                           132 T.C. No. 9



                    UNITED STATES TAX COURT



NEW PHOENIX SUNRISE CORPORATION AND SUBSIDIARIES, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket No. 23096-05.               Filed April 9, 2009.



         P is the parent of a consolidated group of corporations
    and a wholly owned subsidiary S. During 2001 S sold
    substantially all of its assets, realizing a gain of about
    $10 million. Also during 2001, S entered into a transaction
    whereby: (1) S purchased from and sold to a foreign bank
    respectively a long and a short option in foreign currency,
    paying only the net premium to the foreign bank; (2) S and
    W, a part owner of P, formed partnership O; and (3) S
    contributed the long and short options to O, increasing its
    basis in O by the amount of the premium on the purchased
    long option but not reducing its basis by the amount of the
    premium on the sold short option. The long and short
    options expired worthless. Shortly thereafter the
    partnership dissolved and distributed shares of stock in
    Cisco Systems, Inc., to S in redemption of its partnership
    interest. S sold the stock for a small economic loss. On
    its consolidated return P claimed a loss of about $10
    million on S’ sale of the stock. P calculated the amount of
    the loss by claiming an inflated basis of about $10 million
    in the Cisco Systems, Inc. stock distributed by O. The
                               - 2 -

     claimed $10 million loss was used to offset the $10 million
     gain on the sale of S’ assets. O filed an information
     return showing a loss on the expiration of the long and
     short options and allocating that loss to S and W.

          Because O qualified as a small partnership under sec.
     6231(a)(1)(B)(i), I.R.C., the unified audit and litigation
     procedures of the Tax Equity and Fiscal Responsibility Act
     of 1982, Pub. L. 97-248, sec. 401, 96 Stat. 648, do not
     apply. R issued a notice of deficiency to S, and P
     petitioned upon a consolidated return which included S. The
     notice of deficiency disallowed the claimed loss on the sale
     of the stock, the claimed flowthrough loss from O, and
     claimed deductions for legal fees. The notice was based in
     part on R’s belief that the transaction entered into by P
     lacked economic substance and should be disregarded for
     Federal tax purposes. The notice also imposed the penalty
     under sec. 6662, I.R.C.

          Held: The transaction S entered into lacked economic
     substance and is disregarded.

          Held, further, the legal fees are not deductible by P.

          Held, further, S is liable for sec. 6662, I.R.C.,
     penalty.


     John P. Tyler, Anthony J. Rollins, and Willard N. Timm, for

petitioner.

     R. Scott Shieldes and Kathryn F. Patterson, for respondent.



     GOEKE, Judge:   Respondent determined a deficiency of

$3,355,906 in petitioner’s Federal income tax for 2001 and

imposed a penalty under section 6662 of $1,298,284.1   For the




     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code).
                                - 3 -

reasons stated herein, we uphold the determinations in the notice

of deficiency and find the section 6662 penalty applicable.

                         FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulations

of fact and the accompanying exhibits are incorporated herein by

this reference.

     On April 30, 1973, the Pruett-Wray Cattle Co. was

incorporated pursuant to the laws of the State of Arizona.     In

1990 it changed its name to New Phoenix Sunrise Corp. (New

Phoenix).

1.   Mr. Wray

     Timothy Wray (Mr. Wray) became president and CEO of New

Phoenix in 1996.   Mr. Wray graduated from Princeton University

with a bachelor of arts degree and then obtained a master’s

degree in business administration from Stanford University.     Mr.

Wray was a member of the U.S. Rowing Team from 1990 through 1995.

After graduating from college, but while still a member of the

rowing team, Mr. Wray worked for Vanguard, a securities firm.

     After retiring from rowing, Mr. Wray began to examine the

family business, New Phoenix.   At that time New Phoenix was

managed by nonfamily members and experiencing financial

difficulties.   Mr. Wray worked to refinance the company’s debt by

securing a new lender and as part of the arrangement took over as

president and CEO until New Phoenix’s dissolution in 2001.     In
                                - 4 -

addition to serving as New Phoenix’s president and CEO, Mr. Wray

worked from 1996 until 2001 as a research analyst for Questor

Management Co., a private equity firm.

2.   Capital Poly Bag

     Capital Poly Bag, Inc. (Capital), was incorporated in 1972

under the laws of the State of Ohio.    Capital manufactured

plastic bags for sale to large institutions and had manufacturing

facilities in Columbus, Ohio, and Atlanta, Georgia.    New Phoenix

purchased the stock of Capital in 1986.    At all relevant times

thereafter, Capital was a subsidiary of New Phoenix and filed

consolidated income tax returns with the New Phoenix group of

corporations.

3.   Elsea, Collins & Co.

     Elsea, Collins & Co. (Elsea Collins) was an accounting firm

in Columbus, Ohio.   Elsea Collins provided financial accounting

and performed State and local tax work for Capital starting in

the 1980s.   During 2001 and 2002 James Hunter (Mr. Hunter) was a

C.P.A. and a partner at Elsea Collins.

4.   Bricker & Eckler, L.L.P.

     Bricker & Eckler, L.L.P. (Bricker & Eckler), is a law firm

based in Columbus, Ohio.    Bricker & Eckler provided legal

services for Capital from the 1970s until the company’s

dissolution.    During 2001 and 2002 Gordon F. Litt (Mr. Litt) was

an attorney and a partner at Bricker & Eckler.
                                 - 5 -

5.   Joseph W. Roskos & Co.

     In 2001 and 2002 Joseph W. Roskos & Co. (Roskos & Co.) was a

subsidiary of Bryn Mawr Bank Corp. in Bryn Mawr, Pennsylvania.

Roskos & Co. provided office services, including accounting,

consulting, tax services, and fiduciary support for high-net-

worth individuals.     Elsea Collins prepared New Phoenix’s

financial statements, upon which Roskos & Co. relied in providing

services to New Phoenix.

     In 2001 and 2002 Robert M. Fedoris (Mr. Fedoris) was Roskos

& Co.’s president, and Andrew King (Mr. King) was an employee.

Mr. Fedoris prepared New Phoenix’s consolidated Form 1120, U.S.

Corporation Income Tax Return, as well as Form 1065, U.S. Return

of Partnership Income, for Olentangy Partners, discussed below.

6.   Jenkins & Gilchrist

     During 2001 and 2002 Jenkens & Gilchrist, P.C. (Jenkens &

Gilchrist), was a law firm based in Dallas, Texas, with offices

in Chicago, Houston, Austin, San Antonio, Los Angeles, and

Washington, D.C.

7.   Sale of Capital

     In November 2000 negotiations commenced regarding the sale

of substantially all of Capital’s assets to Pitt Plastics, Inc.,

an unrelated third party (the asset sale).     At the time, Capital

was the only operating company within the New Phoenix

consolidated group of corporations.
                                - 6 -

     On April 24, 2001, the shareholders of New Phoenix approved

the sale of substantially all of Capital’s assets to Pitt

Plastics, Inc.   On April 30, 2001, the asset sale was

consummated.   Capital sold substantially all of its assets to

Pitt Plastics, Inc., for $15,292,767.   Mr. Litt represented New

Phoenix in connection with the asset sale and also advised New

Phoenix regarding the tax consequences of the asset sale and the

contemplated liquidation of the New Phoenix group.

     After the asset sale Mr. Wray became Capital’s president,

treasurer, and sole director.   Capital realized a gain of

$10,338,071 from the asset sale.   After the asset sale Capital’s

only real asset consisted of approximately $11 million in cash.

In July 2001 New Phoenix estimated that its gain from the asset

sale was approximately $10.3 million.

8.   Mr. Wray Meets Attorneys of Jenkens & Gilchrist

     In the fall of 2001 Mr. Litt introduced Mr. Wray to Paul

Daugerdas (Mr. Daugerdas) and John Beery (Mr. Beery) of Jenkens &

Gilchrist.   Messrs. Daugerdas and Beery were promoting a tax

strategy called “Basis Leveraged Investment Swap Spread” (the

BLISS transaction or the transaction at issue).   A one-page

executive summary of the BLISS transaction provided the following

steps:

          1. Taxpayer, through a single-member limited liability
     company treated as a disregarded entity for tax purposes,
     enters into two swaps (notional principal contracts) paying
     an upfront payment (yield adjustment fee) to acquire one
                              - 7 -

     swap, and receiving an upfront payment with respect to the
     other. Such transaction is a nontaxable event,
     notwithstanding the receipt of cash proceeds as an upfront
     payment, however such amount (and the amount paid for the
     other swap) must be amortized into income and expense over
     the life of the swap. A business and/or investment reason
     for this investment strategy must exist (e.g., the position
     should hedge an investment, or currency prices will increase
     or decrease, etc.).

          2. Taxpayer and another partner or his wholly owned S
     Corporation (“S Corp.”) form a partnership or limited
     liability company designed to be taxed as a partnership
     (referred to herein as “Partnership”), in which Taxpayer is
     99% partner, and S Corp. (or other party) is a 1% partner.

          3. Taxpayer contributes the purchased swap entered
     into to the Partnership, together with the short swap. This
     contribution should result in Taxpayer’s tax basis in his
     partnership or membership interest being equal to the cost
     of the swap contributed. The short swap is, more likely
     than not, not treated as a liability for tax purposes,
     achieving this result.

          4. Throughout the duration of the swap, the
     Partnership makes or receives payments pursuant to the swap
     terms and conditions, and recognizes economic gain or loss
     on the transaction. At maturity, the swap terminates.

          5. Partnership purchases foreign currency or
     marketable securities for investment. Alternatively, the
     Partnership may receive a capital asset as a contribution
     from its partners.

          6. Taxpayer (and, other partner) contributes his
     stepped-up Partnership interest to S. Corp. This results in
     the Partnership only having one partner, and therefore it
     liquidates. This results in a step-up in the basis of the
     assets formerly held by Partnership to the stepped-up
     outside basis of the S. Corp. partner.

          7. S Corp. sells the stepped-up assets, generating an
     ordinary or capital loss, as the case may be.

     On November 15, 2001, Mr. Daugerdas sent Mr. Litt a blank

information questionnaire pertaining to Mr. Wray and Capital.
                                  - 8 -

Mr. Litt completed the questionnaire and returned it to Mr.

Daugerdas the following day.      Jenkens & Gilchrist prepared

documents and correspondence used to implement the BLISS

transaction.

9.    Olentangy Partners

      On or before November 19, 2001, Mr. Wray authorized Jenkens

& Gilchrist to form Olentangy Partners.      Olentangy Partners was

organized as a general partnership on November 19, 2001, pursuant

to the laws of the State of Ohio.      The partnership agreement was

signed by Mr. Wray, both in his individual capacity and as

president of Capital.      The partnership agreement identifies

Capital as having a 99-percent interest and Mr. Wray as having a

1-percent interest in Olentangy Partners.      Jenkens & Gilchrist

prepared all documents related to the formation of Olentangy

Partners and filed all documents for Olentangy Partners with the

appropriate government agencies.      Olentangy Partners did not

contemplate or engage in any activities other than the BLISS

transaction.

10.   Deutsche Bank AG

      Deutsche Bank AG (Deutsche Bank) is an international bank

headquartered in Germany with a branch office in London, England.

The London branch does business as Deutsche Bank AG London

Branch.   Deutsche Banc Alex. Brown (DBA Brown) is a licensed

broker-dealer engaged in the securities brokerage business in the
                                - 9 -

United States.   DBA Brown is a division of Deutsche Bank

Subsidiaries, Inc., and Deutsche Bank Alex. Brown, L.L.C., which

are indirect subsidiaries of Deutsche Bank.

11.   Options in General

      An option is a contract that gives the buyer the right, but

not the obligation, to buy or sell an asset at a predetermined

price (the strike price).    In exchange for selling an option, the

seller receives from the purchaser a premium which reflects the

value of the option.   The risk to a purchaser of an option is

limited to the premium.    The risk to the seller of an option can

be unlimited; it is the difference between the strike price and

the market price of the asset at expiration less the premium.    A

European option is one that can be exercised only on its

expiration date.   A digital option is one in which the payout is

a fixed amount agreed to by the buyer and the seller at the time

of the option’s inception.

      An option to purchase property such as foreign currency is

“in the money” if at expiration the strike price is at or below

the price at which the referenced currency is trading in the

foreign currency market (the spot rate).   An option to purchase

such property is “out of the money” if at expiration the strike

price is above the spot rate.

      A European digital option on foreign currency typically

expires at 10 a.m. New York time on the termination date
                              - 10 -

referenced in the option contract.     The buyer of a European

digital option on foreign currency typically pays an upfront

premium in exchange for a predetermined payout if the option is

in the money.   This premium is typically expressed as a

percentage of the payout and delineates the odds that the option

will be in the money at the time of expiration.

      An option spread trade involves the simultaneous purchase

and sale of linked options.   The purchase of one option is either

partially or completely financed by the sale of another option at

a different strike price.   An option spread trade limits the gain

the purchaser can realize on the options because the option sold

puts a ceiling on the total profit.     Similarly, the seller of the

option spread has limited its potential loss to the amount of the

spread purchaser’s potential gain.

12.   The Digital Option Spread

      On or about November 30, 2001, Mr. Wray simultaneously

opened two separate brokerage accounts with DBA Brown–-one on

behalf of Olentangy Partners (the Olentangy Partners account) and

the other on behalf of Capital (the Capital account).

      Capital purchased a digital option spread on the U.S.

dollar/Japanese yen (USD/JPY) exchange rate from DBA Brown.      On

December 12, 2001, DBA Brown sent Mr. Berry letter agreements

between Capital and Deutsche Bank AG London Branch for use in the
                               - 11 -

transaction.    The letter agreements included incorrect notional

amounts.

       On December 14, 2001, DBA Brown issued corrected letter

agreements identifying each as a “Digital Swap Transaction” and

describing purported transactions entered into between Deutsche

Bank AG London Branch and Capital.      The letter agreements, Letter

Agreement 533865-1/ODET 59299 (the long contract) and Letter

Agreement 533866-1/ODET 59299 (the short contract), were dated

December 14, 2001, identified the trade date as December 7, 2001,

and had a corrected notional amount of $105 million.

       Deutsche Bank gave Mr. Wray a choice of one of three

currencies to use for the digital option spread:     The Japanese

yen, the British pound, or the euro.     Mr. Wray chose the Japanese

yen.    The long contract required Capital to pay:   (1) A premium

of $10,631,250 on December 11, 2001, and (2) two other fixed

payments of $63 million each, the first on December 14, 2001, and

the second on December 20, 2001.    In exchange the long contract

called for Deutsche Bank AG London Branch to make the following

contingent payments:    (1) $73,631,250 on December 14, 2001, but

only if the spot rate on the USD/JPY exchange rate at 10 a.m. on

December 12, 2001, as determined by the calculation agent, was

greater than or equal to ¥ 127.75; and (2) $73,631,250 on

December 20, 2001, but only if the spot rate at 10 a.m. on
                              - 12 -

December 18, 2001, as determined by the calculation agent, was

greater than or equal to ¥ 128.75.

     The short contract called for Deutsche Bank AG London branch

to pay:   (1) A premium of $10,368,750 on December 11, 2001, and

(2) two other fixed payments of $63,065,625 each, one on December

14, 2001, and the other on December 20, 2001.   In exchange, the

short contract called for Capital to make the following

contingent payments:   (1) $73,500,000 on December 14, 2001, but

only if the spot rate at 10 a.m. on December 12, 2001, as

determined by the calculation agent, was greater than or equal to

¥ 127.77; and (2) $73,500,000 on December 20, 2001, but only if

the spot rate at 10 a.m. on December 18, 2001, as determined by

the calculation agent, was greater than or equal to     ¥ 128.77.

     Capital and Deutsche Bank did not pay the full amounts of

their respective premiums under the digital option spread.

Instead, Capital paid the net difference of $262,500 (the

$10,631,250 premium on the long contract minus the $10,368,750

premium on the short contract) on December 21, 2001.2

     The short contract’s strike prices (¥ 127.77 and ¥ 128.77)

exceeded the long contract’s strike prices (¥ 127.75 and ¥

128.75) by only 2 pips.   A pip is one ten-thousandth of a quoted

price in foreign exchange.   In USD/JPY terms, a pip is worth


     2
      After Capital paid Deutsche Bank $262,500, Deutsche Bank
returned $131,250, leaving Capital at risk for the remaining
$131,250.
                                - 13 -

$0.0008.   Both contracts listed Deutsche Bank as the calculation

agent.   As discussed more fully below, Deutsche Bank’s role as

calculation agent limited the profit potential of the

transaction.

     On December 17, 2001, Jenkens & Gilchrist forwarded to Mr.

Wray the remaining documents necessary to implement the BLISS

transaction.   The package consisted of:    (1) Letter agreements

memorializing the digital option spread; (2) an agreement

assigning the digital option spread to Olentangy Partners; (3) an

agreement liquidating Olentangy Partners; and (4) correspondence

authorizing DBA Brown to transfer the digital option spread to

Olentangy Partners, to purchase and sell securities, and to make

certain deposits to and withdrawals from the Capital and

Olentangy Partners accounts.    Many of the documents were not

dated, and Jenkens & Gilchrist advised Mr. Wray not to date the

documents.

     On December 18, 2001, the digital option spread expired

worthless.   On December 20, 2001, Mr. Wray signed and returned

the above-referenced documents to Jenkens & Gilchrist.     Mr. Wray

also sent copies to Mr. Litt.    That same day Jenkens & Gilchrist

forwarded to DBA Brown the assignment agreement and the letter

signed by Mr. Wray authorizing the assignment of the digital

option spread to Olentangy Partners.     The assignment agreement

and the letter were both dated December 7, 2001.     They were among
                               - 14 -

the documents that Mr. Wray signed on December 20, 2001, but was

told not to date.

     Pursuant to the assignment agreement and Mr. Wray’s letter,

DBA Brown transferred the digital option spread from the Capital

account to the Olentangy Partners account.    In contributing the

digital option spread to Olentangy Partners, Capital stepped up

its outside basis in Olentangy Partners by the amount of the long

position’s premium but did not reduce its outside basis by the

amount of the transferred short position’s premium.   On December

24, 2001, DBA Brown transferred the amount of $393,740 from the

Capital account to the Olentangy Partners account as a capital

contribution.    Also on that same day, Olentangy Partners

purchased 8,110 shares of Cisco Systems, Inc. stock for $149,958

(the Cisco stock).

     Pursuant to the liquidation agreement signed by Mr. Wray,

Olentangy Partners was liquidated effective December 26, 2001,

and as of that date DBA Brown liquidated the Olentangy Partners

account and transferred the Cisco stock and $304,839 from that

account to the Capital account.

     On December 28, 2001, Capital sold the 8,110 shares of the

Cisco stock for $148,467, realizing an economic loss of $1,491

from the sale.
                              - 15 -

     13.   The IRS Response to Alleged Abusive Tax Shelters

     On February 28, 2000, the Department of the Treasury

(Treasury Department) issued temporary regulations requiring

corporate taxpayers to disclose listed and other reportable

transactions.   Sec. 301.6111-2T, Temporary Income Tax Regs., 65

Fed. Reg. 11218 (Mar. 2, 2000).   Notice 2000-44, 2000-2 C.B. 255,

was issued on August 11, 2000, and published in the Internal

Revenue Bulletin on September 5, 2000.    Notice 2000-44, 2000-36

I.R.B. 255.   The notice warned taxpayers of transactions calling

for the simultaneous purchase and sale of offsetting options

which were then transferred to a partnership.   The notice

determined that the purported losses from such offsetting option

transactions did not represent bona fide losses reflecting actual

economic consequences and that the purported losses were not

allowable for Federal tax purposes.    See Jade Trading, LLC v.

United States, 80 Fed. Cl. 11 (2007).

     14.   Reporting of the Transaction

     On February 20, 2002, Mr. Hunter calculated Capital’s gain

from the asset sale.   Of the total, he attributed $1,115,967 to

ordinary gain and $9,222,104 to capital gain.

     On April 18, 2002, Mr. Litt emailed Mr. Daugerdas to inform

him that he felt incapable of advising New Phoenix’s accountants

regarding the proper reporting of the BLISS transaction.     Mr.

Litt anticipated questions from Roskos & Co. concerning whether
                               - 16 -

the BLISS transaction had to be reported as a listed transaction

or as a confidential corporate tax shelter.

     On May 29, 2002, Mr. Litt emailed Mr. Wray, attaching a copy

of a news article about the Treasury Department’s action

regarding abusive tax shelters.   In the email Mr. Litt suggests

that in view of the news article and possible Treasury Department

action, it was important to prepare and file the New Phoenix tax

returns as soon as possible.

     The Treasury Department amended its temporary regulations

regarding disclosure requirements, effective June 14, 2002, to

include noncorporate taxpayers who directly or indirectly entered

into listed transactions on or after January 1, 2000.   67 Fed.

Reg. 41324-01 (June 18, 2002).

     On June 25, 2002, Mr. Litt and Mr. Daugerdas spoke, and they

discussed the June 14, 2002, Treasury Department amendments as

well as the section 6662 accuracy-related penalty.   Mr. Daugerdas

indicated that the June 14, 2002, amendments applied to the BLISS

transaction and that not disclosing it was an aggressive position

to take.

     On June 26, 2002, Jenkens & Gilchrist issued a written tax

opinion to Capital concerning treatment of the BLISS transaction.

The opinion concluded that Capital would more likely than not

prevail if the Internal Revenue Service (IRS) challenged

Capital’s Federal income tax reporting of the BLISS transactions.
                               - 17 -

Mr. Wray instructed New Phoenix’s advisers and return preparers

to prepare New Phoenix’s Federal income tax returns in accordance

with the Jenkens & Gilchrist opinion letter.

     On July 1, 2002, Mr. Litt discussed the June 14, 2002,

amendments with Mr. Wray and informed him that not disclosing the

BLISS transaction was an aggressive position requiring approval

of New Phoenix’s tax return preparer.

     On July 8, 2002, Mr. Wray sent Mr. Litt an email indicating

his intention of taking as aggressive a position as possible in

filing the return.    On July 11, 2002, Mr. Daugerdas and Mr. Litt

discussed the possibility that the BLISS transaction was

substantially similar to those transactions discussed in Notice

2000-44, supra; the section 6662 accuracy-related penalty; and

the potential of being audited if New Phoenix disclosed the BLISS

transaction.

     On July 26, 2002, Roskos & Co. sent draft copies of Federal

tax returns for 2001 for Capital and New Phoenix to Mr. Daugerdas

and Mr. Hunter.   A letter enclosed with the drafts indicated that

Mr. Wray wanted to file the returns as soon as possible in view

of the new regulations.    A second set of draft returns was sent

on August 29, 2002.    The second set included two different

versions of Capital’s Schedules M-1, Reconciliation of Income

(Loss) per Books With Income per Return, and Schedules M-2,

Analysis of Unappropriated Retained Earnings per Books, and
                               - 18 -

attached statements.   The difference between the two versions was

in how the BLISS transaction was reported.    The first version

included a Schedule M-1 adjustment on line 8, Deductions on this

return not charged against book income this year, of $10,588,013,

to show the book to tax difference of the sale of the Cisco

stock.   The second version did not include any adjustment

regarding the sale of the Cisco stock.

     On September 19, 2002, New Phoenix filed a consolidated Form

1120 for the taxable year ending December 31, 2001.    The Form

1120 was signed on behalf of New Phoenix by Mr. Wray as president

and Mr. Fedoris as paid tax return preparer.    The return reported

a Federal income tax liability of $261,977.    New Phoenix reported

a net capital gain of $9,222,104 and an ordinary gain of

$1,115,967 from the asset sale.    On Schedule D, Capital Gains and

Losses, New Phoenix reported a $10,504,462 loss on the sale of

the Cisco stock by Capital.    To arrive at this amount New Phoenix

reported a sale price of $148,474 and an adjusted basis in the

Cisco stock of $10,652,936.    New Phoenix derived this adjusted

basis from Capital’s stepped-up basis in Olentangy Partners less

cash distributions.    New Phoenix also reported $129,897 as

Capital’s distributive share of loss from Olentangy Partners and

claimed a deduction of $500,000 for payments to Jenkens &

Gilchrist.
                              - 19 -

     The New Phoenix consolidated return Schedule M-1 did not

include an adjustment to account for the difference between book

and tax treatment of the sale of the Cisco stock.    The attached

statement showing Schedule M-1 adjustments for New Phoenix

subsidiaries also did not contain a Schedule M-1 adjustment for

Capital to account for the difference in treatment.

     On or about November 6, 2002, Olentangy Partners filed an

information return reporting a loss of $131,250 from the digital

option spread’s expiring worthless.    Of this loss, Olentangy

Partners reported Capital’s distributive share as $129,938 and

Mr. Wray’s distributive share as $1,312.    On Capital’s Schedule

K-1, Partner’s Share of Income, Credits, Deductions, etc.,

Olentangy Partners reported capital contributions of $11,018,428

and distributions of $10,888,531.   On Mr. Wray’s Schedule K-1,

Olentangy Partners reported capital contributions of $6,562 and

distributions of $5,250.   On or about October 22, 2002, Mr. Wray

filed his Federal income tax return for tax year 2001.    In

reporting the BLISS transaction for Federal income tax purposes,

New Phoenix and its officers and advisers relied solely on the

advice of Jenkens & Gilchrist.

     On September 14, 2005, respondent issued a timely notice of

deficiency (the notice) to petitioner.3    The notice determined a


     3
      The unified audit and litigation procedures of the Tax
Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. 97-
                                                   (continued...)
                              - 20 -

deficiency in income tax of $3,355,906 and imposed a penalty of

$1,298,284 pursuant to section 6662.     Attached to the notice was

an explanation of items which provided various grounds for the

disallowance of the claimed $10,504,462 loss on the sale of the

Cisco stock and for the imposition of the section 6662 penalty.

      On December 8, 2005, a petition was filed on behalf of New

Phoenix.   A trial was held on January 22 and 23, 2008, during the

Court’s Atlanta, Georgia, session.     Petitioner produced three

fact witnesses and one expert witness.     Respondent produced two

expert witnesses.   Pursuant to section 7482(b)(2), the parties

stipulated that the decision in this case will be appealable to

the Court of Appeals for the Sixth Circuit.

                              OPINION

I.   Introduction

      Respondent makes arguments in support of the notice of

deficiency including that the digital option spread is a sham

lacking economic substance; that Olentangy Partners was a sham

and should be ignored for Federal income tax purposes; and,

should we find economic substance in the digital option spread


      3
      (...continued)
248, sec. 401, 96 Stat. 648, do not apply to Olentangy Partners.
Olentangy Partners qualifies as a small partnership under sec.
6231(a)(1)(B)(i) and did not elect pursuant to sec.
6231(a)(1)(B)(ii) to have TEFRA apply. See Wadsworth v.
Commissioner, T.C. Memo. 2007-46 (“The small partnership
exception permits this Court to review in a deficiency suit items
that otherwise would be subject to partnership-level
proceedings.”).
                              - 21 -

and respect Olentangy Partners as a partnership, that petitioner

treated the digital option spread incorrectly on its return.

      Separately, respondent argues that because the transaction

lacks economic substance, New Phoenix is not entitled to deduct

the $500,000 paid to Jenkens & Gilchrist.

      Lastly, respondent argues that should we uphold his

determinations, New Phoenix is liable for an accuracy-related

penalty based upon the resulting underpayment.    The notice

determined a variety of section 6662 penalties.    Respondent

argues that a section 6662(h) 40-percent gross valuation penalty

applies because New Phoenix made a gross valuation misstatement

by overstating its basis in the Cisco stock.   Should we find that

New Phoenix did not make a gross valuation misstatement,

respondent argues that a 20-percent penalty should be imposed

because New Phoenix made a substantial understatement of income

tax on its return and acted negligently by disregarding Notice

2000-44, supra.   Anticipating petitioner’s claimed reasonable

cause and good faith defense, respondent argues that New Phoenix

was not reasonable in relying on the Jenkens & Gilchrist opinion

letter because it was issued by a promoter of the transaction.

II.   Burden of Proof

      In general, the burden of proof with regard to factual

matters rests with the taxpayer.   Under section 7491(a), if the

taxpayer produces credible evidence with respect to any factual
                               - 22 -

issue relevant to ascertaining the taxpayer’s liability and meets

other requirements, the burden of proof shifts from the taxpayer

to the Commissioner as to that factual issue.    Because we decide

this case on the basis of the preponderance of the evidence, we

need not decide upon which party the burden rests.

III.    Sham Transaction Doctrine

       As stated above, the parties have stipulated that an appeal

in this case would lie in the Court of Appeals for the Sixth

Circuit.    Pursuant to Golsen v. Commissioner, 54 T.C. 742 (1970),

affd. 445 F.2d 985 (10th Cir. 1971), we follow the law of that

Court of Appeals as it applies to this case.

       “The legal right of a taxpayer to decrease the amount of

what otherwise would be his taxes, or altogether avoid them, by

means which the law permits, cannot be doubted.”     Gregory v.

Helvering, 293 U.S. 465, 469 (1935).    However, even if a

transaction is in formal compliance with Code provisions, a

deduction will be disallowed if the transaction is an economic

sham.    Am. Elec. Power Co. v. United States, 326 F.3d 737, 741

(6th Cir. 2003).

       The Court of Appeals for the Sixth Circuit has stated that

“‘The proper standard in determining if a transaction is a sham

is whether the transaction has any practicable economic effects

other than the creation of income tax losses.’”    Dow Chem. Co. v.

United States, 435 F.3d 594, 599 (6th Cir. 2006) (quoting Rose v.
                               - 23 -

Commissioner, 868 F.2d 851, 853 (6th Cir. 1989), affg. 88 T.C.

386 (1987)).   “If the transaction has economic substance, ‘the

question becomes whether the taxpayer was motivated by profit to

participate in the transaction.’”    Id. (quoting Illes v.

Commissioner, 982 F.2d 163, 165 (6th Cir. 1992), affg. T.C. Memo.

1991-449).   “‘If, however, the court determines that the

transaction is a sham, the entire transaction is disallowed for

federal tax purposes’,” id., and no subjective inquiry into the

taxpayer’s motivation is made, id.      A court “will not inquire

into whether a transaction’s primary objective was for the

production of income or to make a profit, until it determines

that the transaction is bona fide and not a sham.”      Rose v.

Commissioner, supra at 853.

     Accordingly, we must first determine whether the BLISS

transaction had any practical economic effect.      Dow Chem. Co. v.

United States, supra at 599.   The presence or lack of economic

substance for Federal tax purposes is determined by a fact-

specific inquiry on a case-by-case basis.      Frank Lyon Co. v.

United States, 435 U.S. 561, 584 (1978).     If we find that the

BLISS transaction did in fact have a practical economic effect,

we will then look to Mr. Wray’s and New Phoenix’s motives in

entering into the transaction at issue.
                                - 24 -

IV.   Economic Effect

      A.   Respondent’s Arguments

      Respondent argues that the transaction lacked economic

substance and should therefore be disregarded.       Respondent

premises this argument on two factors:       (1) That the digital

option spread had no practical economic effect, and (2) that the

transaction served no business purpose and was developed as a tax

avoidance mechanism and not an investment strategy.

            1.   Practical Economic Effect

      Respondent argues that a prudent investor would not have

engaged in the digital option spread because there was no

reasonable possibility, after taking into account transaction

costs, of making a profit.    Respondent contends that Capital paid

Deutsche Bank a net amount of $131,250 in exchange for four

possible outcomes:

      (1) If the contracts were “out of the money” on both
      expiration dates, Capital would lose its $131,250 net
      investment;

      (2) If the contracts were “in the money” on only one
      expiration date, Capital would break even;

      (3) If the contracts were “in the money” on both expiration
      dates, Capital would earn a maximum net profit of $131,250;

      (4) If the long contract was “in the money” and the short
      contract was “out of the money” on one or both of the two
      expiration dates, Capital could earn either $73 million or
      $147 million, referred to as hitting the “sweet spot.”

      Although it appears that respondent is conceding economic

substance on the basis of the third and fourth possible outcomes,
                              - 25 -

respondent argues that any profits in scenario 3 were dwarfed by

the transactions fees, while hitting the “sweet spot” was not

possible.

     Concerning the third possible outcome, respondent argues

that although a profit potential existed if both contracts

expired in the money, it would not be a true economic profit

because the fees Capital paid to enter into the transaction,

including fees paid to Deutsche Bank and the $500,000 paid to

Jenkens & Gilchrist, would exceed any amount Capital earned.

     Regarding the fourth possible outcome, respondent relies on

expert testimony concerning two factors that in his view prevent

Capital from ever hitting the “sweet spot”.   Respondent produced

two expert witnesses--Steven Pomerantz (Dr. Pomerantz) and Thomas

P. Murphy (Mr. Murphy).   Dr. Pomerantz holds a Ph.D. in

mathematics from the University of California at Berkeley and has

taught classes in statistics, probability, operations research,

and finance at both the undergraduate and graduate level.    Dr.

Pomerantz has also worked in the investment community for more

than 20 years, holding positions in research and management for

fixed income, equities, derivatives, and alternative investments

at several major firms.

     Mr. Murphy received a B.A. in psychology and economics from

the University of Pennsylvania and an M.B.A. in finance and

accounting from Columbia Business School.   Mr. Murphy has worked
                               - 26 -

in the foreign exchange markets for about 25 years, as a market

maker providing quotes to customers, a buy-side user seeking

quotes from market makers, and as a manager of both.

     The crux of respondent’s argument is that although there was

a very small theoretical possibility of hitting the “sweet spot”,

the structure of the transaction and industry practice lowered

that theoretical possibility to zero.

     Dr. Pomerantz testified about the probabilities of the

following outcomes:    (1) There was a 95.8-percent chance that

neither option would pay, and Capital would lose its $131,250

investment; (2) there was a 3.4-percent chance that one option

would pay, and Capital would break even; (3) there was a 0.6-

percent chance that both options would pay, earning Capital a

$131,250 profit; and (4) there was a 0.2-percent chance that

Capital would hit at least one “sweet spot”, earning at least $73

million.   Dr. Pomerantz further testified that taking into

account the costs associated with entering into the BLISS

transaction, Capital would lose money in the first three

scenarios.

     Mr. Murphy also testified about Capital’s chances of hitting

either “sweet spot”.    Mr. Murphy testified that the probability

of the long option’s hitting the “sweet spot” was 0.182 percent,

and the probability of the short option’s hitting the “sweet

spot” was 0.115 percent.    Mr. Murphy also testified that during
                               - 27 -

his currency trading career he had never entered into a spread

trade where the strike prices were so narrow.

     Respondent argues further that even if we find the small

percentage chance of hitting the “sweet spot” to be sufficient to

satisfy the first prong of Dow Chemical, the digital option

spread, and accordingly the BLISS transaction, ultimately lacked

economic substance because Deutsche Bank could in effect prevent

hitting the “sweet spot” either by virtue of its being the

calculation agent or by taking advantage of its large trading

position to move the market and the strike price itself.

     Mr. Murphy testified that pursuant to industry practice

hitting the “sweet spot” was impossible.    Mr. Murphy’s conclusion

centered on Deutsche Bank’s role as calculation agent, which made

this result impossible.    Mr. Murphy’s expert report defined the

calculation agent as the entity, normally the seller of the

digital option structure, that determined whether the payout

event occurred at expiration on the termination date.    Mr. Murphy

explained that to make this determination in 2001, the

calculation agent would contact four other banks for a spot

price.    The other banks would then provide a range within which

they would be willing to buy and sell the particular currency

pair.    Mr. Murphy testified that in 2001 industry practice was

such that the counterparty banks contacted always gave a spread

that was at least 3 pips wide.    Mr. Murphy further explained that
                                   - 28 -

the calculation agent would then choose any rate within the range

provided by the four banks.

     In Mr. Murphy’s view, hitting the “sweet spot” was

impossible because Deutsche Bank was the calculation agent for

the digital option spread and, facing the prospects of making a

large payout to Capital if the “sweet spot” was hit, could simply

choose a rate from those provided by the four other banks that

was most beneficial to Deutsche Bank.           Respondent, relying on Mr.

Murphy’s testimony, argues that hitting the “sweet spot” was

impossible because the option spreads were 2 pips wide and the

market spread was 3 pips wide in accordance with industry

practice. Respondent contends that Deutsche Bank would never use

the “sweet spot” as the calculation rate, thereby allowing itself

to avoid making the large payments required.

     Mr. Murphy provided the following example in his report:

     Example: On the day of expiration at 10:00 AM, the spot FX
     market is trading around the strike prices of the USD/JPY
     option. CPD is long USD/JPY Digital Call with a strike
     price at 127.75 and short a USD/JPY Digital Call with a
     strike price at 127.77. DB calls 4 banks for prices in
     USD/JPY and receives the following quotes:

          i.     Bank   A:   USD/JPY   127.75   -   127.78
          ii.    Bank   B:   USD/JPY   127.74   -   127.77
          iii.   Bank   C:   USD/JPY   127.73   -   127.76
          iv.    Bank   D:   USD/JPY   127.72   -   127.75

     DB has complete discretion as to where the 10:00 AM rate
     should be. DB can determine that all the options are out of
     the money by setting the rate at 127.72, 127.73 or 127.74
     and no payout is made. Alternatively, and less likely, DB
     could set the calculation rate at 127.77 or 127.78 and thus
     both options would have paid out for a small profit to CPB.
                               - 29 -

     The sweet spot would have occurred only if the fixing were
     either 127.75 or 127.76 and DB would have complete
     discretion not to set it at those rates. * * * This shows
     that there was no way the sweet spot was going to be paid
     out.

     In addition to the above arguments, respondent argues that

Deutsche Bank, on account of its ability to make large-volume

trades, would be able to manipulate the market in such a way as

to make sure that the “sweet spot” was unattainable.

          2.    Lack of Business Purpose

     In addition to the digital option spread’s alleged inherent

lack of profitability, respondent argues that the BLISS

transaction served no business purpose because it was developed

as a tax avoidance mechanism and not as an investment strategy.

Respondent contends that the true purpose behind Capital’s

entering into the BLISS transaction was to reduce the

consolidated tax liability of the New Phoenix group of

corporations.   Respondent points to memorandums produced by Mr.

Wray and sent to New Phoenix shareholders, documents related to

the promotion and implementation of the transaction, and Deutsche

Bank’s control over the terms of the contracts.

     Respondent points to memorandums prepared by Mr. Wray and

sent to New Phoenix shareholders on July 31 and December 20,

2001, to support respondent’s contention that the transaction was

entered into for tax avoidance purposes.   The July 31, 2001,

memorandum states in part that New Phoenix planned to take steps
                                  - 30 -

to “reduce the potential tax burden by approximately $2 million”.

The December 20, 2001, memorandum states in part:

     [New Phoenix] has determined, subject to receipt of written
     confirmation of such opinion of tax counsel, to take an
     aggressive tax position which will permit a significantly
     greater proceeds amount * * * from the sale of CPB to be
     distributed to the shareholders.

     Respondent also points to Deutsche Bank’s control over the

terms of the digital option spread contracts, including setting

the possible currencies, the strike prices, the expiration dates,

and the premiums.   Respondent argues that Deutsche Bank’s

limiting of Capital’s potential profit and its own risk shows the

fictional character of the BLISS transaction.

     Lastly respondent argues that the assignment of the options

to Olentangy Partners is evidence of the tax avoidance nature of

the transaction because there was no reason to contribute the

options other than to claim tax benefits.

     B.   Petitioner’s Arguments

           1.   Economic Effect

     Petitioner argues that the digital option spread and the

BLISS transaction did in fact have economic effect.   Petitioner

argues that similar trades were done for purely economic reasons

outside of the potential tax benefits present in the instant

case.

     Petitioner points to testimony by its expert witness, Scott

Hakala, Ph.D. (Dr. Hakala), in support of its argument.   Dr.
                              - 31 -

Hakala earned a Ph.D. in economics, focusing on monetary and

financial theory and international finance from the University of

Minnesota in 1989.   From 1982 to 1992 Dr. Hakala taught courses

in international finance at both the undergraduate and master’s

level at Southern Methodist University.   For the past 15 years

Dr. Hakala has served as a consultant on international finance.

Dr. Hakala concluded that (1) the commercial terms of the digital

option spread were priced consistently with market conditions and

prices, and (2) the digital option spread provided a prospect of

economic gain for Capital.   Dr. Hakala’s conclusions were based

on extensive study of market conditions, trends, and pricing of

the USD/JPY exchange rate for the year before the trade date.

Dr. Hakala testified that this data supported Mr. Wray’s belief

that the U.S. dollar would increase in value relative to the

Japanese yen.

     Petitioner disputes respondent’s contention that Deutsche

Bank had total control over the outcome of the digital option

spread and would never allow Capital to profit because Deutsche

Bank could manipulate the spot rate or manipulate the market to

affect the spot rate.

     Disputing respondent’s expert testimony concerning industry

practices in 2001, petitioner contends that the spot rate was

determined by the Federal Reserve Board and could not be altered

by Deutsche Bank as respondent argues.    Petitioner contends that
                               - 32 -

the confirmation documents and all included terms are governed by

the International Swaps and Derivatives Association, Inc. (ISDA),

and assorted ISDA documents and policies.

     Petitioner further contends that Deutsche Bank had neither

the motivation nor the ability to manipulate the market.

Petitioner argues that Deutsche Bank simply served as a broker-

dealer in this transaction and, acting in accordance with

standard broker-dealer practice, would enter into an offsetting

transaction to the digital option spread.   This offsetting

transaction, petitioner argues, would remove any risk to Deutsche

Bank and any conflict of interest that would cause Deutsche Bank

to selectively choose the market rate.    Petitioner also points to

the size of the foreign exchange market as proof of Deutsche

Bank’s inability to manipulate the market by virtue of its large

trading position, arguing that Deutsche Bank would not attempt to

make large trades in order to move the market because that would

open Deutsche Bank to risk on other contracts with other parties.

          2.   Lack of Business Purpose

     Petitioner disputes respondent’s contention that the digital

option spreads were assigned to Olentangy Partners simply to

produce tax benefits.   Petitioner argues that the digital option

spread was transferred to Olentangy Partners in order to

compensate Mr. Wray.    Mr. Wray testified that over the course of

his time with New Phoenix he was not compensated on a day-to-day
                                  - 33 -

basis but instead would receive equity in New Phoenix according

to the type of work he did for the company.     Mr. Wray further

testified that because he was not compensated on a day-to-day

basis, he would not be able to share any profits that New Phoenix

received on account of the BLISS transaction.     Mr. Wray stated

that transferring the digital option spreads to Olentangy

Partners would allow him, as a partner in the partnership, to

receive a share of any profits in a way that his normal

compensation from New Phoenix would not.

     C.    Conclusion

     We agree with respondent that the BLISS transaction lacks

economic substance and fails the first prong of Dow Chem. Co. v.

United States, 435 F.3d 594 (6th Cir. 2006).

             1.   Economic Loss

     We note at the outset that neither Mr. Wray, New Phoenix,

nor Capital actually suffered a $10 million economic loss during

2001.     The loss claimed as a result of the stepped-up basis in

the Cisco stock was purely fictional.      Although Capital purchased

and sold the long option to Deutsche Bank for a premium, it paid

only the difference between the long and short options.     See Jade

Trading, LLC v. United States, 80 Fed. Cl. at 45; Maguire

Partners-Master Invs., LLC v. United States, 103 AFTR 2d 763,

772, 2009-1 USTC par. 50,215, at 87,444 (C.D. Cal. 2009) (“First,

the claimed basis is fictional, because * * * [the taxpayers]
                              - 34 -

paid only $1.5 million and $675,000, * * * but gained an

increased basis of $101,500,000 and $45,675,000, respectively.”);

see also Kornman & Associates, Inc. v. United States, 527 F.3d

443, 456 (5th Cir. 2008) (“The Trust acknowledges that it only

suffered a $200,000 economic loss in connection with these

transactions, yet it claimed a $102.6 Million tax loss on its

return.”); Cemco Investors, L.L.C. v. United States, 515 F.3d

749, 750-751 (7th Cir. 2008); Klamath Strategic Inv. Fund, L.L.C.

v. United States, 472 F. Supp. 2d 885, 894 (E.D. Tex. 2007).

          2.   Deutsche Bank Controlled the Market Rate

     Petitioner points to Mr. Wray’s testimony concerning his

background and research into currency markets before entering

into the BLISS transaction as evidence that a reasonable investor

would enter into this type of transaction.   While we do not

discount and respondent does not disregard Mr. Wray’s education

and experience in the field of finance, documents prepared by

Jenkens & Gilchrist to promote the BLISS transaction cast doubt

on Mr. Wray’s proffered reasons for entering into the

transaction.   The one-page executive summary discussed above

provided in part that “A business and/or investment reason for

this investment strategy must exist (e.g., the position should

hedge an investment, or currency prices will increase or

decrease, etc.).”   Mr. Wray’s testimony that he decided to enter

into the transaction after researching currency markets served
                               - 35 -

only as an attempt to make an illegitimate transaction appear to

have a legitimate basis.

     Respondent’s experts credibly testified that on the basis of

industry practice the BLISS transaction had no realistic

probability of earning a profit.    As respondent argues, the

documents memorializing the digital option spread list Deutsche

Bank as the calculation agent.    Although petitioner argues that

Deutsche Bank would not intentionally choose a market rate to

avoid making a payment, it is important to note that the

contracts specifically state that neither party owes a fiduciary

duty to the other.    Because Deutsche Bank acted as calculation

agent, and because the strike price of the options was only 2

pips, Deutsche Bank would always be able to choose a market rate

outside that range.    Capital never had a true opportunity to earn

a profit because Deutsche Bank would never let that happen.     To

do so would be to voluntarily make itself liable for payments of

more than $70 million.    See Stobie Creek Invs., LLC v. United

States, 82 Fed. Cl. 636, 693 (2008).

     The digital option spread was a closed transaction and

Olentangy Partners soon disappeared. There could be no chance of

future profits, much less future profits “consistent with the

taxpayer’s actual past conduct.”    Dow Chem. Co. v. United States,

supra at 602 n.14.    A prudent investor would not have entered

into the BLISS transaction.
                               - 36 -

          3.    Contribution to Partnership

     Respondent argues that Capital and Mr. Wray’s formation of

Olentangy Partners was necessary so that Capital could assign its

inflated interest in Olentangy Partners to another asset--the

Cisco stock.    Respondent further contends that this was done for

one reason:    to claim a noneconomic tax loss of more than $10

million when that stock was finally sold.     Respondent concludes

by arguing that this lends support to his argument that the BLISS

transaction lacked economic substance.

     Petitioner argues that the digital option spread was

contributed to Olentangy Partners in order to allow Mr. Wray to

participate in any profits that might be earned.    Mr. Wray also

testified that the digital option spread was contributed in order

to allow him to take part in any profits earned by the

transaction.

     We do not find Mr. Wray credible on this point.    The

contribution of the options to Olentangy Partners was required in

order to claim the tax benefits of the BLISS transaction.     Jade

Trading, LLC v. United States, supra at 46 (“Funneling the trades

through the partnership * * * was crucial for tax purposes to

have the individual partners contribute the spreads to Jade and

redeem the unexercised spreads from Jade in order to generate the

inflated bases.”); Maguire Partners-Master Invs., LLC v. United

States, supra at 772, 2009-1 USTC par. 50,215, at 87,444 (“there
                              - 37 -

is no evidence that the contribution to the partnerships, which

was part of the design of the prepackaged transactions, had any

effect ‘on the investment’s value, quality, or profitability.’

However, the contribution was required for the creation of an

increased basis.”); Stobie Creek Invs., LLC v. United States,

supra at 694 (“This series of routings through the various

investment vehicles * * * nevertheless, were an integral

requirement for achieving the basis-enhancing effects of the J &

G strategy, demonstrating the primary structure and function of

these FXDOT as tax-planning instruments over their nominal

structure and function as investments.”).   By contributing the

digital option spread to Olentangy Partners, Capital was able to

increase its basis in the partnership by the value of the

purchased long option, while ignoring the sold short option under

Helmer v. Commissioner, T.C. Memo. 1975-160, and its progeny.4

     The BLISS transaction executive summary discussed above

sheds light on the decision to contribute the digital option

spread to Olentangy Partners and lends support to respondent’s

argument that the transaction as a whole lacked economic

substance.   Step 3 of the summary provided that




     4
      We do not decide whether Helmer v. Commissioner, T.C. Memo.
1975-160, requires or allows this treatment of the contributed
short option. Because we find the BLISS transaction lacked
economic substance, we do not consider respondent’s alternative
arguments in support of the notice.
                               - 38 -

      Taxpayer contributes the purchased swap entered into to the
      partnership, together with the short swap. This
      contribution should result in taxpayer’s tax basis in his
      partnership or membership interest being equal to the cost
      of the swap contributed. The short sale swap is, more
      likely than not, not treated as a liability for tax
      purposes, achieving this result.

      Absent the benefit of the claimed tax loss, there was

nothing but a cashflow that was negative for all relevant

periods--the “‘hallmark[] of an economic sham’” as the Court of

Appeals for the Sixth Circuit has held.     Dow Chem. Co. v. United

States, 435 F.3d at 602 (quoting Am. Elec. Power Co. v. United

States, 326 F.3d 737, 742 (6th Cir. 2003).    Such a deal lacks

economic substance.   Id.   Because we find that the transaction at

issue lacked economic substance, we do not consider Mr. Wray’s

and Capital’s profit motive in entering into the transaction.

Id.   at 605; Illes v. Commissioner, 982 F.2d at 165; Rose v.

Commissioner, 868 F.2d at 853.    Pursuant to the aforementioned

cases, the BLISS transaction must be ignored for Federal income

tax purposes.   Accordingly, the overstated loss claimed as a

result of the sale of the CISCO stock is disregarded, as is the

flowthrough loss from Olentangy Partners.

      Because we find that the BLISS transaction lacked economic

substance, we do not consider respondent’s alternative arguments

in support of the notice.
                               - 39 -

V.   Fees

      We next consider fees related to the BLISS transaction.   On

its Federal income tax return New Phoenix claimed a deduction of

$500,000 for fees paid to Jenkens & Gilchrist to implement the

BLISS transaction and to provide the written tax opinion.

Petitioner alleges that respondent erred by disallowing the

claimed deduction.

      Respondent argues that petitioner is not entitled to deduct

the legal fees because the transaction at issue lacked economic

substance.    Respondent relies on Winn-Dixie Stores, Inc. & Subs.

v. Commissioner, 113 T.C. 254, 294 (1999), affd. 254 F.3d 1313

(11th Cir. 2001), and Brown v. Commissioner, 85 T.C. 968, 1000

(1985), affd. sub nom. Sochin v. Commissioner, 843 F.2d 351 (9th

Cir. 1988).   Respondent argues that petitioner cannot deduct the

fees because those expenses relate to a transaction that lacks

economic substance.

      Petitioner contends that respondent’s reliance on Winn-Dixie

Stores, Inc. & Subs. and Brown is inappropriate.   Petitioner

argues that the fees at issue in those cases were administrative

fees connected with a disregarded corporate-owned life insurance

plan.   Petitioner, however, argues that the fees paid to Jenkens

& Gilchrist were not administrative fees and are deductible under

Saba Pship. v. Commissioner, T.C. Memo. 1999-359, vacated and

remanded 273 F.3d 1135 (D.C. Cir. 2001).
                              - 40 -

     Petitioner’s reading of Saba Pship. is overly broad.    The

Court in Saba Pship. did not impose a broad rule that all

nonadministrative fees paid in connection with a disregarded

transaction are allowed as deductions.   In Saba Pship., we held

that where the taxpayer’s purchases of private placement notes

(PPNs) and certificates of deposit (CDs) were disregarded for

lack of economic substance, and because the taxpayer was not

required to include in income payments received pursuant to the

purchase and sale of those PPNs and CDs, the taxpayer was not

entitled to deduct fees related to those transactions.     Id.

Where the taxpayer was required to include in income payments

received from their participation in the purchases and sales, it

was allowed to deduct related fees.

     Jenkens & Gilchrist was paid $500,000.   However, the invoice

does not provide any detail concerning what the fees were for; it

simply states that the $500,000 was for legal services rendered.

Jenkens & Gilchrist was intimately involved in the development,

promotion, sale, and implementation of the BLISS transaction and

provided a tax opinion meant to shield the purchaser from

penalties should the transaction be challenged.   A finding that

the BLISS transaction lacks economic substance does not trigger

an inclusion of the type of income to petitioner that justified

the deduction of related fees in Saba Pship. v. Commissioner,

supra.   Capital paid Jenkens & Gilchrist to implement a
                                - 41 -

transaction that we have held lacks economic substance.

Accordingly, petitioner is not entitled to a $500,000 deduction

for legal fees paid to Jenkens & Gilchrist.     See Winn-Dixie

Stores, Inc. & Subs. v. Commissioner, supra at 294; Brown v.

Commissioner, supra at 1000-1001.

VI. Penalties

     Section 6662 imposes an accuracy-related penalty on certain

underpayments of tax, and the amount of the penalty is computed

as a percentage of the underpayment.     The explanation of items

attached to the notice imposed alternative section 6662

penalties, including penalties for a gross valuation

misstatement, negligence, and a substantial understatement of

income tax.     Section 1.6662-2(c), Income Tax Regs., provides that

only one accuracy-related penalty may be imposed with respect to

any given portion of an underpayment, even if that portion is

attributable to more than one of the types of conduct listed in

section 6662(b).    See also Jaroff v. Commissioner, T.C. Memo.

2004-276.

     We will take each penalty in turn and determine whether the

individual penalty applies to petitioner’s underpayment.     Should

we determine that a penalty applies, we will then determine

whether petitioner satisfies the reasonable cause exception in

section 6664(c).    Lastly, should we find that petitioner is

liable for a penalty on one or more grounds, and that petitioner
                              - 42 -

did not satisfy the reasonable cause exception, we will apply the

antistacking provisions to determine how each penalty applies to

the different portions of the underpayment.

     A.   Valuation Misstatement Penalty

     Respondent argues that petitioner is liable for either a

substantial or gross valuation penalty pursuant to section

6662(b)(3) and (e) or (h).   Section 6662(b)(3) imposes a 20-

percent penalty on that portion of an underpayment which results

from a substantial valuation misstatement.     There is a

substantial valuation misstatement if the value of any property

claimed on the return is 200 percent or more of the amount

determined to be the correct amount.     Sec. 6662(e)(1)(A).

Section 6662(h) increases the penalty to 40 percent in the case

of a gross valuation misstatement.     There is a gross valuation

misstatement if the value is 400 percent or more of the value

determined to be the correct amount.     Sec. 6662(h)(2)(A)(i).

     Respondent argues that the gross valuation misstatement

penalty applies because petitioner reported an adjusted basis of

$10,652,936 in the Cisco stock when the stock had a true basis of

$148,474.   Accordingly, respondent contends petitioner’s reported

basis is more than 400 percent of the correct amount and the

gross valuation misstatement penalty applies.

     Petitioner argues that the gross valuation misstatement

penalty does not apply as a matter of law because should we
                              - 43 -

disallow the claimed loss, a basis adjustment would not be

required.   Petitioner argues that should we disallow the loss on

the Cisco stock as a result of a finding that the BLISS

transaction lacked economic substance, the underpayment of tax

would stem from a lack of economic substance, not a valuation

misstatement.   Petitioner points to Heasley v. Commissioner, 902

F.2d 380 (5th Cir. 1990), revg. T.C. Memo. 1988-408, Gainer v.

Commissioner, 893 F.2d 225 (9th Cir. 1990), affg. T.C. Memo.

1988-416, and Todd v. Commissioner, 89 T.C. 912 (1987), affd. 862

F.2d 540 (5th Cir. 1988), in support of this argument.    In

Heasley, the Court of Appeals for the Fifth Circuit held that

     Whenever the I.R.S. totally disallows a deduction or credit,
     the I.R.S. may not penalize the taxpayer for a valuation
     overstatement included in that deduction or credit. In such
     a case, the underpayment is not attributable to a valuation
     overstatement. Instead, it is attributable to claiming an
     improper deduction or credit. * * * [Id. at 383.]

     We begin by noting that Heasley is distinguishable.       In

Heasley, the Court of Appeals reasoned that a valuation penalty

should not apply where a deduction is disallowed in full because

the amount of the taxpayer’s liability does not depend on a

misvaluation; the taxpayer’s liability is based upon the

disallowance of the entire deduction.   Id. at 383 (“In this case,

the Heasleys’ actual tax liability does not differ one cent from

their tax liability with the valuation overstatement included.

In other words, the Heasleys’ valuation overstatement does not

change the amount of tax actually owed.”).   Petitioner had some
                              - 44 -

basis in the Cisco stock apart from the basis claimed as a result

of entering into the BLISS transaction.   Heasley does not apply

because by disallowing overvalued basis we are not disallowing

the entire deduction claimed as a result of the sale of the Cisco

stock.

     Respondent also points to Illes v. Commissioner, 982 F.2d

163 (6th Cir. 1992), and argues that the Court of Appeals for the

Sixth Circuit does not follow the Heasley line of cases.     In

Illes v. Commissioner, supra at 167, the court held that a

valuation misstatement penalty applies in situations in which an

underpayment stems from disallowed deductions or credits due to

lack of economic substance.   In the instant proceeding, the

deficiency resulted directly from the incorrect basis in the

Cisco stock.   New Phoenix reported a basis of $10,652,936 in the

Cisco stock.   The correct basis was $149,958.   The reported basis

is more than 400 percent of the correct basis, and the

underpayment results directly from this overstatement.

Accordingly, petitioner is liable for a 40-percent gross

valuation misstatement penalty.   See id.; see also Pasternak v.

Commissioner, 990 F.2d 893, 903-904 (6th Cir. 1993), affg.

Donahue v. Commissioner, T.C. Memo. 1991-181; cf. Keller v.

Commissioner, 556 F.3d 1056 (9th Cir. 2009), affg. in part and

revg. in part T.C. Memo. 2006-131.
                               - 45 -

     B.    Substantial Understatement of Income Tax

     Respondent argues that petitioner is liable for the 20-

percent accuracy-related penalty for a substantial understatement

of income tax pursuant to section 6662(d).    The 20-percent

accuracy-related penalty will apply where the 40-percent gross

valuation penalty does not.    For corporate taxpayers, there is a

substantial understatement of income tax if 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.    Section 6662(d)(2)(B)(i), however, provides

that the amount of an understatement is reduced for any item that

is supported by substantial authority.    Section 1.6662-4(d)(2),

Income Tax Regs., provides that the substantial authority

standard

     is an objective standard involving an analysis of the law
     and application of the law to relevant facts. The
     substantial authority standard is less stringent than the
     more likely than not standard (the standard that is met when
     there is a greater than 50-percent likelihood of the
     position being upheld), but more stringent than the
     reasonable basis standard as defined in § 1.6662-3(b)(3)
     [Income Tax Regs.]. * * *

Section 6662(d)(2)(C)(i) provides that the reduction for

substantial authority does not apply to tax shelters.    Section

6662(d)(2)(C)(ii) defines the term “tax shelter” as “a

partnership or other entity, * * * any investment plan or

arrangement, or * * * any other plan or arrangement, if a
                                - 46 -

significant purpose of such partnership, entity, plan, or

arrangement is the avoidance or evasion of Federal income tax.”

     Respondent argues that New Phoenix was required to show a

tax of $3,617,883 on its return.    Because New Phoenix reported a

tax of only $261,977, respondent contends New Phoenix understated

its tax liability by $3,355,906, which exceeds both $10,000 and

10 percent of the tax required to be shown on the return.

     Petitioner argues that it did not substantially understate

its income tax because it had substantial authority for the

position taken on its tax return.    Respondent argues that

petitioner should not be able to avail itself of the substantial

authority safe harbor because (1) New Phoenix did not have

substantial authority for its position, and (2) the transaction

was a tax shelter.    Respondent argues that the BLISS transaction,

regardless of outcome, was guaranteed to provide Capital with a

$10 million tax loss and tax avoidance was a significant purpose

of the transaction.

     We find that petitioner lacked substantial authority for the

position taken on its return.    Although petitioner claims to have

relied on caselaw in taking the position that the sold short

option was contingent and not required to be taken into account

when calculating Capital’s basis in Olentangy Partners,

petitioner’s advisers were aware of Government efforts to combat

abusive tax shelters that called that conclusion into question.
                               - 47 -

Before New Phoenix filed its tax returns, Mr. Wray, Mr. Litt, and

Mr. Daugerdas all knew that the Government was investigating

transactions substantially similar to the transaction at issue.

Mr. Litt voiced his concerns to Mr. Wray and spoke with Mr.

Daugerdas on numerous occasions, specifically about section 6662

penalties and how similar the BLISS transaction was to those

transactions described in Notice 2000-44, supra, and subsequent

IRS releases.    These releases cast doubt on any claimed reliance

on Helmer v. Commissioner, T.C. Memo. 1975-160, and its progeny,

and petitioner cannot claim to have had substantial authority for

its return position.    See Jade Trading, LLC v. United States, 80

Fed. Cl. at 58 (“At bottom, the fictional nature of the

transaction and its lack of economic reality outweigh Helmer in

the substantial authority assessment.”); cf. Klamath Strategic

Inv. Fund, L.L.C. v. United States, 440 F. Supp. 2d 608 (E.D.

Tex. 2006).

     Accordingly, petitioner substantially understated its income

tax liability and is liable for a 20-percent accuracy-related

penalty.

     C.    Negligence and Disregard of Rules

     Lastly respondent argues that petitioner is liable for a 20-

percent accuracy-related penalty for negligence and disregard of

rules or regulations.    Section 6662(c) provides that “the term

‘negligence’ includes any failure to make a reasonable attempt to
                              - 48 -

comply with the provisions of this title, and the term

‘disregard’ includes any careless, reckless, or intentional

disregard.”   Section 1.6662-3(b)(1)(ii), Income Tax Regs.,

provides that 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.”

     Respondent argues that the tax benefits from the BLISS

transaction were too good to be true, that petitioner was

negligent, and that petitioner disregarded rules and regulations

in its reporting of the transaction at issue.   Respondent points

to Mr. Wray’s lack of investigation and argues that Mr. Wray

failed to apply his financial background to the digital option

spread.   Respondent contends that Mr. Wray had the financial

acumen to correctly evaluate the profit potential of the digital

option spread and to properly value it.   Respondent further

contends that the disparity between the out-of-pocket costs of

the BLISS transaction and the expected tax benefits would have

alerted a reasonable and prudent person that the benefits were

too good to be true.   Respondent disputes Mr. Wray’s testimony

concerning his research and argues that any research Mr. Wray

eventually did was only meant to serve as a pretext and was done

after deciding to enter into the BLISS transaction.
                                - 49 -

     Lastly respondent argues that petitioner acted negligently

because at the time it reported the BLISS transaction, New

Phoenix and its advisers were aware of the IRS investigation and

position concerning transactions similar to the one at issue, yet

relied on Jenkens & Gilchirst and improperly reported the BLISS

transaction.

     Petitioner argues that it was not negligent because at the

time it entered into the transaction caselaw supported the

position taken on its return.    Petitioner again points to Helmer

v. Commissioner, supra, and other cases holding that assumption

of a contingent liability by a partnership does not reduce a

partner’s basis in that partnership.

     We agree with respondent.    At the time petitioner reported

the BLISS transaction on its return, New Phoenix and its advisers

knew that reliance on Helmer was misplaced.    New Phoenix filed

its return well after the IRS issued Notice 2000-44, supra, was

aware of recent developments in this area of tax law, and did not

seek independent advice to guarantee proper reporting of the

BLISS transaction.   See Neonatology Associates, P.A. v.

Commissioner, 299 F.3d 221, 234 (3d Cir. 2002) (“As highly

educated professionals, the individual taxpayers should have

recognized that it was not likely that by complex manipulation

they could obtain large deductions for their corporations and tax

free income for themselves.”), affg. 115 T.C. 43 (2000).
                               - 50 -

Accordingly, the negligence penalty applies.     See Pasternak v.

Commissioner, 990 F.2d at 903; Stobie Creek Invs., LLC v. United

States, 82 Fed. Cl. at 721; Jade Trading, LLC v. United States,

82 Fed. Cl. at 57; Maguire Partners-Master Invs., LLC v. United

States, 103 AFTR 2d at 778, 2009-1 USTC par. 50,215, at 87,450.

     D.    Reasonable Cause and Good Faith

     Separate from its arguments that it had substantial

authority for its position and did not act negligently,

petitioner argues that it acted with reasonable cause and in good

faith in its reporting of the BLISS transaction because

petitioner obtained a “written tax opinion from a nationally

recognized and well respected law firm”.     Section 6664(c)(1)

provides that “No penalty shall be imposed under section 6662 * *

* with respect to any portion of an underpayment if it is shown

that there was a reasonable cause for such portion and that the

taxpayer acted in good faith with respect to such portion.”       If

petitioner is able to show reasonable cause for the position

taken on its return, the penalties discussed above will not

apply.    The decision as to whether the taxpayer acted with

reasonable cause and good faith depends upon all the facts and

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

factors include the taxpayer’s efforts to assess his proper tax

liability, including the taxpayer’s reasonable and good faith
                                - 51 -

reliance on the advice of a professional such as an accountant or

attorney.

      Petitioner draws support for its reasonable cause and good

faith argument from United States v. Boyle, 469 U.S. 241, 251

(1985), in which the Supreme Court stated that “When an

accountant or attorney advises a taxpayer on a matter of tax law,

such as whether a liability exists, it is reasonable for the

taxpayer to rely on that advice.”

     Respondent concedes that under Boyle taxpayers need not

second-guess their independent, professional advisers, but argues

that Jenkens & Gilchrist was not independent, but rather was a

promoter of the BLISS transaction.       Accordingly, respondent

argues, it was not reasonable for petitioner to rely on an

opinion written by Jenkens & Gilchrist.       Respondent points to

Pasternak v. Commissioner, supra, in support of his position.        In

Pasternak, the Court of Appeals for the Sixth Circuit rejected a

taxpayer’s argument that negligence penalties under section 6653

should not be imposed because the taxpayer relied “on the advice

of ‘financial advisors, industry experts, and professionals’”.

Id. at 903.   The court stated that “the purported experts were

either the promoters themselves or agents of the promoters.

Advice of such persons can hardly be described as that of

‘independent professionals.’”    Id.     In Mortensen v. Commissioner,

440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo. 2004-279, the
                             - 52 -

court further stated that “In order for reliance on professional

tax advice to be reasonable * * * the advice must generally be

from a competent and independent advisor unburdened with a

conflict of interest and not from promoters of the investment.”

     We find petitioner’s reliance on Jenkens & Gilchrist and the

tax opinion to be unreasonable rather than reasonable.   Jenkens &

Gilchrist actively participated in the development, structuring,

promotion, sale, and implementation of the BLISS transaction.

Petitioner was not reasonable in relying on the tax opinion in

the face of such a conflict of interest.   See Neonatology

Associates, P.A. v. Commissioner, supra at 234; Pasternak v.

Commissioner, supra at 903; Illes v. Commissioner, 982 F.2d at

166; Maguire Partners-Master Invs., LLC v. United States, supra

at 778, 2009-1 USTC par. 50,215, at 87,450 (“Furthermore, the

partnerships have failed to demonstrate that they * * * sought

and received disinterested and objective tax advice because the

tax advice that they did receive came from Arthur Andersen, which

also arranged the transactions resulting in the increased basis

that is at issue in this case.”); Stobie Creek Invs., LLC v.

United States, supra at 715 (“The evidence nonetheless

unequivocally establishes that both J & G and SLK were tainted by

conflict-of-interest.”).

     As discussed above, Mr. Litt had concerns about the

reporting of the BLISS transaction.   Mr. Litt informed Mr. Wray
                                - 53 -

of these concerns and had numerous discussions with Mr. Daugerdas

centered on the applicability of section 6662 penalties and

recent IRS developments.    Mr. Litt also sent Mr. Wray copies of

tax publication articles detailing the Treasury Department and

the IRS’ actions concerning alleged abusive tax shelters.    See

Maguire Partners-Master Invs., LLC v. United States, supra at

778, 2009-1 USTC par. 50,215, at 87,450.

     These documents show that at the time New Phoenix and its

advisers were considering the proper reporting of the

transaction, Mr. Litt and Mr. Wray were aware that the Government

was investigating transactions similar to the transaction at

issue.    These concerns should have put New Phoenix on notice that

the reporting of the BLISS transaction as recommended by Jenkens

& Gilchrist was unacceptable.     Petitioner should have also known

that Jenkens & Gilchrist had a personal stake in the BLISS

transaction and could not be relied upon to provide independent

advice.   That petitioner’s independent advisers had significant

questions about the BLISS transaction should have caused Mr. Wray

to question Jenkens & Gilchrist’s assurances that the transaction

was reported properly.     These factors should have put petitioner

on notice that reliance on Jenkens & Gilchrist was unreasonable

and that petitioner would have to consult with independent

counsel in order to determine the propriety of New Phoenix’s

reporting.   See Pasternak v. Commissioner, 990 F.2d at 903; Illes
                             - 54 -

v. Commissioner, supra at 166; see also Watson v. Commissioner,

T.C. Memo. 2008-276; Ghose v. Commissioner, T.C. Memo. 2008-80.

It was unreasonable for petitioner and Mr. Wray to rely on

Jenkens & Gilchrist in view of the surrounding facts.

     In summary, Jenkens & Gilchrist’s conflict of interest and

petitioner’s knowledge of recent developments in tax law should

have convinced petitioner of the need for further investigation

into the proper reporting of the BLISS transaction.   Petitioner

claimed a fictional loss of nearly $11 million.   This is exactly

the type of “too good to be true” transaction that should cause

taxpayers to seek out competent advice from independent advisers.

See Neonatology Associates, P.A. v. Commissioner, 299 F.3d at 234

(“When, as here, a taxpayer is presented with what would appear

to be a fabulous opportunity to avoid tax obligations, he should

recognize that he proceeds at his own peril.”); Stobie Creek

Invs., LLC v. United States, supra at 716 (relying on Neonatology

Associates, P.A., holding that the Jenkens & Gilchrist strategy

is the type that should appear to be too good to be true).

Petitioner’s decision to rely exclusively on Jenkens & Gilchrist

in reporting the BLISS transaction was therefore not reasonable.

Petitioner did not have reasonable cause for its position and did

not take that position in good faith.   Accordingly, petitioner

remains liable for the section 6662 penalties.
                                - 55 -

     E.   Conclusion

     Only one accuracy-related penalty may be applied with

respect to any given portion of an underpayment, even if that

portion is characterized by more than one of the types of conduct

described in section 6662(b).    Sec. 1.6662-2(c), Income Tax Regs.

As discussed above, petitioner is liable for an accuracy-related

penalty because of a gross valuation misstatement, a substantial

understatement of income tax, and negligence.   Section 1.6662-

2(c), Income Tax Regs., prevents the Commissioner from stacking

these amounts to impose a penalty greater than the maximum

penalty of 20 percent on any given portion of an underpayment (or

40 percent if such portion is attributable to a gross valuation

misstatement).   See Jaroff v. Commissioner, T.C. Memo. 2004-276.

     Accordingly, petitioner is liable for the 40-percent

accuracy-related penalty on that portion of the underpayment

stemming from its overvaluation of the Cisco stock, and a 20-

percent accuracy-related penalty on the remainder of the

underpayment stemming from the disallowed flowthrough loss from

Olentangy Partners and from the disallowed deduction for payments

made to Jenkens & Gilchrist.
                               - 56 -



VII.   Conclusion

       Respondent’s determinations in the notice are upheld, and

petitioner is liable for the section 6662 accuracy-related

penalty.

       Accordingly,


                                          Decision will be entered

                                     for respondent.
