                          T.C. Memo. 1999-101



                        UNITED STATES TAX COURT



         JERRY AND PATRICIA A. DIXON, ET AL.,1 Petitioners
           v. COMMISSIONER OF INTERNAL REVENUE, Respondent*



     Docket Nos.     9382-83,   17646-83,   Filed March 30, 1999.
                     4201-84,    7323-84,
                    15907-84,   20119-84,
                    40159-84,   22783-85,
                    30010-85,   30979-85,
                    29643-86,   35608-86,
                    19464-92,     621-94,
                     7205-94,    9532-94,
                    17992-95,   17993-95.

     1
        Cases of the following petitioners are consolidated
herewith: Ronald L. Alverson and Mattie L. Alverson, docket No.
17646-83; Hoyt W. and Barbara D. Young, docket Nos. 4201-84,
22783-85, 30010-85; Anthony E. and Carol A. Eggers, docket No.
7323-84; Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84,
30979-85; John L. and Terry E. Huber, docket No. 20119-84;
Terry D. and Gloria K. Owens, docket No. 40159-84; Richard and
Fidella Hongsermeier, docket No. 29643-86; Norman W. and
Barbara L. Adair, docket No. 35608-86; Willis F. McComas, II and
Marie D. McComas, docket No. 19464-92; Wesley Armand and Sherry
Lynn Cacia Baughman, docket No. 621-94; Joe A. and JoAnne
Rinaldi, docket No. 7205-94; Norman A. and Irene Cerasoli, docket
No. 9532-94; Stanley C. and Sharon A. Titcomb, docket No. 17992-
95; Richard B. and Donna G. Rogers, docket No. 17993-95.
     *
        This opinion supplements our previously filed Memorandum
Findings of Fact and Opinion in Dixon v. Commissioner, T.C. Memo.
1991-614, vacated and remanded per curiam sub nom. DuFresne v.
Commissioner, 26 F.3d 105 (9th Cir. 1994).
                         - 2 -


     In Dixon v. Commissioner, T.C. Memo. 1991-614,
vacated and remanded per curiam sub nom. DuFresne v.
Commissioner, 26 F.3d 105 (9th Cir. 1994), following a
trial of 14 docketed test cases of eight Ps, the Court
sustained R's disallowance of interest deductions
claimed by Ps in various tax shelter programs promoted
by K. After the Court entered decisions against the
test case Ps in accordance with its opinion, R moved to
vacate the decisions entered in three test cases (T, C,
and X). R alleged that, before the trial of the test
cases, R's trial attorney and District Counsel had
entered into contingent settlement agreements with T
and C that had not been disclosed to the Court or to
the other test case Ps or their counsel. R asked the
Court to conduct an evidentiary hearing to determine
whether the undisclosed agreements with T and C had
affected the trial of the test cases or the opinion of
the Court.

     The Court granted R's motions to vacate the
decisions entered in the T and C cases, entered revised
decisions in the T and C cases consistent with R's
prior agreements with T and C, denied R's motion to
vacate the decision in the X case, and denied R's
request for an evidentiary hearing on the ground that
the testimony, stipulated facts, and exhibits relating
to the T and C cases had no material effect on the
Court's opinion as it related to the remaining test
case Ps.

     On appeal, the Court of Appeals for the Ninth
Circuit vacated the decisions in the remaining test
cases and remanded them to this Court with directions
"to conduct an evidentiary hearing to determine the
full extent of the admitted wrong done by the
government trial lawyers." DuFresne v. Commissioner,
supra at 107. The Court of Appeals, citing Arizona v.
Fulminante, 499 U.S. 279, 309 (1991), directed the
Court to consider "whether the extent of misconduct
rises to the level of a structural defect voiding the
judgment as fundamentally unfair, or whether, despite
the government's misconduct, the judgment can be upheld
as harmless error." Id. Further, the Court of Appeals
directed this Court to consider on the merits all
motions of intervention filed by affected parties. See
id. This Court ordered that the cases of 10 nontest
case Ps, the majority of whom had previously signed
piggyback agreements, be consolidated with the
remaining test cases for purposes of the evidentiary
hearing. Three groups of Ps participated in all
subsequent phases of the evidentiary hearing.
                              - 3 -


          Ps argue (under various theories) that the Court's
     decisions in the remaining test cases should not be
     reinstated, or, in the alternative, that the piggyback
     agreements are not enforceable. R counters that the
     decisions in the remaining test cases should be
     reinstated on the ground that Ps were not prejudiced by
     the Government misconduct in the trial of the test
     cases and that the piggyback agreements remain in
     force.

          Held: The Government misconduct in the trial of
     the test cases did not result in a structural defect in
     the trial. Held further: The Government misconduct in
     the trial of the test cases resulted in harmless error.
     Held further: The Government misconduct in the trial
     of the test cases does not provide any other basis for
     invalidating the Court's decisions in the remaining
     test cases or for setting aside the piggyback
     agreements. Held further: As a sanction against R,
     program participants who have not been the subject of a
     final determination are not liable for time-sensitive
     additions to tax for negligence under secs. 6653(a)(2)
     and 6653(a)(1)(B), I.R.C., or increased interest under
     sec. 6621(c), I.R.C.



     Joe Alfred Izen, Jr., counsel for petitioners in docket Nos.

9382-83, 4201-84, 15907-84, 40159-84, 22783-85, 30010-85, 30979-

85, 29643-86, and 35608-86.

     Robert Alan Jones, counsel for petitioners in docket Nos.

17646-83, 19464-92, 621-94, and 9532-94.

     Robert Patrick Sticht, counsel for petitioners in docket

Nos. 7323-84, 20119-84, 7205-94, 17992-95, and 17993-95.

     Mary Elizabeth Wynne, Steven A. Wilson, Andrew J. Gottlieb,

Milton J. Carter, Jr., Robert E. Casey, and Richard S. Goldstein,

for respondent.
                                  - 4 -


                                CONTENTS

                                                              Page
Introduction....................................................9

FINDINGS OF FACT...............................................15

I.        Kersting Tax Shelter Programs and Related Matters........15
     A.   The Pike Case............................................15
     B.   Kersting Criminal Investigation..........................16
     C.   Assessments of Kersting Promoter Penalties...............18
     D.   Kersting Notice of Deficiency............................19

II.       Notices of Deficiency Issued to Kersting Program
          Participants ............................................20
     A.   Form of Notices of Deficiency............................20
     B.   Thompson Notices of Deficiency...........................21
     C.   Cravens Notices of Deficiency............................23
     D.   Alexander Notices of Deficiency..........................24
          1. 1974 and 1975.........................................25
          2. 1976 and 1977.........................................26
     E.   Validity of Notices of Deficiency........................27
     F.   Errors in Notices of Deficiency..........................27

III. Commencement of Kersting Project ........................28
   A. Tax Shelter Projects and Test Case Procedures............28
      1. Overview..............................................28
      2. National Office Tax Shelter Branch Functions..........30
   B. Petitions for Redetermination............................31
   C. Brian J. Seery...........................................32
   D. Respondent's Counsel.....................................33
      1. Kenneth W. McWade.....................................33
      2. William A. Sims.......................................34
   E. Adoption of Test Case Procedures in Kersting Project.....34
      1. The Honolulu Session (June 1985)......................34
      2. Test Case Procedure...................................35
      3. Test Case Array.......................................38

IV.       The Maui Session (February 1987).........................42
     A.   Trial Notices............................................42
     B.   Piggyback Agreements.....................................44
     C.   Mr. Seery's Withdrawals as Counsel.......................48
          1. The Thompsons.........................................49
          2. The Test Cases........................................50
     D.   Entries of Appearance by Chicoine and Hallett............51
     E.   Evidentiary Issues.......................................54
          1. The Maui Session......................................54
          2. Dixon I Opinion.......................................55

V.      Kersting Disputes With Program Participants..............55
     A. The Thompsons............................................56
                                - 5 -


      1. The Bauspar Program...................................56
      2. Deterioration of Thompson/Kersting Relationship.......57
   B. The Alexander Dispute....................................67
   C. Collection Actions.......................................72
      1. Steve Hane............................................72
      2. Carl Mott, George Vermef, and Robert Peterson.........73

VI.   Settlements..............................................74
   A. Internal Revenue Service Policy..........................74
      1. National Office Position..............................74
      2. Regional Counsel......................................76
   B. Official Kersting Project Settlement Offer (7-Percent
      Reduction of Deficiency or Out-of-Pocket Expenses).......77
   C. Deviations From Official Project Settlement Offer........78
      1. Modified 7-Percent Settlement Offer...................78
      2. 20-Percent Settlement Offer...........................80
      3. Negotiations for 50-Percent Settlement Offer..........82
      4. Revival of 20-Percent Settlement Offer................84
   D. The Thompson Settlement..................................92
      1. Initial Thompson Settlement Agreement.................92
      2. First Revision of Thompson Settlement.................94
      3. Second Revision of Thompson Settlement................98
   E. The Cravens Settlement..................................100
   F. The Alexander Understanding.............................106
   G. The Kozak Decision......................................115

VII.    Pretrial Developments...................................116
   A.   The Kersting Deposition--Postponed (January 1987).......116
   B.   John Doe Summons/Assessments of Promoter Penalties......118
   C.   Chicoine and Hallett's Withdrawal as Counsel............120
   D.   Mr. Izen's Entry of Appearance..........................120
   E.   The Kersting Deposition (October 1988)..................121

VIII.   Trial of Test Cases (January 1989)......................123
   A.   Mr. Cravens.............................................124
   B.   Mr. Thompson............................................126
   C.   Mr. Kersting............................................129
   D.   Mr. Alexander...........................................130
   E.   Mr. DeCastro............................................133
   F.   Comfort Letters.........................................133
   G.   Mr. Izen's Introduction of Evidence of Collection
        Litigation..............................................135

IX.     Posttrial Developments..................................137
   A.   First Thompson Refund...................................137
   B.   Mr. Izen's Motion To Reopen Record......................141
   C.   Dixon II Opinion........................................142
   D.   Disclosure of Thompson Settlement.......................143
   E.   Disclosure of Cravens Settlement........................152
   F.   Respondent's Motions To Vacate..........................155
                                - 6 -


     G. Attempted Discovery by Counsel for Nontest Case
        Petitioners.............................................156
     H. Closing of Thompson Cases/Further Refunds...............156
     I. Closing of Cravens Cases................................160

PROCEDURAL HISTORY OF EVIDENTIARY HEARING.....................162

I.      Developments Before Evidentiary Hearing.................162
     A. Referral of Thompson and Cravens Settlements to Office
        of Inspector General....................................162
     B. Revival of 7-Percent Settlement Offer...................165
     C. Disciplinary Actions....................................165
     D. Indictment of Mr. Izen..................................166
     E. Pretrial Conference (July 1995).........................167
     F. Pretrial Conference (January 1996)......................168
     G. Denial of Respondent's Motion To Disqualify Mr. Izen....168
     H. Mr. DeCastro's Withdrawal...............................170
     I. Discovery of Alexander Decisions and Referral to
        Office of Inspector General.............................170
     J. Mr. Izen's Motion To Compel Production of Documents
        and Issuance of Protective Orders.......................171
     K. Burden of Proof and Rule 145 Order......................173

II.     The Evidentiary Hearing.................................175
     A. Testimony...............................................176
        1. Mr. Cravens......................................... 176
        2. Mr. Thompson.........................................178
        3. Mr. Alexander........................................179
        4. Mr. McWade...........................................180
        5. Mr. Sims.............................................182
        6. Mr. DeCastro.........................................183
        7. Mr. Izen.............................................184
     B. Mr. Sticht's Allegations of Potential Witness
        Intimidation............................................186
     C. Mr. Bradt's June 12, 1996, Letter to Mr. Kersting.......187
     D. Denial of Mr. Izen's Motion To Refer Thompson and
        Cravens Settlements and Alexander Agreement to
        Department of Justice (Public Integrity Section)........189

III. Developments Following Initial Evidentiary Hearing......189
   A. Denial of Respondent's Motion for Further Hearing
      Regarding Potential Witness Intimidation................189
   B. Supplemental Evidentiary Hearing (August 18, 1997)......192
   C. Denial of Mr. Izen's Motion To Compel Production of
      Documents...............................................194
   D. Denial of Mr. Sticht's Motion To Reopen Record..........195
   E. Denial of Mr. Izen's Motion To Take Judicial Notice.....196
   F. Denial of Mr. Sticht's Motions for Release From
      Piggyback Agreements....................................198
   G. Reports Regarding the Court's Protective Orders.........199
                                  - 7 -


ULTIMATE FINDINGS OF FACT.....................................200

OPINION.......................................................202

I.        Burden of Proof.........................................203

II.       Structural Defect.......................................211
     A.   Case Law................................................211
     B.   Arguments...............................................215
     C.   Summary of Government Misconduct........................218
     D.   Discussion..............................................225

III. Harmless Error Analysis.................................233
   A. Review of Dixon II......................................236
      1. Mr. Kersting's Lack of Credibility...................237
      2. Sham Analysis........................................238
      3. Lack of Genuine Debt/Waltz of Funds..................240
         i.   Subscription Interest...........................241
         ii. Primary Loans...................................242
         iii. Leverage Loans..................................244
      4. Collection Litigation................................244
      5. CAT-FIT Plan.........................................245
      6. Additions to Tax.....................................247
         i.   Negligence......................................247
         ii. Late Filing.....................................247
         iii. Substantial Understatement......................247
         iv. Increased Interest..............................248
   B. Discussion..............................................249
      1. Mr. Cravens.........................................249
         i.   Sham Analysis...................................251
         ii. Lack of Genuine Debt/Waltz of Funds.............254
      2. Mr. Thompson.........................................255
         i.   Sham Analysis...................................257
         ii. Lack of Genuine Debt/Waltz of Funds.............258
         iii. Additions to Tax................................262
      3. Mr. Alexander........................................264
      4. Summary..............................................266

IV.       Fraud, Misrepresentation, and Misconduct................267

V.      Fraud on the Court......................................271
     A. Case Law Survey.........................................271
     B. Discussion..............................................281

VI.       Mr. Izen's Allegations That Mr. DeCastro Was a "Mole"...283

VII. Enforceability of Piggyback Agreements..................284
   A. Principles of Contract Law..............................285
   B. Discussion..............................................290
      1. Benefit of the Bargain...............................290
      2. Mr. Seery's Purported Conflict of Interest...........294
                                 - 8 -


        3. Rejection of Mr. Izen's Argument for Entry of
           Decision On the Basis of Thompson Decisions..........296

VIII. Mary Carter Agreements..................................296

IX.     Mr. Sticht's Motion To Sever Case and for Entry of
        Decision or Alternatively To Sever Case and Set for
        Trial ..................................................300

X.      Protective Orders.......................................302

XI.     Sanctions...............................................305

Conclusion....................................................307


        SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION

       BEGHE, Judge:   Eight of these consolidated cases--with five

petitioners represented by Joe Alfred Izen, Jr. (Mr. Izen),--are

test cases before the Court on remand from the Court of Appeals

for the Ninth Circuit in DuFresne v. Commissioner, 26 F.3d 105

(9th Cir. 1994), vacating and remanding per curiam Dixon v.

Commissioner, T.C. Memo. 1991-614.

       The other 10 consolidated cases--with petitioners in one

case represented by Mr. Izen and the other petitioners

represented by Robert Alan Jones (Mr. Jones) and Robert Patrick

Sticht (Mr. Sticht)--are nontest cases that have been added to

the consolidated group in order to effectuate the direction of

the Court of Appeals "to consider on the merits all motions of

intervention filed by parties affected by this case."     Id. at

107.

       Unless otherwise indicated, section references are to the

Internal Revenue Code, as amended, and Rule references are to the

Tax Court Rules of Practice and Procedure.
                                - 9 -


Introduction

     These consolidated cases are part of a group of more than

1,300 remaining cases--more than 500 cases have settled--arising

from respondent's disallowance of interest deductions claimed by

participants in various tax shelter programs promoted by Henry

F.K. Kersting (Mr. Kersting).   The Kersting group of cases

(hereinafter the Kersting project) was assigned to Judge

William A. Goffe (Judge Goffe) for disposition.   By agreement of

the parties and the Court, the merits of the Kersting programs

were to be litigated in a consolidated trial of 14 docketed cases

of eight petitioners that had been designated as "test cases".

The vast majority of the remaining Kersting project petitioners

signed stipulations to be bound (sometimes referred to herein as

piggyback agreements) in which they agreed with respondent that

their cases would be resolved in accordance with the Court's

opinion in the test cases.

     Before the trial of the test cases, some test case

petitioners argued that a 1981 search of Mr. Kersting's office

had been illegal, that materials seized during the search should

be suppressed in the test case proceedings, and that the burden

of proof and burden of going forward with evidence should be

shifted to respondent.   In Dixon v. Commissioner, 90 T.C. 237

(1988) (Dixon I), the Court held, in an opinion by Judge Goffe,

that the petitioners had failed to establish standing to contest

the Kersting search and seizure.
                                  - 10 -


       Judge Goffe held the trial of the test cases in Honolulu,

Hawaii, during January 1989.      The majority of the test case

petitioners were represented at trial by Mr. Izen.        However, test

case petitioners John R. and Maydee L. Thompson (docket Nos.

19321-83, 31236-84, and 30965-85) were represented at trial by

Luis C. DeCastro (Mr. DeCastro), and test case petitioners John

R. and E. Maria Cravens (docket Nos. 16900-83 and 15135-84)

appeared pro sese.

       Following the trial of the test cases, the Court issued its

memorandum opinion in Dixon v. Commissioner, T.C. Memo. 1991-614,

62 T.C.M. (CCH) 1440, 1991 T.C.M. (RIA) par. 91,614 (Dixon II),

sustaining virtually all of respondent's determinations in each

of the test cases, and entered decisions against the test case

petitioners in accordance with its opinion.

       On March 13, 1992, the Court entered the following decisions

in the Thompson and Cravens cases:

John R. and Maydee L. Thompson

                                       Additions to Tax
                         Sec.        Sec.      Sec.          Sec.
Year     Deficiency     6651(a)     6653(a) 6653(a)(1)     6653(a)(2)

1979     $18,161.00       ---       $908       ---           ---
1980      24,838.00       ---        ---       ---           ---
1981      36,294.52    $4,934.32     ---    $1,958.28     50 percent of
                                                          the interest
                                                          due on the
                                                          deficiency

John R. and E. Maria Cravens
                                              Additions to Tax
       Year            Deficiency               Sec. 6653(a)

       1979             $4,508.00                  $225.40
       1980              5,893.45                   294.67
                               - 11 -


     On June 9, 1992, respondent filed motions for leave to file

motions to vacate the decisions entered against the Thompsons,

the Cravenses, and another test case petitioner, Ralph J. Rina

(Mr. Rina), docket No. 17640-83.    Respondent's motions to vacate

alleged that, before the trial of the test cases, respondent's

trial attorney, Kenneth W. McWade (Mr. McWade), and his

supervisor, Honolulu District Counsel William A. Sims (Mr. Sims),

had entered into contingent settlement agreements with the

Thompsons and the Cravenses that had not been disclosed to the

Court or to the other test case petitioners or their counsel.

Respondent asked the Court to conduct an evidentiary hearing to

determine whether the undisclosed agreements with the Thompsons

and the Cravenses had affected the trial of the test cases or the

opinion of the Court.

     On June 22, 1992, Judge Goffe granted respondent's motions

to vacate filed in the Thompson and Cravens cases, vacated the

decisions entered in those cases, ordered the parties to file

agreed decisions with the Court, or otherwise move as

appropriate, and denied respondent's request for an evidentiary

hearing.    By order dated June 22, 1992, Judge Goffe also denied

respondent's motion to vacate the decision entered against

Mr. Rina, on the ground that the testimony, stipulated facts, and

exhibits relating to the Thompson and Cravens cases had no

material effect on the Court's Dixon II opinion as it related to

Mr. Rina.
                                - 12 -


     On July 22, 1992, the test case petitioners represented by

Mr. Izen filed a motion for reconsideration of the Court's order

denying respondent's motion to vacate the decision in the Rina

case.     By order dated August 4, 1992, Judge Goffe denied

petitioners' motion for reconsideration.

     In August 1992, the Court entered revised decisions in the

Thompson and Cravens cases consistent with Mr. McWade's prior

agreements with the taxpayers in those cases.     Specifically, the

Court entered the following decisions in the Thompson and Cravens

cases:

John R. and Maydee L. Thompson

          Year            Deficiency        Additions to Tax

          1979                ---                  ---
          1980             $15,000                 ---
          1981              15,000                 ---

John R. and E. Maria Cravens

          Year            Deficiency        Additions to Tax

          1979             $3,606.40               ---
          1980              6,175.76               ---

The decisions entered in the Thompson and Cravens cases are now

final.2


     2
        Mr. Izen and Mr. Sticht filed separate motions with the
Court to intervene in the Thompson and Cravens cases. The Court
denied these motions to intervene. Although Mr. Izen and
Mr. Sticht filed separate appeals in the Thompson and Cravens
cases with various courts, including the Courts of Appeals for
the Second, Ninth, and Tenth Circuits, all appeals in the
Thompson and Cravens cases eventually were dismissed. In an
unpublished opinion filed June 15, 1994, the Court of Appeals
for the Ninth Circuit stated:

                                                         (continued...)
                             - 13 -


     Because of Judge Goffe's termination, on September 30, 1992,

of his recall status as a Senior Judge of the Court, all cases in

the Kersting project group were reassigned to Judge Renato Beghe.

     The other test case petitioners, including Mr. Rina,

appealed the decisions entered in their cases to the Court of

Appeals for the Ninth Circuit.   On appeal, those petitioners

argued that the trial of the test cases had been tainted by the

Thompson and Cravens settlement agreements.    The response of the

Court of Appeals was to vacate the decisions in the remaining

test cases and remand them to this Court with directions "to

conduct an evidentiary hearing to determine the full extent of

the admitted wrong done by the government trial lawyers."

DuFresne v. Commissioner, 26 F.3d at 107.     The Court of Appeals,

citing Arizona v. Fulminante, 499 U.S. 279, 309 (1991), directed

the Court to consider "whether the extent of misconduct rises to

the level of a structural defect voiding the judgment as

fundamentally unfair, or whether, despite the government's

misconduct, the judgment can be upheld as harmless error."

DuFresne v. Commissioner, supra at 107.     Further, the Court of




     2
      (...continued)
          The Tax Court's August 25 and 26, 1992 decisions
     entering settlement in the Cravens and Thompson cases,
     respectively, are final. 26 U.S.C. § 7481(a)(1); Fed.
     R. App. P. 13. The Tax Court lacks jurisdiction to
     vacate those decisions. Billingsley v. CIR, 868 F.2d
     1081, 1084 (9th Cir. 1989). Because there is no case
     remaining in which the taxpayers can intervene, this
     appeal is moot. [Adair v. Commissioner, No. 92-70812,
     26 F.3d 129 (9th Cir. 1994).]
                              - 14 -


Appeals directed this Court to consider on the merits all motions

of intervention filed by parties affected by Dixon II.   See id.3

     On February 2, 1995, respondent filed a Motion for an

Evidentiary Hearing.   On September 14, 1995, the Court granted

respondent's motion.   To effectuate the direction of the Court of

Appeals regarding intervention, the Court ordered that the cases

of 10 nontest case petitioners, the majority of whom had

previously signed piggyback agreements, be consolidated with the

remaining test cases for purposes of the evidentiary hearing.4

As a result, three groups of petitioners have participated in all

subsequent phases of the evidentiary hearing:   Test case and

nontest case petitioners represented by Mr. Izen; nontest case

petitioners represented by Mr. Jones; and nontest case

petitioners represented by Mr. Sticht.5   The positions taken by


     3
        The appellate panel in DuFresne v. Commissioner, 26 F.3d
105, 107 (9th Cir. 1994), vacating and remanding per curiam Dixon
v. Commissioner, T.C. Memo. 1991-614, 62 T.C.M. (CCH) 1440, 1991
T.C.M. (RIA) par. 91,614 (Dixon II), issued an order stating that
the panel would retain jurisdiction over any subsequent appeal.
     4
        On June 13, 1995, test case petitioner Mr. Rina conceded
his case in full, resulting in entry of a stipulated decision in
docket No. 17640-83 that was identical with the decision
originally entered in that case on the basis of the Court's
opinion in Dixon II.
     5
        The group of cases that were consolidated for purposes of
the evidentiary hearing initially included the case of William D.
and Karen S. Booth, docket No. 28950-88, in which Declan J.
O'Donnell (Mr. O'Donnell) had entered his appearance. However,
at the start of the evidentiary hearing, the Court granted
Mr. O'Donnell's motion to sever the Booth case from the cases
consolidated for the evidentiary hearing. Mr. O'Donnell argued
that, in light of the theory underlying a Motion for Summary
Judgment that he had filed on behalf of the Booths, they had no
                                                   (continued...)
                              - 15 -


the various groups of petitioners during these proceedings have

not been consistent in all respects and in some respects the

positions of counsel--primarily Messrs. Izen and Sticht--have

become adversarial.6

     Following pretrial conferences on the record in Los Angeles

on July 17, 1995, and January 16, 1996, the evidentiary hearing

was held at special trial sessions of the Court conducted in Los

Angeles on May 13 to 30 and June 10 to 26, 1996, and August 18,

1997.

     In the interest of chronology and as an aid to understanding

this opinion, the procedural history of the evidentiary hearing

comes after the Court's detailed findings of fact and before the

ultimate findings of fact.

                         FINDINGS OF FACT

I.   Kersting Tax Shelter Programs and Related Matters

A.   The Pike Case

     Mr. Kersting began promoting tax shelter programs in Hawaii

in the early 1970's.   Mr. Kersting's early tax shelter programs

included an "Auto-Leasing Plan" and an "Acceptance Corporation

Plan."   Those plans generally required participants to purchase


     5
      (...continued)
need to participate in the evidentiary hearing. In Gridley v.
Commissioner, T.C. Memo. 1997-210, the Court rejected the
argument, raised in the Booths' Motion for Summary Judgment,
that Kersting petitioners who signed stipulations to be bound
to Dixon II were entitled to entry of decisions in their cases
consistent with the decision entered by the Court in the Thompson
case at docket No. 19321-83.
     6
         See infra pp. 168-169, 171-172, and 187-188.
                              - 16 -


stock in a subchapter S leasing corporation or an acceptance

corporation and/or enter into a subscription agreement to

purchase stock, all in connection with loans to the participants

by various entities created by Mr. Kersting.   The plans were

primarily designed to generate income tax deductions for interest

that the participants purportedly paid to the Kersting entities

on the loans.

     The Commissioner determined that participants in

Mr. Kersting's auto-leasing and acceptance corporation plans were

not entitled to deduct:   (1) "Interest" that participants claimed

to have paid on either the Auto-Leasing stock purchase or

leverage loans; (2) the participants' pro rata shares of losses

or investment credits from the auto leasing companies; and

(3) "interest" that participants claimed to have paid either on

the acceptance corporation stock purchase or stock subscription

loans.

     In Pike v. Commissioner, 78 T.C. 822 (1982), affd. without

published opinion 732 F.2d 164 (9th Cir. 1984), this Court

sustained the Commissioner's disallowances of all deductions for

interest, losses, and credits claimed by participants in

Mr. Kersting's early programs.

B.   Kersting Criminal Investigation

     While the Pike litigation was underway, Mr. Kersting

continued to promote additional tax shelter programs, which came

to be known as the stock purchase plan, the stock subscription

plan, the leasing company plan, and the CAT-FIT plan.   The
                               - 17 -


Court's opinion in Dixon II describes the mechanics of these

programs in detail.7

     On January 22, 1981, following an undercover criminal

investigation, the Internal Revenue Service searched

Mr. Kersting's offices in Hawaii pursuant to a search warrant

issued by the U.S. District Court for the District of Hawaii.

Seventy-seven boxes and two filing cabinets of records were

seized from Mr. Kersting's office, including lists identifying,

by name and address, approximately 1,800 participants in

Mr. Kersting's programs, and schedules of the interest

purportedly paid by each participant to one or more Kersting

companies during the taxable years 1977, 1978, and 1979.

     On January 24, 1981, Mr. Kersting wrote a form letter to the

participants of his programs, one of his many "Dear Friend"

letters, stating that he had been entrapped by an undercover

Internal Revenue Service special agent into creating a backdated

"tax deduction" of $21,600.8   By letter dated February 15, 1981,

Mr. Kersting provided participants in his programs with "tax

reporting notices", presumably for the 1980 tax year, and

encouraged them to "take full advantage of the deductions



     7
        The Kersting programs involved a number of corporations
(hereinafter Kersting corporations). Mr. Kersting served as both
a director and president of most of these corporations and also
sometimes owned stock. For those corporations in which he served
as president during the years in issue, he had exclusive
management authority.
     8
        The record in these cases contains no fewer than 38 "Dear
Friend" letters.
                              - 18 -


reported to you."   Mr. Kersting further informed participants

that the Internal Revenue Service had "accomplished only a

temporary disruption of our operations" and that his office was

"back to almost normal workings".   All records seized in the

January 22, 1981, search were returned to Mr. Kersting by 1987.

     In January 1983, Mr. Kersting filed suit in the U.S.

District Court for the District of Hawaii (docket No. CV-83-0018-

MP) against the United States, the Internal Revenue Service, and

certain Internal Revenue Service agents alleging, inter alia,

that the January 1981 search was illegal and that the defendants

had abused the grand jury process by shopping for a favorable

grand jury, by violating grand jury secrecy, and by using the

grand jury as a civil investigation tool.   Through a number of

unpublished orders, the District Court and the Court of Appeals

for the Ninth Circuit rejected Mr. Kersting's claims.   See

Kersting v. United States, 865 F. Supp. 669, 674-675 (D. Haw.

1994).

C.   Assessments of Kersting Promoter Penalties

     Mr. Kersting's tax shelter activities did not lead to an

indictment.   However, in October 1989, the Commissioner assessed

promoter penalties of $1,545,201 and $2,330,000 against

Mr. Kersting, pursuant to sections 6700 and 6701, respectively,

for the years 1982 through 1988.9   The District Court for the


     9
        Sec. 6700 provides for imposition of a penalty of a
percentage of the gross income derived from promoting an abusive
tax shelter, and sec. 6701 provides for imposition of a penalty
                                                   (continued...)
                               - 19 -


District of Hawaii sustained the Commissioner's assessments.    See

Kersting v. United States, Civil Nos. 90-00304, 91-00747, 92-

00593 (D. Haw., Sept. 30, 1994).   Mr. Kersting's appeal of that

decision to the Court of Appeals for the Ninth Circuit, docket

No. 94-16942, was argued and submitted on May 8, 1996, but

subsequently withdrawn from submission (with an opportunity for

supplemental briefing) until after this Court issues its opinion

in these consolidated cases.

D.   Kersting Notice of Deficiency

     The Commissioner sent Mr. Kersting a notice of deficiency

determining deficiencies in and additions to his Federal income

taxes for the taxable years 1982 through 1988.   The deficiencies

were based upon the Commissioner's determination that cash

payments of so-called leverage loan interest received by Kersting

corporations, which were characterized by the District Court in

the promoter penalty cases as "alter egos" of Mr. Kersting, and

which the Court's Dixon II opinion characterized as fees paid to

Mr. Kersting by program participants in exchange for tax

deductions, were includable in Mr. Kersting's gross income.

Mr. Kersting filed a timely petition for redetermination with

this Court (assigned docket No. 7448-96), and the case was tried

at a Honolulu special trial session that commenced January 27,

1999.



     9
      (...continued)
of $1,000 (per incident) upon a person who knowingly aids or
assists another in understating his tax liability.
                                  - 20 -


II.   Notices of Deficiency Issued to Kersting Program
      Participants

      In 1982, respondent began to issue notices of deficiency to

Kersting program participants, disallowing interest deductions

claimed with respect to the stock purchase plan, the stock

subscription plan, the leasing company plan, and the CAT-FIT plan

for a number of taxable years.

A.    Form of Notices of Deficiency

      The notices of deficiency issued by respondent to many

Kersting program participants used a common format, stating in

pertinent part as follows:

                        EXPLANATION OF ADJUSTMENTS

      1. It is determined that the following amounts claimed
      on your      income tax return as interest deductions
      are not allowable:

             Amount               Purported Payee[10]

           $---------             Any entity owned, associated
                                  with, or controlled, either
                                  directly or indirectly, by
                                  Henry Kersting

      This disallowance is based on the determination that
      the transactions giving rise to the claimed interest
      deduction are shams. This disallowance is further
      based upon your failure to establish that the above
      amounts were paid or properly accrued, or that the
      transactions purportedly generating the claimed amounts
      resulted either in any bona fide indebtedness or in any
      enforceable and bona fide obligation to pay
      compensation for use or forbearance of money on
      indebtedness within the meaning of I.R.C. Section 163.

           Furthermore, if it is established that any portion
      of the above disallowed "interest" is a properly


      10
        In some instances, respondent's notices of deficiency
listed specific Kersting corporations under "Purported Payee".
                               - 21 -


     allowable deduction, it is further determined that such
     interest constitutes interest in investment
     indebtedness and deduction of such amounts is limited
     under the provisions of I.R.C. 163(d).

          Further, and in support of a portion of the
     determined deficiency, if you establish that you are
     entitled to the above-mentioned interest deduction, it
     is determined that you improperly failed to report the
     income resulting from the same transaction.

     2. It is determined that part of the underpayment of
     tax for the taxable year ____ is due to your negligent
     of [sic] intentional disregard of the rules and
     regulations. Consequently, the 5 percent addition to
     the tax is charged for ____ as provided by Section
     6653(a) of the Internal Revenue Code.

B.   Thompson Notices of Deficiency

     John R. Thompson (Mr. Thompson) was a pilot with Continental

Airlines from 1946 until his retirement in October 1982.

Mr. Thompson became aware of Mr. Kersting's programs through a

conversation with another pilot, Michael Provan (Mr. Provan), who

had solicited other pilots to participate in Mr. Kersting's

programs.11   The Thompsons began participating in Mr. Kersting's

programs in 1977.12   In addition to their participation in


     11
        Mr. Provan, who was at one time the president of one of
the Kersting companies, eventually became an adversary of
Mr. Kersting. See infra p. 66.
     12
        Although the Thompsons participated in one of
Mr. Kersting's programs during 1977, the Thompsons did not
claim any Kersting-related interest deductions on their 1977
return because their accountant-return preparer refused to
include them on the return.

    The record suggests that the Thompsons' 1978 tax return
was prepared by Phil Scheff (an accountant recommended by
Mr. Kersting) and that the Thompsons claimed Kersting program
interest deductions on their return for that year. The Thompsons
experienced audit problems with their 1978 tax return that were
                                                   (continued...)
                                   - 22 -


certain programs that were the subject of this Court's opinion in

Dixon II, the Thompsons, along with some 40 other investors,

including Mr. Provan, participated in a transaction arranged by

Mr. Kersting in early 1978 to acquire First Savings and Loan

Association of Hawaii (First Savings).

       The Thompsons filed joint Federal income tax returns for

1979, 1980, and 1981 in which they claimed interest deductions

attributable to their participation in certain Kersting programs.

On May 5, 1983, June 13, 1984, and May 31, 1985, respondent

mailed notices of deficiency to the Thompsons determining

deficiencies in and additions to their Federal income taxes for

the taxable years 1979, 1980, and 1981, as follows:

                                    Additions to Tax
                        Sec.      Sec.       Sec.           Sec.
Year    Deficiency    6651(a)    6653(a) 6653(a)(1)      6653(a)(2)

1979 $18,161.00         ---      $908           ---         ---
1980 24,838.00          ---       ---           ---         ---
1981 36,294.52       $4,934.32    ---       $1,958.28   50 percent of
                                                        the interest due
                                                        on the deficiency

Respondent further determined that the Thompsons were liable for

increased interest for 1981 pursuant to section 6621(d).13            The


       12
      (...continued)
due, in part, to their failure to attach to the return a Form W-2
showing the amount of tax that Continental Airlines had withheld
from Mr. Thompson's wages. In early to mid-1986, the Thompsons'
counsel, Samuel M. Huestis, negotiated a settlement of their tax
liability for 1978. The record does not disclose the terms of
the settlement.
       13
        Sec. 6621(d) was redesignated sec. 6621(c) by sec.
1511(c)(1)(A)-(C) of the Tax Reform Act of 1986 (TRA), Pub. L.
99-514, 100 Stat. 2744. We will hereinafter refer to the
                                                   (continued...)
                                - 23 -


Thompsons filed timely joint petitions for redetermination of the

above-described deficiencies.

C.   Cravens Notices of Deficiency

     John R. Cravens was a pilot with American Airlines during

1979 and 1980.    Mr. Cravens became aware of Mr. Kersting's

programs through conversations with other pilots.

     The Cravenses filed joint Federal income tax returns for

1979 and 1980 in which they claimed interest deductions

attributable to their participation in certain Kersting programs.

On April 15, 1983, and March 20, 1984, respondent mailed notices

of deficiency to the Cravenses determining deficiencies in and

additions to their Federal income taxes for the taxable years

1979 and 1980, as follows:

                                  Additions to Tax
           Year    Deficiency       Sec. 6653(a)

           1979     $4,508.00            $225.40
           1980     19,251.70             962.59

The notice of deficiency issued to the Cravenses for 1979, while

disallowing interest deductions of $9,810, included a credit for

personal exemptions of $4,000, resulting in a net adjustment of

$5,810.   The notice of deficiency issued to the Cravenses for

1980 included disallowed interest deductions of $19,620 and, as

an alternative to the disallowance of such interest, the

inclusion of $18,000 in unreported dividend income from a

Kersting controlled entity known as Candace Acceptance Corp.

     13
      (...continued)
provision as sec. 6621(c).
                              - 24 -


(Candace).   The notice of deficiency issued to the Cravenses for

1980 also included the disallowance of two personal exemptions

claimed for the Cravenses' children.   The Cravenses filed timely

joint petitions for redetermination contesting the above-

described notices of deficiency.

     The Cravenses' reporting position was unique among the test

case petitioners insofar as the Cravenses had adjusted (reduced)

their tax basis in their Candace stock by the amount of a "non-

taxable distribution" from Candace in 1980.   Having reduced the

basis of their Candace stock, the Cravenses reported a capital

gain of $7,200 on their 1980 tax return after surrendering the

stock to Mr. Kersting in exchange for cancellation and return of

the note evidencing their primary loan.14

D.   Alexander Notices of Deficiency

     Denis Alexander (Mr. Alexander) is a broker and investor

who first met Mr. Kersting in Los Angeles in the early 1960's.

Mr. Alexander lent money to Mr. Kersting's subchapter S leasing

corporations in the 1970's, participated in the acquisition of

First Savings, and participated in some of the Kersting programs

at issue in Dixon II.


     14
        Although the Cravenses' reporting position was unique
insofar as they had reported a capital gain in a taxable year in
dispute before the Court, we note that test case petitioners
Robert L. and Carolyn S. DuFresne had also reported a capital
gain (albeit in a year subsequent to the years in dispute)
upon the surrender of stock in Charter Financial Corp. to
Mr. Kersting. Like the Cravenses', the DuFresnes' capital gain
was attributable to their reduction of the tax basis of their
stock as opposed to an increase in its value.
                                - 25 -


     1.      1974 and 1975

     Mr. Alexander and his wife, Freida, filed joint Federal

income tax returns for the taxable years 1974, 1975, 1976, and

1977.     Following an examination of their returns for 1974 and

1975, the Alexanders conceded certain adjustments proposed by

respondent, resulting in agreed assessments of $2,133 and $811

for 1974 and 1975, respectively.15    However, because the

Alexanders declined to agree to other proposed adjustments,

respondent, on November 29, 1979, issued a notice of deficiency

determining deficiencies of $4,891.83 and $40,760.38,

respectively, in their Federal income taxes for 1974 and 1975.

     Respondent's deficiency determinations against the

Alexanders for 1974 and 1975 were based, in part, on disallowance

of interest deductions of $2,917 and $46,500, respectively,

attributable to their participation in Kersting programs for

those taxable years.    Additional adjustments included

disallowance of an $18,500 capital loss claimed by the Alexanders

for 1974 on a sale of stock in Mendocino Financial Corp. and

respondent's determination that they had failed to report a

$59,080 capital gain for 1975 from a sale of real estate to the

Cadillac Drive Apartments partnership.




     15
        The Alexanders were represented during the audit
by their accountant, Gilbert Matsumoto (Mr. Matsumoto). Mr.
Matsumoto had served as the accountant for some of Mr. Kersting's
subchapter S leasing corporations, and Mr. Kersting had
recommended that program participants use Mr. Matsumoto, among
others, to prepare their tax returns.
                                - 26 -


     On February 28, 1980, the Alexanders filed a timely petition

with the Court, assigned docket No. 2758-80, contesting the

notice of deficiency for 1974 and 1975.

     2.    1976 and 1977

     Respondent also examined the Alexanders' joint income tax

returns for 1976 and 1977.     On April 17, 1986, respondent issued

the Alexanders a notice of deficiency determining deficiencies in

and additions to their 1976 and 1977 Federal income taxes, as

follows:

                                           Additions to Tax
           Year        Deficiency            Sec. 6653(a)

           1976            $3,596                 $180
           1977               876                   44

Respondent also determined that the Alexanders were liable for

increased interest for 1976 pursuant to section 6621(c).

     The deficiencies that respondent determined against the

Alexanders for 1976 and 1977 resulted, in part, from respondent's

disallowance of interest deductions of $8,665 and $12,993,

respectively, attributable to their participation in Kersting

programs for those years.     Respondent also disallowed a $5,149

partnership loss claimed by the Alexanders for 1976 on their

investment in the Avista Epsilon and Sarbonne partnership.

     On July 21, 1986, the Alexanders filed a petition through

Mr. Kersting's office, assigned docket No. 30413-86, contesting

the notice of deficiency for 1976 and 1977.
                               - 27 -


E.   Validity of Notices of Deficiency

     In Dixon II, the Court considered and rejected arguments by

the test case petitioners represented by Mr. Izen that the

notices of deficiency issued to them were invalid under Scar v.

Commissioner, 814 F.2d 1363 (9th Cir. 1987), revg. 81 T.C. 855

(1983).    After the evidentiary hearing in these proceedings, the

Court rejected the Scar argument advanced by Mr. Jones on behalf

of a Kersting participant who had settled his case before the

trial of the test cases in Dixon II.    See Richards v.

Commissioner, T.C. Memo. 1997-149, supplemented by T.C. Memo.

1997-299, affd. without published opinion 165 F.3d 917 (9th Cir.

1998).16

F.   Errors in Notices of Deficiency

     Although this Court rejected the argument that notices of

deficiency issued to Kersting program participants were invalid,

it is evident that some notices of deficiency issued to Kersting

program participants did contain errors.   For instance, in

Richards v. Commissioner, supra, it appears that respondent

overstated the deficiency using an excessive tax rate of 70

percent.   In addition, the petition filed in the Richards case

included an allegation that respondent disallowed interest




     16
        Although Luis C. DeCastro had negotiated the settlement
on behalf of Mr. and Mrs. Richards, he did not participate in the
filing or prosecution of Mr. Jones' motion to vacate the decision
entered in their case.
                                 - 28 -


deductions in excess of Kersting interest deductions that the

Richardses actually claimed.17

     Similarly, as observed in the Court's Dixon II opinion,

respondent's alternative determinations in the notice of

deficiency issued to the Cravenses overstated their deficiency

for 1980.    The Court ordered that the Cravenses' deficiency for

1980 be reduced to account for:     (1) The elimination of

respondent's alternative determination that the Cravenses failed

to report $18,000 in dividends paid by Candace; and (2)

respondent's failure to eliminate the capital gain of $7,200

reported by the Cravenses for 1980 on the disposition of their

Candace stock.

III. Commencement of Kersting Project

A.   Tax Shelter Projects and Test Case Procedures

     1.     Overview

     The large volume of cases generated by the Commissioner's

disallowances of deductions claimed by taxpayers participating in

large tax shelter programs during the late 1970's and early

1980's created the largest inventory of cases ever docketed in

the Tax Court.    Among the responses of the Internal Revenue

Service and the Tax Court were the development of procedures that

     17
        Test case petitioners Terry D. and Gloria K. Owens
alleged in their petition that respondent disallowed legitimate
interest deductions in their notice of deficiency. However, it
appears that the allegation was not pursued by or on behalf of
the Owenses, inasmuch as the decision entered by the Court in
their case, following the issuance of the Court's opinion in
Dixon II, was consistent with the deficiency determined by
respondent.
                                - 29 -


were intended to streamline the litigation process, economize on

the use of administrative and judicial resources, and reduce the

costs incurred by taxpayers in resolving disputes over tax

shelter adjustments.    The Internal Revenue Service, Office of

Chief Counsel, created the Tax Shelter Branch in the National

Office to oversee tax shelter litigation across the country and

to organize individual tax shelter projects.    Concurrently, the

Tax Court began working with the Internal Revenue Service and

private parties in tax shelter cases to create what became known

as the test case procedure; i.e., the selection of representative

or test cases from a particular tax shelter project for a single

trial on the merits.    See, e.g., Drobny v. Commissioner, T.C.

Memo. 1995-209 (citing H. Conf. Rept. 98-861, at 985-986 (1984),

1984-3 C.B. (Vol. 2) 1, 239-240), affd. 113 F.3d 670 (7th Cir.

1997).

     The test case procedure is intended to streamline the

litigation process.    To this end, taxpayers who are not selected

as test cases are encouraged to execute a piggyback agreement;

i.e., a stipulation to be bound by the outcome of the test cases.

As a practical matter, the effectiveness of the test case

procedure depends in large part upon the agreement of the

taxpayers not selected as test cases to be bound by the outcome

of the test cases.     Normally, taxpayers in a tax shelter project

who decline or otherwise fail to sign a piggyback agreement will

either have their cases set for trial with the test cases or,

after the trial of the test cases, will be ordered to show cause
                               - 30 -


why their case should not be decided the same way as the test

cases.    See, e.g., Krause v. Commissioner, 99 T.C. 132 (1992),

affd. sub nom. Hildebrand v. Commissioner, 28 F.3d 1024 (10th

Cir. 1994); Acierno v. Commissioner, T.C. Memo. 1997-441;

Karlsson v. Commissioner, T.C. Memo. 1997-432.    Using the order

to show cause procedure to dispose of nontest cases in a tax

shelter project is more cumbersome and consumes more time and

judicial, administrative, and private party resources than using

piggyback agreements.   As discussed in greater detail below, the

Court used the test case procedure in the Kersting project; the

vast majority of the Kersting project participants signed

piggyback agreements.   See infra pp. 34-41.

     2.    National Office Tax Shelter Branch Functions

     The Tax Shelter Branch, established by the Office of Chief

Counsel in the National Office, was given the responsibilities of

coordinating the examination, appeals, and litigation functions

and of overseeing tax shelter projects from the National Office

perspective.   The Tax Shelter Branch provided advice and prepared

material for use by the field in tax shelter cases, reviewed

legal briefs, monitored the status of tax shelter case inventory,

and prepared reports for Internal Revenue Service executives.

     The Tax Shelter Branch monitored tax shelter projects by

reviewing and extracting information from quarterly tax shelter

reports that were required to be submitted by the project

attorney; i.e., the District Counsel trial attorney with primary

responsibility for the project.   Each project attorney was
                             - 31 -


required to submit a quarterly tax shelter report providing an

update on the status of the project, including a summary of the

current project settlement offer and any recent court action

affecting the project.

     One of the goals of the tax shelter program was consistent

treatment of similarly situated taxpayers.   The Tax Shelter

Branch monitored settlement offers in similar tax shelter

projects for disparities and tried to determine whether the

project settlement offers should be similar.   However, actual

supervisory responsibility in a tax shelter project was left

primarily in the Regional Counsel and District Counsel offices

to which the project was assigned.

B.   Petitions for Redetermination

     In or around June 1982, Mr. Kersting facilitated the filing

of petitions with the Tax Court by Kersting program participants.

In letters issued in June and July 1982, Mr. Kersting informed

Kersting program participants that a joint petition was being

prepared on behalf of a large group of taxpayers.   On July 12,

1982, Lu N. Nevels, Jr., filed a consolidated Tax Court petition,

assigned docket No. 17445-82, on behalf of 60 Kersting program

participants.18


     18
        Lu N. Nevels, Jr., had represented the test case
taxpayers in Pike v. Commissioner, 78 T.C. 822 (1982), affd.
without published opinion 732 F.2d 164 (9th Cir. 1984). For an
example of the problems created by using one petition on behalf
of so many different petitioners, see Aaronson v. Commissioner,
T.C. Memo. 1985-131, involving the Hongsermeier petitioners in
what is now docket No. 29643-86. See infra p. 38.
                                - 32 -


C.   Brian J. Seery

     In early 1982, Brian J. Seery (Mr. Seery) began assisting

Kersting program participants with issues arising from the audit

of their income tax returns.    On April 14, 1982, Mr. Kersting

issued a letter to Kersting program participants informing them

that they soon would receive a letter from the Commissioner

proposing to disallow their Kersting program interest deductions.

Mr. Kersting advised program participants that they should not

remit any amount to the Internal Revenue Service until their

liability was determined in court.       On February 15, 1983, Mr.

Kersting issued a letter to Kersting program participants stating

in pertinent part:    "I trust that you have placed the tax

retrievals which we have accomplished for you over the years into

profitable investments and that you are receiving a reasonable

rate of return.    You will not lose any ground if your funds earn

at least a return equal to the interest charges imposed by the

IRS from time to time."

     On March 1, 1985, Mr. Kersting issued a letter to Kersting

program participants stating that he had retained Mr. Seery to

represent them in the Tax Court at no charge to the individual

petitioners.19    The letter requested that each Kersting program

participant provide written authorization for Mr. Seery's


     19
        Initially, Mr. Kersting or the entities that he
controlled paid the legal fees associated with the Tax Court
litigation. Later, however, some Kersting program participants
began paying $100 per month to a legal defense fund managed by
Mr. Kersting.
                                - 33 -


representation.    In a letter to program participants dated August

11, 1986, Mr. Kersting recommended that program participants not

attempt to resolve their cases on their own and instead rely on

counsel that he had hired.

     Mr. Seery subsequently entered his appearance in the Tax

Court on behalf of several hundred Kersting petitioners,

including the Thompsons and the Cravenses.    Mr. Seery's

compensation for legal services rendered to Kersting program

participants was always paid by one of the corporations

controlled by Mr. Kersting.

D.   Respondent's Counsel

     1.     Kenneth W. McWade

     In 1970, Mr. McWade began his career as a trial attorney

with the Office of Chief Counsel.    Mr. McWade's duties with the

Office of Chief Counsel included litigating tax cases.

     In January 1982, Mr. McWade transferred from respondent's

District Counsel office in Seattle, Washington, to respondent's

District Counsel office in Honolulu, Hawaii.    Mr. McWade

initially assisted with the Pike group of cases.    On or about

July 1, 1984, the Kersting project was officially established in

the Honolulu Appeals Office, and Mr. McWade was appointed to

serve as the project attorney.    Wally Kobayashi was appointed to

serve as the key Appeals officer for the Kersting project.

     By late 1986, Mr. McWade had litigated 40 to 50 Tax Court

cases.    However, Mr. McWade had never litigated any cases that

were part of a tax shelter project.
                               - 34 -


     2.     William A. Sims

     In 1972, Mr. Sims began his career with the Office of Chief

Counsel, General Litigation Division, National Office.    Except

for a 6-month assignment doing Tax Court work, Mr. Sims handled

general litigation matters concerning collection, bankruptcy, and

tax liens.    Mr. Sims eventually became Assistant Director of the

General Litigation Division in the National Office.

     In February 1986, Mr. Sims was appointed District Counsel

for Honolulu, Hawaii.    Before his appointment as District

Counsel, Mr. Sims had never worked on a tax shelter project in

any capacity.

E.   Adoption of Test Case Procedures in Kersting Project

     1.     The Honolulu Session (June 1985)

     The Court set for trial the cases of approximately 375

Kersting program participants at a Tax Court session scheduled to

commence on June 10, 1985, in Honolulu, Hawaii (the June 1985

session).

     Before the June 1985 session, Mr. McWade and Mr. Seery

agreed to use the test case procedure in the Kersting project.

During the June 1985 session, Mr. McWade and Mr. Seery discussed

the use of the test case procedure with Judge Goffe during a

chambers conference.    During the conference, Mr. Seery informed

Judge Goffe that, although he was representing petitioners who

were Kersting program participants, he was being paid by Mr.

Kersting.    Judge Goffe indicated that he saw no conflict of

interest as long as Mr. Seery had not participated in the
                                 - 35 -


planning or promotion of the Kersting programs.   See Rule

24(f).20

     Consistent with counsels' agreement to use the test case

procedure in the Kersting project, Judge Goffe granted the

parties' joint motions to continue the cases called at the June

1985 session.   At the same time, the parties began filing

piggyback agreements (discussed in greater detail below), which

they did in the vast majority of the Kersting project cases.

     Mr. Seery reported the results of the June 1985 proceedings

to Mr. Kersting and kept him abreast of developments.   Mr. Seery

relied upon Mr. Kersting to distribute correspondence from

Mr. Seery to petitioners in the Kersting project.

     2.    Test Case Procedure

     Mr. McWade and Mr. Seery agreed to select test cases that

would be representative of all the Kersting programs for all

years in dispute, including the taxable years 1975 through 1983.

At the time that Mr. Seery selected his test cases, he assumed

that the test case petitioners would bear the burden of proof at

trial.

     In selecting test cases, Mr. Seery was not concerned with

whether a case involved other tax issues.   Mr. Seery was simply

looking for cases "where someone did everything right."




     20
        Rule 24(f), which became effective on July 1, 1990, see
93 T.C. 857, addresses conflicts of interest in Tax Court
litigation. Rule 24(f) was redesignated Rule 24(g) effective
Aug. 1, 1998. See 109 T.C. 542.
                               - 36 -


Mr. Seery selected two or three test cases, including the

Cravenses and the Hongsermeiers.

     In an effort to find the best cases for trial from

petitioners' point of view, Mr. Seery selected test cases by

reference to the manner in which the taxpayers had reported the

transactions.   Mr. Seery selected test cases that he thought he

could win, but, as he testified at the evidentiary hearing, he

had difficulty identifying such cases in addition to the

Cravenses and the Hongsermeiers.21

     Mr. Kersting and Mr. Cravens discussed having Mr. Cravens'

case serve as a test case.    Mr. Kersting told Mr. Cravens that

Mr. Seery wanted to use him as a test case because, unlike other

Kersting program participants, the Cravenses had reported a

capital gain when they surrendered their stock in the Kersting

holding company in conjunction with the annual termination of the

Kersting program.   The Cravenses' reporting position was

consistent with Mr. Kersting's advice to program participants

that distributions by Kersting holding companies used by program

participants to pay the principal amount of leverage loans were

tax-free returns of capital rather than taxable dividends.

Mr. Seery viewed the Cravens cases as "unique" in this respect.

     Mr. Cravens believed that he had a choice whether his case

would serve as a test case.    When Mr. Cravens agreed to have his


     21
        Mr. Seery's testimony: "I was having trouble selecting
cases beyond those two that I thought would be good vehicles for
that."
                              - 37 -


case serve as a test case, he did so without condition.    He

believed that he would win his case because he had correctly

reported his tax liabilities, as reduced by reason of his

participation in the Kersting programs.

     Mr. Seery selected the Hongsermeier case because it was his

impression that the Hongsermeiers had used their own funds to pay

the principal of a Kersting leverage loan, rather than using a

"nontaxable distribution" from a Kersting holding company.22

Mr. Seery also selected the Hongsermeiers because they had

participated in the CAT-FIT program, which Mr. Seery viewed as

the strongest Kersting program from the standpoint of sustaining

the interest deductions claimed.

     Mr. McWade analyzed between 400 and 500 project cases; he

selected test cases that he thought would be representative of

all Kersting programs for all years in dispute.   Mr. McWade

selected "clean" cases; i.e., cases that did not include issues

other than Kersting interest deductions.   Mr. McWade tried to

avoid cases that were unique or atypical of the Kersting

programs.   Although Mr. McWade selected at least five of the test

cases, he could not recall the specific cases that he selected.

     In June 1986, Mr. McWade and Mr. Seery agreed on the dockets

that were to serve as the test cases.   By letter dated June 10,

     22
        Mr. Seery's impression was not quite right. The Court
found in Dixon II that the Hongsermeiers were unique insofar as
they paid $250 per month out-of-pocket (rather than use the
proceeds from a leverage loan) to satisfy the interest due on
a CAT-FIT primary loan. See Dixon II, 62 T.C.M. (CCH) at 1480,
1991 T.C.M. (RIA), at 91-3023.
                              - 38 -


1986, Mr. McWade notified Judge Goffe that he and Mr. Seery had

selected the following 14 dockets to serve as test cases with

respect to the Kersting project:

            Case Name                    Docket No.

     Dixon v. Commissioner                  9382-83
     Cravens v. Commissioner               16900-83
     Rina v. Commissioner                  17640-83
     Thompson v. Commissioner              19321-83
     Young v. Commissioner                  4201-84
     Cravens v. Commissioner               15135-84
     DuFresne v. Commissioner              15907-84
     Thompson v. Commissioner              31236-84
     Owens v. Commissioner                 40159-84
     Young v. Commissioner                 22783-85
     Young v. Commissioner                 30010-85
     Thompson v. Commissioner              30965-85
     DuFresne v. Commissioner              30979-85
                                         1
     Hongsermeier v. Commissioner          29643-86
     1
       By order dated Aug. 13, 1986, the Court severed the
Hongsermeiers from docket No. 17445-82 (the Aaronson consolidated
petition filed by Mr. Nevels) and assigned them new docket No.
29643-86. See supra note 18 and accompanying text.


     With the exception of the Cravens case assigned docket No.

16900-83, and the Hongsermeier case assigned docket No. 17445-82,

each of the test case petitioners had filed pro se petitions.    By

August 1986, Mr. Seery had entered his appearance in each of the

test cases with the exception of the Young cases assigned docket

Nos. 4201-84, 22783-85, and 30010-85, the DuFresne case assigned

docket No. 30979-85, and the Thompson case assigned docket No.

30965-85.

     3.     Test Case Array

     The test case petitioners had participated in Kersting

programs during the taxable years 1975 through 1983 as follows:
                             - 39 -


Taxable Year 1975

         Program                  Petitioner(s)

         CAT-FIT                  Owens
         MAURIER LEASING1         Owens
         NORWICK 20/20            Owens

Taxable Year 1976

         Program                  Petitioner(s)

         UNIVERSAL LEASING        Owens
         FORBES 30/30             Owens

Taxable Year 1977

         Program                  Petitioner(s)

         CAT-FIT                  Dixon
         ESCON LEASING            Dixon
         FARGO 30/30              Dixon
         NORWICK 20/20            Owens

Taxable Year 1978

         Program                  Petitioner(s)

         CAT-FIT                  Hongsermeier
         CAT-FIT                  Dixon
         UNIVERSAL LEASING        Hongsermeier
         ESCON LEASING            Dixon
         ESCON LEASING            Hongsermeier
         MAHALO 30/30             Owens
         MAHALO 60/60             Dixon

Taxable Year 1979

         Program                  Petitioner(s)

         CAT-FIT                  Hongsermeier
         CAT-FIT                  Dixon
         UNIVERSAL LEASING        Hongsermeier
         ANSETH LEASING           Rina
         ANSETH LEASING           Young
         ESCON LEASING            Hongsermeier
         ESCON LEASING            Dixon
         ESCON LEASING            Thompson
         CANDACE 60/60            Dixon
         CANDACE 60/60            Cravens
         CANDACE 60/60            Rina
                             - 40 -


         CANDACE 60/60            Thompson
         CANDACE 60/60            Young
         CHARTER 80,000           Rina
         CHARTER 120,000          Young
         INVESTORS 80,000         Rina
         INVESTORS 120,000        Young

Taxable Year 1980

         Program                  Petitioner(s)

         CAT-FIT                  Dixon
         CAT-FIT                  DuFresne
         CAT-FIT                  Hongsermeier
         ANSETH LEASING           Hongsermeier
         ANSETH LEASING           Rina
         ANSETH LEASING           Young
         ESCON LEASING            Dixon
         ESCON LEASING            Hongsermeier
         ESCON LEASING            Thompson
         CANDACE 60/60            Cravens
         CANDACE 60/60            Rina
         DELTA 40/40              Hongsermeier
         DELTA 60/60              Cravens
         DELTA 60/60              Dixon
         DELTA 60/60              DuFresne
         DELTA 60/60              Rina
         DELTA 60/60              Thompson
         DELTA 60/60              Young
         CHARTER 40,000           Rina
         CHARTER 80,000           Rina
         CHARTER 120,000          Dixon
         CHARTER 120,000          DuFresne
         CHARTER 120,000          Thompson
         CHARTER 120,000          Young
         INVESTORS 80,000         DuFresne
         INVESTORS 80,000         Rina
         INVESTORS 80,000         Thompson
         INVESTORS 120,000        Dixon
         INVESTORS 120,000        Young

Taxable Year 1981

         Program                  Petitioner(s)

         ANSETH LEASING           Young
         ESCON LEASING            Dixon
         DELTA 60/60              Young
         CHARTER 120,000          Dixon
         CHARTER 120,000          DuFresne
         CHARTER 120,000          Young
                              - 41 -


         INVESTORS 80,000           DuFresne
         INVESTORS 120,000          Dixon
         INVESTORS 120,000          Young

Taxable Year 1982

         Program                    Petitioner(s)

         ANSETH LEASING             Young
         CHARTER 120,000            DuFresne
         CHARTER 120,000            Young
         INVESTORS 80,000           DuFresne
         INVESTORS 120,000          Young

Taxable Year 1983

         Program                    Petitioner(s)

         ANSETH LEASING             Young
         CHARTER 120,000            DuFresne
         INVESTORS 80,000           DuFresne
     1
       Maurier Leasing, a subch. S leasing program, was
considered by the Court in Pike v. Commissioner, 78 T.C. 822
(1982).

     The notice of deficiency issued to the Thompsons for the

taxable year 1981 states in pertinent part:    "Based on

examination information from the 1978, 1979, and 1980 returns,

the investment interest is generated from the interest deduction

tax shelter.   The purported payees cannot be identified from the

1981 income tax return filed by the taxpayers."     Respondent has

not been able to identify specifically the Kersting programs that

the Thompsons participated in during 1981.     However, the record

suggests that, in addition to the Kersting programs that the

Thompsons participated in during 1979 and 1980, the Thompsons

participated in the Anseth Leasing Program during 1981.

     If the Thompson and Cravens cases had been removed from the

test case array, there would have been no reduction in coverage
                                - 42 -


of the test cases.    In other words, each program in which the

Thompsons and Cravenses participated during the years in issue

was also a program before the Court in which one or more of the

other test case petitioners had participated.

IV.   The Maui Session (February 1987)

      After Messrs. Seery and McWade had selected the test cases,

they initiated settlement negotiations and began to prepare the

test cases for trial.23    Their trial preparations included work

on a proposed stipulation of facts and an attempt to take

Mr. Kersting's deposition.    During this period (June 1986 or

thereabout), Mr. Seery and Mr. Kersting's attorney, L.T. Bradt

(Mr. Bradt), discussed using the 1981 search of Mr. Kersting's

office as a basis for filing a motion to shift the burden of

proof to respondent in the test cases.

A.    Trial Notices

      By letter dated July 30, 1986, Judge Goffe informed

Messrs. Seery and McWade that the test cases would be set for

trial during a special session of the Court commencing on

February 9, 1987, in Wailuku, Maui, Hawaii (the Maui session).

Judge Goffe's letter also informed Messrs. Seery and McWade that

he intended to notify each Kersting petitioner who had not filed

a piggyback agreement that his or her case would be set for trial

during the Maui session.




      23
        Settlement negotiations between Mr. McWade and Mr. Seery
are discussed in greater detail infra pp. 78-80.
                             - 43 -


     In August 1986, the Court issued orders setting the 14 test

cases for trial during the Maui session.   By letter dated

August 5, 1986, Judge Goffe informed all Kersting petitioners who

had not already executed piggyback agreements that their cases

would be set for trial at the Maui session unless they executed

piggyback agreements by September 29, 1986.   Judge Goffe's letter

states as follows:

                                  August 5, 1986

                                                 Dkt #
     Dear _______________:

          Your case involves matters concerning promotions
     by Henry Kersting. Cases with issues identical to the
     issues in your case have been set for trial on
     February 9, 1987, at the courtroom of the Circuit Court
     for the Second Circuit in Wailuku, Maui, Hawaii.

          In order to conserve the time and expense of the
     taxpayers, the government and the Court, all of the
     cases with identical issues will be tried at one time
     unless the parties agree in advance, in writing, to be
     bound by the outcome of the cases set for trial. In
     most of the pending cases, the parties have so agreed
     to be bound.

     You should contact at your earliest convenience the
     lawyer for the government in the Kersting cases if you
     decide to agree to be bound. He is Mr. Kenneth McWade,
     PJKK Federal Building, Room 3304, Box 50089, 300 Ala
     Moana Boulevard, Honolulu, Hawaii 96850. His telephone
     number is (808) 546-7333. If, however, you do not wish
     to be bound, you should advise my office promptly, in
     writing at the above address, in order that your case
     may be set for trial on February 9, 1987. In either
     event, you must advise Mr. McWade or me by
     September 29, 1986.

          If you fail to advise Mr. McWade by September 29,
     1986, that you wish to be bound and have executed a
     stipulation to be bound by that time and if you fail to
     advise me by September 29, 1986, that you wish to have
     your case set for trial, it will automatically be set
     for trial on February 9, 1987. If your case is set for
                               - 44 -


     trial and you do not appear for trial, your case will
     likely be dismissed and you will be required to pay all
     of the income tax which the government contends you
     owe, plus interest thereon as provided by law.

                                        William A. Goffe
                                              Judge

     In November 1986, the Court issued orders notifying Kersting

petitioners who had not filed piggyback agreements that their

cases were set for trial at the Maui session.     As additional

Kersting project cases were docketed and identified, the Court

issued orders setting them for trial at the Maui session, subject

to being stricken if the parties executed a piggyback agreement.

B.   Piggyback Agreements

     As early as June 1985, Kersting program participants had

begun executing piggyback agreements (1985 piggyback

agreements),24 drafted by Messrs. McWade and Seery, that stated

as follows:

     Stipulation of Settlement for Tax Shelter Adjustments

          With   respect to all adjustments in respondent's
     notice of   deficiency relating to the Kersting interest
     deduction   tax shelter(s), the parties stipulate to the
     following   terms of settlement:

          1. The term Kersting programs refers to interest
     expense deductions or other related deductions
     associated with various programs promoted by Henry
     Kersting.

          2. The Kersting program deduction adjustments
     shall be redetermined on the same basis that the same
     program adjustments are resolved with respect to
     taxpayers trying the same program adjustments at the

     24
        Before 1987, there was no uniform format for piggyback
agreements. In 1987 or early 1988, respondent's Tax Shelter
Branch issued a standard form of piggyback agreement.
                               - 45 -


     June 10, 1985 session of the Court in Honolulu, Hawaii,
     or such session as these cases may be adjourned or
     continued to by the Court (hereinafter "TRIED CASE").

          3. All issues involving the Kersting programs
     shall be resolved as if the petitioner(s) in this case
     is the same as the taxpayers in the TRIED CASE;

          4. A decision shall be submitted in this case
     when the decision in the TRIED CASE is entered;

          5. Following entry of the decision in this case,
     petitioner(s) consents to the assessment and collection
     of the deficiencies, attributable to the adjustments
     formulated by reference to the Tax Court's opinion,
     notwithstanding the restrictions contained in I.R.C.
     § 6213(a);

          6. The petitioner(s) in this case will testify or
     provide information in any case involving the same tax
     shelter adjustments, if subpoenaed; and

          7. The petitioner(s) in this case consents to the
     disclosure of all tax returns and tax return
     information for the purpose of respondent's discovering
     or submitting evidence in any case involving the same
     Kersting shelter adjustments.

          The parties agree to this stipulation of
     settlement.

     Piggyback agreements executed by Kersting program

participants after 1985 differed from those executed in 1985.   In

particular, post-1985 piggyback agreements stated as follows:

     Stipulation of Settlement for Tax Shelter Adjustments

          With   respect to all adjustments in respondent's
     notice of   deficiency relating to the Kersting interest
     deduction   tax shelter(s), the parties stipulate to the
     following   terms of settlement:

          1. The Kersting interest deduction tax shelter
     adjustments shall be redetermined on the same basis
     that the same tax shelter adjustments are resolved with
     respect to taxpayers trying the same shelter
     adjustments at the February 9, 1987 session of the
     Court in Wailuku, Maui, Hawaii, or such session as
                        - 46 -


these cases may be adjourned or continued to by the
Court (hereinafter "TRIED CASE").

     2. All issues involving the Kersting interest
deduction tax shelter(s) shall be resolved as if the
petitioner(s) in this case is the same as the taxpayers
in the TRIED CASE;

     3. A decision shall be submitted in this case
when the decision in the TRIED CASE becomes final under
I.R.C. § 7481;

     4. Following entry of the decision in this case,
petitioner(s) consent to the assessment and collection
of the deficiencies, attributable to the adjustments
formulated by reference to the Tax Court's opinion,
notwithstanding the restrictions contained in I.R.C.
§ 6213(a);

     5. The petitioner(s) in this case will testify or
provide information in any case involving the same tax
shelter adjustments, if subpoenaed; and

     6. The petitioner(s) in this case consents to the
disclosure of all tax returns and tax return
information for the purpose of respondent's discovering
or submitting evidence in any case involving the same
shelter adjustments.

     7. If the Court determines the I.R.C. § 6621(d)
penalties are applicable in the test case controlling
petitioner's(s') case, then the petitioner(s) concedes
that I.R.C. § 6621(d) is applicable to any underpayment
of tax determined in their case(s) attributable to the
Kersting interest deduction tax shelter(s), if such
underpayment exceeds $1,000.00 in any one taxable year.

     8. With respect to adjustments in respondent's
notice of deficiency relating to additions to the tax
under I.R.C. § 6653(a), the parties agree to the
following:

          (a) Respondent concedes that the
petitioner(s) are not liable for additions to tax under
I.R.C. § 6653(a) or § 6653(a)(1) or § 6653(a)(2) for
any year prior to the taxable year 1982.

     The parties agree to this stipulation of
settlement.
                               - 47 -



In sum, whereas paragraph 4 of the 1985 piggyback agreements

states that a decision will be entered in the piggyback case

following entry of decision in the test cases, paragraph 3 of the

post-1985 piggyback agreements states that a decision will be

entered in the piggyback case once the decision in the test cases

becomes final.25   See Gridley v. Commissioner, T.C. Memo. 1997-

210.    Unlike 1985 piggyback agreements, post-1985 piggyback

agreements state (at paragraph 7) that petitioners agree to be

bound to the Court's holding in the test cases respecting the

applicability of increased interest under section 6621(c) on any

underpayment of tax of more than $1,000.   Further, while 1985

piggyback agreements make no reference to additions to tax, post-

1985 piggyback agreements state (at paragraph 8) that petitioners

are not liable for additions to tax for negligence for any year

before the taxable year 1982.26



       25
        Despite this distinction, respondent did not move for
entry of decision--upon entry of decisions in the Kersting test
cases in early 1992--in any of the cases in which Kersting
petitioners had executed the 1985 version of the piggyback
agreement. Respondent has taken the position that no decisions
should be entered in any of the piggyback cases until the
decisions in the test cases become final. Cf. Abatti v.
Commissioner, 859 F.2d 115 (9th Cir. 1988), affg. 86 T.C. 1319
(1986).
       26
        Although the record does not reveal why post-1985
piggyback agreements limit respondent's concession of additions
to tax for negligence to taxable years before 1982, a plausible
explanation for selecting 1982 as the line of demarcation would
be that the Tax Court had released its opinion in Pike v.
Commissioner, 78 T.C. 822 (1982), in May 1982, putting taxpayers
on notice for 1982 and later taxable years that Mr. Kersting's
programs did not generate legitimate interest deductions.
                                   - 48 -


        When Messrs. McWade and Seery drafted the piggyback

agreements, Mr. Seery did not consider the possibility that a

test case might be settled.27

     Nontest case petitioners Ronald L. and Mattie E. Alverson

(docket No. 17646-83) executed their piggyback agreement in June

1985.        Nontest case petitioners Anthony E. and Carol A. Eggers

(docket No. 7323-84), John L. and Terry E. Huber (docket No.

20119-84), Stanley C. and Sharon A. Titcomb (docket No. 17992-

95), and Richard B. and Donna G. Rogers (docket No. 17993-95)

executed piggyback agreements in late November 1986.        Nontest

case petitioners Norman W. and Barbara L. Adair (docket No.

35608-86) executed their piggyback agreement in March 1987.

Nontest case petitioners Willis F. McComas, II and Marie D.

McComas (docket No. 19464-92), Wesley Armand and Sherry Lynn

Cacia Baughman (docket No. 621-94), Joe A. and JoAnne Rinaldi

(docket No. 7205-94), and Norman A. and Irene Cerasoli (docket

No. 9532-94) did not execute piggyback agreements for their cases

on these dockets.

C.   Mr. Seery's Withdrawals as Counsel

        During late 1986 and early 1987, and shortly before the Maui

session, Mr. Seery began to withdraw as counsel in the Kersting

cases in the circumstances described below.




        27
        A piggyback agreement that binds the piggyback case to
the outcome of the test case, whether by litigation or
settlement, is not unprecedented. See, e.g., Fisher v.
Commissioner, T.C. Memo. 1994-434.
                              - 49 -


     1.   The Thompsons

     In 1985, the Thompsons had retained Samuel M. Huestis

(Mr. Huestis) to prepare an estate plan for them.   Eventually,

the scope of Mr. Huestis' representation was extended to include

settlement of the Thompsons' 1978 tax liabilities and their

dispute with Mr. Kersting, as described infra pp. 56-67.

     One result of that dispute was Mr. Huestis' letter of

September 10, 1986, to Mr. Seery, notifying him that the

Thompsons were seeking substitute counsel and requesting the

Thompson files.   On September 15, 1986, Mr. Seery sent the

Thompson files to Mr. Huestis and informed him that the Thompsons

were test case petitioners.   Mr. Seery indicated that he was

withdrawing as the Thompsons' counsel in the Tax Court.

     On October 28, 1986, Mr. Huestis wrote to Mr. Seery to

express dissatisfaction with the sufficiency of the Thompsons'

files and to warn Mr. Seery that his earlier representation of

the Thompsons, while he was also apparently representing

Mr. Kersting, could be viewed as a conflict of interest and lead

to an action for "professional negligence".

     On October 31, 1986, Mr. Seery filed motions to withdraw as

counsel in the Thompsons' cases.28   The Court granted Mr. Seery's

motions in November 1986.




     28
        Mr. Seery had entered his appearance only in the
Thompson cases assigned docket Nos. 19321-83 and 31236-84, not
docket No. 30965-85.
                               - 50 -


     In the interim, Mr. Huestis assisted the Thompsons in

locating and interviewing Mr. DeCastro to serve as their counsel

in the Tax Court.29   On November 15, 1986, Mr. Thompson and

Mr. DeCastro's associate, Phillip Hoskins, executed a retainer

agreement under which Mr. Thompson agreed to pay Mr. DeCastro

$5,000 for his effort to negotiate a settlement of the Thompson

tax cases.    The agreement provided that the retainer fee was

limited to settlement negotiations and did not include

preparation for or representation at trial.    In early January

1987, Mr. DeCastro filed an entry of appearance in the Thompson

cases.

     2.     The Test Cases

     On November 7, 1986, Mr. Seery filed a motion to change

the place of trial of the test cases from Maui to Honolulu.

Mr. Seery asserted that a trial in Maui would be inconvenient and

a hardship to Mr. Kersting, who lived and operated a business in

Honolulu.    Mr. Seery's motion included the statement that

          4. Mr. Kersting is providing the financial
     support for the litigation of this and the related
     cases and the additional expense involved in
     transporting witnesses and staff to Wailuku as well
     as paying for accommodations for the staff while in
     Wailuku is a great financial burden to him.

On November 14, 1986, the Court issued an order denying

Mr. Seery's motion to change the place of trial.    In so doing,

     29
        Mr. Huestis had initially referred the Thompsons to a
law firm, Loeb & Loeb, in Los Angeles, California. The Loeb firm
declined to represent the Thompsons because of the short time to
prepare for the Maui session and the incompleteness of the
Thompson files.
                              - 51 -


the Court noted that the motion "implies that * * * [Mr. Seery]

represents not only petitioners but also Henry Kersting, the

promoter of the tax shelters which are the subject of this

litigation."   The Court went on to observe that, if Mr. Seery

were representing both Mr. Kersting and petitioners, the dual

representation would constitute a conflict of interest.    The

Court attached to the order copies of several authorities

concerning conflicts of interest, including Adams v.

Commissioner, 85 T.C. 359 (1985).   Mr. Seery subsequently filed

motions to withdraw as counsel in the Kersting project cases

(both test cases and nontest cases), citing concerns about a

possible conflict of interest.   The Court granted Mr. Seery's

motions.

     By letter dated December 12, 1986, Mr. Kersting informed

Kersting program participants that Judge Goffe had "inferred"

that Mr. Seery might have a conflict of interest.    Although

Mr. Kersting denied that he was represented by Mr. Seery, he

stated that he and Mr. Seery had decided that it would be prudent

for Mr. Seery to withdraw as counsel.   Mr. Kersting further

stated that substitute counsel had been retained to represent

test case and nontest case petitioners alike.

D.   Entries of Appearance by Chicoine and Hallett

     Following Mr. Seery's withdrawal, Mr. Bradt recommended that

Mr. Kersting hire Mr. Izen to serve as counsel for the test
                                - 52 -


cases.30   However, Mr. Kersting, with his son-in-law, an

attorney, Roger Moseley (Mr. Moseley), contacted Robert J.

Chicoine (Mr. Chicoine) and Darrell D. Hallett (Mr. Hallett)

(collectively Chicoine and Hallett), to determine whether they

would represent the test case petitioners at the Maui session.

     On November 22, 1986, Mr. Kersting sent Mr. Hallett a

letter describing the Kersting programs.    Shortly thereafter,

Mr. Kersting interviewed Mr. Hallett in Hawaii.    On December 9,

1986, Chicoine and Hallett reached an agreement with Mr. Kersting

to represent the test case petitioners (other than the

Thompsons).    On December 12, 1986, Mr. Kersting wrote to Kersting

program participants informing them that Mr. Seery had withdrawn

as counsel and that Chicoine and Hallett had been retained.      At

the same time, either Mr. Kersting or Chicoine and Hallett

informed the test case petitioners that they would have to

provide Chicoine and Hallett with written authorization to enter

appearances in their cases.

     Although Mr. Seery sent Chicoine and Hallett his files for

the test cases, most of the documents that Mr. Seery had intended

to use at trial remained in Mr. Kersting's possession.      By

letter dated December 19, 1986, Chicoine and Hallett reminded

Mr. Kersting that they needed all documents in the possession of

Mr. Kersting and Mr. Seery that pertained to the Kersting

programs in dispute in the Tax Court.

     30
           Mr. Bradt and Mr. Izen had been law partners from 1978
to 1981.
                              - 53 -


     By letter dated January 7, 1987, Chicoine and Hallett

outlined the conditions underlying their agreement with

Mr. Kersting to represent the test case petitioners in the Tax

Court.   Chicoine and Hallett's letter states in pertinent part:

          Our representation is conditioned upon the
     following however:

          1. We will represent only the individuals
     selected as test cases and who request us to do so. We
     are not representing or acting on behalf of any other
     taxpayers or litigants who have invested in various
     companies in which you are affiliated and who have
     stipulated to be bound by the outcome of the litigation
     or desire legal advice with respect to whether they
     should accept the Internal Revenue Service's settlement
     proposal.

          2. All parties understand and agree that under
     the circumstances, the Petitioners involved in the test
     cases who have expressly authorized us to represent
     them will be our clients and that we do not represent
     you individually, although you have agreed with those
     Petitioners that you will pay the legal fees to defer
     [sic] the costs of their defense. We will discuss the
     fee arrangement with each of the Petitioners in the
     test cases and their perception of any possible
     conflict of interest which we would require that they
     waive.

          3. It is understood that there will be no
     restrictions on the advice which we may provide to our
     clients and after review of the relevant facts and
     documents, we are free to propose such settlements as
     we may deem appropriate. We need not proceed with
     trial in any situation if which we consider our
     position to be indefensible or frivolous.

     In early January 1987, Messrs. Chicoine and Hallett filed

entries of appearance as counsel in each of the test cases other

than the Thompson and Cravens cases.

     As discussed in greater detail infra pp. 100-106, at the

time of Mr. Seery's withdrawal from the Cravens cases,
                              - 54 -


Mr. Cravens and Mr. McWade had agreed to a settlement of the

Cravens cases.   After reaching an agreement with Mr. McWade, Mr.

Cravens did not authorize Chicoine and Hallett to enter an

appearance in his cases.

E.   Evidentiary Issues

     After undertaking to represent the test case petitioners,

Chicoine and Hallett decided to challenge their deficiency

notices on the ground that the search of Mr. Kersting's office in

January 1981 had been illegal.   Chicoine and Hallett thereupon

filed motions for leave to file amendments to the petitions and

lodged the amendments with the Court.    The amendments included

arguments that the materials seized by the Internal Revenue

Service during the search of Mr. Kersting's office should be

suppressed at trial of the test cases and that the burden of

proof and burden of going forward with evidence should be shifted

to respondent.   On January 14, 1987, the Court granted Chicoine

and Hallett's motions for leave to file amendments to the

petitions and subsequently directed respondent to file answers to

the petitions as amended.

     1.   The Maui Session

     Although the test cases were originally scheduled for trial

at the Maui session, the trial was delayed by the need to use the

Maui session to receive testimony and evidence on the evidentiary

issues raised by Chicoine and Hallett.

     Mr. McWade and Henry E. O'Neill (Mr. O'Neill), another trial

attorney assigned to the Honolulu District Counsel Office,
                               - 55 -


appeared on behalf of respondent at the Maui session.

Mr. DeCastro appeared at the Maui session on behalf of the

Thompsons.    The Cravenses did not appear at the Maui session.

     Following the Maui session, the Court ordered respondent and

petitioners, by May 18 and June 17, 1987, respectively, to file

opening and reply briefs addressing the evidentiary issues raised

by Chicoine and Hallett.    On motions by the parties, the Court

extended the dates for the filing of opening and reply briefs to

June 8 and August 10, 1987, respectively.

     2.   Dixon I Opinion

     On February 11, 1988, the Court issued its Dixon I opinion

rejecting Chicoine and Hallett's evidentiary arguments.

Specifically, the Court held that petitioners had failed to

establish standing to contest the Kersting search.    Dixon v.

Commissioner, 90 T.C. 237 (1988).

     By order dated July 1, 1988, the Court set the test cases

for trial in San Diego, California, on January 9, 1989.    By order

dated October 24, 1988, the Court granted Mr. Izen's motion to

reconsider and set the test cases for trial in Honolulu, Hawaii,

on January 9, 1989.

V.   Kersting Disputes With Program Participants

     Before the trial of the test cases, Mr. Kersting had

disputes, summarized below, with the Thompsons and the

Alexanders.
                                  - 56 -


A.   The Thompsons

     1.     The Bauspar Program

     On August 13, 1979, the Thompsons purchased a condominium

unit in Wahiawa, Hawaii (the Wahiawa property), from Pacific

Universal Corp. (not a Kersting company).      On April 24, 1981, the

Thompsons entered a Kersting program known as Bauspar--not one of

the Kersting programs in dispute at the trial of the test cases--

to effect the payoff of seller-provided financing on the Wahiawa

property.    The Thompsons executed a first mortgage and promissory

note reflecting a loan from Bauspar, Inc. (Bauspar), in the

principal amount of $80,000.      The Thompsons agreed to repay the

$80,000 Bauspar loan, with interest at 7 percent per year,

through monthly payments of principal and interest of $532.24 for

a 10-year period, followed by a balloon payment of $69,182.47.31

In conjunction with the Bauspar loan, the Thompsons agreed to

purchase $80,000 worth of Bauspar stock.      The Thompsons borrowed

$80,000 to purchase the Bauspar stock from another Kersting

company, Paragon Investments, Inc. (Paragon), at an annual

interest rate of 18 percent.      The Thompsons further agreed to

participate in a "savings program" by depositing $1,200 per month

into an account with Citizen's Financial, Inc. (Citizen's

Financial), another Kersting company.

     On August 12, 1982, the Thompsons agreed to sell the Wahiawa

property to Kevin and Ada Shea for $122,500 by an "Agreement of

     31
        It appears that the Thompsons actually made monthly
payments of $535 to Bauspar.
                                - 57 -


Sale" under which the Thompsons apparently took back a purchase

money mortgage on the property.    The Thompsons continued to

participate in the Bauspar program until 1986 when the Sheas

decided to sell the Wahiawa property to a third party.

     On January 30, 1985, Mr. Kersting sent Mr. Thompson a

schedule listing the interest payments that Mr. Thompson had made

during 1984 as follows:

            Payee                            Amount

   Bauspar, Inc.                           $6,420.00
   Paragon Investments, Inc.                9,611.04
   Citizens Financial, Inc.                14,400.00

     Upon sale of the Wahiawa property by the Sheas in 1986,

Bauspar received a check in the amount of $75,511.74 in

satisfaction of the principal amount remaining due on the

Thompsons' loan from Bauspar.

     2.   Deterioration of Thompson/Kersting Relationship

     While working on the Thompsons' estate plan, Mr. Huestis

asked Mr. Kersting for an accounting of the Thompsons'

investments in Kersting programs.    By letter dated March 3, 1986,

Mr. Kersting responded by providing Mr. Huestis a summary list of

the Kersting programs that the Thompsons had participated in

during 1977, 1978, 1979, 1980, and 1981.    By letter dated

March 12, 1986, Mr. Huestis informed Mr. Kersting that the

Thompsons wished to terminate their participation in all Kersting

programs and obtain a complete accounting of their investments.

Mr. Huestis also requested that all future communications
                             - 58 -


regarding the matter be directed to Mr. Huestis rather than to

the Thompsons.

     By letter dated March 17, 1986, Mr. Kersting complained to

Mr. Huestis about his "assertive approach" and said he would

continue to communicate directly with the Thompsons.    By letter

dated March 17, 1986, Mr. Kersting wrote to Mr. Thompson,

confirmed that he would terminate Mr. Thompson's programs, and

inquired whether Mr. Thompson still had any stock certificates

issued in connection with his participation in Kersting programs.

Mr. Kersting's letter also states that Mr. Thompson would incur

tax liability for capital gains that would be realized upon the

termination of his accounts in the Kersting programs.

     On March 21, 1986, Mr. Huestis again wrote to Mr. Kersting,

stating that the Thompsons were disappointed with Mr. Kersting's

failure to respond to their requests or to assist them with the

tax problems arising from their participation in his programs.

By letter to the Thompsons dated March 25, 1986, Mr. Kersting

confirmed that he would liquidate their investments, as discussed

with Mr. Thompson in a recent telephone conversation.

Mr. Kersting requested that Mr. Thompson endorse all relevant

stock certificates and return them to Mr. Kersting so that the

proceeds from the sale of stock represented by such certificates

could be used to retire Mr. Thompson's debts to Kersting

companies.

     By letter dated March 31, 1986, Mr. Kersting wrote to

Mr. Thompson and admitted that he was having difficulty
                              - 59 -


reconciling Mr. Thompson's Bauspar account because Earl LeMond,

Mr. Kersting's son-in-law and the manager of the Bauspar program,

did not keep reliable records.   Nonetheless, Mr. Kersting

prepared an accounting of Mr. Thompson's Bauspar account

indicating that Mr. Thompson had paid $90,769.72 under the

program and had received nontaxable dividends of $27,000 and

Federal tax and State income tax savings (presumably from

interest deductions) of $36,307.79 and $9,000, respectively.

Mr. Kersting further indicated that, in light of Mr. Thompson's

apparent dissatisfaction, he would waive the normal requirement

that the Bauspar program run for a 10-year period, allow

Mr. Thompson to terminate the program prematurely, and pay

Mr. Thompson $27,000 reflecting 3 years of "equity build-up" in

the program.   On the basis of his accounting, Mr. Kersting

concluded that Mr. Thompson would realize a net gain of $8,538.07

from the Bauspar program.   Mr. Kersting advised Mr. Thompson to

check his accounting carefully, and that, if necessary, Mr.

Kersting would make adjustments in Mr. Thompson's favor to avoid

a legal dispute.

     On March 31, 1986, Mr. Kersting wrote a second letter to

Mr. Thompson stating that the Thompsons owed a total of $11,844

to Avalon Acceptance Corp., Aztec Acceptance Corp., Mahalo

Acceptance Corp., Lombard Acceptance Corp., and Candace, for

interest due on leverage notes during 1983 and 1984.

Mr. Kersting's letter states in pertinent part:
                                    - 60 -


          I will assume that you will take the position
     that you should not be paying interest on notes which
     produced deductions which you might not have used.
     While this, of course, would not go well with a bank or
     Credit Union (they would charge you interest whether
     you use the deductions or not) I am willing to make
     adjustments to your advantage. To get that underway I
     suggest that you tell us which of the deductions were
     claimed by you in 1983 and 1984.

                      *     *   *     *      *   *   *

     To keep the spirit of accommodation alive and to remove
     all elements of dissatisfaction we are quite willing to
     lean over into your direction. It has troubled me
     considerably that of all people you would be displeased
     with our services.

     On May 6, 1986, Mr. Thompson wrote to Mr. Kersting

requesting a full accounting for his participation in the Bauspar

program.   Mr. Thompson informed Mr. Kersting that the property

subject to the Bauspar mortgage had been sold.           Mr. Thompson also

said that he was reminding Mr. Kersting that, upon his retirement

in 1982, he had asked to terminate his participation in the

programs for which Mr. Kersting was now seeking interest payments

for leverage loans.

     Beginning in June 1986, Mr. Thompson stopped making the

$1,200 monthly deposits to Citizens Financial as required under

the Bauspar program.      At the same time, Mr. Thompson ignored

Mr. Kersting's written requests to explain his failure to make

the deposits.   Further, on June 23, 1986, at the suggestion of

Mr. Huestis, the Thompsons retained John A. Chanin (Mr. Chanin),

an attorney practicing in Honolulu, to assist them in their

dispute with Mr. Kersting.      Mr. Chanin assigned the matter to his

associate, Keith Y. Yamada (Mr. Yamada).
                              - 61 -


     On August 1, 1986, Mr. Yamada spoke with Mr. Kersting by

telephone and requested a detailed accounting of the amounts that

the Thompsons had paid to Bauspar and Citizen's Financial, as

well as a status report on the promissory notes executed by the

Thompsons in favor of Bauspar, Signet Financial, Inc., and

Paragon.   Following the telephone call from Mr. Yamada,

Mr. Kersting called Mr. Thompson.   During this conversation,

Mr. Thompson reminded Mr. Kersting that the Wahiawa property had

been sold.   Mr. Kersting stated that he would provide Mr. Chanin

with copies of the documents relating to Mr. Thompson's

participation in the Bauspar program as soon as Mr. Thompson

provided Mr. Kersting with a written authorization to release

them.

     By letter dated August 23, 1986, Mr. Kersting notified the

Thompsons that he had turned their file over to Mr. Moseley for

collection and that he sensed that litigation was imminent.

Mr. Kersting's letter states in pertinent part:

     Since the odds, however, are in favor of imminent
     litigation I consider it to be my obligation to point
     out to you the consequences:

     The day after you have allowed your attorneys to file
     suit I will declare all notes which you have executed
     to our companies in default and begin collection
     proceedings. We will make an effort to collect from
     you not only the $11,844.00 of interest on promissory
     notes of which we have sent you billings several times
     we will also file suit to collect the principal of all
     notes which we hold. The aggregate sum is well in
     excess of $250,000.00, as you know.

     I will also ask you to return to us the $40,000.00 we
     advanced to you after the First Savings debacle. We
     will start collection proceedings on the $75,000.00
                                - 62 -


     note which you executed in favor of FEDERATED FINANCE
     COMPANY to facilitate the acquisition of your stock in
     First Savings & Loan Ass. We will ask you to pay a
     pre-payment penalty on your mortgage on the house in
     Wahiawa.

     We will NOT arrange for you a capital gain in your
     BAUSPAR HOLDINGS INC. stock which I had considered--
     even though not due you because of premature withdrawal
     from the Plan--and we will NOT render assistance in
     saving you capital gains taxes on the re-capture of
     basis in your stock holdings.

     We will   NOT provide legal assistance free of cost to
     you any   longer in US Tax Court proceedings. You will
     have to   retain your own attorney to make an appearance
     for you   on February 9/1987 in US Tax Court.

     By letter dated August 24, 1986, Mr. Kersting notified

Mr. Seery that he expected to be in litigation with the Thompsons

and directed Mr. Seery not to "render any services, at our

expense," to the Thompsons.

     By letter dated August 28, 1986, Mr. Huestis notified

Mr. Moseley that he represented the Thompsons in connection with

their Kersting transactions and the pending Tax Court litigation.

Mr. Huestis advised Mr. Moseley to direct all future

communications regarding the Thompsons to Mr. Chanin.32

     By letter dated September 5, 1986, Mr. Kersting again

notified Mr. Seery of his dispute with the Thompsons and

the likelihood of litigation.    Mr. Kersting included a copy

of Mr. Huestis' August 28, 1986, letter to Mr. Moseley.


     32
         As previously mentioned, this was around the time that
Mr. Seery began the process of withdrawing as counsel for the
Thompsons, following Mr. Huestis' notification to Mr. Seery that
the Thompsons were in the process of retaining substitute
counsel.
                               - 63 -


Mr. Kersting told Mr. Seery that he considered it "mandatory"

that the Thompsons be removed as test case petitioners.    On

September 24, 1986, Mr. Kersting again wrote to Mr. Seery,

reminding him of the need to remove the Thompsons from the list

of test cases.   During this period, Mr. Thompson began talking

with other Kersting program participants about filing a class

action lawsuit against Mr. Kersting.

     On January 1, 1987, Mr. Kersting wrote to Bill Witthorne, a

Kersting program participant, requesting help in dealing with

Mr. Thompson.    Mr. Kersting's letter states in pertinent part:

     Yet, I consider it important that someone would bring
     home to Jack the dangers of the action he has in mind.
     He has been hoodwinked by the attorneys out in
     California and I think he is blind to the
     ramifications. Can you think of anyone in California
     who is close to Jack and willing to talk to him?

That same day Mr. Kersting wrote to Benness M. Richards, another

Kersting program participant, stating in pertinent part:

     We have been unsuccessful over the last six months or
     so to convince Jack that he will be better off with the
     legal representation provided by us. Neither has
     anyone be [sic] able to bring home to him that the IRS
     does NOT make him a better deal than offered to all the
     other Petitioners.

     On March 10, 1987, Mr. DeCastro and Mr. Huestis informed

Mr. Thompson that Mr. Kersting would not return the Thompsons'

promissory notes.    Mr. DeCastro indicated that he wanted to

discuss the possible involvement of his firm in bringing legal

action against Mr. Kersting.

     On April 10, 1987, Mr. Thompson wrote a letter to other

Kersting program participants, saying that Mr. Kersting had
                               - 64 -


deceived him.   In his letter, Mr. Thompson said that he had gone

to Mr. Kersting to reduce his tax liabilities but that he now

believed the cost to him would be great because the Internal

Revenue Service was challenging Mr. Kersting's programs.

Mr. Thompson suggested that the biggest worry for Kersting

program participants was Mr. Kersting's "ultimate weapon", the

promissory notes.   Mr. Thompson enclosed a copy of a letter that

he had received from Mr. Kersting as an example of what the

others might face.33   Mr. Thompson informed the other

participants that, although Mr. Kersting had promised to cancel

all promissory notes in exchange for the surrender of the

Kersting company stock that was purchased with the proceeds of

the primary loan, Mr. Thompson had tried to surrender his

Kersting company stock but Mr. Kersting had refused to cancel

Mr. Thompson's promissory notes.   Mr. Thompson indicated that

he no longer trusted Mr. Kersting, and that he had retained

Mr. DeCastro.

     By letter dated May 5, 1987, Mr. Yamada advised Mr. Thompson

that a lawsuit against Mr. Kersting would have merit, and that a

class action lawsuit should be considered.   Around this time,

Mr. DeCastro had proposed to file suit on behalf of the Thompsons

against Mr. Kersting in Federal District Court.




     33
        Although the Court's copy of Mr. Thompson's Apr. 10,
1987, letter does not include a copy of a letter from
Mr. Kersting, we assume that Mr. Thompson circulated
Mr. Kersting's letter of Aug. 23, 1986.
                              - 65 -


     On May 26, 1987, Mr. Huestis called Mr. DeCastro and learned

that, after Mr. Kersting had obtained a copy of Mr. Thompson's

April 10, 1987 letter, Mr. Moseley had written to Mr. DeCastro

on behalf of Mr. Kersting and proposed a settlement of the

Kersting/Thompson dispute.   During a later meeting that day with

Mr. Thompson, Mr. Huestis agreed to contact another lawyer in

Honolulu, Charles R. Kozak (Mr. Kozak), to discuss whether

Mr. Kozak might represent the Thompsons in a lawsuit against

Mr. Kersting.

     On May 27, 1987, Mr. Huestis contacted Mr. Kozak on behalf

of the Thompsons.   Mr. Kozak informed Mr. Huestis that he had

represented two other Kersting participants (David L. Bigelow34




     34
         David L. Bigelow and Patricia L. Bigelow had
participated in the CAT-FIT program during the taxable years
1975 and 1976. In Bigelow v. Commissioner, T.C. Summary 1983-6
(docket No. 3147-78S), the Court held that the Bigelows were
entitled to interest deductions that they had claimed under the
CAT-FIT program, partly on the basis of evidence that the
Bigelows had successfully sued a related Kersting finance company
in State court. Because the Bigelows' case was tried under the
small tax case procedure, the case was not subject to appeal and
is not treated as precedent for any other case. See sec.
7463(b).

     Mr. Kozak had represented Mr. Bigelow in a lawsuit against
Mr. Kersting for payment of the "equity build-up" in a mortgage
funding program (presumably Bauspar) following Mr. Bigelow's
termination of the program. Mr. Bigelow won the suit and
collected damages. According to Mr. Kozak, Mr. Bigelow had
prevailed by virtue of Mr. Kersting's promise not to enforce
notes that Mr. Bigelow had signed in connection with his
participation in other Kersting programs. Mr. Bigelow used
Mr. Kersting's written promise that he would not enforce
promissory notes to prevent Mr. Kersting from asserting the
principal on the notes as a defense or offset to Mr. Bigelow's
claim to the equity buildup in the mortgage funding program.
                               - 66 -


and Michael Provan35) and that he knew the Kersting programs and

how to locate Mr. Kersting's assets.36   On June 2, 1987,

Mr. Huestis agreed to send a copy of the Thompson file to

Mr. Kozak.   On the same date, Mr. Huestis notified Mr. Yamada

that the Thompsons did not plan to retain the Chanin firm to

bring suit against Mr. Kersting.

     Messrs. Bigelow, Provan, and Thompson all asked Mr. Kozak to

investigate the filing of a lawsuit against Mr. Kersting.    On

August 6, 1987, Mr. Kozak wrote to Mr. Thompson and suggested

that there was a good chance of obtaining a large judgment

against Mr. Kersting through a class action lawsuit, but that

collection of any such judgment would be uncertain.   In addition,

Mr. Kozak's letter states in pertinent part:

          As you know, Kersting is now embroiled with the
     IRS on behalf of his clients. I recently had a
     conference with Ken McWade, local counsel for the IRS.
     He tells me the trial of these cases will be no sooner
     than late Spring 1988. I suspect 12-18 months is a
     more realistic date. Also McWade stated he is 100%
     sure Kersting will be unable to show any "purposive"
     function of his corporations other than to avoid taxes.
     Several witnesses including yourself are available to
     McWade to prove Kersting never had any intention of
     enforcing the notes he had his clients execute. Also,
     I am suspicious that Kersting's representation that his

     35
        Mr. Kozak had represented Mr. Provan when he had been
sued as a director of First Savings. The representation ended
with a settlement with the company that provided First Savings'
officers and directors liability insurance. Mr. Kozak did not
represent Mr. Provan in any tax controversies with the Internal
Revenue Service related to the Kersting programs.
     36
        As discussed in   greater detail, infra pp. 115-116,
Mr. Kozak and his wife,   Susan K. Kozak, had participated in one
or more of the Kersting   programs that were the subject of this
Court's opinion in Pike   v. Commissioner, 78 T.C. 822 (1982).
                             - 67 -


     companies are making loans, leasing cars and factoring
     accounts in any meaningful business sense is without
     any merit.

          Further, I believe we will find that Kersting did
     not do many of the "house keeping" accounting and legal
     matters which needed to be done to qualify his schemes
     before the IRS, even if there was an arguable business
     purpose position for his schemes under the tax code.

          In my estimation, those clients of Kersting who
     continue to be represented by Kersting's lawyers are
     headed towards a nightmare. Interest continues to
     mount on the taxes due. By the time the pilots finally
     get a decision from the tax court, they will be in
     terrible financial condition. Of course, they will
     still have to pay the tax since bankruptcy will not
     terminate their tax liability.

          Those who are smart enough should disassociate
     themselves from Kersting's lawyers now, obtain their
     own counsel, offer their testimony as part of their
     negotiations with the IRS and buy out as cheap as they
     can now!

     There is no evidence in the record that the Thompsons have

ever filed a lawsuit against Mr. Kersting or that Mr. Kersting

has ever filed a lawsuit against the Thompsons.    There is no

documentation in the record to support Mr. Thompson's statement

to Mr. Kersting in 1986 that in 1982 he had asked Mr. Kersting to

terminate Mr. Thompson's participation in the Kersting programs.

B.   The Alexander Dispute

     As previously mentioned, Mr. Alexander first met

Mr. Kersting in Los Angeles in the early 1960's.    In the mid-

1970's, Mr. Alexander lent over $100,000 to Mr. Kersting to

assist him in the acquisition of Cosmopolitan Financial Corp.

Mr. Alexander's creditor's interest in Cosmopolitan evolved into

a stock interest in Charter Financial.   Mr. Alexander also lent
                               - 68 -


$80,000 to Mr. Kersting's subchapter S leasing corporations in

the 1970's.

     In 1977, Mr. Alexander, a minority shareholder of First

Savings, met with Mr. Kersting to discuss the possible

acquisition of the company.   Mr. Alexander participated in the

acquisition of First Savings and added to his First Savings stock

holdings in the process.    Mr. Alexander participated in certain

Kersting programs at issue in Dixon II during the taxable years

1974 through 1977.

     In 1980, Mr. Alexander brought suit against Mr. Kersting

in Hawaii State court seeking the repayment or return of

approximately $450,000 that Mr. Alexander claimed he had lent to

or invested with Mr. Kersting.   Mr. Kozak initially represented

Mr. Alexander in this litigation.   Mr. Kersting and/or his

companies eventually filed counterclaims in excess of $4 million

against Mr. Alexander.   Mr. Moseley represented Mr. Kersting in

the Alexander litigation.

     In March 1982, Mr. Alexander received a telephone call from

Internal Revenue Service Special Agents George Scott and Mike

Duncan, who were interested in questioning Mr. Alexander

regarding Mr. Kersting's various programs.   The record does not

reflect whether Mr. Alexander ever agreed to be questioned by the

agents.

     The Alexander/Kersting litigation eventually was submitted

to arbitration during a week-long proceeding in July 1987.

During the arbitration proceeding, Mr. Kersting discovered that
                               - 69 -


Messrs. Alexander, Kozak, and Matsumoto had contacted Mr. McWade

to discuss whether the Government would pay a finder's fee

for information pertaining to Mr. Kersting's programs.

Mr. Alexander's discussions with Mr. McWade on the subject of

a finder's fee are discussed in greater detail, infra pp. 106-

115.

       In a letter dated July 24, 1987, Mr. Kersting brought his

dispute with Alexander to the attention of Chicoine and Hallett,

stating as follows:

       Dear Darrell:

       I have spent the better part of this week in
       arbitration hearings concerning a case whereby we are
       attempting to accomplish an offset of debt owed us by a
       Mr. Denis Alexander against certain obligations we have
       to him. The matter has been going on for more than six
       years and has become sheer agony.

       During the course of the proceedings, however, certain
       matters came to the surface which will become apparent
       to you as you will read the enclosed material. The
       material will disclose a conspiracy between McWade,
       DEnis [sic] Alexander, an accountant by the name of
       Gilbert Matsumoto and an attorney by the name of
       Charles Kozak.

       Here are some short facts to illuminate the case:

       DEnis [sic] Alexander was a long-time friend going back
       more than 25 years, until we locked horns over the debt
       referred to above.

       Gilbert Matsumoto is an accountant who was for years
       the tax preparer for our Finance Company in Aiea,
       Federated Finance Company, and for about 10 to 14 of
       our clients which we had referred to him. He had given
       me an opinion with respect to the viability of the
       SubChapter S concept which we employed in the mid-70s
       for our Leasing Companies. He, in fact, did the filing
       of SubChapter S qualification forms for us with the IRS
       in Fresno, Calif. and did some of the Tax Returns. I
                              - 70 -


     adapted the SubChapter S principles on the strength of
     his advise [sic].

     Charles Kozak is an attorney here in town who was at
     one time a shareholder in one of our SubChapter S
     Leasing Companies and also a participant in other
     programs. He did some legal work for us in the mid-70s
     in chasing a dead-beat by the name of Feliciano and he
     obtained judgement for us. He became an adversary
     after he had made no lease payments on a car which we
     had leased to him which compelled us to repossess the
     car. He was delinquent by more than one year. He has
     stirret [sic] up trouble for me ever since.

     These three characters now conspired with McWade to
     initiate criminal proceedings again against me and, as
     you will read, already discussed among themselves how
     to divide the "finders fee" (more precisely the Judas
     ducats) which they expected to receive from IRS. As we
     took Alexanders [sic] testimony this week it became
     apparent to Kozak that he had acted unethically and he
     read a statement into the records that "he had advised
     his client (Alexander) not to engage in reporting me to
     the IRS in order to extract from me a settlement of his
     claims" which, of course, is self-defeating since he
     was an active participant in the scheme.

     I have reason to believe that all of this led nowhere.
     If even entrapment and subsequent raid on our premises
     did not yield the evidence for the CID characters to
     take me out of circulation the Kozak / Alexander /
     Matsumoto / McWade conspiracy had no prospect of
     success. More than a year has gone by since these rats
     tried to make money by setting me up for execution.

     I will assume that this incident will become a piece
     of the mosaic which should be made known to the US Tax
     Court Judge in support of my contention that IRS and
     it's [sic] representatives have conspired to ruin my
     business and inflict harm on me personally, one way or
     another.

     Following the arbitration hearing, Mr. Moseley filed a

complaint with the Supreme Court of the State of Hawaii, Office

of Disciplinary Counsel (HODC), accusing Mr. Kozak of conflict of

interest and of attempting to extort money from Mr. Kersting in a

civil suit.   On March 17, 1988, Mr. Kozak submitted a written
                              - 71 -


response to the HODC in response to Mr. Moseley's complaint.

Mr. Kozak alleged that he had been offered inducements by the

Internal Revenue Service in exchange for his cooperation in an

Internal Revenue Service investigation of Mr. Kersting,

suggested that HODC should contact Mr. McWade, denied that he

used the threat of Internal Revenue Service litigation against

Mr. Kersting, and denied any conflict of interest.   On April 12,

1988, Mr. Kozak wrote another letter to HODC stating that the

Internal Revenue Service had agreed to pay Mr. Kozak and

Mr. Alexander for their cooperation in an Internal Revenue

Service investigation of Mr. Kersting.   At the evidentiary

hearing in this proceeding, Mr. Kozak testified that his

statements to HODC that the Internal Revenue Service had agreed

to pay him for cooperation in an investigation of Mr. Kersting

were false.

     On July 12, 1988, the arbitrator released his Arbitration

Decision and Award denying all claims and counterclaims between

Messrs. Alexander and Kersting.37   The arbitrator's decision

     37
        Following the issuance of the arbitration decision, the
Alexanders claimed a net operating loss (NOL) on their 1988 tax
return in the amount of $321,000 identified as amounts "expended
for the purpose of starting new businesses deemed to be
unretrievable by the American Arbitration Association". The
Alexanders later claimed an NOL in the amount of $360,260 on
their 1990 tax return and an NOL carryforward of $201,955 and a
loss "due to fraud" in the amount of $129,000 on their 1991 tax
return. The Alexanders' 1991 tax return included the following
statement:

     The loss was $450,000. $321,000 was claimed on the
     1988 returns. $129,000 was not claimed because
                                                  (continued...)
                             - 72 -


turned largely on the lack of credibility of both parties.

     The record does not reflect the outcome of Mr. Kersting's

complaint filed with HODC against Mr. Kozak.

C.   Collection Actions

     In Dixon II, the Court described Mr. Kersting's 1980 dunning

letter to more than 30 program participants and several lawsuits

brought during the period 1983-86 in the names of Kersting

corporations against Kersting program participants to collect

amounts purportedly due on promissory notes.   See Dixon II, 62

T.C.M. (CCH) at 1466-1467, 1505-1506, 1991 T.C.M. (RIA), at 91-

3007 to 91-3008, 91-3048 to 91-3050.   Summarized below are the

Court's findings and conclusions in Dixon II regarding the

collection lawsuits.

     1.   Steve Hane

     In 1983, a Kersting company, Atlas Funding, commenced an

action on a $30,000 renewal primary note for a stock subscription

plan against Kersting program participant Steve Hane.   The Court

noted that the Hane litigation was the only example in the record

     37
      (...continued)
     recovery was expected in the future. In 1991 the
     assets on which the recovery was anticipated
     disappeared because the corporation was absorbed and
     ceased to exist.

     Upon examination of the Alexanders' returns for 1990 and
1991, the Commissioner disallowed the claimed NOL's and fraud
loss. After the Alexanders agreed to these adjustments, the
Commissioner issued a notice of deficiency to the Alexanders
determining accuracy-related penalties attributable in part to
the disallowed losses. In Alexander v. Commissioner, T.C.
Summary 1997-80 (docket No. 8948-95S), the Court sustained the
Commissioner's determinations.
                                - 73 -


of litigation on a primary note.    The Court concluded that the

evidence of the Hane litigation was inconsequential because of

the lack of any testimony about the matter and the fact that

Atlas Funding dismissed the action voluntarily after obtaining a

default judgment.

     2.   Carl Mott, George Vermef, and Robert Peterson

     In Dixon II, the Court found that Kersting corporations

pursued collection lawsuits in 1985-86 on leverage loans against

Kersting program participants Carl Mott, George Vermef, and

Robert Peterson.    The Court noted that while Carl Mott had been

sued only for interest on leverage loans, Messrs. Vermef and

Peterson had been sued for both interest and principal on

leverage loans.     The Court found that there was no explanation in

the record how Messrs. Vermef and Peterson could have owed

principal on leverage loans that would be consistent with the way

the Kersting programs were intended to operate nor with the way

that they apparently actually operated.    Further, the Court found

that the judgments entered against Mr. Vermef were vacated after

the parties agreed to settle the cases and that a default

judgment entered against Mr. Peterson later was set aside on

Mr. Peterson's motion.    The Court summarized its conclusions

regarding collection activities and litigation as follows:

          Five Kersting corporations commenced actions
     against Carl Mott based upon a year of unpaid interest
     on 15 leverage notes, but the principal amounts of the
     notes were not in issue. The record is replete with
     copies of checks, drawn on personal bank accounts other
     than Liberty Bank or Hawaii National Bank, that
     petitioners used to pay interest on leverage notes.
                                 - 74 -


      Respondent does not dispute that Kersting insisted on
      these interest payments, but maintains that to the
      extent they were made they must be characterized as
      fees to Kersting for providing tax deductions.
      Consequently, that Carl Mott allegedly failed to pay
      interest on leverage notes is of no significance to the
      substance of his or anybody else's leverage loans.

                     *   *   *     *      *   *   *

           As illustrated by Kersting's pay-or-else letter
      to over 30 clients on September 25, 1980, and his 1986
      correspondence with the Thompsons, his overriding
      concern was to be compensated by means of leverage loan
      interest. It was this amount that even he often
      referred to as a "fee" or a deductible "cost" of tax
      deductions. In encouraging clients by means of the
      September 25, 1980, letter to "discharge the debt to
      which you are a party," he sought only small amounts
      that could not have represented typical primary or
      leverage loans. His letters to the Thompsons indicate
      that he only threatened or pursued collection of
      principal obligations when the investor neglected or
      refused to pay leverage loan interest. This rare
      occurrence, which Kersting did not testify he either
      intended or expected, is not sufficient to transform
      any of petitioners' loans from Kersting corporations
      into genuine recourse indebtedness.

Dixon II, 62 T.C.M. (CCH) at 1505-1506, 1991 T.C.M. (RIA), at 91-

3049 to 91-3050.

VI.   Settlements

A.    Internal Revenue Service Policy

      1.   National Office Position

      After a tax shelter project is created and a project

attorney and a project Appeals officer are appointed, an official

project settlement offer is determined by the project Appeals

officer, the project attorney, and District Counsel.   The project

attorney and project Appeals officer review the strengths and

weaknesses of the particular tax shelter and evaluate the hazards
                              - 75 -


of litigation to determine an appropriate project settlement

offer.   Upon determination of the project settlement offer, the

terms of the offer are reported to the Tax Shelter Branch in the

National Office for dissemination to Internal Revenue Service

field offices (particularly the examination and appeals

functions) throughout the country to ensure that similarly

situated taxpayers are treated consistently.

     Once a tax shelter project is assigned to a particular

District Counsel office, that office has the authority to settle

any individual case in the project.    District Counsel generally

is expected to adhere to the official project settlement offer.

Nevertheless, District Counsel has the authority in special

circumstances to settle individual tax shelter project cases on a

basis different from the project settlement offer.   For example,

District Counsel could deny a project settlement offer to the

shelter promoter or a participant who had helped to market the

program.   In addition, District Counsel might eliminate an

addition to tax (such as negligence) because of the participant's

lack of education or sophistication in financial matters.

     District Counsel can alter or modify an official project

settlement offer without prior approval of the National Office.

However, District Counsel is required to notify the Tax Shelter

Branch of any change or modification to the official project

settlement offer in order to allow the Tax Shelter Branch to

disseminate the revised offer to Internal Revenue Service offices

throughout the country.
                              - 76 -


     The National Office did not maintain a policy prohibiting

the settlement of a test case.   However, the Commissioner's

practice of withdrawing project settlement offers once the

project test cases have been set for trial would serve to bar

settlements in test cases and nontest cases alike.38

     2.   Regional Counsel

     Benjamin C. Sanchez (Mr. Sanchez) served as Regional Counsel

for the Western Region during the period in question.   His view

of District Counsel's settlement authority in tax shelter cases

differed from the National Office view.   In Mr. Sanchez' view,

District Counsel had authority to settle tax shelter project

cases only on the basis of the official project settlement offer.

Mr. Sanchez believed that District Counsel was obliged to adhere

strictly to the official project settlement offer because of the

overriding need to ensure consistent treatment of tax shelter

project cases.   Although Mr. Sanchez acknowledged that District

Counsel technically had authority to settle a tax shelter project

case on a basis different from the official project settlement

offer, Mr. Sanchez believed that it would be improper to do so.

In his view, disciplinary or other adverse career consequences

might follow if District Counsel deviated from the official

project settlement offer in settling a case.




     38
        Of course, District Counsel might be reluctant to settle
a test case at a time that removal of the case from the test case
array would require delay in the trial to allow the parties to
select a replacement case.
                             - 77 -


     Mr. Sanchez expected that he would be informed by District

Counsel of settlements in tax shelter project cases that deviated

from the official project settlement offer.

B.   Official Kersting Project Settlement Offer (7-Percent
     Reduction of Deficiency or Out-of-Pocket Expenses)

     Between January 1982 and mid-1986, the terms of the official

Kersting project settlement offer were stated as follows:

          You will be allowed your actual out-of-pocket
     expenses, in essence, the interest you actually paid
     to Henry Kersting on the prepayment loan, or leverage
     loan, which amount equals approximately 7% of the
     determined deficiencies in most cases. In addition,
     if you reported capital gain income from the Kersting
     transactions, or recaptured the difference between your
     adjusted basis in the stock and your outstanding
     indebtedness, then an appropriate adjustment will be
     made to reflect this fact. In addition, if you are
     involved in a leasing plan, to the extent there are
     additional allowable I.R.C. Section 162 expenses which
     were not claimed on the return, an appropriate
     allowance will be made for settlement purposes. If
     you were involved in the Uniform Gift to Minors Act
     program, referred to as KAT-FIT (sic), to the extent
     you can establish compliance with the Clifford Trust
     rules, then an appropriate allowance for the deductions
     will be made. The government will concede the
     negligence penalties, I.R.C. Section 6653(1) and I.R.C.
     Section 6653(a)(2), as well as the I.R.C. Section
     6621(c) interest.

The 7-percent reduction of the deficiency reflected a deduction

equal to an average of the actual out-of-pocket expenses in

approximately 25 Kersting project cases.   For this purpose, the

Commissioner treated the "interest" paid on Kersting leverage

loans as the out-of-pocket expense.   From respondent's
                               - 78 -


perspective, the 7-percent settlement offer was equivalent to

allowing a deduction for a theft loss in the year of payment.39

     Under the 7-percent settlement offer, the Commissioner

would:    (1) Concede the negligence addition to tax and increased

interest imposed on tax-motivated transactions pursuant to

section 6621(c); (2) concede an annual deduction under section

162 or 212 to leasing program participants for expenses that

exceeded the out-of-pocket adjustment; (3) concede the deficiency

in full to participants in the CAT-FIT program who could provide

information on how the funds paid to the minor child were used

and establish that such use did not give rise to constructive

receipt of income by the parents; and (4) make appropriate

adjustments if the taxpayer had reported capital gains upon the

surrender of stock certificates to Mr. Kersting.   The purpose of

these concessions and adjustments was to provide similar

treatment of all Kersting program participants who wished to

settle their cases.

C.   Deviations From Official Project Settlement Offer

     1.    Modified 7-Percent Settlement Offer

     Between April and September 1986, Mr. McWade and Mr. Seery

conducted settlement negotiations that led Mr. McWade to offer a

settlement that deviated from the official project settlement


     39
        Respondent's position represented a concession insofar
as the allowance as a deduction of a theft loss of payments
induced by misrepresentation is postponed until the year of
discovery. See sec. 165(e); Bellis v. Commissioner, 61 T.C. 354,
357 (1973), affd. 540 F.2d 448 (9th Cir. 1976).
                                 - 79 -


offer in one significant respect.     Specifically, by September

1986, Mr. McWade and Mr. Seery had agreed to modify the 7-percent

settlement offer to incorporate a new feature they called the

"shelter burnout" that would apply in cases involving more than 1

taxable year.    The shelter burnout feature grew out of Mr.

Seery's contention that Mr. Kersting's programs could be viewed

as a tax deferral mechanism.40    Mr. McWade agreed with Mr. Seery,

for settlement purposes, to allow a shifting of the initial

year's deficiency to a later year as a "shelter burnout".      For

example, in a case involving 2 taxable years, the taxpayer's

liability for statutory interest under section 6601 was computed

under the modified 7-percent settlement offer by treating the

taxpayer's tax liability for the earlier of the 2 years as having

been incurred on the due date for payment of tax for the later

year.     Under this approach, the total amount of the taxpayer's

underlying tax deficiencies remained the same, but the taxpayer's

liability for interest on the deficiencies was reduced by the

amount of such interest that otherwise would have accrued on the

deficiency for the earlier year of the 2-year period.     Variations

of this approach were used in cases involving more than 2 taxable

years.     The modified 7-percent settlement offer negotiated by




     40
        In Dixon II, the Court considered and rejected the
argument that Mr. Kersting's programs resulted in mere tax
deferral. The Court arrived at this conclusion through a
detailed analysis of the Cravenses' tax returns for 1979 and
1980. See Dixon II, 62 T.C.M. (CCH) at 1483-1484, 1991 T.C.M.
(RIA), at 91-3026.
                             - 80 -


Mr. Seery and Mr. McWade provided that the Commissioner would

settle any additions to tax for fraud on a case-by-case basis.

     By letter dated September 29, 1986, Mr. Seery informed

Kersting program participants of the terms of the modified 7-

percent settlement offer and suggested that they give serious

consideration to the proposal.   Mr. McWade informed Mr. Seery

that, because the trial of the test cases had been set for

February 1987, the modified 7-percent settlement offer would be

withdrawn on December 31, 1986, and that Kersting program

participants interested in accepting the settlement should

contact Mr. McWade by November 10, 1986, in order to allow time

to complete the necessary computations before the withdrawal of

the offer.

     On October 10, 1986, Mr. Kersting issued a letter to

Kersting program participants in which he characterized the

modified 7-percent settlement offer as "grossly inadequate."

     Messrs. Sims and McWade did not notify the National Office,

Regional Counsel, or the Appeals Office that they had

incorporated the burnout feature in their offer to settle

Kersting project cases.

     2.   20-Percent Settlement Offer

     Between September and December 1986, Mr. McWade and Mr. Sims

began to offer 20-percent settlements that were based on the same

general approach as their modified 7-percent settlement offer

that included the burnout feature.    The 20-percent settlement

approach originated in late 1986 in separate negotiations between
                              - 81 -


Mr. Sims and Mr. Chicoine and between Mr. McWade and

Mr. DeCastro.   The enhanced 20-percent settlement offer reflected

the perceptions of Messrs. Sims and McWade that the evidentiary

issues raised by Chicoine and Hallett increased respondent's

risks of litigation.

     The 20-percent settlement offer was not disseminated in

writing by either Mr. Sims or Mr. McWade.   The existence of the

20-percent settlement offer became known, if at all, through a

combination of Mr. Kersting's letters to program participants

and calls that Mr. McWade received from Kersting program

participants.   Messrs. Sims and McWade did not request approval

from or otherwise inform the National Office, Regional Counsel,

or the Appeals Office before making the 20-percent settlement

offer.

     Following the February 1987 Maui session, the Honolulu

Appeals Office once again began to offer Kersting program

participants a deduction for their cash out-of-pocket expenses,

or if substantiation was not available, a reduction of the

deficiency by 7 percent, with a waiver of the additions under

section 6653(a)(1) and (2).   The Honolulu Appeals Office did not

learn that Mr. McWade had negotiated 20-percent settlement offers

until mid-1988, following issuance of the Court's opinion in

Dixon I.   At that time, the Honolulu Appeals Office determined

not to extend such offers because it saw no reason to deviate

from the official 7-percent project settlement offer.
                               - 82 -


     3.     Negotiations for 50-Percent Settlement Offer

     In January 1987, Messrs. Sims and Chicoine continued their

efforts to negotiate a settlement of the Kersting project cases.

Initially, their discussions concerned a higher percentage

settlement if Mr. Kersting would agree to quit the tax shelter

business.    They eventually abandoned their discussions to link

the settlement offer with Mr. Kersting's future conduct.

     By letter dated January 16, 1987, Mr. Chicoine notified

Mr. Kersting that he believed he had arrived at an agreement with

Mr. Sims to settle all the Kersting cases docketed in the Tax

Court by allowing 50 percent of the claimed interest deductions.

Mr. Chicoine's letter further states that Chicoine and Hallett

would agree to represent Kersting program participants desiring

to settle their cases on these terms for a flat fee of $550 per

case.

     On January 19, 1987, Mr. Kersting wrote a letter to program

participants stating that a 50-percent settlement had been

negotiated.    Mr. Kersting recommended that the 50-percent

settlement be accepted; he included with his letter a form for

program participants to use to authorize Chicoine and Hallett to

represent them for purposes of settlement.    As a result of

Mr. Kersting's letter, approximately 300 Kersting program

participants contacted Chicoine and Hallett seeking

representation.
                              - 83 -


     In the meantime, Mr. Sims consulted Barbara Leonard, Deputy

Regional Counsel for the Western Region.   She directed him to

terminate negotiations based upon a 50-percent settlement.

     Upon learning of Mr. Kersting's letter, Mr. DeCastro called

Mr. Chicoine to inquire about the terms of the purported 50-

percent settlement.   Mr. DeCastro stated that the terms of the

purported settlement were better than the terms he had

received for his clients and that he intended to attempt to

obtain the same terms for his clients.   During his conversation

with Mr. Chicoine, Mr. DeCastro threatened to "make trouble" for

Mr. Chicoine unless he referred clients residing in California to

Mr. DeCastro for further representation.   Mr. Chicoine flatly

rejected Mr. DeCastro's proposal.

     Following the release of Mr. Kersting's January 19, 1987,

letter, Mr. Sims received numerous telephone calls from Kersting

program participants and attorneys seeking to accept the 50-

percent settlement.   Following his conversation with

Mr. Chicoine, Mr. DeCastro called Mr. Sims to express concern

that Mr. Chicoine's clients might obtain more favorable

settlements than the settlements offered to Mr. DeCastro's

clients.

     By letter to Mr. Chicoine dated February 4, 1987, during the

week immediately preceding the Maui session, Mr. Sims denied that

he had agreed to a 50-percent settlement of the Kersting project

cases.   Mr. Sims' letter states in pertinent part:
                              - 84 -


          1. I have not settled any of the Kersting cases
     with you.

          2. The government has not made any new, blanket
     offer to settle these cases (other than our old 7%
     offer); nor has the government made any offer to wholly
     or partially concede any of the issues presented by
     these cases. To the extent that you may disagree with
     this statement, any such offer of concession that you
     believe has been made by me or any other government
     official is hereby withdrawn.

          3. We do not have a workable basis for settlement
     of any case or any group of cases. If you should
     attempt to represent to the Court that you have such a
     basis, either in order to obtain a continuance of the
     trials in this matter or to attempt to force the
     government into unagreed-to settlements or concessions,
     I will dispute this firmly.

Before the start of the Maui session, Judge Goffe held a chambers

conference with Messrs. Chicoine, Hallett, Sims, McWade, O'Neill,

and DeCastro.   Although Mr. Chicoine told Judge Goffe that the

parties had reached a basis of settlement, Mr. Sims denied that

there was a settlement.   Mr. Sims said that he had "pulled

the plug" on a proposed 50-percent settlement because

Mr. Kersting had interfered with the negotiations.

     4.   Revival of 20-Percent Settlement Offer

     During spring 1987, Mr. Chicoine continued to explore with

Mr. McWade the possibility of a global settlement.   By letter

dated April 13, 1987, Mr. Chicoine provided Kersting program

participants with a detailed status report addressing

developments at the Maui session as well as settlement

negotiations.   Mr. Chicoine's letter also stated that the firm's

representation of nontest case taxpayers was not intended to

extend to general representation in all matters but was limited
                               - 85 -


to the acceptance of an Internal Revenue Service settlement

offer.

     On April 16, 1987, Mr. Chicoine wrote to Mr. Kersting and

confirmed that he would be meeting Mr. McWade in Hawaii the

following week to discuss the possible settlement of six cases.

Mr. Chicoine warned Mr. Kersting not to address the subject of

the status of settlement negotiations in his letters to Kersting

program participants, inasmuch as his comments could be

detrimental to such negotiations.   On or about April 27, 1987,

Mr. Chicoine informed Mr. Kersting that he would recommend that

Kersting program participants accept a 20-percent settlement

offer.

     By letter dated May 22, 1987, Mr. Kersting provided

Mr. Hallett with information pertaining to a purported 30-percent

settlement negotiated by Mr. DeCastro on behalf of Benness M. and

Jane Richards.41   Mr. Kersting stated that he was attempting to

obtain information respecting additional settlements negotiated

by Mr. DeCastro.   Between May 1987 and February 1988,

Mr. Kersting wrote no fewer than seven letters to Chicoine and

Hallett strongly objecting to their communication of a 20-percent

settlement offer to Kersting program participants.   In his

     41
        In Richards v. Commissioner, T.C. Memo. 1997-149,
supplemented by T.C. Memo. 1997-299, affd. without published
opinion 165 F.3d 917 (9th Cir. 1998), we observed that the
settlement may have been detrimental to Mr. and Mrs. Richards
insofar as the original deficiency had been computed using an
excessive tax rate (70 percent) and may have been based in part
upon the disallowance of legitimate non-Kersting interest
deductions. See supra p. 27.
                              - 86 -


May 22, 1987 letter, Mr. Kersting objected to Chicoine and

Hallett's recommendation of a 20-percent settlement in pertinent

part as follows:

     As I have done several times now I ask you again NOT to
     communicate to anyone of my friends a prospect of a 20%
     settlement. The 50% flop has left a $40,000.00 to
     $50,000.00 scar with us. It was a lesson I will take
     with me to the other side. I trust that you have
     reconsidered by now your position in the matter and
     that you will NOT go into an adverse stance to me and
     my enterprises. I assure you that the jolt of April
     27th has not worn off yet.

     On June 10, 1987, Mr. Kersting forwarded to Mr. Chicoine a

letter that he had received from Mr. DeCastro pertaining to a

settlement that Mr. DeCastro purportedly negotiated on behalf of

Boyd S. and Jeannette F. Proctor.   By letter dated June 16, 1987,

Mr. Chicoine responded to Mr. Kersting, stating that he was

satisfied that the Proctors did not receive a settlement in

excess of 50 percent as Mr. Kersting had suggested because the

figures in question did not include the Proctors' liability for

statutory interest.   Mr. Chicoine concluded that the settlement

was in the range of a 14-percent reduction of the Proctors'

deficiency.

     On November 4, 1987, Mr. Kersting sent Mr. Hallett a letter

which states in pertinent part:

          Here I asked you about a year ago to defend my
     friends, here I had high hopes and reasonable
     expectation that you would work with us, that we would
     work on consensus and to the common benefit of my
     friends and here I find that you not only do not care
     to do that, you are actually moving into an adversary
     position. And this after I have paid you an enormous
     amount of legal fees and after I have disciplined
     myself over and over again to keep my temper as I
                              - 87 -


     observe a widening rift between the attorneys who are
     supposed to work for us and who are, instead, looking
     after their strangly [sic] perceived protection from
     liability. My interest in these proceedings and what
     I consider to be the best interest of my friends is
     arrogantly overlooked and we are, if your scheme of
     things would prevail, relegated to onlookers to a
     spectacle for which we are compelled to pay but in
     which we are not allowed to take part. It is simply
     absurd.

     On January 12, 1988, Mr. Kersting issued a letter

encouraging nontest case Kersting program participants who had

paid $550 to Chicoine and Hallett for representation in the

settlement process to "recall your funds".

     By letter dated January 20, 1988, Mr. Chicoine notified the

test case petitioners represented by his firm that Mr. McWade was

offering a 20-percent settlement.   Mr. Chicoine's letter states

in pertinent part:

     Mr. McWade has stated that you may settle your case
     along the grounds set forth above. Since you are a
     test case, however, you will not be permitted to
     withdraw if you wish to enter into the settlement
     proposed. Accordingly, we would enter into an
     agreement with Mr. McWade that regardless of the
     outcome of the trial, you would be allowed the
     settlement. Thus, if the case were lost in its
     entirety, your tax deficiency would be calculated in
     accordance with the settlement.

By letter dated January 22, 1988, Mr. Hallett informed

Mr. Kersting that Chicoine and Hallett were seeking an opinion

from an expert on legal ethics whether it would be appropriate

for the firm to accept new clients seeking to settle Kersting

project cases.   However, Mr. Hallett stated that the firm would

continue to inform its existing clients regarding the status of

settlement discussions.
                               - 88 -


     By letter dated January 29, 1988, Mr. Chicoine sent

Mr. Kersting copies of proposed stipulated decisions reflecting

settlements that Mr. Chicoine had negotiated with Mr. McWade in

three Kersting cases.42   Mr. Chicoine stated that Chicoine and

Hallett were obliged to inform all Kersting program participants

who had retained his firm that Mr. McWade was continuing to offer

settlements despite Mr. Kersting's misrepresentations in his

letters to Kersting program participants that no settlement was

being offered.

     By letter dated February 5, 1988, John A. Strait, Associate

Professor of Law at the University of Puget Sound School of Law

(Professor Strait), responded to Chicoine and Hallett's request

for an expert opinion regarding their ethical obligations as

counsel in the Kersting project.    Professor Strait advised

Chicoine and Hallett that the firm did not have an attorney/

client relationship with, or owe attorney/client duties to,

Mr. Kersting, but that Chicoine and Hallett did have an

attorney/client relationship with the test case petitioners as

well as the nontest case Kersting program participants who had

sent Chicoine and Hallett the $550 retainer and authorization

forms.    Concerning the nontest case clients, Professor Strait

concluded that Chicoine and Hallett were obliged to "evaluate

settlement proposals and to transmit to them your recommendation


     42
        Mr. Chicoine's letter identified the taxpayers as
Muller, Lipsky, and Mellows. The record does not reflect the
terms of the settlements in these cases.
                               - 89 -


with the explanation of what the options might be as to the

desirability of accepting any settlement proposal."

     On February 6, 1988, Mr. Kersting wrote to Mr. Hallett

stating in pertinent part:

     I take it from our phone conversation yesterday that
     you are intent now to trigger the melt-down on me and
     our corporations with which you have threatened me now
     for months. And if I have absorbed all this correctly,
     you will do this mainly out of concern that some of my
     friends might sue you at some time down the line if you
     do not advise them of a "settlement" which you perceive
     to be available.

     The bitter irony of all   this is that there was only a
     remote possibility that   anyone of my friends would sue
     you. If you go through    with your threat to cause a run
     on us you will have THE   CERTAINTY that there will be
     litigation. It will be    hell after this.

     On February 8, 1988, Mr. Kersting wrote a letter to Kersting

program participants warning them that Chicoine and Hallett soon

would circulate the details of a 20-percent settlement offer.

Mr. Kersting urged Kersting program participants not to hire

Chicoine and Hallett for purposes of settlement and instead to

await the Court's decision regarding the evidentiary issues

raised by Chicoine and Hallett on behalf of the test cases.

During this period, Mr. Kersting threatened to sue Chicoine and

Hallett if they reported the settlement offer.

     On February 9, 1988, Mr. Chicoine issued two letters, one

addressed to the firm's clients and one addressed to Kersting

program participants who had contacted Chicoine and Hallett

regarding representation.    These letters served as status reports

on the Tax Court case and settlement negotiations.    Mr. Chicoine
                              - 90 -


reported that Mr. McWade had offered to settle docketed Tax Court

cases in accordance with the previously described 20-percent

settlement offer, recommended that program participants seriously

consider the settlement, and suggested that those who desired to

settle on these terms should contact Chicoine and Hallett.

     On February 20, 1988, Mr. Kersting wrote to Chicoine and

Hallett stating in pertinent part:     "I hereby revoke your

appointment as counsel for the test cases".

     On February 23, 1988, Mr. Chicoine wrote to Mr. McWade

seeking a 20-percent settlement on behalf of test case

petitioners Terry D. and Gloria K. Owens.     Mr. Chicoine's letter

states in pertinent part:

     Mr. Owens understands that not all cases will settle
     and you wish to proceed to trial with some test cases.
     It is hoped that under the circumstances he may be
     withdrawn as a test case. If this is not possible,
     he still wishes to settle the case and enter into an
     agreement which will permit him to settle the case
     regardless of the outcome of the trial.

Mr. and Mrs. Owens subsequently decided that they would not

continue efforts to settle their case.

     In early March 1988, Chicoine and Hallett began receiving

requests from Kersting program participants for return of the

$550 retainer fee.   Although Chicoine and Hallett returned the

full amount of the fee to all those who requested it, they were

informed that they might be billed for a "minimal amount"

reflecting the firm's costs associated with the opening of files

and issuance of status reports.
                             - 91 -


     On March 9, 1988, Mr. Kersting issued a letter to program

participants characterizing Chicoine and Hallett as "scoundrels",

and stating that he had fired them and retained Mr. Izen to

represent the test cases (excluding the Thompsons and the

Cravenses).

     By letter dated April 22, 1988, Mr. Chicoine notified

Kersting program participants that the Court had ruled in the

Government's favor in Dixon I; he restated his support for the

20-percent settlement offer described in his February 9, 1988,

letter and revealed that, because of a disagreement with

Mr. Kersting, Chicoine and Hallett would withdraw as counsel for

the test cases.43

     Mr. Kersting later carried out his threat to sue Chicoine

and Hallett for legal malpractice.    Mr. Izen served as an expert

witness for Mr. Kersting in his lawsuit against Chicoine and

Hallett.

     By letter dated April 8, 1988, Mr. McWade notified

Mr. DeCastro that, after June 15, 1988, respondent would no

     43
        Coincidentally, on Apr. 20, 1988, Mr. DeCastro wrote a
letter to a client, James Losey, expressing similar sentiments in
favor of settlement of the Kersting cases. After outlining the
deadlines that Mr. McWade had set for the acceptance of
outstanding settlement offers, Mr. DeCastro's letter states in
pertinent part:

          There is now an urgent need for your friends and
     acquaintances to consult their legal counsel and
     seriously consider settling their case with the IRS.
     The evidence continues to build against the taxpayers
     in these cases and despite Mr. Kersting's assurances,
     we feel the trial will be won by the IRS. The result
     would be very serious for the taxpayers.
                               - 92 -


longer consider settlements, other than on the basis of allowing

out-of-pocket expenses, and that out-of-pocket settlements would

no longer be available after October 3, 1988.   By memorandum

dated October 19, 1988, the Acting Chief of the Tax Shelter

Branch notified the Assistant Commissioner for Examination (with

copies to the Director of the Appeals Office, Mr. McWade, and

several National Office executives) that, because the Kersting

test cases had been set for trial in January 1989, the

Kersting project settlement offer would be withdrawn, effective

October 28, 1988.

D.   The Thompson Settlement

     1.   Initial Thompson Settlement Agreement

     In early December 1986, Mr. McWade and Mr. DeCastro

discussed settlement of the cases of a number of Mr. DeCastro's

clients, including the Thompsons.   Mr. Sims was aware of the

McWade-DeCastro discussions when he also met with Mr. DeCastro in

December 1986 at the Honolulu District Counsel Office and

generally discussed with Mr. DeCastro settlement arrangements for

the Thompson cases.

     On December 23, 1986, Mr. McWade mailed a letter to

Mr. DeCastro enclosing proposed decision documents for the

Thompsons as well as several other taxpayers with cases before

the Court.   Mr. McWade's letter states in pertinent part:

     Dear Mr. DeCastro:

          Enclosed herewith are the Decision documents, as
     per our conference, in the above-captioned cases.
     Please sign the original and one copy of the Decision
     document, in the space provided, and return them to
                                  - 93 -


       this office for signing and filing with the Court.         The
       remaining copy is for your records.

            As previously indicated, the Decision documents in
       John R. and Maydee Thompson will not be filed with the
       Court until the Decision becomes final in the test
       cases. In the interim, the Thompsons can make an
       advance payment, as discussed at our conference, and
       stop the accrual of any additional liability for
       interest.

In response, on December 30, 1986, Mr. DeCastro executed three

separate decision documents on behalf of the Thompsons agreeing

to the following deficiencies:

            Year       Deficiency             Additions to Tax

            1979          ---                        ---
            1980        $34,425                      ---
            1981         30,000                      ---

       The December 1986 settlements that Mr. McWade extended to

Mr. DeCastro's clients differed from the 7-percent official

Kersting project settlement offer used by respondent's Appeals

Office.    In particular, the Thompson settlement included the

burnout feature and was based on a reduction of the deficiencies

that respondent had determined against the Thompsons of

approximately 19 percent as follows:

Year     Adjustment   Deficiency       Settlement          % Reduction

1979      $39,477      $18,161               ---
1980       72,840       24,838             $34,425
            Total       42,999              34,425               20%

1981    $80,782         36,295              30,000               17
  All years total       79,294              64,425               19

The adjustments for each year consisted solely of the

disallowance of deductions that the Thompsons had claimed with

respect to Kersting programs.
                                - 94 -


     On December 30, 1986, Mr. Thompson sent a letter to

Mr. McWade enclosing checks for $34,000 and $25,545 that were

intended as payments of interest on the Thompsons' tax

liabilities for the taxable years 1980 and 1981, respectively.44

     2.   First Revision of Thompson Settlement

     On January 27, 1987, Mr. Huestis sent a letter to

Mr. DeCastro stating that Mr. Thompson did not understand the

terms of his settlement.   On February 3, 1987, Mr. DeCastro

responded to Mr. Huestis as follows:

     Dear Sam:

          Thanks for your letter of January 27, 1987
     indicating questions which Jack Thompson has regarding
     the proposed settlement. I will respond in the order
     of your questions:

          1.     The only years in dispute are 1979, 1980 and
                 1981.

          2. For each year, the amounts claimed due by the
     I.R.S. by category are:

                         1979      1980      1981     Total

     Tax deficiency   $18,161    $24,838   $36,295   $79,294
     Penalty              908      1,242    19,757    21,907
     Interest          19,977     24,838    27,976    72,791
                       39,046     50,918    84,028   173,992

          3. By the terms of the proposed settlement, the
     following amounts are due to be paid by Jack:




     44
        Many Kersting program participants, like the Thompsons,
made interest payments on or immediately before Dec. 31, 1986,
in order take advantage of the full deductibility of interest
in 1986. The deductibility of payments of personal interest was
subject to phase-out for taxable years beginning after Dec. 31,
1986, pursuant to TRA sec. 511(b), 100 Stat. 2246.
                                 - 95 -


                          1979     1980      1981     Total

     Tax deficiency       0      $34,425   $30,000   $64,425
     Interest             0       35,275    24,270    59,545
                          0       69,700    54,270   123,970

          As you can see, this amounts to a substantial
     reduction in tax liabilities.

          4. Jack correctly understands that his recent
     payment of $59,545 was entirely applied to interest.

          5. The IRS is willing to settle with Jack only on
     the basis that his test case remains active. The terms
     are not contingent upon any specific testimony or
     degree of cooperation and will be filed upon completion
     of the test case. Jack need only testify, at the trial
     and is only technically a defendant. Unless some
     dramatic changes in schedule occur, there will be no
     depositions. Essentially, Jack need only testify, be
     protected from Kersting, and does not need to prepare a
     full-blown defense.

          6. As indicated, the IRS insists upon Jack
     continuing as a test case defendant for its own
     purposes. That is presently a condition of the
     settlement. In addition, we simply do not trust
     Kersting to act in accordance with his promises and
     staying in the case appears to be wise insurance to
     obtain cancellation of the notes, etc.

          7. I enclose a copy of a letter we have sent to
     Kersting's attorney regarding the notes issue for your
     information.

          8. If we are unable to obtain a cancellation of
     notes and recovery of funds invested for Jack through
     negotiation, we will certainly look to retain John
     Chanin or other local counsel for that purpose.

On February 6, 1987, Mr. Huestis reviewed Mr. DeCastro's letter

with Mr. Thompson and was satisfied that Mr. Thompson understood

the status of his case.

     On March 13, 1987, following the Maui session, Mr. McWade

sent Mr. DeCastro a revised decision for docket No. 31236-84

reducing the Thompsons' tax deficiency for 1980 from $34,425 to
                               - 96 -


$33,000.    Mr. Sims reviewed and approved Mr. McWade's letter to

Mr. DeCastro.    Although the record contains no explanation for

this revision of the Thompson settlement, the revision

effectively increased the Thompson settlement from 19 percent to

approximately 20 percent.    On April 7, 1987, Mr. DeCastro sent

Mr. Thompson a letter informing him that the Internal Revenue

Service had reduced his tax liability for 1980 by approximately

$1,000.    Mr. DeCastro also informed Mr. Thompson that this

reduction would also save him approximately $1,000 in interest.

     On June 4, 1987, the Court granted respondent's Motion to

Withdraw Stipulation of Settlement for Tax Shelter Adjustments in

the Thompson cases at docket Nos. 19321-83 and 31236-84.45

Mr. McWade filed the motions on the stated ground that, because

the Thompsons had been designated as test cases, it was

inappropriate for the Thompson piggyback agreements to remain in

effect.    Mr. McWade's motions stated that Mr. DeCastro did not

object to the granting of the motions.   Because Messrs. McWade

and DeCastro had previously agreed to settle the Thompson cases,

the above-referenced motion is the first instance in which the

Court was misled by the failure of counsel who were in the know

to disclose that the Thompson cases had been settled.


     45
        The Thompsons had not signed a piggyback agreement for
their case at docket No. 30965-85. The only other test case
petitioners who had signed piggyback agreements were the Dixons,
in their case at docket No. 9382-83, and Mr. Rina, in his case at
docket No. 17640-83. All the piggyback agreements signed by test
case petitioners had been signed in June 1985 and were in the
form of the 1985 agreement set forth supra pp. 44-45.
                              - 97 -


     On June 15, 1987, Mr. DeCastro sent a $63,000 cashier's

check "in partial payment of the total amount due" to the

Internal Revenue Service Center in Fresno, California, on behalf

of the Thompsons.   The remittance was made with respect to the

Thompsons' three docketed cases and included a request that the

matter be referred to a problems resolution officer "so that we

can determine the balance due and conclude this matter."     On

June 17, 1987, the Commissioner "transferred" $775 of the $63,000

payment to the Thompsons' account for 1988 and applied the

$62,225 balance to the Thompsons' account for 1979.46   As of June

1987, the Thompsons had paid a total of $121,770 towards their

tax liabilities (tax and interest) for the taxable years 1979,

1980, and 1981.

     On July 10, 1987, Mr. DeCastro wrote to Mr. McWade

transmitting a Notice of Overdue Tax received by the Thompsons

with respect to their 1981 income tax liability.   Mr. DeCastro

asked Mr. McWade to contact him regarding the notice and to send

him "copies of the decisions entered in this matter."   On

July 24, 1987, Mr. McWade sent Mr. DeCastro copies of proposed

decision documents for the Thompson cases.   Mr. McWade informed

Mr. DeCastro that "per our understanding, since the Thompsons are


     46
        The record does not reflect the basis for the
Commissioner's transfer of $775 of the payment to the Thompsons'
account for 1988. Because the 1988 tax year had not even started
on the date of the transfer, there can be no reasonable
explanation for the transfer; perhaps it was a typographical
error and was intended to refer to the taxable year 1978, which
Mr. Huestis had settled on the Thompsons' behalf.
                                - 98 -


involved as a test case, the documents are being held in our

files, and will be signed and filed with the Court when the test

case litigation has been completed."     The revised decision

documents prepared by Mr. McWade set forth the Thompsons' tax

liabilities as follows:

          Year        Deficiency          Additions to Tax

          1979          ---                     ---
          1980        $33,000                   ---
          1981         30,000                   ---

On August 5, 1987, Mr. DeCastro sent copies of the proposed

decision documents to the Thompsons.

     3.   Second Revision of Thompson Settlement

     Before the trial of the test cases, Mr. DeCastro informed

Mr. McWade that the Thompsons were having financial difficulties

and that he did not think that it was fair to require the

Thompsons to remain as test case petitioners.     Mr. DeCastro

expressed concern to Mr. McWade about the amount of legal fees

the Thompsons would incur as test case petitioners and informed

Mr. McWade that he would attempt to have the Thompsons removed

from the list of test cases.    Mr. McWade told Mr. DeCastro that

he did not want the Thompsons to be removed as test case

petitioners because he did not want to change the test cases so

close to trial.   Mr. DeCastro thought that Mr. McWade's desire to

retain the Thompsons on the list of test cases was caused by

administrative or technical concerns.

     Mr. DeCastro and Mr. McWade resolved their respective

concerns by further modifying the Thompson settlement.       In
                                 - 99 -


particular, Mr. McWade agreed to reduce the Thompsons'

deficiencies in an amount sufficient to compensate them for the

cost of having an attorney represent them at the trial of the

test cases.   Mr. DeCastro estimated that his legal fees for

representing the Thompsons at the trial of the test cases would

be approximately $60,000.   Under the revised settlement

agreement, the Thompsons' tax deficiencies were reduced to the

following:

       Year           Deficiency          Additions to Tax

       1979              ---                   ---
       1980            $15,000                 ---
       1981             15,000                 ---

By reason of the Thompsons' having previously remitted $121,770

to the Internal Revenue Service for the taxable years 1979, 1980,

and 1981, Mr. DeCastro and Mr. McWade calculated that the above-

described reductions of the Thompsons' deficiencies would

generate refunds of tax and interest to the Thompsons of

approximately $60,000.   Mr. DeCastro and Mr. McWade understood

that the refunds generated by the reduced deficiencies would be

used for the purpose of paying the Thompsons' attorney's fees to

Mr. DeCastro.

     Although Mr. McWade and Mr. DeCastro agreed to revise the

Thompson settlement in this manner before the trial of the test

cases, the first written confirmation of their agreement appears

after the trial, in the form of an April 10, 1989, memorandum

from Mr. McWade to Tom Stevens (Mr. Stevens), Chief of Special

Procedures in the Collection Division of the Honolulu District
                                - 100 -


Director's Office, requesting that the latter process a refund to

the Thompsons in the amount of $30,000.47

E.   The Cravens Settlement

     By letter dated September 29, 1986, Mr. Seery informed

Mr. Cravens of the terms of the modified 7-percent settlement

offer.    On October 28, 1986, Mr. McWade disseminated the modified

7-percent settlement offer by form letter mailed to all known

Kersting program participants, including the Cravenses.48

Considering the nature and purpose of the form letter, it appears

that issuance of the letter to the Cravenses, who had already

been designated test case petitioners, was inadvertent.

     On October 15, 1986, Mr. Cravens wrote to Mr. Seery asking

him to explain how the proposed settlement offer affected him and

to give him a recommendation.    By letter dated October 23, 1986,

Mr. Seery advised Mr. Cravens to consult a tax preparer or

accountant because the offer was complicated in its application

to his case.    Mr. Seery also noted that Mr. Cravens could take

advantage of the unlimited deduction for personal interest in

effect for 1986 by paying the liability in full in 1986 whether

or not he settled his case.49



     47
        The full text of Mr. McWade's memorandum is set forth
infra p. 137.
     48
        Mr. McWade's letter included a statement that the
modified 7-percent settlement offer would be withdrawn on
Dec. 31, 1986.
     49
           See supra note 44 regarding the Thompsons' interest
payment.
                               - 101 -


     On October 31, 1986, Mr. Cravens again wrote to Mr. Seery

with questions about the settlement offer.    In the letter,

Mr. Cravens informed Mr. Seery that he had paid a cash bond

against the deficiency for 1979 and felt "in good shape for that

year."    Mr. Cravens then asked whether respondent's determination

to include a dividend in his income for 1980 would be eliminated

to reduce the deficiency for that year.    If so, Mr. Cravens

indicated that he would pay the amount that would be due, "and

not take the gamble on the courts" since the amount due would be

"catastrophic" if he lost.    In closing, Mr. Cravens offered to

pay Mr. Seery for the extra effort on his case, and reminded him

that the deadline for accepting the settlement offer was drawing

near.

     As previously mentioned, Mr. Seery began to withdraw as

counsel for test case petitioners following the Court's

November 14, 1986, order indicating that Mr. Seery might have a

conflict of interest.

     Sometime after receiving Mr. McWade's October 28, 1986,

letter, Mr. Cravens contacted Mr. McWade by telephone with the

intent of settling his case.    Mr. Cravens took notes of his

conversation with Mr. McWade, which indicate that they discussed:

(1) Eliminating the dividend adjustment for 1980; (2) eliminating

all penalties for both 1979 and 1980; (3) backing out the tax

already paid with respect to the capital gains that the Cravenses

had reported for 1980; and (4) eliminating statutory interest for

1979.    Mr. McWade told Mr. Cravens that he would call him back
                             - 102 -


with figures reflecting "the amount due for the settlement."

Mr. McWade called Mr. Cravens back on December 15, 1986.

    On December 16, 1986, Mr. Cravens wrote to Mr. McWade

confirming the terms of his settlement as follows:

          Dear Ken:

          As per our telephone conversation 12/15/86, I am
     enclosing a check for $10,678.67. According to the
     amount we agreed on via telephone, the figures break
     down like this:

          Deficiency for 1979 and 1980    $9,782.16
          Less cash bond                   4,508.00
          Total                            5,274.16
          Plus 1.02474 interest            5,404.51
          Total due                       10,678.67

          I wish to thank you for being so agreeable and
     assisting me in settling this matter.

     Mr. Cravens' payment of $10,678.67 on December 16, 1986, was

processed on December 31, 1986, pursuant to a payment posting

voucher bearing Mr. McWade's initials.   The payment posting

voucher provided for the application of the funds as follows:

          Year        Advance Payment     Designated Interest

          1979           $3,000.00            $3,000.00
          1980            2,274.16             2,404.51
            Total         5,274.16             5,404.51

     Mr. Cravens believed his settlement assured that he could

neither win nor lose at the trial of the test cases.   At the time

that he entered into his settlement, Mr. Cravens was not aware

that Mr. McWade intended to allow the Cravenses the better of the

above-described settlement or the outcome based upon the Court's

opinion following the trial of the test cases.
                              - 103 -


     Although Mr. Cravens intended to accept the modified 7-

percent settlement offer, the Cravenses' settlement was less

favorable to them than the modified 7-percent settlement offer.

In particular, the Cravenses' correct tax liabilities for 1979

and 1980 were $4,508 and $5,893.45, respectively, for a total of

$10,401.45.50   Thus, the Cravens settlement in the amount of

$9,782.16 represents a reduction of approximately 6 percent of

the correct amount of the Cravenses' deficiencies.    In addition,

the Cravens settlement was not structured to include the burnout

feature.   At the time that Mr. Cravens settled his cases, Messrs.

Sims and McWade were offering 20-percent settlements with the

burnout feature to Mr. DeCastro's clients and Chicoine and

Hallett's clients.

     Mr. McWade was aware that Mr. Cravens was a test case when

he spoke to Mr. Cravens about settling his cases.    Mr. McWade

told Mr. Cravens that the Cravenses would have to continue as

test case petitioners as a condition of the settlement.

Mr. McWade did not tell Mr. Cravens to cooperate with the

Government in the trial of the test cases, or to keep his

settlement a secret.   Mr. McWade did not tell Mr. Cravens that he

had to settle so-called open years, nor did Mr. McWade examine


     50
        The $4,508 figure for 1979 is consistent with the
deficiency notice issued to the Cravenses for that year. The
$5,893.45 figure for 1980 represents the Cravenses' correct tax
liability after eliminating the dividend adjustment set forth in
the notice of deficiency for 1980 and backing out the tax on the
capital gain that the Cravenses had reported on their 1980 tax
return.
                              - 104 -


Mr. Cravens' returns for years still open under the applicable

statute of limitations to determine whether he had claimed

Kersting deductions for years not before the Tax Court.

     Mr. McWade initially told Mr. Cravens that his settlement

assured that the Cravenses could not win or lose in the trial of

the test cases.   Mr. McWade also told Mr. Cravens that, by reason

of the settlement, the Cravenses did not need an attorney.

Mr. Cravens therefore concluded that he no longer needed legal

representation.   When Mr. Cravens asked Mr. McWade why he had to

remain a test case despite his settlement, Mr. McWade responded

that to remove the Cravenses from the group of test cases would

cause a delay in the trial of the test cases while a replacement

test case was selected.

     After Mr. Seery's withdrawal from their cases, the Cravenses

did not retain new counsel.   When Mr. Kersting asked Mr. Cravens

why the Cravenses had failed to authorize Chicoine and Hallett to

represent them, Mr. Cravens informed Mr. Kersting that he had

settled his cases.

     On December 13, 1988, within 1 month before the trial of the

test cases, which began January 9, 1989, Mr. McWade forwarded to

the Cravenses proposed decision documents fixing their tax

liabilities for 1979 and 1980, to be signed and returned to

Mr. McWade.   The proposed decision documents provided as follows:
                               - 105 -


        Year             Deficiency       Additions to Tax

        1979             $3,606.40              ---
        1980              6,175.76              ---

The $3,606.40 figure for 1979 represents a 20-percent reduction

of the $4,508 deficiency that respondent determined against the

Cravenses for that year.    However, the derivation of the

$6,175.76 figure for 1980 is not known; it exceeded the correct

deficiency of $5,893.45 for 1980, including adjustments

eliminating both the capital gains that the Cravenses reported

for that year and respondent's alternative determination that the

Cravenses failed to report dividends paid to them by Candace.

The sum of the two figures ($9,782.16) is equal to the total tax

deficiency Messrs. Cravens and McWade had previously agreed

to, as shown by Mr. Cravens' letter of December 16, 1986, to

Mr. McWade.

     Mr. Sims approved Mr. McWade's decision to forward decision

documents to the Cravenses for their signature 1 month before

trial of the test cases, believing that the Cravenses had

accepted the 20-percent settlement offer.    When Mr. Cravens

testified at the trial of the test cases, Mr. Sims continued to

believe that Mr. Cravens was entitled to the 20-percent

settlement.    On December 23, 1988, the Cravenses signed the

decision documents and returned them to Mr. McWade.

     When Mr. Cravens appeared at the trial of the test cases, he

was surprised and suspicious when Mr. McWade informed him that he
                             - 106 -


would be entitled to the better of his settlement or the Tax

Court's decision in the test cases.

F.   The Alexander Understanding

     On June 3, 1986, Mr. Alexander wrote to Mr. Matsumoto,

suggesting that they might "blow the whistle" on Mr. Kersting.

Mr. Alexander's letter displays animosity and resentment against

Mr. Kersting arising out of their unresolved dispute, which had

not yet been submitted to arbitration.   Shortly after writing to

Mr. Matsumoto, Mr. Alexander listened in on a telephone

conference call between Mr. McWade and Mr. Matsumoto as confirmed

in a subsequent letter that Mr. Alexander wrote to Mr. Kozak.

Mr. Alexander's letter to Mr. Kozak, dated July 16, 1986, states:

     Dear Chuck:

     I just had a long phone conversation with Gilbert
     Matsumoto relative to blowing the whistle on you know
     who. During this long phone call Gilbert "patched" me
     in to his phone while he called McWade, the attorney
     at the IRS. I must say Gilbert's phone mechanism works
     very well, I heard every word McWade said and he did
     not know I was on the line. Gilbert instructed me not
     to say anything.

     After the conversation with McWade Gilbert agreed to
     call you and fill you in on the latest information.
     McWade will be now talking to Myron Chang, the IRS
     attorney on the Criminal Investigation side of the IRS.
     McWade also said to go ahead with the Affidavits and
     then we can discuss with himself and with Myron Chang
     what the next step will be. In the conversation with
     McWade, Gilbert also discussed the amount of "finder's
     fee" and method of payment to the person(s) supplying
     the information. It was very clear to me that the fees
     are negotiable and that they could be on the amount
     assessed or the amount collected. This is also
     negotiable and from their eagerness to get you know who
     I believe the fees could be sizeable.
                             - 107 -


     My suggestion to Gilbert was to go ahead with you and
     draft the Affidavits, at least yours and mine and we
     (you, Gilbert and me) would review the Affidavits
     before sitting down with McWade and Myron Chang. The
     conversation with McWade ended with him saying he would
     get back to Gilbert after another meeting with Chang,
     however, we should go ahead with drafting the
     Affidavits.

     Chuck, as Gilbert may have told you, this means blowing
     the whistle on 1400 of you know who's [sic] clients, 10
     or 12 of which are Gilbert's clients. As you and I
     discussed, when the Nazi knows that 1400 of his
     client's [sic] are going to be clobbered and that he
     will have the Criminal Investigation Division of the
     IRS coming down on him I think he will be inclined to
     pay me my money.

In the weeks that followed, Messrs. Alexander and Kozak prepared

draft affidavits for submission to Mr. McWade.

     On August 12, 1986, Mr. Alexander sent copies of his draft

affidavit to Messrs. Matsumoto and Kozak by overnight mail.    On

August 15, 1986, Messrs. Alexander, Matsumoto, and Kozak held a

conference call regarding the affidavits.   In a letter to Messrs.

Kozak and Matsumoto dated August 16, 1986, Mr. Alexander stated

as follows:

     Dear Chuck & Gilbert:

     Following our conference call of yesterday, August
     15th, I am submitting the following for both of your
     considerations:

     1. I suggest that we submit to the IRS AFFIDAVITS in
     DRAFT FORM ONLY.

     2. It is against my better judgment to submit executed
     and notarized affidavits without having some idea what
     the IRS will do and what they will pay.

     3. They can make their determination (s) and eat up 30
     days based on drafts or I should say final drafts. We
     can agree verbally to execute the final drafts when
                              - 108 -


     they tell us exactly what else they want and what they
     will do for us.

     4. With executed affidavits we would leave ourselves
     open to the following:

     a. They could investigate and audit all our past tax
     returns.

     b.   They could refuse immunity.

     c. They could claim Alexander was an associate/
     conspirator with Kersting.

     d. They could claim Alexander was in violation of IRS
     regulations by not turning Kersting in years ago.

     e. They could claim Alexander knew the notes were a
     "sham" tax avoidance/evasion scheme early on and under
     IRS regulations Alexander was obligated to report this
     to IRS early on.

     4. [sic] I understand that Gilbert is not expecting a
     large fee for his cooperation in this matter, however,
     I have told Gilbert that if the IRS payment to me for
     this testimony is a large amount that I will contribute
     something toward whatever amount Gilbert's 8 or 10
     clients will be forced to pay as a result of my
     testimony.

     5. What does Chuck expect for his role in this
     matter???


     On August 20, 1986, Mr. Kozak sent a letter to Mr. McWade,

enclosing draft affidavits from both himself and Mr. Alexander.

Mr. Kozak's letter states:   "We are willing to negotiate an

arrangement with the IRS, wherein we would execute the affidavits

enclosed and provide testimony consistent with the affidavits or

in clarification thereof."   The draft affidavits that Mr. Kozak

sent to Mr. McWade contained information regarding the various

Kersting programs in dispute in the test cases.   Mr. Kozak's

draft affidavit alleged that Mr. Kersting refused to pay David
                              - 109 -


Bigelow the "equity" in a mortgage funding program and that

Mr. Provan knew other airline pilots who were "shocked and angry

that Kersting would attempt to collect these notes after he had

assured them the notes would not be collectable."   Both draft

affidavits alleged that Mr. Kersting had sued Mr. Alexander for

over $500,000 on the basis of promissory notes with respect to

which Mr. Alexander "never received any money whatsoever or

anything of value in exchange for the promissory notes."     Mr.

Alexander's draft affidavit alleged that:   (1) Mr. Alexander was

in litigation with Mr. Kersting "over funds Kersting supposedly

was to invest in auto leasing and factoring at Universal Leasing

and Federal Finance & Mortgage", and that "Kersting refused to

pay the yield or return the funds"; (2) "no client of Kersting's

has ever repaid a promissory note * * * with funds other than

provided by Kersting through his closed circulation of funds from

one Kersting controlled entity to another"; and (3) Mr. Alexander

believed that Mr. Kersting's only legitimate business was the

purchase of First Savings, in which Mr. Alexander was a

shareholder.

      Mr. Alexander's affidavit reveals that Mr. Alexander

expected a "quid pro quo" for his testimony, as follows:

"9.   Affiant is ready and willing to testify to the above facts

or any others within his knowledge concerning Kersting provided

an agreement quid pro quo can be worked out through affiant's

representatives, Charles R. Kozak and Gilbert Matsumoto."
                                - 110 -


     Mr. Kozak submitted his draft affidavit to Mr. McWade in

August 1986 in an effort to have Mr. McWade eliminate the

deficiencies in Mr. Kozak's case, assigned docket No. 25812-81,

concerning the Kozaks' tax liabilities for 1973, 1974, and 1975,

arising from their participation in Pike programs.

     Messrs. Alexander, Kozak, and Matsumoto met Mr. McWade in

Hawaii in early September 1986.    During the meeting, Mr. McWade

informed Mr. Alexander that his authority was limited and that

there were a number of prerequisites to payment of an informant's

award or "finder's fee".    The prerequisites that Mr. McWade

mentioned included the submission of an affidavit, an Internal

Revenue Service investigation, and an assessment resulting from

the information provided.    The amount of an award was not

discussed during the meeting.    Mr. McWade suggested that

Mr. Alexander should see Myron Chang, head of the Internal

Revenue Service Criminal Investigation Division in Honolulu, to

determine whether the Criminal Investigation Division was

interested in Mr. Alexander's affidavit.     Mr. McWade told

Mr. Kozak that he could do nothing to reduce the Kozaks' tax

deficiencies.

     Mr. Alexander's efforts to cooperate with the Internal

Revenue Service remained dormant until Mr. Alexander again met

with Mr. McWade in late 1988 to discuss his tax liabilities for

the years 1974, 1975, 1976, and 1977.     During this meeting,

Mr. McWade told Mr. Alexander to search his records for
                               - 111 -


documentation to support the Alexanders' reporting position for

the years 1974 through 1977.

     On October 20, 1988, Mr. Alexander sent a letter to

Mr. McWade enclosing copies of several documents purporting to

substantiate the Alexanders' position that they realized a loss

of $55,152.04 in 1975 on a sale of real estate to the Cadillac

Drive Apartments partnership, as opposed to the $59,080 capital

gain determined in the notice of deficiency.

     On December 8, 1988, Jean Samuels (Ms. Samuels), an Appeals

auditor in the Honolulu Appeals Office, sent a two-page

memorandum to Mr. McWade addressing Mr. Alexander's October 20,

1988, letter.   Ms. Samuels recommended one adjustment to the

notice of deficiency for 1975 in the Alexanders' favor.

Specifically, Ms. Samuels concluded that the Alexanders had

substantiated a higher cost basis in the property that they sold

to the Cadillac Drive Apartments partnership than had been used

in the notice of deficiency.   Giving effect to this higher basis

would have reduced the Alexanders' capital gain on the sale by

$23,084.   Taking into account the corresponding adjustment to the

section 1202 deduction previously allowed in the notice of

deficiency, Ms. Samuels recommended a net decrease of $11,542 to

the Alexanders' taxable income as determined in the notice of

deficiency.   However, Ms. Samuels referred to certain covenants

in an agreement of sale in the file before her, and cautioned

Mr. McWade that the consideration paid to the Alexanders on the
                              - 112 -


sale may actually have been higher than the amount used in the

notice of deficiency.

     If Ms. Samuels' recommended adjustment to the notice of

deficiency issued to the Alexanders for 1974 and 1975 had been

accepted, the total adjustments for 1975 would have been reduced

from $127,562 to $116,020, but the deficiency would not have been

eliminated.

     Mr. McWade believed that Mr. Alexander was familiar with the

operation of Mr. Kersting's various programs.   Before the trial

of the test cases, Mr. McWade arrived at a general understanding

with Mr. Alexander that the Alexanders' tax liabilities for the

taxable years 1974, 1975, 1976, and 1977 would be reduced in

exchange for Mr. Alexander's agreement to serve as an undeclared

consultant or assistant to Mr. McWade during the trial of the

test cases.   Mr. McWade's understanding with Mr. Alexander is

reflected in decision documents that were executed by Mr. McWade

on April 6, 1989, and approved by Mr. Sims.   In particular,

Mr. McWade executed a stipulated decision in docket No. 2758-80

conceding the deficiencies determined against the Alexanders for

the taxable years 1974 and 1975 and allowing the Alexanders

overpayments for the taxable years 1974 and 1975 in the amounts

of $2,133 and $811, respectively.   In sum, Mr. McWade completely

eliminated all deficiencies determined against the Alexanders for

the taxable years 1974 and 1975 and relieved the Alexanders of

the concessions that they had made before the issuance of the

notice of deficiency for those years.   The stipulation
                             - 113 -


accompanying the decision document submitted to the Court in

docket No. 2758-80 states as follows:

                           STIPULATION

          It is hereby stipulated that the following
     statement shows the petitioners’ income tax liabilities
     for the taxable years 1974 and 1975:

                              1974

     NET TAX ASSESSED AND PAID . . . . . . . . . . $3,646.00

          Payments: April 15, 1975         $1,513.00
                    December 15, 1984       2,133.00

                    Total payments         $3,646.00

     TAX LIABILITY . . . . . . . . . . . . . . .       $1,513.00

     OVERPAYMENT . . . . . . . . . . . . . . . .       $2,133.00

          I.R.C. §§ 6512(b)(2)(B) and 6511(b)(2)(B)
          Return filed April 15, 1975
          No claim filed
          No agreement executed
          Deficiency notice mailed November 29, 1979

                              1975

     NET TAX ASSESSED AND PAID . . . . . . . . . . $1,114.00

          Payments: April 15, 1976         $303.00
                    December 15, 1984       811.00

                    Total payments       $1,114.00

     TAX LIABILITY . . . . . . . . . . . . . . . .       $303.00

     OVERPAYMENT . . . . . . . . . . . . . . . . .       $811.00

          I.R.C. §§ 6512(b)(2)(B) and 6511(b)(2)(B)
          Return filed April 15, 1976
          No claim filed
          No agreement executed
          Deficiency notice mailed November 29, 1979
                             - 114 -


     At the time that Mr. McWade submitted the above-described

decision document to the Court, respondent's legal file did not

include any explanation of the elimination of the Alexanders'

deficiencies for the taxable years 1974 and 1975.   The Court

entered the parties' stipulated decision in docket No. 2758-80 on

April 13, 1989.

     On April 6, 1989, Mr. McWade also executed a stipulated

decision in docket No. 30413-86, approved by Mr. Sims, conceding

in full the deficiencies determined against the Alexanders for

the taxable years 1976 and 1977 as follows:

           ORDERED AND DECIDED: That there are no
     deficiencies in income taxes due from, or overpayments
     due to, the petitioners for the taxable years 1976 and
     1977;

          That there are no additions to the taxes due from
     the petitioners for the taxable years 1976 and 1977,
     under the provisions of I.R.C. § 6653(a); and

          That there are no additions to the taxes due from
     the petitioners for the taxable years 1976 and 1977,
     under the provisions of I.R.C. § 6621(c).

     On April 6, 1989, Messrs. Sims and McWade signed a Counsel

Settlement Memorandum relating to the Alexanders’ case at docket

No. 30413-86, which states as follows:

          The above-entitled case is being settled on the
     basis that there are no deficiencies in income taxes
     due from, nor overpayments due to, the petitioners for
     the taxable years 1976 and 1977.

          Discussion: The above-entitled case is part of
     the Kersting interest deduction tax shelter program.
     The basis for settlement represents allowance of
     petitioners’ out-of-pocket expense, approximately 7% of
     the deficiency, and concession of penalties for
     settlement purposes.
                              - 115 -


          If more than one year is involved, the settlement
     reflects a shelter burn-out for the first half of
     petitioners’ participation, and a disallowed deduction
     for the later years.

          Non-Kersting Issues:   None.

The Counsel Settlement Memorandum signed by Messrs. Sims and

McWade contains two false statements:    (1) That the basis for

settlement represents the Alexanders' out-of-pocket expenses; and

(2) that the case did not include any non-Kersting issues.

The Court entered the parties' stipulated decision in docket No.

30413-86 on April 13, 1989.

     The stipulated decisions described above reflect

Mr. McWade's general understanding with Mr. Alexander, made

before the trial of the test cases, to reduce the Alexanders' tax

liabilities, in exchange for Mr. Alexander's cooperation and

assistance at the trial of the test cases.

G.   The Kozak Decision

     On July 23, 1981, the Commissioner issued a joint notice of

deficiency to Mr. Kozak and his wife, Susan K. Kozak, disallowing

subchapter S losses and interest deductions that the Kozaks

claimed on their tax returns for 1973, 1974, and 1975 with

respect to their participation in Kersting programs that were the

subject of Pike v. Commissioner, 78 T.C. 822 (1982).    The Kozaks

filed a petition with the Court, assigned docket No. 25812-81,

contesting the notice of deficiency.

     On May 12, 1986, Mr. McWade filed a motion for order to show

cause why a decision should not be entered in the Kozaks' case
                                - 116 -


consistent with the Court's opinion in the Pike case, less out-

of-pocket expenditures.   The Kozaks did not respond to the

Court's order, and on September 30, 1986, the Court entered an

Order and Decision against the Kozaks for deficiencies in tax in

the amounts of $1,641, $1,844, and $902 for the taxable years

1973, 1974, and 1975, respectively, reflecting approximately a 7-

percent reduction of the deficiencies that respondent had

determined against the Kozaks.

VII. Pretrial Developments

A.   The Kersting Deposition--Postponed (January 1987)

     On November 17, 1986, Mr. Seery and Mr. McWade signed a

stipulation to take Mr. Kersting's deposition in Honolulu.    On

January 7, 1987, the day to which the deposition had been

adjourned, Mr. Bradt and Mr. Moseley filed a motion for

protective order with the Court on behalf of Mr. Kersting.    Judge

Goffe denied the motion in a telephone conference call with the

parties on the morning of January 7, 1987.

     Mr. Seery did not appear at the deposition because he had

withdrawn or was in the process of withdrawing from the Kersting

project test cases.   Mr. Moseley appeared at the deposition and

stated that Mr. Kersting would not be deposed until Mr. Kersting

was provided with copies of any prior statements he had made to

the Internal Revenue Service.    Although Mr. Kersting was not

deposed on January 7, 1987, Messrs. McWade, Moseley, and Chicoine

agreed on a procedure for respondent to review a large number of

documents produced by Mr. Kersting at that time.
                                - 117 -


     The following colloquy ensued upon Mr. DeCastro's appearance

at the deposition, at a time when Mr. DeCastro had already

executed and delivered the initial Thompson settlement agreement

to Mr. McWade:

          MR. McWADE: Let the record show that Mr. Luis
     DeCastro from Los Angeles, who represents Mr. Thompson,
     has arrived.

     (Off the record.)

          MR. MOSELEY: Not to stray from the subject, but I
     could, for the record, find out, you represent Mr. --

          MR. DeCASTRO:    Thompson.

          MR. MOSELEY: Thompson.       He's one of the test
     cases that were designated?

          MR. McWADE:    Yes.

          MR. MOSELEY: I would just like for the record to
     object to Mr. DeCastro's appearance here. And the
     objection is on the basis that I have been informed
     that Mr. DeCastro has informed at least some of the
     petitioners' counsel that in fact they are planning to
     settle Mr. Thompson's case, and if they are planning to
     settle Mr. Thompson's case, then essentially his
     appearance at a deposition of my client would not be
     appropriate. I just want to enter that for the record.
     And I'm going to go on, then, with the description of
     what I was talking about in terms of the other
     documents.

          MR. McWADE: If we can take a break here, just so
     I can advise Mr. DeCastro of where we are at this
     point.

There is no further mention of the possible settlement of the

Thompson cases appearing in the transcript of the January 7,

1987, proceedings.   As discussed below, Mr. Kersting eventually

was deposed in October 1988.
                              - 118 -


B.   John Doe Summons/Assessments of Promoter Penalties

     In early 1987, Mr. O'Neill, on behalf of the Honolulu

District Examination Division, requested the Justice Department

to initiate legal proceedings to serve Mr. Kersting with a John

Doe Summons (summons).51   The purpose of the summons was to

compel Mr. Kersting to identify the participants in

Mr. Kersting's programs during the taxable years 1984, 1985, and

1986, and to aid the Internal Revenue Service in developing a

case against Mr. Kersting for so-called promoter penalties under

sections 6700 and 6701.

     On May 15, 1987, the U.S. Attorney's Office filed a petition

in the Federal District Court for Hawaii to serve Mr. Kersting

with the summons.   The summons requested production of all books

and records in Mr. Kersting's custody and control relating to

participants in Mr. Kersting's programs for 1984, 1985, and 1986.

The summons specifically requested production of customer lists

and similar documents containing the names, addresses, and other

identifying information of the participants.   Mr. Kersting moved

to quash the summons.

     51
        Sec. 7609(f) provides that the Secretary may issue a
John Doe summons, i.e., a summons that does not identify the
person with respect to whose liability the summons is issued,
only with court approval after the Secretary establishes that:
(1) The summons relates to the investigation of a particular
person or ascertainable group or class of persons; (2) there is a
reasonable basis for believing that such person or group or class
of persons may fail or may have failed to comply with any
provision of any internal revenue law; and (3) the information
sought to be obtained and the identity of the person or persons
with respect to whose liability the summons is issued are not
readily available from other sources.
                              - 119 -


     On July 1, 1987, the District Court granted the Government's

petition to serve Mr. Kersting with the summons.   Mr. Kersting

produced some documents to Revenue Agent Larry Tahara in response

to the summons but did not fully comply with the summons.

Mr. Kersting challenged the summons during protracted summons

enforcement proceedings that followed.

     Following an August 1987 hearing, the District Court ordered

Mr. Kersting to produce the summoned documents by February 1988.

After another hearing in March 1988, the District Court, in May

1988, held Mr. Kersting in contempt and threatened him with fines

if the summoned documents were not produced.   During this period,

Mr. Izen filed a motion to intervene in the summons proceedings

on behalf of his test case petitioners.   The District Court

denied Mr. Izen's motion.

     Both Mr. Kersting and Mr. Izen appealed the District Court's

decision enforcing the summons to the Court of Appeals for the

Ninth Circuit.   The Court of Appeals remanded the case to the

District Court to determine whether Mr. Kersting had

substantially complied with the summons so as to moot the

appeals.   See United States v. Kersting, 891 F.2d 1407, 1410-1411

(9th Cir. 1989).   Despite its remand, the Court of Appeals

considered and rejected Mr. Kersting's arguments that the

District Court erred in concluding that the Internal Revenue

Service acted in good faith in issuing the summons.    See id. at

1411-1413.   Mr. Kersting eventually produced the summoned

documents.
                              - 120 -


     As previously mentioned supra pp. 18-19, in October 1989,

the Commissioner assessed promoter penalties of $1,545,201 and

$2,330,000 against Mr. Kersting pursuant to sections 6700 and

6701, respectively, for the years 1982 through 1988.

C.   Chicoine and Hallett's Withdrawal as Counsel

     By February 1988, Mr. Kersting's dissatisfaction with

Chicoine and Hallett over evaporation of the 50-percent

settlement and their promotion and reporting of 20-percent

settlements led him to terminate their employment as counsel for

the test cases and to encourage their other Kersting program

clients to recall their settlement retainers.   In April 1988, the

Court granted Chicoine and Hallett's motions to withdraw their

appearances as counsel for test case petitioners.

D.   Mr. Izen's Entry of Appearance

     In February 1988, Mr. Kersting retained Mr. Izen to

represent the test case petitioners, other than the Thompsons and

the Cravenses.   At the time, Mr. Izen had no experience

representing test case taxpayers in the Tax Court, although he

did have experience representing taxpayers who had signed

piggyback agreements to be bound by the outcome of test cases in

a tax shelter project.

     Mr. Izen filed entries of appearance as counsel for test

case petitioners during February 1988 through January 1989.

Mr. Izen examined the deductions claimed by the test case

petitioners he represented to determine whether they were

representative of the Kersting programs.   Mr. Izen analyzed the
                               - 121 -


various Kersting programs and documents regarding each of the

test case petitioners that he represented.    On the basis of his

analysis, Mr. Izen determined that the test case petitioners that

he represented would be representative of the nontest cases.

     On April 29, 1988, Mr. Izen filed a motion to compel

Chicoine and Hallett to provide him with the client files and

papers of certain test case petitioners he represented.    On

June 6, 1988, Mr. Chicoine filed an objection to Mr. Izen's

motion, asserting that Chicoine and Hallett had returned to

Mr. Izen's clients all original documents that had been provided

to Chicoine and Hallett.    By order dated July 11, 1988, the Court

denied Mr. Izen's motion as moot.

     From the beginning of his representation of the test case

petitioners until late 1995, Mr. Izen's fees were paid by check

signed by Mr. Kersting and written on bank accounts of

corporations controlled by Mr. Kersting.    Commencing December

1995, Mr. Izen's fees have been paid from a "pool" or "fund"

contributed by a group of test and nontest case petitioners.

E.   The Kersting Deposition (October 1988)

     On July 8, 1988, respondent served Mr. Kersting and the test

case petitioners with a notice of deposition pursuant to Rule 75.

On July 25, 1988, Mr. Kersting served Mr. McWade with an

objection stating, inter alia, that Mr. Kersting should not be

deposed because he had reason to believe that he was under

criminal investigation.    Mr. Kersting's objection included
                               - 122 -


allegations that Mr. Alexander was assisting the Government in

the criminal investigation.

       On August 25, 1988, Mr. McWade filed a motion to take

Mr. Kersting's deposition in the test cases.    Mr. McWade attached

a number of documents to his motion for the purpose of refuting

Mr. Kersting's allegations that he was under criminal

investigation.    In particular, Mr. McWade attached copies of the

affidavits that Messrs. Alexander and Kozak had submitted to

Mr. McWade in August 1986, as well as copies of the various

documents and letters circulated between Messrs. Alexander,

Matsumoto, and Kozak during that same period.    See supra pp. 106-

111.    By order dated August 30, 1988, the Court granted

Mr. McWade's motion to depose Mr. Kersting.

       During October 24 through 27, 1988, Mr. Kersting was deposed

in Honolulu.    Mr. Bradt represented Mr. Kersting at the

deposition.    Mr. McWade, along with Jeffrey A. Hatfield

(Mr. Hatfield), and Thomas A. Dombrowski (Mr. Dombrowski),

questioned Mr. Kersting on behalf of respondent.52   Mr. Izen and

Mr. DeCastro questioned Mr. Kersting on behalf of their clients.

Mr. Cravens did not participate in the deposition.

       Mr. Kersting did not bring any documents to the deposition;

he claimed that the documents had already been produced in


       52
        Messrs. Dombrowski and Hatfield were both trial
attorneys with the Office of Chief Counsel assigned to the
San Diego District Counsel Office. In September 1988,
Messrs. Dombrowski and Hatfield were assigned to assist
Mr. McWade in the trial of the Kersting test cases.
                              - 123 -


response to respondent's summons.   During the deposition, the

parties conducted a telephone conference call with Judge Goffe

regarding Mr. Kersting's failure to produce the requested

documents.   As a result of the conference call, the parties

agreed that Mr. McWade could inspect documents that Mr. Kersting

had produced in response to the summons.    Mr. McWade's review of

these documents was intended to satisfy Mr. Kersting's obligation

to produce documents at his deposition.    Mr. Kersting and

Mr. Bradt agreed to this procedure.

VIII. Trial of Test Cases (January 1989)

     The trial of the test cases was conducted before Judge Goffe

during January 9 through 27, 1989, at Honolulu, Hawaii.

Respondent was represented at the trial by Messrs. McWade,

Dombrowski, and Hatfield.   Mr. Sims attended the trial but did

not enter an appearance for respondent.    Mr. Sims and Mr. McWade

did not inform Judge Goffe, the National Office, the Regional

Office, or Mr. Izen of the Thompson and Cravens settlements or

the Alexander understanding before or during the January 1989

trial of the test cases.

     Respondent issued subpoenas duces tecum to all test case

petitioners, directing them to appear, testify, and produce

documents at the trial of the test cases.    Each of the eight test

case petitioners testified during the trial of the test cases.

Mr. Hatfield conducted the cross-examination of test case

petitioners Dixon, Owens, Young, DuFresne, Rina, and

Hongsermeier.   Mr. McWade conducted the cross-examination of
                                - 124 -


Messrs. Cravens, Thompson, Moseley, and Kersting, and the direct

examination of Messrs. Kersting, Toyota, Ing, and Alexander.

Mr. Dombrowski conducted the direct examination of Alice Combs

and Margo Akamine, Mr. Kersting's bookkeepers.

A.   Mr. Cravens

     Following Mr. Seery's withdrawal from the Cravens cases in

early 1987, Mr. Cravens did not retain substitute counsel because

he regarded his cases as settled.     Mr. Cravens arrived in Hawaii

1 day before he was scheduled to testify at the trial of the test

cases.     The Government paid Mr. Cravens' travel, food, and

lodging expenses while he was in Hawaii.53

     Mr. McWade prepared and submitted to the Court requested

findings of fact respecting Mr. Cravens' participation in the

disputed Kersting programs.    When Mr. Cravens testified during

the trial of the test cases, he made a brief statement to the

Court about his participation in the Kersting programs, told the

Court and the parties that he had absolutely nothing to hide, and

said that he would answer any questions to the best of his

ability.

     Mr. McWade cross-examined Mr. Cravens at the trial and

elicited testimony to support respondent's proposed finding of

fact that Mr. Cravens' primary reason for participating in the

Kersting programs was to obtain tax benefits.    Mr. Cravens


     53
        Inasmuch as respondent subpoenaed all the test case
petitioners, it is assumed that they were all reimbursed for
their expenses. See sec. 7610.
                              - 125 -


testified that he participated in Stock Subscription Plans in

1979 (Candace) and 1980 (Delta), and that he closed out his

participation in the Kersting programs by endorsing his stock

certificates and returning them to Mr. Kersting in exchange for

the return of his promissory notes.

     Mr. McWade introduced exhibits at the trial pertaining to

Mr. Cravens' participation in Kersting programs that were

referred to in the stipulation of facts that had been signed by

Mr. McWade and Mr. Cravens.   Mr. Izen briefly cross-examined

Mr. Cravens after Judge Goffe asked what right Mr. Izen had to

question a test case petitioner who was not his client.    In the

absence of an objection from Mr. Cravens, and in light of

Mr. McWade's assent to a brief cross-examination, Judge Goffe

stated:   "I'll permit a certain amount of questioning, but we'll

just see where it goes."   Mr. DeCastro did not question

Mr. Cravens, nor did the Court.

     Mr. Cravens never informed the Court that he had settled his

case because he believed the matter was common knowledge.

Mr. Cravens had no intention of having a secret settlement.

Following the trial, the Cravenses did not file any briefs with

the Court.
                               - 126 -


B.   Mr. Thompson

     Mr. Thompson appeared at the trial of the test cases and

produced eight pages of documents in response to the subpoena

duces tecum issued by Mr. McWade.54      The Government paid

Mr. Thompson's travel, food, and lodging expenses.

     Mr. DeCastro conducted direct and redirect examinations of

Mr. Thompson.   Mr. DeCastro questioned Mr. Thompson about his

participation in the acquisition of First Savings as well as the

Bauspar program to show that the Thompsons had financial dealings

with Mr. Kersting other than through the programs at issue in the

trial.    Mr. Thompson testified that, following a forced merger

between First Savings and First Federal Savings of Honolulu,

Mr. Kersting returned the Thompsons' $20,000 initial investment

in First Savings.   Mr. Thompson further testified that he lost

$80,000 in the Bauspar program.

     Mr. McWade cross-examined Mr. Thompson.      Mr. Thompson had

never met Mr. McWade until he was scheduled to testify.        Pursuant


     54
        When Mr. McWade moved to have the Thompson documents
admitted as evidence during Mr. Thompson's testimony, Mr. Izen
objected on the grounds that he had not had an opportunity to
review them. Although Judge Goffe initially questioned whether
Mr. Izen should be permitted to object to the admission of the
Thompson documents, Mr. DeCastro indicated that he had no
objection. Judge Goffe then called a brief recess to allow
Mr. Izen to review the documents and indicated that he would
allow Mr. Izen to subject Mr. Thompson to a voir dire
examination. Following the recess, Mr. Izen raised a limited
objection to the admissibility of the documents insofar as they
contained statements of Mr. Kersting's opinion of the tax laws.
Judge Goffe overruled Mr. Izen's objection and admitted the
documents in evidence as respondent's exhibit SL. Mr. Izen was
allowed to cross-examine Mr. Thompson without limitation.
                             - 127 -


to a stipulation of facts, Mr. McWade introduced exhibits at the

trial of the test cases pertaining to the Thompsons'

participation in the disputed Kersting programs.   During

Mr. McWade's cross-examination, Mr. Thompson made the following

statement:

          Mr. McWade: When did you terminate your
     participation in these plans, Mr. Thompson?

          Mr. Thompson: In--let's see--1984. No, wait a
     minute; 1982. I retired, and I went to my retirement
     party, came home, and I had notice from the Internal
     Revenue Service regarding my 1978 taxes. And I went up
     to the house, called him up, and said, "Henry, I've got
     a problem." And he said to just send it to him and
     he'd take care of it.

          Two and half years later he was still taking care
     of it. I still didn't know what was wrong. And I was
     becoming very disenchanted with his taking care of it.
     To be quite honest with you, I went to an attorney over
     it.

          And an agent actually came to our house and was
     interested in my paying him $23,346, as I remember, on
     the spot.

          In the interim period I had received no notice
     that our house had a lien slapped on it from the
     Internal Revenue Service, but I didn't know about this.

           But anyway, this was all the thing that brought
     all my investments with Mr. Kersting to a head. I got
     absolutely no support that was effective from him. I
     wanted to know what the problem was so that I could
     address it--not in a manner of putting a band-aid on
     it; I wanted it settled. I was retired. I couldn't go
     on with this business that, "Oh, we'll go to court and
     they'll never get us," and all of this business that we
     had. I was out money, lots of it: $80,000, on the one
     hand. And $23,000 goes over 100--pretty easy, right
     then.

          I was in the process of doing a trust. I went to
     the attorney that was running that for me, and he wrote
     a letter to Kersting wanting to know what he had done,
     and got a rotten letter back from him. I tried to get
                              - 128 -


     him to do something for me on the 1978 situation, and
     there wasn't anything happening.

          The procedure went through a tax firm in Los
     Angeles known as Loeb & Loeb, and I wound up with the
     DeCastro Law Corporation by way of their direction, and
     made several discoveries that were startling to me.
     And of course, I settled. To be quite honest, I had to
     get out of this. I was not going to spend my life--

          Mr. McWade:   Well, let me--

          Mr. Thompson:   --doing all this.

          Mr. McWade:   Let me stop you here for a moment.

          Mr. Thompson:   Okay.   I'm sorry.   I beg your
     pardon.

          Mr. McWade: Mr. Thompson, can you tell me: have
     we been successful in getting the lien removed from
     your house?

The subject of the Thompson settlement did not arise again during

Mr. Thompson's testimony at the trial of the test cases.55

     Mr. McWade followed the colloquy quoted above by asking

Mr. Thompson whether he had ever tendered stock certificates to

Mr. Kersting.   Mr. Thompson responded that, contrary to

Mr. Kersting's promises, he tried twice (through Mr. DeCastro and

Mr. Chanin) to tender his stock certificates to Mr. Kersting in

exchange for the cancellation of his promissory notes but had

been refused.


     55
        In Dixon II, Judge Goffe interpreted Mr. Thompson's
remarks concerning settlement as pertaining to the resolution
of Mr. Thompson's tax liability for 1978--a year for which the
Thompsons had not been issued a notice of deficiency. See Dixon
II, 62 T.C.M. (CCH) at 1472-1473, 1991 T.C.M. (RIA), at 91-3014
to 91-3015. In retrospect, and in the light of what has come
out, it is more likely that Mr. Thompson in his above-quoted
testimony was referring to the settlement on his behalf that
Mr. DeCastro had negotiated with Mr. McWade.
                              - 129 -


     Mr. McWade prepared and submitted to the Court requested

findings of fact respecting the Thompsons' participation in

the disputed Kersting programs.   Mr. McWade relied upon

Mr. Thompson's testimony at trial to support respondent's

proposed findings of fact that Mr. Thompson "lost $80,000

maintained in the savings program with the Kersting company."

     Mr. Izen was permitted to cross-examine Mr. Thompson.

Mr. Izen questioned Mr. Thompson about his purported $80,000 loss

from the Bauspar program, Mr. Thompson's dispute with

Mr. Kersting, and Mr. Kersting's threats to bring a lawsuit

against the Thompsons.56

C.   Mr. Kersting

     Mr. McWade subpoenaed Mr. Kersting to testify at the trial

of the test cases.   Mr. Kersting testified extensively at the

trial of the test cases regarding the Kersting programs in

dispute.   As discussed in greater detail below, Judge Goffe

concluded in Dixon II that Mr. Kersting's testimony lacked

credibility.

     Mr. Kersting testified about the First Savings acquisition.

In particular, Mr. Kersting testified that the acquiring group of

approximately 40 investors (including Mr. Thompson) had been



     56
        Mr. Thompson testified that the $80,000 loss arose from
Mr. Kersting's failure to remit to the Thompsons the buildup in
the forced savings leg of the Bauspar transaction under which the
Thompsons had paid $1,200 per month to Citizen's Financial, Inc.
Mr. Thompson testified that Mr. Kersting treated the $1,200
payments as interest payments, rather than as contributions to a
savings plan.
                              - 130 -


required to pledge their First Savings stock to secure a loan

from First Hawaiian Bank to provide partial financing for the

acquisition.   Mr. Kersting further testified that, following the

initial acquisition, he arranged for the acquiring group to

relinquish their interest in First Savings and become

shareholders of a newly organized Kersting holding company known

as Investors Financial Corp. (Investors Financial), which was to

be a holding company for First Savings.   Mr. Kersting testified

that initially he had been erroneously informed that regulatory

approval was not required for Investors Financial to serve as a

holding company for First Savings.   Mr. Kersting testified that

the Federal Home Loan Bank Board eventually approved Investors

Financial as a holding company for First Savings.

D.   Mr. Alexander

     Mr. McWade subpoenaed Mr. Alexander to testify at the trial

of the test cases.   The Government paid Mr. Alexander's travel,

food, and lodging expenses while he was in Hawaii.    Unlike most

witnesses, Mr. Alexander remained in Hawaii during the entire

trial; this was pursuant to arrangement with Mr. McWade so that,

as previously described, Mr. Alexander could serve as an

undeclared consultant or assistant to Mr. McWade.    The record

does not reflect the extent to which Mr. McWade actually relied

upon Mr. Alexander as an assistant or consultant during the trial

of the test cases.

     Mr. McWade's direct examination of Mr. Alexander focused

largely on the details of the First Savings acquisition.
                                - 131 -


Mr. Alexander's testimony regarding the transaction differed from

Mr. Kersting's testimony in one material respect.    Specifically,

contrary to Mr. Kersting's testimony, Mr. Alexander testified

that the Federal Home Loan Bank Board denied Mr. Kersting's

application for Investors Financial to serve as a holding company

for First Savings.57    Mr. Alexander further testified that

Mr. Kersting "watered down" the First Savings shares by issuing

additional Investors Financial shares to individuals other than

the original acquiring group.    Mr. Alexander testified that when

he questioned Mr. Kersting about the matter, Mr. Kersting stated

that there was no problem with issuing additional Investors

Financial shares because Mr. Kersting could have the shares

returned at any time.

     Mr. Alexander testified that in February 1980, Federal

banking authorities forced First Savings to merge with First

Federal Savings of Honolulu.    Mr. Alexander testified that,

following the forced merger, Mr. Kersting returned the initial

investments of some members of the original acquiring group but

that Mr. Kersting did not return Mr. Alexander's investment of

approximately $125,000.

     Under direct examination by Mr. McWade, Mr. Alexander

admitted that he had filed a lawsuit against Mr. Kersting, which

resulted in the arbitration proceeding in July 1987, and that he


     57
        In Dixon II, the Court found that Investors Financial
was not approved as a holding company for First Savings and that
Investors Financial had no other assets. See Dixon II, 62 T.C.M.
(CCH) at 1447, 1991 T.C.M. (RIA), at 91-2987.
                               - 132 -


was not on good terms with Mr. Kersting.    Under cross-examination

by Mr. Izen, Mr. Alexander admitted that he had talked with

Mr. McWade about submitting an affidavit concerning

Mr. Kersting's programs.    When asked by Mr. Izen whether he and

Mr. McWade had discussed a reduction of Mr. Alexander's tax

liability in exchange for the affidavit, Mr. Alexander responded,

"Specifically, no."58   Mr. Izen's cross-examination of

Mr. Alexander included questions concerning Mr. Alexander's

various dealings with Mr. Kersting, including First Savings and

Mr. Alexander's participation in the Kersting programs at issue

in the trial.

     After Mr. Izen had questioned Mr. Alexander about his

participation in the Kersting programs at issue in the trial,

Mr. McWade elicited testimony from Mr. Alexander (on redirect

examination) that Mr. Kersting had represented to Mr. Alexander

and others that the promissory notes underlying the interest

expense deductions would not be called for payment.




     58
          Mr. Izen questioned Mr. Alexander as follows:

          Mr. Izen: Have you ever offered * * * Mr. McWade,
     or any other person connected with the Internal Revenue
     Service, an affidavit concerning your testimony
     concerning these tax shelters?

           Mr. Alexander:   We talked about it.

          Mr. Izen: Did you ever offer to them to testify
     in return for reducing your own personal taxes? The
     amount of.

           Mr. Alexander:   Specifically, no.
                               - 133 -


E.   Mr. DeCastro

     Mr. DeCastro attended the trial of the test cases and

conducted Mr. Thompson's direct examination.    Following the

trial, Mr. DeCastro filed an eight-page brief with the Court on

behalf of the Thompsons.    Mr. DeCastro's brief included an

argument that the Thompsons entered into the Kersting programs in

dispute with the intention of making a profit.    This argument was

based upon the Thompsons' prior investment experience with

Mr. Kersting, including their participation in the First Savings

acquisition.    Mr. DeCastro's brief also acknowledged that "one

of the primary motives for the stock purchase was to realize

the substantial tax savings promised by the Kersting plan".

Mr. DeCastro also argued, contrary to Mr. Thompson's testimony,

that the promissory notes signed by the Thompsons "are valid and

enforceable."    Mr. DeCastro filed no reply brief on behalf of the

Thompsons.

F.   Comfort Letters

     The record in the trial of the test cases included evidence

that Mr. Kersting had assured certain Kersting program

participants, whom Mr. Kersting referred to as "nervous Nellies",

that their primary loan obligations could be satisfied in full at

any time by mere surrender of the associated stock certificates.

In Dixon II, the Court summarized the evidence as follows:

     [Mr. Kersting] testified that he provided so-called
     "comfort letters" only to those "nervous Nellies" who
     insisted on having them, which did not include any of
     petitioners.
                        - 134 -


     We do not doubt that Kersting only provided these
personalized comfort letters to investors who insisted
and that petitioners were not among that group. It
does not necessarily follow, however, that the policy
embodied in the letters was unknown or unavailable to
petitioners or other investors. In fact, the record
contains several indications, covering a span of
several years, that Kersting applied this policy to
everyone whether they requested personalized comfort
letters or not:

     (1) Thompson testified that Kersting assured him
of the policy at the outset, and no other petitioner
testified that he tendered stock to Kersting and was
refused. Kersting's refusal to accommodate Thompson is
reasonably attributed to the serious falling out that
occurred previously and to Thompson's apparent refusal
to pay leverage loan interest.

     (2) Kersting described a 1976 Forbes Acceptance
Stock Subscription Plan to Mil Harr this way: "The
deal is self-liquidating as you can retire all of your
debt by simple surrender of the stock certificate
issued to you."

     (3) Gabriele Kersting sent a form letter to Owens
also relating to the 1976 Forbes Acceptance Stock
Subscription Plan, in which she advised him to "Keep
the [stock] certificate in a safe place as you will
need it later to retire the $30,000.00 note."

     (4) In a form letter transmitting initiating
documents for the Leasing Corporation Plan of Universal
Leasing, Kersting stated: "All of your debt, except
your monthly payment obligation, can be discharged at
any time at your option by surrender of the stock
certificate which will be issued to you after we have
received the executed documents from you."

     (5) In a form letter marking the first anniversary
of a Leasing Corporation Plan for Anseth Leasing,
Kersting noted that "you do have the continuing option
to retire the existing notes by a sale to your
corporation of the stock which you have acquired."

     (6) Although in the form of a personalized
comfort letter, Kersting wrote expansively in 1977:
"there is, of course, no problem to reassure you of the
self-sustaining and self-liquidating aspects of the
transaction. We would, in fact, issue a letter to
every participant in the deal outlining that
                             - 135 -


     understanding if it would not weaken YOUR position with
     the IRS."

          (7) In another personalized comfort letter, this
     time from 1978, Kersting again wrote broadly: "As to
     the obligation under the promissory notes and
     subscription agreements there is no ongoing obligation
     as far as we are concerned. We will always repurchase
     the stock issued at a price sufficient to allow a
     borrower to discharge all of his debt."

          (8) In a 1980 credit-reference letter to a third
     party, Kersting wrote that the investor's "liabilities
     at * * * [the time of his stock purchases] and from
     there on would be equal to the assets acquired. His
     debt can be canceled at any time of his choice by the
     sale of the assets in his possession."

          (9) Dixon received a 1985 form letter that told
     him how to terminate his participation in his Charter
     Financial stock purchase plan by returning an endorsed
     stock certificate, after which his notes and stock
     certificate would be canceled and notes marked "paid"
     would be returned to him. The letter contained similar
     unused "cancellation" lines for leasing corporation
     stock certificates and acceptance corporation stock
     certificates.

Dixon II, 62 T.C.M. (CCH) at 1499-1500, 1991 T.C.M. (RIA), at 91-

3043 to 3044-91.

G.   Mr. Izen's Introduction of Evidence of Collection Litigation

     During the trial of the test cases, Mr. Moseley testified

(on direct examination by Mr. Izen) that he had represented

several Kersting companies in collection litigation against

several Kersting program participants.59   When Mr. Izen attempted


     59
        Before the trial of the test cases, Mr. McWade became
aware of the Kersting collection cases through settlement
discussions with Kersting program participant Lou Galli.
Mr. McWade subsequently discovered that certain corporations
controlled by Mr. Kersting had obtained collection judgments
against no fewer that 10 Kersting program participants. In
addition, Mr. McWade issued a subpoena to Mr. Kersting requesting
                                                   (continued...)
                                - 136 -


to offer collection litigation records into evidence through

Mr. Moseley, Judge Goffe initially questioned why Mr. Izen had

not obtained the documents before trial so that the documents

could have been subjected to the stipulation process.   Mr. Izen

responded that, although he had requested the documents from

Mr. Kersting earlier, ultimately he had relied upon the subpoena

that respondent had served on Mr. Kersting, and he had only

recently received the documents.

     During Mr. Moseley's testimony, Mr. Izen offered into

evidence records from the bankruptcy case of Mr. Provan

indicating that certain corporations controlled by Mr. Kersting

were creditors of Mr. Provan.    The Court sustained Mr. McWade's

objections to admission of these records on grounds of relevance

and incompleteness.60   The Court also sustained Mr. McWade's

objections to the admission of several documents pertaining to

collection litigation against George Vermef, although these

documents were later admitted into evidence through

Mr. Kersting's testimony.61




     59
      (...continued)
the production of records of any other collection actions against
Kersting program participants.
     60
        The documents in question did not reveal the particular
debts that the Kersting corporations had apparently asserted
against Mr. Provan.
     61
        Judge Goffe's treatment of the collection litigation
evidence is summarized supra pp. 72-74. Mr. Izen's bringing up
the collection litigation again, following the evidentiary
hearing, is described infra pp. 196-197.
                                 - 137 -


IX.   Posttrial Developments

A.    First Thompson Refund

      Around the time of the Dixon II trial, Mr. DeCastro asked

Mr. McWade to arrange for the Thompsons to receive a refund of

$30,000 of their advance payments, in accordance with the second

revision of the Thompson settlement.       In a memorandum dated

April 10, 1989, Mr. McWade requested Mr. Stevens to process a

$30,000 refund to the Thompsons.     Mr. McWade's April 10, 1989,

memorandum states:

           The above-named taxpayers are part of     the Kersting
      Interest Deduction Project. Because their      case was
      designated as one of the "test cases", the     basis for
      settlement agreed to prior to trial cannot     be finalized
      until after the Court enters its decision,     projected to
      be after mid-year 1990.

           The basis for settlement will result in
      approximate deficiencies, as follows:


       Tax Year   Deficiencies        Interest          Total
        1980      $15,000.00         $19,241.66       $34,241.66
        1981      $15,000.00         $15,191.44       $30,191.44

           Based upon the enclosed transcript, the taxpayers
      have made advance payments as follows:

           Tax Year               Advance Payment
            1979                    $63,000.00
            1980                    $35,373.09
            1981                       $145.88

           In an effort to minimize the interest expense to
      the government, it is requested that $30,000.00 of
      advance payment be refunded to the taxpayers, the
      allocations and/or inter-year adjustments being made,
      as necessary.

           Following the refund, there will be sufficient
      advance payments to full pay the agreed deficiencies,
      plus accrued interest, with a $4,085.87 reserve.
                               - 138 -


     Mr. McWade's memorandum apparently did not raise any

concerns in the Special Procedures office.62    On July 11, 1989,

the Government issued a refund check to the Thompsons in the

amount of $30,000.    The Thompsons endorsed the check to DeCastro

Law Corp. without depositing it in their own checking account.

     On August 3, 1989, Mr. DeCastro wrote a letter to Mr. McWade

confirming the revision of the Thompson settlement that had been

agreed to before the trial of the test cases.    Mr. DeCastro's

letter states in pertinent part as follows:

     Re: Jack and Maydee Thompson

     Dear Ken:

          Please confirm following is our agreement with
     respect to settlement of above taxpayer's cases for
     open years:

           We have agreed that the total taxes due for all
     the open years are $15,000 for 1980 and $15,000 for
     1981.

          Further, in the event a final decision in this
     case is more favorable they are to receive the benefit
     of such decision.

            Please sign below so I can have for my files.


Mr. McWade signed the letter and returned it to Mr. DeCastro.

     On August 24, 1989, Mr. DeCastro wrote to Mr. McWade

requesting that Mr. McWade arrange for the Thompsons to receive

the balance of their refund.    Mr. DeCastro's letter states in

pertinent part:



     62
           Mr. Stevens was not called to testify at the evidentiary
hearing.
                               - 139 -


     Dear Ken:

          The following are my calculations of the refund
     due the Thompsons:

     1980 Deficiency:           $15,000
     Interest on Deficiency:     15,300             $30,300
     (To 12-31-86)

     1981 Deficiency:           $15,000
     Interest on Deficiency      12,150              27,150

     Total Tax and Interest due to 12-31-86         $57,150

     Amount Paid 12-31-86 ($25,545 plus $34,269)    $59,814

     Overpayment as of 12-31-86                       2,664

     Additional amount paid
     on account 6-11-87                              63,000

       TOTAL OVERPAYMENT DUE TAXPAYER               $65,664

          Please calculate the interest due on the
     overpayment and arrange to refund the balance due them
     (less the $30,000 recently received).

           Thanks for your cooperation.


On October 3, 1989, Mr. DeCastro sent the Thompsons a letter

reporting that Mr. McWade had confirmed that they were due a

large refund, plus interest, which would not be refunded until

the Court issued its opinion in the test cases.    Mr. DeCastro

advised the Thompsons that, because the Internal Revenue Service

would be paying interest, he believed it was fair to add interest

to the Thompsons' bill.

     On or about November 6, 1989, Mr. McWade received an undated

letter from Mr. Thompson which stated in pertinent part as

follows:
                        - 140 -


Dear Mr. McWade:

There are some questions in mind that I feel you can
help me answer.

Owing to the fact that the Kersting hearing is behind
and my testimony is complete I ask; have I completed my
portion of this case? If in fact my portion is
complete I question the requirement for counsel any
longer.

Secondly--I received a check from IRS in the amount of
thirty thousand dollars--($30,000). I endorsed this
over to DeCastro Law Corp; this did not retire the
billed amount. I am completely amazed at the billings
we are receiving. I am now in receipt of additional
billings that exceed realistic amounts. In fact the
total comes to sixty six thousand two hundred forty
three and 66/100 dollars ($66,243.66). At some point I
know a reconciliation will come. Luis says don't be
concerned. I am very concerned, I am the one being
billed.

Thirdly--it was Maydee and me who stood up to be
counted at the hearing. In crossing paths with former
friends I know not whether they will be friendly or
not. The percentage is still in my favor. And soon
now I feel that all will have to come to grips with
reality in this matter. So be it, it is a factor in
our lives.

Fourth--I came forward to help bring about justice for
Henry Kersting. While it is true that I was aware that
a measure of direct animosity would result, and I
accepted this. Maydee has experienced additional
illness this I am very sorry about.

Most emphatically I did not expect to be a channel
through which IRS funneled funds to any law firm.
Certainly not in this magnitude. I have the feeling at
this point that I am correct in this--the bill is to
[sic] much. I want to know the exact legal position I
occupy. We have been frustrated long enough. We wish
to close this chapter.

Ken we spent little time with you, however Maydee and I
both agree, we like you. I hope as Maydee does that
you are on your way out of the smoking habit. I truly
hope that this will be accepted in the context I feel.
I guess I am tired of this matter. All the broken
                               - 141 -


     dreams the Kersting fraud has shattered are everywhere
     I look. I only know a few by comparison.

     Best regards,      Jack

The payment of Mr. DeCastro's legal fees is also discussed in a

letter dated November 17, 1989, from Mr. DeCastro to Mr. Huestis

which states in pertinent part:

          Thank you for your letter regarding the matter of
     the Thompsons' fees. As I have told Jack, we are
     looking for payment of his fees to the IRS, not him. I
     am enclosing a copy of my letter to him in this regard
     for your information.

          I am not sure how there got to be any confusion on
     this score, but hope this lays that to rest. We have
     been told by the IRS that they will not release any
     additional funds until after the judgment and in the
     meantime we give Jack and Maydee our statements to keep
     them informed of the balances.

          Just to make it all very clear, we are looking
     only to the payments from the IRS for our fees and do
     not expect Jack and Maydee to come up with money on
     that score.

Mr. DeCastro sent a similar letter to the Thompsons on the same

date.

B.   Mr. Izen's Motion To Reopen Record

     On January 23, 1991, Mr. Izen filed a motion to reopen the

record in the trial of the test cases to receive newly discovered

evidence.   In particular, Mr. Izen sought to introduce evidence

that certain Kersting program participants had reported a capital

gain upon the termination of their participation in a particular

Kersting program and later filed a claim for refund based upon

the Commissioner's determination that the transaction was a sham.

Mr. Izen argued that the Commissioner's denial of the taxpayers'
                              - 142 -


refund claims constituted an admission against interest.

Respondent opposed Mr. Izen's motion on the grounds that the

taxpayers in question had claimed Kersting interest deductions

for the 3 taxable years before the year that they reported a

capital gain, and that the Commissioner had accepted those tax

returns as filed.   Respondent asserted that under the

circumstances it was not inequitable for the Commissioner to deny

the taxpayers the claimed refunds.   On February 26, 1991, the

Court denied Mr. Izen's motion.

C.   Dixon II Opinion

     Messrs. Sims and McWade did not inform Judge Goffe, the

National Office, Regional Counsel, or Mr. Izen of the Thompson

and Cravens settlements or the Alexander understanding before the

issuance of the Court's Dixon II opinion.

     On December 11, 1991, the Court filed its Dixon II opinion.

In particular, the Court rejected Mr. Izen's contention that the

cases should be dismissed for lack of jurisdiction on the ground

that the notices of deficiency issued to his clients were

invalid.   The Court also sustained respondent's disallowance of

the interest deductions claimed with respect to the Kersting

stock purchase, stock subscription, leasing corporation, and CAT-

FIT plans.   The Court determined that the loans were sham

transactions lacking economic substance and that the loans did

not constitute genuine indebtedness.    Finally, the Court

sustained respondent's determinations against test case

petitioners who had been charged with additions to tax for
                             - 143 -


negligence, failure to file a timely return, and the increased

rate of interest for substantial understatement of income tax

attributable to tax-motivated transactions.

D.   Disclosure of Thompson Settlement

     On March 13, 1992, the Court entered decisions pursuant to

its Dixon II opinion in each of the test cases.    The Court

entered decisions in the Thompson cases consistent with the

notices of deficiency issued to the Thompsons as follows:

                                       Additions to Tax
                                  Sec.      Sec.        Sec.
 Year         Deficiency        6653(a) 6653(a)(1) 6651(a)(1)

 1979         $18,161.00         $908       ---           ---
 1980          24,838.00          ---       ---           ---
 1981          36,294.52          ---    $1,958.28     $4,934.32


The decisions provided that the Thompsons were liable for 50

percent of the interest due on the deficiency for 1981 pursuant

to section 6653(a)(2) as well as increased interest pursuant to

section 6621(c).

     By letter dated April 23, 1992, Mr. McWade forwarded to

Mr. DeCastro waiver agreements which, if executed by

Mr. DeCastro, would authorize the Internal Revenue Service to

enter assessments against the Thompsons before expiration of the

90-day appeal period prescribed by section 7481.    Mr. McWade's

letter stated that, on the basis of the Thompsons' earlier

payments, there would be due a refund of approximately $56,873.03
                                - 144 -


for 1979, 1980, and 1981.   Finally, the letter stated that the

Thompsons' refund was attributable to the resolution of Kersting

interest deduction programs, including the Bauspar program.    Mr.

DeCastro signed the waivers and returned them to Mr. McWade on

April 27, 1992.   Mr. Sims and Mr. McWade initialed the waivers on

May 1, 1992.   By letter dated May 8, 1992, Mr. DeCastro wrote to

Mr. Thompson stating in pertinent part:    "Finally I have been

advised that the Infernal [sic] Revenue Service is processing a

refund to you.    I expect to be in excess of $55,000 [sic] so as I

mentioned it will finally take care of my bill and leave some

left over for you."

     During this same period, Mr. Sims informed Larry Martucci

(Mr. Martucci), an Associate Chief of Appeals in the San

Francisco Appeals Office,63 that a Kersting test case petitioner

had accepted the project settlement offer made to all Kersting

petitioners, but, because the petitioner was one of the test

cases, he had tried his case.    Mr. Sims told Mr. Martucci that

the Court had entered a decision in the case in accordance with

its opinion.   Mr. Martucci told Mr. Sims that he did not know

what could be done.   Mr. Martucci told Mr. Sims that, at a

minimum, Mr. Sims should contact Mr. Sanchez, Regional Counsel

for the Western Region, Office of Chief Counsel.


     63
        From November 1988 through March 1992, Mr. Martucci
supervised the Appeals officers assigned to the Honolulu Appeals
Office, including Gary Lipetzky and Mel Iwane. Mr. Martucci
first became aware of the Kersting tax shelter project in 1988 or
1989 when the project was in District Counsel jurisdiction and no
longer with the Appeals Office.
                              - 145 -


     During the week of April 13, 1992, Mr. Sims contacted Jerry

Li (Mr. Li), another Associate Chief of Appeals in San Francisco,

about the need to assess amounts in the Thompson cases that were

less than the amounts set forth in the Tax Court's decisions.

Mr. Sims did not mention the Thompsons' participation in the

Bauspar program in his conversation with Mr. Li.   Mr. Li told

Mr. Sims that he would have to check with his superiors before

processing the case.   Mr. Li asked Mr. Sims for a memorandum

explaining the situation.

     Mr. Sims and Mr. McWade sent Mr. Li a memorandum dated

May 8, 1992, which states:

          Forwarded herewith are the administrative files
     for the above-entitled cases, which were part of the
     test cases in the Kersting Interest Deduction Program.
     As per our discussion, the petitioners indicated a
     desire to settle their cases, based upon the then
     outstanding settlement offer, prior to the trial of the
     test cases. Because of the stipulations of settlement
     of tax shelter issues filed in the remaining non-test
     cases, we felt settlement with petitioners, as test
     cases, without trial was inappropriate. In lieu of a
     stipulated settlement, we agreed to allow petitioners
     the better of the settlement or trial results, once the
     litigation was completed. Petitioners also established
     their entitlement to additional actual losses
     associated with another of Mr. Kersting's programs,
     Balspar [sic]. We agreed to reflect the tax
     consequences of such transactions in the final
     determination of their tax liability for the respective
     years.

          The Court has now rendered its opinion in the
     Kersting test case litigation and entered its decision.
     In accordance with our agreement with petitioners, the
     tax liabilities to be assessed in these cases, the
     decision notwithstanding, are as follows:
                                 - 146 -


                                       I.R.C. Sections
     Year Deficiency     6651(a)(1) 6653(a)(1) 6653(a)(2) 6621(c)

     1979    -0-           N/A         -0-        N/A      -0-
     1980 $15,000.00       N/A         N/A        N/A      -0-
     1981 $15,000.00       -0-         -0-       -0-       -0-

          In order to expedite the closing of these cases,
     petitioners, through counsel, have executed waivers of
     the limitations contained in I.R.C. § 6213(a), copies of
     which are included in the files. Immediate processing
     of the assessments are [sic] therefore appropriate.

          If you have any questions regarding the processing
     of this matter, pleased contact me at (808) 541-3350.

     Shortly after receiving this memorandum, Mr. Li called Gary

Lipetzky (Mr. Lipetzky), an Appeals officer in Honolulu, who had

begun to gather information about the Bauspar program.

Mr. Lipetzky informed Mr. Li that he was the key Appeals officer

on the Bauspar program and that he had not formulated any

settlement offer for that program.

     Mr. Li subsequently contacted his supervisor, Ron Wise

(Mr. Wise), Assistant Chief of Appeals in San Francisco, about

Mr. Sims' request.     On May 22, 1992, Mr. Wise talked to Mr. Sims

about the Thompson cases.    Mr. Sims told Mr. Wise that the

Thompsons had been selected as Kersting test cases, the Thompsons

had their own attorney, Mr. Kersting had threatened to sue the

Thompsons, Mr. Kersting had denied the Thompsons the return

on one of their investments, and Mr. Kersting considered

Mr. Thompson to be a renegade.     Mr. Sims told Mr. Wise that he

and Mr. Thompson had worked out an informal arrangement that

the Thompsons would receive the better of the Tax Court decision

or the best settlement allowed to other Kersting program
                               - 147 -


participants before the trial.   Mr. Sims told Mr. Wise that he

was concerned about the piggyback cases because the Thompsons

would be getting a better settlement and the Government had won

all the test cases.

     Mr. Wise believed that Mr. Sims' request to make an

assessment that differed from a Tax Court decision required

higher level approval.   On May 15, 1992, Mr. Wise forwarded

Mr. Sims' May 8, 1992, memorandum to his supervisor, Christian G.

Beck, Chief of the San Francisco Appeals Office.   Mr. Wise told

Mr. Sims that he did not have authority to process his request

and indicated he was going to seek approval from Danny Cantalupo

(Mr. Cantalupo), Regional Director of Appeals for the Western

Region.   On May 22, 1992, Mr. Cantalupo informed Peter D. Bakutes

(Mr. Bakutes) Deputy Regional Counsel (Tax Litigation) for the

Western Region, that the Appeals Office had received a request

from Mr. Sims to make an assessment in a Kersting test case on a

basis that differed from the Tax Court's decisions.

     Under the management structure of the Western Regional

Counsel's Office, Mr. Bakutes reported directly to Mr. Sanchez.

As Deputy Regional Counsel, Mr. Bakutes was responsible for

general oversight of tax litigation in the Western Region,

including tax shelter cases, and for evaluating how such cases

should be handled.    Mr. Bakutes had experience with tax shelter

procedures before becoming Deputy Regional Counsel.   Mr. Bakutes

expected that, in the Western Region, a project attorney and the

attorney's manager would contact the Regional Office if they
                              - 148 -


wished to settle a project case on grounds different from the

official project settlement offer.   Mr. Sanchez considered Mr.

Bakutes his key executive staff person and had directed all

District Counsel, including Mr. Sims, to discuss any unusual or

novel matters with Mr. Bakutes.

     Mr. Bakutes and Mr. Cantalupo immediately informed

Mr. Sanchez about the Thompson settlement.   This was the first

time Mr. Sanchez heard of the Thompson settlement.   No one in the

Western Regional Counsel's Office knew of the unusual settlement

of Kersting cases before May 22, 1992.   No one in the Western

Regional Office had approved the settlements.

     Mr. Sanchez immediately called Mr. Sims, who admitted the

basic facts regarding the Thompson settlement arrangement.

Mr. Sims stated that his motivation for the settlement was to

prevent Mr. Kersting from perpetrating a fraud on the Court.

Mr. Sims stated that the best way to do this was to have at least

one attorney not paid by Mr. Kersting participate in litigating

the test cases.

     After discussing the matter with Mr. Sims, Mr. Sanchez

contacted Mr. DeCastro and learned more of the details

surrounding the settlement.   Mr. DeCastro informed Mr. Sanchez

that Mr. Sims and Mr. McWade had agreed to a proposal to keep the

Thompsons in the litigation by rebating to the Thompsons an

amount sufficient to pay their legal fees.   Mr. Sanchez told
                               - 149 -


Mr. DeCastro that Mr. Sims had no authority to enter into such a

settlement.64

     Mr. Sanchez promptly notified David Jordan (Mr. Jordan),

Acting Chief Counsel (National Office) of the basic facts

surrounding the Thompson settlement.     Mr. Jordan told Mr. Sanchez

that Chief Counsel attorneys in the Tax Litigation Division in

the National Office would be brought into the matter for two

reasons:   The gravity of the situation and the role of the Tax

Litigation Division in the National Office as the prime liaison

of the Internal Revenue Service with the Tax Court.    Mr. Jordan

and Mr. Sanchez agreed that the Tax Court had to be notified

immediately.

     Mr. Sanchez assigned Mr. Bakutes to investigate the matter

on behalf of Regional Counsel.    Mr. Bakutes spent several weeks

gathering facts, so that the matter could be reported to the Tax

Court.    Mr. Bakutes recognized that he needed to move quickly

because the period for appealing the decisions entered in the

Thompson cases would expire on June 11, 1992.




     64
        Mr. Sanchez believed that Mr. Sims was acting outside
the scope of his employment and authority when he deviated from
the terms of the official project settlement offer in the
Thompson cases, and when he purportedly used as a basis for
settlement a transaction (Bauspar) that had occurred in a tax
year over which he, as District Counsel, had no jurisdiction. We
observe that the Thompsons' participation in the Bauspar program
apparently originated in 1981--one of the years that the
Thompsons had pending before the Court--although the record does
not detail the deductions, if any, claimed by the Thompsons with
respect to the Bauspar program on their 1981 return.
                             - 150 -


     On May 29, 1992, Mr. Sims sent a letter to Mr. DeCastro

informing him that the Thompson settlement had been rejected by

Regional Counsel, stating in pertinent part as follows:

          As I'm sure you recall, on or about October, 1986,
     you approached Ken McWade of this office with an offer
     to settle * * * [the Thompson] cases based on the
     Government's then outstanding settlement position for
     the Kersting project. At that time, I informed you
     that, since the Thompsons' cases had been designated as
     test cases in the Kersting project litigation, I would
     not approve of any settlement of these cases prior to
     trial. Nonetheless, I represented to you that I would
     exert my personal best efforts to see that the
     Thompsons were not disadvantaged by my decision not to
     settle. I also advised you that I was not in a
     position to guarantee success inasmuch as approval of a
     higher authority might be required. Finally, I advised
     you that if the test case petitioners won, we would
     allow you to enjoy that result. I am certain that both
     you and I left with the clear understanding as a result
     of what I had said, the [sic] we remained adversaries
     with respect to the litigation.

Mr. Sims' letter further states that, absent an appeal, the

Internal Revenue Service would assess the full deficiencies in

the Thompson cases, consistent with the Court's Dixon II opinion,

plus all applicable statutory additions to tax.   The total

assessment, including interest, would have been $302,396.12.

     On June 1, 1992, Mr. Sims sent Mr. Sanchez a copy of

Mr. DeCastro's August 3, 1989 letter, signed by Mr. McWade,

acknowledging the second revision to the Thompson settlement.    On

June 2, 1992, Mr. Sanchez and Mr. Bakutes had a conference call

with Messrs. Sims, McWade, and DeCastro.   During the call,

Mr. DeCastro claimed that Mr. Thompson had a profit motive and

that Mr. Thompson's testimony was stronger on this point than

that of any of the other test case petitioners.   Mr. DeCastro
                              - 151 -


also denied that the Thompson settlement was attributable in any

way to the Thompsons' participation in the Bauspar program.

     On June 2, 1992, Mr. Bakutes directed Mr. Sims to send him

immediately the files in the Kersting test cases.

     Mr. Bakutes assigned Mr. Dombrowski to assist him in

formulating respondent's position with respect to the settlement

arrangement.   On June 3, 1992, Mr. Bakutes directed

Mr. Dombrowski to prepare motions to vacate the decisions in the

Thompson cases.

     On June 3, 1992, Mr. Li prepared a memorandum summarizing

his earlier conversations with Mr. Sims, stating in pertinent

part as follows:

     Per Bill Sims, the main reason for the lower deficiency
     to be assessed was that the Thompsons wanted to settle
     their case, based upon the then outstanding settlement
     offer prior to the trial of the test cases. Sims
     stated that because of the stipulations of settlement
     of tax shelter issues filed in the remaining non-test
     cases, Honolulu District Counsel felt settlement with
     the petitioners, as test cases, without trial was
     inappropriate.

     Bill then stated to me that also Mr. Thompson was taken
     by Mr. Kersting and that Mr. Thompson was considered a
     traitor by all of the other Kersting's investors.
     Mr. Thompson helped the government's case against
     Mr. Kersting promotion with his testimony about the
     Kersting promotion. Mr. Thompson was cooperative with
     District Counsel and therefore District Counsel will
     reduce the tax deficiency for all three years.

     On June 4, 1992, Mr. Sims informed Mr. Bakutes that "Except

for the Thompson and Cravens cases, neither Ken nor I entered

into any 'best of both worlds' settlements, agreements, or

understandings, oral or written, formal or informal, with any
                               - 152 -


taxpayer or taxpayer's representative in any Kersting project

case."

       On or about June 11, 1992, Mr. Sanchez decided that

Messrs. Sims and McWade should no longer have any authority over

the Kersting cases.    At that time, Mr. Bakutes reassigned all 14

test case dockets to Mr. Dombrowski, and all the nontest cases in

the Kersting project to Mr. O'Neill.      On June 12, 1992,

Mr. Sanchez informed Mr. Sims that he had withdrawn Mr. Sims'

delegation of authority to settle any matters relating to the

Kersting project, and that management of the Kersting project was

reassigned to Mr. Bakutes.

       While Mr. Bakutes was carrying out his orders from

Mr. Sanchez, Mr. Jordan directed two senior attorneys in the Tax

Litigation Division in the National Office, Thomas J. Kane

(Mr. Kane), and Steven M. Miller (Mr. Miller), to investigate the

Thompson settlement on behalf of the National Office.

       Messrs. Kane and Miller conducted in-house depositions and

interviewed various individuals who had participated in the test

case trial and the Thompson settlement.      Mr. Bakutes directed

Mr. Dombrowski to provide information to aid Messrs. Kane and

Miller in their investigation.

E.     Disclosure of Cravens Settlement

       The Cravens case for the 1980 taxable year was the only test

case that required a computation for entry of decision under Rule

155.    The computation was required in order to account for the

capital gain that the Cravenses had reported for 1980 on their
                               - 153 -


surrender of their shares in Candace.    An adjustment was also

required in order to eliminate respondent's alternative

determination that the Cravenses had unreported dividend income

for 1980.    The Cravens case was the only test case presenting

these two issues.

     On January 14, 1992, Mr. McWade forwarded a decision

document for the 1980 tax year to the Cravenses for their

signature.    The decision was formulated by reference to the Tax

Court's December 11, 1991, opinion, as well as respondent's

computation for entry of decision, together with a computation

statement explaining how the decision was reached.    Mr. O'Neill

prepared the aforementioned computations.    Mr. O'Neill was not

aware at the time that Mr. McWade had entered into an agreement

to settle the Cravens cases before trial.    The computation

statement accompanying respondent's computation for entry of

decision indicates that the proposed decision was based upon a

complete disallowance of the interest deductions listed in the

notice of deficiency issued to the Cravenses for 1980.

     On January 30, 1992, the Cravenses signed the decision

documents and returned them to Mr. McWade.    On February 4, 1992,

Mr. McWade signed the same documents and submitted them to the

Court.   On March 13, 1992, the Court entered decisions in the

Cravens cases as follows:
                               - 154 -


                                       Additions to Tax
                                  Sec.        Sec.       Sec.
Year         Deficiency         6653(a)    6653(a)(1) 6651(a)(1)

1979         $4,508.00          $225.40       ---           ---
1980          5,893.45           294.67       ---           ---

       The decisions entered in the Cravens cases did not

give effect to the settlement between Mr. Cravens and Mr. McWade.

Mr. Sims testified that he allowed the Court to enter decisions

in the Cravens cases for the full amount of the deficiencies as

computed by reference to the Court's opinion after the trial of

the test cases because he intended to honor his agreement with

the Cravenses by ensuring that a lower assessment would be

processed by the Appeals Office.

       Mr. Sims spoke to Mr. Cravens about the difference between

the numbers in his settlement agreement and the larger numbers in

the Rule 155 computation and the decision documents.    Mr. Sims

believed that Mr. Cravens understood that an assessment

consistent with his settlement would be made administratively.

However, when Messrs. Sims and McWade sent the Cravens cases to

the San Francisco Appeals Office for closing and assessment, they

did not request or instruct the Appeals Office to assess amounts

in accordance with the arrangement reached with Mr. Cravens in

December 1986.

       Shortly after Messrs. Sanchez and Bakutes discovered the

Thompson settlement, Messrs. Sims and McWade disclosed the

Cravens settlement to them.
                               - 155 -


F.   Respondent's Motions To Vacate

     On June 9, 1992, respondent filed motions for leave to file

motion to vacate the decisions that the Court had entered against

the Thompsons, the Cravenses, and Mr. Rina.   Respondent's motions

included allegations that, before the trial of the test cases,

Messrs. McWade and Sims had entered into contingent settlement

agreements with the Thompsons and the Cravenses that were not

disclosed to the Court or to the other test case petitioners or

their counsel.   Respondent requested the Court to conduct an

evidentiary hearing to determine whether the agreements with the

Thompsons and Cravenses had affected the trial of the test cases

or the opinion of the Court.

     On June 22, 1992, the Court granted respondent's motions to

vacate filed in the Thompson and Cravens cases, vacated the

decisions entered in those cases, and ordered the parties to file

agreed decisions with the Court, or otherwise move as

appropriate.   The Court denied respondent's request for an

evidentiary hearing.   Also on June 22, 1992, the Court denied

respondent's motion to vacate the decision entered against

Mr. Rina, stating:

          The Court has reviewed the testimony of Cravens,
     the testimony of Thompson, the stipulated facts and
     stipulated exhibits relating to the Cravenses and the
     Thompsons, and the exhibits offered through Thompson as
     a witness. The Court finds that these reviewed items
     had no material effect on the opinion which the Court
     filed on December 11, 1991, as that opinion relates to
     petitioner Rina. If the reviewed items were stricken
     from the record, the Court would file an opinion in all
     material respects like the opinion it filed on
     December 11, 1991 (with the exception of certain
                              - 156 -


     portions relating specifically and expressly to the
     Cravenses or the Thompsons), and the Court's findings,
     analyses, and conclusions relating to petitioner Rina
     would remain the same. * * *

G.   Attempted Discovery by Counsel for Nontest Case Petitioners

     By letters dated June 24 and August 12, 1992, Messrs. Jones

and O'Donnell jointly requested that Mr. Dombrowski provide

informal discovery regarding the Thompson and Cravens

settlements.   The earlier of the two letters included allegations

that Mr. Kersting withheld documents from the test case

petitioners that would have described "an underlying business of

great substance" because Mr. Kersting feared that the information

would increase his personal tax liability.   Respondent declined

to respond to the informal discovery requests and did not allow

Messrs. Jones and O'Donnell to participate in any of the in-house

investigations conducted by Messrs. Bakutes, Dombrowski, Kane,

and Miller.

H.   Closing of Thompson Cases/Further Refunds

     In July 1992, Mr. DeCastro filed a motion for entry of

decision in accordance with the terms of the Thompson settlement

set forth in Mr. DeCastro's letter to Mr. McWade dated August 3,

1989; i.e., deficiencies of zero, $15,000, and $15,000 for the

taxable years 1979, 1980, and 1981, respectively.   On August 20,

1992, respondent filed objections, with respondent's Motions for

Entry of Decision and respondent's Memoranda of Points and

Authorities, to Mr. DeCastro's motion for entry of decision.

Respondent's Motions for Entry of Decision described the facts
                                - 157 -


discovered by Messrs. Miller, Kane, and Dombrowski in their

investigation of the Thompson settlement.      Respondent alleged

that, sometime before the test case trial, Messrs. Sims and

McWade had agreed to settle the Thompson cases by reducing the

Thompsons' deficiencies in amounts sufficient to compensate the

Thompsons for their projected attorney's fees.      Respondent

alleged that this "New Agreement" was designed--and constituted

an agreement by Messrs. Sims and McWade--to pay Mr. DeCastro's

legal fees.   Respondent alleged that the "New Agreement" was

unauthorized and had no legal basis.      Consequently, respondent

asked the Court to enter decisions in the Thompson cases

consistent with the initial McWade-DeCastro agreement of December

1986, which had allowed the Thompsons a reduction of

approximately 19 percent of their deficiencies with the burnout

feature; i.e., deficiencies of zero, $34,425, and $30,000 for the

taxable years 1979, 1980, and 1981, respectively.

     On August 26, 1992, the Court granted Mr. DeCastro's motions

for entry of decision and entered decisions in the Thompson cases

as follows:

          Year       Deficiency       Additions to Tax

          1979           ---                  ---
          1980        $15,000                 ---
          1981         15,000                 ---

     In January 1993, respondent entered assessments against the

Thompsons for the taxable years 1979, 1980, and 1981 based upon

the decisions entered by the Court in August 1992.       Shortly

thereafter, the Thompsons received a refund check for $32,225,
                               - 158 -


dated February 19, 1993, which the Thompsons endorsed to DeCastro

Law Corp.

     The refund of $32,225 to the Thompsons was based upon the

conclusion that, as of December 30, 1986, when the Thompsons

first remitted a total of $59,545 as interest payments for the

years 1979, 1980, and 1981, the Thompsons' total tax liability

for those years, as reflected in the Court's decisions entered

on August 26, 1992, was approximately $57,500--comprising $30,000

in tax and $27,500 in interest.    Accordingly, the Thompsons'

December 1986 remittance of $59,545 resulted in an overpayment

of approximately $2,045.    In addition to this overpayment, on

June 17, 1987, the Thompsons had made an additional payment of

$62,225 towards their tax liability for 1979.    The $32,225 refund

paid to the Thompsons on February 19, 1993, represents the

difference between the Thompsons' $62,225 payment and the $30,000

refund that the Thompsons had previously received in July 1989.

     Following the receipt of the $32,225 refund, Mr. DeCastro

wrote to Mr. Dombrowski to complain that respondent had erred in

computing the amount of the Thompsons' overpayment.    After

review of the matter, Mr. Dombrowski prepared a memorandum to

Mr. Bakutes dated September 17, 1993, requesting approval to

process an additional refund to the Thompsons of approximately

$32,000.    Mr. Dombrowski stated that, in calculating the prior

refund of $32,225, respondent had erroneously treated the $62,225

payment that the Thompsons made in June 1987 as a cash bond

rather than an advance payment of tax.    Viewing the $62,225
                                - 159 -


payment as an advance payment of tax, Mr. Dombrowski concluded

that the Thompsons were entitled to interest on the resulting

overpayment.

     Mr. Bakutes approved Mr. Dombrowski's request.       Shortly

thereafter, Mr. Dombrowski requested the Fresno Appeals Office to

adjust the Thompsons' account, resulting in the Thompsons'

receipt of a third refund check, dated October 22, 1993, for

$32,116.68.

     In November 1993, the Thompsons received a fourth refund

check for $4,107.93 with respect to their overpayment for the

taxable years 1979, 1980, and 1981.       Presumably this check

reflected a refund of the overpayment of approximately $2,045

(with interest) that arose from the Thompsons' December 1986

payment of $59,545.

     In sum, the Thompsons were refunded $98,449.61 of the

$121,770 that they paid for the taxable years 1979, 1980, and

1981.   Of the $98,449.61 in refunds, the Thompsons assigned

$62,225 to DeCastro Law Corp.

     As mentioned supra note 2, the Court of Appeals for the

Ninth Circuit held that the Thompson decisions became final

pursuant to section 7481(a)(1), despite the attempts by Messrs.

Sticht and Izen to appeal those decisions on behalf of nontest

case petitioners who sought to intervene.
                                - 160 -


I.   Closing of Cravens Cases

     On July 1, 1992, Mr. Dombrowski wrote to the Cravenses

enclosing documents that were intended to enable them to

determine the proper decisions to be entered in their cases.

Mr. Dombrowski stated that, upon receipt of the Cravenses'

response, he would coordinate the matter with Mr. Bakutes to

determine the terms of agreed decisions that respondent would be

willing to submit to the Tax Court.       On July 3, 1992, Mr. Cravens

responded to Mr. Dombrowski's letter with a written chronology of

the events leading to the settlement of his cases in December

1986.

     On August 25, 1992, the Court entered agreed decisions in

the Cravens cases consistent with the proposed decisions that

Mr. McWade forwarded to the Cravenses in December 1988.      The

decisions provide that the Cravenses are liable for deficiencies

for the taxable years 1979 and 1980 in the amounts of $3,606.40

and $6,175.76, respectively, and that the Cravenses are not

liable for any additions to tax.    The decision for 1979 includes

a stipulation that the agreed deficiency does not take into

account advance payments in the amounts of $4,508 and $6,000 that

the Cravenses made in May 1983 and December 1986, respectively.

The decision for 1980 includes a stipulation that the agreed

deficiency does not take into account an advance payment in the

amount of $4,678.67 that the Cravenses made in December 1986.

     On October 26, 1992, the Regional Director of Appeals for

the Western Region wrote a memorandum to the San Francisco
                              - 161 -


Appeals Office requesting that the Cravens cases be closed in

accordance with special closing instructions.    The intent of

these instructions as stated in the memorandum was "to cause the

taxpayers' 1979 and 1980 accounts to zero out with no further

amounts due."   This was to be accomplished by adjusting the

interest that would otherwise have become due on the assessments

made in accordance with the stipulated decision previously

entered by the Tax Court on August 25, 1992.    The memorandum

explained the proposed interest adjustment as follows:

          The amount of interest being assessed has been
     adjusted because the decision document tendered to
     petitioners and subsequently filed with the Court in
     settlement of this case did not comport with District
     Counsel's 1986 settlement offer. The settlement offer
     provided that the first year deficiency would be
     shifted to the second year. Accordingly, there would
     have been no deficiency for 1979 and the deficiency for
     1980 would have been increased to $9,782 ($3,606 +
     $6,176). The amount of interest being assessed has
     been adjusted because this provision was not included
     in the decision documents and because the decision
     documents in this case were not promptly prepared and
     filed with the Tax Court in December 1986 when the case
     was settled. The balance of the adjustment relates to
     computational errors in District Counsel's original
     computation of the amounts due.

The authority stated in the memorandum for reducing the amounts

due from the Cravenses was section 6404(a)(1), relating to

excessive assessments, and section 6404(e)(1), relating to

abatement of interest.

     As mentioned supra note 2, the Court of Appeals for the

Ninth Circuit held that the Cravens decisions became final

pursuant to section 7481(a)(1), despite the attempts by Messrs.
                                - 162 -


Sticht and Izen to appeal those decisions on behalf of Kersting

project nontest case petitioners who sought to intervene.

            PROCEDURAL HISTORY OF EVIDENTIARY HEARING

I.   Developments Before Evidentiary Hearing

A.   Referral of Thompson and Cravens Settlements to Office of
     Inspector General

     When Mr. Sanchez learned of the Thompson and Cravens

settlements, he decided to refer the matters to the Department

of the Treasury, Office of the Inspector General (the OIG).65     On

June 30, 1992, Robert J. Wilson (Mr. Wilson), Special Litigation

Assistant, General Legal Services, Western Region, made a written

referral to the OIG.   In the referral, Mr. Wilson alleged that

Messrs. Sims and McWade had entered into undisclosed, contingent

settlements with the Thompsons and the Cravenses.    The referral

further alleged that the Thompsons' deficiencies had been reduced

to pay their attorney's fees.    Mr. Wilson's referral further

alleged that Messrs. Sims and McWade had grossly violated

procedures, and that Mr. McWade might have made false statements.

     Mr. Wilson served as the liaison between the Western

Regional Counsel's Office and the OIG.    Mr. Sanchez believed that

the Region's referral to the OIG ended his investigatory



     65
        The Office of the Inspector General (Dept. of the
Treasury) was established under the Inspector General Act
Amendments of 1988, Pub. L. 100-504, 102 Stat. 2515, codified as
amended at 5 U.S.C. app. at 1381 (1994). The Inspector General's
duties include the conduct, supervision, and coordination of
audits and investigations to prevent and/or detect fraud and
abuse in the Treasury Department and the reporting of possible
criminal violations to the Attorney General.
                                - 163 -


authority over the matter and that his only remaining

responsibility was to assist the OIG with its investigation.

     Upon receipt of the referral, OIG assigned Senior Special

Agent Leland D. Halleck (Mr. Halleck) to investigate the matter.

Mr. Sanchez directed Mr. Dombrowski to provide Mr. Halleck with

all documents in respondent's possession that Mr. Halleck might

request and to answer Mr. Halleck's questions.     As part of his

investigation, Mr. Halleck considered whether there had been any

bribery in violation of 18 U.S.C. section 201.     A violation of

this section had not been included in the Internal Revenue

Service referral but was added by the OIG.     Mr. Halleck was not

restricted from investigating any other possible violations

relating to the Thompson and Cravens settlements.

     Mr. Halleck interviewed Messrs. Sims and McWade in October

1992.     Messrs. Sims and McWade told Mr. Halleck that they would

not allow any of the Kersting test case petitioners to settle

because:     (1) They did not want the test case litigation

delayed;66 (2) they would have had to find replacement cases with


     66
        As indicated supra pp. 41-42, removal of the Thompson
and Cravens cases from the test case array in January 1987 would
not necessarily have caused a delay in the trial of the test
cases insofar as the Kersting programs in which the Thompsons and
Cravenses had participated during the years in issue were before
the Court in other test cases. On the other hand, removal of the
Cravens cases might have caused the remaining test case
petitioners to argue that the Cravens cases should be replaced
because Mr. Cravens was the only test case petitioner to report
capital gains upon the termination of his Kersting program. In
any event, the nearly 2-year delay in the trial of the test cases
after Chicoine and Hallett were allowed to file amendments to
petitions raising evidentiary issues provided ample time for
                                                   (continued...)
                               - 164 -


similar characteristics; and (3) they were concerned about the

possible effect on the other Kersting project cases.   The OIG

report includes Mr. Sims' affidavit, executed October 29, 1992,

which states that it was his recollection that the final version

of the Thompson settlement agreement was agreed to before the

trial of the test cases.   Mr. Sims' affidavit also includes the

following statement:   "I can recall numerous discussions with

McWade concerning our own trial strategy as well as discussions

concerning the anticipated strategies of both Izen and DeCastro,

but no discussions whatsoever concerning any ‘settlement’."

     On December 9, 1992, the OIG report prepared by Mr. Halleck

was completed.   The OIG report concluded that Messrs. Sims and

McWade had:   (1) Agreed to special arrangements with the

Thompsons and the Cravenses; and (2) provided a special

arrangement for the Thompsons designed to compensate them for

their attorney's fees.   Mr. Halleck concluded that Messrs. Sims

and McWade had not benefited financially or otherwise by agreeing

to the special arrangements.

     In Mr. Halleck's opinion, Messrs. Sims' and McWade's

agreement to arrange a refund to be used to pay the Thompsons'

legal fees violated 31 C.F.R. section 0.735.30(a)(5) (making a

decision outside of official channels).




     66
      (...continued)
Messrs. Sims and McWade to disclose the Thompson and Cravens
settlements to the Court and to reach agreement with test case
petitioners' counsel for selection of replacement cases.
                              - 165 -


B.   Revival of 7-Percent Settlement Offer

     In January 1993, Mr. O'Neill notified all known Kersting

nontest case petitioners that the Commissioner would settle their

cases on a basis "consistent with the original project settlement

offer that was extended to Kersting investors before the trial

of the test cases":   A 7-percent reduction of the deficiency,

elimination of all additions to tax, and interest imposed at the

normal rate prescribed in section 6621; the burnout feature was

not provided for.   The settlement offer, which was extended for

only 60 days, was accepted by a few Kersting petitioners.

C.   Disciplinary Actions

     On July 29, 1993, Mr. Sanchez sent Notices of Proposed

Disciplinary Action to Messrs. Sims and McWade.   The notices

asserted that Messrs. Sims and McWade had violated:

(1) Department of the Treasury Minimum Standards of Conduct,

section 0.735-30(a)(2) (an employee shall avoid any action which

might result in or create the appearance of giving preferential

treatment to any person); (2) Department of the Treasury Minimum

Standards of Conduct, section 0.735-30(a)(6) (an employee shall

avoid any action that might adversely affect the confidence of

the public in the integrity of the Government); and (3) Internal

Revenue Service Rule of Conduct 214.5 (an employee will not

intentionally make false or misleading verbal or written

statements in matters of official interest).   The notices

proposed to suspend both Messrs. Sims and McWade for 14 calendar

days without pay.
                              - 166 -


     Mr. Sanchez' Notices of Proposed Disciplinary Action to

Messrs. Sims and McWade listed the following reasons for the

proposed disciplinary actions:   (1) Negotiating an unauthorized

settlement agreement with the Thompsons; (2) basing the Thompson

settlement on unaudited and insufficiently documented losses from

an unrelated shelter; (3) allowing the Thompsons a settlement

that provided them more favorable treatment than other taxpayers;

(4) compensating the Thompsons for their attorney's fees; and (5)

not informing the Tax Court of the Thompson settlement

arrangements.

     Mr. Sims responded in writing to Mr. Sanchez on

September 14, 1993.   Nonetheless, Mr. Sanchez sustained the

Notice of Proposed Disciplinary Action issued to Mr. Sims.

     Mr. McWade retired from the Internal Revenue Service

effective October 2, 1993, rather than accept a transfer to the

Los Angeles District Counsel Office.    On November 2, 1993,

Mr. Jordan approved Mr. Sanchez' proposed disciplinary action.

Mr. Sims was suspended from duty without pay for 14 days and was

transferred to the San Francisco Regional Counsel Office, where

he was assigned nonsupervisory duties as a Special Litigation

Assistant in the General Litigation area.

D.   Indictment of Mr. Izen

     On May 3, 1995, following an investigation by the Criminal

Investigation Division of the Internal Revenue Service, a Federal

grand jury indicted Mr. Izen on four counts of conspiracy and

money laundering under 18 U.S.C. sections 371 and 1956(a)(3)(A)
                               - 167 -


and (B).   Approximately 1 year later, in May 1996, shortly before

commencement of the evidentiary hearing, the indictment was

dismissed.   Mr. Izen testified at the commencement of the

evidentiary hearing that the indictment had been a distraction

that made it difficult for him to prepare for the evidentiary

hearing, but that he had participated in discovery and was ready

to go forward and participate in the evidentiary hearing on

behalf of the test case petitioners.

E.   Pretrial Conference (July 1995)

     On July 17, 1995, the Court held a pretrial conference on

the record for the purpose of addressing various issues,

including the scheduling of the evidentiary hearing,

identification of the parties who would participate in the

evidentiary hearing, and scheduling of discovery.    The Court also

commented at the conference that the Thompson and Cravens

settlements appeared to share some characteristics with so-called

Mary Carter agreements.

     Respondent was represented at the conference by Mr. O'Neill

and Mr. Dombrowski.    During the conference, Mr. O'Neill

questioned whether Mr. Izen should be disqualified as counsel

because he would probably be called as a witness at the

evidentiary hearing.    During the conference, the Court questioned

whether Mr. Dombrowski should represent respondent at the
                              - 168 -


evidentiary hearing, in view of his participation as counsel in

the trial of the test cases.67

F.   Pretrial Conference (January 1996)

     On January 16, 1996, the Court held a second pretrial

conference on the record to obtain oral status reports from the

parties respecting discovery and the stipulation process, to

establish the format for the evidentiary hearing, and to discuss

possible conflicts of interest affecting counsel.68

Specifically, the Court and the parties discussed possible

conflicts of interest of Mr. Izen and Mr. DeCastro.

G.   Denial of Respondent's Motion To Disqualify Mr. Izen

     On February 12, 1996, respondent filed a motion to

disqualify Mr. Izen as counsel on the ground that he would be a

necessary witness at the evidentiary hearing.69   By order dated

April 1, 1996, the Court noted that, because Mr. Izen was likely

to testify at the evidentiary hearing, Mr. Izen's testimony might

in some sense prove to be adverse to the interests of his

clients.   With these concerns in mind, and relying on ABA Model


     67
        While both Messrs. Dombrowski and O'Neill testified at
the evidentiary hearing, neither of them served as respondent's
counsel at the evidentiary hearing.
     68
        By order dated May 2, 1996, the Court indicated that it
would defer ruling on the assignment of the burden of proof and
the standard of proof to be applied in these cases.
Nevertheless, the Court established a procedure for the orderly
presentation of evidence at the evidentiary hearing.
     69
        On Oct. 4, 1995, respondent had filed a motion to
disqualify Mr. Izen as counsel on similar grounds. By order
dated Oct. 17, 1995, the Court had denied respondent's motion
without prejudice to renew pending the completion of discovery.
                              - 169 -


Rules of Professional Conduct rules 1.7(b) and 3.7(a), the Court

directed Mr. Izen to contact each of his clients in writing and

to inform them of the potential for a conflict of interest and to

file a report with the Court revealing whether his clients

consented to his remaining as counsel.70   On April 22, 1996, Mr.

Izen filed a report with the Court, attaching thereto a copy of a

letter that he had written to each of his clients describing the

possible conflict of interest along with executed waivers signed

by his clients consenting to his continued representation of them

at the evidentiary hearing.   By order dated April 23, 1996, the

Court denied respondent's motion to disqualify Mr. Izen, citing

the consents of his clients to his continued representation of

them and the financial hardship that his disqualification would

impose on them.   In so doing, the Court rejected the suggestions

of Messrs. Sticht and Jones that Mr. Izen should associate

himself with additional counsel for the conduct of the

evidentiary hearing.




     70
        ABA Model Rules of Professional Conduct rule 1.7(b)
states in pertinent part that a lawyer shall not represent a
client if the representation may be materially limited by the
lawyer's own interests unless that lawyer reasonably believes the
representation will not be adversely affected and the client
consents after consultation. ABA Model Rules of Professional
Conduct rule 3.7(a) states in pertinent part that a lawyer
generally shall not act as advocate at a trial in which the
lawyer is likely to be a necessary witness. See Ewing v.
Commissioner, 91 T.C. 396, 397 n.2 (1988), affd. without
published opinion 940 F.2d 1534 (9th Cir. 1991); Para Techs.
Trust v. Commissioner, T.C. Memo. 1992-575.
                              - 170 -


H.   Mr. DeCastro's Withdrawal

     By order dated April 3, 1996, the Court directed

Mr. DeCastro to show cause why he should not be disqualified from

serving as counsel or otherwise representing the Thompsons at the

evidentiary hearing.71   On April 10, 1996, the Court received a

letter from Mr. DeCastro stating that he had withdrawn his

representation of the Thompsons and that they would retain

substitute counsel to represent them at the evidentiary hearing.

By order dated April 11, 1996, the Court discharged as moot its

order to show cause dated April 3, 1996.   Mr. Huestis entered his

appearance on behalf of the Thompsons at the evidentiary hearing.

I.   Discovery of Alexander Decisions and Referral to Office of
     Inspector General

     Shortly before commencement of the evidentiary hearing, the

parties discovered that decisions had been entered in the

Alexander cases eliminating their deficiencies for 1974, 1975,

1976, and 1977.72   On May 10, 1996, Martha Sullivan

(Ms. Sullivan), successor to Mr. Sanchez as Regional Counsel,

Western Region, referred the matter to the OIG.   The referral

questioned whether the Alexanders had received a beneficial



     71
        Again, the Court relied primarily upon ABA Model Rules
of Professional Conduct rules 1.7(b) and 3.7(a) as the bases for
its order.
     72
        It appears that the Alexander correspondence that had
been attached to Mr. McWade's motion to take Mr. Kersting's
deposition, filed in the test cases on Aug. 25, 1988, piqued
Mr. Sticht's curiosity and led him to request discovery of the
Alexander files of the Internal Revenue Service for the taxable
years 1974-77.
                              - 171 -


resolution of their tax cases that was inconsistent with the

settlements offered to other Kersting program participants.

     Ms. Sullivan's referral to the OIG was assigned to

Mr. Halleck.   On July 29, 1996, the OIG informed Ms. Sullivan

that the OIG would take no further action.   The stated grounds

were the expiration of the period of limitations for criminal

prosecution of any acts of wrongdoing by Messrs. Sims and McWade

and the OIG's prior investigation and report.

J.   Mr. Izen's Motion To Compel Production of Documents and
     Issuance of Protective Orders

     On April 26, 1996, the Court granted Mr. Izen leave to file

a Motion to Compel Answers to Deposition Questions and Production

of Documents.73   Mr. Izen argued that the Court should rule that

the crime-fraud exception to the attorney-client privilege

applies to these cases and that various witnesses, including

Messrs. Thompson, DeCastro, Sims, McWade, and a number of

additional Government attorneys, were barred from asserting

the attorney-client privilege in response to outstanding

discovery requests.74   The Court initially ordered respondent,

Mr. Thompson, and Mr. DeCastro to file responses to Mr. Izen's


     73
        Leave to file the motion to compel was necessary insofar
as the motion was filed beyond the Mar. 29, 1996, deadline for
completing discovery as set forth in the Court's order dated
Sept. 14, 1995, as amended by order dated Dec. 28, 1995.
     74
        The documents that the Government declined to produce
were listed in a privilege log and supplemental privilege log
that were attached to Mr. Sticht's Supplement to Petitioners'
Motion for Court Order Permitting Department of Treasury to
Disclose Information Pursuant to Privacy Act and Response to
Objections to Notice of Deposition filed Apr. 8, 1996.
                              - 172 -


motion attaching thereto any documents alleged to be privileged

for in camera inspection.   However, on May 6, 1996, Mr. Sticht

filed an objection to Mr. Izen's motion, arguing that it would be

inappropriate and potentially harmful to petitioners' cases for

the Court to review respondent's documents before the evidentiary

hearing, and that Mr. Izen's motion violated a private agreement

between Messrs. Izen and Sticht concerning discovery matters.

Mr. Sticht further stated that he could not support Mr. Izen's

motion insofar as it pertained to Messrs. Thompson, DeCastro, and

Huestis, without a privilege log describing the documents in

dispute.

     On May 6, 1996, the Court issued an order amending its prior

order directing respondent, Mr. Thompson, and Mr. DeCastro to

submit documents to the Court for in camera inspection.    On

May 9, 1996, the Court issued an order directing Messrs. DeCastro

and Huestis to appear at the call of the calendar at the

commencement of the evidentiary hearing and file with the Court

written responses to Mr. Izen's motion to compel and privilege

logs describing any disputed documents.   Messrs. DeCastro

and Huestis complied with the Court's order.   In addition,

Mr. Huestis filed motions to quash trial subpoenas duces tecum

that Mr. Sticht had served on Messrs. Thompson and Huestis.

     On May 15, 1996, pursuant to the Court's directive and in

response to trial subpoenas duces tecum that Mr. Sticht had

served on Mr. Huestis and Mr. Thompson, Mr. Huestis filed a

response, attaching thereto a privilege log.   On May 17, 1996,
                              - 173 -


Mr. Huestis filed a supplemental privilege log.   On May 24, 1996,

following an in camera review of the documents that Mr. Huestis

claimed were privileged, the Court ruled that the majority of the

documents in question were not protected from disclosure.     In

response to the Court's ruling, Mr. Huestis made an oral motion

for a protective order on behalf of Mr. Thompson requesting that

the parties maintain the confidentiality of all documents

identified in Mr. Huestis' privilege logs.   On June 10, 1996, the

Court issued an order granting Mr. Huestis' oral motion for

protective order.   In particular, the Court placed under seal

Exhibits 943-AMD through 975-ANJ, 978-ANM, and 979-ANN, and

directed the parties to maintain the confidentiality of the

documents.   By order dated June 26, 1996, the Court placed

additional exhibits under seal, including Exhibits 995-ANO

through 1015-AOI and 1018.   The Court's order also placed under

seal a relevance memorandum filed by Mr. Sticht on June 24, 1996.

The Court indicated that the affected parties would be given

notice and an opportunity to respond before the Court lifted its

protective orders with respect to these documents.75

K.   Burden of Proof and Rule 145 Order

     By order dated May 2, 1996, the Court announced that it

would defer ruling on assignment of the burden of proof and



     75
        By order dated Aug. 27, 1998, the Court directed the
parties to file reports with the Court stating in detail any
objection to the lifting of the Court's protective orders. As
discussed in greater detail below, the Court will lift its
protective orders dated June 10 and 26, 1996.
                              - 174 -


standard of proof to be applied with respect to the evidentiary

hearing.   Nevertheless, the Court prescribed a structure for the

orderly presentation of witnesses at the evidentiary hearing.    In

particular, consistent with the Court's view that respondent was

in the best position in the first instance to present the Court

with the facts critical to an understanding of the misconduct of

respondent's attorneys in the trial of the test cases, the Court

directed that respondent's case would be put on first.

Respondent's witnesses were to be called to testify in turn,

subjected to direct examination by respondent, and then passed to

Mr. Sticht, Mr. Izen, and Mr. Jones, respectively, for additional

direct or cross-examination.76   Following the examination of

respondent's witnesses, Mr. Sticht's remaining witnesses would be

called to testify in turn, subjected to direct examination by

Mr. Sticht, and then passed to respondent, Mr. Izen, and

Mr. Jones, respectively, for additional direct or cross-

examination.   This process would be repeated for Mr. Izen's and

Mr. Jones' witnesses.

     In the same order, the Court invoked Rule 145, which

provides that, on the Court's own motion, the Court may order

witnesses excluded from the courtroom so that they cannot hear




     76
        Because each of the parties listed many of the same
witnesses in their trial memoranda, the Court ruled that those
witnesses would be subjected to direct examination by each
party’s counsel who had listed the witness in his trial
memorandum, regardless of the order in which the witness was
passed to the party.
                                - 175 -


the testimony of other witnesses.77       The Court further directed

that any witness testifying at the evidentiary hearing would be

precluded from discussing his or her testimony with any other

witness or providing any other witness with a transcript of his

testimony.

II.   The Evidentiary Hearing

      The evidentiary hearing in these cases was conducted in

Los Angeles on May 13 to 30, 1996, June 10 to 26, 1996, and

August 18, 1997.    The Court heard testimony from 29 witnesses

during the evidentiary hearing and received approximately 500

exhibits.    The transcripts of the proceedings consist of more

than 6,700 pages.    In addition, between May 13, 1996, and

October 6, 1997, the parties filed with the Court a stipulation

of facts and first through sixth supplemental stipulations of

facts.




      77
        Rule 145(a) is designed to prevent witnesses from
tailoring their testimony to that of prior witnesses and to
minimize altered testimony. See Thompson v. Commissioner, 92
T.C. 486, 494 (1989).
                               - 176 -


A.   Testimony78

     1.    Mr. Cravens

     Mr. Cravens appeared at the evidentiary hearing and

confirmed and expressly adopted every aspect of his prior

testimony at the Dixon II trial.   Mr. Cravens testified that he

did not intend to have a secret settlement, that he did not

change his testimony at the original trial even though he had

settled his case, that he would not have "sold out" the other

pilots for money or a greater settlement offer, and that he had

no disputes with Mr. Kersting when he testified at the original

trial.    Mr. Cravens testified that his testimony at the trial of

the test cases was incomplete insofar as he had failed to testify

that he believed that the promissory notes that he had signed

were valid and enforceable.

     Mr. Cravens testified that he did not keep the fact that he

had settled his case a secret before the trial of the test cases.

He discussed his settlement with Mr. Kersting several times



     78
        The following summaries of the testimony of various
witnesses at the evidentiary hearing are provided for the sake of
convenience and are not part of the Court's findings of fact.
Also, these summaries do not cover the testimony of all witnesses
who testified at the evidentiary hearing.

     On the basis of our observations at trial and our review
of the record, we conclude that the testimony of Messrs. Sims
and McWade lacks credibility, particularly their testimony
regarding the reasons for and circumstances surrounding the
Thompson and Cravens settlements and the Alexander understanding.
Mr. Alexander's testimony lacks credibility because of its
evasiveness, particularly his misleading response at the original
trial concerning his understanding with Mr. McWade regarding
reduction of the Alexanders' tax liabilities. See supra note 58.
                               - 177 -


before the trial.    Mr. Kersting was concerned that Mr. Cravens'

settlement would affect his testimony.   Mr. Cravens told

Mr. DeCastro that he was representing himself at the trial

because he had settled and did not need to incur the legal

expense.   Mr. Cravens was uncertain whether he informed Mr. Izen

of his settlement.

     Mr. Cravens understood that he would testify at the trial of

the test cases "that I sold the stock and received a profit off

the stock, and * * * that I paid taxes on the sale of the stock."

These are the two reasons he recalls being selected as a test

case by Mr. Seery.   Mr. Cravens assured Mr. Kersting that he was

going to testify truthfully regardless of his settlement.

      Between the time of his December 1986 settlement and the

trial of the test cases in January 1989, Mr. Cravens received

"reams of documents" relating to the trial that he paid no

attention to and did not question.   Before the trial of the test

cases, Mr. Cravens did not know the identities of the remaining

test case petitioners.   Mr. Cravens had never met any of the

other test case petitioners, and he never participated in any

joint strategy sessions to prepare for trial.   Mr. Cravens did

not understand the difference between being a witness and

allowing his case to serve as a test case.

     Upon his arrival in Hawaii, Mr. Cravens met Mr. McWade in

person for the first time.   Until Mr. Cravens arrived at the

trial, he was not sure of his exact role in the process, although

he believed that his testimony would be very important to the
                               - 178 -


outcome.   Mr. Cravens became surprised and suspicious when

Mr. McWade told him that he would receive a refund of the money

he had paid pursuant to his settlement if the petitioners in test

cases prevailed at trial.    Mr. Cravens was not prepared for this

"change" in his settlement.   Mr. Cravens asked Mr. McWade about

the change, but did not get a satisfactory answer.   Mr. Cravens

had the impression that Mr. McWade did not want to discuss the

subject.   Mr. Cravens denied that he had an added incentive to

testify at the trial because he was told he could get his money

back if the taxpayers won.    He thought that all he could do was

testify truthfully to the matters that had caused his case to be

selected as a test case.

     Mr. Cravens recalled that Mr. DeCastro's demeanor outside

the courtroom was "very anti-taxpayer * * * at least Kersting

taxpayers."   Mr. Cravens had lunch with Mr. McWade and a group of

other persons before testifying at the trial of the test cases.

The group did not discuss Mr. Cravens' testimony during lunch.

After lunch, Mr. McWade informed Mr. Cravens that he would have

to make a statement to the Court because he was not represented

by an attorney who could ask him questions.   Mr. McWade did not

tell Mr. Cravens what to say in his statement to the Court, or

how to respond to Mr. McWade's questions.

     2.    Mr. Thompson

     Mr. Thompson appeared at the evidentiary hearing and

testified that he retained Mr. DeCastro to negotiate a settlement

in his tax cases and that it was his understanding in December
                               - 179 -


1986 that his cases were settled for a fixed amount although he

would receive a refund if the test case petitioners prevailed at

trial.    Mr. Thompson further testified that, by virtue of his

settlement, he had informed Mr. DeCastro that he would not pay

attorney's fees for representation at the trial of the test

cases.

     Mr. Thompson testified that the testimony that he provided

at the trial of the test cases was completely truthful, that his

testimony was not coached by either Mr. DeCastro or Mr. McWade,

and that he wanted to testify in part to influence Mr. Kersting

to withdraw his threats.    Mr. Thompson testified that the $80,000

Bauspar loss that he mentioned in his testimony at the trial of

the test cases was not an out-of-pocket loss but the loss of the

returns he expected as a result of his participation in the

Bauspar program.

     3.     Mr. Alexander

     Mr. Alexander appeared at the evidentiary hearing only after

Mr. Sticht made several unsuccessful attempts to serve him with a

subpoena.    Mr. Alexander's credibility as a witness at the

evidentiary hearing was severely impaired by his evasive

testimony and total lack of recall of the circumstances that led

to the decisions eliminating his tax liabilities for 1974, 1975,

1976, and 1977.    Mr. Alexander testified that he did not receive

a "finder's fee" for the information or assistance that he

provided to Mr. McWade during the trial of the test cases, nor

would he admit that he had arrived at an understanding with
                                - 180 -


Mr. McWade for any reduction of the tax liabilities on his joint

returns for the years 1974, 1975, 1976, and 1977.

     4.     Mr. McWade

     Mr. McWade appeared at the evidentiary hearing and testified

that, when settlement discussions first arose in the Thompson

and Cravens cases, he believed he had a problem with conflicting

Government policies.     In particular, Mr. McWade testified that

while he was obliged by Internal Revenue Service policy to treat

similarly situated taxpayers alike, the Internal Revenue Service

also had a policy against settling test cases.79    Mr. McWade did

not confer with anyone in the National Office or the Regional

Counsel's office regarding resolution of the conflict that he

perceived; Mr. Sims was the only person with whom Mr. McWade

discussed the alleged conflicting policies.    Mr. McWade did not

feel any obligation to coordinate the Thompson settlement

arrangement with the National Office or Regional Counsel because

he had discussed the arrangements with Mr. Sims.

     Mr. McWade testified that the Thompson settlement was

revised in the summer of 1989 in order to dispose of the Bauspar

issue.    Mr. McWade denied that the Thompson settlement was

revised to provide a means for the Thompsons to pay

Mr. DeCastro's attorney's fees.




     79
        Contrary to Mr. McWade's testimony, we found that the
Internal Revenue Service did not maintain a policy prohibiting
the settlement of a test case. See supra p. 76.
                              - 181 -


     Mr. McWade initially testified that he informed Messrs.

Dombrowski and Hatfield about the Thompson and Cravens settlement

agreements before the trial of the test cases.   However,

Mr. McWade later testified that he may have not informed Messrs.

Dombrowski and Hatfield of the agreements.   Mr. McWade testified

that he had no recollection that he had informed Mr. O'Neill

about the Thompson and Cravens settlement agreements.80

     Mr. McWade denied offering Mr. Alexander any inducements to

either cooperate with the Government or testify at the trial of

the test cases.   Mr. McWade acknowledged that Mr. Alexander

provided assistance to him in understanding certain aspects of

the Kersting programs during the trial of the test cases.

Mr. McWade did not provide the Court with any credible

explanation or justification of the decisions entered in the

Alexander cases for the taxable years 1974 through 1977, which

completely wiped out the deficiencies previously determined on

the statutory notices.81

     Mr. McWade denied that Mr. DeCastro passed information to

him regarding Mr. Izen's trial strategy or that Mr. DeCastro




     80
        Messrs. Dombrowski, Hatfield, and O'Neill denied having
any knowledge of the Thompson and Cravens settlements before
their discovery in 1992.
     81
        Contrary to the Court's Dixon II opinion, the decisions
in the Alexander cases for 1974 and 1975 reflected overpayments
of $2,133 and $811, respectively, while the decisions in the
Alexander cases for 1976 and 1977 reflected no deficiencies. See
supra pp. 112-115.
                              - 182 -


otherwise acted as a "mole" or "plant" for respondent with

respect to the Kersting test cases.

     5.    Mr. Sims

     Mr. Sims testified that he approved the Thompson and Cravens

settlements with the understanding that he would do his best to

process the proposed decisions but that he did not guarantee the

outcome.   Mr. Sims testified that Mr. McWade's letters to

Mr. DeCastro stating that the decisions would be filed with the

Court later indicate that Mr. McWade misunderstood Mr. Sims'

intentions.   Mr. Sims further testified that decisions could not

be entered in the Thompson and Cravens cases before the trial

of the test cases out of concern that taxpayers who had signed

piggyback agreements would argue that they were entitled to

similar settlements.   Mr. Sims characterized as an oversight his

approval of Mr. McWade's decision to forward decision documents

to the Cravenses for their signature 1 month before trial of the

test cases.

     With regard to the Thompson settlement, Mr. Sims testified

that he felt it was important to keep Mr. DeCastro in the case

because, unlike Mr. Izen, Mr. DeCastro was not being paid by

Mr. Kersting.   However, Mr. Sims testified that he was aware, as

early as December 1986, that Mr. DeCastro did not believe that

Kersting interest deductions could be defended in court.

Mr. Sims further testified that he felt sympathy for Mr. Thompson

because of Mr. Kersting's threats and that he suggested that

Mr. Thompson's participation in the Bauspar program could be used
                             - 183 -


to offset or reduce the Thompsons' tax liability.   Mr. Sims was

unable to confirm that he reviewed Mr. Thompson's Bauspar records

as a basis for revising the Thompson settlement agreement.

Mr. Sims testified that he and Mr. McWade had reached an

agreement in principle with Mr. DeCastro before the trial of the

test cases to further reduce the Thompsons' tax liabilities.

     Mr. Sims testified that he did not know the basis upon which

the Alexander cases were settled and that he never discussed the

settlements with either Mr. McWade or Mr. Alexander.

     Mr. Sims denied that Mr. DeCastro passed information to the

Government regarding Mr. Izen's trial strategy or that

Mr. DeCastro otherwise acted as a "mole" or "plant" for

respondent with respect to the Kersting test cases.

     6.    Mr. DeCastro

     Mr. DeCastro testified that the settlement agreement that he

negotiated with Mr. McWade assured the Thompsons of the better of

the pretrial settlement or the outcome in the trial of the test

cases and that the agreement was not contingent on Mr. Sims' best

efforts.

     Mr. DeCastro testified that the final revision to the

Thompson settlement was agreed to before the trial of the test

cases, that the revision was made to account for the attorney's

fees that Mr. Thompson would incur in the trial of the test

cases, and that Mr. Thompson's participation in the Bauspar

program was not the basis for the revision.
                              - 184 -


     Mr. DeCastro testified that Mr. McWade considered various

elements in negotiating settlements in Kersting cases, including

the level of the taxpayer's participation in the Kersting

programs and whether the taxpayer had escaped liability in other

years by virtue of the expiration of the period of limitations.

     Mr. DeCastro denied passing any information to

Messrs. McWade or Sims regarding Mr. Izen's trial strategy or

that he otherwise acted as a "mole" or "plant" for respondent

with respect to the Kersting test cases.

     7.    Mr. Izen

     Mr. Izen was the first witness to testify at the evidentiary

hearing.

     Mr. Izen testified that he had several discussions with

Mr. DeCastro, beginning with Mr. Kersting's deposition in October

1988 through the eve of the trial of the test cases, during which

he revealed his trial strategy to Mr. DeCastro.   Mr. Izen

testified that he attempted to "enlighten" Mr. DeCastro, who was

openly pessimistic regarding the chances for success in the trial

of the test cases.

     Mr. Izen testified that Mr. DeCastro was upset on the eve of

trial of the test cases that all documentation needed to support

the test case petitioners' position had not been made available

to petitioners.   Mr. Izen testified that he did not serve a

subpoena on Mr. Kersting before the trial of the test cases

because he had relied upon the subpoena that Mr. McWade had

served on Mr. Kersting.
                              - 185 -


     Mr. Izen testified that he met Mr. DeCastro, with

Mr. Hongsermeier and Mr. Bradt, in a hotel room on the eve of

trial of the test cases.   Mr. Izen testified that he discussed

confidential matters with Mr. Hongsermeier in Mr. DeCastro's

presence that he would not have revealed to Mr. DeCastro had he

known of the settlement that Mr. DeCastro had negotiated on

behalf of the Thompsons.   Mr. Izen testified that he was aware

that respondent planned to rely on the so-called comfort letters

at the trial of the test cases, inasmuch as some of the letters

were included in stipulations of fact filed with the Court, and

that he informed Mr. DeCastro that he would offer evidence of

collection actions brought by various Kersting companies against

Kersting program participants to counter the comfort letters.

     Mr. Izen testified that Mr. DeCastro grabbed notes out of

his hand during the trial of the test cases, that Mr. DeCastro

was in a position to overhear Mr. Izen's conversations with his

witnesses during the trial of the test cases, and that Mr. Izen

observed Mr. DeCastro conducting a "private" conversation with

Mr. McWade during the trial of the test cases.   Mr. Izen

testified that his allegations in oral argument before the Court

of Appeals for the Ninth Circuit in the DuFresne appeal that

Mr. DeCastro was a "mole" or "plant" for respondent during the

trial of the test cases were not based upon personal knowledge

but that Mr. Izen only wanted the opportunity to prove the point.

Mr. Izen did not provide any further evidence that Mr. DeCastro
                                  - 186 -


was a mole or plant who passed Mr. Izen's trial strategy to

Messrs. Sims or McWade.

     Mr. Izen denied having personal knowledge, at the time that

Messrs. Thompson and Cravens testified at the trial of the test

cases, that Messrs. Thompson and Cravens had entered into

settlement agreements with Mr. McWade.

B.   Mr. Sticht's Allegations of Potential Witness Intimidation

     During the evidentiary hearing, following the testimony of

Lois Fisher (Ms. Fisher) on June 12, 1996, Mr. Sticht made the

following statement to the Court:

          But if there's any intention to obstruct or
     interfere with the presentation of any of my clients'
     cases in this trial, in this courtroom, or even to
     interfere with their presentation by outside
     harassment, intimidation or other means that are
     normally used to influence or attempt to influence the
     independent presentation of the case in any trial, and
     I want to go on record today, stating that I reserve
     the right to revisit this day in much the same way that
     has been alleged in the past with respect to the 1989
     trial.

                    *     *   *     *   *   *   *

          So, I will also state to the Court, along these
     lines, and I use Ms. Fisher as the segue to this final
     point, that at least two, possibly three of my clients,
     have received what I believe are properly characterized
     as potential intimidation for their presentation of
     this case. Now, that is something I'm going to leave
     at that point, without specifics and details, today.

Following Mr. Sticht's remarks, the Court stated that, while the

Court would respect Mr. Sticht's request not to pursue the matter

immediately, Mr. Sticht was "obligated to put it to rest or to

present it in a way that will enable it to be resolved".

Mr. Sticht did not return to the subject of potential witness
                              - 187 -


intimidation during the remainder of the evidentiary hearing,

which, as described below, eventually led to a further

evidentiary hearing held on August 18, 1997.

C.   Mr. Bradt's June 12, 1996, Letter to Mr. Kersting

     Mr. Bradt first testified at the evidentiary hearing on

June 10, 1996.   Mr. Bradt testified that he had no direct

knowledge that Mr. DeCastro passed Mr. Izen's trial strategy to

Mr. McWade, but that he suspected the same by virtue of

Mr. McWade's opposition to Mr. Izen's efforts to introduce

evidence concerning collection litigation through Mr. Moseley.

See supra pp. 135-136.

     Mr. Jones recalled Mr. Bradt to testify on June 14, 1996,

for the purpose of rebutting testimony by Mr. O'Neill on the

propriety of the summons issued by respondent to Mr. Kersting in

1987.   During Mr. Sticht's examination of Mr. Bradt, Mr. Sticht

offered into evidence a one-page facsimile of a letter that Mr.

Bradt had sent Mr. Kersting in Hawaii at 10:15 a.m. on June 12,

1996, which apparently was then inadvertently forwarded by

Mr. Kersting's secretary to Mr. Sticht's office in Los Angeles

at 10:52 a.m. on the same day.    Mr. Bradt's letter includes a

discussion of testimony presented by Mr. Sticht's witness,

Ms. Fisher, on June 10 and 11, 1996, and testimony presented by

Mr. O'Neill.   Mr. Bradt's letter refers to a letter that

Mr. Sticht wrote to Ms. Fisher.    Mr. Bradt's letter also includes

disparaging remarks regarding Mr. Sticht's trial strategy and

tactics.
                                - 188 -


     Mr. Bradt asserted that his letter to Mr. Kersting was

subject to the attorney-client privilege.    Mr. Bradt declined to

disclose how he had obtained a copy of Mr. Sticht's letter to

Ms. Fisher.

     Pursuant to the Court's order excluding witnesses from the

courtroom, Mr. Bradt had not been in the courtroom when either

Ms. Fisher or Mr. O'Neill had testified.82 Mr. Izen admitted that

he had disclosed Ms. Fisher's testimony to Mr. Bradt so that he

could prepare Mr. Kersting to testify in rebuttal of Ms. Fisher's

testimony.    Similarly, Mr. Jones admitted that he had disclosed

Mr. O'Neill's testimony to Mr. Bradt in order to prepare Mr.

Bradt to testify in rebuttal.    Mr. Sticht suggested that Mr.

Bradt's letter would tend to inflame Mr. Kersting against Ms.

Fisher.83


     82
        The Court had ruled that Mr. Bradt would not be allowed
in the courtroom until Mr. Kersting had testified.
     83
        Mr. Sticht's receipt and disclosure to the Court of
Mr. Bradt's letter to Mr. Kersting raise interesting questions
concerning the professional responsibilities of attorneys.
Compare Committee on Professional Responsibility, Ethical
Obligations Arising Out of an Attorney's Receipt of Inadvertently
Disclosed Information, 50 The Record of the Association of the
Bar of the City of New York 660 (1995), with Committee on
Professional Responsibility, The Attorney's Duties to Report the
Misconduct of Other Attorneys and to Report Fraud on a Tribunal,
47 The Record of the Association of the Bar of the City of New
York 905 (1992). The disclosures by Messrs. Izen and Jones that
were prompted by the introduction of Mr. Bradt's letter also
raise questions of possible conflict between the operation of
Rule 145 and the need to prepare a witness to testify and bring
documents in response to a subpoena duces tecum. Compare Berry
Petroleum Co. v. Commissioner, 104 T.C. 584, 609-611 (1995),
affd. on other issues without published opinion 142 F.3d 442 (9th
Cir. 1998), with Smith v. Commissioner, 92 T.C. 1349 (1989), and
                                                   (continued...)
                              - 189 -


D.   Denial of Mr. Izen's Motion To Refer Thompson and Cravens
     Settlements and Alexander Agreement to Department of Justice
     (Public Integrity Section)

     On June 26, 1996, Mr. Izen filed a Motion to Refer the

Thompson and Cravens Settlements and the Alexander Agreement to

the Department of Justice (Public Integrity Section) for

prosecution.   Mr. Izen identified approximately 17 alleged crimes

associated with the Thompson and Cravens settlements and the

Alexander understanding and asked the Court to refer those

matters to the Department of Justice for prosecution.    By order

dated June 26, 1996, the Court denied Mr. Izen's motion.

III. Developments Following Initial Evidentiary Hearing

A.   Denial of Respondent's Motion for Further Hearing Regarding
     Potential Witness Intimidation

     On October 28, 1996, after completion of the bulk of the

evidentiary hearing, respondent filed a motion to take additional

evidence concerning Mr. Sticht's unresolved allegations at the

evidentiary hearing of potential witness intimidation.    During

this same period, the parties filed with the Court third, fourth,

and fifth supplemental stipulations of facts that did not comply

with the Court's Rules concerning stipulations and amounted to

little more than a proffer of documents subject to an extensive

list of objections.




     83
      (...continued)
Thompson v. Commissioner, 92 T.C. 486 (1989). None of these
questions have been resolved; they became moot with respect to
Mr. Kersting and Mr. Bradt by reason of Mr. Kersting's failure to
testify at the evidentiary hearing.
                              - 190 -


     In a response to respondent's motion, Mr. Sticht alleged

(and the record now shows) that Mr. Sticht's clients received

unsolicited phone calls and written communications from

Mr. Kersting and from Joseph A. Peterman (Mr. Peterman), a

Kersting program participant and nontest case petitioner,84

throughout these proceedings encouraging them to ask Mr. Sticht

to cooperate and otherwise present a unified case with the test

case and nontest case petitioners represented by Messrs. Izen and

Jones, promising financial assistance in the form of

disbursements from a "legal defense fund" in exchange for such

cooperation, and ridiculing Mr. Sticht's representation of his

clients.85

     On January 30, 1997, the Court issued an order denying

respondent's motion.   Although the Court expressed concern over

Mr. Sticht's allegations, the Court was not persuaded that the

activities in question satisfied the legal definition of witness

intimidation.   See, e.g., Griffith v. Commissioner, T.C. Memo.



     84
        Mr. Peterman currently has eight cases docketed with
the Court all of which appear to involve Kersting adjustments:
docket Nos. 1676-84, 36324-85, 19467-86, 23493-90, 12628-91,
7155-92, 15005-93, and 3029-94. Mr. Peterman executed piggyback
agreements in the first five dockets listed above.
     85
        Mr. Kersting's various letters to Mr. Sticht's clients
are included within the exhibits associated with the parties'
fourth supplemental stipulations of facts, filed Nov. 27, 1996.

     On Aug. 11 and Aug. 18, 1997, Mr. Sticht filed a Status
Report and a First Supplemental Status Report, respectively,
attaching thereto copies of letters, some of which contain
obscene and inflammatory statements, that Mr. Peterman had sent
to Mr. Sticht and his clients.
                              - 191 -


1988-123; see also United States v. Thompson, 76 F.3d 442, 452-

453 (2d Cir. 1996); United States v. Elwell, 984 F.2d 1289, 1293-

1294 (1st Cir. 1993).   Nevertheless, the Court directed

Mr. Sticht to file a report with the Court identifying any of his

witnesses who may have declined to testify at the evidentiary

hearing, including a brief summary of the testimony that such

witnesses were expected to provide, with a view to arriving at an

agreement among the parties to stipulate such testimony or, if

that should not be possible, to having a further hearing to

receive such testimony.   The Court further directed the parties

to cooperate in the elimination of the various objections

associated with the fourth and fifth supplemental stipulations of

facts.

     Mr. Sticht subsequently filed a report with the Court

identifying Mr. Kersting, Richard B. Rogers (Mr. Rogers), and

JoAnne Rinaldi (Ms. Rinaldi) as persons who were scheduled to,

but did not, testify at the evidentiary hearing and providing a

summary of the testimony expected from each witness.   At

approximately the same time, respondent filed a response with the

Court stating that the parties were unable to eliminate many of

the objections raised with respect to the documents attached to

the parties' fourth and fifth supplemental stipulations of facts.

     With a view to completing the record in these cases, the

Court ordered a further evidentiary hearing for the purpose of

receiving the testimony of Mr. Kersting and Ms. Rinaldi.    It was

hoped that Mr. Kersting's testimony would eliminate some or all
                                - 192 -


of the parties' objections to the documents attached to the

parties' fourth and fifth stipulations of fact, and that having

Ms. Rinaldi testify would complete the record insofar as she

might have declined to testify at the initial evidentiary hearing

because of perceived intimidation.    However, the Court rejected

Mr. Sticht's request to call Mr. Rogers to testify on the grounds

that:     (1) Mr. Rogers' testimony was not related to the documents

attached to the parties' fourth and fifth stipulations of fact;

(2) there was no indication that Mr. Rogers had declined to

testify during the initial evidentiary hearing because of

perceived intimidation;86 and (3) Mr. Sticht's proffer of

Mr. Rogers' testimony revealed that the testimony, which

primarily concerned the First Savings acquisition, would amount

to an attempt to retry the Dixon test cases on the merits or

would concern a transaction that was not in issue in the trial of

the test cases.

B.   Supplemental Evidentiary Hearing (August 18, 1997)

     On July 24, 1997, Mr. Kersting filed a Motion for Protection

or to Quash asserting that the supplemental evidentiary hearing

and production of the documents identified in the subpoena that

Mr. Sticht had served on him in May 1996 (before the initial

evidentiary hearing) would amount to an attempt to retry the



     86
        On June 17, 1997, at the initial evidentiary hearing,
Mr. Sticht stated on the record that he was reconsidering whether
Mr. Rogers' testimony was necessary in light of other evidence
already in the record.
                              - 193 -


test cases.   By order dated July 25, 1997, the Court denied

Mr. Kersting's motion as moot on the ground that Mr. Sticht's

subpoena had expired on June 26, 1996--the date of adjournment of

the original evidentiary hearing.

      Mr. Sticht was unable to locate Mr. Kersting for purposes

of service of a new subpoena directing him to appear and testify

at the evidentiary hearing.   Nevertheless, on August 7, 1997,

Mr. Kersting filed a Second Motion for Protection or to Quash

Subpoena asserting that he was too ill to travel from Hawaii to

Los Angeles for the evidentiary hearing because of recent cancer

surgery.   Because Mr. Kersting did not appear at the supplemental

evidentiary hearing, the Court later denied Mr. Kersting's motion

as moot.

     On August 18, 1997, the Court conducted a supplemental

evidentiary hearing in these cases in Los Angeles.    Ms. Rinaldi

was the sole witness at the supplemental evidentiary hearing.

Ms. Rinaldi testified that she participated in the Kersting

programs during the taxable years 1980 and 1983-91 with her

husband, a flight engineer for American Airlines, with a view

towards profiting as a stock holder and for the tax benefits.87

Ms. Rinaldi testified that she believed that Kersting promissory

notes were enforceable against her.     Ms. Rinaldi testified that

she relied upon and was assured by the various "Dear Friend"

letters that Mr. Kersting sent to her during the period 1981 to


     87
        Ms. Rinaldi testified that she legally separated from
her husband in 1994.
                               - 194 -


1992.   Ms. Rinaldi did not consult with a certified public

accountant regarding her tax liability until after the Court

released its opinion in Dixon II.

C.   Denial of Mr. Izen's Motion To Compel Production of
     Documents

     On August 29, 1997, Mr. Izen submitted to the Court a

document that the Court filed as a supplement to Mr. Izen's

motion to compel filed April 26, 1996.    Relying on a recent case,

In re Grand Jury Subpoena Duces Tecum, 112 F.3d 910 (8th Cir.

1997), Mr. Izen argued that respondent could not rely upon the

attorney-client privilege, executive privilege, or the attorney

work product doctrine in these cases as bases for refusing to

disclose documents.

     By order dated September 4, 1997, the Court denied

Mr. Izen's motion to compel.   The Court denied Mr. Izen's motion

as moot insofar as Mr. Izen sought to compel the testimony of

Messrs. Thompson, DeCastro, Sims, and McWade, and to compel

Messrs. Thompson and DeCastro to produce documents.    In so

ruling, the Court noted that Mr. Thompson had waived the

attorney-client privilege, produced the documents requested in

discovery, and testified at the evidentiary hearing.     In

addition, the Court had heard testimony from Messrs. DeCastro,

Sims, McWade, and additional Government witnesses.    Further, the

Court denied Mr. Izen's motion insofar as Mr. Izen moved to

compel respondent to produce documents.   Specifically, although

the Court declined to decide whether the admitted Government
                              - 195 -


misconduct in the presentation and trial of the test cases in

Dixon v. Commissioner, docket No. 9382-83, et al., amounted to

fraudulent or criminal conduct, the Court did conclude that the

disputed documents did not contain material subject to the crime-

fraud exception, i.e., legal advice obtained in the furtherance

or in aid of a future fraudulent scheme or criminal activity.

Moreover, the Court rejected Mr. Izen's contention that

respondent's activities since May 1992 amounted to an effort to

"cover up" what Mr. Izen alleged to be fraudulent or criminal

conduct.   On the basis of a review of respondent's privilege log

and supplemental privilege log, the Court held that the documents

described therein qualified for protection from disclosure

pursuant to the corresponding privilege(s) relied upon by

respondent.

D.   Denial of Mr. Sticht's Motion To Reopen Record

     On October 10, 1997, Mr. Sticht filed a Motion to Reopen

the Record seeking to submit to the Court a written offer of

proof comprising a written declaration by Mr. Rogers, a nontest

case petitioner, along with numerous documents that purport to

describe some connection or link between the series of

transactions underlying Mr. Rogers' participation in the First

Savings acquisition and his related participation in the

Investors Financial stock purchase plan.   Mr. Sticht's motion

included allegations that Messrs. Thompson, Alexander, DeCastro,

Kozak, and McWade compromised the trial of the test cases "by
                              - 196 -


making an incomplete an inaccurate presentation" of the First

Savings acquisition.88

     By order dated November 24, 1997, the Court denied

Mr. Sticht's motion on the ground that the materials that

Mr. Sticht was seeking to submit to the Court should have been

offered into evidence during the initial evidentiary hearing in

May and June 1996, where all of the implicated parties had been

called to testify.   Insofar as Mr. Sticht was arguing that there

was a meaningful link or connection between the First Savings

acquisition and the Investors Financial stock purchase plan, the

Court further observed that the First Savings acquisition was not

among the Kersting programs at issue in the trial of the test

cases, and that petitioners' theory of a link between the two

transactions would be ripe for consideration only if respondent

were to move for entry of decision based in part on adjustments

attributable to the First Savings acquisition.

E.   Denial of Mr. Izen's Motion To Take Judicial Notice

     On April 9, 1998, Mr. Izen filed a Motion to Take Judicial

Notice, asserting that the Court is obliged by rule 201 of the

Federal Rules of Evidence to take notice that the Hawaii District



     88
        The bulk of the testimony presented at the trial of the
test cases concerning the First Savings acquisition was offered
by Messrs. Kersting and Alexander. Although their testimony
concerning the transaction generally was consistent, the Court in
Dixon II apparently accepted Mr. Alexander's testimony that
Federal regulators rejected Investors Financial as a holding
company for First Savings despite Mr. Kersting's testimony to the
contrary. See Dixon II, 62 T.C.M. (CCH) at 1447, 1991 T.C.M.
(RIA), at 91-2987.
                               - 197 -


Court held that "the note indebtedness involved in the present

case (tried previously before Judge Goffe) is legally viable and

collectible under Hawaii state law."     By order dated April 14,

1998, the Court indicated that Mr. Izen's motion would be decided

in the Court's opinion in these cases.

     On November 2, 1998, Mr. Izen filed a Petition for Mandamus

with the Court of Appeals for the Ninth Circuit for a writ of

mandamus directing this Court to grant Mr. Izen's Motion to Take

Judicial Notice.    By order filed December 16, 1998, the Court of

Appeals denied Mr. Izen's petition.

     All materials attached to Mr. Izen's motion, which concern

Kersting program participant Carl Mott,89 were received in

evidence at the trial of the test cases and considered by Judge

Goffe in Dixon II.    See discussion of collection cases supra pp.

72-74.    Mr. Izen's motion, which amounts to another attempt to

retry matters previously decided in Dixon II, goes beyond the

scope of the mandate of the Court of Appeals in its remand of

these cases and will be denied.




     89
        Mr. Izen's continued reliance on the collection
litigation concerning Carl Mott indicates that Mr. Izen regards
the collection litigation as a complete rebuttal to all evidence
in the record that Mr. Kersting and program participants did not
intend or expect that promissory notes would be enforced in
accordance with their purported terms. In so doing, Mr. Izen
ignores the Court's conclusion in Dixon II, 62 T.C.M. (CCH) at
1505-1506, 1991 T.C.M. (RIA), at 91-3048 to 91-3050, that,
even if an obligation to pay leverage loan “interest” were
enforceable, it would properly be characterized as a
nondeductible “fee” for creating tax deductions rather than as
“interest”.
                              - 198 -


F.    Denial of Mr. Sticht's Motions for Release From Piggyback
      Agreements

      On June 9, 1998, Mr. Sticht filed Motions for Release from

Piggyback Agreement on behalf of nontest case petitioners

Richard B. and Donna G. Rogers, Anthony E. and Carol A. Eggers,

and John L. and Terry E. Huber.   Mr. Sticht contends that

Mr. Seery's apparent conflict of interest, at a time when

Mr. Seery represented the Rogerses, the Eggerses, and the Hubers,

provides an independent basis for releasing nontest case

petitioners from their piggyback agreements.   In the alternative,

Mr. Sticht contends, in light of respondent's misconduct in the

trial of the test cases, that the Court should conclude that

respondent did not comply with the terms of the piggyback

agreements.

      On June 9, 1998, Mr. Sticht filed a Motion to Sever Case and

for Entry of Decision; Or Alternatively to Sever Case and Set for

Trial on behalf of Joe A. and JoAnne Rinaldi in docket No. 7205-

94.   The Rinaldis' case at docket No. 7205-94 concerns the

Rinaldis' tax liabilities for 1990 and 1991 and is based upon a

notice of deficiency issued after the disclosure of the

misconduct in the trial of the test cases.   Because the Rinaldis

did not sign a piggyback agreement in docket No. 7205-94,

Mr. Sticht contends that the Court's opinion in Dixon II does not

bind the Rinaldis.   Mr. Sticht contends, relying upon the

misconduct of respondent's attorneys in the trial of the test

cases, that the Court should either enter a decision in the
                              - 199 -


Rinaldis' favor or sever the Rinaldis' case from the consolidated

cases and set the case for trial.

     On July 7, 1998, respondent filed objections to Mr. Sticht's

motions.   Respondent contends that the validity of the piggyback

agreements in dispute is not affected by either events occurring

during the trial of the test cases or Mr. Seery's alleged

conflict of interest.

     On July 10, 1998, Mr. Jones filed an opposition to

Mr. Sticht's motions asserting that it would be premature to

grant the motions.90

     As discussed in greater detail infra pp. 284-295 and pp.

300-302, we will deny Mr. Sticht's motions.

G.   Reports Regarding the Court's Protective Orders

     By order dated August 27, 1998, the Court directed

Messrs. Huestis and Sticht to file reports with the Court

detailing any objection to the lifting of the Court's protective

orders dated June 10 and 26, 1996.   Mr. Huestis filed a report

with the Court objecting to the lifting of the Court's protective

orders on the ground that Mr. Kersting might attempt to use the

records in question to harass the Thompsons.   Mr. Sticht and

respondent filed separate reports with the Court indicating no

objection to the lifting of the protective orders.   As discussed




     90
        On July 20, 1998, Mr. Sticht filed a Motion to Strike
allegedly scandalous and impertinent matters from Mr. Jones'
opposition. On Aug. 6, 1998, the Court denied Mr. Sticht's
motion to strike.
                               - 200 -


in greater detail infra pp. 302-305, we will lift the protective

orders.

                      ULTIMATE FINDINGS OF FACT

     Messrs. Sims and McWade negotiated a series of contingent

settlement agreements with Mr. DeCastro in respect of the

Thompsons' tax liabilities in advance of the trial of the test

cases.    The final Thompson settlement agreement provided for a

reduction in the Thompsons' tax liabilities for 1979, 1980, and

1981 for the purpose of generating refunds of tax and interest

that were used to pay Mr. DeCastro's attorney's fees.    The

refunds actually made were more than sufficient for this purpose;

the excess was received and retained by the Thompsons.    The

Thompson settlement was not based upon or influenced by the

Thompsons' participation in the Bauspar program.

     Messrs. Sims and McWade negotiated a contingent settlement

agreement with Mr. Cravens in respect of the Cravenses' tax

liabilities for 1979 and 1980 in advance of the trial of the test

cases.    Messrs. Sims and McWade misled Mr. Cravens as to the

nature and legal effect of his settlement and the need for

counsel at the trial of the test cases.    In so doing, they

foreclosed the possibility that the Cravenses would become

clients of Chicoine and Hallett, and later, of Mr. Izen.    They

thereby reduced the effectiveness of Mr. Cravens' presentations

to the Court from the point of view of all petitioners; the

likelihood that Mr. Cravens would have informed counsel for test
                              - 201 -


case petitioners that his cases had been settled was also

reduced.

     Messrs. Sims and McWade were the only persons in the

Honolulu District Counsel Office with knowledge of the Thompson

and Cravens settlements before and during the trial of the test

cases.   Other than Mr. Stevens, no one else within the Internal

Revenue Service was aware of the Thompson and Cravens settlements

before or during the trial of the test cases through the times

that the Court issued its Dixon II opinion and entered the

initial decisions in the test cases.

     Before the trial of the test cases, Mr. McWade intentionally

misled the Court, with the complicity of Mr. DeCastro, by not

disclosing the settlement of the Thompson cases when he moved to

set aside the Thompson piggyback agreements.   At the trial of the

test cases, Messrs. Sims, McWade, and DeCastro intentionally

misled the Court regarding the status of the Thompson cases by

not disclosing the settlement of the Thompson cases.   At the

trial of the test cases, Messrs. Sims and McWade intentionally

misled the Court in similar fashion regarding the settlement of

the Cravens cases.

     Mr. McWade allowed Mr. Alexander to offer misleading

testimony to the Court during the trial of the test cases

regarding his understanding that his tax liabilities would be

reduced in exchange for providing assistance to Mr. McWade.

     Mr. DeCastro did not act as a Government "mole" during the

trial of the test cases or convey any of Mr. Izen's trial
                                - 202 -


strategies or confidential information to the Government.         Cf.

Kersting v. United States, 865 F. Supp. at 671-674.

     Mr. Izen had no knowledge, before and at the trial of the

test cases through the times that the Court issued the Dixon II

opinion and entered the initial decisions in the test cases, that

Messrs. Thompson and Cravens had entered into settlement

agreements with Mr. McWade.

                                OPINION

     The Court of Appeals for the Ninth Circuit vacated this

Court's decisions in Dixon II and remanded the test cases for an

evidentiary hearing "to determine the full extent of the admitted

wrong done by the government trial lawyers."        DuFresne v.

Commissioner, 26 F.3d at 107.    The Court of Appeals, citing

Arizona v. Fulminante, 499 U.S. at 309, directed the Court to

consider "whether the extent of misconduct rises to the level of

a structural defect voiding the judgment as fundamentally unfair,

or whether, despite the Government's misconduct, the judgment can

be upheld as harmless error."     Id.     Further, the Court of Appeals

directed the Court to consider on the merits all motions of

intervention filed by parties affected by Dixon II.       See id.

Pursuant to this last direction, the Court consolidated the cases

of three groups of petitioners to allow them to participate in

the evidentiary hearing:   Test case and nontest case petitioners

represented by Mr. Izen, nontest case petitioners represented by

Mr. Jones, and nontest case petitioners represented by

Mr. Sticht.
                             - 203 -


     While the parties have primarily addressed the specific

issues posed by the mandate of the Court of Appeals, whether the

Government misconduct constitutes a structural defect or harmless

error, our analysis is not limited to these issues.    At the

inception of this proceeding, the Court raised the issue whether

the Thompson and Cravens settlements share significant

characteristics with improper "Mary Carter" agreements; Mr. Izen

has consistently maintained throughout this proceeding that the

Government misconduct amounted to fraud on the Court; and

Mr. Sticht has asserted that nontest case petitioners were not

only harmed by the Government misconduct, but also by Mr.

Kersting's interference in the attorney-client relationships

between test case petitioners and their counsel.    In an effort to

spread the blame, respondent has asked the Court to find that

Mr. Izen, as well as Mr. Kersting, was aware of the Thompson and

Cravens settlements at or before the trial of the test cases.

     Before turning to our analysis of the foregoing issues, we

will address the burden of proof in this proceeding.

I.   Burden of Proof

     The Court deferred ruling on the parties' requests for

assignment of the burden of proof and the fixing of the standard

of proof for purposes of the evidentiary hearing.   The Court

nevertheless placed on respondent the initial burden of coming

forward with evidence and prescribed a structure for the orderly

presentation of witnesses at the evidentiary hearing.
                               - 204 -


     The burden of proof consists of two burdens--the burden of

production of evidence and the burden of persuasion.    See

Wigmore, Evidence in Trials at Common Law, secs. 2485 to 2488

(Chadbourn rev. 1981).   Assignment of the burden of proof and

fixing the standard of proof serve a procedural function by

delineating the parties' obligations respecting the presentation

of evidence at trial.

     Although assignment of the burden of proof was not resolved

before the evidentiary hearing, the Court is satisfied that the

evidentiary hearing has produced a record that contains all

relevant facts necessary for the Court to discharge its

obligations under the mandate.    The parties' versions of the

facts as set forth in their respective proposed findings of fact

generally are in accord,91 with one immaterial exception

discussed infra pp. 209-211.     Consequently, from a purely

procedural standpoint, assignment of the burden of proof and

fixing the standard of proof are not necessary.

     We likewise are convinced that assignment of the burden of

proof is not necessary for the Court to decide whether the Sims-

McWade misconduct resulted in a structural defect in the trial of

the test cases.   The structural defect question raises a legal




     91
        In those instances where the parties have not agreed
with respect to a particular fact, or the record does not clearly
reflect the date of a particular event, the Court generally has
adopted the finding of fact proposed by the test case and nontest
case petitioners.
                                - 205 -


issue requiring the Court to apply a settled body of case law to

essentially agreed facts.

     In contrast, assignment of the burden of proof and fixing

the standard of proof have greater substantive significance with

respect to harmless error analysis.       As discussed in greater

detail infra pp. 233-236, harmless error analysis ultimately

requires the Court to consider whether the Sims-McWade misconduct

affected the outcome in the trial of the test cases.       Because the

assignment of the burden of proof, and particularly the standard

of proof, could influence the outcome of the Court's harmless

error analysis, we will decide the issue.

     Proper placement of the burden of proof in these cases for

purposes of the evidentiary hearing is not easily resolved and

raises some perplexing questions.    Rule 142(a) provides the

general rule that the burden of proof (or burden of persuasion)

will be upon the taxpayer, except as otherwise provided by

statute or determined by the Court.92      See Welch v. Helvering,

290 U.S. 111 (1933).   Normally, the taxpayer bears the initial

burden of producing enough evidence to make a prima facie case;

i.e., evidence to support a finding contrary to the

Commissioner's determination.    See Rockwell v. Commissioner, 512



     92
        Under sec. 3001 of the Internal Revenue Service
Restructuring and Reform Act of 1998, Pub. L. 105-206, 112 Stat.
726, Congress enacted new sec. 7491, which provides, effective
with respect to examinations commenced after July 22, 1998, that
the burden of proof shifts to the Commissioner when the taxpayer
produces credible evidence in opposition to the Commissioner's
determination of a deficiency and satisfies other requirements.
                              - 206 -


F.2d 882, 885 (9th Cir. 1975), affg. T.C. Memo. 1972-133.     Where

the taxpayer succeeds in producing evidence supporting a finding

contrary to the Commissioner's determination, the burden of

production or burden of going forward with evidence shifts to the

Commissioner.   See Bernuth v. Commissioner, 470 F.2d 710, 714 (2d

Cir. 1972), affg. 57 T.C. 225 (1971).   The taxpayer nonetheless

continues to bear the ultimate burden of persuasion.

     There is a well-recognized exception to the normal placement

of the burden of proof in cases where the Commissioner determines

that the taxpayer is liable for an addition to tax for fraud.    In

such cases, the Commissioner bears the burden of proving fraud by

clear and convincing evidence.   See sec. 7454(a); Smith v.

Commissioner, 91 T.C. 1049, 1053 n.3 (1988), affd. 926 F.2d 1470

(6th Cir. 1991).

     The Court has also recognized an exception to the normal

rule respecting the placement of the burden of proof in motions

practice.   For example, in Pietanza v. Commissioner, 92 T.C. 729

(1989), supplemented by T.C. Memo. 1990-524, affd. without

published opinion 935 F.2d 1282 (3d Cir. 1991), the parties filed

cross-motions to dismiss for lack of jurisdiction.   The taxpayers

moved to dismiss on the ground that the Commissioner had failed

to issue a valid notice of deficiency; the Commissioner moved to

dismiss on the ground that the taxpayers had failed to file a

timely petition.   Because the very existence of the notice of

deficiency was in dispute, the Court held that the Commissioner

should bear the burden of proof on the point because it would be
                                - 207 -


unfair to require the taxpayer to prove "the nonexistence of a

notice which they swear they have never seen and which respondent

is unable to provide."     Pietanza v. Commissioner, supra at 736-

737.

       Because these cases are not now before the Court in the

normal posture of a deficiency case, the parties agree that the

Court should disregard Rule 142(a).       The parties also agree that

the Court should instead look to rule 60(b) of the Federal Rules

of Civil Procedure to determine the proper assignment of the

burden of proof, notwithstanding that the decisions in the test

cases have not become final.93    Under that rule a party may move

to be relieved from a final judgment, order, or proceeding, in

the case of fraud, misrepresentation, or other misconduct of an

adverse party.    Normally, the moving party bears the burden of

producing clear and convincing evidence that relief should be

granted under that rule.    See Anderson v. Cryovac, Inc., 862 F.2d

910 (1st Cir. 1988).    Predictably, respondent and petitioners

each argue that the burden of proof should be imposed on the

other side.

       Respondent contends that, because petitioners "now seek to

affirmatively invalidate the Court's Dixon II opinion",

petitioners bear the burden of proof as the moving parties.



       93
        Rule 1(a) states that, where there is no applicable rule
of procedure, "the Court or the Judge before whom the matter is
pending may prescribe the procedure, giving particular weight to
the Federal Rules of Civil Procedure to the extent that they are
suitably adaptable to govern the matter at hand."
                               - 208 -


Further, relying on cases such as Jones v. Aero/Chem Corp., 921

F.2d 875, 878-879 (9th Cir. 1990), Drobny v. Commissioner, 113

F.3d 670, 678 (7th Cir. 1997), and England v. Doyle, 281 F.2d

304, 309 (9th Cir. 1960), respondent maintains that the proper

standard of proof is clear and convincing evidence irrespective

of whether the theory of relief is structural defect, reversible

error, fraud on the Court, or attorney misconduct under rule

60(b)(3) of the Federal Rules of Civil Procedure.

     Relying on virtually the same authorities, petitioners

counter that respondent should bear the burden of proof and that

the standard of proof is clear and convincing evidence.

Petitioners reason that respondent should bear the burden of

proof insofar as it was respondent who moved for an evidentiary

hearing before the appeal of the test cases and again after the

Court of Appeals remanded the test cases to the Court for an

evidentiary hearing on the significance of the misconduct of

respondent's attorneys.

     We note that the decisions entered by the Court in the test

cases have not become final.   Timely appeals were taken and the

test cases are before the Court pursuant to the mandate of the

Court of Appeals, which vacated the decisions for further

proceedings.

     We disagree with petitioners' contention that respondent

should bear the burden of proof on the technical ground that

respondent is the moving party.   Nonetheless, the unusual aspects

of these cases persuade us that it would be inappropriate to
                              - 209 -


place the burden of proof on petitioners.   First, we observe that

in Arizona v. Fulminante, 499 U.S. at 295-296, the Supreme Court

ruled that the State had the burden of proving that the erroneous

admission of the defendant's confession was harmless beyond a

reasonable doubt.   By analogy, respondent should bear the burden

of proving that the admitted misconduct of his attorneys was

harmless and had no material effect on the outcome of the trial.

In addition, we note that respondent has had direct and immediate

access to the critical witnesses and most of the relevant

documents since May 1992, when respondent first discovered the

misconduct in question.   Further, respondent conducted an initial

investigation of the misconduct, to the exclusion of all private

parties, shortly after discovering the misconduct.   Finally,

respondent, by asserting various privileges in response to

Mr. Izen's motion to compel production of documents, succeeded in

protecting from discovery various documents generated during

respondent's investigation.   Taken together, these factors

persuade us that the interests of justice are better served by

placing the burden of proof on respondent, and we so hold.

Because these cases concern attorney misconduct in the civil

context, the standard of proof and persuasion that we apply is

clear and convincing evidence.   See, e.g., Bunch v. United

States, 680 F.2d 1271, 1283 (9th Cir. 1982) (attorney

misconduct).

     For purposes of completeness, we briefly address the

immaterial exception alluded to above.   That exception arises
                             - 210 -


from respondent's requests for findings of fact and argument that

Mr. Izen was aware of the Cravens and Thompson settlements at the

time of the trial before Judge Goffe.94   Placing the burden of

proof on respondent--for reasons discussed above--we have found

that Mr. Izen was not aware of the settlements.   However, the

record contains evidence, such as Mr. Kersting's, Mr. Moseley's,

and Mr. Bradt's knowledge of the settlements, Mr. Bradt's prior

partnership with Mr. Izen and their cooperation and sharing of

information during the evidentiary hearing, and statements by Mr.

Cravens--which he ultimately recanted on grounds of uncertainty

and lack of clear recollection--from which it could be inferred

that Mr. Izen had been informed or had become aware of the

settlements at or before the trial of the test cases.95   Although

such evidence does not suffice to require a finding to that

effect, we might have found, if petitioners had to bear the


     94
        Respondent has not carried through and addressed the
significance for these cases of Mr. Izen's awareness or lack of
awareness of the settlements. We do not believe that Mr. Izen's
awareness of the settlements would have any bearing on our
conclusion that the Court's decisions on the tax deficiencies of
the test case petitioners should be reinstated. Although
nondisclosure of the settlements by Mr. Izen--if he had been
aware of them--would have amounted to misconduct on his part, we
would not regard such misconduct as having any bearing on the
reinstatement of the decisions in the test cases. See discussion
infra pp. 230-232 of Mr. Kersting's misconduct.
     95
        We recognize that there is circumstantial evidence that
Mr. Izen was not aware of the Thompson and Cravens settlements.
If Mr. Izen had been aware of the Thompson settlement, it does
not seem likely that he would have allowed Mr. DeCastro to attend
the meeting that he held with Mr. Hongsermeier on the eve of the
trial of the test cases or shared other information with Mr.
DeCastro. It is also likely that Mr. Izen would have brought the
settlements to the Court's attention before respondent did.
                               - 211 -


burden of proof on that question, that petitioners had not

carried that burden.96

      We regard the exception as immaterial because we are

satisfied that our conclusions and the outcome would remain the

same, even if we were to conclude that Mr. Izen had been aware of

the settlements.   We would so conclude on essentially the same

grounds on which we reject Mr. Sticht's argument over

Mr. Kersting's interferences with the attorney-client

relationships of the attorneys whom he employed to represent the

test case petitioners.    See infra pp. 230-232.

II.   Structural Defect

A.    Case Law

      The Court of Appeals for the Ninth Circuit vacated this

Court's decisions in the test cases and remanded the cases with

directions "to conduct an evidentiary hearing to determine the

full extent of the admitted wrong done by the government trial

lawyers" and to consider "whether the extent of misconduct rises

to the level of a structural defect voiding the judgment as

fundamentally unfair, or whether, despite the government's


      96
        This would have been made even more likely by
Mr. Kersting's failure to appear and testify at the evidentiary
hearing, which might have brought into play the doctrine of
Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165
(1946), affd. on other grounds 162 F.2d 513 (10th Cir. 1947),
that the failure of a party to introduce evidence within his
possession or control which, if true, would be favorable to him,
gives rise to the presumption that if produced it would be
unfavorable. Mr. Kersting's assertions in his motion to quash
subpoena that he was too sick to attend the evidentiary hearing
might have been well taken, but consideration could have been
given to alternative means of obtaining his testimony.
                              - 212 -


misconduct, the judgment can be upheld as harmless error."

DuFresne v. Commissioner, 26 F.3d at 107.

     The term "structural defect" normally refers to the

violation of a fundamental constitutional right occurring during

a criminal trial that affects the very framework within which the

trial proceeds, so that the trial cannot reliably serve its

function as a vehicle for determination of guilt or innocence.

See Arizona v. Fulminante, supra at 309-310.     The presence of a

structural defect in a criminal trial requires    automatic

reversal of the conviction and a new trial.    See, e.g., id.;

Chapman v. California, 386 U.S. 18 (1967).

     Significantly, not all constitutional errors occurring

during a trial result in a structural defect in the proceedings.

To the contrary, there are a number of constitutional errors,

characterized as lesser "trial errors", that are susceptible to

harmless error analysis.

     In Arizona v. Fulminante, 499 U.S. 279 (1991), a plurality

opinion, the Supreme Court discussed the distinction between a

constitutional violation that causes a structural defect in a

trial and a constitutional violation that is subject to harmless

error analysis.   A majority of the Justices concluded that the

admission of the defendant's coerced confession at his murder

trial did not constitute a structural defect requiring automatic

reversal of the defendant's conviction.   However, a separate

majority further concluded that the defendant was entitled to a

new trial because the State of Arizona had failed to meet its
                               - 213 -


burden of establishing beyond a reasonable doubt that the

admission of the confession was harmless error.    See id. at 295-

296.

       The Supreme Court described the distinction between a

constitutional violation that may be characterized as a trial

error as opposed to a structural defect as follows:

            Since this Court's landmark decision in Chapman v.
       California, 386 U.S. 18 (1967), in which we adopted the
       general rule that a constitutional error does not
       automatically require reversal of a conviction, the
       Court has applied harmless-error analysis to a wide
       range of errors and has recognized that most
       constitutional errors can be harmless. See, e.g.,
       Clemons v. Mississippi, 494 U.S. 738, 752-754
       (1990)(unconstitutionally overbroad jury instructions
       at the sentencing stage of a capital case); Satterwhite
       v. Texas, 486 U.S. 249 (1988)(admission of evidence at
       the sentencing stage of a capital case in violation of
       the Sixth Amendment Counsel Clause); Carella v.
       California, 491 U.S. 263, 266 (1989)(jury instruction
       containing an erroneous conclusive presumption); Pope
       v. Illinois, 481 U.S. 497, 501-504 (1987)(jury
       instruction misstating an element of the offense); Rose
       v. Clark, 478 U.S. 570 (1986)(jury instruction
       containing an erroneous rebuttable presumption); Crane
       v. Kentucky, 476 U.S. 683, 691 (1986)(erroneous
       exclusion of defendant's testimony regarding the
       circumstances of his confession); Delaware v. Van
       Arsdall, 475 U.S. 673 (1986)(restriction on a
       defendant's right to cross-examine a witness for bias
       in violation of the Sixth Amendment Confrontation
       Clause); Rushen v. Spain, 464 U.S. 114, 117-118, and
       n.2 (1983)(denial of a defendant's right to be present
       at trial); United States v. Hasting, 461 U.S. 499
       (1983)(improper comment on defendant's silence at
       trial, in violation of the Fifth Amendment Self-
       Incrimination Clause); Hopper v. Evans, 456 U.S. 605
       (1982)(statute improperly forbidding trial court's
       giving a jury instruction on a lesser included offense
       in a capital case in violation of the Due Process
       Clause); Kentucky v. Whorton, 441 U.S. 786
       (1979)(failure to instruct the jury on the presumption
       of innocence); Moore v. Illinois, 434 U.S. 220, 232
       (1977)(admission of identification evidence in
       violation of the Sixth Amendment Confrontation Clause);
                           - 214 -


Brown v. United States, 411 U.S. 223, 231-232
(1973)(admission of the out-of-court statement of a
nontestifying codefendant in violation of the Sixth
Amendment Confrontation Clause); Milton v. Wainwright,
407 U.S. 371 (1972)(confession obtained in violation of
Massiah v. United States, 377 U.S. 201 (1964));
Chambers v. Maroney, 399 U.S. 42, 52-53
(1970)(admission of evidence obtained in violation of
the Fourth Amendment); Coleman v. Alabama, 399 U.S. 1,
10-11 (1970)(denial of counsel at a preliminary hearing
in violation of the Sixth Amendment Counsel Clause).

     The common thread connecting these cases is that
each involved "trial error"--error which occurred
during the presentation of the case to the jury, and
which may therefore be quantitatively assessed in the
context of other evidence presented in order to
determine whether its admission was harmless beyond a
reasonable doubt. In applying harmless-error analysis
to these many different constitutional violations, the
Court has been faithful to the belief that the
harmless-error doctrine is essential to preserve the
"principle that the central purpose of a criminal trial
is to decide the factual question of the defendant's
guilt or innocence, and promotes public respect for the
criminal process by focusing on the underlying fairness
of the trial rather than on the virtually inevitable
presence of immaterial error." Van Arsdall, supra, at
681 (citations omitted).

               *   *   *     *   *   *   *

     The admission of an involuntary confession--a
classic "trial error"--is markedly different from the
other two constitutional violations referred to in the
Chapman footnote [Chapman v. California, 386 U.S. 18,
23 n.8 (1967)] as not being subject to harmless-error
analysis. One of these violations, involved in Gideon
v. Wainwright, 372 U.S. 335 (1963), was the total
deprivation of the right to counsel at trial. The
other violation, involved in Tumey v. Ohio, 273 U.S.
510 (1927), was a judge who was not impartial. These
are structural defects in the constitution of the trial
mechanism, which defy analysis by "harmless-error"
standards. The entire conduct of the trial from
beginning to end is obviously affected by the absence
of counsel for a criminal defendant, just as it is by
the presence on the bench of a judge who is not
impartial. Since our decision in Chapman, other cases
have added to the category of constitutional errors
which are not subject to harmless error the following:
                              - 215 -


     unlawful exclusion of members of the defendant's race
     from a grand jury, Vasquez v. Hillery, 474 U.S. 254
     (1986); the right to self-representation at trial,
     McKaskle v. Wiggins, 465 U.S. 168, 177-178 n.8 (1984);
     and the right to public trial, Waller v. Georgia, 467
     U.S. 39, 49, n.9 (1984). Each of these constitutional
     deprivations is a similar structural defect affecting
     the framework within which the trial proceeds, rather
     than simply an error in the trial process itself.
     "Without these basic protections, a criminal trial
     cannot reliably serve its function as a vehicle for
     determination of guilt or innocence, and no criminal
     punishment may be regarded as fundamentally fair."
     Rose v. Clark, 478 U.S., at 577-578 (citation omitted).

Id. at 306-310.

     The Court of Appeals for the Ninth Circuit recently relied

upon the Supreme Court's opinion in Arizona v. Fulminante, supra,

to support its holding that a defendant's absence from the

courtroom when the jury returned the death sentence did not

result in a structural defect in the proceedings.   See Rice v.

Wood, 77 F.3d 1138, 1144 (9th Cir. 1996).   The Court of Appeals

further concluded that the error was harmless because the

defendant's absence from the courtroom did not have a

"substantial and injurious effect or influence" in determining

the jury's verdict.   Id. at 1144 (citing Brecht v. Abrahamson,

507 U.S. 619, 623 (1993) (quoting Kotteakos v. United States, 328

U.S. 750, 776 (1946))).

B.   Arguments

     Messrs. Izen and Jones argue that the Government misconduct

in these cases resulted in a structural defect on the ground

that their clients, both test case and nontest case petitioners,

were deprived of a fair trial.   Messrs. Izen and Jones argue that
                               - 216 -


the Government misconduct included the illegal search of

Mr. Kersting's office, the issuance of erroneous notices of

deficiency intended to pressure taxpayers, secret settlements

with the Thompsons, Cravenses, and Alexanders, the use of

Mr. Thompson as a conduit for the payment of Mr. DeCastro's

attorney's fees, Mr. McWade's misrepresentations to Mr. Cravens

regarding the terms and effect of his settlement, and

respondent's denial of Mr. Jones' request to participate in the

discovery/investigation process that respondent undertook in

1992.    Messrs. Izen and Jones contend that the confluence of all

of these factors amounted to Government misconduct so egregious

as to prevent the test case petitioners from fully developing

their positions at trial.

     In the alternative, but in reliance upon the same factors,

Messrs. Izen and Jones contend that the Government misconduct

resulted in reversible error in the trial of the test cases.

Mr. Izen further asserts that:    (1) The Government misconduct

resulted in a fraud upon the Court; and (2) respondent's use of

Mr. DeCastro to "infiltrate" petitioners' camp requires a new

trial.    We will address separately the latter two contentions.

     Mr. Izen contends that the proper remedy in these cases is

entry of decision in favor of all petitioners.    In the

alternative, Mr. Izen contends that all petitioners should be

awarded a new trial.    Mr. Jones contends that the Court should

order respondent to show cause why respondent should not be
                              - 217 -


barred from further proceedings against all Kersting

petitioners.97

     Mr. Sticht also contends that the Government's misconduct

resulted in a structural defect in the trial of the test cases,

but he characterizes the defect differently.   Mr. Sticht asserts

that the Court effectively was precluded from supervising the

trial process because Judge Goffe was not informed of the

Thompson and Cravens settlement agreements.    In conjunction with

this argument, Mr. Sticht maintains that nontest case petitioners

were deprived of procedural due process insofar as their

decisions to execute piggyback agreements, as opposed to

accepting one of the Government's settlement offers before the

trial, were made without knowledge that two test case petitioners

had decided to settle their cases.   Mr. Sticht relies on United

States v. Noushfar, 78 F.3d 1442 (9th Cir. 1996), and Riley v.

Deeds, 56 F.3d 1117, 1121 (9th Cir. 1995), for the proposition

that an "abdication of judicial control over" a trial constitutes

a structural defect.   Citing United States v. Annigoni, 96 F.3d

1132, 1143-1147 (9th Cir. 1996), Mr. Sticht argues in the

alternative that, even if the Government misconduct did not cause

a structural defect in the trial of the test cases, these cases

are not amenable to harmless error analysis because the impact of


     97
        Our research does not disclose any case in which this
Court has invoked such an extraordinary remedy, and petitioners
have brought no such case to our attention. A new trial normally
is the proper remedy in the case of a structural defect or
reversible error in a trial. See Arizona v. Fulminante, 499 U.S.
279 (1991).
                              - 218 -


the misconduct "cannot be fairly assessed without engaging in

sheer speculation".   In short, taking a different route from

Mr. Izen and Mr. Jones, Mr. Sticht would bring his clients to the

same destination:   that nontest case petitioners are entitled to

entry of decisions that no deficiencies are due in their cases.

     In response to respondent's contention that the Government

misconduct did not result in a structural defect because Mr. Izen

was not inhibited in fully and fairly presenting his clients'

cases, Mr. Sticht asserts that nontest case petitioners

nevertheless were harmed by Mr. Kersting's firing of Chicoine and

Hallett at a time when they were attempting to settle the

Kersting project cases.   Mr. Sticht further suggests (in very

general terms) that Mr. Izen's performance at the trial of the

test cases was deficient and that the trial of the test cases

should have included an attorney who was not being paid by

Mr. Kersting.

C.   Summary of Government Misconduct

     Our first step in deciding whether the Government misconduct

resulted in a structural defect in the trial of the test cases is

to describe and characterize the Government misconduct.

     Messrs. Sims and McWade negotiated a series of contingent

settlement agreements in the Thompson and Cravens cases in

advance of the trial of the test cases under which the Thompson

and Cravens would receive the more favorable of:   (1) The Tax

Court's decision if the test case petitioners should prevail in
                               - 219 -


the Tax Court; or (2) the agreed decisions based on the

settlements of their test cases.

     Messrs. Sims and McWade were the only persons in the

Honolulu District Counsel Office with knowledge of the Thompson

and Cravens settlements before and during the trial of the test

cases.   Other than Mr. Stevens no one else within the Internal

Revenue Service was aware of the Thompson and Cravens settlements

before or during the trial of the test cases up to the times that

the Court issued its Dixon II opinion and entered the initial

decisions in the test cases.

     Before the trial of the test cases, Mr. McWade intentionally

misled the Court, with the complicity of Mr. DeCastro, by not

disclosing the settlement of the Thompson cases when he moved to

set aside the Thompson piggyback agreements.    Messrs. Sims,

McWade, and DeCastro intentionally misled the Court regarding the

status of the Thompson cases at the trial of the test cases.

When Mr. Thompson alluded to his settlement during his testimony

at the trial of the test cases,    Mr. McWade interrupted Mr.

Thompson in order to divert him from the subject and thus

intentionally prevented Judge Goffe from learning about the

Thompson settlement.   Messrs. Sims and McWade also intentionally

misled the Court regarding the status of the Cravens cases at the

trial of the test cases.

     The decisions entered in the Thompson cases provided for

agreed reductions in the Thompsons' tax liabilities for 1979,

1980, and 1981 that generated refunds of tax and interest that in
                              - 220 -


turn were used to pay Mr. DeCastro's attorney's fees.    The

refunds actually made were more than sufficient for this purpose;

the excess was received and retained by the Thompsons.    Contrary

to McWade's testimony at the evidentiary hearing, the Thompson

settlement was not based upon or influenced by the Thompsons'

participation in the Bauspar program.

     Although the contingent aspect of the secret settlement

agreements provided an ostensible incentive for Messrs. Thompson

and Cravens to defend vigorously the Kersting interest deductions

that they had reported on their tax returns, the record shows

that the secret settlements had the effect of diluting the

adversarial character of the Thompsons' and Cravenses'

presentations of their cases to the Court.

     Mr. Thompson's testimony at the trial of the test cases

reveals that he strongly defended the position that he had

participated in the Kersting programs with the objective of

making a profit.   However, Mr. Thompson was the only test case

petitioner to testify that Mr. Kersting had assured him that his

promissory notes would not be enforced.   Although Mr. Thompson's

testimony on this point merely served to corroborate Mr.

Kersting's statements to other Kersting program participants in

the comfort letters, the circumstances indicate that Mr. Thompson

participated in the trial of the test cases in part to lay the

groundwork for a defense against Mr. Kersting's earlier threats
                               - 221 -


to collect on Mr. Thompson's promissory notes.98   Considering

Mr. Thompson's mixed motivations, Mr. Thompson was not fully

representative of the class of Kersting program participants

interested in contesting the Commissioner's determinations

disallowing Kersting interest deductions.

       Mr. Thompson's testimony aside, Mr. Thompson's settlement

agreement placed his counsel, Mr. DeCastro, in a conflict of

interest.    In particular, Mr. Thompson's settlement agreement was

altered so that Mr. DeCastro's attorney's fees in effect would be

paid out of tax refunds that were guaranteed to be paid to the

Thompsons.    In short, with Mr. Thompson serving as a conduit,

Messrs. Sims and McWade arranged for the Government to pay

Mr. DeCastro's attorney's fees to ensure that Mr. Thompson would

ostensibly remain a test case petitioner.    As observed by the

Court of Appeals, Mr. DeCastro "was the main beneficiary of the

[Thompson] settlement".    DuFresne v. Commissioner, 26 F.3d at

107.    Mr. DeCastro's additional legal fee paid from the refunds

generated by the final Thompson settlement--$62,225--was

disproportionately high in relation to the amount remaining in

issue for the Thompsons--$30,000 plus interest.

       The record indicates that Mr. DeCastro had concluded before

the trial of the test cases that Kersting program participants



       98
        Although Judge Goffe was not informed of Mr. Thompson's
settlement, Mr. Thompson's dispute with Mr. Kersting was
disclosed to Judge Goffe through Mr. Thompson's testimony.
Consequently, Judge Goffe was able to weigh Mr. Thompson's
credibility on this point.
                               - 222 -


did not have a viable case.    He candidly admitted as much to

Mr. Izen on the eve of the trial.    Consistent with this view,

Mr. DeCastro had advised his clients, including the Thompsons, to

try to obtain the best settlements they could get and not abide

the outcome of the trial of the test cases.    Before the final

sweetening of the Thompson settlement, Mr. DeCastro had

effectively represented his clients, including the Thompsons, in

obtaining a number of settlements (with the burnout feature) on

the order of 20 percent.

     Against this background, Mr. DeCastro's conflict in the

Thompson cases became acute when he agreed, in the context of the

final sweetening of the Thompson settlement to provide the

wherewithal to pay his legal fees, to continue to participate in

Messrs. Sims' and McWade's scheme to keep the Thompsons among the

test cases petitioners and to provide the masquerade of trial

representation for the Thompsons as one of the test cases.

Before the trial of the test cases, Mr. DeCastro had written to

Mr. Huestis that Mr. Thompson's participation in the trial

"appears to be wise insurance to obtain cancellation of the

notes".

     Mr. McWade, with the knowledge of Mr. Sims, negotiated a

contingent settlement agreement with Mr. Cravens in advance of

the trial of the test cases.    However, Mr. McWade intentionally

misled Mr. Cravens as to the nature and legal effect of his

settlement and the need for counsel at the trial of the test

cases.    Mr. McWade improperly advised Mr. Cravens that, by virtue
                               - 223 -


of his settlement, Mr. Cravens could not win or lose and would

not need an attorney to represent him at the trial of the test

cases.   In so doing, Mr. McWade foreclosed the possibility that

the Cravenses would become clients of Chicoine and Hallett, and

later, of Mr. Izen, and thereby reduced the effectiveness of

Mr. Cravens' presentations to the Court from the point of view of

all petitioners.    The likelihood that Mr. Cravens would have

informed counsel for test case petitioners that his cases had

been settled was also thereby reduced.

     Mr. Cravens relied upon Mr. McWade's advice and appeared at

the trial of the test cases without counsel, whereupon he was

informed by Mr. McWade that he would enjoy the better of the Tax

Court decision in the trial of the test cases or the previously

arranged settlement agreement.    We have no doubt that Mr. Cravens

would have been better prepared and would have offered a more

complete case had he been represented by counsel at the trial of

the test cases.    At a minimum, counsel could have assisted

Mr. Cravens in completing his testimony regarding his motivations

for participating in Kersting programs and his belief that his

promissory notes were valid.

     During the trial of the test cases and thereafter, Messrs.

Sims and McWade intentionally misled the Court and the remaining

test case petitioners regarding the status of the Thompson and

Cravens cases.    Messrs. Sims and McWade consciously continued

their efforts to mislead the Court during the evidentiary hearing

by denying that the Thompson settlement was a vehicle for paying
                              - 224 -


Mr. DeCastro's legal fees for representing the Thompsons at the

trial of the test cases, by testifying that the Thompson

settlement was attributable to the Thompsons' participation in

the Bauspar program, and by trying to cover up the bases for the

stipulated decisions that were entered by the Court in the

Alexander cases.

     Mr. McWade also failed to disclose to the Court his

understanding with Mr. Alexander and allowed Mr. Alexander to

offer misleading testimony to the Court during the trial of the

test cases.   Although we are unable to find that Mr. McWade and

Mr. Alexander agreed before the trial to a specific reduction of

the Alexanders' tax liabilities in exchange for Mr. Alexander's

assistance to Mr. McWade during the trial of the test cases, we

are convinced that Mr. McWade and Mr. Alexander had a general

understanding that the Alexanders' tax liabilities would be

reduced.   In this regard, Mr. Alexander misled the Court when he

ambiguously answered "Specifically, no." to Mr. Izen's question

at trial whether Mr. Alexander had an agreement with Mr. McWade

to reduce his tax liabilities.99



     99
        Mr. Alexander's response could be understood as a
statement (consistent with the Court's finding in these cases)
that, although Mr. Alexander did not reach an agreement with
Mr. McWade for a specific reduction in the amount of his tax
deficiencies, he and Mr. McWade had a general understanding that
Mr. Alexander's tax liabilities would be reduced. Considering
the ambiguity in Mr. Alexander's response, it seems surprising
that Mr. Izen did not pursue the matter further. In any event,
by virtue of Mr. McWade's duty of candor toward the Court, see
ABA Model Rules of Professional Conduct rule 3.3, Mr. McWade was
obliged to disclose his understanding with Mr. Alexander to the
Court.
                               - 225 -


       In sum, the record in these cases reveals a scheme by

Messrs. Sims and McWade to mislead the Court and manipulate the

test case procedure in a misplaced effort to enhance the already

overwhelming likelihood that respondent would prevail on the

merits of the Kersting adjustments and their continuing efforts

at the evidentiary hearing to cover up what they had done.

D.     Discussion

       Petitioners unanimously advance the view that the Government

misconduct should be considered a structural defect.    We are

convinced that Messrs. Sims' and McWade's misconduct diluted the

adversarial character of the presentation of what the Court and

the other petitioners were led to believe were the Thompson and

Cravens test cases.    To conclude, however, that the Government

misconduct resulted in a structural defect in the trial of the

test cases, one also must accept the proposition that the harm

caused by the Government misconduct pervaded and altered the

basic constitution of the trial mechanism in all the test cases.

       As previously indicated, Messrs. Izen and Jones contend that

the Government misconduct in these cases includes the alleged

illegal search of Mr. Kersting's office and the issuance of

erroneous notices of deficiency.    However, Messrs. Izen and Jones

disregard the fact that every court considering the matter has

rejected the contention that the search of Mr. Kersting's office

was illegal.    See Kersting v. United States, 865 F. Supp. at 674-

675.    In addition, the Court held in Dixon I that petitioners
                                - 226 -


lack standing to contest the alleged violation of Mr. Kersting's

Fourth Amendment rights.    Further, there is no credible evidence

in the record that respondent issued notices of deficiency to

Kersting program participants that were so erroneous as to render

them invalid.100   Consequently, we will limit our consideration to

the misconduct associated with the secret settlements that

Messrs. Sims and McWade entered with Messrs. Thompson and Cravens

and Mr. McWade's understanding with Mr. Alexander.

     The impact of the Government misconduct in these cases must

be evaluated in the context in which it occurred.    Specifically,

whereas the typical structural defect case arises in a trial of a

single criminal defendant, the test case procedures employed in

these cases concern the tax liabilities of more than 1,300

Kersting program participants who agreed to be bound by the

outcome in a trial of eight test case petitioners, six of whom

were represented by Mr. Izen.

     Although we are convinced that the Thompson and Cravens

settlements had the effect of diluting or diminishing the

adversarial character of the presentation of their cases, we are



     100
         There is no evidence in the record that such errors as
have been discovered in Kersting project statutory notices were
attributable to an improper intention of pressuring taxpayers.
However, the existence of such errors, see, e.g., Richards v.
Commissioner, T.C. Memo. 1997-149, supplemented by T.C. Memo.
1997-299, affd. without published opinion 165 F.3d 917 (9th Cir.
1998), should alert nontest case petitioners and their counsel in
nontest cases not yet disposed of to review their notices and
carefully compare them with their return positions for the
taxable years in question.
                              - 227 -


equally convinced that the Thompson and Cravens settlements

neither prevented Mr. Izen from fully and fairly presenting his

clients' cases to the Court nor resulted in any reduction in the

effectiveness of his presentation on their behalves.    There is no

indication in the record that the Thompson and Cravens

settlements affected Mr. Izen's trial preparation or trial

strategy, or his trial tactics or presentation.    Although Mr.

Thompson's testimony at the trial of the test cases that Mr.

Kersting had orally assured him that his promissory notes would

be canceled in exchange for the return of Kersting stock may have

surprised Mr. Izen, the record reveals that Mr. Izen was well

aware that respondent intended to rely on the so-called comfort

letters to establish the same point.    Mr. Izen's strategy--

conceived before the trial of the test cases and continuing

through the evidentiary hearing--was to rebut the comfort letters

with evidence that Kersting corporations had initiated collection

litigation against Kersting program participants who failed to

make loan payments.   In addition to developing the testimony of

the test case petitioners that he represented, Mr. Izen cross-

examined Messrs. Thompson, Cravens, and Alexander during the

trial of the test cases.   Considering all the facts and

circumstances, we are convinced that the misconduct of Messrs.

Sims and McWade in connection with the Thompson and Cravens

settlements and the Alexander understanding did not alter the

basic framework within which the trial of the test cases was

conducted.   We are convinced that the trial of the test cases
                              - 228 -


served its fundamental function as the vehicle for redetermining

the tax liabilities of the broad array of test case petitioners

represented by Mr. Izen.

     We are not persuaded by Mr. Sticht's argument that the Court

effectively was precluded from supervising the trial of the test

cases because Judge Goffe was not informed of the Thompson and

Cravens settlement agreements.   Judge Goffe was aware that

Messrs. Thompson and Alexander were hostile towards Mr. Kersting.

Although a disclosure of the Thompson and Cravens settlements and

the Alexander understanding would have given Judge Goffe a more

comprehensive basis for weighing their credibility, we do not

equate Judge Goffe's lack of knowledge of the settlements with

the proposition that he was precluded from supervising the trial

of the test cases.   To the contrary, the record in the trial of

the test cases and the evidentiary hearing shows that Judge Goffe

accurately assessed the credibility of Messrs. Thompson, Cravens,

Alexander, and Kersting and maintained firm control of the

proceedings.

     The Ninth Circuit cases that Mr. Sticht relies upon for the

proposition that the nondisclosures to the Court precluded Judge

Goffe from supervising the trial of the test cases are readily

distinguishable from the facts at hand.   In United States v.

Noushfar, 78 F.3d at 1144-1145, the Court of Appeals held that

there was a structural defect in a criminal trial in which the

trial judge abdicated control of the presentation of evidence by

allowing the jury to take into the jury room tapes of the
                              - 229 -


defendants' conversations that had never been played in open

court.   In Riley v. Deeds, 56 F.3d at 1119, the Court of Appeals

held that there was a structural defect in a criminal trial in

which, in the trial judge's absence, the trial judge's law clerk

convened the court and permitted the court reporter to read back

part of the victim's testimony to the jury.   Considering the

obvious distinctions between the errors of omission of the trial

judges in the jury trial cases relied upon by Mr. Sticht, and

Judge Goffe's role in the trial of the test cases, we reject Mr.

Sticht's structural defect argument.

     We likewise reject Mr. Sticht's argument that a structural

defect occurred by reason of respondent's failure to inform

nontest case petitioners who signed piggyback agreements that

two test case petitioners had received contingent settlements.

Although Mr. Sticht characterizes this failure as a structural

defect, Mr. Sticht's argument amounts to little more than a

breach of contract theory--a matter we address more fully below.

In any event, we restate our earlier conclusion that the trial of

the test cases served its fundamental function as the vehicle for

redetermining the tax liabilities of Mr. Izen's test case

petitioners to embrace the broader proposition that the nontest

case petitioners who signed piggyback agreements received what

they bargained for, an opinion and a series of decisions on the

merits in Dixon II that covers a broad array of Kersting programs

for the taxable years 1975 through 1983.
                             - 230 -


     Mr. Sticht contends that Mr. Izen's representation of test

case petitioners does not provide a sound basis for concluding

that the Government misconduct did not cause a structural defect

in the trial of the test cases.   In particular, Mr. Sticht points

to Mr. Kersting's interference in the Chicoine and Hallett

settlement negotiations and his eventual firing of Chicoine and

Hallett, and Mr. Izen's alleged lack of preparation for the

trial, as evidence that nontest case petitioners were not

afforded due process.

     Mr. Kersting, the shelter promoter, had the incentive and

initially the resources to finance the test case litigation.    By

so doing, Mr. Kersting positioned himself to influence or

determine the choice of counsel hired to represent the test case

petitioners, creating the potential for conflicts of interest.

Mr. Kersting repeatedly used his control of the purse strings to

interfere in the attorney-client relationships of participants

in his programs, as evidenced by his attempts to initiate

Mr. Seery's withdrawal as test case counsel for the Thompsons

and his efforts to forestall dissemination to Kersting program

participants of Internal Revenue Service settlement offers

solicited by Mr. Seery and by Chicoine and Hallett.   The pattern

of interference continued in Mr. Kersting's firing of Chicoine

and Hallett as counsel for test case petitioners and encouraging

nontest case petitioners to recall their settlement retainers
                                - 231 -


from Chicoine and Hallett.101   The record of the evidentiary

hearing contains evidence that Mr. Kersting participated in and

perhaps orchestrated efforts to create disaffection among

Mr. Sticht's clients.

     It is also ironic--if true--that Mr. Kersting did not inform

Mr. Izen of the Thompson and Cravens settlements at or before the

trial of the test cases.   If Mr. Kersting had informed Mr. Izen

and Mr. Izen had informed Judge Goffe, the trial might have been

somewhat delayed, but the tax liabilities of the nonsettling

Kersting test case and nontest case petitioners would have been

finally resolved long ago, with attendant avoidance or reduction

     101
         A lawyer who planned or helped to promote a tax shelter
or is otherwise under the control of a tax shelter promoter has a
conflict of interest in representing participants in the tax
shelter because he will not (or may not) give disinterested
advice regarding settlement offers that may conflict with his
original advice or the interests of the promoter. See Ewing v.
Commissioner, 91 T.C. at 397 n.2; Para Techs. Trust v.
Commissioner, T.C. Memo. 1992-575.

     Chicoine and Hallett, in their retainer agreements with the
test case petitioners and by their actions, made clear that
although they were not averse to obtaining additional business,
they had no conflict of interest and that their primary loyalty
was to their clients. Mr. Kersting fired Chicoine and Hallett
when, on the basis of their independent appraisal of the weakness
of the Kersting programs, they tried to obtain the most favorable
settlements available on behalf of as many participants, test
case and nontest case petitioners, as possible. Because of his
potential personal liability for both promoter penalties and
Federal income taxes, and his financial interest in trying to
vindicate himself and his programs, Mr. Kersting scuttled the
settlements, fired Chicoine and Hallett, and found another
attorney to represent the test case petitioners in the trial of
the test cases. Mr. Kersting's lack of sensitivity to the
conflict issue and counsel's obligation to issue disinterested
advice to clients is exemplified by his misplaced emphasis in
mischaracterizing Chicoine and Hallett's actions as primarily
stemming from fear of suit by their clients.
                              - 232 -


of interest costs, legal fees, and expenditure of private party,

administrative, attorney, and judicial resources.

     Nevertheless, Mr. Kersting's misconduct does not somehow tip

the scale in favor of finding a structural defect in the trial of

the test cases.   While Mr. Kersting endeavored to keep all the

nontest case petitioners under his wing through his numerous

"Dear Friend" letters and through the hiring and firing of

counsel for test case petitioners, nontest case petitioners

should have been alerted to the potential for and presence of

conflicts between their interests and those of Mr. Kersting by

Mr. Seery's withdrawal as counsel, as well as by the firing of

Chicoine and Hallett.   However, neither Mr. Kersting's payment of

Mr. Izen's fees, nor our review of the record in Dixon II,

suggests that Mr. Izen's representation of the test case

petitioners was inadequate, in the sense that there is anything

more that he or any other attorney could have done that would

have led to a different outcome.

     At the end of the day, the Government misconduct in these

cases is not readily comparable to any of the fundamental

constitutional violations that the Supreme Court has identified

as a structural defect, e.g., denial of the right to counsel or

the right to self-representation, the right to an impartial

judge, or the right to a public trial.   In this regard, we are

mindful of the Supreme Court's statement in Arizona v.

Fulminante, 499 U.S. 279 (1991), that most constitutional errors

are amenable to harmless-error analysis.   Considering all the
                                - 233 -


facts and circumstances, including the unique nature of the test

case procedure, the specific configuration adopted for the trial

of the Kersting test cases, and Mr. Izen's ability fully and

fairly to present his clients' cases during the trial, we find

that the Government misconduct did not result in a trial that was

fundamentally unfair.     See id. at 308; see also Greer v. Miller,

483 U.S. 756, 768 (1987) (Stevens, J., concurring).      Stated

differently, although we disapprove Messrs. Sims' and McWade's

misconduct, as well as the misconduct of Mr. Kersting and

Mr. DeCastro, we do not conclude that their misconduct resulted

in a structural defect in the trial of the test cases mandating

either a new trial or entry of decisions in petitioners' favor.

III. Harmless Error Analysis

     Although we have concluded that the Sims-McWade misconduct

did not result in a structural defect in the trial of the test

cases, we must consider whether petitioners are entitled to a new

trial on the ground that the misconduct resulted in reversible

error as opposed to harmless error.       See Arizona v. Fulminante,

supra at 307-308.     Although structural defect inquiries have

generally been limited to criminal cases, reversible versus

harmless error analysis appears in civil as well as criminal

cases.102

     The Court's Rules of Practice and Procedure set forth the

principle of harmless error as follows:

     102
            See generally Traynor, "The Riddle of Harmless Error"
(1970).
                                - 234 -


     Rule 160. HARMLESS ERROR

          No error in either the admission or exclusion of
     evidence, and no error or defect in any ruling or order
     or in anything done or omitted by the Court or by any
     of the parties, is ground for granting a new trial or
     for vacating, modifying, or otherwise disturbing a
     decision or order, unless refusal to take such action
     appears to the Court inconsistent with substantial
     justice. The Court at every stage of a case will
     disregard any error or defect which does not affect the
     substantial rights of the parties.

Rule 160 is "substantially the same as" rule 61 of the Federal

Rules of Civil Procedure.   See 60 T.C. 1144; see also Fed. R.

Crim. P. 52(a).

     In civil cases, an error related to admission of evidence or

attorney misconduct is considered harmless if there is no

prejudicial effect and/or the error did not affect the judgment.

See Chalmers v. City of Los Angeles, 762 F.2d 753, 761-762 (9th

Cir. 1985); see also Mateyko v. Felix, 924 F.2d 824, 827-828 (9th

Cir. 1991) (new trial is warranted only if misconduct affected

the verdict).   The standard of proof in such cases is normally

clear and convincing evidence.    See, e.g., Bunch v. United

States, 680 F.2d at 1283.

     The Supreme Court has adopted a similar standard for

reviewing errors associated with prosecutorial misconduct in

criminal cases.   See United States v. Bagley, 473 U.S. 667

(1985); Smith v. Phillips, 455 U.S. 209 (1982); United States v.

Agurs, 427 U.S. 97 (1976); Giglio v. United States, 405 U.S. 150

(1972); Brady v. Maryland, 373 U.S. 83 (1963); Napue v. Illinois,
                               - 235 -


360 U.S. 264 (1959).103   In criminal cases, the Government

generally is obliged to show beyond a reasonable doubt that the

alleged error did not affect the verdict.    See Arizona v.

Fulminante, supra at 295-296; Chapman v. California, 386 U.S. at

24.

       Consistent with the approach of the cases on harmless error

in both the civil and criminal contexts, our inquiry is not

focused on the merits of the matter or the correctness of the

result in Dixon II, as such, but on what Justice Roger Traynor,

in his seminal essay, "The Riddle of Harmless Error" (1970),

called the "effect on the judgment" test of harmless error.     Id.

at 22.104   We therefore will assess the effects of the Sims-McWade

misconduct in the cases at hand in the light of evidence

presented at the trial of the test cases and the evidentiary

hearing in order to determine whether the Government misconduct

was material to the outcome of the trial of the test cases.

Arizona v. Fulminante, supra at 307-308; United States v. Bagley,

supra at 679-680 n.9.



      103
         Although these criminal cases concern the prosecutor's
use of false testimony, as well as the prosecutor's suppression
of exculpatory and impeachment evidence, we believe they are
sufficiently analogous to the cases at hand where, at a minimum,
the Thompson and Cravens secret settlements and the Alexander
understanding could be viewed either as evidence that was
improperly admitted or impeachment evidence that was improperly
excluded.
      104
         For a more recent espousal of the same test in a
discussion limited to criminal cases see Edwards, “To Err Is
Human, But Not Always Harmless: When Should Legal Error Be
Tolerated?”, 70 N.Y.U.L. Rev. 1167 (1995).
                                - 236 -


     Although our task has been made onerous by the magnitude of

the record of the original trial and the evidentiary hearing, the

task has been facilitated by the Court's detailed and

discriminating findings of fact and discussion of law in Dixon

II, as required by section 7459(a).       We are not confronted by the

opacity of a jury general verdict or cursory findings by a trial

judge sitting without a jury.     See Traynor, supra at 22-25.    We

reject Mr. Sticht's assertions that we are engaging in sheer

speculation or embarking on uncharted waters in proceeding with

the reversible error versus harmless error analysis mandated by

the Court of Appeals.     The road map provided by the Court's

findings and opinion in Dixon II could not be more detailed and

specific in relation to the record of the trial and the

evidentiary hearing.

     We therefore will first review the Court's Dixon II opinion

and then consider the relative importance of the testimony and

evidence of Messrs. Thompson, Cravens, and Alexander to the

Court's holdings in Dixon II.

A.   Review of Dixon II

     The Court's opinion in Dixon II contains a detailed

description of the various Kersting programs and a comprehensive

analysis in support of the Court's determination to sustain

respondent's disallowances of Kersting interest deductions.      In

Dixon II, the Court held that the Kersting loans were sham

transactions lacking economic substance, that the loans did not
                              - 237 -


constitute genuine debt, and that interest was not "paid" on

Kersting loans within the meaning of section 163.

     1.   Mr. Kersting's Lack of Credibility

     In Dixon II, the test case petitioners bore the burden of

proof and were required to show by a preponderance of the

evidence that respondent's determinations disallowing Kersting

interest deductions were erroneous.     See Rule 142(a).   As

discussed below, it is evident the test case petitioners' efforts

to satisfy their burden of proof were frustrated by the lack of

credibility of their principal witness, Mr. Kersting.

     Judge Goffe made it abundantly clear in Dixon II, on the

bases of both his observations of Mr. Kersting at trial and his

review of the record, that Mr. Kersting lacked credibility,

particularly his testimony having a bearing on the tax viability

of his programs.   Examples cited by Judge Goffe as evidence of

Mr. Kersting's lack of credibility included his false testimony

regarding:   (1) The filing of tax returns for Kersting

corporations; (2) the reasons behind the closing of Kersting

accounts at Hawaii National Bank; (3) the level of Gabriele

Kersting's participation in daily corporate operations; (4) the

reasons for the frequent creation of new acceptance corporations;

and (5) the methods used to value Kersting stock.     See Dixon II,

62 T.C.M. (CCH) at 1482, 1484, 1487, 1991 T.C.M. (RIA), at 91-

3024 to 91-3025, 91-3026 to 91-3027, 91-3029 to 91-3031.
                              - 238 -


     2.   Sham Analysis

     The Dixon II opinion reveals that Judge Goffe relied upon

evidence that was both qualitatively and quantitatively

substantial in support of the conclusion that the Kersting stock

transactions in dispute were shams.     Although acknowledging that

some Kersting corporations engaged in businesses unrelated to the

disputed Kersting programs, Judge Goffe concluded that the

viability and activities of the various Kersting corporations

were not determinative of whether the specific Kersting

transactions in dispute were shams.     See id. at 1485-1486, 1991

T.C.M. (RIA), at 91-3028; see also ACM Partnership v.

Commissioner, T.C. Memo. 1997-115, affd. on this issue 157 F.3d

231, 260 (3d Cir. 1998).

     Judge Goffe reviewed the relevant testimony and particular

circumstances of each test case petitioner and concluded that the

presence of several factors common to all of them invariably

required the finding that petitioners had no subjective business

purpose for engaging in the Kersting programs other than tax

avoidance.   In particular, Judge Goffe found that the test case

petitioners entered into the Kersting programs without specific

knowledge about the Kersting corporations involved, the

industries in which they operated, and the impact of prevailing

economic conditions on their investment decisions, and without

obtaining the assistance of an independent adviser.    Judge Goffe

further found that the test case petitioners entered into the

Kersting programs without regard to whether the purchase price
                               - 239 -


for the stock that they purported to purchase was reasonable and

appropriate.    See Dixon II, 62 T.C.M. (CCH) at 1486-1491, 1991

T.C.M. (RIA), at 91-3027 to 91-3034.     Indeed, Judge Goffe found

that Mr. Kersting had failed to explain clearly, consistently, or

credibly how he had determined the value of Kersting stock upon

both its sale and reacquisition from test case petitioners and

other Kersting program participants.     See id. at 1487, 1991

T.C.M. (RIA), at 91-3030.

     Judge Goffe noted that Mr. Cravens had testified that his

purpose for entering into the Kersting programs was "mainly" for

tax shelter, that Mr. Cravens had failed to offer any other

reason for his participation in the Kersting programs, and that

Mr. Cravens had opened and closed two Kersting programs (stock

subscription plans) during a 2-year period (1979 and 1980)

without any economic profit or loss other than being out-of-

pocket the cash payments on his leverage notes.    See id. at 1488,

1991 T.C.M. (RIA), at 91-3031.

     As with several other test case petitioners, Judge Goffe

disregarded Mr. Thompson's testimony that he expected to profit

from his participation in the Kersting programs on the ground

that Mr. Thompson's testimony was vague and not supported by the

record.    Judge Goffe rejected Mr. Thompson's argument that his

participation in the First Savings acquisition contributed to his

profit motive for participating in the Kersting programs at

issue.    See id. at 1489-1490, 1991 T.C.M. (RIA), at 91-3032 to

91-3033.
                              - 240 -


     Judge Goffe further concluded that the test case petitioners

failed to show that the Kersting programs had economic substance

beyond the creation of tax benefits.    Relying primarily upon the

manner in which Mr. Kersting actually operated the programs,

Judge Goffe found that there was little if any likelihood of

either corporate profitability or shareholder profitability.

Even assuming some level of corporate profitability and a

related increase in the value of Kersting stock, Judge Goffe

found it significant that no evidence was offered either through

Mr. Kersting or the test case petitioners that Kersting program

participants were ever in a position to sell their stock at an

increased value relative to the purchase price of the stock.

Finally, Judge Goffe found that Mr. Kersting routinely

disregarded standard corporate practices.   See id. at 1491-1494,

1991 T.C.M. (RIA), at 91-3034 to 91-3038.

     Consistent with his findings that the test case petitioners

had no business purpose for entering into the Kersting programs

other than tax avoidance and that the transactions lacked

economic substance, Judge Goffe held that the stock transactions

were shams.

     3.   Lack of Genuine Debt/Waltz of Funds

     After concluding that the stock transactions were shams,

Judge Goffe went on to consider whether the primary and leverage

loans constituted genuine debt that qualified for deduction under

section 163(a).   Judge Goffe independently examined each of the

Kersting programs and loans in dispute.
                                - 241 -


           i.     Subscription Interest

     Relying upon the specific language in the stock subscription

agreements underlying the stock subscription plan and the leasing

corporation plan, Judge Goffe held that the agreements, standing

alone, did not create an unconditional debt obligation.    See id.

at 1494-1496, 1991 T.C.M. (RIA), at 91-3038 to 91-3040.

     Judge Goffe further denied deductions for subscription

interest under the Stock Subscription and Leasing Corporation

Plans on the ground that such interest was not "paid" within the

meaning of section 163(a).    In so holding, Judge Goffe focused on

Mr. Kersting's practice of carrying out a circular flow of checks

among Kersting corporations and investors at the same bank on the

same day--the so-called waltz of funds.    See, e.g., Davison v.

Commissioner, 107 T.C. 35 (1996), affd. per curiam 141 F.3d 403

(2d Cir. 1998).    In particular, Judge Goffe identified two

specific instances in which Mr. Kersting waltzed funds affecting

Stock Subscription Plans.    In one instance, Mr. Kersting waltzed

primary loan funds; in the other instance, he waltzed leverage

loan funds.     Relying upon evidence that there were several other

potential waltz situations across the board with respect to the

stock purchase plan, the stock subscription plan, and the leasing

corporation plan, Judge Goffe found that waltzes were essential

elements of all the Kersting stock transactions.    See Dixon II,

62 T.C.M. (CCH) at 1496-1499, 1991 T.C.M. (RIA), at 91-3040 to

91-3043.
                                 - 242 -


           ii.   Primary Loans

     Judge Goffe determined that several features of the primary

loans prevented them from being genuine debt in substance.

First, Judge Goffe found that Mr. Kersting and program

participants had an understanding at the commencement of a

program, as reflected in a number of so-called comfort letters,

that a primary loan obligation could be satisfied in full at any

time by a mere surrender of the associated stock certificate.     In

so finding, Judge Goffe rejected Mr. Kersting's testimony that he

did not represent to program participants that they could

exchange their stock for cancellation of a primary note at any

time.   To the contrary, Judge Goffe listed the following nine

items in support of his conclusion that Mr. Kersting applied the

policy outlined in his so-called comfort letters to all program

participants:    (1) Mr. Thompson's testimony that Mr. Kersting

assured him of the exchange policy; (2) Mr. Kersting's

description of a stock subscription plan to Mil Harr; (3)

Gabriele Kersting's form letter to test case petitioner Terry D.

Owens describing a stock subscription plan; (4) Mr. Kersting's

form letter describing a leasing corporation plan; (5)

Mr. Kersting's form letter issued on the first anniversary of a

leasing corporation plan; (6) Mr. Kersting's acknowledgment in a

comfort letter that such a letter would be issued to "every

participant * * * if it would not weaken YOUR position with the

IRS"; (7) Mr. Kersting's broad statement in a later comfort

letter that "We will always repurchase the stock issued at a
                              - 243 -


price sufficient to allow a borrower to discharge all of his

debt"; (8) Mr. Kersting's statements in a credit-reference letter

written on behalf of a program participant; and (9) a form letter

issued to test case petitioner Jerry R. Dixon describing the

process for the termination of his participation in a stock

purchase plan.   See id. at 1499-1500, 1991 T.C.M. (RIA), at 91-

3043 to 91-3044.

     Continuing his analysis, Judge Goffe concluded that, even

assuming that there was no prearranged understanding between

Mr. Kersting and program participants, neither Mr. Kersting nor

the program participants ever contemplated that the principal

obligation on a primary loan would be paid except by a surrender

of the underlying stock.   Judge Goffe reached this conclusion

after finding that:   (1) No evidence was produced of a primary

note ending up in the hands of anyone not associated with

Mr. Kersting; (2) primary loans issued during later years

included an express notation that they were nonnegotiable and

nonassignable; and (3) primary loans were unsecured, with the

primary notes failing to list even the purchased stock as

collateral.   See id. at 1500, 1991 T.C.M. (RIA), at 91-3044.

Judge Goffe further concluded that program participants would not

have assumed liability for the high level of debt that the

primary loans represented, considering their lack of

understanding of the Kersting corporations in which they were

purportedly investing, "unless they had no expectation or

intention of ever paying off those loans with cash".   Id.
                                 - 244 -


     Judge Goffe found additional support for his conclusion that

the primary loans did not constitute genuine debt in

Mr. Kersting's backdating of documents relevant to the loan

transactions and the apparent waltz of primary loan funds under

the stock purchase plan and the leasing corporation plan.   See

id. at 1500-1502, 1991 T.C.M. (RIA), at 91-3044 to 91-3046.

     Judge Goffe held in the alternative that, even assuming that

the primary loans represented genuine debt, the test case

petitioners had failed to show that they actually "paid" interest

on the primary loans within the meaning of section 163(a)

inasmuch as Mr. Kersting apparently waltzed leverage loan funds

that were used to pay interest on primary loans.   See id. at

1502, 1991 T.C.M. (RIA), at 91-3046.

           iii. Leverage Loans

     Judge Goffe determined that leverage loans did not represent

genuine debt because of several factors, including the waltzing

of funds, backdating of documents, substance not following form,

and mutual expectations that program participants would not incur

personal liability for the principal amounts of the leverage

loans.    See id. at 1502-1503, 1991 T.C.M. (RIA), at 91-3046 to

91-3047.

     4.    Collection Litigation

     As previously discussed, Mr. Izen offered evidence on behalf

of test case petitioners that various Kersting corporations

initiated collection actions against Kersting program

participants in an attempt to rebut respondent's evidence that
                                 - 245 -


there was a mutual understanding between Mr. Kersting and his

program participants that primary and leverage loans would not be

enforced.    Judge Goffe rejected the collection litigation

evidence as a basis for sustaining the validity of the Kersting

loans as follows:

          As illustrated by Kersting's pay-or-else letter
     to over 30 clients on September 25, 1980, and his 1986
     correspondence with the Thompsons, his overriding
     concern was to be compensated by means of leverage loan
     interest. It was this amount that even he often
     referred to as a "fee" or a deductible "cost" of tax
     deductions. In encouraging clients by means of the
     September 25, 1980, letter to "discharge the debt to
     which you are a party," he sought only small amounts
     that could not have represented typical primary or
     leverage loans. His letters to the Thompsons indicate
     that he only threatened or pursued collection of
     principal obligations when the investor neglected or
     refused to pay leverage loan interest. This rare
     occurrence, which Kersting did not testify he either
     intended or expected, is not sufficient to transform
     any of petitioners' loans from Kersting corporations
     into genuine recourse indebtedness.

Id. at 1506, 1991 T.C.M. (RIA), at 91-3049 to 91-3050.

     5.     CAT-FIT Plan

     Judge Goffe found that the record in the trial of the test

cases did not provide a basis for the Court to understand fully

how the CAT-FIT program operated or how Mr. Kersting intended the

program to operate.105     In any event, Judge Goffe concluded that:

(1) The CAT-FIT program was a sham transaction that provided no

economic benefit other than the creation of tax losses; (2) the


     105
         The test case petitioners who participated in the CAT-
FIT program included the Dixons, DuFresnes, Owenses, and
Hongsermeiers. See Dixon II, 62 T.C.M. (CCH) at 1507, 1991
T.C.M. (RIA), at 91-3050 to 91-3051.
                             - 246 -


CAT-FIT primary loan did not constitute genuine debt because the

parties never contemplated that such loans would be paid except

by means of a redemption of the investment certificate;106 (3)

CAT-FIT participants did not pay interest on primary loans

insofar as Mr. Kersting waltzed leverage loan funds; (4) the CAT-

FIT leverage loan did not constitute genuine debt inasmuch as (a)

Kersting program participants failed to demonstrate how the

leverage loan principal obligations were satisfied or intended to

be satisfied;107 and (b) Mr. Kersting waltzed leverage loan funds;

and (5) the CAT-FIT primary and leverage loans did not result in

allowable interest deductions under the rationale of Goldstein v.

Commissioner, 364 F.2d 734 (2d Cir. 1966) (form of transaction

will not be exalted over substance when sole objective of

transaction is an interest deduction, even if transaction has

some minimal economic gain potential), affg. 44 T.C. 284 (1965).

See Dixon II, 62 T.C.M. (CCH) at 1508-1509, 1991 T.C.M. (RIA), at

91-3051 to 91-3053.




     106
         Judge Goffe further concluded that the CAT-FIT primary
loan did not constitute genuine debt insofar as the record
indicated that Mr. Kersting had waltzed primary loan funds. See
Dixon II, 62 T.C.M. (CCH) at 1508, 1991 T.C.M. (RIA), at 91-3052.
     107
         In this regard, Judge Goffe rejected the test case
petitioners' attempt to show that CAT-FIT leverage loans were
genuine recourse debt through evidence of collection litigation
brought against George Vermef. See Dixon II, 62 T.C.M. (CCH) at
1509, 1991 T.C.M. (RIA), at 91-3053.
                                - 247 -


     6.    Additions to Tax

           i.     Negligence

     Judge Goffe sustained respondent's determinations that the

test case petitioners were liable for additions to tax for

negligence.     In particular, Judge Goffe found that the test case

petitioners failed to show that they were unsophisticated

taxpayers, that they relied upon independent return preparers or

tax advisers, the nature of any professional advice that they may

have received, or that any such professional advice was based

upon a disclosure of all of the relevant facts.      See id. at 1512-

1513, 1991 T.C.M. (RIA), at 91-3056 to 91-3057.108

           ii.    Late Filing

     Judge Goffe sustained respondent's determination that the

Thompsons were liable for the addition to tax for late filing

under section 6651(a)(1) for 1981 on the ground that they did not

contest the matter and were deemed to have conceded the point.109

See id. at 1513, 1991 T.C.M. (RIA), at 91-3057.

           iii. Substantial Understatement

     Judge Goffe sustained respondent's determination that the

Youngs and the DuFresnes were liable for additions to tax for



     108
         Although Judge Goffe sustained respondent's
determinations that the test case petitioners were liable for
additions to tax for negligence, nontest case petitioners who
signed post-1985 piggyback agreements were to be relieved of
liability for such additions to tax for tax years before 1982.
See supra pp. 43-45.
     109
         We note that the Thompsons had no need to contest this
addition to tax by virtue of their settlement agreement.
                               - 248 -


substantial understatements of their income tax liabilities for

the taxable years 1982 and 1983 at a rate equal to 10 percent of

the underpayment.   In short, the Youngs and the DuFresnes had

contested the addition to tax only insofar as their liabilities

depended upon respondent's prevailing on their deficiencies to a

sufficient extent to exceed the substantial understatement

threshold of section 6661(b)(1)(A) (deficiency must exceed

greater of 10 percent of the tax required to be shown on the

return, or $5,000).   See id. at 1513-1514, 1991 T.C.M. (RIA), at

91-3058.

           iv.   Increased Interest

     Judge Goffe sustained respondent's determinations that the

Thompsons were liable for interest computed at the increased rate

prescribed in section 6621(c) for 1981, that the Youngs were

liable for such increased interest for the taxable year 1982, and

that the DuFresnes were liable for such increased interest for

the taxable years 1982 and 1983.110   In short, Judge Goffe

sustained these determinations on the ground that the Court had

already determined that the test case petitioners' underpayments

were attributable to "tax motivated transactions"; viz, sham

transactions, as provided in section 6621(c)(3)(A)(v).    See id.

at 1514, 1991 T.C.M. (RIA), at 91-3058.




     110
         Nontest case petitioners who signed post-1985 piggyback
agreements agreed to be bound by the Court’s determination in the
test cases regarding the applicability of sec. 6621(c).
                                - 249 -


B.   Discussion

     Whether the Government misconduct in these cases constitutes

reversible error as opposed to harmless error does not turn on

the "culpability of the prosecutor" but on whether nondisclosure

of the Thompson and Cravens settlements and the Alexander

understanding was material to the outcome in Dixon II.    See Smith

v. Philips, 455 U.S. at 219; Brady v. Maryland, 373 U.S. at 87;

Mateyko v. Felix, 924 F.2d at 827-828; Chalmers v. City of Los

Angeles, 762 F.2d at 761-762.    We evaluate the impact of the

Government misconduct on the outcome in Dixon II on the basis of

the entire record.

     1.   Mr. Cravens

     Mr. McWade's settlement agreement with Mr. Cravens placed

a cap on the Cravenses' tax liabilities for 1979 and 1980.

However, we have found that Mr. McWade deliberately misled

Mr. Cravens regarding the nature and effect of his settlement.

In particular, Mr. McWade initially misinformed Mr. Cravens that

he could neither win nor lose at the trial of the test cases as

the basis for advising him that he need not retain counsel.

Relying on this misinformation and bad advice, Mr. Cravens

appeared at the trial of the test cases without counsel.    Mr.

Cravens was surprised when Mr. McWade informed him immediately

before his testimony at the trial of the test cases that he would

receive the better of his earlier settlement or a Tax Court

decision in favor of the test case petitioners.
                              - 250 -


     Mr. Cravens' testimony at the trial of the test cases was

brief.   Mr. Cravens testified that he participated in stock

subscription programs in 1979 (Candace) and 1980 (Delta).

Mr. Cravens testified that he participated in the Kersting

programs mainly for the tax benefits; he did not offer any other

motivation for his participation.   Mr. Cravens did not testify

regarding the validity of his promissory notes or his level of

sophistication as an investor.   Mr. Cravens testified that he

closed out his participation in the Kersting programs by

endorsing his stock certificates and returning them to Mr.

Kersting in exchange for his promissory notes.

     Although we believe that Mr. Cravens' testimony at the trial

of the test cases was truthful in all material respects, we do

believe that counsel could have assisted Mr. Cravens in

presenting a more detailed and better organized case,

particularly with regard to Mr. Cravens' motivation for

participating in Mr. Kersting's programs and Mr. Cravens' view of

the validity of his promissory notes.

     We have also found that Messrs. Sims and McWade misled the

Court and the remaining parties to these cases by not disclosing

the Cravens settlement before the trial of the test cases.     We

recognize that Judge Goffe might have removed the Cravens cases

from the test case array had he been informed of their settlement

before the trial.   Indeed, an argument can be made that Judge

Goffe would have removed the Cravens cases from the test case
                               - 251 -


array, inasmuch as the remaining test cases provided full

coverage of the Kersting programs and taxable years in dispute.

     Under the circumstances, we must weigh the impact of the

Government misconduct in the Cravens cases on two levels.   First,

because Mr. McWade led Mr. Cravens to believe that he did not

need counsel at the trial of the test cases, we must consider

whether Mr. Cravens' pro se status (and attendant lack of

preparation and organization) was material to the outcome in the

trial of the test cases.   Second, because Judge Goffe might

have removed the Cravens cases from the test case array if he had

known that they had been settled, we must consider whether Mr.

Cravens' testimony was material to the outcome in Dixon II.    As

discussed in greater detail below, we are convinced that the

outcome in Dixon II would not have been different irrespective of

whether Mr. Cravens had been represented at trial by competent

counsel or whether Judge Goffe would have excluded Mr. Cravens'

testimony in its entirety.

          i.   Sham Analysis

     We will assume that, but for Mr. McWade's interference,

Mr. Cravens would have appeared at the trial of the test cases

with counsel and testified (consistent with the testimony of the

other test case petitioners) that he participated in the Kersting

programs with a view towards making a profit and that his

promissory notes constituted genuine indebtedness.   Nevertheless,

on the basis of our review of Dixon II, we are convinced that
                              - 252 -


Mr. Cravens' testimony would not have changed Judge Goffe's

conclusion that the test case petitioners had no business purpose

for participating in the Kersting programs.   Judge Goffe relied

upon factors common to all test case petitioners in rejecting

their testimony that they had entered into the Kersting

transactions with a view towards making a profit on stock

appreciation.   Specifically, Judge Goffe found that the test case

petitioners participated in the Kersting programs without regard

to whether the purchase price for the stock that they purported

to purchase was reasonable and appropriate, and without specific

knowledge about the Kersting corporations involved, the

industries in which they operated, or the impact of prevailing

economic conditions on their investment decisions.   Under the

circumstances, we are convinced that Mr. Cravens' pro se status

was not material to Judge Goffe's holding that the test case

petitioners had no business purpose for participating in the

Kersting transactions.

     We are also convinced that Mr. Cravens' testimony was not

material to Judge Goffe's holding that the test case petitioners

lacked a business purpose for participating in the Kersting

programs.   In particular, although Mr. Cravens testified that he

participated in the Kersting programs mainly for the tax

benefits, we are convinced, upon the basis of Judge Goffe's

comprehensive analysis of the test case petitioners' lack of

business purpose, that Mr. Cravens' testimony on this point was
                             - 253 -


cumulative of other evidence in the record and was not material

to Judge Goffe's holding.

     Judge Goffe also concluded that the test case petitioners

failed to prove that the Kersting programs had economic substance

beyond the creation of tax benefits.   Relying primarily upon the

manner in which Mr. Kersting actually operated the programs,

Judge Goffe found that there was little if any likelihood of

either corporate profitability or shareholder profitability, that

there was no evidence that Kersting program participants were in

a position to sell their stock at an increased value relative to

the purchase price of the stock, and that Mr. Kersting routinely

disregarded standard corporate practices.   Because Judge Goffe

focused on the manner in which Mr. Kersting actually operated the

programs, we are convinced that Mr. Cravens' pro se status was

not material to Judge Goffe's holding that the Kersting programs

lacked economic substance.

     Similarly, we are convinced that Mr. Cravens' testimony was

not material to Judge Goffe's holding on this point.   Although

Mr. Cravens had terminated his participation in consecutive stock

subscription plans in 1979 and 1980 without any economic benefit,

we note that none of the test case petitioners presented any

evidence that they enjoyed any economic benefit from their

participation in the Kersting programs in dispute.   In this

light, we are convinced that Mr. Cravens' testimony was

cumulative of other evidence and was not material to Judge

Goffe's holding that the test case petitioners failed to prove
                              - 254 -


that the Kersting programs had economic substance beyond the

creation of tax benefits.

     ii.   Lack of Genuine Debt/Waltz of Funds

     Judge Goffe also concluded that the test case petitioners

failed to show that Kersting promissory notes constituted genuine

debt or that interest was actually "paid" on the loans within the

meaning of section 163(a).   As previously mentioned, Mr. Cravens

participated in consecutive stock subscription plans in 1979 and

1980.   Relying upon the specific language used in stock

subscription agreements underlying the stock subscription plan

and the leasing corporation plan, Judge Goffe held that the

agreements, standing alone, did not create an unconditional debt

obligation.   Judge Goffe further denied deductions for

subscription interest under the Stock Subscription Plan and the

leasing corporation plan on the ground that such interest was

not "paid" within the meaning of section 163(a) by virtue of

Mr. Kersting's waltz of funds.   In particular, Judge Goffe

identified two specific instances in which Mr. Kersting waltzed

funds affecting stock subscription plans.   In one instance, the

waltz concerned primary loan funds, while in the other the waltz

concerned leverage loan funds.   Considering the bases for Judge

Goffe's analyses on these points, we are convinced that neither

Mr. Cravens' pro se status nor his testimony was material to

Judge Goffe's holdings that the test case petitioners failed to

show that Kersting promissory notes constituted genuine debt or
                              - 255 -


that interest was actually "paid" on Kersting loans within the

meaning of section 163(a).

     In sum, we conclude that the Government misconduct relating

to the Cravens cases constituted harmless error with respect to

Judge Goffe's holdings that the Kersting transactions were shams,

that the loans underlying the various Kersting programs did not

constitute genuine indebtedness, and that interest was not paid

on Kersting loans within the meaning of section 163(a).

     2.    Mr. Thompson

     Mr. McWade's settlement agreement with Mr. Thompson placed a

cap on the Thompsons' tax liabilities for the taxable years 1979,

1980, and 1981, and ensured that the Thompsons would receive

refunds of tax and interest previously remitted to respondent

for those years.   The Thompson settlement was amended shortly

before the trial of the test cases to assure that the refunds

that the Thompsons would receive would be more than sufficient

to pay Mr. DeCastro's attorney's fees.   The Thompson settlement

created conflicts of interest for Mr. Thompson and Mr.

DeCastro.111

     By virtue of his settlement, Mr. Thompson was in a position

to use the trial of the test cases as a forum either to attempt

to further reduce his personal tax liabilities by contesting

     111
         Mr. DeCastro's conflict in the Thompson cases became
acute when he agreed, in the context of the final revision to the
Thompson settlement, to participate in Messrs. Sims and McWade's
scheme to keep the Thompsons among the test cases petitioners and
to provide the masquerade of trial representation for the
Thompsons as one of the test cases.
                              - 256 -


respondent's deficiency determinations or to air his grievances

against Mr. Kersting and possibly achieve some advantage against

Mr. Kersting's threats to collect on Mr. Thompson's promissory

notes.   Our review of Mr. Thompson's testimony at the trial of

test cases, which testimony was both favorable and detrimental

to the cause of the test case petitioners, suggests that

Mr. Thompson may have viewed the trial of the test cases as an

opportunity to attempt to attain both objectives.    On the one

hand, Mr. Thompson sought to prove that, because of his prior

involvement in the First Savings acquisition, he had a legitimate

business purpose; i.e., a profit motive, for participating in

Mr. Kersting's programs.   On the other hand, Mr. Thompson was the

only test case petitioner to testify that Mr. Kersting had orally

assured him that promissory notes would not be enforced.

     Despite Mr. Thompson's apparently conflicting objectives, we

are convinced that Mr. Thompson's testimony at the trial of the

test cases was truthful.   Although Mr. Thompson testified that

Mr. Kersting had assured him that promissory notes would not be

enforced, Mr. Thompson's testimony merely corroborated

Mr. Kersting's written assurances or comfort letters to so-called

"nervous Nellies".   Moreover, in a March 1986 letter, Mr.

Kersting had confirmed to Mr. Thompson that his promissory notes

would be canceled if Mr. Thompson would surrender all relevant

stock certificates to Mr. Kersting.     It appears that Mr. Kersting

later reneged on this confirmation by requiring that Mr. Thompson
                                 - 257 -


also pay $11,844 to Mr. Kersting for interest purportedly due on

certain leverage loans; i.e., Mr. Kersting's fees.112

     We have found that Messrs. Sims and McWade misled the Court

and the remaining parties to these cases by not disclosing the

Thompson settlement before the trial of the test cases.     As with

Mr. Cravens, an argument can be made that Judge Goffe would have

removed the Thompson cases from the test case array, inasmuch as

the remaining test cases provided full coverage of the Kersting

programs and taxable years in dispute.     Proceeding on the

assumption that Judge Goffe would have precluded Mr. Thompson

from testifying at the trial of the test cases, we consider

whether Mr. Thompson's testimony was material to the outcome in

Dixon II.

            i.   Sham Analysis

     Judge Goffe relied upon factors common to all the test case

petitioners in rejecting their testimony that they had entered

into the Kersting transactions with a business purpose.     Those

factors included the test case petitioners' participation in the

Kersting programs without regard to whether the purchase price

for the stock they purported to purchase was reasonable and

appropriate, and without specific knowledge about the Kersting

corporations involved, the industries in which they operated, or

the impact of prevailing economic conditions on their investment

     112
         In Dixon II, Judge Goffe concluded that interest
payments on leverage loans reflected Mr. Kersting's fee for
generating interest deductions. Dixon II, 62 T.C.M. (CCH) at
1506, 1991 T.C.M. (RIA), at 91-3050.
                                - 258 -


decisions.   Although Mr. Thompson's testimony regarding profit

motive was favorable to the test case petitioners' cause, Judge

Goffe rejected his testimony as vague and unsupported by the

record.   Because Judge Goffe rejected the testimony of all the

test case petitioners in holding that they had not entered into

the Kersting transactions with a business purpose, we are

convinced that Mr. Thompson's testimony was not material to Judge

Goffe's holding on the point.

     Judge Goffe also held that the test case petitioners had

failed to prove that the Kersting transactions had economic

substance beyond the creation of tax benefits.   In particular,

Judge Goffe focused on the manner in which Mr. Kersting actually

operated the programs, the lack of corporate profitability or

shareholder profitability, the absence of any evidence or

likelihood that Kersting program participants were or would ever

be in a position to sell their stock at an increased value

relative to the purchase price of the stock, and Mr. Kersting's

routine disregard of standard corporate practices.     Because Judge

Goffe focused on the manner in which Mr. Kersting actually

operated the programs, we are convinced that Mr. Thompson's

testimony was not material to Judge Goffe's holding that the

programs lacked economic substance.

           ii.   Lack of Genuine Debt/Waltz of Funds

     Judge Goffe relied upon the specific language of the stock

subscription agreements underlying the Stock Subscription Plan

and the Leasing Corporation Plan to conclude that the agreements,
                               - 259 -


standing alone, did not create unconditional debt obligations.

Considering the narrow basis for Judge Goffe's holding, we are

convinced that Mr. Thompson's testimony was not material to this

holding.

     Judge Goffe sustained respondent's disallowance of

deductions for subscription interest under the stock subscription

plan and the leasing corporation plan on the ground that such

interest was not "paid" within the meaning of section 163(a) by

virtue of Mr. Kersting's practice of waltzing loan funds.   Judge

Goffe identified two specific instances in which Mr. Kersting

waltzed funds affecting both primary and leverage loans

underlying the stock subscription plan.   Mr. Thompson's testimony

was not material to Judge Goffe's finding that Mr. Kersting made

a practice of waltzing loan funds.

     Judge Goffe held that primary loans, although recourse in

form, did not represent genuine debt in substance because of

several factors.    First, Judge Goffe found that Mr. Kersting and

program participants had an understanding at the commencement of

a program that a primary loan obligation could be satisfied in

full at any time by a mere surrender of the associated stock

certificate.   In so holding, Judge Goffe rejected Mr. Kersting's

testimony that he did not represent to program participants that

they could exchange their stock for cancellation of a primary

note at any time.   To the contrary, Judge Goffe listed nine

items, including Mr. Thompson's testimony on the subject, in

support of his finding of a pervasive stock surrender policy.
                              - 260 -


     Although Judge Goffe listed Mr. Thompson's testimony first

among the nine items identified in support of the Court's holding

on the point, we are convinced for the reasons set forth below

that Mr. Thompson's testimony was cumulative of other evidence

and was not material to this holding.

     Although Mr. Thompson was the only test case petitioner to

testify that Mr. Kersting had assured him that promissory notes

would not be enforced, Judge Goffe listed eight additional items,

including a number of comfort letters, in support of his holding

that there was a pervasive stock surrender policy.   In short,

there is ample evidence in the record, independent of

Mr. Thompson's testimony, to support Judge Goffe's holding on the

point.   Along the same lines, we observe that the record in the

trial of the test cases reveals that, at one time or another,

each of the test case petitioners had terminated various Kersting

programs by endorsing their stock certificates and returning them

to Mr. Kersting in exchange for the return of their promissory

notes marked "paid".

     Even assuming for the sake of argument that Mr. Thompson's

testimony was material to Judge Goffe's finding that there was

a pervasive stock surrender policy, we are convinced that

Mr. Thompson's testimony was not material to the final outcome in

Dixon II.   In particular, Judge Goffe's analysis of the validity

of primary loans was not limited to his holding that Mr. Kersting

and program participants had an understanding regarding the stock

surrender policy.   To the contrary, Judge Goffe also found that,
                              - 261 -


regardless of whether there was a prearranged understanding,

Mr. Kersting and program participants never contemplated that the

principal obligation on a primary loan would be paid except by a

surrender of the stock.   In so holding, Judge Goffe found it

significant that:   (1) No evidence was produced of a primary

note ending up in the hands of anyone not associated with

Mr. Kersting; (2) primary loans issued during later years

included an express notation that they were nonnegotiable and

nonassignable; and (3) primary loans were unsecured, with the

primary notes failing to list even the purchased stock as

collateral.

     In completing his analysis, Judge Goffe found further

support for his holding that the primary loans did not constitute

genuine debt by virtue of Mr. Kersting's waltz of primary loan

funds underlying the stock subscription plan, the apparent waltz

of funds under the stock purchase plan and the leasing

corporation plan, and Mr. Kersting's practice of backdating

documents relating to the loans.

     In the alternative, Judge Goffe found that, even assuming

that the test case petitioners had established that the primary

loans represented genuine debt, the test case petitioners had

nevertheless failed to show that they actually paid primary loan

interest within the meaning of section 163(a).   Specifically,

Judge Goffe concluded that the test case petitioners had not paid

primary loan interest by virtue of Mr. Kersting's waltz of

leverage loan funds (the funds used to pay primary loan interest)
                             - 262 -


underlying the stock subscription plan, and the apparent waltz

of (1) first-year subscription interest under the leasing

corporation plan, (2) distribution checks under the leasing

corporation plan, and (3) leverage loan funds in each of the

stock subscription, stock purchase, and leasing corporation

plans.

     In sum, considering Judge Goffe's copious list of factors

in support of his conclusion that Mr. Kersting and program

participants had an understanding regarding the stock surrender

policy, as well as Judge Goffe's alternative analyses in support

of his holding that primary loans did not constitute genuine debt

and that interest on primary loans was not paid within the

meaning of section 163, we are convinced that Mr. Thompson's

testimony was not material to the outcome in Dixon II.

     Judge Goffe also determined that leverage loans did not

represent genuine debt because of several factors, including the

waltzing of funds, backdating of documents, substance not

following form, and mutual expectations of no personal liability.

Again, given the variety of the factors cited by Judge Goffe, we

are convinced that Mr. Thompson's testimony was not material to

Judge Goffe's holding that leverage loans did not represent

genuine debt.

          iii. Additions to Tax

     Judge Goffe sustained respondent's determinations that the

Thompsons were liable for interest computed at the increased rate

prescribed in section 6621(c) for 1981, and that the Youngs and
                               - 263 -


the DuFresnes were liable for such increased interest for the

taxable years 1982 and 1983.    In short, Judge Goffe sustained

these determinations on the ground that the Court had already

determined that the test case petitioners' underpayments were

attributable to sham transactions.    Consistent with our finding

that Mr. Thompson's testimony was not material to Judge Goffe's

conclusion that the Kersting transactions were shams, we are

convinced that Mr. Thompson's testimony was not material to Judge

Goffe's decision to sustain respondent's determinations

respecting increased interest.

     Although Judge Goffe also sustained respondent's

determinations that the Thompsons were liable for an addition to

tax for late filing under section 6651(a)(1) for 1981 and

additions to tax for negligence for the taxable years 1979 and

1981, these holdings have no bearing on nontest case petitioners.

In particular, nontest case petitioners who signed 1985 piggyback

agreements did not agree to be bound by the Court's holdings

regarding additions to tax.    Further, while nontest case

petitioners who signed post-1985 piggyback agreements agreed to

be bound by the Court's holding regarding test case petitioners'

liability for increased interest under section 6621(c), they did

not agree to be bound by the Court's holding regarding test case

petitioners' liability for additions to tax under section 6651(a)

and they were to be relieved of liability for additions to tax

for negligence for years before 1982.
                                - 264 -


      3.    Mr. Alexander

      We have found that Mr. McWade and Mr. Alexander had an

understanding before the trial of the test cases that the

Alexanders' tax liabilities would be reduced in exchange for

Mr. Alexander's informal assistance to Mr. McWade during the

trial.     We have also found that Mr. McWade allowed Mr. Alexander

to present misleading testimony to the Court during the trial

of the test cases in response to Mr. Izen's question whether

Mr. Alexander had an agreement with Mr. McWade for the reduction

of his tax liabilities.     Although Judge Goffe was aware that Mr.

Alexander was hostile towards Mr. Kersting and that Mr. Alexander

had offered an affidavit to Mr. McWade regarding the Kersting

programs, Judge Goffe, had he been informed of Mr. Alexander's

understanding with Mr. McWade, might have precluded Mr. Alexander

from testifying at the trial of the test cases or at least taken

that understanding into account in weighing Mr. Alexander's

credibility.    Consequently, we must consider whether

Mr. Alexander's testimony was material to the outcome in Dixon

II.

      Mr. Alexander was called to testify in part to rebut

Mr. Kersting's testimony regarding the First Savings transaction.

Indeed, Mr. Alexander directly contradicted Mr. Kersting as to

whether Federal regulators ever approved Investors Financial as a

holding company for First Savings.    While Judge Goffe concluded

that Mr. Kersting was not a credible witness, our review of Dixon

II convinces us that Mr. Kersting's lack of credibility was by
                              - 265 -


and large attributable to Mr. Kersting's lack of candor as

demonstrated by both inherent contradictions and inconsistencies

with the written record.   We are convinced that Mr. Alexander's

testimony was not material to Judge Goffe's findings respecting

Mr. Kersting's lack of credibility.

     Like Mr. Thompson, Mr. Alexander testified that Mr. Kersting

had represented to him that stock subscription plan promissory

notes would not be enforced and would be returned or destroyed

upon the termination of the plan.   Although Judge Goffe concluded

that there was a pervasive stock surrender policy in the Kersting

programs, we note that Judge Goffe did not list Mr. Alexander's

testimony among the nine items listed in support of his

conclusion on the point.   In any event, assuming that Judge Goffe

took Mr. Alexander's testimony into account, we are satisfied

that Mr. Alexander's testimony was not material to Judge Goffe's

holdings that there was a pervasive stock surrender policy within

the Kersting programs or that Kersting promissory notes did not

constitute genuine debt.   As previously discussed in our analysis

of the lack of materiality of Mr. Thompson's testimony on this

same subject, Judge Goffe relied upon a long list of items in

support of these holdings.   Considering all the evidence in

support of Judge Goffe's holdings, we are convinced that Judge

Goffe would have reached the same conclusions without Mr.

Alexander's testimony on the subject.   Moreover, even assuming

for the sake of argument that Mr. Alexander's testimony was

material to Judge Goffe's holding respecting a pervasive stock
                             - 266 -


surrender policy, Judge Goffe's reliance upon alternative bases

to support the conclusion that Kersting promissory notes did not

constitute genuine debt convinces us that Mr. Alexander's

testimony was not material to the outcome in Dixon II.

     4.   Summary

     We hold that the Government misconduct in the trial of the

test cases in Dixon II resulted in harmless error in the trial of

the test cases insofar as the Court concluded that:   (1) The

Kersting transactions were shams; (2) the Kersting promissory

notes did not constitute genuine debt; and (3) interest on

Kersting loans was not paid within the meaning of section 163(a).

     In so holding, we reject Messrs. Izen's and Jones'

contention that, by virtue of the totality of the Government's

misconduct, their clients were denied due process.

     We likewise reject Mr. Sticht's contention that his

clients--nontest case petitioners--were denied due process on the

ground that Judge Goffe effectively was precluded from

supervising the trial of the test cases.   Although Judge Goffe

might have removed the Thompson and Cravens cases from the test

case array and struck Mr. Alexander's testimony if he had been

informed of the Thompson and Cravens settlements and the

Alexander understanding, we are convinced that the outcome in the

trial of the test cases would not have changed.

     Consistent with the preceding discussion, we are convinced

that the test case and nontest case petitioners enjoyed a fair

trial, encompassing "not only fair notice and an adequate
                               - 267 -


opportunity to be heard before the appropriate tribunal, but also

an orderly presentation of evidence and a rational application of

the law thereto".    Traynor, "The Riddle of Harmless Error", at 80

(1970).   Having placed the burden of proof by clear and

convincing evidence on respondent, we are left with the definite

and firm conviction that the Government misconduct had no effect

on the decisions in the test cases whose petitioners were

represented by Mr. Izen.

IV.   Fraud, Misrepresentation, and Misconduct

      Mr. Izen contends that the Court should not reinstate

its decisions in Dixon II on the ground that the Government

misconduct in the trial of the test cases amounted to fraud,

misrepresentation, or misconduct under rule 60(b)(3) of the

Federal Rules of Civil Procedure.   Mr. Izen's contention is akin

to a motion for reconsideration of the Court's Dixon II opinion

under Rule 161 or a motion to vacate a decision under Rule 162.

Relief under either of these Rules may be granted in the Court's

discretion to prevent injustice.    See Chao v. Commissioner, 92

T.C. 1141, 1144-1145 (1989); see also Adams v. Commissioner, 85

T.C. at 375.

      Rule 60(b)(3) of the Federal Rules of Civil Procedure states

in pertinent part:

           On motion and upon such terms as are just, the
      court may relieve a party or a party's legal
      representative from a final judgment, order, or
      proceeding for the following reasons: * * * (3) fraud
      (whether heretofore denominated intrinsic or
      extrinsic), misrepresentation, or other misconduct of
      an adverse party * * *.
                               - 268 -


In sum, District Courts are vested with discretion to relieve a

party from a final judgment where the adverse party has committed

a fraud, misrepresentation, or other misconduct.     See Atchison,

Topeka & Santa Fe R.R. Co. v. Barrett, 246 F.2d 846, 849 (9th

Cir. 1957).

     Although the decisions in these cases are not final, the

parties seem to agree that these proceedings may be analogized to

proceedings under rule 60(b)(3) of the Federal Rules of Civil

Procedure.    We will assume for present purposes that the analogy

is valid in light of the apparent agreement of the parties.

     A judgment may be set aside under rule 60(b)(3) of the

Federal Rules of Civil Procedure where fraud, misrepresentation,

or misconduct prevents a party from fully and fairly presenting

his or her case at trial.   See In re M/V Peacock, 809 F.2d 1403,

1405 (9th Cir. 1987); Simons v. Gorsuch, 715 F.2d 1248, 1253 (7th

Cir. 1983); Bunch v. United States, 680 F.2d at 1283; Atchison,

Topeka & Santa Fe Ry. Co. v. Barrett, supra at 849.     Relief does

not depend on whether the judgment is incorrect, only on whether

the judgment was obtained unfairly.      See Lonsdorf v. Seefeldt, 47

F.3d 893, 897 (7th Cir. 1995); Anderson v. Cryovac, Inc., 862

F.2d at 924 n.10.

     Some courts have held that the willful presentation of

perjured testimony is grounds for granting the innocent party a

new trial pursuant to rule 60(b)(3) of the Federal Rules of Civil

Procedure.    See Diaz v. Methodist Hosp., 46 F.3d 492, 497 (5th

Cir. 1995).   However, it has been said that
                                - 269 -


     The very purpose of a trial is to test the truthfulness
     of testimony and other evidence proffered by the
     parties. Examining the possibility that testimony is
     perjurious is one of the principal functions of cross-
     examination. * * * Rule 60(b) should not reward the
     lazy litigant who did not adequately investigate his or
     her case, or who did not vigorously cross-examine a
     witness. [Fn. refs. omitted.]

12 Moore, Moore's Federal Practice, sec. 60.43[1][c], at 60-131

to 60-132 (3d ed. 1998).   In this regard, courts have denied

relief under rule 60(b)(3) of the Federal Rules of Civil

Procedure where the moving party had a full and fair opportunity

to uncover the alleged fraud or perjury at trial.     See Bunch v.

United States, supra at 1283.

     We have already described the Government misconduct in these

cases supra pp. 218-225.   Arguably, Messrs. McWade's and Sims'

failure to disclose the Thompson and Cravens settlements and the

Alexander understanding to the Court constitute fraud,

misrepresentation, or misconduct within the meaning of rule

60(b)(3) of the Federal Rules of Civil Procedure.     However, as

discussed above, fraud, misrepresentation, or misconduct alone is

not sufficient to require or justify relief under rule 60(b) of

the Federal Rules of Civil Procedure.     To the contrary, relief

under rule 60(b) of the Federal Rules of Civil Procedure is

warranted only where the fraud, misrepresentation, or misconduct

has prevented the adversely affected party from fully and fairly

presenting his or her case at trial.      In re M/V Peacock, supra.

     We are convinced that the Government misconduct did not

prevent the remaining test case petitioners from fully and fairly
                               - 270 -


presenting their cases at trial.    In particular, our review of

the record convinces us that Mr. Izen, who represented

petitioners in six of the eight test cases, was not impeded in

any sense by the Government misconduct in presenting his cases to

the Court.    Because Mr. Izen was aware before the trial that the

Government intended to rely on the so-called comfort letters at

the trial of the test cases, we are satisfied that Mr. Izen was

not unduly surprised by Messrs. Thompson's and Alexander's

testimony that Mr. Kersting had assured them that they could

exchange their Kersting corporation stock certificates for the

cancellation of their promissory notes.113   Further, Mr. Izen was

prepared and permitted to cross-examine Messrs. Thompson,

Cravens, and Alexander and to probe and expose the bases of

Messrs. Thompson's and Alexander's hostility towards Mr.

Kersting.    Considering all the facts and circumstances, we

conclude that petitioners are not entitled to relief under rule

60(b) of the Federal Rules of Civil Procedure or Rule 161 or 162.




     113
         Mr. Izen testified at the evidentiary hearing that he
was aware of the comfort letters because some of them were
part of the stipulated record. Further, Mr. Izen informed
Mr. DeCastro before the trial of the test cases that he would
offer evidence of collection actions brought by various Kersting
companies against Kersting program participants to counter
respondent's reliance on the comfort letters. However,
Mr. McWade was aware of collection litigation before the trial
because Mr. Kersting had encouraged certain program participants
to raise the point with Mr. McWade during pretrial settlement
discussions.
                               - 271 -


V.   Fraud on the Court

     Although rule 60(b) of the Federal Rules of Civil Procedure

provides a list of the grounds upon which a court may relieve a

party or a party's legal representative from a final judgment,

the rule also includes a so-called saving clause which states:

"This rule does not limit the power of a court * * * to set aside

a judgment for fraud upon the court."    It is well settled that

the Tax Court may reopen and set aside a decision on the basis of

fraud on the Court.    See Toscano v. Commissioner, 441 F.2d 930

(9th Cir. 1971) (fraud on the court properly raised where the

taxpayer asserted that the Court's decision sustaining the

Commissioner's determination of joint deficiencies was based on

tax returns on which the taxpayer's signature was either forged

or made under duress), vacating 52 T.C. 295 (1969).

A.   Case Law Survey

     Hazel-Atlas Glass Co. v. Hartford-Empire Co., 322 U.S. 238

(1944), overruled on other grounds Standard Oil v. United

States, 429 U.S. 17, 18 (1976), is the leading case considering

fraud on the court.    In Hazel-Atlas Glass, certain officials and

attorneys representing Hartford Empire Co. (Hartford)

fraudulently prepared and published an article in a trade

publication that Hartford subsequently used to support its

pending application for a patent before the Patent Office.    After

obtaining the patent, Hartford sued Hazel-Atlas Glass Co. (Hazel)

for infringement in a District Court.    The District Court

dismissed the case on the ground that no infringement had been
                                - 272 -


proved.   In response, Hartford filed an appeal with the Court of

Appeals for the Third Circuit and specifically directed the

court's attention to the fraudulent article.    Relying in part on

the fraudulent article, the Court of Appeals for Third Circuit

reversed the District Court and held that the patent had been

infringed.   Nine years later, Hazel returned to the Court of

Appeals seeking relief on the ground that the Hartford article

was fraudulent.   However, the Court of Appeals declined to set

aside the District Court decree on the grounds that:    (1) the

fraud was not newly discovered; (2) the fraudulent article was

not the primary basis for its earlier decision, and (3) the Court

of Appeals lacked the power to set aside the District Court

decree because of the expiration of the term during which its

decision had been rendered.

     Upon review of the matter, the Supreme Court held that the

Court of Appeals had equitable power to set aside the District

Court decree despite the fact that the decree was otherwise

final.    See id. at 244-245.   The Supreme Court explained its

holding as follows:

          Every element of the fraud here disclosed demands
     the exercise of the historic power of equity to set
     aside fraudulently begotten judgments. This is not
     simply a case of a judgment obtained with the aid of a
     witness who, on the basis of after-discovered evidence,
     is believed possibly to have been guilty of perjury.
     Here, even if we consider nothing but Hartford's sworn
     admissions, we find a deliberately planned and
     carefully executed scheme to defraud not only the
     Patent Office but the Circuit Court of Appeals. Cf.
     Marshall v. Holmes, [141 U.S. 589 (1891]. Proof of the
     scheme, and of its complete success up to date, is
     conclusive. * * *
                               - 273 -


Id. at 245-246.

     The Supreme Court further rejected the argument that alleged

lack of diligence by Hazel in discovering the fraud should serve

to bar relief.    Observing that the fraud in question did not

concern only private parties or a single litigant, the Supreme

Court stated:

     There are issues of great moment to the public in a
     patent suit. Mercoid Corporation v. Mid-Continent
     Investment Co., 320 U.S. 661 * * *; Morton Salt Co. v.
     G.S. Suppiger Co., 314 U.S. 488 * * *. Furthermore,
     tampering with the administration of justice in the
     manner indisputably shown here involves far more than
     an injury to a single litigant. It is a wrong against
     the institutions set up to protect and safeguard the
     public, institutions in which fraud cannot complacently
     be tolerated consistently with the good order of
     society. Surely it cannot be that preservation of the
     integrity of the judicial process must always wait upon
     the diligence of litigants. * * *

Id. at 246.

     Finally, the Supreme Court rejected the assertion that

relief should be denied on the ground that the fraudulent article

was not "basic" to the Court of Appeals' decision.    In short, the

Supreme Court held that an appraisal of the influence of the

fraudulent article on the Court of Appeals' decision was not

necessary insofar as Hartford had considered the article material

and relied upon the article in obtaining a decision in its favor

from the Court of Appeals.    See id. at 246-247.

     Some courts hold that the term “fraud on the court” should

be construed consistently with the policy of preserving the

finality of judgments.    See Drobny v. Commissioner, 113 F.3d at
                               - 274 -


677-678;114 Broyhill Furniture Indus., Inc. v. Craftmaster

Furniture Corp., 12 F.3d 1080, 1085 (Fed. Cir. 1993); Toscano v.

Commissioner, supra at 934.    In this regard, not all fraudulent

or deceptive acts constitute fraud on the Court.    It has been

said that fraud on the court concerns egregious conduct affecting

the ability of the court to function impartially.    See Broyhill

Furniture Indus., Inc. v. Craftmaster Furniture Corp., supra at

1085-1086, and cases cited therein.

     Since the Supreme Court's decision in Hazel-Atlas Glass Co.

v. Hartford-Empire Co., supra, a number of courts, including the

Court of Appeals for the Ninth Circuit, have relied upon or

adopted the definition of fraud on the court set forth in

12 Moore, Moore's Federal Practice, par. 60.21[4][a], at 60-52

(3d ed. 1998), which states:

          "Fraud on the court" is defined in terms of its
     effect on the judicial process, not in terms of the
     content of a particular misrepresentation or
     concealment. Fraud on the court must involve more than
     injury to a single litigant; it is limited to fraud
     that "seriously" affects the integrity of the normal
     process of adjudication. Fraud on the court is limited
     to fraud that does, or at least attempts to, "defile
     the court itself" or that is perpetrated by officers of
     the court "so that the judicial machinery can not
     perform in the usual manner its impartial task of
     adjudging cases". [Fn. refs. omitted.]




     114
         In Drobny v. Commissioner, 113 F.3d 670, 678 (7th Cir.
1997), affg. T.C. Memo. 1995-209, the Court of Appeals for the
Seventh Circuit held that the taxpayers were required to
demonstrate "not only that the respondent engaged in conduct that
was intended to mislead the court, but--of paramount importance--
that the actual conduct affected the outcome of their case."
                             - 275 -


See Drobny v. Commissioner, supra at 677-678 (citing Kenner v.

Commissioner, 387 F.2d 689 (7th Cir. 1968)); Broyhill Furniture

Indus., Inc. v. Craftmaster Furniture Corp., supra at 1085; In re

Intermagnetics Am., Inc., 926 F.2d 912, 916 (9th Cir. 1991)

(citing Alexander v. Robertson, 882 F.2d 421, 424 (9th Cir.

1989)); Senate Realty Corp. v. Commissioner, 511 F.2d 929, 931

(2d Cir. 1975).

     The Court of Appeals for the Ninth Circuit has addressed

the issue of fraud on the court in a number of cases.   Before

proceeding with our analysis, we will glean these cases for the

insights they yield on the views of the Court of Appeals.

     In Toscano v. Commissioner, 441 F.2d 930 (9th Cir. 1971),

the taxpayer, Josephine Zelasko (Zelasko), asserted that the Tax

Court had erred in failing to vacate a decision entered against

Zelasko and her purported husband, John Toscano.   Zelasko argued

that the decision should be vacated on the ground of fraud on the

Court because she was never married to Toscano, her signatures

were placed on joint tax returns with Toscano either by forgery

or under duress, and she was completely unaware that Toscano had

filed a joint petition for redetermination with the Tax Court.

After concluding that the Tax Court had the authority to set

aside a final decision on the ground of fraud on the court, the

Court of Appeals vacated this Court's decision against Zelasko

after finding that she had alleged sufficient facts in support of

her claim of fraud on the court to justify an evidentiary hearing
                              - 276 -


in the Tax Court.   More specifically, the Court of Appeals

concluded:

          When a deficiency was assessed, and Toscano
     petitioned the Tax Court for redetermination, he
     carried the fraud into the Tax Court. Thus he was
     continuing to defraud the Commissioner, and he was
     continuing to attempt to subject Miss Zelasko to a
     liability that was not hers. But he was doing more; he
     was also perpetrating a fraud upon the Tax Court, which
     culminated in a determination of joint deficiencies
     against Miss Zelasko as well as himself. This, we
     think, was as much a fraud on the court as was the use
     of the spurious article in the Court of Appeals in
     Hazel-Atlas.

Id. at 935.

     In Abatti v. Commissioner, 859 F.2d 115 (9th Cir. 1988),

affg. 86 T.C. 1319 (1986), the taxpayers argued that the Tax

Court had erred in failing to vacate final decisions against them

that were consistent with their agreements to be bound by certain

test cases.   In particular, after the Tax Court had granted

summary judgment in favor of the Commissioner in the test cases,

decisions were entered against the taxpayers in both the test

cases and the piggyback cases.   Although two test case taxpayers

and a number of the taxpayers who had signed piggyback agreements

filed timely appeals and persuaded the Court of Appeals to

reverse the Tax Court's decisions, the remaining taxpayers in the

test cases and piggyback cases did not file appeals.   Following

the remand of the appealed cases to the Tax Court for further

proceedings, the taxpayers who had not filed appeals argued

unsuccessfully in the Tax Court that the otherwise final

decisions entered against them should be vacated pursuant to
                              - 277 -


their piggyback agreements, which provided that all taxpayers

would be afforded the outcome of the test cases.

     The Court of Appeals rejected the taxpayers' contention that

the Commissioner's position regarding entry of decision under the

piggyback agreements constituted fraud on the court.

Specifically, the Court of Appeals observed that, while fraud on

the court may occur when the acts of a party prevent his

adversary from fully and fairly presenting his case or defense,

it was the taxpayers' misunderstanding of the piggyback

agreements, rather than the Commissioner's fraud, that had caused

their misfortune.   See id. at 118-119.

     In Alexander v. Robertson, supra, the Court of Appeals

considered whether the entry of appearance at trial by counsel

who was not a licensed attorney in the jurisdiction constituted

fraud on the court in the following circumstances.   Alexander

sued Robertson in the District Court for the Northern District of

California for failing to make required payments under a contract

to purchase a boat.   Robertson in turn cross-claimed against

Fraser, Inc. (Fraser), the broker who had arranged for the sale

of the boat.

     Following a trial, the District Court sustained Alexander's

claim against Robertson and rejected Robertson's cross-claims

against Fraser.   However, Robertson subsequently learned that

David Warren (Warren), counsel for Fraser, had not been licensed

to practice law in the State of California at the time of the

trial.   Robertson thereupon moved the District Court to vacate
                              - 278 -


the judgment, relying on Warren's alleged fraud on the Court.

The District Court denied Robertson's motion.

     On appeal, the Court of Appeals, citing Moore's definition

of fraud on the court, observed that relief from a judgment for

fraud on the court does not necessarily require the moving party

to show that he was prejudiced by the misconduct.    Quoting Hazel-

Atlas Glass Co. v. Hartford-Empire Co., 322 U.S. at 246, the

Court of Appeals stated:   "The Supreme Court, for example, has

explained this provision of the Rule not so much in terms of

whether the alleged misconduct prejudiced the opposing party but

more in terms of whether the alleged misconduct 'harms' the

integrity of the judicial process".     Alexander v. Robertson,

supra at 424; see In re Intermagnetics Am., Inc., 882 F.2d at

916-917.

     Reading Hazel-Atlas Glass in conjunction with Moore's

definition of fraud upon the court, the Court of Appeals further

observed that Robertson's assertion that Warren's misconduct had

subverted the integrity of the judicial process seemed to fit

with the proposition that relief may be granted pursuant to rule

60(b) of the Federal Rules of Civil Procedure for fraud upon the

court where there is an extraordinary harm to the public.    See

Alexander v. Robertson, supra at 424.

     Nevertheless, the Court of Appeals sustained the District

Court's denial of Robertson's motion to vacate the judgment on

the grounds that:   (1) There was no showing that Warren's

misconduct was designed to improperly influence the court in its
                              - 279 -


decision; (2) setting aside the judgment pursuant to rule 60(b)

of the Federal Rules of Civil Procedure would be a "fruitless"

gesture, inasmuch as Robertson could not prevail on his cross-

claims against Fraser in any event; and (3) other remedies, such

as disciplinary proceedings, were available to protect the

judicial system from the harm arising from Warren's misconduct.

See id. at 425; see also Chao v. Commissioner, 92 T.C. at 1144-

1145 (where the Court declined to set aside a final judgment for

alleged fraud on the Court where the taxpayers could not show

that the Court's decision would be different).

     The final case in the survey, Pumphrey v. K.W. Thompson Tool

Co., 62 F.3d 1128 (9th Cir. 1995), held that in-house counsel for

a defendant/gun manufacturer had committed fraud on the court in

a products liability action by failing to disclose an

incriminating videotape of a product test.   Melvin Sparks

(Sparks) had dropped a handgun manufactured by defendant K.W.

Thompson Tool Co. (Thompson) and was killed when the gun

discharged.   In a wrongful death action by Sparks' heirs,

Thompson introduced a videotape of drop tests of the handgun, and

relied upon the testimony of its expert witness who had conducted

the tests, to support its contention that the gun had never fired

in a drop test.   The jury held that the plaintiffs had suffered

$100,000 in damages, but that Sparks was 80 percent

contributorily negligent.

     Following entry of judgment in the case, the plaintiffs

learned that Thompson possessed a videotape, made the same day as
                                - 280 -


the videotape offered at trial, which showed that the handgun in

question had in fact fired during a drop test.      On the basis of

this evidence, the District Court granted the plaintiff's motion

to set aside the verdict and ordered a new trial.

     On appeal, the Court of Appeals affirmed the District

Court's decision ordering a new trial.    The Court of Appeals

first held that Thompson's general counsel was an officer of the

court, even though he had not entered his appearance at trial,

because he had significantly participated in the case by

attending the trial, gathering information to respond to

discovery requests, and participating in the videotaping of the

drop tests.   See id. at 1130-1131.

     The Court of Appeals further defined fraud on the court to

include both attempts to subvert the integrity of the court and

fraud by an officer of the court, involving an unconscionable

plan or scheme designed to influence the court improperly in its

decision.   See id. at 1131.    In concluding that Thompson's

general counsel had engaged in a scheme to defraud the court, the

Court of Appeals cited the general counsel's role in providing

misleading and incomplete responses to discovery, as well as his

participation in the presentation of fraudulent evidence and his

failure to correct the false impression created by the testimony

of Thompson's expert witness.    See id. at 1132.

     The Court of Appeals went on to reject Thompson's contention

that there was no fraud on the court because the videotape was

not material to the issues in the trial.    Although questioning
                             - 281 -


Thompson's assertion that the videotape was not material, the

Court of Appeals observed that "Rule 60(b) focuses not so much in

terms of whether the alleged fraud prejudiced the opposing party

but more in terms of whether the alleged fraud harms the

integrity of the judicial process."    Id. at 1133.

B.   Discussion

     With the preceding review as background, we address whether

the Government misconduct in these cases constitutes fraud on the

Court.

     By entering into secret settlements with the Thompsons and

Cravenses, Messrs. McWade and Sims frustrated the Court's and the

public's expectations that all litigants before the Court would

be adversaries in the full sense of the word.    Such expectations

were particularly heightened in these cases, which affect more

than a thousand other taxpayers.

     Notwithstanding the Government misconduct in these cases, we

are convinced, for the reasons set forth below, that the Court's

deficiency determinations in Dixon II should be reinstated over

petitioners' claims of fraud on the Court.

     The misconduct in these cases is not typical of the

fraudulent acts committed in cases in which other courts have

overturned decisions for fraud on the court.    In particular,

although Messrs. Sims, McWade, and DeCastro misled the Court

regarding the status of the Thompson and Cravens cases, there was

no attempt to present fraudulent evidence to the Court that had

any bearing on the substantive issues concerning the transactions
                              - 282 -


that the Court was called upon to review in the trial of the test

cases.

     We also observe that, upon discovery of Messrs. McWade's and

Sims' misconduct, respondent promptly reported the matter to the

Court.   Respondent's actions upon discovery of the misconduct and

respondent's overall conduct in these proceedings exhibit

respondent's institutional good faith.

     Further, we are not convinced that justice would be served

if we were to adopt the extraordinary remedy, after the

evidentiary hearing and our review of the record, of renouncing

the Court's deficiency determinations in Dixon II.   Consistent

with the views stated earlier in this opinion, we are convinced

that the test case petitioners were afforded a fair trial,

despite the Government misconduct, and that the Government

misconduct was not material to the outcome in Dixon II.    We are

firmly convinced that the outcome of the retrial of the test

cases would be the same if we were to order a new trial.

Moreover, more discriminating remedies are available both to

punish the offenders and to deter similar conduct in the future,

see Alexander v. Robertson, 882 F.2d at 425.   Considering all the

facts and circumstances, we will--with the exceptions discussed

below--reinstate the decisions entered in the test cases

remaining before the Court.
                              - 283 -


VI.   Mr. Izen's Allegations That Mr. DeCastro Was a "Mole"

      Mr. Izen created the strong impression, in oral argument

before the Court of Appeals for the Ninth Circuit in the DuFresne

appeal, that Mr. DeCastro had acted as a "mole" or "plant" for

the Internal Revenue Service before and during the trial of the

test cases.   Mr. Izen returned to this subject in his opening

brief following the evidentiary hearing, which argues:

           Any advantage gained by the Commissioner in
      utilizing DeCastro to "infiltrate" the test case
      Petitioners' camp is grounds for a new trial, standing
      alone. This would be so, in the civil, as well as a
      criminal context. Sims and McWade unlawfully paid
      DeCastro's attorney's fees in a successful effort to
      subvert the test cases. They inserted DeCastro into
      the Petitioners' camp. They converted what should have
      been a taxpayer's advocate into a government operative.
      All of the Petitioners' interests were harmed by this
      infiltration, since it prevented the cases from being
      "fairly" tried. [Citations omitted.]

      Although we agree that it was improper for the Government to

use Mr. Thompson as a conduit to pay Mr. DeCastro's attorney's

fees, there is no credible evidence in the record that Mr.

DeCastro acted as a Government "mole" during the trial of the

test cases or that Mr. DeCastro conveyed any of Mr. Izen's

trial strategies or confidential information to the Government.

Accordingly, we reject Mr. Izen's argument that Mr. DeCastro's

misconduct, standing alone, or in conjunction with the misconduct

of Messrs. McWade and Sims, warrants a new trial of the test

cases, or a trial of any other cases in the Kersting project

group on the issues that were tried on the test cases, for that

matter.
                             - 284 -


VII. Enforceability of Piggyback Agreements

     Petitioners contend that the piggyback agreements executed

by nontest case petitioners should be set aside on the ground

that Messrs. Sims and McWade fraudulently induced nontest case

petitioners to execute piggyback agreements by misrepresenting

the status of the Thompson and Cravens cases.115   In the

alternative, petitioners contend that the piggyback agreements

should be set aside on the ground that Messrs. Sims' and McWade's

failure to disclose the Thompson and Cravens settlements before

the trial of the test cases resulted in a breach of contract.

Mr. Sticht contends that enforcement of the piggyback agreements

would result in manifest injustice on the ground that Messrs.

Sims and McWade used the piggyback agreements as a means to

proceed to trial under what Mr. Sticht calls the "sporting theory

of justice".

     Mr. Sticht raised additional contract arguments in posttrial

Motions for Release From Piggyback Agreement that he filed on

behalf of nontest case petitioners Richard B. and Donna G.

Rogers, Anthony E. and Carol A. Eggers, and John L. and Terry E.


     115
         Nontest case petitioners Ronald L. and Mattie L.
Alverson executed their piggyback agreement in June 1985--well
before Mr. McWade had negotiated the Thompson and Cravens
settlements. Nontest case petitioners Anthony E. and Carol A.
Eggers, John L. and Terry E. Huber, Stanley C. and Sharon A.
Titcomb, and Richard B. and Donna G. Rogers executed piggyback
agreements in late November 1986--about the time that Mr. McWade
began settlement discussions with Messrs. Thompson and Cravens.
Nontest case petitioners Norman W. and Barbara L. Adair executed
their piggyback agreement in March 1987--well after Mr. McWade
had negotiated the Thompson and Cravens settlements.
                                - 285 -


Huber.     Mr. Sticht contends that Mr. Seery's apparent conflict of

interest, at a time when Mr. Seery represented nontest case

petitioners Rogers, Eggers, and Huber, provides a basis for

releasing nontest case petitioners from their piggyback

agreements.

     Respondent contends that Messrs. Sims' and McWade's failure

to disclose the Thompson and Cravens settlements did not rise to

the level of failure to perform a contractual duty owed to the

nontest case petitioners.    Respondent further contends that the

piggyback agreements should be enforced on the ground that the

nontest case petitioners were not prejudiced by Messrs. Sims' and

McWade's misconduct.116

     Respondent also filed objections to Mr. Sticht's Motions for

Release From Piggyback Agreement.    In short, respondent contends

that the validity of the piggyback agreements is not adversely

affected by either Mr. Seery's alleged conflict of interest or

the events occurring during the trial of the test cases.

A.   Principles of Contract Law

     Although the piggyback agreements in dispute are titled

"Stipulation of Settlement For Tax Shelter Adjustments", we have

noted that such agreements do not reflect a settlement or


     116
         Respondent did not address the enforceability of the
piggyback agreements in respondent's opening brief in the belief
that it was premature to address the question pending the Court's
decision whether the Government misconduct in the trial of the
test cases constituted a structural defect. By order dated
Feb. 27, 1998, the Court directed respondent to address the
question in respondent's reply brief, and respondent did so.
                                - 286 -


compromise of the taxpayer's case but merely prescribe the

procedure for the adjudication of the case.    See Adams v.

Commissioner, 85 T.C. at 369.    Nevertheless, we have relied

upon general principles of contract law in construing piggyback

agreements and settlement agreements alike.    See Gridley v.

Commissioner, T.C. Memo. 1997-210; see also Saigh v.

Commissioner, 26 T.C. 171, 177 (1956); Fisher v. Commissioner,

T.C. Memo. 1994-434; Applestein v. Commissioner, T.C. Memo.

1989-42.

     Mr. Izen contends that the piggyback agreements constitute

public contracts that are governed by the Federal common law of

contracts.   Neither respondent nor the other petitioners have

addressed the question.117   In any event, as in Fisher v.

Commissioner, supra, we see no consequential choice of law

problem in the cases at hand.    We are satisfied that the general

contract principles relied upon herein are consistent with the

principles applied by State courts.

     Petitioners argue that the piggyback agreements may be set

aside because of   Messrs. Sims' and McWade's failure to disclose

the true status of the Thompson and Cravens cases at the time

nontest case petitioners executed the agreements.    Every contract


     117
         For a detailed discussion whether Federal or State law
governs the validity of a purported joint return that is impugned
on the ground of duress, reviewing the matter under 1
Restatement, Contracts 2d (1981), and New Jersey common law, see
Berger v. Commissioner, T.C. Memo. 1996-76. The Berger opinion
concludes that the result would be same under the State law and
the putative Federal common law.
                              - 287 -


imposes upon the parties thereto an implied duty of good faith

and fair dealing.   See San Jose Prod. Credit Association v. Old

Republic Life Ins. Co., 723 F.2d 700, 703 (9th Cir. 1984); Smith

v. Empire Sanitary Dist., 127 Cal. App. 2d 63, 71, 273 P.2d 37,

43 (1954); 3A Corbin on Contracts, sec. 654A, at 86 (1998 Supp.).

A contract generally is voidable if one party's assent to the

agreement is induced by a fraudulent or material

misrepresentation by the other party to the contract.    See

Dorchester Indus. Inc. v. Commissioner, 108 T.C. 320, 335 (1997);

1 Restatement, supra sec. 164(1).    A party's nondisclosure of a

fact known to him is treated as an assertion that the fact does

not exist where he knows that the disclosure of the fact would

correct a mistake of the other party as to a basic assumption

on which that party relies in making the contract.    See 1

Restatement, supra sec. 161(b).   The nondisclosure of a fact

known to a party to a contract may be considered a fraudulent

misrepresentation if the party intends   the nondisclosure to

mislead the other party.   See id. sec. 162(1)(a).    The Court has

held that a settlement stipulation may be set aside for

excusable, damaging reliance upon a false or untrue

representation of the other party.   See Saigh v. Commissioner,

supra at 180; Fisher v. Commissioner, supra.

     Although a contract may be voidable because of a fraudulent

or material misrepresentation, the right to avoid the contract

may lapse if the effect of the misrepresentation is cured or the

substance of the performance promised has been delivered before
                               - 288 -


the affected party gives notice of his intent to avoid the

contract.    See Ice v. Benedict Nuclear Pharms., Inc., 797 P.2d

757, 759 (Colo. Ct. App. 1990); 1 Restatement, supra sec. 165.

       Petitioners also contend that Messrs. Sims' and McWade's

failure to disclose the Thompson and Cravens settlements before

the trial of the test cases constitutes a breach of contract.

The conditions and obligations underlying a contract may be

implied from the terms or nature of the agreement, particularly

where the matter is presumed to have been perfectly obvious to

the parties.    See Sacramento Navigation Co. v. Salz, 273 U.S.

326, 328-329 (1927) (contract for the transportation of barley on

a barge (which lacked a power source) implied that the barge

would be used with a steamer or tug); see also Hudson Canal Co.

v. Pennsylvania Coal Co., 75 U.S. (8 Wall.) 276 (1868) (contract

between coal producer and canal company for transportation of

coal by way of canal, under which coal company constructed

railroad from its mine to the canal and canal company enlarged

its canal, did not imply that coal company would use the canal as

sole means for transporting its coal).

       A contract may be avoided or rescinded where a party fails

to satisfy a material or essential term or condition of the

agreement.    See First Interstate Bank v. SBA, 868 F.2d 340, 343-

344 (9th Cir. 1989), and cases cited therein.    A material breach

of contract is one that substantially defeats its purpose so that

the injured party is justified in treating the matter as at an

end.    See 4 Corbin on Contracts, supra sec. 946, at 809.   The
                               - 289 -


materiality of a breach generally is considered a question of

fact to be decided on the basis of all the facts and

circumstances.    See Smith v. Empire Sanitary Dist., supra, and

cases cited therein.    In First Interstate Bank v. SBA, supra at

343-344, the Court of Appeals for the Ninth Circuit stated that

the test of whether a breach of a Federal contract is material is

an "all-the-circumstances-test" and that the Court of Appeals

considers the five factors listed under 1 Restatement, supra sec.

241, as significant in applying the test.118




     118
           1 Restatement, Contracts 2d, sec. 241 (1981), states as
follows:

     In determining whether a failure to render or to offer
     performance is material, the following circumstances
     are significant:

          (a) the extent to which the injured party will be
     deprived of the benefit which he reasonably expected;

          (b) the extent to which the injured party can be
     adequately compensated for the part of that benefit of
     which he will be deprived;

          (c) the extent to which the party failing to
     perform or to offer to perform will suffer forfeiture;

          (d) the likelihood that the party failing to
     perform or to offer to perform will cure his failure,
     taking account of all of the circumstances including
     any reasonable assurances;

          (e) the extent to which the behavior of the party
     failing to perform or to offer to perform comports with
     standards of good faith and fair dealing.
                              - 290 -


B.   Discussion

     1.   Benefit of the Bargain

     The piggyback agreements executed in these cases reflect a

bargained-for exchange:   Nontest case petitioners who executed

piggyback agreements surrendered their rights to have their own

cases tried on the merits of the Kersting adjustments in exchange

for respondent's agreement that their deficiencies would be

redetermined in accordance with the outcome of the trial on the

merits of the test cases.   Both respondent and nontest case

petitioners expected to benefit under the piggyback agreements by

avoiding the expenses of a trial on the merits.

     It is apparent that nontest case petitioners who signed

piggyback agreements did so with the assumption, shared by the

Court, that the trial of the test cases would not include cases

that had been settled before the trial.   That the trial of the

test cases would not include settled cases is a matter that we

presume to have been perfectly obvious to the parties and an

implied term of the piggyback agreements.

     We now know that Messrs. Sims and McWade misled the Court,

the remaining test case petitioners, and the nontest case

petitioners who signed piggyback agreements by entering into--and

not disclosing--settlements with Messrs. Thompson and Cravens.

Under the circumstances, we are persuaded that nontest case

petitioners who executed their piggyback agreements after the

Thompson and Cravens settlements were negotiated, were partially

induced to execute the piggyback agreements by Messrs. Sims' and
                              - 291 -


McWade's failures to disclose the true status of all the test

cases.   Moreover, we conclude that Messrs. Sims and McWade

violated an implied term of the piggyback agreements by allowing

the trial of the test cases to proceed without disclosing the

Thompson and Cravens settlements.

     Notwithstanding the foregoing, we are obliged to consider,

under either of petitioners' theories for relief, whether

petitioners' received the substance of the performance promised

under the piggyback agreements; i.e., whether petitioners

received the benefit of the bargain.    See Ice v. Benedict Nuclear

Pharms., Inc., supra; 1 Restatement, supra sec. 165.    Stated

differently, we must determine whether Messrs. Sims and McWade

violated a material or essential term or condition of the

piggyback agreements before we can declare the piggyback

agreements invalid.   See First Interstate Bank v. Small Bus.

Admin., supra.

     We begin with the observation that Messrs. Sims' and

McWade's misconduct did not deprive petitioners of the benefit

that they reasonably expected under the piggyback agreements.     As

previously discussed, petitioners expected that their cases would

be decided in accordance with the Court's opinion following a

trial of test cases that would be representative of the various

Kersting programs in dispute in their cases.   The piggyback

agreements imply an understanding that the trial of the test

cases would be an adversarial proceeding (and that the trial

would not include test cases that had been settled).   Although
                              - 292 -


the Thompson and Cravens settlements were contrary to

petitioners' assumption or expectation that none of the test

cases would be settled before the trial, the record shows that

the trial of the cases of the six test case petitioners

represented by Mr. Izen remained fully adversarial.   Further, we

have already observed that Mr. Izen was not prevented or

inhibited from fully and fairly presenting his cases to the Court

and that the testimony and evidence associated with the Thompson

and Cravens cases did not affect the outcome in Dixon II.

Considering that the cases of the six test case petitioners

presented by Mr. Izen were representative of the various Kersting

programs in dispute, see table setting forth test case array

supra pp. 38-41, we conclude that petitioners were not deprived

of the benefit that they reasonably expected under the piggyback

agreements.

     We balance the fact that petitioners were not deprived of

the benefit of their bargain under the piggyback agreements

against Messrs. Sims' and McWade's misconduct in failing to

disclose the Thompson and Cravens settlements before the trial of

the test cases, as well as the indirect damages that petitioners

have suffered as a result of Messrs. Sims' and McWade's

misconduct.   As a consequence of Messrs. Sims' and McWade's

violation of an implied term of the piggyback agreements, some

petitioners undoubtedly have suffered consequential damages such

as accrual of additional statutory interest under section 6601
                               - 293 -


and/or attorney's fees incurred for representation at the

evidentiary hearing.119

     We note that Messrs. Sims and McWade are not solely

responsible for the accrual of additional statutory interest in

these cases.   Petitioners have always had the ability to stop the

accrual of additional interest by remitting a payment in the

nature of a cash bond.    See sec. 6213(b)(4).   However,

Mr. Kersting advised program participants that they should not

remit any amount to the Internal Revenue Service until their

liability was determined in court, and many of the nontest case

petitioners appear to have relied upon that advice.     We further

observe that Mr. Kersting's interference in the Chicoine and

Hallett settlement negotiations, and his recommendation that

program participants reject the 20-percent settlement offer, can

be viewed as indirect causes of the accrual of additional

interest in many of these cases that would have otherwise

settled.

     On balance, we conclude that Messrs. Sims' and McWade's

misconduct in failing to disclose the Thompson and Cravens

settlements to nontest case petitioners who signed piggyback

agreements, and in violating an implied term of the piggyback

agreements, does not rise to the level of materiality that would


     119
         We observe that a number of petitioners, including the
Thompsons and the Cravenses, paid their deficiencies and interest
in late 1986 in order to stop the running of interest and to
obtain the full benefit of deductions for interest that would
have been subject to phaseout if paid in later years.
                               - 294 -


justify setting aside the piggyback agreements.    Accordingly, we

will decline to avoid or rescind the piggyback agreements.

     Even if we were to conclude that Messrs. Sims' and McWade's

failure to disclose the Thompson and Cravens settlements

constituted a breach of the piggyback agreements that would

justify their rescission or cancellation, petitioners would not

be entitled to a new trial.    In due course, petitioners would be

ordered to show cause why their cases should not be decided

consistently with Dixon II.    See, e.g., Krause v. Commissioner,

99 T.C. 132 (1992); Acierno v. Commissioner, T.C. Memo. 1997-441;

Karlsson v. Commissioner, T.C. Memo. 1997-432; Bokum v.

Commissioner, T.C. Memo. 1990-21, affd. 992 F.2d 1136 (11th Cir.

1993).    Considering the entire record in these cases, we are

convinced that nontest case petitioners inevitably would be bound

by the Court's opinion in Dixon II.

     2.     Mr. Seery's Purported Conflict of Interest

     We likewise reject Mr. Sticht's contention that the

piggyback agreements should be set aside on the ground that

Mr. Seery had a conflict of interest when he executed the

piggyback agreements.    The short answer to Mr. Sticht's

contention is that Judge Goffe did not find that Mr. Seery had a

conflict of interest.    Judge Goffe merely indicated that Mr.

Seery's motion to change the place of trial, filed November 7,

1986, gave rise to the possible inference that Mr. Seery was

engaged in dual representation of both Mr. Kersting and Kersting

program participants.    Similarly, Mr. Seery's motions to withdraw
                              - 295 -


as counsel stated that Mr. Seery felt obliged to withdraw because

the Court had raised an issue of his possible conflict of

interest.

     The record in these cases does not reflect that Mr. Seery

had a conflict of interest as the result of his possible dual

representation of Mr. Kersting and Kersting program participants.

Mr. Seery negotiated the modified 7-percent settlement offer with

Mr. McWade and arranged to have it disseminated to Kersting

program participants, notwithstanding Mr. Kersting's disapproval

of the offer as inadequate.   Equally important, because Mr. Seery

revealed in his motions to withdraw as counsel that he felt

obliged to withdraw because the Court had raised an issue of his

possible conflict of interest, Mr. Sticht's clients had ample

opportunity at that time to move to have their piggyback

agreements set aside.

     Finally, even assuming for the sake of argument that

Mr. Seery had a conflict of interest, petitioners have failed to

show that they were prejudiced by his actions.   See Adams v.

Commissioner, 85 T.C. at 375-376.   Accordingly, we will deny Mr.

Sticht's Motions for Release From Piggyback Agreement filed on

behalf of nontest case petitioners Richard B. and Donna G.

Rogers, Anthony E. and Carol A. Eggers, and John L. and Terry E.

Huber.120

     120
         Mr. Sticht included as an attachment to the Rogers
motion a copy of a piggyback agreement executed by Mr. Seery (on
the Rogerses' behalf) and by Mr. McWade. Mr. Sticht contends
                                                   (continued...)
                               - 296 -


     3.    Rejection of Mr. Izen's Argument for Entry of Decision
           on the Basis of Thompson Decisions

     Mr. Izen contends that, pursuant to the piggyback

agreements, petitioners are entitled to entry of decision

consistent with the decisions entered in the Thompson cases.   In

Gridley v. Commissioner, T.C. Memo. 1997-210, we rejected this

argument on the ground that nontest cases petitioners who signed

piggyback agreements agreed to be bound by the Court's opinion in

Dixon II as opposed to a specific decision entered in a

particular test case.   Consistent with our analysis in Gridley v.

Commissioner, supra, we reject Mr. Izen's argument.

VIII. Mary Carter Agreements

     At common law, a plaintiff had only one cause of action

against joint tort-feasors; therefore a plaintiff's release of

one joint tort-feasor would release all the joint tort-feasors.121



     120
       (...continued)
that the Rogerses may rescind this piggyback agreement on the
ground that it was never filed with the Court. We reject
Mr. Sticht's argument as contrary to this Court's recent holding
in Dorchester Indus., Inc. v. Commissioner, 108 T.C. 320 (1997)
(settlement agreement is binding even though it has not been
filed as a stipulation with the Court). Moreover, we are
satisfied that the Rogerses are bound by a piggyback agreement
executed by Mr. Seery and Mr. McWade and filed with the Court in
Aaronson v. Commissioner, docket No. 17445-82, on Dec. 1, 1986,
at a time when the Rogerses were parties to that consolidated
docket.
     121
         See Note, "The Mary Carter Agreement--Solving the
Problems of Collusive Settlements in Joint Tort Actions", 47 S.
Cal. L. Rev. 1393, 1395-1396 (1974). This note is referenced in
d'Hedouville v. Pioneer Hotel Co., 552 F.2d 886, 895 (9th Cir.
1977), one of the few cases in which the Court of Appeals for the
Ninth Circuit has addressed Mary Carter Agreements (MCA's),
thereby meriting special attention.
                              - 297 -


In order to avoid this result and encourage partial settlements

of cases, a number of legal devices were developed to circumvent

the common law rule.   One of these devices is known as the Mary

Carter agreement (MCA),122 taking its name from Booth v. Mary

Carter Paint Co., 202 So. 2d 8 (Fla. Dist. Ct. App. 1967),

overruled by Ward v. Ochoa, 284 So. 2d 385 (Fla. 1973).

     As in Mary Carter Paint Co., MCA's typically consist of four

elements:   (1) The plaintiff enters into an agreement with some

but not all the defendants not to enforce the court's judgment

against the settling defendants; (2) the settling defendants

agree to pay the plaintiff a guaranteed minimum payment, thereby

placing a limit on their liability to the plaintiff; (3) the

settling defendants agree to remain parties to the action until a

verdict has been rendered or until they have been released by the

court or the plaintiff; and (4) the parties agree to keep the

agreement secret from the court and the nonsettling defendants.

Usually, the defendant's guaranteed minimum payment is reduced or

extinguished if the plaintiff recovers against the nonsettling

defendants in an amount greater than the guaranteed minimum

payment (hereinafter the Sliding Scale Clause), thereby giving

     122
         But see Note, "It's a Mistake to Tolerate the Mary
Carter Agreement", 87 Colum. L. Rev. 368, 379 (1987), arguing
that MCA's actually encourage litigation, rather than promote
settlement of disputes, because the agreement requires continued
litigation against the nonsettling defendants. The Supreme
Courts of Texas and Florida, in declaring MCA's void as against
public policy, have done so for a variety of reasons, one of them
being that MCA's, rather than encouraging settlements, actually
promote litigation. See Dosdurian v. Carsten, 624 So. 2d 241
(Fla. 1993); Elbaor v. Smith, 845 S.W.2d 240 (Tex. 1992).
                              - 298 -


the settling defendant a direct financial stake in the outcome of

the case that is adverse to that of the nonsettling defendants.

     MCA's that include a Sliding Scale Clause generally are

considered invalid or void because such agreements leave the

finder of fact with the false impression that there is adversity

between the plaintiff and all of the defendants while in reality

there is adversity between the settling defendants and

nonsettling defendants.   See Dosdourian v. Cartsen, 624 So. 2d

241 (Fla. 1993); Fullenkamp v. Newcomer, 508 N.E.2d 37 (Ind. Ct.

App. 1987); General Motors Corp. v. Lahocki, 410 A.2d 1039 (Md.

1980); Lum v. Stinnett, 488 P.2d 347 (Nev. 1971); Cox v. Kelsey-

Hayes Co., 594 P.2d 354 (Okla. 1978).123   However, some courts

have declined to invalidate such agreements, depending upon the

particular facts and circumstances of the case.    See Hoops v.

Watermelon City Trucking, Inc., 846 F.2d 637 (10th Cir. 1988);

d'Hedouville v. Pioneer Hotel Co., 552 F.2d 886 (9th Cir. 1977);

Slusher v. Ospital, 777 P.2d 437 (Utah 1989).




     123
         See Note, "It's a Mistake to Tolerate the Mary Carter
Agreement", 87 Colum. L. Rev. 368, 370 (1987); see also Cox v.
Kelsey-Hayes Co., 594 P.2d 354, 359 (Okla. 1978), where the court
stated:

          Courts and commentators, recognizing the
     substantial prejudice to the non-agreeing defendants,
     are nearly unanimous in their belief the agreements
     must be disclosed prior to trial and if the agreeing
     defendant's maximum liability will be reduced by
     increasing the liability of his codefendant, the jury
     must be informed of the contents of the agreement
     * * *.
                               - 299 -


     Although the Thompson and Cravens settlement agreements

contain the basic elements of an MCA, the tax liabilities of the

Thompsons and the Cravenses were not tied to a Sliding Scale

Clause.    Rather than having a direct financial stake in the

outcome of the case adverse to that of the remaining test case

petitioners, the Thompsons and Cravenses had their tax

liabilities capped, and those liabilities would have been further

reduced or eliminated if the test case petitioners had prevailed

at trial.    Although the Thompsons' and Cravenses' adversarial

posture toward respondent had been diluted, they remained

adversaries of respondent in some residual sense.

     Even more important, the Thompson and Cravens settlement

agreements did not realign their interests so as to justify the

conclusion that they had become adversaries of the remaining test

case petitioners.    The record shows that Mr. Cravens appeared at

the trial of the test cases and testified in support of the test

case petitioners' position.    Although Mr. Thompson did not have a

direct interest in a decision against the remaining test case

petitioners, the record indicates that Mr. Thompson may have

viewed the trial of the test cases as an opportunity to gain

some advantage against Mr. Kersting's threats to enforce Mr.

Thompson's promissory notes.124   While it might be argued that the

Thompsons expected or received some benefit from the Court's


     124
         Of course, Judge Goffe was aware that Mr. Thompson
was hostile towards Mr. Kersting and was able to assess
Mr. Thompson's credibility from that standpoint.
                              - 300 -


holding in Dixon II that the disputed promissory notes did not

create genuine indebtedness for tax purposes, it was not a direct

financial benefit in the sense that Judge Goffe's opinion is not

dispositive of the question whether Mr. Thompson's notes are

enforceable against him for State law purposes.   Unlike MCA's

with Sliding Scale Clauses that provide settling defendants with

an immediate financial reward for large verdicts against

nonsettling defendants, Mr. Thompson's reward was a moral victory

at best.   Any financial stake the Thompsons did have in the

outcome of the test cases is at least one long step removed from

the distinct and immediate financial stake a settling defendant

normally has under a Sliding Scale Clause in an MCA.

      Considering all the facts and circumstances, we hold that

the family resemblances between Mary Carter agreements and the

Thompson and Cravens settlements do not bar the Court from

reinstating its decisions in the test cases.

IX.   Mr. Sticht's Motion To Sever Case and for Entry of Decision
      or Alternatively To Sever Case and Set for Trial

      On June 9, 1998, Mr. Sticht filed a Motion to Sever Case and

for Entry of Decision; Or Alternatively to Sever Case and Set for

Trial on behalf of Joe A. and JoAnne Rinaldi in docket No. 7205-

94.   The Rinaldis' case at docket No. 7205-94 concerns the

Rinaldis' tax liabilities for 1990 and 1991 and is based upon a

notice of deficiency that was issued after the disclosure of the

misconduct in the trial of the test cases.   Because the Rinaldis

did not sign a piggyback agreement in docket No. 7205-94, Mr.
                                    - 301 -


Sticht contends that the Court's opinion in Dixon II is not

binding on the Rinaldis.125       Mr. Sticht relies upon the misconduct

in the trial of the test cases to contend that the Court should

either enter a decision in the Rinaldis' favor or sever the

Rinaldis' case from the consolidated cases and set the case for

trial.         Mr. Sticht contends that the Court's opinion in Dixon II

has no effect in the Rinaldis' dockets in which they did not

execute piggyback agreements.

         Respondent contends that Mr. Sticht's motion should be

denied on the grounds that:        (1) The record does not support

entry of decision in the Rinaldis' favor; and (2) the Rinaldis'

motion amounts to a premature attempt to avoid a "show cause"

proceeding.        Respondent further contends that, if the Court's

opinion in Dixon II should be reinstated, it provides an

appropriate basis for resolving any deductions claimed by the

Rinaldis with respect to Kersting programs in dispute in Dixon

II.126

         Consistent with our holdings that the Government misconduct

did not cause a structural defect in the trial of the test cases

         125
         The Rinaldis have seven cases docketed with the Court
assigned docket Nos. 31065-83, 21615-87, 6981-89, 11439-90,
27556-90, 14907-93, and 7205-94. The Rinaldis executed piggyback
agreements in each of the dockets listed above except docket Nos.
14907-93 and 7205-94.
         126
         Respondent states that the Rinaldis may have
participated in Mr. Kersting's Bauspar program during some of the
years for which they have filed petitions with the Court.
Respondent acknowledges that, because the Bauspar program was not
litigated in Dixon II, the Court's opinion would not dispose of
Bauspar deductions claimed by the Rinaldis or others.
                               - 302 -


and that the misconduct resulted in harmless error, we see no

basis or justification for entry of decision in favor of the

Rinaldis.    Nor will we sever the Rinaldis' case from the

consolidated group and/or set the case for trial at this time.

To the contrary, because we will reinstate our opinion in Dixon

II and enter decisions in the remaining original test cases, we

will abide the outcome of any appeal that follows the issuance of

this opinion.    If affirmed by the Court of Appeals, we will, upon

respondent's motion, issue an Order to Show Cause in due course

directing the Rinaldis to show cause why the resolution of the

substantive tax issues in their case should not be controlled by

our opinion in Dixon II.    See Krause v. Commissioner, 99 T.C. 132

(1992); Acierno v. Commissioner, T.C. Memo. 1997-441; Karlsson v.

Commissioner, T.C. Memo. 1997-432; Bokum v. Commissioner, T.C.

Memo. 1990-21.

X.   Protective Orders

     As previously discussed, the Court issued protective orders

in these cases dated June 10 and 26, 1996, with respect to

documents produced by Mr. Thompson.      By order dated August 27,

1998, the Court directed the parties, particularly Messrs.

Huestis and Sticht, to file reports with the Court stating in

detail any objection to the lifting of the Court's protective

orders.   Mr. Huestis filed a report with the Court objecting to

the lifting of the Court's protective orders on the ground that

Mr. Kersting might use the records in question to harass the

Thompsons.    Mr. Sticht and respondent filed separate reports with
                              - 303 -


the Court indicating no objection to the lifting of the

protective orders.

     Section 7458, which governs hearings before the Tax Court,

provides that such hearings shall be open to the public.   In

addition, section 7461, entitled "Publicity of Proceedings",

provides in pertinent part:

          SEC. 7461(a). General Rule.--Except as provided in
     subsection (b), all reports of the Tax Court and all
     evidence received by the Tax Court and its divisions,
     including a transcript of the stenographic report of
     the hearings, shall be public records open to the
     inspection of the public.

          (b) Exceptions.--

            (1) Trade Secrets or Other Confidential
     Information.--The Tax Court may make any provision
     which is necessary to prevent the disclosure of trade
     secrets or other confidential information, including a
     provision that any document or information be placed
     under seal to be opened only as directed by the court.

     Rule 103 provides that upon motion by a party or other

affected person, and upon good cause shown, the Court may make

any order which justice requires to protect a party or other

person from annoyance, embarrassment, oppression, or undue burden

or expense.

     Sections 7458 and 7461 reflect the well-established

principle that official proceedings and records of all courts,

including the Tax Court, generally shall be open and available to

the public.   See Nixon v. Warner Communications, Inc., 435 U.S.

589, 597 (1978); Willie Nelson Music Co. v. Commissioner, 85 T.C.

914, 917 (1985).   However, section 7461 and Rule 103 provide that

the Court has the discretionary authority to order all or part of
                                - 304 -


a record to be sealed where such action is necessary to protect

trade secrets and confidential information or to avoid annoyance,

embarrassment, oppression, or undue burden or expense.     See

Willie Nelson Music Co. v. Commissioner, supra at 918-919, and

cases cited thereat.

       In resolving whether a permanent protective order sealing a

portion of the evidentiary record is warranted in these cases, we

must weigh the public's interest in free and open access to Tax

Court proceedings against the individual interests advanced in

these cases.    See Nixon v. Warner Communications, Inc., supra at

602.    The public's interest in open judicial proceedings is

presumed to be paramount to the interests of an individual

seeking to close the proceedings in that open proceedings allow

the public an opportunity to understand the underlying dispute

and its disposition, thereby enhancing public confidence in our

system of taxation.    See Willie Nelson Music Co. v. Commissioner,

supra at 919.

       The Court is of the view that its protective orders sealing

the documents described above have served their purpose and that

the public's interest in open proceedings outweighs any

continuing individual interests at stake in these cases.

Mr. Huestis has not persuaded us otherwise.    We note that there

is no indication that Mr. Kersting has initiated litigation

against the Thompsons, nor any imminent threat of any such

litigation.     We do not believe that unsealing the documents in

question would increase the likelihood of any such threat.
                              - 305 -


Moreover, the Court has disclosed the contents of a number of the

disputed documents in this opinion.     Considering all the facts

and circumstances, we will lift the protective orders dated

June 10 and 26, 1996.

XI.   Sanctions

      The Court has inherent power "to protect our own process

from abuse, oppression, and injustice."     Griffith v.

Commissioner, T.C. Memo. 1988-123 (citing Gumbel v. Pitkin, 124

U.S. 131, 145-146 (1888), and Eash v. Riggins Trucking Inc., 757

F.2d 557 (3d Cir. 1985) (en banc)).

      Messrs. Sims' and McWade's misconduct in the trial of the

test cases has caused a substantial delay in the resolution of

Kersting project cases.   Considering the unique circumstances of

these cases, and the harm resulting from the Government

misconduct in the trial of the test cases, we consider this is an

appropriate occasion for the Court to impose limited sanctions

against respondent under Rule 123(a).     See Vermouth v.

Commissioner, 88 T.C. 1488 (1987) (discussing and relying on

United States v. Sumitomo Marine & Fire Ins. Co., 617 F.2d 1365

(9th Cir. 1980)); see also Betz v. Commissioner, 90 T.C. 816, 823

(1988).

      Respondent determined that Kersting program participants are

liable for additions to tax for negligence under section 6653.

For the taxable years 1981 through 1985, section 6653(a)(2)

provides that the addition to tax for negligence includes a

component equal to 50 percent of the interest due on the
                               - 306 -


deficiency.    For the taxable years 1986 and 1987, the interest

component of the addition to tax for negligence is codified under

section 6653(a)(1)(B).

     Respondent also determined that Kersting program

participants are liable for interest computed at the increased

rate prescribed under section 6621(c).   Section 6621(c) provides

that interest on a deficiency shall be computed at an increased

rate with respect to any substantial underpayment attributable to

a tax-motivated transaction.

     The interest component of the addition to tax for negligence

and interest computed at the increased rate prescribed under

section 6621(c) are time-sensitive provisions whose impact will

be amplified in these cases as a consequence of the delay

occasioned in large part by the Government misconduct described

herein.    With a view to promoting basic fairness and justice in

the Kersting project cases, and to discourage future acts of

Government misconduct, we hold that Kersting program participants

who either have not had decisions entered in their cases or whose

decisions are not yet final are not liable for the interest

component of the addition to tax for negligence under sections

6653(a)(2) and 6653(a)(1)(B) or interest computed at the

increased rate prescribed in section 6621(c).127

     127
         As previously mentioned, see supra pp. 44-47, there is
an inconsistency between the 1985 piggyback agreements and the
post-1985 piggyback agreements concerning additions to tax: the
1985 piggyback agreements are silent about additions to tax,
while the post-1985 piggyback agreements provide that Kersting
                                                   (continued...)
                                - 307 -


                              Conclusion

     Consistent with all the foregoing, we will issue an order

reinstating the Court's opinion in Dixon v. Commissioner, T.C.

Memo. 1991-614, excepting the portions sustaining respondent's

determinations that test case petitioners were liable for

additions to tax for negligence under sections 6653(a)(2) and

6653(a)(1)(B) and increased interest under section 6621(c), and

directing the parties, where appropriate, to file stipulated

decisions with the Court.


                            An appropriate order will be issued

                    and decisions will be entered in docket

                    Nos. 9382-83, 4201-84, 15907-84, 40159-84,

                    22783-85, 30010-85, 30979-85, and 29643-86.

                            An appropriate order will be issued in

                    docket Nos. 17646-83, 7323-84, 20119-84,

                    35608-86, 19464-92, 621-94, 7205-94,

                    9532-94, 17992-95, and 17993-95.

     127
       (...continued)
program participants are not liable for additions to tax for
negligence for taxable years before 1982. We have surmised that
respondent limited this concession to taxable years before 1982
on the ground that the Court’s May 1982 release of its opinion in
Pike v. Commissioner, 78 T.C. 822 (1982), put prospective
Kersting program participants on notice that the Kersting
programs did not generate legitimate interest deductions. See
supra note 26. The record does not disclose whether respondent
intends to extend the same relief across the board to all
participants in the Kersting programs whose cases have not been
the subject of a final determination. We observe that extending
such relief would promote the consistency in treatment among
similarly situated taxpayers that piggyback agreements and the
test case procedure are intended to promote.
