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March 29, 1989


The opinion of the court was delivered by: LUDWIG


 In 1986, the Internal Revenue Service assessed penalties against plaintiffs American Technology Resources, Albert S. Pitts, James A. Pitts, and Thomas M. Pitts for promoting abusive tax shelters as to tax years 1982 and 1983. 26 U.S.C. § 6700. Pursuant to 26 U.S.C. § 6703(c), plaintiffs, having paid 15 percent of the penalties, filed this action contesting their liability. *fn1" Jurisdiction exists under 28 U.S.C. §§ 1340 and 1346(a)(1).


 The following statement of facts is based on the parties' extensive pretrial stipulation.

 Plaintiff American Technology Resources (ATR) is a Nevada corporation, incorporated in 1982, with its principal place of business in Media, Pennsylvania. On June 1, 1983 its stock was issued to plaintiff Albert Pitts and his sons, plaintiffs James Pitts and Thomas Pitts. As of 1987 they owned 77.5 percent of the issued and outstanding shares. The other shareholders have not been active in the operation of the corporation.

 Albert Pitts became president of ATR in 1982 succeeding Rolph Fuhrman. *fn2" United States Motion Picture Institute (USMPI) is a non-profit Nevada corporation, and since 1982 Rolph Fuhrman has been its president. ATR Financial, also a Nevada corporation incorporated in 1982, became wholly owned by ATR in 1983. In 1982, Fuhrman was its president. ATR Product Marketing is a sole proprietorship of Albert Pitts, formed by him in 1982.

 ATR produces and sells an "ATR Video Image System," which includes high-technology video-image storage and retrieval products, services and equipment. On November 15, 1982 it entered into an agreement with USMPI permitting USMPI to sell ATR territorial distributorships. In 1982 and 1983, 34 such distributorships were sold pursuant to agreements signed by representatives of ATR and USMPI and by the distributor. Each agreement granted the distributor the exclusive right to market the ATR system - "product" - within a designated territory in New Jersey, eastern Pennsylvania, or Delaware for a term of 43 years. These distributorships were sold to 32 individuals and two limited partnerships, ATR Philadelphia and ATR Delaware. Each distributor also entered into a "Consulting Agreement" with ATR Product Marketing, under the terms of which ATR Product Marketing manages, administers, and supervises the sale, lease and licensing of the ATR product for the distributor.

 In return for the right to market the ATR product, each individual distributor agreed to incur a liability called a "Contingent Principal Sum," due USMPI in 23 installments: An "Incurred Annual Contingent Amount" equal to 20 percent of the "Contingent Principal Sum" payable in each of years one, two and three; no amount in years four through 10; and two percent of the "Contingent Principal Sum" for 20 years thereafter. The "Contingent Principal Sum" varied, depending on the population of the distributorship's territory.

 Most of the distributors also paid to ATR Financial in each of the first three years a "Guaranteed Performance Deposit" equaling five percent of the "Contingent Principal Sum." These payments were not credited against the "Contingent Principal Sum." They were the only specific cash payments a distributor was required to make.

 Each individual distributor received a promotional package before signing the distributorship agreement. According to the promotional material, a distributor could elect to be personally "at risk" for all or a part of the 20 percent "Incurred Annual Contingent Amounts" due in years one, two, and three. This personal obligation became due in 20 years as reduced by the distributor's allocation of profits from sales of ATR product. The promotional material also represented that a distributor could deduct on his federal income tax returns the amount of the "Incurred Annual Contingent Amount" for which he assumed personal liability. A distributor could thereby obtain a federal income tax deduction of up to four times the payment to ATR Financial.

 Under the agreement between ATR and USMPI, USMPI was to retain 25 percent of the "Contingent Principal Sum" payments and was to lend the balance, of 75 percent, to ATR without interest for an indefinite term. In 1982 and 1983, USMPI did not receive any payment on account of a "Contingent Principal Sum." Effective March 1, 1984, ATR, USMPI, ATR Product Marketing, and most of the distributors entered into a "Profit-Sharing and Joint Management Agreement." Under this agreement, all net profits or losses from ATR product sales made within New Jersey, eastern Pennsylvania and Delaware were to be divided among the distributors in proportion to the distributors' payments.

 The following elections of personal liability by distributors and financial activities on the part of ATR occurred during the years shown:

 In 1982, the distributors, including limited partners, chose to be "at risk" for $ 2,895,000. They received no distributions from ATR.

 In 1983, the "at risk" amount was $ 4,235,000, with no distributions from ATR.

 In 1984, the "at risk" amount was, again, $ 4,235,000. Distributions from ATR were $ 12,081, and the "Contingent Principal Sum" due USMPI was reduced by $ 4,066.

 In 1985, the "at risk" amount was $ 1,340,000. ATR distributions were $ 24,448 with a reduction of the "Contingent Principal Sum" due USMPI of $ 29,744.

 In 1986, the ATR distribution was $ 23,753 and the reduction of the "Contingent Principal Sum" was $ 59,113.

 ATR and USMPI also entered into an "Agreement re Modification of Rights . . ." under which ATR Product Marketing created an escrow fund that reduced the "Contingent Principal Sums" due USMPI. This fund was used to pay plaintiffs' legal fees and those of a number of distributors in tax litigation arising from the "ATR Territorial Distributorship Program." As of July, 1987 $ 123,000 was paid into the fund.

 According to ATR's promotional material issued in 1982, a sale of one video disk system for $ 88,000 in a "minimum" territory - a population of 50,000 and a "Contingent Principal Sum" of $ 200,000 - would cost ATR $ 50,000 and the distributor would receive $ 9,900. All sales outside designated territories would be credited solely to ATR. Thereafter, 55 to 60 percent of sales, in dollar amounts, took place outside the distributorship territories. In 1982, ATR's only sale of its product was one video disk player to ATR Product Marketing. In 1983, the only sale was one such player to an advertising agency that was retained by ATR.

 In 1982, Albert Pitts was a paid consultant for ATR while its program was being organized and before any distributorships were sold. Since May, 1983 he has been signing checks for ATR Financial, which paid commissions on sales of ATR distributorships. ATR owns no patents. Until 1983, Albert Pitts sold mutual funds and tax-advantaged investments and his sons worked with him. He provided the ATR promotional package and, in 1982 and 1983, explained the ATR program to a number of purchasers of distributorships. In this period, he also trained his sons and others to enable them to sell distributorships. James Pitts presented the ATR program to members of the financial community and gave out the ATR promotional package and private placement memorandums for the limited partnerships. Thomas Pitts did the same with purchasers of the distributorships.

 The ATR promotional package of 1982 for individual distributors contained the following items:

 (a) a cover sheet with table of contents consisting of two pages;

 (b) "Overview" consisting of six pages;

 (c) a letter dated July 15, 1982 from Rolph Fuhrman as president of USMPI;

 (d) a letter dated July 15, 1982 from Nemecek, Gonzalez & Linsley;

 (e) a tax opinion letter dated July 15, 1982 and addressed to USMPI consisting of 18 pages;

 (f) "Territorial Distributorship Agreement" consisting ...

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