How not to create corporate substance: The Flowers Case

By F Hale Stewart, JD, LLM, CAM, CWM, CTEP

The Law Office of Hale Stewart

As we approach the end of the year, the annual tax scam circus will start coming around. Expect promoters to make pitches for numerous half-baked schemes. A good example is the Flowers case from 1983 (80 T.C. 914). The case's facts are still a great example of how to not create corporate substance, thereby making the whole transaction suspect.

The facts are very simple: The promoters sought to form a limited partnership which invested in the record business by buying the rights to four albums and then selling the right to use the copyrights. (The judge went so far as to describe all music albums as poorly performed and recorded). Unfortunately for the taxpayers, the transaction was an utter sham, as shown by the following facts:

The promoters had no experience in the business — absolutely none

While this alone is not fatal to their business venture, they also didn't seek the input of people who did have the experience. All businesses require a special skill set in order to make money. Some, such as the music business, are especially skill specific. When no one involved in the transaction has any expertise, it's a sure bet there's something wrong.

There was no arms length negotiation

The promoters purchased four master recordings from a recording studio who simply named their price. There was no secondhand evaluation of product to determine if the valuation was in any way realistic.

The promotional literature was heavy on the promoter CYA and tax benefits

Essentially, the promoters wrote the package to escape all liability. They assumed no responsibility for the potential sales of the product and stated that the shelter could be audited by the IRS. In addition, the sales brochures were heavy on promoting the tax benefits.

The promoters were completely unaware of their responsibilities as managing partners

When questioned at trial, it became apparent the promoters had no idea what a general partner in a limited partnership was supposed to do. And after forming the limited partnership, the promoters simply walked away. They did not hold meetings nor they did not keep any corporate records.

There was no physical business

The limited partnership had no fixed address, no phone and no equipment. There was literally nothing save a state level filing to prove the business even existed.

Fantastical business projections

The individuals who sold the albums projected all four would be rise to platinum level status (over one million units sold). The promoters did not challenge these projections, nor did they seek a second opinion.

Like all tax plans, if it sounds too good to be true, it probably is.