                        T.C. Memo. 2003-250



                      UNITED STATES TAX COURT



ADVANCED DELIVERY AND CHEMICAL SYSTEMS NEVADA, INC., Petitioner
         v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8852-00.               Filed August 20, 2003.



     Donald P. Lan, Jr., for petitioner.

     Candace M. Williams, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   Respondent determined deficiencies in

petitioner’s Federal income taxes for petitioner’s short taxable

year beginning October 8 and ending December 31, 1996, and for

petitioner’s short taxable year beginning January 1 and ending

October 10, 1997, as follows:
                                  - 2 -

             Short Taxable
              Year Ending                       Deficiency
             Dec. 31, 1996                      $ 494,101
             Oct. 10, 1997                       1,578,112


     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

     The issue for decision is whether petitioner is subject to

the accumulated earnings tax for the above short taxable years.


                             FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

     Petitioner, a Nevada corporation, was incorporated on

June 13, 1996.    At the time the petition was filed, petitioner

maintained a registered address in Las Vegas, Nevada.

     Petitioner is the successor to Advanced Delivery & Chemical

Systems, Inc. (ADCS), an Illinois corporation that was

incorporated on March 22, 1988, and that merged into petitioner

on July 9, 1996.    On October 10, 1997, petitioner was acquired by

ATMI Holdings, Inc. (ATMI), a public company.

     Stephen H. Siegele, a chemical engineer, was the founder of

and primary stockholder in ADCS.      From 1988 until its merger into

petitioner on July 9, 1996, ADCS was engaged in the business of

developing, manufacturing, and marketing ultra high purity

chemicals for use in the computer industry.     The primary chemical
                               - 3 -

product manufactured and sold by ADCS was tetraethylorthosilicate

(TEOS), which is used as an insulating and conducting material on

semiconductor computer chip wafers.

     In 1988, Siegele started up ADCS with an initial

capitalization of $150,000.   Initially, ADCS maintained its small

laboratory and manufacturing plant in Amherst, Wisconsin, and its

sales office in Siegele’s apartment in San Jose, California.

Beginning with its first year of operation, ADCS was successful

and profitable.

     In 1990, with a $72,000 10-year commercial bank loan which

it had obtained, ADCS purchased approximately 1.8 acres of land

in Burnet, Texas, on which ADCS constructed a new 3,000- to

4,000-square-foot manufacturing plant into which ADCS relocated

its laboratory and manufacturing plant that had been located in

Amherst, Wisconsin.   The $72,000 bank loan was paid off in 1993.

     In the early 1990s, ADCS developed and began manufacturing

stainless steel canisters that allowed for safe handling and

processing of TEOS and of other chemicals used in the computer

industry.

     In the mid-1990s, ADCS developed and patented, and then

began manufacturing and selling, a dual canister chemical

refilling system that allowed TEOS and other chemicals to be

continuously applied to computer chip wafers through a processing

tool without interrupting the chip manufacturing process while
                               - 4 -

the chemical canisters were being refilled.   ADCS’ startup costs

for manufacturing the dual canister refilling system were

approximately $1.1 million.

     By the mid-1990s, ADCS was selling TEOS and the other

chemicals and canisters that it manufactured in Texas to computer

chip manufacturing companies located throughout the World,

including Europe and South Korea.

     In South Korea, in 1995, as a result of pressure from the

South Korean Government and from computer chip manufacturing

companies doing business in South Korea, ADCS and an unrelated

Korean company jointly formed under Korean law ADCS-Korea Co.,

Ltd. (ADCS-Korea), for the purpose of manufacturing in South

Korea TEOS and other chemical products that ADCS manufactured in

the United States.

     The shares of stock in ADCS-Korea were owned 70 percent by

ADCS and 30 percent by South Korean interests.

     In 1995, to the initial capitalization of ADCS-Korea, ADCS

contributed $1.55 million and the South Korean company

contributed $664,000.   These funds were used by ADCS-Korea to

purchase machinery, equipment, vehicles, tools, and furniture, to

hire employees and to purchase land in an industrial park in

Anseong, South Korea, on which a chemical manufacturing plant was

built.
                                - 5 -

     In 1996, ADCS granted to ADCS-Korea a nonexclusive license

to manufacture and to sell in South Korea TEOS and other

chemicals over which ADCS had control, in return for which ADCS

was to receive a royalty of 10 percent of gross sales.

     The activities and operations of ADCS-Korea were conducted

pursuant to a written joint venture agreement under which ADCS

retained control of the management of ADCS-Korea.   The executives

of ADCS and, after July 9, 1996, the executives of petitioner,

were active on a daily basis in supervising and managing the

activities of ADCS-Korea.   Senior executives of ADCS and of

petitioner frequently traveled to South Korea to participate in

the management of ADCS-Korea.

     In July of 1995, ADCS moved its sales and executive offices

from San Jose, California, to Austin, Texas, near its new

manufacturing plant in Burnet, Texas.

     During 1996, ADCS and petitioner considered and investigated

establishing a chemical manufacturing plant in Belgium or in

Scotland at an estimated cost of $3.5 million.

     In January of 1996, ADCS adopted a plan of reorganization

involving, among other things, a transfer of all of ADCS’

operating assets to Advanced Delivery & Chemical Systems, Ltd.

(ADCS-Limited), a Texas business limited partnership.    The

transfer to a Texas limited partnership of the operating assets

of a corporation doing business in Texas constituted, during the
                              - 6 -

mid-1990s, a common form of business reorganization utilized by

corporations to eliminate or to reduce substantially the 4.5-

percent Texas corporate franchise tax on business income.    See

Tex. Tax Code Ann. sec. 171.001(a)(1), (b)(3) (West 2002)

(imposing the Texas franchise tax on various business entities,

but not on partnerships).

     The six specific steps in ADCS’ reorganization, all

occurring between January 18 and January 22, 1996, are reflected

below:


     1.   ADCS-Limited was formed as a Texas limited
          partnership;

     2.   Advanced Delivery & Chemical Systems Holdings LLC
          (Holdings LLC), was formed as a Delaware limited
          liability company to be taxed as a partnership.
          ADCS owned a 99-percent membership interest in
          Holdings LLC. The individual shareholders of ADCS
          owned the remaining 1-percent membership interest
          in Holdings LLC;

     3.   Advanced Delivery & Chemical Systems Operating,
          LLC (Operating LLC) was formed as a Delaware
          limited liability company to be taxed as a
          partnership. ADCS owned a 99-percent membership
          interest in Operating LLC;

     4.   Advanced Delivery & Chemical Systems Manager, Inc.
          (ADCS-Manager) was formed as a Delaware
          corporation owned 100 percent by the individual
          shareholders of ADCS. ADCS-Manager owned the
          remaining 1-percent membership interest in
          Operating LLC;

     5.   After the above entities were formed, 99 percent
          of the operating assets of ADCS were transferred
          to Holdings LLC, and the remaining 1 percent of
          the operating assets of ADCS were transferred to
          Operating LLC, except that (as stipulated by the
                                - 7 -

          parties) certain patents, intangibles, and other
          stock interests in other business entities owned
          by ADCS were retained by ADCS;

     6.   Holdings LLC and Operating LLC then both
          contributed to ADCS-Limited the operating assets
          they had received from ADCS in exchange,
          respectively, for the receipt of a 99-percent
          limited partnership interest and a 1-percent
          general partnership interest in ADCS-Limited.


     After the above six steps in the reorganization of ADCS were

implemented, ADCS filed with respondent an election for

subchapter S status, effective April 1, 1996.

     In June of 1996, petitioner was formed as a Nevada

corporation.   Upon its formation, petitioner filed with

respondent an election for subchapter S status, effective

June 13, 1996.    On July 9, 1996, ADCS was merged into petitioner.

     In 1996, the initial shareholders in petitioner and their

respective ownership interests in petitioner were as set forth

below:

                                            Percentage
                         Name                Interest
                 Stephen H. Siegele            68.4
                 Frederick H. Siegele          11.5
                 Bernard McKeown               11.5
                 Stuart F. Siegele              3.8
                 Frederick J. Siegele           3.3
                 Robert Jackson                 1.6


     Before ADCS’ merger into petitioner, the shareholders in

ADCS and their respective ownership interests in ADCS were

identical to petitioner’s initial shareholders as set forth
                               - 8 -

above.   Also, before the merger, Stephen Siegele was president of

ADCS, and after the merger Stephen Siegele was president of

petitioner.   Also, the other officers and directors of petitioner

were essentially the same as the officers and directors of ADCS

before the merger.1

     As a result of ADCS’ 1996 merger into petitioner, petitioner

acquired ADCS’ 99-percent membership interests in Holdings LLC

and in Operating LLC, ADCS’ 70-percent stock interest in ADCS-

Korea, ADCS’ licensor rights under the license agreement with

ADCS-Korea, and the patents, intangibles, and stock interests

that were retained by ADCS in the January reorganization.

     ADCS-Limited was managed by the same individuals who had

managed ADCS and who continued to manage petitioner.

     The same business activities that had been conducted by ADCS

before ADCS’ merger into petitioner were conducted by petitioner

after ADCS’ merger into petitioner.

     In 1997, ADCS-Limited purchased for $65,860 4.383 acres of

land adjacent to its chemical manufacturing plant in Burnet,

Texas, for the purpose of constructing thereon a 22,500-square-

foot chemical manufacturing plant at a projected cost of $6

million.




     1
        Robert Jackson, a vice president of ADCS, became a
shareholder in petitioner, but the record is unclear as to
whether he became a vice president of petitioner.
                               - 9 -

     In 1997 and in 1998, ADCS-Limited spent a total of

approximately $3.4 million on equipment and improvements to its

manufacturing plant in Burnet, Texas, including additional clean

rooms, a new research and development lab, a quality control

department, and a new computer system.

     In July of 1997, ADCS-Limited began looking for additional

office space to accommodate the growth of its sales and executive

offices.   Management estimated that it would cost ADCS-Limited

$400,000 to relocate its administrative offices.

     The chemical products manufactured by ADCS and by ADCS-

Limited constituted hazardous materials, and the liability risks

associated with such materials were significant for petitioner

and for petitioner’s affiliated companies.   For example, in 1998

a former employee sued ADCS-Limited and ADCS for damages in

excess of $35 million relating to exposure to hazardous

materials.   To avoid the high insurance premiums associated with

such risks, during 1996 and 1997, petitioner retained funds in

the range of $3 million to self-insure against such risks.

     As indicated, ADCS had obtained a number of valuable patents

relating to ADCS and to ADCS-Limited’s chemical manufacturing

processes.   Petitioner anticipated that litigation would occur

involving petitioner and its affiliated companies relating to the

scope of the patents.   Petitioner estimated the cost of filing a
                              - 10 -

patent lawsuit at $1 million and the cost of defending a patent

lawsuit at $2 million.2

     Over the years from its founding in 1988 until the October

1997 acquisition by ATMI, management of ADCS, of petitioner, of

Holdings LLC and Operating LLC, and of ADCS-Limited generally

maintained a policy of funding their activities and growth with

internally generated funds, and they did not seek or obtain

outside long-term financing to fund research and development of

new products, corporate moves, new plant and office construction,

or working capital.   With the exception of the $72,000 bank loan

obtained in 1990, all of the growth and expansion of ADCS, of

petitioner, and of the affiliated companies was financed with

funds raised within the affiliated companies.

     During the calendar years of 1996 and 1997, Siegele was paid

by ADCS-Limited a salary of approximately $2 million.   Other

senior management personnel of ADCS-Limited and of the affiliated

companies also were paid, apparently by ADCS-Limited, annual

salaries of approximately $300,000 each.

     For each of the 1996 and 1997 calendar years, a consolidated

income statement of ADCS, of petitioner, of the affiliated

limited liability companies, and of ADCS-Limited reflected sales




     2
        In 1999, ATMI paid approximately $2.7 million in
connection with patent litigation relating to the business
activities of petitioner and of its affiliated companies.
                              - 11 -

revenue, cost of sales, operating expenses, and net income after

taxes as follows:3


                                       1996            1997
     Sales Revenue                 $22,041,000     $24,600,452
     Cost of Sales                   6,567,000       8,352,577
     Operating Expenses              8,577,000       8,658,527
     Net Income After Taxes          6,027,000       4,202,672


     For 1996 and 1997, the respective yearend financial balance

sheets of petitioner, of Holdings LLC, of Operating LLC, and of

ADCS-Limited reflected cash assets as follows:


                                  1996               1997
         Petitioner           $    16,549        $     7,876
         Holdings LLC              12,582             11,623
         Operating LLC              9,974              8,880
         ADCS-Limited           3,545,495          5,212,451


     Prior to the years in issue, ADCS had retained, and not

distributed to its individual shareholders, a cumulative total of

$9.7 million in earnings.

     During petitioner’s 1996 and 1997 short taxable years in

issue, ADCS-Limited retained approximately $1.9 million and $2.9

million, respectively, in current earnings, and petitioner did

not distribute any retained earnings to shareholders.

Petitioner, however, did make distributions on behalf of its


     3
        The figures for 1996 for sales revenue, cost of sales,
operating expenses, and net income after taxes do not include
figures for ADCS-Korea as such figures were not included in the
record. The figures for 1997 reflect the figures for all of
petitioner’s affiliated companies and for ADCS-Korea.
                               - 12 -

shareholders in the form of payments to respondent with respect

to the shareholders’ 1996 Federal income tax liability relating

to the reported income of petitioner for the months in 1996 for

which petitioner qualified as an S corporation.

     In the fall of 1996, ATMI began negotiations with the

management of petitioner for the acquisition of petitioner and of

its affiliated corporations, limited liability companies, and

partnership.   On January 10, 1997, a letter of intent was signed

between petitioner and ATMI.   On April 7, 1997, a formal written

agreement and plan of merger was executed under which the

proposed merger between petitioner and ATMI was to be accounted

for as a “pooling of interests”.   Under the written merger

agreement between petitioner and ATMI, and in accord with

accounting standards applicable to pooling of interest

transactions during the pendency of the transaction, petitioner

was prohibited from making distributions to its shareholders

other than for the shareholders’ projected tax obligations

relating to the income of petitioner.   See also Accounting

Principles Board Opinion 16, par. 47(c) (1970) (providing that

for transactions accounted for as a pooling of interests, a

corporation can only make distributions to its shareholders

consistent with the corporation’s historic dividend policy).

     In April of 1997, management of petitioner still considered

petitioner to be qualified as an S corporation.
                                - 13 -

     As indicated, on October 10, 1997, ATMI’s acquisition of

petitioner and indirectly of petitioner’s affiliated

corporations, limited liability companies, and partnership was

consummated.

     On or about April 15, 1997, there was filed on behalf of

petitioner a subchapter S Federal corporate income tax return for

petitioner’s stated short taxable year commencing April 1, 1996,

and ending December 31, 1996.    At the time this subchapter S

corporate tax return was filed, management of petitioner and

petitioner’s tax return preparer were unaware that on October 7,

1996, petitioner’s subchapter S status inadvertently had been

terminated when one of petitioner’s individual shareholders,

apparently without knowing the transfer would terminate

petitioner’s subchapter S status, transferred to a partnership,

an ineligible subchapter S corporate shareholder, his minority

stock interest in petitioner.

     Thereafter, on approximately June 30, 1997, when termination

of petitioner’s subchapter S status had come to the attention of

petitioner’s management, there was filed on behalf of petitioner

an amended subchapter S Federal corporate income tax return for

petitioner’s corrected short taxable year commencing

April 1, 1996, and ending October 7, 1996, to reflect the
                                - 14 -

October 7, 1996, termination of petitioner’s subchapter S

status.4

     On or about June 30, 1997, there was filed on behalf of

petitioner a subchapter C Federal corporate income tax return for

petitioner’s 1996 short taxable year beginning October 8, 1996,

and ending December 31, 1996.    On this subchapter C corporate tax

return, petitioner reported the approximate $1.9 million in

current year retained earnings, and petitioner reflected the

approximate $9.7 million in retained earnings accumulated in

prior years, essentially all of which earnings were merely

allocated to petitioner from and through ADCS-Limited, Holdings

LLC, and Operating LLC (because ADCS-Limited, Holdings LLC, and

Operating LLC were treated as nontaxable partnerships).

Essentially all the funds reported as retained earnings by

petitioner actually were held and retained by ADCS-Limited, and

were never actually distributed to petitioner.

     On or about June 15, 1998, there was filed on behalf of

petitioner a subchapter C, Federal corporate income tax return

for petitioner’s 1997 short taxable year beginning January 1,

1997, and ending October 10, 1997.       On this subchapter C




     4
        Even though petitioner was not incorporated until
June 13, 1996, petitioner’s original and amended subchapter S
corporate Federal income tax returns for its first short taxable
period apparently were filed for the short taxable period
beginning as of Apr. 1, 1996.
                              - 15 -

corporate tax return, petitioner reported the approximate

$2.9 million in current year retained earnings, and petitioner

reflected the approximate $11.6 million in retained earnings

accumulated in prior years.   Similar to the situation in the

prior taxable year, essentially all of the earnings reported as

retained earnings in petitioner’s October 10, 1997, short taxable

year were merely allocated to petitioner from and through ADCS-

Limited, Holdings LLC, and Operating LLC.   None of the retained

earnings were actually distributed to petitioner.

     On audit, respondent determined that during petitioner’s

short taxable years ending December 31, 1996, and October 10,

1997, petitioner constituted a mere holding company, that

petitioner did not establish reasonable business needs for

retaining the approximate $1.9 million and $2.9 million in

current year earnings allocated to petitioner from and through

ADCS-Limited, Holdings LLC, and Operating LLC, and that

petitioner, therefore, was subject to the accumulated earnings

tax for each of the short taxable years in issue.

     On July 31, 2000, respondent issued to petitioner a notice

of deficiency with respect to petitioner’s short taxable years

ending December 31, 1996, and October 10, 1997, wherein

respondent, relying on the provisions of section 535, calculated

petitioner’s accumulated taxable income and accumulated earnings

tax thereon as follows:
                               - 16 -


       Short Taxable         Accumulated         Accumulated
        Year Ending         Taxable Income       Earnings Tax
       Dec. 31, 1996          $1,247,731          $ 494,101
       Oct. 10, 1997           3,985,131           1,578,112


                               OPINION

     Generally, under section 532(a), a corporation that permits

earnings and profits to accumulate for the purpose of avoiding

the Federal income tax that would be imposed on its shareholders

with respect to distributions of earnings and profits made to the

shareholders is subject to the accumulated earnings tax of

sections 531 through 537.   S corporations, however, are not

subject to the accumulated earnings tax.     See sec. 1363(a).

     Whether a corporation accumulated earnings for the

prohibited purpose of avoiding the Federal income tax with

respect to its shareholders involves a question of fact.     E.g.,

Snow Manufacturing Co. v. Commissioner, 86 T.C. 260, 269 (1986)

(citing Bremerton Sun Publg. Co. v. Commissioner, 44 T.C. 566,

582 (1965)).   A conclusion as to whether a corporation was formed

or availed of for the prohibited purpose of avoiding Federal

income tax is made with respect to the state of mind of those

individuals who were in control of the corporation.     Helvering v.

Natl. Grocery Co., 304 U.S. 282, 292-294 (1938).

     A conclusion that a corporation is to be treated as a “mere

holding company” or that the management of the corporation has

permitted its earnings and profits to accumulate beyond the
                                  - 17 -

“reasonable needs” of the corporation’s business generally is

determinative as to whether the corporation accumulated earnings

for the prohibited purpose of avoiding the Federal income tax

with respect to its shareholders.       Sec. 533(a) and (b).

       A corporation held to be a mere holding company or to have

accumulated earnings and profits in excess of the reasonable

needs of its business nevertheless may avoid imposition of the

accumulated earnings tax if it is established that the

corporation was not formed or availed of for the prohibited

purpose of avoiding the Federal income tax with respect to its

shareholders.       Sec. 1.533-1(a)(2), Income Tax Regs.


Mere Holding Company

       For purposes of the accumulated earnings tax, whether a

corporation’s activities constitute sufficient activities to

avoid classification as a mere holding company turns upon the

facts and circumstances of each case.       Dahlem Found., Inc. v.

Commissioner, 54 T.C. 1566, 1574 (1970) (citing Beim Co. v.

Landy, 113 F.2d 897, 900 (8th Cir. 1940)).       The burden of proof

as to whether a corporation constitutes a mere holding company is

placed on the corporation and may not be shifted under section

534.       See Rule 142(a); H.C. Cockrell Warehouse Corp. v.

Commissioner, 71 T.C. 1036, 1045-1046 (1979).5


       5
            It appears that with certain limitations a shift in the
                                                       (continued...)
                              - 18 -

     In Dahlem Found., Inc. v. Commissioner, supra, we concluded

that a corporation’s activities (e.g., locating land for a

shopping center, negotiating and paying the purchase price for

the land, securing leases for occupancy of buildings in the new

shopping center, and performing management functions with respect

to the shopping center) established that the corporation did not

constitute a mere holding company for purposes of the accumulated

earnings tax.   Id. at 1576-1577.   We explained that the word

“mere” in the statutory language at issue is meant to draw a

distinction between corporations that are strictly passive in

nature and those which engage in some measure of business

activity.   Id. at 1576; see also sec. 1.533-1(c), Income Tax

Regs. (defining a holding company as a corporation that has

practically no activities except holding property and collecting

income therefrom).

     Under section 1.537-3(b), Income Tax Regs., it is provided

that, for purposes of the accumulated earnings tax, where a

corporation substantially owns and effectively operates a

subsidiary company, the business activities of the subsidiary may




     5
      (...continued)
burden of proof as to whether a corporation constitutes a mere
holding company for purposes of the accumulated earnings tax may
be available under the provisions of sec. 7491. The parties
herein, however, do not request any such shift in the burden of
proof as to the issue of petitioner’s status as a mere holding
company.
                             - 19 -

be attributed to the parent corporation.   The relevant language

of section 1.537-3(b), Income Tax Regs., provides as follows:


     If one corporation owns the stock of another
     corporation and, in effect, operates the other
     corporation, the business of the latter corporation may
     be considered in substance, although not in legal form,
     the business of the first corporation. * * * Thus, the
     business of one corporation may be regarded as
     including the business of another corporation if such
     other corporation is a mere instrumentality of the
     first corporation; that may be established by showing
     that the first corporation owns at least 80 percent of
     the voting stock of the second corporation. If the
     taxpayer’s ownership of stock is less than 80 percent
     in the other corporation, the determination of whether
     the funds are employed in a business operated by the
     taxpayer will depend upon the particular circumstances
     of the case. * * *


See also Inland Terminals, Inc. v. United States, 477 F.2d 836,

839-841 (4th Cir. 1973) (holding that the above regulation

generally allows a subsidiary corporation to accumulate earnings

for the business needs of its parent corporation); Montgomery Co.

v. Commissioner, 54 T.C. 986, 1006-1007 (1970) (applying the

above regulation and concluding that a corporation did not

constitute a mere holding company where the taxpayer pursued a

business venture through its wholly owned subsidiary); Farmers &

Merchs. Inv. Co. v. Commissioner, T.C. Memo. 1970-161 (applying

the above regulation and concluding that, although a corporation

owned less than 80 percent of the voting stock of its subsidiary,

the subsidiary’s business was attributable to the corporation
                             - 20 -

because the facts and circumstances indicated that at all times

the corporation had effective control over the subsidiary).

     Petitioner contends that the activities of ADCS-Limited and

of ADCS-Korea should be attributed to it and that it therefore

should not be treated as a mere holding company.

     Respondent argues that petitioner did not engage in business

activities of its own, that petitioner merely collected income

from its affiliated entities whose activities should not be

attributed to petitioner, and that petitioner should be regarded

as a mere holding company.

     Respondent argues further that section 1.537-3(b), Income

Tax Regs., should not be applied to attribute to petitioner the

business activities of ADCS-Limited because petitioner’s

ownership interest in ADCS-Limited was tiered rather than direct,

and because section 1.537-3(b), Income Tax Regs., according to

respondent, applies only to controlled corporate subsidiaries and

not to controlled partnerships.   As a reason for not allowing the

activities of ADCS-Limited and of ADCS-Korea to be attributed to

petitioner, respondent cites to Commissioner v. Natl. Alfalfa

Dehydrating & Milling Co., 417 U.S. 134, 149 (1974), and to the

general rule that taxpayers are held to the form of their

transactions.

     Petitioner counters with the argument that the clear intent

and effect of section 1.537-3(b), Income Tax Regs., is that
                             - 21 -

corporate taxpayers, in appropriate circumstances, are allowed to

take into account business activities of and to accumulate

earnings for the needs of business entities they control, even

though the taxpayer constitutes a separate legal entity.

Petitioner also argues that through general partnership

principles the business needs of a partnership may be attributed

to a corporate partner that controls the partnership.

     We agree generally with petitioner.   For accumulated

earnings tax purposes, respondent’s own regulations allow

corporations, depending on the facts and circumstances to treat

the business activities of affiliated entities as their own.    See

sec. 1.537-3(b), Income Tax Regs.

     Respondent cites to Turner v. Commissioner, T.C. Memo. 1965-

101, wherein it was found that a corporate taxpayer, for purposes

of the accumulated earnings tax, had unreasonably accumulated

earnings and profits for the needs of a partnership in which the

corporation owned a limited partnership interest.   The basis for

the holding in this Memorandum Opinion appears to be that, as a

limited partner, the corporation had limited risk and liability

and therefore could not be called upon to pay any of the debts of

the partnership and therefore could not be forced to invest

additional funds in the limited partnership.   In this regard, we

believe respondent reads too much into Turner.   For accumulated

earnings tax purposes, in addition to what a corporation is
                             - 22 -

required or legally obligated to do, it is also relevant what

management of a corporation reasonably believes constitutes the

reasonable needs of the business.   See, e.g., Ivan Allen Co. v.

United States, 422 U.S. 617, 624-628 (1975).

     We also note that in Turner v. Commissioner, supra, the

activities of a partnership in which the taxpayer held a general

partnership interest were taken into account in concluding that

the taxpayer did not constitute a mere holding company.   We

believe that this aspect of the holding in Turner supports our

holding herein that activities of an affiliated partnership may

support the accumulation of earnings by a corporation that owns a

controlling interest in the partnership.   We note that, through

Holdings LLC and Operating LLC, petitioner owned 99 percent of

the limited and 99 percent of the general partnership interests

in ADCS-Limited.

     Under the particular facts and circumstances of this case,

in evaluating the earnings retained by petitioner as of the end

of its short 3-month taxable year ending December 31, 1996, and

as of the end of its short 9-month taxable year ending October

10, 1997, we believe it appropriate to take into account the

business activities of ADCS-Limited and of ADCS-Korea.    The facts

before us establish that petitioner and its affiliated

corporations, limited liability companies, and partnership
                              - 23 -

maintained a close-knit structure, management, and operation

despite the different levels and forms of the affiliate entities.

     In certain respects, as a partnership controlled by

petitioner, the activities of ADCS-Limited had a closer business

relationship to petitioner than they would have had if ADCS-

Limited had been a corporate subsidiary of petitioner.     As

explained, as a partnership, ADCS-Limited was not treated as a

taxable entity.   Income taxes relating to the activities of ADCS-

Limited were the responsibility of its partners, and because its

partners (namely, Holdings LLC and Operating LLC) also were taxed

as partnerships (i.e., also as passthrough entities), the

liability for the taxes relating to the earnings and income of

ADCS-Limited was passed on to petitioner, including exposure to

an adjustment for the accumulated earnings tax, even though ADCS-

Limited, not petitioner, actually retained the earnings in

question.   A conclusion that the business activities of ADCS-

Limited should not be attributable to petitioner, for purposes of

the accumulated earnings tax, would be inconsistent with the fact

that the retained earnings in question actually were held by

ADCS-Limited but the Federal income taxes relating to those

earnings were the obligation of, and were to be paid by,

petitioner.
                               - 24 -

       Petitioner also effectively controlled and operated ADCS-

Korea.    Further, petitioner held certain patents and intangibles

relating to the business activities of its controlled entities.

       On the facts of this case and for accumulated earnings tax

purposes, we conclude that petitioner is not to be regarded as a

mere holding company for purposes of the accumulated earnings

tax.


Reasonableness of Retained Earnings

       In general, a corporation is allowed to retain earnings to

provide for the reasonable needs of its business without

imposition of the accumulated earnings tax.    Secs. 533(a),

535(c), 537(a)(1).

       Generally, for the following purposes, among others, a

corporation may retain earnings without incurring an accumulated

earnings tax liability:    (1) To provide for bona fide business

expansion and plant replacement, sec. 1.537-2(b)(1), Income Tax

Regs.; (2) to provide necessary working capital for the business,

sec. 1.537-2(b)(4), Income Tax Regs.; (3) to provide for

contingent business liabilities such as product liability losses,

sec. 537(b)(4); sec. 1.537-2(b)(6), Income Tax Regs.; and (4) to

provide for anticipated litigation involving intellectual

property.    See Steelmasters, Inc. v. Commissioner, T.C. Memo.

1976-324; Fotocrafters, Inc. v. Commissioner, T.C. Memo. 1960-

254.
                               - 25 -

      Whether a corporation has permitted its earnings and profits

to accumulate beyond the reasonable needs of its business

constitutes a question of fact, and we generally defer to the

determinations of the reasonable business needs that were made by

corporate officers and directors, unless the facts and

circumstances require us to substitute our business judgment for

theirs.6    Snow Manufacturing Co. v. Commissioner, 86 T.C. 260,

269 (1986) (citing Atl. Prop., Inc. v. Commissioner, 62 T.C. 644,

656 (1974), affd. 519 F.2d 1233 (1st Cir. 1975); Faber Cement

Block Co. v. Commissioner, 50 T.C. 317, 329 (1968)).

      In order to classify retained earnings as accumulations for

reasonable business needs, a corporation is required to have

specific, definite, and feasible plans for using the retained

earnings.    Sec. 1.537-1(b)(1), Income Tax Regs.   The plans for

use of retained earnings that will be treated as reasonable are

those that project use of the earnings within a reasonable time

period viewed in light of all of the facts and circumstances.

Id.   It is not necessary that plans for the use of retained

earnings be set forth in formal minutes, but evidence of a

definitive plan coupled with action taken toward the realization

thereof are expected.    See Doug-Long, Inc. v. Commissioner, 72



      6
        Under the procedures outlined in sec. 534, the burden of
proof regarding whether petitioner accumulated earnings and
profits beyond the reasonable needs of its business has been
placed on respondent.
                               - 26 -

T.C. 158, 171 (1979).    The test is whether the alleged plan

appears to have been “‘a real consideration during the taxable

year, and not simply an afterthought to justify challenged

accumulations.’”    Faber Cement Block Co. v. Commissioner, supra

at 332-333 (quoting Smoot Sand & Gravel Corp. v. Commissioner,

274 F.2d 495, 499 (4th Cir. 1960), affg. T.C. Memo. 1958-221).

     On this question, respondent’s arguments are well presented

and well briefed. Respondent argues primarily that petitioner

lacked definite and specific plans for the use of the $1.9

million and the $2.9 million in earnings that were retained as of

the end of the 1996 3-month and the 1997 9-month short taxable

years in issue.    Further, respondent contends that had the above

retained earnings been distributed to petitioner from and through

ADCS-Limited, Holdings LLC, and Operating LLC, and then

distributed by petitioner as dividends to its shareholders, ADCS-

Limited’s $9.7 million in retained earnings from prior years

would have remained available for use in ADCS-Limited’s business

and would have been sufficient to meet petitioner’s and its

affiliate’s reasonable business needs.

     Based on our analysis of the evidence and on our

understanding of the facts before us, however, we conclude that

ADCS-Limited’s and petitioner’s retention of the earnings in

question in the short taxable years before us was reasonable.

Petitioner’s management developed not exhaustive but
                              - 27 -

sufficiently specific plans that are reflected in minutes of

ADCS’ and of petitioner’s board meetings, in cost and design

estimates, and in other documentation.   Some of the reasonably

anticipated business needs and the amount of the projected

expenditures relating thereto are set forth below:


     European Manufacturing Plant                 $ 3,500,000
     Burnet, Texas, New Manufacturing Plant         6,000,000
     Relocation of Administrative Offices             400,000
     Product Liabilities                            3,000,000
     Patent Litigation                              3,000,000
          Total                                   $15,900,000


     The decision of the management of petitioner and of ADCS-

Limited to retain its current earnings during the 1996 3-month

short taxable year and during the 1997 9-month short taxable

year, rather than have ADCS-Limited distribute the earnings

through Holdings LLC and Operating LLC to petitioner and have

petitioner pay out the earnings as dividends to its individual

shareholders, reflected the reasonable business plans developed

by management of petitioner and of its affiliated entities to use

the earnings to finance the continued rapid growth of petitioner

and the expanding business activities of petitioner’s

affiliates.7   For the years in issue, the plans established by


     7
        With the exception of petitioner’s plan to locate a
manufacturing plant in Europe, the planned expenses of petitioner
set forth above were carried out or realized either by petitioner
or by ATMI within a short period of time following ATMI’s
acquisition of petitioner. The planned 22,500-square-foot
                                                   (continued...)
                             - 28 -

the management of petitioner and of petitioner’s affiliated

corporations, limited liability companies, and partnership for

using the retained earnings were especially reasonable in light

of the short time in which petitioner had operated as a

corporation, having just been organized in June of 1996.

     In light of the relatively rapid growth of ADCS from the

time of its formation in 1988 until its merger into petitioner in

1996, and in light of petitioner’s plans to continue growing and

expanding the business operations and activities after

petitioner’s merger with ADCS, we conclude that the $1.9 million

and the $2.9 million in earnings retained by ADCS-Limited and

reported by petitioner during the short taxable years in issue

did not exceed petitioner’s reasonable business needs and did not

exceed a reasonable accumulation of earnings.8

     Respondent argues that the reorganization of petitioner’s

corporate structure to produce favorable Texas franchise tax

consequences represents strong evidence of the tax sensitivity


     7
      (...continued)
manufacturing plant was never constructed by ADCS or by
petitioner, but, at the time of trial in 2002, a new 70,000-
square-foot chemical manufacturing plant was being constructed by
ATMI on 200 acres of land in Burnet, Texas, at an estimated cost
of $20 million.
     8
        In accord with Bardahl Manufacturing Corp. v.
Commissioner, T.C. Memo. 1965-200, on brief petitioner sets forth
calculations for its working capital needs for the 1996 and 1997
calendar years, but the record was incomplete for purposes of
verifying petitioner’s calculations. Respondent provided no
Bardahl working capital calculations for petitioner.
                              - 29 -

and tax motivation of petitioner’s management and indicates that

petitioner’s management intended to avoid the shareholder level

Federal income tax with respect to petitioner’s corporate

earnings.

     We do not regard the State tax planning of petitioner’s

management on behalf of petitioner and its affiliated companies

as establishing an intent on the part of petitioner’s management

to avoid the shareholder level tax on petitioner’s retained

earnings.   To the contrary, and as we have explained, petitioner

operated during the second half of 1996 and during the first half

of 1997 (during most of the short taxable years in issue) with

the understanding of petitioner’s management that petitioner

qualified as an S corporation, under which only a single level

tax would be imposed.   By the time petitioner’s management

discovered in mid-1997 that petitioner’s subchapter S status had

been inadvertently terminated, petitioner’s management was

restricted under the pending merger agreement with ATMI and under

generally accepted accounting principles from making any

significant dividend distributions to its shareholders.    This

then extant and legitimate misunderstanding of petitioner’s

management with regard to petitioner’s subchapter S status and

the single level tax applicable thereto runs counter to

respondent’s argument that avoidance of the shareholder level tax
                              - 30 -

with respect to petitioner’s retained earnings constituted the

reason such earnings were retained and not distributed.

     On the credible evidence before us, even if petitioner were

regarded as a mere holding company for purposes of the

accumulated earnings tax, and even if petitioner were regarded as

having accumulated earnings beyond the reasonable needs of its

business, the evidence establishes that petitioner did not

accumulate its earnings during its 1996 and 1997 short taxable

years before us for the purpose of avoiding the Federal income

tax with respect to its shareholders.

     We conclude that for the short taxable years in issue

petitioner did not permit its earnings and profits to accumulate

for the purpose of avoiding the Federal income tax with respect

to its shareholders.   Petitioner is not subject to the

accumulated earnings tax for the years in issue.



                                    Decision will be entered

                               for petitioner.
