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T.C. Memo. 1991-614

UNITED STATES TAX COURT

JERRY R. AND PATRICIA A. DIXON, ET AL.,' Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 9382-83,

17640-83,

4201-84,

15907-84,

40159-84,

30010-85,

16900-83,

19321-83,

15135-84,

31236-84,

22783-85,

30965-85,

Filed December 11, 1991.

30979-85, 29643-86.

Cases of the following petitioners are consolidated

herewith: John R. and E. Maria Cravens, docket Nos. 16900-83,

15135-84; Ralph J. Rina, docket No. 17640-83; John R. and Maydee

L. Thompson, docket Nos. 19321-83, 31236-84, 30965-85; Hoyt W.

and Barbara D. Young, docket Nos. 4201-84, 22783-85, 30010-85;

Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84, 3097985; Terry D. and Gloria K. Owens, docket No. 40159-84; and

Richard and Fidella Hongsermeier, docket No. 29643-86.

SERVED

DEC 111991

226

- 2 TABLE OF CONTENTS

Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . |. 6

Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . |. 8

I. Promoter Background. . . . . . . . . . . . . . . . . . 8

II.

Kersting Corporations. . . . . . . . . . .

. . . . .10

A. Generally. . . . . . . . . . . . . . . . . . . . .10

Holding Companies and Subsidiaries .

1. Charter Financial Corporation. .

2. Investors Financial Corporation.

Acceptance Corporations. . . . . . .

. . .12

. . .16

. . i.19

Other Kersting Corporations. . . . . . . . . . . |.26

Books and Records; Tax Return Preparation. . . . |.27

D. Leasing Corporations . . . . . . . . . . . . . . .22

III.

G. Collection Litigation. . . . . . . . . . . . . . |.32

Kersting Investment Programs .

.34

A. Generally. . . . . . . . . . . . . . . . . . . . .34

B. Stock Purchase Plan. . . . . . . . . . . . . . . .43

Stock Subscription Plan. . . . . . . . . . . . . .46

Leasing Corporation Plan . . . . . . . . . . . . .53

E. CAT-FIT Plan . . . . . . . . . . . . . .. . . . . .61

F. Flow of Funds. . . . . . . . . . . . . . . . . . .66

1. Generally. . . . . . . . . . . . . . . . . . .66

Stock Purchase Plan. . . . . . . . . . . . . .68

Stock Subscription Plan. . . . . . . . . . . .69

Leasing Corporation Plan . . . . . . . . . . .71

5. CAT-FIT Plan . . . . . . . . . . . . . . . . .74

Termination of Stock Programs. . . . . . . . . . .76

Collection Activities. . . . . . . . . . . . . . .80

Notices of Deficiency. . . . . . . . . . . . . . .83

Jerry R. and Patricia A. Dixon . . . . . . . . .

John R. and E. Maria Cravens . . . . . . . . . .

Robert L. and Carolyn S. DuFresne.

Terry D. and Gloria K. Owens . . . . . . . .

Richard and Fidella Hongsermeier . . . . . .

IV. Petitioners. . . . . . . . . . . . . . . . . . . . . .83

.83

.92

C. Ralph J. Rina. . . . . . . . . . . . . . . . . . !.95

D. John R. and Maydee L. Thompson . . . . . . . . . 100

E. .Hoyt W. and Barbara D. Young . . . . . . . . . . 104

. 110

. . 116

. . 125

Opinion . . . . . . . . . . . . . . . . . . . . . . . . . . . 130

Issue 1:

Validity of Deficiency Notices . . . . . . . .

Issue 2:

04033

Section 163(a) Interest Deductions . . . . . . J35

A. Stock Programs . . .. . . . . . . . . . . . . . . 135

1. Generally. . . . . . . . . . . . . . . . . . 135

2. Sham Analysis. . . . . . . . . . . . . . . . 141

3. Subscription Agreements. . . . . . . . . . . 175

4. Primary Loans. . . . . . . . . . . . . . . . 189

5. Leverage Loans . . . . . . . . . . . . . . . 202

Other Waltz Issues . . .

Collection Litigation. .

. .

. . . 205

. . . 210

8. Summary. . . . . . . . . . . . . . . . . . . 214

B. CAT-FIT. . . . . . . . . . . . . . . . . . . . . 215

Issue 3: Income from Corporate Distributions. . . . . .

Issue 4: Owens Subchapter S Corporations, Mortgage

Funding, and Investment Expenses . . . . . . . . . . .

Issue 5: Section 163(d) Investment Interest Limitation.

Issue 6: Section 6653(a) Negligence . . . . . . . . . .

Issue 7: Section 6651(a)(1) Failure to File . . . . . .

Issue 8: Section 6661(a) Substantial Understatement . .

Issue 9: Section 6621(c) Increased Interest Rate. . . .

226

228

233

234

238

239

240

Joe Alfred Izen, ,Ir., for the petitioners in docket Nos.

9382-83, 17640-83, 4201-84, 15907-84, 40159-84, 22783-85, 3001085, 30979-85, and 29643-86.2

Luis C. DeCastro and Philip J. Hoskins, for the petitioners

in docket Nos. 19321-83, 31236-84, and 30965-85.

John R. Cravens, pro se in docket Nos. 16900-83 and 1513584.

Kenneth W. McWade, Jeffrey A. Hatfield, and Thomas A.

. Dombrowski, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GOFFE, Judge:

The Commissioner determined deficiencies in

and additions to petitioners' Federal income taxes, as follows:

Subsequent to the filing of the Court's opinion in Dixon v.

Commissioner, 90 T.C. 237 (1988), which addresses certain matters

severed from the issues herein, the Court granted the motions of

Robert J. Chicoine, Darrell D. Hallett, and Robert M. McCallum to

withdraw as counsel of record for the petitioners in docket Nos.

9382-83, 17640-83, 4201-84, 15907-84, 40159-84, 22783-85, 3001085, and 30979-85, and the motions of Robert M. McCallum and L. N.

Nevels, Jr., to withdraw as counsel of record for the petitioners

in docket No. 29643-86.

- 8 1983 are liable for the increased interest rate provided in

section 6621(c).

We previously resolved other matters relating to these

cases, concerning the issuance and execution of a search warrant,

in Dixon v. Commissioner, 90 T.C. 237 (1988).

FINDINGS OF FACT

Promoter Background

Henry Kersting (Kersting) created and administered the

investment programs at issue in these cases, and also managed

most of the participating corporations.

Born in Germany in 1923, Kersting emigrated to Canada in

1951.

Before leaving Germany, he graduated from high school,

served in the military, spent several semesters pursuing but not

attaining a college medical degree, and in 1949 married.

In 1952

or 1953, while employed as an aircraft mechanic in Toronto, he

started a mail order business that he managed until moving hi

family to Los Angeles, California, in 1959.

While there he

invested in Eastern Lenders Services, which originated Federally

approved mortgages.

Among the subjects he learned about. from

this investment were originating, warehousing, and selling

mortgages, and negotiating lines of credit.

In about 1964, he

separated from Eastern Lenders Services and invested in a savings

and loan association in Ukiah, California.

1968 and has lived there ever since.

He moved to Hawaii in

- 9 One of the first entities that Kersting incorporated while

living in Hawaii was First Atlas Funding Corporation in 1968,

which engaged in what Kersting termed a "mortgage funding"

business.

A participating investor borrowed approximately 10

times his monthly home mortgage payment from a corporation with

which Kersting was associated and invested this amount to start

the program.

Thereafter, the investor had both an investment

account and a loan account with Kersting.

For the investment

account, the investor typically supplied funds in a constant

monthly amount, and First Atlas Funding6 reported investment

results.

From the loan account, the investor borrowed monthly

amounts, approximately equal to his monthly investments, in order

to make payments on his home mortgage.

To the extent that the

balance in the investment account exceeded the balance in the

loan account, periodic printed statements informed the investor

that the overall account had a "net value."

These statements

also compared the investment earnings to the interest expenses

for "net results."

mid-1970s.

First Atlas Funding ceased operations in the

The State of Hawaii considered it involuntarily

dissolved in 1977 for failure to make required annual filings

with the State.

In 1972 or 1973, Kersting organized his first of many

automobile-leasing entities structured as subchapter S

For convenience, corporations with name endings such as

"Corporation," "Inc.," "Co.," or "Ltd." will often be referred to

without the ending after the first reference.

- 10 corporations.

Prior.to organizing this corporation, he had no

direct experience in the leasing business, having only read about

it.

Over the next few years, this corporation leased 8 to 10

automobiles.7

Kersting's involvement with subchapter S leasing

corporations was considered by this Court in some detail in Pike

v. Commissioner, 78 T.C. 822 (1982), affd. without published !

opinion 732 F.2d 164 (9th Cir. 1984).

Kersting has had no formal education or specialized training

in either business or law.

He and his wife, Ute Charlotte

Kersting (Ute Kersting), have four children, including two

daughters whose married names are Gabriele LeMond and Heidi

Moseley.

II.

Kersting Corporations

Generally

References herein to "Kersting corporations" are to

corporations that participated in the investment programs

Kersting oversaw during the years at issue.

He served as both a

director and president of most of these corporations and also

sometimes owned stock.

For those corporations in which he served

as president during the years at issue, he had exclusive

"Lease" as a verb in ordinary usage can refer to what the

lessor does or what the lessee does. As we use the term herein,

a corporation that "leases" is a lessor and an individual who

"leases" is a lessee.

The "years at issue" outside of part IV of these findings

are 1975 through 1983. The "years at issue" within part IV are

the years before the Court for the particular petitioner or

petitioners being discussed.

management authority.

His administrative assistant and secretary

throughout these years was Sherrill Pang (Ms. Pang)? who knew

nearly as much as he did about the workings of his investment

programs.

Ms. Pang, who was heavily involved in the day-to-day

clerical tasks associated with those programs, worked under

Kersting's managerial control.

For most of the Kersting corporations, Ute Kersting was an

incorporator, an officer, a director, or some combination.

She

did not, however, play any meaningful active role in management

or operations.

Heidi Kersting had a similar status and

eventually asked her father to stop using her name on corporate

documents.

Gabriele Kersting did some work related to the

investment programs, at least to the extent of corresponding with

investors on occasion.

Most of the Kersting corporations most of the time had

Hawaii offices located together, with one benefit being minimized

expenses.

These offices contained the normal trappings of a

business office, including desks, telephones, and personnel.

given clerical worker generally performed duties for any of

several corporations depending upon where the need was at the

time.

The Kersting corporations did not each maintain a separate

file for a given investment transaction, but instead shared a

file that was referenced by the name of the investor and one of

the corporations involved in the transaction.

Throughout the years at issue, at least some of the Kersting

corporations solicited proxies from shareholders.and, in

- 12 -

combination rather than separately, held shareholders meetings

that Kersting attended.

Kersting generally held a sufficient

number of proxies from shareholders to take the actions he

desired regardless of how the attending shareholders voted.

Although Kersting announced and attended shareholders meetings

after 1981, he never prepared corporate minutes of these later-

year meetings.

The Kersting corporations did not prepare annual reports

during the years at issue, and there was no active market for

their stock.

Kersting did not participate in any public

offerings of stock during this time.

Holding Companies and Subsidiaries

Charter Financial Corporation

Kersting organized Kershwin, Ltd., in the 1950s while living

in Toronto.

The shareholders during the years at issue were his

four children and a trust for their benefit.

In the early 1970s,

Kershwin, Ltd., acquired most of the stock of Confidential

Finance Company, Ltd., which had been incorporated in Hawaii in

1959.

Confidential Finance had been an industrial loan company

that dealt primarily with local people in Hawaii, and, with

Kersting now the president, activity relating to outstanding

loans continued.

Kersting was initially both a director and the president of

Colt Financial Corporation, which was incorporated in Hawaii in

1975 with Confidential Finance subscribing for the initial

shares.

Ms. Pang was also an initial director and officer.

- 13 -

After a transaction involving exchanges of stock, Kershwin, Ltd.,

became the direct owner of about 80 percent of the Colt Financial

stock, an interest that was first diluted over the years by the

addition of new shareholders and then eventually sold.

Also as a

result of the exchange transaction, Confidential Finance became a

subsidiary of Colt Financial, which in 1976 changed its name to

Charter Financial Corporation.

Kersting acquired the outstanding stock and became a

director of Carey Trading Inc., a Nevada corporation that changed

its name in 1980 to Charter Financial Corporation.

This new

Charter Financial Corporation took over the activities of its

Hawaii namesake, and, without corporate formalities or the

issuance of new stock, Kersting began to treat the shareholders

of the Charter Financial incorporated in Hawaii as shareholders

of the Charter Financial incorporated in Nevada.9

He was a

director and the president of Charter Financial (Nevada) through

the last year at issue.

During this period, Ute Kersting was a

director and both she and Ms. Pang were officers.

Confidential Finance changed its name to Federated Finance

Co., Ltd., in 1976, at which time Kersting was the president and

Ute Kersting held the office of secretary.

The State of Hawaii

granted the renamed corporation an industrial loan business

We sometimes distinguish these entities and others by

parenthetical reference to the State of incorporation, such as

Charter Financial (Hawaii) and Charter Financial (Nevada).

References without State designation are general and not directed

specifically toward either.

- 14 -

license in July of that year.

In May of 1978, Federated Finance

Co. Inc. was incorporated in Nevada.

Kersting was an

incorporator, an initial director, and through the last year at

issue the president of Federated Finance (Nevada).

Ms. Pang and

Heidi Kersting were the other incorporators and initial

directors, and Ms. Pang and Ute Kersting were the other officërs

during this time.

At least most of the lending activity of

Federated Finance (Nevada) consisted of loans to airline pilots

to facilitate their purchases of stock.

Federated Finance (Hawaii) at some point voluntarily

surrendered its industrial loan business license, which the State

of Hawaii then canceled in late 1981.

Sometime before this, with

the exception of outstanding loans owed to and retained by

Federated Finance (Hawaii), the principal activities of that

corporation, including the making of loans for stock purchases,

shifted to Federated Finance (Nevada).

Although Federated

Finance (Hawaii) never formally liquidated, the State of Hawaii

considered the corporation involuntarily dissolved in December of

1983 for failure to make required filings with the State.

In about 1975, the president of Cosmopolitan Financial

Corporation, a widely held Hawaii corporation engaged primarily

in factoring accounts receivable, discussed with Kersting the

possibility of selling the corporation.

Confidential Finance

soon acquired most of the Cosmopolitan Financial stock through a

tender offer, and in 1976 Cosmopolitan Financial changed its name

to Federal Finance & Mortgage Ltd.

Federal Finance & Mortgage

- 15 sometimes made loans to pilots, but it was mainly a licensed

industrial loan company involved in factoring accounts

receivable.

It was not a regular participant in the Kersting

investment programs that are the subject of the instant cases.

Kersting was an officer and director of Federal Finance &

Mortgage for several years, and exercised management control, but

he left these positions near the end of or after the years at

issue.

Federated Finance (Hawaii) was wholly owned by Charter

Financial during the years at issue, and Charter Financial

conducted no significant business other than as a holding

company.

Federated Finance (Nevada) was wholly owned by either

Charter Financial or Federated Finance (Hawaii) during this time.

At least from 1978 through 1981, Federated Finance (Hawaii) and

Charter Financial owned 75 percent or more of the Federal Finance

& Mortgage stock.

At the end of 1983, a wholly owned subsidiary

of Charter Financial named Quintana Investments, Inc., owned 89

percent of the Federal Finance & Mortgage common stock.

Although most of the eventual Charter Financial shareholders

were airline pilots, not all were.

example, was a shareholder.

Kersting himself, for

Even the nonpilots, however,

generally acquired their shares the same way the pilots did, as

part of a Kersting investment program.

An exception was Denis

Alexander (Alexander), a broker and investor who knew that

Charter Financial was a holding company.

Throughout the years at

issue, he held over 100,000 shares indirectly acquired in the

- 16 mid-1970s.

He had lent over $100,000 to assist in the

acquisition of Cosmopolitan Financial, and this creditor's

interest evolved into his stock interest in Charter Financial.

As of December 30, 1988, Charter Financial, as common parent

of an affiliated group, had filed consolidated Federal income tax

returns for calendar years 1976, 1978, and 1979, but had filedi no

returns for 1977 or 1980 through 1983.

2. Investors Financial Corporation

Kersting and Alexander first met in Los Angeles in the early

1960s.

Alexander, who moved to Hawaii in 1964, lent $80,000 to

Kersting's subchapter S leasing corporations during the 1970s,

which he understood would be used to purchase automobiles.

The

two met in about 1977 to discuss the possible acquisition of

First Savings and Loan Association (First Savings) in Honolulu,

Hawaii, a State-chartered and Federally insured institution.

Alexander was a minority shareholder of First Savings and

acquainted with the majority shareholder.

Kersting and Alexander eventually arranged for the

acquisition of most of the stock of First Savings, with 40-some

Kersting clients (including petitioner John R. Thompson) becoming

shareholders.

Alexander, who expected First Savings to profit

from its real estate loans, joined the acquiring group and thus

added to his First Savings stockholdings.

The total cost to the

acquiring group was approximately $2.8 million, with about $1

million of that amount paid in cash.

The remaining $1.8 million

was borrowed from First Hawaiian Bank, which required a pledge of

- 17 -

the First Savings stock as security.

Charter Financial was a

guarantor on this loan, and Kersting corporations rather than the

individual investors paid at least some of the interest.

Kersting was an incorporator, an initial director, and the

initial president of Investors Financial Corporation, which was

incorporated in Nevada in April of 1978, the month after the

acquisition of First Savings.

Ms. Pang and Heidi Kersting were

the other incorporators and initial directors.

Kersting arranged

for the members of the First Savings acquiring group to

relinquish their stock in First Savings and become shareholders

of Investors Financial, which was to be a holding company for

First Savings.

Investors Financial later began to sell its stock

to other people than those in the First Savings acquiring group,

including some of petitioners, thereby diluting the interests of

the acquiring group.

shareholders.

In 1980 Investors Financial had over 200

Although Investors Financial applied to Federal

banking authorities to be approved as a holding company for First

Savings, those authorities never approved the application.

Michael Provan was the president of Investors Financial from

1978 into 1982.

into 1980.

Alexander was an officer, a director, or both

For at least some parts of 1978 and 1979, Kersting

was neither an officer nor a director.

served as secretary/treasurer.

Beginning in 1980, he

He became the president in 1982

and continued at least through 1983, during which time the other

officers included Ms. Pang and Ute Kersting.

- 18 -

Sometime prior to February of 1980, during a period of

sharply rising interest rates, Federal banking authorities

determined that First Savings should be merged with another

institution.

The banking authorities forced a merger with First

Federal Savings of Honolulu in February of 1980, which terminated

the stock interest of Investors Financial in First Savings.

Although the initial arrangement was for First Federal Savings to

assume the liabilities of First Savings and to purchase the

assets at a price somewhat above the audited net worth, First

Federal Savings ultimately paid nothing to First Savings.

Shortly after the forced merger, Federal banking authorities

and First Hawaiian Bank commenced a lawsuit against Mortgage

Guarantee Insurance Corp. based upon a First Savings director

and-officer policy.

Most members of the First Savings acquiring

group assigned their interests in the litigation to First

Hawaiian Bank, which agreed to release them from their

obligations on the First Savings stock acquisition indebtedness.

The parties eventually settled.

Much of the over $3-million

recovery went to First Hawaiian Bank and attorneys, but none óf

it went to the First Savings acquiring group or Investors

Financial.

Almost all members of the First Savings acquiring

group eventually recouped their original cash investments from

Kersting, who used Charter Financial funds.

At the time of the forced merger, the only significant asset

of Investors Financial was its stock interest in First Savings.

Investors Financial has not acquired any additional significant

- 19 assets since then.

As of December 30, 1988, Investors Financial

had filed Federal income tax returns for its taxable years ending

in 1978 and 1980, 442

but for no years since.

Acceptance Corporations

The word "Acceptance" in the name of a Kersting corporation

indicated that it was not licensed by the State of Hawaii, which

did require licenses for certain types of lending institutions

such as commercial banks and savings and loan institutions.

Kersting acceptance corporations did not actively solicit

business from the general public, but instead engaged in lending

activity directed primarily at airline pilots.

For each of the following entities, incorporated in Nevada

in the year parenthetically indicated, Kersting was an

incorporator, an initial director, and throughout the years of

corporate existence that coincide with the years at issue the

president of the corporation:

Forbes Acceptance Corporation

(1976), Fargo Acceptance Corporation (1977), Candace Acceptance

Corporation (1978), Mahalo Acceptance Corporation (1978), Windsor

Acceptance Corporation (1978), Delta Acceptance Corporation

(1979), Avalon Acceptance Corporation (1980), and Lombard

Acceptance Corporation (1982).

The Fargo Acceptance

incorporators signed the Certificate of Incorporation on

March 11, 1977, and filed it with the State of Nevada on

March 17, 1977.

Investors Financial, like most of the other Kersting

corporations, used a noncalendar taxable·year.

- 20 -

The other two incorporators and initial directors of these

acceptance corporations were, with one exception, Ms. Pang and

either Ute or Heidi Kersting.

The exception was Larry Rinaldis,

who, along with Kersting and Ms. Pang, was an incorporator and

initial director of Forbes Acceptance.

Rinaldis structured

leases for Kersting's subchapter S leasing corporations.

The

other officers of these acceptance corporations throughout the

years at issue were, with two exceptions, Ms. Pang and Ute

Kersting.

Rinaldis was an officer of Forbes Acceptance until Ute

Kersting replaced him in 1977.

Gabriele Kersting was an officer

of Fargo Acceptance until Ute Kersting replaced her in 1977 or

1978.

Kersting was also a director and the president of Aztec

Acceptance Corporation, which was incorporated in Nevada in the

late 1970s or early 1980s.

Prior to the Nevada incorporation of Windsor Acceptance

Corporation in 1978, Windsor Acceptance Corporation Ltd. had been

incorporated in Hawaii in 1974 with Kersting's mother-in-law as

the initial shareholder.

The initial officers and directors had

been Kersting and his two daughters.

Without consideration of or

adherence to legal formalities, Kersting considered the

corporation shifted from Hawaii to Nevada in 1978.

Norwick Acceptance Corporation was incorporated in Nevada

under another name, Mendocino Financial Corporation, in 1966.

Kersting was an incorporator, an initial director, and the

initial president of Mendocino Financial.

The name change to

- 21 Norwick Acceptance Corporation was filed with the State of Nevada

in 1979, but an entity calling itself Norwick Acceptance engaged

in transactions well before that time in connection with

Kersting's subchapter S leasing corporations.

Kersting was the

president of Mendocino Financial/Norwick Acceptance during all of

the years at issue.

Ute Kersting was also an officer throughout

this period, as was Ms. Pang beginning in 1976.

Except for Windsor Acceptance and Norwick Acceptance, the

shareholders of each of the acceptance corporations were

predominantly or entirely airline pilots.

Although Kersting

required a pilot who became a shareholder to execute what was in

form a subscription agreement for the purchase of additional

stock, the acceptance corporation never issued the additional

stock to the shareholder or otherwise sought to consummate the

stock purchase transaction called for by the agreement.

Sometime after 1981, Kersting authored a form letter'2 to

investors that began as follows:

If you have been with us over the years you will

have noticed that we have organized by now eight

Acceptance Companies. We will list below in which of

these companies you became an investor and shareholder.

All of these companies were structured to make a

profit after a reasonable start-up period. This, in

turn, assured the profit motive which the IRS expects

of you when you engage in investments and the prospects

of taxable income or gains. All of your companies are

Pike v. Commissioner, 78 T.C. 822, 845 & n.36 (1982), affd.

without published opinion 732 F.2d 164 (9th Cir. 1984).

A "form letter" is a typed letter with a general "Dear

Friend" or "Dear Friends" salutation rather than a personalized

one.

- 22 operating and money making entities today. The stock

which you initially purchased has increased in value

intrinsically which, I trust, will some day be

reflected in a market price in excess of your

acquisition cost.

As it would be impractical to take each of the

Acceptance Companies public separately we decided years

ago to combine all of the companies in a Financial

Holding Company * * *

Kersting then discussed the mechanics of exchanging acceptance

corporation stock for the stock of the proposed holding company,

Escon Financial Corporation.

As of December 30, 1988, Federal income tax returns had not

been filed by Avalon Acceptance, Forbes Acceptance, and Lombard

Acceptance for any taxable year that overlaps the years at issue.

Four other acceptance corporations had filed the following

returns on September 25, 1985, for taxable years ending as

indicated, but no other returns that overlap the years at issùe:

Fargo Acceptance for 1977 and 1978, Mahalo Acceptance for 1978

and 1979, Candace Acceptance for 1979 and 1980, and Delta

Acceptance for 1980 and 1981.

Kersting signed each of these

eight returns on September 10, 1985.

Although Fargo Acceptance

reported a tax liability of over $30,000 on its initial return

for a short taxable year ending in 1977, it has made no payments

on this liability.

Leasing Corporations

Kersting was the initial president and an initial director

of Aztec Leasing Inc., which filed articles of association with

the State of Hawaii on October 1, 1974, and Maurier Leasing Inc.,

- 23 which made a similar filing on December 2, 1974.

The other

initial officers and directors of these two corporations were

Gabriele Kersting and Heidi Kersting.

All or almost all of the

leasing activities of these corporations were with their

respective shareholders.

Aztec Leasing filed a U.S. Small Business Corporation Income

Tax Return (Form 1120S) for calendar year 1975 that indicated

December 1, 1974, as its date of election as a small business

corporation.

Maurier Leasing also filed a Form 1120S for

calendar year 1975, which indicated March 15, 1975, as its date

of election.

Aztec Leasing and Maurier Leasing were abandoned as

corporate entities in part due to Internal Revenue Service (IRS)

audit challenges and in part due to the cumbersome administrative

tasks attributable to the large number of Kersting's subchapter S

corporations.

The first Kersting leasing corporation for which subchapter

S status was not sought was Universal Leasing Corporation,

incorporated in Nevada in 1976.

Kersting, who intended

Universal Leasing to replace the several subchapter S leasing

corporations, had the leases transferred from the subchapter S

corporations to Universal Leasing.

Anseth Leasing, Inc., and

Although both names appear on documents in the record,

Universal Leasing Corporation and Universal Corporation are the

same entity.

- 24 -

Escon Leasing Corporation were incorporated in Nevada in 1977.

The Escon Leasing incorporators signed the Certificate of

Incorporation on February 4, 1977, and filed it with the State of

Nevada on February 11, 1977.

Kersting was an incorporator, an initial director, and

through the last year at issue the president of Universal

Leasing, Anseth Leasing, and Escon Leasing.

For Anseth Leasing

and Escon Leasing, the other two incorporators and initial

directors were Ms. Pang and Heidi Kersting, and the other

officers throughout these years were Ms. Pang and Ute Kersting.

Ms. Pang was also an incorporator, an initial director, and an

officer of Universal Leasing.

All three leasing corporations engaged in the business of

automobile leasing, primarily to pilots, and Universal Leasing

also leased other items such as boats and aircraft.

They did not

advertise, employ salespersons, or otherwise actively solicit a

substantial amount of business from the general public.

From its

inception, however, Universal Leasing leased some automobiles to

businesses, as did Anseth Leasing and Escon Leasing in 1980 and

following years.

Kersting's duties included structuring leases,

negotiating purchases and trade-ins of automobiles, monitoring

leasing revenue, and ensuring that the residual values of the

automobiles would be realized.

Unless otherwise indicated, a reference hereinafter to an

unspecified "leasing corporation" or "leasing corporations" is to

one or more of the three non-subchapter S corporations described

in this part II (D).

- 25 The leasing corporations, which annually filed corporate

exhibits with the State of Nevada listing officers and directors,

registered to do business in Hawaii as foreign corporations in

October of 1982.

They repossessed automobiles occasionally and

had dealings with General Motors Acceptance Corp. (GMAC).

For 1977 and following years, Hawaii registration and

ownership certificates that show Escon Leasing as the registered

owner of automobiles also often show Federal Finance & Mortgage

or GMAC as the "legal owner or lien holder."

During this period,

Hawaii registration certificates that show Universal Leasing as

the registered owner show as the "legal owner or lien holder,"

among others, Universal Leasing itself, Federal Finance &

Mortgage, and Federated Finance (Hawaii).

Although Kersting's family-owned corporation, Kershwin,

Ltd., initially subscribed for Universal Leasing stock, new

shareholders, who were airline pilots, gradually replaced it.

The shareholders of Anseth Leasing and Escon Leasing were also,

for the most part, pilots, although beginning in 1978 or 1979

Universal Leasing held a $5,000 stock interest in Anseth Leasing.

Universal Leasing also had a $240,000 investment in Mahalo

Acceptance and a $120,000 investment in Investors Financial that

began at this time.

On September 25, 1985, Anseth Leasing filed Federal income

tax returns for its taxable years ending in 1977 through 1979 and

1981 through 1984.

On the same date, Escon Leasing filed returns

for its taxable years ending in 1977 through 1984.

Kersting had

- 26 -

signed all of these returns for the two leasing corporations on

September 10, 1985.

Although Universal Leasing filed a return in

each of 1979 and 1981 for taxable years ending in 1977 and 1978,

respectively, it did not file returns for its taxable years

ending in 1979 and following until 1985 or later.

Other Kersting Corporations

Atlas Funding Corporation, which made loans primarily to

pilots, was incorporated in Nevada in 1976.

Kersting was an

incorporator, an initial director, and the president through the

last year at issue.

initial director.

Ms. Pang was also an incorporator and

From July of 1977, Ms. Pang and Ute Kersting

were the only other officers.. Kershwin, Ltd., was the initial

stock subscriber and remained the sole shareholder.

As of

December 30, 1988, Atlas Funding had not filed a Federal income

tax return for any taxable year other than that ending in 1976.

Atlas Guarantee Corporation issued interest-bearing

investment certificates as part of the Kersting investment

program called "CAT-FIT," described in part III (E), below.

Kersting and Ute Kersting owned all of the stock.

Ventures Funding Corporation, which became inactive before

the mid-1980s, was incorporated in Nevada in 1978 and made loans

for the purchase of stock in other Kersting corporations.

Kersting was an incorporator, an initial director, and throughout

its active existence the president of the corporation.

The other

incorporators and initial directors were Ms. Pang and Ute

Kersting, both of whom were also officers from 1981 through 1983.

- 27 No one outside of the immediate family of pilot Leon Lipsky, who

was a corporate officer from 1978 to 1981, ever owned stock in

Ventures Funding.

As of January 6, 1989, Ventures Funding had

not filed a Federal income tax return for any year.

Books and Records; Tax Return Preparation

Alice Combs was a bookkeeper, but not a certified public

accountant, from 1942 until her retirement in 1983.

She met

Kersting through her employer shortly before becoming selfemployed in 1971, and she eventually began to keep the books for

some Kersting corporations.

She and her daughter, Margo Akamine,

were both self-employed as bookkeepers in the same office space

in the mid-1970s when Ms. Akamine began to assist her mother with

Kersting's subchapter S corporations.

The women incorporated a

bookkeeping. business in 1980, and when Ms. Combs retired in 1983,

Ms. Akamine continued to perform bookkeeping duties for Kersting

corporations.

Ms. Combs and Ms. Akamine did not keep the books for all of

the Kersting corporations.

Ms. Akamine did no such work, for

example, for Ventures Funding or Windsor Acceptance, and neither

woman did such work for Norwick Acceptance or Atlas Funding.

Federal Finance & Mortgage used its own in-house accountant and

hired outside certified public accountants to prepare audited

financial statements.

The women generated manual journals and ledgers in a doubleentry bookkeeping system, primarily from bank statements and

canceled checks.

Among the records they maintained were accounts

- 28 -

receivable and related subsidiary accounts for the leasing and

acceptance corporations, which accounts corresponded to a list of

promissory notes supplied by the Kersting offices.

The

subsidiary accounts were eventually computerized.

Ms. Combs did

not keep a stock record book per se, but she attempted to keep

records of Kersting's investors by means of general ledger

accounts such as accounts receivable, notes receivable, and

capital stock.

She was not aware of direct transfers of stock

from shareholders to other individuals.

At some point she

suggested to Ms. Pang that better stock records should be kept.

The women prepared financial statements (balance sheets and

profit-and-loss statements) at Kersting's request and not on a

regular monthly or quarterly basis.

He usually requested

financial statements, which were always done by hand rather than

on a computer, at least once a year.

The women also prepared

Federal income tax returns for Kersting corporations, again when

instructed by Kersting, and by 1976 Ms. Combs was experienced in

preparing consolidated returns.

They did not always prepare tax

returns annually, and Ms. Akamine was never certain whether the

returns she prepared were actually filed with the IRS.15

However, as far as Ms. Combs knew, Kersting and his associates

did not alter the tax returns or bookkeeping work she submitted.

The record contains some prepared and signed corporate tax

returns that were not filed with the IRS. In describing return

contents, we refer to both filed and unfiled returns.

- 29 For those acceptance and leasing corporations with

outstanding subscription agreements applicable to their stock,

Kersting often instructed Ms. Akamine to treat the interest

received under those agreements as deferred and thus to exclude

it from current taxable income.

Among the returns that show a

Schedule M adjustment reducing book income for deferred

subscription interest are the following, for taxable years ending

as indicated:

Fargo Acceptance for 1978, Mahalo Acceptance for

1978 and 1979, Candace Acceptance for 1979 and 1980, Delta

Acceptance for 1980 and 1981, Avalon Acceptance for 1981 and

1982, Anseth Leasing for 1977 through 1979 and 1981 through 1984,

and.Escon Leasing for 1977 through 1984.

For at least most of

these corporations, the deferred amounts were not reported as

taxable income in following years.

Based upon her experience with a public accounting firm, Ms.

Combs believed that a 2-percent bad debt reserve, measured

against outstanding receivables, was appropriate for the Kersting

corporations.

Ms. Akamine had been taught in a bookkeeping class

that 1 or 2 percent was an appropriate bad debt reserve figure,

although she had no training relating specifically to reserves in

the tax shelter area.

Kersting told the women that 20 to 25

percent, or higher, was not inappropriate for the corporations.

He directed them generally to set up reserves that would offset

taxable income not otherwise offset by items such as net

operating loss carryforwards.

For corporations with taxable

- 30 -

years ending as indicated, yearend bad debt reserves as a

percentage of accounts receivable were as follows:

Fargo Acceptance

1978

30%

Mahalo Acceptance

1978, 1979

25%

Candace Acceptance

1979, 1980

25%

Delta Acceptance

. 1980, 1981

20%

Universal Leasing

1977

1978

1979

1981

1982

1983

1984

1985

22%

29%

40%

45%

51%

67%

72%

92%

Ms. Combs and Ms. Akamine kept the Kersting records in their

office, which was at a different location than the Kersting

offices.

As detailed in Dixon v. Commissioner, 90 T.C. 237

(1988), Kersting was under criminal investigation when the IRS

executed a search warrant at his offices on January 22, 1981, and

seized voluminous records.

The IRS did not, however, take any

Kersting records from the bookkeepers.

Their work was therefore

largely unaffected, except occasionally when the Kersting offices

informed one of them that the documents she was requesting had

been taken by the IRS.

Neither woman ever thought that anything

she requested from the Kersting offices was intentionally

withheld.

Kersting sent a form letter to clients dated February 15,

1981, in which he began:

Here at last are the tax reporting notices which

we would have mailed to you in January had it not been

for the IRS raid at our offices. I regret very much

- 31 the delay by which these notices will be received by

you.

The IRS accomplished only a temporary disruption

of our operations. We are back today to almost normal

workings, but the shock and distaste will last for a

while.

In a May 30, 1981, form letter devoted largely to this IRS

"raid," Kersting wrote:

Over the weeks which have elapsed since the Raid,

all of the Promissory Notes which are our most valuable

asset have been returned to us. We have made copies of

. all of our records which we need to keep track of our

042

accounts receivable and -payable. It has allowed us to

return to normalcy of operations. * * *

The IRS returned the bulk of the seized Kersting records

beginning in late 1985 or early 1986.

Ms. Akamine prepared only one return for a Kersting

corporation in which she reported significant net taxable income.

This was the Fargo Acceptance initial return for the short

taxable year from March 17, 1977, through June 30, 1977, with

reported interest income of $91,200 and no deductions.

On the

Schedule L balance sheet, she recorded $91,200 as an investment

in Charter Financial and as unappropriated retained earnings, but

she recorded no capital stock amount.

No other acceptance

corporation reported significant net taxable income in returns

corresponding to the years at issue.

Unlike the initial return

of Fargo Acceptance, other initial returns of acceptance

corporations included a bad debt reserve, a Schedule M adjustment

for deferred subscription interest, or both.

- 32 Ms. Akamine generally did not sign the returns she prepared

for Kersting because she was not comfortable with some of the

things he asked the women to do.

In anticipation of selling her

bookkeeping business, she prepared many returns for Kersting

corporations during 1984.

She sold her business in 1985 in part

because Kersting was considering some transactions that she did

not feel comfortable recording.

One such transaction was a

consolidation of several corporations.

Kersting was prompted to

consider these transactions because the bad debt reserves

intended to offset income were so high compared to outstanding

accounts receivable.

By letter dated December 2, 1981, and addressed to an IRS

revenue agent who had sought certain corporate tax returns,

Kersting wrote:

We have held back over the years the Tax Returns

for the Acceptance Companies and some of the Leasing

Companies as we expect that the decision Judge Drennen

of the United States Tax Court is to render will have a

material effect on all of these companies. You will

recall that Norwick Acceptance Company was at issue in

the US Tax Court proceedings and to some extent

Universal Leasing Corporation.

Collection Litigation

For lending and leasing matters originating during the years

at issue but not relating directly to the Kersting investment

programs, Kersting corporations sometimes sought relief in Hawaii

State court.

Delta Acceptance filed a complaint on March 16, 1983, based

upon an $8,000 promissory note with a 1982 date, and obtained a

- 33 default judgment in November 1983.

Fargo Acceptance filed a

complaint on May 12, 1986, based upon a $7,560 promissory note

with a 1982 date.

The court dismissed this case in January 1987

for lack of valid service on the defendant.

Universal Leasing filed a complaint on May 20, 1982, based

upon alleged unpaid lease obligations, and the court granted its

motion for summary judgment in September 1984.

Escon Leasing

filed a complaint on June 23, 1983, based upon alleged unpaid

lease obligations, and obtained a default judgment in December

1983.

Anseth Leasing filed complaints on July 6, 1983, and

June 4, 1986, also based upon alleged unpaid lease amounts.

The

court dismissed the first case for want of prosecution in May

1984, and the second resulted in default judgments against the

defendants in November 1986.

Atlas Funding filed a complaint on June 6, 1983, based upon

a $13,440 promissory note with a 1980 date in favor of Delta

Acceptance.

The court entered judgment for Atlas Funding after a

hearing in October 1983.

As an assignee of Charter Financial,

Atlas Funding filed a complaint on March 8, 1984, based upon a

$22,000 promissory note with a 1981 date in favor of Charter

Financial.

Atlas Funding alleged that this amount had been lent

to Larry Rinaldis to cover a margin call on a brokerage account.

- 34 III.

Kersting Investment Programs

Generally

Most of Kersting's investors, or clients, first heard about

him and his investment programs by word-of-mouth from those

already involved.

He sometimes asked satisfied clients to

introduce him to friends who might need tax assistance.

He also

paid a few "contact men," such as pilots Michael Provan and

Robert Campbell at Continental Airlines, Inc.

(Continental), to

tell other pilots about the basic structure of the transactions

and to encourage them to call or visit Kersting.

Sometimes an

accountant, such as Robert Knapp of Memphis, Tennessee,

recommended to clients that they contact Kersting about his

programs.

Kersting was particularly interested in pilots,

largely because of their high incomes.

Kersting never registered with the Securities and Exchange

Commission, the State of Hawaii, or the State of Nevada any of

the stock sold through his investment programs.

He met with a

Securities and Exchange Commission attorney in California in the

mid-1970s and also spoke on occasion with the Hawaii Corporations

Commissioner, discussing registration requirements with both men.

He never took the procedural steps necessary, however, to

determine formally whether registration was required under either

Federal or State law.

Kersting treated the stock as subject to a private offering

exemption and never prepared any prospectuses.

In a letter dated

- 35 -

November 12, 1980, he described factors he considered important

to exempt status:

As we discussed we are walking on a very fine line

separating us from offering securities publicly. We

have claimed an exemption from registration over the

years on the grounds that we are meeting the tests for

offering securites [sic] without registration, i.e.

that we are dealing with sophisticated investors, that

everyone of our clients has a net worth in excess of

$75,000.00 and that we do NOT SELL ANYTHING AND DO NOT

ASK FOR ANY INVESTMENT, supported by the fact that we

do not engage brokers or salespeople to whom sales

commissions would be paid.

If we were to advertise our services or offer our

services by direct mail we would place the above

mentioned premise in jeopardy. It is important that we

observe that.

Kersting also operated on the premise that registration was

not required for shares of a given corporation if those shares

were offered to existing shareholders of that corporation.

Thus,

he sometimes had an acceptance corporation distribute to a

shareholder a small amount of stock of a second acceptance

corporation, commonly 100 shares, thereby making the investor a

shareholder of the second corporation and setting the stage for

an "exempt" offering of much more stock of the second corporation

during the upcoming year.

The stock subscription agreements used by Kersting,

discussed in more detail below in connection with the specific

investment programs, included representations by the investor

that he was acquiring the subscribed stock for investment

purposes rather than for resale and not as a representative of

- 36 someone else.

An investor made no such representations, however,

for stock purchases not tied to the subscription agreements.

Although a potential investor sometimes met with Kersting in

his Hawaii offices, the first contact for many was by telephone

or letter.

Prior to starting someone in one of his programs,

Kersting questioned him about his general financial situation.

Because of Kersting's largely homogeneous client base and the

relatively standardized salary scales within an airline, he often

knew the prospect's approximate salary even before being told.

He rarely if ever asked for an application form or financial

statements, and credit checks were also rare or nonexistent.

Because he was aware of the grounds for certain IRS audit

challenges to his programs, he sometimes informed a prospect that

he had to have a profit motive.

He never mentioned, however,

that there would be ongoing profits in the form of normal

corporate dividends.

He always discussed anticipated tax

benefits and often sent a pilot the. documents associated with an

investment program so he could examine them before deciding

whether to participate.

Although Kersting sometimes jotted down

some notes while talking to a prospect, he discarded them by the

time participation in his programs commenced.

For those who agreed to participate in one or more of his

programs, Kersting often recommended specific accountants the

investors should consider using to prepare their tax returns.

These included Gilbert Matsumoto, Earl LeMond, and enrolled agent

Philip Scheff.

Matsumoto, who had been the accountant for

- 37 -

Confidential Finance when Kersting became its president in the

early 1970s, had later become the accountant for some of

Kersting's subchapter S leasing corporations.

The four main types of Kersting investment programs under

consideration in these cases will be referred to as a Stock

Purchase Plan, a Stock Subscription Plan, a Leasing Corporation

Plan, and a CAT-FIT Plan.

All involved both "primary" loans and

notes and "leverage" loans and notes with Kersting

corporations.

These notes, along with other investment

initiating documents, sometimes bore a date that was long before

the date on which the documents were actually executed and even

before the date on which the investor informed Kersting he was

ready to commence that investment program.

A primary loan supplied the funds with which the investor

purchased either stock of a Kersting corporation or, in the case

of the CAT-FIT Plan, an investment certificate.

A leverage loan,

almost always made by an acceptance corporation, generally

supplied the funds with which the investor paid interest on the

primary loan and, if applicable, interest on an unpaid

subscription balance.

Sometimes leverage loans, in years after

Although the usual function of a note is to document a

lending transaction, the note and loan must sometimes be

distinguished. Under the Uniform Commercial Code, for example, a

negotiable note and its underlying obligation can be

independently actionable. U.C.C. sec. 3-310(b) (1990).

Nonetheless, because the parties do not attempt to differentiate

between the notes and their underlying obligations in the context

of these transactions, we likewise generally assume only one

obligation, except In our more precise descriptions of collection

litigation undertaken by Kersting corporations.

- 38 the investor's first year in a program, supplied the funds to pay

off an outstanding leverage loan.

In correspondence with

investors and in summary schedules he prepared for their benefit,

Kersting often referred to the amount payable as interest on a

leverage loan as a "fee" or as a deductible "cost" of interest

deductions.

Primary notes (and leverage notes used in the Leasing

Corporation Plan) were detailed, preprinted forms entitled "Note

and Security Agreement" and containing appropriate blanks to be

filled in.

When completed and executed, these notes did not

describe any collateral in the space so designated on the form,

nor did they call for interest to be prepaid annually.

considered the loans to be unsecured.

Kersting

Beginning in late 1979,

the designated space for a description of collateral usually

contained a typed-in statement that the note was nonnegotiable

and nonassignable.

Leverage loans (except for those used in the

Leasing Corporation Plan) were commonly documented with much

shorter and simpler promissory note forms that made no mention of

collateral, negotiability, or assignability.

Both types of

notes, primary and leverage, were in form recourse."

The primary lender in a Kersting investment program was,

except for the very early years, a different Kersting corporation

In the early years of Kersting's investment programs, these

loans were nonrecourse. The sec. 465 at-risk provisions, added

to the Internal Revenue Code by the Tax Reform Act of 1976, Pub.

L. 94-455, sec. 204,. 90 Stat. 1520, 1531-1532, caused Kersting to

make the change from nonrecourse to recourse.

- 39 than the leverage lender.

In Battelstein v. Internal Revenue

Service, 611 F.2d 1033 (5th Cir. 1980), on rehearing en banc 631

F.2d 1182 (5th Cir. 1980), the court concluded that interest

deductions were not allowable to taxpayers who had exchanged

checks with their lender in the amount of the interest due.

When

asked by a concerned client about the implications of the

analysis by the Court of Appeals, Kersting replied by letter

dated January 11, 1981:

042

There seems to be a fundamental distinction

between the moves attributed to the Battlesteins and

the leveraged interest deductions which we engender.

Namely, where the Battlesteins used "the lenders cash"

[sic] in making their interest payments we have always

employed an arms-length-lender to create the second

layer of debt and to engender the cash to make interest

payments. We have studied several Tax Court decisions

of related connotation before arriving at the strategy

which we follow today.

In the early phases of our enterprises we retained

a Tax Consultant here in Honolulu, Clyde Lee, who had

been a Conferee at the Internal Revenue Service in

Honolulu. He pointed out to us at that time the perils

which one evokes if "the lenders cash" is being used to

make interest payments on the primary loan granted by

the same lender. We have purposely and by design

circumnavigated over the years the obstacles which the

Battlesteins apparently encountered.

To enable Kersting better to control the flow of funds

through his investment programs, Kersting corporations issued

loan proceeds checks and annual distribution checks that were

either unsigned by the drawer corporation or payable jointly to

- 40 the investor and a Kersting corporation,

or both unsigned and

payable jointly.

A letter preceded or accompanied the first annual cash

distribution made by a Kersting corporation, stating that the

amount being distributed was not taxable to the shareholder.

Subsequent distributions were also represented to be nontaxable.

Often the letter characterized the distribution as a nontaxable

"return of capital."

The stated rationale for the tax-free

status varied, sometimes emphasizing a lack of either corporate

earnings or an earned surplus account, and other times

emphasizing that the corporation charged the distribution on the

corporate books to paid-in capital rather than to earnings.

Regardless of how a letter described a distribution,

Kersting considered the distribution to be a partial return of

the shareholder's investment.

He believed that nontaxable

treatment was available under applicable law, however, only if

the corporation had no current or accumulated earnings and the

books of the corporation reflected a charge to paid-in capital.

He also believed that the trade-off for a nontaxable return-of-

capital distribution was a corresponding reduction of the

We sometimes refer to these checks having "and" between two

listed payees as "two-party" checks.

Paid-in or contributed capital, in this context, is the sum

of capital stock recorded at par value and paid-in surplus.

Paid-in surplus is sometimes known as paid-in capital in excess

of par value or as additional paid-in capital.

- 41 adjusted basis in the stock, which reduction was subject to

"recapture" as a capital gain upon disposition of the stock.

The acceptance corporations that sold their stock at $10 per

share, as described in detail below, generally split contributed

capital as described in this Avalon Acceptance form letter:

However, so that your company will have the means

to pay you later on this year a non-taxable (return of

capital type) dividend we have decided to allocate 10%

of your [stock acquisition] funds towards the common

stock account on your company's books and 90% towards

paid-in surplus. The result will be that your company

can pay you this year a cash dividend which can be

charged against the surplus account without any need to

adjust the common stock account.

Kersting did not believe, however, that a paid-in surplus balance

was necessary to make a distribution nontaxable.

Anseth Leasing,

Escon Leasing, and Universal Leasing made distributions

represented to be nontaxable even though none of the three ever

had a paid-in surplus account during the years at issue.

The

bookkeepers recorded their distributions as debits to capital

(common) stock.

The capital stock account for Universal Leasing,

which was reported at over $11 million in its initial tax return

(for its taxable year ending in 1977), was smaller each

succeeding year and was less than $4 million for its taxable year

ending in 1984.

The capital stock account for Escon Leasing,

which was reported at $925,000 in its initial return (for its

taxable year ending in 1977), was smaller each succeeding year

except one.

$600,000.

The one increase was from a negative $17,360 to over

- 42 Kersting wrote a form letter dated October 1, 1979, in which

he stated:

As we are going today into the last quarter of the

current taxation year it seems appropriate that we

remind you that only a few days will be available to

you (and to us) to record your tax deductions for the

year of 1979.

We produced earlier this year certain documents

which are to generate for you tax deductions which can

be applied against your 1979 taxable income.

Generally

speaking, the tax deductions are to cost you 18% of the

taxes retrieved or 9% of the deduction arranged. * * *

Tax deductions will be of value to you only,

however, if properly documented and recorded. That, in

turn, has to be done well before year-end.

If you have not already returned to us the

documents which were mailed to you earlier this year,

we urge you to attend to the matter at your earliest

opportunity.

On the other hand, if you do not wish to make use

of the tax shelter we will appreciate hearing from you

to that effect.

Kersting often encouraged his investors to adjust their

withholding allowances with their employers.

He wrote in a form .

letter sometime after October of 1979:

So that you will gain maximum advantage from the

Tax Shelter Plans in which you are involved we strongly

suggest to you to file IRS Form W-4 (Employee

Witholding [sic] Allowance Certificate) with your

employer. * * *

Many of our clients have accomplished "wall to

wall" protection from taxation. In that case "EXEMPT"

could be entered on line 3b of Form W-4. No tax will

be witheld [sic].

* * *

If you find that you do not have a sufficient

amount of tax deductions yet for this year please

communicate with us by using attached coupon. We will

- 43 be glad to make suggestions as to how you could reduce

your taxes even further.

Stock Purchase Plan

A participant in the Stock Purchase Plan paid $40,000 or a

multiple thereof for the stock of a Kersting holding company,

either Charter Financial or Investors Financial.

The holding

company issued a stock certificate in the investor's name for the

number of shares corresponding to a per-share price of $10.50.

The stock certificate, as in all of the Kersting investment

programs,

042

was usually unnumbered.

By means of a primary loan, the investor borrowed the funds

from Federated Finance, at an annual interest rate of 18 percent,

to acquire the stock of the holding company.

The primary note

was by its terms payable on demand or in 3 years if not demanded

earlier.

Federated Finance supplied the loan proceeds in the

form of a two-party check made payable to the investor and the

holding company, which, like all of the loan proceeds checks used

in the investment programs, the investor was instructed to

endorse and return.

The investor also borrowed funds from an acceptance

corporation, by means of a leverage loan with a 9-percent annual

interest rate, to prepay the first year of interest on the

primary loan.

year.20

The leverage note was by its terms payable in 1

The^ acceptance corporation, like Federated Finance,

2°

On the short and simple promissory note forms for this and

the other investment programs, Kersting's clerical personnel

always typed in "on demand" before the preprinted words "after

(continued...)

- 44 -

issued a two-party check for the loan proceeds, this time payable

to the investor and Federated Finance.

The investor had the

option of paying the interest on the leverage loan in a lump sum

or in six monthly installments.

Leverage lenders in·this and the

other investment programs frequently provided coupon payment

books to those borrowers who preferred to make installment

payments.

The stock certificate, the primary note, the leverage note,

and the checks representing loan proceeds all bore the same date,

which was early in January or early in July.

Like the initiating

documents in the other investment programs, the investor

generally received all of these documents.together by mail, to be

signed and (except for the stock certificate) returned to the

Kersting offices.

The holding company issued a distribution check,2' dated in

December, payable to the investor in the amount of the principal

balance of the leverage loan.

As already noted, a preceding or

accompanying letter stated that this amount was nontaxable.

The

letter also suggested that the investor endorse the check and

2°(...continued)

date." Because the note contained two typed-in dates, an

effective date and a "due" date, it is not clear from the face of

the note when the demand feature became operative. When we

describe the term of a leverage note as some number of years,

without express reference to a demand nature, we are referring to

the time period between the effective date and the due date.

"Distribution" checks are those issued by Kersting

corporations to their shareholders as part of the investment

programs, and not representing loan proceeds.

- 45 return it to satisfy his obligation for the principal due on the

leverage loan, which, to the best of Kersting's knowledge,

invariably happened.

The leverage note was then returned to the

investor marked "paid."

A condensed example of the Stock Purchase Plan is as

follows.

To make a $40,000 investment in the stock of a holding

company, an investor borrowed $40,000 from Federated Finance (the

primary loan) and $7,200 from an acceptance corporation (the

leverage loan), with the stock certificate, notes, and loan

proceeds checks all bearing the same date.

He applied the $7,200

to prepay the 18-percent annual interest on the primary loan and

paid 9-percent annual interest on this borrowed $7,200, or $648,

in either a lump sum or six installments.

The holding company

issued a $7,200 distribution check to the investor, dated in

December, which he used to pay off the like principal balance of

the leverage loan.

By documents dated in early January or early July of the

following year, the cycle was repeated.

The investor used the

proceeds of a new leverage loan from a different acceptance

corporation, with the leverage note again providing for a 9percent annual interest rate and a 1-year term, to prepay another

year of interest on the outstanding primary loan.

The leverage

loan proceeds took the form of a check made payable to the

investor.

The holding company again issued a distribution check

dated in December and payable to the investor, to enable him to

satisfy his principal obligation on this new leverage loan.

- 46 -

If the investor wished to participate beyond the 3-year term

of the original primary note, he in effect renewed or refinanced

the primary loan by executing a new note in favor of Federated

Finance for another 3-year term.

Both Charter Financial and Investors Financial issued

distribution checks dated December 15, 1980, for investors on a

July annual cycle.

Stock Subscription Plan

In the Stock Subscription Plan, an investor purchased stock

of an acceptance corporation at $10 per share,22 and the

acceptance corporation issued a corresponding stock certificate

in the investor's name.

The investor also subscribed in writing

for additional shares at $1 per share.

The purchase amount and

the subscription amount were equal, so a purchase of 6,000

shares, for example, at $10 per share accompanied a subscription

for 60,000 additional shares at $1 per share.

The subscription agreement began with a statement in the

following form:

"I hereby subscribe for and agree to purchase23

from * * * [a specific acceptance corporation, a specific number

of] shares of common stock of $1.00 par value at a price of $1.00

per share."

The agreement, with an express term of 3 years,

called for the investor to pay 12-percent annual interest on the

unpaid subscription balance.

The agreement also contained a

From 1975 into 1978 the cost was $1 per share.

The word "buy" often appeared instead of "purchase."

- 47 provision acknowledging receipt by the acceptance corporation of

a specific amount "paid on account" equal to a year of such

interest.

As Kersting viewed it, the subscription agreement did

not give the investor the right to tender payment and thereby

become entitled to the additional shares.

Instead, Kersting

understood the agreement to provide the acceptance corporation

with the right at any time to require the investor to purchase

the shares.

Nonetheless, no acceptance corporation ever

attempted to issue the stock or demand payment of the funds

called for by a subscription agreement.

As with the Stock Purchase Plan, the investor borrowed the

funds necessary for the immediate stock purchase by means of a

primary loan with an 18-percent annual interest rate.

The

primary lender was often Federated Finance, but others included

Atlas Funding, Ventures Funding, and Windsor Acceptance.

The

primary note was by its terms payable on demand or in 2 years if

not demanded earlier.

The primary lender supplied the loan

proceeds in the form of a two-party check made payable to the

investor and the acceptance corporation.

By means of a leverage loan with a 9-percent annual interest

rate,24 the investor borrowed funds from a second acceptance

corporation in order to pay a year of interest on the primary

loan and a year of interest on the unpaid subscription balance.

The leverage note was by its terms payable in 1 year.

This

The annual interest rate was 6 percent during 1975 and 1976

and 7 percent during 1977 and into 1978.

- 48 -

lending acceptance corporation issued a check for the loan

proceeds made payable to the investor.

The investor had the

option of paying the interest on the leverage loan in a lump sum

or in six monthly installments.

In the early years, the investor

could opt for 12 monthly payments.

The stock certificate, the subscription agreement, the

primary note, the leverage note, and the checks representing loan

proceeds all bore the same date, which was usually early in

January or early in July.

At the outset, Kersting instructed those wishing to

participate in the Stock Subscription Plan to open a checking

account in Hawaii at a specified local bank at which Kersting

corporations had accounts.

This was generally Hawaii National

Bank into 1979 and Liberty Bank from 1979 on.

After the investor endorsed the leverage loan proceeds check

and returned it with the other initiating documents, he received

a form thank-you letter with instructions on how to complete the

transaction.23

In this letter, the investor was requested to

send two signed checks drawn on his local account at the

specified bank, along with some deposit slips for that account.

One check was to be payable to the primary lender in the amount

necessary to pay a year of interest on the primary loan.

The

Sometimes the instructions on how to complete the

transaction were included with the package of initiating

documents sent to the investor. In such a case, Kersting

expected the investor to return signed initiating documents and

comply with the additional instructions at the same time.

- 49 other check was to be payable to the stock-issuing acceptance

corporation in the amount necessary to pay a year of interest on

the unpaid subscription balance.

The letter also stated that a

deposit (meaning the endorsed leverage loan proceeds check) would

be made to the investor's account to allow his two checks to

clear.

The investor wrote his checks on the account designated

by Kersting.

The stock-issuing acceptance corporation issued a

distribution check, dated in December and payable to the

investor, in the amount of the principal balance of the leverage

loan.

As noted, a preceding or accompanying letter stated that

this amount was nontaxable.

After the investor returned the

endorsed check to the Kersting offices, the leverage note was.

marked "paid" and returned to the investor.

An example of the Stock Subscription Plan is as follows.

purchase 6,000 shares of an acceptance corporation, an investor

borrowed $60,000 from Federated Finance (the primary loan) and

signed a subscription agreement for additional shares, also in

the amount of $60,000.

With $18,000 borrowed from a second

acceptance corporation (the leverage loan), he wrote checks for

$10,800 to pay the 18-percent annual interest on the primary loan

and $7,200 to pay the 12-percent annual interest on the unpaid

subscription balance.

The stock certificate, subscription

agreement, notes, and loan proceeds checks all bore the same

date.

The first acceptance corporation issued a check for

$18,000 to the investor, dated in December, which he used to pay

- 50 -

off the like principal balance of the leverage loan from the

second acceptance corporation.

He paid 9-percent interest on the

$18,000 leverage loan, or $1,620, in either a lump sum or six

installments.

Kersting offered the stock of a different acceptance

corporation for each calendar year:

Norwick Acceptance in 1975,

Forbes Acceptance in 1976, Fargo Acceptance in 1977, Mahalo

Acceptance in 1978, Candace Acceptance in 1979, Delta Acceptance

in 1980, and Avalon Acceptance in 1981.

He annually sent

participants in the Stock Subscription Plan an order form with

which they could select the desired amount of·stock for the next

acceptance corporation.

A common format was:

Please arrange for me the purchase and financing

of stock of * * * [a specific acceptance corporation]

for a unit as indicated below:

Amount of

Tax

Deduction

30,000

40,000

50,000

60,000

$ 9,000

12,000

15,000

18,000

Anticipated Tax Refunds (Federal only)

30% Tax Bracket

40% Bracket

$2,700

3,600

4,500

5,400

$3,600

4,800

6,000

7,200

Sometimes the order form had an additional column labeled "Actual

Cost to You," with the listed amounts of $810, $1,080, $1,350,

and $1,620.

There was typically no accompanying specific

information about this new acceptance corporation other than that

it would have the "same advantages" as the acceptance corporation

in which the investor already held stock.

An investor named Mil Harr returned to Kersting in January

of 1977 executed initiating documents dated August 1, 1976, for a

- 51 Forbes Acceptance Stock Subscription Plan.

In his accompanying

letter, which listed the enclosed documents, Harr asked Kersting

about his investment:

At this point I am sort of wondering what this is

all about. I basically recognize all this as a deal

where I bought into Forbes Acceptance Corporation and

borrowed money to do it (with resulting interest

deductions on borrowed money), but where does this deal

lead? Is this something you have structured for tax

purposes only, or why am I desiring to be buying stock

in Forbes Acceptance, other than that?

In his written reply, Kersting stated:

has tax deduction purpose only.

"At this time the deal

I can foresee, however, that the

corporation will make a profit in its second year of operation."

He further informed Harr that "The deal is self-liquidating as

you can retire all of your debt by simple surrender of the stock

certificate issued to you."

Kersting wrote to another inquiring investor named Willis

McComas in February of 1978:

When I referred to a "closed deal" I meant to convey

the impression that that deal would be available only

for one year, such as Fargo Acceptance or this year

Mahalo Acceptance Corp. The reason is quickly evident

when you recall that Fargo Acceptance Corp. paid you a

dividend in 1977 of $18,000.00 which was a return of

capital. That can not be done the second year as the

company is expected to make a profit then. Once there

is an earned surplus account all dividends become

taxable dividends (unless the Carter Administration

accomplishes to change that). It is for this reason

that we have organized every year another Acceptance

Corporation allowing us to pay the first dividend as a

"return of capital."

* * *

* * * All notes which you have executed are selfsustaining now. The cash dividends which Fargo

Acceptance Corp. will pay you from now on will be

sufficient to service the debt to which you are a

- 52 -

party. As you will be receiving taxable dividends in

[the] future you will also have a tax deduction in a

like amount. The result will be a washout for taxation

purposes.

Sometime before 1977, Kersting wrote a form letter

describing the Stock Subscription Plan and sent it to some of his

clients, including petitioner Terry D. Owens.

The letter began:

In line with our policy to facilitate your

involvement by arranging the financing we propose to

you the following:

1. We will organize an Acceptance Corporation for the

purpose of lease financing as you know it. You are

invited to acquire equity in the corporation in

$10,000.00 increments. We will arrange a loan for you

for the full amount of the stock you wish to acquire.

* * * The advance will be a non-recourse loan

confining your liability to the value of the stock to

be acquired, none beyond that. * * *

In this letter, Kersting went on to describe both further

mechanics of the program, including the subscription agreement

and leverage loan, and detailed tax advantages.

He also stated

that the corporation would pay a dividend early the next year

that the investor could use to pay off the principal balance of

the leverage loan.

Apart from "the purpose of lease financing,"

Kersting did not mention either the business or the profit

potential of the acceptance corporation.

Sometime later, Kersting wrote a similar tax-oriented letter

entitled "The Acceptance Corporation Plan" that focused

specifically on Candace Acceptance, but he did not refer to

nonrecourse loans and lack of personal liability.

He stated

without elaboration that Candace Acceptance was organized for the

purpose of "automobile and lease financing" and was "expected to

- 53 make profits."

He further stated that the investor's "actual

out-of-pocket expense" and "only expense ever" would be 9 percent

of the leverage loan amount.

The letter ended with a standard

order form for Candace Acceptance stock.

Kersting form letters that transmitted initiating documents

for the Mahalo Acceptance, Delta Acceptance, and Avalon

Acceptance Stock Subscription Plans also stated that the "actual

out-of-pocket expense" would amount to 9 percent of the leverage

loan.

These letters ended with this sentence:

"If you feel that

you have benefited from our services, please introduce us to your

friends who might also need tax assistance."

A package of

initiating documents sent to prospective investors in 1980 or

1981 contained this paragraph:

The funds which will be generated by the

promissory note you are about to execute will be

applied in full to purchase for your account a certain

amount of common stock of Avalon Acceptance

Corporation. The stock which you will acquire will be

equal in value to the face amount of the promissory

note. As we go along the value of your stock is

expected to be higher than the price you are paying

today.

Leasing Corporation Plan

A participant in the Leasing Corporation Plan purchased

stock at $1 per share from a Kersting leasing corporation (Anseth

Leasing, Escon Leasing, or Universal Leasing), and the leasing

corporation issued a corresponding stock certificate in the

investor's name.

The investor also subscribed for additional

shares at $1 per share.

Although a common ratio was a $19,000

stock purchase and a $55,000 subscription agreement, the ratio

- 54 -

was often exactly 1 to 3.

The subscription agreement was like

that used in the Stock Subscription Plan, including an express

term of 3 years, an annual interest rate of 12 percent on the

unpaid subscription balance, and an acknowledgment of a year of

interest "paid on account."

The investor borrowed the funds necessary for the immediate

stock purchase by means of a Federated Finance primary loan with

an 18-percent annual interest rate.

The primary note was by its

terms payable on demand or in 2 years if not demanded earlier.

Federated Finance supplied the loan proceeds in the form of a

two-party check made payable to the investor and the leasing

corporation.

By means of a leverage loan with a 15-percent annual

interest rate, the investor borrowed funds from an acceptance

corporation in order to prepay interest on the primary loan and

interest on the unpaid subscription balance.

The leverage note

was by its terms payable on demand or in 1 year if not demanded

earlier.

The acceptance corporation supplied the loan proceeds

in the form of two-party checks, one payable to the investor and

Federated Finance and one payable to the investor and the leasing

corporation, in amounts equal to a year of interest on the

primary loan and a year of interest on the unpaid subscription

balance, respectively.

The investor generally paid annual

interest on the leverage loan in 12 monthly installments.

The stock certificate, the subscription agreement, the

primary note, the leverage note, and the checks representing loan

- 55 proceeds all bore the same date, which was usually early in

January or early in July.

As an example of the Leasing Corporation Plan to this point,

an investor borrowed $19,000 from Federated Finance at 18-percent

annual interest (the primary loan), which he used to purchase

19,000 shares of leasing corporation stock.

He subscribed for an

additional 55,000 shares at $1 per share, agreeing to pay 12percent annual interest on the unpaid balance of $55,000.

With

$10,020 borrowed from an acceptance corporation (the leverage

loan), he used $3,420 to prepay a year of interest on the primary

loan and $6,600 to prepay a year of interest on the unpaid

subscription balance.

All of these documents were dated as of

the same date.

Each of the leasing corporations had two checking accounts

at Liberty Bank, a "general" account and a "special" account.

The leasing corporation annually issued a distribution check,

with a January date, drawn on its general account and made

payable to the investor in the amount of the principal balance of

the leverage loan.

Sometimes the distribution check was in an

amount slightly less than the principal balance of the leverage

loan; for example, the Escon Leasing distribution check

corresponding to a leverage loan of $10,020 was in the .amount of

$9,990.

A letter accompanying the distribution check stated that

the distribution amount was nontaxable to the investor.

This

letter also informed the investor that his endorsed distribution

check, after return to the Kersting offices, would be deposited

- 56 -

to the special account, from which the leasing corporation would

disburse funds to establish interest deductions for that year.

The checks drawn on the special account, which were dated

the same as and accompanied the distribution check, totaled to

the amount of the distribution check.

One check, in an amount

equal to a year of interest on the Federated Finance primary

loan, was payable to the investor and Federated Finance.

The

other check, in an amount equal to a year of interest on the

unpaid subscription balance, was payable to the investor and the

leasing corporation.

For the occasional distribution check that

did not equal the leverage loan amount, the check corresponding

to subscription interest was less than a year of such interest by

the same amount that the distribution check was less than the

leverage loan amount.

As a continuation of the example begun above, which is a

$19,000 stock purchase coupled with a $55,000 subscription

agreement, the leasing corporation sent to the investor the

following group of checks:

A distrïbution check from its general

account for $10,020 payable to the investor; a check from its

special account for $3,420 payable to the investor and Federated

Finance; and a check again from its special account for $6,600

payable to the investor and the leasing corporation.

Each year the investor signed a new 1-year leverage note in

favor of a different acceptance corporation, again with a 15-

percent annual interest rate and the same principal amount as the

original leverage loan.

This was in effect a renewal of the

- 57 leverage loan because the loan proceeds were applied to the

outstanding leverage loan.

The loan proceeds took the form of

either a check payable to the investor or a two-party check

payable to the investor and the acceptance corporation on the

expiring leverage note.

If an investor wished to participate in

the Leasing Corporation Plan beyond the 2-year term of the

original primary note, he in effect renewed the primary loan by

executing a new note in favor of Federated Finance for another

2-year term.

The loan proceeds took the form of either a check

payable to the investor or a two-party check payable to the

investor and Federated Finance.

With documents dated a few days before the end of the 3-year

term of the initial subscription agreement, the investor

sometimes both borrowed funds to purchase additional stock from

the leasing corporation and executed a new subscription

agreement.

The number of newly purchased shares plus the number

of newly subscribed shares equaled the number of shares

originally subscribed.

Thus, if the original subscription

agreement covered 55,000 shares, an investor who borrowed $36,000

to purchase 36,000 new shares also executed a new subscription

agreement for 19,000 shares at $1 per share.

The new stock

acquisition note, in favor of an acceptance corporation, provided

for 12-percent annual interest and payment on demand or in 3

years if not demanded earlier.

The new subscription agreement,

with a term of 3 years and an annual interest rate of 12 percent,

- 58 acknowledged receipt of an amount "paid on account" equal to a

year of subscription interest.

In connection with this new stock purchase and subscription

agreement, the leasing corporation again issued a January

distribution check from its general account made payable to the

investor in the amount of the outstanding leverage loan, except

that again there was sometimes a slight difference in amount.

The leasing corporation also issued three checks from its special

account that together equaled the amount of the outstanding

leverage loan.

One check was payable to the investor and

Federated Finance and equal to a year of interest on the renewed

primary note, one check was payable to the investor and the

leasing corporation and equal to.a year of interest on the new

subscription agreement, and one check was payable to the investor

and the new acceptance corporation and equal to a year of

interest on the new stock acquisition loan.

The sale and leaseback of an automobile was sometimes a part

of the Leasing Corporation Plan.26

In a common scenario, a pilot

purchased an automobile outside of the Kersting organization,

financing it through an airline credit union.

The pilot then

sold the automobile to a Kersting leasing corporation, which took

subject to the credit union loan, and became a shareholder of the

leasing corporation.

Thereafter, as the pilot made lease

The tax effect of lease payments is not at issue in these.

cases.

- 59 payments to the leasing corporation, the leasing corporation made

loan payments to the credit union.

In a January 1980 letter to a potential client who was

considering the purchase of a new automobile, Kersting urged him

to consider the sale-leaseback benefits associated with the

Leasing Corporation Plan:

"The tax retrievals which this plan is

scheduled to generate for you will fully pay for all lease

payments and other fees you sustain in the program.

The result

of this will be that you will be driving the car entirely free of

any cost to you."

A pamphlet entitled "The Universal Plan," which Kersting

authored or at least authorized, describes an early version of

the Leasing Corporation Plan with emphasis on the mechanics and

the tax advantages.

The cover lists Kersting and Ms. Pang as

sources of further information.

Although the pamphlet mentions

an "investment opportunity," there is no reference to either the

business of "Universal Corp." outside of this program or its

profit potential.

The investment opportunity is described not in

terms of dividends or stock appreciation, but in terms of a tax

savings return on the ultimate cash outlay:

"A taxpayer in the

20% bracket would be entitled to a tax refund of $1485.

In other

words on an investment of $756 [for leverage loan interest] a

return of $1485 can be obtained.

This equals a percentage return

of 196% which is entirely free of tax."

An undated form letter to automobile lessees that included

petitioner Terry D. Owens described, in addition to tax

- 60 advantages, the economic benefits available to shareholders in a

Leasing Corporation Plan:

As the leasing concept gains popularity,

investment opportunities will become available

comparable to the early stages of growth industries

* * *

Profits in leasing are essentially generated from

two sources: lease revenues and realization of

residual values inherent in automobiles or equipment.

Profits are, for all practical purposes, untaxed as

they can be sheltered by generous depreciation

allowances and investment credits. As a consequence,

an accumulation of intrinsic values takes place at a

faster rate than generally attainable if a portion of

profits must be shared with the government. As profits

go untaxed per share earnings will increase and

additions to book value (or shareholders equity) will

rise. This, in turn, will sooner or later be

recognized in the market place if the stock of the

company which we have organized shall be offered to the

public.

Following a description of the stock purchase, the letter stated

that the purchaser "would be an investor only.

He may expect,

however, captial (sic] appreciation and dividend income as the

years go by."

In another undated form letter received by petitioner Terry

D. Owens, this one transmitting initiating documents for

Universal Leasing, Kersting emphasized the tax aspects but also

wrote:

All of your debt, except your monthly payment

obligation, can be discharged at any time at your

option by surrender of the stock certificate which will

be issued to you after we have received the executed

documents from you. As a shareholder of this

corporation you will have access to capital gains

prospects which we intend to develop. If our judgement

is secure and if we are successful in creating a public

market for the stock of this company it is reasonable

to assume that the stock of this company will

eventually sell at an earnings multiplier well in

- 61 -

excess of the price which you are paying today.

We are

convinced of this to the point where we are willing to

accept your stock in settlement of your indebtedness.

Kersting also wrote a form letter, as president of Anseth

Leasing, marking the first anniversary of the recipients'

participation in the Leasing Corporation Plan.

He encouraged the

shareholders to renew their outstanding leverage notes by

executing new ones, and added that "you do have the continuing

option to retire the existing notes by a sale to your corporation

of the stock which you have acquired."

CAT-FIT Plan27

Kersting made the CAT-FIT Plan available to those interested

clients with children, generally at a participation level of

$17,000 per child.

The parent borrowed $17,000 from Windsor

Acceptance by means of a primary loan with an annual interest

rate of 12 percent.

The primary note was by its terms payable on

demand or in 2 or sometimes 3 years if not demanded earlier.

Windsor Acceptance supplied the loan proceeds in the form of a

check payable to the parent, and Atlas Guarantee issued a $17,000

"investment certificate" in the name of the child.

The

investment certificate stated that Atlas Guarantee would pay

interest to the child at an annual rate of 12 percent.

The parent usually borrowed funds from an acceptance

corporation by means of a leverage loan, $2,040 for each child,

to pay the annual interest to the primary lender, Windsor

CAT-FIT is an inexact acronym for Children's Assistance To

Financially Indigent (or Indolent) Parents.

- 62 Acceptance.

The leverage note, with a 9-percent annual interest

rate,28 was by its terms payable in 1 year.

The parent endorsed

the loan proceeds check, which was payable to the parent, and,

with the other initiating documents, sent it back to the Kersting

offices.

The parent usually paid interest on the leverage loan

in a lump sum.

The investment certificate, the primary note, the leverage

note (if applicable), and the checks representing loan proceeds

all bore the same date, which was early in January or early in

July.

As with the Stock Subscription Plan, Kersting at the outset

instructed those wishing to participate in the leverage loan

version of the CAT-FIT Plan to open a checking account in Hawaii

at a specified local bank at which Kersting corporations had

accounts.

This was either Liberty Bank or Hawaii National Bank

into 1979 and Liberty Bank from 1979 on.

After the parent endorsed the proceeds check from the

leverage loan and returned the initiating documents to Kersting,

Atlas Guarantee sent a form letter with instructions on how to

complete the transaction.2°

In this letter, Atlas Guarantee

asked the parent to send a signed check drawn on his local

The Annual interest rate on CAT-FIT leverage loans was 6

percent in 1976, 6 or 7 percent in 1977, and 7 percent into 1978.

Somehimes the instructions on how to complete the

transaction were included with the package of initiating

documents sent to the parent. In such a case, Kersting expected

the parent to return signed initiating documents and comply with

the additional instructions at the same time.

- 63 account at the specified bank and made payable to Windsor

Acceptance in the amount of a year of interest on the primary

loan.

The letter stated that an appropriate deposit (meaning the

endorsed leverage loan proceeds check) would be made to the

parent's account to allow his check to clear.

Atlas Guarantee paid interest on the investment certificates

semi-annually, with checks made payable to the child and dated in

June or July and December or January.

By an accompanying letter

or otherwise, the parent was requested to obtain the child's

endorsement or endorse for the child, and then to return the

check so that Atlas Guarantee could add the check amount to the

face amount of the investment certificate.

The parent usually

agreed to this procedure, but some parents arranged to receive

signed and negotiable interest checks.

Kersting told these

parents not to use the child's earnings from the investment

certificate to discharge their normal parental obligations, such

as the provision of food, shelter, and clothing.

Otherwise,

Kersting believed, the earnings belonged to the parents for

income tax purposes.

For the second and each succeeding year of the CAT-FIT Plan,

the parent participating in the leverage loan version borrowed

funds by means of a new leverage loan in order to pay another

year of interest to Windsor Acceptance.

The new leverage note,

again with a 1-year term and a 9-percent interest rate, was in

favor of a different acceptance corporation than the original

leverage lender.

The loan proceeds, in the amount of the annual

- 64 -

interest payable to Windsor Acceptance, took the form of a check

payable to the parent.

The parent again wrote a check to Windsor

Acceptance drawn on his local account in an amount equal to a

year of interest on the primary loan.

If a parent wished to participate in the CAT-FIT Plan beyond

the term of the original primary note, he in effect renewed or

refinanced the primary loan by executing a new note in favor,of

Windsor Acceptance, again at an annual interest rate of 12

percent.

Kersting at some point authored this description of the CATFIT Plan:

Under existing tax regulations each parent * * *

can make a TAX FREE gift of $3,000.00 per year to each

of their children. Furthermore, they have a lifetime

allowance of $30,000 of TAX FREE gifts to their

children. No gift tax will be payable on either the

annual gifts in the amount of $3,000 or the once-in-alifetime gift of $30,000.

The object of the plan is to shift income from

parents to their children. Children can be taxpayers

in their own right and are permitted to earn as much as

$2,300 per year before they begin to pay taxes.

Although children under the CAT FIT PLAN become

taxpayers by reason of the income they might earn,

their parents will not loose [sic] the exemption,

presently $1,000 [per] child, if they contribute more

than 50% of their children's annual support.

The implementation of the plan requires a few

simple steps:

1. Each parent will make a gift in the amount of

$17,000 to any one or all of their children. A

certificate savings account in the amount of $17,000

will be opened with Atlas Guarantee Corp. in the name

of the child. The account will earn interest at the

rate of 12% per year. The earnings will accrue to the

child.

- 65 2. If the lifetime allowance or any part thereof is

used, the savings account can be increased accordingly.

3. One of our subsidiary acceptance corporations will

make a loan to the parents in the amount of $17,000 or

whatever the savings account in the child's name should

amount to. We will charge interest at the rate of 12%

per year on that loan. The interest payment becomes a

deduction for federal and state tax purposes to the

parents.

The effect of the above-described transaction will

be that the children will earn a return on the savings

account in their names which will be free of income tax

to the point where they reach $2,300 and the parents

will have a tax deduction in the amount of $2,040 * * *

The actual net return to parents and children,

will depend upon the tax brackets of the parents * * *

In an undated form letter that accompanied initiating

documents received by petitioner Terry D. Owens, Kersting wrote:

Enclosed please find the promissory note (issued

to our Acceptance Corporation) by which you will

engender the funds needed to create the educional [sic]

fund for your children. Please sign white copy of note

and endorse the attached check. Return both to us.

* * *

Upon receipt of your executed promissory note and

check we will issue to your children Thrift

Certificates as per enclosed sample copy. Your

children will earn as of the date of the Thrift

Certificate 12% interest on the face amount of the

Certificate. For every $17,000.00 of Thrift

Certificates your children will earn $2,040.00 per

year. * * *

When a parent decided to discontinue participation in the

CAT-FIT Plan, he sent the investment certificate back to Kersting

to be redeemed.

The redemption check sent to the child was

endorsed, returned, and then used to pay off the primary loan.

- 66 F.

Flow of Funds

Generally

The "waltz" was what Kersting called the procedure he used

to guide checks through the bank checking accounts of several

corporations and investors on the same date.

All of the Kersting

corporations involved in a given waltz had checking accounts at

the same local bank in Hawaii,·either Hawaii National Bank or

Liberty Bank.

These waltzes were not always perfect in terms of

same-day timing and identical amounts flowing between accounts,

but both types of discrepancies were relatively few and

insignificant.

The Kersting corporations conducted banking transactions at

Hawaii National Bank during the 1970s.

Kersting himself made

deposits to the accounts of the various Kersting corporations and

to the accounts of various investors who had opened accounts at

the bank.

He often provided a schematic drawing to a bank

employee and explained that the funds were moving from one party

to the next in a circular fashion.

Because there were usually

negligible balances in the accounts affected by the circular

transactions, the bank processed checks as a simultaneous

transaction, in effect depositing and paying checks at the same

time so that payment of a check from an account was covered by a

deposit to that account of a like amount.

Eventually, Hawaii National Bank became concerned about the

nature of these transactions, specifically the possibility of

- 67 check-kiting,

and informed Kersting that all accounts would be

closed, which occurred in March of 1979.

There had been no

possibility of check-kiting up to this time because all of the

affected accounts were within Hawaii National Bank.

Nonetheless,

Kersting was involving more and more accounts, and the Hawaii

National Bank administrators, who began to track drawing-on-sameday-deposit reports, decided that the transactions should cease.

Several Kersting corporations had checking accounts at

Liberty Bank even before closing of the accounts at Hawaii

National Bank.

At least from 1978 through 1983, either Kersting

or women who worked in his offices would go to the Kahala Mall

branch of Liberty Bank to conduct banking transactions.

Several

checks would usually be deposited, most or all of which were

drawn on Liberty Bank.

The total deposited amount was sometimes

large enough to make the deposit volume for the branch on that

day seem unusually high.

Checks associated with Kersting's investment programs

usually cleared the bank, Hawaii National Bank or Liberty Bank,

at least several weeks after their dates, and sometimes the date

difference was over a year.

In addition, Kersting generally

waltzed funds associated with primary loans separately from those

Check-kiting is a fraudulent scheme in which the wrongdoer

profits from a continual interchange of worthless checks between

accounts at two or more banks, taking advantage of both the

several-day check collection process and the willingness of the

banks to pay a check even though the account balance consists

only of a deposited check not yet collected. See generally H.

Bailey, Brady on Bank Checks, par. 18.11, pp. 18-22 to 18-25 (6th

ed. 1987).

- 68 funds associated with leverage loans, at least for the Stock

Subscription Plan.

These factors sometimes affected the work of

the bookkeepers, who relied on bank statements and canceled

checks.

For example, as already noted, Fargo Acceptance in its

initial income tax return for the period ending June 30, 1977,

reported interest income of $91,200, but indicated no capital

stock on the Schedule L balance sheet.

Kersting had waltzed

leverage loan funds for a Fargo Acceptance Stock Subscription

Plan on June 15, 1977, which included interest on subscription

agreements of $91,200.

He did not waltz the primary loan funds

with which the investors purchased the Fargo Acceptance stóck

until July 29, 1977.

Kersting's intercorporate fund transfers as part of a waltz

were at least sometimes documented as loans or deposits (by means

of notes or other evidences of indebtedness) or as stock

purchases.

Stock Purchase Plan

The holding companies that participated in the Stock

Purchase Plan, Charter Financial and Investors Financial,

periodically transferred the funds received from new shareholders

to Federated Finance.

On February 8, 1980, Liberty Ba2k recorded 20 checks issued

by Charter Financial in amounts of either $14,400 or $21,600.

Among the deposits recorded on the slme date were two for

$151,200 each.

The account balance vas the same at both the

beginning and end of the day, $1,399.36.

For Candace Acceptance

- 69 on the same date, Liberty Bank recorded three deposits totaling

$302,400 (among other smaller deposits), with each of the three

evenly divisible by $7,200.

Among the issued checks recorded on

the same date were two for $151,200 each.

The ending account

balance for the day differed by less than $50 from the beginning

balance.

On May 22, 1980, Liberty Bank recorded 37 checks issued by

Charter Financial in amounts of $7,200, $14,400, and $21,600.

Among the deposits recorded on the same date was one for

$597,600.

The account balance was the same at both the beginning

and end of the day, $780.53.

For Candace Acceptance on the same

date, Liberty Bank recorded four deposits evenly divisible by

$7,200 (among others not so divisible), and these four totaled

$597,600.

Among the issued checks recorded on the same date was

one for $597,600.

The ending account balance for the day, which

was less than $900, differed by less than $30 from the beginning

balance.

Stock Subscription Plan

For the Stock Subscription Plan, the waltz of primary loan

funds typically occurred several months after the date on the

initiating documents.

After several investors had endorsed and

returned to Kersting the two-party loan proceeds checks from

their primary loans, the bank processed the following check

transactions (paying a check from the drawer's account and

depositing it to the payee's account) on the same date:

(1) The

loan proceeds checks were paid from the account of the primary

- 70 lender and deposited as a group to :he account of the second

Payee named on the checks, which was the acceptance corporation

selling its stock; (2) this acceptance corporation issued a

check, equal to the amount deposited to its account, to Federated

Finance; and (3) Federated Finance, if the primary lender was

other than Federated Finance, issued a check in the same amount

to the primary lender.

Although the amount flowing from point to

point in a waltz of this type often exceeded $500, 000, it was not

uncommon for the account balances of the primary lender and the

acceptance corporation, immediately before· and after the waltz,

to equal a small fraction of the circulating amount.

The waltz of leverage loan funds for the Stock Subscription

Plan also typically occurred several months after the date on the

initiating documents.

This waltz incorporated the investor's

checking account at the same bank into the loop.

As part of the leverage loan t

nsaction, the investor

returned one check to Kersting and s nt two of his own.

specifically, he endorsed and return d the leverage loan proceeds

check and-also sent two signed check

drawn on his account (for

primary loan interest and subscripti n interest) that taken

together equaled the amount of the proceeds check.

After several

investors had returned this three-check package, the bank

processed the following check transactions on the same date:

(1 )

The loan proceeds checks were paid from the account of the

leverage lender and deposited separately to the account of each

investor; (2) the check for subscription interest was paid from

- 71 the account of each investor, and these checks were deposited as

a group to the account of the acceptance corporation selling its

stock; (3) the check for primary loan interest was paid from the

account of each investor, and these checks were deposited as a

group to the account of the primary lender; (4) the stock-issuing

acceptance corporation and the primary lender issued checks, each

equal to the amount deposited to its account, to Charter

Financial or Federated Finance; and (5) Charter Financial or

Federated Finance issued a check, equal to the amount deposited

to its account, to the leverage lender.

The amounts flowing into and out of the accounts of the

stock-issuing acceptance corporation and the primary lender

usually exceeded $100,000.

The amounts flowing into and out of

the accounts of the leverage lender and Charter Financial usually

exceeded $200,000.

It was not uncommon, however, for each of

these account balances, immediately before and after the waltz,

to equal less than $1,000.

Leasing Corporation Plan

The leasing corporations that sold their stock under the

Leasing Corporation Plan, like the holding companies in the Stock

Purchase Plan, periodically transferred the funds received from

new shareholders to Federated Finance.

-- 72 On July 22, 1981, Liberty Bank recorded deposits of $28,800

and $82,000 in the general account c4f Anseth Leasing.3'

The

$28,800 consisted of checks from fot.r individuals, three for

$6,600 each and one for $9,000.

The $82,000 consisted of checks

from the same individuals, three for $19,000 and one for $25,000.

As recorded on the same date, Ansett Leasing issued checks from

this account that included one for $28,800 and another for

$82,000.

Also on July 22, 1981, Liberty Bank recorded deposits of

$14,520 and $41,000 in the general tccount of Escon Leasing.

The

$14,520 consisted of checks from twc4 individuals, one for $6,600

and one for $7,920.

The $41,000 cor.sisted of checks from the

same individuals, one for $19,000 ar.d one for $22,000.

recorded on the same date, Escon Letsing issued checks from this

account that included one for $14,520 and another for $41,000.

On April 27, 1978, Liberty Bank recorded the following

activity in the Escon Leasing genertl account:

10 checks issued

in the amount of $9,990, 5 of $6,48(, 3 of $5,400, 2 each of

$10,800, $8,640, $7,560, and $3,240, and 1 each of $8,100,

$2,970, and $1,620, for a total of $221,670, and deposits of

$143,730, $78,000, and $2,000.

The recorded special account

activity for the same date was a sir.gle deposit of $221,670 and

58 issued checks:

10 each of $6,57C and $3,420, 7 of $2,160, 5

The activity in the general accounts of the leasing

corporations often included deposits and checks in addition to

those we mention specifically.

- 73 each of $4,320 and $3,600, 3 each of $1,800 and $1,080, 2 each of

$7,200, $5,760, $5,040, $2,880, and $2,520, and 1 each of $5,400,

$2,700, $1,530, $1,440, and $540.

The ending special account

balance for the day was the same as the beginning balance, $100.

On November 8, 1978, Liberty Bank recorded the following

activity in the Escon Leasing general account:

5 checks issued

in the amount of $9,990 and 1 each of $8,640, $6,480, and $3,240,

for a total of $68,310, and deposits of $45,090 and $23,000.

The

recorded special account activity for the same date was a single

deposit of $68,310 and 16 issued checks:

5 each of $6,570 and

$3,420, 2 of $2,160, and 1 each of $5,760, $4,320, $2,880, and

$1,080.

The ending special account balance for the day was the

same as the beginning balance, $88.77.

On August 6, 1979, Liberty Bank recorded the following

activity in the Anseth Leasing general account:

4 checks issued

in the amount of $10,020 and 2 of $9,748.80, for a total of

$59,577.60, and a deposit of $39,417.60.

The recorded special

account activity for the same date was a single deposit of

$59,577.60 and 12 issued checks:

4 each of $6,600 and $3,420,

and 2 each of $6,508.80 and $3,240.

The ending special account

balance for the day was the same as the beginning balance,

$78.90.

On August 16, 1979, Liberty Bank recorded the following

activity in the Anseth Leasing general account:

15 checks issued

in the amount of $10,020, 6 of $9,748.80, 3 of $6,499.20, and 1

each of $5,416 and $4,062, for a total of $237,768.40, and

- 74 deposits of $156,948.40 and $81,000.

The recorded special

account activity for the same date was a single deposit of

$237,768.40 and 52 issued checks:

15 each of $6,600 and $3,420,

6 each of $6,508.80 and $3,240, 3 each of $4,339.20 and $2,160,

2 of $1,800, and 1 each of $3,616 and $2,262.

The ending special

account balance for the day was the same as the beginning

balance, $78.90.

CAT-FIT Plan

During 1979 and 1980, Liberty Hank recorded the following

amounts in the accounts of Atlas Guarantee and Windsor

Acceptance:"

Date

8/30/79

9/24/79

10/30/79

11/29/79

1/25/80

2/22/80

3/ 7/80

3/18/80

4/18/80

7/24/80

8/ 8/80

8/13/80

8/21/80

11/19/80

Atlas Guarantee

Checks Issued

Windsor Acceptance

Deposits

$500,000;

85,000

408,000

391,000

102,000

17,000;

17,000

339,000;

459,000

17,000;

306,000

17,000;

306,000

$500,000; $510,000

85,000

408,000

391,000

102,000

34,000

17,000

339,000; 374,000

459,000

34,000

306,000

34,000

306,000

$510,000

17,000

374,000

17,000

On all of these dates, the deposits to the Atlas Guarantee

account exactly offset Atlas Guarantee checks, and the checks

paid from the Windsor Acceptance account (most of which were

The listed dates are not all of those with recorded activity

during 1979 and 1980. For a given date, the listed amounts do

not necessarily represent the only activity in the accounts.

- 75 either $17,000 or a multiple thereof) exactly offset Windsor

Acceptance deposits.

Thus, the beginning and ending account

balances for the day were equal.

The Atlas Guarantee beginning

and ending account balances never exceeded $100 on these dates,

and the Windsor Acceptance account balances, with the exception

of January 25, 1980, did not exceed $5,000.

The waltz of leverage loan funds for the CAT-FIT Plan, like

the Stock Subscription Plan waltzes, typically occurred several

months after the date on the initiating documents.

Like the

waltz of Stock Subscription Plan leverage loan funds, this waltz

incorporated the parent's checking account into the loop.

As part of the leverage loan version of the CAT-FIT Plan,

the parent endorsed and returned the leverage loan proceeds check

and also sent a signed check drawn on his account (for primary

loan interest) that equaled the amount of the proceeds check.

After several parents had sent both of these checks to Kersting,

the bank processed the following check transactions on the same

date:

(1) The loan proceeds checks were paid from the account of

the leverage lender and deposited separately to the account of

each parent; (2) the parent's check for primary loan interest was

paid from the account of each parent, and these checks were

deposited as a group to the account of the primary lender,

Windsor Acceptance; (3) Windsor Acceptance issued a check, equal

to the amount deposited to its account, to Federated Finance; and

(4) Federated Finance issued a check, equal to the amount

deposited to its account, to the leverage lender.

- 76 The amounts flowing into and ot.t of the accounts of Windsor

Acceptance and the leverage lender tsually exceeded $50,000 for

this type of waltz.

It was not unccmmon, however, for each of

their account balances, immediately before and after the waltz,

to equal less than $500.

Termination of Stock Programs

Before someone began a stock investment program,. Kersting

assured him that he could surrender the purchased stock at any

time in full payment of the corresponding primary loan.

For

those relatively few who insisted on written documentation of

this policy, which did not include any of petitioners, Kersting

obliged them.

In effect, he agreed with the investor to

repurchase the shares at the price for which they were issued.

As a mechanical matter, the investor gen.erally returned an

endorsed stock certificate in exchange for a check, which he.

endorsed and returned to pay off th

outstanding primary loan.

Although Kersting sometimes provided written assurances of

the termination policy after an investor began participating, the

letters in such instances merely confirmed the understanding

reached before participation began.

As an example of a letter

confirming an earlier understanding, Kersting wrote to a new

participant on July 28, 1977:

We received today your exeputed note #420 of which

I will be enclosing a copy for identification.

This is to confirm that yo have a continuing

option to offset any obligation arising from execution

of this note by surrender of th Fargo Acceptance Corp.

- 77 -

stock certificate which was issued to you (Certificate

#39, 30,000 shares of stock).

Similarly, on August 18, 1977, Kersting wrote to someone else:

This is to confirm our verbal understanding that

you will have a perpetual option to offset any

obligation arising from execution of your note in the

amount of $30,000.00 (copy attached for identification)

.by surrender of the stock certificate issued to you by

Fargo Acceptance Corp. of which a copy is enclosed with

this letter.

Kersting sometimes represented that surrendered stock would

satisfy all outstanding debt, which would include outstanding

leverage loans.

On January 18, 1978, he wrote to a prospective

investor on behalf of Forbes Acceptance, Fargo Acceptance,

Federated Finance, Federal Finance & Mortgage, Mahalo Acceptance,

and Atlas Funding:

"This is to confirm our verbal assurance that

you will be permitted to offset any of the promissory notes which

you might execute at one time or another to any of our lending

companies by surrender of the stock certificates which will be

issued to you in that connection."

In some correspondence, Kersting disclosed why he was

reluctant to provide written assurance to all participants as a

matter of course.

A letter he wrote to a prospect on July 21,

1977, explained:

there is, of course, no problem to reassure you of the

self-sustaining and self-liquidating aspects of the

transaction. We would, in fact, issue a letter to

every participant in the deal outlining that

understanding if it would not weaken YOUR position with

the IRS. IRS wants to see you "at risk" and not on a

non-recourse basis. The fact is, if they would

determine that you are on a non-recourse basis you

would likely lose your deduction.

- 78 His February 1978 letter to Willis McComas similarly stated:

As to the obligation under the promissory notes

and subscription agreements there is no ongoing

obligation as far as we are coÅcerned. We will always

repurchase the stock issued at a price sufficient to

allow a borrower to discharge all of his debt. That,

unfortunately, can not be stated before the Revenue

Service. The Tax Reform Act of 1976 has essentially

eliminated non-risk or non-recóurse notes. Your

deductions would be materially |weakened if we would

admit to an offset arrangment [sic] as to notes and

stock certificates. I wish I could be more explicit in

writing.

In a letter serving as a credit reference to a third party

on December 10, 1980, Kersting described a specific client's

t 540ypical

investments:

"His liabilities at * * * [ the time of the

stock purchases ] and from there on would be equal to the assets

acquired.

His debt can be cancelled at any time of his choice by

the sale of the assets in his possession.

We maintain a stable

and assured market for these securitiies."

The letter also

included this summation:

"The results of this sort of investment

planning have been considerable tax retrievals * * * at a nominal

cost and negligible risk. "

Kersting did not always provide.. an original of a termination

assurance letter directly to the concerned prospect or

participant.

In some instances, with the approval of the

concerned party, he gave the original to a mutual acquaintance

such as Michael Provan or Robert Campbell for safekeeping.

one instance, Kersting sent the oridinal to a mutual acquaintance

and attached a letter that read:

IRS.

"Be sure this never gets to the

It would be most damaging to all of us."

- 79 Although Kersting sometimes described the stock surrender

part of the transaction to a prospect as a stock redemption by

the corporate issuer, he also sometimes characterized it as a

direct sale to another buyer with Kersting acting in the role of

a broker.

Regardless of how Kersting characterized the

transaction, the prospect understood that his surrender of stock

would relieve him of liability on at least the principal balance

of the primary loan.

Kersting also assured all participants that if they

conformed to the investment programs as set up and operated, they

would not be liable for the principal amounts of their leverage

loans.

A participant in the Stock Purchase Plan or the Stock

Subscription Plan understood from the beginning that annual

distributions from the corporation would satisfy his principal

balance obligation on the outstanding leverage loan.

Kersting

personnel processed terminations of these programs as of the end

of the calendar year so that December distribution checks could

be applied to pay off the last leverage loan.

A participant in

the Leasing Corporation Plan was assured that an outstanding

leverage loan would be refinanced annually with a new leverage

loan.

At termination, the annual distribution check from the

leasing corporation satisfied the investor's obligation on the

principal balance of the then outstanding leverage loan.

- 80 H.

Collection Activities

Kersting wrote a letter dated Saptember 25, 1980, to over 30

clients, which read in part:

We have sent you several r3minders, most of them

friendly, now to encourage you :o discharge the debt to

which you are a party for some :ime. As it appears

that our reminders had no beari:1g on you, we * * *

alert you now to the prospect t:lat your tax deductions

which we have generated for you might evaporate.

It is

not reasonable to expect us to deliver and not be

compensated for it in return.

Please be advised that we will reverse on our

records your tax deductions for which we have not been

paid and as referenced above if we do not receive

payment in full by not later than October 10, 1980.

* * *

The programs involved were the Stock Subscription Plan, the

Leasing Corporation Plan, and the CAT-FIT Plan.

Of the various

amounts sought from these people, none was over $4,000 and

several coincided with the annual in:erest on a leverage loan for

a typical Stock Subscription Plan or Leasing Corporation Plan.

The Kersting corporations sometimes engaged attorneys,

including Kersting's son-in-law, Rogear Moseley (Moseley), to

pursue missed payments from those who participated in the

investment programs during the years at issue.

Some investors

stopped making payments to Kersting after hearing of the IRS

search and seizure activities on January 22, 1981.

activities were more vigorous after

Collection

982 than before, and

Kersting first engaged Moseley after 1983.

At the time of trial,

Moseley had been used for fewer than 10 debtors, with most of

their cases involving more than one note.

Generally, Moseley

- 81 first sent a demand letter and then, if he received either no

response or an unacceptable response, he took action to commence

a lawsuit.

Attorney Thomas Dunn filed a complaint in Hawaii State court

in 1983 on behalf of Atlas Funding.

Atlas Funding sought to

collect $46,200 as the payee on a stock subscription plan renewal

primary note dated June 1, 1979, with Continental pilot Steven

Hane the maker.

(A lower-case reference to a "stock purchase

plan," "stock subscription plan," "leasing corporation plan," or

"CAT-FIT plan" relates to a specific participant and indicates a

program that, based on information available in the record, is

not materially inconsistent with its upper-case namesake

described in part III (B), (C), (D), or (E), above.)

The

principal amount of the note was $30,000, and 3 years of 18percent annual interest equaled $16,200.

The court entered a

default judgment in October 1983, but Atlas Funding voluntarily

dismissed the case the next month.

Carl Mott, a pilot with American Airlines, Inc., was the

defendant in lawsuits commenced in Hawaii State court in 1985 by

Aztec Acceptance, Avalon Acceptance, Delta Acceptance, Lombard

Acceptance, and Candace Acceptance.

Moseley filed the five

complaints, which involved 15 leverage notes dated between

January 1982 and January 1984, inclusive.

Each corporation

sought a year of interest on the note or notes attached to its

complaint.

The court entered default judgments in all five suits

- 82 in February 1986, and Moseley with some success took steps to

collect the judgments.

In 1985, Moseley also filed lawsuits in Hawaii State court

on behalf of Candace Acceptance and Wahalo Acceptance against

George Vermef, another Continental pilot.

Candace Acceptance

sought to collect $38,700 on two stock purchase plan leverage

notes, both dated July 1, 1980.

The principal amounts of the

notes were $21,600 and $14,400.

Mahalo Acceptance sought to

collect $23,430 on two leverage notes, one, with a principal

amount of $18,000, that related to a stock subscription plan, and

the other, with a principal amount of $4,080, that related to a

CAT-FIT plan.

Both of these notes were dated July 1, 1980.

The

court entered default judgments for both Candace Acceptance and

Mahalo Acceptance in April 1986.

court later vacated the

judgments, after salary garnishment had begun, when the parties

agreed to settle the cases.

In 1986, Moseley filed a complaint in Hawaii State court on

behalf of Delta Acceptance against Robert Peterson, a pilot for

Delta Airlines.

Delta Acceptance sought to collect $27,219 on

two leverage notes, one, with a principal amount of $14,400, that

related to a stock purchase plan, and the other, a renewal

leverage note with a principal amount of $10,020, that related to

a leasing corporation plan.

The $14,400 note was dated July 1,

1980, and the $10,020 note was dated July 1, 1982.

The $27,219

sought by Delta Acceptance equaled t e sum of the principal

amounts of the notes and one year of interest on each.

The court

- 83 entered a default judgment for Delta Acceptance in June 1986,

after which salary garnishment began, but later the court granted

the defendant's motion to set aside the default and relieve him

from judgment.

Notices of Deficiency

The Commissioner determined that specified amounts claimed

as interest deductions in connection with the Kersting investment

programs are not allowable because:

(1) The transactions that

gave rise to the claimed deductions were shams; (2) petitioners

did not establish that they paid or properly accrued the interest

claimed as deductions in the years claimed; and (3) the

underlying transactions did not give rise to bona fide

indebtedness or enforceable and bona fide obligations to pay

compensation for the use or forbearance of money.

The Commissioner further determined that, to the extent the

claimed interest deductions are otherwise allowable, the amounts

constitute investment interest the deductibility of which is

subject to limitation under section 163(d), and petitioners

failed to report properly the income received in the same

transactions.

IV.

Petitioners

Jerry R. and Patricia A. Dixon

Petitioners Jerry R. Dixon (Dixon) and Patricia A. Dixon

(Mrs. Dixon) resided in El Paso, Texas, when they filed their

petition and throughout their years at issue, 1977 through 1981.

- 84 They filed a joint Federal income tag return for each of these

years with the Internal Revenue Service Center at Austin, Texas.

Dixon, 56 years old at the time of trial, is a high school

graduate with over 3 years of a collage education in business

administration.

He served 4 years i:1 the military, where he

received pilot training from the Navy, before an honorable

discharge in 1958.

He has been empløyed by Continental

continuously since 1959, except for k 3-year break in service

after the years at issue attributabl3 to Continental' s bankruptcy

and associated pilot strike.

Mrs. Dtxon was not employed during

the years at issue.

Dixon first heard of Kersting i:1 about 1972 when fellow

pilots were discussing the possibility of leasing an automobile

from him for their use during layovers.

By 1976, when Dixon

decided he should try to shelter his income, he and Kersting were

exchanging correspondence about Kersting's investment programs.

Dixon had discussed these programs with other Continental pilots

who were already involved, the most influential of whom were

Michael Provan and Leon Lipsky.

In Dixon's first letter to Kersting, in which he informed

Kersting that he was a Continental pilot, he referred at the top

to "CAT-FIT and Stock Sub-Program" and wrote:

"I will gross

about $50,000.00 this year and need some help if it is not too

late.

I would like to know about ho

much tax dollar return

[ there would be ] per dollar spent on the twb programs above. "

Dixon did not inquire about corporate profitability or stock

- 85 appreciation potential in this letter.

Later, in a letter with

which he included a completed stock subscription form of some

sort, he stated that he would like to participate in the CAT-FIT

Plan "to the maximum extent" and to begin an "auto leasing

program" as of January 1, 1977.

He also asked Kersting for the

name and address of the "tax man" Kersting used in southern

California.

In Kersting's reply letter dated November 20, 1976,

he instructed Dixon to fill out a form to open an account at

Hawaii National Bank.

Dixon's first investments with Kersting were for 1977.

Prior to this time, Dixon had been involved with one taxfavorable investment, an apartment building limited partnership

in El Paso.

The largest amount the Dixons had borrowed was about

$50,000 for the purchase of a home.

Before investing in a

Kersting program, Dixon did not receive printed material, such as

a prospectus, nor did he receive financial statements or earnings

histories of the participating corporations.

He did, however,

routinely receive written statements describing the tax benefits

he might expect from particular Kersting investments.

At the

time of his investments, he knew that the leasing corporations in

which he invested leased automobiles, and he thought that the

other Kersting corporations in which he invested, including

Investors Financial and Charter Financial, were in the business

of making loans.

He did not, however, know the number of

shareholders of any of these Kersting corporations.

- 86 By letter dated March 17, 1977, Gabriele Kersting, as vice

president of Atlas Funding, apologised to Dixon for being

"somewhat negligent in our correspondence. "

The rest of the

letter read:

If you are still interested in our Stock

Subscription Agreement and CAT-FIT (gifts to children)

programs, we would certainly like to have you

participate. The SSA program dould engender a

$9,000.00 deduction for you and CAT-FIT would generate

a $6,120.00 deduction.

If you|are in the 30% tax

bracket, these deductions would retrieve $4,536.00 for

you for 1977, notwithstanding dny deductions you may

generate on your own.

If you are interested, please notify me at your

early convenience and I will sde that the appropriate

documents are sent to you immediately.

With initiating documents dated January 2, 1977, the Dixons

entered into CAT-FIT plans for three children, with each

investment certificate in the face

ount of $17, 000.33

As Dixon

understood it, the CAT-FIT Plan was meant to facilitate tax-free

transfers of up to $3,000 annually per child.

The Dixon CAT-FIT

plans differ from the CAT-FIT Plan in several respects.

First,

both Dixon and Mrs. Dixon were makers of separate primary notes

by the terms of which Dixon promised to pay $25, 500 and Mrs.

We do not find as facts that Dixon and the other investing

petitioners necessarily executed the various initiating documents

(or even necessarily received complete sets of the documents)

described in our part III discussion of the four investment

programs. When we state in our findings that a petitioner

"entered into" a given program, we niean only that he, in some way

satisfactory to Kersting, commenced |an investment that was

patterned after the applicable program in part III. Although our

findings disclose certain inconsistencies between a petitioner's

specific transactions and their part III counterparts, we do not

mean to imply that in all other respects precise or complete

conformance with our part III descriptions has been established.

- 87 Dixon promised to pay $21,0ó0, for a total of $46,500."

Second,

both Dixon and Mrs. Dixon were makers of separate renewal primary

notes dated January 2, 1979, each of which included a promise to

pay $25,500.

Third, each of the third and fourth leverage notes,

dated January 2, 1979, and January 2, 1980, was signed by both

Dixon and Mrs. Dixon, and each of the leverage loan proceeds

checks was payable to both.

Kersting used Hawaii National Bank to waltz leverage loan

funds for the Dixon CAT-FIT plans on August 31, 1977, and June 9,

1978.

The check that Dixon wrote for primary loan interest and

that Kersting waltzed on August 31, 1977, was dated May 2, 1977.

The similar check that Kersting waltzed on June 9, 1978, was

dated May 24, 1978.

By form letter dated January 1, 1980, Windsor Acceptance

informed Dixon that, among other things, he could terminate his

CAT-FIT plans by returning renewal documents unsigned along with

the investment certificates.

In 1980 or shortly thereafter,

Dixon terminated the CAT-FIT plans by returning the investment

certificates to Kersting.

With initiating documents dated January 2, 1977, Dixon

entered into a leasing corporation plan involving Escon Leasing

($19,000 purchase and $55,000 subscription), in connection with

which he leased automobiles by means of sale-leaseback

transactions throughout the years at issue.

He had originally

Dixon's primary note, however, listed loan proceeds of

$30,000, making the combined loan proceeds $51,000.

- 88 purchased the automobiles with financing from Conair Federal

Credit Union or Coronado Bank, neither of which was associated

with Kersting.

This leasing corpor6tion plan differs from the

Leasing Corporation Plan in that Di on's Escon Leasing stock

certificate was dated July 1, 1977, unlike the other initiating

documents .

With initiating documents dated January 2, 1977, January 3,

1978, January 3, 1979, and January 3, 1980, Dixon entered into

stock subscription plans involving, respectively, Fargo

Acceptance ($30,000 purchase and $3(,000 subscription), Mahalo

Acceptance ($60,000 purchase and $60,000 subscription), Candace

Acceptance ( $60 , 000 purchase and $60, 000 subscription ) , and Delta

Acceptance ( $60 , 000 purchase and $60, 000 subscription ) .

He had

started with Mahalo Acceptance by checking the box next to

"60, 000" shares on the standard acceptance corporation order

form.

He had responded the same way to a similar form for

Candace Acceptance.

His Fargo Acceptance stock subscription plan

differs from the Stock Subscription Plan in that the primary note

had a 1-year term rather than 2.

For this Fargo Acceptance stock subscription plan, Kersting

used Hawaii National Bank to waltz primary loan funds on July 29,

1977, and leverage loan funds on Jure 15, 1977.

The checks Dixon

wrote for primary loan interest and subscription interest were

dated May 23, 1977.

For Dixon's Mahalo Acceptance stock

subscription plan, Kersting used Hawaii National Bank to waltz

leverage loan funds on May 12, 1978.

The checks Dixon wrote for

- 89 -

primary loan interest and subscription interest were dated

April 20, 1978.

For Dixon's Candace Acceptance stock

subscription plan, Kersting used Liberty Bank to waltz primary

loan funds on April 10, 1979, and leverage loan funds on May 2,

1979.

The checks Dixon wrote for primary loan interest and

subscription interest were dated April 15, 1979.

Sometime after January 3, 1980, Kersting wrote Dixon that he

had gone over Dixon's accounts and defined "the need for

additional shelter" based in part on Dixon's response to a

questionnaire.

This letter continued:

You will find that you will have total deductions

of $84,901.80 for this year. All of it can be claimed

as the meter started running for you on the 3rd day of

January of 1980. Please return to us all documents

called for by the additional deductions (Charter Fin.

Corp. and Investors Fin. Corp.) at your early

convenience so that we can put the checks through the

Bank.

With initiating documents dated January 3, 1980, Dixon entered

into stock purchase plans involving Investors Financial ($120,000

purchase) and Charter Financial ($120,000 purchase).

Although the Dixons had checking and savings accounts

outside of Hawaii, Dixon had opened a checking account at Hawaii

National Bank in 1977, which he used in dealings with Kersting.

In early 1979, he closed this account and began to use another

Hawaii bank account, a joint account with Mrs. Dixon at Liberty

Bank.

Kersting, through Atlas Funding, set up the Liberty Bank

account for the Dixons by making an initial deposit of $100.

Dixon was unusual among Kersting's investors in that he paid

- 90 -

interest on leverage loans with checks drawn on Hawaii National

Bank and Liberty Bank.

Dixon became aware of the IRS search of the Kersting offices

shortly after it occurred.

Although he was still participating

in Kersting investment programs during 1984 and 1985 in the sense

that he continued to pay interest on some leverage notes, he and

Mrs. Dixon no longer claimed interest deductions relating to

those programs.

This was due in part to the advice of their

return preparer, an attorney and certified public accountant

named Mary Mangrum who suggested wa2.ting until any Tax Court

controversy was resolved, and in part to Continental's 1983

bankruptcy, which resulted in lower pay to Dixon and less need

for deductions.

Delta Acceptance sent Dixon a form letter dated August 28,

1985, which stated:

Enclosed you will find the necessary checks to

terminate any and all particip Ltion you have in our

programs. Please endorse the acks of the checks as

per instructions on each ticket stapled to the checks.

Then, return them to us at you earliest convenience.

We will use these funds to can el your notes all of

which will be sent to you upon their cancellation

marked "PAID." Please refer now to any items marked

below which may pertain to you

If you are requested

to return any further document , please include them

along with the enclosed checks

* * *

Please return your Charter Financial * * *

stock certificate for candellation. PLEASE

SIGN OFF ON BACK OF (EACH) CERTIFICATE!!

- 91 This letter contained similar unchecked "cancellation" lines for

leasing corporation stock certificates, acceptance corporation

stock certificates, and CAT-FIT investment certificates.

The Dixons reported adjusted gross income for the years 1977

through 1981 in the respective amounts of $61,964, $68,911,

$91,535, $100,121, and $105,538.

They reported no capital gains

or losses relating to Kersting corporations during these years

and reported $117 of dividend income for 1978.

For their taxable

year 1977, the Dixons' return was prepared by a certified public

accountant with the Haskins & Sells firm in El Paso.

acquaintance of Dixon's, whom Dixon knew to be involved in

Kersting's investments, had recommended this accountant.

Philip

Scheff prepared the Dixons' 1978 and 1979 returns, and Earl

LeMond, whom Kersting had recommended to Dixon, prepared their

1980 and 1981 returns.

Among the information Dixon provided to

the return preparers were yearend statements of interest paid

that Kersting corporations had sent to him.

In his notice of deficiency, the Commissioner disallowed

claimed interest deductions as follows:

- 92 Payee

Federated Finance

Escon Leasing

Windsor Acceptance

Fargo Acceptance

Forbes Acceptance

Atlas Funding

Norwick Acceptance

Mahalo Acceptance

Candace Acceptance

Ventures Funding

Delta Acceptance

1977

1978

1979

1980

1981

$3,420

6,600

6,120

3,600

2,028

5,400

428

-----

$3,420

6,600

6,120

1,503

1,688

10,800

-7,200

----

$3,420

6,600

6,120

1,745

---1,253

7,200

10,800

$47,520 $46,620

2,280

6,120

-551

-428

-----6,191

4,320

1,503

3,888

--600

1,503

$27,596 $37,331 $37,138

$65,193 $58,611

John R. and E. Maria Cravens

Petitioners John R. Cravens (Cravens) and E. Maria Cravens

(Mrs. Cravens) resided in Laguna Niglel, California, when they

filed their petitions and throughout their years at issue, 1979

and 1980.

They filed a joint Federal income tax return for each

of these years with the Internal Rev3nue Service Center at

Fresno, California.

During these years, Cravens was a pilot with

American Airlines.

Mrs. Cravens was not employed during 1979 and

worked as a flight attendant for American Airlines during 1980.

After hearing about Kersting and his programs from several

other pilots, Cravens, who was seekiag a tax shelter, telephoned

him to discuss possible investments.

With initiating documents dated July 1, 1979, Cravens

entered into a stock subscription plan involving Candace

Acceptance ($60,000 purchase and $60,000 subscription), for which

the primary lender was Ventures Funding and the leverage lender

was Fargo Acceptance.

Kersting used Liberty Bank to waltz

primary loan funds on October 5,. 1971, and leverage loan funds on

- 93 October 26, 1979.

Cravens had opened a checking account at

Liberty Bank in September of 1979, and the checks he wrote for

primary loan interest and subscription interest were dated

October 1, 1979.

For the next year, with initiating documents

dated July 1, 1980, he entered into a stock subscription plan

involving Delta Acceptance ($60,000 purchase and $60,000

subscription).

He never did anything with a check issued by

Candace Acceptance or Delta Acceptance except endorse and return

it.

Consistent with his understanding that he could terminate

his participation in these programs at any time by selling his

stock back to the corporation, Cravens did so for both stock

subscription plans.

He was very unusual among Kersting's clients

in being content to report a capital gain after remaining in a

program for only a year.

By letter dated September 10, 1980,

Candace Acceptance informed Cravens that an enclosed check

represented the "repurchase of stock" of the corporation.

The

unsigned check, dated July 1, 1980, was payable to Cravens in the

amount of $60,000.

The letter asked him to endorse the check and

return it to Candace Acceptance.

He had earlier mailed his

endorsed Candace Acceptance stock certificate to the Kersting

offices and in exchange received the Ventures Funding primary

note marked "paid."

Along with his Candace Acceptance stock

certificate, he had sent a handwritten letter stating in part:

"I'm looking forward to receiving my $60,000 note and the

paperwork for the 6,000 shares of Delta Corp."

- 94 Cravens terminated his Delta A(:ceptance stock subscription

plan in 1981, exchanging his stock <:ertificate for a "paid"

primary note and reporting a capita . gain on the 1981 return.

The Cravenses reported adjusted gross income for 1979 and

1980 of $64, 694 and $75, 394, respec ively.

In their 1980 return,

they reported a Schedule D long-term capital gain of $18,000 on

the Candace Acceptance stock, derived from a reported adjusted

basis of $42,000 on the reported selling date, August 1, 1980.

Because of a 60-percent capital gains deduction, they reported

$7,200 as taxable income from this stock sale.

They reported no

other Schedule D transactions in either year.

Neither the 1979

nor the 1980 return includes the name or signature of a paid

preparer.

In his notices of deficiency, the Commissioner disallowed

claimed interest deductions as follows:

Payee

1 979

Ventures Funding

Candace Acceptance

Fargo Acceptance

Federated Finance

Delta Acceptance

Mahalo Acceptance

1980 042

$5,400

3,600

810

----

$5,400

3,600

810

5,400

3,600

810

$9, 810

$19 , 620

The disallowed amounts for Ventures Funding, Candace Acceptance,

and Fargo Acceptance all related to ,the Candace Acceptance stock

subscription plan.

The disallowed amounts for the other three

corporations related to the Delta Acceptance stock subscription

plan.

The Commissioner also increased the Cravenses' 1980 income

- 95 by $18,000, which they had reported as a Schedule B nontaxable

dividend distribution by Candace Acceptance.

Ralph J. Rina

Petitioner Ralph J. Rina (Rina) resided in Sunset Beach,

California, when he filed his petition and throughout his years

at issue, 1979 and 1980.

He filed a Federal income tax return

for each of these years with the Internal Revenue Service Center

at Fresno,. California.

Rina completed high school and 3 years of college before he

began to pilot aircraft full-time.

He served 6 years in the

Marine Corps reserve program beginning in 1964, and he has been

employed as a pilot by Continental since 1966.

Rina first learned of Kersting in 1978 or 1979 from pilots

who had invested in his programs.

Before this time, he had not

been involved with tax shelters because he did not believe his

salary warranted such investments.

His annual salary of $85,350

in 1979 was approximately 50 percent higher than his 1977 salary.

He eventually met with Kersting in Kersting's Hawaii offices to

discuss the programs.

Kersting later sent Rina a letter dated November 7, 1979,

which made no mention of profit potential for any Kersting

corporation:

I have structured the enclosed shelter program for

you. You will find that you could have a total of

$62,535.00 of total interest deductions this year, if

you wish. However, due to the fact that interest must

be apportioned from date of origination of a promissory

note through year-end only 50% of the deductions could

be claimed this year, i.e. $31,267.50. The remaining

50% can be claimed in 1980.

- 96 -

If you want us to go ahead and produce the

necessary documents, please call me upon receipt of

this letter. * * *

I will be enclosing forms ;o open a bank account

here in Hawaii which we will need to facilitate

clearing of tax deduction checkg through your bank

account before year-end.

During a telephone conversation with Kersting on November 10,

1979, Rina gave his approval to document these deductions.

In a

short letter to Rina on November 12, 1979, Kersting wrote:

"Candace Acceptance Corp. documents still to come.

We did not

have sufficient time this weekend to complete all documentation.

You can count on this deduction, however."

Rina opened a checking account with Liberty Bank in November

of 1979 by making an initial deposit of $100.

Although he wrote

checks drawn on this account, he never personally made another

deposit, leaving that activity to Kersting, and he never used the

account for anything other than Kersting-related transactions.

He also had an account with Continen al Federal Credit Union in

1979 and 1980, which he used to pay interest on his leverage

loans.

With initiating documents dated July 1, 1979, Rina entered

into stock purchase plans involving Charter Financial ($80,000

purchase) and Investors Financial ($80,000 purchase), a stock

subscription plan involving Candace Acceptance ($60,000 purchase

and $60,000 subscription), and a leasing corporation plan

involving Anseth Leasing ($19,000 purchase and $55,000

subscription)..

He did not lease an automobile as part of his

- 97 -

leasing corporation plan, nor did he purchase additional stock

under the subscription agreement.

For his Candace Acceptance

stock subscription plan, Kersting used Liberty Bank to waltz

primary loan funds on December 11, 1979, and leverage loan funds

on December 17, 1979.

The checks Rina wrote for primary loan

interest and subscription interest were dated November 28, 1979.

At the time of Rina's investments in Charter Financial,

Investors Financial, and Candace Acceptance, he thought that they

were lending institutions of some sort, but he did not have an

idea of the specific types of loans they made.

He knew of

several pilots who were Charter Financial shareholders, but he

did not know how many shareholders there were in total.

He also

did not know how long Charter Financial and Investors Financial

had been in existence at the time he purchased their stock.

had heard from Kersting and participants in leasing corporation

plans that Anseth Leasing owned automobiles.

Kersting also told

him that Anseth Leasing might enter into a leasing transaction

with Rina for aircraft that neither Rina nor Anseth Leasing then

owned, but which Rina was interested in acquiring.

Whatever information Rina had about the businesses of any of

the Kersting corporations in which he invested was obtained from

other participating pilots or Kersting himself.

He believed that

at least some of the corporations had access to lendable funds

that were available for purposes other than Kersting's investment

programs.

- 98 One of Rina's fellow pilots and acquaintances at Continental

was Matt Bomis.

Rina received an undated letter from Kersting

that read in part:

"Matt Bomis asked us this week to produce an

additional $35,000.00 of tax deductions for you which we have

done and which is summarized on enclosed sheet.

now a total of $81,906.00 in tax offsets."

You will have

The enclosed sheet,

which lacked any information meaningful to Rina except tax

information, included three investments that were to be dated

January 3, 1980:

Charter Financial, Delta Acceptance, and Escon

Leasing.

Later, with initiating documents dated January 3, 1980, Rina

entered into a stock purchase plan involving Charter Financial

($40,000 purchase) and a stock subscription plan involving Delta

Acceptance ($60,000 purchase and $60 000 subscription).

This

stock subscription plan differs from the Stock Subscription Plan

in that the Delta Acceptance stock certificate had a January 1983

date rather than a January 1980 date

Rina decided not to enter

into the Escon Leasing leasing corporation plan and mailed that

package of documents back to Kersting unsigned.

Rina did nothing with any check received from a Kersting

corporation except endorse and return it, as instructed.

He did

not think it unusual that Kersting corporations issued two-party

checks as loan proceeds.

To him this was a reasonable procedure

to assure the lender that the loan proceeds would be used

consistently with the purpose of the loan.

- 99 Prior to entering a Kersting investment program, Rina never

received a prospectus, a projection of income for the

corporations participating, or a written indication of

anticipated appreciation in stock value.

He did, however,

sometimes receive written projected summaries of the annual

interest deductions he could expect from specific Kersting

investments.

Even after entering a program, he never received a

financial statement from a Kersting corporation or otherwise

acquired any meaningful firsthand knowledge about whether the

corporations ever had profits.

He sometimes received requests

for proxies and notices of shareholders meetings, but he did not

attend.

Acting upon assurances by Kersting that he would never have

any trouble selling his stock, Rina did so by returning the

endorsed stock certificate to Kersting, a procedure that Rina

thought was comparable to using a broker.

On at least one

occasion, Kersting told him that he was matching him as seller

with a specific buyer.

Rina and Kersting had no prearranged

understanding on valuing stock that was inconsistent with

Kersting's treating its value as equal to its original issuance

price.

For his Charter Financial stock, Rina received in return

the primary note marked "paid" and nothing else.

He has not

attempted to sell his Investors Financial stock.

He also still

has his Delta Acceptance stock, and Kersting has not demanded

payment of the principal balance of the associated primary loan.

- 100 Rina and Kersting agreed to await the outcome of litigation and

IRS investigations concerning the investment programs.

Rina reported adjusted gross in ome for 1979 and 1980 of

$80,647 and $121,938, respectively.

He reported no capital gains

or losses relating to Kersting corporations for either year.

His

return preparer for 1979 was Philip Scheff and for 1980 was Earl

LeMond.

He did not tell his return preparers how to report the

annual distributions received from Kersting corporations.

In his notice of deficiency, th

Commissioner disallowed

claimed interest deductions as follows:

Payee

Federated Finance

Candace Acceptance

Anseth Leasing

Ventures Funding

Fargo Acceptance

Delta Acceptance

Mahalo Acceptance

1979

1980

$16,110

3, 600

3, 300

5,400

----

$49,806

6, 1 92

3, 300

5,400

3,123

8,496

1,620

$28,410

$77,937

John R. and Maydee L. Thompson

Petitioners John R. Thompson (Thompson) and Maydee L.

Thompson (Mrs. Thompson) resided in Camarillo, California, when

they filed their petitions.

They filed a joint Federal income

tax return for 1979 with the Internal Revenue Service Center at

Fresno, California.

They also filed joint returns for their

other years at issue, 1980 and 1981.

Throughout most of the

years at issue, the Thompsons resided in Hawaii, returning to

California in 1982.

- 101 -

Thompson had a high school education but no college when he

entered the Army Air Corps in 1942 at age 19.

Except for

military service during the Korean War, he worked for Continental

from 1946 until his retirement in October of 1982.

was not employed during the years at issue.

Mrs. Thompson

From 1946 to 1980,

Thompson had some technical training and courses both in and out

of the military, but he never received any formal instruction in

business or accounting.

When involved in business transactions,

he sometimes relied on other people, including professionals, for

guidance.

Thompson first heard of Kersting in mid-1977 from Michael

Provan when the two pilots were discussing ways to lessen and

avoid income taxes.

Thompson began a Kersting investment in that

year, but the accounting firm that prepared the Thompsons' 1977

return refused to include the associated deductions because it

wanted nothing to do with the Kersting programs.

Provan also

told Thompson about an investment opportunity concerning First

Savings (described in part II (B), above), in which Thompson

invested $20,000 cash.

He knew that Kersting was promoting this

investment to pilots, and First Savings appeared to him to be a

healthy business when he visited and observed the premises.

Sometime after 1979, Kersting returned Thompson's $20,000

investment by making a deposit to the Thompsons' Liberty Bank

account.

Kersting at some point also arranged for the Thompsons

to finance a Hawaii home purchase through a savings/mortgage

- 102 program that had a below-market interest rate on the mortgage.

They lost several thousand dollars in this program.

By 1979, the Thompsons' first year at issue, Thompson was

already participating in a leasing corporation plan involving

Escon Leasing ($19,000 purchase and $55,000 subscription), in

connection with which he leased an Lutomobile.

With initiating documents dated January 3, 1980, Thompson

entered into stock purchase plans involvinh Investors Financial

($80,000 purchase) and Charter Financial ($120,000 purchase), and

a stock subscription plan involving Delta Acceptance ($60,000

purchase and $60,000 subscription).

Kersting had sent him a

letter that, without mentioning anything else about the

corporations, listed the annual interest deductions from these

"tax shelter" investments.

The letter also stated:

"While this

might not yet make you a zero taxpayer it will get you close to

the zero line."

Thompson knew nothing about the businesses of

Charter Financial, Investors Financial, and Delta Acceptance, or

who the other shareholders were, when he bought their stock.

also did not receive prospectuses, which he thought always

accompanied stock transactions of this sort.

Thompson did not own stock in the corporations that made

the primary and leverage loans for his investments.

He made

interest payments on leverage loans for 1980 with checks drawn on

the Thompsons' account at Liberty Bank, which was the only

account they had at the time.

- 103 Thompson quit participating in Kersting's programs beginning

in 1982 when he received a notice from the IRS regarding the

Thompsons' 1978 taxes.

He immediately telephoned Kersting, who

said he would take care of the problem.

Thompson was not

satisfied with Kersting's assistance, so he eventually sought out

tax lawyers and settled the dispute with the IRS.

When Thompson had originally begun participating in the

Kersting programs, Kersting had assured him that he could return

his stock certificates at any time in exchange for the notes used

to acquire the shares.

Nonetheless, when Thompson twice tendered

his stock certificates after 1982, they were not accepted.

has not received back canceled or "paid" promissory notes.

Kersting sent Thompson .a letter dated March 31, 1986, which,

in addition to showing a "total amount owing" of $11,844, read:

"As we are trying to terminate your accounts I find that there

are some unattended bills on our books of which you might not be

aware.

All of the bills reflect interest on leverage notes

which, as you know, produce the funds to pay interest on the

primary notes."

By letter dated August 23, 1986, Kersting informed the

Thompsons that he had turned their file over to attorney Moseley,

and added:

Since the odds * * * are in favor of imminent

litigation I consider it to be my obligation to point

out to you the consequences:

The day after you have allowed your attorneys to

file suit I will declare all notes which you have

executed to our companies in default and begin

collection proceedings. We will make an effort to

- 104 collect from you not only the $11,844.00 of interest on

promissory ñotes of which ®we have sent you billings

several times[,] we will also file suit to collect the

principal of all notes which we hold. The aggregate

sum is well in excess of $250,000.00, as you know.

At the time of trial, Kersting was still not committed to taking

the litigation initiative to pursue Thompson's outstanding

principal amounts.

The Thompsons reported adjusted gross income for 1979

through 1981 in the respective amounts of $86,158, $89,571, and

$113,711.

They reported no capital gains or losses relating to

Kersting corporations for these years.

Their return preparer for

1979 was Philip Scheff and for 1981 was Earl LeMond.

Their 1980

return does not include the name or signature of a paid preparer.

In his notices of deficiency, the Commissioner disallowed

claimed interest deductions as follo.ws:

Payee

1979

1980

1981

Ventures Funding

$10,800

Candace Acceptance

Fargo Acceptance

Escon Leasing

Federated Finance

Mahalo Acceptance

Delta Acceptance

7,200

2,124

6,600

11,250

1,503

---$ 2,280

57,420

5,940

7,200

-------

$89,782

$39,477

$72,840

$89,782

Unidentified

Hoyt W. and Barbara D. Young

Petitioners Hoyt W. Young (Young), also known as Wayne

Young, and Barbara D. Young (Mrs. Young) resided in Cordova,

Tennessee, when they filed their petitions.

They also resided in

Tennessee throughout their years at issue, 1979 through 1983.

- 105 They filed joint Federal income tax returns for 1979 and 1980

with the Internal Revenue Service Center at Memphis, Tennessee,

and also filed joint returns for 1981, 1982, and 1983.

Young, 50 years old at the time of trial, earned a college

degree in business administration in 1961.

He then served in the

Marine Corps for 10 years, toward the beginning of which he

learned to pilot aircraft at Naval Flight School, and was

honorably discharged in 1971.

In that year he became a

registered representative for Waddell & Reed, selling mostly

mutual funds and term insurance.

During the years at issue, he

was a pilot for Federal Express Corp., where he had worked since

1972.

Mrs. Young was not employed during 1979, 1980, and 1983,

but on the 1981 and 1982 returns, each of which includes a

Schedule C relating to Amway products, she reported a "sales"

occupation.

Young first learned of Kersting and his investment programs

in about 1978 from a former Federal Express employee, Gary

Humphries.

Because of his increasing income, Young was

interested in possible tax shelters.

Humphries explained the tax

advantages of the Kersting programs with reference to interest

deductions.

Prior to making his Kersting investments, Young had

some finance company borrowing experience, but the most money he

had ever borrowed at one time related to the purchase of an

automobile.

He had never leased an automobile.

He had

previously owned common stock, with mixed results.

- 106 Young did not fill out a loan application or submit

financial statements prior to borrowing funds from Kersting

corporations, but Kersting was aware of his occupation.

Although

Young understood what a prospectus was, he neither requested nor

received any relating to Kersting investme'nts.

He received

written projections of tax benefits for Kersting programs and

annual statements reflecting interest he had paid during the

year, but he did not receive profit or income projections for any

Kersting corporation.

Although he

ad no firsthand knowledge of

the business operations of the corpórations in which he invested,

Kersting and other participants told him that they engaged in

lending and automobile leasing.

With initiating documents dated July 1, 1979, Young entered

into stock purchase plans involving Charter Financial ($120,000

purchase) and Investors Financial (:;120,000 purchase), and a

stock subscription plan involving Candace Acceptance ($60,000

purchase and $60,000 subscription).

He also entered into a

leasing corporation plan as of the same date involving Anseth

Leasing ($19,000 purchase and $55,000 subscription), in

connection with which he neither leased an automobile nor

executed a subsequent subscription agreement.

He received other

documents dated July 1, 1979, relating to a CAT-FIT plan, but he

did not participate.

The form letters that accompanied Young's 1979 and 1980

annual distributions from Charter Financial included this

sentence:

"We recommend to you * * * to remain a shareholder so

- 107 that you will participate in the progress of your company in the

future."

Each of the letters that accompanied his 1979 annual

distribution from Candace Acceptance and his 1980 annual

distribution from Delta Acceptance included a similar sentence

and also stated:

"The investment funds of your company * * * are

primarily.employed in lending and l

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