Petition for Writ of Certiorari — Kenco Restaurants, Inc. v. Commissioner

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9.918 34 WAY) 6 2000

No. Qrrre OF Tur cisox

In the

Supreme Court of the Hnited States

KENCO RESTAURANTS, INC. ; K-K RESTAURANTS, INC. ;

TIFFIN AVENUE REALTY COMPANY, INC. ;

BRYAN REALTY, INC. ,

Petitioners,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

On Petirion For Writ OF CERTIORARI TO THE

Untrep States Court OF APPEALS FOR THE SIXTH CIRCUIT

PETITION FOR A WRIT OF CERTIORARI

JOHN D. STEFFAN MARINA TRAMONTOZZI

4020 University Drive Counsel of Record

Suite 207 . Suite 601-S

Fairfax, VA 22030 815 15 Street, N.W.

(703) 691-4810 Washington, D.C. 20005

(202) 393-1070

Attorneys for Petitioners

~, de ¥

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II.

QUESTIONS PRESENTED FOR REVIEW

WHETHER THE SIXTH CIRCUIT HAS MISAPPLIED THE

BURDEN(S) OF PROOF AND PRODUCED AN

INEQUITABLE OUTCOME

WHETHER THE COMMISSIONER’S REALLOCATIONS IN

THE NODs Lost THEIR PRESUMPTION OF

CORRECTNESS WHEN SHE ABANDONED HER REVENUE

AGENT AT TRIAL

PARTIES TO THE PROCEEDINGS

Kenco Restaurants, Inc.; K-K Restaurants,

Inc.; Tiffin Avenue Realty Company, Inc.; and Bryan Realty,

Inc. are not publicly-owned and none has a publicly-owned

parent or a non-wholly owned subsidiary.

lil

TABLE OF CONTENTS

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JURISDICTION.........2..00000+ israiabihicalistitieniile s seainildaavieaiidines l

RELEVANT CONSTITUTIONAL , STATUTORY ORDINANCE

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APPENDIX

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TABLE OF AUTHORITES

CASES

BRYAN REALTY, INC. V. COMMISSIONER OF INTERNAL

REVENUE, 206 F.3D 588 (6TH CIR. 2000) ..............eseeeseeeees |

BRYAN REALTY, INC. V. COMMISSIONER OF INTERNAL

PREVIIGIE,, FC. CR TI IGE visiccccsssicsccccsnicseecsssnsnsces 1,9

DHL CorpP., ET AL. V. COMMISSIONER, TC MEMO 1998-461

PD isiskiis ccsctsihiseasasesithaiiasibalesietdaselspualahidaciabaesilictanseaasoniaas passim

ELI LILLY & COMPANY, ET AL. V. COMMISSIONER, 856 F.2D

Ba ET PRs Reid sitenchcicacsiscisbaninieeaieaptisnsiendetones passim

_ FOSTER V. COMMISSIONER, 756 F.2D 1430, 1432 (9TH CIR.

1985, CERT. DENIED, 474 U.S. 1055 (1986)..........ccceeeeeeee 9

HULL V. COMMISSIONER, 87 F.2D 260 (4TH Cir. 1937)....... 16

NATIONAL SEMICONDUCTOR CoRP., ET AL. V. COMMISSIONER,

T.C. MEMO 1994-195 (1994)............cssscssssscsssssenees 9, 10, 17

PIKEVILLE COAL Co. ET AL. V. UNITED STATES, 37 FED. CL.

SIO Ce rnin isan nicccanebissaxtucccieeiitntebtaldaacieneiaimedial 10

POWERS V. COMMISSIONER, 724 F.2D 64, 66 (7TH Cir. 1983)9

SEAGATE TECHNOLOGY V. COMMISSIONER OF INTERNAL

PVE, BGS TA. FP CD a iveincsisnicenitnsaveixcmisdentivaveniicn 10

SPICER THEATRE, INC. Vv. COMMISSIONER, 346 F.2D 704, 706

Cit TI i ee 9

SUNDSTRAND CORPORATION, ET AL. V. COMMISSIONER, 96

TX. 2 Fe iii binainn 10

WELCH V. HELVERING, 290 U.S. 11 Sb | Senn 9

ZARIN V. COMMISSIONER, 92 T.C. 68 (1989), REV'D ON OTHER

GROUNDS, 916 F.2D 110 (3RD CIR. 1990) ....eccccccccccoseesss... 16

)

STATUTES

PO GE TCT os iiiichinsipiiccasincsiisiacig age passim

46 USL. SUCTION 12HMUI) l

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INTERNAL REVENUE CODE - 26 0.......csccsssscssssscssscsecccoseeeccccss.... 2

SUPREME COURT RULE Di citdieiiitiien ds eo ]

OPINIONS BELOW

Four cases were consolidated for trial and appeal.

The opinion of the United States Court of Appeals for the

Sixth Circuit in Kenco Restaurants, Inc.; K-K Restaurants,

Inc.; Tiffin Avenue Realty Company, Inc; and Bryan Realty,

Inc. v. Commissioner of Internal Revenue, 206 F.3d 588 (6"

Cir. 2000), is set forth in the Appendix hereto (APP 1a).

The Memorandum Findings of Fact and Opinion of

the United States Tax Court in Kenco Restaurants, Inc.; K-K

Restaurants, Inc.; Tiffin Avenue Realty Company, Inc; and

Bryan Realty, Inc. v. Commissioner of Internal Revenue, T.C.

Memo 1998-342 (9/24/98) is set forth in the Appendix hereto

(APP 18).

BASIS FOR JURISDICTION

The final judgment of the United States Court of

Appeals for the Sixth Circuit affirming the decision of the

United States Tax Court was entered on February 16, 2000

(APP la). This petition for writ of certiorari is filed within

ninety (90) days from that date. 28 U.S.C. Section 2101(c).

The jurisdiction of this Court is invoked pursuant to

the provisions of 28 U.S.C. Section 1254(1).

The Considerations Governing Review on Certiorari

as a matter of judicial discretion is that the United States

Court of Appeals for the Sixth Circuit has entered a decision

in conflict with precedent of the United States Court of

Appeals for the Seventh Circuit in Eli Lilly & Company, et

al. v. Commissioner, 856 F.2d 855 (7" Cir. 1988). Supreme

Court Rule 10(a).

CONSTITUTIONAL AND STATUTORY PROVISIONS -

INVOLVED.

Internal Revenue Code - 26 U.S.C. Section 482:

Allocation of income and deductions among

taxpayers.

In any case of two or more Organizations,

trades, or businesses (whether or not

incorporated, whether or not Organized in the

United States, and whether or not affiliated)

owned or controlled directly or indirectly by

the same interests, the Secretary may

distribute, apportion, or allocate gross income,

deductions, credits, or allowances between or

among such organizations, trades, or

businesses, if he determines that such

distribution, apportionment, or allocation is

necessary in order to prevent evasion of taxes

or Clearly to reflect the income of any of such

organizations, trades, or businesses. In the

case of any transfer (or license) of intangible

Property (within the meaning of section

936(h)(3)(B)), the income with respect to such

transfer or license shall be commensurate with

the income attributable to the intangible.

STATEMENT OF THE CASE

These cases concern the propriety of the

Commissioner’s reallocation of the costs of a management

company among several related corporations for the tax years

1990, 1991 and 1992 pursuant to 26 U.S.C. Section 482.

Consolidated tria! on the merits in the United States Tax

Court, the Honorable Judge Halpren presiding, resulted in

Decisions in favor of the Commissioner on September 28,

1998. The taxpayers appealed to the United States Court of

Appeals for the Sixth Circuit which affirmed the Tax Court.

STATEMENT OF THE FACTS

The taxpayers are part of a group of 13 corporations

owning and operating Taco Bell restaurants throughout Ohio

and/or holding the underlying real estate for some of the

operating restaurants. Another related corporation providing

the management and administrative services, BKK

Management, Inc. (“BKK”), did not own or operate any

restaurant or realty corporations. For the tax years involved,

all group members were owned in equal shares by three men,

either individually or with their wives (collectively the

“Owners”). Two of the Owners provided operational

management of restaurants and worked full-time for BKK.

The third Owner, an attorney who worked half-time for BKK,

was responsible for the group’s administrative and legal

needs.

The costs of operating BKK, "payroll-related"

(BKK’s gross payroll, payroll taxes and health insurance) and

"incidental" (BKK’s office rent, office supplies, etc.), were

allocated among the related corporations. Incidental costs

were allocated using a simple weighting system designed to

approximate consumption by the related corporations.

Payroll-related costs were allocated on the basis of the

number of hours that the Owners spent at or on behalf of each

of the related corporations based on 6,000 annual hours

dedicated each year by the Owners. 5,000 hours were

allocated to specific corporations (the “direct” hours) and

1,000 hours were applicable to all corporations (the “indirect”

hours). The indirect hours were allocated in the same ratio as

the direct hours.

The total Owner hours for each corporation for each

tax year were initially estimated at the beginning of each tax

year (using the number of hours spent the previous year as

the starting point), with the projected hours

contemporaneously recorded on computer spreadsheets

prepared and developed for that purpose by Ms. Nancy

Borsani, BKK’s accountant. These estimates were

subsequently and continuously examined and revised. At

mid-year, an evaluation was conducted to determine whether

the actual hours were close to the projected hours and

adjustments were made as necessary depending upon the

experience to date for the first half of the year, and any

changes in the projections for the remaining half of the year.

Through regular reporting to and _ interaction among

themselves and with Ms. Borsani, the Owners were able to

monitor actual and anticipated events and develop reasonable

estimates of the allocation of their time among the

corporations. In result, their almost daily contact made

maintaining written time logs of actual hours spent on

various activities superfluous - they worked together in the

same office and conferred regularly as to their activities. (TR

81-82, L 14-18, APP 36a-37a). The allocated costs were

actually paid by check by the related corporations as they

were incurred -- on a pay-as-you-go basis -- every week.

There was never an adjustment made based on the inability of

any corporation to pay its cost share.

The original BKK computer spreadsheets were

amended by the taxpayers to add captions and explanations

after the case was transferred from Examination to Appeals.

Because the original BKK computer spreadsheets were not

“saved” before the additional explanatory information was

incorporated, they were destroyed. However, all numerical

data and the actual allocation percentages in the original

BKK computer spreadsheets were preserved and not altered

in the restructured spreadsheets.

The allocation of Owner service hours was based on:

actual hours; historical experience; evaluations/adjustments

on a regular, on-going basis; and evaluations and adjustments

at mid- year based on actual experience.

The only substantive, factual evidence introduced at

trial was that of the Owners and the corporate accountant

(Nancy Borsani). The Commissioner never contested: (1) the

number of annual hours invested by the Owner for any year,

or (2) the total costs of BKK that were allocated among the

corporations.

At trial, the Commissioner proffered the opinion of

her expert, Alpha Consulting Alliance (“ACA”) as

representing the position of the Government. In doing so, the

revenue agent, Diane Camper, testified briefly, but was

dismissed when the Tax Court brought her cross-

examination to a close in holding:

The [Commissioner] has not put forward the

revenue agent's allocations as representing the

market value. They've got an expert who they

say is going to do that who came up with

different allocations than the revenue agent.

(TR 230, L 20-24, APP 38a).

As a result, it is submitted that the Commissioner

abandoned its Revenue Agent’s reallocation methodology,

and, instead, relied upon her expert, ACA. This was

fortunate for the taxpayers as their effort to qualify an expert

of their own on the issue was unsuccessful; abandonment

altered the burden of proof: and because ACA’s opinion

supported the taxpayers in theory and result and satisfied an

otherwise onerous burden.

ACA agreed that the taxpayers’ method of allocating

overhead costs on the basis of the number of hours of service

provided to each of the corporations is a reasonable method

of allocating such costs. ACA adjusted neither the total

dollars allocated nor the total hours of the Owners. Instead,

among other flaws, ACA merely "backed in" more hours into

its computations by including the projected hours of selected

second- and third-tier, modestly compensated employees -- a

district manager, a maintenance man, and BKK’s in-house

accountant (who was not even employed at BKK throughout

the pertinent periods).

ACA found that a "comparison between locations on

the basis of estimated valuation conclusions appear to most

closely support the allocations presented by management"

and "did not challenge the overall methodology based on

time." (TR 294, L 13-23, APP 40a (emphasis added)). ACA

concluded that allocating overhead costs on the basis of

service hours allocable to each of the corporations is a

reasonable method. (TR 297, L 1 1-17, APP 42a-43a).

ACA changed neither the total dollars allocated, (TR

295, L 17-23, APP 41a), nor the per hour allocation (although

ACA effectively cut this in half by doubling the hours in its

allocation formula), (TR 295-296, L 24-2, APP 4la), and

concluded that the overall hours of the Owners were

reasonable, ( TR 296, L 11-13; APP 42a).

In its analysis, ACA relied upon the Robert Morris

Associates Industry Guidelines (the “RMA”) in evaluating an

arm’s length standard. ACA, however, perverted the RMA

data, which is based on officer compensation costs -- strictly

upper management level, (TR 303, L 17-19, APP 44a), by

including non-officer compensation costs.

In essence, ACA used “certain financial analysis and

fluctuating industry norms to criticize the results [the

taxpayers’] got without being able to say with any degree of

confidence that they simply didn’t do things the way they

said.” (TR 323, L 9-22, APP 44a-45a ; TR 325, L 4-6, APP

45a). It is apparent that ACA started with its desired results

and derived the number of hours that it deemed appropriate

for that result. It did not start with the number of hours and

answer the question as to whether those hours were spent as

the taxpayers testified they were. (TR 335, L 8-19, APP 49a-

50a).

At trial, the Commissioner was compelled to concede

that the adjustments in the Notices of Deficiency do not

reflect the conclusions of ACA. (TR 327, L 14-19, APP

47a).

In its Memorandum Opinion, the Tax Court held that

in order for the Court to redetermine a Section 482

deficiency, the taxpayers bear the heavier than normal burden

of proving that the Commissioner’s allocation is arbitrary,

capricious or unreasonable. (Opinion at 9, APP 26).

Recognizing an “ambiguity” in the case law

interpreting Section 482 - whether the taxpayer must prove

that (1) the amount of the Commissioner’s allocation is

arbitrary, capricious or unreasonable, or (2) whether the

method or theory of the reallocation was arbitrary, capricious

—

or unreasonable (Opinion at 13, fn. 2, APP 35) -- the Court

held it moot ruling that the taxpayers did not direct any

argument to proving the Commissioner’s method (revenue

agent Camper’s gross sales method) produces an arbitrary,

capricious or unreasonable result, to wit “that gross sales is

not indicative of management and administrative services

provided.” /d.

The taxpayers appealed to the United States Court of

Appeals for the Sixth Circuit which affirmed the Tax Court

holding that: 1) the IRS had not abandoned its notices of

deficiency (“NODs”); 2) the taxpayers failed to carry their

burdens of proof, and; 3) the imposition of accuracy-related

penalties was appropriate.

REASONS FOR GRANTING THE WRIT.

I. THE APPLICABLE BURDENS OF PROOF

Section 482 is a broad statute that enables the

Commissioner to reallocate income and deductions among

related entities when she deems such reallocation necessary

to clearly reflect income. The statute can be and is applied in

a wide variety of settings. Section 482 reallocations can

involve the transfer of tangible or intangible property. They

can also involve the charges for rendering services or lending

money. Section 482 can be applied in transactions involving

domestic and/or foreign entities. Because of the potential to

-_shift income earned in the United States to lower-tax regimes,

most significant transactions involving a related foreign

entity are scrutinized for possible Section 482 reallocations.

As commerce becomes increasingly global, Section 482

becomes increasingly significant.

The dollars involved in Section 482 reallocations can

be enormous and tax deficiencies in the tens of millions of

dollars are common.' Section 482 is not a taxpayer-friendly

provision and taxpayers bear a very heavy burden of proof in

Section 482 controversies. Unfortunately, this heavy burden

is qualitative and often poorly articulated. While the tax

dollars herein are modest relative to many other Section 482

cases, the principles involved are extremely important and

will have significant impact in future cases.

A reallocation by the Commissioner under Section

482 is presumptively correct’ and, in order to rebut that

presumption, a taxpayer must demonstrate that the IRS’s

reallocation is “arbitrary, capricious, or unreasonable.”’ The

manner in which both the Tax Court and the Sixth Circuit

interpreted this initial burden of proof herein illustrates just

how onerous and how unclear that burden is.

The correct burdens of proof are enunciated in the

Seventh Circuit, in Eli Lilly & Co., which, upon reviewing

the relevant case law, held that a taxpayer’s burden of proof

under Section 482 has two elements:

The Commissioner exercises broad authority

under section 482. The courts will overrule a

'See, e.g., Eli Lilly & Company, et al. v. Commissioner, 856 F.2d 855 (7*

Cir. 1988); DHL Corp., et al. v. Commissioner, T.C. Memo 1998-461

(1998); National Semiconductor Corp., et al. v. Commissioner, T.C.

Memo 1994-195 (1994).

? Welch v. Helvering, 290 U.S. 111, 115 (1933).

Eli Lilly & Co., 856 F.2d 855, 860 (7" Cir. 1988); Foster v.

Commissioner, 756 F.2d 1430, 1432 (9" Cir. 1985, cert. denied, 474

U.S. 1055 (1986); Powers v. Commissioner, 724 F.2d 64, 66 (7 Cir.

1983); Spicer Theatre, Inc. v. Commissioner, 346 F.2d 704, 706 (6"

1965).

section 482 reallocation by the Commissioner

only if it is found to be arbitrary, capricious or

unreasonable. [Citations omitted.] When a

taxpayer rebuts the presumption of

reasonableness afforded the Commissioner’ s

determinations, [citations omitted], the Tax

Court (or district court) must determine

whether the taxpayers own allocations

conform to the arm’s length requirement.

856 F.2d at 860.

In essence, the taxpayer has two separate burdens of

proof. First, the taxpayer must demonstrate that the

Commissioner’s reallocation is arbitrary, capricious, or

unreasonable. Should the taxpayer prevail, the second

burden of proof arises. Then the taxpayer has the opportunity

to demonstrate that its own allocations conform to an arm’s

length transfer price. Significantly, if the taxpayer carries the

first burden, but not the second, Eli Lilly & Co. correctly

holds that the trial court is to make the proper reallocation.

The Seventh Circuit’s dual-burden Eli Lilly & Co.

standard has been, for the most part, uniformly applied.*

Here, the Sixth Circuit ostensibly adopted it, but reduced the

Eli Lilly & Co. standard to a single, very different, burden.

Here, the taxpayers met their initial burden upon two

showings at trial: (1) the Commissioner abandoned her

NODs; and (2) the Commissioner’s expert, ACA, ultimately

‘Pikeville Coal Co. et al. v. United States, 37 Fed. Cl. 304 (1997);

National Semiconductor Corp. v. Commissioner, T.C. Memo 1994-195

(1994); Seagate Technology v. Commissioner, 102 T.C. 149 (1994);

Sundstrand Corporation, et al. v. Commissioner, 96 T.C. 226, 353

(1991).

proved that the NODs were arbitrary, capricious or

unreasonable.

II. THE SIXTH CIRCUIT HAS MISAPPLIED THE BURDEN(S)

Or PROOF AND PRODUCED AN _ INEQUITABLE

OUTCOME

If the Commissioner is deemed not to have abandoned

the NODs, the taxpayers have to demonstrate that the Section

482 reallocations in the NODs were arbitrary, capricious or

unreasonable. This task was exacerbated for at least three

reasons. ;

First, the Section 482 reallocations in the NODs

differed from revenue agent Camper’s proposed reallocations

without explanation of the manner in which the reallocations

in the NODs were made.

Second, the Commissioner introduced no evidence as

to how the Section 482 reallocations in the NODs were made.

The only document the Commissioner attempted to introduce

at trial was deemed inadmissible for authenticity reasons.

Revenue agent Camper’s direct testimony was cursory at

best, did not involve any records or documents, and failed to

“put in one wick of evidence.” (TR 231, L 3-4, APP 39a).

Third, when taxpayers’ counsel attempted to: ascertain

how revenue agent Camper had established her arm’s length

price, he was admonished by the trial judge that such a line of

questioning was irrelevant since the Commissioner had an

expert that would support a different arm’s length price - it

was a finding of abandonment and a release of the burden of

proving the arbitrary, capricious or unreasonable method that

it was.

In short, the taxpayers found it difficult to challenge

the Section 482 reallocations in the NODs for the simple

reason that there was virtually nothing to challenge.

Taxpayers should not have to bear a burden of demonstrating

what the Commissioner did and how she did it before they

undertake the real burden of demonstrating that what the

Commissioner did was arbitrary, capricious, or unreasonable.

The taxpayers did not know how the Section 482

reallocations in the NODs were arrived at nor were they able

to deduce or elicit those facts at trial. Thus, the taxpayers did

what they had to do -- vigorously challenge the analyses and

testimony of ACA.

The Sixth Circuit’s decision may seem to have

adopted the Seventh Circuit’s Eli Lilly & Co.'s dual burden-

of-proof requirement. However, the Sixth Circuit actually

departed from Eli Lilly & Co. and created a new and incorrect

standard. There is now a major conflict between the Sixth

Circuit and at least the Seventh Circuit as to taxpayers’

burden(s) of proof in a Section 482 controversy.

The Sixth Circuit summarized the burden(s) of proof

facing the taxpayers as follows:

The second issue we address is whether [the

taxpayers] have shown that the reallocations

contained in the notice of deficiency are

arbitrary, capricious, or unreasonable.

Because deficiency notices have a

presumption of correctness, [the taxpayers]

have the burden of overcoming _ this

presumption by proving that their initial

allocations were arm’s length.

(APP 10).

The Sixth Circuit has seriously misstated the Eli Lilly

& Co. burden-of-proof which is clearly and correctly

articulated. Taxpayers must first demonstrate that the

Commissioner’s reallocations are arbitrary, capricious, or

unreasonable. The second burden, which arises only if

taxpayers meet the first burden, requires taxpayers to prove

that their own allocations satisfy the arm’s length standard.

However, a taxpayer’s failure to carry the second burden is

not fatal under Eli Lilly & Co. If a taxpayer cannot

demonstrate that its own allocations meet the arm’s length

standard then, according to Eli Lilly & Co., it is incumbent on

the trial court to ascertain an appropriate transfer price.

Interestingly, the Sixth Circuit recognized these principles,

but failed to apply them, effectively merging the two burdens.

In discussing the taxpayer’s first burden, the Sixth

Circuit cited DHL Corp., for the proposition that, “[t]o prove

arbitrary, capricious, or unreasonable, [taxpayers] must show

that their own allocations reflect an arm’s-length charge.”

(Emphasis added.) .

The Sixth Circuit’s interpretation of DHL Corp. is

incorrect in that DHL Corp. did not contain a mandate. What

DHL Corp. actually said was that:

[a taxpayer’s] burden is to show that each

section 482 adjustment is arbitrary, capricious,

and unreasonable. To do that, taxpayers

normally show that the questioned

transactions were conducted under an arm’s

length standard.

_ 1998 T.C. Memo at 98-2759 (Emphasis added.)

POS Ce Ne ne eas

Peat bee ee een aren ae he

nleer

There is a major distinction between what taxpayers

“must” do (the Sixth Circuit’s version of DHL Corp.) and

what taxpayers “normally” do (what DHL Corp. actually

said).

When a taxpayer demonstrates that its own allocations

meet the arm’s length standard, that should be adequate to

demonstrate that the Section 482 reallocations by the

Commissioner are unreasonable. If the taxpayer carries the

second burden, he should be deemed to have carried the first

burden. But, considering the two burdens separately, if the

taxpayer fails to carry the second burden, no conclusion can

be drawn as to whether the first burden has been carried. In

short, the Commissioner should not prevail entirely when

both it and the taxpayer are wrong!

If the Sixth Circuit’s interpretation of DHL Corp.

were correct, the first burden of Eli Lilly & Co. would be

moot. Under the Sixth Circuit’s interpretation, taxpayers

would satisfy both the first and the second burdens by

demonstrating that their own allocations reflect an arm’s

length charge (the second burden in Eli Lilly & Co.).

However, Eli Lilly & Co. clearly indicates that a taxpayer

could meet the first burden without meeting the second. In

other words, Eli Lilly & Co. allows for the very real

possibility that both the government’s reallocation and the

taxpayer’s initial allocation are substantially wrong.

Under Eli Lilly & Co., when a taxpayer carries the

first burden but fails to carry the second burden, the trial

court is to determine the appropriate transfer price. And, the

appropriate transfer price might be significantly closer to the

taxpayer’s transfer price than to the transfer price resulting

from the Section 482 reallocation by the Commissioner.

According to the Sixth Circuit, the taxpayer fails to carry the

: 15

critical first burden by virtue of failing to carry the second

burden. And, when a taxpayer fails to carry the first burden,

the presumption of correctness for the Commissioner’s

reallocation becomes absolute.

Under the Sixth CCircuit’s standard, the

Commissioner’s reallocation is upheld in its entirety when

the taxpayer fails to carry the second burden because that

failure is deemed to be a failure to carry the first burden.

When the IRS reallocation is “a lot” wrong while the

taxpayer’s initial allocations is only “a little’ wrong, the

Seventh Circuit’s Eli Lilly & Co. decision produces a sound

answer while the Sixth Circuit’s interpretation of DHL Corp.

produces a bad one.

Because the Sixth Circuit’s view of the taxpayers’

burdens of proof herein can produce an inequitable result and

conflicts with the established and well-reasoned opinion of

the Seventh Circuit in Eli Lilly & Co., this Honorable Court

should grant the Petition for Writ of Certiorari.

Ill. THE COMMISSIONER’S REALLOCATIONS IN THE NODs

Lost THEIR PRESUMPTION OF CORRECTNESS WHEN

SHE ABANDONED HER REVENUE AGENT AT TRIAL

A Section 482 controversy is complicated by the

uncertainty as to what constitutes the Government’s

“reallocation.” Here, the Commissioner produced ACA’s

transfer price study approximately 30 days before trial. This

study took a fundamentally different approach than that

undertaken by her revenue agent, Diane Camper and came to

a significantly different result. Both ACA and the taxpayers

employed a time-based methodology whereas that used by

revenue agent Camper was based on relative gross sales. .

eC DP WO ae DE Nat eee ELIE EO,

Because of the Tax Court’s termination of the cross-

examination of revenue agent Camper, neither it nor the Sixth

Circuit came to appreciate that the deficiencies set forth in the

NODs differed from the deficiencies originally proposed by

revenue agent Camper. This is because revenue agent

Camper’s original proposed Section 482 reallocations had

been adjusted by an Appeals Officer. It is the Appeals

Officer’s recalculated Section 482 reallocations that appear in

the NODs, not revenue agent Camper’s original Section 482

reallocations. In light of the basis for their findings, the

failure of the Tax Court and the Sixth Circuit to distinguish

between revenue agent Camper’s results and those in the

NODs were not significant.

ACA reached different results than those detailed in

the NODs, and both ACA’s results and those in the NODs

differed from those of revenue agent Camper. In any event,

the taxpayers were confronted with having to digest, on short

notice, a methodology that differed from the Revenue

Agent’s and a set of results that differed from both the

Revenue Agent’s results and those in the NODs. After

evaluating the methodology and results of ACA’s transfer

pricing study, the taxpayers then had to decide how to

challenge them.

When the Commissioner abandons her Revenue

Agent, and with it both the methodology supporting the

NODs and their results, the Commissioner loses any

presumption of correctness and bears an affirmative burden

of proof. Aull v. Commissioner, 87 F.2d 260 (4th Cir.

1937); Zarin v. Commissioner, 92 T.C. 1084 (1989), rev'd on

other grounds, 916 F.2d 110 (3rd Cir. 1990); DHL Corp., et

al. v. Commissioner, TC Memo 1998-46] (1988).

Furthermore, where: (1) the determinations in the

NODs are based on a different methodology than the

Commissioner’s trial expert; (2) the ultimate impact is a

greater adjustment in tax (where the reallocation results in a

smaller deduction); (3) the Commissioner fails to support

her NODs at trial; and (4) the Commissioner relies on the

trial expert’s analysis of the case, then the Commissioner

cannot contend that the adjustments in the NODs are

reasonable: “Respondent cannot contend that the notice

adjustments are “reasonable” on the one hand while adopting

an analysis that rejects such adjustments as unreasonable on

the other.” National Semiconductor Corp., et al., T.C.

Memo, 1994-195 (1994). All four of these factors are present

in the case at bar.

The instant case is on all fours with National

Semiconductor Corp., et al. Approximately 30 days prior to

trial, the Service produced the ACA transfer price study that

employed a different methodology (time spent v. gross sales).

ACA’s study resulted in different reallocations than those

proposed by revenue agent Camper. The Commissioner

introduced no evidence regarding the methodology used to

craft the NODs. And, the Commissioner relied solely and

entirely on her trial expert’s analysis of the case.

The Sixth Circuit addressed the issue of whether the

Commissioner had abandoned her brief and nondescript

NODs. They contained no analyses, computations, or

explanation of the basis for the Section 482 reallocations.

The sum and substance of each NOD was: 1) that the

respective taxpayer’s deductions for BKK’s management fee

was “paid under an agreement which [was] not at arm’s

length”; 2) that the BKK management fee was being

reallocated “among the controlled corporations under Section

482", and; 3) that such action was “necessary to clearly

reflect the true taxable income of each controlled corporation

and to prevent income manipulation.” The reallocations in

the NODs differed from revenue agent Camper’s proposed

Section 482 reallocations and there is no indication in the

NODs of how the reallocations were computed.

In holding that the Commissioner had not abandoned

her NODs, the Sixth Circuit cited the following commentary

of Judge Halpren:

Although the Moore [ACA] allocation differs

from the amounts allowed by respondent in

the notices of deficiency, respondent is explicit

in stating that he has not abandoned the notice

and, we believe, relies on the Moore allocation

only to prove a reasonable allocation on the

contingency that petitioners succeed in

showing the respondent’s allocation to be

arbitrary, capricious, or unreasonable.

(APP 10 (Emphasis added.)).

The basis for Judge Halpren’s observation is not

obvious in the trial transcript. At trial, it seems that Judge

Halpren was under the impression that the Commissioner had

abandoned revenue agent Camper, from which one could

reasonably conclude that the Commissioner had also

abandoned its NODs. Consider the following question

directed to revenue agent Camper and the comments of Judge

Halpren as he interrupted the cross-examination:

Q [MR. STEFFAN]: Did you [Ms. Camper]

do an evaluation of what would be arm’s

length charges for the services that these

people --

THE COURT: Mr. Steffan, I don’t see the

relevance of this line of questioning. The

[Commissioner] has not put forward the

revenue agent’s allocations as representing the

market value [of the BKK services]. They’ve

got an expert [ACA] who they say is going to

do that who came up with different allocations

than the revenue agent.

MR. STEFFAN: That’s true, Your Honor.

(TR 230, L 17-25, APP 38a).

By finding revenue agent Camper’s testimony to be

irrelevant, Judge Halpren adopted ACA’s method, one which

was inconsistent with the method employed in the NODs.

The Commissioner concurred: “MS. HELFGOTT: Right. So

our position is the position of our expert. To the extent that

her position requires a concession on our part, that’s our

position.” (TR 328, L 7-8, APP 47a ).

The IRS would seem to be in a tenuous position if it

had to admit: 1) that the only IRS employee it called as a

witness during its case in chief, revenue agent Camper,

computed Section 482 reallocations that differed from the

Section 482 reallocations in the NODs, and; 2) that these two

sets of Section 482 reallocations differed from those of the

Commissioner’s expert, ACA. The Commissioner may have

been reluctant to disclose that it had three different sets of

Section 482 reallocations. In any event, Judge Halpren

dismissed the significance of the reallocations that he

assumed (incorrectly) revenue agent Camper had proposed,

i.e., the Section 482 reallocations in the NODs.

te LEAR LCE. 1 at #

Nothing in Judge Halpren’s comments suggest that he

considered ACA’s position to be contingent in nature. These

comments, standing alone, afforded the taxpayers a

reasonable basis on which to conclude that the reallocations

they needed to address for the remainder of trial were those

of the expert ACA, not revenue agent Camper. Comments by

the Government’s trial attorney reinforce that conclusion:

THE COURT: Ms. Helfgott, do the

adjustments in the notice - well, let me put it

this way. The notice - the adjustments in the

notice of deficiency do not reflect the

conclusions of your expert, do they?

MS. HELFGOTT: Not entirely, Your Honor.

THE COURT: Well, not exactly.

MS. HELFGOTT: The position of

Respondent is the allocation made by

Respondent’s experts as to the restaurant

corporation [sic].

THE COURT: Okay. In other words, you

concede any excess of the adjustments - of the

adjustments that would be made under Ms.

Moore’s allocations.

MS. HELFGOTT: However _ that

computationally shakes out for each

deficiency at issue.

THE COURT: Well, [ACA] has amounts that

[it] thinks are the proper allocation and your

revenue agent did the same thing, but they’re

different.

MS. HELFGOTT: Right. So our position is

the position of our expert. To the extent that

her position requires a concession on our part,

that’s our position.

(TR 327-28, L 14-8, APP 47a).

Nothing in this exchange suggests that the

Commissioner’s position at trial was that of revenue agent

Camper, and nothing in this exchange suggests that the

position of ACA was merely a contingent position. It seems

clear from this exchange that Judge Halpren believed that the

Section 482 reallocations in the NODs were revenue agent

Camper’s. Had the taxpayers been given the opportunity to

establish the contrary, the Commissioner would have been

compelled to abandon the NODs at trial. This is because the

only witness called by the Commissioner during her case in

chief, revenue agent Camper, did not compute the Section

482 reallocations in the NODs and may have had no

knowledge of how those reallocations had been computed. In

any event, the Government’s trial attorney did nothing to

dispel Judge Halpren’s apparent belief that the Section 482

reallocations in the NODs were computed by revenue agent

Camper.

One more fact compels the conclusion that the

Commissioner abandoned the NODs at trial. The

Government’s trial attorney conducted an extremely modest

direct examination of revenue agent Camper and was unable

to introduce any documents or substantive discussion of her

reallocations. After interrupting Mr. Steffan’s cross

examination of revenue agent Camper, Judge Halpren

observed that the Commissioner had “not put in one wick of

evidence” as to what revenue agent Camper did. (TR 231, L

3-4, APP 39a). It may well be that the Government’s trial

attorney had no desire to establish what revenue agent

Camper did because it would reveal the differences in the

Section 482 reallocations proposed by revenue agent Camper

and those in the NODs. If so, the IRS had good reason to

abandon its NODs and cast its fate with its expert, ACA.

The Sixth Circuit agreed with the Tax Court that the

Commissioner had not abandoned its NODs and concluded

that “the record does not Support that either the

{[Commissioner] or ACA rejected revenue agent Camper’s

method in favor of [ACA’s] time-based method.”

Interestingly, the Sixth Circuit made this observation in terms

of revenue agent Camper’s “method” and ACA’s “method”,

not the “results” produced by their methods. In the case of

Section 482 reallocations, it is well established that the

reasonableness of the results obtained in a transfer pricing

Study outweighs the details of the methodologies employed to

obtain the results. Furthermore, the fact that the Sixth Circuit

refers to revenue agent Camper’s method suggests that it was

under the impression that revenue agent Camper’s Section

482 reallocations were those set forth in the NODs.

If the Sixth Circuit meant “result” when it said

“method” or if it meant to include the notion of a “result” in

the notion of a “method”, the taxpayers cannot appreciate

how the record fails to Support a rejection of revenue agent

Camper’s method (result) when: 1) the Government’s trial

attorney stated on the record that the Commissioner’s

position was that of its expert, ACA; 2) ACA’s methodology

and results clearly differed from those of revenue agent

Camper, and; 3) the trial judge observed that the

Commissioner did “not put in one wick of evidence” as to

what revenue agent Camper did.

In any event, if the Commissioner had abandoned the

NODs, and substantial evidence supports that view, the

NODs would lose their presumption of correctness. If that

presumption had been lost, the taxpayers would then have

been relieved of having to demonstrate that the

Commissioner’s reallocations were arbitrary, capricious or

unreasonable.

Even were the Sixth Circuit correct in finding no

abandonment, that does not end the inquiry. It is the

taxpayers’ position that the ACA testimony and report

establish that the NODs are arbitrary, capricious or

unreasonable. In short, when ACA’s analysis is corrected to

reflect actual events -- the dedicated 6000 annual hours of the

Owners only -- ACA’s report then arrives at substantially

similar results to that of the taxpayers and well within the

statistical ambit of the RMA Industry Guidelines which ACA

used to establish arm’s length prices.

CONCLUSION

For the foregoing reasons, a writ of certiorari should

issue to review the decision of the United States Court of

Appeals for the Sixth Circuit as to the applicable burdens of

proof, i.e., a finding that Eli Lilly & Co. re presents the

correct burdens of proof; a finding that the Commissioner

abandoned the NODs and therefore the taxpayers met their

first burden of proof and satisfied the second burden through

its own testimony and that of ACA; or in the alternative, if

the Commissioner is deemed not to have abandoned its

NODS, the taxpayers carried its burden of proof that the

NODs were arbitrary, capricious or unreasonable through

their own and ACA’s testimony; and further more that the

taxpayers met the second burden of proof through their own

and ACA’s testimony. In any event, if the Commissioner is

deemed not to have abandoned the NODS and if the

taxpayers are deemed not to have carried its burden, the case

should be remanded to the Tax Court for additional evidence

to determine the correct transfer price.

Marina Tramontozzi

Counsel of Record

815 15" Street, N.W.

Suite 601

Washington, D.C. 20005

(202) 393-1070

John D. Steffan

Steffan & Associates, P.C.

Suite 207

4020 University Drive

Fairfax, Virginia 22030

(Any footnotes trail end of each document)

Nos. 98-2416/98-2417/98-2418/98-

2420

UNITED STATES COURT OF APPEALS FOR THE

SIXTH CIRCUIT

Kenco Restaurants, Inc. (98-2416); K-K Restaurants, Inc.

(98-2417); Tiffin Avenue Realty Company, Inc. (98-2418);

Bryan Realty, Inc. (98-2420),

Petitioners-Appellants,

Commissioner of Internal Revenue, Respondent-Appellee.

December 10, 1999, Argued

February 16, 2000, Decided

February 16, 2000, Filed

COUNSEL:

ARGUED: John D. Steffan, STEFFAN & ASSOCIATES,

Fairfax, Virginia, for Appellants.

Charles F. Marshall, U.S. DEPARTMENT OF JUSTICE,

APPELLATE SECTION TAX DIVISION, Washington,

D.C., for Appellee.

ON BRIEF: John D. Steffan, STEFFAN & ASSOCIATES,

Fairfax, Virginia, for Appellants.

Charles F. Marshall, Teresa E. McLaughlin, U.S.

DEPARTMENT OF JUSTICE, APPELLATE SECTION

TAX DIVISION, Washington, D.C., for Appellee.

JUDGES:

Before: BOGGS and SUHRHEINRICH, Circuit Judges;

POLSTER, District Judge. *

OPINIONBY:

SUHRHEINRICH

OPINION:

SUHRHEINRICH, Circuit Judge. The Commissioner of

the Internal Revenue Service ("Commissioner") sent

Petitioners notices of deficiency that reallocated fees

Petitioners paid for management and administrative services.

The notices of deficiency also imposed accuracy-related

penalties. Petitioners filed separate petitions in the United

States Tax Court seeking a _ redetermination of the

deficiencies and accuracy-related penalties.

The tax court sustained the reallocations and penalties

because Petitioners failed to overcome the presumption of

correctness afforded to the notices of deficiency. Petitioners

appeal. We AFFIRM.

Petitioners-Appellants, _ Kenco Restaurants, _Inc.

("Kenco"); K-K Restaurants, Inc. ("K-K"); Tiffin Avenue

Realty Co., Inc. ("Tiffin"); and Bryan Realty, Inc. ("Bryan")

(collectively "Petitioners"), are members of a commonly

owned group of fourteen corporations (collectively "Group").

During the years 1990 through 1992, George Kentris ("G.

Kentris"), Michael Kentris ("M. Kentris"), and Kenneth

Baerwaldt ("Baerwaldt"), either individually or with their

wives (collectively "Owners"), owned equal shares of the

Group.

Of the fourteen Group members, thirteen either own and

Operate one or more Taco Bell restaurants ("Restaurant

Corporations") or own the real estate ("Realty Corporation")

on which another member of the Group operates a Taco Bell

restaurant. The following is a chart identifying the thirteen

Restaurant and Realty Corporations:

Restaurant Realty

Corporations Location Corporations

K-K Findlay, OH Tiffin

K-K Findlay, OH Tranton Ave. Realty

Kenco Lima, OH Harding Highway

Realty

Kenco Lima, OH Allentown Road

Realty

Bowling Bowling Green, OH Bowling Green

Green

GMK Defiance, OH unrealated

corporation

Perrysburg Perrysburg, OH Perrysburg

Wapak Wapakoneta, OH Apollo Drive Realty

Bryan Rest. Bryan, OH Bryan

The fourteenth Group member, BKK Management, Inc.

("BKK"), neither owns a Restaurant Corporation nor owns a

Realty Corporation. Instead, BKK provides management and

administrative services to the thirteen Group members and

bills each Group member for these services. These services

are not in dispute and, according to the tax court's Opinion,

include "accounting and administrative services, advertising,

coordination and _ installation of Taco Bell menus,

renovations, remodeling and repairs, building and equipment

maintenance, insurance coverage, training, inspections, and

contracting." Kenco Restaurants, Inc. y. Commissioner, 1998

Tax Ct. Memo LEXIS 343, 76 T.CM. (CCH) 512, 513, 1998

T.C. Memo 342 (1998). The services are performed by

Owners and BKK's support staff, and BKK pays their

salaries. Baerwaldt and M. Kentris provide the operational

management of the restaurants, and G. Kentris, an attorney,

works half as many hours as the former two and is

responsible for the Group's administrative and legal needs,

which include payroll, contracts, finances, and legal matters.

All costs that BKK incurs for providing these services are

allocated to Group members as a "management cost share"

fee. These fees have two categories: payroll related (salaries,

employment taxes, and health benefits) and incidental (office

supplies, telephone charges, and rent). Approximately 85

percent of BKK's payroll related costs are attributable to

Owners, and approximately 15 percent are attributable to the

support staff.

Petitioners contend that BKK's payroll related costs were

allocated according to the number of hours each Owner spent

with each Group member. For an upcoming year, the Owners

projected the hours they would spend with each Group

member based on the hours they spent the previous year.

Then, they adjusted their projections for upcoming projects

and reevaluated them at midyear. However, the Owners did

not maintain time logs or written documents recording their

actual hours. Petitioners further contend that BKK allocated

its incidental costs to Group members based on their

consumption.

The fees that Group members paid to BKK are reflected

in the following chart. To the right of each fee is the

percentage that the fee represents of BKK's total annual fees.

Reataurant Corporations

1990 1991 1992

Kenco FEE/% 313,700.00/43/ 413,000.00/4 389,000.0

++ 0% 2/3% 0/33.5%

K-K** FEE/% 279,650.00/39 283,500.00/29 380,600.

Tiffin*

Trento

Allento

Hardin

Highw

Apollo

FEE/%

FEE /%

FEE/%

FEE /%

9,100.00/1.0%

29,000.00/4.0

30,500.00/4.2

0.00/0.0%

21,700.00/2.2

60,415.00/6.2

82,000.00/8.4

29,600.00/3.0

Realty Corporation

1990

199]

28,000.00/3.9 31,000.00/3.2

12,000.00/1.7 14,500.00/1.5

2,000.00/0.35% 8,700.00/0.9%

18,000.00/2.5 24,000.00/2.5

00/32.9

87,200.0

0/7.5%

42,700.0

0/3.7%

112,000.

00/9.7%

52,366.0

0/4.5%

6,000.00

/0.5%

1992

26,000.0

0/2.2%

16,100.0

0/1.4%

11,100.0

0/1.0%

25,000.0

0/2.2%

3,000.00/0.4% 7,700.00/0.8% 7,200.00

/0.6%

Bryan* FEE/% -- -- 3,000.00

* /0.3%

** Petitioners on appeal.

After an audit, IRS Agent Camper ("Camper") calculated the

reallocations of BKK's management fees to reflect each

Group member's yearly gross sales.' These reallocations

decreased the share of BKK fees claimed by each Petitioner

and thus decreased each Petitioner's deductions.

Consequently, the lowered deductions increased each

Petitioner's taxable income and created a disparity between

the taxable income as represented by Petitioners and the

taxable income as represented by the Commissioner's

reallocations. The notices of deficiency that the

Commissioner mailed separately to each Petitioner on June

13, 1995, reflect this disparity. The deficiencies and their

accuracy-related penalties (20 percent) are illustrated in the

following chart:

Petitioners Year Deficiency Penalty Total

Kenco 1990 $36,664.00 $7,333.00 $

43,997.00

Kenco 199] 23,068.00 4,614.00 27,682.00

K-K 1990 35,056.00 7,011.00 42,067.00

K-K 1991 18,962.00 3,792.00 22,754.00

K-K 1992 21,304.00 4,261.00 25,566.00

Tiffin 1990 4,772.00 954.00 5,726.00

Tiffin 1992 4,124.00 825.00 4,949.00

Bryan 1992 174.00 35.00 209.00

TOTAL _ $184,435.00 $ 36,887.00 $

221,323.0

On August 18, 1995, Petitioners filed separate petitions in

the United States Tax Court for a redetermination of the

deficiencies and accuracy-related penalties. These petitions

were consolidated at trial.

At trial, the Commissioner retained Sharon Moore

("Moore"), a business valuation expert with Alpha

Consulting Alliance, to decide whether BKK's fee allocations

were consistent with an arm's-length transaction. Moore

determined that Petitioners’ allocations were not arm's length

and devised her own time-based allocations. To calculate

these time-based allocations, Moore used the hours that each

Owner and BKK employee spent in performing services for

each Group member, which Moore obtained through

interviews with Owners and BKK employees, rather than

adopting Petitioners' method of using only Owner hours.

Moore included the projected hours of a district manager, a

maintenance man, and BKK's in-house accountant

("Borsani"). In contrast to Petitioners’ allocations, Moore

weighed Owner and employee hours equally because Moore

found that both Owners and employees performed similar

operational tasks. Moore then converted the total hours

allocated to each Group member into a corresponding fee

allocation and concluded that her time-based allocations were

more consistent with an arm's-length charge than were

Petitioners’ allocations.

However, Moore's allocations pertained only to the six

Restaurant Corporations. Moore neither addressed any fees

attributable to the Realty Corporations nor allocated any fees

to Bryan Restaurant, Inc., which was created in 1992.

At trial, Petitioners disputed Moore's time-based

allocations because Moore never considered special

circumstances that varied the time that Owners dedicated to

particular Group members. Specifically, these special events

include a fire that demolished a Kenco restaurant in 1990, a

scrape and rebuild of a K-K restaurant in 1990, a unique

employment problem in 1990 (i.e., civil rights commission

case filed by former employee), a worker's compensation

claim in 1990, additions and remodeling of a K-K restaurant

in 199i, land acquisitions and zoning litigation, dramatic

decreases in sales caused by rumors of intentionally tainted

food in 1992, and the development and opening of the new

Bryan restaurant in 1992.

Petitioners also dispute Moore's time-based allocations

because Moore included hours of modestly compensated,

nonowner employees. Additionally, Petitioners dispute

Moore's treatment of Owner's hours as equal to maintenance

workers’ hours. Moreover, Petitioners dispute Moore's

inclusion of 2,000 hours for Borsani in 1992 because Borsani

worked at BKK for only one month in 1992.

The tax court ruled in favor of the Commissioner and

found that Petitioners failed to prove that the reallocations in

the notice of deficiency, based upon gross sales, were

arbitrary, capricious, or unreasonable. The tax court also

sustained the Commissioner's imposition of accuracy-related

penalties.

IT.

We review factual findings of the tax court for clear error

and legal questions de novo. See Hoover v. Commissioner,

102 F.3d 842, 844 (6th Cir. 1996) (citing Conti v.

Commissioner, 39 F.3d 658, 662 (6th Cir. 1994)). We review

mixed questions of law and fact under the "clearly erroneous"

‘Standard. See Eli Lilly & Co. y. Commissioner, 856 F.2d 855,

860-61 (7th Cir. ] 988) (citing Standard Office Bldg. Corp. v.

United States, 819 F.2d 13 71, 1374 (7th Cir. 1 987)). Whether

the Commissioner abused or exceeded his discretion in

determining deficiencies against a taxpayer is a question of

fact. See Spicer T, heatre, Inc. v. Commissioner, 346 F.2d 704,

706 (6th Cir. 1965); see also American Terrazzo Strip Co.,

Inc. v. Commissioner, 56 TC. 961, 97] (1971).

The first issue we address is whether the Commissioner

abandoned the notice of deficiency. Petitioners contend that

the Commissioner abandoned the allocations contained in the

notice of deficiency at trial and instead relied upon Moore's

reallocations. Also, Petitioners contend that the

Commissioner has to establish the reasonableness of his

adjustments because the burden of proof shifted when he

abandoned the original allocations.

The Commissioner, however, contends that he never

abandoned the notice of deficiency and that the Purpose of

Moore's testimony was merely to provide a reasonable

allocation in the event Petitioners were successful in proving

that the allocations contained in the notice of deficiency were

arbitrary, capricious, or unreasonable.

Under current law, the Commissioner may rely on

alternative theories Supported by a different methodology

than that used in the notice of deficiency. This reliance does

not necessarily place the burden on the Commissioner or

render the notice of deficiency arbitrary, Capricious, or

unreasonable. See Altama Delia Corp. v. Commissioner, 104

T.C. 424, 458 (1995) [**10] (citing Sundstrand Corp. v.

Commissioner, 96 T.C. 226, 354-355 (1991)).

However, if the Commissioner abandons the notice of

deficiency, then the notice of deficiency is no longer

presumed correct, and all that remains is for Petitioners to

show that the transaction was conducted at arm's length. See

DHL Corp. v. Commissioner, T.C. Memo | 998-461, 1998

10a

Tax Ct. Memo LEXIS 461, *60, 76 T.C.M. (CCH) 1122, 1144

(1998).

In the instant case, the tax court found that the

Commissioner had not abandoned the notices of deficiency:

"Although the Moore allocation differs

from the amounts allowed by respondent in

the notices of deficiency, respondent is

explicit in stating that he has not abandoned

the notice and, we believe, relies on the Moore

allocation only to prove a_ reasonable

allocation on the contingency that petitioners

succeed in showing the respondent's allocation

to be arbitrary, capricious, or unreasonable.”

Kenco Restaurants, Inc. v. Commissioner, 1998 Tax Ct.

Memo LEXIS 343, 76 T.C.M. (CCH) 512, 517, 1998 T.C.

Memo 342 (1998).

Upon our review of the record, we agree with the tax

court and find that the Commissioner did not abandon the

notices of deficiency. The record does not support that either

the Commissioner or Moore rejected Camper's method in

favor of the time-based method. Also, as shown below in the

second issue, the Commissioner had no reason to establish an

arm's-length charge other than as a contingency argument in

case Petitioners overcame the initial presumption.

The second issue we address is whether Petitioners have

shown that the reallocations contained in the notice of

deficiency are arbitrary, capricious, or unreasonable. Because

deficiency notices have a presumption of correctness,

Petitioners have the burden of overcoming this presumption

by proving that their initial allocations were arm's length.

Petitioners contend that the Commissioner's reallocation

method is arbitrary, capricious, or unreasonable for the

following three reasons. First, the Commissioner's

lla

methodology ignores the special situations that justified

Petitioners’ initial allocations. Second, Petitioners contend

that their fee allocation is reasonable and arm's length

because it represents the actual time spent on managing and

operating each Group member. Petitioners further argue that

these records were in fact created and monitored even

though they were inadvertently destroyed. Third, Moore, the

Commissioner's expert, conceded that Petitioners' method of

allocating time was reasonable because Moore's method is

identical and differs only as to hours.

The Commissioner contends that Petitioners have failed

to show that the reallocations contained in the notice of

deficiency are arbitrary, Capricious, or unreasonable. In the

alternative, the Commissioner contends that assuming we

find the notices of deficiency arbitrary, capricious, or

unreasonable, then Moore's time-based allocations represent

an arm's-length charge. For this alternative contention,

Commissioner asserts that Moore's allocations more properly

reflect value added to each Group member.

Section 482 of the Internal Revenue Code and its

regulations govern the instant case:

In any case of two or more organizations,

trades, or businesses . . . owned or controlled

directly or indirectly by the same interests, the

Secretary may distribute, apportion, or

allocate gross income, deductions, credits, or

allowances between or among = such

Organizations, trades, or businesses, if he

determines that such distribution,

apportionment, or allocation is necessary in

order to prevent evasion of taxes or Clearly to

reflect the income of any of such

organizations, trades, or businesses... .

l2a

LR.C. § 482°.

The "purpose of section 482 is to place a controlled

taxpayer On a tax parity with an uncontrolled taxpayer... ."

Commissioner v. First Security Bank of Utah, 405 U.S. 394,

400, 31 L. Ed. 2d 318, 92 S. Ct. 1085 (1972). If an

arrangement between related parties differs from those

reached in an uncontrolled, arm's-length dealing, the

Commissioner may reallocate under section 482. See Lufkin

Foundry and Machine Co. v. Commissioner, 468 F.2d 805,

807 n.2 (Sth Cir. 1972) (citing Spicer Theatre, 346 F.2d at

706). This authority includes reallocating charges among

controlled corporations for "marketing, managerial,

administrative, technical, or other services" that do not

represent an arm's-length charge. See Treas. Reg. § 1.482-

2(b)(1).

Whether the notices of deficiency are arbitrary,

Capricious, or unreasonable depends, in part, on whether the

charges were arm's length. If the charges were equivalent to

charges made at arm's length, then Petitioners have satisfied

their burden of proving that the notices of deficiency are

arbitrary, capricious, or unreasonable. The regulations of

section 482 govern the definition of an arm's-length charge.

If BKK's services are not an "integral part of the business

activity," then an arm's-length charge is generally equal to the

costs or deductions incurred in rendering such services. See

Treas. Reg. § 1.482-2(b)(3). However, if BKK's services are

an "integral part of the business activity," then the costs or

deductions incurred are not an arm's-length charge. See

Treas. Reg. § 1.482-2(b)(7). Rather, an arm's-length charge

is "the amount which was charged or would have been

charged for the same or similar services in independent

transactions with or between unrelated parties under similar

circumstances considering all relevant facts." Treas. Reg. §

1.482-2(b)(3).

l3a

Of the four situations that the regulations consider an

"integral part of the business activity,"* the most applicable to

the instant facts is Treasury Regulation 1.482-2(b)(7)(ii). In

this section, "services are an integral part of the business

activity of a member of a controlled group where the renderer

renders services to one or more related parties as one of its

principal activities." Treas. Reg. § 1.482-2(b)(7)(ii). Services

are considered "principal activities" if the following two tests

are satisfied. First, the renderers cost of services*

“attributable to the rendition of services for the taxable year

to related parties" must exceed "25 percent of the total costs

or deductions of the renderer for the taxable year [25 percent

test]." Treas. Reg. § 1.482-2(b)(7)(ii)(a). Second, the facts

and circumstances determine whether the rendition of

services to related parties is one of the principal activities of

the renderer ("facts and circumstances test"). See Treas. Reg.

§ 1.482-2(b)(7)(ii)(a). The regulations consider six factors:

the time devoted to the rendition of the

services, the relative cost of the services, the

regularity with which the services are

rendered, the amount of capital investment,

the risk of loss involved, and whether the

services are in the nature of supporting

services or independent of the other activities

of the renderer.

Treas. Reg. § 1.482-2(b)(7)(ii)(a).

We conclude that BKK's performance of services for

other Group members is an "integral part" of its business

activity and that an arm's-length charge is equal to "the

amount which was charged or would have been charged" for

same or similar services "in independent transactions with or

between unrelated parties under similar circumstances."

l4a

Treas. Reg. § 1.482-2(b)(3). We reach this conclusion

because BKK is a member of a controlled group and renders

services as its principal activity.

The Group members are members of a "controlled

group,” as used in Treasury Regulation § 1.482-2(b)(7)(ii),

because each Group member is a "controlled taxpayer."

"Controlled taxpayer" is defined as "any one of two or more

organizations, trades, or businesses owned or controlled

directly or indirectly by the same interests." Treas. Reg. §

1.482-1(a)(4). In the instant case, Petitioners are controlled

taxpayers because it is undisputed that they are commonly

owned corporations and are owned equally by Owners. Also,

BKK renders services to Group members as its principal

activity because the parties have stipulated that the primary

purpose of BKK is to provide services to Group members.

Thus, both the "25 percent test" and the "facts and

circumstances test" of Treasury Regulation § 1.482-

2(b)(7)(ii) are satisfied.

Now that we have defined an arm's-length charge, we

must next determine whether Petitioners have overcome two

burdens of proof. Under the first burden, Petitioners must

prove that the Commissioner's reallocations are wrong,

because the notices of deficiency have a presumption of

correctness. See Welch v. Helvering, 290 U.S. 111, 115, 78 L.

Ed. 212, 54 S. Ct. 8 (1933). This presumption is overcome if

Petitioners prove that the reallocations contained in the

notices of deficiency are arbitrary, capricious, or

unreasonable. See Spicer Theatre Inc., 346 F.2d at 706; see

also Eli Lilly & Co. 856 F.2d at 860. To prove arbitrary,

Capricious, or unreasonable, Petitioners must show that their

own allocations reflect an arm's-length charge. See DHL

Corp. & Subs. v. Commissioner, 1998 Tax Ct. Memo LEXIS

461, *60, 76 T.CM. (CCH) 1122, 1145 (1998); see also

Treas. Reg. § 1.482-1(b). This is accomplished by providing

evidence of similar transactions between uncontrolled

15a

taxpayers. See Lufkin Foundry & Machine Co., 468 F.2d at

808; see also Treas. Reg. § 1.482-2(b)(3).

For this first burden, the Commissioner is not required to

Support the notice of deficiency with proof because courts

generally do not examine the underlying motives or policy of

the Commissioner's determination. See Pasternak vy.

Commissioner, 990 F.2d 893, 898 (6th Cir. 1993). Also,

when determining whether the Commissioner's reallocation is

reasonable, courts focus on the reasonableness of the result

and not the details of the methodology employed. See

Seagate Tech., Inc. & Consol. Subs. v. Commissioner, 102

T.C. 149, 164 (1994); see also Bausch & Lomb, Inc. vy.

Commissioner, 92 T.C. 525, 582 (1 989).

Under the second burden, which only arises after

Petitioners have satisfied the first burden, Petitioners "still

have the burden of proving that their own allocation satisfies

the arm's length standard." Jnverworld, Inc. v. Commissioner,

1996 Tax Ct. Memo LEXIS 291, 71 T.CM. (CCH) 3231,

3237-62, 1996 T.C. Memo 301 (1996); see also Achiro v.

Commissioner, 77 T.C. 881, 900 (1981). If Petitioners fail to

carry this burden, the tax court must determine a proper

allocation based on the record. See Inverworld, Inc. 71

T.C.M. (CCH) at 3237-62 (citing Eli Lilly 7 Co, 856 F.2d at

860).

We conclude that Petitioners’ allocations are not an arm's-

length charge because Petitioners provide no evidence of an

independent transaction between unrelated parties in similar

circumstances. Also, the facts support our conclusion that

Petitioners were not dealing at arm's length but were, instead,

allocating their costs based on an ability to pay. Petitioners

charged Wapak, a Restaurant Corporation, no management

fee in 1990, but when its income increased in 1991 and 1992,

so did its fees.” GMK's fees increased more than 900%

between 1990 and 1992, and its share of the total fees

increased by a factor of seven. However, no evidence was

l6a

presented that there was a corresponding increase in Owner

hours. In 1990, Kenco required special attention to rebuild

the restaurant. Yet, in 1991, the fee allocated to it was higher

than 1990. There is no claim that K-K required special

attention in 1992, but its fee was higher in 1992 than in 1991.

Perrysburg was charged $ 29,000 in 1990, $ 60,415 in 1991,

and $ 42,700 in 1992, but Petitioners provided no

explanation, in terms of services, that would account for

these differences.

The third issue we address is whether Petitioners are

liable, under § 6662(a) of the Internal Revenue Code, for

accuracy-related penalties due to their negligence. Petitioners

contend that the facts do not support the imposition of

negligence penalties because Petitioners never made

adjustments based upon the ability or inability of a Group

member to pay. However, the Commissioner contends that

Petitioners allocated fees based on each Group member's

ability to pay.

We review an imposition of § 6662(a) "negligence"

penalties for clear error. See Leuhsler v. Commissioner, 963

F.2d 907, 910 (6th Cir. 1992); see also Sacks v.

Commissioner, 82 F.3d 918, 920 (9th Cir. 1996).

"Commissioner's assessment of a negligence penalty is

presumptively correct, and the taxpayer has the burden of

proving that an underpayment was not due to his negligence .

..." Leuhsler, 963 F.2d at 910.

If there is an underpayment of tax on a return, a penalty

in the amount of twenty percent of the underpayment is

imposed. See I.R.C. § 6662(a). This applies to the portion of

the underpayment that is attributable to negligence. See

L.R.C. § 6662(b)(1). "Negligence" is defined to include "any

failure to make a reasonable attempt to comply with the

provisions of this title... ." LR.C. § 6662(c). It has also

been defined as a "lack of due care or a failure to do what a

reasonable and prudent person would do under the

17a

circumstances." Hofstetter v. Commissioner, 98 T.C. 695, 704

(1992). We find and conclude that Petitioners allocated

BKK's management fees on the ability of each Group

member to pay.

* The Honorable Dan A. Polster, United States District

Judge for the Northern District of Ohio, sitting by

designation.

Camper testified that she used the gross sales method

because Petitioners provided no actual time logs or any other

information from which Camper could calculate the actual

hours Owners spent with each Group member.

"Unless otherwise indicated, all section references are to

the Internal Revenue Code and its Regulations that are in

effect for the taxable years in issue.

> Subdivisions (i) through (iv) describe those situations

that are considered an "integral part of the business activity."

See Treas. Reg. § § 1.482-2(b)(7)(i) through (iv).

* Cost of services includes "all costs or deductions

directly or indirectly related to the rendition of such

services." Treas. Reg. § 1.482-2(b)(7)(ii)(b).

> The Tax Court Suspected "that Wapak's insufficient

cash-flow was the determinant factor in BKK's management

decision not to allocate Wapak a management fee in 1990."

We agree.

18a

Tax Ct. Dkt. No. 15949-95. Docket No. 15950-95, 15951-95,

15952-95

UNITED STATES TAX COURT

KENCO RESTAURANTS, INC., ET AL.,

Petitioners

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

KENCO RESTAURANTS, INC., ET AL.,'

Petitioners

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

September 24, 1998, Filed

COUNSEL:

Diane D. Helfgott, for respondent.

John D. Steffan, for petitioners.

JUDGES:

HALPERN, JUDGE.

OPINIONBY:

HALPERN

OPINION:

TT BN A wwe OED id Ale A EO

19a

MEMORANDUM FINDINGS OF FACT AND

OPINION

HALPERN, JUDGE: These cases have been consolidated

for trial, briefing, and opinion. Respondent has determined

deficiencies in income tax and accuracy-related penalties as

follows:

Petitioner Year Deficiency Penalty

Kenco Restaurants, 1990 $ 36m664 = $ 7,333

Inc. (Kenco) 199] 40,311 8,062

1992 23,068 4,614

K-K Restaurants, 1990 35,056 7,011

Inc. (K-K) 1991 18,962 3,792

1992 21,304 4,261

Tiffin Avenue Realty, 1990 4,772 954

Co., Inc. (Tiffin) 1992 4,124 825

Bryan Realty, Inc. 1992 174 35

(Bryan)

After concessions, the remaining issues to be determined

are: (1) Whether respondent's reallocations of deductions

among petitioners and certain other commonly controlled

corporations under section 482 were necessary to clearly

reflect the income of such corporations, and (2) whether

petitioners are liable for the accuracy-related penalties

imposed pursuant to section 6662.

Unless otherwise indicated all section references are to

the Internal Revenue Code as in effect for the years in issue,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

FINDINGS OF FACT

INTRODUCTION

20a

Some of the facts have been stipulated and are so found.

The stipulation of facts, with accompanying exhibits, is

incorporated herein by this reference. At the time of the filing

of the petitions in these cases, the principal places of business

of all petitioners were in Ohio.

THE COMMONLY OWNED GROUP

Petitioners are members of a commonly owned group of

14 corporations (the group). Except for one member of the

group, BKK Management, Inc. (BKK), each member of the

group either owns and operates one or more Taco Bell

restaurants or owns the real estate on which another member

of the group operates a Taco Bell restaurant. BKK provides

management and administrative support services to the other

13 members of the group. During the years at issue, each

member of the group was owned in equal shares by George

L. Kentris (G. Kentris), Michael N. Kentris (M. Kentris), and

Kenneth J. Baerwaldt (Baerwaldt), either individually or

together with their spouses. Messrs. G. Kentris, M. Kentris,

and Baerwaldt were also the directors and managing officers

of each member of the group (collectively, the owner-

managers).

BKK MANAGEMENT, INC.

BKK was established as a "cost company", to provide

management and administrative support services to the other

members of the group (the purchasing members) at cost.

Among the services BKK provided to the purchasing

members were the following: accounting and administrative

services, advertising, coordination and installation of Taco

Bell menus, renovations, remodeling and repairs, building

and equipment maintenance, insurance coverage, training,

inspections, and contracting. BKK's costs, which were passed

on to the purchasing members, included payroll-related costs

(including salaries, employment taxes, and the cost of health

benefits) and incidental costs (including office supplies,

telephone charges, and rent). The payroll-related costs

2la

represented the vast majority of BKK's costs in providing the _

management and administrative services to the purchasing

members. Approximately 85 percent of BKK's payroll-

related costs was attributable to the Owner-managers. The

remaining approximately 15 percent was attributable to

support staff.

The owner-managers were employed by BKK to provide

services to the purchasing members. They received salaries

and certain other fees from BKK. They did not receive any

other compensation for their services as Officers or directors

of the members of the group. Messrs. M. Kentris and

Baerwaldt were full-time employees of BKK. Mr. G. Kentris,

an attorney, who maintained an active law practice, worked

part-time for BKK. All three owner- managers, however,

received substantially identical salaries.

The owner-managers did not maintain time logs or

written documents recording the hours that they spent

working on behalf of any individual member of the group.

During the years at issue, in consideration of the services

received from BKK, each of the purchasing members paid

BKK a fee (the BKK fees). The following table lists the

purchasing members and sets forth (1) the BKK fees paid

during each of the years in issue and (2) the corresponding

percentage that each such fee is of the total BKK fees for

each year.

Members 1990 199] 1992

Kenco * $ 43.0 $ 42.3% $ 33.5%

313,700 % 413,000 389,0

K-K * 279,650 39.0 283,500 29.0 380,6 32.9

Tiffin* 28,000 3.9 31,000 3.2 26,0 2.2

Bryan *

GMK,

Inc.

Perrysbu

Restaura

nts, Inc.

Bowling

Green

Restaura

nts, Inc.

Wapak

Restaura

nts,

Inc.

Trenton

Avenue

Realty,

Inc.

Allentow

n Road

Realty,

Inc.

Harding

Highway

Realty,

Inc.

Apollo

Drive

Realty,

Inc.

9,100 1.0

29,000 4.0

30,500 4.2

enn 29,600

12,000 1.7

2,000 0.3

18,000 2.5

3,000 04

22a

3,000

21,700 2.2

60,415 6.2

82,000 8.4

3.0 52,36

14,500 1.5

8,700 0.9

24,000 2.5

7,700 0.8

87,200

42,700

16,100

7,200

Ne ee En

0.3

9.7

4.5

1.4

1.0

2.2

0.6

23a

Bryan --- --- 6,000 0.5

Restaura

nts,

Inc.

Total $ 100% $976,115 100 $ 1,158,266 10

724,950 % 0%

* Petitioners in these consolidated cases

OPINION

I. INTRODUCTION

Petitioners are members of a commonly owned group of

14 corporations (the group), 13 of whom (the purchasing

members), during one or more of the years in issue,

purchased management services from the 14th, BKK

Management, Inc. (BKK). Each of the purchasing members

deducted its payments to BKK for management services (the

BKK fees). In order to clearly reflect the incomes of the

purchasing corporations, respondent has reallocated the BKK

fees among the purchasing corporations (generally,

respondent's reallocation). Respondent has decreased the

share of the BKK fees claimed by each petitioner. Petitioners

argue that respondent's reallocation is arbitrary, capricious,

and unreasonable. We must determine whether respondent

abused his discretion in making his reallocation. We must

further determine whether any underpayments of tax are due

to negligence or disregard of rules or regulations.

Il. REALLOCATION OF DEDUCT IONS

A. CODE AND REGULATIONS

In pertinent part, section 482 provides:

In any case of two or more organizations,

trades, or businesses * * * owned or controlled

24a

directly or indirectly by the same interests, the

Secretary may distribute, apportion, or

allocate gross income, deductions, credits, or

allowances between or among _— such

organizations, trades, or businesses, if he

determines that such distribution,

apportionment, or allocation is necessary in

order to prevent evasion of taxes or clearly to

reflect the income of any such organizations,

trades, or businesses. * * *

In pertinent part, section 1.482-1(b), Income Tax Regs.,

provides:

"The purpose of section 482 is to place a

controlled taxpayer on a tax parity with an

uncontrolled taxpayer, by determining,

according to the standard of an uncontrolled

taxpayer, the true taxable income from the

property and business of a _ controlled

taxpayer."

In pertinent part, section 1.482-1(aX6), Income Tax

Regs., provides:

The term "true taxable income" means, * * *

the taxable income (or, as the case may be, any

item or element affecting taxable income) which

would have resulted to the controlled taxpayer,

had it in the conduct of its affairs (or, as the case

may be, in the particular contract, transaction,

arrangement, or other act) dealt with the other

member or members of the group at arm's length.

In pertinent part, section 1.482-2(b)(1), Income Tax

Regs., provides:

Where one member of a group of

controlled entities performs marketing,

25a

managerial, administrative, technical, or

other services for the benefit of * * *

another member of the group * * * at a

charge which is not equal to an arm's length

charge as defined in paragraph (b)(3) of this

section, the district director may make

appropriate allocations to reflect an arm's

length charge for such services.

Paragraph (b\3) of section 1.482-2, Income Tax Regs.,

provides:

ARM'S LENGTH CHARGE. For the purpose of this

paragraph an arm's length charge for services rendered shall

be the amount which was charged or would have been

charged for the same or similar services in independent

transactions with or between unrelated parties under similar

circumstances considering all relevant facts. However, except

in the case of services which are an integral part of the

business activity of either the member rendering the services

or the member receiving the benefit of the services * * * the

arm's length charge shall be deemed equal to the costs or

deductions incurred with respect to such services * * * unless

the taxpayer establishes a more appropriate charge * * *

In pertinent part, section 1.482-2(b)(7)(ii)(A), Income

Tax Regs., provides: "Services are an integral part of the

business activity of a member of a controlled group where the

renderer renders services to one or more related parties as one

of its principal activities."

Section 1.482-1(a)(4), Income Tax Regs., provides: "The

term ‘controlled taxpayer’ means any one of two or more

organizations, trades, or businesses owned or controlled

directly or indirectly by the same interests."

B. BURDEN OF 7 ROOF

Respondent's authority to make allocations under section

482 is broad. Bausch & Lomb, Inc. v. Commissioner, 92 T.C.

26a

525, 581- 582 (1989), affd. 933 F.2d 1084 (2d Cir. 1991);

Edwards v. Commissioner, 67 T.C. 224, 230 (1976); PPG

Indus., Inc. v. Commissioner, 55 T.C. 928, 990-991 (1970).

Respondent's section 482 determination must be sustained

absent a showing that he has abused his discretion. Paccar,

Inc. v. Commissioner, 85 T.C. 754, 787 (1985), affd. 849

F.2d 393 (9th Cir. 1988). The determination of whether

respondent abused his discretion presents a question of fact,

and petitioners bear the burden of proof. Rule 142(a). Indeed,

in order for us to redetermine a deficiency attributable to

section 482, petitioners bear the heavier than normal burden

of proving that respondent's section 482 allocation is

arbitrary, capricious, or unreasonable. Bausch & Lomb, Inc.

v. Commissioner, supra; G.D. Searle & Co. v. Commissioner,

88 T.C. 252, 359 (1987); see also Altama Delta Corp. v.

Commissioner, 104 T.C. 424, 456-457 (1995); Seagate Tech.

Inc. & Consol. Subs. v. Commissioner, 102 T.C. 149, 163-

164 (1994).

Neither the absence of tax avoidance motives, nor the

existence of a business purpose, precludes respondent from

reallocating costs under section 482 in order to reflect clearly

the respective incomes of members of the controlled group.

Central Cuba Sugar Co. v. Commissioner, 198 F.2d 214, 215-

216 (2d Cir. 1952) (dealing with 26 U.S.C. sec. 45 (I.R.C.

1939), the precursor to section 482), revg. and remanding on

this issue, 16 T.C. 882 (1951); Eli Lilly & Co. v. United

States, 178 Ct.Cl. 666, 372 F.2d 990, 998- 999 (1967); G.D.

Searle & Co. v. Commissioner, supra at 359.

C. COMMON CONTROL

Petitioners are commonly owned corporations, owned in

equal shares by the owners either individually or with their

respective spouses, and are, thus, "controlled taxpayers"

within the meaning of section 482. See sec. 1.482-1(a)(4),

Income Tax Regs.

D. ARM'S-LENGTH CHARGES

27a

The parties have stipulated, and we have found, that the

primary purpose of BKK is to provide management and

administrative support services to the other 13 members of

the group. BKK provided such services to the purchasing

members, and all of its costs were charged to the purchasing

members as fees for those services. Thus, we find that BKK

rendered services to related parties as one of its principal

activities. As a consequence, rendering services was an

integral part of BKK's business activity within the meaning

of section 1.482-2(b)(7)(ii), Income Tax Regs. Because of

that, the cost or deductions incurred by BKK with respect to

the services rendered by BKK to the purchasing members

(and passed through to the purchasing members) is not

deemed equal to an arm's-length charge for those services.

See sec. 1.482-2(b)(3), Income Tax Regs. Instead, an arm's-

length charge is the amount that would have been charged for

the same or similar services in independent transactions with

or between unrelated parties under similar circumstances

considering all the relevant facts (the independent

transactions standard). Id.

Before concluding this discussion of arm's-length

charges, it is important to note that we are not here concerned

with the arm's-length charge for the totality of services

provided by BKK to the purchasing members for each year

(BKK's total yearly fees), which respondent does not

challenge, but rather with the ALLOCATION of BKK's total

yearly fees AMONG the purchasing members.

E. REASONABLENESS OF ALLOCATION

1. RESPONDENT'S REALLOCATION

Respondent's reallocation is reflected in the statutory

notice of deficiency received by each petitioner. Each such

notice contains one or more negative adjustments (depending

on the number of years in issue) for "management cost share

expenses". Those adjustments are explained in substantially

similar language, as follows:

28a

It is determined the management fee was paid under an

agreement which is not at arm's length. Therefore, this

expense is reallocated among the controlled corporations

under section 482 of the Internal Revenue Code. This action

is necessary to clearly reflect the true taxable income of each

controlled corporation and to prevent income manipulation. *

Respondent called as a witness Diane Camper, a revenue

agent for the Internal Revenue Service. Ms. Camper is

responsible for calculating the adjustments respecting

management cost share expenses set forth in the notices of

deficiency. Ms. Camper was questioned on _ cross-

examination about the methodology she used to make those

adjustments. She testified that she made those allocations

based on the gross sales of the purchasing corporations,

making some adjustments with respect to time spent with

respect to certain of the purchasing corporations that were

merely real estate holding companies.

At trial, respondent called as an expert witness Sharon

Moore. Ms. Moore is a certified public accountant and a

senior appraiser accredited by the American Society of

Appraisers. She is affiliated with Alpha Consulting Alliance

(Alpha) and, along with others affiliated with Alpha,

prepared a report that was offered as her expert testimony

(the report). The report was prepared in response to

respondent's request that Alpha opine as to whether BKK's

management cost fee allocation represented an arm's-length

price to each of the purchasing corporations. Ms. Moore was

of the opinion that "the management costs allocated by BKK

Corporation for managerial and administrative services are

not accurately allocated based on value-add sic to the

operating restaurant entities." Ms. Moore also reached a

conclusion as to a fair allocation of such costs. Ms. Moore

was accepted by the Court as an expert with respect to

business valuation, and her report was received into evidence

as her expert testimony.

29a

2. PETITIONERS' ALLEGATIONS

Petitioners recognize that they must show that respondent

abused his discretion: They must show that respondent's

allocations are arbitrary, capricious, or unreasonable.” See,

e.g., Bausch & Lomb, Inc. v. Commissioner, 92 T.C. at 582.

Ms. Camper testified that she allocated BKK's total yearly

fees among the purchasing members based primarily on gross

sales, with some adjustments with respect to the realty

holding corporations, which did not have any sales

(respondent's method). Although petitioners allege that their

allocation (which is based on the Owner-managers' service

hours) is reasonable, they have not directed any of their

argument to proving that respondent's method produces an

arbitrary, capricious, or unreasonable result, to wit, that gross

sales is not indicative of management and administrative

services provided. Petitioners do, however, make a collateral

argument assaulting respondent's method, alleging that Ms.

Camper did not take into account certain unusual events that

occurred during the years at issue, which required BKK to

provide unusual types and amounts of services to the affected

purchasing members.’ Ms. Camper testified that she

considered allocation methodologies based on both hours and

gross sales. Although she admitted that the "top" method

would have been based on hours or time spent, she was

limited by the information available to her. The owner-

manager's failure to maintain time logs or other

documentation recording the allocation of their time spent

among the purchasing members, along with their failure to

Separately account for the time spent by support staff (whose

activities gave rise to 15 percent of payroll-related costs),

made it impossible for her to determine the impact of the

unusual events on the services provided using an hour-based

allocation methodology. Petitioners have, therefore, failed to

prove that respondent's method, based as it was on gross

sales, did not satisfy the independent transactions standard

and, thus, reflect arm's-length charges for purposes of this

30a

case. See supra sec. II.D. Further, petitioners did not even

address the individual allocations resulting from respondent's

method beyond arguing that they would be different had Ms.

Camper's method weighed the unusual events more heavily.

Finally, since the practice of the group was to separate real

estate ownership from restaurant operation, the unusual

events in question that involved the destruction or

construction of improvements to real property (see supra,

note 3), affected the real estate holding companies. n4 Ms.

Camper testified that, in allocating management cost share

expenses to the real estate holding companies, she took into

account not only those members' gross sales (which were

very low) but also some measure of the time spent with

respect to those members. Undoubtedly, management time

was necessary to deal with the destruction and construction

caused by the unusual events and, to that extent, Ms. Camper

did take account of the unusual events. Petitioners have not

persuaded us that it was arbitrary, capricious, or unreasonable

for Ms. Camper to deal with the real estate holding

companies as she did, nor have petitioners proposed a

formula for quantifying the value of any additional

management and administrative services necessitated by such

unusual events. Therefore, petitioners have failed to prove

that the allocations resulting from respondent's method do not

satisfy the independent transactions standard or reflect arm's-

length charges.

Petitioners’ principal engagement at trial and on brief was

with Ms. Moore's allocation, apparently due to their belief

that respondent had abandoned his method in favor of Ms.

Moore's. Although the Moore allocation differs from the

amounts allowed by respondent in the notices of deficiency,

respondent is explicit in stating that he has not abandoned the

notice and, we believe, relies on the Moore allocation only to

prove a reasonable allocation on the contingency that

petitioners succeed in showing the respondent's allocation to

be arbitrary, capricious, or unreasonable. Having concluded

3la

that petitioners have failed to carry their initial burden, we

need not consider petitioners’ criticism of Ms. Moores's

allocation.

3. CONCLUSION

Petitioners have failed to carry their burden of proving

that respondent abused his discretion; i.e., that the allocations

resulting from respondent's method were arbitrary,

Capricious, or unreasonable. The management cost fee

allocation determined in petitioners’ notices of deficiency is

therefore sustained.

Il]. ACCURACY-RELATED PENALTIES

In the case of an underpayment of tax required to be

shown on a return, section 6662(a) and (b)(1) impose a

penalty in the amount of 20 percent of the portion of the

underpayment that is attributable to negligence or intentional

disregard of the rules or regulations (hereafter, simply,

negligence). Negligence has been defined as lack of due care

or failure to do what a reasonable and prudent person would

do under like circumstances. E.g., Hofstetter v.

Commissioner, 98 T.C. 695, 704 (1992). Negligence includes

any failure to make a reasonable attempt to comply with the

provisions of the internal revenue laws or to exercise

ordinary and reasonable care in the preparation of a tax

return; it also includes any failure by the taxpayer to keep

adequate books and records or to substantiate items properly.

Sec. 1.6662-3(b)(1), Income Tax Regs.

Respondent determined penalties under section 6662(a)

and (b)(1), and petitioners assigned error to those

determinations. On brief, however, petitioners fail to identify

those penalties as an issue in this case. We assume that

petitioners principally rely on our finding no deficiencies in

tax to avoid the penalties. In that tactic, petitioners are not

successful.

32a

Respondent's notices of deficiency do not particularize

petitioners’ negligence. On brief, respondent explains:

"Petitioners were negligent in claiming deductions for

management expenses that were solely based on petitioners'

ability to assume the cost of such expenses, and that

petitioners continued to do so even after they were informed

by respondent's agents that the method of determining such

costs was arbitrary." That explanation, at least the first

clause, is not a model of clarity. We deduce that respondent's

principal complaint is that petitioners were negligent in

allocating the BKK fees on a basis that did not reflect the

relative usage of BKK services by the purchasing members.

Ms. Moore was of the opinion that petitioners’ method of

allocating the management cost share fee did not satisfy a

value added standard. Ms. Moore opined that each restaurant

showed profitability consistent with industry averages before

the management cost share fee allocation, but not after,

concluding that petitioners’ allocation distorted the individual

store performances and did not clearly reflect the economic

income of those locations.

Petitioners claim: "The representations of hours spent by

the owner/managers is highly reliable and was neither

rebutted nor impeached at trial." We assume that petitioners’

claim is that the representation of hours spent by the owner-

managers is reliable in the sense that it accurately reflects the

hours spent with respect to each purchasing member.

Petitioners state: "The time allocation was based on historical

experience; was evaluated on a regular, on-going (almost

daily) basis by the owner/managers; was evaluated and

adjusted at midyear based on actual experience; and was

recorded in contemporaneous records kept in computer

spreadsheets." We, thus, assume that petitioners’ implicit

defense to the claim of negligence rests on the accuracy of

their time allocations. Petitioners bear the burden of proof.

Rule 142(a). Petitioners have not carried that burden.

33a

Petitioners make much of the unusual events, which

occurred during the years at issue, and which, petitioners

claim, required BKK to dedicate unusual amounts of time to

certain of the purchasing corporations. Those events,

however, do not account for petitioners’ allocations, and the

record does not support petitioners' contentions that the

Owner-managers spent most of their time working on behalf

of K-K and Kenco. Although no special projects required

additional managerial attention for Kenco's restaurants in

1991, unlike in 1990, the management cost fee allocated to

Kenco for 1991 was higher in absolute terms, and only

slightly lower in relative terms, than the fee BKK charged to

Kenco in 1990. Although petitioners do not claim that K-K

required unusual management attention in 1992 as compared

to 1991, its allocated fee was higher in both absolute and

relative terms in 1992 than in 1991. It is telling that, between

1990 and 1992, GMK's management cost fee allocation

increased more than 900 percent. That percentage increase

substantially exceeds the increases in the management cost

fee allocated to the other members of the commonly

controlled group. In relative terms, GMK's share of the total

BKK management cost fee allocation increased by a factor of

seven. During that period, facts stipulated by the parties show

that GMK's gross receipts increased substantially as well.

During that period, there were no unusual events or other

requirements of GMK that justified a substantial increase in

management services required in 1991 and 1992 as compared

to 1990.

Additionally, Perrysburg, which allegedly required

minimal management services, was charged $29,000 in 1990,

$60,415 in 1991, and $42,700 in 1992. Petitioners did not

provide any explanation, in terms of services required by

Perrysburg from year to year, that would account for those

differences.

Finally, it defies explanation how Wapak was not

allocated any of BKK's management costs in 1990.

34a

Petitioners allege that BKK's management costs were

allocated using an allocation methodology predicated on the

number of hours that the owners spent at or on behalf of each

of the commonly controlled corporations. Wapak was

incorporated and operating a Taco Bell restaurant in 1990.

We suspect that Wapak's insufficient cash-flow was the

determinant factor in BKK's management's decision not to

allocate Wapak a management cost fee in 1990.

Petitioners claim that contemporaneous records of time

allocations "were actually created, maintained and used in

making the Petitioners’ allocations." Those records,

petitioners claim, were inadvertently destroyed. The only

evidence of contemporaneous time records was Ms. Borsani's

and Mr. G. Kentris' testimony that Mr. G. Kentris' allocations

of the owner-manager’s hours for the upcoming year were

recorded and served as the basis for allocating the BKK fees.

Such forecasts, even if recorded, merely frame the problem,

the accuracy of petitioners’ estimates; the recording of

estimates does not make them any more or less accurate.

Petitioners have failed to persuade us that the owner-

managers, time allocations accurately reflected the hours

spent by them with respect to each purchasing member. A

close examination of petitioners’ "unusual events" argument,

along with a consideration of the allocations to Perrysburg

and Wapak, convinces us that petitioners’ allocations were, at

best, what petitioners' counsel characterized them as during

his examination of Mr. G. Kentris: a "guesstimation based on

conversations between sic the owner- managers". Petitioners

have failed to prove that they were not negligent in allocating

the BKK fees according to petitioners’ ability to "assume" the

cost of such expenses. Respondent's determination of a

section 6662 penalty is therefore sustained.

Decisions will be entered for respondent.

35a

' Cases of the following petitioners are consolidated

herewith: K-K Restaurants, Inc., docket No. 15950-95;

Bryan Realty, Inc., docket No. 15951-95; Tiffin

Avenue Realty Co., Inc., docket No. 15952-95.

* The case law interpreting sec. 482 illustrates that there

is some ambiguity as to whether the taxpayer has the burden

of proving that (1) the AMOUNT of the allocation proposed

by the Commissioner is arbitrary, capricious, or

unreasonable, or (2) the method or theory upon which the

allocation was based is arbitrary, Capricious, or unreasonable.

Compare Perkin-Elmer Corp. & Subs. v. Commissioner, T.C.

Memo. 1993-414 (theory was arbitrary, and Capricious), with

Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226,

354 (1991) (result was arbitrary and capricious), and Eli Lily

& Co. v. United States, 178 Ct. Cl. 666, 676, 372 F.2d 990,

997 (1967) (same). That ambiguity does not affect resolution

of this case.

* The unusual events include: (1) A fire at one of Kenco's

restaurants that burned the restaurant to the ground on Dec. 7,

1989, and the subsequent construction of a new, larger

restaurant, (2) the owners razed Tiffin Realty's only

restaurant and rebuilt a new facility in 1990, (3) the owners

remodeled Bowling Green's only restaurant and expanded the

dining room of K-K's restaurant located on Trenton Ave. in

1991, and (4) Bryan was incorporated on June 3, 1992, and

Bryan's restaurant opened in Oct. 1992.

* For instance, it was Harding Highway Realty, Inc. and

not Kenco, that incurred the loss from the fire, filed the

claim, received the proceeds from the insurance company,

sold the property and received the proceeds therefrom, and

incurred the costs of building the new facility.

36a

G. KENTRIS - DIRECT 81

1 matters, unemployment compensation matters; in this

2 instance, claim of discrimination.

3 Q. Anything that -- was it fair to say anything that

4 came up requiring legal work, you were it?

5 A Correct.

6 Q Did the companies employ -- ever employ outside

7 lawyers in 1990, 1991, and '92?

8 A_ I think you're the first outside lawyer we ever

9 employed.

10 Q_ So, none in 1990, '91, or '92.

11 A Other than -- other than for title work. I mean,

12 if we would buy a piece of property, we'd have a -- a

title

13. agent who would be an attorney conduct a title report.

14 Q_ When you are looking at a known prospective

time-

15 consuming event such as the fire at Harding, or at

Kenco,

16 how do you guesstimate or evaluate how much time, in

hours,

17 will be necessary to address the problem?

18 A Primarily in experience.

19 Q_ And these numbers were revised at somewhere

around

20 mid-year?

21 A Yes.

22 Q. Okay.

23 In that revision process, what physically took

24 place amongst and between the owners and employees

to make

25 those revisions?

G. KENTRIS - DIRECT 82

| A Well, my father, Michael Kentris, and Ken and I

2 meet on almost a daily basis or at least talk to each other

37a

3 several times a week. So, I -- I'm probably the most

well-

informed of the three of us as far as knowing what all of

5 are doing.

6 I'm also, from a logistics standpoint, the guy

7 who's in the office; they're in the field. During two of

8 these years, Nancy Borsani worked under the same roof,

and |

9 would see her on almost a daily basis, sometimes more

often.

10 So, when it came time to revisit the allocations,

11 Nancy would have a fairly good idea of this, also,

because

12 she worked in the same office. I'm there every day. My

13 father and Ken would be there often, several times a

week,

14 if not every day.

15 So, based on what had happened the previous six

16 months, Nancy and I were, you know, cognizant of what

was

17 going on and what was in the works, and we'd make

18 adjustments as needed.

19 Q_ The adjustments that occurred at mid-year --

were

20 they significant adjustments in any areas?

21 A I don't know that they were drastic. When you

say

22 significant, I -- there wasn't anything that happened of

23 great -- of such great magnitude that it distorted the

whole

24 half-year previous plan.

25 Q And in 1991, calendar year 1991, the -- were

there

38a

CAMPER - CROSS 230

hours or time spent. And since that wasn't available, I

to look at what else I had available to use.

There are other methods, but off the top of my

head, I would say I didn't really purposely think through

many, many methods.

Q Is part of your analysis predicated on relative

sales, gross sales? Did you do any investigation or

determination of the separate services that were being

provided by the owner/managers to the related entities?

10 A_Inconsidering all of the entities and the type of

11 operations that they had and the fact that there was a

major

12 fire in the first year and there were subsequent building

13 another location, plus the fire location, I did look at all

14 those, trying to determine how in the world we could

15 allocate, because those type situations would require

16 management skills, decision-making type processes.

17 Q_ Did you do an evaluation of what would be arm's

18 length charges for the services that these people --

19 THE COURT: Mr. Steffan, I don't see the

relevance

20 of this line of questioning. The Respondent has not put

21 forward the revenue agent's allocations as representing

the

22 market value. They've got an expert who they say is

going

23 todo that who came up with different allocations than

Oo OeOnND YU & WwW lO

24 revenue agent.

25 MR. STEFFAN: That's true, Your Honor.

39a

CAMPER - CROSS 231

THE COURT: And I don't want to tell you how to

try your case, but you're making a case they didn't make.

They have not put in one wick of evidence that what this

woman did --

MR. STEFFAN: I understand.

THE COURT: -- represents fair market value. |

mean, I couldn't find, from the basis of her direct

testimony, that it did.

MR. STEFFAN: I understand that, Your Honor.

THE COURT: Okay.

MR. STEFFAN: May I have one moment?

THE COURT: Yes.

BY MR. STEFFAN:

Q Do you know what the year end is fo: BKK as

opposed to the operating real estate corporations, their

accounting period?

A My understanding is they're all year end.

18 Q Both of them are identical?

19 A Calendar year end. As far as I know.

SOM MrADAWawnhn

IAARSHS

20 Q BKK--

21 A Without looking, you know, this has been a long

22 time ago.

23 Q Okay. I mean, if you don't remember, that's a

24 fair answer. Thank you. Did any of the allocations that

25 you made create a loss at any of the underlying

companies?

**e*

| allocated the time of Unruh, Silver and Borsani in

2 accordance with the same allocation, the allocation that

you

actually did on Kentris, Kentris and Baerwaldt, correct?

A Yes. I believe I've represented that we didn't

make that simplifying assumption.

Q_ And you've testified that you haven't done any

nW & Ww

40a

7 weighting for the lesser paid non-owner/managers.

8 A No.

9 MR. STEFFAN: I have nothing further. Thank

you,

10 Your Honor.

11 MS. HELFGOTT: I have nothing further, Your

Honor.

12 THE COURT: Ms. Moore, I have a few

questions.

13 Turn to page 11 of your report. Under the heading

Fiscal

14 Analysis, the paragraph that begins "comparison

between

15 locations on the basis of estimated valuation conclusions

16 appears to most closely support the allocations presented

17 management." What does that mean?

18 THE WITNESS: Let me read that one more time.

19 THE COURT: Pardon?

20 THE WITNESS: Let me read that one more time.

Oh,

21 okay. I think the point I was trying to make was that --

22 a big picture level -- was that we didn't challenge the

23 overall methodology based on time. We didn't feel like

24 was implemented in a way that gave reasonable results.

25 what I was trying to make is that implementing the --

using

MOORE - RECROSS 295

1 amethodology based on time and using the information

they

2 gave us, we felt like, in the way that we implement it,

gave

Noman kth ko ciniendae beeen eins ae

peat brea LNG

4la

a reasonable answer in terms of the value of the services

that was calculated.

That doesn't appear to be very clear, but that was

really the point I was trying to make; was that if we did

the allocation using the methodology, but the way we

implemented it, we thought we got good results.

THE COURT: So do I take it that one of your

10 conclusions is that an allocation based on time is proper

11 time is accurately allocated to the costs?

12 THE WITNESS: If the time is accurately

allocated

13 and if the underlying services provided for are provided

for

14 at areasonable dollar value. So I guess, yes, we're

saying

15 that I don't have a problem with allocating it based on

16 time.

17 THE COURT: But here you didn't change the

18 underlying dollar value because indeed that was fixed by

19 your commission, wasn't it?

OMOxAIKHNA Hh W

- 20 THE WITNESS: Oh, you mean the total dollar

21 allocated?

22 THE COURT: Yes.

23 THE WITNESS: Correct. No, we didn't.

24 THE COURT: Nor per hour dollar allocation,

25 because you didn't change the total number of hours,

either.

MOORE - RECROSS 296

1 You allocated the time --

2 THE WITNESS: Right.

3 THE COURT: -- based on percentages allocable

4 of total time or each individual time actually allocable to

5 each restaurant, right?

42a

THE WITNESS: Right.

THE COURT: You accepted the number of hours.

THE WITNESS: Yes. That they provided to us?

THE COURT: That was provided to you.

10 THE WITNESS: Yes. Yes.

1] THE COURT: And you thought that was a

reasonable

12 number of hours overall, I take it.

13 THE WITNESS: Yes.

14 THE COURT: And since you were only

allocating, I

15 think, $900,000 worth of cost a year.

16 THE WITNESS: Well, it varied slightly with the

17 year, but that's average, right.

18 THE COURT: Well, whatever it was. But you

19 thought that was reasonable, too, I take it.

20 THE WITNESS: Well, let me --

21 THE COURT: It was fixed, at least.

22 THE WITNESS: It was fixed. We didn't

question

23 the total dollar amount that was allocated. That was

24 outside the scope of what we were told to do.

25 THE COURT: So not having questioned the total

Oo on DN

MOORE - RECROSS 297

amount that was allocated and not having questioned the

number of hours involved, you certainly then weren't

questioning the dollar value per hour, because that was

simply a product of division, wasn't it?

When you divide the number of hours into the

dollars, you come out with a per hour allocation.

THE WITNESS: Yes. Per hour based on total

SAM hWN —

5°

THE COURT: On the figures you were given.

THE WITNESS: Right. That's correct.

1] THE COURT: So I guess the conclusion -- just to

—

en uae Le

43a

12 reemphasize this one more time and we'll come back to

this :

13 in other parts of your report -- was the methodology of

14 allocating overhead costs on the basis of hours allocable

15 each of the targets is a reasonable method of allocation.

16 Is that your conclusion?

17 THE WITNESS: Yes.

18 THE COURT: Yes. Fine. And indeed that's one

19 the conclusions expressed in this badly written sentence.

20 THE WITNESS: Very badly written.

21 THE COURT: But that is one of the conclusions

22 that's inherent in there. Go to page 13. I was somewhat

23 puzzled by the table in that I didn't understand what the

24 ratio was relating. In other words, I can see that Wapak

25 one-to-one, but what is the one? What are the ratios

MOORE - RECROSS 303

1 same as net sales as calculated for the industry.

2 THE WITNESS: Yes.

3 THE COURT: Why do you make that assumption

with

4 regard to the management costs? In other words, what

I'm

5 getting at, it was only some of the management functions

6 that were performed by BKK, right? I mean, some were

7 performed at the store level.

8 THE WITNESS: This is true. That's true.

9 THE COURT: And so the ratio or the percentage

10 net sales to management cost allocated was a ratio of net

11 sales to a sub-class of management costs, was it not?

12 THE WITNESS: Yes.

44a

13 THE COURT: But isn't the ratio that you have

for

14 RMA industry guidelines a ratio of net sales to a

different

15 class of management costs; i.e., that class that was

16 standard for management cost allocations for RMA?

17 THE WITNESS: Well, the RMA data is for

officer

18 compensation costs. So it's strictly upper management

19 level. So that's why we felt that would be comparable.

20 THE COURT: So you think you could have

21 corresponded to the --

22 THE WITNESS: Yes.

23 THE COURT: Okay.

24 THE WITNESS: Yes.

25 THE COURT: Fine. I didn't understand that.

MOORE - RECROSS 323

l THE COURT: And if indeed those charges related

2 the hours -- were related to the hours spent by the BKK

3 personnel, you would have said I don't want to be billed

4 the basis of hours.

5 THE WITNESS: I guess I would say that, yes.

6 THE COURT: Right?

7 THE WITNESS: Right. I would like to pay for

the

8 benefit I received.

9 THE COURT: But it again strikes me that what

you

10 were doing is using certain financial analysis and

industry

gut arrearage pennies

PRA EBNE ELSES

45a

11 norms to criticize the results they got without being able

12 to say with any degree of confidence that they simply

didn't

13 do things the way they said. That, simply put, they

didn't

14 allocate the hours the way they did. It's just that if they

15 did that, they were bad businessmen.

16 You don't have anything to tell me as to how

many

17 hours each of these individuals actually spent with each

18 the stores. I mean, that's not -- there's nothing the

19 matter with that.

20 THE WITNESS: No. I can't -- no. I can't -- that

21 wold be -- I don't have any way to tell you that, no. I

22 --

23 THE COURT: What you can basically tell me is

that

24 an efficient group would not have allocated either --

would

25 not have allocated hours in a way that produced these

MOORE - RECROSS/BORSANI - DIRECT 325

l THE WITNESS: Right. And -- right -- and other

2 trends, identification of trends within the corporations,

3 yes.

4 THE COURT: But just to cross the T one more

time.

5 You can't say that they didn't spend those hours.

6 THE WITNESS: No, sir.

7 THE COURT: Okay. Mr. Steffan, do you have

any

8 more questions?

46a

9 MR. STEFFAN: If I may have just one moment,

Your

10 Honor. No, I don't, Your Honor. Thank you.

11 MS. HELFGOTT: Nothing further, Your Honor.

12 THE COURT: Thank you.

13 [ Witness excused. ]

14 THE COURT: Do you have any further

witnesses?

15 MS. HELFGOTT: No, Your Honor.

16 MR. STEFFAN: Your Honor, I have a

two-minute

17 rebuttal witness, Nancy Borsani.

18 THE COURT: Okay.

19 Whereupon,

20 NANCY BORSANI,

21 arebuttal witness, was called for examination by

counsel on

22 behalf of the Petitioner and, having been previously duly

23 sworn, was further examined and testified as follows:

24 DIRECT EXAMINATION

25 BY MR. STEFFAN:

BORSANI - DIRECT 327

l Q Okay. Have you ever driven from BKK

headquarters

2 to each of the Findlay stores?

3 A Yes.

4 Q_ And what's the mileage for each?

5 A It's about two miles.

6 Q_ Equidistant, both stores?

7 A Yes.

8 Q One way?

9 A Yes.

MR. STEFFAN: Thank you. Nothing further.

MS. HELFGOTT: Nothing, Your Honor.

—

— ©

l 47a

12 THE COURT: Thank you.

13 [Witness excused. ]

14 THE COURT: Ms. Helfgott, do the adjustments

15 __ the notice -- well, let me put it this way. The notice --

16 the adjustments in the notice of deficiency do not reflect

d 17 the conclusions of your expert, do they?

18 MS. HELFGOTT: Not entirely, Your Honor.

; 19 THE COURT: Well, not exactly.

20 MS. HELFGOTT: The position of Respondent is

E the

3 21 allocation made by Respondent's experts as to the

restaurant

22 corporation.

23 THE COURT: Okay. In other words, you

é concede any

24 excess of the adjustments -- of the adjustments that

would

25 be made under Ms. Moore's allocations.

reese

RRS NE nein tees

***

328

4 1 MS. HELFGOTT: However that computationally

shakes

3 2 out for each deficiency at issue.

3 THE COURT: Well, she has amounts that she

thinks

4 are the proper allocation and your revenue agent did the

5 same thing, but they're different.

6 MS. HELFGOTT: Right. So our position is the

npatrabannioegatiy eter suena:

position of our expert. To the extent that her position

requires a concession on our part, that's our position.

THE COURT: Okay. What about the

corporations

10 with negative adjustments, what happened to them?

Pe Mas baleian nas:

SS nl

LCA RE BAS)

48a

11 MS. HELFGOTT: In terms of?

12 THE COURT: Where are they? Not in this case,

are

13 they?

14 MS. HELFGOTT: Well, we didn't determine a

15 deficiency with respect to the corporations where we

16 allocated a higher --

17 THE COURT: No, certainly you didn't, but --

18 MS. HELFGOTT: We advised them to file

protective

19 claims. We made those adjustments.

20 THE COURT: What did you do with regard to

those,

21 Mr. Steffan?

22 MR. STEFFAN: I'm sorry. I was taking some --

23 THE COURT: They made negative adjustments

for pies

24 some of the corporations which gave rise to deficiencies.

25 They just told you that they made positive adjustments

with

MOORE - DIRECT 334

1 from this process, but I'll try again.

2 BY MS. HELFGOTT:

3 Q_If, based on your interviews with the various

4 personnel, you determined -- you interpret -- and the

5 interpretation you made as to the interviews as to how

they

6 were spending your time, you concluded that they had

spent

7 80 percent of your -- their time at the two largest

8 corporations and that -- and not the allocation that you

9 interpreted from your interviews, and then tested that

10 allocation based on the operational statistics of each

49a

11 corporation and industry data, would your -- what would

your

12 conclusion have been?

13 A My conclusion would have been, as it is now,

that

14 the charges allocated to the individual operating entities

15 didn't represent, according to the statistics and the

16 industry information, the arm's length value of those

17 services. If we had been able to determine, based on

your

18 interviews with management, if they had been able -- if

they

19 had proven to us that they had records, if we knew that's

20 how they spent their time, we probably would not have

gone

21 through the steps we went through to do this allocation.

22 would simply have said, okay, here's the dollar amount,

23 let's test it and see if it's reasonable.

24 But since the records were not available to us,

25 the first step that we did was try to recreate this

MOORE - DIRECT 335

1 methodology and recreate this allocation and develop

ome

2 relationship to hours.

3 So the conclusion whether or not we agreed with

4 the hours would still be whether or not the dollar value

5 charged to the individual operating entities represented,

6 based on the information in our research, an arm's length

~”

value, and the answer in either case would have been no.

THE COURT: You see what I'm getting at? They

started with the results and derived the number of hours

10 that were appropriate for that result. They didn't start

11 with the number of hours and answer the question as to

12 whether those hours were spent. That's what I got from

you,

50a

13 isn't it, Ms. Moore?

14 THE WITNESS: No. No. I mean, I -- that's not

15 what I intended to say. What I intended to say was that

16 attempted to evaluate the implementation of the

methodology

17 by doing it ourselves since there was no records

available.

18 THE COURT: No.

19 THE WITNESS: Okay.

20 THE COURT: And Ms. Helfgott's question to

you was

21 start with the assumption that there is uncontradicted

proof

22 that 80 percent of the hours were indeed spent on the

two

23 largest stores.

24 THE WITNESS: Right.

25 THE COURT: That was -- was it not, Ms. Helfgott?

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.