported a loss
of $2,247,552.
The loss consisted of the following:
Salaries and wages
Rent--independent contractors
Payroll taxes
Pension plan
Insurance
Professional fees
Total
6
$456,618
1,673,742
35,877
37,109
41,823
2,383
2,247,552
Fred explained that, with respect to the employee leasing
partnerships, all but 5 percent of the compensation fee
constituted interest paid by Machise. It purportedly owed such
interest because of the partnerships' advances of payroll costs
during their first-year operations. This interest component is
to be distinguished from the "late charges". The late charges
represent interest imposed as a result of Machise's election not
to pay compensation fees in years after completion of the
respective partnerships' obligations to supply workers.
- 21 Petitioner Crescenzo's Deduction of MIT 80 Partnership Loss
On his individual income tax return for 1980, Dr. Crescenzo
reported a Schedule E partnership loss from MIT 80 of $140,472,
representing his 6.25-percent share of the loss purportedly
incurred in 1980 by the MIT 80 partnership.
Respondent has
issued a statutory notice of deficiency to Dr. Crescenzo,
disallowing this claimed loss deduction.
Post-1980 Transactions of MIT 80
In 1981, Machise "advanced" $6,509 in cash to MIT 80.
80 then paid a net $2,109.97 in payroll taxes.
MIT
On its
partnership return for 1981, MIT 80, under its cash method of
accounting, reported a loss of $2,110, which is the net payroll
tax payment, rounded off.
In 1981, MIT 80's bank account, which
had been used as the payroll account during 1980, was closed.
MIT 80 billed Machise $2,587,110.96 as its compensation fee
on April 30, 1981, the scheduled payment date.
This amount
represented the actual payroll costs of $2,247,551.73 plus the
$2,109.97 net payroll tax paid in 1980, plus $337,449.26--which
represented the 15-percent "override" of the payroll costs
provided for in the employee leasing agreement.7
7
Machise did not
There are often minor differences between the amount of
cash paid into the payroll account during the years at issue, the
cash paid out as payroll costs, and the amount of such costs that
form the basis of Machise's compensation fee calculations. The
parties have not always explained these relatively minor
differences, and they are not relevant to our holdings herein.
- 22 pay this amount to MIT 80 in 1981, or in 1982, or in 1983.
It
instead deferred payment of the compensation fee, thus becoming
subject to the 10-percent annual "late charge".
On its books for
each of those years, Machise accrued and deducted for Federal
income tax purposes the late charges payable to MIT 80.
Throughout 1981 and 1982, investors in MIT 80 continued to
make monthly cash payments of interest and principal on their
notes to Intercoastal.
By the end of March 1983, Dr. Crescenzo
had made 32 payments on his note to Intercoastal in the total
amount of $63,432.
Of this amount, $26,727 was principal and
$36,705 was interest.8
Ingemi died early in 1983 and Bucci became owner of 100
percent of the stock of Intercoastal/Machise.
In the first few months of 1983, Dr. Crescenzo and the other
MIT 80 investors executed new notes, prepared by Fred, in favor
of Machise.
These notes served as substitutes for the partners'
original $2.4 million notes to Intercoastal, which were canceled.
Some of the new notes were in reduced amounts, reflecting
investors' intervening payments to Intercoastal.
Other notes
reflected increased amounts as a result of some investors'
increased obligations to BBPA, which had occasionally made
monthly payments to Intercoastal on behalf of those investors.
8
In the aggregate, all the investors in MIT 80 paid cash of
$755,142, of which $310,672 was principal and $444,470 was
interest.
- 23 On June 3, 1983, Machise drew a check in the amount of
$150,338 to MIT 80.
This was the amount by which the "advances"
from MIT 80 to Machise had exceeded the total weekly amounts paid
in 1980 by Machise, through the MIT 80 payroll account, to the
employees and independent contractors.
In a memorandum to one of
the partners, Bruce described this check as a nontaxable return
of an advance.
Bruce's memorandum stated that the $150,338 had
been distributed to the partners pro rata and used by them to
make partial payments on the interest due on their notes payable
to Machise.
Thus, the amount of Machise’s check circled back to
Machise.
On June 30, 1984, Fred prepared, and Machise issued to MIT
80, a demand note bearing no interest in the face amount of
$285,952.34.
This note was a partial payment of the 10-percent
late charge on the compensation fee due under the employee
leasing agreement.
pay the note.
Fred doubted that Machise had enough money to
It was Fred's intention, however, that the note
would be endorsed back to Machise in a circular movement and
never presented for payment in cash.
On the back of this note was typed:
Pay to the order of: Machise
Interstate Transportation Co.
[Machise]
MIT 80
The note also contains the following legend:
By this endorsement, MIT 80
- 24 distributed $285,952.34 to its
partners who used the proceeds to
pay the annual installments on
their notes payable to MIT
[Machise] (See schedules)
As a result of the endorsement on the $285,952.34 note, the
investors did not make any cash payments on their notes to
Machise in 1984.
Machise issued similar notes, similarly endorsed, in June
1985 and 1986, although in those years the notes were each in the
amount of $443,415.
Each year, the note was issued to MIT 80,
distributed to the partners, and then credited against their
liabilities to Intercoastal.
In 1986, an entity named Machise Personnel Co. (MPC)
purchased all of the financial assets of Machise (subject to any
related liabilities) that had been generated by the yearly
employee leasing agreements to which Machise was a party.
MPC
was a partnership consisting of Bucci, who had a 99.999-percent
interest, and Intercoastal, with a .001-percent interest.
MPC
was used to remove from the books of Machise the receivables and
several million dollars of liabilities to MIT 80 and its
successor partnerships.
This was done in order to satisfy
lenders and suppliers of Machise.
The MIT 80 investors' notes to
Machise were accordingly assigned to MPC.
On June 30, 1987, MPC, like Machise in prior years, issued
to MIT 80 a demand note, bearing no interest, in the face amount
- 25 of $443,415.
This note was a partial payment of the compensation
fee and 10-percent late charges due under the employee leasing
agreement.
Like earlier similar notes from Machise, this note
bore endorsements reflecting that it had been deemed distributed
to the MIT 80 partners and then credited to their obligations on
their notes to Intercoastal.
The following illustration depicts the purported
transactions and flows of funds to which MIT 80 was a party.
Purported Transactions--MIT 80
A.
B.
C.
Investment Phase
1.
Partners execute 10-percent notes aggregating $2.4
million to Intercoastal.
2.
Intercoastal draws checks aggregating $2.4 million to
investors.
3.
Investors endorse the checks to MIT 80 as capital
investment in MIT 80.
4.
Bookkeeping entries indicate the $2.4 million in
Intercoastal checks endorsed to Intercoastal, although
checks are neither endorsed nor otherwise enter banking
channels.
Payroll Phase
5.
During 1980, Machise makes weekly transfers totaling
$2,243,495.73 to MIT 80 payroll account.
6.
Employees and independent contractors are paid from the
amounts transferred to the MIT 80 payroll account with
checks signed by officers of Machise.
Repayment Phase
7.
In 1984, repayment begins. Repayments take the form of
Machise demand notes of $443,415 in compensation fees
and late charges issued to MIT 80. (Although the 1984
- 26 note was for $285,942, Machise had earlier "advanced"
$6,509 and issued a check for $150,338, for a total of
$442,789.) After 1986, the notes were issued by MPC.
8.
The demand notes (and the check for $150,338) are
deemed distributed to the MIT 80 partners.
9.
Endorsements reflect that the demand notes (and the
check for $150,338) are used to pay partners'
installments on their 10-percent notes to Machise,
which had replaced the notes to Intercoastal.
10.
MIT 80 employee leasing program terminated in 1988 with
MPC's assignment of partners' notes to MIT 80 for
credit against MPC's obligations to the partnership.
MCP remained indebted to the partnership for
$1,295,108, most of which was later claimed as bad debt
loss by MIT 80 partners, on transfer of MIT Personnel
Co. stock in 1992. See infra pp. 27-30.
Termination Agreement of MIT 80
Fred prepared a Termination Agreement dated January 1, 1988,
between MIT 80 and MPC with respect to the employee leasing
agreement.
Fred signed the Termination Agreement as vice
president of BBPA on behalf of both MIT 80 and MPC.
As stated in that agreement, MPC owed $2,401,416.25 to MIT
80, but it reduced that amount by $1,407,627 by assigning to MIT
80 the partners' notes to Machise (these notes were the
substitutes for the notes originally issued by the partners to
Intercoastal).
MIT 80 was then to distribute these notes to its partners.
No formal documents to effectuate the assignment of notes from
MPC to MIT 80 were prepared, nor were any such documents prepared
to carry out either the distribution of the notes to the partners
or the assignment of those notes by the partners to Machise.
- 27 Additionally, under the Termination Agreement, MIT 80
purportedly forgave MPC's unpaid late charges on the compensation
fee in exchange for MPC's promise to pay $301,318.95 as a
"Contract Renegotiation Fee".
The purportedly scheduled date of payment of the amounts due
under the agreement (including the "Contract Renegotiation fee")
was January 1, 1992.
This was 1 day past the date upon which the
partnership, according to the partnership agreement, was to
terminate.
Fred testified that there was an oral amendment of
the partnership agreement extending the life of the partnership.
However, the provisions of the partnership agreement relating to
amendments require that amendments be consented to in writing by
all of the partners within 20 days of the notice thereunder.
The Termination Agreement provided that, effective as of
January 1, 1988, MIT 80 would issue an invoice to MPC in the
amount of $301,318.95 for the Contract Renegotiation fee.
No
such invoice was issued.
In the agreement, MPC agreed to pay to MIT 80 a balance due
of $1,295,108.
This amount included the $301,318.95 that MPC had
agreed to pay in exchange for forgiveness of the late charges.
The MIT 80 partners' notes were accordingly marked "Paid 1-1-88".
The debt of $1,295,108 from MPC to MIT 80 remained outstanding
for several years, and was ultimately dealt with as shown infra
pp. 30-31.
- 28 The operation of the MIT 80 Termination Agreement may be
depicted as follows:
Owed by MPC to MIT 80 as unpaid
compensation fee
Owed by MPC to MIT 80 as Contract
Renegotiation fee
Credited by MPC to MIT 80 as assignment
of partners' notes to Machise
Amount still owed MIT 80 by MPC
$2,401,416
301,319
(1,407,627)
1,295,108
Partnership Income of MIT 80
In 1985 and 1986, MIT 80 reported net partnership taxable
income of $443,415, reflecting the receipt of the notes (bearing
no interest) from Machise, and treating them as the equivalent of
cash.
For the year 1987, MIT 80 changed its method of accounting
from the cash method to the accrual method.9
On its partnership
return for 1987, MIT 80 reported partnership taxable income of
$840,838, consisting of $667,997 (one-fourth of the $2,671,990
deferred income that it was allocating over 4 years due to the
change in accounting method), plus $241,590.43, shown as late fee
9
In a statement attached to the Form 3115 in which MIT 80
changed its method of accounting, BBPA explained that MIT 80 was
a "tax shelter as defined in Section 461(i)(3)". As such, it was
precluded from using the cash method after Dec. 31, 1986. BBPA
further indicated that MIT 80's "accrued but not received" income
was $2,671,990. Under the pertinent regulations, sec. 1.4481T(g)(2)(i), Temporary Income Tax Regs., 52 Fed. Reg. 22772 (June
16, 1987), it was required to take this amount into account
ratably over the next 4 years. If it ceased business before the
end of those 4 years, it was to take the entire balance into
account for its last taxable year. Sec. 1.448-1T(g)(3)(iii),
Temporary Income Tax Regs., 52 Fed. Reg. 22773 (June 16, 1987).
- 29 income, less a $68,750 management fee expense to BBPA.
On its
partnership return for 1988, MIT 80 reported partnership taxable
income of $969,315, consisting of $667,997 (one-fourth of the
$2,671,990 deferred income that it was allocating over 4 years
due to the change in accounting method), plus $301,319, the
"Contract Renegotiation fee", less a $1 fee expense to BBPA.
On its partnership return for 1989, MIT 80 reported
partnership taxable income of $1,335,995, which was the remaining
one-half of the $2,671,990 deferred income that it was allocating
due to the change in accounting method, and no expenses.
MIT 80 has pending claims in one of these consolidated cases
to adjust its reported income to zero for the years 1985, 1986,
1987, 1988, and 1989, if we should determine that MIT 80 is a
sham that is not entitled to deduct losses for its prior years.
Respondent agrees that, if we should so find, the requested
adjustments would be appropriate.
During 1990, Dr. Crescenzo transferred his 6.25-percent
interest in MIT 80 in approximately equal shares to Bruce, Bucci,
and Richard Adamucci.
Dr. Crescenzo received $63,300 for this
interest, or $132 less than he had invested in MIT 80.
MIT 80 had no activity in 1990 or in 1991, and its
partnership returns reflect no income or loss for those years.
The business of Machise was thereafter transferred to MIT
Transportation Co., Inc., which was wholly owned by Bucci.
On
- 30 January 1, 1992, Bucci, MPC, MIT 80, and BBPA executed an
agreement, prepared by Fred, whereby Bucci agreed to transfer 500
shares of his stock in MIT Transportation Co., Inc., to MPC.
The
agreement recited that MIT 80 agreed to accept the 500 shares
from MPC in full payment of the $1,295,108 due to it from MPC.
None of the parties to this transaction were represented by
counsel.
No one made a formal appraisal of the MIT Transportation Co.
stock.
Bruce nevertheless issued a memorandum to the MIT 80
partners explaining that since the value of the MIT Transportation stock was $250,000, MIT 80 could claim a bad debt deduction
for 1992 in the amount of $1,045,108 ($1,295,108 - $250,000).
The stock sale may be depicted as follows:
Amount owed MIT 80 by MPC from 1988 to (1992)
Claimed value of MIT Transportation Co.,
Inc. stock given to MPC, then to MIT 80
Amount BBPA advised MIT 80 partners to
claim as a loss in 1992
$1,295,108
(250,000)
1,045,108
The partners were allocated pro rata amounts of this
$1,045,108 loss in 1992.
None of the investors in MIT 80 received more from the
operation of the partnership than he had invested.
- 31 MIT 82
Formation of MIT 82
On January 1, 1982, Fred and Bruce organized and promoted
MIT 82, in the form of a general partnership.10
MIT 82's address was the same as BBPA's.
As with MIT 80,
MIT 82 used the
calendar year as its tax year and the cash method of accounting
from its inception through December 31, 1986.
BBPA made the
general journal entries for MIT 82 for the years 1982 through
1986 and adjusting journal entries for 1982 through 1987.
Like MIT 80 before it, MIT 82 entered into an employee
leasing agreement with Machise under which MIT 82 was to provide
all the individual employees and independent contractors required
by Machise for the period January 1 through December 31, 1982.
The arrangement was essentially the same as that of MIT 80, but
this time BBPA paid more attention to details.
The employee
leasing agreement again stated that the partnerships would
provide Machise with employees, independent contractors, and
equipment, plus biographical information about those workers.
It
also provided that the partnership would have the right to
control and direct the employees and that the partnership would
10
Fred had also organized MIT 81 to lease employees and
independent contractors to Machise for the period Jan. 1 through
Dec. 31, 1981. There are no cases before this Court involving
adjustments to the partnership returns of MIT 81 or to the tax
returns of the individual participants in MIT 81 with respect to
their interests in MIT 81.
- 32 "instruct each individual as to his work hours and nature of his
duties."
As to the contractors, the partnership again had "the
exclusive right to determine the contractor to be used" in
Machise's business.
MIT 82 and BBPA entered into a management agreement,
prepared by Fred and dated January 1, 1982, whereby BBPA would
manage MIT 82.
The management agreement provided that BBPA would
receive "such compensation as shall be mutually agreed upon by
the parties", but no less than $45,000 per year.
MIT 82 had several accounts at various banks.
One of these
accounts was a checking account at the Guarantee Bank, which was
the payroll account.
Pursuant to authorization of BBPA, Bucci
and Ingemi were authorized signatories on the MIT 82 account at
the Guarantee Bank.
Investors in MIT 82
Fred prepared the MIT 82 partnership agreement.
Petitioners
Barry and Nancy Bealor, James Cameron, and Frank Pettisani were
clients of BBPA who became investors and partners in MIT 82.
There were 23 other individuals and three partnerships, also
clients of BBPA, who were also investor partners in MIT 82.
Some of the prospective investors in MIT 82 received a four-page
document prepared by BBPA (or a later version of three pages).
These documents made projections of income, expenses, and cashflow for MIT 82 to the end of the partnership term.
- 33 Organization and Management of MIT 82
As the program was structured, the investors were required
to execute notes to Machise representing ten-elevenths of their
investment in MIT 82.
Pursuant thereto, the Bealors executed a
note to Machise on October 1, 1982, for $100,000; Cameron
executed a note to Machise on September 9, 1982, for $100,000;
and Pettisani executed a note to Machise on July 1, 1982, in
the amount of $200,000.
These notes bore interest at a rate of
10 percent per annum and were payable in level installments.
The
other partners executed similar notes; taken together, the
partners' notes to Machise totaled $3,075,000.
The first
installments on these notes were not due until July 1, 1983.
In 1982, in exchange for their notes to Machise, Machise
lent $3,075,000 to the investors in MIT 82.
This amount was
equal to ten-elevenths of MIT 82's capital.
Machise’s loans
lacked physical form; they did not exist as checks, notes, or
cash.
They were recorded only by journal entries on Machise’s
books.
These amounts were then deemed to be contributed to the
MIT 82 partnership with no supporting documentation other than
journal entries on the books of MIT 82 maintained by BBPA.
In addition to executing the notes, the investors were
required to pay, in the aggregate, $307,500 in cash to MIT 82 as
the other one-eleventh of their capital investment in MIT 82.
Some of the investors in MIT 82 paid their share of the required
- 34 cash in full in 1982.
Others paid part, or none at all.
Some of
the amounts not paid were eliminated by offsetting journal
entries, reflecting an apparent decision by BBPA not to attempt
to collect the unpaid amounts.
In order to obtain access to this cash, Bruce executed a
"line-of-credit" note, dated January 1, 1982, from BBPA to MIT
82, whereby BBPA could borrow up to $300,000 from MIT 82 at a 15percent interest rate.
If BBPA borrowed this amount, it would
owe $45,000 annually to MIT 82 as interest.
Fred intended that
this interest would be offset by the $45,000 management fee that
MIT 82 owed to BBPA.
During the time the line-of-credit note was
outstanding, the annual interest (owed to MIT 82) was $28,500, or
15 percent of the $190,000 borrowed by BBPA under the line-ofcredit note.
BBPA accordingly lowered its management fee to
$28,500, in order to offset exactly the interest owed by MIT 82.
On the same date, Machise executed a separate line-of-credit
note to BBPA, whereby it could borrow up to $180,000 of the
partners’ cash investment from BBPA, at 7-1/2-percent interest.
During 1982, some $190,00011 of the investors' cash passed from
MIT 80 to BBPA.
11
BBPA retained 40 percent of this amount, some
BBPA's note indicates that it borrowed $190,000 at the end
of 1982, although the books maintained for MIT 82 reflect that
only a total of $174,000 in cash was paid in during 1982. It was
deposited into an account controlled by BBPA. The record also
indicates, however, that some investors transferred other
investment instruments or accounts receivable in lieu of cash for
purposes of meeting their cash requirements. The $190,000 figure
thus may reflect that some of these noncash assets were advanced
to BBPA.
- 35 $76,000, and the remaining 60 percent, $114,000, went to Machise.
Machise's receipt of 60 percent of the cash put up by the
investors was one of its incentives to participate in the deal.
MIT 82 Employee Leasing Agreement
The employee leasing agreement of MIT 82 and Machise,
prepared by Fred, was dated as of January 1, 1982.
Like the MIT
80 employee leasing agreement, the MIT 82 agreement provided that
MIT 82 would furnish all the employees and independent
contractors needed by Machise to conduct its business for the
1982 calendar year.
It stated that Machise would provide the
partnership with estimates of the number of employees or
contractors Machise would need to carry on its business.
It
further stated that the partnership would provide Machise with
the employees, independent contractors, and equipment, plus
antecedent biographical information about the workers.
It again
provided that the partnership would have the right to control and
direct the employees and that the partnership would "instruct
each individual as to his work hours and nature of his duties."
As to the contractors, the partnership again retained "the
exclusive right to determine the contractor to be used" in
Machise's business.
Unlike the MIT 80 arrangement, the MIT 82 employee leasing
agreement specifically required MIT 82 to advance the lesser of
its invested capital or $3 million to Machise.
As of
December 31, 1982, the books of MIT 82 showed that it had
- 36 advanced $3,075,000 to Machise.
Fred explained that the parties
had orally agreed to increase the amount that the partners could
invest.
Other than journal entries, however, there are no
documents showing that this amount was ever paid.
Illustration No. 2, infra p. 42, depicts the purported
transactions and flows of funds of MIT 82.
Operation of MIT 82
The employees and independent contractors were the same
employees and independent contractors who provided their services
to Machise before the employee leasing agreement was made.
The
employees and independent contractors were not consulted about
the employee leasing agreement.
They did not submit formal
employment applications to MIT 82, nor did they explicitly
consent to the execution of the employee leasing agreement.
MIT
82 provided no work space or tools or equipment to the workers
after the execution of the leasing agreement.
In contrast to the situation of MIT 80, MIT 82,
Intercoastal, and Machise entered into a management contract
dated January 1, 1982.
This agreement, prepared by Fred,
provided that Intercoastal would manage Machise on behalf of
MIT 82 for the period January 1 to December 31, 1982.
The
compensation to be paid by MIT 82 was to be the amount of
Intercoastal's costs, plus a "supplemental management fee" to be
determined by Machise's board of directors.
Following the
execution of this agreement, Bucci and Ingemi still directed and
- 37 controlled the employees.
In contrast to the situation of MIT 80, the employee leasing
agreement specifically required Machise to make advances of cash
to MIT 82.
These cash advances were to be equal to the actual
costs of meeting the Machise payroll.
During 1982, Machise made
these advances by transferring $2,550,150 into the MIT 82 payroll
account so that MIT 82 could cover the payroll costs.
These weekly cash advances took place by means of a transfer
from a Machise bank account to the MIT 82 Guarantee Bank payroll
account.
The employees and independent contractors were paid
from this account with MIT 82 checks signed by either Bucci or
Ingemi.12
Payroll taxes were withheld from employees' wages and
remitted to the appropriate State and Federal agencies under MIT
82's employer identification number.
The name MIT 82 appeared on
New Jersey unemployment compensation documents.
MIT 82 also
appeared as the employer on the employment tax returns that were
12
Although not spelled out in the MIT 82 employee leasing
agreement, Fred testified that the payroll procedure was to be
like that in MIT 80, whereby Machise would advance enough money
to cover its payroll in the first 6 months. After July 1, 1982,
when the partners' money came in, MIT 82 would pay over enough
for the entire year's payroll. The resulting difference between
the $3,075,000 allegedly advanced by MIT 82 to Machise and the
$2,550,150 advanced to MIT 82 by Machise resulted in an asset
called "Due from MIT 82-Advanced" in the amount of $524,850.
(This amount was later increased, probably reflecting the
difference between the amounts transferred to the payroll account
and the amount paid from this account.) In subsequent years,
Machise applied alleged payments of compensation fees toward
these advances.
- 38 filed.
MIT 82 paid $1,947,852 to employees and independent
contractors and taxing authorities.
Some $51,908 was paid or
accrued for workmen's compensation, health, and group life
insurance premiums.
MIT 82 paid an additional $461,092 for
professional and management fees and $106 for bank charges.
Of
this amount, some $460,000 constituted fees paid to Intercoastal
for the management of Machise.
MIT 82 also accrued a pension
contribution expense of $43,907.13
The total was $2,504,865.
As with MIT 80, the employee leasing agreement required
Machise to pay to MIT 82 a "compensation fee" of 115 percent of
the payroll costs paid by MIT 82, plus 115 percent of the amount
MIT 82 paid to Intercoastal for management services.
Under the
employee leasing agreement, no part of this compensation fee was
due and payable until June 30, 1983, 6 months after MIT 82's
obligation to furnish employees and independent contractors had
ceased.
Machise could also defer payment of the compensation fee
for more than 10 years, until July 1, 1993, if it paid a 10percent per year late charge from June 30, 1983, on all deferred
13
The exhibits include a "Valuation Report" of the "M.I.T.
82 Money Purchase Pension Plan" prepared by an independent
pension-administration company. This report contains, as an
attachment, a Form 5500-R "Registration Statement of Employee
Benefit Plan". That form indicates that the plan sponsor was MIT
Personnel Co. and that the plan was instituted on Dec. 31, 1973.
The form, which bears the date 1982, also indicates that the plan
was not "terminated during this plan year or any prior plan
year." As with the other partnerships, MIT 82 was a party
apparently only by virtue of a "participation agreement" with the
MIT Personnel Co. plan. See supra note 5.
- 39 unpaid portions of the compensation fee.
Thus, Machise was not required to, and did not, make any
payment of the "compensation fee" to MIT 82 during 1982.
MIT 82,
under its cash method of accounting, accordingly reported a net
loss of $2,488,164.
This loss was the excess of the $2,504,865
payroll costs and other expenses over reported partnership
interest income of $16,701.
Individual Petitioners' Deductions of Partnership Loss
On their individual income tax return for 1982, the Bealors
reported a loss of $80,915, representing their 3.252-percent
share of MIT 82's partnership loss.
James Cameron reported the
same amount as his 3.252-percent share of those losses in his
1982 Federal income tax return.
Frank Pettisani, in his 1983
return, reported a Schedule E loss of $161,830, representing his
6.504-percent share of MIT 82 losses.
The other investors in MIT
82 also reported Schedule E partnership losses from MIT 82, in
proportion to their interests.
Respondent issued statutory notices of deficiency to the
named investors and the other investors, disallowing the claimed
MIT 82 losses for 1982.
Intercoastal's Deduction of Compensation Fee
For the 6-month period January 1, 1982, to the end of its
fiscal year on June 30, 1982, Machise/Intercoastal accrued and
deducted, as "rents" for Federal income tax purposes, $1,389,950
with respect to payroll costs.
For the next 6-month period of
- 40 the following fiscal year--July 1 to December 31, 1982-Machise/Intercoastal accrued, and deducted as rents, another
$1,490,645.
For the combined 12-month period, these amounts
totaled $2,880,595, or 115 percent of the payroll costs allegedly
paid by MIT 82.
Respondent issued a statutory notice of deficiency to
Intercoastal disallowing Intercoastal's claimed deduction, for
the fiscal years ended June 30, 1982 and 1983, of those parts of
its "rents" expense that represent 15 percent of the compensation
fee under the employee leasing agreement, for the management fee
expense, and for the interest expense.
Post-1982 Transactions of MIT 82
On July 1, 1983, some 6 months after MIT 82's obligation to
provide Machise with employees and independent contractors had
ended, MIT 82 billed Machise for 115 percent of the payroll
costs, as the compensation fee pursuant to the employee leasing
agreement.
Under the employee leasing agreement, Machise was not
required to pay this amount until July 1, 1993, if it paid the
10-percent annual late charges.
MIT 82 closed its bank accounts in 1983.
The journal
entries for 1983 indicate that Machise issued to MIT 82 a check
for $473,458, which was circled from MIT 82 through the partners
and back to Machise, without being deposited.
of any such check appears in the record.
However, no copy
All of MIT 82’s
subsequent years’ financial operations were effected through
- 41 noncash transactions, made by issuing, endorsing, or canceling
notes, and recorded only by journal entries.
These were
Machise's payments, in 1984, 1985, and 1986, of $473,458 as
deferred payments of the compensation fee, plus interest (the 10percent late charge).
The payments took the form of demand notes
executed by Machise.
These payments were recorded as passing
through MIT 82, as compensation fee income or as a return of
advances under the employee leasing agreement.
exited as capital distributions to the partners.
The payments
The payments,
which took the form only of endorsements to the Machise demand
notes, then passed from the partners as payments on their notes
to Machise, which reported them as income.
For the year 1987, MPC, which had succeeded to the interests
of Machise, assumed the responsibility of making its payments.
The books of MIT 82 reflect that, in 1987, MPC transferred
$473,458 to MIT 82.
The Pettisanis' Deductions of Interest Payments
Each year, Fred treated as deductible interest some part of
the $473,458 amount that was applied against the partners' note
obligations to Machise.
The partners in MIT 82, following
instructions from BBPA, accordingly filed individual income tax
returns (Forms 1040) on which they claimed their pro rata shares
of the resulting deductions.
Frank and Lucille Pettisani claimed Schedule E interest
deductions of $20,000, $18,921, $17,733, $16,427, and $21,697 on
- 42 Frank Pettisani's note obligations incurred to finance his
participation in MIT 82 for the years 1983 through 1987,
respectively.
Respondent has disallowed these deductions.
MIT 82 journal entries indicate that, on December 31, 1987,
MIT 82 distributed its $190,000 line-of-credit note from BBPA to
the partners, who in turn endorsed it to MPC for credit against
their notes, originally made to Machise.
The following illustration depicts the purported
transactions and flows of funds to which MIT 82 was a party.
Purported Transactions--MIT 82
A.
B.
Investment Phase
1.
Partners issue $3,075,000 in 10-percent notes to Machise,
representing ten-elevenths of MIT 82's capital.
2.
Machise lends $3,075,000 to investors in MIT 82,
represented only by journal entries.
3.
The MIT 82 partners advance $3,075,000 to MIT 82,
represented by their subscription agreements.
4.
Pursuant to the employee leasing agreement, MIT 82
advances $3,075,000 to Machise, represented only by
journal entries.
5.
In addition to long-term notes, during 1982 partners
invest cash of $174,000 plus other assets.
6.
During 1982, BBPA takes $190,000 from the partners'
cash investment account pursuant to a line-of-credit
note with MIT 82.
7.
During 1982, BBPA advances $114,000 of this cash to
Machise.
Payroll Phase
8.
During 1982, Machise makes weekly transfers totaling
- 43 $2,550,150 to MIT 82 payroll account.
9.
C.
Employees and independent contractors are paid
$2,504,865 from the amounts transferred to the MIT 82
payroll account on a weekly basis with checks signed by
officers of Machise.
Repayment Phase.
10.
In 1983, annual repayment begins with an alleged
Machise check and then its demand notes to MIT 82 of
$473,458 in compensation fees and late charges. After
1986, the repayment is made by MPC.
11.
The demand notes are deemed to pass through the MIT 82
partners. Also on December 31, 1987, MIT 82
distributes the $190,000 line-of-credit note from BBPA
to its partners.
12.
The demand notes, and the BBPA line-of-credit note, are
used to pay partners' installments on their 10-percent
notes to Machise.
Termination Agreement of MIT 82
On January 1, 1988, Fred drafted a Termination Agreement to
end the obligations of MIT 82 and MPC under the employee leasing
agreement.
As recited in the agreement, MPC owed $2,307,059 to
MIT 82, and it offered to pay $1,974,901 by means of a 10-percent
note to MIT 82.
MIT 82 accepted the offer as full payment and
agreed to terminate the employee leasing agreement.
Under the
termination agreement, MIT 82 gave up rights to collect the
difference, some $332,158, from MPC.
The Termination Agreement required MIT 82 to distribute
MPC's note for $1,974,901, executed pursuant to the Termination
Agreement, to its partners.
Under the Termination Agreement, the
partners were to direct MIT 82 to assign that note in payment of
amounts they owed MPC on their notes originally payable to
- 44 Machise but subsequently assigned to MPC.
There is no evidence
that MPC issued any note for $1,974,901.
A summary of the effect
of the MIT 82 Termination Agreement shows the following:
Owed by MPC to MIT 82 as unpaid
compensation fee
Accepted by MIT 80 in full satisfaction of
amounts owed by MPC; this amount to be
used to offset Partners' notes to Machise
Amount forgone by MIT 82 in unpaid
compensation fees
$2,307,059
(1,974,901)
332,158
Fred designed the Termination Agreement so that everything
would "zero out".
He signed it under the heading "Bryen & Bryen,
P.A." on behalf of both MIT 82 and MPC.
Fred explained "the
whole reason they [the MIT 82 partners] did it is to get rid of
the risk.
They owed $2 million and if Machise [sic, read "MPC"]
did not pay the compensation fee, these partners would be after
me with guns."
Partnership Income of MIT 82
For the year 1986, MIT 82 reported partnership taxable
income of $428,142.
This amount included the $473,458 payment,
in the form of a Machise demand note, of compensation fee income,
plus interest from BBPA of $30,669, less $75,985 in accounting
fees and management expenses to BBPA.
For the year 1987, MIT 82, like MIT 80, changed its method
of accounting from the cash method to the accrual method,
reflecting the new requirements of the Tax Reform Act of 1986.
MIT 82 accordingly reported partnership taxable income of
$840,069 for 1987.
This consisted of $637,316, one-fourth of the
- 45 $2,549,264 deferred income that it was allocating over 4 years,
plus $231,253 in accrued interest payable from MPC, less
$28,500--a management fee expense to BBPA.
On its partnership return for 1988, MIT 82 reported
partnership taxable income of $275,156.
This amount consisted of
$637,316, again one-fourth of the $2,549,264 deferred income that
MIT 82 was allocating over 4 years, less $332,159--the amount,
rounded off, that MIT 82 had agreed to forgo in exchange for
early payment to terminate the employee leasing agreement--less
professional fees of $30,001.
On its partnership return for 1989, MIT 82 reported gross
income of $1,274,633.
This was the remaining one-half of the
$2,549,264 deferred income that MIT 82 allocated over 4 years due
to the change in accounting method.
MIT 82 reported no expenses.
MIT 82 thus reported substantial amounts of income for the
years 1986, 1987, 1988, and 1989.
In two of these consolidated
cases (docket Nos. 14819-91 and 3456-92) MIT 82 has claims
pending that the amounts of income it reported for those years
should be reduced to zero if we determine that MIT 82 is a sham
that is not entitled to deduct losses for its prior years.
Respondent agrees that, if we should so determine, the requested
adjustments would be appropriate.
None of the investors in MIT 82 ever received any cash
return from his investment.
- 46 MIT 83
The organization and operation of MIT 83 resembled those of
MIT 82.
However, the program was further complicated by the
addition of other entities.
On January 1, 1983, Fred and Bruce organized and promoted
MIT 83 as a general partnership.
Like MIT 80 and MIT 82, MIT 83
used the calendar year as its tax year and the cash method of
accounting from its inception until December 31, 1986.
As with
MIT 80 and MIT 82, its address was the same as BBPA's.
BBPA made
the journal entries of MIT 83 for 1983 and 1984 and its adjusting
journal entries for 1984, 1985, 1987, and 1988.
As with MIT 80 and MIT 82, MIT 83 had a bank account at the
Guarantee Bank, which was the payroll account.
Pursuant to
authorization by BBPA, Bucci was an authorized signatory on the
MIT 83 account.
MIT 83 Investors
Fred prepared the MIT 83 partnership agreement.
25 partners, 23 individuals and 2 partnerships.
There were
Some of the
prospective investors in MIT 83 received a three-page document
prepared by BBPA.
It set forth projections of financial income,
expense, and cash-flow to the end of the partnership term.
Organization and Management of MIT 83
A corporation named Qulart, Inc. (Qulart), had been formed
on December 4, 1979, with Bruce as its sole shareholder.
Qulart
used a fiscal year ending June 30 as its tax year and employed
- 47 the accrual method of accounting.
Qulart was inactive through
its fiscal year ending June 30, 1983.
On July 1, 1983, Bruce
transferred all of the stock of Qulart to Marion Hunt, the third
owner-employee of BBPA.
BBPA.
Qulart had the same business address as
Qulart did not, however, have a bank account, nor did it
prepare financial statements for credit purposes.
Fred intended Qulart to be a conduit between Machise and the
MIT 83 partners.
As with MIT 82 and MIT 80, Machise was the
funding source of the noncash portion of the partners'
investments, but the loans from Machise to the partners and their
notes to Machise in return were both to pass through Qulart.
Qulart's borrowings and lendings, like its reported income and
expenses for tax purposes, were a wash.
During the years in issue, the stated purpose of Qulart was
to prevent Machise from assigning to third parties the investors'
notes used to finance the employee leasing operations.
Other
than the change made by inserting Qulart, the funding of MIT 83
was the same as that of MIT 82.
Thus, the plan was that MIT 83
would advance ten-elevenths of its capital to Machise.
Accordingly, 23 of the MIT 83 partners executed notes to
Qulart, dated July 1, 1983, in amounts aggregating $2,623,666.
The notes required annual payments of interest only, at a rate of
12 percent per annum, and did not provide for repayment of the
principal until July 1, 1994, 11 years after their dates of
execution.
Fred and Bruce were partners in MIT 83 and executed
- 48 similar notes totaling, in the aggregate, $265,000.
Fred's and
Bruce's notes, however, were made out to Machise, and not to
Qulart, apparently because of an error.
The total of the
investor notes was therefore $2,888,666, an amount equal to tenelevenths of MIT 83's capital.
On July 1, 1983, Qulart issued to Machise a 12-percent
promissory note in the amount of $2,888,666, whose provisions
tracked the provisions of the partners' notes to Qulart.
Machise then lent $2,888,666 to Qulart by means of a demand
note, providing for no interest.
Qulart then lent $2,888,666 to
the 25 investors in MIT 83, including Fred and Bruce.
Instead of
taking the proceeds from Qulart, however, the MIT 83 partners
purportedly directed Qulart to provide directly to MIT 83 the
$2,888,666 that the partners had borrowed from Qulart.
Qulart
therefore endorsed to MIT 83 the $2,888,666 demand note that
Qulart had received from Machise.
In addition to their notes, the investors were required to
put up, in the aggregate, $288,866 in cash as the other oneeleventh of their capital investment in MIT 83.
Seventeen of the
25 investors in MIT 83 paid their share of the required cash in
full in 1983, in the amount of $118,868, plus $13,902 in
interest.
BBPA issued a note receivable to MIT 83 representing payment
in respect of the cash required of the other eight investors in
MIT 83, who issued short-term promissory notes to MIT 83.
The
- 49 notes, aggregating $170,000, were dated January 1, 1983.
were payable January 1, 1984.
They
Some of the investors paid these
notes with cash, while others paid by means of offsets.
Some
portions of these notes remain unpaid.
As with MIT 82, Bruce executed a "line-of-credit" note,
dated January 1, 1983, from BBPA to MIT 83, whereby BBPA could
borrow up to $300,000 in investor cash from MIT 83 at a 15percent interest rate.
Of the investors' cash paid in, BBPA
retained $46,500, a draw on the line-of-credit note.
Pursuant to
the line-of-credit note, MIT 83 also endorsed, or otherwise
transferred to BBPA, the $170,000 in short-term partner notes.
Machise executed a second line-of-credit note to BBPA, also
dated January 1, 1983, whereby Machise could borrow up to
$180,000 of the investors' cash from BBPA.
Some $69,800 in
investor cash was originally disbursed to Machise.
Machise
became obligated to BBPA in this amount.
As a result, MIT 83 had a corresponding "receivable" account
from BBPA for $284,300, represented by its line-of-credit note
from BBPA.14
14
Another $13,669 of investors' cash went to BBPA as
This amount consisted of the $46,500 of investor cash BBPA
retained, plus the $69,800 given to Machise, plus $168,000 in
short-term investor notes owed by BBPA in lieu of the unpaid cash
required of the eight investors. The difference between the
$170,000 figure for the short-term notes and $168,000 reflects a
correction with respect to deposits. The cash paid out exceeds
the amounts of cash stipulated as having been paid in during
1983. The difference of $2,559 is not explained; it may have
come from interest payments or from additional payments on the
(continued...)
- 50 professional fees, and $5,330 went to BBPA as an "exchange
account".
MIT 83 Employee Leasing Agreement
As with MIT 80 and MIT 82, MIT 83 and Machise entered into
an employee leasing agreement, dated January 1, 1983.
Therein
MIT 83 agreed to provide all the individual employees and
independent contractors required by Machise to conduct its
business for the period January 1 through December 31, 1983.
Like the prior agreements, the MIT 83 agreement stated that
Machise would provide the partnerships with estimates of the
number of employees or contractors it would need to carry on its
business.
It further stated that the partnerships would provide
Machise with employees, independent contractors, and equipment,
plus biographical information about those workers.
It again
provided that the partnership would have the right to control and
direct the employees and that the partnership would "instruct
each individual as to his work hours and nature of his duties."
As to the contractors, the partnership again had "the exclusive
right to determine the contractor to be used" in Machise's
business.
The employee leasing agreement specifically required MIT 83
to advance ten-elevenths of its invested capital--or $2,888,666-to Machise.
MIT 83 accomplished this advance by endorsing to
(...continued)
partners' short-term obligations.
- 51 Machise the $2,888,666 non-interest-bearing demand note
originally made by Machise in favor of Qulart (which Qulart, at
the MIT 83 partners' behest, had endorsed to MIT 83).
Because
Machise received back its own note, that note was retired.
Operation of MIT 83
Another new entity, a partnership named MIT Associates
(MITA), was formed on January 1, 1983, with Bucci and
Intercoastal as its two partners.
Bucci had a 99-percent
interest in MITA, and Intercoastal had the 1-percent interest.
MITA employed the calendar year as its tax year and used the cash
method of accounting.
The address of MITA was the same as that
of Machise--500 North Egg Harbor Road, Hammonton, New Jersey.
Ingemi's widow had instituted a lawsuit against Bucci and his
companies, and MITA was formed to prevent that litigation from
affecting the MIT partnerships.
MIT 83, MITA, and Machise entered into a management
agreement dated January 1, 1983.
This agreement, prepared by
Fred, provided that MITA would manage Machise on behalf of MIT 83
for the period January 1 through December 31, 1983, for a "fee to
be determined by mutual agreement".
After execution of the
management agreement, Bucci still controlled and directed the
employees and independent contractors.
The employees and independent contractors were the same
employees and independent contractors who had provided their
services to Machise prior to the MIT 83 employee leasing
- 52 agreement.
They did not receive written notice of termination
either by Machise or by MIT 82.
They did not submit formal
employment applications to MIT 83.
The employee leasing agreement required Machise to make
advances of cash to MIT 83.
These cash advances were equal to
the actual costs of meeting the Machise payroll.
During 1983,
Machise advanced $3,061,723 to MIT 83 to cover the payroll
costs.15
These weekly cash advances were transferred from a Machise
bank account to the MIT 83 Guarantee Bank payroll account.
The
employees and independent contractors were paid by checks drawn
on this account and signed by Bucci.
Payroll taxes were withheld from employees' wages and
remitted to the appropriate State and Federal agencies under MIT
83's employer identification number.
MIT 83 appeared as the
employer on the employment tax returns that were filed.
On February 26, 1983, the New Jersey Department of Labor
wrote to "William Bryen and Bruce Bryen, t/a MIT 83".
The letter
stated that "our records indicated that you were not registered
under the New Jersey Unemployment Compensation Law".
Machise,
not MIT 83, was listed as the insured on the Standard Workmen's
Compensation and Employer's Liability Insurance policy for the
15
Machise ultimately advanced $189,908.85 more to MIT 83
than MIT 83 had advanced, as ten-elevenths of its capital, to
Machise. Therefore, Fred prepared a demand note without interest
in order to pay off the unpaid balance of this excess.
- 53 period July 1, 1983, through July 1, 1984.
Additionally, in
1983, Bucci, as president of "MIT" (which we are calling
"Machise") verified the employment of one of its drivers to a
mortgage company.
MIT 83 was, however, listed as the employer on
workmen's compensation claim forms.
Machise's controller did not
remove Machise from the workmen's compensation policy; he just
added the name of the new lessor partnerships to the policy.
He
did not, however, remove the previous partnership names for
several years, “just to be sure”.
MIT 83 paid $2,528,416 to employees and independent
contractors and taxing authorities.
It paid out additional
professional and bank fees, pension expenses and workmen's
compensation, health, and group life insurance premiums.
In
addition, on December 22, 1983, MIT 83 issued a check to MITA, in
the amount of $363,000, as the total management fee due under the
management contract.16
The total paid by MIT 83 during 1983 was
$3,080,528.
Under its cash method of accounting, MIT 83 claimed a net
loss of $3,066,626, which was the excess of the $3,080,528
16
The check was drawn on the Guaranty Bank account and
signed by Bucci. The amount was recommended by Fred. The
balance in the MIT 83 account when this check was written was
$86,327.79. Fred intended this check to circle back into the MIT
83 account. On the day this check was issued, MITA endorsed it
to Machise as payment of an alleged guaranty fee and the advance
by Bucci to Machise to reduce his account. Machise endorsed the
check back to MIT 83 as part of the advances required under the
employee leasing agreement. On the day the check was drawn, it
was deposited into the account upon which it was drawn. The
check, in effect, funded itself.
- 54 payroll costs over reported partnership income of $13,902.
The
reported partnership income was interest income that came from
BBPA.
The interest was based upon BBPA's borrowing of the
investors' cash on the line-of-credit note.
This income was
offset by a claimed deductible payment to BBPA of professional
fees of $14,366.
Tax Deductions
On their individual income tax return for 1983, the 25
participants in MIT 83 reported Schedule E partnership losses
from MIT 83 in proportion to their interests in the partnership.
Respondent issued a notice of final partnership
administrative adjustment to MIT 83, in which respondent
disallowed the entire claimed MIT 83 partnership loss of
$3,066,626 for the year 1983.
For the period January 1 through June 30, 1983, Machise
accrued and deducted, for Federal income tax purposes, "rents" of
$1,468,830.
For the period July 1 through December 31, 1983,
Machise/Intercoastal accrued, and deducted for Federal income tax
purposes, "rents" of $2,061,962.
For the two periods, these
amounts totaled $3,530,792, which is 115 percent of the
$3,070,25317 paid by MIT 83 for payroll and independent
contractor costs.
17
There is a relatively minor difference between the preoverride amount that Machise used as a basis for computing its
“rents” for the two 6-month periods in question and the amount
claimed as a loss by MIT 83. The difference reflects an amount
spent by MIT 83 in 1984.
- 55 Respondent has issued statutory notices of deficiency to
Intercoastal for its fiscal years ended June 30, 1983 and 1984.
In those deficiency notices, respondent has disallowed the
deduction of the portions of the "rents" paid to MIT 83 that
represent 15 percent of the compensation fee under the employee
leasing agreement, the management fee expense, and the interest
expense attributable to Machise's accrued late fees.
Other Developments
William Crescenzo, a nephew of Dr. Crescenzo, a petitioner
in docket No. 27614-90, had been hired as the controller of
Machise during 1982.
Machise.
He considered himself an employee of
He knew, however, that there were companies, which he
called "payrolls", whose name appeared on paychecks.
He was
unaware of the existence of Qulart, and of the fact that large
amounts of money were being lent at zero percent interest.
He
did not understand the purpose of checks coming in and going back
to the maker, but at Bucci's direction, he followed written
instruction from BBPA.
Frank Peretti succeeded Ingemi as Machise's operations
manager after Ingemi's death and later became the company
controller.
Peretti understood that the various partnerships
were his employers, because "every year our payroll company
changed."
Ingemi had explained to Peretti that the details were
complicated, and that Ingemi did not fully understand them
himself, but to trust him and "you still have a job."
Among
- 56 Peretti's responsibilities were changing truck leases and
insurance forms to reflect the name of the new employers.
Post-1983 Transactions of MIT 83
MIT 83 closed its bank accounts early in 1984.
Machise owed MIT 83 a compensation fee of 115 percent of the
payroll costs.
However, under the terms of the employee leasing
agreement, this payment could be deferred until July 1, 1994, for
a 10-percent-per-year late charge.
The MIT 83 agreement differed
from the MIT 82 agreement in a minor respect:
Machise had no
obligation to make any payment whatsoever to MIT 82 for 10 years;
however, Machise was obligated to pay interest annually to MIT 83
on the unpaid compensation fee.
On July 1, 1984, MIT 83 billed Machise for 115 percent of
the payroll costs.
In 1984, 1985, and 1986, Machise made annual
payments of $519,960 as deferred payment of the compensation fee
plus interest (the 10-percent late charge).
the payments were made by MPC.
transactions.
After July 1, 1986,
No cash changed hands in these
All the payments consisted of the issuance of non-
interest-bearing notes by Machise, and were recorded by journal
entries.
The purported payments were recorded as passing through
MIT 83, coming in as compensation fee income, and exiting as
capital distributions to its partners.
The payments to MIT 83 then passed through the partners,
going from them as payments on their notes to Qulart.
The
payments then passed from Qulart to Machise as payment on
- 57 Qulart's 12-percent note to Machise.
For the year 1987, MIT 83, like the other partnerships,
changed its method of accounting from the cash method to the
accrual method.
At the end of 1987, the cash paid and short-term notes
issued by the partners in 1983 were still reflected by BBPA's
line-of-credit note for $284,300 in favor of MIT 83.
On
December 31, 1987, Fred applied this note as a deemed
distribution to the partners and the further use by them as
partial payment of their notes to Qulart.
The following illustration depicts the purported
transactions and flows of funds to which MIT 83 was a party.
Investment Program--MIT 83
A.
Investment Phase
1.
Partners issue 12-percent notes to Qulart in the amount
of $2,888,666, representing ten elevenths of MIT 83's
capital. (Fred and Bruce themselves execute $265,000
of such notes by mistake to Machise).
2.
Qulart issues a 12-percent note to Machise for
$2,888,666.
3.
Machise issues a zero-percent demand note to Qulart for
$2,888,666.
4.
Qulart endorses the $2,888,666 note directly to MIT 83,
allegedly at partners' request.
5.
By virtue of the endorsement in No. 4, above, the
partners are deemed to have invested $2,888,666 in the
capital of MIT 83.
6.
Pursuant to the employee leasing agreement, MIT 83
advances $2,888,666 to Machise by endorsing the zeropercent demand note to Machise.
- 58 -
B.
D.
7.
In addition to long-term notes, during 1982, partners
invest cash of $118,868, and pay $13,902 interest, plus
$168,000 in short-term notes.
8.
BBPA retains $46,500 from the partner cash account
pursuant to a line-of-credit note with MIT 83, plus
$13,699 as professional fees and $5,330 as an "exchange
account".
9.
Machise receives $69,800 of partner cash for which it
becomes obligated to BBPA under its line-of-credit
note.
10.
BBPA becomes obligated to MIT 83 for "receivable"
account of $284,300.
Payroll Phase
11.
During 1983, Machise makes weekly transfers totaling
$3,061,723 to the MIT 83 payroll account.
12.
Employees and independent contractors are paid by MIT
83 from the amounts transferred to the MIT 83 payroll
account by Machise.
Repayment Phase
13.
In 1984, repayment begins with Machise notes of
$519,960 to MIT 83 as compensation fee and late
charges.
14.
Notes for $519,960 pass through MIT 83 to its partners.
15.
Partners transfer the notes for $519,960 to Qulart as
payments on the partners' 12-percent notes. At the end
of 1987, the BBPA line-of-credit note with a balance of
$284,300 is also assigned to Qulart to be applied as
payment on the MIT 83 partners' notes to Qulart.
16.
The notes for $519,960 then exit to Machise as payments
on Qulart's 12-percent note to Machise.
- 59 Termination Agreement of MIT 83
On January 1, 1988, Fred prepared a handwritten Termination
Agreement to terminate the obligations of MIT 83 and MPC under
the employee leasing agreement.
The Termination Agreement stated
that MPC owed $2,148,764 to MIT 83 under the leasing agreement
(the $2,148,764 amount is an error; the amount that should have
appeared in the Termination Agreement was $2,135,260), and that
MPC offered to pay $1,899,633.
MPC proposed to do so by
transferring to MIT 83 the note made by Qulart on July 1, 1983,
in favor of Machise in the amount of $2,888,666.
The balance on
the note as of January 1, 1988, was $1,899,633.
MIT 83 accepted
the offer as full payment and agreed to terminate the agreement.
It thus agreed to forego, as a “Contact Renegotiation Fee”, some
$231,253.
No formal assignment of the note was ever made.
Under the Termination Agreement, MIT 83 was required to
distribute the note to its partners, who in turn were to direct
MIT 83 to assign the note to Qulart in payment of amounts they
owed Qulart on their investor notes.
No formal distribution of
this note was ever made.
Fred signed the Termination Agreement under the heading
"Bryen & Bryen, P.A." on behalf of both MIT 83 and MPC.
Fred
caused MPC to enter into the Termination Agreement with MIT 83
in 1988 in order to remove from its books the "huge note
liabilities"--presumably the accrued and unpaid compensation fee.
Fred caused the partners of MIT 83 to enter into the termination
- 60 agreement with MPC so as to avoid the risk of being required to
pay their notes without MPC paying the partners themselves.
Fred
intended that all the parties to the MIT 83 employee leasing
transactions would be "zeroed out" (with no further liabilities)
following the purported termination.
In addition, Fred never
considered having Bucci obtain any legal representation or
independent advice other than Fred himself concerning the alleged
termination.
MIT 83 Income
On its partnership returns for 1985 and 1986, MIT 83
reported partnership taxable income of $519,960.
On its
partnership return for 1987, MIT 83 reported partnership taxable
income of $797,976.
This amount included one-fourth of the
$2,437,470 deferred income that MIT 83 allocated over 4 years due
to the change in accounting method imposed by section 448.
this amount was added “fee income” of $231,253.
To
This fee income
included accrued interest payable from MPC and an item of
“portfolio income” in the amount of $42,645.
The partnership’s
taxable income further reflects a deduction of management fees
payable to BBPA in the amount of $42,645--the same amount as the
“portfolio income”.
On its partnership return for 1988, MIT 83 reported
partnership taxable income of $360,236; this amount included onefourth of the $2,437,470 deferred income that it allocated over 4
years due to the change in accounting method, less $235,627,
- 61 which was the "Contract Renegotiation Fee" and other expenses.
On its partnership return for 1989, MIT 83 reported partnership
taxable income of $1,218,735, which was the remaining one-half of
the $2,437,470 deferred income that it had allocated due to the
change in accounting method.
For the years 1986, 1987, 1988, and 1989, MIT 83 has filed
administrative adjustment requests to reduce its reported taxable
income to zero if we determine that MIT 83 is a sham that is not
entitled to deduct losses for the prior years.
These requests
are pending in two of these consolidated cases, docket Nos.
14820-91 and 3551-92.
Respondent has agreed that, if we so
determine, the requested adjustments would be appropriate.
None of the investors in MIT 83 received any cash return on
his or her investment.
MIT 84
On January 1, 1984, Fred and Bruce organized and promoted
MIT 84 as a general partnership.
In almost all particulars, the
organization and operation of MIT 84 were the same as those of
MIT 83.
BBPA made the general ledger entries of MIT 84 for 1984,
and its adjusting journal entries for 1984, 1985, 1987, and 1988.
The 18 individuals and 3 partnerships who participated in
MIT 84 were clients of BBPA.
There were no prospectuses or
offering memoranda or terms sheets for MIT 84.
Like the previous partnerships, MIT 84 agreed to provide all
the individual employees and independent contractors required by
- 62 Machise to conduct business for the period January 1 through
December 31, 1984.
Machise and the partnership assumed duties
similar to those set forth in the earlier partnership agreements.
The employees and independent contractors were the same
employees and independent contractors who had provided their
services to Machise before the MIT 84 employee leasing agreement
was made.
Bucci continued to direct and control the employees.
He determined the amount of wages to be paid, did the hiring and
firing, took any necessary disciplinary action, and set the hours
to be worked.
New independent contractor agreements were made containing
the name "MIT 84" as one of the parties and signed by Fred Bryen
as "partner" of MIT 84.
These agreements imposed rights and
responsibilities upon the contractor, the partnership, and the
"carrier", which was Machise.
For example, under the agreement,
both the carrier and the contractor agreed to carry liability
insurance.
When the lease began, Bucci himself signed as
"partnership agent".
The investment program followed a familiar pattern.
The 21
partners executed 12-percent notes, in amounts aggregating
$3,035,000, to Qulart.
The notes required annual payments of
interest, with the principal and remaining interest due 11 years
after the notes’ dates of execution.
note to Machise.
84's capital.
Qulart executed a similar
This amount was equal to ten-elevenths of MIT
Machise then lent Qulart $3,035,000 in a zero
- 63 percent demand note dated July 1, 1984.
Qulart then lent
$3,035,000 to the 21 investors in MIT 84.
The MIT 84 partners
then allegedly directed Qulart to pay the $3,035,000 that they
had borrowed from Qulart directly to MIT 84.
MIT 84 completed
the investment circle by endorsing the $3,035,000 Machise zeropercent demand note back to Machise.
Because Machise had its own
note back, that note was retired.
In addition to the notes, the investors were required to put
up, in the aggregate, $303,500 in cash as the other one-eleventh
of their capital investment in MIT 84.
None of the investors in
MIT 84 initially paid this one-eleventh in cash to MIT 84.
Instead, they issued short-term notes to BBPA, which had set up a
line-of-credit arrangement with MIT 84.
The investors’ short-
term notes to BBPA were dated January 1, 1984, and were payable
July 1, 1984, with interest at the annual rate of 15 percent.
The investors fully paid these notes to BBPA in 1984.
During
1984, BBPA advanced $182,100 of this amount to Machise, pursuant
to a second line-of-credit note, executed by Machise in favor of
BBPA.
During 1984, Machise made transfers totaling $4,183,049 to
the MIT 84 payroll account.
The employees and independent
contractors were paid with checks on this account that were
signed by Bucci.
In addition to the payroll costs, on December 21, 1984, MIT
84 issued a check to MITA, in the amount of $400,000, as the
- 64 total management fee due under the management contract.
amount was recommended by Fred.
This
As with the MIT 83 check for
$363,000, the MIT 84 check passed around in a circle to MIT 84,
its maker.
Under its cash method of accounting, MIT 84 claimed a net
loss of $3,035,000.
This was the excess of the $4,194,361
payroll costs over reported partnership income of $1,159,361.18
On their individual income tax returns for 1984, the 21
investors in MIT 84 reported Schedule E partnership losses from
MIT 84 in proportion to their interests in the partnership.
Respondent issued to MIT 84 a notice of final partnership
administrative adjustment in which respondent disallowed the
entire claimed MIT 84 partnership loss of $3,035,000 for the year
1984.
The employee leasing agreement required Machise to pay a
compensation fee to MIT 84 of 120 percent of the payroll costs.
This was a 5-percent increase in the compensation fees charged by
earlier partnerships.
Once again, however, this payment could be
deferred for 11 years, until July 1, 1995, for a 10-percent
annual late charge.
18
MIT 84 took into income, as compensation fees, $1,112,394
to reflect that it had received more in advances from Machise
than it had lent to Machise. The other income reported by MIT 84
for 1984 consisted of interest income of $46,967. Some $45,525
of the latter amount represented interest paid by BBPA based upon
its use of the investors' cash under the line-of-credit note.
This interest income was exactly offset by MIT 84's claimed
payment of a $45,525 professional fee to BBPA.
- 65 For the period January 1 through June 30, 1984, Machise
accrued and deducted, for Federal income tax purposes, "rents",
of $2,425,881.
For the period July 1 through December 31, 1984,
Machise/Intercoastal accrued, and deducted for Federal income tax
purposes, rents of $2,556,722.
Respondent issued a statutory notice of deficiency to
Intercoastal disallowing Intercoastal's claimed deduction for its
fiscal year ended June 30, 1984 and 1985, of those parts of its
"rents" expense paid to MIT 84 that represent 20 percent of the
compensation fee under the employee leasing agreement, the
management fee expense, and the interest expense.
MIT 84 closed its bank accounts early in 1985.
All its
subsequent years’ financial operations were effected through noncash transactions, made by issuing, endorsing, or canceling noninterest-bearing notes, and recorded only by journal entries.
These included Machise's payments, in 1985 and 1986, of $546,300,
in the form of demand notes, as deferred compensation fee plus
interest (the 10-percent late charge).
In 1987, MPC made the
payment of this amount; it was recorded only by journal entries.
These payments took the form of endorsements to the Machise
notes; after July 1, 1986, they existed only as bookkeeping
entries.
They were recorded as passing through MIT 84, coming in
as compensation fee income and exiting as capital distributions
to its partners, going from them as payments on their notes to
- 66 Qulart and then exiting as payments on Qulart's 12-percent note
to Machise.
The $303,500 line-of-credit note from BBPA, representing the
partners' cash investment, remained unchanged until December 31,
1987, when it was assigned to Qulart to be applied as a payment
on the MIT 84 partners' notes to Qulart.
That amount passed from
Qulart as payment to MPC on Qulart's 12-percent note for
$3,035,000 originally issued by Qulart to Machise, now held by
MPC.
MPC offset the Qulart note against liabilities to BBPA, and
the note was canceled.
This line-of-credit note receivable was
thus treated in the same manner as BBPA's corresponding line-ofcredit obligations to MIT 83 for $284,300 and to MIT 82 for
$190,000.
The net effect was that, as of December 31, 1987, the
MIT 82, MIT 83, and MIT 84 partnerships could no longer collect
BBPA's $777,800 line-of-credit obligations, which had represented
the cash that the partners had paid in and which BBPA and Machise
had divided between themselves.
For the year 1987, MIT 84, like the other partnerships,
changed its method of accounting from the cash method to the
accrual method.
On January 1, 1988, Fred prepared a Termination Agreement to
end the obligations of MIT 84 and MPC under the employee leasing
agreement.
Fred signed the Termination Agreement under the
heading "Bryen & Bryen, P.A." on behalf of both MIT 84 and MPC.
- 67 The Termination Agreement recited that MPC owed $2,950,256
to MIT 84, and it offered to pay $2,262,253 by transferring to
MIT 84 the $3,035,000-note made by Qulart to Machise, now held by
MPC, with a current unpaid balance of $2,262,253.
MIT 84 thus
settled its receivable for MPC for $688,003 less than it was
owed.
This amount was again termed a "Contract Renegotiation
fee."
No formal assignment of the note, however, was ever made.
The Termination Agreement also required MIT 84 to distribute
the Qulart note for $3,035,000 to its partners, who were to
direct MIT 84 to assign that note to Qulart in payment of amounts
they owed Qulart on their investor notes.
of that note was ever made.
No formal assignment
The partners' investor notes,
however, were marked "Paid 1-1-88".
MIT 84 reported partnership taxable income of $546,300 for
1986 and, by virtue of having changed its accounting method,
$1,360,877 for 1987, $23,899 for 1988 (reflecting a deduction of
the $688,003 Contract Renegotiation fee), and $1,423,786 for
1989.
MIT 84 has filed one of the petitions in this consolidated
proceeding (docket No. 3461-92) seeking to have its reported
taxable income for those years reduced to zero should we
determine that MIT 84 was a sham.
In the event we make such a
determination, respondent has agreed that such adjustments would
be appropriate.
None of the investors in MIT 84 ever received any cash
return on his or her investment in MIT 84.
- 68 MIT 85
On January 1, 1985, Fred and Bruce organized and promoted
MIT 85 as a general partnership.
Its organization and operation
are similar to those of the partnerships previously described.
The four individuals and six partnerships who were investors
in MIT 85 were clients of BBPA.
BBPA made the adjusting journal
entries of MIT 85 for 1985, 1987, and 1988.
There were no
prospectuses or offering memoranda or terms sheets for MIT 85.
Some of the prospective investors in MIT 85, however, were given
a four-page document, prepared by BBPA, which described the tax
advantages of investing in MIT 85 and made projections to the end
of the partnership term.
The document stated, in part:
In 1985, each unit investor will report a loss of
$100,000. During the next 10 years, each unit investor
will report taxable income ranging from $3,286 in 1986
to $11,560 in 1995. In 1996, each unit investor will
report taxable income of $41,263.
MIT 85 and Machise, and MPC, newly inserted as a
"subcontractor",19 entered into an employee leasing agreement,
dated January 1, 1985, under which MIT 85 would provide all of
the individual employees and independent contractors required by
Machise to conduct its business for the period January 1 through
December 31, 1985.
19
Fred testified that he inserted MPC as a subcontractor in
order to deter questions by the creditors of Machise about
Machise's large liabilities to the partnerships. Additionally,
inserting MPC, in which Bucci was the principal partner, exposed
Bucci's assets to possible claims of MIT 85 in the event of
Machise's inability to pay its liabilities.
- 69 The MIT 85 agreement was similar to those of the earlier
partnerships.
The employees and independent contractors were the
same employees and independent contractors who had earlier
provided their services to Machise before the MIT 85 employee
leasing agreement was made.
After this agreement, Bucci still
directed and controlled the employees.
The 10 partners executed notes to Qulart in face amounts
aggregating $2,160,000.
This aggregate amount was equal to 80
percent of MIT 85's capital.
annual rate of 15 percent.
annual payments.
The notes bore interest at the
They were to be repaid in 10 level
Qulart issued a similar note to Machise, which
then issued a $2,160,000 demand note dated July 1, 1985, to
Qulart.
This note circled from Qulart to the 10 investors who
allegedly directed Qulart to endorse the note directly to MIT 85.
In addition to issuing the notes, the investors were
required to put up, in the aggregate, $540,000 in cash as the
other 20 percent of their capital investment in MIT 85.20
The
investors paid substantial amounts of this cash to BBPA during
1985.
BBPA was supposed to advance to MIT 85 the cash required
of the investors in MIT 85.
BBPA issued neither cash, nor a
check, nor notes to accomplish this advance.
20
The advance,
The employee leasing agreement for the previous
partnership, MIT 84, had required MIT 84 to advance ten-elevenths
of its invested capital to Machise. The MIT 85 employee leasing
agreement, however, required MIT 85 to advance all its invested
capital to Machise. This totaled $2,700,000--$2,160,000 in notes
from its partners and $540,000 in cash.
- 70 however, was recorded by a journal entry.
The total cash paid by the investors under the subscription
agreements in 1985 was $334,096.80, plus $16,255 interest.
Of
this amount, BBPA was to retain some 20 percent as a promoter's
fee from Machise.
The balance apparently went to Machise,
although some amounts that BBPA credited to Machise were in the
form of setoffs.21
This "promoter's fee" arrangement for BBPA
was new; it replaced the line-of-credit arrangement whereby
BBPA--and, through it, Machise--had divided the cash invested by
the partners in the earlier partnerships.
Machise again made weekly transfers to the payroll accounts
to cover the Machise payroll.
amount of $3,508,786.
During 1985, these totaled a net
The employees and independent contractors
were paid with MIT 85 checks drawn on this account and signed by
Bucci.
In addition to the payroll costs, on December 24, 1985, MIT
85 issued a check to MITA, in the amount of $400,000, as the
total management fee due under the management contract.
amount was recommended by Fred.
This
As with the MIT 84 check for the
same amount, the MIT 85 check passed around in a circle to MIT
85, its maker.
21
Fred testified that, because all the investors’ cash was
to go from MIT 85 to Machise it was not necessary for BBPA to
forward all of the investors’ cash to Machise. Fred recalled
that BBPA merely reduced an obligation that Machise had to BBPA
in lieu of forwarding some of the investors’ cash to Machise.
- 71 Under its cash method of accounting, MIT 85 claimed a net
loss of $2,700,000, which was the excess of the $3,512,527
payroll costs over reported partnership income of $812,527, an
amount that includes compensation fee income and a relatively
small amount of interest earned.22
On their individual income tax returns for 1985, the 10
investors in MIT 85 reported Schedule E partnership losses
totaling $2,700,000 from MIT 85 in proportion to their interests.
Respondent issued a notice of final partnership
administrative adjustment to MIT 85, wherein respondent
disallowed the entire claimed MIT 85 partnership loss of
$2,700,000 for the year 1985.
For the period January 1 through June 30, 1985, Machise/
Intercoastal accrued and deducted, on its consolidated income tax
return, "Rents" of $2,110,835.
For the period July 1 through
December 31, 1985, Machise/Intercoastal accrued, and deducted for
Federal income tax purposes, an additional $2,104,042.23
For the
22
The $3,512,399 amount "advanced" by Machise to the MIT 85
payroll account exceeds the $2,700,000 amount "advanced" by MIT
85 to Machise under the employee leasing agreement. See supra
note 20. Some $808,786 of the difference between the amounts
allegedly advanced by MIT 85 and those advanced to MIT 85 was
recorded as a prepayment of the compensation fee on Dec. 31,
1985, and is reflected in MIT 85's income for that year.
Additionally, the payroll figure includes some $3,741 in
interest.
23
Intercoastal/Machise filed an amended Form 1120 for the
fiscal year ended June 30, 1986, in order to reflect a change in
its net operating loss carryover from a prior year.
- 72 two periods, these amounts totaled $4,214,877, or 120 percent of
the amounts paid by MIT 85 for payroll costs.
Respondent issued a statutory notice of deficiency to
Intercoastal.
Therein respondent disallowed Intercoastal's
claimed deductions for the fiscal years ended June 30, 1985 and
1986, of those parts of its "rents" expense paid to MIT 85 that
represent 20 percent of the compensation fee under the employee
leasing agreement.
Respondent also disallowed the management fee
expense and the interest expense.
MIT 85 closed its bank accounts early in 1986.
On July 1,
1986, after the payroll costs were paid, MIT 85 billed Machise
for 120 percent of their total amount, as the compensation fee.
By that time, however, MIT 85 should have billed MPC, which, the
day before, had purchased all of the financial paper assets of
Machise that had been generated in the yearly employee leasing
agreements to which Machise was a party.
In subsequent years, MIT 85 engaged in noncash transactions,
made by issuing, endorsing, and canceling notes, and recorded by
journal entries.
These included Machise's execution of demand
notes without interest to MIT 85 in the amount of $412,722 as
deferred payment of the compensation fee plus interest (the 10percent late charge).
As with MIT 84, the payments went from
Machise to MIT 85, then to its partners, then to Qulart, and
finally back to Machise.
Thus, on its partnership return for
1986, MIT 85 reported partnership taxable income of $412,722,
- 73 which it called compensation fee income, and no expenses.
In 1987, MPC issued a similar note, which circled through
the partners, the partnership, and Qulart, and back to MPC.
MIT
85 reported partnership taxable income of $1,865,187 on its
partnership return for 1987.
This amount consisted of $1,571,520
(one-half of the $3,143,039 deferred income that it was
allocating over 2 years due to the change in accounting method),
plus $293,667, which it called fee income, and which represented
the accrual of interest payable from MPC, and no expenses.
On January 1, 1988, Fred prepared a Termination Agreement to
end the obligations of MIT 85 and MPC under the employee leasing
agreement.
Under the terms of the employee leasing agreement,
MPC owed $3,023,984 to MIT 85.
MPC offered to pay $2,116,938 by
transferring to MIT 85 the $2,160,000 note made by Qulart to
Machise, now held by MPC, with a balance, including accrued
interest, of $2,116,938.
The Termination Agreement recited that, after assignment of
the note, the balance due to MIT 85 was $907,045.98, but that MIT
85 had agreed to reduce that amount by $151,531.98 and to cancel
the 10-percent annual late charge.
Fred calculated the net
amount due to MIT 85, some $755,514, so that it would equal the
amount that he had projected as the aggregate income to the MIT
85 investors.
Additionally, under the Termination Agreement, MIT 85 was
required to distribute the note to its partners who were to
- 74 direct MIT 85 to assign the note to Qulart in payment of amounts
they owed Qulart on their investor notes.
of this note, however, was ever made.
No formal assignment
The partners' notes were
nevertheless marked "Paid 1-1-88".
Fred signed the Termination Agreement under the heading
"Bryen & Bryen, P.A." on behalf of both MIT 85 and MPC.
On its partnership return for 1988, MIT 85 reported
partnership taxable income of $1,419,986, consisting of
$1,571,520 (the remaining one-half of the $3,143,039 deferred
income that was originally allocated over 2 years due to the
change in accounting method), less $151,532, which it called a
"Contract Renegotiation fee".
This amount corresponds to the
amount that MIT 85 agreed to forgo in exchange for early payment
to terminate the employee leasing agreement, less an accounting
fee to BBPA of $1.
For the years 1986, 1987, and 1988, Fred, as vice president
of BBPA, the tax matters partner of MIT 85, has filed an amended
Form 1065 as a protective administrative adjustment request.
Therein he seeks to have the income reported by MIT 85 for those
years reduced to zero, in the event that we determine MIT 85 to
be a sham, not entitled to deduct the losses for 1985.
claims are pending in docket No. 3453-92.
Those
As with the other
partnerships, respondent has agreed that such adjustments would
be appropriate if we so determine.
After the termination, MPC still owed MIT 85 some $755,514.
- 75 Fred recommended that the partnership distribute this $755,514
receivable to its partners.
The partners were thereafter listed
as creditors against the estate in bankruptcy of Anthony S. and
Miriam A. Bucci (Bucci was the 99.999-percent partner of MPC;
Intercoastal held the other .001-percent interest).
The Notice of Commencement of the Bucci bankruptcy case
stated:
"At this time there appear to be no assets available
from which payment may be made to unsecured creditors."
No
representative of BBPA attended the Creditors' Meeting in the
Bucci bankruptcy proceeding held on July 20, 1994.
Fred
explained that it is "an absolute waste of time to attend * * *
these creditors' meeting when we know that there are no assets
available to be distributed."
BBPA recommended that the partners
claim the amounts owed to them as bad debt deductions for the
year 1994.
None of the investors in MIT 85 ever received any cash
return on his or her investment in MIT 85.
MIT 86
Fred and Bruce organized and promoted MIT 86 as a general
partnership at the beginning of 1986.
to the previous partnerships.
It also was very similar
BBPA prepared financial statements
for MIT 86 as of December 31, 1986, and made adjusting journal
entries for 1987 and 1988.
MIT 86 had nine partners--six individuals, two partnerships
and one corporation.
All were clients of BBPA.
There were no
- 76 prospectuses or formal offering memoranda or terms sheets for MIT
86.
Some of the prospective investors in MIT 86, however,
received a four-page document prepared by BBPA.
The document
described the provisions for investing in MIT 86 and made taxable
income and cash-flow projections to the end of the partnership
term.
The arrangements for MIT 86 followed the familiar pattern.
MIT 86, Machise, and MPC entered into an employee leasing
agreement, dated January 1, 1986, under which MIT 86 would
provide all the individual employees and independent contractors
required by Machise to carry on business for the period January 1
through December 31, 1986.
The employees and independent
contractors were the same employees and independent contractors
who had earlier provided their services to Machise before the
employee leasing agreement was made.
After this agreement, Bucci
still directed and controlled the employees.
The nine partners executed notes to Qulart in amounts
aggregating $3,080,000.
This amount was equal to 80 percent of
the capital of MIT 86.
The notes bore interest at a rate of 15
percent per annum and were to be repaid in annual level
installments.
Qulart issued a similar note to Machise, which
issued a $3,080,000 demand note dated July 1, 1986.
Backed by a
series of reciprocal obligations, this note circled from Qulart
back to the nine investors, who allegedly directed Qulart to
endorse the note directly to MIT 86.
- 77 In addition to the notes, the investors were required to put
up, in the aggregate, $770,000 in cash as the other 20 percent of
their capital investment in MIT 86.
BBPA was supposed to advance
to MIT 86 the cash required of its investors in MIT 86.
BBPA
issued neither cash, nor a check, nor notes to accomplish this
advance, which was, however, recorded by a journal entries on the
books of BBPA and MIT 86.
The nine investors signed General Partnership Subscription
Agreements by which they agreed to pay the 20 percent cash part
of their investment in 10 monthly installments at 15 percent
interest, commencing on January 1, 1986.
The MIT 86 investors
paid the $770,000 to BBPA in cash or by offsets in 1986.
Machise made weekly transfers to the MIT 86 First Jersey
payroll accounts to cover the Machise payroll costs.
During
1986, these transfers totaled a net amount of $3,983,476.
The
employees and independent contractors were paid with MIT 86
checks signed by Bucci.
Although the books and records of MIT 86 and MITA reflect
payment of a management fee of $400,000 by MIT 86 to MITA, no
check for that amount appears in the record.
Under its cash method of accounting, MIT 86 claimed a net
loss of $3,850,000.
This was the excess of the payroll costs
over reported partnership income.24
24
The employee leasing agreement required MIT 85 to advance
(continued...)
- 78 On their individual income tax returns for 1986, the nine
investors in MIT 86 reported Schedule E partnership losses from
MIT 86 in proportion to their interests.
Respondent issued a notice of final partnership
administrative adjustment to MIT 86, in which respondent
disallowed the entire claimed MIT 86 partnership loss of
$3,850,000 for the year 1986.
For the period January 1 through June 30, 1986, Machise/
Intercoastal accrued and deducted, on its consolidated income tax
return, "rents" of $1,925,000.
Respondent issued a statutory notice of deficiency to
Intercoastal disallowing Intercoastal's claimed deduction for
fiscal year June 30, 1986, of those parts of its rents paid to
MIT 86 that represent 20 percent of the compensation fee under
the employee leasing agreement, the management fee expense, and
the interest expense.
MIT 86 closed its bank accounts early in 1986.
Like the
other partnerships, in its subsequent years MIT 86 engaged in
noncash transactions, made by issuing, endorsing, and canceling
notes, and recorded by journal entries.
Thus, MPC issued MIT 86
(...continued)
all its invested capital, notes of $3,080,000 plus cash of
$770,000, to Machise. The $133,476 excess of the amounts
allegedly advanced to MIT 86 over the $3,850,000 advanced by MIT
86 was recorded as a prepayment of the compensation fee on
Dec. 31, 1986.
- 79 a demand note in the amount of $585,511,25 without interest,
dated July 1, 1987.
The demand note bore endorsements that were recorded by
journal entries as capital distributions from MIT 86 to its
partners and then as payments on their notes to Qulart.
As a
result of these endorsements, the notes were credited against the
partners' notes to Qulart, then applied as Qulart's payment of
its note to Machise.
The partners in MIT 86 made no cash
payments in 1987 on their notes to Qulart.
For the year 1987, MIT 86 changed its method of accounting
from the cash method to the accrual method.
On its partnership
return for 1987, MIT 86 reported partnership taxable income of
$4,855,505, which consisted of $4,652,314 (the deferred income
that it reported due to the change in accounting method), plus
$203,191, which it called fee income and which represented the
accrual of interest payable from MPC, and no expenses.
For the year 1987 Fred, as vice president of BBPA, the tax
matters partner of MIT 86, has filed an amended Form 1065 as a
protective administrative adjustment request.
Therein he seeks
to have the income reported by MIT 86 for the year 1987 reduced
to zero, in the event that we determine MIT 86 to be a sham, not
entitled to deduct the losses claimed for 1986.
25
The claim is
The amount of $585,511 appearing on the note was incorrect
and should have been $588,511. The transaction was recorded on
the books of MIT 86 and MPC in the amount of $588,511.
- 80 pending in docket No. 3462-92.
Respondent has agreed that such
an adjustment would be appropriate if we so determine.
On January 1, 1988, Fred prepared a Termination Agreement to
end the obligations of MIT 86 and MPC under the employee leasing
agreement.
MPC owed $4,266,993.53 to MIT 86 pursuant to the
employee leasing agreement.
Under the Termination Agreement, MPC
offered to pay $3,175,000 to MIT 86 by transferring to MIT 86 the
$3,080,000 note made by Qulart to Machise, now held by MPC, with
a balance, including accrued interest, of $3,175,000.67.
No
formal assignment of this amount took place, however.
The Termination Agreement also recited that, after MPC
assigned the Qulart note to MIT 86, the balance due to MIT 86
would be $1,091,992.86.
The Termination Agreement further
provided that MIT 86 had agreed to reduce that balance by
$14,685.86 and to cancel the 10-percent annual late charge.
Fred
computed the net amount due to MIT 86, some $1,077,307, so that
it would equal the amount that he had projected as the aggregate
income to the MIT 86 investors.
Additionally, under the Termination Agreement, MIT 86 was
required to distribute the Qulart note to its partners.
They
were to direct MIT 86 to assign that note back to Qulart, the
note's maker, in payment of amounts they owed Qulart on their
investor notes.
ever made.
No formal assignment of this note, however, was
- 81 Fred signed the Termination Agreement under the heading
"Bryen & Bryen, P.A." on behalf of both MIT 86 and MPC.
None of
the investors in MIT 86 received a return on his or her
investment.
Fred caused MPC to enter into the Termination Agreement with
MIT 86 in 1988 in order to relieve it of its liabilities to MIT
86.
Fred caused the partners of MIT 86 to enter into the
Termination Agreement with MPC in 1988 so as to minimize their
exposure to risk on their notes.
On its partnership return for 1988, MIT 86 reported a loss
of $14,687; this is the amount that MIT 86 agreed to forgo in
exchange for early payment to terminate the employee leasing
agreement), plus an accounting fee to BBPA of $1.
After the termination, MPC still owed MIT 86 some
$1,077,307.
Fred recommended that the partnership distribute
this $1,077,307 obligation to its partners.
The partners were
thereafter listed as creditors against the estate in bankruptcy
of Anthony S. and Miriam A. Bucci.26
26
While the $1,077,307 allegedly owed by MPC to the
investors in MIT 86 was still on the books at the time of the
trial herein, Fred conceded that he will probably recommend that
the debt be written off as an uncollectible loss by the
investors.
- 82 W & A Payroll Service
On July 1, 1986, Fred and Bruce organized and promoted W & A
Payroll Service (W & A) as a general partnership.
BBPA prepared
a schedule for cash receipts of W & A through March 31, 1988, and
a schedule of W & A's cash disbursements through June 30, 1988.
BBPA made adjusting journal entries as of January 1, 1987, and
January 1, 1988.
W & A was in substance similar to the earlier partnerships.
There were, however, some notable differences, chiefly the
absence of any checks or notes in the partnership's financial
transactions.
As with the previous partnerships, W & A used the calendar
year as its tax year and the cash method of accounting from its
inception until December 31, 1987.
It also had the same address
as BBPA.
W & A had a bank account at the First Jersey Bank/South
(First Jersey) Bank, which was the payroll account.
Andrew
Bryen, Fred's brother and a partner in W & A, was an authorized
signatory on the W & A payroll account at the First Jersey Bank.
Andrew has an eighth-grade education.
He owns half of a meat
company, of which Fred was the vice president.
With respect to
Fred's financial directives, Andrew "trusted anything Fred said,
and if he told me--if he sent something over for me to sign, I'd
sign it.
I wouldn't even look at it.
I'd just sign it."
Andrew
- 83 was nominally a managing partner for W & A, but he was not aware
that he held that position.
He did not engage in management of
W & A.
Fred had installed Andrew as the managing partner of W & A
in an attempt to comply with a provision of section 469, added to
the Internal Revenue Code by the Tax Reform Act of 1986.
Fred
had believed that a tax shelter partnership could continue to use
the cash method of accounting if investors with more than a 65percent interest--here, allegedly, Andrew--participated in the
partnership's activity.
It later became clear that Fred's
interpretation was not correct.
W & A originally had six partners, consisting of four
individuals and two corporations.
All were clients of BBPA.
There were no prospectuses or formal offering sheets for W & A.
On September 26, 1986, W & A, MPC, BBPA, and Machise entered
into an employee leasing agreement, prepared by Fred.
This
agreement was much less detailed about the parties' rights and
responsibilities than the prior versions had been.
Nevertheless,
as with the prior partnerships, W & A was to provide all the
individual employees and independent contractors required by
Machise to conduct its business for the period January 1 through
December 31, 1987.
The employees and independent contractors
were the same employees and independent contractors who worked
for Machise before the W & A employee leasing agreement was made.
- 84 The six W & A investors signed General Partnership
Subscription Agreements in which they agreed to invest $4 million
in cash before January 1, 1987.
The initial capitalization of
W & A was accomplished by BBPA lending the entire $4 million in
capital to the six W & A investors.
The six investors in W & A
did not execute promissory notes for their subscription amounts
to BBPA.
BBPA did not issue a promissory note to W & A for the
initial capitalization, but it did create an account payable to
W & A for $4 million.
The employee leasing agreement required W & A to deposit $3
million with BBPA, "the escrow agent", on January 1, 1987, so
that BBPA could fulfill its obligations under the employee
leasing agreement (the $3 million figure was incorrect and
inconsistent with the partnership's and partners' subscription
agreements; it should have been $4 million as the entire
capitalization of W & A).
in BBPA.
W & A purportedly deposited $4 million
No checks or notes were exchanged in these
transactions; however, the transactions involving the shift of $4
million between BBPA, the investors in W & A, and W & A itself
were all recorded in journal entries.
Machise was required to pay to MPC, and MPC was required to
pay to W & A, 105 percent of the payroll costs of the employees
and independent contractors.
fee.
This payment was the compensation
It was due and payable weekly as payroll costs were
- 85 incurred by W & A.
payment.
MPC, however, had the election to defer
If MPC made such an election, the unpaid balance of the
compensation fee plus the late charge computed to January 1,
1988, was to be paid in 36 equal monthly installments with 10
percent interest, with the first payment due on January 31, 1988,
and the balance due in installments on the last day of each month
thereafter.
The employee leasing agreement provided that, upon
presentation of the weekly payroll register approved by MPC, BBPA
would release and deposit directly into W & A's payroll bank
account 125 percent of the gross pay.
The funds so deposited
originated in Machise and passed through BBPA as the "escrow
agent".
Although the actual flow of funds was from Machise to
BBPA to W & A, journal entries recorded the alleged transactions
to include MPC and Bucci.
Thus, the journal entries showed the
funds going from Machise to MPC as an advance, then from MPC to
Bucci as a capital distribution, then from Bucci to BBPA as a
loan to BBPA, and then from BBPA to W & A.
The employees and independent contractors were paid with
W & A checks stamped with the signature of Andrew Bryen (Andrew
Bryen physically signed three W & A checks in 1987).
One of the employees paid with W & A checks was Loretta
Wilcox, a secretary with Machise.
She had been hired by Bucci in
September 1980, after she had filled out a formal employment
- 86 application.
She could not identify any of the partnerships, MIT
80 through 86, nor W & A.
She acknowledged that W & A appeared
as payor on her 1987 paychecks and on the Form W-2 filed with her
Federal income tax return for that year.
However, she was not
aware that she had been a leased employee.
Machise considered the amount spent by W & A, some
$3,586,269 in 1987, as the amount of payroll costs incurred under
the employee leasing agreement.
In 1987, W & A reported a loss
of $3,586,269, and a separate item of portfolio income of $113.
On their individual income tax returns for 1987, the
investors in W & A reported on Schedule E the partnership losses
from W & A in proportion to their interests.
Respondent issued a
notice of final partnership administrative adjustment to W & A,
in which respondent disallowed the entire claimed loss of
$3,586,269 for the year 1987.
In 1987, the New Jersey Department of Labor canceled the
unemployment tax accounts of the partnerships whose accounts
could be reached under the applicable statute of limitations.
The Department of Labor transferred credits for the funds that
had been ostensibly paid by the partnerships from the
partnerships' accounts to Machise.
The Department did so because
it had determined Machise to be the party that was liable for
unemployment tax contributions.
By 1988, Fred had decided that his assumption or legal
conclusion underlying the W & A arrangements--that W & A could
- 87 use the cash basis method of accounting--had been a "mutual
mistake".
Therefore, as of January 1, 1988, W & A changed its
method of accounting from the cash method to the accrual method.
There was no formal termination agreement for the W & A employee
leasing program.
Instead, a flurry of journal entries closed out
W & A's existence.
Journal entries for January 1, 1988, reflect
that W & A had a issued a credit to MPC in the amount of $397,431
and reversed a late charge of $199,202.
This caused W & A's
receivable balance from MPC to equal $3,586,603.27.
Additional
journal entries indicate that W & A then assigned its $3,586,603
receivable from MPC to BBPA in exchange for a receivable from
BBPA in that amount.
This assignment brought the total amount
due from BBPA to W & A to $4 million.
On the same day, a W & A journal entry recorded the
distribution of this $4 million receivable from BBPA to its
partners.
The partners were deemed to have received this capital
distribution pro rata.
BBPA reflected this distribution by
reclassifying the $4 million payable as being payable to the
W & A partners, not to W & A itself.
At this point, since the
W & A partners owed BBPA $4 million pursuant to their
27
For the year 1987, after the payroll and other costs had
been paid, W & A had issued a bill to MPC in the amount of
$3,984,034, plus accrued interest--a late charge--of $199,202,
for a total receivable due of $4,183,236. The amount accrued by
Machise was more than the 105 percent of the actual payroll costs
required by the employee leasing agreement. The charge of
$3,984,034 was the result of Fred's estimating the payroll costs
as $3,794,318 and adding 5 percent--in the amount of $189,716.
- 88 subscription agreements and since BBPA now owed the same amount
to the W & A partners, BBPA caused these offsetting balances to
be canceled.
The other entities involved with W & A also recorded
offsetting journal entries to cancel the assets and liabilities
associated with their W & A transactions.28
Pursuant to these
journal entries, W & A was terminated because it owned no assets
and owed no liabilities.
On its partnership return for 1988, W & A reported
partnership taxable income of $3,586,156.
This amount consisted
of $3,984,034, which W & A had billed as a "compensation fee",
less various net expenses of $447 and less $397,431, which Fred
called "Contract Termination Expense".
This was the amount that
W & A agreed to forgo in exchange for early payment to terminate
the employee leasing agreement.
For the year 1988, W & A has filed an administrative
adjustment request, seeking to have its reported income of
$3,586,156 for 1988 reduced to zero if we determine that W & A is
28
For example, at the time of the offsets BBPA owed Bucci
$3,771,517 as a loan of the borrowed payroll costs. Meanwhile
MPC, Bucci's entity, owed $3,586,603 to BBPA, which had accepted
W & A's account receivable from MPC in that amount. Moreover,
another Bucci entity, MIT Payroll Service, owed $184,712 to BBPA
(including a miscellaneous 1988 expense of $500). Since MPC and
MIT Payroll Service were controlled by Bucci, BBPA made a journal
entry offsetting its $3,771,517 payable to Bucci against its
$3,771,315 receivables from MPC and MIT Payroll Service,
resulting in an alleged net amount payable to Bucci of $202.
This payable was later eliminated when the MIT Payroll Service
entity was terminated.
- 89 a sham, as respondent contends.
No. 3221-93.
That claim is pending in docket
Respondent has agreed that, in the event we so
determine, the requested reduction is appropriate.
None of the investors in W & A ever received any return from
their participation in W & A.
The Investors
In promoting the various partnership as tax shelters, Bruce
told the investors that the shelters were "set up on a cash
basis, there was a partnership and the loss would flow through to
them on their personal return."
Bruce advised the investors that
an economic return on their investment could be paid quickly or
"it could be deferred for 10 years, and they would be paid right
after the beginning of the eleventh year, that it was up to the
payer, to the operating company."
One of the investors in MIT 82, as well as other of the MIT
shelters partnerships, was Anthony Schweiger (Schweiger).
Schweiger is a mortgage banker.
He was aware that the
partnerships in which he invested were employee leasing
arrangements with 1-year terms.
He was aware of no partnership
meetings, however, nor of any partnership votes.
Schweiger and the other investors received occasional
memoranda about developments during the year with respect to
their investments.
TO:
A typical memorandum reads as follows:
FROM:
Mr. Anthony Schweiger
Bruce Bryen
- 90 RE:
MIT 82
On July 1, 1984, Machise Interstate Transportation Company,
Inc. paid MIT 82 $473,458.00 consisting of the following:
Repayment of balance of advance
at July 1, 1983
Interest due on above at 10% to
July 1, 1984
Late charge on Fee due at July 1,
1983 (10% x $2,880,595.08)
Partial payment of fee
$120,919.90
12,091.99
288,059.51
52,386.60
$473,458.00
Your share of this payment was $7,698.50 which we used
to pay the annual installment due on your note on July
1, 1984. The interest portion of this payment which
you may deduct on your 1984 income tax return is
$4,730.15
The remaining balance due on your note after the
July 1, 1984, payment is $ 44,333.15.
For financial statement purposes the market value of
your interest in MIT 82 at July 1, 1984 was $50,500.00.
We will be sending you an accounting (Form K-1) soon
after the end of the year which will contain all of the
information needed for your 1984 income tax return.
Please call me if you have any questions about MIT 82.
Schweiger received no financial statements for Machise.
He
had a great deal of faith in Fred, and, as he explained, did not
"dot the I's and cross the T's in a very sophisticated manner
about asking for financial statements * * * and things like
that."
Schweiger understood that he had signed a note for which he
was liable, but he received no demand for repayments.
instead informed that the note had been paid off.
aware of the termination agreements.
He was
He was not
- 91 Schweiger's primary consideration in participating in the
MIT partnerships was to obtain tax benefits.
He had previously
invested in three other tax shelters promoted by Fred and Bruce
through BBPA.
Schweiger identified one of these shelters as "P&G
which was the school bus operation, Pat & Gordon".
Charles Thompson (Thompson) was another investor in the MIT
shelters.
He was told that his taxes would be reduced, but he
does not recall any representation being made about investment
profits.
votes.
He recalls no partnership meeting nor partnership
He was not aware that he was a general partner in the
partnerships.
He did not understand how his notes were paid off,
nor did he receive news of the termination of the employee
leasing arrangement.
Thompson did not have regular meetings with the accountants
at BBPA; he only went to them with his tax materials for purposes
of preparing his income tax returns.
Another of the investors in W & A was Alexander M. Churchill
(Churchill), a civil engineer.
BBPA was the accountant for
Churchill's engineering business, and Churchill’s tax preparer.
Churchill saw Bruce two or three times a year, with respect to
Churchill's individual tax matters.
Bruce had induced him to
invest in W & A, as well as other earlier tax shelters.
Churchill participated for "investment purposes and also to
shelter some of my income."
In addition to the MIT tax shelter
partnerships, the Bryens also brought other tax shelters to
- 92 Churchill's attention.
Bruce did not explain to Churchill the significance of being
a general partner in the MIT partnerships.
Churchill knew of no
partnership meetings, nor was he consulted on partnership
operations.
He did not know the other partners.
He did not
understand the accounting mechanisms of the partnerships, but he
relied upon Bruce.
Asked specifically about his participation in
MIT 82, Churchill did not recall being consulted before
termination of that partnership’s employee leasing agreement.
Before trial in these cases, Fred informed the investors in
writing that the trial was in the offing.
A typical letter from
Fred to an investor advises-If you are called as a witness, Steve Jozwiak will
prepare you for trial. In general, he will tell you to
tell the truth and try not to become confused.
Steve will expect you to testify to the true facts
that you knew that you were at risk for $137,500.00 and
that you expected to earn 13% on your investment which
would be more than enough to pay your note. In
addition you had the protection of your tax savings but
you knew that you would have to pay taxes on the income
that you would be reporting over the 10 year period.
Steve will also expect you to testify that you expected
Bryen & Bryen P.A. to manage your investment and MIT 82
and to take care of all of the details without
consulting you.
OPINION
Three aspects of the employee leasing programs structured by
Fred Bryen are in issue in these consolidated test cases.
Respondent’s first set of determinations denies, for the years
1980 and 1982, to the partners, and in subsequent years (1983,
- 93 1984, 1985, 1986, and 1987) to the partnerships, deductions for
claimed losses attributable to payments of Machise's payroll
costs.
Respondent’s second set of determinations denies, for the
years 1983, 1984, 1985, and 1986, deductions for the interest
alleged by the Pettisani petitioners to have been paid on their
1982 note to Machise.
Respondent’s third set of determinations
denies Intercoastal, which filed consolidated returns with
Machise, deductions for the years 1982 and 1983 for any amount of
the "overrides" on its payroll costs, the "management fees", and
the interest accrued on its alleged borrowings.
We hold that petitioners are not entitled to the deductions
at issue.
Our holdings are based on the overall conclusion that
the transactions giving rise to the claimed deductions had
neither economic substance nor a profit objective.
I.
Neither the Partners Nor the Partnerships Are Entitled to
Loss Deductions Based Upon Payment of Machise's Payroll
Costs
The initial question we must answer is whether the partners
(for 1980 and 1982) and the partnerships (for 1983-87) may
deduct, as partnership expenses, the payroll costs for the years
in issue.
A.
The Requirement of Economic Substance
"The incidence of taxation depends upon the substance of a
transaction.
* * *
To permit the true nature of a transaction
to be disguised by mere formalisms, which exist solely to alter
tax liabilities, would seriously impair the effective
- 94 administration of the tax policies of Congress."
Commissioner v.
Court Holding Co., 324 U.S. 331, 334 (1945).
The Court of Appeals for the Third Circuit, to which all
these cases are appealable, has recently applied the principle
that the substance of a transaction, and not its form, governs
its tax consequences.
As that court explained,
The general rule on sham transactions in this circuit
is well-established: "If a transaction is devoid of
economic substance . . . it simply is not recognized
for federal taxation purposes, for better or for worse.
This denial of recognition means that a sham
transaction, devoid of economic substance, cannot be
the basis for a deductible loss." [United States v.
Wexler, 31 F.3d 117, 122 (3d Cir. 1994) (quoting Lerman
v. Commissioner, 939 F.2d 44, 45 (3d Cir. 1991), affg.
Fox v. Commissioner, T.C. Memo. 1988-570).]
See, in this regard, Foxman v. Commissioner, 352 F.2d 466,
469 (3d Cir. 1965), affg. 41 T.C. 535 (1964); see also Weller v.
Commissioner, 270 F.2d 294, 296 (3d Cir. 1959)(quoting Gregory v.
Helvering, 293 U.S. 465, 469 (1935)), affg. 31 T.C. 33 and Emmons
v. Commissioner, 31 T.C. 26 (1958), in which the Court of Appeals
for the Third Circuit noted that the Supreme Court had refused to
give effect to "`an elaborate and devious form of conveyance
masquerading'" as a legitimate transaction.
The activities there
described were found to be "`a mere device which put on the form
* * * as a disguise for concealing its real character'".
Petitioners bear the burden of proving that the challenged
transactions were not sham transactions, devoid of economic
substance.
Rule 142(a); Sheldon v. Commissioner, 94 T.C. 738,
- 95 753 (1990); Arrowhead Mountain Getaway, Ltd. v. Commissioner,
T.C. Memo. 1995-54 (taxpayer bears burden of disproving
determination in FPAA in case filed under TEFRA partnership
provisions).
1.
The Relationship of the Employees and Independent
Contractors to Machise and to the Partnerships
The "real character" of the transactions at issue, as
displayed by the entire record, is that Machise, and not the
partnerships, incurred and paid the payroll costs of the workers
who performed services for Machise.
Accordingly, Machise, and
not the partnerships, is entitled properly to deduct those costs
as ordinary and necessary business expenses.
See Whipple v.
Commissioner, 373 U.S. 193, 202 (1963); Madison Gas & Elec. Co.
v. Commissioner, 72 T.C. 521, 566-567 (1979), affd. 633 F.2d 512
(7th Cir. 1980).
Conventional employee leasing business arrangements have
presented some interesting tax issues, but we have no occasion to
reach them here.
Some employers contended that, by using
employee leasing arrangements, they could avoid application of
the Code provisions that require qualified retirement plans to
make provisions for lower-paid employees.
Commissioner, 68 T.C. 387 (1977).
See, e.g., Burnetta v.
To deal with those issues,
Congress added section 414(n) and (o) to the Code.29
29
In 1982, Congress added sec. 414(n), Tax Equity & Fiscal
Responsibility Act of 1982, Pub. L. 97-248, sec. 248(a), 96 Stat.
(continued...)
- 96 The issues underlying the enactment of section 414(n) and
(o) have no bearing on this case.
The purported employee leasing
arrangements at issue here are not the otherwise presumably valid
leasing organizations addressed in section 414(n).30
The
arrangements in the cases at hand instead fall within the
category of arrangements we have called "generic tax shelters".
See Rose v. Commissioner, 88 T.C. 386, 412-413 (1987), affd. 868
F.2d 851 (6th Cir. 1989).
Petitioners argue that modern employee leasing arrangements
have modified strict employer-employee roles.
The evolution of
such arrangements, however, does not lend substance to the
activities of the lessor partnerships in the cases before us.
The parties have asked the Court to take judicial notice of
Willey, The Business of Employee Leasing (2d ed. 1988).
Dr.
29
(...continued)
526, whose general purpose was to treat certain leased employees
as employees of the recipient of their services for purposes of
the qualified plan requirements. H. Conf. Rept. 97-760, at 79
(1982), 1982-2 C.B. 600, 679. In 1984, Congress added sec.
414(o), Deficit Reduction Act of 1984, Pub. L. 98-369, sec.
526(d)(1), 98 Stat. 875, granting authority to the Secretary to
issue regulations deemed necessary to prevent employee leasing or
other arrangements from being used to avoid statutory employee
benefit requirements. In the Tax Reform Act of 1986, Pub. L. 99514, sec. 1146, 100 Stat. 2491, Congress amended sec. 414(n) to
expand further the qualified plan restrictions on the use of
leased employees.
30
By a parity of reasoning, the organization and use of
Intercoastal and MIT Personnel in efforts to maximize qualified
plan benefits for Bucci and Ingemi and effectuate other business
purposes have no bearing on the issues in this case, which
concern the efforts to use the MIT partnerships to create tax
benefits for investors and Intercoastal/Machise.
- 97 Willey’s introduction, id. at 2, to his book explains the
operation of conventional employee leasing arrangements:
In employee leasing arrangements, two legally
separate employers share some, or all, of the employer
responsibilities with the same employees. Leasedemployees are employed by the leasing employer, which
pays their wages and benefits, but whose employees also
report for work at the utilizing business. There their
work activities are directed by the utilizing employer.
These workers do the work of the business of the
leasing employer and the business of the utilizing
employer. The employer responsibilities may be
allocated between the employers, by mutual agreement.
* * *
As Dr. Willey explains, the employer responsibilities may be
allocated between the employers, by mutual agreement.
Here,
however, notwithstanding the written employee leasing agreements,
none of the responsibilities changed.
There is no indication
that, as provided in the agreements, Machise provided the
partnerships with estimates of the number of employees or
contractors it would need to carry on its business.
Nor is there
any indication that the partnerships undertook in any substantive
way to provide Machise with the employees, independent
contractors, equipment, or antecedent biographical information
called for in the agreement.
We have seen no instance in which
the partnerships undertook to "control and direct the performance
of the services of the individuals", despite the explicit
reservation of the right to do so contained in each of the
agreements.
Nor have we seen any attempt by the partnerships
either to "instruct each individual as to his work hours and the
- 98 nature of his duties", or to "determine the contractor to be
used" to carry out Machise's business.
To the contrary, Machise continued to act through its owner
employees, Bucci and Ingemi, and, after Ingemi's death, Bucci
alone.
Bucci and Ingemi, and not the partnerships, made the work
assignments to the employees and independent contractors.
and Ingemi directed and controlled the employees.
Bucci
Bucci and
Ingemi determined the amount of wages to be paid, did the hiring
and firing, took any necessary disciplinary action, and set the
hours to be worked.
Machise, and not the partnerships, provided
work space and equipment to the workers.
Cf. Professional &
Executive Leasing, Inc. v. Commissioner, 89 T.C. 225, 232 (1987),
affd. 862 F.2d 751 (9th Cir. 1988).
Dr. Willey, supra at 6, also lists a number of employer
functions usually taken over by an employee leasing company.
These functions include issuing paychecks, payroll management,
paid leave management, payroll tax deposits, recruitment,
enrollment in benefits, maintenance of employee benefits, and
benefit claims administration.
Here, there is no showing that
the partnerships actually performed any of these functions.
Machise continued to perform the services usually provided by
employee leasing companies.
The partnerships’ participation was
limited to the use of their names on checks, forms, or
transmittal documents.
- 99 Dr. Willey also explains, id., that in a typical employee
leasing arrangement a subscribing company places its regular
workforce on the leasing firm’s payroll.
“The employees have to agree to this too.”
He adds, significantly:
Id.
In the present
case, the employees did not submit formal employment applications
to the partnerships, nor did they explicitly consent to the
execution of the employee leasing agreements.
They were not
consulted or informed about the employee leasing agreements, and
they were for the most part unaware of the existence of their
putative new employers.
As indicated by the testimony of Ms.
Wilcox, Machise's workers did not ascribe any significance to the
appearance of the partnerships' names on their pay checks.
Indeed, the fact that the workers were hired by Machise
Interstate Transport (which was often called "MIT") may help
explain why the workers paid little attention to the fact that
their checks were drawn, for example, on an account in the name
of "MIT 86".
Dr. Willey also writes that “The leasing arrangement with
the subscriber begins with the assumption that this will be a
long-term affiliation”.
Id.
In this case, however, the
assumption was that there would be only short-term 1-year
arrangements with each of the successive partnerships.
The
employees would remain with the subscribing company while
changing employers--that is, the partnerships--every year.
- 100 Finally, Dr. Willey indicates that “Most employee leasing
firms are charging anywhere between three and eight percent of
employee gross wages”.
Id. at 217.
Here, the partnerships
charged “overrides” of between 15 and 20 percent--more than twice
the going rates--in exchange for services that were merely
illusory.31
We conclude that Machise, through Bucci and Ingemi, filled
the role ostensibly claimed by the partnerships.
Machise
operated its business without the aid of the partnerships.
None
of the partnerships, and none of their partners, undertook any
substantive activities with respect to Machise's employees or
independent contractors.
Machise, and not the partnerships, was
the employer and the party responsible for paying the payroll
costs.
Accordingly, Machise, and not the partnerships, was
entitled to claim those costs as a deduction of ordinary and
necessary business expenses.
Petitioners' arguments to the contrary are unavailing.
They
seek support from cases that impose liability for employment tax
obligations on the party that controls wage payments, e.g., Evans
31
Fred has insisted that the inflated "overrides" included
interest paid to the partnerships for their "advances" of payroll
costs. We have found that the partnerships' "advances" are as
illusory as their services. The alleged interest components of
the overrides are also illusory. In addition, there is no
indication by Dr. Willey that a hallmark of conventional employee
leasing arrangements is that the subscribing company will defer
the reimbursement of payroll costs to succeeding years.
- 101 v. Internal Revenue Service, 607 F.2d 1237 (9th Cir. 1979).
Petitioners argue that because the employees and independent
contractors were paid from accounts in the names of the
partnerships, the partnerships must be deemed to be the
employers.
Petitioners are wrong.
Their argument fails to take
into account that Machise, through Bucci and Ingemi, determined
who would be paid and how much, provided Machise money for the
payroll accounts, and signed the paychecks drawn on those
accounts.
Machise controlled the wage payments.
The use of the
partnerships' names on the payroll accounts is a facade that does
not evidence an employment or other service provider relationship
between the partnerships and the worker providers of the actual
services that were needed to carry on the business of Machise.
There were numerous other attempts to insert the name of the
partnership into Machise's business.
These attempts did not,
however, impose any genuine responsibilities upon the
partnerships.
The appearance of the partnerships' names on some
of the agreements with independent contractor truckers does
not affect our conclusion.
A reading of those agreements shows
that the operative provisions generally described the reciprocal
rights and responsibilities of the truck driver and the
"carrier", Machise.
To the extent any rights or obligations
devolved upon the partnerships under those agreements, we regard
it as significant that Bucci--and none of the partners--signed as
"partnership agent".
- 102 Nor can petitioners derive comfort from correspondence
between officials of the New Jersey Department of Labor and the
partnerships concerning their liabilities for employment taxes.
The New Jersey Department of Labor subsequently canceled the
unemployment tax accounts of the partnerships.
The Department
transferred credits for the funds that had been ostensibly paid
by the partnerships from the partnerships' accounts to the
Machise account with the Department.
The Department did so
because it ultimately determined that Machise was the party
liable for unemployment tax contributions.
Its ultimate
determination, once it caught on to the charade, strengthens our
conclusion that the partnerships were not the employers, and
exposes the lack of significance of the earlier correspondence.
Petitioners have also failed to show that there was any
substance in the inclusion of the partnerships' names, as
"participants", on some of the employees' pension plan documents.
The plan documents reveal that the employees' pension plan
existed long before the partnerships were formed.
Even after the
partnerships were formed, Bucci and Ingemi provided Machise's
money to fund the pension payments, as they had done for the
other payroll costs.
Bucci, and not the partnerships, decided
where the pension deposits would be invested, and Machise’s
controller prepared the quarterly financial statements for the
plan.
Petitioners have not shown that the partnerships performed
any meaningful role with respect to the pension payments or the
- 103 administration of the plan.
In sum, the operative facts of these cases show that the
substance of the partnerships' employee leasing arrangements is
that Machise, and not the partnerships, was the employer of the
employees and the party who hired the independent contractors for
purposes of deducting the payroll costs at issue.
2.
Lack of Economic Substance of the Employee Leasing
Agreements
Petitioners also argue that the substance of the
transactions has been given economic effect by the execution of
the financing agreements.
Petitioners again are wrong.
These
agreements lack economic substance and are ineffective, for
Federal tax purposes, to change the character of the transactions
at issue.32
In Levy v. Commissioner, 91 T.C. 838, 856 (1988), we listed
a number of "particularly significant" factors in determining
whether a financial transaction has economic substance apart from
tax benefits.
These factors include the presence or absence of
arm's-length negotiations, the relationship between sales price
and fair market value, the structure of the financing, the degree
32
In focusing on the transactions at issue, we find it
unnecessary to resolve related questions such as whether or when
the investors formed valid partnerships. See Commissioner v.
Culbertson, 337 U.S. 733 (1949). Nor need we decide whether the
partners' claimed losses exceeded the bases of their partnership
interests. See CRC Corp. v. Commissioner, 693 F.2d 281 (3d Cir.
1982), affg. in part and revg. and remanding in part Brountas v.
Commissioner, 73 T.C. 491 (1979).
- 104 of adherence to contractual terms, and the reasonableness of the
income and residual value projections.
See also Helba v.
Commissioner, 87 T.C. 983, 1005-1011 (1986), affd. without
published opinion 860 F.2d 1075 (3d Cir. 1988).
Levy concerned a sale and leaseback of computer equipment;
the present case concerns the financial arrangements purporting
to undergird an employee leasing program.
Although the
relationship of sales price to fair market value and questions of
residual value are not relevant to our inquiry, the other factors
provide a useful framework for evaluating the employee leasing
and financial agreements at issue.
a.
Structure of the Financing
The structure of the financing is the most important factor
in evaluating the claimed economic substance of the employee
leasing arrangements.
The true nature of the financing was straightforward.
There
were two types of transaction that occurred in cash, and, in the
context of this case, had economic substance.
The first was the
partners' investment of cash in tax shelters.
BBPA and Machise
divided this cash between themselves.33
33
The second type of
Petitioners do not contend that the investors may deduct
this cash itself. We note that a taxpayer is not entitled to
deduct out-of-pocket cash losses under sec. 165(c)(2) arising
from a tax shelter that lacks economic substance. Mahoney v.
Commissioner, 808 F.2d 1219, 1220 (6th Cir. 1987), affg. Forseth
v. Commissioner, 85 T.C. 127 (1985); Hoffpauir v. Commissioner,
T.C. Memo. 1996-41.
- 105 substantive transaction was the payment of Machise’s cash to the
employees and independent contractors who were its service
providers.
These payments took the form of checks signed by
Machise's principals, drawn upon an account funded by Machise,
but maintained in the name of the partnership.
Petitioners contend that the transactions were much more
complicated.
And, as Fred designed them, they were very
complicated indeed.
In general terms, petitioners claim that
Machise lent millions of dollars to the partners.
The partners
then invested this money in the partnerships, which in turn
circled this money, as an "advance", back to Machise.
For the
first half of the calendar year, Machise again advanced this
money, in weekly amounts, to the partnerships.
The partnerships
then used this borrowed money to meet Machise's payroll costs.
During the second half of the calendar year, the partnerships
allegedly reimbursed Machise for the advances and continued to
meet Machise's payroll costs.
Because the partnerships had no
income of their own for the years they made these payments, they
claimed losses, which their partners deducted on their own
returns.
In subsequent years, this investment circle was reversed.
Once again, no cash changed hands.
The claimed payments took the
form only of notes or bookkeeping entries.
Machise thus
allegedly made payments to the partnerships as its compensation
fee and an additional annual late charge.
The amounts of these
- 106 payments were deemed distributed to the partners.
The partners,
in turn, were credited with making payments in these amounts on
their original loans from Machise--or from Machise through
Qulart.
These elaborate arrangements among Machise, Qulart, BBPA,
the partners, and the partnerships existed in form only.
They
were examples of the classic circle transactions that lack
economic reality, to which we have refused to give effect.
For example, in Drobny v. Commissioner, 86 T.C. 1326 (1986),
the taxpayers contributed cash and the proceeds of short-term
loans to research-and-development tax shelters.
Some $900,000 of
these amounts--allegedly deductible research and development
costs--were distributed to the bank account of a corporation
known as "Isle".
On December 27, 1979, the amounts were then
advanced to subcontractor corporations called FAL and ARL.
The
promoters of the tax shelters then used the funds to purchase
commercial debt instruments.
When, 2 weeks into the new year,
these instruments matured, the proceeds were repaid to the
taxpayers.
This Court said:
"The transactions surrounding the
circular flow of the $900,000 proceeds of the bank loans had no
substance for tax purposes".
Id. at 1346.
The taxpayers in that
case had contended that the ARL and FAL corporations could have
broken the circle and prevented the taxpayers from receiving
their repayments.
substance.
That would have been an event of economic
We disagreed with the taxpayers' argument, however,
- 107 and explained:
This argument is meritless because both corporations
were controlled by * * * [a promoter] * * *; while in
theory such interference might have occurred, it was
realistically impossible. Therefore, we conclude that
the transactions that resulted in the circular flow of
the $900,000 proceeds of the bank loans were shams
entered into solely to create the illusion of research
and experimental expenditures, while in substance
insuring that no part of such funds would be so used.
[Id. at 1346.]
In Karme v. Commissioner, 73 T.C. 1163 (1980), affd. 673
F.2d 1062 (9th Cir. 1982), the taxpayer, in an effort to reduce
his taxes, purportedly borrowed money to purchase stock in a
corporation.
The purchase would take place "if and when" a
public offering of that corporation's stock occurred.
The
resulting transactions, designed by Harry Margolis, all occurred
on December 16 and 17, 1969.
They began with the taxpayer's
borrowing $600,000 from the Union Bank in California.
That bank
then wired that amount to the account of a company named World
Minerals at Banco Popular in the Netherlands West Antilles.
The
$600,000 then moved to another account, held by an entity named
Alms, at the Banco Popular.
Alms then "loaned" that amount to
the taxpayer by transferring it to the taxpayer's Union Bank
account.
On December 17, 1969, Union Bank used the amount to
repay the taxpayer's loan.
The taxpayer wrote a check to Alms
for $60,000 as interest, but only after receiving a $50,000 loan
from another Margolis entity named Anglo-Dutch Capital.
(The
$10,000 difference was later credited to the taxpayer for his use
- 108 in an investment vehicle known as the "Karme Trust".)
The
taxpayer, however, deducted the $60,000 interest payment from his
income taxes for 1969.
On the facts of the case, we found that
the loan transaction was a sham.
We stated:
When the transfer of $600,000 from Alms to
petitioner is viewed as a part of the entire money
movement transaction, it becomes apparent that Alms was
not a true lender but was a mere conduit in the
circulation of the Union Bank loan proceeds back to
petitioner and the Union Bank. * * * [W]e believe
that no purpose, from anyone's standpoint, has been
shown for the transfer of the $600,000 from World
Minerals back to Alms. There is no reason to presume
that the World Minerals-Alms transaction was conducted
at arm's length since both entities were effectively
controlled by Margolis. * *
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