                                             GERDAU MACSTEEL, INC. & AFFILIATED SUBSIDIARIES,
                                                PETITIONERS v. COMMISSIONER OF INTERNAL
                                                         REVENUE, RESPONDENT
                                                    Docket No. 12642–01.                      Filed August 30, 2012.

                                                 Q and its subsidiaries are an affiliated group (Ps). During
                                               Ps’ taxable year ended Oct. 31, 1997 (TYE 1997), Ps actively
                                               pursued Q’s making of two sales expected to result in millions
                                               of dollars in taxable capital gains for TYE 1997 and TYE
                                               1998. Ps’ outside accountants (D), mindful of the expected
                                               gains, approached Ps with an idea that D promoted to create
                                               a multimillion-dollar tax loss to shelter the gains for Federal
                                               income tax purposes. Q has a group benefits plan under which
                                               Q provides health and welfare benefits to its eligible
                                               employees and their dependents. Q’s subsidiaries included two
                                               inactive corporations, QS and QW. In order to report a desired
                                               tax loss of approximately $38 million to shelter Ps’ taxable
                                               gains from Federal income tax, Ps entered into a series of
                                               interrelated transactions in late October 1997 that included,
                                               among others, a recapitalization of QW (renamed QHMC),
                                               and Q’s transfer to QS (and then QS’ transfer to QHMC in
                                               exchange for newly issued class C stock) of $38 million and
                                               the assumption of certain contingent liabilities (i.e., Q’s
                                               obligations to pay medical plan benefits (MPBs) under Q’s
                                               benefits plan) which Ps valued at $37,989,000. Ps reported
                                               that the transfers qualified for nonrecognition under I.R.C.
                                               sec. 351(a) and that QS’ basis in the class C stock was deter-
                                               mined by taking into account the $38 million transferred to
                                               QHMC but not the value of the MPBs. Each share of class C
                                               stock was entitled to receive annual dividends of $9.50 and
                                               was not allowed to receive any other dividend. Upon the class
                                               C stock’s redemption, which QHMC and the class C share-
                                               holders could respectively cause five and seven years after the
                                               stock’s issuance, the class C shareholders were entitled to
                                               receive for each share the greater of $125 or an amount equal
                                               to the lesser of a percent of any cumulative cost savings in
                                               MPBs or of QHMC’s book net equity. The transactions were
                                               structured in such a way that it was highly likely when the

                                                                                                                                   67




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00001   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     68                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                               class C stock was issued that the class C stock would be
                                               redeemed within the five- and seven-year periods and that the
                                               redemption payment would be $125 per share. Shortly after
                                               the transfer to QHMC, QS sold its class C stock to a former
                                               employee of a Q subsidiary for $11,000 (the difference
                                               between $38 million and $37,989,000). Ps claimed that QS
                                               realized a $37,989,000 short-term capital loss on the sale, and
                                               Ps used that loss to offset Ps’ unrelated capital gains totaling
                                               a similar amount. After the transactions, Q continued to
                                               process claims for MPBs, and Q’s handling of the claims
                                               transferred to QHMC was the same as the handling of claims
                                               with respect to individuals whose MPBs were not transferred
                                               to QHMC. QHMC’s reimbursements to Q for claims were
                                               made through intercompany entries recorded on Q’s books as
                                               a receivable due from QHMC and on QHMC’s books as a pay-
                                               able. QHMC lent the $38 million to a subsidiary of Ps, and
                                               QHMC eventually reimbursed Q for the MPBs when QHMC
                                               received payments on the loan. Held: The class C stock is non-
                                               qualified preferred stock under I.R.C. sec. 351(g) because it
                                               ‘‘does not participate in corporate growth to any significant
                                               extent’’ within the meaning of I.R.C. sec. 351(g)(3)(A). Accord-
                                               ingly, pursuant to the agreement of the parties, Ps are not
                                               entitled to deduct the claimed capital loss. Held, further, the
                                               transactions underlying the claimed capital loss lacked eco-
                                               nomic substance. Accordingly, $352,251 in fees incurred to
                                               effect the transactions is not deductible as an ordinary and
                                               necessary business expense under I.R.C. sec. 162. Held, fur-
                                               ther, in accordance with Heasley v. Commissioner, 902 F.2d
                                               380 (5th Cir. 1990), rev’g T.C. Memo. 1988–408, and Todd v.
                                               Commissioner, 862 F.2d 540 (5th Cir. 1988), aff ’g 89 T.C. 912
                                               (1987), which we follow under Golsen v. Commissioner, 54
                                               T.C. 742, 757 (1970), aff ’d, 445 F.2d 985 (10th Cir. 1971), Ps
                                               are not liable for the 40% accuracy-related penalty under
                                               I.R.C. sec. 6662(h) that R determined applied to any under-
                                               payment of tax attributable to the disallowed claimed capital
                                               loss. Held, further, Ps are liable for the 20% accuracy-related
                                               penalty under I.R.C. sec. 6662(a) to the extent of the under-
                                               payment of tax attributable to the disallowed claimed capital
                                               loss, and Ps are liable for that 20% accuracy-related penalty
                                               to the extent of the underpayment of tax attributable to the
                                               disallowed deduction for the fees.

                                       Jasper G. Taylor III, Lawrence Kalinec, Richard L. Hunn,
                                     Shawn R. O’Brien, and Stephen M. Feldhaus, for petitioners.
                                       Dennis M. Kelly and Jill A. Frisch, for respondent.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00002   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                     GERDAU MACSTEEL, INC. v. COMMISSIONER                                                         69


                                                                                            CONTENTS

                                     FINDINGS OF FACT .............................................................................                        74
                                           I.     Preliminary Matters .....................................................................                74
                                           II.       Quanex .........................................................................................      74
                                           III.       Petitioners’ Expectation of Realizing Millions of Dollars in
                                                        Taxable Capital Gains During TYE 1997 and TYE 1998 ...                                             75
                                           IV.        The Plan ......................................................................................      76
                                                A.   Background ...............................................................................            76
                                                B.   Health Care Offerings ..............................................................                  76
                                                C.   Health Care Cost Management Strategies ............................                                   77
                                                   1. Background ............................................................................              77
                                                   2. CS ...........................................................................................       77
                                                     a. Background ........................................................................                77
                                                     b. Quanex’s Introduction to CS .............................................                          78
                                                     c. CS Fee Arrangements ........................................................                       79
                                           V.      D&T ...............................................................................................     79
                                           VI.        Other Quanex Employees/Officers ............................................                         80
                                                A.      Rose ...........................................................................................   80
                                                B.      Parikh ........................................................................................    80
                                                C.      Royce .........................................................................................    81
                                           VII.        Liability Management Companies ...........................................                          81
                                                A.     Overview ...................................................................................        81
                                                B.     Rev. Rul. 95–74 ........................................................................            82
                                                C.     D&T’s Matrix ............................................................................           82
                                                     1. Background ............................................................................            82
                                                     2. DDCL .....................................................................................         82
                                                     3. Singer Promotes DDCL-Type Transaction to Quanex .......                                            85
                                           VIII.        Sales of LaSalle and Tube Group ...........................................                        85
                                                A.      LaSalle Sale ..............................................................................        85
                                                B.      Tube Group Sale .......................................................................            86
                                           IX.        Engaging D&T To Structure QHMC Transactions ..................                                       87
                                           X.      Developing QHMC Transactions ................................................                           89
                                                A.  Quanex’s First Proposal to CS ................................................                         89
                                                B.  D&T’s First Outline of Proposed Joint Venture Trans-
                                                     actions ....................................................................................          91
                                                C. WW ............................................................................................         92
                                                  1. In General ..............................................................................             92
                                                  2. FASB 106 ...............................................................................              92
                                                  3. WW’s First Present Value Calculation of Quanex’s
                                                       Health Care Benefits ........................................................                       93
                                                D. D&T’s Revisions to Proposed Transaction ..............................                                  95




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897        PO 20012      Frm 00003     Fmt 2847     Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     70                      139 UNITED STATES TAX COURT REPORTS                                                   (67)


                                                  1.
                                                  August 6–7, 1997, Revisions .................................................                     95
                                                  2.
                                                  August 13, 1997, Revisions and Cashflow Analysis ...........                                      97
                                                  3.
                                                  August 22, 1997, Revisions ...................................................                    99
                                             E. Quanex’s Negotiations With CS ..............................................                        99
                                             F. WW’s Present Value Calculation Revisions ...........................                               103
                                             G. Patrick Wannell .......................................................................            105
                                               1. Background ............................................................................          105
                                               2. Wannell and Health Care Costs at LaSalle ........................                                105
                                               3. Quanex’s Offer to Wannell ...................................................                    106
                                             H. D&T’s Revised Cashflow Model ...............................................                       107
                                           XI.     Executing QHMC Transactions ................................................. 110
                                             A.  Quanex’s October 21–22, 1997, Board Meeting .....................                                 110
                                             B.  October 23, 1997 .......................................................................          113
                                               1. QW Recapitalization .............................................................                113
                                               2. Amendment and Restatement of QW’s Certificate of
                                                     Incorporation .....................................................................           113
                                                 a. Background ........................................................................            113
                                                 b. Dividend Rights .................................................................              114
                                                 c. Preferences Upon Liquidation ...........................................                       114
                                                 d. Voting Rights .....................................................................            116
                                                 e. Call Rights ..........................................................................         116
                                                 f. Put Rights ...........................................................................         116
                                               3. Quanex’s Transfer of QW Stock and Cash to QHMC in
                                                     Exchange for Class A and Class B Stocks and Elec-
                                                     tion of Directors .................................................................           117
                                               4. Quanex’s Transfer of Cash and MPB Obligations to QS
                                                     in Exchange for QS Stock .................................................                    117
                                             C. October 24, 1997 .......................................................................           118
                                               1. Consulting Agreement Between Quanex and CS ...............                                       118
                                               2. CS’ Transfer of Cash to Quanex in Exchange for Class B
                                                     Stock ...................................................................................     119
                                               3. Class B Directors ...................................................................            121
                                             D. October 25, 1997 ......................................................................            121
                                               1. CS’ Transfer of Cash to QHMC in Exchange for Class C
                                                     Stock ...................................................................................     121
                                               2. QS’ Transfer of Cash and MPBs to QHMC in Exchange
                                                     for Class C Stock ...............................................................             121
                                               3. MPB Selection .......................................................................            122
                                               4. Class C Director ....................................................................            123
                                             E. October 28, 1997: QHMC’s Transfer of Cash to Piper in
                                                   Exchange for Promissory Note ............................................                       123
                                             F. October 30, 1997: QS’ Transfer of Class C Stock to
                                                   Wannell in Exchange for Cash ............................................                       124
                                           XII.     Posttransaction Activities ......................................................... 125
                                             A.     D&T’s Draft Opinion ................................................................           125
                                             B.     1997 Return ..............................................................................     127
                                                  1. Background ............................................................................       127
                                                  2. Income ....................................................................................   127




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897     PO 20012     Frm 00004    Fmt 2847     Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                    GERDAU MACSTEEL, INC. v. COMMISSIONER                                                     71


                                                   3. Enclosed Statements .............................................................              128
                                                    a. Overview .............................................................................        128
                                                    b. Statement 20 ......................................................................           128
                                                    c. Statement 22 ......................................................................           129
                                                    d. Statement 23 ......................................................................           129
                                                    e. Statement 24 ......................................................................           129
                                                  4. Deduction of Fees ..................................................................            129
                                                C. WW’s 1999 Valuations .............................................................                130
                                                D. D&T’s 1999 Cashflow Model ....................................................                    134
                                                E. QHMC Operations ....................................................................              140
                                                  1. QHMC’s Officers and Directors ............................................                      140
                                                    a. QHMC’s Board Meetings and Shareholders Meetings ...                                           141
                                                    b. Parikh as Director and Officer .........................................                      141
                                                    c. Peery as Director and Officer ............................................                    141
                                                  2. Bank Accounts .......................................................................           141
                                                  3. Processing and Paying MPB-Related Expenses ..................                                   142
                                                  4. Shareholder Efforts To Manage MPB Obligations .............                                     145
                                                    a. CS’ Efforts ..........................................................................        145
                                                      i. Background ......................................................................           145
                                                      ii. PPO Project ....................................................................           146
                                                      iii. Union Negotiations .......................................................                147
                                                      iv. CS’ Consulting Bills ......................................................                148
                                                    b. Wannell’s Efforts ...............................................................             149
                                                  5. Dividend Payments ...............................................................               150
                                                  6. Return on Investment Projections .......................................                        150
                                                  7. QHMC’s Tax Returns ............................................................                 151
                                                  8. Financial Statements ............................................................               152
                                                F. Notice of Deficiency ..................................................................           152
                                     OPINION ................................................................................................. 154
                                           I.     Burden of Proof ............................................................................. 154
                                           II.       Witness Testimony ...................................................................... 155
                                                A.   Background ...............................................................................      155
                                                B.   Fact Witnesses ..........................................................................       156
                                                C.   Expert Witnesses ......................................................................         156
                                                   1. Background ............................................................................        156
                                                     a. Overview .............................................................................       156
                                                     b. Strombom ...........................................................................         157
                                                     c. Ross .....................................................................................   157
                                                     d. Eisenstadt ..........................................................................        157
                                                   2. Analysis ..................................................................................    158
                                           III.       Net Short-Term Capital Loss .................................................... 158
                                                A.   Overview ...................................................................................    158
                                                B.   Section 351(g) ...........................................................................      159
                                                C.   Economic Substance Doctrine .................................................                   167
                                                   1. Overview ................................................................................      167
                                                   2. Standard of Analysis .............................................................             168
                                                   3. QHMC Transactions .............................................................                171




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897       PO 20012    Frm 00005     Fmt 2847    Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     72                    139 UNITED STATES TAX COURT REPORTS                                                  (67)


                                                   a.   Objective Economic Substance ..........................................                 171
                                                     i. Background ......................................................................       171
                                                     ii. Lack of Substantive Changes as a Result of QHMC
                                                            Transactions ...............................................................        172
                                                     iii. Lack of Reasonable Expectation of Nontax Benefits
                                                            on Petitioners’ Part ....................................................           174
                                                   b. Subjective Business Purpose ............................................                  175
                                                     i. Background ......................................................................       175
                                                     ii. Petitioners’ Entering Into QHMC Transactions
                                                            Solely as Means To Generate Artificial Capital
                                                            Loss To Offset Capital Gains ....................................                   176
                                                     iii. Petitioners’ Selection of Transferred MPBs Without
                                                            Regard to Effective Medical Cost Management ......                                  179
                                                     iv. Equity Interest in QHMC Granted to CS and
                                                            Wannell as Meaningless Incentive to Reduce
                                                            Health Care Costs ......................................................            180
                                                     v. Unnecessary Assumption of MPB Obligations by
                                                            QHMC .........................................................................      181
                                                   c. Conclusion ...........................................................................    182
                                           IV.    Fees Incurred in Furtherance of QHMC Transactions ........... 182
                                           V.    Accuracy-Related Penalties ......................................................... 183
                                             A. Background ...............................................................................      183
                                             B. Gross Valuation Misstatement ................................................                   183
                                             C. Negligence .................................................................................    186
                                             D. Substantial Understatement ...................................................                  188
                                             E. Section 6664(c) Reasonable Cause Exception ........................                             191
                                               1. Overview ................................................................................     191
                                               2. Analysis ..................................................................................   193
                                           VI.    Conclusion ................................................................................... 197


                                        MARVEL, Judge: Quanex Corporation (Quanex) 1 and its
                                     affiliated subsidiary corporations (collectively, petitioners)
                                     petitioned the Court to redetermine respondent’s determina-
                                     tion as to petitioners’ taxable year ended October 31, 1997
                                     (TYE 1997). Respondent determined a $9,561,458 deficiency in
                                     petitioners’ Federal income tax and a $3,799,926 accuracy-
                                     related penalty under section 6662(a), (b), and (h). 2 The par-
                                     ties dispute three issues relating to respondent’s determina-
                                     tion, and they agree that certain subissues and arguments
                                       1 After the petition was filed, Quanex changed its name to Gerdau Macsteel, Inc., and became

                                     and remains the agent of the affiliated group for TYE 1997. See sec. 1.1502–77A(a), Income Tax
                                     Regs. We hereinafter refer to Gerdau Macsteel, Inc., as Quanex.
                                       2 Unless indicated otherwise, section references are to the applicable versions of the Internal

                                     Revenue Code (Code), and Rule references are to the Tax Court Rules of Practice and Procedure.




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897   PO 20012     Frm 00006    Fmt 2847    Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      73


                                     underlie a decision regarding those issues. The three issues
                                     are:
                                        1. whether petitioners may deduct a $37,989,000 net short-
                                     term capital loss from the sale of stock of Quanex Health
                                     Management Co., Inc. (QHMC). The sale was part of a series
                                     of transactions (QHMC transactions) that occurred in October
                                     1997 between and among Quanex, certain of Quanex’s affili-
                                     ated subsidiaries, and two independent (yet loyal)
                                     facilitators. Petitioners claimed a $37,989,000 loss deduction
                                     on the sale and applied $26,966,201 of the claimed loss to
                                     TYE 1997 and the balance to TYE 1998. Respondent dis-
                                     allowed the claimed loss deduction in full. We hold that peti-
                                     tioners are not entitled to deduct any of the claimed loss;
                                        2. whether petitioners may deduct $352,251 of transaction
                                     costs incurred to effect the QHMC transactions as ordinary
                                     and necessary business expenses under section 162(a). Peti-
                                     tioners claimed the $352,251 as a deduction for TYE 1997,
                                     and respondent disallowed the claimed deduction in full. We
                                     hold that petitioners are not entitled to deduct any of this
                                     amount;
                                        3. whether petitioners are liable for the 40% accuracy-
                                     related penalty that respondent determined under section
                                     6662(a) and (h) (or alternatively, the 20% accuracy-related
                                     penalty that respondent determined under section 6662(a)
                                     and (b)) with respect to the underpayment of tax attributable
                                     to the disallowed capital loss deduction, and whether peti-
                                     tioners are liable for the 20% accuracy-related penalty that
                                     respondent determined under section 6662(a) and (b) with
                                     respect to the underpayment of tax attributable to the dis-
                                     allowed transaction costs deduction. We hold in accordance
                                     with Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990),
                                     rev’g T.C. Memo. 1988–408, and Todd v. Commissioner, 862
                                     F.2d 540 (5th Cir. 1988), aff ’g 89 T.C. 912 (1987), which we
                                     follow under Golsen v. Commissioner, 54 T.C. 742 (1970),
                                     aff ’d, 445 F.2d 985 (10th Cir. 1971), that petitioners are not
                                     liable for the 40% accuracy-related penalty. We also hold that
                                     petitioners are liable for the 20% accuracy-related penalty
                                     under section 6662(a) to the extent of the underpayment of
                                     tax attributable to the disallowed capital loss deduction and
                                     to the disallowed deduction for the transaction costs.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00007   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     74                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                                                         FINDINGS OF FACT

                                     I. Preliminary Matters
                                        The parties have stipulated many facts. Some stipulations
                                     note a party’s objection to the admissibility of the stipulated
                                     fact(s), and we have sustained some of those objections. We
                                     incorporate herein the stipulated facts to the extent we have
                                     not sustained an objection to their admissibility, and the
                                     stipulated facts are so found (except to the extent we sus-
                                     tained an objection to their admissibility). Quanex’s principal
                                     office and principal place of business were in Texas when the
                                     petition was filed.
                                     II. Quanex
                                        Quanex is a Delaware corporation whose common stock is
                                     publicly traded on the New York Stock Exchange. Quanex
                                     was organized in 1927, and its principal activity is manufac-
                                     turing specialized metal products made from carbon and
                                     alloy steel and aluminum. From at least 1995 through
                                     October 31, 1997, Quanex’s main operating groups consisted
                                     of a hot and cold finish steel bar business, a hot and cold
                                     finish tubing business, and an aluminum building products
                                     business.
                                        Quanex is the common parent of petitioners’ ‘‘affiliated
                                     group’’ (as that term is defined in section 1504(a)). On July
                                     14, 1998, petitioners filed a consolidated corporate Federal
                                     income tax return for TYE 1997 (1997 return). Petitioners
                                     reported in the 1997 return that Quanex was the common
                                     parent of the affiliated group and that its subsidiaries and
                                     their principal business activities were as follows:

                                                                                                 Principal business
                                                         Subsidiaries                                activities
                                                Michigan Seamless Tube Co.                            Manufacturing
                                                LaSalle Steel Co.                                     Manufacturing
                                                Piper Impact, Inc.                                    Manufacturing
                                                Quanex Wire, Inc.                                     Investments
                                                Quanex Bar, Inc.                                      Investments
                                                Quanex Solutions, Inc.                                Investments
                                                Quanex Mfg., Inc.                                     Investments
                                                Quanex Steel, Inc.                                    Investments
                                                Quanex Enters., Inc.                                  Inactive




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00008   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      75


                                                                                                 Principal business
                                                         Subsidiaries                                activities

                                                Quanex Tech. Inc.                                     Inactive
                                                Quanex Metals, Inc.                                   Inactive
                                                Nichols-Homeshield, Inc.                              Inactive

                                       For TYE 1997 through TYE 2001 petitioners had an annual
                                     accounting period ending on October 31, and they each main-
                                     tained books and records using an accrual method of
                                     accounting. As of October 31, 1997, petitioners had 13 manu-
                                     facturing plants throughout the United States and 1 plant in
                                     the Netherlands. Also as of that date, petitioners had 3,771
                                     employees, approximately 1,000 of whom were covered by
                                     collective bargaining agreements.
                                     III. Petitioners’ Expectation of Realizing Millions of Dollars in
                                          Taxable Capital Gains During TYE 1997 and TYE
                                          1998
                                       During TYE 1997 Quanex was actively pursuing the sales
                                     of two subsidiaries. Those sales were expected to generate
                                     millions of dollars in taxable capital gains during TYE 1997
                                     and TYE 1998. The first sale involved Quanex’s wholly owned
                                     subsidiary LaSalle Steel Co. (LaSalle). Quanex’s board of
                                     directors (Quanex’s board) resolved on February 27, 1997, to
                                     make that sale, and the sale closed shortly thereafter in TYE
                                     1997. For TYE 1997, petitioners reported as to that sale (and
                                     to a minor extent the sale of other business property) that
                                     they realized a capital gain of $26,966,201 and ordinary
                                     income of $21,374,634. The second sale involved Quanex’s
                                     decision to sell a portion of its tubing operations (Tube
                                     Group). 3 In or before September 1997 Quanex began negoti-
                                     ating that sale, and the sale occurred on December 3, 1997.
                                     For TYE 1998 petitioners reported as to that sale that they
                                     realized a net capital gain of $12,458,171 and ordinary
                                     income of $8,090,766.
                                       Contemporaneous with petitioners’ activities with respect
                                     to the two sales, and with knowledge of petitioners’ intent to
                                     make those sales, petitioners’ outside accounting firm,
                                       3 The Tube Group included Michigan Seamless Tube Co. (MST), Gulf States Tube Division

                                     (GST), and the Tube Group administrative office. The Tube Group also included Quanex’s Heat
                                     Treating and Nitro Steel Divisions, but Quanex retained those divisions, and they were still a
                                     part of Quanex as of the time of trial.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00009   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     76                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     Deloitte & Touche, LLP (D&T), through one of its tax part-
                                     ners, Steven Singer, approached petitioners and promoted an
                                     idea for a multistep transaction that, if artfully structured to
                                     comply literally with the Code and certain interpretations
                                     thereunder, could create for petitioners a multimillion-dollar
                                     tax loss to shelter the gains from the unrelated sales for Fed-
                                     eral income tax purposes. Quanex entered into the QHMC
                                     transactions as a result of that promotion, and Quanex
                                     claimed that it realized a $37,989,000 capital loss on one of
                                     the steps in the QHMC transactions that effectively offset the
                                     amount of gains on the unrelated sales. The QHMC trans-
                                     actions were ostensibly structured around the Quanex Cor-
                                     poration Group Benefits Plan (plan) with an aim towards
                                     generating an artificial multimillion-dollar tax loss that
                                     would offset the large gains on the sales and would appear
                                     to be generated from Quanex’s business activities.
                                     IV. The Plan
                                           A. Background
                                       Effective September 1, 1949, Quanex established the plan
                                     to provide certain health, welfare, and other similar benefits
                                     for eligible Quanex employees and their dependents. Quanex
                                     reserved the right to amend the plan at any time and
                                     reserved the right, without an authorizing resolution from
                                     Quanex’s board, to reduce or completely eliminate any cov-
                                     erage provided under the plan for current and/or former
                                     employees and their beneficiaries. Quanex also could termi-
                                     nate the plan at any time by a written resolution of Quanex’s
                                     board.
                                           B. Health Care Offerings
                                       Pursuant to the plan, Quanex offered both its nonunion
                                     and union employees a choice of medical plans, which were
                                     generally indemnity and health maintenance organization
                                     (HMO) plans. In the early 1990s Quanex also instituted cafe-
                                     teria benefits with respect to its indemnity plan offerings.
                                     Under the plan, Quanex was required to appoint a committee
                                     to perform any administrative function with respect to the
                                     plan that the respective insurer or HMO was not required to
                                     perform.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00010   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      77


                                       Effective January 1, 1995, Quanex amended and restated
                                     the plan, and the plan remained in effect for TYE 1997. 4
                                     From 1995 through the end of TYE 1997, Quanex provided
                                     group medical benefits to its employees under the plan, and
                                     Quanex deducted the costs of those benefits as they were
                                     incurred as ordinary and necessary business expenses.
                                           C. Health Care Cost Management Strategies
                                           1. Background
                                       The cost of providing health care is influenced by
                                     numerous factors, e.g., an employee’s age, number of depend-
                                     ents, and geographic location. Other less predictable compo-
                                     nents, such as political pressures, also can influence health
                                     care costs. From at least 1985 Quanex experienced a rise in
                                     the cost of providing health care to its employees. As early
                                     as 1985 Quanex began to look at ways to reduce its overhead
                                     and streamline its benefits, including its health care costs,
                                     pensions, and medical benefits for both active and retired
                                     employees.
                                           2. CS
                                           a. Background
                                        ChapmanSchewe, Inc. (CS), is a health care management
                                     firm that Doug Schewe and Harry Chapman organized on
                                     July 1, 1992. 5 As of the time of trial CS had 12 subcompa-
                                     nies, all of which were devoted to health care, and its
                                     employee benefits practice managed health benefits for
                                     approximately 9 million individuals throughout the United
                                     States. During TYE 1997 Chapman was CS’ chairman and
                                     chief executive officer, and he owned approximately 37% of
                                     CS’ stock. Chapman has a bachelor’s degree and a master’s
                                     degree in public administration, and as of the time of trial
                                     he had 23 years of experience in the health care industry.



                                       4 As of October 31, 1997, petitioners provided health care benefits to their nonunion employees

                                     through either an indemnity (self-insurance) medical plan or a managed care program.
                                       5 While CS was apparently formed under a different name, we refer to CS and any of its pred-

                                     ecessors as CS.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00011   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     78                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                           b. Quanex’s Introduction to CS
                                       Ron Howard joined CS in 1994 as an associate/benefits
                                     consultant. Howard was a former financial portfolio manager
                                     with a master of business administration (M.B.A.) degree
                                     and 10 years of experience in banking. During his previous
                                     career in banking, Howard had formed relationships with
                                     members of Quanex’s senior management, including
                                     Quanex’s then chief financial officer (CFO), Wayne Rose.
                                     Howard contacted Quanex shortly after he joined CS to per-
                                     suade his Quanex contacts to let CS negotiate Quanex’s HMO
                                     contracts and to pursue a working relationship with Quanex.
                                       On April 7, 1994, CS representatives met with Quanex rep-
                                     resentatives. During the April 7 meeting, Howard and
                                     Chapman gave a sales presentation to Joseph Peery. Peery
                                     has a bachelor’s degree in business administration and 34
                                     years of experience in human resources, and he was
                                     Quanex’s vice president of human resources from 1984 until
                                     he retired in April 1998. Shortly after the April 7 meeting,
                                     Quanex gave CS the opportunity to reduce Quanex’s health
                                     care costs through HMO negotiations.
                                       In CS’ first project, Howard negotiated a fee for Quanex
                                     with one HMO, which saved Quanex money. Quanex then
                                     expanded its involvement with CS but still limited CS to
                                     HMO work. The substance of CS’ work consisted of negoti-
                                     ating Quanex’s premium amounts with HMOs and of ana-
                                     lyzing HMO cost structures.
                                       Howard was the CS executive in charge of the Quanex
                                     account during TYE 1997, and sometime before 1998 he
                                     attempted to negotiate rate guaranties for Quanex. Howard
                                     had previously informed Quanex that CS could negotiate
                                     multiyear rate guaranties and performance guaranties with
                                     HMOs.
                                       Before the QHMC transactions, Chapman participated in
                                     the negotiation of Quanex’s HMO contracts. Chapman tried to
                                     achieve the best results possible from the negotiations, and
                                     Chapman used the negotiations to speak more frequently
                                     with Quanex’s human resources department and to sell
                                     Quanex additional health care consulting services.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00012   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                   GERDAU MACSTEEL, INC. v. COMMISSIONER                                      79


                                            c. CS Fee Arrangements
                                       CS offered flexibility to its clients through different pay-
                                     ment arrangements (e.g., CS’ fee might be a percentage of
                                     the expense saved, or it might be calculated on the basis of
                                     a percentage of revenue). Before the QHMC transactions, CS
                                     informed Quanex that CS’ compensation was performance
                                     based; i.e., CS would be compensated only if, and to the
                                     extent, CS saved Quanex money. Before the QHMC trans-
                                     actions, CS and Quanex did not have a written consulting
                                     agreement, 6 but CS acted as a broker to secure medical cov-
                                     erage for Quanex’s employees through HMOs, and the HMOs
                                     (or Quanex in one or two instances) paid CS a brokerage
                                     commission for its services.
                                     V. D&T
                                       Quanex first engaged D&T (or one of its predecessors) as
                                     early as 1978 for external auditing, tax, and consulting serv-
                                     ices. The consulting services related to, among other things,
                                     debt restructuring, potential bankruptcy filings, and the pur-
                                     chases and sales of assets and subsidiaries. During TYE 1997
                                     D&T certified petitioners’ consolidated financial statements
                                     and reviewed petitioners’ consolidated Federal income tax
                                     returns, in addition to providing petitioners with other
                                     professional services.
                                       Singer is an attorney and a certified public accountant
                                     (C.P.A.), and he has practiced in the field of taxation for over
                                     three decades. He joined D&T in 1981, and he became a
                                     partner in D&T’s tax practice one year later. He became the
                                     D&T partner in charge of the Quanex account in 1989. Singer
                                     was based in D&T’s office in Houston, Texas, during TYE
                                     1997, and he remained in charge of D&T’s Quanex account
                                     as of the time of trial.
                                       From 1989 through the end of TYE 1997, Singer consulted
                                     with Quanex regarding its current and prospective pur-
                                     chases, and he reviewed and signed Quanex’s corporate
                                     returns as a paid preparer. From 1995 through the end of
                                     TYE 1997, Singer had intimate, first-hand knowledge of
                                     Quanex and its business, acquired mainly from his super-
                                     vising and managing D&T’s Quanex account since 1989, his
                                           6 It   was not unusual for CS to forgo a consulting agreement with a client.




VerDate Nov 24 2008   09:57 Jun 05, 2014     Jkt 372897     PO 20012   Frm 00013   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     80                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     visits to some of Quanex’s facilities, his participation in
                                     Quanex’s financial statement audits, and his conversations
                                     with Quanex’s senior management.
                                     VI. Other Quanex Employees/Officers
                                           A. Rose
                                       Rose is a C.P.A. with a bachelor’s degree and an M.B.A.
                                     degree, and he was Quanex’s CFO from 1986 through 1998.
                                     He was Quanex’s controller before 1986 (and before that, he
                                     worked for a large national public accounting firm for six
                                     years), he was the president of Quanex’s engineered products
                                     group from the end of 1998 until 2001, and he was Quanex’s
                                     vice president of special assignments from June 2000
                                     through March 2001.
                                       When Quanex bought or sold a substantial asset, Rose, as
                                     CFO, and his department were responsible for projecting the
                                     results of that transaction. Rose generally knew what tax
                                     results he wanted going into purchase or sales negotiations,
                                     and he preferred to buy net assets and to sell subsidiaries.
                                     During his tenure as Quanex’s CFO, Rose knew the impor-
                                     tance of tax basis and the effect that liabilities had on a
                                     determination of Quanex’s bases in its subsidiaries.
                                           B. Parikh
                                        Viren Parikh is a C.P.A. with a bachelor’s degree and a
                                     master’s degree, both in accounting, and he was Quanex’s
                                     controller from 1993 through December 2002. He left Quanex
                                     on December 31, 2002.
                                        As Quanex’s controller, Parikh was responsible for
                                     Quanex’s accounting department; its duties included finan-
                                     cial reporting, corporate accounting, and tax return prepara-
                                     tion. Parikh, as controller, also (with Thomas Royce and
                                     Rose) was responsible for reviewing Quanex’s asset sales and
                                     projecting their results. If Quanex sold a significant asset,
                                     Parikh decided how the transaction would be recorded on
                                     Quanex’s financial statements, and he was involved in
                                     deciding how any tax implication would be reported. He and
                                     his department also, while negotiations for Quanex’s poten-
                                     tial sales were ongoing, would project gains and losses on
                                     those potential sales for purposes of financial reporting,




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00014   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      81


                                     periodically updating the projections as the negotiations drew
                                     to a close.
                                           C. Royce
                                        Royce is a C.P.A. with a bachelor’s degree in business
                                     administration (majoring in accounting), and he was
                                     Quanex’s tax director. Beginning in TYE 1997, Royce also was
                                     Quanex’s director/manager of financial benefits administra-
                                     tion (FBA manager). Royce reported to Parikh during TYE
                                     1997, and Royce remained Quanex’s tax director and FBA
                                     manager as of the time of trial.
                                        As tax director, Royce was responsible for Quanex’s
                                     consolidated Federal income tax returns and any subsidiary
                                     returns, for all tax planning, for tax audits, for employee
                                     benefit returns, and for all State income and franchise tax
                                     returns. As FBA manager, Royce was responsible for the
                                     accounting of the employee benefits in Quanex’s pension and
                                     section 401(k) plans, for audit preparation, for the filing of
                                     employee benefit information returns, and for working with
                                     welfare benefit plans and third-party administrators for both
                                     pension and section 401(k) plans.
                                        Royce, as tax director and eventually also FBA manager,
                                     also reviewed Quanex’s sales and made corresponding projec-
                                     tions. When Quanex negotiated the sale of a substantial
                                     asset, Royce projected the potential Federal income tax rami-
                                     fications from the sale during the negotiations. 7 If a sale was
                                     concluded, Quanex would usually at the end of the year cal-
                                     culate the actual Federal income tax consequences of the
                                     sale. Parikh would review the overall tax provision that had
                                     been made for the sale for financial statement purposes, but
                                     Parikh would not review Royce’s estimates of the potential
                                     income tax consequences.
                                     VII. Liability Management Companies
                                           A. Overview
                                       As of the end of TYE 1996, Quanex had a potential liability
                                     for medical plan benefits (MPBs) that might be provided
                                     under the plan. Quanex also faced a potential environmental
                                       7 Royce testified that when Quanex negotiated the sale of a significant asset, neither he nor

                                     anyone else at Quanex projected what tax benefits and detriments would result from the sale.
                                     We do not find Royce’s testimony on this point to be credible, and we decline to rely upon it.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00015   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     82                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     liability of $15 million to $20 million. Quanex assumed the
                                     potential environmental liability in 1996 when Quanex
                                     acquired Piper Impact, Inc. (Piper). As part of that acquisi-
                                     tion, the seller established an escrow to cover this exposure.
                                           B. Rev. Rul. 95–74
                                        Singer, Parikh, Royce, and Rose attended a Quanex quar-
                                     terly meeting in 1996, in or before the summer of that year.
                                     During that meeting, Singer informed the Quanex represent-
                                     atives that the Internal Revenue Service (IRS) had issued a
                                     ruling, Rev. Rul. 95–74, 1995–2 C.B. 36 (revenue ruling),
                                     which Singer believed allowed Quanex to achieve tax benefits
                                     by transferring either its environmental liabilities or its MPB
                                     obligations to a liability management company in a joint ven-
                                     ture. In the revenue ruling the IRS ruled that certain contin-
                                     gent environmental liabilities that a transferee assumed in a
                                     section 351 exchange were not liabilities for purposes of sec-
                                     tions 357(c)(1) and 358(d) and that the transferee, in accord-
                                     ance with its method of accounting, could, as appropriate,
                                     either deduct the liabilities as business expenses under sec-
                                     tion 162 or capitalize the liabilities as capital expenditures
                                     under section 263.
                                           C. D&T’s Matrix
                                           1. Background
                                       D&T maintained an electronic repository of tax ideas that
                                     D&T professionals could discuss with D&T clients to increase
                                     D&T’s business with those clients and generate additional
                                     revenue for D&T. Various D&T professionals contributed
                                     ideas in their areas of expertise to the repository (referred to
                                     as D&T’s client service matrix (matrix)), and D&T envisioned
                                     that D&T might provide the client with a tax opinion on any
                                     transaction described in the matrix which a client entered
                                     into. The matrix was for internal use only, and D&T believed
                                     it would be at a competitive disadvantage if competitors
                                     gained access to the ideas in the matrix.
                                           2. DDCL
                                       Singer occasionally consulted the matrix to obtain ideas to
                                     present to D&T clients. In the summer of 1996, after Singer
                                     learned of the revenue ruling, he read an undated section of




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00016   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      83


                                     the matrix referenced as ‘‘Double Deducting Environmental
                                     and Other Contingent Liabilities’’ (DDCL). Singer was not
                                     responsible for the ideas in the DDCL, and he believed the
                                     DDCL was the only section of the matrix referencing the rev-
                                     enue ruling. 8
                                       The DDCL proposed a transaction for accrual method tax-
                                     payers whom the accrual method prevented from deducting
                                     accruals on their balance sheets for estimated future environ-
                                     mental liabilities. The DDCL concluded that, in the setting of
                                     a consolidated group, a transaction could be structured to
                                     allow such a taxpayer to immediately deduct a capital loss
                                     equal to the amount of the environmental reserve and to
                                     claim an additional deduction when the accrued liability was
                                     paid. The DDCL stated that the ‘‘proper structuring’’ of the
                                     transaction revolved around the use of an environmental
                                     management company and the sale outside the group of some
                                     of the company’s stock at a price equal to the stock’s fair
                                     market value. The DDCL summarized the transaction as fol-
                                     lows:
                                     SUMMARY OF TRANSACTION
                                     Parent Corporation (Parent) is a parent corporation in a consolidated
                                     group, which includes Environmental Management Company (EMCo) and
                                     several other operating companies. EMCo is a newly established, wholly-
                                     owned subsidiary of Parent. Parent also owns S1, and S1 owns S2. Parent
                                     now desires to use EMCo to strategically manage the groups [sic] environ-
                                     mental liabilities and clean-up efforts. S1 has a reserve for environmental
                                     liabilities on its books in the amount of $10x, which has not been deducted
                                     for income tax purposes. S1 also has an intercompany receivable account
                                     with S2 in excess of $10x.
                                     First, S2 pays off a portion of its intercompany debt to S1 by issuing a 10-
                                     year promissory note for $10x. S1 then contributes this note receivable,
                                     and its $10x environmental reserve, to EMCo in exchange for 100 shares
                                     of new, voting Class B stock. These shares may be either preferred or
                                     common. These shares have only a nominal value, as the net book value
                                     of the contributed property is nominal. (S1 remains legally liable for the
                                     environmental costs if EMCo is unable to pay them.) These shares should
                                     be designated as being entitled to a limited percentage of dividends and
                                     distributions paid to all classes of stock (for example, 15%). The percentage
                                     must be established so that at least 80% of the vote and value of all stock
                                     remains with the Class A (common) stock.

                                       8 After the QHMC transactions were completed, D&T added to the matrix another idea dealing

                                     with a contingent liability transaction.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00017   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     84                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     S1 then sells the Class B shares of EMCo to EMCos [sic] officers for their
                                     fair market value, a nominal amount. As the tax basis in this stock is
                                     $10x, S1 recognizes a capital loss of $10x on the sale. As EMCo makes
                                     expenditures on the environmental reserve, it also has a deduction for
                                     these payments.

                                     The DDCL noted that ‘‘it is clear that a business purpose is
                                     required for the transaction’’ and listed the following busi-
                                     ness purposes for the transaction: (1) better management of
                                     S1’s environmental liabilities through EMCo’s devotion of its
                                     resources solely to environmental projects, (2) the ability to
                                     provide incentives more easily for the better management of
                                     the environmental liabilities by creating a separate company,
                                     and (3) improvement of S1’s credit arrangements and
                                     banking relationships by taking its environmental liabilities
                                     off its balance sheet and transferring them to another of P’s
                                     subsidiaries. The DDCL described the business purposes
                                     regarding incentives (No. (2) above) as follows:
                                     S1 will sell Class B stock in EMCo to the EMCo officers in order to give
                                     these individuals an ownership interest in EMCo. S1 also then agrees to
                                     repurchase each officers [sic] shares, once the environmental liabilities
                                     have been settled or the officer leaves the employment of EMCo, at the
                                     greater of their cost to the officer * * * or the per share book value of
                                     EMCo. If the environmental liabilities are satisfied for less than the
                                     amount originally estimated, the book value of EMCo will increase, pro-
                                     viding the individual officers with a gain when their shares are sold back
                                     to S1.

                                        The DDCL acknowledged that the transaction referenced
                                     therein presented risks and could be subject to antiavoidance
                                     provisions such as section 269 or section 1.1502–20, Income
                                     Tax Regs. The DDCL envisioned that its substance could be
                                     adapted for use with a variety of contingent liabilities and
                                     reserves, including medical claims. D&T structured the trans-
                                     action described in the DDCL to offer to its qualifying clients
                                     a deductible capital loss equal to the amount of contingent
                                     liabilities transferred in the transactions. The appeal of the
                                     DDCL transaction (or a variation thereof) was to minimize a
                                     taxpayer’s Federal income tax liability by accelerating the
                                     deduction of and double deducting environmental or other
                                     contingent liabilities.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00018   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      85


                                           3. Singer Promotes DDCL-Type Transaction to Quanex
                                        Singer decided to approach Quanex to promote to Quanex
                                     the transaction described in the DDCL, or a variation thereof.
                                     While the DDCL referenced a consolidated setting, Singer pre-
                                     ferred implementing the transaction described therein in a
                                     deconsolidated setting because he was concerned about rules
                                     under which the loss could be disallowed in the consolidated
                                     setting.
                                        Before discussing the DDCL and the revenue ruling with
                                     Quanex, Singer read some of the cases mentioned in the
                                     ruling. He had developed an understanding of the revenue
                                     ruling and its implications, and he had previously discussed
                                     a contingent liability transaction with at least one other
                                     client. Singer took the position that an implication of the rev-
                                     enue ruling was that a taxpayer could use a liability manage-
                                     ment company to create a capital loss which, in turn, could
                                     reduce the taxpayer’s Federal income tax liability.
                                        In February 1997 at Quanex’s quarterly review meeting
                                     with D&T, Singer advised Rose, Parikh, and Royce that D&T
                                     could structure a contingent liability transaction for Quanex
                                     to generate a tax loss for Quanex. At that time, Singer knew
                                     that Quanex was selling LaSalle and would have a signifi-
                                     cant gain on the sale.
                                     VIII. Sales of LaSalle and Tube Group
                                           A. LaSalle Sale
                                        On February 27, 1997, Quanex’s board resolved to sell all
                                     of Quanex’s stock in LaSalle to a third party. The LaSalle
                                     sale closed on April 18, 1997. Singer knew at least as early
                                     as the 1996 quarterly meeting that this sale was probable,
                                     and he understood in or before March 1997 that Quanex
                                     hoped to close the sale by April 1997. Singer and Rose also
                                     both knew that the sale was expected to generate a signifi-
                                     cant gain.
                                        On January 13, 1998, petitioners filed their Form 10–K,
                                     Annual Report Pursuant to Section 13 or 15(D) of the Securi-
                                     ties Exchange Act of 1934, for TYE 1997 (1997 Form 10–K).
                                     Petitioners reported in the 1997 Form 10–K that they com-
                                     pleted the LaSalle sale for approximately $65 million. In
                                     their 1997 return petitioners reported that they realized a




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00019   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     86                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     $28,697,957 capital gain and a $20,721,360 ordinary gain on
                                     the sale. Petitioners’ 1997 return included their section
                                     338(h)(10) election regarding the sale of LaSalle. From April
                                     18, 1997 (the date of the LaSalle sale), through July 14, 1998
                                     (the date petitioners filed their 1997 return), LaSalle’s buyer
                                     tried to renegotiate a lower purchase price, and the buyer
                                     and Quanex disagreed on purchase price allocation issues
                                     related to the section 338(h)(10) election. In or before that
                                     period Quanex made several estimates of the income tax
                                     ramifications of the sale. 9 Royce, in particular, performed
                                     rough calculations comparing the results of completing the
                                     sale as a stock sale rather than an assets sale under section
                                     338(h)(10). Royce shared his calculations with Parikh.
                                        Singer knew during April 1997 that petitioners would
                                     realize millions of dollars of ordinary income and capital gain
                                     on the LaSalle sale. 10 Over the next five months, he devoted
                                     a substantial portion of his time to determining the tax
                                     implications of the sale, including the amount of ordinary
                                     income and capital gain to be generated from the sale. 11
                                     Before the QHMC transactions closed, Singer and Royce dis-
                                     cussed the anticipated amount of capital gain on the LaSalle
                                     sale.
                                           B. Tube Group Sale
                                        The Tube Group sale involved the sale of both stock and
                                     assets. The first closing occurred on December 3, 1997. Peti-
                                     tioners reported on their 1997 Form 10–K that the Tube
                                     Group sale was completed for approximately $30 million, and
                                     they reported a $12,458,171 capital gain and $8,090,766 of
                                     ordinary income from the Tube Group sale on their Federal
                                     income tax return for TYE 1998 (1998 return).

                                        9 Contrary to other testimony, Royce testified that Quanex did not consider the tax con-

                                     sequences during the negotiations because the buyer and Quanex had agreed to the sec.
                                     338(h)(10) election, that the tax consequences of the LaSalle sale were not important to Quanex
                                     before the April 1997 closing, and that the tax consequences were irrelevant for purposes of ne-
                                     gotiating LaSalle’s sale price. We do not find Royce’s testimony on this matter to be credible,
                                     and we decline to rely upon it.
                                        10 Singer testified that he knew by April 18, 1997, that Quanex had an economic gain on the

                                     sale but that he did not know the exact amount of the capital gain on the sale until approxi-
                                     mately a week or two before he finalized petitioners’ 1997 return. We do not find this testimony
                                     to be credible, and we decline to rely upon it.
                                        11 For June 29 through September 20, 1997, D&T billed Quanex $22,190 for 60.5 hours of

                                     ‘‘Consultations regarding the sale of LaSalle’’ by Singer and other D&T professionals.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00020   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      87


                                     IX. Engaging D&T To Structure QHMC Transactions
                                        Over several months, at a time when D&T and Quanex
                                     were already aware of petitioners’ expected multimillion-
                                     dollar sales, D&T and Quanex discussed the possibility of
                                     Quanex’s engaging in a series of transactions similar to those
                                     in the DDCL and the revenue ruling. During some of these
                                     discussions, D&T gave presentations either through Singer
                                     alone or through Singer and one of his Houston-based tax
                                     partners, Mark Schneider. Singer asked Schneider during
                                     1997 to help him structure a contingent liability transaction
                                     for Quanex, and they discussed the potential tax implications
                                     of the transaction. When Singer initially discussed the DDCL
                                     and the revenue ruling with Quanex, he informed Quanex
                                     about potential issues with section 1.1502–20, Income Tax
                                     Regs., and similar loss limitation rules that applied to
                                     consolidated groups. Singer advised Quanex that its liability
                                     management company (QHMC), if deconsolidated from peti-
                                     tioners’ affiliated group, could be reconsolidated with the
                                     group if puts and calls were exercised in relation to the com-
                                     pany’s stock. 12 Singer advised Quanex that it needed a busi-
                                     ness purpose for the QHMC transactions.
                                        On the basis of the discussions between D&T and Quanex,
                                     Rose believed that D&T’s structuring of a joint venture to
                                     manage petitioners’ liabilities could result in a capital tax
                                     loss that petitioners could use to shelter the anticipated
                                     unrelated gains. Singer advised Quanex from the outset,
                                     however, that he did not know whether D&T could actually
                                     structure such a joint venture. Nevertheless, at some time on
                                     or before March 24, 1997, Rose asked D&T for an engage-
                                     ment letter concerning the structuring of a series of trans-
                                     actions between Quanex, some of Quanex’s affiliates, and a
                                     third-party liability management consulting firm (what
                                     became the QHMC transactions). 13 Singer wanted the engage-
                                     ment letter so that he could be certain that D&T would be
                                     paid for its time whether or not the transactions were com-
                                     pleted.
                                        12 As discussed infra, Quanex characterized QHMC, formerly know as Quanex Wire, Inc.

                                     (QW), a wholly owned inactive subsidiary of Quanex, as its liability management company to
                                     effect the QHMC transactions.
                                        13 Rose directed Royce and Parikh to help complete the QHMC transactions. Parikh, however,

                                     did not make decisions about the details of the transaction’s structure.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00021   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     88                  139 UNITED STATES TAX COURT REPORTS                                      (67)


                                       Quanex and D&T entered into an agreement that was set
                                     out in an engagement letter dated March 24, 1997 (engage-
                                     ment letter). The engagement letter was signed by Singer on
                                     D&T’s behalf, and it was executed by Rose on Quanex’s
                                     behalf on June 30, 1997. Through the engagement letter,
                                     which was prepared by or under the direction of Singer,
                                     Quanex asked D&T to provide Quanex with—
                                     assistance in considering the federal income tax consequences associated
                                     with a series of prospective transactions between Quanex Corporation and
                                     several of its affiliates * * * an independent third party management con-
                                     sulting firm specializing in either employee benefits and medical insurance
                                     matters, or in environmental matters,* * * [14] as well as with a form of
                                     the prospective transaction that additionally or alternatively may con-
                                     template an independent third party investor.

                                     The engagement letter notes that ‘‘the form and content of
                                     this prospective transaction is [sic] somewhat fluid at
                                     present’’ and that D&T would participate in meetings and
                                     discussions related to the structuring of the transaction.
                                     Singer informed Rose that the transaction contemplated by
                                     the engagement letter was a recent development, and Singer
                                     did not represent that he had experience with the type of
                                     transaction described. The engagement letter stated that
                                     D&T’s professional fees would be calculated on the basis of
                                     its standard hourly charges, but if the transaction were com-
                                     pleted, the fees would be approximately $400,000 plus an
                                     estimated additional $10,000 for out-of-pocket expenses.
                                        D&T and Quanex contemplated under the engagement
                                     letter that D&T’s assistance and advice would ‘‘culminate in
                                     the delivery to Quanex of a tax opinion letter * * * limited
                                     solely to the specific federal income tax consequences to
                                     Quanex’’ and that the opinion letter would be ‘‘based upon all
                                     the facts of the transactions and representations made to
                                     * * * [D&T] in a Letter of Representation provided by
                                     Quanex.’’ The engagement letter stated that D&T could not
                                     confirm the conclusions it reached until it signed its opinion
                                     letter, although it might ‘‘informally indicate prior to that
                                     point whether or not * * * [D&T] anticipate[d] that a posi-
                                     tion taken by Quanex should be sustained on its merits if
                                     challenged by the IRS’’, and conditioned D&T’s agreement to
                                       14 Although Rose had previously rejected Singer’s suggestion to use a liability management

                                     company to control Quanex’s environmental liabilities, Singer referenced those liabilities in case
                                     Rose changed his mind.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00022   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      89


                                     provide a tax opinion on D&T’s ‘‘ability to satisfy ourselves
                                     that all of our professional standards for the conduct of this
                                     work and the issuance of our opinion have been met.’’ D&T
                                     required as a condition of the engagement that Quanex agree
                                     in the engagement letter that D&T’s liability for any dam-
                                     ages arising out of the services that D&T provided in the
                                     engagement be limited to the fees paid to D&T for its services
                                     giving rise to the liability. D&T required as a condition of the
                                     engagement that Quanex agree in the engagement letter that
                                     it would indemnify D&T from any liability, cost, or expense
                                     (including attorney’s fees and expenses) stemming from the
                                     engagement, absent D&T’s bad faith or willful misconduct.
                                     When Singer signed the engagement letter, he contemplated
                                     that D&T would provide Quanex with a tax opinion letter if
                                     a transaction were completed and Quanex wanted such a
                                     letter.
                                        D&T assisted Quanex with the QHMC transactions, and the
                                     process of developing the transactions (including the discus-
                                     sions before the engagement letter) extended from approxi-
                                     mately February through October 1997. Petitioners con-
                                     ducted no independent investigation of the tax consequences
                                     of the QHMC transactions.
                                     X. Developing QHMC Transactions
                                           A. Quanex’s First Proposal to CS
                                       On several occasions in 1997, Rose met with Quanex’s
                                     management group and Singer to form an initial proposal to
                                     tender to CS as to its participation in the QHMC transactions.
                                     By letter dated July 21, 1997, Peery contacted Chapman to
                                     determine CS’ interest in the proposal for the ‘‘somewhat
                                     unique arrangement we are seeking’’ to ‘‘manage[ ] our cor-
                                     poration’s non-union medical expenses, including both HMO
                                     and indemnity plan coverage for active employees and
                                     retirees.’’ Rose and Peery drafted this letter together, and
                                     they showed the letter to Singer before Peery sent it.
                                       The July 21 letter described Quanex’s proposal as an
                                     opportunity for an employee benefits firm to enter into a
                                     partnering arrangement with Quanex for a term of approxi-
                                     mately 7 to 15 years to assume responsibility for and
                                     management of ongoing health care costs. The letter stated
                                     that the management responsibilities would include meeting




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00023   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     90                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     the insured health care needs of certain nonunion Quanex
                                     employees at care levels comparable to those already in
                                     place, but with more efficient service delivery to Quanex’s
                                     employees and an ultimate result of reduced costs to Quanex.
                                     The letter explained that the management firm would
                                     acquire a class of stock in a medical management subsidiary
                                     of Quanex, the subsidiary would hold a 7- to 15-year promis-
                                     sory note issued by a Quanex entity, and the subsidiary
                                     would use the interest and principal payments on that note
                                     to reimburse the insured health care costs of the covered
                                     nonunion Quanex employees.
                                       The July 21 letter further explained that although CS
                                     would be paid, in part, for contract services on a periodic
                                     basis, Quanex was seeking an arrangement where CS’
                                     performance premium for economic savings under the con-
                                     tract would be partially realized by efficiencies and cost
                                     savings. According to the letter, Quanex anticipated that
                                     these savings would lead to an accretion in the value of a
                                     designated class of the subsidiary’s stock and that the pre-
                                     mium for performance would be shared through equity
                                     holdings in the subsidiary. The letter stated that Quanex
                                     designed this arrangement because ‘‘The senior management
                                     of Quanex is committed to delivering above market returns
                                     to our equity shareholders, and as such, has increasingly
                                     focused on reconfiguring certain central business relation-
                                     ships into a shared ownership or joint venturing mode.’’ 15
                                       Because Quanex was a good customer for CS and CS
                                     wanted to retain its relationship with Quanex in any way it
                                     could, CS agreed to meet with Quanex to discuss the pro-
                                     posal. CS and Quanex met during the summer of 1997, and
                                     Quanex informed CS that Quanex wanted to create a medical
                                     management business unit that would focus on self-insured,
                                     indemnified contracts. 16




                                       15 As of then, Rose had not considered using a consulting agreement, rather than a separate

                                     corporate structure, to provide incentives to reduce the health care costs.
                                       16 Chapman also attended a meeting where Singer made a presentation about the proposed

                                     transactions. The record is not clear regarding whether this presentation occurred during this
                                     initial meeting.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00024   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      91


                                           B. D&T’s First Outline of Proposed Joint Venture Trans-
                                              actions
                                        Sometime on or before July 30, 1997, but at a time when
                                     Quanex knew it would have substantial gains from the
                                     LaSalle and Tube Group sales, Quanex requested that D&T
                                     prepare an outline of the first draft of the proposed QHMC
                                     transactions. Singer and Schneider prepared the outline.
                                     Schneider reviewed the outline before it left D&T, and by
                                     letter dated July 30, 1997 (July 30 outline), he sent the out-
                                     line to Parikh, Rose, and Peery. 17
                                        The July 30 outline stated that Quanex wished to broaden
                                     the scope of CS’ HMO evaluation services to include review of
                                     Quanex’s indemnity medical plan and other medical cost and
                                     quality matters. The outline reiterated that CS’ compensa-
                                     tion with regard to the additional scope of services would be
                                     paid pursuant to a consulting agreement that provided for
                                     either hourly or performance-based compensation and for
                                     ‘‘additional long term incentive equity’’. The outline proposed
                                     that (1) Quanex or QHMC have the option of purchasing the
                                     incentive equity after five years for cash, (2) CS have the
                                     option of selling the same to Quanex or QHMC after seven
                                     years for cash, and (3) the purchase or sales price be the
                                     greater of $12,500 or a formula value based, in part, on
                                     QHMC’s expectations for its medical claim expenses.
                                        The capital loss deduction generated through the QHMC
                                     transactions would be approximately equal to the amount of
                                     the MPBs that were transferred in those transactions, and the
                                     amount of the MPBs Quanex would transfer in the QHMC
                                     transactions would be based on the amount of the capital
                                     gains Quanex wanted to offset. Under the proposal set forth
                                     in the outline, all actuarial calculations for the QHMC trans-
                                     actions, including calculations of the present values of the
                                     MPBs to be transferred, would be done by the actuarial firm
                                     of Watson Wyatt & Co. (WW) or another Quanex designee.
                                     WW was Quanex’s then-current consultant on pension plans
                                     and retiree health care plans. Sometime before June 30,
                                     1997, Royce asked WW to compute the present value of
                                       17 Although Peery was included on some of the correspondence relating to the structuring of

                                     the transaction, Peery did not have any discussions with D&T about the structure of QHMC.
                                     Peery also did not participate in any decisions or make any recommendations with respect to
                                     how QHMC would be structured.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00025   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     92                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     Quanex’s future health care benefits for active and retired
                                     Quanex employees. Royce did so because he wanted Quanex
                                     to know the amount of its outstanding MPBs as it analyzed
                                     the structure of the proposed transactions.
                                           C. WW
                                           1. In General
                                        As part of WW’s consulting services provided to Quanex,
                                     WW prepared Quanex’s report (FASB 106 report) required by
                                     Financial Accounting Standards Board Statement No. 106
                                     (FASB 106). The FASB 106 report includes a calculation of a
                                     liability for the balance sheet and an annual expense for the
                                     income statement as to an organization’s retiree health care
                                     plans and other retiree welfare plans. An FASB 106 liability
                                     is a liability for financial statement purposes. The MPB
                                     obligation, i.e., the future health care costs for active
                                     employees of Quanex, is not an FASB 106 liability. 18
                                           2. FASB 106
                                             106 sets forth standards for determining the present
                                           FASB
                                     value of an employer’s future retiree health care payments
                                     owed to currently retired individuals and current employees
                                     who will retire in the future and ratably accruing that
                                     present value on the employer’s financial statement over
                                     each employee’s career in an effort to match the benefits paid
                                     to employees to their service as they earn the benefits. FASB
                                     106 requires the making of certain actuarial assumptions on
                                     matters such as the average cost of health care per person,
                                     the projection of increases in future average costs, and a dis-
                                     counting of projected future costs to calculate present value.
                                     (An assumption relating to increases in health care costs into
                                     the future is referred to as health care cost inflation or a
                                     health care cost trend.) Other assumptions relate to
                                     employee demographics, including mortality, job turnover,
                                     retirement age, and the likelihood of electing coverage under
                                     the employer’s plan upon retirement.
                                       Different types of trends exist for short-term and long-term
                                     calculations. For purposes of FASB 106, the timeframe for
                                       18 As discussed infra, the transferred MPB obligations had not been incurred by Quanex as

                                     of October 31, 1997, and when those obligations were assumed by QHMC, they were not re-
                                     ported as a liability on Quanex’s financial statements.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00026   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      93


                                     short-term calculations is typically from 4 to 10 years. Com-
                                     monly, for a valuation under FASB 106, after a trend rate is
                                     determined for the first year of the calculation (initial trend
                                     rate), the initial trend rate gradually changes over the years
                                     to an ultimate health care inflation rate (ultimate trend
                                     rate). From the initial year of the calculation until the ulti-
                                     mate trend starts, the ultimate trend rate can be adjusted
                                     and is generally not the same number for all 4 to 10 years.
                                     The initial trend rate may be either greater or less than the
                                     ultimate trend rate.
                                           3. WW’s First Present Value Calculation of Quanex’s Health
                                              Care Benefits
                                        WW had the information to perform the present value cal-
                                     culations requested on or before June 30, 1997, because it
                                     had prepared Quanex’s FASB 106 report for TYE 1996. 19 By
                                     letter dated June 30, 1997, Michael Ringuette, a WW
                                     actuary, sent Royce (in his capacity as Quanex’s tax man-
                                     ager) the requested calculations for FASB 106 (June 30 cal-
                                     culations). The letter stated that the calculations applied
                                     only to people employed by or retired from Quanex as of
                                     November 1, 1996, and that WW did not include any addi-
                                     tional amounts for employees that might be hired later. The
                                     letter was the first written product WW gave Royce as a
                                     result of the assignment to compute the present value of the
                                     future benefits, and Quanex knew WW’s calculations were
                                     estimates. Rose decided which groups of employees were
                                     included in WW’s calculations and the length of the term
                                     WW’s projections covered. Rose also ratified WW’s decisions
                                     about what assumptions were included in the calculations.
                                        WW’s June 30 calculations were entitled ‘‘Present Value of
                                     Active Health Care Benefits Provided to Employees Hired as
                                     of 11/1/96’’. The calculations relied on data from Quanex’s
                                     salaried employees at its Corporate, GST, Heat Treating,
                                        19 Later, WW also prepared Quanex’s FASB 106 report for TYE 1997. For the purpose of the

                                     FASB 106 reports, WW measured the present value of the annual retiree health care expense
                                     as of the first day of the fiscal year; e.g., for Quanex’s TYE 1997 report, the expense was meas-
                                     ured as of November 1, 1996. In addition, usually in the November right after the close of the
                                     fiscal year, WW made a subsequent measurement as of October 31 of the just-closed fiscal year
                                     to determine the liabilities to be disclosed on Quanex’s yearend financial statements; e.g., for
                                     Quanex’s TYE 1997 report, the subsequent expense was most likely measured in November
                                     1997. During October 1997, WW knew the assumptions for TYE 1997 that it would make as
                                     to the discount and inflation rates because it and Quanex discussed those assumptions during
                                     that month.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00027   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     94                        139 UNITED STATES TAX COURT REPORTS                                                 (67)


                                     Macsteel (MS)–Michigan, MS–Arkansas, MS–General Office,
                                     MST, and Tube Group Office locations, and from Quanex’s
                                     hourly employees at its GST, MS–Michigan, MS–Arkansas,
                                     and MST locations. 20 The calculations were broken down by
                                     the estimated present value of active health care benefits
                                     and of retiree health care benefits for active employees, on
                                     the one hand, and for retired employees, on the other hand.
                                     WW provided the following estimated present values of the
                                     active health care benefits:
                                                                                                                       Estimated P.V. of
                                                                                               Current                 active health care
                                                          Location                            employees                     benefits
                                              Salaried employees:
                                                Corporate                                             35                      $2,468,146
                                                GST                                                   55                       3,741,751
                                                Heat Treating                                         27                       2,148,863
                                                MS–Michigan                                          112                       8,113,866
                                                MS–Arkansas                                          120                       8,976,903
                                                MS–General Office                                     30                       2,044,664
                                                MST                                                   66                       4,530,899
                                                Tube Group Office                                     51                       3,471,742

                                                       Total                                         496                      35,496,834

                                              Hourly employees:
                                               GST                                                   248                      15,799,142
                                               MS–Michigan                                           165                      11,399,603
                                               MS–Arkansas                                           252                      17,479,494
                                               MST                                                   222                      13,164,471

                                                       Total                                         887                      57,842,710

                                        The June 30 calculations relied on the following assump-
                                     tions:
                                                   Aging ..............................................................................       2%
                                                   Initial trend rate ............................................................        9.29%
                                                   Ultimate trend rate (2004) ...........................................                   5.5%
                                                   Average cost per employee (1997 age 40) ....................                           $3,500
                                                   Interest rate ...................................................................        7.5%

                                     The accompanying letter stated that the interest rate and
                                     trend rate assumptions for the active employee and retiree
                                     health care were the same as those used for WW’s
                                     ‘‘November 1, 1996 FASB valuation (published February 20,
                                     1997)’’.
                                           20 MS   was a division of Quanex.




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897       PO 20012     Frm 00028      Fmt 2847    Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      95


                                           D. D&T’s Revisions to Proposed Transaction
                                           1. August 6–7, 1997, Revisions
                                        Quanex and D&T revised the terms of the QHMC trans-
                                     actions according to information that Royce gave D&T on how
                                     the QHMC transactions could be structured. Upon Quanex’s
                                     request, by letter dated August 6, 1997, D&T (through Singer
                                     and Schneider) provided Quanex with revisions to the July
                                     30 outline (August 6 outline). Singer and Schneider prepared
                                     the letter together, and Singer signed the letter and reviewed
                                     it before it left D&T. The revisions included an outline of the
                                     proposed capitalization and subsequent sale of QHMC and
                                     Quanex Steel, Inc. (QS), another wholly owned Quanex sub-
                                     sidiary, which the letter characterized as ‘‘part of the overall
                                     plan to expand the scope of services of consultants’’.
                                        The August 6 outline combined the proposed QHMC trans-
                                     actions into five steps. Step 1 provided for the reconfigura-
                                     tion of an inactive Quanex subsidiary (which eventually was
                                     QW) through certain substeps that included, among others:
                                     (1) renaming the subsidiary QHMC; (2) amending QHMC’s arti-
                                     cles of incorporation to provide for three classes of stock, to
                                     wit, class A voting common stock (class A stock), class B
                                     voting preferred stock (class B stock), which the letter
                                     termed ‘‘Incentive Equity’’, and class C voting preferred stock
                                     (class C stock); (3) providing for voting rights measured in
                                     terms of ability to elect directors, and including CS principals
                                     or employees on QHMC’s board of directors (QHMC’s board)
                                     and as officers; (4) providing for dividends on the class A
                                     stock as declared and dividends of 9.5%, payable quarterly
                                     and cumulative, for the class B and class C stocks; (5)
                                     allowing for the transfer of stock only with the consent of all
                                     shareholders; (6) providing that the class A stock be subject
                                     to assessment for capital calls and that the capital call
                                     assessment for the class B and class C stocks be limited to
                                     an assumed $100 per share investment price; (7) providing
                                     Quanex or QHMC with call rights after five years and CS with
                                     put rights after seven years; and (8) providing for a liquida-
                                     tion value of the class B and class C stocks at an amount
                                     equal to the greater of $125 or a formula value that was
                                     based on CS’ success in achieving certain performance goals




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00029   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     96                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     set by Quanex and on the difference between the value of
                                     QHMC’s projected and actual MPB expenses.
                                        Step 2 of the August 6 outline addressed the ‘‘Determina-
                                     tion of Medical Liability and Contribution of Note’’ and
                                     stated that the present value of Quanex’s and Piper’s medical
                                     liabilities had to be determined. The purpose of this step was
                                     to determine which groups of employees would have their
                                     contingent medical liabilities contributed to QHMC. Under
                                     this step, Quanex would contribute $45 million and
                                     $44,998,000 worth of contingent liabilities to QS, and Piper
                                     would contribute $2 million and $1.99 million of contingent
                                     liabilities to QS. As a footnote to Quanex’s proposed contribu-
                                     tions to QS (footnote), the outline stated that for purposes of
                                     the document, ‘‘we have assumed that $36 million pertains
                                     to LaSalle and $9 million to MST (and possibly GST).’’ 21 This
                                     footnote referred to the anticipated gains on the sales of
                                     those assets.
                                        Step 3 provided for CS’ purchase of all of the class B stock
                                     for $41,700. Step 4 provided for CS to contribute $6,000 to
                                     QHMC in exchange for class C stock, and for QS to contribute
                                     the cash and liabilities it received from Quanex to QHMC in
                                     exchange for class C stock with a net fair market value of
                                     $11,000. Step 5 provided for QS to sell some or all of its class
                                     C stock for the same price per share that CS ‘‘paid’’ for its
                                     class C stock.
                                        Royce gave D&T some comments on the August 6 outline,
                                     and those comments were read by Singer, Schneider, and
                                     Walt Mooney. Mooney was a recently hired senior tax man-
                                     ager in the D&T tax department in Houston, and he was
                                     assigned to the Quanex engagement to work under Singer,
                                     assisting him with tasks related to the QHMC transactions
                                     but without any authority to make material decisions about
                                     the structure of the transactions. Mooney, in consultation
                                     with Singer or Schneider, prepared a memorandum (Mooney
                                     memorandum) with respect to Royce’s comments, and D&T
                                     forwarded a copy of the Mooney memorandum to Royce on
                                     August 7, 1997. The Mooney memorandum stated that the
                                       21 In addition to providing Quanex with requested revisions in the August 6 outline, D&T pro-

                                     vided Quanex with a chart summarizing the updated steps of the transaction. According to the
                                     chart, Quanex would contribute $35 million and $34,990,100 of MPBs to QS, and Piper would
                                     contribute $10 million and $9,998,900 of MPBs to QS. The chart made no mention of any cash
                                     or MPB contributions from LaSalle, MST, or GST.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00030   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                  GERDAU MACSTEEL, INC. v. COMMISSIONER                                      97


                                     August 6 outline was incorrect in that QS was to contribute
                                     a note to QHMC along with the liabilities rather than cash.
                                     The Mooney memorandum stated in response to one of
                                     Royce’s comments, ‘‘Why do we need Quanex Steel?’’, that QS
                                     ‘‘creates tax basis in the note.’’ 22 The Mooney memorandum
                                     did not state that the footnote in the August 6 outline was
                                     incorrect or otherwise address the footnote. The Mooney
                                     memorandum also gave no indication that Royce or anyone
                                     else had commented on the footnote.
                                        In a letter dated August 7, 1997, D&T provided Quanex
                                     (through Parikh, Perry, Rose, and Royce) with revisions that
                                     Quanex requested with respect to the August 6 outline. The
                                     August 7 letter proposed the same general structure for the
                                     QHMC transactions as the August 6 outline, but revised step
                                     4 to propose that QS contribute a $45 million note to QHMC,
                                     rather than cash, along with $44,998,000 of contingent liabil-
                                     ities. The August 7 letter retained the proposal that Quanex
                                     contribute $45 million and $44,998,000 of contingent liabil-
                                     ities to QS and included a footnote stating that D&T assumed
                                     that $36 million pertained to LaSalle and $9 million to MST
                                     and GST. Singer reviewed and signed the August 7 letter.
                                            2. August 13, 1997, Revisions and Cashflow Analysis
                                        By a fax transmission dated August 13, 1997 (August 13
                                     fax), Singer sent Rose a letter with new versions of the pro-
                                     posed transactions that were designed to overcome what
                                     Singer believed was a potential issue with section 1.1502–
                                     13(g), Income Tax Regs. The August 13 fax stated that
                                     Singer and Schneider had ‘‘further refined’’ the transactions
                                     as Quanex had requested and included details with respect
                                     to the class C stock.
                                        The primary changes to the transactions as described in
                                     the August 13 fax were the deletion of a provision requiring
                                     Piper to contribute cash and liabilities to QS and the addi-
                                     tion of a provision stating that in no event would the formula
                                     value result in the aggregate value of the class B and class
                                     C stocks’ equaling or exceeding 50% of the total value of all
                                     classes of stock. The August 13 fax retained the same five
                                     general steps as the previous outlines of the proposed trans-
                                     actions. In addition, the August 13 fax retained the proposed
                                           22 At   trial, Singer could not (or would not) explain what this response meant.




VerDate Nov 24 2008   09:57 Jun 05, 2014     Jkt 372897    PO 20012   Frm 00031   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     98                   139 UNITED STATES TAX COURT REPORTS                                                (67)


                                     Quanex contribution to QS and the accompanying footnote
                                     regarding LaSalle, MST, and GST.
                                        By a second fax dated August 13, 1997 (second August 13
                                     fax), D&T provided Quanex with two documents to assist
                                     Quanex in its presentations to and negotiations with CS. One
                                     document was a checklist entitled ‘‘QHMC/QUANEX TRANS-
                                     ACTION TASK CHECKLIST FOR CHAPMAN’’ (checklist). The
                                     checklist retained most of the provisions discussed in the
                                     August 13 fax, but eliminated those that did not directly
                                     address CS’ potential role in the transactions. The second
                                     document was a discounted cashflow analysis (August 13
                                     cashflow analysis) that D&T used to value all of the proposed
                                     classes of QHMC stock as of October 1997. The August 13
                                     cashflow analysis assumed, among other things, that QHMC
                                     would hold a $38 million note receivable with a 15-year term
                                     and that a $4,714,000 payment, comprising both interest and
                                     principal, would be made on the note each year.
                                        The August 13 cashflow analysis projected Quanex’s ‘‘Cash
                                     Flow from Operating and Investing Activities’’ over a 15-year
                                     period. The analysis projected that 576 employees would be
                                     covered by QHMC in each year, that interest income from the
                                     note receivable would decrease steadily, and that the pro-
                                     jected medical costs for the covered employees would increase
                                     steadily. The August 13 cashflow analysis projected that the
                                     ‘‘Cash Flows from Financing Activities (excluding Dividends)’’
                                     would consist of 15 annual principal payments on the note in
                                     amounts that increased from $1,294,000 in year 1 to
                                     $4,325,000 in year 15 (for total principal payments of $38
                                     million over the 15-year period) and that positive cashflow
                                     would be available to the equity holders for only the first 6
                                     years. The analysis projected increasing net operating losses
                                     (NOLs) for years 2 through 7. The relevant specifics of the
                                     August 13 projections included the following amounts (in
                                     thousands): 23
                                                                                  Total                   Cashflow
                                                                                cashflow                  available
                                                                                  from                       to
                                                        Interest   Medical      operating     Principal    equity     Cumulative
                                               Year     income      costs     and investing    repaid      holders     cashflow     NOL

                                                 1      $3,420     ($3,193)      $227          $1,294      $1,521       $1,521      $227
                                                 2       3,304      (3,470)      (166)          1,411       1,244        2,765       (166)
                                                 3       3,177      (3,748)      (572)          1,538         966        3,731       (738)
                                                 4       3,038      (4,026)      (988)          1,676         689        4,419     (1,726)

                                       23 We note some computational errors in the projections. These errors are not material to our

                                     analysis.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012    Frm 00032     Fmt 2847    Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                                99


                                                                                  Total                   Cashflow
                                                                                cashflow                  available
                                                                                  from                       to
                                                        Interest   Medical      operating     Principal    equity     Cumulative
                                               Year     income      costs     and investing    repaid      holders     cashflow     NOL

                                                 5       2,887      (4,298)     (1,411)         1,827          416       4,836     (3,137)
                                                 6       2,723      (4,561)     (1,839)         1,991          153       4,988     (4,975)
                                                 7       2,544      (4,812)     (2,269)         2,171          (98)      4,890     (7,244)
                                                 8       2,348      (5,077)     (2,729)         2,366         (363)      4,528       -0-
                                                 9       2,135      (5,356)     (3,221)         2,579         (642)      3,885       -0-
                                                10       1,903      (5,651)     (3,748)         2,811         (937)      2,949       -0-
                                                11       1,650      (5,962)     (4,311)         3,064       (1,247)      1,701       -0-
                                                12       1,375      (6,290)     (4,915)         3,340       (1,575)        126       -0-
                                                13       1,074      (6,635)     (5,562)         3,640       (1,921)     (1,795)      -0-
                                                14         746      (7,000)     (6,254)         3,968       (2,286)     (4,081)      -0-
                                                15         389      (7,385)     (6,996)         4,325       (2,671)     (6,753)      -0-

                                               Total    32,714     (77,466)    (44,753)        38,000       (6,753)      No D&T    No D&T
                                                                                                                           total     total


                                           3. August 22, 1997, Revisions
                                        By letter dated August 22, 1997 (August 22 letter), Singer
                                     sent Parikh and Royce some documents to assist them in
                                     their presentation of the QHMC transactions to CS. These
                                     documents included, among other things, a schematic dia-
                                     gram of the capitalization of QHMC (and other transfers
                                     related thereto), two examples of CS’ potential return on
                                     investment, another task checklist for CS (which was nearly
                                     identical to the previous CS task checklist), and a proposed
                                     Letter of Intent to be executed by Quanex and CS. The dia-
                                     gram proposed the following transactions related to QHMC’s
                                     capitalization: (1) Quanex transfers $50,000 to QHMC in
                                     exchange for class A stock; (2) Quanex transfers $13,000 to
                                     QHMC in exchange for class B stock; (3) Quanex transfers
                                     class B stock to CS in exchange for $13,000; (4) CS transfers
                                     $2,000 to QHMC in exchange for class C stock; (5) QS trans-
                                     fers $38 million and $37,989,000 worth of MPBs to QHMC in
                                     exchange for class C stock; and (6) Piper transfers a $38 mil-
                                     lion affiliated note to QHMC in exchange for $38 million. The
                                     $37,989,000 assigned to the MPBs was the present value ulti-
                                     mately assigned to the MPBs that were transferred as a part
                                     of the QHMC transactions.
                                           E. Quanex’s Negotiations With CS
                                       By letter dated September 3, 1997, Singer provided Royce
                                     with a set of documents for WW and a set of documents for
                                     CS. Quanex had asked D&T to prepare those documents for
                                     Quanex to gauge CS’ and WW’s interests in becoming med-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012    Frm 00033     Fmt 2847    Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     100                 139 UNITED STATES TAX COURT REPORTS                                        (67)


                                     ical consultants with QHMC. 24 D&T prepared the documents
                                     with input from Quanex, and Singer considered the docu-
                                     ments to be part of an effort to present CS with key points
                                     of the transaction. 25 The documents contained a PowerPoint
                                     presentation of key deal terms (September 3 presentation), a
                                     task checklist for the investing medical consultant, and the
                                     same capitalization diagram that D&T provided to Quanex in
                                     the August 22 letter.
                                       According to the September 3 presentation, CS would pro-
                                     vide health management consulting services, including
                                     vendor management for both HMO and indemnity plans, con-
                                     tinue its HMO consulting agreements, receive service con-
                                     tracts for specific additional projects, and purchase QHMC
                                     stock for an equity stake in QHMC. The terms did not differ
                                     significantly from those discussed above with respect to the
                                     August 6 outline and its subsequent revisions. According to
                                     the September 3 presentation, the purpose of the QHMC
                                     transactions was to ‘‘reduce Quanex’s overall medical costs,
                                     without compromising quality of care provided to employees.’’
                                     The September 3 presentation contained no reference to the
                                     tax aspects of the QHMC transactions or to the role that tax
                                     aspects played in structuring the transactions.
                                       The September 3 presentation also included a summary of
                                     return-on-investment scenarios which assumed annual
                                     savings in medical costs of 5%, on the one hand, and 10%,
                                     on the other hand. The example scenarios projected the fol-
                                     lowing net returns for a five-year investment and for a seven-
                                     year investment:
                                                                                                  Net return

                                                                           Annual savings of 5%           Annual savings of 10%

                                           Length of investment                5 Years        7 Years        5 Years      7 Years

                                            If personnel remain
                                               constant                        $170,502      $295,072       $413,783     $660,073
                                            If personnel increase
                                               5% per annum for
                                               the first 5 years                182,666        313,322       438,111       696,573

                                       24 Sometime during 1997 Ringuette and Clay Cprek, a WW retirement consultant, attended

                                     a meeting in WW’s Southfield, Mich., office where Quanex (through Parikh, Royce, and possibly
                                     Rose) gave WW the opportunity to invest in what became QHMC. Quanex informed Ringuette
                                     and Cprek that the tax aspects of the QHMC transactions were proprietary and declined to ex-
                                     plain the details of the tax aspects to WW. WW did not invest in QHMC.
                                       25 We do not discuss the WW documents separately because they do not differ significantly

                                     from the CS documents, and WW did not invest in the transactions.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00034    Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                       101


                                                                                                 Net return

                                                                           Annual savings of 5%          Annual savings of 10%

                                            Length of investment               5 Years       7 Years        5 Years      7 Years

                                            If personnel decrease
                                               5% per annum for
                                               the first 5 years               158,338        276,822       389,455       623,572

                                        Sometime on or before September 10, 1997, Peery again
                                     contacted CS about the potential transactions and to inquire
                                     into whether CS would be interested in participating in
                                     them. On September 10, 1997, Chapman and Howard met
                                     with Quanex to discuss the proposal. Quanex proposed all
                                     aspects of the structure of the transactions to CS, including
                                     that Quanex’s MPB obligations be put in a separate corpora-
                                     tion, and the substance of Quanex’s presentation at the Sep-
                                     tember 10 meeting was the same as at the September 3
                                     presentation. Quanex provided CS with the return on invest-
                                     ment example scenarios, but Quanex did not give Chapman
                                     any support for the computations. When CS and Quanex rep-
                                     resentatives discussed Quanex’s participation in the QHMC
                                     transactions, CS was not represented by counsel, CS was not
                                     involved in structuring the relevant corporate entities or
                                     transfers, CS did not determine the QHMC stock’s issue price,
                                     and CS did not select the liabilities that were ultimately
                                     transferred to QHMC.
                                        Chapman prepared a memorandum for CS’ board of direc-
                                     tors and officers dated September 11, 1997 (memo). In the
                                     memo, Chapman informed CS’ board of the terms of the pro-
                                     posal and stated that, under the proposal, CS and Quanex
                                     would enter into a joint venture that would be responsible for
                                     the cost of Quanex’s benefits program. Chapman also
                                     informed CS’ board that for a $15,000 investment in QHMC
                                     stock, Quanex would guarantee the stock, CS would earn a
                                     guaranteed annual dividend of 9.5%, and ‘‘when Quanex re-
                                     acquires the stock it will be based on its actual value but no
                                     less than $125 per share.’’ Chapman explained that the stock
                                     value would be calculated on the basis of actual savings as
                                     compared to actuarial formulas that WW developed.
                                     Chapman understood that the only risk CS faced from
                                     participating in the QHMC transactions was Quanex’s credit
                                     risk and that CS, by accepting the proposal, could potentially
                                     expand its business relations with Quanex.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00035   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     102                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                        In describing the proposed transactions, Chapman
                                     explained that the number of Quanex employees that CS
                                     served would increase significantly because CS would have
                                     responsibility with respect to approximately 600 salaried
                                     nonunion employees (whose health benefits were included in
                                     the QHMC transactions), in addition to all other employees at
                                     Quanex facilities (not included in the QHMC transactions).
                                     Chapman also explained that Quanex had 3,900 employees
                                     at that time but planned to sell two divisions with a com-
                                     bined total of 900 employees, which in turn, Chapman
                                     explained, meant that CS would lose the commission income
                                     it was earning on those 900 employees. Chapman stated in
                                     the memo that if CS took part in the joint venture, it would
                                     have global responsibility for 3,000 employees, with the 600
                                     salaried/nonunion employees being covered by the proposed
                                     health care arrangement and the remaining 2,400 by CS’
                                     standard commission schedule. 26 Chapman explained that
                                     CS would earn an estimated $50,000 in consulting fees for
                                     servicing the QHMC population as well as CS’ standard
                                     earnings formula on the nonunion employees whose MPBs
                                     would be transferred to QHMC.
                                        By letter dated September 19, 1997, Parikh informed
                                     Chapman that Quanex was pleased with Chapman’s interest
                                     in the proposal, that Quanex believed ‘‘a proven employee
                                     benefits firm can offer an expertise in the management of
                                     ongoing health costs’’, and that ‘‘Establishing a health
                                     management company and allowing your employee benefits
                                     firm an opportunity to participate in its ownership can prove
                                     to be beneficial to all parties.’’ Parikh also stated that
                                     Quanex was still in the process of refining the pool of MPBs
                                     that would be transferred to QHMC.
                                        Parikh included a draft set of working documents with the
                                     September 19 letter, and he requested that Chapman provide
                                     Quanex with his comments to the documents ‘‘by Friday,
                                     September 26, 1997.’’ Parikh emphasized in the letter that
                                     Quanex was on a ‘‘tight time schedule’’ for completing the
                                     transactions, as CS already knew. Parikh wanted the trans-
                                     actions completed by October 31, 1997, because he knew that
                                     Quanex anticipated a gain from the LaSalle sale and that the
                                       26 CS’ HMO arrangement with Quanex would therefore not change because it had always been

                                     on a commission basis and remained on a commission basis.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00036   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    103


                                     QHMC   transactions would result in an artificial capital loss
                                     that could offset the gain.
                                           F. WW’s Present Value Calculation Revisions
                                        Royce was Ringuette’s main contact for most aspects of
                                     Ringuette’s assignments related to present value calcula-
                                     tions. Before September 19, 1997, but after receiving the
                                     June 30 calculations, Royce directed WW to revise the June
                                     30 calculations without taking into account the Tube Group
                                     locations that Quanex intended to sell. Royce gave WW the
                                     Quanex companies to use in the calculations. In addition,
                                     Quanex gave WW the actual claims activity for the given
                                     locations.
                                        WW had further discussions with Quanex relating to
                                     present value calculations, and WW gathered more specifics
                                     on the claims experience for the Quanex locations and per-
                                     formed additional present value calculations. On September
                                     19, 1997, Ringuette sent Cprek and Maureen Cotter, a WW
                                     health care consultant, an email describing a conversation
                                     with Royce on September 18, 1997. Ringuette stated that
                                     Royce wanted WW to value all Quanex salaried groups
                                     (except for the Tube Group) and the MS–Arkansas nonunion
                                     hourly group and that ‘‘this calculation will be used to deter-
                                     mine the amount of the promissory note to be given to the
                                     medical management subsidiary.’’
                                        By letter dated October 13, 1997, that Ringuette prepared
                                     and signed, WW provided Royce with the revised calculations
                                     of the present value of lifetime health care benefits for cer-
                                     tain groups of active Quanex employees. Ringuette stated in
                                     the cover letter that the calculations addressed Quanex’s cor-
                                     porate, MS–Michigan salaried, MS–Arkansas salaried, MS–
                                     Arkansas nonunion hourly, MS–General Office, Heat
                                     Treating, and Nitro Steel employees. No retirees were
                                     included in the analysis. As Ringuette and Royce had dis-
                                     cussed, WW based its calculations on only those employees
                                     employed by Quanex as of October 13, 1997, and did not
                                     include any amounts for future Quanex hires.
                                        WW determined the number of active employees and their
                                     average age using November 1, 1996, employee census data
                                     provided for the FASB 106 valuation performed as of that
                                     date, and WW assumed the number and average age of




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00037   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     104                   139 UNITED STATES TAX COURT REPORTS                                                  (67)


                                     employees in each division from November 1, 1996, to
                                     November 1, 1997, would not change. WW also projected the
                                     assumed number of employees remaining in future years and
                                     their average age using assumptions used for the November
                                     1, 1996, FASB 106 valuation, and WW assumed the average
                                     cost of health care would increase in future years in accord-
                                     ance with the following assumptions: ‘‘2.0% increase in cost
                                     for each/year increase in average age’’ and ‘‘8.75% inflation
                                     in 1998, decreasing linearly over time to 5.50% in 2004 and
                                     remaining at that level thereafter (same as FASB Statement
                                     No. 106 assumption).’’ The 2% aging assumption was chosen
                                     on the basis of data WW had collected on health care costs
                                     for many different health care plans and was used, in part,
                                     because WW wanted to reflect that some of the groups had
                                     a higher average age than others and might have cor-
                                     responding higher health care costs. Ringuette used the
                                     8.75% initial trend to project the increase in the average
                                     health care costs per person from November 1, 1997, through
                                     October 31, 1998, to November 1, 1998, through October 31,
                                     1999.
                                       WW also assumed an average health care cost per
                                     employee of ‘‘$5,877 (1998 Age 40)’’, which represented the
                                     estimated health care cost per employee included in the
                                     present value calculation for TYE 1998, adjusted to assume
                                     an average age of 40, and a 7.5% interest rate to discount
                                     future cashflows to November 1, 1997. WW included with the
                                     October 13 letter a chart entitled ‘‘Development of Average
                                     Health Care Cost Per Active Employee’’, which showed how
                                     WW arrived at its $5,877 assumption.
                                       WW’s October 13, 1997, ‘‘Present Value of Active Health
                                     Care Benefits Provided to Employees Hired as of 11/1/97’’
                                     calculations were as follows: 27
                                                                                                            Estimated present
                                                                                                           value retiree health
                                                              No. of     Avg.     Avg.                        care benefits
                                                                em-       at-    retire-     Active
                                                              ployees   tained    ment     health care    Active em-    Retired     Grand
                                                Location       today      age     age       benefits       ployees     employees     total

                                              Corporate         35       46        63      $3,792,243        -0-          -0-      $3,792,243
                                              Heat treating     27       35        63       3,302,078        -0-          -0-       3,302,078
                                              MS–Michigan      112       45        63      12,469,349        -0-          -0-      12,469,349
                                              MS–Arkansas      120       42        63      13,796,098        -0-          -0-      13,796,098
                                              MS–General
                                                Office          30       47        63       3,142,329        -0-          -0-       3,142,329


                                       27 We note that the average attained age is actually 43.5. The discrepancy does not affect our

                                     analysis.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012     Frm 00038   Fmt 2847     Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                                  105


                                                                                                           Estimated present
                                                                                                          value retiree health
                                                             No. of     Avg.     Avg.                        care benefits
                                                               em-       at-    retire-     Active
                                                             ployees   tained    ment     health care    Active em-    Retired     Grand
                                                Location      today      age     age       benefits       ployees     employees     total

                                              Nitro Steel      13       46        63       1,337,608        -0-          -0-       1,337,608

                                                Total         337       43        63      37,839,705        -0-          -0-      37,839,705


                                        At various times from approximately a week or two after
                                     receiving the October 13 report through early 1999, Royce
                                     asked WW to change its present value calculations to, for
                                     example, (1) include the MS–Arkansas nonunion hourly
                                     information in the present value calculation, (2) change the
                                     lifetime until retirement projection to a 15-year projection for
                                     estimated present value, and (3) exclude the Heat Treating
                                     and Nitro Steel Divisions in the groups of employees.
                                           G. Patrick Wannell
                                           1. Background
                                       Patrick Wannell is a chartered engineer and an Institution
                                     of Metallurgists fellow. He received his formal education and
                                     professional training in England, and he worked for approxi-
                                     mately 20 years primarily in technical positions for a large
                                     integrated steel company in England. He later joined LaSalle
                                     in the summer of 1980 and was given a range of manage-
                                     ment responsibilities. He became LaSalle’s vice president and
                                     general manager in May 1991, and he worked in that
                                     capacity until he retired in February 1997. After LaSalle was
                                     sold in April 1997, Wannell consulted for LaSalle’s new
                                     owners for approximately one year to help them understand
                                     LaSalle’s operations, and he performed one other consulting
                                     project for Quanex, primarily reviewing documents related to
                                     the sale for accuracy. Neither consulting project dealt with
                                     medical expenses.
                                           2. Wannell and Health Care Costs at LaSalle
                                        While working for LaSalle, Wannell believed that the busi-
                                     ness was ‘‘clearly struggling’’ because it was breaking even
                                     financially. He reviewed the business and concluded that
                                     LaSalle’s health care costs were high in relation to those of
                                     other Quanex divisions and were rising annually by approxi-
                                     mately 30%. He formed a two-step approach to reduce
                                     LaSalle’s health care costs. First, he renegotiated the health




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012    Frm 00039   Fmt 2847     Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     106                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     care contract for LaSalle’s hourly employees because it did
                                     not require an employee payment. Second, he developed a
                                     wellness program that looked at the causes of employees’ ill-
                                     nesses rather than the employees’ symptoms. The wellness
                                     program addressed issues (such as weight, diet, exercise,
                                     stress, and smoking) through, among other things, annual
                                     physicals, exercise facilities, and subsidized health club mem-
                                     berships. When Wannell retired, LaSalle had approximately
                                     450 employees, and LaSalle’s health care costs were
                                     declining by approximately 10% per year.
                                           3. Quanex’s Offer to Wannell
                                       Rose had known Wannell since 1982 and was familiar with
                                     his efforts to control health care costs at LaSalle. By letter
                                     dated October 13, 1997, Rose asked Wannell to join QHMC’s
                                     board as a director. The letter stated:
                                     We are establishing a company to manage our health care benefits and
                                     selling a minority interest to a benefits management consulting firm. We
                                     believe giving the consulting firm an equity interest will be an extra incen-
                                     tive for them to come up with creative and innovative strategies in health
                                     care management. Since this is a new concept we will start small and try
                                     this out on Corporate and MACSTEEL salaried employees health benefits
                                     only. * * *

                                     Further, the letter stated, Quanex wanted Wannell to join
                                     QHMC’s board because

                                     We need your knowledge and experience in the areas of labor relations,
                                     negotiations, employee management, and morale. This company will man-
                                     age the health care benefits of employees. We want it to be efficient as pos-
                                     sible but also fair to the employees it will effect [sic]. We need an outside
                                     director who will bring a balance to the discussion and consider all points
                                     of view, not just those of * * * [QHMC] or * * * [CS].

                                       On or about October 20, 1997, after the negotiations
                                     between Quanex and CS were completed, Wannell spoke
                                     with Rose by telephone. During that call, Rose offered
                                     Wannell the opportunity to invest $11,000 in QHMC. Peery,
                                     Quanex’s vice president of human resources, did not know
                                     that Rose was inviting Wannell to participate in QHMC, and
                                     Peery was not asked for his advice or recommendation on
                                     individuals who might be interested in participating.
                                       Wannell expressed concern that he would have to incur
                                     travel and hotel costs for QHMC board meetings, but Rose




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00040   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                     107


                                     assured Wannell that the costs would be reimbursed,
                                     meetings would be minimal, and Wannell could vote by fax.
                                     Rose also informed Wannell that although the term of the
                                     investment would be 15 years, the parties could unwind the
                                     investment in either 5 or 7 years. Wannell made handwritten
                                     notes during the call that expressed, in part, his under-
                                     standing of the worst case scenarios for his offered invest-
                                     ment. Under the heading ‘‘worst case’’, Wannell made three
                                     entries: ‘‘9.5%/yr’’, which reflected his understanding of the
                                     annual dividend he would receive; ‘‘no loss of $11,000’’, which
                                     reflected his understanding that he would not lose his invest-
                                     ment; 28 and ‘‘+ 25% over 5 yrs’’, which reflected his under-
                                     standing that his investment would grow 5% each year to the
                                     five-year point where Quanex could wind things up. 29
                                        Wannell accepted Rose’s October 20, 1997, offer to invest
                                     in QHMC the same day. The terms of Wannell’s investment
                                     were set by Quanex, without any negotiations between
                                     Quanex and Wannell. Wannell viewed the dividend pay-
                                     ments as approximately equivalent to consultant fees for his
                                     time and the five-year, total $25 per share return on his $100
                                     per share investment as equivalent to what he was earning
                                     in his bank account. Wannell understood that QHMC’s credit
                                     risk was minimal because it was a subsidiary of Quanex.
                                           H. D&T’s Revised Cashflow Model
                                       D&T prepared revised cashflow calculations for Quanex for
                                     the proposed transactions and gave them to Royce in a docu-
                                     ment entitled ‘‘Cash Flow Model as of 10/21/97’’ (October 21
                                     calculations). The purpose of these calculations was to model
                                     the liabilities QHMC would need to satisfy, the payments
                                     QHMC would be obligated to make, and the income QHMC
                                     would need to pay the liabilities. The calculations also were
                                     needed to set the reported fair market value of QHMC’s stock.
                                       Within the October 21 calculations, D&T estimated the
                                     present value for the medical costs associated with Quanex’s
                                     corporate, MS–Arkansas, MS–General Office, and Nitro Steel
                                     locations to total $37,320,000, as determined as follows:
                                       28 In contradiction to his notes, Wannell testified that he did not consider the risk to be zero

                                     that he would lose his $11,000 investment. We do not find this testimony to be credible, and
                                     we decline to rely upon it.
                                       29 If the class C shares were redeemed after five years for $125 per share, the holders of each

                                     share would receive $25 more than the $100 initially paid to purchase the share, which averages
                                     to $5 per year or 5% of $100 for each of the five years.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00041   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     108                  139 UNITED STATES TAX COURT REPORTS                                              (67)


                                                                                Grand                               Employees
                                                                                 total           Cashflows            as of
                                                        Location                of PV              1997             10/21/97

                                                  Corporate                  $3,496,000          $420,000                    35
                                                  MS–Arkansas                11,051,000            86,000                    27
                                                  MS–Arkansas                18,421,000           470,000                   112
                                                  MS–General
                                                    Office                      3,062,000          457,000                  120
                                                  Nitro Steel
                                                    Division                    1,290,000          128,000                  30

                                                     Total                   37,320,000         1,561,000                   324

                                     D&T also projected that for all years of the investment, other
                                     than the first year, medical costs would exceed the interest
                                     income from the $38 million note receivable but, taking into
                                     account the principal repayments, cashflow would be avail-
                                     able to equity holders for the first seven years of the invest-
                                     ment and NOLs would accumulate in years 2 through 6 of the
                                     investment. D&T also projected positive net present value of
                                     the cashflows. Relying on these factors and others, D&T pro-
                                     jected that the total value of equity for all classes of QHMC
                                     stock would equal $76,000, as determined as follows:
                                            Total PV of cashflows ......................................................      $879,000
                                            Plus cash on hand ...........................................................       65,000
                                            Less uncertainty of future medical costs adjustment ...                           (868,000)

                                            Equals total value of equity ............................................             76,000

                                       Within the October 21 calculations, D&T also projected liq-
                                     uidation and net return values with respect to QHMC’s pre-
                                     ferred stock. D&T projected that if the five-year call option
                                     was exercised and a five-year cumulative savings of
                                     $1,622,959 was assumed, the liquidation value of the class B
                                     and class C stocks would be $356,441 and the net return on
                                     investment for the underlying shareholders would be
                                     $348,566. D&T projected that if the seven-year put option
                                     was exercised and a seven-year cumulative savings of
                                     $2,430,142 was assumed, the liquidation value of the class B
                                     and class C stocks would be $565,998 and the net return on
                                     investment for the underlying shareholders would be
                                     $560,973. D&T also made cumulative savings projections for
                                     1998 through 2012 as follows (in thousands):




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897    PO 20012   Frm 00042   Fmt 2847    Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
VerDate Nov 24 2008
09:57 Jun 05, 2014
                                                                                                                                                                                                                              (67)




Jkt 372897
PO 20012
                                                                                       1998     1999     2000     2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012




Frm 00043
                                                               Initial undiscounted
                                                                 MPBs                  $2,793   $3,017   $3,245   $3,473   $3,701   $3,927   $4,145   $4,358   $4,569   $4,792   $5,025   $5,270   $5,527   $5,797   $6,081
                                                               Actual MPBs              2,514    2,715    2,921    3,126    3,331    3,534    3,731    3,922    4,112    4,312    4,523    4,743    4,975    5,217    5,473




Fmt 2847
                                                               Yearly savings             279      302      325      347      370      393      415      436      457      479      503      527      553      580      608
                                                               Aggregate yearly cum.
                                                                 savings                 279      581      905     1,253    1,623    2,016    2,430    2,866    3,323    3,802    4,305    4,832    5,384    5,964    6,572




Sfmt 2847
                                                                                                                                                                                                                              GERDAU MACSTEEL, INC. v. COMMISSIONER
                                                                                                                                                                                                                              109




V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG
JAMIE
                                     110                 139 UNITED STATES TAX COURT REPORTS                                       (67)


                                     The projections assumed a 10% variance factor and 324 cov-
                                     ered plan participants per year.
                                       D&T also included in its October 21 calculations a section
                                     entitled ‘‘Analysis of NOL Usage’’ for 1998 through 2004. D&T
                                     included this section to show Quanex the amount of NOLs
                                     that QHMC would generate but that the Quanex consolidated
                                     group could not use if QHMC were deconsolidated. The NOL
                                     projections assumed a 6% risk-free rate and a 40% tax rate
                                     and were as follows (in thousands):
                                                                    1998       1999    2000        2001       2002     2003      2004

                                      NOL generated                  -0-       $276        $622    $976       $1,339   $1,710   $2,086
                                      NOL carryforward               -0-        276         897    1,873       3,213    4,923    7,009
                                      PV of annual NOL
                                       tax benefit                   -0-         98        209          309     400       482      555
                                      Cumulative PV of
                                       NOL benefits
                                       (as rounded)
                                       at the end of
                                       year 7                                                                                     2,054

                                       At a time not disclosed in the record, Royce reviewed the
                                     October 21 calculations. Royce subsequently requested new
                                     calculations from both D&T and WW. Royce testified at trial
                                     that the October 21 cashflow model used the wrong groups
                                     of employees and assigned the wrong numbers of employees
                                     to those groups.
                                     XI. Executing QHMC Transactions
                                           A. Quanex’s October 21–22, 1997, Board Meeting
                                       On October 21 and 22, 1997, Quanex’s board held a regular
                                     meeting which addressed, in part, the QHMC transactions.
                                     The meeting was attended by Quanex’s board members and,
                                     among others, Peery, Rose, James Davis, and Michael
                                     Conlon. Davis was Quanex’s executive vice president and
                                     chief operating officer (COO) from 1997 through February
                                     1999 and Quanex’s president and COO from March 1999
                                     through December 2000. Conlon was an attorney with Ful-
                                     bright & Jaworski, LLP (Fulbright).
                                       At the board meeting, Rose explained the venture, which
                                     the meeting minutes described as
                                     a proposal to establish one of the Company’s subsidiaries as the holder of
                                     all rights and obligations of the medical plan benefits for the Company’s
                                     active salaried employees at its corporate offices in Houston and within the




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00044    Fmt 2847    Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    111


                                     MacSteel Group * * * and to enter into a relationship with a professional
                                     health plan advising firm, * * * [CS], to create incentives to reduce the
                                     overall health plan costs to the Company.

                                     Rose provided materials to Quanex’s board through which
                                     the participants of the meeting discussed the general nature
                                     of the proposed transactions and the various resolutions
                                     needed to implement them.
                                        Under the proposed resolutions, Quanex would effect the
                                     QHMC transactions through a series of steps, each of which
                                     was part of a single plan, and all of which Rose considered
                                     interrelated. These steps were as follows:
                                        (1) designate QS and QW as restricted subsidiaries under
                                     the Quanex $250,000,000 revolving credit and term loan
                                     agreement dated July 23, 1996, as amended (revolving credit
                                     agreement); 30
                                        (2) ratify the actions of Quanex’s officers in amending the
                                     revolving credit agreement to provide for the designation of
                                     certain subsidiaries as restricted subsidiaries if Quanex
                                     owned an interest in the subsidiary of as little as 60%;
                                        (3) approve, as QW’s sole shareholder, QW’s plan of
                                     recapitalization, which provided for authorization of stock in
                                     the form of the class A stock, the class B stock, and the class
                                     C stock;
                                        (4) approve and adopt QW’s amended and restated certifi-
                                     cate of incorporation, by which QW changes its name to
                                     ‘‘Quanex Health Management Company, Inc.’’ and changes
                                     its authorized capital as described in the plan of recapitaliza-
                                     tion;
                                        (5) approve and acknowledge that as a result of QW’s
                                     recapitalization, the 1,000 shares of QW common stock that
                                     Quanex held would be converted to 500 shares of class A
                                     stock and 130 shares of class B stock;
                                        (6) make a $62,000 capital contribution to QW in anticipa-
                                     tion of QW’s recapitalization;
                                        (7) assign all of its rights, duties, and obligations relating
                                     to approximately $37,989,000 of selected MPBs to QS;
                                        30 In this context, a restricted subsidiary is a Quanex subsidiary that guarantees a debt of

                                     Quanex and consolidates its funds with those of Quanex in accordance with Quanex’s revolving
                                     credit agreement. Royce believed that QHMC had to be a restricted subsidiary of Quanex to par-
                                     ticipate in the transactions. QHMC eventually (on a date not disclosed in the record) guaranteed
                                     the obligations of Quanex pursuant to the revolving credit agreement.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00045   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     112                     139 UNITED STATES TAX COURT REPORTS                                    (67)


                                       (8) transfer $38 million and assign its rights, duties, and
                                     obligations relating to all the selected MPBs in exchange for
                                     1 share of common stock and the assumption of the duties
                                     and obligations under the MPBs;
                                       (9) enter into an assignment and assumption of liabilities
                                     agreement with QS under which rights related to MPBs
                                     would be assigned to QS and related duties and obligations
                                     would be assumed by QS;
                                       (10) enter into a consulting agreement with CS pursuant
                                     to which CS would agree to assist Quanex in evaluating and
                                     implementing cost-saving strategies with respect to health
                                     care plans for the benefit of certain employees of Quanex for
                                     an hourly fee, and Quanex would agree to sell to CS an
                                     equity interest in QHMC, with Quanex having the right to
                                     purchase from CS the shares representing the equity interest
                                     after five years and CS having the right to sell those shares
                                     to Quanex or QHMC after seven years at a price calculated on
                                     the basis of a formula value but not less than $125 per share;
                                       (11) sell its 130 shares of class B stock that it would hold
                                     as a result of the recapitalization of QHMC to CS for a
                                     $13,000 cash payment;
                                       (12) enter into a stock purchase agreement between
                                     Quanex and CS with respect to its proposed sale of the class
                                     B stock to CS;
                                       (13) upon its sale of the class B stock to CS, enter into a
                                     shareholders agreement among QHMC, CS, and Quanex pro-
                                     viding for restrictions on the disposition of QHMC stock, and
                                     agree, as the holder of the class A stock, to provide QHMC
                                     with additional capital to pay for any forecasted cash short-
                                     falls, as determined by QHMC’s board;
                                       (14) upon issuance of QHMC’s class C stock to QS and CS,
                                     enter into a first amendment to shareholders agreement to
                                     reflect additional stock issuances; and
                                       (15) upon QS’ subsequent sale of the class C stock to
                                     another investor, enter into an amended and restated share-
                                     holders agreement to reflect the additional investor.
                                       Also at the meeting, Rose explained the tax benefits of the
                                     transactions to Quanex’s board, informing the board that the
                                     transactions would generate a large artificial capital loss. 31
                                     On October 22, 1997, Quanex’s board unanimously approved
                                           31 Rose   knew that the loss was not an actual economic loss.




VerDate Nov 24 2008   09:57 Jun 05, 2014     Jkt 372897    PO 20012   Frm 00046   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    113


                                     all of the proposed resolutions. As of that time, Quanex
                                     intended to sell the class C stock to Wannell.
                                           B. October 23, 1997
                                           1. QW Recapitalization
                                       Before October 17, 1997, QW was a Delaware corporation
                                     that was an inactive, wholly owned subsidiary of Quanex.
                                     QW had assets of $1,000 in cash, no liabilities, and 1,000
                                     outstanding shares of capital stock. On October 17, 1997,
                                     Quanex wired $62,000 into QW’s account at Comerica Bank
                                     in anticipation of QW’s recapitalization.
                                       Six days later, on October 23, 1997, Quanex approved
                                     QW’s plan of recapitalization, and QW was recapitalized.
                                     Under that plan of recapitalization, QW was authorized to
                                     issue 760 shares of capital stock, of which 500 shares were
                                     class A stock, 130 shares were class B stock, and 130 shares
                                     were class C stock. All 760 shares had a par value of $100.
                                     Under the plan of recapitalization, Quanex, as record holder,
                                     was to receive 0.5 share of class A stock and 0.13 share of
                                     class B stock for each share of QW common stock that
                                     Quanex held before the recapitalization.
                                       Also on October 23, 1997, QW’s board unanimously con-
                                     sented to the plan of recapitalization. QW’s directors were
                                     Rose, Peery, and Vernon Oechsle. Oechsle was Quanex’s
                                     president and chief executive officer (CEO) from 1997 through
                                     February 1999, Quanex’s CEO from March 1999 through Feb-
                                     ruary 2001, Quanex’s vice president from March through
                                     July 2001, and Quanex’s corporate initiatives executive from
                                     August 2001 through May 2002.
                                           2. Amendment and Restatement of QW’s Certificate of
                                               Incorporation
                                           a. Background
                                        Also on October 23, 1997, QW was renamed QHMC
                                     (incident to the recapitalization) and its certificate of incorpo-
                                     ration was amended and restated (certificate) to provide for
                                     the three classes of stock. 32 The certificate set forth rights
                                       32 We hereinafter refer to QW as QHMC with respect to events that occurred after the name

                                     change.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00047   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     114                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     on dividends, liquidation preferences, voting, and the right to
                                     call or put shares.
                                           b. Dividend Rights
                                        Under the certificate, QHMC’s board generally could declare
                                     dividends on class A stock as it deemed appropriate. As one
                                     exception, a dividend could not be declared or paid on the
                                     class A stock during any period when QHMC failed to pay a
                                     dividend on the class B or class C stock for any preceding
                                     quarter. The class B and class C shareholders were entitled
                                     to receive from QHMC’s surplus or net profits, when and as
                                     declared by QHMC’s board, cash dividends of $9.50 per share
                                     per annum, payable quarterly. The cash dividends for the
                                     class B stock were cumulative and payable for the current
                                     year and for all previous fiscal years during which any class
                                     B stock was outstanding (and applicable quarters thereof).
                                     The same was true for the class C stock when any class C
                                     stock was outstanding. If QHMC’s available funds were
                                     insufficient to pay the dividends on the class B or class C
                                     stock, then the class B and class C shareholders would share
                                     ratably in the amount available for payment in proportion to
                                     the full dividend payment to which they were otherwise enti-
                                     tled. The class B and class C shareholders were not entitled
                                     to receive any dividends or share of profits, whether payable
                                     in cash, stock, or property, in excess of these dividends.
                                           c. Preferences Upon Liquidation
                                        If Quanex was liquidated, class A shareholders were enti-
                                     tled, after payment of all liabilities, and subject to the liq-
                                     uidation preferences of the class B and class C stocks, to
                                     receive QHMC’s assets on the basis of the number of shares
                                     held. The liquidation preferences of class B shareholders
                                     were as follows:
                                     In the event of liquidation, dissolution, or winding up [collectively, liquida-
                                     tion] of the Company, whether voluntary or involuntary, the holders of the
                                     issued and outstanding Class B Voting Preferred Stock shall be entitled to
                                     receive out of the assets of the Company legally available for distribution
                                     to stockholders and before any distribution to the holders of the Class A
                                     Common Stock liquidation distributions in an amount equal to the greater
                                     of (i) $125 for each share or (ii) the Formula Value * * * for each share,
                                     plus all accrued but unpaid dividends thereon to the date fixed for redemp-
                                     tion. After payment of the full amount of the liquidating distributions to




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00048   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    115


                                     which they are entitled, the holders of shares of Class B * * * Stock will
                                     have no right or claim to any of the remaining assets of the Company.

                                     Class C shareholders had the same rights as those provided
                                     to class B shareholders.
                                       The certificate defined the formula value (formula value)
                                     as the lesser of:
                                     (a) 45% of (i) the sum of the savings or deficiency of the Initial
                                     Undiscounted Medical Plan Benefits (‘‘IUMPB’’ * * *) over the Actual
                                     Medical Plan Benefits (‘‘AMPB’’ * * *) for each completed fiscal year, com-
                                     mencing with the fiscal year ending October 31, 1998, divided by (ii) the
                                     total number of outstanding shares of Class B Voting Preferred Stock and
                                     Class C Voting Preferred Stock on the applicable date of the event of liq-
                                     uidation, dissolution or winding up of the company, or (b) 50% of the net
                                     equity shown on the books and records of the Company as of the calendar
                                     month immediately preceding that date (as determined in accordance with
                                     generally accepted accounting principles). * * *

                                     The certificate defined ‘‘AMPBs’’ as the actual medical plan
                                     benefits paid by QHMC to participants in medical benefit
                                     plans that QHMC managed during the applicable fiscal year
                                     and ‘‘IUMPBs’’ as the medical plan benefits as computed for
                                     purposes of the net present value of the expected cashflows
                                     of QHMC as of October 31, 1997, determined in accordance
                                     with the cashflow model used by D&T to value QHMC on
                                     October 31, 1997. 33 The certificate stated that the savings or
                                     deficiency of the IUMPB over the AMPB would be determined
                                     for each of QHMC’s fiscal years and computed as follows:
                                     (A) The difference between (a) an amount (which may be a positive or a
                                     negative number) equal to (i) the IUMPB divided by the number of the
                                     assumed covered plan participants, reduced by (ii) the AMPB for the
                                     applicable fiscal year divided by the number of the actual covered plan
                                     participants for that year, multiplied by (b) the number of actual covered
                                     plan participants for that year, and (B) the amount of consulting fees paid
                                     or accrued by the Company during the applicable fiscal year. * * *

                                       The certificate also stated that the formula value would be
                                     zero if the formula value of the total number of shares of the
                                     class B and class C stock was less than zero, or if the date
                                     of liquidation occurred before October 31, 1998. The certifi-
                                     cate also stated that upon QHMC’s liquidation, the class B
                                     and class C shareholders would share ratably in any dis-
                                       33 Quanex would bear all medical costs in excess of these benchmark amounts; i.e., the QHMC

                                     preferred shareholders would never bear these costs.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00049   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     116                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     tribution of assets in proportion to the full liquidating dis-
                                     tributions to which they would otherwise be entitled if
                                     QHMC’s available assets were insufficient to pay the liquida-
                                     tion distributions on all outstanding shares of class B and
                                     class C stock.
                                           d. Voting Rights
                                       Under the certificate, each share of QHMC stock entitled
                                     the holder to one vote in all proceedings in which action
                                     might be taken by the QHMC shareholders. If any share of
                                     class B or class C stock was issued and outstanding, class A
                                     shareholders had the right to elect six directors of the com-
                                     pany, class B shareholders had the right to elect two direc-
                                     tors, who would be designated class B directors, and class C
                                     shareholders had the right to elect one director, who would
                                     be designated a class C director. Class A shareholders had
                                     the right to elect all of QHMC’s directors if no class B or class
                                     C shares were issued and outstanding.
                                           e. Call Rights
                                       The certificate did not provide any redemption rights for
                                     class A stock. The certificate did provide redemption rights
                                     for the class B and the class C stocks, and these rights were
                                     the same for both classes. At any time after September 30,
                                     2002, QHMC could redeem any or all shares of class B and
                                     class C stocks by paying cash equal to the greater of (i) $125
                                     per share or (ii) the formula value per share, plus an amount
                                     equal to all distributions accrued and unpaid thereon to the
                                     date fixed for redemption. For this purpose, any reference in
                                     the formula value to the ‘‘date of liquidation, dissolution or
                                     winding up of the Company’’ would be replaced with a ref-
                                     erence to the ‘‘Notice Date’’.
                                           f. Put Rights
                                       The certificate did not provide any put rights for class A
                                     shareholders. The certificate did provide put rights for the
                                     class B and class C stocks, and these rights were the same
                                     for both classes. After September 30, 2004, each holder of
                                     class B or class C stock could require QHMC to purchase from
                                     the holder all or any portion of the shares of class B stock
                                     or class C stock at a cash price equal to the greater of (i)




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00050   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    117


                                     $125 per share or (ii) the formula value per share, plus an
                                     amount equal to all distributions accrued and unpaid thereon
                                     to the put date. For this purpose, any reference in the for-
                                     mula value to the ‘‘date of liquidation, dissolution or winding
                                     up of the Company’’ would be replaced with a reference to
                                     the ‘‘Put Date’’.
                                           3. Quanex’s Transfer of QW Stock and Cash to QHMC in
                                              Exchange for Class A and Class B Stocks and Election
                                              of Directors
                                        On October 23, 1997, Quanex transferred the $62,000 that
                                     was previously wired into QW’s bank account and 1,000
                                     shares of QW common stock to QHMC in exchange for 500
                                     shares of class A stock and 130 shares of class B stock. Also
                                     on October 23, 1997, Quanex, as QHMC’s sole class A and
                                     class B shareholder, elected Oechsle, Peery, Rose, Parikh,
                                     Wannell, and Carolyn Babb 34 as QHMC’s class A directors,
                                     and Gary Hellner and Bewley as QHMC’s class B directors.
                                     Also on October 23, 1997, Hellner and Bewley informed
                                     QHMC they were resigning effective the same day, doing so
                                     through a one-page document that apparently had been
                                     typed for each of them simply to sign and to date. The text
                                     of each document contained a single sentence which stated:
                                     ‘‘The undersigned hereby resigns as a Class B director of
                                     Quanex Health Management Co., Inc., a Delaware corpora-
                                     tion, such resignation to be effective as of the date set forth
                                     under my signature below.’’
                                           4. Quanex’s Transfer of Cash and MPB Obligations to QS
                                              in Exchange for QS Stock
                                       QS was incorporated in 1990 as a wholly owned subsidiary
                                     of Quanex, and QS remained as such until October 23, 1997.
                                     Before October 23, 1997, QS was an inactive corporation and
                                     had assets of $1,000 in cash, no liabilities, and 1,000 shares
                                     of outstanding capital stock. Under QS’ certificate of incorpo-
                                     ration, dated August 7, 1990, QS was authorized to issue
                                     10,000 shares of common stock.
                                        34 Babb was Quanex’s compensation and benefits manager from 1997 through July 1999, and

                                     she was Quanex’s compensation and benefits director from August 1999 through the time of
                                     trial.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00051   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     118                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                        As of October 23, 1997, in exchange for 1 share of QS cap-
                                     ital stock, Quanex transferred $38 million to QS and
                                     assigned to QS certain obligations relating to certain MPBs.
                                     Under an exchange agreement bearing the same date,
                                     Quanex and QS agreed to treat the exchange as one
                                     described in, and qualifying for nonrecognition treatment
                                     under, section 351. Parikh, as Quanex’s corporate controller
                                     and as QS’ vice president and treasurer, signed the Quanex-
                                     QS exchange agreement on behalf of both parties. 35
                                        The transferred MPBs were health care benefits provided
                                     under the plan, and they represented the future medical
                                     costs of active Quanex employees working in selected groups
                                     during the 15-year period beginning November 1, 1997, and
                                     ending October 31, 2012. An assignment and assumption of
                                     liabilities agreement executed between Quanex and QS on
                                     October 23, 1997, and signed by Rose on behalf of both
                                     Quanex and QS, described the transferred obligations as
                                     ‘‘relating to those MPB’s computed for purposes of the net
                                     present value of the expected cashflows of Assignee [QS] as
                                     of October 31, 1997, determined in accordance with the cash
                                     flow model which was used by Deloitte & Touche LLP to
                                     value the Assignee [QS] on such date’’.
                                           C. October 24, 1997
                                           1. Consulting Agreement Between Quanex and CS
                                        Quanex and CS entered into a consulting agreement dated
                                     October 24, 1997 (consulting agreement). Under the con-
                                     sulting agreement, CS agreed to review the costs and bene-
                                     fits of the health care plans that Quanex maintained and
                                     administered for the benefit of the active salaried employees
                                     from Quanex’s Corporate, MS–General Office, and MS–
                                     Michigan locations, and both active salaried and nonunion
                                     hourly employees from MS–Arkansas, and to recommend,
                                     among other things, ‘‘several * * * potential cost saving
                                     strategies (‘Strategies’) for the Plans, the implementation of
                                     which could result in substantial cost savings to Quanex.’’
                                     Quanex and CS also agreed that it would be in their respec-
                                     tive best interests to provide CS a means of compensation
                                       35 Approximately four years later, on February 20, 2001, QS’ board of directors, consisting

                                     solely of Oechsle and Terry M. Murphy, ratified the actions that QS’ corporate officers took to
                                     execute the exchange agreement and to issue the share of QS stock.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00052   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                  GERDAU MACSTEEL, INC. v. COMMISSIONER                                           119


                                     that (1) took into consideration the potential value added by
                                     CS’ services in the successful implementation of the cost
                                     saving strategies, (2) gave CS a voice in QHMC’s management,
                                     and (3) required CS to maintain a financial risk in QHMC.
                                     Under the consulting agreement, Quanex thus agreed to hire
                                     CS to assist Quanex
                                     in evaluating and implementing the Strategies, including, but not limited
                                     to reviewing, analyzing, and making recommendations regarding the
                                     Strategies and other relevant cost-savings measures, advising Quanex
                                     regarding the operational, organizational and governance aspects of the
                                     Company, serving on the board of directors of the Company, negotiating
                                     with third-party administrators, assisting in the request for proposal
                                     (‘‘RFP’’) process with potential outside vendors, claims administration,
                                     enrollment, benefits coordination, and any other services as requested from
                                     time to time by Quanex during the term of this Agreement.

                                       Pursuant to the consulting agreement, CS was entitled to
                                     consulting fees in accordance with CS’ benefits consulting fee
                                     schedule, but in no case more than $250 per hour, plus
                                     reasonable out-of-pocket costs actually incurred. The con-
                                     sulting agreement also entitled CS to buy ‘‘more than a 20%
                                     limited equity interest’’ in QHMC from Quanex, QHMC’s sole
                                     shareholder as of the time of the consulting agreement, sub-
                                     ject to CS’ entering into a shareholder agreement with
                                     Quanex. The consulting agreement further stated that in the
                                     event the put or call rights described in the certificate were
                                     exercised, the price CS would be paid for the equity interest
                                     would equal the greater of $125 per share or the formula
                                     value.
                                       Although CS executed a consulting agreement with
                                     Quanex, 36 no such agreement was executed between CS and
                                     QHMC between 1997 and 2002. Before October 31, 1997,
                                     Howard did not receive requests from Quanex for advice on
                                     the QHMC project, see any WW reports for the QHMC proposal,
                                     or review any assumptions with respect to the proposal.
                                            2. CS’ Transfer of Cash to Quanex in Exchange for Class
                                               B Stock
                                       Before October 23, 1997, Quanex offered CS the oppor-
                                     tunity to purchase (1) 130 shares of the class B stock from
                                     Quanex for $13,000 and (2) 20 shares of the class C stock
                                           36 CS   was still responsible for negotiating Quanex’s HMO contracts as of the time of trial.




VerDate Nov 24 2008   09:57 Jun 05, 2014     Jkt 372897    PO 20012   Frm 00053   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     120                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     from QHMC for $2,000. Chapman did not consider the $15,000
                                     cost for the QHMC stock ($13,000 for class B stock plus $2,000
                                     for class C stock) to be a material amount of money for CS.
                                        On October 24, 1997, CS purchased 130 shares of class B
                                     stock from Quanex for $13,000, 37 and Quanex and CS signed
                                     a stock purchase agreement of the same date. That agree-
                                     ment described the class B stock the same way the class B
                                     rights were described in the certificate and included a copy
                                     of the certificate as an attachment thereto.
                                        Quanex, QHMC, and CS also entered into a shareholders’
                                     agreement dated October 24, 1997 (October 24 share-
                                     holders’ agreement). Parikh executed the October 24 share-
                                     holders’ agreement as Quanex’s controller and as QHMC’s vice
                                     president and treasurer. John Micale, who as of the time of
                                     trial had been a CS employee for approximately five years,
                                     signed the agreement as CS’ president and COO.
                                        Under the October 24 shareholders’ agreement, Quanex
                                     and CS agreed that they would not transfer their QHMC stock
                                     or permit it to be transferred without the express written
                                     consent of all QHMC shareholders. Quanex also agreed that,
                                     as the holder of QHMC’s class A stock, it was subject to
                                     assessment for capital calls as determined by QHMC’s board,
                                     and it acknowledged that ‘‘The Board shall assess the holders
                                     of shares of Class A Common Stock in the event that the
                                     Board determines that * * * [QHMC] will have a Forecasted
                                     Cash Shortfall for any calendar quarter.’’ The October 24
                                     shareholders’ agreement defined a ‘‘Forecasted Cash Short-
                                     fall’’ as ‘‘the excess, if any, of forecasted cash expenditures
                                     (including a reasonable reserve for future expenditures and
                                     dividends on the Class B Voting Preferred Stock and Class
                                     C Voting Preferred Stock, as determined by the Board) over
                                     forecasted cash receipts, determined with respect to any cal-
                                     endar quarter.’’ No such provision was made with respect to
                                     class B or class C shareholders.
                                        The October 24, 1997, QHMC stock purchase was the first
                                     time CS acquired an equity interest in a client. Chapman
                                     believed that CS’ participation in the QHMC transactions
                                       37 Because of Singer’s concerns regarding deconsolidation, Singer structured the QHMC trans-

                                     actions so that Quanex’s interest in QHMC and Quanex’s voting power with respect to QHMC
                                     would be less than 80%. Accordingly, on October 24, 1997, the date CS purchased the class B
                                     stock from Quanex, QHMC ceased to be a member of petitioners’ affiliated group for Federal
                                     income tax purposes.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00054   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    121


                                     would both continue and expand CS’ consulting relationship
                                     with Quanex and give CS the potential to earn fee-based rev-
                                     enue.
                                           3. Class B Directors
                                      On October 24, 1997, CS (through Micale)                                              elected
                                     Chapman and Micale as QHMC’s class B directors.
                                           D. October 25, 1997
                                           1. CS’ Transfer of Cash to QHMC in Exchange for Class C
                                              Stock
                                       As of October 25, 1997 (a Saturday), CS contributed $2,000
                                     to QHMC in exchange for 20 shares of class C stock. CS was
                                     not involved in setting the price of the class C stock (or the
                                     class B stock). Although CS purchased both class B and class
                                     C stocks, it made no difference to CS which class of preferred
                                     stock it acquired.
                                           2. QS’ Transfer of Cash and MPBs to QHMC in Exchange
                                              for Class C Stock
                                       Also as of October 25, 1997, QS contributed $38 million to
                                     QHMC,   and by an assignment and assumption of liabilities
                                     agreement dated October 25, 1997 (QS–QHMC assignment
                                     and assumption agreement), QS assigned to QHMC the MPBs
                                     Quanex had assigned to QS by agreement dated October 23,
                                     1997. Parikh, as vice president and treasurer of each entity,
                                     signed the QS–QHMC assignment and assumption agreement
                                     on behalf of both QS and QHMC. An October 25, 1997,
                                     exchange agreement executed between QHMC and QS
                                     described the transferred MPBs as ‘‘certain medical plan
                                     benefits (MPB’s), being those MPB’s computed for purposes of
                                     the net present value of the expected cash flows of * * *
                                     [QHMC] as of October 31, 1997, determined in accordance
                                     with the cash flow model * * * which was used by [D&T]
                                     * * * to value [QHMC] on such date.’’ Quanex had not
                                     deducted the medical costs represented by the MPBs trans-
                                     ferred to QHMC. If Quanex had retained the MPBs, the MPBs
                                     would have been an expense of Quanex’s trade or business;
                                     and if Quanex had paid the MPBs as they were incurred,




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00055   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     122                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     Quanex could have deducted the payments as ordinary and
                                     necessary business expenses.
                                       In return for the cash and MPBs assumption, QS received
                                     from QHMC 110 shares of class C stock. Upon becoming a
                                     QHMC shareholder, QS signed a first amendment to share-
                                     holders’ agreement (amended shareholders’ agreement),
                                     dated October 25, 1997, through which QS agreed to become
                                     a party to the October 24 shareholders’ agreement. QHMC and
                                     QS also agreed to treat this exchange as one qualifying for
                                     nonrecognition treatment under section 351. The amended
                                     shareholders agreement was signed by Rose on behalf of QS,
                                     Quanex, and QHMC, as vice president of each entity, and by
                                     Micale as the president and COO of CS.
                                           3. MPB Selection
                                       The selected employee groups covered by the MPBs that
                                     QHMC transferred were the following active Quanex
                                     employees located at petitioners’ facilities:

                                                                                                                  No. of
                                               Location                           Group                         employees1
                                               Houston                     Corporate                                   37
                                               Arkansas                    MS–Salaried                                117
                                               Arkansas                    MS–Nonunion hourly                         249
                                               Michigan                    MS–General Office                           31
                                               Michigan                    MS–Salaried                                112

                                                  Total                                                               546
                                                 1 This column lists the number of active employees working
                                               in the identified groups as of October 1997. The actual num-
                                               ber of employees covered by the MPBs could fluctuate during
                                               the 15-year period that QHMC assumed the obligation to pay
                                               the MPBs.

                                     The identified employee groups were considered a part of
                                     Quanex’s core businesses and were nonunion when they were
                                     selected (although not all of Quanex’s nonunion employees
                                     were selected). The health benefits of Quanex’s union
                                     employees were subject to union contracts. Quanex could not
                                     unilaterally change the terms of the union contracts, which
                                     usually spanned 3 to 4 years, and Quanex’s primary oppor-
                                     tunity to reduce health care costs subject to those contracts
                                     was upon their renewal. Quanex was not so restrained
                                     regarding nonunion employees.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00056   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      123


                                        Both Royce and Rose were involved in the MPB selection
                                     process, 38 and Royce determined which groups’ MPBs would
                                     be included in QHMC on the basis of WW’s June 30, 1997,
                                     present value calculation. Peery, Quanex’s vice president of
                                     human resources, made no recommendation about which
                                     groups of employees should have their MPBs transferred to
                                     QHMC. Peery also made no specific recommendation
                                     regarding which types of health care benefits should be
                                     included in the QHMC transactions. Parikh also was not
                                     involved in selecting which employee groups would have
                                     their MPBs transferred to QHMC. The only Quanex employees
                                     who were notified that Quanex had assigned the designated
                                     health care benefit obligations to QHMC were the Quanex
                                     employees who worked on the QHMC transactions and the
                                     accounting therefor.
                                        Wannell, who was invited to participate in the QHMC trans-
                                     actions allegedly because of his experience managing
                                     LaSalle’s health care costs, also played no part in deciding
                                     which MPBs would be transferred to QHMC. No one asked
                                     Wannell for any recommendation specific to the MPB obliga-
                                     tions either before or after he agreed to invest in QHMC.
                                           4. Class C Director
                                      On October 25, 1997, QHMC’s class C shareholders elected
                                     Davis to be the class C director.
                                           E. October 28, 1997: QHMC’s Transfer of Cash to Piper in
                                              Exchange for Promissory Note
                                        On October 28, 1997, QHMC transferred the $38 million it
                                     received from QS to Piper, and Piper issued to QHMC a
                                     promissory note (Piper note) in return. 39 Piper promised in
                                     the Piper note to pay QHMC ‘‘the principal sum of Thirty-
                                     Eight million dollars ($38,000,000) together with interest on
                                     the unpaid principal balance from time to time remaining
                                     outstanding at an interest rate of seven and one-half percent
                                     (7 1⁄2%).’’ The Piper note provided that interest was due and
                                        38 Rose testified that he chose the transferred liabilities and that, rather than making a deci-

                                     sion about the amount of the liability Quanex was willing to transfer, he first decided which
                                     liabilities would be transferred to QHMC and then had WW assign a value to those liabilities.
                                     We do not find Rose’s testimony on this point credible, and we decline to rely upon it.
                                        39 Although Quanex contributed the $38 million to QS, which in turn contributed the $38 mil-

                                     lion to QHMC, Quanex wanted the use of that money and understood at the time of the con-
                                     tributions that the $38 million would be lent back to Quanex or to its affiliates.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00057   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     124                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     payable quarterly as it accrued and that the outstanding
                                     unpaid principal balance was due and payable in full on
                                     October 31, 2012, but let Piper prepay all or part of the note
                                     at any time without penalty. Rose signed the Piper note as
                                     Piper’s vice president.
                                        Also on October 28, 1997, QHMC’s board unanimously
                                     approved the loan to Piper pursuant to the terms and condi-
                                     tions of the Piper note. That loan was the first loan that
                                     QHMC ever made, and the interest on the loan was QHMC’s
                                     only source of income. Piper’s board of directors also
                                     approved the $38 million loan from QHMC. As of that date,
                                     Piper’s directors were Oechsle, Peery, and Rose.
                                        Singer understood that Quanex wanted to use the $38 mil-
                                     lion that was put into QHMC, but the $38 million was trans-
                                     ferred to Piper because Piper had a more immediate need for
                                     the cash than Quanex. Piper used the funds primarily for
                                     plant expansion, equipment purchases, and short-term debt
                                     reduction; Piper spent approximately $32.5 million in plant
                                     construction during TYE 1998.
                                           F. October 30, 1997: QS’ Transfer of Class C Stock to
                                              Wannell in Exchange for Cash
                                       On October 30, 1997, QS sold 110 shares of class C stock
                                     to Wannell for $11,000. Wannell did not negotiate the price
                                     of this stock, which according to a stock purchase agreement
                                     executed between QS and Wannell on October 30, 1997,
                                     retained the rights and attributes described in the certificate.
                                     Wannell, QHMC, Quanex, and CS executed an amended and
                                     restated shareholders’ agreement dated October 30, 1997, to
                                     reflect the substitution of Wannell for QS as a QHMC share-
                                     holder/investor.
                                       When Wannell purchased the QHMC stock, he understood
                                     that as a QHMC director he was expected to attend some
                                     QHMC board meetings and to contribute to the business
                                     between board meetings as appropriate. He also understood
                                     QHMC to be responsible for everything related to the costs of
                                     the employee medical expenses in the venture, including
                                     paying, managing, and reducing them, but he had only a
                                     vague idea of how QHMC would pay those costs. Wannell had
                                     no knowledge of QHMC’s assets, liabilities, or overall worth,
                                     and he did not know why put and call provisions were in his




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00058   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                     125


                                     stock arrangement. He also did not know why he had pur-
                                     chased the stock from QS, rather than directly from QHMC,
                                     and why he was offered preferred stock rather than common
                                     stock. The only choice Quanex gave Wannell in relation to
                                     his QHMC investment was whether to invest. 40
                                     XII. Posttransaction Activities
                                           A. D&T’s Draft Opinion
                                       On April 13, 1998, Singer delivered a 59-page unsigned
                                     draft opinion letter (draft opinion) to Quanex that provided
                                     D&T’s opinion on certain Federal income tax consequences of
                                     the QHMC transactions. The draft opinion was prepared
                                     under Singer’s supervision, and Singer told Quanex the draft
                                     was subject to final review although he believed it to be cor-
                                     rect. Singer included with the draft a cover letter that simi-
                                     larly stated that he hoped the draft was ‘‘the final draft of
                                     the opinion letter’’ but reaffirmed he was ‘‘awaiting final
                                     review approval from our Washington National Tax partner.’’
                                     The draft opinion was stamped ‘‘DRAFT’’ in large bold letters
                                     at the top of each of its 59 pages and was never finalized or
                                     signed by D&T.
                                       In the draft opinion, D&T reached the following conclu-
                                     sions:
                                     A. Deconsolidation. The sale of the Class B Voting Preferred Stock to
                                     Consultant [CS] should cause QHMC to break affiliation with Parent on
                                     the date of sale under section 1504.
                                     B. Tax Basis of Transferor’s QHMC Stock.
                                     1. Parent’s [Quanex’s] transfer of cash and the assignment of certain
                                     MPB’s to Transferor [QS] constitutes an exchange governed by section 351.
                                     Transferor’s transfer of cash to QHMC in exchange for QHMC Class C
                                     Voting Preferred Stock plus the assumption by QHMC of the MPB’s also
                                     constitutes an exchange governed by section 351. Accordingly, no gain or
                                     loss should be recognized by either Parent or Transferor on the transfers.
                                     Section 351(a).
                                     2. Transferor should have a basis for tax purposes in its QHMC Class C
                                     Voting Preferred Stock equal to the cash transferred to QHMC. Section
                                     358(a). Accordingly, the MPB’s, which will be assumed by QHMC, should
                                     not be taken into account in determining Transferor’s basis in the QHMC
                                     shares received in the section 351 exchange. Section 357(c)(3).
                                       40 Wannell testified that it was not certain when he purchased his stock in 1997 that he would

                                     exercise his redemption rights at the first opportunity. We do not find this testimony to be cred-
                                     ible, and we decline to rely upon it.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00059   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     126                  139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     C. Deductibility of Medical Payments to QHMC. The MPB’s assumed by
                                     QHMC in the section 351 exchanges described above more likely than not
                                     will be deductible by QHMC as medical expenses under section 162(a) or
                                     as capital expenditures under section 263, as appropriate, when they
                                     would otherwise be deductible under QHMC’s method of accounting. No
                                     income should be recognized by Parent (or any member of Parent’s affili-
                                     ated group) as a result of the payment by QHMC of the MPB’s.
                                     D. Transferor’s Loss on Sale of Shares. To the extent Transferor realized
                                     a loss in connection with the taxable sale of its shares of QHMC Class C
                                     Voting Preferred Stock to Investor, any such loss should be recognized in
                                     the year of sale.

                                     D&T cited various Code sections, revenue rulings, and cases
                                     to support its conclusions in the draft. The draft opinion also
                                     includes the following section:
                                     c. Application of section 351(g), added by TRA of 1997. The Taxpayer
                                     Relief Act of 1997 added new section 351(g) which provides that certain
                                     preferred stock which is callable or puttable is not to be treated as stock
                                     for purposes of section 351(a).48 The term ‘‘preferred stock’’ for purposes
                                     of section 351(g) does not include stock which participates in corporate
                                     growth to any significant extent.49 As discussed above, the Class C Voting
                                     Preferred Stock has a liquidation value which is equal to the Formula
                                     Value. The Formula Value is equal to forty-five (45%) [sic] of the increase
                                     in the equity value of QHMC. Although there is no guidance in the statute
                                     or legislative history regarding the extent to which the stock must partici-
                                     pate in corporate growth to be considered ‘‘significant’’, we believe the
                                     Class C stock should not be treated as ‘‘preferred stock’’ for purposes of
                                     section 351(g). It is difficult to argue that 45% is not significant.
                                           48 Section    351(g)(2).
                                           49 Section    351(g)(3)(A).

                                       Rose was unaware of a letter of representations that was
                                     prepared and provided to D&T, and the record does not
                                     establish how D&T obtained the background information it
                                     relied on in the draft opinion. In addition, Royce knew that
                                     the draft opinion was a draft. Yet Royce never asked anyone
                                     at D&T to provide petitioners with a final tax opinion, and
                                     petitioners never received a final tax opinion from D&T.
                                     Quanex’s tax department did not prepare a tax opinion or a
                                     memorandum discussing the tax consequences of the QHMC
                                     transactions.




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897   PO 20012   Frm 00060   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    127


                                           B. 1997 Return
                                           1. Background
                                       Petitioners filed their 1997 return on July 14, 1998. Royce
                                     decided what to put into the 1997 return regarding the QHMC
                                     transactions, and he, upon consultation with Singer, caused
                                     Quanex personnel to draft the return in accordance with the
                                     draft opinion. Royce reviewed Quanex’s work and had Singer
                                     cause one of his managers to review the 1997 return. Royce
                                     also caused Singer to review the manager’s comments and
                                     then to look at the return himself. Singer signed the 1997
                                     return on behalf of D&T as the paid preparer.
                                       Parikh signed the return as Quanex’s controller, but he did
                                     not prepare the return or make decisions on how specific
                                     transactions would be reported on the return. Parikh also did
                                     not review the return line by line before signing it. Parikh
                                     asked Royce if D&T thoroughly reviewed the return and
                                     agreed upon how it was prepared, but Parikh did not speak
                                     with anyone at D&T about how the QHMC transactions were
                                     recorded on the return.
                                       Before signing the return, Parikh knew that an approxi-
                                     mately $38 million capital loss was reported on the return.
                                     Parikh saw Singer’s signature on the return, and he was
                                     aware of D&T’s draft opinion. Parikh did not read the draft
                                     opinion before signing the return.
                                           2. Income
                                        On their 1997 return petitioners reported a $37,989,000
                                     short-term capital loss from QS’ sale of the 110 shares of
                                     class C stock to Wannell and a gain or loss of zero from
                                     Quanex’s sale of the 130 shares of class B stock to CS. Peti-
                                     tioners reported specifics of those sales as follows:

                                                                Date               Date                               Sale
                                               Stock          acquired             sold               Basis           price

                                              Class C          10/25/97          10/30/97         $38,000,000       $11,000
                                              Class B          10/23/97          10/24/97              13,000        13,000

                                       Petitioners also reported on the 1997 return that they
                                     realized a $26,966,201 net capital gain and a $21,374,634 net
                                     ordinary gain from the sale of the LaSalle stock and other




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00061   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     128                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     business property. 41 Petitioners offset the net capital gain by
                                     $26,966,201 of the reported capital loss and carried the
                                     remainder of the reported loss, $11,022,799 ($37,989,000 –
                                     $26,966,201), to TYE 1998. Petitioners applied the
                                     $11,022,799 to TYE 1998 to offset almost all of their
                                     $12,090,938 net long-term capital gain primarily from the
                                     Tube Group sale. 42
                                       For financial statement purposes, in or about September
                                     1998 Quanex established a $9,621,000 reserve for taxes due
                                     in the future regarding the capital loss claimed on the sale
                                     to Wannell. Subsequently, after claiming the $11,022,799
                                     capital loss carryover to TYE 1998, Quanex increased that
                                     reserve to $13,479,000.
                                           3. Enclosed Statements
                                           a. Overview
                                       Petitioners’ 1997 return includes various ‘‘Statements’’
                                     related to the QHMC transactions. These statements include
                                     Statement 20, Statement Pursuant to IRC Regulation Section
                                     1.368–3(a); Statement 22, Statement Regarding Tax Free
                                     Contribution to Capital Pursuant to Regulation Section
                                     1.351–3(a); Statement 23, Statement Regarding Tax Free
                                     Contribution to Capital Pursuant to Regulation Section
                                     1.351–3(a)&(b); and Statement 24, Statement Regarding Tax
                                     Free Contribution to Capital Pursuant to Regulation Section
                                     1.351–3(a). Petitioners did not notify any Government agency
                                     other than the IRS of the transactions involving the MPBs.
                                           b. Statement 20
                                        Statement 20 reported the October 23, 1997, amendment
                                     and restatement of QW’s certificate pursuant to its plan of
                                     reorganization to provide for class A, class B, and class C
                                     stocks in a tax-free reorganization under section 368(a)(1)(E).
                                     This statement also reported QW’s name change to ‘‘Quanex
                                     Health Management Company, Inc.’’ in a tax-free reorganiza-
                                     tion under section 368(a)(1)(F). 43
                                       41 As discussed above, petitioners reported a $28,697,957 capital gain and $20,721,360 of ordi-

                                     nary gain from their sale of LaSalle.
                                       42 As discussed above, petitioners reported on their 1998 return a $12,458,171 capital gain and

                                     $8,090,766 of ordinary gain from the Tube Group sale.
                                       43 Petitioners reported elsewhere in their 1997 return that QW acquired 500 shares of class

                                     A stock, acquired and disposed of 130 shares of class B stock, and disposed of 1,000 shares of




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00062   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    129


                                           c. Statement 22
                                       Statement 22 reported Quanex’s October 23, 1997,
                                     exchange of $62,000 and 1,000 shares of QHMC common stock
                                     for 500 shares of class A stock and 130 shares of class B
                                     stock as a tax-free contribution by Quanex to QHMC.
                                           d. Statement 23
                                        Statement 23 reported Quanex’s October 23, 1997, con-
                                     tribution to QS of $38 million in exchange for 1 share of QS
                                     common stock and QS’ assumption of $37,989,000 of MPBs as
                                     a tax-free contribution.
                                           e. Statement 24
                                       Statement 24 reported QS’ October 25, 1997, contribution
                                     to QHMC of $38 million in exchange for 110 shares of class
                                     C stock and QHMC’s assumption of the $37,989,000 of MPBs
                                     as a tax-free contribution.
                                           4. Deduction of Fees
                                        On their 1997 return, petitioners deducted fees of
                                     $320,692, $29,114, and $2,445 that Quanex paid to D&T, Ful-
                                     bright, and WW, respectively. The fees Quanex paid to Ful-
                                     bright and to WW were for services provided to effect the
                                     QHMC transactions. The fees Quanex paid D&T were for serv-
                                     ices D&T performed, as memorialized in invoices listing the
                                     following relevant data: 44
                                                   Date                   Billing                                  Hours
                                                of invoice             period ending            Amount             billed
                                                  7/21/97                  6/28/97               $12,775             35
                                                  8/20/97                  7/26/97                 21,055            53
                                                   9/2/97                   8/9/97                 41,566            99
                                                  9/17/97                  8/23/97               1 65,801           205
                                                 10/13/97                  9/20/97                 65,140           176
                                                 10/28/97                 10/18/97                 46,950           102




                                     common stock. That reporting listed the name of QW as ‘‘QUANEX WIRE, INC (QUANEX
                                     HEALTH MAN)’’.
                                       44 The ‘‘amount’’ and ‘‘hours billed’’ columns show the hours and fees on D&T invoices dated

                                     July 21, 1997, through January 5, 1998, that were labeled ‘‘Consultations regarding the manage-
                                     ment of medical liabilities’’. Although D&T employed both health care consultants and tax con-
                                     sultants, no one from D&T’s health care consulting group appeared on the invoices.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00063   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     130                  139 UNITED STATES TAX COURT REPORTS                                    (67)


                                                   Date                   Billing                                  Hours
                                                of invoice             period ending            Amount             billed
                                                   12/4/97                11/15/97                50,880           2 130

                                                    1/5/98                12/13/97                16,525             39

                                                        Total                                    320,692            839
                                                  1 While the parties stipulated that this amount is
                                                $65,801, the record indicates that the amount should be
                                                $65,800. The discrepancy does not affect our resolution of
                                                the issues in this case.
                                                  2 While the parties stipulated this amount, the record in-
                                                dicates that this amount should be 131.5. The discrepancy
                                                does not affect our resolution of the issues in this case.

                                     D&T’s work on the transactions that resulted in petitioners’
                                     reporting the $37,989,000 loss was included within the scope
                                     of D&T’s engagement letter.
                                           C. WW’s 1999 Valuations
                                       Although petitioners reported a $37,989,000 capital loss on
                                     their 1997 return as a result of the MPB transfers and related
                                     stock sales and relied on that amount in their workpapers,
                                     Quanex continued to request new MPB valuations from WW
                                     and D&T through 1999. By email dated January 17, 1999,
                                     Ringuette sent Royce a calculation of the present value of
                                     active health care benefits as of November 1, 1998, for the
                                     groups of employees who had their MPBs transferred to
                                     QHMC. That email also provided tables for the ‘‘Projected
                                     Cashflow of Active Health Care Benefits as of 11/1/98’’ and
                                     the ‘‘Development of Average Health Care Cost Per Active
                                     Employee’’. The January 1999 calculation is the earliest valu-
                                     ation document in the record to include only the employee
                                     groups whose MPBs were transferred to QHMC. All previous
                                     valuation documents (i.e., the WW June 30, 1997, PV Cal-
                                     culations; the WW October 13, 1997, PV Calculations; and
                                     the D&T Oct. 21, 1997, cashflow model) used information
                                     from either different or additional employee groups. The rel-
                                     evant data from those previous documents is as follows:




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00064   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                GERDAU MACSTEEL, INC. v. COMMISSIONER                                                131


                                           Employee groups                                                                     D&T Oct. 21,
                                           incl. in the calc.               WW June 30,                 WW Oct. 13,               1997,
                                              and No. of                     1997, PV                    1997, PV               cashflow
                                              employees                     calculations                calculations             model
                                      Groups transferred:
                                        Corporate                                     35                          35                 35
                                        MS–General Office                             30                          30                120
                                        MS–Arkansas
                                          hourly                                     252                        ---                 ---
                                        MS–Arkansas                                  120                        120                  27
                                        MS–Arkansas                                  ---                        ---                 112
                                        MS–Michigan                                  112                        112                 ---
                                      Groups not trans-
                                        ferred:
                                        Heat Treating                                27                          27                 ---
                                        Nitro Steel                                 ---                          13                  30
                                        GST                                          55                         ---                 ---
                                        GST hourly                                  248                         ---                 ---
                                        MST                                          66                         ---                 ---
                                        MST hourly                                  222                         ---                 ---
                                        Tube Group office                            51                         ---                 ---
                                        MS–Michigan
                                          hourly                                     165                        ---                 ---

                                              Total                              1,383                          337                 324

                                       WW relied on the following assumptions to perform its
                                     January 1999 calculations on the ‘‘Present Value of Active
                                     Health Care Benefits as of 11/1/98’’:
                                                Aging ....................................................................            2%
                                                Initial trend rate ..................................................                8%
                                                Ultimate trend rate (2003) .................................                      4.75%
                                                Average cost per employee (1998/1999) .............                               $6,437
                                                Interest rate .........................................................           6.75%
                                                ‘‘Target Present Value’’ .......................................             $37,989,000

                                     Those calculations were as follows: 45
                                                                              Number of         Average          Estimated      Present value
                                                                              employees         attained          through         through
                                                  Location                      today              age           2008/2009       2009/2010

                                            Corporate                              37                46         $2,771,431       $3,000,623
                                            MS–Arkansas salaried                  117                42          8,096,317        8,765,867
                                            MS–Arkansas non-
                                              union hourly                        249                36         15,300,295       16,565,601
                                            MS–General Office                      31                47          2,368,451        2,564,317
                                            MS–Michigan salaried                  112                45          8,224,701        8,904,868

                                              Total                               546                40         36,761,195       39,801,276

                                       45 We note that the average attained age is actually 43.2. The discrepancy does not affect our

                                     analysis.




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897   PO 20012     Frm 00065     Fmt 2847     Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     132                 139 UNITED STATES TAX COURT REPORTS                                        (67)


                                       Quanex requested present value calculations for selected
                                     groups of employees from the Corporate, MS–Michigan sala-
                                     ried, MS–Arkansas salaried, MS–Arkansas nonunion hourly,
                                     and MS–General Office groups from WW in addition to those
                                     provided in the January 17, 1999, email. Sometime after
                                     January 17, 1999, in approximately early 1999, Quanex
                                     received the additional calculations in an undated letter
                                     signed by Ringuette (undated calculations). Ringuette either
                                     prepared or supervised the preparation of the undated cal-
                                     culations.
                                       Royce asked Ringuette to determine how many years of
                                     cashflows would result in a present value of $37,989,000 for
                                     the MPBs. The resultant calculations were as follows: 46
                                                 Present Value of Active Health Care Benefits as of 11/1/97

                                                                        Number of          Average      Estimated      Present value
                                                                        employees          attained      through         through
                                                 Location                 today               age       2010/2011       2011/2012

                                           Corporate                            37            46        $2,775,851     $2,952,832
                                           MS–Arkansas salaried                117            42         8,109,224      8,626,248
                                           MS–Arkansas non-
                                             union hourly                      249            36        15,324,695     16,301,759
                                           MS–General Office                    31            47         2,372,226      2,523,473
                                           MS–Michigan salaried                112            45         8,237,814      8,763,036

                                            Total                              546            40        36,819,810     39,167,348

                                        The undated calculations relied on factors and assumptions
                                     different from those used in the WW calculations of October
                                     13, 1997, and January 17, 1999. For example, in contrast to
                                     the October 13 valuation, WW based the undated calcula-
                                     tions on the assumption that the number and average age of
                                     employees in each group would remain constant over time. In
                                     the undated calculations, WW also projected the value over
                                     an approximately 15-year period rather than the approxi-
                                     mately 12-year period used in the January 17 valuation and
                                     the lifetime calculation in the October 13 valuation. 47 Both
                                     of these changes affected how WW measured the present
                                     value of the health benefits.
                                        WW also used the following assumptions for the undated
                                     calculations:
                                       46 We note that the average attained age is actually 43.2. The discrepancy does not affect our

                                     analysis.
                                       47 Rose chose the length of the period.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00066    Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                GERDAU MACSTEEL, INC. v. COMMISSIONER                                             133


                                                Aging ....................................................................            2%
                                                Initial trend rate ..................................................                7%
                                                Ultimate trend rate (2003/2004) ........................                              5%
                                                Average cost per employee (1997/1998) .............                               $5,238
                                                Interest rate .........................................................           6.75%
                                                ‘‘Target Present Value’’ .......................................             $37,989,000

                                     Ringuette believed the assumptions were within a reasonable
                                     range, but they differed from those used in the valuations of
                                     October 13, 1997, and January 17, 1999. The assumptions
                                     WW used for its June 30, 1997, October 13, 1997, January
                                     17, 1999, and undated 1999 present value calculations com-
                                     pare as follows:
                                                                                                                                   Undated
                                                                              6/30/97          10/13/97            1/17/99           1999
                                             Assumption used                  valuation        valuation           valuation       valuation

                                           Aging                                  2%               2%                  2%              2%
                                           Initial trend rate                   9.29%            8.75%                 8%              7%
                                           Ultimate trend rate                   5.5%             5.5%               4.75%             5%
                                                                                (2004)           (2004)              (2003)       (2003/2004)
                                           Interest rate                         7.5%             7.5%               6.75%           6.75%
                                           Avg. cost per employee               $3,500           $5,877             $6,437           $5,238
                                                                                (1997)           (1998)           (1998/1999)     (1997/1998)

                                       Quanex’s 1997 Form 10–K stated with respect to FASB 106
                                     information and assumptions that ‘‘The assumed healthcare
                                     cost trend rate was 8.8% in 1997, decreasing uniformly to
                                     5.5% in the year 2003 and remaining level thereafter. The
                                     assumed discount rate used to measure the accumulated
                                     postretirement benefit obligation was 7.5% at October 31,
                                     1997 and October 31, 1996,’’ Quanex’s Form 10–K for TYE
                                     1998 stated that ‘‘The assumed healthcare cost trend rate
                                     was 8% in 1998, decreasing uniformly to 4.75% in the year
                                     2003 and remaining level thereafter. The assumed discount
                                     rate used to measure the accumulated postretirement benefit
                                     obligation was 6.75% and 7.5% at October 31, 1998 and 1997,
                                     respectively.’’ WW chose the 8% health care cost trend rate
                                     assumption for 1998, and the rate related back to November
                                     1, 1997. Quanex was not obligated to use the 8% assumption.
                                       Royce was dissatisfied with the initial and ultimate trend
                                     inflation rates and the aging assumptions WW used in the
                                     October 13, 1997, valuation. Consequently, Royce instructed
                                     WW to change the initial trend rate to 7%. Royce also
                                     wanted WW to raise the ultimate trend assumption. Royce
                                     wanted a 5% rate rather than the 4.75% rate WW used in




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897   PO 20012     Frm 00067     Fmt 2847     Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     134                  139 UNITED STATES TAX COURT REPORTS                                                 (67)


                                     its January 17, 1999, calculation. Royce also wanted WW to
                                     change the interest rate from the 7.5% WW used in the
                                     October 13 calculation to 6.75%. WW agreed to make the
                                     changes. When asked at trial ‘‘why was it necessary for you
                                     to see if it [the target present value] was within the range
                                     [of values WW determined for the selected employees
                                     MPBs]?’’, Royce testified: ‘‘Because the transaction had
                                     already been done, the cash to fund the expected MPBs of $38
                                     million had been transferred. We were trying to transfer the
                                     substantial assets equal to the cash contributed.’’
                                        Royce also instructed WW to include employees in the
                                     undated calculations that were different from the October 13
                                     valuation, but the same as those used in the January 17 cal-
                                     culations. Changing the number of employees helped WW
                                     target $38 million. The October 13 valuation did not contain
                                     a target present value assumption. The January 17, 1999,
                                     calculation and the undated calculations used a $37,989,000
                                     target value.
                                        Although numerous changes were made between the
                                     October 13, 1997, January 17, 1999, and undated calcula-
                                     tions, in each instance WW arrived at approximately the
                                     same present value for the MPBs of the employee groups
                                     considered. 48 The present value totals were as follows:

                                                                                                                                 Present
                                                                                                                                 value of
                                             Calculation                                                                          MPBs

                                                10/13/97 ...................................................................    $37,839,705
                                                1/17/99 .....................................................................    36,761,195
                                                1/17/99 .....................................................................    39,801,276
                                                Undated ..................................................................       36,819,810
                                                Undated ..................................................................       39,167,348

                                           D. D&T’s 1999 Cashflow Model
                                       The undated calculations represented WW’s final report on
                                     the present value of the MPBs, and Royce did not ask WW to
                                     prepare any additional revisions or reports on the matter.
                                     Royce did ask D&T to prepare calculations on the basis of the
                                     undated WW calculations. By letter dated March 25, 1999,
                                       48 At trial, Ringuette did not remember Quanex’s expressing any dissatisfaction with the

                                     methodology that he used in performing the present value calculations or with the product con-
                                     tained in the calculations.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012     Frm 00068     Fmt 2847     Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                GERDAU MACSTEEL, INC. v. COMMISSIONER                                     135


                                     D&T provided the revised calculations to Royce (March 25
                                     analysis). The letter, which was signed by David Roth of
                                     D&T, stated that upon Royce’s request D&T ‘‘modified and
                                     refined the calculations previously made in October 1997
                                     relating to the valuation of * * * [QHMC] for the purpose of
                                     closing the transaction’’ and that D&T understood that QHMC
                                     would use the analysis, along with other information, ‘‘in
                                     establishing cash flows to various classes of its capital stock.’’
                                     D&T also stated in the letter that it had not independently
                                     assessed discount rates, cashflows, or other terms relating to
                                     the Piper note. D&T provided Quanex with the following
                                     table, which calculated the present values of the cashflows of
                                     the MPBs transferred to QHMC:

                                                                                                                         No. of
                                                                                Grand total                            employees
                                                        Location                  of PV                Cashflow          today

                                           Corporate                            $2,947,000              $151,000           37
                                           MS–Arkansas salaried                  8,610,000               429,000          117
                                           MS–Arkansas non-
                                             union hourly                       16,271,000              1,064,000         249
                                           MS–General Office                     2,819,000                100,000          31
                                           MS–Michigan salaried                  8,747,000                517,000         112

                                              Total                             39,394,000             1 2,262,000        546
                                             1 Although the cashflows totaled $2,261,000, the table indicated
                                           the total was $2,262,000.

                                        The March 25 analysis also stated that the ‘‘total payments
                                     to Quanex * * * under QHMC’s note receivable’’ would equal
                                     $5.5 million at the conclusion of each of the first 2 years, $4
                                     million at the conclusion of years 3 and 4, $3 million at the
                                     conclusion of years 5 through 7, $5 million at the conclusion
                                     of years 8 through 14, and $310,000 at the conclusion of year
                                     15, and that the payment schedule indicated a total value of
                                     equity for all classes of QHMC stock of $76,000. D&T cal-
                                     culated its present values of cashflows on the basis of the
                                     cashflow analysis, and D&T calculated the equity value as
                                     follows:
                                             Total PV of cashflows ................................................    $594,000
                                             Plus cash on hand .....................................................     65,000




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897    PO 20012   Frm 00069   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     136                   139 UNITED STATES TAX COURT REPORTS                                                    (67)


                                              Less uncertainty of future medical costs adjust-
                                                ment ........................................................................        (583,000)

                                              Equals total value of equity ......................................                       76,000

                                     Royce used the note payment schedule to anticipate the prin-
                                     cipal payments on the note throughout 15 years.
                                       In addition to the present value cashflow calculations for
                                     the employee groups and the equity determination, D&T’s
                                     March 25 analysis contained several other projections and
                                     calculations, including the following discounted cashflow
                                     analysis (in thousands): 49
                                                                                                                                 Cashflow
                                                                     Prin-                     Cashflow                            from
                                                     Int. inc.       cipal                       avail.                         operating/
                                                       from          from        Medical       to equity         Cum.             invest.      NOL
                                           Year        note          note         costs         holders        cashflow          activities   buildup

                                           1998         $2,850      $2,650       ($2,870)        $2,630         $2,630              ($20)       ($20)
                                           1999          2,651       2,849        (3,071)         2,429           5,059             (420)       (420)
                                           2000          2,438       1,562        (3,274)           726           5,785             (836)     (1,256)
                                           2001          2,320       1,680        (3,479)           521           6,306           (1,159)     (2,415)
                                           2002          2,194         806        (3,685)          (685)          5,621           (1,491)     (3,905)
                                           2003          2,134         866        (3,892)          (892)          4,729           (1,758)     (5,663)
                                           2004          2,069         931        (4,097)        (1,097)          3,632           (2,028)       -0-
                                           2005          1,999       3,001        (4,302)           698           4,331           (2,302)       -0-
                                           2006          1,774       3,226        (4,517)           483           4,814           (2,742)       -0-
                                           2007          1,532       3,468        (4,742)           258           5,072           (3,210)       -0-
                                           2008          1,272       3,728        (4,980)            20           5,092           (3,707)       -0-
                                           2009            993       4,007        (5,229)          (229)          4,864           (4,238)       -0-
                                           2010            892       4,308        (5,490)          (490)          4,374           (4,798)       -0-
                                           2011            369       4,631        (5,764)          (764)          3,609           (5,395)       -0-
                                           2012             22         258        (6,053)        (5,743)         (2,133)          (6,031)       -0-

                                           Total        25,310      38,000       (65,443)         (2,133)       No D&T           (40,133)     No D&T
                                                                                                                 total                         total

                                     D&T thus projected for every year that QHMC’s medical costs
                                     would exceed its interest income from the Piper note and
                                     that QHMC’s equity holders would have negative cashflow for
                                     7 of the 15 years of the investment. 50 D&T also projected
                                     that QHMC would build up NOLs over the first six years, but
                                     D&T did not project the NOLs for the remaining nine years.
                                     D&T provided specific NOL projections as follows (in thou-
                                     sands):
                                                                       1998      1999        2000        2001          2002          2003        2004

                                      NOL generated                     -0-       $420        $838       $1,159       $1,491         $1,758   $2,028
                                      NOL carryforward                  -0-        420       1,258        2,415        3,905          5,663    7,691

                                        49 We note some computational errors in the projections. These errors are not material to our

                                     analysis.
                                        50 At trial Royce admitted that if none of the principal on the note was paid off in years 1

                                     through 15, the maximum interest income to QHMC would be the $2,850,000 reflected in the
                                     first year of the schedule. In no year were the projected medical expenses less than $2,850,000.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897    PO 20012     Frm 00070     Fmt 2847     Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    137


                                                                   1998    1999      2000        2001       2002      2003     2004

                                      PV of annual NOL
                                       tax benefit                  -0-        149        281         367     446       496      539
                                      Cumulative PV of
                                       NOL benefits
                                       at the end of
                                       year 7                                                                                 12,278


                                           1D&T   assumed a risk-free rate of 6% and a tax rate of 40% for the NOL analysis.

                                     Royce understood the concept of NOLs, and he admitted that
                                     on the basis of the information on projected medical expenses
                                     provided in the March 25 analysis, which he accepted, QHMC
                                     would have an NOL every relevant year. Royce also admitted
                                     that as Quanex’s in-house tax adviser he would have been
                                     aware of existing NOLs and would have considered how to use
                                     them.
                                       In its March 25 analysis, D&T also made projections with
                                     respect to the formula value. D&T projected that there would
                                     be 546 actual and projected covered plan participants each
                                     year and calculated the following (in thousands):




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00071   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
VerDate Nov 24 2008
09:57 Jun 05, 2014
                                                                                                                                                                                                                              138




Jkt 372897
PO 20012
                                                                                       1998     1999     2000     2001     2002     2003     2004     2005     2006     2007     2008     2009     2010     2011     2012




Frm 00072
                                                               Initial undiscounted
                                                                 MPBs                  $2,870   $3,071   $3,274   $3,478   $3,685   $3,892   $4,097   $4,302   $4,517   $4,742   $4,980   $5,229   $5,490   $5,764   $6,053
                                                               Actual MPBs              2,583    2,764    2,946    3,131    3,317    3,503    3,687    3,871    4,065    4,268    4,482    4,706    4,941    5,168    5,447




Fmt 2847
                                                               Yearly savings             287      307      327      348      369      388      410      430      452      474      498      523      549      576      605
                                                               Aggregate yearly cum.
                                                                 savings                 287      594      922     1,269    1,638    2,027    2,437    2,867    3,319    3,793    4,291    4,814    5,363    5,939    6,544




Sfmt 2847
                                                                                                                                                                                                                              139 UNITED STATES TAX COURT REPORTS
                                                                                                                                                                                                                              (67)




V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG
JAMIE
                                     (67)                GERDAU MACSTEEL, INC. v. COMMISSIONER                                        139


                                     On the basis of these numbers, D&T determined that if the
                                     call option was exercised in year 5, the class B and class C
                                     shares would have a $360,327 liquidation value and a
                                     $352,452 net return, and if the put option were exercised in
                                     year 7 (with the call option still outstanding), the liquidation
                                     value of the class B and class C shares would equal $567,719
                                     with a net return of $562,694. D&T calculated these liquida-
                                     tion and net return values as follows:
                                           Preferred stock called in 5 years                    Preferred stock called in 7 years

                                       Cum. savings at end of yr. 5         $1,637,928       Cum. savings at end of yr. 7      $2,436,768
                                       Less management consulting                            Less management consulting
                                         fees                                    (250,000)     fees                              (250,000)
                                       Net savings                              1,387,928    Savings                            2,186,768
                                       Performance weighting factor                  45%     Performance weighting factor            45%
                                       Formula value = 45% savings                624,568    Formula value = 45% savings          984,046
                                       No. of B and C shares out-                            No. of B and C shares out-
                                         standing                                    260       standing                              260
                                       Est. max. formula value per                           Est. max. formula value per
                                         share                                      2,402      share                                3,785
                                       No. of CS class B and C shares                 150    No. of CS class B and C shares           150
                                       Liquidation value of B and C                          Liquidation value of B and C
                                         shares                                  360,327       shares                            567,719
                                       Total dividends paid                        7,125     Total dividends paid                  9,975
                                       Total return over 5 years                 367,452     Total return over 7 years           577,694
                                       Less initial investment                   (15,000)    Less initial investment             (15,000)
                                       Net return                                352,452     Net return                          562,694

                                     D&T also projected the following values (in thousands) under
                                     the heading ‘‘Total Value of All Classes of Stock on Redemp-
                                     tion Date’’:

                                                                     Modified
                                                                     cashflow
                                                                     assuming               Value at end       Value at end
                                                    Year              savings                of year 5          of year 7

                                                        1998            $2,917                   $3,814              $4,480
                                                        1999             2,736                    3,439               3,919
                                                        2000             1,054                    1,241               1,414
                                                        2001               869                      958               1,092
                                                        2002              (317)                    (327)               (373)
                                                        2003              (503)                    (486)               (554)
                                                        2004              (687)                    (823)               (710)
                                                        2005             1,128                      959               1,092
                                                        2006               935                      744                 848
                                                        2007               732                      545                 622
                                                        2008               518                      382                 412
                                                        2009               294                      193                 219
                                                        2010                59                       38                  41
                                                        2011              (188)                    (108)               (123)
                                                        2012            (5,137)                  (2,762)             (3,148)




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897    PO 20012   Frm 00073    Fmt 2847    Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     140                     139 UNITED STATES TAX COURT REPORTS                                                      (67)


                                       The record does not contain credible evidence that
                                     Quanex’s board was informed of WW’s and D&T’s valuation
                                     changes. The meeting minutes for QHMC’s board meetings
                                     (QHMC board meetings) reflected no discussion of the
                                     changes. 51 (QHMC’s board meetings are discussed in greater
                                     detail below.)
                                           E. QHMC Operations
                                           1. QHMC’s Officers and Directors
                                       From 1997 through the time of trial,                                          QHMC        had the fol-
                                     lowing officers and directors: 52
                                                         10/23/97–     10/24/97–      10/25/97–        4/9/99–      4/10/00–        4/17/01–03
                                                         10/24/97      10/25/97        4/9/99          4/10/00      4/17/01        annual meeting

                                           Oechsle       Dir., pres.   Dir., pres.   Dir., pres.     Dir., pres.   Dir., pres.           ---
                                           Jean               ---           ---           ---             ---           ---      Dir., pres.
                                           Parikh        Dir., V.P.,   Dir., V.P.,   Dir., V.P.,     Dir., V.P.,   Dir., V.P.,   Dir., V.P., treas.
                                                           treas.        treas.        treas.          treas.        treas.
                                           Rose          Dir., V.P.    Dir., V.P.    Dir., V.P.      Dir., V.P.         ---              ---
                                           Peery         Dir., V.P.    Dir., V.P.    Dir., V.P.           ---           ---              ---
                                           Davis         V.P.          V.P.          Dir., V.P.      Dir., V.P.    Dir., V.P.    V.P. (until 10/1/02)
                                           Giddens            ---           ---           ---        Dir., V.P.    Dir., V.P.    Dir., V.P.
                                           Murphy             ---           ---           ---             ---      Dir., V.P.    Dir., V.P.
                                           Wannell       Dir.          Dir.          Dir.            Dir.          Dir.          Dir.
                                           Babb          Dir.          Dir.          Dir.            Dir.          Dir.          Dir.
                                           Hellner       Dir.               ---           ---             ---           ---      Dir.
                                           Bewley        Dir.               ---           ---             ---           ---              ---
                                           Micale             ---      Dir.          Dir.            Dir.          Dir.          Dir.
                                           Chapman            ---      Dir.          Dir.            Dir.          Dir.          Dir.
                                           Conlon        Sec.          Sec.          Sec.            Sec.          Sec.          Sec.
                                           Royce         Asst. sec.    Asst. sec.    Asst. sec.      Asst. sec.    Asst. sec.    Asst. sec.
                                           Dockery       Asst. sec.    Asst. sec.    Asst. sec.      Asst. sec.    Asst. sec.    Asst. sec.


                                     Except for Wannell, each class A director was a Quanex
                                     employee as of the date he or she was elected. Except for
                                     Conlon and Dockery, both attorneys with Fulbright, each
                                     QHMC officer was a Quanex employee as of the date he or she
                                     was elected. QHMC did not compensate its directors or its offi-
                                     cers.
                                       QHMC had no employees, other than, possibly, some
                                     individuals whom the Code deems to be employees for certain
                                     purposes such as employment taxes. See, e.g., sec. 3121(d)
                                     (providing that the term ‘‘employee’’ includes certain common
                                     law employees and corporate officers).
                                        51 Royce testified that both WW’s and D&T’s new calculations were discussed at QHMC’s April

                                     9, 1999, board meeting and that he adequately informed the board of the changes. Because
                                     Royce prepared the April 9 board meeting minutes (and all other QHMC meeting minutes), and
                                     because he testified that he put the important activities that took place during the meetings
                                     in the minutes, we do not find his testimony that the board was informed of the changes cred-
                                     ible.
                                        52 Jean, Giddens, and Dockery are Raymond Jean, Paul Giddens, and Harva Dockery, respec-

                                     tively.




VerDate Nov 24 2008   09:57 Jun 05, 2014    Jkt 372897     PO 20012    Frm 00074     Fmt 2847      Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    141


                                           a. QHMC’s Board Meetings and Shareholders Meetings
                                       QHMC held board meetings and shareholders meetings on
                                     April 9, 1999, April 10, 2000, April 17, 2001, and October 1
                                     and 16, 2001. No board meetings or shareholders meetings
                                     were held in 1998. 53
                                           b. Parikh as Director and Officer
                                        In his capacity as a QHMC board member and a QHMC
                                     officer, Parikh participated in QHMC board meetings and
                                     discussions relating to health management plans, signed
                                     QHMC’s tax returns, and reviewed QHMC’s financial state-
                                     ments. Parikh had no specific daily activities or responsibil-
                                     ities to perform for QHMC.
                                           c. Peery as Director and Officer
                                       From the time the QHMC transactions were completed until
                                     his retirement in April 1998, Peery attended meetings with
                                     CS in relation to Quanex matters. Peery was not involved in
                                     QHMC’s operations.
                                       Following his retirement, Peery attended no meetings with
                                     respect to QHMC, and no one called him to discuss any matter
                                     related to QHMC. For the first five or six months after he
                                     retired, he stayed on with Quanex in a limited advisory role
                                     serving at his successor’s pleasure and making himself avail-
                                     able to answer the successor’s questions. The successor did
                                     not ask questions related to benefits or the QHMC arrange-
                                     ment, and Peery did not explain the QHMC arrangement to
                                     the successor.
                                           2. Bank Accounts
                                       QHMC has maintained one bank account since October
                                     1997. The account is with Comerica Bank (QHMC’s Comerica
                                     account), 54 and the monthly bank statements are mailed to
                                     QHMC at the address of Quanex’s principal office. Petitioners
                                     were unable to find the account’s bank statements for June
                                        53 On February 19, 1998, a ‘‘Quanex Strategic Meeting’’ was held, and Rose and Chapman tes-

                                     tified that the meeting was about starting QHMC operations. However, both the meeting’s agen-
                                     da and a followup letter to the meeting, which was dated February 20, 1998, and addressed
                                     to Micale from Babb, made no mention of QHMC and referenced employee groups not covered
                                     by QHMC.
                                        54 Since October 1997 Quanex also has maintained a bank account with Comerica Bank

                                     (Quanex’s Comerica account).




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00075   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     142                 139 UNITED STATES TAX COURT REPORTS                                              (67)


                                     1, 1998, through December 31, 1999, and respondent under-
                                     took no efforts to obtain those statements directly from
                                     Comerica Bank.
                                           3. Processing and Paying MPB-Related Expenses
                                        The processing of claims under Quanex’s HMO and indem-
                                     nity plans was the same before and after October 1997. From
                                     October 23, 1997, employees or agents of Quanex processed
                                     the claims for the MPBs transferred to QHMC, and personnel
                                     at the employees’ respective plants input the covered
                                     employees’ medical enrollment information. The individuals
                                     involved and the basic procedures for processing employee
                                     claims for the MPBs were generally the same before and after
                                     October 23, 1997, and the QHMC-covered employees’ claims
                                     were not handled any differently from those for employees
                                     whose MPBs were not transferred to QHMC. Quanex bore all
                                     MPB claims processing costs, and QHMC paid no fees to
                                     Quanex for the services Quanex provided in processing
                                     claims. The cost to Quanex for processing the claims did not
                                     include the actual amounts of the claims.
                                        QHMC also paid no fees for any administrative, manage-
                                     ment, or other service that Quanex provided in connection
                                     with the MPBs. While Quanex’s accounting department main-
                                     tained QHMC’s books and records, Quanex’s tax department
                                     prepared QHMC’s tax returns for TYE 1997 through TYE 2002,
                                     and Royce prepared the minutes for QHMC’s board meetings,
                                     QHMC did not reimburse Quanex for these services.
                                        After October 23, 1997, Quanex initially paid the covered
                                     employees’ actual medical claim costs and the employer’s
                                     share of HMO premiums for or related to the MPBs. Quanex
                                     employees or agents continued to select the HMO insurers
                                     and to perform the annual negotiations related to the HMO
                                     premiums for the MPBs, and all costs related to those activi-
                                     ties were borne by the HMOs and by Quanex (QHMC paid no
                                     fees to Quanex for these services). The annual costs for the
                                     claims and premiums for 1998 through 2001 were as follows:

                                                                                                                              Medical
                                            Fiscal year 1                                                                    expenses 2
                                              TYE 1998 ...................................................................   $2,656,249
                                              TYE 1999 ...................................................................    3,396,854
                                              TYE 2000 ...................................................................    3,685,133




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012    Frm 00076     Fmt 2847    Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                                  143


                                                                                                                                   Medical
                                            Fiscal year 1                                                                         expenses 2
                                              TYE 2001 ...................................................................         4,390,632

                                                 Total ........................................................................   14,128,868
                                              1 The parties did not provide the total cost for the covered em-
                                            ployees’ claims and the employer’s share of the covered employ-
                                            ees’ HMO premiums for years after TYE 2001.
                                              2 The computation attributed the expenses to Corporate sala-
                                            ried, MS–General Office salaried, MS–Michigan salaried, MS–Ar-
                                            kansas salaried, and MS–Arkansas hourly employees.

                                        Quanex’s payments of the medical benefit costs for the cov-
                                     ered employees were handled through its treasury depart-
                                     ment, the same way medical benefit costs were handled for
                                     all Quanex employees. The claims were paid out of individual
                                     medical accounts that the treasury department set up for
                                     each Quanex division so that Quanex was able to identify
                                     each division’s claims and losses. At the end of each payment
                                     period, Quanex determined which expenses were paid for the
                                     covered groups of employees.
                                        QHMC eventually reimbursed Quanex for the employees’
                                     claims and the employer’s share of the HMO premiums that
                                     Quanex paid. QHMC’s ability to reimburse Quanex was
                                     directly related to its receipt of payments on the Piper note.
                                     QHMC paid no fees or interest to Quanex for the use of the
                                     Quanex funds expended in connection with the payment of
                                     the MPBs.
                                        After the QHMC transactions were completed, QHMC’s busi-
                                     ness came solely from Quanex, and the Piper note was
                                     QHMC’s sole source of income. QHMC could not reimburse
                                     Quanex for the MPB expenses until QHMC received payments
                                     on the note. Piper did not pay the interest on the note as it
                                     came due, and Piper and QHMC initially recorded the respec-
                                     tive interest obligations as payables and receivables on their
                                     respective books.
                                        QHMC’s obligation to reimburse Quanex for claims and pre-
                                     mium payments was initially reflected through entries in
                                     intercompany accounts, e.g., recorded as a receivable due
                                     from QHMC on Quanex’s books and as a payable on QHMC’s
                                     books. On May 12, 2000, $45,156,667 was wired into QHMC’s
                                     Comerica account from Quanex’s Comerica account to pay off
                                     the Piper note’s $38 million principal and $7,156,667 accrued




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012     Frm 00077      Fmt 2847     Sfmt 2847     V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     144                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     interest. QHMC transferred the $7,156,667 back to Quanex
                                     the same day to reimburse Quanex for the MPB expenses for
                                     the first time. 55 Also on May 12, 2000, QHMC transferred the
                                     $38 million to Nichols Aluminum-Golden, Inc. (NAG), another
                                     wholly owned Quanex subsidiary, as a loan.
                                        The transfers relating to the Piper note began a pattern
                                     whereby QHMC received principal and interest payments from
                                     Quanex for loans QHMC had made to certain Quanex subsidi-
                                     aries, and QHMC immediately thereafter made MPB expense
                                     reimbursements to Quanex and loans to other Quanex enti-
                                     ties. QHMC made loans to NAG, Temroc Metals (TFP), Imperial
                                     Products, Inc. (IFP) and Colonial Craft, Inc. (CCI), all then
                                     wholly owned subsidiaries of Quanex, as follows:

                                                               Principal          Date of          Wire         Cancellation/
                                             Borrower           amount             note          transfer        repayment

                                                NAG            $38   million       5/1/00         5/12/00          4/27/01
                                                TFP             20   million       4/1/01         4/27/01          5/28/02
                                                IFP             18   million       4/1/01         4/27/01          7/31/02
                                                CCI             20   million       5/1/02         5/28/02          7/31/02
                                                CCI             38   million       8/1/02         7/31/02        Outstanding
                                                                                                                   at trial

                                     The wire transfers from QHMC for the TFP and IFP loans were
                                     made to Quanex’s Comerica account, and the repayments for
                                     the NAG, TFP, and IFP notes were wire transfers to QHMC’s
                                     account from Quanex. Each note was due on December 31,
                                     2012, but could be prepaid in whole or in part at any time
                                     without penalty. Similarly, Quanex made interest payments
                                     on the NAG, TFP, IFP, and CCI notes by wire transfer from its
                                     Comerica account to QHMC’s, and QHMC made corresponding
                                     reimbursements to Quanex.
                                        The payments made between Quanex and QHMC were as
                                     follows:

                                       55 The parties stipulated that QHMC made the first reimbursement payment of $7,156,667 on

                                     May 7, 2000. However, the parties also stipulated QHMC’s bank account summary of activity
                                     for October 1, 1997, through March 31, 2003, which shows that the $7,156,667 payment was
                                     made on May 12, 2000, the same date the $45,156,667 transfer from the Quanex account was
                                     deposited. Because the bank summary of activity also shows that QHMC had only $61,316.70
                                     in its account immediately before the May 12 transfer from Quanex’s account, we find that the
                                     $7,156,667 payment could not have been made before that date. See Cal-Maine Foods, Inc. v.
                                     Commissioner, 93 T.C. 181, 195 (1989) (stating that, where justice requires, the Court may dis-
                                     regard a stipulation which is clearly contrary to the record); see also Rules 90(f), 91(e).




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00078   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                       145


                                                          Interest payments                            Reimbursement payments

                                                                                                      Date of        MPB expense
                                              Loan         Date of wire           Interest         QHMC wire          repayment
                                            recipient       to QHMC               amount            to Quanex          amount

                                             Piper            5/12/00          $7,156,667.00            5/12/00     $7,156,667.00
                                             NAG              7/25/00             593,222.22            7/25/00        593,222.22
                                             NAG             10/25/00             902,499.99           10/25/00        902,499.99
                                             NAG               1/8/01             902,499.99             1/8/01        902,499.99
                                             NAG               4/4/01             818,055.56             4/4/01        818,055.56
                                             TFP              7/27/01             500,000.00            7/27/01        950,000.00
                                             IFP              7/27/01             450,000.00             ---              -0-
                                             TFP             10/30/01             500,000.00           10/30/01        950,000.00
                                             IFP             10/30/01             450,000.00             ---              -0-
                                             TFP              1/16/02             500,000.00            1/16/02        950,000.00
                                             IFP              1/16/02             450,000.00             ---              -0-
                                             TFP              4/16/02             500,000.00            4/16/02        950,000.00
                                             IFP              4/16/02             450,000.00             ---              -0-
                                             TFP              5/28/02             166,667.00            5/28/02        166,667.00
                                             CCI              7/31/02             333,000.00            7/31/02        933,333.00
                                             CCI              7/31/02             600,000.00             ---              -0-
                                             CCI             10/24/02             800,334.00           10/24/02        800,334.00
                                             CCI              1/13/03             950,000.00            1/13/03        950,000.00

                                               Total                           17,022,945.76                        17,023,278.76

                                           4. Shareholder Efforts To Manage MPB Obligations
                                           a. CS’ Efforts
                                           i. Background
                                        Following the QHMC transactions, CS did more work for
                                     Quanex than it had before the QHMC transactions, but the
                                     nature of CS’ work did not change. During the course of a
                                     typical year following the fall of 1997, CS negotiated HMO
                                     contracts and evaluated medical savings opportunities for
                                     QHMC covered employees as part of a broader effort to reduce
                                     Quanex’s medical expenses. CS attempted to meet with the
                                     companies from which the covered employees had been
                                     chosen, and it sometimes participated in Quanex’s meetings
                                     with those companies. CS met annually with QHMC’s board to
                                     provide updates and to assess savings opportunities for the
                                     following contract year.
                                        Both Howard and Chapman attended and made presen-
                                     tations at the QHMC board meetings. Howard was Quanex’s
                                     main CS contact from 1997 through the time of trial, and
                                     Babb was Howard’s main Quanex contact both before and
                                     after the QHMC transactions. Howard used the QHMC board
                                     meetings as a venue to speak to Quanex management about
                                     Quanex generally and the health care problems of all of




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00079    Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     146                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     Quanex’s employees. Chapman and Howard also used the
                                     meetings as an opportunity to inform Quanex management
                                     about the services CS could provide for Quanex as a whole.
                                     After the QHMC transactions were consummated, Quanex
                                     provided data to CS for all Quanex employees, and CS’
                                     presentation materials for the QHMC board meetings included
                                     recommendations for both QHMC covered and non-QHMC cov-
                                     ered employees. CS provided some of the same materials at
                                     both the April 10, 2000, and the April 17, 2001, board
                                     meetings.
                                           ii. PPO Project
                                       At QHMC’s April 17, 2001, board meeting, CS suggested
                                     that Quanex replace its indemnity plan with a PPO option as
                                     a cost savings strategy. 56 CS believed that establishing a PPO
                                     would be valuable to all Quanex employees, and Quanex ulti-
                                     mately agreed. Previously, before October 31, 1997, CS had
                                     discussed using PPOs with Quanex, but Quanex did not then
                                     act on those discussions. 57 CS helped clients in which it did
                                     not have an equity interest implement PPO plans.
                                       Quanex wanted to provide the PPO option to all its non-
                                     union employees. CS prepared a ‘‘Request for Information
                                     Healthcare Management and Administration for Quanex
                                     Corporation’’ (RFI) for the PPO project. The RFI stated that its
                                     intent was to partner Quanex with a health care company
                                     that could successfully improve Quanex’s health care costs by
                                     implementing a PPO network access product, and in a portion
                                     of the document entitled ‘‘COMPANY INTRODUCTION’’, the RFI
                                     gave an overview of Quanex that made no reference to QHMC.
                                     The RFI also requested information on medical services pro-
                                     vided in locations that did not contain QHMC covered
                                     employees. CS also prepared a Request for Proposal (RFP)
                                     that was entitled ‘‘Request for Proposal Healthcare Manage-
                                     ment and Administration for Quanex Corporation’’. The RFP
                                     contained a company introduction that did not refer to QHMC.
                                       By letter dated February 21, 2002, CS provided Parikh
                                     with a bill for services performed between August 27 and
                                       56 At trial Chapman defined a PPO as ‘‘purely a network * * * it’s a point of access into a

                                     medical delivery system.’’
                                       57 CS typically received remuneration with respect to indemnified contracts but not PPO

                                     plans. After Quanex’s PPO plan was in effect, however, CS received commissions from Quanex
                                     because there was a contract to provide insurance coverage.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00080   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    147


                                     December 31, 2001, which characterized CS’ PPO efforts as
                                     work for Quanex generally. The invoice stated that CS cre-
                                     ated ‘‘Quanex specific’’ RFP and RFI documents, and that CS
                                     prepared an analysis of the viable PPO health networks and
                                     providers ‘‘for every location where Quanex employees and
                                     retirees reside’’ to implement and create the PPO benefit plan.
                                     The invoice stated that CS performed a detailed interpreta-
                                     tion of the services, quality, and financial benefits among
                                     multiple vendors and administrators ‘‘for each operating divi-
                                     sion of Quanex,’’ and that CS identified the vendor best
                                     capable of ‘‘meeting the current and future needs of Quanex
                                     based on given demographic and financial goals of Quanex’’
                                     as a part of the PPO project.
                                        Effective January 1, 2002, Quanex established a PPO plan
                                     to replace its indemnity plan. The change, which was to take
                                     place over time, applied to all of Quanex’s nonunion
                                     employees, including those covered by QHMC. The majority of
                                     QHMC covered employees were HMO participants, and all
                                     Quanex employees under the HMO program had an oppor-
                                     tunity to transfer to a PPO when their policy year expired.
                                     Many HMO-covered employees chose not to switch. The same
                                     PPO provider, Unicare, was chosen for both QHMC covered and
                                     non-QHMC covered employees. 58
                                           iii. Union Negotiations
                                       CS also participated in union negotiations to reduce
                                     Quanex’s medical expenses. The employees of Quanex’s MS–
                                     Fort Smith, Arkansas, location unionized in 1999. Although
                                     the employees were originally part of the QHMC covered
                                     employees group, they were no longer QHMC covered
                                     employees after they unionized. Because Quanex wanted to
                                     determine which medical benefits to include in the union
                                     contract, and the contract involved an Arkansas HMO with
                                     which Howard had previously negotiated for Quanex, Quanex
                                     asked CS to help devise a strategy for negotiations with the
                                     union as to the amount and terms of the medical benefits
                                     Quanex would provide. With CS’ assistance, Quanex success-
                                     fully negotiated the inclusion of an employee contribution
                                     requirement in the union contract. Before the union contract,
                                       58 Royce testified that CS’ efforts on the PPO project resulted in approximately $800,000 of

                                     health care cost savings for Quanex by the end of TYE 2002. We do not find this testimony cred-
                                     ible, and we decline to rely upon it.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00081   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     148                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     the MS–Fort Smith, Arkansas, employees were not required
                                     to contribute to their health care plan. CS did not need the
                                     QHMC structure to assist Quanex in the union negotiations. 59

                                           iv. CS’ Consulting Bills
                                        By letters dated February 1 and June 24, 1999, February
                                     21, 2002, and March 18, 2003, CS provided Quanex with bills
                                     for its services. In each bill CS generally described its work
                                     underlying the bill as ‘‘consulting services as provided for in
                                     our consulting agreement dated October 24, 1997 by and
                                     among Quanex Corporation and Chapman Schewe Inc. as
                                     part of the Quanex Health Management, Inc. provisions.’’
                                     Each bill provided itemized descriptions of the work per-
                                     formed and stated who performed the work and at what rate.
                                        The February 1999 bill was for services CS performed in
                                     1998 as a part of its efforts to manage Quanex’s health plan
                                     expense. The bill charged $13,000 for 52 hours of work per-
                                     formed by Chapman, Howard, and Micale at a rate of $250
                                     per hour. Although the bill’s itemized work descriptions
                                     referred to Quanex by name several times, none of the
                                     descriptions made any specific reference to QHMC or to the
                                     covered groups. On or about March 24, 1999, Quanex paid
                                     CS the invoiced $13,000.
                                        The June 1999 bill was for services CS performed from
                                     January 1 to April 30, 1999, and the charges reflected ‘‘the
                                     initiation of saving solutions strategies and request for pro-
                                     posals from national vendors for the QHMC project.’’ The bill
                                     charged $23,100 for 90 hours of work performed by Micale,
                                     Chapman, and Howard at a rate of $250 per hour and 12
                                     hours of clerical work at a rate of $50 per hour. This bill’s
                                     itemized work descriptions made specific references to
                                     Quanex but none to QHMC or to the covered employee groups.
                                     On or about August 1999 Quanex paid CS the invoiced
                                     $23,100.
                                        The February 2002 bill charged as to the PPO project
                                     $44,375 for 45 hours of work performed by Micale, Chapman,
                                     and Howard at a rate of $250 per hour and for 265 hours of
                                     work performed by Betty Speery at a rate of $125 per hour.
                                     The itemized work descriptions in this bill made no direct
                                       59 Wannell did not provide any suggestions with respect to the unionization directly to CS,

                                     nor did he directly participate in the union negotiations. Wannell’s knowledge of what occurred
                                     with the negotiations was limited to what Royce told him.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00082   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    149


                                     mention of QHMC or of the covered employee groups. The
                                     record does not show that Quanex, or anyone else, had paid
                                     the $44,375 to CS by the time of trial.
                                         The March 2003 bill was for services CS performed in 2002
                                     ‘‘for the benefit of Quanex Corporation and QHMC’’. CS
                                     described most of the billable hours as time spent coordi-
                                     nating and negotiating the renewal of the Unicare PPO plan
                                     administration and analyzing the viability of integrating six
                                     additional divisions into the plan. The bill stated that CS
                                     was responsible for selecting various health care providers
                                     and for contracting claims runout services and terminations
                                     of vendors servicing five divisions. The bill charged $53,750
                                     for 83 hours of work performed by Micale, Chapman, and
                                     Howard at a rate of $250 per hour and 264 hours of work
                                     performed by Speery at a rate of $125 per hour. The bill
                                     made no specific mention of QHMC or of the covered employee
                                     groups in its itemized work descriptions, and the record does
                                     not indicate that CS was paid the $53,750 by the time of
                                     trial.
                                           b. Wannell’s Efforts
                                       Wannell had limited involvement with QHMC following the
                                     completion of the QHMC transactions. Between October 1997
                                     and April 1999 Wannell did not attend any meetings
                                     regarding QHMC business, and he did not receive any calls or
                                     written materials from CS or with respect to work CS was
                                     doing. On one (and possibly a couple more) occasions, Royce
                                     called Wannell to tell him about the state of CS’ work and
                                     to solicit Wannell’s off-the-cuff comments on that work so
                                     that Royce could relay those comments to CS. Royce did not
                                     provide Wannell with any written material related to the
                                     work CS was doing.
                                       Wannell did not attend the QHMC board meetings or share-
                                     holder meetings held on April 10, 2000, October 16, 2001,
                                     and October 1, 2002, but he did attend the meetings held on
                                     April 9, 1999, and April 17, 2001. Wannell was invited to
                                     attend all of the meetings, and he typically received advance
                                     notice of the topics and documents to be discussed from
                                     Royce, his main contact with respect to QHMC. With the
                                     exception of the two board meetings that Wannell did attend,
                                     his only QHMC contact was with Royce. Other than the ref-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00083   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     150                 139 UNITED STATES TAX COURT REPORTS                                          (67)


                                     erenced conversations with Royce, Wannell did not partici-
                                     pate in any meeting regarding QHMC business in between the
                                     board meetings, nor was he asked to participate in any such
                                     meeting. QHMC did not institute any of the wellness pro-
                                     grams that Wannell had instituted at LaSalle.
                                           5. Dividend Payments
                                       On April 21, 1999, QHMC paid a total of $3,088 in dividends
                                     to its class B and class C shareholders, which represented
                                     the annual dividend of $9.50 per share due for TYE 1998 and
                                     a quarterly dividend of $2.375 per share due for the first
                                     quarter of TYE 1999. After January 31, 1999, QHMC had no
                                     current or accumulated earnings and profits from which to
                                     pay dividends for the balance of TYE 1999 or for TYE 2000,
                                     TYE 2001, or TYE 2002, and QHMC paid no additional divi-
                                     dends for those years.
                                           6. Return on Investment Projections
                                       The minutes of QHMC’s October 1, 2002, board meeting con-
                                     tained projections of the amounts CS and Wannell would be
                                     entitled to receive if QHMC was dissolved or liquidated. The
                                     computations were as follows:
                                                                                 TYE 1998       TYE 1999         TYE 2000      TYE 2001

                                       Actual medical costs                      $2,656,249     $3,396,854       $3,685,133    $4,390,632
                                       Divided by yearend headcount                     564             573             598            595
                                       Actual cost per employee                       4,710          5,928            6,162          7,379
                                       Percent change                                ---            25.87%           3.95%         19.75%
                                       Projected cost per employee                    5,257          5,625            5,996          6,372
                                       Projected percentage change                   ---                 7%            6.6%         6.27%
                                       Difference in projected over actual              547            (303)           (166)        (1,007)
                                       Times yearend headcount                          564             573             598            595
                                       Current year savings                         308,699       (173,729)         (99,525)     (599,292)
                                       Less consulting fees                           -0-          (36,100)           -0-            -0-
                                       Net savings                                  308,699       (209,829)         (99,525)     (599,292)
                                       Cumulative prior-year savings                  -0-          308,699           98,870           (655)
                                       Total cumulative savings                     308,699         98,870             (655)     (599,947)
                                       Times 45%                                       0.45            0.45            0.45           0.45
                                       Formula value                                138,915         44,492             (295)     (269,976)
                                       Less original investment                     (26,000)       (26,000)         (26,000)      (26,000)
                                       Net return to date                           112,915         18,492             (295)     (269,976)
                                       Return on investment                           434%             71%           ---            ---

                                       CS’ portion of investment

                                       Formula value                                 80,143            25,668          (170)     (155,755)
                                       Less original investment                     (15,000)          (15,000)      (15,000)      (15,000)

                                       Net return to date                            65,143           10,668           (170)     (155,755)




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00084   Fmt 2847   Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                          151


                                                                                  TYE 1998       TYE 1999         TYE 2000      TYE 2001

                                       Wannell’s portion of investment

                                       Formula value                                  58,772            18,823         (125)     (114,221)
                                       Less original investment                      (11,000)          (11,000)     (11,000)      (11,000)

                                       Net return to date                             47,772            7,823          (125)     (114,221)

                                       The record contains another set of projections of the
                                     amounts QHMC preferred shareholders would be entitled to
                                     receive in the event of liquidation or dissolution of QHMC.
                                     These computations were pursuant to the liquidation pref-
                                     erences described in QHMC’s certificate, and projected, in
                                     part, as follows:
                                                                                  10/31/98       10/31/99         10/31/00      10/31/01

                                       Actual medical costs                       $2,656,249      $3,396,854      $3,685,133    $4,390,632
                                       (a) MPBs savings                              138,915          44,492           -0-           -0-
                                       (b) 50% of net equity                      19,055,451      18,875,986      18,725,324    18,480,107
                                       Formula value—lesser of (a) or (b)            138,915          44,492           -0-           -0-
                                       Fixed payout rate per share                       125             125              125           125
                                       No. of preferred shares                           260             260              260           260
                                       Fixed payout                                   32,500          32,500          32,500        32,500
                                       Greater of formula or fixed payout            138,915          44,492          32,500        32,500
                                       Less original investment                       26,000          26,000          26,000        26,000
                                       Net return to date                            112,915          18,492            6,500         6,500
                                       Cumulative return on investment                 434%             71%              25%           25%
                                       Annual return on investment                     434%             36%                8%            6%
                                       CS return                                      65,143          10,668            3,750         3,750
                                       Wannell return                                 47,772           7,823            2,750         2,750

                                     The record does not reflect that CS or Wannell received any
                                     payments from QHMC other than the dividend payments
                                     described above.
                                           7. QHMC’s Tax Returns
                                       QHMC ceased to be a member of petitioners’ affiliated group
                                     as of October 24, 1997, and QHMC filed a separate Federal
                                     income tax return for the short period October 24 through
                                     31, 1997, and for each of its taxable years TYE 1998 through
                                     TYE 2001. QHMC reported the following on those returns:
                                                                   10/31/97        10/31/98       10/31/99        10/31/00      10/31/01

                                      Taxable income

                                      Interest income                 $31,667     $2,850,000      $2,850,000      $3,221,555    $3,636,390
                                      E’ee insurance &
                                        benefits                        -0-        (2,776,666)    (3,200,059)     (3,761,512)   (4,390,632)
                                      Legal & audit costs               -0-          (152,543)         -0-             -0-           -0-
                                      Travel costs                      -0-             -0-             (596)          -0-            (714)
                                      Net income/(loss)               331,667         (79,209)      (350,655)       (539,957)     (754,956)

                                      NOL carryover                      -0-          47,542           398,197       938,154     1,693,110




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00085    Fmt 2847   Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     152                 139 UNITED STATES TAX COURT REPORTS                                         (67)


                                                                   10/31/97        10/31/98       10/31/99       10/31/00      10/31/01

                                      Schedule L balance
                                        sheet

                                      Cash                             65,000         65,000            61,316       61,317        61,317
                                      Notes receivable                  -0-            -0-               -0-          -0-      38,316,667

                                        Total assets                   65,000         65,000            61,316       61,317     8,377,984
                                      Accounts payable                  -0-            -0-               -0-          -0-       1,437,295
                                      Accrued Fed. inc. tax           (11,083)        21,390           144,119       20,175       (19,523)
                                      Intercompany liabil-
                                        ities                      38,031,667     37,946,241      37,596,182     37,369,153         -0-

                                        Total liabilities          38,020,584     37,967,631      37,740,301     37,389,328     1,417,772
                                      Common stock                     50,000         50,000          50,000         50,000        50,000
                                      Paid-in capital              38,015,000     38,015,000      38,015,000     38,015,000    38,015,000

                                        Total stock                38,065,000     38,065,000      38,065,000     38,065,000    38,065,000
                                      Retained earnings                20,584        (32,369)       (263,383)      (614,355)   (1,104,788)

                                        S/H’s equity (SE)          38,085,584     38,032,631      37,801,617     37,450,645    36,960,212
                                      Total liabilities & SE           65,000         65,000          61,316         61,317    38,377,984
                                      Distributions                     -0-            -0-             3,088          -0-           -0-

                                        QHMC’s 1997 return (for the short period) included three
                                     statements entitled ‘‘Statement Regarding Tax Free Con-
                                     tribution to Capital Pursuant to Regulation Section 1.351–
                                     3(b)’’. On the first statement, QHMC reported Quanex’s
                                     October 23, 1997, contribution to QHMC of $62,000 and 1,000
                                     shares of QHMC common stock in return for 500 shares of
                                     class A stock and 130 shares of class B stock. On the second
                                     statement, QHMC reported QS’ October 25, 1997, contribution
                                     to QHMC of $38 million and $37,989,000 of MPBs in return for
                                     110 shares of class C stock. On the third statement, QHMC
                                     reported CS’ October 25, 1997, contribution to QHMC of
                                     $2,000 in return for 20 shares of class C stock.
                                           8. Financial Statements
                                        On its financial statements, QHMC reported net income
                                     (loss) of $19,116, $26,785, ($355,842), ($301,325), and
                                     ($490,433) for TYE 1997 through TYE 2001, respectively. In
                                     addition, QHMC reported equity of $38,084,116, $38,110,901,
                                     $37,751,972, $37,450,647, and $36,960,214 as of the end of
                                     each of those respective years. As discussed infra, QHMC’s
                                     financial statements did not take into account QHMC’s
                                     assumption of the transferred MPBs.
                                           F. Notice of Deficiency
                                       On or about November 20, 2000, respondent contacted
                                     Royce to inform petitioners that the IRS would be conducting




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00086    Fmt 2847   Sfmt 2847    V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                       153


                                     an examination of Quanex’s 1997 return. 60 Approximately
                                     eight months later, on July 13, 2001, respondent hand-deliv-
                                     ered and mailed to petitioners a notice of deficiency (notice)
                                     for TYE 1997. Respondent explained in the notice that he dis-
                                     allowed petitioners’ claimed $37,989,000 short-term capital
                                     loss and that he correspondingly increased petitioners’ cap-
                                     ital gain income by $26,966,201. Respondent explained that
                                     he disallowed the loss because petitioners failed to establish
                                     that Quanex’s basis in the stock exceeded $11,000; the loss
                                     arose from transactions ‘‘that have no economic substance or
                                     business purpose, were entered into solely for tax avoidance,
                                     and were prearranged and predetermined’’; and petitioners
                                     failed to establish that the loss otherwise met the deduction
                                     requirements under the Code.
                                        Respondent further explained, as an alternative to the rea-
                                     sons previously stated, that he had disallowed the loss
                                     because either (1) the ‘‘purported nonrecognition transaction’’
                                     did not meet the requirements of section 351, including but
                                     not limited to the business purpose requirement, so that
                                     Quanex’s basis was determined by section 1001 (as opposed
                                     to a carryover basis); (2) QHMC’s assumption of the MPBs
                                     reduced the basis of the stock received in the exchange
                                     pursuant to section 358(d)(1) because the MPBs obligation is
                                     not a liability excluded under section 357(c)(3); or (3) the
                                     principal purpose of the transfer of the MPBs was not a bona
                                     fide business purpose such that section 357(b) applied, the
                                     assumption of the liability was a distribution of money, and
                                     Quanex’s basis was reduced by $37,989,000. Respondent fur-
                                     ther explained, as yet another alternative, that he had dis-
                                       60 The parties stipulated that respondent’s revenue agents interviewed Rose on March 23,

                                     2001, and that one of the agents stated during the interview that
                                     we (IRS) recognize Quanex’s business purpose for needing better management and control over
                                     its medical costs. It was explained that we (IRS) are concerned only with the tax consequences
                                     of the transaction and that we do not try to tell taxpayers how to run their business. It was
                                     explained to Mr. Rose that our concern was that Quanex had converted a contingent liability
                                     into a short-term capital loss.
                                     Respondent reserved an objection to the admissibility of this stipulation on the ground of rel-
                                     evance. Although we deferred ruling on the admissibility of this stipulation at trial, the com-
                                     ments of a revenue agent during an audit are generally not relevant, and we shall sustain re-
                                     spondent’s objection to the admissibility of this stipulation. See Greenberg’s Express, Inc. v. Com-
                                     missioner, 62 T.C. 324, 327–328 (1974) (holding that the Court decides deficiency cases on a de
                                     novo basis and that events during an audit, with limited exceptions none of which is applicable
                                     here, are irrelevant to our de novo review); see also Rountree Cotton Co. v. Commissioner, 113
                                     T.C. 422, 426 (1999), aff ’d, 12 Fed. Appx. 641 (10th Cir. 2001); Barnes v. Commissioner, T.C.
                                     Memo. 2004–266.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00087   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     154                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     allowed the loss because (1) the loss is disallowed under sec-
                                     tion 1.1502–20, Income Tax Regs., (2) petitioners
                                     deconsolidated QHMC with the intent to avoid section 1.1502–
                                     20, Income Tax Regs., (3) QHMC was not treated as holding
                                     a member security as of the time of the sale, and (4) peti-
                                     tioners transferred an asset within two years by direct or
                                     indirect disposition, or a deconsolidation of stock, with a view
                                     to avoid the disallowance of a loss on the disposition, or a
                                     basis reduction on the deconsolidation of stock of a sub-
                                     sidiary, or the recognition of unrealized gain.
                                        Respondent also stated in the notice that the deficiency
                                     resulted from petitioners’ improperly deducting expenses. To
                                     that end, respondent stated, he disallowed $323,137 of out-
                                     side consultant expenses and $29,114 of legal and audit
                                     expenses that petitioners deducted with respect to the
                                     ‘‘reorganization/recapitalization and sale of the stock’’ of
                                     QHMC because these expenses were not ordinary and nec-
                                     essary.
                                        With respect to the accuracy-related penalty under section
                                     6662, respondent determined that the 40% accuracy-related
                                     penalty of section 6662(a) and (h) (or alternatively the 20%
                                     accuracy-related penalty under section 6662(a) and (b)(1) (or
                                     alternatively (b)(2))) applied to the portion of the under-
                                     payment attributable to a gross valuation misstatement (or
                                     alternatively negligence or disregard of rules or regulations
                                     (or alternatively a substantial understatement of income
                                     tax)) with respect to the class C stock. Respondent also deter-
                                     mined that petitioners were liable for the 20% accuracy-
                                     related penalty under section 6662(a) and (b)(1) (or alter-
                                     natively (b)(2)) to the extent of the underpayment attrib-
                                     utable to the erroneous deductions. In none of those cases,
                                     respondent stated, had petitioners shown that they had
                                     reasonable cause for the underpayment and had acted in
                                     good faith.
                                                                                  OPINION

                                     I. Burden of Proof
                                       Taxpayers generally bear the burden of proof in this Court.
                                     Rule 142(a)(1). However, if a taxpayer produces credible evi-
                                     dence with respect to one or more factual issues relevant to
                                     ascertaining the taxpayer’s Federal income, estate, or gift tax




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00088   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    155


                                     liability, the burden of proof may shift to the Secretary as to
                                     that issue (or those issues). See sec. 7491(a)(1). Section
                                     7491(a)(1) applies to court proceedings arising in connection
                                     with examinations that the Commissioner commences after
                                     July 22, 1998. See Williams v. Commissioner, 123 T.C. 144,
                                     146 n.3 (2004); Nis Family Trust v. Commissioner, 115 T.C.
                                     523, 537 (2000). Section 7491(a)(1) applies to this proceeding
                                     because respondent informed Royce in late 2000 that the IRS
                                     would be conducting an examination of petitioners’ 1997
                                     return.
                                        For the burden of proof to shift to respondent under section
                                     7491(a)(1), petitioners must prove that they met the fol-
                                     lowing requirements of section 7491(a)(2): (1) petitioners
                                     substantiated any item as required by the Code, (2) peti-
                                     tioners maintained all records required by the Code, and (3)
                                     petitioners cooperated with respondent’s reasonable requests
                                     for witnesses, information, documents, meetings, and inter-
                                     views. Section 7491(a)(2)(C) also requires that in order to
                                     shift the burden of proof, a taxpayer that is a partnership,
                                     a corporation, or a trust (other than a qualified revocable
                                     trust as defined in section 645(b)(1)) must meet the require-
                                     ments of section 7430(c)(4)(A)(ii) (which in turn references
                                     the net worth requirements of 28 U.S.C. sec. 2412(d)(2)).
                                        Petitioners do not argue that section 7491(a)(1) shifts the
                                     burden of proof to respondent in this case. In addition, peti-
                                     tioners have not established (nor do we find) that they satis-
                                     fied the requirements of section 7491(a)(2). We hold that sec-
                                     tion 7491(a)(1) does not shift the burden of proof to
                                     respondent. See Goosen v. Commissioner, 136 T.C. 547, 558
                                     (2011); Stipe v. Commissioner, T.C. Memo. 2011–92.
                                     II. Witness Testimony
                                           A. Background
                                        We observe the candor, sincerity, and demeanor of each
                                     witness in order to evaluate his or her testimony and assign
                                     it weight for the primary purpose of finding disputed facts.
                                     We determine the credibility of each witness, weigh each
                                     piece of evidence, draw appropriate inferences, and choose
                                     between conflicting inferences in finding the facts of a case.
                                     The mere fact that one party presents unopposed testimony
                                     on that party’s behalf does not necessarily mean that the




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00089   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     156                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     elicited testimony will result in a finding of fact. We will not
                                     accept the testimony of witnesses at face value if we find
                                     that the outward appearance of the facts in their totality con-
                                     veys an impression contrary to the spoken word. See
                                     Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 84
                                     (2000), aff ’d, 299 F.3d 221 (3d Cir. 2002); cf. Gallick v. Balt.
                                     & Ohio R.R. Co., 372 U.S. 108, 114–115 (1963); Boehm v.
                                     Commissioner, 326 U.S. 287, 293 (1945); Wilmington Trust
                                     Co. v. Helvering, 316 U.S. 164, 167–168 (1942).
                                           B. Fact Witnesses
                                       Petitioners and respondent called six and four witnesses,
                                     respectively, to testify as to the facts of this case. Petitioners’
                                     fact witnesses were Wannell, Peery, Rose, Singer, Chapman,
                                     and Royce. Respondent’s fact witnesses were Schneider,
                                     Parikh, Ringuette, and Howard. To the extent we dis-
                                     regarded or discounted any of the testimony of these wit-
                                     nesses, we generally perceived the witnesses giving that
                                     testimony to be untrustworthy during that testimony or
                                     considered the testimony self-serving, vague, elusive,
                                     uncorroborated, and/or inconsistent with documentary or
                                     other reliable evidence. We are not required to rely on testi-
                                     mony that we consider to be untrustworthy and/or unreli-
                                     able, and we do not rely on any such testimony given in
                                     these cases to support either our findings of fact or our
                                     decisions with respect to the issues at hand. 61 See
                                     Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 84–
                                     87; see also Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).
                                           C. Expert Witnesses
                                           1. Background
                                           a. Overview
                                       On direct examination, each party called one witness to
                                     testify as an expert. Petitioners’ witness was Bruce A.
                                     Strombom, Ph.D. Respondent’s witness was David J. Ross.
                                     Petitioners also called David M. Eisenstadt, Ph.D., to testify
                                     as an expert in rebuttal of some of Ross’ testimony.
                                       61 We have noted in our findings of fact some examples of the testimony of the fact witnesses

                                     that we have decided not to rely upon.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00090   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    157


                                     Respondent recalled Ross to testify as an expert in rebuttal
                                     of some of Strombom’s testimony.
                                           b. Strombom
                                       Strombom has a B.A. in economics and a Ph.D. in
                                     economics. He is employed as the vice president of an inter-
                                     national economic, financial, and consulting firm, and most of
                                     his work involves the health care industry. He has published
                                     various articles in the area of his practice.
                                       Strombom concluded that the QHMC transactions have eco-
                                     nomic substance and a business purpose.
                                           c. Ross
                                        Ross has a B.A. in economics and an M.B.A. He works as
                                     the senior vice president of a consulting firm that specializes
                                     in applying economics to legal and regulatory issues, and he
                                     specializes (and has published articles) in financial economics
                                     and the economics of corporate law. He has previously testi-
                                     fied as an expert in this and other courts.
                                        Ross concluded that it was virtually certain that either
                                     QHMC or its preferred shareholders, if each acted rationally,
                                     would exercise their redemption rights by October 2004. Ross
                                     also concluded that the preferred stock is limited and pre-
                                     ferred as to dividends and does not participate in corporate
                                     growth in any meaningful way. Ross also concluded that the
                                     QHMC transactions were not necessary to provide incentives
                                     to CS and Wannell and that petitioners effectively retained
                                     their economic interest in the assets and liabilities trans-
                                     ferred to QHMC.
                                           d. Eisenstadt
                                       Eisenstadt has a B.S. in economics, an M.S. in economics,
                                     and a Ph.D. in economics. He works as an economist and a
                                     principal of a consulting and research firm. He has published
                                     various articles in the area of his practice.
                                       Eisenstadt concluded that Ross concluded incorrectly that
                                     it was virtually certain that either QHMC or its preferred
                                     shareholders, if each acted rationally, would exercise their
                                     redemption rights by October 2004. Eisenstadt also con-
                                     cluded that Ross concluded incorrectly that the preferred
                                     stock is limited and preferred as to dividends and does not




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00091   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     158                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     participate in corporate growth in any meaningful way.
                                     Eisenstadt did not opine as to any of Ross’ other conclusions.
                                           2. Analysis
                                       The Court recognized each of the proffered expert wit-
                                     nesses as an expert on his proffered area of expertise. Each
                                     expert then testified on direct examination primarily through
                                     his expert report, see Rule 143(g)(1), which the Court
                                     accepted into evidence. Each expert then testified on cross-
                                     examination, redirect examination, and re-cross-examination,
                                     through the typical question and answer process.
                                       We may accept or reject the findings and conclusions of
                                     these experts, according to our own judgment. See Parker v.
                                     Commissioner, 86 T.C. 547, 561–562 (1986). In addition, we
                                     may be selective in deciding what parts (if any) of their opin-
                                     ions to accept. See id. As discussed herein, we generally
                                     found Ross’ conclusions to be more persuasive than those of
                                     the other two experts.
                                     III. Net Short-Term Capital Loss
                                           A. Overview
                                        We now decide whether petitioners may deduct their
                                     claimed short-term capital loss from the sale of the class C
                                     stock. The parties agree that petitioners may not deduct the
                                     claimed loss if we decide any of the following six subissues
                                     in favor of respondent:
                                        1. whether the class C stock participates in corporate
                                     growth to any significant extent for purposes of section
                                     351(g);
                                        2. whether QHMC’s assumption of the MPB obligations con-
                                     stituted ‘‘other property’’ received by QS, within the meaning
                                     of section 358(a)(1)(A)(i);
                                        3. whether, for purposes of section 358(d), payment of the
                                     MPB obligations ‘‘would give rise to a deduction’’ within the
                                     meaning of section 357(c)(3)(A)(i), or if not, whether the
                                     incurrence of the MPB obligations ‘‘resulted in the creation of,
                                     or an increase in, the basis of any property’’ within the
                                     meaning of section 357(c)(3)(B);
                                        4. whether petitioners’ principal purpose with respect to
                                     QHMC’s assumption of the MPB obligations was a bona fide
                                     business purpose under section 357(b)(1)(B);




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00092   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    159


                                       5. whether the QHMC transactions lacked sufficient busi-
                                     ness purpose or economic substance or effect to be recognized
                                     for Federal income tax purposes; and
                                       6. whether the step transaction doctrine applies to re-
                                     characterize petitioners’ sale of the class C stock to Wannell
                                     as QHMC’s issuance of the stock to Wannell.
                                       We proceed to address these subissues to the extent nec-
                                     essary.
                                           B. Section 351(g)
                                        The parties dispute whether the class C stock was ‘‘pre-
                                     ferred stock’’ within the meaning of section 351(g)(3)(A), and
                                     they agree that the resolution of this dispute turns on
                                     whether the class C stock, as of the time it was issued,
                                     ‘‘participate[d] in corporate growth to any significant extent’’
                                     within the meaning of section 351(g)(3)(A). Petitioners argue
                                     that the class C stock was not such preferred stock because,
                                     they state, the class C stock participated significantly in
                                     QHMC’s corporate growth through the formula value.
                                     Respondent argues that the class C stock was such preferred
                                     stock because, he states, the class C stock did not participate
                                     significantly in QHMC’s corporate growth. If the class C stock
                                     participated in QHMC’s corporate growth to a significant
                                     extent, then the parties agree that the class C stock is not
                                     ‘‘preferred stock’’ (and thus is not nonqualified preferred
                                     stock (NQPS)) for purposes of section 351(g). If the class C
                                     stock did not so participate, then the parties agree that the
                                     class C stock is ‘‘preferred stock’’ (and further that the class
                                     C stock is NQPS) for purposes of section 351(g). We agree with
                                     respondent that the class C stock is ‘‘preferred stock’’ within
                                     the meaning of section 351(g)(3)(A) and, hence, that the stock
                                     is NQPS.
                                        Section 1001 requires that a taxpayer recognize any gain
                                     or loss realized on the sale or exchange of property, absent
                                     a contrary provision in subtitle A of the Code. One such con-
                                     trary provision is section 351(a), which generally provides
                                     that no gain or loss is recognized where one or more persons
                                     transfer property to a corporation solely in exchange for stock
                                     of the corporation if the transferor(s) control the corporation
                                     immediately after the exchange. Where a transferor in such
                                     an exchange receives only stock, the transferor’s basis in the




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00093   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     160                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     stock is the same as the transferor’s basis in the transferred
                                     property, see sec. 358(a)(1), such that the transferor, upon
                                     sale of the stock, will generally then recognize any unrecog-
                                     nized gain or loss that inhered in the transferred property as
                                     of the time of its transfer. Where, however, the transferee
                                     corporation assumes a liability of the transferor incident to
                                     receiving the transferred property, then the transferor’s basis
                                     in the received stock is reduced by the amount of the
                                     assumed liability, unless (in relevant part) the payment of
                                     the assumed liability ‘‘would give rise to a deduction’’. See
                                     sec. 358(a)(1), (d); see also sec. 357(c)(3).
                                        Section 351(a) does not apply to the extent that the trans-
                                     feree’s stock received in the exchange is NQPS. See sec.
                                     351(g)(1). Section 351(b) requires that a transferor recognize
                                     any inherent gain in property transferred to a corporation in
                                     a section 351 exchange, to the extent of the amount of money
                                     and the fair market value of ‘‘other property’’ received in
                                     return, and NQPS is ‘‘other property’’ for that purpose. See
                                     sec. 351(g)(1)(B). If the only stock received by the trans-
                                     feror(s) in the exchange is NQPS, then the transfer is com-
                                     pletely outside the nonrecognition rule of section 351(a). See
                                     sec. 351(g)(1). The parties agree that, if the class C stock is
                                     NQPS, then the basis in the class C stock sold to Wannell was
                                     $11,000 as of the time of that sale (rather than the claimed
                                     basis of $38 million) and, accordingly, that the sale did not
                                     result in the claimed loss.
                                        Section 351(g) was added to the Code as part of the Tax-
                                     payer Relief Act of 1997, Pub. L. No. 105–34, sec. 1014(a),
                                     111 Stat. at 919, generally effective for transactions after
                                     June 8, 1997. The special rule for NQPS was included in sec-
                                     tion 351 to remove from that nonrecognition provision ‘‘cer-
                                     tain exchange transactions’’ where an ‘‘investor has * * *
                                     obtained a more secure form of investment’’ in the form of
                                     ‘‘preferred stock’’. See H.R. Rept. No. 105–148, at 472 (1997),
                                     1997–4 C.B. (Vol. 1) 319, 794. For this purpose, ‘‘preferred
                                     stock’’ is ‘‘stock which is limited and preferred as to divi-
                                     dends and does not participate in corporate growth to any
                                     significant extent.’’ See sec. 351(g)(3)(A). With limited excep-
                                     tions, none of which is applicable here, this preferred stock
                                     is then ‘‘nonqualified’’ (and thus NQPS) if the preferred stock
                                     meets any of the following four conditions: (1) the holder of
                                     the stock may require the issuer or a related person to




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00094   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)                   GERDAU MACSTEEL, INC. v. COMMISSIONER                                    161


                                     redeem or purchase the stock, (2) the issuer or a related per-
                                     son must redeem or purchase the stock, (3) the issuer or a
                                     related person may redeem or purchase the stock and, as of
                                     the issue date, it is more likely than not that this right will
                                     be exercised, or (4) the dividend rate on the stock varies in
                                     whole or in part (directly or indirectly) with reference to
                                     interest rates, commodity prices, or other similar indices. See
                                     sec. 351(g)(2)(A); see also sec. 351(g)(2)(B) and (C).
                                        Neither the statute, the regulations, nor the legislative his-
                                     tory of section 351(g) defines the phrase ‘‘participate in cor-
                                     porate growth to any significant extent’’ for purposes of sec-
                                     tion 351(g)(3)(A). However, the regulations under section 305,
                                     which detail the tax consequences of certain distributions of
                                     stock and stock rights, use the same phrase to define the
                                     term ‘‘preferred stock’’ for purposes of section 305. Both par-
                                     ties rely upon those regulations under section 305 to inter-
                                     pret the phrase ‘‘participate in corporate growth to any
                                     significant extent’’ for purposes of section 351(g)(3)(A). So do
                                     we. See also 2 Martin D. Ginsburg & Jack S. Levin, Mergers,
                                     Acquisitions, and Buyouts, par. 604.3.1.1, at 6–87 (2012); 11
                                     Jacob Mertens, Law of Federal Income Taxation, sec. 43.8
                                     (2011). We also note that the definition of the term ‘‘pre-
                                     ferred stock’’ as set forth in section 351(g)(3)(A) mirrors the
                                     text of section 1504(a)(4)(B), which is part of the description
                                     of preferred stock that is deemed not to be stock for purposes
                                     of determining the members of an affiliated group. We under-
                                     stand the principle there to be that ‘‘stock’’ described in sec-
                                     tion 1504(a)(4) has a limited claim on the earnings and
                                     equity of the issuer and, thus, is more akin to debt than to
                                     equity.
                                        Section 1.305–5(a), Income Tax Regs., contains regulations
                                     under section 305 that are relevant to our analysis. 62 Those
                                           62 Sec.   1.305–5(a), Income Tax Regs., states in relevant part:
                                     The term ‘‘preferred stock’’ generally refers to stock which, in relation to other classes of stock
                                     outstanding, enjoys certain limited rights and privileges (generally associated with specified div-
                                     idend and liquidation priorities) but does not participate in corporate growth to any significant
                                     extent. The distinguishing feature of ‘‘preferred stock’’ for the purposes of section 305(b)(4) is
                                     not its privileged position as such, but that such privileged position is limited and that such
                                     stock does not participate in corporate growth to any significant extent. However, a right to par-
                                     ticipate which lacks substance will not prevent a class of stock from being treated as preferred
                                     stock. Thus, stock which enjoys a priority as to dividends and on liquidation but which is enti-
                                     tled to participate, over and above such priority, with another less privileged class of stock in
                                     earnings and profits and upon liquidation, may nevertheless be treated as preferred stock for
                                     purposes of section 305 if, taking into account all the facts and circumstances, it is reasonable
                                                                                                   Continued




VerDate Nov 24 2008   09:57 Jun 05, 2014     Jkt 372897     PO 20012   Frm 00095   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     162                 139 UNITED STATES TAX COURT REPORTS                                      (67)


                                     regulations describe corporate growth for purposes of section
                                     305(b)(4) with reference to the corporation’s earnings and
                                     rights upon liquidation and indicate that the substance of a
                                     stock’s right to participate in corporate growth controls over
                                     mere written declarations that the stock is allowed to so
                                     participate. The regulations also indicate that in order for
                                     stock not to be characterized as ‘‘preferred stock’’, the
                                     attributes of the stock, when considered in the setting of the
                                     surrounding facts as of the time the stock is issued, must
                                     establish that it is reasonably likely that the stock will
                                     meaningfully participate in corporate earnings and growth
                                     beyond the stock’s preferred limited interests. 63 For this pur-
                                     pose, a corporation’s earnings and growth are best evidenced
                                     through the corporation’s payment of dividends and an
                                     increase in the corporation’s equity (e.g., through a retention
                                     of earnings, asset appreciation, or contributions), and the
                                     ability of a class of stock to participate in its issuer’s
                                     earnings and growth is best evidenced through the extent to
                                     which the stock is entitled to receive dividends and liquida-
                                     tion (including by way of the stock’s redemption) proceeds
                                     representing the corporation’s increased equity. Preferred
                                     stock is generally more akin to a secure form of debt than
                                     it is to a less secure form of equity in that preferred stock
                                     characteristically is entitled to receive without regard to cor-
                                     porate profits a set share of corporate earnings and/or liq-
                                     uidation proceeds (if not redeemed earlier). ‘‘Preferred stock’’
                                     for purposes of sections 305 and 351(g) follows this character-
                                     ization in that it enjoys limited rights and privileges with
                                     regard to dividends and liquidation proceeds and does not
                                     meaningfully participate in corporate growth beyond this
                                     amount.
                                     to anticipate at the time a distribution is made (or is deemed to have been made) with respect
                                     to such stock that there is little or no likelihood of such stock actually participating in current
                                     and anticipated earnings and upon liquidation beyond its preferred interest. Among the facts
                                     and circumstances to be considered are the prior and anticipated earnings per share, the cash
                                     dividends per share, the book value per share, the extent of preference and of participation of
                                     each class, both absolutely and relative to each other, and any other facts which indicate wheth-
                                     er or not the stock has a real and meaningful probability of actually participating in the earn-
                                     ings and growth of the corporation. * * *
                                        63 Petitioners gauge this reasonableness through the eyes of the class C shareholders, namely,

                                     CS and Wannell. We do not do the same. The answer to the question of whether stock partici-
                                     pates in corporate growth under sec. 351(g) or sec. 1.305–5(a), Income Tax Regs., turns on a
                                     consideration of the attributes of that stock in the setting at hand, and a shareholder’s subjec-
                                     tive expectations in buying the stock carry no weight in deciding that answer.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00096   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    163


                                        The class C stock fits squarely within the section
                                     351(g)(3)(A) definition of ‘‘preferred stock’’ as gleaned from its
                                     text (and the text of section 1504(a)(4)), from the legislative
                                     history under section 351(g), and from the referenced regula-
                                     tions under section 305. In relation to QHMC’s common stock
                                     (i.e., the class A stock), the class C stock enjoys set
                                     preestablished limited rights and privileges as to dividends
                                     and liquidation proceeds and does not participate in QHMC’s
                                     growth to a significant extent. In lieu of giving its holders a
                                     significant interest in QHMC’s corporate growth, the class C
                                     stock gives its holders a guaranteed fixed annual income
                                     preference in the form of a set, cumulative dividend and,
                                     upon that stock’s redemption (including incident to QHMC’s
                                     liquidation), a fixed payout that is unrelated to QHMC’s cor-
                                     porate growth (and, as of the time the stock was issued, was
                                     most likely to be $125 per share). While the class C stock by
                                     its terms states that its holders are entitled to receive
                                     redemption payments determined on the basis of cost savings
                                     or net equity, if those amounts are greater than $125 per
                                     share, this entitlement is meaningless in that the redemption
                                     provisions merely allow the class C shareholders to poten-
                                     tially share in the MPB cost savings, an allowance which
                                     under the facts herein is not akin to sharing in QHMC’s cor-
                                     porate growth. Moreover, this entitlement is unlikely to
                                     occur. Instead, as we find, the expected return on each share
                                     of the class C stock, when viewed as of the time the class C
                                     stock was issued, was capped at, and was intended and
                                     understood to be, 9.5% annually and $125 upon its redemp-
                                     tion in five to seven years.
                                        The parties do not dispute the fact that the class C stock’s
                                     right to receive QHMC’s earnings annually is preferred, fixed,
                                     and limited. The class C stock, which QHMC specifically des-
                                     ignated and labeled as preferred stock (as opposed to
                                     common stock), entitles its holders to receive from QHMC’s
                                     surplus or net profits, when and as declared by QHMC’s
                                     board, annual dividends of $9.50 per share, and these divi-
                                     dends are cumulative and payable for the current year and
                                     for all previous years before any dividend may be paid on
                                     QHMC’s common stock. The class C shareholders may not
                                     participate in or receive any dividends or share of profits,
                                     whether payable in cash, stock, or property, in excess of
                                     these dividends. The class C shareholders’ ability to partici-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00097   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     164                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     pate significantly in corporate growth, therefore, rests on
                                     their redemption rights. 64
                                        Respondent argues that the class C stock’s redemption
                                     rights do not give the class C shareholders a meaningful
                                     interest in QHMC’s corporate growth. We agree. Any partici-
                                     pation rights formally set forth in the redemption provisions
                                     applicable to the class C stock are illusory in that the class
                                     C shareholders, upon redemption of their stock, are reason-
                                     ably foreseen, as of the time that the class C stock was
                                     issued, to be entitled to receive only a preferred and limited
                                     amount of QHMC’s assets equal to $125 a share. Contrary to
                                     petitioners’ position, the formula value will not operate to
                                     allow those shareholders to receive more than that set
                                     amount. The formula value is simply a clever facade dis-
                                     guising the fact that the class C shareholders have no mean-
                                     ingful rights to the liquidation proceeds of QHMC beyond the
                                     $125-per-share preferred amount. While the formula value
                                     on its face was carefully and artfully tailored to appear to
                                     allow for the possibility of a larger payout upon the class C
                                     stock’s redemption, the formula value also was carefully and
                                     artfully tailored so that the possibility of a larger payout
                                     lacks any meaningful substance in that ‘‘it is reasonable to
                                     anticipate at the time a distribution is made (or is deemed
                                     to have been made) with respect to such stock that there is
                                     little or no likelihood of such stock actually participating in
                                     current and anticipated earnings and upon liquidation
                                     beyond its preferred interest.’’ Sec. 1.305–5(a), Income Tax
                                     Regs. In fact, as we conclude from the record at hand, when
                                     the class C stock was issued, the reasonable likelihood was
                                     that the stock would fail to meaningfully participate in cor-
                                     porate earnings at all, given that QHMC had no accumulated
                                     earnings when the class C stock was issued and that QHMC
                                     was reasonably expected to have little to no earnings before
                                     the class C stock was most likely to be redeemed.
                                        Petitioners rely heavily upon the ‘‘cumulative net savings’’
                                     prong of the formula value to argue that the class C share-
                                     holders have an opportunity to participate in QHMCs’ growth
                                     and earnings beyond their preferred interest. As petitioners
                                     see it, the class C shareholders participate in QHMC’s growth
                                      64 We use the term ‘‘redemption rights’’ to include the class C shareholders’ rights upon

                                     QHMC’s liquidation or upon QHMC’s earlier redemption of those shares.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00098   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    165


                                     on the basis of cost savings produced in managing the MPB
                                     obligations. In other words, they state, the greater the
                                     amount of savings, the more the QHMC class shareholders
                                     may participate in QHMC’s growth. We see things differently.
                                        The redemption provisions apply when QHMC is liquidated,
                                     if QHMC exercises its call option after September 30, 2002, or
                                     if a class C shareholder exercises the shareholder’s put
                                     option after September 30, 2004. When one of those events
                                     occurs, a class C shareholder is entitled to receive the greater
                                     of $125 per share or the formula value. The formula value
                                     is stated to be the amount that is the lesser of: (1) 45% of
                                     the cumulative cost savings as to the MPBs or (2) 50% of the
                                     net equity (i.e., assets minus liabilities) as of the time of
                                     redemption, as shown on QHMC’s books and records through
                                     the application of Generally Accepted Accounting Principles.
                                        Thus, under the redemption provisions, when $125 is
                                     greater than or equal to the formula value, class C share-
                                     holders are entitled to receive no more than $125 for each of
                                     their shares. In that circumstance, the class C shareholders’
                                     right to participate in liquidation proceeds is capped at $125
                                     per share, and class C shareholders may not participate in
                                     QHMC’s liquidation proceeds beyond the stock’s limited pref-
                                     erence.
                                        If, on the other hand, $125 is less than the formula value,
                                     then the class C shareholders are entitled to receive the
                                     amount of the formula value. In that case, Ross tells us (and
                                     we agree), any redemption payment to the preferred share-
                                     holders would depend solely on cumulative cost savings, not
                                     on the amount of net equity, no matter how much QHMC may
                                     realistically grow. Such is so, Ross explains, because 50% of
                                     net equity will under the facts herein always exceed 45% of
                                     the MPB cash savings, and the net equity component of the
                                     formula value will therefore never control the formula value.
                                     This is partly because QHMC’s net equity as of the start of the
                                     QHMC transactions was artificially high because the MPB
                                     obligations transferred to QHMC were neither reportable nor
                                     reported as a liability under Generally Accepted Accounting
                                     Principles, and QHMC’s net equity was anticipated to remain
                                     artificially high through the end of TYE 2011. 65 The ‘‘lesser
                                        65 All three experts agreed that the net equity component of the formula value would not be

                                     triggered through at least the end of TYE 2011. While Strombom and Eisenstadt concluded that
                                                                                                 Continued




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00099   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     166                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     of ’’ provision in the formula value, therefore, eliminated any
                                     realistic possibility that the class C stock would participate
                                     in QHMC’s net equity.
                                        As to the formula value’s cost savings provision, this provi-
                                     sion does not amount to a participation in corporate growth.
                                     The redemption provisions gave the preferred shareholders
                                     an interest in reducing the amount of the MPB obligations
                                     assumed by QHMC, as opposed to participating in QHMC’s cor-
                                     porate growth, and reducing those obligations will not nec-
                                     essarily generate earnings for QHMC or otherwise cause QHMC
                                     to grow following the issuance of the class C stock. QHMC’s
                                     sole source of income was interest, and under each of D&T’s
                                     cashflow models, QHMC’s interest income for 1998 through
                                     2012 was projected to be substantially less than the projected
                                     MPB costs. MPB costs would have to be reduced by an amount
                                     significantly higher than petitioners’ projections for QHMC to
                                     have earnings; and we are not persuaded that, when the
                                     class C stock was issued, it was probable that those costs
                                     would be so reduced in the relevant future. In addition, even
                                     if QHMC were to have grown as of the time of the class C
                                     stock’s redemption (e.g., it invested its assets profitably), the
                                     class C shareholders would receive none of that growth if
                                     there were no cost savings. Instead, the benefit of the growth
                                     in that case would go only to Quanex, as the holder of QHMC’s
                                     common stock. 66 We conclude that the cost savings compo-
                                     nent of the formula value does not allow the class C stock to
                                     participate in QHMC’s corporate growth.
                                     the net equity component could be operative in TYE 2012, Ross has persuaded us that their
                                     conclusion is wrong because, when the class C stock was issued, the preferred stock was reason-
                                     ably foreseen to be redeemed before TYE 2012. As Ross noted, QHMC’s preferred stock had a
                                     five- and seven-year redemption right, and it was virtually certain that the class B and class
                                     C stocks, if the shareholders and QHMC acted reasonably, would be redeemed by October 2004.
                                     Such is so because by that time, (1) the value that QHMC would have to pay the preferred
                                     shareholders upon exercise would be less than the value QHMC would have to pay the share-
                                     holders in the absence of exercise (namely, future dividends and other amounts resulting from
                                     the stock’s redemption) or (2) the shareholders’ exercise price would be greater than the value
                                     QHMC would have to pay them in the absence of exercise. Thus, Ross noted (and we agree),
                                     as of the time that the preferred stock was issued, either QHMC or the preferred shareholders
                                     would consider it economical to redeem the preferred shares at their earliest opportunity; i.e.,
                                     no later than October 2004. Ross also opined persuasively that Quanex had an economic incen-
                                     tive to redeem the preferred stock as soon as it could (October 1, 2002) because, if it did, then
                                     Quanex could deduct all of the MPB expenses incurred, which amount was most likely going
                                     to be larger than the corresponding interest expense Quanex deducted.
                                        66 Further, QHMC’s reduction of costs did not necessarily mean that QHMC would grow, e.g.,

                                     any cost reduction could be accompanied by a decline in the value of QHMC’s assets. Yet if the
                                     cost savings exceeded the $125 threshold, the additional cost savings would increase the re-
                                     demption price without a corresponding growth of QHMC.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00100   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      167


                                        In sum, we find that the class C stock vis-a-vis QHMC’s
                                     common stock enjoys certain limited and preferred rights and
                                     privileges associated with dividend and liquidation priorities
                                     and that the class C stock, as of the time the stock was
                                     issued, did not actually allow the holders thereof to partici-
                                     pate in QHMC’s corporate growth to a significant extent. We
                                     hold that the class C stock is NQPS. Given the parties’ agree-
                                     ment that such a holding means that petitioners are not enti-
                                     tled to deduct the short-term capital loss, we reach the same
                                     conclusion.
                                           C. Economic Substance Doctrine
                                           1. Overview
                                       Given our just-stated holding, we need not decide any of
                                     the parties’ other disputes as to the claimed loss. We bear in
                                     mind, however, that respondent maintains that the QHMC
                                     transactions are disregarded for Federal income tax purposes
                                     under the economic substance doctrine and that two Courts
                                     of Appeals have discussed this doctrine in the setting of simi-
                                     larly structured transactions. See Coltec Indus., Inc. v.
                                     United States, 454 F.3d 1340 (Fed. Cir. 2006); Black &
                                     Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006). 67
                                     We also note that respondent determined that the fees
                                     incurred to effect the QHMC transactions were not ordinary
                                     and necessary business expenses and clarifies in his brief
                                     that such is so because those transactions lacked economic
                                     substance. We consider it necessary to decide whether the
                                     QHMC transactions had economic substance, and we proceed
                                     to do so.

                                        67 In Black & Decker Corp. v. United States, 436 F.3d 431, 433 (4th Cir. 2006), a taxpayer

                                     transferred $561 million to a controlled subsidiary in exchange for stock in the subsidiary and
                                     the subsidiary’s assumption of $560 million in contingent medical liabilities. The taxpayer
                                     claimed that its basis in the subsidiary’s stock was $561 million and that it realized a $560 mil-
                                     lion capital loss when it sold the stock for $1 million. Id. at 434–438. The taxpayer claimed that
                                     the liabilities were excluded under sec. 357(c)(3) and that, under sec. 358(d)(2), the taxpayer did
                                     not need to reduce its basis in the subsidiary stock by the liabilities assumed by the subsidiary.
                                     Id. at 434. In Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1344 (Fed. Cir. 2006), the tax-
                                     payer transferred $375 million to one of its subsidiaries in exchange for stock in the subsidiary
                                     and the subsidiary’s assumption of contingent asbestos-related liabilities against the taxpayer.
                                     The taxpayer claimed that the liabilities were excluded under sec. 357(c)(3) and, under sec.
                                     358(d)(2), did not reduce its basis in the subsidiary stock. Id. at 1345–1346. The taxpayer as-
                                     serted a $379.2 million basis in the subsidiary stock and claimed a $378.7 million loss when
                                     it sold the stock for $500,000. Id.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00101   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     168                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                           2. Standard of Analysis
                                        D&T and Quanex structured the QHMC transactions as an
                                     elaborate and devious multistep transaction, each individual
                                     step of which D&T promoted as meeting a literal reading of
                                     the Code, the regulations thereunder, and various judicial
                                     and administrative interpretations. The essence of the trans-
                                     actions, however, was simply to create an artificial multi-
                                     million-dollar tax loss that petitioners could report as an
                                     offset to their unrelated capital gains of a similar amount.
                                     Although taxpayers may structure their business trans-
                                     actions in a manner that produces the least amount of tax,
                                     see Boulware v. United States, 552 U.S. 421, 430 n.7 (2008)
                                     (citing Gregory v. Helvering, 293 U.S. 465, 469 (1935));
                                     Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 781
                                     (5th Cir. 2001), rev’g 113 T.C. 214 (1999), the economic sub-
                                     stance doctrine requires that a court disregard a transaction
                                     that a taxpayer enters into without a valid business purpose
                                     in order to claim tax benefits not contemplated by a reason-
                                     able application of the language and the purpose of the Code
                                     or the regulations thereunder, 68 see, e.g., ACM P’ship v.
                                     Commissioner, 157 F.3d 231, 248 (3d Cir. 1998), aff ’g in part,
                                     rev’g in part T.C. Memo. 1997–115; Rice’s Toyota World, Inc.
                                     v. Commissioner, 752 F.2d 89, 91–92 (4th Cir. 1985), aff ’g in
                                     part, rev’g in part 81 T.C. 184 (1983); New Phoenix Sunrise
                                     Corp. & Subs. v. Commissioner, 132 T.C. 161 (2009), aff ’d,
                                     408 Fed. Appx. 908 (6th Cir. 2010); Blum v. Commissioner,
                                     T.C. Memo. 2012–16; Palm Canyon X Invs., LLC v. Commis-
                                     sioner, T.C. Memo. 2009–288. Such a transaction is dis-
                                     regarded even though it may otherwise comply with the lit-
                                     eral terms of the Code and the regulations thereunder. See,
                                     e.g., Coltec Indus., Inc., 454 F.3d at 1351–1355.
                                        While the origin of the economic substance doctrine is gen-
                                     erally traced to the Supreme Court’s holding in Gregory v.
                                     Helvering, 69 293 U.S. 465, current application of the doctrine
                                       68 Congress codified the economic substance doctrine mostly as articulated by the U.S. Court

                                     of Appeals for the Third Circuit in ACM P’ship v. Commissioner, 157 F.3d 231, 247–248 (3d Cir.
                                     1998), aff ’g in part, rev’g in part T.C. Memo. 1997–115. See sec. 7701(o) (as added to the Code
                                     by the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111–152, sec. 1409,
                                     124 Stat. at 1067); see also H.R. Rept. No. 111–443(I), at 291–299 (2010), 2010 U.S.C.C.A.N.
                                     123, 222–231. The codified doctrine does not apply here, pursuant to its effective date.
                                       69 In Gregory v. Helvering, 293 U.S. 465, 469–470 (1935), the Supreme Court held that a reor-

                                     ganization complying with formal statutory requirements was disregarded for tax purposes be-
                                     cause the creation and immediate liquidation of the transferee corporation was an attempt to




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00102   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                      169


                                     stems primarily from the Supreme Court’s decision in Frank
                                     Lyon Co. v. United States, 435 U.S. 561 (1978). In Frank
                                     Lyon Co., 435 U.S. at 566–568, the taxpayer borrowed $7.1
                                     million from one bank, bought a building from another bank
                                     for $7.6 million, and leased the building back to the same
                                     bank which had sold the property for rent equal to the tax-
                                     payer’s payments of principal and interest on the $7.1 million
                                     loan. The taxpayer claimed depreciation deductions on the
                                     building and interest deductions on the loan and reported the
                                     payments from the bank as income from rent. Id. at 573. The
                                     United States argued that the transaction should be dis-
                                     regarded because it was merely an elaborate financing
                                     scheme designed to manufacture tax deductions. Id. The
                                     Court disagreed, holding that the transaction was not a
                                     sham. Id. at 583–584. The Court set forth the following
                                     standard for determining when a transaction should be
                                     respected for tax purposes:
                                     [W]here, as here, there is a genuine multiple-party transaction with eco-
                                     nomic substance which is compelled or encouraged by business or regu-
                                     latory realities, is imbued with tax-independent considerations, and is not
                                     shaped solely by tax-avoidance features that have meaningless labels
                                     attached, the Government should honor the allocation of rights and duties
                                     effectuated by the parties. * * * [Id.]

                                       The Courts of Appeals have construed the quoted language
                                     as creating an economic substance doctrine with the fol-
                                     lowing two prongs: (1) whether the transaction had economic
                                     substance beyond tax benefits (objective prong), and (2)
                                     whether the taxpayer had a nontax business purpose for
                                     entering the disputed transaction (subjective prong). See, e.g.,
                                     ACM P’ship v. Commissioner, 157 F.3d at 247–248; Bail
                                     Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d
                                     1543, 1549 (9th Cir. 1987), aff ’g T.C. Memo. 1986–23; Rice’s
                                     Toyota World, Inc. v. Commissioner, 752 F.2d at 91–92. The
                                     Courts of Appeals are split on the proper weight to be given
                                     to these prongs in deciding whether to respect a transaction
                                     convert ordinary income into capital gain. The Court recognized the right of a taxpayer to avoid
                                     the payment of tax through legal means but noted that ‘‘the question for determination is
                                     whether what was done, apart from the tax motive, was the thing which the statute intended.’’
                                     Id. at 469. The Court examined the applicable statutory text and held that the taxpayer had
                                     not formed a corporation within the intended meaning of the statute. Id. at 470. The Court stat-
                                     ed that the undertaking was ‘‘in fact an elaborate and devious form of conveyance masquerading
                                     as a corporate reorganization, and nothing else’’ and ‘‘upon its face lies outside the plain intent
                                     of the statute.’’ Id.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00103   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     170                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     under the economic substance doctrine, and alternative
                                     approaches have emerged. Some Courts of Appeals apply a
                                     disjunctive analysis, under which a transaction is valid if it
                                     has economic substance or a business purpose. See, e.g., Horn
                                     v. Commissioner, 968 F.2d 1229, 1236–1238 (D.C. Cir. 1992),
                                     rev’g Fox v. Commissioner, T.C. Memo. 1988–570; Rice’s
                                     Toyota World, Inc. v. Commissioner, 752 F.2d at 91. Other
                                     Courts of Appeals apply a conjunctive analysis, under which
                                     a transaction is valid only if the transaction has economic
                                     substance beyond tax objectives and the taxpayer had a
                                     nontax business purpose for entering into the transaction.
                                     See Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th
                                     Cir. 2006); Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d
                                     1313, 1316 (11th Cir. 2001), aff ’g 113 T.C. 254 (1999); United
                                     Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014,
                                     1018 (11th Cir. 2001), rev’g T.C. Memo. 1999–268. Still other
                                     Courts of Appeals adhere to the view that a lack of economic
                                     substance is sufficient to invalidate the transaction regard-
                                     less of whether the taxpayer has motives other than tax
                                     avoidance. See, e.g., Coltec Indus., Inc., 454 F.3d at 1355.
                                     And still other Courts of Appeals treat the objective and
                                     subjective prongs merely as factors to consider in deter-
                                     mining whether a transaction has any practical economic
                                     effects beyond tax benefits. See, e.g., ACM P’ship v. Commis-
                                     sioner, 157 F.3d at 248.
                                        Under Golsen v. Commissioner, 54 T.C. at 757, we follow
                                     a holding of a court to which appeal lies that is squarely on
                                     point. The Court of Appeals for the Fifth Circuit, to which
                                     this case is appealable absent a stipulation to the contrary,
                                     has interpreted the economic substance test delineated in
                                     Frank Lyon Co., 435 U.S. 561, as ‘‘a multi-factor test’’. See
                                     Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d
                                     537, 544 (5th Cir. 2009). 70 In Klamath Strategic Inv. Fund,
                                     LLC, 568 F.3d at 544, the Court of Appeals for the Fifth Cir-
                                     cuit stated that the relevant factors include whether the
                                     transaction (1) has economic substance compelled by busi-
                                       70 At the time of the original and supplemental briefings in this case, the Court of Appeals

                                     for the Fifth Circuit had not decided how it would apply the economic substance test. See, e.g.,
                                     Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 781 (5th Cir. 2001) (declining to adopt
                                     a particular approach and finding that a transaction had both economic substance and a legiti-
                                     mate business purpose and stating that the transaction had economic substance under any ap-
                                     proach), rev’g 113 T.C. 214 (1999). The Court of Appeals later decided Klamath Strategic Inv.
                                     Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009), on which we rely in this Opinion.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00104   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    171


                                     ness or regulatory realities, (2) is imbued with tax-inde-
                                     pendent considerations, and (3) is not shaped totally by tax-
                                     avoidance features. The court stressed that in Frank Lyon
                                     Co., 435 U.S. at 583–584, the Supreme Court phrased the
                                     factors in the conjunctive. See Klamath Strategic Inv. Fund,
                                     LLC, 568 F.3d at 544. The court concluded that a taxpayer’s
                                     failure to meet any one of these three factors renders the
                                     transaction void for tax purposes. Id. The court noted that ‘‘if
                                     a transaction lacks economic substance compelled by busi-
                                     ness or regulatory realities, the transaction must be dis-
                                     regarded even if the taxpayers profess a genuine business
                                     purpose without tax-avoidance motivations.’’ Id.
                                           3. QHMC Transactions
                                           a. Objective Economic Substance
                                           i. Background
                                        Petitioners point to several factors supporting their argu-
                                     ment that the QHMC transactions had objective economic sub-
                                     stance. According to petitioners, QHMC engaged in numerous
                                     bona fide economically based transactions in managing the
                                     MPB obligations. QHMC assumed liability for the health care
                                     claims of a large portion of Quanex’s employees, took on the
                                     role of managing health care costs, and developed health care
                                     cost containment strategies that Quanex implemented and
                                     which resulted in demonstratable cost savings. Petitioners
                                     also argue that the QHMC transactions affected petitioners’
                                     net economic position, their legal relations, and their nontax
                                     business interests. Petitioners contend that while the trans-
                                     actions presented a reasonable possibility of controlling
                                     health care costs that would otherwise be borne by peti-
                                     tioners, the transactions were attended by a real risk that
                                     the objective of controlling health care costs would not be
                                     achieved.
                                        In further support of their argument for objective economic
                                     substance, petitioners assert that they projected that the
                                     QHMC transactions could result in a substantial pretax profit
                                     and a substantial yield on petitioners’ cash investment.
                                     Strombom concluded that there was a reasonable expectation
                                     that the nontax benefits from the QHMC transactions would
                                     be at least commensurate with the transaction costs.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00105   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     172                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     Strombom compared the present value of the savings under
                                     various assumptions regarding QHMC’s ability to generate
                                     medical cost savings and the time when QHMC repurchases
                                     its preferred shares. 71 Strombom’s calculations show that
                                     petitioners would realize nontax benefits with a present
                                     value of over $600,000 if medical benefits costs were 10% less
                                     than projected and QHMC repurchased the preferred shares
                                     after seven years. Petitioners point to the track record of suc-
                                     cesses by CS and Wannell in reducing petitioners’ health
                                     care costs to justify their expectation that QHMC could obtain
                                     additional future savings. Expected values of incremental
                                     savings in the range of 5% to 15% were also shown to be
                                     reasonable given the recent success of other businesses, and
                                     of petitioners themselves, in reducing health care spending.
                                     Petitioners conclude that these factors demonstrate that
                                     there was a reasonable possibility of earning a pretax profit
                                     as a result of the QHMC transactions.
                                        The record does not support petitioners’ contention that
                                     the QHMC transactions had objective economic substance. To
                                     the contrary, the record establishes that the QHMC trans-
                                     actions were structured (from a generic product D&T pro-
                                     moted to petitioners) and implemented to manufacture an
                                     approximately $38 million artificial tax loss and without
                                     serious regard to Quanex’s desire to reduce its medical ben-
                                     efit costs. We base our holding on our analysis of the factors
                                     discussed in the following parts ii. and iii.
                                           ii. Lack of Substantive Changes as a Result of QHMC
                                               Transactions
                                       Although as early as 1996 or 1997 Quanex and CS had
                                     general discussions regarding a possible joint venture as a
                                     long-term approach to controlling Quanex’s health care costs,
                                     QHMC did not become that joint venture. Despite petitioners’
                                     assertions, QHMC did not serve any meaningful purpose and
                                       71 Strombom calculated petitioners’ net present value from pursuing the QHMC transactions

                                     under the assumption that the transactions had no tax implications. In measuring the net
                                     present value of the transactions, Strombom determined the timing of the incremental cashflows
                                     that would result from the transactions. The incremental cashflows included: the parties’ initial
                                     investments in QHMC, any medical savings realized by QHMC relative to the benchmark, divi-
                                     dends, consulting fees, and the cashflows to the parties when QHMC repurchased the preferred
                                     stock. For purposes of these calculations, Strombom also assumed that petitioners incurred
                                     $352,251 of transaction costs.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00106   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    173


                                     nothing of substance changed as a result of the QHMC trans-
                                     actions.
                                        The record contains no evidence that QHMC conducted any
                                     type of business operations. QHMC had no employees of its
                                     own. Except for Wannell, each class A director was a Quanex
                                     employee when he or she was elected. Except for two Ful-
                                     bright attorneys, each QHMC officer was a Quanex employee
                                     when he or she was elected. Parikh, who served as a QHMC
                                     board member, vice president, and treasurer, testified that
                                     he had no specific daily activities or responsibilities to per-
                                     form for QHMC. Peery, who also was a QHMC board member
                                     and vice president from October 23, 1997, through April 9,
                                     1999, testified that he was not involved in QHMC’s operations
                                     and that he did not know he was a QHMC officer. As class C
                                     shareholders, CS performed the same consulting work it had
                                     provided for Quanex in the past and Wannell played vir-
                                     tually no role in developing or implementing any cost savings
                                     strategies.
                                        In addition, petitioners carried on the administration of the
                                     transferred MPB obligations as if QHMC did not exist. Peti-
                                     tioners continued after the QHMC transactions to process the
                                     claims for the MPBs transferred to QHMC in the same manner
                                     as before the QHMC transactions, and the QHMC-covered
                                     employees’ claims were not handled differently from other
                                     employees’ claims that were not transferred to QHMC. Peti-
                                     tioners paid for all the costs associated with processing the
                                     MPB claims, and QHMC paid no fees to petitioners for these
                                     services. Petitioners also initially paid the medical claims
                                     costs and the employer’s share of HMO premiums for or
                                     related to the transferred MPBs. Petitioners handled these
                                     payments through their treasury department in the same
                                     manner that such costs were handled for all of their
                                     employees. While QHMC subsequently reimbursed petitioners
                                     for the employees’ claims and the employer’s share of the
                                     HMO premiums that petitioners paid, QHMC’s reimbursement
                                     was tied directly to its receipt of payments on the Piper note
                                     and other loans to various subsidiaries of petitioners. These
                                     notes represented QHMC’s sole source of income, as QHMC’s
                                     business came solely from petitioners. Petitioners fail to
                                     explain why QHMC made these loans, and we find them to be
                                     an arrangement by which petitioners could continue to pay




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00107   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     174                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     for the costs of the               MPBs,     despite       QHMC’s      assumption of the
                                     MPB obligations.

                                           iii. Lack of Reasonable Expectation of Nontax Benefits on
                                                Petitioners’ Part
                                        We are not persuaded by Strombom’s projections that the
                                     QHMC transactions would result in any meaningful nontax
                                     benefit for petitioners. To the contrary, the economic con-
                                     sequences of the transactions were inconsequential when
                                     compared with the tax benefits to be received. As Ross
                                     persuasively observes, Strombom’s conclusion that the QHMC
                                     transactions had a reasonable possibility of nontax benefits
                                     is flawed because he failed to take into account the prob-
                                     ability of petitioners’ attaining any cost savings at all, let
                                     alone the probability of achieving any particular magnitude
                                     of cost savings. Petitioners provide no support for the prob-
                                     ability that the assumed cost savings would occur.
                                        Even more significantly, as Ross points out, Strombom’s
                                     calculations are flawed because he considers any medical
                                     savings realized by QHMC to be incremental cashflows attrib-
                                     utable to the QHMC transactions. In other words, Strombom
                                     assumes that any cost savings achieved by QHMC (or, more
                                     accurately, CS) are the result of the formation of QHMC and
                                     its management of the assumed MPB obligations. However,
                                     only medical savings realized by QHMC that petitioners would
                                     not have obtained in the absence of the QHMC transactions
                                     should constitute incremental cashflows in Strombom’s anal-
                                     ysis. Petitioners and CS were achieving cost savings before
                                     the QHMC transactions through their prior consulting
                                     arrangement. Because Strombom does not factor in the med-
                                     ical savings that petitioners would have obtained without the
                                     QHMC transactions or demonstrate that the cost savings are
                                     linked to the formation of QHMC, his projections as to the cost
                                     savings produced by the QHMC transactions are inherently
                                     flawed. 72 We reject petitioners’ argument that the QHMC
                                     transactions had a reasonable expectation of nontax benefits.
                                       72 We also note that Strombom failed to consider potentially perverse incentives resulting from

                                     the QHMC transactions, which might result in cost increases instead of cost savings. For exam-
                                     ple, because the preferred shareholders would share the benefits of any cumulative cost savings
                                     with Quanex, but Quanex alone would bear the burden of any cost increase, the preferred share-
                                     holders have an incentive to engage in high-risk strategies that have some potential to result
                                     in large cost savings but which in fact result in large cost increases.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00108   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    175


                                           b. Subjective Business Purpose
                                           i. Background
                                        Petitioners argue that they entered into the QHMC trans-
                                     actions for the business purpose of making a profit and not
                                     for the sole purpose of obtaining tax benefits. Petitioners
                                     assert that they hoped to achieve cost savings through iso-
                                     lating and controlling contingent liabilities for Quanex’s
                                     health care costs. According to petitioners, because Quanex
                                     spent millions of dollars every year on its employee health
                                     benefits, controlling the growth of these costs represented an
                                     important and useful business purpose. Petitioners claim
                                     that they conducted an extensive pretax and aftertax anal-
                                     ysis that evaluated the risks of engaging in the deal and con-
                                     cluded that the transactions would be profitable. Petitioners
                                     argue that they sold the class C stock to CS and to Wannell
                                     to allow them to retain a portion of the net health care
                                     savings they produced, thus providing an incentive to lower
                                     the cost of QHMC’s medical benefits. CS and Wannell, peti-
                                     tioners argue, were not accommodating a tax shelter scheme
                                     but had special expertise in the management of health care
                                     costs and had valid business reasons for entering the trans-
                                     actions. Petitioners contend that the transactions were
                                     rationally related to a useful nontax purpose that addressed
                                     petitioners’ economic concerns over rising health care costs.
                                        On the basis of our analysis of petitioners’ motives for
                                     entering the QHMC transactions, we find that petitioners
                                     have failed to establish a business purpose for the QHMC
                                     transactions. While petitioners make general statements
                                     about cutting health care costs, they offer little explanation
                                     as to how the QHMC transactions furthered that goal. Accord-
                                     ingly, we decline to conclude that petitioners have met their
                                     burden of proving that they entered into the QHMC trans-
                                     actions for the purpose of reducing their health care costs.
                                     Rather, the record and reasonable inferences drawn there-
                                     from support a conclusion that petitioners’ purported busi-
                                     ness purpose was merely window dressing conceived in an
                                     attempt to satisfy Federal tax law while manufacturing high
                                     basis stock that they preplanned to sell to generate a large
                                     artificial tax loss. We base our holding on our analysis of the




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00109   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     176                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     following four factors, discussed in the following parts ii., iii.,
                                     iv., and v.
                                           ii. Petitioners’ Entering Into QHMC Transactions Solely as
                                               Means To Generate Artificial Capital Loss To Offset
                                               Capital Gains
                                        Petitioners did not implement the QHMC transactions for a
                                     nontax business reason. To the contrary, the QHMC trans-
                                     actions stemmed from a turnkey tax shelter that was
                                     designed and promoted by D&T and was quickly imple-
                                     mented with prearranged steps designed to generate an
                                     artificial multimillion-dollar tax loss to offset petitioners’
                                     unrelated multimillion-dollar capital gains. Singer, on behalf
                                     of D&T, initially introduced petitioners to the idea of using
                                     the QHMC transactions as a method of achieving tax avoid-
                                     ance. Singer sought out petitioners for a contingent liability
                                     transaction because of their foreseen capital gains, not
                                     because of any desire to reduce their health care costs, and
                                     petitioners retained D&T for tax advice on the transaction,
                                     including a proposed course of action to effect that advice.
                                     Singer and Schneider, the two D&T professionals who were
                                     most connected with the implementation of the QHMC trans-
                                     actions, specialized in tax advice; the record does not estab-
                                     lish, nor do we find, that either of them also was a competent
                                     adviser on the legitimate savings of health care costs.
                                        The QHMC transactions were consummated after the
                                     planting of that initial seed; i.e., the claim that a significant
                                     noneconomic loss could be artificially generated on the basis
                                     of a literal reading of the Code and the regulations and
                                     administrative rulings thereunder, sufficient to offset peti-
                                     tioners’ anticipated capital gains. The use of D&T’s tax
                                     shelter promotion drove the planning and the consummation
                                     of the QHMC transactions, with each step of the transaction
                                     prearranged and with the intended goal of tax avoidance in
                                     sight, and was specifically designed to mask the QHMC trans-
                                     actions with an appearance of legitimacy. Petitioners’ recruit-
                                     ment of Chapman and Wannell as necessary participants in
                                     the transactions was then done without negotiations over the
                                     terms of the transactions, but with Quanex’s offer of an
                                     essentially guaranteed and risk-free return. Quanex was in
                                     such a hurry to implement the QHMC transactions to gen-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00110   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    177


                                     erate the desired loss for TYE 1997 that its board in a single
                                     sitting approved each step of the transactions at or shortly
                                     after the time that the board was first asked to consider
                                     them. The fact that the QHMC transactions were designed to
                                     accomplish the single objective of tax savings is further seen
                                     by the short time in which all of the prearranged steps were
                                     taken.
                                        The approximately $38 million loss generated by the QHMC
                                     transactions was prearranged, artificial, and intentional.
                                     Singer represented to petitioners that the revenue ruling
                                     made tax benefits available to them through a contingent
                                     liability transaction. Singer based his representation on
                                     knowledge he obtained from the DDCL, which stated that
                                     through the proper structuring of a series of transactions
                                     that revolved around the use of an environmental manage-
                                     ment company and the sale of some of its stock outside the
                                     group at a loss, a taxpayer may be allowed immediately to
                                     deduct a capital loss equal to the amount of the environ-
                                     mental reserve and to deduct an additional amount when an
                                     expenditure was actually made to satisfy the accrued
                                     liability. Relying on the DDCL and the revenue ruling, D&T
                                     and petitioners discussed the possibility of placing some of
                                     Quanex’s liabilities in a separate entity through a similar
                                     series of transactions so as to generate a significant report-
                                     able artificial loss. Singer initially proposed structuring the
                                     transaction using environmental liabilities, but Rose opted
                                     for medical liabilities. 73
                                        Singer and petitioners intended to use the contingent
                                     liability transaction as a means to generate a substantial
                                     capital loss that could be used to offset the capital gains
                                     resulting from the impending sales of LaSalle and the Tube
                                     Group. While developing the QHMC transactions, petitioners
                                     were finalizing the LaSalle and Tube Group sales that would
                                     result in millions of dollars in capital gains to petitioners.
                                     Rose and Singer both knew of the LaSalle deal when Singer
                                     introduced the idea of the QHMC transactions, and Rose also
                                     knew that petitioners were trying to sell the Tube Group
                                     when Singer and petitioners discussed using a joint venture
                                     to manage the MPB obligations. Singer worked on the LaSalle
                                      73 Petitioners already had the escrow account to cover their potential exposure to the environ-

                                     mental liabilities.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00111   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     178                 139 UNITED STATES TAX COURT REPORTS                                      (67)


                                     sale during the time he worked on the QHMC transactions,
                                     and Singer knew that petitioners expected a large capital
                                     gain on the sale.
                                        Importantly, petitioners arranged the QHMC transactions so
                                     that the amount of liabilities transferred to QHMC, and thus
                                     the amount of capital loss, would be enough to offset the
                                     anticipated gains from the LaSalle and Tube Group sales. 74
                                     Before the QHMC transactions closed, Singer and Royce dis-
                                     cussed the hypothetical amount of capital gain on the
                                     LaSalle sale. In a footnote appearing in several outlines of
                                     the proposed QHMC transactions, D&T references the
                                     assumed gains resulting from the LaSalle and Tube Group
                                     sales with regard to the amount of liabilities to be trans-
                                     ferred. The amount of liabilities transferred to QHMC thus
                                     was determined by anticipated tax benefits and not by any
                                     purported business purpose.
                                        With respect to the footnote in the August 6 outline,
                                     Singer, Royce, and Rose testified that the footnote referred to
                                     the amount of contingent liabilities D&T mistakenly expected
                                     LaSalle and MST to contribute to QHMC. Singer testified that
                                     the footnote was in error because LaSalle and MST were sold
                                     or in the process of being sold as of the date of the August
                                     6 letter. Singer further testified that the footnote was erro-
                                     neous because Quanex intended to use liabilities from core
                                     businesses, and LaSalle and MST were not core businesses.
                                     Royce testified that the names of the entities contributing
                                     the liabilities were not relevant as of August 6, 1997, and
                                     that only the structure of the transactions was relevant at
                                     that time, so that if D&T operated under the assumption that
                                     LaSalle was contributing MPBs, that would not necessarily
                                     lead Quanex to the wrong conclusions. Rose testified that he
                                     did not instruct D&T or Singer that the amount of the
                                     liability that was going to be transferred to QS in the plan-
                                     ning of the transactions should be related to the amount of
                                     gain on the sales of LaSalle and MST.
                                        We reject the testimony of Singer, Royce, and Rose on this
                                     point as not credible. No version of the D&T proposal ever
                                     mentioned any cash or MPB contributions from LaSalle, MST,
                                     or GST. The LaSalle sale closed on April 18, 1997, almost four
                                       74 The predetermined loss to be recognized as part of the QHMC transactions was

                                     $37,989,000, while the capital gain ultimately recognized by petitioners on the sale of its inter-
                                     ests in LaSalle and the Tube Group was $41,156,128.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00112   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    179


                                     months before the August 6 letter, and as of August 6, 1997,
                                     Quanex, which was guiding the QHMC transactions’ revision
                                     process through Royce, knew LaSalle would not be available
                                     to provide MPBs because it had been sold. Singer, who helped
                                     prepare and review the August 6 outline, worked on the
                                     LaSalle sale and knew LaSalle had been sold by that time.
                                        In our finding that the footnote addressed the gains on the
                                     assets sales rather than the MPBs that LaSalle and the Tube
                                     Group would contribute, we give weight to the Mooney
                                     memorandum. The Mooney memorandum addressed various
                                     items that Mooney believed were incorrect in the August 6
                                     outline, and it did not state that the footnote in the August
                                     6 outline was in error or otherwise address the footnote. The
                                     Mooney memorandum also did not indicate that anyone had
                                     commented on the footnote or had questioned why LaSalle
                                     and the Tube Group, which Quanex had sold or was in the
                                     process of selling, would contribute MPBs to QHMC. Also,
                                     Schneider testified that he understood the phrase ‘‘$36 mil-
                                     lion pertains to LaSalle’’ to refer to the anticipated gain on
                                     the LaSalle sale. Although Schneider also testified that
                                     Singer should be relied on to interpret a difference of opinion
                                     as to the meaning of something in the August 6 outline
                                     because only Singer signed the letter, we find Schneider’s
                                     testimony on this issue more credible. Accordingly, we find,
                                     on the basis of the evidence in the record as a whole, that
                                     the footnote referred to the amounts of anticipated gains on
                                     the LaSalle and the Tube Group sales.
                                           iii. Petitioners’ Selection of Transferred MPBs Without
                                                Regard to Effective Medical Cost Management
                                       The manner in which petitioners selected the pool of med-
                                     ical liabilities to be assumed by QHMC also demonstrates that
                                     petitioners lacked a valid business purpose for entering into
                                     the QHMC transactions. Petitioners, after estimating the
                                     amount of their anticipated capital gains, selected the nec-
                                     essary amount of MPB obligations to transfer to QHMC to
                                     achieve the desired capital loss. Petitioners offer no rationale
                                     as to why they selected the particular MPB obligations trans-
                                     ferred, and the record lacks any evidence suggesting that the
                                     selection of the MPB obligations related to managing the MPB
                                     obligations in an effective and cost-efficient manner. In addi-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00113   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     180                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     tion, while Royce and Rose, Quanex’s tax director and CFO,
                                     respectively, played active roles in choosing which MPB
                                     obligations were to be transferred, Peery, Quanex’s vice
                                     president of human resources, who was in charge of
                                     employee benefits and the most knowledgeable source for
                                     Quanex’s employee health benefits problems, made no rec-
                                     ommendation about the groups of employees or the types of
                                     health care benefits to be included in the QHMC transactions.
                                     Additionally, Wannell and CS, on whose expertise petitioners
                                     had purportedly planned to capitalize in the QHMC trans-
                                     actions, were not consulted regarding the medical liabilities
                                     transferred to QHMC and did not participate in any decisions
                                     concerning liability selection.
                                           iv. Equity Interest in QHMC Granted to CS and Wannell
                                               as Meaningless Incentive To Reduce Health Care Costs
                                        Although petitioners proffer a potentially valid purpose of
                                     offering equity incentives to Wannell and CS, the formation
                                     of QHMC as a healthcare management company was meaning-
                                     less given that CS managed Quanex’s healthcare costs in the
                                     same manner both before and after the QHMC transactions.
                                     While CS did a greater amount of work for Quanex after the
                                     formation of QHMC, the nature of CS’ work did not change.
                                     Petitioners continued to provide data to CS for all Quanex
                                     employees, and CS advanced potential medical savings
                                     strategies for all Quanex employees, not just those whose
                                     medical benefit obligations petitioners assigned to QHMC. 75
                                     Additionally, CS continued to bill petitioners in the same
                                     manner it had before the QHMC transactions, failing to make
                                     any specific reference to QHMC or to the covered groups. CS
                                     thus maintained essentially the same business relationship
                                     with Quanex before and after the QHMC transactions, con-
                                     tinuing to give its best effort in performing the exact same
                                     consulting services it had before the transactions. The argu-
                                     ment that the QHMC transactions encouraged CS to provide
                                     better services because of its new shareholder status does not
                                     conform with the evidence in the record.
                                        The record also does not support petitioners’ argument
                                     that petitioners wanted Wannell to own class C stock as an
                                       75 For example, CS worked extensively on implementing a PPO plan for all Quanex employees

                                     as a cost savings strategy.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00114   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    181


                                     incentive. Wannell’s involvement with QHMC was extremely
                                     limited. Wannell attended just two board meetings, and he
                                     did not participate in any other aspect of QHMC’s business.
                                     Quanex’s health care benefits personnel never discussed
                                     benefits issues with Wannell, and his only contact was with
                                     Royce, Quanex’s tax director. Because of Wannell’s extremely
                                     limited involvement with the MPB obligations and in QHMC,
                                     we do not find credible petitioners’ assertion that Wannell
                                     was allowed to purchase an equity interest as an incentive
                                     to achieve cost savings on QHMC’s behalf. Instead, as we find,
                                     petitioners selected Wannell (and CS) to serve as trusted and
                                     loyal facilitators for the QHMC transactions. Petitioners set
                                     the costs of Wannell’s and CS’ equity interests at relatively
                                     low amounts ($11,000 and $15,000, respectively) and lowered
                                     those costs even further by effectively quickly returning a
                                     portion of the initial cash outlays to Wannell and CS in the
                                     form of the first five quarterly dividends. In addition, peti-
                                     tioners structured the QHMC transactions so that the money
                                     Wannell and CS devoted to the transactions was guaranteed
                                     to be returned to them, both as to principal and with a
                                     reasonable premium, and allowed Wannell and CS to accom-
                                     plish their desired results (i.e., for Wannell, a guaranteed
                                     return at least commensurate with his other opportunities
                                     and for CS, an opportunity to increase its business with peti-
                                     tioners).
                                           v. Unnecessary Assumption of MPB Obligations by QHMC
                                        Petitioners also do not sufficiently explain the reason for
                                     QHMC’s    assumption of the MPB obligations. While petitioners
                                     contend that QHMC assumed the MPB liabilities to ‘‘isolate
                                     costs within QHMC, in order to facilitate controlling such
                                     costs’’, the transfer of the liabilities in exchange for $38 mil-
                                     lion is separate and distinct from the alleged purpose behind
                                     QHMC’s formation—to assume a managerial role in reducing
                                     the cost of health care and making a profit. The cost-reducing
                                     benefits of QHMC, as alleged by petitioners, resulted from the
                                     creation of a separate entity and the alleged ability of its new
                                     shareholders to manage and reduce health care costs, and
                                     not from QHMC’s assumption of the MPB obligations them-
                                     selves. Simply put, QHMC did not need to assume the MPB
                                     obligations for petitioners to reduce health care costs. CS




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00115   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     182                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     effectively managed Quanex’s health care costs in the same
                                     manner before and after the creation of QHMC; whether peti-
                                     tioners or QHMC was responsible for the ultimate payment of
                                     the MPB obligations is irrelevant.
                                        Nor do petitioners explain why the class C stock had to
                                     detour briefly through QS. QS’ ownership lasted less than a
                                     week, and its sale of stock to Wannell had been preplanned
                                     at the outset of the QHMC transactions. Diverting an equity
                                     interest presumably intended for Wannell through QS was a
                                     key element in reaping the claimed tax benefits of the QHMC
                                     transactions: Under D&T’s (and petitioners’) reading of the
                                     Code and interpretations thereunder, the issuance of stock to
                                     QS allowed QS to obtain a high basis in the QHMC stock, and
                                     the subsequent sale to Wannell allowed QS to realize and
                                     recognize the purported loss.
                                           c. Conclusion
                                       On the basis of our analysis of the QHMC transactions, we
                                     conclude and hold that the QHMC transactions lacked both
                                     objective economic substance and a subjective business pur-
                                     pose. See Klamath Strategic Inv. Fund, LLC, 568 F.3d at
                                     544. We therefore disregard the effects of the transactions
                                     that gave rise to petitioners’ $38 million basis in the class C
                                     stock. Consequently, given the parties’ agreement that our
                                     holding means that petitioners are not entitled to deduct the
                                     short-term capital loss, we reach the same conclusion.
                                     IV. Fees Incurred in Furtherance of QHMC Transactions
                                       Deductions are strictly a matter of legislative grace, and
                                     taxpayers bear the burden of producing sufficient evidence to
                                     substantiate any deduction that would otherwise be allowed
                                     by the Code. Sec. 6001; Rule 142(a)(1); INDOPCO, Inc. v.
                                     Commissioner, 503 U.S. 79, 84 (1992). While section 162(a)
                                     generally lets a corporate taxpayer deduct the ordinary and
                                     necessary expenses of its trade or business, expenditures
                                     made in an attempt to obtain abusive tax shelter benefits are
                                     not ordinary and necessary business expenses or otherwise
                                     deductible under section 162(a). See Klamath Strategic Inv.
                                     Fund, LLC, 568 F.3d at 549; see also Karr v. Commissioner,
                                     924 F.2d 1018, 1023–1025 (11th Cir. 1991) (expenses arising
                                     from transactions lacking economic substance were not




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00116   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    183


                                     deductible), aff ’g Smith v. Commissioner, 91 T.C. 733 (1988);
                                     Kirchman v. Commissioner, 862 F.2d 1486, 1490 (11th Cir.
                                     1989) (if a transaction lacks economic substance, ‘‘then
                                     expenses or losses incurred in connection with the trans-
                                     action are not deductible’’), aff ’g Glass v. Commissioner, 87
                                     T.C. 1087 (1986); Winn-Dixie Stores, Inc. v. Commissioner,
                                     113 T.C. at 294 (administrative fees were not deductible
                                     because they were ‘‘incurred in connection with, and were an
                                     integral part of, a sham transaction’’).
                                       On their 1997 return, petitioners claimed deductions of
                                     $320,692 for consulting fees paid to D&T, $29,114 for legal
                                     fees paid to Fulbright, and $2,445 for appraisal fees paid to
                                     Watson Wyatt. Petitioners paid all of these fees in further-
                                     ance of implementing the QHMC transactions. Because we
                                     hold that the QHMC transactions lacked economic substance,
                                     we affirm respondent’s determination that petitioners may
                                     not deduct these transaction costs on their 1997 return.
                                     V. Accuracy-Related Penalties
                                           A. Background
                                        Respondent determined that petitioners’ reporting an
                                     inflated basis of $38 million in the class C stock constituted
                                     a gross valuation misstatement and that petitioners were
                                     liable for a 40% penalty under section 6662(a) and (h) to the
                                     extent of any underpayment of tax attributable to the
                                     claimed capital loss. In the alternative, respondent deter-
                                     mined that petitioners were liable under section 6662(a) and
                                     (b)(1) (or alternatively (b)(2)) for a 20% accuracy-related pen-
                                     alty as to that portion of any underpayment, finding that the
                                     underpayment resulting from the disallowance of the short-
                                     term capital loss was attributable to negligence or disregard
                                     of rules and regulations (or alternatively resulted in a
                                     substantial understatement of income tax). Respondent also
                                     determined that the 20% accuracy-related penalty under sec-
                                     tion 6662(a) and (b)(1) (or alternatively (b)(2)) applied to the
                                     extent of the underpayment of tax attributable to the dis-
                                     allowed deduction for the transaction fees.
                                           B. Gross Valuation Misstatement
                                       Respondent determined that the 40% accuracy-related pen-
                                     alty applies to any underpayment of tax resulting from the




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00117   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     184                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     disallowed capital loss deduction. To that end, respondent
                                     notes, petitioners claimed a $38 million basis in the class C
                                     stock sold to Wannell, and the basis in that stock is actually
                                     $11,000 through our application of section 351(g) or zero
                                     through our application of the economic substance doctrine.
                                        Section 6662(a) and (b)(3) imposes an accuracy-related pen-
                                     alty of 20% on the portion of an underpayment attributable
                                     to any ‘‘substantial valuation misstatement’’. A substantial
                                     valuation misstatement exists ‘‘if the value of any property
                                     (or the adjusted basis of any property) claimed * * * is 200
                                     percent or more of the amount determined to be the correct
                                     amount of such valuation or adjusted basis’’. Sec. 6662(e)(1).
                                     The penalty imposed by section 6662(a) increases from 20%
                                     to 40% if the underpayment is attributable to a ‘‘gross valu-
                                     ation misstatement’’. Sec. 6662(h). A gross valuation
                                     misstatement occurs if the value of any property, or the
                                     adjusted basis of any property, reported by the taxpayer is
                                     400% or more of the amount determined to be the correct
                                     amount of such valuation or adjusted basis. Sec.
                                     6662(h)(2)(A). In the case of a corporation, the substantial or
                                     gross valuation misstatement penalty may only apply where
                                     the portion of the underpayment for the taxable year attrib-
                                     utable to the substantial valuation misstatement exceeds
                                     $10,000. Sec. 6662(e)(2).
                                        Petitioners contend that respondent wrongly determined
                                     that the gross valuation misstatement penalty applies to the
                                     portion of an underpayment attributable to the disallowed
                                     capital loss. As petitioners see it, that portion of the under-
                                     payment did not involve a valuation misstatement because it
                                     is attributable to our finding that petitioners’ claimed capital
                                     loss deduction was improper. Petitioners cite Heasley v.
                                     Commissioner, 902 F.2d 380, and Todd v. Commissioner, 862
                                     F.2d 540, for the proposition that the Commissioner may not
                                     penalize a taxpayer for a valuation overstatement where the
                                     Commissioner totally disallows a deduction, because the
                                     underpayment from the disallowance is attributable to the
                                     claiming of an improper deduction, not to a valuation over-
                                     statement. In those cases, the taxpayers made valuation
                                     overstatements of certain property and claimed depreciation
                                     deductions and/or investment tax credits on the basis of the
                                     overstated values. See Heasley v. Commissioner, 902 F.2d at
                                     381; Todd v. Commissioner, 862 F.2d at 541. The Commis-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00118   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    185


                                     sioner disallowed the claimed deductions and investment tax
                                     credits and determined that the taxpayers were liable for
                                     valuation overstatement penalties. See Heasley v. Commis-
                                     sioner, 902 F.2d at 382; Todd v. Commissioner, 862 F.2d at
                                     541. The Court of Appeals for the Fifth Circuit held that the
                                     disallowances did not result from a misstatement of the
                                     assets’ values or bases but from the claiming of an improper
                                     deduction. See Heasley v. Commissioner, 902 F.2d at 383;
                                     Todd v. Commissioner, 862 F.2d at 543–545. Under these
                                     cases, the portion of a tax underpayment that is attributable
                                     to a valuation overstatement is determined after taking into
                                     account any other proper adjustment to tax liability. Todd v.
                                     Commissioner, 862 F.2d at 542–543.
                                        We have found and have held that the capital loss deduc-
                                     tion was improper because the relevant contributions did not
                                     qualify for nonrecognition treatment under section 351(a)
                                     and, alternatively, the QHMC transactions lacked economic
                                     substance. This case is appealable to the Court of Appeals for
                                     the Fifth Circuit, absent a stipulation to the contrary. The
                                     view of that court is that a valuation misstatement penalty
                                     does not apply when a transaction is disregarded, or when a
                                     deduction is otherwise disallowed for a reason unrelated to
                                     valuation. That view is contrary to the view of various other
                                     Courts of Appeals. See Merino v. Commissioner, 196 F.3d
                                     147, 155 (3d Cir. 1999) (‘‘[W]henever a taxpayer knowingly
                                     invests in a tax avoidance entity which the taxpayer should
                                     know has no economic substance, the valuation overstate-
                                     ment penalty is applied as a matter of course.’’), aff ’g T.C.
                                     Memo. 1997–385; Zfass v. Commissioner, 118 F.3d 184, 191
                                     (4th Cir. 1997) (the valuation overstatement penalty applied
                                     because the value overstatement was a primary reason for
                                     the disallowance of the claimed tax benefits), aff ’g T.C.
                                     Memo. 1996–167; Illes v. Commissioner, 982 F.2d 163, 167
                                     (6th Cir. 1992) (the entire artifice of the tax shelter at issue
                                     was constructed on the foundation of the overvaluation of its
                                     assets), aff ’g T.C. Memo. 1991–449; Gilman v. Commissioner,
                                     933 F.2d 143, 151 (2d Cir. 1991) (‘‘The lack of economic sub-
                                     stance was due in part to the overvaluation, and thus the
                                     underpayment was attributable to the valuation overstate-
                                     ment.’’), aff ’g T.C. Memo. 1989–684 as supplemented by T.C.
                                     Memo. 1990–205; Massengill v. Commissioner, 876 F.2d 616,
                                     619–620 (8th Cir. 1989) (‘‘When an underpayment stems




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00119   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     186                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     from disallowed depreciation deductions or investment credit
                                     due to lack of economic substance, the deficiency is attrib-
                                     utable to overstatement of value[.]’’), aff ’g T.C. Memo. 1988–
                                     427; see also Fid. Int’l Currency Advisor A Fund v. United
                                     States, 661 F.3d 667 (1st Cir. 2011). The Court of Appeals for
                                     the Fifth Circuit’s view also is contrary to the view of this
                                     and other courts. See, e.g., Santa Monica Pictures, LLC v.
                                     Commissioner, T.C. Memo. 2005–104; Jade Trading, LLC v.
                                     United States, 80 Fed. Cl. 11, 54 (2007).
                                        Under Golsen v. Commissioner, 54 T.C. at 757, we follow
                                     a holding of the court to which an appeal lies if that holding
                                     is squarely on point. We believe that the court’s holdings in
                                     Heasley v. Commissioner, 902 F.2d 380, and Todd v. Commis-
                                     sioner, 862 F.2d 540, meet that standard in that the grounds
                                     underlying our disallowance of the capital loss deduction are
                                     not directly related to petitioners’ valuation of the class C
                                     stock or to petitioners’ reporting of the proper basis therein,
                                     a basis that flows from the applicability or nonapplicability
                                     of section 351(a). The cases of Heasley and Todd, therefore,
                                     require us to hold in this case that any overvaluation of the
                                     stock or basis was subsumed in the disallowance of the cap-
                                     ital loss deduction and that any resulting underpayment is
                                     attributable not to an overvaluation of stock or basis, but to
                                     the disallowance of the capital loss deduction on account of
                                     the inapplicability of section 351(a). Accord Klamath Stra-
                                     tegic Inv. Fund, LLC v. United States, 472 F. Supp. 2d 885,
                                     899–900 (E.D. Tex. 2007) (noting that the Court of Appeals
                                     for the Fifth Circuit’s view on the applicability of the valu-
                                     ation misstatement penalty is contrary to the views of other
                                     Courts of Appeals, but holding that the court must follow the
                                     law of the Fifth Circuit), aff ’d in part, vacated in part, and
                                     remanded, 568 F.3d 537 (5th Cir. 2009); NPR Invs., LLC v.
                                     United States, 105 A.F.T.R.2d (RIA) 2010–1082, 2010–1 U.S.
                                     Tax Cas. para. 50,251 (E.D. Tex. 2010) (same). Accordingly,
                                     on the basis of Heasley v. Commissioner, 902 F.2d 380, and
                                     Todd v. Commissioner, 862 F.2d 540, we hold that the valu-
                                     ation misstatement penalty does not apply to this case.
                                           C. Negligence
                                       Section 6662(a) and (b)(1) imposes an accuracy-related pen-
                                     alty of 20% on any portion of an underpayment of tax attrib-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00120   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    187


                                     utable to ‘‘[n]egligence or disregard of rules or regulations.’’
                                     For purposes of section 6662, the term ‘‘negligence’’ includes
                                     any failure to make a reasonable attempt to comply with
                                     Code provisions. Sec. 6662(c). Negligence is determined by
                                     testing a taxpayer’s conduct against that of a reasonable,
                                     prudent person. See Sandvall v. Commissioner, 898 F.2d 455,
                                     458–459 (5th Cir. 1990), aff ’g T.C. Memo. 1989–189, and
                                     aff ’g T.C. Memo. 1989–56. ‘‘Rules or regulations’’ include the
                                     provisions of the Code, temporary or final regulations issued
                                     under the Code, and revenue rulings or notices issued by the
                                     IRS. Sec. 1.6662–3(b)(2), Income Tax Regs. A return position
                                     that has a reasonable basis is not attributable to negligence.
                                     Sec. 1.6662–3(b)(1), Income Tax Regs. A reasonable basis
                                     connotes significantly more than not being frivolous or pat-
                                     ently improper. Sec. 1.6662–3(b)(3), Income Tax Regs. The
                                     reasonable basis standard is not satisfied by a return posi-
                                     tion that is merely arguable or colorable. Id.
                                        Respondent determined that the negligence penalty
                                     applied to the underpayment attributable to the disallowed
                                     deductions for transaction costs. Respondent also determined
                                     that the negligence penalty applied to the underpayment
                                     attributable to the capital loss adjustment. Petitioners con-
                                     tend that they made a reasonable attempt to comply with the
                                     provisions of the Code and that they did not carelessly, reck-
                                     lessly, or intentionally disregard rules or regulations.
                                     According to petitioners, their 1997 return was prepared
                                     through a careful and deliberate process in conformity with
                                     the advice of qualified tax professionals, including Royce,
                                     Parikh, and Singer. Petitioners also contend that they had a
                                     reasonable basis for the position they took on their 1997
                                     return with respect to both disallowed items. Petitioners
                                     lastly argue that the negligence penalty is inappropriate
                                     because the issues surrounding the QHMC transactions
                                     involved complex legal determinations on issues that were
                                     reasonably debatable or on which there could be honest dif-
                                     ferences of opinion. Petitioners primarily cite the case of
                                     Kantor v. Commissioner, 998 F.2d 1514, 1522–1523 (9th Cir.
                                     1993) (involving allocation and deduction of research and
                                     experimentation expenses to and by taxpayer partnership’s
                                     limited partners), aff ’g in part, rev’g in part T.C. Memo.
                                     1990–380, in support of this last argument.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00121   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     188                   139 UNITED STATES TAX COURT REPORTS                                     (67)


                                        The record does not support petitioners’ arguments. To the
                                     contrary, we find that petitioners did not make a reasonable
                                     attempt to comply with existing tax laws and that they failed
                                     to exercise ordinary and reasonable care in the preparation
                                     of their 1997 return. Rose, Royce, Parikh, and Singer were
                                     well-educated tax professionals with extensive tax experi-
                                     ence. 76 On the basis of their knowledge and experience, they
                                     should have known (and in fact probably knew) that formal
                                     compliance with statutory provisions, even if present, is
                                     insufficient to sustain transactions that have no economic
                                     substance and are mere contrivances designed solely to
                                     obtain tax benefits. 77 They also should have known (and in
                                     fact probably knew) that the class C stock, as of the time of
                                     it issuance, was limited and was most likely not going to
                                     include a share of any QHMC growth to a significant extent.
                                     We cannot agree with petitioners’ contention that the QHMC
                                     transactions had a reasonable basis or that the complexity of
                                     the transactions concerns issues that are reasonably debat-
                                     able. The QHMC transactions were part of an economic sham
                                     designed to generate a substantial tax loss. Petitioners have
                                     not presented an alternative view to which we can affix a
                                     reasonable interpretation of the transactions. 78 We sustain
                                     respondent’s determination that negligence penalties are
                                     appropriate in this case.
                                            D. Substantial Understatement
                                       Section 6662(a) and (b)(2) imposes an accuracy-related pen-
                                     alty of 20% on the portion of an underpayment attributable
                                     to any substantial understatement of income tax. An under-
                                     statement is defined as the excess of the amount of tax
                                     required to be shown on the return for a taxable year over
                                     the amount of tax imposed that is shown on the return,
                                           76 Rose,
                                                Royce, and Parikh were C.P.A.s, and Singer was a C.P.A. and a tax attorney.
                                           77 In
                                             fact, given the scale of their efforts to disguise the QHMC transactions as a legitimate
                                     transaction, we can only presume that Rose, Royce, Parikh, and Singer each knew quite well
                                     that a transaction without economic substance is invalid.
                                       78 Petitioners also argue that it is inappropriate to impose the negligence penalty against

                                     them because, they state, this case is a ‘‘close case’’ and the Government lost Black & Decker
                                     Corp. v. United States, 340 F. Supp. 2d 621 (D. Md. 2004), aff ’d in part, rev’d in part and re-
                                     manded, 436 F.3d 431 (4th Cir. 2006), and Coltec Indus., Inc. v. United States, 62 Fed. Cl. 716
                                     (2004), vacated and remanded, 454 F.3d 1340 (Fed. Cir. 2006), two cases which involve similar
                                     facts and legal issues. We disagree with this argument. We do not consider the issues here to
                                     present a ‘‘close case’’. In addition, the two cases which petitioners rely upon were decided after
                                     petitioners filed their 1997 return. Further, neither trial court’s view of the economic substance
                                     doctrine was accepted by the Court of Appeals upon appeal of those judgments.




VerDate Nov 24 2008   09:57 Jun 05, 2014     Jkt 372897   PO 20012   Frm 00122   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    189


                                     reduced by any rebate. Sec. 6662(d)(2)(A). For corporations,
                                     an understatement of income tax is substantial if the under-
                                     statement exceeds the greater of 10% of the tax required to
                                     be shown on the return for the taxable year, or $10,000. Sec.
                                     6662(d)(1)(A) and (B).
                                        Any understatement is reduced to the extent it is attrib-
                                     utable to an item: (1) for which there is or was substantial
                                     authority for the taxpayer’s treatment for such item, or (2)
                                     with respect to which the relevant facts affecting the item’s
                                     tax treatment are adequately disclosed in the return or in a
                                     statement attached to the return and there is a reasonable
                                     basis for the tax treatment of the item by the taxpayer. Sec.
                                     6662(d)(2)(B). The exceptions for understatements supported
                                     by substantial authority or by adequate disclosure are not
                                     available for any item that is attributable to a ‘‘tax shelter’’
                                     of a corporation. Sec. 6662(d)(2)(C)(ii). In that context, a ‘‘tax
                                     shelter’’ is: (1) a partnership or other entity, (2) any invest-
                                     ment plan or arrangement, or (3) any other plan or arrange-
                                     ment, if a significant purpose of such partnership, entity,
                                     plan, or arrangement is the avoidance or evasion of Federal
                                     income tax. Sec. 6662(d)(2)(C)(iii).
                                        Respondent determined as an alternative to the applica-
                                     bility of the accuracy-related penalty for negligence that the
                                     underpayment resulting from the disallowed capital loss and
                                     the disallowed deduction of the transaction fees results in a
                                     substantial understatement of income tax warranting a 20%
                                     penalty under section 6662. Additionally, respondent con-
                                     tends that the QHMC transactions constitute a ‘‘tax shelter’’
                                     under section 6662(d)(2)(C)(iii) and, consequently, the
                                     substantial authority and adequate disclosure exceptions to
                                     the substantial understatement penalty are unavailable to
                                     petitioners.
                                        Petitioners do not dispute that the understatement of
                                     income tax resulting from the items is substantial. Peti-
                                     tioners argue that their position on the 1997 return was sup-
                                     ported by both substantial authority and adequate disclosure,
                                     reducing the understatement to zero under section
                                     6662(d)(2)(B). In support of this argument, petitioners assert
                                     that respondent conceded the issue of whether the under-
                                     statement is attributable to a tax shelter. Petitioners contend
                                     that the following statement in the notice indicated to peti-
                                     tioners that they could demonstrate substantial authority or




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00123   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     190                 139 UNITED STATES TAX COURT REPORTS                                       (67)


                                     adequate disclosure to defeat the substantial understatement
                                     penalty: ‘‘the underpayment is attributable to a substantial
                                     understatement of income tax and you have not shown that
                                     you had substantial authority for the way you reported the
                                     items and you did not make any disclosures explaining the
                                     adjusted items.’’ Additionally, petitioners claim that
                                     respondent failed to raise the tax shelter issue in the notice,
                                     in any of the pleadings, or at trial, and as a result, peti-
                                     tioners would suffer substantial detriment because they were
                                     not able to address the specific elements relating to section
                                     6662(d)(2)(C). Petitioners conclude that the question of
                                     whether the QHMC transactions are a tax shelter for section
                                     6662(d) purposes is a new issue that should not be heard by
                                     the Court.
                                        Petitioners’ argument is baseless. Respondent did not con-
                                     cede the tax shelter issue by merely asserting that peti-
                                     tioners failed to meet the substantial authority and adequate
                                     disclosure defenses to the substantial understatement pen-
                                     alty. Petitioners bear the burden of proving that respondent’s
                                     determination to assess the substantial understatement pen-
                                     alty is inappropriate. 79 See Rule 142(a)(1). Accordingly, peti-
                                     tioners must demonstrate that the QHMC transactions were
                                     not a tax shelter item and, if that is the case, that substan-
                                     tial authority and/or adequate disclosure are present. Given
                                     respondent’s argument that the QHMC transactions lacked
                                     economic substance, petitioners were on notice of the possi-
                                     bility that the transactions could be found to be a tax shelter
                                     under section 6662(d)(2)(C)(iii). See, e.g., Palm Canyon X
                                     Invs., LLC v. Commissioner, T.C. Memo. 2009–288; Santa
                                     Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005–
                                     104.
                                        Because we hold that the QHMC transactions had no eco-
                                     nomic substance and that their only purpose was to manufac-
                                     ture high-basis stock to generate a tax loss, we find that the
                                     multistep contingent liability transaction in which petitioners
                                     engaged was a tax shelter for purposes of section 6662. Tax
                                     avoidance was clearly a significant (if not the sole) purpose
                                     of the QHMC transactions. Petitioners are therefore unable to
                                       79 While sec. 7491(c) places a burden of production upon the Commissioner with respect to an

                                     individual’s liability for an accuracy-related penalty under sec. 6662, sec. 7491(c) has no applica-
                                     bility where, as here, the taxpayer is a corporation. See NT, Inc. v. Commissioner, 126 T.C. 191,
                                     194–195 (2006).




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00124   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    191


                                     claim that the underpayment resulting from the improperly
                                     claimed tax loss should be reduced because of substantial
                                     authority or adequate disclosure. We sustain respondent’s
                                     alternative determination that the substantial understate-
                                     ment penalty is appropriate in this case. We note, however,
                                     that only one section 6662 accuracy-related penalty may be
                                     imposed with respect to a given portion of an underpayment,
                                     even if that portion is attributable to more than one of the
                                     types of conduct listed in section 6662(b). See New Phoenix
                                     Sunrise Corp. v. Commissioner, 132 T.C. at 187; sec. 1.6662–
                                     2(c), Income Tax Regs.
                                           E. Section 6664(c) Reasonable Cause Exception
                                           1. Overview
                                       The accuracy-related penalty imposed under section 6662
                                     does not apply with respect to any portion of an under-
                                     payment to which the taxpayer can demonstrate reasonable
                                     cause and good faith. Sec. 6664(c). Reasonable cause requires
                                     that the taxpayer have exercised ordinary business care and
                                     prudence as to the disputed item. See Neonatology Assocs.,
                                     P.A. v. Commissioner, 115 T.C. at 98. The determination of
                                     whether a taxpayer acted with reasonable cause and in good
                                     faith is made on a case-by-case basis, taking into account all
                                     pertinent facts and circumstances. Sec. 1.6664–4(b)(1),
                                     Income Tax Regs. The most important factor is generally the
                                     extent of the taxpayer’s effort to assess the taxpayer’s proper
                                     tax liability. Id. Circumstances that may indicate reasonable
                                     cause and good faith include an honest misunderstanding of
                                     fact or law that is reasonable in light of all the facts and cir-
                                     cumstances, including the experience, knowledge, and edu-
                                     cation of the taxpayer. Id.
                                       A taxpayer may demonstrate reasonable cause through
                                     reliance on the advice of a professional tax adviser as to the
                                     proper treatment of an item. Id.; see also Neonatology
                                     Assocs., P.A. v. Commissioner, 115 T.C. at 98. The taxpayer
                                     must demonstrate that reliance on the professional’s advice
                                     was reasonable and that the taxpayer acted in good faith.
                                     Sec. 1.6664–4(b)(1), Income Tax Regs. All facts and cir-
                                     cumstances are taken into account in determining whether a
                                     taxpayer has reasonably relied in good faith on professional
                                     tax advice as to the treatment of the plan or arrangement




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00125   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     192                 139 UNITED STATES TAX COURT REPORTS                                       (67)


                                     under Federal tax law. Sec. 1.6664–4(c)(1), Income Tax Regs.
                                     The professional’s advice must be based upon all pertinent
                                     facts and circumstances and the law as it relates to those
                                     facts and circumstances. Sec. 1.6664–4(c)(1)(i), Income Tax
                                     Regs. The advice must take into account the taxpayer’s pur-
                                     poses for entering a transaction and for structuring a trans-
                                     action in a particular manner. Id. The advice must not be
                                     rendered on the basis of unreasonable factual or legal
                                     assumptions and must not unreasonably rely on the rep-
                                     resentations, statements, findings, or agreements of the tax-
                                     payer or any other person. 80 Sec. 1.6664–4(c)(1)(ii), Income
                                     Tax Regs. Reliance is generally unreasonable where it is
                                     placed upon insiders or promoters (or their offering mate-
                                     rials) or when the person relied upon has an inherent conflict
                                     of interest that the taxpayer knew or should have known
                                     about. See Neonatology Assocs., P.A. v. Commissioner, 115
                                     T.C. at 98.
                                        For purposes of the substantial understatement penalty
                                     under section 6662(b)(2), a taxpayer must meet a more strin-
                                     gent reasonable cause exception when the understatement is
                                     attributable to a tax shelter. Sec. 1.6664–4(e)(1), Income Tax
                                     Regs. We determine whether a corporation acted with
                                     reasonable cause and in good faith in its treatment of a tax
                                     shelter item on the basis of all pertinent facts and cir-
                                     cumstances. Id. A corporation’s ‘‘legal justification’’ 81 for the
                                     transaction may be taken into account, as appropriate, in
                                     establishing that the corporation acted with reasonable cause
                                     and in good faith in its treatment of a tax shelter item. Sec.
                                     1.6664–4(e)(2)(i), Income Tax Regs. However, a corporation’s
                                     legal justification may be taken into account only if the cor-
                                     poration satisfies both the authority and belief requirements
                                     described in section 1.6662–4(e), Income Tax Regs. Satisfac-
                                     tion of those requirements is not necessarily dispositive, but
                                     it is an important factor to consider in determining whether
                                     a corporate taxpayer acted with reasonable cause and in good
                                        80 For example, the advice must not be based upon a representation or assumption which the

                                     taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representa-
                                     tion or assumption as to the taxpayer’s purposes for entering into a transaction or for struc-
                                     turing a transaction in a particular manner. Sec. 1.6664–4(c)(1)(ii), Income Tax Regs.
                                        81 Legal justification includes ‘‘any justification relating to the treatment or characterization

                                     under the Federal tax law of the tax shelter item or of the entity, plan, or arrangement that
                                     gave rise to the item.’’ Sec. 1.6664–4(e)(2)(ii), Income Tax Regs. Accordingly, a taxpayer’s belief
                                     as to the merits of the taxpayer’s underlying position is a legal justification. Id.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00126   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                     193


                                     faith. Sec. 1.6664–4(e)(3), Income Tax Regs. Facts and cir-
                                     cumstances other than a corporation’s legal justification may
                                     be taken into account in determining whether the corpora-
                                     tion acted with reasonable cause and in good faith with
                                     respect to a tax shelter item, regardless of whether the min-
                                     imum requirements are satisfied. Sec. 1.6664–4(e)(4), Income
                                     Tax Regs.
                                        The authority requirement is satisfied if there is substan-
                                     tial authority for the tax treatment of the item, as defined
                                     in section 1.6662–4(d), Income Tax Regs. 82 See sec. 1.6664–
                                     4(e)(2)(i)(A), Income Tax Regs. The belief requirement is
                                     satisfied only if, on the basis of all facts and circumstances,
                                     the corporation reasonably believed, when the return was
                                     filed, that the tax treatment of the item was more likely than
                                     not the proper treatment. See sec. 1.6664–4(e)(2)(i)(B),
                                     Income Tax Regs. A corporation is considered reasonably to
                                     believe that the tax treatment of an item is more likely than
                                     not the proper tax treatment if:
                                       (1) The corporation analyzes the pertinent facts and authorities in the
                                     manner described in § 1.6662–4(d)(3)(ii), and in reliance upon that anal-
                                     ysis, reasonably concludes in good faith that there is a greater than 50-
                                     percent likelihood that the tax treatment of the item will be upheld if chal-
                                     lenged by the Internal Revenue Service; or
                                       (2) the corporation reasonably relies in good faith on the opinion of a
                                     professional tax advisor, if the opinion is based on the tax advisor’s anal-
                                     ysis of the pertinent facts and authorities in the manner described in §
                                     1.6662–4(d)(3)(ii) and unambiguously states that the tax advisor concludes
                                     that there is a greater than 50-percent likelihood that the tax treatment
                                     of the item will be upheld if challenged by the Internal Revenue Service.
                                     * * *
                                       [Sec. 1.6664–4(e)(2)(i)(B)(1) and (2), Income Tax Regs.]

                                           2. Analysis
                                       Petitioners bear the burden of proof in establishing their
                                     reasonable cause defense. See Higbee v. Commissioner, 116
                                     T.C. 438 (2001). Petitioners argue that an accuracy-related
                                        82 Whether substantial authority exists is determined by an objective standard involving an

                                     analysis of the law and an application of the law to relevant facts. Sec. 1.6662–4(d)(2), Income
                                     Tax Regs. The taxpayer’s belief that there is substantial authority for the tax treatment of an
                                     item is thus not relevant in determining whether there is substantial authority for that treat-
                                     ment. Sec. 1.6662–4(d)(3)(i), Income Tax Regs. Substantial authority is present for the tax treat-
                                     ment of an item only if the weight of the authorities supporting the treatment is substantial
                                     in relation to the weight of authorities supporting contrary treatment. Id. The weight accorded
                                     an authority depends on its relevance and persuasiveness, as well as the type of document pro-
                                     viding the authority. Sec. 1.6662–4(d)(3)(ii), Income Tax Regs.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00127   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     194                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     penalty under section 6662(a) does not apply because, under
                                     section 6664(c), petitioners had reasonable cause and acted in
                                     good faith with respect to the underpayment resulting from
                                     both the disallowed capital loss and the disallowed deduction
                                     of the transaction fees. Petitioners’ primary defense is that
                                     they reasonably relied in good faith on the opinion of their
                                     professional tax adviser, Singer. Petitioners assert that
                                     Singer provided petitioners with comprehensive and detailed
                                     advice in D&T’s draft opinion, which was prepared under
                                     Singer’s supervision and reflected advice given by Singer and
                                     other specialists at D&T regarding the tax treatment of the
                                     QHMC transactions and the claimed capital loss. The ultimate
                                     conclusion of Singer’s tax advice was that petitioners’ tax
                                     treatment of the QHMC transactions would more likely than
                                     not be sustained. Petitioners argue that they followed
                                     Singer’s tax advice in the preparation of the 1997 return and
                                     that Singer signed the return on behalf of D&T as the paid
                                     return preparer. Petitioners conclude that none of the section
                                     6662 accuracy-related penalties determined by respondent is
                                     appropriate because petitioners relied in good faith on profes-
                                     sional tax advice regarding complex tax issues.
                                        On the basis of our examination of the facts and cir-
                                     cumstances surrounding the QHMC transactions, we do not
                                     find that petitioners had reasonable cause and acted in good
                                     faith. Petitioners conducted no independent investigation of
                                     the tax consequences of the QHMC transactions, and Quanex’s
                                     tax department did not prepare any internal written tax
                                     opinion or memorandum discussing the tax consequences of
                                     the QHMC transactions. Further, none of Quanex’s officers
                                     testified that he or she analyzed the facts or authorities nec-
                                     essary to make a good-faith conclusion regarding the tax
                                     treatment of the transactions. Rose understood that the
                                     transactions generated a significant artificial capital loss, but
                                     he conducted no independent investigation. Parikh knew that
                                     the QHMC transactions generated a significant artificial cap-
                                     ital loss, but he did not speak with anyone at D&T about the
                                     QHMC transactions or read the draft opinion before signing
                                     petitioners’ 1997 return. Royce, Quanex’s tax director, knew
                                     that the QHMC transactions generated a significant artificial
                                     capital loss, but he prepared no tax opinion on the subject
                                     and he did not obtain a tax opinion from an independent
                                     professional tax adviser.




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00128   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    195


                                        We also do not find that petitioners’ reliance on the tax
                                     advice of Singer was reasonable or in good faith. Neither
                                     Singer nor D&T was an independent adviser on the tax con-
                                     sequences of the QHMC transactions. Singer (on behalf of
                                     D&T) promoted to Quanex a generic contingent liability
                                     transaction that could be molded to meet Quanex’s desire to
                                     shelter the upcoming gains, and Quanex’s officers worked
                                     closely with Singer to develop the QHMC transactions to
                                     shelter the impending capital gains resulting from the sales
                                     of LaSalle and the Tube Group. When Singer introduced the
                                     contingent liability transaction to petitioners, Rose agreed to
                                     structure the transaction as a joint venture to manage med-
                                     ical liabilities in a more cost-efficient manner. At the same
                                     time, however, Rose knew that the QHMC transactions served
                                     no meaningful purpose outside of tax benefits. The primary
                                     officers involved in implementing the QHMC transactions,
                                     Rose, Parikh, and Royce, were sophisticated professionals
                                     with significant tax experience. Yet none of them ever con-
                                     sulted Quanex’s own health care benefits experts, Peery and
                                     Howard, regarding the structure of the QHMC transactions.
                                     The named officers merely caused Quanex to transfer the
                                     amount of liabilities needed to shelter the capital gains.
                                     Given the significant tax loss generated from a transaction
                                     devoid of economic substance, the officers should have con-
                                     ducted a more extensive analysis with respect to the pro-
                                     priety of the transaction. See, e.g., Nicole Rose Corp. v.
                                     Commissioner, 320 F.3d 282, 285 (2d Cir. 2002) (taxpayer’s
                                     ‘‘scheme was sufficiently blatant that the participation of
                                     experts cannot convert its actions into a ‘reasonable attempt
                                     to comply with the provisions’ of the tax code’’), aff ’g 117 T.C.
                                     328 (2001); Neonatology Assocs., P.A. v. Commissioner, 299
                                     F.3d at 234 (‘‘As highly educated professionals, the * * * tax-
                                     payers should have recognized that it was not likely that by
                                     complex manipulation they could obtain large deductions for
                                     their corporations[.]’’). Such is especially so, given that D&T
                                     was promoting an engagement whereby petitioners could pay
                                     D&T $400,000 to structure a transaction that would let peti-
                                     tioners deduct an approximately $38 million tax loss on the
                                     sale of $11,000 in securities which had just recently been
                                     purchased for the same amount, and that this result, to a
                                     savvy, experienced businessman such as Rose, Parikh, or




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00129   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     196                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     Royce, would clearly appear to be too good to be true. 83
                                     Neonatology Assocs., P.A. v. Commissioner, 299 F.3d at 234
                                     (‘‘When, as here, a taxpayer is presented with what would
                                     appear to be a fabulous opportunity to avoid tax obligations,
                                     he should recognize that he proceeds at his own peril.’’); New
                                     Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. at
                                     195; Blum v. Commissioner, T.C. Memo. 2012–16.
                                        We also reject petitioners’ contention that petitioners’ reli-
                                     ance on D&T’s draft opinion was reasonable because (1) D&T
                                     never finalized the opinion, 84 and (2) even if the opinion had
                                     been issued by D&T, Singer based his conclusion in the
                                     opinion on the incorrect assumption that petitioners entered
                                     into the QHMC transactions for a valid business purpose, to
                                     manage their medical liabilities in a more cost-efficient
                                     manner, that petitioners knew was incorrect. See sec.
                                     1.6664–4(c)(1)(ii), Income Tax Regs. Thus, while the D&T
                                     draft opinion cites various Code sections, revenue rulings,
                                     and court cases to support Singer’s conclusion as to the Fed-
                                     eral income tax consequences of the QHMC transactions, 85
                                     petitioners cannot in good faith rely on the tax opinion
                                     because petitioners knew that the only purpose of the trans-
                                     actions was to achieve a tax loss. We also note that the draft
                                     opinion was authored by the same firm that promoted the
                                     QHMC transactions (initially in a generic form) to Quanex,
                                     and which helped Quanex then fine tune and implement the
                                     generic transaction to Quanex’s situation, and that the draft
                                     opinion was given to Quanex as part of the overall purchase
                                     price of that promotion. D&T is a ‘‘promoter’’ in the setting
                                     of this case, see 106 Ltd. v. Commissioner, 136 T.C. 67, 79–
                                     80 (2011), aff ’d, 684 F.3d 84 (D.C. Cir. 2012); Blum v.
                                     Commissioner, T.C. Memo. 2012–16, and petitioners could
                                     not reasonably rely on the advice of D&T to support its pro-
                                        83 We also note the specific terms of D&T’s compensation as to the QHMC transactions. The

                                     engagement letter informed petitioners that D&T would be compensated on the basis of its
                                     standard hourly rates if the QHMC transactions were not ultimately consummated. However,
                                     the letter stated, if the transactions were consummated, D&T would be paid (in lieu of the hour-
                                     ly rates) a set fee of $400,000 plus out-of-pocket expenses estimated to total $10,000.
                                        84 Petitioners claim that the draft opinion actually was D&T’s ‘‘final advice’’ on the subject.

                                     The record does not establish that point, and we decline to find it as a fact.
                                        85 The draft opinion, however, provided little meaningful analysis as to sec. 351(g). The draft

                                     opinion merely misstated as a fact that the liquidation value of the class C stock equaled 45%
                                     of the increase in QHMC’s equity value and concluded that the class C stock should not be treat-
                                     ed as preferred stock for purposes of sec. 351(g) because ‘‘[i]t is difficult to argue that 45% is
                                     not significant.’’




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00130   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     (67)               GERDAU MACSTEEL, INC. v. COMMISSIONER                                    197


                                     motion given the obvious conflict of interest, see, e.g., Blum
                                     v. Commissioner, T.C. Memo. 2012–16.
                                        Accordingly, we reject petitioners’ contention that they
                                     meet the reasonable cause exception under section 6664(c),
                                     and we sustain respondent’s determination that petitioners
                                     are liable for the 20% accuracy-related penalty. On the basis
                                     of this holding, we logically also hold that petitioners fail to
                                     meet the more stringent requirements needed to establish
                                     reasonable cause when the substantial understatement pen-
                                     alty is attributable to a tax shelter. See sec. 1.6664–4(e),
                                     Income Tax Regs. Consequently, whether petitioners meet
                                     the authority and belief requirements of section 1.6664–4(e),
                                     Income Tax Regs., is irrelevant.
                                     VI. Conclusion
                                        Respondent properly disallowed the short-term capital loss
                                     deduction petitioners claimed from the sale of the class C
                                     stock to Wannell. Further, petitioners improperly deducted
                                     the fees incurred to implement the QHMC transactions. Fur-
                                     ther, on the basis of our Golsen rule, we do not sustain
                                     respondent’s determination as to the 40% gross valuation
                                     misstatement penalty imposed under section 6662(h) with
                                     respect to the disallowed capital loss. We do, however, sus-
                                     tain respondent’s determination that petitioners are liable for
                                     the 20% accuracy-related penalty attributable to negligence
                                     and to a substantial understatement of income tax. See sec.
                                     6662(a) and (b)(1) and (2). We also hold that petitioners
                                     failed to establish that they met the reasonable cause excep-
                                     tion of section 6664(c).


                                       We have considered all arguments that the parties made,
                                     and to the extent not discussed above, conclude those argu-




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00131   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
                                     198                 139 UNITED STATES TAX COURT REPORTS                                     (67)


                                     ments are irrelevant, moot, or without merit. To reflect the
                                     foregoing,
                                                                         Decision will be entered under Rule 155.

                                                                               f




VerDate Nov 24 2008   09:57 Jun 05, 2014   Jkt 372897   PO 20012   Frm 00132   Fmt 2847   Sfmt 2847   V:\FILES\BOUND VOL. WITHOUT CROP MARKS\B.V.139\MACSTEEL1.AUG   JAMIE
