t c memo united_states tax_court pacific management group bsc leasing inc tax_matters_partner et al petitioners v commissioner of internal revenue respondent docket nos filed date 1cases of the following petitioners are consolidated herewith cory m severson and rochelle severson docket no pacific aquascape inter- national inc docket no pacific environmental resources corp dock- et no mark e krebs and janet b krebs docket no johan a perslow and marie majkgard perslow docket no pacific aquascape inc docket no curtis hartwell docket no pacific advanced civil engineering inc docket no richard f boultinghouse and loraine boultinghouse docket no and johan a perslow docket no ernest scribner ryder richard v vermazen and alvah lavar taylor for petitioners kevin w coy heather k mccluskey hans famularo jeffrey l heinkel and louis b jack for respondent memorandum findings_of_fact and opinion 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 corpora- tions and inevitably a partnership this scheme was devised by ernest s ryder who serves as co-counsel for petitioners in these cases the scheme relied in part on sec_1361 effective for tax years after which allowed esops to 2tax court rule g provides that i f any counsel of record is a potential witness in a case then such counsel must withdraw from the case or take whatever other steps are necessary to obviate a conflict of interest we ruled before trial that mr ryder would not be required to withdraw provided that the entire trial was conducted by mr vermazen his co-counsel who does not have a conflict of interest neither party called mr ryder as a witness during the trial 3unless otherwise noted all statutory references are to the internal_revenue_code code in effect for the years at issue and all rule references are to the tax_court rules_of_practice and procedure we round all monetary amounts to the continued be shareholders of s_corporations see small_business job protection act of pub_l_no sec a stat pincite 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 distribu- tions 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 sup- port 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 sec_3 continued nearest dollar 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 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 findings_of_fact 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 e 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 pages of his opening brief comply with this requirement petitioners’ proposed findings_of_fact occupying 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 135_tc_353 brewer quality homes inc v commissioner tcmemo_2003_ 86_tcm_29 n implementation of the tax_shelter scheme entailed many thousands of cash transfers among 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 compan- ies 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 refer- ences to individuals with these surnames are to petitioner husbands we will sometimes refer to each petitioner husband as a principal of the water compa- nies and refer to them collectively as the five principals all individual petition- ers resided in california when they filed their petitions b business structure and operations before the story begins with paq which was formed in date 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 and full-time employees in and added other workers as its projects required as of date paq’s officers and share- holders were as follows percentages do not total because of rounding individual perslow severson krebs hartwell boultinghouse office ownership chairman secretary president treasurer vice president vice president cfo pace was originally a division of paq functioning as its in-house engineering design group it was separately incorporated in 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 employees in to employees in 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 date pace’s officers and shareholders were as follows individual perslow severson krebs hartwell boultinghouse office ownership chairman secretary president treasurer vice president vice president cfo pai was incorporated in to perform in nevada and utah the same types of construction and engineering services that paq performed in california initially pai had its own employees who also worked on paq projects pai’s employees were later put on paq’s payroll and pai reimbursed paq for employee time spent on pai projects mr perslow had no nominal ownership_interest in pai because of complications caused by a prior bankruptcy pai’s profits nevertheless appear to have been distributed roughly on the basis of the five principals’ ownership interests in paq and pace perc was incorporated in to provide services as a general contractor for the other three companies perc arose out of paq’s need for wastewater treatment plants to ensure that its water systems were algae free perc was also the entity that bore the costs of any liability associated with the water companies’ design and construction of wastewater treatment plants perc had employees in and its headcount tripled during the ensuing six years as of date perc’s officers and shareholders were as follows individual perslow severson krebs boultinghouse office chairman president --- cfo ownership the water companies were all organized as c corporations during the tax years at issue apparently because mr perslow’s status as a foreign national made the s_corporation structure unavailable see sec_1361 although each company had its own website the four functioned in most respects as a single integrated entity they shared office space and overhead costs used the same accounting and administrative staff and used the same it personnel and email system sherry quarry who began working for the water companies in man- aged the corporate ledgers made payments on accounts_payable and prepared cli- ent invoices two or more companies often worked on the same client project the accounting software enabled her to generate debits and credits for cross- company services whereby each company would be charged expenses in propor- tion to the services it consumed these expenses included among other things employee wages and benefits rent payments and overhead and facility costs before mr perslow was employed and paid_by perc mr severson and mr hartwell were employed and paid_by paq and mr krebs and mr boult- inghouse were employed and paid_by pace the employing company was then reimbursed by the other water companies for the time its employee devoted to the other companies’ assignments before the water companies had a bonus program for staff employees and a separate bonus pool for the five principals who received bonuses only if the companies had sufficient cashflow petitioners submitted no evidence to establish for years before the amounts of the bonuses the five principals received the manner in which those bonuses were determined or the ratio of their bonuses to their basic_pay the water companies experienced substantial growth between and their aggregate revenues increased from approximately dollar_figure million to more than dollar_figure million during this period they doubled their employee count during these years c business structure and operations after by the water companies had multi-million-dollar contracts with nu- merous landowners although they and their shareholders were prospering they were unhappy that operating income was subject_to tax separately at the corporate and shareholder levels like many taxpayers during those boom years they sought professional advice in search of a solution to this perceived problem in date the five principals were introduced to mr ryder whose practice focused on employee benefit plans he specialized in creating tax struc- tures that purportedly enabled shareholder-employees to defer taxation of a sub- stantial portion of their income free of the normal limitations on contributions to qualified_retirement_plans and pay tax only on income needed to defray current living_expenses the balance of the income would accumulate in a retirement ac- count or tax-free entity and remain tax deferred until the owners elected to take distributions mr ryder proposed two related strategies designed to minimize the tax lia- bilities of the c corporations and maximize tax-deferred income for the five prin- cipals he proposed an employee_leasing deferred_compensation plan involving a newly created s_corporation for each of the five principals all of the stock of each s_corporation would be owned by an esop whose sole participant would be that principal he also proposed an accounts_receivable factoring program under mr ryder’s scheme a partnership would extract cash from the c corporations in the form of alleged management fees and factoring fees thus eliminating most of the water companies’ taxable_income the partnership would transfer this cash to or for the benefit of the s_corporations ratably to each prin- cipal’s approximate percentage ownership_interest in the c corporations each principal would receive and pay tax on a salary from his s_corporation but most of the cash would accumulate tax free in the five s_corporations because all of the stock of each was owned by an esop a tax-exempt_entity the five principals formally engaged mr ryder’s services in date he agreed to design a structure that would achieve petitioners’ tax goals by creating corporations esops or more partnerships or more management service agreements and or more master factoring arrangements he agreed to supply an opinion letter on the purported validity of the structure and represent petitioners should the structure be challenged by the irs as compensation_for his efforts the water companies agreed to pay mr ryder a dollar_figure documentation fee and an annual fee computed as of the income earned by the s_corporations that is not subject_to immediate taxation documents and agreements underlying the tax-minimization plan in date mr ryder formed and elected s-status for a new one- man corporation for each of the five principals we will refer to these entities as perslow inc severson inc krebs inc hartwell inc and boultinghouse inc and collectively as the s_corporations each s_corporation had the same address as the water companies each s_corporation sponsored an esop the sole participant in and bene- ficiary of each esop was the principal for whom the s_corporation had been formed during the tax years at issue each esop owned of the stock of its sponsoring s_corporation each principal purportedly executed with his s_corporation an agreement of employment by which he agreed to furnish services as an employee the agreements did not specify what positions the principals were to hold or what duties they were to perform rather the agreements simply recited that each principal would render and perform services under the direction and designation of his respective s_corporation the agreements entitled each principal to receive base monthly compensation and also to receive additional compensation if 4the record contains no documentary_evidence concerning the tax treatment of the five esops however respondent has not challenged their validity and does not dispute that the irs originally recognized their tax-exempt status authorized by the s_corporation in relation to the principal’s individual productivity and services to and longevity with the s_corporation on date mr ryder formed two california general partner- ships pacific management group sometimes referred to as pacific management co pmg and perc management group the two partnerships merged pur- portedly on date with pmg as the surviving entity the evidence at trial established that the merger agreement was created on date and backdated to date for ease of reference we will refer to both partnerships as pmg for all years the partners in pmg all denominated general partners were the s corpora- tions four of the s_corporations were partners from the outset hartwell inc was added as a partner on date and received an interest at that time pmg had capital accounts of dollar_figure thus hartwell inc should have made an initial capital_contribution in excess of dollar_figure in fact it made a capital_contribution of dollar_figure each s corporation’s percentage interest in pmg approximated the corre- sponding principal’s aggregate ownership_interest in the c corporations to en- 5the five principals held or regarded themselves as holding identical own- ership interests in paq pai and pace but different ownership interests in continued sure that each s corporation’s interest in pmg continued to approximate its respective principal’s ownership percentage in the water companies the s_corporations entered into mutual buy sell agreements as reflected on the schedules k-1 partner’s share of income deductions credits etc included in pmg’s partnership tax returns the s_corporations as of date had the following percentage ownership interests in pmg amounts do not total because of rounding s_corporation interest perslow inc severson inc krebs inc hartwell inc boultinghouse inc the partnership_agreement stated that the primary purpose of the partner- ship is to provide business management and financial services to clients of the partnership to enable pmg to do this each s_corporation agreed to supply continued perc each s corporation’s ownership_interest in perc management group before it merged with pmg was determined by the corresponding principal’s ownership_interest in perc after perc management group merged into pmg the s corporations’ ownership interests in pmg were adjusted accordingly pmg with the services of its employee the partnership_agreement stated that each s_corporation would also devote through its principal whatever time and attention is necessary to manage and conduct the business of the partnership on date pmg supposedly entered into independent con- tractor agreements for management services icas with the water companies under the icas pmg denominated the consultant agreed to supply to the water companies denominated the client the management services that the five principals supplied to pmg these management services consisted of sub- stantially the same services that the five principals had previously performed for the water companies directly as its officers and employees these services included design engineering and construction services construction manage- ment services and value engineering all services were to be performed on site at the water companies’ office in huntington beach the icas stated that pmg would issue monthly invoices to the water com- panies for management fees in exchange for the services the five principals sup- plied these management fees took the form of base monthly compensation plus discretionary bonuses the icas nominally entitled pmg to render management services to clients other than the water companies but there is no evidence in the record that pmg ever did this or that the parties ever intended that pmg would do this the water companies except perc entered into master factoring agreements mfas with pmg with a supposed effective date of date factoring is a financial transaction by which one party the factor provides services to another party the client and is compensated by payment of factoring fees the services that the factor provides typically include pur- chasing the client’s accounts_receivable for cash collecting on the accounts_receivable from the account debtors and assuming the downside risk if an account debtor becomes insolvent factoring benefits the client by enabling it to monetize an illiquid asset immediately in exchange for its services the factor receives a fee typically computed as a discount from the face_amount of the receivables the water companies had never investigated factoring as a financial tool before they met mr ryder before adopting his factoring proposal they did not 6the base compensation the five principals received during sub- stantially exceeded the base compensation specified in the icas as most recently amended in in during the irs audit mr ryder’s firm prepared new employment agreements and corresponding corporate action documents reciting the higher amounts of base compensation then backdated all of those documents to the relevant prior years investigate the availability or the cost of factoring with banks or financial institutions boultinghouse admitted to ms quarry that the main purpose of the factoring arrangement was tax_deferral under the mfas pmg purportedly purchased from the water companies except perc accounts_receivable that they assigned to it because pmg had virtually no capital--the total capital contributed by its five partners was dollar_figure--it initially lacked the funds necessary to purchase the receivables it thus deferred its alleged factoring activity until it had received sufficient management fees from the water companies pmg began its alleged factoring activity in date it earned factor- ing fees equal to the difference between the face_amount of the receivables and its discounted purchase_price none of the factoring agreements specified what dis- count would be applied the discounts in fact applied were and for pace pai and paq respectively boultinghouse apparently picked these rates after making inquiries to several banks about typical rates the factoring agree- ments included the following terms the water companies would sell the accounts_receivable to pmg on a nonrecourse basis with title passing to pmg pmg would purchase the accounts_receivable and remit payment to the water companies as soon as the assignment of the receivables was completed funds collected on accounts_receivable would be deposited into a bank account titled in pmg’s name pmg accepted the risk of loss for non- collectible accounts however the water companies were to act as collection agents for pmg with pmg supposedly reimbursing the water companies for the collection services provided by their employees the water companies would provide pmg with security interests in their present and future accounts_receivable but in no other assets the water companies would not notify their clients the account debtors that the accounts were being sold to pmg operations under the tax-minimization plan the implementation of mr ryder’s tax-minimization strategy caused no change in how the water companies conducted their business or related to the outside world all present and future clients executed contracts with the water companies as they had done previously the five principals retained their pre- existing titles as officers of the water companies and clients continued to interact with them as they had done before boultinghouse for example had previously been the cfo of all four water companies under mr ryder’s tax structure boultinghouse remained the cfo of all four companies and he continued to provide them with exactly the same finan- cial and accounting services he had supplied previously but now he supplied those services as an employee of his s_corporation which allegedly supplied his services to pmg which allegedly supplied his services as an independent_contractor to the water companies water company clients were not aware of pmg’s existence and engaged in no business activity with it pmg had no employees no telephone system no email address and no website its books_and_records were kept by water com- pany employees including sherry quarry who also ran payroll for the s corpora- tions the water companies’ accounting systems remained the same as previous- ly all water company employees including the five principals recorded their time on timesheets exactly as they had done before when recording time each principal input a project code to indicate the water company to which his time should be billed the changes wrought by mr ryder’s tax-minimization strategy occurred mostly on paper or in the form of electronic transactions pmg’s receipts in the form of management fees and factoring fees were separated into three pools 7in pmg supposedly became the lessee of the building that housed the water companies the five principals signed the lease on behalf of pmg the lease made them personally liable for the rent payments pmg then subleased the building back to pace and pace reimbursed pmg for the rent owed to the les- sor the evidence at trial established that the sublease agreements and related corporate action documents were created in and backdated to pool a-1 performance bonuses pool a-2 shareholder bonuses and pool b working_capital allocations to pools a-1 and a-2 were determined according to a percentage of the water companies’ normalized profits normalized profits were calculated by adding back to the water companies’ reported profits the factoring fees and management fees paid to pmg as well as interest_expenses these allocations were split between the two pools the remainder of pmg’s receipts were routed into pool b the water companies could whenever necessary access funds in these pools to pay their expenses typically through a loan or a revolving line of credit pmg used the profits in pools a-1 and a-2 to make distributions to the s_corporations which were made in two tranches the first tranche consisted of guaranteed payments these payments were generally made monthly and cor- responded to the base monthly compensation due to the five principals under the icas the guaranteed payments that pmg made to the s_corporations during the tax years at issue were as follows s_corporation perslow inc severson inc krebs inc dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number hartwell inc boultinghouse inc total big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number out of these distributions the s_corporations paid salaries to the five princi- pals reimbursed the water companies for health insurance provided to the those individuals and their families and paid certain other expenses the s_corporations provided each principal with forms w-2 wage and tax statement reporting the salary amounts after withholding applicable employment_taxes the form_w-2 wages the five principals received from their s_corporations for the tax years at issue were as follows principal perslow severson krebs hartwell boultinghouse total dollar_figure big_number big_number big_number big_number big_number dollar_figure -0- big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number the second tranche of distributions that pmg made to the s_corporations consisted of bonuses these distributions were made intermittently often at the time bonuses were paid to the water companies’ rank and file employees pmg made bonus distributions to the s_corporations as follows s_corporation perslow inc severson inc krebs inc hartwell inc boultinghouse inc total dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number -0- big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number all pmg receipts not distributed to the s_corporations were credited to their respective partner capital accounts as reported on pmg’s tax returns the part- ners’ capital accounts on january of each year were as follows s_corporation perslow inc severson inc krebs inc hartwell inc boultinghouse inc total dollar_figure big_number big_number big_number big_number big_number dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number big_number big_number all pmg receipts not distributed to the five principals currently were retained and invested for their benefit in accounts titled in the names of the s_corporations pursuant to the mfas pmg nominally purchased from paq pai and pace during the tax years at issue aggregate accounts_receivable as follows year a r purchased dollar_figure big_number big_number big_number the total factoring fees that pmg received from paq pai and pace in ex- change for its alleged services exceeded dollar_figure million for these four years the actual operation of pmg’s factoring activity differed in important re- spects from the manner in which factoring is typically conducted by financial in- stitutions in a typical factoring arrangement the factor assumes responsibility for collecting the purchased accounts under the pmg arrangement by contrast the water companies were to act as collection agents for pmg the supposed factor this was apparently done because the water companies did not wish their clients to know that their accounts had been sold pmg was given a security_interest in the water companies’ accounts re- ceivable contrary to normal factoring practice however pmg did not perfect its security_interest by a uniform commercial code ucc filing again this was evidently because the water companies did not wish their clients to know that their accounts had been sold both before and after implementation of the supposed factoring arrange- ment mr boultinghouse in his capacity as cfo was directly responsible for col- lecting on the water companies’ accounts including past-due accounts if ac- counts became delinquent mr boultinghouse would direct the water companies’ employees to telephone clients to ascertain the expected payment_date if accounts remained delinquent he would direct project managers or other high-level em- ployees to contact the clients if accounts became seriously delinquent he would consult with the staff of the water companies to determine whether mechanics liens should be filed or a collection agency retained the mfas stipulated that pmg would reimburse the water companies for these collection services but there is no evidence in the record that such reimbursements were ever made nor is there any evidence about the manner in which such reimbursements were supposed to have been calculated the actual operation of the supposed factoring activity also departed in several respects from the terms specified in the mfas pmg often made payments on accounts_receivable before the water companies had executed forms assigning those accounts to pmg or verified the outstanding balances on the accounts this was contrary to the terms of the agreements and to accepted factoring practice pmg often paid in installments for the accounts it purchased rather than paying the entire purchase_price to the water companies up front in some cases payment was made in seven or eight installments spread over many months this was contrary to the terms of the agreements and to standard factoring practice whose goal is to provide the client with immediate liquidity the evidence estab- lished that the timing of the supposed factoring payments was dictated not by the terms of the mfas but by when there was money in the bank to do it as ms quarry testified while factoring receivables theoretically enabled the water companies to accelerate their incoming cashflow this benefit was illusory given how the fac- toring 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 see supra p 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 the factoring arrangement between pmg and the water companies was insufficient to support the water companies’ working_capital needs chiefly be- cause of the large management fees they were paying to pmg consequently the water companies each established lines of credit with pmg on which they could draw to fund their operations during the years at issue the water compan- ies also borrowed regularly from each other as needed d transition to a new structure after mr ryder informed the principals that the structure outlined above would no longer provide preferential tax treatment as of date because congress had amended the code to prohibit single-participant esops see eco- nomic growth and tax relief reconciliation act of pub_l_no sec d stat pincite codified as sec_409 revrul_2003_6 2003_1_cb_286 he accordingly advised that the existing esops should be phased out and that new esops would need to have more than participants on the basis of mr ryder’s advice the principals formed and elected s stat- us for a new company water speciality group wsg formed new esops inten- 8congress provided that the amendment codified as sec_409 generally would apply to plan years beginning after date the esops had a plan_year beginning date with the result that the amendment would apply to their plan years beginning date ded to comply with the legislative amendment and solicited other employees of the water companies to be plan participants in the newly formed esops wsg its affiliated entities and numerous individuals were petitioners in cases pincite docket numbers that were originally consolidated with the cases currently before the court on date the parties filed a stipulation of settled issues that resolved all issues with respect to the wsg structure for taxable years and decisions in those cases have been entered e tax returns and irs examination for the water companies timely filed forms u s_corporation income_tax return for on which they claimed deductions for among other things the management fees and factoring fees paid to pmg pmg timely filed forms u s return of partnership income for and issued schedules k-1 to the s_corporations the five principals timely filed in some cases jointly form sec_1040 u s individual_income_tax_return for on which they reported the salaries they received from their s_corporations and nomi- nal payments from the water companies it is unclear what the latter payments covered 9a list of the docket numbers for the cases that were settled appears in ap- pendix a see infra p the irs selected all of these returns for examination it determined numer- ous adjustments and issued notices of deficiency to the water companies notices of deficiency to the five principals and a notice of final_partnership_administrative_adjustment fpaa to pmg the parties have conceded or settled a variety of is- suesdollar_figure respondent has also made partial concessions on certain of the issues that remain in dispute the issues remaining in dispute with dollar amounts adjusted to reflect partial concessions are as follows with respect to the four c corporations the irs allowed deductions for the portions of the management fees corresponding to the form_w-2 wages received by the five principals it disallowed deductions for the balance of the management fees and for the totality of the factoring fees the claimed deductions were disallowed on various alternative grounds including failure to satisfy the requirements of sec_162 lack of economic_substance and lack of arm’s-length pricing under sec_482 after concessions some of which 10a description of the issues the parties have settled or explicitly conceded by docket number appears in appendix b see infra pp petitioners did not challenge at trial or in their post-trial briefs any of the accuracy-related penal- ties that the irs determined the penalties are therefore deemed conceded to the extent we determine deficiencies see rule e and 92_tc_661 schladweiler v commissioner tcmemo_2000_351 aff’d 28_fedappx_602 8th cir reflected math errors the adjustments remaining in dispute appear to be as follows disallowed management fees company perc pace paq pai year period amount dollar_figure -0- -0- -0- big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number 11respondent has stipulated that any changes to the water companies’ ulti- mate tax_liabilities will need to be apportioned under sections we leave those apportionments to the parties’ rule_155_computations disallowed factoring fees company pace paq pai year period amount dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number with respect to the individual petitioners the irs determined that disal- lowance of deductions for the corporate payments listed above generated taxable_income for the five principals either as constructive dividends or on another theory assignment_of_income lack of economic_substance or lack of arm’s-length pricing under sec_482 after concessions the amounts of individual taxable_income remaining in dispute appear to be as follows principal perslow severson dollar_figure dollar_figure big_number big_number dollar_figure big_number dollar_figure big_number krebs hartwell boultinghouse big_number big_number big_number big_number -0- -0- big_number big_number -0- big_number big_number big_number with respect to pmg the irs made the following alternative adjustments increased its ordinary_income by disallowing deductions for various expenses and distributions to the s_corporations disregarded for lack of economic sub- stance the s_corporations and any transactions entered into between them and pmg and determined that the principals were pmg’s actual partners i burden_of_proof opinion the irs’ determinations in a notice_of_deficiency or an fpaa are generally presumed correct and taxpayers bear the burden of proving them erroneous see rule a 290_us_111 107_tc_94 deductions are a matter of legislative grace and taxpayers bear the burden of proving their entitlement to any deductions claimed and of substantiating the amounts underlying claimed deduc- tions 503_us_79 292_us_435 sec_1_6001-1 income_tax regs generally a taxpayer may deduct ordinary and necessary business_expenses paid_or_incurred during the taxable_year in carrying_on_a_trade_or_business sec_162 whether an expense constitutes an ordinary_and_necessary_expense within the meaning of sec_162 generally presents a question of fact commis- sioner v heininger 320_us_467 under sec_7491 the burden_of_proof may shift to the commissioner if the taxpayer produces credible_evidence with respect to any relevant factual issue and meets other requirements petitioners have not argued that sec_7491 applies and have not shown that they meet the requirements to shift the burden_of_proof the burden_of_proof thus remains on them ii jurisdiction we must first address two jurisdictional questions four months after post- trial briefing concluded petitioners moved to dismiss for lack of jurisdiction with respect to pmg and the four c corporationsdollar_figure this court is a court of limited jur- isdiction and may exercise jurisdiction only to the extent authorized by congress sec_7442 85_tc_527 when a jurisdic- tional question is raised we must address it before deciding the case 127_tc_109 12the relevant docket numbers are pmg pai perc paq and pace this court generally has jurisdiction over a partnership-level case under sec_6226 if the irs issues a valid fpaa and the tmp or another eli- gible partner timely files a petition with this court relating to the fpaa rule see 123_tc_64 the irs issued a timely fpaa to pmg on date and the tmp timely petitioned this court on date this court generally has jurisdiction over a deficiency case under sec_6213 if the irs issues the taxpayer a valid notice_of_deficiency and the taxpayer timely petitions this court rule a c see 93_tc_22 90_tc_142 the irs issued timely notices of deficiency to the water companies on december and and they timely petitioned this court a partnership case with respect to pmg a tefra partnership petitioners assert that the irs failed to issue to each notice_partner a timely notice of the beginning of an admin- istrative proceeding nbap as provided in sec_6223 and d this failure according to petitioners allowed pmg’s partners--namely the five s corporations- -to opt_out of the tefra proceeding and convert the partnership items to non- partnership items under sec_6223 petitioners contend that these elections deprive the court of jurisdiction over the partnership case because there are no partnership items left for us to adjudicate see sec_6226 we note at the outset that an untimely nbap does not invalidate the fpaa to which it relates see 143_tc_83 stat- ing that the commissioner’s failure to adhere to the 120-day timeframe means that the nbap is untimely but does not invalidate either notice 94_tc_787 sec_301_6223_e_-2 proced admin regs thus any failure by the irs to issue timely nbaps to the notice partners did not prevent it from issuing a valid fpaa to pmg and bsc leasing inc the partnership’s tmpdollar_figure the irs issued to pmg and its tmp on date a valid fpaa for for tax_year the record establishes that the irs sent nbaps to each notice_partner more than days before date thus no partners were eligible to opt_out for and this court has jurisdiction over pmg for that year for tax_year sec_2002 and the record establishes that the irs issued an nbap to bsc leasing inc the partnership’s tmp on date that date 13bsc leasing inc the one-man s_corporation for mr boultinghouse is also referred to in this opinion as boultinghouse inc was more than days before the date on which the irs issued the fpaa regardless of whether other partners successfully opted out there are partnership items for us to adjudicate because at least one partner remains we therefore have jurisdiction over pmg for and for tax_year the parties agree that all five of pmg’s partners including bsc leasing inc effectively elected out of the tefra proceeding although the tmp filed a valid petition it appears that we lack jurisdiction over pmg’s year because there remain no partnership items left to adjudicate in seeking to have the pmg case dismissed petitioners may be suggesting a backdoor statute_of_limitations argument to prevent the court from determining the validity of certain transactions to which pmg was a nominal party if the irs mails an fpaa to the tmp and if a partner opts out of the tefra proceeding under sec_6223 then the period of limitations on assessment as to that partner does not expire before one year after the partnership items are converted to nonpartnership_items see sec d f cross-referencing sec_6231 14electing out of the tefra proceeding did not preclude bsc leasing inc from filing a petition with the court relating to the fpaa under sec_301_6231_a_7_-1 proced admin regs the filing of an opt-out election by a tmp is not listed among the actions that terminate a tmp designation all of pmg’s partners are s_corporations which as flow-through entities could not receive notices of deficiency the taxable parties are the five individu- als who are alter egos of the s_corporations concurrently with mailing the fpaa the irs mailed notices of deficiency to all five individuals thus even if the partnership items were deemed to have become nonpartnership_items notices of deficiency were mailed to the five principals while the assessment_period of limitations remained open see ibid none of the five principals was a partner directly or indirectly in pmg see watkins v commissioner tcmemo_2014_197 108_tcm_337 stating that individuals cannot be indirect partners in a partnership by virtue of their being participants in esops that hold shares in s_corporations holding partnership interests petitioners do not dispute that the irs issued timely notices of deficiency to the five principals and to the four c corporations all of the adjustments we sustain in these cases are to the income_tax liabilities of the five principals and the four c corporations all of them are properly subject_to our jurisdiction since dismissal of the pmg proceeding would have no effect on our deter- minations and would not seem to help petitioners the motion to dismiss as to pmg appears to have been improvidently filed we nevertheless must decide what to do with this motion bsc leasing inc the partnership’s tmp filed a timely petition under sec_6226 as to all four years for partnership items remain for at least one partner so we have jurisdiction with respect to the fpaa for those years because all the partners appear to have opted out for no partnership items remain for us to adjudicate so we appear to lack jurisdiction with respect to the fpaa for we shall therefore deny petitioners’ motion to dismiss the pmg case with respect to and grant the motion with respect to we reiterate that this has no effect on our jurisdiction to decide the substantive tax_liabilities at issue in these cases because all of the adjustments we sustain are to the income_tax liabilities of the five principals and the four c corporations which are properly before us in the deficiency cases over which we have jurisdiction b water company cases petitioners contend that the notices of deficiency issued to the four c cor- porations--paq pai pace and perc--are invalid in part that is assertedly so because the notices relate to matters that must be adjudicated in a partnership-level proceeding eg the economic_substance of pmg and the economic_substance of transactions between the water companies and pmg alternatively petitioners contend that the notices of deficiency include affected items see sec_6231 and are invalid because they were issued before the related tefra proceeding was concluded we find that the notices of deficiency issued to the water companies are valid and that we have jurisdiction to adjudicate all items therein in each notice_of_deficiency the irs determined that the deductions claimed by the c_corporation for management fees and factoring fees should be disallowed on one or more grounds including lack of substantiation lack of economic_substance failure to constitute ordinary and necessary expenses under sec_162 and failure to reflect arm’s-length pricing under sec_482 petitioners are correct that the question whether pmg as an entity lacks economic_substance is a partnership- level item see 655_f3d_1060 9th cir aff’g tcmemo_2009_104 but that question is entirely separate from the questions presented by the notices of deficiency issued to the water companies whether payments made by the water companies qualify for deduction under sec_162 is a question properly determined in these deficiency proceedings because the answer to that question will determine whether the water companies correctly reported their taxable_income we likewise reject petitioners’ contention that the notices of deficiency is- sued to the water companies include affected items the c corporations are not partners in pmg the notices issued to them therefore cannot possibly include affected items see sec_6231 the term ‘affected item’ means any item to the extent such item is affected by a partnership_item we will accordingly deny petitioners’ motions to dismiss in docket nos and iii deductions claimed by the water companies sec_162 allows a deduction for all the ordinary and necessary ex- penses paid_or_incurred during the taxable_year in carrying on any trade or busi- ness including a reasonable allowance for salaries or other compensation_for_personal_services actually rendered an expense is ordinary if it is customary or usual within a particular trade business or industry or relates to a common or fre- quent transaction in the type of business involved see 308_us_488 an expense is necessary if it is appropriate and helpful to the operation of the taxpayer’s business see 383_us_687 83_tc_356 aff’d 777_f2d_662 11th cir a factoring fees when the five principals met with mr ryder in he explained that his factoring program would enable the water companies to convert a portion of their regular monthly business income into profits of a tax-free factoring entity that could be accumulated for retirement 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 busi- ness see sec_162 as courts have often stated the substance of a transaction controls over its form see 435_us_561 877_f3d_1086 9th cir the u s court_of_appeals for the ninth circuit generally applies a two-pronged inquiry addressing the objective nature of the transaction whether it has economic_substance beyond tax benefits and the subjective motivation of the taxpayer whether the taxpayer had a non-tax business_purpose for the transaction 755_f3d_1051 9th cir aff’g tcmemo_2012_106 t he economic_substance_doctrine is not a ‘rigid two-step analysis ’ but instead focuses holistically on whether ‘the transaction had any practical economic effects’ other than creation of tax benefits id pincite first quoting sacks v commissioner f 3d 9th cir rev’g tcmemo_1992_596 then quoting 843_f2d_351 9th cir respondent offered and the court recognized robert zadek as an expert in factoring mr zadek has extensive experience with factoring arrangements having worked in the industry for more than years he operates his own factoring company lenders funding it provides factoring services to third-party clients and has a dollar_figure million factoring portfolio we found mr zadek to be a knowledgeable and credible witness mr zadek opined that the factoring arrangement between pmg and the water companies departed in many respects from arm’s-length factoring norms he first noted that the water companies before embracing mr ryder’s proposal did no due diligence to investigate the costs and benefits of factoring they did not compare the cost of factoring to the cost of securing working_capital via bank loans they did no comparison shopping to ascertain whether more advantageous factoring terms could be obtained from an independent company and they did not bother to calculate the economic cost of the arrangement mr ryder proposed mr zadek determined that the factoring fees the water companies paid or of the receivables’ face value coupled with the expected turnaround time for collection yielded an effective annual percentage rate apr of he con- cluded that this rate was at the high end of or above the range of aprs that independent factors would have charged the five principals’ insensitivity to price suggests that their true objective was not to obtain low-cost working_capital for the water companies but rather as mr ryder proposed to convert a portion of their regular monthly business income into profits of a tax-free factoring entity in an arm’s-length factoring arrangement the factor typically receives an assignment of accounts_receivable from the client verifies the genuineness of the accounts and balances shown and 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 mr zadek pointed to other aspects of the factoring arrangement in conclud- ing that it did not comply with arm’s-length norms contrary to usual factoring practice pmg received a lien only against the accounts_receivable themselves to the exclusion of any other assets of the water companies pmg did not perfect even this limited security_interest by a ucc filing so that its supposed lien would have been ineffective against any of the water companies’ secured creditors nor did the water companies provide notification rights that would have enabled pmg to inform the water companies’ clients that their accounts had been assigned to it for collection in a typical factoring arrangement the factor assumes responsibility for col- lecting the accounts that have been assigned to it under the pmg arrangement by contrast the water companies were to act as collection agents for pmg the supposed factor this was apparently done because the water companies did not wish their clients to know that their accounts had been sold both before and after implementation of the supposed factoring arrange- ment mr boultinghouse in his capacity as cfo was directly responsible for col- lecting the water companies’ accounts_receivable including past-due accounts if accounts became delinquent mr boultinghouse would direct the water companies’ employees to telephone clients to ascertain the expected payment_date if accounts remained delinquent he would direct project managers or other high-level employees to contact the clients if accounts became seriously delinquent he would consult with the staff of the water companies to determine whether mechanics liens should be filed or a collection agency retained the mfas stipulated that pmg would reimburse the water companies for these collection services but there is no evidence in the record that such reimbursements were ever made nor is there any evidence to establish how such reimbursements were supposed to have been calculated notwithstanding the factoring arrangement the water companies remained responsible for collection activity and bore of the costs of collection they thus derived no benefits from the factoring arrangement in this respect as mr zadek aptly noted the factoring arrangement likewise conferred no liquidity benefits on the water companies pmg the supposed factor initially had no meaningful capital the total capital contributed by its five partners was only dollar_figure because lack of capital prevented it from engaging in factoring for the first months of its existence it did not start factoring until date by which time it had received sufficient management fees from the water companies to supply it with the requisite cash in a true factoring relationship the factor supplies working_capital and liquidity to the client here the opposite was true the client provided working_capital to the factor to enable the factor to do the factoring there is no factual basis whatever for petitioners’ assertion that the factoring arrangement facilitated working_capital the scheme was a circular flow of funds whereby the water companies supplied liquidity to themselvesdollar_figure petitioners contend that the factoring arrangement had economic_substance for three reasons first they contend that pmg received actual title to the ac- counts petitioners’ paperwork however was extremely lax many documents were backdated and pmg made no ucc filings with respect to the receivables it is thus unclear from the record whether title to the receivables actually passed to pmg even if title to some receivables did pass to pmg on some occasions mere passage of title does not imbue transactions with economic_substance especially 15in further support of his conclusion that the factoring arrangement pro- vided no working_capital benefits mr zadek noted that the water companies en- gaged in substantial inter-company lending before the pmg structure was created and continued to engage in substantial inter-company lending even after the fac- toring arrangement was put in place where the transactions occur between related parties see eg 779_f3d_448 7th cir aff’g t c memo 2011-dollar_figure second petitioners contend that the water companies received cash pay- ments from pmg more rapidly than they would have received payment from the account debtors in the absence of factoring this was not always true in some in- stances pmg paid the water companies in installments over many months in any event the water companies supplied pmg with the cash to make these payments had the water companies truly desired to conserve working_capital they would simply have held on to this cash as well as to the dollar_figure million in cash they wasted by paying bogus factoring fees to pmg third petitioners contend that pmg suffered the risk of loss for non- collectible accounts petitioners did not establish the required factual basis for this argument because the record does not show that actual title to the accounts vested in pmg to start with see supra p in any event because the water compa- nies as opposed to pmg were responsible for actual collection of the accounts the true risk of noncollection fell on them since the entire scheme was a circular 16petitioners err in citing 77_tc_1221 to support their position we there held that transactions in which taxpayers purportedly purchased cattle were not true sales and lacked suf- ficient substance apart from tax manipulation to be recognized for federal tax purposes flow of funds it does not matter on which entity’s books particular losses were formally recorded petitioners rely on the rebuttal report of brett solomon to support the eco- nomic substance of the factoring arrangement he there asserts that the fac- toring arrangement facilitated meaningful working_capital financing pmg’s factoring rate was reasonable relative to similar arm’s-length transactions and the factoring arrangement had sufficient formalities to be respected making al- lowances for its status as a related-party transaction we recognized mr solomon as an expert in general financing arrangements particularly with reference to the management fees that the water companies claimed as deductions see infra pp mr solomon has no particular expertise in factoring and we found this portion of his rebuttal report unpersuasive first as explained above the factoring arrangement provided no meaningful working_capital financing to the water companies because they supplied the cash that enabled pmg to factor second we found credible mr zadek’s testimony that the apr paid_by the water companies was not an arm’s- length rate but was at the high end of or above the range of aprs that indepen- dent factors would have charged third the essential defect of the factoring scheme was not the lack of formalities though it was extremely deficient in that respect its central defect was that the water companies paid out dollar_figure million but received no meaningful economic benefit in return for these reasons we conclude that the purported factoring arrangement had no economic_substance in an objective sense it provided no economic benefit to the water companies beyond the tax benefits they hoped to achieve by disguising as deductible payments what were actually distributions of corporate profits see reddam f 3d pincite in a subjective sense the arrangement lacked econom- ic substance because the five principals had no non-tax business_purpose for the transaction ibid their sole purpose was the one mr ryder had urged when pitching his factoring scheme to them viz to enable the water companies to convert a portion of their regular monthly business income into profits of a tax- free factoring entity that could be accumulated for retirement even if the water companies were deemed to have derived some marginal economic benefit from the factoring arrangement petitioners have not shown that 17petitioners cite various authorities to support their contention that the fac- toring arrangement had economic_substance including sec_864 treatment of related_person_factoring_income revrul_66_98 1966_1_cb_200 and sev- eral private letter rulings plrs all of this material is irrelevant sec_864 addresses when related_party_factoring_income should be treated as subpart_f in- come earned by a controlled_foreign_corporation revrul_66_98 refers to dividends from cooperatives and the plrs which are not precedential see sec_6110 do not address related-party factoring arrangements the fees they paid were ordinary and necessary expenses under sec_162 assuming arguendo that factoring were regarded as customary or ordinary within their industry petitioners have failed to prove that expending dollar_figure million for this purpose was appropriate and helpful to the operation of the water companies’ businesses see tellier u s pincite carbine t c pincite nor have they substantiated what lesser amount would have satisfied this test petitioners have thus failed to carry their burden_of_proof see indopco inc u s at dollar_figure b management fees in form the water companies paid management fees to pmg pmg was a paper entity and its partners--the five s corporations--were likewise paper entities neither pmg nor the s_corporations provided the water companies with actual management services of any kind rather they were simply vehicles for supplying the personal services of the five principals who performed for the water companies during essentially the same services they had performed as direct employees of the water companies previously in assessing the reasonableness of the management fees therefore the question is whether 18given our disposition we need not address respondent’s alternative con- tentions that the factoring fees should be reallocated under sec_482 and that the factoring arrangement was a loan between the water companies and pmg those sums represented reasonable_compensation for the personal services rendered by five principals or instead represented at least in part nondeductible distributions of corporate profits whether compensation_for_personal_services is reasonable is a question of fact determined on the basis of all the facts and circumstances 503_f2d_359 9th cir aff’g tcmemo_1971_200 399_f2d_603 9th cir aff’g tcmemo_1967_7 95_tc_525 aff’d 965_f2d_1038 11th cir sec_1_162-7 income_tax regs the reasonableness concept has particular significance in determining whether payments between related parties represent ordinary and necessary expenses fuhrman v commissioner tcmemo_2011_236 102_tcm_347 petitioners bear the burden of proving the reasonableness of the compensation paid see rule a the court_of_appeals for the ninth circuit the appellate venue in these cases absent stipulation to the contrary applies five factors to determine the reasonableness of compensation the employee’s role in the company a comparison of the employee’s salary with salaries paid_by similar companies for similar services the character and condition of the company potential con- flicts of interest and the internal consistency of the company’s compensation arrangement 716_f2d_1241 9th cir rev’g and remanding tcmemo_1980_282 the ninth circuit also considers whether the amounts paid would be regarded as reasonable by a hypothetical independent investor see 376_f3d_1015 9th cir aff’g 119_tc_8 elliotts inc f 2d pincite if the bulk of the corporation’s earnings are being paid out in the form of compensation so that the corporate profits after payment of the compensation do not represent a reasonable return on the shareholder’s equity in the corporation then an independent shareholder would probably not approve of the compensation arrangement respondent has allowed deductions for some of the management fees as reported by the s_corporations on forms w-2 issued to the five principals see supra p deductions for these amounts having been allowed the disallowed management fee deductions consist of additional base monthly compensation and bonuses paid_by pace in his post-trial briefs respondent did not chal- lenge the former and we find that he has conceded pace’s entitlement to deduc- tions for additional base monthly compensation of dollar_figure for dollar_figure for and dollar_figure for the management fees that remain in dispute are thus the bonuses paid_by pace as follows year bonuses paid dollar_figure big_number big_number respondent advances several arguments against the deductibility of these bonus payments including lack of economic_substance and reallocation under sec_482 we will decide this issue on the basis of respondent’s third alternative contention namely that the bonus payments constituted unreasonable compensa- tion for services rendered by the five principals and hence were not ordinary and necessary business_expenses under sec_162 both parties introduced expert testimony that addressed this question re- spondent offered and the court recognized j t atkins as an expert in valuation financial analysis and customary business practices he has worked in investment banking for more than years and currently heads an advisory firm specializing in mergers acquisitions and restructurings he has performed dozens of 19perc paid a bonus of dollar_figure in because the notice_of_deficiency did not disallow any management fee deductions claimed by perc for we need not further discuss that payment corporate valuations chiefly involving companies with revenues of less than dollar_figure million we found mr atkins to be a knowledgeable and credible witness respondent retained mr atkins to determine the values of the water com- panies during the years at issue and to determine whether the management fees paid to pmg represented reasonable_compensation employing familiar valuation techniques mr atkins determined year-end valuations for pace as follows year value dollar_figure big_number big_number mr atkins evaluated the water companies’ profitability and bonus pay- ments against data from similarly situated companies using zweig white survey informationdollar_figure he determined that the water companies frequently ranked in the 20mr atkins valued pace using a comparable company ebitda multiple analysis a widely used valuation technique he first determined an earnings multiple for a group of comparable publicly traded companies then applied a dis- count to calculate an earnings multiple for pace he applied that multiple to pace’s annual ebitda earnings before interest taxes depreciation and amortization before bonuses to determine its fmv each year 21mr atkins explained that zweig white is an organization that tracks an- nual surveys of more than firms to derive data concerning the financial per- formance of firms in the engineering architecture and environmental consulting industry top quartile of comparable companies for revenue growth but in the bottom quartile for pretax profit with respect to pace in particular he determined that it ranked in the top quartile of similarly situated companies for revenue growth the top quartile for bonus payments but the bottom quartile for pretax after-bonus profit he concluded that this inconsistency resulted mainly from the extremely high management fees paid to pmg as a corollary of this determination he concluded that the five principals in their capacity as shareholders of the water companies received returns on their equity_investment that were abnormally low mr atkins noted that the water companies’ gross_profits steadily increased during the years at issue while their net_income steadily decreased he attributed a substantial part of this phenomenon to excessively high management fees he ultimately opined that no bonuses should have been paid at all petitioners offered and the court recognized brett solomon as an expert in general financing arrangements mr solomon is currently a national director for valuation advisory services at cohn reznick he has provided numerous valua- tion opinions during his career and has advised many companies with respect to their financial arrangements mr solomon determined that the five principals generated considerable economic value for the water companies but he did not perform an independent valuation of them instead he relied on a valuation performed in by the strategic equity group seg for the purpose of determining buy-in values for employee share purchases for seg valued pace at dollar_figure million then ap- plied to this figure an aggregate discount of for lack of control and marketa- bility employing the relatively low equity value thus determined mr solomon opined that a hypothetical independent investor in pace would have received a reasonable return on his investment after the bonus payments were made on the valuation issue we find that respondent has the better side of the ar- gument mr solomon did not perform an independent valuation of the water companies and no one from seg testified as an expert witness or otherwise at trial the seg valuation was prepared in it sheds no light on the proper valuation of pace for and when its revenues were growing very rapidly the seg valuation was also intended for a very specific purpose ascer- taining an appropriate buy-in price for employee purchases of pace stock peti- tioners have provided no evidence to establish that a discount for lack of con- trol and marketability would be appropriate for purposes of conducting the rea- sonable compensation analysis involved here we will accordingly adopt the valuations for pace that mr atkins derived although we found mr atkins’ valuations and overall approach credible we find it necessary to adjust his prebonus pretax numbers in light of our holding regarding the factoring fees mr atkins based his calculations on the income and expenses shown on the water companies’ books because we have held that the factoring fees were not bona_fide expenses but rather were distributions of profits we believe these amounts must be added back to pretax income for purposes of conducting the reasonable_compensation analysis we will now apply the elliotts factors to determine the extent to which pace’s bonus payments were reasonable in all cases we use the term em- ployees to refer not to pmg or the s_corporations but to the five principals who performed all relevant services and collectively owned of pace’s stock employee’s role in the company in applying this factor we consider how significant the employee is to the company elliotts inc f 2d pincite relevant considerations include the position held by the employee hours worked and duties performed as well as the general importance of the employee to the success of the company ibid the five principals were indisputably critical to the water companies’ suc- cess most of them had been employed by the water companies since the incep- tion of their businesses and they were responsible for all customer relationships if the factors we discuss below justify the payment of bonuses the five principals would be entitled to them comparison of salaries with salaries paid_by similar companies for similar services mr atkins determined that pace’s bonus payments were excessive in all years based on the zweig white survey of similarly situated firms we find mr atkins’ general approach to be reasonable but we must adjust his results for the factoring fees which we add back to pace’s pretax profit for start- ing with mr atkins’ computations we show below our calculation of pace’s revised prebonus profit and the bonuses it paid year atkins pre- bonus profit add’l factoring fees revised pre- bonus profit bonuses paid dollar_figure dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number bonus as mr atkins determined that for firms similarly situated to pace the median percentage of pretax profit devoted to bonus payments was approximately and for and respectively as shown above the corresponding percentages for pace were and dollar_figure we ac- 22these figures exclude bonuses paid to rank-and-file pace employees cordingly find that the bonuses paid_by pace were higher than bonuses paid_by comparable engineering firms character and condition of the company in applying this factor we consider the bonus payments in light of the company’s size as indicated by its sales net_income or capital value elliotts inc f 2d pincite as discussed above the water companies experienced very rapid growth during the years at issue pace’s revenues in particular rose from dollar_figure in to dollar_figure in a increase as shown in the table on the preceding page pace in each year had ample pretax profits after adding back factoring fees from which to pay bonuses potential conflicts of interest in applying this factor we consider whether some relationship exists be- tween the taxpaying company and its employee which might permit the company to disguise nondeductible corporate_distributions of income as salary expenditures deductible under sec_162 elliotts inc f 2d pincite that is un- questionably the case here the five principals who received the bonuses in ques- tion were pace’s sole shareholders and the management fees comprising the bonuses were a central component of mr ryder’s tax-minimization scheme which the five principals implemented we also consider whether pace’s postbonus profits would be considered adequate from the viewpoint of a hypothetical independent investor ibid starting with mr atkins’ valuations we show below our calculation of the equity re-turns earned by the principals in their capacity as shareholders of pace year atkins valuation revised pre- bonus profit bonuses paid profits for shareholders return on equity dollar_figure dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number mr atkins’ analysis indicates that these returns on equity were quite low for a firm like pace especially for and dollar_figure cf elliotts inc f 2d pincite concluding that a return on equity would satisfy an independent investor brinks gilson lione v commissioner tcmemo_2016_20 111_tcm_1079 normandie metal fabricators inc v commissioner tcmemo_2000_102 79_tcm_1738 concluding that returns on equity between and would not satisfy an independent investor aff’d 10_fedappx_26 2d cir 23mr atkins computed the water companies’ returns on equity using a capital_asset pricing model which determines a company’s cost of equity i e its required rate of return from the perspective of a third-party investor internal consistency of company’s compensation payments in applying this factor we consider whether the company maintains a struc- tured formal consistently applied program that evidences a reasonable long- standing consistently applied compensation plan elliotts inc f 2d pincite the water companies had a consistently applied bonus program for rank- and-file employees who received bonuses according to a fixed schedule when funds were available under mr ryder’s scheme however the water companies had no plan of any sort for paying bonuses to the five principals none of the principals who testified at trial could explain how the bonus plan worked or what standards were applied mr krebs testified that there was no set formula or schedule for determining the principals’ bonuses there is no evidence that bonuses were paid according to any regular schedule or were actually designed to reflect the value of the principals’ services and petitioners offered no evidence as to how the principals’ bonuses if any were determined for years before when mr ryder’s scheme was put into effectdollar_figure 24a consideration that may be relevant in applying this fifth factor is wheth- er the employee-shareholder’s compensation is comparable to that of other com- pany employees elliotts inc f 2d pincite given the distinct roles the five principals played in the water companies’ success we find that such a compari- son would not be relevant or helpful here see eg clymer v commissioner tcmemo_1984_203 47_tcm_1576 conclusion applying the elliotts factors in light of the record evidence we find that a portion of pace’s bonus payments constituted reasonable_compensation in each year given the absence of any structured bonus plan for the five principals the existence of conflicts of interest and the principals’ clear intention to disguise nondeductible corporate_distributions of income as deductible salary expendi- tures elliotts inc f 2d pincite we conclude that pace is entitled to deduct bonus costs that are in the lowest quartile of similarly situated engineering firms mr atkins determined that for similarly situated firms the lowest quartile of bonus costs divided by pretax prebonus profit was approximately for for and for adopting these percentages and running pace’s revised prebonus profit through mr atkins’ valuation methodo- logy we achieve the following results year atkins valuation revised pre- bonus profit bonus bonuses allowed profits for shareholders return on equity dollar_figure dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number allowing bonuses of this magnitude leaves sufficient profits in pace to provide shareholder returns on equity of and for and respectively the data supplied by mr atkins suggest that these returns would be deemed adequate by a hypothetical investor in a company like pace we accordingly find and hold that pace is entitled to deductions under sec_162 for bonus expenses of dollar_figure for dollar_figure for and dollar_figure for the balances of the bonuses paid--dollar_figure for dollar_figure for and dollar_figure for 2005--do not represent bona_fide compensation_for services rendered but rather constituted nondeductible distributions of corporate profits we have reached these conclusions u sing our best judgment based on all the evidence in the record clymer t c m cch pincite see also 16_tc_1452 aff’d 199_f2d_629 5th cir aries commc’n inc subs v commissioner tcmemo_2013_97 105_tcm_1585 iv consequences for the five principals in the notices of deficiency the irs determined that the five principals had received unreported income by virtue of the various corporate payments discussed above respondent subsequently conceded that the unreported income amounts appearing in the notices of deficiency should be reduced by the salary amounts shown on forms w-2 issued to the five principals after making that offset the amounts of unreported income remaining in dispute appear to be as follows principal perslow severson krebs hartwell boultinghouse dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number -0- -0- dollar_figure big_number big_number big_number -0- dollar_figure big_number big_number big_number big_number the irs based its determinations of unreported income on four alternative theories constructive dividends assignment_of_income lack of economic sub- stance and lack of arm’s-length pricing under sec_482 we will decide this is- sue chiefly on the basis of respondent’s constructive_dividend theory a constructive dividends the irs’ determination of constructive_dividend income is a determination of unreported income see coastal heart med grp inc v commissioner tcmemo_2015_84 109_tcm_1424 the ninth circuit has held that the irs must provide some reasonable foundation connecting the taxpayer with the income-producing activity see 596_f2d_358 9th cir rev’g 67_tc_672 once the irs has produced evidence linking the taxpayer with an income-producing activity the burden_of_proof shifts to the taxpayer to prove by a preponderance_of_the_evidence that the irs’ determinations are arbitrary or erroneous 293_us_507 respondent has clearly established an evidentiary foundation to shift the burden to petitioners the five principals owned of the water companies’ stock the funds that flowed out of the water companies as disguised expenses represented either compensation_for the principals’ services or distributions and those amounts were either paid to them or held and invested for their future benefit sec_301 and sec_316 govern the characterization for federal_income_tax purposes of corporate_distributions of property to shareholders if the distributing_corporation has sufficient earnings_and_profits e_p the distribution is a divi- dend that the shareholder must include in gross_income sec_301 if the distribution exceeds the corporation’s e_p the excess represents a nontaxable re- turn of capital or capital_gain sec_301 and the taxpayer bears the burden of proving that the corporation lacks suffi- cient e_p to support dividend treatment at the shareholder level 89_tc_1280 fazzio v commissioner tcmemo_1991_130 aff’d 959_f2d_630 6th cir zalewski v commissioner tcmemo_1988_340 delgado v commissioner tcmemo_1988_66 petition- ers produced no evidence concerning the water companies’ e_p during the years at issue and have thus failed to satisfy their burden_of_proof see truesdell t c pincite6 vlach v commissioner tcmemo_2013_116 105_tcm_1690 n we therefore deem the water companies to have had after add-back of the disallowed deductions for bonuses and factoring fees suffi- cient e_p in each year to support dividend treatment dividends may be formally declared or constructive a constructive divi- dend is an economic benefit conferred upon a shareholder by a corporation with- out an expectation of repayment truesdell t c pincite citing 368_f2d_439 9th cir aff’g t c memo cor- porate expenditures constitute constructive dividends only if the expenditures do not give rise to a deduction on behalf of the corporation and the expendi- tures create ‘economic gain benefit or income to the owner-taxpayer ’ 820_f2d_1084 9th cir quoting me- ridian wood prods co v united_states 725_f2d_1183 9th cir aff’g tcmemo_1984_549 corporate payments to third parties may constitute constructive dividends if they are made on behalf of a shareholder or for his economic benefit 923_f2d_67 7th cir see eg 182_f3d_275 4th cir corporate payments for family vacations aff’g tcmemo_1996_452 noble f 2d pincite corporate payment for repairs and painting of shareholder’s residence and for shareholder’s travel_expenses the amount of the constructive_dividend equals the fair_market_value of the benefit received 37_tc_650 schank v commissioner tcmemo_2015_235 110_tcm_542 whether corporate expenditures are disguised dividends presents a question of fact 685_f3d_730 8th cir aff’g in part rev’g in part tcmemo_2011_29 schank t c m cch pincite in disallowing the water companies’ deductions for factoring fees and the bulk of pace’s claimed deductions for bonuses we have determined that none of these expenditures give s rise to a deduction on behalf of the corporation p r farms inc v commissioner f 2d pincite the remaining question is whether these expenditures create d ‘economic gain benefit or income to the owner-taxpayer ’ ibid we find that they did the principals hired mr ryder to create a tax structure that would enable them to defer taxation of substantial portions of their income paying current tax only on income needed to defray current living_expenses the bulk of the water companies’ profits was distributed through pmg as disguised expenses and was invested for the principals’ benefit on a tax-free basis it is clear that the funds extracted from the water companies in this way create d ‘economic gain benefit or income to the owner-taxpayer s ’ ibid we have determined that the following amounts were not deductible by the water companies but were disguised distributions of corporate profits expense paq factoring pai factoring -0- total dollar_figure dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number pace factoring dollar_figure big_number big_number big_number big_number pace bonuses big_number big_number big_number big_number total big_number big_number big_number big_number big_number we must now apportion these amounts among the five principals this is no easy task the principals had differing ownership interests in the water com- panies and pai’s profits appear to have been distributed in a manner that did not reflect actual share ownership the water companies had differing amounts of disallowed expenses and those expenses differed in character perc for ex- ample did no factoring the calculation is further complicated by the water companies’ use of different fiscal years scientific accuracy being impossible we will apportion the corporate distri- butions among the five principals on the basis of the s corporations’ respective ownership interests in pmg which were designed to approximate the principals’ blended ownership interests in the water companies as reflected on the sched- ules k-1 included in pmg’s partnership tax returns the s_corporations as of de- cember had the following percentage ownership interests in pmg amounts do not total because of rounding s_corporations interest perslow inc severson inc krebs inc hartwell inc boultinghouse inc applying these percentage ownership interests we apportion the water companies’ disallowed expenses among the five principals as follows amounts do not total exactly due to rounding of ownership percentages year disallowed expenses perslow severson krebs hartwell b’house dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number total big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number for each year in issue the disallowed corporate expenses that we have apportioned to messrs perslow severson krebs and hartwell as shown above exceed the amounts of unreported income on which the irs seeks to tax those individuals the notices of deficiency shed no light on how the irs determined the amounts of unreported income and respondent offered no explanation of his calculations at trial or in his post-trial briefs nor has respondent moved to amend his pleadings to assert increased deficiencies against these individuals we ac- cordingly find that the following four individuals received taxable constructive dividends equal to the amounts of unreported income remaining in dispute as follows principal perslow severson krebs hartwell dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number dollar_figure big_number big_number big_number the situation is different for mr boultinghouse respondent has alleged no unreported income for him in or but alleges unreported income of dollar_figure in the disallowed corporate expenses we have apportioned to mr boultinghouse for are only dollar_figure we accordingly find that he received a taxable constructive_dividend in of dollar_figure b assignment_of_income we have determined that pace is entitled to deductions for the following amounts of compensation_for services in addition to the salary amounts reflected on the forms w-2 issued to the five principals compensation add’l base comp bonuses total dollar_figure big_number big_number dollar_figure big_number big_number dollar_figure big_number big_number these amounts were paid to pmg as nominal management fees then dis- tributed in part to the five s_corporations then distributed in part to the five esops we must consider whether these amounts were taxable to the five princi- pals individually under respondent’s assignment_of_income theory our resolu- tion of this issue is properly adjudicated in the deficiency proceedings because the assignment_of_income relates to determinations with respect to the five principals in their deficiency cases not to partnership items of pmg see 95_tc_74 holding in the context of an s_corporation then sub- ject to tefra partnership procedures that whether the taxpayer was the beneficial_owner of the interest was a shareholder-level item olsen-smith ltd v commissioner tcmemo_2005_174 90_tcm_64 holding same in the context of a partnership subject_to tefra procedures grigoraci v commissioner tcmemo_2002_202 84_tcm_186 as explained previously the constructive dividends we have determined exceed by themselves the amounts of unreported income that respondent con- tends were received by messrs perslow severson krebs and hartwell during the years at issue because we cannot allocate to those four individuals unreported income in excess of the amounts set forth in the notices of deficiency we need not consider respondent’s assignment_of_income argument as applied to them the situation again differs for mr boultinghouse respondent alleges that he received unreported income of dollar_figure for but we find that he received constructive dividends of only dollar_figure for that year we accordingly must consider respondent’s assignment_of_income theory as applied to the dollar_figure balance of the alleged unreported income a longstanding principle of tax law is that income is taxed to the person who earns it 410_us_441 h e who earns income may not avoid taxation through anticipatory arrangements no matter how clever or subtle citing 281_us_111 a person who earns income cannot avoid taxation by entering into a contractual arrangement whereby that income is diverted to some other person or entity id pincite under mr ryder’s tax-minimization scheme mr boultinghouse remained the cfo of all four water companies and he continued to provide them with exactly the same financial and accounting services he had supplied previously but now he supplied those services as an employee of his s_corporation which allegedly supplied his services to pmg which allegedly supplied his services as an independent_contractor to the water companies he signed a purported agreement of employment with his s_corporation but that document did not specify what position he was to hold or what duties he was to perform rather it simply recited that he would render and perform services under the direction and designation of his s_corporation because his s_corporation was a paper entity and functionally his alter ego that recitation was meaningless in reality he performed services for the water companies under the direction and designation of himself the agreement of employment like pmg’s purported agreement to pro- vide mr boultinghouse’s services as an independent_contractor to the water companies did not in any meaningful way change the employer-employee relationship he had with those corporations mr ryder’s tax-minimization plan was a classic assignment_of_income scheme whereby mr boultinghouse used a series of contractual arrangements to divert salary income that would otherwise have flowed directly to him see basye u s pincite but no anticipatory arrangement can hide the fact that his share of the management fees was in substance earned by and owed to him we recognize the principle that a corporation including an s_corporation is a separate taxable entity see 319_us_436 but the relevant question is not simply who earned the income but rather who controls the earning of the income see 78_tc_882 citing 73_tc_1246 aff’d without published opinion 734_f2d_20 9th cir fleis- cher v commissioner tcmemo_2016_238 112_tcm_723 in a setting such as this two elements are generally required before the corporation will be regarded as the party that controls the earning of the income the corporation must be able to direct and control the employee in a meaning- ful way and there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation’s controlling position johnson t c pincite see 57_f3d_752 9th cir same we find that the first requirement is not satisfied here because boulting- house inc the s_corporation was not able to and did not in fact direct and control mr boultinghouse in any meaningful way the s_corporation was a paper entity his purported agreement of employment with it did not specify what position he was to hold or what duties he was to perform and far from rendering his services under the direction and designation of his s_corporation he in fact supervised his own employment by directing the day-to-day activities of the water companies the documents mr ryder drafted were not worth the paper they were printed on they were designed to create and they had the effect of producing an anticipatory assignment of mr boultinghouse’s income to a tax- exempt entity mr ryder had created for that purpose see 621_f2d_1318 8th cir aff’g tcmemo_1979_164 in sum we conclude that the assignment-of-income principle is fully appli- cable here because mr boultinghouse’s s_corporation was not able to and did not in fact direct or control in some meaningful sense the activities of the service provider idaho ambucare ctr inc f 3d pincite johnson t c pincite same dollar_figure once again we must apportion to mr boultinghouse his ratable share of the dollar_figure additional compensation that we have allowed the water companies to deduct for for lack of any better evidence we will again consider boultinghouse inc ’s ownership_interest in pmg which was designed to approximate mr boultinghouse’s blended ownership interests in the water companies that percentage interest being we find that mr boultinghouse for is taxable under the assignment-of-income doctrine on unreported income of dollar_figure dollar_figure v pmg in light of our holdings above with respect to the water companies and the five principals we need not address any of respondent’s determinations in the fpaa issued to pmg the water companies and the principals are the only taxpaying persons in these cases having adjudicated all items in the notices of deficiency issued to them we have no reason to discuss any of respondent’s arguments in the fpaa which respondent tendered as alternative grounds for ruling in his favor 25in view of our disposition we need not address whether the second re- quirement of the johnson test is met viz whether there existed a bona_fide con- tract or similar indicium recognizing the corporation’s controlling position johnson t c pincite to reflect the foregoing decisions will be entered under rule appendix a johan a perslow docket no mark e krebs janet torrey b krebs docket no pacific environmental resources corporation docket no gary j tolosa zoila m tolosa docket no derek h karimoto debbie j karimoto docket no andrew d komor summer j komor docket no mark e krebs janet b krebs docket no michael g krebs laura m krebs docket no james a matthews jr kristen l matthews docket no johan a perslow docket no bruce m phillips laura k phillips docket no cory m severson rochelle l severson docket no sonny o sim emily c ang docket no pacific aquascape california incorporated docket no sonny o sim emily a sim docket no gary j tolosa zoila m tolosa docket no water specialty group incorporated a k a water specialty group docket no perc water corporation subsidiaries a k a perc water corporation docket no pacific environmental resources corporation a arizona corporation perc docket no michael g krebs laura m krebs docket no mark e krebs janet torrey krebs docket no gary j tolosa zoila m tolosa docket no cory m severson rochelle l severson docket no sonny o sim emily a sim docket no bruce m phillips and laura k phillips deceased docket no james a matthews jr kristen l matthews docket no andrew t komor summer j komor docket no derek h karimoto debbie j karimoto docket no and johan a perslow docket no appendix b cory m severson rochelle severson docket no respondent con- cedes that petitioners did not have unreported ordinary dividend income of dollar_figure for petitioners concede that they have unreported constructive_dividend income of dollar_figure dollar_figure dollar_figure and dollar_figure for respec- tively pacific aquascape international inc docket no petitioner concedes that it is not entitled to claim interest_expense deductions in the amounts of dollar_figure dollar_figure and dollar_figure for respectively respondent concedes that petitioner is entitled to deductions for facility costs in the amounts of dollar_figure dollar_figure and dollar_figure for respectively pacific environmental resources corp docket no petitioner concedes that it is not entitled to claim deductions for personal expenses of dollar_figure for mark e krebs janet b krebs docket no respondent concedes that petitioners are entitled to an additional capital_loss deduction of dollar_figure for that they did not have unreported capital_gains income of dollar_figure for and that they did not have unreported ordinary dividend income of dollar_figure for petitioners concede that they have unreported constructive_dividend income of dollar_figure dollar_figure dollar_figure and dollar_figure for respectively johan a perslow marie majkgard perslow docket no petitioners concede they are liable for an addition_to_tax under sec_6651 of dollar_figure for petitioners concede that they have unreported constructive_dividend income of dollar_figure dollar_figure and dollar_figure for respectively pacific aquascape inc docket no petitioner concedes that it is not entitled to claim deductions for personal expenses in the amounts of dollar_figure dollar_figure and dollar_figure for respectively and that it is not entitled to claim a deduction for marketing expenses paid to pai in the amount of dollar_figure for petitioner also concedes that it is not entitled to claim interest_expense deductions in the amounts of dollar_figure dollar_figure and dollar_figure for re- spectively and that it is not entitled to claim a net_operating_loss_deduction of dollar_figure for pacific advanced civil engineering inc docket no petitioner con- cedes that it is not entitled to claim deductions for personal expenses in the amounts of dollar_figure dollar_figure dollar_figure and dollar_figure for respectively that it is not entitled to claim deductions under sec_179 for qualified asset purchases in the amounts of dollar_figure dollar_figure dollar_figure and dollar_figure for respectively and that it is entitled to claim depreciation_deductions in the amounts of dollar_figure dollar_figure dollar_figure and dollar_figure for respectively petitioner also concedes that it is not entitled to claim interest_expense deductions in the amounts of dollar_figure dollar_figure and dollar_figure for and respec- tively richard f boultinghouse loraine boultinghouse docket no peti- tioners concede that they are not entitled to claim a net_operating_loss carryforward deduction of dollar_figure for johan a perslow docket no petitioner concedes that he is liable for an addition_to_tax under sec_6651 of dollar_figure for petitioner concedes that he has unreported constructive_dividend income of dollar_figure for