                        T.C. Memo. 1996-216



                      UNITED STATES TAX COURT



     CARL J.D. BAUMAN AND MARGARET A. BAUMAN, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 37669-85, 38099-85.            Filed May 2, 1996.



     Robert L. Manley, for petitioners.

     Linda J. Wise, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     WRIGHT, Judge:   Respondent determined deficiencies in and

additions to petitioners’ Federal income taxes as follows:1



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



Docket No. 37669-85

                                            Additions to Tax

Year1        Deficiency    Sec. 6653(a)(1) Sec. 6653(a)(2) Sec. 6651
                                2
1979         $12,476             $624              --              --
                                2
1980          19,023                951            --              --
                                                    3
1981          13,573                679                          $4,072



Docket No. 38099-85

                                      Additions to Tax

Year1       Deficiency    Sec. 6653(a)(1)     Sec. 6653(a)(2) Sec. 6651
                                                        3
1982         $28,019           $1,705                           $3,167
        1
       Increased interest under sec. 6621(c) was imposed.
        2
       The additions to tax for 1979 and 1980 were determined
pursuant to sec. 6653(a).
     3
       50 percent of the interest due on $13,573 and $28,019 for
taxable years 1981 and 1982, respectively.

        After concessions, the issues for decision are:2

        (1)    Whether a lease transaction entered into by Energy

Resources, Ltd. (ERL), a limited partnership of which petitioner

husband was a limited partner, was devoid of economic substance.

We hold that it was.



        2
      The petition also presents an issue of whether respondent
is barred from assessing the taxes at issue pursuant to sec.
6501. Petitioners, however, did not address this issue at trial,
nor did they discuss it in their posttrial briefs. Accordingly,
the issue is deemed to have been conceded and is not discussed
herein.
                                 - 3 -

     (2)   Whether notes ERL issued with respect to advance

royalty payments due under a lease agreement represented bona

fide indebtedness.   We hold that they did not.

     (3)   Whether annual payments ERL agreed to pay under a lease

agreement were properly accrued and deducted as advance royalties

due under a minimum royalty provision described under section

1.612-3(b), Income Tax Regs.    We hold that they were not.

     (4)   Whether ERL was engaged in an activity for profit.      We

hold that it was not.

     (5)   Whether petitioners have established their entitlement

to various other deductions stemming from ERL’s mining operations

pursuant to section 183(b).    We hold that they have not.

     (6)   Whether petitioners are liable for the addition to tax

under section 6653(a) for taxable year 1980 and under section

6653(a)(1) and (2), for taxable years 1981 and 1982.    We hold

that they are.

     (7)   Whether the increased interest rate attributable to

tax-motivated transactions under section 6621(c) applies.     We

hold that it does to the extent stated herein.

     (8)   Whether petitioners are liable for the addition to tax

under section 6651(a)(1) for failure to file their 1982 tax

return by the prescribed date.    We hold that they are.

                         FINDINGS OF FACT

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

The stipulation of facts and the exhibits attached thereto are
                               - 4 -

incorporated herein.   At the time the petition was filed in this

case, petitioners resided in Anchorage, Alaska.

     This case is part of a group of cases identified by

respondent as McIntyre-CN.   McIntyre-CN is a national litigation

project involving coal mining partnerships promoted by Richard

McIntyre (McIntyre).

     Petitioner husband (Bauman) has been employed as an attorney

with the same law firm (law firm) in Anchorage, Alaska, since

1973.   He has been a partner in that law firm since 1975.

     Petitioners timely filed their Federal income tax return for

1979.   Petitioners’ Federal income tax return for 1980 was not

received by the Internal Revenue Service (IRS) until May 8, 1981.

Attached to petitioners’ return for taxable year 1980 is a brief

handwritten note in which Bauman explains the reason for the

untimely filing.   This note essentially states that confusion

brought about by petitioner wife’s (Mrs. Bauman) second pregnancy

caused the couple to overlook the filing deadline.   The note

concludes with the statement “it won’t happen again”.

Petitioners’ Federal income tax return for 1982 was not received

by the IRS until June 10, 1983.   Attached to petitioners’ return

for taxable year 1982 is a brief typewritten note in which Bauman

explains the reason for the couple’s delinquent filing.    In this

note, Bauman principally asserts that the couple was unable to

satisfy their obligation to file their return by the prescribed

date because Bauman’s father was ill and that such illness
                                - 5 -

required Bauman’s periodic attention.    Petitioners’ Federal

income tax return for 1981 was not received by the IRS until June

30, 1983.    The record does not contain an explanation for the

tardiness of petitioners’ return for taxable year 1981.

Background

       During the taxable years at issue,3 Bauman was a limited

partner in ERL.    In 1980, ERL, as lessee, entered into a lease

agreement with JAD Coal Co., Inc. (JAD), as lessor, to mine and

market coal underlying certain land in Harlan County, Kentucky.

This lease transaction was the subject of this Court’s opinion in

Bauman v. Commissioner, T.C. Memo. 1988-122 (occasionally Bauman

I).4    In Bauman I, this Court held that ERL’s royalty obligations

under its lease agreement with JAD were not “substantially

uniform” and were not “paid at least annually”.    As such, we

further held that the royalty obligations were not deductible as

advance royalties paid or accrued “as a result of a minimum

royalty provision” under section 1.612-3(b), Income Tax Regs.

The Court granted respondent’s motion for partial summary

judgment with respect to this minimum royalty issue.    Bauman I,

however, was limited to the question of whether the royalty

obligations qualified under a minimum royalty provision as

       3
      The parties have reached settlement with respect to taxable
year 1979. The issues before the Court pertain to taxable years
1980, 1981, and 1982.
       4
      The parties in Bauman v. Commissioner, T.C. Memo. 1988-122,
are identical to the parties in the instant case.
                               - 6 -

envisioned by section 1.612-3(b), Income Tax Regs.   Bauman I

involved taxable years 1979, 1980, and 1981.    Bauman v.

Commissioner, supra.

     Subsequent to this Court’s decision in Bauman v.

Commissioner, supra, we decided Coggin v. Commissioner, T.C.

Memo. 1993-209, affd. 71 F.3d 855 (11th Cir. 1996) (occasionally

the Coggin case).   The Coggin case was among a number of cases

included in respondent’s national litigation project entitled

McIntyre-CN.   Like Bauman in the instant case, the taxpayer in

the Coggin case was a limited partner in ERL.   As a majority of

the facts in the Coggin case are identical to the facts in the

instant case, the parties have stipulated pertinent parts of the

record in the Coggin case.

     As a result of Bauman’s investment in ERL, petitioners

claimed certain losses and credits on their Federal income tax

returns for 1980, 1981, and 1982.   Respondent determined that ERL

was a sham, engaged in solely for the resulting tax benefits, and

disallowed the losses and credits claimed by petitioners for each

year at issue.

Energy Resources, Ltd.

     ERL was a Tennessee limited partnership.   It operated under

the accrual method of accounting.   Investors were solicited

through a private placement memorandum (the offering memorandum

or offering materials) dated October 1, 1980.   The offering

materials explained that ERL was organized to lease (the lease)
                               - 7 -

3,520 acres of land in Harlan County, Kentucky (occasionally the

coal property), and that ERL would earn future income for its

partners by exploiting its rights under the lease.    The offering

materials consisted of 94 pages of information concerning the

offering and contained a discussion of a variety of matters,

including the partnership’s objectives, the terms of the

agreement, potential risk factors, and related Federal tax

issues.   Sixteen pages of the 94-page offering memorandum

consisted of a discussion regarding the Federal income tax

consequences relating to the offering.    Attachments to the

offering memorandum included a tax opinion, a Coal Reserve

Report, and accounting and productivity projections.    Although

many of these attachments were lacking in detail and specificity,

the tax opinion was an exception.   The tax opinion, which was

authored by the taxpayer in the Coggin case, exceeded 100 pages

in length and was extensive and thorough.    The offering

memorandum also contained 12 exhibits.    Included among the

exhibits were a copy of the limited partnership agreement, a copy

of the lease agreement, and copies of various partnership

promissory notes.

     McIntyre was ERL’s managing general partner and the sponsor

of the offering materials.   ERL’s associate general partner was

McIntyre’s brother, Charles McIntyre.    The offering materials

advised potential investors that McIntyre was the president of

Economic Research Analysts, Inc. (ERA).    ERA was an entity with
                                - 8 -

various specialties, including tax incentive investments.

Potential investors were further advised that McIntyre’s

experience in the coal mining business was limited and that

McIntyre’s involvement as a general partner in other mining

partnerships might compete with ERL for McIntyre’s time.

     Pursuant to the offering materials, 200 limited partnership

units were available to prospective investors.     The minimum

investment was one unit per investor; however, McIntyre possessed

authority to issue fractional units to a maximum of 35 investors.

According to the terms set forth in the offering materials, the

capital contribution for each unit was $190,000.     This amount

consisted of $45,000 in cash and a promissory note in the amount

of $145,000 executed by each investor and payable to ERL.     The

cash portion of each investor’s capital contribution was payable

in three annual installments.   The offering materials explained

that each investor’s capital contribution represented his or her

proportionate personal liability for three recourse notes, which

were to be executed by ERL and payable to JAD, for advance

minimum royalties due during the first 3 years of the lease.

Accordingly, the total capital contribution by limited partners

was designed to equal $38 million.

     The offering materials contained a copy of the ERL limited

partnership agreement (agreement).      Pursuant to the terms of the

agreement, 99 percent of ERL’s profits and losses were to be

allocated to the limited partners.      The two general partners were
                               - 9 -

to receive the remaining 1 percent of ERL’s profits and losses.

The agreement explained that McIntyre, as managing general

partner, had the responsibility of managing the partnership’s

affairs.   The offering materials further explained that McIntyre

would receive an acquisition fee equal to 22 percent of the total

cash contributions made by the limited partners to ERL in 1980,

1981, and 1982.   As managing general partner, McIntyre was also

entitled to a management fee in the amount of $1 per ton of coal

mined by or for the partnership.   Payment of this fee, however,

was conditioned on ERL’s realization of a minimum per-ton profit

of $4.   Additionally, the management fee was structured to

terminate once the limited partners received cash distributions

equal to their total cash contributions.

     The principal term of ERL’s lease with JAD was 30 years;

however, ERL could terminate the lease in the event the retrieval

of coal became economically prohibitive.   Additionally, if and to

the extent that ERL determined it to be economically feasible,

ERL had the option of extending the primary term of the lease on

a yearly basis.

     The terms of the lease obligated ERL to pay JAD an advance

production royalty of 8 percent of ERL’s gross coal sales.    The

lease also obligated ERL to pay JAD a minimum annual advance

royalty of $10 million.   ERL was required to pay the minimum

advance royalties annually and each such payment was due without

regard to actual production levels; however, such payments were
                                - 10 -

subject to credits from actual production.        The first two minimum

annual royalty payments were to consist of a cash payment and a

promissory note.    All remaining payments were to consist of

individual promissory notes.    The first 3 notes were to be

denoted as “recourse” notes, while the remaining 17 notes were to

be considered “nonrecourse” notes.        The first note was to be

executed on the date the lease was created, and each subsequent

note was to be delivered to JAD on the same date of each

successive year.    This payment pattern was to continue for the

shorter of 20 years or the life of the lease.        The following

table depicts the manner in which the offering materials

presented the discharge of the annual royalty payments:


Source             1980            1981            1982         1983-99

Cash             $750,000        $250,000           --              --

Recourse        9,250,200       9,750,000        $10,000,000
  note

Nonrecourse
   notes         ---              ---              ---         $10,000,000
                                                                  (each)

 Total         10,000,000      10,000,000        10,000,000    170,000,000




       The partnership agreement was structured such that the $29

million in notes issued by the limited partners to purchase the

partnership units represented the limited partners’ personal

liability for the first three annual notes of the partnership for
                               - 11 -

royalty payments.    ERL’s total liability for the advance

royalties, however, totaled $200 million in cash and notes.

     Each note, recourse and nonrecourse, became due 20 years

after execution; however, at the election of either JAD or ERL,

each note could be extended for an additional 10 years.      Although

each note bore annual interest at a rate of 6 percent, no partner

was personally liable for the payment of such interest.      The

maturity date of each recourse note would not change if the lease

were terminated prior to its primary term.    The offering

materials explained that the coal reserves underlying the leased

property would serve as security for each note.

     The coal property was acquired by JAD in 1977 for

$3,750,000.    Information pertaining to this acquisition was

presented in the offering materials.    The offering materials

explained that the coal property contained three principal coal

seams; namely the Mason, Harlan, and Wallins Creek seams.      The

offering materials further explained that the objective of the

partnership was to develop these three seams and then to develop

other seams if such development were practicable.    The Coal

Reserve Report, which accompanied the offering memorandum,

however, did not lend solid support for this objective.      Although

it maintained that the Mason seam was “of good quality”, the Coal

Reserve Report noted that the Mason seam was not without serious

limitations.    The report further indicated that coal recovered

from the Harlan seam would be burdened by a high ash content and
                                - 12 -

would require additional premarketing procedures.    Moreover,

because the Wallins Creek seam had already been extensively

mined, the Coal Reserve Report concluded that no recoverable coal

reserves existed in the Wallins Creek seam.    The Coal Reserve

Report continued and further discussed several shortcomings with

other potential seams.

     The record does not support a finding that the Coal Reserve

Report was prepared by a qualified expert.    The author of the

Coal Reserve Report subsequently became an employee of ERL and

performed other work for the coal partnerships organized and

operated by McIntyre.    Nevertheless, the report estimates that

the property contained approximately 52.6 million tons of total

potential coal reserves.    This figure consists of 23.6 million

tons in calculated recoverable reserves and 29 million tons in

possible additional reserves.    The Coal Reserve Report explained,

however, that the above figure regarding possible additional

reserves was uncertain and that additional exploration was needed

to verify its accuracy.    The Coal Reserve Report did not conclude

whether it would be profitable to mine the underlying property,

but it did indicate that a prudent production estimate was

approximately 1 million tons of coal per year.    The Coal Reserve

Report did, however, warn potential investors that an in-depth

study was necessary before an assessment of the property’s

profitability could be made.    No such study was ever performed.
                              - 13 -

     The tax opinion contained in the offering materials was

exhaustive.   It discussed essentially all relevant Code sections,

Treasury regulations, and revenue rulings pertaining to the

structure of ERL and its transactions.     Much case law was also

presented, explaining how the courts had interpreted the various

Code sections, regulations, and rulings discussed therein.

     The accounting projections accompanying the offering

materials included an estimate of ERL’s taxable income for 1980,

1981, and 1982.   Also included in the accounting projections was

an analysis of ERL’s estimated mining operations for the 29-year

period ending with 2009.   The accounting projections estimated

that ERL would realize a net loss of $10,105,000 in 1980.

Similarly, for 1981 and 1982, net losses were estimated to be

$9,200,000 and $7,712,500, respectively.     As previously stated,

all but 1 percent of these losses were allocable to the limited

partners pursuant to the partnership agreement.     The accounting

projections further explained that, in light of this loss

forecast, and based on the limited partners’ cash capital

contributions, the ratios of the tax deductions to the cash

capital contributions would be 333 percent, 304 percent, and 255

percent, respectively, for 1980, 1981, and 1982.

     The accounting projections also contained a tabular analysis

of projected mining operations.   It was projected that ERL would

sell 200,000 tons of coal in 1981.     The projections increased

annually, and during the period from 1989 through 2009 it was
                               - 14 -

projected that ERL would sell in excess of 2 million tons of coal

per year.   This tabular analysis, however, bore the qualification

that all projections were hypothetical and were in no way

warranted or guaranteed.

     The offering materials advised potential investors that

there were no assurances as to the accuracy of the recoverable

coal estimates upon which the substance of the offering materials

depended.   Potential investors were also advised by the offering

materials that ERL did not have any existing long-term contracts

for the sale of coal and that future demand for coal was

unpredictable.   The offering materials further advised potential

investors that McIntyre had limited experience in the mining

business and that extensive competition should be expected from

entities with substantially superior financial, technical, and

intellectual resources.    The offering materials also discussed

the probable likelihood of labor disputes common to the

geographic area in which the land covered by the lease was

situated.

     ERL executed the lease agreement for the coal property on

December 1, 1980.   The terms of the lease were consistent with

the representations presented in the offering materials.

     In 1980 and 1981, ERL received eight mining permits.    Two of

the mines were never operated; the remaining six mines produced

an approximate total of 167,000 tons of coal.    All ERL mining

operations ceased by the end of 1981, and no other coal was
                               - 15 -

produced from the coal property subsequent to that time.    The

mines were not reclaimed or restored to their premining

condition, and ERL forfeited the reclamation bonds it had posted

in order to obtain the mining permits.

Mr. and Mrs. Bauman

     Neither Bauman nor Mrs. Bauman had any formal education,

training, or experience in coal mining.    Bauman purchased two-

thirds of a partnership unit in ERL.     This purchase was motivated

at least in part by Bauman’s prior participation in a coal mining

project promoted and managed by McIntyre.    Many of the partners

in Bauman’s law firm were also involved in McIntyre-related coal

projects.    Several of these partners were also limited partners

in ERL.    The members of the law firm routinely discussed with one

another the potential opportunities presented by an ERL

investment.    Bauman’s preinvestment research of ERL was

principally limited to these intrafirm discussions and a review

of the information contained in the offering materials.

                               OPINION

     Petitioners maintain that respondent has erroneously

determined that they are liable for the deficiencies, additions

to tax, and increased interest set forth at the beginning of this

opinion.    The essence of petitioners’ argument is twofold.

First, petitioners maintain that ERL was a legitimate entity

organized and managed with a true and objective profit motive.

Petitioners also contend that they invested in ERL only after
                                - 16 -

consulting various professionals and that such investment was

undertaken with the intent of making a profit.    Accordingly,

petitioners conclude, such consultation and reliance preclude a

finding that they were negligent.

     Respondent rejects petitioners’ arguments as self-serving

and contends that the sole purpose underlying ERL’s formation was

to enable the limited partners to claim tax benefits based on the

pass-through of enormous losses.    As a result, respondent

maintains, ERL’s lease transaction was devoid of economic

substance and, as such, must be disregarded for Federal income

tax purposes.    Respondent further maintains that ERL was not

engaged in an activity for profit and that petitioners have

failed to substantiate various ERL deductions.    Respondent also

maintains that certain additions to tax are appropriate for each

year at issue.

Issues 1 & 2.    Economic Substance & Bona Fide Indebtedness

     Numerous cases hold that transactions which are devoid of

economic substance are to be disregarded for Federal tax

purposes.   See Larsen v. United States, 89 T.C. 1229, 1252

(1987), affd. in part and revd. in part sub nom.; Casebeer v.

Commissioner, 909 F.2d 1360 (9th Cir. 1990); Rose v.

Commissioner, 88 T.C. 386, 410 (1987), affd. 868 F.2d 851 (6th

Cir. 1989).     In James v. Commissioner, 87 T.C. 905, 918 (1986),

affd. 899 F.2d 905 (10th Cir. 1990), we summarized the holdings

of such cases and explained that a transaction will not be
                              - 17 -

recognized for Federal income tax purposes if it is a sham or is

otherwise devoid of economic substance.    See Frank Lyon Co. v.

United States, 435 U.S. 561, 573 (1978); Knetsch v. United

States, 364 U.S. 361, 366 (1960); Bail Bonds by Marvin Nelson,

Inc. v. Commissioner, 820 F.2d 1543 (9th Cir. 1987), affg. T.C.

Memo. 1986-23; Falsetti v. Commissioner, 85 T.C. 332 (1985).     The

substance of the transaction, not its form, determines its tax

consequences.   Gregory v. Helvering, 293 U.S. 465 (1935).   A

transaction must have economic substance which is compelled or

encouraged by business or regulatory realities, is imbued with

tax-independent considerations, and is not shaped solely by tax

avoidance features that have meaningless labels attached.     Frank

Lyon Co. v. United States, supra; Hilton v. Commissioner, 74 T.C.

305 (1980), affd. per curiam 671 F.2d 316 (9th Cir. 1982).

     There are several key indicators which are helpful in

determining whether a transaction possesses or lacks economic

substance.   Among these are (1) the presence or absence of arm’s-

length price negotiations, (2) the relationship between the sales

price and fair market value, (3) the structure of the

transaction’s financing, (4) the degree of adherence to

contractual terms, and (5) whether there was a shifting of the

benefits and burdens of ownership.     See, e.g., Helba v.

Commissioner, 87 T.C. 983 (1986), supplemented by T.C. Memo.

1987-529, affd. without published opinion 860 F.2d 1075 (3d Cir.

1988); Zirker v. Commissioner, 87 T.C. 970 (1986); James v.
                               - 18 -

Commissioner, supra; Grodt & McKay Realty, Inc. v. Commissioner,

77 T.C. 1221 (1981); Karme v. Commissioner, 73 T.C. 1163 (1980),

affd. 673 F.2d 1062 (9th Cir. 1982)

     In evaluating whether a transaction is a sham, the Court of

Appeals for the Ninth Circuit, to which this case is appealable,

applies a two-factor test.    The analysis requires an examination

of both the objective and subjective aspects of the transaction.

The objective factor focuses on whether the transaction would

have been likely to produce economic benefits aside from tax

benefits.    The subjective analysis focuses on whether the

taxpayer entered into the transaction with a bona fide business

purpose other than tax avoidance.     Bail Bonds by Marvin Nelson,

Inc. v. Commissioner, supra.    The Court of Appeals, however, does

not apply these two factors in a rigid fashion.     Sochin v.

Commissioner, 843 F.2d 351 (9th Cir. 1988), affg. Brown v.

Commissioner, 85 T.C. 968 (1985).     Instead, both factors are

viewed in a manner intended to aid the court’s traditional

analysis with respect to alleged sham transactions.    The

underlying objective is to determine whether the transaction had

any practical economic effects other than the creation of tax

losses.   Id.

     In the instant case, respondent determined that ERL’s lease

transaction lacked economic substance.    Accordingly, petitioners

have the burden of proving that respondent’s determination is

erroneous.    Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).
                                 - 19 -

       The issue involving the economic substance of ERL’s lease

transaction has twice before been decided in respondent’s favor.

In both Coggin v. Commissioner, T.C. Memo. 1993-209, and Suivski

v. Commissioner, T.C. Memo. 1993-291, this Court held that ERL’s

lease transaction lacked economic substance and, pursuant to the

line of cases identified above, was to be disregarded for Federal

income tax purposes.    Petitioners have failed to persuade us that

a different outcome is now appropriate.

       On brief, petitioners have expended much effort in an

attempt to convince us that ERL was a legitimate entity that

should not be disregarded as a sham.       Despite this effort,

however, we find petitioners’ argument cursory and unconvincing.

We agree with respondent that the majority of the offering

materials consisted of information pertaining to the tax benefits

associated with the venture.     We also agree that such material

was extensive and thorough as compared to most of the remaining

contents of the offering materials.       The offering materials

provide minimal insight as to the actual profit-making potential

of the    coal mining venture.   See Rose v. Commissioner, supra at

412.

       Petitioners contend that the offering materials focus

principally on the risks rather than the benefits of the

underlying investment.    We disagree.     Having carefully examined

the offering materials, we are convinced that such materials,

when collectively considered, heavily emphasize relevant tax
                              - 20 -

issues properly characterized as benefits ensuing from the

investment.

     Respondent argues that ERL entered into the lease agreement

with JAD without regard to whether the royalty obligations were

commensurate with the fair market value of the coal that could

reasonably be extracted from the leased property.   Petitioners

contend that respondent fails to understand the complexities of

the financial transaction as structured by McIntyre.   In light of

the evidence contained in the record, however, we agree with

respondent and conclude that the royalty obligations at issue

substantially exceed the fair market value of ERL’s rights under

its lease with JAD.   See Coggin v. Commissioner, supra.

Petitioners have failed to establish that ERL’s purported royalty

obligations of $200 million were reasonably commensurate with the

fair market value of the coal underlying the leased property.

Perhaps the most compelling fact rendering support to this

conclusion is that JAD acquired the land covered by the lease for

$3,750,000 on July 30, 1977, approximately 3 years prior to ERL’s

execution of the lease with JAD for the same property.      Id.

Petitioners attempt to address this disparity in two ways.

First, they advance a misguided argument based on the concept of

present valuation analysis.   Petitioners also argue that

subsequent to JAD’s acquisition of the subject property, the

infrastructure of the property underwent extensive development.
                              - 21 -

     We find neither argument persuasive.    Petitioners have

failed to offer sufficient evidence to establish that the coal

property’s fair market value had so greatly appreciated to an

amount which would justify ERL’s agreement to pay $200 million in

minimum royalties during the initial 20-year period of its lease.

Rose v. Commissioner, supra at 412-419.     A grossly inflated price

is a hallmark of a sham transaction.   Sacks v. Commissioner, 69

F.3d 982 (9th Cir. 1995), revg. T.C. Memo. 1992-596.

Additionally, the record establishes that McIntyre acted without

adequate information regarding the coal property when he executed

ERL’s lease with JAD.   Although McIntyre commissioned a firm to

prepare the Coal Reserve Report contained in the offering

materials, the report is inherently flawed as the leased property

constitutes only a portion of the property covered by the report.

Furthermore, McIntyre’s actions and representations conflict with

the substance of the Coal Reserve Report.    That is, despite the

Coal Reserve Report’s conclusion that the property subject to its

scope could realistically be expected to produce 1 million tons

of raw coal annually, McIntyre represented in the offering

materials that the coal property would yield annually 2 million

tons of marketable coal.   Moreover, the author of the report

cautioned McIntyre that the report was based upon insufficient

data and an additional in-depth study was necessary in order to

render a determination of probable profitability.    No additional

study was engaged.   See Rose v. Commissioner, 88 T.C. at 415.
                              - 22 -

     Petitioners also contest respondent’s argument that McIntyre

disregarded evidence of comparable minimum royalty obligations in

use at the time ERL entered into the lease with JAD.   Petitioners

restrict their attack on this argument to a challenge of

respondent’s expert’s ability to appreciate the nature and

quality of the transaction.   Respondent’s argument, however, is

convincing.   JAD leased a portion of the same property in October

1979 to an independent company.   The terms of that agreement

required the lessee to pay an annual minimum royalty of just

under $25,000.   Furthermore, ERL’s manager of mining operations,

a person possessing a thorough knowledge of the coal mining

industry, testified that the largest minimum royalty with which

he was familiar, excluding those in which McIntyre was a party,

involved a lease which required an annual minimum royalty of

$200,000 on an 80,000-acre tract of land.   This witness did,

however, attempt to justify the disparity by noting that while

ERL’s minimum royalty obligations were considerably higher than

the minimum royalty obligations with which he was familiar, they

were justified because ERL could defer each payment for up to 30

years.   We reject this attempted justification and, based upon

the record, conclude that ERL’s minimum royalty obligations were

not reasonably comparable to those provided under similar leases

in the geographic region.

     Respondent next argues that petitioners have failed to

establish that ERL had an actual and bona fide objective to
                               - 23 -

satisfy its royalty obligations and generate a profit.     We agree.

Neither the testimony at trial nor the unreliable Coal Reserve

Report persuades us that ERL intended to generate sufficient

revenue to meet its royalty obligations and earn profits.

     Petitioners assert that the lease between ERL and JAD was

negotiated at arm’s length and that the notes representing ERL’s

minimum royalty obligations were of a type commonly used in

business.   Essentially, petitioners attribute the structure of

the ERL’s lease agreement to the financial wizardry of McIntyre.

We are not persuaded by petitioners’ argument.     The entire

transaction is covered by a blanket of suspicion.     The terms of

the lease agreement, in effect, permit ERL to postpone payment on

each note for 30 years.   Moreover, no partner, limited or

general, was personally liable for the interest payable on such

notes.     Additionally, except for the first three notes, all

notes representing ERL’s obligations were to be nonrecourse.

Nonrecourse financing is a common indicator of a sham

transaction.    Sacks v. Commissioner, supra; Ferrell v.

Commissioner, 90 T.C. 1154 (1988).      Such notes are not the type

of obligations commonly used in commerce or by banks and other

financial institutions.    See Rose v. Commissioner, supra at

419-421.

     The Court is not convinced that the notes were bona fide

debt instruments.    Although petitioners claim that a letter from

JAD to Bauman which notified Bauman of ERL’s default constitutes
                              - 24 -

evidence of the bona fide nature of the notes, we find

petitioners’ argument to be unpersuasive.    That a note is labeled

“recourse” is not itself dispositive; substance, not form, must

govern.   Gregory v. Helvering, 293 U.S. 465 (1935); Zmuda v.

Commissioner, 731 F.2d 1417 (9th Cir. 1984), affg. 79 T.C. 714

(1982).   A nonrecourse debt may be disregarded for tax purposes

where it appears likely from all the facts and circumstances that

the obligation will not be paid.   Waddell v. Commissioner, 86

T.C. 848, 902 (1986), affd. per curiam on other issues 841 F.2d

264 (9th Cir. 1988).   Even a recourse debt may not be recognized

if its payment is unlikely or too contingent.    Id.   The three

recourse notes at issue have a “strong nonrecourse flavor”, and,

because the record fails to establish that payment of any note,

recourse or nonrecourse, was reasonably likely, we are not

convinced that such notes represented bona fide indebtedness.

     In sum, petitioners have not sustained their burden of

establishing that ERL’s activities were motivated by anything

other than a desire to obtain the related tax benefits.     See Karr

v. Commissioner, 924 F.2d 1018, 1023 (11th Cir. 1991), affg.

Smith v. Commissioner, 91 T.C. 733 (1988).    The nature of the

offering materials, the manner in which the partnership’s

activities were actually conducted, and the illusory nature of

the lease agreement’s financing convince us that ERL’s lease with

JAD was devoid of economic substance.   Consequently, having
                              - 25 -

considered the underlying subjective business motivation and the

objective economic substance of ERL’s activity, we sustain

respondent’s determination that ERL’s lease transaction was a

sham which is to be disregarded for Federal income tax purposes.

Issue 3.   Minimum Royalty

     ERL claimed substantial loss deductions on its 1980, 1981,

and 1982 returns.   In material part, these deductions were

attributable to “accrued advance royalties”.   In Bauman v.

Commissioner, T.C. Memo. 1988-122, a case involving the same

partnership and the same lease, the Court held that the royalty

obligations with respect to taxable years 1980 and 1981 were

neither “substantially uniform” nor “paid at least annually”.

Consistent with that holding, the Court further held that such

royalties were not deductible as advance royalties paid or

accrued “as a result of a minimum royalty provision” under

section 1.612-3(b), Income Tax Regs.

     The facts before the Court in the instant case are

essentially identical to those before the Court in Bauman v.

Commissioner, supra, where the Court granted a motion by

respondent for partial summary judgment regarding the minimum

royalty issue.   That case involved the years 1980 and 1981.   An

additional year, 1982, is now before the Court.   The facts with

respect to 1982, however, do not differ in any material aspect

from those pertaining to 1980 and 1981.   Therefore, we reaffirm

our earlier decision, and, for the reasons stated therein, hold
                              - 26 -

that, with respect to taxable year 1982 as well, ERL’s royalty

obligations are not deductible as advance royalties paid or

accrued “as a result of a minimum royalty provision” under

section 1.612-3(b), Income Tax Regs.    Accordingly, we decline

petitioners’ invitation to reverse our earlier decision and

sustain respondent’s determination as to this issue.

Issues 4 & 5.   Profit Motive & Substantiation

     In the notice of deficiency, respondent also determined that

ERL’s activities were not engaged in for profit.    We sustain that

determination, primarily for the reasons stated in Coggin v.

Commissioner, T.C. Memo. 1993-209.     Petitioners have adduced no

persuasive evidence or argument to distinguish their case from

Coggin in this respect.   The objective facts presented in this

case fail to establish that ERL entered into the lease with an

actual and honest objective of making an economic profit,

independent of tax savings.   See generally Drobny v.

Commissioner, 86 T.C. 1326 (1986); Dreicer v. Commissioner, 78

T.C. 642 (1982), affd. without opinion 702 F.2d 1205 (D.C. Cir.

1983).   Consequently, we resolve this issue in favor of

respondent.

     Petitioners argue in the alternative that, if ERL was not

engaged in an activity for profit, they are entitled to deduct

their allocable share of ERL’s expenses, excluding the royalty

obligations, in accordance with section 183(b) for each year at

issue.   Respondent contends that petitioners are in any event
                                - 27 -

precluded from taking such deductions because they have failed to

substantiate their entitlement to them.     We agree with

respondent.

     Deductions are a matter of legislative grace, and

petitioners bear the burden of proving that they are entitled to

the deductions claimed.    Rule 142(a); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290 U.S.

at 115.

     Petitioners argue that, because respondent had possession of

25 boxes of ERL’s records for a substantial period of time prior

to trial, it is incumbent upon respondent to come forward with

evidence establishing that the claimed deductions were not in

fact paid or incurred by ERL.     We reject such a contention and

decline to shift the burden of proof to respondent.     On brief,

petitioners claim entitlement to various expenses, but the

exhibits and self-serving testimony on which they rely fail to

substantiate that the alleged expenses were in fact paid or

incurred.     Consequently, respondent is sustained on this ssue.

Issue 6.    Section 6653(a) and Section 6653(a)(1) and (2)

     Respondent determined that petitioners are liable for an

addition to tax under section 6653(a) for 1980 and additions to

tax under section 6653(a)(1) and (2) for 1981 and 1982.

Petitioners bear the burden of proof in establishing that they

are not liable for such additions to tax.     Rule 142(a).   Section

6653(a) for 1980 and section 6653(a)(1) for 1981 and 1982 provide
                                - 28 -

for an addition to tax equal to 5 percent of the underpayment of

tax if any part of such underpayment is due to negligence or

intentional disregard of rules or regulations.     Section

6653(a)(2), as in effect for 1981 and 1982, provides for an

addition to tax of 50 percent of the interest on that portion of

the underpayment attributable to negligence.     Negligence under

section 6653(a) is the failure to do what a reasonable or

ordinarily prudent person would do under the circumstances.

Zmuda v. Commissioner, 731 F.2d at 1422; Neely v. Commissioner,

85 T.C. 934, 947 (1985).

     Petitioners advance several arguments in an attempt to

convince the Court that no addition to tax under section 6653(a)

or section 6653(a)(1) and (2) is appropriate.     Each argument,

however, is self-serving and without merit.     Petitioners first

argue that section 6653's extensive history of amendments

suggests that the section is inherently flawed, and, as such,

should not be applied against them.      We reject such an argument.

     Petitioners next argue that respondent has treated various

taxpayers in the McIntyre-CN litigation project differently with

respect to the application of section 6653.     This argument must

be rejected because it is the well-established position of this

Court that our responsibility is to apply the law to the facts of

the case before us and to determine the tax liability of the

taxpayer in that case.     Davis v. Commissioner, 65 T.C. 1014, 1022
                               - 29 -

(1976).    In reaching our decision, the Commissioner’s treatment

of other taxpayers is generally considered irrelevant.       Id.

       Petitioners next argue that Bauman invested in ERL only

after extensive discussions with other partners in his law firm.

They also contend that certain professional financial advisers

were consulted by various partners of Bauman’s law firm and that

such consultations contributed to Bauman’s decision to invest in

ERL.    We reject this argument as self-serving; it is not

supported by the facts of the record.

       Petitioners further argue that Bauman relied heavily on the

contents of the offering materials, which petitioners contend

were prepared by various experts.    But those responsible for

preparing the contents of the offering materials were not

disinterested advisers, nor were they shown to be in fact

experts.    Moreover, Bauman was not an unsophisticated investor.

We find his testimony regarding his alleged good faith reliance

questionable.    At best, the information contained in the offering

materials was speculative conjecture.     The offering materials

were “long on conclusions, but short on reasoning”, and we are

skeptical that an intelligent, educated person such as Bauman

could in good faith rely thereon in hope of earning a profit

independent of tax considerations.      See Lieber v. Commissioner,

T.C. Memo. 1993-424.

       Reliance on the advice of professionals may serve to defeat

a finding of negligence, but we are not convinced that
                               - 30 -

petitioners have shown that the purported reliance in the instant

case was reasonable.    See Freytag v. Commissioner, 89 T.C. 849,

889 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S.

868 (1991).   "In the face of a transaction which clearly lacked

economic substance, and which was designed to produce tax

benefits out of proportion with total investment, * * *

[petitioners’ arguments] do not establish the exercise of due

care.”   Hildebrand v. Commissioner, 967 F.2d 350, 353 (9th Cir.

1992), affg. Ames v. Commissioner, T.C. Memo. 1990-87.     Had there

been a bona fide examination of the offering materials, no

ordinarily prudent person would have found ERL to be a legitimate

investment.   “Warning bells tolled, but * * * [Bauman] ignored

them”.   Freytag v. Commissioner, supra at 889; see also Kantor v.

Commissioner, 998 F.2d 1514, 1522-1523 (9th Cir. 1993), affg. in

part and revg. in part T.C. Memo. 1990-380.    At the very least,

Bauman was negligent.    Accordingly, respondent’s determination

that petitioners are liable for the addition to tax under section

6653(a) for 1980 and additions to tax under section 6653(a)(1)

and (2) for 1981 and 1982 is sustained.

Issue 7.   Section 6621(c)

     Section 6621(c) provides for an increased rate of interest

with respect to any substantial underpayment of tax attributable

to one or more tax motivated transactions.    An underpayment is

substantial if it exceeds $1,000.    Sec. 6621(c)(2).   A tax-

motivated transaction includes any sham or fraudulent
                              - 31 -

transaction.   Sec. 6621(c)(3)(A)(v).   Additionally, section

6621(c)(3)(B) authorizes the Secretary to specify by regulation

additional types of transactions which will be treated as

tax-motivated transactions.   Section 301.6621-2T, Q&A-4,

Temporary Proced. & Admin. Regs., 49 Fed. Reg. 50392 (Dec. 28,

1984), provides that deductions disallowed for any period in the

case of an activity not engaged in for profit within the meaning

of section 183 are considered to be attributable to a

tax-motivated transaction.

     Petitioners contend that section 6621(c) cannot be properly

applied to them because the “any sham or fraudulent transaction”

clause of section 6621(c)(3)(A)(v) was not added to the Internal

Revenue Code until 1984, which was after the years presently at

issue.   This argument must fail.   The statute, as so amended,

applies to interest accrued after December 31, 1984, even though

the transaction was entered into prior to that date.    See

Solowiejczyk v. Commissioner, 85 T.C. 552 (1985), affd. per

curiam without published opinion 795 F.2d 1005 (2d Cir. 1986);

Kozlowski v. Commissioner, T.C. Memo. 1993-430, affd. without

published opinion 70 F.3d 1279 (9th Cir. 1995).

     The section 6621(c) increased rate of interest does not

apply to deductions disallowed on separate and independent

grounds which do not fall within the specified categories of

tax-motivated transactions.   McCrary v. Commissioner, 92 T.C.

827, 858-860 (1989).   Here, we have sustained the disallowance of
                               - 32 -

the deductions claimed as advance minimum royalty payments under

section 1.612-3(b), Income Tax Regs.     The basis for disallowance

of the advance minimum royalty payments is independent of and

separable from the tax-motivated transactions upon which the

other deductions of ERL were disallowed.    Therefore, to the

extent that petitioners’ underpayment of tax is attributable to

the disallowed advance minimum royalty payments, petitioners are

not liable for the increased interest under section 6621(c).     All

other disallowed deductions, however, have been sustained on

grounds of economic sham and lack of profit objective.

Accordingly, petitioners will be liable for increased interest

under section 6621(c) for the underpayment in tax attributable to

these adjustments, if the underpayments for each year exceed

$1,000.

Issue 8.   Late Filing Addition to Tax

     Section 6651(a)(1) provides for an addition to tax for

failure to timely file a Federal income tax return.    Section

6651(a)(1) also provides for an exception to this addition when

the taxpayer shows that the failure to file was due to reasonable

cause and not due to willful neglect.    Willful neglect has been

defined as “a conscious, intentional failure or reckless

indifference”.     United States v. Boyle, 469 U.S. 241, 245

(1985).    Merely demonstrating an absence of willful neglect does

not meet the burden of proof required of the taxpayer; the

taxpayer must also make an affirmative showing that a reasonable
                              - 33 -

cause existed for the untimely filing.     Paula Constr. Co. v.

Commissioner, 58 T.C. 1055, 1061 (1972), affd. without published

opinion 474 F.2d   1345 (5th Cir. 1973).    In order to establish

reasonable cause, petitioners must show that they exercised

ordinary business care and prudence and were nevertheless unable

to file the return by the prescribed date.     Crocker v.

Commissioner, 92 T.C. 899, 913 (1989); sec. 301.6651-1(c)(1),

Proced. & Admin. Regs.

     Petitioners advance three arguments with respect to this

issue.   First, petitioners argue that their failure to timely

file their 1982 return was due to Bauman’s preoccupation with his

father’s ailing health and that such preoccupation constitutes

sufficient cause to excuse their untimely filing.     Petitioners

further argue that the late filing addition to tax should not be

applied to them because their 1982 return was in fact filed prior

to the expiration of the automatic 4-month extension period that

they would have received had they filed an application for an

extension of time to file.   Finally, petitioners argue that the

late filing addition to tax should not be applied to them because

their explanation for the untimely filing was accepted by an

agent for respondent when their 1982 return was being audited in

1983.

     Respondent, in contrast, contends that petitioners’ failure

to timely file their 1982 return was not due to reasonable cause,

but rather due to willful neglect.     Respondent explains that
                                - 34 -

despite the poor health of Bauman’s father, Bauman managed to

continue his practice of law.    This ability to continue managing

his normal affairs, respondent contends, indicates that Bauman

was not so overwhelmed by his concern for his father that he

could not comply with his obligation to file the tax return.

Respondent also argues that Bauman’s concern for his father did

not preclude Mrs. Bauman from fulfilling their obligation to file

a timely return.   We agree with respondent.

     Petitioners have not established that their failure to file

their 1982 tax return by the prescribed date was due to

reasonable cause and not due to willful neglect.   While we

appreciate the emotional difficulties Bauman may have experienced

while caring for his father, the record does not support his

contention that he was so overwhelmed by his father’s

deteriorating health as to preclude a timely filing.    The fact

that Bauman continued to practice law throughout this period

indicates that his father’s condition did not prevent him from

filing the return on time.   See Dickerson v. Commissioner, T.C.

Memo. 1990-577.    Moreover, petitioners failed to explain why Mrs.

Bauman was unable to satisfy the couple’s obligation to file a

timely return.

     We reject petitioners’ contention that the late filing

addition to tax should not be applied to them merely because

their return was in fact filed prior to the expiration of the 4-

month extension period that would have been granted automatically
                             - 35 -

had they filed an application for extension of time to file.    The

fact remains that no such extension was applied for or granted.

We also reject petitioners’ argument that the late filing

addition to tax should not be applied to them in light of

discussions which they allegedly had with respondent’s agent

regarding the untimely filing.   Bauman’s testimony as to the

nature of these discussions was self-serving, and the record

lacks evidence to corroborate his testimony.   Accordingly,

respondent’s determination as to this issue is sustained.

     To reflect the foregoing,

                                         Decisions will be

                                    entered under Rule 155.
