                                  T.C. Memo. 2014-25



                            UNITED STATES TAX COURT



   CHRISTOPHER CARL CLOSE AND LISA MARIE CLOSE, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 20645-07.                           Filed February 10, 2014.



      Christopher Carl Close and Lisa Marie Close, pro sese.

      Catherine L. Campbell and Danae M. Rawson, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      MARVEL, Judge: Respondent determined deficiencies in Christopher Carl

Close and Lisa Marie Close’s Federal income tax and additions to tax under

sections 6651(a)(1) and (2) and 66541 as follows:


      1
          Unless otherwise indicated, all section references are to the Internal
                                                                           (continued...)
                                         -2-

[*2]

                                               Additions to tax

                                        Sec.          Sec.        Sec.
                 Year   Deficiency   6651(a)(1)    6651(a)(2)     6654

                                      Mr. Close

                 2003    $68,843      $15,490         TBD         $1,802
                 2004     17,358        3,906         TBD            504

                                     Mrs. Close1

                 2003    $52,800      $11,880         TBD         $1,382
                 2004     17,358        3,906         TBD            504
             1
              Respondent attributed some of the income Mr. Close
       purportedly earned during these years to Mrs. Close because Idaho,
       where petitioners then resided, is a community property State.




       1
        (...continued)
Revenue Code in effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Monetary amounts have been rounded
to the nearest dollar.
                                          -3-

[*3] After concessions,2 the issues for decision are: (1) whether Mr. Close had

unreported income of $323,246 from logging activities on a 750-acre parcel of real

property with an address on Winch Avenue, Rathdrum, Idaho (Winch Road

property), in 2003; (2) whether Mr. Close had unreported income of $48,262 from

logging activities on a 120-acre parcel of real property with an address on Nelson

Loop Road, Rathdrum, Idaho (Nelson Loop Road property), in 2003; and (3)

whether petitioners are liable for additions to tax under sections 6651(a)(1) and (2)

and 6654 for 2003.

                                 FINDINGS OF FACT

         Some of the facts have been stipulated. The stipulations of facts are

incorporated herein by this reference. When they petitioned this Court, Mr. Close

was incarcerated in a Federal prison camp in California and Mrs. Close resided in

Idaho.




         2
      Petitioners concede that (1) Mr. Close received unemployment
compensation of $6,026 in 2003; (2) Mrs. Close received taxable income of
$3,721 from J.D. Lumber in 2003; (3) Mrs. Close received wages of $201 from
Columbia Lighting, Inc., in 2003; (4) Mrs. Close received wages of $599 and
$4,366 from O’Malley’s Sports Pub Grill in 2003 and 2004, respectively.

       Respondent concedes that petitioners (1) had no taxable gain from the sale
of real property in Hayden Lake, Idaho, in 2004; and (2) are not liable for
additions to tax under secs. 6651(a)(1) and (2) and 6654 for 2004.
                                         -4-

[*4] I.         Background

          Petitioners married in 1990. They have four children. In 1995 Mr. Close

started a medical equipment business. On a date that is unclear from the record he

sold the medical equipment business.

          In 2001 the Federal Government (Government) executed multiple search

warrants with respect to Mr. Close’s medical equipment business and the entity

that purchased it. One of those warrants was executed in November 2001.

          On March 12, 2003, the Government filed an indictment, and on August 14,

2003, a superseding indictment, against Mr. Close in the U.S. District Court for

the District of Idaho. On July 27, 2004, a jury found Mr. Close guilty of 30 counts

of healthcare fraud, 9 counts of money laundering, 1 count of obstructing a

Federal audit, and 1 count of obstructing a Federal healthcare fraud investigation.

Mr. Close was incarcerated on March 30, 2005. On February 1, 2011, he was

released to a halfway house, and on July 30, 2011, he was released from custody.

The last Federal income tax return that petitioners filed before Mr. Close’s

incarceration was their 2001 return.
                                      -5-

[*5] II.     Winch Road Property

       A.    Option To Purchase the Winch Road Property

       In January 2003 Mr. Close and Mike Leach proposed purchasing the Winch

Road property from Jerry and Edna Tefft and drafted an option to purchase the

Winch Road property dated January 20, 2003 (original Winch Road option). Mr.

Close, Mr. Leach, and Mr. and Mrs. Tefft signed the original Winch Road option.

Under the original Winch Road option, the Teffts agreed to grant Mr. Close and

Mr. Leach an option to purchase the Winch Road property for $1.4 million, and

Mr. Close and Mr. Leach agreed to pay the Teffts $1,000 as consideration for the

option. The original Winch Road option further provided that Mr. Close and Mr.

Leach would pay 70% of the proceeds of any timber sales to Mr. and Mrs. Tefft

until Mr. Close and Mr. Leach paid off the balance owed on the property. The

original Winch Road option was recorded on January 30, 2003.

       Also on January 30, 2003, Mr. Close, Mr. Leach, and Mr. and Mrs. Tefft

recorded an amended Winch Road option. Under the amended Winch Road

option, Mr. Close and Mr. Leach gave notice that they would exercise their option

to purchase the Winch Road property and agreed to execute a promissory note of

$1.4 million for the purchase of the property. Of that amount, $700,000 was to be

due by August 1, 2003, and the remainder was to be due by May 1, 2004. Mr.
                                       -6-

[*6] Close and Mr. Leach agreed that 70% of the proceeds of any timber sales

would go toward satisfying the balance due on the promissory note. The amended

Winch Road option granted Mr. Close and Mr. Leach the right to immediately

commence logging operations on the Winch Road property.

      B.    Hidden Valley Ranch, LLC

      In February 2003 Mr. Close and Mr. Leach formed Hidden Valley Ranch,

LLC, for the purpose of managing the logging, farming, and other operations on

the Winch Road property. Hidden Valley Ranch, LLC, managed logging and

other activities on the Winch Road property throughout 2003 and 2004. It also

maintained a checking account, and on November 24, 2004, it filed a Form 1065,

U.S. Return of Partnership Income (partnership return), for 2003. Clark,

Anderson, McNelis & Co. (Clark Anderson), a public accounting firm, prepared,

and Mr. Leach signed, Hidden Valley Ranch, LLC’s 2003 partnership return.

      On a date that is unclear from the record and for reasons that are unclear

from the record Mr. Leach’s wife, Donna Leach, who is an accountant but not a

certified public accountant (C.P.A.), began to summarize the income and expenses

of the logging activities on the Winch Road property. Because she was unable to

access the databases on Hidden Valley Ranch, LLC’s computer, she had to

reconstruct Hidden Valley Ranch, LLC’s records for 2003 and 2004. She
                                        -7-

[*7] prepared balance sheets and profit and loss statements for Hidden Valley

Ranch, LLC, and gave these to Lynn Anderson, a C.P.A. at Clark Anderson, to

prepare an amended 2003 partnership return for Hidden Valley Ranch, LLC.

      C.     Lost Creek Trust

      On February 28, 2003, petitioners, Mr. Leach, and John A. Dixon purported

to form Lost Creek Irrevocable Trust (Lost Creek Trust) by signing a trust

agreement. Petitioners and Mr. Leach signed the trust agreement as the grantors,

and Mr. Dixon signed the trust agreement as the trustee. Under the Lost Creek

Trust agreement, the grantors purported to convey their interest in the Winch Road

property to the trustee. Thereafter, on a date that is not in the record Mr. and Mrs.

Tefft conveyed the Winch Road property to Mr. Dixon as trustee of Lost Creek

Trust.3

      Petitioners’ four children, Mr. Leach’s two children, and Mrs. Leach’s two

children are the beneficiaries of Lost Creek Trust. The Lost Creek Trust

agreement requires the trustee to pay for the benefit of each beneficiary such sums

from principal and interest as the trustee deems reasonable “for the maintenance,

      3
        We infer from the terms of the option agreements, from the conveyance of
title by Mr. and Mrs. Tefft, and from the income respondent is claiming was
generated from timber sales that the purchase price of the Winch Road property
was paid in whole or in part out of the proceeds from timbering activities on that
property.
                                         -8-

[*8] education, support and health of the beneficiaries”. The agreement also

provided that Carrie Loomis, Mr. Close’s sister, and Kelly Scott, Mr. Leach’s

sister, would serve as successor cotrustees to Mr. Dixon if he would no longer be

able or willing to serve. However, on or about December 4, 2004, when Mr.

Dixon resigned as trustee, Ms. Scott became the sole successor trustee.

      D.     Lost Creek Partnership

      On January 24, 2005, the District Court in Mr. Close’s criminal case issued

a postconviction preforfeiture restraining order. The restraining order prohibited,

among other things, any harvesting of timber on the Winch Road property.

      On March 2, 2005, the District Court issued a preliminary order of

forfeiture, preliminarily forfeiting Mr. Close’s interest in, among other things, the

Winch Road property. On March 29, 2005, Ms. Scott filed a petition to adjudicate

the third-party interest of Lost Creek Trust in the Winch Road property.

      On February 23, 2006, the Government filed a motion for the District Court

to issue an order to show cause with respect to certain alleged violations by Mr.

Leach of the January 24, 2005, postconviction preforfeiture restraining order. On

February 24, 2006, the District Court issued the requested order to show cause.

      On a date that is unclear from the record, Mr. and Mrs. Leach met with

Revenue Agent Nicoli Ferrell, Assistant U.S. Attorney Anthony Hall, a Federal
                                        -9-

[*9] marshal, and Mike Anderson, an attorney, at the courthouse in Coeur

d’Alene. At the meeting Mr. and Mrs. Leach were told to disregard Lost Creek

Trust and Hidden Valley Ranch, LLC, and to instead file partnership returns for

what would be known as Lost Creek Partnership. Mr. and Mrs. Leach were also

told that the Internal Revenue Service (IRS) would file the partnership returns for

them--without including any expenses--if they failed to file the partnership returns

themselves.

      On April 6, 2006, Revenue Agent Ferrell sent a letter to Mr. Leach

informing him that the IRS had determined that Lost Creek Trust is not a valid

trust, that Mr. Leach should file amended returns for Hidden Valley Ranch, LLC,

reporting zero income, and that Mr. Leach should instead report all income and

expenses from timber operations on the Winch Road property on partnership

returns for Lost Creek Partnership. Additionally, the letter stated as follows:

             As previously discussed, in addition to being required by the
      circumstances and the law applicable in this case, the partnership
      filing is likely to be the most economically advantageous position for
      you and should allow the United States Attorney’s office to go
      forward in its criminal-forfeiture-ancillary-proceeding claims against
      the defendant, * * * [Mr.] Close, and that portion of the
      property/partnership subject to the Preliminary Order of Forfeiture,
      without involving you in lengthy litigation in that proceeding.
                                        - 10 -

[*10] On April 10, 2006, the Government filed a notice of status of show-cause

proceeding, informing the District Court that it was satisfied that all timber

harvested on the Winch Road property had been properly accounted for.4 Also on

April 10, 2006, Revenue Agent Ferrell sent a letter to Mr. Close informing him

that the IRS had determined that Lost Creek Trust is not a valid trust and that he

should instead file partnership returns for Lost Creek Partnership.

      On a date that is unclear from the record Assistant U.S. Attorney Hall

provided to Mrs. Leach a summary of income earned from timber operations on

the Winch Road property in 2003. The summary was originally prepared by the

Department of Health and Human Services (HHS), apparently in connection with

Mr. Close’s criminal case.5

      Laima Swanson, who was then a C.P.A. at Clark Anderson, used a balance

sheet and a profit and loss statement that Mrs. Leach had prepared for Hidden

Valley Ranch, LLC, to prepare various documents and schedules, and ultimately,

to prepare 2003 and 2004 partnership returns for Lost Creek Partnership. The


      4
       The Government’s notice erroneously refers to the Nelson Loop Road
property instead of the Winch Road property.
      5
       This is Exhibit 25-R. See infra note 12. The copy of the summary that is in
the record is dated September 8, 2006. It reflects receipts of $2,435,983 for timber
operations in 2003. It is unclear whether Mrs. Leach used this summary in
preparing the 2003 profit and loss statement for Hidden Valley Ranch, LLC.
                                        - 11 -

[*11] balance sheet and the profit and loss statement are dated April 27, 2006.

The profit and loss statement and a related timber schedule reflect receipts of

$2,045,562 for timber operations in 2003. On May 4, 2006, Mr. Leach signed and

filed Lost Creek Partnership’s partnership returns for 20036 and 2004. Lance

Woodall, who was then a manager at Clark Anderson, signed Lost Creek

Partnership’s 2003 and 2004 partnership returns as the preparer because Ms.

Anderson was unavailable to review the return at the time and Clark Anderson

was under pressure from the IRS to file the partnership returns promptly.

      The 2003 Lost Creek Partnership return reported total assets, total income,

and ordinary income of $913,403, $747,146, and $747,146, respectively. The

return also reported on attached Schedules K-1, Partner’s Share of Income,

Credits, Deductions, etc., that Mr. Leach and Mr. Close each had distributive

shares of ordinary income, section 179 expense, and other deductions of $373,573,

$50,000, and $327, respectively, for 2003.7



      6
        Form 4797, Sales of Business Property, of the 2003 partnership return
reported timber sales of $2,045,562, cost or other basis of $1,229,091, and
ordinary gain of $816,471, which was included in calculating the partnership’s
total and ordinary income of $747,146.
      7
       Mr. and Mrs. Leach have since entered into a collection agreement with
respondent, and as of the date of trial they were still paying off their purported
2003 tax liability.
                                       - 12 -

[*12] On July 12, 2007, the U.S. Attorney’s Office and Mr. and Mrs. Leach filed a

stipulation in the District Court with respect to the custody and management of the

Winch Road property. The stipulation states, in relevant part, as follows:

      7. The Leaches concede that the Lost Creek Irrevocable Trust is
      inoperative to insulate it from the Government’s claim of forfeiture
      against * * * [Mr.] Close’s interest in the Winch Road [p]roperty.
      The property was in fact operated as a partnership between the
      Leaches and * * * [Mr.] Close. To that end the Leaches have
      cooperated with the Government by preparing [F]ederal income tax
      returns for the operations relating to the ranch characterizing the
      operation as a partnership between the Leaches and * * * [Mr.] Close.
      The Leaches have further cooperated with the Government by
      accounting for activities on the Winch Road [p]roperty, including
      timber harvesting, which has the potential for affecting the value of
      the Winch Road [p]roperty. The Leaches agree to appear and testify
      truthfully in all proceedings related to the pending criminal ancillary
      matter herein, and to produce such documents and records as may be
      required to conclude these proceedings.

                      *     *      *     *      *    *      *

      9. The Government and the Leaches desire to market and sell the
      Winch Road [p]roperty for the purpose of resolving the Government’s
      forfeiture claim against the interest of * * * [Mr.] Close in the Winch
      Road [p]roperty, and for the purpose of effecting a termination and
      winding up of the partnership between * * * [Mr.] Close and the
      Leaches in the Winch Road [p]roperty.

                      *     *      *     *      *    *      *

      16. The Government and the Leaches agree that the Leaches shall
      manage, operate, and maintain the Winch Road [p]roperty in an
      efficient, reasonable, and satisfactory manner, subject to this
      Stipulation. The relationship between the Leaches and the
                                        - 13 -

      [*13] Government will be one of trust in which the Leaches will
      comply with all of the obligations of a fiduciary. * * *

                       *     *      *     *      *     *      *

      19. The Leaches will take all action necessary to reasonably and
      efficiently operate the Winch Road [p]roperty. * * *

                       *     *      *     *      *     *      *

      22. In consideration of Leaches’ services as provided in this
      Stipulation, the Leaches will be entitled to retain the proceeds from
      the use of the Winch Road [p]roperty, to wit: the haying operation.
      ***

      23. The Government acknowledges that the Leaches intend to board
      their personal livestock on the Winch Road [p]roperty and agrees that
      the Leaches may do so * * *.

      The Leaches have since operated a ranch on the Winch Road property, and

they have earned $15,000 per annum from haying operations on the property.

Additionally, Mr. Leach has sold off or used up many of the assets that were

originally reported on Hidden Valley Ranch, LLC’s 2003 partnership return.

      On July 31, 2007, Mr. and Mrs. Leach filed a petition to adjudicate their

joint third-party interest in the Winch Road property. As of the date of trial in this

case, no hearings had been held and no motions had been filed with respect to

either (1) Ms. Scott’s petition to adjudicate the interest of Lost Creek Trust in the
                                        - 14 -

[*14] Winch Road property or (2) Mr. and Mrs. Leach’s petition to adjudicate

their joint interest in the Winch Road property.

III.   Nelson Loop Road Property

       A.    Original Hidden Valley Trust Agreement

       On September 23, 1998, Mr. Close and Norman Gissel formed Hidden

Valley Trust by signing a trust agreement (original Hidden Valley Trust

agreement). Mr. Close signed the original Hidden Valley Trust agreement as the

grantor, and Mr. Gissel signed the original Hidden Valley Trust agreement as the

trustee. Pursuant to the original Hidden Valley Trust agreement, Mr. Close

transferred $12,500 to the trust. Under the original Hidden Valley Trust

agreement, the trust could be revoked, altered, amended, modified, or terminated

at the will of Mr. Close, and he was the sole beneficiary of the trust.

       B.    Purchase of the Nelson Loop Road Property

       On a date that is unclear from the record Mr. Gissel, as trustee of Hidden

Valley Trust, used the $12,500 that Mr. Close had transferred to the trust as part of

the consideration for the purchase of the Nelson Loop Road property. Petitioners

personally guaranteed the mortgage on the Nelson Loop Road property. On

September 30, 1998, Mr. Gissel resigned as the trustee.
                                       - 15 -

[*15] Petitioners operated an unincorporated ranch called Triple C Ranch on the

Nelson Loop Road property. At some time in 2001 petitioners and their four

children moved to the Nelson Loop Road property.

      C.     Amended Hidden Valley Trust Agreement

      On December 13, 2001, petitioners and Ms. Loomis8 amended the original

Hidden Valley Trust agreement by signing an amended trust agreement (amended

Hidden Valley Trust agreement). The amended Hidden Valley Trust agreement

was prepared by an attorney. Petitioners signed the amended Hidden Valley Trust

agreement as the grantors, and Ms. Loomis signed it as the trustee. The amended

Hidden Valley Trust agreement purports to amend, in its entirety, the original

Hidden Valley Trust agreement.

      The amended Hidden Valley Trust agreement created two trust shares: (1)

Hidden Valley Trust Revocable Share (revocable share), and (2) Hidden Valley

Trust Irrevocable Share (irrevocable share). Petitioners were the beneficiaries of

the revocable share, and petitioners’ four children were the beneficiaries of the

irrevocable share. The amended Hidden Valley Trust agreement provided that the

revocable share of the trust continued to hold the Nelson Loop Road property, and

      8
       We infer from the amended Hidden Valley Trust agreement that Ms.
Loomis became the trustee of Hidden Valley Trust sometime after Mr. Gissel
resigned.
                                         - 16 -

[*16] the grantors transferred $1 to the irrevocable share of the trust. The

amended Hidden Valley Trust agreement further provided that the grantors could

transfer a portion of their interest in the revocable share to the irrevocable share,

and that after a short period in which the beneficiaries of the irrevocable share

would be permitted to demand a distribution of the transferred assets, the

transferred portion of the revocable share would become an asset of the

irrevocable share.

      Also on that date petitioners assigned a one-half interest in the revocable

share to the irrevocable share. On December 14, 2001, Hidden Valley Trust filed

a trust registration with Kootenai County. On February 4, 2002, petitioners

assigned their remaining one-half interest in the revocable share to the irrevocable

share. The irrevocable share was thereafter known as Hidden Valley Trust and

was to be administered by the trustee for the benefit of petitioners’ children.

Specifically, the amended Hidden Valley Trust agreement requires the trustee to

pay for the benefit of each beneficiary such sums from principal and interest as the

trustee deems reasonable “for the maintenance, education, support and health of

each such beneficiary.” The trustee was specifically instructed not to use trust

assets to relieve petitioners of “any statutory obligation” with respect to minor

beneficiaries.
                                       - 17 -

[*17] D.     Logging Activities

      In November 2002, after learning that the price of timber had recently

increased, Mr. Close suggested to Ms. Loomis that Hidden Valley Trust should

harvest timber off the Nelson Loop Road property. Logging activities on the

Nelson Loop Road property began in 2003. Some of the timber proceeds were

used to pay down the mortgage on the Nelson Loop Road property and some of

the proceeds were used to improve the property. Hidden Valley Trust filed a

Federal income tax return for 2003.

      E.     Forfeiture Proceedings

      On March 2, 2005, the District Court in Mr. Close’s criminal case issued an

order preliminarily forfeiting Mr. Close’s interest in the Nelson Loop Road

property. In doing so the District Court determined that the Nelson Loop Road

property had the requisite nexus with Mr. Close’s criminal activity so as to be

subject to forfeiture.

      On March 31, 2005, Ms. Loomis, as trustee of Hidden Valley Trust, filed a

petition to adjudicate the trust’s interest in the Nelson Loop Road property. On

April 23, 2007, the District Court dismissed Ms. Loomis’ petition on the basis of

the following uncontested facts: (1) the criminal acts that Mr. Close committed

began in January 1998; (2) Hidden Valley Trust was formed on September 23,
                                         - 18 -

[*18] 1998; (3) the trust was twice modified, the trustee was changed, and

transfers of property were made to Hidden Valley Trust; and (4) the petition did

not allege facts that demonstrated that Hidden Valley Trust was a bona fide

purchaser for value of the right, title, or interest in the Nelson Loop Road property.

Accordingly, the District Court concluded that Hidden Valley Trust failed to

allege a prima facie case and dismissed the petition.9 On July 17, 2012, the

District Court entered a final order of forfeiture with respect to the Nelson Loop

Road property.

IV.   Notices of Deficiency

      On July 30, 2007, respondent issued to petitioners separate notices of

deficiency. On the Form 4549-A, Income Tax Discrepancy Adjustments, attached

to the notice of deficiency that respondent issued to Mr. Close, respondent

indicated that he adjusted Mr. Close’s income to reflect, among other items, (1)

income of $323,246 and loss of $13,569 for 2003 and 2004, respectively, reported

on Schedule E, Supplemental Income and Loss (partnership income adjustments);


      9
        To allege a prima facie case Hidden Valley Trust was required to show that
it either “(1) had a vested or superior right, title, or interest in the property when
* * * [Mr. Close] committed the acts giving rise to the forfeiture, or (2) is a bona
fide purchaser for value of the right, title, or interest in the property and at the time
of the purchase was reasonably without cause to believe the property was subject
to forfeiture”. United States v. Lazarenko, 476 F.3d 642, 648 (9th Cir. 2007).
                                       - 19 -

[*19] and (2) other income of $51,983 for 2003 (other income adjustment). On an

attached Form 886-A, Explanation of Items, respondent explained the partnership

income adjustments and the other income adjustment as follows:

      Schedule E--Income/Loss--Partnerships/S-Corporations--
      Passive/Non-Passive

               Tax period    Per return    Per exam    Adjustment

                  2003           -0-      $323,246       $323,246
                  2004           -0-       (13,569)       (13,569)

             It is determined that the taxpayer received gross income or net
      loss from the flow-through of ordinary income/loss from the
      partnership, Hidden Valley Ranch LLC, for the tax years as shown
      above. We determined the amounts from Schedules K-1 filed with
      the partnership returns. It is further determined that the non-passive
      income is self employment income subject to the self employment
      tax.

      Other Income

               Tax period    Per return    Per exam    Adjustment

                  2003           -0-       $51,983        $51,983

            It is determined that the taxpayer received gross income from a
      grantor trust, Hidden Valley Irrevocable Trust and from sales
      associated with J.D. Lumber. The amounts are as follows.

                   Hidden Valley Irrevocable Trust $48,262
                   J.D. Lumber                       3,721
                    Total                           51,983
                                        - 20 -

[*20]                                 OPINION

        Respondent contends that (1) Mr. Close had income of $323,246 from

logging activities by Lost Creek Partnership10 on the Winch Road property in 2003

because Lost Creek Trust is a sham;11 and (2) Mr. Close had income of $48,262

from logging activities on the Nelson Loop Road property in 2003 because Hidden

Valley Trust is either a grantor trust or a sham.




        10
        The unified audit and litigation procedures of the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, sec. 402(a), 96 Stat. at
648, do not apply to the purported Lost Creek Partnership because it 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 New Phoenix Sunrise Corp. v.
Commissioner, 132 T.C. 161, 173 n.3 (2009), aff’d, 408 Fed. Appx. 908 (6th Cir.
2010).
        11
         Respondent asserts for the first time on brief that Lost Creek Trust is
invalid under State law because petitioners and Mr. Leach, the purported grantors
of Lost Creek Trust, had not yet acquired title to the Winch Road property when
they purported to convey it to the trustee, Mr. Dixon, on February 28, 2003. In
short, respondent contends that Lost Creek Trust is invalid because it lacked a
corpus.

       As a general rule, we will not consider issues first asserted on brief. See
Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 346-349 (1991). This is
particularly so in this case because petitioners had no opportunity to address
respondent’s contention or to demonstrate the trust’s validity under Idaho law.
See, e.g., Peterson v. Gentillon, 296 P.3d 390, 396 (Idaho 2013) (discussing
resulting trusts under Idaho law).
                                       - 21 -

[*21] I.    Preliminary Matters

      A.    Summary Documents

      On September 4, 2012, respondent filed a request for admissions.

Petitioners’ response to respondent’s request for admissions was due within 30

days. See Rule 90(c). On October 24, 2012, petitioners submitted their response

to respondent’s request for admissions. However, pursuant to Rule 90(c),

respondent’s requested admissions had already been deemed admitted. On

October 25, 2012, we withdrew petitioners’ deemed admissions. See Rule 90(f).

Trial was held in this case on November 29, 2012.

      At trial respondent introduced several exhibits that are purportedly derived

from documents and records that respondent did not share with petitioners before

trial. These exhibits include all of the evidence supporting respondent’s

computations of the income received by the purported Lost Creek Partnership

from the logging activities on the Winch Road property and some of the evidence

supporting respondent’s computations of the income received by Hidden Valley

Trust from the logging activities on the Nelson Loop Road property. We admitted

these exhibits solely for the purpose of showing how the revenue agent determined

petitioners’ deficiencies. On brief respondent contends that we should admit these
                                        - 22 -

[*22] exhibits as summaries of voluminous evidence pursuant to rule 1006 of the

Federal Rules of Evidence. We decline to do so.

      The contents of voluminous writings that cannot conveniently be examined

in court may be presented in summary form only if the writings are made available

for examination or copying, or both, by other parties at a reasonable time and

place. See Fed. R. Evid. 1006. Respondent admits that the underlying documents

were not made available to petitioners before trial; respondent contends that this

was because we relieved petitioners of their deemed admissions shortly before

trial. We reject respondent’s suggestion that there was insufficient time to make

the underlying documents available to petitioners. We relieved petitioners from

their deemed admissions more than a month before trial, and respondent had more

than sufficient time to make the documents available to petitioners. Because

respondent failed to make the underlying documents available to petitioners before

trial, we reject respondent’s attempt to rely on these exhibits to prove the truth of

the matters asserted therein.12

      12
        Additionally, Exhibit 25-R, which is a document that purports to
summarize income earned from logging activity on the Winch Road property in
2003, and Exhibit 36-R, which is a document that purports to summarize income
earned from logging activity on the Nelson Loop Road property in 2003, are
largely unsupported by any evidence. Revenue Agent Erin Lewis testified that
both of these documents were prepared by HHS in connection with Mr. Close’s
                                                                     (continued...)
                                         - 23 -

[*23] B.     Judicial Notice

      On November 21, 2012, respondent filed with the Court a motion requesting

judicial notice of certain facts established by several documents that were filed in

Mr. Close’s criminal case. We granted respondent’s motion; we now explain.

      Generally, under rule 201(b) of the Federal Rules of Evidence, an

adjudicative fact can be judicially noticed only if it is (1) generally known within

the trial court’s territorial jurisdiction or (2) capable of accurate and ready

determination by sources whose accuracy cannot reasonably be questioned. See

Estate of Reis v. Commissioner, 87 T.C. 1016, 1026 (1986). We may take judicial

notice on our own, and we must take judicial notice if a party requests it and

supplies the Court with the necessary information. See Fed. R. Evid. 201(c). We

may take judicial notice at any stage of the proceeding. See id. subdiv. (d).

      As respondent recognizes on brief, we may not take judicial notice of the

specific findings of fact in another case because “[s]uch findings do not satisfy the

two tests of [r]ule 201(b). They are not generally known to the public, nor are


      12
        (...continued)
criminal case. Revenue Agent Lewis did not testify regarding how and from what
these documents were prepared, and respondent did not call any HHS
representative to testify concerning the preparation of these documents. As
presented, these exhibits lack a foundation and are inadmissable to prove the truth
of the matters asserted therein. See Fed. R. Evid. 901.
                                        - 24 -

[*24] they so indisputable that their accuracy cannot reasonably be questioned.”

Estate of Reis v. Commissioner, 87 T.C. at 1028. However, we may take judicial

notice of the text of judicial opinions and orders and of court filings to determine

what issues the other court decided. See Reyn’s Pasta Bella, LLC v. Visa USA,

Inc., 442 F.3d 741, 746 n.6 (9th Cir. 2006); Estate of Reis v. Commissioner, 87

T.C. at 1027. If we determine that issues of fact or law were litigated in the prior

proceeding that are identical to issues of fact or law being litigated in the current

proceeding, we “may apply the principle of collateral estoppel or res judicata to

bar further litigation of the same issues in the present proceeding.” Estate of Reis

v. Commissioner, 87 T.C. at 1027.

II.   Burden of Proof

      A.     Burden of Proof Generally

      Generally, the Commissioner’s determination of a deficiency is presumed

correct, and the taxpayer bears the burden of proving that the determination is

improper. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).

However, if the Commissioner raises a new matter, seeks an increase in a

deficiency, or asserts an affirmative defense, the Commissioner has the burden of

proof as to the new matter or increased deficiency. Rule 142(a)(1).
                                        - 25 -

[*25] A new theory that merely clarifies or develops the original determination

without being inconsistent or increasing the amount of the deficiency is not a new

matter. See Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989)

(citing Achiro v. Commissioner, 77 T.C. 881, 890 (1981), Estate of Jayne v.

Commissioner, 61 T.C. 744, 748-749 (1974), and McSpadden v. Commissioner,

50 T.C. 478, 492-493 (1968)). But a new theory that either alters the original

deficiency or requires the presentation of different evidence is a new matter. See

id. (citing Colonnade Condo., Inc. v. Commissioner, 91 T.C. 793, 795 n.3 (1988),

and Achiro v. Commissioner, 77 T.C. at 890-891).

      Under section 7522, a notice of deficiency must “describe the basis for” any

tax deficiency included in the notice. Consequently, we have held that

      where a notice of deficiency fails to describe the basis on which the
      Commissioner relies to support a deficiency determination and that
      basis requires the presentation of evidence that is different than that
      which would be necessary to resolve the determinations that were
      described in the notice of deficiency, the Commissioner * * * bear[s]
      the burden of proof regarding the new basis. * * *

Shea v. Commissioner, 112 T.C. 183, 197 (1999).

      B.     Presumption of Correctness in Unreported Income Cases

      The U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this

case appears to lie absent a stipulation to the contrary, see sec. 7482(b)(1)(A), (2),
                                        - 26 -

[*26] has held that for the presumption of correctness to attach to the notice of

deficiency in unreported income cases, the Commissioner must establish some

evidentiary foundation connecting the taxpayer with the income-producing

activity, see Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir.

1979), rev’g 67 T.C. 672 (1977), or demonstrating that the taxpayer actually

received unreported income, see Edwards v. Commissioner, 680 F.2d 1268,

1270-1271 (9th Cir. 1982).13 If the Commissioner introduces some evidence that

the taxpayer received unreported income, the burden shifts to the taxpayer. See

Hardy v. Commissioner, 181 F.3d 1002, 1004 (9th Cir. 1999), aff’g T.C. Memo.

1997-97. The U.S. Court of Appeals for the Ninth Circuit has also held that, if the

taxpayer succeeds in showing that the unreported income adjustment was arbitrary

or erroneous, the burden of proof shifts back to the Commissioner to show that the

determination was correct. See id. at 1005 (citing Palmer v. United States, 116

F.3d 1309, 1312 (9th Cir. 1997), and Keogh v. Commissioner, 713 F.2d 496, 501

(9th Cir. 1983), aff’g Davies v. Commissioner, T.C. Memo. 1981-438); see also

Helvering v. Taylor, 293 U.S. 507, 515 (1935).

      13
         The Commissioner can rely on evidence that the IRS did not have when it
issued the notice of deficiency. See Llorente v. Commissioner, 74 T.C. 260, 265
(1980), aff’d in part, rev’d in part, 649 F.2d 152 (2d Cir. 1981); Cook v. United
States, 46 Fed. Cl. 110, 115 & n.10 (2000).
                                        - 27 -

[*27] Because we conclude that respondent’s theories in this case are new matters

and we can resolve the substantive issues in this case on the basis of the allocation

of the burden of proof, we do not address whether respondent has satisfied his

burden of production under Weimerskirch v. Commissioner, 596 F.2d at 361-362,

or whether petitioners have shown that the unreported income adjustments were

arbitrary or erroneous under Hardy v. Commissioner, 181 F.3d at 1005 (citing

Palmer, 116 F.3d at 1312, and Keogh v. Commissioner, 713 F.2d at 501).14

      14
       We note, however, that the record contains little reliable evidence
concerning the amount of income that Mr. Close purportedly earned from the
logging activities on the Winch Road and Nelson Loop Road properties.

       With respect to the Winch Road property the summary exhibits that
respondent introduced--with the possible exception of Exhibit 25-R, which is for
other reasons inadmissible, see supra note 12--all relied on Mrs. Leach’s
reconstruction of Hidden Valley Ranch, LLC’s business records. However, Mrs.
Leach, who is not a C.P.A., was operating under pressure from the IRS and the
U.S. Attorney’s Office, and under the circumstances of this case, we do not find
her unsupported reconstruction to be reliable or credible.

        With respect to the Nelson Loop Road property respondent introduced (1) a
summary exhibit, Exhibit 36-R, of payments made to Hidden Valley Trust in
2003; (2) “check stubs” from Riley Creek Lumber Co. that show amounts paid to
Hidden Valley Trust of $2,633, $14,889, and $1,599 in 2003; and (3) information
from a Form 1099-S, Proceeds From Real Estate Transactions, from J.D. Lumber,
Inc., reporting a payment of $637 to Hidden Valley Trust. Revenue Agent Lewis
testified that someone from HHS prepared Exhibit 36-R and that it was in the case
file that she received from the criminal case. When asked whether she verified the
amounts listed in the summary, Revenue Agent Lewis testified that “some of the
items were verified”, but she did not say by whom. We infer from Revenue Agent
                                                                     (continued...)
                                        - 28 -

[*28] C.     Burden of Proof Regarding Winch Road Property Income

      In the notice of deficiency issued to Mr. Close respondent explained that the

basis for the partnership income adjustment was that Mr. Close had passthrough

income from Hidden Valley Ranch, LLC, in 2003. Respondent alleged for the

first time in a pretrial memorandum that Mr. Close had passthrough income from

Lost Creek Partnership and alleged for the first time at trial that Lost Creek Trust

is a sham.

      Respondent concedes that the entity identified in the notice of deficiency--

Hidden Valley Ranch, LLC--never owned the Winch Road property nor any

timber on that property. Instead, respondent now asserts that Mr. Close had

income from logging activities on the Winch Road property through Lost Creek

Partnership because Lost Creek Trust is a sham. The new theory, which is

inconsistent with the determination in the notice of deficiency, requires different

evidence, and it is therefore a new matter. See Shea v. Commissioner, 112 T.C. at

197. Because we conclude that respondent’s theory that Lost Creek Trust is a




      14
        (...continued)
Lewis’ testimony that she did not verify the unsupported amounts listed in Exhibit
36-R and that she did not know, and was not told, who prepared Exhibit 36-R,
why it was prepared, or on the basis of what information it was prepared.
                                        - 29 -

[*29] sham is a new matter, respondent bears the burden of proof with respect to

this theory.15 See Rule 142(a)(1); Shea v. Commissioner, 112 T.C. at 197.

       D.       Burden of Proof Regarding Nelson Loop Road Property Income

       In the notice of deficiency issued to Mr. Close respondent explained that the

basis for the Hidden Valley Trust adjustment was that Hidden Valley Trust is a

grantor trust. Respondent first alleged that Hidden Valley Trust is a sham in a

pretrial memorandum that was filed on November 9, 2012, less than three weeks

before trial.

       Respondent’s theory that Hidden Valley Trust is a sham is a new theory that

requires evidence different from evidence for the theory that respondent disclosed

in the notice of deficiency, and it is therefore a new matter. See Shea v.

Commissioner, 112 T.C. at 197. Accordingly, petitioners normally would bear the

burden of proof with respect to the grantor trust theory,16 and respondent bears the



       15
       Although respondent failed to assert in the answer that Lost Creek Trust is
a sham, see Rule 36(b), we conclude that the parties tried this issue by implied
consent, see Rule 41(b).
       16
         We conclude below, however, that respondent does not contend that the
irrevocable share of Hidden Valley Trust is a grantor trust or that the revocable
share included any interest in the Nelson Loop Road property after petitioners
assigned their interest in the revocable share to the irrevocable share. See infra
part V.A. Accordingly, the allocation of the burden of proof with respect to this
issue is irrelevant.
                                         - 30 -

[*30] burden of proof with respect to the sham trust theory.17 See Rule 142(a)(1);

Shea v. Commissioner, 112 T.C. at 197.

       Having assigned the burden of proof, we turn to an analysis of the

applicable law as it relates to the issues presented.

III.   General Principles

       A.    Sham Trusts

       A taxpayer may elect a business form to minimize or altogether avoid the

incidence of taxation by any means that the law permits. See Gregory v.

Helvering, 293 U.S. 465, 469 (1935). However, a taxpayer may not structure a

paper entity to avoid tax when that entity is without economic substance. Zmuda

v. Commissioner, 79 T.C. 714, 719 (1982), aff’d, 731 F.2d 1417 (9th Cir. 1984).

We have held that a trust, though valid under State law, may be treated as a nullity

for Federal income tax purposes if it lacks economic reality. See Markosian v.

Commissioner, 73 T.C. 1235, 1241 (1980); Furman v. Commissioner, 45 T.C. 360,

364 (1966), aff’d, 381 F.2d 22 (5th Cir. 1967).

       In Furman, we indicated that it was the “extreme case” where we would

disregard for Federal income tax purposes the existence of a trust valid under State

       17
         Although respondent failed to assert in the answer that Hidden Valley
Trust is a sham, see Rule 36(b), we conclude that the parties tried this issue by
implied consent, see Rule 41(b).
                                         - 31 -

[*31] law. See Furman v. Commissioner, 45 T.C. at 366; Downing v.

Commissioner, T.C. Memo. 2003-347, 86 T.C.M. (CCH) 738, 749 (2003). In

Markosian v. Commissioner, 73 T.C. at 1243-1244, we looked to the following

four factors to determine whether a trust had economic substance: (1) whether the

taxpayer’s relationship to the transferred property differed materially before and

after the trust’s creation; (2) whether the trust had an independent trustee; (3)

whether an economic interest passed to other trust beneficiaries; and (4) whether

the taxpayer respected restrictions imposed on the trust’s operation as set forth in

the trust documents or by the law of trusts. Accord Sparkman v. Commissioner,

509 F.3d 1149, 1155 (9th Cir. 2007), aff’g T.C. Memo. 2005-136.

      B.     Grantor Trusts

      For purposes of the grantor trust provisions, see secs. 671-679, a grantor

includes any person to the extent that person either creates a trust or gratuitously

transfers property, directly or indirectly, to a trust, see sec. 1.671-2(e)(1), Income

Tax Regs. If one person creates or funds a trust on behalf of another person, both

persons are treated as grantors of the trust. See id. The grantor of the trust is

taxed on the income of the trust under the grantor trust provisions if any of the

following conditions are met: (1) the grantor possesses a disqualifying

reversionary interest, see sec. 673; (2) specified powers to control beneficial
                                        - 32 -

[*32] enjoyment of the corpus or income are vested in the grantor or certain other

persons, see sec. 674; (3) certain administrative powers are exercisable by the

grantor or a nonadverse party,18 see sec. 675; (4) the trust can be revoked by the

grantor or a nonadverse party, see sec. 676; or (5) trust income can be distributed

to the grantor or the grantor’s spouse or be used to pay for insurance on their lives

without the consent of an adverse party, see sec. 677.

IV.   Winch Road Property Income

      We examine Lost Creek Trust using the four-factor test that we applied in

Markosian v. Commissioner, 73 T.C. at 1243-1244.

      A.     Petitioners and Mr. Leach’s Relationship With the Winch Road
             Property

      Petitioners and Mr. Leach did not own the Winch Road property before they

purported to form Lost Creek Trust. We therefore cannot compare their

relationship to the Winch Road property before and after the formation of the trust.




      18
        “[T]he term ‘adverse party’ means any person having a substantial
beneficial interest in the trust which would be adversely affected by the exercise or
nonexercise of the power which he possesses respecting the trust. A person
having a general power of appointment over the trust property shall be deemed to
have a beneficial interest in the trust.” Sec. 672(a). “[T]he term ‘nonadverse
party’ means any person who is not an adverse party.” Sec. 672(b).
                                        - 33 -

[*33] B.     Whether Mr. Dixon Was an Independent Trustee

      Respondent did not call Mr. Dixon to testify and failed to introduce

credible, probative evidence showing that Mr. Dixon was not an independent

trustee. Additionally, respondent failed to solicit testimony from Mr. Leach or to

produce other credible evidence with respect to (1) how Lost Creek Trust

operated, (2) how Hidden Valley Ranch, LLC, operated, and (3) how the two

entities interacted with each other.

      C.     Whether an Economic Interest Passed to the Trust Beneficiaries

      Assuming that Lost Creek Trust was validly formed, see supra note 11, the

beneficiaries of Lost Creek Trust received an economic interest in the Winch Road

property, which will presumably have some value even after its timber is harvested

and the purchase price is fully paid. Mr. Leach testified that he and petitioners

originally set up the trust to be a long-term investment for his and petitioners’

children. Mr. Leach eventually took the position that the trust is a sham, but this

was only after he was told to do so by Assistant U.S. Attorney Hall and Revenue

Agent Ferrell. Respondent has introduced no credible evidence showing that

petitioners in any significant way disregarded the beneficiaries’ economic interest

in Lost Creek Trust.
                                        - 34 -

[*34] D.     Respect for Trust Restrictions

       Respondent has introduced no credible evidence showing that petitioners

disregarded any restrictions imposed by the Lost Creek Trust agreement or by the

law of trusts in 2003.

       The weight of the evidence generally supports finding that Lost Creek Trust

is not a sham. We therefore conclude that respondent, who carries the burden of

persuasion on this issue, has failed to prove that this is the “extreme case”

requiring us to disregard an entity valid under State law. See Furman v.

Commissioner, 45 T.C. at 366; Downing v. Commissioner, 86 T.C.M. (CCH) at

749.

V.     Nelson Loop Road Property Income

       A.    Grantor Trust Theory

       In the notice of deficiency issued to Mr. Close respondent determined that

Mr. Close “received gross income from a grantor trust, Hidden Valley Irrevocable

Trust.” On brief respondent contends that the revocable share of Hidden Valley

Trust is a grantor trust but does not contend that the irrevocable share of Hidden

Valley Trust is a grantor trust or that the revocable share included any interest in

the Nelson Loop Road property after petitioners assigned their interest in the
                                             - 35 -

[*35] revocable share to the irrevocable share.19 We therefore conclude that

respondent has abandoned his determination in the notice of deficiency, and we

will not address it.

      Instead, respondent contends that we should disregard the transfer of

petitioners’ interest in the revocable share of Hidden Valley Trust to the

irrevocable share of Hidden Valley Trust because petitioners continued to have

unfettered access to Hidden Valley Trust’s assets. This contention is

indistinguishable from respondent’s sham trust theory for which respondent bears

the burden of proof, see supra part II.D, and which we address below, see infra

part V.B.2.

      B.      Sham Trust Theory

      Respondent contends that (1) the Court should on its own motion apply the

doctrine of collateral estoppel to bar petitioners from contending that Hidden

Valley Trust is not a sham and (2) the evidence shows that it is a sham.

              1.       Collateral Estoppel

      Respondent did not affirmatively plead collateral estoppel in the answer as

required under Rule 39. Respondent contends that this is because the District

      19
        We infer that respondent concedes that the irrevocable share is not a
grantor trust and that the irrevocable share formally held the Nelson Loop Road
property after petitioners assigned to it their interest in the revocable share.
                                         - 36 -

[*36] Court did not issue the final order regarding the Nelson Loop Road property

until nearly five years after he filed the answer. But respondent does not explain

why he failed to move to amend the answer. See Rule 41(a). Instead, respondent

suggests that we should apply collateral estoppel even though the issue has not

been properly raised in the pleadings.

      Under the doctrine of collateral estoppel, once an issue of fact or law is

“actually and necessarily determined by a court of competent jurisdiction, that

determination is conclusive in subsequent suits based on a different cause of

action involving a party to the prior litigation.” Montana v. United States, 440

U.S. 147, 153 (1979). Collateral estoppel is a judicially created equitable

principle the purposes of which are to protect the parties from unnecessary and

redundant litigation, to conserve judicial resources, and to foster certainty in and

reliance on judicial action. Id. at 153-154.

      Before we may apply collateral estoppel in the context of a factual dispute,

the following five conditions must be satisfied: (1) the issue in the second suit

must be identical in all respects with the issue decided in the first suit; (2) the issue

in the first suit must have been the subject of a final judgment entered by a court of

competent jurisdiction; (3) the person against whom collateral estoppel is asserted

must have been a party or in privity with a party in the first suit; (4) the parties
                                         - 37 -

[*37] must actually have litigated the issue in the first suit and resolution of the

issue must have been essential to the prior decision; and (5) the controlling facts

and applicable legal principles must remain unchanged from those in the first suit.

See Bussell v. Commissioner, 130 T.C. 222, 239-240 (2008); Peck v.

Commissioner, 90 T.C. 162, 166-167 (1988), aff’d, 904 F.2d 525 (9th Cir. 1990).

      The Court may raise the issue of collateral estoppel on its own motion. See

Arizona v. California, 530 U.S. 392, 412 (2000) (“‘[I]f a court is on notice that it

has previously decided the issue presented, the court may dismiss the action sua

sponte, even though the defense has not been raised.’” (quoting United States v.

Sioux Nation, 448 U.S. 371, 432 (1980) (Rehnquist, J., dissenting))); Monahan v.

Commissioner, 109 T.C. 235, 250 (1997). However, “[w]here no judicial

resources have been spent on the resolution of a question, trial courts must be

cautious about raising a preclusion bar sua sponte, thereby eroding the principle of

party presentation so basic to our system of adjudication.” Arizona v. California,

530 U.S. at 412-413.

      The issue of whether Hidden Valley Trust is a sham was not decided by the

District Court. Rather, the District Court dismissed Ms. Loomis’ petition to

adjudicate Hidden Valley Trust’s interest in the Nelson Loop Road property

because the petition failed to allege a prima facie case. Accordingly, we decline to
                                         - 38 -

[*38] raise the issue of collateral estoppel on our own motion because “no judicial

resources have been spent on the resolution of * * * [the] question” of whether

Hidden Valley Trust is a sham. See id. at 412. Moreover, even were we to raise

the issue of collateral estoppel on our own motion, we would conclude that

collateral estoppel does not apply because the District Court never determined in a

final order that Hidden Valley Trust is a sham.20 See Montana, 440 U.S. at 153.

             2.    The Merits

      We examine Hidden Valley Trust using the four-factor test that we applied

in Markosian v. Commissioner, 73 T.C. at 1243-1244.

                   a.     Petitioners’ Relationship With the Nelson Loop Road
                          Property

      Mr. Close testified that, after petitioners transferred their interest in the

revocable share of Hidden Valley Trust to the irrevocable share of the trust, Triple

C Ranch made lease payments of $2,000 per month to Hidden Valley Trust.

Respondent did not introduce any credible evidence to rebut this testimony or to

show that the lease payment was inadequate.21


      20
       We also note that neither petitioner was a party to Ms. Loomis’ petition to
adjudicate Hidden Valley Trust’s interest in the Nelson Loop Road property.
      21
        The April 10, 2006, letter that Revenue Agent Ferrell sent to Mr. Close,
see supra p. 9, contains vague references to various out-of-court statements of Ms.
                                                                       (continued...)
                                         - 39 -

[*39]               b.     Whether Ms. Loomis Was an Independent Trustee

        Respondent did not call Ms. Loomis to testify and failed to introduce any

credible evidence showing that Ms. Loomis was not an independent trustee.

                    c.     Whether an Economic Interest Passed to the Trust
                           Beneficiaries

        The beneficiaries of the irrevocable share of Hidden Valley Trust received

an economic interest in the Nelson Loop Road property because they are the

formal beneficiaries of the trust pursuant to the amended Hidden Valley Trust

agreement. Additionally, Mr. Close testified that the logging proceeds were used

to pay down the mortgage on the Nelson Loop Road property and to improve the

property. Respondent has introduced no credible evidence showing that

petitioners in any significant way disregarded the beneficiaries’ formal economic

interest in the irrevocable share of Hidden Valley Trust.

                    d.     Respect for Trust Restrictions

        Respondent has introduced no evidence showing that petitioners

disregarded any restrictions imposed by the amended Hidden Valley Trust

agreement or by the law of trusts.

        21
         (...continued)
Loomis. However, respondent failed to call Revenue Agent Ferrell or Ms. Loomis
to testify at trial. We do not find the matters asserted in that letter to be credible or
reliable absent testimony from Ms. Loomis, who allegedly made the statements.
                                         - 40 -

[*40] The weight of the evidence generally supports a finding that Hidden Valley

Trust is not a sham. We therefore conclude that respondent, who carries the

burden of persuasion on this issue, has failed to prove that this is the “extreme

case” requiring us to disregard an entity valid under State law. See Furman v.

Commissioner, 45 T.C. at 366; Downing v. Commissioner, 86 T.C.M. (CCH) at

749.

VI.    Additions to Tax

       A.    Burden of Proof

       The Commissioner bears the burden of production with respect to a

taxpayer’s liability for additions to tax and must produce sufficient evidence

indicating that it is appropriate to impose the additions to tax. See sec. 7491(c);

Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner

carries the burden of production, the taxpayer must come forward with persuasive

evidence that the Commissioner’s determination is incorrect or that the taxpayer

had reasonable cause or substantial authority for the position. See Higbee v.

Commissioner, 116 T.C. at 446-447.

       B.    Additions to Tax Under Section 6651(a)(1)

       Section 6651(a)(1) authorizes the imposition of an addition to tax for failure

to timely file a return, unless it is shown that such failure is due to reasonable
                                        - 41 -

[*41] cause and not due to willful neglect. See United States v. Boyle, 469 U.S.

241, 245 (1985); United States v. Nordbrock, 38 F.3d 440, 444 (9th Cir. 1994). A

failure to timely file a Federal income tax return is due to reasonable cause if the

taxpayer exercised ordinary business care and prudence but nevertheless was

unable to file the return within the prescribed time. See sec. 301.6651-1(c)(1),

Proced. & Admin. Regs. Circumstances that are considered to constitute

reasonable cause for failure to timely file a return are typically those outside of the

taxpayer’s control, including, for example: (1) unavoidable postal delays; (2) the

timely filing of a return with the wrong office; (3) the death or serious illness of

the taxpayer or a member of the taxpayer’s immediate family; (4) a taxpayer’s

unavoidable absence from the United States; (5) destruction by casualty of a

taxpayer’s records or place of business; and (6) reliance on the erroneous advice of

an IRS officer or employee. McMahan v. Commissioner, 114 F.3d 366, 369 (2d

Cir. 1997), aff’g T.C. Memo. 1995-547.

      The parties agree that petitioners failed to timely file a Federal income tax

return for 2003. Accordingly, if the Rule 155 computations show that petitioners

were obligated to file a return for that year, see sec. 6012(a)(1)(A)(iv), respondent

has carried the burden of producing evidence showing that the additions to tax

under section 6651(a)(1) for 2003 are appropriate.
                                         - 42 -

[*42] Mr. Close testified that petitioners failed to timely file their 2001 Federal

income tax return because of difficulties they faced in preparing the return after

the Government executed multiple search warrants with respect to Mr. Close’s

medical equipment business and the entity that purchased it in 2001. Mr. Close

further testified that petitioners did not timely file their 2003 Federal income tax

return because he thought that they first had to file returns for the earlier years.

However, Mr. Close had no reasonable basis for this belief. We find that

petitioners have not shown that they exercised ordinary business care and

prudence with respect to their failure to timely file a 2003 return. Accordingly, if

the Rule 155 computations show that petitioners were obligated to file a return for

2003, petitioners are liable for the additions to tax under section 6651(a)(1) for

2003.

        C.    Additions to Tax Under Section 6651(a)(2)

        Section 6651(a)(2) imposes an addition to tax for failure to pay the amount

of tax shown on a taxpayer’s Federal income tax return on or before the payment

due date, unless such failure is due to reasonable cause and not due to willful

neglect.22 The section 6651(a)(2) addition to tax applies only when an amount of

        22
       The amount of the addition to tax under sec. 6651(a)(2) reduces the
amount of the addition to tax under sec. 6651(a)(1) for any month for which an
                                                                      (continued...)
                                       - 43 -

[*43] tax is shown on a return filed by the taxpayer or a section 6020 substitute for

return prepared by the Secretary. Sec. 6651(a)(2), (g)(2); Cabirac v.

Commissioner, 120 T.C. 163, 170 (2003). Where the taxpayer did not file a

return, the Commissioner must introduce evidence that a substitute for return

satisfying the requirements of section 6020(b) was made. See Wheeler v.

Commissioner, 127 T.C. 200, 210 (2006), aff’d, 521 F.3d 1289 (10th Cir. 2008).

A failure to timely pay the amount due on a Federal income tax return is due to

reasonable cause if the taxpayer exercised ordinary business care and prudence in

providing for the timely payment of his or her tax liability but nevertheless was

either unable to pay the tax or would suffer an undue hardship if he or she paid on

the due date. See sec. 301.6651-1(c)(1), Proced. & Admin. Regs.

      Respondent introduced certified Forms 4340, Certificate of Assessments,

Payments, and Other Specified Matters, for each of petitioners’ individual income

tax accounts for 2003 that purport to show that respondent filed substitutes for

returns for Mr. Close and Mrs. Close on April 20, 2006, and April 10, 2007,

respectively, for 2003. However, respondent failed to introduce copies of any of

the substitutes for returns. Because respondent has failed to show that petitioners


      22
        (...continued)
addition to tax applies under both paragraphs. Sec. 6651(c)(1).
                                          - 44 -

[*44] failed to pay the tax shown on a validly executed return or section 6020(b)

substitute for return that meets the requirements of section 6020(b), respondent

has failed to satisfy the burden of proving that the additions to tax under section

6651(a)(2) for 2003 are appropriate. See sec. 7491(c); Wheeler v. Commissioner,

127 T.C. at 210. Accordingly, petitioners are not liable for the additions to tax

under section 6651(a)(2) for 2003.

      D.     Additions to Tax Under Section 6654

      Section 6654 imposes an addition to tax on an individual who underpays his

or her estimated tax. The addition to tax is calculated with reference to four

required installment payments of the individual’s estimated tax liability. See sec.

6654(c) and (d). Each required installment of estimated tax is equal to 25% of the

“required annual payment”. Sec. 6654(d). The “required annual payment” is

equal to the lesser of (1) 90% of the tax shown on the individual’s return for that

year (or, if no return is filed, 90% of his or her tax for such year), or (2) if the

individual filed a return for the immediately preceding taxable year, 100% of the

tax shown on that return. Sec. 6654(d)(1)(A), (B), and (C). An individual has an

obligation to pay estimated tax only if he or she has a “required annual payment”.

Wheeler v. Commissioner, 127 T.C. at 211-212; see also Mendes v.

Commissioner, 121 T.C. 308, 324 (2003).
                                         - 45 -

[*45] There are two relevant exceptions to the applicability of the section 6654

addition to tax. First, the addition to tax is inapplicable if the tax shown on the

individual’s return for the year in question (or, if no return is filed, the individual’s

tax for that year), reduced by any allowable credit for wage withholding, is less

than $1,000. See sec. 6654(e)(1). Second, the addition to tax is inapplicable if the

individual’s tax liability for the preceding taxable year was zero, subject to certain

conditions.23 See sec. 6654(e)(2).

      Respondent introduced certified records showing that petitioners did not file

Federal income tax returns for 2002 and 2003 and made no estimated tax

payments for 2003. However, respondent also introduced certified Forms 4340 for

each of petitioners’ individual income tax accounts for 2002 that each show no tax

assessed, no payments made, and an account balance of zero. The Forms 4340

further show that respondent filed a substitute for return for Mr. Close but did not

file a substitute for return for Mrs. Close for 2002. The Forms 4340 do not show

that respondent issued a notice of deficiency to either petitioner for 2002. We

therefore conclude on the preponderance of the evidence that the section




      23
        The preceding taxable year must have been a taxable year of 12 months,
and the taxpayer must have been a U.S. citizen or resident throughout the
preceding taxable year. See sec. 6654(e)(2).
                                       - 46 -

[*46] 6654(e)(2) exception applies. Accordingly, petitioners are not liable for the

additions to tax under section 6654 for 2003.

VII. Conclusion

      This case would have benefited from a more fully developed record

regarding the creation, funding, and administration of Lost Creek Trust and

Hidden Valley Trust; the conduct of logging operations on both the Winch Road

and Nelson Loop Road properties; the use and amount of the income generated by

the logging activities; and the acquisition of and payment for the two properties.

This case would also have benefited from the earlier assertion and development of

respondent’s sham trust theories. Unfortunately, respondent chose to rely on

actions taken in connection with Mr. Close’s criminal case and particularly the

Government’s misguided attempt to position itself for an easy forfeiture of the

trusts’ assets. The resulting product was poorly developed and unconvincing.

      We have considered the parties’ remaining arguments, and to the extent not

discussed above, conclude those arguments are irrelevant, moot, or without merit.

      To reflect the parties’ concessions and the foregoing,


                                                     Decision will be entered

                                                under Rule 155.
