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T.C. Memo.

1999-101

UNITED STATES TAX COURT

JERRY AND PATRICIA A. DIXON, ET AL. , Petitioners

v. COMMISSIONER OF INTERNAL REVENUE, Respondent*

Docket Nos.

9382-83,

4201-84,

15907-84,

40159-84,

30010-85,

29643-86,

19464-92,

7205-94,

17992-95,

17646-83,

73;23-84,

20119-84,

22783-85,

30979-85,

35608-86,

621-94,

9532-94,

17993-95.

Filed March 30,

1999.

Cases of the followins petitioilers are consolidated

herewithi Ronald L. Alverson and Matt'ie L. Alverson, docket No.

17646-83; Hoyt W. and Barbara D. Young, docket Nos. 4201-84,

22783-85, 30010-85; Anthony E. ancPCarol A. Eggers, docket No.

7323-84; Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84,

30979-85; John L. and Terry E. Huber, docket No. 20119-84;

Terry D. and Gloria K. Owens, docket No. 40159-84; Richard and

Fidella Hongsermeier, docket No. ·29643-86;'Norman -W. and

Barbara L. Adair, docket No. 35608-86; Willis F. McComas, II and

Marie D. McComas, docket No. 19464-92; Wésley Arniand 'and Sherry

Lynn Cacia Baughman, docket No. 6 1-94; Joe Ai and JoAnne

Rinaldi, docket No. 7205-94; Normen A. and Irene Cerasoli, docket

No. 9532-94; Stanley C. and Sharor Ä. Titcomb, do^cket No. 1799295; Richard B. and Donna G. Rogerc, docket No. 17993-95.

* This opinion suppleinents 02r previously filed Memorandum

Findings of Fact and Opinion in Dixon v Commissioneí-, T.C. Memo.

1991-614, vacated and remanded per curiam sub nom. DuFresne v.

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

ÈERVED MAR 3 0

In Dixon v. Commissioner, T.C. Memo. 1991-614,

vacated and remanded per curi m sub nom. DuFresne v.

Com issioner, 26 F.3d 105 (9t Cir. 1994), following a

triallof 14 docketed test cas s of eight Ps, the Court

sustained R's disallowance of interest deductions

claimed by Ps in various tax helter programs promoted

by.K.i After the Court enter

decisions against the

test case Ps in accordance w' h its opinion, R moved to

vacate the decisions entered 'n three test cases (T, C,

and X). R alleged that,;befo e the trial of the test

cases! R's trial attorney and District Counsel had

entered into contingent settl ment agreements with T

änd b that had not been disclþsed to the Court or to

the other test case Ps or th r counsel. R asked the

Court to conduct an evidenti

hearing to determine

whether the undisclosed agree ents with T and C had

affected the trial of the tes cases or the opinion of

the Court .

TheoCourt granted R's mo ions to vacate the

decisions entered in the T a

C cases, entered revised

decisions in the T and C cas s consistent with R's

prior agreements with T and , denied R's motion to

vacate'the decision in the X case, and.denied R's

request for an evidentiarysh aring on the ground that

the testimony, stipulated fa ts, and exhibits relating

to the T and C cases.had no

terial effect on the

Court's opinion as it relate to the remaining test

case Ps.

On appeal, the Court o

peals for the Ninth

Circuit vacated the decision in the remaining test

cases and remanded them to t 's Court with directions

"to conduct an evidentiary h ring to determine the

full extent. of the admitted

ong done by the

government trial lawyers . "

Fresne v . Commissioner ,

supra at 107. The Court of ppeals, citing Arizona v.

Fulminante, 499 U.S. 279, 30

(1991), directed the

Court.to consider "whether t e 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. Further, the Court of Appeals

directed this Court to consicer on the merits all

motions of intervention filec by affected parties. See

id. This Court ordered that lthe cases of 10 nontest

case Ps, the majority of whon had previously signed

piggyback -agreements, be ,contolidated with the

remaining test cases for purposes of the evidentiary

hearing. Three groups of Ps participated in all

subsequent phases of the evicentiary hearing.

Ps .argue (under various theories) that the Court's

decisions in the remaining tE st cases should not be

reinstated, or, in the alterrative, that the piggyback

. .agreements .are not enforceab]e. R counters that the

decisions in the remaining te st cases should be

. reinstated on the ground that Ps were not prejudiced by

the Government misconduct in the trial of the test

cases and that the piggyback agreements remain in

force.

Held: The Government misconduct in the trial of

the test cases did not result in a structural defect in

the trial. Held further: The Government misconduct in

the trial of the test cases resulted in harmless error.

Held further: The Government misconduct in the trial

of the test cases does not provide any other basis for

invalidating the Court's decisions in the remaining

test cases or for setting aside the piggyback

agreements. Held further: As a sanction against R,

program participants who have not been the subject of a

final determination are not liable for time-sensitive

additions to tax for negligence iinder secs. 6653 (a) (2)

and 6653 (a) (1) (B) , I . R . C. , or increased interest under

sec. 6621(c), I.R.C.

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

9382-83, 4201-84, 15907-84, 40159-84, 22783-85, 30010-85, 3097985, 29643-86, and 35608-86.

Robert Alan Jones, counsel for petitioners in docket× Nos.

17646-83, 19464-92, 621-94, .and 9532-94.

Robert Patrick Sticht, counsel for petitioners in docket

Nos. 7323-84, 20119-84, 7205-94, 17992-95, and 17993-95.

Mary Elizabeth Wynne, Steven A. Wilson, Andrew J. Gottlieb,

Milton J. Carter, .Jr. , Robert E. Casey, .and Richard S. Goldstein,

for respondent.

- 4 CONTEl(TS

Page

Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , , , . . . . . . . . . . . . . . . . . 9

FINDINGS OF FACT. . . . . . . . . . . . . . . . . . . . . . ... . . . . . . . . . .; . . . . . . . . . . . .15

Kersting Tax Shelter Programs and Related Matters . . . . . . . .15

A. The Pike Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15

B. Kersting Criminal Investigat Lon. . . . . . . . . . . . . . . . . . . . . . . . . .16

C. Assessments of Kersting PromOter Penalties*. . . . . . . . . . . . . . .18

D. Kersting Notice of Deficienc . . . . . . . . . . . . . . . . . . . . . . . . . . .19

II.

Notices of .Deficiency Issued to Kersting Program

Kersting.Disputes With Program Participants..............55

Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

A. Form of Notices of Deficienc . . . . . . . . . . . . . . . . . . . . . . . . . . . .20

B. Thompson Notices of Deficien y. . . . . . . . . . . . . . . . . . . . . . . . . . .21

C. Cravens Notices of Deficienc . . . . . . . . . . . . . . . . . . . . . . . . . . . .23

D. Alexander Notices of Deficie lcy. . . . . . . . . . . . . . . . . . . . . . . . . .24

1. 1974 and 1975. .......................................25

2. 1976 and 1977 ... ............................. .......26

E. Validity of Notices of Deficiency. . . . . . . . . . . . . . . . . . . . . . . .27

F. Errors in Notices of Deficielcy. . . . . . . . . . . . . . . . . . . . . . . . . .27

III. Commencement of Kersting Pro ject . . . . . . . . . . . . . . . . . . . . . . . .28

A. Tax Shelter Projects and Tes : Case Procedures . . . . . . . . . . . . 28

1. Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28

2 .. National Of f ice Tax Shelt 3r Branch Functions . . . . . . . . . . 30

B. Petitions for Redeterminatio 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

C. Brian J. Seery. . . . . . . . .s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

D. Respondent ' s Counsel . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

1. Kenneth W. McWade . . . . . . . . . . . . . . . . .'. . . . . . . . . . . . . . . . . . . . 33

2. William A. Sims.......................................34

E. Adoption of Test Case Procedares in Kersting Project . . . . . 34

1. The Honolulu Session (Jun3 1985) . . . . . . . . . . . . . . . . . . . . . . 34

2. Test Case Procedure . . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

3. Test Case Array.......................................38

IV. The Maui Session (February 1987) . . . . . . . . . . . . . . . . . . . . . . . . . 42

A. Trial Notices . . . . . . ..:. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

B. Piggyback Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

C. Mr. Seery' s Withdrawals .as Counsel. . . . . . . . . . . . . . . . . . . . . . . 48

1. The Thompsons.........................................49

2 . The Test Cases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

D. Entries of Appearance by Chicoine and Hallett . . . . . . . . . . . . 51

E . Evidentiary Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . : . . . . . . . . . . 54

1. The Maui Session......................................54

2. Dixon I Opinion.......................................55

A. The Thompsons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

1. The Bauspar Program... . . . . . . ". . . . . . .-. . . . . . . . . . . . . . . . . . . . 56

B. The Alexander Dispute . . . . . . . . . . . . . . . . . . . . . ... . . . . . . . . . . . . . 67

C. Collection Actions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1. . . . . . . . 72

1. Steve Hane. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72

2. Deterioration . of Thompsor /Kersting Relationship. . . . . . . 57

2. Carl Mott, -George Vermef , and Robert Peterson. . 1; . . . . . 73

VI.

Settlements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74

Internal Revenue Service Policy. . . . . . ... . . . . . . . . . . . . . . ; . . .74

1. National Office. Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .74

2. Regional Counsel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .76

B. Official Kersting Project Settlement Offer (7-Percent

Reduction of Def iciency or Cut -of -Pocket Expenses) . . . . . . . 77

C. Deviations From Of ficial Prc ject .Settlement Of fer. . . . . . . . 78

1. Modified 7-Percent Settlement Offer. . . . . . . ... . . . . . . . . . 78

2 . 20 -Percent Settlement Offer. . . . .:. . . . . . . . . . . . . . . . . . . . . . 80

3 . Negotiations for 50-Percent Settlement Offer. . . . . . . . . . 82

4 . Revival of 20-Percent Settlement Of fer. . . . . . . . . . . . . . . . 84

The Thompson Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92

2 . First Revision of Thompscn Settlement . . . . . ; .? . . . . . . . . 94

3 . Second Revision of Thompson Settlement . . . . . . . . . . . . . . 98

E. The Cravens Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .100

F. The Alexander Understanding. . . :n . . . . . . . : . . . . . . . . : . . . . . . 106

G. The Kozak Decision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . : . . 115

VI I . Pretrial Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

1. Initial Thompson Settlement Agreement . . ; . . . . . . . . . . . . . . 92

A. The Kersting Deposition--Postponed (January 1987) . : . . . . . 116

B. John Doe Summons/Assessments of Promoter Penalties . . . . . . 118

C. Chicoine and Hallett' s Withdrawal as Counsel. . . . . . . . . . . .120

D. Mr . Izen' s Entry of Appearance . . . . . . . . . . . . . . . . . . . . . . . .120

E . The Kersting Deposition (October 1988) . . . . . . . . . . . . . . . . . .121

VIII. Trial of Test Cases (January 1989) . . . . . . . . . . . . . . . . . . . . . .123

A. Mr. Cravens. . . . . . . . ... . . . . . . . . :. . . . . . :. . . . . . . . . . . . . . . . . .124

B. Mr. Thompson. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . . . . .126

C. Mr. Kersting. . . . ... . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .129

D. Mr. Alexander. . . . . . . . . . . . . . . . ... .·. . . . . . . . . . . . . ... . .». . . . . .130

E. Mr. DeCastro............................................133

F. Comfort Letters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .133

G. Mr. Izen's Introduction of Evidence of Collection.

Litigation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . . . . .135

IX. Posttrial Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137

A. First Thompson Refund. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .137

B. Mr. Izen' s Motion To Reopen Record. . . . . . . . .:. . . . . . . . . . . . .141

C. Dixon II Opinion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .142

D. Disclosure of Thompson Settlement . . . .:. . . . . . . . . . . . . . . . . . . 143

. E . Disclosure of Cravens Settlement . . . . . . . . . . . . . . . . . . . . . . . . 152

F . Respondent ' s Motions To Vacate . . . . . . . . . . . . . . . . . . . . . . . . . .155

G. Attempted Discovery by Counsel for Nontest Case

Petitioners.............................................156

I. Closing of Cravens Cases..-..............................160

H. Closing of Thompson Cases/Further Refunds...............156

PROCEDURAL HISTORY OF EVIDENTIARY HEARING. . . . . . . . . . . . . . . . . . . . .162

Developments Before Evidentiary Hearing.................162

of Inspector General....................................162

B. Revival.of 7-Percent Settlement Offer...................165

C. Disciplinary Actions......!.............................165

D. Indictment of Mr. Izen..................................166

E. Pretrial Conference- (July 1995).........................167

F. Pretrial Conference (January 1996)......................168

G. Denial of Respondent's Moticln To Disqualify Mr. Izen....168

H. Mr. DeCastro's Withdrawal. . . . . . . . . .~. . . . . . . . . . . . . . . . . . . .170

I. Discovery of Alexander Decisions and Referral to

Office of Inspector General.............................170

J. Mr. Izen's Motion To Compel Production of Documents

and Issuance of Protective Crders.......................171

K. Burden of Proof and Rule 145 Order......................173

II. The Evidentiary Hearing...'..............................175

A. Testimony. . . . ... . . . . . . . . . . . . . . . . . . . . ; . ... . . . . . . . . . . . . . . . . .176

1. Mr. Cravens......................................... 176

2. Mr. Thompson.................5..............r!^........178

3. Mr. Alexander. . . . . . . :. . . .~. . . . . . . . . . . . . . . . . . . . . . . . . . . .179

4. Mr. McWade.c......:...................................180

5. Mr. Sims..............................................182

6. Mr..DeCastro.........................................183

. . . 7. Mr. Izen. . . . . . . . . . . . . . . . . . . . . . . .?. . . . . . . . . . . . . . . . . . . .184

B. Mr. Sticht's Allegations of Potential Witness

. . Intimidation............................................186

A. Referral of Thompson and Cravens Settlements to Office

C. Mr. Bradt's June 12, 1996, -letter to Mr. Kersting.......187

D. Denial of Mr. Izen's Motion To Refer Thompson and

Cravens Settlements and Alexander Agreement to

Department of Justice (Public Integrity Section)........189

III. Developments Following Initial Evidentiary Hearing......189

A. Denial of Respondent's Moticn for Further Hearing

.Regarding Potential Witness Intimidation................189

B. Supplemental Evidentiary Hesring (August 18, 1997)......192

C. Denial of Mr. Izen's.Motion To Compel Production of

Documents...............................................194

D. Denial of Mr. Sticht's Moticn To Reopen Record..........195

E. Denial of Mr. Izen's Motion To Take Judicial Notice.....196

F. Denial of Mr. Sticht's Motiens for Release From

Piggyback Agreements....................................198

G. Reports Regarding -the Court's Protective Orders..........199

- 7 -

ULTIMATE FINDINGS OF FACT . . . . . . . . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . 200

OPINION.......................................................202

Burden of Proof.........................................203

I I . Structural Defect . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... . . . . . . . 211

A. Case Law................................................211

B. Arguments...............................................215

C. Summary of Government Miscor,duct........................218

D. Discussion..............................................225

III. Harmless Error Analysis.................................233

. A. Review of Dixon II.......................................236

1. Mr. Kersting's Lack of Credibility...................237

2. Sham Analysis........................................238

3.. Lack of Genuine Debt/Walt z of Funds..................240

i. Subscription Interect............................241

ii. . . Primary Loans . ... . . . . . . . .'. . . . . . . . ... . . . . . . . . . . . . . . 242

iii. Leverage Loans..................................244

4. Collection Litigation.................................244

5. CAT-FIT Plan.........................................245

6. Additions to Tax.......................................247

i. Negligence......................................247

ii. Late Filing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

iii. Substantial Understatement......................247

iv. Increased Interest........................... ...248

B. Discussion..............................................249

1. Mr. Cravens.........................................249

i. Sham Analysis...................................251

ii. Lack of Genuine Debt /Waltz of Funds . . . . . . . . . . . . . 254

2. Mr. Thompson.........................................255

i . Sham Analysis . . . . . . . . . . . . . . . . . . . . . ..... . . . . . ... . . . ..257

ii. Lack of Genuine Debt/Waltz of Funds.............258

iii. Additions to'Tax................................262

3. Mr. Alexander........................................264

4. Summary. . . . . . . . . ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .266

IV.

Fraud, Misrepresentation, ar.d Misconduct................267

Fraud on the Court...................-...................271

A. Case Law Survey.........................................271

B. Discussion..............................................281

VI.

Mr. Izen's Allegations That Mr. DeCastro Was a "Mole"...283

VII.

Enforceability of Piggyback Agreements...................284

A. Principles of Contract Law..............................285

B. Discussion.................-............................290

1. Benefit of the Bargain.. ............................290

2. Mr. Seery's Purported Conflict of Interest...........294

- 8 3. Rejection of Mr. Izen's »rgument for Entry of

Decision On the Basis of Thompson Decisions..........296

VIII. Mary Carter Agreements..................................296

IX.

Mr. Sticht's Motion To Sever Case and for Entry of

Decision or Alternatively Tc Sever Case and Set for

Trial . . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . . . . . . . . . . . ... . . . . . . .300

X..

Protective Orders........................................302

XI.

Sanctions...............................................305

Conclusion.....................................................307

SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION

BEGHE, Judge:

Eight of these consolidated cases--with five

petitioners represented by Joe Alfred Izen, Jr.

(Mr. Izen),--are

test cases before the Court on remand from the Court of Appeals

for the Ninth Circuit in DuFresne v. Commissioner, 26 F.3d 105

(9th Cir. 1994), vacating and remanding per curiam Dixon v.

Commissioner, T.C. Memo. 1991-614

The other 10 consolidated cases--with petitioners in one

case represented by.Mr. Izen and the other petitioners

represented by Robert Alan Jones

Mr. Jones) and Robert Patrick

Sticht (Mr..Sticht)--are nontest cases that have been added to

the consolidated group in order to effectuate the direction of

the Court of Appeals "to consider on the merits all motions of

intervention filed by parties aff cted by this case."

Id. at

107.

Unless otherwise indicated,- aection references are to the

Internal Revenue Code, as amended, and Rule references are to the

Tax Court Rules of Practice and P-ocedure.

Introduction

These consolidated cases are part of a group of more- than

1,300 remaining cases--more than 500 cases have settled--arising

from respondent'stdisallowance of interest deductions claimed by

participants in varlous tax shelter programs promoted by Hen ý

F.K. Kersting (Mr. Kersting) .

Tha Kersting group of cases

(hereinafter the Kersting project) was assigned to Judge

William A. Goffe (Judge Goffe) for disposition.

By agreement of

the parties and the Court, the·merits of the Kersting programs

were to be litigated in a consolidated trial of '14 docketed cases

of eight petitioners that had. been designated as "test cases".

The vast majority of the remainins Kersting project ·petitioners

signed stipulations to be bound . (bometimes referred to herein as

piggyback agreements) in which they agreed with respondent that

their cases would be resolved in Lccordance with the Court's

opinion in the test cases.

Before the trial of the test cases, some test case

petitioners argued that a 1981 setrch of Mr. Kersting's office

had been illegal,. that materials rieized during the search should

be suppressed in the test case proceedings, and that the burden

of proof and burden of going forwerd with evidence should be

shifted to respondent.

(1988)

In Dixon v. Commissioner, 90 T.C. 237

(Dixon I), the Court held, in an opinion by Judge Goffe,

that the petitioners had failed to establish standing to contest

the Kersting search and seizure.

- 10 -

Judge Goffe held the trial of the test cases in Honolulu,

Hawaii, during January 1989.

The najority of the test case

petitioners were represented at trial by Mr. Izen.

However, test

case petitioners John R. and Maydea L. Thompson (docket Nos.

19321-83, 31236-84, and 3Ó965-85) were represented at trial by

Luis C. DeCastro (Mr. DeCastro), and test case petitioners John

R. and E. Maria Cravens (docket Nos. 16900-83 and 15135-84)

appeared - pro sese .

Following the trial of the test cases, the Court issued its

042 memorandum opinion in Dixon v. Comnissioner, T. C. Memo. 1991-614,

62 T..C.M.

(CCH) 1440, 1991 T.C.M.

(RIA) par. 91,614

(Dixon II),

sustaining,virtually all of respondent's determinations in each

of the test cases, and entered decisions against the test case

petitioners in accordance with its opinion.

On March 13, 1992

the Court entered the following decisions

in the Thompson and Cravens cases:

John R. and Maydee L. Thompson

Sec.

Additions to Tax

Sec.

Y_e.gr

Def iciency

6651 (a)

6653 (a)

6653 (a) (1)

1979

$18,161.00

---

$908

---

1981

36, 294 . 52

$4, 934 . 32

---

$1, 958 . 28

1980

24,838.00

---

Sec.

6653 (a) (2)

---

50 percent of

the interest

due on the

deficiency

John R. and E. Maria Cravens

Year

Deficiency

Additions to Tax

Sec. 6653(a)

1979

1980

$4,508.00

5,893.45

$225.40

294.67

- 11 -

On June 9, (1992, respondent filed motions for leave to file

motions to .vacate: the decisions eittered against the Thompsons,

the Cravenses, and another, test case petitioner,. Ralph J. Rina

(Mr. Rina), docket No. 17640-83.

Respondent's motions. to vacate

alleged that,· before the trial of, the. test cases, respondent's

trial attorney, Kenneth W. McWade (Mr. «McWade), and his

supervisor, Honolulu District Courtsel William A.~.Sims (Mr. Sims),

had entered into contingent settlement agreements with the

Thompsons and the Cravenses that hadi not been disclosed to the

Court or to the other test case petitioners or their counsel.

Respondent asked the Court to conduct an evidentiary hearing to

determine whether the undisclosed agreements with the Thompsons

and the Cravenses had affected the trial of the test cases or the

opinion of the Court.

On June 22, 1992, Judge Goffe granted respondent's motions

to vacate filed in the Thompson arid Cravens cases, vacated the

decisions entered in those cases, ordered the parties to file

agreed decisions with the Court, or otherwise move as

appropriate, and denied respondent's request for an evidentiary

hearing.

By order dated June 22, 1992, Judge Goffe also denied

respondent's motion to vacate the decision entered against

Mr. Rina, on the ground that the testimony, stipulated facts, and

exhibits relating to the Thompson and Cravens cases had no

material effect on the Court's Di::on II op1nlon as it related to

Mr. Rina.

- 12 -

On July 22, 1992, the test case petitioners represented by

Mr. Izen filed a motion for reconsideration of the Court's order

denying respondent':s motion to vacate the decision in the Rina

case.

By order dated August 4, 1992, Judge Goffe denied

petitioners' motion for reconsideration.

In August 1992, the Court entered révised decisions in the

Thompson and Cravens cases -consistent with Mr. McWade's prior

agreements with the taxpayers in those cases.

Specifically, the

Court entered the following decisions in the Thompson. and Cravens

cases:

John R . and Maydee L . Thompson v

Year

1979

1980

1981

Deficiency

---

$15,000

15, 000

Additions to Tax

---

-----

John R . and E . Maria Cravens

Year

Deficiency

Additions to Tax

1979

1980

$3,606.40

6,175.76

---'

---

The decisions entered in the Thompson and. Cravens cases are now

final.2

2 Mr. Izen and Mr. Sticht filed separate motions with the

Court to intervene in the Thompsor and Cravens cases. The Court

denied these motions to intervene

Although Mr. Izen and

Mr. Sticht filed separate appeals in the Thompson and Cravens

cases with various courts, including the Courts of Appeals for

the Second, Ninth, and Tenth Circuits, all appeals in the

Thompson and Cravens cases eventually were dismissed. In an

unpublished opinion filed June 15, 1994, the Court of Appeals

for the Ninth Circuit stated:

(continued. . . )

Because of Judge:Goffe's ternination, mon September 30, 1992,

of his recallastatus as a Senior

udge of the Court, all cases in

the Kersting project group were re asigned to Judge Renató Beghe .

The other test case petitioners,1 including .Mr. Rina,

appealed the decisions entiered in their casess to the Court of

Appeals for the.Ninth Circuit'.

Or appeal, those petitioners

argued that the trial of the test cases had been tainted by the

Thompson.and Cravens settlement acreements.

The response of the

Court of Appeals was toevacate the .decisions in the remaining

test cases and remand them to this Court with directions "to

conduct an evidentiary hearing to determine the full extent of

the admitted wrong done by the government trial lawyers."·

DuFresne v. Commissioner, 26 F.3d at 107.

The Court of Appeals,

citing Arizona . v. Fulminante , 499 U. S . 279, 309 (1991) , directed

the . Court to consider "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 ul;held as harmless error. "

DuFresne v. Commissioner, supra at 107.

Further, the Court of

2(...continued) .

The Tax Court's August 25 and 26, 1992 decisions

entering settlement in the Cravens and Thompson cases,

respectively, are finalx

26 U.S.C.

§ 7481(a) (1); Fed.

R. App. P. 13. The Tax Cour lacks jurisdiction to

vacate those decisions. Bil ingsley 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, No. 92,70812,

26 F.3d 129 (9th Cir. 1994) .]

14 -

Appeals directed this Court to corsider on the merits all motions

of intervention filed by parties affected by Dixon II. ·See id.3

On February 2, 1995, respond 254nt

filed a Motion for an

Evidentiary Hearing.

On September 14, 1995, the Court granted

respondent's motion.

To effectuate the« direction of the Court of

Appeals regarding intervention, the Court ordered that the cases

of 10 nontest case petitioners, the majority of whom had

previously signed piggyback agreen.ents, be consolidated with the

remaining test cases for purposes of the evidentiary hearing.'

As a result, three groups of petitioners have participated in all

subsequent phases of the evidentiary hearing:

Test case and

nontest case petitioners represented by Mr: Izen; nontest case

petitioners represented by Mr. Joïes; and.nontest case

petitioners represented by Mr..Sticht.5

The positions taken by

3 The appellate panel in DuFresne v. Commissioner, 26 F.3d

105, 107' (9th Cir. 1994), vacatinc and remanding per curiam Dixon

v. Commissioner, T.C. Memo. 1991-£14, 62 T.C.M.

(CCH) 1440, 1991

T.C.M. (RIA) par. 91,614 (Dixon I)), issued an order stating that

the panel would retain jurisdiction over any subsequent appeal.

* On June 13, 1995, test case petitioner Mr. Rina conceded

his case in full, resulting in ent ry of a stipulated decision in

docket No. 17640-83 that was ident ical with the decision

originally entered in that case oï the basis of the Court's

opinion in Dixon II.

s 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 (Mr. O'Donnell) had ent red his appearance. However,

at the start of the evidentiary hearing, the Court granted

Mr. O'Donnell's motion to sever the Booth case from the cases

consolidated for the evidentiary hearing. Mr. 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

(continued...)

- 15 -

the various groups . of petitioners dtiring . thesel proceedings have

not been consist;ent in call respect s andv in2some arespects the

positions of counsel--primarily Messrs. Izen 'and Sticht--have

become adversarial.

Following pretrial conferences on the record in Los Angeles

on July 17, 1995, nând January 16

1996, the evidentiary hearing

was held at special trial sessione of the Court conducted in Los

Angeles on May 13 to 30 and June ] O ,to 26, 71996, and August 18,

1997.

In the interest öf chronology and as arí aid to understanding

this opiniori, the procedural history of the evidentiary hearing

comes after the Court'.s detailed findings> of fact and before the

ultimate findings of fact.

FINDINGS

F FACT

Kersting Tax Shelter Programe and Related Matters

The Pike Case

Mr . Kersting began promoting tax shelter programs in Hawaii

in the early 1970 ' s .

Mr . 042

Kerst ing ' s early tãx sheltei programs

included an "Auto-Leasing Plan" ar.d an "Acceptance Corporation

Plan. "

Those plans generally r~egtired participants to purchase

s ( . . . continued)

need to participate in the evident.iary hearing.

In Gridley v.

Commissioner, T.C. Memo. 1997-210, the·Court rejected the

argument, raised in the Booths' Motion for Summary Judgment,

that Kersting petitioners who sigtred stipulations to be bound

to Dixon II were entitled to entry of decisions in their cases

consistent with the decision entered by the Court in the Thompson

case at docket No.

19321-83.

See infra pp. 168-169, 171-172, and 187-188.

-- 16 -

stock in a subchapter S leasing corporation or an acceptance

corporation and/or enter into a stbscription agreement.to

purchase stock, all in connection with loans to the participants

by various entities created by Mr.. Kersting.

The plans were

primarily designed to generate income tax deductions for interest

that the participants purportedly paid to the Kersting entities

on the loans.

042

The Commissioner determined that participants in

Mr. Kersting's auto-leasing and acceptance corporation plans were

not entitled to deduct:

(1)

"Interest" that participants claimed

to have paid on eithet the Auto-L(asing stock purchase or

leverage loans;

(2). thesparticipal ts' pro rata shares of losses

or investment credits from the auto leasing companies; and

(3)

"interest" that participants claimed to have paid either on

the acceptance corporation stock purchase or stock subscription

loans.

In.Pike v. Commissioner, 78 U.C. 822 (1982), affd. without

published opinion 732 F.2d 164 (9th Cir. 1984), this Court

sustained the Commissioner's disa _lowances of all deductions for

interest, losses, and credits claimed by participants in

Mr. Kersting's early programs.

Kersting Criminal Investigation

While the Pike litigation waã underway, Mr. Kersting

continued to promote additional tax shelter programs, which came

to be known as the stock purchase plan, the stock subscription

plan, the leasing company plan, and the CAT-FIT plan.

The

- 17 -

Court'Eopinion iirï Dixon II desch.bes the tnechanics oft these

programà in detail.

On January 22, 1981, following an undercover criminal

investigation, the Internal Revenue Service searched

Mr. Kersting's offices in Hawaii pursuant to a -search warrant

issued by the U.S. District Court for the .District of Hawaii.

Seventy-seven boxes and two filing cabinets of irecords were

seized from Mr. Kersting's office

including lists identifying,

by name and addres s , approximatel

1, 80 0 , part icipant s in

Mr. Kersting's programs, and schedules of the interest

purportedly paid by each participant to _one .or more Kersting

companles during the taxable years 1977, 1978, and' 1979.

On January 24, 1981, Mr. Ker ting wrote a. form letter to the

participants of his programs, one of his many "Dear Friend"

letters, stating that he had been entrapped by an undercover

Internal Revenue Service special agent into creating a backdated

"tax deduction" of $21,600.a

By Jetter dated February 15, 1981,

Mr. Kersting provided participanta in his programs. with "tax

reporting notices",. presumably fo: the 19.80 tax year, and

encouraged them to "take full advantage of the .deductions

7 The Kersting. programs involved a number of corporations

(hereinafter Kersting corporations) . Mr. Kersting served as both

a director and president of most af these corporations and also

sometimes owned stock. For those corporations in which he served

as president during the years in issue, he had exclusive

management authority.

8 The record in these cases contains no fewer than 38 "Dear

Friend" letters.

- 18 -

reported to you. "

Mr. Kersting f rther informed participants

that the Internal Revenue Service had "accomplished only a

temporary disruption of our opera ions" and that his office was

"back to almost normal workings".

All records seized in thè

January 22, 1981, search were rettrned to Mr. Kersting by 1987.

In .January 1983, Mr. Kerstinç filed suit in the U.S.

District Court for the District of Hawaii (docket - No . CV-83-0018MP) against the United States, th 254

Internal Revenue Service, and

certain Internal Revenue Service igents alleging, inter alia,

that the January 1981 search was i llegal and that the defendants

had abused the. grand jury process by shopping for a favorable

grand jury, by violating grand ju y secrecy, and by using the

grand jury as a civil investigati n tool.

Through a number of

unpublished orders, the District

ourt and the Court of Appeals

for the Ninth Circuit rejected Mr

'Kersting's claims.

See

Kersting v. United States, 865 F. Supp. 669, 674-675 (D. Haw.

1994) .

Assessments of Kersting Prom ter Penalties

Mr. Kersting's tax shelter a tivities did not lead to an

indictment .

However, in October

989, the Commissioner assessed

promoter penalties of $1, 545, 201

nd $2, 330 , 000 against

Mr. Kersting, pursuant to section

6700 and 6701," respectively,

for the years'1982 through 1988.

The District Court for the

Sec. 6700 provides for im osition of a penalty of a

percentage of the gross income de ived from promoting an abusive

tax shelter, and sec. 6701 provid s for imposition of a penalty

(dontinued...)

District of Hawaii sustained the Cþmmissioner' s assessments .

See

Kersting v. United States, Civil N s. 90-00304, 91-00747, 92-

00593 (D. Haw., Sept. 30, 1994) .

Mr. Kersting's appeal of that

decision to the Court of Appeals

r the Ninth Circuit, docket

No. 94-16942, was argued and subm

ted on May 8, 1996, but

subsequently withdrawn from submi

ion (with an opportunity for

supplemental briefing) until afte

this Court issues its opinion

in these consolidated cases.

Kersting Notice of Deficienc

The Commissioner sent Mr. Ke sting a notice of deficiency

determining deficiencies in and a ditions to his Federal income

taxes for the taxable years .982

hrough 1988.

The deficiencies

were based upon the Commissioner'

determination that cash

payments of so-called leverage lo n interest received by Kersting

corporations, which were characte ized by the District Court in

the promoter penalty cases as "al er egos" of Mr. Kersting, and

which the Court's Dixon II opinio

characterized as fees paid to

Mr. Kersting by program participa ts in- exchange for= tax

deductions, were includable in Mr

Kersting' s gross income .

Mr. Kersting filed a timely petit on for redetermination with

this Court (assigned docke

No. 7 48 96), -and the case was tried

at a Honolulu special trial sessi n that commenced January 27,

1999.

9 ( . . . COntinue

of $1,000 (per incident) upon a p rson who knowingly aids or

assists another in understating h a tax liability.

- 20 -

II.

Notices of Deficiency Issued to Kersting.Program

Participants

In 1982, respondent began to issue notices of deficiency to

Kersting program participants, diEallOwing interest deduCtions

claimed with respect to the stock purchase plan, the stock

subscription plan, the leasing conipany plan, and the CAT-FIT plan

for a number of taxable years.

Form of Notices of Deficiency

The notices of deficiency istued by respondent to many

Kersting program participants usec a common format, stating in

pertinent part as follows:

EXPLANATION OF ADJUSTMENTS

1. It is determined that the following amounts claimed

on your

income tax return as interest deductions

are.not allowable:

Amount

$---------

Purported Payee U°l

Any entity owned, associated

witl, or controlled, either

dir$ctly or indirectly, by

Henry Kersting.

This.disallowance is based oli the determination that

the transactions giving rise to the claimed interest

deduction are shams. This d:.sallowance is further

based upon your failure to entablish that the above

amounts were paid or properly accrued, or that, the

transactions purportedly generating the claimed amounts

resulted either in any bona :!ide indebtedness or in any

enforceable and bona fide ob:.igation to pay

compensation for use or forboarance of money on

indebtedness within the mean _ng of I.R.C. Section 163.

Furthermore, if it is eatablished that any portion

of the above disallowed "intorest" is a properly

1° In some instances, respondent's notices of deficiency

listed specific Kersting corporations under "Purported Payee".

- 21 -

allowable deduction,7it is ftrther determined that such

interest constitutes interest in investment

indebtedhess and deduction of .such amounts is limited

under the provisions of I.R.C. 163(d).

Further, and in -support of a portion-of the

determined deficiency, if yot establish that you are

entitled to the above-mentiored interest deduction, it

is determined that you improperly failed to report the

income resulting from the sane.transaction.

2. It is determined that part of the underpayment of

tax for the taxable year

is due to your negligent

of [sic] intentional disregard of the rules and

regulations. Consequently, the 5 percent addition to

the tax is charged for

ss provided by Section

6653(a) of the Internal Reverue Code.

Thompson Notices nof Deficiency

John R. Thompson (Mr. Thompscn) was a pilot with Continental

Airlines from 1946 until his retirement in October 1982.

Mr. Thompson became aware of Mr. Kersting's programs through a

conversation with another pilot, Fichael Provan (Mr. Provan), who

had solicited other pilots to participate in Mr. Kersting's

programs."

The Thompsons began participating in Mr. Kersting's

programs in 1977."

In addition to their participation in

Mr. Provan, who was at one time the president of one of

the Kersting companies, eventually became an adversary of

Mr. Kersting. See infra p. 66.

Although the Thompsons participated in one of

Mr . Kers ting ' s programs during 19 , 7, the Thompsons did not

claim,any Kersting-related intereEt deductions on their 1977

return because their accountant-return preparer refused to

include them on the return.

The record suggests that the Thompsons' 1978 tax return

was prepared by Phil Scheff (an ancountant recommended by

Mr. Kersting).and that the Thompsons claimed Kersting program

interest deductions on their return for that year. The Thompsons

experienced audit problems with.tbeir 1978 tax return that were

(continued...)

- 22 -

certain programs that were the subject of this Court's opinion in

Dixon I-I, the Thompsons, along with some 40 other investors,

including Mr. Provan, participated in a transaction arranged by

Mr. Kersting in early 1978.to acquire First Savings and Loan

Association of Hawaii ~(First Savings) .

The Thompsons filed joint Federal income tax returns for

1979, ·1980, and.1981 in which they claimed interest deductions

attributable to their participation in certain Kersting programs.

On May 5, 1983, June 13, 1984,. and May 31, 1985, respondent

mailed notices of deficiency to the "Thompsons determining

deficiencies in and additions to their Federal income taxes for

the taxable years 1979, 1980., and 1981, as follows:

Year..Deficiency

Sec.

6651(a)

Additions to Tax

Sec.

6653(a)

6653(a) (1)

1979 $18,161.00

; ---

$908

---

$4,934.32

---

$1,958.28

50 percent of

1980

1981

24,838.00

36,294..52

---

Sec.

6653(a) (2)

---

the interest due

on the deficiency

Respondent further determined that the Thompsons were liable for

increased interest for 1981 pursuaat to section 6621(d)."

The

(...continued)

due, in part, to their failure to attach to.the return a Form W-2

showing the amount of tax.that Continental Airlines had withheld

from Mr. Thompson's wages. In early to mid-1986, the Thompsons'

counsel, Samuel M. Huestis, negotiated a.settlement of their tax

liability for 1978. The record does not disclose the terms of

the -settlement.

Sec. 6621(d) was redesignated sec.r6621(c) by sec.

1511(c) (1) (A)-(C) of the Tax Reforn Act of 1986

99-514, 100 Stat. 2744.

(TRA), Pub. L..

We will hereinafter refer to the

(continued...)

- 23 -

Thompsons filed titnely7 joint petitions for redetermination ·of the

above-described deficieñcies.

Cravens Notices of Deficiency

John R. Cravens was a pilot with American Airlines during

1979 and 198.0.

Mr. Cravens became aware of Mr. Kersting's

programs through conversations with other pilots.

The Cravenses filed joint Fec.eral income. tax returns .for

1979 and.1980 in which they.claimed interest deductions

attributable to their participaticn in certain'Kersting programs.

On April 15, 1983, and March 20, 1984, respondent mailed notices

of deficiency to the Cravenses determining deficiencies in and

additions to their Federal- income taxes for the taxable years

1979 and 1980; as follows:

Year

Deficiency

Acditions to Tax

Sec. 6653(a)

1979

1980

$4,508.00

19,251.70

$225.40

962.59

The notice of.deficiency issued tc the Cravenses for 1979, while

disallowing interest deductions oi $9,810, included a credit for

personal exemptionsvof.$4,000, reculting in a net adjustment of

$5,810.

The notice of deficiency issued to the cravenses for

1980 included disallowed interest deductions of $19,620 and, as

an alternative to the disallowanco of such interest.,; the

inclusion of $18,000 in.unreportec. dividend income from a

Kersting controlled entity known cs Candace'Acceptance Corp.

(...continued)

provision as sec. 6621(c).

- 24 -

(Candace) .

The _notice of deficiency issued 2to the Cravenses for

1980 also included the disallowance of two personal exemptions

claimed for the Cravenses' children.

The Cravenses filed timely

oint petitions for tedetermination contesting the abovedescribed notices of deficiency.

The Cravenses' reporting position was unique among the test

case petitioners insofar as: the Cravenses had adjusted (reduced)

their tax basis in their Candace stock by the amount of a "non-

taxable distribution" from Candace in 1980.

Having reduced the

basis of their Candace stock, the Cravenses reported a capital

gain of $7.,200 on their 1980 tax return after surrendering the

stock to Mr. Kersting in exchange for cancellation and return of

the note evidencing their primary toan.

Alexander Notices of Deficiency

Denis Alexander (Mr. Alexandec) is a broker and investor

who first met Mr. Kersting in Los Angeles in the early 1960's.

Mr. Alexander lent money to Mr. Kecsting's -subchapter S leasing

corporations in the 19'70's, participated in the acquisition of

First Savinc)s, and participated in some of the Kersting programs

at issue in Dixon II.

" Although the Cravenses' reporting position was unique

insofar as they had reported a capi.tal gain in a taxable year ·in

dispute before the Court, we note chat test case petitioners

Robert L. and Carolyn S. DuFresne 2ad also reported a capital

gain (albeit in a year subsequent :o the years in dispute)

upon the surrender of stock in Chacter Financial Corp. to

Mr. Kersting. Like the Cravenses', the DuFresnes' capital gain

was attributable to their reductio2 of the tax basis of their

stock as opposed to an increase in its value.

-. 25 1.

1974 and 1975

Mr. Alexander and his wife, Freida, filed.joint Federal

income tax returns for the taxable years 1974, 1975, 1976, and.

1977.

Following an examination of their -returns for 1974 and

1975, the Alexanders conceded certain adjustments proposed by

respondent, resulting in agreed" assessments of $2,133 and $811

for 1974 and 1975, respectively.15

However, because the

Alexanders declined to agree to other proposed adjustments,

respondent, on November 29, 1979, issued a notice of deficiency

determining deficiencies of $4,891.83 and $40,760.38,

respectively, in their Federal income taxes for 1974 and 1975.

Respondent's deficiency determinations against the

Alexanders for 1974 and 1975 were based, in partfon disallowance

of interest deductions of $2,917 and $46,500, respectively,

attributable to their participaticn in Kersting programs for

those taxable years.

Additional adjustments included

disallowance.of an.$183500 capital loss_ claimed by the Alexanders

for 1974 on_a sale of stock in Mendocino Financial Corp. and

respondent's determination that they had failed to report a

$59,080 capital gain for 1975 froa·a sale of real estate to the

Cadillac Drive Apartments partnership.

is The Alexanders were represented during the audit

by their accountant,.Gilbert Matsumoto (Mr. Matsumoto).. Mr.

Matsumoto had served as the accountant for some of Mr. Kersting's

subchapter S leasing corporations, and Mr. Kersting had

recommended that program participants use Mr. Matsumoto, among

others, to prepare their tax returns.

- 26 -

On February L28, 1980, the Alexanders filed a timely petition

with the Court·, assigned docket No. 2758-80, contesting the

notice of deficiency for. 1974 and 1975.

1976 and 1977

Respondent also.examined the Alexanders' joint income tax

returns for 1976 and 1977.

On. April 17, 1986, respondent issued

the Alexanders _a notice of deficiency determining deficiencies in

and additions to their 1976 and 1977 Federal income taxes, as

follows:

Year

Deficiency

1976

1977

$3,596

876

Additions to Tax

Sec.. 6653(a)

$180

Respondent also determined that the Alexanders. were liable for

increased interest for 1976 pursuLnt to section 6621(c) .

The deficiencies that responcient determined against the

Alexanders for 1976 and 1977 resulted,. in part, from respondent's

disallowance of interest deductiorss of $8, 665 and $12, 993,

respectively, attributable to their participation in Kersting

programs for those years.

Respondent also disallowed a $5,149

partnership loss claimed by the Alexanders for 1976 on their

investment in the Avista Epsilon and Sarbonne partnership.

On July 21, 1986, the Alexanclers filed a petition through

Mr. Kersting's office, assigned docket No. 30413-86, contesting

the notice of deficiency for 1976 and 1977.

- 27 -

Validity of Notices of Deficiency

042

In Dixon II, the Court considered and rejected arguments by

the test case petitioners represer.ted,by Mr. Izen that the

notices of deficiency-issued to them were invalid under Scar v.

Commissioner, 814 F.. 2d 1363

(1983).

(9th Cir . 1987) , revg . 81 . T . C. 855

After the evidentiary hesring in these proceedings, the

Court rejected the Scar argument sdvanced by Mr. Jones on behalf

of a Kersting participant who had2 settledihis case before the

trial of the test cases - in Dixon J I .

See Richards v.

Commissioner, T;C. Memo. 1997-149, supplemented by T.C. Memo.

1997-299., affd. without.published opinion 165 F.3d 917 (9th Cir.

1998)."

Errors in Notices of Deficiency

Although this.Court.rejected.the argument that notices of-

deficiency issued to Kersting program participants were invalid,

it is evident that some-notices. of deficiencylissued to Kersting

program participants did contain errors:

For instance, in

Richards v. Commissioner, supra, it appears that respondent.

overstated the deficiency using an excessive tax rate of 70

percent.

In addition, the petition.filed in the Richards case

included an allegation thatirespondent disallowed interest

Although Luis C. DeCastro had negotiated the settlement

on behalf of Mr. and. Mrs. Richards, he did not participate in the

filing or prosecution of Mr. Jones' motion to vacate the decision

entered in their case.

- 28 -

deductions in excess of Kersting interest deductions that the

Richardses actually claimed."

Similarly, as observed in the Court's Dixon II opinion,

respondent's alternative determinations in the notice of

deficiency issued to the Cravenses overstated their deficiency

for 1980.

The Court ordered-that the Cravenses' deficiency for

1980.be reduced to account for:

(1) The,elimination of

respondent's alternative.determination that the Cravenses failed

to report $18,000 in dividends paid by.Candace; and (2)

respondent's failure.to eliminate the capital gain of $7,200

reported by the Cravenses for 198C on the disposition of their

Candace stock.

....

III. Commencement of Kersting Project

Tax Shelter Projects and Test Case Procedures

Overview

The large volume of cases gererated by the Commissioner's

disallowances of deductions claimcd by taxpayers participating in

large tax shelter programs during the late 1970's and early

1980's created the largest inventcry

the Tax Court.

042of

cases ever docketed in

Among the responses of the Internal Revenue

Service and the Tax Court were the development of procedures that

Test case petitioners Terry D. and Gloria K. Owens

alleged in their petition that respondent disallowed legitimate

interest deductions in their notice of deficiency. However, it

appears that the allegation was nc-t pursued by or on behalf of

the Owenses, inasmuch as the decision entered by the Court in

their case, following the issuance of the Court's opinion in

Dixon II, was consistent with the deficiency determined by

respondent.

- 29 were intended to streamline the .1:.tigatiron process, economize on

the use of administrative and jud:.cial resources, and reduce the

costs incurred by taxpayers in renolving disputes over tax

shelter adjustments.

The Interna.1 Revenue Service, Office of

Chief Counsel, created the Tax Shelter Branch in the National

Office to oversee tax shelter lit:.gation across the country. and

to organize individual tax shelter projects.

Concurrently, the

Tax Court began working with the ::nternal Revenue Service' and

private parties in tax shelter canes to create what became known

as the, test case procedure; i.e., the selection of representative

or test cases from a particular tax shelter project for a single

trial on the merits.

See, e.g., Drobny v. Commissioner, T.C.

Memo. 1995-209 (citing H. Conf. Rept. 98-861, at 985-986

1984-3 C.B.

(Vol. 2) .1, 239-240), affd. 113 F.3d 670

(1984),

(7th Cir.

1997) .

The test case procedure is intended to streamline the

litigation process.

To thise end, taxpayers who are not sel·ected

. as testo cases are encouraged to e2:ecute a piggyback agreement;

i.e., a stipulation to be bound by the outcome of the test cases.

As a practical matter, . the effectiveness of the .test. Case

procedure depends in large part upon the agreement of the

taxpayers not selected as test cases to be bound by the outcome

of the test cases.

Normally, taxpayers in a tax shelter project

who decline orgotherwise fail to nign a piggyback agreement will

either have their cases set for trial with the test cases or,

after the trial of the test cases, will be. ordered to show cause

30 -

why their case should not be decided the same way as the test

cases .

See, e . g . , Krause v. Comm:.ssioner, 99 T . C: .132 (1992 ) ,

affd. sub nom. Hildebrand v. Comm:.ssioner, 28 F.3d 1024

Cir.

1994); Acierno v. Commissioner, T.C. Memo.

Karlsson v. Commissioner,: T.C. Meno. .1997-432.

(10th

1997-441;

Using the order

to show cause procedure to dispose of nontest cases in a tax

shelter project .is more cumbersome and consumes more time .and

judicial, administrative, and private party resources than using

piggyback agreements .

As: discussed in greater detail below, the

Court used the test case procedura in the Kersting project; the

vast majority of the Kersting pro:ect participants signed

piggyback agreements.

See infra pp. 34-41.

National Office Tax Shelter Branch Functions

The Tax Shelter Branch, established by the Office of Chief

Counsel in the National Office, wus given the responsibilities of

coordinating the examination, appeals, and litigation functions

and of overseeing tax shelter projects from the National Office

perspective .

The Tax Shelter Branch provided advice and prepared

material for use by the field in tax shelter cases, reviewed

legal briefs, .monitored the statu

of tax shelter case inventory,

and prepared reports for Internal Revenue Service executives.

The. Tax Shelter Branch monitored tax shelter projects by

reviewing and extracting informat:.on .from quarterly tax shelter

reports that were required to be nubniitted by the project

attorney; i.e., the District Counnel trial attorney with primary

responsibility for the project .

ach project attorney was

- 31 -

required to submit a quarterly ta:

shelter report providing an

update on the status of the projec t, including a summary of the

current project settlement offer and any fecent court action

affecting the project.

One of the goals of the tax 13heltef'program was consistent

treatment of similarly situated taxpayers.

The Táx Shelter

Branch monitored settlement offers in similar tax shelter

projects for disparities and tried to determine whèther the

project settlement offers should be similar. .However, actual

supervisory responsibility in a tax shelter project was left

primarily in the Regional' Counsel and District' Counsel offices

to which the project was assigned.

-Petitions for Redetermination

In or around June 1982, Mr. Kersting facilitated the filing

of petitions with the Tax Court bv Kersting program participants.

In letters issued in June and Jul

1982, Mr. Kersting informed

Kersting program participants that a joint petition was being

prepared on behalf of a large gfouþ of taxpayers.

On July 12,

1982, Lu N. Nevels, Jr., filed a consolidated Tax Court petition,

assigned docket No. 17445-82, on behalf of 60 Kersting þrogram

participants.18

18 Lu N. Nevels, Jr., had represented the test case

taxpayers in Pike v. Commissioner. 78 T.C.'822 (1982), affd.

without published opinion 732 F.2ci 164 (9th Cir. 1984). For an

example of the problems created by using oné petition on behalf

of so many different petitioners, see Aaronson v. Commissioner,

T.C. Memo. 1985-131, involving the Hongsermeier petitioners in

what is now docket No. 29643-86. See infra p. 38.

- 32 -

Brian J. Seery

In early 1982, Brian J. Seery (Mr. 'Seery) began assisting

Kersting program participants with issues arising from the audit

of their income tax returns.

On April 14, 1982,3 Mr. Kersting

issued a . letter to Kersting program participants informing them .

that they soon would receive sa letter from the Commissioner

proposing to disallow their Kerstung program interest. deductions.

Mr. Kersting advised program part;.cipants that they should not

remit any amount to the Internal Itevenue Service until their

liability was determined in 3pourt

042On February:15, 1983, Mr.

Kersting issued a letter to Kerst:.ng program participants stating

in pertinent part:

"I trust that you have placed the tax

retrievals which we have accomplished for you over the years into

profitable investments and that you are receiving a reasonable

rate of return.

You will .not losm any ground if your funds earn

at least a return equal to ;the ini erest charges imposed by the

IRS from time to time."

On March 1, 1985, Mr. Kersting issued a -letter to Kersting

program part:icipants stating: that he had retained Mr. Seery to

represent them in the Tax Court at no charge to the individual

petitioners."

The letter requestod that each Kersting program

participant provide written autho"ization for Mr. Seery's

Initia'lly, Mr. Kersting oc the entities that he

controlled paid the legal . fees asaociated with the Tax Court

litigation. Later, however, some Kersting program participants

began paying $100 per month to a .egal defense fund managed by

Mr. Kersting.

representation.

In a letter to program participahts dated August

11, 1986, Mr. Kersting; recommendect that program 'participants not

attempt to resolve their cases on their own and instead rely on

counsel that he had hired.

Mr.. Seery subsequently entered his appearance in the Tax

Court on behalf of several hundrect Kersting petitioners,

including the Thompsons and the Cravenses. 'Mr. Seery's

compensation for legal services rendered to Kersting program

participants was always paid by one of the corporations

controlled by Mr. Kersting. .

Respondent's Counsel

Kenneth W.. . McWade

In 1970, Mr. McWade began hi

career as a trial attorney

with. the Office of Chief Counsel.

Mr. McWade's. duties with the

Of·fice of Chief Counsel.included litigating tax cases.

In January 1982/ Mr. McWade transferred from respondent's~

District Counsel office .in Seattle , Washington, to respondent's

District Counsel office in Honolulu, Hawaii...

initially assisted with the Pike

Mr. McWade

roup of cases.

On or about

July 1, 1984, the Kersting project was officially established in

the Honolulu Appeals Office, and Nr;. McWade was appoiñted'to

serve as the project -attorney.

W2 lly Kobayashi was appointed to

serve as the .key Appeals officer f or the Kersting project.

By late 1986, Mr. McWade had litigated 40 to 50 Tax Court .

cases.

However, Mr. McWade-had never litigated any cases that

were part of a tax shelter project .

- 34 -

William A.. Sims

In 1972, Mr. Sims began his. career with the. Office of Chief

Counsel, General Litigation Division, National Office.

Except

for a 6-month assignment doing Ta>: Court work, Mr. 'Sims handled

general litigation matters concerr.ing collection, bankruptcy, and

tax liens.

Mr. Sims eventually became Assistant Director of the

General Litigation Division in the National Office.

In February 1986, Mr. Sims w2 s appointed District Counsel

for Honolulu, Hawaii.

Before his. appointment as District

Counsel, Mr. Sims had never workec on a tax shelter project in

any capacity.

Adoption of Test Case Procedures in Kersting Project

The Honolulu Session (J ne 1985)

The Court set for. trial the c ases of approximately 375

Kersting program participants at

Tax Court session scheduled to

commence on June 10, 1985, in -Honc lulu, ~Hawaii (the June 1985

session) .

Before the June 1985 . session, Mr. McWade and Mr. Seery

agreed to use the . test case procecure in the Kersting project .

During the -June 1985 session, Mr. McWade and Mr. Seery discussed

the use of the test case procedurc with Judge Goffe during a

chambers conference.

Judge Gof fe, that

During the conference, Mr.' Seery informed

although he was representing petitioners who

were Kersting program participante , he was beiñg paid by Mr.

Kersting.

Judge Goffe indicated that-he saw. no conflict of

interest as long as Mr. Seery had not participated in the

- 35 planning or promotion of the Kersting programs .

See Rule

24 (f) .2o

Consistent with :counsels' agreement to use the test case

procedure . in athe Kersting project

Judge Goffe granted the

parties' joint motions to continue the cases called at the June

1985 session. . At the same time, the parties began filing

piggyback agreements (discussed in greater detail below) , which

they did in the vast majority of the Kersting project cases.

Mr. Seery reported the results of- the June 1985 proceedings

to Mr. Kersting and 'kept him abreast of developments.

Mr. Seery

relied upon' Mr. Kersting to distr::bute correspondence from

Mr. Seery to .petitioners in:the Kursting project.

Test Case Procedure

Mr. McWade and Mr.. Seery agreed to select test cases that

would be representative of all the Kersting programs for all

years in dispute, including the taxable years 1975 through 1983 .

At the time that Mr. Seery selectod his test 'cases, he assumed

that the test case petitioners would bear the burden of proof,at

trial.

In selecting test· cases, Mr. Seery was not concerned with

whether a case involved other tax issues.^ Mr. Seery was simply

looking for cases ,"where someone did everything right . "

2° Rule 24 (f), which became effective n dufy 1, 1990, see

93 T.C. 857, addresses conflicts of interest in Tax Court

litigation. Rule 24 (f) was redes .gnated Rule 24 (g) veffective

Aug. 1,

1998.

See 109 T.C. 542.

_ 36 -

Mr. Seery selected two or three test cases, including the

Cravenses and the Hongsermeiers .

In an effort to find the best; cases for trial from

petitioners' point of view, Mr.·.Seery selected test cases by

reference to the manner in which t,he taxpayers had reported the

transactions.

Mr. Seery selected test cases that he thought he

could win, but, as he testified at; the evidentiary hearing, he

had difficulty identifying such cases in addition to the

Cravenses and the Hongsermeiers ."

Mr. Kersting and Mr.' Cravens discussed having Mr. Cravens'

case serve as a test case. . Mr. Kersting told Mr. Cravens that

Mr. Seery wanted to use him as a t est case because, unlike other

Kersting program participants, the Cravenses had reported a

capital gain when they surrendered their stock in the Kersting

holding company in conjunction wit h the annual termination of the

Kersting program!

The Cravenses' reporting position was

consistent with Mr. Kersting's advice to program participants

that distributions. by Kersting ho]ding companies used by program

participants to pay the principal amount of leverage loans were

tax-free returns of capital rather than taxable dividends.

Mr.. Seery. viewed the Cravens cases. as "unique" in this respect.

Mr. Cravens believed that he had a choice whether his case

would serve as a test case.

When Mr. Cravens agreed to have his

Mr. Seery's testimony:

":: was having trouble selecting

cases beyond those two that I thotght would be good vehicles for

that."

- 37 case serve as a test case, he did.so without condition.

believed that he would win his case because he had correctly

reported his tax liabilities, as reduced by reason of his

participation in the Kersting pro rams.

Mr. Seery selected the Hongs rmeier case because it was his

impression that the Hongsermeiers had used their own funds to pay

the principal of a Kersting levertige loan, rather than using a

"nontaxable distribution" from a Eersting holding company 22

Mr. Seery also selected the Hongsermeiers because they had

participated in the CAT-FIT progr2.m, which Mr. Seery viewed as

the strongest Kersting program from the standpoint of sustaining

the interest deductions claimed.

Mr. McWade analyzed between 400 and 500 project cases; he

selected test cases thatuhe thought would be representative of

all Kersting programs for all years in dispute.

Mr. McWade

selected "clean" cases; i.e., cases that did not include issues

other than Kersting interest deductions.

Mr. McWade tried to

avoid cases that were unique or at pical of the Kersting

programs.

Although Mr. McWade selected at least five of the test

cases, he could not recall the sp(cific cases that he selected.

In June 1986, Mr. McWade and Mr. Seery agreed on the dockets

that were to serve as the test cases.

By letter dated June 10,

22 Mr. Seery's impression wan not quite :right. The Court

found in Dixon II that the Hongsermeiers were unique insofar as

they paid $250 per month out-of-pocket (rather than use the

proceeds.from a leverage loan) to satisfy the interest due on

a CAT-FIT primary loan.

See Dixon II, 62 T.C.M.

1991 T.C.M. (RIA), at 91-3023.

(CCH) at 1480,

- 38 1986, Mr. McWade notified Judge Goffe that he and Mr. Seery had

selected the following 14 dockets to serve as test cases with

respect to the Kersting project:

Case Name

Docket No.

Dixon v. Commissioner

9382-83

Cravens v.. Commissioner

16900-83

Rina v. Commissioner

Thompson v. Commissioner

Young v. Commissioner

Cravens v. Commissioner

DuFresne v. Commissioner

Thompson v. Commissioner

17640-83

19321-83

4201-84

15135-84

15907-84

31236-84

Owens v. Commissioner

40159-84

Young v. Commissioner

Thompson v. Commissioner

DuFresne v. Commissioner

Hongsermeier v. Commissioner

22783-85

30010-85

30965-85

10979-85

129643-86

1 By order dated Aug. 13, 1986, the Court severed the

Hongsermeiers from docket No. 17405-82 (the Aaronson consolidated

petition filed by Mr. Nevels) and assigned them new docket No.

29643-86. See supra note 18 and accompanying text.

With the exception of the Cravens case assigned docket No.

16900-83, and the Hongsermeier case assigned docket No. 17445-82,

each of the test case petitioners had filed pro se petitions.

August 1986, Mr. Seery had entered his appearance in each of the

test cases with the exception of t.he Young cases assigned docket

Nos. 4201-84, 22783-85, and 30010- 85, the DuFresne case assigned

docket No. 30979-85, and the Thompson case assigned docket No.

30965-85.

Test Case Array

The test case petitioners had participated in Kersting

programs during the taxable years 1975 through 1983 as follows:

- 39 -

Taxable Year 1975

Program

Petitioner (s)

CAT-FIT

MAURIER LEASING

NORWICK 20/20

Owens

Taxable Year 1976

Program

Petitioner (s)

UNIVERSAL LEASING

FORBES 30/30

Owens

Taxable Year 1977

Program

Petit ioner (s)

CAT-FIT

ESCON LEASING

FARGO 30/30

NORWICK 20/20

Dixon

Owens

Taxable Year 1978

Program

Petitioner (s)

CAT-FIT

UNIVERSAL LEASING

ESCON LEASING

MAHALO 30/30

MAHALO 60/60

Hongsermeiere

Dixon

Hongsermeier

Dixon

Hongsermeier

Owens

Dixon

Taxable Year 1979

Program

Petitioner (s)

CAT-FIT

UNIVERSAL LEASING

ANSETH LEASING

ESCON LEASING

CANDACE 60/60

Hongsermeier

Dixon

Hongsermeier

Rina

Young

Hongsermeier

Dixon

Thompson

Dixon

Cravens

Rina

- 40 Thompson

Young

CANDACE 60/60

CHARTER 80 , 000

CHARTER 120 , 000

INVESTORS 80 , 000

INVESTORS 12ò, 000

Rina

Young

Rina

Young

Taxable Year 1980

Program

Petitioner(s)

CAT-FIT

Dixon

DuFresne

CAT-FIT

Hongsermeier

ANSETH LEASING

ESCON LEASING

Hongsermeier

Rina

Young

Dixon

ESCON LEASING

CANDACE 60/60

DELTA 40/40

DELTA 60/60

CHARTER 40 , 000

CHARTER 80 , 000

CHARTER 120 , 000

CHARTER 120 , 00 0

INVESTORS 80 , 000

INVESTORS 80, 000

INVESTORS 80 , 000

INVESTORS 120 , 000

Hongsermeier

Thompson

Cravens

Rina

Hongsermeier

Cravens

Dixon

DuFresne

Rina

Thompson

Young

Rina

Dixon

DuFresne

Thompson

Young

DuFresne

Rina

Thompson

Dixon

Young

Taxable Year 1981

Program

Petitioner(s)

ANSETH LEASING

ESCON LEASING

DELTA 60/60

CHARTER 120 , 0 0 0

CHARTER 120, 000

CHARTER 120 , 00 0

Young

Dixon

Young

Dixon

DuFresne

Young

41 INVESTORS 80, 000

INVESTORS 120 , 0 0 0

DuFresne

Dixon

Young

Taxable Year.1982

Program

Petitioner (s)

ANSETH LEASING

CHARTER 120 , 000

CHARTER 120 , 0 00

INVESTORS 80 , 00 0

INVESTORS 120 , 0 00

Taxable . Year 1983

Program

Young

DuFresne

Young

DuFresne

Young

ANSETH LEASING

CHARTER^120 , 000

INVESTORS 80 , 000

Petitioner (s )

Young

DuFresne

DuFresne .

1 Maurier Leasing, a subch. S leasing program, was

considered by the Court in Pike v. Commissioner, 78 T.C. 822

(1982) .

The notice of deficiency issued to the Thompsons for the

taxable year 1981 states in pertin nt part:

"Based on

examination information from the 1978, 1979, and 1980 returns,

the investment interest is .generated from the interest deduction

tax shelter.

The purported payees cannot be identified from the

1981 income tax return filed by the taipayers."

Respondent has

not been able to identify specifically the Kersting programs that

the Thompsons participated ;in during 1981. ' However, the record

suggests that, in addition to the ^I:ersting programs that the

Thompsons participated in during 1979 and 1980, the'Thompsons

participated in the Anseth Leasing Program during 1981.

If the Thompson and Cravens cases had been removed from the

test case array, there would have been no reduction in coverage

- 42 -

of the test cases.

In other words, each program in which the

Thompsons and Cravenses participated during the years in issue

was also a program before the Cour; in which one or more of the

other test case petitioners had pacticipated.

IV.

The Maui Session (February 1937)

After Messrs. Seery and McWad3 had selected the test cases,

they initiated settlement negotiations and began to prepare the

test cases for trial.23

Their trial preparations included work

on a proposed stipulation of facts and an attempt to take

Mr. Kersting's deposition.

During this period (June 1986 or

thereabout), Mr. Seery and Mr. Kerating's attorney, L.T. Bradt

(Mr. Bradt), discussed using the.1381 search of Mr. Kersting's

office as a basis for filing a motion to shift the burden of

proof to respondent in the test cases

Trial Notices

By letter dated July 30, 1986, Judge Goffe informed

Messrs. Seery and McWade that.the

est cases would be set for

trial during a special session of :he Court commencing on

February 9, 1987, in.Wailuku, Maui

Hawaii (the Maui session).

Judge Goffe's letter also informed Messrs. Seery and McWade that

he intended to notify each Kersting petitioner who had not filed

a piggyback agreement that his or her case would be set for trial

during the Maui session.

042

23 Settlement negotiations between Mr. McWade and Mr. Seery

are discussed in greater detail inEra pp. 78-80.

- 43 In August 1986, the Court issued orders setting the 14 test

cases for trial during the Maui seusion.

By letter dated

August 5, 1986, Judge Goffe informnd all Kersting petitioners who

had not already executed piggyback agreements that their cases

would be set for trial at 'the Maui session unless they executed

piggyback agreements by September ±9, 1986.

Judge Goffe's letter

states as follows:

hugust 5, 1986

Dear

Dkt #

Your case involves matters concerning promotions

by Henry Kersting. Cases with issues identical to the

issues in your case haVë been set for trial on

February 9, 1987, at the courtroom of the Circuit Court

for the Second Circuit .in Wailuku, Maui, Hawaii.

In order to conserve the time and expense of the

taxpayers, the government and the Court, all of the

cases with identical issues w:.ll be tried at one time

unless the parties agree in advance, in writing, to be

bound by the outcome of the cases set for trial.

most of the pending cases, thÅ parties have so agreed

to be bound.

You should contact atiyour earliest: convenience the

lawyer for the government in the Kersting cases if you

decide to agree to be bound. He is Mr. Kenneth McWade,

PJKK Federal Building, Room 3304, Box 50089, 300 Ala

Moana Boulevard, Honolulu, Hagaii 96850

His telephone

number is (808) 546-7333. r If however, you do not wish

to be bound, you should advise my office promptly, in

writing at the above address, in order that your case

may be set for trial on February 9, 1987.

In either

event, you must advise Mr. McHade or me by

September 29, 1986.

If you fail to advise Mr McWade by September 29,

1986, that you wish to be bound and have executed a

stipulation to be bound by that time and if you fail to

advise me by September 29,- 1936, that you wish to have

your case set for trial, it wull automatically be set

for trial on February 9, 1987

If-your case is set for

trial and you do not appear f or trial,p your case will

likely be dismissed and you will be required to pay all

of the -income tax which. the government contends you

owe) plus interest thereon as provided by law.

William A. Goffe

Judge

In November 1986,. the Court issued orders notifying Kersting

petitioners who had not filed pigcyback agreements that their

cases were set for trial at the Maui session.

As additional

Kersting project cases were docketed and identified, the Court

issued orders setting them for trial at the Maui session, subject

to being stricken if the parties executed a piggyback agreement .

Piqqyback Agreements

As early as June 1985, Kersting program participants had

begun executing piggyback agreements (1985 piggyback

agreements);2' drafted by Messrs. McWade and. Seery, that stated

as follows:

Stipulation of Settlement for Tax Shelter Ad-justments

With respect to all adjustments in respondent's

notice of deficiency relating to the Kersting interest

deduction tax shelter (s) , thel parties stipulate to the

following terms of settlement:

1. The term Kersting programs refers to interest

expense deductions or other related deductions

associated with various programs promoted by Henry

Kersting.

2. The Kersting program deduction.adjustments

shall be redetermined on the same basis that the same

program adjustments are resolved with respect to

taxpayers trying the same program adjustments at the

24 Before 1987, there was no uniform format for piggyback

agreements.

In.1987 or early 1988, respondent's Tax shelter

Branch issued a standard form of piggyback agreement .

June 10, 1985 session of the . < ourt in Honolulu, Hawaii,

or such session as. these casea may be adjourned or

continued to by the Court (he::einafter "TRIED CASE") .

3. All issues involving the·.Kersting programs

shall be =resolved as if the putitioner (s) in this case

is the same as the taxpayers :.n the TRIED CASE;

4 . A decision shall be »ubmitted in. this case

when the decision in the TRIEu CASE is entered;

5. Following entry of the decision in this case,

petitioner(s) consents to the assessment and collection

of the deficiencies, attributable to: the adjustments

formulated by reference to th Tax Court's opinion,

notwithstanding the restricti«ns contained in I.R.C.

§ 6213 (a) ;

6. The petitioner(s) in this case will testify or

provide information in any case2involving the same tax

shelter adjustments, if subpoenaed; and

7. The petitioner (s) in this case consents to the

disclosure of all tax returns and tax return

information for the purpose o¯ respondent's discovering

or submitting evidence in any case involving the same

Kersting shelter adjustments.

The parties agree to thi3 stipulation of

settlement.

Piggyback. agreements executed by Kersting. program

participants after 1985 differed f com those executed in 1985.

particular, post-1985 piggyback agreements stated as follows:

Stipulation of Settlement for Tax Shelter Ad-justments

With respect to all adj.uatments in respondent'.s

notice of deficiency relating to the Kersting interest

deduction tax shelter(s), the parties stipulate to the

following terms of settlement:

1. The Kersting interest deduction tax shelter

adjustments shall be redetermined on the same basis

that the same tax shelter adjastments are resolved with

respect to taxpayers trying ttle same shelter

adjustments at the February 9, 1987 session of the

Court in Wailuku, Maui, Hawaii, or such session as

- 46 -

these cases may be adjourned or continued to by the

Court (hereinafter "TRIED CAEE")'.

2. All issues involvinc the Kersting interest

deduction tax shelter(s) shall be resolved as if the

petitioner(s) in this case ie the same as the taxpayers

in the TRIED CASE;

3. A decision shall be submitted in this case

when the decision in the TRIED CASE becomes final under

I.R.C. § 7481;

4. Following entry of the decision in this case,

petitioner(s) consent to the assessment and collection

of the deficiencies, attributable to the adjustments

formulated by reference to the Tax Court's opinion,

notwithstanding the restrictions contained in I.R.C.

§ 6213(a);

5. The petitioner(s) in this case will testify or

provide information in any case involving the same tax

shelter adjustments, if subpcenaed; and

6. The petitioner(s) in this case consents to the

disclosure of all tax returns and tax return

information for the purpose cf respondent's discovering

or submitting evidence in any case involving the same

shelter adjustments.

If the Court determines the I.R.C. § 6621(d)

penalties are applicable in the test case controlling

petitioner's(s') case, then the petitioner(s) concedes

that I.R.C. § 6621(d) is applicable to any underpayment

of tax determined in their case(s) attributable to the

Kersting interest deduction tax shelter(s), if such

underpayment exceeds $1,000.00 in any one taxable year.

8. With respect to adjustments in respondent's

notice of deficiency relating to additions to the tax

under I.R.C. § 6653(a), the parties agree to the

following:

(a) Respondent concedes that the

petitioner(s) are not liable for additions to tax under

I.R.C.

§ 6653(a)

or § 6653(a) (1) or § 6653(a) (2)

any year prior to the taxable year 1982.

The parties agree to this stipulation of

settlement.

for

- 47 -

In sum, whereas paragraph 4 of the .1985 piggyback agreements

states that a decision will ·be entered in the pigsyback case

following entry of decision in the test cases, paragraph 3 of the

. post-1985 piggyback agreements states that a decision will be

entered in .the piggyback case once the decision ·in the test cases

becomes final..2s

210.

See Gridley.v. Commissioner, T.C. Memo. 1997-

Unlike 1985 piggyback agreements, post-1985 piggyback

agreements state (at paragraph 7)

hat petitioners agree to be

bound to the Court's. holding in the test cases respecting the

applicability of increased interes

under section 6621(c) on any

underpayment of tax of more than "$ L, 000 .

Further, while 1985

piggyback agreements make no reference to -additions to tax, post-

1985 piggyback agreements state (ai paragraph 8) that petitioners

are not liable for additions to tac for negligence for' any year

before the taxable_year 1982.2

2s Despite this distinction, respondent did not move for

entry of decision--upon entry of dacisions in the Kersting test

cases in.early 1992--in any of the cases in which Kersting

petitioners had executed the 1985 ,rersion of the piggyback

agreement. Respondent has taken t2e position that no decisions

.should be entered in any of the piggyback cases until the

decisions in the test cases become final. Cf . Abatti v.

Commissioner, 859 F.2d 115

(1986) .

(9th Cir.. 1988), affg. 86 T.C. 1319

26 Although the record does not reveal why post-1985

piggyback agreements limit respondent's concession of additions

to tax for negligence to taxable years before 1982, a plausible

explanation for selecting 1982 as the line of demarcation would

be that the Tax Court had released its opinion- in Pike v.

Commissioner, 78·T.C. 822 ·(1982), in May 1982, .putting taxpayers

on notice for 1982 and later taxable years that Mr. Kersting's

programs did not generate legitimaLe interest deductions.

- 48 When Messrs . .McWade and Seery draf ted the piggyback

agreements, Mr. Seery did not cons ider the possibility that a

test case might be settled."

Nontest case petitioners Ronsld L. and Mattie E. Alverson

(docket No. 17646-83) executed their piggyback agreement in June

1985.

·Nontest case petitioners Arthony E. and Carol A. Eggers

(docket No. 7323-84), John L. and Terry E. Huber (docket No.

20119-84), Stanley C. and Sharon R. Titcomb (docket No. 1799295) , and Richard B. and Donna G. E¡ogers (docket No. 17993-95)

executed piggyback agreements in late November 1986.

Nontest

case petitioners Norman W. and Barbara L. Adair (docket No.

35608-86) executed their piggyback agreement in March 1987.

Nontest case petitioners 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), and Norman A. and Irene Cerasoli (docket

No. 9532-94) did not execute piggyback agreements for their cases

on these dockets.

Mr. Seery's Withdrawals as Counsel

During late 1986 and early 1987, and shortly before the Maui

session, Mr. Seery began to withdraw as counsel in the Kersting

cases in the circumstances describsd below.

A piggyback agreement that binds the piggyback case to

the outcome of the test case, whether by litigation or

settlement, is not unprecedented. See, e.g., Fisher v.

Commissioner, T.C. Memo. 1994-434.

- 49 1.

The Thompsons

In 1985, the Thompsons had re ained Samuel M. Huestis' ~

(Mr. Huestis) to prepare an estate plan for them.

-Eventually,

the scope of Mr. Huestis' representation was extended to include

settlement of the Thompsons' 1978

ax liabilities and their

dispute with Mr. Kersting, as desc ibed infra pp. 56-67.

One result of that dispute was Mr. Huestis' letter of

September 10, 1986, to Mr. Seery, notifying him that the

Thompsons were seeking substitute counsel and requesting the

Thompson f iles .

On September 15, 1986, Mr . Seery sent the

Thompson files to Mr. Huestis and informed him that the Thompsons

were test case petitioners.

Mr. S±ery indicated that he was

withdrawing as the Thompsons

coun el in the Tax Court .

On October 28, 1986, Mr. Hues is wrote' to Mr. Seery to

express dissatisfaction with the s fficiency of the Thompsons'

files and to warn Mr. Seery that h s earlier representation of

the Thompsons, while he was also a parently representing

Mr. Kersting, could be viewed as

conflict of - interest and lead

to an action for "professional neg ïgence".

On October 31, 1986, Mr. Seer

filed motions to withdraw as

counsel in the Thompsons' cases.2s

he Court granted Mr. Seery's

motions in November 1986.

2a Mr. Seery had entered his appearance only in the

Thompson cases assigned docket No . 19321-83 and 31236 84, not

docket No. 30'965-85.

- 50 -

In the interim, Mr. Huestis ässisted the Thompsons in

locating and interviewing Mr. DeCastro to serve as their counsel

in the Tax Court.29

On November 15, 1986, Mr. Thompson and

Mr. DeCastro's associate, Phillip Hoskins, executed a retainer

agreement under which Mr. Thompson agreed to pay Mr. DeCastro

$5,000 for his effort to negotiate a settlement of the Thompson

tax cases.

The agreement provided that the retainer fee was

limited to settlement negotiations-and did not include

preparation for or representation at trial.

In early January

1987, Mr. DeCastro filed an entry of appearance in the Thompson

cases.

The Test Cases

On November 7, 1986, Mr. Seery filed a motion to change

the place of trial of the test cases from Maui to Honolulu.

Mr. Seery asserted that a trial in Maui would be inconvenient and

a hardship to Mr. Kersting, who lived-and operated a business in

Honolulu.

Mr. Seery's motion included the statement that

4. Mr. Kersting is providing the financial

support for the litigation of this and the related

cases and the additional expense involved in

transporting witnesses and staff to Wailuku as well

as paying for accommodations for the staff while in

Wailuku is a great financial purden to him.

On November 14, 1986, the Court issued an order denying

Mr. Seery's motion to change the place of trial.

In so doing,

29 Mr. Huestis had initially referred the Thompsons to a

law firm, Loeb & Loeb, in Los Angeles, California. The Loeb firm

declined to represent the.Thompsons becausesof the short time to

prepare for the Maui session and the incompleteness of the

Thompson files.

- 51 -

the Court noted that the motion "iinplies that .* * * [Mr. Seery]

represents not on'ly.petitioners bu: also Henry Kersting, the

promoter of the tax shelters which are the subject of this

litigation."

The Court went on to observe that, if.Mr. Seery

were representing both Mr. Kerstint and petitioners, the dual

representation would constitute a :onflict of interest1

The

Court attached to the orderucopies of several authorities

concerning conflicts of interest,

including Adams v.

Commissioner, 85 T.C. 359 -(1985)

Mr. Seery subsequently filed

motions to withdraw- as counsel in ;he Kersting project cases

(both test cases and nontest cases), citing concerns about a

possible conflict of interest.

Tha>Court granted Mr. Seery's

motions.

By letter dated December 12,

L986, Mr. Kersting informed

Kersting program participants that Judge Goffe.had "inferred"

that Mr. Seery might have a conflict of interest.

Although

Mr. Kersting denied that he was represented by Mr. Seery, he,

stated that he and Mr. Seery had d3cided that it would be prudent

for-Mr. Seery to withdraw as couns 1.

Mr. Kersting further

stated that substitute counsel -had been retained to represent

test case and nontest case petitioners alike.

D..

Entries of Appearance by Chicaine and Hallett

Following Mr. Seery's withdrasal, Mrd Bradt.recommended.that

Mr. Kersting hire Mr. Izen to serv3 as counsel.for the testn,

52 -

cases.3° ·However, Mr. Kersting, w:.th his son-in-law, an

attorney, Roger Moseley (Mr. Mose]ey), contacted Robert J.

Chicoine (Mr. Chicoine) and Darre)1 D. Hallett (Mr. Hallett)

(collectively Chicoine and Hallett), to determine whether they

would ;represent the test case petitioners at the Maui session.

On November 22, 1986, Mr. Kersting sent Mr. Hallett a

letter describing the Kersting programs.

Shortly thereafter,

Mr. Kersting interviewed Mr. HallEtt in Hawaii.

On December 9,

1986, Chicoine and Hallett reachec an agreement with Mr. Kersting

to represent. the.test case petitioners (other than the

Thompsons).

On.December 12, 1986, Mr. Kersting wrote to Kersting

program participants informing them that Mr. Seery had withdrawn

as counsel and that Chicoine and Eallett had been retained.

the same time, either Mr. Kerstinc or Chicoine and Hallett

informed the.test case petitioners that they would have to

provide Chicoine and Hallett with written authorization to enter

appearances in their cases.

Although Mr. Seery sent Chicoine and Hallett his files for

the test cases, most of the documents that Mr. Seery had intended

to use at trial remained in Mr. Kersting's possession.

letter dated December 19, 1986, Chicoine and Hallett reminded

Mr. Kersting that they needed all documents in the possession of

Mr. Kersting and Mr. Seery that pE:rtained to the Kersting

programs in dispute in the Tax Court.

3°

to 1981.

Mr. Bradt and Mr. Izen had been law partners from 1978

- 53 By letter dated January 7, 19 7, Chicoine and Hallett

outlined the conditions underlying their agreement with

Mr. Kersting to represent the test case petitioners*in the Tax

Court.

Chicoine and Hallett's let;er states in pertinent part:

Our representation is conditioned upon the

following however:

1. We will represent only the individuals

selected as test cases and who request us to do so. We

are not representing or acting on behalf of any other

taxpayers or litigants who have invested in various

companies in which you are afEiliated and who have

stipulated to be bound by the outcome of the litigation

or desire legal advice with r±spect to whether they

should accept the Internal Rezenue Service's settlement

proposal.

2. All parties underst d and agree that under

the _circumstances, the Petiti ners involved in the test

cases who have expressly aut rized us to represent

them will be our clients. and hat we do not represent

you individually, although y

have agreed with those

Petitioners that you will pay the legal fees to defer

[sic] the costs of their defeþse. We will discuss the

fee arrangement with each of he Petitioners.in the

test cases and their perceptibn of any possible

conflict of interest which we would require that they

waive.

3. It is understood that there will be no

restrictions on the advice which we may provide to,our

clients and after review of t e relevant facts and

documents, we are free to pro ose such settlements as

we may deem appropriate. We eed not proceed with

trial in any situation if which we consider our

position to be indefensible r frivolous.

In early January 1987, Messr . Chicoine and Hallett filed

entries of appearance as counsel

each of the test cases other

than the Thompson and Cravens cas s.

As discussed in greater deta 1 infra pp. 100-106, at the

time of Mr. Seery's withdrawal fr

the Cravens cases,

- 54 -

Mr. Cravens and Mr. McWade had agreed to a settlement of the

Cravens cases.

After reaching an agreement with Mr. McWade, Mr.

Cravens did not authorize Chicoine and Hallett to enter an

appearance in his cases.

Evidentiary Issues

After undertaking to represent the test case petitioners,

Chicoine and Hallett decided to challenge their'deficiency

notices on the ground that the search of Mr. Kersting's office in

January 1981 had been illegal.

Chicoine and Hallett- thereupon

filed motions for leave to file amendments to the petitions and

lodged the amendments with the Cotrt.

The amendments included

arguments that the materials seized by the Internal Revenue

Service during the.search of Mr. Eersting's office should be

suppressed at trial of the test cLses and that the burden of

proof and burden of going forward with evidence should be shifted

to respondent.

On January 14, 19E7, the Court granted Chicoine

and Hallett's motions for.leave tc- file amendments to the

petitions and subsequently directed respondent to file answers to

the petitions as amended.

The Maui Session

Although the test cases were originally scheduled for trial

at the Maui session, the trial was delayed by the need to use the

Maui session to receive testimony and evidence on the evidentiary

issues raised by Chicoine and Hal]ett.

Mr. McWade and Henry E. O'Nejll (Mr. O'Neill), another trial

attorney assigned to the Honolulu District Counsel Office,

- 55 -

appeared on behalf of respondent a

the Maui session.

Mr. DeCastro appeared at the Maui

ession on behalf of the

Thompsons.

ppear at the Maui session.

The Cravenses did not

Following the .Maui session, t e Court ordered respondent and

petitioners, by May 18 and June 17, 1987, respectively, to file

opening and reply briefs addressing the evidentiary issues raised

by Chicoine and Hallett.

On motions by the parties, the Court

extended the dates for the filing of openirig and reply briefs to

June 8 and August 10, 1987, respectively.

2-.

Dixon I Opinion

On February 11, 1988, the Co

t issued its Dixon I opinion

rejecting Chicoine and Hallett's

identiary arguments.

Specifically, the. Court held that

etitioners had failed to

establish standing to contest the

ersting search.

Commissioner,

90 T.C. 237

Dixon v.

(1988) .

By order dated July 1, 1988

he Court set the test cases

for trial in San Diego, California

on January 9, 1989.

By order

dated October 24, 1988, the Court

ranted Mr. Izen's motion to

reconsider and set the test cases for trial in Honolulu, Hawaii,

on January 9, 1989.

Kersting Disputes With Progra

Participants,

Before the trial of the test cases, Mr. Kersting had

disputes, summarized below, with the Thompsons and the

Alexanders .

.- 56 -

The Thompsons

The Bauspar Program

On August 13, 1979, the Thompsons purchased a condominium

unit in Wahiawa, Hawaii (the.Wahitwa property), from'Pacific

Universal Corp.

(not a Kersting company).

On April 24; 1981, sthe

Thompsons entered a Kersting program known as Bauspar--not one of

the Kersting programs -in dispute Lt the trial of the test cases-to effect the payoff of seller-provided financing on the Wahiawa

property.

The Thompsons executed a first mortgage and promissory

note reflecting a loan from Bauspär, Inc.

principal.amount of $80,000.

(Bauspar), in the

The Thompsons agreed to·repay the

$80,000.Bauspar loan, with interest at 7 percent per year,

through monthly- payments of principal and interest of $532.24 for

a 10-year period, followed by a bëlloon payment of $69,182.47.31

In conjunction with the Bauspar lc·an, the Thompsons agreed to

purchase $80,000 worth of Bauspar stock.

The Thompsons borrowed

$80,000 to purchase the Bauspar stock from another Kersting

company., Paragon Investments, .Inc.

interest rate of 18 percent.

(Paragon), at an annual

The Thompsons further agreed to

participate in a "savings program'' by depositing $1,200 per month

into an account with Citizen's^Fir.ancial, Inc.

(Citizen's

Financial), another Kersting'compäny.

On August 12, 1982, the Thompsons agreed to sell the Wahiawa

property to Kevin and Ada Shea for $122,500 by an "Agreement of

31 It appears that the Thompnons actually made monthly

payments of $535 to Bauspar.

-.. 57 -

Sale" :under which the Thompsons apparently took back a purchase

money mortgage on the property.

The Thompsons continued to

participate in the Bauspar program until 1986 when the Sheas

decided to sell the Wahiawa proper:y to a third party.

On January 30, 1985, Mr. -Kers;ing sent Mr. Thompson a

schedule listing the interest. payments that Mr_. Thompson had made

during 1984 as follows:

Payee

Bauspar, Inc .

Amount

$6., 420 ..0 0

Paragon Investment s , Inc .

9, 611. 04

Citizens Financial, Inc.

14,400.00

. Upon sale of the-Wahiawa prop rty by the Sheas in 1986,

Bauspar received a .check in the am unt of $75, 511. 74 in

satisfaction of the principal amou t remaining due on the

Thomps ons ' loan f rom Bauspar .

042 2.

Deterioration of Thompsob/Kersting Relationship

While working ron the,Thompso s' estate plan, ,Mr. Huestis

asked 2Mr. Kersting for an accounting of the Thompsons'

investments in Kersting programs.

By»letter dated March;3, 1986,

Mr. Kersting responded by providi g Mr. Huestis a summary list sof

the Kersting programs that the Th mpsons had participated in during 1977, 1978, 1979, 1980, an

1981.

By letter dated

March 12, 1986, Mr. Huestis. info

ed Mr.. Kersting that the

Thompsons wished to terminate the r participation insall Kersting

programs and obtain a complete ac ounting of their investments..

Mr. Huestis also requested that a 1 future communications

- 58 -

regarding the matter be directed to Mr. Huestis rather than to

the Thompsons.

By letter dated March 17, 19E6, Mr. Kersting complained to

Mr. Huestis about his "assertive approach" and said he'would

continue to communicate directly with the Thompsons.

By letter

dated March 17, 1986, Mr. Kerstinc wrote to Mr. Thompson,

confirmed that he would terminate Mr. Thompson's programs, and

inquired whether Mr. Thompson still had any stock certificates

issued in connection with his participation in Kersting programs.

Mr. Kersting's letter also states that Mr. Thompson would incur

tax liability for capital gains that would be realized upon the

termination of his accounts in the Kersting programs.

On March 21, 1986, Mr. Huestis again wrote to Mr. Kersting,

stating that the Thompsons were disappointed with Mr. Kersting's

failure to respond to their requests or to assist them with the

tax problems arising from their participation in his programs.

By letter.to the Thompsons dated March 25, 1986, Mr. Kersting

confirmed that.he would liquidate their investments, as discussed

with Mr. Thompson in a recënt telephone conversation.

Mr. Kersting requested that Mr. Thompson endorse all relevant stock certificates and return them to Mr: Kersting so that the

proceeds from the sale of stock represented by'such certificates

could be used to retire Mr. Thompson's debts to Kersting:

companies.

By letter dated March 31, 1986, Mr. Kersting wrote to

Mr. Thompson and admitted that he was having difficulty

reconciling Mr. Thompson's Bauspar account because Earl LeMond,

Mr. Kersting's son-in-law and the

did not keep reliable records.

anager- of the Bauspar program,

No Étheless, Mr. Kersting

prepared an accounting of Mr. Thom son's Bauspar account

indicating that Mr. Thompson had p id $90, 769. 72 under the

program and had received nontaxabl

dividends of $27, 000 and

Federal tax and State income tax

vings (presumably from

interest deductions) of $36 307.79 a d $9,000, respectively.

Mr. Kersting further indicated th

, in light of Mr. Thompson's

apparent dissatisfaction, he woul

waive the normal requirement

that the Bauspar program. run for

10-year period, allow

Mr. Thompson to terminate the pro ram prematurely, . and pay

Mr. Thompson $27,000 reflecting 3 years of. "equity build-up" in

the program:

On the basis of his accounting, Mr. Kersting

concluded that Mr. Thompson would

from the Bauspar program.

ealize a net gain of $8,538.07

Mr. Ke sting advised Mr. Thompson -to

check his .accounting carefully, ar d that, if necessary, Mr.

Kersting would make adjustments i

Mr. Thompson s favor to avoid

a legal dispute.

On March 31, 1986, Mr. Kerst ng wrote a second letter to

Mr . Thompson stating that the Tho

sons owed a total of $11, 844

to Avalon Acceptancee Corp . , Aztec Acceptance . Corp. , Mahalo

Acceptance +Corp. , Lombard Accept a ce Corp. , and . Candace, for

interest due on leverage notes du ing 1983 and 1984 .

Mr. Kersting's letter states in p rtinent part:

- 60 -

I will assume that you vill take the position

that you should not be payinc: interest on notes which

produced deductions which yot might not have used.

While this, of course, would not go well with a bank or

Credit Union (they would cha¶ge you interest whether

you use the deductions or not) I am willing to make

adjustments to your advantage. To get that underway I

suggest that you tell us which of the deductions were

·claimed by you in 1983 and 1584.

·*

To keep the spirit of accommcdation alive and to remove

all elements of dissatisfaction we are quite willing to

lean over into your directior.

It has troubled me

considerably that of all people you would be displeased

with our services.

On May 6, 1986, Mr. Thompson wrote to Mr. Kersting

requesting a full accounting for=bis participation in the Bauspar

program.

Mr. Thompson informed Mr. Kersting that the property

subject to the Bauspar mortgage had been sold.

Mr. Thompson also

said that he was.reminding Mr. Kersting that, upon his retirement

in 1982, he had asked to terminate his participation in the

programs for which Mr.. Kersting-was now seeking interest payments

for leverage loans.

Beginning in June 1986, Mr. Thompson stopped making the $1,200 monthly deposits to Citizens Financial as required under

the Bauspar program.

At the same time, Mr. Thompson ignored

Mr. Kersting's. written requests to explain his failure to make

the deposits.

Further, on June 23, 1986, 'at the suggestion of

Mr. Huestis, the Thompsons retained John A. Chanin-(Mr. Chanin),

an attorney practicing in Honolulu, to assist them in their

dispute with Mr. Kersting.

Mr.. Chanin assigned the matter to his

associate, Keith Y. Yamada (Mr. Yamada).

On August 1, 1986,.Mr. Yamada, spoke with Mr. Kersting by

telephone and- requested a detailed accounting of the amounts that

the Thompsons had paid to Bauspar And Citizen's Financial, as

well as a status report.on the promissory notes executed by the

Thompsons in favor of Bauspar, Sig:1et, Financial, Inc., and

Paragon.

Following. the telephone kall from Mr. Yamada,

Mr. Kersting called Mr. Thompson.

During this conversation,

Mr. Thompson reminded Mr. Kersting that the Wahiawa property had

been sold.

Mr. Kersting stated that he would provide Mr. Chanin

with copies of the documents relat:.ng to Mr. Thompson's

participation in the Bauspar program as soon as Mr. Thompson

provided be:. Kersting with a writtén authorization to release

them.

By letter dated August 23, 19f6, Mr. Kersting notified the

Thompsons.that he had turned their file over to Mr. Moseley for

collection and that he sensed that litigation·'was imminent.

Mr. Kersting's letter states in pertinent part:

Since the odds, however, are inifavor of imminent

litigation I consider it to be my obligation to point

out to you the consequences: a

The day after.you have allowec your attorneys to file

suit I will declare all notes which you have executed

to our companies in default and begin collection

proceedings. We will make an effort to collect from

you not only the n$11,844.00 of interest on.promissory

notes of which we have sent ycu billings several times

we will also file suit to collect the principal of all

notes which we hold. The aggregate sum is well in

excess of $250,000.00, as you know.

I will also ask you to return to us the $40,000.00 we

advanced to you after the First Savings debacle. We

will start collection proceedings on the $75,000.00

note which you executed in fa or"of.-FEDERATED FINANCE

COMPANY to facilitate the ac isition of your stock in

First Savings & Loan Ass. We will ask you to-pay a

pre-payment penalty on your m rtgage on the house in

Wahiawa.

We will NOT arrange for-you a capital gain in your

BAUSPAR HOLDINGS INC. stock which I had considered--

even though not dué you becauue of premature withdrawal

from the Plan--and we will NO'' render assistance in

saving you capital gains taxem on the re-capture of

basis in your stock holdings.

We will NOT provide legal ass«.stance 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, 19 6, Mr. Kersting notified

Mr. Seery that he expected to be i

litigation with the Thompsons

and directed Db:. Seery not to ?ren er any services, at our

expense,'ï to the Thompsons.

By "letter dated August 28, 19 6,.Mr. Huestis notified

Mr. Moseley that he represented th

Thompsons in connection with

their Kersting transactions and th

pending Tax Court litigation.

Mr. Huestis advised Mr. Moseley.to direct all future

communications regardingr the Tho p ons to Mr: Chanin.

By letter dated September 5, 1986, Mr. Kersting again

notified Mr. Seery of.his dispute

the likelihood of litigation.

ith the Thompsons and

Mr. Kersting included a copy

of Mr. Huestis' August 28, 1986, 1 tter to Mr. Moseley.

As previously mentioned, his was around the time that

Mr. Seery began the process of wi hdrawing as counsel for the

Thompsons, following Mr. Huestis' notification to Mr. Seery that

the Thompsons were in the process of retaining substitute

- 63 Mr. Kersting told Mr..Seery that he.considered it "mandatory"

that the Thompsons be removed as test case petitioners.

September 24, 1986, Mr. Kersting again wrote to*Mr. Seery,

reminding him of the need to remove the Thompsons from the list

of test cases.

During this period, Mr. Thompson began talking

with other Kersting program participants about filing a class

action lawsuit against Mr. Kersting.

On January 1rF1987, Mr. Kersting wrote to Bill Witthorne, a

Kersting program participant, requesting help in dealing with

Mr. Thompson.

Mr. Kersting's letter states in pertinent part:

Yet, I consider it important that someone would bring

home to Jack the dangers of the action he has in mind.

He has been hoodwinked by the attorneys.out in

California and I think he is blind to the

ramifications. Can you think of anyone in California

who is close to Jack and willing to talk to him?

That same day Mr. Kersting wrote to Benness M. Richards, another

Kersting program.participant, stating in pertinent part:

We have been unsuccessful over the last six months or

so to convince Jack that he will be better off with the

legal representation provided by us. Neither has

anyone be [sic] able.to bring home to him that the IRS

does NOT make him a better deal than offered to all the

other Petitioners.

On March 10, 1987,;Mr. DeCastro and Mr. Huestis informed

Mr. Thompson that Mr. Kersting would not'return the Thompsons'

promissory notes.

Mr; DeCastro indicated that he wanted to '

discuss the possible involvement of his firm in bringing legal

action against Mr. Kersting.

On April 10, 1987, Mr. Thompson wrote a letter to other

Kersting program participants, saying that Mr. Kersting had

deceived him.

In his letter, Mr. Thompson said that he had gone

to Mr. Kersting to reduce his tax liabilities but that he now

believed the cost to him would be great because the Internal

Revenue Service was challenging Mr. Kersting's programs.

Mr. Thompson suggested that the biggest worry for Kersting

program participants was Mr. Kersting's "ultimate weapon", the

promissory notes.

Mr. Thompson enclosed a copy of a letter that

he had, received from Mri Kersting as an example of what the

others might face.33

Mr. Thompson informed the other

participants that, although Mr. Keesting had promised to cancel

all promissory notes in exchange f 3r the surrender of the

Kersting company stock that was purchased with the proceeds of

the primary loan, Mr. Thompson had tried to surrender his

Kersting company stock but Mr. Ker sting had refused to cancel

Mr. Thompson's promissory notes.

Mr. Thompson indicated that

he no longer trusted Mr. Kersting, and that he had retained

Mr. DeCastro.

By letter dated May 5, 1987, Mr. Yamada advised Mr. Thompson

that a lawsuit against Mr. Kersting would have merit, and that a

class action law suit should be considered.

Around this time,

Mr. DeCastro had proposed. to. file :3uit on behalf of the Thompsons

against Mr. Kersting in Federal Di:3trict Court.

33 Although the Court's copy of Mr. Thompson's Apr. 10,

1987, letter does not include a copy of a letter from

Mr. Kersting, we assume that Mr. Thompson circulated

Mr. Kersting's letter of Aug. 23, :.986.

- 65 On May 26, 1987, Mr. Huestis called 'Mr. DeCastro and learned

that, after Mr. Kersting had obtained a copy of Mr. Thompson's

April 10, 1987 letter, Mr. Moseley had written to Mr. DeCastro

on behalf of Mr. Kersting and proposed a settlement of the

Kersting/Thompson dispute.

Durinc a later meeting. that day with

Mr. Thompson, Mr. Huestis agreed to contact another lawyer in

Honolulu, Charles R. Kozak (Mr.vKczak), to discuss whether

Mr . Kozak might represent the Thonpsons in a lawsuit against

Mr. Kersting.

On May 27, 1987, Mr. Huestis contacted Mr. Kozak on behalf

of the Thompsons.

Mr. Kozak informed Mr. Huestis that he had

represented two other Kersting participants (David L. Bigelow"

David L. Bigelow and Patricia L. Bigelow had.

participated in the CAT-FIT- program during the taxable years

1975 and 1976.

In Bigelow v. Comnissioner, T.C. Summary 1983-6

(docket No. 3147-.78S) , the Court teld that the Bigelows were

entitled to interest deductions that they had claimed under the

CAT-FIT program, partly on the basis of evidence that the

Bigelows had successfully sued a related Kersting finance company

in State court . Because the Bigelows' case was tried under the

small tax case procedure, the case was not subject to appeal and

is not treated as precedent for ary other case. See sec.

7463 (b) .

Mr. Kozak had represented Mr. Bigelow in a lawsuit against

Mr. Kersting for payment of the "equity build-up" in. a mortgage

funding program (presumably Bauspar) following Mr Bigelow's

termination of the program. Mr. Eigelow won- the suit and .

collected damage s . Accòrding to . IV r . Kozak, Mr . Bigelow had

prevailed by virtue of Mr. Kerstirg's promise not to enforce

notes that Mr. Bigelow had signed in connection with his

- <

participation in other Kersting programs. Mr. Bigelow used

Mr.,Kersting's written promise that he woulddnot. enforce

promissory notes to prevent .Mr.. Kersting from asserting the

principal on the notes as a defense or offset to Mr. Bigelow's.

claim to the equity buildup in the mortgage funding program.

and Michael Provan35) -and that he±new.the Kersting programs and

how .to locate Mr . Kersting' s asset s .

On . June 2 / 1987,

Mr. Huestis agreed .to send 'a copy of the .Thompson file to

Mr. Kozak.

On the same date, Mr. Huestis notified Mr. Yamada

.that the :Thompsons did not eplan tc retain the Chanin firm to

bring suit against Mr:. Kersting.

Messrs; Bigelow,s Provan, .and Thompson all asked Mr. Kozak to

investigate; the filing of a lawsuit against Mr. Kersting.

On .

August 6, 1987, Mr. Kozak wrote to Mr. Thompson and suggested

that. there was" a good chance of obtaining a large judgment

against Mr. Kersting through a class action·lawsuit/ bilt- that

collection of. any_ such judgment would be uncertain.

In addition,

Mr. Kozak's letter states in pertinent part:

As you know, Kersting is now embroiled with the

IRS on behalf of' hiis clients. I recentl'y had a

conference with Ken McWade, local counsel for the IRS.He tells me. the trial of these cases will be no sooner

than late Spring 1·988..

I sus pect 12-18 months is a

more orealistic date. Also McWade Estated he is 100%

sure Kersting willl be. .unable to show any "purposive"

function of« his corporations other than to avoid taxes .

Several witnesses including yourself are available to

McWade to prove Kersting neve r had any intention of

enforcing the notes he had his clients execute. Also,

I am suspicious that Kersting's representation that his

Mr. Kozak had represented Mr. Provan when he had been

sued as a director of First Savings. The representation ended

with a settlement with the .company that provided First Savings'

officers and directors liability i:2surance. Mr. Kozak did not

represent Mr. Provan in any tax co:2troversies with the Internal

Revenue Service related to the Ker sting programs . 042

As) discussed in greater detail, infra pp. 115-116,

Mr. Kozak and his wife, Susan K. Kozak, had participated in one

or more of the Kersting programs that were the subject of this

Court's opinion^in Pi-ke v. Commissioner, 78 T.C. 822

(1982) .

- 67 -

companies.are making loans,.leasing cars and factoring

accounts in any.meaningful business sense is without

any merit.

Further, I believe we will find that Kersting did

not do cmany of - the "house keeping" accounting and legal

matters which needed to be dcne to qualify his schemes

before the IRS, even if there was an arguable business

purpose position for"his schemes under the tax code.

In my estimation, those clients of Ke'rsting who

continue to be represented by Kersting's lawyers are

headed towards a nightmare. Interest continues to

mount on the taxes due. By the time the pilots finally

get a·decision from the tax court, they will be in

terrible financial condition. Of course, they will

still have to pay the tax since bankruptcy will not

terminate their tax liability.

Those who are smart enough should disassociate

themselves from.Kersting's lawyers now, obtain.their

own counsel, offer their testimony as part of.their

negotiations with the IRS and buy out as cheap as they

can now!

There is no evidence in the record that the Thompsons have

ever filed a lawsuit against Mr. Kersting or that Mr. Kersting

has ever filed a. lawsuit against the Thompsons.

There is no

documentation in the record to support Mr. Thompson's statement

to Mr. Kersting in 1986 that in 1982 he had asked Mr. Kersting to

terminate Mr. Thompson's participation in the Kersting programs.

The Alexander Dispute

As previously mentioned, Mr.. Alexander first met

Mr. Kersting in Los Angeles in the early 1960's.

In the mid-

1970's, Mr. Alexander lent over $100,000 to Mr. Kersting to

assist him in the acquisition of Cosmopolitan Financial Corp.

Mr. Alexander's creditor's interest in Cosmopolitan evolved into

a stock interest in Charter Financial.

Mr. Alexander also lent

- 68 -

$80,.000 to Mr. Kersting's subchapt,er S leasing corporations in

the 1970 ' s ..

042In 1977, Mr. Alexander, a mir.ority shareholder of First

Savings, met with Mr. Kersting to discuss the possible

acquisition of. the. company.

Mr. A.lexander participated in the

acquisition of First Savings and added to his First Savings stock

holdings in the process.

Mr. Alexander participated in certain

Kersting programs at. issue in Dixcn II during the taxable years

1974 through 1977.

In 1980, Mr. Alexander brought suit against Mr. Kersting

in Hawaii State court seeking the repayment or return of

approximately $450,000 that Mr. Albxander claimed he had lent to

or invested with Mr. Kersting.

Mr. Kozak initially represented

Mr. Alexander in this litigation.

Mr. Kersting and/or his

companies eventually filed counter:laims in excess of $4 million

against Mr. Alexander.

Mr. Mosele:f represented Mr. Kersting in

the Alexander litigation.

In March 1982, Mr. Alexander ::eceived a telephone call from

Internal Revenue Service Special Agents George Scott and Mike

Duncan, who were interested in questioning Mr. Alexander

regarding Mr. Kersting's various p::ograms.

The record does not

reflect whether Mr. Alexander ever agreed to be questioned by the

agents.

The Alexander/Kersting litigation eventually was submitted

to arbitration during a week-long proceeding in July 1987.

During the arbitration proceeding, Mr. Kersting discovered that

- 69 -

Messrs. Alexander, Kozak, and MatEuMOto had tcontacted Mr. McWade

to discuss whether the Government would pay a finder's fee

for information pertaining to Mr. Kersting's programs.

Mr. Alexander's discussions with Fr. McWade on the subject of

a finder's fee are discussed in greater detail, infra pp. 106115.

In a letter dated July 24, 1987, Mr. Kersting brought his

dispute with Alexander to the attention.of Chicoine and Hallett,

stating as follows:

Dear Darrell:

I have spent the better part of this week in

arbitration hearings concerning ascase whereby we are

attempting to accomplish an cffset of debt owed us by a

Mr. Denis Alexander against certain obligations we have

to him. The matter has been going on.for more than six

years and has become sheer agony.

During the course of the proceedings,. however, certain

matters came to the surface which will become apparent

to you as you will read the enclosed material. The

material will disclose a conspiracy between McWade,

DEnis [sic] Alexander, an accountant by the name of

Gilbert Matsumoto and.an attorney by the name of

Charles Kozak.

Here are some short facts to illuminate the case:

DEnis [sic] Alexander was a long-time friend going back

more than 25 years, until we locked horns over the debt

referred to above.

Gilbert Matsumoto is an accountant who was for years

the tax preparer for our Finance Company.in Aiea,

Federated Finance Company, and for about 10 to 14 of

our clients which we had referred to him. He had given

me an opinion with respect to the viability of the

SubChapter S concept which we employed in the mid-70s

for our Leasing Companies. He, in fact, did the filing

of SubChapter S qualification forms for us with the.IRS

in Fresno, Calif. and did some of the Tax Returns.

- 70 adapted the Subchapter S prir.ciples on the strength of

his advise [sic].

Charles Kozak is an attorney here in town who was at

one time a shareholder in one -of our SubChapter S

Leasing Companies and also a participant in other

programs. He did some legal work for us in the mid-70s

in chasing a dead-beat by the name of Feliciano and he

obtained judgement fór us. Be became an adversary

after he had made no lease payments on a car which we

had leased to him which compelled us to repossess the

car. He was delinquent by mcre than one year. He has

stirret [sic] up trouble for me ever since.

These three characters now conspired with McWade to

initiate criminal proceedings again against me and, as

you will read, already discussed among themselves how

to divide the "finders fee" (more precisely the Judas

ducats) which they expected to receive from IRS. As we

took Alexanders [sic] testimony this week i.t became

apparent ,to Kozak that he had acted unethically and he

read a statement into the records that "he had advised

his client (Alexander) not to engage in reporting me to

the IRS in order to extract from me a settlement of his

claims" which, of course, is self-defeating since he

was an active participant in the scheme.

I have reason to believe that all of this led nowhere.

If even entrapment and subseq2ent raid on our premises

did not.yield the evidence foc.the CID characters to

take me out of circulation the Kozak / Alexander /

Matsumoto / McWade conspiracy had no prospect of

success. More than a year has gone by since these rats

tried to make money by setting me up for execution.

I will assume that this incident will become a piece

of the mosaic which should be made known to the US Tax

Court Judge in support of my wontention that IRS and

it's [sic] representatives have conspired to ruin my

business and inflict harm on me personally, one way or

another.

Following the arbitration hea::ing, Mr. Moseley filed a

complaint with the Supreme Court of the State of Hawaii, Office

of Disciplinary Counsel (HODC), accusing Mr. Kozak of conflict of

interest and of attempting to exto::t money from Mr. Kersting in a

civil suit.

On March 17, 1988, Mr. Kozak submitted a written

- 71 response to the HODC in response to Mr

Moseley's complaint.

Mr. Kozak alleged that he had been offered inducements by the

Internal Revenue Service in exchange for his cooperation in an

Internal Revenue Service investigation of Mr. Kersting

suggested that HODC should contact Mr. McWade, denied that he

used·the threat of Internal Revenus Service litigation against

Mr. Kersting, and denied any conflict of interest.

On April 12,

1988, Mr. Kozak wrote another letter to HODC stating that the

Internal Revenue Service had agreed to pay Mr.'Kozak and

Mr. Alexander for.their cooperation in an Internal Revenue

Service investigation of Mr. Kersting.

.At the evidentiary

hearing in this proceeding, Mr. Kozak testified that his

statements to HODC that the Internal Revenue Service had agreed

to pay him for cooperation in an investigation of Mr. Kersting

were false.

On July 12, 1988, the arbitrator released his Arbitration

Decision and Award denying all claims and counterclaims between

Messrs. Alexander and Kersting."

The.arbitrator's decision

Following the issuance of the arbitration decision, the

Alexanders claimed a net operating loss (NOL) on.their 1988 tax

return in the amount of $321,000 identified as amounts "expended

for the purpose of starting new businesses deemed.to be

unretrievable by.the American Arbitration Association". The

Alexanders later claimed an NOL in the amount of $360,260 on

their 1990 tax return and an NOL carryforward of $201,955 and a

loss "due to fraud" in the amount of ;$129,000 on their 1991 tax

return. The Alexanders'-1991 tax return included the following

statement:

The loss.was $450 000. $321,000 was claimed on the

1988 returns.

$129,000 was not claimed because

(continued...)

72 -

turned largely:on the lack of credibility.of both parties.

.. The record does not reflect the outcome of Mr.. Kersting's·

complaint filed with HODC.against Mr. Kozak.

Collection Actions .

In Dixon, II, the Court described Mr. Kersting's 1980 dunning

letter to,more than 30 program participants and severalilawsuits

brought during the period 1983-86 in the names of Kersting

corporations against Kersting program participants to collect

amounts purportedly due; on promissory notes. " See Dixon II, 62

T.C.M. .e(CCH) at 1466-1467, 1505-1506, 1991 T.C.M.

3007 to 91-3008, 91-3048 to 91-3050.

(RIA), at 91

Summarized below are the

Court's findings and conclusions in Dixons II regarding the

collection lawsuits.

11.

Steve Hane

In 1983, a Kersting company, Atlas Funding, commenced an

action on· a- $30, 000 renewal primary note for a stock subscription

plan against Kersting program .participant Steve Hane .

The Court

noted-that the Hane .litigation was'the only example in the recárd

( . .'. cont inued)

042

recoveryswas expected· in the future.

In 1991 the

assets on which the recovery was anticipated

disappeared because the corporation was absorbed and

ceased to exist

Upon examination of the Alexanders' returns for 1990 and .

1991, the Commissioner disallowed the claimed NOL's and fraud

loss. After the: Alexanders agreed to these adjustments, the

Commissioner issued a notice of deficiency to the Alexanders

determining accuracy-related penalties attributable in part to

the disallowed losses .: InuAlexander v. Commissioner , T . C.

Summary 1997-80 (docket .No. 8948-95S), the Court sustained the

Commis s ioner ' s de t erminat ions .

- 73 of litigation on a-primary note.

The Court concluded that the

evidence of the Hane litigation was inconsequential because of

the lack of any testimony about the matter and the fact that

Atlas Funding dismissed the action voluntarily after obtaining a

default judgment.

2.-

Carl Mott,. George Vermef,| and 'Robert Peterson

In Dixon II, the Court found that Kersting corporations

pursued collection lawsuits in 1985-86 on leverage loans against

Kersting program participants Carl Mott/ George Vermef, and

Robert Peterson.

The Court noted that while Carl Mott had been

sued only for interest on leverage loans, Messrs. Vermef.and

Peterson had been sued for both interest and principal on

leverage loans.

The Court found that there was no explanation in

the record how Messrs. Vermef and Peterson could have owed

principal on leverage loans that would be consistent with the way

the Kersting programs. were.intended. to operate nor with the way

that they apparently actually operated.

.Further, the Court found

that the judgments entered against Mr. Vermef were vacated after

the parties agreed to settle the cases and that a default

judgment entered against Mr. Peterson later was set aside on

Mr. Peterson's motion.

The Court summarized its conclusions

regarding collection activities and litigation as follows:

Five Kersting corporaticns commenced actions

against Carl Mott based upon a year of unpaid interest

on 15 leverage notes, but the principal amounts of the

notes were not in issue. The record is replete with

copies of checks, drawn on personal bank accounts other

than Liberty Bank or Hawaii bational Bank, that

petitioners used to pay interest on leverage notes.

Respondent does not dispute that·Kersting..insisted on

these interest payments, but maintains that to the

extent they were made they mt.st be characterized as

fees to Kersting for providir.g tax deductions.

Consequently, that Carl Mott allegedly failed to pay ,

interest on~leverage notes is of no significance to the

substance of his or anybody else's leverage loans.

As ;illustrated by Kersting's pay-or-else letter

to over 30 clients on September 25, 1980, and his 1986

correspondence with the Thompsons, his overriding

concern was to be compensatec by means of leverage loan

interest. It was this amount that even he often

referred to as a "fee" or a ceductible "cost" of tax

deductions.

In encouraging clients by means of.the

September 25, 1980, letter tc "discharge the debt to

which you are a party," he scught only small amounts

that could not have represented typical primary or

leverage loans. His letters. to the Thompsons indicate

that he only threatened or pursued collection of

principal obligations when the investor neglected or

refused to pay leverage loan interest. This rare

occurrence, which Kersting did not testify he either

intended or expected, is not sufficient to transform

any. of petitioners' loans.from Kersting. corporations

into genuine recourse indebtedness.

Dixon II,

62 T.C.M.

(CCH) at 1505-1506, 1991 T.C.M.

(RIA), at 91-

3049 to 91-3050.

VI..

Settlements

Internal Revenue Service Policy

National Office Position

After a tax shelter project is created and a project

attorney and a project Appeals officer are appointed, an official

project settlement offer is determined by the project Appeals

officer, the project attorney, and District Counsel.

.The project

attorney and project Appeals officer review the strengths and

weaknesses of the particular tax shelter and evaluate the hazards

- 75 -

of litigation -to determine an appropriate project settlement

offer.

Upon determination of the project settlement offer, the

terms of the offer are reported to the Tax Shelter Branch in the

National Office for dissemination·to Internal Revenue. Service

field offices (particularly the examination and appeals

functions) throughout the country to ensure that similarly

situated taxpayers are treated consistently.

Once a tax shelter project- is.assigned to a particular

District Counsel office, that office has the authority to settle

any individual case in the, project.

District Counsel generally

is expected to adhere to the official project settlenent offer.

Nevertheless, District Counsel has the.authority in special

circumstances to settle individual tax shelter project cases on a

basis-.different from. the.project settlement offer.. For example,

District Counsel could deny a project settlement offer to the

shelter promoter or a participant who had helped to market the

program.

In addition, District Counsel might eliminate an

addition to tax (such as negligence) because'of the participant's

lack of education.or sophisticaticn in financial.matters.

District Counsel can alter or modify an official project

settlement offer without prior approval of the National Office.

However, District Counsel is required to notify the Tax Shelter

Branch of any change or modification to the official project

settlement offer in order to allow the Tax Shelter Branch to

disseminate the revised offer to Internal Revenue Service *offices

throughout the country.

- 76 -

The National Office did not maintain a policy prohibiting

the settlement of a test case.

However, the Commissioner's

practice ofv withdrawing project se:ttlement offers once the

project test cases have been set for trial would serve to bar

settlements in test cases and nontest cases alike.3a

. Regional Counsel

Benjamin C. Sanchez (Mr. Sanchez) served as Regional Counsel

for the Western Region during thë period in question.

His view

of District Counsel's settlement authority in tax shelter cases

differed from the National Office view.

In Mr. Sanchez' view,

District Counsel had authority to settle tax shelter project

cases only on the basis.of the official project settlement offer.

Mr. Sanchez believed that District Counsel was obliged to adhere

strictly tó the~ official project settlement offer because of the

overriding need to ensure consistent treatment of tax shelter

project cases.

Although Mr. Sanchez acknowledged that District

Counsel technically had authority to settle a tax shelter project

case on a basis different from the official project settlement

offer, Mr. Sanchez believed that it woùld be improper to do so.

In.his view, disciplinary or other adverse career consequences

might follow if District'Counsel deviated from the official

project settlement offer in settling a case.

3s Of course, District Counsel might be reluctant to settle

a test case at a time; that removal of the case from the test- case

array would require delay in the tcial to allow the parties to

select a replacement case.

- 77 -

Mr. Sanchez expected that he would.be*informed by District

Counsel. of settlements in tax shelter project cases that deviated

from the official project settlement offer.

Official Kersting Project Setitlement Offer (71Percent

Reduction of Deficiency or Out-of-Pocket Expenses)

Between January

982 and mid-1986, the terms of the official

Kersting project settlement offer were stated as follows:

042

You will be allowed your actual out-of-pocket

expenses, in essence, the interest you actually paid

to Henry Kersting on the prepayment loan, or leverage

loan, which amount equals approximately 7% of the

determined deficiencies in most cases.

In addition,

if you reported capital gain income from the Kersting

transactions, or recaptured the difference between your

adjusted basis in the stock and your outstanding

indebtedness, then an appropriate adjustment will be

made to reflect this fact. In addition, if you are

involved in a leasing plan, to the extent there are

additional allowable ·I.R.C. Section 162 expenses which

were not claimed on the return, an appropriate

allowance will be made for settlement purposes.

you were involved in the Uniform Gift to Minors Act

program, referred to as KAT-FIT (sic) , to the extent

you can establish compliance with the Clifford Trust

rules, then an appropriate allowance for the deductions

will be made. The government will concede the

negligence penalties, I.R.C. Section 6653(1) and I.R.C.

Section 6653(a) (2), as well as the I.R.C. Section

. 6621 (c) interest .

The 7-percent reduction of the.deficiency reflected a deduction

equal to an average of the actual out-of-pocket expenses in

approximately 25 Kersting project cases.. For this purpose, the

Commissioner treated the "interest" paid on Kersting leverage

loans as the out-of-pocket expense.

From respondent's

- 78 perspective, the 7-percent settlenent offer was equivalent to

allowing a deduction for a theft loss in the year of payment.38

Under the 7-percent settlemént offer, the Commissioner

would:

(1) Concede the negligence addition to tax and increased

interest imposed on tax-motivated transactions pursuant to

section 6621 (c) ;

(2) concede an annual deduction under section

162 or 212 to leasing program participants for expenses that

exceeded the out-of-pocket adjustment;

(3) concede the deficiency

in full to participants in the CAT-FIT program who could provide

information on how the funds paid to the minor child were used

and establish that such use did not give rise to constructive

receipt of income by the parents; and (4) make appropriate

adjustments if the taxpayer had reported capital gains upon the

surrender of stock certificates to Mr. Kersting.

The puï-pose of

these concessions and adjustments was to provide similar

treatment of all Kersting program participants who wished to

settle their cases.

Deviations From Official Project Settlement Offer

Modified 7-Percent Settlement Offer

Between April and September 1986, Mr. McWade and Mr. Seery

conducted settlement negotiations that led Mr. McWade to offer a

settlement that deviated from the :>fficial project settlement

39 Respondent's position represented a concession insofar

as the allowance as a deduction of a theft loss of payments

induced by misrepresentation is postponed until the year of

discovery. See sec. 165(e); Bellis v. Commissioner, 61 T.C. 354,

357 (1973), affd. 540 F.2d 448 (9th Cir. 1976) .

offer-in one significant respect.

Specifically, by September -

1986, Mr; McWade and Mr. Seery had agreed to modify the^7-percent

settlement offer to incorporate a new featurerthey called the

"shelter burnout" that, would apply in cases involving more than 1

taxable year.

The shelter burnout feature*grew out of Mr.

Seery's contention that Mr. Kersting's programs could be viewed

as a tax deferral mechanism.'°

Mr. McWade agreed with Mr. Seery,

for settlement purposes, to allow a shifting of the initial

year's deficiency to a later year as a "shelter burnout".

For

example, in a case involving 2 taxable years, the taxpayer's

liability for statutory interest under section 6601 was computed

under the modified 7-percent settlement offer by treating the

taxpayer's tax liability for the earlier of the 2 years as having

been incurred.on.the due date for paymeht of tax for the later

year.

Under this approach, the tctal amount of the taxpayer's

underlying tax deficiencies remained the same; but the taxpayer's

liability for interest on the deficiencies was reduced by the

amount of such interest that otherwise would have accrued on the

deficiency for the earlier year of the 2-year period. -Variations

of this approach were used in cases involving more than 2 taxable

years.

.The modified 7-percent settlement offer negotiated by

4° In Dixon II, the Court considered and rejected the

argument that Mr. Kersting's programs resulted in mere tax

deferral. The Court arrived at.tris conclusion through a

detailed analysis of the Cravensee' tax returns for 1979 and

1980.

See Dixon II,

(RIA), at 91-3026.

62 T.C.M.

(CC:H) at 1483-1484, 1991 T.C.M.

- 80

Mr.- Seery and Mr. McWade provided that the Ccimmissioner would

settle any additions to. tax for fraud on a case-by-case basis.

By letter .dated September 29; 1986, Mr. Seery informed

Kersting program participants of . the~terms öf. the modified 7percent - settlement of fer and sugge sted that they give serious

consideration to the proposal.

Mr . McWade informed Mri Seery

that, because the trial of the teet. cases had been set for

February 1987, the modified 7-percent settlement offer would be

withdrawn on December 31, 1986, 'ard that Kersting program

participants interested in accepting the settlement should

contact Mr. McWade by November 10, :1986, in o der to allow time

to complete thegnecessary computations before the withdrawal of

the offer.

On October'10, 1986, Mri Kereting issued"a letter to

Kersting program participants in which he characterized the

modified 7-percent settlement offer as "grossly inadequate."

Messrs: Sims and McWade did rot notify- the National Office,

Regional:.Counsel, or the Appeals Cffice that they had

incorporated the ,burnout feature in their offer to-settle

Kersting project cases.

2. '

20-Percent Settlement O fer

Between September and December 1986, Mr. McWade and Mr. Sims

began to offer 20-percent settlements that were based on the same

general-approach as their modifiec 7-percent settlement offer

t;hat included thecburnout feature.

The 20 percent settlement

approach originated in late 1986 in separate negotiations bêtween

- 81 -

Mr. Sims.and Mr. Chicoine .and betw en Mr. McWade and

Mr. DeCastro.

The. enhanced 20-per ent settlement offer reflected

the perceptions of Messrs. Sims an

McWade that the evidentiary

issues raised by Chicoine and Hall tt increased respondent's

risks of litigation.

The 20-percent settlement off r was not disseminated in

writing by either Mr. Sims or Mr.

cWade.

The existence of the

20-percent settlement offer became known, if at all, through a

combination of Mr. Kersting's lett rs to þrogram participants

and calls that Mr. .McWade receive

participants.

from Kersting program

Messrs. Sims and Mc ade did not request approval

from or otherwise inform the Nat.io al Office, Regional Counsel,

or the Appeals Office before makin

the 20-percent settlement

offer.

Following the February 1987

aui session, the Honolulu

Appeal s Of f ice once again began t

o f fer Kerst ing program

participants a deduction for thei

cash out-of-pocket expenses,

or if substantiation was not avai able, a reduction of the

deficiency by 7 percent, with a w iver of the additions under

section 6653 (a) (1) and (2) .

The

onolulu Appeals Office did not

learn that Mr. McWade had negotia ed 20-percent settlement offers

until mid-1988, following issuanc

Dixon I.

of the Court's opinion in

At that time, the Honol lu Appeals Office determined

not to extend such offers because it saw no reason to deviate

from the official 7-percent proje t settlement offer.

. - 82 -

Negotiations . for 50-Percent Settlement Of fer

In January 1987, Messrs. .Sims and Chicoine continued their

efforts to negotiate a ssettlement of the Kersting project cases.

Initially, their discussions conceened a higher percentage

settlement if Mr. Kersting would agree to quit the tax.shelter

business.

They eventually abandoned their discussions to link

the settlement offer with Mr. Kers;ing's future conduct.

By letter dated January 16, 1387, Mr. Chicoine; notified

Mr. Kersting that he believed he had arrived at an agreement with

Mr. Sims to settle all the Kersting cases docketed in the Tax

Court by allowing 50 percent of the claimed interest deductions.

Mr. Chicoine's letter further states that Chicoine and Hallett

would agree to represent Kersting program participants desiring

to settle their cases on these terns for a flat fee of $550 per

case.

On January 19, 1987, Mr. Kersting wrote a letter to- program

participants stating that a 50'percent settlement had been .

negotiated. . Mr. Kersting recommended that the 50-percent

settlement be accepted; he included with his letter a form for

program participants to use to authorize Chicoine and Hallett to

represent them for purposes of sett:lement . ., .As a result of

Mr. Kersting's letter, approximate:.y 300 Kersting program

participants . contacted Chicoine .and Hallett seeking

representation.

- 83 In the meantime, Mr. Sims con ulted Barbara Leonard, Deputy

Regional Counsel for the Western Region.

She directed him to

terminate negotiations based upon a 50-percent settlement.

Upon learning of Mr. Kersting's letter, Mr.. DeCastro called

Mr. Chicoine to inquire about the ;erms of the purported 50percent settlement.

Mr. DeCastro stated (that. the. terms of the

purported settlement were better t 1an the terms he had

received for his clients and that le intended to attempt to

obtain the same terms for his clie its.

During his conversation

with Mr. Chicoine, Mr. DeCastro th eatiened to "make trouble" for

Mr. Chicoine unless he referred c

ents residing in California to

Mr. DeCastro for further represen

tion.

Mr. Chicoine flatly

rejected Mr. DeCastro's proposal.

Following the release ofi Mr.

ersting's January 19,. 1987,

letter, ·Mr. Sims .received numerous telephone calls from Kersting

program participants and attorneys seeking to accept the 50-

percent settlement.

Following his conversation with

Mr. Chicoine, Mr. DeCastro called Mr. Sims to express concern

that Mr. Chicoine's clients might obtain more favprable

settlements than the settlements

ffered to Mr. DeCastro's

clients.

By letter to Mr. Chicoine da ed February 4, 1987, during the

week immediately preceding the Ma i session, Mr. Sims denied that

he had agreed to a 50-percent set lement of the Kersting project

cases.

Mr. Sims' letter states i

pertinent part:

- 84 -

I have not settled any of the Kersting cases

with you.

2. The government has rot made any new, blanket

offer to settle these cases (other than our old 7%

offer); nor has the governmert made any offer to wholly

or partially concede any of the issues presented by

these cases. To the extent dhat you may disagree with

this statement, any such offdr of concession that you

believe has been made by me dr any other government

official is hereby withdrawn.

3. We do not'have a wodkable basis for settlement

of any case or any group of dases.

If you should

attempt to represent to..the dourt that you have süch a

basis, either- in order to obtain a continuance of the

trials in this matter or to ëttempt to force the

government into unagreed-to settlements or concessions,

I will dispute this firmly.

Before the start of the Maui.session, Judge Goffe held a chambers

conference with Messrs. Chicoine, Hallett, Sims, McWade, O'Neill,

and DeCastro.

Although Mr. Chicoine told Judge Goffe that the

parties had reached a basis of set'tlement, Mr. Sims denied that

there was a settlement.

Mr. Sims said that he had "pulled-

the plug" on a proposed 50-percent settlement because

Mr. Kersting had interfered with the negotiations.

Revival of 20-Percent Settlement Offer

During spring 1987, Mr. Chicoine continued to explore with

Mr. McWade the possibility of a global settlement.

By letter

dated April 13, 1987, Mr. Chicoine provided Kersting program

participants with a détailed statis report addressing

developments at the Maui session Ls well as settlement

negotiations.

Mr. Chicoine's lett,ef also stated that the firm's

representation of nontest case ta>:payers was not intended to

extend to general representation in all matters but was limited

- 85 -

to the acceptance of an Internal R venue Service settlement

offer.

On April 16, 1987, Mr. Chicoi e wrote to Mr. Kersting and

confirmed that he would be meeting Mr. McWade ·in Hawaii the

following week to discuss the possuble settlement of six cases.

Mr. Chicoine warned Mr. Kersting not to address the subject of

the status of settlement negotiations >in his letters to Kersting

program participants, inasmuch as his comments could be

detrimental to such negotiations.

On or about April 27, 1987,

Mr. Chicoine. informed Mr. Kersting that he would recommend that

Kersting program participants acce t a.20-percent settlement

offer.

By letter dated May 22, 1987, Mr. Kerstingsprovided

Mr. Hallett with information perta ning to è purported 30-percent

settlement negotiated by Mr. DeCas ro on behalf of Benness M. and

Jane Richards.

Mr. Kersting stat d that"he'was*attempting to

obtain information respecting addi ió~nal settlemeñts negotiated

by Mr. DeCastro.. Between May 1987 and February 1988,

Mr. Kersting wrote no fewer than s ven letters to Chicoine and

Hallett strongly objecting to thei

communication of a 20-percent

settlement offer to Kersting progr m participants.

In his

In Richards v. Commissioner, T.C. Memo. 1997-149,

supplemented by T.C. Memo. 1997-29 , affd. without published

opinion 165 F.3d.917

(9th Cir. 199 ), we observed that the

settlement may have been detriment 1 to Mrt and Mrs. Richards

insofar as the original deficiency had been computed using an

excessive tax rate (70 percent) an may hãve been based in part

upon the disallowance of legitimat non-Kersting interest

deductions. See supra p. 27.

- 86 -

May 22, 1987 letter, Mr. Kersting 'objected to Chicoine and

Hallett's recommendation of a 20-gercent settlement in pertinent

part as follows:

As I have done several times 'now I ask you again NOT to

communicate to anyone of my friends a prospect of a 20%

settlement. +The 50% flop hae, left a $40,000.00 to

$50,000.00 scar with us. It was a lesson I will take

with me ·to the other side

3 trust that you have

reconsidered by now your position in the matter and

that you will NOT go into an adverse stance to me and

my enterprises. I assure you that the jolt of April

27th has not worn off yet..

On June 10, 1987, Mr. Kerstirg forwarded to Mr. Chicoine a

letter that he had received from Fr. DeCastro pertaining to a

settlement that Mr. DeCastro purpcrtedly negotiated on behalf of

Boyd S. and Jeannette F. Proctor..

By letter dated June 16, 1987,

Mr. Chicoine responded,to Mr. KerEting, stating that he was

satisfied that the Proctors did nct receive a settlement in

excess o:E 50 percent as Mr. Kersting had suggested because the

figures in.question did not incluce the Proctors' liability for

statutory interest.

Mr. Chicoine concluded that the settlement

was in the range.of a 14-percent reduction. of the Proctors'

deficiency.

On November 4, 1987,,Mr. Kerïting sent.Mr. Hallett a letter

which states in pertinent·part:

Here I asked you about L year ago to defend my

friends, here I had high hopes and reasonable

expectation that you.would wÅrk with us, that we would

work on consensus and to the common benefit of my

friends and here I find that you not only do not care

to do that, you are actually moving into an adversary

position. And this after I have paid you an enormous

amount of legal fees and after I have disciplined

myself over and over again to keep my temper as I

- 87 -

observe a widening rift between the attorneys who are

supposed to work for us and who are, instead, looking

after their strangly [sic] perceived protection from

liability, My interest in these proceedings and what

I consider to be the best interest óf my friends is arrogantly overlooked and we are, if your scheme of

things would prevail, relegated to onlookers to a

spectacle for which we are compelled to pay but in

'which we are not allówed to take part. It is simply

absurd.

On January 12, 1988, Mr. Kersting issued a.letter

encouraging nontest case Kersting program participants who had

paid $550 to Chicoine and Hallett for representation in the

settlement process to "recall your funds".

By letter dated January 20, 1988, Mr. Chicoine notified the

test case petitioners represented by his firm that Mr. McWade was

offering a 20-percent settlement.

Mr. Chicoine's letter states

in pertinent part:

Mr. McWade has stated that ycu may settle your case

along the grounds set forth above. Since you are a

test case, however, you will not be permitted to

withdraw if you wish to enter into the settlement

proposed. Accordingly, we wculd enter into an

agreement with Mr. McWade that regardléss of the

outcome of the trial, you would be allowed the

settlement . Thus, if the case were lost in its

entirety, your tax deficiency would be calculated in

accordance with the settlemert.

By letter dated.January 22, 1988, Mr. Hallett informed

Mr. Kersting that Chicoine and-Ha]lett were seeking an opinion

from an expert on legal ethics whether it would be appropriate

for the firm to-accept new cliente seeking to settle Kersting

project cases.

However, Mr. Hallett stated that the firm would

continue to inform its existing clients regarding the status of

settlement discussions.

- 88 -

By letter dated January 29, 1988, Mr. Chicoine sent

Mr. Kersting copies of proposed stipulated. decisions reflecting

settlements that Mr. Chicoine had negotiated with Mr. McWade in

three Kersting cases.42

Mr. Chico:.ne stated that Chicoine and

Hallett were obliged to inform all Kersting program participants

who had retained his firm that Mr. McWade was continuing to offer

settlements despite Mr. Kersting's misrepresentations in his

letters to Kersting program participants that no settlement was

being offered.

By letter dated F bruary 5, J988, John A. Strait, Associate

Professor of Law at the University of Puget Sound School of Law

(·Professor Strait), responded to Chicoine and Hallett's request

for an expert opinion regarding their ethical obligations as

counsel in the Kersting project.

Professor Strait advised

Chicoine and Hallett that the.firm did not have an attorney/

client relationship with, or owe Ettorney/client duties to,

Mr. Kersting, but that Chicoine ard Hallett did have an

attorney/client relationship with the test case petitioners as

well as the nontest case Kersting program participants who had

sent Chicoine and Hallett the $55C retainer and authorization

forms.

Concerning the nontest care clients, Professor Strait

concluded that Chicoine and Hallett were obliged to "evaluate

settlement proposals and to transmit to them your recommendation

42 Mr. Chicoine's letter identified the taxpayers as

Muller, Lipsky, and Mellows. The record does not reflect the

terms of the settlements in these cases.

- 89 -

with the explanation of what the options might be as to the

desirability of accepting any sett Lement proposal. "

On February 6, 1988, Mr. Kers;ing wrote to Mr. Hallett

stating in pertinent part :

I take it from our phone conversation yesterday that

you are intent now to trigger the melt-down on me and

our corporations with which you have threatened me now

for months. And if I have absorbed all this correctly,

you will do this mainly out o E concern that some of my

friends might sue you at some time down the line if you

do not advise them of a "setti.ement" which you perceive

to be available.

The bitter irony of all this is that there was only a

remote possibility that anyons of my friends would sue

you.

If you.go through with your threat to cause a run

on us you will have THE CERTAINTY that there will be

litigation. .It will be hell after this.

On February 8, 1988, Mr; Kersting wrote a letter to Kersting

program participants warning them that Chicoine and Hallett soon

would circulate the details of a 20-percent settlement offer.

Mr. Kersting urged Kersting progra

participants not to hire

Chicoine and Hallett for purposes

f settlement and instead to

await the Court's decision regarding the evidentiary issues

raised by Chicoine and Hallett on behalf of the test cases .

During this period, Mr. Kersting threatened to sue Chicoine and

Hallett if they reported the settlement offer.

On February 9, 1988, Mr. Chicoine.issued two letters, one

addressed to the firm's clients and one addressed to Kersting

program participants who had contacted Chicoine and Hallett

regarding representation.

These letters served as status reports

on the Tax Court case and settlement negotiations.

Mr. Chicoine

- 90 -

reported that Mr. McWade had offered to settle docketed Tax Court

cases in accordance with the previously described 20-percent

settlement offer, recommended that program participants seriously

consider the settlement, and sugge sted that those who desired to

settle on these terms shoùld contact Chicoine and Hallett.

On February 20, 1988, Mr. Kersting wrote to Chicoine and

Hallett stating in pertinent part:

"I hereby revoke your

appointment as counsel= for the teEt Cases".

On February 23, 1988, Mr. Chicoine wrote to Mr. McWade

seeking a 20-percent settlement or behalf of test case

petitioners Terry D. and Gloria K. Owens.

Mr. Chicoine's letter

states in pertinent part :

Mr. Owens understands that nct all cases will settle

and you wish to proceed to trial with some test cases.

It is hoped that under the circumstances he may be

withdrawn as a test case. If this is not possible,

he still wishes to settle thc case and enter into an

agreement which will permit 1 im to settle the case

regardless of the outcome of the trial.

Mr. and Mrs. Owens subsequently dccided that they would not

continue efforts to settle their case.

In early March 1988, Chicoinc and Hallett began receiving

requests from Kersting program participants for return of the

$550 retainer fee .

Although Chicc ine and Hallett returned the

full amount of the fee to all thoee who requested it, they were

informed that they might be billed for a "minimal amount"

reflecting the firm's costs associated with the opening-of files

and issuance of status reports.

- 91 -

. On March .9, 1988, Mr. Kersting issued a letter to program

participants characterizing Chicoine and Hallett as "scoundrels",

and stating that he had fired them and retained Mr. Izen to

represent the test cases (excluding the Thompsons and the

Cravenses) .

By letter dated April 22, 1988, Mr. Chicoine notified

Kersting program participants that the Court had ruled in the

Government's favor in Dixon I; he restated his support for the

20-percent settlement of fer described in his February 9, 1988-,

letter and revealed that, because of a disagreement with

Mr. Kersting, Chicoine and Hallett would withdraw as counsel for

the test cases.43

Mr. Kersting later carried out his threat to sue Chicoine

and Hallett for legal malpractice.

Mr. Izen served as an expert

witness for Mr. Kersting in his lawsuit against Chicoine and

Hallett .

By. letter dated April 8, 198E, Mr. .McWade notified

Mr. DeCastro. that, after June 15, 1988, respondent would no

43 Coincidentally, on Apr. 20, 1988, Mr. DeCastro wrote a

letter to a client, James Losey, Expressing similar sentiments in

favor of settlement of the Kerstir.g cases. After outlining the

deadlines that Mr. McWade had set for the acceptance of

outstanding settlement offers, Mr. DeCastro's letter states in

pertinent part :

There is now an urgent r.eed for your friends and

acquaintances to consult their legal counsel and

seriously consider settling t heir case with the IRS.

The evidence continues to build against the taxpayers

in these cases and despite Mr.. Kersting'.s assurances,

we feel the trial will be wor. by the IRS. The result

would be very serious for the taxpayers.

- 92 -

longer consider settlements, other than on the basis of allowing

out-of-pocket expenses, and that cut-of-pocket settlements would

no longer be available after October 3,.1988.

By memorandum

dated October 1SF, 1988, the Actinc Chief of the Tax Shelter

Branch notified the Assistant Comnissioner for Examination (with

copies to the Director of the Appeals Office, Mr. McWade,- and

several National Office executives) that, because the Kersting

test cases had been- set for trial in January 1989, the

Kersting project settlement offer would be withdrawn, effective

October 28, 1988.

The Thompson Settlement

.Initial Thompson Settledent Agreement

In.early December 1986, Mr. VcWade and Mr. DeCastro

discussed settlement of the cases of a number of Mr. DeCastro's

clients, including the Thompsons.

Mr. Sims was aware of-the

McWade-DeCastro discussions when te also met with Mr. DeCastro in

December 1986 at the HonoluluiDistrict Counsel Office. and

generally discussed with Mr. DeCastro settlement arrangements for

the Thompson cases.

On December 23, 1986, Mr. McFade mailed a letter to

Mr. DeCastro enclosing proposed decision documents for the

Thompsons as well as several other taxpayers with cases before

the Court.

Mr. McWade's letter states in pertinent part:

Dear Mr. DeCastro:

Enclosed herewith are the Decision documents, as

per our conference, in the above captioned cases.

Please sign the original and one copy of the Decision

document, in the space proviced, and return them to

- 93 -

this office for signing and filing with the Court.

remaining copy is for your records.

The

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 ;1iability for

interest.

In response, on December 30, 1986, Mr. DeCastro executed three

separate decision documents on behalf of the Thompsons agreeing

to the following deficiencies:

Year

Deficiency

1979

1980

1981

Additions to Tax

---

$34, 425

30,000

^ ----y

The December 1986 settlements that Mr. McWade extended to

Mr. DeCastro's clients differed from the 7-percent official

Kersting project settlement offer used by respondent's Appeals

Office.

In particular, the Thompson settlement included the

burnout feature and was based on a reduction of the deficiencies

that respondent had determined against the Thompsons of

approximately 19 percent as follows:

Year

Adiustment

Deficiency

Settlement

% Reduction

1979

1980

$39,477

72,840

Total

$18,161

24,838

42,999

--$34.425

34,425

20%

30 , 000

64,425

1981

$80, 782

All years total

36, 295

79,294

The adjustments for each year consisted solely of the

disallowance of deductions that the Thompsons had claimed with

respect to Kersting programs.

- 94 -

On December 30, 1986, Mr. Thcmpson sent a letter to

Mr. McWade enclosing checks for $24,000 and $25,545 that were

intended as payments of interest on the Thompsons' tax

liabilities for the taxable years 1980 and 1981, respectively."

First Revision of Thompeon; Settlement

On January 27, 1987, Mr. Huestis sent a letter to

Mr. DeCastro stating that Mr. Thonpson did not understand the

terms of his settlement.

On Febr1:ary 3, 1987, Mr. DeCastro

responded to Mr. Huestis as follows:

Dear Sam:

Thanks for your letter cf January 27, 1987

indicating questions which Jack Thompson has regarding

the proposed settlement.

I will respond in the order

of your questions:

The only years in c ispute are 1979, 1980 and

1981.

2. For each year, the amounts claimed due by the

I . R . S . by category are :

Tax deficiency

Penalty

Interest

1979

1980

1981

Total

$18,161

908

19, 977

39,046

$24,838

1, 242

24 , 838

50,918

$36,295

19, 757

27, 976

84,028

$79,294

21, 90 7

72 , 791

173,992

3. By the terms of the proposed settlement, the

following amounts are due to be paid by Jack:

" Many Kersting program part icipants, like the Thompsons,

made interest payments on.or immeciately before Dec. 31, 1986,

in order take advantage of the full deductibility of interest

in 1986. . The deductibility of payments of personal interest was

subject to phase-out for taxable years beginning after Dec. 31,

1986, pursuant to TRA sec . 511 (b) , 100 Stat . 2246 .

- 95 -

Tax deficiency

Interest

1979

19 0

1981

Total

$34, 25

35 75

69, 700

$30,000

24,270

54, 270

$64,425

59,545

123, 970

As you can see, this amo nts to a substantial

reduction in tax liabilities.

4 . Jack correctly understands that his recent

payment of $59, 545 was entirely applied to interest .

5. The IRS is willing t settle with Jack only- on

the basis that his test case remains active. The terms

are not contingent upon any s ecific testimony or

degree of cooperation and will be filed upon completion

of the test case. Jack need nly testify, at the trial

and is only technically a def ndant . Unless some

dramatic changes in schedule ccur, there will be no

depositions. Essentially, J k need only testify, be

protected from Kersting, and oes~not need to prepare a

full-blown defense.

6. As indicated, the I S insists upon Jack

continuing as a test case de endant for its own

purposes. That is presently a condition of the

settlement .

In addition, we simply do not trust

Kersting to act in accordance with his promises and

staying in the case appears

be wise insurance to

obtain cancellation of the n es, etc.

7. I enclose a copy of a letter we have sent to

Kersting's attorney regardin the3notes issue for your

information.

If we are unable to btain a cancellation of

notes and recovery of funds nvested for Jack through

negotiation, we will certain y .look to retain John

Chanin or other local counse £or that purpose .

On February 6, 1987, Mr. Huestis

eviewed-Mr. DeCastro's letter

with Mr. Thompson and was satisfi d that Mr. Thompson understood

the status of his case.

On March 13,.1987, following the Maui session, Mr. McWade

sent Mr. DeCastro a revised decis on for docket No. 31236-84

reducing the Thompsons' tax defi

ency for 1-980 from $34,425 to

- 96 $33,000.

Mr. Sims reviewed and approved Mr. McWade's letter to

Mr. DeCastro.

Although the record contains no explanation for

this revision of the Thompson settlement, the revision

effectively increased the Thompsor. settlement from 19 percent to

approximately 20 percent.

On April 7, 1987, Mr. DeCastro sent

Mr. Thompson a letter informing him that the Internal Revenue

Service had reduced his tax liability for 1980 by approximately

$1,000.

Mr. DeCa

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