67

GERDAU MACSTEEL, INC. & AFFILIATED SUBSIDIARIES, 

PETITIONERS v. COMMISSIONER OF INTERNAL

REVENUE, RESPONDENT

Docket No. 12642–01. Filed August 30, 2012. 

Q and its subsidiaries are an affiliated group (Ps). During 

Ps’ taxable year ended Oct. 31, 1997 (TYE 1997), Ps actively 

pursued Q’s making of two sales expected to result in millions 

of dollars in taxable capital gains for TYE 1997 and TYE 

1998. Ps’ outside accountants (D), mindful of the expected 

gains, approached Ps with an idea that D promoted to create 

a multimillion-dollar tax loss to shelter the gains for Federal 

income tax purposes. Q has a group benefits plan under which 

Q provides health and welfare benefits to its eligible 

employees and their dependents. Q’s subsidiaries included two 

inactive corporations, QS and QW. In order to report a desired 

tax loss of approximately $38 million to shelter Ps’ taxable 

gains from Federal income tax, Ps entered into a series of 

interrelated transactions in late October 1997 that included, 

among others, a recapitalization of QW (renamed QHMC), 

and Q’s transfer to QS (and then QS’ transfer to QHMC in 

exchange for newly issued class C stock) of $38 million and 

the assumption of certain contingent liabilities (i.e., Q’s 

obligations to pay medical plan benefits (MPBs) under Q’s 

benefits plan) which Ps valued at $37,989,000. Ps reported 

that the transfers qualified for nonrecognition under I.R.C. 

sec. 351(a) and that QS’ basis in the class C stock was determined by taking into account the $38 million transferred to 

QHMC but not the value of the MPBs. Each share of class C 

stock was entitled to receive annual dividends of $9.50 and 

was not allowed to receive any other dividend. Upon the class 

C stock’s redemption, which QHMC and the class C shareholders could respectively cause five and seven years after the 

stock’s issuance, the class C shareholders were entitled to 

receive for each share the greater of $125 or an amount equal 

to the lesser of a percent of any cumulative cost savings in 

MPBs or of QHMC’s book net equity. The transactions were 

structured in such a way that it was highly likely when the 

68 139 UNITED STATES TAX COURT REPORTS (67) 

class C stock was issued that the class C stock would be 

redeemed within the five- and seven-year periods and that the 

redemption payment would be $125 per share. Shortly after 

the transfer to QHMC, QS sold its class C stock to a former 

employee of a Q subsidiary for $11,000 (the difference 

between $38 million and $37,989,000). Ps claimed that QS 

realized a $37,989,000 short-term capital loss on the sale, and 

Ps used that loss to offset Ps’ unrelated capital gains totaling 

a similar amount. After the transactions, Q continued to 

process claims for MPBs, and Q’s handling of the claims 

transferred to QHMC was the same as the handling of claims 

with respect to individuals whose MPBs were not transferred 

to QHMC. QHMC’s reimbursements to Q for claims were 

made through intercompany entries recorded on Q’s books as 

a receivable due from QHMC and on QHMC’s books as a payable. QHMC lent the $38 million to a subsidiary of Ps, and 

QHMC eventually reimbursed Q for the MPBs when QHMC 

received payments on the loan. Held: The class C stock is nonqualified preferred stock under I.R.C. sec. 351(g) because it 

‘‘does not participate in corporate growth to any significant 

extent’’ within the meaning of I.R.C. sec. 351(g)(3)(A). Accordingly, pursuant to the agreement of the parties, Ps are not 

entitled to deduct the claimed capital loss. Held, further, the 

transactions underlying the claimed capital loss lacked economic substance. Accordingly, $352,251 in fees incurred to 

effect the transactions is not deductible as an ordinary and 

necessary business expense under I.R.C. sec. 162. Held, further, in accordance with Heasley v. Commissioner, 902 F.2d 

380 (5th Cir. 1990), rev’g T.C. Memo. 1988–408, and Todd v. 

Commissioner, 862 F.2d 540 (5th Cir. 1988), aff ’g 89 T.C. 912 

(1987), which we follow under Golsen v. Commissioner, 54 

T.C. 742, 757 (1970), aff ’d, 445 F.2d 985 (10th Cir. 1971), Ps 

are not liable for the 40% accuracy-related penalty under 

I.R.C. sec. 6662(h) that R determined applied to any underpayment of tax attributable to the disallowed claimed capital 

loss. Held, further, Ps are liable for the 20% accuracy-related 

penalty under I.R.C. sec. 6662(a) to the extent of the underpayment of tax attributable to the disallowed claimed capital 

loss, and Ps are liable for that 20% accuracy-related penalty 

to the extent of the underpayment of tax attributable to the 

disallowed deduction for the fees. 

Jasper G. Taylor III, Lawrence Kalinec, Richard L. Hunn, 

Shawn R. O’Brien, and Stephen M. Feldhaus, for petitioners. 

Dennis M. Kelly and Jill A. Frisch, for respondent. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 69

CONTENTS 

FINDINGS OF FACT ............................................................................. 74 

I. Preliminary Matters ..................................................................... 74 

II. Quanex ......................................................................................... 74 

III. Petitioners’ Expectation of Realizing Millions of Dollars in 

Taxable Capital Gains During TYE 1997 and TYE 1998 ... 75 

IV. The Plan ...................................................................................... 76 

A. Background ............................................................................... 76 

B. Health Care Offerings .............................................................. 76 

C. Health Care Cost Management Strategies ............................ 77 

1. Background ............................................................................ 77 

2. CS ........................................................................................... 77 

a. Background ........................................................................ 77 

b. Quanex’s Introduction to CS ............................................. 78 

c. CS Fee Arrangements ........................................................ 79 

V. D&T ............................................................................................... 79 

VI. Other Quanex Employees/Officers ............................................ 80 

A. Rose ........................................................................................... 80 

B. Parikh ........................................................................................ 80 

C. Royce ......................................................................................... 81 

VII. Liability Management Companies ........................................... 81 

A. Overview ................................................................................... 81 

B. Rev. Rul. 95–74 ........................................................................ 82 

C. D&T’s Matrix ............................................................................ 82 

1. Background ............................................................................ 82 

2. DDCL ..................................................................................... 82 

3. Singer Promotes DDCL-Type Transaction to Quanex ....... 85 

VIII. Sales of LaSalle and Tube Group ........................................... 85 

A. LaSalle Sale .............................................................................. 85 

B. Tube Group Sale ....................................................................... 86 

IX. Engaging D&T To Structure QHMC Transactions .................. 87 

X. Developing QHMC Transactions ................................................ 89 

A. Quanex’s First Proposal to CS ................................................ 89 

B. D&T’s First Outline of Proposed Joint Venture Transactions .................................................................................... 91 

C. WW ............................................................................................ 92 

1. In General .............................................................................. 92 

2. FASB 106 ............................................................................... 92 

3. WW’s First Present Value Calculation of Quanex’s 

Health Care Benefits ........................................................ 93 

D. D&T’s Revisions to Proposed Transaction .............................. 95 

70 139 UNITED STATES TAX COURT REPORTS (67) 

1. August 6–7, 1997, Revisions ................................................. 95 

2. August 13, 1997, Revisions and Cashflow Analysis ........... 97 

3. August 22, 1997, Revisions ................................................... 99 

E. Quanex’s Negotiations With CS .............................................. 99 

F. WW’s Present Value Calculation Revisions ........................... 103 

G. Patrick Wannell ....................................................................... 105 

1. Background ............................................................................ 105 

2. Wannell and Health Care Costs at LaSalle ........................ 105 

3. Quanex’s Offer to Wannell ................................................... 106 

H. D&T’s Revised Cashflow Model ............................................... 107 

XI. Executing QHMC Transactions ................................................. 110 

A. Quanex’s October 21–22, 1997, Board Meeting ..................... 110 

B. October 23, 1997 ....................................................................... 113 

1. QW Recapitalization ............................................................. 113 

2. Amendment and Restatement of QW’s Certificate of 

Incorporation ..................................................................... 113 

a. Background ........................................................................ 113 

b. Dividend Rights ................................................................. 114 

c. Preferences Upon Liquidation ........................................... 114 

d. Voting Rights ..................................................................... 116 

e. Call Rights .......................................................................... 116 

f. Put Rights ........................................................................... 116 

3. Quanex’s Transfer of QW Stock and Cash to QHMC in 

Exchange for Class A and Class B Stocks and Election of Directors ................................................................. 117 

4. Quanex’s Transfer of Cash and MPB Obligations to QS 

in Exchange for QS Stock ................................................. 117 

C. October 24, 1997 ....................................................................... 118 

1. Consulting Agreement Between Quanex and CS ............... 118 

2. CS’ Transfer of Cash to Quanex in Exchange for Class B 

Stock ................................................................................... 119 

3. Class B Directors ................................................................... 121 

D. October 25, 1997 ...................................................................... 121 

1. CS’ Transfer of Cash to QHMC in Exchange for Class C 

Stock ................................................................................... 121 

2. QS’ Transfer of Cash and MPBs to QHMC in Exchange 

for Class C Stock ............................................................... 121 

3. MPB Selection ....................................................................... 122 

4. Class C Director .................................................................... 123 

E. October 28, 1997: QHMC’s Transfer of Cash to Piper in 

Exchange for Promissory Note ............................................ 123 

F. October 30, 1997: QS’ Transfer of Class C Stock to 

Wannell in Exchange for Cash ............................................ 124 

XII. Posttransaction Activities ......................................................... 125 

A. D&T’s Draft Opinion ................................................................ 125 

B. 1997 Return .............................................................................. 127 

1. Background ............................................................................ 127 

2. Income .................................................................................... 127 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 71

3. Enclosed Statements ............................................................. 128 

a. Overview ............................................................................. 128 

b. Statement 20 ...................................................................... 128 

c. Statement 22 ...................................................................... 129 

d. Statement 23 ...................................................................... 129 

e. Statement 24 ...................................................................... 129 

4. Deduction of Fees .................................................................. 129 

C. WW’s 1999 Valuations ............................................................. 130 

D. D&T’s 1999 Cashflow Model .................................................... 134 

E. QHMC Operations .................................................................... 140 

1. QHMC’s Officers and Directors ............................................ 140 

a. QHMC’s Board Meetings and Shareholders Meetings ... 141 

b. Parikh as Director and Officer ......................................... 141 

c. Peery as Director and Officer ............................................ 141 

2. Bank Accounts ....................................................................... 141 

3. Processing and Paying MPB-Related Expenses .................. 142 

4. Shareholder Efforts To Manage MPB Obligations ............. 145 

a. CS’ Efforts .......................................................................... 145 

i. Background ...................................................................... 145 

ii. PPO Project .................................................................... 146 

iii. Union Negotiations ....................................................... 147 

iv. CS’ Consulting Bills ...................................................... 148 

b. Wannell’s Efforts ............................................................... 149 

5. Dividend Payments ............................................................... 150 

6. Return on Investment Projections ....................................... 150 

7. QHMC’s Tax Returns ............................................................ 151 

8. Financial Statements ............................................................ 152 

F. Notice of Deficiency .................................................................. 152 

OPINION ................................................................................................. 154 

I. Burden of Proof ............................................................................. 154 

II. Witness Testimony ...................................................................... 155 

A. Background ............................................................................... 155 

B. Fact Witnesses .......................................................................... 156 

C. Expert Witnesses ...................................................................... 156 

1. Background ............................................................................ 156 

a. Overview ............................................................................. 156 

b. Strombom ........................................................................... 157 

c. Ross ..................................................................................... 157 

d. Eisenstadt .......................................................................... 157 

2. Analysis .................................................................................. 158 

III. Net Short-Term Capital Loss .................................................... 158 

A. Overview ................................................................................... 158 

B. Section 351(g) ........................................................................... 159 

C. Economic Substance Doctrine ................................................. 167 

1. Overview ................................................................................ 167 

2. Standard of Analysis ............................................................. 168 

3. QHMC Transactions ............................................................. 171 

72 139 UNITED STATES TAX COURT REPORTS (67) 

1 After the petition was filed, Quanex changed its name to Gerdau Macsteel, Inc., and became 

and remains the agent of the affiliated group for TYE 1997. See sec. 1.1502–77A(a), Income Tax 

Regs. We hereinafter refer to Gerdau Macsteel, Inc., as Quanex. 

2 Unless indicated otherwise, section references are to the applicable versions of the Internal 

Revenue Code (Code), and Rule references are to the Tax Court Rules of Practice and Procedure. 

a. Objective Economic Substance .......................................... 171 

i. Background ...................................................................... 171 

ii. Lack of Substantive Changes as a Result of QHMC 

Transactions ............................................................... 172 

iii. Lack of Reasonable Expectation of Nontax Benefits 

on Petitioners’ Part .................................................... 174 

b. Subjective Business Purpose ............................................ 175 

i. Background ...................................................................... 175 

ii. Petitioners’ Entering Into QHMC Transactions 

Solely as Means To Generate Artificial Capital 

Loss To Offset Capital Gains .................................... 176 

iii. Petitioners’ Selection of Transferred MPBs Without 

Regard to Effective Medical Cost Management ...... 179 

iv. Equity Interest in QHMC Granted to CS and 

Wannell as Meaningless Incentive to Reduce 

Health Care Costs ...................................................... 180 

v. Unnecessary Assumption of MPB Obligations by 

QHMC ......................................................................... 181 

c. Conclusion ........................................................................... 182 

IV. Fees Incurred in Furtherance of QHMC Transactions ........... 182 

V. Accuracy-Related Penalties ......................................................... 183 

A. Background ............................................................................... 183 

B. Gross Valuation Misstatement ................................................ 183 

C. Negligence ................................................................................. 186 

D. Substantial Understatement ................................................... 188 

E. Section 6664(c) Reasonable Cause Exception ........................ 191 

1. Overview ................................................................................ 191 

2. Analysis .................................................................................. 193 

VI. Conclusion ................................................................................... 197 

MARVEL, Judge: Quanex Corporation (Quanex) 1 and its 

affiliated subsidiary corporations (collectively, petitioners) 

petitioned the Court to redetermine respondent’s determination as to petitioners’ taxable year ended October 31, 1997 

(TYE 1997). Respondent determined a $9,561,458 deficiency in 

petitioners’ Federal income tax and a $3,799,926 accuracyrelated penalty under section 6662(a), (b), and (h). 2 The parties dispute three issues relating to respondent’s determination, and they agree that certain subissues and arguments 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 73

underlie a decision regarding those issues. The three issues 

are: 

1. whether petitioners may deduct a $37,989,000 net shortterm capital loss from the sale of stock of Quanex Health 

Management Co., Inc. (QHMC). The sale was part of a series 

of transactions (QHMC transactions) that occurred in October 

1997 between and among Quanex, certain of Quanex’s affiliated subsidiaries, and two independent (yet loyal) 

facilitators. Petitioners claimed a $37,989,000 loss deduction 

on the sale and applied $26,966,201 of the claimed loss to 

TYE 1997 and the balance to TYE 1998. Respondent disallowed the claimed loss deduction in full. We hold that petitioners are not entitled to deduct any of the claimed loss; 

2. whether petitioners may deduct $352,251 of transaction 

costs incurred to effect the QHMC transactions as ordinary 

and necessary business expenses under section 162(a). Petitioners claimed the $352,251 as a deduction for TYE 1997, 

and respondent disallowed the claimed deduction in full. We 

hold that petitioners are not entitled to deduct any of this 

amount; 

3. whether petitioners are liable for the 40% accuracyrelated penalty that respondent determined under section 

6662(a) and (h) (or alternatively, the 20% accuracy-related 

penalty that respondent determined under section 6662(a) 

and (b)) with respect to the underpayment of tax attributable 

to the disallowed capital loss deduction, and whether petitioners are liable for the 20% accuracy-related penalty that 

respondent determined under section 6662(a) and (b) with 

respect to the underpayment of tax attributable to the disallowed transaction costs deduction. We hold in accordance 

with Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), 

rev’g T.C. Memo. 1988–408, and Todd v. Commissioner, 862 

F.2d 540 (5th Cir. 1988), aff ’g 89 T.C. 912 (1987), which we 

follow under Golsen v. Commissioner, 54 T.C. 742 (1970), 

aff ’d, 445 F.2d 985 (10th Cir. 1971), that petitioners are not 

liable for the 40% accuracy-related penalty. We also hold that 

petitioners are liable for the 20% accuracy-related penalty 

under section 6662(a) to the extent of the underpayment of 

tax attributable to the disallowed capital loss deduction and 

to the disallowed deduction for the transaction costs. 

74 139 UNITED STATES TAX COURT REPORTS (67) 

FINDINGS OF FACT 

I. Preliminary Matters 

The parties have stipulated many facts. Some stipulations 

note a party’s objection to the admissibility of the stipulated 

fact(s), and we have sustained some of those objections. We 

incorporate herein the stipulated facts to the extent we have 

not sustained an objection to their admissibility, and the 

stipulated facts are so found (except to the extent we sustained an objection to their admissibility). Quanex’s principal 

office and principal place of business were in Texas when the 

petition was filed. 

II. Quanex 

Quanex is a Delaware corporation whose common stock is 

publicly traded on the New York Stock Exchange. Quanex 

was organized in 1927, and its principal activity is manufacturing specialized metal products made from carbon and 

alloy steel and aluminum. From at least 1995 through 

October 31, 1997, Quanex’s main operating groups consisted 

of a hot and cold finish steel bar business, a hot and cold 

finish tubing business, and an aluminum building products 

business. 

Quanex is the common parent of petitioners’ ‘‘affiliated 

group’’ (as that term is defined in section 1504(a)). On July 

14, 1998, petitioners filed a consolidated corporate Federal 

income tax return for TYE 1997 (1997 return). Petitioners 

reported in the 1997 return that Quanex was the common 

parent of the affiliated group and that its subsidiaries and 

their principal business activities were as follows: 

Subsidiaries

Principal business 

activities 

Michigan Seamless Tube Co. Manufacturing 

LaSalle Steel Co. Manufacturing 

Piper Impact, Inc. Manufacturing 

Quanex Wire, Inc. Investments 

Quanex Bar, Inc. Investments 

Quanex Solutions, Inc. Investments 

Quanex Mfg., Inc. Investments 

Quanex Steel, Inc. Investments 

Quanex Enters., Inc. Inactive 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 75

3The Tube Group included Michigan Seamless Tube Co. (MST), Gulf States Tube Division 

(GST), and the Tube Group administrative office. The Tube Group also included Quanex’s Heat 

Treating and Nitro Steel Divisions, but Quanex retained those divisions, and they were still a 

part of Quanex as of the time of trial. 

Subsidiaries

Principal business 

activities 

Quanex Tech. Inc. Inactive 

Quanex Metals, Inc. Inactive 

Nichols-Homeshield, Inc. Inactive 

For TYE 1997 through TYE 2001 petitioners had an annual 

accounting period ending on October 31, and they each maintained books and records using an accrual method of 

accounting. As of October 31, 1997, petitioners had 13 manufacturing plants throughout the United States and 1 plant in 

the Netherlands. Also as of that date, petitioners had 3,771 

employees, approximately 1,000 of whom were covered by 

collective bargaining agreements. 

III. Petitioners’ Expectation of Realizing Millions of Dollars in 

Taxable Capital Gains During TYE 1997 and TYE 

1998 

During TYE 1997 Quanex was actively pursuing the sales 

of two subsidiaries. Those sales were expected to generate 

millions of dollars in taxable capital gains during TYE 1997 

and TYE 1998. The first sale involved Quanex’s wholly owned 

subsidiary LaSalle Steel Co. (LaSalle). Quanex’s board of 

directors (Quanex’s board) resolved on February 27, 1997, to 

make that sale, and the sale closed shortly thereafter in TYE

1997. For TYE 1997, petitioners reported as to that sale (and 

to a minor extent the sale of other business property) that 

they realized a capital gain of $26,966,201 and ordinary 

income of $21,374,634. The second sale involved Quanex’s 

decision to sell a portion of its tubing operations (Tube 

Group). 3 In or before September 1997 Quanex began negotiating that sale, and the sale occurred on December 3, 1997. 

For TYE 1998 petitioners reported as to that sale that they 

realized a net capital gain of $12,458,171 and ordinary 

income of $8,090,766. 

Contemporaneous with petitioners’ activities with respect 

to the two sales, and with knowledge of petitioners’ intent to 

make those sales, petitioners’ outside accounting firm, 

76 139 UNITED STATES TAX COURT REPORTS (67) 

Deloitte & Touche, LLP (D&T), through one of its tax partners, Steven Singer, approached petitioners and promoted an 

idea for a multistep transaction that, if artfully structured to 

comply literally with the Code and certain interpretations 

thereunder, could create for petitioners a multimillion-dollar 

tax loss to shelter the gains from the unrelated sales for Federal income tax purposes. Quanex entered into the QHMC

transactions as a result of that promotion, and Quanex 

claimed that it realized a $37,989,000 capital loss on one of 

the steps in the QHMC transactions that effectively offset the 

amount of gains on the unrelated sales. The QHMC transactions were ostensibly structured around the Quanex Corporation Group Benefits Plan (plan) with an aim towards 

generating an artificial multimillion-dollar tax loss that 

would offset the large gains on the sales and would appear 

to be generated from Quanex’s business activities. 

IV. The Plan 

A. Background 

Effective September 1, 1949, Quanex established the plan 

to provide certain health, welfare, and other similar benefits 

for eligible Quanex employees and their dependents. Quanex 

reserved the right to amend the plan at any time and 

reserved the right, without an authorizing resolution from 

Quanex’s board, to reduce or completely eliminate any coverage provided under the plan for current and/or former 

employees and their beneficiaries. Quanex also could terminate the plan at any time by a written resolution of Quanex’s 

board. 

B. Health Care Offerings 

Pursuant to the plan, Quanex offered both its nonunion 

and union employees a choice of medical plans, which were 

generally indemnity and health maintenance organization 

(HMO) plans. In the early 1990s Quanex also instituted cafeteria benefits with respect to its indemnity plan offerings. 

Under the plan, Quanex was required to appoint a committee 

to perform any administrative function with respect to the 

plan that the respective insurer or HMO was not required to 

perform. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 77

4 As of October 31, 1997, petitioners provided health care benefits to their nonunion employees 

through either an indemnity (self-insurance) medical plan or a managed care program. 

5While CS was apparently formed under a different name, we refer to CS and any of its predecessors as CS. 

Effective January 1, 1995, Quanex amended and restated 

the plan, and the plan remained in effect for TYE 1997. 4

From 1995 through the end of TYE 1997, Quanex provided 

group medical benefits to its employees under the plan, and 

Quanex deducted the costs of those benefits as they were 

incurred as ordinary and necessary business expenses. 

C. Health Care Cost Management Strategies 

1. Background 

The cost of providing health care is influenced by 

numerous factors, e.g., an employee’s age, number of dependents, and geographic location. Other less predictable components, such as political pressures, also can influence health 

care costs. From at least 1985 Quanex experienced a rise in 

the cost of providing health care to its employees. As early 

as 1985 Quanex began to look at ways to reduce its overhead 

and streamline its benefits, including its health care costs, 

pensions, and medical benefits for both active and retired 

employees. 

2. CS 

a. Background 

ChapmanSchewe, Inc. (CS), is a health care management 

firm that Doug Schewe and Harry Chapman organized on 

July 1, 1992. 5 As of the time of trial CS had 12 subcompanies, all of which were devoted to health care, and its 

employee benefits practice managed health benefits for 

approximately 9 million individuals throughout the United 

States. During TYE 1997 Chapman was CS’ chairman and 

chief executive officer, and he owned approximately 37% of 

CS’ stock. Chapman has a bachelor’s degree and a master’s 

degree in public administration, and as of the time of trial 

he had 23 years of experience in the health care industry. 

78 139 UNITED STATES TAX COURT REPORTS (67) 

b. Quanex’s Introduction to CS 

Ron Howard joined CS in 1994 as an associate/benefits 

consultant. Howard was a former financial portfolio manager 

with a master of business administration (M.B.A.) degree 

and 10 years of experience in banking. During his previous 

career in banking, Howard had formed relationships with 

members of Quanex’s senior management, including 

Quanex’s then chief financial officer (CFO), Wayne Rose. 

Howard contacted Quanex shortly after he joined CS to persuade his Quanex contacts to let CS negotiate Quanex’s HMO

contracts and to pursue a working relationship with Quanex. 

On April 7, 1994, CS representatives met with Quanex representatives. During the April 7 meeting, Howard and 

Chapman gave a sales presentation to Joseph Peery. Peery 

has a bachelor’s degree in business administration and 34 

years of experience in human resources, and he was 

Quanex’s vice president of human resources from 1984 until 

he retired in April 1998. Shortly after the April 7 meeting, 

Quanex gave CS the opportunity to reduce Quanex’s health 

care costs through HMO negotiations. 

In CS’ first project, Howard negotiated a fee for Quanex 

with one HMO, which saved Quanex money. Quanex then 

expanded its involvement with CS but still limited CS to 

HMO work. The substance of CS’ work consisted of negotiating Quanex’s premium amounts with HMOs and of analyzing HMO cost structures. 

Howard was the CS executive in charge of the Quanex 

account during TYE 1997, and sometime before 1998 he 

attempted to negotiate rate guaranties for Quanex. Howard 

had previously informed Quanex that CS could negotiate 

multiyear rate guaranties and performance guaranties with 

HMOs. 

Before the QHMC transactions, Chapman participated in 

the negotiation of Quanex’s HMO contracts. Chapman tried to 

achieve the best results possible from the negotiations, and 

Chapman used the negotiations to speak more frequently 

with Quanex’s human resources department and to sell 

Quanex additional health care consulting services. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 79

6 It was not unusual for CS to forgo a consulting agreement with a client. 

c. CS Fee Arrangements 

CS offered flexibility to its clients through different payment arrangements (e.g., CS’ fee might be a percentage of 

the expense saved, or it might be calculated on the basis of 

a percentage of revenue). Before the QHMC transactions, CS 

informed Quanex that CS’ compensation was performance 

based; i.e., CS would be compensated only if, and to the 

extent, CS saved Quanex money. Before the QHMC transactions, CS and Quanex did not have a written consulting 

agreement, 6 but CS acted as a broker to secure medical coverage for Quanex’s employees through HMOs, and the HMOs 

(or Quanex in one or two instances) paid CS a brokerage 

commission for its services. 

V. D&T 

Quanex first engaged D&T (or one of its predecessors) as 

early as 1978 for external auditing, tax, and consulting services. The consulting services related to, among other things, 

debt restructuring, potential bankruptcy filings, and the purchases and sales of assets and subsidiaries. During TYE 1997 

D&T certified petitioners’ consolidated financial statements 

and reviewed petitioners’ consolidated Federal income tax 

returns, in addition to providing petitioners with other 

professional services. 

Singer is an attorney and a certified public accountant 

(C.P.A.), and he has practiced in the field of taxation for over 

three decades. He joined D&T in 1981, and he became a 

partner in D&T’s tax practice one year later. He became the 

D&T partner in charge of the Quanex account in 1989. Singer 

was based in D&T’s office in Houston, Texas, during TYE

1997, and he remained in charge of D&T’s Quanex account 

as of the time of trial. 

From 1989 through the end of TYE 1997, Singer consulted 

with Quanex regarding its current and prospective purchases, and he reviewed and signed Quanex’s corporate 

returns as a paid preparer. From 1995 through the end of 

TYE 1997, Singer had intimate, first-hand knowledge of 

Quanex and its business, acquired mainly from his supervising and managing D&T’s Quanex account since 1989, his 

80 139 UNITED STATES TAX COURT REPORTS (67) 

visits to some of Quanex’s facilities, his participation in 

Quanex’s financial statement audits, and his conversations 

with Quanex’s senior management. 

VI. Other Quanex Employees/Officers 

A. Rose 

Rose is a C.P.A. with a bachelor’s degree and an M.B.A. 

degree, and he was Quanex’s CFO from 1986 through 1998. 

He was Quanex’s controller before 1986 (and before that, he 

worked for a large national public accounting firm for six 

years), he was the president of Quanex’s engineered products 

group from the end of 1998 until 2001, and he was Quanex’s 

vice president of special assignments from June 2000 

through March 2001. 

When Quanex bought or sold a substantial asset, Rose, as 

CFO, and his department were responsible for projecting the 

results of that transaction. Rose generally knew what tax 

results he wanted going into purchase or sales negotiations, 

and he preferred to buy net assets and to sell subsidiaries. 

During his tenure as Quanex’s CFO, Rose knew the importance of tax basis and the effect that liabilities had on a 

determination of Quanex’s bases in its subsidiaries. 

B. Parikh 

Viren Parikh is a C.P.A. with a bachelor’s degree and a 

master’s degree, both in accounting, and he was Quanex’s 

controller from 1993 through December 2002. He left Quanex 

on December 31, 2002. 

As Quanex’s controller, Parikh was responsible for 

Quanex’s accounting department; its duties included financial reporting, corporate accounting, and tax return preparation. Parikh, as controller, also (with Thomas Royce and 

Rose) was responsible for reviewing Quanex’s asset sales and 

projecting their results. If Quanex sold a significant asset, 

Parikh decided how the transaction would be recorded on 

Quanex’s financial statements, and he was involved in 

deciding how any tax implication would be reported. He and 

his department also, while negotiations for Quanex’s potential sales were ongoing, would project gains and losses on 

those potential sales for purposes of financial reporting, 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 81

7 Royce testified that when Quanex negotiated the sale of a significant asset, neither he nor 

anyone else at Quanex projected what tax benefits and detriments would result from the sale. 

We do not find Royce’s testimony on this point to be credible, and we decline to rely upon it. 

periodically updating the projections as the negotiations drew 

to a close. 

C. Royce 

Royce is a C.P.A. with a bachelor’s degree in business 

administration (majoring in accounting), and he was 

Quanex’s tax director. Beginning in TYE 1997, Royce also was 

Quanex’s director/manager of financial benefits administration (FBA manager). Royce reported to Parikh during TYE

1997, and Royce remained Quanex’s tax director and FBA

manager as of the time of trial. 

As tax director, Royce was responsible for Quanex’s 

consolidated Federal income tax returns and any subsidiary 

returns, for all tax planning, for tax audits, for employee 

benefit returns, and for all State income and franchise tax 

returns. As FBA manager, Royce was responsible for the 

accounting of the employee benefits in Quanex’s pension and 

section 401(k) plans, for audit preparation, for the filing of 

employee benefit information returns, and for working with 

welfare benefit plans and third-party administrators for both 

pension and section 401(k) plans. 

Royce, as tax director and eventually also FBA manager, 

also reviewed Quanex’s sales and made corresponding projections. When Quanex negotiated the sale of a substantial 

asset, Royce projected the potential Federal income tax ramifications from the sale during the negotiations. 7 If a sale was 

concluded, Quanex would usually at the end of the year calculate the actual Federal income tax consequences of the 

sale. Parikh would review the overall tax provision that had 

been made for the sale for financial statement purposes, but 

Parikh would not review Royce’s estimates of the potential 

income tax consequences. 

VII. Liability Management Companies 

A. Overview 

As of the end of TYE 1996, Quanex had a potential liability 

for medical plan benefits (MPBs) that might be provided 

under the plan. Quanex also faced a potential environmental 

82 139 UNITED STATES TAX COURT REPORTS (67) 

liability of $15 million to $20 million. Quanex assumed the 

potential environmental liability in 1996 when Quanex 

acquired Piper Impact, Inc. (Piper). As part of that acquisition, the seller established an escrow to cover this exposure. 

B. Rev. Rul. 95–74 

Singer, Parikh, Royce, and Rose attended a Quanex quarterly meeting in 1996, in or before the summer of that year. 

During that meeting, Singer informed the Quanex representatives that the Internal Revenue Service (IRS) had issued a 

ruling, Rev. Rul. 95–74, 1995–2 C.B. 36 (revenue ruling), 

which Singer believed allowed Quanex to achieve tax benefits 

by transferring either its environmental liabilities or its MPB

obligations to a liability management company in a joint venture. In the revenue ruling the IRS ruled that certain contingent environmental liabilities that a transferee assumed in a 

section 351 exchange were not liabilities for purposes of sections 357(c)(1) and 358(d) and that the transferee, in accordance with its method of accounting, could, as appropriate, 

either deduct the liabilities as business expenses under section 162 or capitalize the liabilities as capital expenditures 

under section 263. 

C. D&T’s Matrix 

1. Background 

D&T maintained an electronic repository of tax ideas that 

D&T professionals could discuss with D&T clients to increase 

D&T’s business with those clients and generate additional 

revenue for D&T. Various D&T professionals contributed 

ideas in their areas of expertise to the repository (referred to 

as D&T’s client service matrix (matrix)), and D&T envisioned 

that D&T might provide the client with a tax opinion on any 

transaction described in the matrix which a client entered 

into. The matrix was for internal use only, and D&T believed 

it would be at a competitive disadvantage if competitors 

gained access to the ideas in the matrix. 

2. DDCL 

Singer occasionally consulted the matrix to obtain ideas to 

present to D&T clients. In the summer of 1996, after Singer 

learned of the revenue ruling, he read an undated section of 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 83

8 After the QHMC transactions were completed, D&T added to the matrix another idea dealing 

with a contingent liability transaction. 

the matrix referenced as ‘‘Double Deducting Environmental 

and Other Contingent Liabilities’’ (DDCL). Singer was not 

responsible for the ideas in the DDCL, and he believed the 

DDCL was the only section of the matrix referencing the revenue ruling. 8

The DDCL proposed a transaction for accrual method taxpayers whom the accrual method prevented from deducting 

accruals on their balance sheets for estimated future environmental liabilities. The DDCL concluded that, in the setting of 

a consolidated group, a transaction could be structured to 

allow such a taxpayer to immediately deduct a capital loss 

equal to the amount of the environmental reserve and to 

claim an additional deduction when the accrued liability was 

paid. The DDCL stated that the ‘‘proper structuring’’ of the 

transaction revolved around the use of an environmental 

management company and the sale outside the group of some 

of the company’s stock at a price equal to the stock’s fair 

market value. The DDCL summarized the transaction as follows: 

SUMMARY OF TRANSACTION 

Parent Corporation (Parent) is a parent corporation in a consolidated 

group, which includes Environmental Management Company (EMCo) and 

several other operating companies. EMCo is a newly established, whollyowned subsidiary of Parent. Parent also owns S1, and S1 owns S2. Parent 

now desires to use EMCo to strategically manage the groups [sic] environmental liabilities and clean-up efforts. S1 has a reserve for environmental 

liabilities on its books in the amount of $10x, which has not been deducted 

for income tax purposes. S1 also has an intercompany receivable account 

with S2 in excess of $10x. 

First, S2 pays off a portion of its intercompany debt to S1 by issuing a 10- 

year promissory note for $10x. S1 then contributes this note receivable, 

and its $10x environmental reserve, to EMCo in exchange for 100 shares 

of new, voting Class B stock. These shares may be either preferred or 

common. These shares have only a nominal value, as the net book value 

of the contributed property is nominal. (S1 remains legally liable for the 

environmental costs if EMCo is unable to pay them.) These shares should 

be designated as being entitled to a limited percentage of dividends and 

distributions paid to all classes of stock (for example, 15%). The percentage 

must be established so that at least 80% of the vote and value of all stock 

remains with the Class A (common) stock. 

84 139 UNITED STATES TAX COURT REPORTS (67) 

S1 then sells the Class B shares of EMCo to EMCos [sic] officers for their 

fair market value, a nominal amount. As the tax basis in this stock is 

$10x, S1 recognizes a capital loss of $10x on the sale. As EMCo makes 

expenditures on the environmental reserve, it also has a deduction for 

these payments. 

The DDCL noted that ‘‘it is clear that a business purpose is 

required for the transaction’’ and listed the following business purposes for the transaction: (1) better management of 

S1’s environmental liabilities through EMCo’s devotion of its 

resources solely to environmental projects, (2) the ability to 

provide incentives more easily for the better management of 

the environmental liabilities by creating a separate company, 

and (3) improvement of S1’s credit arrangements and 

banking relationships by taking its environmental liabilities 

off its balance sheet and transferring them to another of P’s 

subsidiaries. The DDCL described the business purposes 

regarding incentives (No. (2) above) as follows: 

S1 will sell Class B stock in EMCo to the EMCo officers in order to give 

these individuals an ownership interest in EMCo. S1 also then agrees to 

repurchase each officers [sic] shares, once the environmental liabilities 

have been settled or the officer leaves the employment of EMCo, at the 

greater of their cost to the officer * * * or the per share book value of 

EMCo. If the environmental liabilities are satisfied for less than the 

amount originally estimated, the book value of EMCo will increase, providing the individual officers with a gain when their shares are sold back 

to S1. 

The DDCL acknowledged that the transaction referenced 

therein presented risks and could be subject to antiavoidance 

provisions such as section 269 or section 1.1502–20, Income 

Tax Regs. The DDCL envisioned that its substance could be 

adapted for use with a variety of contingent liabilities and 

reserves, including medical claims. D&T structured the transaction described in the DDCL to offer to its qualifying clients 

a deductible capital loss equal to the amount of contingent 

liabilities transferred in the transactions. The appeal of the 

DDCL transaction (or a variation thereof) was to minimize a 

taxpayer’s Federal income tax liability by accelerating the 

deduction of and double deducting environmental or other 

contingent liabilities. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 85

3. Singer Promotes DDCL-Type Transaction to Quanex 

Singer decided to approach Quanex to promote to Quanex 

the transaction described in the DDCL, or a variation thereof. 

While the DDCL referenced a consolidated setting, Singer preferred implementing the transaction described therein in a 

deconsolidated setting because he was concerned about rules 

under which the loss could be disallowed in the consolidated 

setting. 

Before discussing the DDCL and the revenue ruling with 

Quanex, Singer read some of the cases mentioned in the 

ruling. He had developed an understanding of the revenue 

ruling and its implications, and he had previously discussed 

a contingent liability transaction with at least one other 

client. Singer took the position that an implication of the revenue ruling was that a taxpayer could use a liability management company to create a capital loss which, in turn, could 

reduce the taxpayer’s Federal income tax liability. 

In February 1997 at Quanex’s quarterly review meeting 

with D&T, Singer advised Rose, Parikh, and Royce that D&T 

could structure a contingent liability transaction for Quanex 

to generate a tax loss for Quanex. At that time, Singer knew 

that Quanex was selling LaSalle and would have a significant gain on the sale. 

VIII. Sales of LaSalle and Tube Group 

A. LaSalle Sale 

On February 27, 1997, Quanex’s board resolved to sell all 

of Quanex’s stock in LaSalle to a third party. The LaSalle 

sale closed on April 18, 1997. Singer knew at least as early 

as the 1996 quarterly meeting that this sale was probable, 

and he understood in or before March 1997 that Quanex 

hoped to close the sale by April 1997. Singer and Rose also 

both knew that the sale was expected to generate a significant gain. 

On January 13, 1998, petitioners filed their Form 10–K, 

Annual Report Pursuant to Section 13 or 15(D) of the Securities Exchange Act of 1934, for TYE 1997 (1997 Form 10–K). 

Petitioners reported in the 1997 Form 10–K that they completed the LaSalle sale for approximately $65 million. In 

their 1997 return petitioners reported that they realized a 

86 139 UNITED STATES TAX COURT REPORTS (67) 

9 Contrary to other testimony, Royce testified that Quanex did not consider the tax consequences during the negotiations because the buyer and Quanex had agreed to the sec. 

338(h)(10) election, that the tax consequences of the LaSalle sale were not important to Quanex 

before the April 1997 closing, and that the tax consequences were irrelevant for purposes of negotiating LaSalle’s sale price. We do not find Royce’s testimony on this matter to be credible, 

and we decline to rely upon it. 

10Singer testified that he knew by April 18, 1997, that Quanex had an economic gain on the 

sale but that he did not know the exact amount of the capital gain on the sale until approximately a week or two before he finalized petitioners’ 1997 return. We do not find this testimony 

to be credible, and we decline to rely upon it. 

11For June 29 through September 20, 1997, D&T billed Quanex $22,190 for 60.5 hours of 

‘‘Consultations regarding the sale of LaSalle’’ by Singer and other D&T professionals. 

$28,697,957 capital gain and a $20,721,360 ordinary gain on 

the sale. Petitioners’ 1997 return included their section 

338(h)(10) election regarding the sale of LaSalle. From April 

18, 1997 (the date of the LaSalle sale), through July 14, 1998 

(the date petitioners filed their 1997 return), LaSalle’s buyer 

tried to renegotiate a lower purchase price, and the buyer 

and Quanex disagreed on purchase price allocation issues 

related to the section 338(h)(10) election. In or before that 

period Quanex made several estimates of the income tax 

ramifications of the sale. 9 Royce, in particular, performed 

rough calculations comparing the results of completing the 

sale as a stock sale rather than an assets sale under section 

338(h)(10). Royce shared his calculations with Parikh. 

Singer knew during April 1997 that petitioners would 

realize millions of dollars of ordinary income and capital gain 

on the LaSalle sale. 10 Over the next five months, he devoted 

a substantial portion of his time to determining the tax 

implications of the sale, including the amount of ordinary 

income and capital gain to be generated from the sale. 11

Before the QHMC transactions closed, Singer and Royce discussed the anticipated amount of capital gain on the LaSalle 

sale. 

B. Tube Group Sale 

The Tube Group sale involved the sale of both stock and 

assets. The first closing occurred on December 3, 1997. Petitioners reported on their 1997 Form 10–K that the Tube 

Group sale was completed for approximately $30 million, and 

they reported a $12,458,171 capital gain and $8,090,766 of 

ordinary income from the Tube Group sale on their Federal 

income tax return for TYE 1998 (1998 return). 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 87

12 As discussed infra, Quanex characterized QHMC, formerly know as Quanex Wire, Inc. 

(QW), a wholly owned inactive subsidiary of Quanex, as its liability management company to 

effect the QHMC transactions. 

13 Rose directed Royce and Parikh to help complete the QHMC transactions. Parikh, however, 

did not make decisions about the details of the transaction’s structure. 

IX. Engaging D&T To Structure QHMC Transactions 

Over several months, at a time when D&T and Quanex 

were already aware of petitioners’ expected multimilliondollar sales, D&T and Quanex discussed the possibility of 

Quanex’s engaging in a series of transactions similar to those 

in the DDCL and the revenue ruling. During some of these 

discussions, D&T gave presentations either through Singer 

alone or through Singer and one of his Houston-based tax 

partners, Mark Schneider. Singer asked Schneider during 

1997 to help him structure a contingent liability transaction 

for Quanex, and they discussed the potential tax implications 

of the transaction. When Singer initially discussed the DDCL

and the revenue ruling with Quanex, he informed Quanex 

about potential issues with section 1.1502–20, Income Tax 

Regs., and similar loss limitation rules that applied to 

consolidated groups. Singer advised Quanex that its liability 

management company (QHMC), if deconsolidated from petitioners’ affiliated group, could be reconsolidated with the 

group if puts and calls were exercised in relation to the company’s stock. 12 Singer advised Quanex that it needed a business purpose for the QHMC transactions. 

On the basis of the discussions between D&T and Quanex, 

Rose believed that D&T’s structuring of a joint venture to 

manage petitioners’ liabilities could result in a capital tax 

loss that petitioners could use to shelter the anticipated 

unrelated gains. Singer advised Quanex from the outset, 

however, that he did not know whether D&T could actually 

structure such a joint venture. Nevertheless, at some time on 

or before March 24, 1997, Rose asked D&T for an engagement letter concerning the structuring of a series of transactions between Quanex, some of Quanex’s affiliates, and a 

third-party liability management consulting firm (what 

became the QHMC transactions). 13 Singer wanted the engagement letter so that he could be certain that D&T would be 

paid for its time whether or not the transactions were completed. 

88 139 UNITED STATES TAX COURT REPORTS (67) 

14 Although Rose had previously rejected Singer’s suggestion to use a liability management 

company to control Quanex’s environmental liabilities, Singer referenced those liabilities in case 

Rose changed his mind. 

Quanex and D&T entered into an agreement that was set 

out in an engagement letter dated March 24, 1997 (engagement letter). The engagement letter was signed by Singer on 

D&T’s behalf, and it was executed by Rose on Quanex’s 

behalf on June 30, 1997. Through the engagement letter, 

which was prepared by or under the direction of Singer, 

Quanex asked D&T to provide Quanex with— 

assistance in considering the federal income tax consequences associated 

with a series of prospective transactions between Quanex Corporation and 

several of its affiliates * * * an independent third party management consulting firm specializing in either employee benefits and medical insurance 

matters, or in environmental matters,* * * [14] as well as with a form of 

the prospective transaction that additionally or alternatively may contemplate an independent third party investor. 

The engagement letter notes that ‘‘the form and content of 

this prospective transaction is [sic] somewhat fluid at 

present’’ and that D&T would participate in meetings and 

discussions related to the structuring of the transaction. 

Singer informed Rose that the transaction contemplated by 

the engagement letter was a recent development, and Singer 

did not represent that he had experience with the type of 

transaction described. The engagement letter stated that 

D&T’s professional fees would be calculated on the basis of 

its standard hourly charges, but if the transaction were completed, the fees would be approximately $400,000 plus an 

estimated additional $10,000 for out-of-pocket expenses. 

D&T and Quanex contemplated under the engagement 

letter that D&T’s assistance and advice would ‘‘culminate in 

the delivery to Quanex of a tax opinion letter * * * limited 

solely to the specific federal income tax consequences to 

Quanex’’ and that the opinion letter would be ‘‘based upon all 

the facts of the transactions and representations made to 

* * * [D&T] in a Letter of Representation provided by 

Quanex.’’ The engagement letter stated that D&T could not 

confirm the conclusions it reached until it signed its opinion 

letter, although it might ‘‘informally indicate prior to that 

point whether or not * * * [D&T] anticipate[d] that a position taken by Quanex should be sustained on its merits if 

challenged by the IRS’’, and conditioned D&T’s agreement to 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 89

provide a tax opinion on D&T’s ‘‘ability to satisfy ourselves 

that all of our professional standards for the conduct of this 

work and the issuance of our opinion have been met.’’ D&T 

required as a condition of the engagement that Quanex agree 

in the engagement letter that D&T’s liability for any damages arising out of the services that D&T provided in the 

engagement be limited to the fees paid to D&T for its services 

giving rise to the liability. D&T required as a condition of the 

engagement that Quanex agree in the engagement letter that 

it would indemnify D&T from any liability, cost, or expense 

(including attorney’s fees and expenses) stemming from the 

engagement, absent D&T’s bad faith or willful misconduct. 

When Singer signed the engagement letter, he contemplated 

that D&T would provide Quanex with a tax opinion letter if 

a transaction were completed and Quanex wanted such a 

letter. 

D&T assisted Quanex with the QHMC transactions, and the 

process of developing the transactions (including the discussions before the engagement letter) extended from approximately February through October 1997. Petitioners conducted no independent investigation of the tax consequences 

of the QHMC transactions. 

X. Developing QHMC Transactions 

A. Quanex’s First Proposal to CS 

On several occasions in 1997, Rose met with Quanex’s 

management group and Singer to form an initial proposal to 

tender to CS as to its participation in the QHMC transactions. 

By letter dated July 21, 1997, Peery contacted Chapman to 

determine CS’ interest in the proposal for the ‘‘somewhat 

unique arrangement we are seeking’’ to ‘‘manage[ ] our corporation’s non-union medical expenses, including both HMO

and indemnity plan coverage for active employees and 

retirees.’’ Rose and Peery drafted this letter together, and 

they showed the letter to Singer before Peery sent it. 

The July 21 letter described Quanex’s proposal as an 

opportunity for an employee benefits firm to enter into a 

partnering arrangement with Quanex for a term of approximately 7 to 15 years to assume responsibility for and 

management of ongoing health care costs. The letter stated 

that the management responsibilities would include meeting 

90 139 UNITED STATES TAX COURT REPORTS (67) 

15 As of then, Rose had not considered using a consulting agreement, rather than a separate 

corporate structure, to provide incentives to reduce the health care costs. 

16 Chapman also attended a meeting where Singer made a presentation about the proposed 

transactions. The record is not clear regarding whether this presentation occurred during this 

initial meeting. 

the insured health care needs of certain nonunion Quanex 

employees at care levels comparable to those already in 

place, but with more efficient service delivery to Quanex’s 

employees and an ultimate result of reduced costs to Quanex. 

The letter explained that the management firm would 

acquire a class of stock in a medical management subsidiary 

of Quanex, the subsidiary would hold a 7- to 15-year promissory note issued by a Quanex entity, and the subsidiary 

would use the interest and principal payments on that note 

to reimburse the insured health care costs of the covered 

nonunion Quanex employees. 

The July 21 letter further explained that although CS 

would be paid, in part, for contract services on a periodic 

basis, Quanex was seeking an arrangement where CS’ 

performance premium for economic savings under the contract would be partially realized by efficiencies and cost 

savings. According to the letter, Quanex anticipated that 

these savings would lead to an accretion in the value of a 

designated class of the subsidiary’s stock and that the premium for performance would be shared through equity 

holdings in the subsidiary. The letter stated that Quanex 

designed this arrangement because ‘‘The senior management 

of Quanex is committed to delivering above market returns 

to our equity shareholders, and as such, has increasingly 

focused on reconfiguring certain central business relationships into a shared ownership or joint venturing mode.’’ 15

Because Quanex was a good customer for CS and CS 

wanted to retain its relationship with Quanex in any way it 

could, CS agreed to meet with Quanex to discuss the proposal. CS and Quanex met during the summer of 1997, and 

Quanex informed CS that Quanex wanted to create a medical 

management business unit that would focus on self-insured, 

indemnified contracts. 16

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 91

17 Although Peery was included on some of the correspondence relating to the structuring of 

the transaction, Peery did not have any discussions with D&T about the structure of QHMC. 

Peery also did not participate in any decisions or make any recommendations with respect to 

how QHMC would be structured. 

B. D&T’s First Outline of Proposed Joint Venture Transactions 

Sometime on or before July 30, 1997, but at a time when 

Quanex knew it would have substantial gains from the 

LaSalle and Tube Group sales, Quanex requested that D&T 

prepare an outline of the first draft of the proposed QHMC

transactions. Singer and Schneider prepared the outline. 

Schneider reviewed the outline before it left D&T, and by 

letter dated July 30, 1997 (July 30 outline), he sent the outline to Parikh, Rose, and Peery. 17

The July 30 outline stated that Quanex wished to broaden 

the scope of CS’ HMO evaluation services to include review of 

Quanex’s indemnity medical plan and other medical cost and 

quality matters. The outline reiterated that CS’ compensation with regard to the additional scope of services would be 

paid pursuant to a consulting agreement that provided for 

either hourly or performance-based compensation and for 

‘‘additional long term incentive equity’’. The outline proposed 

that (1) Quanex or QHMC have the option of purchasing the 

incentive equity after five years for cash, (2) CS have the 

option of selling the same to Quanex or QHMC after seven 

years for cash, and (3) the purchase or sales price be the 

greater of $12,500 or a formula value based, in part, on 

QHMC’s expectations for its medical claim expenses. 

The capital loss deduction generated through the QHMC

transactions would be approximately equal to the amount of 

the MPBs that were transferred in those transactions, and the 

amount of the MPBs Quanex would transfer in the QHMC

transactions would be based on the amount of the capital 

gains Quanex wanted to offset. Under the proposal set forth 

in the outline, all actuarial calculations for the QHMC transactions, including calculations of the present values of the 

MPBs to be transferred, would be done by the actuarial firm 

of Watson Wyatt & Co. (WW) or another Quanex designee. 

WW was Quanex’s then-current consultant on pension plans 

and retiree health care plans. Sometime before June 30, 

1997, Royce asked WW to compute the present value of 

92 139 UNITED STATES TAX COURT REPORTS (67) 

18 As discussed infra, the transferred MPB obligations had not been incurred by Quanex as 

of October 31, 1997, and when those obligations were assumed by QHMC, they were not reported as a liability on Quanex’s financial statements. 

Quanex’s future health care benefits for active and retired 

Quanex employees. Royce did so because he wanted Quanex 

to know the amount of its outstanding MPBs as it analyzed 

the structure of the proposed transactions. 

C. WW 

1. In General 

As part of WW’s consulting services provided to Quanex, 

WW prepared Quanex’s report (FASB 106 report) required by 

Financial Accounting Standards Board Statement No. 106 

(FASB 106). The FASB 106 report includes a calculation of a 

liability for the balance sheet and an annual expense for the 

income statement as to an organization’s retiree health care 

plans and other retiree welfare plans. An FASB 106 liability 

is a liability for financial statement purposes. The MPB

obligation, i.e., the future health care costs for active 

employees of Quanex, is not an FASB 106 liability. 18

2. FASB 106 

FASB 106 sets forth standards for determining the present 

value of an employer’s future retiree health care payments 

owed to currently retired individuals and current employees 

who will retire in the future and ratably accruing that 

present value on the employer’s financial statement over 

each employee’s career in an effort to match the benefits paid 

to employees to their service as they earn the benefits. FASB

106 requires the making of certain actuarial assumptions on 

matters such as the average cost of health care per person, 

the projection of increases in future average costs, and a discounting of projected future costs to calculate present value. 

(An assumption relating to increases in health care costs into 

the future is referred to as health care cost inflation or a 

health care cost trend.) Other assumptions relate to 

employee demographics, including mortality, job turnover, 

retirement age, and the likelihood of electing coverage under 

the employer’s plan upon retirement. 

Different types of trends exist for short-term and long-term 

calculations. For purposes of FASB 106, the timeframe for 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 93

19Later, WW also prepared Quanex’s FASB 106 report for TYE 1997. For the purpose of the 

FASB 106 reports, WW measured the present value of the annual retiree health care expense 

as of the first day of the fiscal year; e.g., for Quanex’s TYE 1997 report, the expense was measured as of November 1, 1996. In addition, usually in the November right after the close of the 

fiscal year, WW made a subsequent measurement as of October 31 of the just-closed fiscal year 

to determine the liabilities to be disclosed on Quanex’s yearend financial statements; e.g., for 

Quanex’s TYE 1997 report, the subsequent expense was most likely measured in November 

1997. During October 1997, WW knew the assumptions for TYE 1997 that it would make as 

to the discount and inflation rates because it and Quanex discussed those assumptions during 

that month. 

short-term calculations is typically from 4 to 10 years. Commonly, for a valuation under FASB 106, after a trend rate is 

determined for the first year of the calculation (initial trend 

rate), the initial trend rate gradually changes over the years 

to an ultimate health care inflation rate (ultimate trend 

rate). From the initial year of the calculation until the ultimate trend starts, the ultimate trend rate can be adjusted 

and is generally not the same number for all 4 to 10 years. 

The initial trend rate may be either greater or less than the 

ultimate trend rate. 

3. WW’s First Present Value Calculation of Quanex’s Health 

Care Benefits 

WW had the information to perform the present value calculations requested on or before June 30, 1997, because it 

had prepared Quanex’s FASB 106 report for TYE 1996. 19 By 

letter dated June 30, 1997, Michael Ringuette, a WW 

actuary, sent Royce (in his capacity as Quanex’s tax manager) the requested calculations for FASB 106 (June 30 calculations). The letter stated that the calculations applied 

only to people employed by or retired from Quanex as of 

November 1, 1996, and that WW did not include any additional amounts for employees that might be hired later. The 

letter was the first written product WW gave Royce as a 

result of the assignment to compute the present value of the 

future benefits, and Quanex knew WW’s calculations were 

estimates. Rose decided which groups of employees were 

included in WW’s calculations and the length of the term 

WW’s projections covered. Rose also ratified WW’s decisions 

about what assumptions were included in the calculations. 

WW’s June 30 calculations were entitled ‘‘Present Value of 

Active Health Care Benefits Provided to Employees Hired as 

of 11/1/96’’. The calculations relied on data from Quanex’s 

salaried employees at its Corporate, GST, Heat Treating, 

94 139 UNITED STATES TAX COURT REPORTS (67) 

20MS was a division of Quanex. 

Macsteel (MS)–Michigan, MS–Arkansas, MS–General Office, 

MST, and Tube Group Office locations, and from Quanex’s 

hourly employees at its GST, MS–Michigan, MS–Arkansas, 

and MST locations. 20 The calculations were broken down by 

the estimated present value of active health care benefits 

and of retiree health care benefits for active employees, on 

the one hand, and for retired employees, on the other hand. 

WW provided the following estimated present values of the 

active health care benefits: 

Location

Current 

employees 

Estimated P.V. of 

active health care 

benefits 

Salaried employees: 

Corporate 35 $2,468,146

GST 55 3,741,751

Heat Treating 27 2,148,863

MS–Michigan 112 8,113,866

MS–Arkansas 120 8,976,903

MS–General Office 30 2,044,664

MST 66 4,530,899

Tube Group Office 51 3,471,742

Total 496 35,496,834

Hourly employees: 

GST 248 15,799,142

MS–Michigan 165 11,399,603

MS–Arkansas 252 17,479,494

MST 222 13,164,471

Total 887 57,842,710

The June 30 calculations relied on the following assumptions: 

Aging .............................................................................. 2% 

Initial trend rate ............................................................ 9.29% 

Ultimate trend rate (2004) ........................................... 5.5% 

Average cost per employee (1997 age 40) .................... $3,500 

Interest rate ................................................................... 7.5% 

The accompanying letter stated that the interest rate and 

trend rate assumptions for the active employee and retiree 

health care were the same as those used for WW’s 

‘‘November 1, 1996 FASB valuation (published February 20, 

1997)’’. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 95

D. D&T’s Revisions to Proposed Transaction 

1. August 6–7, 1997, Revisions 

Quanex and D&T revised the terms of the QHMC transactions according to information that Royce gave D&T on how 

the QHMC transactions could be structured. Upon Quanex’s 

request, by letter dated August 6, 1997, D&T (through Singer 

and Schneider) provided Quanex with revisions to the July 

30 outline (August 6 outline). Singer and Schneider prepared 

the letter together, and Singer signed the letter and reviewed 

it before it left D&T. The revisions included an outline of the 

proposed capitalization and subsequent sale of QHMC and 

Quanex Steel, Inc. (QS), another wholly owned Quanex subsidiary, which the letter characterized as ‘‘part of the overall 

plan to expand the scope of services of consultants’’. 

The August 6 outline combined the proposed QHMC transactions into five steps. Step 1 provided for the reconfiguration of an inactive Quanex subsidiary (which eventually was 

QW) through certain substeps that included, among others: 

(1) renaming the subsidiary QHMC; (2) amending QHMC’s articles of incorporation to provide for three classes of stock, to 

wit, class A voting common stock (class A stock), class B 

voting preferred stock (class B stock), which the letter 

termed ‘‘Incentive Equity’’, and class C voting preferred stock 

(class C stock); (3) providing for voting rights measured in 

terms of ability to elect directors, and including CS principals 

or employees on QHMC’s board of directors (QHMC’s board) 

and as officers; (4) providing for dividends on the class A 

stock as declared and dividends of 9.5%, payable quarterly 

and cumulative, for the class B and class C stocks; (5) 

allowing for the transfer of stock only with the consent of all 

shareholders; (6) providing that the class A stock be subject 

to assessment for capital calls and that the capital call 

assessment for the class B and class C stocks be limited to 

an assumed $100 per share investment price; (7) providing 

Quanex or QHMC with call rights after five years and CS with 

put rights after seven years; and (8) providing for a liquidation value of the class B and class C stocks at an amount 

equal to the greater of $125 or a formula value that was 

based on CS’ success in achieving certain performance goals 

96 139 UNITED STATES TAX COURT REPORTS (67) 

21 In addition to providing Quanex with requested revisions in the August 6 outline, D&T provided Quanex with a chart summarizing the updated steps of the transaction. According to the 

chart, Quanex would contribute $35 million and $34,990,100 of MPBs to QS, and Piper would 

contribute $10 million and $9,998,900 of MPBs to QS. The chart made no mention of any cash 

or MPB contributions from LaSalle, MST, or GST. 

set by Quanex and on the difference between the value of 

QHMC’s projected and actual MPB expenses. 

Step 2 of the August 6 outline addressed the ‘‘Determination of Medical Liability and Contribution of Note’’ and 

stated that the present value of Quanex’s and Piper’s medical 

liabilities had to be determined. The purpose of this step was 

to determine which groups of employees would have their 

contingent medical liabilities contributed to QHMC. Under 

this step, Quanex would contribute $45 million and 

$44,998,000 worth of contingent liabilities to QS, and Piper 

would contribute $2 million and $1.99 million of contingent 

liabilities to QS. As a footnote to Quanex’s proposed contributions to QS (footnote), the outline stated that for purposes of 

the document, ‘‘we have assumed that $36 million pertains 

to LaSalle and $9 million to MST (and possibly GST).’’ 21 This 

footnote referred to the anticipated gains on the sales of 

those assets. 

Step 3 provided for CS’ purchase of all of the class B stock 

for $41,700. Step 4 provided for CS to contribute $6,000 to 

QHMC in exchange for class C stock, and for QS to contribute 

the cash and liabilities it received from Quanex to QHMC in 

exchange for class C stock with a net fair market value of 

$11,000. Step 5 provided for QS to sell some or all of its class 

C stock for the same price per share that CS ‘‘paid’’ for its 

class C stock. 

Royce gave D&T some comments on the August 6 outline, 

and those comments were read by Singer, Schneider, and 

Walt Mooney. Mooney was a recently hired senior tax manager in the D&T tax department in Houston, and he was 

assigned to the Quanex engagement to work under Singer, 

assisting him with tasks related to the QHMC transactions 

but without any authority to make material decisions about 

the structure of the transactions. Mooney, in consultation 

with Singer or Schneider, prepared a memorandum (Mooney 

memorandum) with respect to Royce’s comments, and D&T 

forwarded a copy of the Mooney memorandum to Royce on 

August 7, 1997. The Mooney memorandum stated that the 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 97

22 At trial, Singer could not (or would not) explain what this response meant. 

August 6 outline was incorrect in that QS was to contribute 

a note to QHMC along with the liabilities rather than cash. 

The Mooney memorandum stated in response to one of 

Royce’s comments, ‘‘Why do we need Quanex Steel?’’, that QS 

‘‘creates tax basis in the note.’’ 22 The Mooney memorandum 

did not state that the footnote in the August 6 outline was 

incorrect or otherwise address the footnote. The Mooney 

memorandum also gave no indication that Royce or anyone 

else had commented on the footnote. 

In a letter dated August 7, 1997, D&T provided Quanex 

(through Parikh, Perry, Rose, and Royce) with revisions that 

Quanex requested with respect to the August 6 outline. The 

August 7 letter proposed the same general structure for the 

QHMC transactions as the August 6 outline, but revised step 

4 to propose that QS contribute a $45 million note to QHMC, 

rather than cash, along with $44,998,000 of contingent liabilities. The August 7 letter retained the proposal that Quanex 

contribute $45 million and $44,998,000 of contingent liabilities to QS and included a footnote stating that D&T assumed 

that $36 million pertained to LaSalle and $9 million to MST

and GST. Singer reviewed and signed the August 7 letter. 

2. August 13, 1997, Revisions and Cashflow Analysis 

By a fax transmission dated August 13, 1997 (August 13 

fax), Singer sent Rose a letter with new versions of the proposed transactions that were designed to overcome what 

Singer believed was a potential issue with section 1.1502– 

13(g), Income Tax Regs. The August 13 fax stated that 

Singer and Schneider had ‘‘further refined’’ the transactions 

as Quanex had requested and included details with respect 

to the class C stock. 

The primary changes to the transactions as described in 

the August 13 fax were the deletion of a provision requiring 

Piper to contribute cash and liabilities to QS and the addition of a provision stating that in no event would the formula 

value result in the aggregate value of the class B and class 

C stocks’ equaling or exceeding 50% of the total value of all 

classes of stock. The August 13 fax retained the same five 

general steps as the previous outlines of the proposed transactions. In addition, the August 13 fax retained the proposed 

98 139 UNITED STATES TAX COURT REPORTS (67) 

23We note some computational errors in the projections. These errors are not material to our 

analysis. 

Quanex contribution to QS and the accompanying footnote 

regarding LaSalle, MST, and GST. 

By a second fax dated August 13, 1997 (second August 13 

fax), D&T provided Quanex with two documents to assist 

Quanex in its presentations to and negotiations with CS. One 

document was a checklist entitled ‘‘QHMC/QUANEX TRANSACTION TASK CHECKLIST FOR CHAPMAN’’ (checklist). The 

checklist retained most of the provisions discussed in the 

August 13 fax, but eliminated those that did not directly 

address CS’ potential role in the transactions. The second 

document was a discounted cashflow analysis (August 13 

cashflow analysis) that D&T used to value all of the proposed 

classes of QHMC stock as of October 1997. The August 13 

cashflow analysis assumed, among other things, that QHMC

would hold a $38 million note receivable with a 15-year term 

and that a $4,714,000 payment, comprising both interest and 

principal, would be made on the note each year. 

The August 13 cashflow analysis projected Quanex’s ‘‘Cash 

Flow from Operating and Investing Activities’’ over a 15-year 

period. The analysis projected that 576 employees would be 

covered by QHMC in each year, that interest income from the 

note receivable would decrease steadily, and that the projected medical costs for the covered employees would increase 

steadily. The August 13 cashflow analysis projected that the 

‘‘Cash Flows from Financing Activities (excluding Dividends)’’ 

would consist of 15 annual principal payments on the note in 

amounts that increased from $1,294,000 in year 1 to 

$4,325,000 in year 15 (for total principal payments of $38 

million over the 15-year period) and that positive cashflow 

would be available to the equity holders for only the first 6 

years. The analysis projected increasing net operating losses 

(NOLs) for years 2 through 7. The relevant specifics of the 

August 13 projections included the following amounts (in 

thousands): 23

Year 

Interest 

income 

Medical 

costs 

Total 

cashflow 

from 

operating 

and investing 

Principal 

repaid 

Cashflow 

available 

to 

equity 

holders 

Cumulative 

cashflow NOL 

1 $3,420 ($3,193) $227 $1,294 $1,521 $1,521 $227

2 3,304 (3,470) (166) 1,411 1,244 2,765 (166)

3 3,177 (3,748) (572) 1,538 966 3,731 (738)

4 3,038 (4,026) (988) 1,676 689 4,419 (1,726)

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 99

Year 

Interest 

income 

Medical 

costs 

Total 

cashflow 

from 

operating 

and investing 

Principal 

repaid 

Cashflow 

available 

to 

equity 

holders 

Cumulative 

cashflow NOL 

5 2,887 (4,298) (1,411) 1,827 416 4,836 (3,137)

6 2,723 (4,561) (1,839) 1,991 153 4,988 (4,975)

7 2,544 (4,812) (2,269) 2,171 (98) 4,890 (7,244)

8 2,348 (5,077) (2,729) 2,366 (363) 4,528 -0-

9 2,135 (5,356) (3,221) 2,579 (642) 3,885 -0-

10 1,903 (5,651) (3,748) 2,811 (937) 2,949 -0-

11 1,650 (5,962) (4,311) 3,064 (1,247) 1,701 -0-

12 1,375 (6,290) (4,915) 3,340 (1,575) 126 -0-

13 1,074 (6,635) (5,562) 3,640 (1,921) (1,795) -0-

14 746 (7,000) (6,254) 3,968 (2,286) (4,081) -0-

15 389 (7,385) (6,996) 4,325 (2,671) (6,753) -0-

Total 32,714 (77,466) (44,753) 38,000 (6,753) No D&T 

total

No D&T 

total

3. August 22, 1997, Revisions 

By letter dated August 22, 1997 (August 22 letter), Singer 

sent Parikh and Royce some documents to assist them in 

their presentation of the QHMC transactions to CS. These 

documents included, among other things, a schematic diagram of the capitalization of QHMC (and other transfers 

related thereto), two examples of CS’ potential return on 

investment, another task checklist for CS (which was nearly 

identical to the previous CS task checklist), and a proposed 

Letter of Intent to be executed by Quanex and CS. The diagram proposed the following transactions related to QHMC’s 

capitalization: (1) Quanex transfers $50,000 to QHMC in 

exchange for class A stock; (2) Quanex transfers $13,000 to 

QHMC in exchange for class B stock; (3) Quanex transfers 

class B stock to CS in exchange for $13,000; (4) CS transfers 

$2,000 to QHMC in exchange for class C stock; (5) QS transfers $38 million and $37,989,000 worth of MPBs to QHMC in 

exchange for class C stock; and (6) Piper transfers a $38 million affiliated note to QHMC in exchange for $38 million. The 

$37,989,000 assigned to the MPBs was the present value ultimately assigned to the MPBs that were transferred as a part 

of the QHMC transactions. 

E. Quanex’s Negotiations With CS 

By letter dated September 3, 1997, Singer provided Royce 

with a set of documents for WW and a set of documents for 

CS. Quanex had asked D&T to prepare those documents for 

Quanex to gauge CS’ and WW’s interests in becoming medVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00033 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
100 139 UNITED STATES TAX COURT REPORTS (67) 

24Sometime during 1997 Ringuette and Clay Cprek, a WW retirement consultant, attended 

a meeting in WW’s Southfield, Mich., office where Quanex (through Parikh, Royce, and possibly 

Rose) gave WW the opportunity to invest in what became QHMC. Quanex informed Ringuette 

and Cprek that the tax aspects of the QHMC transactions were proprietary and declined to explain the details of the tax aspects to WW. WW did not invest in QHMC. 

25We do not discuss the WW documents separately because they do not differ significantly 

from the CS documents, and WW did not invest in the transactions. 

ical consultants with QHMC. 24 D&T prepared the documents 

with input from Quanex, and Singer considered the documents to be part of an effort to present CS with key points 

of the transaction. 25 The documents contained a PowerPoint 

presentation of key deal terms (September 3 presentation), a 

task checklist for the investing medical consultant, and the 

same capitalization diagram that D&T provided to Quanex in 

the August 22 letter. 

According to the September 3 presentation, CS would provide health management consulting services, including 

vendor management for both HMO and indemnity plans, continue its HMO consulting agreements, receive service contracts for specific additional projects, and purchase QHMC

stock for an equity stake in QHMC. The terms did not differ 

significantly from those discussed above with respect to the 

August 6 outline and its subsequent revisions. According to 

the September 3 presentation, the purpose of the QHMC

transactions was to ‘‘reduce Quanex’s overall medical costs, 

without compromising quality of care provided to employees.’’ 

The September 3 presentation contained no reference to the 

tax aspects of the QHMC transactions or to the role that tax 

aspects played in structuring the transactions. 

The September 3 presentation also included a summary of 

return-on-investment scenarios which assumed annual 

savings in medical costs of 5%, on the one hand, and 10%, 

on the other hand. The example scenarios projected the following net returns for a five-year investment and for a sevenyear investment: 

Length of investment 

Net return 

Annual savings of 5% Annual savings of 10% 

5 Years 7 Years 5 Years 7 Years 

If personnel remain 

constant $170,502 $295,072 $413,783 $660,073 

If personnel increase 

5% per annum for 

the first 5 years 182,666 313,322 438,111 696,573 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 101

Length of investment 

Net return 

Annual savings of 5% Annual savings of 10% 

5 Years 7 Years 5 Years 7 Years 

If personnel decrease 

5% per annum for 

the first 5 years 158,338 276,822 389,455 623,572 

Sometime on or before September 10, 1997, Peery again 

contacted CS about the potential transactions and to inquire 

into whether CS would be interested in participating in 

them. On September 10, 1997, Chapman and Howard met 

with Quanex to discuss the proposal. Quanex proposed all 

aspects of the structure of the transactions to CS, including 

that Quanex’s MPB obligations be put in a separate corporation, and the substance of Quanex’s presentation at the September 10 meeting was the same as at the September 3 

presentation. Quanex provided CS with the return on investment example scenarios, but Quanex did not give Chapman 

any support for the computations. When CS and Quanex representatives discussed Quanex’s participation in the QHMC

transactions, CS was not represented by counsel, CS was not 

involved in structuring the relevant corporate entities or 

transfers, CS did not determine the QHMC stock’s issue price, 

and CS did not select the liabilities that were ultimately 

transferred to QHMC. 

Chapman prepared a memorandum for CS’ board of directors and officers dated September 11, 1997 (memo). In the 

memo, Chapman informed CS’ board of the terms of the proposal and stated that, under the proposal, CS and Quanex 

would enter into a joint venture that would be responsible for 

the cost of Quanex’s benefits program. Chapman also 

informed CS’ board that for a $15,000 investment in QHMC

stock, Quanex would guarantee the stock, CS would earn a 

guaranteed annual dividend of 9.5%, and ‘‘when Quanex reacquires the stock it will be based on its actual value but no 

less than $125 per share.’’ Chapman explained that the stock 

value would be calculated on the basis of actual savings as 

compared to actuarial formulas that WW developed. 

Chapman understood that the only risk CS faced from 

participating in the QHMC transactions was Quanex’s credit 

risk and that CS, by accepting the proposal, could potentially 

expand its business relations with Quanex. 

102 139 UNITED STATES TAX COURT REPORTS (67) 

26 CS’ HMO arrangement with Quanex would therefore not change because it had always been 

on a commission basis and remained on a commission basis. 

In describing the proposed transactions, Chapman 

explained that the number of Quanex employees that CS 

served would increase significantly because CS would have 

responsibility with respect to approximately 600 salaried 

nonunion employees (whose health benefits were included in 

the QHMC transactions), in addition to all other employees at 

Quanex facilities (not included in the QHMC transactions). 

Chapman also explained that Quanex had 3,900 employees 

at that time but planned to sell two divisions with a combined total of 900 employees, which in turn, Chapman 

explained, meant that CS would lose the commission income 

it was earning on those 900 employees. Chapman stated in 

the memo that if CS took part in the joint venture, it would 

have global responsibility for 3,000 employees, with the 600 

salaried/nonunion employees being covered by the proposed 

health care arrangement and the remaining 2,400 by CS’ 

standard commission schedule. 26 Chapman explained that 

CS would earn an estimated $50,000 in consulting fees for 

servicing the QHMC population as well as CS’ standard 

earnings formula on the nonunion employees whose MPBs 

would be transferred to QHMC. 

By letter dated September 19, 1997, Parikh informed 

Chapman that Quanex was pleased with Chapman’s interest 

in the proposal, that Quanex believed ‘‘a proven employee 

benefits firm can offer an expertise in the management of 

ongoing health costs’’, and that ‘‘Establishing a health 

management company and allowing your employee benefits 

firm an opportunity to participate in its ownership can prove 

to be beneficial to all parties.’’ Parikh also stated that 

Quanex was still in the process of refining the pool of MPBs 

that would be transferred to QHMC. 

Parikh included a draft set of working documents with the 

September 19 letter, and he requested that Chapman provide 

Quanex with his comments to the documents ‘‘by Friday, 

September 26, 1997.’’ Parikh emphasized in the letter that 

Quanex was on a ‘‘tight time schedule’’ for completing the 

transactions, as CS already knew. Parikh wanted the transactions completed by October 31, 1997, because he knew that 

Quanex anticipated a gain from the LaSalle sale and that the 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 103

QHMC transactions would result in an artificial capital loss 

that could offset the gain. 

F. WW’s Present Value Calculation Revisions 

Royce was Ringuette’s main contact for most aspects of 

Ringuette’s assignments related to present value calculations. Before September 19, 1997, but after receiving the 

June 30 calculations, Royce directed WW to revise the June 

30 calculations without taking into account the Tube Group 

locations that Quanex intended to sell. Royce gave WW the 

Quanex companies to use in the calculations. In addition, 

Quanex gave WW the actual claims activity for the given 

locations. 

WW had further discussions with Quanex relating to 

present value calculations, and WW gathered more specifics 

on the claims experience for the Quanex locations and performed additional present value calculations. On September 

19, 1997, Ringuette sent Cprek and Maureen Cotter, a WW 

health care consultant, an email describing a conversation 

with Royce on September 18, 1997. Ringuette stated that 

Royce wanted WW to value all Quanex salaried groups 

(except for the Tube Group) and the MS–Arkansas nonunion 

hourly group and that ‘‘this calculation will be used to determine the amount of the promissory note to be given to the 

medical management subsidiary.’’ 

By letter dated October 13, 1997, that Ringuette prepared 

and signed, WW provided Royce with the revised calculations 

of the present value of lifetime health care benefits for certain groups of active Quanex employees. Ringuette stated in 

the cover letter that the calculations addressed Quanex’s corporate, MS–Michigan salaried, MS–Arkansas salaried, MS– 

Arkansas nonunion hourly, MS–General Office, Heat 

Treating, and Nitro Steel employees. No retirees were 

included in the analysis. As Ringuette and Royce had discussed, WW based its calculations on only those employees 

employed by Quanex as of October 13, 1997, and did not 

include any amounts for future Quanex hires. 

WW determined the number of active employees and their 

average age using November 1, 1996, employee census data 

provided for the FASB 106 valuation performed as of that 

date, and WW assumed the number and average age of 

104 139 UNITED STATES TAX COURT REPORTS (67) 

27We note that the average attained age is actually 43.5. The discrepancy does not affect our 

analysis. 

employees in each division from November 1, 1996, to 

November 1, 1997, would not change. WW also projected the 

assumed number of employees remaining in future years and 

their average age using assumptions used for the November 

1, 1996, FASB 106 valuation, and WW assumed the average 

cost of health care would increase in future years in accordance with the following assumptions: ‘‘2.0% increase in cost 

for each/year increase in average age’’ and ‘‘8.75% inflation 

in 1998, decreasing linearly over time to 5.50% in 2004 and 

remaining at that level thereafter (same as FASB Statement 

No. 106 assumption).’’ The 2% aging assumption was chosen 

on the basis of data WW had collected on health care costs 

for many different health care plans and was used, in part, 

because WW wanted to reflect that some of the groups had 

a higher average age than others and might have corresponding higher health care costs. Ringuette used the 

8.75% initial trend to project the increase in the average 

health care costs per person from November 1, 1997, through 

October 31, 1998, to November 1, 1998, through October 31, 

1999. 

WW also assumed an average health care cost per 

employee of ‘‘$5,877 (1998 Age 40)’’, which represented the 

estimated health care cost per employee included in the 

present value calculation for TYE 1998, adjusted to assume 

an average age of 40, and a 7.5% interest rate to discount 

future cashflows to November 1, 1997. WW included with the 

October 13 letter a chart entitled ‘‘Development of Average 

Health Care Cost Per Active Employee’’, which showed how 

WW arrived at its $5,877 assumption. 

WW’s October 13, 1997, ‘‘Present Value of Active Health 

Care Benefits Provided to Employees Hired as of 11/1/97’’ 

calculations were as follows: 27

Location 

No. of 

employees 

today 

Avg. 

attained 

age 

Avg. 

retirement 

age 

Active 

health care 

benefits 

Estimated present 

value retiree health 

care benefits 

Grand 

total 

Active employees Retired 

employees 

Corporate 35 46 63 $3,792,243 -0- -0- $3,792,243 

Heat treating 27 35 63 3,302,078 -0- -0- 3,302,078 

MS–Michigan 112 45 63 12,469,349 -0- -0- 12,469,349 

MS–Arkansas 120 42 63 13,796,098 -0- -0- 13,796,098 

MS–General 

Office 30 47 63 3,142,329 -0- -0- 3,142,329 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 105

Location 

No. of 

employees 

today 

Avg. 

attained 

age 

Avg. 

retirement 

age 

Active 

health care 

benefits 

Estimated present 

value retiree health 

care benefits 

Grand 

total 

Active employees Retired 

employees 

Nitro Steel 13 46 63 1,337,608 -0- -0- 1,337,608 

Total 337 43 63 37,839,705 -0- -0- 37,839,705 

At various times from approximately a week or two after 

receiving the October 13 report through early 1999, Royce 

asked WW to change its present value calculations to, for 

example, (1) include the MS–Arkansas nonunion hourly 

information in the present value calculation, (2) change the 

lifetime until retirement projection to a 15-year projection for 

estimated present value, and (3) exclude the Heat Treating 

and Nitro Steel Divisions in the groups of employees. 

G. Patrick Wannell 

1. Background 

Patrick Wannell is a chartered engineer and an Institution 

of Metallurgists fellow. He received his formal education and 

professional training in England, and he worked for approximately 20 years primarily in technical positions for a large 

integrated steel company in England. He later joined LaSalle 

in the summer of 1980 and was given a range of management responsibilities. He became LaSalle’s vice president and 

general manager in May 1991, and he worked in that 

capacity until he retired in February 1997. After LaSalle was 

sold in April 1997, Wannell consulted for LaSalle’s new 

owners for approximately one year to help them understand 

LaSalle’s operations, and he performed one other consulting 

project for Quanex, primarily reviewing documents related to 

the sale for accuracy. Neither consulting project dealt with 

medical expenses. 

2. Wannell and Health Care Costs at LaSalle 

While working for LaSalle, Wannell believed that the business was ‘‘clearly struggling’’ because it was breaking even 

financially. He reviewed the business and concluded that 

LaSalle’s health care costs were high in relation to those of 

other Quanex divisions and were rising annually by approximately 30%. He formed a two-step approach to reduce 

LaSalle’s health care costs. First, he renegotiated the health 

106 139 UNITED STATES TAX COURT REPORTS (67) 

care contract for LaSalle’s hourly employees because it did 

not require an employee payment. Second, he developed a 

wellness program that looked at the causes of employees’ illnesses rather than the employees’ symptoms. The wellness 

program addressed issues (such as weight, diet, exercise, 

stress, and smoking) through, among other things, annual 

physicals, exercise facilities, and subsidized health club memberships. When Wannell retired, LaSalle had approximately 

450 employees, and LaSalle’s health care costs were 

declining by approximately 10% per year. 

3. Quanex’s Offer to Wannell 

Rose had known Wannell since 1982 and was familiar with 

his efforts to control health care costs at LaSalle. By letter 

dated October 13, 1997, Rose asked Wannell to join QHMC’s 

board as a director. The letter stated: 

We are establishing a company to manage our health care benefits and 

selling a minority interest to a benefits management consulting firm. We 

believe giving the consulting firm an equity interest will be an extra incentive for them to come up with creative and innovative strategies in health 

care management. Since this is a new concept we will start small and try 

this out on Corporate and MACSTEEL salaried employees health benefits 

only. * * * 

Further, the letter stated, Quanex wanted Wannell to join 

QHMC’s board because 

We need your knowledge and experience in the areas of labor relations, 

negotiations, employee management, and morale. This company will manage the health care benefits of employees. We want it to be efficient as possible but also fair to the employees it will effect [sic]. We need an outside 

director who will bring a balance to the discussion and consider all points 

of view, not just those of * * * [QHMC] or * * * [CS]. 

On or about October 20, 1997, after the negotiations 

between Quanex and CS were completed, Wannell spoke 

with Rose by telephone. During that call, Rose offered 

Wannell the opportunity to invest $11,000 in QHMC. Peery, 

Quanex’s vice president of human resources, did not know 

that Rose was inviting Wannell to participate in QHMC, and 

Peery was not asked for his advice or recommendation on 

individuals who might be interested in participating. 

Wannell expressed concern that he would have to incur 

travel and hotel costs for QHMC board meetings, but Rose 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 107

28 In contradiction to his notes, Wannell testified that he did not consider the risk to be zero 

that he would lose his $11,000 investment. We do not find this testimony to be credible, and 

we decline to rely upon it. 29 If the class C shares were redeemed after five years for $125 per share, the holders of each 

share would receive $25 more than the $100 initially paid to purchase the share, which averages 

to $5 per year or 5% of $100 for each of the five years. 

assured Wannell that the costs would be reimbursed, 

meetings would be minimal, and Wannell could vote by fax. 

Rose also informed Wannell that although the term of the 

investment would be 15 years, the parties could unwind the 

investment in either 5 or 7 years. Wannell made handwritten 

notes during the call that expressed, in part, his understanding of the worst case scenarios for his offered investment. Under the heading ‘‘worst case’’, Wannell made three 

entries: ‘‘9.5%/yr’’, which reflected his understanding of the 

annual dividend he would receive; ‘‘no loss of $11,000’’, which 

reflected his understanding that he would not lose his investment; 28 and ‘‘+ 25% over 5 yrs’’, which reflected his understanding that his investment would grow 5% each year to the 

five-year point where Quanex could wind things up. 29

Wannell accepted Rose’s October 20, 1997, offer to invest 

in QHMC the same day. The terms of Wannell’s investment 

were set by Quanex, without any negotiations between 

Quanex and Wannell. Wannell viewed the dividend payments as approximately equivalent to consultant fees for his 

time and the five-year, total $25 per share return on his $100 

per share investment as equivalent to what he was earning 

in his bank account. Wannell understood that QHMC’s credit 

risk was minimal because it was a subsidiary of Quanex. 

H. D&T’s Revised Cashflow Model 

D&T prepared revised cashflow calculations for Quanex for 

the proposed transactions and gave them to Royce in a document entitled ‘‘Cash Flow Model as of 10/21/97’’ (October 21 

calculations). The purpose of these calculations was to model 

the liabilities QHMC would need to satisfy, the payments 

QHMC would be obligated to make, and the income QHMC

would need to pay the liabilities. The calculations also were 

needed to set the reported fair market value of QHMC’s stock. 

Within the October 21 calculations, D&T estimated the 

present value for the medical costs associated with Quanex’s 

corporate, MS–Arkansas, MS–General Office, and Nitro Steel 

locations to total $37,320,000, as determined as follows: 

108 139 UNITED STATES TAX COURT REPORTS (67) 

Location

Grand 

total 

of PV 

Cashflows 

1997 

Employees 

as of 

10/21/97 

Corporate $3,496,000 $420,000 35

MS–Arkansas 11,051,000 86,000 27

MS–Arkansas 18,421,000 470,000 112

MS–General 

Office 3,062,000 457,000 120

Nitro Steel 

Division 1,290,000 128,000 30

Total 37,320,000 1,561,000 324

D&T also projected that for all years of the investment, other 

than the first year, medical costs would exceed the interest 

income from the $38 million note receivable but, taking into 

account the principal repayments, cashflow would be available to equity holders for the first seven years of the investment and NOLs would accumulate in years 2 through 6 of the 

investment. D&T also projected positive net present value of 

the cashflows. Relying on these factors and others, D&T projected that the total value of equity for all classes of QHMC

stock would equal $76,000, as determined as follows: 

Total PV of cashflows ...................................................... $879,000

Plus cash on hand ........................................................... 65,000

Less uncertainty of future medical costs adjustment ... (868,000) 

Equals total value of equity ............................................ 76,000

Within the October 21 calculations, D&T also projected liquidation and net return values with respect to QHMC’s preferred stock. D&T projected that if the five-year call option 

was exercised and a five-year cumulative savings of 

$1,622,959 was assumed, the liquidation value of the class B 

and class C stocks would be $356,441 and the net return on 

investment for the underlying shareholders would be 

$348,566. D&T projected that if the seven-year put option 

was exercised and a seven-year cumulative savings of 

$2,430,142 was assumed, the liquidation value of the class B 

and class C stocks would be $565,998 and the net return on 

investment for the underlying shareholders would be 

$560,973. D&T also made cumulative savings projections for 

1998 through 2012 as follows (in thousands): 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 109 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Initial undiscounted MPBs $2,793 $3,017 $3,245 $3,473 $3,701 $3,927 $4,145 $4,358 $4,569 $4,792 $5,025 $5,270 $5,527 $5,797 $6,081 Actual MPBs 2,514 2,715 2,921 3,126 3,331 3,534 3,731 3,922 4,112 4,312 4,523 4,743 4,975 5,217 5,473 Yearly savings 279 302 325 347 370 393 415 436 457 479 503 527 553 580 608 Aggregate yearly cum. savings 279 581 905 1,253 1,623 2,016 2,430 2,866 3,323 3,802 4,305 4,832 5,384 5,964 6,572 

110 139 UNITED STATES TAX COURT REPORTS (67) 

The projections assumed a 10% variance factor and 324 covered plan participants per year. 

D&T also included in its October 21 calculations a section 

entitled ‘‘Analysis of NOL Usage’’ for 1998 through 2004. D&T 

included this section to show Quanex the amount of NOLs 

that QHMC would generate but that the Quanex consolidated 

group could not use if QHMC were deconsolidated. The NOL

projections assumed a 6% risk-free rate and a 40% tax rate 

and were as follows (in thousands): 

1998 1999 2000 2001 2002 2003 2004 

NOL generated -0- $276 $622 $976 $1,339 $1,710 $2,086 

NOL carryforward -0- 276 897 1,873 3,213 4,923 7,009 

PV of annual NOL 

tax benefit -0- 98 209 309 400 482 555 

Cumulative PV of 

NOL benefits 

(as rounded) 

at the end of 

year 7 2,054 

At a time not disclosed in the record, Royce reviewed the 

October 21 calculations. Royce subsequently requested new 

calculations from both D&T and WW. Royce testified at trial 

that the October 21 cashflow model used the wrong groups 

of employees and assigned the wrong numbers of employees 

to those groups. 

XI. Executing QHMC Transactions 

A. Quanex’s October 21–22, 1997, Board Meeting 

On October 21 and 22, 1997, Quanex’s board held a regular 

meeting which addressed, in part, the QHMC transactions. 

The meeting was attended by Quanex’s board members and, 

among others, Peery, Rose, James Davis, and Michael 

Conlon. Davis was Quanex’s executive vice president and 

chief operating officer (COO) from 1997 through February 

1999 and Quanex’s president and COO from March 1999 

through December 2000. Conlon was an attorney with Fulbright & Jaworski, LLP (Fulbright). 

At the board meeting, Rose explained the venture, which 

the meeting minutes described as 

a proposal to establish one of the Company’s subsidiaries as the holder of 

all rights and obligations of the medical plan benefits for the Company’s 

active salaried employees at its corporate offices in Houston and within the 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 111

30 In this context, a restricted subsidiary is a Quanex subsidiary that guarantees a debt of 

Quanex and consolidates its funds with those of Quanex in accordance with Quanex’s revolving 

credit agreement. Royce believed that QHMC had to be a restricted subsidiary of Quanex to participate in the transactions. QHMC eventually (on a date not disclosed in the record) guaranteed 

the obligations of Quanex pursuant to the revolving credit agreement. 

MacSteel Group * * * and to enter into a relationship with a professional 

health plan advising firm, * * * [CS], to create incentives to reduce the 

overall health plan costs to the Company. 

Rose provided materials to Quanex’s board through which 

the participants of the meeting discussed the general nature 

of the proposed transactions and the various resolutions 

needed to implement them. 

Under the proposed resolutions, Quanex would effect the 

QHMC transactions through a series of steps, each of which 

was part of a single plan, and all of which Rose considered 

interrelated. These steps were as follows: 

(1) designate QS and QW as restricted subsidiaries under 

the Quanex $250,000,000 revolving credit and term loan 

agreement dated July 23, 1996, as amended (revolving credit 

agreement); 30

(2) ratify the actions of Quanex’s officers in amending the 

revolving credit agreement to provide for the designation of 

certain subsidiaries as restricted subsidiaries if Quanex 

owned an interest in the subsidiary of as little as 60%; 

(3) approve, as QW’s sole shareholder, QW’s plan of 

recapitalization, which provided for authorization of stock in 

the form of the class A stock, the class B stock, and the class 

C stock; 

(4) approve and adopt QW’s amended and restated certificate of incorporation, by which QW changes its name to 

‘‘Quanex Health Management Company, Inc.’’ and changes 

its authorized capital as described in the plan of recapitalization; 

(5) approve and acknowledge that as a result of QW’s 

recapitalization, the 1,000 shares of QW common stock that 

Quanex held would be converted to 500 shares of class A 

stock and 130 shares of class B stock; 

(6) make a $62,000 capital contribution to QW in anticipation of QW’s recapitalization; 

(7) assign all of its rights, duties, and obligations relating 

to approximately $37,989,000 of selected MPBs to QS; 

112 139 UNITED STATES TAX COURT REPORTS (67) 

31 Rose knew that the loss was not an actual economic loss. 

(8) transfer $38 million and assign its rights, duties, and 

obligations relating to all the selected MPBs in exchange for 

1 share of common stock and the assumption of the duties 

and obligations under the MPBs; 

(9) enter into an assignment and assumption of liabilities 

agreement with QS under which rights related to MPBs 

would be assigned to QS and related duties and obligations 

would be assumed by QS; 

(10) enter into a consulting agreement with CS pursuant 

to which CS would agree to assist Quanex in evaluating and 

implementing cost-saving strategies with respect to health 

care plans for the benefit of certain employees of Quanex for 

an hourly fee, and Quanex would agree to sell to CS an 

equity interest in QHMC, with Quanex having the right to 

purchase from CS the shares representing the equity interest 

after five years and CS having the right to sell those shares 

to Quanex or QHMC after seven years at a price calculated on 

the basis of a formula value but not less than $125 per share; 

(11) sell its 130 shares of class B stock that it would hold 

as a result of the recapitalization of QHMC to CS for a 

$13,000 cash payment; 

(12) enter into a stock purchase agreement between 

Quanex and CS with respect to its proposed sale of the class 

B stock to CS; 

(13) upon its sale of the class B stock to CS, enter into a 

shareholders agreement among QHMC, CS, and Quanex providing for restrictions on the disposition of QHMC stock, and 

agree, as the holder of the class A stock, to provide QHMC

with additional capital to pay for any forecasted cash shortfalls, as determined by QHMC’s board; 

(14) upon issuance of QHMC’s class C stock to QS and CS, 

enter into a first amendment to shareholders agreement to 

reflect additional stock issuances; and 

(15) upon QS’ subsequent sale of the class C stock to 

another investor, enter into an amended and restated shareholders agreement to reflect the additional investor. 

Also at the meeting, Rose explained the tax benefits of the 

transactions to Quanex’s board, informing the board that the 

transactions would generate a large artificial capital loss. 31

On October 22, 1997, Quanex’s board unanimously approved 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 113

32We hereinafter refer to QW as QHMC with respect to events that occurred after the name 

change. 

all of the proposed resolutions. As of that time, Quanex 

intended to sell the class C stock to Wannell. 

B. October 23, 1997 

1. QW Recapitalization 

Before October 17, 1997, QW was a Delaware corporation 

that was an inactive, wholly owned subsidiary of Quanex. 

QW had assets of $1,000 in cash, no liabilities, and 1,000 

outstanding shares of capital stock. On October 17, 1997, 

Quanex wired $62,000 into QW’s account at Comerica Bank 

in anticipation of QW’s recapitalization. 

Six days later, on October 23, 1997, Quanex approved 

QW’s plan of recapitalization, and QW was recapitalized. 

Under that plan of recapitalization, QW was authorized to 

issue 760 shares of capital stock, of which 500 shares were 

class A stock, 130 shares were class B stock, and 130 shares 

were class C stock. All 760 shares had a par value of $100. 

Under the plan of recapitalization, Quanex, as record holder, 

was to receive 0.5 share of class A stock and 0.13 share of 

class B stock for each share of QW common stock that 

Quanex held before the recapitalization. 

Also on October 23, 1997, QW’s board unanimously consented to the plan of recapitalization. QW’s directors were 

Rose, Peery, and Vernon Oechsle. Oechsle was Quanex’s 

president and chief executive officer (CEO) from 1997 through 

February 1999, Quanex’s CEO from March 1999 through February 2001, Quanex’s vice president from March through 

July 2001, and Quanex’s corporate initiatives executive from 

August 2001 through May 2002. 

2. Amendment and Restatement of QW’s Certificate of 

Incorporation 

a. Background 

Also on October 23, 1997, QW was renamed QHMC

(incident to the recapitalization) and its certificate of incorporation was amended and restated (certificate) to provide for 

the three classes of stock. 32 The certificate set forth rights 

114 139 UNITED STATES TAX COURT REPORTS (67) 

on dividends, liquidation preferences, voting, and the right to 

call or put shares. 

b. Dividend Rights 

Under the certificate, QHMC’s board generally could declare 

dividends on class A stock as it deemed appropriate. As one 

exception, a dividend could not be declared or paid on the 

class A stock during any period when QHMC failed to pay a 

dividend on the class B or class C stock for any preceding 

quarter. The class B and class C shareholders were entitled 

to receive from QHMC’s surplus or net profits, when and as 

declared by QHMC’s board, cash dividends of $9.50 per share 

per annum, payable quarterly. The cash dividends for the 

class B stock were cumulative and payable for the current 

year and for all previous fiscal years during which any class 

B stock was outstanding (and applicable quarters thereof). 

The same was true for the class C stock when any class C 

stock was outstanding. If QHMC’s available funds were 

insufficient to pay the dividends on the class B or class C 

stock, then the class B and class C shareholders would share 

ratably in the amount available for payment in proportion to 

the full dividend payment to which they were otherwise entitled. The class B and class C shareholders were not entitled 

to receive any dividends or share of profits, whether payable 

in cash, stock, or property, in excess of these dividends. 

c. Preferences Upon Liquidation 

If Quanex was liquidated, class A shareholders were entitled, after payment of all liabilities, and subject to the liquidation preferences of the class B and class C stocks, to 

receive QHMC’s assets on the basis of the number of shares 

held. The liquidation preferences of class B shareholders 

were as follows: 

In the event of liquidation, dissolution, or winding up [collectively, liquidation] of the Company, whether voluntary or involuntary, the holders of the 

issued and outstanding Class B Voting Preferred Stock shall be entitled to 

receive out of the assets of the Company legally available for distribution 

to stockholders and before any distribution to the holders of the Class A 

Common Stock liquidation distributions in an amount equal to the greater 

of (i) $125 for each share or (ii) the Formula Value * * * for each share, 

plus all accrued but unpaid dividends thereon to the date fixed for redemption. After payment of the full amount of the liquidating distributions to 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 115

33Quanex would bear all medical costs in excess of these benchmark amounts; i.e., the QHMC 

preferred shareholders would never bear these costs. 

which they are entitled, the holders of shares of Class B * * * Stock will 

have no right or claim to any of the remaining assets of the Company. 

Class C shareholders had the same rights as those provided 

to class B shareholders. 

The certificate defined the formula value (formula value) 

as the lesser of: 

(a) 45% of (i) the sum of the savings or deficiency of the Initial 

Undiscounted Medical Plan Benefits (‘‘IUMPB’’ * * *) over the Actual 

Medical Plan Benefits (‘‘AMPB’’ * * *) for each completed fiscal year, commencing with the fiscal year ending October 31, 1998, divided by (ii) the 

total number of outstanding shares of Class B Voting Preferred Stock and 

Class C Voting Preferred Stock on the applicable date of the event of liquidation, dissolution or winding up of the company, or (b) 50% of the net 

equity shown on the books and records of the Company as of the calendar 

month immediately preceding that date (as determined in accordance with 

generally accepted accounting principles). * * * 

The certificate defined ‘‘AMPBs’’ as the actual medical plan 

benefits paid by QHMC to participants in medical benefit 

plans that QHMC managed during the applicable fiscal year 

and ‘‘IUMPBs’’ as the medical plan benefits as computed for 

purposes of the net present value of the expected cashflows 

of QHMC as of October 31, 1997, determined in accordance 

with the cashflow model used by D&T to value QHMC on 

October 31, 1997. 33 The certificate stated that the savings or 

deficiency of the IUMPB over the AMPB would be determined 

for each of QHMC’s fiscal years and computed as follows: 

(A) The difference between (a) an amount (which may be a positive or a 

negative number) equal to (i) the IUMPB divided by the number of the 

assumed covered plan participants, reduced by (ii) the AMPB for the 

applicable fiscal year divided by the number of the actual covered plan 

participants for that year, multiplied by (b) the number of actual covered 

plan participants for that year, and (B) the amount of consulting fees paid 

or accrued by the Company during the applicable fiscal year. * * * 

The certificate also stated that the formula value would be 

zero if the formula value of the total number of shares of the 

class B and class C stock was less than zero, or if the date 

of liquidation occurred before October 31, 1998. The certificate also stated that upon QHMC’s liquidation, the class B 

and class C shareholders would share ratably in any disVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00049 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
116 139 UNITED STATES TAX COURT REPORTS (67) 

tribution of assets in proportion to the full liquidating distributions to which they would otherwise be entitled if 

QHMC’s available assets were insufficient to pay the liquidation distributions on all outstanding shares of class B and 

class C stock. 

d. Voting Rights 

Under the certificate, each share of QHMC stock entitled 

the holder to one vote in all proceedings in which action 

might be taken by the QHMC shareholders. If any share of 

class B or class C stock was issued and outstanding, class A 

shareholders had the right to elect six directors of the company, class B shareholders had the right to elect two directors, who would be designated class B directors, and class C 

shareholders had the right to elect one director, who would 

be designated a class C director. Class A shareholders had 

the right to elect all of QHMC’s directors if no class B or class 

C shares were issued and outstanding. 

e. Call Rights 

The certificate did not provide any redemption rights for 

class A stock. The certificate did provide redemption rights 

for the class B and the class C stocks, and these rights were 

the same for both classes. At any time after September 30, 

2002, QHMC could redeem any or all shares of class B and 

class C stocks by paying cash equal to the greater of (i) $125 

per share or (ii) the formula value per share, plus an amount 

equal to all distributions accrued and unpaid thereon to the 

date fixed for redemption. For this purpose, any reference in 

the formula value to the ‘‘date of liquidation, dissolution or 

winding up of the Company’’ would be replaced with a reference to the ‘‘Notice Date’’. 

f. Put Rights 

The certificate did not provide any put rights for class A 

shareholders. The certificate did provide put rights for the 

class B and class C stocks, and these rights were the same 

for both classes. After September 30, 2004, each holder of 

class B or class C stock could require QHMC to purchase from 

the holder all or any portion of the shares of class B stock 

or class C stock at a cash price equal to the greater of (i) 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 117

34 Babb was Quanex’s compensation and benefits manager from 1997 through July 1999, and 

she was Quanex’s compensation and benefits director from August 1999 through the time of 

trial. 

$125 per share or (ii) the formula value per share, plus an 

amount equal to all distributions accrued and unpaid thereon 

to the put date. For this purpose, any reference in the formula value to the ‘‘date of liquidation, dissolution or winding 

up of the Company’’ would be replaced with a reference to 

the ‘‘Put Date’’. 

3. Quanex’s Transfer of QW Stock and Cash to QHMC in 

Exchange for Class A and Class B Stocks and Election 

of Directors 

On October 23, 1997, Quanex transferred the $62,000 that 

was previously wired into QW’s bank account and 1,000 

shares of QW common stock to QHMC in exchange for 500 

shares of class A stock and 130 shares of class B stock. Also 

on October 23, 1997, Quanex, as QHMC’s sole class A and 

class B shareholder, elected Oechsle, Peery, Rose, Parikh, 

Wannell, and Carolyn Babb 34 as QHMC’s class A directors, 

and Gary Hellner and Bewley as QHMC’s class B directors. 

Also on October 23, 1997, Hellner and Bewley informed 

QHMC they were resigning effective the same day, doing so 

through a one-page document that apparently had been 

typed for each of them simply to sign and to date. The text 

of each document contained a single sentence which stated: 

‘‘The undersigned hereby resigns as a Class B director of 

Quanex Health Management Co., Inc., a Delaware corporation, such resignation to be effective as of the date set forth 

under my signature below.’’ 

4. Quanex’s Transfer of Cash and MPB Obligations to QS 

in Exchange for QS Stock 

QS was incorporated in 1990 as a wholly owned subsidiary 

of Quanex, and QS remained as such until October 23, 1997. 

Before October 23, 1997, QS was an inactive corporation and 

had assets of $1,000 in cash, no liabilities, and 1,000 shares 

of outstanding capital stock. Under QS’ certificate of incorporation, dated August 7, 1990, QS was authorized to issue 

10,000 shares of common stock. 

118 139 UNITED STATES TAX COURT REPORTS (67) 

35 Approximately four years later, on February 20, 2001, QS’ board of directors, consisting 

solely of Oechsle and Terry M. Murphy, ratified the actions that QS’ corporate officers took to 

execute the exchange agreement and to issue the share of QS stock. 

As of October 23, 1997, in exchange for 1 share of QS capital stock, Quanex transferred $38 million to QS and 

assigned to QS certain obligations relating to certain MPBs. 

Under an exchange agreement bearing the same date, 

Quanex and QS agreed to treat the exchange as one 

described in, and qualifying for nonrecognition treatment 

under, section 351. Parikh, as Quanex’s corporate controller 

and as QS’ vice president and treasurer, signed the QuanexQS exchange agreement on behalf of both parties. 35

The transferred MPBs were health care benefits provided 

under the plan, and they represented the future medical 

costs of active Quanex employees working in selected groups 

during the 15-year period beginning November 1, 1997, and 

ending October 31, 2012. An assignment and assumption of 

liabilities agreement executed between Quanex and QS on 

October 23, 1997, and signed by Rose on behalf of both 

Quanex and QS, described the transferred obligations as 

‘‘relating to those MPB’s computed for purposes of the net 

present value of the expected cashflows of Assignee [QS] as 

of October 31, 1997, determined in accordance with the cash 

flow model which was used by Deloitte & Touche LLP to 

value the Assignee [QS] on such date’’. 

C. October 24, 1997 

1. Consulting Agreement Between Quanex and CS 

Quanex and CS entered into a consulting agreement dated 

October 24, 1997 (consulting agreement). Under the consulting agreement, CS agreed to review the costs and benefits of the health care plans that Quanex maintained and 

administered for the benefit of the active salaried employees 

from Quanex’s Corporate, MS–General Office, and MS– 

Michigan locations, and both active salaried and nonunion 

hourly employees from MS–Arkansas, and to recommend, 

among other things, ‘‘several * * * potential cost saving 

strategies (‘Strategies’) for the Plans, the implementation of 

which could result in substantial cost savings to Quanex.’’ 

Quanex and CS also agreed that it would be in their respective best interests to provide CS a means of compensation 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 119

36 CS was still responsible for negotiating Quanex’s HMO contracts as of the time of trial. 

that (1) took into consideration the potential value added by 

CS’ services in the successful implementation of the cost 

saving strategies, (2) gave CS a voice in QHMC’s management, 

and (3) required CS to maintain a financial risk in QHMC. 

Under the consulting agreement, Quanex thus agreed to hire 

CS to assist Quanex 

in evaluating and implementing the Strategies, including, but not limited 

to reviewing, analyzing, and making recommendations regarding the 

Strategies and other relevant cost-savings measures, advising Quanex 

regarding the operational, organizational and governance aspects of the 

Company, serving on the board of directors of the Company, negotiating 

with third-party administrators, assisting in the request for proposal 

(‘‘RFP’’) process with potential outside vendors, claims administration, 

enrollment, benefits coordination, and any other services as requested from 

time to time by Quanex during the term of this Agreement. 

Pursuant to the consulting agreement, CS was entitled to 

consulting fees in accordance with CS’ benefits consulting fee 

schedule, but in no case more than $250 per hour, plus 

reasonable out-of-pocket costs actually incurred. The consulting agreement also entitled CS to buy ‘‘more than a 20% 

limited equity interest’’ in QHMC from Quanex, QHMC’s sole 

shareholder as of the time of the consulting agreement, subject to CS’ entering into a shareholder agreement with 

Quanex. The consulting agreement further stated that in the 

event the put or call rights described in the certificate were 

exercised, the price CS would be paid for the equity interest 

would equal the greater of $125 per share or the formula 

value. 

Although CS executed a consulting agreement with 

Quanex, 36 no such agreement was executed between CS and 

QHMC between 1997 and 2002. Before October 31, 1997, 

Howard did not receive requests from Quanex for advice on 

the QHMC project, see any WW reports for the QHMC proposal, 

or review any assumptions with respect to the proposal. 

2. CS’ Transfer of Cash to Quanex in Exchange for Class 

B Stock 

Before October 23, 1997, Quanex offered CS the opportunity to purchase (1) 130 shares of the class B stock from 

Quanex for $13,000 and (2) 20 shares of the class C stock 

120 139 UNITED STATES TAX COURT REPORTS (67) 

37 Because of Singer’s concerns regarding deconsolidation, Singer structured the QHMC transactions so that Quanex’s interest in QHMC and Quanex’s voting power with respect to QHMC 

would be less than 80%. Accordingly, on October 24, 1997, the date CS purchased the class B 

stock from Quanex, QHMC ceased to be a member of petitioners’ affiliated group for Federal 

income tax purposes. 

from QHMC for $2,000. Chapman did not consider the $15,000 

cost for the QHMC stock ($13,000 for class B stock plus $2,000 

for class C stock) to be a material amount of money for CS. 

On October 24, 1997, CS purchased 130 shares of class B 

stock from Quanex for $13,000, 37 and Quanex and CS signed 

a stock purchase agreement of the same date. That agreement described the class B stock the same way the class B 

rights were described in the certificate and included a copy 

of the certificate as an attachment thereto. 

Quanex, QHMC, and CS also entered into a shareholders’ 

agreement dated October 24, 1997 (October 24 shareholders’ agreement). Parikh executed the October 24 shareholders’ agreement as Quanex’s controller and as QHMC’s vice 

president and treasurer. John Micale, who as of the time of 

trial had been a CS employee for approximately five years, 

signed the agreement as CS’ president and COO. 

Under the October 24 shareholders’ agreement, Quanex 

and CS agreed that they would not transfer their QHMC stock 

or permit it to be transferred without the express written 

consent of all QHMC shareholders. Quanex also agreed that, 

as the holder of QHMC’s class A stock, it was subject to 

assessment for capital calls as determined by QHMC’s board, 

and it acknowledged that ‘‘The Board shall assess the holders 

of shares of Class A Common Stock in the event that the 

Board determines that * * * [QHMC] will have a Forecasted 

Cash Shortfall for any calendar quarter.’’ The October 24 

shareholders’ agreement defined a ‘‘Forecasted Cash Shortfall’’ as ‘‘the excess, if any, of forecasted cash expenditures 

(including a reasonable reserve for future expenditures and 

dividends on the Class B Voting Preferred Stock and Class 

C Voting Preferred Stock, as determined by the Board) over 

forecasted cash receipts, determined with respect to any calendar quarter.’’ No such provision was made with respect to 

class B or class C shareholders. 

The October 24, 1997, QHMC stock purchase was the first 

time CS acquired an equity interest in a client. Chapman 

believed that CS’ participation in the QHMC transactions 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 121

would both continue and expand CS’ consulting relationship 

with Quanex and give CS the potential to earn fee-based revenue. 

3. Class B Directors 

On October 24, 1997, CS (through Micale) elected 

Chapman and Micale as QHMC’s class B directors. 

D. October 25, 1997 

1. CS’ Transfer of Cash to QHMC in Exchange for Class C 

Stock 

As of October 25, 1997 (a Saturday), CS contributed $2,000 

to QHMC in exchange for 20 shares of class C stock. CS was 

not involved in setting the price of the class C stock (or the 

class B stock). Although CS purchased both class B and class 

C stocks, it made no difference to CS which class of preferred 

stock it acquired. 

2. QS’ Transfer of Cash and MPBs to QHMC in Exchange 

for Class C Stock 

Also as of October 25, 1997, QS contributed $38 million to 

QHMC, and by an assignment and assumption of liabilities 

agreement dated October 25, 1997 (QS–QHMC assignment 

and assumption agreement), QS assigned to QHMC the MPBs 

Quanex had assigned to QS by agreement dated October 23, 

1997. Parikh, as vice president and treasurer of each entity, 

signed the QS–QHMC assignment and assumption agreement 

on behalf of both QS and QHMC. An October 25, 1997, 

exchange agreement executed between QHMC and QS 

described the transferred MPBs as ‘‘certain medical plan 

benefits (MPB’s), being those MPB’s computed for purposes of 

the net present value of the expected cash flows of * * * 

[QHMC] as of October 31, 1997, determined in accordance 

with the cash flow model * * * which was used by [D&T] 

* * * to value [QHMC] on such date.’’ Quanex had not 

deducted the medical costs represented by the MPBs transferred to QHMC. If Quanex had retained the MPBs, the MPBs 

would have been an expense of Quanex’s trade or business; 

and if Quanex had paid the MPBs as they were incurred, 

122 139 UNITED STATES TAX COURT REPORTS (67) 

Quanex could have deducted the payments as ordinary and 

necessary business expenses. 

In return for the cash and MPBs assumption, QS received 

from QHMC 110 shares of class C stock. Upon becoming a 

QHMC shareholder, QS signed a first amendment to shareholders’ agreement (amended shareholders’ agreement), 

dated October 25, 1997, through which QS agreed to become 

a party to the October 24 shareholders’ agreement. QHMC and 

QS also agreed to treat this exchange as one qualifying for 

nonrecognition treatment under section 351. The amended 

shareholders agreement was signed by Rose on behalf of QS, 

Quanex, and QHMC, as vice president of each entity, and by 

Micale as the president and COO of CS. 

3. MPB Selection 

The selected employee groups covered by the MPBs that 

QHMC transferred were the following active Quanex 

employees located at petitioners’ facilities: 

Location Group

No. of 

employees1

Houston Corporate 37

Arkansas MS–Salaried 117

Arkansas MS–Nonunion hourly 249

Michigan MS–General Office 31

Michigan MS–Salaried 112

Total 546

1This column lists the number of active employees working 

in the identified groups as of October 1997. The actual number of employees covered by the MPBs could fluctuate during 

the 15-year period that QHMC assumed the obligation to pay 

the MPBs. 

The identified employee groups were considered a part of 

Quanex’s core businesses and were nonunion when they were 

selected (although not all of Quanex’s nonunion employees 

were selected). The health benefits of Quanex’s union 

employees were subject to union contracts. Quanex could not 

unilaterally change the terms of the union contracts, which 

usually spanned 3 to 4 years, and Quanex’s primary opportunity to reduce health care costs subject to those contracts 

was upon their renewal. Quanex was not so restrained 

regarding nonunion employees. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 123

38 Rose testified that he chose the transferred liabilities and that, rather than making a decision about the amount of the liability Quanex was willing to transfer, he first decided which 

liabilities would be transferred to QHMC and then had WW assign a value to those liabilities. 

We do not find Rose’s testimony on this point credible, and we decline to rely upon it. 

39 Although Quanex contributed the $38 million to QS, which in turn contributed the $38 million to QHMC, Quanex wanted the use of that money and understood at the time of the contributions that the $38 million would be lent back to Quanex or to its affiliates. 

Both Royce and Rose were involved in the MPB selection 

process, 38 and Royce determined which groups’ MPBs would 

be included in QHMC on the basis of WW’s June 30, 1997, 

present value calculation. Peery, Quanex’s vice president of 

human resources, made no recommendation about which 

groups of employees should have their MPBs transferred to 

QHMC. Peery also made no specific recommendation 

regarding which types of health care benefits should be 

included in the QHMC transactions. Parikh also was not 

involved in selecting which employee groups would have 

their MPBs transferred to QHMC. The only Quanex employees 

who were notified that Quanex had assigned the designated 

health care benefit obligations to QHMC were the Quanex 

employees who worked on the QHMC transactions and the 

accounting therefor. 

Wannell, who was invited to participate in the QHMC transactions allegedly because of his experience managing 

LaSalle’s health care costs, also played no part in deciding 

which MPBs would be transferred to QHMC. No one asked 

Wannell for any recommendation specific to the MPB obligations either before or after he agreed to invest in QHMC. 

4. Class C Director 

On October 25, 1997, QHMC’s class C shareholders elected 

Davis to be the class C director. 

E. October 28, 1997: QHMC’s Transfer of Cash to Piper in 

Exchange for Promissory Note 

On October 28, 1997, QHMC transferred the $38 million it 

received from QS to Piper, and Piper issued to QHMC a 

promissory note (Piper note) in return. 39 Piper promised in 

the Piper note to pay QHMC ‘‘the principal sum of ThirtyEight million dollars ($38,000,000) together with interest on 

the unpaid principal balance from time to time remaining 

outstanding at an interest rate of seven and one-half percent 

(7 1⁄2%).’’ The Piper note provided that interest was due and 

124 139 UNITED STATES TAX COURT REPORTS (67) 

payable quarterly as it accrued and that the outstanding 

unpaid principal balance was due and payable in full on 

October 31, 2012, but let Piper prepay all or part of the note 

at any time without penalty. Rose signed the Piper note as 

Piper’s vice president. 

Also on October 28, 1997, QHMC’s board unanimously 

approved the loan to Piper pursuant to the terms and conditions of the Piper note. That loan was the first loan that 

QHMC ever made, and the interest on the loan was QHMC’s 

only source of income. Piper’s board of directors also 

approved the $38 million loan from QHMC. As of that date, 

Piper’s directors were Oechsle, Peery, and Rose. 

Singer understood that Quanex wanted to use the $38 million that was put into QHMC, but the $38 million was transferred to Piper because Piper had a more immediate need for 

the cash than Quanex. Piper used the funds primarily for 

plant expansion, equipment purchases, and short-term debt 

reduction; Piper spent approximately $32.5 million in plant 

construction during TYE 1998. 

F. October 30, 1997: QS’ Transfer of Class C Stock to 

Wannell in Exchange for Cash 

On October 30, 1997, QS sold 110 shares of class C stock 

to Wannell for $11,000. Wannell did not negotiate the price 

of this stock, which according to a stock purchase agreement 

executed between QS and Wannell on October 30, 1997, 

retained the rights and attributes described in the certificate. 

Wannell, QHMC, Quanex, and CS executed an amended and 

restated shareholders’ agreement dated October 30, 1997, to 

reflect the substitution of Wannell for QS as a QHMC shareholder/investor. 

When Wannell purchased the QHMC stock, he understood 

that as a QHMC director he was expected to attend some 

QHMC board meetings and to contribute to the business 

between board meetings as appropriate. He also understood 

QHMC to be responsible for everything related to the costs of 

the employee medical expenses in the venture, including 

paying, managing, and reducing them, but he had only a 

vague idea of how QHMC would pay those costs. Wannell had 

no knowledge of QHMC’s assets, liabilities, or overall worth, 

and he did not know why put and call provisions were in his 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 125

40Wannell testified that it was not certain when he purchased his stock in 1997 that he would 

exercise his redemption rights at the first opportunity. We do not find this testimony to be credible, and we decline to rely upon it. 

stock arrangement. He also did not know why he had purchased the stock from QS, rather than directly from QHMC, 

and why he was offered preferred stock rather than common 

stock. The only choice Quanex gave Wannell in relation to 

his QHMC investment was whether to invest. 40

XII. Posttransaction Activities 

A. D&T’s Draft Opinion 

On April 13, 1998, Singer delivered a 59-page unsigned 

draft opinion letter (draft opinion) to Quanex that provided 

D&T’s opinion on certain Federal income tax consequences of 

the QHMC transactions. The draft opinion was prepared 

under Singer’s supervision, and Singer told Quanex the draft 

was subject to final review although he believed it to be correct. Singer included with the draft a cover letter that similarly stated that he hoped the draft was ‘‘the final draft of 

the opinion letter’’ but reaffirmed he was ‘‘awaiting final 

review approval from our Washington National Tax partner.’’ 

The draft opinion was stamped ‘‘DRAFT’’ in large bold letters 

at the top of each of its 59 pages and was never finalized or 

signed by D&T. 

In the draft opinion, D&T reached the following conclusions: 

A. Deconsolidation. The sale of the Class B Voting Preferred Stock to 

Consultant [CS] should cause QHMC to break affiliation with Parent on 

the date of sale under section 1504. 

B. Tax Basis of Transferor’s QHMC Stock. 

1. Parent’s [Quanex’s] transfer of cash and the assignment of certain 

MPB’s to Transferor [QS] constitutes an exchange governed by section 351. 

Transferor’s transfer of cash to QHMC in exchange for QHMC Class C 

Voting Preferred Stock plus the assumption by QHMC of the MPB’s also 

constitutes an exchange governed by section 351. Accordingly, no gain or 

loss should be recognized by either Parent or Transferor on the transfers. 

Section 351(a). 

2. Transferor should have a basis for tax purposes in its QHMC Class C 

Voting Preferred Stock equal to the cash transferred to QHMC. Section 

358(a). Accordingly, the MPB’s, which will be assumed by QHMC, should 

not be taken into account in determining Transferor’s basis in the QHMC 

shares received in the section 351 exchange. Section 357(c)(3). 

126 139 UNITED STATES TAX COURT REPORTS (67) 

C. Deductibility of Medical Payments to QHMC. The MPB’s assumed by 

QHMC in the section 351 exchanges described above more likely than not 

will be deductible by QHMC as medical expenses under section 162(a) or 

as capital expenditures under section 263, as appropriate, when they 

would otherwise be deductible under QHMC’s method of accounting. No 

income should be recognized by Parent (or any member of Parent’s affiliated group) as a result of the payment by QHMC of the MPB’s. 

D. Transferor’s Loss on Sale of Shares. To the extent Transferor realized 

a loss in connection with the taxable sale of its shares of QHMC Class C 

Voting Preferred Stock to Investor, any such loss should be recognized in 

the year of sale. 

D&T cited various Code sections, revenue rulings, and cases 

to support its conclusions in the draft. The draft opinion also 

includes the following section: 

c. Application of section 351(g), added by TRA of 1997. The Taxpayer 

Relief Act of 1997 added new section 351(g) which provides that certain 

preferred stock which is callable or puttable is not to be treated as stock 

for purposes of section 351(a).48 The term ‘‘preferred stock’’ for purposes 

of section 351(g) does not include stock which participates in corporate 

growth to any significant extent.49 As discussed above, the Class C Voting 

Preferred Stock has a liquidation value which is equal to the Formula 

Value. The Formula Value is equal to forty-five (45%) [sic] of the increase 

in the equity value of QHMC. Although there is no guidance in the statute 

or legislative history regarding the extent to which the stock must participate in corporate growth to be considered ‘‘significant’’, we believe the 

Class C stock should not be treated as ‘‘preferred stock’’ for purposes of 

section 351(g). It is difficult to argue that 45% is not significant. 

48Section 351(g)(2). 49Section 351(g)(3)(A). 

Rose was unaware of a letter of representations that was 

prepared and provided to D&T, and the record does not 

establish how D&T obtained the background information it 

relied on in the draft opinion. In addition, Royce knew that 

the draft opinion was a draft. Yet Royce never asked anyone 

at D&T to provide petitioners with a final tax opinion, and 

petitioners never received a final tax opinion from D&T. 

Quanex’s tax department did not prepare a tax opinion or a 

memorandum discussing the tax consequences of the QHMC

transactions. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 127

B. 1997 Return 

1. Background 

Petitioners filed their 1997 return on July 14, 1998. Royce 

decided what to put into the 1997 return regarding the QHMC

transactions, and he, upon consultation with Singer, caused 

Quanex personnel to draft the return in accordance with the 

draft opinion. Royce reviewed Quanex’s work and had Singer 

cause one of his managers to review the 1997 return. Royce 

also caused Singer to review the manager’s comments and 

then to look at the return himself. Singer signed the 1997 

return on behalf of D&T as the paid preparer. 

Parikh signed the return as Quanex’s controller, but he did 

not prepare the return or make decisions on how specific 

transactions would be reported on the return. Parikh also did 

not review the return line by line before signing it. Parikh 

asked Royce if D&T thoroughly reviewed the return and 

agreed upon how it was prepared, but Parikh did not speak 

with anyone at D&T about how the QHMC transactions were 

recorded on the return. 

Before signing the return, Parikh knew that an approximately $38 million capital loss was reported on the return. 

Parikh saw Singer’s signature on the return, and he was 

aware of D&T’s draft opinion. Parikh did not read the draft 

opinion before signing the return. 

2. Income 

On their 1997 return petitioners reported a $37,989,000 

short-term capital loss from QS’ sale of the 110 shares of 

class C stock to Wannell and a gain or loss of zero from 

Quanex’s sale of the 130 shares of class B stock to CS. Petitioners reported specifics of those sales as follows: 

Stock

Date 

acquired 

Date 

sold Basis 

Sale 

price 

Class C 10/25/97 10/30/97 $38,000,000 $11,000

Class B 10/23/97 10/24/97 13,000 13,000

Petitioners also reported on the 1997 return that they 

realized a $26,966,201 net capital gain and a $21,374,634 net 

ordinary gain from the sale of the LaSalle stock and other 

128 139 UNITED STATES TAX COURT REPORTS (67) 

41 As discussed above, petitioners reported a $28,697,957 capital gain and $20,721,360 of ordinary gain from their sale of LaSalle. 

42 As discussed above, petitioners reported on their 1998 return a $12,458,171 capital gain and 

$8,090,766 of ordinary gain from the Tube Group sale. 

43Petitioners reported elsewhere in their 1997 return that QW acquired 500 shares of class 

A stock, acquired and disposed of 130 shares of class B stock, and disposed of 1,000 shares of 

business property. 41 Petitioners offset the net capital gain by 

$26,966,201 of the reported capital loss and carried the 

remainder of the reported loss, $11,022,799 ($37,989,000 – 

$26,966,201), to TYE 1998. Petitioners applied the 

$11,022,799 to TYE 1998 to offset almost all of their 

$12,090,938 net long-term capital gain primarily from the 

Tube Group sale. 42

For financial statement purposes, in or about September 

1998 Quanex established a $9,621,000 reserve for taxes due 

in the future regarding the capital loss claimed on the sale 

to Wannell. Subsequently, after claiming the $11,022,799 

capital loss carryover to TYE 1998, Quanex increased that 

reserve to $13,479,000. 

3. Enclosed Statements 

a. Overview 

Petitioners’ 1997 return includes various ‘‘Statements’’ 

related to the QHMC transactions. These statements include 

Statement 20, Statement Pursuant to IRC Regulation Section 

1.368–3(a); Statement 22, Statement Regarding Tax Free 

Contribution to Capital Pursuant to Regulation Section 

1.351–3(a); Statement 23, Statement Regarding Tax Free 

Contribution to Capital Pursuant to Regulation Section 

1.351–3(a)&(b); and Statement 24, Statement Regarding Tax 

Free Contribution to Capital Pursuant to Regulation Section 

1.351–3(a). Petitioners did not notify any Government agency 

other than the IRS of the transactions involving the MPBs. 

b. Statement 20 

Statement 20 reported the October 23, 1997, amendment 

and restatement of QW’s certificate pursuant to its plan of 

reorganization to provide for class A, class B, and class C 

stocks in a tax-free reorganization under section 368(a)(1)(E). 

This statement also reported QW’s name change to ‘‘Quanex 

Health Management Company, Inc.’’ in a tax-free reorganization under section 368(a)(1)(F). 43

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 129

common stock. That reporting listed the name of QW as ‘‘QUANEX WIRE, INC (QUANEX 

HEALTH MAN)’’. 44The ‘‘amount’’ and ‘‘hours billed’’ columns show the hours and fees on D&T invoices dated 

July 21, 1997, through January 5, 1998, that were labeled ‘‘Consultations regarding the management of medical liabilities’’. Although D&T employed both health care consultants and tax consultants, no one from D&T’s health care consulting group appeared on the invoices. 

c. Statement 22 

Statement 22 reported Quanex’s October 23, 1997, 

exchange of $62,000 and 1,000 shares of QHMC common stock 

for 500 shares of class A stock and 130 shares of class B 

stock as a tax-free contribution by Quanex to QHMC. 

d. Statement 23 

Statement 23 reported Quanex’s October 23, 1997, contribution to QS of $38 million in exchange for 1 share of QS 

common stock and QS’ assumption of $37,989,000 of MPBs as 

a tax-free contribution. 

e. Statement 24 

Statement 24 reported QS’ October 25, 1997, contribution 

to QHMC of $38 million in exchange for 110 shares of class 

C stock and QHMC’s assumption of the $37,989,000 of MPBs 

as a tax-free contribution. 

4. Deduction of Fees 

On their 1997 return, petitioners deducted fees of 

$320,692, $29,114, and $2,445 that Quanex paid to D&T, Fulbright, and WW, respectively. The fees Quanex paid to Fulbright and to WW were for services provided to effect the 

QHMC transactions. The fees Quanex paid D&T were for services D&T performed, as memorialized in invoices listing the 

following relevant data: 44

Date 

of invoice 

Billing 

period ending Amount 

Hours 

billed 

7/21/97 6/28/97 $12,775 35

8/20/97 7/26/97 21,055 53

9/2/97 8/9/97 41,566 99

9/17/97 8/23/97 1 65,801 205

10/13/97 9/20/97 65,140 176

10/28/97 10/18/97 46,950 102

130 139 UNITED STATES TAX COURT REPORTS (67) 

Date 

of invoice 

Billing 

period ending Amount 

Hours 

billed 

12/4/97 11/15/97 50,880 2 130

1/5/98 12/13/97 16,525 39

Total 320,692 839

1While the parties stipulated that this amount is 

$65,801, the record indicates that the amount should be 

$65,800. The discrepancy does not affect our resolution of 

the issues in this case. 2While the parties stipulated this amount, the record indicates that this amount should be 131.5. The discrepancy 

does not affect our resolution of the issues in this case. 

D&T’s work on the transactions that resulted in petitioners’ 

reporting the $37,989,000 loss was included within the scope 

of D&T’s engagement letter. 

C. WW’s 1999 Valuations 

Although petitioners reported a $37,989,000 capital loss on 

their 1997 return as a result of the MPB transfers and related 

stock sales and relied on that amount in their workpapers, 

Quanex continued to request new MPB valuations from WW 

and D&T through 1999. By email dated January 17, 1999, 

Ringuette sent Royce a calculation of the present value of 

active health care benefits as of November 1, 1998, for the 

groups of employees who had their MPBs transferred to 

QHMC. That email also provided tables for the ‘‘Projected 

Cashflow of Active Health Care Benefits as of 11/1/98’’ and 

the ‘‘Development of Average Health Care Cost Per Active 

Employee’’. The January 1999 calculation is the earliest valuation document in the record to include only the employee 

groups whose MPBs were transferred to QHMC. All previous 

valuation documents (i.e., the WW June 30, 1997, PV Calculations; the WW October 13, 1997, PV Calculations; and 

the D&T Oct. 21, 1997, cashflow model) used information 

from either different or additional employee groups. The relevant data from those previous documents is as follows: 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 131

45We note that the average attained age is actually 43.2. The discrepancy does not affect our 

analysis. 

Employee groups 

incl. in the calc. 

and No. of 

employees 

WW June 30, 

1997, PV 

calculations 

WW Oct. 13, 

1997, PV 

calculations 

D&T Oct. 21, 

1997, 

cashflow 

model 

Groups transferred: 

Corporate 35 35 35 

MS–General Office 30 30 120 

MS–Arkansas 

hourly 252 - - - - - - 

MS–Arkansas 120 120 27 

MS–Arkansas - - - - - - 112 

MS–Michigan 112 112 - - - 

Groups not transferred: 

Heat Treating 27 27 - - - 

Nitro Steel - - - 13 30 

GST 55 - - - - - - 

GST hourly 248 - - - - - - 

MST 66 - - - - - - 

MST hourly 222 - - - - - - 

Tube Group office 51 - - - - - - 

MS–Michigan 

hourly 165 - - - - - - 

Total 1,383 337 324 

WW relied on the following assumptions to perform its 

January 1999 calculations on the ‘‘Present Value of Active 

Health Care Benefits as of 11/1/98’’: 

Aging .................................................................... 2% 

Initial trend rate .................................................. 8% 

Ultimate trend rate (2003) ................................. 4.75% 

Average cost per employee (1998/1999) ............. $6,437 

Interest rate ......................................................... 6.75% 

‘‘Target Present Value’’ ....................................... $37,989,000 

Those calculations were as follows: 45

Location

Number of 

employees 

today 

Average 

attained 

age 

Estimated 

through 

2008/2009 

Present value 

through 

2009/2010 

Corporate 37 46 $2,771,431 $3,000,623

MS–Arkansas salaried 117 42 8,096,317 8,765,867

MS–Arkansas nonunion hourly 249 36 15,300,295 16,565,601

MS–General Office 31 47 2,368,451 2,564,317

MS–Michigan salaried 112 45 8,224,701 8,904,868

Total 546 40 36,761,195 39,801,276

132 139 UNITED STATES TAX COURT REPORTS (67) 

46We note that the average attained age is actually 43.2. The discrepancy does not affect our 

analysis. 

47 Rose chose the length of the period. 

Quanex requested present value calculations for selected 

groups of employees from the Corporate, MS–Michigan salaried, MS–Arkansas salaried, MS–Arkansas nonunion hourly, 

and MS–General Office groups from WW in addition to those 

provided in the January 17, 1999, email. Sometime after 

January 17, 1999, in approximately early 1999, Quanex 

received the additional calculations in an undated letter 

signed by Ringuette (undated calculations). Ringuette either 

prepared or supervised the preparation of the undated calculations. 

Royce asked Ringuette to determine how many years of 

cashflows would result in a present value of $37,989,000 for 

the MPBs. The resultant calculations were as follows: 46

Present Value of Active Health Care Benefits as of 11/1/97 

Location

Number of 

employees 

today 

Average 

attained 

age 

Estimated 

through 

2010/2011 

Present value 

through 

2011/2012 

Corporate 37 46 $2,775,851 $2,952,832

MS–Arkansas salaried 117 42 8,109,224 8,626,248

MS–Arkansas nonunion hourly 249 36 15,324,695 16,301,759

MS–General Office 31 47 2,372,226 2,523,473

MS–Michigan salaried 112 45 8,237,814 8,763,036

Total 546 40 36,819,810 39,167,348

The undated calculations relied on factors and assumptions 

different from those used in the WW calculations of October 

13, 1997, and January 17, 1999. For example, in contrast to 

the October 13 valuation, WW based the undated calculations on the assumption that the number and average age of 

employees in each group would remain constant over time. In 

the undated calculations, WW also projected the value over 

an approximately 15-year period rather than the approximately 12-year period used in the January 17 valuation and 

the lifetime calculation in the October 13 valuation. 47 Both 

of these changes affected how WW measured the present 

value of the health benefits. 

WW also used the following assumptions for the undated 

calculations: 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 133

Aging .................................................................... 2% 

Initial trend rate .................................................. 7% 

Ultimate trend rate (2003/2004) ........................ 5% 

Average cost per employee (1997/1998) ............. $5,238 

Interest rate ......................................................... 6.75% 

‘‘Target Present Value’’ ....................................... $37,989,000 

Ringuette believed the assumptions were within a reasonable 

range, but they differed from those used in the valuations of 

October 13, 1997, and January 17, 1999. The assumptions 

WW used for its June 30, 1997, October 13, 1997, January 

17, 1999, and undated 1999 present value calculations compare as follows: 

Assumption used

6/30/97 

valuation 

10/13/97 

valuation 

1/17/99 

valuation 

Undated 

1999 

valuation 

Aging 2% 2% 2% 2% 

Initial trend rate 9.29% 8.75% 8% 7% 

Ultimate trend rate 5.5% 5.5% 4.75% 5% 

(2004) (2004) (2003) (2003/2004) 

Interest rate 7.5% 7.5% 6.75% 6.75% 

Avg. cost per employee $3,500 $5,877 $6,437 $5,238 

(1997) (1998) (1998/1999) (1997/1998) 

Quanex’s 1997 Form 10–K stated with respect to FASB 106 

information and assumptions that ‘‘The assumed healthcare 

cost trend rate was 8.8% in 1997, decreasing uniformly to 

5.5% in the year 2003 and remaining level thereafter. The 

assumed discount rate used to measure the accumulated 

postretirement benefit obligation was 7.5% at October 31, 

1997 and October 31, 1996,’’ Quanex’s Form 10–K for TYE

1998 stated that ‘‘The assumed healthcare cost trend rate 

was 8% in 1998, decreasing uniformly to 4.75% in the year 

2003 and remaining level thereafter. The assumed discount 

rate used to measure the accumulated postretirement benefit 

obligation was 6.75% and 7.5% at October 31, 1998 and 1997, 

respectively.’’ WW chose the 8% health care cost trend rate 

assumption for 1998, and the rate related back to November 

1, 1997. Quanex was not obligated to use the 8% assumption. 

Royce was dissatisfied with the initial and ultimate trend 

inflation rates and the aging assumptions WW used in the 

October 13, 1997, valuation. Consequently, Royce instructed 

WW to change the initial trend rate to 7%. Royce also 

wanted WW to raise the ultimate trend assumption. Royce 

wanted a 5% rate rather than the 4.75% rate WW used in 

134 139 UNITED STATES TAX COURT REPORTS (67) 

48 At trial, Ringuette did not remember Quanex’s expressing any dissatisfaction with the 

methodology that he used in performing the present value calculations or with the product contained in the calculations. 

its January 17, 1999, calculation. Royce also wanted WW to 

change the interest rate from the 7.5% WW used in the 

October 13 calculation to 6.75%. WW agreed to make the 

changes. When asked at trial ‘‘why was it necessary for you 

to see if it [the target present value] was within the range 

[of values WW determined for the selected employees 

MPBs]?’’, Royce testified: ‘‘Because the transaction had 

already been done, the cash to fund the expected MPBs of $38 

million had been transferred. We were trying to transfer the 

substantial assets equal to the cash contributed.’’ 

Royce also instructed WW to include employees in the 

undated calculations that were different from the October 13 

valuation, but the same as those used in the January 17 calculations. Changing the number of employees helped WW 

target $38 million. The October 13 valuation did not contain 

a target present value assumption. The January 17, 1999, 

calculation and the undated calculations used a $37,989,000 

target value. 

Although numerous changes were made between the 

October 13, 1997, January 17, 1999, and undated calculations, in each instance WW arrived at approximately the 

same present value for the MPBs of the employee groups 

considered. 48 The present value totals were as follows: 

Calculation 

Present 

value of 

MPBs 

10/13/97 ................................................................... $37,839,705 

1/17/99 ..................................................................... 36,761,195 

1/17/99 ..................................................................... 39,801,276 

Undated .................................................................. 36,819,810 

Undated .................................................................. 39,167,348 

D. D&T’s 1999 Cashflow Model 

The undated calculations represented WW’s final report on 

the present value of the MPBs, and Royce did not ask WW to 

prepare any additional revisions or reports on the matter. 

Royce did ask D&T to prepare calculations on the basis of the 

undated WW calculations. By letter dated March 25, 1999, 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 135

D&T provided the revised calculations to Royce (March 25 

analysis). The letter, which was signed by David Roth of 

D&T, stated that upon Royce’s request D&T ‘‘modified and 

refined the calculations previously made in October 1997 

relating to the valuation of * * * [QHMC] for the purpose of 

closing the transaction’’ and that D&T understood that QHMC

would use the analysis, along with other information, ‘‘in 

establishing cash flows to various classes of its capital stock.’’ 

D&T also stated in the letter that it had not independently 

assessed discount rates, cashflows, or other terms relating to 

the Piper note. D&T provided Quanex with the following 

table, which calculated the present values of the cashflows of 

the MPBs transferred to QHMC: 

Location 

Grand total 

of PV Cashflow 

No. of 

employees 

today 

Corporate $2,947,000 $151,000 37 

MS–Arkansas salaried 8,610,000 429,000 117 

MS–Arkansas nonunion hourly 16,271,000 1,064,000 249 

MS–General Office 2,819,000 100,000 31 

MS–Michigan salaried 8,747,000 517,000 112 

Total 39,394,000 1 2,262,000 546 

1 Although the cashflows totaled $2,261,000, the table indicated 

the total was $2,262,000. 

The March 25 analysis also stated that the ‘‘total payments 

to Quanex * * * under QHMC’s note receivable’’ would equal 

$5.5 million at the conclusion of each of the first 2 years, $4 

million at the conclusion of years 3 and 4, $3 million at the 

conclusion of years 5 through 7, $5 million at the conclusion 

of years 8 through 14, and $310,000 at the conclusion of year 

15, and that the payment schedule indicated a total value of 

equity for all classes of QHMC stock of $76,000. D&T calculated its present values of cashflows on the basis of the 

cashflow analysis, and D&T calculated the equity value as 

follows: 

Total PV of cashflows ................................................ $594,000

Plus cash on hand ..................................................... 65,000

136 139 UNITED STATES TAX COURT REPORTS (67) 

49We note some computational errors in the projections. These errors are not material to our 

analysis. 

50 At trial Royce admitted that if none of the principal on the note was paid off in years 1 

through 15, the maximum interest income to QHMC would be the $2,850,000 reflected in the 

first year of the schedule. In no year were the projected medical expenses less than $2,850,000. 

Less uncertainty of future medical costs adjustment ........................................................................ (583,000) 

Equals total value of equity ...................................... 76,000

Royce used the note payment schedule to anticipate the principal payments on the note throughout 15 years. 

In addition to the present value cashflow calculations for 

the employee groups and the equity determination, D&T’s 

March 25 analysis contained several other projections and 

calculations, including the following discounted cashflow 

analysis (in thousands): 49

Year 

Int. inc. 

from 

note 

Principal 

from 

note 

Medical 

costs 

Cashflow 

avail. 

to equity 

holders 

Cum. 

cashflow 

Cashflow 

from 

operating/ 

invest. 

activities 

NOL 

buildup 

1998 $2,850 $2,650 ($2,870) $2,630 $2,630 ($20) ($20)

1999 2,651 2,849 (3,071) 2,429 5,059 (420) (420)

2000 2,438 1,562 (3,274) 726 5,785 (836) (1,256)

2001 2,320 1,680 (3,479) 521 6,306 (1,159) (2,415)

2002 2,194 806 (3,685) (685) 5,621 (1,491) (3,905)

2003 2,134 866 (3,892) (892) 4,729 (1,758) (5,663)

2004 2,069 931 (4,097) (1,097) 3,632 (2,028) -0-

2005 1,999 3,001 (4,302) 698 4,331 (2,302) -0-

2006 1,774 3,226 (4,517) 483 4,814 (2,742) -0-

2007 1,532 3,468 (4,742) 258 5,072 (3,210) -0-

2008 1,272 3,728 (4,980) 20 5,092 (3,707) -0-

2009 993 4,007 (5,229) (229) 4,864 (4,238) -0-

2010 892 4,308 (5,490) (490) 4,374 (4,798) -0-

2011 369 4,631 (5,764) (764) 3,609 (5,395) -0-

2012 22 258 (6,053) (5,743) (2,133) (6,031) -0-

Total 25,310 38,000 (65,443) (2,133) No D&T 

total 

(40,133) No D&T 

total

D&T thus projected for every year that QHMC’s medical costs 

would exceed its interest income from the Piper note and 

that QHMC’s equity holders would have negative cashflow for 

7 of the 15 years of the investment. 50 D&T also projected 

that QHMC would build up NOLs over the first six years, but 

D&T did not project the NOLs for the remaining nine years. 

D&T provided specific NOL projections as follows (in thousands): 

1998 1999 2000 2001 2002 2003 2004 

NOL generated -0- $420 $838 $1,159 $1,491 $1,758 $2,028

NOL carryforward -0- 420 1,258 2,415 3,905 5,663 7,691

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 137

1998 1999 2000 2001 2002 2003 2004 

PV of annual NOL 

tax benefit -0- 149 281 367 446 496 539

Cumulative PV of 

NOL benefits 

at the end of 

year 7 12,278

1D&T assumed a risk-free rate of 6% and a tax rate of 40% for the NOL analysis. 

Royce understood the concept of NOLs, and he admitted that 

on the basis of the information on projected medical expenses 

provided in the March 25 analysis, which he accepted, QHMC

would have an NOL every relevant year. Royce also admitted 

that as Quanex’s in-house tax adviser he would have been 

aware of existing NOLs and would have considered how to use 

them. 

In its March 25 analysis, D&T also made projections with 

respect to the formula value. D&T projected that there would 

be 546 actual and projected covered plan participants each 

year and calculated the following (in thousands): 

138 139 UNITED STATES TAX COURT REPORTS (67) 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Initial undiscounted MPBs $2,870 $3,071 $3,274 $3,478 $3,685 $3,892 $4,097 $4,302 $4,517 $4,742 $4,980 $5,229 $5,490 $5,764 $6,053 Actual MPBs 2,583 2,764 2,946 3,131 3,317 3,503 3,687 3,871 4,065 4,268 4,482 4,706 4,941 5,168 5,447 Yearly savings 287 307 327 348 369 388 410 430 452 474 498 523 549 576 605 Aggregate yearly cum. savings 287 594 922 1,269 1,638 2,027 2,437 2,867 3,319 3,793 4,291 4,814 5,363 5,939 6,544 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 139

On the basis of these numbers, D&T determined that if the 

call option was exercised in year 5, the class B and class C 

shares would have a $360,327 liquidation value and a 

$352,452 net return, and if the put option were exercised in 

year 7 (with the call option still outstanding), the liquidation 

value of the class B and class C shares would equal $567,719 

with a net return of $562,694. D&T calculated these liquidation and net return values as follows: 

Preferred stock called in 5 years Preferred stock called in 7 years 

Cum. savings at end of yr. 5 $1,637,928 Cum. savings at end of yr. 7 $2,436,768

Less management consulting Less management consulting 

fees (250,000) fees (250,000) 

Net savings 1,387,928 Savings 2,186,768

Performance weighting factor 45% Performance weighting factor 45%

Formula value = 45% savings 624,568 Formula value = 45% savings 984,046

No. of B and C shares out- No. of B and C shares outstanding 260 standing 260

Est. max. formula value per Est. max. formula value per 

share 2,402 share 3,785

No. of CS class B and C shares 150 No. of CS class B and C shares 150

Liquidation value of B and C Liquidation value of B and C 

shares 360,327 shares 567,719

Total dividends paid 7,125 Total dividends paid 9,975

Total return over 5 years 367,452 Total return over 7 years 577,694

Less initial investment (15,000) Less initial investment (15,000) 

Net return 352,452 Net return 562,694

D&T also projected the following values (in thousands) under 

the heading ‘‘Total Value of All Classes of Stock on Redemption Date’’: 

Year 

Modified 

cashflow 

assuming 

savings 

Value at end 

of year 5 

Value at end 

of year 7 

1998 $2,917 $3,814 $4,480

1999 2,736 3,439 3,919

2000 1,054 1,241 1,414

2001 869 958 1,092

2002 (317) (327) (373)

2003 (503) (486) (554)

2004 (687) (823) (710)

2005 1,128 959 1,092

2006 935 744 848

2007 732 545 622

2008 518 382 412

2009 294 193 219

2010 59 38 41

2011 (188) (108) (123)

2012 (5,137) (2,762) (3,148)

140 139 UNITED STATES TAX COURT REPORTS (67) 

51 Royce testified that both WW’s and D&T’s new calculations were discussed at QHMC’s April 

9, 1999, board meeting and that he adequately informed the board of the changes. Because 

Royce prepared the April 9 board meeting minutes (and all other QHMC meeting minutes), and 

because he testified that he put the important activities that took place during the meetings 

in the minutes, we do not find his testimony that the board was informed of the changes credible. 

52 Jean, Giddens, and Dockery are Raymond Jean, Paul Giddens, and Harva Dockery, respectively. 

The record does not contain credible evidence that 

Quanex’s board was informed of WW’s and D&T’s valuation 

changes. The meeting minutes for QHMC’s board meetings 

(QHMC board meetings) reflected no discussion of the 

changes. 51 (QHMC’s board meetings are discussed in greater 

detail below.) 

E. QHMC Operations 

1. QHMC’s Officers and Directors 

From 1997 through the time of trial, QHMC had the following officers and directors: 52

10/23/97– 

10/24/97 

10/24/97– 

10/25/97 

10/25/97– 

4/9/99 

4/9/99– 

4/10/00 

4/10/00– 

4/17/01 

4/17/01–03 

annual meeting 

Oechsle Dir., pres. Dir., pres. Dir., pres. Dir., pres. Dir., pres. - - - 

Jean - - - - - - - - - - - - - - - Dir., pres. 

Parikh Dir., V.P., 

treas. 

Dir., V.P., 

treas. 

Dir., V.P., 

treas. 

Dir., V.P., 

treas. 

Dir., V.P., 

treas. 

Dir., V.P., treas. 

Rose Dir., V.P. Dir., V.P. Dir., V.P. Dir., V.P. - - - - - - 

Peery Dir., V.P. Dir., V.P. Dir., V.P. - - - - - - - - - 

Davis V.P. V.P. Dir., V.P. Dir., V.P. Dir., V.P. V.P. (until 10/1/02) 

Giddens - - - - - - - - - Dir., V.P. Dir., V.P. Dir., V.P. 

Murphy - - - - - - - - - - - - Dir., V.P. Dir., V.P. 

Wannell Dir. Dir. Dir. Dir. Dir. Dir. 

Babb Dir. Dir. Dir. Dir. Dir. Dir. 

Hellner Dir. - - - - - - - - - - - - Dir. 

Bewley Dir. - - - - - - - - - - - - - - - 

Micale - - - Dir. Dir. Dir. Dir. Dir. 

Chapman - - - Dir. Dir. Dir. Dir. Dir. 

Conlon Sec. Sec. Sec. Sec. Sec. Sec. 

Royce Asst. sec. Asst. sec. Asst. sec. Asst. sec. Asst. sec. Asst. sec. 

Dockery Asst. sec. Asst. sec. Asst. sec. Asst. sec. Asst. sec. Asst. sec. 

Except for Wannell, each class A director was a Quanex 

employee as of the date he or she was elected. Except for 

Conlon and Dockery, both attorneys with Fulbright, each 

QHMC officer was a Quanex employee as of the date he or she 

was elected. QHMC did not compensate its directors or its officers. 

QHMC had no employees, other than, possibly, some 

individuals whom the Code deems to be employees for certain 

purposes such as employment taxes. See, e.g., sec. 3121(d) 

(providing that the term ‘‘employee’’ includes certain common 

law employees and corporate officers). 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 141

53On February 19, 1998, a ‘‘Quanex Strategic Meeting’’ was held, and Rose and Chapman testified that the meeting was about starting QHMC operations. However, both the meeting’s agenda and a followup letter to the meeting, which was dated February 20, 1998, and addressed 

to Micale from Babb, made no mention of QHMC and referenced employee groups not covered 

by QHMC. 

54Since October 1997 Quanex also has maintained a bank account with Comerica Bank 

(Quanex’s Comerica account). 

a. QHMC’s Board Meetings and Shareholders Meetings 

QHMC held board meetings and shareholders meetings on 

April 9, 1999, April 10, 2000, April 17, 2001, and October 1 

and 16, 2001. No board meetings or shareholders meetings 

were held in 1998. 53

b. Parikh as Director and Officer 

In his capacity as a QHMC board member and a QHMC

officer, Parikh participated in QHMC board meetings and 

discussions relating to health management plans, signed 

QHMC’s tax returns, and reviewed QHMC’s financial statements. Parikh had no specific daily activities or responsibilities to perform for QHMC. 

c. Peery as Director and Officer 

From the time the QHMC transactions were completed until 

his retirement in April 1998, Peery attended meetings with 

CS in relation to Quanex matters. Peery was not involved in 

QHMC’s operations. 

Following his retirement, Peery attended no meetings with 

respect to QHMC, and no one called him to discuss any matter 

related to QHMC. For the first five or six months after he 

retired, he stayed on with Quanex in a limited advisory role 

serving at his successor’s pleasure and making himself available to answer the successor’s questions. The successor did 

not ask questions related to benefits or the QHMC arrangement, and Peery did not explain the QHMC arrangement to 

the successor. 

2. Bank Accounts 

QHMC has maintained one bank account since October 

1997. The account is with Comerica Bank (QHMC’s Comerica 

account), 54 and the monthly bank statements are mailed to 

QHMC at the address of Quanex’s principal office. Petitioners 

were unable to find the account’s bank statements for June 

142 139 UNITED STATES TAX COURT REPORTS (67) 

1, 1998, through December 31, 1999, and respondent undertook no efforts to obtain those statements directly from 

Comerica Bank. 

3. Processing and Paying MPB-Related Expenses 

The processing of claims under Quanex’s HMO and indemnity plans was the same before and after October 1997. From 

October 23, 1997, employees or agents of Quanex processed 

the claims for the MPBs transferred to QHMC, and personnel 

at the employees’ respective plants input the covered 

employees’ medical enrollment information. The individuals 

involved and the basic procedures for processing employee 

claims for the MPBs were generally the same before and after 

October 23, 1997, and the QHMC-covered employees’ claims 

were not handled any differently from those for employees 

whose MPBs were not transferred to QHMC. Quanex bore all 

MPB claims processing costs, and QHMC paid no fees to 

Quanex for the services Quanex provided in processing 

claims. The cost to Quanex for processing the claims did not 

include the actual amounts of the claims. 

QHMC also paid no fees for any administrative, management, or other service that Quanex provided in connection 

with the MPBs. While Quanex’s accounting department maintained QHMC’s books and records, Quanex’s tax department 

prepared QHMC’s tax returns for TYE 1997 through TYE 2002, 

and Royce prepared the minutes for QHMC’s board meetings, 

QHMC did not reimburse Quanex for these services. 

After October 23, 1997, Quanex initially paid the covered 

employees’ actual medical claim costs and the employer’s 

share of HMO premiums for or related to the MPBs. Quanex 

employees or agents continued to select the HMO insurers 

and to perform the annual negotiations related to the HMO

premiums for the MPBs, and all costs related to those activities were borne by the HMOs and by Quanex (QHMC paid no 

fees to Quanex for these services). The annual costs for the 

claims and premiums for 1998 through 2001 were as follows: 

Fiscal year 1

Medical 

expenses 2

TYE 1998 ................................................................... $2,656,249

TYE 1999 ................................................................... 3,396,854

TYE 2000 ................................................................... 3,685,133

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 143

Fiscal year 1

Medical 

expenses 2

TYE 2001 ................................................................... 4,390,632

Total ........................................................................ 14,128,868

1The parties did not provide the total cost for the covered employees’ claims and the employer’s share of the covered employees’ HMO premiums for years after TYE 2001. 2The computation attributed the expenses to Corporate salaried, MS–General Office salaried, MS–Michigan salaried, MS–Arkansas salaried, and MS–Arkansas hourly employees. 

Quanex’s payments of the medical benefit costs for the covered employees were handled through its treasury department, the same way medical benefit costs were handled for 

all Quanex employees. The claims were paid out of individual 

medical accounts that the treasury department set up for 

each Quanex division so that Quanex was able to identify 

each division’s claims and losses. At the end of each payment 

period, Quanex determined which expenses were paid for the 

covered groups of employees. 

QHMC eventually reimbursed Quanex for the employees’ 

claims and the employer’s share of the HMO premiums that 

Quanex paid. QHMC’s ability to reimburse Quanex was 

directly related to its receipt of payments on the Piper note. 

QHMC paid no fees or interest to Quanex for the use of the 

Quanex funds expended in connection with the payment of 

the MPBs. 

After the QHMC transactions were completed, QHMC’s business came solely from Quanex, and the Piper note was 

QHMC’s sole source of income. QHMC could not reimburse 

Quanex for the MPB expenses until QHMC received payments 

on the note. Piper did not pay the interest on the note as it 

came due, and Piper and QHMC initially recorded the respective interest obligations as payables and receivables on their 

respective books. 

QHMC’s obligation to reimburse Quanex for claims and premium payments was initially reflected through entries in 

intercompany accounts, e.g., recorded as a receivable due 

from QHMC on Quanex’s books and as a payable on QHMC’s 

books. On May 12, 2000, $45,156,667 was wired into QHMC’s 

Comerica account from Quanex’s Comerica account to pay off 

the Piper note’s $38 million principal and $7,156,667 accrued 

144 139 UNITED STATES TAX COURT REPORTS (67) 

55The parties stipulated that QHMC made the first reimbursement payment of $7,156,667 on 

May 7, 2000. However, the parties also stipulated QHMC’s bank account summary of activity 

for October 1, 1997, through March 31, 2003, which shows that the $7,156,667 payment was 

made on May 12, 2000, the same date the $45,156,667 transfer from the Quanex account was 

deposited. Because the bank summary of activity also shows that QHMC had only $61,316.70 

in its account immediately before the May 12 transfer from Quanex’s account, we find that the 

$7,156,667 payment could not have been made before that date. See Cal-Maine Foods, Inc. v. 

Commissioner, 93 T.C. 181, 195 (1989) (stating that, where justice requires, the Court may disregard a stipulation which is clearly contrary to the record); see also Rules 90(f), 91(e). 

interest. QHMC transferred the $7,156,667 back to Quanex 

the same day to reimburse Quanex for the MPB expenses for 

the first time. 55 Also on May 12, 2000, QHMC transferred the 

$38 million to Nichols Aluminum-Golden, Inc. (NAG), another 

wholly owned Quanex subsidiary, as a loan. 

The transfers relating to the Piper note began a pattern 

whereby QHMC received principal and interest payments from 

Quanex for loans QHMC had made to certain Quanex subsidiaries, and QHMC immediately thereafter made MPB expense 

reimbursements to Quanex and loans to other Quanex entities. QHMC made loans to NAG, Temroc Metals (TFP), Imperial 

Products, Inc. (IFP) and Colonial Craft, Inc. (CCI), all then 

wholly owned subsidiaries of Quanex, as follows: 

Borrower 

Principal 

amount 

Date of 

note 

Wire 

transfer 

Cancellation/ 

repayment 

NAG $38 million 5/1/00 5/12/00 4/27/01 

TFP 20 million 4/1/01 4/27/01 5/28/02 

IFP 18 million 4/1/01 4/27/01 7/31/02 

CCI 20 million 5/1/02 5/28/02 7/31/02 

CCI 38 million 8/1/02 7/31/02 Outstanding 

at trial 

The wire transfers from QHMC for the TFP and IFP loans were 

made to Quanex’s Comerica account, and the repayments for 

the NAG, TFP, and IFP notes were wire transfers to QHMC’s 

account from Quanex. Each note was due on December 31, 

2012, but could be prepaid in whole or in part at any time 

without penalty. Similarly, Quanex made interest payments 

on the NAG, TFP, IFP, and CCI notes by wire transfer from its 

Comerica account to QHMC’s, and QHMC made corresponding 

reimbursements to Quanex. 

The payments made between Quanex and QHMC were as 

follows: 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 145

Interest payments Reimbursement payments 

Loan 

recipient 

Date of wire 

to QHMC 

Interest 

amount 

Date of 

QHMC wire 

to Quanex 

MPB expense 

repayment 

amount 

Piper 5/12/00 $7,156,667.00 5/12/00 $7,156,667.00

NAG 7/25/00 593,222.22 7/25/00 593,222.22

NAG 10/25/00 902,499.99 10/25/00 902,499.99

NAG 1/8/01 902,499.99 1/8/01 902,499.99

NAG 4/4/01 818,055.56 4/4/01 818,055.56

TFP 7/27/01 500,000.00 7/27/01 950,000.00

IFP 7/27/01 450,000.00 - - - -0-

TFP 10/30/01 500,000.00 10/30/01 950,000.00

IFP 10/30/01 450,000.00 - - - -0-

TFP 1/16/02 500,000.00 1/16/02 950,000.00

IFP 1/16/02 450,000.00 - - - -0-

TFP 4/16/02 500,000.00 4/16/02 950,000.00

IFP 4/16/02 450,000.00 - - - -0-

TFP 5/28/02 166,667.00 5/28/02 166,667.00

CCI 7/31/02 333,000.00 7/31/02 933,333.00

CCI 7/31/02 600,000.00 - - - -0-

CCI 10/24/02 800,334.00 10/24/02 800,334.00

CCI 1/13/03 950,000.00 1/13/03 950,000.00

Total 17,022,945.76 17,023,278.76

4. Shareholder Efforts To Manage MPB Obligations 

a. CS’ Efforts 

i. Background 

Following the QHMC transactions, CS did more work for 

Quanex than it had before the QHMC transactions, but the 

nature of CS’ work did not change. During the course of a 

typical year following the fall of 1997, CS negotiated HMO

contracts and evaluated medical savings opportunities for 

QHMC covered employees as part of a broader effort to reduce 

Quanex’s medical expenses. CS attempted to meet with the 

companies from which the covered employees had been 

chosen, and it sometimes participated in Quanex’s meetings 

with those companies. CS met annually with QHMC’s board to 

provide updates and to assess savings opportunities for the 

following contract year. 

Both Howard and Chapman attended and made presentations at the QHMC board meetings. Howard was Quanex’s 

main CS contact from 1997 through the time of trial, and 

Babb was Howard’s main Quanex contact both before and 

after the QHMC transactions. Howard used the QHMC board 

meetings as a venue to speak to Quanex management about 

Quanex generally and the health care problems of all of 

146 139 UNITED STATES TAX COURT REPORTS (67) 

56 At trial Chapman defined a PPO as ‘‘purely a network * * * it’s a point of access into a 

medical delivery system.’’ 

57 CS typically received remuneration with respect to indemnified contracts but not PPO 

plans. After Quanex’s PPO plan was in effect, however, CS received commissions from Quanex 

because there was a contract to provide insurance coverage. 

Quanex’s employees. Chapman and Howard also used the 

meetings as an opportunity to inform Quanex management 

about the services CS could provide for Quanex as a whole. 

After the QHMC transactions were consummated, Quanex 

provided data to CS for all Quanex employees, and CS’ 

presentation materials for the QHMC board meetings included 

recommendations for both QHMC covered and non-QHMC covered employees. CS provided some of the same materials at 

both the April 10, 2000, and the April 17, 2001, board 

meetings. 

ii. PPO Project 

At QHMC’s April 17, 2001, board meeting, CS suggested 

that Quanex replace its indemnity plan with a PPO option as 

a cost savings strategy. 56 CS believed that establishing a PPO

would be valuable to all Quanex employees, and Quanex ultimately agreed. Previously, before October 31, 1997, CS had 

discussed using PPOs with Quanex, but Quanex did not then 

act on those discussions. 57 CS helped clients in which it did 

not have an equity interest implement PPO plans. 

Quanex wanted to provide the PPO option to all its nonunion employees. CS prepared a ‘‘Request for Information 

Healthcare Management and Administration for Quanex 

Corporation’’ (RFI) for the PPO project. The RFI stated that its 

intent was to partner Quanex with a health care company 

that could successfully improve Quanex’s health care costs by 

implementing a PPO network access product, and in a portion 

of the document entitled ‘‘COMPANY INTRODUCTION’’, the RFI

gave an overview of Quanex that made no reference to QHMC. 

The RFI also requested information on medical services provided in locations that did not contain QHMC covered 

employees. CS also prepared a Request for Proposal (RFP) 

that was entitled ‘‘Request for Proposal Healthcare Management and Administration for Quanex Corporation’’. The RFP

contained a company introduction that did not refer to QHMC. 

By letter dated February 21, 2002, CS provided Parikh 

with a bill for services performed between August 27 and 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 147

58 Royce testified that CS’ efforts on the PPO project resulted in approximately $800,000 of 

health care cost savings for Quanex by the end of TYE 2002. We do not find this testimony credible, and we decline to rely upon it. 

December 31, 2001, which characterized CS’ PPO efforts as 

work for Quanex generally. The invoice stated that CS created ‘‘Quanex specific’’ RFP and RFI documents, and that CS 

prepared an analysis of the viable PPO health networks and 

providers ‘‘for every location where Quanex employees and 

retirees reside’’ to implement and create the PPO benefit plan. 

The invoice stated that CS performed a detailed interpretation of the services, quality, and financial benefits among 

multiple vendors and administrators ‘‘for each operating division of Quanex,’’ and that CS identified the vendor best 

capable of ‘‘meeting the current and future needs of Quanex 

based on given demographic and financial goals of Quanex’’ 

as a part of the PPO project. 

Effective January 1, 2002, Quanex established a PPO plan 

to replace its indemnity plan. The change, which was to take 

place over time, applied to all of Quanex’s nonunion 

employees, including those covered by QHMC. The majority of 

QHMC covered employees were HMO participants, and all 

Quanex employees under the HMO program had an opportunity to transfer to a PPO when their policy year expired. 

Many HMO-covered employees chose not to switch. The same 

PPO provider, Unicare, was chosen for both QHMC covered and 

non-QHMC covered employees. 58

iii. Union Negotiations 

CS also participated in union negotiations to reduce 

Quanex’s medical expenses. The employees of Quanex’s MS– 

Fort Smith, Arkansas, location unionized in 1999. Although 

the employees were originally part of the QHMC covered 

employees group, they were no longer QHMC covered 

employees after they unionized. Because Quanex wanted to 

determine which medical benefits to include in the union 

contract, and the contract involved an Arkansas HMO with 

which Howard had previously negotiated for Quanex, Quanex 

asked CS to help devise a strategy for negotiations with the 

union as to the amount and terms of the medical benefits 

Quanex would provide. With CS’ assistance, Quanex successfully negotiated the inclusion of an employee contribution 

requirement in the union contract. Before the union contract, 

148 139 UNITED STATES TAX COURT REPORTS (67) 

59Wannell did not provide any suggestions with respect to the unionization directly to CS, 

nor did he directly participate in the union negotiations. Wannell’s knowledge of what occurred 

with the negotiations was limited to what Royce told him. 

the MS–Fort Smith, Arkansas, employees were not required 

to contribute to their health care plan. CS did not need the 

QHMC structure to assist Quanex in the union negotiations. 59

iv. CS’ Consulting Bills 

By letters dated February 1 and June 24, 1999, February 

21, 2002, and March 18, 2003, CS provided Quanex with bills 

for its services. In each bill CS generally described its work 

underlying the bill as ‘‘consulting services as provided for in 

our consulting agreement dated October 24, 1997 by and 

among Quanex Corporation and Chapman Schewe Inc. as 

part of the Quanex Health Management, Inc. provisions.’’ 

Each bill provided itemized descriptions of the work performed and stated who performed the work and at what rate. 

The February 1999 bill was for services CS performed in 

1998 as a part of its efforts to manage Quanex’s health plan 

expense. The bill charged $13,000 for 52 hours of work performed by Chapman, Howard, and Micale at a rate of $250 

per hour. Although the bill’s itemized work descriptions 

referred to Quanex by name several times, none of the 

descriptions made any specific reference to QHMC or to the 

covered groups. On or about March 24, 1999, Quanex paid 

CS the invoiced $13,000. 

The June 1999 bill was for services CS performed from 

January 1 to April 30, 1999, and the charges reflected ‘‘the 

initiation of saving solutions strategies and request for proposals from national vendors for the QHMC project.’’ The bill 

charged $23,100 for 90 hours of work performed by Micale, 

Chapman, and Howard at a rate of $250 per hour and 12 

hours of clerical work at a rate of $50 per hour. This bill’s 

itemized work descriptions made specific references to 

Quanex but none to QHMC or to the covered employee groups. 

On or about August 1999 Quanex paid CS the invoiced 

$23,100. 

The February 2002 bill charged as to the PPO project 

$44,375 for 45 hours of work performed by Micale, Chapman, 

and Howard at a rate of $250 per hour and for 265 hours of 

work performed by Betty Speery at a rate of $125 per hour. 

The itemized work descriptions in this bill made no direct 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 149

mention of QHMC or of the covered employee groups. The 

record does not show that Quanex, or anyone else, had paid 

the $44,375 to CS by the time of trial. 

The March 2003 bill was for services CS performed in 2002 

‘‘for the benefit of Quanex Corporation and QHMC’’. CS 

described most of the billable hours as time spent coordinating and negotiating the renewal of the Unicare PPO plan 

administration and analyzing the viability of integrating six 

additional divisions into the plan. The bill stated that CS 

was responsible for selecting various health care providers 

and for contracting claims runout services and terminations 

of vendors servicing five divisions. The bill charged $53,750 

for 83 hours of work performed by Micale, Chapman, and 

Howard at a rate of $250 per hour and 264 hours of work 

performed by Speery at a rate of $125 per hour. The bill 

made no specific mention of QHMC or of the covered employee 

groups in its itemized work descriptions, and the record does 

not indicate that CS was paid the $53,750 by the time of 

trial. 

b. Wannell’s Efforts 

Wannell had limited involvement with QHMC following the 

completion of the QHMC transactions. Between October 1997 

and April 1999 Wannell did not attend any meetings 

regarding QHMC business, and he did not receive any calls or 

written materials from CS or with respect to work CS was 

doing. On one (and possibly a couple more) occasions, Royce 

called Wannell to tell him about the state of CS’ work and 

to solicit Wannell’s off-the-cuff comments on that work so 

that Royce could relay those comments to CS. Royce did not 

provide Wannell with any written material related to the 

work CS was doing. 

Wannell did not attend the QHMC board meetings or shareholder meetings held on April 10, 2000, October 16, 2001, 

and October 1, 2002, but he did attend the meetings held on 

April 9, 1999, and April 17, 2001. Wannell was invited to 

attend all of the meetings, and he typically received advance 

notice of the topics and documents to be discussed from 

Royce, his main contact with respect to QHMC. With the 

exception of the two board meetings that Wannell did attend, 

his only QHMC contact was with Royce. Other than the refVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00083 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
150 139 UNITED STATES TAX COURT REPORTS (67) 

erenced conversations with Royce, Wannell did not participate in any meeting regarding QHMC business in between the 

board meetings, nor was he asked to participate in any such 

meeting. QHMC did not institute any of the wellness programs that Wannell had instituted at LaSalle. 

5. Dividend Payments 

On April 21, 1999, QHMC paid a total of $3,088 in dividends 

to its class B and class C shareholders, which represented 

the annual dividend of $9.50 per share due for TYE 1998 and 

a quarterly dividend of $2.375 per share due for the first 

quarter of TYE 1999. After January 31, 1999, QHMC had no 

current or accumulated earnings and profits from which to 

pay dividends for the balance of TYE 1999 or for TYE 2000, 

TYE 2001, or TYE 2002, and QHMC paid no additional dividends for those years. 

6. Return on Investment Projections 

The minutes of QHMC’s October 1, 2002, board meeting contained projections of the amounts CS and Wannell would be 

entitled to receive if QHMC was dissolved or liquidated. The 

computations were as follows: 

TYE 1998 TYE 1999 TYE 2000 TYE 2001 

Actual medical costs $2,656,249 $3,396,854 $3,685,133 $4,390,632

Divided by yearend headcount 564 573 598 595

Actual cost per employee 4,710 5,928 6,162 7,379

Percent change - - - 25.87% 3.95% 19.75%

Projected cost per employee 5,257 5,625 5,996 6,372

Projected percentage change - - - 7% 6.6% 6.27%

Difference in projected over actual 547 (303) (166) (1,007) 

Times yearend headcount 564 573 598 595

Current year savings 308,699 (173,729) (99,525) (599,292) 

Less consulting fees -0- (36,100) -0- -0-

Net savings 308,699 (209,829) (99,525) (599,292) 

Cumulative prior-year savings -0- 308,699 98,870 (655) 

Total cumulative savings 308,699 98,870 (655) (599,947) 

Times 45% 0.45 0.45 0.45 0.45

Formula value 138,915 44,492 (295) (269,976) 

Less original investment (26,000) (26,000) (26,000) (26,000) 

Net return to date 112,915 18,492 (295) (269,976) 

Return on investment 434% 71% - - - - - -

CS’ portion of investment 

Formula value 80,143 25,668 (170) (155,755) 

Less original investment (15,000) (15,000) (15,000) (15,000) 

Net return to date 65,143 10,668 (170) (155,755) 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 151

TYE 1998 TYE 1999 TYE 2000 TYE 2001 

Wannell’s portion of investment 

Formula value 58,772 18,823 (125) (114,221) 

Less original investment (11,000) (11,000) (11,000) (11,000) 

Net return to date 47,772 7,823 (125) (114,221) 

The record contains another set of projections of the 

amounts QHMC preferred shareholders would be entitled to 

receive in the event of liquidation or dissolution of QHMC. 

These computations were pursuant to the liquidation preferences described in QHMC’s certificate, and projected, in 

part, as follows: 

10/31/98 10/31/99 10/31/00 10/31/01 

Actual medical costs $2,656,249 $3,396,854 $3,685,133 $4,390,632 

(a) MPBs savings 138,915 44,492 -0- -0-

(b) 50% of net equity 19,055,451 18,875,986 18,725,324 18,480,107 

Formula value—lesser of (a) or (b) 138,915 44,492 -0- -0-

Fixed payout rate per share 125 125 125 125 

No. of preferred shares 260 260 260 260 

Fixed payout 32,500 32,500 32,500 32,500 

Greater of formula or fixed payout 138,915 44,492 32,500 32,500 

Less original investment 26,000 26,000 26,000 26,000 

Net return to date 112,915 18,492 6,500 6,500 

Cumulative return on investment 434% 71% 25% 25% 

Annual return on investment 434% 36% 8% 6% 

CS return 65,143 10,668 3,750 3,750 

Wannell return 47,772 7,823 2,750 2,750 

The record does not reflect that CS or Wannell received any 

payments from QHMC other than the dividend payments 

described above. 

7. QHMC’s Tax Returns 

QHMC ceased to be a member of petitioners’ affiliated group 

as of October 24, 1997, and QHMC filed a separate Federal 

income tax return for the short period October 24 through 

31, 1997, and for each of its taxable years TYE 1998 through 

TYE 2001. QHMC reported the following on those returns: 

10/31/97 10/31/98 10/31/99 10/31/00 10/31/01 

Taxable income 

Interest income $31,667 $2,850,000 $2,850,000 $3,221,555 $3,636,390

E’ee insurance & 

benefits -0- (2,776,666) (3,200,059) (3,761,512) (4,390,632) 

Legal & audit costs -0- (152,543) -0- -0- -0-

Travel costs -0- -0- (596) -0- (714) 

Net income/(loss) 331,667 (79,209) (350,655) (539,957) (754,956) 

NOL carryover -0- 47,542 398,197 938,154 1,693,110

152 139 UNITED STATES TAX COURT REPORTS (67) 

10/31/97 10/31/98 10/31/99 10/31/00 10/31/01 

Schedule L balance 

sheet 

Cash 65,000 65,000 61,316 61,317 61,317

Notes receivable -0- -0- -0- -0- 38,316,667

Total assets 65,000 65,000 61,316 61,317 8,377,984

Accounts payable -0- -0- -0- -0- 1,437,295

Accrued Fed. inc. tax (11,083) 21,390 144,119 20,175 (19,523) 

Intercompany liabilities 38,031,667 37,946,241 37,596,182 37,369,153 -0-

Total liabilities 38,020,584 37,967,631 37,740,301 37,389,328 1,417,772

Common stock 50,000 50,000 50,000 50,000 50,000

Paid-in capital 38,015,000 38,015,000 38,015,000 38,015,000 38,015,000

Total stock 38,065,000 38,065,000 38,065,000 38,065,000 38,065,000

Retained earnings 20,584 (32,369) (263,383) (614,355) (1,104,788) 

S/H’s equity (SE) 38,085,584 38,032,631 37,801,617 37,450,645 36,960,212

Total liabilities & SE 65,000 65,000 61,316 61,317 38,377,984

Distributions -0- -0- 3,088 -0- -0-

QHMC’s 1997 return (for the short period) included three 

statements entitled ‘‘Statement Regarding Tax Free Contribution to Capital Pursuant to Regulation Section 1.351– 

3(b)’’. On the first statement, QHMC reported Quanex’s 

October 23, 1997, contribution to QHMC of $62,000 and 1,000 

shares of QHMC common stock in return for 500 shares of 

class A stock and 130 shares of class B stock. On the second 

statement, QHMC reported QS’ October 25, 1997, contribution 

to QHMC of $38 million and $37,989,000 of MPBs in return for 

110 shares of class C stock. On the third statement, QHMC

reported CS’ October 25, 1997, contribution to QHMC of 

$2,000 in return for 20 shares of class C stock. 

8. Financial Statements 

On its financial statements, QHMC reported net income 

(loss) of $19,116, $26,785, ($355,842), ($301,325), and 

($490,433) for TYE 1997 through TYE 2001, respectively. In 

addition, QHMC reported equity of $38,084,116, $38,110,901, 

$37,751,972, $37,450,647, and $36,960,214 as of the end of 

each of those respective years. As discussed infra, QHMC’s 

financial statements did not take into account QHMC’s 

assumption of the transferred MPBs. 

F. Notice of Deficiency 

On or about November 20, 2000, respondent contacted 

Royce to inform petitioners that the IRS would be conducting 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 153

60The parties stipulated that respondent’s revenue agents interviewed Rose on March 23, 

2001, and that one of the agents stated during the interview that 

we (IRS) recognize Quanex’s business purpose for needing better management and control over 

its medical costs. It was explained that we (IRS) are concerned only with the tax consequences 

of the transaction and that we do not try to tell taxpayers how to run their business. It was 

explained to Mr. Rose that our concern was that Quanex had converted a contingent liability 

into a short-term capital loss. 

Respondent reserved an objection to the admissibility of this stipulation on the ground of relevance. Although we deferred ruling on the admissibility of this stipulation at trial, the comments of a revenue agent during an audit are generally not relevant, and we shall sustain respondent’s objection to the admissibility of this stipulation. See Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 327–328 (1974) (holding that the Court decides deficiency cases on a de 

novo basis and that events during an audit, with limited exceptions none of which is applicable 

here, are irrelevant to our de novo review); see also Rountree Cotton Co. v. Commissioner, 113 

T.C. 422, 426 (1999), aff ’d, 12 Fed. Appx. 641 (10th Cir. 2001); Barnes v. Commissioner, T.C. 

Memo. 2004–266. 

an examination of Quanex’s 1997 return. 60 Approximately 

eight months later, on July 13, 2001, respondent hand-delivered and mailed to petitioners a notice of deficiency (notice) 

for TYE 1997. Respondent explained in the notice that he disallowed petitioners’ claimed $37,989,000 short-term capital 

loss and that he correspondingly increased petitioners’ capital gain income by $26,966,201. Respondent explained that 

he disallowed the loss because petitioners failed to establish 

that Quanex’s basis in the stock exceeded $11,000; the loss 

arose from transactions ‘‘that have no economic substance or 

business purpose, were entered into solely for tax avoidance, 

and were prearranged and predetermined’’; and petitioners 

failed to establish that the loss otherwise met the deduction 

requirements under the Code. 

Respondent further explained, as an alternative to the reasons previously stated, that he had disallowed the loss 

because either (1) the ‘‘purported nonrecognition transaction’’ 

did not meet the requirements of section 351, including but 

not limited to the business purpose requirement, so that 

Quanex’s basis was determined by section 1001 (as opposed 

to a carryover basis); (2) QHMC’s assumption of the MPBs 

reduced the basis of the stock received in the exchange 

pursuant to section 358(d)(1) because the MPBs obligation is 

not a liability excluded under section 357(c)(3); or (3) the 

principal purpose of the transfer of the MPBs was not a bona 

fide business purpose such that section 357(b) applied, the 

assumption of the liability was a distribution of money, and 

Quanex’s basis was reduced by $37,989,000. Respondent further explained, as yet another alternative, that he had disVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00087 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
154 139 UNITED STATES TAX COURT REPORTS (67) 

allowed the loss because (1) the loss is disallowed under section 1.1502–20, Income Tax Regs., (2) petitioners 

deconsolidated QHMC with the intent to avoid section 1.1502– 

20, Income Tax Regs., (3) QHMC was not treated as holding 

a member security as of the time of the sale, and (4) petitioners transferred an asset within two years by direct or 

indirect disposition, or a deconsolidation of stock, with a view 

to avoid the disallowance of a loss on the disposition, or a 

basis reduction on the deconsolidation of stock of a subsidiary, or the recognition of unrealized gain. 

Respondent also stated in the notice that the deficiency 

resulted from petitioners’ improperly deducting expenses. To 

that end, respondent stated, he disallowed $323,137 of outside consultant expenses and $29,114 of legal and audit 

expenses that petitioners deducted with respect to the 

‘‘reorganization/recapitalization and sale of the stock’’ of 

QHMC because these expenses were not ordinary and necessary. 

With respect to the accuracy-related penalty under section 

6662, respondent determined that the 40% accuracy-related 

penalty of section 6662(a) and (h) (or alternatively the 20% 

accuracy-related penalty under section 6662(a) and (b)(1) (or 

alternatively (b)(2))) applied to the portion of the underpayment attributable to a gross valuation misstatement (or 

alternatively negligence or disregard of rules or regulations 

(or alternatively a substantial understatement of income 

tax)) with respect to the class C stock. Respondent also determined that petitioners were liable for the 20% accuracyrelated penalty under section 6662(a) and (b)(1) (or alternatively (b)(2)) to the extent of the underpayment attributable to the erroneous deductions. In none of those cases, 

respondent stated, had petitioners shown that they had 

reasonable cause for the underpayment and had acted in 

good faith. 

OPINION 

I. Burden of Proof 

Taxpayers generally bear the burden of proof in this Court. 

Rule 142(a)(1). However, if a taxpayer produces credible evidence with respect to one or more factual issues relevant to 

ascertaining the taxpayer’s Federal income, estate, or gift tax 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 155

liability, the burden of proof may shift to the Secretary as to 

that issue (or those issues). See sec. 7491(a)(1). Section 

7491(a)(1) applies to court proceedings arising in connection 

with examinations that the Commissioner commences after 

July 22, 1998. See Williams v. Commissioner, 123 T.C. 144, 

146 n.3 (2004); Nis Family Trust v. Commissioner, 115 T.C. 

523, 537 (2000). Section 7491(a)(1) applies to this proceeding 

because respondent informed Royce in late 2000 that the IRS

would be conducting an examination of petitioners’ 1997 

return. 

For the burden of proof to shift to respondent under section 

7491(a)(1), petitioners must prove that they met the following requirements of section 7491(a)(2): (1) petitioners 

substantiated any item as required by the Code, (2) petitioners maintained all records required by the Code, and (3) 

petitioners cooperated with respondent’s reasonable requests 

for witnesses, information, documents, meetings, and interviews. Section 7491(a)(2)(C) also requires that in order to 

shift the burden of proof, a taxpayer that is a partnership, 

a corporation, or a trust (other than a qualified revocable 

trust as defined in section 645(b)(1)) must meet the requirements of section 7430(c)(4)(A)(ii) (which in turn references 

the net worth requirements of 28 U.S.C. sec. 2412(d)(2)). 

Petitioners do not argue that section 7491(a)(1) shifts the 

burden of proof to respondent in this case. In addition, petitioners have not established (nor do we find) that they satisfied the requirements of section 7491(a)(2). We hold that section 7491(a)(1) does not shift the burden of proof to 

respondent. See Goosen v. Commissioner, 136 T.C. 547, 558 

(2011); Stipe v. Commissioner, T.C. Memo. 2011–92. 

II. Witness Testimony 

A. Background 

We observe the candor, sincerity, and demeanor of each 

witness in order to evaluate his or her testimony and assign 

it weight for the primary purpose of finding disputed facts. 

We determine the credibility of each witness, weigh each 

piece of evidence, draw appropriate inferences, and choose 

between conflicting inferences in finding the facts of a case. 

The mere fact that one party presents unopposed testimony 

on that party’s behalf does not necessarily mean that the 

156 139 UNITED STATES TAX COURT REPORTS (67) 

61We have noted in our findings of fact some examples of the testimony of the fact witnesses 

that we have decided not to rely upon. 

elicited testimony will result in a finding of fact. We will not 

accept the testimony of witnesses at face value if we find 

that the outward appearance of the facts in their totality conveys an impression contrary to the spoken word. See 

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 84 

(2000), aff ’d, 299 F.3d 221 (3d Cir. 2002); cf. Gallick v. Balt. 

& Ohio R.R. Co., 372 U.S. 108, 114–115 (1963); Boehm v. 

Commissioner, 326 U.S. 287, 293 (1945); Wilmington Trust 

Co. v. Helvering, 316 U.S. 164, 167–168 (1942). 

B. Fact Witnesses 

Petitioners and respondent called six and four witnesses, 

respectively, to testify as to the facts of this case. Petitioners’ 

fact witnesses were Wannell, Peery, Rose, Singer, Chapman, 

and Royce. Respondent’s fact witnesses were Schneider, 

Parikh, Ringuette, and Howard. To the extent we disregarded or discounted any of the testimony of these witnesses, we generally perceived the witnesses giving that 

testimony to be untrustworthy during that testimony or 

considered the testimony self-serving, vague, elusive, 

uncorroborated, and/or inconsistent with documentary or 

other reliable evidence. We are not required to rely on testimony that we consider to be untrustworthy and/or unreliable, and we do not rely on any such testimony given in 

these cases to support either our findings of fact or our 

decisions with respect to the issues at hand. 61 See 

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 84– 

87; see also Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). 

C. Expert Witnesses 

1. Background 

a. Overview 

On direct examination, each party called one witness to 

testify as an expert. Petitioners’ witness was Bruce A. 

Strombom, Ph.D. Respondent’s witness was David J. Ross. 

Petitioners also called David M. Eisenstadt, Ph.D., to testify 

as an expert in rebuttal of some of Ross’ testimony. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 157

Respondent recalled Ross to testify as an expert in rebuttal 

of some of Strombom’s testimony. 

b. Strombom 

Strombom has a B.A. in economics and a Ph.D. in 

economics. He is employed as the vice president of an international economic, financial, and consulting firm, and most of 

his work involves the health care industry. He has published 

various articles in the area of his practice. 

Strombom concluded that the QHMC transactions have economic substance and a business purpose. 

c. Ross 

Ross has a B.A. in economics and an M.B.A. He works as 

the senior vice president of a consulting firm that specializes 

in applying economics to legal and regulatory issues, and he 

specializes (and has published articles) in financial economics 

and the economics of corporate law. He has previously testified as an expert in this and other courts. 

Ross concluded that it was virtually certain that either 

QHMC or its preferred shareholders, if each acted rationally, 

would exercise their redemption rights by October 2004. Ross 

also concluded that the preferred stock is limited and preferred as to dividends and does not participate in corporate 

growth in any meaningful way. Ross also concluded that the 

QHMC transactions were not necessary to provide incentives 

to CS and Wannell and that petitioners effectively retained 

their economic interest in the assets and liabilities transferred to QHMC. 

d. Eisenstadt 

Eisenstadt has a B.S. in economics, an M.S. in economics, 

and a Ph.D. in economics. He works as an economist and a 

principal of a consulting and research firm. He has published 

various articles in the area of his practice. 

Eisenstadt concluded that Ross concluded incorrectly that 

it was virtually certain that either QHMC or its preferred 

shareholders, if each acted rationally, would exercise their 

redemption rights by October 2004. Eisenstadt also concluded that Ross concluded incorrectly that the preferred 

stock is limited and preferred as to dividends and does not 

158 139 UNITED STATES TAX COURT REPORTS (67) 

participate in corporate growth in any meaningful way. 

Eisenstadt did not opine as to any of Ross’ other conclusions. 

2. Analysis 

The Court recognized each of the proffered expert witnesses as an expert on his proffered area of expertise. Each 

expert then testified on direct examination primarily through 

his expert report, see Rule 143(g)(1), which the Court 

accepted into evidence. Each expert then testified on crossexamination, redirect examination, and re-cross-examination, 

through the typical question and answer process. 

We may accept or reject the findings and conclusions of 

these experts, according to our own judgment. See Parker v. 

Commissioner, 86 T.C. 547, 561–562 (1986). In addition, we 

may be selective in deciding what parts (if any) of their opinions to accept. See id. As discussed herein, we generally 

found Ross’ conclusions to be more persuasive than those of 

the other two experts. 

III. Net Short-Term Capital Loss 

A. Overview 

We now decide whether petitioners may deduct their 

claimed short-term capital loss from the sale of the class C 

stock. The parties agree that petitioners may not deduct the 

claimed loss if we decide any of the following six subissues 

in favor of respondent: 

1. whether the class C stock participates in corporate 

growth to any significant extent for purposes of section 

351(g); 

2. whether QHMC’s assumption of the MPB obligations constituted ‘‘other property’’ received by QS, within the meaning 

of section 358(a)(1)(A)(i); 

3. whether, for purposes of section 358(d), payment of the 

MPB obligations ‘‘would give rise to a deduction’’ within the 

meaning of section 357(c)(3)(A)(i), or if not, whether the 

incurrence of the MPB obligations ‘‘resulted in the creation of, 

or an increase in, the basis of any property’’ within the 

meaning of section 357(c)(3)(B); 

4. whether petitioners’ principal purpose with respect to 

QHMC’s assumption of the MPB obligations was a bona fide 

business purpose under section 357(b)(1)(B); 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 159

5. whether the QHMC transactions lacked sufficient business purpose or economic substance or effect to be recognized 

for Federal income tax purposes; and 

6. whether the step transaction doctrine applies to recharacterize petitioners’ sale of the class C stock to Wannell 

as QHMC’s issuance of the stock to Wannell. 

We proceed to address these subissues to the extent necessary. 

B. Section 351(g) 

The parties dispute whether the class C stock was ‘‘preferred stock’’ within the meaning of section 351(g)(3)(A), and 

they agree that the resolution of this dispute turns on 

whether the class C stock, as of the time it was issued, 

‘‘participate[d] in corporate growth to any significant extent’’ 

within the meaning of section 351(g)(3)(A). Petitioners argue 

that the class C stock was not such preferred stock because, 

they state, the class C stock participated significantly in 

QHMC’s corporate growth through the formula value. 

Respondent argues that the class C stock was such preferred 

stock because, he states, the class C stock did not participate 

significantly in QHMC’s corporate growth. If the class C stock 

participated in QHMC’s corporate growth to a significant 

extent, then the parties agree that the class C stock is not 

‘‘preferred stock’’ (and thus is not nonqualified preferred 

stock (NQPS)) for purposes of section 351(g). If the class C 

stock did not so participate, then the parties agree that the 

class C stock is ‘‘preferred stock’’ (and further that the class 

C stock is NQPS) for purposes of section 351(g). We agree with 

respondent that the class C stock is ‘‘preferred stock’’ within 

the meaning of section 351(g)(3)(A) and, hence, that the stock 

is NQPS. 

Section 1001 requires that a taxpayer recognize any gain 

or loss realized on the sale or exchange of property, absent 

a contrary provision in subtitle A of the Code. One such contrary provision is section 351(a), which generally provides 

that no gain or loss is recognized where one or more persons 

transfer property to a corporation solely in exchange for stock 

of the corporation if the transferor(s) control the corporation 

immediately after the exchange. Where a transferor in such 

an exchange receives only stock, the transferor’s basis in the 

160 139 UNITED STATES TAX COURT REPORTS (67) 

stock is the same as the transferor’s basis in the transferred 

property, see sec. 358(a)(1), such that the transferor, upon 

sale of the stock, will generally then recognize any unrecognized gain or loss that inhered in the transferred property as 

of the time of its transfer. Where, however, the transferee 

corporation assumes a liability of the transferor incident to 

receiving the transferred property, then the transferor’s basis 

in the received stock is reduced by the amount of the 

assumed liability, unless (in relevant part) the payment of 

the assumed liability ‘‘would give rise to a deduction’’. See 

sec. 358(a)(1), (d); see also sec. 357(c)(3). 

Section 351(a) does not apply to the extent that the transferee’s stock received in the exchange is NQPS. See sec. 

351(g)(1). Section 351(b) requires that a transferor recognize 

any inherent gain in property transferred to a corporation in 

a section 351 exchange, to the extent of the amount of money 

and the fair market value of ‘‘other property’’ received in 

return, and NQPS is ‘‘other property’’ for that purpose. See 

sec. 351(g)(1)(B). If the only stock received by the transferor(s) in the exchange is NQPS, then the transfer is completely outside the nonrecognition rule of section 351(a). See 

sec. 351(g)(1). The parties agree that, if the class C stock is 

NQPS, then the basis in the class C stock sold to Wannell was 

$11,000 as of the time of that sale (rather than the claimed 

basis of $38 million) and, accordingly, that the sale did not 

result in the claimed loss. 

Section 351(g) was added to the Code as part of the Taxpayer Relief Act of 1997, Pub. L. No. 105–34, sec. 1014(a), 

111 Stat. at 919, generally effective for transactions after 

June 8, 1997. The special rule for NQPS was included in section 351 to remove from that nonrecognition provision ‘‘certain exchange transactions’’ where an ‘‘investor has * * * 

obtained a more secure form of investment’’ in the form of 

‘‘preferred stock’’. See H.R. Rept. No. 105–148, at 472 (1997), 

1997–4 C.B. (Vol. 1) 319, 794. For this purpose, ‘‘preferred 

stock’’ is ‘‘stock which is limited and preferred as to dividends and does not participate in corporate growth to any 

significant extent.’’ See sec. 351(g)(3)(A). With limited exceptions, none of which is applicable here, this preferred stock 

is then ‘‘nonqualified’’ (and thus NQPS) if the preferred stock 

meets any of the following four conditions: (1) the holder of 

the stock may require the issuer or a related person to 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 161

62Sec. 1.305–5(a), Income Tax Regs., states in relevant part: 

The term ‘‘preferred stock’’ generally refers to stock which, in relation to other classes of stock 

outstanding, enjoys certain limited rights and privileges (generally associated with specified dividend and liquidation priorities) but does not participate in corporate growth to any significant 

extent. The distinguishing feature of ‘‘preferred stock’’ for the purposes of section 305(b)(4) is 

not its privileged position as such, but that such privileged position is limited and that such 

stock does not participate in corporate growth to any significant extent. However, a right to participate which lacks substance will not prevent a class of stock from being treated as preferred 

stock. Thus, stock which enjoys a priority as to dividends and on liquidation but which is entitled to participate, over and above such priority, with another less privileged class of stock in 

earnings and profits and upon liquidation, may nevertheless be treated as preferred stock for 

purposes of section 305 if, taking into account all the facts and circumstances, it is reasonable 

Continued 

redeem or purchase the stock, (2) the issuer or a related person must redeem or purchase the stock, (3) the issuer or a 

related person may redeem or purchase the stock and, as of 

the issue date, it is more likely than not that this right will 

be exercised, or (4) the dividend rate on the stock varies in 

whole or in part (directly or indirectly) with reference to 

interest rates, commodity prices, or other similar indices. See 

sec. 351(g)(2)(A); see also sec. 351(g)(2)(B) and (C). 

Neither the statute, the regulations, nor the legislative history of section 351(g) defines the phrase ‘‘participate in corporate growth to any significant extent’’ for purposes of section 351(g)(3)(A). However, the regulations under section 305, 

which detail the tax consequences of certain distributions of 

stock and stock rights, use the same phrase to define the 

term ‘‘preferred stock’’ for purposes of section 305. Both parties rely upon those regulations under section 305 to interpret the phrase ‘‘participate in corporate growth to any 

significant extent’’ for purposes of section 351(g)(3)(A). So do 

we. See also 2 Martin D. Ginsburg & Jack S. Levin, Mergers, 

Acquisitions, and Buyouts, par. 604.3.1.1, at 6–87 (2012); 11 

Jacob Mertens, Law of Federal Income Taxation, sec. 43.8 

(2011). We also note that the definition of the term ‘‘preferred stock’’ as set forth in section 351(g)(3)(A) mirrors the 

text of section 1504(a)(4)(B), which is part of the description 

of preferred stock that is deemed not to be stock for purposes 

of determining the members of an affiliated group. We understand the principle there to be that ‘‘stock’’ described in section 1504(a)(4) has a limited claim on the earnings and 

equity of the issuer and, thus, is more akin to debt than to 

equity. 

Section 1.305–5(a), Income Tax Regs., contains regulations 

under section 305 that are relevant to our analysis. 62 Those 

162 139 UNITED STATES TAX COURT REPORTS (67) 

to anticipate at the time a distribution is made (or is deemed to have been made) with respect 

to such stock that there is little or no likelihood of such stock actually participating in current 

and anticipated earnings and upon liquidation beyond its preferred interest. Among the facts 

and circumstances to be considered are the prior and anticipated earnings per share, the cash 

dividends per share, the book value per share, the extent of preference and of participation of 

each class, both absolutely and relative to each other, and any other facts which indicate whether or not the stock has a real and meaningful probability of actually participating in the earnings and growth of the corporation. * * * 

63Petitioners gauge this reasonableness through the eyes of the class C shareholders, namely, 

CS and Wannell. We do not do the same. The answer to the question of whether stock participates in corporate growth under sec. 351(g) or sec. 1.305–5(a), Income Tax Regs., turns on a 

consideration of the attributes of that stock in the setting at hand, and a shareholder’s subjective expectations in buying the stock carry no weight in deciding that answer. 

regulations describe corporate growth for purposes of section 

305(b)(4) with reference to the corporation’s earnings and 

rights upon liquidation and indicate that the substance of a 

stock’s right to participate in corporate growth controls over 

mere written declarations that the stock is allowed to so 

participate. The regulations also indicate that in order for 

stock not to be characterized as ‘‘preferred stock’’, the 

attributes of the stock, when considered in the setting of the 

surrounding facts as of the time the stock is issued, must 

establish that it is reasonably likely that the stock will 

meaningfully participate in corporate earnings and growth 

beyond the stock’s preferred limited interests. 63 For this purpose, a corporation’s earnings and growth are best evidenced 

through the corporation’s payment of dividends and an 

increase in the corporation’s equity (e.g., through a retention 

of earnings, asset appreciation, or contributions), and the 

ability of a class of stock to participate in its issuer’s 

earnings and growth is best evidenced through the extent to 

which the stock is entitled to receive dividends and liquidation (including by way of the stock’s redemption) proceeds 

representing the corporation’s increased equity. Preferred 

stock is generally more akin to a secure form of debt than 

it is to a less secure form of equity in that preferred stock 

characteristically is entitled to receive without regard to corporate profits a set share of corporate earnings and/or liquidation proceeds (if not redeemed earlier). ‘‘Preferred stock’’ 

for purposes of sections 305 and 351(g) follows this characterization in that it enjoys limited rights and privileges with 

regard to dividends and liquidation proceeds and does not 

meaningfully participate in corporate growth beyond this 

amount. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 163

The class C stock fits squarely within the section 

351(g)(3)(A) definition of ‘‘preferred stock’’ as gleaned from its 

text (and the text of section 1504(a)(4)), from the legislative 

history under section 351(g), and from the referenced regulations under section 305. In relation to QHMC’s common stock 

(i.e., the class A stock), the class C stock enjoys set 

preestablished limited rights and privileges as to dividends 

and liquidation proceeds and does not participate in QHMC’s 

growth to a significant extent. In lieu of giving its holders a 

significant interest in QHMC’s corporate growth, the class C 

stock gives its holders a guaranteed fixed annual income 

preference in the form of a set, cumulative dividend and, 

upon that stock’s redemption (including incident to QHMC’s 

liquidation), a fixed payout that is unrelated to QHMC’s corporate growth (and, as of the time the stock was issued, was 

most likely to be $125 per share). While the class C stock by 

its terms states that its holders are entitled to receive 

redemption payments determined on the basis of cost savings 

or net equity, if those amounts are greater than $125 per 

share, this entitlement is meaningless in that the redemption 

provisions merely allow the class C shareholders to potentially share in the MPB cost savings, an allowance which 

under the facts herein is not akin to sharing in QHMC’s corporate growth. Moreover, this entitlement is unlikely to 

occur. Instead, as we find, the expected return on each share 

of the class C stock, when viewed as of the time the class C 

stock was issued, was capped at, and was intended and 

understood to be, 9.5% annually and $125 upon its redemption in five to seven years. 

The parties do not dispute the fact that the class C stock’s 

right to receive QHMC’s earnings annually is preferred, fixed, 

and limited. The class C stock, which QHMC specifically designated and labeled as preferred stock (as opposed to 

common stock), entitles its holders to receive from QHMC’s 

surplus or net profits, when and as declared by QHMC’s 

board, annual dividends of $9.50 per share, and these dividends are cumulative and payable for the current year and 

for all previous years before any dividend may be paid on 

QHMC’s common stock. The class C shareholders may not 

participate in or receive any dividends or share of profits, 

whether payable in cash, stock, or property, in excess of 

these dividends. The class C shareholders’ ability to particiVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00097 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
164 139 UNITED STATES TAX COURT REPORTS (67) 

64We use the term ‘‘redemption rights’’ to include the class C shareholders’ rights upon 

QHMC’s liquidation or upon QHMC’s earlier redemption of those shares. 

pate significantly in corporate growth, therefore, rests on 

their redemption rights. 64

Respondent argues that the class C stock’s redemption 

rights do not give the class C shareholders a meaningful 

interest in QHMC’s corporate growth. We agree. Any participation rights formally set forth in the redemption provisions 

applicable to the class C stock are illusory in that the class 

C shareholders, upon redemption of their stock, are reasonably foreseen, as of the time that the class C stock was 

issued, to be entitled to receive only a preferred and limited 

amount of QHMC’s assets equal to $125 a share. Contrary to 

petitioners’ position, the formula value will not operate to 

allow those shareholders to receive more than that set 

amount. The formula value is simply a clever facade disguising the fact that the class C shareholders have no meaningful rights to the liquidation proceeds of QHMC beyond the 

$125-per-share preferred amount. While the formula value 

on its face was carefully and artfully tailored to appear to 

allow for the possibility of a larger payout upon the class C 

stock’s redemption, the formula value also was carefully and 

artfully tailored so that the possibility of a larger payout 

lacks any meaningful substance in that ‘‘it is reasonable to 

anticipate at the time a distribution is made (or is deemed 

to have been made) with respect to such stock that there is 

little or no likelihood of such stock actually participating in 

current and anticipated earnings and upon liquidation 

beyond its preferred interest.’’ Sec. 1.305–5(a), Income Tax 

Regs. In fact, as we conclude from the record at hand, when 

the class C stock was issued, the reasonable likelihood was 

that the stock would fail to meaningfully participate in corporate earnings at all, given that QHMC had no accumulated 

earnings when the class C stock was issued and that QHMC

was reasonably expected to have little to no earnings before 

the class C stock was most likely to be redeemed. 

Petitioners rely heavily upon the ‘‘cumulative net savings’’ 

prong of the formula value to argue that the class C shareholders have an opportunity to participate in QHMCs’ growth 

and earnings beyond their preferred interest. As petitioners 

see it, the class C shareholders participate in QHMC’s growth 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 165

65 All three experts agreed that the net equity component of the formula value would not be 

triggered through at least the end of TYE 2011. While Strombom and Eisenstadt concluded that 

Continued 

on the basis of cost savings produced in managing the MPB

obligations. In other words, they state, the greater the 

amount of savings, the more the QHMC class shareholders 

may participate in QHMC’s growth. We see things differently. 

The redemption provisions apply when QHMC is liquidated, 

if QHMC exercises its call option after September 30, 2002, or 

if a class C shareholder exercises the shareholder’s put 

option after September 30, 2004. When one of those events 

occurs, a class C shareholder is entitled to receive the greater 

of $125 per share or the formula value. The formula value 

is stated to be the amount that is the lesser of: (1) 45% of 

the cumulative cost savings as to the MPBs or (2) 50% of the 

net equity (i.e., assets minus liabilities) as of the time of 

redemption, as shown on QHMC’s books and records through 

the application of Generally Accepted Accounting Principles. 

Thus, under the redemption provisions, when $125 is 

greater than or equal to the formula value, class C shareholders are entitled to receive no more than $125 for each of 

their shares. In that circumstance, the class C shareholders’ 

right to participate in liquidation proceeds is capped at $125 

per share, and class C shareholders may not participate in 

QHMC’s liquidation proceeds beyond the stock’s limited preference. 

If, on the other hand, $125 is less than the formula value, 

then the class C shareholders are entitled to receive the 

amount of the formula value. In that case, Ross tells us (and 

we agree), any redemption payment to the preferred shareholders would depend solely on cumulative cost savings, not 

on the amount of net equity, no matter how much QHMC may 

realistically grow. Such is so, Ross explains, because 50% of 

net equity will under the facts herein always exceed 45% of 

the MPB cash savings, and the net equity component of the 

formula value will therefore never control the formula value. 

This is partly because QHMC’s net equity as of the start of the 

QHMC transactions was artificially high because the MPB

obligations transferred to QHMC were neither reportable nor 

reported as a liability under Generally Accepted Accounting 

Principles, and QHMC’s net equity was anticipated to remain 

artificially high through the end of TYE 2011. 65 The ‘‘lesser 

166 139 UNITED STATES TAX COURT REPORTS (67) 

the net equity component could be operative in TYE 2012, Ross has persuaded us that their 

conclusion is wrong because, when the class C stock was issued, the preferred stock was reasonably foreseen to be redeemed before TYE 2012. As Ross noted, QHMC’s preferred stock had a 

five- and seven-year redemption right, and it was virtually certain that the class B and class 

C stocks, if the shareholders and QHMC acted reasonably, would be redeemed by October 2004. 

Such is so because by that time, (1) the value that QHMC would have to pay the preferred 

shareholders upon exercise would be less than the value QHMC would have to pay the shareholders in the absence of exercise (namely, future dividends and other amounts resulting from 

the stock’s redemption) or (2) the shareholders’ exercise price would be greater than the value 

QHMC would have to pay them in the absence of exercise. Thus, Ross noted (and we agree), 

as of the time that the preferred stock was issued, either QHMC or the preferred shareholders 

would consider it economical to redeem the preferred shares at their earliest opportunity; i.e., 

no later than October 2004. Ross also opined persuasively that Quanex had an economic incentive to redeem the preferred stock as soon as it could (October 1, 2002) because, if it did, then 

Quanex could deduct all of the MPB expenses incurred, which amount was most likely going 

to be larger than the corresponding interest expense Quanex deducted. 

66Further, QHMC’s reduction of costs did not necessarily mean that QHMC would grow, e.g., 

any cost reduction could be accompanied by a decline in the value of QHMC’s assets. Yet if the 

cost savings exceeded the $125 threshold, the additional cost savings would increase the redemption price without a corresponding growth of QHMC. 

of ’’ provision in the formula value, therefore, eliminated any 

realistic possibility that the class C stock would participate 

in QHMC’s net equity. 

As to the formula value’s cost savings provision, this provision does not amount to a participation in corporate growth. 

The redemption provisions gave the preferred shareholders 

an interest in reducing the amount of the MPB obligations 

assumed by QHMC, as opposed to participating in QHMC’s corporate growth, and reducing those obligations will not necessarily generate earnings for QHMC or otherwise cause QHMC

to grow following the issuance of the class C stock. QHMC’s 

sole source of income was interest, and under each of D&T’s 

cashflow models, QHMC’s interest income for 1998 through 

2012 was projected to be substantially less than the projected 

MPB costs. MPB costs would have to be reduced by an amount 

significantly higher than petitioners’ projections for QHMC to 

have earnings; and we are not persuaded that, when the 

class C stock was issued, it was probable that those costs 

would be so reduced in the relevant future. In addition, even 

if QHMC were to have grown as of the time of the class C 

stock’s redemption (e.g., it invested its assets profitably), the 

class C shareholders would receive none of that growth if 

there were no cost savings. Instead, the benefit of the growth 

in that case would go only to Quanex, as the holder of QHMC’s 

common stock. 66 We conclude that the cost savings component of the formula value does not allow the class C stock to 

participate in QHMC’s corporate growth. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 167

67 In Black & Decker Corp. v. United States, 436 F.3d 431, 433 (4th Cir. 2006), a taxpayer 

transferred $561 million to a controlled subsidiary in exchange for stock in the subsidiary and 

the subsidiary’s assumption of $560 million in contingent medical liabilities. The taxpayer 

claimed that its basis in the subsidiary’s stock was $561 million and that it realized a $560 million capital loss when it sold the stock for $1 million. Id. at 434–438. The taxpayer claimed that 

the liabilities were excluded under sec. 357(c)(3) and that, under sec. 358(d)(2), the taxpayer did 

not need to reduce its basis in the subsidiary stock by the liabilities assumed by the subsidiary. 

Id. at 434. In Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1344 (Fed. Cir. 2006), the taxpayer transferred $375 million to one of its subsidiaries in exchange for stock in the subsidiary 

and the subsidiary’s assumption of contingent asbestos-related liabilities against the taxpayer. 

The taxpayer claimed that the liabilities were excluded under sec. 357(c)(3) and, under sec. 

358(d)(2), did not reduce its basis in the subsidiary stock. Id. at 1345–1346. The taxpayer asserted a $379.2 million basis in the subsidiary stock and claimed a $378.7 million loss when 

it sold the stock for $500,000. Id. 

In sum, we find that the class C stock vis-a-vis QHMC’s 

common stock enjoys certain limited and preferred rights and 

privileges associated with dividend and liquidation priorities 

and that the class C stock, as of the time the stock was 

issued, did not actually allow the holders thereof to participate in QHMC’s corporate growth to a significant extent. We 

hold that the class C stock is NQPS. Given the parties’ agreement that such a holding means that petitioners are not entitled to deduct the short-term capital loss, we reach the same 

conclusion. 

C. Economic Substance Doctrine 

1. Overview 

Given our just-stated holding, we need not decide any of 

the parties’ other disputes as to the claimed loss. We bear in 

mind, however, that respondent maintains that the QHMC

transactions are disregarded for Federal income tax purposes 

under the economic substance doctrine and that two Courts 

of Appeals have discussed this doctrine in the setting of similarly structured transactions. See Coltec Indus., Inc. v. 

United States, 454 F.3d 1340 (Fed. Cir. 2006); Black & 

Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006). 67

We also note that respondent determined that the fees 

incurred to effect the QHMC transactions were not ordinary 

and necessary business expenses and clarifies in his brief 

that such is so because those transactions lacked economic 

substance. We consider it necessary to decide whether the 

QHMC transactions had economic substance, and we proceed 

to do so. 

168 139 UNITED STATES TAX COURT REPORTS (67) 

68 Congress codified the economic substance doctrine mostly as articulated by the U.S. Court 

of Appeals for the Third Circuit in ACM P’ship v. Commissioner, 157 F.3d 231, 247–248 (3d Cir. 

1998), aff ’g in part, rev’g in part T.C. Memo. 1997–115. See sec. 7701(o) (as added to the Code 

by the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111–152, sec. 1409, 

124 Stat. at 1067); see also H.R. Rept. No. 111–443(I), at 291–299 (2010), 2010 U.S.C.C.A.N. 

123, 222–231. The codified doctrine does not apply here, pursuant to its effective date. 

69 In Gregory v. Helvering, 293 U.S. 465, 469–470 (1935), the Supreme Court held that a reorganization complying with formal statutory requirements was disregarded for tax purposes because the creation and immediate liquidation of the transferee corporation was an attempt to 

2. Standard of Analysis 

D&T and Quanex structured the QHMC transactions as an 

elaborate and devious multistep transaction, each individual 

step of which D&T promoted as meeting a literal reading of 

the Code, the regulations thereunder, and various judicial 

and administrative interpretations. The essence of the transactions, however, was simply to create an artificial multimillion-dollar tax loss that petitioners could report as an 

offset to their unrelated capital gains of a similar amount. 

Although taxpayers may structure their business transactions in a manner that produces the least amount of tax, 

see Boulware v. United States, 552 U.S. 421, 430 n.7 (2008) 

(citing Gregory v. Helvering, 293 U.S. 465, 469 (1935)); 

Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 781 

(5th Cir. 2001), rev’g 113 T.C. 214 (1999), the economic substance doctrine requires that a court disregard a transaction 

that a taxpayer enters into without a valid business purpose 

in order to claim tax benefits not contemplated by a reasonable application of the language and the purpose of the Code 

or the regulations thereunder, 68 see, e.g., ACM P’ship v. 

Commissioner, 157 F.3d 231, 248 (3d Cir. 1998), aff ’g in part, 

rev’g in part T.C. Memo. 1997–115; Rice’s Toyota World, Inc. 

v. Commissioner, 752 F.2d 89, 91–92 (4th Cir. 1985), aff ’g in 

part, rev’g in part 81 T.C. 184 (1983); New Phoenix Sunrise 

Corp. & Subs. v. Commissioner, 132 T.C. 161 (2009), aff ’d, 

408 Fed. Appx. 908 (6th Cir. 2010); Blum v. Commissioner, 

T.C. Memo. 2012–16; Palm Canyon X Invs., LLC v. Commissioner, T.C. Memo. 2009–288. Such a transaction is disregarded even though it may otherwise comply with the literal terms of the Code and the regulations thereunder. See, 

e.g., Coltec Indus., Inc., 454 F.3d at 1351–1355. 

While the origin of the economic substance doctrine is generally traced to the Supreme Court’s holding in Gregory v. 

Helvering, 69 293 U.S. 465, current application of the doctrine 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 169

convert ordinary income into capital gain. The Court recognized the right of a taxpayer to avoid 

the payment of tax through legal means but noted that ‘‘the question for determination is 

whether what was done, apart from the tax motive, was the thing which the statute intended.’’ 

Id. at 469. The Court examined the applicable statutory text and held that the taxpayer had 

not formed a corporation within the intended meaning of the statute. Id. at 470. The Court stated that the undertaking was ‘‘in fact an elaborate and devious form of conveyance masquerading 

as a corporate reorganization, and nothing else’’ and ‘‘upon its face lies outside the plain intent 

of the statute.’’ Id. 

stems primarily from the Supreme Court’s decision in Frank 

Lyon Co. v. United States, 435 U.S. 561 (1978). In Frank 

Lyon Co., 435 U.S. at 566–568, the taxpayer borrowed $7.1 

million from one bank, bought a building from another bank 

for $7.6 million, and leased the building back to the same 

bank which had sold the property for rent equal to the taxpayer’s payments of principal and interest on the $7.1 million 

loan. The taxpayer claimed depreciation deductions on the 

building and interest deductions on the loan and reported the 

payments from the bank as income from rent. Id. at 573. The 

United States argued that the transaction should be disregarded because it was merely an elaborate financing 

scheme designed to manufacture tax deductions. Id. The 

Court disagreed, holding that the transaction was not a 

sham. Id. at 583–584. The Court set forth the following 

standard for determining when a transaction should be 

respected for tax purposes: 

[W]here, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not 

shaped solely by tax-avoidance features that have meaningless labels 

attached, the Government should honor the allocation of rights and duties 

effectuated by the parties. * * * [Id.] 

The Courts of Appeals have construed the quoted language 

as creating an economic substance doctrine with the following two prongs: (1) whether the transaction had economic 

substance beyond tax benefits (objective prong), and (2) 

whether the taxpayer had a nontax business purpose for 

entering the disputed transaction (subjective prong). See, e.g., 

ACM P’ship v. Commissioner, 157 F.3d at 247–248; Bail 

Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 

1543, 1549 (9th Cir. 1987), aff ’g T.C. Memo. 1986–23; Rice’s 

Toyota World, Inc. v. Commissioner, 752 F.2d at 91–92. The 

Courts of Appeals are split on the proper weight to be given 

to these prongs in deciding whether to respect a transaction 

170 139 UNITED STATES TAX COURT REPORTS (67) 

70 At the time of the original and supplemental briefings in this case, the Court of Appeals 

for the Fifth Circuit had not decided how it would apply the economic substance test. See, e.g., 

Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 781 (5th Cir. 2001) (declining to adopt 

a particular approach and finding that a transaction had both economic substance and a legitimate business purpose and stating that the transaction had economic substance under any approach), rev’g 113 T.C. 214 (1999). The Court of Appeals later decided Klamath Strategic Inv. 

Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009), on which we rely in this Opinion. 

under the economic substance doctrine, and alternative 

approaches have emerged. Some Courts of Appeals apply a 

disjunctive analysis, under which a transaction is valid if it 

has economic substance or a business purpose. See, e.g., Horn 

v. Commissioner, 968 F.2d 1229, 1236–1238 (D.C. Cir. 1992), 

rev’g Fox v. Commissioner, T.C. Memo. 1988–570; Rice’s 

Toyota World, Inc. v. Commissioner, 752 F.2d at 91. Other 

Courts of Appeals apply a conjunctive analysis, under which 

a transaction is valid only if the transaction has economic 

substance beyond tax objectives and the taxpayer had a 

nontax business purpose for entering into the transaction. 

See Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th 

Cir. 2006); Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 

1313, 1316 (11th Cir. 2001), aff ’g 113 T.C. 254 (1999); United 

Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014, 

1018 (11th Cir. 2001), rev’g T.C. Memo. 1999–268. Still other 

Courts of Appeals adhere to the view that a lack of economic 

substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax 

avoidance. See, e.g., Coltec Indus., Inc., 454 F.3d at 1355. 

And still other Courts of Appeals treat the objective and 

subjective prongs merely as factors to consider in determining whether a transaction has any practical economic 

effects beyond tax benefits. See, e.g., ACM P’ship v. Commissioner, 157 F.3d at 248. 

Under Golsen v. Commissioner, 54 T.C. at 757, we follow 

a holding of a court to which appeal lies that is squarely on 

point. The Court of Appeals for the Fifth Circuit, to which 

this case is appealable absent a stipulation to the contrary, 

has interpreted the economic substance test delineated in 

Frank Lyon Co., 435 U.S. 561, as ‘‘a multi-factor test’’. See 

Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 

537, 544 (5th Cir. 2009). 70 In Klamath Strategic Inv. Fund, 

LLC, 568 F.3d at 544, the Court of Appeals for the Fifth Circuit stated that the relevant factors include whether the 

transaction (1) has economic substance compelled by busiVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00104 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 171

ness or regulatory realities, (2) is imbued with tax-independent considerations, and (3) is not shaped totally by taxavoidance features. The court stressed that in Frank Lyon 

Co., 435 U.S. at 583–584, the Supreme Court phrased the 

factors in the conjunctive. See Klamath Strategic Inv. Fund, 

LLC, 568 F.3d at 544. The court concluded that a taxpayer’s 

failure to meet any one of these three factors renders the 

transaction void for tax purposes. Id. The court noted that ‘‘if 

a transaction lacks economic substance compelled by business or regulatory realities, the transaction must be disregarded even if the taxpayers profess a genuine business 

purpose without tax-avoidance motivations.’’ Id. 

3. QHMC Transactions 

a. Objective Economic Substance 

i. Background 

Petitioners point to several factors supporting their argument that the QHMC transactions had objective economic substance. According to petitioners, QHMC engaged in numerous 

bona fide economically based transactions in managing the 

MPB obligations. QHMC assumed liability for the health care 

claims of a large portion of Quanex’s employees, took on the 

role of managing health care costs, and developed health care 

cost containment strategies that Quanex implemented and 

which resulted in demonstratable cost savings. Petitioners 

also argue that the QHMC transactions affected petitioners’ 

net economic position, their legal relations, and their nontax 

business interests. Petitioners contend that while the transactions presented a reasonable possibility of controlling 

health care costs that would otherwise be borne by petitioners, the transactions were attended by a real risk that 

the objective of controlling health care costs would not be 

achieved. 

In further support of their argument for objective economic 

substance, petitioners assert that they projected that the 

QHMC transactions could result in a substantial pretax profit 

and a substantial yield on petitioners’ cash investment. 

Strombom concluded that there was a reasonable expectation 

that the nontax benefits from the QHMC transactions would 

be at least commensurate with the transaction costs. 

172 139 UNITED STATES TAX COURT REPORTS (67) 

71Strombom calculated petitioners’ net present value from pursuing the QHMC transactions 

under the assumption that the transactions had no tax implications. In measuring the net 

present value of the transactions, Strombom determined the timing of the incremental cashflows 

that would result from the transactions. The incremental cashflows included: the parties’ initial 

investments in QHMC, any medical savings realized by QHMC relative to the benchmark, dividends, consulting fees, and the cashflows to the parties when QHMC repurchased the preferred 

stock. For purposes of these calculations, Strombom also assumed that petitioners incurred 

$352,251 of transaction costs. 

Strombom compared the present value of the savings under 

various assumptions regarding QHMC’s ability to generate 

medical cost savings and the time when QHMC repurchases 

its preferred shares. 71 Strombom’s calculations show that 

petitioners would realize nontax benefits with a present 

value of over $600,000 if medical benefits costs were 10% less 

than projected and QHMC repurchased the preferred shares 

after seven years. Petitioners point to the track record of successes by CS and Wannell in reducing petitioners’ health 

care costs to justify their expectation that QHMC could obtain 

additional future savings. Expected values of incremental 

savings in the range of 5% to 15% were also shown to be 

reasonable given the recent success of other businesses, and 

of petitioners themselves, in reducing health care spending. 

Petitioners conclude that these factors demonstrate that 

there was a reasonable possibility of earning a pretax profit 

as a result of the QHMC transactions. 

The record does not support petitioners’ contention that 

the QHMC transactions had objective economic substance. To 

the contrary, the record establishes that the QHMC transactions were structured (from a generic product D&T promoted to petitioners) and implemented to manufacture an 

approximately $38 million artificial tax loss and without 

serious regard to Quanex’s desire to reduce its medical benefit costs. We base our holding on our analysis of the factors 

discussed in the following parts ii. and iii. 

ii. Lack of Substantive Changes as a Result of QHMC 

Transactions 

Although as early as 1996 or 1997 Quanex and CS had 

general discussions regarding a possible joint venture as a 

long-term approach to controlling Quanex’s health care costs, 

QHMC did not become that joint venture. Despite petitioners’ 

assertions, QHMC did not serve any meaningful purpose and 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 173

nothing of substance changed as a result of the QHMC transactions. 

The record contains no evidence that QHMC conducted any 

type of business operations. QHMC had no employees of its 

own. Except for Wannell, each class A director was a Quanex 

employee when he or she was elected. Except for two Fulbright attorneys, each QHMC officer was a Quanex employee 

when he or she was elected. Parikh, who served as a QHMC

board member, vice president, and treasurer, testified that 

he had no specific daily activities or responsibilities to perform for QHMC. Peery, who also was a QHMC board member 

and vice president from October 23, 1997, through April 9, 

1999, testified that he was not involved in QHMC’s operations 

and that he did not know he was a QHMC officer. As class C 

shareholders, CS performed the same consulting work it had 

provided for Quanex in the past and Wannell played virtually no role in developing or implementing any cost savings 

strategies. 

In addition, petitioners carried on the administration of the 

transferred MPB obligations as if QHMC did not exist. Petitioners continued after the QHMC transactions to process the 

claims for the MPBs transferred to QHMC in the same manner 

as before the QHMC transactions, and the QHMC-covered 

employees’ claims were not handled differently from other 

employees’ claims that were not transferred to QHMC. Petitioners paid for all the costs associated with processing the 

MPB claims, and QHMC paid no fees to petitioners for these 

services. Petitioners also initially paid the medical claims 

costs and the employer’s share of HMO premiums for or 

related to the transferred MPBs. Petitioners handled these 

payments through their treasury department in the same 

manner that such costs were handled for all of their 

employees. While QHMC subsequently reimbursed petitioners 

for the employees’ claims and the employer’s share of the 

HMO premiums that petitioners paid, QHMC’s reimbursement 

was tied directly to its receipt of payments on the Piper note 

and other loans to various subsidiaries of petitioners. These 

notes represented QHMC’s sole source of income, as QHMC’s 

business came solely from petitioners. Petitioners fail to 

explain why QHMC made these loans, and we find them to be 

an arrangement by which petitioners could continue to pay 

174 139 UNITED STATES TAX COURT REPORTS (67) 

72We also note that Strombom failed to consider potentially perverse incentives resulting from 

the QHMC transactions, which might result in cost increases instead of cost savings. For example, because the preferred shareholders would share the benefits of any cumulative cost savings 

with Quanex, but Quanex alone would bear the burden of any cost increase, the preferred shareholders have an incentive to engage in high-risk strategies that have some potential to result 

in large cost savings but which in fact result in large cost increases. 

for the costs of the MPBs, despite QHMC’s assumption of the 

MPB obligations. 

iii. Lack of Reasonable Expectation of Nontax Benefits on 

Petitioners’ Part 

We are not persuaded by Strombom’s projections that the 

QHMC transactions would result in any meaningful nontax 

benefit for petitioners. To the contrary, the economic consequences of the transactions were inconsequential when 

compared with the tax benefits to be received. As Ross 

persuasively observes, Strombom’s conclusion that the QHMC

transactions had a reasonable possibility of nontax benefits 

is flawed because he failed to take into account the probability of petitioners’ attaining any cost savings at all, let 

alone the probability of achieving any particular magnitude 

of cost savings. Petitioners provide no support for the probability that the assumed cost savings would occur. 

Even more significantly, as Ross points out, Strombom’s 

calculations are flawed because he considers any medical 

savings realized by QHMC to be incremental cashflows attributable to the QHMC transactions. In other words, Strombom 

assumes that any cost savings achieved by QHMC (or, more 

accurately, CS) are the result of the formation of QHMC and 

its management of the assumed MPB obligations. However, 

only medical savings realized by QHMC that petitioners would 

not have obtained in the absence of the QHMC transactions 

should constitute incremental cashflows in Strombom’s analysis. Petitioners and CS were achieving cost savings before 

the QHMC transactions through their prior consulting 

arrangement. Because Strombom does not factor in the medical savings that petitioners would have obtained without the 

QHMC transactions or demonstrate that the cost savings are 

linked to the formation of QHMC, his projections as to the cost 

savings produced by the QHMC transactions are inherently 

flawed. 72 We reject petitioners’ argument that the QHMC

transactions had a reasonable expectation of nontax benefits. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 175

b. Subjective Business Purpose 

i. Background 

Petitioners argue that they entered into the QHMC transactions for the business purpose of making a profit and not 

for the sole purpose of obtaining tax benefits. Petitioners 

assert that they hoped to achieve cost savings through isolating and controlling contingent liabilities for Quanex’s 

health care costs. According to petitioners, because Quanex 

spent millions of dollars every year on its employee health 

benefits, controlling the growth of these costs represented an 

important and useful business purpose. Petitioners claim 

that they conducted an extensive pretax and aftertax analysis that evaluated the risks of engaging in the deal and concluded that the transactions would be profitable. Petitioners 

argue that they sold the class C stock to CS and to Wannell 

to allow them to retain a portion of the net health care 

savings they produced, thus providing an incentive to lower 

the cost of QHMC’s medical benefits. CS and Wannell, petitioners argue, were not accommodating a tax shelter scheme 

but had special expertise in the management of health care 

costs and had valid business reasons for entering the transactions. Petitioners contend that the transactions were 

rationally related to a useful nontax purpose that addressed 

petitioners’ economic concerns over rising health care costs. 

On the basis of our analysis of petitioners’ motives for 

entering the QHMC transactions, we find that petitioners 

have failed to establish a business purpose for the QHMC

transactions. While petitioners make general statements 

about cutting health care costs, they offer little explanation 

as to how the QHMC transactions furthered that goal. Accordingly, we decline to conclude that petitioners have met their 

burden of proving that they entered into the QHMC transactions for the purpose of reducing their health care costs. 

Rather, the record and reasonable inferences drawn therefrom support a conclusion that petitioners’ purported business purpose was merely window dressing conceived in an 

attempt to satisfy Federal tax law while manufacturing high 

basis stock that they preplanned to sell to generate a large 

artificial tax loss. We base our holding on our analysis of the 

176 139 UNITED STATES TAX COURT REPORTS (67) 

following four factors, discussed in the following parts ii., iii., 

iv., and v. 

ii. Petitioners’ Entering Into QHMC Transactions Solely as 

Means To Generate Artificial Capital Loss To Offset 

Capital Gains 

Petitioners did not implement the QHMC transactions for a 

nontax business reason. To the contrary, the QHMC transactions stemmed from a turnkey tax shelter that was 

designed and promoted by D&T and was quickly implemented with prearranged steps designed to generate an 

artificial multimillion-dollar tax loss to offset petitioners’ 

unrelated multimillion-dollar capital gains. Singer, on behalf 

of D&T, initially introduced petitioners to the idea of using 

the QHMC transactions as a method of achieving tax avoidance. Singer sought out petitioners for a contingent liability 

transaction because of their foreseen capital gains, not 

because of any desire to reduce their health care costs, and 

petitioners retained D&T for tax advice on the transaction, 

including a proposed course of action to effect that advice. 

Singer and Schneider, the two D&T professionals who were 

most connected with the implementation of the QHMC transactions, specialized in tax advice; the record does not establish, nor do we find, that either of them also was a competent 

adviser on the legitimate savings of health care costs. 

The QHMC transactions were consummated after the 

planting of that initial seed; i.e., the claim that a significant 

noneconomic loss could be artificially generated on the basis 

of a literal reading of the Code and the regulations and 

administrative rulings thereunder, sufficient to offset petitioners’ anticipated capital gains. The use of D&T’s tax 

shelter promotion drove the planning and the consummation 

of the QHMC transactions, with each step of the transaction 

prearranged and with the intended goal of tax avoidance in 

sight, and was specifically designed to mask the QHMC transactions with an appearance of legitimacy. Petitioners’ recruitment of Chapman and Wannell as necessary participants in 

the transactions was then done without negotiations over the 

terms of the transactions, but with Quanex’s offer of an 

essentially guaranteed and risk-free return. Quanex was in 

such a hurry to implement the QHMC transactions to genVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00110 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 177

73Petitioners already had the escrow account to cover their potential exposure to the environmental liabilities. 

erate the desired loss for TYE 1997 that its board in a single 

sitting approved each step of the transactions at or shortly 

after the time that the board was first asked to consider 

them. The fact that the QHMC transactions were designed to 

accomplish the single objective of tax savings is further seen 

by the short time in which all of the prearranged steps were 

taken. 

The approximately $38 million loss generated by the QHMC

transactions was prearranged, artificial, and intentional. 

Singer represented to petitioners that the revenue ruling 

made tax benefits available to them through a contingent 

liability transaction. Singer based his representation on 

knowledge he obtained from the DDCL, which stated that 

through the proper structuring of a series of transactions 

that revolved around the use of an environmental management company and the sale of some of its stock outside the 

group at a loss, a taxpayer may be allowed immediately to 

deduct a capital loss equal to the amount of the environmental reserve and to deduct an additional amount when an 

expenditure was actually made to satisfy the accrued 

liability. Relying on the DDCL and the revenue ruling, D&T 

and petitioners discussed the possibility of placing some of 

Quanex’s liabilities in a separate entity through a similar 

series of transactions so as to generate a significant reportable artificial loss. Singer initially proposed structuring the 

transaction using environmental liabilities, but Rose opted 

for medical liabilities. 73

Singer and petitioners intended to use the contingent 

liability transaction as a means to generate a substantial 

capital loss that could be used to offset the capital gains 

resulting from the impending sales of LaSalle and the Tube 

Group. While developing the QHMC transactions, petitioners 

were finalizing the LaSalle and Tube Group sales that would 

result in millions of dollars in capital gains to petitioners. 

Rose and Singer both knew of the LaSalle deal when Singer 

introduced the idea of the QHMC transactions, and Rose also 

knew that petitioners were trying to sell the Tube Group 

when Singer and petitioners discussed using a joint venture 

to manage the MPB obligations. Singer worked on the LaSalle 

178 139 UNITED STATES TAX COURT REPORTS (67) 

74The predetermined loss to be recognized as part of the QHMC transactions was 

$37,989,000, while the capital gain ultimately recognized by petitioners on the sale of its interests in LaSalle and the Tube Group was $41,156,128. 

sale during the time he worked on the QHMC transactions, 

and Singer knew that petitioners expected a large capital 

gain on the sale. 

Importantly, petitioners arranged the QHMC transactions so 

that the amount of liabilities transferred to QHMC, and thus 

the amount of capital loss, would be enough to offset the 

anticipated gains from the LaSalle and Tube Group sales. 74

Before the QHMC transactions closed, Singer and Royce discussed the hypothetical amount of capital gain on the 

LaSalle sale. In a footnote appearing in several outlines of 

the proposed QHMC transactions, D&T references the 

assumed gains resulting from the LaSalle and Tube Group 

sales with regard to the amount of liabilities to be transferred. The amount of liabilities transferred to QHMC thus 

was determined by anticipated tax benefits and not by any 

purported business purpose. 

With respect to the footnote in the August 6 outline, 

Singer, Royce, and Rose testified that the footnote referred to 

the amount of contingent liabilities D&T mistakenly expected 

LaSalle and MST to contribute to QHMC. Singer testified that 

the footnote was in error because LaSalle and MST were sold 

or in the process of being sold as of the date of the August 

6 letter. Singer further testified that the footnote was erroneous because Quanex intended to use liabilities from core 

businesses, and LaSalle and MST were not core businesses. 

Royce testified that the names of the entities contributing 

the liabilities were not relevant as of August 6, 1997, and 

that only the structure of the transactions was relevant at 

that time, so that if D&T operated under the assumption that 

LaSalle was contributing MPBs, that would not necessarily 

lead Quanex to the wrong conclusions. Rose testified that he 

did not instruct D&T or Singer that the amount of the 

liability that was going to be transferred to QS in the planning of the transactions should be related to the amount of 

gain on the sales of LaSalle and MST. 

We reject the testimony of Singer, Royce, and Rose on this 

point as not credible. No version of the D&T proposal ever 

mentioned any cash or MPB contributions from LaSalle, MST, 

or GST. The LaSalle sale closed on April 18, 1997, almost four 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 179

months before the August 6 letter, and as of August 6, 1997, 

Quanex, which was guiding the QHMC transactions’ revision 

process through Royce, knew LaSalle would not be available 

to provide MPBs because it had been sold. Singer, who helped 

prepare and review the August 6 outline, worked on the 

LaSalle sale and knew LaSalle had been sold by that time. 

In our finding that the footnote addressed the gains on the 

assets sales rather than the MPBs that LaSalle and the Tube 

Group would contribute, we give weight to the Mooney 

memorandum. The Mooney memorandum addressed various 

items that Mooney believed were incorrect in the August 6 

outline, and it did not state that the footnote in the August 

6 outline was in error or otherwise address the footnote. The 

Mooney memorandum also did not indicate that anyone had 

commented on the footnote or had questioned why LaSalle 

and the Tube Group, which Quanex had sold or was in the 

process of selling, would contribute MPBs to QHMC. Also, 

Schneider testified that he understood the phrase ‘‘$36 million pertains to LaSalle’’ to refer to the anticipated gain on 

the LaSalle sale. Although Schneider also testified that 

Singer should be relied on to interpret a difference of opinion 

as to the meaning of something in the August 6 outline 

because only Singer signed the letter, we find Schneider’s 

testimony on this issue more credible. Accordingly, we find, 

on the basis of the evidence in the record as a whole, that 

the footnote referred to the amounts of anticipated gains on 

the LaSalle and the Tube Group sales. 

iii. Petitioners’ Selection of Transferred MPBs Without 

Regard to Effective Medical Cost Management 

The manner in which petitioners selected the pool of medical liabilities to be assumed by QHMC also demonstrates that 

petitioners lacked a valid business purpose for entering into 

the QHMC transactions. Petitioners, after estimating the 

amount of their anticipated capital gains, selected the necessary amount of MPB obligations to transfer to QHMC to 

achieve the desired capital loss. Petitioners offer no rationale 

as to why they selected the particular MPB obligations transferred, and the record lacks any evidence suggesting that the 

selection of the MPB obligations related to managing the MPB

obligations in an effective and cost-efficient manner. In addiVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00113 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
180 139 UNITED STATES TAX COURT REPORTS (67) 

75For example, CS worked extensively on implementing a PPO plan for all Quanex employees 

as a cost savings strategy. 

tion, while Royce and Rose, Quanex’s tax director and CFO, 

respectively, played active roles in choosing which MPB

obligations were to be transferred, Peery, Quanex’s vice 

president of human resources, who was in charge of 

employee benefits and the most knowledgeable source for 

Quanex’s employee health benefits problems, made no recommendation about the groups of employees or the types of 

health care benefits to be included in the QHMC transactions. 

Additionally, Wannell and CS, on whose expertise petitioners 

had purportedly planned to capitalize in the QHMC transactions, were not consulted regarding the medical liabilities 

transferred to QHMC and did not participate in any decisions 

concerning liability selection. 

iv. Equity Interest in QHMC Granted to CS and Wannell 

as Meaningless Incentive To Reduce Health Care Costs 

Although petitioners proffer a potentially valid purpose of 

offering equity incentives to Wannell and CS, the formation 

of QHMC as a healthcare management company was meaningless given that CS managed Quanex’s healthcare costs in the 

same manner both before and after the QHMC transactions. 

While CS did a greater amount of work for Quanex after the 

formation of QHMC, the nature of CS’ work did not change. 

Petitioners continued to provide data to CS for all Quanex 

employees, and CS advanced potential medical savings 

strategies for all Quanex employees, not just those whose 

medical benefit obligations petitioners assigned to QHMC. 75

Additionally, CS continued to bill petitioners in the same 

manner it had before the QHMC transactions, failing to make 

any specific reference to QHMC or to the covered groups. CS 

thus maintained essentially the same business relationship 

with Quanex before and after the QHMC transactions, continuing to give its best effort in performing the exact same 

consulting services it had before the transactions. The argument that the QHMC transactions encouraged CS to provide 

better services because of its new shareholder status does not 

conform with the evidence in the record. 

The record also does not support petitioners’ argument 

that petitioners wanted Wannell to own class C stock as an 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 181

incentive. Wannell’s involvement with QHMC was extremely 

limited. Wannell attended just two board meetings, and he 

did not participate in any other aspect of QHMC’s business. 

Quanex’s health care benefits personnel never discussed 

benefits issues with Wannell, and his only contact was with 

Royce, Quanex’s tax director. Because of Wannell’s extremely 

limited involvement with the MPB obligations and in QHMC, 

we do not find credible petitioners’ assertion that Wannell 

was allowed to purchase an equity interest as an incentive 

to achieve cost savings on QHMC’s behalf. Instead, as we find, 

petitioners selected Wannell (and CS) to serve as trusted and 

loyal facilitators for the QHMC transactions. Petitioners set 

the costs of Wannell’s and CS’ equity interests at relatively 

low amounts ($11,000 and $15,000, respectively) and lowered 

those costs even further by effectively quickly returning a 

portion of the initial cash outlays to Wannell and CS in the 

form of the first five quarterly dividends. In addition, petitioners structured the QHMC transactions so that the money 

Wannell and CS devoted to the transactions was guaranteed 

to be returned to them, both as to principal and with a 

reasonable premium, and allowed Wannell and CS to accomplish their desired results (i.e., for Wannell, a guaranteed 

return at least commensurate with his other opportunities 

and for CS, an opportunity to increase its business with petitioners). 

v. Unnecessary Assumption of MPB Obligations by QHMC 

Petitioners also do not sufficiently explain the reason for 

QHMC’s assumption of the MPB obligations. While petitioners 

contend that QHMC assumed the MPB liabilities to ‘‘isolate 

costs within QHMC, in order to facilitate controlling such 

costs’’, the transfer of the liabilities in exchange for $38 million is separate and distinct from the alleged purpose behind 

QHMC’s formation—to assume a managerial role in reducing 

the cost of health care and making a profit. The cost-reducing 

benefits of QHMC, as alleged by petitioners, resulted from the 

creation of a separate entity and the alleged ability of its new 

shareholders to manage and reduce health care costs, and 

not from QHMC’s assumption of the MPB obligations themselves. Simply put, QHMC did not need to assume the MPB

obligations for petitioners to reduce health care costs. CS 

182 139 UNITED STATES TAX COURT REPORTS (67) 

effectively managed Quanex’s health care costs in the same 

manner before and after the creation of QHMC; whether petitioners or QHMC was responsible for the ultimate payment of 

the MPB obligations is irrelevant. 

Nor do petitioners explain why the class C stock had to 

detour briefly through QS. QS’ ownership lasted less than a 

week, and its sale of stock to Wannell had been preplanned 

at the outset of the QHMC transactions. Diverting an equity 

interest presumably intended for Wannell through QS was a 

key element in reaping the claimed tax benefits of the QHMC

transactions: Under D&T’s (and petitioners’) reading of the 

Code and interpretations thereunder, the issuance of stock to 

QS allowed QS to obtain a high basis in the QHMC stock, and 

the subsequent sale to Wannell allowed QS to realize and 

recognize the purported loss. 

c. Conclusion 

On the basis of our analysis of the QHMC transactions, we 

conclude and hold that the QHMC transactions lacked both 

objective economic substance and a subjective business purpose. See Klamath Strategic Inv. Fund, LLC, 568 F.3d at 

544. We therefore disregard the effects of the transactions 

that gave rise to petitioners’ $38 million basis in the class C 

stock. Consequently, given the parties’ agreement that our 

holding means that petitioners are not entitled to deduct the 

short-term capital loss, we reach the same conclusion. 

IV. Fees Incurred in Furtherance of QHMC Transactions 

Deductions are strictly a matter of legislative grace, and 

taxpayers bear the burden of producing sufficient evidence to 

substantiate any deduction that would otherwise be allowed 

by the Code. Sec. 6001; Rule 142(a)(1); INDOPCO, Inc. v. 

Commissioner, 503 U.S. 79, 84 (1992). While section 162(a) 

generally lets a corporate taxpayer deduct the ordinary and 

necessary expenses of its trade or business, expenditures 

made in an attempt to obtain abusive tax shelter benefits are 

not ordinary and necessary business expenses or otherwise 

deductible under section 162(a). See Klamath Strategic Inv. 

Fund, LLC, 568 F.3d at 549; see also Karr v. Commissioner, 

924 F.2d 1018, 1023–1025 (11th Cir. 1991) (expenses arising 

from transactions lacking economic substance were not 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 183

deductible), aff ’g Smith v. Commissioner, 91 T.C. 733 (1988); 

Kirchman v. Commissioner, 862 F.2d 1486, 1490 (11th Cir. 

1989) (if a transaction lacks economic substance, ‘‘then 

expenses or losses incurred in connection with the transaction are not deductible’’), aff ’g Glass v. Commissioner, 87 

T.C. 1087 (1986); Winn-Dixie Stores, Inc. v. Commissioner, 

113 T.C. at 294 (administrative fees were not deductible 

because they were ‘‘incurred in connection with, and were an 

integral part of, a sham transaction’’). 

On their 1997 return, petitioners claimed deductions of 

$320,692 for consulting fees paid to D&T, $29,114 for legal 

fees paid to Fulbright, and $2,445 for appraisal fees paid to 

Watson Wyatt. Petitioners paid all of these fees in furtherance of implementing the QHMC transactions. Because we 

hold that the QHMC transactions lacked economic substance, 

we affirm respondent’s determination that petitioners may 

not deduct these transaction costs on their 1997 return. 

V. Accuracy-Related Penalties 

A. Background 

Respondent determined that petitioners’ reporting an 

inflated basis of $38 million in the class C stock constituted 

a gross valuation misstatement and that petitioners were 

liable for a 40% penalty under section 6662(a) and (h) to the 

extent of any underpayment of tax attributable to the 

claimed capital loss. In the alternative, respondent determined that petitioners were liable under section 6662(a) and 

(b)(1) (or alternatively (b)(2)) for a 20% accuracy-related penalty as to that portion of any underpayment, finding that the 

underpayment resulting from the disallowance of the shortterm capital loss was attributable to negligence or disregard 

of rules and regulations (or alternatively resulted in a 

substantial understatement of income tax). Respondent also 

determined that the 20% accuracy-related penalty under section 6662(a) and (b)(1) (or alternatively (b)(2)) applied to the 

extent of the underpayment of tax attributable to the disallowed deduction for the transaction fees. 

B. Gross Valuation Misstatement 

Respondent determined that the 40% accuracy-related penalty applies to any underpayment of tax resulting from the 

184 139 UNITED STATES TAX COURT REPORTS (67) 

disallowed capital loss deduction. To that end, respondent 

notes, petitioners claimed a $38 million basis in the class C 

stock sold to Wannell, and the basis in that stock is actually 

$11,000 through our application of section 351(g) or zero 

through our application of the economic substance doctrine. 

Section 6662(a) and (b)(3) imposes an accuracy-related penalty of 20% on the portion of an underpayment attributable 

to any ‘‘substantial valuation misstatement’’. A substantial 

valuation misstatement exists ‘‘if the value of any property 

(or the adjusted basis of any property) claimed * * * is 200 

percent or more of the amount determined to be the correct 

amount of such valuation or adjusted basis’’. Sec. 6662(e)(1). 

The penalty imposed by section 6662(a) increases from 20% 

to 40% if the underpayment is attributable to a ‘‘gross valuation misstatement’’. Sec. 6662(h). A gross valuation 

misstatement occurs if the value of any property, or the 

adjusted basis of any property, reported by the taxpayer is 

400% or more of the amount determined to be the correct 

amount of such valuation or adjusted basis. Sec. 

6662(h)(2)(A). In the case of a corporation, the substantial or 

gross valuation misstatement penalty may only apply where 

the portion of the underpayment for the taxable year attributable to the substantial valuation misstatement exceeds 

$10,000. Sec. 6662(e)(2). 

Petitioners contend that respondent wrongly determined 

that the gross valuation misstatement penalty applies to the 

portion of an underpayment attributable to the disallowed 

capital loss. As petitioners see it, that portion of the underpayment did not involve a valuation misstatement because it 

is attributable to our finding that petitioners’ claimed capital 

loss deduction was improper. Petitioners cite Heasley v. 

Commissioner, 902 F.2d 380, and Todd v. Commissioner, 862 

F.2d 540, for the proposition that the Commissioner may not 

penalize a taxpayer for a valuation overstatement where the 

Commissioner totally disallows a deduction, because the 

underpayment from the disallowance is attributable to the 

claiming of an improper deduction, not to a valuation overstatement. In those cases, the taxpayers made valuation 

overstatements of certain property and claimed depreciation 

deductions and/or investment tax credits on the basis of the 

overstated values. See Heasley v. Commissioner, 902 F.2d at 

381; Todd v. Commissioner, 862 F.2d at 541. The CommisVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00118 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 185

sioner disallowed the claimed deductions and investment tax 

credits and determined that the taxpayers were liable for 

valuation overstatement penalties. See Heasley v. Commissioner, 902 F.2d at 382; Todd v. Commissioner, 862 F.2d at 

541. The Court of Appeals for the Fifth Circuit held that the 

disallowances did not result from a misstatement of the 

assets’ values or bases but from the claiming of an improper 

deduction. See Heasley v. Commissioner, 902 F.2d at 383; 

Todd v. Commissioner, 862 F.2d at 543–545. Under these 

cases, the portion of a tax underpayment that is attributable 

to a valuation overstatement is determined after taking into 

account any other proper adjustment to tax liability. Todd v. 

Commissioner, 862 F.2d at 542–543. 

We have found and have held that the capital loss deduction was improper because the relevant contributions did not 

qualify for nonrecognition treatment under section 351(a) 

and, alternatively, the QHMC transactions lacked economic 

substance. This case is appealable to the Court of Appeals for 

the Fifth Circuit, absent a stipulation to the contrary. The 

view of that court is that a valuation misstatement penalty 

does not apply when a transaction is disregarded, or when a 

deduction is otherwise disallowed for a reason unrelated to 

valuation. That view is contrary to the view of various other 

Courts of Appeals. See Merino v. Commissioner, 196 F.3d 

147, 155 (3d Cir. 1999) (‘‘[W]henever a taxpayer knowingly 

invests in a tax avoidance entity which the taxpayer should 

know has no economic substance, the valuation overstatement penalty is applied as a matter of course.’’), aff ’g T.C. 

Memo. 1997–385; Zfass v. Commissioner, 118 F.3d 184, 191 

(4th Cir. 1997) (the valuation overstatement penalty applied 

because the value overstatement was a primary reason for 

the disallowance of the claimed tax benefits), aff ’g T.C. 

Memo. 1996–167; Illes v. Commissioner, 982 F.2d 163, 167 

(6th Cir. 1992) (the entire artifice of the tax shelter at issue 

was constructed on the foundation of the overvaluation of its 

assets), aff ’g T.C. Memo. 1991–449; Gilman v. Commissioner, 

933 F.2d 143, 151 (2d Cir. 1991) (‘‘The lack of economic substance was due in part to the overvaluation, and thus the 

underpayment was attributable to the valuation overstatement.’’), aff ’g T.C. Memo. 1989–684 as supplemented by T.C. 

Memo. 1990–205; Massengill v. Commissioner, 876 F.2d 616, 

619–620 (8th Cir. 1989) (‘‘When an underpayment stems 

186 139 UNITED STATES TAX COURT REPORTS (67) 

from disallowed depreciation deductions or investment credit 

due to lack of economic substance, the deficiency is attributable to overstatement of value[.]’’), aff ’g T.C. Memo. 1988– 

427; see also Fid. Int’l Currency Advisor A Fund v. United 

States, 661 F.3d 667 (1st Cir. 2011). The Court of Appeals for 

the Fifth Circuit’s view also is contrary to the view of this 

and other courts. See, e.g., Santa Monica Pictures, LLC v. 

Commissioner, T.C. Memo. 2005–104; Jade Trading, LLC v. 

United States, 80 Fed. Cl. 11, 54 (2007). 

Under Golsen v. Commissioner, 54 T.C. at 757, we follow 

a holding of the court to which an appeal lies if that holding 

is squarely on point. We believe that the court’s holdings in 

Heasley v. Commissioner, 902 F.2d 380, and Todd v. Commissioner, 862 F.2d 540, meet that standard in that the grounds 

underlying our disallowance of the capital loss deduction are 

not directly related to petitioners’ valuation of the class C 

stock or to petitioners’ reporting of the proper basis therein, 

a basis that flows from the applicability or nonapplicability 

of section 351(a). The cases of Heasley and Todd, therefore, 

require us to hold in this case that any overvaluation of the 

stock or basis was subsumed in the disallowance of the capital loss deduction and that any resulting underpayment is 

attributable not to an overvaluation of stock or basis, but to 

the disallowance of the capital loss deduction on account of 

the inapplicability of section 351(a). Accord Klamath Strategic Inv. Fund, LLC v. United States, 472 F. Supp. 2d 885, 

899–900 (E.D. Tex. 2007) (noting that the Court of Appeals 

for the Fifth Circuit’s view on the applicability of the valuation misstatement penalty is contrary to the views of other 

Courts of Appeals, but holding that the court must follow the 

law of the Fifth Circuit), aff ’d in part, vacated in part, and 

remanded, 568 F.3d 537 (5th Cir. 2009); NPR Invs., LLC v. 

United States, 105 A.F.T.R.2d (RIA) 2010–1082, 2010–1 U.S. 

Tax Cas. para. 50,251 (E.D. Tex. 2010) (same). Accordingly, 

on the basis of Heasley v. Commissioner, 902 F.2d 380, and 

Todd v. Commissioner, 862 F.2d 540, we hold that the valuation misstatement penalty does not apply to this case. 

C. Negligence 

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(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 187

utable to ‘‘[n]egligence or disregard of rules or regulations.’’ 

For purposes of section 6662, the term ‘‘negligence’’ includes 

any failure to make a reasonable attempt to comply with 

Code provisions. Sec. 6662(c). Negligence is determined by 

testing a taxpayer’s conduct against that of a reasonable, 

prudent person. See Sandvall v. Commissioner, 898 F.2d 455, 

458–459 (5th Cir. 1990), aff ’g T.C. Memo. 1989–189, and 

aff ’g T.C. Memo. 1989–56. ‘‘Rules or regulations’’ include the 

provisions of the Code, temporary or final regulations issued 

under the Code, and revenue rulings or notices issued by the 

IRS. Sec. 1.6662–3(b)(2), Income Tax Regs. A return position 

that has a reasonable basis is not attributable to negligence. 

Sec. 1.6662–3(b)(1), Income Tax Regs. A reasonable basis 

connotes significantly more than not being frivolous or patently improper. Sec. 1.6662–3(b)(3), Income Tax Regs. The 

reasonable basis standard is not satisfied by a return position that is merely arguable or colorable. Id. 

Respondent determined that the negligence penalty 

applied to the underpayment attributable to the disallowed 

deductions for transaction costs. Respondent also determined 

that the negligence penalty applied to the underpayment 

attributable to the capital loss adjustment. Petitioners contend that they made a reasonable attempt to comply with the 

provisions of the Code and that they did not carelessly, recklessly, or intentionally disregard rules or regulations. 

According to petitioners, their 1997 return was prepared 

through a careful and deliberate process in conformity with 

the advice of qualified tax professionals, including Royce, 

Parikh, and Singer. Petitioners also contend that they had a 

reasonable basis for the position they took on their 1997 

return with respect to both disallowed items. Petitioners 

lastly argue that the negligence penalty is inappropriate 

because the issues surrounding the QHMC transactions 

involved complex legal determinations on issues that were 

reasonably debatable or on which there could be honest differences of opinion. Petitioners primarily cite the case of 

Kantor v. Commissioner, 998 F.2d 1514, 1522–1523 (9th Cir. 

1993) (involving allocation and deduction of research and 

experimentation expenses to and by taxpayer partnership’s 

limited partners), aff ’g in part, rev’g in part T.C. Memo. 

1990–380, in support of this last argument. 

188 139 UNITED STATES TAX COURT REPORTS (67) 

76 Rose, Royce, and Parikh were C.P.A.s, and Singer was a C.P.A. and a tax attorney. 77 In fact, given the scale of their efforts to disguise the QHMC transactions as a legitimate 

transaction, we can only presume that Rose, Royce, Parikh, and Singer each knew quite well 

that a transaction without economic substance is invalid. 

78Petitioners also argue that it is inappropriate to impose the negligence penalty against 

them because, they state, this case is a ‘‘close case’’ and the Government lost Black & Decker 

Corp. v. United States, 340 F. Supp. 2d 621 (D. Md. 2004), aff ’d in part, rev’d in part and remanded, 436 F.3d 431 (4th Cir. 2006), and Coltec Indus., Inc. v. United States, 62 Fed. Cl. 716 

(2004), vacated and remanded, 454 F.3d 1340 (Fed. Cir. 2006), two cases which involve similar 

facts and legal issues. We disagree with this argument. We do not consider the issues here to 

present a ‘‘close case’’. In addition, the two cases which petitioners rely upon were decided after 

petitioners filed their 1997 return. Further, neither trial court’s view of the economic substance 

doctrine was accepted by the Court of Appeals upon appeal of those judgments. 

The record does not support petitioners’ arguments. To the 

contrary, we find that petitioners did not make a reasonable 

attempt to comply with existing tax laws and that they failed 

to exercise ordinary and reasonable care in the preparation 

of their 1997 return. Rose, Royce, Parikh, and Singer were 

well-educated tax professionals with extensive tax experience. 76 On the basis of their knowledge and experience, they 

should have known (and in fact probably knew) that formal 

compliance with statutory provisions, even if present, is 

insufficient to sustain transactions that have no economic 

substance and are mere contrivances designed solely to 

obtain tax benefits. 77 They also should have known (and in 

fact probably knew) that the class C stock, as of the time of 

it issuance, was limited and was most likely not going to 

include a share of any QHMC growth to a significant extent. 

We cannot agree with petitioners’ contention that the QHMC

transactions had a reasonable basis or that the complexity of 

the transactions concerns issues that are reasonably debatable. The QHMC transactions were part of an economic sham 

designed to generate a substantial tax loss. Petitioners have 

not presented an alternative view to which we can affix a 

reasonable interpretation of the transactions. 78 We sustain 

respondent’s determination that negligence penalties are 

appropriate in this case. 

D. Substantial Understatement 

Section 6662(a) and (b)(2) imposes an accuracy-related penalty of 20% on the portion of an underpayment attributable 

to any substantial understatement of income tax. An understatement is defined as the excess of the amount of tax 

required to be shown on the return for a taxable year over 

the amount of tax imposed that is shown on the return, 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 189

reduced by any rebate. Sec. 6662(d)(2)(A). For corporations, 

an understatement of income tax is substantial if the understatement exceeds the greater of 10% of the tax required to 

be shown on the return for the taxable year, or $10,000. Sec. 

6662(d)(1)(A) and (B). 

Any understatement is reduced to the extent it is attributable to an item: (1) for which there is or was substantial 

authority for the taxpayer’s treatment for such item, or (2) 

with respect to which the relevant facts affecting the item’s 

tax treatment are adequately disclosed in the return or in a 

statement attached to the return and there is a reasonable 

basis for the tax treatment of the item by the taxpayer. Sec. 

6662(d)(2)(B). The exceptions for understatements supported 

by substantial authority or by adequate disclosure are not 

available for any item that is attributable to a ‘‘tax shelter’’ 

of a corporation. Sec. 6662(d)(2)(C)(ii). In that context, a ‘‘tax 

shelter’’ is: (1) a partnership or other entity, (2) any investment plan or arrangement, or (3) any other plan or arrangement, if a significant purpose of such partnership, entity, 

plan, or arrangement is the avoidance or evasion of Federal 

income tax. Sec. 6662(d)(2)(C)(iii). 

Respondent determined as an alternative to the applicability of the accuracy-related penalty for negligence that the 

underpayment resulting from the disallowed capital loss and 

the disallowed deduction of the transaction fees results in a 

substantial understatement of income tax warranting a 20% 

penalty under section 6662. Additionally, respondent contends that the QHMC transactions constitute a ‘‘tax shelter’’ 

under section 6662(d)(2)(C)(iii) and, consequently, the 

substantial authority and adequate disclosure exceptions to 

the substantial understatement penalty are unavailable to 

petitioners. 

Petitioners do not dispute that the understatement of 

income tax resulting from the items is substantial. Petitioners argue that their position on the 1997 return was supported by both substantial authority and adequate disclosure, 

reducing the understatement to zero under section 

6662(d)(2)(B). In support of this argument, petitioners assert 

that respondent conceded the issue of whether the understatement is attributable to a tax shelter. Petitioners contend 

that the following statement in the notice indicated to petitioners that they could demonstrate substantial authority or 

190 139 UNITED STATES TAX COURT REPORTS (67) 

79While sec. 7491(c) places a burden of production upon the Commissioner with respect to an 

individual’s liability for an accuracy-related penalty under sec. 6662, sec. 7491(c) has no applicability where, as here, the taxpayer is a corporation. See NT, Inc. v. Commissioner, 126 T.C. 191, 

194–195 (2006). 

adequate disclosure to defeat the substantial understatement 

penalty: ‘‘the underpayment is attributable to a substantial 

understatement of income tax and you have not shown that 

you had substantial authority for the way you reported the 

items and you did not make any disclosures explaining the 

adjusted items.’’ Additionally, petitioners claim that 

respondent failed to raise the tax shelter issue in the notice, 

in any of the pleadings, or at trial, and as a result, petitioners would suffer substantial detriment because they were 

not able to address the specific elements relating to section 

6662(d)(2)(C). Petitioners conclude that the question of 

whether the QHMC transactions are a tax shelter for section 

6662(d) purposes is a new issue that should not be heard by 

the Court. 

Petitioners’ argument is baseless. Respondent did not concede the tax shelter issue by merely asserting that petitioners failed to meet the substantial authority and adequate 

disclosure defenses to the substantial understatement penalty. Petitioners bear the burden of proving that respondent’s 

determination to assess the substantial understatement penalty is inappropriate. 79 See Rule 142(a)(1). Accordingly, petitioners must demonstrate that the QHMC transactions were 

not a tax shelter item and, if that is the case, that substantial authority and/or adequate disclosure are present. Given 

respondent’s argument that the QHMC transactions lacked 

economic substance, petitioners were on notice of the possibility that the transactions could be found to be a tax shelter 

under section 6662(d)(2)(C)(iii). See, e.g., Palm Canyon X 

Invs., LLC v. Commissioner, T.C. Memo. 2009–288; Santa 

Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005– 

104. 

Because we hold that the QHMC transactions had no economic substance and that their only purpose was to manufacture high-basis stock to generate a tax loss, we find that the 

multistep contingent liability transaction in which petitioners 

engaged was a tax shelter for purposes of section 6662. Tax 

avoidance was clearly a significant (if not the sole) purpose 

of the QHMC transactions. Petitioners are therefore unable to 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 191

claim that the underpayment resulting from the improperly 

claimed tax loss should be reduced because of substantial 

authority or adequate disclosure. We sustain respondent’s 

alternative determination that the substantial understatement penalty is appropriate in this case. We note, however, 

that only one section 6662 accuracy-related penalty may be 

imposed with respect to a given portion of an underpayment, 

even if that portion is attributable to more than one of the 

types of conduct listed in section 6662(b). See New Phoenix 

Sunrise Corp. v. Commissioner, 132 T.C. at 187; sec. 1.6662– 

2(c), Income Tax Regs. 

E. Section 6664(c) Reasonable Cause Exception 

1. Overview 

The accuracy-related penalty imposed under section 6662 

does not apply with respect to any portion of an underpayment to which the taxpayer can demonstrate reasonable 

cause and good faith. Sec. 6664(c). Reasonable cause requires 

that the taxpayer have exercised ordinary business care and 

prudence as to the disputed item. See Neonatology Assocs., 

P.A. v. Commissioner, 115 T.C. at 98. The determination of 

whether a taxpayer acted with reasonable cause and in good 

faith is made on a case-by-case basis, taking into account all 

pertinent facts and circumstances. Sec. 1.6664–4(b)(1), 

Income Tax Regs. The most important factor is generally the 

extent of the taxpayer’s effort to assess the taxpayer’s proper 

tax liability. Id. Circumstances that may indicate reasonable 

cause and good faith include an honest misunderstanding of 

fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer. Id. 

A taxpayer may demonstrate reasonable cause through 

reliance on the advice of a professional tax adviser as to the 

proper treatment of an item. Id.; see also Neonatology 

Assocs., P.A. v. Commissioner, 115 T.C. at 98. The taxpayer 

must demonstrate that reliance on the professional’s advice 

was reasonable and that the taxpayer acted in good faith. 

Sec. 1.6664–4(b)(1), Income Tax Regs. All facts and circumstances are taken into account in determining whether a 

taxpayer has reasonably relied in good faith on professional 

tax advice as to the treatment of the plan or arrangement 

192 139 UNITED STATES TAX COURT REPORTS (67) 

80For example, the advice must not be based upon a representation or assumption which the 

taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a particular manner. Sec. 1.6664–4(c)(1)(ii), Income Tax Regs. 

81Legal justification includes ‘‘any justification relating to the treatment or characterization 

under the Federal tax law of the tax shelter item or of the entity, plan, or arrangement that 

gave rise to the item.’’ Sec. 1.6664–4(e)(2)(ii), Income Tax Regs. Accordingly, a taxpayer’s belief 

as to the merits of the taxpayer’s underlying position is a legal justification. Id. 

under Federal tax law. Sec. 1.6664–4(c)(1), Income Tax Regs. 

The professional’s advice must be based upon all pertinent 

facts and circumstances and the law as it relates to those 

facts and circumstances. Sec. 1.6664–4(c)(1)(i), Income Tax 

Regs. The advice must take into account the taxpayer’s purposes for entering a transaction and for structuring a transaction in a particular manner. Id. The advice must not be 

rendered on the basis of unreasonable factual or legal 

assumptions and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. 80 Sec. 1.6664–4(c)(1)(ii), Income 

Tax Regs. Reliance is generally unreasonable where it is 

placed upon insiders or promoters (or their offering materials) or when the person relied upon has an inherent conflict 

of interest that the taxpayer knew or should have known 

about. See Neonatology Assocs., P.A. v. Commissioner, 115 

T.C. at 98. 

For purposes of the substantial understatement penalty 

under section 6662(b)(2), a taxpayer must meet a more stringent reasonable cause exception when the understatement is 

attributable to a tax shelter. Sec. 1.6664–4(e)(1), Income Tax 

Regs. We determine whether a corporation acted with 

reasonable cause and in good faith in its treatment of a tax 

shelter item on the basis of all pertinent facts and circumstances. Id. A corporation’s ‘‘legal justification’’ 81 for the 

transaction may be taken into account, as appropriate, in 

establishing that the corporation acted with reasonable cause 

and in good faith in its treatment of a tax shelter item. Sec. 

1.6664–4(e)(2)(i), Income Tax Regs. However, a corporation’s 

legal justification may be taken into account only if the corporation satisfies both the authority and belief requirements 

described in section 1.6662–4(e), Income Tax Regs. Satisfaction of those requirements is not necessarily dispositive, but 

it is an important factor to consider in determining whether 

a corporate taxpayer acted with reasonable cause and in good 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 193

82Whether substantial authority exists is determined by an objective standard involving an 

analysis of the law and an application of the law to relevant facts. Sec. 1.6662–4(d)(2), Income 

Tax Regs. The taxpayer’s belief that there is substantial authority for the tax treatment of an 

item is thus not relevant in determining whether there is substantial authority for that treatment. Sec. 1.6662–4(d)(3)(i), Income Tax Regs. Substantial authority is present for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial 

in relation to the weight of authorities supporting contrary treatment. Id. The weight accorded 

an authority depends on its relevance and persuasiveness, as well as the type of document providing the authority. Sec. 1.6662–4(d)(3)(ii), Income Tax Regs. 

faith. Sec. 1.6664–4(e)(3), Income Tax Regs. Facts and circumstances other than a corporation’s legal justification may 

be taken into account in determining whether the corporation acted with reasonable cause and in good faith with 

respect to a tax shelter item, regardless of whether the minimum requirements are satisfied. Sec. 1.6664–4(e)(4), Income 

Tax Regs. 

The authority requirement is satisfied if there is substantial authority for the tax treatment of the item, as defined 

in section 1.6662–4(d), Income Tax Regs. 82 See sec. 1.6664– 

4(e)(2)(i)(A), Income Tax Regs. The belief requirement is 

satisfied only if, on the basis of all facts and circumstances, 

the corporation reasonably believed, when the return was 

filed, that the tax treatment of the item was more likely than 

not the proper treatment. See sec. 1.6664–4(e)(2)(i)(B), 

Income Tax Regs. A corporation is considered reasonably to 

believe that the tax treatment of an item is more likely than 

not the proper tax treatment if: 

(1) The corporation analyzes the pertinent facts and authorities in the 

manner described in § 1.6662–4(d)(3)(ii), and in reliance upon that analysis, reasonably concludes in good faith that there is a greater than 50- 

percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service; or 

(2) the corporation reasonably relies in good faith on the opinion of a 

professional tax advisor, if the opinion is based on the tax advisor’s analysis of the pertinent facts and authorities in the manner described in § 

1.6662–4(d)(3)(ii) and unambiguously states that the tax advisor concludes 

that there is a greater than 50-percent likelihood that the tax treatment 

of the item will be upheld if challenged by the Internal Revenue Service. 

* * * 

[Sec. 1.6664–4(e)(2)(i)(B)(1) and (2), Income Tax Regs.] 

2. Analysis 

Petitioners bear the burden of proof in establishing their 

reasonable cause defense. See Higbee v. Commissioner, 116 

T.C. 438 (2001). Petitioners argue that an accuracy-related 

194 139 UNITED STATES TAX COURT REPORTS (67) 

penalty under section 6662(a) does not apply because, under 

section 6664(c), petitioners had reasonable cause and acted in 

good faith with respect to the underpayment resulting from 

both the disallowed capital loss and the disallowed deduction 

of the transaction fees. Petitioners’ primary defense is that 

they reasonably relied in good faith on the opinion of their 

professional tax adviser, Singer. Petitioners assert that 

Singer provided petitioners with comprehensive and detailed 

advice in D&T’s draft opinion, which was prepared under 

Singer’s supervision and reflected advice given by Singer and 

other specialists at D&T regarding the tax treatment of the 

QHMC transactions and the claimed capital loss. The ultimate 

conclusion of Singer’s tax advice was that petitioners’ tax 

treatment of the QHMC transactions would more likely than 

not be sustained. Petitioners argue that they followed 

Singer’s tax advice in the preparation of the 1997 return and 

that Singer signed the return on behalf of D&T as the paid 

return preparer. Petitioners conclude that none of the section 

6662 accuracy-related penalties determined by respondent is 

appropriate because petitioners relied in good faith on professional tax advice regarding complex tax issues. 

On the basis of our examination of the facts and circumstances surrounding the QHMC transactions, we do not 

find that petitioners had reasonable cause and acted in good 

faith. Petitioners conducted no independent investigation of 

the tax consequences of the QHMC transactions, and Quanex’s 

tax department did not prepare any internal written tax 

opinion or memorandum discussing the tax consequences of 

the QHMC transactions. Further, none of Quanex’s officers 

testified that he or she analyzed the facts or authorities necessary to make a good-faith conclusion regarding the tax 

treatment of the transactions. Rose understood that the 

transactions generated a significant artificial capital loss, but 

he conducted no independent investigation. Parikh knew that 

the QHMC transactions generated a significant artificial capital loss, but he did not speak with anyone at D&T about the 

QHMC transactions or read the draft opinion before signing 

petitioners’ 1997 return. Royce, Quanex’s tax director, knew 

that the QHMC transactions generated a significant artificial 

capital loss, but he prepared no tax opinion on the subject 

and he did not obtain a tax opinion from an independent 

professional tax adviser. 

(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 195

We also do not find that petitioners’ reliance on the tax 

advice of Singer was reasonable or in good faith. Neither 

Singer nor D&T was an independent adviser on the tax consequences of the QHMC transactions. Singer (on behalf of 

D&T) promoted to Quanex a generic contingent liability 

transaction that could be molded to meet Quanex’s desire to 

shelter the upcoming gains, and Quanex’s officers worked 

closely with Singer to develop the QHMC transactions to 

shelter the impending capital gains resulting from the sales 

of LaSalle and the Tube Group. When Singer introduced the 

contingent liability transaction to petitioners, Rose agreed to 

structure the transaction as a joint venture to manage medical liabilities in a more cost-efficient manner. At the same 

time, however, Rose knew that the QHMC transactions served 

no meaningful purpose outside of tax benefits. The primary 

officers involved in implementing the QHMC transactions, 

Rose, Parikh, and Royce, were sophisticated professionals 

with significant tax experience. Yet none of them ever consulted Quanex’s own health care benefits experts, Peery and 

Howard, regarding the structure of the QHMC transactions. 

The named officers merely caused Quanex to transfer the 

amount of liabilities needed to shelter the capital gains. 

Given the significant tax loss generated from a transaction 

devoid of economic substance, the officers should have conducted a more extensive analysis with respect to the propriety of the transaction. See, e.g., Nicole Rose Corp. v. 

Commissioner, 320 F.3d 282, 285 (2d Cir. 2002) (taxpayer’s 

‘‘scheme was sufficiently blatant that the participation of 

experts cannot convert its actions into a ‘reasonable attempt 

to comply with the provisions’ of the tax code’’), aff ’g 117 T.C. 

328 (2001); Neonatology Assocs., P.A. v. Commissioner, 299 

F.3d at 234 (‘‘As highly educated professionals, the * * * taxpayers should have recognized that it was not likely that by 

complex manipulation they could obtain large deductions for 

their corporations[.]’’). Such is especially so, given that D&T 

was promoting an engagement whereby petitioners could pay 

D&T $400,000 to structure a transaction that would let petitioners deduct an approximately $38 million tax loss on the 

sale of $11,000 in securities which had just recently been 

purchased for the same amount, and that this result, to a 

savvy, experienced businessman such as Rose, Parikh, or 

196 139 UNITED STATES TAX COURT REPORTS (67) 

83We also note the specific terms of D&T’s compensation as to the QHMC transactions. The 

engagement letter informed petitioners that D&T would be compensated on the basis of its 

standard hourly rates if the QHMC transactions were not ultimately consummated. However, 

the letter stated, if the transactions were consummated, D&T would be paid (in lieu of the hourly rates) a set fee of $400,000 plus out-of-pocket expenses estimated to total $10,000. 

84Petitioners claim that the draft opinion actually was D&T’s ‘‘final advice’’ on the subject. 

The record does not establish that point, and we decline to find it as a fact. 

85The draft opinion, however, provided little meaningful analysis as to sec. 351(g). The draft 

opinion merely misstated as a fact that the liquidation value of the class C stock equaled 45% 

of the increase in QHMC’s equity value and concluded that the class C stock should not be treated as preferred stock for purposes of sec. 351(g) because ‘‘[i]t is difficult to argue that 45% is 

not significant.’’ 

Royce, would clearly appear to be too good to be true. 83

Neonatology Assocs., P.A. v. Commissioner, 299 F.3d at 234 

(‘‘When, as here, a taxpayer is presented with what would 

appear to be a fabulous opportunity to avoid tax obligations, 

he should recognize that he proceeds at his own peril.’’); New 

Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. at 

195; Blum v. Commissioner, T.C. Memo. 2012–16. 

We also reject petitioners’ contention that petitioners’ reliance on D&T’s draft opinion was reasonable because (1) D&T 

never finalized the opinion, 84 and (2) even if the opinion had 

been issued by D&T, Singer based his conclusion in the 

opinion on the incorrect assumption that petitioners entered 

into the QHMC transactions for a valid business purpose, to 

manage their medical liabilities in a more cost-efficient 

manner, that petitioners knew was incorrect. See sec. 

1.6664–4(c)(1)(ii), Income Tax Regs. Thus, while the D&T 

draft opinion cites various Code sections, revenue rulings, 

and court cases to support Singer’s conclusion as to the Federal income tax consequences of the QHMC transactions, 85

petitioners cannot in good faith rely on the tax opinion 

because petitioners knew that the only purpose of the transactions was to achieve a tax loss. We also note that the draft 

opinion was authored by the same firm that promoted the 

QHMC transactions (initially in a generic form) to Quanex, 

and which helped Quanex then fine tune and implement the 

generic transaction to Quanex’s situation, and that the draft 

opinion was given to Quanex as part of the overall purchase 

price of that promotion. D&T is a ‘‘promoter’’ in the setting 

of this case, see 106 Ltd. v. Commissioner, 136 T.C. 67, 79– 

80 (2011), aff ’d, 684 F.3d 84 (D.C. Cir. 2012); Blum v. 

Commissioner, T.C. Memo. 2012–16, and petitioners could 

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(67) GERDAU MACSTEEL, INC. v. COMMISSIONER 197

motion given the obvious conflict of interest, see, e.g., Blum 

v. Commissioner, T.C. Memo. 2012–16. 

Accordingly, we reject petitioners’ contention that they 

meet the reasonable cause exception under section 6664(c), 

and we sustain respondent’s determination that petitioners 

are liable for the 20% accuracy-related penalty. On the basis 

of this holding, we logically also hold that petitioners fail to 

meet the more stringent requirements needed to establish 

reasonable cause when the substantial understatement penalty is attributable to a tax shelter. See sec. 1.6664–4(e), 

Income Tax Regs. Consequently, whether petitioners meet 

the authority and belief requirements of section 1.6664–4(e), 

Income Tax Regs., is irrelevant. 

VI. Conclusion 

Respondent properly disallowed the short-term capital loss 

deduction petitioners claimed from the sale of the class C 

stock to Wannell. Further, petitioners improperly deducted 

the fees incurred to implement the QHMC transactions. Further, on the basis of our Golsen rule, we do not sustain 

respondent’s determination as to the 40% gross valuation 

misstatement penalty imposed under section 6662(h) with 

respect to the disallowed capital loss. We do, however, sustain respondent’s determination that petitioners are liable for 

the 20% accuracy-related penalty attributable to negligence 

and to a substantial understatement of income tax. See sec. 

6662(a) and (b)(1) and (2). We also hold that petitioners 

failed to establish that they met the reasonable cause exception of section 6664(c). 

We have considered all arguments that the parties made, 

and to the extent not discussed above, conclude those arguVerDate Nov 24 2008 09:57 Jun 05, 2014 Jkt 372897 PO 20012 Frm 00131 Fmt 2847 Sfmt 2847 V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG JAMIE
198 139 UNITED STATES TAX COURT REPORTS (67) 

ments are irrelevant, moot, or without merit. To reflect the 

foregoing, 

Decision will be entered under Rule 155. 

f