Petition for Writ of Certiorari — Erhard v. Commissioner
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Suprenss Cout U.S.
Pid ED
No. OR 135 JUL 24 1995
| IN THE
Supreme Court of the United States
OCTOBER TERM, 1995
WERNER H. ERHARD,
Petitioner,
-against-
COMMISSIONER OF INTERNAL REVENUE,
Respondent.
PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
PETITION FOR A WRIT OF CERTIORARI
MICHAEL I. SALTZMAN
(Counsel of Record)
LESLIE BOOK
STUART B. KATZ
KEVIN J. LISS
Baker & McKenzie
805 Third Avenue
New York, New York 10022
(212) 751-5700
Counsel for Petitioner
CASILLAS PRESS, INC., 1717 K STREET, N.W., WASHINGTON, D.C. 20036
QUESTION PRESENTED
Is the requirement of I.R.C. § 7443A(b)(4), that only a Tax
Court judge and not a special trial judge may decide a case
assigned to the special trial judge for hearing and report,
satisfied (1) when the Tax Court judge adopts the special trial
judge’s lengthy report verbatim, (2) when there is no oppor-
tunity for a party to make oral or written objections to the
special trial judge’s report, and (3) when the applicable Tax
Court rule presumes that the decision of a special trial judge
is correct?
ny
TABLE OF CONTENTS
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STATEMENT OF THE CASE........ Cr
REASONS FOR GRANTING THE WRIT........ Py a5 wae
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APPENDIX A........... Pee avaveehs saa la
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APPENDIX E........... ea rh ia BA Scan 3h dC
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APPENDIA H........... =e : LE ere ee re eee
Teen enn eka eames —h Ree 123a
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TABLE OF AUTHORITIES
CASES Page
Anderson v. City of Bessemer City,
ee ee es Sy oe oo ee ee eee ee ened ll
Burlington N.R.R. Co. v. Department of Revenue,
2 em 8. fe Re | eee reer 1Z, 15
Estate of Halas v. Commisswner,
Oe i Ee tc a aks ew hee whee ee area 16
Freytag v. Commissioner,
501 U.S. 868 (1991)........... 4,5, 10, 11, 12, 13, 14, 16
Pacemaker Diagnostic Clinic of Amenca v. Instromedix,
725 F.2d 537 (9th Cir.),
cert. dented, 469 U.S. 824 (1984).................266.- 15
Reed v. Board of Election Comm'rs,
rg BBB) ge Re, oy rere ree Perr 12
Stone v. Commissioner,
i ee ee ee ee eo iii ve veecuwns nner’ 11
United States v. Wilson,
864 F.2d 1219 (5th Cir.)
cert. dented, 492 U.S. 918 (1989)..................056. 12
Vaughn v. Commissioner,
ey ee GN Ss Svc cite ac he See een ta eae 16
STATUTES
SR, Se a ee AOE Anan Whee grt 4
[at *e ce ee 2, 9, 13, 14, 16
ERR See soiree ci eenecereeeecrer ere e 2,4
Smee | Ree Per erCe rere rer rT Tre, Sere 4
ee
Page
ILR.C. § 7443A(b(4)........0.006. ....i, 4, 10, 11, 13, 16
CoC SO Oe eae ie ee 13
USC Cee i ee ee 14, 15
USC: Se fo a ee 2
MISCELLANEOUS
Oe ee es rer pre ce rte rh wt: 14
Pee, Be. he. Fa ok oe eed dee ces eae ee 15
5S. Hep.No. 375, See Cems. tee Seat. Te. ec es 15
United States Constitution, Article III.................... 15
Chnstie, J/udwial Review of Findings of Fact,
Sr ee. Oke Bee BO, Oe Cs Koos ee ee 11
Linda Silberman, Masters and Magistrates Part II: The
American Analogue, 50 N.Y.U. L. Rev. 1297 (1975)......17
SA Wright & Miller, Federal Practice & Procedure,
Fe re ree reer ery re Per Tere rr 1]
Tax Court Rules of Practice and Procedure, Rule 151.......3
Tax Court Rules of Practice and Procedure, Rule 161...... 16
Tax Court Rules of Practice and Procedure, Rule 182...... 3
Tax Court Rules of Practice and Procedure,
TR Re abe Sete Mud ego GT a. Eee
Tax Court Rules of Practice and Procedure,
Se Re a ha aes eee le be eke een whe Gee
Tax Court Rules of Practice and Procedure,
NG ee oe ee ee 5 6 li, 2, 15
IN THE
Supreme Court of the United States
OCTOBER TERM, 1995
No.
WERNER H. ERHARD,
Petitioner.
-against-
COMMISSIONER OF INTERNAL REVENUE,
Respondent.
PETITION FOR A WRIT OF CERTIORARI
TO THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
PETITION FOR A WRIT OF CERTIORARI
Petitioner, Werner H. Erhard, prays that a writ of certioran
issue to review a judgment of the United States Court of
Appeals for the Ninth Circuit affirming a judgment of the United
States Tax Court.
OPINIONS BELOW
The opinion of the United States Court of Appeals for the
Ninth Circuit is reported at 46 F.3d 1470 (1995), and is
reprinted at Appendix B, page 3a.! The initial memorandum
opinion of the United States Tax Court is unofficially reported
at 62 T.C.M. (CCH) 1 (1991), and is reprinted at Appendix
F, page 49a. The supplemental memorandum opinion of the
‘All page references of the form ‘‘__a’’ are to the Appendices to this
petition.
Tax Court, which was issued pursuant to Petitioner’s Motion
for Reconsideration, is unofficially reported at 64 T.C.M.
(CCH) 10 (1992), and is reprinted at Appendix E, page 35a.
The second supplemental memorandum opinion of the Tax
Court, which was issued pursuant to the parties’ computa-
tions for entry of decision submitted to the Tax Court, is unof-
ficially reported at 65 T.C.M. (CCH) 1786 (1993), and is
reprinted at Appendix D, page 30a.
JURISDICTION
The decision of the Court of Appeals below was entered
on February 8, 1995 (Appendix B, page 3a). On April 25, 1995,
the Court of Appeals denied a timely petition for rehearing
(Appendix A, page la). The jurisdiction of this Court is in-
voked under 28 U.S.C. § 1254(1).
STATUTES AND RULES
Section 7443A(a), (b) and (c) of the Internal Revenue
Code:
(a) Appointment.—The chief judge may, from time to
time, appoint special trial judges who shall proceed
under such rules and regulations as may be pro-
mulgated by the Tax Court.
(b) Proceedings Which May be Assigned to
Special Trial Judges.—The chief judge may
assign—
(1) any declaratory judgment proceeding,
(2) any proceeding under section 7463,
(3) any proceeding where neither the amount of the
deficiency placed in dispute (within the mean-
ing of section 7463) nor the amount of any
3
claimed overpayment exceeds $10,000, and
(4) any other proceeding which the chief judge may
designate, to be heard by the special trial judges
of the court.
(c) Authority to Make Court Decisions.—The court
may authorize a special trial judge to make the deci-
sion of the court with respect to any proceeding
described in paragraph (1), (2), or (3) of subsection
(b), subject to such conditions and review as the
court may provide.
Tax Court Rules of Practice & Procedure,
Rule 183:
RULE 183. Cases Involving More Than
$10,000. Except in cases subject to the provisions
of Rule 182 or as otherwise provided, the following
procedure shall be observed in cases tried before
a Special Trial Judge:
(a) Trial and Briefs: A Special Trial Judge shall
conduct the trial of any such case assigned for such
purpose. After such trial, the parties shall submit
their briefs in accordance with the provisions of Rule
151. Unless otherwise directed, no further briefs
Shall be filed.
(b) Special Trial Judge’s Report: After all the
briefs have been filed by all the parties or the time
for doing so has expired, the Special Trial Judge shall
submit a report including findings of fact and opi-
nion, to the Chief Judge, and the Chief Judge will
assign the case to a Judge or Division of the Court.
(c) Action on the Report: The Judge to whom
or the Division to which the case is assigned may
adopt the Special Trial Judge’s report or may modify
it or may reject it in whole or in part, or may direct
the filing of additional briefs or may receive further
evidence or may direct oral argument, or may
recommit the report with instructions. Due regard
shall be given to the circumstance that the Special
Trial Judge had the opportunity to evaluate the
credibility of witnesses, and the findings of fact
recommended by the Special Trial Judge shall be
presumed to be correct.
STATEMENT OF THE CASE
The United States Tax Court is comprised of 19 judges ap-
pointed by the President for 15-year terms with the advice
and consent of the Senate. I.R.C. § 7443. There are current-
ly 14 special trial judges, more than two-thirds of the total
number of Tax Court judges, who are appointed by the chief
judge of the Tax Court. I.R.C. § 7443A(a).
The chief judge is authorized to assign four categories of
cases to a special trial judge. I.R.C. § 7443A(b). In the first
three categories of cases, subject to such conditions and review
as the Tax Court may provide, the special trial judge has
the authority to make the decision of the Tax Court. In the
fourth category, the chief judge may assign to a special trial
judge ‘‘any other proceeding that the chief judge may
designate.’’ I.R.C. § 7443A(b)(4). However, in this fourth
category, the chief judge may authorize the special trial judge
‘‘only to hear the case and prepare proposed findings and an
opinion. The actual decision then is rendered by a regular judge
of the Tax Court.’ Freytag v. Commissioner, 501 U.S. 868,
874 (1991). In Freytag, this Court concluded that pursuant to
I.R.C. § 7443A(b)(4), the chief judge may ‘‘assign any Tax
Court proceeding, regardless of complexity or amount, to a
special trial judge for hearing and the preparation of proposed
findings and written opinion,’’ and confirmed that the special
trial judge has no authority actually to decide the case. Jd. at
877 (emphasis added).
Rule 183(c) of the Tax Court’s Rules of Practice and Pro-
cedure requires the Tax Court judge to give ‘‘due regard’’
to the fact that the special trial judge ‘‘had the opportunity
to evaluate the credibility of witnesses,’’ and states that the
findings of fact recommended by the special trial judge are
‘‘presumed to be correct.’’ Moreover, Rule 183(b) provides
that following post-trial briefs from the parties, the special trial
judge ‘‘shall submut a report, including findings of fact and opi-
nion to the Chief Judge, and the Chief Judge will assign the
case to a Judge or Division of the Court.’’ The report is not
served on the parties, and the rule does not require that a
party have an opportunity to be heard on objections to the
report before it is acted on by the Tax Court judge.
At issue in this case is whether the statutory obligation of
the Tax Court judge to make the decision of the Tax Court
(and the prohibition of the special trial judge from making the
decision of the court) is satisfied when under Tax Court Rule
183 the Tax Court judge must review the findings of fact of
the special trial judge under a highly deferential standard, and
parties are not given an opportunity to object and be heard
on objections to the report before the judge acts on it.
Petitioner’s case involved the determination of whether his
purchase of the operating assets of a multi-million dollar,
multinational educational training business and certain other
assets from a separate corporate taxpayer, est, a.e.c., had
economic substance for tax purposes, or whether it was a sham
transaction. Erhard petitioned the U.S. Tax Court for a
redetermination of the deficiencies determined by the IRS for
the years 1981, 1982 and 1983. Initially, the cases were as-
signed to a judge of the Tax Court. Then, without notice to
Erhard and over Erhard’s objection, the chief judge assigned
the cases to a special trial judge for tnial.2 Erhard objected
to the assignment to the special trial judge for two reasons:
(1) there were disputed issues of fact which, because of the
deferential standard of review accorded a special trial judge’s
findings, would likely become the findings of the court, and
(2) the special trial judge assigned to the case might be im-
properly influenced by previous cases he had tned involving
est, a.e.c. (not Erhard) and its controversial tax advisor,
Harry Margolis. The chief judge advised the special trial judge
of Erhard’s objections, and after the special trial judge orally
assured the chief judge of his objectivity, the chief judge denied
the objections on the basis of this assurance.
Before his case was tried by the special trial judge, Erhard
pressed his objections to the assignment by petitioning the
Court of Appeals for the Ninth Circuit for a writ of mandamus
directing the chief judge of the Tax Court to assign the case
to a Tax Court judge. Erhard again pointed out the prejudice
to him that would result if his case were tried by a special
trial judge because of his partiality, and because under Tax
Court Rule 183(c)’s deferential standard of review, the deci-
sion of the Tax Court would effectively be made by the special
trial judge, not by the Tax Court judge. The Ninth Circuit
denied the petition ‘‘for failure to show damage not correc-
table on appeal and for failure to show that tax court [sic] clearly
erred as a matter of law.’’ (Appendix H, page 122a).
2This case is unlike Freytag where the taxpayer did not object to the
assignment of the case to the special trial judge for trial.
eee
The trial before the special trial judge lasted six weeks in
three sessions beginning on November 1, 1988 and ending
February 3, 1989. Petitioner presented 21 witnesses, including
legal advisors, the executives of the business operations, and
an Arthur Young partner, who testified at length about the
business purpose and economic substance of the acquisition
by petitioner, as well as four expert witnesses: 721 exhibits
were received in evidence. The parties submitted post-trial
briefs to the special trial judge on July 6, 1989, October 4.
1989, December 1, 1989, and January 16, 1990. Petitioner’s
briefs totalled approximately 750 pages. The case was under
consideration by the special trial judge until July 1, 1991, ap-
proximately 20 months later.
On July 1, 1991, the Tax Court entered an order assigning
the case to Tax Court Judge Irene F. Scott for review of the
special trial judge’s report. Judge Scott filed an opinion that
same day adopting the special trial judge’s 87 page report,
T.C. Memo 1991-290, Appendix F, page 49a. Judge Scott had
observed none of the trial, nor had she read the 27 volumes
of trial transcript and the 721 exhibits. Without serving the
parties with a copy of the report or giving Erhard the oppor-
tunity to file objections to the report, the judge adopted the
special trial judge’s report verbatim as the decision of the Tax
Court.
The report of the special trial judge recommended disallow-
ing all depreciation claimed by Erhard on the business pro-
perties purchased and all interest deductions accrued and paid
on the financing of the transaction. Under Tax Court Rule 183.
not only did Erhard have no opportunity to take exceptions
to the report of the special trial judge before Judge Scott
adopted the report, Judge Scott deferred to the special trial
judge’s findings of fact and reviewed them under a clearly er-
roneous standard that required her to ‘‘presume that the
special trial judge’s findings of fact are correct.’’ See 46 F.3d
at 1476, Appendix B, at page 16a.
On September 3, 1991, Erhard filed a motion for recon-
sideration on two legal issues. He contended that, even assum-
ing the correctness of the sham determination, the Tax Court
erred in denying him any depreciation on the purchased assets
or any deductions for interest actually paid on the disputed
loans, and in upholding the substantial understatement of tax
penalty and tax-motivated interest. On September 3, 1991,
Judge Scott held a hearing on Erhard’s motion for reconsidera-
tion. At the hearing, Judge Scott stated that she had been sent
the case five to six weeks before the order assigning the case
to her was filed, and that she had conferred with the special
trial judge about the case. The judge stated that she had not
read the entire record. During the course of the hearing, the
judge admitted:
Then I discussed [the case with Special Trial Judge
Gussis] and I won’t pretend I read all of these ex-
hibits. I didn’t ...
Excerpts of Record on Appeal, p. 797.
[ want to hasten to tell you that I relied on what Judge
Gussis said about credibility...
Excerpts of Record on Appeal, p. 799.
... [don’t pretend to have read every one of these
exhibits or this whole transcript...
Excerpts of Record on Appeal, p. 800.
... my review of the record, and I grant you, it is not
as extensive as tf I, personally had heard it. | did rely
on the Special Trial Judge’s findings, although I didn’t
just take them carte blanche. And I’m certainly not
as familiar with the record as either party is.
Excerpts of Record on Appeal, p. 801 (emphasis added).
In a supplemental memorandum opinion filed on July 6, 1992,
T.C. Memo. 1992-376, Judge Scott granted Erhard’s motion
as to the depreciation and substantial understatement issues.
holding that Erhard should be allowed depreciation computed
as if there had been no sale and that no substantial understate-
ment penalty was due. (Appendix E, page 35a). The issues
on which Judge Scott granted Erhard’s motion were issues
of law rather than fact, and therefore she was required to
review them de novo, with no presumption of correctness. In
the course of her supplemental opinion, Judge Scott remarked
that her consideration had not been helped by Erhard’s at-
tempt to reargue the case:
Our attempt to review the record to ascertain what
basis, if any, the record supports for these assets
in the hands of WEA has not been assisted by peti-
tioners’ continuous argument that the sham transac-
tions purportedly purchasing these assets should be
recognized and that the values assigned to the assets
by petitioners in the returns for 1981, 1982, and 1983
be accepted.
64 T.C.M. (CCH) 10, 11 (1992), Appendix E, page 38a.
Petitioner appealed the Tax Court decision to the Court of
Appeals, arguing, inter alia, that the case had been effective-
ly decided by the special trial judge, in contravention of I.R.C.
\ 7443A. The court below held that the Tax Court had not
improperly allowed the special trial judge to decide the case.
Although Judge Scott had admitted that she had not read every
exhibit or the entire transcript, the Court of Appeals found
that the judge was required under the Tax Court rules to give
due regard to the special trial judge’s report on findings of
fact and credibility and to review his report under a clear error
10
standard. Although the petitioner’s claim was that Judge Scott
had not decided the case, but abdicated this duty to the special
trial judge, the Court of Appeals nevertheless upheld the Tax
Court’s decision on the theory that, since the record was so
voluminous, “‘it was perfectly reasonable for Judge Scott not
to read every word.’’ 46 F.3d at 1476, Appendix B, page 17a.
REASONS FOR GRANTING THE WRIT
Certiorari should be granted in order to resolve an impor-
tant question left undecided four years ago in Freytag. That
issue was whether ‘‘the deferential standard with which Tax
Court Rule 183 requires a Tax Court judge to review the fac-
tual findings of a special trial judge allows the latter not only
to hear a case but effectively to resolve it.’’ Freytag v. Com-
missioner, 501 U.S. 868, 874 n.3 (1991). Tax Court Rule 183
violates I.R.C. § 7443A(b)(4) and this Court’s decision in
Freytag because Tax Court Rule 183 (1) requires the Tax Court
judge to defer to a special trial judge’s factual findings, and
(2) does not give the parties the right to object to the special
trial judge’s report before the judge acts on it. Since Freytag,
no court has addressed the issue of whether the deferential
standard of Tax Court Rule 183 allows the special trial judge
to not only hear but to decide the case. As a result, the deci-
sion of the Court of Appeals in this case does not conflict with
the decisions of any other court of appeals. Nonetheless,
review of this important question is appropriate for the follow-
ing reasons:
1. The Court should consider this issue because it is an issue
of first importance in the administration of the tax laws. Fur-
ther consideration of the issue through court of appeals review
is both unnecessary and will result in uncertainty in procedure
in the Tax Court, where taxpayers file approximately 95 per-
cent of all tax cases. In 1994, special trial judges rendered
approximately 23% of the Tax Court’s published decisions.
1]
They handle not only small cases, but also other cases pur-
suant to I.R.C. § 7443A(b)(4). These cases constitute approx-
imately 10% of the Tax Court’s published decisions in 1994.
2. Freytag’s requirement that the Tax Court judge decide
the case cannot be met if a deferential standard, and certainly
not if a clear error standard of review, is used. The opinion
of the court below says that, ‘‘whichever course [the judge
takes under Tax Court Rule 183 with regard to the special
trial judge’s report], she must presume that the special trial
judge's findings of fact are correct, and she must give ‘[d]ue
regard’’’ to the special trial judge’s opportunity to evaluate
the credibility of the witnesses (Appendix B, page 16a). The
presumptively correct standard of Tax Court Rule 183(c)
‘sought to establish the relatively high level of deference that
the phrase ‘clearly erroneous’ entails.’’ Stone v. Commis-
stoner, 865 F.2d 342, 344 (D.C. Cir. 1989). But a clear error
standard of review by the Tax Court judge does not comply
with Freytag’s requirement that the judge make the decision
of the Tax Court. Freytag, supra, at 874 (‘‘Petitioners appear
not to appreciate the distinction between the special trial
judges’ authority to hear cases and prepare proposed findings
and opinions . . . and their lack of authority actually to decide
those cases, which is reserved exclusively for judges of the
Tax Court.’’).
The clear error standard ‘‘plainly does not entitle a reviewing
court to reverse the finding of the trier of fact simply because
it is convinced that it would have decided the case different-
ly.’’ Anderson v. City of Bessemer City, 470 U.S. 564, 574
(1985). Even if the reviewing court disagrees with the findings,
it must accept the trier of fact’s determination, provided only
that it have some evidentiary support and is a permissible or
plausible view of the evidence. 9A Wright & Miller, Federal
Practice & Procedure, §2585: 572; Christie, Judicial Review
of Findings of Fact, 87 Nw. U. L. Rev. 14, 44 (1992). By
12
deferring to the special trial judge’s findings under the clearly
erroneous standard, therefore, the Tax Court judge could not
have substituted her judgment for that of the special trial judge
on his factual findings and the conclusions he drew from them.
There is no reason to believe that a special trial judge’s find-
ings of fact are entitled to any greater deference on review
than those of a magistrate or special master. A complete and
careful review of a subordinate judicial officer’s report is re-
quired to avoid improper ‘‘rubber-stamping’’ of the report by
a district court judge. Burlington N.R.R. Co. v. Department
of Revenue, 934 F.2d 1064, 1072-74 (9th Cir. 1991) (case
remanded back to district court, which affirmed the special
master’s report in a one sentence order, which constituted
improper ‘‘rubber stamp’’ of report); United States v. Wilson,
864 F.2d 1219, 1222 (5th Cir.) (court remanded case to district
court judge because judge did not give ‘‘sufficient indication
that he made his own determination based upon the record
and unrestrained by the findings and conclusions of the
magistrate’), cert. dented, 492 U.S. 918 (1989); Reed v. Board
of Election Comm’rs, 459 F.2d 121, 123 (1st Cir. 1972) (when
magistrate’s findings of fact are approved by a “‘laying on of
hands”’ by the district court, an ‘‘abnegation of judicial authori-
ty’’ has occurred). A deferential standard of review is incon-
sistent, therefore, with independent decision-making by the
judge.
Judge Scott’s review was not ‘‘adequate’’ for Freytag pur-
poses because Freytag assumes that a Tax Court judge will
review the special trial judge’s report in sufficient depth so
that it can fairly be said that the decision of the Tax Court is the
judge’s decision. In fact, apart from the Circuit Court’s obser-
vation that Judge Scott followed Rule 183(c)’s deferential
standard of review, there is no real indication of what stan-
dard Judge Scott actually used in reviewing Special Trial Judge
13
Judge Gussis’s report. The judge only said she did not take
the special trial judge’s findings ‘‘carte blanche,’’ even though
she adopted his report verbatim. If Judge Scott did not give
the special trial judge full discretionary power, she also did
not indicate in what respect she limited that power.
Accordingly, Judge Scott could not and did not give the
special trial judge’s findings of fact and findings of ultimate fact
sufficient review to have made the decision in this case, as
she was required to do by I.R.C. §7443A and this Court’s
opinion in Freytag. The Ninth Circuit’s conclusion that the
judge’s review of the special trial judge’s report was ‘‘ade-
quate’’ overlooks the requirement of Freytag that the Tax
Court judge must actually make the court’s decision.
Finally, permitting the Tax Court judge to review the fin-
dings of fact of the special trial judge under a clear error stan-
dard will lead to an unconstitutional result. If the judge of the
Tax Court is to review the special trial judge’s findings of fact
under a clear error standard, review by the judge of the Tax
Court is the same as review by a court of appeals. A court
of appeals must accept findings of fact of the Tax Court unless
there is clear error. See I.R.C. § 7482(a). If this same stan-
dard applies to the Tax Court judge’s review of the special
trial judge’s report, the effect will be to create a Tax Court
trial division comprised of special trial judges and a Tax Court
appellate division consisting of the reviewing judges. Nothing
in Freytag or the Internal Revenue Code authorizes Tax Court
supervision of special trial judge findings and opinions in (b)(4)
cases to be appellate in nature. These cases are meant to be
decided by the Tax Court in the first instance, not merely
3Tax Court review may actually compare unfavorably even with review
by a court of appeals. At least a court of appeals is briefed on the issues
raised by the court below. In a Tax Court proceeding, the parties have
no opportunity to file objections to the special trial judge’s report.
14
reviewed after a special trial judge heard the case and drafted
the opinion.
3. The Tax Court rules must allow the parties to file objec-
tions and the judge must hold a hearing on those objections
under procedures similar to those provided in the Federal
Rules of Civil Procedure for the district court review of special
master and magistrate reports. Anything less is inconsistent
with I.R.C. § 7443A and this Court’s decision in Freytag. The
Federal Rules of Civil Procedure are instructive in this case4
because the referral of a Tax Court case to a special tral judge
is similar to the referral of a case by a district court for hear-
ing and report to a magistrate judge or special master. The
Tax Court special trial judge is a subordinate judicial officer
analogous in status and function to a magistrate judge or a
special master. See Freytag, supra. The special trial judge
prepares a report, including findings of fact, in the same man-
ner as a special master or a magistrate judge. Compare Tax
Court Rule 183(b) with Fed. R. Civ. P. 53(e)(1) and 28 U.S.C.
} 636(b). As is the case with special trial judges, the decision
of a district court must be that of the district court judge and
not of the magistrate.
Indeed, a special trial judge’s findings of fact are subject to
the same level of deference given by a district court judge to
a special master’s report. A special trial judge’s findings are
‘‘presumed to be correct,’’ and a special master’s findings
of fact are not to be set aside ‘‘unless clearly erroneous.’’
These standards are, in substance, the same. Notes of Ad-
visory Committee on Rules, Note to Subdivision (e). The
district court ‘‘may adopt the [master’s] report or may modify
‘Tax Court Rule 1(a) itself provides, ‘‘Where in any instance there is
no applicable rule of procedure, the Court or the Judge before whom the
matter is pending may prescribe the procedure, giving particular weight
to the Federal Rules of Civil Procedure to the extent that they are suitably
adaptable to govern the matter at hand.”’
15
it or may reject it in whole or in part or may recommit it with
instructions.’’ Fed. R. Civ. P. 53(e)(2). Tax Court Rule 183(c)
gives the Tax Court judge the same discretion.
There is one crucial difference, however, between the
review procedures in the district court and those applicable
to the Tax Court. After a special master prepares a report,
but before the district court acts on it, the report must be
served on the parties, who are entitled to file objections. Fed.
R. Civ. P. 53(e)(2). If a party files objections, the district court
must hold a hearing before ruling on the report. Moreover,
the district court may not merely ‘‘rubber stamp’’ the master’s
report. Rather, the district court must respond to the par-
ticular facts of the case and address any objections to the report
made by the parties. See Burlington N.R.R. Co. v. Depart-
ment of Revenue, 934 F.2d 1064, 1072 (9th Cir. 1991) (district
court’s ‘‘rubber stamp’’ of master’s order was ‘‘inexcusable
abdication of judicial responsibility’ ’).
Similarly, when a district court assigns a case to a magistrate
judge pursuant to 28 U.S.C. § 636(b), the district court must
follow a notice and objection procedure virtually identical to
that applicable to special masters’ reports. However, the
district court judge is expressly required to make a de novo
determination of any matters to which objections are raised.
"The merit of the de novo determination scheme lies in the
duty of the district court to make its own determinations of
magistrate rulings to which the parties object....’’ Pacemaker
Diagnostic Clinic of America v. Instromedix, 725 F.2d 537,
546 (9th Cir.), cert. dented, 469 U.S. 824 (1984). The pur-
pose of these procedures in the case of magistrates and
masters is to ensure that these officers are not allowed to make
the decision of the district court, in violation of Article III of
the Constitution. S. Rep. No. 371, 90th Cong., lst Sess. 12.
16
In contrast to the notice and objection procedures of the
Federal Rules applicable to district court review of reports
of magistrates and masters, under Tax Court Rule 183(b) par-
ties are not entitled to receive prior notice of or an opportuni-
ty to file objections to the special trial judge’s report before
the Tax Court judge acts on it. This was not the case before
1984 when Congress enacted I.R.C. § 7443A(b)(4) to permit
special trial judges to hear any proceeding assigned by the chief
judge. Before 1984, the Tax Court’s review procedures under
the predecessor of Tax Court Rule 183 had virtually the same
notice and objection procedures as the district court rules. It
is doubtful that Congress would have sanctioned the use of
special trial judges by statute if it had been informed that judges
would review reports of special trial judges without giving the
parties the right to make objections before they were acted
on by the judges. Freytag, supra, at 875 (‘‘The 1984 amend-
ment was ‘technical’ in light of the historical development of
the special trial judge’s role ...’’).
With no other avenue to pursue under the Tax Court’s rules,
Erhard filed a motion for reconsideration pursuant to Tax Cour:
Rule 161. This, however, was no substitute for the oppor-
tunity to object to the report before the judge acted on it
because the granting of a motion for reconsideration pursuant
to Tax Court Rule 161 rests within the discretion of the Court.
Estate of Halas v. Commissioner, 94 T.C. 570, 574 (1990);
Vaughn v. Commissioner, 87 T.C. 164, 166-67 (1986). A mo-
tion for reconsideration will not be granted unless unusual cir-
cumstances or substantial error is shown. This standard is too
stringent to substitute for the review of special tnal judges’
reports required by I.R.C. § 7443A.
The lack of any opportunity to file objections to the special
trial judge’s findings before the Tax Court judge ruled,
therefore, created in this case exactly the same danger that
17
exists in the district court when cases are assigned to a
magistrate or special master for trial — that is, ‘‘a danger that
the district court [or Tax Court] will merely endorse the
. . report as its own decision.’’ Linda J. Silberman, Masters
and Magistrates Part II: The American Analogue, 50 N.Y.U.
L. Rev. 1297, 1344 n.268 (1975). Because the statute pro-
hibits perfunctory review or rubber-stamping of special trial
judges’ reports by the Tax Court, the Tax Court rules are
inconsistent with I.R.C. § 7443A because they do not give
taxpayers an opportunity to object to the report before its
adoption by the Tax Court.
CONCLUSION
The petition for a writ of certiorari should be granted.
July 24, 1995 Respectfully submitted.
Michael I. Saltzman
(Counsel of Record)
Baker & McKenzie
805 Third Avenue
New York, New York 10022
(212) 751-5700
Counsel for Petitioner
Of Counsel:
Leslie Book
Stuart B. Katz
Kevin J. Liss
LEESON RIOT OY yA BSG are
oO
la
FILED
ADPDDHE'NAN] r 4 APR 25 1995
APPENDIX A ng
CLERK
U.S. COURT OF APPEALS
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
Nos. 93-70357
Tax Ct. No. 39473-85
WERNER H. ERHARD,
Petitioner-Appellant,
V.
COMMISSIONER INTERNAL REVENUE SERVICE,
Respondent-Appellee.
Nos. 93-70359
Tax Ct. No. 46712-86
WERNER H. ERHARD,
Petitioner-Appellant,
V.
COMMISSIONER INTERNAL REVENUE SERVICE.
Respondent-Appellee.
Nos. 93-70360
Tax Ct. No. 49532-87
ORDER
WERNER H. ERHARD.
Petitioner-Appellant,
"ws
COMMISSIONER INTERNAL REVENUE SERVICE.
Respondent-Appellee.
Za
Before: LAY,* PREGERSON, and O’SCANNLAIN, Circuit
Judges.
The panel has voted to deny the petition for rehearing.
Judges Pregerson and O’Scanniain have voted to reject the
suggestion for rehearing en banc, and Judge Lay has so
recommended.
The full court has been advised of the en banc suggestion,
and no judge of the court has requested a vote on it.
The petition for rehearing is DENIED and the suggestion
for rehearing en banc is REJECTED.
*The Honorable Donald P. Lay, Senior United States Circuit Judge for
the Eighth Circuit, sitting by designation.
CC ————
3a
APPENDIX B
FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
Nos. 93-70357
Tax Ct. No. 39473-85
WERNER H. ERHARD.
Petitioner-Appellant,
7:
COMMISSIONER INTERNAL REVENUE SERVICE.
Respondent-Appellee.
Nos. 93-70359
Tax Ct. No. 46712-86
WERNER H. ERHARD.
Petitioner-Appellant,
v.
COMMISSIONER INTERNAL REVENUE SERVICE,
Respondent-Appellee.
Nos. 93-70360
Tax Ct. No. 39532-87
OPINION
WERNER H. ERHARD.
Petitioner-Appellant,
V.
COMMISSIONER INTERNAL REVENUE SER‘ ICE,
Respondent-Appellee.
4a
Appeal from a Decision of the
United States Tax Court
Argued and Submitted
November 17, 1994 — San Francisco, California
Filed February 8, 1995
Before Donald P. Lay,* Harry Pregerson,
and Diarmuid F. O’Scanniain, Circuit Judges.
Opinion by Judge O’Scannlain
SUMMARY
Tax/Income/Interest
The court of appeals affimed a decision of the United States
Tax Court. The court held that the tax court, in deciding
whether a taxpayer was entitled to interest deductions, com-
mitted no clear error in finding that the taxpayer’s circular
borrowing transactions lacked economic substance.
Appellant Werner Erhard hired tax attorney Harry Margolis
to be his personal financial and legal advisor. Margolis created
a corporation, ‘‘est, a.e.c.,’’ the stock of which was seem-
ingly owned by a complex web of offshore entities created by
Margolis. Erhard purported to be just an employee of est,
a.e.c., without any legal ownership interest. Integral to est,
a.e.c. was the Margolis ‘‘system.’’ The system was composed
of offshore and domestic corporations, trusts, banks, partner-
ships and other entities that were used to implement Margolis’
*The Honorable Donald P. Lay, Senior United States Circuit Judge for
the Eighth Circuit, sitting by designation.
a
5a
tax planning. Such ‘‘system entities’’ were controlled by
Margolis. The est, a.e.c. organizational structure was a maze
of intertwined organizations with numerous agreements among
the entities involved. Margolis created a variety of system en-
tities which dealt only with est, a.e.c.. The purpose of this
organization was to ‘“‘try to get money paid offshore in a deduct-
ible fashion,’’and have it ‘‘find its way onshore in a non-income
fashion.”’ In a typical circular money movement, funds would
pass from one system entity to a taxpayer, and then from the
taxpayer to a second system entity for some ostensible
business purpose of the taxpayer. Thus, the taxpayer would
appear to have incurred a substantial expenditure, whereas
he in reality had merely taken money from, and then return-
ed it to, the system. Transactions between system entities
were not recorded. Margolis maintained only one combined
_ System accounting’’ for Erhard and est, a.e.c.
After Margolis was acquitted of criminal tax charges, Erhard
set out to ‘‘create est anew.’’ Werner Erhard and Associates
(WEA) was established. WEA needed to acquire the assets
of est, a.e.c. and needed funds for the acquisition.
The asset acquisition was accomplished in four phases. In
phase one, Erhard borrowed money that originated with the
system and then transferred back an amount to various system
entities, retaining some of the money for operating expenses.
In phase two, a system entity loaned WEA money. WEA re-
tained some of the money and transferred the rest back into
the system. In phase three, Margolis arranged for a nonsystem
entity, the Intercultural Cooperation Foundation (ICF) to ac-
cept funds from a Margolis system entity and then lend those
funds to WEA. Margolis also contacted the co-founder of
another nonsystem entity, the St. John Fundacion, who
likewise agreed to act as a conduit for the loan so long as the
funds were made available to him. The ultimate source of the
6a
$14 million loaned to Erhard during phase three was Island
Bank, a system entity. Phase four was financed with a $1
million demand loan from ICF through St. John. System en-
tities were the source of the funds. At the close of the four
phases, WEA had acquired all of est, a.e.c.’s operating assets.
The two remaining loans were owed to ICF.
WEA paid interest to ICF on the loans. WEA properly
withheld ICF’s federal income tax from its payments to ICF
and transmitted these amounts to the Internal Revenue Ser-
vice (IRS). WEA paid $1 million, purportedly in repayment
of the $1 million demand loan.
On their returns for three tax years, Erhard and WEA claimed
depreciation and interest deductions based on their trans-
actions. The IRS disallowed all the deductions and asserted
additions to tax, as well as increased interest. Erhard peti-
tioned the tax court for a redetermination of the asserted defi-
clencies, and the cases were assigned to a special trial judge
(STJ) for hearing. After a six-week tnal, the cases were assign-
ed to a tax court judge, who adopted the STJ’s opinion, which
held that Erhard was not entitled to interest or depreciation
deductions because the transactions through which they were
generated lacked economic substance. The opinion also sus-
tained the determination and imposition of increased interest.
After Erhard filed a motion for reconsideration, the tax court
determined that he was entitled to some depreciation
deductions.
Erhard appealed, challenging the disallowance of interest
deductions, the imposition of increased interest and the tax
court’s computations of his deficiency. Erhard contended that
the case should be remanded to the tax court because the tax
court judge improperly allowed the STJ to make the decision
of the tax court. Erhard also challenged the tax court’s find-
ing of sham.
ee
oo
fa
[1] The chief judge of the tax court may assign a case to
be heard by an STJ, but the STJ has no authority to decide
the case. The STJ submits a report to the assigned tax court
judge. [2] In this case, the record was so voluminous that it
was perfectly reasonable for the tax court judge not to read
every word. The tax court judge made it clear that while she
did rely on the STJ’s findings, she did not ‘‘take them carte
blanche.’’ [3] The tax court judge’s review of the case was
adequate. The few errors that the tax court judge made were
understandable in light of the case’s enormous complexity.
Thus, there was no reason to remand.
[4] In order to be deductible, interest must be paid on gen-
uine indebtedness, an indebtedness in substance and not
merely in form. The burden is on the taxpayer to show that
the borrowing scheme was a bona fide arrangement entered
into for economic purposes, rather than merely a tax avoidance
scheme. [5] In this case, the tax court committed no clear
error in finding that the transactions at issue lacked economic
substance. [6] During phases one and two, even though it ap-
peared as though Erhard transferred millions of dollars to est,
a.e.c. in exchange for assets, the system was the source not
only for the purchase money but also for the additional $3
million that represented est, a.e.c.’s cash reserves. [7] Fur-
ther, the convoluted, circular path of the two ICF loans in
phases three and four simply made it hard to believe that the
loans were bona fide. The funds began with the system, went
through nonsystem entities in order to provide the trans-
action with legitimacy, and then went back to the system.
Margolis was intimately involved in all the transfers. He ar-
ranged for the loans and helped prepare the agreements be-
tween the parties. Thus, the fact that Erhard made some
subsequent payments to ICF did not lead to the conclusion
that the tax court committed clear error in its finding of sham.
8a
[8] Before its repeal, Internal Revenue Code 6621(e) im-
posed increased interest on an understatement of tax to the
extent that the understatement was a ‘‘substantial underpay-
ment attributable to tax motivated transactions.’’ [9] This sec-
tion, on its face, applied to any sham or fraudulent transaction.
[10] Erhard also contended that the tax court abused its
discretion by refusing to accept his computations as to the
useful lives of ther depreciable assets and by refusing to credit
him for amounts that he withheld from his payments to ICF.
[11] However, the tax court did not abuse its discretion in
refusing to accept his calculations. The record did not disclose
the useful life of each of the assets which remained at the time
of the asset acquisition. [12] In addition, the amounts Erhard
remitted to the IRS were withheld from payments to ICF and
thus were in payment of ICF’s tax, not Erhard’s tax.
COUNSEL
Michael I. Saltzman, Baker & McKenzie, New York, New
York, for the petitioner-appellant.
William J. Patton, Tax Division, United States Department of
Justice, Washington, D.C., for the respondent-appellee.
OPINION
O’SCANNLAIN, Circuit Judge:
We are invited to follow the winding paths of circular money
movements to determine whether they lead to transactions
of economic substance for federal income tax purposes.
I.
Werner Erhard has offered a variety of seminars,
workshops, and other programs in personal effectiveness since
1971. At that time, Erhard hired tax attorney Harry Margolis
er , j
Ya
to be his personal financial and legal advisor. Margolis arranged
the formation and financing of Erhard Seminars Training, Inc.
In 1975, Margolis created a new corporation, ‘‘ est, a.e.c..”’ to
assume the activities of Erhard Seminars Training, Inc. The stock
of est, a.e.c. was seemingly owned by a complex web of off-
shore entities created by Margolis.! Erhard purported to be just
an employee of est, a.e.c., without any legal ownership interest.
Integral to both est, a.e.c. and its predecessor, Erhard
Seminars Training, Inc., was the Harry Margolis ‘‘system.”’
The system was composed of offshore and domestic corpora-
tions, trusts, banks, partnerships, and other entities that were
used to implement Margolis’ tax planning. Such so-called
~ System entities’ were controlled either directly or indirectly
by Margolis. The est, a.e.c. organizational structure devised
by Margolis was a maze of intertwined organizations with
numerous agreements among the entities involved. After
Margolis created est, a.e.c., he created a variety of system
entities which dealt only with est, a.e.c. As Erhard’s counsel]
explained, the main purpose of such an organization was ‘‘to
try to get money paid offshore in a deductible fashion, and then
the money would find its way onshore in a non-income
fashion,’’ Reporter’s Transcript, volume 22 at 102.
In implementing this tax planning, Margolis devised or-
chestrated money movements that were structured by con-
tractual arrangements. Ina typical circular money movement,
funds would pass from one system entity to a taxpayer, and
then from the taxpayer to a second system entity for some
ostensible business purpose of the taxpayer. Thus, the tax-
payer would appear to have incurred a substantial expenditure.
whereas he in reality had merely taken money from,
eens
'The ownership of est, a.e.c. was so complex that when Erhard decid-
ed to alter the organizational structure in 1981, it apparently took his legal
and financial advisors months to sort through the complicated legal and
financial structures that Margolis had used in his planning.
10a
and then returned it to, the system. Consequently, Margolis’
transactions have been descnibed as ‘‘financial gymnastics,
devoid of economic substance.’’ Goldberg v. United States, 789
F.2d 1341, 1343-44 (9th Cir. 1986).
Margolis maintained so-called “‘system accounting’’ for his
clients which consisted of a chronological list of the client's
transactions within the system and which kept tract of the
client’s balance, either positive or negative, vis-a-vis the
system. All funds that went into the system from a client or
a nonsystem entity were entered as a credit to the client while
all funds that went out of the system to a client or a nonsystem
entity were entered as a debit to the client. A client earned
interest on positive balances in the system accounting and was
charged interest on negative balances. Transactions between
system entities were not recorded because the funds stayed
in the system. Though Erhard purportedly had no ownership
interest in est, a.e.c., Margolis maintained only one combin-
ed system accounting for Erhard and est, a.e.c.
The tax court found that Margolis’ representation of clients
generally consisted of three phases. During the initial phase, the
client’s goals were defined and documents were drafted to realize
the goals. Then, followed an implementation stage during which
the required relationships were established. Finally, there was
a clean-up phase when the client wished to terminate the con-
tractural relationships. Where required, money movements
would be made in order to complete the clean-up phase. Erhard
v. Commissioner, 62 T.C.M. (CCH) 1, 3 (1991). In a memoran-
dum of May 1980, Margolis stated that at the time est, a.e.c.
was formed in 1975, it was contemplated that the corporation
would not exist for more than three years. /d. at 4.
In 1976, Margolis was indicted on criminal tax charges. He
was acquitted of all charges in 1977, but after the indictment,
Erhard allegedly became concerned about negative publicity
lla
surrounding Margolis’ involvement in est. a.e.c. Further, the
Margolis system was so complex that Erhard could not assess
his own financial condition or that of est, a.e.c. Thus, in January
1980, Erhard announced the initiation of a project to ‘‘create
est anew.’’ To that end, Erhard formed a task force composed
of est, a.e.c. executives, staff members, and outside legal ad-
visors. In May 1980, Erhard issued a memorandum advising
his staff that Erhard, Margolis, and the task force had jointly
determined to replace Margolis as the general and tax counsel!
of est, a.e.c.
The task force recommended that Erhard convert the opera-
tion into a sole proprietorship. Accordingly, Werner Erhard
and Associates (‘‘WEA’’) was established as a sole proprietor-
ship in February 1981. At this point, WEA needed to acquire
the assets of est, a.e.c. WEA also needed funds for the ac-
quisition. As for the funds, Margolis indicated that. ‘[t]he truth
is that there is no source other than the accumulated values
of the past decade.’’ Jd. at 12.
The asset acquisition was accomplished in four phases. In
the first phase, which occurred in June and July 1981, Erhard
borrowed $2,200,000 from Terla, B.V., a system entity and
$5,000,000 from Barclays Bank of San Francisco. Barclays
Bank was not a system entity, but the loan was a back-to-
back loan secured by Parallax Corp., a system entity.2 Thus,
the money lent to WEA onginated with the system. WEA im-
mediately transferred $4,950,677 back to various system en-
tities, alleged in payment for assets. However, out of the ag-
gregate loan proceeds of $7,200,000, Erhard retained
$2,249,323 for operating expenses.
*A back-to-back loan occurs when a bank loan is collateralized with a
cash deposit from a third party. When the loan principal is repaid, then
the compensating deposit is released. In the Margolis’ system accoun-
ting, a system entity’s deposit securing a back-to-back loan was treated
as a charge against the client receiving the loan from the bank. The client’s
account was credited when the loan was repaid and the deposit released
back to the system entity.
12a
Phase two occurred on or about August 27, 1981 and was
financed through three separate loans to WEA from Terla,
a system entity, in the aggregate amount of $6,580,000. WEA
retained $850,854 and transferred the rest back into the
system through a number of system entities. Thus, in phases
one and two, Erhard retained a total of approximately $3 million
while the rest of the money cycled out of, and back into, the
system.
Phase three took place on September 15, 1981. At this point,
WEA owed approximately $13,800,00 in short-term debt to
Terla and Barclays Bank. Erhard desired to replace his short-
term debt with a long-term loan. Accordingly, Erhard called
Wolfgang Somary, co-founder of Intercultural Cooperation
Foundation (‘‘ICF’’), seeking to borrow money for WEA. ICF
had no money to lend; however, shortly thereafter, Margolis
called Somary and arranged for ICF to accept funds from a
Margolis system entity and then to lend those funds to WEA.
Margolis also contacted Fernando Flores, co-founder of the
St. John Fundacion, who likewise agreed to act as a conduit
for the loan so long as the funds were made available to him.
As nonsystem entities, ICF and St. John were enlisted to par-
ticipate because Erhard’s outside lawyers regarded a fully
disclosable source of the loan as essential to an acceptable asset
acquisition plan.
The ultimate source of the $14 million eventually loaned to
Erhard during phase three was Island Bank, a system entity.
On September 15, 1981, Island Bank transferred $96 million
to Sineuri, S.A., another system entity. From this amount,
Sineuri transferred $15 million to Brown Education Corp.,
(‘‘BEC’’). BEC had been formed just prior to this transac-
tion as part of Margolis’ tax planning. BEC then purported
to loan $14 million to ICF. BEC transferred the money to an
account in the name of Everd van Walsum, a Margolis associate
ree i rn
13a
who was acting on behalf of ICF.3 BEC was ostensibly loan-
ing this money to ICF, yet ICF never provided BEC financial
statements. The agreement that ICF and BEC did execute
had been drafted with significant help from Margolis.
Moreover, ICF agreed to receive funds from BEC only on
condition that ICF would not be liable to BEC if WEA defaulted
on the loan.
ICF then loaned the $14 million to St. John Fundacion,
transferring the money to Paul Mason, a Margolis associate
who was acting on behalf of St. John. Margolis also had a hand
in drafting the documents executed between ICF and St. John.
St. John then made a loan of $14 million to Erhard and WEA.
St. John did nothing to ensure that the loan would be repaid
by Erhard. Indeed, Flores immediately endorsed the instru-
ment to ICF. BEC also assigned to Island Bank all right, title,
and interest in the promissory note from ICF.
On the same day that Erhard received the money (which
was the same day that all the above transactions occurred),
Erhard transferred it all back to Island Bank, a system entity.
Island Bank then transferred $8,976,284.95 to Terla B.V. as
payment for the loans Erhard obtained during phases one and
two. Island Bank also transferred $5,023,500 to Barclays Bank
in payment for the loan Erhard obtained during phase one.
Payment of the Barclays loan released the collateral deposit
back to Parallax, the system entity that had secured the loan.
Phase four took place in December 1981, ostensibly because
Erhard needed more money to complete the asset acquisi-
tion. This phase was financed with a $1 million demand loan
again from ICF through St. John. The source of the funds was
Antigua Banking, Ltd., and ABC Trust Company, both system
entities. Over a four-month period, Antigua and ABC funneled
3BEC also transferred $1 million back to Island Bank.
14a
the funds to the Harry E. Wright, Jr. Charitable Trust, a
Margolis client. On August 27, 1981, the Trust transferred
$750,000 to Island Bank. On December 17, 1981, the Trust
transferred $250,000 to Island Bank. On December 18, 1981,
Island Bank transferred $1 million to ICF. ICF then transfer-
red $1 million to St. John, which on the same day transferred
the funds to WEA. WEA then transferred the $1 million, plus
an additional $547,645 to est, a.e.c.
Thus, at the close of the four phases, WEA had acquired
all of est, a.e.c.’s operating assets.4 It had replaced its short-
term loans and owed a total of $15 million, consisting of a $1
million demand loan and a $14 million long-term loan. Both
loans were owed to ICF.
WEA paid interest to ICF on both the demand loan and the
long-term loan. WEA properly withheld ICF’s federal income
tax from its payments to ICF and transmitted these amounts
to the IRS. In early 1985, WEA paid $1 million, purportedly
in repayment of the $1 million demand loan. However, Erhard
transferred $550,000 directly to Island Bank rather than to
ICF. Island Bank informed ICF that it would not release the
$550,000 unless ICF initiated legal action in California to uphold
the validity of the $14 millon note in Erhard’s then-active
matrimonial action. Thus, of the $450,000 ICF did receive,
it spent approximately $400,000 to defend the $14 million note.
On their returns for the tax years of 1981, 1982 and 1983,
Erhard and WEA claimed depreciation and interest deductions
based on the transactions described above. The IRS disallowed
all the deductions and asserted additions to tax under sections
6653(a)(1), 6653(a)(2), and 6661, as well as increased interest
under section 6621(c). Erhard petitioned the tax court for a
redetermination of the asserted deficiencies, and the cases
4WEA had also acquired some artwork, an auxiliary sloop, and various
recreational vehicles.
L5a
were assigned to Special Trial Judge Gussis for hearing. Erhard
objected to the assignment on the ground that Judge Gussis
was biased against Erhard because he presided over two prior
cases involving est, a.e.c. The tax court denied Erhard’s mo-
tion, and this court denied jis petition for mandamus. After
a six-week tnial, the cases were assigned to Tax Court Judge
Scott, who adopted Judge Gussis’ opinion. The opinion held
that Erhard was not entitled to interest or depreciation deduc-
tions because the transactions through which they were
generated lacked economic substance, and it sustained the
determination and imposition of increased interest under sec-
tion 6621(c).
On September 3, 1991, Erhard filed a motion for recon-
sideration. The tax court reaffirmed its conclusions with regard
to the disallowance of interest deductions and the determina-
tion and imposition of increased interest. The court determin-
ed, however, that Erhard was entitled to some depreciation
deductions. The court then stated that ‘‘decisions will be
entered under Rule 155.’’ Erhard v. Commissioner, 64 T.C.M.
(CCH) 10, 15 (1992). Erhard and the Commissioner disagreed
about the appropriate computations under Tax Rule 155 and
this appeal followed.
Erhard raises three issues on appeal: (1) the disallowance
of interest deductions; (2) the imposition of increased interest;
and (3) the tax court’s computations of Erhard’s deficiency.
Il
Erhard first argues that this court should remand the case
to the tax court, asserting that Judge Scott improperly allow-
ed the special trial judge to make the decision of the tax court.
[1] The chief judge of the tax court may assign a case to
be heard by a special trial judge, IRC § 7443A(b)(4); however,
the special trial judge has no authority to decide the case. IRC
16a
§ 7443A(c). Rather, the special trial judge submits a report
to the assigned tax court judge, who must ‘‘review the work
of the special tria: judge.’’ Freytag v. Commissioner, 111 S.
Ct. 2631, 2635 n.2 (1991). The litigants do not automatically
receive a copy of the report and, therefore, are not routinely
allowed to file objections to it.
Once the tax court judge has reviewed the report, she
may adopt the Special Trial Judge’s report, or may
modify it or may reject it in whole or in part, or may
direct the filing of additional briefs or may receive
further evidence or may direct oral argument, or may
recommit the report with instructions.
Tax Court Rule 183(c). Whichever course the tax court
judge takes, she must presume that the special trial judge's
findings of fact are correct, and she must give ‘‘[d]ue regard’’
to the fact ‘‘that the Special Trial Judge had the opportunity
to evaluate the credibility of witnesses.’’ Jd. Here, Judge Scott
adopted Special Trial Judge Gussis’ report. Erhard was not
permitted to file objections to the report prior to Judge Scott’s
action.
Erhard first argues that because the parties are not provided
an opportunity to object to the special trial judge’s report, it
is likely that the special trial judge will end up deciding the
case.° Indeed, permitting the litigants to file objections to the
special judge’s report might well decrease the danger that the
tax court judge will simply endorse the report without review,
see Linda J. Silberman, Masters and Magistrates Part II: The
American Analogue, 50 N.Y.U. L. Rev. 1297, 1344
5Erhard analogizes special trial judges in the tax court to special masters
and magistrates in the district court, pointing out that litigants in the district
court are permitted to file objections to the special master’s report before
the district judge acts on it.
17a
n.268 (1975). Yet, absent such a procedure, the tax court judge
will not necessarily abdicate her judicial responsibility. The
Supreme Court has cautioned specifically that ‘‘ ‘rubber stamp’
activity’’ on the part of the tax court judge is not to be as-
sumed. Freytag, 111 S. Ct. at 2653 n.z.
[2] Second, Erhard maintains that Judge Scott, in fact, did
not adequately review the case. Erhard makes much of several
quotes from Judge Scott where she admits that she relied on
Special Judge Gussis’ findings and did not examine every ex-
hibit nor read the entire transcript. However, these admis-
sions do not lead tu the conclusion that Judge Scott’s review
was inadequate. First of all, Tax Court Rule 183 requires Judge
Scott to give ‘‘due regard’’ to Judge Gussis’ report on find-
ings of fact and credibility. Further, the record in this case
is sO voluminous® that it was perfectly reasonable for Judge
Scott not to read every word. Judge Scott made clear that
while she did rely on Judge Gussis’ findings, she did not ‘‘take
them carte blanche.”’
Finally, Erhard maintains that Judge Scott’s comments dur-
ing the reconsideration hearing showed that she misunderstood
important facts. Erhard points out that Judge Scott mistaken-
ly believed that ICF and the Harry E. Wright, Jr. Charitable
Trust were system entities, and that Erhard owned stock in
est, a.e.c. Erhard contends that these mistakes show that
Judge Scott did not adequately review the record.
[3] After carefully examining the record and Judge Scott’s
comments, we are convinced that Judge Scott’s review of the
case was adequate. Erhard points to isolated mistakes;
however, Judge Scott’s other comments indicate a satisfac-
tory understanding of the case. Further, we believe that the
few errors Judge Scott did make were understandable in light
°The transcript comprised 27 volumes.
ae
18a
of the case’s enormous complexity. Although the Wnght Trust
was not a system entity, it was a Margolis client, and the Com-
missioner has claimed that it was effectively controlled by
Margolis. Similarly, ICF, though not a system entity, clearly
took part in the transactions at Margolis’ request and with
his direction. Finally, Judge Scott’s confusion about Erhard’s
ownership of est, a.e.c. also is understandable given that
everyone seemed to acknowledge that Erhard was the
‘‘owner’’ of the business, and given est, a.e.c.’s purposeful-
ly complicated organization structure. Accordingly, we see no
reason to remand.
Il
Erhard next challenges the tax court’s finding of sham. The
tax court’s determination that a transaction is lacking in
economic substance is a factual determination that this court
reviews for clear error. Karme v. Commissioner, 673 F.2d
1062, 1065 (9th Cir. 1980)?
[4] At issue here are interest deductions that Erhard claim-
ed for the ICF loans and the Terla B.V. loans. Section 163(a)
of the Internal Revenue Code provides for an income tax
deduction for ‘‘interest paid or accrued within the taxable year
on indebtedness.”’ In order to be deductible, however, interest
must be paid on genuine indebtedness, an indebtedness in
substance and not merely in form. Knetsch v. United States,
364 U.S. 361 (1960). The burden is on the taxpayer to show
that the borrowing scheme was a bona fide arrangement
entered into for economic purposes, rather than merely a tax
avoidance scheme. Valley Title Co. v. Commissioner, 559 F.2d
1139, 1141 (9th Cir. 1977).
7Contrary to Erhard’s contention, Casebeer v. Commissioner, 909 F.2d
1360, 1362 (9th Cir. 1990) does not set forth a de novo standard for review
of sham transactions.
19a
The tax court found that the transactions at issue here were
without economic substance; that they were merely circular
money movements that ‘‘began and ended with system en-
tities, with no change in the economic position of the system
viewed as a whole.’’ 62 T.C.M. (CCH) 1, 26 (1991).
After conducting a detailed examination of each of the
phases, the court concluded the following: In phases one and
two, most of the borrowed money simply circled out of the
system, through WEA, and back into the system. However,
WEA retained approximately $3 million purportedly to use for
operating expenses. In phase three, the entire $14 million loan
circled through the system in one day. Jd. After recounting
the convoluted series of transactions involved in phase three,
the court concluded that the ‘‘loans which had originated from
system funds (directly or indirectly) in phases one and two
were repaid with system funds in phase three, and the total
amount of such repayments were returned, directly or indirect-
ly, to the system.’’ Zd.
The court found that the $1 million loan in phase four followed
a similar pattern. ‘‘Again, the funds originated in a money
movement from the Margolis system through the Harry E.
Wright, Jr., Charitable Trust, to Island Bank, Ltd.. to Inter-
cultural Cooperation Foundation to St. John Fundacion to WEA
and from WEA to est, a.e.c.’’ Jd. Consequently, the tax court
concluded that ‘‘the $14,000,000 and $1,000,000 loans pur-
portedly obtained by petitioner to finance the acquisitions were
sham transactions completely lacking in economic substance.’’
Id. at 27.
The court’s findings of sham are based on its conclusion that
the complex est, a.e.c. organizational structure was simply
a means of shielding ‘‘the true ownership of assets that in reali-
ty belonged to the Werner Erhard operation.’’ Jd. at 28. The
court concluded that the entire series of transactions ‘‘merely
a
20a
represented the so-called ‘clean-up’ phase in which the struc-
ture created by Margolis for Werner Erhard in 1975 was shed
as a prelude to a new structure.’’ Jd. at 27. The court, noting
that no ‘‘effort was made in the system accounting to differen-
tiate between Werner Erhard and the entities (Erhard
Seminars Training, Inc., and est, a.e.c.) which were used to
conduct the Erhard business over the years,’ found that the
system accounting simply served to reflect a client’s cash posi-
tion within the system. Jd. Thus, when est, a.e.c. was to be
dismantled in favor of a new structure, Erhard needed to
balance accounts with the system and to remove the assets
which, in reality were his, but which had been acquired in the
name of various system entities.
This was accomplished in the transactions which took
place for the most part in phases one through four
in 1981. Werner Erhard or (WEA) obtained all the
business assets needed to continue his operations.
Personal loans owed by Werner Erhard in substan-
tial amounts were paid. He also acquired possession
of art work valued at some $765,038 which had been
held in the name of a system entity, the auxiliary
sloop Sirona valued at $225,000 which had also been
held in the name of a system entity and certain motor
vehicles. It also appears that some $3,000,000 re-
mained with Erhard (or WEA) as a result of the cir-
cular money movements in phases one and two.
Id.
Thus, the court concluded: ‘‘We believe that est, a.e.c. was
in effect terminated as originally contemplated in 1975, a finan-
cial accounting was rendered for Werner Erhard covering some
10 years of close invoviement with the system and its entities,
and the assets transferred to Wemer Erhard in an artifical
series of transactions that produced . . . interest expense
deductions.’ Jd. at 28.
2la
[5] Although Erhard valiantly attempts to discredit these fin-
dings, we are more than satisfied that the tax court commit-
ted no clear error in finding that the transactions lacked
economic substance.
Erhard first points out that est, a.e.c. was a multi-million
dollar business before the asset purchase, as was WEA after
the purchase. This, however, is beside the point. The tax court
found the asset acquisition to be a sham, not because est, a.e.c.
itself was a sham, but because Erhard never really bought est,
a.e.c.
Second, Erhard maintains that the court’s conclusions about
circular money movements are contradicted by the court’s own
finding that WEA retained a portion of the borrowed funds.
However, the court was fully aware that not ail the money
circulated. Indeed, the court found that the funds that Erhard
retained constituted est, a.e.c.’s excess cash balances that
needed to be transferred to Erhard in order to square the ac-
counts. This conclusion is supported by the evidence. In a May
20, 1981 memorandum, Margolis indicated that when all the
contemplated transactions were concluded, the cash position
of est, a.e.c. would be reduced by $2,950,000 while the cash
holdings of WEA would increase by that amount.®
Third, Erhard maintains that he had a clear business pur-
pose for engaging in the transactions because he desired to
Erhard also argues that the tax court erred as a matter of law by ad-
mutting inaccurate IRS charts as evidence of circular money movements.
Erhard’s claim is meritless, however. Erhard is correct that the charts
do not include certain transactions, but it is clear from the court’s opinion
that the court was aware of and considered these transactions in making
its determination.
22a
terminate his relationship with Margolis.? However, even if
Erhard had a legitimate business purpose for terminating his
relationship with Margolis, that did not give him a business
purpose for engaging in the specific transactions at issue here.
The fact that he may have had a good business reason for
separating from Margolis does not necessarily justify resort-
ing to circular money movements (that just happened to create
tax benefits) to effectuate that separation.
Finally, Erhard points out that even though the $14 million
loan in phase three and the $1 million loan in phase four came
from system entities and were immediately returned to system
entities, Erhard nonetheless paid over $2 million in interest
on the loans over the next several years. He also repaid the
$1 million demand loan in 1985. These payments, according
to Erhard, are evidence that he was genuinely indebted; after
all, he would not have made any payments if the loans had
been shams.
(6] We agree that such payments would ordinarily indicate
genuine indebtedness; however, the facts of this case im-
mediately dispel such a suggestion. The evidence shows the
following: Margolis created the amazingly complicated est,
a.e.c. organizational structure, with its numerous offshore en-
tities, in order that money could be ‘‘paid offshore in a deduct-
ible fashion, and then the money would find its way onshore
in a non-income fashion.’’ Reporter’s Transcript, volume 22
at 102. Though nominally just an employee of est, a.e.c.,
9Erhard also claims that the court applied the wrong test for business
purpose. Erhard claims that because the court rejected his asserted
business purpose argument on the ground that it was not ‘‘convincing’’
the court erroneously applied an objective test rather than a subjective
test. 62 T.C.M. (CCH) 1, 28 (1991). However, Erhard seems to be argu-
ing that unless the court blindly accepts Erhard’s assertions, then it is
applying an objective test. The text of the opinion shows that the court
was not substituting its opinion for Erhard’s. Rather, the court was merely
stating that, based on the evidence, it did not believe Erhard’s assertions.
23a
Erhard was understood to be its owner. So, when Erhard
decided to transform est, a.e.c. into a sole propnetorship, the
assets that were ostensibly the property of est, a.e.c. were
transferred to Erhard in exchange for payments that were real-
ly just circular money movements. Thus, during phases one
and two, even though it appeared as though Erhard transfer-
red millions of dollars to est, a.e.c. in exchange for assets,
the system was the source not only for the purchase money
but also for the additional $3 million that represented est,
a.e.c.’S cash reserves.
[7] Further, the convoluted, circular path of the two ICF
loans in phases three and four simply makes it hard to believe
that these loans were bona fide. The funds began with the
system, went through two nonsystem entities in order to pro-
vide the transaction with legitimacy, and then went back to
the system. Margolis was intimately involved in all these
transfers. He arranged for the loans between BEC, ICF, and
St. John, and he helped prepare the agreements between the
parties. None of these parties knew each other before the
transactions, nor did they conduct any of the investigations
that are customary in an arms-length transaction. Given this
evidence, the fact that Erhard made some subsequent
payments to ICF does not lead to the conclusion that the tax
court committed clear error in its finding of sham. Indeed,
these payments to ICF can be explained in any number of
ways’° that are wholly in keeping with the tax court’s conclu-
sion that the transactions lacked economic substance.
‘For example, the payments could very well have been rendered as
a part of the final accounting between Erhard and the system. That is,
the transactions that occurred during the four phases may have been
calculated to take account of Erhard’s subsequent payments to ICF.
24a
IV
Erhard next contends that the tax court erred in imposing
increased interest. This court reviews the tax court’s imposi-
tion of increased interest pursuant to section 6621 for clear
error. Wolf v. Commissioner, 4 F.3d 709, 715 (9th Cir. 1993).
[8] Before its repeal, IRC section 6621(c) imposed increased
interest on an understatement of tax to the extent that the
understatement was a “‘substantial underpayment attributable
to tax motivated transactions.’’ Prior to 1986, the section
defined ‘‘tax motivated transactions’’ as including only four
specific types of transactions.!! The Tax Reform Act of 1986,
Pub. L. 99-514, 100 Stat. 2750, amended section 6621(c) to
add ‘‘any sham or fraudulent transaction’’ to the list of tax
motivated transactions. The Commissioner imposed increased
interest on Erhard on the basis of this last category.
{9} Erhard maintains that the legislative history indicates that
a transaction does not come within the ‘‘sham or fraudulent
transaction’’ category unless the transaction is a fraudulent
version of one of the specific types of transactions that were
originally defined to be tax motivated transactions.’2 However,
Erhard’s argument is not supported by language of the sec-
tion or by precedent. See Hildebrand v. Commissioner, 967
F.2d 350, 353 (9th Cir. 1992). See also Estate of Carberry,
933 F.2d 1124, 1129-30 (2d Cir. 1991). The section, on its
face, applies to any sham or fraudulent transaction. Thus, we
reject the limitation Erhard urges as not plausible in light of
the statute’s clear language.
'1They were (1) any valuation overstatement; (2) any loss disallowed
under the at-risk investment credit provisions; (3) any straddle transac-
tion; or (4) any use of an accounting method that created distortion.
'2Erhard argues that Congress added the ‘‘sham’’ category in order
to reverse a line of tax court cases that refused to impose increased in-
terest to a fraudulent straddle because fraudulent straddles are not really
straddles.
EE
[10] Finally, Erhard challenges the tax court’s computations
under Tax Court Rule 155. Computations under Rule 155 are
reviewed for an abuse of discretion. Kelly v. Commissioner.
877 F.2d 756, 760 (9th Cir. 1989). Erhard alleges that the
tax court abused its discretion (1) by refusing to accept his
computations as to the useful lives of the depreciable assets,
and (2) by refusing to credit him for amounts that he withheld
from his payments to ICF.
A
Upon reconsideration, the tax court held that Erhard was
entitled to depreciation deductions for certain assets that WEA
acquired from est, a.e.c. The court directed that decisions
would be entered under Tax Court Rule 155. The parties could
not agree on the useful lines of those assets: therefore. each
party submitted its own computation under Rule 155.
The Commissioner computed the useful lives of the assets
by using the class life guidelines contained in the tables in Rev.
Proc. 77-10, 1977-1 C.B. 548. Under this method, the Com-
missioner allowed Erhard to depreciate the assets from the
date that est, a.e.c. transferred the assets to WEA. Erhard
maintains, by contrast, that the useful lives of the assets should
be computed from the earlier date the assets were acquired
by est, a.e.c. in the amount identified from the est, a.e.c. tax
returns that had been admitted into evidence.
A computation under Rule 155 must be made solely from
the evidence in the record and the opinion of the tax court:
it cannot be used to reopen the evidence or raise a new issue.
Tax Court Rule 155(c). See also Paccar. Inc. v. Commissioner,
849 F.2d 393, 399-400 (9th Cir. 1988). Here, the tax court
found that Erhard’s computation was an accounting opinion
26a
that raised a new issue of fact. Erhard disagrees, contending
that, because the record already included est, a.e.c. tax
returns, the remaining useful lives could be calculated ‘‘by sim-
ple mathematical computations from those returns.”’
[11] The tax court did not abuse its discretion in refusing
to accept Erhard’s calculations. The record does not disclose
the useful life of each of the assets which remained at the time
of the asset acquisition. Rather, Erhard’s computations are
based on information from est, a.e.c. tax returns. Though the
returns are in the record, they were not stipulated to for ac-
curacy or truth, and the Commissioner had no opportunity to
contest the accuracy of particular items on the returns. Thus,
we agree with the district court that determining the accuracy
of Erhard’s computations would require reopening the record
to permit opinion testimony from both Erhard’s accountant
and the Commissioner’s expert.
B
WEA withheld amounts from its purported interest
payments to ICF and properly remitted the withheld amounts
to the IRS on ICF’s behalf. Erhard now claims that since the
Commissioner has determined that he never really had an
obligation to pay interest to ICF, then he was not a bona fide
withholding agent and thus must have made the payments to
the IRS for his own account.
[12] We are not persuaded by Erhard’s argument. The
amounts Erhard remitted to the-IRS were withheld from
payments to ICF and thus were in payment of ICF’s tax, not
Erhard’s tax. Section 1464 provides that a refund or credit
of an overpayment of tax which has actually been withheld
at the source shall be made to the taxpayer from whose
income the amount of such tax was in fact withheld. I.R.C.
§1464; Treas. Reg. §1.1464-1(a); Bank of America v. Anglin,
27a
138 F.2d 7, 8 (9th Cir. 1943). Thus, the IRS may refund any
overpaid amount only to ICF, the taxpayer from whose in-
come the tax was withheld. That the IRS deemed the loans
shams does not transform payments made on behalf of ICF
into payments made on behalf of Erhard. Erhard withheld that
money on ICF’s behalf regardless of the underlying purpose
of the payments.
AFFIRMED.
28a
APPENDIX C
UNITED STATES TAX COURT
WASHINGTON, D.C. 20217
Docket No. 39473-85
WERNER H. ERHARD AND
ELLEN V. ERHARD,
Petitioners,
V.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.
DECISION
Pursuant to the opinion of this Court filed July 1, 1991, and
the Supplemental Opinion filed July 6, 1992, petitioners on Oc-
tober 13, 1992, filed their computations for entry of decision
under Rule 155 and on November 6, 1992, respondent filed
a reply thereto, and on November 6, 1992, respondent filed
her computations for entry of decision under Rule 155 and on
December 11, 1992, petitioners filed objections thereto.
After consideration of the computations and the objections
thereto, the Court on January 21, 1993, filed a Second Sup-
plemental Memorandum Opinion in which it discussed and gave
the reasons for its decision as to the differences in the com-
putations filed by the parties and set forth its conclusion with
respect to a proper computation. The premises considered,
pursuant to the Memorandum Findings of Fact and Opinion
filed July 1, 1991, the Supplemental Memorandum Opinion filed
July 6, 1992, and the Second Supplemental Memorandum Opin-
ion filed January 21, 1993, and incorporating herein as the find-
29a
ings of the Court those findings as set forth in respondent’s
computations filed November 6, 1992, which were adopted
by the Court in its Second Supplemental! Memorandum Opin-
ion filed January 21, 1993, it is
ORDERED AND DECIDED that there is a deficiency in
income tax due from the petitioners for the taxable year 1981
in the amount of $396,920.00, without taking into considera-
tion the jeopardy assessment made on April 8, 1991, against
Werner H. Erhard and without taking into consideration
payments made by petitioners after the mailing of the notice
of deficiency, which amount is an overpayment by petitioners
if the $396,920.00 deficiency is considered paid.
That there is no addition to tax due from petitioners for the
taxable year 1981 pursuant to the provisions of I.R.C. sec-
tion 6653(a).
That there is no addition to tax due from petitioners for the
taxable year 1981 prusuant to the provisions of I.R.C. sec-
tion 6661.
That the entire deficiency for the taxable year 1981 is a
substantial underpayment for the purposes of computing the
interest payable with respect to such amount pursuant to
I.R.C. section 6621(c).
/s/ Irene F. Scott
Irene F. Scott
Judge
Entered: FEB 2 1993
a
30a
ILLEGIBLE
APPENDIX D JAN 23 1993
ILLEGIBLE
SERVED JAN 21 1993
T.C. Memo. 1993-25
UNITED STATES TAX COURT
WERNER H. ERHARD AND ELLEN V. ERHARD, Peti-
tioners, v. COMMISSIONER OF INTERNAL REVENUE,
Respondent
Docket Nos. 39473-85, 46712-86, Filed January 21, 1993.
39532-87, 137-88,
Michael I. Saltzman, Barbara T. Kaplan, and Robert F. Her-
mann, for petitioners.
Carmen Baerga, Craig Connell, Mildred Moon, and Raymond
Kahn, for respondent.
SECOND SUPPLEMENTAL MEMORANDUM OPINION
SCOTT, Judge: The Memorandum Findings of Fact and Opin-
ion in these cases, T.C. Memo. 1991-290, was filed July 1,
1991. Petitioners timely filed a motion for reconsideration and
a hearing on this motion was held on October 30, 1991. The
Court granted the motion for reconsideration with respect to
the allegation therein that the Court erred in holding that peti-
tioners had not established a basis for depreciation for the years
1981, 1982, and 1983 for assets transferred to them in 1981
and in holding that petitioners were liable for the addition to
tax under section 6661. All section references are to the In-
ternal Revenue Code in effect for the years in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
In a Supplemental Memorandum Opinion, T.C. Memo.
1992-376, filed July 6, 1992, we concluded that the record was
3la
sufficient to establish the basis in the hands of petitioners for
certain assets which petitioners took over from an entity, est,
a.e.c., and, therefore, it was necessary to discuss among other
things “‘what the useful life of these assets was at the time
they were transferred to WEA’’. We stated that it appeared
that the record was sufficient to determine the useful life of
certain of the items which had been shown on the return of
est, a.e.c., for its fiscal year ended June 30, 1981. Based on
the Supplemental Memorandum Opinion filed July 6, 1992, we
granted in part and denied in part petitioners’ motion for recon-
sideration and stated that decisions would be entered under
Rule 155.
Petitioners filed their computations for entry of decision
alle gedly in accordance with the Memorandum Findings of Fact
and Opinion of the Court filed July 1, 1991, and the Supplemen-
tal Memorandum Opinion filed July 6, 1992, on October 13,
1992. On November 20, 1992, respondent filed objections to
petitioners’ computations. On November 6, 1992, respondent
filed her computations for entry of decision, and on December
11, 1992, petitioners filed objections thereto.
The differences in the computations filed by the parties relate
to: (1) The useful life which should be applied to the basis of
the assets to compute depreciation on a straight line basis;
(2) whether an amount which petitioners paid over to the In-
ternal Revenue Service as a withholding tax on interest due
to Intercultural Cooperation Foundation (ICF), an organiza-
tion established under the laws of Switzerland, should be con-
sidered as a payment of tax made by petitioners, and, if so,
how it should be reflected in the computations under Rule 155
and decisions of the Court; and (3) how some payments made
by petitioners after the mailing of the notices of deficiency
should be reflected in the computations under Rule 155 and
decisions of the Court. Also, there are minor differences in
BEST AVAILABLE COPY
32a
the amounts shown by the parties as payments made by peti-
tioners after the mailing of the notices of deficiency.
Respondent computed the useful life of office equipment and
furniture, vehicles, and computers, the items with respect to
which there is disagreement between the parties with respect
to the useful life to be used, by using the class life tables con-
tained in Rev. Proc. 77-10, 1977-1 C.B. 548. Respondent used
the lower range of the useful life of each class of asset as set
forth in Rev. Proc. 77-10, 1977-1 C.B. 548. Petitioners were
unable to point to any specific evidence in the record setting
forth the remaining useful life of any of the assets. Since peti-
tioners contended that the depreciation should be on the re-
maining useful life of the assets considering the date the assets
were acquired by est, a.e.c. rather than the date of the transfer
of the assets to petitioners, petitioners employed an accoun-
tant to make a computation from various figures on the returns
of est, a.e.c., to arrive at a computed remaining useful life
of the assets. Petitioners referred to their method as one which
could ‘‘constructively determine the original asset lives used
by est, a.e.c. and the years remaining based on the deprecia-
tion amounts reported and the date at which the assets were
placed into service by est, a.e.c.”’
Petitioners attached to their objection to respondent’s com-
putations under Rule 155 an affidavit of a partner in the ac-
counting firm of Ernst & Young explaining the method she
used in computing ‘‘constructive useful lives’’ to arrive at her
opinion of the constructively determined remaining useful lives.
It is well settled that a computation under Rule 155 must
be made from the record and opinion of the Court and cannot
be used to raise a new issue. Estate of Stein v. Commissioner,
40 T.C. 275, 280 (1963). Clearly, where it would be necessary
to reopen the record to admit new evidence to decide a con-
tention which a party attempts to raise under Rule 155, the is-
33a
sue Is a new issue which may not be raised in a Rule 155 com-
putation. See Cloes v. Commissioner, 79 T.C. 933, 935 (1982).
Clearly here the record does not actually disclose the useful
life of each of the assets involved which remained at the time
petitioners received the assets from est, a.e.c. From the af-
fidavit of the accountant and computations attached thereto
we conclude that the computed remaining useful life of each
asset Is an accounting opinion of the accountant who did the
computations and raises a new issue as to whether in fact these
computations do properly result in the remaining useful life
of each asset. To determine whether the useful lives as so
computed are appropriate to use in computing depreciation
for petitioners would require a reopening of the record to per-
mit the accountant to give her opinion testimony and to afford
respondent the opportunity to cross-examine with respect to
her opinion, and, if appropriate, to offer the opinion of another
accounting expert. This is not the province of a computation
under Rule 155. We, therefore, sustain respondent’s deter-
mination of the useful life of each of the classes of assets here
involved.
The record is clear that the amount withheld from interest
which petitioners claim was due to ICF was not a payment
of petitioners’ own tax, but rather a withholding of the tax
of that foreign entity. Because we held that petitioners were
not entitled to deduct the interest which they alleged was paid
to ICF, petitioners contend that the withholding should be con-
sidered as tax paid by them. We do not agree with petitioners’
logic. We held that the deduction petitioners claimed as an
interest deduction was not properly allowable. However,
whether or not peittioners made some payment to ICF from
which a withholding was properly made was not an issue in
these cases. Certainly the amount petitioners paid to the In-
ternal Revenue Service as withholding from the payment to
34a
ICF was in payment of a tax stated to be the tax of ICF and
not petitioners’ tax. This record shows that the amount which
petitioners designated as ‘‘withholding tax’’ was in fact a pay-
ment of tax of ICF and not of petitioners. The withholding of
a tax of ICF is not a payment of tax by petitioners.
It appears that petitioners did make some payments to the
Government subsequent to the issuance of the notices of defi-
ciency. However, there is nothing in the record in these cases
to show the exact amounts of these payments, when they were
made, and for what they were designated. The determina-
tion in this case is made as of the date of the issuance of the
notices of deficiency unless the parties by stipulation agree
otherwise. We will, therefore, determine in these cases the
deficiency in each year without taking into consideration the
jeopardy assessments made by respondent on Apmil 8, 1991,
against Werner H. Erhard and without taking into considera-
tion payments made by petitioners after the date of the is-
suance of the notices of deficiency. The payments made after
the issuance of the notices of deficiency can be handled by
the parties in connection with collection of the deficiencies.
Decisions will be entered in accordance with respon-
dent’s computations as modified herein with respect
to the payments made after the issuance of the notices
of deficiency.
35a
APPENDIX E
[CCH Dec. 48,325(M)}
Werner H. Erhard and Ellen V.. Erhard vy.
Commissioner.
Docket Nos. 39473-85, 46712-86, 39532-87, 137-88. T.C.
Memo. 1992-376, Filed July 6, 1992. [Appealable, barring
stipulation to the contrary, to CA-9.—CCH .
[Code Secs. 163, 167, 6621(c) (Prior to repeal by P.L. 101-239),
6653 (Prior to amendment by P.L. 101-239) and 6661 (Pnor
to repeal by P.L. 101-239)]
Depreciation: Deductions: Unrecovered basis: Depreciable
assets: Additions to tax: Penalties: Negligence: Substantial
understatement of tax: Reasonable reliance: Good faith. —
Upon a motion for reconsideration (Dec. 47,434(M)), an in-
dividual was entitled to certain depreciation deductions for the
unrecovered basis of assets transferred from a corporation
to his sole proprietorship. The deductions were allowed for
assets transferred to the extent that they could clearly be
traced as going from the corporation to the sole proprietor-
ship and used by the sole proprietorship in its business of con-
ducting personal effectiveness seminars. Although many of the
transactions between the corporation and the sole proprietor-
ship were sham, the sole proprietorship was in substance one
and the same as the corporation. In addition, the individual
was not liable for additions to tax for substantial understate-
ment of tax because there was sufficient evidence that he
reasonably relied in good faith on the advice of lawyers and
accountants in following a plan of taking over the assets of the
corporation.—CCH.
36a
Michael I. Saltzman, Barbara T. Kaplan, 805 Third Ave..,
New York, N.Y., and Robert F. Hermann, 820 Second Ave..,
New York, N.Y., for the petitioners. Carmen Baerga, Craig
Connell, Mildred Moon, and Raymond Kahn, for the
respondent.
Supplemental Memorandum Opinion
Scott, Judge: These cases are before us on petitioners’ mo-
tion for reconsideration of the Memorandum Findings of Fact
and Opinion filed in the above consolidated cases on July 1,
1991, T.C. Memo. 1991-290.
The motion for reconsideration alleged that the Court er-
red in concluding in its Memorandum Findings of Fact and Opi-
nion (1) that petitioners were not entitled to interest expense
deductions in 1981, 1982, and 1983 with respect to certain
purported loans which the Court held not to be bona fide loans,
but rather sham transactions, (2) that the Court erred in
holding that petitioners had not established a basis for deprecia-
tion of assets transferred to them in 1981 for the years 1981,
1982, and 1983, and (3) in concluding that petitioners were
liable for the addition to tax under section 6661! and increas-
ed interest under section 6621(c) in 1982 and 1983. A hear-
ing was held on October 30, 1991, on petitioners’ motion and
thereafter the parties filed briefs.
Oral argument was held before Judge Scott with Special Trial
Judge Gussis present in the courtroom. Judge Gussis joins in
the conclusions in this opinion.
1All section references are to the Internal Revenue Code in effect for
the years in issue and all Rule references are to the Tax Court Rules of
Practice and Procedure, unless otherwisde indicated.
37a
Upon consideration of the arguments made by the parties
orally and on brief, we conclude that for the reasons expressed
in our Memorandum Findings of Fact and Opinion filed July
1, 1991, the purported loans of $14 million and $1 million
discussed in that opinion were not in fact bona fide loans but
were sham transactions, the result primarily of money
movements. Therefore, based on the Memorandum Findings
of Fact and Opinion filed on July1, 1991, we deny petitioners’
motion for reconsideration with respect to our conclusion that
interest deductions are not allowable with respect to the pur-
ported $14 million and $1 million loans since these purported
loans were not bona fide indebtedness of petitioners. We also
deny petitioners’ motion for reconsideration of our holding that
the purported purchases by petitioners of assets of est, An
Educational Corporation (est, a.e.c.), with purported proceeds
of such loans were sham transactions. We also deny peti-
tioners’ motion for reconsideration of our holding that peti-
tioners are liable for increased interest under section 6621(c)
because we reaffirm our conclusion that the transactions giv-
ing rise to the deficiencies in these cases were sham transac-
tions and thus tax motivated within the meaning of section
6621(c)(3).
In our opinion we recognized and found that certain physical
assets of a depreciable nature were transferred from est, a.e.c.
to petitioners’ sole proprietorship, Werner Erhard Associates
(WEA), but held that the purported purchases were shams
and the purported purchase price did not establish any basis
of petitioners in the various assets. After reciting the facts
with respect to the transfer of assets from est, a.e.c. to WEA,
we concluded that in our view est, a.e.c. was in effect ter-
minated as originally contemplated in 1975, that a financial ac-
counting was rendered for Werner Erhard from the Margolis
firm covering some 10 years of Erhard’s involvement with the
Margolis system and its entities, and that the est, a.e.c. assets
38a
were transferred to WEA in an artificial series of transactions
that were designed to produce depreciation expense deduc-
tions in 1981, 1982, and 1983 in the amounts of $884,024,
$1,471,211, and $1,332,998, respectively. We stated that the
circular money movements used with respect to the purported
loans were shams designed merely to create tax deductions.
On this basis we concluded that on the record before us peti-
tioners were not entitled to the depreciation expense deduc-
tions claimed under section 167(a), stating: “‘In short, there
is nothing in this record that would permit a finding of any basis
for any of the assets in the hands of WEA.’’
Effectively we recognized that assets which had been in the
stated possession of est, a.e.c. and on which depreciation had
been claimed on the returns of est, a.e.c. had come into the
hands of WEA. It is apparent from the nature of the assets
that at least some of these assets were depreciable, and if
the record were adequate to establish the basis, if any, of these
assets in the hands of WEA and the remaining useful life of
these assets at the time of transfer, WEA would be entitled
to some depreciation deduction with respect to some of the
assets transferred to WEA.
Our attempt to review the record to ascertain what basis,
if any, the record supports for these assets in the hands of
WEA has not been assisted by petitioners’ continuous argu-
ment that the sham transactions purportedly purchasing these
assets should be recognized and that the values assigned to
the assets by petitioners in the returns for 1981, 1982 and
1983 be accepted. However, petitioners did call our attention
to, and we find in the record, petitioners’ Exhibit 177-6, a
schedule of depreciation claimed by est, a.e.c. for its year end-
ing June 30, 1981, which shows the following as it appears
in Exhibit 177-6:
est, An Educational Corporation
Federal Corporation Statements — Year Ending 06/30/81
Depreciation As Computed Under Federal Statutes Statement 7 — Amortization
Non-Recovery Property
Useful
Date Cost Or Other Accumulated Life Current
Description Acquired Basis Amortization Method Yrs Pct Amortization
License . 09/01/75 10,000,000 4 833,332 SL 10 916,653;
Graduate List 09/01/75 631,760 305,355 SL 10 57,925
Graduate List
ie 06/01/81 -531,470 -248 166 SL 0
Registration List
Wnitten Off 06/01/81 -118,290 -57,189 SL 0)
Totals 10,000,000* 4,833 ,332* 974 ,578*
Total Depreciation
4la
We also find that the record contains as petitioners’ Exhibit
659 the docket entries of respondent’s motion to dismiss for
failure to properly prosecute to which is attached a copy of
the notice of deficiency and the order of dismissal in the case
of est, An Educational Corporation, docket No. 3014-85. The
deficiency notice with respect to the depreciation schedule for
the fiscal year of est, a.e.c. ended June 30, 1981, which is
the year involved in docket No. 3014-85, shows adjustments
disallowing a claimed interest deduction, disallowing amortiza-
tion of $974,578, and determining other income by disallow-
ing a claimed Hopi partnership loss of $773,762, and ‘‘ward-
robe”’ of $3,111. The only other adjustment in this notice was
an increase in the claimed deduction for contributions of
$3,628. The deficiency notice with respect to the disallowance
of the amortization expense states:
The amount of $974,587 claimed as amortization expense
is disallowed because it has not been established that:
(1) You are the equitable or beneficial owner of the pro-
perty; and
(2) The basis claimed for the property should be
recognized as bona fide for tax purposes; and
(3) The amount claimed represents a reasonable
allowance for amortization expense.
Amortization of license granted by
Wales a eae eee ees ss..... $916,653
Amortization graduate list.................. 57,925
Total Disses 75 eee ss... $974,578
In the notice of deficiency the claimed depreciation for the fiscal
year of est, a.e.c. ended June 30, 1981, of $598,033 was not
disallowed and was not at issue in the case before this Court.
42a
It is clear from our findings in our Memorandum Findings
of Fact and Opinion filed July 1, 1991, that leasehold im-
provements, office furniture, office equipment, audiovisual
equipment, other equipment, vehicles, and computer hard-
ware and software were transferred by est, a.e.c. to WEA
around July 1, 1981. The record shows that the ‘‘Franklin
Building’’ was transferred by est, a.e.c. to WEA around the
end of July 1981. It is not clear from the record whether the
building and addition listed on the depreciation schedule of est,
a.e.c. on its return for its fiscal year ended June 30, 1981,
was the Franklin Building which in our Memorandum Findings
of Fact and Opinion filed July 1, 1991, we found was trans-
ferred to WEA at the end of July 1981.
Petitioners, in an exhibit attached to their brief with respect
to their motion for reconsideration, submitted a computation
with respect to items transferred by est, a.e.c. to WEA, go-
ing back and making adjustments based on returns of est, a.e.c.
for the year 1975 forward. However, it appears to us that the
remaining basis that est, a.e.c. had in the building and addi-
tion, leasehold improvements, office furniture, and the other
items listed on the schedule attached to est, a.e.c.’s return
for its fiscal year ending June 30, 1981, should properly be
determined by subtracting from the cost or other basis of these
assets in the hands of est, a.e.c. the amount of accumulated
depreciation and current depreciation shown on the schedule.
We do notice that on this same schedule the leasehold im-
provements of $934,442 are shown as sold or abandoned as
are the items of $123,670 of other equipment and $124,008
of vehicles sold. Apparently this statement was intended to
in some way be connected with the transfer by est, a.e.c. of
certain items to WEA. However, it appears to us that if the
schedule of depreciation of est, a.e.c. is accepted as evidence
of the remaining basis of est, a.e.c. in the various assets at
the time they were transferred to WEA, that the schedule
of transferred or abandoned assets has no relevance.
Tine eb RM DL ty
43a
Having found some evidence of the basis of est, a.e.c. in
a number of the assets transferred to WEA shortly before the
transfer, we need to discuss: (1) What evidence is available
to show that this basis should carry over to WEA, (2) what
the useful life of these assets was at the time they were
transferred to WEA, and (3) whether there is anything in the
record to justify WEA’s using for depreciation purposes the
remaining basis of the assets in the hands of est, a.e.c. at the
time they were transferred to WEA.
Obviously, in view of the dismissal of the case of est, a.e.c.
for its fiscal year June 30, 1981, the portion of the statement
dealing with amortization of license and graduate lists sold has
no semblance of reliability. However, the leasehold im-
provements and other items shown on the depreciation
schedule appear to be probative evidence of the basis of those
items to est, a.e.c.
Petitioners in their income tax return for the calendar year
1981, which is joint Exhibit 1-A in these cases, on Schedule
C assigned various useful lives to various pieces of property
used in the business of WEA. Also Schedule C of petitioners’
returns for 1982 and 1983 show this same information. The
items shown on Schedule C of petitioners’ returns as capitaliz-
ed leases are not assets which are shown on the returns of
est, a.e.c. for its fiscal year ended June 30, 1981. Therefore
WEA would have no depreciable basis in ‘‘capitalized leases’’
based on any carryover basis from est, a.e.c. The graduate
lists have not been shown to have a basis to est, a.e.c. or
WEA and except for ‘‘Building and addition’ listed by est,
a.e.c. with a cost or other basis of $501,088, no basis for
building improvements is shown. It appears that the leasehold
improvements with a basis of $331,624 ($934,442 less the
$498,668 of accumulated depreciation and the $104,150 of cur-
rent depreciation) may be allocated useful lives as shown on
44a
Schedule C of petitioners’ 1981 return and on this basis
depreciation computed for WEA on those assets. The remain-
ing basis of est, a.e.c. in office furniture, audiovisual equip-
ment, other equipment, vehicles, and computer software and
hardware may be allocated useful lives in the same manner
in order to compute depreciation for each year here in issue
and that a similar computation may be made for the ‘‘Building
and addition’’ as shown on the return of est, a.e.c. for its fiscal
year ended June 30, 1981.
Respondent argues that if we permit petitioners to use the
unused basis of est, a.e.c., it is necessary to determine the
gain or loss to petitioners from a distribution to them of the
est, a.e.c. assets. Under certain circumstances respondent
might be correct in this contention. However, here the weight
of the evidence seems to be that although returns were filed
by est, a.e.c. and its ownership was stated to be in Werner
Erhard Charitable Settlement, on the accounting system used
by Margolis est, a.e.c., the Werner Erhard Charitable Set-
tlement, and the Erhard’s personal accounts were kept as one
and intermixed. Effectively the result of this method of book-
keeping was that, regardless of the technical ownership of est,
a.e.c. and regardless of the recognition of this ownership in
several cases before this Court (see Erhard Seminars Train-
ing v. Commissioner [Dec. 43,456(M)], T.C. Memo.
1986-526, in which we held that claimed amortization deduc-
tions were sham transactions and certain claimed expense
deductions were disallowed because they were personal ex-
penses of Werner Erhard and his family and est, An Educa-
tional Corporation v. Commissioner (Dec. 43,457(M)], T.C.
Memo 1986-527, in which we held that a purported in-
debtedness incurred by the taxpayer in acquiring a 10-year
license was a sham transaction and the taxpayer was held not
to be entitled to amortization expenses or claimed interest ex-
pense deductions) on the Margolis books the two corporations
45a
and the Erhards were treated as one. We referred to the cases
of est, a.e.c. for the years 1981 and 1982 in our Memoran-
dum Findings of Fact and Opinion in these cases filed July 1,
1991. In those cases deficiencies as determined by respon-
dent were sustained when the cases were dismissed for lack
of prosecution. One of these cases involved the fiscal year
ending June 30, 1981, of est, a.e.c. and the other fiscal year
of est, a.e.c. ending June 30, 1982. While none of these cases
actually held that Werner Erhard and the corporations were
in substance one and the same, in all of them the transactions
under consideration were considered shams. By determining
that the basis of the assets WEA obtained from est, a.e.c.
is the remaining basis at June 30, 1981, of est, a.e.c. in those
assets, we are not determining whether in fact est, a.e.c. was
separate and distinct from Werner Erhard and what the owner-
ship of est, a.e.c. was. We have merely concluded that most
of the transactions involving the financial affairs of est, a.e.c.,
as was the purported purchase in these cases, were sham tran-
sactions and for that reason have concluded for the purposes
of a basis of WEA in the physical assets which were transfer-
red from est, a.e.c. to WEA, the sole proprietorship of Werner
Erhard, the unrecovered basis of est, a.e.c. at the time the
assets were transferred to WEA is the basis of WEA in those
assets. Our conclusion is that WEA should be entitled to
recover through depreciation the unrecovered basis in the
depreciable assets of est, a.e.c. transferred to WEA to the
extent that, on this record, those assets can clearly be traced
as going from est, a.e.c. to WEA and used by WEA in its
business of conducting seminars. Upon reconsideration we
modify our Memorandum Findings of Fact and Opinion filed
July 1, 1991, by allowing depreciation deductions to WEA on
the basis outlined herein. We are aware of the fact that the
parties in these cases stipulated that est, a.e.c. was a seprate
entity from petitioners and WEA. We have considered this
46a
stipulation in reaching our conclusion of the basis of WEA in
the assets it received from est, a.e.c. and concluded that con-
sidering the unusual facts in this record, WEA did have the
basis for depreciation in the assets received from est, a.e.c.
which we have found.
The final argument made by petitioners is that under a
holding of the Ninth Circuit Court of Appeals we incorrectly
determined that petitioners were subject to the addition to
tax under section 6661 (a) for the years 1982 and 1983. In the
case of Vorsheck v. Commissioner [91-1 USTC $50,258], 933
F.2d 757 (9th Cir. 1991), affg. in part and revg. in part an
Oral Opinion of this Court, the Ninth Circuit held that the tax-
payer was not liable for the addition to tax under section
6661 (a).
In Vorsheck v. Commissioner, supra, we held that the tax-
payers were not liable for the additions to tax under section
6653(a) since they had relied on the advice of an accountant
in claiming deductions with respect to an investment in a limited
partnership. We held the limited partnership to be a tax shelter
without a profit objective. We held that the partnership did
not engage in a trade or business, but was merely organized
to offer investors a tax shelter. However, since the taxpayers
in the Vorsheck case had entered into the transaction on the
advice of an accountant in good faith with the objective on their
part to make a profit, we concluded that they were not sub-
ject to the addition to tax under section 6653(a). We held
however that since there was a substantial understatement
of income tax, the the taxpayers in Vorsheck were subject to
the addition to tax under section 6661. The Ninth Circuit
pointed out that section 6661(c) provides that the Secretary
may waive the ‘‘penalty’’ provided for in section 6661(a) on
a showing by the taxpayer that there was reasonable cause
for the understatement and that the taxpayer acted in good
faith. The court then stated:
a
47a
Thus, if it was reasonable for the taxpayer to rely
upon the advice of an accountant under the cir-
cumstances, and the taxpayer did so in good faith,
then the Commissioner may waive the penalty.
Here, the tax court found that, although the fact
that WROG was a tax shelter would have been ap-
parent to an ‘‘experienced businessman,’’ the Vor-
shecks were not sophisticated business persons.
‘‘(T]hey relied upon the advice of their trusted tax
adviser who assured them that they would obtain
certain deductions.’’
j On the basis of its evaluation of the motives and
experience of the Vorshecks, the tax court denied
the penalties under sections 6653 and 6659. The tax
court, however, found that the Vorshecks were liable
for the penalty under section 6661. We do not agree.
4 If the Vorshecks were acting as ‘‘an ordinary pru-
dent person in the circumstances,’’ then their
| reliance upon the investment advice of their accoun-
tant was ‘‘reasonable”’ and ‘‘in good faith under all
the circumstances.’’ See Treas. Reg. § 1-6661.6(b);
Heasley [90-1 USTC 4 50,314], 902 F.2d at 385.
Thus, the Vorshecks meet the standard for waiver
of the penalty under section 6661. Accordingly, we
reverse the tax court’s decision upholding the Com-
missioner’s assessment of a 10% penalty under sec-
tion 6661. [Vorsheck v. Commissioner, supra at 759;
fn. ref. omitted; citation omitted. ]
sabe: nibs Atari al ;
In the instant case we found that petitioners’ reliance on
the advice of lawyers and accountants in following the plan
| of taking over the assets of est, a.e.c. was reasonable and
in good faith. However, for reasons we explained in the opi-
nion, we did not consider that these same facts required a con-
48a
clusion that the taxpayers were not liable for the addition to
tax under section 6661. However, we see no distinction in
the instant case and the case of Vorsheck v. Commissioner,
supra. Since an appeal in the instant case lies to the Ninth Cir-
cuit, we reconsider our opinion with respect to the section
6661 addition to tax, and based purely on the holding of the
Ninth Circuit in the case of Vorsheck v. Commissioner, supra,
conclude that because petitioners’ reliance on their lawyers
and accountants with respect to the transactions here involv-
ed was reasonable and in good faith, petitioners met the stan-
dard for waiver of the addition to tax under section 6661. Ac-
cordingly, we hold that petitioners are not liable for the addi-
tion to tax under section 6661. Except in the two respects
outlined above we reaffirm our holding in all respects as set
forth in our Memorandum Findings of Fact and Opinion filed
July 1, 1991.
An order denying in part and granting tn part petitioners’ mo-
tion for reconsideration will be issued and decisions will be
entered under Rule 155.
49a
APPENDIX F RECEIVED
7-5-91
T.C. Memo. 1991-290
UNITED STATES TAX COURT
WERNER H. ERHARD and ELLEN V. ERHARD,
Petitioners
V.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
Docket Nos. 39473-85, 46712-86, Filed July 1, 1991.
39532-87, 137-88.
Michael I. Saltzman, Barbara T. Kaplan, and Robert F. Her-
mann, for the petitioner.
Carmen Baerga, Craig Connell, Mildred Moon, and Ray
Kahn, for the respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
SCOTT, Judge: These consolidated cases were assigned
for trial or other disposition to Special Trial Judge James M.
Gussis pursuant to section 7443A(b) of the Internal Revenue
Code and Rule 180 et seq.! This Court Agrees with and adopts
the opinion of the Special Tnal Judge which is set forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
GUSSIS, Special Tnal Judge: Respondent has determined
the following Federal income tax deficiencies, increased in-
terest and additions to tax:
‘All section references are to the Internal Revenue Code of 1954 as
amended and in effect for the years in issue unless otherwise indicated.
All Rule references are to the Tax Court Rules of Practice and Procedure.
Depreciation As Computed Under Federal Statutes
Non-Recovery Property
Date Cost Or Other Accumulated
Description Acquired Basis Amortization
Building & Addition 02/01/77 501,088 17,054
Leasehold Improvements VAR 934,442 498 668
Office Furniture VAR 853,323 328,403
Office Equipment VAR 369,407 160,402
Audio Visual Equipment VAR 405,503 241,058
Other Equipment VAR 650,962 117,730
Vehicles VAR 124,008 60,274
Software VAR 179,390 38,555
Hardware VAR 358,489 67,281
Leasehold Improvements
—Sold or Abandoned VAR -934 442 -498 668
Other Equipment
— Sold or Abandoned VAR -123,670 -12,634
Vehicles — Sold VAR -124,008 -60,274
Totals 3,194,492* 957,849*
Total Depreciation
Method
SL
SL
~¥
SL
SL
SL
SL
SI
SI
Statement 8 — Depreciation
Useful
Life
Yrs Pet
VAR
VAR
VAR
VAR
VAR
VAR
VAR
VAR
VAR
Current
Amortization
5,767
104,150
117,324
93,339
68,423
88,553
31,369
90,022
73,586
0
598,033"
598 ,033*
FOF
Docket
Nos.
39473-85
46712-86
39532-87
137-88
Year
1981
1982
1983
1983
Income Tax
Deficiency
$456,431.00
747,413.50
494 446.00
494 446.00
Increased Interest and
Additions to Tax Sections
6621(c) 6653(a)(1) 6653(a)(2)
— $22 ,822 .00
Applicable 37,676.00 ies
Applicable 24,722.00 —
Applicable 24,722.00 Te
6661
$ 75,352.00
123,612.00
123,612.00
*50 percent of the interest due on the underpayment of $456,431.00 attributable to negligence.
**50 percent of the interest due on the underpayment of $747,413.50 attributable to negligence.
***50 percent of the interest due on the underpayment of $494,446.00 attributable to negligence.
20S
5la
On November 1, 1988, the Court granted respondent’s mo-
tion in docket No. 39473-85 to increase the interest rate on
the underlying deficiency for the year 1981 pursuant to sec-
tion 6621(c). In an amendment to his answer in docket No.
46712-86 respondent claimed an increased addition to tax under
section 6661 of 25 percent of the underpayment for the year
1982, or $186,853.37.
Petitioner Ellen V. Erhard did not appear at the trial of these
cases. On March 23, 1989, she filed with the Tax Court an
Agreement to be Bound by the decision of the Tax Court in
these cases.
The issues, which were consolidated for purposes of trial,
briefing and opinion, are (1) whether petitioners are entitled
to an interest expense deduction in 1981 with respect to cer-
tain purported loans from Terla, B.V.; (2) whether petitioners
are entitled to an interest expense deduction in 1981, 1982
and 1983 with respect to a purported $14,000,000 loan from
Intercultural Cooperation Foundation; (3) whether petitioners
are entitled to an interest expense deduction in 1982 with
respect to a purported $1,000,000 loan from Intercultural
Cooperation Foundation; (4) whether petitioners have
established a basis for depreciation purposes in 1981, 1982,
and 1983 in the assets purportedly acquired from est, an educa-
tional corp., the Werner Erhard Charitable Settlement,
Associated Advisors, Presentaciones Musicales, S.A., and
Welbehagen; (5) whether petitioners are liable for the addi-
tions to tax under section 6653(a)(1) and (2) in 1981, 1982,
and 1983; (6) whether petitioners are liable for additions to
tax under section 6661 in 1982 and 1983; and (7) whether peti-
tioners are liable for the increased interest under section
6621(c) in 1981, 1982, and 1983.
BEST AVAILABLE COPY
52a
FINDINGS OF FACT
Some of the facts were stipulated and they are herein in-
corporated by this reference. Werner H. Erhard (sometimes
referred to herein individually as petitioner) was a resident
of Sausalito, California, and petitioner Ellen Erhard was a resi-
dent of Novato, California, at the time the petitions herein were
filed. Petitioners timely filed joint Federal income tax returns
for the years 1981, 1982, and 1983 with the Fresno Service
Center.?
Werner Erhard is the proprietor of Werner Erhard &
Associates (hereinafter WEA) which was formed in 1981 to
offer seminars, workshops and other programs in personal ef-
fectiveness to the public. Prior to the formation of WEA, a
variety of programs, seminars, workshops and lectures con-
cerned with personal effectiveness were offered to the public
by est, a.e.c. The major program marketed by est, a.e.c. was
the est training program which involved the effective delivery
of certain ideas, concepts and know-how embodied within the
collective term, the Body of Knowledge. The Body of
Knowledge was created by Werner Erhard, who was also the
original developer of the est training. Erhard continued as the
primary developer of the training and he decided when a par-
ticular trainer was qualified or capable of leading the training.
Erhard received W-2 income from est, a.e.c. in the years 1975
through early 1981. Prior to the formation of WEA in 1981,
est, a.e.c. had between 300 and 350 employees and owned
the requisite business assets for its operations such as
leaseholds, leasehold improvements and computer equipment.
?The use of such words as ‘‘borrow,’’ ‘‘loan,”’ ‘‘interest,’’ ‘‘purchase,”’
and ‘‘payment”’ in our findings of fact is for narrative convenience, describ-
ing the form of the transaction, and is not intended to indicate any conclu-
sion concerning the actual substance of the transaction in question.
53a
By 1980, the est training program had been delivered to be-
tween 250,000 and 300,000 individuals. The various services
provided by Erhard were indispensable to the effectiveness
and profitability of the est, a.e.c. operations.
Harry Margolis became the personal legal and financial ad-
visor for Werner Erhard in 1971, in which year Margolis also
arranged for the formation and financing of Erhard Seminars
Training, Inc., for the purpose of presenting seminars to the
public. These seminars were based upon concepts which
Werner Erhard originated and which became known as the
Body of Knowledge. Margolis became legal advisor to Erhard
Seminars Training, Inc., and handled the accounting and finan-
cial aspects of the corporation. The activities of Erhard
Seminars Training, Inc., were subsequently taken over in 1975
by a new corporation, est, a.e.c., a corporation formed under
the laws of Nevada.
The stock of est, a.e.c. was held by the Werner Erhard
Charitable Settlement, an entity formed under the laws of the
Channel Island of Jersey. Alexia Trust Co. was the trustee
for the Werner Erhard Charitable Settlement. The Werner
Erhard Charitable Settlement, together with a charitable
organization in Switzerland called the Werner Erhard Foun-
dation for est, a.e.c., owned a holding company in Switzerland,
WEF est Holding, A.G., which in turn owned a company in
the Netherlands called Welbehagen, B.V.
Margolis devised the financial and legal structure of est,
a.e.c. and continued in his involvement and tax planning for
the new corporation. Margolis was the legal and financial ad-
visor, tax return preparer, banker and accountant for est,
a.e.c. between 1975 and 1981. For the most part, the
employees of Erhard Seminars Training, Inc., continued in the
employment of est, a.e.c.
54a
Under agreements prepared by or at the direction of
Margolis, effective September 1, 1975, Presentaciones
Musicales, S.A. (PMSA), a Panamanian Co., sold the Body
of Knowledge to Welbehagen, B.V., which licensed the Body
of Knowledge in the United States to est, a.e.c. and to
organizations in other countries. Under this arrangement, est,
a.e.c. deducted amortization and interest paid to Welbehagen.
est, a.e.c. received funds of capital contributions from Werner
Erhard Charitable Settlement.
est, a.e.c., with headquarters at 765 California Street in San
Francisco, California, was managed by professional and fully
qualified managers. In 1980, there were centers in some 30
cities throughout the United States managed by local managers
who reported to headquarters through area managers. Per-
sonnel matters, administration, communications, training pro-
grams and international operations were managed from head-
quarters. A division of est, a.e.c. called the office of Werner
Erhard was located at the Franklin House at 1945 Franklin
Street in San Francisco, with its own staff of aides, com-
municators and administrative personnel.
The members of the office of Chief Executive and other ex-
ecutives made up an executive group which oversaw the opera-
tions of seven divisions: Centers management, international,
communications, personnel, the academy, administration and
the office of Werner Erhard.
The delivery of programs by est, a.e.c. was seasonal in
nature, with business operations running in trimesters begin-
ning in February, June and October. Revenues were highest
in the trimester from June through September. The trimester
beginning in October was the seasonal low. For its fiscal year
ended June 30, 1980, est, a.e.c. reported gross receipts from
operations in the amount of $23,368,328 and, after deductions
= aan tite
55a
which included amortization and interest expense deductions,
reported zero taxable income.
The Harry Margolis system was a group of off-shore and
domestic corporations, trusts, banks, partnerships and other
entities used by Margolis to implement his tax planning for
clients. A system entity refers to an individual entity within
the system. System entities were controlled either directly
or indirectly by Margolis, his law office or his employees.
System entities included the following: Alexia Trust Co.,
(hereinafter Alexia); Antigua Banking, Ltd.; Aruba Bonaire
Curacao Trust Co., (hereinafter ABC Trust); Associated Ad-
visors; Erik Holding Co.; Island Bank (British Virgin Islands)
Ltd., (hereinafter Island Bank, Ltd.); Kempold, B.V.; Mator,
S.A.; Mundial Investment; Parallax Corp., a Panamanian
Corp.; Presentaciones Musicales, S.A. (hereinafter PMSA);
Sineuri, S.A., a Panamanian Co.; Terla, B .V.; Truma, B.V.,
a Netherlands Co.; Welbehagen, B.V.; Werner Erhard
Charitable Settlement; and Werner Erhard Foundation for est,
a.e.c.
Erik Holding, B.V., Terla, B.V., and Kempold, B.V., were
sysems entities registered in the Netherlands that provided
almost identical functions in the Harry Margolis system. The
system entities served identical functions in that they processed
loans for individuals and entities who generally were clients
of Margolis. With respect to the functions of Island Bank, Ltd.,
almost all of its customers were affiliated with Margolis. Island
Bank, Ltd., itself did not make loans. Instead, Island Bank,
Ltd., made funds available to overseas system entities which
in turn would make the actual loans. The process by which
Island Bank, Ltd., made funds available to an overseas system
entity followed a standard procedure in the operation of the
Harry Margolis system. Generally, the overseas system en-
tity would agree to make a loan and Island Bank, Ltd., would
56a
then provide the necessary financing by making the funds
available to the lending entity. The lending process would be
initiated by a request from the office of Harry Margolis. Island
Bank, Ltd., and the lending entity would both be managed by
Mator, S.A., and the same individuals would act for both.
Mator, S.A., was a trust management company providing ac-
counting, adminsitrative, statutory and other related services
for corporate entities.
The representation of clients in the office of Harry Margolis
generally consisted of (1) an initial phase during which the
client’s goals were defined and documents were drafted to
realize such goals; and (2) an implementation stage during
which the required relationsips were established; and (3) a
so-called clean-up phase when the client desired to terminate
the contractual relationships which were then phased out.
Where required, money movements would be made in order
to complete the clean-up phase.
The est, a.e.c. organizational structure devised by Margolis
in 1975 was a maze of intertwined organizations with numerous
agreements among the entities involved. After est, a.e.c. was
formed by Margolis in 1975, he created system entities which
dealt only with est, a.e.c. These system entities included
Welbehagen, B.V., Werner Erhard Charitable Settlement, the
Werner Erhard Foundation for est, and WEF est Holding, A.G.
Welbehagen, B.V., was an entity in Holland; Werner Erhard
Charitable Settlement was situated in the Isle of Jersey;
Werner Erhard Foundation for est and WEF est Holding, A.G.,
were Swiss entities; est, a.e.c. was a Nevada Corp. Alexia,
the trustee of Werner Erhard Charitable Settlement, was a
trust company situated in the Isle of Jersey.
Werner Ehard Charitable Settlement, in addition to owning
all of the stock in est, a.e.c., also held an interest in the Swiss
holding company, which in turn owned all of the stock in
Welbehagen, B.V.
57a
The gross profits reported by est, a.e.c. in the taxable years
ended June 30, 1975, through 1981 were in the following
respective amounts: $7,294,742, $9,322,668, $11,271,827,
$14,956,956, $17,155,518 and $15,510,121. During this en-
tire period est, a.e.c. reported total taxable income of approx-
imately $100,000.
In the course of the management by Margolis of the finan-
cial affairs of Werner Erhard, Erhard incurred an indebtedness
of about $1,000,000 to Barclays Kol in the Netherlands and
also incurred financial obligations to the system entities
Associated Advisors and Antigua Banking, Ltd.
In 1976 Margolis was indicted on criminal tax charges aris-
ing from his tax planning activities. He was acquitted of all
charges in 1977. After the indictment of Margolis, Erhard and
his executives became concerned over the impact on their
business operations in view of the role played by Margolis in
such operations.
On or about January 11, 1980, Werner Erhard announced
his initiation of a project to reexamine and analyze the legal,
financial and organizational structure of est, a.e.c. and its
predecessor, Erhard Seminar Training, and the formation of
a task team to implement the project. The task team was com-
posed of several est, a.e.c. executives and staff members and
other professionals in the fields of law and management. The
purpose of the project was to ‘‘create est anew.’’ In April
1980 the est organization was informed of the formation of a new
office of Chief Executive within est, a.e.c. All of the legal, finan-
cial, accounting, banking and tax work for both Erhard Seminar
Training and est, a.e.c. had been conducted by Margolis.
Neither Erhard nor the est, a.e.c. executives had a clear
understanding of the maze of foreign and domestic entities,
all associated with Margolis, that surrounded est, a.e.c. Nor
did Erhard have a complete and accurate understanding of his
personal financial situation in early 1980. In May 1980
58a
Margolis, in a memorandum to Charles O. Johnston, an est,
a.e.c. executive, outlined his recommendations concerning the
distribution of 10-year bonuses to est, a.e.c. employees. In
a May 8, 1980, memorandum Erhard advised the est staff that,
together with Margolis and the task team, Erhard had for some
time been examining the role of est’s legal counsel in the pro-
ject to ‘‘create est anew’’, and had now jointly determined
to replace the Harry Margolis office as the general and tax
counsel of est, a.e.c.
In a memorandum dated April 30, 1980, from Margolis to
Ellie M. Deull, and attorney for est, a.e.c. and for Werner
Erhard personally, Margolis indicated his understanding with
Werner Erhard that the office of Harry Margolis would be
responsible for the tax matters of est, a.e.c. through June 30,
1980. With respect to the period after July 1, 1980, Margolis
indicated in the memorandum that in the event ‘‘our struc-
ture is utilized, we expect to collect fees and costs as in the
past.’’ In a memorandum to Deull dated May 24, 1980,
Margolis stated that at the time est, a.e.c. was formed in 1975,
it was contemplated that the new corporation would probably
not remain in existence for more than three years.
Prior to 1981, the office of Harry Margolis maintained a so-
called system accounting for the clients of Margolis which
recorded funds flowing into the system from the client or non-
system entities and funds flowing out of the system to the client
or non-system entities. The system accounting was a
chronological history of the transactions of a client within the
system and kept track of the client’s balance, either positive
or negative, within the system. All funds flowing into the
system from a client or a non-system entity were entered in
the system accounting as a credit while all funds flowing out
of the system to a client or a non-system entity were entered
in the system accounting as a debit. A client earned
Wate? Ces ninth atin nils “
59a
interest on positive balances in the system accounting main-
tained for him and was charged interest on negative balances.
Transactions between system entities were not recorded in
the system accounting since the funds stayed within the
system. The office of Harry Margolis maintained only one com-
bined system accounting for Werner Erhard and est, a.e.c.
Inez Teague was employed in the office of Harry Margolis
in 1971 as a staff accountant and then undertook the duties
of coordinating the banking activities of the office. Her employ-
ment continued with the office until 1984. Paul T. Mason was
a business associate of Margolis and was managing director
of Island Bank, Ltd., and Sineuri, S.A., in Panama. Prior to
1982, he also managed Mator, S.A., a trust management com-
pany that provided management services to various corporate
entities. Such services included accounting, administrative, and
other statutory services required under government regula-
tions. Most of the Mator, S.A., clients were corporations that
had dealings with Margolis and attorneys currently or previous-
ly associated with him. Everd B. van Walsum was a business
associate of Margolis. During the year 1981 van Walsum was
president of Mator, S.A. He was also the managing director
of Alexia and Truma, B.V.
Arthur H. Schreiber was house counsel for est, a.e.c. from
1979 to 1981. In June 1981 he became general counsel to WEA
and since the middle of 1987 he has been the chief operating
officer fo WEA. During the period from about February 20,
1981, to May 31, 1981, Schreiber served in the dual capacity
as an employee of est, a.e.c. and as an associate of WEA.
Michael Eisenberg was an executive in the accounting of-
fice of est, a.e.c. from September 1978 through May 1981.
He was employed by WEA in various financial capacities from
June 1981 through February 1988. Johnston was employed
as chief financial officer for est, a.e.c. in or about Janaury 1980,
60a
and in June 1981 he commenced employment with WEA. He
left WEA in or about May 1982. Robert R. Curtis was
employed in various executive capacities by est, a.e.c. until
May 31, 1981, when he became employed by WEA. Pat Dillan
was employed in an administrative capacity in the chief ex-
ecutive office of est, a.e.c. in 1979 and 1980. In or about
September 1980 she was assigned to the office of Werner
Erhard within the est, a.e.c. organization as project manager
and in 1981 she continued in that capacity for WEA. Myron
A. Wick was manager of the office of Werner Erhard and then
chief executive officer of est, a.e.c. during the period from
1980 until May 1981. In June 1981 he became chief executive
officer of WEA until he resigned from WEA in September
1983.
Brown Educational Corp. (hereinafter BEC) was formed in
or about September 1981 as a holding company and an educa-
tional service company for sales organizations. BEC did not
implement its stated purpose of acting as an educational ser-
vce company. Am-Pro Marketing, Inc., (hereinafter Am-Pro)
is a sales and marketing company primarily engaged in
marketing a fuel additive product manaufacured by Bell
Laboratories in Florida. BEC filed a petition in bankruptcy in
1985 or 1986. Johnny Brown was president of both BEC and
Am-Pro. Glenn J. Beadle was employed by Am-Pro as a
motivational speaker and as the adminstrator of the company.
Beadle was also an officer, director and shareholder of BEC.
John D. Singleton, an attorney in Oklahoma, was retained by
4m-Pro to perform tax-planning services. In 1980 and 1981, _
Singleton, together with Beadle, consulted Margolis with
respect to tax-planning. Kenneth H. Reiserer, a California at-
trney employed in the office of Harry Margolis from 1973
to 1976 and later from June 1977 to about January or February
1981, also participated in the tax-planning for Am-Pro. Am-
Pro eventually entered into certain contractual arrangements
6la
suggested by the office of Harry Margolis involving Sineuri,
S.A., and Truma, B.V.
The Harry E. Wright, Jr., Charitable Trust was established
on May 24, 1971, by Margolis pursuant to the will of Harry
E. Wright, Jr. John E. Thorne, a California attorney, was a
trustee of the Harry E. Wright, Jr., Charitable Trust.
The First National Bank of Boston, Panama, was a branch
of the First National Bank of Boston, a national bank chartered
in the United States.
Margolis, in the implementation of his tax planning for clients
over the years, devised orchestrated cash flows or money
movements that were structured by contractual arrangements.
To create these money movements, Margolis on occasion
would obtain the use of certificates of deposit for a fee from
est, a.e.c. for a few days to use as collateral in obtaining the
temporary use of funds for the money movements. When the
cash flow was completed, usually in a brief period of time, the
collateral was released and the certificates were returned to
est, a.e.c. Generally transaction requests and check requests
were used in the office of Harry Margolis to implement pre-
arranged money movements. Transactions involving money
movements would be accumulated and executed at the same
time. These transactions would be coordinated by a designated
employee in the office of Harry Margolis.
In March 1980, Pat Dillan, an administrator in the chief ex-
ecutive office of est, a.e.c., conducted a survey of the advisory
board of est, a.e.c. to ascertain, inter alia, the attitudes of
the board members toward the legal and financial structure
of est, a.e.c. In August 1980, the board members were ap-
prised of the results of the survey, which emphasized the view
that the complexities of the legal and financial structure of est,
a.e.c. were difficult to understand and engendered skepticism
from the public.
62a
In late 1979 or 1980 est, a.e.c. retained Deull (see supra
p. 11), who in conjunction with the ongoing ‘‘create est anew’’
project, undertook to investigate the legal and financial struc-
ture of est, a.e.c. and to explore the various legal and finan-
cial aspects of a transaction from est, a.e.c. to a new organiza-
tion. Deull, in additions to his legal services for est, a.e.c.,
also performed personal legal services contemporaneously for
Werner and Ellen Erhard. He ceased representing est, a.e.c.
in January 1981 and began representing WEA in February
1981. He continued to represent WEA until October 1984.
Deull was a member of the est, a.e.c. advisory board which
consisted of approximately 50 professionals and individuals who
had participated in programs delivered by est, a.e.c. During
the pendency of the criminal case involving Margolis, Deull
expressed to Werner Erhard the view that the structure
created for est, a.e.c. by Margolis was unduly complicated,
confusing and anti-ethical to the work conducted by Werner
Erhard and that the association with Margolis would, with
respect to certain segments of the community, have a negative
impact on the growth potential of est, a.e.c. The est, a.e.c.
executives were also dissatisfied with the involvement by
Margolis in the management and operation of est, a.e.c.
Margolis was made aware of the task team and his coopera-
tion was sought in providing information and materials
necessary for the completion of the investigation. Margolis
was also informed of the retention of Deull, van Merkensteijn
and Seth Hufstedler, an attorney, as outside legal counsel for
est, a.e.c. and of the intention to eventually relieve the
Margolis office of any ongoing responsibility. The initial offer
of Margolis to resign immediately from the est, a.e.c. account
was rejected by Deull.
Deull retained John van Merkensteijn, an attorney, to
analyze the tax aspects of the existing legal structure of est,
eg a Co A OR a
63a
a.e.c., to recommend a future structure for the ongoing
business operation and to recommend suitable methods for
the transition to the new structure. One of the concerns of
van Merkensteijn was the avoidance of any transferee liabilities
resulting from the transfer of assets from est, a.e.c. to any
new business organization. John van Merkensteijn was subse-
quently retained as counsel by est, a.e.c. On April 25, 1981,
he resigned as counsel to est, a.e.c. William C. Gifford, an
attorney, was contacted by van Merkensteijn in 1980 to assist
in the tax aspects of the transition form est, a.e.c. to a new
entity. Gifford later became the personal attorney for Werner
Erhard and Ellen Erhard and, on or about April 25, 1981, he
became tax counsel for WEA.
During the spring and summer of 1980, Deull and other at-
torneys examined possible ways of reorganizing the est, a.e.c.
enterprise. Among the alternatives they considered were a
sole proprietorship, a corporation and a combination of a sole
proprietorship with a section 501(c)(3) organization. In August
1980, Deull and van Merkensteijn recommended to Werner
Erhard and the est, a.e.c. executives that Erhard should con-
duct the enterprise in the future as a sole proprietorship. In
a memorandum to Werner Erhard dated September 16, 1980,
Deull and van Merkensteijn explained their recommendation
as follows:
* * *
The difficulty with the present situation is that it
is (1) technically complex, (2) difficult, if not impossi-
ble to explain or understand and (3) subject to both
public criticism and litigation with the Internal
Revenue Service. Overall, many perceive it as ac-
ting as a barrier to your effectiveness.
If we intend to deal the death blow to these
perceptions and problems, we want a legal and finan-
64a
cial structure which is simple, easy to explain and
honest, one which can be understood by anyone and
which is morally right, ethical and consistent with
purpose. If we have no intention or purpose to be
at loggerheads with the tax system, the structure
should be one in which substance and form are the
same, in which both truth and reality correspond,
which expresses the quality of integrity, and which
not only permits you and the organization to func-
tion without hindrance but facilitates such
functioning.
From the tax point of view, the reflection of your
perceived intention will be through one of three alter-
native structures:
1. no structure (everything in a sole proprietor-
ship and fully subject to tax);
2. everything in a charitable organization and not
subject to tax;
3. a coordinated combination of (1) and (2).
Choice (1) from the tax point of view is truly par-
ticipating in a death blow to the current organiza-
tional ethic that beating the tax system is the objec-
tive of ‘‘planning’’ and a necessity for survival. This
puts no box around any activities, is consistent with
you as source, supports and allows everything you
have said you intend or want to do to happes: without
hindrance. While it may not be easy or even possi-
ble to get there, it is the direction in which we believe
you should go. As we discussed on August 19, it
has non-tax considerations which are that you will
be seen to be making the money (although you can
avoid being seen to be wealthy by giving it away)
65a
and it will be inconsistent with previous public
statements (such as the 1976 Legal-Financial Let-
ters) and these may effect your ability to accomplish
and contribute.
In the September 16, 1980, memorandum to Werner
Erhard, the attorneys also stated:
The existing legal and financial structure of est is
and has been consistent with your intention to own
est by giving it away; a structure consistent with
your desire not be seen to be ‘‘in it for the money”’
while maximizing your ability to expand your con-
tribution to people’s well-being and the transforma-
tion of the quality of their lives.
* * *
In our paradigm, it is only possible to either be
seen making the money and therefore being able to
dispose of it, or not to be seen making the money
and not being able to dispose of it or having it; and
it is not possible within our system not to be seen
making the money and having control or power to
dispose of it. That option only exists in the present
situation and, of course, leaving everything essen-
tially as it is, is a choice that can still be made.
In October 1980, a discussion group of some six tax at-
torneys, including Gifford, which had been formed by van
Merkensteijn in the mid-1970s, met in the Franklin House in
San Franscisco. A topic of discussion was the restructuring
of the business operations of est, a.e.c. and how Werner
Erhard and the business enterprise could leave the Margolis
system. The consensus of the group was that the association
of Margolis with est, a.e.c. was a commercial impediment to
66a
the operation of the enterprise, that a purchase of the business
assets from est, a.e.c. for fair market value was the best vehi-
cle for obtaining the needed assets to continue the business
operations in a new form, and that a sole proprietorship was
the best alternative for enabling Werner Erhard and the enter-
prise to operate free of Margolis.
The recommendation of Deull and van Merkenstejjn to con-
tinue the enterprise as a sole proprietorship was accepted by
Werner Erhard and the est, a.e.c. management with the ex-
pectation that the est, a.e.c. management and employees
would become employees of the sole proprietorship. John van
Merkenstejjn advised that a valuation of the business and the
assets of est, a.e.c. should be obtained.
A Settlement and Consulting Agreement was entered into
by est, a.e.c. and Werner Erhard effective as of December
31, 1980, pursuant to which Erhard terminated his employ-
ment relationship with est, a.e.c., entered into a consulting
agreement with est, a.e.c., and confirmed the retention by
Erhard of his individually owned programs which he had per-
mitted est, a.e.c. to market and deliver.
John van Merkensteijn did not know of the Barclays Kol
back-to-back loan to Werner Erhard which was collateralized
by the Werner Erhard Charitable Settlement. Van
Merkenstelyjn recommended that the Body of Knowledge
matenials be devalued, notwithstanding the fact that est, a.e.c.
had contracts with Welbehagen, B.V., to pay $1,000,000 a
year for the Body of Knowledge. In June 1980, van
Merkensteijn recommended that the personal assets held by
systems entities be acquired by Werner Erhard personally.
In view of the key role of Werner Erhard in the services
offered by the est, a.e.c. organization, the departure of Erhard
together with some of his executives and trainers would de-
67a
prive the est, a.e.c. organization of its capability to function
and to produce income and would leave the organization with
nothing other than real estate, rental obligations and a
miscellany of hardware.
WEA was formally established as a sole proprietorship under
California law in February 1981. A senes of agreements
effective as of February 20, 1981, was entered into by WEA
and est, a.e.c. which established interim arrangements
governing the administration, marketing, consulting and
employee service associated with the business of WEA. In
large part, the agreements were intended to compensate est,
a.e.c. for administrative services associated with the business
of WEA, for program enrollment marketing services performed
by est, a.e.c., and to compensate WEA for services by its
employees for est, a.e.c. Eisenberg, director of finance of
WEA, prepared interim accounting procedures for the sole
proprietorship, established separate books and records and
opened new book accounts.
In planning the acquisition of the est, a.e.c. assets by Werner
Erhard, attorneys van Merkensteijn, Gifford and Deull recom-
mended in April 1981 that Werner Erhard acquire the assets
through leases. In a memorandum dated April 23, 1981, to
Margolis, counsel included this recommendation in a list of
some 18 steps to accomplish the transfer of the est, a.e.c.
assets to WEA. On or about April 25, 1981, the lease plan
was presented to the est, a.e.c. executives by van
Merkensteijn. The executives rejected the lease plan largely
because of concerns over an insufficient cash flow to meet the
required lease obligations. An alternative approach calling for
the purchase of the assets from est, a.e.c. was then considered
by the executives. Margolis supported the purchase alternative
and suggested that the assets could be purchase with funds
borrowed at low cost and with no interest. It was deemed
68a
, essential by the parties to complete the purchase by the end
of May prior to the start of the high revenue period, June
through September. On or about April 25, 1981, Gifford re-
placed van Merkensteijn and assumed responsiblity as out-
side tax counsel for WEA and Erhard personally. The final
decision to adopt the asset purchase plan was reached by WEA
about the middle of May 1981.
In accomplishing the transfer of est, a.e.c. assets to WEA,
the attorneys Gifford, van Merkensteijn and Deull made other
recommendations which were not followed by WEA. Counsel
recommended that WEA not purchase the existent nghts to
the Body of Knowledge held by est, a.e.c. or by any other
party. However, WEA agreed to purchase the Body of
Knowledge. Counsel recommended that the Werner Erhard
Charitable Settlement contribute its ownership of est, a.e.c.
to a domestic section 501(c)(3) organization. However, at the
completion of the asset transfer to WEA, Margolis and his
system entities were left in control of est, a.e.c.
In addition to the assets acquired by WEA from est, a.e.c.
needed for WEA to operate its business, WEA also purchased
personal assets for Werner Erhard, such as the auxiliary sloop,
Sirona, from Associated Advisors. Associated Advisors had
previously purchased, in addition to the Sirona, an automobile
to be used by Werner Erhard, held the unrecorded mortgage
on the home of Werner Erhard, had made loans to Werner
Erhard, and had provided funds to Werner Erhard for use in
the so-called Breakthrough racing activities in or about 1979.
WEA also purchased art works from the Werner Erhard
Charitable Settlement during the period of the asset transfer
from est, a.e.c. to WEA in 1981.
Gary Grace was financial officer for est, a.e.c. at the time
he left the organization in 1979. In late 1979 or early 1980,
Werner Erhard retained Gary Grace to conduct an investiga-
69a
tion of Erhard Seminars Training and est, a.e.c. and the system
accounting in order to ascertain the financial situation of both
entities as well as the personal financial situation of Werner
Erhard vis-a-vis the Margolis system. Grace was given ac-
cess to all financial records and files in the office of Harry
Margolis which pertained to the entities Erhard Seminars
Training, Inc., and est, a.e.c. as well as to Werner and Ellen
Erhard in their individual capacities. In his analysis of these
records, Gary Grace did not separate the entities and the in-
dividuals involved. In his investigation, Grace traced funds go-
ing into the system and coming out of the system. Funds mov-
ing between system entities were not recorded in systems
accounting and Gary Grace was not concerned with such move-
ment of funds. Since the investigation entailed a study of all
the relevant records at the Margolis office, Gary Grace con-
ducted the investigation in the capacity of consultant to
Margolis. The records examined included the records of
Erhard Seminar Training, est, a.e.c., and the records per-
taining to Ellen and Werner Erhard. At some point, at the in-
sistence of Deull, Gary Grace continued the investigation under
a fee arrangement with the Deull law firm. In all, the entire
project conducted by Gary Grace lasted over a period of some
nine months.
Grace determined that all amounts paid by est, a.e.c. dur-
ing the relevant period into the Margolis system were pro-
perly recorded as receipts in the Erhard system accounting.
Gary Grace also determined that these payments by est, a.e.c.
into the system were expended for the benefit of Werner
Erhard and est, a.e.c. After September 1, 1975, est, a.e.c.
made interest and principle payments to Welbehagen, B.V.,
and also made payments of legal fees and costs to Margolis.
These amounts were credited to the Erhard accounting.
Payments from Werner Erhard Charitable Settlement to est,
a.e.c. (generally as capital contributions) were charged to the
Erhard accounting. Payments from Werner Erhard Charitable
70a
‘Settlement to purchase art were charged to the Erhard ac-
counting. Payments from Associated Advisors to purchase the
auxiliary sloop, Sirona, were charged to the Erhard accounting.
Payments from Welbehagen, B.V., to pay for Werner Erhard’s
travel expenses on a Bali/India trip and his sabbatical expenses
were charged to the Erhard accounting. Payments from
Associated Advisors to purchase a Porsche automobile for
Werner Erhard and to pay his automobile racing expenses were
charged to the Erhard accounting. Payments from
Welbehagen, B.V., to finance deficits of the foreign opera-
tions of est, a.e.c. were charged to the Erhard accounting.
Payments made from the Werner Erhard Charitable Settle-
ment for donations by Werner Erhard were charged to the
Erhard accounting. On occasion, the system made back-to-
back collateral deposits for loans to est, a.e.c.
The result of the analysis performed by Gary Grace was
recommendations and questions to be resolved as to the
system accounting. In 1982 Werner Erhard and Margolis
entered negotiations concerning outstanding balances due
between the parties. A settlement was eventually reached in
which no payments were required by either party.
On or about May 22, 1981, Teague, an employee of
Margolis, was given a special power of attorney by the Parallax
Corp., empowering her to open a bank account for Parallax
Corp., with Barclays Bank of San Francisco, to pledge funds
in the Parallax Corp. account to secure a loan or loans made
by the bank to Werner Erhard or WEA, and to perform other
functions related to this specific transaction. On June 1, 1981,
Parallax Corp. provided general security agreements to
Barclays Bank of San Francisco and Barclays Bank Interna-
tional, Ltd., to secure the loans to WEA. In a memorandum
termed ‘‘cash flow’’ dated May 20, 1981, Margolis advised
Michael Eisenberg, who had the responsibility for drawing
checks and arranging transfers of funds for WEA, on aspects
EN
7la
of the financing and the various transactions associated with
the transfer of operations from est, a.e.c. to WEA in mid-198].
Check requests and cash receipt forms, which were general-
ly employed by the office of Harry Margolis in documenting
cash flows and money transfers in its tax-planning transactions,
were used in connection with aspects of the asset transfer
in mid-1981 from est, a.e.c. to WEA.
The transfer of assets in mid-1981 from est, a.e.c. to WEA
involved the following money movements:
1. On May 27, 1981, WEA made transfers of $16,000 and
$250,000 to Associated Advisors.
2. On May 28, 1981, est, a.e.c. transferred $4,657,000 to
Welbehagen, B.V.
3. On May 29, 1981, WEA transferred $100,000 to Alexia.
4. On May 29, 1981, WEA transferred $50,000 to PMSA.
5. On June 1, 1981, Parallax Corp. made separate transfers
of $1,000,000 and $4,000,000 to Barclays Bank of San Francisco.
6. On June 1, 1981, Barclays Bank of San Francisco made
a loan of $5,000,000 to WEA. The total of $5,000,000 transfer-
red by Parallax Corp. to Barclays Bank of San Francisco on
June 1, 1981, guaranteed the loan made by Barclays Bank of
San Francisco to WEA.
7. On June 1, 1981, Terla, B.V., transferred $2,200,000
to WEA.
8. In June 1981 WEA transferred $2,706,792 to est, a.e.c.
9. On June 1, 1981, WEA transferred $1,602,847.22 to
Barclays Kol in the Netherlands in repayment of a loan from
Barclays Kol.
10. On June 2, 1981, Alexia transferred $610,000 to est,
a.e.c.
72a
11. On July 22, 1981, WEA transferred $765,038 to Alexia.
12. On August 27, 1981 , est, a.e.c. made three transfers
to Welbehagen, B.V., in the following amounts: $1,571,000,
$1,000,000 and $2,000,000.
13. On August 27, 1981, est, a.e.c. transferred $1,115,000
to Alexia.
14. On August 27, 1981, Alexia transferred $1,390,000 to
est, 2.€.C.
15. On August 27, 1981, Terla, B.V., made transfers of
$2,300,000, $780,000 and $3,500,000 to WEA.
16. On August 27, 1981, WEA transferred $3,693,868 to
Cnt, 2.€.c.
17. On August 27, 1981, WEA transferred $1,385,000 to
Island Bank, Ltd., for the account of Welbehagen, B.V.
18. On August 27, 1981, WEA transferred $213,000 to est,
a.e.c. for Associated Advisors.
19. On August 24, 1981, WEA made transfers to Antigua
Banking, Ltd., in the amounts of $94,449.47, $342,829,
$2,100,000 and $900,000.
20. On August 28, 1981, Antigua Banking, Ltd., transfer-
red $3,000,000 to WEA.
In the May 20, 1981, ‘‘cash flow’’ memorandum from Mar-
golis to Eisenberg, Margolis indicated that when all the con-
templated transactions were concluded, the cash position of
est, a.e.c. would be reduced by $2,950,000 and the cash
holdings of WEA would increase by the same amount.
In 1977 or 1978, Barclays Kol made a loan of $1,000,000
to Wemer Erhard. The Barclays Kol loan was secured by a back-
73a
to-back collateral deposit from the Werner Erhard Charitable
Settlement. The Erhard accounting in the Harry Margolis
sysem of accounting was charged $1,000,000 for the Barclays
Kol loan. The Erhard accounting was credited for interest earned
for one year on the $1,000,000 collateral deposit made at
Barclays Kol for the Barclays Kol loan. In his report to Deull
dated June 13, 1980, summarizing his review of the financial
interactions of the Harry Margolis office with Werner Erhard,
est, a.e.c. and related entities, Gary Grace recommended that
interest for an additional year be credited to the Erhard ac-
counting with respect to the $1,000,000 collateral deposit.
Werner Erhard paid the interest on the Barclays Kol loan with
bonus payments he received from Associated Advisors.
In May and June 1981 , WEA and est, a.e.c. entered into
a series of agreements with respect to the acquisition by WEA
of certain operating assets from est, a.e.c. These agreements
involve the lease/purchase of assets at fair market values to
be determined by independent appraisals. Additional
agreements were also reached for the purchase by WEA of
art works, an auxiliary sloop (the Sirona), the Body of
Knowledge and certain quitclaims relating to the Body of
Knowledge from Associated Advisors, PMSA and the Werner
Erhard Charitable Settlement.
In implementing the documentation for the asset transfer
in mid-1981 from est, a.e.c. to WEA, Margolis deemed it ap-
propriate for Schreiber to make final decisions for est, a.e.c.
as well as for WEA as to the documentation to be utilized.
In a memorandum to Pat Dillan and William Gifford dated
August 1, 1981, Margolis indicated that some $2,000,000 in
assets involved in the asset transfer were handled without his
involvement. Margolis also stated in the August 1, 1981,
memorandum that he had no confidence in the appraisals used
in connection with the asset transfer.
74a
By agreements dated May 15, 1981, est, a.e.c. leased to
WEA certain personal property and leasehold improvements
at locations throughout the United States and granted WEA
an option to purchase the personal property leases and
leasehold improvements. By agreement dated July 31, 1981,
WEA exercised its option to purchase the personal property
and leasehold improvements from est, a.e.c. On August 24,
1981, WEA paid $1,610,370.80 pursuant to this agreement.
On May 15, 1981, est, a.e.c. and WEA executed some 32
agreements for the sale of existing real estate leases in various
states by est, a.e.c. to WEA at stated valuations. On July 31,
1981, WEA agreed to pay an additional $1,465,318 to est,
a.e.c. for the 32 leaseholds in order to reflect the valuation
subsequently determined for such leaseholds by an indepen-
dent appraisal. By checks dated May 27, 1981, WEA paid
$1,143,932 to est, a.e.c. for the acquisition of the 32 leases
subject to adjustment upon receipt of independent appraisals
at fair m
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