                       T.C. Memo. 2000-208



                     UNITED STATES TAX COURT



         JACOB AND CHANA PINSON, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 7561-98,     7562-98,         Filed July 6, 2000.
                 7563-98,     7564-98,
                 7565-98,     7566-98,
                 7567-98,     19353-98,
                 19354-98,    19355-98,
                 19356-98,    19357-98,
                 19358-98,    19359-98.




          These cases involve the proper tax treatment of

     1
       Cases of the following petitioners are consolidated
herewith: B. Mayer and Ella Zeiler, docket No. 7562-98; Joseph
and Sara Deitsch, docket No. 7563-98; Joshua and Rachel Sandman,
docket No. 7564-98; Deitsch Plastic Company, Inc., docket No.
7565-98; Mordecai and Bonnie Deitsch, docket No. 7566-98; David
and Sara Deitsch, docket No. 7567-98; B. Mayer and Ella Zeiler,
docket No. 19353-98; Mordecai and Bonnie Deitsch, docket No.
19354-98; Deitsch Plastic Company, Inc., docket No. 19355-98;
Joshua and Rachel Sandman, docket No. 19356-98; David and Sara
Deitsch, docket No. 19357-98; Jacob and Chana Pinson, docket No.
19358-98; Joseph and Sara Deitsch, docket No. 19359-98.
                               - 2 -

     two types of payments received by Ps from an Israeli
     corporation: (1) Payments made directly to certain of
     Ps and upon which taxes were paid to the Israeli
     Government, and (2) payments made to a partnership and
     reported by certain of Ps as their distributive shares
     of partnership income.

          Held: The payments made directly to Ps are to be
     characterized as compensation for services performed
     within the United States. Hence, the amounts are not
     to be treated as foreign source income for purposes of
     calculating the credit for foreign taxes under sec.
     901, I.R.C.

          Held, further, the payments made to the
     partnership were not properly reported as partnership
     income. They are not to be allocated as income to the
     corporate P. Like the remittances above, these
     payments are to be characterized as compensation for
     services earned by the individual Ps, and as U.S.
     source income to the individual Ps, except as to the
     two Ps who resided in Israel.

          Held, further, Ps are not entitled to seek a
     deduction for foreign taxes paid under sec. 164,
     I.R.C., in lieu of the disallowed foreign tax credits.

          Held, further, the individual Ps are liable for
     accuracy-related penalties pursuant to sec. 6662(a),
     I.R.C., but the corporate P is not.


     Robert J. Percy and Bruce Judelson, for petitioners.

     Stephen C. Best and Bradford A. Johnson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     NIMS, Judge:   Respondent determined the following

deficiencies and penalties with respect to petitioners’ Federal

income taxes for the taxable years 1991 through 1994:
                              - 3 -

                                                    Penalties

    Petitioners       Year   Deficiency   Sec. 6662(a)    Sec. 6662(h)



  Jacob and Chana     1991    $351,904       $48,478            $38,990

      Pinson          1992     708,327       120,628             30,538

                      1993      48,566           131             19,120

                      1994     429,683        59,695             52,483



 B. Mayer and Ella    1991          --            --                 --

      Zeiler          1992          --         2,419                 --

                      1993      12,730           153              2,041

                      1994     121,574        24,315                 --



  Joseph and Sara     1991     353,295        47,921             48,528

      Deitsch         1992     792,926       136,778             43,838

                      1993     100,364           122             39,935

                      1994     421,993        58,038             52,720



 Joshua and Rachel    1991     296,413        40,472             41,808

      Sandman         1992     786,596       134,161             38,484

                      1993     111,174           131             44,163

                      1994     440,885        58,943             43,960



  Deitsch Plastic     1991     485,976            --            194,390

   Company, Inc.      1992     728,139            --            291,256

                      1993     823,513            --            329,405

                      1994     748,409        27,085            245,193



Mordecai and Bonnie   1991          --            --                 --

      Deitsch         1992     115,312         1,787             42,070

                      1993      99,372           153             39,442

                      1994      44,571         8,914                 --
                                - 4 -

  David and Sara   1991         363,170       48,775       50,770

     Deitsch       1992         790,380      130,075       60,296

                   1993          30,004          153       11,972

                   1994         314,102       37,868       49,904



Respondent further determined that if the 40-percent section

6662(h) accuracy-related penalty were deemed inapplicable,

amounts upon which it had been computed were subject, in the

alternative, to the 20-percent section 6662(a) penalty.

Respondent has since conceded the section 6662(h) penalty.

     Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the years in

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.   Dollar amounts are rounded to the

nearest dollar.

     These cases have been consolidated for purposes of trial,

briefing, and opinion.    Hereinafter and unless directed toward

the collective position of all petitioning litigants, references

to petitioners shall be to the individual petitioners, with the

exception of B. Mayer and Ella Zeiler.    The Zeilers’

circumstances involve different considerations, and counsel

represented at trial that their case has been entirely settled

through stipulation.   We shall discuss facts pertaining to the
                                 - 5 -

Zeilers only to the extent necessary to comprehend the underlying

context.   The corporate petitioner shall be referred to as

Deitsch Plastic Company, Inc., or DPC.

      After concessions, the issues remaining for decision are:

      (1) The proper tax treatment of payments made directly from

Flocktex Industries, Ltd. (FIL), an Israeli corporation, to

certain of petitioners, and of foreign taxes paid thereon;

      (2) the proper tax treatment of payments made from FIL to

Deitsch Plastic Partners (DPP) and reported by certain of

petitioners as their distributive shares of partnership income;

and

      (3) the applicability of accuracy-related penalties pursuant

to section 6662(a) for negligence, intentional disregard of rules

or regulations, and/or substantial understatement of income tax.

                         FINDINGS OF FACT

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

The stipulations of the parties, with accompanying exhibits, are

incorporated herein by this reference.

The Deitsch Family

      The individuals involved in these consolidated cases are all

members of the Deitsch family.    David Deitsch is the patriarch of

the family, and Sara is his wife.    Mordecai Deitsch, Joseph

Deitsch, Rachel Sandman, Ella Zeiler, and Chana Pinson are the

children of David Deitsch.   Joshua Sandman, B. Mayer Zeiler, and
                                   - 6 -

Jacob Pinson are David Deitsch’s sons-in-law.     At the time of

filing their petitions in these cases, the David Deitsches, the

Joseph Deitsches, and the Sandmans resided in New Haven,

Connecticut.   The Mordecai Deitsches and the Pinsons resided in

Brooklyn, New York.     The Zeilers were residents of Kiryat

Malachi, Israel.

Deitsch Plastic Company, Inc.

     DPC was founded by David Deitsch and was incorporated in

1960.   DPC is a U.S. corporation which maintained a principal

place of business in West Haven, Connecticut, at the time of

filing its petitions.     The company is engaged in the manufacture

and sale of coated vinyl and urethane laminated materials,

primarily for use in the production of upholstery.

     DPC has at all times been a privately held corporation with

all stock being controlled by members of the Deitsch family.

During the years in issue, ownership of DPC was distributed as

follows:

     David Deitsch          17   percent
     Mordecai Deitsch       15   percent
     Joseph Deitsch         17   percent
     Joshua Sandman         15   percent
     B. Mayer Zeiler        17   percent
     Jacob Pinson           17   percent

(The fact that these stipulated percentages total only 98 is not

further explained by the record.)

     The above six shareholders were also employed in the DPC

business.   David Deitsch, the director and chief executive
                                 - 7 -

officer of the company, oversaw all financial and administrative

functions.   Each of the men, however, performed a variety of

duties within the organization.     As stated by Joseph Deitsch, “in

our company, * * * everybody is involved in everything” and

“Everybody wears many hats.”

Flocktex Industries, Ltd.

     In the early 1970’s, David Deitsch began, at the suggestion

of his rabbi, to investigate the possibility of opening a

business in Israel.     FIL was then established in 1974 as an

Israeli corporation.     The company is located in Kiryat Malachi,

Israel, and manufactures flocked fabrics principally for use in

the production of drapery and upholstery.     Like DPC, FIL has at

all times been closely held by members of the Deitsch family.

Stock ownership during the years at issue is set forth below:

     David Deitsch          .0001 percent
     Sara Deitsch           .0001 percent
     Mordecai Deitsch       20 percent
     Joseph Deitsch         20 percent
     Rachel Sandman         19.999 percent
     B. Mayer Zeiler        20 percent
     Jacob Pinson           20 percent

(Again, we note that the stipulated values total only 99.9992

percent.)

     Financing for the startup of FIL was provided through the

Industrial Development Bank of Israel, Ltd., an Israeli

governmental organization.     To obtain financing of this type, the

Deitsches were required to comply with conditions designed by
                                - 8 -

Israeli officials to ensure that adequate backing existed for the

investment.   In order to satisfy such requirements, two

agreements were entered by DPC during 1975.   DPC agreed to

purchase at least 60 percent and up to 80 percent of FIL’s

production until the loan was repaid.   DPC also executed a

License, Technical and Marketing Assistance Agreement in which it

contracted to provide FIL with technical and marketing

information in connection with the setup and operation of the

flocked fabrics enterprise.   The document further recited that

Pervel Industries, Inc. (Pervel), had in turn agreed to aid DPC

in supplying the requisite technical assistance and know-how.

This contract with Pervel, a U.S. manufacturer of flocked

fabrics, had been obtained in order to address the fact that

differences in the flocked fabric and plastic laminate industries

rendered DPC without sufficient expertise to advise FIL on

certain technical aspects of the business.

     In preparation for the commencement of the FIL operations,

Jacob Pinson spent several months in Israel performing such tasks

as negotiating for utility services and finalizing the

installation of machinery.    Thereafter, B. Mayer Zeiler arrived

in Israel and has since been the member of the Deitsch family

residing in Kiryat Malachi and running the FIL business.    His job

description as an employee of DPC states that he “is responsible

for all financial, administrative, sales, and production
                                - 9 -

functions as they relate to the products sold to and purchased

from Flocktex Industries, Ltd.”    His enumerated duties include:

     1.     Responsibility for the sales and purchases
            relating to Israeli and European markets.

     2.     Sales negotiation and procurement of products sold
            to Flocktex, including relations with its
            customers in an effort to maintain market
            presence.

     3.     Purchasing negotiations regarding product
            purchases from Flocktex, Ltd.

     4.     Application of expertise regarding selling,
            purchasing, and other business matters particular
            to middle east and European market.

     5.     Representative to maintain marketing presence.

All other members of the family resided in the United States

throughout the period at issue.

     On January 14, 1980, DPC and FIL entered an agreement

superseding the 1975 License, Technical and Marketing Assistance

Agreement, wherein DPC contracted to furnish to FIL the following

services:

     1.1    Market research in the United States for the
            product manufactured by FLOCKTEX, provided that
            FLOCKTEX shall notify DEITSCH in advance of any of
            these products which it is willing and able to
            manufacture for export.

     2.1    [sic] Sales promotion services, namely,
            introduction to potential purchasers, promotion
            through DEITSCH salesmen and dissemination of
            information and data.

     1.3    Advice and recommendation concerning the future
            development of the manufacture, production and
            marketing.
                                - 10 -

     1.4   Counsel regarding the economic purchase of raw
           materials.

     1.5   Warehousing of the products in the United States.

In return, DPC was to receive 15 percent of the net price of the

products exported by FIL.    The agreement further stated that it

could be terminated by either party with 30 days’ written notice.

     From 1980 through 1989, DPC reported the payments received

from FIL under this agreement on its corporate income tax

returns.   Then, by a letter dated January 9, 1990, FIL notified

DPC that it was terminating the 1980 agreement, effective in 30

days.   The decision to end the agreement was made because, after

approximately 1986, FIL relied upon markets developed in Europe

for its product.   FIL did, however, continue to purchase raw

materials from Deitsch International Sales Corporation (Deitsch

Sales), a U.S. corporation also owned by the Deitsch family.

Deitsch Sales obtained the materials from suppliers in the United

States and then sold and exported them to FIL at a profit.     After

the 1990 letter, FIL also continued to make payments of 15

percent of the net price of its exported products, but DPC was no

longer the sole recipient.   DPC was paid $662,500 in 1990 and

last reported “consulting income” under the 1980 agreement on its

1991 return in the amount of $189,995.   The table below

summarizes FIL’s sales pattern for the years 1978 through 1994,

as stipulated by the parties:
                                       - 11 -

           Year       U.S. and Canadian             Other Sales        Total Sales

                               Sales

           1978                 $464,786               $635,399        $1,100,185

           1979                  946,456              1,076,376         2,022,832

           1980                1,688,033              1,198,674         2,886,677 [sic]

           1981                2,288,980                959,419         3,248,399

           1982                1,634,377                459,995         2,094,332 [sic]

           1983                1,266,613              1,933,287         3,200,000 [sic]

           1984                  231,696              2,395,812         2,627,508

           1985                   79,832              3,499,999         3,579,831

           1986                          0            4,433,073         4,433,073

           1987                   12,796              6,748,714         6,761,510

           1988                   10,876             10,105,617        10,116,496 [sic]

           1989                          0            8,801,212         8,801,321 [sic]

           1990                   10,485             11,314,441        11,324,926

           1991                          0           12,728,255        12,728,255

           1992                   16,698             16,580,935        16,597,633

           1993                          0           17,236,134        17,236,134

           1994                   23,158             15,094,572        15,117,730

Deitsch Plastic Partners

     DPP was formed by members of the Deitsch family in 1990.

The entity was organized as a general partnership and had no

written partnership agreement.               Partnership interests were

divided as follows for the 1991 through 1994 years:

                    1991                 1992              1993               1994
David Deitsch     25 percent           20 percent      16.66 percent      16.66 percent

Mordecai                               20 percent      16.66 percent      16.66 percent

Deitsch

Joseph Deitsch    25 percent           20 percent      16.66 percent      16.66 percent

Joshua Sandman    25 percent           20 percent      16.66 percent      16.66 percent

B. Mayer Zeiler                                        16.66 percent      16.66 percent

Jacob Pinson      25 percent           20 percent      16.66 percent      16.66 percent
                              - 12 -

     During the years at issue, DPP received no capital

contributions from any partner, held no formal partnership

meetings at which minutes were maintained, and had no employees.

DPP’s stated address was identical to that of DPC.

     Beginning in 1990, DPP received from FIL payments equaling

15 percent of the net price of FIL’s exported products, less the

sums described above as remitted to DPC in 1990 and 1991.    The

payments were made by wire transfer from FIL into bank accounts

maintained by DPP in the United States and England.   DPP did not,

however, enter any written contracts or agreements with FIL

regarding these amounts and performed no services for FIL.

     DPP was included as an affiliated entity for purposes of the

combined financial statements prepared for “Deitsch Plastic

Company, Inc. and Affiliates”.   The payments received from FIL

were reported in the financial statements as “Consulting Income”.

An accompanying note for years 1991 through 1993 explained:    “All

consulting income was earned from Flocktex Industries Limited,

Inc.”   A similar note with respect to 1994 read:   “All consulting

income was from Flocktex.”

     DPP filed a Form 1065, U.S. Partnership Return of Income,

for each of the taxable years in contention.   Thereon, DPP listed

its principal business activity as “consulting” and its principal

product or service as “plastics”.   DPP’s reported gross receipts

consisted solely of the payments from FIL.   The spaces for type
                                - 13 -

of income on DPP’s attached Schedules K, Partners’ Shares of

Income, Credits, Deductions, Etc., were completed with the word

“consulting”.   DPP also deducted from its income “commissions”

paid to B. Mayer Zeiler of $75,000, $75,000, and $400,000 for the

years 1992, 1993, and 1994, respectively.    B. Mayer Zeiler also

continued to receive a salary from DPC.

     The individual partners reported their distributive shares

of DPP’s income on their Forms 1040, U.S. Individual Income Tax

Return, and accompanying Schedules E, Supplemental Income and

Loss.   The amounts were reflected as income or loss from

partnerships but were not included on the partners’ Schedules B,

Interest and Dividend Income.

     For the 1991 year, the income was shown as nonpassive.    The

description of the nonpassive activity given in the returns of

David Deitsch, Joseph Deitsch, and Joshua Sandman is

“consulting”, and the amounts were designated as self-employment

earnings on the returns of Joseph Deitsch, Joshua Sandman, and

Jacob Pinson.   In 1992, David Deitsch again reported his

distributive share as nonpassive income, this time with the

description “trade or business--material participation”.    The

other partners categorized their 1992 DPP income as passive, and

in subsequent years all partners, except B. Mayer Zeiler,

utilized the passive designation.    They continued, however, to

label the income as self-employment earnings in the following
                              - 14 -

instances:   Joshua Sandman in 1992 and 1994, Jacob Pinson in 1992

and 1994, David Deitsch in 1994, Mordecai Deitsch in 1994, and

Joseph Deitsch in 1994.   B. Mayer Zeiler reported his share as

nonpassive income from “trade or business--material

participation” in both 1993 and 1994, and as self-employment

earnings in 1994.

     With the exception of B. Mayer Zeiler, all partners included

their distributive shares of DPP’s gross income as part of their

foreign source income for the 1991, 1993, and 1994 years.     They

typically categorized this income as “General limitation income”

for purposes of the Forms 1116, Foreign Tax Credit, filed with

their returns.   For 1993, however, Mordecai Deitsch and Jacob

Pinson categorized the amounts as “Passive income”.   David

Deitsch followed the practice of deeming the payments foreign

source income for 1992 as well, while the other partners placed

their 1992 distributive shares among their U.S. source income.

     FIL, on its financial statements and tax returns for 1991

through 1994, reported the payments to DPC and DPP as “selling

expenses”.   FIL’s financial statements explain the payments in

the following language:   “The Company paid the sum of * * *

[amount in New Israeli Shekels] to an affiliated company in

respect of sales commission and marketing and storage expenses”,

or “The Company paid the sum of * * * [amount in New Israeli

Shekels] to an affiliated company in respect of sales and
                                      - 15 -

marketing commission.”           The financial statements do not show

dividends as having been paid to shareholders.             The Israeli tax

returns reflect a deduction for these expenses and likewise do

not show any amount as having been paid as a dividend to

shareholders.     No taxes were withheld or remitted to the State of

Israel on the payments to DPC and DPP.

The Special Commissions

     Commencing in 1987, FIL also began making payments by wire

transfer directly to accounts in the name of “Flocktex

shareholders”.     For the years at issue, the recipients and

amounts of these payments are set forth below:

                      1991              1992        1993            1994
David Deitsch        $875,000        $2,350,000      $0          $1,000,000

Mordecai                     0                 0      0                    0

Deitsch

Joseph Deitsch        875,000         2,350,000       0           1,000,000

Rachel Sandman        875,000         2,350,000       0           1,000,000

B. Mayer Zeiler              0                 0      0                    0

Jacob Pinson          875,000         2,350,000       0           1,000,000

Through withholding, income taxes were paid by the recipients to

the State of Israel on the amounts shown above.            Letters issued

by Israeli authorities certifying receipt of the income taxes

specify that the sums were due in respect of “commission fees”

from FIL.

     On its financial statements, FIL again classified these

payments as “selling expenses” and included the following

explanation:      “In accordance with an agreement with the Company’s
                              - 16 -

shareholders the Company paid them a special commission in the

amount of * * * [a sum in New Israeli Shekels].”   (Hereinafter,

we shall for convenience adopt this terminology and shall refer

to these payments from FIL as special commissions.)    The special

commissions were also deducted as selling expenses by FIL for

purposes of its Israeli tax returns.

     The individual recipients reported the special commissions

on the line of their income tax returns designated “Other

income”.   They also attached statements further describing this

other income as “commission income Flocktex Ind” or simply

“Flocktex Ind” (with various terms and abbreviations being used

for Industries).   They did not report the amounts as dividends on

their Schedules B.   For each of the years that special

commissions were paid, the sums were included as foreign source

income in the “General limitation income” category.    Statements

accompanying their Forms 1116 for 1991 additionally identify the

income as derived from a “business or profession”.    The

recipients claimed foreign tax credits on their 1991, 1992, and

1994 returns for the Israeli taxes withheld by FIL on the special

commissions.

The Other Deitsch Entities

     Members of the Deitsch family also conducted business and

investment dealings through other partnerships and S corporations

during the period at issue.   In particular, the family members
                              - 17 -

carried on real estate rental activities through a variety of

passthrough entities.   The Federal income tax returns of

individuals involved in these ventures reported the income or

loss therefrom on Schedules E.   Dividends from these entities, as

well as from Deitsch Sales, were reflected as “Dividend income”

on their Forms 1040 and the accompanying Schedules B.

The Preparation and Examination of the Deitsch Returns

     The combined financial statements and the tax returns for

DPC, DPP, Deitsch Sales, and various real estate entities were

prepared by the accounting firm of Weinstein & Anastasio, P.C.

The tax returns here at issue of individual members of the

Deitsch family were also prepared by the firm.   Anthony

Valentino, a certified public accountant, has been petitioners’

primary accountant at the firm since the mid-1980’s.    The

financial statements and tax returns for FIL were prepared by

petitioners’ accountant in Israel, Itzhak Timor.

     For purposes of preparing these documents, Mr. Valentino was

given access to the records for the Deitsch entities kept at the

corporate facility in West Haven.   The individual family members,

although they did not typically fill out the annual questionnaire

sent by the accounting firm, would provide original data such as

Forms W-2 and Forms 1099.   Information regarding the payments

from FIL was obtained from the FIL financial statements sent to
                              - 18 -

Mr. Valentino by Mr. Timor.   The intent of Weinstein & Anastasio

in reporting these payments was “to be consistent with the

reporting that was presented to us by Flocktex.”

     Preparation of petitioners’ tax returns was frequently

completed with little time remaining before the filing deadline.

It was not uncommon for family members to sign the returns

without reviewing or discussing the items therein with their

accountant.   Petitioners relied on Mr. Valentino for the accuracy

of their returns.

     FIL’s tax returns were examined by the Israeli taxing

authorities for the years 1991, 1992, and 1993.    Examination by

the Internal Revenue Service (IRS) of the domestic returns began

in 1993, and the audit was eventually expanded to include the

1991 through 1996 years.   During the examination process, IRS

agents conducted several interviews with members of the Deitsch

family.   Also pursuant to the audit, the IRS in January and

November of 1998 sent letters to Israel’s Ministry of Finance

requesting information on the nature of the payments from FIL.

     In a reply dated September 8, 1999, which addressed the 1994

to 1996 years, the Ministry of Finance stated:    “All Payments

made by Flocktex to Deitsch Plastic are written as an expense to

Flocktex.   Flocktex did not pay Dividends to shareholders in the
                              - 19 -

years 1994-1996, but instead paid a special commission.”    The

letter continued, specifically in response to inquiries about the

payments to DPP, with the following:

     The payments described were reported and deducted,
     following the tax commisioners’ [sic] inquiry, the
     company’s representations and ultimately an agreement
     reached by the two parties, as consulting fees. There
     has been no change in this position in the company’s
     reports. The deduction was not removed and the taxable
     income remained as before. The agreement included,
     however, additional taxation of these payments prior to
     the Tax Commissioners [sic] permit to transfer these
     funds abroad. Therefor, [sic] it seems that in terms
     of Israeli taxation, there could be no adjustments made
     at this point and there would be no effect on Israeli
     taxation as a result of the adjustments made in the
     U.S.

Then, in answer to questions regarding the special commissions,

the taxing authorities provided that “These payments were

reported and deducted as described above.”

     After receiving this communication, the IRS sent an

additional letter requesting from the Israeli administration the

further specific assistance set forth below:

     (a)   Confirm that, similar to 1994-1996, for 1991-1993,
           FIL did not pay any dividends to shareholders.

     (b)   Explain which entity you mean by the name “Deitsch
           Plastic”. Does it mean Deitsch Plastic Company or
           Deitsch Plastic Partners? Does it recognize that
           these are two separate companies? Provide any
           information submitted by FIL and/or its
           accountants explaining its relationship to Deitsch
           Plastic Company and Deitsch Plastic Partners.
                              - 20 -


    (c)    Irrespective of whether you understand the entity
           receiving the funds to be Deitsch Plastic Company
           or Deitsch Plastic Partners, please explain your
           understanding of the work performed to earn the
           funds received from FIL.

                 *   *    *    *    *    *    *

     (e)   Explain your understanding of the work performed
           by the shareholders to earn the special
           commissions. Please provide any documentation
           supporting this understanding.

     The October 14, 1999, response from Israel’s Ministry of

Finance reads:

     These are the answers from the Assessing Office:

     (a)   Flocktex did not pay dividends to shareholders in
           the years 1992-1993, but instead paid a special
           commission.

           Files or reports for the 1991-tax year are
           unobtainable at such short notice. We requested
           this information and would be able to complete our
           answer upon its arrival.

     (b)   The Assessing Officer does not distinguish between
           the two separate companies.

     (c)   The taxpayers contended that the payments were for
           services rendered in form of management and
           consulting services. The Israeli company reported
           the payments as such. There was no question that
           management services have actually been given.

           Examination of the work performed to earn this
           income was not pursued any further.

     (e)   As in (c) above.
                               - 21 -


                               OPINION

I.   Contentions of the Parties

      A.   Petitioners’ Position

      Petitioners primarily contend that both the special

commissions paid by FIL directly to members of the Deitsch family

and the payments from FIL to DPP are properly characterized as

dividend income from a foreign source.    Petitioners maintain that

the nature or substance of the payments must be determined in

accordance with U.S. tax principles and that labels affixed for

Israeli reporting purposes are not conclusive.

      With respect to the special commissions, petitioners claim

dividend treatment is appropriate because no services were

rendered by the recipients to FIL and because the amount of the

payments was so large as to make it unreasonable to view them as

compensation.    Regarding the payments to DPP, petitioners aver

that because the agreement under which such sums were paid to DPC

for services was terminated prior to the years in issue, and

because DPC in fact provided no services to FIL during the 1991

through 1994 period, the payments were properly reported as

income to DPP.    Furthermore, it is petitioners’ position that

since neither DPP nor the individual family members performed

services for FIL (with the exception of B. Mayer Zeiler who was
                              - 22 -

otherwise compensated therefor), the payments constitute

dividends from a foreign source received by DPP on behalf of the

shareholder-partners.

     Based then on the above characterizations as foreign source

income, petitioners assert that they are entitled to foreign tax

credits for the taxes paid to the Israeli Government on the

special commissions and that both types of payments are to be

included in calculating the amount of the credits.   In the

alternative, if the claimed credits are reduced or disallowed,

petitioners seek a deduction for foreign taxes paid.

     Lastly, petitioners dispute application of the section

6662(a) penalty on the grounds that they acted reasonably and in

good faith in relying on a professional tax adviser, with respect

to complex matters.

     B.   Respondent’s Position

     Conversely, respondent asserts that petitioners’

characterizations impermissibly seek to reduce U.S. income taxes

through improper claiming of foreign tax credits and assigning of

income among entities.   Concerning the special commissions,

respondent maintains that petitioners should not be permitted to

depart from the position repeatedly taken for both U.S. and

Israeli reporting purposes that the amounts represented

compensation for services.   Moreover, since no recipient
                               - 23 -

performed work for FIL outside of the United States during the

years in issue, respondent avers that the payments constitute

U.S. source income.

     As regards the payments to DPP, respondent again contends

that petitioners should be bound by their representations that

such sums were in the nature of compensation for services.

Respondent further argues, however, that the funds are properly

characterized as income to DPC, not DPP.   In respondent’s view,

the alleged termination of the 1980 assistance agreement and the

creation of DPP were merely a scheme to eliminate corporate level

tax, unaccompanied by actual change in the entities’ relationship

and evidenced through continued adherence to the 15-percent

payment formula.   Hence, according to respondent, the amounts

reported by individual family members must be viewed as

constructive dividends from DPC and, consequently, as U.S. source

income from a domestic corporation.

     Given the above designation of both types of payments as

U.S. source income, respondent disallows petitioners’ claimed

foreign tax credits.   Respondent also denies such credits on the

alternative basis that petitioners have failed to establish that

the Israeli withholding is a creditable tax.   In addition,

respondent argues that DPC is liable for corporate level tax on

the amounts reported by DPP.
                                 - 24 -

      Finally, respondent alleges that petitioners’ improper

attempts to manipulate the Internal Revenue Code, inconsistent

reporting and statements, and failure to review their returns

render them liable for the section 6662(a) accuracy-related

penalty.

II.   Proper Tax Treatment of Payments

      A.    General Rules

             1.   Foreign Taxes and Sources of Income

      Payment of taxes to a foreign Government may give rise to

either a deduction or a credit.      See secs. 164, 901.   Section

164(a)(3) provides that a deduction is allowed for foreign income

taxes.     In lieu of this deduction, section 901(a) and (b)(1)

permits a taxpayer to elect a credit for foreign income taxes

which meet the requirements set forth in the statute and the

regulations promulgated thereunder.       Section 904(a), however,

places the following limitation on the amount of the foreign tax

credit:

           The total amount of the credit taken under section
      901(a) shall not exceed the same proportion of the tax
      against which such credit is taken which the taxpayer’s
      taxable income from sources without the United States
      (but not in excess of the taxpayer’s entire taxable
      income) bears to his entire taxable income for the same
      taxable year.

      To determine the source of income, reference must be made to

the source rules enumerated in sections 861 and 862.       Section

861(a)(2)(A) and (3) states that, in general, dividends from a
                              - 25 -

domestic corporation and compensation for labor or personal

services performed in the United States are to be treated as

income from sources within the United States.   Conversely,

section 862(a)(2) and (3) specifies that dividends other than

those derived from sources within the United States under section

861(a)(2) and compensation for labor or personal services

performed without the United States are to be treated as income

from without the United States.   Thus, payment for services

rendered outside the United States and dividends from a foreign

corporation typically constitute foreign source income for

purposes of calculating the section 901 credit.

     In the instant matter, the parties apparently do not dispute

these basic principles.   They disagree, however, as to the

characterization of the payments at issue and, therefore, as to

the source from which they must be deemed to flow.

          2.   Form and Substance of Transactions

     In characterizing a payment for tax purposes, consideration

must often be given to ideas of substance and form and to the

proper resolution of any dichotomy between the two.   As a general

rule, the substance of a transaction controls tax treatment.    See

Gregory v. Helvering, 293 U.S. 465, 469-470 (1935).   Nonetheless,

where either the Commissioner or a taxpayer seeks to assert the

substance of a transaction over its form, his or her respective

ability to do so differs.   See Commissioner v. National Alfalfa
                              - 26 -

Dehydrating & Milling Co., 417 U.S. 134, 148-149 (1974); Gregory

v. Helvering, supra at 467-470; Norwest Corp. v. Commissioner,

111 T.C. 105, 145 (1998); Estate of Durkin v. Commissioner, 99

T.C. 561, 571 (1992).

     It is well settled that the Commissioner may both look

behind the form of a transaction to its substance, see Gregory v.

Helvering, supra at 467-470, and bind a taxpayer to the form in

which the taxpayer has cast a transaction, see Commissioner v.

National Alfalfa Dehydrating & Milling Co., supra at 149.     See

also Estate of Durkin v. Commissioner, supra at 571.   As stated

by the Court of Appeals for the Second Circuit, to which appeal

in these cases would normally lie,

     The Commissioner is justified in determining the tax
     effect of transactions on the basis in which taxpayers
     have molded them, although he may not always be
     required to do so. It would be quite intolerable to
     pyramid the existing complexities of tax law by a rule
     that the tax shall be that resulting from the form of
     transaction taxpayers have chosen or from any other
     form they might have chosen, whichever is less.
     [Television Indus., Inc. v. Commissioner, 284 F.2d 322,
     325 (2d Cir. 1960), affg. 32 T.C. 1297 (1959);
     citations omitted.]

     A taxpayer, in contrast, “may have less freedom than the

Commissioner to ignore the transactional form that he has

adopted.”   Bolger v. Commissioner, 59 T.C. 760, 767 n.4 (1973);

see also Norwest Corp. v. Commissioner, supra at 145; Estate of

Durkin v. Commissioner, supra at 571; Coleman v. Commissioner, 87

T.C. 178, 201-202 (1986), affd. without published opinion 833
                              - 27 -

F.2d 303 (3d Cir. 1987).   In determining whether a taxpayer may

attempt to disavow the form adopted for a transaction, this Court

has considered at least four factors:    (1) Whether the taxpayer

seeks to disavow his or her own tax return treatment for the

transaction; (2) whether the taxpayer’s tax reporting and other

actions show an honest and consistent respect for the alleged

substance of the transaction; (3) whether the taxpayer is

unilaterally attempting to have the transaction treated

differently after it has been challenged; and (4) whether the

taxpayer will be unjustly enriched if permitted to alter the

transactional form.   See Taiyo Hawaii Co. v. Commissioner, 108

T.C. 590, 601-602 (1997); Estate of Durkin v. Commissioner, supra

at 574-575; FNMA v. Commissioner, 90 T.C. 405, 426-427 (1988),

affd. 896 F.2d 580 (D.C. Cir. 1990); Illinois Power Co. v.

Commissioner, 87 T.C. 1417, 1430 (1986); Little v. Commissioner,

T.C. Memo. 1993-281, affd. 106 F.3d 1445 (9th Cir. 1997); Norwest

Corp. v. Commissioner, supra at 144-146.

     If a taxpayer is not precluded from arguing that substance,

as opposed to form, should control tax consequences, he or she

must then establish the claimed substance of the transaction

under a heightened burden of proof.     See Norwest Corp. v.

Commissioner, supra at 140, 144; Estate of Durkin v.

Commissioner, supra at 572-574; Illinois Power Co. v.

Commissioner, supra at 1434; Little v. Commissioner, supra.     This
                                 - 28 -

Court typically applies the “strong proof” rule unless appeal

would lie to a Court of Appeals which has adopted the more

restrictive rule of Commissioner v. Danielson, 378 F.2d 771 (3d

Cir. 1967), vacating and remanding 44 T.C. 549 (1965).    See

Estate of Durkin v. Commissioner, supra at 572-573; Illinois

Power Co. v. Commissioner, supra at 1434; Little v. Commissioner,

supra.    The strong proof standard requires the taxpayer to

present more than a preponderance of the evidence in support of

his or her characterization.     See Ullman v. Commissioner, 264

F.2d 305, 308-309 (2d Cir. 1959), affg. 29 T.C. 129 (1957);

Illinois Power Co. v. Commissioner, supra at 1434 n.15; Little v.

Commissioner, supra.    Alternatively, where a taxpayer is not

attempting to disavow form, his or her burden of proof is to

establish by a preponderance that respondent’s determinations are

incorrect.    See Rule 142(a).

     B.    The Special Commissions

     Given the principles described above, we begin our analysis

of the special commissions with the threshold inquiry of whether

petitioners are attempting to assert substance over form.

Petitioners state on brief:

     The petitioners take issue with the premise * * * that
     the petitioners are seeking to disavow the form of the
     transaction that they originally adopted. In fact, the
     only “form” to the special commission payments was wire
     transfers of the money to the petitioners. The
     petitioners are not seeking to change the form of the
     transactions but are merely asking the Court to
     properly characterize the payments in accordance with
                               - 29 -

     the objective facts, notwithstanding the labels that
     were attached to the payments for Israeli tax and
     reporting purposes. * * *

They then cite United States v. Goodyear Tire & Rubber Co., 493

U.S. 132 (1989), and LDS, Inc. v. Commissioner, T.C. Memo. 1986-

293, as support for their position.

     We conclude, however, that petitioners by this statement

essentially concede that the payment transactions were previously

presented with a “form” or “label” other than dividend

distribution.   We further note that their reliance on the cited

cases to minimize the importance of this fact is misplaced.

United States v. Goodyear Tire & Rubber Co., supra, simply

decided that the statutory term “accumulated profits” should be

defined according to domestic tax principles and did not raise or

consider a taxpayer’s ability to disavow form.      LDS, Inc. v.

Commissioner, supra, addressed whether transfers of property to a

corporation constituted debt or capital contributions and

explicitly confined willingness to look beyond “labels” to this

narrow context.    The Court explained:    “‘where the nature of a

taxpayer’s interest in a corporation is in issue, courts may look

beyond the form of the interest and investigate the substance of

the transaction.    These situations present an exception to the

general proposition that a shareholder/taxpayer is bound by the

form of her transaction.’”    Id. (quoting Selfe v. United States,

778 F.2d 769, 774 (11th Cir. 1985)).      Similarly, “‘while a
                              - 30 -

taxpayer must in other contexts accept the tax consequences of

the way in which he deliberately chose to cast his transaction,’

the determination of whether advances to a corporation are loans

or equity contributions depends on the ‘economic reality for the

year at issue.’”   Id. (quoting Georgia-Pacific Corp. v.

Commissioner, 63 T.C. 790, 795 (1975)).     LDS, Inc. v.

Commissioner, supra, thus in actuality reaffirms that where, as

here, the characterization of advances to a corporation as debt

or equity is not at issue, taxpayers are typically bound by form

and labels.

     Having determined that petitioners are seeking to make a

substance over form argument, we turn to the question of whether

they should be permitted to do so.     We consider the circumstances

of these cases in light of the aforementioned factors.

     With respect to tax return treatment, petitioners reported

the special commissions as “Other income” on their Forms 1040.

If any explanation which went beyond simply identifying FIL as

the payer was included on the attached statements, the

description so given was “commission income”.    A commission is

generally defined as “a fee paid to an agent or employee for

transacting a piece of business or performing a service”.

Webster’s Third New International Dictionary 457 (1976).

Conversely, petitioners never reported the income on the line of
                               - 31 -

their Forms 1040 designated for dividend income, nor did they

ever list the payments as dividends on their Schedules B,

although amounts from other Deitsch entities were reflected

thereon.

     Petitioners did include the sums paid as foreign source

income on their Forms 1116 for purposes of calculating the

foreign tax credit, but they indicated on these forms that their

foreign source income fell within the “General limitation income”

category.   We note that the instructions for Form 1116 specify:

“Any income from sources outside the United States that does not

fall into one of the categories above is general limitation

income.    Common examples of general limitation income are wages,

salary, and overseas allowances of an individual as an employee.”

Further, among the “categories above” is “Passive income”, a

choice not selected by petitioners on their Forms 1116.    The

instructions state that “Passive income generally includes

dividends, interest, royalties, rents, [and] annuities”.

     Petitioners’ tax return treatment is thus largely consistent

with the special commissions being in the nature of compensation

for services but seems to negate any conclusion that petitioners

were receiving dividends.   Their present claims of distributions

of earnings and profits are therefore far more akin to a

disavowal of their tax return treatment than to an affirmance.
                              - 32 -

     The broader inquiry of whether petitioners’ tax reporting

and other actions show an honest and consistent respect for the

transactions’ alleged substance likewise demands an answer

unfavorable to petitioners’ position.   In addition to their own

return treatment, the returns of FIL, which was at all times

wholly owned and controlled by the individual petitioners and run

by B. Mayer Zeiler, never reported a dividend.   Rather,

deductions were taken for the amounts transferred.   FIL’s

financial statements similarly designate the payments “selling

expenses” and explain that the company paid shareholders “a

special commission”.

     Moreover, those acting on FIL’s behalf apparently made

representations to Israeli authorities directly contrary to the

position advocated here.   Documentation from Israel’s Ministry of

Finance reads:   “The taxpayers contended that the payments were

for services rendered in form of management and consulting

services.   The Israeli company reported the payments as such.

There was no question that management services have actually been

given.”   The taxing authorities were convinced that “Flocktex did

not pay dividends to shareholders * * * but instead paid a

special commission.”   Similarly, the IRS agent conducting

interviews with petitioners during the subsequent domestic audit,

whom we find credible, testified that when he inquired in January

of 1994 what the special commissions were for, Joseph Deitsch
                               - 33 -

“explained to me that there were services being performed by the

1040s--I mean the individuals when I say the 1040s--to achieve

these special commissions.”

     An additional circumstance which weighs against a finding

that actions respected dividend substance is the fact that the

distributions bear little correlation to stockholdings.    Mordecai

Deitsch and B. Mayer Zeiler, both of whom held 20-percent

ownership interests in FIL, received no special commissions

during the years at issue.    Other 20-percent shareholders were

each paid the full $875,000 to $2,350,000 commission amount.    In

contrast, David Deitsch, who was a .0001-percent owner, also

received the full $875,000 to $2,350,000 commission amount.    Yet

Sara Deitsch, likewise a .0001-percent owner, received no

payment.   Since a dividend is typically understood as a

“distribution * * * to the shareholders of a corporation pro rata

based on the number of shares owned”, Black’s Law Dictionary 478

(6th ed. 1990), petitioners’ position is at least weakened by the

arbitrary dispersal of the special commissions.    Hence, there is

nothing in the record which leads us to conclude that the actions

of the individual petitioners or their entities show an honest

and consistent respect for the alleged dividend substance of the

disputed payments.

     As regards a unilateral change of position after challenge,

the examining agent further testified:    “It was in the May 5th
                               - 34 -

[1994] interview that special commissions were represented as

actually dividends.    Up to that point, we were under the

impression that there was some type of consulting income going

on.”    Furthermore, since no documentation relating to the

transactions ever characterized the payments as dividend income,

and since this treatment was clearly not pursued in the earlier

Israeli examination, we are satisfied that respondent’s challenge

motivated petitioners to advance their present theory.

       Lastly, as sole owners of FIL, petitioners did obtain some

benefit or enrichment from the corporation’s deduction, which

left greater funds available for use and distribution.

       When we compare these inconsistencies with the situations

presented in cases where taxpayers were precluded from arguing

substance over form, we believe that like treatment is warranted

here.    For instance, in Norwest Corp. v. Commissioner, 111 T.C.

at 145-146, 147, we acknowledged that our approach might forsake

the true substance of the transaction but stated:     “when a

taxpayer seeks to disavow its own tax return treatment of a

transaction by asserting the priority of substance only after the

Commissioner raises questions with respect thereto, this Court

need not entertain the taxpayer’s assertion of the priority of

substance.”    We refused to become embroiled in the taxpayer’s

post-transactional tax planning.    See id. at 147.   We likewise

opined in Little v. Commissioner, T.C. Memo. 1993-281, that “when
                                - 35 -

raising a substance over form argument, the taxpayer must have

‘clean hands’ before he is allowed to present strong proof that

the form chosen does not reflect the true substance of the

transaction.”

     Similarly, Coleman v. Commissioner, 87 T.C. 178 (1986),

stands for the proposition that the above principles lose none of

their relevance in an international context.    We reasoned

therein:

     The fact that the purpose underlying the form of the
     transactions between * * * [foreign parties involved in
     an equipment leasing transaction, one of which was the
     party from whom the U.S. taxpayers derived their
     interest in the scheme] was to take advantage of U.K.
     rather than U.S. tax laws does not, in our opinion,
     provide a sufficient foundation for permitting
     petitioners to disavow that form in order to obtain the
     benefits of U.S. tax laws. * * * [Id. at 202-203.]

     Given the foregoing, we hold that petitioners are bound by

the various representations that these payments constituted

commission or consulting income, rather than dividends.    Further,

since the record is devoid of any evidence that the recipients

were residing or working outside the United States during the

years at issue, we decide that the sums must be treated as

compensation for services performed in the United States and,

hence, as U.S. source income.    Petitioners are not entitled to

treat the special commissions as foreign source income for

purposes of calculating foreign tax credits.
                                - 36 -

     C.   The Payments to DPP

     Turning to the payments from FIL to DPP, we first observe

that both petitioners and respondent seek to diverge to some

degree from the “form” or apparent import of the documentary

record.   Petitioners assert that the payments were properly

included as income of DPP but should be treated as dividends from

FIL for purposes of computing their foreign tax credits.

Although no Israeli taxes were withheld on these payments, their

characterization as U.S. or foreign source income is significant

in that the amount of the foreign tax credit available for taxes

that were paid depends upon the overall proportion of U.S. to

foreign source income.   Respondent avers that the amounts should

be treated in accordance with representations that they

constituted compensation for services but that such income was

earned by and taxable to DPC, rather than DPP, and was received

by petitioners as a constructive dividend from DPC.

     Nonetheless, the parties have stipulated that if we find the

payments from FIL “were properly reported by DPP”, petitioners

will be permitted to treat them as dividends from FIL.    We

therefore begin with this issue, but we note our reservations

about the seeming facial inconsistency of this statement.      Since

DPP reported the amounts as “Ordinary income (loss) from trade or

business activities” on its Forms 1065, and listed the type of

income as “consulting” on the attached Schedules K, treatment as
                                - 37 -

a dividend appears contrary to a finding of proper reporting.

This concern becomes moot, however, in that we fail to see how

the payments from FIL can on this record be deemed “properly

reported” by DPP either as compensation or as dividends.

       The parties stipulated that DPP performed no services for

FIL.    This implies that any consulting services rendered to FIL

by members of the Deitsch family were not performed in their

capacity as partners of DPP.     DPP thus cannot be said to have

earned income from the business activity of consulting.      With

respect to dividends, DPP was at no time a shareholder in FIL.

Hence, if the income in question represents dividends to

shareholders, it is properly reportable only by those

stockholders, not by an entity to whom they never transferred

even nominal title to their shares.      We find that the payments

from FIL were not properly reported by DPP.

            1.   Characterization of the Payments

       Having determined that a particular treatment is improper,

we proceed to address proper treatment.      To do so, we must

consider both how the payments from FIL are to be characterized

and by whom they are to be reported.      As regards

characterization, petitioners maintain on brief that the DPP

payments “were intended as distribution of profits to Flocktex

shareholders”.    They then state:   “the classification of the

payments as commission by the Israeli accountant is not
                               - 38 -

conclusive as to whether the payments were compensation for

services.    The payments constitute dividends for U.S. tax

purposes.”    We, however, again decline any invitation by

petitioners to engage in a substance over form analysis.      For

reasons which parallel those discussed above, we find that

petitioners are not entitled to now advance a position that

conflicts with the paper trail they have created.

     Petitioners’ tax returns reflect the payments to DPP as

partnership income, and attached Schedules E in some years

designate the income as nonpassive and in others as passive.

Descriptions of “consulting” or “trade or business--material

participation” are typically included in those years where a

nonpassive classification is shown, and even in a number of years

where the income is marked passive, it is nevertheless labeled

self-employment earnings.    Section 1402(a) defines “net earnings

from self-employment” as “the gross income derived by an

individual from any trade or business carried on by such

individual,” less allowable deductions, plus the individual’s

distributive share from any trade or business carried on by a

partnership.    However, the statute explicitly provides that “in

computing such gross income and deductions and such distributive

share of partnership ordinary income or loss * * * there shall be

excluded dividends on any share of stock”.    Sec. 1402(a), (a)(2).
                              - 39 -

Petitioners also never reported the amounts as dividends on their

Schedules B, although as noted previously, sums from other of

their partnership entities were so listed.

     Further, with few exceptions petitioners’ returns

inexplicably characterize the DPP income as derived from a

foreign source in 1991, 1993, and 1994, but not in 1992.

Moreover, the returns claiming foreign source treatment

repeatedly place the payments in the “General limitation income”

category, rather than in the “Passive income” category.    Based on

the aforementioned instructions for Form 1116, such a choice is

not consistent with the payments’ being in the nature of

dividends but is appropriate for compensation.

     Documentation pertaining to DPP and FIL is similarly devoid

of any hint that the payments were dividends as opposed to

compensation.   Combined financial statements including DPP show

the amounts as “consulting income” earned from FIL.   In addition,

DPP’s returns and Schedules K report the payments as “Ordinary

income (loss) from trade or business activities” and specify the

type of income as “consulting”.

     FIL likewise reported and deducted the payments as “selling

expenses” on its financial statements and tax returns, and no

dividend is recorded thereon as having been paid.   Furthermore,

the conclusions of the Israeli authorities regarding the payments

to DPP were identical to those reached about the special
                               - 40 -

commissions:    “The taxpayers contended that the payments were for

services rendered in form of management and consulting services.

The Israeli company reported the payments as such.    There was no

question that management services have actually been given.”

     Lastly, we note that in no year did the partnership

interests in DPP mirror shareholdings in FIL.    In addition,

interests in DPP fluctuated repeatedly while FIL stockholdings

remained constant.   Such dichotomy undercuts petitioners’

argument that DPP was created as a vehicle to distribute earnings

and profits to FIL shareholders.

     Faced with the foregoing, we will not permit petitioners now

to advance a position amounting to a disavowal of tax return

treatment, unsupported by any consistent respect in reporting and

actions, and subsequent to receipt of a tax benefit in a foreign

jurisdiction based upon contrary assertions.    We hold that the

payments from FIL to DPP must be characterized as compensation

for services.

          2.    Earner of the Income

     We next consider the question of which party or parties is

to be treated as earning, and hence must report, this

compensation.   Because we have already eliminated DPP, our focus

turns to the relative merits of deeming either DPC or the

individual petitioners the earners of the income.    Respondent has

determined that the payments must be allocated to DPC.
                               - 41 -

Specifically, respondent maintains that DPC in substance

continued to render services to FIL under the 1980 assistance

agreement, and that the letter of July 1990 formally terminating

the agreement should be disregarded.    Respondent also relies

heavily on the presence and activities of B. Mayer Zeiler in

Israel to show that DPC continued to perform the services called

for in the 1980 agreement.

     We believe, however, that the record in this case

establishes the lack of a formal consulting relationship between

DPC and FIL.   To the extent that the individual petitioners

advised FIL, the evidence suggests that they did so informally,

on behalf of the Deitsch family, rather than specifically in

their capacities as employees of DPC.    We base this conclusion on

documentary evidence regarding the sales pattern of FIL and the

services detailed in the 1980 agreement, as well as on the

testimony of petitioners concerning the mode of business

operation of the Deitsch family and entities.

     Stipulated sales figures for years 1978 through 1994 reveal

that of FIL’s total sales of $61,679,752 during the 1991 to 1994

period at issue, only $39,856 was derived from sales in the

United States and Canada.    Moreover, this trend wherein North

American sales accounted for a very small percentage of FIL’s

sales volume was established in the mid-1980’s.    Yet under the

1980 agreement, two of the five enumerated services to be
                              - 42 -

furnished by DPC expressly involved operations within the United

States, and a third implies as much.   FIL’s shift away from U.S.

markets thus indicates that these functions were no longer being

performed.

     The specific tasks of “Market research in the United States

for the product manufactured by Flocktex” and “Warehousing of the

products in the United States” would have become largely

unnecessary once FIL ceased marketing or selling any significant

portion of its output in the United States.    Further, given that

DPC was a domestic corporation with a domestic market and sales

force, “Sales promotion services * * * through DEITSCH salesmen”

implicitly contemplates U.S. activities which would not have been

pursued after the shift to European markets.   Of the remaining

items, we find it reasonable that after approximately 15 years in

business, FIL in 1990 would have had a well-established network

of suppliers, such that “Counsel regarding the economic purchase

of raw materials” would have been minimal at best.

     The final task set forth in the 1980 agreement is “Advice

and recommendation concerning the future development of the

manufacture, production and marketing,” and we have precluded

petitioners from arguing that no consulting services were

performed.   However, to the extent that advice continued to flow

between petitioners and FIL, we believe testimony revealing the

mode of operation within the Deitsch entities shows that such
                               - 43 -

information was furnished by individuals in their role as family

members, not because they were obligated to do so as DPC

employees bound by a formal contract.

     During trial Joseph Deitsch was asked, “What was the family

culture of the Deitsches?”    He responded, “Well, what Papa said--

that’s what goes.    We lived together, worked together, and it

was--and there was no question everybody had what they needed,

and we--I thought we had a good work ethic, and we tried our

best.”    The following exchange then expanded upon this idea:

     Q.     Did this attitude get reflected in other areas of
            the business?

     A.     It was a lifestyle reflected in everything which
            we did, as a family and individuals.

     Q.     All of the businesses were basically family
            businesses?

     A.     Basically, yeah. Everybody worked together.
            Everybody did. It wasn’t for his own, it was for
            everybody together.

     A similar sentiment is apparent in Jacob Pinson’s statement

that “most of the decisions were done by Mr. David Deitsch, and

everybody understood that this was a family business, and

everybody would be treated as a family, but the final decision

was really Mr. David Deitsch.”    Likewise, when questioned

regarding the existence of communications between patriarch David

Deitsch and B. Mayer Zeiler about FIL’s affairs, Jacob Pinson

said that “there were a lot of communications, family

communications.”
                                 - 44 -

     One further example illustrating the business environment

within the Deitsch entities is found in Joseph Deitsch’s reply

when asked whether DPC had an official research and development

department:   “Official?   No.   Everybody wears many hats.      So,

anybody has an idea, they try to expand.       The company is on a

first-name basis, no titles.”

     Hence, on the basis of this record, we conclude that any

formal consulting relationship established by the 1980 agreement

had ceased prior to issuance of the July 1990 termination letter.

For the reasons summarized below, we are satisfied that form was

by such letter brought into harmony with substance.       First, the

majority of the specific services called for in the agreement had

been rendered obsolete by FIL’s shift away from U.S. markets.

Second, to attribute to DPC whatever assistance continued to pass

to FIL, by deeming DPC the true earner of the income, would

require a finding that the individual petitioners were acting on

behalf of DPC when furnishing advice.       Such a conclusion,

however, is contrary to evidence that petitioners worked

primarily for the collective good of the Deitsch family and

without regard to corporate roles.        We are convinced that status

as DPC employees did not motivate their actions in this area.          In

addition, since nearly all payments after 1990 were made to DPP,

not DPC, and because FIL was owned by petitioners in their

individual capacities, with DPC having no direct stake therein,
                               - 45 -

it is unlikely that petitioners saw themselves as discharging

corporate duties when counseling the Israeli enterprise.

     Furthermore, we reject respondent’s argument that B. Mayer

Zeiler’s presence and activities in Israel show DPC continued to

render the services enumerated in the 1980 agreement.    B. Mayer

Zeiler’s job description indicates that his role as a DPC

employee with respect to FIL consists of responsibility for

managing and running all aspects of the FIL business on a day-to-

day basis.    The description contemplates active involvement in

selling, purchasing, negotiating, and procuring, and testimony

reflected the B. Mayer Zeiler does in fact run FIL’s daily

operations.    In contrast, the 1980 agreement calls for services

which are advisory or supportive in nature and distinct from

active management.    Thus, if B. Mayer Zeiler performed any such

consulting services for FIL, our grounds for concluding that he

did so in his official capacity as a DPC employee are not

significantly greater than with respect to the other petitioners.

     We therefore hold that the individual petitioners are to be

treated as the earners of the consulting income remitted to DPP

by FIL, and that they are entitled to claim an appropriate

deduction for their pro rata share of DPP’s reported expenses.

The record fails to support respondent’s assertions that such

amounts are to be allocated first as income to DPC, then

classified as constructive dividends to the individuals.    Since
                              - 46 -

the income is to be treated as compensation to the individuals,

we further conclude that payments are U.S. source income to the

individual petitioners other than Mr. and Mrs. Zeiler.

     D.   Alternative Availability of Deduction

     Without further argument or discussion, petitioners included

the following statement in their opening brief:

     if the effect of * * * [the Court’s] holdings is to
     reduce the amount of foreign tax credits available to
     the petitioners during the years at issue, then, as
     part of the Rule 155 Computation, the petitioners
     reserve the right to elect to take a deduction for the
     stipulated foreign taxes paid in lieu of the foreign
     tax credit for any or all of such years pursuant to
     Code § 164(a)(3) and Treas. Reg. § 1.901-1(d).


This issue had not previously been raised through the pleadings

or at trial, and respondent objected thereto in his reply brief,

asserting that petitioners’ claim was not a proper subject for a

Rule 155 computation and should have been addressed as part of

the merits of the case.   Respondent’s opening brief had also

contained, within a general discussion of the law relating to the

foreign tax credit, the statement that “Once a taxpayer elects to

take the credit, section 275(a)(4)(A) prohibits the claiming of

the taxes as a deduction.”   Petitioners responded to this remark

in their reply brief with a single paragraph:

          Moreover, the respondent contends that once a
     taxpayer elects to take a foreign tax credit, Section
     275(a)(4)(A) prohibits the claiming of the taxes as a
     deduction. In fact, Treas. Reg. § 1.901-1(d) allows a
     taxpayer to claim a deduction in lieu of a foreign tax
     credit at any time before the expiration of the statute
                                - 47 -

     of limitations prescribed by Section 6511(d)(3)(A),
     which is generally 10 years from the date of filing of
     the return. In the event that the Court holds that
     either or both the special commission payments and the
     DPP payments constitute U.S. source income, and such
     holding or holdings are sustained on appeal or not
     appealed, the petitioners reserve the right to elect to
     take a deduction for the stipulated foreign taxes paid
     in lieu of the foreign tax credit for any or all of the
     years of the relevant period.

We, however, conclude that petitioners may not reserve such a

right in the procedural posture presented.

     Petitioners have raised for the first time on brief not only

their entitlement to a deduction under section 164 but also an

issue of statutory and regulatory interpretation.   It is the

well-settled rule of this Court that a matter raised for the

first time on brief will not be considered when to do so would

prejudice the opposing party.    See DiLeo v. Commissioner, 96 T.C.

858, 891-892 (1991), affd. 959 F.2d 16 (2d Cir. 1992); Markwardt

v. Commissioner, 64 T.C. 989, 997 (1975).    Such prejudice arises

when the opposing party would be prevented from presenting

evidence that might have been offered if the issue had been

timely raised, or would otherwise be surprised and placed at a

disadvantage.   See DiLeo v. Commissioner, supra at 891-892;

Markwardt v. Commissioner, supra at 997.

     Here, respondent was denied the opportunity to present

evidence concerning whether petitioners satisfied the

requirements for a deduction.    Respondent’s choices as to which

items to stipulate and which to litigate might also have been
                                - 48 -

affected.    In addition, we find the sentence in petitioners’

opening brief regarding a Rule 155 computation insufficient to

alert respondent of the need to address on the merits the

interplay between section 275(a)(4)(A) and section 1.901-1(d),

Income Tax Regs.

III.   Applicability of the Accuracy-Related Penalty

       Subsection (a) of section 6662 imposes an accuracy-related

penalty in the amount of 20 percent of any underpayment that is

attributable to causes specified in subsection (b).    Subsection

(b) of section 6662 then provides that among the causes

justifying imposition of the penalty are:    (1) Negligence or

disregard of rules or regulations and (2) any substantial

understatement of income tax.

       “Negligence” is defined in section 6662(c) as “any failure

to make a reasonable attempt to comply with the provisions of

this title”, and “disregard” as “any careless, reckless, or

intentional disregard.”    Case law similarly states that

“‘Negligence is a lack of due care or the failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances.’”    Freytag v. Commissioner, 89 T.C. 849, 887

(1987) (quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th

Cir. 1967), affg. on this issue 43 T.C. 168 (1964) and T.C. Memo.

1964-299)), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S.

868 (1991).    Pursuant to regulations, “‘Negligence’ also includes
                                - 49 -

any failure by the taxpayer to keep adequate books and records or

to substantiate items properly.”    Sec. 1.6662-3(b)(1), Income Tax

Regs.

     A “substantial understatement” is declared by section

6662(d)(1) to exist where the amount of the understatement

exceeds the greater of 10 percent of the tax required to be shown

on the return for the taxable year or $5,000 ($10,000 in the case

of a corporation).   For purposes of this computation, the amount

of the understatement is reduced to the extent attributable to an

item:   (1) For which there existed substantial authority for the

taxpayer’s treatment thereof, or (2) with respect to which

relevant facts were adequately disclosed on the taxpayer’s return

or an attached statement.   See sec. 6662(d)(2)(B).

     An exception to the section 6662(a) penalty is set forth in

section 6664(c)(1) and reads:    “No penalty shall be imposed under

this part with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for such portion and that

the taxpayer acted in good faith with respect to such portion.”

The taxpayer bears the burden of establishing that this

reasonable cause exception is applicable, as respondent’s

determination of an accuracy-related penalty is presumed correct.

See Rule 142(a).

     Regulations interpreting section 6664(c) state:

          The determination of whether a taxpayer acted with
     reasonable cause and in good faith is made on a case-
                               - 50 -

       by-case basis, taking into account all pertinent facts
       and circumstances. * * * Generally, the most important
       factor is the extent of the taxpayer’s effort to assess
       the taxpayer’s proper tax liability. * * * [Sec.
       1.6664-4(b)(1), Income Tax. Regs.]

       Furthermore, reliance upon the advice of an expert tax

preparer may, but does not necessarily, demonstrate reasonable

cause and good faith in the context of the section 6662(a)

penalty.    See id.; see also Freytag v. Commissioner, supra at

888.    Such reliance is not an absolute defense, but it is a

factor to be considered.    See Freytag v. Commissioner, supra at

888.    In order for this factor to be given dispositive weight,

the taxpayer claiming reliance on a professional such as an

accountant must show, at minimum, that (1) the accountant was

supplied with correct information and (2) the incorrect return

was a result of the accountant’s error.    See, e.g., Westbrook v.

Commissioner, 68 F.3d 868, 881 (5th Cir. 1995), affg. T.C. Memo.

1993-634; Cramer v. Commissioner, 101 T.C. 225, 251 (1993), affd.

64 F.3d 1406 (9th Cir. 1995); Ma-Tran Corp. v. Commissioner, 70

T.C. 158, 173 (1978); Pessin v. Commissioner, 59 T.C. 473, 489

(1972); Garcia v. Commissioner, T.C. Memo. 1998-203, affd. 190

F.3d 538 (5th Cir. 1999).

       As a threshold matter, we first address the situation of

DPC.    Due to our determination above that the payments to DPP are

not to be allocated as income to DPC, there exists no
                               - 51 -

underpayment attributable to these items upon which to premise an

accuracy-related penalty.    We hold that DPC is not liable under

section 6662(a).

     With respect to the individual members of the Deitsch family

(again other than B. Mayer Zeiler, whose penalty liability has

been settled by stipulation), petitioners seek to defend against

the imposition of section 6662(a) penalties on the grounds of

preparer reliance.   They maintain that reliance upon their

accountant demonstrates the requisite reasonable cause and good

faith to relieve them of negligence and to render applicable the

section 6664(c) exception.   We, however, disagree.

     Even if we accept the uncorroborated testimony that

petitioners informed Mr. Valentino the payments from FIL were

distributions of earnings and profits, the record at best

reflects that Mr. Valentino was supplied with inconsistent and

contradictory information.   Mr. Valentino was faced with written

documents, namely FIL’s financial statements, reflecting one

characterization and with oral assertions reflecting another.    In

addition, the discrepancies between years and among petitioners

indicate that petitioners’ representations may have at times been

incomplete or even conflicting.   Moreover, there is no evidence

whatsoever that petitioners provided Mr. Valentino with facts

underlying the FIL transactions that would have enabled him to

make an independent decision regarding their actual nature.
                               - 52 -

Since the record before us fails to explain how or why particular

individuals were selected to receive the distributed amounts, we

believe there exists a reasonable probability that Mr. Valentino

was likewise without the benefit of such data.   The various

aberrations in reporting treatment further support this view that

Mr. Valentino may have had a limited understanding of the streams

of funds flowing out of FIL.

     In these circumstances, we hold that petitioners have failed

to prove that their reliance on their accountant was reasonable

and in good faith.   Petitioners are liable for the section

6662(a) accuracy-related penalties on the alternative grounds of

negligence and/or substantial understatement of income tax.

Other contentions of the parties have been considered and, to the

extent not discussed herein, have been resolved by our

determinations above, rendered moot, or found unconvincing.

     To reflect the foregoing,



                                         Decisions will be entered

                                    under Rule 155.
