                         T.C. Memo. 2010-206



                       UNITED STATES TAX COURT



             JAMES P. AND JOAN E. KENNEDY, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 2180-08.                 Filed September 22, 2010.



     Adam S. Fayne and Kathleen M. Lach, for petitioners.

     Danielle R. Dold, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     MORRISON, Judge:    James and Joan Kennedy (the Kennedys)

brought this action under section 6213(a)1 to redetermine

deficiencies in income tax and penalties for the 2001 and 2002

tax years.    Any reference to “Kennedy” is to James Kennedy.    The


     1
      All section references are to the Internal Revenue Code in
effect for the years at issue.
                                - 2 -

respondent in this case is the Commissioner of Internal Revenue,

whom we will refer to as the IRS.   In a deficiency notice, the

IRS determined the following deficiencies and penalties:

                                               Penalty
        Year           Deficiency            Sec. 6662
        2001            $71,071                $14,214
        2002             11,240                  2,248

The IRS now concedes (in its post-trial brief) that the

deficiency notice contained computational errors.   The IRS

asserts the following deficiencies and penalties instead of those

determined in the deficiency notice:

                                               Penalty
        Year           Deficiency            Sec. 6662
        2001            $63,006                $12,601
        2002             10,318                  2,064

The issues to be decided are:   (1) whether payments from Mack &

Parker to Kennedy, in the amounts of $176,100 for 2001 and

$32,758 for 2002, should be treated as ordinary income or the

proceeds from the sale of a capital asset (we conclude that the

payments are ordinary income), (2) whether the Kennedys are

liable for self-employment tax under section 1401 on the same

payments (we conclude that they are liable), and (3) whether the

Kennedys are liable for the accuracy-related penalty under

section 6662 for each of the tax years 2001 and 2002 (we conclude

that they are not liable for the penalty).
                                - 3 -

                         FINDINGS OF FACT

     The parties have stipulated some of the facts.    These

stipulated facts are adopted by the Court as factual findings.

The Kennedys resided in Illinois at the time they filed their

petition.

1.   Before the 2000 Sale of KCG’s Business

     Kennedy formed a sole proprietorship in 1990 to engage in

employee benefits consulting.   An employee benefits consultant

provides advice to an employer about the benefits that the

employer offers to its employees.   For example, the consultant

gives advice on what types of benefits should be offered, how the

benefits should be funded, and how the benefits should be priced.

In 1995, Kennedy incorporated his employee benefits consulting

business as a C corporation called KCG International, Inc.     This

corporation will be referred to here simply as KCG.    From 1995 to

2006, Kennedy was KCG’s sole shareholder.    He was also its

president.   KCG was incorporated under the laws of Illinois.2

     After its incorporation, KCG provided employee benefits

consulting services to employers.   KCG’s revenue consisted of the

consulting fees received from its clients.    The clients did not

have service contracts with KCG or with Kennedy.




     2
      KCG was originally named KOG International, Inc.
                                   - 4 -

       KCG had only two full-time employees.3    These employees were

Kennedy and Thomas Dolatowski.       Kennedy did not have an

employment agreement with KCG.       Nor did he have a noncompetition

agreement with KCG.

       KCG’s clients did business with KCG primarily because

Kennedy worked for that company.       Kennedy commanded loyalty among

the clients.       Kennedy attended all significant meetings with the

clients.       Dolatowski had good relationships with KCG’s clients,

too.       Dolatowski also attended client meetings.

       In the middle of the year 2000, Kennedy was approached by

Edward E. Mack III.       Mack was the president of Mack & Parker,

Inc., a company that was a subsidiary of Hub International, Ltd.

Mack proposed that Kennedy join Mack & Parker.         Mack and Kennedy

began negotiating the sale of the employee benefits consulting

business.       Early in the negotiations, the two men contemplated

that the price to be paid by Mack & Parker should be 150 percent

of the predicted annual income to be generated from KCG clients,

reduced by Dolatowski’s base salary, with adjustments to reflect

any changes in annual income over the next five years.         It was

estimated that 150 percent of the annual income would amount to

150 percent of $440,000, or $660,000.       It was negotiated that the

purchase price would be payable in installments with 40 percent

of the purchase price to be paid at the closing, and that the 60


       3
      More precisely, we know that at the time KCG was sold in
2000, it had two full-time employees.
                               - 5 -

percent balance would be paid periodically over the next five

years.   It was only later in the negotiation process (at some

time after September 8, 2000), that it was determined that a

portion of the purchase price (25 percent) should be designated

as payment for consulting services and that the remainder (75

percent) should be designated as payment for Kennedy’s goodwill.

     For legal advice on the transaction, Mack & Parker turned to

attorney Jerry Roberts of the Chicago law firm of Fitzsimmons,

Roberts & Paine.   In an email of September 1, 2000, Roberts asked

Mack to confirm what the terms of the agreement would be.

Roberts postulated that the terms would be as follows:

     Jim Kennedy has established an employee benefits
     consulting firm which has one additional professional
     employee (Tom [Dolatowski]) and one part time secretary
     and which operates out of offices with a month to month
     lease. Tom is to be employed by M&P. I assume the
     part time secretary is not to be employed by M&P. The
     price to be paid to Jim for his business is 150% of
     some revenue figure (see discussion below) less the
     $48,000 base salary to be paid to Tom and adjusted for
     changes in revenue produced by the “book” of business
     over the five year payout period and any new business
     presented by Jim to M&P (we will have to carefully
     define what this means). Forty percent of the purchase
     price is to be paid at closing with the balance to be
     paid in equal but adjusted installments over the next
     five years.

Roberts then made several suggestions about the transaction, and

noted that he would need to consult a tax accountant, Philip

Czajkowski, for tax advice: “I look to Phil for advise and as the

tax treatment of the transaction and any preferences that he had
                                - 6 -

for structuring it to enhance the tax benefits.”   (Errors in

original.)

     Roberts consulted with Czajkowski.   On September 8, 2000,

Roberts wrote another email to Mack.    Focusing on taxes, Roberts

discussed different methods of structuring the purchase of the

employee benefits consulting business.    Roberts observed that if

the transaction were structured as an asset purchase (i.e., if

Mack & Parker bought the assets of KCG rather than buying KCG

stock), then the payment would be taxed twice.   First, KCG would

recognize capital gains income.   Second, Kennedy would recognize

income when KCG distributed the proceeds to Kennedy.   Roberts

observed that if the transaction were instead structured as a

purchase by Mack & Parker of KCG’s stock, there would be only one

level of tax:   Kennedy would pay tax at capital gains rates on

the payment for the stock.   The disadvantage of a stock sale was

that Mack & Parker would not be able to claim amortization

deductions.   Finally, Roberts explained to Mack that Czajkowski

had suggested that “M&P could take the position that Kennedy owns

KCG’s customer list and the good will with the customers and

hence could sell them directly to M&P.”   Roberts observed that

this structure--which is a variation of an asset purchase--would

have advantages.   Kennedy would be taxed only once (at capital

gains rates, presumably).    Mack & Parker could amortize the cost
                                 - 7 -

of the assets over 15 years.     Czajkowski’s suggested structure

would be reflected in the final transactional documents.

     On October 20, 2000, Roberts wrote an email to Mack

describing draft transactional documents that, if executed, would

effect the sale of KCG’s business.       Roberts noted that these

documents would allocate 75 percent of the purchase price to

Kennedy’s “goodwill” and the remaining 25 percent to consulting

services that would be provided by Kennedy through KCG.       This is

the first document in the record to reflect this 75/25-percent

split of the purchase price between goodwill and services.       It

was an allocation that would be reflected in the final

transactional documents.

     Kennedy’s longtime accountant was James Vourvoulias.       A

certified public accountant, Vourvoulias had prepared the income-

tax returns for the Kennedys and KCG for several years.       Shortly

before the sale was consummated, Vourvoulias attended one large

“due diligence” meeting between Kennedy and Mack & Parker

employees.

2.   The 2000 Sale Transaction

     On October 31, 2000, Mack & Parker purchased the employee

benefits consulting business of KCG.      The sale was effected by

three contracts:   (1) the Agreement for Assignment of Know-How

and Goodwill (“the Goodwill Agreement”), (2) the Asset Purchase

Agreement, and (3) the Consulting Agreement.      The three
                                 - 8 -

agreements were functionally interdependent, and were expressly

made contingent on each other.       The major obligations required by

the agreements are summarized in the table below. (The arrows in

the table point from the party who was burdened by a particular

obligation; the arrows point to the party who benefited from the

obligation). “M&P” refers to Mack & Parker.

                          Goodwill Agreement

Five years of payments to Kennedy                     M&P    -->   Kennedy
Relationships with KCG clients                        M&P    <--   Kennedy
Know-how regarding benefits consulting                M&P    <--   Kennedy
Will not compete with M&P until 12/31/07              M&P    <--   Kennedy

                         Consulting Agreement

Five   years of payments to KCG                        M&P   -->   KCG
Five   years of services                               M&P   <--   KCG
Five   years of services (through KCG)                 M&P   <--   Kennedy
Will   not compete with M&P until 12/31/07             M&P   <--   KCG
Will   not compete with M&P until 12/31/07             M&P   <--   Kennedy

                        Asset Purchase Agreement

$10,000 payment                                        M&P --> KCG
Customer lists and relationships, data, name           M&P <-- KCG
Will not compete with M&P until 12/31/07               M&P <-- KCG

       a.   The Goodwill Agreement

       The parties to the Goodwill Agreement were Kennedy and Mack &

Parker.     Kennedy had three major obligations under the Goodwill

Agreement.    First, Kennedy agreed to “[convey]” to Mack & Parker

his “special personal relationships” with 46 clients (all of whom

were listed in exhibit A to the agreement), as well as the

“personal goodwill” incident to those relationships.         Second,

Kennedy agreed to “[convey]” to Mack & Parker his “know-how”
                                 - 9 -

relating to the business of employee benefits consulting.        Third,

Kennedy was prohibited from engaging in employee benefits

consulting until December 31, 2007, except that he could consult

on behalf of Mack & Parker.

     The Goodwill Agreement obligated Mack & Parker to make a

series of payments to Kennedy.    The first payment was a flat sum

of $176,100, to be paid on January 2, 2001.      Five other payments

were required to be made in February 2002, February 2003, February

2004, February 2005, and February 2006, respectively.      The amounts

of these five payments were determined by formulas.      Under these

formulas, each payment amount depended on the amounts that would

be collected by Mack & Parker from “Kennedy clients” during the 5-

year period after the execution of the agreement.      This period,

from November 1, 2000, to December 31, 2005, was divided into five

subperiods for purposes of the formulas.      The first period

comprised November 1, 2000, to December 31, 2001.      The second,

third, fourth, and fifth periods were the calendar years 2002,

2003, 2004, and 2005, respectively.      “Kennedy clients” were

defined in the agreement as clients that KCG had served in the

two-year period before the agreement and any clients introduced to

Mack & Parker by KCG or Kennedy.

     The formulas were written so that each payment could turn out

to be a negative number.   A payment amount would be negative if

the amounts collected by Mack & Parker from the Kennedy clients
                                - 10 -

during the relevant subperiod were relatively low.    The effect of

a negative payment was that the payment flow would be reversed:

instead of Mack & Parker making the payment to Kennedy, Kennedy

would be required to make the payment to Mack & Parker.4

     Attached to the Goodwill Agreement was a table that

illustrated how the payment formulas worked in various situations.

If actual revenues from Kennedy clients were $440,000 in each of

the five subperiods, the total payments to Kennedy (the sum of all

six payments, including the initial payment) would be $451,500.

If actual revenues were $440,000 in the first period and increased

$20,000 in each succeeding year, the total payments to Kennedy

would increase to $519,000.    If actual revenues started at

$440,000 in the first period and then decreased $20,000 for each

succeeding year, then Kennedy would receive $364,000 in total

payments.

     b.     The Consulting Agreement

     The Consulting Agreement obligated Mack & Parker to make a

series of payments to KCG.    The first payment was a flat sum of

$58,700 to be paid on October 31, 2000.    Five other payments were

required to be made in February 2002, February 2003, February

2004, February 2005, and February 2006, respectively.    The amounts

of these five payments depended on the amounts collected by Mack &

Parker from “KCG clients” during the period from November 1, 2000,


     4
      For example, if the formula produced the number -$100,000,
Kennedy would be required to pay Mack & Parker $100,000.
                                - 11 -

to December 31, 2005.    “KCG clients” were defined as clients that

KCG had served in the two-year period before the agreement, and

any clients introduced to Mack & Parker by KCG or Kennedy.    If the

amounts collected were low enough, the payment amounts could be

negative.   If the amounts were negative, then KCG would be

required to pay Mack & Parker the amounts.

     A table that illustrated the calculation of the payment

amounts was attached to the agreement.    If actual revenue was

$440,000 in each of the five periods, the total payment to KCG

(i.e. the sum of all six payments) would be $150,500.    If actual

revenue started at $440,000 and increased $20,000 for each

succeeding year, then the total payment to KCG would increase to

$173,000.   If actual revenue started at $440,000 and decreased

$20,000 for each succeeding year, then KCG would receive $128,000

in total payments.

     Under the Consulting Agreement, KCG obligated itself to

provide consulting and advisory services to Mack & Parker from

October 31, 2000, to December 31, 2005.    The services expressly

included (1) transferring to Mack & Parker the know-how of the

benefits consulting business possessed by Kennedy and KCG, (2)

assisting in the transition of existing KCG clients to Mack &

Parker, and (3) cultivating new clients and business for the

benefit of Mack & Parker.    Kennedy agreed to provide the services

as an employee of KCG.   KCG also agreed to “cause Kennedy to
                                - 12 -

devote such time, attention, knowledge and skill to the business

and interests of M&P as may be reasonably requested”.    The

agreement expired December 31, 2005.     Kennedy and KCG agreed that

during the term of the agreement they would not render employee

benefits consulting services, except on behalf of Mack & Parker.

They also agreed not to render any employee benefits consulting

services for two years after the term of the agreement without the

written consent of Mack & Parker.

     c.     The Asset Purchase Agreement

     Under the Asset Purchase agreement, Mack & Parker agreed to

pay KCG $10,000.    The payment was due on October 31, 2000.     In

exchange, KCG agreed to convey to Mack & Parker all the customer

relationships of KCG’s business of providing employee benefits

consulting services.    The customer relationships to be transferred

were expressly limited to the relationships with 46 customers

listed in exhibit 1.1.2 of the Asset Purchase Agreement.       This

list of 46 customers is identical to the list attached to the

Goodwill Agreement.    KCG also agreed to convey to Mack & Parker

all computer data used in the operation of its business, all

“going concern value”, all customer files, all customer lists and

other customer-based intangibles, the name “KCG International,

Inc.”, and KCG’s telephone number.     Cash and furniture were not

conveyed.    KCG agreed that neither it nor its employees would
                                 - 13 -

render employee benefits consulting services through December 31,

2007, except on behalf of Mack & Parker.

     d.   Some Additional Aspects of All Three Agreements

     As explained earlier, the Asset Purchase Agreement required

KCG to convey its relationships with 46 clients.      The Goodwill

Agreement required Kennedy to convey his personal relationships

with the same 46 clients.    Almost all of these 46 employers had

been clients of Kennedy before 1995, when he incorporated his

consulting business.   Thus, only a few became clients after 1995.

     The payments required of Mack & Parker under the agreements

can be classified into three types:       (1) a flat $10,000 payment to

KCG, which was required by, and attributed to, the Asset Purchase

Agreement, (2) payments to KCG, which were required by, and

allocated to, the Consulting Agreement, and (3) payments to

Kennedy, which were required by, and allocated to the Goodwill

Agreement.    The last two types of payments were estimated to be

$58,700 and $176,100, respectively.       The ratio between these two

amounts is 25/75.

     All three agreements imposed on Kennedy an obligation not to

compete with Mack & Parker in the area of employee benefits

consulting.   These covenants were extremely valuable to Mack &

Parker.   The covenants barred Kennedy from competing with Mack &

Parker for the 46 KCG clients.    They also provided an incentive
                                 - 14 -

for Kennedy to work with Mack & Parker, for he would have no other

way of earning a living from employee benefits consulting.

     The payments due to Kennedy under the Goodwill Agreement, and

to KCG under the Consulting Agreement, depended on the amounts

Mack & Parker received from KCG’s former clients.     Therefore,

Kennedy had an incentive to work to ensure that KCG’s former

clients continued to do business with Mack & Parker.

3.   After the Sale

     The three agreements that effected the sale were executed on

October 31, 2000.     Around November 1, 2000, Kennedy sent a letter

to the KCG clients explaining that KCG was joining Mack & Parker.

Kennedy stated:   “This move will also mark the beginning of a

‘five-year plan’ for my retirement on December 31, 2005.”     The

letter continued:

     The primary motivation for this change is to increase
     our employee benefits consulting staff so that Tom
     Dolatowski and I can address your consulting needs more
     efficiently and in a cost effective manner. * * *

Kennedy began work at Mack & Parker.      He was given a cubicle, a

computer, business cards, and the title “Consulting Practice

Director”.   Dolatowski, another former employee of KCG, was

appointed head of a new Mack & Parker unit serving the KCG

clients.   However, he quit work at Mack & Parker after two months.

As a result of Dolatowski’s departure, Kennedy devoted more time

to Mack & Parker than he had expected he would at the time of the

sale.   During the first year after the sale transaction, 46
                               - 15 -

percent of Mack & Parker’s revenue was traceable to time directly

billed from Kennedy’s personal billable time.   Kennedy did not

receive any compensation from Mack & Parker other than the

payments that Mack & Parker was required to make under the 2000

sale transaction.   Kennedy did not receive wages.

     Kennedy became convinced that he was undercompensated.

Although Kennedy was barred by his non-competition obligations

from forming his own consulting business, he would have been

permitted to work in an area other than employee benefits

consulting.   In November 2001, Kennedy informed Mack that he had

been working full-time since joining Mack & Parker, that he

thought he was undercompensated for his work, and that he would

leave Mack & Parker unless his compensation was increased.    Mack &

Parker reached an employment agreement with Kennedy.   Kennedy

began work for Mack & Parker under the new arrangement in May

2002.   When this case went to trial, Kennedy was still an employee

of Mack & Parker.   After Kennedy began receiving wages as an

employee of Mack & Parker, he continued to receive payments under

the Goodwill Agreement.   The record does not reveal whether KCG

continued to receive payments under the Consulting Agreement.

     KCG continued its existence as a corporation after the sale

of its assets.   In December 2000, KCG changed its name to JK

Partners, Inc.   This name change was necessitated by the Asset

Purchase Agreement, which transferred the ownership of the name
                                - 16 -

KCG International, Inc. to Mack & Parker.    KCG was finally

dissolved in 2006.

     On April 24, 2001, nearly six months after the sale, Mack &

Parker issued a press release announcing the acquisition of KCG.

The press release said:   “Mr. Kennedy will continue to manage the

consulting services provided to KCG clients from the offices of

Mack and Parker in Chicago, Illinois.”

     On October 31, 2000, Mack & Parker made two payments to KCG.

The first payment, in the amount of $10,000, was required by the

Asset Purchase Agreement.   The second payment, in the amount of

$58,700, was required by the Consulting Agreement.

     The Kennedys did not report any income from a trade or

business on a Schedule C, Profit or Loss From Business, of their

joint income-tax return for 2000.

     During 2001, Kennedy received $176,100 from Mack & Parker.

On their 2001 joint income-tax return, the Kennedys reported that

Kennedy received the $176,100 as proceeds on the sale of the

goodwill and the client list of KCG.     They recorded that the basis

in these two assets was zero.   The resulting $176,100 in long-term

capital gain was offset with $173,658 of capital losses that were

unrelated to the sale of the consulting business.

     During 2002, Kennedy received $32,757.94 from Mack & Parker.

As with the payment he received in 2001, the Kennedys reported on

their 2002 joint income-tax return that Kennedy received the
                               - 17 -

payment as the proceeds from the sale of the goodwill and the

client list of KCG.   They reported that the basis in these two

assets was zero.   The resulting $32,759 in long-term capital gain

reported on the 2001 return was completely offset with $157,621 of

capital losses unrelated to the sale of the consulting businesses.

     Vourvoulias prepared the 2001 and 2002 returns for the

Kennedys.   Kennedy expected Vourvoulias to advise him if the tax

return was incorrect.

     Mack & Parker made payments to Kennedy of $71,508 in 2003,

$64,112 in 2004, $40,300 in 2005, $76,764 in 2006.   As they had in

2001 and 2002, the Kennedys reported on each income-tax return for

years 2003-2006 that the payments were gross proceeds from the

sale of goodwill and the client list of KCG.   They reported the

resulting gain as long-term capital gain.   On their 2003, 2004,

and 2005 returns, the capital gain they reported was entirely

offset by capital losses.   On their 2006 return, the $76,764

reported as capital gain from the sale of goodwill and the client

list was only partially offset by capital losses: i.e. after

accounting for a $8,467 capital loss from the dissolution of JK

Partners and accounting for a combined capital loss of $56,770

resulting from various unrelated capital gains and losses, the

Kennedys recognized long-term capital gain of $11,528.

     As discussed above, the IRS mailed a deficiency notice to the

Kennedys for the tax years 2001 and 2002.   The payments that
                                 - 18 -

Kennedy received in 2001 and 2002, in the amounts of $176,100 and

$32,758, respectively, and reported as income from the sale of

capital assets, were recharacterized by the IRS as ordinary

income.   As a result, the IRS determined that the Kennedys owed

deficiencies in income tax, and accuracy-related penalties.        In

its post-trial brief, the IRS has conceded some of the amounts of

the deficiencies and corresponding penalties.

                              OPINION

1.   Evidentiary Issues

     We initially address some evidentiary issues that have not

been resolved.   During trial, the respondent (i.e. the IRS) moved

for the admission of the following documents:      Exhibits 20-R, 21-

R, 32-R, 33-R, 41-R, 42-R, and 43-R.      The Kennedys objected on

relevancy and hearsay grounds.    The Court immediately overruled

the relevancy objections but reserved its ruling on the validity

of the hearsay objections.   At no point did the IRS attempt to

build a foundation to defeat the hearsay objections.      We now

determine that the hearsay objections are valid.      The documents

will therefore be excluded from evidence.

2.   Capital Gain Versus Ordinary Income Treatment of the Payments
     From Mack & Parker

     The Kennedys take the position that the payments Kennedy

received from Mack & Parker are given capital treatment, because,

they argue, the payments are the proceeds from the sale of

goodwill.   Goodwill is a type of property.     McCubbin v. McCubbin,
                               - 19 -

465 N.E.2d 672, 674 (Ill. App. Ct. 1984).     It represents “the

personal relationships and customer contacts which the owner of

the business has been able to develop.”     Id.5   The IRS makes

several arguments why the payments to Kennedy should not be

considered payments for goodwill.   First, the IRS argues that the

owner of the customer list was not Kennedy, but KCG.      Without the

customer list, the IRS contends, Kennedy could not transfer

goodwill.

     Second, the IRS argues that the Kennedys have failed to prove

that Kennedy owned a goodwill asset.    The IRS notes, for example,

that the Kennedys provided the Court no appraisal of the goodwill

asset that Kennedy supposedly owned before the 2000 sale.      It

notes furthermore that Kennedy did not have any contracts with any

clients, and thus the Kennedys cannot rely on such contracts as

proof of the existence of a goodwill asset.

     Third, the IRS contends that even if Kennedy had owned the

goodwill asset before the 2000 sale, this asset should not be

considered a vendible asset.   Any goodwill asset would be based

upon the value of Kennedy’s relationships with his customers.

These relationships, the IRS maintains, had no value unless

Kennedy continued to perform services to the clients.


     5
      The term carries a similar meaning in the context of the
federal income tax. Newark Morning Ledger Co. v. United States,
507 U.S. 546, 555-556 (1993); sec. 1.1060-1(b)(2)(ii), Income Tax
Regs. (effective generally for any asset acquisition occurring
after Mar. 15, 2001).
                               - 20 -

     The IRS also argues that Kennedy could not have sold goodwill

because he did not own the employee benefits consulting business

before the 2000 sale.   The IRS maintains that the business was

owned by KCG, the company that employed Kennedy.   In support of

its contention that Kennedy could not sell goodwill without owning

the underlying business, the IRS cites Baker v. Commissioner, 338

F.3d 789 (7th Cir. 2003), affg. 118 T.C. 452 (2002).6

     Finally, the IRS asserts the substance-over-form doctrine

requires that the payments from Mack & Parker be considered either

payments for Kennedy’s services, or payments for Kennedy’s promise

not to compete, or both.   The IRS justifies its substance-over-

form argument by the following facts:

     •The sale of the consulting business was structured to

     minimize taxes (in that the parties attempted to characterize


     6
      In Baker v. Commissioner, 338 F.3d 789, 791 (7th Cir.
2003), affg. 118 T.C. 452 (2002), Baker was an insurance agent
for the State Farm Insurance Company. Under his agreement with
State Farm, all records regarding policyholders were the property
of State Farm. Id. The agreement further provided that upon his
retirement, Baker would be entitled to a termination payment, the
amount of which would be determined by the number of policies in
effect at the time of retirement. Id. at 792. Upon Baker’s
retirement in 1997, he received the termination payment of more
than $38,000. He claimed that the payment was in consideration
for goodwill and that therefore it should be considered long-term
capital gain income. Id. at 792-793; 118 T.C. at 460. The Tax
Court rejected the argument that the payment was for goodwill.
118 T.C. at 465. The Tax Court observed the principle that a
person can sell goodwill only when that person has also sold the
business to which the goodwill attaches. Id. Holding that Baker
was not the owner of the assets of the insurance agency business,
the Tax Court determined that Baker did not sell goodwill. Id.
Employing similar reasoning, Court of Appeals for the Seventh
Circuit affirmed the Tax Court’s decision. 338 F.3d at 793.
                                - 21 -

     the payments as payments for a capital asset);

     •the Consulting Agreement required Kennedy to provide future

     services to Mack & Parker;

     •Kennedy indeed performed substantial services for Mack &

     Parker;

     •KCG’s clients would not have switched to Mack & Parker

     unless Kennedy worked for Mack & Parker;

     •emails sent by Kennedy after he began work at Mack & Parker

     implied that he considered the payments to be compensation

     for his services; and

     •Kennedy’s covenant not to compete was valuable.

     The Kennedys rejoin that Martin Ice Cream Co. v.

Commissioner, 110 T.C. 189 (1998), compels the conclusion that

Kennedy owned a goodwill asset and that the payments he received

from Mack & Parker were to purchase that asset.   The Kennedys also

argue that KCG could not have been the owner of the goodwill

associated with the client relationships because Kennedy did not

have a non-compete agreement with KCG.

     We agree with the IRS that Kennedy did not sell a goodwill

property to Mack & Parker.   Our reasoning--set forth below--is not

necessarily the same reasoning as the IRS’s.    “Whether goodwill

does exist as a capital asset of a sole proprietor and if so

whether such goodwill was transferred are questions of fact in

each case.”    Butler v. Commissioner, 46 T.C. 280, 287 (1966).     A
                                 - 22 -

taxpayer has the burden of proving facts in a tax dispute with the

federal government.   See Rule 142(a); Welch v. Helvering, 290 U.S.

111, 115 (1933).   Thus, the Kennedys have the burden of proving

that the payments Kennedy received from Mack & Parker were

payments for his goodwill asset.    Section 7491(a) places the

burden of proof on the IRS if a taxpayer produces credible

evidence with respect to a factual issue and meets other

conditions.   Among these conditions is, first, that the taxpayer

met all substantiation requirements.      Second, the taxpayer must

have maintained all required records and complied with the IRS’s

requests for information.   The Kennedys do not contend that they

meet these requirements.    It is therefore inappropriate to shift

the burden of proof to the IRS.

     Before Kennedy sold the consulting business to Mack & Parker

in 2000, he had developed a loyal following among his clients.        In

order for Mack & Parker to benefit from Kennedy’s reputation, it

needed to employ his services.    This alone does not mean that the

money Mack & Parker paid to Kennedy should be considered payments

for services.   A payment to someone who provides ongoing services

can be considered a payment for goodwill.     This proposition was

established by Horton v. Commissioner, 13 T.C. 143, 145, 149

(1949) (five years of payments promised to a solo practitioner CPA

upon joining an accounting partnership--payments that were equal

to 10 percent of the fees collected by the partnership from
                               - 23 -

clients in the city of the CPA’s former practice--were considered

to be half for the CPA’s pre-existing goodwill and half for the

CPA’s covenant not to compete with the partnership), Wyler v.

Commissioner, 14 T.C. 1251, 1260 (1950) ($50,000 lump-sum payment

received by a solo practitioner CPA upon joining an accounting

firm--a payment that was additional to yearly $10,000 payments

denominated as “salary”--was considered a payment for goodwill)

and Watson v. Commissioner, 35 T.C. 203, 208 (1960) (lump-sum

payment to solo practitioner CPA who joined two new partners in an

accounting partnership--a payment that was equal to the gross

annual receipts of the CPA’s practice--was payment for goodwill).

     Even though a payment to a service provider can be considered

a payment for goodwill in certain circumstances, we are convinced

that the payments to Kennedy were consideration for services

rather than goodwill.   We find it significant that there is a lack

of economic reality to the contractual allocation of the payments

to goodwill.   In other cases, the contractual allocation of a

portion of a payment to goodwill has been important in determining

that the payment was indeed for goodwill.   In those other cases,

the contractual allocation appeared to genuinely reflect the

relative value of the seller’s customer relationships compared to

the value of the seller’s ongoing personal services.7   Here,


     7
      An example is Wyler v. Commissioner, 14 T.C. 1251 (1950).
The taxpayer was a certified public accountant who had originally
practiced with five employees and no partners. Id. at 1252. His
                              - 24 -

however, the allocation of 75 percent of the total consideration

paid by Mack & Parker to goodwill was a tax-motivated afterthought

that occurred late in the negotiations.   An initial issue that was

resolved by the parties to the transaction was the amount that

Kennedy should receive from Mack & Parker.   This amount was

initially estimated to be $660,000 minus Dolatowski’s base salary.

The amount of the payment was to be adjusted over five years to

reflect the degree of success Kennedy had in integrating KCG’s

clients into the Mack & Parker fold.   But the decision to allocate

75 percent of the total payments to goodwill appears not to be



practice was therefore a sole proprietorship, one which operated
under the name Richard S. Wyler & Co. Id. In 1944 the taxpayer
joined the partnership of Peat, Marwick, Mitchell & Co. Id. at
1254. Peat Marwick agreed that it would pay the taxpayer $50,000
in cash in “consideration of the transfer of good will” by the
taxpayer to Peat Marwick. Id. at 1255. The taxpayer was also to
be paid a “salary” of $10,000 per year during the term of the
agreement, which was a 3-1/2-year period from Feb. 7, 1944, to
June 30, 1947. Id. at 1254-1255. The taxpayer was also to be
paid “additional compensation” during the term of the agreement.
Id. at 1256. The “additional compensation” was equal to 1
percent of the profits of the Peat Marwick firm. Id. at 1255-
1256. The additional compensation would never be less than
$10,000 per year. Id. The amount of additional compensation for
the last year of the agreement was to be reduced by 1/4
($200,000-R), where R is equal to the gross fees received by Peat
Marwick from the taxpayer’s former clients over the 3-1/2-year
term of the agreement. Id. at 1256. The amount of the reduction
could not exceed the additional compensation that would have
otherwise been payable for the last year. Id. The Tax Court
held that the taxpayer had possessed vendible good will before
the agreement with Peat Marwick, and that the $50,000 payment was
in exchange for goodwill. Id. at 1260. In making the later
finding, the Court relied on the agreement and on an interoffice
memorandum by a Peat Marwick partner that claimed that the
$50,000 payment was for taxpayer’s “practice”. Id.
                                - 25 -

grounded in any business reality.    It did not reflect the value of

goodwill in relation to the other valuable aspects of the

transaction, such as the services to be performed by Kennedy for

Mack & Parker.    Rather, the 75 percent allocation was driven by a

desire to minimize taxes.

       Setting aside that the contracts allocated 75 percent of the

consideration for the sale to goodwill, the record reveals that

Kennedy undertook to work for Mack & Parker for five years until

his planned retirement date of December 31, 2005, that he gave

Mack & Parker the valuable promise not to compete in the area of

employee benefits consulting, and that he worked for Mack & Parker

for 18 months without compensation for his services (other than

relatively meager amounts paid to KCG under the terms of the

Consulting Agreement).    Under these circumstances, we find that

the payments Kennedy received were not payments for goodwill.

       Having determined that the payments were not for Kennedy’s

goodwill, we now turn to the question of what the payments were

for.    As the respondent contends, the payments were for one of two

things:    (1) Services to be performed by Kennedy, and (2)

Kennedy’s promise not to compete with Mack & Parker.    Payments for

services are includable in ordinary income.    Sec. 61(a)(1).

Payments for an agreement not to compete are also includable in

ordinary income.    See Baker v. Commissioner, 338 F.3d at 794.

Consequently we need not allocate the payments between services
                                 - 26 -

and noncompetition obligations.       See Baker v. Commissioner, 118

T.C. at 466-467.   The payments are includable in ordinary income.

     The Kennedys’ legal case relies primarily on Martin Ice Cream

Co. v. Commissioner, 110 T.C. 189 (1998).      Their brief states:

     it is clear from Martin Ice Cream * * * that Mr.
     Kennedy did own this capital asset, the know-how and
     goodwill. The Payments were directed to the payment
     of know-how and goodwill. * * *

We disagree that Martin Ice Cream Co. determines the outcome here,

and we explain why.    Martin Ice Cream Co. was a corporation that

distributed ice cream to both supermarkets and small stores.          Id.

at 196.   It was the first distributor of Häagen-Dazs ice cream.

Id. at 193.   Arnold Strassberg was an officer of Martin Ice Cream.

He also owned 51 percent of Martin Ice Cream Co.      Id. at 192.     He

concentrated his efforts on the supermarket business as opposed to

the small-store business.     Id. at 194.   As a result, Strassberg

had valuable relationships with supermarkets.      Id. at 195-196.     On

May 31, 1988, SIC was formed as a wholly owned subsidiary of

Martin Ice Cream Co.    Id. at 198.    On June 15, 1988, Martin Ice

Cream Co. transferred to SIC its rights to distribute ice cream to

supermarkets.   Id. at 200.   On the same day, Arnold exchanged his

stock in Martin Ice Cream for the stock of SIC.      Id.   Then, on

July 22, 1988, SIC and Strassberg transferred to Häagen-Dazs the

right to distribute ice cream to supermarkets.      Id. at 202-203.

SIC and Strassberg also transferred SIC’s business records,

customer records, and associated goodwill.      Id. at 204.   In
                                  - 27 -

exchange, Strassberg and SIC received $1,430,340.        Id. at 206.

Strassberg concurrently signed a consulting and non competition

agreement with Häagen-Dazs, for which he was paid $150,000 per

year for 3 years.   Id. at 204.    SIC’s tax return for 1988 reported

that it had sold the assets and that because it was an S

corporation, with only one shareholder at the end of the tax year

(Strassberg), Strassberg would be taxed on the gain.        Id. at 205.

The IRS took the position that the true seller of the assets was

Martin Ice Cream Co., and that therefore Martin Ice Cream Co.

should recognize the gain.      Id. at 206.   The Tax Court found that

the owner of the assets--until the sale to Häagen Dazs on July 22,

1988--was Strassberg.   Id.     The Court reasoned that Strassberg

never entered into an agreement with Martin Ice Cream Co. under

which his relationships became property of Martin Ice Cream Co.

It held that the customer relationships of Strassberg were a

“personal [asset] entirely distinct from the intangible corporate

asset of corporate goodwill.”      Id. at 207.    Martin Ice Cream Co.

is not dispositive here.      Martin Ice Cream Co. held that a

corporation (Martin Ice Cream Co.) was not taxable on payments

that were made to Strassberg, the corporation’s controlling

shareholder, for his customer relationships.        But the Court in

Martin Ice Cream Co. had no occasion to address how the

shareholder should be taxed on the payments, inasmuch as the

shareholder had no case before the Court.        Therefore, the Court
                                 - 28 -

was not called to opine on whether the payments should be treated

as payments for services or payments for a capital asset.

3.   The Kennedys’ Liability for Self-Employment Tax Under Section
     1401 on the Payments Received From Mack & Parker

     The IRS determined that the payments of $176,100 in 2001 and

$32,758 in 2002 should be included in Kennedy’s self-employment

income.   The Kennedys respond that the payments are not includable

in self-employment income because the payments are not ordinary

income.   Having already rejected this argument, we conclude that

the payments are includable in self-employment income.

4.   The Accuracy-Related Penalty Under Section 6662(a)

     The IRS determined that the Kennedys were liable for the

section accuracy-related penalty for the tax years 2001 and 2002.

Section 6662(a) and (b)(2) imposes a penalty equal to 20 percent

of the portion of the underpayment of tax attributable to any

substantial understatement of income tax.    A substantial

understatement of income tax exists if the amount of the

understatement exceeds the greater of $5,000 or 10 percent of the

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

Pursuant to section 7491(c), the IRS bears the burden of producing

sufficient evidence showing the imposition of a penalty is

appropriate in a given case.     Higbee v. Commissioner, 116 T.C.

438, 446 (2001).    Once the IRS meets this burden, the taxpayer

must come forward with persuasive evidence that the penalty is

inappropriate.     Id. at 447.
                                - 29 -

     The Kennedys’ returns for 2001 and 2002 erroneously reported

the payments from Mack & Parker to Kennedy (in the amounts of

$176,100 and $32,758, respectively) as proceeds from the sale of a

capital asset rather than as ordinary income.     This erroneous

treatment resulted in the returns’ showing an understatement of

tax for each year at issue.   The understatement for each year

greatly exceeds $5,000 and 10 percent of the tax required to be

shown on the return.

     The IRS also argues that the accuracy-related penalty is

justified because the Kennedys’ capital gains treatment was

attributable to negligence.   Sec. 6662(c).    However, we find that

the accuracy-related penalty should not be imposed because the

Kennedys had reasonable cause for the tax treatment and acted in

good faith.   Sec. 6664(c).   Reliance on a tax opinion provided by

a professional tax adviser may serve as a basis for the

reasonable-cause-and-good-faith exception to the accuracy-related

penalty.   Sec. 1.6664-4(b)(1), Income Tax Regs.    For a taxpayer to

rely reasonably upon advice of a tax adviser, the taxpayer must at

a minimum prove by a preponderance of the evidence that:     (1) the

adviser was a competent professional with sufficient expertise to

justify reliance, (2) the taxpayer provided necessary and accurate

information to the adviser, and (3) the taxpayer actually relied

in good faith on the adviser’s judgment.      Neonatology Associates,

P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd. 299 F.3d 221
                                - 30 -

(3d Cir. 2002).   We find that Kennedy did indeed rely on

Vourvoulias to prepare the return accurately, that Kennedy

provided to Vourvoulias the relevant documents underlying the 2000

sale transaction, and that Vourvoulias concluded that the

transaction should be considered a capital transaction.     We

further find--considering his background and experience--that

Vourvoulias was a sufficiently reliable tax adviser.   Under the

facts of the case, Kennedy has demonstrated reasonable reliance on

the advice of a professional.   The Kennedys should therefore not

be subject to the accuracy-related penalty for the years at issue.


                                          An appropriate decision

                                will be entered.
