canal corporation and subsidiaries formerly chesapeake corporation and subsidiaries petitioner v commissioner of internal revenue respondent docket no filed date w a wholly owned subsidiary of parent p proposed to transfer its assets and most of its liabilities to a newly formed llc in which w and gp an unrelated corporation would have ownership interests p hired s an investment bank and pwc an accounting firm to advise it on structuring the transaction with gp p also asked pwc to issue an opinion on the tax consequences of the transaction and conditioned the closing on receiving a should opinion from pwc that the transaction qualified as tax free pwc issued an opinion that the transaction should not be treated as a taxable sale but rather as a tax-free contribution of property to a partnership w contributed approximately two-thirds of the llc’s total assets in in exchange for a 5-percent interest in the llc and a special distribution of cash w used a portion of the cash to make a loan to p in return for a note from p w’s only assets after the transaction were its llc interest the note from p and a corporate jet the llc obtained the funds for the cash distribution by receiving a bank loan gp guaranteed the llc’s obligation to repay the loan w agreed to indemnify gp if gp were called on to pay the principal of the bank loan pursuant to its guaranty the llc thereafter borrowed funds from a financial subsidiary of gp to retire the bank loan gp entered into a separate transaction in that required it to divest its entire_interest in the llc for antitrust purposes w subsequently sold its llc interest to gp and gp then sold the entire_interest in the llc to an unrelated party p reported gain from the sale on its consolidated federal_income_tax return for r determined that p should have reported a gain when w contributed its assets to the llc in r has also asserted a substantial_understatement pen- alty under sec_6662 i r c against p in his amended answer verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports held w’s asset transfer to the llc was a disguised sale under sec_707 i r c p must include gain from the sale on its consolidated federal_income_tax return for held further p is liable for an accuracy-related_penalty for a substantial_understatement_of_income_tax under sec_6662 i r c clifton b cates iii robert h wellen and david d sher- curt m rubin matthew i root and steven n balahtsis wood for petitioner for respondent kroupa judge respondent determined a dollar_figure deficiency in petitioner’s chesapeake federal_income_tax for the year at issue respondent asserts in his amended answer that chesapeake owes a dollar_figure substantial_understatement_of_income_tax_penalty under sec_6662 for we must determine whether chesa- peake’s subsidiary’s contribution of its assets and most of its liabilities to a newly formed limited_liability_company and the simultaneous receipt of a dollar_figure million distribution should be characterized as a disguised sale requiring chesa- peake to recognize a dollar_figure million gain in the year of contribution and distribution we hold that the transaction was a disguised sale requiring chesapeake to recognize the gain we must also determine whether chesapeake is liable for the substantial_understatement_penalty under sec_6662 we hold chesapeake is liable for the penalty findings_of_fact some of the facts have been stipulated and are so found we incorporate the stipulation of facts and the accompanying exhibits by this reference chesapeake’s principal_place_of_business at the time it filed the petition was richmond vir- ginia background of chesapeake and wisco chesapeake is a virginia corporation organized as a cor- rugated paper company in chesapeake’s business ha sec_1 all monetary amounts are rounded to the nearest dollar chesapeake corporation changed its name to canal corporation in date we refer to the corporation as chesapeake in this opinion all section references are to the internal_revenue_code code and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner expanded over time into several paper industry segments including merchandising and specialty packaging tissue and forest and land development chesapeake eventually became a publicly traded company and served as the common parent of a group of subsidiary corporations filing consolidated fed- eral income_tax returns each subsidiary managed its own assets and liabilities chesapeake received dividends from the subsidiaries and made loans to the subsidiaries as needed chesapeake’s largest subsidiary was wisconsin tissue mills inc wisco chesapeake purchased wisco’s stock from philip morris in in a leveraged_buyout transaction wisco manufactured commercial tissue paper products including napkins table covers towels place mats wipes and facial and bathroom tissue wisco sold its products to commercial and industrial businesses such as restaurants hotels schools offices hospitals and airlines wisco accounted for percent of chesapeake’s sales and per- cent of chesapeake’s earnings before interest and tax for chesapeake and wisco shared most of the same execu- tive officers wisco incurred significant environmental liabilities during the 1950s and 1960s the environmental protection agency epa determined that a mill wisco operated contaminated the fox river in wisconsin with polychlorinated biphenyls pcbs the epa designated the fox river area as a super- fund site and held five companies including wisco involved in the contamination jointly and severally liable for the cleanup costs fox river liability philip morris indemnified chesapeake for any fox river liability costs up to the pur- chase price of wisco approximately dollar_figure million of the phillip morris indemnity remains chesapeake also pur- chased dollar_figure million of environmental remediation insurance to pay costs beyond those covered by the indemnity chesa- peake’s management estimated that wisco’s remaining fox river liability costs varied between dollar_figure million and dollar_figure mil- lion in in addition to the fox river liability wisco and other chesapeake subsidiaries also guaranteed a dollar_figure mil- lion credit facility enabling chesapeake to acquire another company in verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports tissue business tissue is a capital intensive commodities business and only the largest companies have the ability to make the investment needed to compete in the industry in the late 1990s the tissue business experienced much consolidation fort howard corporation merged with james river corpora- tion to form fort james corporation kimberly-clark cor- poration purchased scott paper company these consolida- tions put smaller tissue businesses at a strategic disadvan- tage chesapeake through wisco and chesapeake’s mexican subsidiary wisconsin tissue de mexico s a de c v wismex was a second tier player in the tissue industry chesapeake sold its retail tissue business to the fonda group inc in wisco and wismex serviced only commercial accounts and lacked the large timber bases needed to support a retail business chesapeake had only two paper mills one in wisconsin and one in arizona and thus was at a significant logistical disadvantage in servicing the southeast and northeast restructuring of chesapeake chesapeake hired tom johnson as its chief_executive_officer and chairman in mr johnson sought to restruc- ture chesapeake he wanted to move chesapeake away from its historic commodity products business and focus on spe- cialty packaging and merchandising services chesapeake’s speciality packaging business involved producing high-value custom packaging for such goods as perfume liquor and pharmaceuticals to that end chesapeake sold certain assets including a mill corrugated box plants a building products business and substantial land chesapeake acquired other businesses and assets to further its specialty packaging business commercial tissue did not fit the new specialty packaging strategy chesapeake examined several options for the future direction of wisco’s tissue business chesapeake considered maintaining the status quo management concluded how- ever that wisco would be too small to compete management further determined that internal expansion would be too dif- ficult and costly management also considered selling chesa- verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner peake and all its subsidiaries management surmised that no one would buy all the diverse subsidiary businesses for an acceptable price pete correll chief_executive_officer of georgia pacific gp made overtures to mr johnson regarding gp purchasing wisco gp’s primary business was the manufacture and dis- tribution of building products timber and paper products gp also had a small profitable tissue business that accounted for to percent of its total sales gp wanted to expand its tissue business but questioned whether gp’s business could grow internally gp viewed the purchase of wisco as a stra- tegic piece in advancing its tissue business chesapeake considered selling wisco to generate capital for chesapeake’s new specialty packaging business given chesapeake’s low tax basis in wisco however the after-tax proceeds would have been low compared to the pre-tax pro- ceeds this tax differential caused chesapeake to decide a direct sale of wisco would not be advantageous chesapeake thereafter engaged salomon smith barney salomon and pricewaterhousecoopers pwc to explore stra- tegic alternatives for the tissue business salomon rec- ommended to chesapeake’s management that the best alter- native for maximizing shareholder value would be a leveraged partnership structure with gp the leveraged partnership structure required wisco to first transfer its tissue business_assets to a joint_venture gp would then transfer its tissue business_assets to the joint_venture next the joint_venture would borrow funds from a third party and distribute the proceeds to chesapeake special distribution chesapeake would guarantee the third-party debt through a subsidiary wisco would hold a minority interest in the joint_venture after the distribution and gp would hold a majority interest salomon presented the leveraged partnership struc- ture as tax advantageous to chesapeake because it would allow chesapeake to get cash_out of the business yet still protect chesapeake from recognizing a gain when the part- nership distributed to chesapeake the proceeds from the third-party loan salomon referred to the leveraged_partnership_deal as project odyssey after homer’s the odyssey and identified chesapeake as calypso and gp as zeus verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports chesapeake’s board liked the leveraged partnership idea and thought gp seemed like a good fit as a partner chesa- peake made clear to pwc and salomon that the asset transfer and special distribution had to be nontaxable for it to approve the transaction tax_deferral enabled chesapeake to accept a lower price gp’s executives accepted the leveraged partnership struc- ture to expand its tissue business gp did not have any interest in chesapeake receiving a tax_deferral gp recog- nized however that it was a necessary part of bridging the purchase_price gap chesapeake agreed to a lower up-front valuation of wisco dollar_figure million because of the tax_deferral benefit pwc assisted salomon in negotiating and structuring the joint_venture pwc examined the transaction from both an accounting and a tax perspective pwc had served as chesa- peake’s auditor and tax preparer for many years donald compton mr compton a partner in pwc’s richmond office managed the chesapeake account and had given chesapeake advice on different tax matters in the past david miller mr miller worked with mr compton on the chesapeake and gp joint_venture pwc advised that chesapeake did not need to guarantee the debt but needed only to provide an indem- nity to the guarantor to defer tax pwc also determined that the transaction should be treated as a sale for accounting purposes mr miller helped structure the indemnity agree- ment and aided in writing the partnership_agreement indemnity agreement gp agreed to guarantee the joint venture’s debt and did not require chesapeake to execute an indemnity mr miller advised chesapeake however that an indemnity was required to defer tax on the transaction chesapeake’s execu- tives wanted to make the indemnity an obligation of wisco rather than chesapeake to limit the economic risk to wisco’s assets not the assets of chesapeake the parties to the transaction agreed that gp would guarantee the joint ven- salomon had valued wisco between dollar_figure and dollar_figure million in mr miller is a licensed attorney he practiced law with the law firm jenkens gilchrist before joining coopers lybrand’s now pwc’s washington national tax practice in he was not a practicing attorney at the time he gave the legal opinion here verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner ture’s debt and that wisco would serve as the indemnitor of gp’s guaranty wisco attempted to limit the circumstances in which it would be called upon to pay the indemnity first the indem- nity obligation covered only the principal of the joint ven- ture’s debt due in years not interest next chesapeake and gp agreed that gp had to first proceed against the joint venture’s assets before demanding indemnification from wisco the agreement also provided that wisco would receive a proportionately increased interest in the joint ven- ture if wisco had to make a payment under the indemnity obligation no provision of the indemnity obligation mandated that wisco maintain a certain net_worth mr miller determined that wisco had to maintain a net_worth of dollar_figure million to avoid taxation on the transaction gp was aware that wisco’s assets other than its interest in the joint_venture were limited gp nonetheless accepted the deal and never invoked the indemnity obligation joint_venture agreement chesapeake wisco and gp executed the joint_venture agreement the two members partners of the joint_venture were wisco and gp the agreement provided that gp would reimburse wisco for any_tax cost wisco might incur if gp were to buy out wisco’s interest in the joint_venture pwc tax opinion chesapeake hired pwc to issue an opinion on the trans- action’s federal tax implications in fact chesapeake condi- tioned the transaction’s closing upon pwc’s issuing a should tax opinion instead of mr compton the pwc partner with the long-term relationship to chesapeake pwc assigned mr miller to write the opinion in effect mr miller’s job was to review the transaction he helped structure mr miller considered three issues whether the joint_venture quali- fied as a partnership for tax purposes whether wisco was a partner in the joint_venture and whether the distribu- we use the terms partners partnership and llc for narrative convenience only as these are the terms used by the parties to the transaction no inference should be drawn from our use of such terms regarding any legal status or relationship verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports tion to chesapeake should be treated as part of a sale or qualifies under the debt-financed distribution exception chesapeake agreed to pay pwc an dollar_figure fixed fee for issuing the opinion the payment did not depend on time spent or expenses_incurred by pwc a letter pwc sent to chesapeake stated that pwc would bill chesapeake at the closing of the joint_venture financing chesapeake’s board informed mr miller that as a condition to closing the trans- action pwc would need to issue the opinion that the special distribution should not be currently taxable a should opinion is the highest level of comfort pwc offers to a client regarding whether the position taken by a taxpayer will suc- ceed on the merits mr miller and his pwc team reviewed the transaction’s structure and approved each item that could affect the tax consequences mr miller crafted an all or nothing test for allocating the joint_venture debt either all the liability would be allocated to wisco or none of it would mr miller reasoned that the transaction would not be characterized as a sale provided the entire liability was allocated to wisco mr miller found no legal authority for such a test he cre- ated the test using his own analysis of then existing rulings and procedures mr miller based his opinion on wisco’s indemnification of gp’s guaranty being respected mr miller assumed that wisco had the ultimate legal liability for the full amount of the debt if the joint_venture became wholly worthless mr miller concluded that wisco could defer gain until it sold its remaining assets paid off the debt or sold its partnership_interest mr miller advised that wisco maintain assets of at least percent of its maximum exposure under the indem- nity mr miller did not have direct authority requiring this percentage he merely made this determination based on revproc_89_12 1989_1_cb_798 which was declared obso- lete by revrul_2003_99 2003_2_cb_388 moreover revproc_89_12 supra makes no reference to allocation of part- nership liabilities revproc_89_12 sec_4 1989_1_cb_798 states that the internal_revenue_service will generally rule that an organization lacks limited_liability if the net_worth of the corporate general partners equals at least percent of the total contributions to the limited_partnership and is expected to continue to equal at least percent throughout the life of the partnership verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner chesapeake also sought to transfer the assets of wismex to the joint_venture pwc informed chesapeake that neither the united_states nor mexico could tax the transfer of wismex’s assets to wisco or the asset transfer from wisco to the joint_venture chesapeake caused wismex to transfer its assets to wisco as advised by pwc mr miller wrote and signed the should opinion before issuing it to chesapeake the parties effected the transaction on the same day pwc issued the should opinion the transaction gp and wisco formed georgia-pacific tissue llc llc as the vehicle for the joint_venture gp and wisco treated the llc as a partnership for tax purposes both partners contrib- uted the assets of their respective tissue businesses to the llc gp transferred to the llc its tissue business_assets with an agreed value of dollar_figure million in exchange for a 95-per- cent interest in the llc wisco contributed to the llc all of the assets of its tissue business with an agreed value of dollar_figure million in exchange for a 5-percent interest in the llc the llc borrowed dollar_figure million from bank of america boa on the same day it received the contributions from gp and wisco the llc immediately transferred the loan proceeds to chesapeake’s bank account as a special cash distribution gp guaranteed_payment of the boa loan and wisco agreed to indemnify gp for any principal payments gp might have to make under its guaranty the llc had approximately dollar_figure million in net_worth based on the parties’ combined initial contribution of assets dollar_figure1 billion less the boa loan dollar_figure million and it had a debt to equity ratio of around to the llc assumed most of wisco’s liabilities but did not assume wisco’s fox river liability chesapeake and wisco both indemnified gp and held it harmless for any costs and claims that it might incur with respect to any retained liabilities of wisco including the fox river liability wisco used a portion of the funds from the special distribu- tion to repay an intercompany loan to cary street chesa- peake’s finance subsidiary wisco also used portions of the chesapeake maintained the bank accounts for its subsidiaries the value of wisco’s assets contributed dollar_figure million less the distribution dollar_figure million equals the initial value of wisco’s 5-percent llc interest dollar_figure million verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports funds to pay a dividend to chesapeake repay amounts owed to chesapeake and lend dollar_figure million to chesapeake in exchange for a note intercompany note the intercompany note was a 5-year note with an 8-percent interest rate chesapeake used the loan proceeds to repay debt repurchase stock and purchase additional specialty packaging assets wisco’s assets following the transaction included the inter- company note with a face value of dollar_figure million and a cor- porate jet worth approximately dollar_figure million wisco had a net_worth excluding its llc interest of approximately dollar_figure mil- lion this represented percent of its maximum exposure on the indemnity wisco remained subject_to the fox river liability refinancing the debt the llc refinanced the boa loan in two parts soon after the transaction closed first the llc borrowed approximately dollar_figure million from a gp subsidiary georgia-pacific finance llc gp finance to partially retire the boa loan this trans- action occurred about a month after the closing date then the llc borrowed dollar_figure million from gp finance the following year to repay the balance on the boa loan the gp finance loans had terms similar to those of the boa loans gp executed a substantially identical guaranty in favor of the new lender and wisco executed a substantially identical indemnity obligation pwc issued another opinion finding that the refinancing was tax free as well characterization of the transaction for tax and non-tax purposes chesapeake timely filed a consolidated federal tax_return for chesapeake disclosed the transaction on schedule m of the return and reported dollar_figure book gain but no corresponding tax gain chesapeake treated the special dis- tribution as non-taxable on the theory that it was a debt- financed transfer of consideration not the proceeds of a sale unlike its treatment for tax purposes chesapeake treated the transaction as a sale for financial_accounting purposes chesapeake did not treat the indemnity obligation as a liability for accounting purposes because chesapeake deter- mined that there was no more than a remote chance the verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner indemnity would be triggered despite chesapeake’s characterization for tax purposes pwc and salomon each referred to the transaction as a sale standard poor’s moody’s and stock analysts also treated the transaction as a sale chesapeake executives represented to standard poor’s and moody’s that the only risk associ- ated with the transaction came not from wisco’s agreement to indemnify gp but from the tax risk moody’s downgraded chesapeake after the announced joint_venture because of chesapeake’s readjusted focus the monetization of wisco and the resulting loss of operating income standard poor’s kept its rating of chesapeake the same because chesapeake generated significant cash by divesting itself of wisco for dollar_figure million and of its timberlands for dollar_figure million end of the joint_venture the joint_venture operated for only a full year it ended in when gp sought to acquire the fort james corporation the department of justice required gp to sell its llc interest for antitrust purposes gp contacted svenska cellulosa aktiebolaget sca a swedish company about pur- chasing its llc interest sca informed gp that it was interested in purchasing only the entire llc not just gp’s interest in the llc therefore gp needed to buy wisco’s interest in the joint_venture wisco agreed to sell its minority interest in the llc to gp for dollar_figure million which rep- resented a gain of dollar_figure million from its initial valuation of dollar_figure million gp also paid chesapeake dollar_figure million to com- pensate chesapeake for any loss of tax_deferral wisco declared a dollar_figure dividend to chesapeake payable by cancelling chesapeake’s promissory note in chesapeake reported a dollar_figure million capital_gain on its consolidated federal tax_return for chesapeake deter- mined that the termination of the indemnity resulted in wisco receiving a deemed_distribution under sec_752 chesapeake also reported the dollar_figure million tax cost payment it received from gp as ordinary_income on its consolidated federal tax_return for respondent issued chesapeake the deficiency_notice for in the deficiency_notice respondent determined the joint_venture transaction to be a disguised sale that produced verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports dollar_figure million of capital_gain includable in chesapeake’s consolidated income for chesapeake timely filed a peti- tion respondent asserted in an amended answer a dollar_figure accuracy-related_penalty under sec_6662 for substantial_understatement_of_income_tax opinion we are asked to decide whether the joint_venture trans- action constituted a taxable sale respondent argues that chesapeake structured the transaction to defer dollar_figure million of capital_gain for a period of years or more specifically respondent contends that wisco did not bear any economic risk of loss when it entered the joint_venture agreement because the anti-abuse rule disregards wisco’s obligation to indemnify gp see sec_1_752-2 income_tax regs respondent concludes that the transaction should be treated as a taxable disguised sale chesapeake asserts that the transaction should not be recast as a sale instead chesapeake argues that the anti- abuse rule does not disregard wisco’s indemnity and that the llc’s distribution of cash to wisco comes within the excep- tion for debt-financed transfers we disagree and begin with the general rules on disguised sales i disguised sale transactions the code provides generally that partners may contribute capital to a partnership tax free and may receive a tax free return of previously taxed profits through distributions see sec_721 sec_731 these nonrecognition rules do not apply however where the transaction is found to be a disguised sale of property see sec_707 a disguised sale may occur when a partner contributes property to a partnership and soon thereafter receives a dis- tribution of money or other consideration from the partner- sec_731 concerns distributions to a partner acting in his capacity as a partner neither party asserts that sec_731 applies in this case moreover sec_731 does not apply if a partner contributes property to a partnership and the partnership distributes property to the partner within a short_period to effect an exchange of property between two or more partners or between the partnership and a partner sec_1_731-1 income_tax regs we will not therefore con- sider the effect of sec_731 on the transaction see sec_1_707-1 income_tax regs transfers described in sec_707 are treated as occurring between a partnership and a non-partner or partner acting outside his capacity as a member of the partnership sec_707 b verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner ship id a transaction may be deemed a sale if based on all the facts and circumstances the partnership’s distribution of money or other consideration to the partner would not have been made but for the partner’s transfer of the property sec_1_707-3 income_tax regs emphasis added such con- tribution and distribution transactions that occur within two years of one another are presumed to effect a sale unless the facts and circumstances clearly establish otherwise the year presumption sec_1_707-3 income_tax regs here wisco transferred its assets with an agreed value of dollar_figure million to the llc and simultaneously received a cash distribution of dollar_figure million after the transfer and distribu- tion wisco had a 5-percent interest in the llc its assets included only its interest in the llc the intercompany note and the jet we therefore view the transactions together and presume a sale under the disguised sale rules unless the facts and circumstances dictate otherwise chesapeake contends that the special distribution was not part of a disguised sale instead it was a debt-financed transfer of consideration an exception to the disguised sale rules see sec_1_707-5 income_tax regs chesapeake argues that the debt-financed transfer of consideration excep- tion to the disguised sale rules limits the applicability of the disguised sale rules and the 2-year presumption in this case a debt-financed transfer of consideration we now turn to the debt-financed transfer of consideration exception to the disguised sale rules the regulations except certain debt-financed distributions in determining whether a partner received money or other consideration for disguised sale purposes see id a distribution financed from the pro- ceeds of a partnership_liability may be taken into account for disguised sale purposes to the extent the distribution exceeds the distributee partner’s allocable share of the partnership_liability see sec_1_707-5 income_tax regs respondent argues that the entire distribution from the llc to wisco should be taken into account for purposes of determining a disguised sale because wisco did not bear any of the allo- cable share of the llc’s liability to finance the distribution a distribution qualifies as a debt-financed transfer if it meets certain requirements see sec_1_707-5 income_tax regs we consider only the requirements at issue verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports we turn now to whether wisco had any allocable share of the llc’s liability to determine whether the transaction fits within the exception b partner’s allocable share of liability in general a partner’s share of a recourse partnership_liability equals the portion of that liability if any for which the partner bears the economic risk of loss see sec_1 a income_tax regs a partner bears the economic risk of loss to the extent that the partner would be obligated to make an unreimbursable payment to any person or con- tribute to the partnership if the partnership were construc- tively liquidated and the liability became due and payable sec_1_752-2 income_tax regs see 122_tc_295 chesapeake contends that wisco’s indemnity of gp’s guaranty imposes on wisco the economic risk of loss for the llc debt respondent con- cedes that an indemnity agreement generally is recognized as an obligation under the regulations respondent asserts however that wisco’s agreement should be disregarded under the anti-abuse rule for allocation of partnership debt c anti-abuse rule chesapeake counters that wisco was legally obligated to indemnify gp under the indemnity agreement and therefore wisco should be allocated the entire economic risk of loss of the llc’s liability we assume that all partners having an obligation to make payments on a recourse_debt actually per- form those obligations irrespective of net_worth to ascertain the economic risk of loss unless the facts and circumstances indicate a plan to circumvent or avoid the obligation sec_1_752-2 income_tax regs the anti-abuse rule provides that a partner’s obligation to make a payment may be dis- regarded if the facts and circumstances indicate that a principal purpose of the arrangement between the parties is a partner’s allocable share of a partnership’s recourse_liability equals the partner’s share of liability pursuant to sec_752 and its regulations multiplied by a fraction of which the numer- ator is the portion of the liability that is allocable to the distribution under sec_1_163-8t tem- porary income_tax regs fed reg date and the denominator is the total amount of the liability see sec_1_707-5 sec_1_752-1 sec_1_752-2 income_tax regs the parties agree that the llc’s liability to boa was recourse the parties do not dispute that the special distribution to wisco and the boa loan were both dollar_figure million we need only deter- mine wisco’s share of the llc’s liability under sec_752 and its regulations verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner to eliminate the partner’s risk of loss or to create a facade of the partner’s bearing the economic risk of loss with respect to the obligation or the facts and circumstances of the transaction evidence a plan to circumvent or avoid the obligation see sec_1_752-2 income_tax regs given these two tests we must review the facts and circumstances to determine whether wisco’s indemnity agreement may be disregarded as a guise to cloak wisco with an obligation for which it bore no actual economic risk of loss see ipo ii v commissioner supra pincite purpose of the indemnity agreement we first consider the indemnity agreement the parties agreed that wisco would indemnify gp in the event gp made payment on its guaranty of the llc’s dollar_figure million debt gp did not require the indemnity and no provision of the indemnity mandated that wisco maintain a certain net_worth wisco was chosen as the indemnitor rather than chesapeake after pwc advised chesapeake’s executives that wisco’s indemnity would not only allow chesapeake to defer tax on the transaction but would also cause the economic risk of loss to be borne only by wisco’s assets not chesa- peake’s moreover the contractual provisions reduced the likelihood of gp invoking the indemnity against wisco the indemnity covered only the loan’s principal not interest in addition gp would first have to proceed against the llc’s assets before demanding indemnification from wisco in the unlikely event wisco had to pay on the indemnity wisco would receive an increased interest in the llc proportionate to any payment made under the indemnity we find compel- ling that a chesapeake executive represented to moody’s and standard poor’s that the only risk associated with the transaction was the tax risk we are left with no other conclusion than that chesapeake crafted the indemnity agreement to limit any potential liability to wisco’s assets wisco’s assets and liabilities we now focus on whether wisco had sufficient assets to cover the indemnity regardless of how remote the possibility it would have to pay chesapeake maintains that wisco had sufficient assets to cover the indemnity agreement wisco verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports contributed almost all of its assets to the llc and received a special distribution and a 5-percent interest in the llc moreover chesapeake contends that wisco did not need to have a net_worth covering the full amount of its obligations with respect to the llc’s debt see sec_1_752-2 income_tax regs wisco’s assets after the transfer to the llc included the dollar_figure million intercompany note and the dollar_figure million jet wisco had a net_worth excluding its llc interest of approximately dollar_figure million or percent of the maximum exposure on the indemnity the value of wisco’s llc interest would have been zero if the indemnity were exercised because the agreement required gp to proceed and exhaust its remedies against the llc’s assets before seeking indem- nification from wisco we may agree with chesapeake that no code or regulation provision requires wisco to have assets covering the full indemnity amount we note however that a partner’s obliga- tion may be disregarded if undertaken in an arrangement to create the appearance of the partner’s bearing the economic risk of loss when the substance of the arrangement is in fact otherwise see sec_1_752-2 income_tax regs wisco’s principal asset after the transfer was the intercompany note the indemnity agreement did not require wisco to retain this note or any other asset further chesapeake and its management had full and absolute control of wisco nothing restricted chesapeake from canceling the note at its discre- tion at any time to reduce the asset level of wisco to zero in fact wisco’s board which included many chesapeake executives did cancel the note and issued an intercompany dividend to chesapeake in we find wisco’s intercom- pany note served to create merely the appearance rather than the reality of economic risk for a portion of the llc debt in addition wisco remained subject_to the fox river liability and wisco and other chesapeake subsidiaries guaranteed a dollar_figure million credit line obtained by chesa- peake in this guaranty and the fox river liability fur- ther reduced wisco’s net_worth gp neither asked for nor received any assurances that wisco would not further encumber its assets we find that wisco’s agreement to indemnify gp’s guaranty lacked economic_substance and afforded no real protection to gp verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner anti-abuse rule illustration chesapeake seeks to distinguish the transaction in this case from the transaction illustrated in the anti-abuse rule see sec_1_752-2 income_tax regs illustrating when payment obligations may be disregarded the illustration considers a consolidated_group of corporations that use a thinly capitalized subsidiary as a partner in a general part- nership with a recourse_debt payment guaranteed by the other partner the circumstances are deemed indicative of a plan enabling the corporate group to enjoy the losses gen- erated by the partnership’s property while avoiding the subsidiary’s obligation to restore any deficit in its capital_account chesapeake argues wisco was not a newly-created entity as was the subsidiary in the illustration but had been in business before the transaction we find wisco’s preexis- tence insufficient to distinguish this transaction from the illustration a thinly capitalized subsidiary with no business operations and no real assets cannot be used to shield a parent corpora- tion with significant assets from being taxed on a deemed sale chesapeake intentionally used wisco rather than itself to limit its exposure under the indemnity agreement it fur- ther limited its exposure only to the assets of wisco we refuse to interpret the illustration to provide additional protection moreover this appears to be a concerted plan to drain wisco of assets and leave wisco incapable as a prac- tical matter of covering more than a small fraction of its obligation to indemnify gp we find this analogous to the illustration because in both cases the true economic burden of the partnership debt is borne by the other partner as guar- antor accordingly we do not find that the anti-abuse rule illustration extricates chesapeake but rather it dem- onstrates what chesapeake strove to accomplish revproc_89_12 does not apply to anti-abuse rule chesapeake also argues that it would be found to bear the economic risk of loss if the court would apply a 10-percent net_worth requirement in so arguing chesapeake relies on revproc_89_12 1989_1_cb_798 which stated that a lim- ited partnership would be deemed to lack limited_liability for advance_ruling purposes if a corporate general_partner of the verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports partnership had a net_worth equaling percent or more of the total contributions to the partnership we decline chesa- peake’s invitation to extend the 10-percent net_worth test requirements for advance_ruling purposes have no bearing on whether a partner will be treated as bearing the economic risk of loss for a partnership’s liability there are no mechan- ical tests the anti-abuse rule mandates that we consider the facts and circumstances we decline to establish a bright-line percentage_test to determine whether wisco bore the eco- nomic risk of loss with respect to the llc’s liability speculative fraudulent conveyance claims chesapeake argues alternatively that wisco bore the eco- nomic risk of loss because gp had a right to make fraudulent conveyance claims against chesapeake and chesapeake’s financial subsidiary cary street chesapeake contends that such potential claims exposed wisco to a risk of loss in excess of wisco’s net_worth this argument is flawed on many points first a fraudulent conveyance is simply a cause of action not an obligation see 90_tc_465 see also 71_tc_1 supplemented by 71_tc_724 affd in part and remanded on other grounds 660_f2d_416 10th cir the court may consider obligations only in allocating recourse_liabilities of a partner- ship see sec_1_752-2 income_tax regs next chesa- peake’s fraudulent conveyance argument connotes that chesapeake engaged in a plan to circumvent or avoid the obligation this argument completely undercuts and over- rides chesapeake’s attempt to create an obligation on behalf of chesapeake and cary street finally we would render the anti-abuse rule meaningless by creating an automatic excep- tion for speculative fraudulent conveyance claims accord- ingly we reject this argument we have carefully considered the facts and circumstances and find that the indemnity agreement should be dis- regarded because it created no more than a remote possi- bility that wisco would actually be liable for payment chesapeake used the indemnity to create the appearance that wisco bore the economic risk of loss for the llc debt when in substance the risk was borne by gp we find that verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner wisco had no economic risk of loss and should not be allo- cated any part of the debt incurred by the llc consequently the distribution of cash to wisco does not fit within the debt-financed transfer exception to the disguised sale rules instead we find chesapeake has failed to rebut the 2-year presumption the facts and circumstances evince a disguised sale accordingly we conclude that wisco sold its business_assets to gp in the year it contributed the assets to the llc not the year it liquidated its llc interest ii whether chesapeake is liable for an accuracy-related_penalty under sec_6662 we now turn to respondent’s determination that chesa- peake is liable for the accuracy-related_penalty under sec_6662 and b for a substantial_understatement_of_income_tax respondent bears the burden_of_proof for a penalty asserted in an amended answer see rule a a substantial_understatement_of_income_tax exists for a corporation 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 sec_1_6662-4 income_tax regs chesapeake’s correct_tax for is dollar_figure which includes the dollar_figure deficiency determined in the deficiency_notice respondent has estab- lished the understatement of income_tax is substantial as it exceeds both percent of the correct_tax dollar_figure and dollar_figure the accuracy-related_penalty under sec_6662 does not apply however to any portion of an underpayment if a taxpayer shows that there was reasonable_cause for and that the taxpayer acted in good_faith with respect to that portion sec_6664 sec_1_6664-4 income_tax regs we con- sider the pertinent facts and circumstances including the taxpayer’s efforts to assess his or her proper tax_liability the taxpayer’s knowledge and experience and the reliance on the advice of a professional in determining whether the taxpayer acted with reasonable_cause and in good_faith sec_1 b income_tax regs generally the most important factor is the extent of the taxpayer’s effort to assess the proper tax_liability id verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports reasonable_cause has been found when a taxpayer selects a competent tax adviser supplies the adviser with all rel- evant information and in a manner consistent with ordinary business care and prudence relies on the adviser’s profes- sional judgment as to the taxpayer’s tax obligations sec_6664 469_us_241 sec_1_6664-4 income_tax regs a taxpayer may rely on the advice of any_tax adviser lawyer or accountant united_states v boyle supra pincite the right to rely on professional tax_advice however is not unlimited neither reliance on the advice of a professional tax adviser nor reliance on facts that unknown to the tax- payer are incorrect necessarily demonstrates or indicates reasonable_cause or good_faith see 330_fsupp2d_122 d conn affd 150_fedappx_40 2d cir the advice must not be based on unreasonable factual or legal assumptions and must not unreasonably rely on representa- tions statements findings or agreements of the taxpayer or any other person sec_1_6664-4 income_tax regs courts have repeatedly held that it is unreasonable for a tax- payer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest see eg 440_f3d_375 6th cir affg tcmemo_2004_279 990_f2d_893 6th cir affg donahue v commissioner tcmemo_1991_181 115_tc_43 affd 299_f2d_221 3d cir a professional tax adviser with a stake in the outcome has such a conflict of interest see pasternak v commissioner supra pincite chesapeake claims it reasonably relied in good_faith on pwc’s tax_advice and should opinion and therefore no pen- alty should be imposed respondent contends that chesa- peake unreasonably relied on an opinion riddled with improper assumptions written by a tax adviser with a con- flict of interest we look to whether pwc’s advice was reason- able and inquire whether pwc’s advice was based on all pertinent facts and circumstances and not on unreasonable factual or legal assumptions see long term capital holdings v united_states supra pincite verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner a pwc based its advice on unreasonable assumptions we now focus on whether pwc’s advice was reasonable chesapeake contends that it relied on legal analysis pre- scribed in pwc’s should opinion chesapeake submitted a draft not the original of the should opinion into evidence we therefore look to the draft opinion to determine whether pwc’s advice was reasonable chesapeake paid pwc an dollar_figure flat fee for the opinion not based on time devoted to preparing the opinion mr miller testified that he and his team spent hours on the opinion we find this testimony inconsistent with the opinion that was admitted into evidence the court questions how much time could have been devoted to the draft opinion because it is littered with typographical errors disorganized and incomplete moreover mr miller failed to recognize sev- eral parts of the opinion the court doubts that any firm would have had such a cavalier approach if the firm was being compensated solely for time devoted to rendering the opinion in addition the opinion was riddled with questionable conclusions and unreasonable assumptions mr miller based his opinion on wisco maintaining percent of the llc debt mr miller had no case law or code authority to support this percentage however he instead relied on an irrelevant rev- enue procedure as the basis for issuing the should opinion a should opinion is the highest level of comfort pwc offers to a client regarding whether the position taken by the client will succeed on the merits we find it unreasonable that anyone let alone an attorney would issue the highest level opinion a firm offers on such dubious legal reasoning we are also nonplused by mr miller’s failure to give an understandable response when asked at trial how pwc could issue a should opinion if no authority on point existed he demurred that it was what chesapeake requested the only mr miller testified that tax practitioners render different levels of opinion based on their comfort that the legal conclusions contained in the opinion are correct as a matter of law assum- ing the factual representations and assumptions set forth in the opinion are also correct a rea- sonable basis opinion has a 33-percent chance of success on the merits see sec_1_6662-3 income_tax regs a substantial_authority opinion has a 40-percent chance of success on the merits see sec_1_6662-4 income_tax regs a more_likely_than_not opinion has a percent chance of success on the merits see id mr miller did not give an exact percentage regarding a should opinion but he testified that it is materially higher than that of a more_likely_than_not opinion verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports explanation that makes sense to the court is that no lesser level of comfort would have commanded the dollar_figure fixed fee that chesapeake paid for the opinion we are also troubled by the number of times the draft opinion uses it appears for example it states i n focusing on the language of the regs it appears that such regulation adopts an all or nothing approach mr miller had no basis for that position other than his interpretation of the regulations further mr miller assumed that the indemnity would be effective and that wisco would hold assets sufficient to avoid the anti-abuse rule pwc assumed away the very crux of whether the trans- action would qualify as a nontaxable contribution of assets to a partnership in so doing pwc failed to consider that the indemnity lacked substance neither the joint_venture agree- ment nor the indemnity agreement included provisions requiring wisco to maintain any minimum level of capital or assets wisco and chesapeake could also remove wisco’s main asset the intercompany note from wisco’s books at any time and for any reason this possibility gutted any sub- stance for the indemnity we find that chesapeake’s tax position did not warrant a should opinion because of the numerous assumptions and dubious legal conclusions in the haphazard draft opinion that has been admitted into the record further we find it inher- ently unreasonable for chesapeake to have relied on an anal- ysis based on the specious legal assumptions b chesapeake lacked good_faith moreover chesapeake did not act with reasonable_cause or in good_faith as it relied on mr miller’s advice chesapeake argues that it had every reason to trust pwc’s judgment because of its long-term relationship with the firm pwc crossed over the for prior accounting purposes to advocate for a position with no authority that was based on an opinion with a high price tag-dollar_figure from trusted adviser line any advice chesapeake received was tainted by an inherent conflict of interest we would be hard pressed to identify which of his hats mr miller was wearing in ren- dering that tax opinion there were too many mr miller not verdate 0ct date jkt po frm fmt sfmt v files canal sheila canal corp subs v commissioner only researched and drafted the tax opinion but he also audited wisco’s and the llc’s assets to make the assump- tions in the tax opinion he made legal assumptions separate from the tax assumptions in the opinion he reviewed state law to make sure the assumptions were valid regarding whether a partnership was formed in addition he was intri- cately involved in drafting the joint_venture agreement the operating_agreement and the indemnity agreement in essence mr miller issued an opinion on a transaction he helped plan without the normal give-and-take in negotiating terms with an outside party we are aware of no terms or conditions that gp required before it would close the trans- action we are aware only of the condition that chesapeake’s board would not close unless it received the should opinion chesapeake acted unreasonably in relying on the advice of pwc given the inherent and obvious conflict of interest see 132_tc_161 reliance on opinion by law firm actively involved in developing structuring and promoting transaction was unreasonable in face of conflict of interest see also cma consol inc v commissioner tcmemo_2005_16 reliance not reasonable as advice not furnished by disinterested objective advisers 82_fedclaims_636 affd fed 3d fed cir we also find suspect the exorbitant price tag associated with the sole condition of closing chesapeake essentially bought an insurance_policy as to the taxability of the trans- action pwc received an dollar_figure fixed fee for its tax opinion pwc did not base its fee on an hourly rate plus expenses the fee was payable and contingent on the closing of the joint_venture transaction pwc would receive payment only if it issued chesapeake a should opinion on the joint_venture transaction pwc therefore had a large stake in making sure the closing occurred considering all the facts and circumstances pwc’s opinion looks more like a quid pro quo arrangement than a true tax advisory opinion if we were to bless the closeness of the relationship we would be providing carte blanche to pro- moters to provide a tax opinion as part and parcel of a pro- motion independence of advisers is sacrosanct to good_faith reliance we find that pwc lacked the independence nec- verdate 0ct date jkt po frm fmt sfmt v files canal sheila united_states tax_court reports essary for chesapeake to establish good_faith reliance we further find that chesapeake did not act with reasonable_cause or in good_faith in relying on pwc’s opinion we sustain respondent’s determination that chesapeake is liable for the accuracy-related_penalty under sec_6662 for we have considered all remaining arguments the parties made and to the extent not addressed we find them to be irrelevant moot or meritless to reflect the foregoing decision will be entered for respondent f this holding should not be interpreted as requiring taxpayers to obtain a second tax opinion to qualify for the reasonable reliance exception under sec_6664 rather we hold that tax- payers may not reasonably rely on an adviser tainted by an inherent conflict of interest the tax- payer had reason to know of verdate 0ct date jkt po frm fmt sfmt v files canal sheila


t c memo united_states tax_court john h nix iii petitioner v commissioner of internal revenue respondent docket nos filed date john h nix iii pro_se randall b childs and robert walter dillard for respondent memorandum findings_of_fact and opinion paris judge on date respondent issued to petitioner a notice_of_deficiency which determined a federal_income_tax deficiency of dollar_figure and the following additions to tax for tax_year dollar_figure under section f dollar_figure under sec_6651 and dollar_figure under sec_6654 on date respondent issued to petitioner a second notice_of_deficiency that determined a federal_income_tax deficiency of dollar_figure and the following additions to tax for tax_year dollar_figure under sec_6651 dollar_figure under sec_6651 and dollar_figure under sec_6654 petitioner timely filed petitions with this court for tax years and on march and date respectively on date these cases were consolidated for the purpose of trial briefing and opinion after concessions by the parties the issues for determination are whether petitioner failed to report income in the amounts respondent determined including miscellaneous dividends and capital_gain income for tax years and whether petitioner is liable for an addition_to_tax under sec_6651 for fraudulent_failure_to_file for tax years and whether petitioner is liable for an addition_to_tax under sec_6651 for failure to timely pay income_tax for tax years and whether petitioner is liable for an 1all section references are to the internal_revenue_code in effect for the years at issue and all rule references are to the tax_court rule_of practice and procedure unless otherwise indicated 2petitioner previously filed his and tax returns with a filing_status of single petitioner has conceded among other things that he was married during and and should have used a filing_status of married_filing_separately addition_to_tax under sec_6654 for failure to make estimated_tax payments for tax years and whether if petitioner is not liable under sec_6651 petitioner is liable for a fraud_penalty under sec_6663 or an accuracy- related penalty for negligence under sec_6662 for tax years and and whether petitioner is liable for a penalty under sec_6673 findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts and the exhibits received in evidence are incorporated herein by this reference petitioner resided in florida at the time his petitions were filed beginning in date petitioner began working for and receiving compensation from t-mobile usa t-mobile in tax_year petitioner submitted to t-mobile a form_w-4 employee’s withholding allowance certificate claiming he was exempt from federal tax at the end of tax_year t-mobile issued to petitioner a form_w-2 wage and tax statement form_w-2 the form_w-2 showed wages of dollar_figure and withholding of dollar_figure for federal_income_tax dollar_figure for social_security_tax and dollar_figure for medicare_tax petitioner filed a federal_income_tax return for tax_year on date claiming single filing_status and a refund of dollar_figure petitioner reported that he had zero taxable_income and zero tax_liability for tax_year petitioner submitted with his tax_return a self-prepared form_4852 substitute for form_w-2 wage and tax statement or form 1099-r distributions from pensions annuities retirement or profit-sharing_plans iras insurance contracts etc showing zero wages and withholdings of dollar_figure for federal_income_tax dollar_figure for social_security_tax and dollar_figure for medicare_tax in petitioner again completed and submitted a form_w-4 to t-mobile in which he claimed to be exempt from federal_income_tax at the end of tax_year t-mobile again issued to petitioner a form_w-2 form_w-2 the form_w-2 showed wages of dollar_figure and withholding of zero for federal_income_tax dollar_figure for social_security_tax and dollar_figure for medicare_tax petitioner filed a federal_income_tax return for tax_year on date claiming single filing_status and a refund of dollar_figure petitioner again reported that he had zero taxable_income and zero tax_liability for tax_year petitioner attached to his federal_income_tax return another self-prepared form_4852 showing zero wages with withholdings of dollar_figure for state_income_tax dollar_figure for social_security_tax and dollar_figure for medicare_tax on date petitioner filed form 1040x amended u s individual_income_tax_return for tax_year reflecting a change in filing_status from single to married_filing_separately petitioner again reported that he had zero taxable_income and that he was entitled to a refund of dollar_figure petitioner again attached to his amended_return a self-prepared form_w-2 in which he claimed he had zero taxable_income and withholdings of dollar_figure for state_income_tax dollar_figure for social_security_tax and dollar_figure for medicare_tax on date respondent prepared a substitute for return on behalf of petitioner under sec_6020 stating that for tax_year petitioner received dollar_figure in wages dollar_figure in qualified dividends and dollar_figure in capital_gain income on date respondent prepared a substitute for return on behalf of petitioner under sec_6020 stating that for tax_year petitioner received dollar_figure in wages and dollar_figure in dividends these substitutes for returns each consisted of a form_4549 income_tax examination changes a form 886-a explanation of items and a form sec_6020 certification opinion i unreported income sec_61 defines gross_income as all income from whatever source derived including c ompensation for services including fees commissions fringe_benefits and similar items wages and salaries are compensation_for services that are includible in gross_income see sec_1_61-2 income_tax regs additionally both dividends and gain realized on the sale_or_exchange of property are includible in gross_income sec_1_61-6 sec_1_61-9 income_tax regs ordinarily the commissioner’s determination of tax_liability is presumed correct rule a 290_us_111 see 324_f3d_1289 11th cir aff’g tcmemo_2001_43 however when a case involves unreported income the u s court_of_appeals for the eleventh circuit to which these cases would be appealable absent a stipulation to the contrary has held that the commissioner’s determination of unreported income is entitled to a presumption of correctness only if the determination is supported by a minimal evidentiary foundation linking the taxpayer to an income- producing activity 994_f2d_1542 11th cir aff’g tcmemo_1991_636 once the commissioner produces evidence linking the taxpayer to an income-producing activity the presumption of correctness applies and the burden of production shifts to the taxpayer to rebut that presumption by establishing that the commissioner’s determination is arbitrary or erroneous id the record establishes and petitioner has conceded that he received payments as reported by t-mobile on forms w-2 for the years at issue the court concludes that respondent has laid the requisite minimal evidentiary foundation for the contested unreported income and that respondent’s determinations are entitled to the presumption of correctness petitioner argues that the compensation amounts he received are not wages and that the term wage is undefined and thus has no force or effect of law the relevant code section for the computation of taxable_income is sec_61 which does not use the word wages but instead defines gross_income as all income from whatever source derived including compensation_for services sec_61 136_tc_498 petitioner’s argument resembles others which have been deemed frivolous by this court and the u s court_of_appeals for the eleventh circuit see 136_tc_498 see also 419_fedappx_958 11th cir 833_f2d_1538 11th cir petitioner admitted at trial to receiving compensation_for services he provided to his employer t-mobile in tax years and petitioner’s own statement falls within the definition of gross_income under sec_61 petitioner has failed to provide any credible_evidence or sound reasoning as to why his compensation from t-mobile is not taxable_income in addition petitioner has failed to dispute at all respondent’s determination that he received dollar_figure of dividend income for tax_year dollar_figure of capital_gain for tax_year and dollar_figure of dividend income for tax_year accordingly respondent’s determinations with respect to petitioner’s unreported income for tax years and are sustained ii sec_6651 addition_to_tax respondent determined that petitioner was liable for a sec_6651 addition_to_tax for fraudulently failing to timely file his and federal_income_tax returns respondent must establish by clear_and_convincing evidence that petitioner’s failure to timely file was an intentional attempt to evade tax believed to be owing see sec_7454 rule b 102_tc_632 herrington v commissioner tcmemo_2011_73 sec_6651 imposes an addition_to_tax for failure to timely file a federal_income_tax return sec_6651 provides that the sec_6651 addition_to_tax shall be increased to of the tax required to be shown on the return for each month or fraction thereof for which there is a failure_to_file a return up to in the aggregate where such failure to timely file is fraudulent fraud is established by proving that a taxpayer intended to evade tax believed to be owing by conduct intended to conceal mislead or otherwise prevent the collection of tax clayton v commissioner t c pincite fraud consists of two elements the existence of an underpayment and fraudulent intent with respect to some portion of the underpayment 39_f3d_658 6th cir aff’g 99_tc_370 and tcmemo_1992_616 96_tc_858 aff’d 959_f2d_16 2d cir respondent bears the burden of proving fraud by clear_and_convincing evidence see sec_7454 rule b the first element of fraud has been satisfied in this case respondent has presented clear_and_convincing evidence through petitioner’s own admissions that petitioner had unreported income for the years at issue which would result in an underpayment petitioner has failed to submit any evidence which would overcome respondent’s showing the existence of the second element fraudulent intent is determined by looking at the entire record and petitioner’s conduct see garavaglia v commissioner tcmemo_2011_228 barrow v commissioner tcmemo_2008_264 fraud is never presumed and must be proven by independent evidence 55_tc_85 lain v commissioner tcmemo_2012_99 in determining whether there was fraudulent intent the court will look at a nonexclusive list of factors or badges_of_fraud 796_f2d_303 9th cir aff’g tcmemo_1984_601 99_tc_202 91_tc_874 these factors include failing to file income_tax returns understating income failing to maintain adequate_records concealing income or assets failing to cooperate with tax authorities asserting frivolous arguments and objections to the tax laws lack of credibility in testimony and failing to make estimated_tax payments niedringhaus v commissioner t c pincite while no single factor is determinative for establishing fraud the existence of several badges_of_fraud may constitute compelling circumstantial evidence of fraud bradford v commissioner f 2d pincite rossman v commissioner tcmemo_2006_128 petitioner’s behavior exhibits many of the badges listed above first petitioner failed to file valid federal_income_tax returns for the years at issue in order to be considered a valid tax_return a document must meet the following four requirements there must be sufficient data to calculate a tax_liability the document must purport to be a return there must be an honest and reasonable attempt to satisfy the requirements of the tax law and the taxpayer must execute the return under penalties of perjury 82_tc_766 aff’d 793_f2d_139 6th cir applying the test in beard the court has consistently held that a form_1040 u s individual_income_tax_return with zeros on every income line is devoid of financial data and is therefore not a valid_return see eg 120_tc_163 mooney v commissioner tcmemo_2011_35 turner v commissioner tcmemo_2004_251 petitioner’s returns for the years at issue reported zeros on every income line accordingly the returns petitioner submitted were not valid petitioner also filed false forms w-4 with his employer in which he claimed that he was not subject_to federal_income_tax it has been held that filing a false form_w-4 is circumstantial evidence of fraud mooney v commissioner tcmemo_2011_35 teeters v commissioner tcmemo_2010_244 holding that when the commissioner has shown substantial amounts of unreported income on which the withholding has been reduced by submission of a false form_w-4 fraud has been established by clear_and_convincing evidence additionally petitioner filed his and tax returns with the filing_status of single evidence of fraud may exist where a taxpayer knowingly files a federal_income_tax return with the wrong filing_status duncan v commissioner tcmemo_2003_156 petitioner was in fact married during tax years and and knowingly selected single filing_status although petitioner did correct his filing_status on a 1040x for tax_year he did not file the amended_return until date in addition to the indicia discussed above petitioner also failed to make estimated_tax payments for the years at issue failed to maintain adequate_records of his income and expenses and advanced many arguments that this court has deemed frivolous the court concludes that the record demonstrates by clear_and_convincing evidence that petitioner’s failure_to_file timely tax returns was fraudulent petitioner is therefore liable for the addition_to_tax under sec_6651 for tax years and since petitioner is liable under sec_6651 there is no need to discuss respondent’s alternative additional penalties under sec_6663 and sec_6662 determined in the notices of deficiency iii sec_6651 addition_to_tax respondent determined that petitioner is liable for additions to tax under sec_6651 for failure to timely pay his and taxes sec_6651 provides for an addition_to_tax of per month up to for failure to pay the amounts shown on the return unless it is shown that the failure is due to reasonable_cause and not due to willful neglect respondent must produce sufficient evidence that petitioner filed returns showing tax_liability for the years at issue see 127_tc_200 aff’d 521_f3d_1289 10th cir a return prepared by the commissioner in accordance with sec_6020 is treated as the return filed by the taxpayer for the purpose of determining the amount of the addition under sec_6651 sec_6651 wheeler v commissioner t c pincite glover v commissioner tcmemo_2010_228 respondent has the burden of proving that substitutes for returns satisfying the requirements of sec_6020 were submitted see cabirac v commissioner t c pincite gleason v commissioner tcmemo_2011_154 a return for sec_6020 purposes must be subscribed it must contain sufficient information from which to compute the taxpayer’s tax_liability and the return form and any attachments must purport to be a return spurlock v commissioner tcmemo_2003_124 the court has held that the requirements stated in spurlock have been met where the substitutes for returns consist of forms 4549-a forms 886-a and forms and the forms contain the taxpayer’s name and social_security_number and sufficient information to compute a tax_liability gleason v commissioner tcmemo_2011_154 respondent’s substitutes for returns included forms 4549-a forms 886-a and forms furthermore they contained petitioner’s name and social_security_number and sufficient information upon which to compute a tax_liability accordingly respondent’s substitutes for returns constitute valid sec_6020 returns deemed to have been filed by petitioner for the purposes of sec_6651 petitioner did not pay any of his tax_liabilities for tax years and petitioner has failed to present any evidence that would establish that his failure to pay was due to reasonable_cause and instead he has sought to rely solely on unreasonable and unsupportable arguments accordingly petitioner is liable for the addition_to_tax under sec_6651 for tax years and iv sec_6654 addition_to_tax sec_6654 imposes an addition_to_tax for a taxpayer’s failure to pay estimated income_tax the addition_to_tax is calculated with reference to four installment payments each equal to of the required_annual_payment sec_6654 d a the annual payment is the lesser_of of the tax_shown_on_the_return for the taxable_year or if no return is filed of the tax for such year or of the tax shown on the taxpayer’s return for the preceding taxable_year sec_6654 option does not apply where a taxpayer has not filed a return_for_the_preceding_taxable_year sec_6654 for the tax years at issue respondent introduced evidence to prove that petitioner had federal_income_tax liabilities that petitioner was required to file federal_income_tax returns that petitioner did not file valid federal_income_tax returns for the tax years at issue and that petitioner did not make any estimated_tax payments therefore respondent met his burden under sec_7491 to show that for each tax_year at issue petitioner had a required_annual_payment under sec_6654 but did not make any estimated_tax payments petitioner had taxable_income for the years at issue additionally petitioner was forestalled from calculating estimated_tax payments for tax_year using the tax shown on hi sec_2002 return because he failed to file a valid_return for tax_year petitioner stipulated that he did not make any estimated_tax payments for tax years and in his filings with the court petitioner did not allege that any of the statutory exemptions under sec_6654 applies petitioner is therefore liable for the sec_6654 additions to tax 3petitioner’s tax_return for tax_year also contained zeros for all income items and was therefore invalid for the reasons previously discussed with respect to tax years and v sec_6673 penalty sec_6673 allows the court to impose a penalty payable to the united_states and not in excess of dollar_figure whenever it appears that the proceedings before it have been instituted or maintained by the taxpayer primarily for delay the taxpayer’s position in such proceedings is frivolous or groundless or the taxpayer unreasonably failed to pursue available administrative remedies respondent has moved for imposition of this penalty because of petitioner’s lack of cooperation and his numerous frivolous filings with the court petitioner should be warned that while the court will refrain from imposing such a penalty at this time severe penalties may be imposed in the future if he continues to advance frivolous arguments accordingly respondent’s motion to impose a penalty under sec_6673 will be denied the court has considered all of the parties’ arguments and to the extent not addressed herein concludes they are moot irrelevant or without merit to reflect the foregoing an appropriate order will be issued and decisions will be entered under rule


internal_revenue_service number release date index number -------------------------------------- ------------------------------------------------- ------------------------------- -------------------------------- in re --------------------------------- department of the treasury washington dc third party communication date of communication month dd yyyy person to contact -------------------------- id no ------------- telephone number --------------------- refer reply to cc psi plr-118175-04 date date ---------------------------------------------------------------- ----------------------------- ----------------------------- ---------------------- ----------- ----------- ---------------------------------------------------- -------------------------------------------------- ------------------------------------------------------------ ------------------------------------- ----------------------------------------------------------- legend decedent spouse family_trust marital trust gst exempt marital trust gst nonexempt marital trust child child date a b dear this is in response to your letter dated date requesting an extension of time under sec_301_9100-3 of the procedure and administration regulations to sever a_trust into an exempt and nonexempt trust for purposes of the generation- skipping transfer gst tax and to make a reverse qualified_terminable_interest_property qtip_election under sec_2652 of the internal_revenue_code with respect to the exempt trust the facts and representations submitted are summarized as follows decedent died on date survived by his spouse child and child after making certain specific bequests section ii paragraph e of decedent’s will provides that family_trust is to be formed and funded with an amount equal to decedent’s available unified_credit paragraph f provides that marital trust is to be formed and funded with the residuary of decedent’s estate pursuant to section iii spouse is to receive all of the net_income of marital trust at least quarterly and so much or all of the corpus of the trust to provide for spouse’s health education maintenance and support spouse has a limited testamentary power to appoint the assets of marital trust to or for the benefit of any one or more of decedent’s descendants assets not effectively appointed are to be contributed to family_trust and administered pursuant to that trust’s terms upon spouse’s death spouse’s estate is to receive any undistributed_net_income of marital trust section iv provides that the trustee of family_trust may distribute net_income and or corpus of family_trust to spouse child and child to provide for their health education maintenance and support spouse has a testamentary limited power to appoint the assets of family_trust to or for the benefit of decedent’s descendants family_trust assets not effectively appointed are to be divided into one share each for child and child if child survives spouse the share for child is to be distributed free of trust to child if child survives spouse the share for child is to be held in further trust for child 2’s benefit during the life of child child is to receive distributions of net_income and or corpus from her trust to provide for her health education maintenance and support upon child 2’s death the remaining trust assets are to be held in further trust for the then living descendants of child or if none to decedent’s then living descendants per stirpes or if none to the heirs at law of decedent and spouse section iv further provides that if child and or child predeceases spouse leaving living descendants or if child dies survived by descendants before receiving all of the assets in her trust the assets of the trust designated for child and child are to be held in a separate trust for descendants of child and child these descendants are to receive distributions of net_income and or corpus from their respective trust to provide for their health education maintenance and support when there is no longer a living child of the deceased child under the age of the trust is to terminate and all of the remaining assets are to be distributed to the then living descendants of the deceased child per stirpes or if none to decedent’s then living descendants per stirpes or if none to the heirs at law of decedent and spouse section v provides the executor with the power to allocate decedent’s available gst_exemption divide marital trust into a gst exempt and nonexempt trust and make the reverse_qtip_election under sec_2652 for the exempt trust section viii authorizes the executor to divide any trust established under the will at any time into two or more separate trusts so that the federal gst tax inclusion_ratio as defined in sec_2642 for each trust shall be either zero or any such separate trusts are to have provisions that are identical to the original trust if a_trust is divided into separate trusts the executor may make different tax elections including the allocation of decedent’s available gst_exemption to each separate trust upon decedent’s death the executors of his estate engaged an accounting firm to prepare the form_706 estate and generation-skipping_transfer_tax return for decedent’s estate the return reported that assets equal to dollar_figurea will fund family_trust the qtip_election was made on schedule m of the form_706 for the assets in the marital trust the accounting firm however failed to sever or advise the executors to sever the marital trust into a gst exempt and nonexempt trust and to make the reverse_qtip_election under sec_2652 for the gst exempt trust this failure was discovered when spouse retained an attorney to review her estate_planning documents no allocation of decedent’s available gst_exemption was made on the form_706 in addition it has been represented that all of decedent’s gst_exemption was available for allocation at his death further it has been represented that none of the trusts established under the will have been funded and the administration of decedent’s estate remains open the executors propose to divide marital trust into the gst exempt marital trust and the gst nonexempt marital trust the gst exempt marital trust will be funded with a fractional share of the residue of decedent’s estate passing to the marital trust the numerator of which is equal to the decedent’s remaining gst_exemption after taking into account the automatic allocation of gst_exemption to family_trust and the denominator of which is equal to the amount of the residue passing to the marital trust the gst nonexempt marital trust will be funded with the balance of the property passing to the marital trust the gst exempt marital trust and the gst nonexempt marital trust will be funded on a non pro_rata basis based on either the fair_market_value of the assets on the date of funding or in a manner that fairly reflects the net appreciation or depreciation in the value of the assets measured from the decedent’s date of death to the date of funding executors are requesting an extension of time under sec_301_9100-3 to sever marital trust into the gst exempt marital trust and the gst nonexempt marital trust pursuant to sec_26_2654-1 and to make a reverse_qtip_election under sec_2652 for the gst exempt marital trust by filing a supplemental form_706 so that the unused portion of decedent’s gst_exemption will be deemed allocated to the gst exempt marital trust resulting in the trust having a zero inclusion_ratio law and analysis sec_2001 imposes a tax on the transfer of the taxable_estate of every decedent who is a citizen or resident_of_the_united_states sec_2056 provides that for purposes of the tax imposed by sec_2001 the value of the taxable_estate is to be determined by deducting from the value of the gross_estate an amount equal to the value of any interest in property that passes or has passed_from_the_decedent to the surviving_spouse sec_2056 provides the general_rule that no deduction shall be allowed for an interest passing to the surviving_spouse if on the lapse of time on the occurrence of an event or contingency or on the failure of an event or contingency to occur the interest will terminate or fail and a an interest in such property passes or has passed for less than an adequate_and_full_consideration in money or moneys worth from the decedent to any person other than the surviving_spouse or the estate of such spouse and b if by reason of such passing such person or his heirs or assigns may possess or enjoy any part of such property after such termination or failure of the interest so passing to the surviving_spouse sec_2056 provides that in the case of qualified_terminable_interest_property the entire property shall be treated as passing to the surviving_spouse for purposes of sec_2056 and no part of the property shall be treated as passing to any person other than the surviving_spouse for purposes of sec_2056 sec_2056 defines qualified_terminable_interest_property as property which passes from the decedent in which the surviving_spouse has a qualifying_income_interest_for_life and to which an election under sec_2056 applies sec_2056 provides that an election under sec_2056 with respect to any property shall be made by the executor on the return of tax imposed by sec_2001 the election once made is irrevocable under sec_2044 any property in which the decedent possessed a qualifying_income_interest_for_life and for which a deduction was allowed under sec_2056 is includable in the decedent’s gross_estate sec_2601 imposes a tax on every generation-skipping_transfer sec_2602 provides that the amount of tax is the taxable_amount multiplied by the applicable_rate sec_2641 defines applicable_rate as the product of the maximum_federal_estate_tax_rate and the inclusion_ratio with respect to the transfer sec_2642 provides the method for determining the inclusion_ratio sec_2631 provides that for purposes of determining the inclusion_ratio every individual shall be allowed a gst_exemption of dollar_figure adjusted for inflation under sec_2631 that may be allocated by such individual or by his or her executor to any property with respect to which such individual is the transferor sec_2631 provides that once an allocation of gst_exemption is made it is irrevocable under sec_2632 the allocation of the gst_exemption may be made at any time on or before the date prescribed for filing the individual’s estate_tax_return including extensions plr-118175-04 sec_2632 provides that in general any portion of an individual’s gst_exemption which has not been allocated within the time prescribed by sec_2632 shall be deemed to be allocated as follows a first to property which is the subject of a direct_skip occurring at the individual’s death and b second to trusts with respect to which the individual is the transferor and from which a taxable_distribution or a taxable_termination might occur at or after the individual’s death sec_2652 provides that in the case of any trust with respect to which a deduction is allowed to the decedent’s estate under sec_2056 the estate of the decedent may elect to treat all of the property in the trust for purposes of the gst tax as if the election to be treated as qtip had not been made this election is referred to as the reverse_qtip_election the consequence of a reverse_qtip_election is that the decedent remains for gst tax purposes the transferor of the qtip_trust for which the election is made as a result the decedent’s gst_exemption may be allocated to the qtip_trust sec_26_2652-2 of the generation-skipping_transfer_tax regulations provides that the reverse_qtip_election is to be made on the return on which the qtip_election is made sec_26_2654-1 provides in part that if there is more than one transferor with respect to a_trust the portions of the trust attributable to the different transferors are treated as separate trusts for purposes of chapter sec_26_2654-1 provides that the severance of a_trust that is included in the transferor's gross_estate or created under the transferor's will into two or more trusts is recognized for purposes of chapter if the governing instrument does not require or otherwise direct severance but the trust is severed pursuant to discretionary authority granted either under the governing instrument or under local law and a the terms of the new trusts provide in the aggregate for the same succession of interests and beneficiaries as are provided in the original trust b the severance occurs or a reformation proceeding if required is commenced prior to the date prescribed for filing the federal estate_tax_return including extensions actually granted for the estate of the transferor and c either the new trusts are severed on a fractional basis if severed on a fractional basis the separate trusts need not be funded with a pro_rata portion of each asset held by the undivided trust the trusts may be funded on a non pro_rata basis provided funding is based on either the fair_market_value of the assets on the date of funding or in a manner that fairly reflects the net appreciation or depreciation in the value of the assets measured from the valuation_date to the date of funding or plr-118175-04 if the severance is required by the terms of the governing instrument to be made on the basis of a pecuniary amount the pecuniary payment is satisfied in a manner that would meet the requirements of paragraph a ii of this section if it were paid to an individual under sec_301_9100-1 the commissioner may grant a reasonable extension of time under the rules set forth in sec_301_9100-2 and sec_301_9100-3 to make a regulatory election or a statutory election but no more than months except in the case of a taxpayer who is abroad under all subtitles of the code except subtitles e g h and i sec_301_9100-1 through provide the standards the commissioner will use to determine whether to grant an extension of time to make a regulatory election sec_301_9100-2 provides for automatic extensions of time for making certain elections sec_301_9100-3 provides that in general requests for extensions of time for regulatory elections that do not meet the requirements of sec_301_9100-2 must be made under the rules of sec_301_9100-3 requests for relief subject_to sec_301_9100-3 will be granted when the taxpayer provides the evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and the grant of relief will not prejudice the interests of the government sec_301_9100-3 provides that a taxpayer is deemed to have acted reasonably and in good_faith if the taxpayer reasonably relied on a qualified_tax professional including a tax professional employed by the taxpayer and the tax professional failed to make or advise the taxpayer to make the election in this case it has been represented that all of decedent’s gst_exemption was available for allocation at his death although no allocations of decedent's gst_exemption were made on the form_706 as filed pursuant to sec_2632 and sec_26_2632-1 dollar_figurea of decedent’s available gst_exemption was automatically allocated to the family_trust leaving dollar_figureb of decedent’s available gst_exemption unused as a result of the qtip_election made on the estate_tax_return the marital trust’s assets will be includible in spouse's gross_estate pursuant to sec_2044 spouse accordingly will be the transferor of the marital trust’s assets for gst tax purposes therefore decedent's remaining gst_exemption may not be allocated to marital trust's assets however if the marital trust is severed into two trusts the gst exempt marital trust and the gst nonexempt marital trust and a reverse_qtip_election under sec_2652 is made with respect to the gst exempt marital trust decedent will be treated as the transferor of the gst exempt marital trust’s assets under the automatic allocation rules in sec_2032 decedent's remaining gst tax exemption of dollar_figureb will be allocated to the gst exempt marital trust the gst exempt marital trust will have an inclusion_ratio of zero plr-118175-04 provided that dollar_figureb is equal to the value of the trust’s assets for federal transfer_tax purposes based on the facts submitted and the representations made we conclude that the requirements of sec_301_9100-3 have been satisfied accordingly the estate is granted an extension of time of sixty days from the date of this letter to sever the marital trust into the gst exempt marital trust and the gst nonexempt marital trust and to file a supplemental form_706 on which the reverse_qtip_election is made for the gst exempt marital trust the supplemental form_706 should be filed with the internal_revenue_service center cincinnati ohio a copy of this letter should be attached to the return a copy is enclosed for this purpose an extension of time to make the reverse_qtip_election under sec_2652 does not extend the time to make an allocation of any remaining gst_exemption once the reverse_qtip_election is made sec_2632 and sec_26_2632-1 will operate to allocate dollar_figureb of decedent’s remaining gst_exemption to the gst exempt marital trust except as expressly provided herein no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter specifically no opinion is expressed or implied as to the value of the assets included in decedent’s gross_estate for federal estate_tax purposes this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent in accordance with the power_of_attorney on file with this office a copy of this letter is being sent to your authorized representative the rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed plr-118175-04 by an appropriate party while this office has not verified any of the material submitted in support of the request for rulings it is subject_to verification on examination sincerely heather c maloy heather c maloy associate chief_counsel passthroughs special industries enclosures copy for ' purposes copy of this letter cc