                        T.C. Memo. 2010-177



                      UNITED STATES TAX COURT



  MICHAEL V. DOMULEWICZ AND MARY ANN DOMULEWICZ, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

        DANIEL J. DESMET AND LINDA K. DESMET, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent*



    Docket Nos. 10434-05, 10436-05.    Filed August 5, 2010.



         Ps commenced these TEFRA partner-level cases to
    challenge affected items notices of deficiency. Ps
    used a partnership (D), an S corporation (S), U.S.
    Treasury notes, and publicly traded stock to create an
    artificial “loss” by way of a Son-of-BOSS transaction.
    J, a copromoter of the transaction, billed S for J’s
    legal fees related to the transaction. S paid and
    claimed a deduction for the bill. A portion of the
    deduction passed through to each P, who claimed it as
    an ordinary loss on his Federal income tax return. In
    a previous partnership-level proceeding involving D, R
    determined as a partnership item that D was a sham


    *
      This opinion supplements Domulewicz v. Commissioner,
129 T.C. 11 (2007), affd. in part and remanded sub nom. Desmet v.
Commissioner, 581 F.3d 297 (6th Cir. 2009).
                                 - 2 -

     whose existence was disregarded. That partnership-item
     determination became final when no partners timely
     contested it. Ps dispute that the fees that S paid J
     are affected items.
          Held: The fees are affected items subject to the
     deficiency procedures of subch. B of ch. 63, I.R.C.,
     because the disallowance of their deductibility flows
     from R’s partnership-item determination that D was a
     disregarded sham, but the disallowance of the deduction
     required a further partner-level determination as to
     the extent to which the claimed deduction was related
     to the partnership and to the transaction.



     Paul L. B. McKenney, for petitioners.

     Meso T. Hammoud, for respondent.



                    SUPPLEMENTAL MEMORANDUM OPINION


     LARO, Judge:    These consolidated cases are before this Court

on remand from the Court of Appeals for the Sixth Circuit.    See

Desmet v. Commissioner, 581 F.3d 297 (6th Cir. 2009), affg. in

part and remanding Domulewicz v. Commissioner, 129 T.C. 11

(2007).    The Court of Appeals remanded these cases to this Court

to decide “whether the Jenkens & Gilchrist fees [(fees)] were

nonpartnership items subject to the statute of limitations in

I.R.C. § 6501(a) or whether they were affected items subject to

TEFRA”.1   Id. at 305.   The parties agree that we can decide this


     1
      Unless otherwise indicated, section and subchapter
references are to the applicable versions of the Internal Revenue
Code. TEFRA references are to the Tax Equity and Fiscal
Responsibility Act of 1982, Pub. L. 97-248, sec. 402, 96 Stat.
                                                   (continued...)
                               - 3 -

issue without a trial, on the basis of the evidence in the record

and their joint statement of facts.    We hold that the fees were

affected items subject to the deficiency procedures of subchapter

B of chapter 63 (deficiency procedures).

                             Background

     Michael V. Domulewicz and Daniel J. Desmet (petitioners)

implemented a Son-of-BOSS transaction (transaction) promoted by

BDO Seidman and Jenkens & Gilchrist.      The transaction was

designed to create an artifical multimillion dollar “loss” that

petitioners could report as an offset to unrelated multimillion

dollar gains that petitioners were required to report for 1999.

The “loss” was reportedly generated by using a newly formed

partnership, a newly formed S corporation, U.S. Treasury notes,

and publicly traded stock.

     Petitioners formed the S corporation on December 23, 1998,

and they formed the partnership on April 30, 1999.2     Each

petitioner’s interests in the partnership and in the S

corporation were held by his grantor trust (trust).      Each trust

reported on Form 1041, U.S. Income Tax Return for Estates and



     1
      (...continued)
648, as amended.
     2
      The S corporation and the partnership were both passthrough
entities that did not pay income taxes themselves but instead
passed their income tax attributes on to their owners. A third
individual who is not a party to these proceedings also
participated in the formation of the entities.
                               - 4 -

Trusts, that the trust’s Federal tax attributes passed through to

the grantor.   The partnership was dissolved in August 1999 when

its partners contributed their partnership interests to the S

corporation.   For 1999, the partnership reported as to the

transaction that the partnership (1) realized a short-term

capital loss and (2) was entitled to deduct interest.

     Jenkens & Gilchrist billed the S corporation $1,053,400 for

legal fees related to the transaction.   The S corporation paid

that bill in August 1999 and claimed a deduction for the payment

on its 1999 Form 1120S, U.S. Income Tax Return for an S

Corporation.   The S corporation issued each trust a Schedule K-1

(Form 1120S), Shareholder’s Share of Income, Credits, Deductions,

etc., reporting that the trust’s share of the $1,053,400

deduction (in the form of a $1,053,400 ordinary loss) passed

through to the trust as a shareholder of the S corporation.    Each

trust reported on its return that its share of the ordinary loss

(which each trust reported as a nonpassive loss) passed through

to the petitioner who was the trust’s grantor.   Each petitioner

reported his share of the passthrough nonpassive loss as an

ordinary loss on his 1999 Federal income tax return.3


     3
      As to the transaction, the S corporation also reported on
its 1999 tax return that it realized an approximately $29.3
million long-term capital loss from the sale of publicly traded
stock. The S corporation reported that portions of this loss
passed through to each trust, which in turn reported that the
item passed through to the petitioner who was the grantor of the
                                                   (continued...)
                                - 5 -

     Respondent issued a notice of final partnership

administrative adjustment (FPAA) as to the partnership in October

2003.    In the FPAA, respondent determined that the partnership

was a sham whose existence was disregarded (disregarded sham) and

that the partnership therefore was not entitled to claim the

short-term capital loss or the interest expense.    The FPAA was

not timely contested by a partner of the partnership, and the

FPAA became final.    Respondent then assessed the tax and

penalties attributable to the disallowance of the short-term

capital loss and the interest expense.

     In March 2005, respondent issued to each petitioner an

affected items notice of deficiency for 1999 disallowing the

passthrough losses from the S corporation (i.e., the long-term

capital loss and the ordinary loss) and determining penalties.

As stated supra note 3, the parties agree that petitioners may

not deduct any of the long-term capital loss.    The notices of

deficiency stated that the ordinary losses were disallowed

because “no deduction is allowed for any legal, accounting,


     3
      (...continued)
trust. Each petitioner reported the passthrough long-term
capital loss on his 1999 tax return as an offset to his unrelated
multimillion dollar gain. We previously held that this long-term
capital loss was an affected item subject to the deficiency
procedures, and the Court of Appeals for the Sixth Circuit agreed
with us upon appeal. See Domulewicz v. Commissioner, 129 T.C. 11
(2007), affd. on that issue and remanded to decide the issue at
hand sub nom. Desmet v. Commissioner, 581 F.3d 297 (6th Cir.
2009). The parties agree that petitioners may not deduct any of
the long-term capital loss.
                                 - 6 -

consulting and advisory fees claimed since * * * [petitioners]

failed to establish that such expenditures were incurred, and if

incurred are deductible under any provision of the Internal

Revenue Code, including but not limited to Internal Revenue Code

§§ 183 and 212.”   The parties agree that this determination is

correct if the fees are affected items subject to the deficiency

procedures.

                               Discussion

     We decide whether the fees were affected items subject to

the deficiency procedures.     If the fees were not affected items,

then any Federal income tax on the disallowance of their

deductibility must be assessed within 3 years of the later of the

filing or the due date of petitioners’ 1999 Federal income tax

returns.   See sec. 6501(a).    Those periods of limitation appear

to have expired.   If the fees were affected items, then the

period for assessing Federal income tax attributable to the fees

would be no shorter than the period prescribed by section

6229(a); i.e., within 3 years of the later of the filing or the

due date of the partnership’s 1999 Federal tax return.     That

period, if applicable, was suspended upon respondent’s issuance

of the FPAA as to the partnership, see sec. 6229(d), and remains

suspended until 60 days after the decisions in these cases become

final, see sec. 6503(a)(1).     The period for assessing tax
                                 - 7 -

attributable to the fees therefore remains open if the fees are

affected items.

     Petitioners argue that the fees were not affected items (and

hence that the applicable limitation periods for assessment have

expired pursuant to section 6501(a)).    To that end, petitioners

assert, the fees were unrelated to the partnership because they

were not billed to the partnership, they were not paid by the

partnership, and they were not deducted on the partnership

return.   Respondent argues that the fees were affected items (and

hence that the applicable limitation periods for assessment

remain open).   To that end, respondent asserts, his disallowance

of petitioners’ passthrough deductions of the fees claimed on

their personal returns as ordinary losses is affected by his

partnership-level determination that the partnership was a

disregarded sham.    We agree with respondent.

     The TEFRA procedures determine the proper treatment of

“partnership items” at the partnership level in a single, unified

audit and judicial proceeding.    See Domulewicz v. Commissioner,

129 T.C. at 17-18.    The term “partnership item” includes any item

of income, gain, loss, deduction, or credit that the Secretary

has determined is “more appropriately determined at the

partnership level than at the partner level.”    Sec. 6231(a)(3);

see also sec. 301.6231(a)(3)-1(a), Proced. & Admin. Regs.
                                - 8 -

     After a partnership-level adjustment has been made to a

partnership item in a unified partnership proceeding, a

corresponding “computational adjustment” must be made to the tax

liability of the partners.   See sec. 6231(a)(6) (defining the

term “computational adjustment”).   Where an increase in a

partner’s tax liability is attributable to an “affected item”

that flows strictly from a computational adjustment, no notice of

deficiency need be sent to the partner, and any error in the

computational adjustment must be challenged in a refund suit.

See sec. 6230(c); Domulewicz v. Commissioner, supra at 19; see

also sec. 6231(a)(5) (defining “affected item” as “any item to

the extent such item is affected by a partnership item”); Maxwell

v. Commissioner, 87 T.C. 783, 790-791 (1986) (stating that an

“affected item” is “An item whose existence or amount is

dependent on any partnership item”).    If an increased liability

stemming from an affected item requires a factual determination

at the partner level, however, the deficiency procedures apply,

and the Commissioner must issue an affected items notice of

deficiency to the partner in order to assess tax attributable to

the affected item.    See sec. 6230(a)(2)(A)(i); Domulewicz v.

Commissioner, supra at 19.

     In the FPAA, respondent determined that the partnership was

a disregarded sham.   Such a determination implicates a

partnership item.    See Keener v. United States, 551 F.3d 1358,
                                 - 9 -

1365-1366 (Fed. Cir. 2009); RJT Invs. X v. Commissioner, 491 F.3d

732, 738 (8th Cir. 2007); see also Petaluma FX Partners, LLC v.

Commissioner, 591 F.3d 649, 652-654 (D.C. Cir. 2010), affg. on

this issue 131 T.C. 84 (2008).    Respondent’s partnership-item

determination that the partnership was a disregarded sham became

final when none of the partners timely contested the

determination.   See N.C.F. Energy Partners v. Commissioner,

89 T.C. 741, 744-745 (1987).

     To the extent that the fees were related to the partnership

and to the transaction, the fees (and the S corporation’s claimed

deduction of the fees) were affected by the partnership-item

determination in that the fees were nondeductible given the lack

of an income, profit, or business-related motive encompassed in,

and then flowing from, the partnership-level determination.    See

Thomas v. United States, 166 F.3d 825, 831-832 (6th Cir. 1999)

(and cases cited thereat); cf. Frank Lyon Co. v. United States,

435 U.S. 561, 583-584 (1978) (holding that a transaction

characterized as a sham is imbued solely with tax-avoidance

features); New Phoenix Sunrise Corp. & Subs. v. Commissioner,

132 T.C. 161, 185-186 (2009) (disallowing a taxpayer’s deduction

for fees that it paid to Jenkins & Gilchrist to implement a

variant of a Son-of-BOSS transaction and to provide a written tax

opinion letter, because the transaction lacked economic

substance).   In other words, the partnership-level determination
                              - 10 -

that the partnership was a disregarded sham means that

petitioners, as ultimate passthrough owners of both the

partnership and the S corporation, and the S corporation, as

payee of the fees, lacked as to the transaction (and as to the

payment of the fees, which were related thereto) the requisite

business-related, profit, or income motive that served as a

precondition to deducting the fees under section 162, 183, or

212, respectively, the only statutory provisions that would have

permitted such a deduction.   See sec. 162(a) (deductions allowed

for ordinary and necessary business expenses); sec. 183(a) and

(b) (deductions allowed to the extent of income in the case of an

activity not engaged in for profit); sec. 212(1) and (2) (an

individual may deduct the ordinary and necessary expenses paid or

incurred for the production or collection of income, or for the

management, conservation, or maintenance of property held for the

production of income).   To the extent that the fees were

unrelated either to the partnership or to the transaction, the

fees were not necessarily items affected by the partnership-item

determination that the partnership was a disregarded sham.4

     Petitioners note that the fees were neither incurred nor

deducted by the partnership and argue that the fees were



     4
      For example, the fees would not be affected items to the
extent that the fees related to services provided directly to
petitioners or to the S corporation as to matters other than the
formation or the conduct of the partnership.
                                - 11 -

therefore not affected items.    Petitioners rely erroneously upon

that fact in seeking their desired result.   The mere fact that

the fees were neither incurred nor deducted by the partnership

does not necessarily remove the fees from a characterization as

affected items.   The fees, to the extent related to the

partnership and to the transaction, were affected items because,

as discussed above, petitioners were ultimate owners of both the

partnership and the S corporation, and the disallowance of the S

corporation’s deduction of the fees was directly affected by the

partnership-level determination that the partnership is a

disregarded sham.

     The parties essentially ask the Court to decide the

characterization of the fees as affected items on an all or

nothing basis.5   Because the parties agree that all of the fees

were related to the transaction, and we find on the record before

us that the fees were related to the partnership in that they

were paid, at least in part, to form the partnership and to

effect the transaction as it related to the partnership, we hold

that all of the fees were affected items.

     Affected items may be one of two types.   The first type is

immediately assessable.   See Domulewicz v. Commissioner, 129 T.C.



     5
      In this regard, the parties stipulated that respondent’s
disallowance of petitioners’ deductions of the ordinary loss
should be sustained in full if the applicable periods of
limitation remain open.
                                - 12 -

at 19.   The second type is assessable only through the deficiency

procedures.    Id.   The fees are affected items of the second type

in that they required partner-level determinations to ascertain

the portion (if not all) of the fees that were nondeductible in

that that portion related to the partnership and to the

transaction.   See sec. 6230(a)(2)(A)(i) (providing that the

deficiency procedures apply to any deficiency attributable to

“affected items which require partner level determinations (other

than penalties, additions to tax, and additional amounts that

relate to adjustments to partnership items)”).

     Petitioners, through the trusts, were both the ultimate

partners of the partnership and the ultimate shareholders of the

S corporation.   The partnership’s 1999 Federal tax return,

however, did not reveal that the partnership and the S

corporation were commonly owned or that those two entities were

integral parts of the Son-of-BOSS transaction underlying the S

corporation’s payment of the fees.       Nor did the partnership’s tax

return indicate that petitioners were indirect owners of the S

corporation.   The relationship between the partnership, on the

one hand, and the fees, the S corporation, and petitioners, on

the other hand, could not readily have been ascertained at the

partnership level but had to be ascertained in a partner-level

proceeding based on the relevant facts concerning petitioners and

the S corporation, and the relationship between them.      A
                              - 13 -

partner-level determination also was required to ascertain the

amount of the fees deducted on the S corporation’s return that

related to the transaction and to ascertain that the nonpassive

losses reported on the returns of the trusts and the ordinary

losses deducted on petitioners’ returns derived from the

deduction of the fees on the S corporation’s return.

     In sum, we hold that all of the fees were affected items

subject to the deficiency procedures.   The parties agree that a

holding to that effect requires entry of decisions for

respondent.   Thus, we shall reenter the stipulated decisions that

upheld respondent’s disallowance of the fees and were appealed to

the Court of Appeals for the Sixth Circuit.    We have considered

all of the parties’ arguments, and we have found it unnecessary

to reach those arguments not discussed herein or have otherwise

rejected those arguments as without merit.    Accordingly,


                                         Appropriate orders and

                                    decisions will be entered.
