Eyefull Inc. v. Commissioner

T.C. Memo. 1996-238

UNITED STATES TAX COURT

EYEFULL INCORPORATED, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3893-94. Filed May 22, 1996.

1. Over several years M performed substantial
services without compensation for P, a
domestic corporation that M owned indirectly
through two tiers of foreign entities. There
was no written agreement for the services and
no contemporaneous record of an obligation to
pay for them. When P made a payment to M and
deducted it as compensation for the prior
services, R recharacterized the payment as a
dividend. Held: The payment is deductible
as compensation, because remuneration was
consistent with the expectation of the
parties at the time the services were
performed.

2. P accumulated earnings without specific,
definite and feasible plans to use the
accumulations and lent substantial amounts to
affiliates for purposes unrelated to its
 - 2 -

business. Held, further, P is liable for the
accumulated earnings tax.

Robert E. Miller and Edith S. Thomas, for petitioner.

Alexandra E. Nicholaides and Eric R. Skinner, for

respondent.

MEMORANDUM OPINION

LARO, Judge: Petitioner sought redetermination of

deficiencies in Federal income taxes, additions to tax, and

penalties determined by respondent as follows:

Taxable Year Additions to Tax Penalty
Ended Sec. Sec. Sec.
August 31 Deficiency 6651(a)(1) 6653(a) 6662

1989 $124,721 $1,192 $11,396 ---
1990 208,903 1,487 --- $1,189
1991 216,364 36,336 --- 29,069
1992 16,706 --- --- ---

After concessions by both parties, the issues for decision are:1

(1) Whether petitioner may deduct payments made to one of its

ultimate beneficial owners as compensation for services. We hold

that it may. (2) Whether petitioner is liable for accumulated

earnings tax. We hold that it is liable with respect to 3 of the

4 taxable years at issue. (3) Whether petitioner is liable for

additions to tax under sections 6651 and 6653(a) and for

1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years at issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.
 - 3 -

accuracy-related penalties for negligence under section 6662. We

hold that it is liable. Some of the facts have been stipulated

and are so found. The stipulation of facts and joint exhibits

attached thereto are incorporated herein by this reference.

Issue 1: Compensation

Background

Petitioner was incorporated under California law in 1984.

At the time the petition was filed, petitioner’s principal place

of business was in the city of Ontario, in San Bernardino County,

California. Petitioner owns and operates an adult entertainment

complex comprising a nightclub, bookstore, video arcade, and live

peep show. Petitioner is one of a large group of corporations in

the same industry (the Mohney Group) that are owned, directly or

indirectly, by Harry V. Mohney (Mohney), either alone or as one

of several beneficiaries of a trust. During the years at issue,

petitioner’s stock was owned in equal shares by three Turks &

Caicos Islands holding companies, Fun Films Ltd., Tornado Trading

Inc., and Azid Trading Corp. Each of these holding companies

was, in turn, wholly owned by the Amaranta Trust, a foreign trust

established by Mohney. During the years at issue the trustee of

the Amaranta Trust was Andrew Newlands (Newlands) and the

beneficiaries were Mohney and members of his family. Under the

terms of the trust instrument Mohney had no control over trust

assets and no power to discharge the trustee or appoint his

successor in the event that he retired.
 - 4 -

Mohney served as an officer of several corporations in the

Mohney Group. Many others, including petitioner, retained him as

a “consultant”. Pursuant to a general understanding with

Newlands, in his capacity as a “consultant” Mohney actually

exercised the highest executive authority with respect to each of

the corporations. Although he was ultimately accountable to the

trustee, he understood that he had Newlands complete confidence

and managed the companies effectively without supervision.

Mohney submitted no written report of his work to Newlands but

informed him of the progress of the companies under his control

from time to time.

On his individual income tax returns, Forms 1040, Schedule

C, for each of the years 1985 through 1991, Mohney reported his

principal business or profession as consulting and included

payments he received from corporations in the Mohney Group in his

gross receipts for the taxable year. The amounts reported as

consultation income from the Mohney Group for each year are as

follows:

Year Number of Companies Total
1
1985 2 $10,894
1986 2 36,823
2
1987 3 68,389
1988 4 175,917
1989 2 100,863
1990 12 364,448
1991 49 2,706,827
1
This figure comes from a schedule prepared by petitioner.
Mohney’s return shows a total of $30,408, which may include
receipts from sources outside the Mohney Group.
 - 5 -
2
This figure comes from a schedule prepared by petitioner.
Mohney’s return shows the amount received from only one of the
three, $59,702. The discrepancy was not explained.

Under his usual “consulting” arrangement, the amount and timing

of payments Mohney received were not fixed in advance, but varied

based on his assessment of the company’s performance and its

needs.

Mohney’s “consulting” relationship with petitioner conformed

to the general pattern. From the founding of the company through

the taxable years at issue, Mohney exercised the highest

executive responsibilities and actively participated in making

and implementing major corporate decisions. In petitioner’s

early years of operation he designed the floor plan for the

complex, negotiated the purchase of the building site, oversaw

construction of the building, and procured merchandise and

credit. In 1988 he hired Jacqueline Hagerman (Hagerman) to serve

as petitioner’s president, and the determination of her annual

salary was his responsibility. During the years at issue he was

consulted on a regular basis by Hagerman and the other management

concerning administration, operations, promotions, advertising,

and the myriad legal problems that arose in regard to zoning,

building code compliance, and restrictive ordinances.

Hagerman moved to Michigan in 1990 and Donald Krontz

(Krontz) was hired as manager to supervise daily operations in

her absence. It was these two with whom Mohney regularly worked.

Both understood that there was a preexisting consulting agreement
 - 6 -

between him and petitioner or the shareholders. Their

understanding was based on what they had been told, by Mohney

himself and perhaps others, and it was confirmed by his

availability 24 hours a day to participate in decisions on any

corporate matter of importance that arose. Neither had ever seen

documentation of a consulting relationship, and none existed.

There is no written consulting agreement between petitioner and

Mohney relating to any period between 1985 and 1992. Petitioner

has no timesheets, statements or bills detailing the dates,

hours, or specific times for which compensation was payable to

Mohney. Petitioner did not accrue a liability for consulting

fees on its books at the time Mohney rendered services.

Beginning in or around 1991, petitioner engaged the services

of Deja Vu, Inc. (Deja Vu). This company provides management

consulting for nightclubs. At all relevant times its president

was Krontz and Mohney was one of its salaried employees. Mohney

performed some services for petitioner in this capacity. While

it is clear that petitioner paid Deja Vu for its consulting work,

it is not clear how much of the work was performed by Mohney or

how much Deja Vu was paid for Mohney’s work. Mohney reported

wages from Deja Vu of $252,000 in 1990 and $261,000 in 1991.

It was Mohney’s original understanding from discussions with

Newlands that eventually he would receive 10 percent of

petitioner’s gross receipts. Petitioner made no payments to him

during 1985 through 1987. In 1988 Mohney caused petitioner to
 - 7 -

pay him $30,000. Mohney believed that payment of more than this

amount would have been unwise at a time when the company’s

viability was uncertain. The next payment occurred in July 1991.

The amount and form had been decided at some time during the

previous year by agreement between Mohney and Newlands. In

November 1990 Mohney discussed the accounting aspects of the

transaction with David Shindel (Shindel), an independent

certified public accountant who had been retained to oversee tax

compliance for several companies within the Mohney Group.

Hagerman, petitioner’s president and sole member of the board of

directors, had no part in the decision. Newlands, acting as

representative of petitioner’s shareholders, notified her that

petitioner was to transfer to Mohney $274,980 worth of precious

metals--Krugerrands and the like--that it had recently acquired

on Mohney’s instructions; the remaining $65,000 of precious

metals was to be distributed to the shareholders. An attorney

close to Mohney drafted a resolution of petitioner’s board of

directors authorizing the payment. The resolution acknowledged

that petitioner had “availed itself of the expertise, consulting

services and advisory assistance of HARRY V. MOHNEY * * * in

connection with the operation of this Corporation’s retail

business since 1985 * * * pursuant to and in accordance with

agreements reached between said HARRY V. MOHNEY and an authorized

representative of the shareholders.” It stated that the

conveyance of precious metals was “in full and final
 - 8 -

satisfication of any amounts due him for consulting and advisory

services,” and that “the amount has been acknowledged by the

authorized representative of the shareholders to be consistent

with the agreements and understandings previously made and

entered into.” Hagerman approved the resolution on July 30,

1991. The payment represented 3.3 percent of petitioner’s

cumulative gross receipts since 1985.

Mohney received a Form 1099 reflecting the payment and

included it in income for 1991 as gross receipts from his

consulting business. Petitioner deducted the payment in

computing its taxable income for the taxable year ended August

31, 1991 (TYE 8/31/91). In her notice of deficiency respondent

disallowed the full deduction.

Discussion

The first issue raised by petitioner’s payment to Mohney of

$274,980 in TYE 8/31/91 is whether it may be deducted as

compensation. If so, we must decide for what taxable year(s) it

is deductible. Section 162(a)(1) provides that deductible

business expenses include a reasonable allowance for salaries or

other compensation for personal services actually rendered. In

general the deductibility of a payment characterized as

compensation turns on two requirements: The payment must be

purely for services, and it must be reasonable in amount.

Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243-1244 (9th

Cir. 1983), revg. T.C. Memo. 1980-282; sec. 1.162-7(a), Income
 - 9 -

Tax Regs. The focus of the controversy in this case is the

former requirement.2 It is well established that a payment may

be deducted as compensation only to the extent that it was

actually intended as such. Jefferson Block & Supply Co. v.

Commissioner, 59 T.C. 625, 633-634 (1973), affd. without

published opinion 492 F.2d 1243 (6th Cir. 1974); Paula Constr.

Co. v. Commissioner, 58 T.C. 1055 (1972), affd. without published

opinion 474 F.2d 1345 (5th Cir. 1973); Electric & Neon, Inc. v.

Commissioner, 56 T.C. 1324, 1340 (1971), affd. without published

opinion 496 F.2d 876 (5th Cir. 1974). Respondent takes the

position that compensation for prior services was not the purpose

of the payment to Mohney, because (1) the services had not been

rendered with a view toward compensation; (2) to the extent the

services may have been rendered for compensation they were

otherwise fully compensated; and (3) the circumstances of the

payment indicate a purpose other than compensation. In

respondent’s view, the payment was in substance a nondeductible

dividend disguised as compensation for prior services and its

principal motivation was to avoid liability for the accumulated

earnings tax. We disagree.

2
We do not understand respondent to challenge the
reasonableness of the payment in relation to the services
performed. In the notice of deficiency there was no indication
that this was a reason for disallowing the deduction, and
respondent presented no argument on this issue at trial or on
brief.
 - 10 -

Respondent acknowledges that Mohney performed substantial

services for petitioner on a regular basis:

Mr. Mohney had considerable involvement in
every facet of the operation of petitioner.
He made virtually every kind of decision
needed to operate the petitioner from hiring
employees, and making decisions on building,
remodeling, and sign design, to financial and
investment decisions and lending to related
parties.

She concludes: “Mr. Mohney’s involvement is tantamount to that of

an owner, someone who has financial stake in the petitioner,

rather than that of a consultant.” Thus, respondent believes

that Mohney performed these services not for compensation, but

for a return on his investment in petitioner.

We agree with respondent that, by themselves, Mohney’s

extensive activities on petitioner’s behalf do not establish the

existence between them of a business relationship consistent with

the payment of compensation. See Paula Constr. Co. v.

Commissioner, supra at 1058; cf. Whipple v. Commissioner, 373

U.S. 193, 202-203 (1963). There must also be evidence that at

the time the services were rendered the parties understood them

to be part of a business transaction conducted for profit.

Respondent’s disguised dividend theory relies heavily on the

absence of a written consulting agreement, timesheets, invoices,

bills, work reports, accrued liabilities on petitioner’s books or

other contemporaneous documentation of a consulting relationship.
 - 11 -

We do not find the absence of such documentation to be

dispositive. The fact that petitioner’s books do not reflect the

accrual of a liability at the time services were rendered is not

necessarily inconsistent with an understanding that the company

was obligated to pay for the services. The amount and timing of

the payment were understood to be contingent on business

performance over an indefinite period. To have made a reasonable

estimate of the accrued expense for Mohney’s compensation in the

company’s accounts would have been extremely difficult under

these circumstances. Assuming that a business relationship did

exist between petitioner and Mohney, plainly it would not have

been conducted at arm’s length, and therefore, in general,

documentation of the kind sought by respondent would have served

little, if any, useful function. Where the owner of a closely

held corporation takes an active part in managing its business,

neglect of formal documentation of the compensation arrangement

between them is not uncommon. In recognition of this fact, our

cases have not required formal documentation as a condition for

deductibility of executive compensation in the context of a

closely held corporation. Levenson & Klein, Inc. v.

Commissioner, 67 T.C. 694, 713-714 (1977); Reub Isaacs & Co. v.

Commissioner, 1 B.T.A. 45, 48 (1924); Pulsar Components Intl.,

Inc. v. Commissioner, T.C. Memo. 1996-129; Mad Auto Wrecking, Inc

v. Commissioner, T.C. Memo. 1995-153.
 - 12 -

In this case the absence of documentation reflects not only

the flexibility and informality that the circumstances permitted,

but also a deliberate policy. Mohney testified that he has been

indicted on obscenity charges over a hundred times. Having

learned from experience that documentary evidence of his

relationship to the adult entertainment businesses he controlled

posed a risk of incrimination, he kept such documents to a

minimum.

Contemporaneous documentation of a business relationship is

not altogether lacking. On his individual income tax returns for

the years 1985-91 Mohney described his principal business as

consulting and reported the payments from petitioner and the

other corporations he managed as gross receipts from this

business. In addition, we have the uncontradicted testimony of

Hagerman and Krontz that they understood a consulting agreement

to exist, and the testimony of Mohney that he always expected

compensation for his work. To be sure, such testimony serves

their interest, but we cannot reject it for that reason alone.

Lewis & Taylor, Inc. v. Commissioner, 447 F.2d 1074, 1077

(9th Cir. 1971), revg. T.C. Memo. 1969-82; Loesch & Green Constr.

Co. v. Commissioner, 211 F.2d 210, 212 (6th Cir. 1954), revg. a

Memorandum Opinion of this Court.

The evidence strongly suggests that Mohney did expect to

receive payment in some form from petitioner. In addition to the

payment in 1991, Mohney received a payment from petitioner in
 - 13 -

1988. He also received payments from other Mohney Group

corporations that he managed under the title of “consultant” in

every year between 1985 and 1991. If the reward he expected was,

as respondent contends, a return on his investment, then he

expected not only the appreciation in equity value resulting from

his efforts, but also distribution of some of the earnings. Thus

respondent’s argument implies that Mohney expected that he could

withdraw earnings from petitioner just as if he had owned a

controlling interest in the corporation directly, rather than a

beneficial interest in the trust that owned petitioner’s

shareholders.

The little evidence we have concerning the Amaranta Trust

does not support this conclusion. Mohney testified that he

established the trust for the benefit of his children and

grandchildren; although he too possesses a beneficial interest,

the trust is structured in such a way that he cannot realize any

tangible benefit during his lifetime. This would suggest that

Mohney does not have--or is not aware of having--a right to

distribution of current income or right to withdraw income or

corpus. Therefore earnings of petitioner that Mohney did not

cause to be paid out as compensation would not have come back to

him through distributions from the trust. Presumably a

substantial share would have accrued to the other beneficiaries.

And any share of the trust’s dividend income to which he may have

been entitled would have been accumulated; he would not have been
 - 14 -

able to realize this gain without selling all or part of his

interest in the trust. If the trustee had arranged for

petitioner to distribute dividends so that the funds could then

be distributed by the trust to Mohney, he would likely have been

acting in violation of his legal obligations. As a practical

matter, Mohney could not have compelled Newlands to distribute

trust income to him, for Mohney had no power to discharge

Newlands. If Newlands retired, he would select his own

successor. In the absence of any basis for doubting the

independence and integrity of the trustee, we are unwilling to

assume that Mohney expected him to act in derogation of his

duties. The implications of respondent’s argument seem therefore

to be at variance from the facts. The payments that Mohney

claims to have expected to receive as compensation for his

services and which he ultimately received in 1988 and 1991

differed materially from the returns he received on his

investment through the trust.

Respondent points out that petitioner paid Deja Vu for

consulting work during the years at issue, and that Mohney was

employed by Deja Vu. Therefore, if Mohney did sell his services

to petitioner, those services were likely to have been fully

compensated through Deja Vu’s regular billings.

According to the uncontradicted testimony of Krontz, who

served as both petitioner’s manager and the president of Deja Vu,

the consulting work that Deja Vu performed for petitioner did not
 - 15 -

begin until sometime in 1990, at the earliest. Mohney had

already been providing services to petitioner for 5 to 6 years.

There is no evidence that the extent or character of Mohney’s

activities with respect to petitioner changed in any way after

the relationship with Deja Vu commenced. Although it appears

that Mohney did do some work for petitioner as an employee of

Deja Vu, the scope of these services was limited to petitioner’s

nightclub. We believe that Mohney’s involvement in general

administration, advertising, legal matters, the bookstore,

theater, arcade machines, and other facilities of petitioner’s

entertainment complex was independent of any work he performed

under the Deja Vu contracts.

Respondent finds support for her disguised dividend theory

in circumstances surrounding the timing of the payment. She

dismisses petitioner’s argument that Mohney deferred collection

of his compensation until 1991 out of concern for petitioner’s

financial situation, pointing out that petitioner had been

profitable in each year since 1986. Respondent proposes that the

real reason for the payment in 1991 was concern about potential

liability for the accumulated earnings tax. In this connection

she attaches significance to the fact that the Internal Revenue

Service audit of several Mohney Group corporations had already

begun, and at some point in 1991 the revenue agent specifically

raised the accumulated earnings tax issue with Shindel, the
 - 16 -

certified public accountant who had been retained to review tax

compliance within the group.

It was almost certainly not the revenue agent’s inquiries

that precipitated Mohney’s decision to collect payment from

petitioners and the other Mohney Group companies he managed.

Shindel testified that the decision had already been made by

November 1990. This does not mean that concern about potential

liability for the accumulated earnings tax was not a principal

reason for Mohney’s decision, however. Shindel also testified

that he had become aware of the accumulated earnings tax problem

in regard to a number of Mohney Group companies before the IRS

audit began, and that he discussed the problem with Mohney. The

sheer number of companies making payments and the size of the

amounts paid to Mohney in 1991 relative to prior years supports

the inference that the 1991 payments marked a departure from

Mohney’s usual policy of collecting payment only as, and to the

extent that, the financial situation of each company permitted.

Yet even if concern over accumulated earnings tax liability was

indeed the principal motivation for Mohney’s decision, this fact

would be no less consistent with characterization of the payment

as compensation for prior services than with characterization of

the payment as a disguised dividend. In the absence of

documentation establishing an amount of compensation owed to

Mohney for his services, Mohney would have had reason to be

concerned about petitioner’s ability to justify accumulations to
 - 17 -

fund deferred compensation obligations. Thus, the circumstances

of petitioner’s payment to Mohney in 1991 provide no reason to

doubt that it was what it purported to be. We are satisfied that

the payment should not be recharacterized as a dividend.

Having determined that the payment is deductible, we turn to

the issue of when the deduction may be taken. Petitioner

proposes to spread the $274,980 deduction ratably over the

7 taxable years to which the payment applies. This would entail

a deduction in the amount of $43,568 for each taxable year

between TYE 8/31/85 and TYE 8/31/91.3 Petitioner is an accrual

basis taxpayer. Under the accrual method, a liability is taken

into account for the taxable year in which all events have

occurred that establish the fact of the liability, the amount can

be determined with reasonable accuracy and economic performance

has occurred. Sec. 1.446-1(c)(1)(ii)(B), Income Tax Regs.

Petitioner could not determine the amount payable to Mohney for

compensation until notified thereof by Newlands during TYE

3
The figure that petitioner proposes on brief as the amount
of the annual deduction is $39,280 ($274,980 ÷ 7). Considering
the $30,000 payment made to Mohney in 1988, the more appropriate
calculation would appear to be as follows: $274,976 = 6x + (x -
$30,000); hence, x = $43,568.
Inasmuch as the first four of these taxable years are not
before the Court and the period of limitations for claiming a
refund with respect to these years appears to have expired, sec.
6511(a), presumably petitioner takes this position in reliance on
the availability of relief under the mitigation provisions of the
Code. See secs. 1311(a), 1312(4), 1313(a)(1), and 1314(b).
Resort to the mitigation provisions to reopen closed taxable
years will be neither necessary nor warranted.
 - 18 -

8/31/91. Therefore the full $274,980 must be deducted in that

year. Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 120 (1930).

Issue 2: Accumulated Earnings Tax

Background

Like many adult entertainment businesses, petitioner

operated in the face of intense and unremitting hostility from

residents of the local community and local government

authorities. Exclusionary zoning, stringent enforcement of

building code requirements and licensing requirements, indecency

ordinances and criminal prosecution are weapons commonly deployed

to contain the growth of such businesses or eradicate them

altogether. The authorities of San Bernardino County used this

full arsenal against petitioner. The history of this conflict

and of petitioner’s other legal problems bears directly on the

question of the extent of petitioner’s expected and actual needs

for funds during the years at issue.

Trouble with the local authorities dates back to 1985, the

year in which petitioner commenced operations. In that year the

county adopted Ordinance No. 2940, which prohibited adult

entertainment businesses from locating in the area where

petitioner was currently operating and where a new building was

being constructed for its use. Petitioner sought an injunction

against enforcement of the ordinance on the ground that it was

unconstitutional. The lawsuit concluded in 1987 with a decision
 - 19 -

of the Ninth Circuit Court of Appeals in petitioner’s favor.

Petitioner moved into the new building in 1986.

In June 1988 six women who worked as independent contractors

for petitioner were arrested for dancing in the nude at

petitioner’s nightclub. Petitioner undertook their legal defense

and bore all the costs thereof, in accordance with its policy of

offering to underwrite all the legal expenses of employees and

contractors that arose out of the business relationship. This is

common practice in the adult entertainment business. A letter

addressed to Hagerman from petitioner's attorneys in that case

dated July 8, 1988, indicates that petitioner was contemplating a

lawsuit against the county for the purpose of invalidating the

nudity ordinance under which the dancers had been arrested.

There is no evidence that such a lawsuit was ever filed. The

dancers were tried in June 1989, after which the representation

appears to have ended.

At least two further legal problems appear to have caused

petitioner’s president especial concern during TYE 8/31/89. One

was an ordinance that required theater operators to provide

unobstructed visibility of viewing areas from the aisle. The

so-called “no-door ordinance” had been adopted by San Bernardino

County in July 1987, yet, for reasons that were not explained at

trial, compliance with this ordinance was an issue for petitioner

2 years later. At this time Hagerman believed that the costs of

making the structural adjustments to petitioner’s theater that
 - 20 -

were required by the ordinance would be in the neighborhood of

$50,000-$100,000. The basis for her estimate is not clear. Nor

does the record disclose whether these adjustments were made

during the years at issue.

Hagerman foresaw the potential for much greater expenditures

in connection with the Child Protection and Obscenity Enforcement

Act, Federal record keeping and labeling law that took effect in

May 1989. Hagerman seems to have learned about the act from her

attorneys in the first half of 1989. If petitioner was subject

to liability under provisions of the act, a lawsuit challenging

its constitutionality would be very costly. Based on what she

had learned from the experiences of others in the business, she

anticipated a protracted legal battle over several years costing

hundreds of thousands of dollars. By a letter from petitioner’s

attorneys dated June 12, 1989, however, Hagerman was advised that

as a result of a recent District Court decision holding the act

unconstitutional, the U.S. Department of Justice had confirmed

that it would not seek to enforce the act. Petitioner was

involved in no lawsuit concerning the act during the taxable

years at issue, and there is no indication in the record that

petitioner’s management communicated further with counsel on this

subject.

Petitioner’s exposure to liability increased substantially

in TYE 8/31/90, as a result of the cancellation of its workers’

compensation insurance policy. Petitioner attempted to obtain
 - 21 -

replacement coverage without success. For TYE 8/31/90 through

TYE 8/31/92, petitioner was effectively self-insured. No reserve

was established to fund potential liabilities, however.

Toward the end of TYE 8/31/89, Hagerman discovered that,

owing to an oversight on her part, petitioner’s theater license

had expired earlier in the fiscal year. Operating without a

license, petitioner was at risk of being closed down by the

county at any time. Petitioner was not closed for this reason

during the years at issue, but neither were its efforts to secure

renewal of its license successful. At some time early in TYE

8/31/90, the County Building and Safety Department inspected

petitioner’s complex and identified several violations of the

building code. Some of these violations were promptly corrected,

but over the next 1-1/2 to 2 years further inspections followed,

and the violations uncovered by the Building and Safety

Department multiplied. Citations from the Building and Safety

Department required remedial action in order to stay open for

business. Compliance with the building code was also a condition

for renewal of petitioner’s theater license. In the early part

of TYE 8/31/90, when petitioner received the first citations,

Hagerman expected that the total cost of correcting the

violations would amount to around $200,000-$400,000, much of

which would be attributable to the cost of reinforcing the first

floor ceiling with cement. Hagerman did not obtain an estimate

for the cement work from a contractor.
 - 22 -

Meanwhile petitioner had its architects draw up plans for

remodeling. In or around January 1990, petitioner submitted

these plans to the Building and Safety Department for approval.

In March 1990 county officials notified petitioner that the

proposed remodeling, by increasing seating capacity in the

complex, would also increase the required minimum parking

capacity for the complex from 36 to 55 spaces. At the time,

available parking was limited to 39 spaces. For the next year

and a half the remodeling plans were suspended while petitioner’s

management attempted to rent or purchase additional parking

space. After numerous inquiries, Krontz successfully negotiated

for the purchase of a nearby parcel. The sale agreement was duly

submitted to the county for approval, but the county refused, on

the ground that petitioner’s use of the land for additional

parking would contravene a preexisting ordinance imposing a

moratorium on the expansion of adult entertainment businesses.

Accordingly, Krontz arranged for an affiliate named MIC, Ltd.

(MIC), to purchase the land and rent it to petitioner. Under the

final terms of the deal, MIC acquired the land for $490,000,

financed in part by a loan of approximately $150,000 from

petitioner, and MIC leased the land to petitioner at a rental

rate of $8,000 per month. The record does not disclose the dates

of the sequence of events leading to the conclusion of the lease

agreement.
 - 23 -

Remodeling work began in October 1991. In November county

officials closed petitioner’s complex because the remodeling had

been undertaken without a permit. The work was allowed to resume

in January 1992 on the condition that most of it be redone in

accordance with county specifications. Remodeling was completed,

and petitioner reopened in the following month.

The need for parking space was only one of the reasons that

petitioner’s management looked for real estate during the years

at issue. Hagerman was always interested in opportunities to

expand the adult entertainment business to new locations. In the

spring of 1989 Hagerman negotiated for the purchase of a nearby

video store for a price of $163,000. In a letter to her attorney

dated April 10, 1989, she explained her intentions: “This

purchase should be in my name I think. Maybe we will get a

corporation later. What do you think? I plan to have a

partner.” A draft sale agreement dated May 1989 records the

purchaser as “Platinum Paradise, Inc., a California Corporation

to be formed.” Hagerman discussed a number of potential

acquisitions with Mohney and made some inquiries. At Mohney’s

suggestion, in 1991 she traveled to Melbourne, Australia, to look

at a brothel advertised in the Wall Street Journal. At one time

Mohney identified a chicken ranch in Nevada, and at another a

golf course in Mexico. Petitioner reported no real estate

holdings on Schedule L of its U.S. Corporation Income Tax
 - 24 -

Returns, Forms 1120, for any of the taxable years at issue. No

written plans for petitioner’s expansion were ever prepared.

The threat of exclusionary zoning or closure by county

authorities provided another reason to explore other possible

locations. Krontz began looking for potential relocation sites

when his employment began in June 1990, and he continued his

search through the remainder of the years at issue. Initially

there was only an apprehension that petitioner might be required

to relocate at some time in the future. With the enactment of

Ordinance No. 3465 in October 1991, the date for petitioner’s

departure was fixed. Under the new ordinance adult entertainment

businesses were prohibited in all areas where prior zoning laws

had required them to locate and were permitted only in an area

from which prior law had excluded them. All existing adult

entertainment businesses rendered nonconforming by the zoning

change were required to cease operations at their current

locations by January 1, 1995. Krontz entered into negotiations

for the purchase of 16 acres in Mira Loma, California.

Negotiations probably began in late 1991 and continued into 1994.

Petitioner made an offer for the property of $1.15 million; the

owner made a counteroffer of $1.25 million. The parties were

contemplating a downpayment of $100,000 and seller financing for

the balance. Ultimately the parties reached agreement, but the

deal was abandoned before closing on account of a preemptive

zoning change in the Mira Loma area. Krontz looked for several
 - 25 -

properties for sale or rent as potential relocation sites. But

there is no evidence of negotiations for specific properties

besides the Mira Loma parcel at any time during the years at

issue.

On its U.S. Corporation Income Tax Returns, Forms 1120,

petitioner reported the following receipts and expenditures for

each taxable year:

Taxable Depr. Nonresidential Depr.
Year Ended Gross Legal Repair Real Property Equipment
August 31 Receipts Expenses Expenses Improvement Costs Costs

1985 $117,092 $1,014 $6,592 --- $12,491
1986 192,046 19,174 3,074 --- 19,036
1987 635,823 51,243 12,656 --- ---
1988 1,483,367 24,501 11,331 --- 255,358
1989 1,780,816 52,951 22,420 --- 8,332
1990 2,157,610 11,306 17,582 $7,125 34,448
1991 2,036,202 4,316 21,394 --- 17,078
1992 1,568,110 14,649 24,823 352,420 130,523

Petitioner made no distributions to its shareholders before

TYE 8/31/91. In that year it distributed $65,000 as a dividend.

In the following taxable year it distributed a dividend of

$50,000. During the years at issue petitioner made sizeable loans

to other corporations within the Mohney Group. With the

exception of the loan it made to MIC in order to help finance the

acquisition of parking space for the use of petitioner’s patrons,

no connection between these loans and petitioner’s business is

apparent from the evidence. Petitioner's loans to affiliates for

purposes unrelated to its business totaled at least $50,000 in
 - 26 -

TYE 8/31/88, $702,000 in TYE 8/31/90, and $306,000 in TYE

8/31/91.

Discussion

Section 531 imposes a penalty tax on the accumulated taxable

income of a corporation that is availed of for the purpose of

avoiding tax with respect to its shareholders by permitting

earnings and profits to accumulate instead of distributing them.

Secs. 531, 532(a). The fact that earnings and profits have

accumulated beyond the reasonable needs of the business

establishes a presumption that tax avoidance was a purpose of the

accumulation. Sec. 533(a). The reasonable needs of the business

include reasonably anticipated future needs. Sec. 1.537-1(a),

Income Tax Regs. In order to justify an accumulation for

reasonably anticipated future needs, in general, the corporation

must demonstrate a need warranting such accumulation and the

existence, as of the end of the relevant taxable year, of

specific, definite, and feasible plans to use the accumulation

within a reasonable time to meet this need. Sec. 1.537-1(b),

Income Tax Regs. In recognition of the informality which

commonly characterizes planning within a closely held

corporation, neither the regulations nor the cases require

meticulously drawn formal blueprints for action. Faber Cement

Block Co. v. Commissioner, 50 T.C. 317, 332 (1968); Bremerton Sun

Publishing Co. v. Commissioner, 44 T.C. 566, 584-585 (1965). But

where such documentation is lacking, the intention to dedicate
 - 27 -

corporate resources to identified business needs must be

unambiguously evidenced by some contemporaneous course of action

toward this end. Cheyenne Newspapers, Inc. v. Commissioner, 494

F.2d 429, 433-434 (10th Cir. 1974), affg. T.C. Memo. 1973-52;

Smoot Sand & Gravel Corp. v. Commissioner, 241 F.2d 197, 202 (4th

Cir. 1957), affg. in part and revg. in part T.C. Memo. 1956-82;

Snow Manufacturing Co. v. Commissioner, 86 T.C. 260, 273-274, 277

(1986). Section 534 provides that under certain circumstances

the burden of proof with respect to the question whether earnings

and profits have accumulated beyond the reasonable needs of the

business may be shifted to the Government. The parties have

stipulated that petitioner continues to bear the burden of proof.

Rule 142(a).

Working Capital

A corporation may accumulate earnings in order to provide

necessary working capital for its business. Sec. 1.537-2(b)(4),

Income Tax Regs. Respondent determined the amount of working

capital that petitioner needed for one operating cycle by the

approach originally expounded in Bardahl Manufacturing Corp. v.

Commissioner, T.C. Memo. 1965-200. Petitioner has offered its

own Bardahl calculations.4 The details of our own calculations

4
In its trial memorandum and on cross-examination, however,
petitioner questioned the use of the Bardahl analysis to
determine working capital needs of a business like petitioner’s
that involves substantial services in addition to the sale of
inventory. The measurement of petitioner’s working capital needs
(continued...)
 - 28 -

of petitioner’s available net liquid assets and working capital

needs are set forth in the Appendix, together with annotations

discussing certain methodological issues on which we disagreed

with one or both of the parties.

Reserve for Legal Expenses

Petitioner contends that the various legal risks to which it

was exposed would have justified the accumulation of a reserve

for legal expenses equal to $250,000 for each of the taxable

years at issue. Respondent determined that no amounts were

allowable as accumulations for this purpose. We are satisfied

that respondent’s determination is correct.

Petitioner attempted to prove the extent of its need

attributable to the policy of providing legal representation to

employees and independent contractors subject to prosecution. We

do not question the reasonableness of the policy. The testimony

petitioner presented on this issue did not establish how much

petitioner expected to require for this purpose, however.

4
(...continued)
is a question of fact on which petitioner has the burden of
proof. Rule 142; Smoot Sand & Gravel Corp. v. Commissioner,
241 F.2d 197, 207 (4th Cir. 1957), affg. in part T.C. Memo.
1956-82. We think petitioner is correct to question the
applicability to this case of a methodology developed for
nonservice businesses. See Myron’s Ballroom v. United States,
382 F. Supp. 582, 588 (C.D. Cal. 1974), revd. on other grounds
sub nom. Myron’s Enterprises v. United States, 548 F.2d 331 (9th
Cir. 1977); Simons-Eastern Co. v. United States, 354 F. Supp.
1003, 1007 (N.D. Ga. 1972). But petitioner has not suggested any
alternative. Therefore we shall use the parties’ Bardahl
calculations as the starting point for our analysis.
 - 29 -

Hagerman testified regarding petitioner’s representation of the

six dancers in 1988. She was asked how much she anticipated

their representation would cost at the time of their arrest. She

replied: “At the time I thought around $20,000 apiece if each

one had their own attorney if they didn’t want us to represent--

the corporation to represent them.” When asked whether she meant

that petitioner was prepared to pay this amount, she confirmed

that that was not the case: petitioner would have covered their

legal expenses only if they did not want their own individual

attorneys. Thus, while we know that petitioner paid for the

dancers’ defense, we do not know how much petitioner’s management

expected this representation would cost. The amount petitioner

actually spent to defend the dancers was clearly much less than

the amount Hagerman believed it would have cost the dancers to

secure their own representation. The arrests occurred in June

1988, the trial June 1989. On its Forms 1120 for TYE 8/31/88 and

TYE 8/31/89, petitioner reported aggregate legal expenses in the

amounts of $24,501 and $52,951, respectively.

Petitioner presented no evidence that any amount was set

aside for the dancers’ defense. Even if some specific amount was

set aside, this fact would not explain accumulations in any of

the taxable years at issue, since the evidence indicates that the

representation concluded before the end of the first of these

years. Based on the amounts petitioner actually spent for the

dancers’ defense in TYE 8/31/88 and TYE 8/31/89, we are not
 - 30 -

persuaded that petitioner’s management would have believed that

current cash-flows would be insufficient to finance the company’s

legal defense obligations to employees and contractors as they

arose.

Hagerman testified regarding concerns she had during TYE

8/31/89 that the company might become involved in protracted

litigation costing several hundred thousand dollars as a result

of liability under the Child Protection and Obscenity Enforcement

Act. We do not believe her testimony establishes a specific and

definite plan to prepare for such a lawsuit. She evidently

possessed no clear idea of how provisions of the act might apply

to petitioner and what challenging it would entail at the time.5

Nor does there appear to have been any reason to plan for

litigation in determining whether to retain or distribute

earnings at the close of TYE 8/31/89--or at the close of any

subsequent taxable year--in light of the reassurances petitioner

received from its attorneys in June 1989 about the Government’s

decision not to pursue enforcement of the act.

5
When asked whether she anticipated a need to hold funds in
reserve when she learned about the act, she replied: “My first
inkling was we may have to fight this if we were somehow cited *
* * because we weren’t complying with something that we knew
nothing about.” “Anything when you fight the United States
Government is going to cost hundreds of thousands of dollars it
seems that way. It goes on and on for years.” There is no
evidence that her thinking on this matter advanced beyond the
initial stage of vague alarm and consternation she described.
 - 31 -

Petitioner presented expert testimony that it would have

been reasonable to set aside $100,000 to $250,000 to provide for

the legal expense of defending itself against exclusionary

zoning. Petitioner argues that it was therefore justified in

accumulating this amount in each taxable year. If petitioner in

fact planned accumulations for this purpose, the accumulations

may well have been justified. The existence of a reasonable

need, however, does not suffice to establish the existence of a

specific, definite, and feasible plan to meet the need.

Snow Manufacturing Co. v. Commissioner, 86 T.C. at 277. Krontz

testified that he had been expecting Ordinance No. 3465 for some

time before its enactment in October 1991. Yet there is no

evidence that petitioner’s management formulated plans to

challenge the ordinance, let alone provide for the costs of such

a challenge at any time during the years at issue. Based upon

the company’s experience challenging the constitutionality of the

predecessor of Ordinance No. 3465 between 1985 and 1987, it would

have been reasonable to expect the costs of such litigation would

be spread over more than 1 year and could easily be covered by

the current year’s cash flow. Petitioner’s total legal expenses

during the years of the prior litigation amounted to only

approximately $70,000. We are not persuaded that any portion of

the accumulations for TYE 8/31/89 through TYE 8/31/92 can be

accounted for by plans to provide for anticipated legal expenses.

Workers’ Compensation
 - 32 -

Petitioner argues that owing to the cancellation of its

workers’ compensation insurance, it was justified in accumulating

$50,000 in each of TYE 8/31/90 through TYE 8/31/92. Respondent

properly allowed no amounts as a reserve for this purpose. There

is no question that petitioner would have been justified in

reserving funds for self-insurance. Petitioner’s argument fails

because there is no evidence to substantiate the existence of a

plan to accumulate $50,000 or any other amount specifically to

meet this need. The testimony of petitioner’s president leaves

little doubt that there was no such plan.6

Business Interruption

Petitioner alleges on brief that it had always planned for a

business interruption like the one it experienced from November

1991 through February 1992, and that it recognized the need to

reserve funds. Therefore “prudent business practice requires

retaining an amount of earning equal to three (3) months

operating expenses because of the nature of the business.” The

6
After counsel elicited from Hagerman the general
observation that “the size of lawsuits these days--everybody asks
for at least a half a million to several million for no matter
what they do,” the following colloquy occurred:
Q: Did--but did you consider yourself a minimum amount
that Eyefull should have on hand in the event that any
employee was injured?
A: No, not really, knowing that you’d need at least a half
a million. I would just guess a half a million.
Q: Did you as president of Eyefull set aside some funds
for that contingency?
A: Not particularly for the Workers’ Comp. There was
always funds set aside for the rainy days. I suppose
that would be a rainy day problem.
 - 33 -

record contains no support for these allegations. That

petitioner’s business was interrupted for 3 months does not imply

that petitioner could have expected or did expect the need for a

3-month reserve. Nor do we understand why operating costs, which

are generally not incurred during a period of business

suspension, would be an appropriate measure of the funds needed.

The argument is a transparent effort to rationalize accumulations

after the fact, and respondent properly rejected it.

Building Improvements and Equipment Replacement

Petitioner contends that plans for building improvements and

investment in new equipment, both executed during TYE 8/31/92,

justify accumulations of $450,000 at the end of TYE 8/31/90 and

TYE 8/31/91. Respondent allowed no amounts for these purposes

for either taxable year.

On its Form 1120 for TYE 8/31/92, petitioner reported

capital expenditures for building improvements carried out

between October 1991 and February 1992 at a cost of $352,420.

Testimony confirmed that this work consisted, in part, of

remodeling for which petitioner had submitted an architect’s

plans to the county for approval in or around January 1990. In

part, the work also involved correction of building code

violations. Petitioner had been notified of building code

violations on several occasions between early TYE 8/31/90 and TYE

8/31/91, and internal corporate documents indicate that some of

these violations were corrected before TYE 8/31/92. The most
 - 34 -

costly structural changes, including cement reinforcement of the

first floor ceiling, were probably performed at the same time as

the remodeling work in TYE 8/31/92 because the expenditures for

repairs and improvements reflected on petitioner’s tax returns

for TYE 8/31/89, TYE 8/31/90, and TYE 8/31/91 are comparatively

modest and do not even approach Hagerman’s estimate of the total

cost of compliance. The need to make these structural changes

had been identified in TYE 8/31/90, and specific plans for

compliance were required. Consequently we believe that the plans

that were eventually executed at a cost of $352,420 in the first

half of TYE 8/31/92 could reasonably explain an accumulation of

approximately this amount at the end of both TYE 8/31/90 and TYE

8/31/91.

Under some circumstances, a lengthy delay in the execution

of alleged plans invites skepticism as to whether the plans were

sufficiently definite and specific to satisfy the requirements of

the regulations. See Suwannee Lumber Manufacturing Co. v.

Commissioner, T.C. Memo. 1979-477; sec. 1.537-1(b), Income Tax

Regs. In this case the delay is understandable. Remodeling was

contingent on county approval, county approval was contingent on

the availability of additional parking space, and coordination of

the major structural corrections with the elective remodeling

work was likely to have been efficient from both an economic and

architectural standpoint. Considering the bureaucratic and

technical complications, we do not interpret a delay of 1 to 2
 - 35 -

years as an indication that petitioner lacked either a clear idea

of the work to be done or a determination to do it as soon as

practicable.

Petitioner’s tax return for TYE 8/31/92 shows that $130,523

was incurred in that year to acquire numerous items of

depreciable property ranging in cost from a few hundred to a few

thousand dollars. The property consists of lighting, sound

system, video vender booths, and the like, for the most part

equipment that would have been used for normal business

operations. Virtually all the items were classified as 7-year

property for ACRS purposes. During the 7-year history of its

business operations, in only one other year, TYE 8/31/88, had

petitioner made comparable expenditures on equipment. Some of

the purchases seem to represent normal replacement; some may

represent expansion of capacity concomitant with the remodeling

work that occurred in the same year. The nature of the items and

the circumstances of their acquisition suggest that the

expenditures could reasonably have been anticipated as of the end

of TYE 8/31/90 and TYE 8/31/91. But nothing in the record

confirms that large-scale equipment replacement and expansion of

capacity were in fact contemplated at these times. The evidence

is equally consistent with the inference that, for most of the

items, the purchase decision was made during TYE 8/31/92. Even

if petitioner’s management did plan the acquisitions prior to TYE

8/31/92, the total cost was not so large in relation to
 - 36 -

petitioner’s cash flow that they could not reasonably have

expected to be able to finance the acquisitions without

accumulation. Therefore the acquisitions do not explain any part

of the accumulations in TYE 8/31/90 and TYE 8/31/91.

Parking

Petitioner argues that its efforts to secure additional

parking to comply with County Building and Safety Department

requirements justify an accumulation of $500,000 in TYE 8/31/91

and TYE 8/31/92. Respondent allowed no amount for this purpose.

Petitioner presented evidence of only one definite purchase

plan that would have warranted an accumulation in any of the

years at issue. This was the plan to acquire the property that

petitioner is currently renting from MIC. Once petitioner

concluded leasing arrangements with MIC, its needs would have

been satisfied and no accumulation of funds to acquire property

for parking would be justified. No evidence in the record fixes

the time of this transaction. We can confidently infer, however,

that petitioner and MIC had reached an agreement before the end

of TYE 8/31/92, because the loan to MIC, which partly financed

MIC’s acquisition of the rental property, appears on petitioner’s

tax return for TYE 8/31/92.

It is possible that petitioner had already abandoned its

plan to purchase the property before the end of TYE 8/31/91.

Krontz testified that petitioner paid MIC $8,000 per month, or

$96,000 per year under the lease. On its tax return for TYE
 - 37 -

8/31/92, petitioner claimed a deduction for rent that was $91,681

higher than the deduction it had claimed for TYE 8/31/91. If the

increase in rental payments was attributable to the MIC lease,

then petitioner paid MIC an amount corresponding to slightly less

than 11-1/2 months rent. The lease might therefore have taken

effect within the first few weeks of TYE 8/31/92.

Corroboration of this inference can be found in the fact

that after a delay of 1-1/2 years due largely to its inability to

comply with the county parking requirements, petitioner commenced

remodeling work in October 1991, the second month of TYE 8/31/92.

To have proceeded with its remodeling plans before securing

additional parking space in defiance of the Building and Safety

Department would have been self-defeating and utterly

inconsistent with the deferential and responsible attitude that

petitioner’s management had hitherto displayed in its dealings

with the department. If petitioner began leasing the property

just after the start of TYE 8/31/92, there is a high probability

that by the end of TYE 8/31/91 either there was an agreement in

principle with MIC or the county had rendered its decision

denying approval to petitioner’s plan to purchase the property.

In either case the abandoned purchase plan could not justify any

part of the accumulations at the end of TYE 8/31/91. Having

failed to fix the chronology of these events more precisely in

relation to the close of TYE 8/31/91, petitioner has not

satisfied its burden of proof.
 - 38 -

Expansion and Relocation

Petitioner attempted to prove that its accumulations were

needed to finance costs of relocation amounting to $1 million or

more and to finance the expansion and diversification of its

business. Respondent determined that no accumulations were

allowable for these purposes.

There is no basis for concluding that petitioner reasonably

retained earnings for expansion or diversification during the

years at issue. Hagerman testified regarding a number of

specific investment possibilities that she considered. The only

one for which there is evidence of actual negotiations was the

video store that she offered to purchase in 1989. Contrary to

her account at trial, however, contemporaneous documents indicate

that she was not negotiating the acquisition on petitioner’s

behalf.

The threat to petitioner’s continued operation that arose

first from the expiration of its theater license and later from

Ordinance No. 3465 would have warranted financial preparations

for relocation. The various costs of reestablishing petitioner’s

business in a new location would have been substantial. Hagerman

anticipated that they could exceed $1 million. It does not

follow, however, that petitioner’s management had specific,

definite, and feasible plans to provide for such costs. If after

expiration of the theater license petitioner’s management

recognized a need to accumulate $1 million and were determined to
 - 39 -

do so, the financial policies they actually implemented in

TYE 8/31/90 and TYE 8/31/91 belied their intentions.

In TYE 8/31/90, petitioner made loans unrelated to its

business totaling $702,000, leaving it with net liquid assets

sufficient to cover only its needs for working capital and a

portion of the expected costs of remodeling (see Appendix Table

2). If all the loans had been made early in the taxable year,

one might be able to argue that petitioner’s management approved

them on the basis of an overestimate of petitioner’s earnings for

the year. In fact the loans were made throughout the year.

In TYE 8/31/91, we observe a similar pattern. Petitioner

ended the taxable year with a modest excess of net liquid assets

over its needs for working capital and remodeling (see Appendix

Table 2). But it could have accumulated an additional $650,000

toward the $1 million target if it had not made further loans

unrelated to its business totaling $306,000 and in the last month

of the taxable year transferred $340,000 in precious metal

holdings to Mohney and its shareholders. If these assets were

genuinely needed for a relocation fund, a distribution to the

shareholders could not be justified. Nor was there an obligation

to pay the consulting fees. Since TYE 8/31/85, Mohney had

permitted petitioner to defer payment of the fees so long as

financial circumstances required retention of the funds. During

TYE 8/31/90 and TYE 8/31/91, petitioner’s management looked for

replacement property, but there is no evidence that their
 - 40 -

inquiries advanced to the point of negotiating for any of the

properties they saw.

Petitioner’s situation changed markedly in TYE 8/31/92. The

taxable year began with the enactment of Ordinance No. 3465

requiring petitioner to relocate by January 1, 1995. If this

were not sufficient to impress petitioner’s management with the

urgent need for resolute action, shortly thereafter they received

a strong foretaste of the fate that awaited when, in November,

county officials closed petitioner’s complex and business

stopped. Now Krontz’ searches bore fruit. A property was

identified in Mira Loma. An offer of $1.15 million was made; a

counteroffer of $1.25 million was received. Negotiations over

details of the transaction carried over into the next taxable

year. There is no evidence that petitioner made any loans

unrelated to its business in TYE 8/31/92.

Once petitioner’s management had concrete prospects of an

investment exceeding $1 million, the likelihood that they took

this into account in their financial planning greatly increases.

How much they could reasonably have accumulated for this purpose

is not clear. The Mira Loma deal would have involved seller

financing: to acquire the property petitioner would have had an

immediate need for only the $100,000 downpayment. But there

would have been various other costs as well, including

construction costs and costs to secure permits and favorable

zoning. Petitioner did not prove exactly how much it would have
 - 41 -

needed. But we need not determine this. We need only determine

whether petitioner has adequately explained the excess of its net

liquid assets as of the close of TYE 8/31/92 over the amount it

would have required for working capital. This excess was

approximately $45,000 (see Appendix Table 2). Since the required

downpayment alone would have exceeded this amount, we are

satisfied that petitioner did not allow its earnings to

accumulate beyond the reasonable needs of its business in this

year.

Conclusions

Table 2 in the Appendix sets forth the calculations

supporting our conclusion that petitioner allowed its earnings to

accumulate beyond the reasonable needs of its business for the

first 3 of the 4 taxable years at issue. The underlying

methodology is well established in the case law and requires no

elaboration. See Snow Manufacturing Co. v. Commissioner, 86 T.C.

at 280-282; Alma Piston Co. v. Commissioner, T.C. Memo. 1976-107,

affd. 579 F.2d 1000 (6th Cir. 1978); Bardahl Manufacturing Corp.

v. Commissioner, T.C. Memo. 1965-200; Grob, Inc. v. United

States, 565 F. Supp. 391 (E.D. Wis. 1983). For purposes of

comparing petitioner’s reasonable needs with the net liquid

assets available to meet those needs, the loans made to

affiliates for purposes that had no relation to petitioner’s

business are treated as liquid assets. Faber Cement Block Co. v.
 - 42 -

Commissioner, 50 T.C. at 330; Bardahl Manufacturing Corp. v.

Commissioner, supra.

The fact that a corporation accumulated earnings and profits

beyond the reasonable needs of the business is determinative of

the purpose to avoid income tax with respect to its shareholders,

unless the corporation proves the contrary by a preponderance of

the evidence. Sec. 533(a). This presumption cannot be rebutted

merely by evidence that tax avoidance was not the exclusive,

primary or dominant motive for the accumulations: to escape

liability for the accumulated earnings tax the corporation must

prove that tax avoidance was not one of the purposes.

United States v. Donruss Co., 393 U.S. 297 (1969). Cases in

which unreasonable accumulations have been fully explained by

legitimate corporate considerations are few. See, e.g.,

Bremerton Sun Publishing Co. v. Commissioner, 44 T.C. 566 (1965).

Viewing the record as a whole, we find that petitioner had a

general policy of retaining its earnings. As petitioner’s

president confirmed when asked whether the company was setting

aside funds or whether she herself made a decision to set aside

funds for any purpose during the years at issue: “It was not a

conscious decision. We knew always that you had to have funds

for anything that you would want to expand, or build, or do

renovations.” By routinely retaining earnings, whether or not an

identifiable need for a specific amount existed at the time,

petitioner’s management assured themselves that, as she put it,
 - 43 -

“there was always funds set aside for the rainy days.”

Petitioner accumulated partly to provide for its own potential

needs. Evidently an understanding existed among companies within

the Mohney Group that any surplus accumulated by one member

should be made available to other members who needed the funds.

“We are all friends, we help each other out,” Hagerman explained.

Thus, through loans to its affiliates of over $1 million in TYE

8/31/90 and TYE 8/31/91, petitioner’s surpluses were applied to a

constructive use somewhere in the group.

Petitioner attempts to justify its policy by the observation

that commercial lending is essentially impossible for adult

entertainment businesses to obtain. This may well be true, but

it does not satisfactorily account for the retention of earnings

without specific, definite, and feasible plans to use them. By

consenting to the accumulation and pooling of earnings by

petitioner and other members of the Mohney Group, the common

owners were implicitly providing the financing that was

unavailable from commercial sources. If petitioner had regularly

distributed surplus funds, there is no reason to expect that its

shareholders would not have been willing to reinvest their

dividends in the Mohney Group wherever and whenever a definite

need arose. Petitioner’s explanation is not sufficient to rule

out the possibility that its policy was designed to serve tax

avoidance purposes as well. Petitioner has not carried its

burden of proof. Accordingly, it is liable for accumulated
 - 44 -

earnings tax for TYE 8/31/89, TYE 8/31/90, and TYE 8/31/91 in the

amounts of $26,105, $159,153, and $93,515, respectively (see

Appendix Table 2).

Issue 3: Additions to Tax and Penalties

Background

During the taxable years at issue petitioner retained Modern

Bookkeeping, Inc. (Modern), to provide bookkeeping services and

to prepare petitioner’s tax returns. In late 1987 Modern had

hired Certified Public Accountant David Shindel (Shindel) to

oversee tax compliance with respect to five of Modern’s clients.

Shindel supervised the preparation of work papers and tax returns

and signed the returns when satisfied that they reasonably

complied with the tax laws. The scope of Shindel’s engagement

was extended to petitioner by 1989. In the course of his review,

he soon became concerned that petitioner’s sizeable retained

earnings might subject it to liability for the accumulated

earnings tax. He attempted to determine whether the

accumulations were reasonable. At some time in 1989 he brought

this problem to Mohney’s attention, because he knew Mohney was

actively involved in petitioner’s management.

Shindel prepared and signed petitioner’s Forms 1120 for each

of the taxable years at issue. The Forms 1120 for TYE 8/31/89,

TYE 8/31/90, and TYE 8/31/91 were filed on November 14, 1990,

December 11, 1991, and June 3, 1992, respectively. In her notice

of deficiency, respondent determined that petitioner was liable
 - 45 -

for additions to tax under section 6651 for TYE 8/31/89, TYE

8/31/90, and TYE 8/31/91; the addition to tax under section

6653(a) for TYE 8/31/89; and accuracy-related penalties under

section 6662(a) for TYE 8/31/90 and TYE 8/31/91.

Discussion

An addition to tax is imposed under section 6651 for failure

to file a return within the prescribed period, unless it is shown

that such failure was due to reasonable cause and not due to

willful neglect. Sec. 6651(a)(1). The amount of the addition is

5 percent of the amount required to be shown as tax for each

month that the delinquency persists, up to a maximum of

25 percent. Delinquent filing is due to reasonable cause if the

taxpayer exercised ordinary business care and prudence, but was

nevertheless unable to file its tax return in a timely manner.

Sec. 301.6651-1(c)(1), Proced. & Admin. Regs. Reliance upon a

professional return preparer does not constitute reasonable cause

for failure to meet the filing deadline. United State v. Boyle,

469 U.S. 241, 253 (1985). The burden of proving reasonable cause

and the absence of willful neglect is on the taxpayer. Rule

142(a).

Petitioner filed its returns for TYE 8/31/89 and TYE 8/31/90

approximately 1 year late and its return for TYE 8/31/91 more

than 6 months late. Petitioner argues that it exercised ordinary

business care and prudence because it relied upon Modern to
 - 46 -

handle its returns. United States v. Boyle, supra, forecloses

this argument. Petitioner is liable for the addition to tax.

For TYE 8/31/89, section 6653(a) provides for an addition to

tax equal to 5 percent of an underpayment of tax if any part of

the underpayment is due to negligence. “Negligence” includes any

failure to make a reasonable attempt to comply with the

provisions of the Code. Sec. 6653(a)(3). For purposes of

section 6653(a), the term “underpayment” has the same meaning as

“deficiency” as defined in section 6211(a), except that the

amount shown on the return is treated as zero if the return was

filed after the prescribed deadline, including any extension.

Sec. 6653(c)(1). Delinquent filing is prima facie evidence of

negligence. Emmons v. Commissioner, 92 T.C. 342, 349 (1989),

affd. 898 F.2d 50 (5th Cir. 1990). Where the taxpayer cannot

prove reasonable cause and the absence of willful neglect for

purposes of section 6651(a)(1), the taxpayer cannot carry its

burden of proof for purposes of section 6653(a). Condor Intl.,

Inc. v. Commissioner, 98 T.C. 203, 225 (1992), affd. in part and

revd. in part 78 F.3d 1355 (9th Cir. 1996).

Since petitioner’s return for TYE 8/31/89 was untimely

filed, the entire amount of the tax due is treated as an

underpayment. Since this underpayment was attributable to
 - 47 -

conduct that constitutes negligence and petitioner can offer no

excuse, it is liable for the addition to tax.7

Section 6662(a) and (b)(1)8 imposes an accuracy-related

penalty equal to 20 percent of the portion of an underpayment of

tax that is attributable to negligence. For purposes of section

6662, unlike section 6653, the amount shown on a late return is

not treated as an underpayment. Sec. 6664(a)(1). Consequently

delinquency, by itself, is not grounds for the accuracy-related

penalty. Sec. 1.6662-2(a), Income Tax Regs. As under prior law,

“negligence” includes any failure to make a reasonable attempt to

comply with the provisions of the Code. Sec. 6662(c). A

position with respect to an item is attributable to negligence if

the taxpayer failed to maintain adequate records to substantiate

7
Cf. Lazore v. Commissioner, 11 F.3d 1180, 1188-1189 (3d
Cir. 1993), revg. in relevant part T.C. Memo. 1992-404 (holding
that an underpayment was not attributable to delinquency because
the taxpayers would have reported no tax due even if they had
filed on time). In a footnote to its decision, the Court of
Appeals for the Third Circuit questioned the soundness of the
holding in Emmons v. Commissioner, 92 T.C. 342 (1989), affd. 898
F.2d 50 (5th Cir. 1990), that in the absence of extenuation
delinqency is grounds for imposition of the addition to tax under
sec. 6653. Lazore v. Commissioner, supra at 1189 n.4. Although
we reaffirm our belief in the logic of Emmons v. Commissioner,
supra and Condor Intl., Inc. v. Commissioner, 98 T.C. 203 (1992),
affd. in part and revd. in part 78 F.3d 1355 (9th Cir. 1996), we
note that our result for TYE 8/31/89 would not differ under the
negligence analysis we use in applying sec. 6662(a) and (b)(1) to
TYE 8/31/90 and TYE 8/31/91, infra. See Pessin v. Commissioner,
59 T.C. 473, 489 (1972).
8
Although the notice of deficiency determined negligence
(sec. 6662(b)(1)) and substantial understatement (sec.
6662(b)(2)) as alternative theories for imposition of the
penalty, on brief respondent pursued only the former theory.
 - 48 -

it properly. Valadez v. Commissioner, T.C. Memo. 1994-493;

sec. 1.6662-3(b), Income Tax Regs.

The accuracy-related penalty does not apply to any part of

an underpayment for which the taxpayer had reasonable cause and

acted in good faith. Sec. 6664(c)(1). In order for reliance on

the judgment of a competent tax return preparer to qualify for

this exception, the taxpayer must demonstrate that the return

preparer formed his judgment on the basis of information that the

taxpayer believed, and had reason to believe, was complete and

accurate. United Circuits, Inc. v. Commissioner, T.C. Memo.

1995-605; Conway v. Commissioner, T.C. Memo. 1994-405; Saghafi v.

Commissioner, T.C. Memo. 1994-238; sec. 1.6664-4(b)(1), Income

Tax Regs.

The underpayments for TYE 8/31/90 and TYE 8/31/91 are

attributable to a bad debt deduction that was conceded before

trial and unreasonable accumulations of earnings. Petitioner

presented no evidence in regard to the basis for the bad debt

deduction that it did not litigate. It could offer scarcely more

documentation to substantiate the business plans by which it

attempted to justify its accumulations. The underpayments are

therefore attributable to negligence.

Petitioner takes the position that the unsubstantiated

positions to which the underpayments are attributable can be

justified by its reliance on Modern. Shindel prepared and signed

petitioner’s tax returns for both years. His experience and
 - 49 -

qualifications clearly were sufficient to warrant reliance upon

his judgment. Yet without knowing what Shindel understood the

purposes for the accumulations to be and on what information this

understanding was based, we cannot conclude that petitioner

reasonably and in good faith relied on his judgment. Shindel

discussed the accumulated earnings problem with Mohney,

petitioner’s de facto chief executive. Counsel might have

elicited from Shindel and/or Mohney testimony bearing on this

important question. It remains, however, unanswered. Petitioner

could not have underpaid its tax in good faith if, as section

533(a) requires us to presume, petitioner’s management permitted

corporate earnings to accumulate unreasonably in order to defer

shareholder-level withholding tax, and they were aware that this

motive subjected petitioner to liability for the accumulated

earnings tax. Petitioner has not satisfied its burden of proof.

The accuracy-related penalty therefore applies.

To reflect the foregoing,

Decision will be entered

under Rule 155.
 - 50 -

Appendix

Table 1

TYE TYE TYE TYE
Bardahl Computations Aug. 31, 1989 Aug. 31, 1990 Aug. 31, 1991 Aug. 31, 1992
1,2 9,10 15,16 23
Operating Expenses 1,452,981 1,596,783 1,807,151 1,838,351
Cost of Goods Sold 324,128 433,311 440,046 322,254
Peak Inventory 93,197 93,197 68,597 68,597
Days in Inventory Cycle 104.95 78.50 56.90 77.70
Days in Receivables Cycle - 0 - - 0 - - 0 - 0.88
Average Payables 77,840 41,665 37,384 38,549
3 11 17 24
Days in Credit Cycle 19.55 9.52 6.85 7.65
Days in Operating Cycle 85.40 68.98 50.05 70.05
Amount of Working Capital Needs,
4 12 18 25
One Cycle 339,943 301,753 247,580 352,793
5 19 26
Current Assets 673,078 925,474 1,211,367 504,060
6 20
Current Liabilities 243,264 405,318 452,127 106,638
Net Liquid Assets Available
for Needs 429,814 520,156 759,240 397,422

Computation of Accumulated
Taxable Income
7 13 21
Taxable Income 656,329 1,107,258 736,378 166,160
8 8 22
Less Income Taxes Paid or Accrued 223,152 376,468 205,535 56,494
Less Dividends Paid Deduction - 0 - - 0 - 65,000 50,000
Current Earnings and Profits
Retained 433,177 730,790 333,981 59,666
Less Accumulated Earnings Credit 339,943 162,387 - 0 - 59,666
Accumulated Taxable Income 93,234 568,403 333,981 - 0 -
 - 51 -

Table 2

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Anticipated Accumulation
Increase Working Beyond
In Earnings Net Capital Total Excess Investment Loans Reasonable
Accumulated & Profits Liquid Needs Anticipated Reasonable Liquid Unrelated Unrelated Needs
Earnings & Over Prior Assets For One Extraordinary Needs Assets To To (3)+(8)
TYE Profits Year Available Cycle Needs (4)+(5) (3)-(6) Business Business +(9)-(6)
8/31/88 268,371

8/31/89 701,548 433,177 429,814 339,943 -0- 339,943 89,871 -0- -0- 89,871

8/31/90 1,432,338 730,790 520,156 301,753 352,000 653,753 (133,597) -0- 702,000 568,403

8/31/91 1,766,319 333,981 759,240 247,580 352,000 599,580 159,660 -0- 306,000 465,660

8/31/92 1,825,985 59,666 397,422 352,793 >44,629 >397,422 -0- -0- -0- -0-

TYE 8/31/89 TYE 8/31/90 TYE 8/31/91 TYE 8/31/92
(1) Assets in columns (3)+(8)+(9) 429,814 1,222,156 1,065,240 397,422

(2) Less current earnings and profits retained 433,177 730,790 333,981 59,666

(3) Prior accumulation available for reasonable -0- 491,366 731,259 337,756
needs

(4) Reasonable needs 339,943 653,753 599,580 >397,422

(5) Current earnings and profits retained for
reasonable needs (4)-(3) sec. 535(c)(1) 339,943 162,387 -0- 59,666

(6) Accumulated taxable income (2)-(5)
sec. 535(a) 93,234 568,403 333,981 -0-

Accumulated earnings tax sec. 531 26,105 159,153 93,515 -0-
 - 52 -

Annotations to Table 1

TYE 8/31/89

1. In computing operating expenses for the year,

respondent excluded amounts as to which a claim for deduction

was disallowed in the notice of deficiency. After trial

respondent conceded that payments for insurance premiums were

properly deducted as ordinary and necessary expenses.

Therefore we have included them.

2. Respondent included in operating expenses for the

year the amount of Federal income tax determined in the notice

of deficiency. The taxes that should be taken into account are

petitioner’s estimated tax payments. Doug-Long, Inc. v.

Commissioner, 72 T.C. 158, 176-177 (1979); Empire Steel

Castings, Inc. v. Commissioner, T.C. Memo. 1974-34.

3. Respondent calculated the length of petitioner’s

credit cycle by multiplying the number of days in the year by a

quotient of which the numerator is peak payables for the year

and the denominator is total merchandise purchased for the

year. Petitioner argues that the length of its credit cycle

for each of the taxable years at issue was no more the 10 days.

The basis for this figure is Hagerman’s testimony that

petitioner regularly paid its bills every 2 weeks. Our cases
 - 53 -

do not prescribe a single method for determining credit cycle.

However, the data do not corroborate petitioner’s position and

we are not aware of any authority for respondent’s formula.

Accordingly, we have used the quotient of average payables

divided by total operating expenses. See Snow Manufacturing

Co. v. Commissioner, 86 T.C. 260 (1986); Kingsbury Invs., Inc.

v. Commissioner, T.C. Memo. 1969-205.

4. The amount of working capital that a taxpayer could

reasonably expect to need for one operating cycle is determined

by multiplying total operating expenses for 1 year by the

length of its operating cycle expressed as a fraction of a

year. In her Bardahl calculations, respondent used the current

year’s operating expenses for this purpose. This Court has

often found it more appropriate to use the actual operating

expenses for the subsequent year as a proxy for the amount of

operating expenses that the taxpayer expected as of the close

of the year. Empire Steel Castings, Inc. v. Commissioner,

supra; Delaware Trucking Co. v. Commissioner, T.C. Memo. 1973-

29. The use of subsequent year operating expenses for purposes

of this calculation will result in a higher estimate of working

capital needs when a business’ costs are subject to inflation

or the business is growing. Petitioner argues that respondent

should have used its operating expenses for the subsequent

year. One problem with petitioner’s position is that for TYE
 - 54 -

8/31/92 current year operating expenses must be used because

data on subsequent year operating expenses were not presented

in evidence. The more important problem is that petitioner has

suggested no reason to believe that the assumption of perfect

foresight would produce a closer approximation of the amount

petitioner actually estimated it would need at the time.

Ultimately the question is one of fact, and petitioner has not

satisfied its burden of proof. We have used current operating

expenses.

5. Respondent included prepaid expenses in current

assets. This treatment of prepaid expenses is supported by

authority. Bardahl Intl. Corp. v. Commissioner, T.C. Memo.

1966-182. Petitioner argues that this is inappropriate, since

prepaid expenses are not funds available for distribution to

shareholders. In the Bardahl analysis we compare working

capital needs with available net liquid assets. What matters

is not the absolute amounts, but the difference between them.

For purposes of this comparison, including prepaid expenses in

available net liquid assets is effectively equivalent to

deducting these expenses from working capital needs.

6. In the worksheet accompanying the notice of

deficiency the amount of “other current obligations” was stated

as $195,801, a figure taken directly from petitioner’s Form

1120, Schedule L, for TYE 8/31/89. Schedule L discloses that
 - 55 -

the amount consists of State and Federal taxes payable.

Respondent revised this figure to $21,985 in the Bardahl

calculations she prepared for trial. The revision has the

effect of increasing available net liquid assets, the excess of

new liquid assets over working capital needs, and hence the

accumulated earnings tax liability. Therefore the revision

constitutes “new matter” for which respondent bears the burden

of proof. Rule 142(a); Achiro v. Commissioner, 77 T.C. 881,

890 (1981). Respondent provided no explanation at trial.

Consequently we must use the figure originally accepted in the

notice of deficiency.

7. The starting point for computing accumulated taxable

income is petitioner’s correct taxable income for the year.

Sec. 535(a). The figure used by respondent improperly failed

to reflect a deduction for the insurance premium.

8. In her computation of accumulated taxable income

respondent deducted from taxable income the amount of Federal

income tax due for the year as determined in the notice of

deficiency. This was an error. Section 535 provides for the

deduction of Federal income tax accrued during the taxable

year. Sec. 535(b)(1). For this purpose a tax liability is not

treated as accrued during the taxable year if the taxpayer

contested it at the time it was proposed. Dixie Pine Prods.

Co. v. Commissioner, 320 U.S. 516 (1944); Goodall’s Estate v.
 - 56 -

Commissioner, 391 F.2d 775 (8th Cir. 1968), revg. T.C. Memo.

1965-154; Doug-Long, Inc. v. Commissioner, 73 T.C. 71 (1979);

sec. 1.535-2(a)(1), Income Tax Regs. Accordingly, we use the

amount of Federal income tax shown on petitioner’s return.

TYE 8/31/90

9. See note 1.

10. See note 2.

11. See note 3.

12. See note 4.

13. See note 7.

14. See note 8.

TYE 8/31/91

15. Operating expenses should include the amount of

consulting fees paid to Mohney, which petitioner properly

deducted as an ordinary and necessary business expense.

16. No estimated Federal income tax payments were in fact

made. Arguably, estimated tax payments should be included in

operating expenses even if not actually made, because

petitioner would have expected to comply with the requirement

to pay estimated tax in the following taxable year. For the

sake of consistency we include only estimated taxes that

petitioner paid, but this should not distort the results of our

analysis. The unpaid tax seems to have been included in the

amount of “current liabilities” stated on Form 1120, Schedule
 - 57 -

L, for TYE 8/31/91, which we have used to determine available

net liquid assets. Thus, if we omit unpaid estimated tax from

the calculation of working capital needs, the effect is offset

by a corresponding reduction in available net liquid assets.

17. See note 3.

18. See note 4.

19. For reasons that were not explained, in her Bardahl

computations for trial respondent omitted an investment in gold

listed on petitioner’s Form 1120, Schedule L. Respondent had

included this item in the worksheet accompanying the notice of

deficiency. Since the investment appears to be a cash

equivalent, its inclusion in current assets would appear to be

appropriate.

20. We use the amount of “other current obligations”

stated on Form 1120, Schedule L, and accepted by respondent in

computations on the worksheet accompanying the notice of

deficiency. The revised amount that she used in computations

for purpose of trial was not explained. See note 6.

21. Taxable income reflects amounts properly deducted for

insurance premiums and consulting fees.

22. See note 8.

TYE 8/31/92

23. See note 2.

24. See note 3.
 - 58 -

25. See note 4.

26. We use the year-end balance stated on Form 1120,

Schedule L, and the worksheet accompanying the notice of

deficiency. For reasons that were not explained, in her

Bardahl computations for trial respondent used the much higher

balance for the beginning of the year, which has the effect of

increasing available net liquid assets and, ultimately,

accumulated earnings tax liability. Thus, the revision would

constitute “new matter” for which respondent offered no proof.