                          T.C. Memo. 2006-90



                        UNITED STATES TAX COURT



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

     Docket Nos.     9382-83,   10588-83,   Filed May 2, 2006.
                    17642-83,   17646-83,

     1
      Cases of the following petitioners have been treated as
cases related to the above-captioned case for purposes of the
additional evidentiary hearing required to give effect to the
mandates of the Court of Appeals for the Ninth Circuit in Dixon
v. Commissioner, 316 F.3d 1041, 1047 (9th Cir. 2003), as amended
Mar. 18, 2003 (Dixon V), revg. and remanding T.C. Memo. 1999-101
(Dixon III): Robert H. and Barbara A. Gridley, docket Nos.
10588-83, 10931-84, 38757-84; Norman W. and Barbara L. Adair,
docket Nos. 17642-83, 38965-84, 35608-86, 479-89, 8070-90; Ronald
L. and Mattie L. Alverson, docket No. 17646-83; Russell L. Fleer,
Sr. and Sally A. Fleer, docket Nos. 27053-83 and 13477-87; Hoyt
W. and Barbara D. Young, docket Nos. 4201-84, 22783-85, 30010-85;
Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84,
30979-85; John L. and Terry E. Huber, docket No. 20119-84; Arden
L. and Barbara G. Blaylock, docket No. 28723-84; Terry D. and
Gloria K. Owens, docket No. 40159-84; Richard and Fiorella
Hongsermeier, docket No. 29643-86; Willis F. McComas, II and
Marie D. McComas, docket No. 19464-92; Wesley Armand and Sherry
Lynn Cacia Baughman, docket No. 621-94; Joe A. and JoAnne
Rinaldi, docket No. 7205-94; Norman A. and Irene Cerasoli, docket
No. 9532-94; Stanley C. and Sharon A. Titcomb, docket No. 17992-
95; Richard B. and Donna G. Rogers, docket No. 17993-95. The 27
related cases have been consolidated for briefing and opinion.
                          - 2 -


            27053-83,    4201-84,
            10931-84,   15907-84,
            20119-84,   28723-84,
            38757-84,   38965-84,
            40159-84,   22783-85,
            30010-85,   30979-85,
            29643-86,   35608-86,
            13477-87,     479-89,
             8070-90,   19464-92,
              621-94,    7205-94,
             9532-94,   17992-95,
            17993-95.



     In Dixon v. Commissioner, 316 F.3d 1041 (9th Cir.
2003), revg. and remanding T.C. Memo. 1999-101, the
Court of Appeals held that the misconduct of R’s trial
attorney and his supervisor in the trial of the test
cases for the Kersting tax shelter project, in agreeing
with counsel for T, one of the test case Ps, to a
secret settlement of T’s deficiencies (not disclosed to
IRS management, to this Court, or to counsel for other
test case Ps), was a fraud on the Court. The Court of
Appeals ordered this Court to sanction R by entering
judgment in favor of the remaining test case Ps and
other Ps in the Kersting tax shelter group before the
Court on “terms equivalent to those provided in the
[final] settlement agreement with [T] and the IRS”,
leaving to this Court’s discretion “the fashioning of
such judgments, which to the extent possible and
practicable, should put these taxpayers in the same
position as provided in the [T] settlement”.

     R argues that the substance of the T settlement
was a 20-percent reduction of T’s 1979-1981
deficiencies, plus the payment of T’s attorney’s fees.
Ps argue that the T settlement was, in form and
substance, a 62.17-percent reduction of T’s 1979-1981
deficiencies, plus other benefits that bring the T
settlement to a 79.92-percent reduction in the
deficiencies. The parties agree that the T settlement
also included cancellation of all additions and
penalties, including nonshelter-related additions and
penalties, and the use of a “burnout” to reduce the
accrual of interest on the remaining deficiencies. Ps
                                 - 3 -


     argue that interest on the deficiencies should not be
     charged beyond Dec. 31, 1986, which, in their view,
     marks the inception of the fraud on the court. R has
     conceded that no interest will be charged on the
     deficiencies for the period of the appeals to the Ninth
     Circuit commencing in 1992.

          Held: The final settlement of T’s 1979-1981
     deficiencies amounts to a 62.17-percent reduction of
     those deficiencies.

          Held, further: Two minor additional benefits
     included in the T settlement bring the reduction
     percentage up to 63.37 percent.

          Held, further: The T settlement encompasses and
     requires the vacating of the portion or portions of the
     deficiencies determined against any Ps that may be
     attributable to the “Bauspar” shelter that was also
     promoted by Kersting and to any other issues not
     arising from shelters promoted by Kersting.

          Held, further: Interest on the reduced
     deficiencies shall not be charged beyond the date in
     1992 fixed by R’s concession and shall not be stopped
     as of any earlier date.



     Henry G. Binder and John A. Irvine, for petitioners

in docket Nos. 9382-83, 15907-84, and 30979-85.

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

17642-83, 4201-84, 38965-84, 40159-84, 22783-85, 30010-85,

35608-86, 479-89, and 8070-90.

     Robert Alan Jones, for petitioners in docket Nos. 17646-83,

10931-84, 38757-84, 19464-92, 621-94, and 9532-94.

     Declan J. O’Donnell, for petitioners in docket Nos.

10588-83, 27053-83, 28723-84, and 13477-87.
                               - 4 -


      Michael Louis Minns and Enid M. Williams, for petitioners in

docket No. 29643-86.

      Robert Patrick Sticht and Boris Orlov, for petitioners in

docket No. 7205-94.

      Robert Patrick Sticht, for petitioners in docket Nos.

20119-84, 17992-95, and 17993-95.

      Henry E. O’Neill and Peter R. Hochman, for respondent.



                             CONTENTS

                                                                                 Page

FINDINGS OF FACT   . . . . . . . . . . . . . . . . . . . . . .                    11

I.    The Kersting Tax Shelters . . . . .    . . .   .   .   .   .   .   .   .    12
      A.   Background . . . . . . . . . .    . . .   .   .   .   .   .   .   .    12
      B.   Respondent’s Kersting Project .   . . .   .   .   .   .   .   .   .    13
           1.   In General . . . . . . . .   . . .   .   .   .   .   .   .   .    13
           2.   Bauspar . . . . . . . . .    . . .   .   .   .   .   .   .   .    14
      C.   Respondent’s Project Settlement   Offer       .   .   .   .   .   .    15

II.   The Thompsons’ Participation in the Kersting
           Tax Shelters . . . . . . . . . . . . . . . . .                .   .    16
      A.   The Thompsons’ Tax Returns . . . . . . . . . .                .   .    16
           1.   Prepetition Years--1977 and 1978 . . . . .               .   .    16
           2.   Years Before the Court . . . . . . . . . .               .   .    16
                1979 . . . . . . . . . . . . . . . . . . .               .   .    16
                1980 . . . . . . . . . . . . . . . . . . .               .   .    17
                1981 . . . . . . . . . . . . . . . . . . .               .   .    17
           3.   Years Following Those Before the Court . .               .   .    17
                1982 . . . . . . . . . . . . . . . . . . .               .   .    17
                1983 . . . . . . . . . . . . . . . . . . .               .   .    18
                1984 . . . . . . . . . . . . . . . . . . .               .   .    18
                1985 . . . . . . . . . . . . . . . . . . .               .   .    18
      B.   Examination of the Thompsons’ 1978-1981 Returns               .   .    19

III. The Test Case Litigation and the Thompson Settlements .                      22
     A.   Selection of the Test Cases . . . . . . . . . . . .                     22
                               - 5 -

      B.   Deterioration of the Thompson-Kersting
           Relationship . . . . . . . . . . . . . . . . .                      . .     23
      C.   The Thompsons Engage DeCastro, Who Settles
           Their Cases . . . . . . . . . . . . . . . . . .                     . .     25
      D.   IRS Activity Regarding the Thompsons’
           1983-85 Returns . . . . . . . . . . . . . . . .                     . .     30
      E.   The Reporting and Resolution of the Thompsons’
           Deficiency Interest Payments for 1986 and 1987                      . .     33
      F.   The Thompson Settlement Revised as Trial
           Approaches . . . . . . . . . . . . . . . . . .                      . .     35
      G.   Trial and Entry of Decisions . . . . . . . . .                      . .     38
      H.   Discovery and Disclosure of the Thompson
           Settlements . . . . . . . . . . . . . . . . . .                     . .     42
      I.   Implementation and Effects of the
           Final Thompson Settlement . . . . . . . . . . .                     . .     52
      J.   Respondent’s Disciplinary Action
           Against Sims and McWade . . . . . . . . . . . .                     . .     57

IV.   Ninth Circuit Remand and Subsequent Proceedings                  . . . .         58
      A.   Ninth Circuit Orders in the DuFresne Case .                 . . . .         58
      B.   Evidentiary Hearing and Opinions
           After the Remand in DuFresne . . . . . . .                  . . . .         60
      C.   The Ninth Circuit’s Opinion and
           Mandates in These Cases . . . . . . . . . .                 . . . .         64
      D.   Proceedings Following Remand . . . . . . .                  . . . .         67
      E.   Further Disciplinary Proceedings . . . . .                  . . . .         68

OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . .                          70

Preliminary Comments   . . . . . . . . . . . . . . . . . . . .                         70

I.    Procedural Issues Following Remand   .   .   .   .   .   .   .   .   .   .   .   77
      A.   Procedural Posture . . . . .    .   .   .   .   .   .   .   .   .   .   .   78
      B.   Law of the Case   . . . . . .   .   .   .   .   .   .   .   .   .   .   .   79
      C.   Parties Before the Court . .    .   .   .   .   .   .   .   .   .   .   .   80
      D.   Burden of Proof . . . . . . .   .   .   .   .   .   .   .   .   .   .   .   81

II.   Defining and Applying the Thompson Settlement .                  . . . .         84
      A.   Overview . . . . . . . . . . . . . . . . .                  . . . .         84
      B.   Areas of Agreement . . . . . . . . . . . .                  . . . .         86
      C.   Starting Point: The Thompsons’ Settlement
           of Proposed Deficiencies for 1979-1981 . .                  .   .   .   .   88
           1.   Respondent’s Position . . . . . . . .                  .   .   .   .   88
           2.   Petitioners’ Position . . . . . . . .                  .   .   .   .   90
           3.   Analysis . . . . . . . . . . . . . . .                 .   .   .   .   91
      D.   Other Benefits Relating to the Thompsons’
           1981 Tax Year . . . . . . . . . . . . . . .                 . . . .         99
                              - 6 -

          1.   Elimination of the Thompsons’ Late
               Filing (Non-Kersting) Addition for 1981 .    . .     99
          2.   Respondent’s Failure To Address the
               Bauspar Issue in the Thompsons’ Statutory
               Notice for 1981 . . . . . . . . . . . . .    . . 100
    E.    Benefits to the Thompsons Relating to Years
          Other Than 1979-1981 . . . . . . . . . . . . .    . . 100
          1.   In General . . . . . . . . . . . . . . . .   . . 100
          2.   The Thompsons’ Escape From Kersting
               Liability with Respect to 1982 . . . . . .   . . 102
          3.   The Thompsons’ 1983 Kersting Deficiency
               and the Disappearing Statutory Notice . .    . . 108
          4.   The Thompsons’ 1983-85 Bauspar
               Deductions   . . . . . . . . . . . . . . .   . . 109
          5.   The Thompsons’ Deduction of Prepaid
               Interest on Their 1986 and 1987 Returns .    . . 111
               1986 . . . . . . . . . . . . . . . . . . .   . . 111
               1987 . . . . . . . . . . . . . . . . . . .   . . 115
          6.   The Thompsons’ Attorney’s Fee
               Deduction for 1993 . . . . . . . . . . . .   . . 117
          7.   The Thompsons’ Failure To Report
               Tax Benefit Income for 1993 . . . . . . .    . . 119
          8.   Payment of Witness Fees to Mr. Thompson .    . . 122
          9.   Release of Lien on the Thompsons’
               Property and Other Intangible Benefits . .   .   .   123
     F.   The Percentage Reduction Summarized . . . . . .   .   .   125
     G.   Additional Relief . . . . . . . . . . . . . . .   .   .   126
          1.   Elimination of Non-Kersting Additions . .    .   .   126
          2.   Allowance of Bauspar Deductions . . . . .    .   .   127
          3.   Elimination of Non-Kersting Deficiencies .   .   .   127
          4.   Attorney’s Fees . . . . . . . . . . . . .    .   .   128

III. Interest on Deficiencies and Overpayments   . . . . . . . 129
                               - 7 -

            MEMORANDUM FINDINGS OF FACT AND OPINION2


     BEGHE, Judge:   With this opinion, the Court hopes to provide

a template for resolution of the more than 1,3003 remaining cases




     2
      This opinion is issued pursuant to the mandates of the
Court of Appeals for the Ninth Circuit in Dixon V, revg. and
remanding Dixon III. Dixon III had supplemented our Memorandum
Findings of Fact and Opinion in Dixon v. Commissioner, T.C. Memo.
1991-614 (Dixon II), vacated and remanded per curiam sub nom.
DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994). For the
record, Dixon I is reported as Dixon v. Commissioner, 90 T.C. 237
(1988), holding that petitioners had failed to establish standing
to contest a search of Kersting’s office, thereby sustaining the
validity of the deficiency notices generated by the information
discovered in that search. Dixon IV, reported as Dixon v.
Commissioner, T.C. Memo. 2000-116, provided for awards of
attorney’s fees under sec. 6673(a)(2) to petitioners in Dixon
III.

     Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
     3
      In addition to the more than 1,300 open cases, petitioners
in 52 of the more than 500 other dockets in the Kersting project
in which stipulated decisions were entered, both before and after
discovery and disclosure of the misconduct held by the Court of
Appeals in Dixon V to have constituted fraud on the Court, have
filed motions for leave to file motions to vacate their
decisions. The Court has returned unfiled numerous other such
motions because of procedural defects. Petitioners filing or
attempting to file such motions have thereby sought to become
entitled to the benefits of the Thompson settlement as mandated
by the Court of Appeals in Dixon V. Motions for reconsideration
have been filed in the three dockets addressed in Lewis v.
Commissioner, T.C. Memo. 2005-205, in which we denied
petitioners’ motions for leave to file motions to vacate
stipulated decisions in Kersting-related cases.
                               - 8 -

of petitioner participants in the second generation4 of tax

shelter programs (the Kersting project) promoted by Henry F.K.

Kersting (Kersting).5   During the trial on the merits of the test

cases used to try to resolve the vast majority of the pending

cases in the Kersting project,6 respondent’s trial counsel

Kenneth W. McWade (McWade) (with the knowledge and connivance of



     4
      In Pike v. Commissioner, 78 T.C. 822 (1982), affd. without
published opinion 732 F.2d 164 (9th Cir. 1984), this Court
sustained respondent’s disallowance of all deductions for
interest, losses, and credits claimed by participants in
Kersting’s first-generation programs.
     5
      For additional information about the Kersting project, see
infra Parts I.A. and I.B. Before his death on Mar. 4, 2000,
Kersting and the tax shelter programs he promoted were frequently
before the courts. In addition to those cases cited supra notes
2, 3, and 4, see also, e.g., United States v. Kersting, 891 F.2d
1407 (9th Cir. 1989) (holding that an IRS summons was enforceable
against some Kersting program participants); Richards v.
Commissioner, T.C. Memo. 1997-149, Supplemental Opinion T.C.
Memo. 1997-299 (upholding Kersting project deficiency notice),
affd. without published opinion 165 F.3d 917 (9th Cir. 1998);
Gridley v. Commissioner, T.C. Memo. 1997-210 (denying
petitioners’ motions for summary judgment to obtain benefit of
Thompson settlement); Kersting v. United States, 206 F.3d 817
(9th Cir. 2000) (promoter penalties upheld); Kersting v.
Commissioner, T.C. Memo. 1999-197 (sustaining deficiencies
against Kersting personally); United States v. Kersting, 77 AFTR
96-1717 (Bankr. D. Haw. 1996) (denying Kersting bankruptcy
discharge).
     6
      In 1986, counsel for the parties in the Kersting-related
cases agreed to a test case procedure, under which a few typical
cases are selected as test cases, while the petitioners whose
cases are not selected as test cases are encouraged to execute a
“piggyback” agreement, i.e., a stipulation to be bound by the
outcome of the test cases. The majority of petitioners in the
Kersting-related cases executed piggyback agreements. See the
discussion in Gridley v. Commissioner, supra note 5.
                               - 9 -

his supervisor, Honolulu District Counsel William A. Sims

(Sims)), entered into secret settlements with Luis DeCastro

(DeCastro), counsel for test case petitioners John R. and Maydee

Thompson (the Thompsons).   The financial terms of the final

settlement were much more advantageous to the Thompsons than the

settlements generally made available to other petitioner

participants in the Kersting project.7   The final settlement with

the Thompsons was intended to provide refunds of tax and interest

paid by the Thompsons under a prior settlement, plus interest

thereon, that were to be used--and the bulk of the refunds was

used--to pay DeCastro’s fees for providing the appearance of his

independent representation of the Thompsons at the trial of the

test cases.   After this Court upheld respondent’s determinations

and entered decisions in favor of respondent in all the test

cases, see Dixon v. Commissioner, T.C. Memo. 1991-614 (Dixon II),

respondent’s senior management discovered the settlements, moved

this Court to vacate the decisions (including the decisions in

the Thompsons’ cases) that had not already been appealed to the


     7
      One nontest case petitioner, Denis Alexander, in exchange
for his acting as a witness and serving as an undeclared
consultant to McWade during the original trial of the test cases,
as described in Dixon III at Findings of Fact V.B. and VI.F.,
received a settlement even more favorable than that afforded the
Thompsons. Although the Court of Appeals in Dixon V noted
Alexander’s settlement, the Court of Appeals did not rely on or
refer to that settlement in formulating the sanction to be
imposed by its mandates.
                                - 10 -

Court of Appeals for the Ninth Circuit, and requested an

evidentiary hearing.    After vacating the decisions, the Court

denied the motion for evidentiary hearing, entered decisions for

the Thompsons in accordance with their final settlement, and

reentered or allowed to stand its decisions in the other test

cases.    The Court thereafter denied motions by test case and

nontest case petitioners to intervene in the Thompsons’ cases

shortly before the new decisions in those cases became final.      In

DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994) (hereafter

DuFresne), the Court of Appeals for the Ninth Circuit vacated the

decisions against the other test case petitioners on the ground

that the misconduct of Sims and McWade required further inquiry.

The Court of Appeals directed this Court to hold an evidentiary

hearing to determine:    “whether the extent of misconduct rises to

the level of a structural defect voiding the judgment as

fundamentally unfair, or whether, despite the government’s

misconduct, the judgment can be upheld as harmless error.”       Id.

at 108.

     This Court conducted the evidentiary hearing directed by the

Court of Appeals and held that the misconduct of the Government

attorneys did not create a structural defect but rather resulted

in harmless error.     See Dixon v. Commissioner, T.C. Memo. 1999-

101 (Dixon III).    We imposed sanctions against respondent in the

form of relief from the accrual of interest on additions to tax
                              - 11 -

for negligence as well as relief from additional interest under

section 6621(d)/(c) (hereafter, section 6621(c)).8

     The other test case petitioners again appealed.   The Court

of Appeals for the Ninth Circuit reversed and remanded our

decisions in those test cases in Dixon v. Commissioner, 316 F.3d

1041 (9th Cir. 2003), as amended on March 18, 2003 (Dixon V).

The Court of Appeals held that the misconduct of respondent’s

counsel constituted a fraud on the court and directed this Court

to enter decisions “in favor of Appellants and all other

taxpayers properly before this Court on terms equivalent to those

provided in the settlement agreement with Thompson and the IRS.”

Id. at 1047.   In this opinion, we determine the terms of the

Thompson settlement and their application to the Kersting project

participants before the Court.

                         FINDINGS OF FACT

     The parties have filed a stipulation of facts for

evidentiary hearing on September 20, 2004; a first supplemental

stipulation of facts for evidentiary hearing on September 20,

2004; a second supplemental stipulation of facts for evidentiary

hearing on November 22, 2004; a third supplemental stipulation of


     8
      Sec. 6621(d) was redesignated sec. 6621(c) by the Tax
Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 1511(c)(1)(A)-(C),
100 Stat. 2744, and repealed by sec. 7721(b) of the Omnibus
Budget Reconciliation Act of 1989, Pub. L. 101-239, 103 Stat.
2399.
                               - 12 -

facts for evidentiary hearing on March 29, 2005; a fourth

supplemental stipulation of facts, filed on June 17, 2005, and a

stipulation of settled issues, filed on June 22, 2005.      The facts

stipulated therein are so found.    The stipulation of facts and

the attached exhibits are incorporated herein by this reference.

The parties have further stipulated that, for purposes of the

present opinion, the Court may incorporate its findings of fact

as stated in earlier proceedings unless such facts are

inconsistent with the opinion of the Court of Appeals in Dixon V

or are inconsistent with facts stipulated or proven in

proceedings held after the issuance of Dixon V.

I.   The Kersting Tax Shelters

     A.     Background

     All the cases before the Court concern proposed

deficiencies, additions to tax, and interest that related to

petitioners’ participation in tax shelter programs promoted by

Kersting.    All the programs involved both “primary” loans and

notes and “leverage” loans and notes with corporations organized

by Kersting that have been held to be his alter egos.      See

Kersting v. Commissioner, T.C. Memo. 1999-197.    These notes

sometimes bore dates that were long before the date on which the

documents were actually executed and even before the date on

which the participant informed Kersting he was ready to

participate in a particular program.    Kersting advised
                                - 13 -

participants in his programs that the programs created legitimate

investments that would entitle participants to interest

deductions that they should claim on their individual tax

returns.

     B.     Respondent’s Kersting Project

            1.    In General

     Kersting’s promotion of his tax shelter programs had

attracted the attention of the Internal Revenue Service (IRS),

which instituted a tax shelter project known as the Kersting

project.9   In furtherance of that project, respondent sent

deficiency notices to more than 1,800 taxpayers who had

participated in the Kersting programs.

     The IRS established the Kersting project in its Honolulu

Appeals Office.    In any given tax shelter project, a project

Appeals officer typically works with a project attorney from the

District Counsel’s Office.     In the Kersting project, McWade, from


     9
      Tax shelter projects were initiated to deal with the large
volume of cases generated by tax shelter examinations during the
late 1970s and the early 1980s. Among the responses of the IRS
and the Tax Court were the development of procedures, including
tax shelter projects, that were intended to streamline the
litigation process, economize on the use of administrative and
judicial resources, and reduce the costs incurred by taxpayers in
resolving disputes over tax shelter adjustments. The IRS, Office
of Chief Counsel, created the Tax Shelter Branch in the National
Office to oversee tax shelter litigation across the country and
to organize individual tax shelter projects. The projects
generally focused upon a specific type of tax shelter, such as
those promoted by Kersting that constituted the Kersting project.
                              - 14 -

the Honolulu District Counsel’s Office, served as the project

attorney.

    Once a tax shelter project is assigned to a particular

District Counsel’s Office, that District Counsel has the

authority to settle any individual case in the project.    The

District Counsel generally is expected to adhere to the official

project settlement offer.   Nevertheless, the District Counsel has

the authority in special circumstances to settle individual tax

shelter project cases on a basis different from the project

settlement offer.

            2.   Bauspar

     One Kersting program that was not part of respondent’s

Kersting project was known as Bauspar.   Kersting had promoted the

Bauspar program as a combination savings and low interest

mortgage plan.   While the precise manner in which the Bauspar

program operated for each participant remains uncertain, the

total amount of home mortgage interest deducted by Bauspar

participants appears to have been overstated.

      Respondent’s officials believed that there were relatively

few participants in the Bauspar program, that there was no easy

way to identify participants in the Bauspar program from a review

of their income tax returns, and that an investigation of Bauspar

deduction claimants would not be cost effective.   Accordingly,

respondent ultimately decided not to systematically pursue
                             - 15 -

Bauspar participants through the Kersting project.   Respondent’s

identification of Bauspar participants appears instead to have

been a “hit or miss” proposition; although respondent has

disallowed some Bauspar deductions claimed by a few Kersting

project petitioners, those disallowances have been sporadic.

     Because the Bauspar program was not included in respondent’s

Kersting project, we refer to interest deductions claimed under

the Bauspar program as Bauspar deductions rather than Kersting

deductions.

     C.   Respondent’s Project Settlement Offer

     Between 1982 and 1988, respondent had in effect an official

settlement offer for the Kersting project.   In general, the offer

permitted participants in the Kersting programs to resolve their

cases by agreeing to pay income tax deficiencies that averaged 7

percent less than those determined in their deficiency notices.

The offer also released participants from negligence additions

and increased interest.

     By September 1986, respondent’s counsel had agreed to modify

the 7-percent reduction settlement offer to incorporate a new

feature, called the “burnout”, that would apply in cases

involving more than one taxable year.   Under this procedure, the

interest on a taxpayer’s total unpaid deficiencies for the first

and second years of tax liability would not begin to accrue until

the return due date for the second year.   The burnout thus
                              - 16 -

postponed for a year the accrual of interest on the first year’s

deficiency, thereby reducing the total interest that accrued on

the deficiencies.   This was accomplished by zeroing out the

taxpayer’s agreed deficiency for the first year and adding it to

the agreed deficiency for the second year.

II.   The Thompsons’ Participation in the Kersting
      Tax Shelters

      A.   The Thompsons’ Tax Returns

           1.   Prepetition Years--1977 and 1978

      Although the Thompsons participated in one of Kersting’s

programs during 1977, they did not claim any Kersting-related

interest deductions on their income tax return for that year,

because their accountant refused to claim those deductions on the

return.

      The record suggests the Thompsons first claimed Kersting

deductions on their 1978 tax return, which was prepared by an

accountant recommended by Kersting.

           2.   Years Before the Court

                               1979

      The Thompsons filed their 1979 tax return, pursuant to an

extension, on May 29, 1980.   The Thompsons reported Kersting

deductions of $39,477 on that return.
                               - 17 -

                                1980

     The Thompsons received an extension of time to file their

1980 tax return until June 15, 1981.    On that return (received by

the IRS on June 19, 1981), the Thompsons reported Kersting

deductions of $72,840.

                                1981

     The Thompsons late filed their 1981 tax return on July 19,

1982, reporting Kersting deductions of $80,782 as investment

interest expense.   The Kersting deductions claimed on that return

were the principal factor in reducing the Thompsons’ adjusted

gross income of $113,711 to taxable income of $18,685--a

reduction of $95,026.    The Thompsons also reported $8,000 of home

mortgage interest expense that was probably attributable to the

Bauspar program, in which the Thompsons began participating in

April 1981.

          3.   Years Following Those Before the Court

                                1982

     The Thompsons filed their 1982 tax return on May 6, 1983.10

On that return, the Thompsons reported Kersting (and probably

Bauspar) deductions sufficient to reduce their adjusted gross

income of $99,364 to taxable income of $4,336--a reduction of



     10
      By October 1982, Mr. Thompson had retired as a pilot with
Continental Airlines.
                               - 18 -

$95,028.    Neither petitioners nor respondent have been able to

locate a copy of the Thompsons’ 1982 tax return.    The 3-year

period of limitations under section 6501 expired with no action

by respondent concerning the Thompsons’ 1982 tax return.

                                1983

     The IRS received the Thompsons’ 1983 income tax return on

July 2, 1984.    The Thompsons reported no tax liability on that

return; they also reported Kersting interest expense deductions

of $67,620 as well as Bauspar deductions.

                                1984

     Respondent received the Thompsons’ 1984 income tax return in

April 1985.    On that return, the Thompsons claimed Kersting

interest expense deductions from two Kersting programs:    “Mahaio”

(Mahalo), in the amount of $4,320, and Federated Finance, in the

amount of $3,420.    The mortgage interest deduction included in

the return also included interest paid pursuant to the Bauspar

program.    The Thompsons paid $2,269 as tax shown on the return to

be owing.

                                1985

     On their 1985 income tax return, the Thompsons reported

itemized deductions of $37,932 and reported adjusted gross income

of $22,507, resulting in zero taxable income.    Although the

Thompsons did not claim any Kersting deductions on the return,
                               - 19 -

they overstated their mortgage interest expense as a result of

their participation in the Bauspar program.

     B.   Examination of the Thompsons’ 1978-1981 Returns

     The Thompsons experienced audit problems with their 1978 tax

return that were due, in part, to their failure to attach to the

return a Form W-2, Wage and Tax Statement, showing the amount of

income tax that Continental Airlines had withheld from Mr.

Thompson’s wages.   In early to mid-1986, the Thompsons’ personal

counsel, Samuel M. Huestis (Huestis), negotiated a settlement of

their income tax liability for 1978.    The record does not

disclose the terms of that settlement.

     On May 5, 1983, the Los Angeles District Director issued a

statutory notice of deficiency with respect to the Thompsons’

1979 taxable year, disallowing Kersting deductions of $39,477 and

determining a deficiency in tax of $18,161.    The notice of

deficiency also determined a negligence addition of $908 under

section 6653(a).    On July 11, 1983, the Thompsons filed a pro se

petition in this Court seeking a redetermination of the

deficiency and addition.

     On June 13, 1984, the Honolulu District Director issued a

statutory notice of deficiency with respect to the Thompsons’

1980 taxable year, disallowing Kersting deductions of $72,840 and

determining a deficiency in tax of $24,838.    On September 4,
                               - 20 -

1984, the Thompsons filed a pro se petition in this Court seeking

a redetermination of the asserted deficiency.

     On March 1, 1985, Kersting sent a letter to Kersting program

participants stating that he had retained attorney Brian Seery

(Seery) to represent them in the Tax Court at no charge to

individual petitioners.    The letter requested that each Kersting

program participant provide written authorization for Seery’s

representation.11   Seery’s compensation for legal services

rendered to Kersting program participants was always paid by one

of Kersting’s alter ego corporations.    On March 20, 1985, Seery

entered appearances for the Thompsons in their Tax Court cases

for their 1979 and 1980 taxable years.   He also entered his

appearance for hundreds of other taxpayers.

     On May 31, 1985, the Los Angeles District Director issued a

statutory notice of deficiency with respect to the Thompsons’

1981 taxable year, disallowing claimed Kersting deductions of

$80,782 and determining a deficiency in tax of $36,294.52.     The

notice of deficiency also determined negligence additions against

the Thompsons under section 6653(a)(1) and (2), a late filing

addition under section 6651(a)(1), and increased interest under

section 6621(c).    Respondent did not disallow the $8,000 claimed


     11
      In a letter to program participants dated Aug. 11, 1986,
Kersting recommended that program participants not attempt to
resolve their cases on their own and instead rely on counsel he
had hired.
                                     - 21 -

as home mortgage interest that was probably attributable to the

Bauspar program.         On August 13, 1985, the Thompsons filed a pro

se petition in this Court seeking a redetermination of the

asserted deficiency, additions, and increased interest for

1981.12

       The Thompsons thus had three of their taxable years before

the Court in three docketed cases.            Respondent’s determinations

of the Thompsons’ Federal income tax deficiencies and additions

for their taxable years 1979-1981 were as follows:

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

1979         $18,161        ---        $908          ---        ---
1980          24,838        ---        ---           ---        ---
1981          36,295       $4,934      ---          $1,958    50% of the
                                                              interest due
                                                              on the
                                                              deficiency

  Total       79,294        4,934      908          1,958       ---

Respondent also determined that the Thompsons were liable for

increased interest for 1981 pursuant to section 6621(c).

       On November 21, 1985, the Chief Judge of this Court assigned

all the Kersting project cases to Judge William A. Goffe (Judge

Goffe) for trial or other disposition.            Subsequent Kersting

project cases were automatically assigned to Judge Goffe.


       12
      The Thompsons apparently filed their petition for their
1981 taxable year pro se, even after Seery had entered his
appearance in the earlier cases.
                               - 22 -

III. The Test Case Litigation and the Thompson Settlements

     A.   Selection of the Test Cases

      McWade and Seery planned to use the test case procedure to

dispose of the cases of the Kersting program petitioners who

wished to contest the deficiencies determined against them by

respondent.    Most of these petitioners entered into stipulations

of settlement for tax shelter adjustments, also called “piggyback

agreements”.   Respondent and petitioners who entered into

piggyback agreements thereby agreed to be bound by the results in

the selected test cases.   On June 10, 1986, McWade and Seery

provided the names of the test case petitioners they had selected

to Judge Goffe.

     Seery and McWade had agreed to the selection of test cases

in 14 dockets of seven married couples who had filed joint

returns and one individual who had not filed jointly.   Among the

couples selected to be test case petitioners were the Thompsons,

John R. and E. Maria Cravens (the Cravenses), and Richard and

Fiorella Hongsermeier (the Hongsermeiers).

     Seery particularly sought to include the Cravenses as test

case petitioners because they treated their payments to Kersting

as basis reductions that resulted in capital gain upon the

termination of their interests in the programs.   The Cravenses
                                 - 23 -

later decided to proceed without counsel and to settle their

cases.13

     Seery also selected the Hongsermeiers as test case

petitioners because he mistakenly believed that they had used

their own funds, rather than “nontaxable distributions” from

Kersting corporations, to repay loans to other Kersting

corporations.     The Hongsermeiers’ 1978-1980 taxable years were

before the Court; respondent had failed to audit their 1981 and

1982 taxable years.

     There is no clear indication whether it was Seery or McWade

who originally proposed the participation of the Thompsons.       As

noted, the Thompsons’ 1979-1981 taxable years were before the

Court.     Respondent had failed to audit their 1982 taxable year.

     B.       Deterioration of the Thompson-Kersting
              Relationship

     Around the time Seery and McWade selected the test cases,

the relationship between the Thompsons and Kersting deteriorated.

Earlier in 1986, the Thompsons’ personal counsel, Huestis, had

asked Kersting for an accounting of the Thompsons’ participation

in the Kersting programs.      Huestis’s request led to a dispute

between the Thompsons and Kersting.       On June 23, 1986, the

Thompsons retained John Chanin, a Honolulu attorney, to help them

in their dispute with Kersting.      In a letter dated August 23,


     13
          See infra note 23.
                                - 24 -

1986, Kersting informed the Thompsons he had turned their file

over to his own attorney for collection and further stated:

     The day after you have allowed your attorneys to file
     suit I will declare all notes which you have executed
     to our companies in default and begin collection
     proceedings. * * * The aggregate sum is well in
     excess of $250,000.00, as you know.

                 *    *    *     *       *   *   *

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

     By letter dated August 24, 1986, Kersting notified Seery

that he expected to be in litigation with the Thompsons and

directed Seery not to “render any services, at our expense” to

the Thompsons.    On September 10, 1986, Huestis wrote to Seery,

notifying him that the Thompsons were seeking substitute counsel

and requesting their files.     On September 15, 1986, Seery sent

the Thompson files to Huestis and informed him that the Thompsons

were test case petitioners.     Seery indicated that he was

withdrawing as the Thompsons’ counsel.

     On October 28, 1986, Huestis again wrote to Seery to express

dissatisfaction with the sufficiency of the Thompsons’ files and

to warn Seery that his earlier representation of the Thompsons,

while he was also apparently representing Kersting, could be

viewed as a conflict of interest and lead to an action for

“professional negligence”.     On October 31, 1986, Seery filed
                                - 25 -

motions to withdraw as counsel in the Thompsons’ cases, which the

Court granted.

     In ruling on a subsequent motion, Judge Goffe observed that

there could be a conflict of interest if Seery represented both

petitioners and Kersting.     Seery subsequently filed motions to

withdraw as counsel in the Kersting project cases (both test

cases and nontest cases), citing concerns about a possible

conflict of interest.    The Court granted Seery’s motions in

November 1986.

     C.     The Thompsons Engage DeCastro, Who Settles
            Their Cases

      On or about November 15, 1986, the Thompsons retained

attorney Luis DeCastro (DeCastro), who was also a certified

public accountant, to settle their Kersting tax issues.     Mr.

Thompson retained DeCastro to resolve all the Thompsons’ Kersting

tax years, not only the 1979-1981 years docketed in the Tax

Court.    The Thompsons provided DeCastro with tax records for all

those years.     The retainer agreement between the Thompsons and

DeCastro provided for a $5,000 fee, which covered only efforts to

negotiate a settlement; it did not cover preparation for and

conduct of a trial.     None of the other petitioners in the

Kersting project, whether test case petitioners or piggybackers,

incurred any attorney’s fees in connection with the preparation

and trial of the test cases.     Kersting paid all such fees.
                              - 26 -

     Meanwhile, in the wake of Seery’s withdrawal, Kersting

engaged attorneys Robert J. Chicoine (Chicoine) and Darrell D.

Hallett (Hallett) to represent the test case petitioners (other

than the Thompsons and the Cravenses) at the Tax Court’s trial

session in Maui, Hawaii, which had been scheduled to commence

February 9, 1987.   Chicoine and Hallett agreed to do so with the

understanding that they would not represent Kersting.   In late

1986, Chicoine and Hallett apparently indicated to McWade and

Sims that they intended to challenge the admissibility of

evidence that had been seized in the January 1981 search of

Kersting’s office that became the subject of this Court’s opinion

in Dixon v. Commissioner, 90 T.C. 237 (1988) (Dixon I).     See

supra note 2.   About the same time, McWade and Sims began to

offer 20-percent reduction settlements that were based on the

same general approach as their modified 7-percent reduction

settlement offer that included the burnout feature.

     In December 1986, DeCastro traveled to Hawaii on behalf of

the Thompsons and a number of other clients who had participated

in the Kersting shelters.   There DeCastro, accompanied by Gary

Poltash (Poltash), the Thompsons’ new accountant, who was not

associated with Kersting, began settlement discussions with

McWade.   Their initial agreement called for a reduction in the

Thompsons’ 1979-1981 deficiencies of approximately 18.8 percent.

The settlement also provided for the elimination of all additions
                                  - 27 -

to tax and for the elimination of the increased interest rate

under section 6621(c) for 1981.      The burnout would also apply so

as to combine the agreed deficiencies for the years 1979 and 1980

in the year 1980.     During this trip, DeCastro and McWade also

discussed the Bauspar program in which the Thompsons were

involved.

       On December 23, 1986, McWade signed and sent DeCastro

stipulated decision documents in the Thompsons’ cases.          The

transmittal letter stated that:

             As previously indicated, the Decision documents
       in John R. and Maydee Thompson will not be filed with
       the Court until the Decision becomes final in the test
       cases. In the interim, the Thompsons can make an
       advance payment, as discussed at our conference, and
       stop the accrual of any additional liability for
       interest.

On December 30, 1986, DeCastro signed and returned to McWade the

executed decision documents agreeing to the reduced deficiencies.

Neither McWade nor Sims communicated the terms or existence of

the Thompsons’ settlement to their superiors.

       The result of the pending settlement upon the Thompsons’ tax

liabilities would have been as follows:

           Income      Determined           Proposed    Percentage
Year     Adjustment    Deficiency          Settlement   Reduction

1979    $39,477         $18,161               ---
1980     72,840          24,838             $34,425
  Total                  42,999              34,425        20

1981     80,782          36,295              30,000        17
  All years total        79,294              64,425        18.8
                              - 28 -



     DeCastro, Poltash, and McWade had also agreed that the

Thompsons would be able to deduct the interest payable on the

deficiencies agreed to under the settlement by prepaying such

interest by December 31, 1986.14   As of December 31, 1986, the

accrued interest on the Thompsons’ newly settled deficiencies was

$35,275.81 for 1980, and $24,270.62 for 1981--a total of

$59,546.43, which the parties rounded to $59,545.    Accordingly,

the decision documents returned to McWade by DeCastro stated:

“By separate cover you will also be receiving a check in the

amount of $59,545 representing interest on the tax deficiencies

reflected in the decision documents.”   With a letter dated

December 30, 1986, Mr. Thompson sent McWade two checks:    check

No. 54 for $34,000, and check No. 242 for $25,545, for a total of

$59,545.   Mr. Thompson’s letter stated:   “I am at the present

time doing the necessary procedures to take care of the balance.”

     At McWade’s direction, IRS personnel in Honolulu prepared

payment posting vouchers (Form 3244) allocating the Thompsons’

prepayment of $59,545 between the 2 years before the Court,



     14
      The Internal Revenue Code was amended in 1986 to add a new
sec. 163(h) that repealed the deduction for “personal interest”.
See TRA sec. 511(b), 100 Stat. 2246. Under the new sec. 163(h),
1986 was the last taxable year in which taxpayers could deduct
100 percent of such personal interest. TRA sec. 511(e), 100
Stat. 2249. For 1987, only 65 percent of personal interest was
deductible, and the deduction for personal interest was phased
out entirely by the end of 1989. Sec. 163(h)(6).
                              - 29 -

indicating designated interest for 1980 in the amount of

$35,275.78 and designated interest in the amount of $24,269.22

for 1981.   The entire amount of check No. 242 ($25,545) and

$9,730.78 from check No. 54 was applied to 1980; the remainder of

check No. 54 ($24,269.22) was applied to 1981.   The Thompsons’

$34,000 check (check No. 54) was subsequently dishonored.    This

was reflected as a debit for the Thompsons’ accounts for 1980 and

1981.   In February 1987, the Thompsons made a replacement payment

of $34,340, representing the amount of the dishonored check plus

a 1-percent bad check penalty.   The replacement payment was

restored as a credit as of December 31, 1986.

     The Thompsons were the only test case petitioners for whom

the IRS processed a prepayment of interest without receiving a

concurrent “advance payment on deficiency” to which the interest

was attributable.

     In January 1987, Chicoine and Hallett filed motions in this

Court seeking to suppress the evidence that had been seized in

the raids on Kersting’s office and to shift to respondent the

burden of proof and burden of going forward with evidence.     The

Chicoine and Hallett motions in effect turned the February 1987

Maui trial session into a hearing on the motions and resulted in

a continuation of the trial of the test cases.

     On March 13, 1987, McWade sent DeCastro a revised decision

document for the Thompsons’ 1980 taxable year, making a minor
                               - 30 -

change that reduced the deficiency for that year from $34,425 to

$33,000.    McWade later explained:   “It must have been I

miscomputed something.”   With this modification of the

settlement, the Thompsons’ aggregate deficiencies for 1979-1981

were reduced by 20.55 percent of the deficiencies originally

determined by respondent (i.e., from $79,294 to $63,000).

     On June 15, 1987, DeCastro sent a $63,000 cashier’s check

“in partial payment of the total amount due” to the Internal

Revenue Service Center in Fresno on behalf of the Thompsons.

Respondent received the payment of $63,000 on June 17, 1987, and

credited it to the Thompsons’ 1979 account as an advance payment,

less offset of a credit of $775 that was applied to their 1988

tax year.    Accordingly, by June 1987, the Thompsons’ payments to

the IRS with respect to the taxable years 1979-1981 totaled

$121,770 ($62,225 as an advance payment of tax, and $59,545 as

interest).

     D.     IRS Activity Regarding the Thompsons’
            1983-85 Returns

     In the meantime, an employee of respondent at the Fresno

Service Center in California (with initials A.A.K.) prepared a

statutory notice of deficiency (subsequently dated March 17,

1987) disallowing $67,620 of Kersting deductions claimed on the

Thompsons’ 1983 income tax return.      Because the Thompsons had

little taxable income that year, the first whole year of Mr.
                              - 31 -

Thompson’s retirement, the deficiency resulting from this

disallowance was only $980.   There is some indication that the

notice of deficiency was mailed and that it caused an inquiry.

An internal document of the IRS (Form 4700) reflects a

handwritten entry dated May 8, 1987:   “No reason to change

determination – refiling case.”   Nevertheless, no petition for

the Thompsons’ 1983 taxable year was filed in this Court, and the

deficiency was never assessed or collected.

     On October 6, 1987, Revenue Agent Carolyn Speers (Speers),

based in San Jose, California, audited the Thompsons’ 1984 income

tax return and noted $7,740 of Kersting deductions claimed on the

return.   On that date, she wrote the Thompsons a letter proposing

to dispose of the Kersting issue identified on the return

consistent with respondent’s general 7-percent reduction

settlement proposal.   In her letter, Speers also requested

additional information regarding the Thompsons’ participation in

the Kersting tax shelter programs, including a request for a copy

of the Thompsons’ 1985 income tax return.

     Speers did not receive a response from the Thompsons to her

October 6, 1987 letter nor to a followup letter dated November

17, 1987.   On November 27, 1987, Mr. Thompson called Speers to

report that he had forwarded her request to DeCastro.

     On December 23, 1987, DeCastro sent Speers an executed copy

of the 7-percent reduction settlement agreement for 1984, along
                                - 32 -

with a power of attorney executed by the Thompsons for the

taxable years 1984 and 1985, and a Form 872-A, Special Consent to

Extend the Time to Assess Tax.    Because DeCastro did not include

the requested additional information or a copy of the Thompsons’

1985 return, Speers declined to proceed on the basis of the 7-

percent reduction settlement.    Instead, by letter to DeCastro

dated January 12, 1988, Speers proposed to dispose of the

Thompsons’ 1984 year by disallowing the claimed Kersting interest

expense deductions in their entirety.    She again requested a copy

of the Thompsons’ 1985 return “to verify that interest from

Kersting was not deducted in this year.”

     Beginning October 6, 1987, and continuing through

February 24, 1988, Speers documented (in her case history

worksheet) telephone or written contact in the course of her

examination of the Thompsons’ 1984 income tax return with the

Thompsons, DeCastro, Philip Hoskins (of DeCastro’s firm), and an

accountant named “Rick.”   Speers’s case history worksheet

reflects no contacts with McWade, Sims, or any other of

respondent’s counsel.

     By letter dated February 22, 1988, DeCastro agreed to a

complete disallowance of the $7,740 of Kersting deductions

claimed by the Thompsons for 1984 and the resulting deficiency of

$1,863.   The Thompsons paid the deficiency and interest; by
                              - 33 -

virtue of this disposition of the matter, respondent issued no

notice of deficiency to the Thompsons for 1984.

     On March 4, 1988, DeCastro sent Speers a copy of the

Thompsons’ 1985 income tax return.     As noted above, the

Thompsons’ 1985 income tax return did not reflect any Kersting

deductions (although it did include Bauspar deductions).      In a

letter dated March 25, 1988, Speers notified the Thompsons that

she “was able to verify that interest from the Kersting project

was not deducted” on that return.    Respondent issued no notice of

deficiency to the Thompsons for 1985.

     E.    The Reporting and Resolution of the Thompsons’
           Deficiency Interest Payments for 1986 and 1987

     The Thompsons claimed their $59,545 interest payments to the

IRS as an itemized interest deduction on Schedule A - Itemized

Deductions of their 1986 income tax return.     However, because

their adjusted gross income for that year was relatively low, the

Thompsons were able to use only $16,251 of the $59,545 deduction.

The Thompsons did not claim any Kersting or Bauspar deductions on

their 1986 return.

     Poltash prepared the Thompsons’ 1987 income tax return.       On

that return, the Thompsons deducted $27,914 as interest paid to

the IRS.   That figure represents 65 percent of $42,945.     See

supra note 14.   Apparently, the Thompsons were attempting to

carry over the unused portion of the interest deduction of
                              - 34 -

$59,545 from their 1986 taxable year.15   The Thompsons did not

claim any Kersting or Bauspar deductions on their 1987 return.

Poltash did not discuss the preparation of the Thompsons’ 1986 or

1987 returns with McWade or Sims.

     Revenue Agent Speers examined the Thompsons’ 1986 income tax

return.   She asked about the $59,545 interest deduction in

letters to the Thompsons dated February 26 and March 25, 1988.

In a telephone conversation with Speers on May 23, 1988, Mr.

Thompson explained the $59,545 interest expense deduction to her

satisfaction.   Speers closed the examination of the Thompsons’

1986 return without making any adjustments to the return.     Her

examination workpapers reflect her notation that “TP paid large

interest to IRS on Schedule A--verified per transcripts.”

     In June 1989 a revenue agent16 screened the Thompsons’ 1987

income tax return for Kersting deductions.   The return bears a

stamp stating “Income Tax Survey After Assignment”, meaning that

the agent saw nothing obvious for examination and returned the



     15
      Although Poltash claimed to lack any recollection of his
attempt to claim the interest deduction, he conceded the $42,945
amount might have represented an attempt to claim for 1987 the
portion of the $59,545 claimed on the 1986 return that produced
no tax benefit to the Thompsons. We note a slight discrepancy
between the amount of the deduction actually used on the
Thompsons’ 1986 return ($16,251) and the figure underlying the
$42,945 “carryover” for 1987 ($59,545 - $42,945 = $16,600).
     16
      The signature of the examining agent is difficult to
decipher; it appears to be “Art (or Pat) Taylor.”
                              - 35 -

1987 return to files without examining it or transmitting it for

examination.

     F.   The Thompson Settlement Revised as Trial Approaches

     Although Chicoine and Hallett ultimately recommended that

their test case clients accept respondent’s 20-percent settlement

offer, Kersting disagreed and replaced Chicoine and Hallett with

attorney Joe Alfred Izen, Jr. (Izen) in April 1988.   Counsel on

both sides began to prepare for trial, which was scheduled for

January 1989 in Honolulu, Hawaii.

     In an order dated August 30, 1988, the Court granted

McWade’s motion to depose Kersting.    In October 1988, while in

Honolulu for the Kersting deposition, DeCastro met McWade to

discuss the Thompson cases.   DeCastro told McWade he wanted to

withdraw the Thompsons from the test case trial.   DeCastro’s

reason for withdrawing the Thompsons was to avoid their having to

pay the fees and expenses of the trial and to enable them to take

the settlement they had already agreed to.   McWade wanted to keep

Mr. Thompson as a party to the trial because he was a test case

petitioner who was represented by an attorney, DeCastro, who had

not been hired and paid by Kersting.   From respondent’s

standpoint, there was also a benefit to having, as a party

witness, a participant in the Kersting program who was feuding

with Kersting and could be expected to testify against him.
                              - 36 -

     Recalling the withdrawal of Seery, Sims was concerned by the

potential conflict of interest from Kersting’s paying the fees of

the attorney representing the test case petitioners.

Accordingly, he wanted to keep DeCastro in the trial of the test

cases as an independent attorney, paid by the taxpayer, to

provide an apparent safeguard against the trial appearing to be

slanted toward protecting the promoter’s (as opposed to

petitioners’) interest.

     McWade and DeCastro also apparently discussed the status of

an outstanding Federal tax lien on the Thompsons’ house

(unrelated to their participation in Kersting shelters), which

the IRS had yet to remove more than a year after the Thompsons

had satisfied the underlying liability.17   On November 22, 1988,

respondent issued a certificate of release with respect to the

Federal tax lien on the Thompsons’ house.

     Shortly before trial of the test cases in this Court in

January 1989, McWade and DeCastro reached an oral agreement (the

new agreement) calling for reduced amounts of agreed deficiencies

for 1979-1981 of zero, $15,000, and $15,000, respectively.   The

purpose of the reductions was to compensate the Thompsons for the

cost of having an attorney represent them at the trial of the



     17
      Under sec. 6325(a)(1), the IRS was required to release the
lien not later than Oct. 7, 1987, 30 days after the liability had
been satisfied.
                               - 37 -

test cases.   DeCastro estimated that his legal fees for

representing the Thompsons at the trial of the test cases would

be approximately $60,000.18   It was estimated that the newly

agreed reductions would generate approximately $60,000 of refunds

to the Thompsons from the $121,770 they had paid earlier toward

satisfaction of the deficiencies and interest under the earlier

settlement.   The new agreement also preserved the Thompsons’

chances to prevail on the merits of the litigation.   McWade and

DeCastro agreed that if the results of the trial were more

favorable to the Thompsons than the new agreement, the Thompsons

would be entitled to the results of the trial.

     When the new agreement was reached, respondent’s official

settlement policy still provided for a 7-percent reduction in

determined deficiencies, elimination of the negligence penalty,

and other minor concessions, although, as the time for trial

approached, some nontest case petitioners’ attorneys continued to

negotiate 20-percent reduction settlements.   The new agreement,



     18
      As petitioners point out, DeCastro was somewhat
inconsistent in his recollection of his proposed billing. On
June 2, 1992, he initially denied that the new agreement was
designed as a mechanism for respondent to pay his fees, but he
admitted to the contrary 8 days later. On Aug. 11, 1992,
DeCastro recalled estimating that it would cost a minimum of
$30,000 to try the Thompsons’ case. After being shown documents
indicating he had billed the Thompsons for more than $30,000,
DeCastro said he had told McWade that his fees would be roughly
$65,000. As respondent points out, DeCastro’s bills to the
Thompsons, as of Nov. 29, 1989, totaled $58,738.20.
                                - 38 -

however, reduced the Thompsons’ deficiencies for the years at

issue from the originally determined $79,294 to $30,000--a

reduction of 62.17 percent.     The new agreement substantially

deviated from respondent’s official settlement policy and from

the 20-percent reduction settlements obtained by DeCastro and

Chicoine and Hallett and other attorneys on behalf of other

clients.   None of Sims’s or McWade’s superiors approved the new

agreement.   To the contrary, Sims’s and McWade’s superiors did

not discover the new agreement until after this Court had tried

the test cases, issued its opinion, and entered its initial

decisions therein.

     G.    Trial and Entry of Decisions

     The trial of the test cases was conducted before Judge Goffe

from January 9 through January 27, 1989, at Honolulu, Hawaii.

Neither Sims, McWade, nor DeCastro informed Judge Goffe, the

National Office, the Regional Office, or Izen of the Thompson

settlement or the Cravens settlement before or during the January

1989 trial of the test cases, or thereafter.

     The Government paid the travel, food, and lodging expenses

of Mr. Cravens and Mr. Thompson while they were in Hawaii.     Mr.

Thompson’s reimbursed expenses amounted to $1,105.13.     We stated

in Dixon III, n.53:     “Inasmuch as respondent subpoenaed all the

test case petitioners, it is assumed they were all reimbursed for

their expenses.”     Although there is no evidence in the record
                              - 39 -

that any other test case petitioner, other than Mr. Cravens and

Mr. Thompson, was reimbursed by the Government for the expenses

of attending the test case trial, neither is there any record

evidence that any or all of the other test case petitioners who

requested reimbursement of their trial attendance expenses had

their requests denied, or indeed that requests for reimbursement

were made by any such petitioners.

     Around the time of the 1989 trial, DeCastro asked McWade to

arrange for the Thompsons to receive a refund of $30,000 of their

advance payments.   In a memorandum dated April 10, 1989, McWade

requested respondent’s administrative officials to process a

$30,000 refund to the Thompsons.   On July 11, 1989, the

Government issued a refund check of $30,000 to the Thompsons.

The Thompsons endorsed the check to DeCastro Law Corp. without

depositing it in their own checking account.    The Thompsons did

not claim a deduction on their 1989 return for the $30,000 they

paid DeCastro.

     On August 3, 1989, DeCastro wrote a letter to McWade

confirming the revision of the Thompson settlement that had been

agreed to before the trial of the test cases.   DeCastro’s letter

states in pertinent part as follows:
                              - 40 -

     Re: Jack and Maydee Thompson

     Dear Ken:

          Please confirm following is our agreement with
     respect to settlement of above taxpayer’s cases for
     open years:

           We have agreed that the total taxes due for all
     the open years are $15,000 for 1980 and $15,000 for
     1981.

          Further, in the event a final decision in this
     case is more favorable they are to receive the benefit
     of such decision.

     Please sign below so I can have for my files.

McWade signed the letter and returned it to DeCastro.

     On August 24, 1989, DeCastro wrote McWade requesting him to

arrange for the Thompsons to receive the balance of their refund.

McWade replied that the balance would not be released until the

Tax Court had issued its opinion, and DeCastro so informed the

Thompsons.   DeCastro told the Thompsons that, because the IRS

would be paying interest, he believed it was fair to add interest

to the Thompsons’ bill.

     On or about November 6, 1989, McWade received an undated

letter from Mr. Thompson, which stated in pertinent part as

follows:

     Dear McWade:

     There are some questions in mind that I feel you can
     help me answer.

                 *   *    *    *    *    *    *
                              - 41 -

     I received a check from IRS in the amount of thirty
     thousand dollars--($30,000). I endorsed this over to
     DeCastro Law Corp; this did not retire the billed
     amount. I am completely amazed at the billings we are
     receiving. I am now in receipt of additional billings
     that exceed realistic amounts. In fact the total comes
     to sixty six thousand two hundred forty three and
     66/100 dollars ($66,243.66). At some point I know a
     reconciliation will come. Luis [DeCastro] says don’t
     be concerned. I am very concerned, I am the one being
     billed.

                  *   *   *   *    *    *    *

     Most emphatically I did not expect to be a channel
     through which IRS funneled funds to any law firm.
     Certainly not in this magnitude. I have the feeling at
     this point that I am correct in this--the bill is to
     [sic] much. I want to know the exact legal position I
     occupy. We have been frustrated long enough. We wish
     to close this chapter.

     DeCastro wrote to Huestis on November 17, 1989, stating, in

pertinent part:

          Thank you for your letter regarding the matter of
     the Thompsons’ fees. As I have told Jack, we are
     looking for payment of his fees to the IRS, not him. I
     am enclosing a copy of my letter to him in this regard
     for your information.

     DeCastro sent a similar letter to the Thompsons on the same

date.

     On December 11, 1991, the Court issued its opinion in Dixon

v. Commissioner, T.C. Memo. 1991-614 (Dixon II), sustaining

almost all of respondent’s determinations that the Kersting

programs at issue lacked merit for tax purposes.
                              - 42 -

     On March 13, 1992, the Court entered decisions against

petitioners in the test cases in accordance with its opinion.

On May 14, 1992, the test case petitioners--other than test case

petitioner Ralph J. Rina (Rina) and the Thompsons and the

Cravenses--appealed the decisions in their cases to the Court of

Appeals for the Ninth Circuit.

     H.   Discovery and Disclosure of the Thompson
          Settlements

     On May 8, 1992, Sims and McWade, by memorandum, requested

the San Francisco Appeals Office to process the Thompsons’

account administratively in accordance with the Thompson

settlement, not the Tax Court’s decisions.   On May 22, 1992,

Danny Cantalupo, Regional Director of Appeals for the Western

Region, informed Peter D. Bakutes (Bakutes), Deputy Regional

Counsel for Tax Litigation for the Western Region in San

Francisco, of Sims’s and McWade’s request to process the Thompson

settlement.   Bakutes informed Benjamin Sanchez (Sanchez), the

Western Regional Counsel in San Francisco, who informed officials

in the National Office of the Office of Chief Counsel in

Washington, D.C.   The circumstances surrounding the Thompson

settlement became a matter of widespread concern within the IRS.

     On May 29, 1992, Sims, at the direction of Sanchez, informed

DeCastro by letter that the Thompson settlement would not be

honored, and that assessments would be made in accordance with
                              - 43 -

the decisions entered on March 13, 1993, pursuant to Dixon II.

The letter advised that assessment of the taxes owing, plus

statutory additions and interest, would be “approximately

$302,396.12.”   The letter further noted:   “Of course, your

clients’ advance payments will be credited toward the

assessments.”

     DeCastro had several telephone conversations with

respondent’s officials, in which he maintained that the Thompson

settlement, as memorialized in the August 3, 1989 letter

agreement, was an enforceable contract, and that he was prepared

to appeal any decision to the contrary.

     Bakutes prepared a motion that was filed in this Court on

June 9, 1992, seeking leave to vacate the decisions entered in

the Thompson cases, as well as the Cravens and the Rina cases.

Respondent requested the Court to conduct an evidentiary hearing

to determine whether the agreements with the Cravenses and the

Thompsons had affected the trial of the test cases or the ensuing

decisions of the Court.

     On June 10, 1992, Judge Goffe granted respondent’s motions

to vacate filed in the Thompson and the Cravens cases.    That same

day, Bakutes called DeCastro to tell him that the decisions in

the Thompson cases had been vacated.   During this call, DeCastro

told Bakutes that in 1988 McWade had reduced the Thompsons’

deficiencies to keep the Thompsons in the case.    Although he had
                             - 44 -

earlier told Bakutes that attorney’s fees were not awarded in the

settlement, DeCastro admitted in this conversation that the

deficiencies were reduced to pay the Thompsons’ legal fees for

his representation of them in the test case trial.

     On or about June 11, 1992, Sanchez decided that Sims and

McWade should no longer have any authority over the Kersting

cases and that the cases should be assigned to other attorneys

who had been involved in the Kersting project.   Bakutes

accordingly reassigned the 14 test case dockets to Thomas A.

Dombrowski (Dombrowski) and the nontest cases to Henry E. O’Neill

(O’Neill).

    On June 22, 1992, Judge Goffe denied respondent’s request for

an evidentiary hearing and ordered the parties to file agreed

decisions with the Court, “or otherwise move within 30 days of

the date hereof.”

     In a separate order filed on the same date, the Court denied

respondent’s motion to vacate the decision filed in Rina’s case,

stating:

          The Court has reviewed the testimony of Cravens,
     the testimony of Thompson, the stipulated facts and
     stipulated exhibits relating to the Cravenses and the
     Thompsons, and the exhibits offered through Thompson as
     a witness. The Court finds that these reviewed items
     had no material effect on the opinion which the Court
     filed on December 11, 1991, as that opinion relates to
     petitioner Rina. If the reviewed items were stricken
     from the record, the Court would file an opinion in all
     material respects like the opinion it filed on December
     11, 1991 (with the exception of certain portions
                              - 45 -

     relating specifically and expressly to the Cravenses or
     the Thompsons), and the Court’s findings, analyses, and
     conclusions relating to petitioner Rina would remain
     the same. * * *[19]

     During the summer of 1992, respondent’s Acting Chief Counsel

David Jordan (Jordan) directed two senior attorneys in the Tax

Litigation Division in the National Office, Thomas J. Kane (Kane)

and Steven M. Miller (Miller), to investigate the Thompson

settlement on behalf of the National Office.   Kane and Miller

conducted in-house depositions and interviewed various

individuals who had participated in the test case trial and the

Thompson settlement.

     Bakutes assigned Dombrowski to help Kane and Miller in their

investigation.   Dombrowski’s immediate problem was how to respond

to this Court’s order of June 22, 1992, that the parties file

agreed decisions with the Court or otherwise move within 30 days.

     Dombrowski learned that McWade and Sims had denied that the

purpose of the new agreement to reduce the Thompsons’

deficiencies was to pay DeCastro’s fees; instead, they claimed,

the lowered deficiencies had something to do with the Thompsons’




     19
      Rina appealed from this denial. Unlike the Thompsons,
Rina had no settlement agreement with Sims and McWade. On June
13, 1995, Rina agreed to the entry of a stipulated decision in
the amounts originally determined in his statutory notice of
deficiency.
                                - 46 -

investment in Bauspar.20    To see whether Bauspar figured in the

Thompson settlement, Dombrowski sought the Thompsons’ post-1981

tax returns.   By July 13, 1992, he had received the Thompsons’

1983-89 returns and a memo that the Thompsons’ 1982 tax return

and administrative file had been destroyed.    Dombrowski analyzed

the returns to see if they shed light on the Bauspar question

raised by McWade’s and Sims’s contentions.    Although the 1982 tax

return was not available, Dombrowski believed it likely that

Kersting deductions had been claimed on that return because of

the disparity between adjusted gross income and taxable income,

and because Kersting deductions were claimed on the Thompsons’

1983 and 1984 returns.     Dombrowski’s “Analysis of Subsequent Year

Returns” noted the mortgage interest deductions claimed on the

Thompsons’ 1983-85 returns and further noted “(Bauspar?).”    He

also noted that entries that may have reflected the Bauspar

deductions had not been audited.    Dombrowski’s reason for putting

a question mark after Bauspar was that he could not tell from the

entries on the returns whether they actually related to Bauspar.



     20
      In a memorandum dated Sept. 11, 1992, Kane had written:
“Sims claimed that McWade had initiated the recommendation to
allow Bauspar losses so that both Thompson and DeCastro would
remain in the case. * * * Thus, Sims told McWade to work with
the Bauspar numbers in order to give Thompson relief and keep him
as a test case.” (Fn. ref. omitted.) Additionally, in 1992,
McWade testified that he reduced the Thompsons’ deficiencies on
his own to make up for the Thompsons’ $80,000 “loss” in the
Bauspar program. We found this testimony not credible.
                                - 47 -

     Dombrowski also noted that the Thompsons appeared to have

defaulted on a statutory notice issued to the Thompsons for 1983

disallowing claimed Kersting deductions of $67,620, but that the

IRS had failed to assess the resulting deficiency of $980.

Dombrowski also noted the May 8, 1987, entry in the Thompsons’

file for 1983 that stated:   “No reason to change determination –

refiling case.”   Dombrowski believed this entry indicated that

someone contacted the Fresno Service Center after receiving and

questioning the notice of deficiency for 1983.    Because the 3-

year period of limitations with respect to the returns he was

examining had expired several years earlier, Dombrowski did not

attempt to determine why the assessment for 1983 had not been

made.   He instead focused on preparing a timely response to the

Court’s June 22, 1992, order in the Thompsons’ cases.

     On June 24, 1992, Marlene Gross (Gross), an official in the

National Office of Chief Counsel, called Bakutes and informed him

that, despite the disclosure of Sims’s and McWade’s misconduct,

the Department of Justice (DOJ) would not seek to remand the test

cases that had been appealed.    The DOJ’s decision was based on

the Tax Court’s refusal to vacate the decision in the Rina case.

That refusal indicated to the DOJ officials that the Tax Court

probably would not vacate its decisions in the other test cases

if asked to do so.   Gross also reported to Bakutes that the DOJ,

and specifically, the Tax Division, Appellate Section Chief Gary
                             - 48 -

Allen, wished to offer the same settlement to the test case

petitioners on appeal that the Thompsons had received:    A 65-

percent reduction in deficiencies (an approximation of the

reduction of the Thompsons’ originally determined deficiencies

from $79,294 to the $30,000 figure finally agreed upon).

Bakutes was opposed to settling the appealed cases on that basis.

There is no evidence that the DOJ made any such settlement offer

to the test case petitioners on appeal.

     On July 16, 1992, DeCastro filed a motion for entry of

decision in the Thompsons’ cases, on the terms of his settlement

agreement with McWade; i.e., deficiencies of zero, $15,000, and

$15,000 for 1979-1981, respectively.

     On August 20, 1992, respondent filed objections to

DeCastro’s motion for entry of decision, together with

respondent’s own motion for entry of decision.   Respondent’s

motion sought a decision that reflected the original 18.8-percent

reduction settlement agreed to by McWade and DeCastro in December

1986.21


     21
      Respondent’s motion stated that the December 1986
agreement between DeCastro, Sims, and McWade to reduce the
Thompsons’ deficiencies by 18.8 percent exceeded the terms of the
standard 7-percent reduction settlement offer. Nevertheless,
respondent conceded: “Respondent’s counsel possessed the
authority to make such an offer, and such offer was accepted by
petitioners herein as well as others.” Respondent also noted the
“approximately 20 percent” reduction settlement offers previously
made to other participants. Respondent’s motion further
                                                   (continued...)
                             - 49 -

     Respondent’s 11-page motion for entry of decision, with a

15-page supporting memorandum, disclosed to the Court the facts

that had been discovered in respondent’s investigation.

Respondent informed the Court that, before the test case trial,

Sims and McWade had agreed to settle the Thompson cases by

reducing the Thompsons’ deficiencies in amounts sufficient to

compensate the Thompsons for their projected attorney’s fees.    As

respondent explained to the Court, Sims and McWade had agreed

with DeCastro that

     All settlement refunds in excess of the amounts
     provided by the December 1986 agreement would go
     ultimately to the benefit of Mr. DeCastro for payment
     of his legal fees and costs. Mr. DeCastro would be
     paid solely from amounts refunded by the Service to
     Thompson. * * * This “New Agreement”, in sum and
     substance, if not explicitly, was designed, and
     constituted an agreement by Messrs. Sims and McWade to
     pay Mr. DeCastro’s legal fees and expenses.22



     21
      (...continued)
indicates that Chicoine and Hallet’s motion to suppress evidence
was pending when McWade offered the 20-percent reduction
settlement to DeCastro in December 1986. Although McWade may
have known of Chicoine and Hallet’s intent to file such a motion,
the motion, in the form of a motion for leave to amend petition,
was not filed until Jan. 12, 1987, after Chicoine and Hallett had
entered their appearances. Any error in this regard, however, is
immaterial, in view of our disposition of this matter.
     22
      On brief, petitioners question the assertions in
respondent’s motion that all settlement refunds “in excess of the
amounts provided in the December 1986 agreement” would go to
DeCastro. This assertion, however, appears to have reflected
respondent’s understanding at the time. Once again, in view of
our disposition of this matter, any error in this respect is
irrelevant.
                                - 50 -

Respondent asserted that the new agreement was unauthorized and

had no legal basis.   If respondent’s motion had been granted, the

Thompsons’ deficiencies would have been zero for taxable year

1979, $34,425 for 1980, and $30,000 for 1981.

     On August 26, 1992, this Court granted DeCastro’s motions

for entry of decision in the Thompson cases, thus holding

respondent to the pretrial concessions made by Sims and McWade in

the new agreement:

           Year       Deficiency     Additions to Tax

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

The Tax Court’s decision for 1981 also relieved the Thompsons of

the non-Kersting late filing addition of $4,934.32 under section

6651(a).   That addition was the only non-Kersting issue in the

Thompsons’ docketed cases.

     Respondent did not appeal the decisions entered by the Court

with respect to the cases of the Thompsons and the Cravenses.23


     23
      The Cravenses, who were not represented by counsel after
Seery’s withdrawal, had agreed with McWade to deficiencies of
$9,782.16 for their taxable years 1979 and 1980, a reduction of
only about 6 percent from the originally determined deficiencies
of $10,401.45. This settlement was less favorable to them
percentagewise than the generally available modified 7-percent
reduction settlement offer and did not include the “burnout”
feature. On Aug. 25, 1992, this Court entered a decision
reflecting the Cravens settlement amounts, but the decision
included the stipulation that certain advance payments made by
the Cravenses had not yet been taken into account. Late in
                                                   (continued...)
                              - 51 -

The Office of Chief Counsel's rationale for not appealing the Tax

Court's entry of the decisions giving effect to the Thompson

settlement was set forth in a memorandum dated September 8, 1992,

and signed by Kane:

     The Chief Counsel and Deputy Chief Counsel have
     concluded that, under the circumstances, we have
     completely fulfilled all applicable ethical and legal
     obligations with respect to this issue and this
     litigation. They have also concluded that given the
     fact that the conduct on the part of our attorneys is
     significantly less than exemplary, there is nothing to
     be gained by further prolonging this aspect of the
     Kersting litigation.

     On September 30, 1992, Judge Goffe terminated his recall

status as a Senior Judge and retired from the bench.   The Chief

Judge of the Tax Court reassigned the Kersting project cases to

Judge Renato Beghe.

     After this Court entered its decisions in the Thompson

cases, Izen, who had represented the test case petitioners (other

than the Thompsons and Cravenses) at the trial and who was

representing them on their appeals, and Robert Patrick Sticht

(Sticht), who represents a number of nontest case petitioners,

filed separate motions with the Court to intervene in the

Thompson and Cravens cases.   On November 6, 1992, the Court



     23
      (...continued)
October 1992, officials in respondent’s Western Region proposed
closing the Cravenses’ cases in such a way as “to cause the
taxpayers’ 1979 and 1980 accounts to zero out with no further
amounts due.”
                              - 52 -

denied their motions to intervene, and Izen and Sticht filed

notices of appeal.

     I.   Implementation and Effects of the
          Final Thompson Settlement

     This Court’s August 1992 decisions enforcing the final

Thompson settlement had a number of financial consequences.    The

Court’s decisions not only reduced the Thompsons’ deficiencies;

it also reduced the interest that had accrued on those

deficiencies.   In December 1986 and in January 1987, the

Thompsons had paid $59,545 of interest on their originally

settled deficiencies of $34,425 for 1980 and $30,000 for 1981.

Because the Court’s decisions giving effect to the new settlement

agreement resulted in deficiencies of only $15,000 for each of

1980 and 1981, the interest that had accrued on those

deficiencies before the Thompsons made their interest payments

was much less than $59,545.   Instead, as of December 31, 1986,

the interest accruals on the $15,000 deficiencies for 1980 and

for 1981 amounted to only $15,370.73 and $12,135.31,

respectively.   As a result, the Thompsons’ aggregate payments of

$59,545 in December 1986-February 1987 were more than sufficient

to cover their total deficiencies and interest as eventually

reduced by the final Thompson settlement.

     In January 1993, respondent made new assessments against the

Thompsons for 1980 and 1981 that were based upon the decisions
                                - 53 -

entered by the Tax Court on August 26, 1992.    The total

assessments for 1980 and 1981 amounted to $57,506.04 (tax and

interest for 1980 of $15,000 and $15,370.73, respectively, plus

tax and interest for 1981 of $15,000 and $12,135.31,

respectively).   Respondent applied the $59,545 credit balance

resulting from the Thompsons’ payments of $59,545 in interest to

satisfy their $57,506.04 liability for 1980 and 1981, leaving a

small credit balance.

     The Thompsons’ having remitted $63,000 in June 1987, in

respect of their previously settled deficiencies, respondent

credited $62,225 of that amount to their 1979 account as an

advance payment of tax.   Because the Thompsons had no deficiency

for 1979 under both the earlier settlements and the Tax Court’s

decision giving effect to the new settlement, the $30,000 refund

issued in July 1989 left a credit balance of $32,225.

Accordingly, in February 1993, respondent issued a refund check

for $32,225 to the Thompsons.    As they had done with their

earlier refund, the Thompsons endorsed this refund check to

DeCastro, as payment of additional legal fees, without depositing

the check in their own checking account.

     DeCastro thereafter complained to Dombrowski that the

Thompsons were entitled to receive even more from respondent.

DeCastro argued that the Thompsons were entitled to receive

interest on the $63,000 advance payment (albeit as successively
                               - 54 -

reduced to $62,225 and then $32,225).   Dombrowski requested

“audit assistance”, which he received from George Guzzardo

(Guzzardo), an appeals auditor in respondent’s San Diego office,

in determining whether the Thompsons were entitled to the

requested interest.   Guzzardo determined that the Thompsons’

$63,000 remittance on June 17, 1987, was an advance payment

rather than a cash bond.   The distinction is important:   An

advance payment resulting in an overpayment entitles the taxpayer

to interest on the overpayment; conversely, a cash bond does not

earn interest.   Having concluded that the previously refunded

$62,225 was an advance payment, Guzzardo determined that the

Thompsons were entitled to additional interest of $31,511.17 as

of July 31, 1993.   Dombrowski did his own computations, and then

asked Jean Samuels (Samuels), an experienced appeals auditor, to

check his and Guzzardo’s figures.   Samuels advised that in the

main she agreed with both Guzzardo’s and Dombrowski’s

calculations.    Relatively small differences in their results were

attributable to their use of different dates for the accrual of

interest.24

     On September 17, 1993, Dombrowski sent Bakutes a memorandum

requesting approval to refund the interest on the Thompsons’


     24
      Samuels saw that the refund included some previously
deducted interest, thus producing tax benefit income, but stated
in her memorandum to Dombrowski, “Most taxpayers would probably
either not know or not remember to include this [tax benefit
income] in income, since they won’t get a Form 1099 for it.”
                               - 55 -

overpayments, with a copy to the National Office.   Bakutes

approved the refund in an e-mail message to Dombrowski.   In

October 1993, respondent issued a refund check to the Thompsons

in the amount of $32,116.68.

     Finally, in December 1993, respondent issued a refund check

of $4,107.93 to the Thompsons for 1980.   The check represented an

overpayment credit of $2,257.54 (the amount by which their

$59,545 interest payment exceeded their deficiencies and interest

for 1980 and 1981 after minor adjustments), plus accrued interest

of $1,850.39 on the overpayment credit.

     The Thompsons deposited these last two refund checks in

their checking account.

     The following table summarizes the payments by the Thompsons

to respondent as well as the subsequent payments, as refunds and

interest on refunds, by respondent to the Thompsons:

     Paid by Thompsons:

     $59,545        December 31, 1986 and February 17,
                    1987 payments of interest on
                    deficiencies under original settlement.

      62,225        June 1987 advance payment of
                    deficiencies for 1979-1981 (net
                    of $775 credited to tax year 1988).

     121,770        Total amount paid for years in issue.
                                 - 56 -

     Received by Thompsons:

     $30,000.00         Refunded July 11, 1989, pursuant to
                        request of McWade, endorsed to
                        DeCastro.

        32,225.00      Refunded February 19, 1993, pursuant
                       to request of DeCastro and endorsed
                       to DeCastro.

        32,116.68       Third refund check, dated October 22,
                        1993, for $32,116.68, representing
                        interest on overpayment resulting from
                        advance payment of deficiencies.

         4,107.93       Refund, with interest, of overpayment
                        resulting from application of $59,545
                        interest payment against 1980-81
                        deficiencies and interest.

        98,449.61       Total amount refunded by IRS
                        for years in issue.

     In sum, the Thompsons were refunded $98,449.61 of the

$121,770 they had paid in deficiencies and interest for 1979-

1981.    Of the $98,449.61 refunded, $81,225 was paid to DeCastro

as legal fees.      Of this amount, $62,225 was paid to DeCastro by

the Thompsons’ endorsement to him of the first two refund checks

they received in 1989 and 1993.      The Thompsons apparently paid

DeCastro an additional $19,000 after receiving the third refund

check later in 1993.

        On their 1993 tax return, the Thompsons reported both the

$32,116 interest income received from the IRS in October and the

smaller interest payment of $1,850 received in December.        Their

return did not reflect the tax benefit arising from the fact

that, while they deducted $44,165 of deficiency interest on their
                              - 57 -

1986 and 1987 returns ($16,251 for 1986 and $27,914 for 1987),

the interest on the reduced deficiencies that were ultimately

assessed in 1993 amounted to only $27,506 ($15,371 for 1980 and

$12,135 for 1981).   Pursuant to written advice from DeCastro, the

Thompsons deducted the fees paid to him in 1993 totaling $51,225

($32,225 + $19,000) in computing their taxable income.     The

description accompanying the deduction claim on the Thompsons’

1993 return was “LEGAL FEES FOR INCLUDABLE INC.”25

     J.   Respondent’s Disciplinary Action
          Against Sims and McWade

     On July 29, 1993, Sanchez sent notices of proposed

disciplinary action to Sims and McWade.     The notices asserted

that Sims and McWade had violated:     (1) Department of the

Treasury Minimum Standards of Conduct, section 0.735-30(a)(2) (an

employee shall avoid any action which might result in or create

the appearance of giving preferential treatment to any person);

(2) Department of the Treasury Minimum Standards of Conduct,

section 0.735-30(a)(6) (an employee shall avoid any action that

might adversely affect the confidence of the public in the

integrity of the Government); and (3) IRS Rule of Conduct 214.5


     25
      The reference to “INCLUDABLE INC.” has not been
satisfactorily explained, even by Poltash, whose office prepared
the return. Petitioners urge that the reference is to “an entity
that never existed.” The Court doubts the reference is to an
entity at all, but the Court’s question to Poltash, whether the
reference was a shorthand reference to “includable income”, as a
justification for deductibility under sec. 212, met with a
protestation of ignorance.
                                - 58 -

(an employee will not intentionally make false or misleading

verbal or written statements in matters of official interest).

The notices proposed to suspend both Sims and McWade for 14

calendar days without pay.

      McWade retired from the IRS effective October 2, 1993.    On

November 2, 1993, Acting Chief Counsel Jordan approved Sanchez’s

proposed disciplinary action.    Sims was suspended from duty

without pay for 14 days and was transferred to the San Francisco

Regional Counsel’s Office, where he was assigned nonsupervisory

duties as a Special Litigation Assistant in the General

Litigation area.

IV.   Ninth Circuit Remand and Subsequent Proceedings

      A.   Ninth Circuit Orders in the DuFresne Case

      On June 14, 1994, the Court of Appeals for the Ninth Circuit

filed a per curiam opinion, vacating and remanding this Court’s

decisions in the remaining test cases, on the ground that the

misconduct of Sims and McWade required further inquiry.    DuFresne

v. Commissioner, 26 F.3d at 107.    Citing Arizona v. Fulminante,

499 U.S. 279, 309 (1991), the Court of Appeals observed:

           We cannot determine from this record whether the
      extent of misconduct rises to the level of a structural
      defect voiding the judgment as fundamentally unfair, or
      whether, despite the government’s misconduct, the
      judgment can be upheld as harmless error. * * *

Accordingly, the Court of Appeals remanded the remaining test

cases to this Court with directions “to conduct an evidentiary
                               - 59 -

hearing to determine the full extent of the admitted wrong done

by the government trial lawyers.”    Id.   It further directed this

Court to “consider on the merits all motions of intervention

filed by parties affected by this case.”    Id.   Finally, the Court

indicated that “All subsequent appeals will be scheduled before

this panel.”     Id.

     Notwithstanding its general endorsement of allowing parties

in related cases to intervene, the Court of Appeals for the Ninth

Circuit dismissed attorneys Izen’s and Sticht’s appeals from this

Court’s denial of their motions to intervene in the Thompson and

Cravens cases.    In an unpublished opinion filed the same day as

the DuFresne opinion, the panel of the Court of Appeals that had

decided DuFresne explained:

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

     On September 29, 1994, the District Court for the District

of Hawaii entered an order in favor of the United States that

approved the assessment of penalties of $1,545,201 and $2,230,000

under sections 6700 and 6701 against Kersting for the promotion

of abusive tax shelters.   Kersting timely appealed.
                               - 60 -

     In December 1994, the Tax Court received the mandate of the

Court of Appeals in DuFresne, and the test cases were assigned to

Judge Beghe for further proceedings under the mandate.

     B.   Evidentiary Hearing and Opinions
          After the Remand in DuFresne

     In response to respondent’s motion for the evidentiary

hearing required by the mandate, this Court, following receipt of

the record from the Court of Appeals, set the test cases for a

pretrial hearing to be held July 17, 1995.    In furtherance of the

Court of Appeals’ directive regarding intervention, the Court

ordered that notice of the hearing be served on all attorneys who

had entered appearances on behalf of nontest case petitioners in

the Kersting project.    Ultimately, the Court ordered that 10

cases of nontest case petitioners, each represented by either

Izen, Sticht, or attorney Robert Alan Jones (Jones), be

consolidated with the remaining test cases for purposes of the

evidentiary hearing.    As a result, three groups of petitioners

participated in all subsequent phases of the evidentiary hearing:

Test case and nontest case petitioners represented by Izen;

nontest case petitioners represented by Sticht; and nontest case

petitioners represented by Jones.26


     26
      The group of cases that were consolidated for purposes of
the evidentiary hearing initially included the case of William D.
and Karen S. Booth, docket No. 28950-88, in which Declan J.
O'Donnell (O'Donnell) had entered his appearance. However, at
the start of the evidentiary hearing, the Court granted
                                                   (continued...)
                             - 61 -

     As directed by the Court of Appeals in DuFresne, Judge Beghe

conducted the evidentiary hearing at special trial sessions of

the Court in Los Angeles, California, from May 13-30 and

June 10-26, 1996, and August 18, 1997.   On March 30, 1999, on the

basis of the record developed at the evidentiary hearing, the

Court issued its supplemental opinion in Dixon v. Commissioner,

T.C. Memo. 1999-101 (Dixon III).   The Court held that the

misconduct of the Government attorneys in the trial of the test

cases did not, in the words of the Court of Appeals for the Ninth

Circuit in DuFresne, constitute a “structural defect” in the

trial, but rather resulted in “harmless error”.   However, the

Court imposed sanctions against respondent, holding that Kersting

program participants who had not had final decisions entered in

their cases would be relieved of liability for (1) the interest

component of the addition to tax for negligence under section

6653(a)(1)(B) and (2), and (2) the incremental interest

attributable to the increased rate prescribed in section 6621(c).




     26
      (...continued)
O’Donnell's motion to sever the Booth case from the cases
consolidated for the evidentiary hearing. O’Donnell argued that,
in light of the theory underlying a motion for summary judgment
that he had filed on behalf of the Booths, they had no need to
participate in the evidentiary hearing. In Gridley v.
Commissioner, T.C. Memo. 1997-210, the Court denied O’Donnell’s
motions for entry of decision consistent with the final Thompson
settlement.
                             - 62 -

     On March 13, 2000, the Court of Appeals for the Ninth

Circuit affirmed the order of the Hawaii District Court that had

imposed almost $3 million in penalties against Kersting for the

promotion of abusive tax shelters.    The opinion of the Court of

Appeals states:

          The district court did not err in finding that
     Kersting knew or had reason to know that his statements
     concerning the allowability of interest were false or
     fraudulent. See 26 U.S.C. § 6700(a)(2); * * *. The
     record indicates that Kersting knew that his tax
     shelters were sham transactions in which participants
     could write off approximately twelve dollars for every
     dollar of actual out-of pocket expenses. Kersting
     himself indicated in a 1977 “comfort letter" to one of
     the “nervous nellies” investing in his scheme that
     these deductions were not legitimate - Kersting warned
     the individual to “be sure this letter does not get
     into the wrong hands. If IRS would become aware of the
     offsetting character of your note you would likely lose
     your interest deduction”.

          Kersting also knew that these fraudulent interest
     deductions originating in a prior version of his tax
     shelter had been previously disallowed by this Court.
     See Pike v. Commissioner, 78 T.C. 822 (1982) (denying
     interest deductions to taxpayers participating in
     Kersting’s tax shelters because the transactions
     conducted by Kersting’s corporations were shams lacking
     economic substance), affd., 732 F.2d 164 (9th Cir.
     1984). After Pike, Kersting made merely cosmetic
     changes to his tax shelter scheme. * * *

Kersting v. United States, 206 F.3d 817, 819 (9th Cir. 2000).

     On March 31, 2000, this Court issued a supplemental opinion,

Dixon v. Commissioner, T.C. Memo. 2000-116 (Dixon IV), awarding

petitioners some of the attorney’s fees they sought for services

performed in the evidentiary hearing mandated by the Court of

Appeals in DuFresne and denying their motions for additional
                                - 63 -

sanctions.    In so doing, the Court denied petitioners’ requests

for the award of attorney’s fees under section 7430, on the

ground that Dixon III had held that none of them was a

“prevailing party” as defined in section 7430(c)(4).     Instead,

the Court awarded fees under section 6673(a)(2), which authorizes

the Tax Court to require the United States to pay excess costs,

expenses, and attorney’s fees whenever the Commissioner’s

attorneys have “multiplied the proceedings in any case

unreasonably and vexatiously”.

     On the same date, the Court entered decisions in the test

cases, and the test case petitioners appealed.     The Court also

certified for interlocutory appeal the cases of nontest case

petitioners represented by Izen, Jones, and Sticht who had also

participated in the evidentiary hearing and nontest case

petitioners represented by O’Donnell whose cases were the subject

of the Court’s opinion in Gridley v. Commissioner, T.C. memo.

1997-210.     These nontest case petitioners also appealed.

     C.      The Ninth Circuit’s Opinion and
             Mandates in These Cases

     On November 21, 2001, following extensive motion practice on

jurisdiction and other issues, the Court of Appeals set a

briefing schedule and confirmed that the cases on appeal would be

scheduled before the panel that issued the DuFresne opinion.

Following receipt of opening and reply briefs from test case
                              - 64 -

petitioners,27 now represented by three sets of attorneys,28 the

DuFresne panel filed an order indicating that, upon

reconsideration, it would not retain jurisdiction, and directing

the Clerk to schedule the appeal in the normal course of events.

On October 10, 2002, the panel that ultimately issued the opinion

in Dixon V heard oral argument in the test cases.

     On January 17, 2003, the Court of Appeals issued its opinion

in the test cases in Dixon v. Commissioner, 316 F.3d 1041 (9th

Cir. 2003), amended on March 18, 2003 (Dixon V), vacating and

remanding the Court’s decisions in the test cases, and directing

the further proceedings that have resulted in this opinion.

Citing Hazel-Atlas Glass Co. v. Hartford-Empire Co., 322 U.S.

238, 247 (1944), overruled on other grounds Standard Oil v.

United States, 429 U.S. 17, 18 (1976), the Court of Appeals

stated:   “There can be no question here but that the actions of

McWade and Sims amounted to a fraud on both the taxpayers and the

Tax Court.”   Dixon v. Commissioner, 316 F.3d at 1046.   The Court




     27
      On Nov. 20, 2001, the DuFresne panel had filed an order
directing that the appeals of nontest case petitioners
represented by Izen, Sticht, Jones, and O’Donnell “shall be held
in abeyance pending resolution of the appeal in No. 00-70858”
(i.e., the test cases).
     28
      The three sets of attorneys are Izen, Michael L. Minns,
and John A. Irvine and Henry G. Binder.
                               - 65 -

of Appeals held that “fraud on the court” occurs regardless of

whether the opposing party is prejudiced.    Id.29

     The Court of Appeals further stated:

          We have the inherent power to vacate the judgment
     of the Tax Court, fashion an appropriate remedy, and
     sanction a party or its lawyers for willful abuse of
     the judicial process, particularly when the party or
     its lawyers have intentionally practiced a fraud upon
     the Court. * * *

          * * * The taxpayers should not be forced to endure
     another trial and the IRS should be sanctioned for this
     extreme misconduct.

          Conversely, we will not enter judgment eradicating
     all tax liability of these taxpayers. Such an extreme
     sanction, while within the court’s power, is not
     warranted under these facts. * * *

Id. at 1047 (citations omitted).   The Court of Appeals instead

reversed the decisions of this Court in the test cases and

directed this Court to “enter judgment in favor of Appellants and

all other taxpayers properly before this Court on terms

equivalent to those provided in the settlement agreement with

Thompson and the IRS.”   Id.   It left “to the Tax Court’s

discretion the fashioning of such judgments which, to the extent

possible and practicable, should put these taxpayers in the same

position as provided for in the Thompson settlement.”     Id. n.11.


     29
      The Court of Appeals acknowledged the contrary holding of
the Court of Appeals for the Seventh Circuit in Drobny v.
Commissioner, 113 F.3d 670 (7th Cir. 1997), affg. T.C. Memo.
1995-209. In Drobny, the Seventh Circuit held that proof of
fraud on the court requires a showing that the alleged misconduct
actually affected the outcome of the case to the taxpayer’s
detriment. Id. at 678-679.
                              - 66 -

     On January 21, 2003, respondent’s then Chief Counsel,

referring to Dixon V, publicly announced:   “We will * * * assure

that no interest is charged on deficiencies for the period of the

appeals to the Ninth Circuit.”30

     On February 3, 2003, Deborah Butler, respondent’s Associate

Chief Counsel for Procedure and Administration, issued a Chief

Counsel notice (CC-2003-008), reminding all Chief Counsel

attorneys, in light of the opinion of the Court of Appeals in

Dixon V, “to adhere to the highest ethical standards when

performing their duties, including when representing the IRS

before the Tax Court.”

     On March 14, 2003, the Court of Appeals issued orders

remanding to the Tax Court for further proceedings consistent

with the opinion in Dixon V the nontest cases that had been

appealed pursuant to their certification for interlocutory

appeal.   On April 23, 2003, the Court of Appeals issued its

mandates with respect to the test cases in accordance with Dixon

V.

     D.    Proceedings Following Remand

     On April 30, 2003, respondent filed a motion for a status

conference regarding disposition on remand of the test cases and

a group of related nontest cases.   On May 1, 2003, this Court


     30
      The original decisions in Dixon II were entered Mar. 13,
1992; the notices of appeal were filed May 14, 1992; the 90-day
appeal period would have expired June 11, 1992.
                                - 67 -

ordered the parties to file status reports regarding subsequent

disposition of the cases.    The responses displayed various

disagreements between respondent and petitioners concerning not

only the scope of the remedy, but the manner of its

implementation.     For example, the status report of petitioners’

counsel Henry Binder states:    “Respondent does not come to this

Court’s fashioning of the equitable remedy ordered by the Ninth

Circuit with clean hands and, therefore, has no standing to argue

the terms or scope of that remedy.”31    The Court conducted status

conferences in Houston, Texas, in August 2003 and in Los Angeles,

California, in September 2003 to address petitioners’ attempts to

settle the cases.    The conferences resulted in no settlement.

     The parties then engaged in protracted motions practice

regarding assertions of privilege by respondent as to some

matters sought in discovery and regarding the award of attorney’s

fees claimed by counsel for petitioners.

     On April 5, 2004, petitioners filed motions for an

evidentiary hearing.    Thereafter, at the behest of the parties,

the Court directed further discovery and conducted further

hearings.   The first hearing took place at Las Vegas, Nevada, in


     31
      Having considered certain issues raised in the status
reports, this Court issued an order dated June 12, 2003,
indicating it was “not inclined to consider attempts to
disqualify counsel” in any of the cases at issue. We
additionally stated: “This Court is not inclined to seek
appointment of counsel from the United States Department of
Justice to represent respondent in these cases”.
                               - 68 -

September 2004, the second hearing at Los Angeles, California, in

November 2004, and the final hearing at Washington, D.C., in

March 2005.    By the end of September 2005, the parties had filed

their briefs regarding the scope and application of the Thompson

settlement.

     E.     Further Disciplinary Proceedings

     On April 1, 1999, the day immediately following the issuance

of the Dixon III opinion, Judge Beghe referred the misconduct of

Sims, McWade, and DeCastro to the Committee on Admissions,

Ethics, and Discipline of the Tax Court for disciplinary

action.32   In accordance with the Court’s practice in such

matters, the referrals were not mentioned in the Dixon III

opinion or otherwise publicized when that opinion was issued.

     On April 22, 2003, the Court, through the Committee on

Admissions, Ethics, and Discipline, issued orders to Sims,

McWade, and DeCastro to show cause why they should not be

suspended or disbarred from practice before the Court or

otherwise further disciplined.    On July 1, 2003, DeCastro

resigned from practice before the Court.




     32
      On June 26, 1996, at what then seemed to be the close of
the evidentiary hearing, Izen had filed a motion requesting this
Court to refer the Thompson and Cravens settlements and McWade’s
settlement with Denis Alexander to the DOJ (Public Integrity
Section) for criminal prosecution. Izen identified approximately
17 alleged crimes associated with these settlements. By order
dated June 26, 1996, the Court denied Izen's motion.
                                - 69 -

      Following complaints filed by petitioners’ counsel Minns in

response to inquiries by the Dixon V panel at oral argument, the

Arkansas State Bar suspended Sims’s license to practice for 1

year in February 2004, and the Oregon State Bar suspended

McWade’s license to practice for 2 years in August 2004.    This

Court, acting on the orders to show cause and the recommendations

of the Committee on Admissions, Ethics, and Discipline, suspended

McWade and Sims from practice for 2 years, commencing February

20, 2004.33   The Director of the IRS Office of Professional

Responsibility suspended McWade and Sims indefinitely from

practice before the IRS, effective June 9, 2004.

     Under Rule 202(c)(1), a practitioner who has been suspended

for more than 60 days or disbarred from practice before this

Court may not resume practice until reinstated by order of the

Court.    Under Rule 202(c)(2), if the disciplinary proceeding

giving rise to a suspension or disbarment was predicated upon the

complaint of a Judge of this Court, a hearing on the petition for

reinstatement is to be held before a panel of three other Judges

appointed by the Chief Judge.    At the hearing on the petition:

     the practitioner shall have the burden of demonstrating
     by clear and convincing evidence that the practitioner


     33
      The first announcement by the Court with respect to the
referrals was the Court’s issuance, on Feb. 20, 2004, of a press
release that disciplinary action had been taken against McWade
and Sims. DeCastro’s resignation was not publicized by the Court
until issuance of the opinion herein.
                                - 70 -

     has the moral qualifications, competency, and learning
     in the law required for admission to practice before
     this Court and that the practitioner’s resumption of
     such practice will not be detrimental to the integrity
     and standing of the Bar or to the administration of
     justice, or subversive of the public interest. [Id.]

                                OPINION

Preliminary Comments

     The Court of Appeals has directed that the remaining test

case petitioners “and all other taxpayers properly before this

Court” receive judgments in their favor “on terms equivalent to

those provided in the settlement agreement with Thompson and the

IRS.”     Dixon v. Commissioner, 316 F.3d at 1047.   The Court of

Appeals has left to this Court’s discretion “the fashioning of

such judgments which, to the extent possible and practicable,

should put these taxpayers in the same position as provided in

the Thompson settlement.”     Id. n.11.

     Throughout the proceedings required to implement the

mandates of the Court of Appeals, petitioners, impelled by

outrage and indignation at the fraud on the Court committed by

respondent’s attorneys, seem to view the mandates as an

invitation to award damages against respondent.      Without in any

way minimizing the seriousness of the misconduct of respondent’s

attorneys, we decline any such invitation.34    The mandates do not

call for the recovery of damages by the taxpayers; they call for


     34
      In any event, we lack jurisdiction to award damages.
Chocallo v. Commissioner, T.C. Memo. 2004-152.
                              - 71 -

sanctions against respondent, to be determined in accordance with

the ascertainable standard provided by the Dixon V opinion.

     We now broach how, in light of the different circumstances

of the Thompsons and the various groups of affected taxpayers, we

can follow and apply the directive of the mandates.   Interpreting

the term “same position” used in footnote 11 of Dixon V to mean

“same financial position”, it might seem, at first blush, that

the test case and nontest petitioners cannot be put in the

financial position the Thompsons found themselves in as a result

of the Thompson settlement.   The Thompson settlement was embodied

in a sequence of payments and refunds that occurred more than 15

to 20 years ago, when personal interest was fully or partially

deductible for income tax purposes, in a different interest rate

environment, and in temporal relationships that are not now

reproducible with respect to any of the other petitioner

participants in the Kersting project.   Also, the bulk of those

refunds was used to pay legal fees the other test case

petitioners were not required to pay for representation in the

test case trial.

     It should be borne in mind that the Thompson settlement

occurred in two distinct phases:   In December 1986 into early

1987, McWade and DeCastro arranged to provide the Thompsons a

reduction of approximately 20 percent in the originally

determined deficiencies; this version of the settlement took
                             - 72 -

account of respondent’s increased litigation risk resulting from

Chicoine and Hallett’s efforts to suppress the evidence

discovered in the IRS raid on Kersting’s office.    Other Kersting

petitioner clients of DeCastro and Chicoine and Hallett obtained

20-percent reduction settlements from McWade prior to the Court’s

1988 opinion in Dixon I, and some other nontest case petitioners

thereafter obtained such settlements.   The Thompsons’ payments to

the IRS in late 1986 and in 1987 were made to satisfy their

obligations under the approximately 20-percent reduction

settlement arranged by McWade and DeCastro.

     DeCastro thereafter played on the fears of Sims and McWade

that he would walk away from the test case trial to extort the

additional reduction agreed to in late 1988 and early 1989 that

would generate the refunds that were to be used to pay his fees

for providing legal representation to the Thompsons at the trial.

The new Thompson settlement had no rationale quantifiably related

to the hazards of litigation or the merits of the case; it was

based on the opportunistic estimates of McWade and Decastro of

what was needed to bring about a particular financial result that

has little or no congruence with the situation in which the

petitioners before the Court now find themselves.   The fact that

the Thompsons had already made the payments required by the

earlier 20-percent reduction settlement provided the fund that

was ripening for the taking under the new settlement.   As it
                              - 73 -

turned out, the overall reduction of approximately 62 percent in

the Thompson deficiencies provided by the new settlement was more

than enough to produce the approximately $60,000 of refunds

McWade and DeCastro thought would be needed to pay DeCastro’s

original estimate of what his fees would be.   As it further

turned out, the additional interest on the Thompsons’ payments

under the original settlement was sufficient to provide DeCastro

with an additional fee that he (and perhaps Mr. Thompson)

probably felt was justified by his success in keeping the new

settlement in effect, as well as leave a surplus to be retained

by the Thompsons.35

     Test case and nontest case petitioners in the main fall into

two groups, both of which are now in different situations from

the situation of the Thompsons 15-20 years ago.   It is the

Court’s impression that a substantial majority of nontest case

petitioners are in the unhappy situation of having followed

Kersting’s advice to stand pat.   They neither settled their cases

nor made any remittances in respect of the deficiencies

determined against them.   With the passage of years and the

operation against them of the force of compound interest, they

claim that they have been facing financial ruin, with all its


     35
      The lack of legal rationale and the opportunistic
character of the new settlement are emphasized by the fact that
it was entered into after the litigation risk that supported the
original 20-percent reduction settlement had evaporated with the
publication of this Court’s opinion in Dixon I.
                               - 74 -

attendant anxieties; this is because they did not have the

foresight or the discipline to invest the chimerical tax savings

they had appropriated by using the Kersting shelters to support

their original return positions.36   On the other hand, there are

a minority of petitioners who, without conceding their

liabilities, have stopped the running of interest against

themselves by prepaying the Kersting deficiencies the IRS had

determined against them.37   With the passage of time and the

operation in their favor of the force of compound interest, this

minority of petitioners are entitled, under the Dixon V opinion

and mandates, to substantial refunds, and properly so.

     A further comment:   The financial burden of petitioners who

did not prepay has been substantially ameliorated--but not

completely eliminated--by respondent’s concession that no

interest will be charged on deficiencies for the period of the


     36
      The bulk of petitioners in the Kersting project appear to
have been commercial airline pilots. There is no evidence in the
record of their financial sophistication or lack thereof, either
individually or as a group.
     37
      The Court understands that this group includes the
remaining test case petitioners, with the exception of the
Dixons, who received a discharge in bankruptcy. By collecting
the deficiencies from the test case petitioners because of their
failure to file appeal bonds, cf. Estate of Kanter v.
Commissioner, T.C. Memo. 2006-46, respondent has put those
petitioners in the advantageous position of being entitled to
collect substantial refunds, on which interest has been accruing
and compounding over the years without attracting current annual
tax liabilities. Of course, the interest component of those
refunds will be includable in gross income of the recipients when
finally paid.
                                - 75 -

appeals to the Ninth Circuit.    That concession, prompted by

respondent’s recognition of responsibility for the delay in

resolving the Kersting project cases caused by the need to

investigate the misconduct of respondent’s attorneys, seems

appropriate, but also generous.    Even if there had been no

misconduct by respondent’s attorneys, the appeals filed by test

case petitioners, before the misconduct was discovered, would

have taken some substantial time beyond June 1992 to resolve.

The amelioration is substantial because it has stopped the

further accrual and compounding of interest on the deficiencies

for more than 13 years.   The amelioration is not complete because

many petitioners have deficiencies going back to the late 1970s

and early 1980s.

     The bottom line is that, in the absence of the misconduct,

petitioners who did not prepay would have been required to pay

substantially more than they will be required to pay under the

mandates.   Moreover, they will be entitled to pay these reduced

amounts many years later than would have been necessary if there

had been no misconduct.   As a result of respondent’s concession,

they have had the use of the money due for their reduced

deficiencies for more than 13 additional years.    Stated

differently, they have enjoyed for more than 13 years the

equivalent of an interest-free loan of the reduced deficiencies

and interest they will now have to pay.
                                - 76 -

     In sum, this Court has determined the terms of the Thompson

settlement.     Our decisions in these cases will apply those terms

to test case and nontest case petitioners alike.     Subject to the

review of the Court of Appeals, our opinion and decisions will

provide the template for the disposition of the more than 1,300

pending cases in the Kersting project.

     The thoughts underlying the foregoing comments have informed

our effort not only to determine and apply the terms of the

Thompson settlement, but also our effort to put petitioners, to

the extent possible and practicable, in positions similar to that

provided by the Thompson settlement.     Although it may be

impossible to put petitioners in the same position, financial or

otherwise, the Thompsons were in 15 to 20 years ago, we observe

that the Code provisions for interest on deficiencies and

overpayments,38 in which are embedded the time value of money

principles that underlie all financial planning,39 provide the

only available appropriate means of approximating the desired

equivalence.40


     38
          Secs. 6601, 6611.
     39
      See generally, e.g., Brealey & Myers, Principles of
Corporate Finance (7th ed. 2003).
     40
      Gokhale & Smetters, “Measuring Social Security’s Financial
Outlook within an Aging Society”, Daedalus 91-92 n.2 (Winter
2006), comment that discounting to present value, an operation
integral to giving effect to the time value of money, makes it
possible “to place dollars accruing at different points in time
                                                   (continued...)
                                - 77 -


     For two reasons, those petitioners who prepaid will receive

refunds many times greater than the Thompsons received:   Most of

those petitioners probably made payments equal to their

originally determined deficiencies, not just 80 percent thereof,

like the Thompsons, and their refunds will be exponentially

increased by interest accruals because they have had to wait much

longer than the Thompsons did to receive their refunds.

     On the other hand, those petitioners who, unlike the

Thompsons, did not prepay will have deficiencies that will be

reduced in the same proportion as the Thompsons’ deficiencies

were finally reduced under the settlement.   Although they will

still have to pay those reduced deficiencies with interest

accruing until mid-1992, their interest obligation will have been

substantially reduced by respondent’s concession.   We conclude

these comments by again observing that these petitioners will

still be substantially better off financially than they would

have been in the absence of respondent’s misconduct.   And so

should it be, in accord with the sanction the Court of Appeals

has fixed as the appropriate judicial response to the misconduct

of respondent’s attorneys.




     40
      (...continued)
on an equal valuation scale”.
                                - 78 -

I.   Procedural Issues Following Remand

     A.    Procedural Posture

     These cases are before the Court pursuant to the DuFresne

and Dixon V opinions and mandates of the Court of Appeals for the

Ninth Circuit.   They therefore present issues in a procedural

posture diametrically different from the standpoint from which we

usually redetermine income tax deficiencies or overpayments

arising from notices of deficiency or refund claims.    Here, the

traditional roles of petitioner and respondent are reversed.      In

this phase of the proceedings, it is respondent, not petitioner,

whose activities are being questioned.    It is respondent, not

petitioners, who is charged with having the necessary records and

the personnel who have recollections regarding the matters at

issue.41   Because of the unique posture of this case, it is

respondent, not petitioner, who often argues that a deduction has

been properly claimed and allowed (and thus should not be

included as one of the taxpayer benefits of the Thompson

settlement), while petitioners argue the contrary.




     41
      It should be noted that, following the remand in Dixon V,
neither side called DeCastro, Mcwade, or Sims as a witness. We
understand that DeCastro is seriously ill, so he was not
available. We have no such information about McWade or Sims;
perhaps their previous failures to persuade this Court of their
credibility discouraged both sides from calling them.
                              - 79 -

    B.    Law of the Case

     The Court of Appeals for the Ninth Circuit recently

explained the law of the case doctrine as follows:

          “The law of the case doctrine requires a district
     court to follow the appellate court’s resolution of an
     issue of law in all subsequent proceedings in the same
     case.” United States ex rel. Lujan v. Hughes Aircraft
     Co., 243 F.3d 1181, 1186 (9th Cir. 2001). The doctrine
     applies to both the appellate court’s “explicit
     decisions as well as those issues decided by necessary
     implication.” United States v. Cote, 51 F.3d 178, 181
     (9th Cir. 1995) (quoting Eichman v. Fotomat Corp., 880
     F.2d 149, 157 (9th Cir. 1989)). * * * [Al-Safin v.
     Circuit City Stores, Inc., 394 F.3d 1254, 1258 (9th
     Cir. 2005).]

In relying upon its inherent authority to sanction the IRS by

extending the benefit of the Thompson settlement to all

interested parties, the Court of Appeals by necessary implication

concluded that the doctrine of inherent authority trumps the

doctrine of sovereign immunity (the latter generally prohibiting

the imposition of monetary sanctions against the United States

absent the express consent of Congress).42   We therefore are not

concerned with that issue.




     42
      The principle that a court has inherent power to impose
sanctions is well established. “It has long been understood that
‘[c]ertain implied powers must necessarily result to our Courts
of justice from the nature of their institution,’ powers ‘which
cannot be dispensed with in a Court, because they are necessary
to the exercise of all others.’” Chambers v. NASCO, 501 U.S. 32,
43 (1991) (quoting United States v. Hudson, 11 U.S. (7 Cranch)
32, 34 (1812)).
                                - 80 -

     C.     Parties Before the Court

     The opinion of the Court of Appeals directs this Court “to

enter judgment in favor of Appellants and all other taxpayers

properly before this Court”.     Dixon v. Commissioner, 316 F.3d at

1047.     In a technical sense, the Dixon V opinion and the

implementing mandates might be deemed to extend only to those

parties who filed notices of appeal.       See Abatti v. Commissioner,

859 F.2d 115, 120 (9th Cir. 1988).       We believe, however, that the

Court of Appeals did not intend a technical, restricted

application of its opinion and mandates, nor, apparently, do the

parties.    Following the hearings in these cases, the parties

filed a stipulation of settled issues.      Among other things, that

stipulation recites:

          1. The Kersting deficiencies of any petitioner
     who has filed a piggyback agreement with the Tax Court
     shall be determined in accord with the Ninth Circuit’s
     mandates as implemented by the Tax Court on remand in
     this proceeding * * *.

          2. The Kersting deficiencies of any petitioner
     in a case docketed before the Tax Court who has not
     filed a piggyback agreement will, absent a showing of
     cause, be determined in accord with the Ninth Circuit’s
     mandates as implemented by the Tax Court on remand in
     this proceeding * * *.

We read these stipulations to apply to all open cases of

petitioner participants in the Kersting tax shelter programs.      In

other words, the parties have agreed--and properly so--that the

sanction applies to benefit not only to test case petitioners,

but also to nontest case petitioners in all remaining docketed
                               - 81 -

cases in the Kersting project, whether or not they signed

piggyback agreements.

     D.    Burden of Proof

     In our Dixon III opinion, we noted several factors that

impelled us to impose the burden of proof on respondent with

respect to whether the misconduct of respondent’s attorneys

resulted in a fundamental defect or in harmless error.    Those

same factors apply to the present proceedings concerning the

scope and application of the Thompson settlement.    As in Dixon

III, respondent has had direct and immediate access to the

critical witnesses and most of the relevant documents since May

1992, when the misconduct of respondent’s attorneys first came to

light.    Further, respondent conducted an internal investigation

of that misconduct, without the participation of outside parties,

soon after discovering the misconduct.    Petitioners, on the other

hand, have had to rely on discovery and circumstantial evidence,

plus whatever evidence respondent has revealed voluntarily.

Petitioners have been far less favorably situated than respondent

to produce the factual record needed to decide these cases on

remand.    Furthermore, and finally, as we have previously

observed, these cases are not in the normal deficiency posture,

and it is the misconduct of respondent’s attorneys that is under

review.    Accordingly, we again conclude that the interests of

justice are better served by placing the ultimate burden of proof
                              - 82 -

and persuasion on respondent, and we so hold.43   See Rockwell v.

Commissioner, 512 F.2d 882, 885-887 (9th Cir. 1975), affg. T.C.

Memo. 1972-133.

     We recognize that imposing the burden of proof on respondent

may put respondent in the difficult position of having to prove a

negative; i.e., that a given outcome or transaction involving the

Thompsons was not a result of the Thompson settlement.   In other

circumstances, when a taxpayer has the burden of proving the

negative of a proposition, such as proving the nonreceipt of

income, the Court of Appeals for the Ninth Circuit requires the

Commissioner to produce at least some substantive evidence

linking the taxpayer to the income-producing activity.   See

Weimerskirch v. Commissioner, 596 F.2d 358, 361 (9th Cir. 1979)

(respondent must offer “some foundational support” of the receipt

of such income), revg. 67 T.C. 672 (1977).   Accordingly, in the

matter at hand, it is appropriate to require petitioners to


     43
      Petitioners have filed a motion, as supplemented by a
later motion, asking the Court to assign the burden of proof to
respondent on 22 specified issues; in so doing, petitioners aver
that they do not seek a general allocation of the burden of proof
to respondent. Respondent has objected to these motions, quoting
Kluger v. Commissioner, 83 T.C. 309, 310 n.1 (1984), for the
proposition that the Court “has never, in any context, invoked
such a sanction”. Our action in Dixon III in shifting the
general burden of proof and persuasion to respondent in that
phase of these proceedings belies respondent’s objections. We
have concluded that no useful purpose would be served by
addressing petitioners’ motions on an issue-by-issue basis.
Suffice to say we have assigned the burden of proof and
persuasion to respondent on each issue of fact that bears on the
scope and terms of the Thompson settlement.
                               - 83 -

produce at least some substantive evidence indicating that

asserted benefits to the Thompsons are the result of the Thompson

settlement, at least when respondent is in the position of having

to prove the contrary.   In this regard, it is appropriate for

petitioners to rely upon circumstantial evidence, although here,

as in other contexts, “‘mere suspicion or speculation does not

rise to the level of sufficient evidence’”.   See United States v.

Dinkane, 17 F.3d 1192, 1196 (9th Cir. 1994) (quoting United

States v. Stauffer, 922 F.2d 508, 514 (9th Cir. 1990)).

     Finally, we believe the factual issues regarding the

operative terms and scope of the Thompson settlement, now that

the existence and overall significance of the misconduct have

been determined, do not present policy considerations that

require a heightened standard of proof, such as the requirement

of “clear and convincing” proof of fraud imposed by our Rule

142(b) in deficiency cases, that we applied in Dixon III against

respondent in an earlier phase of these proceedings.

Accordingly, we hold that the quantum or level of respondent’s

burden is a “preponderance” of the evidence, the traditional

quantum or level of proof required under Rule 142(a) and the case

law thereunder.44   This is the same standard to which we and


     44
      Petitioners have not sought to allocate the burden of
proof to respondent on the ultimate question of whether the
Thomson settlement is characterized as a 20-percent reduction in
deficiencies, plus the payment of the Thompsons’ legal fees, or
                                                   (continued...)
                               - 84 -

other courts have, for many years, held taxpayers on questions of

general tax liability, and we believe that this is the

appropriate standard to apply to respondent in this phase of the

proceedings.    See Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933); Am. Pipe & Steel Corp. v. Commissioner, 243 F.2d 125,

126-127 (9th Cir. 1957), affg. 25 T.C. 351 (1955).

II.   Defining and Applying the Thompson Settlement

      A.    Overview

      In Al-Safin v. Circuit City Stores, Inc., 394 F.3d at 1258,

the Court of Appeals reminded us that its opinion may be

consulted to ascertain what was intended by the mandates.   In

Dixon V, the Court of Appeals described the basis of the “secret

settlement agreements” with the Thompsons and the Cravenses as

follows:    “A condition of their settlements required Thompson and

Cravens to remain test case petitioners. * * * With respect to

Thompson, McWade agreed to have Thompson’s tax deficiencies

reduced in proportion to his attorney’s fees, which exceeded

$60,000.”    Dixon v. Commissioner, 316 F.3d at 1044; fn. ref.


      44
      (...continued)
as a 62-percent reduction. See Part C, infra. We observe that
the significant evidentiary facts on this issue are not in
dispute, so that the burden of proof does not enter into what we
see as a problem of legal characterization. Therefore, the
question does not arise whether we should employ some heightened
standard of proof, such as “strong proof” or “clear and
convincing” proof, that might otherwise arise when a party to a
transaction seeks to disregard the form employed. Our resolution
of this issue does not depend on the allocation or standard of
the burden of proof.
                              - 85 -

omitted.   The Court of Appeals further described the Thompson

settlement as a “vehicle for paying Thompson’s attorney’s fees”,

notwithstanding McWade’s testimony that the settlement “was

attributable to a separate transaction.”    Id. at 1045.45

     The opinion of the Court of Appeals displays its

understanding that the Thompson settlement was a covert

transaction, a “secret settlement agreement” that “was a vehicle”

to provide the Thompsons with advantages--including payment of

attorney’s fees through a drastic reduction of deficiencies, and

elimination of Kersting and non-Kersting additions--over and

above those offered to other taxpayers.    Thus, while our sanction

should put the other affected taxpayers in the position of having

received the benefits the Thompsons received, those benefits

should be fairly traceable to the sanctionable conduct of

respondent’s counsel, McWade and Sims.    As we informed the

parties in an order dated February 28, 2005:




     45
      The reference to a “separate transaction” is to the
Thompsons’ participation in the Bauspar program. In his brief to
the Court of Appeals, Izen explained that McWade and Sims had
misled this Court by “denying that the Thompsons [sic] settlement
was a vehicle for paying DeCastro’s legal fees for representing
the Thompsons at the trial of the test cases, [and] by testifying
that the Thompsons [sic] settlement was attributable to the
Thompsons’ participation in the Bauspar program.”   Additionally,
as we observed in Dixon III, “Mr. McWade testified that the
Thompsons’ settlement was revised in the summer of 1989 in order
to dispose of the Bauspar issue. Mr. McWade denied that the
Thompsons’ settlement was revised to provide a means for the
Thompsons to pay Mr. DeCastro’s attorney’s fees.”
                               - 86 -

     The mere fact that the Thompsons received a tax benefit
     is insufficient to enable the Court to conclude that
     the benefit was part of the settlement. With respect
     to each item, it is also necessary to show, or find it
     appropriate to assume, that respondent’s counsel played
     an enabling or facilitating role in procuring or
     assuring the benefit to the Thompsons.

     B.   Areas of Agreement

     The parties’ stipulation of settled issues, in addition to

delineating the beneficiaries of the Court of Appeals’ mandates,

see supra Part I.C., establishes some common ground regarding the

relief to which those beneficiaries are entitled:

          3. The “burnout” element of the Thompson
     settlement is as follows:

          (a)   for taxpayers with 2-3 taxable years
                before the court, the first year’s
                deficiencies are shifted forward and
                combined with the deficiencies in the
                second year then reduced in accord with
                the Ninth Circuit’s mandate; and

          (b)   for taxpayers with 4 or more taxable
                years before the court, the first year’s
                deficiencies are shifted forward to the
                second year and the second year’s
                deficiencies are shifted forward and
                combined with the deficiencies in the
                third year, after which all deficiencies
                are reduced in accord with the Ninth
                Circuit’s mandate.

          4. No petitioner will incur any penalties
     stemming from such petitioners’s [sic] Kersting
     deficiencies.
                               - 87 -

We incorporate the foregoing stipulations in the relief we

announce today.46

     As for the deficiencies themselves, petitioners and

respondent have agreed that the originally determined Kersting

deficiencies should be reduced in proportion to the monetary

benefit the Thompsons received as a result of the new agreement

between McWade and DeCastro.   As petitioners explain: “To

determine a percentage reduction of aggregate deficiencies

requires a numerator and denominator, the numerator being the

amount the Thompsons actually paid under the settlement and the

denominator being the amount they would have paid absent the

settlement.”47   We agree, with the initial caveat that, inasmuch

as the parties address both interest and Kersting-related

penalties elsewhere, we disregard those items in determining what

the Thompsons paid (the numerator) and would have paid (the

denominator).




     46
      We do not adopt all aspects of the parties’ stipulation of
settled issues. See infra note 67.
     47
      Actually, the resulting percentage would represent the
proportion of proposed deficiencies that affected taxpayers would
be required to pay. To obtain the “percentage reduction” it will
be necessary to subtract the percentage so found from 100
percent.
                                 - 88 -

     C.      Starting Point: The Thompsons’ Settlement
             of Proposed Deficiencies for 1979-1981

             1.   Respondent’s Position

     Respondent’s characterization of the Thompsons’ settlement

of their 1979-1981 deficiencies, as set forth in a status report

dated May 28, 2003, has remained constant throughout the

proceedings on remand from Dixon V.       Respondent maintains,   “from

a substantive standpoint”, that the Thompsons’ settlement of

their 1979-1981 deficiencies “amounted to a 20% reduction of the

deficiencies”48 plus “payment of the Thompsons’ attorney’s fees

incurred with respect to the actual trial of the test cases

resulting in the opinion in Dixon v. Commissioner, T.C. Memo.

1991-614 (Dixon II).”     In other words, respondent maintains that

the settlement fraction numerator--“the amount the Thompsons

actually paid under the settlement”--is $63,000 (the amount of

tax the Thompsons remitted to the IRS in June 1987).       In

respondent’s view, the settlement should not reflect the

additional $33,000 reduction in tax plus the accompanying

interest reductions that generated the refunds of $30,000 in July

1989 and $32,250 in February 199349 that were signed over to

DeCastro, nor the interest refunds on the resulting overpayments




     48
          More accurately, 20.55 percent (from $79,294 to $63,000).
     49
      Respondent applied the remaining $750 to the Thompsons’
1988 tax year.
                              - 89 -

that funded an additional fee payment to Decastro later in 1993

and still left over something that was retained by the Thompsons.

     Respondent argues that, because none of the other

petitioners (test case or nontest case) incurred attorney’s fees

for the test case trial (all such fees were paid by Kersting),

those petitioners would receive an economic windfall if we were

to use the actual 62-percent reduction in the Thompsons’ 1979-

1981 deficiencies as the starting point for our remedy.

Respondent reasons that the 62-percent characterization would

provide a benefit to petitioners (the reduction in their proposed

deficiencies by an additional 42 percent) that the Thompsons did

not enjoy due to their implicit obligation to turn over the bulk

of the resulting refunds to DeCastro as payment for legal

services that conferred no discernible benefit to them.

Respondent further argues that the relatively small portion of

the refunds of tax and interest ultimately retained by the

Thompsons ($17,224.61 out of $98,449.61) is rendered even more

insignificant by the fact that the Thompsons reported almost

twice that amount ($33,966.68) as gross interest income received

from the IRS in 1993 on which they paid tax.50   In sum,

respondent argues, the sweetener embodied in the final settlement



     50
       Respondent overlooks the fact that the refunds of
$33,966.68 of taxable interest income reported by the Thompsons
for 1993 were substantially exceeded by the $51,000 deduction for
legal fees claimed by and allowed to them for that year.
                              - 90 -

that was achieved by increasing the deficiency reduction

percentage from 20 percent to 62 percent in effect should be

disregarded because the refunds generated thereby purchased

nothing of value and provided at most a de minimis increase in

the Thompsons’ net worth.51

          2.   Petitioners’ Position

     In sharp contrast, petitioners view the Thompsons’

settlement of their 1979-1981 deficiencies strictly in terms of

the percentage reduction in the total amount of tax the Thompsons

were required to pay.   Thus, petitioners maintain that the

starting point for determining the percentage reduction in

deficiencies to which they are entitled is 62.17 percent,

representing the final total reduction of the Thompsons’ proposed

deficiencies for the years at issue from $79,294 to $30,000.

     In addition to their argument that the form of the

Thompsons’ settlement of their 1979-1981 deficiencies (62.17-

percent reduction) provides the starting point for determining

the appropriate sanction in these cases, petitioners dispute

respondent’s assertion that the payment of DeCastro’s fees was



     51
      A more nuanced adoption and application of respondent’s
argument might arrive at some percentage between 20 percent and
62 percent by increasing the 20 percent to reflect the amount of
the refunds actually retained by the Thompsons or the amount they
expected or were expected to retain after their endorsement over
to DeCastro of the first two refunds. Neither side has advanced
such an argument.
                              - 91 -

one of the substantive elements of that settlement.   Petitioners

urge that the evidence does not support a finding that the

Thompsons’ use of the refunds generated by the final reduction in

deficiencies was restricted in any way.   They point to some

inconsistencies in the estimate of total fees that DeCastro had

given to McWade, as well as DeCastro’s initial reluctance to

acknowledge that respondent had arranged to pay his fees.

Accordingly, petitioners argue that the substance of the

Thompsons’ settlement of their 1979-1981 deficiencies did not

depart from the form in which respondent provided it--that is, a

reduction of 62.17 percent in the deficiencies originally

determined for those years.

          3.   Analysis

     As a threshold matter, we do not believe that the

inconsistencies perceived by petitioners outweigh the direct and

circumstantial evidence that, in substance, the Thompsons’

settlement of their 1979-1981 deficiencies was, in the words of

the Court of Appeals, a “vehicle for paying Thompson’s attorneys’

fees”.   The preponderance of the evidence shows that, when they

made their final deal, McWade and DeCastro intended that the

refunds generated by the final reduction of the Thompsons’

deficiencies would go to DeCastro in payment of his fees.      The

fact that the Thompsons endorsed the first two refunds--two

checks totaling $62,225--directly to DeCastro’s law firm confirms
                              - 92 -

that intention.   In a telephone call with Bakutes on June 10,

1992, DeCastro himself conceded that the refunds were intended as

a means of paying his fees.

     Although we recognize that the payment of DeCastro’s fees

was an essential element of the Thompsons’ settlement of their

1979-1981 deficiencies, it does not follow that respondent’s

characterization of that settlement (20-percent reduction in

deficiencies plus payment of attorney’s fees) must prevail.    From

a practical standpoint, respondent overlooks the fact that the

refunds generated by the reduction in deficiencies exceeded the

legal fees they were intended to defray.   More importantly,

inasmuch as the Court of Appeals has taken us to task for twice

failing “to equitably resolve” a situation in which respondent’s

attorneys committed fraud on the court, we believe respondent

should be held to the form of the new settlement.   That is, we do

not think it appropriate to define the Thompsons’ settlement of

their 1979-1981 deficiencies only by reference to its asserted

substance, which would require respondent to reduce the proposed

deficiencies of the affected taxpayers by only 20 percent (this

would be the practical effect, because, although respondent would

also be required to reimburse the affected taxpayers for

attorney’s fees, none of the affected taxpayers paid any such
                                - 93 -

fees).52    We instead think it appropriate to hold respondent to

the form of the transaction adopted by his misbehaving attorneys,

i.e., the reduction of the Thompsons’ 1979-1981 deficiencies by

62.17 percent, without regard to the fact that the Thompsons used

the bulk of the refunds generated thereby to pay DeCastro’s fees.

     We recognize that, in the usual case, it is taxpayers who

are held to the form of the transaction they have adopted; once a

party has chosen to organize his affairs in a certain fashion,

“he must accept the tax consequences of his choice, whether

contemplated or not * * * and may not enjoy the benefit of some

other route he might have chosen to follow but did not.”

Commissioner v. Natl. Alfalfa Dehydrating & Milling Co., 417 U.S.

134, 149 (1974).    On the other hand, respondent generally may

disregard the taxpayer’s form, and, if that form is “unreal or a

sham may sustain or disregard the effect of the fiction as best

serves the purposes of the tax statute.”    Higgins v. Smith, 308

U.S. 473, 477 (1940).    We also recognize that, in these cases,

the traditional roles of petitioner and respondent have been

reversed.    Requiring respondent to assume the procedural posture

of a taxpayer does not necessarily prohibit respondent from

asserting substance over form.    We have in mind the following


     52
      The attorney’s fees incurred by petitioners for which
respondent may be liable relate to further proceedings required
by the misconduct of respondent’s attorneys and are in no way
analogous to the Thompsons’ fees to DeCastro for his
representation in the original trial in Dixon II.
                               - 94 -

comment of Judge Wisdom:   “The taxpayer too has a right to assert

the priority of substance--at least in a case where his tax

reporting and actions show an honest and consistent respect for

the substance of a transaction.”    Weinert v. Commissioner, 294

F.2d 750, 755 (5th Cir. 1961), affg. 31 T.C. 918 (1959).53

     Our difficulty with respondent’s assertion of the “priority

of substance” arises from the failure of respondent’s actions to

show “an honest and consistent respect for the substance of [the]

transaction.”   Here, respondent, through his former attorneys,

did not show respect for the substance of the transaction.

McWade and Sims tried to hide the settlement from their

supervisors, from the other parties, and from the Court.     As we

have seen, and the Court of Appeals has noted, Dixon v.

Commissioner, 316 F.3d 1044 n.5, when Thompson was about to

reveal his settlement in open court, McWade immediately steered

him to another subject.    Nor did respondent’s attorneys manifest

a consistent respect for the substance of the transaction.    In

substance, the Thompsons’ settlement of their 1979-1981

deficiencies was a vehicle for payment of their attorney’s fees,

but respondent, again through his former attorneys who

perpetrated the fraud, characterized it as a refund of taxes to

the Thompsons that was solely attributable to Bauspar.



     53
       See Smith, “Substance over Form: A Taxpayer’s Right to
Assert the Priority of Substance”, 44 Tax Law. 137, 142 (1990).
                                - 95 -

     We therefore reject respondent’s assertion of substance over

form.    We shall instead apply to respondent the nondisavowal

principle of Commissioner v. Natl. Alfalfa Dehydrating & Milling

Co., supra at 149, that a party who has chosen to organize his

affairs in a certain fashion “must accept the tax consequences of

his choice, whether contemplated or not * * * and may not enjoy

the benefit of some other route he might have chosen to follow

but did not.”     We believe the settlement of the Thompsons’ 1979-

1981 deficiencies must be applied by giving effect to their

receipt of the entire amount of the refunds, rather than by

disregarding such receipt as a mere formality in the process of

what was, in substance, respondent’s manipulation of the tax

administrative process to use the Thompsons as a conduit to pay

DeCastro’s fees.

        We are not content to rest our conclusion solely by invoking

the nondisavowal principle to hold respondent to the form of the

transaction.     To do so might give rise to the implication that we

have disregarded the substance of the transaction.    If we did no

more than disregard the substance of the Thompson settlement by

upholding its form, respondent might well impeach our conclusion

by arguing that we thereby would have disregarded the mandate of

the Court of Appeals for the Ninth Circuit to put all petitioners

“in the same position as provided in the Thompson settlement”.
                              - 96 -

     We therefore push the analysis further by observing that our

conclusion accords with principles of Federal income taxation

developed by the Supreme Court in analogous situations.

Specifically, our treatment of the Thompson settlement is

analogous to the treatment of taxpayers who are held to have

received gross income, even though that income was paid directly

to a third party.   Petitioners cite Old Colony Trust Co. v.

Commissioner, 279 U.S. 716 (1929), in which the Supreme Court

held that an employer’s payment of its employees’ income taxes

should be recognized as a taxable payment of additional

compensation to the employee.54

     Our conclusion is supported by the recent decision of the

Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005).

There, Mr. Banks settled an employment discrimination suit for

$464,000 and, pursuant to a contingent fee arrangement, paid his

attorneys $150,000 of that amount.     The Supreme Court held that

the $150,000 fee amount was includable in the gross income of Mr.

Banks, notwithstanding his preexisting obligation to pay




     54
      We note that the Thompsons did not report as gross income
the first refund of $30,000, presumably because it was a refund
of tax they had previously paid. Moreover, they did not claim
that amount as a deduction under sec. 212(3) when they endorsed
the check for that amount to DeCastro, as a partial payment on
account of his legal fees. Although their failure to claim the
deduction operated as a tax detriment to the Thompsons, there is
no evidence that their forbearance was in any way related to the
deal with McWade.
                             - 97 -

approximately one-third of his total recovery to his lawyers.55

We read the Supreme Court’s opinion in Banks as confirming and

applying the general principle that the portion of a settlement

that is dedicated to the payment of the plaintiff’s attorney’s

contingent fee is still regarded as received by the plaintiff

even though he is not expected or entitled to retain it.

     Our conclusion is guided also by the fact that the Court of

Appeals has specifically directed us to provide the equivalent of

the Thompson settlement as a sanction against respondent.   We do

not believe that the Court of Appeals contemplated the

application of this aspect of the Thompson settlement in the way

that respondent urges, that is, as a 20-percent reduction in

proposed deficiencies, together with the hollow requirement that

respondent reimburse the many other affected petitioners for

attorney’s fees that in fact they never incurred.   If we did so,



     55
      We note that in Kenseth v. Commissioner, 114 T.C. 399
(2000), affd. 259 F.3d 881 (7th Cir. 2001), a majority of this
Court upheld respondent’s contention that the taxpayers were
chargeable with the receipt of gross income on the portion of a
settlement that was used to pay their attorney under a contingent
fee arrangement. In Kenseth, the taxable year was 1993, the
taxable year for which, in the matter at hand, respondent
contends that we should disregard as a formality the Thompsons’
receipt of the second refund they used to pay their attorney.

     We observe that our hewing to the form of the transaction as
generating refunds of tax and interest to the Thompsons obviates
any argument by petitioners that the Thompsons received a tax
benefit in not being required to report as gross income the
receipt of the refund of tax that enabled them to make their
first installment payment of DeCastro’s attorney’s fees.
                              - 98 -

we would not be applying the equivalent of the Thompsons’ 1979-

1981 settlement; instead we would be applying essentially the

same 20-percent reduction settlement that McWade extended to

other taxpayers, including other clients of Chicoine and Hallett

and DeCastro, the monetary benefit of which respondent would have

been content to allow the Thompsons to retain.   We believe the

modest deficiency reduction percentage urged by respondent would

not provide an appropriate sanction for misconduct that the Court

of Appeals has held to be a fraud on this Court.   To adopt

respondent’s view would be to ignore the financial terms and

effects of the final settlement that was sweetened for the

illicit purpose of creating the fund from which DeCastro’s trial

fees could be paid.

     We conclude that the Court of Appeals intended that the

Thompsons’ “secret agreement” with respect to 1979-1981, to the

extent it reflected the reduction of deficiencies to $30,000 for

those years, is to be applied as a reduction of 62.17 percent in

the Kersting deficiencies of the affected taxpayers, rather than

the 20-percent reduction urged by respondent, or some

intermediate percentage based upon the actual or expected amounts

of the refunds to be retained by the Thompsons after payment of

DeCastro’s fees.   See supra note 51.   In terms of the “settlement

fraction” discussed above, we begin with a numerator of $30,000

(the total 1979-1981 tax deficiency the Thompsons paid) and a
                                  - 99 -

denominator of $79,294 (the 1979-1981 tax deficiencies the

Thompsons would have paid absent the settlement).

     D.   Other Benefits Relating to the Thompsons’
          1981 Tax Year

          1.      Elimination of the Thompsons’ Late
                  Filing (Non-Kersting) Addition for 1981

     Petitioners maintain that the denominator of the settlement

fraction should be increased by $4,934.32, representing the late

filing addition in the Thompsons’ statutory notice for 1981 that

they would have had to pay absent the settlement of their 1979-

1981 tax years.    We disagree.    Respondent’s proposed application

of non-Kersting penalties and additions was specific to

individual taxpayers, unlike the Kersting-related deficiencies

and additions for which all affected taxpayers are liable.     For

that reason, we believe it is appropriate to limit the benefit of

this aspect of the Thompson settlement (relief from liability for

non-Kersting additions) to those affected taxpayers who, like the

Thompsons, were subject to non-Kersting additions.      We therefore

deal with this aspect of the Thompson settlement separately from

our determination of the percentage reduction in Kersting

deficiencies that will apply to all affected taxpayers.     See

infra Part II.G.1.
                                 - 100 -

          2.     Respondent’s Failure To Address the
                 Bauspar Issue in the Thompsons’ Statutory
                 Notice for 1981

     As discussed above, the Thompsons began participating in the

Bauspar program in 1981.      Respondent’s notice of deficiency with

respect to the Thompsons’ 1981 tax year did not disallow the

$8,000 claimed by the Thompsons on their 1981 return as home

mortgage interest, interest that was probably attributable to the

Bauspar program.   By August 1985, when the Thompsons filed their

petition in this Court for 1981, respondent was generally

precluded from revising the statutory notice to include the

Bauspar issue.   See sec. 6212(c)(1).      Because that cutoff date

predates the Thompsons’ retention of DeCastro by more than a

year, respondent’s failure to include the Bauspar issue in the

statutory notice for 1981 could not have been part of the secret

settlement agreement between DeCastro and McWade.56

     E.   Benefits to the Thompsons Relating to Years
          Other Than 1979-1981

          1.     In General

     Respondent maintains that the only years covered by the

Thompson settlement were the Thompsons’ 1979-1981 taxable years

before the Court in this proceeding.       Petitioners, on the other



     56
      Respondent presumably could have raised the Bauspar issue
later by seeking leave to amend his answer in the Thompsons’ 1981
Tax Court case. See sec. 6214(a); Rule 41(a); Rule 142(a)
(shifting the burden of proof to the Commissioner with respect to
the increased deficiency). For reasons discussed infra in Part
II.E.4., we need not concern ourselves with that possibility.
                              - 101 -

hand, maintain that the Thompson settlement covered a number of

years between 1979 and 1993, thereby increasing the percentage

reduction in Kersting deficiencies to which they are entitled to

79.95 percent.57   They base this percentage on their calculation

that, absent the settlement, the amount of taxes the Thompsons

would have paid respondent for the taxable years 1979-1983, 1986-

87, and 1993 was $143,894.10, while the amount they actually paid

was $28,894.87 ($30,000 reduced by $1,105.13 that respondent

maintains Mr. Thompson improperly received as reimbursement for

his travel to Hawaii to testify in the Dixon II trial).   We

examine various suspect benefits below.58


     57
      In a separate brief, petitioners’ counsel Sticht argues
for a “cashflow” approach to the calculation of the reduction
percentage, which would bring the initial reduction percentage to
86.8 percent of petitioners’ aggregate deficiencies, additions,
and interest. Without closely following the mechanics of
Sticht’s calculation, we reject the cashflow approach out of
hand. It completely disregards the time value of money
principles that underlie our Preliminary Comments. See text
accompanying notes 38, 39, and 40, supra.

     We also note that, in the course of the evidentiary hearing
required by the Dixon V mandates, petitioners’ counsel O’Donnell
and Jones filed motions for summary judgment of “100-percent
discount” as a sanction. We denied the motions and the motions
for reconsideration of our denials because of numerous
outstanding issues of material fact. With the completion of the
evidentiary hearing and issuance of our opinion herein, we now
regard petitioners’ motions to characterize the Thompson
settlement as a 100-percent reduction in the Kersting-related
deficiencies as having been denied on the merits.
     58
      We note that petitioners do not question the settlement of
the Thompsons’ 1978 tax year, which was apparently the first year
for which the Thompsons claimed Kersting deductions. In any
                                                   (continued...)
                              - 102 -

          2.    The Thompsons’ Escape From Kersting
                Liability with Respect to 1982

     As discussed earlier, the Thompsons claimed Kersting (and

probably Bauspar) deductions on their 1982 return sufficient to

reduce their adjusted gross income of $99,364 to $4,336.

Respondent took no action with respect to that return, and the

generally applicable 3-year period of limitations for the

Thompsons’ 1982 tax year expired in May 1986.   Given the fact

that the Thompsons did not retain DeCastro until November 1986,

respondent’s failure to act on the Thompsons’ 1982 return before

the expiration of the 3-year period of limitations could not have

been part of the secret settlement agreement between DeCastro and

McWade.

     Petitioners nevertheless maintain that the Thompsons’ escape

from Kersting liability with respect to 1982 is attributable to

the DeCastro/McWade agreement.   In support of that argument, they

point to DeCastro’s August 3, 1989 letter to McWade, which

states: “We have agreed that the total taxes due for all the open

years are $15,000 for 1980 and $15,000 for 1981.” (Emphasis

added.)   Petitioners then argue that the Thompsons’ 1982 tax year

was still fair game at that time because Mr. Thompson’s fraud

rendered the statute of limitations inapplicable pursuant to



     58
      (...continued)
event, that settlement was consummated in early to mid-1986,
before DeCastro came on the scene.
                               - 103 -

section 6501(c)(1).    They argue that Mr. Thompson was liable for

fraud because he had claimed Kersting deductions even though he

believed he wouldn’t have to pay the notes.

     Petitioners’ arguments are farfetched.   Allegations of fraud

are serious business.   The grounds for asserting civil fraud were

succinctly explained in Webb v. Commissioner, 394 F.2d 366, 377

(5th Cir. 1968) (quoting Carter v. Campbell, 264 F.2d 930,

935-936 (5th Cir. 1959)), affg. T.C. Memo. 1966-81:

     “Fraud implies bad faith, intentional wrongdoing and a
     sinister motive. It is never imputed or presumed and
     the court should not sustain findings of fraud upon
     circumstances which at most create only suspicion.
     * * * Negligence, whether slight or great, is not
     equivalent to the fraud with intent to evade tax
     named in the statute. The fraud meant is actual,
     intentional wrongdoing, and the intent required is the
     specific purpose to evade a tax believed to be owing.
     Mere negligence does not establish either. * * * ”

We amplified these requirements in Fields v. Commissioner, T.C.

Memo. 2002-320:

          To succeed in the instant case, respondent must
     show that he had a reasonable basis for believing that
     he could prove his allegation of petitioner’s fraud by
     clear and convincing evidence. See, e.g., Rutana v.
     Commissioner, 88 T.C. 1329, 1337-1338 (1987). More
     particularly, he must show that he had a reasonable
     basis for believing that he could prove by clear and
     convincing evidence that petitioner willfully intended
     to evade a tax she believed to be owing.

In Fields, where we found that respondent lacked a reasonable

basis for asserting fraud, we awarded attorney’s fees to the

petitioner under section 7430.   See also Benson v. Commissioner,

T.C. Memo. 2004-272.
                              - 104 -

     When DeCastro wrote to McWade confirming their deal,

respondent had not asserted fraud for any of the Thompsons’

taxable years that were before the Court, in all three of which

the Thompsons had claimed substantial Kersting-related

deductions.   Respondent, in fact, has not asserted fraud charges

against any of the test case or nontest case petitioners with

respect to Kersting deficiencies.    Nor, for that matter, did

respondent even assert fraud charges against Kersting himself,

when respondent issued a deficiency notice to Kersting for his

failure to report more than $11 million of fee income he received

over a 7-year period (1982-88) from the Kersting project

petitioners through his alter ego corporations.    See Kersting v.

Commissioner, T.C. Memo. 1999-197.

     Nor do we believe the facts of the Thompsons’ case would

support an assertion--much less a finding--of fraud against Mr.

Thompson.   Petitioners point to Mr. Thompson’s trial testimony,

in which he “admitted that he had taken Kersting deductions while

believing the debt to which the deductions related would not have

to be repaid.”   We believe this testimony is true and consistent

with our findings in Dixon II and Dixon III regarding the

Kersting shelters.   We further believe this testimony falls far

short of demonstrating, by clear and convincing evidence, that,

by claiming the Kersting deductions, Mr. Thompson specifically

intended to evade a tax known to be owing.    Our skepticism is
                             - 105 -

based upon our perception that charging Mr. Thompson with fraud

in these circumstances would attribute to Mr. Thompson

substantially more knowledge of tax law than he ever had.     When

his 1982 tax return was filed, Mr. Thompson was a retired airline

pilot, who, like more than 1,000 of his colleagues duped by

Kersting, unwisely bought into a spurious tax shelter.

Petitioners apparently would have us accept the proposition that

Mr. Thompson was familiar with the laws governing the deduction

of interest payments where there is some question whether the

taxpayer involved is personally at risk.

     This Court had substantial opportunity to evaluate the

credibility of Mr. Thompson, who testified for 2 days during the

evidentiary hearing mandated by DuFresne.   We found no basis for

suspecting him of fraud; to the contrary, if he had engaged in

fraud, we doubt he would have admitted that he didn’t think he

was personally at risk on the Kersting notes.   Instead, we

concluded that his testimony at the test case trial “was

truthful.”

     More to the point, we believe Mr. Thompson’s true beliefs

are those shown by his letter to McWade dated November 6, 1989.

In this letter, Mr. Thompson expressed his anger and confusion at

the part he had been made to play by the machinations of DeCastro

and McWade:

     I received a check from IRS in the amount of thirty
     thousand dollars--($30,000). I endorsed this over to
                               - 106 -

     DeCastro Law Corp; this did not retire the billed
     amount. I am completely amazed at the billings we are
     receiving. I am now in receipt of additional billings
     that exceed realistic amounts. In fact the total comes
     to sixty six thousand two hundred forty three and
     66/100 dollars ($66,243.66). At some point I know a
     reconciliation will come. Luis [DeCastro] says don’t
     be concerned. I am very concerned, I am the one being
     billed.

                *    *     *    *    *   *    *

     Most emphatically I did not expect to be a channel
     through which IRS funneled funds to any law firm.
     Certainly not in this magnitude. I have the feeling at
     this point that I am correct in this--the bill is to
     [sic] much. I want to know the exact legal position I
     occupy. We have been frustrated long enough. We wish
     to close this chapter.

Mr. Thompson’s reaction as displayed by this letter is not that

of a willing participant in a fraudulent conspiracy; instead,

it’s the outrage of a mark who finally realizes he’s been a tool

in somebody else’s game.

     The two cases cited by petitioners reinforce our conclusion.

In Popkin v. Commissioner, T.C. Memo. 1988-459, affd. without

published opinion 899 F.2d 21 (11th Cir. 1988), and Fried v.

Commissioner, T.C. Memo. 1989-430, affd. 954 F.2d 730 (11th Cir.

1992), the Commissioner determined fraud penalties against tax

shelter promoters who themselves had invested in four types of

tax shelters, involving books, movies, lithographs, and coal

mining.   This Court rejected the Commissioner’s fraud

determinations in the book, movie, and lithograph shelters.    The

Court did, however, sustain the fraud penalties against the
                               - 107 -

promoters for their participation in the coal-mining shelters.

These conclusions were based upon their complicity in backdating

documents and failing to deliver promissory notes.   Here, in

contrast, there is no evidence of Mr. Thompson’s engaging in any

backdating, failure to make delivery, or any other dishonesty

“upon which, in large part” we relied in finding fraud in Popkin

and Fried.

     In sum, there is not now, nor was there ever before, any

basis to assert fraud against Mr. Thompson for 1982.

Accordingly, the period of limitations for that year expired in

May 1986.    That being the case, the Thompsons’ 1982 tax year was

not an open year to which DeCastro’s August 3, 1989, letter to

McWade could have applied.    We find and hold that the Thompsons’

1982 taxable year was not affected by, and was not part of, the

Thompson settlement.59




     59
       In all likelihood, the Thompsons’ 1982 tax year simply
slipped through the cracks as a result of the haphazard operation
of the audit lottery. The record in these cases reveals numerous
other instances in which respondent failed to catch all the
taxable years of all the Kersting deductions claimed by
participants in Kersting’s shelters. For example, test case
petitioners Richard and Fiorella Hongsermeier escaped audit for
their 1981 and 1982 taxable years, and respondent acknowledges
that the IRS “missed” the 1984 through 1986 taxable years of
other Kersting petitioners.
                              - 108 -

           3.   The Thompsons’ 1983 Kersting Deficiency
                and the Disappearing Statutory Notice

     Concerning the year 1983, matters are substantially

different.   Unlike 1982, the Thompsons’ 1983 tax return did not

slip through the cracks.   Instead, respondent’s Fresno Service

Center had prepared a statutory notice of deficiency dated March

17, 1987, disallowing Kersting deductions and asserting a

deficiency of $980.   The statutory notice appears to have been

issued; notations in respondent’s administrative records indicate

that respondent received an inquiry regarding that notice in May

1987.   Nonetheless, no petition on behalf of the Thompsons was

filed in this Court regarding the deficiencies proposed for 1983.

Nor, moreover, did respondent assess or collect the deficiency

determined in the statutory notice.     Instead, for reasons not

explained, respondent’s determination for 1983 was ignored, and

the year was allowed to lapse.

     Early in 1987, when the Thompson statutory notice of

deficiency for 1983 was being prepared, McWade and DeCastro were

actively involved in resolving the Thompsons’ tax matters

pursuant to their original settlement.     In March 1987, McWade

provided a sweetener of the original settlement that slightly

reduced the determined deficiencies for the years before the

Court to bring the reduction up to 20.55 percent.     Additionally,

during the prior December and January, he had helped process the

Thompsons’ interest payments for 1986.
                              - 109 -

     If there were an explanation for the apparent abandonment of

assessment and collection procedures well under way for the

Thompsons’ 1983 taxable year, we would expect respondent to be

able to provide one, but he has not.    Therefore, under the burden

of proof approach we have adopted, we hold that the Thompsons’

escape from a $980 deficiency for 1983 was part of the Thompson

settlement, and that this amount should be included in the

denominator for determining the percentage reduction in Kersting

deficiencies to be afforded all affected taxpayers before the

Court.60

           4.   The Thompsons’ 1983-85 Bauspar
                Deductions

     The Thompsons, like some other Kersting project

participants, apparently deducted substantial amounts as home

mortgage interest on their 1983-85 returns, on the basis of

payments under the Bauspar program that may not have met the

requirements for deductible home mortgage interest.    While

respondent concedes that the Thompsons probably derived a benefit

from overstated Bauspar interest deductions for those years, the

precise amount of that benefit is not readily ascertainable




     60
      The last year for which the Thompsons claimed Kersting
deductions was 1984. As discussed earlier, Revenue Agent Speers
ultimately disallowed the Thompsons’ Kersting deductions for that
year ($7,740) in full, and the Thompsons paid the resulting
deficiency of $1,830.
                             - 110 -

because the payees of claimed mortgage interest are not

identified on the returns.

     Although the Thompsons were audited by the IRS for each of

the 1983-85 years, no deficiencies were ever determined against

them with respect to the Bauspar program, even though, as

respondent’s counsel O’Neill reported:   “There are some other

docketed cases where we have disallowed mortgage interest.”    We

believe that escaping Bauspar deficiencies was an implied term of

the Thompson settlement; while Sims and McWade knew that the

Thompsons had participated in the Bauspar program, the settlement

that they engineered assured that no Bauspar deficiencies were

determined, assessed, or collected from the Thompsons.    Thus, in

the absence of circumstances indicating that the Thompsons’

escape from Bauspar-related deficiencies was not engineered by

Sims or McWade, we conclude that Bauspar relief was part of the

Thompson settlement.61

     Because the amounts of the Thompsons’ Bauspar deductions are

incapable of determination with any precision, and because

respondent disallowed Bauspar deductions only sporadically for a

small number of taxpayers, we deal with this aspect of the

Thompson settlement separately from our determination of the


     61
      In so holding, we do not retract our conclusion in Dixon
III that McWade and Sims lied in testifying that the final
Thompson settlement had the purpose and effect of giving the
Thompsons refunds by way of carrybacks of amounts they had lost
by reason of their participation in Bauspar.
                               - 111 -

percentage reduction in Kersting deficiencies that will apply to

all affected taxpayers.    See infra Part II.G.2.

           5.    The Thompsons’ Deduction of Prepaid
                 Interest on Their 1986 and 1987 Returns

                                1986

     The Thompsons paid $25,545 of deficiency interest on

December 30, 1986.62   Because the Thompsons’ adjusted gross

income for 1986 was relatively low, they ultimately were able to

use only $16,251 of deficiency interest as a deduction on their

1986 return.    Petitioners maintain that respondent should have

disallowed that deduction in its entirety because the Thompsons

did not pay the corresponding amount of the proposed deficiencies

in 1986.

     Petitioners’ argument requires us to examine the state of

the tax law as of December 30, 1986.     At that time, interest on

Federal income tax deficiencies was treated as “personal

interest”, which was fully deductible by the taxpayer making the

payment.   See Robinson v. Commissioner, 119 T.C. 44, 54 (2002).

During 1986, however, the Internal Revenue Code was amended,

prospectively, to add a new section 163(h), which repealed the

deduction for personal interest.    See TRA, Pub. L. 99-514, sec.



     62
      Although the Thompsons purported to pay $59,545 of
deficiency interest on that date (and reported that amount as
deficiency interest expense on Schedule A, Itemized Deductions,
of their 1986 return), the larger of the two checks issued for
that purpose (in the amount of $34,000) was dishonored, and the
Thompsons did not send a replacement check until February 1987.
                               - 112 -

511(b), 100 Stat. 2246.    Under the provision, 1986 was the last

taxable year in which taxpayers could deduct 100 percent of such

personal interest.   TRA sec. 511(e), 100 Stat. 2246.   For the

next year, 1987, only 65 percent of personal interest was

deductible, and the deduction for personal interest was phased

out entirely by the end of 1989.   Sec. 163(h)(6).

     In a news release issued October 23, 1986, the IRS advised:

“Since under the Tax Reform Act of 1986 interest on most tax

deficiencies of individual taxpayers will not be fully deductible

after 1986, taxpayers may wish to pay actual or contested

deficiencies now to obtain the full interest deduction on 1986

tax returns.”   The news release accordingly included, as an

attachment, Announcement 86-108 (Ann. 86-108), 1986-45 I.R.B. 20,

which provided guidance to taxpayers wishing to obtain the full

deductibility of deficiency interest in 1986.

     Under paragraph 4, “General Considerations”, Ann. 86-108

states:   “In general, a taxpayer may not pay interest on a

contested deficiency without simultaneously paying, or agreeing

to pay, the underlying tax deficiency with respect to which the

interest is being paid.”   The “Detailed Instructions” of Ann. 86-

108 describe two situations that arguably apply here.   Respondent

argues that the Thompsons’ situation was governed by section

C.1.b. (“Taxpayers Desiring to Settle Their Tax Court Cases”).

Under this provision a taxpayer whose case is pending before this
                               - 113 -

Court and who “wishes to settle the case on some other basis than

a full concession” is directed to contact respondent’s attorney

or Appeals officer to whom the case is assigned.     Then, “If a

settlement is agreed to, the attorney or Appeals Officer will

prepare the appropriate decision document.”    Id.

     In this case, when they prepaid their interest, the

Thompsons (through DeCastro) had actually reached a settlement of

their liabilities for 1979-1981 with McWade.    McWade prepared the

appropriate decision documents, and he and DeCastro both signed

those documents, which reflected the settlement and contained an

express waiver of the restrictions against assessment and

collection of the liabilities.    Accordingly, as of December 31,

1986, the Thompsons had agreed to pay approximately 80 percent of

the deficiencies originally determined against them, and their

attorney had, in fact, executed decision documents to that

effect.    Under section C.1.b of Ann. 86-108, the Thompsons’

agreement appears to have qualified their payment of deficiency

interest for full deductibility.

     Petitioners argue that another provision of Ann. 86-108

applies.    Section C.1.c. addresses “Taxpayers Desiring to Make a

Payment in 1986, While Continuing to Contest the Asserted

Deficiency in Tax Court”.    That provision directs that, in order

to obtain an interest deduction for payment made in 1986 while

continuing to litigate before the Tax Court, the taxpayer must
                              - 114 -

simultaneously pay the amount of the contested tax deficiency to

which the interest being paid is attributable.   Petitioners note

that the agreement between DeCastro and McWade permitted the

Thompsons to receive the better of their settlement agreement or

the result of the Tax Court proceedings.   Accordingly,

petitioners argue, the Thompsons were, in effect, continuing to

contest the determined deficiencies in this Court within the

scope of Ann. 86-108, sec. C.1.c.    Petitioners therefore maintain

that because the Thompsons prepaid only the interest and none of

the contested tax deficiencies, the Thompsons were not entitled,

under Ann. 86-108 section C.1.c., to deduct the interest.

     In Perkins v. Commissioner, 92 T.C. 749 (1989), a reviewed

opinion with no dissents, this Court held that a payment

designated as accrued interest made after a notice of deficiency

has been issued is deductible in the year paid, even though the

underlying tax has not been paid.    See also Preble v.

Commissioner, T.C. Memo. 1989-208.    We based our holding on two

provisions of the Internal Revenue Code:   Section 163(a), which

permits a deduction of interest without requiring that the

underlying obligation be paid, and section 461(f), which permits

a deduction of interest in the year in which it is paid, even

though the taxpayer’s liability for the underlying debt is

contested.   We concluded that the revenue procedure upon which

section C.1.c. of Ann. 86-108 is based had imposed “an
                              - 115 -

unwarranted restriction” by requiring payment of the obligation.

Perkins v. Commissioner, supra at 760.

     Petitioners argue that we rejected respondent’s restrictions

on the deductibility of interest on contested deficiencies well

after the Thompsons had deducted such interest.     At that time,

they argue, section C.1.c. of Ann. 86-108 operated to deny the

claimed deduction.   Petitioners’ argument, in sum, is that

respondent should have disallowed the Thompsons’ 1986 interest

deduction under an incorrect legal theory.     Petitioners

essentially ask that we include in the denominator of the

settlement fraction a tax benefit to which the Thompsons were

already entitled under a correct application of the law.       We

decline to do so, regardless of whether McWade played any part in

respondent’s allowance of the deduction.

                               1987

     The Thompsons reported deficiency interest expense of

$42,945 on Schedule A of their 1987 return and deducted 65

percent of that amount ($27,914).     See supra note 14.     The

claimed deduction appears to derive from Poltash’s misguided

attempt to carry over the unused portion of the $59,545 of

deficiency interest expense reported on Schedule A of the

Thompsons’ 1986 return.   See supra note 15.    Such a deduction was

improper; the Internal Revenue Code did not and does not permit
                              - 116 -

the carryover of an individual cash-basis taxpayer’s unused

personal interest deduction from one year to the next.

     The Thompsons did, however, make a valid payment of interest

early in 1987, when they issued a valid check for $34,340 to

replace the dishonored check they had mailed the previous year

(the extra $340 was a bad check charge).   As cash-basis

taxpayers, and under the law applicable for 1987, they would have

been permitted to deduct 65 percent of that amount, or $22,100,

as personal interest.   This valid deduction would have been

$5,814 less than the $27,914 actually claimed and used as an

interest deduction on their 1987 return.   If the $5,814 excess

amount deducted were added back to their taxable income for 1987,

the Thompsons’ tax liability would have been increased by $1,624.

     Accordingly, we conclude that for their taxable year 1987

the Thompsons received a modest tax benefit during the time

McWade and DeCastro were colluding to reduce the Thompsons’ tax

liabilities.   There is no evidence that McWade directly

intervened to cause this excess deduction, but there is evidence

that he took an active role in seeing that the prepaid interest

was posted in time to permit full deduction in 1986.   We conclude

that the excess deduction of personal interest in 1987 is

improper and not one that would have been extended to other

affected taxpayers.   Thus, while it is unclear that McWade

undertook any action to secure the improper deduction, it is also
                               - 117 -

unclear that he did not, and he had the access and ability to do

so.   In accordance with the burden of proof we have imposed upon

respondent, and in the absence of circumstances showing that the

Thompsons’ excess interest deduction for 1987 was not engineered

with the collusion of respondent’s counsel, we find that this

benefit was part of the Thompson settlement.     We shall add the

$1,624 tax benefit to the denominator of the fraction that will

determine the percentage reduction in Kersting deficiencies to be

afforded all affected taxpayers.

           6.    The Thompsons’ Attorney’s Fee
                 Deduction for 1993

      On their 1993 tax return, the Thompsons deducted the

additional $51,000 of legal fees paid in that year to DeCastro.

Petitioners maintain that the deduction of legal fees paid to

DeCastro was improper, and that the amounts so deducted should be

included in the Thompson settlement.     We disagree.

      Section 212(3) allows the deduction of legal fees paid or

incurred “in connection with the determination, collection, or

refund of any tax.”   Regulations further provide that “expenses

paid or incurred by a taxpayer for tax counsel or expenses paid

or incurred in connection with the preparation of his tax returns

or in connection with any proceedings involved in determining the

extent of tax liability or in contesting his tax liability are

deductible.”    Sec. 1.212-1(l), Income Tax Regs.
                                - 118 -

     DeCastro obviously represented the Thompsons in “proceedings

involved in determining the extent of tax liability or in

contesting * * * tax liability.”    The Thompsons hired him to

resolve their tax problems.    He did so, not only by negotiating

the settlements with McWade but also by appearing on behalf of

the Thompsons at the trial of the test cases in 1989.

Additionally, after respondent had discovered and disclosed the

misconduct of respondent’s counsel, DeCastro successfully

enforced the terms of the new settlement, over respondent’s

objections, in the Tax Court.    The Thompsons’ payments to

DeCastro clearly satisfy the definition of deductible legal fees.

     Petitioners complain that, in view of DeCastro’s fraudulent

deal with McWade, DeCastro’s legal fees fail to meet the

statutory requirement that they be “ordinary and necessary”

expenses of the Thompsons.    Petitioners’ complaint ignores the

Supreme Court’s holding in Commissioner v. Tellier, 383 U.S. 687

(1966), that legal fees otherwise qualifying as ordinary and

necessary expenses are deductible without regard to public policy

objections.   Although DeCastro appears to have participated in

the fraud on the court, his fees remain deductible for tax

purposes; the basic proposition is that “the federal income tax

is a tax on net income, not a sanction against wrongdoing.”      Id.

at 691.   Moreover, “With respect to deductions, the basic rule,

with only a few limited and well-defined exceptions, is the
                               - 119 -

same.”63   Id.   We conclude that the Thompsons’ payments of

DeCastro’s legal fees generated allowable deductions that were

not a part of the improper tax benefits provided by the Thompson

settlement.

           7.    The Thompsons’ Failure To Report
                 Tax Benefit Income for 1993

     While we agree with respondent that the Thompsons were

entitled to deduct the attorney’s fees paid to DeCastro in 1993,

we agree with petitioners that the Thompsons’ 1993 return is

incorrect in a different respect:    it does not reflect the

Thompsons’ realization of income under the tax benefit rule.

Recall that the Thompsons deducted $44,165 of deficiency interest

expense for 1986-1987 ($16,251 for 1986 and $27,914 for 1987) as

a result of their interest prepayments for the deficiency years

1979-1981.    This Court’s order and decision of August 26, 1992,

which held respondent to the terms of the Thompson settlement,

resulted in the Thompsons’ ultimately paying only $27,506 in

interest for those years.

     This situation should have resulted in application of the

tax benefit rule.    The tax benefit rule is a judicially created

principle that serves to remedy certain disparities inherent in

the use of an annual accounting system for the reporting of



     63
      The statutory exceptions, none of which applies here, are
contained in sec. 162(c), (f), and (g). See sec. 1.212-1(p),
Income Tax Regs.
                               - 120 -

Federal income taxes.    Hillsboro Natl. Bank v. Commissioner, 460

U.S. 370, 377 (1983).    The tax benefit rule rectifies the

inequity that results when a deduction is taken during one

taxable year and later events show that the deduction would not

have been allowable if all relevant facts had been known at the

time of the deduction.    Id. at 383-384.   In operation, the tax

benefit rule requires the taxpayer to recognize the amount so

deducted as income in the year of the later, inconsistent event.

The amount the taxpayer must include in income, however, is

limited to the amount of the deduction that provided a tax

benefit for the prior year.    E.g., Rojas v. Commissioner, 90 T.C.

1090, 1097 (1988), affd. 901 F.2d 810 (9th Cir. 1990).    In the

case at hand, the excess of the $44,165 deducted over the $27,506

actually paid as interest is $16,659.    The inconsistent event

occurred in January 1993, when respondent assessed only $27,506

of interest with respect to the Thompsons’ 1980 and 1981 tax

years on the basis of the decisions entered by the Tax Court in

August 1992.   Respondent in effect refunded the excess $16,659 to

the Thompsons by applying it as a credit toward their $15,000

deficiencies for each of 1980 and 1981.     The Thompsons thus had a

“tax benefit” of $16,659 in 1993 that they failed to report on

their return for that year.

     Although the Thompsons’ failure to include income under the

tax benefit rule was erroneous, it did not result from the
                              - 121 -

intervention of respondent’s attorneys.    To the contrary, by the

time the Thompsons filed their 1993 income tax return, many

attorneys in respondent’s Office of Chief Counsel, at the local,

regional, and national levels, were seeking to control the damage

caused by McWade’s preferential treatment of the Thompsons for

the years 1979-1981.   The misconduct was also before the Court of

Appeals in the DuFresne appeal.   McWade had retired from the IRS,

and Sims had been disciplined by respondent’s Regional Counsel.

Responsibility for the Kersting project cases had been

transferred to Dombrowski and O’Neill.    The sources of the

misconduct in the handling of the Thompsons’ tax matters had been

effectively removed.

      Dombrowski, who was assigned McWade’s duties with respect to

the test cases, did not engage in or perpetuate any misconduct.

He instead found himself faced with DeCastro’s apparently valid

request for a refund of interest accruing on the payments the

Thompsons had paid for their 1979-1981 taxable years.     Dombrowski

approved that refund only after obtaining the approval of his

superior in the Regional Office and only after having some of

respondent’s experienced employees doublecheck his figures.

      During his testimony, Dombrowski did not recall whether he

had told DeCastro about the income tax ramifications of the

refund under the tax benefit rule, but it was not his duty to do

so.   Dombrowski’s approval of a refund of interest and
                              - 122 -

deficiencies was a result of his assignment to take over McWade’s

duties for the Thompsons’ taxable years 1979-1981 that were

before the Court and that had been affected by the misconduct of

McWade and Sims.   There is no basis for finding that Dombrowski

had an affirmative obligation to demand, or intervene in, any

audit of the Thompsons’ 1993 return as subsequently filed in

1994.   To the contrary, any errors of omission or commission in

failing to report the Thompsons’ tax benefit income were the

responsibility of Poltash, their tax accountant, and DeCastro,

their tax attorney.   We therefore conclude that respondent’s

failure to ensure that the Thompsons reported tax benefit income

on their 1993 return (and respondent’s subsequent failure to

adjust the return accordingly) was not part of the Thompson

settlement.

           8.   Payment of Witness Fees to Mr. Thompson

     Petitioners urge that the Thompson settlement includes

respondent’s payment of witness fees and mileage to Mr. Thompson,

who testified in January 1989 at the trial before Judge Goffe in

response to a subpoena issued by respondent.   We have noted that

respondent subpoenaed all the test case petitioners and also paid

Mr. Cravens’s witness fees.   We have also noted that there is no

record evidence regarding any requests for reimbursement of
                               - 123 -

witness fees on behalf of any other test case petitioner.64    Such

requests would have been required in order to obtain

reimbursement, inasmuch as Rule 148(b) in effect provides that

the Commissioner, unlike a private party, is not required to

tender fees and mileage in order to issue a valid subpoena.

     On the basis of this record, we do not believe respondent’s

payment of Thompson’s witness fees and expenses was a benefit

that was unavailable to the other petitioners who testified at

the trial of the test cases.   Accordingly, we conclude that such

payment was not part of the Thompson settlement.   Having so

concluded, there is no need to reach petitioners’ argument that

the payment of Thompson’s fees was a benefit that should be given

effect by subtracting it from the numerator of the settlement

fraction rather than adding it to the denominator.

          9.   Release of Lien on the Thompsons’
               Property and Other Intangible Benefits

     On February 8, 1982, respondent had filed a notice of

Federal tax lien for the unpaid balance due of $23,385.78 for the

Thompsons’ taxable year 1978, which did not involve the



     64
      Rule 148(a) states: “Any witness summoned to a hearing or
trial, or whose deposition is taken, shall receive the same fees
and mileage as witnesses in the United States District Courts.”
Rule 148(b) refers to sec. 7457(b)(1), which provides in turn:
“In the case of witnesses for the Secretary, such payments [of
fees, mileage and expenses] shall be made by the Secretary out of
any moneys appropriated for the collection of internal revenue
taxes”.
                                - 124 -

disallowance of any Kersting deductions.   As detailed in

respondent’s records, the Thompsons made a number of payments on

the liability, which was finally satisfied in September 1987.

Under section 6325(a)(1), the IRS was required to issue a

certificate of release of lien within 30 days (in this case, by

October 7, 1987).   This was not done in a timely fashion.   The

lien was released, however, following a meeting between DeCastro

and McWade in Hawaii late in 1988 at the time of Kersting’s

deposition.   Again, although this relief may have been brought

about by McWade’s efforts, it was not a tax advantage that would

not have been available to other similarly situated taxpayers.

The Thompsons were entitled to have the lien released by

operation of section 6325(a).    We believe that an inquiry by any

other taxpayer’s representative would have produced the same

relief.   We conclude that the release of the lien was not a part

of the Thompson settlement.

     Petitioners argue that the Thompsons received other

“intangible benefits”, including not only “assistance with

getting the tax lien released from their house”, but also “use of

the test-case trial as a platform for defending against Henry

Kersting, and avoiding the collection, litigation, disillusion

and anxiety that have been experienced by the other taxpayers.”

They concede that, in terms of imposing sanctions, “it does not

seem possible to confer those benefits on other taxpayers.”    They
                                - 125 -

urge, however, that such benefits be deemed “ballast” in weighing

the sanctions to be imposed.

     We believe that, in responding as we have to the mandates of

the Court of Appeals, we have accounted for the problems faced by

the other affected taxpayers.    We are painfully aware, as the

Court of Appeals for the Ninth Circuit has observed, that

“Enormous amounts of time and judicial resources have been

wasted” and further that the “taxpayers should not be forced to

endure another trial”.   Dixon v. Commissioner, 316 F.3d at 1047.

We further recognize the urgent need to “equitably resolve this

situation” to the best of our abilities.    Id.   Despite our

rejection of any notion of “ballast” as an impermissible

invitation to fix damages against respondent, we are confident

that our implementation of the mandates, in conjunction with

respondent’s concession cutting short the accrual of interest on

deficiencies, see infra Part III, will provide substantial relief

to all affected taxpayers.

     F.   The Percentage Reduction Summarized

     To summarize our holdings above, we shall direct that the

Kersting-related deficiencies65 for each of the affected

taxpayers are to be reduced by a factor of 63.37 percent; that

is, affected taxpayers will have to pay 36.63 percent of the



     65
      We do not include in that term deficiencies relating to
Bauspar. See infra Part II.G.2.
                               - 126 -

amounts of tax they would have had to pay.    We have calculated

the reduction percentage as follows:

     The numerator is $30,000, representing the total

deficiencies paid by the Thompsons for the taxable years before

the Court, that is, their taxable years 1979-1981.

     The denominator is initially $79,294, representing the total

deficiencies that respondent asserted against the Thompsons for

their 1979-1981 taxable years.    To this sum we add $980,

representing the deficiency the Thompsons escaped paying for the

year 1983 by virtue of respondent’s unexplained failure to follow

up on the statutory notice of deficiency for that year.      We also

add $1,624 to the denominator, which represents the Thompsons’

tax savings attributable to respondent’s allowance of a 1987

personal interest deduction that was overstated by $5,814

($27,914 - $22,100).    The total denominator is thus $81,898.

                       $30,000/$81,898 = 36.63%

     G.   Additional Relief

          1.   Elimination of Non-Kersting Additions

     Although the parties’ stipulation of settled issues can be

read as limiting penalty relief to Kersting-related additions,

see supra Part II.B., respondent does not dispute that

implementation of the Court of Appeals’ mandates includes the

elimination of all penalties and additions, including non-

Kersting-related items such as late filing additions.    We agree
                               - 127 -

and so hold.    It seems especially incongruous to impose an

addition for a few months’ delay in filing a return at this time,

when 25 years have passed since that delay occurred.      All

affected taxpayers are to be relieved of all penalties and

additions to tax that were determined in their statutory notices

of deficiency, not just Kersting-related items such as negligence

additions.

          2.     Allowance of Bauspar Deductions

     We concluded earlier that Bauspar relief was part of the

Thompson settlement.    See supra Part II.E.4.     Moreover,

respondent’s analysis of the Bauspar program indicates that at

least some of the alleged mortgage payments made to Bauspar by

its borrowers would qualify for mortgage interest deductions; as

respondent’s counsel Henry O’Neill (O’Neill) observed:         “real

dollars are involved”.    Accordingly, we shall direct that any

disallowed deductions relating to Bauspar are to be treated as

valid deductions with respect to those taxpayers who may have

claimed them.    That’s the way Bauspar played out for the

Thompsons, and so should it be for the other taxpayers before the

Court against whom Bauspar-related deficiencies have been

determined.

          3.     Elimination of Non-Kersting Deficiencies

     Respondent indicates that perhaps 100 of the affected

taxpayers have non-Kersting-related items in the deficiencies
                              - 128 -

determined against them.   We see no reason to treat those non-

Kersting deficiencies differently from non-Kersting additions.

As with those additions, the resolution of non-Kersting issues

has been delayed much too long.    Rule 142(a), as in effect during

the years at issue, would impose upon those petitioners the

burden of proving those deficiencies to be erroneous.   We think

it would be inherently unfair to impose upon them the risks that

memories have faded and records have been lost or destroyed

during the long delay in resolution of the Kersting issues, a

delay primarily caused by the misconduct of respondent’s

attorneys.   Moreover, we suspect that the non-Kersting issues are

relatively minor when compared to the Kersting-related deductions

that are at issue in all these cases.   We therefore direct that

all non-Kersting-related deficiencies determined in the notices

of deficiency for all affected taxpayers with taxable years still

before this Court be eliminated.

          4.    Attorney’s Fees

     We further recall that respondent made the somewhat empty

concession that the other affected Kersting petitioners should be

reimbursed for any attorney’s fees they incurred during the trial

of the test cases before Judge Goffe.   The concession is illusory

because, as respondent acknowledges, such fees were incurred and

paid by Kersting himself, not by the affected petitioners.
                              - 129 -

     Respondent’s facile concession gives us occasion to observe

that the Court will address the matter of attorney’s fees for

petitioners’ prosecution of these cases on appeal, as well as

petitioners’ attorney’s fees for the conduct of the postmandate

evidentiary hearing, in separate opinions and orders.

III. Interest on Deficiencies and Overpayments

     Respondent has conceded that the accrual of interest on

taxpayer deficiencies ultimately determined by this Court should

be tolled as of June 1992, in accordance with the then Chief

Counsel’s public announcement on January 21, 2003.   Petitioners,

however, maintain that the accrual of interest on any

deficiencies that remain after application of the Thompson

settlement should be halted as of December 31, 1986--the date by

which, petitioners maintain, the fraudulent McWade-DeCastro

agreement was first entered into.

     The protracted nature of these proceedings has exaggerated

the impact of interest upon amounts that are owed by (or owed to)

the affected taxpayers.   Informed by this realization, at a

status conference held in these cases on August 19, 2003, the

Court asked respondent to compare the fiscal consequences of

characterizing the Thompson settlement as (i) a 20-percent

reduction in the deficiencies determined by respondent, (ii) a

62-percent reduction, or (iii) an 80-percent reduction, with
                              - 130 -

interest accruals terminated as of (a) June 1, 1992, and (b)

December 31, 1986.66

     Respondent produced figures that would approximate the

overall fiscal consequences in the scenarios described above.

Respondent further calculated that, if interest on the aggregate

deficiencies were allowed to accrue unabated, it would amount to

almost 6 times the amount of the deficiencies:

     Deficiencies                   $ 27,442,000
     Interest through 12/31/05       155,078,215
          Total                      182,520,215

Respondent calculates that, in the case of a hypothetical

petitioner who owes $10,000 as a result of Kersting deductions

claimed for the taxable year 1980, the accrued interest payable

at the end of calendar year 2005 would have been $86,336,02.

     For taxpayers who prepaid the deficiencies determined

against them, the results would be similarly substantial, but in

their favor.   For example, we have considered the effect of a 62-

percent reduction in deficiencies on a hypothetical petitioner

who had prepaid a deficiency for 1980 of $10,000.   Our


     66
      On Sept. 17, 2003, Sticht, counsel for some of the nontest
case petitioners, filed a motion to strike respondent’s interest
estimates. The Court held that motion in abeyance, without
examining the estimates, until Nov. 16, 2004, when it entered an
order denying Sticht’s motion. We are aware of no authority
indicating that the Court may not be aware of the financial
consequences of the sanction it is being asked to order at the
conclusion of the case before it. In the final analysis,
however, in determining the sanctions to be imposed under the
mandates, the Court has not been influenced by respondent’s
projections.
                              - 131 -

calculations indicate that, in addition to a $6,200 refund of

tax, respondent would owe that taxpayer $59,728 of interest as of

the close of calendar year 2005.

     It is basic that accrued interest will vary depending upon

the amount owed, the time the amount has been owing, and the

rates at which the interest accrues.    The parties differ not only

over the amount owed, that is, the amount of the deficiencies,

but also the time the deficiencies should be deemed to have been

outstanding (there does appear to be a consensus, with which the

Court agrees, that the applicable rates of interest are those

prescribed pursuant to section 6621 and set forth most recently

in Rev. Rul. 2005-62, 2005-38 I.R.B. 557, which adopts the tables

provided in Rev Proc. 95-17, 1995-1 C.B. 556).

     Inasmuch as this Court is a court of limited jurisdiction,

we may exercise jurisdiction only to the extent expressly

authorized by statute.   Sec. 7442; Judge v. Commissioner, 88 T.C.

1175, 1180-1181 (1987); Naftel v. Commissioner, 85 T.C. 527, 529

(1985).   While this Court has jurisdiction to determine

deficiencies in tax pursuant to section 6214, it is well settled

that such jurisdiction generally does not extend to statutory

interest imposed under section 6601.    See Bax v. Commissioner, 13

F.3d 54, 56-57 (2d Cir. 1993); Pen Coal Corp. v. Commissioner,

107 T.C. 249, 255 (1996); LTV Corp. v. Commissioner, 64 T.C. 589,

597 (1975); see also Betz v. Commissioner, 90 T.C. 816, 823
                              - 132 -

(1988); Asciutto v. Commissioner, T.C. Memo. 1992-564, affd. 26

F.3d 108 (9th Cir. 1994).   Section 6601(e)(1) expressly provides

that interest prescribed by section 6601 is treated as tax

“except [for purposes of] subchapter B of chapter 63, relating to

deficiency procedures”.   Because this exception excludes interest

from the definition of “tax” for purposes of section 6211(a)

(defining the term “deficiency”), it follows that such interest

is not treated as part of the underlying deficiency.   See White

v. Commissioner, 95 T.C. 209, 213 (1990).

     In contrast, as we recognized in Lincir v. Commissioner, 115

T.C. 293, 298 (2000), affd. 32 Fed. Appx. 278 (9th Cir. 2002),

section 6601(e) does not curtail our jurisdiction over interest

on overpayments of taxes.   Instead, the Court does have

jurisdiction to redetermine statutory interest where a taxpayer

has properly invoked the Court’s overpayment jurisdiction

pursuant to section 6512.   The cases before the Court, however,

involve both interest owed by petitioners on deficiencies, over

which we arguably lack jurisdiction, and interest owed by

respondent on overpayments, over which we clearly have

jurisdiction.

     This possible divergence in our jurisdictional authority has

the potential, at least, for interfering with our execution of

the mandates of the Court of Appeals, which, we believe, require
                              - 133 -

relief not only to taxpayers to whom respondent owes interest,

but also to taxpayers who owe interest to respondent.67

     We are given further pause by the holding of the Supreme

Court in Commissioner v. McCoy, 484 U.S. 3 (1987).    In McCoy, the

Court of Appeals for the Sixth Circuit issued an unpublished

order following its affirmance--809 F.3d 333 (6th Cir. 1987),

affg. T.C. Memo. 1985-509--of the Tax Court’s denial of special

use estate tax valuation.   In its order, the Court of Appeals had

granted the taxpayer’s request for relief from interest and

penalties, which “now exceed the assessed tax” and ordered the

Tax Court to forgive the interest and penalties “in order to

achieve a fair and just result.”   Id. at 5-6.   In a per curiam

opinion, Justice Marshall dissenting, the Supreme Court held that

the Court of Appeals had exceeded its jurisdiction in ordering

the Tax Court to forgive interest on the determined deficiency in

estate tax and to forgive the statutorily imposed late payment

penalty.   In so doing, the Supreme Court observed:


     67
      The Court is concerned about the parties’ stipulation
filed on June 22, 2005, wherein they apparently seek to remove
from this Court’s consideration the issue of whether any
remittance by an affected taxpayer is an (interest bearing)
advance payment or a (non-interest bearing) cash bond. This
Court is not bound by such stipulation. We believe the mandates
of the Court of Appeals require that interest be paid to all
affected taxpayers who made remittances with respect to Kersting
deficiencies, as was the case with the Thompsons. Inasmuch as we
have jurisdiction over interest on overpayments, we shall direct
respondent to compute and pay such interest to all affected
taxpayers who made remittances with respect to the deficiencies
that had been determined against them.
                              - 134 -

     Plainly, the court of appeals lacks jurisdiction to
     decide an issue that was not the subject of the Tax
     Court proceeding or to grant relief that is beyond the
     powers of the Tax Court itself. [Id. at 6.]

We conclude our discussion of McCoy by noting, as does

respondent, that the Supreme Court, in overruling the forgiveness

of a generally applicable statutory interest accrual on

deficiencies under section 6601 by the Court of Appeals for the

Sixth Circuit, had no occasion to address a court’s inherent

authority to impose sanctions in a case of Government misconduct.

     Moreover, in Estate of Branson v. Commissioner, 264 F.3d 904

(9th Cir. 2001), the Court of Appeals for the Ninth Circuit

adopted an expansive view of the Tax Court’s equitable or

inherent powers.   The court stated:

     “the Tax Court exercises its judicial power in much the
     same way as the federal district courts exercise
     theirs.” Freytag v. Commissioner of Internal Revenue,
     501 U.S. 868, 891, 111 S.Ct. 2631, 115 L.Ed.2d 764
     (1991). This includes the authority to apply the full
     range of equitable principles generally granted to
     courts that possess judicial powers. “Even if the Tax
     Court does not have far-reaching general equitable
     powers, it can apply equitable principles and exercise
     equitable powers within its own jurisdictional
     competence.” Estate of Ashman v. Commissioner of
     Internal Revenue, 231 F.3d 541, 545 (9th Cir. 2000);
     See also Kelley [v. Commissioner], 45 F.3d [348] at 352
     [(9th Cir. 1995)] (Tax Court has equitable power to
     reform agreements between taxpayer and IRS); Buchine v.
     Commissioner of Internal Revenue Service, 20 F.3d 173,
     178 (5th Cir. 1994) (holding that the Tax Court had the
     authority to apply the “equitable principle of
     reformation to a case over which it had jurisdiction”).
     [Id. at 908-909.]
                              - 135 -

It would appear that, in issuing its opinion and mandates in

Dixon V, the Court of Appeals for the Ninth Circuit, consistent

with its opinion in Commissioner v. Branson, supra, adopted the

view that the Tax Court had and has equitable power to resolve

the situation then before it, and now before us.

     More to the point, we regard respondent’s concession not to

collect interest on deficiencies that would otherwise accrue

beyond June 1992 as an appropriately targeted response to the

consequences of his former attorneys’ fraud on the court, which

caused substantial delay in the resolution of the Kersting

project cases.68   We have respondent’s assurance that he will

give effect to the concession; we are satisfied he will do so.

Moreover, in accepting and endorsing respondent’s concession, we

need not and do not reach petitioners’ argument that the Tax

Court has the power and obligation to abate or cancel interest on

deficiencies as of an earlier date.69


     68
      On May 14, 1992, test case petitioners Dixon, DuFresne,
Young, and Hongsermeier had already appealed their test cases,
before the misconduct of respondent’s attorneys was discovered
and disclosed. It is reasonable to assume that the conduct of
their appeals would have caused a delay of at least 1 or 2 years
before the Kersting project test cases would have been finally
decided, even if there had been no such misconduct. In these
circumstances, we would not be inclined, even if our power to do
so were clear, to cancel or abate interest as of an earlier date
than respondent has conceded.
     69
      In any event, we reject petitioners’ citation and
discussion of United States v. Verdugo-Urquidez, 856 F.2d 1214,
1231 (9th Cir. 1988) (Wallace, J., dissenting), revd. 494 U.S.
                                                   (continued...)
                             - 136 -

     In the unlikely event respondent fails to give effect to the

concession (or if there is a dispute about how the concession is

to be applied), there will be time enough to consider whether and

how to address the matter in a collection action or other

appropriate proceeding.

     To give effect to the foregoing,

                                        Decisions will be entered

                                   under Rule 155.




     69
      (...continued)
259 (1990) and Riggs v. Palmer, 22 N.E. 188, 190 (N.Y. App. Ct.
App. 1889), as authorizing (or even suggesting) the proposition
that accrual of interest on Kersting-related deficiencies as
they have been reduced by our application of the mandates should
cease as of Dec. 31, 1986, the date petitioners argue the fraud
commenced.

     Petitioners also argue that interest should not continue to
accrue beyond Dec. 31, 1986, because the result of the final
settlement arrived at in 1989 was to convert the interest
payments made by the Thompsons as of Dec. 31, 1986, into payments
of tax that satisfied their agreed tax liabilities and stopped
any further accrual of interest against them. It suffices to
point out that the Thompsons made the necessary payments around
the end of 1986. Those petitioners who remain in a deficiency/
underpayment posture under the mandates made no such payments,
and interest on their reduced deficiencies therefore continued to
accrue until the effective date of respondent’s concession.
