t c memo united_states tax_court mark and lucy kerman petitioners v commissioner of internal revenue respondent docket no filed date scott r cox and brennan s cox for petitioners mark d eblen and dessa j baker-inman for respondent memorandum opinion goeke judge during mark and lucy kerman sold big_number shares of kenmark optical inc kenmark stock generating gain and leaving them facing a contingent tax_liability petitioners entered into a custom adjustable rate debt structure cards transaction in order to reduce their tax_liability the cards transaction generated a loss reported on petitioners’ form_1040 u s individual_income_tax_return respondent’s notice_of_deficiency determination would disallow the loss and impose a percent penalty under sec_6662 for the reasons stated herein we find that petitioners are not entitled to the claimed loss and are liable for the penalty background the stipulations of fact and the accompanying exhibits are incorporated herein by this reference petitioners resided in kentucky at the time of filing their petition kenmark kenmark was founded in by mark kerman mr kerman who was in charge of kenmark from its inception through kenmark imports eyeglass frames from the far east italy and france and sells them to retailers optometrists and opticians throughout the united_states and abroad during its first several years of existence kenmark had sales of approximately dollar_figure million in sales increased to about dollar_figure million and by sales were approximately dollar_figure million at the time of trial sales were about dollar_figure million for kenmark was an s_corporation its profits flowed through to its shareholders including mr kerman with his share of the profits shown on his schedule e supplemental income and loss before mr kerman 1all section references are to the internal_revenue_code and all rule references are to the tax_court rules_of_practice and procedure was ceo of kenmark and owned percent of its stock additionally mr kerman was paid dollar_figure as compensation and dollar_figure in rents by kenmark during mr kerman sold percent of his stock to an employee_stock_ownership_plan of kenmark for dollar_figure million and recognized gain of dollar_figure million facing large contingent tax_liabilities as a result of this gain mr kerman sought ways to offset the gain one possible solution was a cards transaction introduction to cards petitioners participated in a cards transaction in the transaction was developed by chenery associates inc chenery a promoter a chenery associates inc chenery was incorporated in roy hahn mr hahn was a principal at chenery chenery developed and promoted tax_shelters working with different investment banks in new york to implement its transactions chenery developed and implemented numerous cards transactions including the cards transaction at issue and received fees for each a portion of the fees was used to pay the third parties involved in the specific cards transaction and their counsel b bruce cohen and craig stone bruce cohen mr cohen and mr kerman have been good friends for years mr cohen learned about the cards transaction at a seminar which taught ways to avoid tax at one of the tax seminars mr cohen met craig stone mr stone an employee at chenery where mr stone was giving a presentation about cards transactions knowing that mr kerman had recently sold stock and needed some tax help mr cohen told him about the cards transactions and introduced mr stone to mr kerman c decision to enter into a cards transaction on or about date petitioners entered into a cards transaction the cards transaction in general a cards transaction has three phases the loan origination phase the loan assumption phase and the operational phase in general three parties are required to carry out a cards transaction a bank a borrower and an assuming party a loan origination phase during the loan origination phase the bank agrees to lend funds to the borrower the borrower is a delaware limited_liability_company with two members both of whom are united kingdom citizens to ensure that there are no u s income_tax effects at the borrower level the bank requires the borrower to be capitalized in an amount equal to percent of the funds to be borrowed the loan is typically for years with principal due after years but interest due annually the credit agreement memorializing the loan imposes restrictions on how the loan proceeds can be used collateralization requirements imposed by the bank require the borrower to use the loan proceeds to acquire highly stable items such as government bonds or highly rated commercial paper after initially collateralizing the loan with high-value stable assets such as treasury bonds or promissory notes from the bank the borrower can substitute collateral and gain access to the loan proceeds in effect the loan proceeds are initially used to purchase high-value items to serve as collateral for the loan until an item of equally high value can be swapped for the purchased items this swapping of collateral purportedly frees some of the loan proceeds to be used for investment purposes as the borrowers see fit however the decision to swap collateral is not left to the discretion of the borrower the bank ultimately decides whether and on what terms a certain asset or security can be used as collateral b loan assumption phase the second_phase is the loan assumption phase--when the assuming party would assume a portion of the loan on behalf of the borrower the assuming party would receive only a portion of the loan proceeds but would agree to become jointly and severally liable for the entire amount of the original loan to the borrower the assuming party would assume a portion of the loan equal to the present_value of the principal_amount due in years c operational phase the operational phase consists of periodic reset dates each reset date allows the borrower to exchange collateral with corresponding adjustments of the interest rate and of the term until the next reset date the decision to swap collateral or adjust the interest rate at a reset date is left to the discretion of the bank if new collateral is proposed it often results in a change_of loan terms to reflect any adjustments to the amount of risk the parties face the purported purpose behind a cards transaction was to provide investment financing a cards participant would enter into the cards transaction and use the assumed portion of the loan proceeds to make an investment the investment_property would then be swapped as collateral in theory the investment would be successful if the rate of return on the investment_property exceeded the costs of entering into the cards transaction 2for instance suppose the amount of the original loan from the bank to the borrower was dollar_figure million the assuming party would assume a portion dollar_figure million of the loan the dollar_figure million would be transferred from the borrower to the assuming party and in exchange the assuming party would become jointly and severally liable for the entire dollar_figure million loan mr kerman and third parties a bayerische hypo-und vereinsbank ag bayerische hypo-und vereinsbank ag hvb acted as the lender in the cards transaction at issue b colindale colindale financial trading l l c colindale was a special-purpose limited_liability_company with elizabeth a d sylvester and michael sherry citizens and residents of the united kingdom as its members the members colindale was formed solely for petitioners’ cards transaction acting as the borrower colindale was capitalized via a note receivable from the members in the amount of big_number the note receivable was colindale’s only asset listed on its balance_sheet on date the cards transaction at issue a origination on date colindale entered into a credit agreement with hvb structured finance hvb as its agent whereby hvb purportedly extended a custom adjustable rate debt loan the loan to colindale in the amount of big_number with a stated year term the credit agreement provided that colindale was required to give hvb its notice of borrowing at least business days before the transaction the loan term was divided into annual interest periods with the exception of the first interest period which extended from date until date and of the second interest period which extended from the end of the first interest period to date under the terms of the loan hvb could adjust the interest rate annually for the first interest period the interest rate was set at the london_interbank_offered_rate libor plu sec_50 basis points or percent the credit agreement provided that the loan could be prepaid by the borrower without premium or penalty on the last day of any interest period excluding the first the interest rate on the loan during the second interest period ending date wa sec_5 percent on date colindale issued a notice of borrowing that stated colindale’s commitment to borrow big_number and requested that the proceeds of the borrowing be credited to colindale’s euro account ending in colindale’s euro account the notice of borrowing provided that the loan proceeds were to be credited to an account ending in maintained at the offices of hvb colindale’s obligation to repay the loan was documented by a promissory note issued by colindale to hvb for big_number due on december on date hvb credited to colindale big_number in colindale’s euro account on date colindale entered into a master pledge and security_agreement mpsa that pledged to hvb all of colindale’s holdings at hvb and their proceeds as collateral for the loan the mpsa provided that if the loan was in default hvb had the right to take possession of hold collect sell lease deliver grant options to purchase or otherwise retain liquidate or dispose_of all or any portion of colindale’s pledged collateral and apply any proceeds from the foregoing to expenses_incurred in retaking holding collecting or liquidating colindale’s pledged collateral as well as to the payment of amounts due under the credit agreement and or other loan documents on date colindale entered into a deposit account pledge in favor of hvb chenery deposited big_number into hvb for credit to colindale’s balance on date colindale purchased an hvb time deposit in the amount of big_number maturing on date at a rate of percent colindale’s hvb time deposit paid a rate that wa sec_50 basis points less than the loan rate b assumption by the members on date colindale entered into an assumption_agreement with petitioners which provided that petitioners became jointly and severally liable for colindale’s obligations under the credit agreement and promissory note which included repayment of the loan principal of big_number on date petitioners entered into an assuming party master pledge and security_agreement the assuming party mpsa that pledged to hvb as collateral all of petitioners’ holdings at hvb and their proceeds if the loan was in default hvb had the right to take possession of hold collect sell lease deliver grant options to purchase or otherwise retain liquidate or dispose_of all or any portion of petitioners’ pledged collateral and apply any proceeds from the foregoing to expenses_incurred in retaking holding collecting or liquidating petitioners’ pledged collateral as well as to the payment of amounts due under the credit agreement and or other loan documents the pledged collateral was held at hvb under a dollar pledge hvb pooled account with a number ending in and in a euro pledge hvb pooled account with a number ending in sylvie demetrio an employee of hvb stated that hvb did not need an account for each purchaser of the cards transaction only a customer number not associated with any account and that hvb would instead use one retail account under financial engineering which will act as an omnibus account running the money through for the clients petitioners’ customer number at hvb was the assuming party mpsa provided that petitioners could request to substitute other collateral in place of the pledged collateral but only at hvb’s discretion if hvb were to release a portion of the loan proceeds the assuming party mpsa required that petitioners execute and deliver a deposit account pledge and a securities account control agreement on date colindale and petitioners entered into a purchase agreement whereby colindale sold to petitioner sec_15 percent or big_number of colindale’s hvb deposit that had been pledged as collateral the purchase agreement provided that petitioners would be jointly and severally liable for all obligations under the loan not covered by colindale’s collateral colindale and petitioners agreed that colindale would be responsible for interest payments on the loan and petitioners would be responsible for all other_amounts due under the terms of the loan to the extent not covered by seller collateral if colindale did not pay the interest petitioners had to pay the interest colindale could have sold some of the collateral to make the interest payments petitioners would have to make up the shortfall in the collateral if colindale did not make the interest payments petitioners waived their right of contribution against colindale petitioners agreed to waive their right of contribution against colindale because the cards promoters told them to do so however the waiver did not prevent petitioners from obtaining reimbursement from colindale’s collateral if colindale violated the payment arrangement sec_5 f of the purchase agreement provided that colindale would not request the release or withdrawal of any collateral without petitioners’ prior written consent petitioners did not waive their right of contribution against colindale for any breach of sec_5 f of the purchase agreement the purchase agreement provided that colindale’s collateral would be applied first to interest payments then to the seller’s profit then to the discharge of credit obligations under the loan other than principal and lastly to the payment of loan principal on date kenmark wired dollar_figure to hvb that amount was credited to petitioners in an hvb pooled account with a number ending in on date kenmark debited its account payable to petitioners in the amount of dollar_figure hvb debited big_number from colindale’s balance and credited it to petitioners’ balance in an hvb pooled account with a number ending in the cards promoters instructed petitioners to sell the euro on the date they wanted the tax loss on date petitioners exchanged big_number of the big_number for dollar_figure on date petitioners told hvb to sell of the euros in my account big_number before the close of business on date hvb had already exchanged for dollar_figure on 3on date petitioners entered into a forward exchange contract to exchange dollar_figure for big_number on date the forward_contract was in the amount necessary to pay off petitioners’ 15-percent portion of the loan date dollar_figure of the euro credited to petitioners’ balance before they told hvb to do so on date petitioners exchanged big_number of the big_number for dollar_figure petitioners were credited with a total of dollar_figure from their foreign_currency exchanges as a result of the conversion petitioners claimed an ordinary_loss of dollar_figure for the taxable_year on form_4797 sales of business property of their federal tax_return petitioners claimed a dollar_figure loss from the sale of foreign_currency on date mr hahn of chenery wired dollar_figure to hvb that amount was credited to petitioners’ balance in an hvb pooled account with a number ending in the amounts credited to petitioners’ balances in the hvb pooled accounts were used to purchase three different time deposits each of which had a maturity_date of date on date petitioners purchased the first time deposit time deposit in the amount of dollar_figure with an interest rate of percent and a maturity_date of date on date petitioners purchased the second time deposit time deposit in the amount of dollar_figure with an interest rate of percent and a maturity_date of date on date petitioners purchased a third time deposit time deposit in the amount of dollar_figure with an interest rate of percent and a maturity_date of date during the year time deposit sec_1 and were in financial engineering’s u s dollar account with a number ending in hvb’s usd account on date time deposit in the amount of dollar_figure plus accrued interest of dollar_figure totaling dollar_figure was credited to petitioners in hvb’s usd account on date dollar_figure of the proceeds of time deposit was wired from hvb to chenery in partial payment of chenery’s fees due from petitioners on date petitioners sent a letter to hvb and colindale stating their intention to pay-off and thereby terminate the loan on date on date time deposit in the amount of dollar_figure plus accrued interest of dollar_figure for a total of dollar_figure was credited to petitioners’ balance in hvb’s usd account in date petitioners executed a control agreement between kerman investments l l c and hvb for a salomon smith barney ssb account with a number ending in and in the name of hvb secured party f b o kerman investments llc sylvie demetrio informed petitioners’ attorneys that to use their portion of the loan as operating capital for kenmark petitioners would have to provide firm collateral to guarantee the proceeds such as a letter_of_credit from a major bank a certificate of deposit or other safe collateral acceptable to hvb as of date hvb notified petitioners’ attorney that it would not be cost effective for petitioners to extend the cards loan past date because the bank would exercise its right under the credit agreement to increase the spread on the loan to an unfavorably high rate on date after petitioners had given hvb notice of their intent to terminate the loan hvb transferred dollar_figure of petitioners’ balance to ssb account no by way of the control agreement hvb controlled the dollar_figure transferred to ssb account no pursuant to the control agreement ssb account no had to be a cash securities account meaning petitioners could invest only in cash cash equivalents or qualified municipal_bonds which were certain aaa-rated bonds petitioners had to obtain hvb’s prior written consent to make any other investments petitioners could not withdraw any of the proceeds from ssb account no unless they replaced those proceeds with cash cash equivalents or qualified municipal_bonds of equal value if petitioners wanted to replace the proceeds with marketable_securities they had to obtain hvb’s prior written consent petitioners stated that the dollar_figure transferred from hvb to ssb account no in the name of kerman investments l l c was a payment of fees to the cards promoters the dollar_figure transferred from hvb to ssb account no could not have been a payment of fees to the cards promoters after hvb wired the dollar_figure to ssb account no the remaining dollar_figure was immediately deposited back to time deposit petitioners could not withdraw or transfer any of the dollar_figure from ssb account no on date hvb issued a mandatory prepayment election notice to petitioners which stated that the outstanding principal_amount of the loan plus accrued interest would be due on date on date sylvie demetrio emailed petitioners’ attorneys that the payoff of petitioners’ portion of the loan was not an early unwind this is a scheduled reset and the bank has simply opted not to continue with the facility as it stands there have been no special circumstances surrounding the unwind of this transaction on date petitioners’ time deposit at hvb matured because of the dollar_figure wire from hvb to kerman investments l l c petitioners had a shortfall of dollar_figure to unwind the cards transaction on date petitioners wired dollar_figure from an account titled hvb secured party f b o kerman investments llc with a number ending in to hvb all of the dollar_figure withdrawn from hvb remained in ssb account no until dollar_figure was transferred back to hvb on date the remaining funds stayed in ssb account no until withdrawn on date which is after the loan was repaid on date on date the forward_contract matured and settled causing dollar_figure in hvb’s usd account to be exchanged for big_number which was credited to petitioners’ balance in an hvb pooled account with a number ending in the actual amount required to pay off petitioners’ 15-percent portion of the loan was big_number on date hvb debited petitioners’ dollar_figure balance in the account with a number ending in and credited this amount to colindale on date colindale paid dollar_figure from its euro account in repayment of the cards loan which comprised big_number of principal and dollar_figure of interest of the big_number petitioners provided big_number which was credited into colindale’s euro account on date after the payoff of petitioners’ portion of the loan hvb held dollar_figure of petitioners’ funds on date hvb wired dollar_figure to ssb account no which was in the name of hvb secured party f b o kerman investments llc on date michael shields mr shields chief financial officer of kenmark during faxed to steve goodman mr goodman petitioners’ attorney their termination agreement dated date for their cards transaction and asked mr goodman to review the agreement and let him know whether he approved of it petitioners did not sign the termination agreement until after date on date hvb sent notice to ssb terminating the control agreement for kerman investments l l c ’s ssb account no thereby releasing this account from collateralization on date petitioners transferred dollar_figure from ssb account no to an ssb account with a number ending in in the name of kerman investments l l c on date petitioners transferred dollar_figure from ssb account no to the ssb account with a number ending in that amount was the balance of account no colindale’s members signed a unanimous written consent to dissolve colindale as of date on date colindale filed a certificate of cancellation with the delaware secretary of state’s office because colindale had no assets and ceased transacting business_discussion i burden_of_proof tax deductions are a matter of legislative grace and a taxpayer has the burden of proving that he is entitled to the deductions claimed rule a 503_us_79 292_us_435 the burden_of_proof on factual issues that affect a taxpayer’s liability for tax may be shifted to the commissioner where the taxpayer introduces credible_evidence with respect to such issue sec_7491 petitioners have failed to establish that they have satisfied the requirements of sec_7491 on the record before us we find that the burden_of_proof does not shift to respondent under sec_7491 ii economic_substance_doctrine the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes or altogether avoid them by means which the law permits cannot be doubted 293_us_465 however even if a transaction is in formal compliance with internal_revenue_code provisions a deduction will be disallowed if the transaction is an economic sham am elec power co v united_states 326_f3d_737 6th cir the parties have not formally stipulated where an appeal of this case would lie both petitioners and respondent focus on caselaw of the sixth circuit in their posttrial briefs the court_of_appeals for the sixth circuit has stated ‘the proper standard in determining if a transaction is a sham is whether the transaction has any practicable economic effects other than the creation of income_tax losses ’ 435_f3d_594 6th cir quoting 868_f2d_851 6th cir affg 88_tc_386 w hen ‘it is patent that there is nothing of substance to be realized by the taxpayer from a transaction beyond a tax deduction ’ the deduction is not allowed despite the transaction’s formal compliance with code provisions am elec power co v united_states supra pincite quoting 364_us_361 if the transaction has economic_substance ‘the question becomes whether the taxpayer was motivated by profit to participate in the transaction ’ dow chem co v united_states supra pincite quoting 982_f2d_163 6th cir affg t c memo ‘if however the court determines that the transaction is a sham the entire transaction is disallowed for federal tax purposes ’ id and no subjective inquiry into the taxpayer’s motivation is made id pincite a court will not inquire into whether a transaction’s primary objective was for the production_of_income or to make a profit until it determines that the transaction is bona_fide and not a sham rose v commissioner supra pincite iii petitioners’ arguments petitioners argue that the cards transaction had economic_substance and was entered into to provide flexible cash reserves and lending opportunities to fund kenmark petitioners contend that the cards transaction was a bona_fide transaction that was specifically designed to create a synthetic 30-year coupon lending facility according to petitioners the cards transaction generated income and had economic_substance separate and distinct from the economic benefit derived from a tax deduction in the form of dollar_figure earned on the amounts held by hvb bank and the off- balance-sheet financing provided to kenmark from the cards loan lastly petitioners argue that they are entitled to claim the loss because they acquired property subject_to a loan by paying consideration and assuming liability for the loan petitioners contend that because they purchased the assets part of the consideration they gave was their assumption of the loan for which they became jointly and severally liable and thus at risk for the repayment of the entire amount of the loan upon the sale of the foreign_currency the basis of which was the entire loan petitioners generated an ordinary_loss valued at the difference between the value of the currency purchased and the entire loan the loss from the exchange and sale of the loan assets was a foreign_currency_loss under sec_988 because it was an acquisition of a nonfunctional_currency consequently petitioners are entitled to claim an ordinary_loss calculated as the difference between the basis of the euro-currency deposit and its value iv respondent’s arguments respondent first argues that the cards transaction lacked economic_substance and had no practical effect other than the creation of income_tax losses because no economic outlay to create basis occurred and the claimed loss was not incurred_in_a_trade_or_business or in a transaction entered into for profit respondent claims that petitioners’ cards transaction was almost identical to the one in country pine fin l l c v commissioner tcmemo_2009_251 in country pine finance losses were disallowed in a cards transaction funded by another bank because the cards transaction lacked economic_substance in the opinion the court determined that the transaction lacked economic_substance because it consisted of prearranged steps entered into to generate a tax loss the loan proceeds were never at risk and the transaction giving rise to the tax loss was cashflow negative similar to country pine finance all of the proceeds remained as security at the bank for the sole source of repayment of the loan and therefore the bank bore no risk petitioners purchased a foreign exchange forward_contract that allowed them to convert bank time deposits denominated in dollars back into euro a year after the loan was initiated like country pine finance less than a year after the bank and the l l c entered into the credit agreement the bank informed the other parties that it was no longer willing to maintain the loan all of the borrowed funds were paid back out of the pledged collateral and all amounts lent by the bank were guaranteed by collateral purchased from the bank with the loan proceeds additionally the promoter in this transaction is the same as in country pine finance respondent argues that even if petitioners believed that the cards transaction was a sensible method to provide financing for kenmark that belief would not save the transaction because they have failed the subjective inquiry as they were not motivated by profit to participate in the cards transaction the steps in the cards transaction were part of a single transaction designed to create an inflated basis and corresponding tax loss without any economic outlay or loss next respondent argues that petitioners were never at risk because all of the proceeds remained as security at the bank for the sole source of repayment of the loan and therefore they bore no risk respondent argues that the bank required the entire loan to be fully collateralized and the loan was collateralized by the funds from the loan itself in a pooled account containing the proceeds of other cards transactions petitioners invested their portion of the loan in hvb time deposits which had a stated_interest rate slightly higher than that of the loan but actually a lower effective_interest_rate petitioners knew that the largest portion of the loan colindale’s portion would remain at the bank as collateral and that they were not at risk for it v analysis a objective analysis we begin by analyzing the objective profit potential of the transaction giving rise to the claimed tax loss the transaction giving rise to the loss was the swap of big_number for dollar_figure as part of the cross-currency swap petitioners claimed a basis totaling dollar_figure million in the euro and the promissory note as a result of this inflated basis petitioners claimed losses totaling dollar_figure there were no independent third parties to this transaction chenery was the initial promoter of cards hvb was one of at least two banks chenery used for the approximately cards transactions it sold like the l l c in country pine finance colindale’s sole purpose was effecting the cards transaction and it dissolved less than a year after the transaction ended the fees paid to accommodating parties in connection with cards were based upon the amount of the loan and tax loss created and dependent upon the assumption of the loan the cards transaction 4included in this amount is dollar_figure for amortization fees consisted of prearranged steps entered into to generate a tax loss the loan proceeds were never at risk further kenmark never received any of the loan proceeds kenmark actually paid dollar_figure on petitioners’ behalf to hvb for their cards transaction the terms of the national city bank loan were much more favorable than those of the loan in and the interest rate on the national city bank loan was prime minus one-half percent instead of the libor plu sec_50 basis points which was the rate on the loan the interest on the national city bank loan was tax deductible for kenmark the interest on the loan was to be paid with colindale’s collateral and petitioners had to replenish the collateral and therefore were effectively making the interest payments however they could not deduct those interest payments no investment-banking fee was charged for kenmark’s national city bank loan and kenmark actually had access to those loan proceeds and could use them in its operations there was no requirement that the proceeds from the national city bank loan be left on deposit with the bank additionally mr shields testified that in kenmark was routinely able to get credit on favorable terms this is supported by the fact that interest on kenmark’s loan was at the rate of prime minus one-half percent for and which equaled a loan rate of percent as of date a lawrence kolbe dr kolbe a financial economist testified that the cards transaction resulted in a negative net present_value to petitioners of big_number on the borrowing of big_number this negative net present_value is created by the loan itself and would be a material drag on any investment undertaken by petitioners dr kolbe calculated that the cost of capital for the loan was approximately percent but that petitioners expected to pay interest at a rate of just under percentage points above the market rate because petitioners were effectively making the annual interest payments on the cards loan dr kolbe testified that the total after-tax interest_expense on the loan was more than twice that of a normal loan he testified that regardless of what investment might have been made with petitioners’ portion of the loan proceeds the additional interest_expense would greatly reduce the profitability of that investment relative to proceeds of a normal loan according to dr kolbe the longer the loan remained outstanding the worse the economic outcome for petitioners petitioners’ obligation to repay the principal in years was a liability with a value approximately twice as large as the amount hvb credited them for accepting it the cards transaction did not provide petitioners with a reasonable possibility of profit kevin gibbs mr gibbs petitioners’ certified_public_accountant admitted that petitioners did not make a profit on the cards transaction further the interest rate paid on petitioners’ time deposits at hvb was actually less than the loan rate hvb effectively paid petitioners a euro rate of about percent not a dollar rate of about percent on their dollar time deposits because hvb paid lower interest rates on petitioners’ deposits than it charged on the loan leaving the loan proceeds in the bank guaranteed a loss to them on their portion of the proceeds dr kolbe testified that a normal loan would be a much less costly way to finance whatever investments petitioners had in mind he determined that putting aside the tax deduction the economically rational course of action is to not undertake the cards transaction at all and to end it as soon as possible the loan makes no economic sense as a source of financing the fact that hvb could permit substitution of collateral does not save this transaction from being a sham while hvb could allow substitution of collateral petitioners had no right to substitute collateral they had only the right to request that collateral be substituted and hvb in its sole discretion could consent or refuse the substitution colindale’s sole purpose was effecting the cards transaction and it dissolved less than a year after the transaction ended even if the other parties had been independent the cards transaction would have had no practicable economic_effect on them hvb issued the loan to colindale and the proceeds were invested in hvb time deposits colindale never received the loan proceeds the proceeds stayed at hvb petitioners did not receive the assets upon purchase rather the assets remained in the possession of the bank and even before petitioners’ instruction to do so hvb converted the assets to dollars the dollars were used to purchase hvb time deposits which remained at hvb petitioners never had access to the loan proceeds the proceeds remained in the possession of hvb petitioners entered into the forward_contract which protected them from any foreign_currency risk at all times hvb had sole dominion and control_over the loan proceeds after year the proceeds which never left the bank were used to repay the loan the only economic consequence of this transaction was petitioners’ dollar_figure tax deduction which created a tax_benefit of dollar_figure the amount of the deficiency here colindale was immune from any offsetting gain because of the members’ foreign citizenship the cards transaction was designed to offset petitioners’ long-term_capital_gain income from their sale of the kenmark stock in hvb kept a spreadsheet of assuming parties and the amounts of their desired losses this spreadsheet shows that the amount of the loss before fees petitioners reported on their income_tax return is the amount of loss petitioners desired the amounts reported on petitioners’ return do not match the realities of the cards transaction but instead work to create a loss in the exact amount petitioners desired although they were credited with dollar_figure when they exchanged the big_number petitioners’ return reports an amount_realized of dollar_figure in foreign_currency this lower basis creates an even larger loss of dollar_figure in fact petitioners did not tell mr gibbs their return preparer the actual amounts from the cards transaction instead mr gibbs relied on the promotional materials provided by chenery to determine the amounts to be reported on petitioners’ tax_return b subjective analysis the claimed loss is also disallowed because the members did not have a nontax business_purpose for entering into the cards transaction although the members testified that the decision was made to secure financing for future kenmark investments that testimony is not credible there is substantial evidence that the decision to enter into the cards transaction was solely tax motivated mr cohen a longtime friend of mr kerman and one of his financial advisers introduced him to mr hahn and mr stone of chenery the cards promoters mr cohen learned about the cards transaction while attending a meeting discussing ways to avoid paying taxes and knew that mr kerman was interested in a way to eliminate his large income_tax_liability from selling his kenmark stock mr cohen’s gross fee from chenery for mr kerman’s cards transaction was percent of chenery’s fee or dollar_figure mr cohen testified that before the cards transaction mr kerman had considered another tax_shelter called the basis boost to mitigate petitioners’ tax_liability he also testified that mr kerman’s interest in the cards transaction had nothing to do with kenmark or its operating needs but was based solely on reducing petitioners’ tax_liability from their sale of the kenmark stock another of petitioners’ stated business purposes for the cards transaction was to borrow euro at a low rate to conduct business in europe and to serve as a low risk hedge to overseas transactions contrary to the stated intent petitioners exchanged the euro for dollars almost as soon as they were credited to them dr kolbe testified that if petitioners’ business_purpose was to borrow euro petitioners’ conversion of the euro to dollars was wasteful because of the implicit fee to hvb for the forward_contract to convert the dollars back to euro at the end of the loan he stated that the forward_contract locked in petitioners’ interest rate on its part of the loan in euro not dollars dr kolbe determined that the conversion of the euro to dollars plus the purchase of the forward_contract had the economic_effect of immediately converting petitioners’ just- converted dollar loan proceeds back into euro mr kerman testified that he thought he was assuming the loan to purchase euro and that his expected profit on the cards transaction was to be based on currency fluctuation however the euro were exchanged for dollars almost as soon as they were credited to him and petitioners had no income from currency fluctuation in connection with their cards transaction before entering into the cards transaction petitioners did not prepare or have prepared for them a business plan risk analysis profitability projection or financial projection mr kerman stated that they instead relied on the business plan risk analysis profitability projection and financial projection in the cards promotional materials however the promotional materials contain none of these petitioners believed that the interest rate on the loan was approximately percent but admitted that they were never able to determine the loan’s actual interest rate if petitioners did not know the interest rate on the loan absent the tax loss they could not have determined how the cards transaction could be profitable mr kerman testified that neither he nor his financial advisers legal advisers or accounting advisers ever prepared business plans or profitability projections because only large companies did those types of things without this information mr kerman could not have determined how he could generate a return on the assets that exceeded the all-in cost of borrowing mr kerman developed kenmark into a successful multimillion- dollar business and that he did so without the use of a business plan or a profitability projection is not credible mr kerman testified that he understood that he was assuming a dollar_figure million loan but did not know whose loan he was assuming or the identity of the original borrower mr kerman never heard of colindale or met either of the members or any of its representatives therefore he is claiming to have been willing to assume a dollar_figure million liability of a newly formed entity owned by strangers petitioners stated that the reason they required colindale to represent that neither it nor the members or its manager had a permanent_establishment in the united_states was that the cards promoters told them to do so petitioners did not take notes during meetings with the cards promoters they did not read the cards transaction documents but merely signed the signature pages and had them faxed from mr goodman’s office because they did not read the transaction documents mr kerman testified that he did not know that the proceeds of the loan had to remain at hvb or that he waived his right of subrogation against colindale as new clients of hvb petitioners had to be approved by the bank as clients before they could proceed with the cards transaction there is no evidence of any negotiations between petitioners and colindale as to the terms of the loan or which party would make the principal or interest payments the cards promoters were responsible for structuring the financing arrangements of the cards transaction including arranging a source of funds and negotiating with the funding institution the terms and conditions of the funding another business_purpose alleged by petitioners was to provide working_capital for kenmark while keeping the debt off kenmark’s books this business_purpose is not credible mr shields chief financial officer of kenmark testified that kenmark had almost reached its credit limit with national city bank in the years immediately preceding the cards transaction and needed additional resources for a new vera wang line of eyewear that the company was considering adding according to mr shields for the first year of the vera wang contract kenmark expected to spend dollar_figure to dollar_figure million on advertising and dollar_figure to dollar_figure million for the product itself contrary to mr shields’ and mr kerman’s testimony kenmark had a line of credit with national city bank that was more than sufficient to cover the expected costs of adding the vera wang line as of date kenmark had drawn only dollar_figure of its dollar_figure million line of credit with national city bank kenmark’s loan balance increased an additional dollar_figure to dollar_figure on date and an additional dollar_figure to dollar_figure a year later the additional borrowing demonstrates that kenmark had ready access to working_capital from its bank further petitioners personally guaranteed kenmark’s dollar_figure million line of credit with their dollar_figure million net_worth so kenmark could have drawn the entire dollar_figure million had it needed funds if kenmark really could not have obtained additional financing from national city bank petitioners could have sought other means of financing however there is no evidence that they explored other financing options for kenmark during and there is no evidence in the record of how colindale could have used the loan proceeds to pursue any investment program that would be expected to generate a profit hvb did not face any of the traditional risks associated with lending including interest-rate risk credit default risk foreign exchange risk and liquidity risk because the cards loan proceeds remained either in hvb or under its control c country pine finance in country pine finance l l c v commissioner tcmemo_2009_251 losses were disallowed in a cards transaction funded by another bank because the cards transaction lacked economic_substance in the opinion of the court the transaction lacked economic_substance because it consisted of prearranged steps entered into to generate a tax loss the loan proceeds were never at risk and the transaction giving rise to the tax loss was cashflow negative petitioners’ cards transaction is almost identical to the transaction in country pine finance both cards transactions had no practical economic_effect other than the creation of income_tax losses for petitioners petitioners recognized a large gain in the approximate amount of dollar_figure million on the sale of kenmark stock and sought ways to offset that gain the cards transaction was developed by chenery and involved a special- purpose limited_liability_company colindale acting as the borrower colindale was formed solely for the cards transaction and had the same members as did fairlop trading in country pine finance united kingdom citizens and residents elizabeth a d sylvester and michael sherry like country pine finance the bank and the l l c entered into a credit agreement whereby colindale was required to pledge collateral in order to borrow from hvb like country pine finance petitioners exchanged their portion of the loan proceeds euro for dollars and completed the exchange within days of signing the assumption_agreement like country pine finance less than a year after the bank and the l l c entered into the credit agreement the bank informed the other parties that it was no longer willing to maintain the loan like country pine finance colindale’s sole purpose was effecting the cards transaction and dissolving less than a year after the transaction ended the fees paid to accommodating parties in connection with cards were not standard banking or financial fees but were based upon the amount of the loan and tax loss created and dependent upon the assumption of the loan like country pine finance petitioners claimed a tax basis in percent of the loan here dollar_figure million a sale price of dollar_figure and a loss of dollar_figure which included dollar_figure in amortized transaction costs the cards transaction lacked economic_substance petitioners did not have a nontax business_purpose for entering into the cards transaction because we find that the cards transaction lacked economic_substance it is disregarded for tax purposes and petitioners’ claimed loss is disallowed vi accuracy-related_penalty under sec_6662 and b a taxpayer may be liable for a penalty of percent on the portion of an underpayment which is attributable to among other things a substantial_understatement_of_income_tax a substantial_valuation_misstatement or negligence or disregard of rules or regulations the term negligence includes any failure to make a reasonable attempt to comply with the provisions of internal revenue laws sec_6662 the term disregard includes any careless reckless or intentional disregard id a substantial_understatement_of_income_tax exists if the amount of the understatement exceeds the greater of percent of the tax required to be shown on the return or dollar_figure sec_6662 the term understatement means the excess of the amount of tax required to be shown on the return for the taxable_year over the amount of tax imposed which is shown on the return reduced by any rebate sec_6662 the amount of the understatement is reduced by that portion of the understatement which is attributable to the tax treatment of any item if there is or was substantial_authority for such treatment or any item if the relevant facts affecting the item’s tax treatment are adequately disclosed in the return or in a statement attached to the return and there is a reasonable basis for the tax treatment of such item by the taxpayer sec_6662 however this reduction does not apply to any item attributable to a tax_shelter which is defined as a partnership or other entity any investment plan or arrangement or any other plan or arrangement if a significant purpose of such partnership entity plan or arrangement is the avoidance or evasion of federal_income_tax sec_6662 there is a substantial_valuation_misstatement if among other things the value or adjusted_basis of any property claimed on any return is percent or more of the amount determined to be the correct amount of such value or adjusted_basis sec_6662 if the value or adjusted_basis of any property claimed on a return is percent or more of the amount determined to be the correct amount of such value or adjusted_basis the valuation misstatement constitutes a gross_valuation_misstatement sec_6662 if there is a gross_valuation_misstatement then the 20-percent penalty under sec_6662 is increased to percent sec_6662 and a palm canyon x invs llc v commissioner tcmemo_2009_288 one of the circumstances in which a valuation misstatement may exist occurs when a taxpayer’s claimed basis is disallowed for lack of economic_substance 982_f2d_163 6th cir 132_tc_161 affd without published opinion aftr 2d ustc par big_number 6th cir in the court_of_appeals for the sixth circuit where a transaction is disallowed for lack of economic_substance and the artifice of the transaction was constructed on the foundation of the overvaluation of assets the valuation_overstatement_penalty applies see illes v commissioner supra pincite the accuracy-related_penalty may not be imposed with respect to an underpayment if the taxpayer’s actions regarding it can be justified by reasonable_cause and the taxpayer acted in good_faith sec_6664 reasonable_cause and good_faith are determined on a case-by-case basis taking into account all pertinent facts and circumstances new phoenix sunrise corp subs v commissioner supra pincite sec_1 b income_tax regs the most important factor in determining reasonable_cause and good_faith is the extent of the taxpayer’s effort to assess his proper tax_liability kolbeck v commissioner tcmemo_2005_253 sec_1 b income_tax regs one application of the exception is to a taxpayer’s reasonable reliance in good_faith on the advice of an independent professional adviser as to the tax treatment of an item menard inc v commissioner tcmemo_2004_207 citing 469_us_241 revd on other grounds 560_f3d_620 7th cir sec_1_6664-4 income_tax regs a taxpayer must show that the adviser was a competent professional who had sufficient expertise to justify the taxpayer’s reliance on him the taxpayer provided necessary and accurate information to the adviser and the taxpayer actually relied in good_faith on the adviser’s judgment menard inc v commissioner supra citing 113_tc_135 the advice must not be based on unreasonable factual or legal assumptions including assumptions as to future events and must not unreasonably rely on the representations statements findings or agreements of the taxpayer or any other person for example the advice must not be based upon a representation or assumption which the taxpayer knows or has reason to know is unlikely to be true such as an inaccurate representation or assumption as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a particular manner sec_1_6664-4 income_tax regs a taxpayer is not reasonable in relying on an adviser burdened with an inherent conflict of interest about which the taxpayer knew or should have known am boat co llc v united_states 583_f3d_471 7th cir citing 299_f3d_221 3d cir affg 115_tc_43 66_f3d_729 5th cir affg in part and revg in part tcmemo_1994_228 990_f2d_893 6th cir affg donahue v commissioner tcmemo_1991_181 and 623_fsupp2d_504 s d n y w hen an adviser profits considerably from his participation in the tax_shelter such as where he is compensated through a percentage of the taxes actually sheltered a taxpayer is much less reasonable in relying on any advice the adviser may provide am boat co llc v united_states supra pincite ‘in order for reliance on professional tax_advice to be reasonable the advice must generally be from a competent and independent advisor unburdened with a conflict of interest and not from promoters of the investment ’ new phoenix sunrise corp subs v commissioner supra pincite quoting 440_f3d_375 6th cir affg t c memo reliance on the professional advice of a tax_shelter promoter is unreasonable when the advice would seem to a reasonable person to be too good to be true edwards v commissioner tcmemo_2002_169 citing pasternak v commissioner supra pincite 90_tc_960 affd without published opinion 899_f2d_18 9th cir and gale v commissioner tcmemo_2002_54 affd 119_fedappx_293 d c cir petitioners reviewed the cards promotional materials all of which focus on the tax consequences of the transaction the materials describe the steps of a cards transaction exactly as petitioners’ transaction was executed and included a statement that the lender is the custodian of and receives a security_interest in the collateral the materials also state that the transaction can be structured to generate ordinary or capital losses and that if ordinary losses are desired the borrowing is denominated in a non-united states currency the promotional materials warn that the irs might challenge the transaction and that the tax law requires taxpayers to possess a business_purpose and a transaction to have economic_substance to be respected for federal_income_tax purposes irs notice_2000_44 2000_2_cb_255 which is included in the cards promotional materials contains the statement that tax losses from transactions similar to cards that are designed to produce noneconomic tax losses by artificially overstating basis are not allowable as deductions for federal_income_tax purposes the materials also alert potential assuming parties that the irs may determine that the cards transaction results in an unintended tax_benefit to the assuming party petitioners understood that they were an assuming party the promotional materials also state that an assuming party includes the entire face_amount of the loan proceeds in its tax basis and that the value of the loan proceeds is only percent of the loan the materials further explain that a tax loss of approximately percent of the loan results when the foreign_currency is converted into united_states dollars and that the taxpayer claims a tax loss even though the taxpayer has incurred no corresponding economic loss the materials contain the caveat that the existence of a nontax business_purpose is a requirement for participating in the transaction and that the tax treatment assumes that the investor expects to earn a return on the use of the loan proceeds in excess of the all-in cost of the loan petitioners knew or should have known that any advice they received from chenery or anyone associated with chenery was not independent because chenery stood to benefit from the promotion of the cards transaction they came into contact with chenery and its associates because petitioners were looking for a way to mitigate their large capital_gain and considering tax savings strategies due to the sale of the kenmark shares chenery was responsible for structuring the financing arrangements of petitioners’ cards transaction including arranging a source of funds negotiating with the funding institution hvb the terms and conditions of the funding and providing a tax opinion chenery received a dollar_figure fee based on the amount of the loss generated for petitioners any advice from chenery or any of its associates was burdened with an inherent conflict of interest petitioners did not read any of the cards transaction documents but provided them to mr shields to review although they claimed to have relied on advice from mr gibbs and louis t roth co the accounting firm neither provided them with a written tax opinion for the cards transaction petitioners could not have reasonably relied upon any other advice given by mr gibbs as they did not provide necessary and accurate information to him this is evidenced by the fact that mr gibbs did not know the most basic facts about petitioners’ cards transaction such as the amount of u s dollars petitioners were credited with when the big_number was exchanged instead of fully disclosing the facts concerning the cards transaction to mr gibbs mr kerman testified that he did not know but assumed that mr gibbs saw the cards transaction documents mr gibbs evidently relied on the promotional materials and a tax opinion prepared by brown wood a law firm in completing petitioners’ income_tax return and in advising petitioners mr kerman also testified that he was not sure but assumed that mr goodman saw the cards promotional materials it appears that mr goodman did see the cards materials because he asked mr stone some questions about the transaction mr goodman gave petitioners no written opinion with respect to petitioners’ cards transaction petitioners estimated that they paid fees to mr goodman in an amount between dollar_figure and dollar_figure to review the transaction but did not provide copies of mr goodman’s bills petitioners also could not have reasonably relied upon the tax opinion provided by r j ruble mr ruble a partner with brown wood before petitioners entered into the cards transaction mr hahn and mr stone assured them that they would receive a tax opinion from brown wood that would ensure they would not be liable for tax penalties if the cards transaction was determined to be an invalid tax_shelter petitioners knew that mr ruble and brown wood were working together with the cards promoters they also knew or should have known that the brown wood opinion was not independent advice and that mr ruble had an inherent conflict of interest mr hahn and mr stone also promised petitioners that they would receive benefits from the cards transaction when filing their tax returns petitioners relied on the representation of the cards promoters that the cards transaction would earn a return on investment that exceeded the dollar_figure cost of the transaction and that it was a sound business transaction with tax advantages petitioners assumed they could earn a profit on their portion of the loan proceeds while mr shields testified that he spoke with mr ruble and mr goodman about several of the cards transaction documents he admitted that they merely discussed that the various documents were consistent with the transaction as presented to him and to petitioners mr shields never testified that he spoke with either mr ruble or mr goodman about the tax treatment of the cards transaction the tax opinion states that chenery is the arranger of the cards transaction developed the structure identified the llc and its members negotiated the credit facility with the bank arranged for the transaction’s documentation and presented completed financing to petitioners for evaluation and assumption the tax opinion discloses that chenery would receive an investment banking fee from petitioners and that colindale would receive a fee for incurring the loan the final version of brown wood’s tax opinion was identical to the draft provided to petitioners by the cards promoters before the transaction consequently they must have known that the cards transaction was not unique to their situation but was instead a transaction for taxpayers seeking tax losses further mr kerman admitted that he did not select brown wood as the law firm to provide the tax opinion and that he had met neither mr ruble nor any attorney at brown wood there is no evidence showing that petitioners had an engagement letter with directly paid any fees to or ever spoke to anyone at brown wood although the credit agreement and the purchase agreement clearly state that brown wood was colindale’s legal counsel in connection with petitioners’ cards transaction mr kerman denied knowing that fact the brown wood tax opinion contains several misstatements and petitioners admitted that the representations in the tax opinion are false and fraudulent it states that the assets were released to petitioners when they purchased them and that they provided substitute collateral as discussed above petitioners never received any of the loan proceeds and never substituted collateral additionally the tax opinion states that petitioners sold the assets on date even though they actually exchanged portions of the euro on december and the tax opinion states that petitioners represented that they had reviewed the transaction summary in the tax opinion and that it was accurate and complete however mr kerman testified that he never reviewed the transaction summary mr kerman represented that he reasonably believed that the assets or the proceeds from the sale could be used to generate a return that would exceed by more than a de_minimis amount the all-in cost of borrowing including fees and costs paid to third parties and without regard to federal income taxes however as discussed above he had no purpose to use the loan proceeds so this representation is false petitioners also represented that every transaction described in the tax opinion actually occurred when it is obvious from the record that the actual cards transaction differed from that represented the tax opinion concludes with a statement that brown wood did not independently verify the representations and documents for the cards transaction and if they were inaccurate in any material respect the tax opinion could not be relied upon petitioners did not read the brown wood tax opinion petitioners cannot rely on an opinion that they knew or should have known came from a law firm with an inherent conflict of interest and that contained blatantly false representations lucy kerman has a college degree in physical therapy mr kerman founded kenmark in and developed it into a successful business he was in charge of kenmark from its inception through was its chairman and ceo in and is currently its chairman of the board in kenmark’s sales were approximately dollar_figure million petitioners became multimillionaires as a result of mr kerman’s efforts with kenmark and had a net_worth of dollar_figure million as of date in general mr kerman testified that he had no knowledge or understanding of the cards transaction he did not read review or remember the documents executed as part of the cards transaction he was either not familiar with or had only a superficial recollection of mr hahn chenery colindale and hvb and its affiliates as mr cohen testified it is obvious that mr kerman was motivated by the tax aspects of the cards transaction to believe mr kerman’s story one must believe that he paid over dollar_figure in fees and costs to receive financing of dollar_figure as a capable businessman and prudent investor mr kerman knew or should have known that the cards transaction was just too good to be true we find petitioners are liable for the 40-percent gross_valuation_misstatement penalty the correct cost_basis of the foreign_currency credited to petitioners’ balance is dollar_figure not dollar_figure million as reported on petitioners’ income_tax return therefore the basis misstatement satisfies the gross_valuation_misstatement threshold pursuant to sec_6662 vii conclusion the cards transaction lacked economic_substance and stood no chance of earning a profit the members did not have a nontax business_purpose for entering into the cards transaction because we find that the cards transaction lacked economic_substance it is disregarded for tax purposes and petitioners’ claimed loss is disallowed petitioners have failed to establish reasonable_cause for the gross_misstatement in the value of the basis of the foreign_currency used in the cards transaction to reflect the foregoing for respondent decision will be entered 5going from dollar_figure to dollar_figure million is a percent increase


t c summary opinion united_states tax_court john a garcia and jamie garcia petitioners v commissioner of internal revenue respondent docket no 498-17s filed date solis cooperson for petitioners sheri a wight for respondent summary opinion thornton judge this case was heard pursuant to the provisions of sec_7463 of the internal_revenue_code in effect when the petition was filed 1unless otherwise indicated all section references are to the internal_revenue_code in effect for the year at issue and all rule references are to the tax_court rules_of_practice and procedure monetary amounts are rounded to the continued pursuant to sec_7463 the decision to be entered is not reviewable by any other court and this opinion shall not be treated as precedent for any other case respondent determined a dollar_figure deficiency and a dollar_figure accuracy-related_penalty with respect to petitioners’ federal_income_tax the issues for decision are whether legal and professional fees paid in are properly deductible as ordinary and necessary business_expenses of petitioners’ wholly owned s_corporation and whether petitioners are liable for the accuracy-related_penalty pursuant to sec_6662 background the parties have stipulated some facts which we incorporate by this reference when they petitioned the court petitioners resided in california shareholder litigation in petitioners purchased big_number shares of stock in randgold exploration co ltd r e a south african exploration and gold mining investment_company at all relevant times petitioners have been the registered owners of the r e shares continued nearest dollar 2the parties filed a stipulation of settled issues resolving all other issues at some point r e shareholders discovered that investec bank ltd investec an international specialist bank had engaged in a fraudulent scheme involving r e stock which ultimately devalued r e shares sometime before a consortium of minority shareholders consortium instituted litigation in a south african court against r e and investec for corporate fraud litigation the purpose of the litigation was to secure judgment in favor of the r e minority shareholders and recover their investments in return for a promised percentage of any ultimate recovery petitioners agreed to finance a portion of the consortium’s legal and related expenses during their commitment totaled at least big_number rand during the consortium made capital calls whereby it invoiced petitioners and other consortium members for their agreed-upon contributions to fund the litigation in response to these capital calls on date petitioners wired dollar_figure from their personal brokerage account with fidelity investments fidelity account 3a group of shareholders that included mr garcia commenced the r e litigation as early as and a second group was formed shortly thereafter to represent a broader group of shareholders on date the applicants ostensibly including petitioners instituted legal proceedings in a south african court seeking an order to require investec to purchase the applicants’ r e shares for a certain price 4in subsequent years petitioners’ commitment increased to at least big_number rand to anglorand securities ltd anglorand another plaintiff in the litigation at the then-current exchange rate this payment satisfied big_number of their total big_number rand commitment to the consortium the remaining big_number rand of the commitment was satisfied by two subsequent roughly equal payments of u s dollars viz on date petitioners wired dollar_figure from their fidelity account to anglorand and on date jgx5 enterprises jgx5 petitioners’ wholly owned subchapter_s_corporation wired dollar_figure from its corporate bank account to anglorand at some unspecified time mr garcia entered into a written_agreement with mankadan investments identified in the record as one of the workers in the consortium to provide professional services to the consortium in return for an extra percentage of any recovery creation of subchapter_s_corporation jgx5 on date jgx5 was incorporated in the state of california with mr garcia as the sole shareholder during jgx5 owned four rental properties described as single-family residences during three of these properties were rented and the fourth was in the process of being rehabbed or refurbished the four rental properties were in southern california during jgx5 managed these properties but did not otherwise engage in property management services to third parties on date petitioners signed two documents each captioned special minutes of jgx5 enterprises one of these documents states in part a money transfers into jgx5 enterprises from john jamie garcia will be deemed loans to the corporation b costs incurred by john jamie garcia associated with the assignment of assets or otherwise transferred to jgx5 enterprises shall be treated as a loan to jgx5 enterprises whereas such costs shall not be in excess of such costs incurred up until the time of the transfer c money transfers out of jgx5 enterprises to john jamie garcia will be deemed repayment of loans or in the event such loans have been repaid such money transfers out of jgx5 enterprises will be considered a sic income distribution or otherwise this document states that any loans are noninterest bearing and are for a term of the greater of years or perpetual term the other document captioned special minutes states that petitioners assign their litigation rights for any investment made by john and jamie garcia to jgx5 enterprises it also states that the business of jgx5 is to make investments including the funding of litigation costs i n exchange for 5although the parties have stipulated that mr garcia was the sole shareholder of jgx5 during mrs garcia signed each of these documents as shareholder a n ownership_interest in the litigation recovery if any the document further states that this memo is to provide further clarity that randgold exploration litigation funding is being done through jgx5 enterprises and that jgx5 enterprises will earn a fair return on its investment for funding such litigation the document states resolved that jgx5 accepts litigation and the costs thereof in return for a reasonable assignment of shares necessary to cover the costs of litigation and provide for a reasonable recovery none of the r e stock was ever actually assigned to jgx5 and as previously stated petitioners remained the registered owners of the r e stock at all relevant times jgx5 never submitted an application to intervene in the r e litigation and none of the legal documents relating to the r e litigation refers to jgx5 tax returns on it sec_2012 form_1120s u s income_tax return for an s_corporation jgx5 listed its business activity code as which corresponds to lessors of residential buildings dwellings including equity reits on the form_1120s jgx5 claimed a deduction for legal and professional fees of dollar_figure and reported an ordinary business loss of dollar_figure on their form_1040 u s individual_income_tax_return petitioners reported wages of dollar_figure earned by mr garcia from his employment as a financial analyst for adp totalsource and claimed a dollar_figure loss on schedule e supplemental income and loss the schedule e loss included the dollar_figure ordinary business loss reported by jgx5 petitioners’ form_1040 reported total_tax of dollar_figure by notice_of_deficiency respondent disallowed dollar_figure of the legal and professional fees deduction claimed by jgx5 respondent also determined that petitioners were liable for the sec_6662 accuracy-related_penalty i deductibility of legal expenses discussion the commissioner’s determinations in a notice_of_deficiency are generally presumed correct and the taxpayer bears the burden of proving those determinations erroneous rule a 290_us_111 deductions are allowed as a matter of legislative grace and the taxpayer bears the burden of proving entitlement to any claimed deduction rule a 6respondent determined in the notice_of_deficiency that petitioners were allowed to deduct dollar_figure of these expenses as a miscellaneous itemized_deduction 503_us_79 292_us_435 the primary issue is whether petitioners are entitled to a pass-through_deduction for certain legal and professional fees that jgx5 claimed on its corporate_income_tax return petitioners claim that dollar_figure of these fees is deductible under sec_162 as ordinary and necessary business_expenses of jgx5 respondent contends that these fees are not deductible under sec_162 but concedes as determined in the notice_of_deficiency that they are properly deductible by petitioners under sec_212 as nonbusiness income- producing expenses the distinction matters inasmuch as a deduction under 7an eligible_small_business corporation that elects s_corporation status is generally exempt from corporate_income_tax see sec_1363 instead the s corporation’s shareholders must report pro_rata shares of the s corporation’s taxable_income losses deductions and credits sec_1366 sec_1 a income_tax regs an s_corporation item generally retains its character for the shareholder sec_1366 an s corporation’s taxable_income is generally computed in the same manner as an individual’s sec_1363 8petitioners have raised no argument and adduced no evidence to support any deduction for dollar_figure of the total dollar_figure of legal and professional fees that respondent disallowed in the notice_of_deficiency we deem petitioners to have waived or conceded any issue as to dollar_figure of the disallowed deduction sec_212 may be less beneficial to petitioners than a deduction under sec_162 sec_162 allows a deduction for all the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business petitioners have not shown that either the first payment of dollar_figure on date or the second payment of dollar_figure on date represented expenses paid_or_incurred by jgx5 so as to support a deduction under sec_162dollar_figure petitioners wired both of these payments to anglorand from their personal account in partial satisfaction of their personal commitment to contribute at least big_number rand of the consortium’s legal expenses we assign little significance to the special minutes that petitioners signed in purportedly assigning the litigation and costs to jgx5 transfers between a corporation and its sole shareholders are subject_to heightened scrutiny and the 9as miscellaneous_itemized_deductions sec_212 deductions unlike sec_162 deductions are generally deductible only to the extent they exceed of an individual’s adjusted_gross_income see sec_67 and may also be limited by application of the alternative_minimum_tax see sec_56 10the taxable_year for which business_expenses may be deducted depends upon whether the taxpayer uses the cash_basis or accrual basis method_of_accounting see sec_7701 the terms ‘paid or incurred’ and ‘paid or accrued’ shall be construed according to the method_of_accounting upon the basis of which taxable_income is computed the record does not reflect whether jgx5 was a cash_basis or accrual basis taxpayer labels attached to such transfers mean little if not supported by other objective evidence e g boatner v commissioner tcmemo_1997_379 aff’d without published opinion 164_f3d_629 9th cir the record contains no objective evidence to suggest that this paperwork altered in any way petitioners’ relationship to the consortium or their personal obligation to the consortium for the legal expenses in question indeed all the evidence shows that the consortium continued to invoice petitioners and not jgx5 for payment of petitioners’ commitment even after the year at issue jgx5 never submitted an application to intervene in the r e litigation and none of the legal documents relating to the r e litigation refers to jgx5 we are similarly unimpressed by petitioners’ assertion that their february and date payments to anglorand represented loans to jgx5 pursuant to the special minutes neither payment could fairly be characterized as a transfer into jgx5 under the terms of the special minutes and there is no objective evidence of a bona_fide expectation of repayment in any event the date payment was made nine days before jgx5 was even incorporated unlike the other two payments the dollar_figure payment on date was in fact made by jgx5 respondent has not argued that this payment was not paid_or_incurred by jgx5 within the meaning of sec_162 as explained below however this payment is also nondeductible by jgx5 because petitioners have failed to show that it was an ordinary and necessary business_expense of jgxdollar_figure for the reasons just discussed the legal and professional fees at issue were the expenses of petitioners rather than of jgx5 a taxpayer generally may not deduct the payment of another person’s expense see 308_us_488 802_f2d_365 9th cir aff’g in part rev’g in part tcmemo_1984_264 115_tc_172 41_tc_358 legal fees paid on behalf of and for services rendered to another are generally not deductible as ordinary and necessary business_expenses of the payer aff’d 373_f2d_87 5th cir an exception to this general_rule may apply if a taxpayer pays someone else’s expenses to protect or promote his own separate trade_or_business see eg 64_tc_132 48_tc_679 this exception 11respondent has not raised and accordingly we do not consider any issue as to whether this amount should be considered a constructive_dividend from jgx5 to petitioners cf 115_tc_172 holding that legal fees a corporation paid for the primary benefit of its sole shareholder constituted nondeductible constructive dividends typically applies only where the taxpayer pays the obligations of another person or entity in financial difficulty and where the obligor’s inability to meet his obligations threatens the taxpayer’s own business with direct and proximate adverse consequences hood v commissioner t c pincite see also 121_tc_168 t he showing a corporation must make to deduct the expenses of its shareholder is a strong one hood v commissioner t c pincite the test is sometimes expressed as having two prongs the taxpayer’s primary motive for paying the expenses must be to protect or promote the taxpayer’s business and the expenditures must constitute ordinary and necessary business_expenses for the furtherance or promotion of the taxpayer’s business lohrke v commissioner t c pincite see also 311_f3d_458 1st cir aff’g tcmemo_2002_40 menard inc v commissioner tcmemo_2004_207 rev’d on other grounds 560_f3d_620 7th cir petitioners do not meet either prong of this test as to the first prong petitioners have not shown that the expenses in question were incurred primarily for the benefit of jgx5 and that any benefit to petitioners was only incidental see capital video corp v commissioner f 3d pincite the benefits to petitioners are obvious the costs were incurred to recover their investments in r e and as they acknowledge on brief treating the payments as business deductions of jgx5 rather than as sec_212 expenses of petitioners would result in more favorable tax treatment for petitioners the business justification for jgx5 to pay these expenses is not at all obvious there is no suggestion for instance that any payment of the expenses by jgx5 would have been motivated by any genuine consideration to avoid adverse business consequences as might result if petitioners were unable to meet their financial obligations the record does not suggest that petitioners were experiencing any financial difficulty in to the contrary in mr garcia reported over dollar_figure of wage income as to the second prong petitioners have not shown that the legal expenses in question represent ordinary and necessary business_expenses in the furtherance of the business of jgx5 the proper focus of our inquiry as applied to legal expenses is on the origin of the subject of the litigation and not on the consequences to the taxpayer capital video corp v commissioner f 3d pincite citing 372_us_39 the origin of the claim was investec’s alleged fraudulent activity that devalued the r e shares that petitioners held as minority shareholders petitioners--not jgx5--joined the shareholder litigation group against investec as noted the litigation and petitioners’ obligation to fund the litigation arose before jgx5 was ever created at all relevant times the r e shares were registered in petitioners’ names as mr garcia testified the purpose of the litigation was to secure judgment in favor of the r e shareholders and recover their investments petitioners contend that in the special minutes they assigned all their r e litigation rights to jgx5 and that the prospect of an ultimate payout to jgx5 from the r e litigation constitutes a legitimate business activity of jgx5 as to which the legal expenses should be deemed an ordinary and necessary business_expense as noted we assign little significance to these special minutes unsupported as they are by any objective evidence in any event contrary to the teaching of gilmore petitioners’ argument focuses improperly on the potential consequences of the r e shareholders’ lawsuit--a potential payout in which jgx5 would allegedly share--rather than upon the origin and character of the underlying claim moreover the absence of any reliable documentation such as a contract defining the role of jgx5 in the litigation or guaranteeing it a share of any future recovery further supports the conclusion that petitioners engaged in the r e litigation in their personal capacities as investors in r e and not on behalf of jgx5 in the light of these considerations we assign little credence to petitioners’ assertions that jgx5 engaged in litigation funding as a business and that petitioners lent money to jgx5 to fund the litigation in the first instance for an activity to constitute a trade_or_business the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit 480_us_23 during the r e litigation was jgx5’s only claimed litigation funding activity we are not convinced that during jgx5 was involved in any litigation funding activity with the continuity and regularity necessary for that activity to constitute a trade_or_business similarly even if as petitioners allege mr garcia through jgx5 provided advisory services to the r e litigation the record does not show that jgx5 provided advisory services with the continuity and regularity necessary for that activity to constitute a trade_or_business petitioners have failed to show that any of the disputed legal and professional fees were paid_or_incurred by jgx5 as ordinary and necessary expenses in carrying on its trade_or_business accordingly we sustain respondent’s determination that these items are not deductible by jgx5 under sec_162 ii accuracy-related_penalty respondent determined that petitioners are liable for a accuracy- related penalty pursuant to sec_6662 and b for an underpayment attributable to a substantial_understatement_of_income_tax under sec_7491 respondent bears the burden of production with respect to this penalty to meet this burden respondent must produce evidence establishing that it is appropriate to impose this penalty once respondent has met his burden of production the burden_of_proof is upon the taxpayer to show that he is not liable for the penalty see 116_tc_438 dollar_figure sec_6662 and b imposes the accuracy-related_penalty on any portion of a tax underpayment that is attributable to any substantial_understatement_of_income_tax defined in sec_6662 as an understatement that exceeds the greater of of the tax required to be shown on the return or dollar_figure the total_tax reported on petitioners’ tax_return was dollar_figure the understatement of income_tax determined in the notice_of_deficiency is dollar_figure therefore the 12the parties have stipulated the existence of a signed supervisory approval form which satisfies any burden of production that respondent has under sec_6751 with respect to the sec_6662 accuracy-related_penalty see graev v commissioner t c __ __ slip op pincite date supplementing and overruling in part 147_tc_460 amount of tax required to be shown on petitioners’ tax_return was dollar_figure petitioners’ understatement_of_tax of dollar_figure exceeds dollar_figure which is of the tax required to be shown on their tax_return thus petitioners’ understatement of income_tax is substantial for purposes of the sec_6662 and b accuracy-related_penalty the court concludes that respondent has met his burden of production for the accuracy-related_penalty for a substantial_understatement_of_income_tax for the accuracy-related_penalty does not apply with respect to any portion of an underpayment if the taxpayer acted with reasonable_cause and in good_faith with regard to that portion sec_6664 reasonable_cause requires that the taxpayer exercised ordinary business care and prudence as to the disputed item 469_us_241 the term good_faith has no precise definition but means among other things an honest belief and the intent to perform all lawful obligations sampson v commissioner tcmemo_2013_212 at the determination of whether a taxpayer acted with reasonable_cause and in good_faith is made on a case-by-case basis taking into account all facts and circumstances higbee v commissioner t c pincite sec_1 b income_tax regs generally the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax_liability sec_1 b income_tax regs other circumstances that may indicate reasonable_cause and good_faith include an honest misunderstanding of fact or law that is reasonable in the light of all of the facts and circumstances including the experience knowledge and education of the taxpayer higbee v commissioner t c pincite sampson v commissioner at sec_1_6664-4 income_tax regs petitioners made no attempts at trial or on brief to establish reasonable_cause and good_faith accordingly we sustain respondent’s determination that petitioners are liable for the sec_6662 penalty for an underpayment attributable to a substantial_understatement of their federal_income_tax the court has considered all of petitioners’ arguments contentions and statements to the extent not discussed herein the court concludes that they are moot meritless or irrelevant to reflect the foregoing decision will be entered for respondent


internal_revenue_service number release date index number --------------------------------------- ----------------------- --------------------------------------- --------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact --------------------- id no ------------ telephone number -------------------- refer reply to cc psi b01 plr-133842-14 date march x a state date date date date date -------------------------------------------------------------------------------------------------------- -------------------------------- -------------------------------------------------------------------------------------------------------- ------------------- -------- ----------------- --------------------- ------------------------- ------------------------- -------------------------------------------------------------------------------------------------------- -------------------- dear -------------- this letter responds to a letter dated date submitted on behalf of x requesting relief under sec_1362 of the internal_revenue_code facts the information submitted states that x was formed under the laws of state on date and elected to be treated as an s_corporation effective date prior to date eligible s_corporation shareholders owned all of the stock of x on date however two of x’s shareholders contributed their stock in x to a a partnership which is an ineligible s_corporation shareholder under sec_1361 x represents that upon discovery of its plr-133842-14 error it promptly took remedial action on date a executed a document transferring all of its x shares to eligible s_corporation shareholders x represents that the transfer of x stock to a an ineligible shareholder was not motivated by avoidance or retrospective tax planning x and its shareholders have continued to treat x as an s_corporation at all times x and its shareholders agree to make any adjustments consistent with the treatment of x as an s_corporation that the secretary may require law sec_1361 defines an s_corporation as a small_business_corporation for which an election under sec_1362 is in effect for the taxable_year sec_1361 provides that a small_business_corporation means a domestic_corporation that is not an ineligible_corporation and that does not have as a shareholder a person other than an estate a_trust described in sec_1361 or an organization described in sec_1361 who is not an individual sec_1362 provides that an election under sec_1362 shall be terminated whenever at any time on or after the first day of the first taxable_year for which a corporation is an s_corporation such corporation ceases to be a small_business_corporation a termination of an s_corporation_election under sec_1362 is effective on and after the date of cessation sec_1362 provides that if an election under sec_1362 by any corporation was terminated under sec_1362 or the secretary determines that the circumstances resulting in such termination were inadvertent no later than a reasonable period of time after discovery of the event resulting in the ineffectiveness steps were taken a so that the corporation is a small_business_corporation or b to acquire the required shareholder consents and the corporation and each person who was a shareholder of the corporation at any time during the period specified pursuant to sec_1362 agrees to make such adjustments consistent with the treatment of the corporation as an s_corporation as may be required by the secretary with respect to such period then notwithstanding the circumstances resulting in such ineffectiveness the corporation shall be treated as an s_corporation during the period specified by the secretary conclusion based solely on the information submitted and the representations made we conclude that x’s s_corporation_election terminated on date when x stock was transferred to a an ineligible shareholder we also conclude that this termination was inadvertent within the meaning of sec_1362 and that under the provisions of sec_1362 x will be treated as plr-133842-14 an s_corporation from date until date when x was restructured provided that x’s s election was valid and was not otherwise terminated except for the specific ruling above we express no opinion concerning the federal tax consequences of the facts described above under any other provision of the code specifically no opinion is expressed concerning whether x was otherwise eligible to be treated as an s_corporation this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent pursuant to a power_of_attorney on file with this office a copy of this letter is being sent to x’s authorized representatives sincerely joy c spies joy c spies senior technician reviewer branch office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes cc