                       T.C. Memo. 2003-101



                     UNITED STATES TAX COURT



 INDECK ENERGY SERVICES, INC., AND SUBSIDIARIES, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

           MICHAEL P. AND MAYA POLSKY, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 21586-97, 23943-97.    Filed April 11, 2003.



     Thomas C. Borders, James L. Malone III, and David J. Duez,

for petitioners Indeck Energy Services, Inc., and Subsidiaries.

     Ronald A. Stein, for petitioners Michael P. and Maya Polsky.

     Jan E. Lamartine and Robert Little, for respondent.
                                   - 2 -


                  MEMORANDUM FINDINGS OF FACT AND OPINION

     GALE, Judge:       By separate notices of deficiency, respondent

determined the following deficiencies and penalties with respect

to petitioners' Federal income taxes:

            Indeck Energy Services, Inc. and Subsidiaries
                        docket No. 21586-97

                                                    Penalty
           Year               Deficiency          Sec. 6662(a)

     FYE 11/30/93             $1,542,339             $231,108
     FYE 11/30/94              4,994,929              999,468
     FYE 11/30/95                536,715              107,343


                        Michael P. and Maya Polsky
                           docket No. 23943-97

                                                    Penalty
            Year              Deficiency          Sec. 6662(a)

           CY 1994             $660,910              $132,182

     These cases were consolidated for trial, briefing, and

opinion.    After concessions, we must decide the following issues:

     (1)    Whether $4,856,922 of a $19,886,922 settlement payment

made by petitioner Indeck Energy Services, Inc. (Indeck), to

petitioner Michael P. Polsky (Mr. Polsky) on May 16, 1994,

constitutes interest deductible by Indeck and recognizable as

ordinary income by petitioners Michael P. and Maya Polsky in

their respective taxable years ended in 1994, or instead is part

of the purchase price for shares of Indeck stock sold by Mr.

Polsky to Indeck; and
                               - 3 -

     (2)   Whether petitioners Indeck Energy Services, Inc., and

Subsidiaries or petitioners Michael P. and Maya Polsky are liable

for accuracy-related penalties under section 6662(a) for their

respective taxable years ended in 1994.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                         FINDINGS OF FACT

Background

     Some of the facts have been stipulated and are so found.

The stipulation of facts and first supplemental stipulation of

facts, together with the exhibits attached thereto, are

incorporated herein by this reference.

     Petitioners Michael P. and Maya Polsky (the Polskys) resided

in Northbrook, Illinois, at the time their petition was filed.

     Indeck is the common parent of an affiliated group of

corporations making a consolidated return.   Indeck’s principal

office was located in Buffalo Grove, Illinois, at the time its

petition was filed.

     Prior to and during the year in issue, Indeck was engaged in

the power supply business, principally through cogeneration, the

simultaneous generation of electricity and another form of useful

thermal energy, such as steam, from the same fuel source.
                                - 4 -

     Mr. Polsky was hired to serve as president of the Indeck

Energy Services Division of Indeck Power Equipment Co. (Indeck

Power) in June 1985 by Indeck Power’s president, Gerald R.

Forsythe.    Indeck Power’s Indeck Energy Services Division was

subsequently incorporated as petitioner Indeck in 1985.    Mr.

Polsky became its president in 1986.

Agreements Covering Employment and Purchase/Sale of Indeck Stock

     On January 21, 1987, Mr. Polsky and Indeck executed an

employment agreement (Employment Agreement) and a shareholders’

agreement (Shareholders’ Agreement),1 both retroactive to June 1,

1986.    The Employment Agreement provided that Indeck would employ

Mr. Polsky for 7 years; i.e., until June 1, 1993.    The Employment

Agreement further conferred upon Mr. Polsky salary, bonuses, and

additional compensation measured as a percentage of Indeck’s net

profits, as well as certain stock options and deferred

compensation rights that entitled him to acquire up to 30 percent

of Indeck’s outstanding shares of common stock.    The

Shareholders’ Agreement restricted the sale of any Indeck shares

acquired by Mr. Polsky, providing in general that Mr. Polsky was

required to sell, and Indeck to purchase, such shares in the

event that Mr. Polsky’s employment with Indeck were terminated

under prescribed conditions, including voluntary or involuntary



     1
       Indeck Power was also a signatory to the Shareholders’
Agreement.
                              - 5 -

termination during the 7-year term of employment provided in the

Employment Agreement, and thereafter.

     While the Employment Agreement provided for Mr. Polsky’s

employment by Indeck for 7 years until June 1, 1993, it further

entitled Indeck in its sole discretion to terminate Mr. Polsky’s

employment after 4 years in prescribed circumstances.2

Specifically, under paragraph 12.c. of the Employment Agreement,

Indeck was entitled to terminate the agreement (with 30 days’

notice) if, as of the fourth anniversary of the effective date of

the agreement, Indeck had a negative net worth of $500,000 or

more, as determined from its audited statements for the 4

previous fiscal years ended November 30, 1986, 1987, 1988, and

1989.

     The Shareholders’ Agreement, which incorporated and cross-

referenced the Employment Agreement, provided that Mr. Polsky was

required to sell, and Indeck required to purchase, any Indeck

shares owned by Mr. Polsky in the event of the involuntary

termination of his employment after 4 years pursuant to paragraph

12.c. of the Employment Agreement.    The Shareholders’ Agreement

further provided that the price to be paid by Indeck in these

circumstances was an amount equal to the greater of:     (1) 100


     2
       Under the Employment Agreement, Indeck could otherwise
terminate Mr. Polsky’s employment at any point during the 7-year
term (with 30 days’ notice) in the event he “[failed] or
[refused] to faithfully or diligently perform the provisions of
this Agreement.”
                               - 6 -

percent of the net book value per share as of the last day of the

month preceding the date of the notice of termination; or (2) the

highest purchase price offered in all bona fide third-party

offers to purchase 100 percent of Indeck’s total voting stock

received within 1 year from the date of employment termination.

The Shareholders’ Agreement further provided that the closing

date for the purchase of Mr. Polsky’s shares was to occur within

13 months of the date of termination, at which time Indeck was to

pay Mr. Polsky 20 percent of the purchase price, with the

remaining 80 percent to be paid equally over four annual

installments with interest on the unpaid balance at a rate equal

to the applicable Federal rate as defined in section 1274(d)

(hereafter, the Federal funds rate).   For purposes of setting the

purchase price of Mr. Polsky’s shares by means of third-party

offers, the Shareholders’ Agreement authorized Mr. Polsky to

solicit offers to purchase Indeck’s shares and required Indeck to

provide “reasonable assistance” in connection with the

solicitations.

     The Employment Agreement provided that any controversy or

claim arising out of the agreement was required to be settled by

arbitration.   The Shareholders’ Agreement provided that, in

addition to any other remedies available to the parties thereto,

any controversy concerning the right or obligation to purchase or
                                - 7 -

sell Mr. Polsky’s shares was enforceable in a court of equity by

a decree of specific performance.

Termination of Mr. Polsky

     On August 2, 1990, Gerald R. Forsythe, Chairman of the Board

of Indeck, notified Mr. Polsky by letter that his employment with

Indeck would terminate on September 5, 1990, in accordance with

paragraph 12.c. of the Employment Agreement, on the ground that

Indeck’s negative net worth exceeded $500,000 as of November 30,

1989.   Shortly thereafter, Mr. Polsky and Mr. Forsythe met

regarding the termination letter and the possibility of

renegotiating the terms of Mr. Polsky’s employment.   When Mr.

Polsky did not accede to terms of a new agreement, he received a

letter on September 21, 1990, advising that his employment with

Indeck would terminate on September 22, 1990.   Mr. Polsky’s

employment with Indeck did terminate on that date.    At that time,

Mr. Polsky held 30 of Indeck’s 100 issued and outstanding shares

of common stock.

Dispute Concerning Payment for Mr. Polsky’s Indeck Stock

     Mr. Polsky commenced an arbitration proceeding against

Indeck on September 21, 1990.   In the arbitration, Mr. Polsky

sought an award of compensatory damages for breach of the

Employment Agreement, including the amount he would have received

in salary, bonuses, and percentage compensation, as well as the

value to which his Indeck shares would have appreciated by June
                                - 8 -

1, 1993, the expiration of his term of employment under the

Employment Agreement.

     Mr. Polsky also began soliciting potential purchasers for

Indeck’s outstanding stock in an attempt to set a value for his

shares under the third-party offer provisions of the

Shareholders’ Agreement.    As a result of Mr. Polsky’s efforts, on

November 9, 1990, PowerLink Corp. (PowerLink), the subsidiary of

a private utility holding company with assets of $2.5 billion,

offered to purchase all 100 of Indeck’s outstanding shares from

its shareholders at a price of $1 million per share, subject to

certain contingencies and a due diligence financial review.

PowerLink revised its offer to $501,000 per share in a letter to

Indeck received on January 31, 1991.    After Indeck’s board of

directors reviewed PowerLink’s offer, Mr. Forsythe wrote to

PowerLink on February 6, 1991, stating that shareholders owning

more than 50 percent of Indeck’s outstanding common stock had

advised the board that they were unwilling to sell their shares.

On February 14, 1991, PowerLink advised Mr. Polsky by letter that

its offer to purchase Indeck’s outstanding shares had not been

accepted and had expired.

     As a result of further efforts by Mr. Polsky, CMS Generation

Co. (CMS Generation), the subsidiary of a private utility company

with $8 billion in assets, made an offer on August 6, 1991, to

purchase the outstanding stock of Indeck for $75 million subject
                               - 9 -

to a due diligence financial review.    On September 24, 1991, Mr.

Forsythe, acting on behalf of Indeck, advised CMS Generation by

letter that Indeck’s obligation to cooperate with Mr. Polsky

under the Shareholders’ Agreement had expired and that, as a

shareholder, he was not interested in selling his shares of

Indeck stock.

     Proceedings in the arbitration action brought by Mr. Polsky

had commenced in January 1991 and continued until May 1991.     Mr.

Polsky filed a post-arbitration brief in June 1991 in which he

contended that Indeck owed him the value of his shares as of the

June 1, 1993, expiration of his employment term under the

Employment Agreement.   Mr. Polsky further contended that the

shares would have appreciated to a present value of $56.3 million

at that time, due to anticipated revenues from existing

cogeneration contracts held by Indeck.   Alternatively, Mr. Polsky

argued that the January 31, 1991, PowerLink offer of $501,000 per

share set a floor but not a ceiling on the damages to which he

was entitled with respect to his Indeck stock.   (The August 6,

1991, CMS Generation offer of $75 million (or $750,000 per share)

was not presented to the arbitrator.)    In response, Indeck argued

that the arbitrator lacked jurisdiction with respect to the value

or sale of Mr. Polsky’s shares.

     At a meeting in February 1991, Indeck’s board of directors

was advised by company counsel that if Mr. Polsky’s termination
                              - 10 -

were found to be wrongful, he had no obligation to sell his

shares to Indeck until the June 1, 1993, expiration of his term

of employment under the Employment Agreement.

     While the arbitrator’s decision was pending, Indeck by

letter dated October 1, 1991, advised Mr. Polsky of Indeck’s

position that, for purposes of the Shareholders’ Agreement’s

terms governing the purchase price payable for Mr. Polsky’s

shares, no bona fide offers for Indeck’s stock had been received

within the requisite 1-year period following the termination of

his employment.   Consequently, Indeck advised, under the

Shareholders’ Agreement, Mr. Polsky was deemed to have offered,

and Indeck was entitled to purchase, Mr. Polsky’s Indeck shares

for a purchase price determined under the “net book value” method

provided in the Shareholders’ Agreement.   Indeck further took the

position that the purchase price under that method was zero, in

light of the negative book value of Indeck’s shares as of August

31, 1990.

     On November 27, 1991, the arbitrator issued an award in

which he concluded that the termination of Mr. Polsky was in

violation of the terms of the Employment Agreement and awarded

Mr. Polsky $21,668,800 plus interest thereon at 10-percent per

annum accruing from January 31, 1991, until paid.   The award

provided that the foregoing sum included “damages and the value

of thirty (30) shares of the common stock of INDECK owned by
                              - 11 -

POLSKY.”   Although the arbitration award did not allocate the

money damages between the damages for Indeck’s breach of the

Employment Agreement and the value of Mr. Polsky’s 30 shares, it

elsewhere provided that seven additional shares of Indeck stock,

with respect to which Mr. Polsky’s claim of ownership was

disputed, had a value of $501,000 per share.   The January 31,

1991, date on which interest began to accrue under the

arbitrator’s award was the date on which Indeck had received the

PowerLink offer, and the per share value assigned by the

arbitrator to the seven disputed Indeck shares was the price

offered by PowerLink.

     On December 3, 1991, Mr. Polsky brought an action seeking

confirmation of the arbitration award and entry of judgment

thereon in the Circuit Court of Cook County, Illinois (Cook

County Lawsuit).   Indeck’s filing in response sought to have the

arbitration award vacated insofar as it required a payment of

$15,030,000 ($501,000 per share) for Mr. Polsky’s 30 shares of

Indeck stock, on the grounds that the arbitrator lacked

jurisdiction over that issue.3   Indeck did not contest the

portion of the award relating to amounts Indeck owed Mr. Polsky


     3
       In the alternative, Indeck sought to vacate the
arbitration award insofar as it required immediate payment of the
$15,030,000 value assigned to Mr. Polsky’s shares, plus interest
at 10 percent from Jan. 31, 1991, rather than imposing the
Shareholders’ Agreement’s terms permitting payment for Mr.
Polsky’s shares in five installments with interest at the Federal
funds rate.
                              - 12 -

for salary, bonus, and lost percentage compensation (which Indeck

computed as $6,638,800).

     On February 20, 1992, the Cook County Circuit Court issued

an order vacating the arbitration award insofar as it awarded

$15,030,000 to Mr. Polsky with respect to his 30 shares of Indeck

stock, based on the court’s conclusion that the arbitrator

exceeded his jurisdiction in making an award with respect to the

stock.   The order confirmed the arbitration award insofar as it

awarded damages based on the Employment Agreement, and entered

judgment in favor of Mr. Polsky and against Indeck in the amount

of $6,638,800, plus interest at 10-percent per annum on that

amount until paid.

     Indeck paid Mr. Polsky $7,301,005.80 on February 28, 1992,

in satisfaction of the judgment entered in the Cook County

Lawsuit.   Mr. Polsky appealed the order in the Cook County

Lawsuit insofar as it vacated the arbitration award and Indeck

cross-appealed.4   These appeals remained pending during the

ensuing 2 years in which Mr. Polsky pursued a different lawsuit

against Indeck in the Circuit Court of Lake County, Illinois

(Lake County Lawsuit).

     The Lake County Lawsuit, commenced by Mr. Polsky on April

20, 1992, against Indeck and certain company directors


     4
       Indeck did not appeal the confirmation of that portion of
the arbitration award that found its termination of Mr. Polsky to
be in violation of the Employment Agreement.
                              - 13 -

individually, including Mr. Forsythe, sought damages for breach

of the Employment Agreement and Shareholders’ Agreement as well

as for tortious interference with contract and with prospective

economic advantage.   In his complaint, Mr. Polsky again alleged

that he was entitled to receive as damages the value to which his

Indeck shares would have appreciated by June 1, 1993, the

expiration of his term of employment under the Employment

Agreement, which damages he alleged were not less than $55

million.   The complaint also alleged certain new theories of

recovery not advanced in the arbitration proceedings.    These new

theories incorporated the CMS Generation offer in addition to the

PowerLink offer, and alleged that Mr. Polsky was entitled to

damages measured by the higher of the two offers.   The new

grounds also included allegations that Indeck and/or its agents

had refused to negotiate in good faith with PowerLink and CMS

Generation, and had created or altered documents in order to

misrepresent the value of Indeck’s shares.   The defendants made

several counterclaims against Mr. Polsky, including claims that

he breached the Employment and Shareholders’ Agreements.

Indeck’s counsel believed that Indeck faced greater exposure in

the Lake County Lawsuit than the Cook County Lawsuit.

Settlement of the Dispute

     From the filing of the original complaint in April 1992

until early April 1994, discovery and various pretrial
                               - 14 -

proceedings were conducted in the Lake County Lawsuit.       Trial

commenced on April 12, 1994.   Immediately following the first

witness’s testimony, the trial judge made the following

observation to Indeck’s trial counsel with respect to Indeck’s

obligation to give reasonable assistance under the Shareholders’

Agreement to potential purchasers of its stock solicited by Mr.

Polsky:

     I’m not sure that this isn’t as a matter of law
     interference with the contract. * * *

                *    *    *     *       *   *       *

     it just jumps out at the Court that this may well be
     failure to give reasonable assistance as a matter of
     law. * * *

     Based on the trial judge’s comments, Indeck’s trial counsel

concluded that Indeck’s strategy should be to seek settlement.

Indeck and Mr. Polsky’s counsel commenced settlement discussions

on that day, which continued on April 13.       On the afternoon of

April 13, counsel for Indeck and Mr. Polsky appeared before the

court to describe the basis for their settlement.       Indeck’s

counsel described the settlement’s terms as requiring, inter

alia, a payment by Indeck to Mr. Polsky of $10 million on or

before May 15, 1994, followed by two additional payments of $5

million each on May 1, 1995 and 1996, respectively, with interest

accruing at the Federal funds rate on the unpaid amounts.       The

settlement was further described by Indeck’s counsel as:
                                 - 15 -

     [revolving] around the arbitration award that had been
     given to Mr. Polsky and is essentially looked at as a
     $15 million award with $5 million of interest that was
     figured at a 10 percent rate as required by the
     arbitrator.

                  *    *     *     *      *      *    *

          * * * the settlement is basically a settlement of
     the arbitration and structured around the arbitration
     award and will include a dismissal of the pending
     appeal * * * [of the Cook County Lawsuit].

Mr. Polsky’s counsel expressed agreement with the terms as

outlined by Indeck’s counsel, and the court issued an order that

day dismissing the case with prejudice and retaining jurisdiction

to enforce the settlement.

Written Settlement Agreement

     Indeck’s counsel served as draftsman for a written agreement

to cover the terms of the settlement.         Successive versions of a

written agreement were drafted or revised between April 21 and

May 11, 1994.   A draft prepared by Indeck’s counsel and submitted

to Mr. Polsky’s counsel on or before April 26, 1994, described

the payment to be made for Mr. Polsky’s 30 Indeck shares as

follows:

     Indeck * * * agrees to purchase * * * the thirty (30)
     shares of * * * stock * * * for the price of * * *
     $501,000 per share, for a total purchase price of * * *
     $15,030,000, plus interest on the purchase price at Ten
     Percent (10%) from January 31, 1991 through April 13,
     1994. * * *

The draft further provided for payment of $10 million at closing

with the remainder payable in two equal annual installments, with
                                - 16 -

interest on the unpaid portion to accrue at the Federal funds

rate.   Tax counsel retained by Mr. Polsky reviewed this draft and

suggested the elimination of the phrase “purchase price” as

describing the $15,030,000 amount and of the term “interest” as

describing the 10-percent amount.    Instead, the tax counsel

recommended that both amounts be listed as components of the term

“price”.

     Another draft prepared by Indeck’s counsel and submitted to

Mr. Polsky’s counsel on May 5 or 6, 1994, described the payment

as follows:

     Indeck * * * agrees to purchase * * * the thirty (30)
     shares of * * * stock * * * for a price computed as
     follows: (i) * * * $501,000 per share, for a purchase
     price of * * * $15,030,000 (the “Purchase Price”), and
     (ii) an amount determined by Ten Percent (10%) per
     annum on the purchase price of $15,030,000 from
     January 31, 1991 through April 13, 1994 (the
     “Interest”). * * *

As compared to the April 26 draft, this draft established

“Purchase Price” and “Interest” as defined terms, and applied

“Purchase Price” to the $15,030,000 amount (hereafter “Component

(i)”), and “Interest” to the amount determined as 10-percent per

annum thereon from January 31, 1991, through April 13, 1994

(hereafter “Component (ii)”).    Like the April 26 draft, this

draft also provided for a $10 million payment at closing and two

equal annual installments of the balance on which interest would

accrue at the Federal funds rate.    This draft also described the
                                - 17 -

combined dollar total of Components (i) and (ii) as the “total

Purchase Price and Interest”.

     A later draft prepared by Indeck’s counsel and submitted to

Mr. Polsky’s counsel on May 9, 1994, described the payment as

follows:

     Indeck * * * agrees to purchase * * * the thirty (30)
     shares of * * * stock * * * for a price computed as
     follows: (i) * * * $501,000 per share, for a total of
     * * * $15,030,000 (the “Purchase Price”); plus (ii) an
     amount determined by Ten Percent (10%) per annum on the
     purchase price of $15,030,000 from January 31, 1991
     through April 13, 1994 for a total of * * * $4,809,600;
     plus (iii) an amount determined by interest on the
     amount in (i) at * * * [the Federal funds rate] between
     April 14, 1994 and May 9, 1994, for a total of * * *
     $47,321.85. The total Purchase Price and Interest of
     * * * $19,886,921.85 shall be paid * * * at the
     Closing.

As compared to the May 5/6 draft, this May 9 draft eliminated the

defined term “Interest” as applicable to Component (ii) but the

labeling of Component (i) as “Purchase Price” was preserved.

This draft also eliminated the provision for installment payments

of amounts over $10 million, calling instead for full payment at

closing, with “interest” at the Federal funds rate accruing on

Component (i) between April 14 and May 9, 1994, and such

“interest” designated as a third component (hereafter “Component

(iii)”).   The combined dollar total of Components (i), (ii), and

(iii) was described as the “total Purchase Price and Interest”.
                             - 18 -

     Mr. Polsky’s counsel proposed the following edits to the

description of the payment in the May 9 draft (additions

underscored, strikeouts lined through):

     Indeck * * * agrees to purchase * * * the thirty (30)
     shares of * * * stock * * * for a price computed as
     follows (“Purchase Price”): (i) * * * $501,000 per
     share, for a total of * * * $15,030,000 (the “Purchase
     Price”); plus (ii) an amount determined by Ten Percent
     (10%) per annum on the purchase price of $15,030,000
     the amount in (i) from January 31, 1991 through April
     13, 1994 for a total of * * * $4,809,600; plus (iii) an
     amount determined by interest on the amount in (i) at *
     * * [the Federal funds rate] between April 14, 1994 and
     May 9 10, 1994, for a total of * * * $47,321.85. The
     total Purchase Price and Interest of * * *
     $19,886,921.85 shall be paid * * * at the Closing.

The changes proposed by Mr. Polsky thus eliminated any

characterization of the $15,030,000 figure as purchase price,

eliminated any characterization of the total settlement payment

of $19,886,921.85 as including interest, and instead denominated

the total of all components of the payment as purchase price.

The foregoing changes proposed by Mr. Polsky were accepted by

Indeck, with a minor exception.5   The language of the executed

settlement agreement (Settlement Agreement) described the payment

as follows:

     Indeck * * * agrees to purchase * * * the thirty (30)
     shares of * * * stock * * * for a price computed as
     follows (“Purchase Price”): (i) * * * $501,000 per
     share, for a total of * * * $15,030,000; plus (ii) an
     amount determined by Ten Percent (10%) per annum on the

     5
       The sole exception was Indeck’s rejection of Mr. Polsky’s
proposal to change the end of the accrual period for Component
(iii) from May 9 to May 10, 1994.
                               - 19 -

     amount in (i) from January 31, 1991 through April 13,
     1994 for a total of * * * $4,809,600; plus (iii) an
     amount determined by interest on the amount in (i) at
     * * * [the Federal funds rate] between April 14, 1994
     and May 9, 1994, for a total of * * * $47,321.85. The
     total Purchase Price of * * * $19,886,921.85 shall be
     paid * * * at the Closing.

Motion To Enforce Settlement

     Prior to the execution of the Settlement Agreement, however,

Mr. Polsky’s counsel notified Indeck (on May 11, 1994) of his

intent to present a motion to enforce settlement to the court in

the Lake County Lawsuit.   In the written motion, which contended

that Indeck was improperly refusing to pay interest it had agreed

to pay between April 13, 1994, and the closing date of the

settlement, Mr. Polsky’s counsel described the contemplated

settlement payment by Indeck of $19,886,921.85 as “[representing]

the total of the Arbitrator’s value of the shares, the

Arbitrator’s award of interest on that value up to April 13, 1994

and interest on the Arbitrator’s original value from April 14,

1994 to May 9, 1994 at the ‘federal rate’.”

     On May 16, 1994, Mr. Polsky’s counsel argued his motion, and

the court ordered payment.   Indeck and Mr. Polsky thereupon

executed the Settlement Agreement, Indeck paid $19,886,921.85 to

Mr. Polsky, and Mr. Polsky relinquished control over his 30

shares of Indeck.
                              - 20 -

Return Positions

     On its return for the fiscal year ended November 30, 1994,

Indeck claimed an interest expense deduction of $4,856,922; i.e.,

equal to the (rounded) total of Component (ii) ($4,809,600) and

Component (iii) ($47,321.85) as described in the Settlement

Agreement.   The Polskys, on the other hand, reported the entire

$19,886,922 settlement payment as proceeds from the sale of Mr.

Polsky’s Indeck shares on their 1994 return as amended.   Indeck

did not issue a Form 1099-INT, Interest Income, to Mr. Polsky

with respect to any portion of the settlement payment made

pursuant to the Settlement Agreement.

Notices of Deficiency

     To prevent a “whipsaw” with respect to the proper tax

treatment of the settlement payment, respondent issued

inconsistent notices of deficiency to the petitioners herein.6

In Indeck’s notice, issued on August 13, 1997, after an

examination, respondent determined that Indeck was not entitled

to an interest deduction claimed with respect to $4,856,9227 of

     6
       Respondent is entitled to defend against inconsistent
results by issuing inconsistent determinations, see Maggie Mgmt.
Co. v. Commissioner, 108 T.C. 430, 446 (1997), and each
determination is entitled to the same presumption of correctness
as if it had been issued separately, see Doggett v. Commissioner,
66 T.C. 101, 103 (1976); Ryan v. Commissioner, T.C. Memo. 1998-
331.
     7
       The notice of deficiency issued to Indeck disallowed an
interest deduction of $4,856,921, while the notice issued to the
                                                   (continued...)
                              - 21 -

the settlement payment it paid.   In the Polskys’ notice,

respondent determined that $4,856,922 of the $19,866,922

settlement payment reported in the Polskys’ 1994 return as long-

term capital gain was instead interest income.   In both notices,

respondent determined that the section 6662 accuracy-related

penalty was applicable with respect to the taxable years ended in

1994.

                              OPINION

     Indeck argues that the $19,886,922 settlement payment

consisted of a $15,030,000 purchase price for Mr. Polsky’s 30

Indeck shares and $4,856,922 in deductible interest, because both

the parties’ intent and the substance of the Settlement Agreement

contemplated the payment of $4,856,922 as interest to compensate

Mr. Polsky for the delay in receiving $15,030,000 for his shares

after January 31, 1991.   Indeck further contends that the Polskys

are estopped from denying that the $19,886,922 settlement payment

includes interest under the doctrine of judicial estoppel.    The

Polskys contend that the entire $19,886,922 settlement payment

constitutes the purchase price for the shares, based on the

express allocation of the entire amount to purchase price in the

parties’ written agreement, and the absence of any “indebtedness”

     7
      (...continued)
Polskys recharacterized $4,856,922 of long-term capital gain as
interest income. Since the latter figure is the appropriate
rounding of the actual $4,856,921.85 in dispute, we use the
latter figure throughout this opinion.
                              - 22 -

within the meaning of section 163(a) on which to base a claim of

interest.   Respondent, after reviewing the evidence adduced at

trial, has abandoned the stakeholder position assumed in the

notices and now argues on brief in support of the Polskys’

position and against Indeck’s, on the grounds that the requisite

“indebtedness” for purposes of an interest deduction under

section 163(a) is lacking and that the substance of the parties’

agreement did not include interest.    For the reasons discussed

below, we agree with the Polskys and respondent and hold that

Indeck has failed to show entitlement to an interest deduction

for any portion of the $19,886,922 payment it made to Mr.

Polsky.8

Allocation in Written Agreement

     Indeck argues that $4,856,922 of the settlement payment

constitutes interest because Indeck and Mr. Polsky in substance

agreed to an interest payment in that amount in settlement of

their dispute.   In support, Indeck points to the Settlement

Agreement’s description of the settlement payment in components

that correspond to the arbitrator’s $15,030,000 value for the

     8
       Deductions are a matter of legislative grace, and Indeck
bears the burden of proof with respect to the interest deduction
at issue in its case. Rule 142(a); INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992). Sec. 7491(a), shifting the
burden of proof to the Commissioner in certain circumstances, is
not applicable here because the examination of Indeck’s return
commenced prior to July 22, 1998. See Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, sec.
3001(c)(1), 112 Stat. 726.
                             - 23 -

shares and the arbitrator’s award of interest at 10-percent per

annum on $15,030,000 commencing January 31, 1991.   Indeck further

cites Mr. Polsky’s attorneys’ representations to the Lake County

Circuit Court--which occurred after the parties reached agreement

on the final language of the Settlement Agreement--to the effect

that the settlement included the arbitrator’s award of interest

at 10 percent from January 31, 1991, on $15,030,000.   Indeck

contends that in the Settlement Agreement, the parties in

substance agreed that Mr. Polsky should receive the arbitrator’s

$15,030,000 valuation for the shares, that he should have

received this amount on January 31, 1991, and that consequently

he should receive the arbitrator’s award of 10-percent interest

from that date as compensation for the delay in payment.9

     Indeck’s contentions regarding the substance of the parties’

agreement cannot be reconciled with the Settlement Agreement.

Contrary to Indeck’s contentions, the written terms of the

Settlement Agreement allocate the entire $19,886,922 payment to

the “purchase price” of the shares.   As a party to the Settlement

Agreement, Indeck may not offer an interpretation of the written

     9
       As Indeck puts it on brief, under the settlement Mr.
Polsky “was being paid for his stock, $501,000 per share [i.e.,
$15,030,000], plus interest from the date it was agreed * * *
that such payment for his stock should have been made to him
[i.e., Jan. 31, 1991].” Thus, Indeck argues, the portion of the
settlement payment exceeding $15,030,000 was paid to Mr. Polsky
“as compensation for Indeck[’s] * * * use of the money due Polsky
from January 31, 1991 through May 9, 1994 [i.e., the closing date
of the Settlement Agreement]” and is therefore interest.
                               - 24 -

agreement at variance with its clear terms except by adducing

“strong proof” that the terms of the written instrument do not

reflect the actual intentions of the contracting parties.

Kreider v. Commissioner, 762 F.2d 580, 586 (7th Cir. 1985), affg.

T.C. Memo. 1984-68; Major v. Commissioner, 76 T.C. 239, 247

(1981).   If the written instrument is ambiguous, Indeck need

offer only proof that satisfies a “‘preponderance of the

evidence’” standard to show the parties’ true intentions.

Kreider v. Commissioner, supra at 586 (quoting Major v.

Commissioner, supra at 247).

     While the Settlement Agreement’s allocation of the entire

payment to “purchase price” is on its face explicit and

unambiguous, an argument exists that an ambiguity regarding any

provision for interest is created by the Settlement Agreement’s

definition of Component (ii) as an amount equal to a percentage

per annum of a stated sum over a designated period and its

definition of Component (iii) as an amount equal to “interest” at

the section 1274(d) rate on the same sum over a designated

period.   It is unnecessary for us to decide whether the

Settlement Agreement is ambiguous, however, because even under

the lesser “preponderance of the evidence” standard of proof,

Indeck has not persuaded us that the parties to the Settlement

Agreement intended any portion of the settlement payment as

interest.   To the contrary, the extrinsic evidence demonstrates
                               - 25 -

that the parties actually agreed to allocate the entire payment

to purchase price.

     The attorneys who negotiated the terms of the Settlement

Agreement on behalf of Indeck and Mr. Polsky testified that

interest was and was not intended, respectively.   We found their

testimony self-serving and accord it little weight.   Far more

reliable, and ultimately persuasive, with respect to the parties’

intent are the contemporaneous draft versions of the Settlement

Agreement that circulated between them during the negotiations

covering the agreement.10   As documented in greater detail in our

fact findings, Indeck’s attorneys, as drafters of the Settlement

Agreement, attempted in various drafts to characterize Component

(ii) (i.e., the amount equal to 10 percent per annum on

$15,030,000 from January 31, 1991 through April 13, 1994) as

“interest” and/or to distinguish it from “purchase price”.    Mr.

Polsky’s attorneys specifically rejected these efforts, and

proposed language that deleted any reference to interest in

respect of Component (ii) and instead described both Components



     10
       We also find it unnecessary to rely on the testimony of
Mr. Polsky in making our findings regarding the intentions of the
parties to the Settlement Agreement, given the probative value of
the draft versions of the Settlement Agreement. In this regard,
Indeck sought to introduce evidence at trial concerning Mr.
Polsky’s compliance with certain other Federal and State income
tax obligations, in an effort to impugn his credibility. We
ruled such evidence inadmissable under rule 403 of the Federal
Rules of Evidence.
                              - 26 -

(ii) and (iii)11 as part of the “purchase price”.   Mr. Polsky’s

attorneys prevailed on this point, resulting in a final version

of the Settlement Agreement that expressly allocates Components

(ii) and (iii) to “purchase price”; defines “purchase price” as

the sum of Components (i), (ii), and (iii), not merely as

Component (i) (i.e., the $15,030,000 amount), as Indeck had

initially sought; and does not anywhere describe Component (ii)

as “interest”, as Indeck had initially sought.   Indeck’s

attorneys’ failed efforts to denominate Component (ii) as

“interest” or Component (i) as the “purchase price”, and Mr.

Polsky’s attorneys’ success in the face of these efforts in

having Components (ii) and (iii) labeled as “purchase price”,

together convince us that Indeck and Mr. Polsky were fully

cognizant of the allocation, negotiated it, and ultimately agreed

that the allocation of the settlement payment would be made

entirely to purchase price.

     Moreover, Indeck never issued a Form 1099-INT to Mr. Polsky

with respect to the $4,856,922 it claims was intended as

interest.   The explanation offered by Indeck’s chief financial

officer to the effect that the failure was a result of oversight

is unconvincing, given the magnitude of the payment and its

circumstances.   A plausible inference from the failure is that

     11
       As used in the Settlement Agreement, Component (iii)
consisted of an amount equal to interest at the Federal funds
rate on $15,030,000 between Apr. 14 and May 9, 1994.
                              - 27 -

Indeck, having agreed in the written Settlement Agreement to

allocate the entire settlement payment to purchase price, had

doubts that the parties had agreed to a payment of $4,886,922 of

interest.

     Overall, the extrinsic evidence persuades us that Indeck and

Mr. Polsky agreed to allocate the entire $19,866,922 settlement

payment to purchase price, notwithstanding any ambiguity

concerning interest that might exist within the four corners of

the Settlement Agreement.   Accordingly, we reject Indeck’s claim

herein that $4,856,922 of the settlement payment was actually

intended as interest by the parties to the Settlement Agreement.

Although Indeck may have preferred an allocation of this amount

to interest, as the drafts of the agreement prepared by its

attorneys suggest, Mr. Polsky objected and prevailed.   The

parties’ final, written agreement allocated the entire payment to

purchase price.

     Where there is an express allocation in a settlement

agreement of a settlement payment, that allocation is generally

respected for tax purposes if the agreement was entered into by

the parties in an adversarial context at arm’s length and in good

faith.   Bagley v. Commissioner, 105 T.C. 396 (1995), affd. 121

F.3d 393 (8th Cir. 1997); Robinson v. Commissioner, 102 T.C. 116

(1994), affd. in part and revd. in part 70 F.3d 34 (5th Cir.

1995).   However, to be respected the allocation must reflect the
                             - 28 -

“reality” of the settlement, and the court must discern, based on

all the facts and circumstances surrounding the settlement, “in

lieu of what” the settlement amount was paid.   Robinson v.

Commissioner, supra at 126; see also Bagley v. Commissioner,

supra at 406.

     It is beyond dispute that Indeck and Mr. Polsky entered the

Settlement Agreement in an adversarial context at arm’s length.

The parties were tax adverse with respect to the characterization

of any portion of the settlement payment as interest versus

purchase price, as Indeck’s ability to deduct the payment, and

Mr. Polsky’s recognition of it as ordinary or capital income,

depended upon such characterization.   As outlined in our previous

discussion of the evolution of the written terms of their

agreement, the effort by Indeck’s attorneys to label the

$15,030,000 portion of the settlement payment as “purchase price”

and the remainder as “interest”, and Mr. Polsky’s attorneys’

rejection of those efforts and successful proffer of language

denominating the entire payment as purchase price, convince us

that the parties considered the allocation and agreed to an

allocation of the entire payment to purchase price.   Thus, the

allocation was the product of arm’s-length, adversarial

negotiations.

     That leaves the question of whether the allocation reflected

the “reality” or substance of the parties’ agreement.   Indeck
                               - 29 -

contends that the agreement, in substance, was for a purchase

price of $15,030,000 for the shares plus $4,856,922 of interest

to compensate for the post-January 31, 1991, delay in payment.

Indeck’s contention is based, in part, on the Settlement

Agreement’s description of the settlement payment in components

that correspond to the arbitrator’s $15,030,000 value for the

shares and his award of 10-percent interest on that amount

commencing January 31, 1991.   Indeck also points to

representations by Mr. Polsky’s attorneys to the Lake County

Circuit Court in connection with the settlement describing the

settlement payment as including “interest” at 10 percent from

January 31, 1991, on $15,030,000, which occurred after agreement

had been reached on the language in the Settlement Agreement

allocating the entire payment to “purchase price”.

     It is obvious that the Settlement Agreement was modeled in

substantial part on the arbitrator’s value for the shares and his

award of interest.   The question remains, however, whether the

parties’ use of the arbitration award as a model indicates that

they in substance agreed on a purchase price of $15,030,000 for

the shares plus $4,856,922 in interest, or simply a purchase

price equal to the total of the foregoing, as the Settlement

Agreement allocation indicates.

     Indeck argues that the parties’ use of the arbitrator’s

award as a model for the settlement payment, and Mr. Polsky’s
                              - 30 -

attorney’s representations to the Lake County Circuit Court that

the settlement payment included the arbitrator’s award of

interest, demonstrate that the parties agreed in substance that

Mr. Polsky was entitled to receive $15,030,000 on January 31,

1991, and therefore was further entitled to $4,856,922 in

interest to compensate him for the delay in payment of

$15,030,000.   We disagree; it does not necessarily follow from

the parties’ use of the arbitrator’s award to arrive at a

settlement figure that they agreed to pay interest.   An inference

equally consistent with their use of the arbitrator’s award is

the proposition that Mr. Polsky agreed to settle the dispute by

selling his shares for the figure derived by employing the

fiction that the arbitrator’s award covering the shares had been

confirmed and had not been paid.   This latter inference is

likewise consistent with Mr. Polsky’s attorneys’ representations

to the Lake County Circuit Court; their use of the term

“interest” could be interpreted as a reference to the formula

employed in reaching the agreed upon figure for settling the

dispute.   Based on the facts and circumstances surrounding the

settlement as outlined below, we conclude that the substance of

the parties’ agreement is consistent with a purchase price of

$19,886,922 for the shares, as the written allocation in the

Settlement Agreement provides.
                              - 31 -

     We note first that in the Settlement Agreement, the parties

were not just settling the Cook County Lawsuit (i.e., the pending

appeal of the arbitrator’s award of $15,030,000 for the shares).

They were also settling the Lake County Lawsuit in which Mr.

Polsky had advanced claims of considerably higher values for his

shares.   The claims for a higher value for the Indeck shares in

the Lake County Lawsuit were based, inter alia, (i) on Mr.

Polsky’s theory that he was entitled to the shares’ value as of

June 1, 1993, due to his wrongful termination12 (which value he

estimated to be $55 million), and (ii) on the higher of the

third-party offers for Indeck’s stock, namely, the CMS Generation

offer of $750,000 per share (or $22.5 million for Mr. Polsky’s 30

shares), which had not been presented to the arbitrator.13

Second, the settlement was prompted by developments in the Lake

County Lawsuit, not the Cook County Lawsuit.   Settlement

discussions were initiated by Indeck when the presiding judge in

the Lake County Lawsuit, after hearing the first witness’s

testimony, expressed his view that Indeck may have failed as a

matter of law to meet its obligations to Mr. Polsky under the

     12
       In this regard, it bears noting that the portion of the
arbitrator’s award finding that Mr. Polsky’s termination had been
in violation of the terms of the Employment Agreement was
confirmed by the Cook County Circuit Court, and that portion of
the decision was not appealed by Indeck.
     13
       One of Indeck’s own attorneys testified herein that
Indeck’s exposure in the Lake County Lawsuit was significantly
greater than in the Cook County Lawsuit.
                              - 32 -

Shareholders’ Agreement.   Thus, we believe the settlement could

be expected to reflect Indeck’s exposure in the Lake County

Lawsuit to the higher share values asserted there by Mr. Polsky

(as compared to the $501,000 per share value awarded by the

arbitrator and on appeal in the Cook County Lawsuit).   Moreover,

a plausible inference, if Indeck had failed to give reasonable

assistance as the judge in the Lake County Lawsuit opined, would

be that Indeck’s failure to cooperate had tainted the third-party

offer process and depressed the offer prices of PowerLink and CMS

Generation.   It would follow that the $15,030,000 value for the

shares awarded by the arbitrator was too low.   In any event, we

are persuaded that, in practical terms, Mr. Polsky was in a

superior bargaining position in the settlement negotiations,

suggesting that he could obtain a value for his shares reflecting

the higher claims advanced in the Lake County Lawsuit, rather

than the $15,030,000 awarded by the arbitrator based on the

PowerLink offer.   In addition, nowhere in his pleadings in the

Lake County Lawsuit did Mr. Polsky claim entitlement to 10-

percent per annum interest on $15,030,000 commencing January 31,

1991.

     Based on the foregoing, we are persuaded that in the

settlement Mr. Polsky was well positioned to obtain a $19,886,922

purchase price for his shares and in substance did so, and that

the arbitrator’s award served merely as a formula for arriving at
                              - 33 -

that purchase price.   The parties’ use of that formula was not

tantamount to an agreement to pay $15,030,000 for the shares and

the remainder as interest.   Accordingly, the facts and

circumstances surrounding the settlement do not suggest that the

parties’ allocation fails to reflect the reality of their

agreement.   See Bagley v. Commissioner, 105 T.C. 396 (1995);

Robinson v. Commissioner, 102 T.C. 1161 (1994).

     In support of its position that the written allocation of

the entire payment to purchase price should be ignored, Indeck

cites Rozpad v. Commissioner, 154 F.3d 1 (1st Cir. 1998), affg.

T.C. Memo. 1997-528, Delaney v. Commissioner, 99 F.3d 20 (1st

Cir. 1996), affg. T.C. Memo. 1995-378, and Smith v. Commissioner,

59 T.C. 107 (1972), cases where the courts disregarded the

absence of an allocation to interest in written settlement

agreements or a court order and instead found that a portion of

the payment included interest income to the payee.14

     Indeck’s case is easily distinguishable.   We note first that

the payor and payee in Rozpad, Delaney, and Smith were not tax

adverse regarding the characterization of any portion of the

payment as interest.   Also, the taxpayers in Rozpad and Delaney

     14
       Indeck also cites Kovacs v. Commissioner, 100 T.C. 124
(1993), affd. without published opinion 25 F.3d 1048 (6th Cir.
1994), but we believe that case is of marginal relevance. In
Kovacs, the issue was not whether interest formed some portion of
a payment, but whether amounts conceded to be interest should be
treated as part of the damages received on account of personal
injury and therefore excludable from income under sec. 104(a)(2).
                              - 34 -

were seeking to uphold the written terms of their settlement

agreement; Indeck seeks to disregard the written terms to which

it agreed, bringing the principles of Kreider v. Commissioner,

762 F.2d 580 (7th Cir. 1985), into play.

     More fundamentally, with respect to Rozpad and Delaney, the

relationship between an appealable verdict and a closely

proximate settlement thereof, as existed in those cases, does not

obtain in Indeck’s case.   In Rozpad and Delaney, settlements were

reached during the appeal period for verdicts obtained by the

taxpayers.   The settlement agreements did not allocate any

portion of the settlement payments to interest, though the

verdicts had included substantial interest components.   In each

case the court sustained the Commissioner’s determination that

the settlement payment contained interest in the same proportion

that the interest awarded in the verdict bore to the total amount

awarded in the verdict, notwithstanding the absence of any

allocation to interest in the written settlement agreement.

     The straightforward causal relationship between the verdict

and settlement in Rozpad and Delaney is not present in the

instant case between the arbitrator’s award and the Settlement

Agreement.   The Settlement Agreement was prompted by developments

in the Lake County Lawsuit, not the pending appeal of the

arbitrator’s award in the Cook County Lawsuit.   The Settlement

Agreement was not a compromise of the arbitrator’s award for a
                               - 35 -

lesser amount; under the Settlement Agreement, the value of the

arbitrator’s award was essentially paid in full.   Instead of

merely compromising the arbitrator’s award, the Settlement

Agreement settled a broader array of claims for significantly

higher share values advanced by Mr. Polsky in the Lake County

Lawsuit.    Although the Cook County Lawsuit was also dismissed as

part of the Settlement Agreement, this feature was incidental to

the primary focus of the settlement, which was to resolve

Indeck’s exposure in the Lake County Lawsuit.    Consequently, the

arbitrator’s award is not analogous to the appealable verdicts in

Rozpad and Delaney, and provides no basis for disregarding the

written allocation between purchase price and interest provided

in the Settlement Agreement.

     Smith v. Commissioner, supra, is likewise not persuasive

authority for Indeck’s treatment of the disputed amounts as

interest.    Smith concerned a situation where the parties’ written

settlement agreement stated that the settlement payment included

interest, but a court order implementing the settlement did not,

providing the taxpayer-payee with his opportunity to argue that

the payment did not include interest.   Based on the settlement

agreement’s written terms covering interest, the taxpayer’s

entitlement to interest under State law in connection with the

condemnation that was the subject of the settlement, and the

State government payor’s documentation showing it intended to pay
                              - 36 -

interest, we concluded that interest had been received by the

taxpayer.   No comparable situation exists in Indeck’s case; Mr.

Polsky was not entitled to interest under a statute, and the

Settlement Agreement specifically negates any contractual

entitlement.

Requirement of Indebtedness

     We also agree with respondent and the Polskys that the

disputed $4,856,922 portion of the settlement payment cannot

constitute interest deductible under section 163(a) by Indeck

because there was no indebtedness within the meaning of that

section.

     In order for an amount to constitute interest deductible

under section 163(a), it must have been paid or accrued on

“indebtedness”.   Midkiff v. Commissioner, 96 T.C. 724 (1991),

affd. sub nom. Noguchi v. Commissioner, 992 F.2d 226 (9th Cir.

1993); Jordan v. Commissioner, 60 T.C. 872 (1973), affd. 514 F.2d

1209 (8th Cir. 1975); Williams v. Commissioner, 47 T.C. 689

(1967), affd. 409 F.2d 1361 (6th Cir. 1968); Kaempfer v.

Commissioner, T.C. Memo. 1992-19.   Indebtedness for this purpose

is “an existing, unconditional, and legally enforceable

obligation for the payment of a principal sum”.   Howlett v.

Commissioner, 56 T.C. 951, 960 (1971); see also Midkiff v.

Commissioner, supra at 744; Jordan v. Commissioner, supra at 881;

Williams v. Commissioner, supra at 692.   In addition, the amount
                              - 37 -

of the indebtedness must have been fixed as of the date the

purported interest began to accrue.    Midkiff v. Commissioner,

supra at 739-740; see also Halle v. Commissioner, 83 F.3d 649

(4th Cir. 1996), revg. on other grounds Kingstowne v.

Commissioner, T.C. Memo. 1994-630.

     Indeck contends that this amount is deductible interest

because the parties to the Settlement Agreement intended it as

such; namely, as compensation to Mr. Polsky for the delay in

receiving payment for his shares between January 31, 1991 and May

9, 1994.   Indeck further argues that the statutory requirement of

indebtedness is satisfied because Indeck had an “unconditional

obligation” under the Shareholders’ Agreement to purchase Mr.

Polsky’s shares at a price determined by third-party offers, and

this obligation was confirmed by the arbitrator’s decision

requiring Indeck to purchase Mr. Polsky’s shares at the PowerLink

offer price (i.e., $15,030,000) as of January 31, 1991 (the date

PowerLink’s offer was received), with 10-percent interest until

payment in full.

     We conclude that the disputed $4,856,922 portion of the

settlement payment is not interest for purposes of section 163(a)

because it was not paid on indebtedness-–that is, it was not paid

with respect to an existing, legally enforceable obligation for

the payment of a principal sum, nor was the amount of the
                               - 38 -

obligation fixed as of the date the purported interest began to

accrue.

     Indeck had no existing, legally enforceable obligation to

pay a discernible sum for Mr. Polsky’s shares prior to May 15,

1994, the date by which closing was to occur under the Settlement

Agreement.    Indeck urges that it had an “unconditional

obligation” to purchase Mr. Polsky’s shares under the

Shareholders’ Agreement, as a result of his involuntary

termination, at a price determined by the highest bona fide offer

received for Indeck’s outstanding shares within one year of the

termination.    But the Shareholders’ Agreement’s formula for

setting the purchase price of Mr. Polsky’s shares was far too

indefinite to give rise to indebtedness.    The terms of the

Shareholders’ Agreement allowed Indeck to contend that the third-

party offers obtained by Mr. Polsky to set the price were not

bona fide (as Indeck in fact contended during the period that the

purported indebtedness gave rise to interest).    For his part, Mr.

Polsky contended that, under the combined terms of the Employment

and Shareholders’ Agreements, the price to be paid for his shares

should be measured as of the expiration of his term of

employment.    In short, upon Mr. Polsky’s termination, the parties

vigorously disputed the terms of Indeck’s obligation to purchase

Mr. Polsky’s shares.
                              - 39 -

     Their dispute first went to arbitration, in a proceeding

initiated by Mr. Polsky in September 1990.   Mr. Polsky contended,

inter alia, that because his termination had been wrongful, he

was entitled to the value of his shares as of the June 1, 1993,

expiration of his employment term under the Employment

Agreement,15 at which time the shares would have appreciated to

$56.3 million, in present value terms, he claimed.

Alternatively, Mr. Polsky claimed that the $501,000 per share

PowerLink offer set a floor, but not a ceiling, on the value of

his shares.   In response, Indeck took the position that the

arbitrator lacked jurisdiction to consider the value or sale of

Mr. Polsky’s shares.   Then, by letter dated October 1, 1991,

Indeck took the position that since no bona fide offers for its

stock had been received within the year following Mr. Polsky’s

termination, the price for his shares should be set under the net

     15
       Mr. Polsky’s position was far from frivolous, as Indeck’s
own counsel advised its board of directors in February 1991 that
if Mr. Polsky’s termination were found to be wrongful, he had no
obligation to sell his shares to Indeck until the June 1, 1993,
expiration of his term of employment under the Employment
Agreement.

     Mr. Polsky’s position, and the advice given by Indeck’s
attorney, were apparently based on the fact that the
Shareholders’ Agreement’s provisions governing Indeck’s purchase
of Mr. Polsky’s shares in the event of his involuntary
termination presupposed a termination effected in accordance with
the provisions of the Employment Agreement. Mr. Polsky contended
that his termination violated the Employment Agreement, and the
arbitrator subsequently agreed. The portion of the arbitration
award covering damages for wrongful termination was confirmed and
not appealed by Indeck.
                                - 40 -

book value method provided in the Shareholders’ Agreement.     Under

that method, Indeck advised it owed Mr. Polsky zero for the

shares.     In sum, given the circumstances of Mr. Polsky’s

termination, the timing and amount of Indeck’s obligation with

respect to the purchase of Mr. Polsky’s shares was unclear under

the Shareholders’ Agreement and vigorously disputed.

     The arbitrator issued an award on November 27, 1991, in

which he concluded that Indeck had wrongfully terminated Mr.

Polsky, and that Indeck must pay damages of $6,638,000, plus

$15,030,00016 ($501,000 per share) for Mr. Polsky’s 30 shares of

Indeck, with interest at 10 percent per annum commencing January

31, 1991.    It is apparent, and the parties herein do not dispute,

that the arbitrator based his $501,000 per-share value and his

interest commencement date on the PowerLink offer, which was made

in that amount and received on that date.     Thus, the principal

amount of $15,030,000, payable as of January 31, 1991, represents

the arbitrator’s determination of Indeck’s obligation to Mr.

Polsky, presumably on the grounds that the PowerLink offer was

bona fide and within the 1-year period following termination,




     16
       Although the arbitrator’s award stated the monetary
damages only as an aggregate total of $21,668,800, the parties
herein do not dispute that this total represented $15,030,000 for
Mr. Polsky’s 30 shares, given that the arbitrator valued seven
other Indeck shares (not at issue herein) at $501,000 per share.
                              - 41 -

triggering Indeck’s obligation under the Shareholders’ Agreement

to purchase Mr. Polsky’s shares at the PowerLink offer price.17

     While the arbitration award contained a fixed amount and a

due date for Indeck’s obligation, this portion of the award never

became legally enforceable.   When Mr. Polsky sought to have the

award confirmed, the Cook County Circuit Court, on Indeck’s

motion, vacated the award insofar as it covered the Indeck

shares, on the grounds that the arbitrator lacked jurisdiction.18

     17
       It bears noting that, in setting the obligation’s due
date at Jan. 31, 1991, and the interest rate at 10 percent, the
arbitrator went outside of, indeed contradicted, the terms of the
Shareholders’ Agreement. The Shareholders’ Agreement provided
that the closing date for the purchase of Mr. Polsky’s shares
need not occur until 13 months after his termination date (which
would have been Oct. 22, 1991), that only 20 percent of the
purchase price need be paid on that date, and that the remainder
could be paid in periodic installments, bearing interest at the
rate provided in sec. 1274(d). Thus, to the extent Indeck claims
it had an “unconditional obligation”, based on the Shareholders’
Agreement, to pay Mr. Polsky $15,030,000 on Jan. 31, 1991, that
claim is inaccurate. The Jan. 31, 1991, due date, as well as the
requirement that the entire balance be paid on that date, arose
entirely from the arbitrator’s Nov. 21, 1991, interpretation of
Indeck’s obligation.

     The arbitration award does not indicate whether the
arbitrator’s determination to impose a more onerous due date and
payment terms than those provided in the Shareholders’ Agreement
was based upon his conclusion that Mr. Polsky’s termination was
in violation of the Employment Agreement, thereby voiding the
payment schedule provided in the Shareholders’ Agreement.
     18
       Under Illinois law, an award in arbitration does not
become an enforceable judgment until it has been confirmed by a
circuit court of that State. 710 Ill. Comp. Stat. 5/11, 5/14,
5/16 (1999). Confirmation may not occur until 90 days after
delivery of the award to each party, during which time a party
may make application to the court to have the award vacated or
                                                   (continued...)
                               - 42 -

The order in the Cook County Lawsuit vacating this portion of the

arbitration award remained on appeal until Indeck and Mr. Polsky

agreed as part of the Settlement Agreement to dismiss the appeal.

     Two months after the arbitration award was vacated, Mr.

Polsky commenced the Lake County Lawsuit, wherein he maintained

his contention that, due to his wrongful termination, he was owed

the value of his shares as of June 1, 1993 (i.e., not the value

determined by third-party offers received during the year

following his September 1990 termination).   He claimed the amount

due him for his shares under this theory was not less than $55

million.   Moreover, he advanced claims premised upon the higher

($750,000 per share) offer received from CMS Generation for

Indeck’s outstanding shares on August 6, 1991, which had not been

presented to the arbitrator.   Indeck, for its part, maintained

its position that the amount it owed Mr. Polsky for his shares

depended upon their net book value as provided in the

Shareholders’ Agreement, since no bona fide offers for Indeck’s

shares had been received within the requisite period provided in

the agreement.

     Thus, during the more than 3-year period that Indeck claims

interest was accruing on a $15,030,000 indebtedness due January

31, 1991, the parties were in fact vigorously disputing the


     18
      (...continued)
modified. Id. at 5/11, 5/12, 5/13.
                              - 43 -

obligation, both as to amount and due date.   During this period,

the only significance of the January 31, 1991, due date (rather

than, e.g., August 6, 1991; June 1, 1993; or some other date) and

the $15,030,000 amount (rather than some other figure) rested in

an arbitration award that had been vacated before confirmation.

Consequently, during the period from January 31, 1991, through

May 9, 1994, in which Indeck contends section 163(a) interest

accrued, Indeck’s obligation to Mr. Polsky was neither fixed in

amount nor legally enforceable.   As such, it was not indebtedness

giving rise to interest under section 163(a).   See Midkiff v.

Commissioner, 96 T.C. 724 (1991); Jordan v. Commissioner, 60 T.C.

at 881-882.

     Jordan v. Commissioner, supra, is instructive on this point.

In that case, the taxpayer participated in the sale of stock to

investors who subsequently sued him, alleging securities law

violations in connection with the sale of the stock.   In response

to the lawsuits, the taxpayer offered to rescind the sale by

repurchasing the stock for its original purchase price plus

“interest” at the rate of 5 percent per annum from the date of

the original sale until the repurchase.   The stock was

repurchased by the taxpayer pursuant to the rescission offer, and

the taxpayer claimed an interest deduction under section 163(a)

for the amounts denominated as 5 percent interest under the terms

of the offer.   We sustained the Commissioner’s disallowance of
                              - 44 -

the deduction on the grounds that no indebtedness for purposes of

section 163 existed, concluding instead that the 5 percent

“interest” was merely part of the purchase price of the stock.

As with the taxpayer in Jordan, Indeck’s payment of an amount

denominated as interest to settle a dispute, even where stated as

a percentage per annum of a designated amount, does not entitle

it to an interest deduction where indebtedness did not exist.

     Indeck’s obligation to Mr. Polsky with respect to the

purchase of his shares did not become fixed in amount or

enforceable until the parties reached an agreement on April 13,

1994, pursuant to which Mr. Polsky would transfer his shares, and

Indeck would become obligated to make payment, on or before May

15, 1994.   As a consequence, Indeck had no indebtedness to Mr.

Polsky prior to May 15, 1994,19 and no interest for purposes of

section 163(a) could have accrued prior to that date.

     Indeck cites Halle v. Commissioner, 83 F.3d 649 (4th Cir.

1996), revg. on other grounds Kingstowne v. Commissioner, T.C.

Memo. 1994-630, and Dunlap v. Commissioner, 74 T.C. 1377 (1980),

revd. on other grounds 670 F.2d 785 (8th Cir. 1982), in support


     19
       The evidence persuades us that Indeck incurred an
existing, legally enforceable obligation to pay Mr. Polsky a
designated sum, on Apr. 13, 1994--the date on which the parties
reached an oral agreement to settle and described that agreement
on the record to the judge presiding in the Lake County Lawsuit,
who dismissed the case on that basis. Indeck’s obligation,
however, was to pay Mr. Polsky a designated sum on or before May
15, 1994.
                              - 45 -

of its position.   However, those cases are distinguishable in a

key respect.   In both, there was agreement between the purported

debtor and creditor as to the amount of the obligation and its

due date, as of the time the purported interest began to accrue.

Here, the amount of Indeck’s obligation, and its due date, were

disputed during the period that the bulk of the claimed interest

purportedly accrued.

     In Halle, the Court of Appeals for the Fourth Circuit,

reversing our opinion in Kingstowne,20 held that an agreement for

the purchase of stock at a specified price and settlement date

created indebtedness on the part of the purchaser such that the

purchaser’s payments to defer settlement beyond the agreed-upon

settlement date constituted interest for purposes of section

163(a) rather than additional purchase price.   Indeck likens the

disputed $4,856,922 portion of the settlement payment here to the

payments made by the purchaser in Halle to defer the settlement

date of the stock purchase-–that is, as a payment for the

forbearance of money owed.   But a critical distinction exists.


     20
       Because Halle v. Commissioner, 83 F.3d 649 (4th Cir.
1996), revg. on other grounds Kingstowne v. Commissioner, T.C.
Memo. 1994-630, is fully distinguishable from the facts of this
case and is not inconsistent with our holding herein that Indeck
has not established indebtedness for purposes of sec. 163(a), we
have no occasion to reconsider our holding in Kingstowne that the
purchase agreement at issue in that case created merely an option
to purchase rather than an indebtedness. See Golsen v.
Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.
1971).
                              - 46 -

In Halle, the mutual agreement of the purchaser and seller

covering a purchase price and settlement date, as well as the

additional compensation due the seller if the settlement date

were deferred, persuaded the court that the parties had

contractually established an indebtedness.    With respect to the

obligation found there to be indebtedness, there was agreement

between the purchaser and seller covering the amount of the

obligation, as of its due date, as well as agreement covering the

due date itself.

     Indeck can meet neither of those conditions with respect to

the obligation it claims is indebtedness.    Prior to the

Settlement Agreement, the amount and timing of any obligation

Indeck owed Mr. Polsky for his shares depended upon the terms of

the Shareholders’ Agreement, the interpretation of which was

disputed by the parties.   The only adjudication of those terms,

by an arbitrator, had been vacated before ripening into an

enforceable judgment.   The contractual arrangement between Indeck

and Mr. Polsky that might have passed muster as indebtedness

under the standard employed in Halle was the Settlement

Agreement, as it fixed the amount of Indeck’s obligation and its

due date.   But under the Settlement Agreement, Indeck was not

required to make payment before May 15, 1994; there was no

forbearance of money by Mr. Polsky until that date and thus no

interest for purposes of section 163(a).
                              - 47 -

     Similarly, in Dunlap v. Commissioner, supra, we found

indebtedness for purposes of section 163(a) notwithstanding the

fact that the obligation on which the purported interest accrued

remained subject to a condition precedent (namely, Federal

Reserve Board approval of the underlying transaction) during a

substantial portion of the period in which the claimed interest

accrued.   The condition precedent was outside the control of the

taxpayer claiming the interest deduction.   But in Dunlap, the

purported debtor and creditor had agreed on the amount of the

obligation and the date on which the obligation would become due,

in advance of the commencement of interest.   As we explained in

distinguishing Dunlap in a later case: “the amount of the

indebtedness upon which interest accrued in Dunlap * * * was

fixed as of the date that the interest began to accrue.”     Midkiff

v. Commissioner, 96 T.C. at 739.    In the instant case, the amount

Indeck owed Mr. Polsky for his shares was not fixed until more

than 3 years after the January 31, 1991, date on which Indeck

asserts interest began to accrue.

     In relying on Dunlap and emphasizing that it had an

“unconditional obligation” under the Shareholders’ Agreement to

purchase Mr. Polsky’s shares, Indeck may be suggesting that it is

entitled to an interest deduction under the principles of Dunlap

because its obligation to pay $15,030,000 to Mr. Polsky for the

shares was only subject to contingencies outside its control
                              - 48 -

(e.g., an adjudication determining that the PowerLink offer was

bona fide).   In other words, Indeck may be suggesting that the

Shareholders’ Agreement imposed upon it an obligation to purchase

the shares, at a price prescribed in the agreement, subject only

to the contingency that ascertainment of the price required a

final determination of whether a bona fide offer had been made.

Thus, the argument apparently goes, Indeck’s unconditional

obligation to purchase qualifies as indebtedness for purposes of

section 163(a).

     Such an argument must fail.   While Indeck may have had an

unconditional obligation under the Shareholders’ Agreement to

purchase Mr. Polsky’s shares upon the termination of his

employment, the terms of that obligation were too indefinite as

to amount and timing to constitute indebtedness.   As noted, the

amount and timing of the obligation deemed indebtedness in Dunlap

were fixed; Indeck’s obligation was not fixed in amount and

timing until the parties reached an agreement to settle.   Cf.

Deputy v. duPont, 308 U.S. 488, 497 (1940) (“although an

indebtedness is an obligation, an obligation is not necessarily

an ‘indebtedness’ within the meaning of * * * [the predecessor of

section 163(a)].”).   Moreover, unlike the case in Dunlap, the

amounts paid by Indeck were not paid because contingencies

outside Indeck’s control resolved in a manner that fixed the

obligation.   The purported interest payment here was paid because
                                - 49 -

Indeck and Mr. Polsky reached an agreement over it, a contingency

well within Indeck’s control.    Indeck instead could have opted

not to settle and taken its chances with a decision in the Lake

County Lawsuit.

Judicial Estoppel

     Indeck also argues that the Polskys are precluded under the

doctrine of judicial estoppel from maintaining in this proceeding

that the settlement payment did not contain interest, because Mr.

Polsky took an inconsistent position in the Lake County Lawsuit

when his counsel represented to that court that the settlement

payment included $4,856,922 in interest.

     Judicial estoppel has been applied in this Court to prevent

a party from maintaining a position that is inconsistent with a

prior position advanced and accepted in this or another court.

See, e.g., Huddleston v. Commissioner, 100 T.C. 17, 26-30 (1993).

There are differences among the Courts of Appeals regarding the

contours of judicial estoppel.    Compare Teledyne Indus., Inc. v.

NLRB, 911 F.2d 1214, 1219 (6th Cir. 1990) (settlements do not

give rise to judicial estoppel unless court in prior proceeding

had duty to ensure fairness of settlement) with Kale v.

Obuchowski, 985 F.2d 360, 361-362 (7th Cir. 1993) (settlement

gives rise to judicial estoppel if party prevailed on basis of

prior inconsistent contention).    For purposes of the instant

cases, we shall apply judicial estoppel as that doctrine has been
                                - 50 -

delineated by the Court of Appeals for the Seventh Circuit, where

appeal in these cases would ordinarily lie.   See Golsen v.

Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.

1971).

     As espoused by the Court of Appeals for the Seventh Circuit,

judicial estoppel is applied only where the prior position is

“clearly inconsistent” and the party to be estopped convinced the

court to accept its position in the earlier litigation.    In re

Cassidy, 892 F.2d 637, 641 (7th Cir. 1990).   In the view of the

Court of Appeals for the Seventh Circuit, the requisite

acceptance by the court may occur where there has been either a

judgment or a settlement in the earlier litigation.    Kale v.

Obuchowski, supra at 361-362.    The Court of Appeals for the

Seventh Circuit has summarized the doctrine as follows:

     The doctrine of judicial estoppel requires * * * that
     the party sought to be estopped have obtained a
     favorable judgment or settlement (Kale v. Obuchowski,
     * * *) on the basis of a legal or factual contention
     that he wants to repudiate in the current litigation.
     * * * [McNamara v. City of Chicago, 138 F.3d 1219,
     1225 (7th Cir. 1998).]

Judicial estoppel rests with the court’s discretion and is

“‘applied with caution to avoid impinging on the truthseeking

function of the court’”.   Levinson v. United States, 969 F.2d

260, 265 (7th Cir. 1992) (quoting Teledyne Indus., Inc. v. NLRB,

supra at 1219); see also Fazi v. Commissioner, 105 T.C. 436, 445

(1995).
                                - 51 -

     In the circumstances of this case, we conclude that judicial

estoppel should not be applied.    First, Indeck has not shown a

clear inconsistency between the positions taken by Mr. Polsky in

the Lake County Lawsuit and in the instant proceedings.    In the

motion to enforce settlement in the Lake County Lawsuit, Mr.

Polsky’s counsel took the position that, under State law, Indeck

had a contractual obligation arising out of the settlement to pay

“interest” of $4,856,922.   Whether that amount constituted

interest for Federal income tax purposes, deductible under

section 163(a), was not a necessary implication of Mr. Polsky’s

position in the motion to enforce settlement in the Lake County

Lawsuit.   The item’s treatment for Federal income tax purposes

was simply not at issue in the State court proceedings to accept

or to enforce the settlement.    Cf. Folio v. City of Clarksburg,

134 F.3d 1211 (4th Cir. 1998) (for purposes of judicial estoppel,

party’s position in State court proceedings that assessment was a

fee under State law not inconsistent with claim that it was a tax

under Federal law in later proceedings); UNUM Corp. v. United

States, 886 F. Supp. 150 (D. Me. 1995) (for purposes of judicial

estoppel, party’s position with State regulators that

distribution of stock was exchange not inconsistent with position

for Federal income tax purposes that distribution was dividend).

     Second, Indeck has not shown that the court in the Lake

County Lawsuit accepted a position of Mr. Polsky’s that is
                              - 52 -

inconsistent with his position herein.   To do so, Indeck would

have to show, as enunciated by the Court of Appeals for the

Seventh Circuit, that Mr. Polsky “obtained a favorable * * *

settlement * * * on the basis of a legal or factual contention

that he wants to repudiate” in these proceedings.   McNamara v.

City of Chicago, supra at 1225.

     The Court of Appeals for the Seventh Circuit adopted the

position that judicial estoppel may arise from a mere settlement,

rather than a judicial decision, in Kale v. Obuchowski, supra.

In that case, the party estopped had denied in State court

divorce proceedings that he held any interest in real property

other than the marital home and had obtained a favorable property

settlement on that basis as part of the proceedings.   When the

party subsequently sought to enforce an alleged interest in an

industrial park in bankruptcy proceedings, the Court of Appeals

affirmed the bankruptcy court’s ruling that the party was

judicially estopped from asserting any interest in the industrial

park.

     No comparable advantage was secured by any contention of Mr.

Polsky’s in connection with the settlement of the Lake County

Lawsuit.   In those proceedings, Mr. Polsky did not obtain a

favorable settlement by prevailing in a contention that, for

Federal income tax purposes, he was entitled to treat $15,030,000

of the settlement payment as capital gain proceeds and $4,856,922
                                - 53 -

as ordinary interest income, while Indeck was entitled to deduct

the latter as interest pursuant to section 163(a).    The Federal

income tax treatment of the settlement payment to either party

was not argued by Mr. Polsky.    Nothing in the record suggests

that the Federal income tax treatment was material or even

considered in the court’s decision to approve or enforce the

settlement.   See UNUM Corp. v. United States, supra (judicial

estoppel does not preclude assertion of position on Federal

income tax treatment in subsequent proceeding where such

treatment not material to decision in earlier State proceedings).

Mr. Polsky’s assertion in the Lake County Lawsuit that the agreed

upon settlement payment included “interest” did not secure for

him any advantage in that proceeding.    At most, the Lake County

Circuit Court accepted a formula for arriving at a payment to be

made by Indeck for Mr. Polsky’s shares, without regard to the

Federal income tax implications for either party.

     We conclude that Indeck has not shown a clear inconsistency

in Mr. Polsky’s positions in the Lake County Lawsuit and herein,

or that Mr. Polsky secured a favorable settlement on the basis of

a contention that $4,856,922 of the settlement payment was

interest.   We accordingly reject the application of judicial

estoppel in these cases.21

     21
       Indeck also argues, for the first time in its reply
brief, that the doctrine of equitable estoppel should be applied
                                                   (continued...)
                             - 54 -

Conclusion

     Based on the foregoing, we sustain respondent’s

determination disallowing a $4,856,922 interest deduction claimed

by Indeck on its return for the taxable year ended in 1994 and do

not sustain respondent’s determination recharacterizing, as

interest income, $4,856,922 of $19,866,922 reported by the

Polskys on their 1994 return as long-term capital gain.

Section 6662 Accuracy-Related Penalty

     Respondent determined section 6662(a) accuracy-related

penalties against all petitioners for their taxable years ended


     21
      (...continued)
to preclude the Polskys from maintaining that the entire
settlement payment consisted of purchase price for Mr. Polsky’s
shares. We do not consider this issue, as it has not been
properly raised in these cases. Issues raised for the first time
in posttrial briefs are not considered where there is surprise
and prejudice to the opposing party. Seligman v. Commissioner,
84 T.C. 191, 198-199 (1985), affd. 796 F.2d 116 (5th Cir. 1986).
Where as here the issue is raised for the first time in a reply
brief, the prejudice is manifest; neither the Polskys nor
respondent had any opportunity to respond to Indeck’s attempt to
raise equitable estoppel.

     Even if this issue had been properly raised, we would reject
Indeck’s argument. Indeck claims equitable estoppel should apply
here because Mr. Polsky’s attorneys represented to Indeck’s
attorneys that the changes sought by Mr. Polsky in the language
of the Settlement Agreement, whereby the three components of the
settlement payment were re-labeled “purchase price”, were “non-
substantive”. Suffice it to say that if Mr. Polsky’s attorneys
in fact characterized the language changes as alleged, their
statements concerned matters of opinion or law, not fact. Cf.
Union Tex. Intl. Corp. v. Commissioner, 110 T.C. 321, 327 (1998)
(party seeking equitable estoppel must show, inter alia, that it
relied on a misrepresentation of fact, as opposed to an opinion
or statement of law).
                                - 55 -

in 1994.    On brief, respondent now concedes the penalty with

respect to the Polskys but argues that Indeck is liable for an

accuracy-related penalty due to an underpayment attributable to a

substantial understatement of tax or to negligence or disregard

of rules or regulations.

       Section 6662 imposes a penalty equal to 20 percent of the

portion of an underpayment of tax that is attributable to

negligence or disregard of rules or regulations, or a substantial

understatement of income tax.    See sec. 6662(a) and (b)(1) and

(2).

       In the case of a corporation, a substantial understatement

of income tax exists if the amount of the understatement exceeds

the greater of 10 percent of the tax required to be shown on the

return, or $10,000.    Sec. 6662(d)(1).   An “understatement” is

defined as the excess of tax required to be shown on the return

over the amount of tax imposed which is shown on the return, less

any rebate.    Sec. 6662(d)(2)(A).   The amount of the

understatement is reduced, however, to the extent it is

attributable to the tax treatment of any item for which there is

or was substantial authority for the treatment, and an authority

for this purpose includes a court case.     Sec. 1.6662-

4(d)(3)(iii), Income Tax Regs.

       Indeck marshaled a number of cases to support its treatment

of the disputed portion of the settlement payment.       While we have
                               - 56 -

concluded that those cases are distinguishable, we are satisfied

that they constitute substantial authority for Indeck’s

treatment.    Accordingly, to the extent Indeck’s understatement of

tax is attributable to its deduction of $4,856,922 of the

settlement payment, it is reduced pursuant to section

6662(d)(2)(B)(i).   See sec. 1.6662-4(d)(3)(ii), Income Tax Regs.

     Respondent asserts in the alternative that Indeck is liable

for a section 6662(a) penalty because the underpayment arising

from Indeck’s disallowed interest deduction is attributable to

negligence or disregard of rules or regulations.   See sec.

6662(b)(1).   In this context, “negligence” includes a failure to

make a reasonable attempt to comply with the provisions of the

internal revenue laws or to exercise ordinary and reasonable care

in the preparation of a tax return, and “disregard” is

characterized as any careless, reckless, or intentional

disregard.    Sec. 6662(c); sec. 1.6662-3(b)(1) and (2), Income Tax

Regs.   A position with respect to an item is attributable to

negligence if it lacks a reasonable basis.   Sec. 1.6662-3(b)(1),

Income Tax Regs.    Respondent’s regulations applicable to Indeck’s

return for the taxable year ended in 1994 do not provide a

definition of reasonable basis, but provide that it is a standard

that is significantly higher than the “not frivolous” standard

applicable under section 6694 and defined in section 1.6694-
                               - 57 -

2(c)(2), Income Tax Regs.22   Sec. 1.6662-7T(d)(2), Temporary

Income Tax Regs., 59 Fed. Reg. 12549 (Mar. 17, 1994).    Because

Indeck had substantial authority for its treatment of $4,856,922

as deductible interest, we are satisfied that it also had a

reasonable basis under the applicable regulations and therefore

was not negligent, nor did it carelessly, recklessly, or

intentionally disregard any rule or regulation.    Accordingly, we

do not sustain respondent’s determination of the accuracy-related

penalty based on negligence or disregard of rules of regulations.

     To reflect the foregoing,

                                      Decision will be entered under

                                 Rule 155 in docket No. 21586-97.

                                      Decision will be entered for

                                 petitioners in docket No. 23943-97.




     22
       For Indeck’s taxable year ended in 1994, a definition of
“reasonable basis” was reserved in sec. 1.6662-3(b)(3), Income
Tax Regs. The definition was provided by subsequent amendment to
sec. 1.6662-3(b)(3), Income Tax Regs., applicable to returns
filed on or after Dec. 2, 1998. Sec. 1.6662-2(d)(4), Income Tax
Regs.
