                        T.C. Memo. 2009-157



                      UNITED STATES TAX COURT



         JAMES T. AND TIFFANY A. MANNING, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 30112-07.               Filed June 30, 2009.



     Farley P. Katz and Charles J. Muller, III, for petitioners.

     Daniel N. Price, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     KROUPA, Judge:   Respondent determined a $714,924 deficiency

in petitioners’ Federal income tax for 2003 and a $142,984.80

accuracy-related penalty under section 6662.1




     1
      All section references are to the Internal Revenue Code in
effect for the year at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
                                -2-

     After concessions, we are left to decide three issues.2

     The first issue is whether payments James Manning

(petitioner) made to Warrior Fund, LLC (Warrior) are deductible

under section 162.   We hold the payments are deductible because

they are ordinary and necessary business expenses.   In so

holding, we also hold that the payments are not illegal payments

under section 162(c)(2), nor are they barred from deductibility

under the economic substance doctrine.   The second issue is

whether petitioner generated taxable gains as a trading agent of

a Warrior subaccount.   We hold he did not because the gains

belonged to Warrior, not petitioner.   The third issue is whether

petitioners are liable for the accuracy-related penalty under

section 6662.   We hold that petitioners are not liable for an

accuracy-related penalty.

                         FINDINGS OF FACT

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

The stipulation of facts, supplemental stipulation of facts,

second supplemental stipulation of facts, and their accompanying

exhibits are incorporated by this reference.

     Petitioners are husband and wife who resided in Texas at the

time they filed the petition.   Petitioners timely filed a joint

Federal income tax return for 2003.


     2
      Respondent concedes that petitioners are not taxable on
$590,862 in unreported gross receipts or sales and that
petitioners are entitled to deduct $60,951 in professional fees.
Petitioners concede they mistakenly deducted $100,000 in
commission rate adjustments in 2003 that were actually paid in
2004.
                                -3-

Petitioner’s Career as a Day Trader

     Petitioner received a bachelor’s degree in business

management from Southwest Texas State University in 1995.

Shortly thereafter, he entered the high-paced day trading

industry.

     Day traders use software to track stock values and may trade

hundreds of thousands of shares per day trying to profit from

minute-to-minute changes in their value.   Day trading is

extremely risky and often results in substantial financial losses

in a short time.   In fact, many day traders buy on borrowed

money, increasing their risk beyond their invested capital.    The

Securities and Exchange Commission (SEC) warns that day traders

should be prepared to lose their entire investment because of the

risk of large and immediate financial losses.   Petitioner,

however, beat the odds and consistently made money as a day

trader.

     Despite his success, petitioner began to desire a more

stable and less stressful job when his first child was born.    He

began to coach other traders in 2001 while continuing to trade

his own account.   Petitioner mastered how the day trading

business operates during this time.   Petitioner then decided to

open his own business and began negotiations with Assent, LLC

(Assent), the largest national broker-dealer that provided

direct-access electronic trading and other services to day

traders.
                                  -4-

     Petitioner became the initial branch manager and General

Securities Principal (GSP) of Assent’s office in Austin, Texas

(branch office).    Petitioner operated the branch office through a

wholly owned entity, James T. Manning, LLC, a disregarded entity

for Federal income tax purposes.    Petitioner leased the offices

and provided computers, monitors, and extremely fast T-1 lines

for Internet connection at the branch office.

     Petitioner’s duties, as branch manager, included handling

compliance matters for the branch office and supervising the

traders.    Petitioner was also a Class B member of Assent.    Class

B members act as group leaders and recruit business to Assent.

Assent compensated petitioner for his work as a Class B member by

permitting him to share in the commissions generated by branch

office customers.    Petitioner was not separately compensated for

serving as branch manager.

Assent’s Commission Arrangement With Petitioner

     Assent charged its customers for various services, including

commissions on executed trades.    Petitioner negotiated the

commission rates with the customers, and the customers paid the

commissions directly to Assent.    Assent charged commissions as an

amount per 1,000 shares of stock purchased or sold; i.e., $5 per

1,000 shares.    Assent kept a portion of the customers’

commissions and paid the rest to petitioner.    Assent’s commission

rate was tied to the volume of shares traded through the branch

office.    Assent lowered its commission rate when the branch

office reached certain tiers in the volume of shares traded.     All
                                 -5-

shares traded through the branch office were charged the lower

rate once the share volume reached the next volume tier.

     Petitioner’s business model focused on increasing the branch

office’s trading volume, thereby lowering Assent’s commission

rate and allowing petitioner more flexibility to negotiate

commissions with branch office customers.    Accordingly,

petitioner actively recruited customers who were group leaders

with multiple traders trading under them.    For example,

petitioner recruited Mike Kestler and Jonathan Kirkland, group

leaders affiliated with a different branch office of Assent.

Other group leaders were organized as limited liability companies

(LLCs).

     Petitioner recruited Vantage Capital, LLC (Vantage) and

Warrior, two high-volume LLCs, to trade through the branch

office.    These LLCs opened a main account with Assent.

Individual traders who were members of the LLCs acted as

designated trading agents and traded the funds in the main

account.    Their trading activity was tracked through individual

subaccounts for accounting purposes.    Petitioner negotiated with

group leaders to determine the commission rates for each of their

trading agents, and these rates were assigned to the trader’s

subaccount.    When a designated trading agent executed a trade,

Assent would charge the LLC the negotiated commission rate for

that subaccount.

     In addition, petitioner brought in many individual accounts.
                                -6-

Commission Rate Adjustments

     The LLCs and the group leaders sought the lowest possible

commission rates because they traded huge volumes of shares.     The

branch office competed against firms nationwide to attract and

keep these customers.   Petitioner could request that Assent make

a commission rebate to a customer who demanded lower commissions.

Assent routinely made commission rebates where the customer

exceeded certain target levels set by a GSP or a branch manager.

Assent required GSPs and branch managers to process requests for

commission rebates on an Assent form.   Petitioner requested that

Assent make rebates to customers on a number of occasions, but

they were not happy with the time it took Assent to process the

requests.   Petitioner began to make payments directly to

customers from his share of the commissions (commission rate

adjustments) to keep them happy.   Assent would have made any

rebates petitioner requested provided they did not affect

Assent’s share of the branch office income.   Accordingly, the

economics were identical for all parties whether Assent processed

a commission rebate or petitioner made a commission rate

adjustment.

     Petitioner made commission rate adjustments for Warrior,

Vantage, Mr. Kirkland, and Mr. Kestler that depended on their

trading volume.   Warrior was the branch office’s largest customer

and generated most of the branch office’s trading volume.     Assent

charged Warrior an average commission of $3.75 to $4.25 per

thousand shares traded.   Assent kept $2 as profit and paid
                                -7-

petitioner the remaining amount.    Petitioner agreed to make

commission rate adjustments so that Warrior’s net commission rate

would be about $2.25 per thousand shares traded.    Accordingly,

petitioner’s net earnings were about 25 cents per thousand shares

traded after commission rate adjustments.

     Petitioner reported the commission rate adjustments as

“commission adjustments” on Forms 1099-B, Proceeds From Broker

and Barter Exchange Transactions, issued to each customer.

Petitioner then deducted $1,335,185 as “commissions” on the

Schedule C, Profit or Loss From Business, for 2003.    Warrior

reported all the commission rate adjustments it received as

income for tax purposes.

     Petitioner maintained his books and records for 2003 on

QuickBooks.   Petitioner wife’s mother, Vicki McGee, entered all

the source data, including checks.    Ms. McGee mistakenly recorded

two commission rate adjustments as paid on December 31, 2003,

even though petitioner actually paid them on January 16, 2004.

Richard Springer, a certified public accountant, prepared

petitioners’ tax return for 2003.     Petitioner believed that the

records he provided to Mr. Springer were accurate, and they were

accurate with the exception of the two commission rate

adjustments that were paid in 2004.

John Manning and Warrior

     John Manning (petitioner’s brother) was a day trader with

the Midas touch.   He partnered with several day traders who

desired to work with him because of his success.    He formed
                                -8-

Warrior in 2002 to consolidate his multiple trading partnerships

under one common entity.   Petitioner’s brother provided most of

Warrior’s capital from his own funds and various loans.

Petitioner lent his brother $500,000 to help fund the initial

trading partnerships, and Warrior took over this debt. Petitioner

became a “preferred member” of Warrior, giving him a priority

right to repayment of the $500,000 loan principal at a 5-percent

interest rate.   Petitioner had no right of control or management

as a result of his interest.   Warrior’s books reflected that

petitioner did not share in its profits or losses.   Petitioner

received $24,375 in interest from Warrior in 2003, and he

reported it.   Petitioner continued to receive interest until the

full principal was repaid.

     The trading partners became designated trading agents of

Warrior, each designated by a separate subaccount.   The trading

agents were authorized to act as agents on Warrior’s behalf.    All

gains or losses on the Warrior account belonged to the entity

itself subject to negotiated subaccount profit splits.    Warrior

entered into written agreements with the trading agents setting

out the terms of the profit splits.   These terms depended on the

amount of capital contributed by the individual trader, if any,

and the trader’s experience.   Warrior issued Schedules K-1,

Member’s Share of Income, Credits, Deductions, etc., to its

members reporting their income from profit-splitting agreements.

     Petitioner occasionally traded a Warrior subaccount during

his downtime to keep a presence in, and check the pulse of, the
                                -9-

market.   His trading activity generated gains of $208,329 during

2003.   Warrior was entitled to all profits generated in the

subaccount.   Petitioner invested no money in the main Warrior

account, had no interest in the subaccount gains, and never

received any of those gains.

2005 Events

     After losing significant customers to better commission

rates, including Vantage, Mr. Kirkland, and Mr. Kestler,

petitioner decided to reevaluate his business model.     Petitioner

had also lost individual customers who left to trade through LLCs

like Vantage or Warrior.

     Petitioner discussed changing his business structure with

his brother in 2005.   Petitioner had found two new scanning

software programs, which he believed could substantially increase

Warrior’s trading profits.   Petitioner advised his brother to

purchase all rights to both programs, and Warrior did, for

$190,000 each.   By purchasing all rights to that software,

Warrior completely controlled it and no competitors could use it.

Warrior’s profitability and volume increased as a result of the

new software, and its retention of traders improved.

     Petitioner agreed to supervise and maintain the new software

for a split of Warrior’s profits.     Petitioner received no

interest in Warrior’s capital, however.

Assent’s Compliance

     Since 2003 Assent has been subject to numerous reviews by

self-regulatory organizations (SROs) like the National
                               -10-

Association of Securities Dealers (NASD) and various exchanges

and has an excellent compliance record.    No complaints were ever

filed by customers against the branch office or against

petitioner.   Assent’s Director of Compliance periodically

conducted compliance reviews of the branch office and concluded

that the office was generally in compliance with Assent’s

requirements.   Assent has never sanctioned petitioner, nor has

petitioner been sanctioned by or had adverse determinations from

the SEC or the Texas Securities Board.

Genesis of Respondent’s Investigation

     Despite petitioner’s excellent compliance record, respondent

challenges the commission rate adjustments petitioner paid to

Warrior.   Respondent questioned the commission rate adjustments

after investigating petitioner’s brother concerning his tax

reporting position that he was a resident of the United States

Virgin Islands (USVI) from 2002 through 2004.   Petitioner’s

brother established residency in the USVI because he was

persuaded that he could obtain significant tax benefits by moving

there and participating in a statutory economic development

program.   He entered into various agreements with The March

Group, LLLP, a Virgin Islands limited liability partnership, to

facilitate obtaining these tax benefits.

     Petitioner’s brother received all Warrior’s income from his

trading gains, shares of the gains generated by other Warrior

traders, and commission rate adjustments from petitioner.    He

reported on the USVI returns all Warrior’s income that flowed
                                 -11-

through to him through various entities, except for some payments

that went to The March Group.    In addition, petitioner’s brother

claimed a 90-percent economic development tax credit.     He stopped

claiming USVI residency in 2005 when guidance was released that

challenged the tax benefits he was receiving.

     Respondent issued petitioners a deficiency notice for 2003

as a result of the investigation into his brother’s alleged tax

sheltering activities in the USVI.      Respondent’s determinations

treat the commission rate adjustments paid to Warrior differently

from those paid to other customers because petitioner’s brother

ultimately received the payments and reported them as income in

the USVI.   Petitioners timely filed a petition.

                                OPINION

I.   Introduction

     We must now determine whether petitioner took part in his

brother’s alleged tax sheltering activities in the manner alleged

by respondent.    Respondent’s determinations depend on the premise

that petitioner made commission rate adjustments to Warrior only

to lower petitioner’s taxable income and that these payments were

funneled back to petitioner in later years.     We ultimately

conclude that the record does not support respondent’s

determinations.

     We first address the burden of proof.     We then determine

whether petitioner’s commission rate adjustments to Warrior are

deductible by petitioner as ordinary and necessary business

expenses under section 162.   In doing so, we decide whether the
                               -12-

commission rate adjustments were illegal payments under section

162(c)(2) or lacked economic substance.   We then turn to whether

petitioners must include Warrior subaccount gains in gross

income.   We finally address whether petitioners are liable for an

accuracy-related penalty under section 6662.

II.   Burden of Proof

      The parties disagree as to whether the burden of proof

shifted to respondent under section 7491(a).3    The Commissioner’s

determinations in the deficiency notice are generally presumed

correct, and the taxpayer has the burden of proving that the

Commissioner’s determinations are in error.     Rule 142(a); Welch

v. Helvering, 290 U.S. 111, 115 (1933).   At trial we granted

petitioners’ motion to shift the burden of proof to respondent

under section 7491(a) because we found that they introduced

credible evidence, substantiated items, maintained required

records, and fully cooperated with respondent’s reasonable

requests.4   See sec. 7491(a)(2)(A) and (B).   We stand by our

ruling.   Accordingly, respondent bears the burden of proof as to

all issues relevant to petitioners’ liability for the deficiency.


      3
      The parties agree that respondent bears the burden of proof
concerning new issues under Rule 142 and whether the commission
rate adjustments were illegal payments under sec. 162(c)(2).
Respondent also bears the burden of production concerning the
accuracy-related penalty. See sec. 7491(c).
      4
      The Court invited the parties to address this issue on
brief. We have carefully reviewed the parties’ arguments and
stand by our ruling that petitioners’ challenge of a summons in
Federal District Court and motion for protective order in the Tax
Court reflected petitioners’ legitimate discovery concerns. See
Kohler v. Commissioner, T.C. Memo. 2006-152.
                                -13-

III. Deductibility of Petitioner’s Payments to Warrior

     We now address whether petitioner’s commission rate

adjustments to Warrior are deductible under section 162.

Initially, we note that respondent allowed deductions to

petitioner for similar payments to Vantage, Mr. Kirkland, and Mr.

Kestler.   Respondent disallowed deductions for the payments to

Warrior under several theories involving the relationship between

petitioner and his brother.    Respondent’s primary argument is

that petitioner’s payments to Warrior are not deductible under

section 162(a) because the payments were not ordinary and

necessary business expenses.    Respondent also makes two

alternative arguments against deductibility.    Respondent first

argues that petitioner is barred from deducting the payments

because they are illegal payments under section 162(c)(2).

Respondent then argues that the payments are not deductible

because the transactions lack economic substance.     We address

each of respondent’s arguments in turn.

     A.    Ordinary and Necessary Business Expenses

     Tax deductions are a matter of legislative grace, and

taxpayers must satisfy the specific statutory requirements for

the item claimed.   Rule 142(a); INDOPCO, Inc. v. Commissioner,
503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292

U.S. 435, 440 (1934).   A taxpayer is generally permitted to

deduct all ordinary and necessary expenses paid or incurred

during the taxable year in carrying on any trade or business.

Sec. 162(a).   The determination of whether an expenditure
                               -14-

satisfies the requirements for deductibility under section 162 is

a question of fact.   See Commissioner v. Heininger, 320 U.S. 467,

475 (1943).   In general, an expense is ordinary if it is

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

particular business out of which it arose.    See Deputy v. du

Pont, 308 U.S. 488, 495 (1940).   Generally, an expense is

necessary if it is appropriate and helpful to the operation of

the taxpayer’s trade or business.     See 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).

     Respondent argues that petitioner’s commission rate

adjustments to Warrior were not ordinary because the payments ran

contrary to Assent’s written policies and the regulatory

framework in which Assent operated.    We disagree.

     It is common in the day trading industry to lower

commissions to attract and retain customers.    Assent, a large,

nationwide broker-dealer servicing day traders, routinely made

commission rebates when requested by a GSP or a branch manager.

Petitioner began making direct commission rate adjustments for

several customers when they complained of the untimeliness of

Assent’s commission rebates.   Whether petitioner or Assent paid

the commission rebates did not change the economics.5    Customers

demanded that their commissions be lowered, and petitioner


     5
      The parties agree that “three-cornered” transactions
between Assent, petitioner, and Assent’s customers are not
rebates for tax purposes and are subject to the rules of
deductibility.
                                 -15-

negotiated the commission rate adjustments at arm’s length to

keep them.

     Respondent does not challenge the ordinary nature of

payments made to Vantage, Mr. Kirkland, or Mr. Kestler, only

those made to Warrior.    Warrior was the branch office’s biggest

customer and generated significant trading volume.       Petitioner

was aware that Warrior could demand a very low commission rate

elsewhere.    In addition, petitioner hoped Warrior’s trading would

cause the branch office to meet certain volume tiers, lowering

Assent’s commission rate.    Petitioner could then have the

flexibility to lower commissions and attract more traders.       The

commission rate adjustments are expenses that would be expected

of someone trying to increase and maintain business in the highly

competitive world of day trading.       This is true regardless of

whether the customer is Warrior, Mr. Kirkland, Mr. Kestler, or

Vantage.     Accordingly, we hold petitioner’s payments to Warrior

were ordinary expenses for section 162 purposes.      See Corrigan v.

Commissioner, T.C. Memo. 2005-119.

     Respondent further argues that the payments were not

necessary because customers chose Assent for reasons beyond the

commission rates, including Assent’s software, and because

petitioner could have processed commission rate adjustments

through Assent.    Again, we disagree.    Petitioner has satisfied

the Court that commission rates were the most critical element to

customers.    Petitioner eventually lost Mr. Kirkland, Mr. Kestler,

and Vantage as customers when they found better commission rates
                               -16-

elsewhere.   Further, petitioner did not use the Assent form to

process volume rebate credits because his customers were

dissatisfied by the untimeliness of these payments.   An expense

may be necessary even where the taxpayer could have avoided it by

pursuing a different course of conduct.   Mason & Dixon Lines,

Inc. v. United States, 708 F.2d 1043, 1044-1045 (6th Cir. 1983).

Petitioner’s payments were appropriate and helpful to keep

customers trading through the branch office given the highly

competitive nature of the day trading industry.   Accordingly, we

hold that petitioner’s payments to Warrior were necessary for

section 162 purposes.

     B.   Illegal Payments Under Section 162(c)(2)

     We now turn to whether petitioner’s commission rate

adjustments to Warrior, while ordinary and necessary, are not

deductible because they are illegal payments under section

162(c)(2).   Respondent argues that petitioner’s payments to

Warrior are illegal payments under section 162(c)(2) because they

were made in violation of Federal law implemented by NASD rule

2110.6

     Deductions are not allowed for payments that constitute an

illegal bribe, an illegal kickback, or other illegal payment

under any law of the United States.   The term “laws of the United

States” includes only Federal statutes, including State laws

which are assimilated into Federal law by Federal statute, and

     6
      We do not address whether an NASD rule can properly be
considered a “law of the United States” as it is unnecessary to
our holding.
                                -17-

legislative and interpretive regulations thereunder.     Sec. 1.162-

18(a)(4), Income Tax Regs.    The term is further limited to

statutes that prohibit some act or acts for the violation of

which there is a civil or criminal penalty.     Sec. 1.162-18(a)(4),

Income Tax Regs.   Respondent bears the burden of establishing by

clear and convincing evidence that the commission rate

adjustments constitute illegal payments.     See secs. 162(c)(2),

7454(a); Rule 142(b).

     The NASD is a nonprofit Delaware corporation registered with

the SEC as a national securities association.7    The NASD serves

as an SRO subject to extensive oversight, supervision, and

control by the SEC on an ongoing basis.    See 15 U.S.C. sec. 78s

(2006).   NASD conduct rule 2110 provides:    “A member, in the

conduct of its business, shall observe high standards of

commercial honor and just and equitable principles of trade.”

Respondent argues that petitioner’s payments to Warrior were

commission-sharing payments that violated NASD rule 2110 and

subjected him to sanction or suspension by the NASD.     See Dept.

of Enforcement v. Ryerson, Complaint No. C9B040033 (N.A.S.D.R.

Aug. 3, 2006) (holding that an NASD member violated rule 2110

when the member shared commissions with an unlicensed person who

directed customers to him).




     7
      An organization’s bylaws and rules must conform to the
Securities Exchange Act of 1934, as amended, to become a
registered securities association. 15 U.S.C. sec. 78o-3(b)
(2006).
                                -18-

     Respondent’s argument is misplaced.   First, petitioner

returned commissions paid by Warrior, a customer, to ensure that

Warrior continued trading through the branch office.     These

payments were not commission-sharing payments made in return for

referrals of business, as in Dept. of Enforcement v. Ryerson,

supra.   Respondent has not otherwise met his burden of showing by

clear and convincing evidence that petitioner’s commission rate

adjustments would be classified by the NASD as commission-sharing

payments or that these payments would result in petitioner’s

being subject to a civil or criminal penalty or losing his

license.   In fact, no adverse compliance determinations were made

against petitioner by Assent, the NASD, or the SEC regarding

these payments.

     Further, deductions are barred under section 162(c)(2) for

payments that are illegal in and of themselves.   Bilzerian v.

United States, 41 Fed. Cl. 134, 138 (1998).   There must be a

“federal or state law that the payment specifically violates.”

Id. at 140.   The relevant statute or regulation must “prohibit

some act or acts.”   Sec. 1.162-18(a)(4), Income Tax Regs.

Respondent cites no statute or regulation specifically

prohibiting petitioner’s payments but relies only on a general

rule requiring ethical conduct.   We conclude that the payments to

Warrior are not illegal per se.   Accordingly, we hold that

respondent has not proven by clear and convincing evidence that

petitioner’s commission rate adjustments were illegal within the

meaning of section 162(c)(2).
                                -19-

     C.   Economic Substance

     We now turn to respondent’s argument that petitioner’s

payments to Warrior are not deductible because they lacked

economic substance.   The effect of disregarding a transaction for

lack of economic substance is that, for taxation purposes, the

transaction is viewed to have never occurred at all.

Klamath Strategic Inv. Fund, LLC v. United States, __ F.3d __, __

(5th Cir., May 15, 2009) (slip op. at 17); see also Winn-Dixie

Stores, Inc. v. Commissioner, 113 T.C. 254, 294 (1999), affd. 254

F.3d 1313 (11th Cir. 2001).    Accordingly, deductions are

generally prohibited for expenditures in furtherance of a

transaction that is disregarded for lack of economic substance.

Klamath Strategic Inv. Fund, LLC v. United States, supra at __

(slip op. at 17); Winn-Dixie Stores, Inc. v. Commissioner, supra

at 294.

     Respondent argues that petitioner and John Manning entered

into a symbiotic business relationship intended to produce mutual

tax benefits in 2003.   He contends petitioner’s payments to

Warrior were returned to petitioner in later years that are not

before the Court and argues that we should use the economic

substance doctrine to disregard petitioner’s payments to Warrior.

We have fully examined the evidence and find that it does not

support respondent’s contention.

     Petitioner has produced credible evidence and testimony

accounting for all payments he received from Warrior in 2005 and

later years.   Petitioner received a return of all principal plus
                                 -20-

interest on his $500,000 loan by the end of 2006.    Petitioner

also received a share of Warrior’s profits in later years when he

became responsible for operating and maintaining new trading

software he convinced Warrior to purchase.     We conclude that the

profit-splitting arrangement was attributable to petitioner’s new

responsibilities at Warrior and not devised for tax avoidance

purposes.   Petitioner properly reported his portion of Warrior

profits reflected on Schedules K-1 for 2005 and later years and

was taxed on these amounts.

      Respondent also argues that petitioner’s arrangement with

Warrior lacked economic substance because it was not an arm’s-

length arrangement.   He contends that low initial commissions,

rather than high initial commissions with the prospect of

rebates, would reflect an arm’s-length arrangement.    We have

found, however, that these arrangements were common practice at

Assent.    Petitioner has satisfied the Court that the commission

rate adjustments paid to Warrior were necessary and legitimate

business expenses, indistinguishable from those paid to unrelated

parties.    These payments resulted in net commissions to Warrior

comparable to those Warrior could have negotiated directly with

Assent or other broker-dealers.    There were no strings attached.

Accordingly, we hold that the deductibility of petitioner’s

payments is not barred by the economic substance doctrine.

IV.   Subaccount Trading Gains

      We now decide whether petitioner must include gains from a

Warrior subaccount in gross income for 2003.    Gross income
                                -21-

includes all income from whatever source derived, unless

specifically excluded from gross income.      Sec. 61(a);

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955).

Respondent argues that the subaccount gains are includable in

petitioner’s gross income because other Warrior traders included

gains generated in their respective subaccounts.      Respondent

ignores the facts.

     The other Warrior traders included their portions of

subaccount gains in gross income because they received these

gains.    Petitioner was not entitled to the gains, nor did he

receive them.    Traders who were entitled to subaccount gains had

written agreements with Warrior setting the terms of the profit

splits.    They also received Schedules K-1 reflecting their

portions of the subaccount gains.      Petitioner had no agreement

with Warrior giving him rights to a share of the subaccount

gains.    Respondent has presented no evidence to the contrary, and

we find petitioner’s testimony credible as to this issue.      In

fact, respondent acknowledges that the subaccount belonged to

Warrior and that all gains generated in the subaccount were

passed through a series of entities and ultimately to

petitioner’s brother.

     We conclude that petitioner had no ownership interest in or

rights to the subaccount and never received any funds from the

subaccount.    Accordingly, we hold that petitioner is not required
                                -22-

to include the subaccount trading gains in gross income for

2003.8

V.   Accuracy-Related Penalty

     We finally consider whether petitioners are liable for an

accuracy-related penalty under section 6662.    Petitioners are

liable for an accuracy-related penalty for any portion of an

underpayment attributable to negligence or disregard of rules and

regulations.    Secs. 6662(a) and (b)(1).   Negligence includes “any

failure to make a reasonable attempt to comply with the

provisions of this title,” and the term “disregard” includes “any

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

Negligence also includes any failure by the taxpayer to keep

adequate books and records or to substantiate items properly.

Sec. 1.6662-3(b)(1), Income Tax Regs.

     We have found for petitioners on all issues.    Petitioners

mistakenly deducted two commission rate adjustments in 2003 even

though they were not in fact paid until the following year.    All

of petitioners’ records were accurate and thorough except for

this mistake.    In fact, respondent conceded more than $500,000 in

alleged unreported deposits after considering the accuracy of

petitioners’ records.    We find, after considering all the facts

and circumstances, that petitioners are not liable for the

accuracy-related penalty under section 6662(a) for 2003.


     8
      Respondent first raised the issue of whether the subaccount
gains were includable in petitioner’s gross income in the answer.
Respondent therefore has the burden of proof as to this issue,
which we find respondent has not met.
                              -23-

     In reaching our holdings, we have considered all arguments

made, and, to the extent not mentioned, we conclude that they are

moot, irrelevant, or without merit.    To reflect the foregoing and

the concessions of the parties,



                                           Decision will be entered

                                      under Rule 155.
