by Don Bromley, CPA, MST.

FACTS:

For the years 1986, 1987, 1989, 1990 & 1991, an assessment of $291,571.00 was levied against SYMS Corp. by the State of Massachusetts. The taxpayer first appealed the Commissioner ruling, and later the Appellate Court affirmed the Commissioner’s refusal to abate the assessment. The assessment was the result of the Commissioner’s disallowance of deductions for royalty payments SYMS Corp. paid to its wholly owned Delaware Holding Company (DHC) subsidiary, SYL, Inc. The royalties were paid to SYL, Inc. in return for the right to use certain trade names, marks, and service marks. SYMS Corp. transferred these marks to the DHC subsidiary in December 1986.

BACKROUND:

· SYMS Corp. (SYMS) sold clothing at two stores it operates in Massachusetts. The prices SYMS charged were lower than those charged by other department stores.

· SYMS owned the DHC 100%. Sy Syms was chairman of the board and owned 56% of the DHC parent, and controlled the votes for another 24% held in family trusts. Marcy Syms, his daughter, was president.

· Before 1986, SYMS owned all marks. After the transfer in1986 to the DHC, the DHC owned all marks.

· A financial consultant brought the idea to create a DHC purely for state tax saving reasons to SYMS’ CFO. The consultant would be compensated based on a percentage of the tax savings.

· SYMS was concerned about the risks under trademark law of placing all marks in a DHC. Trademark counsel advised that the transfer would be valid as a matter of trademark law since SYMS owned the DHC, and therefore all the marks, and would still therefore stand behind the marks.

· Royalty rate on use of marks was 4% of annual net sales.

· Royalties were paid annually. Royalty amounts were held for a few weeks and then wired back to parent as a tax-free dividend.

· DHC income was royalty income only, and expenses were 1/10 of one percent of income.

· A Delaware accountant was paid $1,200 per year to manage the company’s $12.7 million dollar revenue stream.

· Rental expense amounted to $1,200 per year, and SYL, Inc. was one of “a couple of hundred” companies that was serviced by this Delaware holding company service provider. (SYL, Inc. also paid a one-time fee of $1,000 for office equipment).

· All work to protect the marks was performed by and paid for by SYMS, not SYL, Inc. (the DHC). In addition, SYMS created all value inherent in the marks before the December 1986 transfer. Because of the facts, the Appellate Tax Board (Board) argued that it was SYMS that protected and created the marks, and that any payments to the DHC were not necessary or reasonable. Since the deductions were not “ordinary and necessary”, they should be disallowed. The Board asserted the deductions were devised only to shift income.

· Arm’s Length notion for payments to DHC was disregarded by the Board. The reason is that payments were not in return for services provided by SYL, Inc., but appeared as only a circular shifting of income.

· There were three grounds on which the Board disallowed the deductions:

1 - the transfer and leaseback of the marks was a sham

2 - the payments were not ordinary and necessary and should be disallowed

3 – the affiliate payments were in excess of fair market value and should be eliminated from the calculation of net income

ANALYSIS:

First of all, the parent company should have discussed the non-tax aspects of planning for the DHC and the related benefits before the DHC was incorporated. This discussion should then have been documented and approved in Board of Director meetings at the parent. A non-tax business purpose should have been adopted by the DHC as well and should have included such facts as the “defense, protection, and management” of centrally located intellectual property. Activities related to this that would be performed by the DHC would include payment of registration fees for the marks and names, payment of attorneys fees to protect and defend the marks and names, actually recording the marks and names when necessary, and managing the marks and names to show use so as to be certain that the rights are not lost with respect to same.

This business purpose would have helped refute the Board’s assertion that “the parent was paying for the marks twice”. To support this assertion, the Board stated that prior to 1986, the value inherent in the marks was paid for and created by the parent, and that for the parent to pay a royalty fee after 1986, would, in effect, be paying for the marks twice. As an extension of this argument, the board further stated that the payments from the parent were therefore not reasonable or “ordinary and necessary”, and should be disallowed. Had the business purpose been perfected to state that the company was to protect and defend marks, and then in practice actually pay for and perform the defense of the marks, the theory that the company was organized “to merely shift income” may have been rebutted.

To help the DHC’s defense, another idea would have been to gain a formal valuation of the names and marks from a Certified Valuation Analyst (CVA). This valuation would have put forth an arm’s length analysis of the fair value of the marks and names, which would have provided a solid foundation for a royalty rate to be associated with sales relative to those marks. The case does not state that such a valuation was performed. A CVA’s assessment of value would have assured the court that the royalty rate was not conjured up by some tax driven advisor or company owner, especially when the tax advisor’s fees in this case were based upon tax savings for the first and ensuing years of deploying this strategy.

The case states that royalty payments, when made, were held a few weeks and then wired back to the parent as a tax-free dividend. A strategy that would have prevented the appearance of a circular flow of funds would have been to lend the money to affiliates as loans, or to invest the money in permissible DHC assets (stocks, bonds, etc.).

Another flaw in the structure was the fact that expenses were 1/10 of one percent of the royalty income earned. The case also noted that all trademark counsel fees and other related fees were paid from the parent. These are not good facts. The expenses could have been bolstered had all costs of the DHC been paid from the DHC’s Delaware bank account. In addition, the salary of the sole employee in Delaware was a mere $1,200. For all the duties that were discharged to this employee to effectively run a DHC with a $12.7 million revenue stream, the salary was not commensurate with the employee’s required activities. The case did not mention that the employee’s activities were reviewed by anyone in a superior position. A better strategy would have included a review of employee activities at the board meeting and a reasonable salary. Lastly, the rental expense of the DHC was only $1,200, and the office was shared with “a couple of hundred” companies. The DHC would have been better off paying more rent to a smaller, independent service provider that was not subject to sharing the office space of a client with, as the case states, “a couple of hundred" other companies.

Conclusion and Solution

The following lists the three attacks on the structure:

1 - the transfer and leaseback of the marks was a sham

2 - the payments were not ordinary and necessary and should be disallowed

3 – the affiliate payments were in excess of fair market value and should be eliminated from the calculation of net income.

The first attack revolves around the “sham transaction doctrine”. This doctrine states that “to treat a transaction as a sham, the court must find [1] that the taxpayer was motivated by no business purpose other than obtaining tax benefits in entering the transaction, and [2] that the transaction has no economic substance because no reasonable possibility of profit exists”. The financial consultant in this case was motivated by a “tax savings scheme” and brought it to the attention of SYMS management, as the case states. The management team at Delaware Management Services (DMS) helps clients formulate a business purpose and ensures that the strategy makes good business sense before the tax aspects are ever quantified.

The second attack adopted by the court was that the payments were not “ordinary and necessary”, and should be disallowed. The reason the court made this claim was that the DHC added no value to the marks, and that since the parent company created the marks, the parent was in effect “paying for the marks twice”. In these cases, DMS professionals help formulate the meaningful business activities the DHC should perform. Meaningful activities such as monitoring how the marks are used in the marketplace, and paying for the registration and defense of the marks are often suggestions DMS professionals give during the planning phase of the DHC. In this case, the DHC should have been adding value by performing these activities.

The third attack is that the payments were in excess of fair value. As noted above in the analysis section, a valuation to support an arm’s length royalty rate should have been performed. This step is also critical in the DMS “set-up” phase of a DHC incorporated to protect intellectual property. DMS has CVA’s on staff at its affiliate, Gunnip and Company, CPA’s. These CVA’s can assist any client in gaining a fair valuation of intellectual property.

Delaware Management Services helps clients defend and protect their investment in the DHC structure by staying informed of state developments and reporting these developments to client decision makers. We communicate the activities and policies that should be in place for each client after considering the facts and circumstances of each client, and the client’s exposure in certain jurisdictions. We recommend actions at Board of Director meetings, and we follow through to ensure the plans agreed upon with the client are implemented. We strive to provide the best solution for every client.

Please call Donald Bromley at (302) 225-5164 to discuss this case or to inquire about how a DHC could be right for you.

©2002 Delaware Management Services, a Division of Gunnip and Company, CPA’s.

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