internal_revenue_service number release date index number ------------------------------ ------------------------- -------------------------- ---------------------------- ---------------------- ---------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact -------------------- id no ------------- telephone number --------------------- refer reply to cc intl b04 plr-116458-11 date date legend ust -------------------------------------------------------------------------------------- ---------------------------------------------------------------------------------------------- ------------------------------- fc --------------------------------------------------------------------------------------------------- ----------------------------------------------------------------------------------------------------------- ------------------------------- holdco merger sub - ----------------------------------------------------- --------------------------------------------------------------------------------------------------- ------- ------------------------------------------------------ ---------------------------------- ----------------------------------------------------- ----------------------------------------------------------------------------------------------------------------- business a ---------------------------------------------------------------------------------------------------------- -------------------------------------------------------------------------------------------------------- --------------------------------------------------- business b ------------------------------------------------------------------------------------------------------------- -------------------------------------------------- date c ----------------- plr-116458-11 amount d date e f g h year i country j k month l n amount o country p q ---------------- ------------------ ----------- ------------- ------------- ------- ------------ ----------------- -------------- ----------- ---------------- ---------------- -- r s t date u amount v date w ------------------------------------------------------ ------------------------------------------------------ ------------------------------------------------------ -------------------------------------------------- ------ --- ----------------- ------------- ---------------- plr-116458-11 dear ------------------- this is in reply to your letter dated date requesting a ruling under sec_1 a - c of the income_tax regulations that the exchange of shares in a domestic_corporation by u s persons described below will qualify for an exception to the general_rule of sec_367 of the internal_revenue_code the code supplemental information was provided in letters dated april may may june june and date the rulings contained in this letter are predicated upon facts and representations submitted by the taxpayers and accompanied by penalty of perjury statements executed by an appropriate party this office has not verified any of the material submitted in support of the request for rulings verification of the factual information representations and other data may be required as part of the audit process facts ust is a domestic_corporation and is the common parent of an affiliated_group_of_corporations that files a consolidated federal_income_tax return ust common_stock is publicly traded ust and its subsidiaries are engaged in business a as of date c the market capitalization of ust was approximately amount d as of date e employees and directors of ust held i options to acquire approximately f ust shares and ii approximately g restricted_stock units denominated in ust shares of which approximately h units were granted in year i prior to the closing of the merger ust may issue additional equity awards to service providers employees directors and officers in the ordinary course of business consistent with past issuance practices and subject_to the limitations imposed by the business combination agreement there are no other authorized issued or outstanding options warrants conversion rights arrangements calls or rights of any kind that obligate ust to issue or sell any shares of capital stock or other_securities of ust or give any person a right to acquire any shares of capital stock or other_securities of ust fc is a corporation organized under the laws of country j the united_states has a comprehensive_income_tax_treaty with country j fc stock is publicly traded the authorized share capital of fc consists of k shares all of which are issued and outstanding for purposes of country j law fc believes based on information available to it in month l that its largest shareholder at that time owned less than of its shares employees and directors of fc hold options to acquire fc shares as of date e there were approximately n fc shares underlying options to acquire such shares prior to the closing of the merger fc may issue additional equity awards to service providers employees directors and officers in the ordinary course of business consistent with past issuance practices and subject_to the limitations imposed by the business combination agreement as of date c the market capitalization of fc was approximately amount o fc along with its subsidiaries is engaged in business b plr-116458-11 ust's business a and fc's business b are of the same industry type holdco is a newly formed country p corporation which will be used to combine ust and fc in the transactions described below the united_states has a comprehensive_income_tax_treaty with country p merger sub is a newly formed domestic_corporation which is wholly owned by holdco the following transfers are proposed i ii holdco will launch a public exchange_offer the offer to acquire all of the issued and outstanding fc shares pursuant to the offer each fc share tendered and accepted for exchange will be exchanged for q holdco share s the closing of the offer is subject_to a number of conditions including the adoption of a business combination agreement by the holders of a majority of the issued and outstanding ust shares and the satisfaction of a minimum tender condition for the offer the minimum condition the minimum condition requires that there be validly tendered and not withdrawn at the expiration of the offer a number of fc shares that represents at least r less than of the outstanding fc shares on a fully diluted basis ie taking into account all fc shares issuable upon the exercise of any options warrants or rights to purchase or subscribe for fc shares regardless of the number of fc shares acquired pursuant to the offer it is the intention of holdco to ultimately acquire all of the fc shares immediately after the closing of the offer merger sub will merge with and into ust the merger with ust surviving as a direct wholly owned subsidiary of holdco in the merger each ust share will be converted into the right to receive s holdco share s the exchange of ust shares for holdco shares will be executed by an agent on behalf of the ust shareholders for purposes of accomplishing the transfer under country p law immediately after the closing of the merger holdco will own all of the outstanding ust shares and all of the fc shares acquired in the offer in the merger options to acquire ust shares will be converted into options to acquire holdco shares on substantially the same terms and restricted_stock units other than restricted_stock units granted in year i which will be cashed out will vest upon completion of the transaction iii the business combination agreement contemplates that as soon as practicable after the merger the parties will effect a post-closing reorganization intended to cause fc to become a wholly owned subsidiary of holdco a if t or more of the outstanding fc shares are acquired in the offer holdco intends to effect a squeeze-out transaction as a result of which all fc shares not tendered in the offer would be transferred to holdco by operation of law plr-116458-11 b if less than t of the outstanding fc shares are acquired in the offer holdco plans that following the merger it will acquire additional shares of fc stock through open market and private purchases and procedures under country j law that will encourage non-tendering shareholders to exchange their fc shares based on the advice of country j legal counsel the taxpayers believe it is very likely that holdco will pursuant to the same overall plan that includes the offer and the merger acquire at least by vote and value of the outstanding fc shares as a result of the offer and any subsequent acquisitions of fc shares within months from the date of the merger iv ust and fc announced on date u that they had recommended to the board_of directors of holdco that holdco pay a one-time special dividend special dividend of amount v per holdco share shortly after completion of the merger law and analysis the exchange of ust stock by u s persons is subject_to sec_367 of the code which provides that the transfer of appreciated_property including stock by a u_s_person to a foreign_corporation in a transaction that would otherwise qualify as a nonrecognition exchange is treated as a taxable transfer unless an exception applies in the case of a sec_367 transaction in which a u_s_person transfers domestic stock to a foreign_corporation the u s transferor will qualify for nonrecognition treatment if the requirements of sec_1_367_a_-3 are satisfied the requirements of sec_1_367_a_-3 are as follows i ii iii u s persons transferring u s target stock must receive in the aggregate or less of both the total voting power and total value of the stock in the transferee foreign_corporation u s persons who are officers or directors of the u s target_corporation or who are shareholders of the u s target_corporation will own in the aggregate or less of each of the total voting power and the total value of the stock of the transferee foreign_corporation immediately_after_the_exchange of the u s target stock the active trade_or_business test of sec_1_367_a_-3 must be satisfied the three elements of the active trade_or_business test are described below plr-116458-11 a the transferee foreign_corporation or any qualified_subsidiary or qualified_partnership as defined under sec_1_367_a_-3 and viii must have been engaged in the active_conduct_of_a_trade_or_business outside the united_states within the meaning of sec_1_367_a_-2t b and for the entire 36-month period immediately preceding the exchange of u s target stock b at the time of the exchange neither the transferors nor the transferee foreign_corporation or any qualified_subsidiary or qualified_partnership engaged in the active trade_or_business will have the intention to substantially dispose_of or discontinue such trade_or_business c the substantiality test as defined in sec_1_367_a_-3 must be satisfied among the requirements of sec_1_367_a_-3 for a subsidiary of the transferee foreign_corporation to be treated as a qualified_subsidiary the subsidiary must be owned by total voting power and total value by the transferee foreign_corporation with respect to clause a holdco the transferee foreign_corporation will not have been engaged in an active trade_or_business for the entire 36-month period prior to the exchange nor will it have owned any qualified subsidiaries or partnerships so engaged a transferee foreign_corporation may satisfy the test however by acquiring at the time of or prior to the exchange a trade_or_business that has been active for the preceding months this rule does not apply to the acquisition of a trade_or_business of a u s target_corporation see sec_1_367_a_-3 the taxpayers represent that fc or one or more of fc's qualified subsidiaries or qualified partnerships will have been engaged in the active_conduct_of_a_trade_or_business outside the united_states within the meaning of sec_1_367_a_-2t b and for the entire 36-month period immediately preceding the exchange of ust shares for holdco shares under sec_1_367_a_-3 in order for holdco to rely on the active trade_or_business of fc for this purpose however it must own at least of the vote and value of fc at the time of the merger under the substantiality test the fair_market_value of the transferee foreign_corporation must equal or exceed the fair_market_value of the u s target_corporation at the time of the exchange of u s target stock see sec_1_367_a_-3 for this purpose the fair_market_value of the transferee foreign_corporation must be reduced by the value of certain prohibited_assets sec_1_367_a_-3 specifically the fair_market_value of the transferee foreign_corporation must be reduced by the value of any asset that it acquired outside the ordinary course of business during the 36-month period preceding the exchange to the extent that the asset produces or is held for the production of plr-116458-11 passive_income at the time of the exchange or the asset was acquired for the principal purpose of satisfying the substantiality test sec_1_367_a_-3 the value of the transferee foreign_corporation is further reduced by the value of any assets that it received within the 36-month period preceding the exchange if those assets were owned by the u s target_corporation or an affiliate sec_1_367_a_-3 after these adjustments if the fair_market_value of the transferee foreign_corporation continues to equal or exceed the fair_market_value of the u s target then generally the substantiality test will be satisfied sec_1_367_a_-3 in addition sec_1_367_a_-3 requires that the u s target_corporation satisfy the reporting requirements of sec_1_367_a_-3 and that each u s transferor who is a shareholder of the transferee foreign_corporation immediately_after_the_exchange of target stock enter into a 5-year gain_recognition_agreement as provided in sec_1_367_a_-8 by entering into a gain_recognition_agreement the u s transferor agrees to recognize gain with certain exceptions in the event that the transferee foreign_corporation disposes of all or part of the transferred stock_or_securities the corporation the stock of which was transferred disposes of substantially_all of its assets or if certain other triggering events occur within the 5-year term of the agreement see sec_1 a - j in some cases where a disposition qualifies as a nonrecognition_transaction and the u s transferor retains a direct or indirect interest in the transferred stock_or_securities or in the assets of the transferred corporation the disposition does not constitute a triggering event if a new gain_recognition_agreement with respect to the initial transfer is entered into immediately after the disposition see sec_1_367_a_-8 representations a the merger will qualify as a reorganization within the meaning of sec_368 of the code and or the merger and the offer taken together will qualify as a transaction described in sec_351 of the code b ust will satisfy the reporting requirements of sec_1_367_a_-3 c u s persons transferring ust stock pursuant to the merger will receive in the aggregate or less of both the total voting power and the total value of the stock of holdco taking into account the attribution_rules of sec_318 as modified by sec_958 in exchange for ust stock d u s persons who are officers directors or target shareholders as defined in sec_1_367_a_-3 of ust will own in the aggregate immediately after the merger or less of each of the total voting power and value of the stock of holdco taking into account the attribution_rules of sec_318 as modified by sec_958 plr-116458-11 e fc or one or more of its qualified subsidiaries as defined in sec_1_367_a_-3 or qualified partnerships as defined in sec_1_367_a_-3 will have been engaged in the active_conduct_of_a_trade_or_business outside the united_states within the meaning of sec_1_367_a_-2t b and for the entire 36-month period preceding the merger f at the time of the merger neither holdco fc or any qualified_subsidiary of fc nor to the knowledge of ust or fc stockholders of ust will have an intention to substantially dispose_of or discontinue such active trade_or_business g the fair_market_value of fc as measured by its market capitalization exceeded the fair_market_value of ust as measured by its market capitalization on the date the business combination agreement was entered into and over the preceding three-year period in addition as of date w the fair_market_value of fc as measured by its market capitalization exceeded the fair_market_value of ust as measured by its market capitalization by an amount that would be expected to cause the fair_market_value of holdco immediately after the closing of the offer to exceed the fair_market_value of ust even if i no fc shares in excess of r were tendered in the offer and ii the fair_market_value of fc were reduced by the portion of the special dividend if any that may be paid_by holdco shortly following the closing of the merger that is funded or sourced other than by way of intercompany loans directly or indirectly from fc for purposes of this determination the fair_market_value of fc including the value of stock in any qualified_subsidiary or an interest in any qualified_partnership will include assets producing or held for the production of passive_income as defined in sec_1297 which assets were acquired outside the ordinary course of business within the 36-month period preceding the acquisition of the ust stock only to the extent such assets were acquired in a transaction which was not undertaken for a principal purpose of satisfying the substantiality test the value of fc will be further reduced by the value of any assets that it received within the 36-month period preceding the exchange if those assets were owned by ust or an affiliate of ust sec_1_367_a_-3 under sec_1_367_a_-3 the service may in limited circumstances issue a private_letter_ruling to permit the taxpayer to qualify for an exception to sec_367 if the taxpayer is unable to satisfy all of the requirements of the active trade_or_business test but is in substantial compliance with such test and meets all of the other requirements of sec_1_367_a_-3 the taxpayers request a ruling that there will be substantial compliance with the active trade_or_business test notwithstanding that less than of the outstanding fc shares may be acquired by holdco in the offer plr-116458-11 conclusion based solely on the information submitted and on the representations set forth above and provided that holdco acquires at least by vote and value of the outstanding fc shares as a result of the offer and any subsequent acquisitions of fc shares within months from the date of the merger it is held as follows the transfer pursuant to the merger of ust shares by u s persons in exchange for shares of holdco will qualify for an exception to the general_rule of sec_367 sec_1_367_a_-3 and sec_1_367_a_-3 any u_s_person who is a transferee shareholder will qualify for this exception only upon entering into a gain_recognition_agreement sec_1 a - c iii b the gain_recognition_agreement must conform to the requirements set forth in sec_1_367_a_-8 no opinion is expressed as to the tax treatment of the transactions under other provisions of the code and regulations and no opinion is expressed about the tax treatment of any conditions existing at the time of or effects resulting from the transactions that are not specifically covered by this ruling in particular no opinion was requested and no opinion is provided as to i whether the merger qualifies as a reorganization within the meaning of sec_368 of the code and or whether the merger and the offer taken together will be treated as a transaction described in sec_351 of the code or ii the federal_income_tax treatment of the special dividend in addition no opinion is expressed as to the reporting requirements of u s persons exchanging ust stock under sec_6038b and the regulations thereunder this ruling is directed only to the taxpayer who requested it section 6110--------of the code provides that it may not be used or cited as precedent a copy of this letter must be attached to any income_tax return to which it is relevant alternatively taxpayers filing their returns electronically may satisfy this requirement by attaching a statement to their return that provides the date and control number of the letter_ruling plr-116458-11 pursuant to the power_of_attorney on file in this office a copy of this letter is being addressed to the taxpayer's authorized representatives sincerely charles p besecky branch chief branch international


department of the treasury internal_revenue_service attn mandatory review mc dal commerce street dallas texas te xx date address address date date employer_identification_number person to contact id number contact numbers tax_exempt_and_government_entities_division legend org organization name number release date org address dear in a determination_letter dated november 20xx you were held to be exempt from federal_income_tax under sec_501 we have determined that you have not operated in accordance with the provisions of sec_501 we have explained the basis for our determination in the enclosed report of examination on april 20xx you signed form 6018-a consent to proposed action agreeing to the revocation of your exempt status under sec_501 of the code therefore your exemption from federal_income_tax is revoked effective january 20xx you have filed taxable returns on forms u s_corporation income_tax return for the years ended december 20xx 20xx 20xx and 20xx with us for future periods you are required to file form_1120 with the appropriate service_center indicated in the instructions for the return this is a final adverse determination_letter with regard to your status under sec_501 if you have any questions please contact the person whose name and telephone number are shown at the beginning of this letter sincerely nanette m downing director eo examinations enclosures report of examination copy of form 6018-a department of the treasury internal_revenue_service te_ge eo examinations n street box richmond va date tax_exempt_and_government_entities_division org address taxpayer_identification_number form tax_year s ended person to contact id number contact numbers telephone fax certified mail - return receipt requested dear we have enclosed a copy of our report of examination explaining why we believe an adjustment of your organization’s exempt status is necessary if you accept our findings please sign and return the enclosed form 6018-a consent to proposed action we will then send you a final letter modifying or revoking your exempt status if we do not hear from you within days from the date of this letter we will process your case on the basis of the recommendations shown in the report of examination and this letter will become final in the event of revocation you will be required to file federal_income_tax returns for the tax period s shown above if you have not yet filed these returns please file them with the examiner as soon as possible unless a report of income_tax_liability was issued to you with other instructions file returns for later tax years with the appropriate service_center indicated in the instructions for those returns if you do not agree with our position you may appeal your case the enclosed publication the examination process explains how to appeal an internal_revenue_service irs decision publication also includes information on your rights as a taxpayer and the irs collection process please note that fast tract mediation services referred to in publication do not apply to exempt_organizations if you request a conference we will forward your written_statement of protest to the appeals_office and they will contact you for your convenience an envelope is enclosed if you and appeals do not agree on some or all of the issues after your appeals united_states tax_court the united_states court of federal claims or the united_states district_court after satisfying procedural and jurisdictional requirements as described in publication conference or if you do not request an appeals_conference you may file suit in the you have the right to contact the office_of_the_taxpayer_advocate taxpayer_advocate assistance is not a substitute for established irs procedures such as the formal appeals process the taxpayer_advocate cannot reverse a legally correct_tax determination or extend the time fixed by law that you have to file a petition in a united_states court the taxpayer_advocate can however see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling you may call toll-free and ask for taxpayer_advocate assistance if you prefer you may contact your local taxpayer_advocate at you may also request that we refer this matter for technical_advice as explained in publication exempt_organizations appeal procedures for unagreed issues if a determination_letter is issued to you based on technical_advice no further administrative appeal is available to you within the irs on the issue that was the subject of the technical_advice if you have any questions please call the contact person at the telephone number shown in the heading of this letter if you write please provide a telephone number and the most convenient time to call if we need to contact you thank you for your cooperation sincerely nanette m downing acting director eo examinations enclosures publication publication form 6018-a report of examination envelope in lieu of letter form_886 a name of taxpayer explanation of items department of the treasury - internal_revenue_service org 20xx schedule no or exhibit year period ended tax identification_number ein legend org organization name thru bm-6 ra thru bm ra-3 g xx date president president co-1 thru co-5 thru companies ra-1 ra- bm-1 facts the org inc hereinafter referred to as org was incorporated under the laws of the state of state on june 20xx org was recognized as exempt under sec_501 by the internal_revenue_service in a letter dated december 20xx org’s form_990 for period ending december 20xx was selected for examination president is president of org and also owns co-1 and co-2 co-1 owns five for-profit establishments called co-3 which are operationally very similar to org except these establishments are only licensed to operate video lottery terminals while tax exemption allows org to operate video lottery terminals and offer free beverages and snacks co-1 loaned a total of dollar_figuredollar_figure to org to fund initial operations org leases it’s facility from co-2 for dollar_figuredollar_figure per month co-2 also has a management agreement with org for maintenance and bookkeeping of four video lottery terminals for dollar_figuredollar_figure per month org’s bylaws provide as follows article i name the name of this organization shall be the org and each org-1 shall be organized as a subordinate org-1 of the org under the constitution by virtue of the charter granted by the co-3 article it object the object of the org shall be to promote the social and moral welfare of its members to encourage human and spiritual values of life to cooperate in all charitable and civic appeals article ii clubs sec_4 a chartered club shall hold regularly scheduled meetings not less than one each month on such day and at such place as shall be determined by the trustees for transaction of business section a quorum of at least ten members must be present at a meeting in order to transact business article iv election of officers sec_1 a chartered club shall hold its annual meeting and election of officers and trustees not earlier than the first week in november and not later than the second week in december the officers shall serve for one year or until their successors are duly elected by a plurality vote the trustees shall serve for the term prescribed in the club bylaws or until their successors are duly elected by plurality vote sec_2 the elected officers shall be president vice president invocator secretary treasurer warden sentinel picket and three trustees article vi membership sec_1 applicants for membership shall be any person not less than years of age and of good moral character application_for membership shall be received in writing signed by the applicant and by a member of the org-1 in good standing who recommends the applicant and shall give the applicants name age residence occupation and such other information as the chartered club may prescribe sec_2 all applications must be investigated by the secretary and investigating committee before being balloted on in accordance with the balloting procedures of each chartered club the initiation fee for membership shall accompany each application sec_3 active members shall maintain regular attendance at meetings and shall actively participate in activities of the org-1 sec_4 transfer of members from one org to another is allowed by transfer card and after having paid a transfer fee to the chartered club as required and to the home org-1 transferring member must procure an official membership dues paid receipt stating that member is in good standing from the org-1 which transfer is being made sec_5 per capita tax all members shall pay dues annually as set by the subordinate org- which includes the per capita tax paid to the co-3 section initiation a new member processing fee ie initiation fee will be charged to each new member to defray administrative costs for both the subordinate org-1 and home org-1 section all org fees will be set annually by the supreme officers of the home org-1 at their july meeting and become effective on the first of january of each year the review of the minutes of org’s meetings showed the following minutes dated december 20xx state an operational council consisting of bm-1 bm-2 bm-3 bm-4 bm-5 bm-6 and president met for the first time to elect officers president was nominated and elected unanimously to serve as president also elected were bm-4 vp and bm-3 recording secretary president stated that the next order of business would be to establish and operate a social_club meeting date summary of minutes of all other meetings held between 20xx and 20xx notable business transacted of persons attending not stated in minutes loan from co-1 accepted not stated but named hired ra-1 on xx club opened motion hire mgnt co co-1 inc offered to loan start-up money not stated ra-2’s motions to start quarterly meet not stated but named not stated but named not stated but named not stated but named need to find new location almost paid co-1 off for monies loaned buying pleasant county lodge to fix-up purchased lodge rehab co-1 final pymt club robbed new club in old co-3 bdg sublease from co-2 mgnt xx kxx xx xx xx xx no date o1 xx xx xx xx xx xx xx xx air conditioner not cooling roof leak co-2 mgnt to fix discuss planning christmas party none donations of dollar_figure and dollar_figure passed xx xx xx xx xx xx xx xx xx xx xx xx kx xx xx xx xx xx xx no show inch snow a small_group consisting of president bm-3 and a few other officers employees and or contractors were the only persons ever to attend meetings no general members were present at any of the meetings held dollar_figure donation to childrens shelter scholarships to co-4 club must go non-smoking try again to charter member trip to ft ball buy new tractor ra-3 reports can have separate smoking area with air vents donation to phs girls basketball co-2m org does not follow its own bylaws in regards to any of the provisions shown above org failed to conduct regular monthly meeting never had a quorum of members at any meeting and never elected the officers and trustees as required and prescribed in its bylaws org failed to require general members to attend meetings or pay dues or initiation fees as required by the bylaws membership is open to anyone and president admitted that no one has ever been refused membership while members are not allowed guest anyone may become a member simply by filling out a membership application consisting only of date name address and phone number org failed to ask for occupation as required by bylaws some membership applications reviewed only contained a date and name org does not enforce the bylaw requirements that new members must be recommended by a current member and investigated by the secretary or investigation committee initially there was a one dollar initiation fee charged but the fee was eliminated because patrons complained that other clubs did not charge anything org entered an affiliation agreement and paid a charter fee to a parent organization referred to as the home org-1 org could not produce a copy of the affiliation agreement with the home org-1 claiming it was done before the current officers took over org pays the home org-1 a quarterly head tax based on the number of members however the parent home org-1 does not supervise org or exercise any control_over the activities or operations of org no regular general membership meetings have been held and there were no club activities other than video lottery gaming for members to participate in while minutes of board meeting indicated discussions of activities such as organizing a trip to a football game president admitted this activity never actually occurred also members of other org-1 are allowed entry without any fee and members do not pay any annual dues or initiation fee law sec_501 of the internal_revenue_code the code provides for the exemption of fraternal beneficiary societies orders or associations operating_under_the_lodge_system or for the exclusive benefit of the members of a fraternity itself operating_under_the_lodge_system and providing for the payment of life sick accident or other_benefits to the members of such society order or association or their dependents sec_501 of the code provides for the exemption from federal_income_tax of domestic_fraternal_societies orders or associations operating_under_the_lodge_system the net_earnings of which are devoted exclusively to religious charitable scientific literary educational and fraternal purposes and which do not provide for the payment of life sick accident or other_benefits sec_1_501_c_10_-1 of the income_tax regulations the regulations provides that an organization will qualify for exemption under sec_501 of the code if it is a domestic fraternal beneficiary society order or association described in sec_501 and the regulations there under except that it does not provide for the payment of life sick accident or other_benefits to its members and devotes its net_earnings exclusively to religious charitable scientific literary educational and fraternal purposes the leading judicial pronouncement as to what constitutes a fraternal beneficiary society is contained in the following extract from national union v marlow 374_f_775 a fraternal-beneficial society would be one whose members have adopted the same or a very similar calling avocation or profession or who are working in union to accomplish some worthy object and who for that reason have banded themselves together as an association or society to aid and assist one another and to promote the common cause the term fraternal can properly be applied to such an association for the reason that the pursuit of a common object calling or profession usually has a tendency to create a brotherly feeling among those who are thus engaged many of these associations make a practice of assisting their sick and disabled members and of extending substantial aid to the families of deceased members their work is at the same time of a beneficial and fraternal character because they aim to improve the condition of a class of persons who are engaged in a common pursuit and to unite them by a stronger bond of sympathy and interest the national union did not fit this definition because it was an association of individuals who were associated for the purpose of obtaining insurance the court concluded that in its practical operations therefore the defendant company cultivates fraternity and confers benefits in the same manner that every insurance_company doing business on the mutual plan cultivates feelings of fraternity and confers benefits upon its members or in other words when the defendant is stripped of all disguises and judged by the standard of what it is engaged in doing and what it was most likely organized to do it is simply an insurance_company which carries on an extensive business on the assessment plan central to the concept of fraternal beneficiary societies whether described in sec_501 or sec_501 of the code is the requirement of a fraternal element a common bond among members the requirement of a fraternal element is set forth in philadelphia and reading relief association 4_bta_713 in that case an organization composed of railroad employees organized to administer a relief fund for the payment of benefits to its members in case of sickness accident or death fell short of this requirement because it lacked the required fraternalistic element the court noted that the association’s membership consisted of individuals whose vocations were as numerous and diverse as the classifications of jobs ofa railroad company that the only motive for the existence of the association was a mercenary one to provide insurance benefits that the organization did not have rituals ceremonial and regalia commonly associated with fraternal associations and that it was not operated on the lodge_system in another case the u s tax_court held that an organization cannot be classified as fraternal when the only common bond between the majority of its members is their membership in that organization 24_tc_891 affirmed as to nonexempt status 236_f2d_509 only percent of the members had common ties in that they were polish war veterans or children of such veterans who had served in the armed_forces of the western alliance all other dues-paying members were admitted indiscriminately as long as they were elected to membership by a majority vote of members present at any meeting the question as to the meaning of fraternal was also explored in wheeler v ben hur life ass'n s w 2d the court concluded that the organization was not fraternal _ the association's constitution and by-laws duly provide for a lodge_system ritualistic form of work and representative form of government it has no capital stock and is ostensibly organized solely for the mutual benefit of its members but actually while giving superficial attention to these requirements the association has been engaged in the life_insurance business the local agent of the association draws a salary and receives as a commission of the first premium on all insurance policies he receives the association's constitution and by- a smaller percentage of subsequent premiums laws provisions relative to ritualistic work are observed only perfunctorily we are convinced from the evidence in this record that the primary function of the ben hur life association is to sell insurance and that the association actually is an insurance_company operating under the guise of a fraternal benefit society to qualify for recognition of exemption as a fraternal beneficiary organization under sec_501 or sec_501 of the code an organization must also be operated under the lodge_system sec_1_501_c_8_-1 of the regulations states that operating_under_the_lodge_system means carrying on its activities under a form of organization that comprises local branches chartered by a parent organization and largely self-governing called lodges chapters or the like at a minimum this requires separate subordinate lodges that operate under the general control and supervision of a parent lodge and are subject_to the laws and edicts of the parent lodge in 2_f2d_367 the district_court for the eastern district of missouri defined lodge_system as follows by the lodge_system is generally understood an organization which holds regular meetings at a designated place adopts a representative form of government and performs its work according to a ritual that does not seem to be a harsh definition of what is usually understood as the lodge_system and is not so strict in its requirements as the definitions often stated in the statute books revrul_73_165 1973_1_cb_224 concerns an organization that was operated under the lodge_system was engaged in conducting fraternal activities but whose predominant activity was the provision of benefits to its members the ruling concludes that the organization was described in sec_501 because there is no requirement that either the fraternal or the insurance features predominate so long as both are present the ruling is clear however that in order for an organization to be described in section c it must contain substantial fraternal features and conduct substantial fraternal activities the courts have described fraternal activities as a grouping together of like-minded individuals to accomplish a common purpose the group must be bound by more than membership in the organization and motivated by purposes other than solely the provision of insurance benefits revrul_77_258 1977_2_cb_195 provides that a domestic fraternal society operating_under_the_lodge_system which does not provide life sick accident or other_benefits whose members are interested in the use of and philosophy behind a method of attempting to divine the future and whose net_income is used to provide instruction on the use of the method maintain a reference library and supply information on the method to the public qualifies for exemption under sec_501 of the code rationale fraternal purposes although there is no definition of fraternal purpose in the internal_revenue_code we presume that congress used the term in the ordinary sense and according to its legal significance in when sec_501 was added the courts in the cases cited above were clear in requiring at a minimum that the members of a fraternal_organization have a common tie that is more substantial than the desire to purchase insurance or engage in social activities a fraternal-beneficiary society would be one whose members have adopted the same or a very similar calling avocation or profession or who are working in union to accomplish some worthy object and who for that reason have banded themselves together as an association or society to aid and assist one another and to promote the common cause national union v marlow supra an organization cannot be classed as fraternal where the only common bond between the majority of the members is their membership in that organization polish army veterans post evidence of fraternal activities such as rituals ceremonial and regalia helps to establish that an organization has a fraternal purpose philadelphia and reading relief association supra revrul_73_165 echoes congress and the courts in holding that to establish exemption a fraternal_organization must have substantial fraternal features and conduct substantial fraternal activities lastly we look to substance over form the fact that an organization’s constitution and bylaws may provide for a lodge_system a ritualistic form of work and representative form of government is not enough if actual operations establish a primary function that is not fraternal wheeler v ben hur life association supra org does not have substantial fraternal features org’s membership is open to anyone over members are not charged any initiation or membership fee org’s bylaws do state that membership applications should contain occupation however org did enforce that provision and submitted no evidence to establish that its members have a specific calling avocation or profession or a common tie unlike the organization described in revrul_77_258 whose members had a single pursuit org’s activities do not illustrate how its members have joined together or worked in unison to accomplish any worthy objective the only common bond among org’s members appears to be their membership and desire to engage in video lottery further org admitted that it does not follow its own bylaws regarding new or transferred members and initiation and membership fees the effects of these policies lead us to conclude that org is open to the general_public in the same manner as a commercial establishment nor has org submitted evidence that its listed members have actually participated in substantial fraternal activities org’s operation of the club and conduct of gaming is not inherently a fraternal or a charitable activity org’s charter and bylaws do not provide for rituals ceremonials or regalia commonly associated with fraternal associations org has had no member meetings other than those described above nor has org engaged in any member activities in furtherance of its’ stated objectives accordingly org is not operated for fraternal purposes lodge_system an organization is operating_under_the_lodge_system if it operates under the general control and supervision of a parent lodge and is subject_to the laws and edicts of the parent lodge it is generally understood that such an organization holds regular meetings at a designated place adopts a representative form of government and performs its work according to a ritual the courts look to substance over form wheeler v ben hur life association supra a similar result was reached in western funeral benefit association v hellmich supra org could not produce a signed copy of any affiliation agreement with its parent home org-1 org admitted that the home org-1 does not exercise any control_over its activities or operations this is contrary to the requirement that a parent control and supervise separate independent subordinate lodges that are operating_under_the_lodge_system we cannot conclude on the basis of this record that org is properly chartered and under the general control and supervision of a parent lodge further org has had only one meeting since 20xx at which it elected officers since then there have been no meeting attended by the general membership and no elections have been held since org is totally controlled by its founder and does not follow its bylaws as to member input we cannot conclude that org has a representative form of government in addition since org has held neither general membership meetings nor commenced fraternal activities we cannot conclude that org performs its work according to a ritual accordingly org is not operated under the lodge_system conclusion the results of the examination show that org inc failed to establish that it is operated as a domestic fraternal society order or association org inc is not operated under the lodge_system as required and thus does not meet the organizational or operational requirements for exemption under sec_501 or any other code section therefore we are proposing revocation the organization’s exempt status under sec_501 effective january 20xx


t c memo united_states tax_court roy zeluck petitioner v commissioner of internal revenue respondent docket no filed date p invested dollar_figure in an oil_and_gas partnership in dollar_figure of the investment was made in cash and dollar_figure was made by a subscription note maturing date the partnership used p’s and other investors’ notes as security on a turnkey note it wrote to a drilling company p signed an assumption_agreement which made him personally liable on the turnkey note up to the amount of liability on his subscription note as a result of costs the partnership incurred p claimed deductions for and which reduced his capital_account balance from dollar_figure to dollar_figure in the partnership terminated and distributed dollar_figure to p p has not made payments of principal on the dollar_figure subscription note and has failed to meet certain other requirements of the subscription agreement for interest payments r issued a notice_of_deficiency which determined that p’s liability on the subscription note and related assumption_agreement became nongenuine in and that p must recognize dollar_figure in income for as a result p claims that if no liability existed in that no liability existed in either and r would be precluded from contesting p’ sec_2001 return by the expiration of the period of limitations under sec_6501 held p’s liability on the subscription note and related assumption_agreement became nongenuine in held further p must recognize a dollar_figure gain for under sec_465 held further p is liable for an accuracy-related_penalty under sec_6662 n jerold cohen matthew j gries and sheldon m kay for petitioner marion s friedman melanie r urban and derek b matta for respondent memorandum findings_of_fact and opinion goeke judge respondent determined a deficiency in petitioner’s federal_income_tax of dollar_figure for tax_year as a result of the determination that a debt petitioner owed became nongenuine in and the effect on his investment in an oil_and_gas partnership and the disallowance of a deduction resulting from a historic preservation easement donation respondent also determined an accuracy-related_penalty under sec_6662 and h of dollar_figure and dollar_figure respectively the historic preservation easement issue and related sec_6662 penalty were tried separately the issues remaining for decision are whether petitioner must recognize a dollar_figure gain for under the subchapter_k rules or sec_465 we hold that he must recognize the gain under sec_465 and whether petitioner is liable for a accuracy-related_penalty under sec_6662 we hold that he is findings_of_fact at the time the petition was filed petitioner resided in new york i petitioner’s investment in pw partnership petitioner and his brother kevin zeluck are each owners of zeluck inc a 90-year-old family business which manufactures custom doors and 1unless otherwise indicated all section references are to the internal_revenue_code code in effect for the year in issue and all rule references are to the tax_court rules_of_practice and procedure 2respondent concedes that alternative argument set forth in the notice_of_deficiency under sec_446 windows petitioner handles sales and research_and_development for zeluck inc petitioner and kevin zeluck often invest in similar ventures together pw f-w-01 drilling co pw partnership was formed date purportedly for the purposes of investing in the acquisition development and drilling of oil_and_gas leases acquiring oil_and_gas leases developed and operated by other oil_and_gas companies and producing and selling hydrocarbons kevin zeluck learned of the possibility of investing in pw partnership from his longtime friend perry weitz and discussed the investment with petitioner both kevin zeluck and petitioner invested in pw partnership in and became general partners the following people acquired interests in pw partnership partner percentage interest perry weitz arthur luxenberg robert schoenhaut richard siegal gail siegal kevin zeluck roy zeluck petitioner invested a total of dollar_figure in pw partnership of the dollar_figure dollar_figure was in cash and the remaining dollar_figure was in the form of a promissory note subscription note ii the subscription notes in making his investment in pw partnership petitioner signed a dollar_figure subscription note in favor of pw partnership on date the subscription note had a annual interest rate through date after which date the interest rate increased to per annum the subscription note provided that interest before would accrue the subscription note further provided interest from date through date will be paid quarterly by petitioner to the partnership and commencing the following year beginning date such interest will be payable from petitioner’s share of the partnership’s net operating revenues to the extent such revenues are not available or are insufficient such unpaid interest shall accrue twenty-five percent of petitioner’s share of the partnership net operating revenues after the payment of interest shall be applied in payment of the outstanding principal balance of this note any accrued interest and the remaining principal balance were to become due in full on date should the subscription note not be paid in full when due the remaining balance of principal and accrued interest would carry an annual interest rate of as collateral for the payment of the subscription note petitioner granted pw partnership a security_interest in his interest in pw partnership and his rights to the production and proceeds from pw partnership’s wells described further infra petitioner properly made four payments of dollar_figure on the subscription note in thus paying all interest accruing in that year subscription notes were signed by other partners investing in pw partnership including kevin zeluck mr schoenhaut mr luxenberg and mr weitz these subscription notes had terms similar to the subscription note petitioner signed however the amounts of the notes varied with the size of each payor’s interest in pw partnership iii richard siegal’s organization and relationship to pw partnership richard siegal had participated in the oil_and_gas business since the 1970s he had a large operation that was involved in the drilling of approximately big_number wells which produced over trillion cubic feet of gas and million barrels of oil mr siegal’s tax returns and the returns of various entities he owned or operated had been audited by tax authorities including the new york department of taxation and finance and the internal_revenue_service many times over his career with no material changes made to the returns while it was proven that pw partnership’ sec_2001 tax_return was audited by the new york department of taxation and finance it was not established whether any other audits of pw partnership’s returns took place the new york department of taxation and finance described the audit of pw partnership’ sec_2001 tax_return as limited pw partnership was one of the entities owned or organized by mr siegal those entities included palace exploration corp palace exploration vail drilling co vail drilling bistate oil management corp bistate oil management and bistate oil distribution corp bistate oil distribution bistate oil management provided general administrative services for all of the entities mr siegal owned or operated including pw partnership bistate oil distribution received revenue checks for oil_and_gas interests owned by other entities associated with mr siegal including pw partnership bistate oil distribution also wrote the operating revenue distribution checks to the partners of pw partnership described further infra pw partnership and palace exploration entered into an agreement prospect agreement whereby pw partnership would pay dollar_figure to receive an interest in certain well prospects palace exploration owned pw partnership also entered into a turnkey drilling_contract with vail drilling according to the turnkey drilling_contract vail drilling agreed to begin drilling on well prospects in which pw partnership owned an interest by the end of in exchange for providing drilling services vail drilling received dollar_figure from pw partnership dollar_figure in cash and dollar_figure in the form of a promissory note written by pw partnership in favor of vail drilling turnkey note the turnkey note carried the same payment terms and date maturity_date as the subscription notes except no interest was required to be paid on the turnkey note during the turnkey note was secured_by the subscription notes payable to pw partnership all collateral securing the subscription notes and the contract between vail drilling and pw partnership pursuant to the turnkey drilling_contract and the turnkey note pw partnership provided the subscription notes from each partner as collateral for the turnkey note as well as any interests pw partnership held in the well prospects or well production in addition petitioner kevin zeluck mr weitz mr luxenberg and mr schoenhaut each entered into a separate assumption_agreement with vail drilling by which they assumed their pro_rata shares of the turnkey note according to the percentage interests they held in pw partnership the amounts of the individual liabilities could not exceed the amounts due under each partner’s individual subscription note including accrued interest the subscription notes and assumed_liabilities on the turnkey note were coterminous liabilities when a partner made a payment on the subscription note liability both liabilities were reduced by the amount of the payment the same security interests granted to pw partnership in the subscription notes were granted to vail drilling as collateral for the assumption agreements iv perry weitz robert schoenhaut and pw partnership’s management mr weitz was a senior partner at the law firm of weitz luxenberg a law firm that specializes in mass tort litigation mr schoenhaut is a certified_public_accountant with a degree in accounting and an m b a in finance he is mr weitz’s brother-in-law and has served as comptroller for the weitz luxenberg law firm for years mr weitz began investing in mr siegal’s business entities in the 1990s mr weitz invested millions of dollars in oil_and_gas partnerships organized by mr siegal between and one of which was pw partnership before making his investments mr weitz learned that mr siegal’s returns and the returns of his business entities had been audited by tax authorities many times with no resulting material changes made mr weitz also sent mr schoenhaut to make sure wells were being drilled and to otherwise investigate mr siegal’s business entities before investing after his initial investigation on behalf of mr weitz mr schoenhaut began referring people to invest in organizations mr siegal formed mr schoenhaut used his resulting referral fees as well as a subscription note to purchase a interest in pw partnership despite having only one year of prior experience in the oil_and_gas industry gained earlier in his career mr schoenhaut was made the managing partner of pw partnership the pw partnership_agreement vested full and exclusive power and authority in the managing partner to manage control administer and operate the business affairs of pw partnership by operating properties purchasing insurance purchasing or leasing equipment acquiring leases or mineral rights making decisions with respect to which oil_and_gas_properties to acquire and handling partnership funds the pw partnership_agreement also provided that the other partners could take no part in the management of pw partnership or transact any business for it mr schoenhaut did not fulfill his responsibilities as managing partner he did not run the operations of pw partnership or manage any of pw partnership’s finances he did not have signature_authority over pw partnership’s accounts and could not account for what was done with the cash contributions of the other partners however he did sign certain contracts on behalf of pw partnership these contracts included the prospect agreement with palace exploration the turnkey drilling_contract with vail drilling and the turnkey note in favor of vail drilling mr schoenhaut did not participate in the drafting of these documents nor did he negotiate their terms mr schoenhaut did not know whether the dollar_figure to be paid to vail drilling for drilling wells in which pw partnership owned an interest was reasonable and was not capable of making such a decision mr siegal and his entities managed pw partnership in place of mr schoenhaut they selected pw partnership’s drilling prospects and determined the disbursements of the production revenues the secretary for bistate oil management and palace exploration signed all checks and handled all of the banking for pw partnership at mr siegal’s direction v termination of pw partnership pw partnership terminated date pw partnership’s tax_return for showed no activity except liquidation of all assets and final distributions made to the partners the means of the liquidation and where pw partnership’s noncash assets ended up was not established the reasons for the termination of pw partnership are not clear and some partners including petitioner mr weitz and mr luxenberg were not made aware of the termination until this case began mr schoenhaut did not participate in the decision to terminate pw partnership and did not become aware of the termination until at the earliest upon learning of pw partnership’s termination mr schoenhaut took no action with respect to the assets of pw partnership and did not ask mr siegal what was going to happen to the assets he does not know what happened to them after pw partnership’s termination petitioner does not know who holds his subscription note or assumption_agreement the pw partnership_agreement provides that upon termination pw partnership would be required to pay all of its debts and distribute remaining assets to the partners however no payments were made on the turnkey note upon pw partnership’s termination instead of paying down the turnkey note pw partnership distributed dollar_figure to the partners after pw partnership’s termination the partners continued to receive net operating revenue distribution checks from bistate oil distribution vi petitioner’s receipt of net operating revenue distributions from pw partnership and payments on petitioner’s subscription note from to petitioner received net operating revenue distributions as a result of his investment in pw partnership petitioner received one distribution in four distributions in and three or four distributions in all other years the total amount of petitioner’s net operating revenue distributions received was dollar_figure petitioner’s received distributions after accounting for withholdings by year were year distribution dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure five interest payments related to petitioner’s subscription note were made through amounts withheld from net operating revenue distributions as follows date check amount interest total dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure no principal payments had been made on petitioner’s subscription note before trial either through withholdings from net operating revenue distributions or otherwise vii advice petitioner received before investing in the partnership and petitioner’s tax returns at the time of his investment in pw partnership petitioner received a package of documents pertaining to the investment which included the pw partnership_agreement the subscription note the assumption_agreement the turnkey note and the prospect agreement petitioner consulted with the certified accounting firm ross strent with whom he had a longstanding relationship as a result of work ross strent did for zeluck inc although ross strent approved of the investment petitioner did not receive a written opinion from them no one from ross strent was called to testify at trial mr weitz shared all of the information he learned including his knowledge of the previous successful tax audits of the returns of mr siegal’s business entities with kevin zeluck before kevin zeluck and petitioner decided to invest in pw partnership petitioner discussed this information their accountants’ advice and other aspects of the investment with kevin zeluck before becoming a partner in pw partnership petitioner did not otherwise investigate pw partnership before investing in it ross strent prepared petitioner’s tax returns for and on hi sec_2001 return petitioner claimed a dollar_figure nonpassive ordinary_loss deduction resulting from his investment in pw partnership consisting of a deduction for intangible drilling costs of dollar_figure and an ordinary_loss of dollar_figure as a result of this deduction and his dollar_figure investment pw partnership’s tax_return for reported petitioner’s capital_account balance as dollar_figure as of the end of on hi sec_2002 return petitioner reported interest_income of dollar_figure and a nonpassive ordinary_loss deduction of dollar_figure as a result of his investment in pw partnership the dollar_figure loss consisted of a deduction for intangible drilling costs of dollar_figure and an operating loss of dollar_figure as a result of these items and the dollar_figure in net operating revenue distributed to petitioner in pw partnership’s corporate return for reported petitioner’s capital_account balance as dollar_figure as of the end of upon terminating in pw partnership distributed dollar_figure to petitioner eliminating the opening balance reported for his capital_account for petitioner failed to report this distribution on his income_tax return viii other information petitioner kevin zeluck mr luxenberg mr weitz and mr schoenhaut all testified that they were liable under the subscription notes when they signed them in petitioner is not aware of the person or entity to whom he would currently be liable for payment on his subscription note has never received any written notification of the balance due on his subscription note has made no inquiry regarding the balance due and has made no arrangements to pay the balance due no demand for payment has ever been made by any party as a result of the partners’ subscription notes even after date petitioner has never signed an extension of the subscription note or otherwise pushed back the maturity_date petitioner mr schoenhaut and mr weitz each testified that no one had ever indicated to them that they were relieved of their liabilities under the subscription notes and assumption_agreement petitioner testified that if he then had to write a check to cover the dollar_figure in principal plus accrued interest on the subscription note it would be a ridiculously large check for him to write on date respondent issued a notice_of_deficiency to petitioner for tax_year petitioner timely filed a petition contesting the deficiency and penalty i burden_of_proof opinion generally taxpayers bear the burden of proving by a preponderance_of_the_evidence that the determinations of the commissioner in a notice_of_deficiency are incorrect rule a 290_us_111 deductions are a matter of legislative grace and a taxpayer bears the burden of proving entitlement to any claimed deductions rule a 503_us_79 petitioner has not argued that respondent bears the burden_of_proof with respect to the issues discussed below ii whether petitioner’s liability under the subscription note and assumption_agreement became nongenuine in in support of his position that petitioner failed to recognize a dollar_figure gain for respondent argues that petitioner had no liability under the subscription note and assumption_agreement in petitioner argues that he was still liable under the subscription note and assumption_agreement in and if we find that he was not so liable in then he was never liable under the subscription note and assumption_agreement if petitioner was never liable he claims that respondent cannot win because respondent’s theory of the case relies on the claim that the debts became nongenuine in because the expiration of the period of limitations under sec_6501 precludes respondent from contesting petitioner’ sec_2001 income_tax return respondent acknowledges that the period of limitations with respect to petitioner’ sec_2001 return has run 3respondent did not argue that petitioner had forgiveness of indebtedness income in we deem this issue waived by respondent see 238_f3d_860 ndollar_figure 7th cir issues not addressed or developed are deemed waived--it is not the court’s obligation to research and construct the parties’ arguments aff’g tcmemo_1999_192 we find that petitioner’s liability under the subscription note and related assumption_agreement was genuine in and became nongenuine in in reaching our finding we compare the genuineness of the subscription note and coterminous assumption_agreement debt in and with its genuineness in as the subscription note was not signed until date and no other significant facts occurred in that year our inquiry focuses on year sec_2002 and courts have considered various factors in determining whether a genuine indebtedness exists including whether the promise to repay is evidenced by a note or other instrument whether interest was charged whether a fixed schedule for repayments was established whether collateral was given to secure payment whether repayments were made whether the borrower had a reasonable prospect of repaying the debt and whether the parties conducted themselves as if the debt was genuine 135_tc_26 4use of these factors in determining whether a debt is genuine in each of two or more years is consistent with the caselaw test for forgiveness of indebtedness income see jones v commissioner tcmemo_1997_400 the forgiveness of an indebtedness is deemed to have occurred when it becomes reasonable to assume that the debt will probably never be paid citing 492_f2d_1096 5th cir 430_f2d_152 7th cir 23_tc_527 continued n no one factor is necessarily determinative and the factors considered do not constitute an exclusive list it is appropriate to take into account the substance and realities of the financing arrangements presented to us id pincite 88_tc_63 aff’d 894_f2d_1072 9th cir we consider each factor for both and as well as additional facts pertaining to the arrangement in this case a whether the promise to repay was evidenced by a note or other instrument petitioner signed both the subscription note and the assumption_agreement although no evidence or testimony was presented which established what became of the physical note and agreement after the termination of pw partnership we find their existence is evidence of genuine debt existing in both and b whether interest was charged annual interest of was charged on the subscription note in both and we find this is evidence of genuine debt existing in both years continued and estate of marcus v commissioner t c memo aff’d without published opinion 177_f3d_983 11th cir c whether a fixed schedule for repayments was established petitioner was required to make quarterly interest payments of dollar_figure in but not in beginning in interest payments were to be made out of withholdings from pw partnership net operating revenue distributions and accrue to the extent the withholdings were insufficient to cover the interest we find this is evidence of genuine debt existing in both years however because of the uncertainty whether the net operating revenue distributions would be sufficient to cover all interest in we find this factor is somewhat weaker evidence of the existence of a genuine debt in in addition we also consider that of petitioner’s share of net operating revenues after the payment of interest was to be used to pay down his outstanding principal balance on the subscription note and assumption_agreement we find this schedule is evidence of the existence of genuine debt in both and however we note the schedule was not strictly adhered to especially in and the years after a fact further discussed infra d whether collateral was given to secure payment as collateral for the payment of the subscription note petitioner granted pw partnership a security_interest in his interest in pw partnership and his rights to the production and proceeds from pw partnership’s oil_and_gas wells these same security interests were granted to vail drilling as collateral for the assumption_agreement in addition the turnkey note between pw partnership and vail drilling was secured_by the subscription notes payable to pw partnership any collateral securing the subscription notes and the contract between vail drilling and pw partnership we find the existence of collateral is evidence of the existence of genuine debt in both and e whether repayments were made petitioner made the required dollar_figure in interest payments in however petitioner did not pay down principal in even though a net operating revenue distribution was made to him in the terms of the subscription note and assumption_agreement required that of net operating revenue distributions after the payment of interest be used to pay down principal as the amount of the distribution was dollar_figure petitioner failed to pay a required amount of dollar_figure in we find this reflects mixed evidence of whether genuine debt existed in while petitioner successfully made his dollar_figure in interest payments one required principal payment of dollar_figure was not made fewer required repayments were made beginning in in interest payment of only dollar_figure were made all of which were the result of withholdings from net operating revenue distributions made to petitioner despite the withheld interest payments covering only approximately of the dollar_figure in interest which would either need to be paid or accrue in petitioner still received distributions totaling dollar_figure in this trend of failure to withhold the required_interest worsened in the years after only one insufficient interest_withholding was made in both and no interest withholdings were made in other years in addition to fewer interest payments being made in terms of the subscription note relating to principal repayment through withholdings from net operating revenue distributions were violated no withholdings were paid toward principal from any of the four distributions petitioner received in even though he received distributions totaling dollar_figure in that year failure to pay down principal through withholdings continued in all subsequent years another required_payment was not made on the turnkey note by pw partnership in which would have reduced petitioner’s liability under the assumption_agreement the pw partnership_agreement provides that upon termination pw partnership would be required to pay all of its debts and distribute remaining assets to the partners however no payments were made on the turnkey note upon pw partnership’s termination and liquidation instead of paying down the turnkey note pw partnership distributed dollar_figure to the partners including dollar_figure to petitioner in there was a failure to properly repay the required_interest and principal on the subscription note and assumption_agreement through withholding on distributions to petitioner as well as a failure by pw partnership to pay down the turnkey note upon termination we find these facts are strong evidence that no genuine debt existed in f whether the borrower had a reasonable prospect of repaying the loan petitioner testified at trial that if he then had to write a check to cover the dollar_figure in principal plus accrued interest it would be a ridiculously large check for him to write however this was in date after many years of interest accrual and compounding no evidence was specifically presented detailing petitioner’s ability to pay the liabilities as they existed in and however we do note that petitioner was able to obtain dollar_figure in cash to invest in pw partnership in and was able to make dollar_figure in required_interest payments in we also consider that had proper withholdings been made from petitioner’s net operating revenue distributions a small principal payment would have been made in and approximately of the interest would have been paid in taking into account compounding of interest such payments in and could have had a great effect on petitioner’s ability to pay off the subscription note assumption_agreement debt upon maturity at the end of we find these facts are neutral evidence of the existence of genuine debt in both and g whether the parties conducted themselves as if the debt was genuine with the exception of the failure to withhold dollar_figure from the single net operating revenue distribution petitioner received in to be paid toward principal the parties otherwise conducted themselves as if the subscription note and assumption_agreement liabilities were genuine debt in petitioner paid dollar_figure in required_interest and the relationship between petitioner pw partnership and vail drilling was not disrupted we find these facts are evidence of the existence of genuine debt in in multiple failures to make withholdings from petitioner’s net operating revenue distributions occurred totaling dollar_figure the total amount of the distributions petitioner received all of which should have been withheld in addition although the relationship between petitioner pw partnership and vail drilling was severely disrupted in as a result of pw partnership’s termination and liquidation no resulting action was taken by vail drilling to ensure it would be repaid by pw partnership or its partners although proper withholdings were not being made out of petitioner’s net operating revenue distributions to pay down interest or principal owed to vail drilling under the assumption_agreement vail drilling did not seek to obtain ownership of the collateral securing petitioner’s assumption_agreement this collateral included petitioner’s rights to the production and proceeds from pw partnership’s wells instead of obtaining possession of the collateral or otherwise seeking to enforce required_payments vail drilling did nothing in addition to vail drilling’s not acting as though the assumption_agreement liability was genuine in pw partnership did not act as though the turnkey note was a genuine debt in which reflects on the genuineness of the related assumption_agreement upon its termination and liquidation pw partnership ignored a provision in its partnership_agreement requiring liabilities to be paid first upon liquidation instead of paying down the turnkey note pw partnership distributed the proceeds of the liquidation to its partners including petitioner we also note that neither pw partnership or vail drilling notified the partners of pw partnership of its termination and that the partners would have to make payments under the subscription notes to a different entity as a result indeed most of the partners of pw partnership did not find out about the termination until they were notified of this case at trial petitioner was unaware who held his debt or to whom he would make payments on that debt we find these facts are strong evidence that no genuine debt existed in h conclusions regarding the subscription note and assumption_agreement liabilities in and after considering each of the above seven factors we find the subscription note assumption_agreement debt was a genuine debt of petitioner’s at the end of we also find the debt became nongenuine in and petitioner was not liable for the debt as of the end of that year we find that the subscription note and assumption_agreement liabilities were genuine debts in but were not genuine debts in our conclusion turns primarily on the lack of payments made and enforcement sought after the termination and liquidation of pw partnership at the beginning of we also note that additional facts support our conclusion that the debt became nongenuine in no demand for payment was made by any party upon the subscription note maturity_date of date and petitioner had made no arrangements to pay the balance due as of the time of trial even though the amount due was allegedly accruing interest pincite to the extent petitioner 5it also appears that petitioner would not be able to pay the balance due under the note as of the time of trial testifying that it would be a ridiculously large check for him to write claims the subscription note and related assumption_agreement still represented genuine debts at the time of trial we do not agree furthermore taking into account the testimony of petitioner kevin zeluck mr luxenberg mr weitz and mr schoenhaut that they were liable under the subscription notes when they signed them in as well as other facts relating to petitioner’s payments made on his subscription note in discussed supra pp we also reject petitioner’s alternative claim that he was never liable on the subscription note and related assumption_agreement petitioner has testified and the evidence shows that his subscription note assumption_agreement debt was genuine when entered into in date in addition the evidence shows the subscription note assumption_agreement debt was no longer genuine as of the time of trial in date it follows that at some point between these two dates the debt became nongenuine given the facts previously discussed relating to termination of pw partnership and lack of principal and interest payments made in see supra pp we find was the year in which the debt became nongenuine iii whether petitioner must recognize a dollar_figure gain for under sec_465 respondent claims that petitioner’s amount_at_risk in pw partnership was reduced from dollar_figure in to zero upon pw partnership’s termination in as a result of partnership losses flowing through to petitioner as well as distributions made to petitioner respondent argues that petitioner’s amount_at_risk was then further reduced by dollar_figure in as a result of his dollar_figure debt under the subscription note and assumption_agreement becoming nongenuine this would result in petitioner’s amount_at_risk becoming negative dollar_figure requiring him to report a dollar_figure gain for under sec_465 petitioner does not dispute that his amount_at_risk in pw partnership was reduced to zero upon the dollar_figure distribution’s being paid to him after pw partnership’s liquidation in however petitioner argues that sec_465 is inapplicable because there was no change in his liability under the subscription note in in support of his argument petitioner claims that either the subscription note and assumption_agreement liabilities were genuine debts during or if the subscription note and assumption_agreement liabilities were not genuine debts during they were never genuine when an individual is engaged in certain activities sec_465 limits the losses that an individual may claim as deductions to the amount for which the individual is at risk in the activity sec_465 applies to taxpayers engaged in the activity of exploring for or exploiting oil_and_gas resources as a trade_or_business or for the production_of_income sec_465 sec_465 provides that a taxpayer is considered at risk for an activity with respect to the amount of money and the adjusted_basis of other_property contributed by the taxpayer to the activity and for certain amounts borrowed with respect to the activity sec_465 provides that a taxpayer shall be considered at risk with respect to amounts borrowed for use in an activity to the extent that he is personally liable for the repayment of such amounts finally sec_465 provides that if zero exceeds the amount for which the taxpayer is at risk in any activity at the close of any taxable_year the taxpayer shall include in his gross_income for such taxable_year an amount equal to the excess petitioner first argues that he was at risk for dollar_figure in as a result of the subscription note and assumption_agreement however we have already found that petitioner was not liable on the subscription note or assumption_agreement in see supra pp we therefore reject this argument petitioner next argues that if he was not at risk for dollar_figure in he was never at risk for dollar_figure as a result of the subscription note and assumption_agreement and therefore sec_465 does not apply we have held that sec_465 applies only where the debtor genuinely was at risk during the stated recourse period not to promissory notes with respect to which the makers were never genuinely at risk 86_tc_821 however we have already found that although petitioner was not liable on the subscription note or assumption_agreement in he was previously liable on these debts in see supra pp the subscription note assumption_agreement obligation were thus included in petitioner’s at-risk amount in see melvin v commissioner t c pincite obligations due in later years may be included in the computation of a partner’s at-risk amount if the partner is personally liable on the obligation we therefore reject petitioner’s argument petitioner was initially at risk for dollar_figure in pw partnership and reduced his risk to zero in as a result of receiving flowthrough losses and distributions totaling dollar_figure after he had reduced his amount_at_risk to zero his liability for dollar_figure of his original amount_at_risk became nongenuine this 6these flowthrough losses and distributions were from year sec_2001 sec_2002 and lowered his amount_at_risk to negative dollar_figure in see sec_465 we therefore hold that petitioner must recognize a dollar_figure gain for pursuant to sec_465 iv accuracy-related_penalty sec_6662 and b and imposes a accuracy-related_penalty if any part of an underpayment_of_tax required to be shown on a return is due to among other things negligence or disregard of rules or regulations or a substantial_understatement_of_income_tax the penalty is of the portion of the underpayment_of_tax to which the section applies sec_6662 respondent determined that petitioner was liable for the accuracy-related_penalty under sec_6662 for negligence or disregard of rules and regulations or in the alternative under sec_6662 for a substantial_understatement_of_income_tax petitioner claims no penalty is appropriate because he was not negligent and did not disregard any rules or regulations there was substantial_authority supporting his tax treatment of his investment in pw partnership and thus it was not a tax_shelter under sec_6662 and he acted with reasonable_cause and good_faith the commissioner bears the burden of production on the applicability of an accuracy-related_penalty in that he must come forward with sufficient evidence indicating that it is proper to impose the penalty see sec_7491 see also 116_tc_438 once the commissioner meets this burden the burden_of_proof remains with the taxpayer including the burden of proving that the penalty is inappropriate because of reasonable_cause and good_faith see higbee v commissioner t c pincite the facts of this case lead us to conclude that respondent has met his burden of production with respect to the accuracy-related_penalty a whether petitioner was negligent or disregarded rules or regulations sec_6662 provides that the term negligence includes any failure to make a reasonable attempt to comply with the code and the term disregard includes any careless reckless or intentional disregard disregard of rules or regulations is careless if the taxpayer does not exercise reasonable diligence to determine the correctness of a tax_return position that is contrary to rules or regulations sec_1_6662-3 income_tax regs disregard of rules or regulations is reckless if the taxpayer makes little or no effort to determine whether a rule_or_regulation exists id disregard of rules or regulations is intentional if the taxpayer has knowledge of the rule_or_regulation that he disregards id considering the facts we find that petitioner was negligent and at least carelessly disregarded rules in failing to properly reduce his amount_at_risk in pw partnership upon his liabilities’ under the subscription note and assumption_agreement being discharged in b whether there was substantial_authority supporting petitioner’s tax treatment of his investment in pw partnership sec_6662 provides that the amount of an understatement shall be reduced by the portion of the understatement which is attributable to the tax treatment of any item by the taxpayer if there is substantial_authority for such treatment substantial_authority exists when the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment sec_1_6662-4 income_tax regs considering the facts and law we find petitioner did not have substantial_authority for his treatment of his amount_at_risk in pw partnership petitioner clearly ran afoul of sec_465 when he failed to reduce his amount_at_risk in pw partnership by dollar_figure upon his liabilities’ under the subscription note and assumption_agreement being discharged in c whether petitioner acted with reasonable_cause and good_faith pursuant to sec_6664 the accuracy-related_penalty of sec_6662 does not apply to any portion of an underpayment for which a taxpayer establishes that he or she had reasonable_cause and acted in good_faith whether the taxpayer acted with reasonable_cause and in good_faith depends on the pertinent facts and circumstances including the taxpayer’s efforts to assess his or her proper tax_liability his or her knowledge and experience and the extent to which the taxpayer relied on the advice of a tax professional sec_1_6664-4 income_tax regs we have previously held that for a taxpayer to rely reasonably upon advice so as to possibly negate a sec_6662 accuracy-related_penalty determined by the commissioner the taxpayer must prove that the taxpayer meets each requirement of the following three-prong test the adviser was a competent professional who had sufficient expertise to justify reliance the taxpayer provided necessary and accurate information to the adviser and the taxpayer actually relied in good_faith on the adviser’s judgment 115_tc_43 aff’d 299_f3d_221 3d cir in addition reliance may be unreasonable when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about id pincite citing 39_f3d_402 2d cir aff’g t c memo petitioner claims that the reasonable_cause and good_faith exception applies to him because he relied on the advice supplied to kevin zeluck by mr weitz had the accounting firm ross strent review the investment and prepare his tax returns and was made aware that the returns of mr siegal’s entities had been previously audited by tax authorities including the irs with no material changes made as a result we find it was not reasonable for petitioner to rely on any advice provided to him by mr weitz petitioner produced no evidence that mr weitz a member of a mass tort litigation law firm was a competent tax professional whom it was reasonable for him to rely upon in addition mr weitz had a conflict of interest with regard to the businesses of mr siegal as mr weitz had invested millions of dollars with such businesses including pw partnership of which mr weitz owned over since even if petitioner was not actually aware of mr weitz’s conflict of interest he offered no evidence that he made reasonable attempts to discover it after mr weitz told kevin zeluck of the investment opportunity because petitioner failed to independently verify the information he received from a conflicted source his reliance on the information mr weitz provided was not reasonable petitioner claims that he relied on the advice of ross strent both in deciding to invest in pw partnership in and in filing his income_tax return we do not believe the advice petitioner received from ross strent in is relevant the issue in this case is whether petitioner failed to reduce his amount_at_risk in pw partnership when the subscription note and assumption_agreement liabilities became nongenuine in not whether the initial investment in pw partnership was proper petitioner offered no evidence that the advice he received from ross strent in related to the tax treatment of the discharged liabilities in although petitioner did have his tax_return prepared by ross strent he failed to produce any evidence that he notified ross strent that his liability under the subscription note and assumption_agreement was discharged in so that ross strent could properly prepare his return indeed it appears from the 7any information pertaining to pw partnership originating with mr schoenhaut and passed along to petitioner through mr weitz and kevin zeluck also suffered from a conflict of interest because after initially investigating mr siegal’s business entities for mr weitz in the 1990s mr schoenhaut was paid to refer investors to partnerships associated with mr siegal mr schoenhaut used these referral fees to help purchase an interest in pw partnership and was made the managing partner of pw partnership upon its formation evidence that petitioner did not notify ross strent of significant partnership events occurring in as evidenced by the fact that his tax_return did not report the dollar_figure distributed to him upon pw partnership’s termination thus petitioner failed to satisfy his burden_of_proof to show that he provided necessary and accurate information to ross strent see neonatology assocs p a v commissioner t c pincite requiring the taxpayer to provide necessary and accurate information to any adviser we therefore find petitioner’s reliance on ross strent’s advice in preparing his return did not give him reasonable_cause for his failure to report income when his subscription note and assumption_agreement liabilities became nongenuine petitioner also argues that reasonable_cause exists because of prior audits of mr siegal’s business entities’ returns including an audit of pw partnership’s return for it sec_2001 tax_year by the new york department of taxation which did not require material changes be made to the returns however petitioner did not present evidence on the extensiveness of audit s into pw partnership indeed the audit of pw partnership’ sec_2001 tax_return completed by the new york department of taxation was described as limited moreover the issue in this case is not 8it was not established whether any other audits of pw partnership took place petitioner’s actual investment in pw partnership it is whether he failed to properly reduce his amount_at_risk in pw partnership in petitioner provided no evidence that any audits related in any way to his partner liabilities owed to pw partnership or liabilities resulting from assumption agreements signed by the partners becoming nongenuine we therefore find petitioner failed to satisfy his burden_of_proof with respect to this claim we finally note that although petitioner was not aware pw partnership had terminated until the start of this case he made no efforts to determine why he received a dollar_figure distribution in petitioner also repeatedly failed to inquire as to why proper interest and principal payments were not being withheld from the net operating revenue distributions he received instead of making reasonable inquiries which likely would have led him to discover that pw partnership had been terminated petitioner buried his head in the sand petitioner thus choose to ignore strong signals that his liability under the subscription note and assumption_agreement had become nongenuine and that tax consequences would arise as a result petitioner has not established that he had reasonable_cause for his failure to properly reduce his amount_at_risk in pw partnership for we therefore find that the sec_6664 reasonable_cause and good_faith exception does not apply d conclusion regarding the accuracy-related_penalty we have found that petitioner was negligent and disregarded rules in failing to reduce his amount_at_risk in pw partnership for we have also found that petitioner did not have substantial_authority for his treatment of his amount_at_risk in pw partnership and that the sec_6664 reasonable_cause and good_faith exception does not apply we therefore hold that petitioner is liable for a accuracy-related_penalty under sec_6662 v conclusion we hold that petitioner must recognize a dollar_figure gain for under sec_465 we further hold that petitioner is liable for a accuracy-related_penalty under sec_6662 in reaching our holdings herein we have considered all arguments made and to the extent not mentioned above we conclude they are moot irrelevant or without merit to reflect the foregoing an appropriate order will be issued