department of the treasury internal_revenue_service washington d c date number release date cc dom fs corp tl-n-3407-95 uilc internal_revenue_service national_office field_service_advice memorandum for district_counsel attn from deborah butler assistant chief_counsel field service cc dom fs subject sec_351 transfer this field_service_advice responds to your memorandum dated date field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be cited as precedent legend corp1 corp2 corp3 corp4 corp5 corp6 corp9 corp10 corp11 country3 year1 tl-n-3407-95 year2 year3 date1 date2 date3 a b c dollar_figurea dollar_figureb dollar_figurec dollar_figured dollar_figuree dollar_figuref a b c d e f h i j tt type1 type2 tl-n-3407-95 issue sec_1 whether the transfer of properties by corp1 corp2 and corp3 to corp9 on date2 qualified as a non taxable transaction under sec_351 whether corp9 was entitled to a carryover_basis in the properties it received from corp1 in year2 whether corp1 incurred a capital_loss as a result of the sale of tt of the corp9 auction preferred_stock it received in exchange for properties transferred to corp9 on date2 whether sec_269 can be applied to disallow loss on the future sale of the corp1 properties by corp9 whether sec_482 can be applied to adjust the loss that a group filing a consolidated_return purports to recognize on the sale of a portion of one class of stock received by one member of the group corp1 in a sec_351 exchange for built-in_loss_property where other group members corp2 and corp3 participating in the same sec_351 exchange received other classes of stock in the new company corp9 in exchange for built-in_gain property conclusion sec_1 corp1's entitlement to a capital_loss as a result of the sale of tt of the corp9 auction preferred_stock it received in exchange for properties transferred to corp9 on date2 should not be challenged taxpayer’s loss on any future sale of the corp1 properties by corp should not be challenged under sec_269 it should not be argued that sec_5 sec_482 be applied to adjust the loss that a group filing a consolidated_return purports tl-n-3407-95 to recognize on the sale of a portion of one class of stock received by one member of the group corp1 in a sec_351 exchange for built-in_loss_property where other group members corp2 and corp3 participating in the same sec_351 exchange received other classes of stock in the new company corp9 in exchange for built-in_gain property facts corp1 corp2 and corp3 are wholly owned subsidiaries of corp4 which is in turn a wholly owned subsidiary of corp5 corp5 is a wholly owned subsidiary of corp6 corp6 is a country holding_company corp6 files a consolidated_income_tax_return corp2 and corp3 owned and operated a and b properties these properties were highly productive corp1 owned and operated a b and c properties in the country3 many of the corp1 properties were marginally productive or nonproductive these development properties were referred to as assets also in late year1 or year2 corp5 management recognized a need for increased capital to offset its markedly decreased earnings that would allow corp5 to continue to develop those properties that showed the most promise the vehicle selected to raise cash was the issuance of auction preferred_stock aps in a newly-formed subsidiary corp5 formed corp9 on or about date1 on or about date2 corp1 corp2 and corp3 contributed assets in exchange for stock of corp9 in a transaction that corp5 contends qualifies as an sec_351 transaction the corp2 and corp3 properties transferred to corp9 were income producing properties the corp1 properties transferred to corp9 consisted mostly of non-producing properties the assets contributed by corp1 had a combined tax basis of dollar_figurea and a total fair_market_value of only dollar_figureb corp2 and corp3 on the other hand transferred producing a and b properties that had a combined tax basis of dollar_figurec and a fair_market_value of dollar_figured corp2 and corp3 received a shares and b shares of corp9 common_stock respectively and c shares and d shares of corp9 non-voting preferred_stock respectively in exchange for the assets they transferred to corp9 corp1 received e shares of corp9 aps in exchange for the assets it transferred to corp9 an additional f shares of corp9 aps were privately sold for dollar_figuree per share to institutional investors through corp11 tl-n-3407-95 on date3 corp1 sold h shares of its aps to outside investors for dollar_figuref immediately after the sale corp4 constructively owned approximately i of corp9’s combined voting preferred_stock and common_stock and j of the non voting preferred_stock the newly transferred assets from corp1 could not have been developed without a substantial expenditure of capital nevertheless according to the private_placement memorandum corp9 did not intend to make any substantial or significant capital expenditures in the advancement of its business under the terms of the aps a holder of corp9 aps such as corp1 had virtually no power to influence the management of the issuing_corporation ie corp9 if an owner of aps should attempt to intervene in the management of the corporation corp9 had the right to redeem an entire series of aps at any time corp9 commenced operations on date2 corp9 does not file a consolidated_income_tax_return with corp6 although it is included in corp5's reporting group for financial_accounting purposes corp9 has no regular employees corp9 retains the services of corp5 employees through a services agreement with corp5 and the contributing subsidiaries corp9 also retained the services of asset managers for its properties through a separate employment agreement with corp10 a newly formed company corp5 corp10 and the contributing subsidiaries entered into a revolving credit and cash management agreement which provides that corp10 will advance excess cash including net cash resulting from the proceeds of a and b production to corp5 and that corp5 will pay corp10 interest on such advances at a rate equal to the prime rate less one percent sometime in late year1 or early year2 corp5 management was advised by its inside counsel that preferred_stock could be used to raise needed capital without incurring additional debt this initial idea to use preferred_stock evolved into corp5’s decision to use auction preferred_stock and allowed corp9 to achieve its goal of acquiring additional capital corp5 described the purpose of corp9 as follows corp9 will enable corp5 to maximize the value of the assets compared to other alternatives eg sale or other disposal of the undeveloped and non producing assets corp9’s dominant objective was to monetize corp5’s domestic type1 and type2 assets by bringing in cash from outside investors tl-n-3407-95 law sec_351 sec_351 of the internal_revenue_code generally provides for the non- recognition of gain_or_loss upon the transfer of property to a corporation in exchange for stock in circumstances where immediately_after_the_exchange the transferors are in control of the corporation to which the property was transferred in a qualifying sec_351 transaction the assets retain a carryover_basis in the hands of the transferee sec_362 the transferor’s basis in the stock received in the transaction is equal to the basis of the transferred assets sec_358 under sec_351 control is defined as the ownership of stock possessing at least of the total combined voting power of all classes of stock entitled to vote and at least of the total number of shares of all other classes of stock sec_368 the purpose of sec_351 is to facilitate movement into the corporate form by preventing immediate recognition of gain_or_loss when there has been a mere change in the form of ownership 354_fsupp_1172 m d pa doctrine_of substance over form in determining the tax consequences of a transaction including whether transactions qualify for favorable non-recognition treatment the courts will look at the substance of the transaction or relationship not merely its form 324_us_331 the inquiry into whether transactions have sufficient substance to be respected for tax purposes turns on both the objective economic_substance of the transactions and the subjective business motivation behind them 862_f2d_1486 11th cir the objective and subjective prongs of the inquiry are related factors both of which form the analysis of whether the transaction had sufficient substance apart from its tax consequences 157_f3d_231 3d cir doctrine_of economic_substance while a taxpayer may structure a transaction to minimize tax_liability that transaction must have economic_substance apart from tax consequences if it is to be respected for tax purposes see 862_f2d_1486 tl-n-3407-95 11th cir where an entity is created that has no real economic_effect and which affects no cognizable economic relationship the substance of a transaction involving the entity will control_over its form 79_tc_714 transactions which serve no economic purpose other than the generation of tax losses are accorded no tax effect 364_us_361 compaq computer corp v commissioner t c nodollar_figure involved a prearranged transaction designed to eliminate typical market risks p purchased and immediately resold american depository receipts adr’s of a foreign_corporation on the floor of the nyse the court held the transaction lacked economic_substance and business_purpose the court found that every aspect of the transaction was deliberately predetermined and designed to yield a specific result and to eliminate all economic risks and influences from outside market forces in 435_us_561 the supreme court stated that a genuine multi-party transaction with economic_substance compelled or encouraged by business or regulatory realities imbued with tax independent considerations and not shaped by solely tax_avoidance features should be respected for tax purposes in frank lyon co the supreme court held that the arrangement of a contemplated business transaction in a tax advantaged manner should be respected where as a prearranged loss_transaction designed solely for the reduction of tax should not be respected business_purpose doctrine under the general business_purpose doctrine long recognized by the supreme court transactions that have no legitimate business_purpose and that are undertaken purely for tax_avoidance reasons are not recognized for tax purposes 293_us_465 nonetheless it is also well recognized that a taxpayer may prearrange change and divide business activities among business entities normally a choice to transact business in corporate form will be recognized for tax purposes as long is there is a business_purpose or the corporation engages in business activity 319_us_436 courts have hinted at the concept of business_purpose requirement in sec_351 repeatedly opinions discussing other sec_351 issues often indicate that the taxpayer have a valid business_purpose for the transaction in question 490_f2d_1172 3d cir perhaps the most tl-n-3407-95 thorough judicial exploration of the business_purpose doctrine in sec_351 is in 688_fsupp_1129 n d tex in caruth the court explains that sec_351 is tied very closely to the reorganization provisions and reasons that the doctrines applicable there are equally valid for capital contributions under caruth the business_purpose requirement for sec_351 transactions appears to be the same as the business_purpose requirement for acquisitive reorganizations sec_269 sec_269 provides that if a corporation or in certain situations its property is acquired for the principal purpose of evading or avoiding federal_income_tax by securing the benefit of deductions credits or other allowances that the acquiring person or corporation would not otherwise enjoy the secretary may disallow such deductions credits or other allowances accordingly sec_269 is not applicable unless the tax_evasion or avoidance motive is the principal purpose for the acquisition in the context of sec_269 principal purpose means that the evasion or avoidance purpose must outrank or exceed in importance any other purpose 65_tc_162 the intent or purpose of the acquiring person or corporation at the time of the acquisition is examined in determining the principal purpose 54_tc_705 there are three elements which must be present in order for sec_269 to be applied first there must be an acquisition directly or indirectly of control of a corporation or there must be an acquisition of assets with a carryover_basis of a target not controlled before the acquisition by the acquiring_corporation or its shareholders second at the time of the acquisition the primary purpose of each acquisition must be tax_evasion or avoidance and third the taxpayer must secure the benefit of a deduction credit or allowance which it would not otherwise enjoy control for purposes of sec_269 is the ownership of stock possessing at least percent of the total combined voting power of all classes of stock entitled to vote or at least percent of the total value of shares of all classes of stock of the corporation formation of a new corporation is an acquisition of control for purposes of sec_269 280_f2d_394 8th cir in order for sec_269 to apply the principal purpose of the acquisition must be tax_evasion or tax_avoidance the phrase evasion or avoidance is not defined however sec_1_269-1 states that evasion or avoidance is not limited to tl-n-3407-95 cases involving criminal penalties or civil penalties for fraud the phrase principal purpose merely requires that the tax_avoidance purpose outrank or exceed in importance any of the non-tax business purposes for the acquisition it is not necessary for tax_avoidance to be the sole purpose for the acquisition for sec_269 to apply according to sec_1 a in addition the determining factor is the intention or purpose of the taxpayer at the time of the acquisition 291_f2d_761 9th cir transactions identified under sec_269 as being indicative of tax_avoidance include a corporation which acquires property with an aggregate carryover_basis which is materially greater than its aggregate fair market at the time of acquisition and subsequently uses the property to create tax-reducing losses or deductions sec_482 sec_482 provides as follows in any case of two or more organizations trades_or_businesses whether or not incorporated whether or not organized in the united_states and whether or not affiliated owned or controlled directly or indirectly by the same interests the secretary may distribute apportion or allocate gross_income deductions credits or allowances between or among such organizations trades_or_businesses if he determines that such distribution apportionment or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations trades_or_businesses sec_1_482-1a provides the purpose of sec_482 is to place a controlled_taxpayer on a tax parity with an uncontrolled taxpayer by determining according to the standard of an uncontrolled taxpayer the true_taxable_income from the property and business of the controlled_taxpayer the interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled_taxpayer so to conduct its affairs that its transactions and accounting_records truly reflect the taxable_income_from_the_property and business of each of the controlled taxpayers if however this has not been done and the taxable incomes are thereby understated the district_director shall intervene and by making such distributions apportionments or allocations as he may deem necessary of gross_income deductions credits or allowances or of any item or element affecting taxable_income between or tl-n-3407-95 among the controlled taxpayers constituting the group shall determine the true_taxable_income of each controlled_taxpayer sec_1_482-1a provides the appropriate adjustments may take the form of an increase or decrease in gross_income increase or decrease in deductions including depreciation increase or decrease in basis of assets including inventory or any other adjustment which may be appropriate under the circumstances emphasis added accord sec_1_482-1 sec_1_482-1a provides sec_482 may when necessary to prevent the avoidance of taxes or to clearly reflect income be applied in circumstances described in sections of the code such as sec_351 providing for nonrecognition_of_gain_or_loss emphasis added finally it is well-established that sec_482 is applicable in the consolidated_return context sec_1_482-1a provides sec_482 and this section apply to the case of any controlled_taxpayer whether such taxpayer makes a separate or a consolidated_return if a controlled_taxpayer makes a separate_return the determination is of its true separate_taxable_income if a controlled_taxpayer is a party to a consolidated_return the true consolidated_taxable_income of the affiliated_group and the true separate_taxable_income of the controlled_taxpayer are determined consistently with the principles of a consolidated_return case development hazards and other considerations issue1-section-351 business_purpose sec_1 1a a defines a controlled taxpayer’s true_taxable_income as the taxable_income or as the case may be any item or element affecting taxable_income which would have resulted to the controlled_taxpayer had it in the conduct of its affairs or as the case may be in the particular contract transaction arrangement or other act dealt with the other member or members of the group at arm’s length it does not mean the income the deductions the credits the allowances or the item or element of income deductions credits or allowances resulting to the controlled_taxpayer by reason of the particular contract transaction or arrangement the controlled_taxpayer or the interests controlling it chose to make even though such contract transaction or arrangement be legally binding upon the parties thereto tl-n-3407-95 arguably the transfer of properties by corp1 corp2 and corp3 to corp9 on date2 did not qualify as a non-taxable transaction under sec_351 because the transaction lacked business_purpose and economic_substance however the taxpayer will argue that a purpose for the corp9 transaction was to raise cash without incurring additional debt this appears to be a valid business_purpose for entering into the corp9 transaction the fact that this purpose could have been accomplished simply by corp5 issuing auction preferred_stock or merely by corp2 and corp3 transferring assets to corp9 in exchange for the auction preferred_stock is not relevant in determining whether the taxpayer’s stated purpose for the corp9 transaction of raising cash without incurring additional debt is a valid business_purpose the service cannot substitute its own business judgment for that of corp5 in other words poor business judgment on the part of corp5 should not effect whether corp5’s stated business_purpose for the corp9 transaction of raising cash without incurring additional debt should be respected 853_f2d_1275 5th cir arguably corp5’s stated business_purpose for the transfer of corp1 properties to corp9 to monetize the corp1 assets by isolating them in corp9 for future development was not a valid business_purpose because no capital expenditures were ever made by corp9 to develop the properties however corp5 may argue that they should be allowed to arrange their business affairs as they please and the fact that capital expenditures have not yet been made to the corp1 properties transferred to corp9 should be of no consequence to the determination of business_purpose 90_tc_171 economic_substance as contrasted with compaq in the instant case that the purpose of the corp9 transaction was to allow corp5 to raise cash without incurring additional debt in addition every aspect of the corp9 transaction was not deliberately predetermined and designed to yield a specific result and to eliminate all economic risks and influences from outside market forces for example there is always the possibility that the corp1 properties transferred to corp9 could increase in value before there ultimate sale therefore there may not be any loss when the corp1 properties are ultimately sold as contrasted with frank lyon in the instant case corp1’s transfer of its assets to corp9 in exchange for aps stock had some economic_substance as a result of this transaction corp1’s non productive assets were isolated away from corp1 and cash was raised without debt this transaction appears to have economic_substance thus arguably the transfer of the corp1 that tl-n-3407-95 assets to corp9 served a business_purpose other than the generation of tax losses and therefore the transfer of properties by corp1 corp2 and corp3 to corp9 should be considered a non taxable transfer issue-2 entitlement to carryover_basis the issue here is whether corp9 was entitled to a carryover_basis in the properties it received from corp1 in year2 that the transfer of property from corp1 to corp9 had economic_substance and business_purpose and that therefore the transfer of properties by corp1 corp2 and corp3 to corp9 should be considered a sec_351 transfer corp9 will be entitled to the carryover_basis in the corp1 corp2 and corp3 properties received issue-3-capital loss on stock the issue here is whether corp1 incurred a capital_loss as a result of the date3 sale of tt of the corp9 auction preferred_stock it received in exchange for properties transferred to corp9 on date2 that the transfer of property from corp1 to corp9 had economic_substance and business_purpose and that therefore the transfer of properties by corp1 corp2 and corp3 to corp9 should be considered a non taxable sec_351 transfer corp1’s basis in the corp9 auction preferred_stock will be equal to the carryover_basis of the corp1 assets transferred from corp1 to corp9 therefore corp1 should incur a capital_loss as a result of the date3 sale of tt of the corp9 auction preferred_stock because the basis of the auction preferred_stock will be equivalent to the basis of the assets transferred by corp1 to corp9 issue sec_269 arguably sec_269 can be applied to disallow built in loss on the future sales of the corp1 properties by corp9 however the taxpayer will argue that the principal purpose for the corp9 transaction was to raise cash without debt and to isolate corp1’s unproductive assets and therefore because tax_avoidance was not the principal purpose for the corp9 transaction sec_269 does not apply to disallow the built in loss on any future sale of the corp1 properties by corp9 therefore sec_269 should not be applied to disallow built in loss on the future sale of the corp1 properties by corp9 that the principal purpose for the acquisition of the corp1 properties by corp9 was not tax_avoidance tl-n-3407-95 issue sec_482 reallocation although we believe the sec_351 transaction results in a distortion_of_income among the consolidated_group members corp1 corp2 and corp3 we do not recommend a sec_482 theory be pursued in this case the detailed statutory and regulatory provisions governing subchapter_c and consolidated_returns appear to permit the result taxpayer achieved in this case first sec_358 and sec_362 generally provide that for sec_351 transactions the basis_of_property including built-in gains and losses permitted to be received by the corporation contributing the property and to be acquired by the newly formed corporation acquiring the property shall be the same as that in the hands of the transferor_corporation thus corp1’s basis in the aps retains the built-in_loss attributes of the underlying contributed_property and corp9 acquires a carry-over of the same basis including built-in losses in the contributed_property and accordingly subchapter_c permits the duplication of built-in losses in this case that a court as in eli lilly co would respect the form of the corp1 transaction based upon the facts presented we believe reallocation of income in your memo you have stated that the income received by corp1 from the sale of the h shares of auction preferred_stock must be reallocated to corp2 and corp3 since they are viewed as the true owners of this stock you have also stated that corp2’s and corp3’s transfers to corp9 will be respected for sec_351 purposes if it is determined that sec_351 does not apply to the corp9 transaction because the transfer of corp1 properties to corp9 lacked business_purpose the corp1 property transfer to corp9 as well as the corp2 and corp3 property transfers to corp9 will be treated as property sales corp1 corp2 and corp3 will be treated as selling their property to corp9 in exchange for stock in other words corp2’s and corp3’s transfers to corp9 will not be respected for purposes of sec_351 further factual development summary tl-n-3407-95 that the corp9 transaction had business purposes the taxpayer has a of raising cash without additional debt and isolating corp1’s unprofitable assets therefore the field should not pursue the argument that the transfer of properties by corp1 corp2 and corp3 to corp9 does not qualify as a nontaxable_transaction under sec_351 because of lack of business_purpose and economic_substance likewise the sec_269 argument should not be pursued because of the that the corp9 transaction was done primarily for business reasons in addition the sec_482 argument should not be pursued because of the lack of evidence of a tax_avoidance scheme on the part of the taxpayer please call if you have any further questions deborah butler assistant chief_counsel field service by arturo estrada acting chief cc dom fs corp


t c memo united_states tax_court wayne and pamela berry petitioners v commissioner of internal revenue respondent docket no filed date ketia berry wick and rando berry wick for petitioners robert s scarbrough for respondent memorandum findings_of_fact and opinion wolfe special_trial_judge in so-called affected items notices of deficiency respondent determined additions to tax with respect to petitioners’ federal income taxes for the years and in the amounts as shown below -- - additions to tax sec sec sec sec year a a a dollar_figure -- -- dollar_figure --- dollar_figure t big_number --- t big_number ‘50 percent of the interest payable with respect to the portion of the underpayment that is attributable to negligence respondent determined underpayments attributable to negligence of dollar_figure and dollar_figure for and respectively unless otherwise indicated all section references are to the internal_revenue_code in effect for the years in issue and all rule references are to the tax_court rules_of_practice and procedure after concessions ’ the remaining issue for decision is whether petitioners are liable for additions to tax for negligence or intentional disregard of rules or regulations under sec_6653 for and sec_6653 and for and respectively we hold that petitioners are so liable findings_of_fact some of the facts have been stipulated and they are so found the stipulated facts and the attached exhibits are ‘petitioners concede that for each of the years in issue they are liable for additions to tax under sec_6659 for underpayments of tax attributable to valuation overstatements in the amounts determined by respondent also petitioners have abandoned their argument that assessment and collection of the additions to tax for the years in issue are barred by the statute_of_limitations because petitioners allegedly received no notice of the entry of decision from their tax_matters_partner see 220_f3d_1255 lith cir affg tcmemo_1998_347 incorporated herein by this reference petitioners resided in lake stevens washington at the time the petition was filed a the whitman transactions these cases are part of the plastics recycling group of cases the additions to tax arise from the disallowance of losses investment credits and energy credits claimed by petitioners with respect to a partnership known as whitman recycling associates whitman for a detailed discussion of the transactions involved in the plastics recycling group of cases see provizer v commissioner tcmemo_1992_177 affd per curiam without published opinion 996_f2d_1216 6th cir the parties have stipulated that the underlying transactions involving the sentinel recycling machines recyclers in this case are substantially identical to the transactions in provizer v commissioner supra whitman a limited_partnership was organized on date it purported to lease four recyclers manufactured by packaging industries pi of hyannis massachusetts on its federal_income_tax return whitman reported that each recycler had a basis of dollar_figure and the partnership reported a net ordinary_loss of dollar_figure the losses and credits reported by whitman were passed through to petitioners and the other limited partners b petitioners’ background in after graduating from high school in lake stevens washington wayne berry petitioner went to work at a sawmill after working at the sawmill for months he was drafted into the u s army the army sent him to a military school in georgia for training to work with helicopters then he served in vietnam for years as a door gunner on a medivac helicopter in he returned to lake stevens and married pamela berry whom he had met in high school with the assistance of his father in lake stevens he started a business that manufactured various interior house products such as moldings door jambs window trim and base shoe petitioner’s father had owned and sold a similar_business in california in petitioner purchased his father’s interest taking full control of the business petitioner operated it as apex wood products corp apex at the time of trial petitioner owned percent of the stock of apex during the years at issue pamela berry was a flight attendant for united airlines she was married to petitioner until when their divorce was finalized petitioners were financially successful during of the years in issue ’ they received total income excluding claimed 7petitioners’ federal_income_tax return was not part of the record losses from a condominium in hawaii and from whitman and another partnership as follows dollar_figure dollar_figure petitioners’ investment portfolio included a variety of interests including several tax-oriented investments petitioners maintained a brokerage account with merrill lynch they invested in a company called shaman a clothing import company that distributed merchandise through stores in the seattle metropolitan area they conducted a schedule c business involving lithographic prints in addition to petitioners’ investments specifically listed in the record kirk clothier clothier petitioners’ accountant testified that he had joined together with them in several investments petitioner alluded to investments prior to whitman when he testified that in spetitioners reported their lithographic print business on a schedule c profit or loss from business or profession schedule c on the schedule c petitioners indicated the name of their business was wayne d berry arts the main business activity was art works and the product was lithographic prints at trial petitioner briefly summarized the business as an arrangement in which he purchased the rights to the marketing profits generated from the sale of the lithographic prints on each of the two tax returns of petitioners in the record and petitioners reported zero gross_income from the business although the record is incomplete regarding petitioners’ lithographic print business we note that lithographic prints are a familiar tax-sheltering device see eg 88_tc_386 affd 868_f2d_851 6th cir bronson v commissioner tcmemo_1993_233 gangel v commissioner tcmemo_1991_358 ballard v commissioner tcmemo_1988_436 -- - deciding to invest in whitman he felt confident of clothier’s ability and expertise because in all of the investments that i’ve been involved with kirk clothier he has invested in the same ones petitioner also explained that the whitman recycling transaction was the second involvement i had with kirk clothier petitioner was introduced to the whitman investment by clothier clothier explained to petitioner that investing in whitman could serve three purposes to make money to shelter taxes and to help the environment petitioners paid dollar_figure for a 75-percent limited_partnership_interest in whitman petitioners did not personally review whitman’s offering memorandum or investigate whitman before becoming participants in the partnership nor did petitioners have any education or work experience in the plastics materials or the plastics recycling industry as a result of their payment of dollar_figure for their interest in whitman petitioners claimed on their federal_income_tax return a net_operating_loss_deduction of dollar_figure they also claimed investment credits totaling dollar_figure which was limited to their income_tax_liability as reduced by the partnership loss of dollar_figure of the dollar_figure balance of the unused credits dollar_figure was carried back to generating a tax_refund claim of dollar_figure which was petitioners’ total_tax liability for the remaining balance of the unused credits dollar_figure was carried forward to on their federal_income_tax return petitioners claimed a net_operating_loss_deduction of dollar_figure as a result of their investment in whitman c kirk clothier clothier is a certified_public_accountant c p a and holds a master’s degree in taxation his accounting firm is located in seattle washington he has practiced accounting since clothier was introduced to petitioner by petitioner’s brother who played volleyball with clothier in college in or clothier began assisting petitioners with their personal income_tax returns as well as the corporate_income_tax returns and financial statements of apex petitioner and apex continued to employ the services of clothier until when petitioner switched to a local accountant for the purpose of convenience in petitioner’s words every year it became more difficult to get down to seattle from lake stevens which is located miles north of seattle clothier’s services to petitioners were not limited to the preparation of their income_tax returns as apex became more the discrepancy between the amount carried back to dollar_figure and the amount of the refund dollar_figure is due to the fact that the carryback caused petitioners to lose a child_care_credit of dollar_figure for --- - profitable petitioners were left with increasing amounts of discretionary income clothier began providing petitioners with investment advice meeting with petitioner several times each year in or clothier was introduced to the whitman tax_shelter by ed margolin margolin a marketer of whitman after speaking with margolin clothier contacted an attorney connected with the tax_shelter the identity of the attorney is unclear but the parties have stipulated that the attorney was either the attorney for samuel winer general_partner and tax_matters_partner of whitman or the attorney who wrote the legal opinion contained in the offering memorandum for whitman clothier also asked one of his other clients lee connel connel an engineer to discuss the equipment with winer at trial clothier testified that he thought margolin later told him he had gone down and met with mr winer personally and done some personal investigation of the investment at that point clothier proposed the investment to petitioner prior to these conversations clothier had no knowledge of or experience in the plastics recycling industry at trial clothier had difficulty remembering how much information he had given petitioner before petitioner decided to invest in whitman clothier recalled telling petitioner that he had contacted the attorney who wrote the legal opinion that the --- - attorney was from a reputable law firm that one of his clients made some phone calls to investigate the equipment and that he thought that margolin had spoken with winer opinion we have decided many plastics recycling cases most of these cases like the present case have presented issues regarding additions to tax for negligence see eg thornsjo v commissioner tcmemo_2001_129 west v commissioner tcmemo_2000_389 barber v commissioner tcmemo_2000_372 barlow v commissioner tcmemo_2000_339 ulanoff v commissioner tcmemo_1999_170 greene v commissioner tcmemo_1997_296 kaliban v commissioner tcmemo_1997_271 sann v commissioner tcmemo_1997_259 ndollar_figure and cases cited therein affd sub nom 205_f3d_54 2d cir in all but two of the plastics recycling cases we found the taxpayers liable for the additions to tax for negligence moreover in all of those cases we found the taxpayers liable for additions to tax for valuation_overstatement in provizer v commissioner tcmemo_1992_177 the test case for the plastics recycling group of cases this court found that each recycler had a fair_market_value of not more than dollar_figure held that the transaction which was virtually identical to the transaction in the present case was a sham -- - because it lacked economic_substance and a business_purpose sustained the additions to tax for negligence under sec_6653 and sustained the addition_to_tax for valuation_overstatement under sec_6659 because the underpayment of taxes was directly related to the overvaluation of the recyclers and held that the partnership losses and tax_credits claimed with respect to the plastics recycling partnership at issue were attributable to tax-motivated transactions within the meaning of sec_6621 we also found that other recyclers were commercially available during the year in issue in reaching the conclusion that the transaction lacked a business_purpose this court relied heavily upon the overvaluation of the recyclers id neither petitioners nor respondent had a copy of the offering memorandum for whitman available at the time of trial nearly years after petitioners’ investment in barber v commissioner supra where the taxpayers like petitioners were limited partners in whitman we explained in a 4-step series of simultaneous transactions closely resembling those described in the provizer case and stipulated by the parties herein packaging industries of hyannis massachusetts pi manufactured and sold’ four sentinel eps recyclers to eci corp eci for dollar_figure each eci simultaneously resold the recyclers to f g corp f g for dollar_figure each f g simultaneously leased the recyclers to whitman finally whitman simultaneously entered in a joint_venture with pi and resin recyclers inc rri to exploit the recyclers and place them with end-users under this latter arrangement pi was required to pay whitman a monthly joint_venture fee for convenience we refer to the series of transactions between and among pi eci f g whitman and rri as the whitman transactions the sales of the sentinel eps recyclers from pi to eci were financed using 12-year nonrecourse notes the sales of the recyclers from eci to f g were financed using 12-year partial recourse notes however the recourse portion of the notes was payable only after the first percent of the notes the nonrecourse portion was paid no negotiations for the price of the recyclers took place between or among pi eci and f g at the closing of the whitman partnership pi eci f g whitman and rri entered into arrangements whereby pi would pay a monthly joint_venture fee to whitman in the same amount that whitman would pay as monthly rent to f g in the same amount that f g would pay monthly on its note to eci in the same amount that eci would pay monthly on its note to pi further in connection with the closing of the whitman partnership pi eci f g whitman and rri entered into offset agreements providing that the foregoing payments were bookkeeping entries only and were never in fact paid also in connection with the closing of the whitman partnership pi eci f g whitman and rri also entered into cross-indemnification agreements id terms such as sale and lease as well as their derivatives are used for convenience only and do not imply that the particular transaction was a sale or lease for federal tax purposes similarly terms such as joint_venture and agreement are also used for convenience only and do not imply that the particular arrangement was a joint_venture or an agreement for federal tax purposes s-eps stands for expanded polystyrene the case of provizer v commissioner tcmemo_1992_177 affd per curiam without published opinion 996_f2d_1216 6th cir involved sentinel expanded polyethylene epe recyclers however the eps recycler partnerships and the epe recycler partnerships are essentially identical see davenport recycling associates v commissioner tcmemo_1998_347 affd 220_f3d_1255 11th cir see also gottsegen v commissioner tcmemo_1997_314 involving both the epe and eps recyclers ulanoff v commissioner tcmemo_1999_170 same a the private offering memorandum in barber v commissioner supra significant portions of the whitman offering memorandum were summarized as follows by a private_placement offering memorandum dated date the offering memorandum subscriptions for limited_partnership units in whitman were offered by the partnership’s promoter to potential limited partners at dollar_figure per partnership unit pursuant to the offering memorandum the limited partners would own percent of whitman and the general_partner sam winer would own the remaining percent also pursuant to the offering memorandum each limited_partner was required to have a net_worth including residence and personal_property in excess of dollar_figure million or net_income in excess of dollar_figure for each investment_unit the offering memorandum stated that winer would receive dollar_figure for administrative and other services to be paid from the proceeds of the private_placement offering as management fees the offering memorandum also stated that the partnership would pay fees of purchaser representatives and selling commissions from the proceeds of the offering in an amount equal to percent of the aggregate price of the units mthus winer would earn a 10-percent commission upon selling an interest in the partnership in addition the offering memorandum stated that winer could retain as additional compensation all amounts not paid as purchaser representative fees or sales commissions in connection with the offering the face of the offering memorandum warned in bold capital letters that this offering involves a high degree of risk the offering memorandum also warned that an investment in the partnership involves a high degree of business and tax risks and should therefore be considered only by persons who have a substantial net_worth and substantial present and anticipated income and who can afford to lose all of their cash investment and all or a portion of their anticipated tax benefits the offering memorandum went on to enumerate significant business and tax risks associated with an investment in whitman among those risks the offering memorandum stated there was a substantial likelihood of audit by the internal_revenue_service and the purchase_price paid_by f g to eci might be challenged as being in excess of the fair_market_value the partnership had no prior operating history the management of the partnership’s business would be dependent on the services of the general_partner who had limited experience in marketing recycling or similar equipment the limited partners would have no control_over the conduct of the partnership’s business there were no assurances that market prices for virgin resin would remain at their current costs per pound or that the recycled pellets would be as marketable as virgin pellets and certain potential conflicts of interest existed the offering memorandum informed investors that the whitman transactions would be executed simultaneously the offering memorandum prominently touted the anticipated tax benefits for the initial year of investment for an investor in the partnership in this regard the offering memorandum stated in part as follows the principal tax benefits expected from an investment in the partnership are to be derived from the limited partner’s share of investment and energy tax_credits and tax deductions expected to be generated by the partnership in the tax benefits ona per unit basis are as follows projected regular projected investment and tax payment energy tax_credits deductions dollar_figure dollar_figure dollar_figure the limited partners are not liable for any additional payment beyond their cash investment for their units nor are they subject_to any further assessment id b sec_6653 and negligence respondent determined that petitioners were liable for additions to tax for negligence under sec_6653 and with respect to underpayments attributable to petitioners’ investment in whitman petitioners contend that they were not negligent because they lacked investment experience and sophistication and they reasonably relied upon their c p a sec_6653 for and sec_6653 for and provide for an addition_to_tax equal to percent of the underpayment if any part of an underpayment_of_tax is due to negligence or intentional disregard of rules or regulations sec_6653 for and provides for an addition_to_tax equal to percent of the interest payable with respect to the portion of the underpayment attributable to negligence or intentional disregard of rules or regulations negligence is defined as the failure to exercise the due care that a reasonable and ordinarily prudent person would exercise under the circumstances 85_tc_934 the pertinent question is whether a particular taxpayer’s actions are reasonable in light of the taxpayer’s experience the nature of the investment and the taxpayer’s actions in connection with the transactions see 60_tc_728 the determination of negligence is highly factual when -- - considering the negligence addition we evaluate the particular facts of each case judging the relative sophistication of the taxpayers as well as the manner in which the taxpayers approached their investment turner v commissioner tcmemo_1995_363 respondent’s determination of negligence is presumed correct and petitioners bear the burden of proving that they were not negligent neely v commissioner supra see generally rule a 290_us_111 with respect to the large number of plastics recycling cases that have come before this court we have seen taxpayers from all walks of life and with greatly varying levels of education and investment experience in all such cases there have been only two in which we held that the taxpayers were not negligent with respect to their participation in the plastics recycling program dyckman v commissioner tcmemo_1999_79 and zidanich v commissioner tcmemo_1995_382 both cases involved unusual circumstances not present in the instant case as discussed further below compare sec_7491 which places the burden of production on respondent with respect to a taxpayer’s liability for penalties and additions to tax sec_7491 is effective for court proceedings arising in connection with examinations commencing after date petitioners do not contend nor is there evidence that their examination commenced after date or that sec_7491 is applicable in this case the notices of deficiency sent to petitioners with respect to the years in issue are dated date -- - petitioners’ investment experience and sophistication petitioners argue that their lack of education and their lack of investment experience are factors supporting their claim that they were not negligent in investing in whitman petitioners compare their backgrounds with those of the taxpayers in dyckman v commissioner supra and zidanich v commissioner supra in dyckman and zidanich we held for the taxpayers on the issue of negligence based on special and unusual circumstances one of the circumstances favoring taxpayers was their complete lack of sophistication in investment matters in dyckman v commissioner supra the taxpayers were a carpet salesman and an elementary_school teacher their combined net_worth was dollar_figure until the year in issue their investment experience had been limited to bank accounts a few certificates of deposit and securities financed through withholdings from their paychecks for investment through employer plans id in zidanich v commissioner supra mr zidanich was a steel worker and mrs zidanich was a legal secretary prior to their investment at issue their only investments were in stocks and bonds financed through withholding from mr zidanich’s paychecks and purchased through a company plan id petitioner argues that his education level is similar to that of most of the taxpayers in the dyckman and zidanich cases - in that petitioner had no formal education beyond high school while a lack of any significant formal education beyond high school has been a factor in some cases where we have found that taxpayers were not negligent under sec_6653 such cases are exceptions rather than the norm for examples of cases in which we have held the taxpayers negligent despite their modest formal education see singer v commissioner tcmemo_1997_325 taxpayer who worked with success in the floor covering business quit high school during his sophomore year estate of hogard v commissioner tcmemo_1997_174 taxpayer an owner of a business involving coin-operated entertainment machines had a high school education affd without published opinion sub nom gilmore wilson constr co v commissioner 166_f3d_1221 10th cir mcpike v commissioner tcmemo_1996_46 taxpayer a firefighter received no formal education beyond high school except for a few courses in fire science lax v commissioner tcmemo_1994_329 taxpayer who spent his entire working career in the textile business had no formal post-high school education affd without published opinion 72_f3d_123 3d cir klieger v commissioner tcmemo_1992_734 several of the taxpayers had only high school educations gerber associates inc v commissioner tcmemo_1987_446 no formal post-high school education affd without published opinion 876_f2d_106 7th cir -- - the instant case is readily distinguishable from dyckman v commissioner supra and zidanich v commissioner supra at the time he invested in whitman petitioner was a relatively sophisticated investor actively seeking out a variety of investments including tax-oriented investments or speculations petitioner met personally with clothier several times each year to discuss investment opportunities prior to their investment in whitman in petitioners invested without the advice of their accountant in a condominium in maui hawaii anda lithographic print business and maintained a brokerage account at merrill lynch in addition petitioner had made other investments with clothier including shaman a clothing import company that distributed merchandise through stores in the seattle metropolitan area petitioners’ investment experience significantly surpasses the experience of other taxpayers who we have found negligent under sec_6653 for improperly sheltering income see eg mcpike v commissioner supra taxpayers had no previous investment experience other than their personal_residence we also view petitioner’s career path as relevant in determining his level of business and financial sophistication petitioner is a true success story in the tradition of american entrepreneurship petitioner cofounded a company in by he owned the company and from operating the business he earned a six-figure salary partnership losses respectively petitioners’ income exclusive of of dollar_figure and dollar_figure in and shows that petitioners stood to benefit substantially by the deductions and credits that whitman offered clothier explained to petitioner the investment the expectation petitioner to invest in whitman at trial petitioner made a his role in the success of apex strictly limited to production aptitude by saying weaknesses in what they do inclined i’ve been lucky diagnosed with dyslexia and that and mine is as to the source of apex’s success the immediate tax benefits of of such benefits motivated transparent attempt to downplay describing his duties as he described his business t think everybody has strengths and i’m more mechanically petitioner said petitioner also testified that he has been he does not enjoy reading petitioner’s claim that he lacks sophistication is self- serving and inconsistent with the facts it is readily apparent that petitioner completely dominates the operations of apex and is responsible for its remarkable success his alleged choice to devote his efforts to the production operations of apex as well as his aversion to reading are not inconsistent with his possessing business acumen equipment in the name of lake stevens leasing as a d b a for himself we note that petitioner acquired which he described that leased equipment to apex - - petitioner testified that his accountant told him there were tax advantages in this arrangement with respect to investment credits the arrangement certainly is not unique but it is tax- efficient and sophisticated as petitioner himself admitted i do have a business sense of making a business operate and i know what it takes to get the product out the door to get income out of it petitioner’s own testimony that he cofounded built up and now owns percent of the highly successful apex business is inconsistent with his argument that he lacks business capabilities in short petitioner was not lacking in investment experience or sophistication petitioner’s active role in seeking investments as well as founding building and operating a successful corporate enterprise and all the knowledge and experience associated with such a successful business career support the conclusion that he was capable of properly investigating and analyzing the whitman tax_shelter and that his failure to do so was negligent petitioners’ reliance on their c p a petitioners claim that their reliance on clothier’s advice was reasonable under some circumstances a taxpayer may avoid liability for negligence if reasonable reliance on a competent professional adviser is shown see 469_us_241 89_tc_849 - affd 904_f2d_1011 5th cir affd on other grounds 501_us_868 however reliance on professional advice standing alone is not an absolute defense to negligence but rather a factor to be considered freytag v commissioner supra for reliance on professional advice to excuse a taxpayer from negligence the taxpayer must show that the professional had the expertise and knowledge of the pertinent facts to provide informed advice on the subject matter see 79_f3d_726 8th cir affg tcmemo_1994_408 43_f3d_788 2d cir affg tcmemo_1993_621 freytag v commissioner supra sann v commissioner tcmemo_1997_259 moreover reliance on representations by insiders promoters or offering materials has been held an inadequate defense to negligence see 990_f2d_893 6th cir affg donahue v commissioner tcmemo_1991_181 94_tc_637 affd without published opinion 956_f2d_274 9th cir affd in part without published opinion sub nom cowles v commissioner 949_f2d_401 10th cir sann v commissioner supra pleas of reliance have been rejected when neither the taxpayer nor the advisers purportedly relied upon by the taxpayer knew anything about the nontax business aspects of -- - the contemplated venture see david v commissioner supra freytag v commissioner supra the purported value of the recyclers generated the deductions and credits this circumstance was clearly reflected in the offering memorandum although petitioner was given a copy of the offering memorandum petitioner chose not to read it instead he exclusively relied on representations made by clothier in his discussions with petitioner about whitman clothier emphasized the tax benefits that petitioner would enjoy if he made the investment the offering memorandum prominently announced that an investment of dollar_figure in whitman would produce approximately dollar_figure in immediate investment and energy tax_credits petitioners’ investment of dollar_figure produced for them tax_credits totaling dollar_figure like the taxpayers in provizer v commissioner tcmemo_1992_177 except for a few weeks at the beginning petitioners never had any money in the deal under these circumstances a reasonably prudent person would have asked a qualified adviser if such a windfall were not too good to be true see 92_tc_827 in support of their claim that their reliance on clothier on its tax_return whitman reported that each of the four recyclers had a basis of dollar_figure in provizer v commissioner tcmemo_1992_177 affd per curiam without published opinion 996_f2d_1216 6th cir the test cases for the plastics recycling group of cases this court found that each recycler had a fair_market_value of not more than dollar_figure - - was reasonable petitioners emphasized that clothier had invested with them in the investments that clothier had proposed prior to whitman however petitioners did not claim nor is there evidence that clothier invested in whitman apparently clothier’s decision not to invest in whitman did not dissuade petitioners like petitioners clothier had no knowledge of the plastics recycling industry moreover clothier did not consult with any persons who had expertise in plastics recycling instead clothier’s sources of information about whitman were limited to the offering memorandum and the representations of insiders the only persons with whom clothier remembers discussing whitman were margolin a whitman sales representative connel a client of clothier and either winer’s attorney or one of the attorneys who wrote the tax opinion of whitman each of these contacts either had a self-interest in the promotion of whitman or had no knowledge about the plastics recycling industry clothier’s reliance on margolin was unreasonable clothier remembers margolin telling him that whitman was a reasonable investment and that it had tax_shelter advantages these conclusory remarks without further investigation were not a proper basis for reliance especially since there is no evidence that margolin had any expertise with plastics recycling although -- - he was marketing the partnership interests we have consistently held that advice from such persons is better classified as sales promotion see singer v commissioner tcmemo_1997_325 vojticek v commissioner tcmemo_1995_444 we note that margolin did not testify and that circumstance suggests that if he had testified his testimony would have been unfavorable to petitioners see 6_tc_1158 affd 162_f2d_513 10th cir the commission for selling units under the whitman promotion was egqual to percent of the sales_price see barber v commissioner tcmemo_2000_372 clothier’s reliance on his client lee connell was also unreasonable connell was an engineer by profession he had no experience with plastics recycling clothier unreasonably assumed that connel’s engineering background would qualify him to make a reliable evaluation of the recyclers with minimal effort even if connel were qualified reliance on connel would be unreasonable because there is no evidence that connel ever saw the recyclers connel did not testify at trial and our knowledge of his alleged investigation is based entirely on clothier’s vague recollection under these circumstances we are convinced that clothier was not concerned with whitman’s economic or business aspects rather clothier understood that whitman was a tax_shelter clothier failed to consult an independent_appraiser or anyone - - with expertise in plastics recycling if clothier had made a reasonable effort to determine the fair_market_value of the recyclers he would have determined that the recyclers’ price was grossly inflated at that point a reasonable person would have inguired why the partnership would be willing to invest in machines at far in excess of their fair_market_value when it could have purchased other much less expensive machines that performed virtually the same functions it was not reasonable for petitioners to claim the substantial tax_credits and partnership losses in issue on the basis of clothier’s advice petitioners compare their relationship with clothier to the relationships that the taxpayers had with their advisers in dyckman v commissioner tcmemo_1999_79 and zidanich v commissioner tcmemo_1995_382 such comparisons are misplaced in dyckman v commissioner supra the taxpayers were close friends with their accountant mr kipness as well as his family mrs dyckman tutored mr kipness’s daughter when mr kipness and his family moved from new jersey to california the dyckmans continued to mail mr kipness their tax information and he continued to prepare their returns for some time after the move to california id in zidanich v commissioner supra mrs zidanich worked for the adviser’s father and subsequently for the adviser himself for years as to the other taxpayers in zidanich the steinbergs mrs steinberg relied entirely on - - her brother as her adviser and trustee of the funds that she and her brother had inherited from their parents mrs steinberg did not even know of the investment until the internal_revenue_service contacted her in view of her brother’s highly successful career as an investor and investment manager her entrustment of her funds to him was not unreasonable id here there is no evidence of a personal friendship between clothier and petitioners outside of an accountant client relationship clothier was a college acquaintance of petitioner’s brother--not petitioner petitioners terminated their relationship with clothier because a distance of miles was too great an obstacle the dyckmans continued to use their accountant despite his permanent move with his family across the country in sum petitioners’ relationship with clothier was not the long-term relationship of friendship and trust with an adviser that was present in the dyckman and zidanich cases for the foregoing reasons petitioners’ reliance on dyckman v commissioner supra and zidanich v commissioner supra is misplaced in conclusion we find that petitioners failed to exercise due care in claiming large deductions and tax_credits with respect to whitman on their federal_income_tax returns the disproportionately large tax benefits claimed on petitioners’ federal_income_tax returns relative to the dollar amount -- p7 - invested should have alerted petitioners to the need for further investigation of the partnership transactions their reliance on clothier was misplaced because clothier knew little about the business aspects of whitman and there is no reason for us to think he misled petitioners about the extent of his own knowledge in this respect clothier relied on conclusory statements of insiders as well as the conclusion of his client an engineer who had no expertise in either taxes or the plastics recycling industry and made only a casual inguiry about the transaction neither clothier nor petitioners undertook a good_faith investigation of the fair_market_value of the recyclers or the underlying economic viability or financial structure of whitman accordingly we hold that petitioners are liable for the additions to tax for negligence under sec_6653 for and sec_6653 and for and to reflect the foregoing decision will be entered under rule


t c memo united_states tax_court john michael and janice hill brannon petitioners v commissioner of internal revenue respondent docket no filed november john michael brannon pro_se horace crump for respondent memorandum findings_of_fact and opinion carluzzo special_trial_judge respondent determined deficiencies in petitioners' federal income taxes in the amounts of dollar_figure dollar_figure and dollar_figure for the taxable years respectively and the issue for decision for each year in issue is whether income earned as a methodist minister by john michael brannon is subject_to the tax on self-employment_income the resolution of the issue depends upon whether mr brannon submitted a timely application_for exemption from the tax on self-employment_income which in turn depends upon whether the services he performed as a licensed local pastor in the united methodist church constitute the performance of services by a minister of a church within the meaning of sec_1402 unless otherwise indicated section references are to the internal_revenue_code in effect for the years in issue findings_of_fact some of the facts have been stipulated and are so found petitioners are husband and wife they filed a timely joint federal_income_tax return for each year in issue at the time the petition was filed petitioners resided in pike road alabama references to petitioner are to john michael brannon on date while enrolled as a student at huntington college petitioner was licensed as a student local pastor for the united methodist church the church he was assigned to the trinity-weoka church in the alabama-west florida conference trinity--weoka which remained in his charge at least through between and petitioner was enrolled at emory university chandler school of theology seminary in atlanta petitioner was licensed and served as the local pastor as compared to a student local pastor for trinity-weoka from to on date he was ordained a deacon in the church in date he was ordained an elder local pastors are divided into three categories full time part time and student the distinctions are not relevant to the issue before us and need not be discussed a local pastor is defined by the church as a person licensed by the district committee on ordained ministry to perform all the duties of a pastor including the sacraments of baptism and holy communion as well as the service of marriage where state laws allow burial confirmation and membership reception while assigned to a particular charge the ordained ministry of the church consists of deacons and elders an individual can be licensed as a local pastor even though the individual has not been ordained a deacon or elder deacons are defined by the church as ministers who have authority to conduct divine worship to preach the word to perform the marriage ceremony where the laws of the state or province permit and to bury the dead when invited to do so by an elder they may assist in the administration of the sacraments elders are ministers who have completed their formal preparation for the ministry of word sacrament and order the authority of a local pastor is limited by both geography and time local pastors are authorized to act only as described above within the boundaries of their charge and only as long as they are licensed by the church to do so petitioner's annual earnings from performing as a local pastor the services described above exceeded dollar_figure in and the application_for exemption from self-employment_tax contemplated by sec_1402 is embodied in form_4361 application_for exemption from self-employment_tax for use by ministers members of religious orders and christian science practitioners in addition to other information an applicant for exemption must report on that form the date that the applicant was ordained licensed etc line and the first years after the date listed on line that the applicant had net self-employment earnings_of dollar_figure or more any part of which came from services as a minister priest rabbi etc line on date petitioner filed a form_4361 on that form petitioner indicated that the date he was ordained licensed etc was date the date that he was ordained a deacon he reported that and were the first years after the date of his ordination in which he had net self- employment earnings_of dollar_figure or more any part of which came from services as a minister priest rabbi etc relying upon the information reported on the form on date respondent granted petitioner's application_for exemption from self- employment_tax included with petitioners' federal_income_tax return for each year in issue is a schedule c on which petitioners reported the earnings and expenses attributable to petitioner's ministry as follows gross_receipts dollar_figure dollar_figure dollar_figure car truck exp big_number big_number big_number educ exp big_number -q- net profit big_number big_number big_number petitioners did not treat the net profit for any year as net_earnings_from_self-employment in the notice_of_deficiency respondent determined that the services that petitioner provided as a minister during each year in issue were provided as an employee of the church and that the income and expenses attributable to those services must be reported accordingly respondent also determined that the income that petitioner earned as a minister was subject_to the tax on self-employment_income other adjustments made in the notice_of_deficiency are not in dispute opinion although petitioner's employment status as a methodist minister was at one time in dispute the parties now agree that the services that petitioner performed as a minister during the years in issue were performed as an employee of the church see weber v commissioner 103_tc_378 affd 60_f3d_1104 4th cir they disagree however over whether the tax on self-employment_income is applicable to the income that petitioner earned as a minister during those years in addition to other taxes an individual's self-employment_income is subject_to a tax imposed pursuant to sec_1401 subject_to irrelevant exceptions self-employment_income is defined as the net_earnings_from_self-employment derived by an individual during any taxable_year sec_1402 net_earnings_from_self-employment include the gross_income earned by an individual from any trade_or_business less deductions attributable to that trade_or_business see sec_1402 the phrase trade_or_business as used for purposes of the tax on self-employment_income has the same meaning as under sec_162 which allows a taxpayer to deduct ordinary and necessary expenses paid_or_incurred in carrying on any trade_or_business see sec_1402 c although an individual can be in the trade_or_business of being an employee see o'malley v commissi91_tc_352 and 54_tc_374 generally the income earned by an individual who performs services as an employee is not considered to be income earned in a trade_or_business for purposes of the tax on self-employment_income see sec_1402 there are exceptions to this general_rule however and one of the exceptions is relevant here the income earned by an individual in the performance of services as an employee minister of a church is subject_to the tax on self-employment_income unless the individual files a timely application_for exemption see sec_1402 d c e to be effective the application must be timely and the time limitations set forth in the statute are mandatory and strictly enforced see 89_tc_922 sec_1 e -3a income_tax regs for the years involved here an application_for exemption is timely only if the duly ordained commissioned or licensed minister files the application before the due_date of the return for the second taxable_year for which the minister has net_earnings_from_self-employment of dollar_figure or more any part of which was derived from the performance of services in the minister's ministry see sec_1402 petitioner's application_for exemption from the self- employment_tax was filed on date petitioners argue that the application which was approved based upon the information reported thereon was timely because petitioner did not perform services as a minister until he was ordained a deacon on date according to petitioners providing services as a licensed local pastor in previous years did not constitute the performance of services as a minister within the meaning of sec_1402 because the authority of a local pastor is not as extensive as the authority of an ordained deacon respondent disagrees and argues that the services that petitioner performed as a local pastor in and constituted the performance of services as a licensed minister even though petitioner was not yet an ordained minister because petitioner earned more than dollar_figure from the performance of such services in those years a point that is not in dispute respondent maintains that the application was not timely because it was not filed by the due_date of petitioner's federal_income_tax return petitioners' argument that the period for filing the application_for exemption did not begin to run until the date of his ordination is incorrect the phrase duly ordained commissioned or licensed minister as used in the relevant statutory scheme is a disjunctive phrase the statute applie sec_1f the individual is either an ordained minister a commissioned minister or a licensed minister see wingo v commissioner supra pincite 46_tc_190 whether an individual performs services as an ordained commissioned or licensed minister depends upon the type of services performed not just on the official title of the person performing those services consequently we focus upon the services that petitioner performed as a licensed local pastor during and in order to determine whether such services constituted the performance of services as a licensed minister within the meaning of sec_1402 an individual acting pursuant to authority derived from his or her status as a duly ordained commissioned or licensed minister of a church who in the exercise of his or her ministry presides over the ministration of sacerdotal functions conducts religious worship and participates in the control conduct and maintenance of religious organizations including the religious boards societies and other integral agencies of such organizations under the authority of a religious body constituting a church or church denomination performs services as a minister within the meaning of sec_1402 see wingo v commissioner supra pincite sec_1_1402_c_-5 income_tax regs set against these criteria and taking into account the respective positions of the parties we examine what petitioner did as a licensed local pastor in and in order to determine whether the services he performed as such constituted the services of a duly ordained commissioned or licensed minister within the meaning of sec_1402 as a licensed local pastor petitioner was authorized by the church to preside over the ministration of sacerdotal functions -- - such as baptism holy communion and marriage petitioners agree that petitioner performed these services during and but they argue that as a local pastor petitioner was authorized to do so only as long as his license was in effect and only within the boundaries of his charge we recognize that petitioner's authority as a licensed local pastor was limited by the duration of his license and the designated charge to which it applied nevertheless subject_to those limitations during and he presided over the ministration of sacerdotal functions and therefore for those years acted in a manner consistent with the performance of service by a duly ordained commissioned or licensed minister within the meaning of sec_1402 petitioners do not dispute that as a licensed local pastor petitioner conducted religious worship during and petitioners point out that a licensed local pastor is considered a lay person who has no voice or vote on official matters of the church consequently they argue that during and petitioner could not and did not serve in the control conduct and maintenance of the church implicit in petitioners' argument is the suggestion that petitioner's service is measured in the context of the church as a governing organization we rejected a similar argument advanced by the taxpayer in wingo v commissioner supra and concluded as follows to perform services in the control conduct and maintenance of the church or organizations within the church the minister need only have some participation in the conduct control and maintenance of the local church or denomination id pincite emphasis supplied during and as a licensed local pastor petitioner served in the control conduct and maintenance of his charge that is trinity--weoka even though as a licensed local pastor he might not have done so with respect to the church as the governing organization in and as a licensed local pastor petitioner presided over the ministration of sacerdotal functions conducted religious worship and served in the control conduct and maintenance of his charge within the church therefore during those years he performed services as a minister within the meaning of sec_1402 that being so and because for each of those years petitioner had net_earnings of at least dollar_figure derived for the performance of services as a minister to be effective his application_for exemption from the tax on self- employment income should have been filed prior to the due_date of his federal_income_tax return because it was not so filed respondent's determination that petitioner's earnings as a minister are not exempt from the tax on self-employment_income imposed by sec_1401 is sustained for each year in issue in closing we respond briefly to a question raised by petitioners at trial and repeated in their brief they question how an individual could be treated as an employee and therefore not self-employed for purposes of deductions allowable under sec_162 yet be treated as self-employed for purposes of sec_1401 perhaps the question results from the common practice of referring to the tax imposed by sec_1401 as the self-employment_tax that designation is somewhat misleading because it suggests that the tax is imposed only upon individuals who are self-employed technically as noted above that tax is imposed upon an individual's self-employment_income which by definition includes income earned as an employee under various circumstances including those present in this case to reflect the foregoing decision will be entered for respondent


number release date index uil no tam-108646-00 cc intl br2 internal_revenue_service national_office technical_advice_memorandum date taxpayer’s name taxpayer’s address taxpayer’s identification no years involved date of conference legend taxpayer dc fc date date date date date date dollar_figurex a b c state d tam-108646-00 issues i what date controls for determining whether the percent ownership requirement has been satisfied for purposes of the reduced percent rate_of_tax under paragraph of article of the convention between the united_states of america and the federal republic of germany for the avoidance of double_taxation and the prevention of fiscal evasion with respect to taxes on income and capital and to certain other taxes the treaty ii if it is determined that the dividends_paid by dc to fc were subject_to the percent rate_of_tax is the taxpayer liable for the additional percent rate_of_tax facts the taxpayer is a domestic bank that acts as a stock transfer dividend paying agent for various u s_corporations including dc a state d corporation as a dividend paying agent generally taxpayer is responsible for withholding u s taxes on payments of u s source income to foreign persons and filing form sec_1042 and 1042-s on date dc declared a dollar_figurex cash dividend subject_to and contingent upon the closing of an initial_public_offering ipo of dc’s common_stock on or before date to its shareholders of record on date the dividend was payable on the earlier of business days following the closing of the ipo or date at the time of the declaration fc a german corporation was one of dc's shareholders and owned a shares or b percent of dc's c shares on date fc sold all of its shares in dc to an underwriter involved with the ipo of dc shares the shares were subsequently sold to the public in the ipo when fc no longer held any shares of dc stock on date dc through taxpayer made a dividend payment to fc and the other shareholders of record taxpayer withheld u s taxes at the rate of percent pursuant to article of the treaty the taxpayer contends that its application of the lower rate of percent on the dividend distribution was appropriate because the term holds is not defined in the treaty taxpayer argues that under u s tax law the shareholder who owns a dividend is generally the person who holds the underlying stock on the record_date citing revrul_82_11 1982_1_cb_51 and technical_advice_memorandum the taxpayer also represents that a shareholder’s dividend entitlement is governed by a corporation’s by-laws and by resolutions of its board_of directors that authorize the payment of a dividend also as a state d corporation the state d corporate code permits dc to use the record_date to determine its shareholders’ entitlement to declared dividends because the record_date determines a shareholder’s tam-108646-00 ownership of a dividend taxpayer argues that fc only needs to hold directly at least percent of the shares as of the record_date to be eligible for the lower rate of percent under the treaty here on the record_date date fc owned b percent of dc an amount greater than percent therefore taxpayer contends that it correctly withheld percent on the gross amount of dollar_figurex further the taxpayer contends if the payment_date is used to determine ownership the effect would be to create a holding_period requirement such a requirement does not exist under the treaty nor is it required under the oecd model tax_treaty it is exam’s position that the dividend payment_date controls the application of the reduced_rate under the treaty because the convention provides little guidance exam contends that according to the commentary to article a of the oecd model tax_treaty the company receiving the dividends must satisfy the requisite ownership on the date of distribution paragraph of the oecd commentary provides that paragraph a does not require that the company receiving the dividends must have owned at least the threshold_percentage of the capital for a relatively long time before the date of the distribution this means that all that counts regarding the holding is the situation prevailing at the time material for the coming into existence of the liability to the tax to which paragraph applies ie in most cases the situation existing at the time when the dividends become legally available to the shareholders exam cites as further authority for its position that under united_states tax law a shareholder includes a dividend distribution in its gross_income when the cash or other_property is unqualifiedly made subject_to his demand ie usually the date of actual receipt or payment see sec_1_301-1 in addition the liability for withholding_tax under sec_1442 arises when constructive or actual payment is made consequently exam contends that the date of payment controls for determining fc’s corporate ownership in dc because on the payment_date date fc no longer owned any stock in dc exam contends that the taxpayer should have withheld at the percent rate on the gross amount of the dividend distribution law and analysis in general sec_881 of the internal_revenue_code code imposes a tax of percent of the amount received from sources within the united_states by a foreign_corporation as interest dividends rents salaries wages premiums annuities compensations remunerations emoluments and other fixed_or_determinable_annual_or_periodical_gains_profits_and_income the mechanism for collecting the tax imposed by sec_881 is provided in tam-108646-00 sec_1441 and sec_1442 sec_1442 provides that in the case of foreign_corporations there shall be deducted and withheld at the source in the same manner and on the same items of income as is provided in sec_1441 a tax equal to percent thereof sec_1441 states in part that all persons in whatever capacity acting having control receipt custody disposal or payment of any items of income specified in sec_871 of any nonresident_alien_individual or of any foreign_partnership shall deduct and withhold from such items a tax equal to percent thereof dividends are an item_of_income specified in sec_871 sec_1_1441-1 provides that withholding is required when such income is paid to the nonresident_alien_individual or foreign_partnership sec_1461 provides in part that every person required to deduct and withhold tax under sec_1442 is liable for such tax however an applicable income_tax treaty may reduce the rate_of_tax sec_894 states the provisions of this title shall be applied to any taxpayer with due regard to any treaty obligation of the united_states which applies to such taxpayer sec_1_1441-6 provides that the rate of percent shall be reduced in accordance with the treaty that the u s has entered into with another country article of the treaty provides that dividends_paid by a company that is a resident of a contracting state to a resident of the other contracting state may be taxed in that other contracting state article of the treaty further provides that such dividends may also be taxed in the contracting state which the company paying the dividends is a resident and according to the laws in that state but if the beneficial_owner of the dividends is a resident of the other contracting state the tax so charged shall not exceed percent of the gross amount of the dividends if the beneficial_owner is a company that holds directly at least percent of the voting shares of the company paying the dividends and percent of the gross amount of the dividends in all other cases it is undisputed that fc held directly at least percent of dc on the record_date date and thus met the minimum ownership requirement under the treaty at that time however by date the date of payment fc no longer owned any shares of dc taxpayer contends that the date of record_date should control for purposes of determining the requisite minimum ownership consequently the issue of whether the lower rate of percent was appropriate depends on which date the record_date the payment_date or another date controls for determining the requisite minimum ownership under article of the treaty the treaty is silent about what date controls for applying the stock ownership test it is clear however under treasury regulations that the identity of the taxpayer and the right to receive the dividend are fixed on the record_date sec_1_61-9 provides guidance on who is required to include dividend income if there is a sale of stock between the date of declaration and the date of tam-108646-00 payment when stock is sold after the declaration of a dividend and after the date as of which the seller becomes entitled to the dividend the dividend is ordinarily income to the seller when stock is sold between the time of declaration and the time of payment of the dividend and the sale takes place at such time that the purchaser becomes entitled to the dividend the dividend is ordinarily income to him the regulations however do not provide any examples to illustrate when the seller or purchaser is entitled to a dividend instead this subject has been addressed in revrul_82_11 1982_1_cb_51 as well as technical_advice_memorandum june in revrul_82_11 the service states that where the shareholder is contractually entitled to the dividend as of the record_date the shareholder’s right to receive the dividend for federal_income_tax purposes becomes fixed as of that date the ruling dealt with a corporate taxpayer who sold its stock after the record_date but before the payment_date the service reasoned that the selling taxpayer cannot shift the burden of income_taxation on dividends by selling the underlying shares of its stock to another corporation after the dividend has been declared and it has been determined that the selling taxpayer as the record holder of the shares on the record_date is entitled to the dividend similarly in technical_advice_memorandum the service stated that when a corporation declares a dividend payable to stockholders of record on a date subsequent to that of the declaration the holder of the stock on the date of record and not on the date declaration is entitled to the dividend it is also clear that the payment_date controls for purposes of including the dividends in income and determining when taxes are due and payable sec_1_301-1 provides that a shareholder includes a dividend distribution in its gross_income when the cash or other_property is unqualifiedly made subject_to his demand ie usually the date of actual receipt or payment in addition liability for the withholding_tax under sec_1442 arises when payment is made neither authority provides conclusive evidence however of the appropriate date on which to determine the requisite percentage ownership for purposes of article of the treaty the technical explanation to the treaty states that as a starting point for negotiating the treaty the united_states and germany used the model double_taxation convention on income and capital of the organisation_for_economic_co-operation_and_development the oecd model tax_treaty as well as other model treaties for guidance thus it may be helpful to look to the oecd model treaty and the official commentary thereto for guidance regarding the interpretation of the treaty the language of the dividends article of the treaty in substance parallels articles and of the oecd model tax_treaty except for the stock percentage ownership requirement paragraph of the commentary to article a of the oecd model tax_treaty provides language identical to that contained in the commentary to the oecd model tax_treaty cited in both the taxpayer’s and tam-108646-00 exam’s submissions paragraph provides that paragraph a does not require that the company receiving the dividends must have owned at least the threshold_percentage of the capital for a relatively long time before the date of the distribution this means that all that counts regarding the holding is the situation prevailing at the time material for the coming into existence of the liability to the tax to which paragraph applies ie in most cases the situation existing at the time when the dividends become legally available to the shareholders the main purpose of paragraph of the oecd commentary to article is to make clear that the model does not require a specified holding_period of the stock prior to the date of dividend distribution however the commentary is ambiguous about whether the time for determining the requisite ownership of stock is the record_date the date of distribution or some other date the commentary merely says that all that counts regarding the holding is the situation prevailing at the time material for the coming into existence of the liability to the tax this would appear to take into account all of the facts and circumstances surrounding the creation of the liability for tax none of the above cited authorities directly answer the question however after considering all of the above we believe the better view is that the percentage of stock ownership should be determined on the record_date the date that dividend ownership is determined if the date of payment controlled for determining stock ownership under article of treaty only the person who held the stock on the payment_date would be eligible for the lower rate of percent this could lead to unintended and inappropriate results for example if a german company owned percent of a domestic company on the date of record but percent when paid the recipient would receive the reduced_rate of tax on the dividends relating to only percent ownership here fc sold all of its shares in dc after the record_date and before the payment_date fc’s selling of its stock in the ipo cannot change its entitlement to the declared dividend fc’s right to receive the dividend for federal_income_tax purposes became fixed as of the record_date accordingly the record_date should control for purposes of determining fc’s requisite minimum ownership to be eligible for the lower rate of percent under article of the treaty on the dividend distribution to fc although the law of state d supports this position it does not control the analysis in this case see 324_us_393 conclusion i as set forth above in this case the record_date controls for determining whether fc met the stock ownership requirement under article of the treaty on the record_date date fc held directly b percent an amount greater than tam-108646-00 percent and thus met the minimum corporate ownership required by article to be eligible for the lower rate_of_tax of percent accordingly the taxpayer properly withheld tax at the percent rate on the gross amount of the dividend distribution pursuant to sec_1442 ii because we have determined that the taxpayer properly withheld percent on the gross amount of the dividend distribution pursuant to sec_1442 we do not need to address the issue of taxpayer’s liability if the amount of tax due was greater than percent caveat s a copy of this technical_advice_memorandum is to be given to the taxpayer s sec_6110 of the code provides that it may not be used or cited as precedent -end-