Appeal from an order of the United States District Court for the Southern District of New York, Whitman Knapp, Judge, permanently enjoining defendants, pursuant to 26 U.S. C. § 6700, 7408 (1982 & Supp. II 1984) from promoting an abusive tax shelter.
Before: OAKES, WINTER, and MINER, Circuit Judges
The sale of tax shelters, by which taxpayers/investors obtain credits and deductions in return for investments involving risk, has lent itself to sufficient abuses to prompt statutory reform separate from the tax reform presently being discussed in the halls of Congress. The Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), Pub. L. No. 97-248, 96 Stat. 324 (pertinent portions codified in scattered sections of Title 26), sought to check the abuses by providing that anyone organizing or selling an interest in a tax shelter who makes who makes "a gross valuation overstatement as to any material matter" will be subject to penalty. 26 U.S.C. § 6700 (1982 & Supp. II 1984). TEFRA also authorizes the Government to seek an injunction against anyone subject to penalty under section 6700. 26 U.S.C. § 7408 (1982 & Supp. II 1984). Here at issue is an injunction obtained against Philatelic Leasing, Ltd. (Philatelic), Melvin Hersch, its president, and Hambrose Stamps, Ltd. (Hambrose), with reference to a 1982 tax shelter scheme. United States v. Philatelic Leasing, Ltd., 601 F. Supp. 1554 (S.D.N.Y. 1985) (Knapp, J.). Penalties under 26 U.S.C. § 6700 have also been levied against the appellants, but the penalties are not involved in this appeal. We affirm the grant of the injunction. The subject of the shelter here involved was "stamp masters." These are plates used to produce stamps. The stamps involved bore the names of one of four islands located of the coast of Scotland: Staffa, Berera, Eynhallow, and Grunay. These islands are privately owned and not independent political jurisdictions; two of them are uninhabited and another has only two residents. The stamps produced from the plates are not really postage stamps produced from the plates are not really postage stamps produced from the plates are not really postage stamps since they are not valid for the transmission of mail since they are not valid for the transmission since they are not valid for the transmission of mail anywhere except between points on the islands or from these islands to the Scottish island of Mull; for the mail to go any farther regular postage stamps must be applied. One may assume that there is little use for postage stamps on uninhabited islands; on the other hand, there is a vast philatelic market and this shelter was purportedly directed toward the production of stamps for sale in this market.
The tax shelter was generated by Philatelic's lease of a plate to a taxpayer who acquired with the lease of the plate the right to produce approximately 58,000 stamps. The taxpayer then was supposedly to sell these sets of stamps to the public, Philatelic supplying the name of a distributor familiar with the stamp collecting market. The lease was for a seven-year term and required annual payments from the taxpayer to Philatelic ranging from $30,000 for a two-stamp master to $80,000 per year for an eight-stamp master. However, more than eighty percent of the "rent" paid by a taxpayer was in the form of notes on which he had no personal liability, while a substantial portion of the remaining liability was not due to be paid until 1990.
This arrangement was to provide the taxpayer with several benefits, the fist of which was the assignment by Philatelic to him of Philatelic's right to an investment tax credit (ITC) amounting to 10% of the price that Philatelic had paid Hambrose to purchase the stamp masters. As will be seen, the purchase price paid by Philatelic was the inflated product of a series of transactions not at arm's length. The ITC available to a taxpayer/investor ranged from $15,000 for a two-stamp plate to $40,000 for an eight-stamp plate.
Second, the taxpayer obtained a tax deduction for lease payments in the form of either cash or notes allowable as deductions under the "at risk" rules for taxpayers. For a two-stamp master these deductible lease payments amounted to $7,500 in the first year and $30,000 in the second year. The third and final tax benefit consists of deductions for certain expenses incurred by the lessees, such as actual printing costs or fees paid to "distributors" of the "stamps".
By combining tax credits and deductions, the Philatelic 1982 shelter conferred, in tax shelter parlance, a "4-to-1 equivalent write-off." That is to say, a taxpayer would receive tax benefits four times greater than his actual cash outlay. Needless to say, the 4-1 write-off was advertised elaborately in the Philatelic brochure entitled "Confidential Offering Memorandum for the Leasing of Master Plates for the Production of British Local Stamps and Ancillary Products" an promoted in marketing program seminars run out of Newport Beach, California, whereby three to four hundred salespersons learned about the stamp master program and how to sell it. These sales-people were self-employed sellers in what one described as the tax shelter "industry"; certain of their advertising and overhead expenses were paid by Philatelic, and they received expenses were paid by Philatelic, and they received commissions out of cash paid by investors. The sales people held free public seminars around the country of the Philatelic program; these seminars stressed the tax benefits of the program.
Several other aspects of this shelter should be mentioned. Of the 72-page offering memorandum provided to prospective investors, fifty were devoted to an opinion letter from the law firm of Friedman and Shaftan, P.C., of 4 Park Avenue, New York, New York, setting forth the tax consequences of investing in the shelter. Also included in the offering memorandum was a letter from that firm agreeing to represent Philatelic Leasing in connection with any challenge by the IRS and offering, upon request by a lessee/investor, to assist the less's counsel and accountants in the event of any such tax challenge unless satisfactory resolution was obtained at the initial IRS audit level. The memorandum also advised investors that they would receive written appraisals from so-called "recognized Philatelic (stamp) experts" that would both assure that the value of the masters was what it was represented to be and aid the investor in the event of IRS audit. Facts revealed at trial amply demonstrate that these appraisals were untrustworthy. The appraisers involved each arrived at precisely the same value for each of the stamp masters, certainly a remarkable feat. At trial, one failed to recognize the names of three of the four islands issuing the stamps and admitted that he had not prepared the appraisal, only signed it. Another stated at a deposition that he was pretty sure" that stamps from one of the islands were actually valid for the international transmission of mail. And a third, who had participated a an appraiser in similar shelters in 1979, 1980, and 1981, withdrew from the 1982 program, the only one at issue here, because he believed the stamp masters were being overvalued.
The evidence indicated that Philatelic entered into 826 leases with taxpayers in 1982 and received over $16 million in cash from investors. Provided that the investors took their credits and deductions as per the offering memorandum, this would mean that taxpayers were able to obtain in that year alone some $64 million in tax benefits which, assuming that the investors were all in the 50% bracket, would translate into $32 million in tax savings. hence, the interest of the Government in obtaining an injunction.
To understand the contentions of the parties, the arrangements between the various defendants appealing and not appealing are significant. The owners of the islands, who granted exclusive rights to issue the "stamps," received a relatively small amount - a few thousand pounds per island per year - from Crailheath, Ltd., or London & New York Stamp Co., Ltd., two British corporations owned by Clive Feigenbaum, a British stamp dealer. In transactions not at arm's length, Feigenbaum's British corporations sold the rights to Global International, Ltd. ("Global"). Global, a non-appealing codefendant is a Liberian corporation controlled by Feigenbaum; its only office is at trust company in Monrovia, Liberia, and its sole officer is an Israeli attorney and friend of Feigenbaum's, Michael Shine. Feignebaum began to use Global in 1979 to avoid having his British stamp companies directly linked to the shelter marketing operations in the United States. Following negotiations at which it was represented by Feigenbaum, Global sold the stamp master rights to Hambrose Stamps, Ltd., a corporation owned by one Herman Finesod and incorporated in 1979 by the previously-mentioned law firm of Friedman and Shaftan. Finesod hired appellant Melvin Hersch to act as president of Hambrose in 1980 and 1981, during which years Hambrose acquired stamp masters from Global and sold them to taxpayers who took ITCs based on their purchase price. For the 1982 program this approach was modified. Philatelic was established to lease, rather than sell, the masters to investors. On April 20, 1982, Hersch resigned from Hambrose to become president of Philatelic and Finesod became president of Hambrose. Philatelic was incorporated on April 23, 1982, by Friedman and Shaftan, and it began doing business in the same offices on the 28th floor of 950 Third Avenue in Manhattan that Hambrose had occupied, staffed by the people that Hambrose had employed, and aided by employees of other Finesod corporations who had also performed support services for Hambrose.
In the not-at-arm's-length transaction between the Feigenbaum British corporations and Global, Global paid approximately $3.60 per master for the right to produce 10,000 stamp masters. Under an agreement dated May 31, 1982, Hambrose then agreed to pay Global between $106,300 for a single two-stamp master and $207,500 for a single eight-stamp master. This incredible mark-up, however, was illusory. The only cash changing hands was $1,300 to $2,500 per master; the remainder of the purchase price, i.e., more than 98% thereof, was in the form of non-recourse notes to be paid out of revenue derived from sale of the shelters.
Hambrose, one day after purchasing from Global the right to produce these stamp masters, entered into an agreement to sell these rights to Philatelic for prices ranging from $150,000 for a single two-stamp master to $400,000 for a single eight-stamp master. This price was also largely illusory, however, since less than 10% was to be paid in cash. Moreover, the cash was to come from the lessees since under the overall arrangement Philatelic would buy a master from Hambrose and Hambrose from Global only upon a taxpayer's entering into a lease. Admittedly, Philatelic, in an attempt to establish the fact that it was "at risk" (in order for there to be an ITC available to pass through to taxpayers investors), did execute recourse notes for the balance of the purchase price. this commitment, however, was completely lacking in substance. The Philatelic recourse notes bore only 9% simple interest per year, which was non-recourse. No payment was required of principal or interest until 1996, a payment date extendible to 2006 upon payment by Philatelic to Hambrose of the munificent sum of $200. Moreover, Philatelic concededly is "thinly capitalized," so its obligation on the notes is illusory. To preserve the ITC, defendant Hersch, the president of Philatelic, had to "personally guarantee" each note signed by Philatelic. thus, Hersch proceeded to guarantee more than $160 million in Philatelic notes, a guarantee which might also be considered illusory in view of the fact that his net worth at the time was, accordingly to the stipulation executed by the appellants, only $200,000.
As a result of these arrangements, Philatelic had to pay Hambrose 70% of the $16 million received by Philatelic from its 826 taxpayer/investors in 1982, or more than $11,250,000, and Hambrose in turn had to pay Global approximately 10% of that amount, or slightly more than $1.2 million. In addition, the principals of Global, Feigenbaum and Shine, also stood to gain $1,750,000 from the printing of the stamps by another Liberian corporation that they controlled. Out of the 30% of the cash received by Philatelic, it had to pay 26% to its nationwide force of commissioned salespersons, or $4.2 million out of $4.8 million. Thus Philatelic was left with approximately $600,000 to pay its own expenses as well as the cost of advertising and certain other expenses of its salespersons. While Philatelic was entitled under the tax shelter plan to receive from investors 50% of the moneys the investors obtained from the sales of the "stamps," under the agreement with Hambrose, Philatelic had to pay 98% of that amount over to Hambrose Philatelic was thus entitled to only 1% of the moneys received, and this was not a large amount. As Judge Knapp found, no investor in the Hambrose program in 1979, 1980, or 1981 has ever been a able to realize any profit from sales of the "stamps." 601 F. Supp. at 1557. Those taxpayer from the 1981 program who actually tried to sell stamps did not even recoup the advertising costs associated with the sale. There is no indication that the 1982 program was more successful. Thus, with no personal liability on ...