                        T.C. Memo. 2011-246



                      UNITED STATES TAX COURT



 THE HERITAGE ORGANIZATION, LLC, GMK FAMILY HOLDINGS, LLC, TAX
                 MATTERS PARTNER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 12640-04, 13062-05.    Filed October 19, 2011.



     William A. Roberts and Peter M. Anastopulos, for petitioner.

     Elaine H. Harris, Garrett D. Gregory, and Lauren LaRavia,

for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     PARIS, Judge:   These cases are partnership-level proceedings

under the Tax Equity and Fiscal Responsibility Act of 1982

(TEFRA), Pub. L. 97-248, sec. 402, 96 Stat. 648, as amended.

Respondent issued a notice of final partnership administrative
                               - 2 -

adjustment (FPAA) on April 14, 2004, for the taxable year 2000

(tax year 2000) and issued an FPAA on April 15, 2005, for taxable

year 2001 (tax year 2001) to the Heritage Organization, LLC

(Heritage).   Respondent disallowed 11 payments of $550,000 each

(payoff amounts) that Heritage had claimed as research and

development expenses for tax year 2000.1   Respondent also

disallowed Heritage’s protective claim that the payoff amounts

qualified as research and development expenses for tax year 2001.

     GMK Family Holdings, LLC (Holdings), as tax matters partner,

timely filed petitions for readjustment of the partnership items

under section 6226(a)(1).2   The issues for determination are:

(1) Whether the payoff amounts are a tax year 2000 or a tax year

2001 partnership item, (2) whether the payoff amounts are

qualified research expenses under section 174, (3) whether the

payoff amounts to controlled corporations are ordinary and

necessary business expenses under section 162, (4) whether the

transaction should be recharacterized as a constructive

distribution to Gary Kornman (Kornman), and (5) whether an




     1
      The tax year 2000 FPAA disallowed an additional $19,189 as
a nonresearch expense. This issue has been settled between the
parties and is no longer in dispute.
     2
      All section references are to the Internal Revenue Code
(Code) in effect for the years in issue and all Rule references
are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated. These cases were consolidated for purposes
of trial, briefing, and opinion.
                                - 3 -

accuracy-related penalty for negligence under section 6662(a)

applies.

                          FINDINGS OF FACT

     Some facts have been stipulated, and the stipulated facts

are incorporated in our findings by this reference.    At the time

the petition was filed, Heritage was a Delaware limited liability

corporation with its principal place of business in Texas.

     Heritage was formed in 1995 as an LLC and elected to be

taxed as a partnership for Federal tax purposes.    It had four

members with the following ownership percentages:    Holdings owned

5 percent, Steadfast Investments, L.P. (Steadfast), owned 87

percent, TIKCHIK Investment Partnership, L.P. (Tikchik), owned 3

percent, and The Koshland Family Partnership (Koshland), owned 5

percent.   Holdings was wholly owned by Gary Morton Kornman

(Kornman).   Steadfast was owned by The Ettman Family Trust I, the

99-percent limited partner, and Kornman & Associates, Inc., the

1-percent general partner.   Kornman was the sole owner of Kornman

& Associates, Inc.   Tikchik was owned 90 percent by a partnership

controlled by an unrelated family and 10 percent by GMK Corp., an

entity wholly owned by Kornman.   Koshland is a partnership wholly

owned by the Koshland family.   In 1999 Tikchik purchased its LLC

interest for $9 million and Koshland purchased its LLC interest

for $15 million.
                                 - 4 -

     At the time the petition was filed, Kornman was the chief

executive officer of Heritage.    Kornman was an attorney who had

worked in the life insurance industry since the early 1970s.

William Ralph Canada (Canada) was the president and chief

operating officer of Heritage.    Canada had previously been

outside legal counsel to Heritage’s predecessor companies, but in

1995 he was hired by Heritage on a base salary with bonus

commissions to market Heritage’s life insurance and estate

planning opportunities in addition to his officer duties.      Vickie

Walker (Walker) was the secretary-treasurer and chief financial

executive officer of Heritage.    Walker also had check-signing

authority throughout the time at issue.    Walker had worked for

Kornman since the late 1970s, beginning soon after completing

high school.   For the tax years at issue she prepared both

Heritage and most of Heritage’s subsidiary’s tax returns.      She

also performed accounting duties for the numerous entities owned

and managed by Heritage, including classification of items for

accounting purposes.3

     Heritage was the last surviving entity of a long line of

life companies (producer companies4) which represented multiple


     3
      There is no evidence that appropriate cost sharing
agreements existed between Heritage and the other entities it
owned and managed.
     4
      An “insurance producer” as used by the parties is a broker
or agent that solicits or negotiates insurance contracts.
                                                    (continued...)
                               - 5 -

life insurance companies in States across the country.

Initially, the company performed management and administration

services for its life insurance clients and educated clients

about other life insurance products.   Beginning in the early

1990s Heritage became more involved with tax and estate planning

for high-net-worth individuals with the financial ability to

engage in more complicated transactions.

     In the 1990s Heritage began to funnel more resources into

different legal entities that undertook different elements of the

business.   The research entity was charged with using publicly

available information to identify possible clients whose net

worth exceeded $10 million and who might be interested in

Heritage’s planning techniques and insurance products.   The

research group created files on individuals using information it

gathered from a large number of sources, including business

journals, industry journals, public company reports, and Dun &

Bradstreet reports.

     Additionally, the research entity conducted legal and tax

research regarding corporate and trust structures that would

allow individuals to minimize income and estate tax.    It spent

hundreds of thousands of dollars for legal advice from estate and

tax planning attorneys from around the United States.

     4
      (...continued)
Typically, a State requires that an insurance producer be a
company organized in that State, requiring Heritage to form
producer companies in every State in which it wished to do
business.
                                 - 6 -

     Heritage’s subsidiary was responsible for contacting the

targeted individuals and arranging for them to meet with Kornman.

Heritage did not set up the structures or perform the

transactions that it sold to clients.      Instead, Kornman would

present the idea to a client.    The client would then vet the idea

with his own legal counsel.   If the client wanted to proceed, the

client’s counsel and Kornman would work together to complete the

life insurance or estate planning transaction that Heritage had

marketed.

     Heritage was compensated in three ways.     First, Heritage

charged a “tire kicker” fee of $22,500 before presenting

opportunities to potential clients.      Heritage charged an

additional $22,500 before agreeing to work further with clients,

which it would do if the client agreed to use a Heritage producer

life insurance entity if the client purchased life insurance.

Second, if clients wished to proceed with a planning technique,

they paid Heritage a commission based on the transaction type.

Finally, clients paid a fee to Heritage equal to a percentage of

the value of the assets used in the planning techniques.

The Transactions

     In the late 1990s Kornman and Canada decided that Heritage

should sell further future tax planning opportunities in addition

to life-insurance-based ideas.    First, to plan for a potential

repeal of the exemption for the generation-skipping transfer tax
                               - 7 -

on estates, Heritage set up 60 trusts, anticipating that they

would be grandfathered under the old laws.    All the trust

instruments were identical except for the names.    Canada was the

grantor of each trust and provided the initial funding which

Heritage later reimbursed.   The trust beneficiaries were

Kornman’s sons.   Kornman served as the distribution trustee,

administrative trustee, and family trustee.

     Kornman, Canada, and an outside counsel subsequently

developed a strategy to create trust basis through a contingent

liability transaction and create built-in losses in the trusts.

Heritage planned to sell these trusts to clients that could

derive tax benefits from the built-in losses.

     The strategy was to use a partnership contribution of an

open short sale position; that is, the short sale proceeds

subject to the obligation to replace the securities at closing.

A client would open a brokerage account with a margin deposit and

sell short U.S. Treasury notes equal to the amount of the desired

tax benefit.   The client would then contribute the brokerage

account with the still-open position to a partnership in exchange

for a 99.9-percent interest in the partnership and the

partnership’s assumption of the short sale obligation.    The

partnership would not have to account for the short sale

obligation as a partnership liability, and the strategy would
                                 - 8 -

allow the client to overstate his capital contribution by the

amount of the omitted liability.5

        Kornman controlled, directly or indirectly, a number of

dormant, preexisting corporations.       On December 28, 1999, the

ownership of 11 of these corporations6 (11 corporations) was each

transferred to 11 different trusts, from the 60 trusts formed

earlier by Kornman and Canada.

     On January 18, 2000, Heritage lent each of the 11

corporations $1,100,000 repayable on demand with interest on

December 28, 2000.     Each corporation used these funds to open an

individual brokerage account at DLJ (DLJ accounts), and each

corporation engaged in a short sale of U.S. Treasury notes with a

value of $50 million.     Each corporation received approximately

$50 million in proceeds and accrued interest subject to the

obligation to replace the securities at the closing of the short

sale.     Each corporation contributed its DLJ account to a limited



     5
      Eventually this type of transaction was commonly referred
to as a “Son of BOSS” technique, a bond option sale strategy
using subch. K entities.
     6
      The corporations involved were: CA Producer, Inc., CONN
Producer, Inc., GW Producer, Inc., Heritage Producer, Inc., K
Life Producer, Inc., MN Producer, Inc., PL Producer, Inc., SC
Producer, Inc., TA Producer, Inc., WCL Producer, Inc., and
VirtualMalls.com, Inc. Heritage intended to use only S
corporations; however, one C corporation was included by mistake.
All were incorporated in Delaware. Four of the S corporations
were incorporated in 1989, three in 1995, one in 1991, and one in
1999. Kornman indirectly owned the stock of the C corporation
and directly owned the 10 S corporations until Dec. 28, 1999.
                                - 9 -

partnership (trading partnership) in exchange for a 99.9-percent

limited partnership interest and the assumption of the short sale

obligation.   Additionally, each corporation contributed a

proportionate amount of cash in exchange for a 0.1-percent

interest as the general partner in each trading partnership.

     On January 30, 2000, each corporation closed its short sale

position at a loss by purchasing replacement securities with the

proceeds of the short sale.    On January 31, 2000, each trading

partnership entered into partially hedged short and long

positions in $4 million aggregate face amounts of U.S. Treasury

notes that closed on February 10, 2000, at a net loss.

     On February 28, 2000, the balance remaining in the margin

account of each corporation was approximately $825,000,

consisting of the initial margin deposit plus interest, less out-

of-pocket losses.   This amount was transferred back to each of

the 11 corporation accounts.   On March 1, 2000, the 11

corporations transferred the funds out of the corporation

accounts to Heritage as partial payments on the original loans,

leaving an outstanding principal balance on each of the loans of

approximately $275,000.

     On December 28, 2000, the loans from Heritage to the 11

corporations became due, but the corporations had depleted their

assets.   Walker issued 11 checks from Heritage, each in the
                                - 10 -

amount of $550,000, payable from a Heritage bank account at

American Century to each of the 11 corporations’ accounts.

     Walker determined the payoff amount of $550,000 on the basis

of the following.    Walker estimated that the outstanding loan

obligation of each corporation was approximately $275,000 (loan

repayment), plus a gross-up for the Federal income tax due from

each of the 11 corporations for income received (gross-up).    This

amount was rounded up to $550,000 for administrative ease.     None

of the corporations or trusts issued any invoices or accounting

statements indicating that they had performed any activities for

which they should be paid.

     On December 29, 2000, Walker issued the 11 checks on an

American Century account from Heritage and delivered them to

herself in her capacity as an officer of the 11 corporations.     The

checks were credited as having been received the same day,

December 29, 2000.    Walker did not deposit the checks into the 11

corporate accounts at Bank of Texas until January 23, 2001.    On

January 26, 2001, Bank of Texas presented the checks for payment,

but American Century refused to honor them.    On January 29, 2001,

Walker was informed that American Century had returned all 11

checks unpaid.   On January 30, 2001, Walker authorized a wire fund

transfer of $6,050,000 from American Century directly to

Heritage’s separate account at Bank of Texas.    Thereafter,

$550,000 was transferred from Heritage’s Bank of Texas account to
                               - 11 -

each of the 11 corporations’ accounts via intrabank transfer, in

lieu of the original checks.

Return Preparation and Audit

     Heritage was a cash method taxpayer.   It timely filed its tax

year 2000 and 2001 partnership return after submitting accounting

information, including the characterization of the payoff amounts

as research and development expenses, to Deloitte & Touche

(Deloitte), who thereafter prepared the returns.   On its tax year

2000 partnership return Heritage claimed a deduction of $6,069,189

for research and development,7 including $6,050,000 attributable

to the 11 checks.   On its tax year 2001 partnership return, as a

protective position Heritage claimed a deduction for the same

research and development expenses of $6,050,000.

     On April 14, 2004, respondent issued Holdings the FPAA for

tax year 2000.   Respondent denied Heritage’s claimed research

expenses of $6,069,189 as not related to Heritage’s trade or

business under section 162 or, alternatively, not qualified

research and development expenses under section 174.   Respondent

also recharacterized the aggregate payoff amount as a constructive




     7
      Holdings noted that the expense may have qualified as an
inventory expense rather than a research and development expense
but did not develop this argument.
                               - 12 -

distribution to Kornman in excess of his outside basis in the

partnership.8

     On April 15, 2005, respondent issued Holdings the FPAA for

tax year 2001.   Respondent denied Heritage’s protective position

and determined that the $6,050,000 was not an ordinary business

expense.9

     Holdings, as tax matters partner, timely filed a petition

with the Court for tax year 2000 on July 19, 2004.   It also timely

filed a petition for tax year 2001 on July 14, 2005.   On March 1,

2006, these cases were consolidated.

                              OPINION

     As a general rule, the Commissioner’s determinations in a

notice of deficiency are presumed correct and the taxpayer has the

burden of establishing that the determinations are erroneous.

Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Consequently, the taxpayer bears the burden of proving that he is

allowed any deduction that would reduce his deficiency.   INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992).   With respect to



     8
      Respondent later conceded the outside basis issue for 2000;
therefore the Court will consider only the issue of
deductibility.
     9
      After receiving the tax year 2001 FPAA, Holdings filed
amended returns for the 11 corporations, reversing the $6,050,000
of income received from Heritage. Each entity received a refund
check from the Government. Each entity negotiated the refund
check in the amount of $223,349.68. These entities are not
parties to this proceeding.
                                 - 13 -

penalties, the burden of production is placed on the Commissioner.

Sec. 7491(c).

I. The 11 Payments Are Tax Year 2001 Items.

     Holdings argues that the disputed deduction is a partnership

item for tax year 2000.   A cash method taxpayer may deduct

expenditures for the taxable year in which they are paid.      Sec.

1.461-1(a)(1), Income Tax Regs.    A check is not a final payment

relieving a debtor of a liability but is rather a conditional

payment that becomes absolute once the check is presented to the

bank.   See Weber v. Commissioner, 70 T.C. 52, 57 (1978); Thorpe v.

Commissioner, T.C. Memo. 1998-115.     The subsequent payment of the

check relates back to the date of delivery, which allows the

taxpayer to claim the deduction as of the date of delivery even

when a check is presented and honored during a later year.       Weber

v. Commissioner, supra at 57.     However, when a check is not

presented or honored, the Court has held that no payment ever

occurred because the condition upon which the conditional payment

rested was never satisfied.     Id.; Estate of Hubbell v.

Commissioner, 10 T.C. 1207, 1208 (1948).

     The record reflects that Walker, on behalf of Heritage,

issued and delivered the 11 checks to herself, on behalf of the 11

corporations, on December 28, 2000.       Walker did not deposit the

checks until January 23, 2001.    American Century did not honor the

checks and informed Walker that the payments would not be
                               - 14 -

processed.   Because the checks were not presented and honored in

due course, they do not constitute payment for tax year 2000.

     Further, the payments in question were not made via the

checks drafted on December 28, 2000.    Walker canceled the checks

in 2001, and the payments were made via a different funding

mechanism and in a different order.     Rather than transfer funds

via checks written from Heritage’s American Century account to the

11 corporations’ accounts at Bank of Texas, Heritage first had to

wire transfer funds from American Century to its own account at

Bank of Texas, then process intercompany transfers from Heritage

to the 11 corporations’ Bank of Texas accounts.    As the payments

were actually made in 2001, the payoff amounts are therefore tax

year 2001 items.

II. The 11 Payments Are Not Qualified Research Expenses.

     Section 174(a) provides that research or experimental

expenditures paid or incurred during the taxable year in

connection with a taxpayer’s trade or business may be deducted

currently rather than capitalized.     Spellman v. Commissioner, 845

F.2d 148, 149 (7th Cir. 1988), affg. T.C. Memo. 1986-403.     The

taxpayer must establish the right to treat expenditures as

deductible expenses under section 174.     Coors Porcelain Co. v.

Commissioner, 52 T.C. 682, 697-698 (1969) (holding that the

taxpayer was not entitled to a deduction under section 174

because, in part, the taxpayer did not prove that the expenditures
                                 - 15 -

met the definition of research and development under section 174),

affd. 429 F.2d 1 (10th Cir. 1970).

     The term “research or developmental expenditures” is defined

as “expenditures incurred in connection with the taxpayer’s trade

or business which represent research and development costs in the

experimental or laboratory sense.”     Sec. 1.174-2(a)(1), Income Tax

Regs.     The term generally includes all such costs incident to the

development or improvement of a product.     Id.

        The term “product” includes “any pilot, model, process,

formula, invention, technique, patent or similar property, and

includes products to be used by the taxpayer in its trade or

business as well as products to be held for sale”.     Sec. 1.174-

2(a)(2), Income Tax Regs.     Included costs are those to develop the

technique and concept of the product, not the product itself.     See

Mayrath v. Commissioner, 41 T.C. 582, 590-591 (1964), affd. 357

F.2d 209 (5th Cir. 1966); Rev. Rul. 73-275, 1973-1 C.B. 134.

        The Court generally gives the terms “experimental” and

“laboratory” their plain and ordinary meanings.     TSR, Inc. & Sub.

v. Commissioner, 96 T.C. 903, 914 (1991).     In TSR, Inc. & Sub.,

the Court concluded that “‘Experimental’ is defined as ‘relating

to, or based on experience’” and “‘Laboratory’ is defined as ‘a

place devoted to experimental study in any branch of natural

science or to the application of scientific principles in testing

and analysis’” according to the definition of those two terms in
                               - 16 -

Webster’s Third New International Dictionary.   See id.    The Court

has held further that “The goal of the research must be

scientifically reasonable * * * It requires some element of

experimentation.”   Agro Science Co. v. Commissioner, T.C. Memo.

1989-687, affd. 934 F.2d 573 (5th Cir. 1991).   The Court has

consistently held that research and development expenditures are

generally those expenditures related to scientific and laboratory-

based activities.

      The expenditures may qualify as research and development

expenses in “the experimental or laboratory sense” if they are

incurred for activities to “eliminate uncertainty concerning the

development or improvement of a product.”   Sec. 1.174-2(a)(1),

Income Tax Regs.

      Uncertainty exists if the information available to the

taxpayer does not establish the capability or method for

developing or improving the product or the design of the product.

Id.   Whether an expenditure qualifies as a research expenditure

depends on the nature of the activity to which the expenditures

relate, not the nature of the product or improvement being

developed or the level of technological advancement of the

product.   Union Carbide Corp. & Subs. v. Commissioner, T.C. Memo.

2009-50; sec. 1.174-2(a)(1), Income Tax Regs.   The taxpayer must

perform activities intended to discover information not otherwise

available regarding the capability of the product or for improving
                                 - 17 -

the design or development of the product.    Sec. 1.174-2(a)(1),

Income Tax Regs.

     Holdings alleges that the payoff amounts were research and

development expenses as Heritage incurred the expenses to

“develop” a set of shelf corporations with embedded losses.      The

Court disagrees and denies Heritage the research and development

expense deduction.

     The payoff amounts fail to meet the section 174 requirement

that the expenditures be for research in the experimental or

laboratory sense.    The payments were not made for scientific

activities.   The payoff amounts consisted of the amount

outstanding for each corporation on its loan from Heritage, a tax

gross-up amount, and an arbitrary amount to make the payment a

round number.   While a portion of the loss may have been

deductible as a short-term capital loss, the remainder would have

been a nondeductible investment expense.    Holdings relies on the

fact that there were a number of employees of Heritage engaged in

researching tax planning strategies and identifying high-net-worth

individuals, even though these activities were performed by a

different Heritage subsidiary.    These activities are irrelevant to

determining whether the payoff amounts are research and

development expenses.   The activities were unrelated to the payoff

amounts, and further, any expenses associated with those

activities were deducted through a different Heritage subsidiary.
                                - 18 -

     Further, the payoff amounts do not qualify as research and

development expenses as they were not incurred to eliminate

uncertainty concerning the development of a product.    The

uncertainty Heritage wished to eliminate was whether the tax

planning structure created would be useful in a tax system without

the generation skipping transfer tax exemption.   The uncertainty

on Heritage’s part would be resolved by a change in the tax law,

not by any actions undertaken by Heritage.

III. The 11 Payments Are Not Ordinary and Necessary Business
     Expenses.

     Section 162 allows a deduction for ordinary and necessary

expenses paid or incurred during the taxable year in carrying on a

trade or business.    Sec. 162(a); see Deputy v. du pont, 308 U.S.

488, 495 (1940).   “[A]ll expenses of every business transaction

are not deductible.   Only those are deductible which relate to

carrying on a business.”    Higgins v. Commissioner 312 U.S. 212,

217 (1941).   To determine whether a taxpayer is conducting a trade

or business requires an examination of the facts involved in each

case.   Id.   Generally, an expense is ordinary if it is considered

normal, usual, or customary in the context of the business in

which it arose.    Deputy v. du pont, supra at 495.   An expense is

necessary if it is appropriate and helpful to the operation of the

taxpayer’s trade or business.    Commissioner v. Tellier, 383 U.S.

687, 689 (1966); Carbine v. Commissioner, 83 T.C. 356, 363 (1984),

affd. 777 F.2d 662 (11th Cir. 1985).
                                 - 19 -

     Investing one’s money and managing those investments do not

constitute a trade or business.     Whipple v. Commissioner, 373 U.S.

193, 202 (1963).   Without more than time, energy, and expense,

such activities do not rise to the level of constituting expenses

in a trade or business.   Id.    The income and losses derived from

such activities may demonstrate that the investment has value but

this can be distinguished from a trade or business of the

taxpayer.    Id.

     Holdings alleges that the payoff amounts are attributable to

Heritage’s trade or business as the payoff amounts were necessary

to create a valuable asset for Heritage in the future.    The Court

disagrees.   Heritage’s business was consistently described as

estate planning and issuance of life insurance.    Its typical

business expenditures included the cost of educating its employees

through membership in legal and estate planning groups, attending

conferences, and one-on-one discussions with legal professionals.

Heritage also spent funds on subscriptions to legal publications,

industry publications, and research services.    While Heritage and

its employees marketed estate planning techniques to its clients,

the clients’ lawyers were responsible for drafting and conjugation

of the actual transactions.     Heritage’s business purpose was not

selling “off the shelf” entities with embedded losses.

     Looking specifically to the components of the payoff amounts,

none of the components can be considered ordinary and necessary
                               - 20 -

business expenses.   The loan repayment amount was actually the

loss each of the 11 corporations incurred while engaging in short

sale transactions.   Heritage has not shown that it was obligated

to repay the 11 corporations for losses from investment activity.

There is no evidence that any activity was performed by the 11

corporations that should be reimbursed by Heritage.    There are no

invoices from the 11 corporations accounting for the loan payment

component of the payoff amounts.    The 11 corporations simply

undertook an investment transaction that resulted in a loss, for

which they were reimbursed by Heritage, their lender.

      Holdings further failed to present any evidence as to why the

gross-up and amounts attributable to rounding up should be

considered an ordinary and necessary business expense.    There is

no evidence justifying the gross-up calculation or establishing

which entity the gross-up was designed to make whole and no

evidence showing an obligation to do so.    Finally, the component

attributable to rounding is an arbitrary amount that has no basis

in fact or law for deductibility.

IV.   The Payoff Amounts Are Not Constructive Distributions.

      The TEFRA provisions require that partnership items be

determined at the partnership level.    Secs. 6221, 6226(f).   The

term “partnership item” includes any item required to be taken

into account for the partnership taxable year to the extent that

the regulations provide that such item “is more appropriately
                                - 21 -

determined at the partnership level than at the partner level.”

Sec. 6231(a)(3).    The applicable regulations define the term to

include the partnership aggregate and each partner’s share of

items of income, gain, loss, deduction, or credit of the

partnership.    Sec. 301.6231(a)(3)-1(a)(1)(i) and (ii), Proced. &

Admin Regs.    Partnership items also include the amount of

contributions to and distributions from the partnership, including

any associated liabilities.    Sec. 301.6231(a)(3)-1(a)(1)(v), (4),

(c)(2)(iv), Proced. & Admin. Regs.

     Section 704(a) generally provides that a partner’s share of

income, gain, loss, deduction, or credit shall be determined by

the partnership agreement.    If the partnership agreement does not

specify the distributive share of each partner, then each

partner’s share of partnership items is based on its ownership

interest.   Sec. 704(b)(1).

     Respondent argues that the Court should recharacterize the

payoff amounts as constructive distributions from Heritage to

Kornman, contrary to the Heritage ownership structure.    To

determine that the payoff amounts should be treated as

distributions to Kornman, the Court would have to disregard the

partnership.    However, respondent does not argue or prove that

Heritage is a sham partnership.    Tikchick and Koshland are

unrelated partners that paid valid consideration for their

interests in Heritage.    The payoff amounts are not deductible by
                                 - 22 -

Heritage, and pursuant to TEFRA the additional income should be

distributed to each partner of Heritage pursuant to the percentage

ownership of each partner.

V. Accuracy-Related Penalty Under Section 6662

     A. Heritage’s Position Was Negligent.

     The applicability of penalties which relate to an adjustment

to a partnership item are determined at the partnership level.

Sec. 6221.   Assessment of a penalty relating to an adjustment of a

partnership item is based on partnership-level determinations.

Sec. 301.6221-1T(c), Proced. & Admin. Regs.      After a final

partnership-level adjustment has been made to a partnership item

in a partnership proceeding, a corresponding computational

adjustment must be made to the tax liability of each partner.

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

part and remanding Domulewicz v. Commissioner, 129 T.C. 11 (2007).

A computational adjustment then may affect the amounts of the

items on the partner’s return.    Id.     Partnership-level

determinations include all legal and factual defenses to a

penalty, other than partner-specific defenses that must be raised

through a separate refund action following assessment and payment.

Sec. 301.6221-1T(c) and (d), Temporary Proced. & Admin. Regs., 64

Fed. Reg. 3838 (Jan. 26, 1999).

     Section 6662(a) and (b)(1) and (2) imposes a 20-percent

penalty on an underpayment of tax required to be shown on a return
                                - 23 -

if the underpayment is attributable to a taxpayer’s negligence or

disregard of rules or regulations or substantial understatement of

income tax.   For purposes of applying penalties to partnership

items, the determination of negligence depends on the actions of

the general partner of a limited partnership or a managing partner

of an LLC.    See generally Wolf v. Commissioner, 4 F.3d 709, 715

(9th Cir. 1993), affg. T.C. Memo. 1991-212; Fox v. Commissioner,

80 T.C. 972, 1007-1008 (1983), affd. without published opinion 742

F.2d 1441 (2d Cir. 1984).

       For purposes of section 6662, the term “negligence”

includes any failure to make a reasonable attempt to comply with

Code provisions.   Sec. 6662(c).   “Negligence is lack of due care

or failure to do what a reasonable and ordinarily prudent person

would do under the circumstances.”    Marcello v. Commissioner, 380

F.2d 499, 506 (5th Cir. 1967), affg. in part and remanding in part

43 T.C. 168 (1964).   Negligence is strongly indicated where a

taxpayer “fails to make a reasonable attempt to ascertain the

correctness of a deduction, credit or exclusion on a return which

would seem to a reasonable and prudent person to be ‘too good to

be true’ under the circumstances.”    Sec. 1.6662-3(b)(1)(ii),

Income Tax Regs.

     For purposes of section 6662, the term “disregard” includes

any careless, reckless, or intentional disregard.    Sec. 6662(c).

A disregard of the rules is “careless” if “the taxpayer does not
                                - 24 -

exercise reasonable diligence to determine the correctness of a

return position”.    Sec. 1.6662-3(b)(2), Income Tax Regs.   A

disregard is “reckless” if the taxpayer “makes little or no effort

to determine whether a rule or regulation exists, under

circumstances which demonstrate a substantial deviation from the

standard of conduct that a reasonable person would observe.”        Id.

A taxpayer may avoid the penalty under section 6662 where there is

a reasonable basis for the position taken on the return.     Sec.

1.6662-3(b)(1), Income Tax Regs.   The reasonable basis standard is

not satisfied by a position that is “merely arguable” but is based

on “taking into account the relevance and persuasiveness of the

authorities, and subsequent developments.”   Sec. 1.6662-3(b)(3),

Income Tax Regs.    Relevant authorities include the Code and other

statutes; proposed, temporary, and final regulations; revenue

rulings and revenue procedures, and other authorities listed in

section 1.6662-4(d)(3)(iii), Income Tax Regs.

     The classification of the payoff amounts as research and

development expenses was negligent and in disregard of rules and

regulations.   There is no evidence that Walker or anyone else

investigated the appropriateness of the tax treatment of the

payoff amounts.    Walker, while Heritage’s accountant, was not a

tax professional and had never acquired any post-high-school

professional degrees.   Despite this lack of familiarity with the

law, she determined the classification of the payoff amounts
                               - 25 -

without consultation and without confirming the defensibility of

the position.   Further, Holdings noted that the expenses might

have been better classified as inventory-related expenses,

indicating that Heritage’s return filing was not well thought out.

     B. Heritage Did Not Act Reasonably or in Good Faith.

     The accuracy-related penalty may be avoided if Heritage can

show that it acted reasonably and in good faith.   Sec. 6664(c);

sec. 1.6664-4, Income Tax Regs.   The determination of whether a

taxpayer acted in good faith is factual and made on a case-by-case

basis.   Sec. 1.6664-4(b)(1), Income Tax Regs.   Relevant factors

for the Court to consider include the knowledge and experience of

the taxpayer and reliance on the advice of a qualified

professional.   Id.

     In order to prevail on this defense a taxpayer must generally

establish, by a preponderance of the evidence, that “(1) The

adviser was a competent professional who had sufficient expertise

to justify reliance, (2) the taxpayer provided necessary and

accurate information to the adviser, and (3) the taxpayer actually

relied in good faith on the adviser’s judgment.”    Neonatology

Associates, P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd.

299 F.3d 221 (3d Cir. 2002).

     Neither Walker nor Heritage sought or received any

professional tax advice with regard to the treatment of the payoff

amounts as research and development expenses.    Walker classified
                               - 26 -

the payments as such according to her own belief as to what was

appropriate without conducting an investigation of the proper

treatment of the payments, either within Heritage or through an

outside professional.

     Further, Heritage may not characterize Deloitte’s preparation

of the returns as reliance on a tax professional.     The exception

presumes that the taxpayer relied on the advice of a tax

professional and that tax professional made the tax error.     Here,

Heritage did not rely on tax advice from Deloitte.    Heritage

presented the accounting records and characterization of tax items

by Walker.   These numbers were then entered into the return

without further tax advice from Deloitte.    Deloitte provided no

tax advice to Walker or Heritage that can be relied on to support

the tax positions taken.

     In reaching these holdings, the Court has considered all

arguments made and, to the extent not mentioned, concludes that

they are moot, irrelevant, or without merit.

     To reflect the foregoing and the concessions of the parties,


                                            Decisions will be entered

                                    under Rule 155.
