T.C. Mem o. 2 01 3- 21 1

UNITED STAT ES TAX COURT
PAUL GRAFFIA, ET AL. , Pet it io ne rs v. 1 COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt

Doc ke t No s. 40 66 -1 1, 1 56 59 -0 9, Fil edSep te m be r 9, 2 01 3. 15 86 5- 09 , 40 44 -1 1, 40 54 -1 1.

Ps org an iz edPCSC , an S co rp or at io n, i n wh ic h P -M an d P -D ha d o wne rs hi p i nt eres ts . Ps, PCS C, an d afri en dl y th irdpa rty ex ecu te d andex ch an ge d (andlat er ca nc el ed ) rec ip ro cal pro m is so ry no te s. P-M an d P -D de du ct edsubs ta nt ia l fl ow- th ro ug h l os se s fr om PCSC ’s act iv it ie s. R d is al lo wedPs’ flo w-th ro ug h d educ ti on s. In ad di ti on , R di sa ll owe d NOL d educ ti on s an d o th er d educ ti on s n ot rel at edto PCSC , det erm in edth atP-D an d P -A ha d u nr ep orte d in co m e, an d d et erm in edth atPs a re l iabl e fo r acc ur acy-rela te d pe na lt ie s.

Cas es of t he fol lo win g p et it io ne rs are co ns ol id at edhe rewi th : Ma ril ynn e 1 Graffi a, do ck etNos . 15 65 9- 09 an d 4 04 4- 11 ; an d Dav idM. an d Amy L. Graffi a, do ck etNos . 15 86 5- 09 an d 4 05 4- 11
.- 2 -

[* 2] Held : P-M an d P -D are n oten ti tl edto de du ctPCSC ’s lo ss es be cau se (1) Ps d idno t s ub st an ti at e th os e lo ss es , (2) P-M a ndP-D di d no t h av e su ffi ci en t b as is inPCSC ’s st oc k t o s up po rt d educ ti on s, si nc e P-M ’s andP-D’s al le ge d b as is inPCSC ’s st oc k re su lt edfro m a se rie s o f pape r tr an sa ct io ns th atlar ge ly cance le d o uton e an ot he r an d di d n otrefl ecteco no m ic ou tl ay s, an d (3 ) P-D d idno t m at eri al ly pa rti ci pa te inPCSC
. Held , furth er, Ps di d n otsubs ta nt ia te th ei r en ti tl em en t t o a ny ot he r de du ct io ns ; P- D andP-A fai le d t o re po rt c ap it al ga in in co m e; an d P s ar e al l l iabl e fo r acc ur acy-rela te d p en al ti es . Pau l W. Graff

ia , forhi m se lf. Mar il ynn e Graff

ia , forhe rs el f. Dav idM. an d Am

y L. Graffi a, fo r th em se lv es . Mar ia nn S. Carb on e an d J us ti n D. Sch ei d, fo r res po nd en t.
CONTENTS
FINDINGS OF FACT.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 I. Pet it io ne rs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 II. Ten an t Im

pr ov em en t Pr og ram . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 III. PCSC
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 IV. PCSC ’s att em

pt s t o e xp lo itth e Ten an t Im pr ov em en t Pr og ram . . . . . . 9 V. Ro y al ty agree m en ts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 VI. Pau l’s p ro m is so ry

no te to Tho m as Ols on . . . . . . . . . . . . . . . . . . . . . . 12 VII. The m il li on -d ol la r no te s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 VIII. PCSC ’s faci li ta ti on ag reem en t wi th Ols on Co nt ract or s. . . . . . . . . . . 15 IX. PCSC ’s exp en se s an d re tu rn s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16- 3 -

[* 3] A. Ro y al ty fee pa ym en ts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

1. Mar il ynn e Graff

ia ’s royalty

fee co nt rib ut io ns . . . . . . . . 17 2. Set of

f of th e Pau l Gra ffi a n ot e. . . . . . . . . . . . . . . . . . . . 18 3. Ass ig nm en t ag reem en t. . . . . . . . . . . . . . . . . . . . . . . . . . 20 B. Cred itcardpa ym en ts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 X. Pet it io ne rs ’ ta x re tu rn s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 XI. Not ic es of d efi ci en cy an d p et it io ns . . . . . . . . . . . . . . . . . . . . . . . . . . 23 OPINION.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 I. Evi de nt ia ry

pri nc ip le s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 A. Bu rd enof p ro of

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 B. Lackof r eco rd s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 C. Lackof t es ti m on y

by D av idan d M ari lynn e. . . . . . . . . . . . . . . 27 1. Lackof c ou ns el
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 2. Exp ect at io n o f th e Co m mis si on er’s cal li ng th e wit ne ss es . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 II. Dis reg ard in g fi ct it io us arran ge m en ts . . . . . . . . . . . . . . . . . . . . . . . . . 33 III. Ro y al ty fee in co m e. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 A. Actu al rece ip t. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 B. Co ns tru ct iv e rec ei pt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 IV. Pas s- th ro ug h o f PCSC lo ss es . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 A. PCSC ’s tra de or b us in es s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 B. Deduc ti on s und erl y in g P CSC’s l os se s. . . . . . . . . . . . . . . . . . . 45 1. PCSC ’s royalty

ex pe ns es . . . . . . . . . . . . . . . . . . . . . . . . 46 2. Cred itcardex pe nd itur es . . . . . . . . . . . . . . . . . . . . . . . . 48- 4 -

[* 4] C. Sh areh ol de rs ’ m at eri al pa rti ci pa ti on . . . . . . . . . . . . . . . . . . . . 49

D. Sh areh ol de rs ’ ba si s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 V. NOL carryove r de du ct io ns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 VI. Pau l’s Sc he du le C expe ns es . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 VII. Unr ep orte d i nc om e. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 VIII. Accu racy-rela te d p en al ti es . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 A. Subs ta nt ia l u nd ers ta te m en t. . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 B. Neg li ge nc e. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 C. Defen se s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
MEMORANDUM FINDINGS OF FACT AND OPINION GUSTAFSON, Ju dg e: The In te rn al Rev enue Serv ic e (IR S) d et erm in ed de fic ie nc ie s i n p et it io ne rs ’ Fed eral in co m e ta x andpe na lt ie s as fol lo ws: Pet it io ne rs Year Defi ci en cy Sec. 6 66 2 P en al ty Dav idan d 20 05 $6 4,3 84 $12 ,87 6.8 0 Am y Graffi a 20 06 70 ,68 0 14 ,13 6.0 0

20 07 44 ,19 3 8,8 38 .60 Mar il ynn e Graff

ia 20 05 1,0 79 215 .80 20 06 2,5 14 502 .80 20 07 3,9 48 789 .60 Pau l Gra ffi a 20 05 10 ,80 7 2,1 61 .40

20 06 12 ,04 1 2,4 08 .20 20 07 13 ,82 3 2,7 64 .60- 5 -

[* 5] Pu rs ua ntto sec ti on 62 13 (a), Davi d a ndAm y Graffi a, Mar il ynn e Graff ia , and 2 Pau l Gra ffi a h av e p et it io ne d the Co urt fo r red et erm in at io n o f th os e d efi ci en ci es . Fo r th e y ears inis su e Ma ril ynn e an d Dav idha d c om pl et e o wne rs hi p o f Pref

erre d Cap it al Serv ic e Co rp . (“ PCSC ”), anS co rp or at io n t o wh ic h s ev eral of t he is su es in th es e cas es rel at e. Cen tra l t o t hi s ca se is a ci rcu la r an d e ss en ti al ly fict it io us
arra ng em en t o f ob li ga ti on s- -in vo lv in g P CSC, p et it io ne rs , anda bu si ne ss acqua in tanc e o f th ei rs --tha t l arg el y can cel edeach ot he r ou t. The sp eci fic is su es fo r de ci si on are: 3 1. wh ethe r Mar il y

nn e o r Pau l ac tu al ly or co ns tru ct iv el y rece iv edroyalty in co m e fro m

PCSC . W e h ol d t ha t the y di d n ot ; 2. wh ethe r Pau l’s g ro ss in co m e fo r 20 05 or 2 00 6 i nc lu de s an y am ou nt
as so ci at edwith P CSC’s a ll eg edcan cel la ti on of P au l’s p ro m is so ry no te for $3 85 ,00 0. We ho ldth atitdo es no t; 3. wh ethe r Mar il y

nn e an d Dav idan d Amy

are en ti tl edto de du ctfor20 05 ,

Unl es s o th erwi se in di cat ed , all cit at io ns of s ect io ns refe r to th e In te rn al 2 Rev enue Co de (26 U.S.C.) in effe ctforth e ta x years i n i ss ue , andall cit at io ns of Ru le s re fer t o t he Tax C ou rt Rul es of P ract ic e an d P ro cedur e. The re ar e o th er co m

pu ta ti on al ad

jus tm en ts setforth inth e n ot ic es of 3 de fic ie nc y

is su edto Pau l an d t o Dav idan d Amy . Res ol ut io n o f th os e ad jus tm en ts wil l fo ll ow au to m at ic al ly from th e Co urt’s d et erm in at io ns with re ga rdto th e is su es res ol ve d i n t hi s o pi ni on .- 6 -

[* 6] 20 06 , or 2 00 7 a ny am ou ntof d educ ti on s at tri bu tabl e to PCSC . W e h ol d t ha t th ey are n ot , bec au se th ey

fai le d t o s ub st an ti at e an y de du ct io ns for

PCSC , th ey fai le d t o s ho w th atth ey

ha d a ny bas is inPCSC , andDavi d a ndAm y di d n ot
m at eri al ly part ic ip at e in PCSC du rin g t he y ears inis su e; 4. wh ethe r Mar il y

nn e o r Pau l es tabl is he d t ha t ei th er o f th em was e nt it le d t o
ne t o pe rat in g l os s (“NOL”) carry ov er d educ ti on s fo r ta xabl e y ear 2 00 5, 2 00 6, o r 20 07 . W e h ol d tha t n ei th er h as ; 5. wh ethe r Pau l i s en ti tl edto an y of t he de du ct io ns an d o ffs et s tha t h e cl ai m edon hi s Sc he du le C, “ Pro fitor Lo ss Fro m Bu si ne ss ”, fo r ta xabl e y ear 2 00 5. W e h ol d t ha t h e is no t; 6. wh ethe r Dav idan d Amy fai le d t o re po rt $ 4,4 92 of t ax ab le in co m e
as so ci at edwith t he sal e o f st oc ks or b on ds fortax y ear 2 00 7. We ho ldth atth ey di d; an d 7. wh ethe r pe ti ti on ers are l iabl e fo r th e acc ur acy-rela te d p en al ti es de te rm in edag ai ns t the m . W e h ol d tha t the y are. FINDINGS OF FACT Tria l o f th es e cas es was h el d i n C hi cag o, Il li no is . Som e o f th e fac ts inth es e
cas es were s ti pu la te d a ndare s o fo un d. Atth e ti m e th ey fil edth ei r pe ti ti on s, pe ti ti on ers li ve d i n Il li no is
.- 7 -

[* 7] I. Pet it io ne rs Pau l an d M ari lynn e Graff iaare m arri ed , andforth e y ears inis su e th ey fil ed
se pa rat e Fed eral in co m e ta x re tu rn s. Dav idGraffi a is Pau l an d M ari lynn e’s so n. Fo r th e y ears inis su e Dav idan d h is wife Am y fil edjoi ntFed eral in co m e ta x returns . Pau l p rep aredhi s an d M ari lynn e’s ta x re tu rn s fo r th e y ears inis su e. Altho ug h P au l h as ex te ns iv e ex pe rie nc e inacco un ti ng , he i s n otreg is te redor li cen se d a s a c ert ifi edpubl ic acco un ta ntinan y juri sd ic ti on . H&R Bl oc k p rep ared Dav idan d Amy ’s 20 05 , 20 06 , and20 07 joi ntreturns . II. Ten an t Im

pr ov em en t Pr og ram Pau l Gra ffi a cre at edth e Ten an t Im pr ov em en t Pr og ram

in20 01 an d de ve lo pe d a ndm od ifi editinth e su ccee di ng y ears . The p ur po se of t he Tena nt Im pr ov em en t Pr og ram

was t o p ro vi de co m

m erci al pro pe rty owne rs anin no va ti ve way to fin an ce t en an t i m

pr ov em en ts with c ap it al acqui redby the pro gr am pr om ot er i n e xc ha ng e fo r pr og ram fees an d a n i nt eres t i n t he lea se ho ld . (The de ta il s o f th e p ro gr am

are n otsi gn ifi can t t o t hi s ca se .) The reco rdco nt ai ns ex te ns iv e d oc um en ta ti on of m ark etres earc h a ndleg al advi ce Paul us edto de ve lo p t he Tena ntIm pr ov em en t Pr og ram . He hi redlawyers to ass ur e th e v al id it y

of h is co nc ep t an d t o h el p h im pre pa re the do cum en ts- 8 -

[* 8] ne ces sa ry

to effe ctua te it . Peti ti on ers pe rs ua de d u s tha t the y ha d asubjec ti ve in te nt io n t o u se th e p ro gr am to ge ne rat e a p ro fit ; b utth ere i s i ns uf fic ie ntev id en ce to sh ow wh ethe r th e p ro gr am ha d s ub st an ti al co m

m erci al va lu e. III. PCSC PCSC is anIll in oi s co rp or at io n c reat edby Maril ynn e an d Dav id , whi chis
en ga ge d i n t he bu si ne ss of r eal est at e co ns tru ct io n a ndim pr ov em en t fi na nc in g. Fo r th e y ears inis su e PCS C was a subc hapt er S co rp or at io n o n t he accrua l
m etho d. Pe ti ti on ers pu t o n n o e vi de nc e--e xp ertor o th erwi se --t o p ro ve th e v al ue of PCSC at a ny tim e. Fro m PCSC ’s org an iz at io n i n 2 00 1 u nt il Decem be r 31 , 20 06 , Mari lynn e an d Dav idwere the so le sh areh ol de rs of P CSC, wi th Mari lynn e o wni ng 55 .7% an d Dav idown in g 4 4.3 %. In 2 00 7 Dav idacqui red10 0% o wne rs hi p o f PCSC . Pau l he ldhi m se lf o utas arep res en ta ti ve of P CSC ( fo r ex am pl e, as PCSC ’s “

New Bu si ne ss Deve lo pm en t M an ag er”) , andhe als o p rep aredth e Fed eral in co m e ta x returns forPCSC . In 2 01 0 Th om as Ols on (who is di sc us se d i n m or e d et ai l b el ow) acqui redall of Da vi d’s i nt eres t i n P CSC. Inall th ree years i n i ss ue , Davi d was em pl oyed atot he r co m

pa ni es . Em pl oyin g t he bu rd en -o f-p ro of pri nc ip le s d is cu ss edbe lo w, we fin d t ha t Dav iddi d- 9 -

[* 9] no t ex pe ndas m

uc h a s 1 00 ho ur s p er y ear wo rk in g fo r PCSC inan y of t he y ears inis su e o r in pre ced in g years. 4 IV. PCSC ’s att em

pt s t o e xp lo itth e Ten an t Im pr ov em en t Pr og ram Dur in g t he y ears inis su e, PCSC di d n otha ve a ba nkacco un t, an y cas h
rece ip ts or c as h d is bu rs em en ts , or a ny do cu m en te d b oo k v al ue , anddi d n otin vo ic e
an y cu st om ers forservi ces ren de redor f or any ot he r pu rp os e. Howev er, the reco rd sh ows nu m ero us tar ge te d m ark et in g e ffo rts by Paul , onbe ha lf o f PCSC , th at at te m pt edto ge ne rat e in te res t i n t he Tena ntIm pr ov em en t Pr og ram . Alth ou gh th es e m ark et in g e ffo rts di d n otlea d t o t he co m pl et io n o f an y

ten an t i m

pr ov em en t pr ojec ts durin g t he y ears inis su e, Pau l’s wo rkforPCSC inth e y ears inis su e la id th e g ro un d wo rkforat l eas t o ne ten an t i m pr ov em en t p ro

ject t ha t d idlat er co m e to fru it io n (i .e., th e Mark etSqua re Pro ject i n Zi on , Ill in oi s) an d fo r ot he rs th atha d th e p ot en ti al to do so , th ro ug h t he us e o f th e Ten an t Im pr ov em en t Pr og ram

or
so m e o th er PC SC-g ui de d fi na nc in g a rran ge m en t. The in it ia l s ta ge s o f th e Ma rk et Dav iddi d n ottes ti fy

at t ria l. The on ly evi de nc e o ffer edto sh ow the 4 qu an tu m of h is act iv it y

was apu rp orte d l og an d s up po rti ng do cu m en ts th atrel at e to th e p re-s ui t years 2 00 2- 04 . Howev er, the re i s n o e vi de nc e as to th e p rep arat io n orau th or sh ip of t ha t l og , no r can we as su m e th atth e b ackup do cum en ts actua ll y refl ectworkdo ne by D av id(as op po se d t o wo rkdo ne by Paul inhi s n am e). Tria l witne ss es ot he r th anPau l s ho wedli tt le awaren es s o f th e in vo lv em en t o f Dav idin PCSC -rel at edwork , andth e te st im on y ab ou t Dav id ’s in vo lv em en t wi th Mark et Squa re d idno t s pe ci fy

th e y ears in vo lv edan d c on cern eda tr an sa ct io n t ha t cu lm in at edwell aft er the y ears inis su e.- 10 -

[* 10 ] Squa re Pro

ject b eg anin20 04 , andPCSC be cam e in vo lv edwith t he pro ject fin an ci ng in20 08
. W e th eref

or e fi ndth atPau l Gra ffi a was en ga ge d, u nd er the au sp ic es of PCSC , ina bo nafid e b us in es s v en tu re, en te redin to forpro fit
. Howev er, as we 5
no w sh ow, v ari ou s o f PCSC ’s pu rp orte d c on tra ct s l ack edth atsame bo nafid e ch arac te r. V. Ro y al ty agree m en ts Pau l an d M ari lynn e Graff iaex ecu te d thr ee s uc ces si ve ag reem en ts pro vi di ng fo r ro y al ti es : Th e fi rs t h adaneffe ct iv e d at e o f Ja nu ary 1, 2 00 2; th e se co ndha d a n effe ct iv e d at e o f Ja nu ary 1, 2 00 5; an d t he th irdals o h adaneffe ct iv e d at e o f Ja nu ary 1, 2 00 5 (b utwas a ctua ll y no t ex ecu te d b efo re 2 00 8) . Each o f th os e ag reem en ts pu rp orte d t o g iv e PCS C ri gh ts to us e th e Ten an t Im pr ov em en t Pro gr am inex ch an ge forroyalty

pa ym en ts to Pau l an d M ari lynn e. Pet it io ne rs cl ai m th atth e th irdag reem en t, wh ic h was ex ecu te d n o e arl ie r th an20 08 an d was
en ti tl ed“ Ten an t Im

pr ov em en t Pr og ram

Fran ch is e Agr eem en t” (an d wh ic h we refe r to as “ th e Franc hi se Agre em en t” ), was t he on e th atwas e ffec ti ve forth e y ears
The Co m m is si on er d idno t co nt en d, i n t he alt ern at iv e, th atif PC SC was a 5 fo r-p ro fitact iv it y , any exp en di tu res itm ad e were “ st art -up e xp en di tu res ” th atare no t i m m ed ia te ly deduc ti bl e, pu rs uantto sec ti on 19 5( a). W e th eref or e d o n ot ad dr es s thi s i ss ue .- 11 -

[* 11 ] in is su e. The Fr an ch is e Agr eem en t p ro vi de s tha t Paul an d M ari lynn e were

6 du e to rece iv e ro y al ty paym en ts as f ol lo ws: 20 05 20 06 20 07 Mar il ynn e Graff

ia $2 50 ,00 0 $2 75 ,00 0
--- Pau l Gra ffi a 13 5,0 00 25 0,0 00 $1 25 ,00 0 Tota l 38 5,0 00 52 5,0 00 12 5,0 00 As we s etou t b el ow, PC SC d idno t ac tu al ly pay th es e ro y al ti es incas h b ut by deem edcap it al co nt rib ut io ns (in Mari lynn e’s cas e) an d b y pu rp orte d fo rg iv en es s o f fi ct it io us de bt(inPau l’s ca se ). Mari lynn e h adno m at eri al in vo lv em en t i n d ev el op in g t he pro gr am , andth ere was th eref or e n o b us in es s
reas onforhe r to be en ti tl edto royalt ie s. Pet it io ne rs off eredno ev id en ce-- ex pe rt
orot he rwis e--t o s ho w th e v al ue of t he pro gr am or t he am ou ntof r oyalt ie s tha t i t
wou ldha ve warran te d i n a n a rm ’s-le ng thtra ns act io n; an d we f in d, as to bo th Mar il ynn e an d P au l, tha t the royalty ag reem en ts were fi ct it io us , th atroyalt ie s wer e
ne ve r expe ct edor i nt en de d t o b e p ai d, an d t ha t i ns te adth e ro y al ti es were i nt en de d Si nc e th e Fra nc hi se Agre em en t was no t cr eat edbe fo re 2 00 8, i t was no t 6 actua ll y ineffe ctdu rin g t he y ears inis su e. Pet it io ne rs cla im th atth e Fra nc hi se Agr eem en t re pl acedth e two pre de ces so r ro y al ty agree m en ts an d t ha t i t m or e co m pl et el y an d a ccu rat el y

refl ect s the actua l ag reem en t b etweenth e p art ie s tha t was ineffe ctJan ua ry

1, 2 00 5. We do no t fi ndth atan y of t he th ree was a bo nafid e ag reem en t, an d p et it io ne rs di d n otpe rs ua de us th atth ey were ex ecu te d a s al le ge d; bu t we fi ndth atth e Fra nc hi se Agre em en t d idco m po rt wi th pe ti ti on ers ’ de si redtax ou tc om es .- 12 -

[* 12 ] as win do w dre ss in g t o a ddanap pe aran ce o f rea li ty to the ov eral l
arra ng em en t an d, i n M ari lynn e’s cas e, to est ab li sh he r ap pa ren t b as is inPCSC , as we di sc us s b el ow. VI. Pau l’s p ro m is so ry

no te to Tho m as Ols on Tho m as Ols on is th e p res id en t an d s ol e sh areh ol de r of Ols onGene ral Co nt ract or s, In c., a ge ne ral co ns tru ct io n c om pa ny tha t we re fer t o h ere a s “ Ols on Co nt ract or s.” M r. Ols on als o o wns Tho m as Hol di ng s, In c. (“ THI”). Pau l h as kn own Mr. Ols on forov er 3 0 years a ndha s wo rk edwith h im on sev eral joi nt bu si ne ss ve ntur es . Pet it io ne rs co nt en d t ha t i n t he ir p rio r de al in gs Mr. Ols on len t o r advanc ed
m on ey to Pau l; bu t p ro ba ti ve ev id en ce o f su chlo an s o r adva nc es is lac ki ng , an d 7 The all eg edpri or

lo an s an d a dv an ces un de rlyin g P au l’s n ot e are 7 un subs ta nt ia te d. In reac hi ng $3 83 ,40 4 a s the to ta l am ou ntsupp os ed ly due on th e no te , th e cal cu la ti onsh eetap pe nd edto th e n ot e ad ds : $ 40 ,00 0 fo r “ le ga l fe es pa id to Sie ga n B arb ark of

f an d S ka di n Arp s [s ic ] etal. as of J anua ry 19 96 ”; $7 0,0 00 for “ m on ie s d ire ct ly adv an cedto Pau l thr ou gh 19 96 ”; $8 ,60 1 fo r “publ ic st or ag e pa ym en ts ”; $1 55 ,80 3 i n i nt eres t ca lc ul at edat 1 0% a nn ua ll y ; an d $ 10 9,0 00 for “ [a]dd it io na l ad vanc es to Pau l an d/ orMari lynn e in th e fo rm of t ax ab le in co m e n ot subjec t t o i nt eres t ch arg es fro m th e 1 stof F eb ru ary 19 96 th ro ug h t he da te he reo f”. Apa rt f ro m publ ic st or ag e rec ei pt s, the re i s n o d oc um en ta ry ev id en ce t o s up po rt th e und erl y in g a dv an ces to Pau l l is te d o n t he cal cu la ti on sh eet . Eventh e ev id en ce subs ta nt ia ti ng th e p ub li c st or ag e p aym en ts is pro bl em at ic be cau se itst at es th atMr. Ols on , andno t Paul , was the les se e o n t he st or ag e ren ta l ag reem en t, s o t ha t i f Mr. Ol so n p ai d t he se am ou nt s h e was ev id en tl y pay in g h is ownob li ga ti on , no t le nd in g o r adva nc in g a nyth in g t o P au l. Pau l d es cri be s the “ adva nc es ” o f $7 0,0 00 (co nt in ue d...)- 13 -

[* 13 ] we do no t s o fi nd . App aren tl y inlat e 2 00 4, Paul si gn edanun da te d pr om is so ry

no te (whi chwe refe r to as “ th e Pau l Gra ffi a n ot e”) a ndan
acco m panyin g d oc um en t en ti tl ed“ Cal cu la ti on of M on ie s Du e Tho m as A. Olso n” (“ cal cu la ti on sh eet ”). The pro m is so ry no te , whi chco nt ai ns no du e d at e, pa ym en t
sc he du le , or d em an d d at e, st at es th at“ th e und ers ig ne d m ak er [Paul Graffi a] Pro m is es to Pay

to th e o rd er o f Tho m as A. Olso n * * * th e su m refl ect edon th e at ta ch edcal cu la ti on sh eetof m on ie s due ”. The c al cu la ti on sh eetis da te d Decem be r 31 , 20 04 , andli st s amoun ts to ta li ng $3 83 ,40 0. Paul di d n otm ak e an y pr in ci pa l o r in te res t p aym en ts on th e Pau l Gra ffi a n ot e b efo re i t was can cel ed , and we fi ndth atne it he r Pau l n orMr. Ols on in te nd edor e xp ect edth atPau l wo ul d p ay th e n ot e. Sh ortl y aft er Paul ex ecu te d t he no te to Mr. Ols on inlat e 2 00 4, Dav id Graffi a acqui redth e n ot e fro m Mr. Ols on inex ch an ge forDavi d’s o wn $ 38 5,0 00
no te (pa y ab le to “ th e b eare r he reo f”); an d Dav idth enco ntrib ut edth e Pau l Gra ffi a
no te to PCSC as apu rp orte d c ap it al co nt rib ut io n. In earl y 20 05 , PCSC t he n (...co nt inue d) 7 an d $ 10 9,0 00 as a ris in g fr om si tu at io ns inwhi chMr. Ols on wou ldm ak e b us in es s in ve st m en ts an d P au l wo ul d wo rkon th e in ve stm en t an d re cei ve wage s o r “ adva nc es ” fro m

Ols on ’s in ve stm en t b utag reedto pa y Ols on ba ck

when th e ve ntur es tu rn eda pr of

it(whi chth ey

ne ve r di d) . There is no ev id en ce d oc um en ti ng th e p aym en t o r th e p ur

po se of the leg al fees
.- 14 -

[* 14 ] can cel edth e Pau l Gra ffi a n ot e, pu rp orte dl y to setoff royalty pa ym en ts th at
were o st en si bl y

du e to Pau l fo r th e “ Ten an t Im pr ov em en t Pr og ram ”. Pet it io ne rs
co nt en d t ha t Dav id ’s $3 85 ,00 0 n ot e was rep ai d i n fu ll ; h owe ve r, ap artfro m a pr om is so ry

no te st am

pe d “ PAID IN FULL” th ere i s n o c red ib le ev id en ce tha t Dav idactua ll y

rep ai d M r. Ols en$3 85 ,00 0. W e fi ndth atne it he r Dav idno r 8 Mr. Ol so n e xp ect edth atDavi d wo ul d p ay hi s n ot e; an d a s a r es ul t, we fi ndth at
ne it he r Dav idno r PCSC ha d a ny bas is inth e Pau l Gra ffi a n ot e. VII. The m il li on -d ol la r no te s Dav idex ecu te d ano te da te d J anua ry 3, 2 00 5, o st en si bl y

pro m is in g t o p ay

to Mr. Ol so n $ 1 m il li on pl us in te res t n o l at er tha n Dec em be r 31 , 20 10 ; an d Mr. Ol so n e xe cu te d ano te with the same dat e o n b eh al f of THI, os te ns ib ly pr om is in g t o p ay

to Davi d $ 1 m il li on pl us in te res t n o l at er tha n J anua ry 3, 2 00 8. The no te s wer e ex ecu te d i n p ur po rte d fu lfi ll m en t o f anag reem en t en ti tl ed

“ Pro m is so ry

Not e Cre di t Term s o f Agr eem en t” , pu rs ua ntto whi chTHI wou ldlen d

Ourreco rddo es refl ecta ch eckfro m Davi d a ndAm

y to Mr. Ols eninth e 8 am ou ntof $ 83 ,41 1.3 6 d at edMarc h 1 , 20 10 . The ch eck ’s m em o l in e st at es “ In te res t” . Whi le itis po ss ib le to in fer t ha t thi s ch eckm ay ha ve refl ect edan in te res t p aym en t o n Dav id ’s no te to Mr. Ols on , nei th er Dav idno r Mr. Ol so n te st ifi edab ou t thi s ch eck . Giv enth e im po rta nc e o f th e is su e an d t he ab se nc e o f ot he r pr oo f to supp ort a f in di ng of g enui ne in de bt edne ss , we fin d the lac k o f te st im on y ab ou t the ch eckto weig h h eav il y ag ai ns t i ts ha vi ng any

pro ba ti ve va lu e with re ga rdto th e g enui ne ne ss of Da vi d’s p ur po rte d $ 38 5,0 00 de bt
.- 15 -

[* 15 ] $1 m il li onto PCSC (th ro ug h Dav id ), PCSC wou ldcau se th e m on ey “ to be
m ad e p ay ab le to ” THI, Davi d wo ul d c on tri bu te Mr. Ols on ’s no te to PCSC as a cap it al co nt rib ut io n t o P CSC, a ndDavi d’s s ha res of P CSC wo ul d b e d el iv eredan d pl ed ge d t o M r. Ols on as c ol la te ral forth e supp os edlo an . No m on ey ev er ch an ge d ha nd s as a res ul t o f th e p ur po rte d l oa ns . Peti ti on ers ass ertth atDavi d re pa id $6 15 ,00 0 o n h is $1 mil li on no te , whi chth ey co nt en d was th erea fte r can cel edan d a
ne w no te was i ss ue d fo r th e rem ai ni ng unpa idba la nc e inth e am ou ntof $ 38 5,0 00
. Bu t ag ai n, p et it io ne rs off er n o p ro of

of t he $6 15 ,00 0 p art ia l p aym en t ex cep t fo r a
no te st am pe d “ PARTIALLY PAID/ BALANCE VIA RENEWAL”. W e are no t p ers ua de d t ha t ei th er Dav idor M r. Ols on ex pe ct edor i nt en de d to ho no r th es e n ot es an d fi ndin st eadth atth ey were wi nd ow dres si ng to in crea se Dav id ’s app aren t b as is inPCSC , as we d is cu ss be lo w. VIII. PCSC ’s faci li ta ti on ag reem en t wi th Ols on Co nt ract or s InDecem be r 20 05 , PCSC e xe cu te d a“ Faci li ta ti on Agre em en t” with Ol so n Co nt ract or s. Inth e Fac il it at io n Ag reem en t, PC SC ag reedto gi ve Ols on Co nt ract or s the ex cl us iv e ri gh t t o p erfo rm ten an t i m

pr ov em en t co ns tru ct io n wo rk fo r PCSC withi n t he “ Ch ic ag ol an d fr an ch is e te rri to ry ”. Inex ch an ge forth is
ex cl us iv e co ns tru ct io n ri gh t, the Faci li ta ti on Agre em en t p ur po rte dl y ob li ge d Ol so n Co nt ract or s (1 ) to gi ve PCSC “ m os t fa vo redcli en t-b es t p ric in g s ta tu s” forth e- 16 -

[* 16 ] co ns tru ct io n wo rk

th atwas t o b e d on e an d (2 ) to pa y PCSC a co m

mis si on to ta li ng $1 ,60 0,0 00 pa y ab le ou t o f Ols on Co nt ract or s’ pro fit s fr om th e work ge ne rat edby PCSC. Inad di ti on Ols on Co nt ract or s ag reedto pa y PCSC a $1 55 ,00 0 g ua ran te edm in im um pa ym en t i n 2 00 5, wh ic h wo ul d b e d educ ti bl e fro m th e $ 1,6 00 ,00 0 c omm is si on . Pet it io ne rs pu t o n n o e vi de nc e--e xp ertor o th erwi se --t o s ho w th atth e ri gh ts pu rp orte dl y

gra nt edto Ols on Co nt ract or s wer e worth$1 .6 m il li on or a ny oth er
am ou nt . As we ex pl ai n b el ow, the m in im um pa ym en t was pu rp orte dl y sat is fie d b y a p aym en t t o P au l Gra ffi a (wh ic h we f in d d idno t ac tu al ly occur in a y ear i n i ss ue )
an d t he rem ai nd er was ne ve r pa id . W e fi ndth atPau l (t hr ou gh PCSC ) an d Mr. Ol so n (t hr ou gh Ols onCo nt ract or s) di d h op e to do pro jects th atwou ld ge ne rat e p ro fitan d t ha t the y in te nd edto sh are t ho se pro fit s t o s om e d eg ree, b utth e sp eci fic term s o f th e Fac il it at io n Ag reem en t wer e n otin te nd edby the pa rti es to be bi nd in g. IX. PCSC ’s exp en se s an d re tu rn s IRS a cco un t tran sc rip ts forPCSC sh ow tha t PC SC re po rte d n etlo ss es of $4 47 ,69 3 fo r 20 05 , $4 91 ,32 3 fo r 20 06 , and$1 37 ,37 8 fo r 20 07 . Thes e rep orte d lo ss es co rres po ndto th e PCS C fl ow- th ro ug h l os s d educ ti on s tha t wer e cl ai m edby PCSC ’s own ers --i .e., Mari lynn e (wh o c la im edlo ss es of $ 24 9,3 63 for20 05 an d- 17 -

[* 17 ] $2 73 ,66 7 fo r 20 06 ) an d b y Davi d a ndAm

y (who cla im edlo ss es of $ 19 8,3 30 fo r 20 05 , $2 17 ,65 6 fo r 20 06 , and$1 37 ,37 8 fo r 20 07 )--o n S ch edul es E att ach edto th ei r res pe ct iv e returns . PCSC’s Fo rm s 1 12 0, U.S. Co rp or at io n In co m e Tax Returns , are n otinev id en ce, an d we c an no t t el l wh atin co m e, if an y , or d educ ti on s
m ad e up P CSC’s c la im edne t l os se s. Ap artfro m ev id en ce o f PCSC ’s royalty fees
an d c red itcardex pe ns es (whi chwe di sc us s b el ow) , we fin d n o e vi de nc e to
supp ort an y

actua l o r co ns tru ct iv e PCS C expe nd itur es th atm ig htbe de du ct ib le
. A. Ro y al ty fee pa ym en ts Pet it io ne rs po in t t o t he Fran ch is e Agr eem en t an d t he ir t ax returns as
ev id en ce tha t PC SC i nc urredde du ct ib le royalty pa ym en ts inth e y ears inis su e. Howev er, the re i s n o i nd ic at io n tha t PC SC ac tu al ly m ad e cas h ro y al ty paym en ts to Pau l o r Mar il ynn e in an y of t he y ears inis su e. In st ead , th e fo ll owi ng oc cu rred : 1. Mar il ynn e Graff

ia ’s royalty

fee co nt rib ut io ns In20 05 Mari lynn e en te redin to anag reem en t wi th PCSC an d Dav iden ti tl ed

“ Agr eem en t t o P ro vi de Cap it al ”. The Ag reem en t t o P ro vi de Cap it al st at es in rel ev an t p art : Cap it al co nt rib ut io n o f St oc kh ol de r [Ma ril ynn e]: Sto ckho ld er h ereb y ag rees to tra ns fer, as si gnan d c on tri bu te to th e co m pa ny [PCSC] th e fir ston e m il li on do ll ars ($1 ,00 0,0 00 .00 ) in royalty fee p aym en ts m ad e pu rs uantto th e * * * fran ch is e ag reem en t, upo n t he ir p aym en t an d- 18 -

[* 18 ] recei ptby Sto ckho ld er, as pa idincap it al co ntrib ut io n fo r th e acco un t o f St oc kh ol de r. In20 05 when he r $2 50 ,00 0 ro y al ty paym en t was du e, PCSC di d n otactua ll y
m ak e p aym en ts to Mari lynn e. In st ead , Mari lynn e rep orte d o n h er 2 00 5 F ed eral in co m e ta x re tu rnroyalty fee i nc om e o f $2 50 ,00 0 (a lm os t en ti rel y off se t b y PCSC ’s flo w-th ro ug h l os se s tha t s he cla im ed , as we n ot edab ov e) an d P CSC cred it edanad di ti on al $2 50 ,00 0 t o h er capi ta l ac co un t. PCS C’s co rp or at e m in ut es refl ectMari lynn e’s cap it al co nt rib ut io n a ndth atPCSC ’s corres po nd in g ro y al ty fee ob li ga ti on was d is ch arg ed . The s am e ev en ts tra ns pi redin20 06 with M ari lynn e’s
ro y al ty fee of $ 27 5,0 00 . W e fi ndth athe r pu rp orte d re cei ptof r oyalt ie s fr om PCSC an d h er co nt rib ut io n o f th em to PCSC were fi ct it io us m ean s o f in fla ti ng he r ap pa ren t b as is inPCSC to en ab le he r to cla im lo ss es . 2. Set of

f of th e Pau l Gra ffi a n ot e As fo r th e am ou nt s tha t PC SC p ur po rte dl y owedPau l fo r ro y al ty paym en ts , Pau l g ran te d t o P CSC ( in a do cu m en t en ti tl ed“ Loa n/ Not e Set tl em en t Ag reem en t” ) th e ri gh t t o s etoff

hi s d eb t u nd er the Pau l Gra ffi a n ot e (wh ic h P CSC h adacqui red fro m Mr. Ols on ) ag ai ns t tha t ro y al ty obl ig at io n. Thi s s et tl em en t ag reem en t 9

The re was a pr ov is io n i n t he Fran ch is e Agr eem en t tha t p ro hi bi te d P CSC 9 fro m set ti ng off

royalty pa ym en ts with o th er o bl ig at io ns ; b utat t ria l Paul tes ti fie d th athe waiv edth atpro vi si on .- 19 -

[* 19 ] pro vi de s tha t $ 13 5,0 00 wou ldbe setoff in20 05 an d $ 25 0,0 00 in20 06 --the to ta l am ou nt s o f ro y al ti es supp os ed ly due
. Pau l d idrep ort tho se royalty am ou nt s o n S ch edul e E, “ Supp le m en ta l In co m e an d Lo ss ”, of

hi s i nc om e ta x re tu rn s. Ho wev er, the royalty in co m e was fic ti ti ou s, an d we c on cl ud e h e rep orte d i t as win do w dre ss in g. If P CSC c la im ed
co rres po nd in g d educ ti on s fo r it s s up po se d ro y al ty paym en ts to Pau l, the n ju stas th ey were fi ct it io us in co m e to Pau l the y were fi ct it io us ex pe nd itur es of P CSC; an d
an y pa ss -th ro ug h l os se s fr om PCSC th ataro se fro m

th os e ro y al ty deduc ti on s ar e
un subs ta nt ia te d. On h is 20 05 Sch edul e C, Pau l re po rte d i nc om e an d c la im edde du ct io ns (in
m uc h g reat er am ou nt s) ass oc ia te d wi th th e p ur po rte d c an cel la ti on of t he Pau l Graffi a n ot e. Thatis , he r ep orte d $ 13 3,4 04 of “ Gro ss rece ip ts ”, i.e., ar is in g fr om th e p ur po rte d c an cel la ti on of t he Pau l Gra ffi a n ot e, an d t he n h e d educ te d t he fo ll owi ng supp os ed ly relat edit em s: $1 09 ,00 0 o f “ Returns an d a ll owa nc es ”, 1 0 $1 55 ,00 0 o f “ In te res t - Othe r”, $ 40 ,00 0 o f “ Leg al an d p ro fes si on al servi ces ”, an d $8 ,60 1 o f “ Ren t/ Leas e - Oth er Bu si ne ss Pro pe rty”. Paul co nt en ds (wit ho utan y Pau l co nt en ds th at$1 09 ,00 0 due on th e Pau l Gra ffi a n ot e rep res en te d 1 0 al le ge d a dv an ces to Pau l tha t h e in cl ud edinin co m e in th e y ears th atth ey were rece iv ed , andth eref

or e, he co nt en ds , th ey

sh ou ldbe de du ct ib le on hi s 2 00 5 re tu rn . Eve n i f th e n ot e were g enui ne (we h ol d i t was no t), Paul ha s o ffer edno pro of th at he ha d i nc lu de d $ 10 9,0 00 inin co m e fo r pr io r y ears .- 20 -

[* 20 ] do cu m en ta ry

co rro bo rat io n) th atinpre -s ui t years h e u se d b orro wedm on ey to pa y forth e d educ ti on it em s, b utth athe di d n otcla im de du ct io ns forth em

in pr io r y ears , bec au se de du ct io ns forth e it em s wer e “ su sp en de d” un ti l h is pu rp orte d de btwas p ai d. We fin d t ha t the se ex pe ns es de du ct edon Pau l’s 2 00 5 re tu rnwere
no t p ai d i n 2 00 5 (a ndwe do no t re ach th e que st io n wh ethe r th ey were p ai d i n a ny pr e-s ui t year).

3. Ass ig nm en t ag reem en t Pet it io ne rs als o c la im

th atPCSC pa idan d tha t Paul rece iv edroyalty pa ym en ts pu rs ua ntto anag reem en t en te redin to Decem be r 20 05 en ti tl ed

“ Ass ig nm en t o f Co ntractPaym en ts ”. Thi s ag reem en t p ro vi de d, am on g o th er th in gs , th atPCSC wou ldass ig n t o P au l i ts rig ht s t o c omm is si on pa ym en ts du e fro m Ols on Co nt ract or s, wh ic h i nc lu de d a$1 55 ,00 0 g ua ran te edm in im um pa ym en t an d t ha t am ou nt s p ai d t o P au l wo ul d b e d eem edroyalty fee p aym en ts . Acco rd in gl y , Ols onCo nt ract or s o r Mr. Ol so n, h im se lf, was supp os ed ly to p ay $1 55 ,00 0 d ire ct ly to Paul to sat is fy royalty fees th atPCSC supp os ed ly owedhi m . W e fi ndth atno su chpaym en t t oo k p la ce i n a ny of th e y ears inis su e; an d we
can no t t el l wh ethe r PCSC rep orte d t he $1 55 ,00 0 a m ou ntinit s i nc om e--a
ne ces sa ry st ep be fo re i t co ul d c la im it s as si gn m en t as a de du ct io n. Al th ou gh bo th Pau l an d M r. Ols on tes ti fie d tha t thi s p aym en t o ccurred , nei th er i nd ic at edth atth e- 21 -

[* 21 ] all eg edpa ym en t was m ad e dur in g a ny of th e y ears inis su e; an d we c anfin d
no do cu m en ta ry

ev id en ce t o s up po rt a n a ctua l p aym en t o f $1 55 ,00 0 b y Ols on or
rece ip t b y Pau l o f th atam ou nt . Non e o f Pau l’s re tu rn s fo r th e y ears inis su e (i .e., 20 05 , 20 06 , or 2 00 7) ap pe ar t o i nc lu de th is all eg ed$1 55 ,00 0 p aym en t i n i nc om e. W e fi ndth atPCSC m ad e n o s uc h p aym en t. Pet it io ne rs cla im

a se co ndass ig nm en t b y

PCSC to Pau l o ccu rredin20 06
. InJu ly 200 6 P CSC a ndTHI ent eredin to a “ Pu rch as e an d S al e Agr eem en t” by whi chPCSC pu rp orte dl y so ldto THI PCSC’s fr an ch is e b us in es s, wh ic h e nt ai le d PCSC ’s in te res ts an d o bl ig at io ns (in cl ud in g a ll eg edroyalty fee o bl ig at io ns ) in th e Fran ch is e Agr eem en t an d F aci li ta ti on Agre em en t. Pau l cl ai m s tha t p ur su an t t o t he Pu rch as e an d S al e Agr eem en t an d t he Ass ig nm en t Ag reem en t h e rec ei ve d $2 50 ,00 0 i n ro y al ty fees. Ev enth ou gh Pau l d idrep ort $ 25 0,0 00 as “ Ro y al ti es
rece iv ed ” o n S ch edul e E of h is 20 06 return, we fi ndno cred ib le ev id en ce t o
supp ort Paul ’s actua l re cei ptof t hi s $ 25 0,0 00 in20 05 , 20 06 , or 2 00 7. Ag ai n, we
can no t t el l wh ethe r PCSC in cl ud edinit s re po rte d i nc om e th e supp os ed$2 50 ,00 0 pa ym en t fr om

THI; an d we f

in d t ha t i t m ad e n o s uc h p aym en t t o P au l. B. Cred itcardpa ym en ts Pet it io ne rs cla im

th atDavi d m ad e cap it al co ntrib ut io ns to PCSC inth e
am ou nt s o f $4 3,1 79 .85 in20 05 , $3 1,2 01 .60 in20 06 , and$5 6,8 91 in20 07 , inth e- 22 -

[* 22 ] fo rm

of c red itcardpaym en ts th atDavi d s up po se dl y m ad e o n b eh al f of PCSC inpaym en t o f it s ex pe ns es . Peti ti on ers di d s ub st an ti at e th atDavi d i nc urred cred itcardch arg es inth e am ou ntcla im edfor20 05 ; b utth ere i s n o e vi de nc e do cu m en ti ng an y

20 06 or 2 00 7 c red itcardpu rch as es or p aym en ts . Mor eo ve r,
es pe ci al ly in the ab se nc e o f an y tes ti m on y

by D av id , itis un cl ear wh ic h, i f an y , of th es e cre di t ca rdex pe nd itur es actua ll y refl ectexpe ns es of P CSC andwhi ch , if an y , were ac tu al ly clai m edon PCSC ’s returns as d educ ti bl e b us in es s ex pe ns es . W e d o
no t fi ndan y

de du ct ib le bu si ne ss ex pe ns es of P CSC am on g Dav id ’s cred itcard ch arg es . X. Pet it io ne rs ’ ta x re tu rn s Fo r th e y ears inis su e, Pau l an d M ari lynn e fi le d s ep arat e Fed eral in co m e ta x returns on Fo rm s 1 04 0, “ U.S. Ind iv idua l In co m e Tax Return” . Pau l p rep aredhi s
an d M ari lynn e’s ta x re tu rn s fo r th e y ears inis su e. On the Sch edul es E att ach edto th ei r res pe ct iv e 2 00 5 a nd20 06 Fo rm s 1 04 0, Paul an d M ari lynn e eac h re po rte d a s
ro y al ty inc om e am ou nt s co ns is te ntwith t he term s o f th e Fra nc hi se Agre em en t, s et
ou t ab ov e. On h is 20 07 return P au l re po rte d $ 15 9,3 66 of r oyalty in co m e, an d pe ti ti on ers ha ve no t ac co un te d fo r th e $ 34 ,36 6 d is crep an cy be twee n t he $1 25 ,00 0 al le ge dl y du e und er the co nt ractan d t he in co m e Pau l re po rte d. (As we ha ve he ld ab ov e, Pau l an d M ari lynn e rec ei ve d n on e o f th es e am ou nt s.)- 23 -

[* 23 ] On h is tax returns , Pau l cl ai m edNOL carry ov er d educ ti on s o f $1 3,8 50 for 20 05 , $3 15 ,20 8 fo r 20 06 , and$2 31 ,80 4 fo r 20 07 . Mari lynn e al so cla im edNOL de du ct io ns of $ 10 ,28 0 fo r 20 05 , $2 0,1 63 for20 06 , and$2 8,9 00 for20 07 . Pau l
an d M ari lynn e eac h a tt ach ed , to th ei r se pa rat e ta x re tu rn s, i nd iv idua l s ch edul es cal cu la ti ng th ei r res pe ct iv e NOL carryove rs for20 05 , 20 06 , and20 07 , whi chsh ow th atth e cl ai m edlo ss es ori gi na te d i n 2 00 0 a nd20 03 . Howev er, the ir r eturns for 20 00 an d 2 00 3 a re n otinou r rec or d; an d, m or e im po rta nt , th ere i s n o e vi de nc e be fo re u s t o s ub st an ti at e Pau l’s o r Mar il y nn e’s pr io r-y ear l os se s tha t wo ul d h av e gi ve n ri se to NOL deduc ti on s fo r ei th er o f th em . Fo r th e y ears inis su e Dav idan d h is wife Am y fil edjoi ntFed eral in co m e ta x returns . H&R Bl oc k p rep aredDavi d a ndAm y ’s 20 05 , 20 06 , and20 07 joi nt returns . On th ei r return fo r 20 07 , th ey rep orte d $ 4,2 65 of c ap it al ga in onli ne 13
. XI. Not ic es of d efi ci en cy an d p et it io ns On No ve m

be r 22 , 20 10 , th e IRS is su eda no ti ce o f de fic ie nc y to Pau l fo r hi s 20 05 , 20 06 , and20 07 tax y ears . In tha t n ot ic e th e IRS de te rm in edth atPau l d id
no t h av e an y

royalty in co m e fo r an y

of t he y ears inis su e, th atPau l d idno t h av e gr os s re cei pt s o f $1 33 ,40 4 a ris in g fr om th e can cel la ti on of t he Pau l Gra ffi a n ot e, whi chhe rep orte d o n h is 20 05 Sch edul e C, an d tha t h e was no t en ti tl edto an y of fs et s o r de du ct io ns th athe cla im edon hi s 2 00 5 S ch edul e C. The IRS al so- 24 -

[* 24 ] de te rm in edth atPau l was no t en ti tl edto an y of t he NOL deduc ti on s tha t h e cl ai m edan d t ha t h e is li ab le forsec ti on 66 62 (a) a ccu racy-rela te d p en al ti es for 20 05 , 20 06 , and20 07
. The IRS i ss ue d t o M ari lynn e two no ti ces of d efi ci en cy , on e o n Ap ril 1, 20 09 , forhe r 20 05 tax y ear, an d asec on d o n No ve m be r 23 , 20 10 , forhe r 20 06 an d 20 07 tax y ears . In tho se no ti ces th e IRS de te rm in edth atMari lynn e d idno t h av e
ro y al ty inc om e o f $2 50 ,00 0 fo r 20 05 an d $ 27 4,5 62 for 20 06 , andth atsh e was no t
en ti tl edto cla im

de du ct io ns foran y

PCSC flo w-th ro ug h l os se s. Th e IRS als o de te rm in edth atfor20 05 , 20 06 , and20 07 Mari lynn e was no t en ti tl edto cla im an y NOL deduc ti on s an d i s l iabl e fo r se ct io n 6 66 2( a) ac cu racy-rela te d p en al ti es . The IRS i ss ue d t o Dav idan d Amy no ti ces of d efi ci en cy

da te d Ap ril 1, 2 00 9, fo r ta x year 20 05 an d d at edNov em be r 18 , 20 10 , fortax y ears 20 06 an d 2 00 7, i n whi chth e IRS de te rm in edth atDavi d a ndAm y were n oten ti tl edto de du ctan y PCSC flo w-th ro ug h l os se s. Inad di ti on , th e IRS de te rm in edth atDavi d a ndAm y
rece iv eda to ta l o f $8 ,75 7 i n c ap it al ga in s (i .e., no t o nl y th e $ 4,2 65 th ey

rep orte d)
an d t hu s fa il edto rep ort $ 4,4 92 incap it al ga in in co m e fro m th e sa le of s to ck

in- 25 -

[* 25 ] 20 07
. The IR S d et erm in edth atDavi d a ndAm y are l iabl e fo r se ct io n 1 1 66 62 (a) a ccu racy-rela te d p en al ti es for20 05 , 20 06 , and20 07
. Pet it io ne rs each ti m el y

fil edpe ti ti on s s eek in g re de te rm in at io n o f th e de fic ie nc ie s d et erm in edinth ei r res pe ct iv e n ot ic es of d efi ci en cy . Thes e cas es ha ve be enco ns ol id at edforpu rp os es of t ria l. OPINION I. Evi de nt ia ry

pri nc ip le s A. Bu rd enof p ro of Gen eral ly, th e Co m

m is si on er’s d et erm in at io ns setforth ina no ti ce o f de fic ie nc y

are p res um edco rrec t, an d t he tax pa y er b ears th e b ur de n o f pr ov in g t he de te rm in at io ns are erro ne ou s. Ru le 14 2( a); W el chv. Hel ve rin g, 2 90 U.S. 11 1, 11 5 (1 93 3) . Mor eo ve r, de du ct io ns are a m at te r of leg is la ti ve gra ce, an d t he ta xp ay er b ears th e b ur de n o f pr ov in g t ha t h e is en ti tl edto an y de du ct io n c la im ed
. INDOPCO, In c. v. Co m

m is si on er, 5 03 U.S. 79 , 84 (19 92 ).

The no ti ce o f de fic ie nc y

st at es : “ It i s d et erm in edth aty ou r ne t capi ta l 1 1 ga in s ar e $ 8,7 57 .00 fortax ab le y ear 2 00 7, as co m pu te d i n s ch edul e at ta ch ed , rathe r th an$4 ,26 5.0 0 a s re po rte d o n your in co m e ta x re tu rnfor20 07 .” The sc he du le att ach edto th e n ot ic e o f de fic ie nc y refl ect edanen try of $ 4,2 65 (th e sa m e am ou ntrep orte d o n l in e 1 3 o f Dav idan d Amy ’s tax return) as l on g- te rm cap it al ga in an d a n a dd it io na l en try of $ 4,4 92 as s ho rt- te rm cap it al ga in
.- 26 -

[* 26 ] B. Lackof r eco rd s Sect io n 6 00 1 re qu ire s tha t– Eve ry pe rs on li ab le foran y

tax im po se d b y th is ti tl e, orforth e co ll ect io n t he reo f, sh al l k eep su chreco rd s, re nd er s uc h s ta te m en ts , m ak e su chreturns , andco m pl y with s uc h ru le s an d re gu la ti on s as th e Secr et ary m ay

fro m ti m e to ti m e p res cri be . * * * [Em ph as is ad de d.] Tax pay ers are thu s re qu ire d t o k eep su ffi ci en t re co rd s t o s ub st an ti at e th ei r gr os s in co m e, de du ct io ns , cred it s, an d o th er t ax att rib ut es . See al so 26 C.F.R.
se c. 1.6 00 1- 1( a), In co m e Tax Reg s. Tax pa y ers are re qu ire d t o re ta in th ei r bo ok s
an d re co rd s as lo ng as t he y m ay be co m e m at eri al : (e) Re te nt io n o f rec or ds .--Th e b oo ks or r eco rd s re qu ire d b y th is sec ti on sh al l b e k ep t atall ti m es av ai labl e fo r in sp ect io n b y au th or iz edin te rn al rev enue off ic ers or e m

pl oyees, an d s ha ll be ret ai ne d s o l on g a s the co nt en ts th ereo f m ay be co m e m at eri al inth e adm in is tra ti on of a ny int ern al rev enue law. [Em ph as is ad de d.] 26 C.F.R. s ec. 1 .60 01 -1 (e). Fo r m an y of t he di sp ut edpo in ts inth es e cas es , pe ti ti on ers lac k re co rd s en ti rel y . The ex cu se th atPau l o ffer s fo r th is gap i s tha t (h e sa y s) th ei r rec or ds were am on g a rti cl es wron gf ul ly dis card edby a sto rag e faci li ty. Howev er, Pau l d idno t t es ti fy ab ou t the na tu re o f th e rec or ds no r ho w th ey cam e to be inth e st or ag e fac il it y ; an d i n asu itbro ug htby Maril ynn e (n ot Pau l o r Dav id ) an d M r. Ols onag ai ns t the st or ag e fac il it y , an app rai sa l o f th e
m is si ng it em s was ob ta in ed , bu t the reco rd s d o n otap pe ar am on g t he li st edit em s.- 27 -

[* 27 ] Mo reo ve r, pe ti ti on ers all eg e th atMr. Ols on ha d c us to dy of th e st or edit em s be cau se th ey

serve d a s co ll at eral forPau l’s al le ge d d eb ts to Mr. Ols on ; b utitis ha rdto see why bu si ne ss reco rd s wo ul d h av e b eenin cl ud edam on g i te m s o ve r whi chpe ti ti on ers ced edcu st od y to Mr. Ols on . W e are no t p ers ua de d t ha t the
m is si ng reco rd s wer e lo stby the st or ag e fac il it y , no r th atth ey were ev er i n t ha t faci li ty, no r th atth ey

ev er ex is te d. Inad di ti on to a la ckof P CSC’s o wn ac co un ti ng reco rd s (apart f ro m a few ba nkst at em en ts an d re co rd s fo r publ ic st or ag e p aym en ts ), pe ti ti on ers di d n otoff er
acco un ti ng reco rd s fr om

Mr. Ols on or a ny of h is bu si ne ss es th atwou ldha ve
co rro bo rat edpe ti ti on ers ’ co nt en ti on s ab ou t the ir a ndPCSC ’s bu si ne ss de al in gs with M r. Ols on , if tho se co nt en ti on s wer e co rrec t. C. Lackof t es ti m on y

by D av idan d M ari lynn e Fo r m uc h o f th ei r cas e, pe ti ti on ers rel y so le ly on P au l’s t es ti m on y ; an d, i n pa rti cu la r, Dav idan d M ari lynn e--wh o wer e p res en t i n c ou rt t hr ou gh ou t the tri al
-- di d n ottes ti fy , eve n t ho ug h d educ ti on s, l os se s, an d t ran sa ct io ns pa rti cu la r to th em
are a t i ss ue he re. Inev al ua ti ng th e ta xp ay er’s ev id en ce, we k eep inm in d “ [t]he
ru le * * * tha t the fai lu re o f a p arty to in tro du ce ev id en ce wi th in hi s p os se ss io n
an d wh ic h, i f tr

ue , wou ldbe fav or ab le to hi m , gi ve s ri se to th e p res um pt io n t ha t i f pr oduc editwou ldbe un fav or ab le .” See Wich it a Term in al Elev at or Co . v.- 28 -

[* 28 ] Co m

m is si on er, 6 T.C. 11 58 , 11 65 (19 46 ), aff’d, 1 62 F.2d51 3 (1 0t h C ir. 19 47 ). The Co m

m is si on er ap tl y

ob se rv es inhi s p os t-t ria l b rie fs th atth is 1 2 pr in ci pl e co un ts ag ai ns t p et it io ne rs insev eral of the m at te rs indi sp ut e. Pet it io ne rs res po ndas f

ol lo ws: Pet it io ne rs were wi th ou t the ass is ta nc e o f co un se l. Dav idan d Mar il ynn e were n otcal le d t o t es ti fy by Peti ti on ers be cau se Pet it io ne rs fu ll y ex pe ct edRes po nd en t t o c al l the m to tes ti fy wher eupo n Pet it io ne rs co ul d re di rectan d/ orcro ss ex am in e sa vi ng th e Co urt’s ti m e. Notha vi ng Davi d a ndMari lynn e te st ify is t he res ul t o f

Thi s n eg at iv e p res um

pt io n m ay

no t ar is e “ whe re the ev id en ce i s equa ll y 1 2 av ai labl e to bo th pa rti es ”; an d fo r th is pu rp os e te st im on ia l ev id en ce m ay be co ns id ered“ av ai labl e” t o the Co m m is si on er wh ere h e co ul d s ub po en a th e wit ne ss to tes ti fy at tria l. See Jo rd anv. Co m mis si on er, 1 34 T.C. 1, 1 0 (2 01 0) (ci ti ng Kean v. Co m m is si on er, 4 69 F.2d11 83 , 11 87 (9t h C ir. 1 97 2) ). Howev er, “ The de te rm in at io n o f th e que st io n o f equa l av ai labi li ty dep en ds up on all th e fac ts an d ci rcu m st an ces be ari ng up on th e wit ne ss ’s rel at io n t o t he pa rti es an d n otm erel y up on hi s p hysic al pre se nc e attri al or a cces sabi li ty for s erv ic e o f a s ub po en a. The po te nt ia l wi tn es s m

us t b e equa ll y

av ai labl e b ot h l eg al ly andpra ct ic al ly. * * * [Where t he tax pa y ers ] ha d s up eri orkn owl ed ge of t he tes ti m on y th atm ig htbe ex pe ct edfro m

* * * [awitne ss , he] * * * was no t as av ai labl e to th e Co m m is si on er as he was t o” th e ta xp ay ers . Kean v . Commis si on er, 4 69 F.2dat 1 18 8. Th e uncal le d wi tn es se s i n t he se cas es were p et it io ne rs th em se lv es (who are re la ti ve s o f th e o th er p et it io ne r), s o tha t p et it io ne rs ob vi ou sl y ha d s up eri orkn owl ed ge of t he te st im on y th atth ey co ul d b e expe ct edto gi ve (es pe ci al ly sin ce thi s C ou rt’s R ul es de li be rat el y

res tri ctth e Co m

m is si on er’s ab il it y

to de po se a pe ti ti on er; see Ru le 74 (c)) . Mor eo ve r, whe reas th e un- cal le d wi tn es s i n J or da n v . Comm is si on er, 13 4 T.C. at10 , “po te nt ia ll y co ul d c orro bo rat e” o th er t es ti m on y , th e wit ne ss es no t cal le d a t the tri al of t he se cas es co ul d h av e g iv enun ique tes ti m on y ab ou t the ir own supp os edtra ns act io ns . The n eg at iv e p res um pt io n o f W ic hi taTerm in al is ap pr op ria te he re.- 29 -

[* 29 ] in effe ct iv e le ga l re pr es en ta ti on res ul ti ng fro m Pet it io ne rs no t ab le to av ai l the m se lv es of l eg al co un se l. Inso sayin g, p et it io ne rs m ak e two di st in ctpo in ts :

1. Lackof c ou ns el Pet it io ne rs im

pl ic it ly renew the ir o bjec ti on to th e Co urt’s re fu sa l t o a ll ow th em a co nt in ua nc e in th es e cas es to en ab le th em to hi re co un se l. Ho wev er, the
cas es ha d p rev io us ly beenco nt in ue d t hr ee t im es ; an d p et it io ne rs di d h av e co un se l who pre vi ou sl y

withd rew fro m

th e cas e (an d wh o h adrep la cedpri orco un se l wh o ha d a ls o wi th dr awn ). W e co nc lu de d t ha t p et it io ne rs ha d b een gi ve n s uf fic ie nt op po rtu ni ty to h ire co un se l an d t ha t a f urth er co nt in uanc e was no t l ik el y to res ul t in th ei r actua ll y

be in g re pr es en te d b y

co un se l atan y

tri al sch edul edan yti m e in th e
ne ar fu tu re. As we s ta te d i n o ur ord er o f Ja nu ary 24 , 20 12 : Whi le a se lf- rep res en te d p et it io ne r wou ldoft enpre fer t o b e rep res en te d b y

co un se l, m or e th anha lf o f th is Co urt’s p et it io ne rs rep res en t the m se lv es at t ria l. Thi s C ou rt i s the refo re ex pe rie nc ed with t he di ffi cu lt ie s tha t s uc h s el f-re pr es en te d p et it io ne rs face an d i s accu st om edto he lp in g t he m accl im at e th em se lv es to th e co urtro om an d i ts pro cedur es . Mor eo ve r, we no te th atMr. Graf fiais th e pr in ci pa l s po ke sm anfor

th e p et it io ne rs , * * * an d t ha t h is fil in gs sh ow h im to be a li te rat e, or ga ni zed , andart ic ul at e p ers on . The ab se nc e o f co un se l i s n ota co m pe ll in g re as on to de la y

th is cas e--e sp eci al ly whe re two at to rn ey s h av e wit hd rawnbe cau se of di sa gr eem en ts be twee n c ou ns el an d c li en ts . W e se e n o re as on to as su m e th ata th irdatt orne y wou ldfare any

di ffer en tl y . Mor eo ve r, si nc e Mr. Gra ffi a em

ph as iz es hi s d ecl in in g h eal th , we in fer t ha t a- 30 -

[* 30 ] lat er tria l m ay

be m or e p ro bl em at ic forMr. Graf fia , no t l es s, an d we a re the refo re al l the m or e d is in cl in edto de la y th e tr ia l inth is cas e. Pet it io ne rs ’ la ckof c ou ns el do es no t al te r th e b ur de n o f pr oo f in th es e cas es no r th e ap pr op ria te ne ss of d rawi ng ne ga ti ve in fere nc es fro m th e si le nc e o f two of t he pe ti ti on ers . 2. Exp ect at io n o f th e Co m mis si on er’s cal li ng th e wit ne ss es If i t i s tru e th at“ Pet it io ne rs ful ly exp ect edRes po nd en t t o c al l the m to te st ify”, th enth atex pe ct at io n u na cco un tabl y su rv iv edth e Co urt’s warn in g t o t he
co nt rary. At the co nc lu si onof t he fir stda y of t ria l, the fol lo win g e xc ha ng e
oc cu rred : THE COURT: * * * [W] e m us t fi ni sh th is on Thu rs da y m orni ng . Pet it io ne rs , we’ ll fin is h t he tes ti m on y of M r. Pau l Gra ffi a an d th enwil l Pe ti ti on ers be cal li ng th em se lv es as wi tn es se s. Mr . Davi d Graffi a, wil l you b e te st ifyin g? MR. D. GRAFFI A: I’m

no t s ur e atth is po in t. THE COURT: All rig ht . Mari lynn e Graff ia , wil l you b e te st ifyin g? MRS . M. GRAFFIA: I’m no t s ur e ei th er. MR. P. GRAFF IA: We’ re n otsu re.- 31 -

[* 31 ] THE COURT: All rig ht . Of cou rs e, th e ch an ce ex is ts th atif y oudo no t ca ll y ou rs el ve s as witne ss es th atRes po nd en t h as th e p [re]ro ga ti ve of d oi ng th at . MR. P. GRAFF IA: Su re. Whe n t ria l re su m edan d P au l co nc lu de d h is tes ti m on y , pet it io ne rs st at edth ey ha d
no ot he r wit ne ss es to cal l. The y ex pl ai ne d t ha t, i ns te ad , th ey wou ldbe co nt en t t o
cro ss -ex am in e Dav idan d M ari lynn e aft er the Co m m is si on er ca ll edth em

as witne ss es . The Co urt warne d the m as f ol lo ws: THE COURT: All rig ht . Let m e ex pl ai n aco up le of r is ks th aty ou face
. MR. P. GRAFF IA: Ok ay . Than k you , si r. THE COURT: If y oude ci de we won ’t cal l the m an d yousay Pet it io ne r res ts , th atm ean s t ha t you h av e p utony ou r cas e an d you ’re do ne . Youface th e ri skth atat t ha t p oi ntRes po nd en t s ay s, Res po nd en t re st s. An d t he n i f th ere was in fo rm at io n youne ed edto ge t o n t hr ou gh th es e o th er wi tn es se s, you d idn’t p utiton . That ’s on e ris k t ha t you fa ce. [Em ph as is ad de d.] The Co urt the n a dd res se d “ Ano th er ri sk ”--i .e., th atpe ti ti on ers ’ cro ss -ex am in at io n of witne ss es co ul d n otex ceedth e sc op e o f th e Co m mis si on er’s d ire ct
ex am in at io n; bu t b ecau se th e Co m m is si on er the n a gr eedth athe wou ldno t as se rt ob jecti on s ab ou t the sco pe of c ro ss -ex am in at io n, the Co urt the n s ta te d:- 32 -

[* 32 ] THE COURT: Oh, wel l, the n t ha t i s n ota ri skan d t he y wil l n ot ob ject t ha t yourqu es ti on s i n c ro ss go ou ts id e th e sc op e o f th e di rect . Do y ouun de rs ta ndwhatI’m sayin g? MR. P. GRAFF IA: Yes , si r, on e se co ndpl eas e. THE COURT: I’ll b e g la d t o e xp la in itag ai n. MS. M . GRAFFIA: That ’s all rig ht
. THE COURT: Oka y . MR. P. GRAFF IA: Yo urHon or , we wil l n otbe cal li ng an y furth er witne ss es at thi s t im e. Non ethe le ss , Pau l d idres um e th e wit ne ss st an d (wi th ou t o bjec ti on ) to subs ta nt ia te
an d c omm en t o n a n a dd it io na l ex hi bi t, af te r whi chth e Co urt as ke d-
- THE COURT: * * * Do y ouha ve an y ot he r ev id en ce tha t you wi sh to of fer? MR. P. GRAFF IA: No , You r Hon or . THE COURT: The n I’d l ik e to he ar y outel l m e th e Pet it io ne rs res t. MR. P. GRAFF IA: Pe ti ti on ers res t, Yo urHon or . THE COURT: All rig ht , Res po nd en t. MS. CAR BONE: Yo urHon or , Res po nd en t i s n otgo in g t o c al l an y witne ss es . * * * Pet it io ne rs m ad e n o re sp on se to co un se l’s s ta te m en t tha t re sp on de ntwou ldcal l n o witne ss es . To in fo rm

th e p art ie s’ po st tri al bri efi ng of t he cas es th e Co urt the n- 33 -

[* 33 ] m ad e p rel im in ary ob se rv at io ns ab ou t s om e o f th e ev id en ce, i nc lu di ng th e fo ll owi ng : I jus t n ot e th atne it he r Mrs . Mari lynn e Graff iano r Mr. Dav idGraffi a te st ifi ed . Andall we ha ve is rathe r su m m ary te st im on y

ab ou t the ir in vo lv em en t fr om

ot he r wit ne ss es , chi efl y

Mr. Graf fia . W e h av e a pr in ci pl e in ev al ua ti ng ev id en ce fo r whi chth e cas e th atwe us ua ll y [c]it e is W ic hi taElev at or[si c] tha t s ay s tha t wh ere apa rty has th e bu rd enof p ro of

on a po in t an d t he y

pu t o n i nf

eri orev id en ce, n otth e be stev id en ce[, t ]henwe in fer t ha t i f th ey ’d pu t o n the be stev id en ce th e fac ts m ig htno t h av e b een inth ei r fav or . If th e fac ts ab ou t J oe are im po rta ntto th e cas e an d youdo n’t p uton th e te st im on y of J oe , it m ak es itso un d l ik e m ay

be th ey di dn ’t wantJo e to tes ti fy be cau se it wou ldn’t h av e b een so ho t. An yway , th atpri nc ip le is at wo rkin ev al ua ti ng tes ti m on y , andso it ’s rel ev an t t o my co ns id erat io n o f th at is su e, I th in k. The re ca n b e n o p laus ib le su gg es ti on th atpe ti ti on ers were l ul le d i nt o
ex pe ct in g t ha t the Co m

m is si on er wo ul d c al l Dav idor M ari lynn e as witne ss es , no r th atpe ti ti on ers were n otwarn edth atfai li ng to cal l Dav idan d M ari lynn e m ig ht
work a ga in stpe ti ti on ers ’ cas e. Rathe r, pe ti ti on ers m ad e th ei r own tac ti cal jud gm en ts aft er b ei ng ex pl ic it ly w arn ed
. II. Dis reg ard in g fi ct it io us arra ng em en ts W e h av e fo un d tha t the cri ti cal ag reem en ts un de rlyin g p et it io ne rs ’ po si ti on --i .e., th e ro y al ty agree m en ts be twee n P CSC a ndPau l an d M ari lynn e; Pau l’s $ 38 3,4 00 pro m is so ry no te to Mr. Ols on an d Dav id ’s $3 85 ,00 0 p ro m is so ry
no te gi ve n t o M r. Ols on ; an d Dav id ’s andMr. Ols on ’s reci pr oc al $1 m il li on- 34 -

[* 34 ] no te s- -were no t b on a fi de bu t wer e sh am s. “ [W] e d efi ne ‘ sh am in
subs ta nc e’ as th e expe di en t o f dr awin g up p ap ers to ch arac te riz e tr an sa ct io ns
co nt rary to o bjec ti ve eco no m ic real it ie s an d wh ic h h av e n o e co no mic si gn ifi can ce be y on d e xp ect edtax be ne fit s.” Fa ls et ti v. Co m m is si on er, 8 5 T.C. 3 32 , 34 7 (1 98 5) ; s ee al so Fran k Lyon C o. v . Uni te d S ta te s, 4 35 U.S. 56 1, 5 72 -5 73 (19 78 ). The Co urt o f App eal s fo r th e Sev en th Cir cu it(to whi chanap pe al wou ldbe tak en in th is cas e) re vi ewedanin st an ce i n wh ic h “ th e ta x c ou rt c on cl ud edth at* * * tra ns act io ns were s ham s l ack in g e co no m ic subs ta nc e” an d h el d t ha t the qu es ti on 1 3 whe th er a co nt ractis a sh am “ is ‘ es se nt ia ll y

a factua l d et erm in at io n.’” For se th v. Co m m is si on er, 8 45 F.2d74 6, 7 48 (7t h C ir. 1 98 8) (qu ot in g Th om ps on v. Co m m is si on er, 6 31 F.2d64 2, 6 46 (9t h C ir.1 98 0) , aff’g 6 6 T.C. 1 02 4 (1 97 6) ), aff’g 8 5 T.C. 1 27 (19 85 ). Pet it io ne rs fai le d t o p uton a pe rs ua si ve sh owi ng th at th ey en te redin to th es e ag reem en ts ingo odfai th , in te nd in g t o b e b ou ndby the m
Not withs ta nd in g t he refe ren ce i n F or se thv. Co m mis si on er, 8 45 F.2d74 6, 1 3 74 8 (7 thCir . 19 88 ), aff’g 8 5 T.C. 1 27 (19 85 ), to “ sh am s l ack in g i n e co no m ic subs ta nc e”, the same cou rt l at er ch arac te riz edFo rs eth a s a c as e inwhi ch“ th ere a re no tra ns act io ns ”, Yos hav. Co m m is si on er, 8 61 F.2d49 4, 5 00 (7t h C ir. 1 98 8) , aff’g Glas s v . Comm is si on er, 8 7 T.C. 1 08 7 (1 98 6) --i .e., as i f Fo rs eth h adin vo lv edsh am in factrathe r th ansh am

insubs ta nc e. Howev er, Yo sh a su st ai ne d t he Tax C ou rt’s fin di ng th ata tr an sa ct io n “ real ly occu rredbu t h as no eco no m ic subs ta nc e”, ch arac te riz in g i t as a “ fin di ng [th at ] is no t cl earl y erro ne ou s.” Id . Thu s, the Co urt of App eal s fo r th e Sev en th Cir cu itev id en tl y tre at s b oth s ha m s i n fa ctan d s ha m s i n subs ta nc e as factua l i ss ue s.- 35 -

[* 35 ] an d e xp ect in g t o h av e to ho no r th em . On th e co nt rary, thes e ag reem en ts an d th e ci rcu m st an ces su rro un di ng th em be ar i nd ic iaof b ei ng sh am s. Fam il y m em be rs an d fr ie nd s m ay

en te r in to bo nafid e ag reem en ts th atwil l be leg al ly bin di ng ; b utag reem en ts be twee n re la te d p art ie s m ay cal l fo r “ cl os e
sc ru ti ny” inord er t o a ss ur e th atth ey ou gh t t o b e res pe ct ed . Bha ti a v . Co m m is si on er, T.C. Mem o. 1 99 6- 42 9 (“ cl os e sc ru ti ny of tr an sa ct io ns be twee n ta xp ay ers an d t he ir c on tro ll edco rp or at io ns ”). Whe n fa m il y m em be rs Pau l, Mar il ynn e, an d Dav idall eg e ag reem en ts be twee n a ndam on g t he m se lv es an d PCSC (own edby Maril y

nn e an d Dav id ) an d t he ir f rie ndMr. Ols on , th ey

in vi te
su chscr ut in y --an d c anno t b ear up u nd er i t. The royalty ag reem en ts , whi chwere be twee n P CSC ( own edby D av idan d M ari lynn e) an d M ari lynn e an d P au l, pr ov id edno t fo r co m

m is si on s b utrathe r fo r subs tant ia l s etan nu al fees forth e u se of a pr og ram

th atha d n o d em on st rat edpro fitpo te nt ia l, an d t he se ag reem en ts th us
rev eal a pr on ou nc ed“ ab se nc e o f arm ’s len gt h d eal in g” , Fal se tt i v . Commis si on er, 85 T.C. at 3 48 (ci ti ng Est at e o f Fran kl in v. Co m m is si on er, 6 4 T.C. 7 52 (19 75 ), aff’d, 5 44 F.2d10 45 (9t h C ir. 1 97 6) )--e sp eci al ly w it h re ga rdto Mari lynn e, who ha d n o ro le at a ll inth e d ev el op m en t o f th e p ro gr am . The s up po se d o bl ig at io ns
can cel edeach ot he r ou t (i .e., Pau l ex ecu te s a n ot e b utitis ul ti m at el y off se t b y
supp os edroyalt ie s; Davi d a ndMr. Ols on ex ch an ge $1 m il li on no te s) . See Kap la n- 36 -

[* 36 ] v. Co m

m is si on er, T.C. Mem o. 2 00 5- 21 8 (“ pe ti ti on er p ur po rte dl y wou ld ha ve owedth e n ew co rp or at io n $ 80 0,0 00 , whi chwou ldhave be enex act ly offs et by the $8 00 ,00 0 t ha t the ne w cor po rat io n p ur

po rte dl y wou ldha ve owedpe ti ti on er. The se cir cu m st an ces furth er d en ot e ‘the in he ren t l ackof s ub st an ce i n t he lo an s.’” (quo ti ng Orenv. Co m

m is si on er, T.C. Mem o. 2 00 2- 17 2, af f’d, 35 7 F .3d85 4 (8 th Cir . 20 04 ))). “ The pre se nc e o f de ferr edde btth atis insubs tanc e o r in factno t li ke ly to b e p ai d” --i .e., vi rtu al ly all o f th e d eb ts at i ss ue he re-- “ is anin di ci um of la ckof, o r ex ag ge rat io n o f, eco no m ic subs ta nc e.” Horn v . Comm is si on er, 9 0 T.C. 90 8, 9 38 (19 88 ); s ee al so Bro z v . Comm is si on er, 1 37 T.C. 46 , 61 (2 01 1) (“ The ta xp ay er h as no t m ad e aneco no m ic ou tl ay , ho wev er, i f th e le nd er i s a r el at edpa rty
an d i f rep aym en t o f th e fu nd s i s u nc ert ai n” ). “ [F]acto rs de m on st rat in g t ha t the de btwas s ha m

an d n otge nu in e are : n o a rm ’s-le ng th ne go ti at io ns oc cu rred be twee n the pa rti es * * *; th e lo andi d n otrequi re s ecurit y , gu aran ty, orco ll at eral ; th e n ot e d idno t s ta te when in te res t h adto be pa id ; * * * [th e o bl ig or ] m ad e n o pa ym en t o n t he lo anfora si gn ifi can t p eri od ”, Gur di n v . Comm is si on er, T.C. Mem o. 1 98 7- 69 --fa ct or s p res en t i n wh ol e o r in pa rt wi th each of t he de bt s atis su e he re. As the Co urt o f App eal s fo r th e Sev en th Cir cu itha s ex pl ai ne d:- 37 -

[* 37 ] The free do m to arra ng e o ne ’s affai rs to m in im iz e ta xe s do es no t i nc lu de th e ri gh t t o e ng ag e infin an ci al fan ta si es with t he ex pe ct at io n t ha t the Int ern al Rev enue Serv ic e an d t he co urts wil l p la y

alo ng . The Co m

m is si on er an d th e co urts are em

po wered , andinfactdu ty-bo un d, t o lo okbe hi ndth e co nt riv edform s o f tr an sa ct io ns to th ei r eco no m ic subs ta nc e an d t o app ly the tax laws acco rd in gl y . * * * Sav iano v. Co m

mis si on er, 7 65 F.2d64 3, 6 54 (7t h C ir.1 98 5) , aff’g 8 0 T.C. 9 55 (1 98 3) . Whe n we t ak e th atlo okbe hi ndth e Graff ia s’ pap ers , we fin d n o e co no m ic real ity . III. Ro y al ty fee in co m e Cas h b as is tax pa y ers su chas P au l an d M ari lynn e m us t i nc lu de am ou nt s i n th ei r in co m e whe n t ho se am ou nt s ar e actua ll y or c on st ru ct iv el y

rece iv ed . 26 C.F.R. s ec. 1 .45 1- 1( a), In co m e Tax Reg s.; see Co rli ss v. Bo wers , 28 1 U.S. 3 76 , 37 8 (1 93 0) (“ in co m e th atis subjec t t o am an ’s un fet te redco m m an d a ndth athe is free to en joy at h is ownop in io n m ay

be tax edto hi m

as h is in co m e, whe th er h e
se es fitto en

joy itor n ot ”). Pet it io ne rs arg ue th atPau l ac tu al ly recei ve d s om e
ro y al ty paym en ts fro m

PCSC an d t ha t Paul an d M ari lynn e co ns tru ct iv el y rece iv ed th e rem ai nd er o f th e ro y al ty inc om e fro m PCSC
. The Co m

m is si on er re sp on ds 1 4 Altho ug h t hi s co nt en ti on res ul ts intax ab le in co m e to pe ti ti on ers , 1 4 pe ti ti on ers m ak e th is co nt en ti on to supp ort the ir p os it io n t ha t PC SC as pa y orwas en ti tl edto de du ctth os e ro y al ty paym en ts (an d t ha t the lo ss es th ey ge ne rat edwere (co nt in ue d...)- 38 -

[* 38 ] th atPCSC lac ke d the fun ds to m ak e an y royalty pa ym en ts to Pau l o r Mar il ynn e, an d tha t the y

di d n otactua ll y

or c on stru ct iv el y

rece iv e th e ro y al ty in co m e. The C omm is si on er i s co rrec t. A. Actu al rece ip t Pet it io ne rs co nt en d t ha t Paul actua ll y rece iv edroyalty

pa ym en ts of $1 55 ,00 0 a nd$2 50 ,00 0 fr om Mr. Ols on (orhi s co m

pa ni es ), bu t the y

po in t t o n o
cas h, ch eck , or b an k tran sf er ef fectua ti ng th os e p aym en ts . They arg ue th atactua l
rece ip t h ap pe ne d wh enPCSC ass ig ne d t o P au l i ts in te res ts inco ntract s wi th Mr. Ols on (i.e ., PCSC’s Fa ci li ta ti on Agre em en t wi thOls on Co nt ract or s an d t he Pu rch as e an d S al e Agr eem en t wi th THI). Howev er, as we no te d abo ve , th ere i s n o pr oo f th atPCSC in cl ud edth es e am ou nt s i n i nc om e b efo re d educ ti ng th em as pa ym en ts to Pau l; th ere i s n o e vi de nc e d oc um en ti ng Pau l’s re cei ptof the se fun ds ;
an d t he re i s n o e vi de nc e th atMr. Ols on m ad e th e al le ge d p aym en ts durin g t he y ears inis su e. Thu s, we co nc lu de th atPau l d idno t ac tu al ly recei ve $1 55 ,00 0 o r $2 50 ,00 0 i n ro y al ty fees fr om Mr. Ols on or h is co m

pani es .

(...co nt in ue d) 1 4 th enpro pe rly pas se d t hr ou gh to Mari lynn e an d Dav id ), an d tha t M ari lynn e’s co nt rib ut io n o f ro y al ti es ba ckto PCSC in crea se d h er b as is inPCSC (an d e nt it le s he r to de du ctth e p as se d- th ro ug h l os se s) . W e d is cu ss th os e co ro ll ary is su es be lo w.- 39 -

[* 39 ] Pet it io ne rs als o c on te ndth atPau l re cei ve d $ 38 5,0 00 inroyalty pa ym en ts whe n P CSC c an cel edPau l’s n ot e in 20 05 to set of f ro y al ty paym en ts du e h im for 20 05 an d 2 00 6, an d t ha t thi s ca nc el la ti on in co m e was rep orte d o n P au l’s 2 00 5 Sch edul e C. Whi le itis po ss ib le forth e se to ff o f a d eb t t o re su ltinin co m e ei th er as a fo rm of apa ym en t due or d is ch arg e o f in de bt edne ss in co m e und er s ect io n 1 08 , see OKC Co rp . v. Co m

m is si on er, 8 2 T.C. 6 38 , 64 7- 64 9 (1 98 4) , nei th er wo ul d b e ap pr op ria te inth is cas e, be cau se we co nc lu de forth e fo ll owi ng reas on s tha t the
no te Pau l ex ecu te d i n fa vo r of Mr. Ols onwas n otge nu in e in de bt edne ss . The pa rti es co nt en d t ha t M r. Ols on adva nc edso m e co m pe ns at io n t o P au l as th ey work edon de al s t og ethe r an d t ha t Paul was t o re pa y th es e am ou nt s fr om pr of it s tha t the y

ho pe d t he de al s wo ul d g en erat e. Any su charra ng em en t was no t do cu m en te d, an d we a re n otco nv in cedth atth ey ev er ag reedto it . Evenif we cred itth ei r st ory , ho wev er, Mr . Ols on ’s all eg edtra ns fers to Pau l wer e n otm ad e at
arm ’s len gt h, d idno t co m po rt wi th no rm al bu si ne ss pra ct ic e, an d wer e n ottre at ed
as lo an s ei th er b y

Mr. Ols on or b y

Pau l unt il well ov er 1 0 years l at er wh enth ey
were o st en si bl y

m em or ia li zedinth e n ot e Pau l ex ecu te d. Paul di d n otm ak e an y pr in ci pa l o r in te res t p aym en ts on th e d eb t b efo re i t was can cel ed , andth e d eb t d id- 40 -

[* 40 ] no t h av e a fi xe d due da te . See Fri erd ic h v . Comm is si on er, 9 25 F.2d18 0, 18 2- 18 4 (7 th Cir . 19 91 ), aff’g T.C. Me m o. 1 98 9- 39 3. Mo reo ve r, th e co nd it io na l n atur e o f Pau l’s s up po se d o bl ig at io n a dd s ad di ti on al supp ort t o o urco nc lu si on . An o bl ig at io n i s l es s l ik el y to be a true de bt if i t wi ll be rep ai d o nl y

fro m th e p ro fit s o f a b us in es s. Zap po v. Co m m is si on er, 8 1 T.C. 77 , 88 -8 9 (1 98 3) (ci ti ng Lem ery v. Co m m is si on er, 5 2 T.C. 3 67 (19 69 ), aff’d, 45 1 F .2d17 3 (9 thCir . 19 71 )). Mr. Ol so n was supp os ed ly to b e rep ai d wh enth e
ve ntur es tu rn eda pr of

it(whi chth ey

ne ve r di d) . The n ot e Pau l ex ecu te d i n 2 00 4 di d n otrech arac te riz e th e co nd it io na l o bl ig at io n (wh ic h we f in d t o b e th e m os t tha t th e p art ie s m ay

ha ve in te nd ed ) in to a ge nu in e in de bt edne ss . Acco rd in gl y , Pau l s ho ul d n otha ve in cl ud edin co m e fro m can cel la ti on of t he Pau l Gra ffi a n ot e o n h is 20 05 Sch edul e C. See Hud so n v . Comm is si on er, 10 3 T.C. 9 0, 1 08 (19 94 ), aff’d, 7 1 F .3d87 7 (5 th Cir . 19 95 ). Pet it io ne rs m ak e n o ot he r co nt en ti on s re ga rd in g P au l o r Mar il ynn e’s actua l re cei ptof r oyalty pa ym en ts . Accor di ng ly, we co nc lu de th atne it he r Pau l n orMari lynn e actua ll y
rece iv edroyalty

pa ym en ts incas h o r pr op erty . B. Co ns tru ct iv e rec ei pt Pet it io ne rs als o c on te ndth atroyalty pa y m en ts were co ns tru ct iv el y rece iv ed by Paul an d M ari lynn e whe n t he pa ym en ts be cam e co nt ractua ll y du e to th em , and- 41 -

[* 41 ] th atco ns tru ct iv e rec ei ptcan no t b e d efea te d b y PCSC ’s m ere l ackof r eady fu nd s, ci ti ng Sai nt e Cl ai re Co rp . v. Co m m is si on er, T.C. Mem o. 1 99 7- 17 1, af f’d witho utpubl is he d o pi ni on sub n om . Boc card o v . Comm is si on er, 1 64 F.3d62 9 (9 th Cir . 19 98 ). 26 C.F.R. s ect io n 1 .45 1- 2( a), In co m e Tax Reg s., d es cri be s the do ctrin e o f
co ns tru ct iv e rec ei ptas f

ol lo ws: In co m e al th ou gh no t ac tu al ly redu cedto a ta xp ay er’s p os se ss io n i s co ns tru ct iv el y

rece iv edby him

inth e ta xabl e y ear dur in g wh ic h i t i s cred it edto hi s ac co un t, s etap artforhi m , or o th erwi se m ad e av ai labl e so th athe m ay

draw up on itat a ny tim e, orso th athe co ul d h av e dr awnup on itdu rin g t he tax ab le y ear i f no ti ce o f in te nt io n t o withd raw h adbe engi ve n. Ho wev er, i nc om e is no t co ns tru ct iv el y rece iv edif t he tax pa y er’s co nt ro l o f it s re cei ptis subjec t t o s ub st an ti al li mit at io ns or r es tri ct io ns . * * * Whe th er a t ax pay er co ns tru ct iv el y rece iv edin co m e “ is ess en ti al ly a qu es ti on of fact .” Avery

v. Co m mis si on er, 2 92 U.S. 21 0, 2 14 (19 34 ); s ee al so W il li ts v. Co m m is si on er, 5 0 T.C. 6 02 , 61 2- 61 3 (1 96 8) . There is no co ns tru ct iv e rec ei ptif th e p ay orlac ks th e fu nd s t o m ak e th e p aym en ts th atare due . Esta te of No el v. Co m m is si on er, 5 0 T.C. 7 02 , 70 6- 70 7 (1 96 8) ; Wise v. Co m m is si on er, T.C. Mem o. 19 97 -1 35
. Howev er, as pe ti ti on ers co nt en d, the re m ay be co ns tru ct iv e rec ei ptof an
am ou ntdu e th e ta xp ay er wh ere ade bt or , who is ex pe rie nc in g alac k o f rea dy cash ,- 42 -

[* 42 ] ha s the ab il it y

to bo rro w th e fu nd s n eces sa ry forpa ym en t. Bu t PC SC’s fin an ci al si tu at io n i s ea si ly dis ti ng ui sh ab le fro m th atof the ob li go r in Sai nt e Cl ai re Co rp ., who ha d ane t wo rth of o ve r $5 0 m il li on , hadsubs ta nt ia l i nc om e, an d h ada read y ab il it y to bo rro w th e fu nd s n eces sa ry to sat is fy hi s o bl ig at io n. PC SC’s si tu at io n, o n t he ot he r ha nd --n o b an k a cco un t, n o c as h, n o b oo k v al ue , andno pa y in g c us to m ers --i s m or e li ke th atof t he ob li go r in Rh om ba r Co . v. Co m m is si on er, 4 7 T.C. 7 5, 8 5- 86 (19 66 ), aff’d, 3 86 F.2d51 0 (2 d C ir. 1 96 7) , whe re n onpa y

m en t o f am ou nt s due was t he res ul t o f th e o bl ig or ’s “ st rin ge ntcas h po si ti on ” an d t he unpa idam ou nt s wer e, co ns eque nt ly, he ldno t co ns tru ct iv el y
rece iv edby the ob li ge es . On the ev id en ce b efo re u s we fi ndth atPCSC di d n othave en ou gh fun ds
an d was no t i n apo si ti on to bo rro w su ffi ci en t o ut si de fun ds inanarm ’s-le ng th tra ns act io n t o s at is fy

it s ro y al ty obl ig at io ns . On th e b as is of t ho se fin di ng s we
co nc lu de th atne it he r Pau l n orMari lynn e co ns tru ct iv el y rece iv edroyalty

fees du e fro m PCSC . As a res ul t, the fees are n otin cl ud ab le inth ei r gr os s i nc om e fo r 20 05 , 20 06 , or 2 00 7. 1 5 The Co m mis si on er am en de d h is an swe r to in cl ud e th e al te rn at iv e 1 5 co nt en ti on th at , if PC SC was en ga ge d i n atra de or b us in es s fo r pr of it(as we ho ld itwas i n p artIII.A b el ow) , th enth e ro y al ti es sh ou ldbe tax ab le in co m e to Pau l an d Mar il ynn e. Howev er, s in ce we fi ndth atth e ro y al ti es were fi ct it io us , we do no t (co nt in ue d...)- 43 -

[* 43 ] IV. Pas s- th ro ug h o f PCSC lo ss es Pet it io ne rs co nt en d t ha t Dav idan d M ari lynn e inth ei r cap aci ty as S co rp or at io n s ha reh ol de rs are en ti tl edto de du ctth ei r res pe ct iv e sh ares of P CSC lo ss es forth e y ears inis su e. See s ec. 1 36 6( a)(1 ). In o rd er t o b e en ti tl edto flo wth ro ug h d educ ti on s fo r lo ss es att rib ut ab le to PCSC , Mari lynn e an d Dav idm us t sh ow: (a) tha t PC SC was a bu si ne ss en te redin to forpro fit , (b) th atth e sh areh ol de rs m at eri al ly part ic ip at edinPCSC ’s act iv it ie s, (c ) th atPCSC infact in cu rredlo ss es , and(d) th atth e sh areh ol de rs ha d b as es inPCSC equa l t o t he
am ou ntof t he lo ss es cla im ed . As we ex pl ai n b el ow, p et it io ne rs su ccee d i n
es tabl is hi ng th e fi rs t o f th es e p rere qu is it es , andMari lynn e su ccee ds at t he sec on d, bu t the y fai l atsh owi ng th e rem ai nd er. A. PCSC ’s tra de or b us in es s A tax pa y er wh o i s carry in g o n atra de or b us in es s m ay de du ctord in ary an d
ne ces sa ry ex pe ns es in cu rredinco nn ect io n wi thth e o pe rat io n o f th e b us in es s. Sec
. 16 2( a). Howe ve r, a ta xp ay er g en eral ly m ay no t d educ t ex pe ns es in curredin
co nn ect io n wi th a ho bb y

or o th er n onpr of

itact iv it y to off se t t ax ab le in co m e fro m ot he r so ur ces . Sec. 1 83 (a). Sec ti on 18 3( c) d efi ne s an “ act iv ity no t en ga ge d i n fo r (...co nt in ue d) 1 5 su st ai n t hi s al te rn at iv e co nt en ti on .- 44 -

[* 44 ] pr of

it ” as “ an y

act iv it y othe r th anon e with re sp ectto whi chde du ct io ns are al lo wab le forth e ta xabl e y ear u nd er s ect io n 1 62 or u nd er p arag rap h (1 ) or(2) of
se ct io n 2 12 .” An ac ti vi ty con st itut es a “ tra de or b us in es s” withi n t he m ean in g o f
se ct io n 1 62 --an d i t es cap es th e li m it at io n o f se ct io n 1 83 --i f th e ta xp ay er’s actua l
an d h on es t o bjec ti ve is to real iz e a p ro fit . Oste env. Co m m is si on er, 6 2 F .3d35 6, 35 8 (1 1th C ir. 1 99 5) , aff’g i n p art , rev ’g inpa rt T.C. M em o. 1 99 3- 51 9. Th e
ex pe ct at io n o f pr of

itne edno t h av e b een reas on ab le ; h owe ve r, th e ta xp ay er m us t ha ve en te redin to th e act iv it y , or c on ti nu edit , with the ob jecti ve of m ak in g a pr of it . Hul te r v. C omm is si on er, 9 1 T.C. 3 71 , 39 3 (1 98 8) ; 2 6 C .F.R. se c. 1.1 83
- 2( a), In co m e Tax Reg s. 1 6 The Co m m is si on er co nt en ds th atPCSC was n ota bu si ne ss en te redin to for pr of it ; the refo re, d educ ti on s re la ti ng to it s l os se s s ho ul d b e d is al lo wed . W he th er
Sect io n 1 .18 3- 2( b) , Inc om e Tax Reg s., p ro vi de s a l is t o f fac to rs to be 1 6 co ns id eredinth e ev al ua ti on of atax pa y er’s p ro fitob jecti ve : (1 ) th e m an ne r in whi chth e ta xp ay er ca rri es on th e act iv it y ; (2 ) th e expe rti se of t he tax pa y er o r hi s advi se rs ; (3 ) th e ti m e an d e ffo rt e xp en de d b y th e ta xp ay er i n c arrying on th e act iv ity ; (4 ) th e ex pe ct at io n t ha t as se ts us edinth e act iv ity m ay ap pr eci at e in va lu e; (5) th e su cces s o f th e ta xp ay er i n c arrying on ot he r si m il ar o r di ss im il ar act iv it ie s; (6) th e ta xp ay er’s h is to ry of i nc om e o r lo ss es with re sp ectto th e act iv ity ; (7 ) th e am ou ntof o ccas io na l p ro fit s, i f an y , fro m th e act iv it y ; (8 ) th e fin an ci al st atus of t he tax pa y er; an d (9 ) el em en ts of p ers on al pl eas ur e o r recr eat io n. Atlea stfiv e o f th es e fac to rs --i .e., nu m be rs 1, 2 , 3, 8 , and9-- are p la in ly in pe ti ti on ers ’ fav or ; an d the Co m m is si on er’s co nt en ti on s t o t he co nt rary focu s o n Mar il ynn e an d Dav idan d i gn or e Pau l’s s ub st an ti al work
.- 45 -

[* 45 ] pe ti ti on ers th ro ug h P CSC e ng ag edinco ns tru ct io n p ro ject f in an ci ng with t he requi si te ob

jecti ve of m ak in g apro fitis on e o f fac t t o b e res ol ve d o n t he ba si s o f al l the surro un di ng fact s an d c irc um st an ces . Lem m env. Co m

m is si on er, 7 7 T.C. 13 26 , 13 40 (19 81 ); 2 6 C .F.R. se c. 1.1 83 -2 . W e h av e fo un d t ha t PC SC was
se rio us ly acti ve inreal est at e d ev el op m en t an d fi na nc in g a ndha d age nu in e p ro fit
m ot iv e. Altho ug h P au l was no t an own er o f PCSC , he a ct edas i ts ag en t wi th th e
ex pr es s au th or iz at io n o f PCSC ’s own ers (Pau l’s wi fe an d h is so n) , andhe an d t he y cl earl y ho pe d a ndin te nd edfor

PCSC to be pro fit ab le . Alth ou gh PCSC was n ot pr of it ab le du rin g t he y ears inis su e, Pau l d ev el op edanex pe rti se inco ns tru ct io n fin an ci ng (in cl ud in g t en an t i m pr ov em en t fi na nc in g) , andth e work tha t h e d id du rin g t he y ears inis su e la idth e g ro un dwo rk forth e la te r su cces sf

ul co m pe ti ti on of Mark etSqua re Pro

ject i n Zi on , Ill in oi s, an d fo r ot he r de ve lo pm en t p ro jects th at ha d apo ss ib il it y

of c om in g t o frui ti on . The ro y al ty agree m en ts th atpu rp orte d t o tra ns fer t o P CSC t he rig ht s t o t he Tena ntIm pr ov em en t Pr og ram

were fi ct it io us , bu t the Graffi a fam il y ’s col le ct iv e in te nt io n t o m ak e m on ey th ro ug h P CSC wa s
no t. Acco rd in gl y , we con cl ud e th atPCSC was abu si ne ss en ga ge d i n fo r pr of it
. B. Deduc ti on s und erl y in g P CSC’s l os se s Inord er t o d educ t l os se s p as se d t hr ou gh to th em fro m PCSC , pet it io ne rs
m us t es tabl is h, i nt er al ia , th atPCSC infactin curredth e cl ai m edlo ss es of- 46 -

[* 46 ] $4 47 ,69 3 i n 2 00 5, $ 49 1,3 23 in20 06 , and$1 37 ,37 8 i n 2 00 7. Se e Bu rk e v . Co m m is si on er, T.C. Mem o. 1 99 5- 60 8. Pe ti ti on ers ha ve no t ex pl ai ne d h ow tho se rep orte d l os se s wer e cal cu la te d o r in di cat edwhi chPCSC de du ct io ns m ig ht
acco un t fo r th em ; an d t he on ly evi de nc e o f PCSC ex pe ns es th atpo te nt ia ll y co ul d be de du ct ib le rel at es to royalty pa ym en ts an d c red itcardex pe ns es , whi chwe no w di sc us s. 1. PCSC ’s royalty ex pe ns es Fo r th ree r el at edreas on s, PC SC co ul d n otpro pe rly deduc t the royalty
ex pe ns es un de rlyin g i ts cla im edlo ss es . Firs t, p et it io ne rs si m pl y fai le d t o
subs ta nt ia te th e d educ ti on s. Th e ro y al ty agree m en ts th atsupp os ed ly gen erat edth e
ro y al ti es were fi ct it io us , andno royalt ie s wer e in factpa id
. Seco nd , PCSC l ack edsu ffi ci en t b as is inth e Pau l Gra ffi a n ot e to supp ort the de du ct io n. PC SC d educ te d $ 38 5,0 00 as r oyalty ex pe ns e in each of 2 00 5 a nd20 06
no t as th e res ul t o f cl ai m in g t o p ay cas h i n t ha t am ou ntbu t ra th er as th e supp os ed
res ul t o f can cel li ng Pau l’s n ot e in th atam ou nt . The ro y al ty deduc ti on s the refo re de pe ndon PCSC ’s bas is inPau l’s n ot e. PCSC cla im s tha t i ts ba si s i n P au l’s n ot e is $3 85 ,00 0, b ecau se Davi d a cqui reditforhi s o wn n ot e in th atam ou nt(th us gi vi ng Davi d aba si s o f $3 85 ,00 0 i n P au l’s n ot e) an d the n c on tri bu te d i t t o P CSC, whi chto oka carry ov er o f th atba si s. Si nc e we fi ndth atbo thno te s d idno t- 47 -

[* 47 ] ev id en ce g enui ne in de bt edne ss , th ey wil l n oty ie ldan y

ba si s t o s up po rt PCSC ’s deduc ti on s. Kap la n v . Comm is si on er, T.C. Mem o. 2 00 5- 21 8 (b as is no t in crea se d b y

a “pu rp orte d l oan * * * [th at ] in vo lv edno actua l ec on om ic ou tl ay ”). Thi rd , as ati m in g m at te r, se ct io n 2 67 ba rs PCSC ’s deduc ti on s fo r th e y ears in is su e. Gene ral ly, anaccrua l-metho d t ax pa y er l ik e PCS C m ay de du ctord in ary
an d n eces sa ry

bu si ne ss ex pe ns es inth e ta x year th atall ev en ts ha ve oc cu rredth at
es tabl is h t he factof t he li ab il it y , th e am ou ntof the li ab il it y is set , andeco no m ic pe rfo rm an ce h as oc cu rredwith re sp ectto th e li ab il it y . 26 C.F.R. s ec. 1 .44 6- 1( c)(1 )(i i)( A), Inc om e Tax Reg s. Ho wev er, wh enth os e b us in es s ex pe ns es are
owe d t o arel at edcas h- ba si s t ax pa y er, s ect io n 2 67 (a)( 2) pro vi de s tha t an accrua lba si s t axpa y er m ay

de du ctth em

on ly in the tax y ear t ha t the am ou ntin vo lv edis in cl ud ab le inth e g ro ss in co m e o f th e cas h- ba si s p ay ee. Bo th Pau l an d M ari lynn e
are r el at edto PCSC forpu rp os es of s ect io n 2 67 . See s ec. 2 67 (b )(2 ), (c)( 2) , (e)(1 ). PCSC us es th e acc ru al m etho d o f acc ou nt in g; Pau l an d M ari lynn e u se th e cas h
m etho d o f acc ou nt in g. As we co nc lu de d abo ve , th e ro y al ty fees o st en si bl y du e fro m PCSC to Pau l an d M ari lynn e were n otin cl ud ab le inPau l’s o r Mar il ynn e’s gr os s i nc om e fo r 20 05 , 20 06 , or 2 00 7. Th us , pu rs ua ntto sec ti on 26 7( a)(2 ), th e
ro y al ty fees wo ul d n otbe de du ct ib le to PCSC forany of t ho se y ears .- 48 -

[* 48 ] 2. Cred itcardex pe nd itur es A tax pa y er m ay

de du ctord in ary an d n eces sa ry ex pe ns es pa idor i nc urredin
carry in g o n atra de or b us in es s. Sec . 16 2( a). A tax pa y er, h owe ve r, m us t m ai nt ai n
reco rd s s uf

fic ie ntto subs ta nt ia te hi s cl ai m edde du ct io ns . See s ec. 6 00 1; 26 C.F.R.
se c. 1.6 00 1- 1( a). Pet it io ne rs ’ ev id en ce wi th reg ardto PCSC cred itcardex pe ns es in cu rredon Dav id ’s cred itcardis li mit edto a 20 05 y ear- en d s ta te m en t tha t i s m ark edwith ha nd writ te n n ot es to ta li ng th e expe nd itur es th atpe ti ti on ers cla im to be attrib ut ab le to PCSC . The al le ge d P CSC e xp en se s ar e co m m in gl edwith h un dr ed s o f ot he r tra ns act io ns li st edon th e st at em en t, s om e o f whi chap pe ar p ers on al an d o th ers of whi chare ev id en tl y

rel at edto an ot he r bu si ne ss inwhi chDavi d h adanin te res t. W e h av e n o re li ab le way

of d et erm in in g wh ic h p art ic ul ar cr ed itcardpu rch as es
m ay ha ve be enforPCSC or d et erm in in g t he bu si ne ss pu rp os e fo r th os e p art ic ul ar pu rch as es , no r ev enforde te rm in in g t he pu rch as es forwhi chPCSC cla im ed de du ct io ns . There is no ev id en ce wi th reg ardto an y 20 06 or 2 00 7 c red itcard pu rch as es or p aym en ts . The s ub st an ti at io n h ere i s i na de qu at e to supp ort s ect io n 16 2 b us in es s ex pe ns e d educ ti on s. Acco rd in gl y , to th e ex te ntPCSC att em pt edto de du ctam ou nt s ch arg edto Davi d’s cr ed itcard , th os e d educ ti on s ar e n otall owe d to PCSC for

20 05 , 20 06 , or 2 00 7.- 49 -

[* 49 ] W e can fin d n o o th er ev id en ce t o s up po rt a ny oth er PC SC d educ ti on s fo r 20 05 , 20 06 , or 2 00 7. Si nc e n o a ll owabl e d educ ti on s h av e b een est ab li sh edfor PCSC for20 05 , 20 06 , or 2 00 7, p et it io ne rs ha ve fai le d t o c arry the ir b ur de n t o pr ov e th atPCSC in cu rredtax lo ss es inan y am ou nt s fo r th os e y ears . Accor di ng ly, th e en ti rety

of M ari lynn e’s an d Dav id ’s deduc ti on s fo r th ei r res pe ct iv e sh ares of PCSC ’s lo ss es are u ns ub st an ti at ed . Our an al y si s co ul d e ndth ere, b utwe br ie fly ad dr es s the rem ai ni ng pre requi si te s tha t p et it io ne rs ha d t he bu rd ento sat is fy
. C. Sh areh ol de rs ’ m at eri al pa rti ci pa ti on Sect io n 4 69 ge ne ral ly dis al lo ws the curren t d educ ti on of a ny “pa ss iv e act iv ity ” lo ss . A pas si ve act iv it y is an y tra de or b us in es s i n wh ic h t he tax pa y er do es no t “ m at eri al ly part ic ip at e”. Sec . 46 9( c)(1 ). Mat eri al pa rti ci pa ti on is de fin ed
as in vo lv em en t i n t he op erat io ns of t he act iv it y th atis “ reg ul ar”, “ co nt in uo us ”, an d

“ subs ta nt ia l” . Sec. 4 69 (h )(1 ); 2 6 C .F.R. se c. 1.4 69 -5 T(a), Tem po rary Inco m e Tax Reg s., 5 3 F ed . Reg . 57 25 (Feb . 25 , 19 88 ). It i s cl ear t ha t Paul was re gu la rly,
co nt in uo us ly, an d s ub st an ti al ly eng ag edonbe ha lf o f PCSC inatt em pt in g t o e nt er in to de ve lo pm en t an d fi nanc in g d eal s dur in g the y ears inis su e an d i n p rece di ng y ears . Butsi nc e h is wife Mari lynn e an d h is so n Dav idwere the PCSC sh areh ol de rs who cla im edth e lo ss de du ct io ns on th ei r ta x re tu rn s, i t i s the ir s ta tu s- 50 -

[* 50 ] th atm at te rs ; an d t he IRS co nt en ds th atne it he r Mar il ynn e n orDavi d

“ m at eri al ly part ic ip at ed ” in PCSC
. Esp eci al ly in l ig htof t he factth atne it he r of th em tes ti fie d, the reco rddo es
no t s ho w a subs ta nt ia l qua ntum of P CSC a ct iv it y

by eith er o f th em

du rin g the y ears inis su e. As fo r Mar il ynn e, ho wev er, p et it io ne rs ’ pr in ci pa l co nt en ti on is 1 7 th atPau l’s ac ti vi ty is p ro pe rly attrib ut edto he r un de r 26 C.F.R.
se c. 1.4 69 -5 T(f)(3 ), Tem

p. In co m e Tax Reg s.: Part ic ip at io n o f sp ou se . In the cas e o f an y pe rs on who is a m arri ed in di vi du al (wit hi n t he m ean in g o f se ct io n 7 70 3) forth e ta xabl e y ear, an y pa rti ci pa ti on by suc h p ers on 's s po us e inth e act iv it y du rin g t he ta xabl e y ear ( witho utreg ardto whet he r th e sp ou se own s an in te res t i n th e act iv it y

an d wi th ou t re ga rdto whethe r th e sp ou se s fi le a joi nt return fo r th e ta xabl e y ear) sh al l b e tr eat ed , forpu rp os es of app lying se ct io n 4 69 an d t he reg ul at io ns th ereu nd er t o s uc h p ers on , as pa rti ci pa ti on by suc h p ers on inth e act iv ity du rin g t he tax ab le y ear. Pau l’s p art ic ip at io n i s thu s treat edas p art ic ip at io n b y Mari lynn e, an d h er pa rti ci pa ti on was t he refo re m at eri al
. As fo r Dav id , we hav e fo un d t ha t h e m ai nt ai ne d fu ll -ti m e em pl oym en t
ou ts id e o f PCSC , andth atitwas Paul , no t Dav id , who pe rfo rm edsubs ta nt ia ll y all

Pet it io ne rs m ad e th is co nt en ti on as e arl y as t he ir f irs t p retria l 1 7 m em or an du m

fil edinOcto be r 20 10 an d re pe at editat tria l (a t wh ic h P au l t es ti fie d th atMari lynn e was a “ sp ou sa l ac ti vi ty part ic ip an t” ) an d i n b ot h o f th ei r po st -tr ia l br ie fs . The Co m

m is si on er h as ne ve r an swe redor e ve n a ddres se d t hi s co nt en ti on orpa rag rap h (f

)(3 ) of th e reg ul at io n.- 51 -

[* 51 ] of P CSC’s a ct iv it ie s dur in g t he y ears inis su e. W e h av e fo un d t ha t Dav id di d n otex pe ndas m

uc h a s 1 00 ho ur s p er y ear wo rk in g fo r PCSC inan y of the y ears inis su e o r in pre ced in g years. We con cl ud e th athe ha s n otsat is fie d a ny of th e st an da rd s i n s ect io n 4 69 or 2 6 C .F.R se ct io n 1 .46 9- 5T(a ), fo r m at eri al pa rti ci pa ti on inPCSC ; an d Dav id ’s deduc ti on s fo r lo ss es fro m PCSC are di sa ll owe d fo r th e y ears inis su e und er s ect io n 4 69 (a), t o t he ex te ntth ey ex ceed in co m e fro m

hi s p as si ve act iv it ie s. D. Sh areh ol de rs ’ ba si s A sh areh ol de r’s in it ia l b as is inhi s s to ckco rres po nd s t o the co stof t he st oc k pl us cap it al co nt rib ut io ns . Secs . 10 11 -1 01 6; Pu gh v. Co m mis si on er, 2 13 F.3d 13 24 , 13 30 (11 th Cir . 20 00 ), rev ’g T.C. Mem o. 1 99 9- 38 . Neithe r Dav idno r Mar il ynn e subs tant ia te d a n a m ou ntpa idas t he in it ia l co stof t he st oc k, an d t o
es tabl is h b as is bo th of t he m de pe ndon sh owi ng subs eque ntco nt rib ut io ns of cap it al --as to whi chne it he r of th em tes ti fie d. Pe ti ti on ers arg ue th atMari lynn e’s
co nt rib ut io n o f cap it al was h er o st en si bl e as si gn m en t o f ro y al ti es . Like wis e, pe ti ti on ers arg ue th atDavi d’s m ai n c on tri bu ti on s o f cap it al were h is co nt rib ut io n of Pau l’s n ot e fo r $3 85 ,00 0 (wh ic h Dav idacqui redby trad in g h is ownequi va le nt
no te ) an d h is ex ch an ge of h is $1 m il li on no te forTHI’ s $ 1 m il li onno te . Howev er, we ha ve fou ndth es e tr an sa ct io ns to be fic ti ti ou s. Be cau se th e n ot es di d n otres ul t- 52 -

[* 52 ] inan y

real ch an ge inth e eco no m ic si tu at io ns of t he pa rti es , th e n ot es di d n ot
es tabl is h a ny bas is inth e PCS C s to ckforDavi d o r Mar il ynn e. See Kap la n v . Co m m is si on er, T.C. Mem o. 2 00 5- 21 8 (b as is no t i nc reas edby a “pu rp orte d l oa n * * * [tha t] in vo lv edno actua l ec on om ic ou tl ay ”). Dav idals o c on te nd s tha t h e m ad e cre di t ca rdex pe nd itur es on PCSC ’s be ha lf tha t i nc reas e h is ba si s i n P CSC. An d i t i s tru e th at“ anou tl ay by a st oc kh ol de r in be ha lf o f hi s co rp or at io n, ab se ntan y fix edob li ga ti onfor rep aym en t, i s g en eral ly regar de d a s a c on tri bu ti on to cap it al whi chsh ou ldbe ad de d t o t he ba si s o f hi s s to ck .” Kore e v . Comm is si on er, 4 0 T.C. 9 61 , 96 5 (1 96 3)
. Howev er, b ecau se Davi d fa il edto subs ta nt ia te th e b us in es s p ur po se of h is cred it cardex pe nd itur es --i .e., bec au se he fai le d t o s ho w th athe di d i n fa ctm ak e
ex pe nd itur es on PCSC ’s beh al f--t he factua l p red ic at e fo r hi s co nt en ti on is si m pl y ab se nt . See Kap la n v . Comm is si on er, T.C. Mem o. 2 00 5- 21 8 (“ Pet it io ne r be ars th e bu rd enof p ro vi ng th athe in cu rredth e cl ai m edex pe ns es , th atth ey were p ai d t o pr ot ector e nh an ce the va lu e o f hi s i nv es tm en t * * * , andth atth ey were
co nt rib ut io ns to * * * capi ta l” ). Co ns eque nt ly, ne it he r sh areh ol de r co ul d c la im an y lo ss de du ct io ns de riv ed fro m PCSC . Bert ol i v . Commis si on er, 1 03 T.C. 50 1, 5 15 -5 16 (19 94 ).- 53 -

[* 53 ] V. NOL carryove r de du ct io ns Pau l an d M ari lynn e as se rt t ha t the y were ea chen ti tl edto de du ct io ns for 20 05 , 20 06 , and20 07 of NOL carry ov ers fro m 20 00 an d 2 00 3. Inge ne ral , a ta xp ay er i s en ti tl edto de du ct , as an NOL fo r a t ax ab le y ear, an am ou ntequa l t o t he
su m of t he NOL carry ov ers an d NOL carry ba ck s t o t ha t year. Sec. 1 72 (a). A ta xp ay er cl ai m in g a n NOL d educ ti on m us t fi le with h is return “ a co nc is e st at em en t
se tt in g fo rth th e am ou ntof the * * * [NOL] deduc ti on cla im edan d a ll m at eri al an d pe rti ne ntfact s re la ti ve th eret o, i nc lu di ng a de ta il edsch edul e sh owi ng th e
co m pu ta ti on of t he * * * [NOL] deduc ti on .” 26 C.F.R. s ec. 1 .17 2- 1( c), In co m e Tax Reg s. Pau l an d M ari lynn e b ot h b ear t he bu rd enof e st ab li sh in g the ex is te nc e of NOLs in pri ory ears an d t he am ou ntth atm ay be carr ie d fo rwardto th e y ears in is su e. See R

ul e 1 42 (a); Keit h v . Comm is si on er, 1 15 T.C. 60 5, 6 21 (20 00 ). W e ha ve juri sd ic ti on to co ns id er s uc h fa ct s re la te d t o c lo se d years t ha t ar e n otdi rect ly in is su e, to th e ex te ntth atth os e fac ts m ay be rel ev an t t o o ur

red et erm in at io n o f ta x li ab il it ie s fo r th e y ears th atare b efo re the Co urt. See sec . 62 14 (b ); C lu ck v. Co m m is si on er, 1 05 T.C. 32 4, 3 30 (19 95 ). Altho ug h b oth P au l an d M ari lynn e fi le d wi th th ei r returns sch edul es cal cu la ti ng th ei r NOL carryove rs for20 05 , 20 06 , and20 07 , th es e are m erel y st at em en ts of t he ir c la im s an d d o n otest ab li shth e co rrec tn es s o f th e fac ts st at ed- 54 -

[* 54 ] th erei n. Se e Wilk in so n v . Comm is si on er, 7 1 T.C. 6 33 , 63 9 (1 97 9) . Neithe r Pau l n or Mari lynn e o ffer edan y

ev id en ce t o s ub st an ti at e th ei r al le ge d l os se s i n 20 00 an d 2 00 3 t ha t g av e ri se to th e NOL carryove r de du ct io ns th ey pre se nt ly cl ai m forth e y ears be fo re u s. (Th ey di d n otev enoff

er i nt o e vi de nc e th ei r 20 00
an d 2 00 3 re tu rn s, wh ic h m ig htha ve sh own , at l eas t g en eral ly, th e o rig in an d
na tu re o f th e supp os edlo ss es .) Acco rd in gl y , th ey ha ve fai le d t o s ub st an ti at e th ei r
res pe ct iv e NOL carryove rs an d a re n oten ti tl edto cla im an y NOL deduc ti on s fo r th e y ears inis su e. Pet it io ne rs arg ue th at , bec au se th e lo ss -g en erat in g years are “ cl os edy ears ”, th e IRS is ba rredby the st atut e o f li m it at io ns fro m di sa ll owi ng th e NOL de du ct io ns . This arg um en t i s wi th ou t m eri t. If the lo ss -g en erat in g p rio r y ears are

“ cl os ed ” fo r pu rp os es of t he st atut e o f li m it at io ns (se ct io n 6 50 1) , th enforth os e y ears th atst atut e b ars th e as se ss m en t o f ta x b utdo es no t b ar “ ad jus tm en ts ” o r

“ di sa ll owa nc es ” th ateli m in at e th e lo ss (an d t ha t el im in at e NOL deduc ti on s i n ot he r, “ op en ” y ears ). Forth e y ears inis su e th e p eri odof l im it at io n fo r
as se ss m en ts is st il l o pe n (b ecau se of the IRS’s i ss ua nc e o f th e n ot ic e o f de fic ie nc y
an d p et it io ne rs ’ co m

m en cem en t o f th es e cas es ; s ee s ec. 6 50 3( a)(1 )); an d i f pe ti ti on ers can no t s ho w th e ex is te nc e o f pr io r-y ear l os se s tha t can b e carrie d i nt o th es e y ears , th enth e d is al lo wan ce o f th e NOL deduc ti on s i n t he se y ears m us t b e- 55 -

[* 55 ] su st ai ne d, an d t he res ul ti ng de fic ie nc ie s m us t b e d et erm in ed . Peti ti on ers
su gg es t tha t NOLs m ay

be di sa ll owe d, n ot withs ta nd in g t he y ears ’ be in g “ cl os ed ”,
on ly in a c irc um st an ce wh ere t he tax pay er s eek s a r efu ndof t ax ; b utth ere i s n o
su chrul e. See C lu ckv. Co m m is si on er, 1 05 T.C. at 3 30 (“ th e Co m m is si on er m ay
reco m pu te a ta xp ay er’s t ax ab le in co m e o r lo ss fora y ear i n wh ic h t he st atut e o f li mit at io ns wou ldothe rwis e b ar as se ss m en t i n o rd er t o re de te rm in e th e am ou ntof th e NOL deduc ti on cla im edinanop eny ear” ); S ta te Farm in g C o. v . Co m m is si on er, 4 0 T.C. 7 74 , 78 1- 78 3 (1 96 3)
. VI. Pau l’s Sc he du le C expe ns es Pau l co nt en ds th athe is en ti tl edto th e fo ll owi ng de du ct io ns an d o ffs et s tha t he cla im edon a Sch edul e C at ta ch edto hi s 2 00 5 re tu rn :

• $8 ,60 1 fo r “ Ren t/ Leas e - Oth er Bu si ne ss Pro pe rty”;

• $4 0,0 00 for

“ Leg al an d P ro fes si on al Serv ic es ”;

• $1 55 ,80 3 fo r “ In te res t - Othe r”; an d

• $1 09 ,00 0 fo r “ Returns an d a ll owa nc es ”. Howev er, the re i s n o e vi de nc e th atin20 05 Pau l p ai d a ny of th e actua l ex pe ns es he rep orte d o n h is 20 05 Sch edul e C. Pau l ar gu es th is is be cau se th e ex pe ns es were actua ll y pa idby Mr. Olso n d at in g b ackto 19 96 bu t wer e su sp en de d u nt il Pau l rep ai d M r. Ols on . Pau l cl ai m s tha t the ex pe ns es were d educ ti bl e to hi m in20 05- 56 -

[* 56 ] whe n P CSC d is ch arg edth e Pau l Gra ffi a n ot e (wh ic h was ori gi na ll y gi ve n t o Mr. Ol so n) , bec au se th e ex pe ns es were the n d eem edpa idby Paul . Pau l’s arg um en t i s wi th ou t m eri t. Fi rs t, we h av e al read y

co nc lu de d t ha t the Pau l Gra ffi a n ot e d idno t ev id en ce a g enui ne in de bt edne ss , so it s ca nc el la ti on is a no ne ve ntfortax pu rp os es . Seco nd , ev enif the de btwas g enui ne , itis well set tl edth atex pe ns es of acas h m etho d ta xp ay er ar e d educ ti bl e in th e y ear i n wh ic h t he expe ns e is pa id , eve n t ho ug h p ai d with b orro wedfun ds , andth e d educ ti onm ay no t b e p os tp on edto th e y ear i n wh ic h rep aym en t o f th e b orro wedfun ds is m ad e. See C rai n v . Comm is si on er, 7 5 F .2d 96 2, 9 64 (8t h C ir. 1 93 5) ; Harris v. Co m m is si on er, 1 1 T.C. 8 64 , 86 7 (1 94 8)
. Acco rd in gl y , Pau l i s n oten ti tl edto th e 2 00 5 S ch edul e C d educ ti on s o r of fs et s t ha t he cla im ed
. VII. Unr ep orte d i nc om e The Co m m is si on er co nt en ds th atDavi d a ndAm y ha d $ 8,7 57 of c ap it al ga in in co m e in20 07 fro m

th e sa le of s to ckor b on ds bu t re po rte d o nl y $4 ,26 5 o n t he ir 20 07 Fed eral in co m e ta x re turn . Davi d a ndAm y di d n ottes ti fy

on th is is su e, an d th ey off eredno ot he r ev id en ce t o c ha ll en ge th e IRS ’s det erm in at io n t ha t Dav id
an d Amy real iz edbu t d idno t re po rt t he ad di ti on al $4 ,49 2 o f cap it al ga in in co m e in 20 07 . In the ir b rie f, th ey stres s tha t o n t he ir 2 00 7 t ax return t he y di d re po rt- 57 -

[* 57 ] cap it al ga in of $ 4,2 65 --a fa ctno t i nc on si st en t wi th (bu t ra th er p res um edin ) th e n ot ic e o f de fic ie nc y --b utth ey po in t t o n o e vi de nc e, te st im on ia l o r do cu m en ta ry , to di sp ut e th ei r rec ei ptof t he ad di ti on al ga in of $ 4,4 92 . In the ab se nc e o f an y

ev id en ce, we cann otsay tha t the y m ad e a s ho win g t ha t the de te rm in at io n was “ witho utan y rat io na l fo un da ti on ”. Cf. Ru thv. Un it edSta te s, 82 3 F .2d10 91 , 10 94 (7t h C ir. 1 98 7) . Accor di ng ly, we su st ai n t he IRS’s de te rm in at io n o n t hi s i ss ue . VIII. Accu racy-rela te d p en al ti es Sect io n 6 66 2 i m

po se s an “ accu racy-rela te d p en al ty” of 2 0% o f th e p orti on of th e und erp aym en t o f ta x t ha t i s at tri bu tabl e to th e ta xp ay er’s n eg li ge nc e o r di sr eg ardof rul es or r eg ul at io ns or t ha t i s at tri bu tabl e to any subs tant ia l
un de rs ta te m en t o f in co m e ta x. Un de r se ct io n 7 49 1( c), the Co m m is si on er b ears th e bu rd enof p ro du ct io n a ndm us t p ro du ce s uf

fic ie ntev id en ce tha t the im po si ti on of th e p en al ty is ap pr op ria te ina gi ve n c as e. Once th e Co m m is si on er m eet s thi s bu rd en , th e ta xp ay er m

us t co m e fo rwardwith p ers ua si ve ev id en ce tha t the Co m m is si on er’s d et erm in at io n i s i nc orrect . Rul e 1 42 (a); Hig be e v . Co m m is si on er, 1 16 T.C. 43 8, 4 46 -4 47 (20 01 ).- 58 -

[* 58 ] A. Subs ta nt ia l u nd ers ta te m en t By de fin it io n, an un de rs ta te m en t o f in co m e ta x fo r anin di vi du al is
subs ta nt ia l i f itex ceed s the gre at er o f $5 ,00 0 o r 10 % of t he tax requi redto be sh own on th e return. Se c. 66 62 (d )(1 )(A). The no ti ces of d efi ci en cy sh ow tha t fo r each of t he y ears inis su e, Pau l’s an d Dav idan d Amy ’s un de rs ta te m en ts wil l
ex ceedbo th $5 ,00 0 a nd10 % of the tax requi redto be sh own . Accor di ng ly, th e Co m m is si on er h as m ethi s b ur de n o f pr oduc ti on . B. Neg li ge nc e The no ti ces of d efi ci en cy is su edto Mari lynn e sh ow tha t u nd ers ta te m en ts of he r ta x i s l es s tha n $ 5,0 00 ineach of t he y ears inis su e; i.e., the y are n ot

“ subs ta nt ia l u nd ers ta te m en ts ”. Howev er, the Co m m is si on er as se rts th atMari lynn e is li ab le forsec ti on 66 62 accu racy-rela te d p en al ti es be cau se he r un de rp aym en ts of ta x wer e at tri bu tabl e to he r ne gl ig en ce wi th reg ardto th e ru le s o r reg ul at io ns . For pu rp os es of s ect io n 6 66 2, the term “ne gl ig en ce” i nc lu de s a f ai lu re t o e xe rci se
or di na ry an d re as on ab le care inth e p rep arat io n o f a t ax return. 2 6 C .F.R. se c. 1.6 66 2- 3( b) (1 ), In co m e Tax Reg s. Neg li ge nc e is de fin edas alac k o f du e car e o r fai lu re t o d o wh ata reas on ab le an d o rd in ari ly pru de ntpe rs on wou lddo un de r th e ci rcu m st an ces . Neely v. Co m m is si on er, 8 5 T.C. 9 34 (19 85 ). The t erm “ di sr eg ard ” in cl ud es an y

care le ss , reck le ss , or i nt en ti on al di sr eg ardof rul es or r eg ul at io ns .- 59 -

[* 59 ] Sec. 6 66 2( c). Itals o “ in cl ud es an y fai lu re b y

th e ta xp ay er t o k eep ad equa te bo ok s an d re co rd s o r to subs ta nt ia te it em s p ro pe rly.” 26 C.F.R. s ec. 1.6 66 2- 3( b) (1 ), In co m e Tax Reg s. As we no te d abo ve , tax pa y ers are re qu ire d t o ret ai n t he ir b oo ks an d re co rd s “ so lo ng as t he co nt en ts th ereo f m ay be co m e
m at eri al inth e ad m in is tra ti on of a ny int ern al rev enue law.” In th es e cas es , reco rd s
subs ta nt ia ti ng th e al le ge d NOLs fro m 20 00 an d 2 00 3 b ecame m at eri al forth e y ears indi sp ut e whe n M ari lynn e d educ te d s uc h NOLs on he r returns . Bec au se th e PCS C p as s- th ro ug h d educ ti on s tha t M ari lynn e wro ng ly clai m ed were al m os t ex act ly offs etby the fic ti ti ou s ro y al ty inc om e sh e rep orte d, Mar il ynn e’s un de rs ta te m en ts are at tri bu tabl e al m os t en ti rel y to he r cl ai m edNOL de du ct io ns ge ne rat edin20 00 an d 2 00 3. Bu t wh enth os e 2 00 0 a nd20 03 reco rd s be cam e m at eri al to he r di sp ut e as to 20 05 , 20 06 , and20 07 , sh e fai le d t o k eep ad equa te bo ok s an d re co rd s an d t o p ro pe rly subs ta nt ia te th os e NOL deduc ti on s. W e fi ndhe r ne gl ig en t i n t hi s fa il in g. C. Defen se s Altho ug h o th erwi se li ab le forth e acc ur acy-rela te d p en al ty, a ta xp ay er m ay
av oi d t he li ab il it y

if h e su cces sf

ul ly inv ok es on e o f th ree o th er p ro vi si on s, wh ic h we br ie fly con si de r: Fi rs t, s ect io n 6 66 2( d) (2 )(B) pro vi de s tha t an un de rs ta te m en t
m ay be reduc edwher e th e ta xp ay er h adsubs ta nt ia l au th or it y forhi s treat m en t o f- 60 -

[* 60 ] an y it em gi vi ng ris e to th e und ers ta te m en t. The re i s n o autho rit y th atwou ld
warra ntPau l’s, Ma ril ynn e’s, orDavi d a ndAm y ’s po si ti on s. Sec on d, s ect io n 66 62 (d )(2 )(B) pro vi de s tha t an un de rs ta te m en t m ay be reduc edwher e th e rel ev an t fact s af fect in g t he it em ’s tre atm en t wer e ad equa te ly dis cl os edon hi s t ax return a nd th e ta xp ay er h ada reas on ab le ba si s fo r hi s treat m en t o f th atit em . Thes e cri te ria
are n otm ethe re. Thi rd , sec ti on 66 64 (c)( 1) pro vi de s tha t, i f th e ta xp ay er s ho ws, fir st , th atth ere was reas on ab le cau se fora po rti on of a n u nd erp aym en t an d,
se co nd , th athe act edingo odfai th with re sp ectto th atpo rti on , th enno
accu racy-rela te d p en al ty sha ll be im po se d wi th res pe ctto th atpo rti on . Whe th er th e ta xp ay er ac te d wi th reas on ab le cau se an d i n g oo d fa it h d ep en ds on th e pe rti ne ntfact s an d c irc um st an ces , in cl ud in g h is effo rts to ass es s h is pro pe r ta x li ab il it y , hi s kno wled ge an d e xp eri en ce, an d the ex te ntto whi chhe rel ie d o n t he advi ce o f a t ax pro fes si on al . 26 C.F.R. s ec. 1 .66 64 -4 (b )(1 ), In co m e Tax Reg s. Pet it io ne rs ’ br ie f arg ue s (b utMari lynn e d idno t t es ti fy ) th atPau l an d Mar il ynn e “ ex erci se d d il ig en t ca re i n c on fo rm in g t he ir c on du ctan d t ax tre atm en t with p ert in en t s ta tu te s an d re gu la ti on s.” We can no t s ay th atPau l o r Mar il y

nn e h as pr ov edeit he r “ go odfai th ” o r “ reas on ab le cau se ”. They bo th fai le d t o s ho w th at th ey ke ptad equa te bo ok s an d re co rd s t o s ub st an ti at e th ei r res pe ct iv e NOL de du ct io ns . Nor h as Pau l s ho wn ad equa te reco rd s t o s ub st an ti at e an y of t he ot he r- 61 -

[* 61 ] de du ct io ns he cla im edfor th e y ears inis su e. Pau l p rep aredbo thhi s an d Mar il ynn e’s returns forth e y ears inis su e, bu t p et it io ne rs m ad e n o s ho win g t ha t, i n
so do in g, Paul rel ie d o n d oc um en ta ti on ad equa te to subs ta nt ia te th e d educ ti on s h e
an d M ari lynn e cl ai m edon th ei r returns . Accor di ng ly, th e IRS ’s det erm in at io ns with re ga rdto Pau l’s an d M ari lynn e’s acc ur acy-rela te d p en al ti es un de r se ct io n 66 62 (a) a re s us ta in ed
. Si m il arl y , pet it io ne rs ’ br ie f arg ue s tha t Dav idan d Amy “ ex erci se d d il ig en t
care inco nf

ormin g the ir c on du ctan d t ax tre atm en t wi thpe rti ne ntst atut es an d reg ul at io ns .” Even th ou gh Davi d a ndAm y hi redanin de pe nd en t t ax pro fes si on al to pre pa re the ir r eturns , we can no t s ay th atDavi d a ndAm

y ha ve sh own “ go od fai th ” o r “ reas on ab le cau se ”. Davi d a ndAm y ha ve fai le d t o s ho w th atth ey ke pt ad equa te bo ok s an d re co rd s o r pr ov id edth ei r return p rep arerwith re co rd s t o
subs ta nt ia te PCSC ’s deduc ti on s t ha t fl owe d t hr ou gh to th ei r returns . In fa ct , th ey
m ad e n o s ho win g wh at so ev er as to th e in fo rm at io n t ha t the y pro vi de d t o t he ir return p rep arer , no r as to an y advi ce tha t the return p rep arerga ve to th em . Mo reo ve r, th e fi ct it io us na tu re o f Dav id ’s in de bt edne ss to supp ort h is pu rp orte d ba si s i n P CSC i s i nc on si st en t wi th a ta xp ay er’s act in g i n “ go odfai th ”. Acco rd in gl y , th e IRS ’s det erm in at io ns with re ga rdto Davi d a ndAm y ’s accu racyrel at edpe na lt ie s u nd er s ect io n 6 66 2( a) are su st ai ne d.- 62 -

[* 62 ] Becaus e we h av e su st ai ne d i n fu ll th e ad jus tm en ts th atth e IRS m ad e in it s
no ti ces of d efi ci en cy , Deci si on s wi ll be en te redfor
res po nd en t.