                         T.C. Memo. 2015-89



                  UNITED STATES TAX COURT



   IAN D. HUGHES AND VANESSA S. HUGHES, Petitioners v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 14581-11.                          Filed May 11, 2015.



   R determined a deficiency in Ps’ Federal income tax for tax year
2001 on the basis of their amended 2001 Federal income tax return.
R further determined an addition to tax under I.R.C. sec. 6651(a)(1)
for failure to timely file the original 2001 return and an accuracy-
related penalty under I.R.C. sec. 6662. In an amendment to answer R
asserted, for the first time, a gross valuation misstatement penalty
under I.R.C. sec. 6662.

   The parties settled all issues related to the deficiency except one:
On their original return Ps claimed zero bases in shares of K stock
sold in February 2001 and recognized long-term capital gain. They
also reported a substantial capital loss from an unrelated transaction.
On the amended return Ps reduced their reported loss from the
unrelated transaction. They also increased their claimed bases in the
K shares and reduced the gain from the K shares’ sale. Ps contend
that P-H, who is and was a U.S. citizen and who was then a U.K.
resident, gave the K shares to P-W, who was then a U.K. citizen and
resident, in December 2000 and January 2001; that P-W took a fair
                                  -2-

[*2] market value basis in the shares; and that Ps accordingly
recognized the reduced amount of gain reported on their amended
return when the K shares were sold. R contends that P-H did not
make a completed gift to P-W and that Ps had zero bases in the K
shares when they were sold.

   Held: Regardless of whether P-H transferred the K shares to P-W
for U.S. tax purposes before their sale, Ps had zero bases in the K
shares when they were sold.

   Held, further, Ps are liable for the I.R.C. sec. 6662(a), (b)(3), (e),
and (h) gross valuation misstatement penalty with respect to any
underpayment of tax attributable to their overstatement of bases in the
K shares on their amended 2001 tax return.

   Held, further, Ps are not liable for the I.R.C. sec. 6662(a) accuracy-
related penalty for negligence or disregard of rules and regulations
but are liable for the penalty for any substantial understatement of
income tax with respect to the balance of any underpayment.



Sonia M. Agee, for petitioners.

Jonathan E. Behrens and Gerald A. Thorpe, for respondent.
                                         -3-

[*3]        MEMORANDUM FINDINGS OF FACT AND OPINION


       WHERRY, Judge:1 Respondent determined a Federal income tax deficiency

of $364,006 for petitioners’ taxable year 2001 on the basis of the amended return

petitioners filed on February 4, 2005. Respondent also (1) determined a

$36,400.60 section 6651(a)(1)2 addition to tax for failure to timely file the original

tax return (late-filing addition), (2) determined an accuracy-related penalty under

section 6662(a) of $147,286, and (3) asserted in his amendment to answer filed

February 26, 2014, a section 6662(a), (b)(3), (e), and (h) gross valuation

misstatement penalty. Before trial the parties settled with regard to all but one of

the noncomputational adjustments that contributed to the determined deficiency

(settled issues). The parties litigated that remaining adjustment at trial. The

parties also settled the late-filing addition and agreed on the accuracy-related

penalty applicable to the portion of petitioners’ underpayment that was attributable




       1
       Judge Diane Kroupa tried this case on May 6, 2014, and retired from the
Tax Court on June 16, 2014. With the parties’ agreement, the case was reassigned
to Judge Robert A. Wherry, Jr., for the purpose of rendering an opinion.
       2
      All section references are to the Internal Revenue Code (I.R.C.) of 1986, as
amended and in effect for the year at issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure, unless otherwise indicated.
                                          -4-

[*4] to one of the settled issues. The remaining penalties were litigated. Taking

into account the settled issues,3 the issues presented for decision are:

      3
        In the notice of deficiency respondent determined that petitioners received
but did not report a California income tax refund; petitioners conceded this issue.
Respondent also disallowed (1) certain temporary living, travel and transportation,
and automobile expense deductions and an ordinary loss deduction petitioners
claimed on Schedule E, Supplemental Income and Loss, (2) petitioners’ claimed
short-term capital loss deduction attributable to fees incurred to enter into a tax
shelter transaction, (3) petitioners’ claimed long-term capital loss deduction on
their sale of a former residence, (4) a portion of petitioners’ claimed mortgage
interest deduction, and (5) petitioners’ claimed investment interest expense
deduction. Each party conceded some of these issues in whole or in part. The
parties also stipulated a 20% accuracy-related penalty with respect to item (2).
        The notice of deficiency refers to the amounts of short-term capital loss and
long-term capital gain reported on petitioners’ 2001 Form 1040X, Amended U.S.
Individual Income Tax Return, rather than those reported on their original 2001
return. Although respondent thus evidently accepted petitioners’ amended return,
he nevertheless determined in the notice that it was not a qualified amended return
within the meaning of sec. 1.6664-2(c)(3), Income Tax Regs. Petitioners
implicitly challenged this determination in their petition. Whether petitioners’
2001 Form 1040X was a qualified amended return could, in abstract, affect their
liability for the penalties that remain at issue. See sec. 1.6664-2(c)(2), Income Tax
Regs. (providing that additional tax shown on a qualified amended return may
reduce the underpayment upon which any penalty will be calculated). Petitioners’
original and amended returns showed precisely the same amount of tax, however,
so even if the amended return was a qualified amended return, they have not
shown or proven any salutary effect on their penalty liability.
        Although in the notice of deficiency respondent premised his deficiency
determination and the underlying adjustments on the numbers reported in
petitioners’ amended tax return, he nevertheless determined a 40% gross valuation
misstatement penalty with respect to the short-term capital loss deduction from the
tax shelter transaction as petitioners reported it on their original return. The
parties subsequently stipulated a reduced penalty of 35%. Since the trial and filing
of the briefs the parties have responded to an order of the Court pointing out
                                                                           (continued...)
                                         -5-

[*5] (1) whether petitioner husband Ian Hughes transferred ownership, for U.S.

tax purposes, of certain shares of stock in KPMG Consulting, Inc. (KCI), to

petitioner wife Vanessa Hughes (Mrs. Hughes) before the sale of those shares

(KCI shares) in February 2001;

      (2) if so, whether Mrs. Hughes took bases greater than zero in the KCI

shares;

      (3) whether petitioners are liable for the section 6662(a), (b)(3), (e), and (h)

gross valuation misstatement penalty with respect to the portion of any

underpayment of income tax for the 2001 taxable year that is attributable to an

overstatement of bases in the KCI shares; and

      (4) whether petitioners are liable for a section 6662(a) accuracy-related

penalty with respect to any underpayment of income tax for the 2001 taxable year

on the basis of a substantial valuation misstatement, negligence or disregard of

rules and regulations, and/or a substantial understatement of income tax.




      3
        (...continued)
various inconsistencies in their stipulations and computations and requesting
clarification. They now concur that this stipulation is moot and that no portion of
any underpayment redetermined in this proceeding will be attributable to any
valuation misstatement on petitioners’ original return.
                                          -6-

[*6]                            FINDINGS OF FACT

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

stipulation of facts, their three written stipulations of settled issues, and the

additional stipulation of settled issues that was read into the record, at trial, are

incorporated herein by this reference. Petitioners, Ian and Vanessa Hughes, lived

in Portugal when they filed their petition.

I.     Petitioners’ Background

       Ian and Vanessa Hughes married on October 20, 2000, and remained

married through the time of trial. During 2000 and 2001 Mrs. Hughes was a

citizen of the United Kingdom (U.K.). The United States granted her conditional

U.S. permanent resident status as of January 16, 2001. Petitioner Ian Hughes is,

and was during 2000 and 2001, a U.S. citizen. During 2000 and until January 16,

2001, he was a U.K. resident. Both Mr. and Mrs. Hughes became U.S. residents

on January 16, 2001.

       The Hugheses’ joint 2001 Federal income tax return identified Mrs.

Hughes’ occupation as “HOMEMAKER”. Mr. Hughes made his career as a tax

accountant. After majoring in business administration and receiving a bachelor of

arts degree from the University of Toronto in 1974, he earned a bachelor of law

degree from the College of Law London in 2000. Mr. Hughes obtained a certified
                                        -7-

[*7] public accountant’s (C.P.A.) license in Texas in 1979 and took a job with

KPMG LLP (KPMG). He was employed by KPMG from 1979 until he retired on

January 15, 2007.

      During his tenure at KPMG Mr. Hughes rose through the ranks and moved

among KPMG’s international offices. Between September 1979 and 1994 he

worked in the firm’s international tax group in Houston, Chicago, and Toronto,

earning promotions from staff accountant to manager, from manager to senior

manager, and finally, in 1986, to partner. During this period his duties shifted

from preparing corporate and partnership Federal income tax returns to advising

clients, particularly publicly traded corporations. Mr. Hughes also began to

specialize in the international aspects of subchapter C of the Code and cross-

border transactions, particularly mergers and acquisitions (M&A). He returned to

the Chicago office and continued with his transactional work for publicly traded

corporations.

      In 1994 Mr. Hughes moved again, this time to London. There, as partner in

charge of KPMG’s corporate tax practice, he advised British and other European

corporations on the U.S. tax consequences of M&A. In April 1998, while working

in London, Mr. Hughes married Brenda Hughes. Five months later, having

concluded that Brenda Hughes had married him solely for financial reasons, he
                                         -8-

[*8] separated from her. Their divorce was finalized on or about September 25,

2000, and a court decision with respect to the property settlement was entered in

October 2000. Shortly after the divorce was final, Mr. Hughes married Vanessa,

the current Mrs. Hughes, on October 20, 2000. During 2000 Mr. Hughes also

learned that KPMG wanted to transfer him yet again, this time to California.

      When Mrs. Hughes was granted conditional U.S. permanent resident status

on January 16, 2001, Mr. and Mrs. Hughes moved to California, and Mr. Hughes

began working as KPMG’s partner in charge of M&A tax services for Northern

California. Mr. Hughes received a promotion in 2004 to partner in charge of

M&A tax services for the West Area. While in California, Mr. Hughes advised

clients on subchapter C issues--in particular, the U.S. tax consequences of M&A--

and managed due diligence engagements. In 2006 KPMG transferred Mr. Hughes

to Amsterdam, where he again provided corporate tax advice, this time to Dutch

and other European clients, until his January 2007 retirement. Thereafter Mr. and

Mrs. Hughes moved first to a temporary home in Portugal and then to a permanent

home there, which they occupied in October 2007.

      Mr. Hughes’ career at KPMG focused almost entirely on the tax aspects of

corporate transactions. He had little expertise in individual or estate tax or tax

treaty interpretation. He never prepared an individual tax return as a paid return
                                         -9-

[*9] preparer, but he did prepare at least two U.S. tax returns, involving the

transactions at issue in this case, for himself and his wife.

II.   KCI Stock

      During 1999 KPMG spun off its consulting business to a newly formed

corporation, KCI. The firm retained a direct equity stake of approximately 20% of

KCI’s outstanding shares, and these shares were specially allocated among

KPMG’s partners, including Mr. Hughes (K-1 shares), in January 2000. KPMG

caused KCI to issue shares representing the remaining 80% of its equity to

KPMG’s partners, including Mr. Hughes, who received 95,467 shares of KCI

stock (founders’ shares) on January 31, 2000. Mr. Hughes did not contribute

funds to KPMG in connection with KCI’s formation. He took zero bases in the

founders’ shares.

      Mr. Hughes disclosed his interests in the KCI shares on a form completed in

connection with his divorce from Brenda Hughes, but he indicated that, because

there was no public market for KCI stock and at that time no definitive plan for a

public offering, their fair market value could not be ascertained. The divorce had

proven highly contentious, and in late 2000, Mr. Hughes began to fear that if the

KCI shares were sold in the near future, thereby establishing their putative fair

market value, his former wife, Brenda Hughes, would seek to reopen the October
                                        - 10 -

[*10] 2000 court case with respect to the property settlement to argue for a share

of the KCI stock sale proceeds. He therefore decided to give some or all of his

rights in the KCI shares to his new wife, Vanessa.

      Mr. Hughes consulted his divorce lawyer, John Briggs, about how to

accomplish the gift under U.K. law. On Mr. Briggs’ advice, Mr. Hughes prepared

a gift deed, signed it, and had it witnessed. The gift deed apparently provided to

the effect that Mr. Hughes “as the legally vested owner, transferred the economic

and beneficial ownership” of the KCI shares “to be held in trust absolutely” to

Mrs. Hughes.4 The parties viewed the effectiveness of this attempted transfer as

important, if not essential, to the resolution of this case, but because the Court

would reach the same resolution regardless of the attempted transfer’s

effectiveness, we need not resolve the parties’ factual disputes on this issue.


      4
        Mr. Hughes could not produce the original gift deed or any copy thereof.
He explained that several boxes of his business and personal items had gone
missing during the Hugheses’ serial international moves. In 2007 during the audit
that led to this case, Mr. Hughes could not find any documents relating to the gift,
so he traveled to London to review Mr. Briggs’ firm’s records from his
representation. Mr. Hughes did not locate the principal document he sought, the
gift deed, but he did ask Mr. Briggs’ partner, David Isaacs, how the gift deed
would have been worded. On the basis of Mr. Isaacs’ response, Mr. Hughes
drafted and signed a declaration containing the quoted phrases, which respondent
introduced into evidence at trial. We find that the declaration, as explained and
given context by Mr. Hughes’ testimony, suffices to establish the wording of the
original gift deed.
                                        - 11 -

[*11] Mr. Hughes purported to transfer the KCI shares to Mrs. Hughes in two

tranches: an unspecified number of shares having a fair market value of $106,000

in December 2000, and 35,727 shares having a fair market value of $780,992 in

January 2001.5 Petitioners have not identified the specific shares--founders’

shares or K-1 shares--included in each gift.

       KPMG sold the founders’ shares on February 16, 2001. KPMG remitted the

net proceeds from the sale, $326,990.29, by check made payable to Mr. Hughes.

       KPMG also sold most of the K-1 shares during 2001. On Mr. Hughes’ 2001

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

reported that his distributive share of KPMG’s net long-term capital gain for the

year was $857,270. This amount was equal to the net proceeds from the K-1

shares’ sale.

III.   Tax Reporting

       Mr. Hughes did not advise KPMG of his purported gifts of the KCI shares

to Mrs. Hughes either in 2000 or 2001. He did not report the alleged gifts of

shares to the U.K. for either 2000 or 2001. Nor did he file a Form 709, United


       5
        Although petitioners have not identified the specific dates of these alleged
gifts, because they contend that Mrs. Hughes was a U.K. resident when the gifts
occurred, we presume that the January 2001 gift occurred before petitioners
became U.S. residents on January 16 of that year.
                                        - 12 -

[*12] States Gift (and Generation-Skipping Transfer) Tax Return, for the taxable

year 2000, during which he claims to have made the first gift of KCI shares to

Mrs. Hughes. Mr. Hughes did, however, file a Form 709 for the taxable year 2001

on or about May 12, 2004. Although he professed a lack of familiarity with Form

709, Mr. Hughes prepared that return (gift tax return) himself. The gift tax return

reported no gift tax due. Mr. Hughes paid no, gift, inheritance, or capital gains tax

to the U.K., and no gift tax to the United States, with respect to the KCI shares for

2000 or 2001.

      In addition to the gift tax return, Mr. Hughes also prepared the Hugheses’

original, jointly filed 2001 Form 1040, U.S. Individual Income Tax Return

(original return). Respondent received the original return on September 24, 2002.

On Schedule D, Capital Gains and Losses, of the original return, petitioners

reported: (1) $1,105,500 of short-term capital loss attributable to a transaction

unrelated to the KCI shares’ purported transfer and subsequent sale (unrelated

transaction); (2) $326,989 of long-term capital gain attributable to the February

16, 2001, sale of the founders’ shares, in which petitioners claimed zero bases; and

(3) as passthrough gain from a partnership, S corporation, estate or trust, $857,270

of net long-term capital gain from the K-1 shares’ sale.
                                         - 13 -

[*13] During or around 2004, after the Internal Revenue Service (IRS) issued a

notice that classified as a listed transaction a transaction substantially similar to

the unrelated transaction, Mr. Hughes concluded that he and Mrs. Hughes should

amend the original return to reverse almost all of the loss claimed on the unrelated

transaction. Hence, Mr. Hughes prepared a 2001 Form 1040X (amended return).

Respondent received the amended return on February 4, 2005. On the amended

return petitioners reported: (1) $10,500 of short-term capital loss attributable to

the unrelated transaction; (2) zero capital gain attributable to the sale of the

founders’ shares, in which petitioners claimed aggregate bases of $326,989; and

(3) $292,275 of long-term capital gain--realized directly rather than as a

passthrough item from Schedule K-1--as a result of the sale of the K-1 shares, in

which they now claimed aggregate bases of $559,992.

      To summarize, petitioners reported bases in the KCI shares and amounts of

capital gain from their transactions on Schedules D of the original and amended

returns as follows:
                                        - 14 -

 [*14]                    Original return                  Amended return

                 Amount          Where reported    Amount       Where reported
                           Part I, Line 1:                   Part I, Line 1:
                            Short-Term                        Short-Term
 Unrelated                  Capital Gains                     Capital Gains
  transaction ($1,105,500) and Losses              ($10,500) and Losses
                               Part II, Line 8:                Part II, Line 8:
 Bases in                       Long-Term                       Long-Term
  founders’                     Capital Gains                   Capital Gains
  shares           -0-          and Losses         326,989      and Losses
 Gain from                     Part II, Line 8:                Part II, Line 8:
  sale of                       Long-Term                       Long-Term
  founders’                     Capital Gains                   Capital Gains
  shares           326,989      and Losses           -0-        and Losses
                                                               Part II, Line 8:
                                                                Long-Term
 Bases in                                                       Capital Gains
  K-1 shares        ---                n/a         559,992      and Losses
                               Part II, Line 12:
                                Net Long-Term
                                Gain or (Loss)
                                from
                                Partnerships, S
                                Corporations,                  Part II, Line 8:
 Gain from                      Estates and                     Long-Term
  sale of                       Trusts from                     Capital Gains
  K-1 shares       857,270      Schedules(s) K-1   292,275      and Losses

IV.   Reporting Rationale

      Before filing the original return in 2002, Mr. Hughes obtained advice and

information from various sources concerning the gifts of KCI shares to Mrs.
                                        - 15 -

[*15] Hughes. First, he consulted his divorce lawyer, Mr. Briggs, about the legal

mechanism for making a gift under U.K. law. Mr. Briggs advised him to use a gift

deed. Second, over lunch one day, he asked James McLellan, a U.K.-chartered

accountant, about the U.K. gift, inheritance, and income tax consequences of a gift

of shares. Mr. McLellan advised him that the transaction would not be taxable in

the U.K. and that the donee’s bases in the shares would be their fair market value.

Mr. McLellan, who was not familiar with U.S. law, did not opine on the planned

transfer’s U.S. tax consequences or the effect of any applicable tax treaty.

      Third, Mr. Hughes looked at a brief description of transfers between

spouses in the Master Tax Guide and concluded that no recognition of gain or loss

was required for U.S. tax purposes. Fourth, Mr. Hughes asked Jeff Sargent, a

fellow KPMG partner who specialized in international executive individual

income tax returns, to confirm that the transfer of his shares to his nonresident

alien wife would be “tax-free for U.S. tax purposes”. According to Mr. Hughes,

Mr. Sargent confirmed that it would be.

      Although he believed that he was obliged to file a gift tax return in

connection with the share transfers, Mr. Hughes delayed doing so until 2004

because of his lack of familiarity with Form 709. In preparing the return, Mr.

Hughes consulted the Master Tax Guide to ascertain the applicable amount of the
                                        - 16 -

[*16] unified credit against gift and estate tax. He also reread section 1041 of the

Code and concluded on the basis of section 1041(d) and his reading of the

question and answer portion of the regulations thereunder that the gifts to Mrs.

Hughes had been a “taxable transaction” for U.S. tax purposes. Mr. Hughes

testified that, while attending a KPMG seminar in Washington, he spoke with two

colleagues who worked in the estate and gift tax field who advised him that “the

transaction to a nonresident alien spouse was a taxable one”.

      Mr. Hughes further testified, in sum, that at that point he: (1) believed he

had realized capital gain from the gifts to his nonresident alien wife; (2) reviewed,

obviously without considering its effective date, a tax treaty between the United

States and the U.K. that had been adopted after the dates of the gifts (new treaty);

and (3) concluded that, under the new treaty, by virtue of his U.K. residency at the

time of the gifts, he was subject to capital gains tax only in the U.K.

notwithstanding his U.S. citizenship.

      Mr. Hughes reached these conclusions in 2004. When he filed the amended

return in 2005, he took the opportunity to modify his reporting of the KCI shares’

sale to reflect a stepped-up basis that he believed should have resulted from the

taxable gifts. On a statement attached to Form 1040X, he explained his reasoning

that section 1041(d) rendered the KCI stock gifts taxable to him but that pursuant
                                         - 17 -

[*17] to the new treaty, he was taxable on capital gain only in the United

Kingdom, his country of residence at the time of the gifts.

V.    Procedural History

      Respondent mailed petitioners a notice of deficiency on January 19, 2011.

Taking into consideration petitioners’ amended return, respondent determined an

income tax deficiency of $364,006, a section 6651(a)(1) late-filing addition of

$36,400.60, and a section 6662 accuracy-related penalty of $147,286. Petitioners

timely petitioned this Court on June 20, 2011.6

      Respondent’s deficiency determination rested upon multiple adjustments,

some of them computational, to petitioners’ amended return. Before trial the

parties settled with regard to all but one of the noncomputational adjustments as

well as one penalty issue. Before the filing of stipulations of settled issues

concerning these settlements respondent sought, and was granted, leave to file an

amendment to answer. In that amendment to answer respondent asserted a section

6662(a), (b)(3), (e), and (h) gross valuation misstatement penalty solely in relation


      6
        Because petitioners resided outside the United States when respondent
mailed them the notice of deficiency, they had 150 days rather than 90 days within
which to timely file their petition. See sec. 6213(a). The notice of deficiency
incorrectly identified petitioners’ last day to timely file a petition as June 17, 2011.
In fact, the 150th day fell on Saturday, June 18, 2011, so petitioners’ last day to
timely file their petition was Monday, June 20, 2011. See sec. 7503.
                                        - 18 -

[*18] to the single noncomputational adjustment that the parties did not resolve

before trial--that is, petitioners’ claimed bases in the KCI shares at the time of

their sale. Petitioners did not file a reply to the amendment to answer. At trial on

May 6, 2014, the parties litigated the unresolved noncomputational adjustment as

well as the penalties before Judge Kroupa. See supra note 1.

                                      OPINION

      There remain four issues for decision. The first two are: (1) whether Mr.

Hughes transferred ownership of the KCI shares to Mrs. Hughes, and (2) if so,

whether Mrs. Hughes took bases greater than zero in the KCI shares. For

petitioners to prevail, we must answer both questions affirmatively. We conclude

that, regardless of how we resolve the first issue, as to the second issue, petitioners

had zero bases in the KCI shares when they were sold. Therefore, we will assume,

arguendo, that Mr. Hughes gave the KCI shares to Mrs. Hughes and hence proceed

directly to the second issue.

      Here at the outset, we note that this is an income tax case. Respondent has

not determined a deficiency in gift tax, and we do not here consider whether Mr.

Hughes’ gifts of the KCI shares to Mrs. Hughes were taxable transfers under the

gift tax statutes. See, e.g., sec. 2501 (imposing a tax “on the transfer of property

by gift * * * by any individual, resident or nonresident”). We thus analyze only
                                        - 19 -

[*19] the income tax consequences of the transfer. Petitioners bear the burden of

proof.7 See Rule 142(a).

I.    Tax Consequences of Transfer

      Assuming, as petitioners claim, that Mr. Hughes made gifts of the KCI

shares to Mrs. Hughes, the parties dispute whether these gifts resulted in taxable

income to either Mr. or Mrs. Hughes and what bases Mrs. Hughes took in the

shares. Respondent maintains that the gifts did not result in taxable income and

that Mrs. Hughes took transferred bases from Mr. Hughes under section 1015(a).

Petitioners, on the other hand, cite section 1041(d) and United States v. Davis, 370

U.S. 65 (1962), for the twin propositions that (1) the gifts resulted in taxable

income as to Mr. Hughes, the donor, and (2) Mrs. Hughes, the donee, took a fair

market value basis in the KCI shares.

      In Davis, 370 U.S. at 66-67, in a property settlement incident to divorce the

taxpayer agreed to transfer certain appreciated property to his soon-to-be-former

wife in exchange for her release of her Delaware law marital rights. The principal

      7
        As a general rule, the Commissioner’s determination of a taxpayer’s
liability in the notice of deficiency is presumed correct, and the taxpayer bears
the burden of proving that the determination is improper. See Rule 142(a); Welch
v. Helvering, 290 U.S. 111, 115 (1933). Although sec. 7491 may shift the burden
of proof in specified circumstances, petitioners did not argue, and in any event
have not established, that they meet the prerequisites under sec. 7491(a)(1) and (2)
for such a shift.
                                        - 20 -

[*20] question before the Court was whether, in connection with the exchange, the

taxpayer should be required to recognize as income the appreciation in the

property transferred. See id. at 68.

      Under Delaware law, a wife’s “inchoate rights * * * in her husband’s

property * * * partake more of a personal liability of the husband than a property

interest of the wife.” Id. at 70. Accordingly, the Court adopted the Government’s

analogy of the exchange to “a taxable transfer of property in exchange for the

release of an independent legal obligation.” Id. at 69. The exchange was thus a

taxable event to which the basic principles of sections 1001 and 1012 applied:

The husband’s taxable gain was properly measured as the excess of his amount

realized--the fair market value of the wife’s extinguished marital property rights--

over his adjusted basis in the property transferred, and the wife took a cost basis in

the property received. See id. at 71-73. To determine the fair market value of the

extinguished rights, the Court presumed that the parties had acted at arm’s length

and reasoned that the value of the rights must be equal in value to the property for

which they were exchanged. Id. at 72.

      Because the Court’s decision in Davis turned on the nature of the wife’s

rights under State law, its application resulted in disparate Federal tax treatment
                                       - 21 -

[*21] between States of marital property settlements upon divorce. See Berger v.

Commissioner, T.C. Memo. 1996-76, 71 T.C.M. (CCH) 2160, 2177 (1996).

      [U]pon an approximately equal division of community property on
      divorce, no gain was recognized on the theory that there was only a
      nontaxable partition, not a sale or exchange. Carrieres v.
      Commissioner, 64 T.C. 959, 964 (1975), affd. per curiam, 552 F.2d
      1350 (9th Cir. 1977); see also Siewert v. Commissioner, 72 T.C. 326,
      332-333 (1979). The Commissioner applied a like result to the
      partition of jointly held property. See Rev. Rul. 74-347, 1974-2 C.B.
      26. The tax treatment of divisions of property between spouses
      involving other various types of ownership under the different State
      laws was often unclear and resulted in much litigation. See H. Rept.
      98-432 (Part 2), at 1491 (1984). Several common law States had tried
      to avoid the result in the Davis case by amending and bending their
      property and equitable distribution laws. Id.

            Congress was dissatisfied with the resulting patchwork and
      desired to make the Federal tax law less intrusive into marital
      property relationships. Id. at 1492. Section 1041 was the result.
            [Id.]

Today, section 1041(a) provides that “[n]o gain or loss shall be recognized on a

transfer of property from an individual to” a spouse, or to a former spouse incident

to divorce. To complement this nonrecognition rule, the statute provides for the

recipient spouse (or former spouse) to take a transferred basis in the property. Sec.

1041(b)(2).

      When the recipient spouse is a nonresident alien, however, section 1041(a)

does not apply. See sec. 1041(d). In this circumstance, petitioners urge, Davis
                                         - 22 -

[*22] still governs. As they read Davis, the KCI share transfer is taxable to the

transferor spouse and the recipient spouse takes a fair market value basis in the

property received.

      Petitioners’ logic suffers from at least three fatal flaws. First, they fail to

appreciate the distinction between realization of income and its recognition.

Second, Davis is inapposite because it involved an exchange, not a gift. Third,

even if Davis applied here, it would not produce the result petitioners seek.

      A.     Recognition vs. Realization

      First, petitioners fail to appreciate that section 1041(a) is a nonrecognition

provision: It applies where gain or loss has been realized and would otherwise be

recognized under the Code. See Blatt v. Commissioner, 102 T.C. 77, 79 (1994)

(characterizing section 1041 as a nonrecognition provision). Section 1041(d)

simply restores the status quo when the recipient spouse is a nonresident alien,

such that ordinary recognition rules apply to the transferor and transferee. If the

transferor spouse has realized gain or loss, and no other Code section provides for

nonrecognition, then that gain or loss must be recognized.8 See sec. 1.1041-1T(a),

      8
        To support their argument that sec. 1041(d) mandates recognition,
petitioners assert that Congress enacted sec. 1041(d) “to ensure that [property]
* * * transferred * * * from a resident to a non-resident alien would not forever
escape taxation by the United States”. As authority for this proposition, they cite
                                                                       (continued...)
                                         - 23 -

[*23] A-3, Temporary Income Tax Regs., 49 Fed. Reg. 34453 (Aug. 31, 1984)

(“Gain or loss (if any) is recognized (assuming no other nonrecognition provision

applies) at the time of a transfer of property if the property is transferred to a

spouse who is a nonresident alien.” (Emphasis added.)).

      Where, as here, an interspousal property transfer takes the form of a gift, no

gain is realized, so regardless of whether section 1041(a) applies, there is no gain

to be recognized. The Code imposes income tax on individuals’ taxable income,

which consists of gross income less allowable deductions. Secs. 1, 63(a). Gross

income, in turn, means “all income from whatever source derived”, sec. 61(a), and

income encompasses “undeniable accessions to wealth”, Commissioner v.

Glenshaw Glass Co., 348 U.S. 426, 431 (1955). As a general matter, a donor does

      8
        (...continued)
legislation limiting the estate tax marital deduction for transfers to nonresident
alien spouses, the expatriation tax of sec. 877, and the requirement of sec. 6851(d)
that an alien departing the United States obtain a certificate of compliance with
income tax obligations from the IRS. These authorities may illustrate that
Congress generally desires to limit erosion of the U.S. income tax base through the
transfer of untaxed gains beyond its jurisdiction, but they demonstrate nothing
concerning Congress’ intent in enacting sec. 1041(d). The definition of income
and the realization requirement are bedrock principles of U.S. income tax law.
See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955) (interpreting
“income” within the predecessor statute of sec. 61 as “undeniable accessions to
wealth, clearly realized, and over which the taxpayers have complete dominion”).
We will not, on the basis of unrelated legislation enacted at different times by
different Congresses, read into sec. 1041(d) an intent to impose income tax in the
absence of income realization.
                                         - 24 -

[*24] not realize income from making a gift. See Rauenhorst v. Commissioner,

119 T.C. 157, 162-163 (2002) (“‘A gift of appreciated property does not result in

income to the donor so long as he gives the property away absolutely and parts

with title thereto before the property gives rise to income by way of a sale.’”

(emphasis added) (quoting Humacid Co. v. Commissioner, 42 T.C. 894, 913

(1964))). Rather, a gift, by its nature, reduces the donor’s wealth and represents an

economic loss to the donor.

      The donee, on the other hand, realizes an economic gain upon receipt of a

gift. His or her wealth increases by the value of the gift. But for tax purposes

section 102(a) excludes this gain from the donee’s gross income. To preserve the

U.S.’ ability to tax any unrecognized gain in property that is the subject of the gift,

section 1015(a) sets the donee’s basis in the property equal to the lesser of the

donor’s basis (or that of “the last preceding owner by whom it was not acquired by

gift”) or if there is unrecognized loss, then for loss purposes, the property’s fair

market value. Cf. sec. 1015(e) (providing that for interspousal gifts that are

subject to section 1041(a), section 1041(b)(2) determines the transferee’s basis).

      In sum, under these general rules, no income tax is imposed on either donor

or donee because neither party realizes income from the gift. Hence, when Mr.

Hughes gave the KCI shares to Mrs. Hughes, neither spouse realized income, and
                                       - 25 -

[*25] thus neither spouse could recognize income. The gifts were not income

taxable events, and nothing in the Code or the regulations thereunder provided for

Mrs. Hughes to take stepped-up bases in the shares. Rather, she took transferred

bases of zero from her husband, the donor.9

      B.    Gifts vs. Exchanges

      Davis, on which petitioners primarily rely, does not suspend or modify the

essential principles discussed above. Moreover, the facts of Davis differ

materially from those at issue here: Mr. Hughes gave the KCI shares to his wife,

whereas Davis involved an exchange incident to divorce.

      9
         The parties have stipulated that Mr. Hughes had zero bases in the founders’
shares. They did not stipulate his bases in the K-1 shares.
        Petitioners introduced no evidence concerning Mr. Hughes’ alleged bases in
the K-1 shares. Petitioners did claim an aggregate basis of $559,992 in these
shares on the amended return. But an income tax return “is merely a statement of”
a taxpayer’s claim and “is not presumed to be correct.” Roberts v. Commissioner,
62 T.C. 834, 837 (1974). Petitioners provided no explanation of how they
computed their claimed basis and no evidentiary support for it. In his testimony,
Mr. Hughes merely described this number as reflecting the “step-up in basis” that
he believed Mrs. Hughes “was due” under the Code. Even if we assume that he
considered this amount to be the K-1 shares’ fair market value at the time of the
gifts, he provided no information about how he determined it. This amount is
considerably less than the price at which KPMG sold the K-1 shares during the
course of 2001. In contrast, for the founders’ shares, which Mr. Hughes gave to
Mrs. Hughes along with the K-1 shares, he claimed on the amended return an
aggregate basis equal to the price at which the shares were sold. Mr. Hughes
provided no rationale for this disparate treatment of the two blocks of KCI shares.
Petitioners have not carried their burden of proving that Mr. Hughes, and thus
Mrs. Hughes, had bases greater than zero in the K-1 shares.
                                          - 26 -

[*26] Mr. and Mrs. Davis entered into a “voluntary property settlement and

separation agreement” under which Mr. Davis agreed to transfer to Mrs. Davis

1,000 shares of stock “‘in full settlement and satisfaction of any and all claims and

rights against * * * [him] whatsoever (including but not by way of limitation,

dower and all rights under the laws of testacy and intestacy)’”. Davis, 370 U.S. at

66-67. The divorce decree incorporated this agreement. Id. at 67. After Mr.

Davis delivered one-half of the stock pursuant to the agreement, the IRS

determined that he should have recognized gain on the transfer. See id. at 66-67.

      When the dispute over this determination reached the Supreme Court, the

Court framed the question before it as “whether the transfer in issue was an

appropriate occasion for taxing the accretion to the stock.” Id. at 68. Was it a

“‘sale or other disposition’” within the meaning of section 1001, from which Mr.

Davis should recognize taxable gain? Id. at 68-69. Mr. Davis compared the

transaction “to a nontaxable division of property between two co-owners”,

whereas the IRS likened it to “a taxable transfer of property in exchange for the

release of an independent legal obligation.” Id. at 69. The Court sided with the

IRS, concluding that Mr. Davis had exchanged the stock for release from financial

obligations to his former wife created by Delaware law. Id. at 70. Hence, the

transaction was taxable. See id. at 71.
                                         - 27 -

[*27] The stock transfer in Davis occurred pursuant to a written, mutual

settlement agreement under which the parties acted at arm’s length. See id. at 66,

72. In contrast, Mr. Hughes unilaterally prepared and executed a gift deed to

effect the transfer at issue. More important, the transfer in Davis was not a gift but

an exchange. See id. at 69 n.6. Petitioners have never contended that Mr. Hughes

received anything from Mrs. Hughes in exchange for the KCI shares. Even if

petitioners had raised this argument, the record contains no evidence that Mrs.

Hughes transferred property or rights of any kind to her husband in exchange for

the KCI shares. Rather, petitioners have consistently maintained that Mr. Hughes

gave the KCI shares to Mrs. Hughes. The Court in Davis specifically emphasized

that the transaction at issue was not a gift: “Property transferred pursuant to a

negotiated settlement in return for the release of admittedly valuable rights is not a

gift in any sense of the term.” Id. at 69 & n.6.

      These factual distinctions render Davis wholly inapposite. The factual

predicate to taxation in Davis was that Mr. Davis had received something of value;

he realized a gain within the meaning of section 61. See Davis, 370 U.S. at 68-70.

That factual predicate is absent here.
                                        - 28 -

[*28] C.     Fair Market Value vs. Cost

      Even if we were to apply Davis, doing so would not produce the result

petitioners seek: fair market value bases for Mrs. Hughes in the KCI shares. After

determining that the transaction was taxable to Mr. Davis, the Court in Davis

turned to Mrs. Davis’ basis in the stock she received. On that question “all indicia

point[ed] to a ‘cost’ basis for this property in the hands of the wife.” Id. at 73. To

determine Mrs. Davis’ cost, the Court looked to the value of the rights she had

relinquished. See id. Because the Court assumed that the parties had acted at

arm’s length, it concluded that they must have exchanged property of equal value.

Id. at 72. Hence, Mr. Davis had received, and Mrs. Davis had given up, property

having a fair market value equal to that of the transferred stock. See id. at 72-73.

      If we were to treat Mr. Hughes’ gifts of KCI shares to Mrs. Hughes as

taxable transactions under Davis, Mr. Hughes’ amount realized and Mrs. Hughes’

aggregate costs basis in the KCI shares would be the fair market value of what she

transferred to Mr. Hughes in exchange for the KCI shares. There was no

exchange, so that fair market value would be zero.

      Contrary to petitioners’ reading, Davis does not establish a blanket rule that

the recipient of a taxable interspousal transfer takes a fair market value basis in the

property received. The Court in Davis treated Mrs. Davis’ relinquished marital
                                        - 29 -

[*29] rights as having equal value to the shares she received because the rights

were inchoate and thus difficult to value and because “[a]bsent a readily

ascertainable value it is accepted practice where property is exchanged to hold

* * * that the values ‘of the two properties exchanged in an arms-length

transaction are either equal in fact or are presumed to be equal.’” Id. at 72

(citation omitted) (quoting Phila. Park Amusement Co. v. United States, 126 F.

Supp. 184, 189 (Ct. Cl. 1954)). Valuing what Mrs. Hughes transferred to her

husband for the KCI shares presents no such difficulty: She transferred nothing,

so the value transferred was zero.

      D.     Conclusion

      Even had Mr. Hughes made completed gifts of an undivided legal and

beneficial interest in the founders’ shares and the K-1 shares to Mrs. Hughes, Mrs.

Hughes would have zero bases in those shares. See sec. 1015(a). Under the Code,

the gifts were not taxable events for income tax purposes. See secs. 61, 102(a).

As explained above, Davis does not support a contrary conclusion. Regardless of

which of the Hugheses owned the KCI shares when they were sold, that person

had zero bases in the shares. Accordingly, we will sustain respondent’s

determination of a deficiency with respect to petitioners’ gain on the KCI shares’

disposition as reported on their amended return.
                                           - 30 -

[*30] II.    Applicability of Penalties

      In the notice of deficiency, respondent determined that petitioners were

liable for a section 6662(a) and (b)(1), (2), and (3) accuracy-related penalty with

respect to their underpayment of income tax for the 2001 taxable year on the basis

of a substantial valuation misstatement, negligence or disregard of rules and

regulations, and/or a substantial understatement of income tax. In an amendment

to answer, respondent further asserted a section 6662(a), (b)(3), (e), and (h) gross

valuation misstatement penalty with respect to the portion of petitioners’

underpayment of income tax for the 2001 taxable year that was attributable to their

overstatement of bases in the KCI shares on the amended return. Hence,

respondent determined that either a 40% or a 20% penalty would apply to any

underpayment. See sec. 6662(a), (b)(1)-(3), (c)-(e), (h); see also sec. 1.6662-2(c),

Income Tax Regs. (explaining that where more than one penalty could apply to a

portion of an underpayment, penalties do not stack, and only the maximum

potentially applicable penalty applies).

      As a general rule, the Commissioner bears the burden of production and

“must come forward with sufficient evidence indicating that it is appropriate to

impose the relevant penalty.” See Higbee v. Commissioner, 116 T.C. 438, 446

(2001); see also sec. 7491(c). For all but one of the penalties at issue here, once
                                        - 31 -

[*31] respondent has met this burden of production, the burden will shift to

petitioners to prove an affirmative defense or that they are otherwise not liable for

the penalty. See Higbee v. Commissioner, 116 T.C. at 446-447. With respect to

the remaining penalty--the gross valuation misstatement penalty with respect to

petitioners’ claimed bases in the KCI shares, which respondent first asserted in his

amendment to answer--respondent bears the burden of proof. See Rule 142(a)(1)

(the Commissioner bears the burden of proof with respect to a “new matter”);

Seventeen Seventy Sherman St., LLC v. Commissioner, T.C. Memo. 2014-124, at

*35-*36 (the Commissioner bears the burden of proof with respect to a penalty

first raised in his amendment to answer).10

      10
        Where the Commissioner first asserts an addition to tax under sec. 6651(a)
in an answer or amendment thereto, we have described his burden of proof as
requiring him to establish the absence of “exculpatory factors.” See Rader v.
Commissioner, 143 T.C. ___, ___ (slip op. at 22) (Oct. 29, 2014); see also Arnold
v. Commissioner, T.C. Memo. 2003-259, 86 T.C.M. (CCH) 341, 344 (2003). In at
least one instance, we have observed that this rule might be extended to the
penalty context, such that where the Commissioner first asserts a sec. 6662 penalty
in an answer or amendment to answer, his burden of proof entails establishing the
absence of a sec. 6664(c) reasonable cause defense. See Cavallaro v.
Commissioner, T.C. Memo. 2014-189, at *50-*51. There, however, we were able
to resolve the issue of whether sec. 6664(c) applied without having to resolve the
burden of proof issue. See id. at *51 (citing Martin Ice Cream Co. v.
Commissioner, 110 T.C. 189, 210 n.16 (1998) (“[W]e decide the issue on a
preponderance of the evidence; therefore, the allocation of the burden of proof
does not determine the outcome[.]”)). Similarly, here we would reach the same
conclusion with respect to the reasonable cause and good-faith defense no matter
                                                                       (continued...)
                                        - 32 -

[*32] A.     Valuation Misstatement Penalty

      Section 6662(a) and (b)(3) provides for the imposition of a 20% penalty on

the portion of an underpayment of tax required to be shown on a return that is

attributable to a substantial valuation misstatement. For returns filed on or before

August 17, 2006, as is relevant here, a substantial valuation misstatement occurs

when “the value of any property (or the adjusted basis of any property) claimed on

any return of tax imposed by chapter 1 is 200 percent or more of the amount

determined to be the correct amount of such valuation or adjusted basis (as the

case may be)”. Sec. 6662(e)(1)(A). Section 6662(h) increases this penalty to 40%

if the value or adjusted basis claimed on the return is 400% or more of the actual

value or adjusted basis. A regulation clarifies that, when the actual value or basis

is zero, any claimed value is considered 400% or more of the correct amount. Sec.

1.6662-5(g), Income Tax Regs.

      In the notice of deficiency, respondent determined that petitioners had zero

bases in the founders’ shares and the K-1 shares. We have sustained those

determinations in their entirety. Consequently, for both blocks of KCI shares,




      10
       (...continued)
how the burden of proof is allocated. We therefore leave this issue for another
day.
                                         - 33 -

[*33] petitioners’ aggregate basis as reported on their amended return exceeded

the correct value by 400% or more and was a gross valuation misstatement.

      A section 6662 penalty generally will not apply to any portion of an

underpayment resulting from positions taken on the taxpayer’s return for which

the taxpayer had reasonable cause and with respect to which the taxpayer acted in

good faith. See sec. 6664(c). Petitioners claim that they relied reasonably and in

good faith on Mr. McLellan and Mr. Hughes’ colleagues at KPMG and that they

otherwise had reasonable cause for the tax bases in the KCI shares claimed on the

amended return.11

      11
         Petitioners did not raise this affirmative defense or plead any of the
relevant facts in their petition, and they did not file a reply to respondent’s
amendment to answer, in which respondent first asserted the gross valuation
misstatement penalty with respect to the KCI shares’ reported bases. Ordinarily,
an affirmative defense not pleaded “is deemed to be waived.” Gustafson v.
Commissioner, 97 T.C. 85, 90 (1991). Because respondent has not objected,
however, and because both parties address the defense in their briefs, we will treat
it as an issue tried by implied consent of the parties under Rule 41(b)(1).
       In their posttrial briefs petitioners also raised the substantial authority,
reasonable basis, and adequate disclosure defenses. These defenses are not
defenses to the gross valuation misstatement penalty. See sec. 6662(d)(2)(B)
(providing for reduction of the amount of the “understatement” computed under
sec. 6662(d)(2)(A) for purposes of determining the existence of a substantial
understatement of tax, by the portion of the understatement attributable to any tax
position for which the taxpayer had substantial authority, or if the relevant facts
were adequately disclosed on or in an attachment to the taxpayer’s return, for
which the taxpayer had a reasonable basis); see also, e.g., New Phoenix Sunrise
Corp. v. Commissioner, 132 T.C. 161, 189 (2009) (where a taxpayer asserted a
                                                                           (continued...)
                                        - 34 -

[*34] We determine “whether a taxpayer acted with reasonable cause and in good

faith * * * on a case-by-case basis, taking into account all pertinent facts and

circumstances”, sec. 1.6664-4(b)(1), Income Tax Regs., including “[t]he

taxpayer’s mental and physical condition, as well as sophistication with respect to

the tax laws, at the time the return was filed”, Kees v. Commissioner, T.C. Memo.

1999-41, 77 T.C.M. (CCH) 1374, 1378 (1999); accord Ruckman v. Commissioner,

T.C. Memo. 1998-83, 75 T.C.M. (CCH) 1880, 1886 (1998); Escrow Connection,

Inc. v. Commissioner, T.C. Memo. 1997-17, 73 T.C.M. (CCH) 1705, 1714 (1997).

Reliance on professional advice will absolve the taxpayer if “such reliance was

reasonable and the taxpayer acted in good faith.” Sec. 1.6664-4(b)(1), Income Tax

Regs. Otherwise, a taxpayer may show that he took the tax position at issue

because of an honest, reasonable misunderstanding of fact or law. Id.

             1.    Reliance on Professional Advice

      Where a taxpayer claims reliance on professional advice, section 6664(c)

will apply if “the taxpayer meets each requirement of the following three-prong

test: (1) The adviser was a competent professional who had sufficient expertise to


      11
        (...continued)
substantial authority defense, holding the taxpayer liable for the gross valuation
misstatement penalty but analyzing the defense only in connection with the
substantial understatement penalty), aff’d, 408 Fed. Appx. 908 (6th Cir. 2010).
                                         - 35 -

[*35] justify reliance, (2) the taxpayer provided necessary and accurate

information to the adviser, and (3) the taxpayer actually relied in good faith on the

adviser’s judgment.” Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99

(2000), aff’d, 299 F.3d 221 (3d Cir. 2002). The record establishes that petitioners

did not satisfy this test with respect to any of their advisers.

      With respect to Mr. McLellan, Mr. Hughes acknowledged that Mr.

McLellan was not familiar with U.S. tax law and did not opine on the U.S.-U.K.

tax treaty. Mr. McLellan thus plainly lacked sufficient expertise to justify reliance

with respect to a position taken on a U.S. tax return as to the application of U.S.

law. Second, Mr. Hughes testified that, while he did not formally engage Mr.

McLellan, during a lunch meeting he provided “all the relevant details and facts

that were needed for Mr. McLellan to reach a conclusion on the basis of the

application of U.K. tax law”. Petitioners have not established what information

was provided, and it is not clear that the information necessary to a U.S. tax law

analysis, in these circumstances, was coextensive with that necessary to a U.K. tax

law analysis. The evidence indicates that Mr. Hughes did not provide the

“necessary and accurate information” required by Neonatology’s second prong.

      Third, although Mr. Hughes testified that Mr. McLellan told him that Mrs.

Hughes would take fair market value bases in the gift shares under U.K. law, Mr.
                                        - 36 -

[*36] Hughes also testified that Mr. McLellan provided no advice as to the gifts’

U.S. tax consequences. Hence, Mr. Hughes could not have actually relied in good

faith upon Mr. McLellan’s advice in taking the tax position at issue--that is, the

position that, under U.S. income tax law, Mrs. Hughes took fair market value

bases in the KCI shares. Consequently, with respect to Mr. McLellan, petitioners

fail all three prongs of the Neonatology test.

      With respect to Mr. Hughes’ colleagues at KPMG, he testified that Jeff

Sargent, an international executive tax partner who had specialized in individual

income tax returns for U.S. citizens resident in the U.K. and Europe for 25 to 30

years, had advised him that the gifts of KCI shares to Mrs. Hughes “would be tax-

free for U.S. tax purposes.” Even if we accept Mr. Hughes’ brief testimony

concerning Mr. Sargent’s qualifications as evidence of sufficient expertise to

justify reliance, petitioners still face two obstacles. First, Mr. Hughes offered no

testimony as to what information he provided to Mr. Sargent. Indeed, his

testimony reflects that he merely asked Mr. Sargent, informally, to “confirm” his

own prior conclusion about the gifts’ U.S. tax consequences. Second, Mr. Hughes

could not have actually relied on Mr. Sargent’s alleged advice in taking the tax

position at issue--namely, that gifts of the KCI shares were income-taxable

transactions, such that Mrs. Hughes would receive stepped-up bases. This
                                        - 37 -

[*37] position is directly contrary to Mr. Sargent’s advice that the gifts “would be

tax-free for U.S. tax purposes.” Accordingly, petitioners have not satisfied the

Neonatology test with respect to Mr. Sargent.

      Finally, Mr. Hughes testified that, while attending a KPMG seminar in

Washington during or around 2004, he spoke with “a couple of partners who did

work in the estate and gift area” who advised him that the gifts were taxable. Mr.

Hughes did not provide any further information about these unnamed individuals’

qualifications or expertise. He did not describe what information, if any, he

provided to them to elicit their opinions. Moreover, Mr. Hughes did not testify

that these individuals advised him what bases Mrs. Hughes would take in the

shares, which is the ultimate tax position at issue. Petitioners thus offered no

evidence to satisfy any of Neonatology’s three prongs with respect to the unnamed

advisers.

      In sum, the record establishes that petitioners do not qualify for the

reasonable reliance affirmative defense.

             2.    Misunderstanding of Fact or Law

      In addition to reasonable reliance on professional advice, a second,

alternative “[c]ircumstance[] that may indicate reasonable cause and good faith” is

“an honest misunderstanding of fact or law that is reasonable in light of all of the
                                        - 38 -

[*38] facts and circumstances, including the experience, knowledge, and

education of the taxpayer.” Sec. 1.6664-4(b)(1), Income Tax Regs.

      According to his testimony, Mr. Hughes’ rationale for the tax position at

issue--that his gifts of KCI shares to Mrs. Hughes were taxable to him at the times

of the gifts and that she took fair market values bases in the shares--was as

follows: (1) after initially believing, in 2001, that the gifts had been nontaxable

and that petitioners had zero bases in the KCI shares when they were sold, upon

reconsidering these transactions in 2004 he interpreted section 1041(d) and the

regulations thereunder as providing that any transfer of property, including by gift,

to a nonresident alien spouse was taxable to the donor spouse for income tax

purposes; and (2) in mistakenly reviewing the new treaty rather than the one in

effect when the gifts were made, he concluded that--although he was a U.S.

citizen--under the treaty, he was not subject to U.S. capital gains tax on the

transfer by virtue of his then U.K. residency. As we have explained, the gifts did

not generate income to Mr. Hughes, so it was irrelevant whether, under the

applicable tax treaty, the United States could tax a U.S. citizen resident in the

United Kingdom on capital gain. Mr. Hughes plainly misunderstood the law

applicable to the gifts.
                                        - 39 -

[*39] Considering Mr. Hughes’ experience, knowledge, and education, this

misunderstanding was not reasonable. As of 2005, when petitioners took the tax

position at issue in their amended return, Mr. Hughes had worked for more than 25

years as a tax professional at KPMG, where he advised clients on the U.S. tax

consequences of cross-border transactions. For almost 20 of those years, he had

been a KPMG partner. Although he had no expertise in individual tax matters or

tax treaty interpretation, he did have sufficient experience to know that--as with

any authority he might consult when advising a client on a tax issue--he needed to

check the new treaty’s effective date before relying upon it.

      Mr. Hughes’ extensive experience also renders his misinterpretation of

section 1041 difficult to account for. As explained above, section 1041(a)

provides for nonrecognition on interspousal transfers, and section 1041(d)

provides that section 1041(a) does not apply where the transferee spouse is a

nonresident alien. When a nonrecognition provision does not apply to a

transaction, recognition is not automatically required. Other nonrecognition

provisions may apply, or the transaction may be one in which no income is

realized, as is true with regard to the donor when the transaction is a gift. The

foregoing principles represent fundamental premises of income taxation. Mr.

Hughes should reasonably have learned or at least been aware of them in studying
                                         - 40 -

[*40] for his C.P.A. licensing exam, and if he did not, these fundamentals should

not reasonably have eluded him throughout his KPMG career.

      Finally, even if Mr. Hughes’ misreading of section 1041(a) had been

reasonable, his misreading of the treaty was not. Although Mr. Hughes primarily

advised corporate clients, the rule that U.S. citizens are subject to Federal income

taxation on their worldwide income is fundamental to U.S. tax law. See, e.g.,

Cook v. Tait, 265 U.S. 47, 56 (1924); Huff v. Commissioner, 135 T.C. 222, 230

(2010). For this reason, as Mr. Hughes must as a U.S. international tax expert

have been well aware, U.S. income tax treaties regularly include a saving clause

that allows the U.S. to tax its citizens’ income as if the treaty were not in effect.

See, e.g., Duncan v. Commissioner, 86 T.C. 971, 974-975 (1986).

      On the amended income tax return, Mr. Hughes asserted that the new treaty

did not include such a clause. But the new treaty does include a saving clause in

Article 1, General Scope, paragraph 4, subject to the exceptions in paragraph 5.

See Convention between the Government of the United States of America and the

Government of the United Kingdom of Great Britain and Northern Ireland for the

Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect

to Taxes on Income and on Capital Gains, U.S.-U.K., art. I para. 4, July 24, 2001,

T.I.A.S. No. 13,161.
                                       - 41 -

[*41] Given his extensive knowledge of and experience with U.S. tax law, Mr.

Hughes should have realized that the conclusion he reached--that the KCI shares’

bases would be stepped up to fair market value, such that the built-in gain in those

shares would never be subject to tax in either the United States or the United

Kingdom--was too good to be true. Petitioners have not shown that Mr. Hughes’

misreading of section 1041 and the tax treaty was “reasonable in light of all of the

facts and circumstances”. See sec. 1.6664-4(b)(1), Income Tax Regs.

             3.    Conclusion

      For the foregoing reasons, we will sustain respondent’s determination of a

40% gross valuation misstatement penalty with respect to petitioners’

overstatement of their bases in the KCI shares on their amended 2001 return.

Because we find the 40% gross valuation misstatement penalty applicable to any

underpayment resulting from respondent’s determinations with respect to

petitioners’ bases in the KCI shares, we need not address whether the substantial

understatement and negligence penalties would also apply to this portion of

petitioners’ underpayment. See sec. 1.6662-2(c), Income Tax Regs.

      B.     Other Accuracy-Related Penalties

      Section 6662(a) and (b)(1) and (2) provides for the imposition of a 20%

penalty on the portion of an underpayment of tax required to be shown on a return
                                        - 42 -

[*42] that is attributable to negligence, disregard of rules and regulations, or a

substantial understatement of income tax. Negligence “includes any failure to

make a reasonable attempt to comply with the provisions of * * * [the Internal

Revenue Code]”. Sec. 6662(c). It constitutes “‘a lack of due care or the failure to

do what a reasonable and ordinarily prudent person would do under the

circumstances.’” Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting

Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff’g 43 T.C. 168

(1964) and T.C. Memo. 1964-299), aff’d, 904 F.2d 1011 (5th Cir. 1990), aff’d,

501 U.S. 868 (1991). Disregard of rules and regulations “includes any careless,

reckless or intentional disregard of rules or regulations”, including the Code, the

regulations thereunder, and guidance published by IRS. Sec. 1.6662-3(b)(2),

Income Tax Regs. A substantial understatement of income tax, as to an

individual, is an understatement that exceeds the greater of $5,000 or 10% of the

tax required to be shown on the return. Sec. 6662(d)(1)(A). Respondent

determined penalties on each of these two grounds in the notice of deficiency and,

on brief, contends these penalties apply with regard to the settled issues.

      Respondent’s argument concerning negligence and disregard of rules or

regulations is easily answered. Section 7491(c) places the burden of producing

evidence to support a penalty determination on respondent. Respondent did
                                        - 43 -

[*43] produce, and the record does include, some evidence to support a penalty

determination as to one of the settled issues, the unrelated transaction. The parties

agreed upon the penalty applicable to that settled issue before trial. At no point,

however, did respondent produce evidence relevant to the other settled issues, and

the record does not otherwise contain any such evidence. Absent any evidence

that petitioners were negligent or disregarded rules and regulations with regard to

these other settled issues, we cannot sustain respondent’s penalty determination on

the grounds of negligence or disregard of rules and regulations.

      Whether a substantial understatement exists, and if so, in what amount, will

depend upon the recalculation of petitioners’ tax liability on the basis of the

stipulations of settled issues, the parties’ other concessions, and the holdings

reached in this opinion. We leave these calculations to the parties under Rule 155.

To the extent a substantial understatement within the meaning of section

6662(d)(1)(A) exists with respect to the tax stated on the amended return,

petitioners will be liable for the 20% penalty under section 6662(a) and (b)(2) with

respect to the portion of the underpayment attributable to settled issues other than

the unrelated transaction, unless they can establish an affirmative defense.

      Petitioners point to three: (1) reasonable cause and good faith, (2)

substantial authority, and (3) reasonable basis and adequate disclosure. We have
                                        - 44 -

[*44] outlined the law applicable to the reasonable cause and good-faith defense

above. See supra pp. 33-35, 37-38. Under section 6662(d)(2)(B), the amount of

an understatement of income tax is reduced for any item that is supported by

substantial authority or, if the taxpayer adequately disclosed relevant facts on the

return or an attachment statement, by a reasonable basis. The substantial authority

standard is an objective one and involves an analysis of the law and its application

to relevant facts. Sec. 1.6662-4(d)(2), Income Tax Regs. “The substantial

authority standard is less stringent than the more likely than not standard * * * but

more stringent than the reasonable basis standard”. Id. The reasonable basis

standard, in turn, is “significantly higher than not frivolous or not patently

improper * * * [and] is not satisfied by a return position that is merely arguable or

that is merely a colorable claim.” Sec. 1.6662-3(b)(3), Income Tax Regs.

      In raising these three defenses to the substantial understatement penalty,

petitioners face the same problem that respondent faced in arguing for the

negligence and disregard of rules and regulations penalties: The record contains

no evidence tending to suggest that petitioners reasonably relied upon professional

advice, reasonably misunderstood fact or law, or had substantial authority or even

a reasonable basis for the positions they took on their amended return with regard

to the settled issues. Petitioners presented some evidence to support their
                                           - 45 -

[*45] arguments that Mr. Hughes reasonably relied upon professional advice with

regard to Mrs. Hughes’ bases in the KCI shares, that he had substantial authority

for the bases claimed on the amended return, and that he had a reasonable basis for

that position and adequately disclosed it in the statement attached to the amended

return. With regard to the settled issues, however, presumably because they were

settled, the parties did not address them during trial, in their stipulation of facts, or

in their joint or respective exhibits.

      For the foregoing reasons, to the extent the parties’ Rule 155 computation

reflects that a substantial understatement exists with respect to the tax stated on

petitioners’ amended return, petitioners will be liable for the substantial

understatement penalty for 2001 with respect to the portion of their underpayment

attributable to the settled issues (other than the unrelated transaction).

      The Court has considered all of the parties’ contentions, arguments,

requests, and statements. To the extent not discussed herein, we conclude that

they are meritless, moot, or irrelevant.

      To reflect the foregoing,


                                              Decision will be entered under

                                           Rule 155.
