                              T.C. Memo. 2018-181



                        UNITED STATES TAX COURT



    SUGARLOAF FUND, LLC, JETSTREAM BUSINESS LIMITED, TAX
            MATTERS PARTNER, ET AL.,1 Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 30410-12, 15857-13,            Filed October 29, 2018.
                  15858-13, 165-14,
                  28657-14.


      John E. Rogers, for petitioners.

      Craig Connell, Thomas A. Deamus, and Clare W. Darcy, for respondent.




      1
        Cases of the following petitioners are consolidated herewith: Sugarloaf
Fund, LLC, Warwick Trading, LLC, Butler Fund, LLC, Severus Fund, LLC, John
E. Rogers, Partners Other Than the Tax Matters Partner, Jetstream Business
Limited, Tax Matters Partner, docket No. 165-14; and Sugarloaf Fund, LLC,
Jetstream Business Limited, Tax Matters Partner, docket Nos. 15857-13, 15858-
13, and 28657-14.
                                        -2-

[*2]        MEMORANDUM FINDINGS OF FACT AND OPINION


       GOEKE, Judge:2 Before us are five consolidated dockets, each of which

arises from a notice of final partnership administrative adjustment (FPAA) issued

to Sugarloaf Fund, LLC (Sugarloaf), for each year from 2006 through 2010.

However, the years 2009 and 2010 have been resolved by respondent’s

concession. The years 2006, 2007, and 2008 involve issues of whether Sugarloaf

should be recognized for tax purposes, who Sugarloaf’s partners are and who is

taxed on its income, whether Sugarloaf revenue should be subject to self-

employment tax, whether various FPAA adjustments reducing expenses should be

sustained, and whether the penalty under section 6662(a)3 should apply.

                               FINDINGS OF FACT

       John E. Rogers is both Sugarloaf’s representative and the promoter of the

transactions at issue. Mr. Rogers has long been a party to litigation in this Court,

both as a promoter of tax shelters involving distressed debt and as a taxpayer


       2
       These cases were assigned to Judge Robert A. Wherry, Jr., who retired
from judicial service on January 1, 2018. With the parties’ agreement, the cases
were reassigned to Judge Joseph R. Goeke for the purpose of rendering an
opinion.
       3
       Unless otherwise indicated all section references are to the Internal
Revenue Code of 1986 as amended and in effect for the tax years at issue, and all
Rule references are to the Tax Court Rule of Practice and Procedure.
                                         -3-

[*3] himself. The present dockets arise from his role as a promoter. Mr. Rogers

had complete control of Sugarloaf and the transactions at issue in these cases. He

made all the operating decisions. At his direction, Sugarloaf engaged in distressed

asset transactions such as those described in Kenna Trading, LLC v.

Commissioner (Kenna Trading), 143 T.C. 322 (2014), and Derringer Trading,

LLC v. Commissioner, T.C. Memo. 2018-59. In 2003 Mr. Rogers used Warwick

Trading, LLC (Warwick), for the transactions, and he used Sugarloaf beginning in

2004. Mr. Rogers had Warwick and Sugarloaf use trading and holding companies

treated as partnerships for Federal tax purposes for transactions during 2003 and

2004. He had Sugarloaf switch to transactions using trusts for 2005 through 2008.

      The parties have extensively stipulated facts, including the entire record of

trial in Kenna Trading. The stipulated facts are incorporated herein by this

reference. For all relevant periods, including when the petitions were filed, the

parties stipulated that Sugarloaf’s place of business was in Illinois.

      Mr. Rogers implemented and promoted the distressed debt transactions that

give rise to respondent’s adjustments through three business entities: (1) Portfolio

Properties, Inc. (PPI), (2) Sugarloaf, and (3) Jetstream Business, Ltd. (Jetstream).

Mr. Rogers organized PPI as its sole shareholder and caused it to elect S

corporation status in 1992. He formed Sugarloaf and treated it as a partnership for
                                        -4-

[*4] Federal income tax purposes. He formed Jetstream, a British Virgin Islands

limited company, with PPI as its sole shareholder to act as Sugarloaf’s sole

manager and its tax matters partner. Jetstream is a disregarded entity for Federal

tax purposes. Mr. Rogers was Jetstream’s sole director and manager. Mr. Rogers

controlled PPI, Jetstream, and Sugarloaf during the years at issue.

      The present cases involve Mr. Rogers’ treatment of investors in the

distressed debt transactions he had previously structured. Nevertheless, neither

Sugarloaf nor the various investors in the partnerships and trusts received any

proceeds from the distressed debt through 2010. Mr. Rogers restructured the

investments to “roll up” the investors in the distressed debt transactions into

Sugarloaf so he could treat the rollup as transforming the investors into new

partners in Sugarloaf. Sugarloaf is a party to these dockets primarily because of

the rollup of the investors. The rollup transactions started in 2006 and ended in

2008. The first rollup occurred in January 2006 and involved all of the trading

and holding companies used in the 2003 and 2004 transactions promoted through

partnerships. Mr. Rogers structured the rollups so that the trading companies were

treated as contributed to Sugarloaf and in return the holding companies became

partners in Sugarloaf. In 2007 the subtrusts used in the 2005 transactions were

contributed to Sugarloaf, and in return the trusts became partners in Sugarloaf.
                                        -5-

[*5] Likewise, in 2008 the subtrusts used in the 2006 and 2007 transactions were

contributed to Sugarloaf, and in return the 2006 and 2007 trusts became partners

in Sugarloaf. Sugarloaf conducted business in the same manner both before and

after the rollups. Mr. Rogers continued to sell the distressed debt transactions to

new investors. Income, profit, or loss from the sale of the distressed debt

transactions to new investors was not disbursed or allocated to the rolled-up

investors.

      The parties stipulated that neither the investors nor their representatives

received prior notice of the rollups or consented to them in writing. There are no

contracts showing what assets were rolled up or what interests the investors

acquired in Sugarloaf; Mr. Rogers decided on his own what interest each investor

acquired. Mr. Rogers did not reevaluate each investor’s interest in making this

determination. The investors were not asked to consent orally and were not

notified of the rollups until after they had occurred. Mr. Rogers did not have

authority under the terms of the trading companies’ operating agreements or the

trust agreements to make the transfers involving the rollups as the manager of

Sugarloaf, the manager of the trading companies, or the trustee of the trusts.

      With respect to the rollup of the investors from the 2003 and 2004

transactions, the operating agreements are identical except for the investors’
                                         -6-

[*6] names and the amounts of the investments. Article VI of the trading

companies’ operating agreements for the 2003 Warwick transactions and the 2004

Sugarloaf transactions sets forth when and how a member may transfer his interest

in the trading company. There is no provision in the operating agreements for

anyone, other than a member, to transfer a member’s interest. Article VI was not

followed in transferring the ownership of the trading companies to Sugarloaf. As

they were not aware of the transfers, the investors did not provide to the trading

companies the amounts of capital to transfer to Sugarloaf. Moreover, Jetstream

did not consent in writing to the transfers as required by the operating agreement.

Article IV, section 4.1(a) of the operating agreements grants the manager the

authority to manage and control the business, property, and affairs of the trading

companies. It does not provide authority to transfer ownership. The operating

agreements do not grant Mr. Rogers any authority, either implied or express, to

transfer the investors’ ownership of the trading companies without their consents.

      With respect to the rollup of the trust investors from the 2005 and 2006

transactions, the trust agreements are identical in relevant part except for the

investors’ names and the amounts of the investments. Section 2.2(a) of the

supplement to the trust agreements states that no interest in the subtrust may be

transferred except as provided in section 2.2(b) and transfers not in compliance
                                         -7-

[*7] with section 2.2(b) shall be considered null and void. Section 2.2(b) provides

that interests in the subtrusts and the subtrusts’ assets may be transferred only

upon prior written notice by a beneficiary to the trustee. Mr. Rogers did not

receive such written notices from the investors in the trust structures.

      Before the years at issue Sugarloaf was owned by Jetstream. Beginning

with 2006 Sugarloaf’s return listed the rolled-up investors as partners. For 2006 to

2009 the rolled-up investors are listed as the holding companies and trusts. For

2010 the rolled-up investors are listed in their individual capacities. However, for

each year from 2006 through 2010 the Schedules K-1 (Form 1065), Partner’s

Share of Income, Deductions, Credits, etc., list the holding companies’ and trusts’

employer identification numbers and not the investors’ Social Security numbers.

      In addition to the rolled-up investors, evidence of the owners of Sugarloaf is

inconsistent. Jetstream and Warwick are listed on Sugarloaf’s tax returns as

partners for 2006 through 2010. In addition, four entities connected with Mr.

Rogers’ promotion of the distressed debt transactions, Globex, Teviot, Citgo, and

Bernard Equity, were listed as Sugarloaf partners for some but not all the years at

issue. Globex was a Brazilian retailer that contributed distressed debt to Sugarloaf

in exchange for a partnership interest. The other three entities were connected

with Mr. Mazzuchelli, who was involved in the operation of the tax shelter with
                                         -8-

[*8] Mr. Rogers. Teviot and Bernard Equity were owned by Mr. Mazzuchelli and

his father-in-law, respectively. Mr. Rogers did not know who owned Citgo but

suspected that Mr. Mazzuchelli owned it. Sugarloaf’s 2007 tax return shows

Teviot, Citgo, and Bernard Equity as partners. The 2008 return shows the interests

of the four entities as zero. Mr. Rogers eliminated the interests of Teviot, Citgo,

and Bernard Equity because he believed that Mr. Mazzuchelli had cheated him.

Petitioners presented no agreements indicating how Teviot and Bernard Equity

became partners of Sugarloaf. There are no contribution agreements; nor are there

any documents memorializing their interests in the profits, losses, and capital of

Sugarloaf. Mr. Rogers offered no explanation for why Globex’s interest was

reduced to zero. Shelter promoter Michael Hartigan’s clients were listed as

partners for 2010, and petitioners’ represented to the Court that Mr. Hartigan’s

clients were not partners for 2006 and 2007 despite earlier returns listing them as

such.

        With respect to Citgo, documentary evidence indicates that “Citco”

purported to acquire 100,000 shares and/or units of Sugarloaf on January 6, 2006.

However, Sugarloaf issued Schedules K-1 to Citgo only for 2007 and 2008.

Sugarloaf’s operating agreement does not state that it issued shares or units to its
                                         -9-

[*9] members. Instead, capital accounts are maintained. Nothing in the record

establishes the amount, if any, Citgo contributed to Sugarloaf for its interest.

      During 2008 Sugarloaf received $1,876,000 in income from the sale of

interests in Sugarloaf International and incurred $713,867 in cost of goods sold

related to this income. Sugarloaf declared this income and, thus, allocated taxable

income to the partners. However, there is no evidence that cash or some other

economic benefit was ever distributed to the partners from these transactions.

      As part of the distressed debt transactions, the investors deposited into the

investor trust accounts $5,469,971, $2,614,597, and $375,555, for 2006, 2007, and

2008, respectively. In the FPAA respondent determined on the basis of the

deposits that Sugarloaf had unreported income. The fees earned by promoters Mr.

Hartigan, Mr. Greer, and Mr. Agresti and any other sellers of the shelter were paid

separate and apart from the amounts deposited into the investor trust accounts.

Sugarloaf did not collect these fees or disburse them to these individuals.

      On its partnership tax returns for 2006 through 2008, Sugarloaf claimed

business expense deductions that respondent disallowed in the FPAA and that

remain in dispute. See Appendix infra p. 25. In the answer, petitioners asserted

that Sugarloaf is entitled to increase its business expense deduction for legal and

professional fees for 2006 by $1,207,000, for a total deduction of $1,382,000.
                                        - 10 -

[*10] In the FPAAs respondent asserts accuracy-related penalties under section

6662(a) for 2006 through 2008. Prior written supervisory approval for imposing

the penalties was obtained only for 2006 and 2007. The approval for 2008 was

obtained four days after the FPAA was issued.

                                     OPINION

      Kenna Trading has a direct impact on the present cases. The record in

Kenna Trading has been stipulated for inclusion in the records of these cases.

Petitioners seek an interpretation of the record in Kenna Trading different from the

one reached by the Court. Respondent maintains that the findings in Kenna

Trading should form the foundation of our analysis of the present cases.

Petitioners offer us no compelling basis to revisit the findings and legal analysis of

Kenna Trading, and we adopt respondent’s position.

      In Kenna Trading, 143 T.C. at 328-329, we describe the origin of Sugarloaf

as follows:

              Mr. Rogers during or before 2003 conceived a plan that he
      contended would successfully invest in and manage distressed retail
      consumer receivables overseas and remit the proceeds to the United
      States. He used a tiered partnership structure in 2003 and most of
      2004 and a tiered trust structure in 2005, 2006, and 2007 to sell
      interests to individual investors. Mr. Rogers contended the business
      would profit through aggressive collection efforts, translation gain
      from currency speculation, and a planned initial public offering. The
      first step under this plan was for Brazilian retailers to “contribute”
                                       - 11 -

[*11] receivables to a limited liability entity controlled by Mr. Rogers,
      which, for U.S. tax purposes, would accede to the tax basis of the
      retailers in the consumer debt.

             In 2003 he used a limited liability company called Warwick
      Trading, LLC, to purchase receivables from Lojas Arapua, S.A.
      (Arapua), a Brazilian retailer of household appliances and consumer
      electronics. In 2004 he used a different limited liability company,
      Sugarloaf, to which two other Brazilian retailers, Globex Utilidades,
      S.A. (Globex), and Companhia Brasileira de Distribuição (CBD), also
      “contributed” distressed accounts receivable for interests in that
      company. In 2004 Sugarloaf contributed a tranche of those assets to
      other limited liability companies (trading companies). Sugarloaf then
      contributed most or all of its interest in the trading companies to yet
      other limited liability companies (holding companies). In 2005
      Sugarloaf “contributed” assets to trusts (main trusts), which each
      created another trust (subtrust). The main trust assigned the
      beneficial interests of the receivables in the subtrust to an investor
      who contributed money to the main trust. In both years Sugarloaf and
      the trading companies entered loan management and servicing
      agreements with a British Virgin Islands company called Multicred
      Investments Limited and/or a Brazilian company called Multicred
      Investimentos Limitada. * * *

             Mr. Rogers formed Sugarloaf through entities he owned and
      controlled. He was the sole owner of an S corporation, Portfolio
      Properties, Inc. (PPI), which owned Jetstream, at that time a British
      Virgin Islands company. On April 17, 2003, Mr. Rogers, through
      Jetstream, formed Sugarloaf, a Delaware limited liability company.
      According to the operating agreement, Jetstream was the initial
      manager. On July 23, 2003, Mr. Rogers sent an engagement letter to
      Mr. Mazzucchelli as “Managing Member” of Sugarloaf by which
      Sugarloaf agreed to retain Seyfarth Shaw as its legal counsel. In
      August Mr. Rogers represented to Seyfarth Shaw that the owners of
      Sugarloaf were Mr. Mazzucchelli and Ms. Dowek. He never
      disclosed Jetstream’s ownership, which was 100% at that time.
                                        - 12 -

[*12] I.     The Rollups

      Mr. Rogers alleges that after 2005 he made a decision to “roll up” the

distressed debt from the partnerships and trusts he had used to promote his tax

shelter scheme into Sugarloaf with the alleged purpose of allocating ownership in

Sugarloaf to the partners and trust beneficiaries and to sell the debt for the

investors to recover portions of their investments. Petitioners bear the burden to

sustain these allegations; and to put it succinctly, the record lacks any coherent

thread of evidence to support Mr. Rogers’ assertion that a legally enforceable

change in ownership occurred. See Rule 142(a). In addition, no economic

consequence resulted from the alleged rollups as there was no recovery of

distressed debt shared with alleged new owners of Sugarloaf. Accordingly, we

find there was no rollup for Federal tax purposes and the tax consequences to

Sugarloaf in the years before us should be based on the ownerships described in

Kenna Trading.

      In Kenna Trading, 143 T.C. at 366-367, the Court found that all payments

made by trust investors in 2005, whether paid to trust accounts or directly to

Sugarloaf, constituted income to Sugarloaf, less fees retained by the promoters.

The trust transactions for 2006 through 2008 were implemented in the same

manner as they were for 2005. Respondent asserts that the conclusion reached for
                                        - 13 -

[*13] 2005 in Kenna Trading is required in the present case. We agree as the

record before us offers no supportable alternative.

II.   A Viable Business

      In Kenna Trading, the Court found that Sugarloaf was not a partnership for

the years 2004 and 2005 because Jetstream, Globex, and CBD/PDA did not intend

to join together for purposes of carrying on a debt collection business. Id. at 352.

We have previously stated that we will not recognize the alleged rollup of new

owners. Nothing of substance occurred in the years 2006 to 2008 to transform

Sugarloaf into a partnership. Sugarloaf was a sham in fact for 2006 to 2008.

      Petitioners contend that in 2004 CBD/PDA and Globex contributed

distressed debt to Sugarloaf in return for partnership interests. We reject this

argument as it was also rejected in Kenna Trading. The Court found that under the

disguised sale rules and the step transaction doctrine, CBD/PDA and Globex sold

distressed debt to Sugarloaf in 2004. Id. at 353-358. Nothing presented in these

cases changes that holding. Sugarloaf did not acquire new debt in the years at

issue, and the result reached in Kenna Trading controls here as well. Petitioners

contend that Sugarloaf had a business plan that could earn investors money.4

      4
       Petitioners’ contention that investors could earn money on the Sugarloaf
transactions and that the distressed debt had significant value is also contradicted
                                                                         (continued...)
                                        - 14 -

[*14] However the Court’s conclusions in Kenna Trading are not based upon

Sugarloaf’s lacking a business plan. Instead, Sugarloaf was not a partnership, and

the transactions Sugarloaf engaged in lacked substance.

III.   Sugarloaf’s Income

       Petitioners contend that Sugarloaf’s taxable income should not be allocated

to Mr. Rogers. However, this Court found that Jetstream was the sole owner of

Sugarloaf during the years 2004 and 2005. Petitioners have not established there

were any new owners of Sugarloaf during the years 2006 to 2008. The only owner

remaining is Jetstream. Therefore, all of Sugarloaf’s income should be allocated

to Jetstream, and accordingly that income flows through to Mr. Rogers.

       Petitioners assert that Jetstream was a subchapter C corporation and became

a partner in Sugarloaf on September 23, 2008. However, Sugarloaf’s tax returns

for 2006 through 2010 show that Jetstream was a flowthrough entity. In the

petitions and the amended petitions, petitioners did not raise the issue that a

subchapter C corporation known as Jetstream became a partner in 2008 or that

income should be allocated to that partner. In addition, the parties stipulated that

Jetstream has not filed Forms 1120, U.S. Corporation Income Tax Return, for any

       4
       (...continued)
by respondent’s experts, Dr. Finnerty, Mr. Hanan, and Mr. Tostes. Petitioners
offered no evidence to rebut these reports.
                                        - 15 -

[*15] of the 2008 through 2010 years, and petitioners have not proven that a

subchapter C corporation known as Jetstream became a partner in Sugarloaf at any

time in 2008; i.e., petitioners offered no contracts, records, or other documents

showing that Jetstream, a subchapter C corporation, was admitted as a partner. In

fact, Jetstream was originally organized in May 2002 as a limited company under

the laws of the British Virgin Islands. In August 2002 Jetstream elected to be

treated as a disregarded entity for tax purposes. While petitioners assert that

Jetstream became a subchapter C corporation in September 2008, the Schedules

K-1 attached to Sugarloaf’s returns and the designation of Jetstream as tax matters

partner on Sugarloaf’s tax returns did not change. In conclusion, we hold that

Sugarloaf was not a partnership for tax purposes during the years 2006 to 2008,

and all of its income should be allocated to Jetstream.

      The parties stipulated that as part of the distressed debt transactions, the

investors deposited into the investor trust accounts $5,469,971, $2,614,597, and

$375,555 during 2006, 2007, and 2008, respectively. Respondent argues these

amounts (less amounts paid to Mr. Rogers and includible by him) are gross

receipts to Sugarloaf, which Sugarloaf did not report, of $5,469,971, $2,206,597,

and $375,555, for 2006, 2007, and 2008, respectively. In Kenna Trading, 143

T.C. at 367 & n.38, the Court stated:
                                        - 16 -

[*16] Second, and conclusively here, we found that in these 2005
      transactions, the investors each purchased a tranche of receivables
      from Sugarloaf, making the money paid into the trust accounts
      income to Sugarloaf under section 1001. So, regardless of whether
      the 2005 investors’ payments went into the trust accounts or directly
      to Sugarloaf, those amounts were still income to Sugarloaf.38
             38
              We note that respondent has determined only that the six trust
      deposits actually deposited into Sugarloaf's bank account constitute
      income. Under our findings, all payments by the trust investors
      would constitute income to Sugarloaf, less fees retained by the
      promoters. We will not question respondent’s magnanimity.

      The distressed debt transactions for 2006 and 2007 were implemented in the

same manner as they were in 2005, using the same structure, distressed debts

acquired in 2004, deal documents, and trust bank accounts at Heritage Bank.

Thus, in substance, the Brazilian retailers sold distressed assets to Sugarloaf in

2004, and Sugarloaf sold them to the investors in 2006 through 2008. These sales

created taxable income to Sugarloaf, which in substance had control over the

payments. Mr. Rogers agrees Sugarloaf did not report this income.

      The fees earned by Mr. Hartigan, Mr. Greer, and Mr. Agresti and any other

sellers of the shelter were paid separate and apart from the amounts deposited into

the investor trust accounts. Respondent concedes that the amounts of Sugarloaf’s

unreported income for 2006 and 2007 are decreased by the amounts included in

Mr. Rogers’ income for those years. We have previously held that for 2006
                                      - 17 -

[*17] $1,165,000 transferred from the trust accounts to Mr. Rogers was included

in his income as compensation for his services as trustee. See Rogers v.

Commissioner, T.C. Memo. 2018-53, at *35-*37. We also held that $465,000 that

Sugarloaf paid to PPI during 2006 was included in PPI’s 2006 gross income.5 Id.

at *14. For 2007 $408,000 was transferred to Mr. Rogers from the trust accounts

as compensations for services, and he was required to report the $408,000 as

income. These amounts should be subtracted from the Sugarloaf income as they

are Mr. Rogers’ income directly. The income in question is subject to self-

employment tax under section 1401 because the income was earned through Mr.

Rogers’ activities.

IV.   The Deductions

      Deductions are a matter of legislative grace and are allowed only as

specifically provided by statute. INDOPCO, Inc. v. Commissioner, 503 U.S. 79,

84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Generally, a taxpayer must establish that deductions claimed under section 162 are

ordinary and necessary business expenses, and the taxpayer must maintain records

to substantiate the deductions claimed. Sec. 6001; Meneguzzo v. Commissioner,

      5
       In Rogers v. Commissioner, T.C. Memo. 2018-53, Mr. Rogers disputed the
taxability of these transfers to himself for the year 2006. However, we found that
$1,165,500 was taxable to him. Id. at *37.
                                        - 18 -

[*18] 43 T.C. 824, 831-832 (1965); sec. 1.6001-1(a), (e), Income Tax Regs.

Claimed deductions in support of discredited tax shelter transactions are

nondeductible. Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254, 294

(1999), aff’d, 254 F.3d 1313 (11th Cir. 2001). In Kenna Trading, this Court held

that “expenditures made in an attempt to obtain abusive tax shelter benefits are not

ordinary and necessary business expenses or otherwise deductible under section

162(a).” Kenna Trading, 143 T.C. at 365 (quoting Gerdau Macsteel, Inc. v.

Commissioner, 139 T.C. 67, 182 (2012)). Further, the Court stated: “The

transactions in question were tax shelters, and Sugarloaf’s claimed expenditures

were made in an attempt to obtain abusive tax shelter benefits.” Id.

      Respondent maintains that all the deductions in dispute should be

disallowed as supporting illicit tax shelter activities that lack economic substance.

See Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. at 294. While this

argument applies to some of the amounts in dispute, Sugarloaf’s business was

actually to derive income from the investors in the spurious tax shelters. Although

Mr. Rogers maintains all the shelter investments were rolled up into Sugarloaf, we

have rejected that position earlier. Accordingly, we will analyze the disputed

deductions on the basis of what we find to be Sugarloaf’s actual business,

siphoning money from the shelter investors.
                                       - 19 -

[*19] The traditional attacks on loosely documented deductions are also made by

respondent, and they are compelling here. Petitioners have generally failed to

establish that the deducted expenses were actually incurred for the stated business

purpose, were not previously deducted by another entity, or were actually

expended in the first instance. We have here attempted to discern whether any of

the deducted amounts were actually allowable on the basis of the jumbled record

petitioners have offered. We disallow the disputed deductions except to the extent

stated below.

      For 2006 through 2008 Sugarloaf deducted business expenses as set forth in

the Appendix. See infra p. 25. For 2006 petitioners contend that Sugarloaf is

entitled to an additional deduction for legal fees of $1,207,000. Except as stated

infra, petitioners have failed to establish the amounts or business purposes of

disputed business expense deductions. For 2006 Sugarloaf is entitled to deduct

legal expenses and accounting expenses of $175,000 and $22,000, respectively.

For 2006 Sugarloaf is also entitled to deduct $100,000 in management fees paid to

PPI. Petitioners adequately substantiated the amounts and business purpose of

these expenses.

      On the other hand, abandoned amortization, consulting fee, and other

disallowed deductions are not established as having been incurred by Sugarloaf or
                                        - 20 -

[*20] having been amortized by Sugarloaf in the first instance. For 2007 the

deducted legal fees have not been established as being incurred for Sugarloaf’s

business, and the deducted travel expenses do not meet the strict substantiation

requirements of section 274(d). For 2008 various deducted management fees

totaling $375,000 are documented only by checks to PPI. Sugarloaf’s business

purpose for these checks is not proven, and they are not allowed as deductions.

We find the consulting fees deducted for 2008, to the extent they are documented,

were in furtherance of the tax shelter scheme to justify the spurious efforts to

collect the distressed assets. Only $6,750 of the claimed amounts has been

documented, but these amounts are not deductible for the reason stated. The

amortization of startup costs deducted for 2008 is simply not substantiated.6

V.    Accuracy-Related Penalties

      Respondent asserted accuracy-related penalties under section 6662(a)

against Sugarloaf in the FPAAs issued for 2006, 2007, and 2008. Section 6751(b)

provides:

      No penalty under this title shall be assessed unless the initial
      determination of such assessment is personally approved (in writing)

      6
       We note respondent’s reply brief has very carefully set forth the
inconsistencies in the records offered for the Sugarloaf deductions, and those
inconsistencies in themselves establish the lack of general credibility of the
deductions sought.
                                       - 21 -

[*21] by the immediate supervisor of the individual making such
      determination or such higher level official as the Secretary may
      designate.

      We have recently held that challenges to accuracy-related penalties in

partnership cases such as these may include the Commissioner’s alleged

noncompliance with the requirements of section 6751(b)(1). Endeavor Partners

Fund v. Commissioner, T.C. Memo. 2018-96, at *63; see also Graev v.

Commissioner, 149 T.C. ___, ___ (slip op. at 13-14) (Dec. 20, 2017),

supplementing and overruling in part 147 T.C. 460 (2016). When a penalty is

asserted, supervisory approval must be secured in writing before the initial

determination. Sec. 6751(b); Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir.

2017), aff’g in part, rev’g in part T.C. Memo. 2015-42. When the penalty is

asserted in an FPAA, that approval must come before the notice is issued.

Endeavor Partners Fund v. Commissioner, at *63; see also Chai v. Commissioner,

851 F.3d at 221.

      With respect to penalties asserted against partnerships, the Commissioner

has no burden of production, and the taxpayer must show that no penalty should

apply. Sec. 7491(c); Dynamo Holdings v. Commissioner, 150 T.C. ___, ___ (slip

op. at 16-17) (May 7, 2018); Endeavor Partners Fund v. Commissioner, at *64.
                                        - 22 -

[*22] In these cases, written supervisory approval was sought and received for the

penalties asserted in the 2006 and 2007 FPAAs before their issuance. However,

the requisite supervisory approval for the penalties asserted in the 2008 FPAA was

not obtained until four days after the FPAA was issued. “Section ‘6751(b)(1)

requires written approval of [an] initial penalty determination no later than the

date’” the Commissioner issues an FPAA. Endeavor Partners Fund v.

Commissioner, at *65 (quoting Chai v. Commissioner, 851 F.3d at 221). Because

the necessary approval for the 2008 FPAA penalty was not obtained until after the

FPAA was issued, respondent failed to adhere to the statutory requirements and

the 2008 penalty is not sustained.

      Respondent has asserted that the section 6751(b) requirements were

satisfied by his amending his answer and reasserting the penalties after

supervisory approval was received. However, as we recently stated in Endeavor

Partners Fund v. Commissioner, at *65, “[w]e are unable to accept this argument.”

Written approval must be obtained before the initial determination of a penalty.

The initial determination of the 2008 penalty in this case was made before the

penalty was asserted in the FPAA. The requisite approval was not obtained before

the 2008 FPAA was issued and thus failed to satisfy the statutory requirements.
                                       - 23 -

[*23] Respondent urges that by rejecting his ability to cure a defective penalty

assessment in an FPAA through an answer with this Court, we are creating a

conflict between sections 6751(b) and 6226(f). Section 6751(b) requires the

“initial determination” of a penalty to be approved by a supervisor in writing.

Conversely, section 6226(f) allows this Court to determine the “applicability of

any penalty * * * which relates to an adjustment to a partnership item.”7 We fail

to see respondent’s perceived conflict. These sections stand wholly on their own.

      Respondent notes that the purpose of an answer is to place the court and the

parties on notice of disputes. In respondent’s view, that makes the answer an

appropriate place to raise a section 6662 penalty. We find no issue with

respondent’s raising an accuracy-related penalty in his answer, particularly if such

a penalty was previously included in an FPAA after supervisory approval.

Respondent is even free to initially assert a section 6662(a) penalty in his answer

if the requisite approval was obtained first. See Graev v. Commissioner, 149 T.C.


      7
       In 2015 Congress passed the Bipartisan Budget Act of 2015, Pub. L. No.
114-74, sec. 1101(a), 129 stat. at 625, which repealed the previous TEFRA
partnership audit rules, including sec. 6226. Act sec. 1101(c)(1), 129 stat. at 630,
replaced sec. 6226 with an entirely new provision that is not applicable in the
present cases. Our holding today should be limited to interpreting sec. 6226 as it
existed before the amendment and has no applicability to the current rendition of
sec. 6226. Because these cases concern the 2006 through 2010 tax years, prior
sec. 6226 applies.
                                          - 24 -

[*24] at ___ (slip op. at 12) (finding that section 6751(b)(1) was satisfied where

the Commissioner “asserted for the first time” in his amendment to answer an

accuracy-related penalty that had not been previously determined).

         The word “initial” is key. In these cases, respondent’s initial determination

of an accuracy-related penalty was asserted in the 2008 FPAA issued to Sugarloaf

before written supervisory approval had been obtained. Respondent cannot cure a

defective initial determination with an approved subsequent determination; there

can be only one initial determination of a penalty, and that determination must be

timely approved, in writing, by a supervisor. Failure to obtain timely approval for

an initial determination renders it defective and is fatal to respondent’s ability to

assert the 2008 penalty now. Because the requisite timely supervisory approval

was obtained for the 2006 and 2007 penalties, they are sustained.

         The Court has considered all of the parties’ arguments and, to the extent not

discussed above, concludes that those arguments are irrelevant, moot, or without

merit.

         To reflect the foregoing,


                                                   Decisions will be entered under Rule

                                         155.
                              - 25 -

[*25]                      APPENDIX

         Expense            2006        2007       2008
Accounting fees            $22,000     $116,025   $16,257
Amortization                  400       16,000    169,800
Abandonment amortization     -0-         -0-      433,200
Bank service charges          656          614      -0-
Licenses and fees             575        -0-        -0-
Collection expense           -0-       200,456      -0-
Commissions                  -0-                   16,667
Consulting fees            327,486       -0-      360,726
Filing fees                   696        6,173     17,451
Legal and professional
 fees                      175,000     200,000    451,199
Management and director    100,000     400,000    375,000
Office expense                240        -0-        -0-
Rent                         -0-         -0-       40,000
Professional fees            -0-         12,533     -0-
Telephone                    -0-                    -0-
Travel expenses               525        37,604     -0-
