Pacific Management Group v. Commissioner of Internal Revenue, 082018 FEDTAX, 6411-07

Docket Nº:6411-07, 6412-07, 6413-07, 6414-07, 6494-07, 6498-07, 6499-07, 6592-07, 6593-07, 6594-07, 6596-07.
Opinion Judge:LAUBER, Judge.
Attorney:Ernest Scribner Ryder, Richard V. Vermazen, and Alvah Lavar Taylor, for petitioners. Kevin W. Coy, Heather K. McCluskey, Hans Famularo, and Jeffrey L. Heinkel, for respondent.
Case Date:August 20, 2018
Court:United States Tax Court

T.C. Memo. 2018-131




Nos. 6411-07, 6412-07, 6413-07, 6414-07, 6494-07, 6498-07, 6499-07, 6592-07, 6593-07, 6594-07, 6596-07.

United States Tax Court

August 20, 2018

Ernest Scribner Ryder, Richard V. Vermazen, and Alvah Lavar Taylor, for petitioners.

Kevin W. Coy, Heather K. McCluskey, Hans Famularo, and Jeffrey L. Heinkel, for respondent.


LAUBER, Judge.

These consolidated cases involve a complex tax shelter scheme featuring four C corporations, five individual shareholder-employees of the C corporations, five employee stock ownership plans (ESOPs), five S corporations, and (inevitably) a partnership. This scheme was devised by Ernest S. Ryder, who serves as co-counsel for petitioners in these cases.2 The scheme relied in part on section 1361(c)(6), [3] effective for tax years after 1997, which allowed ESOPs to be shareholders of S corporations. See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, sec. 1316(a), 110 Stat. at 1785.

Reduced to its essentials, the scheme worked as follows. The partnership extracted cash from the C corporations in the form of alleged "factoring fees" and "management fees." The C corporations claimed deductions for these payments, wiping out substantial portions of their taxable income.

The partnership distributed much of this cash to its five partners, each of which was an S corporation formed by one of the five individuals. The distributions to each S corporation were made ratably on the basis of the corresponding individual's ownership interest in the C corporations. Each individual received from his S corporation a salary, in whatever amount he believed necessary to support his anticipated living expenses. The individuals reported those amounts as taxable income; the S corporations retained the rest of the cash and (after paying certain expenses) invested it for the individuals' benefit.

All of the stock of each S corporation was owned by an ESOP. The sole participant in (and beneficiary of) each ESOP was the individual who had formed the S corporation. Because the ESOPs were tax exempt, the distributions the S corporations received from the partnership (net of the salaries and benefits paid to the individuals) were purportedly exempt from current Federal income taxation. The desired end result, therefore, was largely to eliminate taxation of the operating profits at the C corporation level and defer indefinitely any taxation of those profits at the individual shareholder level, even though the profits had been distributed ratably for each shareholder's benefit.

Rightly concluding that this scheme was too good to be true, the Internal Revenue Service (IRS or respondent) attacked it on numerous grounds for tax years that (owing to calender and fiscal year differences) span 2002-2005. We hold that the "factoring fees" and most of the "management fees" were not deductible expenses of the C corporations but rather were disguised distributions of corporate profits. To the extent set forth below, we hold that these distributions were currently taxable to the individual shareholders of the C corporations as constructive dividends or as income improperly assigned to the S corporations.


Some of the facts have been stipulated and are so found. The stipulations of facts and the attached exhibits are incorporated by this reference. The record of these consolidated cases, including the trial transcript, the stipulations of facts, and the attached exhibits, totals many thousands of pages.

Rule 151(e)(3) requires that a party provide, for each proposed finding of fact, "references to the pages of the transcript or the exhibits or other sources relied upon to support the statement." Respondent's proposed findings of fact, occupying 140 pages of his opening brief, comply with this requirement. Petitioners' proposed findings of fact, occupying 96 pages of their opening brief, frequently do not. Where facts are in doubt, we have done our best to locate support for petitioners' version. But we have resolved uncertain matters in favor of respondent where petitioners have failed to support with record citations their proposed findings of fact. See 535 Ramona Inc. v. Commissioner, 135 T.C. 353, 359-360 (2010); Brewer Quality Homes, Inc. v. Commissioner, T.C. Memo. 2003-200, 86 T.C.M. (CCH) 29, 30 n.3.

Implementation of the tax shelter scheme entailed many thousands of cash transfers among 15 entities and individuals. In their proposed findings of fact the parties often do not agree on the net results of these transactions, or even on what the dollar amounts remaining in dispute actually are. We have done our best to work our way through this fog. We leave it to the parties' Rule 155 computations to determine the final tax consequences of our redeterminations.

A. The Water Companies and Their Shareholders

The four C corporations whose tax liabilities are at issue are Pacific Aqua-scape, Inc. (PAQ), Pacific Aquascape International, Inc. (PAI), Pacific Advanced Civil Engineering (PACE), and Pacific Environmental Resources Corp. (PERC). We will sometimes refer to the C corporations collectively as the Water Companies. Each of the Water Companies had its principal place of business in California when it filed its petition.

The stock of the Water Companies was owned by five individuals: Johan Perslow, Cory Severson, Mark E. Krebs, Curtis S. Hartwell, and Richard Boulting-house. Some of them filed joint returns for certain years at issue; all ensuing references to individuals with these surnames are to petitioner husbands. We will sometimes refer to each petitioner husband as a "principal" of the Water Companies and refer to them collectively as the "five principals." All individual petitioners resided in California when they filed their petitions.

B. Business Structure and Operations Before 2000

The story begins with PAQ, which was formed in November 1987 by Mr. Perslow and Mr. Severson after a predecessor business, Pacific Lining Co., went bankrupt. PAQ's work initially related chiefly to golf course development but later expanded to include designing, engineering, and constructing various aquatic environments, including manmade lakes, waterfalls, streams, pools, and spas. PAQ had between 30 and 45 full-time employees in 1999 and added other workers as its projects required. As of December 31, 1999, PAQ's officers and shareholders were as follows (percentages do not total 100% because of rounding):

Individual Office % Ownership
Perslow Chairman/Secretary 41.0
Severson President/Treasurer 26.8
Krebs Vice president 20.1
Hartwell Vice president 8.0
Boultinghouse CFO 4.0
PACE was originally a division of PAQ, functioning as its in-house engineering design group. It was separately incorporated in 1994 with the same ownership structure as PAQ. PACE specialized in designing water resource systems, including flood control systems, wastewater systems, and recreational water features. PACE did most of its design work for projects on which PAQ performed construction. Its workforce grew from 30 employees in 1994 to 70 employees in 2001. Its clientele correspondingly expanded from small land developers to include cities and counties throughout the southwestern United States, as well as major national developers. As of December 31, 1999, PACE's officers and shareholders were...

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