                       T.C. Memo. 1996-323



                     UNITED STATES TAX COURT



          LYNNDA SPEER, DONOR, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket Nos.   6626-94, 6627-94,            Filed July 16, 1996.
                  6628-94.


    Michael David Annis, Jeffrey M. Dean, John H. Rains III,

James A. Bruton, III, John D. Cline, and Ari S. Zymelman, for

petitioners.

     Francis C. Mucciolo and Stephen R. Takeuchi, for respondent.




     1
      Cases of the following petitioners are consolidated
herewith: Roy M. and Lynnda L. Speer, docket No. 6627-94, and
Roy M. Speer, Donor, docket No. 6628-94.
                                    - 2 -

              MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:     Respondent determined deficiencies in

petitioners' Federal income and gift taxes and additions to tax

as follows:


                          Lynnda Speer, Donor
                     Gift tax - docket No. 6626-94

                        Year                Deficiency

                        1990                 $625,702


                        Roy M. and Lynnda L. Speer
                     Income tax - docket No. 6627-94

                                                             Accuracy-Related
                             Additions to Tax                     Penalty
 Year   Deficiency      Sec. 6653(a)(1)   Sec. 6661             Sec. 6662(a)

 1988    $530,514          $26,526             $132,629                --
 1989     774,565             --                  --               $131,189
 1990   1,424,760             --                  --                175,653


                           Roy M. Speer, Donor
                      Gift tax - docket No. 6628-94

                Year           Deficiency        Sec. 6651(a)(1)

                1985               $9,643                 $2,411
                1986              233,720                 58,430
                1987            1,103,590                275,898
                1988            1,344,161                336,040
                1989            1,444,955                361,239
                1990              996,254                  -0-



     After concessions, the issues for decision are:               (1) Whether

petitioner Roy M. Speer, the controlling shareholder of Home

Shopping Network, Inc., received constructive dividend income as
                              - 3 -

a result of payments made by Home Shopping Network, Inc., to

Pioneer Data Processing, Inc., pursuant to a license agreement;

(2) if so, whether amounts equal to these license payments

constituted taxable gifts to petitioners' son, Richard M. Speer,

who owned all the stock of Pioneer Data Processing, Inc.; (3)

whether petitioners’ claimed losses from two subchapter S

corporations during the taxable years 1988 through 1990 are

passive activity losses as defined in section 469;2 (4) whether

petitioners are liable for the addition to tax for negligence

under section 6653(a)(1) for the taxable year 1988; (5) whether

petitioners are liable for the accuracy-related penalty under

section 6662 for the taxable years 1989 and 1990; (6) whether

petitioners are liable for the addition to tax for a substantial

understatement of tax liability under section 6661(a) for the

taxable year 1988; and (7) whether petitioner Roy M. Speer is

liable for additions to tax under section 6651(a)(1) for failure

to file a timely gift tax return for the taxable years 1985

through 1989.


                        FINDINGS OF FACT


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

The stipulation of facts and the first, second, third, and fourth

     2
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
                                 - 4 -

supplemental stipulations of facts are incorporated herein by

this reference.

     At the time of filing the petitions in these consolidated

cases, petitioner Roy M. Speer resided in Freeport, Grand

Bahamas, in the Bahamas, and petitioner Lynnda L. Speer resided

in New Port Richey, Florida.   Petitioners filed joint U.S.

Individual Income Tax Returns (Forms 1040) for the taxable years

1988 through 1990.   Petitioner Roy M. Speer filed a U.S. Gift

(and Generation-Skipping Transfer) Tax Return (Form 709) for the

taxable year 1990.   Petitioner Lynnda L. Speer also filed a Form

709 for the taxable year 1990.    Petitioners elected to split

their gifts pursuant to section 2513 for the taxable year 1990.


Constructive Dividend Issue


     Pioneer Data Processing, Inc. (Pioneer), was incorporated

under the laws of the State of Florida in August 1978.3    When

Pioneer was originally incorporated, petitioner Roy M. Speer (Mr.

Speer) was the president and a shareholder.    On July 1, 1981, Mr.

Speer transferred all the stock of Pioneer to Robert L. Cox, Mr.

Speer’s insurance agent, and resigned as president of Pioneer.

Mr. Cox became president of Pioneer.     On March 7, 1984, Mr. Cox

     3
      Pioneer was originally incorporated under the name Pasco
Data Processing, Inc. Pioneer subsequently merged with Western
Hemisphere Sales, Inc., a Florida corporation, in August 1991.
In the merger, Pioneer was the surviving corporation and changed
its name to Western Hemisphere Sales, Inc. For convenience, the
surviving corporation will hereinafter be referred to as Pioneer.
                               - 5 -

transferred all the stock of Pioneer to Richard M. Speer,

petitioners’ son, whereupon Richard M. Speer became president of

Pioneer.   Since the time Mr. Cox transferred the Pioneer stock to

Richard M. Speer, Richard M. Speer has been the sole shareholder

and president of Pioneer.

     Home Shopping Channels, Inc. (HSC), was incorporated in 1981

under the laws of the State of Florida to conduct a business

consisting of selling merchandise at retail prices through

televised programs in the Tampa Bay, Florida, area.    HSC was

cofounded by Mr. Speer and Lowell W. Paxson.    Approximately 51

percent of the stock of HSC was owned by Richard W. Baker, as

trustee of the Roy M. Speer Trust.     The remaining stock was owned

by Mr. Paxson, as trustee of the Barbara A. Paxson Trust, and

approximately 10 other shareholders.

     Pioneer created and developed financial accounting computer

software programs to assist customers in maintaining their

general ledgers, accounts payable systems, and payroll systems.

Pioneer provided such financial accounting software and related

data processing assistance to HSC beginning in 1982.    Other

customers of Pioneer included a construction company, a utility

company, and an oil and gas company.

     In early 1982, Pioneer retained Harris Data, Inc. (Harris

Data), to assist in the development of a customized computer

software program, which would include customer maintenance, order

taking, and inventory control programs (the Local Software) for
                                - 6 -

HSC.    John Pfeiffer was the programmer from Harris Data who was

assigned to work on this project.    Mr. Speer and Mr. Paxson

assisted Mr. Pfeiffer by describing the logic and flow of

information necessary for the business of HSC.    Mr. Pfeiffer used

this information to create and develop the Local Software in RPG

II computer language, which was to be run on Pioneer’s IBM System

34 computer.    Mr. Pfeiffer subsequently joined Pioneer as a full-

time employee on June 1, 1982, where his primary responsibilities

consisted of the continued development of the Local Software.

Although Pioneer billed HSC monthly for the programming and

services in connection with the financial accounting software,

Pioneer did not bill HSC for the creation and development of the

Local Software.

       The initial Local Software programs consisted of the order

taking and inventory control programs, including functions to:

(1) Maintain open customer order files that were indexed by

orders and customer telephone number; (2) maintain a detailed

perpetual inventory file, which included a description of the

merchandise, quantity available, item number, and warehouse

location and activities; (3) maintain customer, or member, master

files, which included a customer’s name, address, member number,

special dates such as anniversary and birth dates, credit card

numbers, all pertinent credit information, and a complete history

of a customer’s purchasing activities; (4) maintain customer

service files; and (5) prepare management reports for the sales
                                - 7 -

and purchasing departments.

     HSC began its operations on July 1, 1982, from a broadcast

studio located in Clearwater, Florida.    HSC show hosts would show

items for sale through the televised programs.    Viewers could

call in to order the items shown for sale.    Items were then moved

to a mart distribution center maintained by HSC for customer

pickup the next day.   In order to purchase merchandise, a viewer

had to enroll as a “member” of HSC.     Once the viewer was assigned

a member number, the viewer could call and purchase the items

being shown on the television program.

     As the number of HSC members grew, additional mart locations

were added by HSC, which, in turn, increased the complexity of

keeping track of the available inventory.    It was important to

keep accurate and current records concerning the inventory sold

by HSC, because most of the items sold by HSC were unique, one-

time acquisitions that could not be reacquired.    HSC’s original

customer base of approximately 2,000 members grew to 5,000

members by its second month of operation.    By the spring of 1985,

HSC had approximately 88,000 members in its database, spanning a

two-county area in Florida.

     Between 1982 and 1985, Pioneer upgraded its computer system

from an IBM System 34 to an IBM System 36 to accommodate HSC’s

expanding business.    This transition required the modification of

the Local Software to enable it to run on an IBM System 36.

Pioneer hired an independent computer consultant for this
                                - 8 -

purpose.   In addition, the Local Software was continually

modified, improved, and expanded throughout this period to handle

HSC’s changing needs.

     Initially, all member orders were accumulated at the end of

the day and sent to Pioneer to be keyed into the Local Software

on Pioneer’s IBM System.   The Local Software would determine the

location of inventory and determine which items needed to be

moved from the warehouse to the marts and among the marts so that

a sufficient quantity of inventory was on hand by 6 a.m. the next

morning at the mart where the member was to pick up the

merchandise.   The Local Software also generated a picking slip,

which provided the HSC personnel with the member’s order and the

specific location of the items so that member orders could be

filled quickly.   Eventually, computer terminals were placed in

the broadcast studio and in the marts so that inventory could be

tracked more quickly and accurately.

     In 1985, Mr. Speer and Mr. Paxson were exploring ways to

expand HSC’s market.    At this time, televised home shopping was

new outside the Tampa Bay area.   Mr. Speer and Mr. Paxson

organized Home Shopping Network, Inc. (HSN), in order to try to

exploit this new, but uncertain, business opportunity.    HSN is a

Delaware corporation that was organized to conduct the business

of selling merchandise at retail prices through televised
                                - 9 -

programs on a national format.4   Mr. Speer owned 60 percent of

the stock of HSN and was the chief executive officer and the

chairman of the board of directors of HSN from the time it was

founded until he sold his stock in February 1993.    Mr. Paxson

owned the remaining 40 percent of the stock and was the president

of HSN.

     On March 28, 1985, HSN entered into an agreement with Modern

Talking Picture Service, Inc., for a 5-hour time segment on

satellite (the Satellite Agreement), which would enable it to

broadcast nationally.   The term of the agreement commenced on

July 1, 1985.    If HSN failed to broadcast for a period of 10

consecutive business days, it would be deemed to have terminated

the agreement.

     On April 15, 1985, the shareholders and directors of HSC

held their annual meeting, during which Mr. Speer and Mr. Paxson

presented a proposal to expand HSC to a national format by

forming a national group with HSN as a subsidiary.    A majority of

the shareholders rejected the proposal, as it required a

significant financial commitment and was perceived as too risky.

HSC was beginning to realize profits after having lost money

during its first fiscal year of operations.    Instead, the HSC

shareholders agreed to authorize HSN to use the trademarks,


     4
      HSN was originally incorporated under the laws of the State
of Florida. Subsequently, in early 1986, HSN organized a wholly
owned Delaware subsidiary and merged into it.
                              - 10 -

management expertise, and development skills of HSC in exchange

for 2 percent of its annual gross profits, in perpetuity, with 1

percent to be paid to Pioneer in return for providing the Local

Software and technical advice to HSN.    The shareholders also

agreed to restrict the activities of HSC to the Tampa Bay area if

HSN would agree to exclude itself from the Tampa Bay area.     This

agreement was reduced to writing in a License Agreement among

HSC, HSN, and Pioneer dated June 21, 1985.    The License Agreement

provided in pertinent part:


          WHEREAS, the Licensor [HSC] has developed a
     localized cable displayed mass merchandising
     programming technique selling quantities of merchandise
     at retail prices, and has developed an established logo
     and trademark * * * and has developed through its
     computer services supplier, Pioneer Data, Inc., the
     necessary computer support and has developed
     warehousing, delivery, sales and logistical support,
     and has developed a corporate infrastructure
     experienced in dealing in all aspects of sales
     management and marketing * * *

              *     *     *     *       *     *     *

     The Licensors [sic] [HSC] hereby grant to the Licensee
     [HSN] the exclusive worldwide right and license to
     enjoy, commercialize and exploit the above described
     processes * * * This right is inclusive of the right
     to exclusively use the trademark and Logo * * * and the
     existing merchandising format and merchandising
     processes of Licensor [HSC]. * * *

              *     *     *     *       *     *     *

     Pioneer Data, Inc., which is the owner of the computer
     product [sic] which are part of the necessary computer
     programming to implement or service the above on a
     national format, shall join in this agreement but its
     services shall be the subject of a separate computer
     services agreement.
                               - 11 -

               *     *     *     *      *     *     *

     The Licensee [HSN] shall pay to the Licensor [HSC] the
     sum of 2% of its gross profits of which 1% of gross
     profits shall be remitted to Pioneer Data, Inc. for its
     development of the existing computer licenses,
     programs, tapes. * * *

               *    *     *     *       *    *     *

     This agreement shall continue in perpetuity * * *


     With its signal being broadcast to a national audience, HSN

believed that it would need a larger computer system to handle

the potentially large customer base.    Time was of the essence in

locating a computer system, because the Satellite Agreement

required HSN to begin broadcasting on July 1, 1985.     HSN and

Pioneer approached IBM and other computer hardware companies to

determine the type of computer system that would best suit HSN’s

needs.   Burroughs was the company ultimately selected to provide

the computer hardware as a result of its ability to upgrade

computer hardware without extensive modification of computer

software, its willingness to have the order entry system

completed by July 1, 1985, its team approach, and its flexible

pricing.

     On May 13, 1985, Pioneer and Burroughs entered into a

contract for the purchase of computer hardware and for Burroughs’

programming services to develop software, based upon the Local

Software but written in a fourth-generation computer language

known as LINC (the National Software), so that the program could
                             - 12 -

be run on the Burroughs computer hardware.   Although Burroughs

had a library of standard computer software available to it, no

such “off-the-shelf” software could be found that would be

sufficient to meet the needs of HSN.    The agreement provided that

Pioneer would own any software developed pursuant to the

agreement.

     In designing the National Software, representatives from

Burroughs met with Mr. Pfeiffer and representatives from HSN to

discuss the operations and needs of HSN so that they could

determine the data structures, the lengths of the various fields,

and the reports that would need to be generated.   Although the

programming code could not be copied from the Local Software as

it was in a different language, the basic descriptions of the

system and reports were taken from the Local Software in

designing the National Software, which saved Burroughs a good

deal of time during the design stage.   The National Software

included the functionality of the Local Software in addition to

other functionality to account for differences in the business of

HSN from that conducted by HSC.

     Although Burroughs originally believed that it could have

the whole system completed by July 1, 1985, it later concluded

that the only portion of the National Software that it would have

running by July 1, 1985, was the order entry system and the show

control system, which included the ability to print daily sales

reports, picking slips, and shipping labels.   The inventory
                              - 13 -

maintenance system continued to be handled by Pioneer on the IBM

System 36 using the Local Software until Burroughs completed that

portion of the software sometime around January 1986.   Until

then, the inventory information was passed between the IBM System

36 computer and the Burroughs computer on a daily basis.    Even

after the Burroughs computer was handling inventory maintenance,

Pioneer continued to generate certain reports related to

inventory and rework inventory (i.e., returned merchandise) using

the Local Software on the IBM System 36 until early 1993.

     During the development of the National Software, Mr.

Pfeiffer added several improvements to the Local Software, which

continued to be used in HSC’s business in the Tampa Bay area.

Mr. Pfeiffer also added specific modules in the Local Software to

handle the functions required by HSN.   These modules provided a

backup system in case the Burroughs system was not ready or

failed in operation.

     On June 17, 1985, HSN hired Stella Tavilla and Carl Brewer

to run the Burroughs computer system for HSN.   By that time, all

the design and specifications of the order entry system had been

completed, although Burroughs was still performing the code

writing, programming, and testing in anticipation of the July, 1,

1985, deadline.

     On July 1, 1985, HSN began operating in a studio located in

the Levitz Shopping Center in Clearwater, Florida, separate from

HSC’s operations.   Although HSN and HSC used the same warehouse
                              - 14 -

to store their merchandise, HSN delivered its merchandise to its

customers via United Parcel Service rather than utilizing the

mart distribution system used by HSC.   HSN’s initial operations

were not successful.   HSN operated at a loss during its first 2

months of operation, and it laid off approximately 100 order

takers during its first 2 days on the air.   In its third month of

operations, HSN began to realize a profit.

     On July 16, 1986, HSN granted to Canadian Home Shopping

Network, Ltd. (CHSN), an exclusive, perpetual, noncancellable

license to use HSN’s home shopping format in Canada.   The license

agreement gave CHSN the right to use, among other things, the

Local Software.5   In exchange for the license, CHSN agreed to pay

HSN 5 percent of CHSN’s net sales, in perpetuity.   CHSN began

operations in early 1987.   HSN owned approximately 20 percent of

the outstanding shares of CHSN,6 and Mr. Speer and Mr. Paxson sat

on the board of directors of CHSN.

     Pursuant to its June 21, 1985, License Agreement with




     5
      The relevant terms of the July 16, 1986, license agreement
gave CHSN the right to use HSN’s computer software programs,
excluding any source material and any software subject to a
Burroughs license agreement (presumably the National Software).
Although Pioneer owned the Local Software, HSN had been granted
an exclusive license to use the software, including the right to
sublicense it, in its June 21, 1985, License Agreement with
Pioneer and HSC.
     6
      HSN was prohibited from acquiring more than 20 percent of
CHSN’s stock, as Canadian law restricted foreign ownership to 20
percent.
                               - 15 -

Pioneer and HSC, HSN made the following payments to Pioneer,7 and

Pioneer included these amounts in its income:


           Calendar Year                   Amount

                 1985                     $56,011.30
                 1986                     700,645.57
                 1987                   2,434,457.52
                 1988                   2,453,928.21
                 1989                   2,637,191.00
                 1990                   3,136,668.00
                 1991                   3,639,988.00
                 1992                   3,441,262.00


Mr. Speer sold his HSN stock to Liberty Media Corp. (Liberty) in

February 1993.   After the sale, HSN discontinued making the 1-

percent license payments to Pioneer.     After engaging in various

litigation, HSN agreed to pay Pioneer approximately $4,500,000 to

terminate the License Agreement.

Passive Activity Loss Issue


     During 1988, 1989, and 1990, Mr. Speer and Mr. Paxson owned

51 percent and 49 percent, respectively, of the stock of Gateway

Marine, Inc. (Gateway).    Gateway was an S corporation that

operated a marine tug and barge business.     Mr. Speer set up the

corporation, hired its employees, handled finances, discussed the

company’s bids, and purchased equipment for the company.

Petitioners reported losses from Gateway of $24,882, $77,909, and


     7
      We note that the 1-percent payment by HSN to HSC under the
License Agreement terminated in early 1986, when HSC merged into
HSN. HSN continued to pay Pioneer the 1-percent license fee.
                                - 16 -

$78,199 on their joint income tax returns for 1988, 1989, and

1990, respectively.

     Also during 1988 through 1990, Mr. Speer and Mr. Paxson

owned 51 percent and 49 percent, respectively, of the stock of

Maximo Marina, Inc. (Maximo).    Maximo was an S corporation that

operated a full-service marina.    Maximo also operated a used car

sales operation (Maximo Motors) during part of 1988 and 1989.

Mr. Speer would visit Maxima Motors on his way to HSN to check on

its operations and review the prior day’s sales.   Mr. Speer

reported losses from Maximo of $477,836, $1,098,156, and $632,643

on petitioners’ joint income tax returns for 1988, 1989, and

1990, respectively.

     Mr. Speer did not keep a diary of the amount of time he

devoted to Gateway and Maximo during 1988, 1989, and 1990.

During those years, Mr. Speer performed work for approximately 30

family-owned companies; however, he devoted a majority of his

time, approximately 75 percent, to his duties at HSN.    Mr. Speer

typically worked for these companies in an executive capacity,

making management decisions.    Generally, Mr. Speer would try to

visit his various companies two or three times a week.


                                OPINION


Constructive Dividend Issue


     The first issue is whether petitioners received constructive
                              - 17 -

dividend income during the taxable years 1988 through 1990, as a

result of payments made by HSN to Pioneer pursuant to the License

Agreement.   Respondent argues that the License Agreement was a

sham designed to distribute profits of HSN to Mr. Speer.

Respondent contends that Mr. Speer essentially controlled Pioneer

and that the payment of 1 percent of HSN’s gross profits for the

ostensible purpose of licensing software from Pioneer constituted

a constructive dividend to Mr. Speer.   Moreover, respondent

contends that the transfer of the constructive dividend amounts

to Pioneer resulted in a gift to Richard M. Speer, petitioners’

son, who was the sole shareholder of Pioneer.   Petitioners, on

the other hand, argue that the License Agreement was an arm’s-

length agreement, agreed to by parties independent of, and whose

interests were adverse to, Mr. Speer.   Alternatively, petitioners

argue that even if the License Agreement were found not to be

arm’s length, the terms of the agreement were fair and reasonable

when judged by standards applicable to parties dealing at arm’s

length, and thus cannot be recharacterized as a constructive

dividend to Mr. Speer.

     It is well established that transfers between related

corporations may result in constructive dividends to a common

shareholder.   Joseph Lupowitz Sons, Inc. v. Commissioner, 497

F.2d 862, 868 (3d Cir. 1974), affg. in part, revg. in part and

remanding T.C. Memo. 1972-238; Gilbert v. Commissioner, 74 T.C.

60, 64 (1980).   However, transfers between related corporations
                              - 18 -

will not result in constructive dividends to a common shareholder

solely by reason of the common ownership.   Sammons v.

Commissioner, 472 F.2d 449, 451 (5th Cir. 1972), affg. in part

and revg. in part on rehearing T.C. Memo. 1971-145.    The transfer

must be for the personal benefit of the common shareholder, and

the resulting benefit must be more than incidental.      Rapid Elec.

Co. v. Commissioner, 61 T.C. 232, 239 (1973); Ross Glove Co. v.

Commissioner, 60 T.C. 569, 595 (1973); Rushing v. Commissioner,

52 T.C. 888, 893 (1969), affd. 441 F.2d 593 (5th Cir. 1971).

     The constructive dividend theory is used to prevent the

siphoning of corporate profits under the guise of a sale or other

transfer of assets by placing any transfer between related

corporations on a tax parity with arm’s-length dealings between

unrelated parties.   Champayne v. Commissioner, 26 T.C. 634, 645

(1956).   Thus, both the bona fide nature of the transaction and

the reasonableness of the payments require consideration.     Id.

Where the evidence is sufficient to establish that the

transaction was bona fide and conducted in an arm’s-length

manner, then the ultimate objective of the constructive dividend

theory has been attained, and it is unnecessary for us to

independently determine the value of the property transferred.

Sparks Nugget, Inc. v. Commissioner, 458 F.2d 631, 635 (9th Cir.

1972), affg. T.C. Memo. 1970-74; Place v. Commissioner, 17 T.C.

199, 203 (1951), affd. 199 F.2d 373 (6th Cir. 1952).     Whether a

transaction is bona fide and arm’s length is a question of fact,
                               - 19 -

and the burden of proof is on the taxpayers.      Rule 142(a); Welch

v. Helvering, 290 U.S. 111, 115 (1933).

     We agree with petitioners that the License Agreement was a

bona fide, arm’s-length agreement.      This is not a case where a

sole shareholder is dealing with a corporation.      To the contrary,

the shareholders of HSC knew of the proposal to move to a

national format and were given an opportunity to share in the

expansion.    However, they were unwilling to risk the success that

HSC had attained in order to share the opportunity to expand

nationally; instead, they approved the terms of the License

Agreement, including the 1-percent license fee payable to Pioneer

for the Local Software.   See Roman Systems, Ltd. v. Commissioner,

T.C. Memo. 1981-273.   The interests of the HSC shareholders with

regard to the transaction were adverse to those of Mr. Speer.        In

particular, the largest minority shareholder of HSC, Mr. Paxson,

as trustee of the Barbara A. Paxson Trust, had every interest in

minimizing the payments to Pioneer, a company in which he held no

stake.   Mr. Paxson testified, however, that at the time the

License Agreement was entered into, he felt that the license fee

payable to Pioneer for the Local Software was equitable and

reasonable.   Moreover, Mr. Baker, as trustee of the Roy M. Speer

Trust, the controlling shareholder of HSC,8 recognized that he


     8
      Respondent argues that Mr. Speer was actually the
controlling shareholder of HSC, because he owned 51 percent of
the stock through the Roy M. Speer Trust. Respondent contends
                                                   (continued...)
                              - 20 -

would have to place the trust assets at risk in order to finance

a national expansion, which he was unwilling to do.   Mr. Baker

testified that he agreed to the terms of the License Agreement.

     Respondent argues that the Local Software was of no use to

HSN, since it could not be used on the Burroughs computer

hardware.   Thus, respondent concludes, the agreement to pay for

the license of such software was a sham.   We disagree.

     HSN substantially benefited from securing the rights to the

Local Software.   Even though Burroughs could not copy the

programming code from the Local Software to develop the National

Software, the basic descriptions of HSN’s system and reports were

taken from the Local Software in designing the National Software.

The sales representatives and one of the system developers at

Burroughs testified that using the Local Software in this manner

saved Burroughs a great deal of time during the design stages of

the software development, which was important if HSN wanted to

have the National Software running by its July 1, 1985, deadline.

The Local Software also provided a valuable backup system in the

event the National Software failed.    As it turned out, HSN relied

on the Local Software to manage its inventory from July 1, 1985,


     8
      (...continued)
that Mr. Baker, the trustee and a longtime business acquaintance
of Mr. Speer, did whatever Mr. Speer wanted of him. Mr. Baker
testified that as the trustee of the Roy M. Speer Trust, he owed
a fiduciary duty to the trust and its beneficiary, Lynnda Speer.
We find Mr. Baker’s testimony to be credible and are, thus,
unwilling to attribute the ownership of the HSC stock to Mr.
Speer.
                             - 21 -

until January 1, 1986, when Burroughs completed the inventory

maintenance system for the National Software.    HSN’s ability to

function during this initial startup phase was critical to its

survival and ultimately to its phenomenal success.

     Respondent also argues that defects in the License Agreement

itself illustrate its sham nature.    For example, respondent

points out that the agreement does not specifically identify the

“computer licenses, programs, tapes” that HSN was licensing from

Pioneer and that the agreement does not define “gross profits”.

Respondent also points out that Mr. Speer signed the agreement as

the president of Pioneer, even though he did not hold that title.

We find this argument unpersuasive.    Although the License

Agreement may have been inartfully drafted, the evidence

indicates that the parties understood the term “computer

licenses, programs, tapes” to refer to the Local Software as

opposed to the financial accounting software and the term “gross

profits” to be used in its general accounting sense (i.e., sales

less returns, breakage, and cost of goods sold).    Moreover, HSN

made payments to Pioneer, and Pioneer accepted these payments and

included them in income on its Federal income tax returns.      We

think that any indefiniteness in the terms of the agreement was

cured by the parties’ subsequent performance.    See 1 Williston on

Contracts, sec. 4:29 (4th ed. 1990).

     Finally, the fact that Mr. Speer was not president of

Pioneer when he signed the License Agreement does not negate the
                              - 22 -

License Agreement.   Mr. Speer provided services to Pioneer during

the years in issue and was compensated for his services by

Pioneer.   Based on the totality of the facts presented, we find

that Mr. Speer was acting on behalf of Pioneer when he signed the

License Agreement.

     The License Agreement served a valid business purpose and

was approved by independent, unrelated shareholders.   Despite

respondent’s assertion that Mr. Speer made the business decisions

and essentially controlled HSN, HSC, and Pioneer, respondent has

not argued that we should disregard the corporations as separate,

viable taxable entities, nor do we find any basis for doing so.

There is no evidence that Mr. Speer or his son, Richard,

personally received the license fees paid by HSN to Pioneer.

Pioneer actually received the license payments and included them

in its income for Federal income tax purposes.9   Any benefit that


     9
      Pioneer is now barred by the statute of limitations from
claiming a refund for the taxable years 1985 through 1987.
Petitioners have asserted the affirmative defense of equitable
recoupment in the event this Court upholds respondent’s
determination that the license payments should be recharacterized
as constructive dividends from HSN to Mr. Speer followed by a
gift to his son, Richard M. Speer. The doctrine of equitable
recoupment prevents unjust enrichment and may be invoked by a
taxpayer to recover taxes erroneously collected from the same
taxpayer or one with a sufficient identity of interest, where the
refund of such erroneously collected taxes is otherwise barred by
the statute of limitations. Stone v. White, 301 U.S. 532 (1937);
Estate of Mueller v. Commissioner, 101 T.C. 551 (1993).
Petitioners contend that respondent is seeking to subject the
license payments to multiple taxes based on inconsistent legal
theories (i.e., gross income to Pioneer and a constructive
dividend followed by a gift). Moreover, respondent has asserted
                                                   (continued...)
                             - 23 -

was received was, at most, derivative or indirect in nature.

Therefore, we find that the License Agreement was a bona fide,

arm’s-length agreement, which did not result in constructive

dividends to Mr. Speer.

     Even if the agreement itself were not arm’s length, it is

still enforceable, and thus will not give rise to constructive

dividends, if its terms, particularly the amount of the payments,

are fair and reasonable when judged by the standards of a

transaction entered into by parties dealing at arm’s length.

Sparks Nugget, Inc. v. Commissioner, 458 F.2d at 635; Stearns

Magnetic Manufacturing Co. v. Commissioner, 208 F.2d 849, 852

(7th Cir. 1954); Place v. Commissioner, 17 T.C. at 203.     We must

assess the reasonableness of the License Agreement at the time it

was entered without the benefit of hindsight.   If the terms were

reasonable as of that date, it is immaterial that HSN’s success

may have gone beyond the parties’ expectations and produced

license fees in excess of what would be considered reasonable for

a single year viewed in isolation.    See Brown Printing Co. v.

Commissioner, 255 F.2d 436, 440 (5th Cir. 1958), revg. T.C. Memo.

1957-37.

     At the time the parties agreed to license the Local Software



     9
      (...continued)
that Mr. Speer really controlled Pioneer. Because of our holding
with respect to the constructive dividend issue, however, we need
not address the question of whether equitable recoupment would
apply.
                              - 24 -

for 1 percent of gross profits, HSN had not begun operations.

The amount of the license fees was contingent upon the success of

HSN and, thus, was quite uncertain.     Televised home shopping was

a new business outside the Tampa Bay area.     The shareholders of

HSC viewed HSN as a risky venture.     Even Mr. Speer and Mr.

Paxson, while hopeful, were unsure whether the concept of home

shopping, which had just started to become successful in a local

market, would catch on nationwide.     In fact, HSN performed poorly

during its first couple of months of operation.     The ultimate

success of HSN was beyond the wildest expectations of Mr. Speer

and Mr. Paxson.

     Both parties presented expert testimony as to the value of

the Local Software as of June 21, 1985, the date of the License

Agreement.   While expert opinions can assist the Court in

evaluating a claim, we are not bound by the opinion of any expert

witness and may reach a decision based on our own analysis of all

the evidence in the record.   Helvering v. National Grocery Co.,

304 U.S. 282, 295 (1938); Silverman v. Commissioner, 538 F.2d

927, 933 (2d Cir. 1976), affg. T.C. Memo. 1974-285.

     Robert F. Reilly, petitioners’ expert,10 utilized several

approaches to valuing the Local Software.     First, he attempted to

perform a market analysis but concluded that there were no

available “off-the-shelf” computer software packages that were


     10
      Petitioners also presented the report of Lawrence H.
Putnam, Sr., as an expert rebuttal report.
                                   - 25 -

comparable to the Local Software in terms of functionality and

utility as of the valuation date.        Next, Mr. Reilly performed two

cost approach methods--the constructive cost model (COCOMO) and

the software lifecycle management (SLIM) model.11       Both models

are empirical cost approach models; that is, the development time

and cost of the subject software are estimated by reference to a

large database of actual software development projects.        These

models are used by companies to project the costs of various

projects.        The COCOMO approach estimates the amount of effort

required to reproduce the software, and the SLIM approach

utilizes a computerized model, which permits the user to estimate

the cost of developing the subject software from a database of

over 3,000 actual software projects.        Next, Mr. Reilly performed

two income approach methods.        He used the SLIM model to estimate

the cost savings, or income increment, associated with having the

Local Software available during the development of the National

Software.        He also applied a lost income method, under which he

estimated the amount of income that would have been lost to HSN

if HSN had not been operational as of the July 1, 1985, startup

date.        Mr. Reilly reached an overall valuation conclusion, giving

similar weight to each approach, of $2,900,000.

     Mr. Reilly then compared this value to the value of the

License Agreement.        Mr. Reilly used the discounted cash-flow


        11
      The SLIM model was developed by Mr. Putnam, petitioners’
rebuttal expert witness.
                              - 26 -

method to determine the present value of the future cash flows

generated by the License Agreement.    Mr. Reilly applied a

discount rate of 49.6 percent to account for the high degree of

risk associated with the startup venture and the risk in general

for small, thinly capitalized equity investments.    Mr. Reilly

applied this discount to two income streams--the actual payments

made by HSN to Pioneer from July 1985 through 1993 and the

projected payments based on estimates of HSN’s penetration level

with nationwide cable operators, average purchases by viewers,

and HSN’s gross profit margin.   Assigning similar weight to each

approach, Mr. Reilly concluded that the value of the License

Agreement as of June 21, 1985, was $2,600,000, within the range

of value for the Local Software.

     Douglas F. Benn and Udo W. Pooch, respondent’s experts,

utilized the VALPRO model, developed by Mr. Benn, to estimate

reproduction and replacement costs for the Local Software.     The

VALPRO model attempts to incorporate and synthesize a number of

widely accepted methods.   It is based on the concept of the

software development process as a long life cycle, a concept

developed by Lawrence H. Putnam, Sr.    The VALPRO model, however,

has had no commercial usage or publication.    Pursuant to this

method, respondent’s experts concluded that the cost to replace

the Local Software was $58,394, and the cost to reproduce the

software (after applying an adjustment for obsolescence) was

$148,960.   Next, Messrs. Benn and Pooch determined from a
                               - 27 -

comparable sales approach that functionally equivalent systems

could be purchased and installed for $21,925.    Finally, Messrs.

Benn and Pooch applied an income approach, capitalizing the

stream of income to HSN that might be derived from the use of the

Local Software.   Under this approach, however, Messrs. Benn and

Pooch concluded that the capitalized income stream had no effect

on the final fair market value determination, because the income

stream was indeterminate.    Overall, respondent’s experts

concluded that the Local Software had a value of $58,394.12

     Mr. Putnam, upon whose work the VALPRO model relies, stated

in his rebuttal report that his work was taken out of context and

inappropriately applied.    Mr. Putnam also noted that he compared

the valuation of Messrs. Benn and Pooch with actual cost data on


     12
      Respondent argues on brief that the value should be only
$42,192 after eliminating duplicate lines of code and programs
that were added to the Local Software after June 21, 1985, and
set out the revised calculations in appendices attached to her
brief. Appendix 1 was prepared by Mr. Benn and appears to be an
amendment to his valuation report. (This would actually
constitute a second amendment, since an amendment to his report
was admitted during the trial.) Appendices 2-4 were prepared by
agents of respondent and set forth a summary of the parsed
software, duplicate lines of code, and programs added after June
21, 1985. On Apr. 21, 1995, petitioners filed a Motion to Strike
Portions of Brief for Respondent, asking this Court to strike
these appendices as an improper attempt to introduce evidence
after the record was closed. We agree. Allowing respondent’s
experts to amend their report after the record is closed would
unfairly prejudice petitioners, as petitioners did not have the
opportunity to rebut or cross-examine respondent’s experts with
respect to these additional matters. Moreover, the agents who
prepared appendices 2-4 were not identified as witnesses in
respondent’s trial memorandum and did not testify in this case.
We, therefore, grant petitioners’ Motion to Strike Portions of
Brief for Respondent.
                              - 28 -

comparable projects completed during the same time period and

found the VALPRO model to be highly biased in favor of producing

very low cost estimates.   Moreover, we note that respondent’s

experts found the income stream from the Local Software to be

indeterminate and, thus, were unable to conclude what the 1-

percent license fee was worth as of June 21, 1985.

     We need not determine the precise value of the software.     We

need only compare the value of the Local Software with the

reasonably anticipated value of the future license payments in

order to determine whether the terms of the agreement are

reasonable when judged by the standards of an arm’s-length

transaction.   Sparks Nugget, Inc. v. Commissioner, 458 F.2d at

635; Stearns Magnetic Manufacturing Co. v. Commissioner, 208 F.2d

at 852; Place v. Commissioner, 17 T.C. at 203.

     We think it is significant that both parties’ experts

determined that the software was of some value to HSN, even

though these values are widely divergent.   The parties to the

License Agreement did not obtain or rely upon an expert valuation

of the Local Software when they entered into the agreement.     Nor

could they have accurately predicted the value of the 1-percent

license fee.   What the parties to the agreement did know at the

time of the agreement was that (1) HSN needed a software program

that would perform the functions that the Local Software

performed, (2) HSN needed such software quickly, (3) HSC and

Pioneer, after spending a considerable amount of time developing
                              - 29 -

and refining the Local Software, had a tested, working, and

successful program in their possession, (4) the Local Software

could be used to develop and supplement the National Software,

and (5) the success of HSN’s new business endeavor was highly

speculative.   Under the circumstances, we think that HSN’s

agreement to pay 1 percent of its gross income for the software

was reasonable.   It is immaterial that HSN’s success may have

gone beyond the parties’ wildest expectations.    See Brown

Printing Co. v. Commissioner, 255 F.2d at 440.     Indeed, had the

other shareholders of HSC anticipated that the gross profits of

HSN would be so great, they would have invested in it when given

the opportunity to do so.

     Finally, in rejecting respondent’s primary argument that the

License Agreement was a sham, we note that the License Agreement

had been disclosed in HSN’s public filings, including its annual

reports, prospectuses, and proxy statements.     After Mr. Speer

sold his interest in HSN, HSN paid Pioneer more than $4 million

to terminate its obligation to pay the 1-percent license fee.

     After considering all the evidence, we hold that Mr. Speer

did not receive constructive dividend income during the taxable

years 1988 through 1990, as a result of payments made by HSN to

Pioneer pursuant to the License Agreement.   It follows that

petitioners did not make gifts during the taxable years 1985

through 1990 in amounts equal to these license payments to their

son, Richard M. Speer.
                               - 30 -

Passive Activity Loss Issue


     The next issue is whether petitioners’ claimed losses for

the taxable years 1988 through 1990 from two subchapter S

corporations, Gateway and Maximo, constitute passive activity

losses as defined in section 469.   Pursuant to section 469(a), a

passive activity loss of an individual for the taxable year is

generally not allowed as a deduction.   A passive activity is

defined as a trade or business in which the taxpayer does not

materially participate.   Sec. 469(c)(1).   Section 469(h)(1)

provides that an individual shall be treated as materially

participating in an activity only if he or she is involved in the

operations of the activity on a basis that is regular,

continuous, and substantial.   The regulations contain seven safe

harbor provisions under which an individual will be treated as

materially participating in an activity.    Sec. 1.469-5T(a),

Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25,

1988).

     Petitioners rely on section 1.469-5T(a)(4), Temporary Income

Tax Regs., 53 Fed. Reg. 5726 (Feb. 25, 1988), which provides:


     The activity is a significant participation activity
     * * * for the taxable year, and the individual’s
     aggregate participation in all significant
     participation activities during such year exceeds 500
     hours;


A significant participation activity is defined as a trade or
                              - 31 -

business activity in which the individual significantly

participates but in which the individual would not be treated as

materially participating under any of the other safe harbor

provisions.   Sec. 1.469-5T(c)(1), Temporary Income Tax Regs., 53

Fed. Reg. 5726 (Feb. 25, 1988).   An individual is treated as

significantly participating in an activity for a taxable year

only if he or she participates in the activity for more than 100

hours.   Sec. 1.469-5T(c)(2), Temporary Income Tax Regs., 53 Fed.

Reg. 5726 (Feb. 25, 1988).

     A taxpayer can establish his or her participation by any

reasonable means.   Reasonable means “may include but are not

limited to the identification of services performed over a period

of time and the approximate number of hours spent performing such

services during such period, based on appointment books,

calendars, or narrative summaries.”    Sec. 1.469-5T(f)(4),

Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).

Contemporaneous daily time reports are not required if the extent

of the taxpayer's participation may be established by other

reasonable means.   Id.

     Petitioners attempt to come within the provisions of section

1.469-5T(f)(4), Temporary Income Tax Regs., supra, by relying on

Mr. Speer's testimony that, during 1988, 1989, and 1990, he

devoted over 150 hours to Gateway, over 250 hours to Maximo, and

over 150 hours to another business named Scheer Commerce Center,

Inc. (Scheer).
                                - 32 -

     Mr. Speer did not keep a diary of the amount of time he

devoted to Gateway, Maximo, and Scheer during 1988, 1989, and

1990, nor did petitioners offer any records similar to those

described in the above regulation.       Petitioners claim, however,

that Mr. Speer’s testimony about the various types of activities

he engaged in with respect to Gateway and Maximo and the

approximate number of hours he spent on these activities

constitutes a “narrative summary” sufficient to establish

material participation.     Although the regulations are somewhat

inconclusive concerning the records needed to substantiate

material participation, we do not think that they contemplate

this type of postevent “ballpark guesstimate” that petitioners

used.     Goshorn v. Commissioner, T.C. Memo. 1993-578.    We,

therefore, find that petitioners have not met their burden of

proving that Mr. Speer materially participated in the activities

in question.     Rule 142(a).


Additions to Tax


        Respondent determined that petitioners were liable for an

addition to tax for negligence or intentional disregard of rules

or regulations pursuant to section 6653(a)(1) for 1988 and a

penalty for negligence pursuant to section 6662(a) for 1989 and

1990 with respect to petitioners’ failure to report constructive

dividend income during those taxable years.      Respondent also

determined that petitioners were liable for the addition to tax
                             - 33 -

for a substantial understatement of tax liability under section

6661(a) and for increased interest on tax-motivated transactions

under section 6621(b) for 1988.    These additions to tax, too,

were applied with respect to petitioners’ failure to report

constructive dividend income during that year.    Finally,

respondent determined that Mr. Speer was liable for additions to

tax for failure to file gift tax returns under section 6651(a)(1)

for the tax years 1985 through 1989.

     Because we have held that petitioners did not receive

constructive dividend income during the years in issue and,

likewise, did not make gifts of the license fees to their son,

Richard M. Speer, we hold that petitioners are not liable for any

of the above additions to tax.



                                      Decisions will be entered

                                 for petitioners in docket Nos.

                                 6626-94 and 6628-94.

                                      Decision will be entered

                                 under Rule 155 in docket No.

                                 6627-94.

                                      An appropriate order will be

                                 issued granting petitioners' Motion

                                 to Strike Portions of Brief for

                                 Respondent.
