                        T.C. Memo. 2002-108



                      UNITED STATES TAX COURT



          JERRY L. THOMAS AND FREDA THOMAS, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 18729-99.                Filed April 30, 2002.



     David D. Aughtry and David R. Mackusik, for petitioners.

     William L. Blagg, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Respondent determined deficiencies in

petitioners’ 1991, 1993, 1994, and 1995 Federal income taxes and
                                - 2 -

accuracy-related penalties under section 6662(a).1      The amounts

of these determinations are as follows:

                                        Accuracy-related penalty
   Year            Deficiency                sec.6662(a)
   1991            $125,996                    - 0 -
   1993              69,018                   $13,804
   1994             581,181                   116,236
   1995               2,247                       449

     Following concessions, we must decide:

     1.   Whether certain transactions increased the basis of

Jerry L. Thomas (Jerry) in two S corporations named Ram

Extrusions, Inc. (Ram), and Innovative Fibers, Inc. (Innovative),

and one limited liability company named Twist-Tex, LLC (Twist-

Tex).

     2.   Whether certain payments made to Jerry in connection

with his sale of his interest in Conquest Carpet Mills, Inc.

(Conquest), are taxable as capital gains or ordinary income.

     3.   Whether petitioners are liable for the accuracy-related

penalties respondent determined for 1993 and 1994.

                         FINDINGS OF FACT

     Some facts were stipulated.   We incorporate herein by this

reference the parties’ stipulation of facts and the exhibits

submitted therewith.   We find the stipulated facts accordingly.

Petitioners are married individuals who filed joint Federal



     1
       Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue. Rule
references are to the Tax Court Rules of Practice and Procedure.
                               - 3 -

income tax returns for the subject years.     Jerry and his wife,

Freda, resided in Georgia and South Carolina, respectively, when

their petition was filed.

Bases in Ram, Innovative, and Twist-Tex

     Jerry works in the carpet industry and owns or has owned

interests in various companies.   These companies include:

(1) Ram, Innovative, and three other S corporations named

American Extrusions (American), Thomas Service Industries, Inc.

(TSI), and Mattel Carpet & Rug, Inc. (Mattel), (2) Twist-Tex and

one other limited liability company named U.S. Extrusions, and

(3) one C corporation named Inter-Con Trading Group, Inc. (Inter-

Con).   Jerry’s ownership interests in these eight entities were

as follows:

                                       1994   1995   1996   1997

     American                           35%    35%   35%   35%
     Innovative                         -0-    25    25    25
     Inter-Con Trading Group, Inc.     100    100   100   100
     Mattel1                            50     50    50    50
     Ram                                -0-    25    25    25
     TSI                               100    100   100   100
     Twist-Tex                          -0-    33.3 33.3 33.3
     U.S. Extrusions                    -0-   -0-    33.3 33.3
          1
             Mattel’s only other shareholder during these
     years was Jerry’s brother Mike.

     Petitioners contend that Jerry had sufficient bases in

certain of the passthrough entities to allow him to carry back

losses incurred in subsequent years.    For 1995, Jerry’s

distributive share of Ram’s ordinary loss was $1,231,845, and his
                                - 4 -

basis in Ram was at least $1,150,000.      That minimum basis does

not reflect certain disputed items (1995 disputed items) related

to Ram’s receipt of two checks in late 1995.      First, on

November 16, 1995, Inter-Con wrote a $60,000 check to Ram,

Inter-Con wrote a $65,000 check to Twist-Tex, and TSI wrote a

$125,000 check to Inter-Con to cover the two checks that it wrote

(November Inter-Con payment).   TSI’s 1995 books and records

(collectively, records) treated the $125,000 check to Inter-Con

as a loan receivable from Ram and Twist-Tex.      Ram’s 1995 and 1996

records treated the $60,000 check as a note payable to Inter-Con.

Inter-Con’s 1995 records treated the $60,000 and $65,000 checks

as notes receivable from Ram and Twist-Tex, respectively, and

treated the $125,000 check as a note payable to TSI.      Second, on

December 5, 1995, Jerry’s brother Perry (Perry) wrote Ram a

$100,000 check, and TSI wrote Perry a $100,000 check to cover the

clearance of Perry’s check (December 1995 payment).      TSI’s 1995

records treated its $100,000 check as a loan receivable from

Perry/Ram.   Ram’s 1995 records initially treated its receipt of

Perry’s $100,000 check as a loan from Jerry to Ram.      That

treatment was changed as of the end of that year to show the

check as a loan from Perry to Ram.      Ram’s 1996 records treated

its receipt of Perry’s $100,000 check as a note payable to Perry.

     During 1996, respondent commenced his examination of

petitioners for the subject years and requested substantiation of
                              - 5 -

Jerry’s bases in various S corporations.   During 1997, the 1995

advances from Perry and Inter-Con were reclassified on Ram’s

books (by Ram) first as a note payable to Jerry and then as

additional paid-in capital of Jerry.

     For 1996, Jerry’s distributive share of Ram’s ordinary loss

was $805,269, and his basis in Ram was at least $260,000.     That

minimum basis does not reflect certain other disputed items (1996

disputed items) set forth below:

          Date            Description                Amount

          1/3/96    TSI check to Inter-Con           $28,000
                      and Inter-Con check to Ram
         1/10/96    TSI check to Inter-Con
                      and Inter-Con check to Ram      75,000
         3/20/96    Mattel check to Jerry,
                      deposited in Inter-Con
                      account and Inter-Con
                      check to Ram                   200,000
          4/4/96    TSI check to Ram                 100,000
         5/17/96    Emerald Carpets1 check
                      to American, endorsed by
                      Ram and deposited in
                      Ram’s bank account             300,000
         7/10/96    Mattel check to Inter-Con
                      and Inter-Con check to Ram     200,000
     12/18/96       Mattel check to Regions
                      Bank and Regions Bank
                      check to Ram                  100,000
     1
       The check to American from Emerald, a third party
corporation unrelated to Jerry, was evidenced by a promissory
note from American to Emerald.

     Ram’s 1996 records reported the $503,000 of these checks

written by Inter-Con to Ram as a note payable to Inter-Con.    That

treatment was reclassified by Ram in 1997 to report the checks

first as a note payable to Jerry and then as additional paid-in
                               - 6 -

capital of Jerry.   The $200,000 in checks written by Mattel were

treated on Mattel’s 1996 records as notes payable to TSI.    Mattel

changed that treatment in 1997 to report the checks as notes

payable to Jerry.

     The balance sheets of TSI for 1995 and 1996 and the balance

sheets of Inter-Con for 1995, 1996, and 1997 showed no loans to

shareholders.   Mattel’s balance sheets for the periods ended

September 30, 1996 and 1997, also showed no loans to

shareholders.

Payments Related To Conquest Sale

     In 1981, Jerry and Paul Walker (Walker) incorporated

Conquest, and they equally owned all of Conquest’s stock until

they sold the stock in 1988.   On or about June 10, 1988, Walker,

Jerry, Penta Enterprises, Inc. (Penta), Beaulieu of America,

Inc., and D&W Carpet & Rug Co., Inc., entered into a stock

acquisition agreement (stock acquisition agreement) providing,

inter alia, that (1) Walker and Jerry shall sell to Penta 100

percent of the issued and outstanding capital stock in Conquest;

(2) the closing of the sale shall take place on or about June 28,

1998; (3) the parties shall enter into “Non-Compete Agreements,”

“Employment Agreements,” “Promissory Notes,” and “Guaranty

Agreements” substantially in the form attached to the Stock

Acquisition Agreement.
                                 - 7 -

    The relevant provisions of the stock acquisition agreement

provided:

    9.     PURCHASE PRICE.

            Subject to the adjustments set forth in
            Section 12 hereof, the “purchase price” of
            the Stock shall be Eight Million
            ($8,000,000.00) Dollars in the aggregate,
            which shall be paid as follows:

                 (a) $3,000,000.00 to each Seller in
            cash or immediately available funds; and

                 (b) $1,000,000.00 to each Seller in 10-
            year promissory notes (collectively referred
            to hereinafter as the “Notes”) substantially
            in the form of Exhibit “R” hereto and bearing
            interest in the case of Thomas, at 8-1/4% per
            annum, and in the case of Walker at 7-7/8%
            per annum.

                 *    *      *   *       *   *   *

    10C.     CONDITIONS TO CLOSING BY EACH PARTY HERETO.

            The obligations of each party hereto to
            consummate the transactions contemplated
            hereby shall be subject to the satisfaction
            (or waiver by such party) on or prior to the
            Closing of the following conditions
            precedent:

                 *    *      *   *       *   *   *

                 (c) The Company shall have entered into
            agreements substantially in the form of
            Exhibit “W” attached hereto, with Walker and
            Thomas, pursuant to which, in consideration
            of their agreement to refrain (in the case of
            Walker for 10 years and in the case of Thomas
            for 6 years) from competing with the Company
            directly or indirectly in the sale or
            manufacture of carpet and carpet products
            (including outdoor carpet), (A) Walker shall
            be paid $8,500,000 in 37 quarterly
            installments of $229,730, commencing on the
                          - 8 -

      first anniversary of the Closing, and (B)
      Thomas shall be paid $7,500,000 in 21
      quarterly installments of $357,143,
      commencing on the first anniversary of the
      Closing. (Such agreements are sometimes
      collectively referred to herein as the
      “Noncompete Agreements”).

           *    *    *    *       *   *   *

12.   PURCHASE PRICE ADJUSTMENTS.

           (a) The parties acknowledge that the
      purchase price is based upon Sellers’
      representation that the Company’s net worth
      (as defined below) at June 4, 1988 will be
      $8,000,000.00. A certified audit of the
      Company will be conducted as of June 4, 1988
      by Peat Marwick, Main & Company (or such
      independent public accountants as are
      satisfactory to Buyer and Sellers) (said
      audit being sometimes referred to herein as
      the “June 4, 1988 Audit”). If said audit
      determines that the net worth of the company
      is less than or greater than as so
      represented by Sellers, then the purchase
      price shall be adjusted in accordance with
      the following formula:

           (i) The portion of the purchase
           price payable to each Seller shall
           be reduced one dollar ($1.00) for
           each dollar that net worth of the
           Company as at June 4, 1988 is below
           $8,000,000.00.

           (ii) The portion of the purchase
           price payable to each Seller shall
           be increased one-half dollar ($.50)
           for each dollar that net worth of
           the Company as at June 4, 1988 is
           above $8,000,000.00.

For the purpose of this Section and June 4, 1988 Audit,
“net worth” shall be the stockholders’ equity
determined as of such date on the accrual basis in
accordance with generally accepted accounting
principles consistently applied less (i) the amount
                                  - 9 -

    payable to the Sellers pursuant to Subsection (b) of
    this Section 12 below, (ii) all receivables from
    Dynasty Carpet, to the extent not already written off,
    and (iii) the amount of all distributions made during
    the current fiscal year which are chargeable to
    stockholders’ equity and which have not already been so
    charged.

                 *    *   *       *       *   *   *

    15. Miscellaneous.

    * * * This Agreement contains the entire agreement of
    the parties hereto with respect to the subject matter
    hereof and there are no representations, warranties,
    agreements, undertakings, or conditions, express or
    implied, except as set forth herein. This Agreement
    may not be amended, supplemented or otherwise modified,
    except by an instrument in writing, signed by each of
    the parties hereto. Whenever used herein, (i) the
    terms “this Agreement”, “herein”, “hereunder”,
    “hereby”, and words of similar import shall be deemed
    to mean this instrument together with all attachments
    hereto. * * *

    The relevant portions of Jerry’s noncompete agreement

provided:

    3.      Seller’s Covenants.

     * * * Seller hereby covenants and agrees that he will
     not, directly or indirectly, during the period
     commencing on the date hereof and ending six years
     hereafter: (i) disclose * * * Confidential Information
     known to him; (ii) own, manage, operate, join control,
     assist, participate in or be connected with, directly
     or indirectly (and including as an officer, director,
     shareholder, partner, proprietor, consultant,
     independent contractor or lender), any person who is
     directly or indirectly in competition within the
     Territory [anyplace the Company is doing business on
     the date of the agreement] with the Business of the
     Company [manufacture and sale of carpets (including
     outdoor carpet), rugs or yarn or any activities
     ancillary thereto, but not including the manufacture
     and sales of chemicals, plastic wrap or cores]
                        - 10 -

4.   Payments for Non-Competition.

In consideration of the Seller’s covenants set forth in
paragraph 3 hereof, the Company [Conquest] promises to
pay the Seller [Jerry] the aggregate sum of
$7,500,000.00 payable (in each case with a five day
grace period) in 21 quarterly installments of
$357,143.00 commencing on the first anniversary of the
date hereof.

          *    *    *    *    *      *   *

7.   The parties hereto acknowledge that Mattel Carpet
& Rugs, Inc. (“Mattel”) and the Company [Conquest] have
been engaged in the manufacture and sale of certain
similar products in the same market, and that they
purchase products from one another and may be in
competition with one another in certain market
segments, and the parties acknowledge that Mattel and
the Company will continue to purchase, manufacture and
sell such products. Anything to the contrary herein
notwithstanding, Seller shall be permitted to own an
interest in and be involved in the management of (i)
Thomas Services Industries, Inc., provided that such
corporation does not compete with the Business of the
Company, (ii) Hawk Extrusions, Inc., provided that such
corporation does not compete with the Business of the
Company other than engaging in the extrusion of bulk
continuous filament (BCF) yarn, and (iii) Mattel
provided that (a) Mattel does not own or operate any
extrusion units, finishing range ovens, carpet backing
ovens, twist, ply and heat set equipment, dying
equipment or tufting equipment, (b) Mattel does not
enter any new market segments in competition with the
Business of the Company, and (c) if Mattel introduces
new products into markets that Mattel is currently in,
Mattel will purchase such new products from the
Company, D&W Carpet & Rug Co., Inc. (“D&W”) or Beaulieu
of American, Inc. (“Beaulieu”) at the following prices:
(1) level loop products – cost plus 8% and (2) grass
(indoor/outdoor) - cost plus 10%; provided, however,
that in the event that (A) neither the Company,
Beaulieu nor D&W elects to manufacture and sell such
new products to Mattel, or (B) the prices offered by
the Company, D&W and Beaulieu are not competitive and
Mattel can either purchase or manufacture such new
products below the prices offered by the Company, D&W
or Mattel, then, in either such event, Mattel may
                              - 11 -

     purchase from other sources or manufacture and sell
     such products without Seller being deemed to have
     breached this Agreement. The ownership of an interest
     in or the involvement in the management of Mattel at a
     time when Mattel owns or operates any extrusion units,
     finishing range ovens, carpet backing ovens, twist, ply
     or heat set equipment, dying equipment or tufting
     equipment shall be deemed to constitute an intentional
     breach hereof by Seller for purposes of Section 4
     hereof. The ownership of an interest in or the
     involvement in the management of Mattel at a time when
     Mattel engages in the manufacture or sale of one or
     more new products (except as permitted by clause (c)
     above) or enters into one or more new markets in
     competition with the Business of the Company shall be
     deemed to constitute an unintentional breach hereof by
     Seller.

     When the stock acquisition and noncompete agreements were

signed, Mattel was equally owned by Jerry and his brother Ronald

(Ronald).   In the fall of 1989, M.E. Ralston (Ralston), an

officer and a 50-percent owner of Conquest, purchased Ronald’s

interest in Mattel.2   A clause in the purchase agreement

provided:

     I [Ralston] will cause Jerry Thomas’s noncompete
     agreement with Conquest Carpet Mills, Inc. to be
     modified in such a manner that neither his
     participation in Specialty [Mattel] nor the loaning of
     money by him to Specialty [Mattel], Turftcraft, or you
     [Ronald] will be in violation of such agreement.

     After Ralston purchased an interest in Mattel, Conquest did

not enforce the provisions of Jerry’s noncompete agreement as to



     2
       After Ralston’s purchase, the company changed its name to
Specialty Carpets, Inc. The right to use the Mattel name was
retained by Ronald, who continued to sell carpet in the
hospitality market. For clarity, we refer to the company as
Mattel throughout this opinion.
                                - 12 -

his involvement with Mattel.    Ralston gave permission to Jerry

for Mattel to compete with Conquest without restriction and to do

whatever was necessary to make Mattel profitable.       From 1990

onward, Mattel introduced new products and entered new markets

without complying with the terms of Jerry’s noncompete agreement.

     Jerry received the following payments attributable to his

noncompete agreement:

                     Year                Amount

                     1989             $589,031
                     1990              987,263
                     1991            1,068,711
                     1992            1,785,715
                     1993            1,071,429
                     1994            1,071,926

Other Facts

     Jerry was an active trader of securities.       During 1992, he

made 322 security trades through licensed brokers.       In 1993, he

made through brokers approximately 226 sales and 285 purchases of

securities having total values of $15,255,341 and $16,465,415,

respectively.   In 1994, he made through brokers approximately 294

sales and 420 purchases of securities having total values of

$19,822,148 and $22,688,408, respectively.        Petitioners reported

these activities on their Federal income tax returns as resulting

in capital gains in 1992 and resulting in ordinary losses in

1993, 1994, and 1995.   Respondent determined, and petitioners

have since conceded, that the losses in 1993, 1994, and 1995 were

reportable as capital losses.
                                - 13 -

                                OPINION

I.   Basis

      Petitioners claim an entitlement to carry back and deduct

for 1994 their proportionate share of Ram’s losses from 1995 and

1996.     A shareholder of an S corporation may take into account

his or her pro rata share of the S corporation’s loss.        Sec.

1366(a)(1).     A shareholder’s deduction of that loss, however, is

limited to the amount that equals his or her adjusted basis in:

(1) The S corporation’s stock and (2) any indebtedness of the S

corporation to the shareholder (collectively, S corporation

investment).     Sec. 1366(d)(1).    Any loss so limited and thereby

disallowed in a particular taxable year may be carried forward

indefinitely.     Sec. 1366(d)(2).   To deduct their pro rata share

of Ram’s losses, petitioners must prove that they had sufficient

adjusted basis in their S corporation investment in Ram.3

      The parties disagree on whether the disputed transactions

increased Jerry’s adjusted basis in Ram.      Each of those

transactions involved funds provided to Ram directly from someone

other than Jerry.     Petitioners contend that Jerry indirectly




      3
       Sec. 7491(a), which places the burden of proof upon the
Commissioner in specified circumstances, is inapplicable to this
case. Sec. 7491(a) applies only to court proceedings arising
from examinations commencing after July 22, 1998. Internal
Revenue Service Restructuring and Reform Act of 1998, Pub. L.
105-206, sec. 3001(c), 112 Stat. 727.
                                - 14 -

provided those funds and that the disputed transactions increased

their basis in Ram.

     The decided cases have established certain principles

concerning when a shareholder may claim increased basis in an S

corporation investment.   First, there must be an actual economic

outlay by the taxpayer who claims the basis increase.     Underwood

v. Commissioner, 535 F.2d 309 (5th Cir. 1976) (rearrangement by

way of exchange of notes in respect of loan of funds by a C

corporation to an S corporation insufficient), affg. 63 T.C. 468

(1975); Estate of Leavitt v. Commissioner, 90 T.C. 206 (1988)

(existence of a contingent liability of a shareholder as

guarantor insufficient), affd. 875 F.2d 420 (4th Cir. 1989);

Perry v. Commissioner, 54 T.C. 1293, 1296 (1970) (exchange of

notes between shareholder and S corporation insufficient), affd.

27 AFTR 2d 71-1464, 71-2 USTC par. 9502 (8th Cir. 1971).     Second,

the indebtedness of the S corporation must run directly to the

shareholder claiming an increase in basis; an indebtedness of an

S corporation to an entity with passthrough characteristics which

advanced the funds and is closely related to the taxpayer does

not satisfy this requirement.    See, e.g., Frankel v.

Commissioner, 61 T.C. 343 (1973) (partnership), affd. without

published opinion 506 F.2d 1051 (3d Cir. 1974); Prashker v.

Commissioner, 59 T.C. 172 (1972) (estate); Burnstein v.

Commissioner, T.C. Memo. 1984-74 (S corporation).
                              - 15 -

     To prevail in this case, petitioners must prove that Jerry,

as opposed to one of his entities, invested in Ram.   E.g.,

Prashker v. Commissioner, supra at 176 (where the estate of which

the taxpayer was executrix and the sole beneficiary advanced

funds to an S corporation of which she was a 50-percent

shareholder, the Court noted that “the key question is whether or

not the debt of the corporation runs ‘directly to the

shareholder’”).   In other words, petitioners must prove that they

made the economic outlay and that the disputed transactions

created indebtedness on the part of Ram that ran directly to

Jerry.   Id. (“a shareholder could borrow the money personally and

then loan the money to the corporation.   In that event the

corporation’s debt would run directly to the shareholder”);

accord Hitchins v. Commissioner, 103 T.C. 711, 715 (1994) (where

the Court stated that an indebtedness to an entity with

pass-through characteristics that had advanced the funds to the S

corporation and was closely related to the taxpayer generally did

not satisfy the statutory requirements necessary to increase a

shareholder’s basis).

     In a limited number of situations, the fact that the

borrowed funds originate with a closely related entity will not

preclude a finding that the indebtedness of the S corporation

runs directly to the shareholder and amounts to an economic

outlay by the shareholder.   See Culnen v. Commissioner, T.C.
                               - 16 -

Memo. 2000-139; see also Yates v. Commissioner, T.C. Memo.

2001-280.    In cases where a shareholder claims basis in an S

corporation for funds advanced initially by a related entity, the

Court will closely scrutinize the facts surrounding the transfer

of funds to determine whether they establish a relationship that

allows the shareholder to satisfy the requirements for an

increase in basis.    “Ordinarily, taxpayers are bound by the form

of the transaction they have chosen; taxpayers may not in

hindsight recast the transaction as one that they might have made

in order to obtain tax advantages.”     Harris v. United States,

902 F.2d 439, 443 (5th Cir. 1990); see also Estate of Leavitt v.

Commissioner, 875 F.2d at 423 (“taxpayers are liable for the tax

consequences of the transaction they actually execute and may not

reap the benefit of recasting the transaction into another one

substantially different in economic effect that they might have

made”).

     In a case where a C corporation acted as the agent of a

shareholder in disbursing funds to an S corporation, and the S

corporation acknowledged a direct debt to the shareholder and not

to the C corporation, the Court held that the shareholder’s basis

in the S corporation was increased.     Culnen v. Commissioner,

supra.    The Court found that the shareholder’s loan account in

his wholly owned C corporation was debited when he requested

funds be disbursed to the S corporation to allow the shareholder
                                - 17 -

to invest in the S corporation.    The Court found that the S

corporation recorded the funds received as a loan from the

shareholder and that the disbursing C corporation reported the

funds disbursed as a loan to the shareholder.

     Here, each of the disputed transactions involved a third

party providing funds to Ram.    In order to determine whether any

of these transactions increased Jerry’s basis in Ram, we examine

each transaction individually.

1995 Disputed Items

     The November Inter-Con Payment

     Inter-Con is a C corporation that is wholly owned by Jerry.

The record does not disclose credible evidence that supports a

finding that the $60,000 Ram received was a loan from Jerry.    In

fact, Inter-Con’s 1995 trial balance records a $60,000 receivable

from Ram and shows no evidence of any loans to shareholders.4

     Petitioners rely, in part, on a $60,000 promissory note

purportedly executed by Ram in favor of Jerry on November 11,

1995, to support a proposed finding that the November Inter-Con

payment created a direct indebtedness to Jerry.    We give no

weight to this note.   It predates the November 16, 1995,


     4
       The general ledgers of TSI and Inter-Con for the relevant
years were not introduced into evidence. Petitioners’ failure to
introduce these records into evidence leads us to conclude that
the records would have treated the disputed transactions as
intercompany loans rather than as loans from Jerry. Wichita
Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946), affd.
162 F.2d 513 (10th Cir. 1947).
                               - 18 -

transaction.    Moreover, we find incredible petitioners’

explanation for why Inter-Con, rather than Jerry, provided the

funds to Ram.    According to petitioners, it was more convenient

to use the Inter-Con account rather than Jerry’s personal account

that was kept approximately 30 miles from Ram’s offices.    We

consider this explanation to be an unsupported, after-the-fact

rationalization in support of petitioners’ position as to the

loans.   We conclude that Jerry may not increase his basis in Ram

on account of the $60,000 November Inter-Con payment.5

December 1995 Payment

     Perry wrote a $100,000 check to Ram on December 5, 1995, and

TSI reimbursed Perry on the same day.    Perry testified that he

advanced these funds on his brother’s behalf, that he did not

have sufficient personal funds to cover his check without being

reimbursed by Jerry, and that he considered the funds he received

from TSI as coming from Jerry.    The parties also stipulated a

$100,000 promissory note dated December 5, 1995, executed by Ram

in favor of Jerry.    We find this evidence, in light of the

credible evidence in the record, to be inadequate to meet

petitioners’ burden as to this transaction.    On the basis of the

record as a whole, we simply cannot conclude that this $100,000

payment constituted an economic outlay by Jerry or that it


     5
       For similar reasons, we also conclude that Jerry may not
increase his basis in Twist-Tex on account of the $65,000
November Inter-Con payment.
                               - 19 -

created a direct indebtedness of Ram to Jerry.    We conclude that

Jerry’s basis in Ram for 1995 may not be increased by this

amount.

1996 Disputed Items

     1/3/96 and 1/10/96 Payments

     We do not find any credible evidence in the record that

Inter-Con was an agent for Jerry when it transferred the relevant

funds.    We conclude that Jerry is not entitled to increase his

basis in Ram on account of either of these payments.

     3/20/96 Payment

     On March 20, 1996, Mattel wrote a $200,000 check to Jerry,

and Jerry deposited the check in Inter-Con’s account.    One day

later, Inter-Con wrote a $200,000 check to Ram.    We have received

no credible explanation of why funds payable to Jerry were

deposited in Inter-Con’s account.

     Petitioners selected the form of the funds flow and are

bound by the form they selected.    Harris v. United States, supra

at 443.    Moreover, they offered no credible explanation why we

should not respect the form of this transaction.    That form

supports the conclusion of an investment in or loan to Inter-Con

by Jerry and a loan by Inter-Con to Ram.

In these circumstances, petitioners failed to meet their burden

of proving that Inter-Con advanced funds to Ram as Jerry’s agent,

that direct indebtedness resulted from Ram to Jerry, or that
                                - 20 -

Jerry made the required economic outlay.    Jerry is not entitled

to increase his basis in Ram by this payment.

     4/4/96 Payment

     Petitioners claim to be entitled to increase their basis in

Ram by $100,000 because of this payment.    Petitioners argue that

TSI acted as Jerry’s agent in advancing the $100,000 to Ram.

Petitioners point to the date of this $100,000 check and to a

non-interest-bearing note from Ram to Jerry of the same date and

in the same face amount.    On the basis of the record as a whole,

we are unpersuaded that this payment constituted an economic

outlay by Jerry or that it created a direct indebtedness of Ram

to Jerry.   Jerry’s basis in Ram for 1996 may not be increased by

this amount.

     05/17/96 Payment

     On May 17, 1996, American borrowed $300,000 from Emerald

Carpets, Inc.   The obligation is secured by guaranties by Walker

and Jerry and is evidenced by an interest-bearing promissory note

of the same date.     Emerald Carpet, Inc., provided these funds by

writing a $300,000 check to American which was deposited into

Ram’s bank account.

     Petitioners claim that this transaction entitles them to

basis of $120,000 in Ram and basis of $30,000 in Innovative.

Petitioners point to a $120,000 non-interest-bearing promissory

note from Ram to Jerry dated June 1, 1996, and a $30,000 non-
                                - 21 -

interest-bearing promissory note from Innovative to Jerry dated

May 22, 1996, as evidence of Ram’s and Innovative’s direct

indebtedness to Jerry.

     The form of this transaction supports a conclusion that

there was an investment or loan by American in or to Ram.    As a

mere guarantor of the American debt, Jerry may neither increase

his basis in American, Estate of Leavitt v. Commissioner, 90 T.C.

206 (1988), nor increase his basis in Ram by virtue of American’s

investment and his partial ownership of American, Frankel v.

Commissioner, 61 T.C. 343 (1973), affd. without published opinion

506 F.2d 1051 (3d Cir. 1974).    In these circumstances,

petitioners failed to meet their burden of proving that American

advanced funds to Ram as Jerry’s agent, that direct indebtedness

from Ram to Jerry resulted from American’s endorsing the Emerald

check to Ram, or that Jerry made the required economic outlay.

Jerry may not increase his basis in Ram by the $120,000 advanced

to Ram (a portion of the $300,000 advanced).    Nor may he increase

his basis in Innovative by $30,000 as a result of this

transaction.

     7/10/96 Payment

     Petitioners assert that the Mattel check issued to Inter-Con

was to repay part of Mattel’s indebtedness to Jerry.    The parties

have stipulated that initially the transaction was reflected on

Mattel’s books as a $200,000 reduction to a note payable to TSI.
                               - 22 -

Mattel’s 1997 books were later changed to reflect that the note

was payable to Jerry rather than TSI, and the amendment was made

by marking through “TSI” and writing “Jerry Thomas” thereafter.

Ram executed a $200,000 promissory note dated July 10, 1996, to

Jerry.   On Ram’s 1996 balance sheet, which was prepared after

respondent commenced his audit, this transaction is shown as part

of $1,968,000 due to Jerry.

     The form of the transaction supports a conclusion that there

was an investment or loan by Inter-Con in or to Ram.      In these

circumstances, petitioners failed to meet their burden of proving

that Inter-Con advanced funds to Ram as Jerry’s agent, that

direct indebtedness resulted from Ram to Jerry, or that Jerry

made the required economic outlay.      Jerry may not increase his

basis in Ram by the $200,000 advanced by Inter-Con to Ram.

     12/18/96 Payment

     On December 18, 1996, Mattel wrote a $100,000 check to

Regions Bank, and Regions Bank issued a $100,000 cashier’s check

which was negotiated by Ram.   As with the Inter-Con-Ram 7/10/96

payment, there is insufficient evidence to convince the Court of

Jerry’s direct investment in Ram.

     For the same reasons set out in relation to the 7/10/96

payment, petitioners failed to meet their burden of proving that

Mattel advanced funds to Ram as their agent, that direct

indebtedness resulted from Ram to Jerry, or that Jerry made the
                               - 23 -

required economic outlay.    Jerry may not increase his basis in

Ram by the $100,000 advanced by Mattel to Ram.

      Innovative Payment

      On February 2, 1996, TSI wrote a $3,000 check to Innovative.

Petitioners assert that TSI acted as Jerry’s agent and was merely

used as Jerry’s incorporated pocketbook.    The credible evidence

in the record does not support this assertion.     We conclude that

Jerry may not increase his basis in Innovative by $3,000 on the

basis of this transaction.

II.   Characterization Of Noncompete Payments

      Petitioners’ 1989, 1990, 1991, and 1992 Federal income tax

returns characterized the noncompete payments as ordinary income.

Petitioners seek to characterize the continuation of those

payments in 1993 and 1994 as capital gains.     Petitioners argue

primarily that they should be relieved of the tax consequences

flowing from the apportionment of the purchase price in the 1988

stock acquisition agreement.    Petitioners assert alternatively

that events in 1989 establish that a new agreement was reached

under which the noncompete payments petitioners received in 1993

and 1994 are treated as capital gains rather than ordinary

income.

      Primary Argument

      Given petitioners’ different residences, this case is

appealable to the Courts of Appeals for the Fourth and Eleventh
                              - 24 -

Circuits.   Because the decisional law of those circuits, as we

understand it, may differ as to when an individual may avoid the

tax consequences of his or her apportionment of a purchase price

in a written contract, we analyze the law of both circuits.       We

conclude that the result is the same under the law in both

circuits.   We also reach the same result under our caselaw.

E.g., Gen. Ins. Agency, Inc. v. Commissioner, T.C. Memo. 1967-

143, affd. 401 F.2d 324 (4th Cir. 1968).

     The Court of Appeals for the Eleventh Circuit has adopted

the rule of Danielson v. Commissioner, 378 F.2d 771 (3d Cir.

1967), vacating and remanding 44 T.C. 549 (1965).     Plante v.

Commissioner, 168 F.3d 1279 (11th Cir. 1999), affg. T.C. Memo.

1997-386; Bradley v. United States, 730 F.2d 718, 720 (11th Cir.

1984).   Respondent argues here, as he did in Danielson, that

where the parties to the sale of a business have entered into a

written agreement setting out the amount to be paid for a

covenant not to compete, they may not for tax purposes attack

that agreement absent fraud, duress, or undue influence.

     Petitioners have adduced extrinsic evidence to attempt to

establish an ambiguity in the apportionment of the Conquest

purchase price.   We find that evidence unpersuasive.   The

relevant terms of the stock acquisition and noncompete

agreements are clear and unambiguous on their face.     Petitioners

have not adduced any evidence that would establish that either of
                                - 25 -

those agreements is unenforceable due to mistake, undue

influence, fraud, duress, or other similar ground.     In fact,

petitioners have stipulated that both agreements are enforceable

contracts.   In these circumstances, petitioners are bound by the

tax consequences flowing from the apportionment of the purchase

price in the agreements.

     The Court of Appeals for the Fourth Circuit has not adopted

the rule in Danielson.6    Gen. Ins. Agency, Inc. v. Commissioner,

401 F.2d 324 (4th Cir. 1968).    In Gen. Ins. Agency, the Court of

Appeals analyzed a transaction involving a sale of an insurance

agency and a covenant not to compete.    Id. at 327.   The court

held that

     the determination of whether a part of the purchase
     price represents payment for a noncapital item, i.e., a
     covenant not to compete, depends upon whether the
     parties to the agreement intended to allocate a portion
     of the purchase price to such covenant at the time they
     executed their formal sales agreement. It is necessary
     also to establish that the covenant “have some
     independent basis in fact or some arguable relationship
     with business reality such that reasonable men,
     genuinely concerned with their economic future, might
     bargain for such an agreement.” [Id. at 330; fn. refs.
     omitted (quoting Schulz v. Commissioner, 294 F.2d 52,
     55 (9th Cir. 1961)).]

     A determination of the intent of the parties to an agreement

and the economic substance of a transaction is a question of


     6
       We have also declined to adopt that rule, e.g., Coleman v.
Commissioner, 87 T.C. 178, 202 n.17 (1986), and apply it only
when a case is appealable to a court that has adopted the rule,
Meredith Corp. & Subs. v. Commissioner, 102 T.C. 406, 439-440
(1994).
                                - 26 -

fact. Id. at 329.   As mentioned above, none of the evidence

adduced by petitioners, including the original offer letters from

the purchasers, persuades us either that the apportionment of the

purchase price is ambiguous or that the intent of the parties to

the stock acquisition and noncompete agreements is other than

that reflected by the terms of the agreements.

     Petitioners rely on a number of facts to argue that the

apportionment lacks economic substance and therefore should not

be respected.   Specifically, petitioners observe that the

noncompete payments inured to the benefit of Jerry’s heirs and

successors, that postclosing adjustments were made to the

noncompete payments, that the aggregate (unadjusted) amount paid

for the noncompete agreements is twice the amount paid for the

underlying business assets, and, purportedly, that the noncompete

payments bore interest.

     None of these arguments taken individually or together

convince us that the apportionment lacked economic substance.

The fact that the benefits of the noncompete agreement enure to

the benefit of Jerry’s heirs and successors is unremarkable given

that the noncompete agreement provided that a set sum would be

paid for Jerry’s noncompetition.    That sum was to be paid over

time, and the purchaser could discontinue further payments, if

Jerry breached the agreement.
                              - 27 -

     Petitioners also allege that the noncompete payments bore

interest.   We find no basis for this allegation.   It is true that

the second offer letter makes reference, in a handwritten

modification, to the payments’ bearing interest.    We are unable

to find, however, that any such term was incorporated into the

final documents.   The stock acquisition agreement explicitly

provides that it constitutes the entire agreement of the parties.

     Finally, the relative proportion of the amount assigned to

the stockholders’ equity and the noncompete payments has not been

proven to be unreasonable.   Conquest started as an

undercapitalized entity a relatively short time before the

agreements, and Jerry and Walker’s efforts increased Conquest’s

value at the time of sale.   We are convinced that restricting

competition from Walker and Jerry had substantial value when the

stock acquisition agreement was signed and that the noncompete

protection was in fact of greater value than the other assets of

the business.   Accordingly, we find that the payments made

pursuant to the noncompete agreement are ordinary income to

petitioners.

     Alternative Argument

     Petitioners argue alternatively that events in 1989

established a new agreement under which the noncompete payments

petitioners received in 1993 and 1994 are taxed at capital gains
                                - 28 -

rates.   As was true with the primary argument, we are unpersuaded

by this alternative argument.

     The noncompete agreement generally restricted Jerry from

disclosing information confidential to Conquest and prohibited

him from directly or indirectly competing with Conquest.     An

exception to the general restrictions, subject to conditions, was

made to accommodate Jerry’s involvement with Mattel.     The general

restriction applied to Jerry’s S corporation, TSI.     It also

applied to Hawk Extrusions, Inc., provided that Hawk did not

compete with Conquest in the production of bulk continuous yarn.

     Petitioners argue that the change of ownership in Mattel and

the release of Jerry’s covenant not to compete as to Mattel

constituted a new agreement.    Although we agree that the terms of

the stock acquisition and noncompete agreements were modified in

1989, we disagree that those modifications changed the proper

characterization of the payments petitioners received pursuant to

the noncompete agreement.   The express language of the agreement

under which Ralston acquired an ownership interest in Mattel

(purchase agreement) indicates that the parties intended the

Jerry noncompete agreement would remain in force except as

modified by the purchase agreement.7     The latter agreement stated



     7
       Jerry was aware of the terms of the purchase agreement.
The purchase agreement was signed by Ronald, Ralston, and Jerry
on behalf of Mattel.
                               - 29 -

that Ralston would cause Jerry’s noncompete agreement with

Conquest to be modified in such a manner that his participation

in Mattel and other incidental matters would not be a violation

of the noncompete agreement.   The explicit acknowledgment that

the noncompete agreement needed to be modified (rather than

abandoned or released) to remove restrictions on Mattel’s

competing with Conquest is probative that the noncompete

agreement survived.   In fact, after Mattel’s ownership change,

Jerry was still restricted from competing with Conquest other

than through Mattel, and he continued to be restricted from

disclosing Conquest’s confidential information.   We conclude that

the noncompete agreement survived and that the payments received

by Jerry continued to be taxed as ordinary income.

     On the basis of the entire record, we conclude that the

allocation contained in the stock acquisition and noncompete

agreements was bargained for by the parties, that no party was

indifferent to the allocation,8 that the allocation reflects the

parties’ intent when the agreements were signed, and that the

allocation has sufficient “economic reality” to be respected for

tax purposes.




     8
        The sellers were represented by counsel during the
negotiation of the stock acquisition agreement.
                               - 30 -

III.    Accuracy-Related Penalties

       Respondent argues that petitioners are liable for the 1993

and 1994 accuracy-related penalties determined under section

6662(a) for, among other things, negligence and intentional

disregard of rules or regulations.      Petitioners focus on the

portion of the accuracy-related penalty attributable to Jerry’s

trading of securities and argue that they exercised ordinary care

in the handling of their tax affairs by hiring accountants to

report those affairs correctly.

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

accuracy-related penalty on the portion of an underpayment that

is due to negligence or intentional disregard of rules or

regulations.    Negligence includes a failure to attempt reasonably

to comply with the Code.    Sec. 6662(c).    Disregard includes a

careless, reckless, or intentional disregard.      Id.   An

underpayment is not attributable to negligence or intentional

disregard to the extent that the taxpayer shows that the

underpayment is due to the taxpayer’s having reasonable cause and

acting in good faith.    Secs. 1.6662-3(a), 1.6664-4(a), Income Tax

Regs.

       Reasonable cause requires that the taxpayer have exercised

ordinary business care and prudence as to the disputed item.

United States v. Boyle, 469 U.S. 241 (1985); see also Neonatology

Associates, P.A. v. Commissioner, 115 T.C. 43, 98 (2000).      The
                                - 31 -

good faith, reasonable reliance on the advice of an independent,

competent professional as to the tax treatment of an item may

meet this requirement.   United States v. Boyle, supra; sec.

1.6664-4(b), Income Tax Regs.    Whether a taxpayer relies on

advice and whether such reliance is reasonable hinge on the facts

and circumstances of the case and the law applicable thereto.

Sec. 1.6664-4(c)(1)(i), Income Tax Regs.    The taxpayer must prove

that:   (1) The adviser was a competent professional who had

sufficient expertise to justify reliance, (2) the taxpayer

provided necessary and accurate information to the adviser, and

(3) the taxpayer actually relied in good faith on the adviser’s

judgment.   Ellwest Stereo Theatres, Inc. v. Commissioner, T.C.

Memo. 1995-610; see also Rule 142(a)(1).

     We are unable to conclude that petitioners have met that

burden of proof.   Whereas they assert on brief that they relied

reasonably upon their accountant, we do not find that such was

the case.   Petitioners had actively traded securities for several

years preceding the subject years and reported capital gains from

securities transactions in 1991 and 1992, including a net capital

gain of over $600,000 in 1992.    Although neither the law nor the

nature of their securities activity changed materially in the

following 2 years, their reporting position as to that activity

changed from capital loss to ordinary loss treatment.    The record

is barren of any credible evidence showing that petitioners ever
                               - 32 -

received, let alone reasonably relied upon, any competent

professional advice concerning that reporting change.   In fact,

the accountant’s own testimony indicates that he lacked

sufficient knowledge to render competent advice on the subject.

We are unpersuaded that petitioners lacked sophistication in tax

matters.

     We also disagree with petitioners’ assertion that the

accuracy-related penalties generally relate to the “unsettled”

law on day trading.   The law in this area has been well settled

for many years in that courts have consistently held that a sale

of securities may result in ordinary losses only when the

securities are held primarily for sale to customers in the

ordinary course of business.   Bielfeldt v. Commissioner, T.C.

Memo. 1998-394 (and cases cited therein), affd. 231 F.3d 1035

(7th Cir. 2000).   Petitioners, by contrast, traded solely for

their own account and never held securities primarily for sale

(or actually sold securities) to customers in the ordinary course

of a trade or business.   We conclude that petitioners are liable

for the accuracy-related penalties determined by respondent,

except as otherwise conceded by respondent.

     All arguments made by the parties and not discussed herein

have been rejected as meritless.   Accordingly,

                                         Decision will be entered

                                    under Rule 155.
