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

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386014_1049%3A1

## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition for Writ of Certiorari
- **Published:** January 1, 2000
- **Citation:** 531 U.S. 814

## Text

eee ———
: Supreme Court, KS, Z

Q) -tLEeD
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 ¥

. +7

II.

i
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

il
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
I ii as inten incctisanned i
PARTIES TO THE PROCEEDINGG....0.....cccccccsccscsscccsccccsee ll
I NI iiiicicis sasdavckcstutiscssnonniadehelseenciaeticleriaasicinasn iii
IE chic icicsdisirinnainiandiciondcvisuineieanoapiics iv
IN iia csi ch tearisinsigctonnapieaiitcenanindiaickosstinsadiauecds l
JURISDICTION.........2..00000+ israiabihicalistitieniile s seainildaavieaiidines l

RELEVANT CONSTITUTIONAL , STATUTORY ORDINANCE

I IN iii inc bcunhihnstigdscecesicctousaanainaconniat 2
SI OR I ss escape aibaeanskinalebaoiukaniasisaaie 2
REASONS FOR GRANTING THE WRIT...........sccssccssssssssescesscseseee 8
I Nh aie ences es ccc osc blbvoisoniaieasnina 24
APPENDIX

SR APMIS OPI oo 5cciccesaresscsensesonessncasesnesonns la
TE BID eiilnisisthcinncctsencsthisssnsisicecanveinicinesns 18a

iV
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

|

V

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
OUD SION isin: ssscdiasicsceccincsecc |
INTERNAL REVENUE CODE - 26 0.......csccsssscssssscssscsecccoseeeccccss.... 2
SUPREME COURT RULE Di citdieiiitiien ds eo ]

l
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).

2

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.

3

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

4

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

5

“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,

6

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).

5

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

—

8

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.

9

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).

10

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.

12

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).

13

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

\4

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,

16

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).

17

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

18

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 --

19

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 #

20

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

21

-

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

22

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

23

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.

24
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

la
(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,

V.

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.

2a
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.

3

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

3a

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

4a

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*

a

Trento
n

Allento
wn

Hardin
7
Highw
ay

Apollo

FEE/%

FEE/%

FEE /%

FEE /%

FEE /%

FEE /%

FEE /%

FEE/%

FEE/%

FEE /%

Sa
%

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

6a

/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

7a

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

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

8a

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"

9a

‘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

ee

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

V.

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

00

K-K * 279,650 39.0 283,500 29.0 380,6 32.9
00

Tiffin* 28,000 3.9 31,000 3.2 26,0 2.2
00

Bryan *

GMK,
Inc.

Perrysbu
rg
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
6
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

ta

me

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.

i

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

>

us
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

ee

38a

CAMPER - CROSS 230
hours or time spent. And since that wasn't available, I

5s
a

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
at
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
more
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

by

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
if
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 —

oF
<G
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
to

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
of

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
is

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

eR

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
of

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
to

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
on

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

eK

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:
eK
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

in
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
7

8

9

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:

"7
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.
We

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
7
8
9

~”

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
we

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?

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386014_1049%3A1. Public record. Not legal advice.