When It’s Too Good to be True (Tax Shelter Edition)

When reading Tax Court decisions, always be on the lookout for the word “scheme.” It’s usually a heads-up that what you’re reading isn’t going to cut it (from a tax perspective). So when the decision begins,

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. [emphasis added]

You know things aren’t going to end up well for the petitioners.

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.

So what happened? Actually, a lot of transactions. Thousands of transactions. Make that many thousands of transactions–all designed to get rid of tax.

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.

First, let me give a fundamental rule in tax: Everything needs an economic substance to be legal. Business transactions can be designed in a tax advantaged way, but there needs to be a real transaction. The scheme involved factoring and management fees. I’m familiar with factoring; it’s common in the garment industry (among other industries). Factoring allows the sale of accounts receivable and the seller to immediately obtain cash; in exchange, the buyer collects the receivables and earns the difference between the sales price and the receivables. The problem was that the way this factoring worked wasn’t the way it works in practice.

While factoring receivables theoretically enabled the Water Companies to accelerate their incoming cashflow, this benefit was illusory given how the “factoring” operated. PMG could not function as a “factor” without the management fees it received from the Water Companies, as shown by the 10-month delay in PMG’s commencement of “factoring.” In effect, the Water Companies had to provide working capital to PMG (rather than the other way around) to enable PMG to purchase the accounts receivable. Given this circular flow of funds, the “factoring” generated no liquidity benefits for the Water Companies…

We conclude that the purported factoring arrangement with PMG had no economic substance but was a device to extract profits from the Water Companies in the guise of tax-deductible payments. The Water Companies derived no economic benefit from this arrangement, and the factoring fees they paid were not “ordinary and necessary” expenses of their business. [internal note omitted]

The factoring also failed an ‘arms-length’ test. When parties are related, the transactions have to follow what I call the disinterested buyer/seller model: What would a disinterested [buyer/seller] pay (or receive) for what’s being sold? A question this court pondered was whether these agreements in practice followed normal factoring practices.

In an arm’s-length factoring arrangement, the factor typically: (1) receives an assignment of accounts receivable from the client, (2) verifies the genuineness of the accounts and balances shown, and (3) immediately pays the client a lump sum equal to the face amount of the receivables less the agreed-upon discount. Mr. Zadek observed that PMG’s payment practices were erratic and regularly flouted these norms. On some occasions PMG would make payment before receiving executed assignments of the receivables and without verifying the account balances. On other occasions PMG would not make the stipulated upfront payment but would instead pay for the receivables in installments, sometimes in seven or eight tranches spread over many months. This was contrary to standard factoring practice, which aims to provide the client with immediate liquidity. The trial evidence supported Mr. Zadek’s conclusion that the timing of the supposed “factoring” payments was largely dictated, not by the terms of the MFAs, but by “when there was money in the bank to do it,” as Ms. Quarry testified.

Add in that the company itself and not the factor did the actual collection efforts (on past due accounts), and you have a facade of factoring and some big tax problems. But, like a bad infomercial, that’s not all! There are also excessive management fees. These were designed to change taxable income into untaxable income. Suffice to say, these didn’t work either.

The conclusion is one I (and others) have been stating for years: There is no Tax Fairy. If you (or your business) makes a lot of income, you will owe tax. Alchemy in the tax world works just as well as alchemy in the physical world: I’ve yet to see someone take lead and turn into gold or some other precious metal. Instead of spending millions on these tax shelter schemes, the businesses’ owners would have done far better using those millions to pay their taxes.

Case: Pacific Management Group v. Commissioner, T.C. Memo 2018-131

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