                          T.C. Memo. 2009-6



                       UNITED STATES TAX COURT



                  DAVID C. LOEB, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

                HAROLD E. MOLAISON, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 6975-07, 7232-07.     Filed January 7, 2009.



     Michael E. Guarisco and Jean K. Niederberger, for

petitioners.

     Joseph Ineich and Mary Beth Calkins, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     HAINES, Judge:    These cases are before the Court

consolidated for purposes of trial, briefing, and opinion.

Respondent determined deficiencies and penalties with respect to

petitioners’ Federal income taxes as follows:
                                  - 2 -



     David C. Loeb, docket No. 6975-07

                                              Fraud Penalty
     Year            Deficiency                 Sec. 6663

     1996             $406,537                  $304,903


     Harold E. Molaison, docket No. 7232-07

                                              Fraud Penalty
     Year            Deficiency                 Sec. 6663

     1996             $295,298                  $221,474

     The issue for decision is whether the statute of limitations

under section 6501(a)1 bars the issuance of the notices of

deficiency.   We hold that it does.

                         FINDINGS OF FACT

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

The stipulation of facts, the supplemental stipulation of facts

and the second supplemental stipulation of facts, together with

the attached exhibits, are incorporated herein by this reference.

At the time petitioners filed their petitions, they resided in

Louisiana.

     Petitioners are attorneys who represented landowners in a

regulatory takings case referred to as the Bayou Aux Carpes (BAC)

litigation.   Mr. Molaison’s practice dealt with general civil


     1
      All section references are to the Internal Revenue Code in
effect for the year in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
                                 - 3 -

litigation and succession work while Mr. Loeb’s practice dealt

with land use and real property law.

     Mr. Molaison was intimately familiar with the property

underlying the BAC litigation.    His father, who passed away in

1991, was also an attorney and had represented BAC landowners in

a prior action against the Environmental Protection Agency (EPA)

in the 1970s in Louisiana State court.    Mr. Molaison had helped

his father in that action as a law clerk and an attorney.    He

also inherited a small tract of BAC property from his father.

     The BAC suits comprised four cases that were filed in 1991

in response to a determination by the EPA that approximately

3,000 acres of land located in southern Louisiana constituted

nonpermitable wetland.   The landowners of the BAC property sought

to develop the property and brought suit in order to contest the

EPA’s designation of the property as wetland.    The landowners in

two of the BAC suits hired petitioners to represent them.    The

four cases were eventually consolidated and petitioners

represented all of the landowners in the consolidated BAC

litigation.

     Petitioners entered into contracts for legal services with

the landowners which gave petitioners an undivided 25-percent

interest in any recovery and prohibited the clients from settling

or otherwise discontinuing the suit without the consent of
                               - 4 -

petitioners.   In late March 1996 petitioners reached an agreement

with the U.S. Government to settle the case for $8,250,000.

     In order to determine the tax issues associated with the

likely settlement, petitioners, who had no expertise in tax law,

sought help from David Lukinovich, an attorney certified as a tax

specialist by the Louisiana State Bar.   On April 23, 1996, after

an initial telephone conversation with Mr. Loeb, Mr. Lukinovich

wrote a letter to Mr. Loeb offering his services to petitioners’

clients on the tax aspects of the settlement.   In his letter Mr.

Lukinovich discussed section 1033 and the income deferral

benefits it extended to landowners in involuntary conversion

proceedings.

     Petitioners believed they had an ownership interest in the

land subject to the BAC litigation as a result of their

contingency fee agreement with the BAC landowners.2   On August

15, 1996, Mr. Loeb wrote to Ann Navaro, one of the assistant U.S.

attorneys (AUSAs) handling the BAC litigation, in response to her

request that he identify all parties to the settlement who had

not been identified in the Government’s initial draft of the

settlement agreement.   In his letter Mr. Loeb identified several


     2
      This was separate and in addition to Mr. Molaison’s status
as an owner because of the small parcel of BAC property he
inherited from his father. Mr. Molaison received settlement
proceeds of $185,971 from the involuntary conversion of his
inherited property. He elected to defer recognition of the
proceeds under sec. 1033(a)(2). The validity of that election is
not in dispute.
                               - 5 -

parties, including himself and Mr. Molaison, who should be added

to the settlement agreement and to the act of sale.    AUSAs Ann

Navaro and Marc Smith agreed to add petitioners as landowners to

the settlement agreement and act of sale.   Ms. Navaro and Mr.

Smith were aware that petitioners intended to classify themselves

as owners in part to take advantage of section 1033.    On August

20, 1996, petitioners were listed as owners on the executed

settlement agreement.

     On August 21, 1996, Mr. Lukinovich sent Mr. Loeb a letter

suggesting that petitioners could potentially defer their

contingency fee income under section 1033(a) if the Government

recognized them as landowners in the BAC litigation.

     On August 29, 1996, petitioners entered into a joint

stipulation for entry of judgment in the BAC cases with the

Government.   On August 30, 1996, the U.S. Court of Federal Claims

entered judgment settling the BAC cases with the payment of

$8,250,000 by the Government in exchange for the BAC property.

     On September 4, 1996, petitioners met with Gerald Duhon, Mr.

Loeb’s certified public accountant (C.P.A.), Shannon Chabaud, Mr.

Molaison’s C.P.A., and Mr. Lukinovich at petitioners’ office

regarding tax planning for petitioners and the preparation of

their 1996 Federal income tax returns.   Mr. Lukinovich conducted

the meeting and explained that his research indicated that

petitioners were entitled to defer recognition of their BAC
                               - 6 -

litigation fees under section 1033(a).   Mr. Lukinovich also

proposed that petitioners prepare a document clarifying that the

intent of petitioners’ clients was to transfer an ownership

interest in the BAC property to petitioners as compensation for

their representation.   Petitioners decided to prepare acts of

correction for their clients to sign.

     Petitioners prepared the acts of correction with the input

of Mr. Lukinovich.   Petitioners did not believe that they had to

obtain the signatures of all of their clients on the acts of

correction for their BAC litigation fees to be qualified under

section 1033.

     In late September and early October 1996 petitioners held a

series of meetings with their clients to have them sign pre-

closing documents.   During these meetings, petitioners requested

that the clients sign the acts of correction.   Petitioners

exerted no pressure or undue influence on any client.

Petitioners did not misrepresent the contents of the acts of

correction to any client.   Out of 53 clients, 32 chose to sign

the acts of correction, 15 chose not to sign and 6 were never

offered the chance to sign.   Two clients consulted with Mr.

Lukinovich regarding the acts of correction before signing them.

     On October 8, 1996, petitioners executed the act of sale of

the BAC property to the Government.    Petitioners executed the act

of sale individually as vendors.   All clients, including those
                                 - 7 -

who did not execute an act of correction, received all of the

proceeds due to them under the act of sale.     As a result of the

settlement, Mr. Loeb and Mr. Molaison received $1,056,000 and

$791,503, respectively.

     On December 1, 1996, and April 4, 1997, Mr. Lukinovich wrote

petitioners letters regarding petitioners’ reinvestment of the

proceeds from the act of sale in order to qualify for rollover

treatment under section 1033(a)(2).      Mr. Lukinovich provided the

language for section 1033(a)(2) elections attached to

petitioners’ 1996 and 1997 income tax returns, and reviewed the

language before the submission of petitioners’ Forms 1040, U.S.

Individual Income Tax Return, for 1996 and 1997.     At no time did

Mr. Lukinovich indicate that petitioners were barred from making

the section 1033(a)(2) election if not all of their clients

signed the acts of correction.

     In 1997 petitioners purchased replacement property and

listed said property on their 1996 Federal income tax returns in

an effort to comply with the requirements of section 1033.

     On November 19, 1999, Revenue Agent William Witteman sent

Mr. Loeb a letter indicating that he was auditing Mr. Loeb’s 1996

Federal income tax return.   On April 20, 2000, Mr. Witteman sent

Mr. Molaison a letter indicating that he was auditing Mr.

Molaison’s 1996 Federal income tax return.     Petitioners fully

complied with their audits and produced all documents requested
                                 - 8 -

by Mr. Witteman, including all acts of correction both signed and

unsigned.

     Respondent prosecuted petitioners for committing criminal

fraud on their 1996 Federal income tax returns.    In May 2005

petitioners were acquitted of all criminal fraud charges related

to their 1996 Federal income tax returns at a trial held in New

Orleans, Louisiana.

     On January 1, 2007, respondent issued notices of deficiency

to petitioners.    Petitioners filed timely petitions with this

Court and trial was held in New Orleans, Louisiana on September

22 and 23, 2008.

                                OPINION

     Petitioners contend that the 3-year period of limitations on

assessment in section 6501(a) expired before respondent issued

the notices of deficiency and respondent’s assessment is barred.

Respondent argues that the period of limitations in section

6501(a) does not apply because petitioners filed false or

fraudulent returns with the intent to evade taxes for 1996.      See

sec. 6501(c)(1).    Accordingly, our determination of whether the

period of limitations expired before the notice of deficiency was

issued depends on whether petitioners committed fraud in the

filing of their 1996 returns.    The determination of fraud for

purposes of section 6501(c)(1) is the same as the determination

of fraud for purposes of the penalty under section 6663.    Neely
                                 - 9 -

v. Commissioner, 116 T.C. 79, 85 (2001); Rhone-Poulenc

Surfactants & Specialties, L.P. v. Commissioner, 114 T.C. 533,

548 (2000).

     Section 6663(a) provides:    “If any part of any underpayment

of tax required to be shown on a return is due to fraud, there

shall be added to the tax an amount equal to 75 percent of the

portion of the underpayment which is attributable to fraud.”    The

Commissioner bears the burden of proving by clear and convincing

evidence that an underpayment of tax was attributable to fraud.

Sec. 7454(a); Rule 142(b).   In order to show fraud, respondent

must prove:   (1) An underpayment exists; and (2) petitioners

intended to evade taxes known to be owing by conduct intended to

conceal, mislead, or otherwise prevent the collection of taxes.

See Parks v. Commissioner, 94 T.C. 654, 660-661 (1990).

A.   Underpayment of Tax

     Respondent must first show by clear and convincing evidence

that there was an underpayment of tax in 1996.   As discussed

below, respondent has satisfied his burden of proof on this

issue.

     Respondent has shown that petitioners received income in

1996 for legal services rendered in the BAC cases.   Petitioners’

sole argument is that their fees constituted a property interest

in the BAC land by virtue of the contracts for legal services and

acts of correction they executed with the BAC landowners.
                              - 10 -

Pursuant to this property interest, petitioners claim they

qualified for the nonrecognition provisions of section 1033.3

     Gross income means all income from whatever source derived,

unless excluded by law.   Sec. 61(a); Commissioner v. Glenshaw

Glass Co., 348 U.S. 426, 433 (1955).   Contingency fees are not

excluded by law from the gross income of an attorney who earns

them through the performance of legal services.   See, e.g.,

Kochansky v. Commissioner, T.C. Memo. 1994-160, affd. in part and

revd. in part 92 F.3d 957 (9th Cir. 1996).




     3
      Petitioners further claim that they obtained their property
interest in the BAC land when it was nonpermitable wetland and
effectively worthless, thus precluding the recognition of income
upon receipt of the interest.
                                 - 11 -

     Section 1033 provides, under prescribed circumstances,4 for

relief from taxpayers’ gains realized from involuntary conversion

of property.   The relief provided by section 1033(a) is deferral

of the gain from involuntary conversion, so long as the proceeds

are used to acquire qualified replacement property.   See, e.g.,

Willamette Indus., Inc. v. Commissioner, 118 T.C. 126, 130-131

(2002).




     4
      Sec. 1033 provides, in pertinent part, as follows:

          SEC. 1033(a). General Rule.–-If property (as a result
     of its destruction in whole or in part, theft, seizure, or
     requisition or condemnation or threat or imminence thereof)
     is compulsorily or involuntarily converted–-

                     *   *   *     *      *   *   *

                (2) Conversion into money.--Into money or into
                property not similar or related in service or use
                to the converted property, the gain (if any) shall
                be recognized except to the extent hereinafter
                provided in this paragraph:

                     (A) Nonrecognition of gain.–-If the taxpayer
                during the period specified in subparagraph (B),
                for the purpose of replacing the property so
                converted, purchases other property similar or
                related in service or use to the property so
                converted, or purchases stock in the acquisition
                of control of a corporation owning such other
                property, at the election of the taxpayer
                the gain shall be recognized only to the extent
                that the amount realized upon such conversion
                (regardless of whether such amount is received in
                one or more taxable years) exceeds the cost of
                such other property or such stock. Such election
                shall be made at such time and in such manner as
                the Secretary may by regulations prescribe. * * *
                                  - 12 -

       State law does not convert an attorney-client relationship

into a partnership or joint venture for purposes of Federal tax

law.       Commissioner v. Banks, 543 U.S. 426, 437 (2005) (stating

that no State laws, even those that purport to give attorneys an

ownership interest in their fees, “convert the attorney from an

agent to a partner”).      Accordingly, petitioners erred in

believing their fees qualified for the nonrecognition provisions

of section 1033(a), and made an underpayment of tax in 1996.5

B.     Fraudulent Intent

       Because direct evidence of fraud is rarely available, fraud

may be proved by circumstantial evidence and reasonable

inferences from the facts.       Petzoldt v. Commissioner, 92 T.C.

661, 699 (1989).      Courts have developed a nonexclusive list of

factors, or “badges of fraud”, that demonstrate fraudulent

intent.       Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).

These badges of fraud include:      (1) Understating income, (2)

maintaining inadequate records, (3) implausible or inconsistent

explanations of behavior, (4) concealment of income or assets,

(5) failing to cooperate with tax authorities, (6) engaging in

illegal activities, (7) an intent to mislead which may be

inferred from a pattern of conduct, (8) lack of credibility of


       5
      However, for reasons discussed below, our holding that
petitioners made an underpayment under the law as it exists today
does not militate in favor of determining that petitioners
intended to commit fraud in 1996.
                              - 13 -

the taxpayer’s testimony, (9) filing false documents, (10)

failing to file tax returns, and (11) dealing in cash.    Id.; see

also Spies v. United States, 317 U.S. 492, 499 (1943); Terrell

Equip. Co. v. Commissioner, 343 F.3d 478, 482 (5th Cir. 2003),

affg. T.C. Memo. 2002-217; Recklitis v. Commissioner, 91 T.C.

874, 910 (1988).   Although no single factor is necessarily

sufficient to establish fraud, the combination of a number of

factors constitutes persuasive evidence.    Niedringhaus v.

Commissioner, supra at 211.   Petitioners’ behavior with respect

to their income may be evaluated in the light of these factors,

as follows.

     (1) Understated Income

     Respondent has disproved petitioners’ assertion that their

fees reflected an interest in the underlying BAC property.

However, this factor is mitigated by petitioners’ inclusion of

these proceeds on their 1996 Federal income tax returns as funds

related to a section 1033 election.    Unlike other fraud cases

where taxpayers attempted to conceal their fees for services or

characterize them as something entirely different, petitioners

never characterized their fees from the BAC cases as anything but

fees.   See, e.g., Talmage v. Commissioner, T.C. Memo. 2008-34

(fraudulent taxpayers attempted to characterize their fees for

services as loans or hide them altogether).
                                  - 14 -



       (2) Inadequate Records

       The record does not indicate that petitioners maintained

inadequate records.      To the contrary, petitioners’ client fee

agreements and section 1033 election were well documented.

       (3) Plausible Behavior

       Petitioners believed, because of the assertions of Mr.

Lukinovich, that their fees represented an interest in BAC

property under Louisiana law.      Mr. Lukinovich believed that

petitioners possessed an interest in the BAC property because of

the acts of correction and the property sale restrictions

petitioners’ contingency fee agreement placed on the BAC

landowners.      Mr. Lukinovich based his advice to petitioners on

Cotnam v. Commissioner, 263 F.2d 119 (5th Cir. 1959), affg. in

part and revg. in part 28 T.C. 947 (1957), overruled by

Commissioner v. Banks, supra, and its application to Louisiana

law.       For purposes of examining fraudulent intent, it is not

necessary for us to determine petitioners’ specific rights to

their contingency fees in 1996 under Louisiana law.

       Petitioners’ reliance on Mr. Lukinovich’s assertion that

their fees represented an interest in BAC property was plausible

given the perceived ambiguity of the law in Louisiana in 1996.6

       6
      Before the Supreme Court’s decision in Commissioner v.
Banks, 543 U.S. 426, 437 (2005), the effect of State law on a
                                                   (continued...)
                               - 15 -

Further, petitioners received affirmation of this belief when

AUSAs Marc Smith and Ann Navaro added petitioners’ names to the

list of BAC landowners on the settlement agreement and act of

sale.    Accordingly, we find petitioners’ behavior regarding their

contingency fees to be both plausible and consistent.

     (4)    Concealment of Income

     Petitioners did not conceal income or assets.   The proceeds

they received from the BAC cases were listed on their 1996

Federal income tax returns as being subject to a section 1033

election.

     (5)    Compliance With Tax Officials

     Petitioners fully complied with the audit process and all

court proceedings.




     6
      (...continued)
lawyer’s right to a contingency fee was unclear. See Cotnam v.
Commissioner, 263 F.2d 119 (5th Cir. 1959), affg. in part and
revg. in part 28 T.C. 947 (1957), overruled by Commissioner v.
Banks, supra. In Cotnam, the old Court of Appeals for the Fifth
Circuit held that the amount of the contingent fee paid out of a
judgment to a taxpayer’s attorneys was not income to the
taxpayer. Id. at 126. The court reasoned that a contingent fee
contract operated as a lien on the recovery under Alabama law,
and thus served to transfer a part of the taxpayer’s claim to the
attorneys. Id. at 125-126. As late as 2001, other Courts of
Appeals followed Cotnam for the proposition that State law
determines the rights and interests of an attorney to a
contingency fee, particularly in the context of postjudgment
interest. See, e.g., Foster v. United States, 249 F.3d 1275,
1279 (11th Cir. 2001), overruled by Commissioner v. Banks, supra;
Estate of Clarks v. United States, 202 F.3d 854, 857 (6th Cir.
2000), overruled in part by Commissioner v. Banks, supra.
                                - 16 -

     (6)   Illegal Activities

     Petitioners never engaged in illegal activities.    None of

their clients were subject to undue influence in signing the acts

of correction, and all received the settlement proceeds to which

they were entitled.

     (7) Pattern of Misconduct With Intent To Mislead

     Petitioners did not engage in a pattern of conduct to

mislead tax authorities.   As previously stated, petitioners

honestly believed they were entitled to a section 1033 election,

and their actions reflect this.

     (8) Credibility of Testimony

     Petitioners’ testimony was credible.

     (9) False Documents

     Petitioners never intentionally filed a false document.

    (10) Failing To File Tax Returns

     Petitioners timely filed their 1996 Federal income tax

returns.

    (11) Dealing in Cash

     Petitioners did not deal in cash.

     As a result of the paucity of badges of fraud in this case,

we find that respondent has failed to show by clear and

convincing evidence that petitioners filed their 1996 returns

with the intent to evade tax.    Therefore, the 3-year period of

limitations under section 6501(a) applies to petitioners’ 1996
                             - 17 -

tax year, and respondent is barred from assessing any

deficiencies in petitioners’ tax for that year.

     To reflect the foregoing,


                                        Decisions will be entered

                                   for petitioners.
