T.C. Memo. 2006-191

UNITED STATES TAX COURT

THOMAS AND JANICE GLEASON, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 18377-04. Filed September 11, 2006.

During 1995, Ps, through P-H, became involved in a

leveraged buyout transaction resulting in ownership of

two S corporations, A and T, and relinquishment of an

interest in another S corporation, E. By early 1996, A

and T were insolvent and thereafter entered bankruptcy

proceedings.

Held: Ps’ income and losses for 1994 and 1995

related to ownership of A, T, and E are to be adjusted

consistent with this opinion.

Held, further, Ps are liable for accuracy-related

penalties pursuant to sec. 6662, I.R.C., for 1994 and

1995 to the extent that underpayments remain following

recomputation in accordance with the Court’s resolution

of substantive issues.
- 2 -

Thomas and Janice Gleason, pro sese.

John W. Stevens, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHERRY, Judge: Respondent determined the following

deficiencies and penalties with respect to petitioners’ Federal

income taxes:

Penalty

Year Deficiency Sec. 6662, I.R.C.

1994 $18,583 $3,717

1995 663,679 132,736

After concessions, the principal issues for decision are:

(1) Whether petitioners’ income for 1995 and 1996 should be

increased on account of (a) their pro rata share of ordinary

income from various S corporations and/or (b) property

distributions from certain of the S corporations.

(2) Whether losses claimed by petitioners with respect to

their interests in two of the S corporations, Alofs Manufacturing

Co. (Alofs) and Target Components, Inc. (Target), should be

adjusted for the years 1994 and 1995. Subsumed in this question

is the proper computation of petitioners’ bases in their Alofs

and Target stock.
- 3 -

1 Unless otherwise indicated, section references are to the

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

references are to the Tax Court Rules of Practice and Procedure.

2 Mrs. Gleason would appear to have had little involvement

with the S corporations, and the record does not clarify the

(continued...)

(3) Whether petitioners are liable for the section 6662

accuracy-related penalty for 1994 and 1995.1

Certain additional adjustments, e.g., to itemized deductions and

exemption amounts, are computational in nature and will be

resolved by our holdings on the foregoing issues.

FINDINGS OF FACT

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

The stipulations of the parties, with accompanying exhibits, are

incorporated herein by this reference. To facilitate disposition

of the above issues, we shall first set forth general findings of

fact and then, where appropriate, make additional findings in

conjunction with our analysis of and opinion on discrete issues.

Petitioners and the S Corporations

Petitioners Thomas and Janice Gleason (individually referred

to as Mr. Gleason and Mrs. Gleason, respectively) are husband and

wife. On the petition filed in this case, petitioners stated

that their mailing address was in Kentwood, Michigan, and their

legal residence was in Long Beach, Mississippi.

The principal issues in this case revolve around

Mr. Gleason’s involvement with various S corporations.2 In 1987,
- 4 -

2(...continued)

extent, if any, of her formal interest in the entities. She is a

party to this action primarily because she filed joint returns

with Mr. Gleason. While we have framed the issues in terms that

would incorporate any potential joint ownership on the part of

Mrs. Gleason, the underlying background and events will, for

simplicity, be described largely from the perspective of

Mr. Gleason’s activities.

Mr. Gleason purchased 35 percent of Target, a metal-stamping

business, for an initial investment of $35,000. Then, in 1992,

Mr. Gleason invested $50,000 in each of two related S

corporations, Alofs and Excellence Manufacturing, Inc.

(Excellence), in exchange for interests of 20 percent. Alofs,

like Target, was a metal-stamping business, and Excellence was a

seat assembly business. All three companies were engaged in

supplying components to major automobile manufacturers. 

Mr. Gleason served as president of each of these corporations and

dealt with operational aspects. A common group of investors

and/or officers was involved with each of the three companies (as

well as with other entities not directly relevant to the instant

litigation), operating to an extent not clearly explained by the

record under the name M/IC Partnership.

LBO Transaction and Aftermath

During late 1994, some shareholders in the companies became

interested in restructuring or monetizing their interests to take

advantage of anticipated consolidation in the automotive supply

industry. Ernst & Young LLP (E&Y) was engaged to advise on
- 5 -

possible transactions. Based on cashflow statements and

projections prepared by E&Y, Mr. Gleason ultimately agreed to

participate in a leveraged buyout (LBO) transaction whereby

through exchange of his Excellence shares and the assistance of

outside financing, he purchased all or most of Alofs and Target

from the other investors. The transaction closed in late 1995.

In connection with this transaction, Mr. Gleason as

“Borrower” on December 20, 1995, executed an agreement for a term

loan or loans (hereinafter referred to in the singular) from

Comerica Bank (Comerica) in the aggregate amount of $6 million. 

The agreement contained a statement that “The proceeds of the

Loan will be used for the following business purpose or purposes

and no other: TO PURCHASE COMMON STOCK OF ALOFS MANUFACTURING

COMPANY AND TARGET COMPONENTS, INC.” On the same date,

Mr. Gleason as “Pledgor” also executed a pledge agreement in

favor of Comerica to secure the $6 million loan. He therein

pledged as collateral 770.528 shares of Alofs and 350 shares of

Target. The pledge agreement entitled petitioner to receive cash

dividends and distributions arising from the collateral so long

as no default on the attendant loan had occurred. In the event

of a default, the pledge agreement afforded Comerica broad rights

with respect to the collateral and any proceeds thereof.

The previous day, on December 19, 1995, Comerica had issued

an irrevocable standby letter of credit addressed to named
- 6 -

beneficiary M/IC Partnership and stating as follows: “WE HEREBY

OPEN OUR IRREVOCABLE STANDBY LETTER OF CREDIT NO. 531075 IN YOUR

FAVOR, FOR ACCOUNT OF THOMAS E. GLEASON, * * * FOR A SUM NOT

EXCEEDING SIX MILLION AND 00/100’S U.S. DOLLARS AVAILABLE BY YOUR

DRAFT AT SIGHT ON COMERICA BANK”.

By January of 1996, neither Alofs nor Target could make

their debt payments and payroll. E&Y’s asset accounting and

cashflow analysis had incorporated substantial errors. 

Mr. Gleason informed Comerica of these developments in midJanuary, and Comerica at that time began sweeping accounts held

at the bank for payments on notes relating to the entities,

including the $6 million note executed by Mr. Gleason and

referenced above.

Both Alofs and Target filed for bankruptcy on October 30,

1996, and were completely liquidated in May of 1997. During the

course of the bankruptcy proceedings, in late 1997, Comerica

agreed to settle “any and all claims for avoidable transfers,

whether based upon allegations of fraudulent conveyance,

preferential transfer or otherwise” by paying a lump sum of

$1,125,000 and funding an “LBO Litigation Fund” in an amount not

to exceed $500,000. Thereafter, in May of 1999, Mr. Gleason and

the bankruptcy trustee for Alofs and Target executed a settlement

agreement and mutual release of claims related to the bankruptcy,
- 7 -

wherein Mr. Gleason also released to the trustee all potential

claims against other former shareholders in the entities.

Prior to the foregoing settlement, beginning in December of

1997, Mr. Gleason had communicated with the law firm of Miller,

Canfield, Paddock and Stone, P.L.C. (Miller, Canfield), with

respect to possible representation of Mr. Gleason on any claims

that he might have had against E&Y and other former shareholders

in connection with the LBO transaction. In a letter dated

December 15, 1997, the firm expressed a willingness to explore

the possibility of representing Mr. Gleason but noted that the

firm’s provision of legal services to Comerica in the LBO

transaction could present conflict issues. A series of meetings

and discussions between Mr. Gleason and attorneys from Miller,

Canfield took place over at least the next several months and

were documented by Mr. Gleason in contemporaneous notes. The

final entry, dated March 10, 1998, read:

TALKING W/ COMERICA ABOUT PARTNERING

& NOT GETTING

AS OF END JANUARY COMERICA WANTED

TO GO AFTER ME

WILL GET BACK TO ME THIS WK

EVEN NO NEW WORD ON COMERICA

Tax Reporting

For tax reporting purposes, Target, Alofs, and Excellence

utilized a fiscal year running from October 1 through

September 30. The record contains copies of Schedules K-1,
- 8 -

Shareholder’s Share of Income, Credits, Deductions, etc.,

prepared for Mr. Gleason by Target for the fiscal years ending

(FYE) 1990 through 1994 and 1996, by Alofs for FYE 1995 and 1996,

and by Excellence for FYE 1994 through 1996. The Schedules K-1

reflect the following amounts as Mr. Gleason’s pro rata share of

ordinary income (loss), of interest income, and of “Property

distributions (including cash) other than dividend distributions

reported to you on Form 1099-DIV”:

TARGET

 Ordinary Interest Property

 FYE Income (Loss) Income Distributions

 1990 $5,675 $3,366 --

 1991 101,485 2,670 --

 1992 (42,242) 2,694 $36,400

 1993 113,311 7,035 --

 1994 245,886 14,825 206,663

 1995 -- -- --

 1996 (2,893,326) -- --

ALOFS

 Ordinary Interest Property

 FYE Income (Loss) Income Distributions

 1995 $470,814 -- $237,000

 1996 (2,518,616) -- 344,082

EXCELLENCE

 Ordinary Interest Property

 FYE Income (Loss) Income Distributions

 1994 $312,699 $5,260 $140,000

 1995 807,012 19,725 360,200

 1996 257,328 7,043 196,000
- 9 -

The Schedules K-1 for Target and Alofs for 1996 contain

handwritten notations suggesting that these schedules are amended

documents and that originals reflected ordinary income (loss) of

($800,000) and zero, respectively. Likewise, on certain copies

of the Schedule K-1 from Excellence for FYE 1996, the property

distribution amount of $196,000 is circled and marked with the

handwritten notation “NEVER PAID”.

Petitioners filed original joint Forms 1040, U.S. Individual

Income Tax Return, for their 1993, 1994, 1995, and 1996 taxable

(calendar) years in August of 1994, October of 1995, May of 1998,

and October of 1997, respectively. They reported thereon

adjusted gross income, taxable income, and total tax as set forth

below:

 Adjusted Taxable Total

 Year Gross Income Income Tax

 1993 $300,328 $288,440 $90,751

 1994 786,481 766,539 279,854

 1995 749,133 686,319 247,127

 1996 (581,774) -0- 182

Attached to each return were pertinent portions of Schedule

E, Supplemental Income and Loss, showing income or loss from

partnerships and S corporations. The Schedules E reported income

or loss from Target, Alofs, and Excellence as follows:
- 10 -

3 It is not clear from the record whether petitioners at any

time in fact submitted a Form 1040X, Amended U.S. Individual Tax

Return, with respect to 1996.

 Year Target Alofs Excellence

 1993 $113,311 -- --

 1994 245,886 $401,192 $312,699

 1995 (616,947) 296,614 807,012

 1996 (800,000) -0- --

Included with the 1996 Schedule E was a statement pertaining to

Target and a statement pertaining to Alofs indicating that the

figures reported were projected amounts in that returns for the

entities had not yet been filed due to recent bankruptcy. For

years 1993, 1994, and 1995, petitioners also included on

Schedules B, Interest and Dividend Income, taxable interest from

Schedules K-1.

Subsequently, petitioners submitted joint Forms 1040X,

Amended U.S. Individual Income Tax Return, signed in September of

1998, for 1993, 1994, and 1995. Each of these amended returns

was based on the carryback of a net operating loss (NOL) from

1996, eliminated petitioners’ taxable income for the respective

periods, and requested substantial refunds. Attached to each

Form 1040X was a “pro forma” Form 1040 for 1996 and supporting

schedules showing the genesis of the NOL.3 As relevant here, the

principal differences between the original 1996 return and the

pro forma version were the inclusion of an additional $7,043 of

taxable interest and the reporting of a loss from Schedule E of
- 11 -

$5,154,614 (rather than $800,000). The Schedule E loss comprised

a loss of $2,518,616 form Alofs, a loss $2,893,326 from Target,

and income of $257,328 from Excellence. The changes resulted in

a $4,948,548 NOL for 1996, which was then carried back to 1993,

1994, and 1995.

Respondent audited petitioners’ 1993 through 1996 tax

returns, and the audit resulted in proposed adjustments to all 4

years. However, the proposed adjustments generated deficiencies

only with respect to 1994 and 1995. The adjustments were based

on the income figures reported on petitioners’ original, as

opposed to amended, returns. The corrected tax liability as so

adjusted was then compared to the tax liability shown on the

amended returns to determine the deficiency and penalty amounts,

if any, for 1993, 1994, and 1995. For 1996, the original Form

1040 and the pro forma Form 1040 reflected the same ultimate tax

liability. Throughout the audit and in this litigation,

petitioners have continued to assert a position with respect to a

1996 loss and attendant carrybacks consistent with that taken on

their amended returns.

OPINION

I. Preliminary Matters--Burden of Proof

As a general rule, the Commissioner’s determinations are

presumed correct, and the taxpayer bears the burden of proving

error therein. Rule 142(a); Welch v. Helvering, 290 U.S. 111,
- 12 -

115 (1933). Section 7491 may modify the foregoing general rule

in specified circumstances, with principles relevant to

deficiency determinations set forth in subsection (a) and rules

governing penalties and additions to tax addressed in subsection

(c).

Section 7491(a)(1) may shift the burden to the Commissioner

with respect to factual issues where the taxpayer introduces

credible evidence, but the provision operates only where the

taxpayer establishes that he or she has complied under section

7491(a)(2) with all substantiation requirements, has maintained

all required records, and has cooperated with reasonable requests

for witnesses, information, documents, meetings, and interviews. 

See H. Conf. Rept. 105-599, at 239-240 (1998), 1998-3 C.B. 747,

993-994. Here, petitioners have made no argument directed toward

burden of proof and consequently have not shown that all

necessary prerequisites for a shift of burden have been met. In

addition, respondent alleged on opening brief that petitioners

bear the burden of proof, and petitioners made no attempt to

rebut that allegation in their reply brief. Their reply brief

does, however, at several junctures offer to present further

substantiating documents to respondent and to the Court, which at

minimum suggests that all pertinent information may not have been
- 13 -

4 The Court notes that petitioners have at no time submitted

a specific motion to reopen the record for receipt of additional

evidence.

provided during the examination.4 The Court therefore cannot

conclude that section 7491(a) effects any shift of burden in the

instant case.

Section 7491(c) provides that “the Secretary shall have the

burden of production in any court proceeding with respect to the

liability of any individual for any penalty, addition to tax, or

additional amount imposed by this title.” The Commissioner

satisfies this burden of production by “[coming] forward with

sufficient evidence indicating that it is appropriate to impose

the relevant penalty” but “need not introduce evidence regarding

reasonable cause, substantial authority, or similar provisions.” 

Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Rather, “it is

the taxpayer’s responsibility to raise those issues.” Id. The

Court’s conclusions with respect to burden under section 7491(c)

will be detailed infra in conjunction with our discussion of the

section 6662(a) penalties.

II. General Rules--S Corporations

Sections 1366 through 1368 govern the tax treatment of S

corporation shareholders with respect to their investments in

such entities. Section 1366(a)(1) provides that a shareholder

shall take into account his or her pro rata share of the S

corporation’s items of income, loss, deduction, or credit for the
- 14 -

S corporation’s taxable year ending with or in the shareholder’s

taxable year. Stated otherwise, section 1366 establishes a

regime under which items of an S corporation are generally passed

through to shareholders, rather than being subject to tax at the

corporate level. Section 1366(d)(1), however, limits the

aggregate amount of such flowthrough losses and deductions that a

shareholder may claim to the sum of (1) his or her adjusted basis

in stock of the S corporation and (2) his or her adjusted basis

in any indebtedness of the S corporation to the shareholder.

As regards basis, section 1012 sets forth the foundational

principle that the basis of property for tax purposes shall be

the cost of the property. Cost, in turn, is defined by

regulation as the amount paid for the property in cash or other

property. Sec. 1.1012-1(a), Income Tax Regs. Section 1367 then

specifies adjustments to basis applicable to investments in S

corporations. Basis in S corporation stock is increased by

income passed through to the shareholder under section 1366(a)(1)

and decreased by, inter alia, distributions not includable in the

shareholder’s income pursuant to section 1368; items of loss and

deduction passed through to the shareholder under section

1366(a)(1); and certain nondeductible, noncapital expenses. Sec.

1367(a).

Section 1368 addresses treatment of distributions and

differentiates between S corporations having accumulated earnings
- 15 -

and profits by reason of prior periods of operation as a C

corporation and those without. The typical rule for entities

without earnings and profits is that distributions are not

included in a shareholder’s gross income to extent that they do

not exceed the adjusted basis of his or her stock (but are

applied to reduce basis), while any distribution amount in excess

of basis is treated as gain from the sale or exchange of

property. Sec. 1368(b). For S corporations with accumulated

earnings and profits, dividend treatment applies in enumerated

circumstances. Sec. 1368(c).

III. Analysis

The crux of the dispute between the parties here involves

the amount of NOL that petitioners are entitled to claim with

respect to Alofs and Target in 1996 and to carry back to 1993,

1994, and 1995. This computation turns on determination of

Mr. Gleason’s basis in Alofs and Target, as basis limits the

allowable loss pursuant to section 1366(d)(1). Likewise, the

basis calculation will be affected by issues pertaining to

Mr. Gleason’s pro rata share of ordinary income and

distributions, as these will generate adjustments to basis under

section 1367(a).

A. Pro Rata Ordinary Income From Schedules K-1

Respondent contends that petitioners’ income for 1995 should

be adjusted to reflect an additional $438,571 as Mr. Gleason’s
- 16 -

pro rata share of ordinary income from S corporations. This

increase is derived from Schedules K-1 and is composed of two

components. One relates to Alofs and the other to Excellence.

The Schedule K-1 for Alofs for FYE 1995 shows Mr. Gleason’s

share of ordinary income from the trade or business as $470,814. 

Petitioners reported on Schedule E of their 1995 return only

$296,614 from Alofs. Nothing in the record elucidates the

$174,200 difference, and petitioners did not address the

discrepancy at trial or on brief. Thus, absent any demonstrated

basis for exclusion, the Court concludes that petitioners’ income

for 1995 must be increased by $174,200.

The remaining portion of the increase alleged by respondent

stems from the Schedule K-1 for Excellence’s FYE 1996. This

Schedule K-1 shows $257,328 of ordinary income from the trade or

business and $7,043 of interest income. Petitioners did not

report these amounts on their original returns for either 1995 or

1996. Respondent takes the position that because Mr. Gleason

sold his interest in Excellence near the end of 1995, the

$264,371 should be treated as received in a short taxable period

ended in 1995 and, accordingly, reported in that year. 

Petitioners do not directly dispute respondent’s position. On

brief they merely point out that they included the $264,371 on

their “amended 1996 tax return”. The revised Form 1040 for 1996

attached to petitioners’ Forms 1040X for each of the years 1993
- 17 -

through 1995 does indeed reflect additional income from

Excellence on Schedule E of $257,328 and additional interest

income of $7,043. Given petitioners’ lack of specific dispute

regarding the proper year for inclusion, the Court will sustain

respondent on this issue. We note, however, that neither party

has cited, nor has the Court’s research revealed, any legal

authority that would definitively resolve the underlying

substantive question of inclusion year in these circumstances. 

We leave this question for another day and a more fully developed

record.

B. Distributions From Schedules K-1

Mr. Gleason’s Schedules K-1 from Alofs and Excellence for

FYE 1995 reflect property distributions of $237,000 and $360,200,

respectively, that were not reported on petitioners’ 1995 return. 

Likewise, the Schedule K-1 from Alofs for FYE 1996 shows a

property distribution of $344,082 that was not reported by

petitioners. Respondent argues that these amounts are includable

as dividend income, principally on account of insufficient basis

to support tax-free treatment under section 1368(b)(1). Although

petitioners’ contentions on this point are less than clear,

statements made on reply brief suggest disagreement with the

premise that the distributions constitute a source of taxable

income.
- 18 -

While the gaps in the documentary record admittedly inhibit

precise computation of all relevant figures, respondent’s stance

would appear to be at odds with the stipulated evidence. 

Concerning Excellence, the parties do not dispute that

Mr. Gleason made an initial contribution of $50,000 in 1992. 

Petitioners’ 1993 return reported no income or loss from

Excellence, but their 1994 and 1995 returns reported ordinary

income (business income and interest income) from Excellence of

$317,959 and $826,737, respectively. We have also just sustained

respondent’s position that an additional $264,371 should have

been reported by petitioners in 1995. These income amounts would

serve to increase basis. Hence, the record supports that

sufficient basis was available to permit the $360,000 distributed

during the entity’s FYE 1995 to qualify for tax-free treatment

under section 1368(b)(1). Remaining basis would then be reduced

by a corresponding amount under section 1367(a)(2)(A) and would

result in a decreased carryover basis upon the subsequent

exchange of Excellence shares for stock in Alofs and Target.

As regards Alofs, again the parties do not dispute a $50,000

initial contribution, and petitioners reported ordinary income

from Alofs of $401,192 on their 1994 return and, as we have held,

are to include $470,814 for 1995. Again, these figures would

seem to support tax-free return of basis treatment for the

$237,000 distribution amount during the company’s FYE 1995. 
- 19 -

Treatment of the $344,082 distribution amount from the K-1 for

FYE 1996 presents additional complexity in that petitioners seek

to claim a $2,518,616 ordinary loss from Alofs for 1996. 

Pursuant to ordering rules contained in regulations promulgated

under section 1367, decreases in basis attributable to losses are

made before those attributable to distributions. Sec. 1.1367-

1(e), Income Tax Regs. However, because the Court concludes for

reasons detailed infra that the $6 million loan incurred in the

LBO transaction generated basis for Mr. Gleason in Alofs and

Target, his basis would appear to be adequate to accommodate both

the claimed losses and tax-free return of basis treatment for the

$344,082 distribution amount. Due to limitations in the record

before us, we leave final calculations to the parties under Rule

155.

C. Claimed Losses and Bases

With respect to their dispute over claimed losses and bases,

the parties have taken the approach of stipulating, first, the

components that petitioners alleged during audit should be

included in computing Mr. Gleason’s bases in Alofs and Target

and, second, which items were allowed and disallowed by

respondent in the basis computations. At trial and on brief,

each side then presented argument focused on specific disputed

components. We structure our discussion in a similar manner.
- 20 -

5 Although the stipulation refers to $5,673 as the amount

from the pertinent Schedule K-1, this would appear to be a

typographical error.

The parties stipulated that petitioners alleged a $7,842,696

basis in Alofs, calculated as follows:

 $50,000 Cash contribution with initial ownership of 20%

6,000,000 Loan from taxpayer through Comerica bank

 500,000 Loan from selling shareholders backed by CD from taxpayer

 196,000 Sales price reduction of Excellence

 696,696 Portion of the sales proceeds from Excellence

 400,000 Loan from Excellence to Alofs

Respondent disallowed most of these amounts and determined a

basis in Alofs of $877,574, comprising the $50,000 contribution,

$356,760 in sales proceeds from Excellence, and the $470,814

shown on the Schedule K-1 from Alofs for FYE 1995.

The parties likewise stipulated that petitioners alleged on

audit a basis in Target of $2,138,304, which amount included the

initial investment of $35,000 and $2,103,304 in sales proceeds

from Excellence. Respondent, in contrast, computed a basis in

Target of $584,133:

 $35,000 Initial investment

1,070,279 Portion of sales proceeds from Excellence

 (616,947) Loss for FYE 1995

 (70,163) Property distribution for FYE 1994

 113,311 Income for FYE 1993

 (42,242) Loss for FYE 1992

 101,485 Income for FYE 1991

 5,675 Income for FYE 19905

 (12,265) Loss for FYE 1989

Incorporated in both parties’ computations as sales proceeds from

Excellence are the basis amounts transferred to Alofs and Target

upon the exchange of Excellence shares for those in Alofs and
- 21 -

6 While the parties’ stipulations to some extent separate

allegations pertaining to Alofs and Target, their discussions at

trial and on brief generally address the matter of basis in the

two entities in a collective sense. The evidence in the record

also typically does not make a distinction. For example, the $6

million loan was to be used to purchase the stock of Alofs and

Target, not just Alofs as the stipulations would suggest. 

Accordingly, the Court’s discussion to follow will likewise

proceed in a generally collective fashion.

Target. The total claimed by petitioners ($2,800,000) was

allegedly based on calculations conducted by E&Y at the time of

the exchange. No documents related to that analysis were

proffered as evidence. Respondent’s total basis from Excellence

($1,427,039) was explained by stipulation as:

 $50,000 Initial investment

 312,699 Income from FYE 1994

 807,012 Income from FYE 1995

 257,328 Income from FYE 1996

According to stipulation, 25 percent of the Excellence stock was

exchanged for Alofs and 75 percent for Target.6

As a threshold matter, it should be observed that both

sides’ computations are problematic when considered vis-a-vis the

record in this case. Many of the components claimed by

petitioners are unsubstantiated by any documentary evidence, and

what explanations were offered at trial and on brief are opaque

and rambling. Respondent’s calculations, while giving an initial

impression of precision, take on a seemingly inexplicable

randomness when evaluated in light of the underlying record.
- 22 -

For instance, as discussed above, respondent argues that for

Excellence’s FYE 1996, petitioners are required to recognize as

ordinary income from Schedule K-1 both business income and

interest income. However, respondent then includes only the

business income in computing basis in Excellence. In fact,

respondent in the proffered basis calculations generally

disregards interest income reported on Schedules K-1 and/or

petitioners’ returns, for no apparent reason. Additionally,

respondent seems in certain instances to ignore even business

income from the S corporations. As one example, in arriving at

basis in Target, respondent takes into account the business

income or loss for FYE 1989 through 1995, with the exception of

FYE 1994. Yet $245,886 of business income was reported both on

Target’s Schedule K-1 and on petitioners’ Form 1040 for 1994. 

Similarly, in figuring basis in Alofs, respondent incorporates

business income from FYE 1995 but ignores the $401,192 from Alofs

reported by petitioners on their 1994 Form 1040. The absence of

any explanation for these omissions does little to inspire

confidence in respondent’s position.

In contrast to the silence just described, most of the basis

items claimed by petitioners were addressed in some fashion by

the parties at trial or on brief. The difficulty here is that

much of what was said is largely incoherent or irrevelvant,

leaving out what would seem to the Court to be basic, pertinent
- 23 -

information in favor of generalized and emotion-driven narrative. 

The Court is therefore left to piece together salient data to the

extent possible from a limited record. We now address various

claimed items in turn.

1. $6 million loan

The linchpin of petitioners’ position rests in the $6

million loan from Comerica. If Mr. Gleason was in substance the

borrower of the $6 million, he would be able to include that

amount in computing his basis in Alofs and/or Target under either

of two scenarios. As one possibility, if he used the borrowed

funds to purchase stock directly from the selling shareholders,

the amount would be included in his cost basis for the purchased

shares. Alternatively, if he lent the funds to Alofs and/or

Target, which the S corporations then used to redeem the stock of

the sellers, he would obtain basis in indebtedness of the S

corporation(s) to him. Conversely, if Alofs and/or Target was in

substance the borrower of the $6 million, with Mr. Gleason being

at most a guarantor, Mr. Gleason would not be entitled to any

accretion to basis when the corporation(s) used the funds to

acquire or redeem the stock from the sellers. Here, petitioners

would have the Court characterize Mr. Gleason as the true

borrower, while respondent maintains that the $6 million was in

substance a loan to Alofs and Target.
- 24 -

An extensive body of caselaw establishes applicable

principles in various loan situations involving S corporations

and their shareholders. Fundamentally, a shareholder may obtain

or increase basis in an S corporation only if there is an

economic outlay on the part of the shareholder that leaves him or

her “‘poorer in a material sense.’” Perry v. Commissioner, 54

T.C. 1293, 1296 (1970) (quoting Horne v. Commissioner, 5 T.C.

250, 254 (1945)), affd. without published opinion 27 AFTR 2d

1464, 71-2 USTC par. 9502 (8th Cir. 1971); see also Maloof v.

Commissioner, 456 F.3d 645, 649-650 (6th Cir. 2006), affg. T.C.

Memo. 2005-75; Estate of Leavitt v. Commissioner, 875 F.2d 420,

422 (4th Cir. 1989), affg. 90 T.C. 206 (1988); Brown v.

Commissioner, 706 F.2d 755, 756 (6th Cir. 1983), affg. T.C. Memo.

1981-608. An economic outlay for this purpose includes a use of

funds for which the taxpayer is directly liable in a purchase of

S corporation shares, in an actual contribution of cash or

property by the shareholder to the S corporation, or in a

transaction that leaves the corporation indebted to the

shareholder. See Maloof v. Commissioner, supra at 649; Bergman

v. United States, 174 F.3d 928, 931-932 (8th Cir. 1999); Estate

of Leavitt v. Commissioner, supra at 423. Stated otherwise, the

shareholder must make an actual “‘investment’” in the entity,

Spencer v. Commissioner, 110 T.C. 62, 78-79 (1998) (quoting

legislative history at S. Rept. 1983, 85th Cong., 2d Sess.
- 25 -

7 The petition filed in this case recites: “The

petitioner’s [sic] mailing address for all correspondence now at:

P.O. Box 8173, Kentwood, MI 49518-8173; and with legal residence

now at: P.O. Box 507, Long Beach, MS 39560”. Petitioners

designated Detroit, Michigan, as the place of trial. Residence

in Mississippi would generally imply the Court of Appeals for the

Fifth Circuit as the appropriate venue for appeal. See sec.

7482(b)(1)(A). Nonetheless, the procedural history of this

litigation suggests a reasonable possibility of an agreement to

alter venue of appeal to the Court of Appeals for the Sixth

Circuit. See sec. 7482(b)(2). In these circumstances, the Court

will take into account all potentially germane precedent. See

Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d

985 (10th Cir. 1971).

(1958), 1958-3 C.B. 922, 1141), thereby incurring a true “cost”,

Borg v. Commissioner, 50 T.C. 257, 263 (1968).

In general, no form of indirect borrowing, e.g., guaranty,

surety, accommodation, comaking, pledge of collateral, etc., will

give rise to the requisite economic outlay unless, until, and to

the extent that the shareholder pays all or part of the

obligation. Maloof v. Commissioner, supra at 649-650; Uri v.

Commissioner, 949 F.2d 371, 373 (10th Cir. 1991), affg. T.C.

Memo. 1989-58; Estate of Leavitt v. Commissioner, supra at 422;

Brown v. Commissioner, supra at 757; Raynor v. Commissioner, 50

T.C. 762, 770-771 (1968). The Court of Appeals for the Eleventh

Circuit7 recognizes a limited exception to this rule, permitting

a shareholder’s guaranty of a loan to an S corporation to effect

an increase in basis “‘where the lender looks to the shareholder

as the primary obligor’”. Sleiman v. Commissioner, 187 F.3d

1352, 1357 (11th Cir. 1999) (quoting Selfe v. United States, 778
- 26 -

F.2d 769, 774 (11th Cir. 1985)), affg. T.C. Memo. 1997-530. 

However, even the Court of Appeals for the Eleventh Circuit

affirms the general principle requiring an economic outlay,

concluding merely that when the shareholder is looked to as the

primary obligor, he or she has in substance borrowed the funds

and advanced them to the corporation. Sleiman v. Commissioner,

supra at 1357; Selfe v. United States, supra at 772-773; see also

Maloof v. Commissioner, supra at 651.

It is against the foregoing backdrop that petitioners’

characterization of Mr. Gleason as the true borrower versus

respondent’s of a loan in substance to Alofs and Target must be

weighed. We observe at the outset that our task is complicated

by the parties’ choice not to include in the record the documents

or agreement by which the share exchange was accomplished, such

that we are left to glean information about the formal structure

of the transaction from tangential materials. Hence, as one

example, we do not even know whether the operative paperwork in

form framed the LBO transaction as a purchase by Mr. Gleason or a

redemption by the corporations. With such limitations in mind,

we turn to the details of the parties’ arguments.

Respondent’s position that the $6 million was in substance a

loan to Alofs and Target rests on the general premise that

Mr. Gleason made no economic outlay in connection with the

transaction because Comerica looked primarily to the S
- 27 -

corporations for repayment. Respondent cites three particular

factual circumstances in support of this stance. First, the loan

stipulated that the funds could only be utilized to obtain the

shares of Alofs and Target. Second, the Alofs and Target stock

was used to collateralize the loan; petitioners pledged no

personal assets. Third, payments on the loans were made by Alofs

and Target, and those payments were not treated as constructive

dividends to petitioners. Respondent contends that these facts

render the case at bar analogous to Hafiz v. Commissioner, T.C.

Memo. 1998-104.

In Hafiz v. Commissioner, supra, a partnership owned a

motel. One of the partners, the taxpayer-husband, decided to

purchase the motel and organized an S corporation to make the

acquisition. Id. A bank agreed to lend funds for the purchase. 

The S corporation, the taxpayers, and the taxpayer-husband’s

medical practice were named as obligors of the loan, and the

proceeds thereof were required to be used to buy the motel. Id.

The loan was secured by the motel, and the taxpayer-husband was

required to pledge personal assets as additional security. Id.

Although the S corporation gave the taxpayer-husband a promissory

note for the amount of the loan, the corporation treated the loan

on its books as from the bank, made the payments due to the bank,

and deducted the interest remitted. Id. Neither the corporation
- 28 -

nor the taxpayers reported the loan payments as constructive

dividends. Id. A second loan was structured similarly. Id.

The taxpayers in Hafiz v. Commissioner, supra, argued that

the loans should be viewed as loans to them, followed by loans

from them to the S corporation. As such, they could increase

their bases and deduct losses incurred by the corporation. Id.

This Court rejected the taxpayers’ plea to ignore the form of the

loans and rely on the asserted economic substance, holding that

the transactions were in form and substance loans from the bank

to the corporation. Id.

While certain of the facts present in Hafiz v. Commissioner,

supra, have parallels here, there remains a critical difficulty

with drawing an analogy from that case, or indeed from much of

the body of caselaw addressing S corporation shareholders and

loans. The majority of this jurisprudence involves situations

where the corporation was a (often the only) primary obligor on

the loan at the time the funds were disbursed. E.g., Sleiman v.

Commissioner, supra at 1354-1355; Bergman v. United States, 174

F.3d at 929; Estate of Leavitt v. Commissioner, 875 F.2d at 421-

422; Brown v. Commissioner, 706 F.2d at 756; Underwood v.

Commissioner, 535 F.2d 309, 310-311 (5th Cir. 1976), affg. 63

T.C. 468 (1975); Spencer v. Commissioner, 110 T.C. at 66-67. The

shareholders were accordingly attempting to overcome the initial

documentary record with a later restructuring and/or with
- 29 -

8 It is also noteworthy that the phrasing of the parties’

stipulations likewise suggests a transaction that was in form a

direct purchase by Mr. Gleason from the selling shareholders. 

One stipulation includes the statement that “petitioner [Mr.

Gleason] agreed to exchange his shares in Excellence to obtain

money to purchase Alofs and Target.” Another reads: “petitioner

exchanged his shares of Excellence and with the assistance of

financing, became the owner of most of the remaining shares of

Alofs and Target.”

allegations of substance over form, which the courts have

typically found insufficiently persuasive. E.g., Sleiman v.

Commissioner, 187 F.3d at 1358-1359; Bergman v. United States,

supra at 932, 934; Estate of Leavitt v. Commissioner, supra at

422; Brown v. Commissioner, supra at 756; Underwood v.

Commissioner, supra at 311; Spencer v. Commissioner, supra at 83-

86.

That is not the scenario with which we are confronted here. 

To the contrary, the only original documents in the record

pertaining to the $6 million show that the debt, from the outset,

was in form a loan to Mr. Gleason as the sole obligor. The

stipulated loan agreement designates Mr. Gleason as the only

“Borrower”. The irrevocable letter of credit that apparently

made these funds available to the selling shareholders states

consistently that it was opened “FOR ACCOUNT OF THOMAS E.

GLEASON”.8 Furthermore, certain facts relied upon by respondent,

such as the restriction requiring proceeds to be used to purchase

the Alofs and Target stock or the pledge of the shares as

collateral, are not necessarily at odds with the form of the
- 30 -

transaction. A stereotypical residential purchase and purchase

money mortgage, for instance, bears many similarities.

Even the fact that payments on the loan were swept from

corporate accounts carries little weight in the highly unusual

circumstances of this case. Respondent’s position rests on the

proposition that Comerica looked primarily to Alofs and Target,

and not to Mr. Gleason or petitioners, for repayment of the $6

million. However, the relevant time for answering this question

is as of when the disbursement was made. See Delta Plastics

Corp. v. Commissioner, 54 T.C. 1287, 1291 (1970) (“Whether a

transfer of money creates a bona fide debt depends upon the

existence of an intent by both parties, substantially

contemporaneous to the time of such transfer, to establish an

enforceable obligation of repayment.”). The loan was executed in

December of 1995. By January of 1996 the entire LBO transaction

was in meltdown, and it is impossible to speculate as to how

those involved might have proceeded had the buyout and underlying

cashflow projections proved sustainable. Presumably, Comerica,

as an independent, third-party commercial entity, did not enter

the transaction expecting it to fail.

Mr. Gleason testified that the intention was for Alofs and

Target to pay dividends to him, which he would then use to make

payments on the $6 million loan. The sudden demise and

Comerica’s subsequent actions may have short circuited any such
- 31 -

plan, but the alleged approach is not unreasonable on its face. 

Nothing in the record suggests that Comerica did not, as of the

date of the loan, intend to operate in accordance with this form. 

Notably, the pledge agreement expressly entitled Mr. Gleason to

receive dividends and distributions. Suffice it to say that

repayments sourced from the S corporations would go farther in

overcoming the form of the loan had they occurred prior to the

almost certain shock and probable visceral every-man-for-himself

reaction provoked by a spectacular and unexpected commercial

failure.

Moreover, the Court’s recent opinion in Ruckriegel v.

Commissioner, T.C. Memo. 2006-78, is instructive in this regard. 

That case involved taxpayers who were shareholders in an S

corporation and partners in a partnership. The partnership made

various borrowings from a bank and advanced funds to the S

corporation in transactions taking one of two forms. Id. Most

of the advances were accomplished by means of checks written

directly from the partnership to the corporation; however,

certain of the advances were structured as back-to-back wire

transfers from the partnership to the taxpayers and then from the

taxpayers to the S corporations. Id. With respect to both

scenarios, principal and interest payments were made directly

from the S corporation to the partnership. Id. The taxpayers

argued that all transactions should be treated in substance as
- 32 -

back-to-back loans, thereby increasing their bases in the S

corporation. Id.

Concerning the direct checks, we noted the interest payments

by the S corporation as a factor weighing against the taxpayers’

attempts to reclassify the advances as back-to-back loans. Id.

In contrast, as to the wire transfers, we declined to consider

the interest payments fatal when the form of the transactions was

otherwise in accordance with the substance advocated by the

taxpayers. Id. The evidence was insufficient to overcome the

form of the wire transfers and show that the taxpayers were not

the intended borrowers but were merely conduits to funnel funds

between the entities. Id. We further observed that although the

back-to-back structure was adopted for the purpose of achieving

tax bases, such was a permissible motivation where there was a

business purpose (i.e., to provide working capital for the

corporation) for the loans. Id.

Likewise, the Court concludes here that the evidence in the

record on balance weighs in favor of the $6 million having been

structured in form as a loan to Mr. Gleason. Moreover, the

evidence allegedly supporting a contrary substance is lacking in

probative heft. Given the surrounding circumstances and

particularly the abrupt implosion of the LBO, nothing proffered

convinces the Court that those involved did not intend at the

time the funds were advanced to operate in accordance with the
- 33 -

form. Hence, the preponderance supports petitioners’ position

with regard to the $6 million, and this amount is properly

included in basis in Alofs and Target.

2. $500,000 loan and $400,000 loan

Two additional amounts labeled as “loans” in the parties’

stipulations are among the items claimed by petitioners to have

resulted in accretions to basis. These include $500,000

characterized as a “Loan from selling shareholders backed by CD

from taxpayer” and $400,000 designated as a “Loan from Excellence

to Alofs”. Petitioners’ contentions with respect to these

amounts can only be described as murky at best. Petitioners on

brief incorporate in a listing of various forms of consideration

exchanged in the LBO transaction the statement that, after

contribution of his Excellence holdings:

Petitioner purchased with $7,160,000 in cash sellers

remaining shares in Alofs and Target, with Alofs and

Target assuming a $500,000 seller note backed by a

Certificate of Deposit of $400,000 to be released to

Petitioner upon pay down of the $500,000 seller note,

plus $196,000 in Excellence dividends payable by Alofs

to Petitioner upon demand * * *

Mr. Gleason also made a number of convoluted references to

$500,000 and $400,000 amounts in his testimony at trial, likewise

suggesting some connection between the two but leaving the Court

with no clear understanding of the relationship or the intended

versus actual circumstances. For example, he stated at one

point: “As the note was paid down, that I would proportionally
- 34 -

get the 400,000 that was put into a CD in Alofs. That, because

we didn’t pay the $500,000 note, I couldn’t draw on the 400-”. 

Later he remarked: “The 400,000 shows as paid in capital by the

sellers as a tax advantage. * * * Excellence lent it to them. 

They put it in as paid in capital. * * * And so I had to effect a

$500,000, just for closing, seller note. There was no seller

note in this transaction. It became secured by 400,000 that was

going to be paid to me in cash.”

The parties’ stipulations with regard to these two amounts

read as follows:

In regard to the $500,000 loan that the respondent did

not allow in basis for Alofs, petitioners indicated

that this was supposed to be received by petitioners. 

During the audit, petitioners indicated that this

amount was never received from the selling

shareholders, nor contributed by petitioners to Alofs.

* * * * * * *

In regard to the $400,000 that the respondent did not

allow in basis for Alofs, petitioners advised that this

amount was a loan from Excellence to the selling

shareholders, and paid directly to Alofs. Attached as

Exhibit 23-J, is the check from Excellence to Alofs.

The referenced exhibit is a copy of a check dated December 18,

1995, in the amount of $400,000, drawn on Excellence’s account

and payable to the order of Alofs. Mr. Gleason commented on this

scenario at trial in a colloquy with the revenue agent who

audited petitioners’ returns:

Q [Mr. Gleason] * * * Also, the $400,000 * * *

the check being made out to Alofs, it is true it was

made out to Alofs, didn’t I tell you that it was handed
- 35 -

to me and I gave it to the banker after the closing and

said, Put this in a CD in the company?

A [revenue agent] I don’t remember that, but if

that had been the case you should have reported that

$400,000 under income for 1995.

Q Okay. It would have been a distribution that

would have reduced my basis. Right?

A If you had recorded the amount in income and

then contributed it to Alofs, then it would be included

in your basis in Alofs.

Q Okay. It wouldn’t have been taxable then if we

had already paid the taxes on that retained earnings,

if it came out of Excellence retained earnings, would

it not?

Suffice it to say that the foregoing record is at least

confusing, if not potentially contradictory, as to petitioners’

claims regarding the $500,000 and $400,000 amounts. The only

documentary evidence related to either item is the $400,000

check, suggesting a remittance that in form should not affect

basis in Alofs or Target. Conversely, nothing offered by

petitioners at trial or on brief is sufficiently clear to suggest

any transaction that in substance would lead to increased basis. 

Respondent’s position as to these amounts is sustained.

3. $196,000 sales price reduction

A $196,000 item is also a subject of dispute in the parties’

basis computations. According to their stipulation on this

matter: “In regard to the $196,000 that the respondent did not

allow in basis for Alofs, petitioners advised that this resulted

from the reduction in the sales price of Excellence by this
- 36 -

amount. During the audit, it was indicated that this amounts

[sic] was never paid to the petitioners or Alofs.” Certain

copies of the Schedule K-1 issued to Mr. Gleason for Excellence’s

FYE 1996 shows a $196,000 property distribution to which a

handwritten notation “NEVER PAID” has been affixed. Petitioners

do not contest that the funds were never paid; in fact,

Mr. Gleason’s testimony indicated that it was he who added the

just-mentioned notation.

In general, petitioners’ references at trial and on brief

with respect to the $196,000 are akin in their rambling and

nebulous tenor to those addressed above concerning the $500,000

and $400,000 amounts. Petitioners offer on opening brief that

“another $196,000 Alofs/Target stock purchase was funded by

agreement not to accept $196,000 Excellence owned dividend”. On

reply brief, they explain:

Respondent’s statement is correct in that it was never

paid to petitioner, but was treated as a reduction in

cash required for purchase of stock from sellers, and

Comerica agreed to permit Petitioner to withdraw

$196,000 from companies without bank restrictions by

April 10, 1996. Because of the cash poor conditions of

the company, Petitioner elected To leave this money in

the company until cash was available. * * * 

Mr. Gleason’s testimony at trial continued in a similar vein,

characterizing the $196,000 as some form of foregone

distribution.

Again, the Court is lacking in any clear evidence as to

precisely what transpired with respect to the $196,000 or how it
- 37 -

was accounted for by those involved in the LBO transaction. In

general, funds neither received by petitioners nor reported by

them as income would not be considered as contributions by them

to another entity such as would result in an increased basis. On

this record, vague allegations of a substance that might support

basis are insufficient to overcome the general rules.

4. Excellence sales price proceeds

The final component specifically addressed by the parties in

their stipulations regarding their respective computations of

basis in Alofs and Target is the sum attributable to the

Excellence shares exchanged in the LBO. As mentioned supra in

our preliminary discussion concerning general computational

problems, petitioners claimed a total of $2,800,000 in sales

proceeds from Excellence, based allegedly on computations

performed by E&Y at the time of the exchange. Mr. Gleason also

testified that he “ended up surrendering my stock in Excellence

for the benefit of reducing the subordinated debt by 2.8

million”, but again no operative documents from the LBO

transaction elucidate this statement or the precise treatment of

the Excellence shares by those involved. Respondent allowed a

total of $1,427,039. To once more reprise our earlier remarks,

neither calculation is adequately supported or explained by the

record. No documentary evidence corroborates petitioners’

assertions, and respondent’s position is difficult to square with
- 38 -

the tax returns and forms on which it purportedly relies. 

Furthermore, adjustments may be rendered necessary by the Court’s

holdings on other issues. Thus, while we reject petitioners’

$2,800,000 for lack of evidence, we would expect that as part of

the parties’ Rule 155 computations, revised calculations

consistent with this opinion would retrace the basis of the

exchanged Excellence shares.

D. Accuracy-Related Penalty

Subsection (a) of section 6662 imposes an accuracy-related

penalty in the amount of 20 percent of any underpayment that is

attributable to causes specified in subsection (b). Subsection

(b) of section 6662 then provides that among the causes

justifying imposition of the penalty are: (1) Negligence or

disregard of rules or regulations and (2) any substantial

understatement of income tax.

“Negligence” is defined in section 6662(c) as “any failure

to make a reasonable attempt to comply with the provisions of

this title”, and “disregard” as “any careless, reckless, or

intentional disregard.” Caselaw similarly states that

“‘Negligence is a lack of due care or the failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances.’” Freytag v. Commissioner, 89 T.C. 849, 887

(1987) (quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th

Cir. 1967), affg. on this issue 43 T.C. 168 (1964) and T.C. Memo.
- 39 -

1964-299), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S.

868 (1991). Pursuant to regulations, “‘Negligence’ also includes

any failure by the taxpayer to keep adequate books and records or

to substantiate items properly.” Sec. 1.6662-3(b)(1), Income Tax

Regs.

A “substantial understatement” is declared by section

6662(d)(1) to exist where the amount of the understatement

exceeds the greater of 10 percent of the tax required to be shown

on the return for the taxable year or $5,000 ($10,000 in the case

of a corporation). For purposes of this computation, the amount

of the understatement is reduced to the extent attributable to an

item: (1) For which there existed substantial authority for the

taxpayer’s treatment thereof, or (2) with respect to which

relevant facts were adequately disclosed on the taxpayer’s return

or an attached statement and there existed a reasonable basis for

the taxpayer’s treatment of the item. See sec. 6662(d)(2)(B).

An exception to the section 6662(a) penalty is set forth in

section 6664(c)(1) and reads: “No penalty shall be imposed under

this part with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for such portion and that

the taxpayer acted in good faith with respect to such portion.”

Regulations interpreting section 6664(c) state:

The determination of whether a taxpayer acted with

reasonable cause and in good faith is made on a caseby-case basis, taking into account all pertinent facts

and circumstances. * * * Generally, the most important
- 40 -

factor is the extent of the taxpayer’s effort to assess

the taxpayer’s proper tax liability. * * * [Sec.

1.6664-4(b)(1), Income Tax Regs.]

Reliance upon the advice of a tax professional may, but does

not necessarily, demonstrate reasonable cause and good faith in

the context of the section 6662(a) penalty. Id.; see also United

States v. Boyle, 469 U.S. 241, 251 (1985); Freytag v.

Commissioner, supra at 888. Such reliance is not an absolute

defense, but it is a factor to be considered. Freytag v.

Commissioner, supra at 888.

In order for this factor to be given dispositive weight, the

taxpayer claiming reliance on a professional must show, at

minimum: “(1) The adviser was a competent professional who had

sufficient expertise to justify reliance, (2) the taxpayer

provided necessary and accurate information to the adviser, and

(3) the taxpayer actually relied in good faith on the adviser’s

judgment.” Neonatology Associates, P.A. v. Commissioner, 115

T.C. 43, 99 (2000), affd. 299 F.3d 221 (3d Cir. 2002); see also,

e.g., Charlotte’s Office Boutique, Inc. v. Commissioner, 425

F.3d 1203, 1212 & n.8 (9th Cir. 2005) (quoting verbatim and with

approval the above three-prong test), affg. 121 T.C. 89 (2003);

Westbrook v. Commissioner, 68 F.3d 868, 881 (5th Cir. 1995),

affg. T.C. Memo. 1993-634; Cramer v. Commissioner, 101 T.C. 225,

251 (1993), affd. 64 F.3d 1406 (9th Cir. 1995); Ma-Tran Corp. v.

Commissioner, 70 T.C. 158, 173 (1978); Pessin v. Commissioner, 59
- 41 -

T.C. 473, 489 (1972); Ellwest Stereo Theatres v. Commissioner,

T.C. Memo. 1995-610.

As previously indicated, section 7491(c) places the burden

of production on the Commissioner. The notice of deficiency

issued to petitioners asserted applicability of the section

6662(a) penalty on account of both negligence and/or substantial

understatement. See sec. 6662(b). Respondent in his pretrial

memorandum and on brief has focused on negligence or disregard of

rules or regulations as the basis for the penalties.

To the extent that we have ruled in petitioners’ favor, some

or all of the underpayments and corresponding penalties may have

been eliminated. However, to the extent that our rulings in

respondent’s favor and concessions by petitioners are shown after

Rule 155 computations to leave in place any portion of the

determined underpayments, the record in this case satisfies

respondent’s burden of production under section 7491(c) with

respect to negligence. The evidence adduced reveals a serious

dearth of adequate records and substantiation for many claimed

items. At the same time, petitioners inexplicably failed to

report various amounts expressly reported to them on Schedules K1. With this threshold showing, the burden shifts to petitioners

to establish that they acted with reasonable cause and in good

faith.
- 42 -

Argument by petitioners specifically directed toward the

penalties is limited to the following statement on reply brief:

Petitioner pleads with the court to accept that

Petitioner indeed relied on Ernst & Young for both the

LBO structure and all tax matters and that Petitioner

did not have cause it [sic] not trust their tax advise

[sic] until Petitioner was provided access to evidence

from company bankruptcy court requested documents, and

that Petitioner did not intentionally cause his tax

returns to be in error, especially with the large Tax

Basis that Petitioner made the assumption that he had a

right to...

Thus, petitioners here would seem to assert a reliance defense as

the grounds upon which they should be relieved of liability for

the section 6662(a) penalties.

The record, however, is insufficient to support such a

defense. While the Court has little doubt that petitioners

relied on E&Y’s work at various junctures during Mr. Gleason’s

participation in the LBO transaction, the nexus between that work

and the specifics reported on petitioners’ returns is simply

unclear. The returns and amended returns were all professionally

prepared, either by Thomas & Associates or by Plante & Moran,

LLP. Nothing in the record addresses the qualifications of those

firms. Petitioners have also declined to offer any evidence, or

even allegations, with respect to the information provided to the

preparers or the extent to which such information might have

incorporated work generated by E&Y.

Consequently, although the Court sympathizes with

petitioners and is confident that they did not set out
- 43 -

intentionally to submit erroneous returns, the paucity of

explanatory material in the record fails to exclude the

possibility that they were negligent in their reporting. Should

computations reveal remaining underpayments, section 6662(a)

penalties are applicable.

To reflect the foregoing and concessions made,

Decision will be entered

under Rule 155.