                                               CANAL CORPORATION AND SUBSIDIARIES, FORMERLY
                                                 CHESAPEAKE CORPORATION AND SUBSIDIARIES,
                                                  PETITIONER v. COMMISSIONER OF INTERNAL
                                                           REVENUE, RESPONDENT
                                                        Docket No. 14090–06.                     Filed August 5, 2010.

                                                 W, a wholly owned subsidiary of parent, P, proposed to
                                               transfer its assets and most of its liabilities to a newly formed
                                               LLC in which W and GP, an unrelated corporation, would
                                               have ownership interests. P hired S, an investment bank, and
                                               PWC, an accounting firm, to advise it on structuring the
                                               transaction with GP. P also asked PWC to issue an opinion
                                               on the tax consequences of the transaction and conditioned
                                               the closing on receiving a ‘‘should’’ opinion from PWC that the
                                               transaction qualified as tax free. PWC issued an opinion that
                                               the transaction should not be treated as a taxable sale but
                                               rather as a tax-free contribution of property to a partnership.
                                               W contributed approximately two-thirds of the LLC’s total
                                               assets in 1999 in exchange for a 5-percent interest in the LLC
                                               and a special distribution of cash. W used a portion of the
                                               cash to make a loan to P in return for a note from P. W’s only
                                               assets after the transaction were its LLC interest, the note
                                               from P and a corporate jet. The LLC obtained the funds for
                                               the cash distribution by receiving a bank loan. GP guaranteed
                                               the LLC’s obligation to repay the loan. W agreed to indemnify
                                               GP if GP were called on to pay the principal of the bank loan
                                               pursuant to its guaranty. The LLC thereafter borrowed funds
                                               from a financial subsidiary of GP to retire the bank loan. GP
                                               entered into a separate transaction in 2001 that required it to
                                               divest its entire interest in the LLC for antitrust purposes. W
                                               subsequently sold its LLC interest to GP, and GP then sold
                                               the entire interest in the LLC to an unrelated party. P
                                               reported gain from the sale on its consolidated Federal income
                                               tax return for 2001. R determined that P should have
                                               reported a gain when W contributed its assets to the LLC in
                                               1999. R has also asserted a substantial understatement pen-
                                               alty under sec. 6662(a), I.R.C., against P in his amended
                                               answer.

                                                                                                                                     199




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                                      200                  135 UNITED STATES TAX COURT REPORTS                                        (199)


                                                     1. Held: W’s asset transfer to the LLC was a disguised sale
                                                   under sec. 707(a)(2)(B), I.R.C. P must include gain from the
                                                   sale on its consolidated Federal income tax return for 1999.
                                                     2. Held, further, P is liable for an accuracy-related penalty
                                                   for a substantial understatement of income tax under sec.
                                                   6662(a), I.R.C.

                                        Clifton B. Cates III, Robert H. Wellen, and David D. Sher-
                                      wood, for petitioner.
                                        Curt M. Rubin, Matthew I. Root, and Steven N. Balahtsis,
                                      for respondent.
                                         KROUPA, Judge: Respondent determined a $183,458,981 1
                                      deficiency in petitioner’s (Chesapeake) 2 Federal income tax
                                      for 1999, the year at issue. Respondent asserts in his
                                      amended answer that Chesapeake owes a $36,691,796
                                      substantial understatement of income tax penalty under sec-
                                      tion 6662(a) 3 for 1999. We must determine whether Chesa-
                                      peake’s subsidiary’s contribution of its assets and most of its
                                      liabilities to a newly formed limited liability company and
                                      the simultaneous receipt of a $755 million distribution
                                      should be characterized as a disguised sale, requiring Chesa-
                                      peake to recognize a $524 million gain in 1999, the year of
                                      contribution and distribution. We hold that the transaction
                                      was a disguised sale, requiring Chesapeake to recognize the
                                      gain. We must also determine whether Chesapeake is liable
                                      for the substantial understatement penalty under section
                                      6662(a). We hold Chesapeake is liable for the penalty.

                                                                            FINDINGS OF FACT

                                        Some of the facts have been stipulated and are so found.
                                      We incorporate the stipulation of facts and the accompanying
                                      exhibits by this reference. Chesapeake’s principal place of
                                      business at the time it filed the petition was Richmond, Vir-
                                      ginia.
                                      Background of Chesapeake and WISCO
                                        Chesapeake is a Virginia corporation organized as a cor-
                                      rugated paper company in 1918. Chesapeake’s business has
                                           1 All
                                              monetary amounts are rounded to the nearest dollar.
                                           2 ChesapeakeCorporation changed its name to Canal Corporation in June 2009. We refer to
                                      the corporation as Chesapeake in this Opinion.
                                        3 All section references are to the Internal Revenue Code (Code), and all Rule references are

                                      to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.




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                                      (199)               CANAL CORP. & SUBS. v. COMMISSIONER                                       201


                                      expanded over time into several paper industry segments,
                                      including merchandising and specialty packaging, tissue, and
                                      forest and land development. Chesapeake eventually became
                                      a publicly traded company and served as the common parent
                                      of a group of subsidiary corporations filing consolidated Fed-
                                      eral income tax returns. Each subsidiary managed its own
                                      assets and liabilities. Chesapeake received dividends from
                                      the subsidiaries and made loans to the subsidiaries as
                                      needed.
                                         Chesapeake’s largest subsidiary was Wisconsin Tissue
                                      Mills, Inc. (WISCO). Chesapeake purchased WISCO’s stock from
                                      Philip Morris in 1985 in a leveraged buyout transaction.
                                      WISCO manufactured commercial tissue paper products,
                                      including napkins, table covers, towels, place mats, wipes,
                                      and facial and bathroom tissue. WISCO sold its products to
                                      commercial and industrial businesses such as restaurants,
                                      hotels, schools, offices, hospitals, and airlines. WISCO
                                      accounted for 46 percent of Chesapeake’s sales and 94 per-
                                      cent of Chesapeake’s earnings before interest and tax for
                                      1998. Chesapeake and WISCO shared most of the same execu-
                                      tive officers.
                                         WISCO incurred significant environmental liabilities during
                                      the 1950s and 1960s. The Environmental Protection Agency
                                      (EPA) determined that a mill WISCO operated contaminated
                                      the Fox River in Wisconsin with polychlorinated biphenyls
                                      (PCBs). The EPA designated the Fox River area as a Super-
                                      fund site and held five companies, including WISCO, involved
                                      in the contamination jointly and severally liable for the
                                      cleanup costs (Fox River liability). Philip Morris indemnified
                                      Chesapeake for any Fox River liability costs up to the pur-
                                      chase price of WISCO. Approximately $120 million of the
                                      Phillip Morris indemnity remains. Chesapeake also pur-
                                      chased $100 million of environmental remediation insurance
                                      to pay costs beyond those covered by the indemnity. Chesa-
                                      peake’s management estimated that WISCO’s remaining Fox
                                      River liability costs varied between $60 million and $70 mil-
                                      lion in 1999. In addition to the Fox River liability, WISCO and
                                      other Chesapeake subsidiaries also guaranteed a $450 mil-
                                      lion credit facility enabling Chesapeake to acquire another
                                      company in 2000.




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                                      202                135 UNITED STATES TAX COURT REPORTS                                        (199)


                                      Tissue Business
                                         Tissue is a capital intensive commodities business, and
                                      only the largest companies have the ability to make the
                                      investment needed to compete in the industry. In the late
                                      1990s, the tissue business experienced much consolidation.
                                      Fort Howard Corporation merged with James River Corpora-
                                      tion to form Fort James Corporation. Kimberly-Clark Cor-
                                      poration purchased Scott Paper Company. These consolida-
                                      tions put smaller tissue businesses at a strategic disadvan-
                                      tage.
                                         Chesapeake, through WISCO and Chesapeake’s Mexican
                                      subsidiary, Wisconsin Tissue de Mexico, S.A. de C.V.
                                      (WISMEX), was a second tier player in the tissue industry.
                                      Chesapeake sold its retail tissue business to the Fonda
                                      Group, Inc. in 1995. WISCO and WISMEX serviced only
                                      commercial accounts and lacked the large timber bases
                                      needed to support a retail business. Chesapeake had only
                                      two paper mills, one in Wisconsin and one in Arizona, and
                                      thus was at a significant logistical disadvantage in servicing
                                      the Southeast and Northeast.
                                      Restructuring of Chesapeake
                                         Chesapeake hired Tom Johnson as its chief executive
                                      officer and chairman in 1997. Mr. Johnson sought to restruc-
                                      ture Chesapeake. He wanted to move Chesapeake away from
                                      its historic commodity products business and focus on spe-
                                      cialty packaging and merchandising services. Chesapeake’s
                                      speciality packaging business involved producing high-value
                                      custom packaging for such goods as perfume, liquor and
                                      pharmaceuticals. To that end, Chesapeake sold certain
                                      assets, including a mill, corrugated box plants, a building
                                      products business and substantial land. Chesapeake acquired
                                      other businesses and assets to further its specialty packaging
                                      business.
                                         Commercial tissue did not fit the new specialty packaging
                                      strategy. Chesapeake examined several options for the future
                                      direction of WISCO’s tissue business. Chesapeake considered
                                      maintaining the status quo. Management concluded, how-
                                      ever, that WISCO would be too small to compete. Management
                                      further determined that internal expansion would be too dif-
                                      ficult and costly. Management also considered selling Chesa-




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                                      (199)               CANAL CORP. & SUBS. v. COMMISSIONER                                       203


                                      peake and all its subsidiaries. Management surmised that no
                                      one would buy all the diverse subsidiary businesses for an
                                      acceptable price.
                                         Pete Correll, chief executive officer of Georgia Pacific (GP),
                                      made overtures to Mr. Johnson regarding GP purchasing
                                      WISCO. GP’s primary business was the manufacture and dis-
                                      tribution of building products, timber, and paper products.
                                      GP also had a small profitable tissue business that accounted
                                      for 5 to 6 percent of its total sales. GP wanted to expand its
                                      tissue business but questioned whether GP’s business could
                                      grow internally. GP viewed the purchase of WISCO as a stra-
                                      tegic piece in advancing its tissue business.
                                         Chesapeake considered selling WISCO to generate capital
                                      for Chesapeake’s new specialty packaging business. Given
                                      Chesapeake’s low tax basis in WISCO, however, the after-tax
                                      proceeds would have been low compared to the pre-tax pro-
                                      ceeds. This tax differential caused Chesapeake to decide a
                                      direct sale of WISCO would not be advantageous.
                                         Chesapeake thereafter engaged Salomon Smith Barney
                                      (Salomon) and PricewaterhouseCoopers (PWC) to explore stra-
                                      tegic alternatives for the tissue business. Salomon rec-
                                      ommended to Chesapeake’s management that the best alter-
                                      native for maximizing shareholder value would be a
                                      leveraged partnership structure with GP. 4 The leveraged
                                      partnership structure required WISCO to first transfer its
                                      tissue business assets to a joint venture. GP would then
                                      transfer its tissue business assets to the joint venture. Next,
                                      the joint venture would borrow funds from a third party and
                                      distribute the proceeds to Chesapeake (special distribution).
                                      Chesapeake would guarantee the third-party debt through a
                                      subsidiary. WISCO would hold a minority interest in the joint
                                      venture after the distribution, and GP would hold a majority
                                      interest. Salomon presented the leveraged partnership struc-
                                      ture as tax advantageous to Chesapeake because it would
                                      allow Chesapeake to get cash out of the business yet still
                                      protect Chesapeake from recognizing a gain when the part-
                                      nership distributed to Chesapeake the proceeds from the
                                      third-party loan.
                                       4 Salomon referred to the leveraged partnership deal as ‘‘Project Odyssey’’ after Homer’s ‘‘The

                                      Odyssey’’ and identified Chesapeake as ‘‘Calypso’’ and GP as ‘‘Zeus.’’




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                                      204                 135 UNITED STATES TAX COURT REPORTS                                        (199)


                                         Chesapeake’s board liked the leveraged partnership idea
                                      and thought GP seemed like a good fit as a partner. Chesa-
                                      peake made clear to PWC and Salomon that the asset transfer
                                      and special distribution had to be nontaxable for it to
                                      approve the transaction. Tax deferral enabled Chesapeake to
                                      accept a lower price.
                                         GP’s executives accepted the leveraged partnership struc-
                                      ture to expand its tissue business. GP did not have any
                                      interest in Chesapeake receiving a tax deferral. GP recog-
                                      nized, however, that it was a necessary part of bridging the
                                      purchase price gap. Chesapeake agreed to a lower up-front
                                      valuation of WISCO, 5 $775 million, because of the tax deferral
                                      benefit.
                                         PWC assisted Salomon in negotiating and structuring the
                                      joint venture. PWC examined the transaction from both an
                                      accounting and a tax perspective. PWC had served as Chesa-
                                      peake’s auditor and tax preparer for many years. Donald
                                      Compton (Mr. Compton), a partner in PWC’s Richmond office,
                                      managed the Chesapeake account and had given Chesapeake
                                      advice on different tax matters in the past. David Miller (Mr.
                                      Miller) 6 worked with Mr. Compton on the Chesapeake and
                                      GP joint venture. PWC advised that Chesapeake did not need
                                      to guarantee the debt but needed only to provide an indem-
                                      nity to the guarantor to defer tax. PWC also determined that
                                      the transaction should be treated as a sale for accounting
                                      purposes. Mr. Miller helped structure the indemnity agree-
                                      ment and aided in writing the partnership agreement.
                                      Indemnity Agreement
                                         GP agreed to guarantee the joint venture’s debt and did
                                      not require Chesapeake to execute an indemnity. Mr. Miller
                                      advised Chesapeake, however, that an indemnity was
                                      required to defer tax on the transaction. Chesapeake’s execu-
                                      tives wanted to make the indemnity an obligation of WISCO
                                      rather than Chesapeake to limit the economic risk to WISCO’s
                                      assets, not the assets of Chesapeake. The parties to the
                                      transaction agreed that GP would guarantee the joint ven-
                                           5 Salomon
                                                   had valued WISCO between $800 and $900 million in 1998.
                                           6 Mr.
                                              Miller is a licensed attorney. He practiced law with the law firm Jenkens & Gilchrist
                                      before joining Coopers & Lybrand’s, now PWC’s, Washington National Tax practice in 1996. He
                                      was not a practicing attorney at the time he gave the legal opinion here.




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                                      ture’s debt and that WISCO would serve as the indemnitor of
                                      GP’s guaranty.
                                        WISCO attempted to limit the circumstances in which it
                                      would be called upon to pay the indemnity. First, the indem-
                                      nity obligation covered only the principal of the joint ven-
                                      ture’s debt, due in 30 years, not interest. Next, Chesapeake
                                      and GP agreed that GP had to first proceed against the joint
                                      venture’s assets before demanding indemnification from
                                      WISCO. The agreement also provided that WISCO would
                                      receive a proportionately increased interest in the joint ven-
                                      ture if WISCO had to make a payment under the indemnity
                                      obligation.
                                        No provision of the indemnity obligation mandated that
                                      WISCO maintain a certain net worth. Mr. Miller determined
                                      that WISCO had to maintain a net worth of $151 million to
                                      avoid taxation on the transaction. GP was aware that
                                      WISCO’s assets other than its interest in the joint venture
                                      were limited. GP nonetheless accepted the deal and never
                                      invoked the indemnity obligation.
                                      Joint Venture Agreement
                                        Chesapeake, WISCO, and GP executed the joint venture
                                      agreement. The two members (partners) 7 of the joint venture
                                      were WISCO and GP. The agreement provided that GP would
                                      reimburse WISCO for any tax cost WISCO might incur if GP
                                      were to buy out WISCO’s interest in the joint venture.
                                      PWC Tax Opinion
                                         Chesapeake hired PWC to issue an opinion on the trans-
                                      action’s Federal tax implications. In fact, Chesapeake condi-
                                      tioned the transaction’s closing upon PWC’s issuing a ‘‘should’’
                                      tax opinion. Instead of Mr. Compton, the PWC partner with
                                      the long-term relationship to Chesapeake, PWC assigned Mr.
                                      Miller to write the opinion. In effect, Mr. Miller’s job was to
                                      review the transaction he helped structure. Mr. Miller
                                      considered three issues: (1) whether the joint venture quali-
                                      fied as a partnership for tax purposes, (2) whether WISCO was
                                      a partner in the joint venture, and (3) whether the distribu-
                                        7 We use the terms ‘‘partners,’’ ‘‘partnership,’’ and ‘‘LLC’’ for narrative convenience only as

                                      these are the terms used by the parties to the transaction. No inference should be drawn from
                                      our use of such terms regarding any legal status or relationship.




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                                      206                135 UNITED STATES TAX COURT REPORTS                                        (199)


                                      tion to Chesapeake should be treated as part of a sale or
                                      qualifies under the debt-financed distribution exception.
                                         Chesapeake agreed to pay PWC an $800,000 fixed fee for
                                      issuing the opinion. The payment did not depend on time
                                      spent or expenses incurred by PWC. A letter PWC sent to
                                      Chesapeake stated that PWC would bill Chesapeake ‘‘at the
                                      closing of the joint venture financing.’’ Chesapeake’s board
                                      informed Mr. Miller that as a condition to closing the trans-
                                      action PWC would need to issue the opinion that the special
                                      distribution should not be currently taxable. A ‘‘should’’
                                      opinion is the highest level of comfort PWC offers to a client
                                      regarding whether the position taken by a taxpayer will suc-
                                      ceed on the merits.
                                         Mr. Miller and his PWC team reviewed the transaction’s
                                      structure and approved each item that could affect the tax
                                      consequences. Mr. Miller crafted an ‘‘all or nothing’’ test for
                                      allocating the joint venture debt. Either all the liability
                                      would be allocated to WISCO or none of it would. Mr. Miller
                                      reasoned that the transaction would not be characterized as
                                      a sale provided the entire liability was allocated to WISCO.
                                      Mr. Miller found no legal authority for such a test. He cre-
                                      ated the test using his own analysis of then existing rulings
                                      and procedures.
                                         Mr. Miller based his opinion on WISCO’s indemnification of
                                      GP’s guaranty being respected. Mr. Miller assumed that
                                      WISCO had the ultimate legal liability for the full amount of
                                      the debt if the joint venture became wholly worthless. Mr.
                                      Miller concluded that WISCO could defer gain until it sold its
                                      remaining assets, paid off the debt, or sold its partnership
                                      interest. Mr. Miller advised that WISCO maintain assets of at
                                      least 20 percent of its maximum exposure under the indem-
                                      nity. Mr. Miller did not have direct authority requiring this
                                      percentage. He merely made this determination based on
                                      Rev. Proc. 89–12, 1989–1 C.B. 798, which was declared obso-
                                      lete by Rev. Rul. 2003–99, 2003–2 C.B. 388. 8 Moreover, Rev.
                                      Proc. 89–12, supra, makes no reference to allocation of part-
                                      nership liabilities.
                                        8 Rev. Proc. 89–12, sec. 4.07, 1989–1 C.B. 798, 801, states that the Internal Revenue Service

                                      will generally rule that an organization lacks limited liability if the net worth of the corporate
                                      general partners equals at least 10 percent of the total contributions to the limited partnership
                                      and is expected to continue to equal at least 10 percent throughout the life of the partnership.




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                                         Chesapeake also sought to transfer the assets of WISMEX to
                                      the joint venture. PWC informed Chesapeake that neither the
                                      United States nor Mexico could tax (1) the transfer of
                                      WISMEX’s assets to WISCO or (2) the asset transfer from WISCO
                                      to the joint venture. Chesapeake caused WISMEX to transfer
                                      its assets to WISCO as advised by PWC.
                                         Mr. Miller wrote and signed the ‘‘should’’ opinion before
                                      issuing it to Chesapeake. The parties effected the transaction
                                      on the same day PWC issued the ‘‘should’’ opinion.
                                      The Transaction
                                         GP and WISCO formed Georgia-Pacific Tissue LLC (LLC) as
                                      the vehicle for the joint venture. GP and WISCO treated the
                                      LLC as a partnership for tax purposes. Both partners contrib-
                                      uted the assets of their respective tissue businesses to the
                                      LLC. GP transferred to the LLC its tissue business assets with
                                      an agreed value of $376.4 million in exchange for a 95-per-
                                      cent interest in the LLC. WISCO contributed to the LLC all of
                                      the assets of its tissue business with an agreed value of $775
                                      million in exchange for a 5-percent interest in the LLC. The
                                      LLC borrowed $755.2 million from Bank of America (BOA) on
                                      the same day it received the contributions from GP and
                                      WISCO. The LLC immediately transferred the loan proceeds to
                                      Chesapeake’s bank account 9 as a special cash distribution. 10
                                      GP guaranteed payment of the BOA loan, and WISCO agreed
                                      to indemnify GP for any principal payments GP might have
                                      to make under its guaranty.
                                         The LLC had approximately $400 million in net worth
                                      based on the parties’ combined initial contribution of assets
                                      ($1.151 billion) less the BOA loan ($755.2 million), and it had
                                      a debt to equity ratio of around 2 to 1. The LLC assumed
                                      most of WISCO’s liabilities but did not assume WISCO’s Fox
                                      River liability. Chesapeake and WISCO both indemnified GP
                                      and held it harmless for any costs and claims that it might
                                      incur with respect to any retained liabilities of WISCO,
                                      including the Fox River liability.
                                         WISCO used a portion of the funds from the special distribu-
                                      tion to repay an intercompany loan to Cary Street, Chesa-
                                      peake’s finance subsidiary. WISCO also used portions of the
                                           9 Chesapeakemaintained the bank accounts for its subsidiaries.
                                           10 The
                                               value of WISCO’s assets contributed ($775 million) less the distribution ($755.2 million)
                                      equals the initial value of WISCO’s 5-percent LLC interest ($19.8 million).




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                                      funds to pay a dividend to Chesapeake, repay amounts owed
                                      to Chesapeake and lend $151.05 million to Chesapeake in
                                      exchange for a note (intercompany note). The intercompany
                                      note was a 5-year note with an 8-percent interest rate.
                                      Chesapeake used the loan proceeds to repay debt, repurchase
                                      stock and purchase additional specialty packaging assets.
                                         WISCO’s assets following the transaction included the inter-
                                      company note with a face value of $151 million and a cor-
                                      porate jet worth approximately $6 million. WISCO had a net
                                      worth, excluding its LLC interest, of approximately $157 mil-
                                      lion. This represented 21 percent of its maximum exposure
                                      on the indemnity. WISCO remained subject to the Fox River
                                      liability.
                                      Refinancing the Debt
                                         The LLC refinanced the BOA loan in two parts soon after
                                      the transaction closed. First, the LLC borrowed approximately
                                      $491 million from a GP subsidiary, Georgia-Pacific Finance
                                      LLC (GP Finance) to partially retire the BOA loan. This trans-
                                      action occurred about a month after the closing date. Then
                                      the LLC borrowed $263 million from GP Finance the following
                                      year to repay the balance on the BOA loan.
                                         The GP Finance loans had terms similar to those of the
                                      BOA loans. GP executed a substantially identical guaranty in
                                      favor of the new lender, and WISCO executed a substantially
                                      identical indemnity obligation. PWC issued another opinion
                                      finding that the refinancing was tax free as well.
                                      Characterization of the Transaction for Tax and Non-Tax
                                      Purposes
                                         Chesapeake timely filed a consolidated Federal tax return
                                      for 1999. Chesapeake disclosed the transaction on Schedule
                                      M of the return and reported $377,092,299 book gain but no
                                      corresponding tax gain. Chesapeake treated the special dis-
                                      tribution as non-taxable on the theory that it was a debt-
                                      financed transfer of consideration, not the proceeds of a sale.
                                         Unlike its treatment for tax purposes, Chesapeake treated
                                      the transaction as a sale for financial accounting purposes.
                                      Chesapeake did not treat the indemnity obligation as a
                                      liability for accounting purposes because Chesapeake deter-
                                      mined that there was no more than a remote chance the




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                                      indemnity would be triggered. Despite Chesapeake’s
                                      characterization for tax purposes, PWC and Salomon each
                                      referred to the transaction as a sale.
                                        Standard & Poor’s, Moody’s and stock analysts also treated
                                      the transaction as a sale. Chesapeake executives represented
                                      to Standard & Poor’s and Moody’s that the only risk associ-
                                      ated with the transaction came not from WISCO’s agreement
                                      to indemnify GP but from the tax risk. Moody’s downgraded
                                      Chesapeake after the announced joint venture because of
                                      Chesapeake’s readjusted focus, the monetization of WISCO,
                                      and the resulting loss of operating income. Standard & Poor’s
                                      kept its rating of Chesapeake the same because Chesapeake
                                      generated significant cash by divesting itself of WISCO for
                                      $755 million and of its timberlands for $186 million.
                                      End of the Joint Venture
                                         The joint venture operated for only a full year. It ended in
                                      2001 when GP sought to acquire the Fort James Corporation.
                                      The Department of Justice required GP to sell its LLC
                                      interest for antitrust purposes. GP contacted Svenska
                                      Cellulosa Aktiebolaget (SCA), a Swedish company, about pur-
                                      chasing its LLC interest. SCA informed GP that it was
                                      interested in purchasing only the entire LLC, not just
                                      GP’s interest in the LLC. Therefore, GP needed to buy
                                      WISCO’s interest in the joint venture. WISCO agreed to sell its
                                      minority interest in the LLC to GP for $41 million, which rep-
                                      resented a gain of $21.2 million from its initial valuation of
                                      $19.8 million. GP also paid Chesapeake $196 million to com-
                                      pensate Chesapeake for any loss of tax deferral. WISCO
                                      declared a $166,080,510 dividend to Chesapeake payable by
                                      cancelling Chesapeake’s promissory note in 2001.
                                         Chesapeake reported a $524 million capital gain on its
                                      consolidated Federal tax return for 2001. Chesapeake deter-
                                      mined that the termination of the indemnity resulted in
                                      WISCO receiving a deemed distribution under section 752.
                                      Chesapeake also reported the $196 million tax cost payment
                                      it received from GP as ordinary income on its consolidated
                                      Federal tax return for 2001.
                                         Respondent issued Chesapeake the deficiency notice for
                                      1999. In the deficiency notice, respondent determined the
                                      joint venture transaction to be a disguised sale that produced




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                                      $524 million of capital gain includable in Chesapeake’s
                                      consolidated income for 1999. Chesapeake timely filed a peti-
                                      tion. Respondent asserted in an amended answer a
                                      $36,691,796 accuracy-related penalty under section 6662 for
                                      substantial understatement of income tax.

                                                                                  OPINION

                                         We are asked to decide whether the joint venture trans-
                                      action constituted a taxable sale. Respondent argues that
                                      Chesapeake structured the transaction to defer $524 million
                                      of capital gain for a period of 30 years or more. Specifically,
                                      respondent contends that WISCO did not bear any economic
                                      risk of loss when it entered the joint venture agreement
                                      because the anti-abuse rule disregards WISCO’s obligation to
                                      indemnify GP. See sec. 1.752–2(j), Income Tax Regs.
                                      Respondent concludes that the transaction should be treated
                                      as a taxable disguised sale.
                                         Chesapeake asserts that the transaction should not be
                                      recast as a sale. Instead, Chesapeake argues that the anti-
                                      abuse rule does not disregard WISCO’s indemnity and that the
                                      LLC’s distribution of cash to WISCO comes within the excep-
                                      tion for debt-financed transfers. We disagree and begin with
                                      the general rules on disguised sales.
                                      I. Disguised Sale Transactions
                                         The Code provides generally that partners may contribute
                                      capital to a partnership tax free and may receive a tax free
                                      return of previously taxed profits through distributions. See
                                      secs. 721, 731. 11 These nonrecognition rules do not apply,
                                      however, where the transaction is found to be a disguised
                                      sale of property. See sec. 707(a)(2)(B). 12
                                         A disguised sale may occur when a partner contributes
                                      property to a partnership and soon thereafter receives a dis-
                                      tribution of money or other consideration from the partner-
                                        11 Sec. 731 concerns distributions to a partner acting in his capacity as a partner. Neither

                                      party asserts that sec. 731 applies in this case. Moreover, sec. 731 does not apply if a partner
                                      contributes property to a partnership and the partnership distributes property to the partner
                                      within a short period to effect an exchange of property between two or more partners or between
                                      the partnership and a partner. Sec. 1.731–1(c)(3), Income Tax Regs. We will not therefore con-
                                      sider the effect of sec. 731 on the transaction. See sec. 1.707–1(a), Income Tax Regs.
                                        12 Transfers described in sec. 707(a)(2)(B) are treated as occurring between a partnership and

                                      a non-partner or partner acting outside his capacity as a member of the partnership. Sec.
                                      707(a)(1), (2)(B).




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                                      ship. Id. A transaction may be deemed a sale if, based on all
                                      the facts and circumstances, the partnership’s distribution of
                                      money or other consideration to the partner would not have
                                      been made but for the partner’s transfer of the property. Sec.
                                      1.707–3(b)(1), Income Tax Regs. (emphasis added). Such con-
                                      tribution and distribution transactions that occur within two
                                      years of one another are presumed to effect a sale unless the
                                      facts and circumstances clearly establish otherwise (the 2-
                                      year presumption). Sec. 1.707–3(c)(1), Income Tax Regs.
                                         Here, WISCO transferred its assets with an agreed value of
                                      $775 million to the LLC and simultaneously received a cash
                                      distribution of $755.2 million. After the transfer and distribu-
                                      tion, WISCO had a 5-percent interest in the LLC. Its assets
                                      included only its interest in the LLC, the intercompany note
                                      and the jet. We therefore view the transactions together and
                                      presume a sale under the disguised sale rules unless the
                                      facts and circumstances dictate otherwise.
                                         Chesapeake contends that the special distribution was not
                                      part of a disguised sale. Instead, it was a debt-financed
                                      transfer of consideration, an exception to the disguised sale
                                      rules. See sec. 1.707–5(b), Income Tax Regs. Chesapeake
                                      argues that the debt-financed transfer of consideration excep-
                                      tion to the disguised sale rules limits the applicability of the
                                      disguised sale rules and the 2-year presumption in this case.
                                           A. Debt-Financed Transfer of Consideration
                                         We now turn to the debt-financed transfer of consideration
                                      exception to the disguised sale rules. The regulations except
                                      certain debt-financed distributions in determining whether a
                                      partner received ‘‘money or other consideration’’ for disguised
                                      sale purposes. 13 See id. A distribution financed from the pro-
                                      ceeds of a partnership liability may be taken into account for
                                      disguised sale purposes to the extent the distribution exceeds
                                      the distributee partner’s allocable share of the partnership
                                      liability. See sec. 1.707–5(b)(1), Income Tax Regs. Respondent
                                      argues that the entire distribution from the LLC to WISCO
                                      should be taken into account for purposes of determining a
                                      disguised sale because WISCO did not bear any of the allo-
                                      cable share of the LLC’s liability to finance the distribution.
                                        13 A distribution qualifies as a debt-financed transfer if it meets certain requirements. See sec.

                                      1.707–5(b)(1), Income Tax Regs. We consider only the requirements at issue.




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                                      We turn now to whether WISCO had any allocable share of
                                      the LLC’s liability to determine whether the transaction fits
                                      within the exception.
                                           B. Partner’s Allocable Share of Liability 14
                                         In general a partner’s share of a recourse partnership
                                      liability equals the portion of that liability, if any, for which
                                      the partner bears the economic risk of loss. See sec. 1.752–
                                      1(a)(1), Income Tax Regs. A partner bears the economic risk
                                      of loss to the extent that the partner would be obligated to
                                      make an unreimbursable payment to any person (or con-
                                      tribute to the partnership) if the partnership were construc-
                                      tively liquidated and the liability became due and payable.
                                      Sec. 1.752–2(b)(1), Income Tax Regs.; see IPO II v. Commis-
                                      sioner, 122 T.C. 295, 300–301 (2004). Chesapeake contends
                                      that WISCO’s indemnity of GP’s guaranty imposes on WISCO
                                      the economic risk of loss for the LLC debt. Respondent con-
                                      cedes that an indemnity agreement generally is recognized as
                                      an obligation under the regulations. Respondent asserts,
                                      however, that WISCO’s agreement should be disregarded
                                      under the anti-abuse rule for allocation of partnership debt.
                                           C. Anti-Abuse Rule
                                        Chesapeake counters that WISCO was legally obligated to
                                      indemnify GP under the indemnity agreement and therefore
                                      WISCO should be allocated the entire economic risk of loss of
                                      the LLC’s liability. We assume that all partners having an
                                      obligation to make payments on a recourse debt actually per-
                                      form those obligations, irrespective of net worth, to ascertain
                                      the economic risk of loss unless the facts and circumstances
                                      indicate a plan to circumvent or avoid the obligation. Sec.
                                      1.752–2(b)(6), Income Tax Regs. The anti-abuse rule provides
                                      that a partner’s obligation to make a payment may be dis-
                                      regarded if (1) the facts and circumstances indicate that a
                                      principal purpose of the arrangement between the parties is
                                        14 A partner’s allocable share of a partnership’s recourse liability equals the partner’s share

                                      of liability pursuant to sec. 752 and its regulations, multiplied by a fraction of which the numer-
                                      ator is the portion of the liability that is allocable to the distribution under sec. 1.163–8T, Tem-
                                      porary Income Tax Regs., 52 Fed. Reg. 24999 (July 2, 1987), and the denominator is the total
                                      amount of the liability. See secs. 1.707–5(b)(2)(i), 1.752–1(a)(1), 1.752–2, Income Tax Regs. The
                                      parties agree that the LLC’s liability to BOA was recourse. The parties do not dispute that the
                                      special distribution to WISCO and the BOA loan were both $755.2 million. We need only deter-
                                      mine WISCO’s share of the LLC’s liability under sec. 752 and its regulations.




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                                      to eliminate the partner’s risk of loss or to create a facade
                                      of the partner’s bearing the economic risk of loss with respect
                                      to the obligation, or (2) the facts and circumstances of the
                                      transaction evidence a plan to circumvent or avoid the
                                      obligation. See sec. 1.752–2(j)(1), (3), Income Tax Regs. Given
                                      these two tests, we must review the facts and circumstances
                                      to determine whether WISCO’s indemnity agreement may be
                                      disregarded as a guise to cloak WISCO with an obligation for
                                      which it bore no actual economic risk of loss. See IPO II v.
                                      Commissioner, supra at 300–301.
                                           1. Purpose of the Indemnity Agreement
                                         We first consider the indemnity agreement. The parties
                                      agreed that WISCO would indemnify GP in the event GP
                                      made payment on its guaranty of the LLC’s $755.2 million
                                      debt. GP did not require the indemnity, and no provision of
                                      the indemnity mandated that WISCO maintain a certain net
                                      worth. WISCO was chosen as the indemnitor, rather than
                                      Chesapeake, after PWC advised Chesapeake’s executives that
                                      WISCO’s indemnity would not only allow Chesapeake to defer
                                      tax on the transaction, but would also cause the economic
                                      risk of loss to be borne only by WISCO’s assets, not Chesa-
                                      peake’s. Moreover, the contractual provisions reduced the
                                      likelihood of GP invoking the indemnity against WISCO. The
                                      indemnity covered only the loan’s principal, not interest. In
                                      addition, GP would first have to proceed against the LLC’s
                                      assets before demanding indemnification from WISCO. In the
                                      unlikely event WISCO had to pay on the indemnity, WISCO
                                      would receive an increased interest in the LLC proportionate
                                      to any payment made under the indemnity. We find compel-
                                      ling that a Chesapeake executive represented to Moody’s and
                                      Standard & Poor’s that the only risk associated with the
                                      transaction was the tax risk. We are left with no other
                                      conclusion than that Chesapeake crafted the indemnity
                                      agreement to limit any potential liability to WISCO’s assets.
                                           2. WISCO’s Assets and Liabilities
                                         We now focus on whether WISCO had sufficient assets to
                                      cover the indemnity regardless of how remote the possibility
                                      it would have to pay. Chesapeake maintains that WISCO had
                                      sufficient assets to cover the indemnity agreement. WISCO




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                                      contributed almost all of its assets to the LLC and received
                                      a special distribution and a 5-percent interest in the LLC.
                                      Moreover, Chesapeake contends that WISCO did not need to
                                      have a net worth covering the full amount of its obligations
                                      with respect to the LLC’s debt. See sec. 1.752–2(b)(6), Income
                                      Tax Regs. WISCO’s assets after the transfer to the LLC
                                      included the $151.05 million intercompany note and the $6
                                      million jet. WISCO had a net worth, excluding its LLC interest,
                                      of approximately $157 million or 21 percent of the maximum
                                      exposure on the indemnity. The value of WISCO’s LLC interest
                                      would have been zero if the indemnity were exercised
                                      because the agreement required GP to proceed and exhaust
                                      its remedies against the LLC’s assets before seeking indem-
                                      nification from WISCO.
                                         We may agree with Chesapeake that no Code or regulation
                                      provision requires WISCO to have assets covering the full
                                      indemnity amount. We note, however, that a partner’s obliga-
                                      tion may be disregarded if undertaken in an arrangement to
                                      create the appearance of the partner’s bearing the economic
                                      risk of loss when the substance of the arrangement is in fact
                                      otherwise. See sec. 1.752–2(j)(1), Income Tax Regs. WISCO’s
                                      principal asset after the transfer was the intercompany note.
                                      The indemnity agreement did not require WISCO to retain
                                      this note or any other asset. Further, Chesapeake and its
                                      management had full and absolute control of WISCO. Nothing
                                      restricted Chesapeake from canceling the note at its discre-
                                      tion at any time to reduce the asset level of WISCO to zero.
                                      In fact WISCO’s board, which included many Chesapeake
                                      executives, did cancel the note and issued an intercompany
                                      dividend to Chesapeake in 2001. We find WISCO’s intercom-
                                      pany note served to create merely the appearance, rather
                                      than the reality, of economic risk for a portion of the LLC
                                      debt.
                                         In addition, WISCO remained subject to the Fox River
                                      liability, and WISCO and other Chesapeake subsidiaries
                                      guaranteed a $450 million credit line obtained by Chesa-
                                      peake in 2000. This guaranty and the Fox River liability fur-
                                      ther reduced WISCO’s net worth. GP neither asked for nor
                                      received any assurances that WISCO would not further
                                      encumber its assets. We find that WISCO’s agreement to
                                      indemnify GP’s guaranty lacked economic substance and
                                      afforded no real protection to GP.




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                                           3. Anti-Abuse Rule Illustration
                                         Chesapeake seeks to distinguish the transaction in this
                                      case from the transaction illustrated in the anti-abuse rule.
                                      See sec. 1.752–2(j)(4), Income Tax Regs. (illustrating when
                                      payment obligations may be disregarded). The illustration
                                      considers a consolidated group of corporations that use a
                                      thinly capitalized subsidiary as a partner in a general part-
                                      nership with a recourse debt payment guaranteed by the
                                      other partner. The circumstances are deemed indicative of a
                                      plan enabling the corporate group to enjoy the losses gen-
                                      erated by the partnership’s property while avoiding the
                                      subsidiary’s obligation to restore any deficit in its capital
                                      account. Chesapeake argues WISCO was not a newly-created
                                      entity, as was the subsidiary in the illustration, but had been
                                      in business before the transaction. We find WISCO’s preexis-
                                      tence insufficient to distinguish this transaction from the
                                      illustration.
                                         A thinly capitalized subsidiary with no business operations
                                      and no real assets cannot be used to shield a parent corpora-
                                      tion with significant assets from being taxed on a deemed
                                      sale. Chesapeake intentionally used WISCO, rather than itself,
                                      to limit its exposure under the indemnity agreement. It fur-
                                      ther limited its exposure only to the assets of WISCO. We
                                      refuse to interpret the illustration to provide additional
                                      protection. Moreover, this appears to be a concerted plan to
                                      drain WISCO of assets and leave WISCO incapable, as a prac-
                                      tical matter, of covering more than a small fraction of its
                                      obligation to indemnify GP. We find this analogous to the
                                      illustration because in both cases the true economic burden
                                      of the partnership debt is borne by the other partner as guar-
                                      antor. Accordingly, we do not find that the anti-abuse rule
                                      illustration extricates Chesapeake, but rather it dem-
                                      onstrates what Chesapeake strove to accomplish.
                                           4. Rev. Proc. 89–12 Does Not Apply to Anti-Abuse Rule
                                         Chesapeake also argues that it would be found to bear the
                                      economic risk of loss if the Court would apply a 10-percent
                                      net worth requirement. In so arguing, Chesapeake relies on
                                      Rev. Proc. 89–12, 1989–1 C.B. 798, which stated that a lim-
                                      ited partnership would be deemed to lack limited liability for
                                      advance ruling purposes if a corporate general partner of the




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                                      partnership had a net worth equaling 10 percent or more of
                                      the total contributions to the partnership. We decline Chesa-
                                      peake’s invitation to extend the 10-percent net worth test.
                                      Requirements for advance ruling purposes have no bearing
                                      on whether a partner will be treated as bearing the economic
                                      risk of loss for a partnership’s liability. There are no mechan-
                                      ical tests. The anti-abuse rule mandates that we consider the
                                      facts and circumstances. We decline to establish a bright-line
                                      percentage test to determine whether WISCO bore the eco-
                                      nomic risk of loss with respect to the LLC’s liability.
                                           5. Speculative Fraudulent Conveyance Claims
                                         Chesapeake argues alternatively that WISCO bore the eco-
                                      nomic risk of loss because GP had a right to make fraudulent
                                      conveyance claims against Chesapeake and Chesapeake’s
                                      financial subsidiary Cary Street. Chesapeake contends that
                                      such potential claims exposed WISCO to a risk of loss in
                                      excess of WISCO’s net worth. This argument is flawed on
                                      many points. First, a fraudulent conveyance is simply a
                                      cause of action, not an obligation. See La Rue v. Commis-
                                      sioner, 90 T.C. 465, 478–480 (1988); see also Long v.
                                      Commissioner, 71 T.C. 1, 7–8 (1978), supplemented by 71
                                      T.C. 724 (1979), affd. in part and remanded on other grounds
                                      660 F.2d 416 (10th Cir. 1981). The Court may consider
                                      obligations only in allocating recourse liabilities of a partner-
                                      ship. See sec. 1.752–2(b)(3), Income Tax Regs. Next, Chesa-
                                      peake’s fraudulent conveyance argument connotes that
                                      Chesapeake engaged in a plan to circumvent or avoid the
                                      obligation. This argument completely undercuts and over-
                                      rides Chesapeake’s attempt to create an obligation on behalf
                                      of Chesapeake and Cary Street. Finally, we would render the
                                      anti-abuse rule meaningless by creating an automatic excep-
                                      tion for speculative fraudulent conveyance claims. Accord-
                                      ingly, we reject this argument.
                                         We have carefully considered the facts and circumstances
                                      and find that the indemnity agreement should be dis-
                                      regarded because it created no more than a remote possi-
                                      bility that WISCO would actually be liable for payment.
                                      Chesapeake used the indemnity to create the appearance
                                      that WISCO bore the economic risk of loss for the LLC debt
                                      when in substance the risk was borne by GP. We find that




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                                      WISCO  had no economic risk of loss and should not be allo-
                                      cated any part of the debt incurred by the LLC.
                                        Consequently, the distribution of cash to WISCO does not fit
                                      within the debt-financed transfer exception to the disguised
                                      sale rules. Instead, we find Chesapeake has failed to rebut
                                      the 2-year presumption. The facts and circumstances evince
                                      a disguised sale. Accordingly, we conclude that WISCO sold its
                                      business assets to GP in 1999, the year it contributed the
                                      assets to the LLC, not the year it liquidated its LLC interest.
                                      II. Whether Chesapeake Is Liable for an Accuracy-Related
                                          Penalty Under Section 6662(a)
                                         We now turn to respondent’s determination that Chesa-
                                      peake is liable for the accuracy-related penalty under section
                                      6662(a) and (b)(2) for a substantial understatement of income
                                      tax. Respondent bears the burden of proof for a penalty
                                      asserted in an amended answer. See Rule 142(a).
                                         A substantial understatement of income tax exists for a
                                      corporation 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); sec. 1.6662–4(b)(1),
                                      Income Tax Regs. Chesapeake’s correct tax for 1999 is
                                      $217,576,519, which includes the $183,458,981 deficiency
                                      determined in the deficiency notice. Respondent has estab-
                                      lished the understatement of income tax is substantial as it
                                      exceeds both 10 percent of the correct tax ($21,757,651) and
                                      $10,000.
                                         The accuracy-related penalty under section 6662(a) does
                                      not apply, however, to any portion of an underpayment if a
                                      taxpayer shows that there was reasonable cause for, and that
                                      the taxpayer acted in good faith with respect to, that portion.
                                      Sec. 6664(c)(1); sec. 1.6664–4(a), Income Tax Regs. We con-
                                      sider the pertinent facts and circumstances, including the
                                      taxpayer’s efforts to assess his or her proper tax liability, the
                                      taxpayer’s knowledge and experience and the reliance on the
                                      advice of a professional in determining whether the taxpayer
                                      acted with reasonable cause and in good faith. Sec. 1.6664–
                                      4(b)(1), Income Tax Regs. Generally, the most important
                                      factor is the extent of the taxpayer’s effort to assess the
                                      proper tax liability. Id.




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                                         Reasonable cause has been found when a taxpayer selects
                                      a competent tax adviser, supplies the adviser with all rel-
                                      evant information and, in a manner consistent with ordinary
                                      business care and prudence, relies on the adviser’s profes-
                                      sional judgment as to the taxpayer’s tax obligations. Sec.
                                      6664(c); United States v. Boyle, 469 U.S. 241, 250–251 (1985);
                                      sec. 1.6664–4(b)(1), Income Tax Regs. A taxpayer may rely on
                                      the advice of any tax adviser, lawyer or accountant. United
                                      States v. Boyle, supra at 251.
                                         The right to rely on professional tax advice, however, is not
                                      unlimited. Neither reliance on the advice of a professional
                                      tax adviser nor reliance on facts that, unknown to the tax-
                                      payer, are incorrect necessarily demonstrates or indicates
                                      reasonable cause or good faith. See Long Term Capital
                                      Holdings v. United States, 330 F. Supp. 2d 122, 205–206 (D.
                                      Conn. 2004), affd. 150 Fed. Appx. 40 (2d Cir. 2005). The
                                      advice must not be based on unreasonable factual or legal
                                      assumptions and must not unreasonably rely on representa-
                                      tions, statements, findings, or agreements of the taxpayer or
                                      any other person. Sec. 1.6664–4(c)(1)(ii), Income Tax Regs.
                                      Courts have repeatedly held that it is unreasonable for a tax-
                                      payer to rely on a tax adviser actively involved in planning
                                      the transaction and tainted by an inherent conflict of
                                      interest. See, e.g., Mortensen v. Commissioner, 440 F.3d 375,
                                      387 (6th Cir. 2006), affg. T.C. Memo. 2004–279; Pasternak v.
                                      Commissioner, 990 F.2d 893 (6th Cir. 1993), affg. Donahue v.
                                      Commissioner, T.C. Memo. 1991–181; Neonatology Associates,
                                      P.A. v. Commissioner, 115 T.C. 43 (2000), affd. 299 F.2d 221
                                      (3d Cir. 2002). A professional tax adviser with a stake in the
                                      outcome has such a conflict of interest. See Pasternak v.
                                      Commissioner, supra at 903.
                                         Chesapeake claims it reasonably relied in good faith on
                                      PWC’s tax advice and ‘‘should’’ opinion and therefore no pen-
                                      alty should be imposed. Respondent contends that Chesa-
                                      peake unreasonably relied on an opinion riddled with
                                      improper assumptions written by a tax adviser with a con-
                                      flict of interest. We look to whether PWC’s advice was reason-
                                      able and inquire whether PWC’s advice was based on all
                                      pertinent facts and circumstances and not on unreasonable
                                      factual or legal assumptions. See Long Term Capital
                                      Holdings v. United States, supra at 205–206.




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                                           A. PWC Based Its Advice on Unreasonable Assumptions.
                                        We now focus on whether PWC’s advice was reasonable.
                                      Chesapeake contends that it relied on legal analysis pre-
                                      scribed in PWC’s ‘‘should’’ opinion. Chesapeake submitted a
                                      draft, not the original, of the ‘‘should’’ opinion into evidence.
                                      We therefore look to the draft opinion to determine whether
                                      PWC’s advice was reasonable.
                                        Chesapeake paid PWC an $800,000 flat fee for the opinion,
                                      not based on time devoted to preparing the opinion. Mr.
                                      Miller testified that he and his team spent hours on the
                                      opinion. We find this testimony inconsistent with the opinion
                                      that was admitted into evidence. The Court questions how
                                      much time could have been devoted to the draft opinion
                                      because it is littered with typographical errors, disorganized
                                      and incomplete. Moreover, Mr. Miller failed to recognize sev-
                                      eral parts of the opinion. The Court doubts that any firm
                                      would have had such a cavalier approach if the firm was
                                      being compensated solely for time devoted to rendering the
                                      opinion.
                                        In addition, the opinion was riddled with questionable
                                      conclusions and unreasonable assumptions. Mr. Miller based
                                      his opinion on WISCO maintaining 20 percent of the LLC debt.
                                      Mr. Miller had no case law or Code authority to support this
                                      percentage, however. He instead relied on an irrelevant rev-
                                      enue procedure as the basis for issuing the ‘‘should’’ opinion.
                                      A ‘‘should’’ opinion is the highest level of comfort PWC offers
                                      to a client regarding whether the position taken by the client
                                      will succeed on the merits. 15 We find it unreasonable that
                                      anyone, let alone an attorney, would issue the highest level
                                      opinion a firm offers on such dubious legal reasoning.
                                        We are also nonplused by Mr. Miller’s failure to give an
                                      understandable response when asked at trial how PWC could
                                      issue a ‘‘should’’ opinion if no authority on point existed. He
                                      demurred that it was what Chesapeake requested. The only
                                         15 Mr. Miller testified that tax practitioners render different levels of opinion based on their

                                      comfort that the legal conclusions contained in the opinion are correct as a matter of law assum-
                                      ing the factual representations and assumptions set forth in the opinion are also correct. A ‘‘rea-
                                      sonable basis’’ opinion has a 33-percent chance of success on the merits. See sec. 1.6662–3(b)(3),
                                      Income Tax Regs. A ‘‘substantial authority’’ opinion has a 40-percent chance of success on the
                                      merits. See sec. 1.6662–4(d)(2), Income Tax Regs. A ‘‘more likely than not’’ opinion has a 51-
                                      percent chance of success on the merits. See id. Mr. Miller did not give an exact percentage
                                      regarding a ‘‘should’’ opinion, but he testified that it is materially higher than that of a ‘‘more
                                      likely than not’’ opinion.




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                                      220                135 UNITED STATES TAX COURT REPORTS                                        (199)


                                      explanation that makes sense to the Court is that no lesser
                                      level of comfort would have commanded the $800,000 fixed
                                      fee that Chesapeake paid for the opinion.
                                         We are also troubled by the number of times the draft
                                      opinion uses ‘‘it appears.’’ For example, it states: ‘‘[i]n
                                      focusing on the language of the 752 regs, it appears that
                                      such regulation adopts an all or nothing approach.’’ Mr.
                                      Miller had no basis for that position other than his
                                      interpretation of the regulations. Further, Mr. Miller
                                      assumed that the indemnity would be effective and that
                                      WISCO would hold assets sufficient to avoid the anti-abuse
                                      rule. PWC assumed away the very crux of whether the trans-
                                      action would qualify as a nontaxable contribution of assets to
                                      a partnership. In so doing PWC failed to consider that the
                                      indemnity lacked substance. Neither the joint venture agree-
                                      ment nor the indemnity agreement included provisions
                                      requiring WISCO to maintain any minimum level of capital or
                                      assets. WISCO and Chesapeake could also remove WISCO’s
                                      main asset, the intercompany note, from WISCO’s books at
                                      any time and for any reason. This possibility gutted any sub-
                                      stance for the indemnity.
                                         We find that Chesapeake’s tax position did not warrant a
                                      ‘‘should’’ opinion because of the numerous assumptions and
                                      dubious legal conclusions in the haphazard draft opinion that
                                      has been admitted into the record. Further, we find it inher-
                                      ently unreasonable for Chesapeake to have relied on an anal-
                                      ysis based on the specious legal assumptions.
                                           B. Chesapeake Lacked Good Faith
                                        Moreover, Chesapeake did not act with reasonable cause or
                                      in good faith as it relied on Mr. Miller’s advice. Chesapeake
                                      argues that it had every reason to trust PWC’s judgment
                                      because of its long-term relationship with the firm. PWC
                                      crossed over the line from trusted adviser for prior
                                      accounting purposes to advocate for a position with no
                                      authority that was based on an opinion with a high price
                                      tag—$800,000.
                                        Any advice Chesapeake received was tainted by an
                                      inherent conflict of interest. We would be hard pressed to
                                      identify which of his hats Mr. Miller was wearing in ren-
                                      dering that tax opinion. There were too many. Mr. Miller not




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                                      (199)               CANAL CORP. & SUBS. v. COMMISSIONER                                       221


                                      only researched and drafted the tax opinion, but he also
                                      ‘‘audited’’ WISCO’s and the LLC’s assets to make the assump-
                                      tions in the tax opinion. He made legal assumptions separate
                                      from the tax assumptions in the opinion. He reviewed State
                                      law to make sure the assumptions were valid regarding
                                      whether a partnership was formed. In addition, he was intri-
                                      cately involved in drafting the joint venture agreement, the
                                      operating agreement and the indemnity agreement. In
                                      essence, Mr. Miller issued an opinion on a transaction he
                                      helped plan without the normal give-and-take in negotiating
                                      terms with an outside party. We are aware of no terms or
                                      conditions that GP required before it would close the trans-
                                      action. We are aware only of the condition that Chesapeake’s
                                      board would not close unless it received the ‘‘should’’ opinion.
                                      Chesapeake acted unreasonably in relying on the advice of
                                      PWC given the inherent and obvious conflict of interest. See
                                      New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132
                                      T.C. 161, 192–194 (2009) (reliance on opinion by law firm
                                      actively involved in developing, structuring and promoting
                                      transaction was unreasonable in face of conflict of interest);
                                      see also CMA Consol., Inc. v. Commissioner, T.C. Memo.
                                      2005–16 (reliance not reasonable as advice not furnished by
                                      disinterested, objective advisers); Stobie Creek Invs., LLC v.
                                      United States, 82 Fed. Cl. 636, 714–715 (2008), affd. 608 Fed.
                                      3d 1366 (Fed. Cir. 2010).
                                         We also find suspect the exorbitant price tag associated
                                      with the sole condition of closing. Chesapeake essentially
                                      bought an insurance policy as to the taxability of the trans-
                                      action. PWC received an $800,000 fixed fee for its tax opinion.
                                      PWC did not base its fee on an hourly rate plus expenses. The
                                      fee was payable and contingent on the closing of the joint
                                      venture transaction. PWC would receive payment only if it
                                      issued Chesapeake a ‘‘should’’ opinion on the joint venture
                                      transaction. PWC therefore had a large stake in making sure
                                      the closing occurred.
                                         Considering all the facts and circumstances, PWC’s opinion
                                      looks more like a quid pro quo arrangement than a true tax
                                      advisory opinion. If we were to bless the closeness of the
                                      relationship, we would be providing carte blanche to pro-
                                      moters to provide a tax opinion as part and parcel of a pro-
                                      motion. Independence of advisers is sacrosanct to good faith
                                      reliance. We find that PWC lacked the independence nec-




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                                      222                135 UNITED STATES TAX COURT REPORTS                                        (199)


                                      essary for Chesapeake to establish good faith reliance. We
                                      further find that Chesapeake did not act with reasonable
                                      cause or in good faith in relying on PWC’s opinion. We sustain
                                      respondent’s determination that Chesapeake is liable for the
                                      accuracy-related penalty under section 6662(b)(2) for 1999. 16
                                         We have considered all remaining arguments the parties
                                      made and, to the extent not addressed, we find them to be
                                      irrelevant, moot, or meritless.
                                         To reflect the foregoing,
                                                                           Decision will be entered for respondent.

                                                                               f




                                        16 This holding should not be interpreted as requiring taxpayers to obtain a second tax opinion

                                      to qualify for the reasonable reliance exception under sec. 6664(c). Rather, we hold that tax-
                                      payers may not reasonably rely on an adviser tainted by an inherent conflict of interest the tax-
                                      payer had reason to know of.




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