                                 T.C. Memo. 2017-218



                           UNITED STATES TAX COURT



          ROBERT E. SMITH, III AND ANGELA K. SMITH, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 21707-15.                            Filed November 6, 2017.



      George W. Connelly, Jr., for petitioners.

      M. Kathryn Bellis and Yvette Nunez, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      GOEKE, Judge: Respondent issued a notice of deficiency determining a

$623,795 income tax deficiency and a $124,759 accuracy-related penalty under

section 6662(a) for petitioners’ 2009 tax year.1 During 2009 petitioners


      1
          Unless otherwise indicated, all Rule references are to the Tax Court Rules
                                                                         (continued...)
                                         -2-

[*2] transferred their personal assets of cash and marketable securities to a wholly

owned S corporation, which in turn transferred the assets to a family limited

partnership. Petitioners dissolved the S corporation and received the partnership

interest in the dissolution of the S corporation. Through this structure and the

transfer of their personal assets, petitioners claimed an ordinary loss deduction on

the liquidating distribution by using a substantially discounted value for the assets

held by the partnership. Petitioners have conceded that to the extent they are

entitled to a loss deduction for 2009, it should be characterized as a short-term

capital loss.

       After concessions the issues for consideration are whether petitioners:

(1) are entitled to deduct a short-term capital loss for 2009 relating to the

dissolution of the S corporation and (2) are liable for a section 6662(a) accuracy-

related penalty for 2009. For the reasons stated herein, we decide both issues for

respondent.




       1
        (...continued)
of Practice and Procedure, and all section references are to the Internal Revenue
Code (Code) in effect for the year at issue. All amounts are rounded to the nearest
dollar.
                                         -3-

[*3]                            FINDINGS OF FACT

       At the time petitioners timely filed their petition, they resided in Texas.2

Mr. Smith worked for National Coupling Co., Inc. (National Coupling), for 36

years, retiring in 2009, the year at issue, and owned 3,000 shares of its stock,

representing an approximately 0.5828% ownership. National Coupling

manufactured pneumatic and hydraulic subsea couplings and valves. Mr. Smith

was the company’s vice president and the manager at its manufacturing facility.

He was in charge of manufacturing, engineering, intellectual property work, and

trademarks. Mr. Smith is an inventor with over 400 patents issued or in

prosecution at the time of trial. Most of Mr. Smith’s inventions relate to subsea

hydraulic couplings and pneumatic couplings from his employment with National

Coupling. One of his inventions was used to fix the space shuttle rocket boosters

after the Challenger disaster. He won a Texas Inventor of the Year Award from

the Texas State Bar Association in 2008. Petitioners have been married for over

50 years. Mrs. Smith is a homemaker. Both Mr. and Mrs. Smith graduated from

high school and have taken some college courses.




       2
       The parties’ stipulation of facts with accompanying exhibits is incorporated
herein by this reference.
                                       -4-

[*4] In June 2009 National Coupling was sold and Mr. Smith retired. Mr. Smith

received a $600,000 bonus, $248,246 from the sale of his stock, and $181,170

from the surrender of two company-sponsored life insurance policies. In total he

received employee compensation, including the bonus, of $664,007 in 2009. After

the sale he began to provide consulting services to National Coupling under a two-

year contract and received $37,800 under that contract in 2009. During his

employment at National Coupling Mr. Smith had worked on a sprinkler device for

home sprinkler systems that would automatically apply fertilizer or insecticide.

He had worked on the sprinkler device in 2005 or 2006, and a patent application

was filed with the U.S. Patent and Trademark Office (USPTO) in 2006. Patent

applications were also filed in Canada and the United Kingdom. The U.S. patent

was issued in 2014, and the Canadian patent was issued in October 2009. The

record does not establish the date of the U.K. patent. Documents relating to the

sale of National Coupling did not grant Mr. Smith the right to the sprinkler device

patent. However, Mr. Smith believed that he would retain the patent rights to the

sprinkler device after the sale.
                                          -5-

[*5] I.         Tax Strategy

          As a result of the National Coupling sale and Mr. Smith’s retirement,

petitioners’ financial adviser recommended that they obtain estate planning advice

and referred them to Richard Shanks of the Shanks Law Firm (Shanks Firm), now

known as Shanks & Hauser. The financial adviser had referred other clients to

Mr. Shanks, an experienced attorney and a certified public accountant. He has an

undergraduate accounting degree from the University of Texas and a law degree

from the University of Texas Law School. His practice focuses on estate planning,

probate, tax planning, and tax return preparation, and he works mostly with

entrepreneurs and executives. Petitioners met with Mr. Shanks on June 23, 2009.

He prepared various estate planning documents for them, including wills and

medical directives. Mr. Shanks also recommended a tax planning strategy

intended to mitigate the effect on petitioners’ tax liability of Mr. Smith’s

compensation from National Coupling. The tax structure involved the

organization of an S corporation and the formation of a family limited partnership.

Under the structure, petitioners would transfer their cash and marketable securities

to a wholly owned S corporation that would then transfer the assets to a family

limited partnership. Mr. Shanks explained to petitioners that the family limited

partnership would provide asset protection. The S corporation would own the
                                        -6-

[*6] limited partnership, and the partnership would hold petitioners’ cash and

marketable securities. As part of the structure, petitioners would organize and

dissolve the S corporation within the same tax year. The S corporation would

distribute the partnership interest to the shareholders upon dissolution. Mr.

Shanks would determine the fair market value of the distributed partnership

interest using large discounts for lack of marketability and lack of control,

generating a tax loss upon the dissolution of the S corporation. The

S corporation’s dissolution and the distribution of the partnership interest were

both necessary to generate the tax loss. A third entity in the planning structure

was a revocable management trust that would hold the general partnership interest.

Mr. Shanks advised that the tax structure could generate either a capital or an

ordinary loss deduction on the basis of the business purpose of the S corporation.

He had implemented similar structures for 10 to 15 other clients between 1999 and

2009.

        On July 9, 2009, petitioners organized RACR Ventures, Inc. (Ventures), an

S corporation, formed RACR Partnership, Ltd. (RACR Partnership), a family

limited partnership, and created the Smith Management Trust (Smith Trust), a

revocable management trust (collectively, RACR structure). Petitioners each

owned 50% of Ventures. Mr. Smith was its president and treasurer, and Mrs.
                                        -7-

[*7] Smith was the vice president and secretary. Both were directors. Ventures

owned a 98% limited partnership interest in RACR Partnership. Initially each

petitioner was a 1% general partner. Petitioners transferred their general

partnership interests to the Smith Trust. Petitioners were cotrustees and

beneficiaries of the Smith Trust. From the outset petitioners understood that

Ventures would not hold any assets, Ventures would immediately transfer its

assets to RACR Partnership, and they would dissolve Ventures by the end of 2009

to accomplish their tax mitigation plan. Petitioners understood that Ventures was

the vehicle they would use to minimize their 2009 income tax liability.

Petitioners’ handwritten notes from their meeting with Mr. Shanks in June 2009

identified the RACR structure as a vehicle to minimize tax for 2009. Email

communications between petitioners and the Shanks Firm in July and August 2009

acknowledge a “liquidation” in 2009, Ventures “goes away” in 2009, and they

“will form a new corp next year”.

II.   Transfer of Assets

      On August 3, 2009, petitioners made a series of transfers of cash and

marketable securities from three personal accounts at Merrill Lynch to three newly

opened accounts of Ventures at Merrill Lynch (Ventures accounts) and then to
                                       -8-

[*8] three newly opened accounts of RACR Partnership at Merrill Lynch (RACR

Partnership accounts) as follows:

                  Account No.           Cash     Securities
                        1           $804,911      $362,095
                        2             65,069       513,557
                        3                766        70,554
                     Total           870,746       946,206

      Petitioners transferred a total of $1,816,952 in cash and marketable

securities to RACR Partnership via Ventures in the above transfers. On August 5,

2009, petitioners made additional nominal cash transfers to two Ventures

accounts, and Ventures in turn transferred the cash to two RACR Partnership

accounts the next day. By August 5, 2009, most of petitioners’ assets were held

by RACR Partnership. Subsequently the RACR Partnership transferred a nominal

amount of cash to Ventures to pay account fees. On August 31 and November 18,

2009, petitioners transferred additional nominal amounts of cash from their

personal account at Merrill Lynch to a Ventures account and then to an RACR

Partnership account at Merrill Lynch. As of the end of August, September,

October, and November 2009, Ventures’ three accounts had zero balances.
                                        -9-

[*9] On August 12, 2009, RACR Partnership distributed $100,000 to petitioners

to purchase long-term care insurance that Mr. Shanks had recommended as part of

their estate planning. Mrs. Smith recorded the $100,000 as a loan to petitioners,

but Mr. Shanks treated the transfer as a distribution. In August 2009 RACR

Partnership also extended a line of credit to petitioners for $500,000. Mr. Shanks

suggested the line of credit as a means for petitioners to have access to RACR

Partnership’s assets to pay their living expenses if necessary. Petitioners signed a

line of credit note on August 9, 2009, payable to RACR Partnership with a

$500,000 principal and a 2.8% interest rate payable at maturity on July 31, 2018.

Petitioners did not withdraw any money from the line of credit and ultimately

canceled it in 2014.

      In August 2009 petitioners opened accounts in the names of Ventures and

RACR Partnership at Morgan Stanley Smith Barney (Smith Barney) and

authorized the transfer of assets held in a personal account at Smith Barney to

Ventures and authorized the transfer of those assets from Ventures to RACR

Partnership. On November 3, 2009, petitioners transferred $57,037 in securities

from a personal account at Smith Barney to a newly opened account for Ventures

at Smith Barney. The next day Ventures transferred the securities to a newly

opened account for RACR Partnership at Smith Barney. Smith Barney recorded
                                       - 10 -

[*10] the transfers in journal entries as effective September 30, 2009. After the

transfer petitioners’ and Ventures’ Smith Barney accounts had zero balances. On

November 18, 2009, petitioners transferred nominal amounts of cash from two

personal accounts at Merrill Lynch to two Ventures accounts at Merrill Lynch, and

Ventures transferred the cash to two RACR Partnership accounts at Merrill Lynch

the next day. During 2009 petitioners transferred a total of $1,881,737 in cash and

marketable securities to Ventures, and Ventures transferred a net amount of

$1,881,467 to RACR Partnership. Petitioners transferred a net amount of

$1,781,467 to RACR Partnership via Ventures, taking into account the $100,000

distribution from RACR Partnership to them for the long-term care insurance.

Ventures did not have any business activities during 2009. It did not have a bank

account, did not issue stock certificates, did not keep minutes of meetings, and did

not follow corporate formalities.

III.   Dissolution of Ventures

       On November 18, 2009, petitioners met with Mr. Shanks and began to

dissolve Ventures, effective December 31, 2009. On December 10, 2009,

petitioners filed required documents with the Texas secretary of state to end

Ventures’ corporate existence, indicating that they had organized Ventures to

pursue business opportunities and were dissolving the corporation to reduce
                                         - 11 -

[*11] overhead expenses because they had not found any profitable opportunities.

The Shanks Firm prepared the legal documents required to dissolve Ventures. In

the dissolution Ventures transferred a 49% limited partnership interest in RACR

Partnership to each petitioner, effective December 10, 2009. Petitioners

transferred 1% limited partnership interests to two trusts in the names of each of

their two sons (children’s trusts), effective December 31, 2009. As of the end of

2009 RACR Partnership was owned as follows: the Smith Trust owned a 2%

general partnership interest, petitioners each owned a 48% limited partnership

interest, and the children’s trusts owned 1% limited partnership interests.

IV.    Legal Fees

      Mr. Shanks generally charged a flat fee for his legal services. He charged

petitioners a flat fee of $23,200 for services relating to their will and relevant

estate planning documents and the RACR structure. Petitioners paid the fee in

two installments of $10,000 and $13,200 at the initial meeting on June 23, 2009,

and on July 9, 2009, respectively. Mr. Shanks did not charge petitioners an

additional fee for Ventures’ dissolution in November 2009. He submitted an

invoice dated January 2, 2010, to petitioners for legal services relating to

Ventures’ dissolution showing a fee of zero.
                                        - 12 -

[*12] V. Tax Returns and Reporting Position

      The Shanks Firm prepared the 2009 returns for petitioners, Ventures, and

RACR Partnership for $3,050. In August 2009 Mrs. Smith met with petitioners’

former accountant and return preparer. She provided relevant documents relating

to the RACR structure to the accountant. After meeting with the former

accountant, Mrs. Smith asked Mr. Shanks to answer the accountant’s questions

concerning the RACR structure. Petitioners understood that their former

accountant did not feel comfortable preparing the necessary returns for the RACR

structure. Petitioners did not consult any other tax professionals regarding the

RACR structure or their 2009 income tax.

      Ventures filed an initial and final corporate tax return for 2009. Ventures

reported gross receipts of $1,120,675 and cost of goods sold of $1,870,527,

resulting in an ordinary loss of $749,852. It reported the values of the 49% limited

partnership interests in RACR Partnership distributed to petitioners as gross

receipts. To calculate the values of the distributed partnership interests, the

Shanks Firm used the cash and the value of the securities that petitioners had

transferred to RACR Partnership via Ventures and applied a 40% discount for lack

of marketability and lack of control. Mr. Shanks used a 40% discount on the basis
                                        - 13 -

[*13] of his research of discounts allowed in reported court opinions. Ventures’

reported gross receipts for 2009 were calculated as follows:3

                             Item                       Amount
              Cash and marketable securities           $1,805,090
              Note payable                               $100,000
              Total assets                             $1,905,090
              98% of total assets                      $1,867,791
             Adjustment for 40% discount
              for partnership interests                    60%
             Gross receipts                            $1,120,675

      To calculate cost of goods sold of $1,870,527, the Shanks Firm used

petitioners’ alleged bases in the cash and marketable securities that they had

transferred to Ventures and then to RACR Partnership. Mr. Shanks intended that

the cost of goods sold would equal petitioners’ bases in Ventures. The parties

have stipulated that petitioners had a total basis of $1,833,558 in Ventures. Mr.

Shanks had Ventures report the values of the distributed partnership interests as

gross receipts and report petitioners’ alleged total basis in Ventures as the cost of

goods sold because the RACR tax strategy was intended to produce an ordinary



      3
       We note that the value of a 98% partnership interest would be $1,866,988
using the above amounts, and a 40% discount would result in gross receipts of
$1,120,193.
                                       - 14 -

[*14] loss to offset Mr. Smith’s compensation from National Coupling.

Petitioners reported the loss on the distribution of the RACR Partnership interests

as an ordinary loss. Ventures did not have any gross receipts for 2009 or any cost

of goods sold. Ventures reported property distributions of $1,115,479, including

$1,120,675 in gross receipts less certain deductions.

      On two separate forms filed with the Internal Revenue Service (IRS)

Ventures’ business activity was reported as trading or management. On its 2009

return RACR Partnership’s business activity was reported as investment. RACR

Partnership’s 2009 return did not report any gross receipts, sales, deductions, or

business income or loss. RACR Partnership reported nominal amounts of interest

income, dividends, and net short-term and long-term capital gains that passed

through to Ventures.

      On their 2009 joint return petitioners reported income of $849,422 from

National Coupling, including $664,007 in compensation, $37,800 in consulting

fees, and $181,170 in capital gain from two company-sponsored life insurance

policies. Petitioners have conceded that the $181,170 received upon the surrender

of the two life insurance policies was ordinary income. Petitioners claimed an

ordinary loss deduction of $749,852 from Ventures. In the notice of deficiency

respondent disallowed the $1,870,527 adjustment for cost of goods sold from
                                        - 15 -

[*15] Ventures as reported on petitioners’ joint return and increased petitioners’

ordinary income by the reported gross receipts of $1,120,675 and, in the

alternative, determined that Ventures had gross receipts of zero, resulting in a

disallowance of petitioners’ claimed ordinary loss deduction. Respondent

advanced the alternative argument at trial.

                                      OPINION

      Respondent contends that petitioners are not entitled to deduct the 2009 loss

upon the dissolution of Ventures because the RACR structure lacked economic

substance, or in the alternative, the loss deduction did not meet the section 165

requirements for a bona fide loss incurred in a trade or business or a transaction

entered into for profit. He further argues that if petitioners are entitled to the 2009

loss deduction, they understated the fair market value of the partnership interests

distributed by Ventures. Each party presented expert testimony on the fair market

value of RACR Partnership upon Ventures’ dissolution. We find that the RACR

structure lacked economic substance and accordingly do not address respondent’s

two alternative arguments.

I.    Economic Substance Doctrine

      Taxpayers generally are free to structure their business transactions as they

wish even if motivated in part by a desire to reduce taxes. Gregory v. Helvering,
                                       - 16 -

[*16] 293 U.S. 465, 469 (1935). The economic substance doctrine, however,

permits a court to disregard a transaction--even one that formally complies with

the Code--for Federal income tax purposes if it has no effect other than generating

an income tax loss. See Knetsch v. United States, 364 U.S. 361 (1960). Whether

a transaction has economic substance is a factual determination. United States v.

Cumberland Pub. Serv. Co., 338 U.S. 451, 456 (1950). The taxpayer bears the

burden of proving that a transaction has economic substance. Coltec Indus., Inc.

v. United States, 454 F.3d 1340, 1355-1356 & n.15 (Fed. Cir. 2006).

      An appeal in this case would lie to the Court of Appeals for the Fifth

Circuit. Accordingly, we follow the law of that circuit with respect to its

interpretation of the economic substance doctrine. See Golsen v. Commissioner,

54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). The Court of Appeals

for the Fifth Circuit has interpreted the economic substance doctrine as a

conjunctive “multi-factor test”. Klamath Strategic Inv. Fund ex rel. St. Croix

Ventures v. United States, 568 F.3d 537, 544 (5th Cir. 2009). In Klamath, the

Court of Appeals stated that a transaction will be respected for tax purposes only

if: (1) it has economic substance compelled by business or regulatory realities,

(2) it is imbued with tax-independent considerations, and (3) it is not shaped

totally by tax-avoidance features. Thus, a transaction must exhibit an objective
                                        - 17 -

[*17] economic reality, a subjectively genuine business purpose, and some

motivation other than tax avoidance. Southgate Master Fund, L.L.C. ex rel.

Montgomery Capital Advisors LLC v. United States, 659 F.3d 466, 480 (5th Cir.

2011). Failure to meet any one of these three factors renders the transaction void

for tax purposes. Klamath, 568 F.3d at 544. While Klamath phrases the economic

substance doctrine as a conjunctive, three-factor test, the Court of Appeals for the

Fifth Circuit has recognized that “there is near-total overlap between the latter two

factors. To say that a transaction is shaped totally by tax-avoidance features is, in

essence, to say that the transaction is imbued solely with tax-dependent

considerations.” Southgate Master Fund, 659 F.3d at 480 & n.40.

      Petitioners claim that they organized Ventures as part of the RACR

structure to manufacture and sell the sprinkler device after Mr. Smith received the

patent. They claim that they transferred their personal assets to Ventures to

finance the start of this new business enterprise. Ventures immediately transferred

the assets to RACR Partnership purportedly for asset protection purposes, but,

according to petitioners, the funds would have been available to Ventures once it

started to manufacture the sprinkler device. According to petitioners, they

dissolved Ventures four months later because of unforeseeable circumstances:

(1) the patent had not been issued and (2) Mr. Smith was busy with his consulting
                                        - 18 -

[*18] work. We find that petitioners’ claims with respect to their purpose for

organizing and dissolving Ventures in 2009 are not credible. Ventures and the

RACR structure fail to meet all three prongs of the economic substance doctrine as

set forth by the Court of Appeals for the Fifth Circuit.

      A.     Objective Economic Reality Inquiry

      For purposes of the objective economic inquiry, a transaction lacks

economic substance if it does not “vary[,] control[,] or change the flow of economic

benefits.” Id. at 481 (quoting Klamath, 568 F.3d at 543). The objective economic

inquiry asks whether the transaction affected the taxpayer’s financial position in

any way, i.e., whether the transaction “either caused real dollars to meaningfully

change hands or created a realistic possibility that they would do so.” Id. at 481 &

n.41. A circular flow of funds among related entities does not indicate a

substantive economic transaction for tax purposes. Merryman v. Commissioner,

873 F.2d 879, 882 (5th Cir. 1989), aff’g T.C. Memo. 1988-72.

      The RACR structure failed to alter petitioners’ economic position in any

way that affected objective economic reality. The RACR structure was a circular

flow of funds among related entities used to generate an artificial tax loss to offset

petitioners’ 2009 income. Petitioners transferred a substantial portion of their

personal assets to a wholly owned S corporation, Ventures, which in turn
                                        - 19 -

[*19] transferred the assets to RACR Partnership in exchange for a 98%

partnership interest. In accordance with petitioners’ prearranged tax scheme,

Ventures dissolved and distributed a 49% partnership interest to each petitioner.

Petitioners controlled RACR Partnership. It held only their personal assets, and

they received those assets back in the liquidating distribution of the partnership

interest. They generated a loss by valuing the combined 98% distributed

partnership interests using a substantial discount for a lack of control and a lack of

marketability. They had constant control over the assets. While the form of

ownership of the cash and securities changed, the substance did not. The RACR

structure and the dissolution of Ventures did not affect petitioners’ financial

position and did not cause real dollars to meaningfully change hands. Moreover,

petitioners understood from the time they implemented the RACR structure that

they would not lose control over their personal assets. Petitioners intended from

the beginning to dissolve Ventures by the end of 2009 and, as discussed below,

never intended that it would manufacture the sprinkler device. Accordingly, we

find that the RACR structure and Ventures’ dissolution lacked objective economic

reality and failed to satisfy the first prong of the economic substance doctrine as

set forth by the Court of Appeals for the Fifth Circuit. Failure to satisfy any one

prong of the multifactor test established by the Court of Appeals causes the
                                          - 20 -

[*20] transaction to lack economic substance. Nevertheless, we will address the

remaining two factors of the economic substance doctrine as interpreted by the

Court of Appeals for the Fifth Circuit.

      B.     Subjective Purpose Inquiry

      The second and third Klamath factors, while enumerated separately, overlap

and derive from an inquiry into the taxpayer’s purpose--whether the taxpayer had

a subjectively genuine business purpose or some motivation other than tax

avoidance. Southgate Master Fund, 659 F.3d at 481. Accordingly we address the

two factors together. Taxpayers are not prohibited from seeking tax benefits in

conjunction with seeking profits for their businesses. Id. Taxpayers who act with

mixed motives of profits and tax benefits can satisfy the subjective test. Id. at

481-482. However, for the subjective purpose inquiry, tax-avoidance

considerations cannot be the taxpayer’s sole purpose for entering into a

transaction. Salty Brine I, Ltd. v. United States, 761 F.3d 484, 495 (5th Cir.

2014). The fact that a taxpayer enters into a transaction primarily to obtain tax

benefits does not necessarily invalidate the transaction under the subjective

purpose inquiry. Compaq Comput. Corp. & Subs. v. Commissioner, 277 F.3d 778,

786 (5th Cir. 2001), rev’g 113 T.C. 214 (1999).
                                        - 21 -

[*21] Petitioners claim that they organized Ventures to manufacture the sprinkler

device but changed their minds because the patent had not been issued by the end

of 2009 and Mr. Smith was busy with his consulting work. The record is not clear

as to whether Mr. Smith owned a right to the sprinkler device patent.4 Even if we

assume that Mr. Smith had the right to the sprinkler device patent, we do not find

petitioners’ claims that they organized Ventures to manufacture the sprinkler

device to be credible. First, Mr. Smith’s testimony relating to the Canadian and

U.S. patents conflicts with the record. He testified the Canadian patent was issued

before the National Coupling sale, but documents in the record show that it was

issued in October 2009. Mr. Smith also testified that on the basis of his

experience he expected that the USPTO would issue the sprinkler device patent

shortly after the Canadian patent’s issuance. Thus, according to his testimony he

should have expected the U.S. patent to be issued shortly after October 2009.

However, petitioners began to dissolve Ventures only one month later. Mr. Smith

is an experienced businessman familiar with patent procedure. The U.S. patent

application was submitted in 2006. By the end of 2009 he had already waited

three years for the patent. In the light of these inconsistencies, we do not find Mr.

      4
       Petitioners assert that Mr. Smith was to receive the patent rights in the
National Coupling sale but did not because of an oversight by the attorneys
involved in the sale. Petitioners allege that this mistake was corrected in 2010.
                                       - 22 -

[*22] Smith’s testimony that he intended to manufacture the sprinkler device

through Ventures to be credible. Nor do we believe that petitioners decided to

dissolve Ventures because the USPTO had not issued the sprinkler device patent

by November 2009. Rather, we find that petitioners never intended to operate

Ventures as a manufacturing business. They intended from the beginning of the

RACR structure to organize and dissolve Ventures within the same year to

generate a tax loss to minimize their 2009 income tax liability.

      Documents in the record establish that it was petitioners’ intent when they

implemented the RACR structure to organize and dissolve Ventures within the

same year. These documents include handwritten notes from their initial meeting

with Mr. Shanks that refer to an S corporation as the “vehicle to minimize tax

event this year” and statements made in August 2009 that Ventures “goes away” in

2009 and they “will form a new corp next year”. Additional inconsistencies in the

record include the identification of Venture’s activity on IRS forms as trading and

management and not the alleged purpose of manufacturing, a reference by an

employee of the Shanks Firm to a “liquidation” in July 2009 when asked about the

preparation of the 2009 tax returns, and Mr. Smith’s testimony stating an incorrect

date for when the Canadian patent was issued. Petitioners tried to explain away

each of these inconsistencies, but we do not find their explanations credible. The
                                        - 23 -

[*23] record establishes that petitioners had a prearranged plan to organize and

dissolve Ventures within the same year to achieve their tax-avoidance strategy.

Petitioners did not have a genuine business purpose for Ventures or the RACR

structure. They organized Ventures and implemented the RACR structure solely

for tax-motivated reasons.

      Irrespective of whether Mr. Smith owned the patent rights, we do not

believe that Ventures was organized to manufacture the sprinkler device.

Ventures existed for only four months and did not conduct any business activities.

It did not have any assets, offices, facilities, employees, or expenses. It did not

hold any funds to use for business operations because it transferred petitioners’

cash and marketable securities to RACR Partnership on the same day or within

one day of the initial transfers to it. The Ventures accounts had zero balances as

of the end of August through November 2009. Ventures did not follow corporate

formalities. Petitioners used the RACR structure to transfer their personal assets

to RACR Partnership and added Ventures as a conduit for the sole purpose of

creating an artificial tax loss by claiming a substantial discount on the value of

their personal cash and securities by holding the assets through a partnership.

      Petitioners claim that they did not discuss the tax consequences of the

RACR structure or the dissolution of Ventures with Mr. Shanks and did not learn
                                       - 24 -

[*24] about the loss until the 2009 returns had been prepared. They contend that

they did not discuss the tax consequences when they implemented the RACR

structure in June 2009. They also claim that they did not discuss the tax impact of

dissolving and liquidating Ventures when they made the decision to liquidate in

November 2009. We find that these claims are not credible and contradict the

record. Petitioners’ handwritten notes from their initial meeting with Mr. Shanks

referred to an S corporation as a tax-mitigation device. An email from an

employee of the Shanks Firm dated July 25, 2009, refers to a liquidation. In an

email dated August 5, 2009, Mrs. Smith stated Ventures “goes away after 2009.

Will there be another corporation beginning in 2010?”, and Mr. Shanks responded

in an email dated August 6, 2009: “We will form a new corp next year.” These

emails show that Mrs. Smith knew that Ventures’ dissolution was part of the

RACR structure from the beginning and they had not changed their minds.

Petitioners’ attempts to explain these inconsistencies are without merit. The

$23,200 flat fee for the RACR structure included a fee for Mr. Shanks’ services to

dissolve Ventures. Petitioners paid the entire fee when they retained Mr. Shanks

and he implemented the RACR strategy. Mr. Shanks did not charge an additional

fee to dissolve Ventures and submitted an invoice to petitioners showing a fee of

zero. Mr. Shanks had other clients organize and dissolve S corporations within
                                        - 25 -

[*25] the same year to achieve tax benefits, although he sought to blame the

S corporations’ dissolutions on the 2009 economy.

      Petitioners knew from the outset that Ventures would not operate a

manufacturing business. They never intended to manufacture the sprinkler device

through Ventures. They planned from the beginning to dissolve Ventures before

the end of 2009 to create an artificial tax loss to offset their 2009 income tax.

They also knew despite their arguments to the contrary that the RACR structure

would generate a loss. Mr. Shanks designed the tax structure to include the

application of a substantial discount on the value of petitioners’ personal assets

used in the strategy, and thereby the structure would produce a loss even if the

marketable securities increased in value during Ventures’ short existence.

Petitioners could have accomplished their alleged estate planning goal of asset

protection through the limited partnership framework without first transferring

their personal assets to Ventures. Ventures was organized for the sole purpose of

tax avoidance. Accordingly, we find that Ventures lacked economic substance,

and petitioners are not entitled to deduct any loss for 2009 relating to Ventures or

the RACR structure.
                                        - 26 -

[*26] II.    Section 6662(a) Accuracy-Related Penalty

      Respondent determined that petitioners are liable for a section 6662(a)

accuracy-related penalty for 2009. Section 6662(a) and (b)(1) and (2) imposes a

penalty equal to 20% of the amount of any underpayment of tax that is attributable

to (1) negligence or disregard of rules or regulations or (2) a substantial

understatement of income tax. The term “negligence” includes any failure to make

a reasonable attempt to comply with the provisions of the Code, and “disregard”

includes any careless, reckless, or intentional disregard of rules and regulations.

Sec. 6662(c). For individual taxpayers, an understatement is substantial if it

exceeds the greater of 10% of the amount of tax required to be shown on the return

or $5,000. Sec. 6662(d)(1)(A). By claiming the ordinary loss deduction on the

liquidating distribution of RACR Partnership interests, petitioners understated the

tax required to be shown on their 2009 joint return by more than 10%, which was

more than $5,000.5 Accordingly, they are liable for the section 6662(a) penalty




      5
        Respondent has conceded any accuracy-related penalty with respect to the
portion of petitioners’ underpayment attributable to the mischaracterization of the
proceeds from the two life insurance policies as capital gain because National
Coupling incorrectly reported the life insurance proceeds as capital gain on
petitioners’ Schedule K-1, Shareholder’s Share of Income, Deductions, Credits,
etc.
                                        - 27 -

[*27] with respect to this portion of the underpayment unless they establish a

defense of reasonable cause.

      Section 6664(c)(1) provides an exception to the section 6662(a) penalty

where the taxpayers demonstrate that they acted with reasonable cause and in good

faith with respect to the underpayment. We determine whether a taxpayer acted

with reasonable cause and in good faith on a case-by-case basis, taking into

account all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax

Regs. Once the Commissioner presents a prima facie case that a penalty should

apply, the taxpayers have the burden to prove that they acted with reasonable

cause and in good faith. Higbee v. Commissioner, 116 T.C. 438, 446-449 (2001).

A taxpayer’s reliance on the advice of a tax professional may constitute reasonable

cause and good faith. United States v. Boyle, 469 U.S. 241, 250 (1985). The

advice must be based on all pertinent facts and circumstances and the law as it

relates to those facts and circumstances and must not be based on any

unreasonable factual or legal assumptions. Sec. 1.6664-4(c)(1), Income Tax Regs.

We have summarized the requirements of reasonable reliance on professional

advice as follows: (1) the taxpayer reasonably believed that the professional was a

competent tax adviser with sufficient expertise to justify reliance, (2) the taxpayer

provided necessary and accurate information to the adviser, and (3) the taxpayer
                                          - 28 -

[*28] actually relied in good faith on the adviser’s judgment. Neonatology

Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), aff’d, 299 F.3d 221

(3d Cir. 2002). A taxpayer’s education and business experience are relevant to the

determination of whether the taxpayer acted with reasonable reliance on an adviser

and in good faith. Sec. 1.6664-4(c)(1), Income Tax Regs. The most important

factor is the extent of the taxpayer’s effort to assess his or her proper tax liability.

Id. para. (b). Due care does not require that the taxpayer challenge his or her

attorney’s advice or independently investigate its propriety. Streber v.

Commissioner, 138 F.3d 216, 219 (5th Cir. 1998), rev’g T.C. Memo. 1995-601.

      The question of whether petitioners’ reliance on Mr. Shanks was reasonable

is a difficult one. Petitioners went to Mr. Shanks upon the recommendation of

their financial adviser for estate planning advice because Mr. Smith was retiring.

Mr. Shanks was a qualified attorney and a competent adviser and had the

necessary and accurate information to provide his tax advice. Up to this point

petitioners’ reliance on Mr. Shanks was reasonable. However, we have found that

petitioners never intended to conduct any business activities through Ventures.

They understood, early in the process, that Ventures would be organized and

dissolved in 2009 but continued to represent, even at trial, that Ventures had a

business purpose. This is not acting in good faith. They knew from the beginning
                                        - 29 -

[*29] that Ventures would not last past 2009, it did not have a genuine business

purpose, and its sole purpose was tax avoidance. That knowledge alone negates a

reliance defense.

      Petitioners knew that the purpose of the RACR structure was to minimize

their 2009 income tax. Their handwritten notes from their first meeting with Mr.

Shanks referred to an S corporation as the vehicle to minimize the tax event in

2009. Mrs. Smith emailed the Shanks Firm in August 2009 and sought to confirm

that Ventures would dissolve by the end of 2009. Petitioners knew from the time

they implemented the RACR structure that Ventures’ sole purpose was to avoid

income tax on Mr. Smith’s bonus from the National Coupling sale. They knew

that Ventures would never manufacture the sprinkler device. Even if Mr. Smith

owned the patent rights as he claims, petitioners had no intent to keep Ventures in

existence until the patent was issued but dissolved it after only four months. Yet

they continued to perpetuate their tax-avoidance scheme through their testimony at

trial that we have found not to be credible or reliable. Nor do we find credible

petitioners’ attempts to explain away multiple inconsistencies in the record.

Petitioners did not act with reasonable reliance on a professional or act in good

faith. Accordingly, we find that petitioners are liable for the section 6662(a)

penalty.
                                      - 30 -

[*30] In reaching our holding, we have considered all arguments made, and, to the

extent not mentioned above, we conclude that they are moot, irrelevant, or without

merit.


                                               Decision will be entered under

                                      Rule 155.
