WILLIAM E. GUSTASHAW, JR. AND NANCY D. GUSTASHAW, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 19668-06
UNITED STATES TAX COURT
Filed August 11, 2011
T.C. Memo. 2011-195
Held: Ps, who concede deficiencies in tax attributable to PH’s participation in a Custom Adjustable Rate Debt Structure (CARDS) transaction, are liable for accuracy-related penalties for gross valuation misstatements or, for 1 year, negligence, on account of resulting underpayments in tax.
William P. Gregory, for petitioners.
Stephen R. Takeuchi and Robert W. Dillard, for respondent.
HALPERN, Judge: By notice of deficiency (the notice), respondent determined deficiencies in, and accuracy-related penalties with respect to, petitioners’ Federal income tax as follows:1
| Year | Deficiency | Penalty Sec. 6662(a) |
|---|---|---|
| 2000 | $3,188,225 | $1,275,290 |
| 2001 | 159,775 | 31,955 |
| 2002 | 85,648 | 17,130 |
| 2003 | 4,492 | 898 |
By amendment to answer to amended petition, respondent increased by $31,955 and $17,130 the accuracy-related penalties he had determined for 2001 and 2002, respectively, for total section 6662(a) penalties for those years of $63,910 and $34,260, respectively. Taking into account both parties’ concessions,2 the only issue for decision is whether petitioners are liable for the accuracy-related penalties of $1,275,290, $63,910, $34,260,
FINDINGS OF FACT
Introduction
Some facts are stipulated and are so found. The stipulation of facts, the supplemental stipulation of facts, the second supplemental stipulation of facts, and the third supplemental stipulation of facts, with accompanying exhibits, are incorporated herein by this reference.
At the time they filed the petition, petitioners lived in Florida.
Background
William and Nancy Gustashaw married in 1971. Two years later, Mr. Gustashaw (sometimes, petitioner3) graduated from Gannon University with a bachelor of sciencе degree in industrial management. While pursuing his degree, he took various business management courses, including courses in managerial cost accounting and the principles of accounting.
From 1973 to 1993, petitioner held management positions with various companies in the food and beverage industry. In 1994, he
Petitioner’s Retirement Plans
Petitioner wished to retire at the age of 50. In 1995, at the age of 45, he began to plan for his retirement. He expected to exercise the majority of his Merck Medco stock options in 1999, or 2000, and, although he had handled almost all of his and Mrs. Gustashaw’s investment decisions throughout their marriage, petitioner sought a financial planner to determine whether the stock option exercise would generate enough income to fund their retirement.
Petitioner and Mrs. Gustashaw hired Ralph Maulorico (Mr. Maulorico), a financial planner at New England Financial. In 1996, upon Mr. Maulorico’s recommendation, petitioner exercised some of his stock options, selling the acquired stock and investing the proceeds in mutual funds.
For all years during thеir marriage, until 2000, Mr. Gustashaw prepared petitioners’ joint Federal income tax returns. In 1997, however, petitioners decided to hire a tax accountant
The CARDS Transaction
In 1999, Merck Medco underwent a reorganization and оffered petitioner the option to retire early. He accepted and retired that same year. In 2000, petitioner exercised his remaining Merck Medco stock options and sold the acquired stock, generating $8,077,376 of income.
That same year, Mr. Maulorico learned of the Custom Adjustable Rate Debt (sometimes, Custom Adjustable Rate Debt Structure; hereafter, without distinction, CARDS) transaction from a colleague and suggested it to petitioner as a possible investment opportunity because of what he thought to be both its profit potential and its ability to shelter the 2000 stock option exercise income. Chenery Associates, Inc. (Chenery), promoted
The transaction works as follows.4 A newly formed Delaware limited liability company (L.L.C.), owned 100 percent by nonresident alien individuals, enters into a credit agreement with a European financial institution (bank) under which the bank extends to the L.L.C. a loan for a term of 30 years with interest payments (but not principal payments) due, generally, annually. The loan may be denominated in either U.S. or European currency (i.e., dollars or euro). The interest rate is set at the London Interbank Offered Rate (LIBOR) plus 50 basis points for the first interest period and reset annually. The bank deposits the loan proceeds directly into the L.L.C.’s account at the bank.
The L.L.C. invests 85 percent of the deposited proceeds in Government bonds and uses the remaining 15 percent to make a short-term time deposit, all of which the L.L.C. pledges as collateral for the loan. To withdraw the loan proceeds, the
If the bank chooses not to maintain the loan for the upcoming interest period, its rejection constitutes delivery to the L.L.C. of a “Mandatory Prepayment Election Notice“, which requires repayment of the loan at the end of the current interest period. The L.L.C. may repay the loan at any time after the first year.
Upon the short-term time deposit’s maturity, the L.L.C. and the taxpayer involved (the taxpayer) enter into an agreement whereby the L.L.C. transfers the deposit’s proceеds, representing 15 percent of the entire loan amount, to the taxpayer in exchange for his assumption of joint and several liability for the L.L.C.’s obligations to the bank, including repayment of the entire loan. The L.L.C. and the taxpayer agree that, as between them, the taxpayer would repay the unpaid principal amount6 of the loan at maturity and the L.L.C. would retain all interest obligations.
The deposit’s proceeds (the taxpayer’s portion of the loan proceeds) are credited to his deposit account maintained at the
The taxpayer may, at the bank’s discretion, withdraw his portion of the loan proceeds after providing substitute collateral on at least a dollar-for-dollar basis. At each annual interest reset date, the L.L.C. may allow the taxpayer to purchase additional portions of the loan proceeds, up to the full principal amount of the loan.7
According to Mr. Hahn, upon converting his portion of the euro-denominated loan into dollars or selling the Government securities in the market, the taxpayer would generate a permanent tax loss of approximately 85 percent of the entire loan amount (the loan from the bank to the L.L.C.). Mr. Hahn further explained that the taxpayer’s only out-of-pocket expense for the entire transaction is an investment banking fee, equal to a percentage of the entire loan amount, payable to Chenery to arrange the transaction.
As discussions with Mr. Hahn progressed, petitioner became interested in the transaction because he understood that it gave him: (1) The potential to generate a tax loss in the first year sufficient to eliminate petitioners’ entire 2000 joint tax liability, (2) access to a large pool of funds, not usually available to individuals, for investment over a 30-year period, and (3) the ability to leverage the euro against the dollar after the first year by drawing down a eurо-denominated loan and repaying the loan in dollars if the euro was valued lower than the dollar at maturity.
In June 2000, petitioner met with Mr. Maulorico and Mr. Gable to discuss the transaction and review the CARDS executive summary, a program overview prepared by Mr. Hahn. After the meeting, Mr. Maulorico “anecdotally” reviewed the transaction’s economics and concluded that, on the basis of past Standard & Poor compound annual returns, it would be profitable to finance long-term investments with the CARDS transaction’s line of credit, promising petitioner that he could make “16 percent on your [petitioner’s] money“. Mr. Maulorico did not accompany his conclusions with a written analysis. Petitioner did not contact other banks to see whether they offered a similar credit arrangement.
Mr. Hahn offered to provide to petitioner a model tax opiniоn letter from the law firm of Brown & Wood LLP (Brown & Wood). Chenery had retained Brown & Wood to produce a tax opinion letter when it first developed the CARDS transaction, and the law firm “stood available” to write tax opinion letters for future CARDS participants.
Mr. Gable informed petitioner of Mr. Hahn’s offer, stating that a tax opinion letter from a major law firm, such as Brown & Wood, concluding that the CARDS transaction would more likely than not withstand an
Despite the fact that the model tax opinion letter was provided by the transaction’s promoter, Mr. Gable viewed it as an “honest opinion of the viability of this transaction” because Brown & Wood was a reputable and “major law firm“. At Mr.
Petitioner was aware that the transaction’s tax ramifications were untested, but he did not seek either a ruling from the IRS on the tax consequences or an opinion regarding the legality, not merely the tax consequences, of the transaction. Instead, he relied on the “credibility” of Mr. Hahn and Brown & Wood, as reported to him by Mr. Gable and Mr. Maulorico.
On July 6, 2000, petitioner asked Mr. Gable, among other things, to: (1) Determine petitioners’ estimated 2000 tax liability, including the income from the Merck Medco stock options exercise, (2) prepare a CARDS investment schedule to create a loss sufficient to offset petitioners’ 1998, 1999, and 2000 tax liabilities, (3) prepare a schedule of rates of return, using reasonable return assumptions, to offsеt the program’s cost and any interest charged by the IRS if generated deductions were disallowed, and (4) complete the program’s after-tax cost using reasonable rates of return if generated deductions were
Mr. Gable’s report, dated August 18, 2000, examined the requested scenarios using exclusively information provided by Mr. Hahn. The report assumed that the CARDS transaction would terminate, prompting the loan’s repayment, on April 30, 2004, a date outside the period of limitations for examination of petitioners’ 2000 joint Federal income tax return. In calculating the earnings generated on tax refunds, Mr. Gable assumed that all tax refunds would be received by June 30, 2001.
Petitioner’s CARDS Participation
Petitioner sent a letter to Chеnery, dated October 5, 2000, agreeing to pay it an $800,000 investment banking fee and enclosed a $10,000 downpayment towards the fee, the balance of which was to be paid upon the loan’s termination. Notwithstanding the $10,000 payment, petitioner remained under no obligation to participate in the CARDS transaction.
After receiving petitioner’s letter, Chenery arranged the CARDS facility, identifying Bayerische Hypo- und Vereinsbank AG (HVB), a German bank, as lender and Osterley Financial Trading LLC (Osterley), a newly formed Delaware L.L.C. wholly owned by two nonresident alien individuals, as the initial borrower.
On December 5, 2000, HVB entered into an agreement with Osterley whereby it extended a €12,900,000 loan to Osterley under
On December 21, 2000, petitioner executed the documents to participate in the transaction. He read the documents before signing them but did not fully understand them. Petitioner did not have an attorney review the documents before executing them, assuming most of the languаge to be boilerplate and the documents merely to formalize his discussions with Mr. Hahn. Petitioner considered the transaction legitimate, believing that Brown & Wood and HVB, a reputable law firm and a major bank, respectively, would not engage in illegitimate transactions. Neither Mr. Gable nor Mr. Maulorico reviewed the transaction documents. The transaction documents did not provide a euro-dollar conversion opportunity during the first year, and the purchase agreement between petitioner and Osterley stated that
On December 22, 2000, HVB released as collateral under the loan €1,577,778 of petitioner’s €1,935,000 portion of the loan’s proceeds, which petitioner converted to $1,448,400. On December 27, 2000, HVB released the remaining portion, €357,222, which petitioner converted to $332,216 on December 29, 2000. Although released, the money remained in petitioner’s account at HVB.
Petitioner received Brown & Wood’s formal tax opinion letter, dated December 31, 2000, and signed by “Brown & Wood LLP“, which arrived at the same “more likely than not” conclusions as the model tax opinion letter. He did not compensate Brown & Wood for either tax opinion letter; Chenery paid the law firm out of the $800,000 fee owed to it by petitioner. Petitioner did not know how much Brown & Wood was ultimately paid for its services.
Mr. Gable reviewed the formal tax opinion letter and read the cited
Wishing to access the loan proceeds (which he had converted from euro to dollars), on April 2, 2001, petitioner pledged substitute collateral, and HVB wired out of his HVB account a
On November 13, 2001, HVB issued to petitioner a Mandatory Prepayment Election Notice, notifying him that the bank was calling in the loan and the entire outstanding principal amount of the loan, including any interest accrued, would be due and payable as of December 5, 2001. Mr. Maulorico asked Mr. Hahn whether another bank would provide the same сredit arrangement; all banks declined. On December 17, 2001, the CARDS transaction was terminated, with all debts satisfied.
Petitioners’ Joint Federal Income Tax Returns for 2000, 2001, 2002, and 2003
Petitioners filed a joint Form 1040, U.S. Individual Income Tax Return, for tax year 2000. Mr. Gable prepared the tax return and reviewed it with petitioners. Form 4797, Sales of Business Property, attached to the Form 1040, reported the CARDS transaction generally in the following terms: On December 5, 2000, petitioners acquired property in a foreign currency transaction pursuant to
The claimed ordinary loss offset all of petitioners’ reported income for 2000, resulting in $1,784,462 of negative adjusted gross income. Petitioners claimed net operating loss carryforward deductions related to the CARDS transaction of $1,231,106, $785,986, and $498,860 on their joint 2001, 2002, and 2003 Forms 1040, respectively.
Respondent’s Examination
Respondent examined petitioners’ joint Forms 1040 for the years in issue. He disallowed the $9,938,324 loss claimed on the 2000 tax return on the grounds, among other, that petitioners failed to establish the claimed $11,739,258 basis and that the transaction lacked economic substance, “was entered into for the primary purpose of tax avoidance, and/or was prearranged and predetermined.” Respondent also disallowed the 2001, 2002, and 2003 claimed net operating loss carryforward deductions because of his adjustments to petitioners’ 2000 return. Finally,
HVB’s Fraudulent Behavior
On February 13, 2006, HVB entered into a deferred prosecution agreement with the U.S. Government in whiсh it admitted that it participated in several tax shelter transactions, including CARDS, between 1996 and 2002 and that the CARDS transactions involved purported 30-year loans, when all parties, including the borrowers, knew that the transactions would be unwound in approximately 1 year so as to generate false tax benefits for the participants. HVB acknowledged that the transactions, therefore, had no purpose other than to generate tax benefits for the participants. HVB further admitted that it engaged in activities with others, including Brown & Wood, “related to the CARDS tax shelter with the intention of defrauding the United States.”
Before trial, and in the light of HVB’s admissions in the deferred prosecution agreement, petitioners conceded the deficiencies in income tax for all years in issue, leaving only the applicability of the accuracy-related penalty at issue. At trial, Mr. Gustashaw admitted that petitioners did not suffer a $9,938,324 economic loss associated with the $9,938,324 tax loss claimed on their 2000 Form 1040.
I. Imposition of the Accuracy-Related Penalty
A. Introduction
The Commissioner bears the burden of production with respect to penalties. See
Respondent detеrmined the accuracy-related penalty, alternatively, upon all three of the above-referenced grounds for the years in issue. On brief, however, respondent states that he determined an accuracy-related penalty with respect to 2003 only on the ground of negligence. We construe that as a concession of other grounds for the penalty for 2003. See Rule 151(e)(4) and (5).
Only one accuracy-related penalty may be applied with respect to any given portion of an underpayment, even if that portion is subject to the penalty on more than one of the grounds set out in
B. Valuation Misstatement Penalty
As stated above,
Respondent argues that petitioners are liable for the 40-percent gross valuation misstatement penalty for taxable year 2000 because petitioners’ claimed $9,938,324 loss resulted from reporting an $11,739,258 basis on their tax return, rather than the correct basis amount of zero. Respondent asserts that the underpayment resulting from the disallowed loss is, therefore, attributable to an overstatement of basis of 400 percent or more of the correct amount. In addition, he argues that the 40-percent penalty applies to the carryover of the loss attributable to the gross valuation misstatement to 2001 and 2002. See
Petitioners argue that the valuation misstatement penalty is inapplicable as a matter of law because respоndent‘s disallowance of their claimed loss in 2000 was attributable not to an overvaluation but rather to the CARDS transaction‘s lack of economic substance and, therefore, its nonexistence. Petitioners
We have previously held the valuation misstatement penalty applicable where a transaction lacks economic substance and the underpayment results from disallowed deductions, credits, or losses computed with оvervalued bases. See, e.g., Zirker v. Commissioner, 87 T.C. 970 (1986) (finding that section 6659, the predecessor of section 6662(a), applies where the transaction lacked economic substance and the underpayment was due to the disallowed deductions and credits caused by a finding of a zero adjusted basis). Indeed, in deciding cases factually similar to the instant case that were appealable to Courts of Appeals other than those for the Ninth and Fifth Circuits, we have expressly distinguished the reasoning of both Klamath and Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990), affg. T.C. Memo. 1988-416, upon which Keller relies. See Palm Canyon X Invs., LLC v. Commissioner, T.C. Memo. 2009-288 (finding Gainer
Petitioners offer no reason for us to deviate from our position, and we are not inclined to do so. Accordingly, we find the valuation misstatement penalty applicable in the instant case. We note that our holding is consistent with the views of many of the Courts of Appeals that have addressed this issue. See, e.g., Zfass v. Commissioner, 118 F.3d 184 (4th Cir. 1997), affg. T.C. Memo. 1996-167; Illes v. Commissioner, 982 F.2d 163 (6th Cir. 1992), affg. T.C. Memo. 1991-449; Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991), affg. T.C. Memo. 1989-684; Massengill v. Commissioner, 876 F.2d 616 (8th Cir. 1989), affg. T.C. Memo. 1988-427.
With respect to the section 6662(h) penalty, respondent bears the burden of production for 2000 and, because he asserted the augmented penalty under section 6662(h) for 2001 and 2002 in the amendment to answer, the burdens of production and proof for
Accordingly, petitioners are liable for the 40-percent accuracy-related penalty under section 6662(h) for tax years 2000, 2001, and 2002 unless they meet the section 6664(c) exception for reаsonable cause and good faith. Because of
C. Negligence Penalty
Respondent contends that, for 2003, petitioners are liable for the 20-percent accuracy-related penalty under
Negligence is defined as a “lack of due care or the failure to do what a reasonable and ordinarily prudent person would do under the circumstances“. Viralam v. Commissioner, 136 T.C. __, ___ (2011) (slip op. at 38). Negligence is strongly indicated where “[a] taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances“.
A return position is not negligent, however, if it is reasonably based on certain enumerated authorities and is not a merely arguable or colorable claim.
Petitioners conceded that they impropеrly claimed the net operating loss carryover deduction on their joint 2003 Form 1040. Their concession is sufficient for us to conclude that respondent
Petitioners, however, failed to do so. Mr. Gustashaw is college educated, has over 20 years of investment experience, and has competently prepared petitioners’ jоint Federal tax returns without the involvement of a tax professional for more than 20 years. Despite this experience, he did not attempt to understand the mechanics of the CARDS transaction, executed the transaction documents without reading them and without an attorney‘s review, and, although aware of the transaction‘s untested tax ramifications, declined to seek a ruling from the IRS. Further, he did not question the claimed carryover loss amount even though he knew that he did not suffer an associated economic loss. Such a “too good to be true” transaction required greater scrutiny. See, e.g., Viralam v. Commissioner, supra at __ (slip op. at 38-39).
Petitioners argue that they were not negligent because the legal authorities underlying the Brown & Wood tax opinion letter provided a reasonаble basis for claiming the 2000 loss and thus
Petitioners also assert that they were not negligent because they made a reasonable attempt to ascertain the correctness of the carryover deduction, a deduction that they seem to argue would not seem to a reasonable and prudent person to be “too good to be true“. They argue that Mr. Gable did not find the
D. Section 6664(c) Reasonable Cause Defense
A taxpayer may avoid the section 6662(a) penalty by showing that he acted with reasonable cause and in good faith.
A taxpayer may demonstrate reasonable cause through the good faith reliance on the advice of an independent professional, such as a tax adviser, lawyer, or accountant, as to the item‘s tax treatment. United States v. Boyle, supra at 251; Canal Corp. & Subs. v. Commissioner, 135 T.C. 199, 218 (2010). To prevail, the
Petitioners assert that Mr. Gustashaw reasonably, and in good faith, relied upon the advice of: (1) Mr. Gable as to Brown & Wood‘s reputation in the legal community, the quality of its tax opinion letter, and the protection that the letter would provide against the possible imposition of penalties; (2) Mr. Maulorico as to the investment potential of the CARDS transaction; and (3) Brown & Wood‘s tax opinion letter.
The only tax advice petitioner sought concerning the CARDS transaction was from Brown & Wood, as neither Mr. Gable nor Mr. Maulorico opined on the tax issues involved. On brief, petitioners’ arguments focus on Mr. Gustashaw‘s lack of knowledge of Brown & Wood‘s subsequently exposеd conflict of interest in advising him.
Petitioners have not carried their burden of proving that they acted with reasonable cause and in good faith in reporting the loss and related net operating loss carryover deductions on their joint Forms 1040 for the years in issue.
Petitioners are liable for the section 6662(a) penalty as applied to the underpayments of tax redetermined herein.
Decision will be entered for respondent.