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T.C. Memo. 2006-90

UNITED STATES TAX COURT

JERRY AND PATRICIA A. DIXON, ET AL.,1 Petitioners

v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos.

9382-83,

17642-83,

10588-83,

17646-83,

. Filed May 2, 2006.

¹Cases of the following petitioners have been treated as

cases related to the above-captioned case for.purposes of the

additional evidentiary hearing required to give effect to the

mandates of the Court of Appeals for the Ninth Circuit in Dixon

v. Commissioner, 316 F.3d 1041, 1047 (9th Cir. 2003), as amended

Mar. 18, 2003 (Dixon V), revg. and remanding T.C. Memo. 1999-101

(Dixon III):

Robert H. and Barbara A. Gridley, docket Nos.

10588-83, 10931-84, 38757-84; Norman W. and Barbara L. Adair,

docket Nos. 17642-83, 38965-84, 35608-86, 479-89, 8070-90; Ronald

L. and Mattie L. Alverson, docket No. 17646-83; Russell L. Fleer,

Sr. and Sally A. Fleer, docket Nos. 27053-83 and 13477-87; Hoyt

W. and Barbara D. Young, docket Nos. 4201-84, 22783-85, 30010-85;

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

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

L. and Barbara G. Blaylock, docket No. 28723-84; Terry D. and

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

Hongsermeier, docket No. 29643-86; Willis F. McComas, II and

Marie D. McComas, docket No. 19464-92; Wesley Armand and Sherry

Lynn Cacia Baughman, docket No. 621-94; Joe A. and JoAnne

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

No. 9532-94; Stanley C. and Sharon A. Titcomb, docket No. 1799295; Richard B. and Donna G. Rogers, docket No. 17993-95.

The 27

related cases have been consolidated for briefing and opinion.

SERVED RAY

2 200

- 2 27053-83,

4201-84,

10931-84,

15907-84,

20119-84, 28723-84,

. 38757-84,

38965-84,

40159-84, . 22783-85,

30.010-85,

30979-85,

29643-86,

35608-86,

13477-87,

479-89,

8070-90,

19464-92,

621-94,

7205-94,

9532-94,

17992-95,

17993-95.

In Dixon v. Commissioner, 316 F.3d 1041 (9th Cir.

2003), revg. and remanding T.C. Memo.. 1999-101, the

Court of Appeals held that the misconduct of R's trial

attorney and his supervisor in the trial of the test

cases for the Kersting tax shelter project, in agreeing

with counsel for T, one of the test case Ps, to a

secret settlement of T's deficiencies (not disclosed to

IRS management, to this Court, or to counsel for other

test case Ps), was a fraud on the Court.

The Court of

Appeals ordered this Court to sanction R by entering

judgment in favor of the remaining test case Ps and

other Ps in the Kersting tax shelter group before the

Court on "terms equivalent to those provided in the

[final] settlement agreement with [T] and the IRS",

leaving to this Court's discretion "the fashioning of

such judgments, which to the extent possible and

practicable, should put these taxpayers in the same

position as provided in the [T] settlement".

R argues that the substance of the T settlement·

was a 20-percent reduction of T's 1979-1981

deficiencies, plus the payment of T's attorney's fees.

Ps argue that the T settlement was, in form and

substance, a 62.17-percent reduction of T's·1979-1981

deficiencies, plus other benefits that bring the T

settlement to a 79.92-percent reduction in the

deficiencies.

The parties agree that the T settlement

also included cancellation of all additions and

penalties, including nonshelter-related additions and

penalties, and the use of a "burnout" to reduce the

accrual of interest on the remaining deficiencies.

- 3 argue that interest on the deficiencies should not be

charged beyond Dec. 31, 1986, which, in their view,

marks the inception of the fraud on the court. R has

conceded that no interest will be charged on the

deficiencies for the period of the appeals to the Ninth

Circuit commencing in 1992.

Held: The final settlement of T's 1979-1981

deficiencies amounts to a 62.17-percent reduction of

those deficiencies.

Held,. further: Two minor additional benefits

included in the T settlement bring the reduction

percentage up to 63.37 percent.

Held, further:

The T settlement encompasses and

requires the vacating of the portion or portions of the

deficiencies determined against any Ps that may be

attributable to the "Bauspar" shelter that was also

promoted by Kersting and to any other issues not

arising from shelters promoted by Kersting.

Held, further:

Interest on the reduced

deficiencies shall not be charged beyond the date in

1992 fixed by R's concession and shall not be stopped

as of any earlier date.

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

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

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

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

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

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

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

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

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

- 4 -

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

docket No. 29643-86.

Robert Patrick Sticht and Boris Orlov, for petitioners in

docket No. 7205-94.

Robert Patrick Sticht, for petitioners in docket Nos.

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

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

CONTENTS

Page

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

I. The Kersting Tax Shelters . . . . .

A. Background . . . . . . . . . .

Respondent's Kersting Project .

1. In General . . . . . . . .

2. Bauspar . . . . . . . . .

II.

. .

. . . .

Respondent's Project Settlement Offer

. . . . . . . . . . . . . . . . . . .

The Thompsons' Participation in the Kersting

Tax Shelters

The Thompsons' Tax Returns . . . . . . .

Prepetition Years--1977 and 1978 . .

Years Before the Court . . . . . . .

1978-1981 Returns .

III. The Test Case Litigation and the Thompson .Settlements

Selectio3n of the Test Cases . . . . . . . . . . .

1979 . . . . . . . . . . . . . . . . . . .

1980 . . . . . . . . . . . . . . . . . . .

1981 . . . . . . . . . . . . . . ... . . .

Years Following Those Before the Court . .

1982 . . . . . . . . . . . . . . . . . . .

1983 . . . . . . . . . . . . . . . . . . .

1984 . . . . . . . . . . . . . . . . . . .

1985 . . . . . . . . . . . . . . . . . . .

. .

Examination of the Thompsons'

- 5 B.

IRS Activity Regarding the Thompsons'

The Reporting and Resolution of the Thompsons'

Deficiency Interest Payments for 1986 and 1987

The Thompson Settlement Revised as Trial

IV.

Deterioration of the Thompson-Kersting

Relationship . . . . . . . . . . . . . . . . . . .

The Thompsons Engage DeCastro, Who Settles

Their Cases . . . . . . . . . . . . . . . . . . . .

1983-85 Returns . . . . . . . . . . . . . . . . . . 30

.33

Approaches . . . . . . . . . . . . . . . . . . . .

Trial and Entry of Decisions . . . . . . . . . . .

Discovery and Disclosure of the Thompson

Settlements -. . . . . . . . . . . . . . . . . . . .

Implementation and Effects of the

Final Thompson Settlement . . . . .

Respondent's Disciplinary Action

Against Sims and McWade . . . . . . . . . . . . . .

OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . .

Preliminary Comments . . . . . . . . . . . . . . . . . . . .

II.

Ninth Circuit Remand and Subsequent Proceedings

Ninth Circuit Orders in the DuFresne Case .

Evidentiary Hearing and Opinions

After the Remand in DuFresne . .. . . . . .

The Ninth Circuit's Opinion and

Mandates in These Cases . . . . . . . . . .

Proceedings Following Remand . . . . . . .

Further Disciplinary Proceedings . . . . .

Procedural Issues Following Remand .

Procedural Posture . . .

Law of the Case . . . .

Parties Before the Court

Burden of Proof . . . . .

. . .

. .

Defining and Applying the Thompson Settlement

. . . .

. 78

. .79

. 80

. 81

Overview . . . . . . . . . . . . . . . . . . . . .

Areas of Agreement . . . . . . . . . . . . . . . .

Starting Point:

The Thompsons' Settlement

of Proposed Deficiencies for 1979-1981

. ..

Respondent's Position . . . . . . . .

2. Petitioners' Position . . . . . . . . . . . .

3. Analysis . . . . . . . . . . . . . . . . . . .

Other Benefits Relating to the Thompsons'

1981 Tax Year . . . . . . . . . . . . . . . . . . .

- 6 1.

Elimination of the Thompsons' Late

Filing (Non-Kersting) Addition for 1981 . . .

Respondent's Failure To Address the

Bauspar Issue in the Thompsons' Statutory

Notice for 1981

. . . . . . . . . . . . . . . 100

Benefits to the Thompsons.Relating to Years

Other Than 1979-1981 . . . . ... . . . . . .

. .

. 100

. 102

In General . . . . . . . . . . . . . . . . . . 100

The Thompsons' Escape From Kersting

Liability with Respect to 1982 . . .

The Thompsons' 1983 Kersting Deficiency

and the Disappearing Statutory Notice . . . . 108

The Thompsons' 1983-85 Bauspar .

Deductions

. . . . . . . . . . . . . . . . . 109

The Thompsons' Deduction of Prepaid

Interest on Their 1986 and 1987 Returns

. 111

1986 . . . . . . . . . . . . . . . . . . . . . 111

1987 . . . . . . . . . . . . . . . . . . . . . 115

The Thompsons' Attorney's Fee

Deduction for 1993 . . . . . . . . . . . . .

The Thompsons' Failure To Report

Tax Benefit Income for 1993 . . . . .. . . .

Payment of Witness Fees to Mr. Thompson . .

Release of Lien on the Thompsons'

Property and Other Intangible Benefits . . .

The Percentage Reduction Summarized . . . . . . .

. 123

. 125

. 126

. 127

. 129

. 117

. 119

. 122

Additional.Relief . . . . . . . . . . . . . . . . . 126

Elimination of Non-Kersting Additions . ;

Allowance of Bauspar Deductions . . . . .

Elimination of Non-Kersting Deficiencies .

Attorney's Fees

. . . . . . . . . . . . . . . 128

III. Interest on Deficiencies and Overpayments

MEMORANDUM FINDINGS OF FACT AND OPINION2

BEGHE, Judge:

With this opinion, .the Court hopes to provide

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

2This opinion is issued pursuant to the mandates of the

Court of Appeals for the Ninth Circuit in Dixon V, revg. and

remanding Dixon III.

Dixon·III had supplemented our Memorandum

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

1991-614 (Dixon II), vacated and remanded per curiam sub nom.

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

For the

record, Dixon I is reported as Dixon v. Commissioner, .90 T.C. 237

(1988), holding that petitioners had failed to establish standing

to contest a search of Kersting's office, thereby sustaining the

validity of the deficiency notices generated by the information

discovered in that search.

Dixon IV, reported as Dixon v.

Commissioner, T.C. Memo. 2000-116, provided for awards of

attorney's fees under sec. 6673(a)(2) to petitioners in Dixon

III.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years at issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

3In addition to the more than 1,300 open cases, petitioners

in 52 of the more than 500 other dockets in the Kersting project

in which stipulated decisions were entered, both before and.after

discovery and disclosure of the misconduct held by the Court of

Appeals in Dixon V to have constituted fraud on the Court, have

filed motions for leave to file motions to vacate- their

decisions. The Court has returned unfiled numerous other such

motions because of procedural defects.

Petitioners filing or

attempting to file such motions have thereby sought to become

entitled to the benefits of the Thompson settlement as mandated

by the Court of Appeals in Dixon V. Motions for.reconsideration

have been filed in the three dockets addressed in Lewis v.

Commissioner, T.C. Memo. 2005-205, in which we denied

petitioners' motions for leave to file motions to vacate

stipulated decisions in Kersting-related cases.

- 8 of petitioner participants in the second generation4 of tax

shelter programs

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

Kersting (Kersting).s

During the trial on the merits of the test

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

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

Kenneth W. McWade (McWade)

(with the knowledge and connivance of

4In Pike v. Commissioner, 78 T.C. 822 (1982), affd. withoutpublished opinion 732 F.2d 164 (9th Cir. 1984), this Court

sustained respondent's·disallowance of all deductions for

interest, losses, and credits claimed by participants in

Kersting's first-generation programs.

5For additional information about the Kersting project, see

infra Parts I.A. and I.B.

Before his death on Mar. 4, 2000,

Kersting and the tax shelter programs he promoted were frequently

before the courts.

In addition to those cases cited supra notes

2, 3, and 4, see also, e.g., United States v. Kersting, 891 F.2d

1407 (9th Cir. 1989) (holding that an IRS summons was enforceable

against some Kersting program participants); Richards v.

Commissioner, T.C. Memo. 1997-149, Supplemental Opinion T.C.

Memo. 1997-299 (upholding Kersting project deficiency notice),

affd. without published opinion 165 F.3d 917 (9th Cir. 1998);

Gridley v. Commissioner, T.C. Memo. 1997-210 (denying

petitioners' motions for summary judgment to obtain benefit of

Thompson settlement); Kersting v. United States, 206 F.3d 817

(9th Cir. 2000) (promoter penalties upheld); Kersting v.

Commissioner, T.C. Memo. 1999-197 (sustaining deficiencies

against Kersting personally); United States v. Kersting, 77 AFTR

96-1717 (Bankr. D. Haw. 1996) (denying Kersting bankruptcy

discharge).

6In 1986, counsel for the parties in the Kersting-related

cases agreed. to a test case procedure, under which a few typical

cases are selected as test cases, while the petitioners whose

cases are not selected as test cases are encouraged to execute a

"piggyback" agreement, i.e., a stipulation to be bound by the

outcome of the test cases.

The majority of petitioners in the

Kersting-related cases executed piggyback agreements.

See the

discussion in Gridley v. Commissioner, supra note 5.

_ 9 _

his supervisor, Honolulu District Counsel William A. Sims

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

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

Thompson (the Thompsons).

The financial terms of the final

settlement were much more advantageous to the Thompsons than the

settlements generally made available to other petitioner

participants in the Kersting project.'

The final settlement with

the Thompsons was intended to provide refunds of tax and interest

paid by the Thompsons under a prior settlement, plus interest

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

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

independent representation of the Thompsons at the trial of the.

test cases.

After this Court upheld respondent's determinations

and entered decisions in favor of respondent in all the test

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

(Dixon II),

respondent's senior management discovered the settlements, moved

this Court to vacate the decisions (including the decisions in

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

70ne nontest case petitioner, Denis Alexander, in exchange

for his acting as a witness and serving as an undeclared ..

consultant to McWade dùring.the original trial of the test cases,

as described in Dixon III at Findings of Fact V.B. and VI.F.,

received a settlement even more favorable than that afforded the

Thompsons. Although the Court of Appeals in Dixon V noted

Alexander's settlement, the Court of Appeals did not rely on or

refer to that settlement in formulating the sanction to be

imposed by its mandates.

- 10 Court of Appeals for the Ninth Circuit, and requested an

evidentiary hearing.

After vacating the decisions, the Court

denied the motion for evidentiary hearing, entered decisions· for

the Thompsons in accordance with their final settlement, and

reentered or allowed to stand its decisions in the other test

cases.

The Court thereafter denied mo.tions by test case and

nontest case petitioners to intervene in the Thompsons' cases

shortly before the new decisions in those cases became final.

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

(hereafter

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

decisions against the other test case petitioners on the ground

that the misconduct of Sims and McWade required further inquiry.

The Court of Appeals directed this Court to hold an evidentiary

hearing to determine:

"whether the extent of misconduct rises to

the level of a structural defect voiding the judgment as

fundamentally unfair, or whether, despite the government's

misconduct, the, judgment can be upheld as harmless error."

Id.

at 108.

This Court conducted the evidentiary hearing directed by the

Court of Appeals and held that the misconduct of the Government

attorneys did not create a structural defect but .rather resulted

in harmless error.

See Dixon v. Commissioner, T.C. Memo. 1999-

101 (Dixon III).

We imposed sanctions against respondent in the

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

- 11 -

for negligence as well as relief from additional interest under

section 6621(d)/(c)

(hereafter, section 6621(c)).8

The other test case petitioners again appealed.

The Court

of Appeals for the Ninth Circuit reversed and remanded our

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

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

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

counsel constituted a fraud on the court and directed this Court

to enter decisions "in favor of Appellants and all other

taxpayers properly before this Court on terms equivalent to those

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

Id. at 1047.

In this opinion, we determine. the terms of the

Thompson settlement and their application to the Kersting.project

participants before the Court.

FINDINGS OF FACT

The parties have filed a stipulation of facts for

evidentiary hearing on September 20, 2004; a first supplemental

stipulation of facts for evidentiary hearing on September 20,

2004; a second supplemental stipulation of facts for evidentiary

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

8Sec. 6621(d) was redesignated sec. 6621(c) by the Tax

Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 1511(c)(1)(A)-(C),

100 Stat. 2744, and repealed by sec. 7721(b) of the Omnibus

Budget Reconciliation Act of 1989, Pub. L. 101-239, 103 Stat.

2399.

- 12 -

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

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

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

stipulated therein are so found.

The facts

The stipulation of facts and

the attached exhibits are incorp.orated herein by this reference.

The parties have further stipulated that, for purposes of the

present opinion, the Court may incorporate its findings of fact

as stated in earlier proceedings unless such facts are

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

or are inconsistent with facts stipulated or proven in

proceedi·ngs held after the issuance of Dixon V.

The Kersting Tax Shelters

Background

All the cases before the Court concern proposed

deficiencies, additions to tax, and interest that related to

petitioners' participation in tax shelter programs promoted by

Kersting.

All the programs involved both "primary" loans and

notes and "leverage" loans and notes with cçrporations organized

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

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

See

These notes

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

documents were actually executed and even before the date on

which the participant informed Kersting he was ready tg

participate in a particular program.

Kersting advised

- 13 participants in his .programs that the programs created legitimate

investments that would entitle participants to interest

deductions that they should claim on their individual tax

returns.

Respondent's Kersting Project

In General

Kersting's promotion of his tax shelter programs had

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

which instituted a tax shelter project known as the Kersting

project.9

In furtherance of that project, respondent sent

deficiency notices to more than 1,800 taxpayers who had

participated in the Kersting programs.

The IRS established the Kersting project in its Honolulu

Appeals Office.

In any given tax shelter project, a project

Appeals officer typically works with a project attorney from the

District Counsel's Office.

In the Kersting project, McWade, from

9Tax shelter projects were initiated to deal with the large

volume of cases generated by tax shelter examinations during the

late 1970s and the early 1980s. Among the responses of the IRS

and the Tax Court were the development of procedures, including

tax shelter projects, that were intended to streamline the

litigation process, economize on the use of administrative and

judicial resources, and reduce the costs incurred by taxpayers in

resolving disputes over tax shelter adjustments.

The IRS, Office

of Chief Counsel, created the Tax Shelter Branch in the National

Office to.oversee·tax shelter litigation across the country and

to organize individual tax shelter projects.

The projects

generally focused upon a specific type of tax shelter, such as

those promoted by Kersting that constituted the Kersting project.

- 14 the Honolulu District Counsel's Office, served.as the project

attorney.

Once a tax shelter project is assigned to a particular

District Counsel's Office, that District Counsel has the

authority to settle any individual case in the project.

The

District Counsel generally.is·expected to adhere to the official

project settlement offer.

Nevertheless, the District Counsel has

the authority in special circumstances to settle iñdividual tax

shelter project cases on a basis different from the project

settlement offer.

Bauspar

One Kersting program that was not part of respondent's

Kersting project was known as Bauspar.

Kersting had promoted the

Bauspar program as a combination savings and low interest

mortgage plan.

While the precise manner in which the Bauspar

program operated for each participant remains uncertain, th.e

total amount of home mortgage interest deducted by Bauspar

participants appears to have been overstated.

Respondent's officials believed that there were relatively

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

way to identify participants in the Bauspar program from a review

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

deduction claimants would not be cost effective.

Accordingly,

respondent ultimately decided not to systematically pursue

- 15 Bauspar participants through the Kersting project.

Respondent's

identification of Bauspar participants appears instead to have

been a "hit or miss" proposition; although respondent has

disallowed some Bauspar deductions claimed by a few Kersting

project petitioners, those disallowances have been sporadic.

Because the Bauspar program was not included in respondent's

Kersting project, we refer to interest deductions claimed under

the Bauspar program as Bauspar deductions rather than Kersting

deductions.

Respondent's Project Settlement Offer

Between 1982 and 1988, respondent had in effect an official

settlement offer for the Kersting project.

In general, the offer

permitted participants in the Kersting programs to resolve their

cases by agreeing to pay income tax deficiencies that averaged 7

percent less .than those determined in their deficiency notices.

The offer also released participants from negligence additions

and increased interest.

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

.the 7-percent reduction settlement offer to incorporate a new

feature, called the "burnout", that would apply in cases

involving more than one taxable year.

Under this procedure, the

interest on a taxpayer's total unpaid deficiencies for. the first

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

the return due date for the second year.

The burnout thus

- 16 postponed for a year the accrual of interest on the first year's

deficiency, thereby reducing the total interest that accrued on

the deficiencies.

This was accomplished by zeroing out the

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

the agreed deficiency for the second year.

II.

The Thompsons' Participation in the Kersting

Tax Shelters

The .Thompsons' Tax Returns

Prepetition Years--1977 and 1978

Although the Thompsons participated in one of Kersting's

programs during 1977, they did not.clafm any Kersting-related

interest deductions on their income tax return for that year,

because their accountant refused to claim those deductions on the

return.

The record suggests the Thompsons first claimed Kersting

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

accountant recommended by Kersting.

Years Before the Court

1979

The Thompsons filed their 1979 tax return, pursuant to an

extension, on May 29,

1980.

The Thompsons reported Kersti.ng

deductions of $39,477 on that return.

- 17 1980

The Thompsons received an extension of time to file their

1980 tax return until June 15, 1981.

On that return (received by

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

deductions of $72,840.

1981

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

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

interest expense.

The Kersting deductions claimed on that return

were the principal factor in reducing the Thompsons' adjusted

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

reduction of $95,026.

The Thompsons also reported $8,000 of home

mortgage interest expense that was probably attributable to the

Bauspar program, in which the Thompsons began participating in

April 1981.

Years Following Those Before the Court

1982

The Thompsons filed their 1982 tax return on May 6,

1983.¹°

On that return, the Thompsons reported Kersting (and probably

Bauspar) deductions sufficient to reduce their adjusted gross

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

¹°By October 1982, Mr. Thompson had retired as a pilot with

Continental Airlines.

- 18 $95,028.

Neither petitioners nor respondent have been able to

locate a copy of the Thompsons' 1982 tax return.

The 3-year

period of limitations under section 6501 expired with no action

by respondent concerning the Thompsons' 1982 tax return.

1983

The IRS received the Thompsons' 1983 income tax return on

July 2, 1984.

The Thompsons reported no tax liability on that

return; they also reported Kersting interest expense. deductions

of $67,620 as well as Bauspar deductions.

1984

Respondent received the Thompsons' 1984 income tax return in

April 1985.

On that return, the Thompsons claimed Kersting

interest expense deductions from two Kersting programs:

"Mahaio"

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

amount of.$3,420.

The mortgage interest deduction included in

the return also included interest paid pursuant to the Bauspar

program.

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

be owing.

1985

On their 1985 income tax return, the Thompsons reported

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

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

Although the

Thompsons did not claim any Kersting deductions on the return,

- 19 -

they overstated their mortgage interest expense as a result of

their participation in the Bauspar program.

Examination of the Thompsons'

1978-1981 Returns

The Thompsons experienced audit problems with their 1978 tax

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

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

income tax that Continental Airlines had withheld from Mr.

Thompson's wages.

In early to mid-1986, the Thompsons' personal

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

their income tax liability for 1978.

The record does not

disclose the terms of that settlement.

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

statutory notice of deficiency with respect to the Thompsons'

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

determining a deficiency in tax of $18,161.

The notice of

deficiency also determined a negligence addition of $908 under

section 6653(a).

On July 11,

1983, the Thompsons filed a pro se

petition in this Court.seeking. a redetermination of the

deficiency and addition.

On June 13,

1984, the Honolulu District Director issued a

statutory notice of deficiency with respect to the Thompsons'

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

determining a deficiency in tax of $24,838.

On September 4,

- 20 1984, the Thompsons filed a pro se petition in this Court seeking

a redetermination of the asserted deficiency.

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

participants stating that he had retained attorney Brian Seery

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

individual petitioners.

The letter requested that each Kersting

program participant provide written authorization for Seery's

representation."

Seery's compensation for legal services

rendered to Kersting program participants was al.ways paid by one

of Kersting's alter ego corporations.

On March 20,

1985, Seery

entered appearances for the Thompsons in their Tax Court cases

for their 1979 and 1980 taxable years.

He also entered his

appearance for hundreds of other taxpayers.

On May 31,

1985, the Los Angeles District Director issued a

statutory notice of deficiency with respect to the Thompsons'

1981 taxable year, disallowing.claimed Kersting deductions of

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

The

notice of deficiency also determined negligence additions against

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

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

section 6621(c).

Respondent did not disallow the $8,000 claimed

"In a letter to program participants dated Aug. 11, 1986,

Kersting recommended that program participants not attempt to

resolve their cases on their own and instead rely on counsel he

had hired..

- 21 as home mortgage interest that was probably attributable to the

Bauspar program.

On August 13, 1985, the Thompsons filed a pro

se petition in this Court seeking a redetermination of the

asserted deficiency, additions, and increased interest for

1981.¹²

The Thompsons thus had three of their taxable years before

the Court in three docketed cases.

Respondent's determinations

of the Thompsons' Federal income tax deficiencies and additions

for their taxable years 1979-1981 were as follows:

Sec.

6651(a)

Additions to tax

Sec.

6653(a)

6653(a) (1)

Sec.

6653(a)(2)

Year

Deficiency

1979

$18,161

---

$908

---

1980

24,838

---

1981

36,295

$4,934

---

$1,958

79,294

4,934

908

1,958

Total

50% of the

interest due

on the

deficiency

---

Respondent also determined that the Thompsons were liable for

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

On November 21,

1985, the Chief Judge of this Court assigned

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

Goffe)

for trial or other disposition.

Subsequent Kersting

project cases were automatically assigned to Judge Goffe.

¹²The Thompsons apparently filed their petition for their

1981 taxable year pro se, even after Seery had entered his

appearance in the earlier cases.

- 22 III. The Test Case Litigation and the Thompson Settlements

Selection of the Test Cases

McWade and Seery planned to use the test case procedure to

dispose of the cases of the Kersting program petitioners who

wished to contest the deficiencies determined.against them by

respondent.

Most of these petitioners entered into stipulations

of settlement for tax shelter adjustments, also called "piggyback

agreements".

Respondent and petitioners who entered into

piggyback agreements thereby·agreed to be bound by the results in

the selected test cases.

On June 10, .19.86, McWade and Seery

provided the names of the test case petitioners they had selected

to Judge Goffe.

.Seery and McWade had agreed .to the selection of test cases

in 14 dockets of seven married couples who had filed joint

returns and one individual who had not filed jointly.

Among the

couples selected to be test case petitioners were the Thompsons,

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

Fiorella Hongsermeier (the Hongsermeiers).

Seery particularly sought to include the Cravenses as test

case petitioners because they treated their payments to Kersting

as basis reductions that resulted in capital gain upon the

termination of their interests in the programs.

The Cravenses

- 23 later decided to proceed without counsel a'hd to settle their

cases.¹³

Seery also selected the Hongsermeiers as test case

petitioners because he mistakenly believed that they had used

their own funds, rather than "nontaxable distributions" from

Kersting corporations, to repay loans to other Kersting

corporations.

The Hongsermeiers' 1978-1980 taxable years were

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

1982 taxable years.

There is no clear indication whether it was Seery or McWade

who originally proposed the participation of the Thompsons.

noted, the Thompsons'

Court.

1979-1981 taxable years were before the

Respondent had failed to audit their 1982 taxable year.

Deterioration of the Thompson-Kersting

Relationship

Around the time Seery and McWade selected the test cases,

the relationship between the Thompsons and Kersting deteriorated.

Earlier in 1986, the Thompsons' personal counsel, Huestis, had.

asked Kersting for an accounting of the Thompsons' participation

in the Kersting programs.

Huestis's request led to a dispute

between the Thompsons and Kersting.

On June 23, 1986, the

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

in their dispute with Kersting.

¹³See infra note 23.

In a letter dated August 23,

- 24 1986, Kersting informed the Thompsons he had.turned their file

over to his own attorney for collection and further stated:

The day after you have allowed your attorneys to file

suit I will declare all notes which you have executed

to our companies in default and begin collection

proceedings.

* * * The aggregate sum is well in

excess of $250,000.00,. as you know.

We will NOT provide legal assistance free of cost to

you any longer in US Tax Court proceedings. You will

have to retain your own attorney to make an appearance

for you on February 9/1987 in US Tax Court.

By letter dated August 24, 1986, Kersting notified Seery

that he expected to be in litigation with the Thompsons and

directed Seery not to "render any services, at our expense" to

the Thompsons.

On September 10,

1986, Huestis wrote to Seery,

notifying him that the Thompsons were seeking substitute counsel

and requesting their files.

On September 15, 1986, Seery sent

the Thompson files to Huestis and informed him that the Thompsons

were test case petitioners.

Seery indicated that he was

withdrawing as the Thompsons' counsel.

On October 28,

1986, Huestis again wrote to Seery to express

dissatisfaction with the sufficiency of the Thompsons' files and

to warn Seery that his earlier representation of the Thompsons,

while he was also apparently representing Kersting, could be

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

"professional negligence".

On October 31, 1986, Seery filed

- 25 motions to withdraw as counsel in the Thompsons' cases, which the

Court granted.

In ruling on, a subsequent motion, Judge Góffe observed that

there could be a conflict of interest if Seery represented both

petitioners and Kersting.

Seery subsequently filed motions to

withdraw as counsel in the Kersting project cases (both test

cases and nontest cases), citing concerns about a possible

conflict of interest.

The Court granted Seery's motions in

November 1986.

The Thompsons Engage DeCastro, Who Settles

Their Cases

On or about November 15,

1986, the Thompsons retained

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

public accountant, to settle their Kersting tax issues.

Mr.

Thompson retained DeCastro to resolve all the Thompsons' Kersting

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

Court.

The Thompsons provided DeCastro with tax records for all

those years.

The retainer agreement between the Thompsons and

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

negotiate a settlement; it did not cover preparation for and

conduct of a trial.

None of the other petitioners in the

Kersting project, whether test case petitioners or piggybackers,

incurred any attorney's fees in connection with the preparation

and trial of the test cases.

Kersting paid all such fees.

- 26 Meanwhile, in the wake of Seery's withdrawal, Kersting

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

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

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

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

February 9,

1987.

Chicoine and Hallett agreed to~ do so with the

understanding that they would not represent Kersting.

In late

1986, Chicoine and Hallett apparently indicated to McWade and

Sims that they intended to challenge the admissibility of

evidence that had been seized in the January 1981 search of

Kersting's offige that became the subject rof this Court's opinion

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

supra note 2.

(Dixon I).

See

About the same time, McWade and Sims began to

offer 20-percent reduction settlements that were based on the

same general approach as their modified 7-percent reduction

settlement offer.that included the burnout feature.

In December 1986, DeCastro traveled to Hawaii on behalf of

the Thompsons and a number of other clients who had participated

in the Kersting shelters.

There DeCastro, accompanied by Gary

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

associated with Kersting, began settlement discussions with

McWade.

Their initial agreement called for a reduction in the

Thompsons'

1979-1981 deficiencies of approximately 18.8 percent.

The settlement also provided for the elimination of all additions

- 27 to tax and for the elimination of the increased interest rate

under section 6621(c) for 1981.

The burnout would also apply so

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

in the year 1980.

During this trip, DeCastro and McWade also

discussed the Bauspar program in which the Thompsons were

involved.

On December 23, 1986, McWade signed and sent DeCastro

stipulated decision documents in the Thompsons' cases.

The

transmittal letter stated that:

As previously indicatéd, the Decision documents

in John R. and Maydee Thompson will not be filed with

the Court until the Decision becomes final in the test

cases.

In the interim, the Thompsons can make an

advance payment, as discussed at our conference, and

stop the accrual of any additional liability for

interest.

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

executed decision documents agreeing to the reduced deficiencies.

Neither McWade nor Sims communicated the terms or existence of

the Thompsons' settlement to their superiors.

The result of the pending settlement upon the Thompsons' tax

liabilities would have been as follows:

Determined

Deficiency

Proposed

Settlement

Percentage

Reduction

1979

$39,477

1980

72,840

Total

$18,161

24,838

42,999

--$34,425

34,425

1981

80,782

All years total

36,295

79,294

30,000

64,425

Year

Income

Adiustment

18.8

- 28 -

DeCastro, Poltash, and McWade had also agreed that the

Thompsons would be able to deduct the interest payable on the

deficiencies agreed to under the settlement by prepaying such

interest by December 31, 1986."

As of December 31, 1986, the

accrued interest on the Thompsons' newly settled deficiencies was

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

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

Accordingly,

the decision documents returned to McWade by DeCastro stated:

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

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

reflected in the decision documents."

With a letter dated

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

check

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

$59,545.

Mr. Thompson's letter stated:

"I am at the present

time doing the neces-sary procedures to take care of the balance.''

At McWade's direction, IRS personnel in Honolulu prepared

payment posting vouchers (Form 3244) allocating the Thompsons'

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

"The Internal Revenue Code was amended in 1986 to add a new

sec. 163(h) that repealed the deduction for "personal interest".

See TRA sec. 511(b), 100 Stat. 2246. Under the new sec. 163(h),

1986. was the last taxable year in which taxpayers could deduct

100 percent of such personal interest.

TRA sec. 511(e), 100

Stat. 2249.

For 1987, only 65 percent of personal interest was

deductible, and the deduction for personal interest was phased

out entirely by the end of 1989.

Sec. 163(h)(6).

- 29 indicating designated interest for 1980 in the amount of

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

for 1981.

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

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

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

The Thompsons'

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

This

was reflected as a debit for the Thompsons' accounts for 198Ó and

1981.

In February 1987, the Thompsons made a replacement payment

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

a 1-percent bad check penalty.

The replacement payment was

restored as a credit as of December 31,

1986.

The Thompsons were the only test case petitioners for whom

the IRS processed a prepayment of interest without receiving a

concurrent "advance payment on deficiency" to which the interest

was attributable.

In January 1987, .Chicoine and Hallett filed motions in this

Court seeking to suppress the evidence that.had been seized in

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

burden of proof and burden of going forward with evidence.

The

Chicoine and Hallett motions in effect turned the February 1987

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

a cóntinuation of the trial of the test cases.

On March 13,

1987, McWade sent DeCastro a revised decision

document for the Thompsons'

1980 taxable year, making a.minor

- 30 -

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

$33,000.

McWade later explained:

miscomputed something."

"It must have been I

With this modification of the

settlement, the Thompsons' aggregate deficiencies for 1979-1981

were reduced by 20...55 pércent of the deficiencies originally

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

On June 15,

1987, DeCastro sent a $63,000 cashier's check

"in partial payment of the total amount due" to the Internal

Revenue Service Center in Fresno on behalf of the Thompsons.

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

credited it to the Thompsons'

1979 account as an advance payment,

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

tax year.

Accordingly, by June 1987, the Thompsons' payments to

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

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

interest).

IRS Activity Regarding the Thompsons'

1983-85 Returns

In the meantime, an employee of respondent at the Fresno

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

statutory notice of deficiency (subsequently dated March 17,

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

Thompsons'

1983 income tax return.

Because the Thompsons had

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

- 31 Thompson's retirement, the deficiency resulting from this

disallowance was only $980.

There is some indication that the

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

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

handwritten entry dated May 8,

determination - refiling case."

the Thompsons'

1987:

"No reason to change

Nevertheless, no petition for

1.983 taxable year was filed in this Court, and the

deficiency was never assessed or collected.

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

based in San Jose, California, audited the Thompsons'

1984 income

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

return.

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

to dispose of the Kersting issue identified on the return

consistent with respondent's general 7-percent reduction

settlement proposal.

In her letter, Speers also requested

additional information regarding the Thompsons' participation in

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

of the Thompsons'

1985 income tax return.

Speers did not receivè a response from the Thompsons to her

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

17,

1987.

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

report that he had forwarded her.request to DeCastro.

On December 23,

1987, DeCastro sent Speers an executed copy

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

- 32 with a power of attorney executed by the Thompsons for the.

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

Extend the Time to Assess Tax.

Because DeCastro did not include

the requested additional informatiön or a copy of the Thompsons'

1985 return, Speers declined to proceed on the basis of the 7percent reduction settlement.

Instead, by letter to DeCastro

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

Thompsons' 1984 year by disallowing the claimed Kersting interest

expense deductions in their entirety.

She .again requested a copy

of the Thompsons' 1985 return "to verify that interest from

Kersting.was not deducted in this year."

Beginning October 6, 1987, and continuing through

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

worksheet) telephone or written contact in the course of her

examination of the Thompsons'

1984 income tax return with the

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

accountant named "Rick."

Speers's case history worksheet

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

respondent's counsel.

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

complete disallowance of the $7,740 of Kersting deductions

claimed by the Thompsons for 1984 and the resulting deficiency of

$1,863.

The Thompsons paid the deficiency and interest; by

- 33 -

virtue of this disposition of the matter, respondent issued no

notice of deficiency to the Thompsons for 1984.

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

Thompsons' 1985 income tax return.

As noted above, the

Thompsons' 1985 income tax return did not reflect any Kersting

deductions (althöugh it did include Bauspar deductions).

letter dated March 25,

In a

1988, Speers notified the Thompsons that

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

was not deducted" on that return.

Respondent issued no notice of

deficiency to the Thompsons for 1985.

The Reporting and Resolution of the Thompsons'

Deficiency Interest Payments for 1986 and 1987

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

IRS as an itemized interest deduction on Schedule A - Itemized

Deductions of their 1986 income tax return.

However, because

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

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

The Thompsons did not claim any Kersting or Bauspar deductions on

their.1986 return.

Poltash prepared the Thompsons'

1987 income tax return.

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

the IRS.

That figure represents 65 percent of $42,945.

supra note 14.

See

Apparently, the Thompsons were attempting to

carry over the unused portion of the interest deduction of

- 34 $59,545 from their 1986 taxable year.¹³

The Thompsons did not

claim any Kersting or Bauspar deductions on their 1987 return.

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

1987 returns with McWade or Sims.

Revenue Agent Speers examined the Thompsons'

return.

1986 income tax

She asked about the $59,545 interest deduction in

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

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

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

satisfáction.

Speers .closed the examination of the Thompsons'

1986 return without making any adjustments to the return.

Her

examination workpapers reflect her.notation that "TP paid large

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

In June 1989 a revenue agent" screened the Thompsons'

income tax return for Kersting deductions.

1987

The return bears a

stamp stating "Income Tax Survey After Assignment", meaning that

the agent saw nothing obvious for examination and returned the

15Although Poltash claimed to ·lack any recollection of his

attempt to claim the interest deduction, he conceded the $42,945

amount might have represented an attempt to claim for 1987 the

portion of .the $59,545 claimed on the 1986 return that produced

no tax benefit to the Thompsons. We note a slight discrepancy

between the amount of the deduction actually used on the

Thompsons' 1986 return ($16,251) and the figure underlying the

$42,945 "carryover" for 1987 ($59,545 - $42,945 = $16,600).

"The signature of the examining agent is difficult to

decipher; it appears to be "Art (or Pat). Taylor."

- 35 1987 return to files without examining it or transmitting it for

examination.

The Thompson Settlement Revised as Trial Approaches

Although Chicoine and Hallett ultimately recommended that

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

offer, Kersting disagreed and replaced Chicoine and Hallett with

attorney Joe Alfred Izen, Jr.

(Izen) in April 1988.

Counsel on

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

January 1989 in Honolulu, Hawaii.

In an order dated August 30,

1988, the Court granted

McWade's motion to depose Kersting.

In October 1988, while in

Honolulu for the Kersting deposition, DeCastro met McWade to

discuss the Thompson cases.

DeCastro told McWade he wanted to

withdraw the Thompsons from the test case trial.

DeCastro's

reason for withdrawing the Thompsons was to avoid their having to

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

the settlement they had already agreed to.

McWade wanted to keep

Mr. Thompson as a party to the tri'al because he was a test case

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

not been hired.and paid by Kersting.

From respondent's

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

witness, a participant in the Kersting program who was feuding

with Kersting and could be expected to testify against him.

- 36 Recalling the withdrawal of Seery, Sims was concerned by the

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

the attorney representing the test case petitioners.

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

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

provide an apparent. safeguard against the trial appearing to be

slanted toward protecting the promoter's (as opposed to

petitioners') interest.

McWade and DeCastro also apparently discussed the status of

an outstanding Federal tax lien on the Thompsons' house

(unrelated to their participation in Kersting shelters), which

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

had satisfied the underlying liability."

On November 22, 1988,

respondent issued a certificate of release with respect to the

Federal tax·lien.on the Thompsons' house.

Shortly before trial of the test cases in this Court in

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

new agreement) calling for reduced amounts of agreed deficiencies

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

The

purpose of the reductions was to compensate the Thompsons for the

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

."Under sec. 6325(a)(1), the IRS was required to release the

lien not later than Oct. 7, 1987, 30 days after the liability had

been satisfied.

- 37 test cases.

DeCastro estimated that his legal fees for

representing the Thompsons at the trial of the test cases would

be approximately $60,000.¹ª

It was estimated that the newly

agreed reductions would generate approximately $60,000 of refunds

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

satisfaction of the deficiencies and interest under the earlier

settlement.

The new agreement also preserved the Thompsons'

chances to prevail on the merits of the litigation.

McWade and

DeCastro agreed that if the results of the trial were more

favorable to the Thompsons than the new agreement, the Thompsons

would be entitled to the results of the trial.

When the new agreement was reached, respondent's official

settlement.policy still provided for a 7-percent reduction in

determined deficiencies, elimination of the negligence penalty,

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

approached, some nontest case petitioners' attorneys continued to

negotiate 20-percent reduction settlements.

The new agreement,

¹8As petitioners point out, DeCastro was somewhat

inconsistent in his recollection of his proposed billing. On

June 2, 1992, he initially denied that the new agreement was

designed as a mechanism for respondent to pay his fees, but he

admitted to ,the contrary 8 days later. On Aug. 11, 1992,

DeCastro recalled estimating that it would cost a minimum of

$30,0.00 to try the Thompsons' case. After being shown documents

indicating he had billed the Thompsons for more than $30,000,

DeCastro said he had told McWade that his fees would be roughly

$65,000. As respondent points out, DeCastro's bills to the

Thompsons, as of Nov. 29, 1989,. totaled $58,738.20.

042

- 38 -

however, reduced the Thompsons' deficiencies for the years at

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

reduction of 62.17 percent.

The new agreement substantially

deviated from respondent's official settlement policy and from

the 20-percent reduction settlements obtained by DeCastro and

Chicoine and Hallett and other attorneys on behalf of·other

clients.

None of Sims's or McWade's superiors approved the new

agreement.

To the contrary, Sims's and McWadels superiors did

not discover the new agreement until after this Court had tried

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

decisions therein.

Trial and Entry of Decisions

The trial of the test cases was conducted before Judge Goffe

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

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

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

settlement or the Cravens settlement before or during the January

1989 trial of the test cases, or thereafter.

The Government paid the travel, food, and lodging expenses

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

Thompson's reimbursed expenses amounted to $1,105.13.

in Dixon III, n.53:

Mr.

We stated

"Inasmuch as respondent subpoenaed all the

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

their expenses."

Although there is no evidence in the record

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

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

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

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

requested reimbursement of their trial attendance expenses had

their requests denied, or indeed that requests for reimbursement

were made by any such petitioners.

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

arra.nge for the Thompsons to receive a refund.of $30,000 of their

advance payments.

In a memorandum dated April 10, 1989, McWade

requested respondent's administrative officials to process a

$30,000 refund to the Thompsons.

On July 11,

1989, the

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

The Thompsons endorsed the check to DeCastro Law Corp. without

depositing it in their own checking account.

The Thompsons did

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

paid DeCastro.

On August 3,

1989, DeCastro wrote a let¯ter to McWade

confirming the revision of the Thompson settlement that had been

agreed to before the trial of the test cases.

states in pertinent part as follows:

DeCastro's letter

- 40 -

Re: Jack and Maydee Thompson

Dear Ken:

Please confirm following is our agreement with

respect to settlement of above.taxpayer's cases for

open years:

We have agreed that the.total taxes due for all

the open years are $15,000 for 1980 and $15,000 for

1981.

Further, in the event a final decision in this

case is more favorable they are to receive the benefit

of such decision.

Please sign below so I can have for my files.

McWade signed the letter and returned it to DeCastro.

On August 24,

1989, DeCastro wrote McWade requesting him to

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

McWade replied that the balance would not be released until the

Tax Court had issued its opinion, and DeGastro so informed.the

Thompsons.

DeCastro told the Thompsons that, because the IRS

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

to the Thompsons' bill.

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

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

follows:

Dear McWade:

There are some questions in mind that I feel you can

help me answer.

- 41 -

I received a check from IRS in the amount of thirty

thousand dollars--($30,000). I endorsed this over to

DeCastro Law Corp; this did not retire the billed

amount.

I am completely amazed at the billings we are

receiving. I am now in receipt of additional billings

that exceed realistic amounts..

In fact the total comes

to sixty six thousand two hundred forty three and

66/100 dollars ($66,243.66). At some point I know a

reconciliation will come.

Luis [DeCastro] says don't

be concerned.

I am very concerned, I am the one being

billed.

Most emphatically I did not expect to be a channel

through which IRS funneled funds to any law firm.

Certainly not in this magnitude.

I have the feeling at

this point that I am correct in this--the bill is to

[sic) much.. I want to know the exact legal position I

occupy. We have been frustrated long enough. We wish

to close this chapter.

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

pertinent part:

Thank you for your letter regarding the matter of

the Thompsons' fees. As I have told Jack, we are

looking for payment of his fees to the IRS, not him.

am enclosing a copy of my letter to him in this regard

for your information.

DeCastro sent a similar letter to the Thompsons on the same

date.

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

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

(Dixon II), sustaining

almost all of respondent's determinations that the Kersting

programs at issue lacked merit for tax purposes.

- 42 On March 13, 1992, the.Court entered decisions against

petitioners in the test cases in accordance with its opinion.

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

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

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

Appeals for the Ninth Circuit.

Discovery and Disclosure of the Thompson

Settlements

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

the San Francisco Appeals Office to process the Thompsons'

account administratively in accordance with the Thompson

settlement, not the Tax Court's decisions.

On May 22, 1992,

Danny Cantalupo, Regional Director of Appeals for the Western

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

Counsel for Tax Litigation for the Western Region in San

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

settlement.

Bakutes informed Benjamin Sanchez (Sanchez), the

Western Regional Counsel in San Francisco, who informed officials

in the National Office of the Office of Chief Counsel in

Washington, D.C.

The ci-rcumstances surrounding the Thompson

settlement became a matter of widespread concern within the IRS.

On May 29,

1992, Sims, at. the direction of Sanchez, informed

DeCastro by letter that the Thompson settlement would not be

honored, and that assessments would be made in accordance with

- 43 the decisions ente.red on March 13, 1993, pursuant to Dixon II.

The letter advised that assessment,of the taxes owing, plus

statutory additions and interest, would be "approximately

$302,396.12."

The letter further noted:

"Of course, your

clients' advance payments will be credited toward the

assessments."

DeCastro had several telephone conversations with

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

settlement, as memorialized in the August 3, 1989 letter

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

to appeal any decision to the contrary.

Bakutes prepared a motion that was filed in this Court on

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

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

Respondent requested the Court to conduct an evidentiary hearing

to determine whether the agreements with the Cravenses and the

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

decisions of the Court.

On June 10,

1992, Judge Goffe granted respondent's motions

to vacate filed in the Thompson and the Cravens cases.

That same

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

the Thompson cases had been vacated.

During this call, DeCastro

told Bakutes that in 1988 McWade had reduced the Thompsons'

deficiencies to keep the Thompsons in the case.

Although he had

- 44 earlier told Bakutes that attorney's fees were not awarded in.the

settlement, DeCastro admitted in this conversation that the

deficiencies were reduced to pay the Thompsons' legal fees for

his representation of them in the test case trial.

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

McWade should no longer have any authority over the Kersting

cases and that the cases should be assigned to other attorneys

who had been involved in the Kersting project.

Bakutes

accordingly reassigned the 14 test case dockets to Thomas A.

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

(O'Neill).

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

an evidentiary hearing and ordered-the parties to file agreed

decisions with the Cóurt, "or otherwise move within 30 days of

the date hereof."

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

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

stating:

The Court has reviewed the testimony of Cravens,

the testimony of Thompson, the stipulated facts and

stipulated exhibits relating to the Cravenses and the

Thompsons, and the exhibits offered through Thompson as

a witness. The Court finds that these reviewed items

had no material effect on the opinion which the. Court

filed on December ll, 1991, as that opinion relates to

petitioner Rina.

If the reviewed items were stricken

from the record, the Court would file an opinion in all

material respects like the opinion it filed on December

11, 1991 (with the exception of certain portions

- 45 relating specifically and expressly to the Cravenses or

the Thompsons), and the Court's findings, analyses, and

conclusions relating to petitioner Rina would remain

the same. * * *[19]

During the.summer of 1992, respondent's Acting Chief Counsel

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

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

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

settlement on behalf of the National Office.

Kane and Miller

conducted in-house depositions and interviewed various

individuals who had participated in the test case trial and the

Thompson settlement.

Bakutes assigned Dombrowski to help Kane and Miller in their

investigation.

Dombrowski's immediate problem was how to respond

to this Court's order of June 22,

1992, that the parties file

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

Dombrowski learned that McWade and Sims had denied that the

purpose of the new agreement to reduce the Thompsons'

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

the lowered deficiencies had something to do with the Thompsons'

¹9Rina appealed from this denial.

Unlike the Thompsons,

Rina had no settlement agreement with Sims and McWade. On June

13, 1995, Rina agreed to the entry of a stipulated decision in

the amounts originally determined in his statutory notice of

deficiency.

- 46 investment in Bauspar.2°

To see whether Bauspar figured in the

Thompson settlement, Dombrowski sought the Thompsons' .post-1981

tax returns.

By July 13, 1992, he had received th'e Thompsons'

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

and administrative file had been destroyed.

Dombrowski analyzed

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

raised by McWade's and Sims's contentions.

Although the 1982 tax

return was not available, Dombrowski believed it likely that

Kersting deductions had been claimed on that return because of

the disparity between adjusted gross income and taxable income,

and because Kersting deductions were claimed on the Thompsons'

1983 and 1984 returns.

Dombrowski's "Analysis of Subsequent Year

Returns" noted the mortgage interest deductions claimed on the

Thompsons' 1983-85 returns and further noted "(Bauspar?)."

also noted that entries that may have reflected the Bauspar

deductions had not been audited.

Dombrowski's reason for putEing

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

entries on the returns whether they actually related to Bauspar.

2oIn a memorandum dated Sept. 11, 1992, Kane had written:

"Sims claimed that McWade had initiated the recommendation to

allow Bauspar losses so that both Thompson and DeCastro would

remain in the case.

* * * Thus, Sims told McWade to work with

the Bauspar numbers in order to give Thompson relief and keep him

as a test case."

(Fn. ref, omitted.)

Additionally, in 1992,

McWade testified that he reduced the Thompsons' deficiencies on

his own to make up for the Thompsons' $80,000 "loss" in the

Bauspar program.

We found this testimony not credible.

- 47 Dombrowski also noted that the Thompsons appeared to have

defaulted on a statutory notice issued to the Thompsons for 1983

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

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

Dombrowski also noted the May 8,

file for 1983 that stated:

refiling case."

1987, entry in the Thompsons'

"No reason to change determination.-

Dombrdwski believed this entry indicated that

someone contacted the Fresno Service Center after receiving and

questioning the notice of deficiency for 1983.

Because the 3-

year period of limitations with respect to the returns he was

examining had expired several years earlier,

Dombrowski did not

attempt to determine why the assessment for 1983 had not been

made.

He instead focused on preparing a timely response to the

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

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

National Office of Chief Counsel, called Bakutes and informed him

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

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

cases that had been appealed.

The DOJ's decision was based on

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

That refusal indicated to the DOJ officials that the Tax Court

probably would not vacate its decisions in the other test cases

if asked to do so.

Gross also reported to Bakutes that the DOJ,

and specifically, the Tax Division, Appellate Section Chief Gary

- 48 Allen, wished to offer the same settlement to the test casé

petitioners on appeal that the Thompsons had received:

A 65-

percent reduction in deficiencies (an approximation of the

reduction of the Thompsons' originally determined deficiencies

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

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

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

to the test case petitioners on appeal.

On July 16,

1992, DeCastro filed a motion for entry of

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

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

$15,000'for 1979-1981, respectively.

On August 20,

1992, respondent filed objections to

DeCastro's motion for entry of decision, together with

respondent's own motion for entry of decision.

Respondent's

motion sought a decision that reflected the original 18.8-percent

reduction settlement agreed to by McWade and DeCastro in December

1986.2¹

21Respondent's motion stated that the December 1986

agreement between DeCastro, Sims, and McWade to reduce the

Thompsons' deficiencies by 18.8.percent exceeded the terms of the

standard 7-percent reduction settlement offer.

Nevertheless,

respondent conceded:

"Respondent's counsel possessed the

authority to make such an offer, and such offer was accepted by

petitioners herein as well as others." Respondent also noted the

"approximately 20 percent" reduction, settlement offers previously

made to other participants. Respondent's motion further

(continued...)

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

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

that had been discovered in respondent's investigation.

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

Sims and McWade had agreed to settle the Thompson cases by

reducing the Thompsons' deficiencies in amounts sufficient to

compensate the Thompsons for their projected attorney's fees.

respondent explained to the Court, Sims and McWade had agreed

with DeCastro that

All settlement refunds in excess of the amounts

provided by the December 1986 agreement would go

ultimately to the benefit of Mr. DeCastro for payment

of his legal fees and costs.. Mr. DeCastro would be

paid solely from amounts refunded by the Service to

Thompson.

* * * This "New Agreement", in sum and

substance, if not explicitly, was designed, and

constituted an agreement by Messrs. Sims and McWade to

pay Mr. DeCastro's .legal fees and expenses.22

2¹(...continued)

indicates that Chicoine and Hallet's motion to suppress evidence

was pending when McWade offered the 20-percent reduction

settlement to DeCastro in December 1986. Although McWade may

have known of Chicoine and Hallet's intent to file such a motion,

the motion, in the form of a motion for leave to amend petition,

was not filed until Jan. 12, 1987, after Chicoine and Hallett had

entered their appearances. Any error in this regard, however, is

immaterial, in view of our disposition of this matter.

22On brief, petitioners question the assertions in

respondent's motion that all settlement refunds "in excess of the

amounts provided in the December 1986 agreement" would go to

DeCastro. This assertion, however, appears to have reflected

respondent's understanding at the time. Once again, in view of

our disposition of this matter, any error in this respect is

irrelevant.

- 50 .

Respondent asserted that the new agreement was unauthorized and

had no legal basis.

If respondent's motion had been granted, the

Thompsons' deficiencies would have been zero for taxable year

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

On August 26,

1992, this Court granted DeCastro's motions

for entry of decision in the Thompson cases, thus holding

respondent to the pretrial concessions made by Sims and McWade in

the new agreement:

Year

Deficiency

Additions to Tax

1979

---

1980

1981

$15,000

15,000

-----

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

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

6651(a).

That addition was the .only non-Kersting issue in the

Thompsons' docketed cases.

Respondent did not appeal the decisions entered by the Court

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

23The Cravenses, who were not represented by counsel after

Seery's withdrawal, had agreed with McWade to deficiencies of

$9,782.16 for their taxable years 1979 and 1980, a reduction of

only about 6 percent from the originally determined deficiencies

of $10,401.45.

This settlement was less favorable to them

percentagewise than the generally availabl.e modified 7-percent

reduction settlement offer and did not include the "burnout"

feature.

On Aug. 25, 1992, this Court entered a decision

reflecting the Cravens settlement amounts, but the decision

included the stipulation that certain advance payments made by

the Cravenses had not yet been taken .into account. Late in

(continued...)

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

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

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

and signed by Kane:

The Chief Counsel and Deputy Chief Counsel have

concluded that, under the circumstances, we have

completely fulfilled all applicable ethical and legal

obligations with respect to this issue and this

litigation.

They have also concluded that given the

fact that the conduct on the part of our attorneys is

significantly less than exemplary, there is nothing to

be gained by further prolonging this aspect of the

Kersting litigation.

On September 30,

1992, Judge Goffe terminated his recall

status as a Senior Judge and retired from the bench.

The Chief

Judge óf the Tax Court reassigned the Kersting project cases to

Judge Renato Beghe.

After this Court entered its decisions in the Thompson

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

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

representing them on their appeals, and Robert Patrick Sticht

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

filed separate motions with the Court to intervene in the

Thompson and Cravens cases.

On November 6, 1992, the Court

23(...continued)

October 1992, officials in respondent's Western Region proposed

closing the .Cravenses' cases in such a way as "to cause the

taxpayers' 1979 and 1980 accounts to zero out with no further

amounts due."

- 52 -

denied their motions to intervene, and Izen and Sticht filed

notices of appeal.

Implementation and Effects of the

Final Thompson Settlement

This Court's August 1992 decisions enforcing the final

Thompson settlement had a number of financial consequences.

The

Court's decisions not only -reduced the Thompsons' deficiencies;

it also reduced the interest that had accrued on those

deficiencies.

In December 1986 and in January 1987,. the.

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

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

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

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

1980 and 1981, the interest that had accrued on those

deficiencies before the Thompsons made their interest payments

was much less than $59,545.

Instead, as of December 31, 1986,

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

for 1981 amounted to only $15,300.73 and $12,135.31,

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

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

to cover their total deficiencies and interest as eventually

reduced by the final Thompson settlement.

In January 1993, respondent made new assessments against the

Thompsons for 1980 and 1981 that were based upon the decisions

- 53 entered by the Tax Court on August 26, 1992.

The total

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

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

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

respectively).

Respondent applied the $59,545 credit balance

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

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

small credit balance.

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

respect of their previously settled deficiencies, respondent

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

advance payment of tax.

Because the Thompsons had no deficiency

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

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

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

Accordingly, in February 1993, respondent issued a refund check

for $32,225 to the Thompsons.

As they had done with their

earlier refund, the Thompsoñs endorsed this refund check to

DeCastro, as payment of additional legal fees, without depositing

the check in their own checking account.

DeCastro thereafter complained to Dombrowski that the

Thompsons were entitled to receive even more from respondent.

DeCastro argued that the Thompsons were entitled·to receive

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

- 54 -

reduced to $6.2,225 and then $32,225).

Dombrowski requested

"audit assistance", which he received from George Guzzardo

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

in determining whether the Thompsons were entitled to the

requested interest.

Guzzardö determined that the Thompsons'

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

rather than a cash bond.

The distinction is important:

advance payment resulting in an overpayment entitles the taxpayer

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

earn interest.

Having concluded that the previously refunded

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

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

of July 31,

1993.

Dombrowski did his own computations, and then

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

check his and Guzzardo's figures.

Samuels advised that in the

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

calculations.

Relatively small differences in their results were

attributable to their use of different dates for the accrual of

interest:24

On September 17, 1993, Dombrowski sent Bakutes a memorandum

requesting approval to refund the interest on the Thompsons'

24Samuels saw that the refund included some previously

deducted interest, thus producing tax benefit income, but stated

in her memorandum to Dombrowski, "Most taxpayers would probably

either not know or not remember to include this [tax benefit

income] in income, since they won't get a Form 1099 for it."

- 55 overpayments, with a copy to the National Office. . Bakutes

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

October 1993, respondent issued a refund check to the Thompsons

in the amount of $32,116.68.

Finally,'in December 1993, respondent issued a refund check

of $4,107.93 to the Thompsons for 1980.

The check represented an

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

$59,545 interest payment exceeded their deficiencies and interest

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

of $1,850.39 on the overpayment credit.

The Thompsons deposited these last.two refund checks in

their checking account.

The following table summarizes the payments by the Thompsons

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

interest on refunds, by respondent to the Thompsons:

Paid by Thompsons:

$59,545

December 31, 1986 and February 17,

1987 payments of interest on

deficiencies under original settlement.

62,225

June 1987 advance payment of

deficiencies for 1979-1981 (net

of $775 credited to tax year 1988).

121,770

Total amount paid for years in issue.

- 56 Received by Thompsons:

$30,000.00

Refunded July 11, 1989, pursuant to

request of McWade, endorsed to

DeCastro.

32,225.00

Refunded February 19, 1993,. pursuant

to request of DeCastro and endorsed

to DeCastro.

32,116.68

Third refund check, dated October 22,

1993, for $32,116.68, representing

interest on overpayment resulting from

advance payment of deficiencies.

4,107.93

Refund, with interest, of overpayment

resulting from application of $59,545

interest payment against 1980-81

deficiencies and interest.

98,449.61

Total amount refunded by IRS

for years in issue.

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

$121,770 they had paid in deficiencies and interest for 19791981.

Of the $98,449.61 refunded,

as legal fees.

$81,225 was paid to DeCastro

Of this amount, $62,225 was paid to DeCastro by

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

they received in 1989 and 1993.

The Thompsons apparently paid

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

check later in 1993.

On their 1993 tax return, the Thompsons reported both the

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

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

Their

return did not reflect the tax benefit arising from the fact

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

- 57 1986 and 1987 returns ($16,251 for 1986 and $27,914 for 1987),

the interest on the reduced deficiencies that were ultimately

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

$12,135 for 1981).

Pursuant to written advice from DeCastro, the

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

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

The

description accompanying the deduction claim on the Thompsons'

1993 return was "LEGAL FEES FOR INCLUDABLE INC."25

Respondent's Disciplinary Action

Against Sims and McWade

on July 29,

1993, Sanchez 'sent notices of proposed

disciplinary action to Sims and McWade.

that Sims and McWade had violated:

The notices asserted

(1) Department of the

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

(an

employee shall avoid any action which might result in or create

the appearance of giving preferential treatment to any person);

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

section 0.735-30(a)(6)

(an employee shall avoid any action that

might adversely affect the confidence of the public in the

integrity of the Government); and (3)

IRS Rule of Cónduct 214.5

25The reference to "INCLUDABLE INC." has not been

satisfactorily explained, even by Poltash, whose office prepared

the return.

Petitioners urge that the reference is to "an entity

that never existed." The Court doubts the reference is to an

entity at all, but the Court's question to Poltash, whether the

reference was a shorthand reference to "includable income", as a

justification for deductibility.under sec. 212, met with a

protestation of ignorance.

- 58 (an employee will.not intentionally make false or misleading

verbal or written statements in matters of official interest).

The notices proposed to suspend both Sims and McWade for 14

calendar days without pay.

McWade retired from the IRS effective October 2, 1993.

November 2,

1993, Acting Chief Counsel Jordan approved Sanchez's

proposed disciplinary action.

Sims was suspended from duty

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

Regional Counsel's Office, where he was assigned nonsupervisory

duties as a Special Litigation Assistant in the General

Litigation area.

IV.

Ninth Circuit Remand and Subsequent Proceedings

Ninth Circuit Orders in the DuFresne Case

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

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

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

misconduct of Sims and McWade required further inquiry.

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

DuFresne

Citing Arizona v. Fulminante,

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

We cannot determine from this record whether the

extent of misconduct rises to the level of a structural

defect voiding the judgment as fundamentally unfair, or

whether, despite the government's misconduct, the

judgment can be upheld as harmless error. * * *

Accordingly, the Court of Appeals remanded the remaining test

cases to this Court with directions "to conduct an evidentiary

- 59 hearing to determine the full extent of the admitted wrong done

by the government trial lawyers."

Id.

.It further directed this

Court to "consider on the merits all motions of intervention

filed by parties affected by this case."

£d.

Finally, the Court

indicated that "All subsequent appeals will be scheduled before

this panel."

Id.

Notwithstanding its general endorsement of allowing parties

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

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

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

Cravens cases.

In an unpublished opinion filed the same day as

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

decided DuFresne explained:

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

entering settlement in the Cravens and Thompson cases,

respectively, are final.

26 U.S.C. § 7481(a)(1); Fed.

R. App. P. 13.

The Tax Court lacks jurisdiction to

vacate those decisions. Billingsley v. CIR, 868 F.2d

1081, 1084 (9th Cir. 1989).

Because there is no case

remaining in which the taxpayers can intervene, this

appeal is moot.

[Adair v. Commissioner, 26 F.3d.129

(9th Cir. 1994).]

On September 29,

1994, the District Court for the District

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

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

under sections 6700 and 6701 against Kersting for the promotion

of abusive tax shelters.

Kersting timely appealed.

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

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

Judge Beghe for further proceedings under the mandate.

Evidentiary Hearing and Opinions

.After the Remand in DuFresne

In response to respondent's motion for the evidentiary

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

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

pretrial hearing to be held July 17, 1995.

In furtherance of the

Court of Appeals' directive regarding intervention, the Court

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

had entered appearances on behalf of nontest case petitioners in

the Kersting project.

Ultimately, the Court ordered that 10

cases of nontest case petitioners, each represented by either

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

consolidated with the remaining .test cases for purposes of the

evidentiary hearing.

As a result, three groups of petitioners

participated in all subsequent phases of the evidentiary hearing:

Test case. and nontest case petitioners represented by Izen;

nontest case petitioners represented by Sticht; and nontest case

petitioners represented by Jones.26

26The group of cases that were consolidated for purposes of

the evidentiary hearing initially included the case of William D.

and Karen S. Booth, docket No. 28950-88, in which Declan J.

O'Donnell (O'Donnell) had entered his appearance. However, at

the start of the evidentiary hearing, the Court granted

(continued...)

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

conducted the evidentiary hearing at special trial sessions of

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

June 10-26, 1996, and August 18, 1997.

On March 30, 1999, on the

basis of the record developed at the evidentiary hearing, the

Court issued its supplemental opinion in Dixon v. Commissioner,

T.C. Memo. 1999-101 (Dixon III).

The Court held that the

misconduct of the Government attorneys in the trial of the test

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

Circuit in DuFresne, constitute a "structural defect" in the

trial, but rather resulted in "harmless error".

However, the

Court imposed sanctions against respondent, holding that Kersting

program participants who had not had final decisions entered in

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

component of the addition to tax for negligence under section

6653(a)(1) (B) and (2), and (2)

the incremental interest

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

26(...continued)

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

consolidated for the evidentiary hearing. O'Donnell argued that,

in light of the theory underlying a motion for summary judgment

that he had filed on behalf of the Booths, they had no need to

participate in the evidentiary hearing.

In Gridley v.

Commissioner, T.C. Memo. 1997-210, the Court denied O'Donnell's

motions for entry of decision consistent with the final Thompson

settlement.

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

Circuit affirmed the order of the Hawaii District Court that had

imposed almost $3 million in penalties against Kersting for the

promotion of abusive tax shelters.

The opinion of the Court of

Appeals states:

The district court did not err in finding that

Kersting knew or had reason to know that his statements

concerning the allowability of interest were false or

fraudulent. See 26 U.S.C. § 6700(a)(2); * * *. The

record indicates that Kersting knew that his tax

shelters were sham transactions in which participants

could write off approximately twelve dollars for every

dollar of actual out-of pocket expenses. Kersting

himself indicated in a 1977 "comfort letter" to one of

the "nervous nellies" investing in his scheme that

these deductions were not legitimate - Kersting warned

the individual to "be sure this letter does not get

into.the wrong hands.

If IRS would become aware of the

offsetting character of your note you would likely lose

your interest deduction".

Kersting also knew that these fraudulent interest

deductions originating in a prior version of his tax

shelter had been previously disallowed by this Court.

See Pike v. Commissioner, 78 T.C. 822 (1982) (denying

interest deductions to taxpayers participating in

Kersting's tax shelters because the transactions

conducted by Kersting's corporations were shams lacking

economic substance), affd., 732 F.2d 164 (9th Cir.

1984). .After Pike, Kersting made merely cosmetic

changes to his tax shelter scheme. * * *

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

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

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

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

performed in the evidentiary hearing mandated by the Court of

Appeals in DuFresne and denying their.motions for additional

- 63 sanctions.

In so doing, the Court denied petitioners' requests

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

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

"prevailing party" as defined in section 7430(c)(4).

Instead,

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

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

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

attorneys have "multiplied the proceedings in any case

unreasonably and vexatiously".

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

cases, and the test case petitioners appealed.

The Court also

certified for interlocutory appeal the cases of nontest case

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

participated in the evidentiary hearing and nontest case

petitioners represented by O'Donnell whose cases were the subject

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

1997-210.

These nontes.t case petitioners also appealed.

The Ninth Circuit's Opinion and

Mandates in These Cases

On November 21, 2001,

following extensive motion practice on

jurisdiction and other issues, the Court of Appeals set a

briefing schedule and confirmed that the cases on appeal would be

scheduled before the panel that issued the DuFresne opinion.

Following receipt of opening and reply briefs from test case

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

DuFresne panel filed an order indicating that, upon

reconsideration, it would not retain jurisdiction, and directing

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

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

in Dixon V heard oral argument in the test cases.

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

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

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

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

the further proceedings that have resulted in this opinion.

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

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

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

stated;

"There can be no question here but that the actions of

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

Tax Court."

Dixon v. Commissioner, 316 F.3d at 1046.

The Court

2'On Nov. 20, 2001, the DuFresne panel had filed an order

directing that the appeals of nontest case petitioners

represented by Izen, Sticht, Jones, and O'Donnell "shall be held

in abeyance.pending resolution of the appeal in No. 00-70858"

(i.e., the test cases).

28The three sets of attorneys are Izen, Michael L. Minns,

and John A. Irvine and Henry G. Binder.

- 65 of Appeals held that "fraud on the court" occurs regardless of

whether the opposing party is prejudiced.

Id.29

The Court of Appeals further stated:

We have the inherent power to vacate the judgment

of the Tax Court, fashion an appropriate remedy, and

sanction a party or its lawyers for willful abuse of

the judicial process, particularly when the party or

its lawyers have intentionally practiced a fraud upon

the Court. * * *

* * * The taxpayers should not be forced to endure

another trial and the IRS should be sanctioned for this

extreme misconduct.

Conversely, we will not enter judgment eradicating

all tax liability of these taxpayers.

Such an extreme

sanction., while within the court's power, is not

warranted under these facts. *.* *

Id. at 1047 (citations omitted).

The Court of Appeals instead

reversed the decisions of this Court in the test cases and

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

all other taxpayers properly before this Court on terms

equivalent to those provided in the settlement agreement with

Thompson and the IRS."

Id.

It left "to the Tax Court's

discretion the fashioning of such judgments which, to the extent

possible and practicable, should put these taxpayers in the same

position as provided for in the Thompson settlement."

Id. n.11.

29The Court of Appeals acknowledged the contrary holding of

the Court of Appeals for the Seventh Circuit in Drobny v.

Commissioner, 113 F.3d 670 (7th Cir. 1997), affg. T.C. Memo.

1995-209.

In Drobny, the Seventh Circuit held that proof of

fraud on the court requires a showing that the alleged misconduct

actually affected the outcome oóf the case to the taxpayer's

detriment. Id. at 678-679.

- 66 On January 21, 2003, respondent's then Chief Counsel,

referring to Dixon V, publicly announced:

"We will * * * assure

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

appeals to the Ninth Circuit."3°

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

Chief Counsel for Procedure and Administration, .issued a Chief

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

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

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

performing their duties, including when representing the IRS

before the Tax Court."

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

remanding to the Tax Court for further proceedings consistent

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

appealed pursuant to their certification for interlocutory

appeal.

On April 23, 2003, the Court of Appeals issued-its

mandates with respect to the test cases in accordance with Dixon

Proceedings Following Remand

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

conference regarding disposition on remand of the test cases and

a group of related nontest cases.

On May 1,

2003, this Court

3°The original decisions in Dixon II were entered Mar. 13,

1992; the notices of appeal were filed May 14, 1992; the 90-day

appeal period would have expired June 11, 1992.

- 67 ordered the parties to file status reports regarding subsequent

disposition of the cases.

The responses displayed various

disagreements between respondent and petitioners concerning not

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

implementation.

For example, the status report of petitioners'

counsel Henry Binder states:

"Respondent does not come to this

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

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

the terms or scope of that remedy."3¹

The Court conducted status

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

California, in September 2003 to address petitioners' attempts to

settle the cases.

The conferences resulted.in no settlement.

The parties then engaged in protracted motions practice

regarding assertions of privilege by respondent as to some

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

fees claimed by counsel for petitioners.

On April 5,. 2004, petitioners filed motions for an

evidentiary hearing.

Thereafter, at the behest of the parties,

the Court directed further discovery and conducted further

hearings.

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

3¹Having considered certain issues raised in the status

reports, this Court issued an order dated June 12, 2003,

indicating it was "not inclined to consider attempts to

disqualify counsel" in any of the cases at issue. We

additionally stated:

"This Court is not inclined to seek

appointment of counsel from the United States Department of

Justice to represent respondent in these cases".

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

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

March 2005.

By the end of September 2005, the parties had filed

their briefs regarding the scope and application of the Thompson

settlement.

Further Disciplinary Proceedings

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

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

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

Ethics, and Discipline of the Tax Court for disciplinary

action.32

In accordance with the Court's practice in such

matters, the referrals were not mentioned in the Dixon III

opinion or otherwise publicized when that opinion was issued.

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

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

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

suspended or disbarred from practice before the Court or

otherwise further disciplined.

On July 1, 2003, DeCastro

resigned from practice before the Court.

32On June 26, 1996, at what then seemed to be the close of

the evidentiary hearing, Izen had filed a motion requesting this

Court to refer the Thompson and Cravens settlements and McWade's

settlement with Denis Alexander to the DOJ (Public Integrity

Section) for criminal prosecution.

Izen identified approximately

17 alleged crimes associated with these settlements. By order

dated June 26, 1996, the Court denied Izen's motion.

- 69 Following complaints filed by petitioners' counsel Minns in

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

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

year in February 2004, and the Oregon State Bar suspended

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

This

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

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

McWade and Sims from practice for 2 years, commencing February

20, 2004.33

The Director of the IRS Office of Professional

Responsibility suspended McWade and Sims indefinitely from

practice before the IRS, effective June 9, 2004.

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

for more than 60 days or disbarred from practice before this

Court may not resume practice until reinstated by order of the

Court.

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

giving rise to a suspension or disbarment was predicated upon the

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

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

appointed by the Chief Judge.

At the hearing on the petition:

the practitioner shall have the burden of demonstrating

by clear and convincing evidence that the practitioner

33The first announcement by the Court with respect to the

referrals was the Court's issuance, on Feb. 20, 2004, of a press

release that disciplinary action had been taken against McWade

and Sims.

DeCastro's resignation was not publicized by the Court

until issuance of the opinion herein.

-. 70 has the moral.qualificatións, competency,.and learning

in the law required for admission to practice before

this Court and that the practitioner's resumption of

such practice will not be detrimental to the integrity

and standing of the Bar or to the administration of

justice, or subversive of the public interest.

[Id.)

OPINION

Preliminary Comments

The Court of Appeals has directed that the remaining test

case petitioners "and all other taxpayers properly before this

Court" receive judgments in their favor "on terms equivalent to

those provided in the settlement agreement with Thompson and the

IRS."

Dixon v. Commissioner, 316 F.3d at 1047.

The Court of

Appeals has left to this Court's discretion "the fashioning of

such judgments which, to the extent possible and practicable,

should put these taxpayers in the same position as provided in

the Thompson settlement."

Id. n.11.

Throughout the proceedings .required to implement the

mandates of the Court of Appeals, petitioners, impelled by

outrage and indignation at the fraud on the Court committed by

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

invitation to award damages against respondent.

Without in any

way minimizing the seriousness of the misconduct of respondent's

attorneys, we decline any such invitation.34

The mandates do not

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

34In any event, we lack jurisdiction to award damages.

Choca110 v. Commissioner, T.C. Memo. 2004-152.

- 71 sanctions against respondent, to be determined in accordance with

the ascertainable standard provided by the Dixon V opinion.

We now broach how, in light of the different circumstances

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

can follow and apply the directive of the mandates.

Interpreting

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

"same financial position", it might seem, at first blush, that

the test case and nontest petitioners cannot be put in the

financial position the Thompsons found themselves in as a result

of the Thompson settlement.

The Thompson settlement was embodied

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

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

deductible for income tax purposes, in a different interest rate

environment, and in temporal relationships that are not now

reproducible with respect to any of the other petitioner

participants in the Kersting project.

Also, the bulk of those

refunds was used to pay legal fees the other test case

petitioners were not required to pay for representation in the

test case trial.

It should be borne in mind that the Thompson settlement

occurred in two distinct phases:

In December 1986 into early

1987, McWade and DeCastro arranged to provide the Thompsons a

reduction of approximately 20 percent in the originally

determined deficiencies; this version of the settlement took

- 72 account of respondent''s increased litigation risk resulting from

Chicoine and Hallett's efforts to suppress the evidence

discovered in the IRS raid on Kersting's office.

Other Kersting

petitioner clients of DeCastro and Chicoine and Hallett obtained

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

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

thereafter obtained such settlements.

.The Thompsons' payments to

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

obligations under the approximately 20-percent reduction

settlement arranged by McWade and DeCastro.

DeCastro thereafter played on the fears of Sims and McWade

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

additional reduction agreed to'in late 1988 and early 1989 that

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

for providing.legal representation to .the Thompsons at the trial.

The new Thompson settlement had no rationale quantifiably related

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

based on the opportunistic estimates of McWade and Decastro of

what was needed to bring about a particular financial result that

has little or no congruence with the situation in which the

petitioners before the Court now find themselves.

The fact that

the Thompsons had already made the payments required by the

earlier 20-percent reduction settlement provided the fund that

was ripening for the taking under the new settlement.

As it

- 73 turned out, the overall reduction of approximately 62 percent in

the Thompson deficiencies provided by the new settlement was more

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

McWade and.DeCastro thought would be needed to pay DeCastro's

original estimate of what his fees would be.

As it further

.turned out, the additional interest on the Thompsons' payments

under the original settlement was sufficient to provide DeCastro

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

probably felt was justified by his success in keeping the new

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

by the Thompsons."

Test case and nontest case petitioners in the main fall into

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

the situation of the Thompsons 15-20 years ago.

It is the

Court's impression that a substantial majority of nontest case

petitioners are in the unhappy situation of having followed

Kersting's advice to stand pat.

They neither settled their cases

nor made any remittances in respect of the deficiencies

determined against them.

With the passage of years and the

operation against them of the force of compound interest, they

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

"The lack of legal rationale and the opportunistic

character of the new settlement are emphasized by the fact that

it was entered into after the litigation risk that supported the

original 20-percent reduction settlement had evaporated with the

publication of this Court's opinion.in Dixon I.

-.74 attendant anxieties; this is because they did not have the

foresight or the discipline to invest the chimerical tax savings

they had appropriated by. using the Kersting. shelters to support

their .original return positions.36

On the other hand, there are

a minority of petitioners who, without conceding their

liabilities, have stopped the running of interest against

themselves by prepaying the Kersting deficiencies the IRS had

determined against them."

With the passage of time and the

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

minority of petitioners .are entitled, under the Dixon V opinion

and mandates, to substantial refunds, and properly so.

A further comment:

The financial burden of petitioners who

did not prepay has been substantially ameliorated--but not

completely eliminated--by respondent's concession that no

interest will be charged on deficiencies for the period of the

36The bulk of petitioners in the Kersting project appear to

have been commercial airline pilots. There is no evidence in the

record of their financial sophistication or lack thereof, ·either

individually or as a group.

"The Court understands that this group includes the

remaining test case petitioners, with the exception of the

Dixons, who received a discharge in bankruptcy. By collecting

the deficiencies from the test case petitioners because of their

failure to file appeal bonds, cf. Estate of Kanter v.

Commissioner, T.C. Memo. 2006-46, respondent has put those

petitioners in the advantageous position of being entitled to

collect substantial refunds, on which interest has been accruing

and compounding over .the years without attracting current annual

tax liabilities. Of·course, the interest component of those

refunds will be includable in gross income of the recipients when

finally paid.

- 75 appeals to the Ninth Circuit.

That concession, prompted by

respondent's recognition of responsibility for the delay in

resolving the Kersting project cases caused by the need to

investigate the misconduct of respondent's attorneys, seems

appropriate, but also generous.

Even if there had been no

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

case petitioners, before the misconduct was discovered, would

have taken some substantial time beyond June 1992 to resolve.

The amelioration is substantial because it has stopped the

further accrual and compounding. of interest on the deficiencies

for more than 13 years.

The amelioration is not complete because

many petitioners have deficiencies going back to the late 1970s

and early 1980s.

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

petitioners who did not prepay would have been required to pay

substantially more than they will be required to pay under the

mandates.

Moreover, they will be entitled to pay these reduced

amounts many years later than would have been necessary if there

had been no misconduct.

As a result of respondent's concession',

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

deficiencies for more than 13 additional years..

Stated

differently, they have enjoyed for more than 13 years the

equivalent of an interest-free loan of the reduced deficiencies

and interest they will now have to pay.

- 76 In sum, this Court has ·determined the terms of the Thompson

settlement.

Our decisions in these cases will apply those terms

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

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

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

pending cases in the Kersting project.

The thoughts underlying the foregoing comments have informed

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

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

the extent possible and practicable, in positions similar to that

provided by the Thompsonisettlement.

Although it may be

impossible to put petitioners in the same position, financial or

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

that the Code provisions for interest on deficiencies and

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

principles that underlie all financial planning,39 provide the

only available appropriate means of approximating the desired

equivalence."

38Secs. 6601,

6611.

39See generall.y, e.g., Brealey & Myers, Principles of

Corporate Finance (7th ed. 2003).

"Gokhale & Smétters, "Measuring Social Security's Financial

Outlook within an Aging Society", Daedalus 91-92 n.2 (Winter

2006), comment that discounting to present value, añ operation

integral to giving effect to the time value of money, makes it

possible "to .place dollars accruing at different points in time

(continued...)

- 77 -

For two reasons, those petitioners who prepaid will receive

refunds many times greater than the Thompsons received:

Most of

those petitioners probably made payments equal to their

originally determined deficiencies, not just 80 percent thereof,

like the Thompsons, and their refunds will be exponentially

increased by interest accruals because they have had to wait.much

longer than the Thompsons did to receive their refunds.

On the other hand, those petitioners who, unlike the

Thompsons, did not prepay will have deficiencies that will be

reduced in the same proportion as the Thompsons' deficiencies

were finally reduced under the settlement.

Although they will

still have to pay those reduced deficiencies with interest

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

substantially reduced by respondent's concession.

We conclude

these comments by again observing that these petitioners will

still be substantially better off financially than they would

have been in the absence of respondent's misconduct.

And so

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

has fixed as the appropriate judicial response to the misconduct

of respondent's attorneys.

4°(...continued)

on an e ual valuation scale".

- 78 I.

Procedural -Issues Following Remand

Procedural Posture

These cases are before the Court pursuant to the DuFresne

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

Ninth Circuit.

·They therefore present issues in a procedural

posture diametrically different from the standpoint from which we

usually redetermine income tax deficiencies or overpayments

arising from notices of deficiency or refund claims.

Here, the

traditional roles of petitioner and respondent are reversed.

.In

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

whose activities are being. questioned.

It is respondent, not

petitioners, who is charged with having the necessary records and

the personnel who have recollections regarding the matters at

issue."

Because of the unique posture of this case, it is

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

been properly claimed and allowed (and thus should not be

included as one of the taxpayer benefits of the Thompson

settlement), while petitioners argue the .cóntrary.

"It should be noted that, following the remand in.Dixon V,

neither side called DeCastro, Mcwade, or Sims as a witness. We

understand that DeCa.stro is seriously ill, so.he was not

available. We have no such information about McWade or Sims;

perhaps their previous failures ta persuade this Court of their

credibility discouraged both sides from calling them.

- 79 B.

Law of the Case

The Court of Appeals for the .Ninth Circuit recently

explained the law of the case doctrine as follows:

"The law of the case doctrine requires a district

court to follow the appellate. court's resolution of an

issue of law in all subsequent proceedings in the same

case." United States ex rel. Luian v. Hughes Aircraft

Co., 243 F.3d 1181, 1186 (9th Cir. 2001). The doctrine

applies to both the appellate court's "explicit

decisions as well as those issues decided by necessary

implication."

United States v. Cote, 51 F.3d 178, 181

(9th Cir. 1995) (quoting Eichman v. Fotomat Corp., 880

F.2d 149, 157 (9th Cir. 1989)). * * *

{Al-Safin v.

Circuit City Stores, Inc., 394 F.3d 1254, 1258 (9th

Cir. 2005).]

In relying upon its inherent authority to sanction the IRS by

extending the benefit of the Thompson settlement to all

interested parties, the Court of Appeals by necessary.implication

concluded that the doctrine of inherent authority trumps the

doctrine of sovereign immunity (the latter generally prohibiting

the imposition of monetary sanctions.against the United States

absent the express consent of Congress).42

We therefore are not

concerned with that issue.

42The principle that a court has inherent power to impose

sanctions is well established.

"It has long been understood that

'[c]ertain implied powers must necessarily result to our Courts

of justice from the nature of their institution,' powers 'which

cannot be dispensed with in a Court, because they are necessary

to the exercise of all others.'" Chambers v. NASCO, 501 U.S. 32,

43 (1991) (quoting United States v. Hudson, 11 U.S. (7 Cranch)

32, 34 (1812)).

- 80 C.

Parties Before the Court

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

enter judgment in favor of Appellants and all other taxpayers

properly before this Court".

1047.

Dixon v. Commissioner, 316 F.3d at

In a technical sense, the Dixon V opinion and the

implementing mandates might be deemed to extend only to those

parties who filed notices of appeal.

See Abatti v. Commissioner,

859 F.2d 115, 120 (9th Cir. 1988).

We believe, however, that the

Court of Appeals did not intend a..technical, restricted

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

parties.

Following the hearings in these cases, the parties

filed a stipulation of settled issues.

Among other things, that

stipulation recites:

1. The Kersting deficiencies of any petitioner

who has filed a piggyback agreement with the Tax Court

shall be determined in accord with the Ninth Circuit's

mandates as implemented by the Tax Court on remand in

. this proceeding * * *.

2. The Kersting deficiencies of any·petitioner

in a case docketed before the Tax Court who has not

filed a piggyback agreement will, absent a showing of

cause, be determined in accord with the Ninth Circuit's

mandates as implemented by the Tax Court on remand in

this proceeding * * *.

We read these stipulations to apply to all open cases of

petitioner participants in the Kersting tax shelter programs.

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

sanction applies to benefit not only to test case petitioners,

but also to nontest case petitioners in all remaining docketed

- 81 cases in the Kersting project, whether or not they signed

piggyback agreements.

Burden of Proof

In our Dixon III opinion, we noted several factors that

impelled us to impose the burden of proof on respondent with

respect to whether the misconduct of respondent's attorneys

resulted in a fundamental defect or in harmless error.

Those

same factors apply to the present proceedings concerning the

scope and application of the Thompson settlement.

As in Dixon

III, respondent has had.direct and immediate access to the

critical witnesses and most of the relevant documents since May

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

light.

Further, respondent conducted an internal investigation

of that misconduct, without the participation of outside part.ies,

soon after discovering the misconduct.

Petitioners, on the other

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

plus whatever evidence respondent has revealed voluntarily.

Petitioners have .been far less favorably situated than respondent

to produce the factual record needed to decide these cases on

remand.

Furthermore, and finally, as we have previously

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

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

review.

Accordingly, we again conclude that the interests of

justice are better served by placing the ultimate burden of proof

- 82 and persuasion on respondent, and we so hold.43

See Rockwell v.

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

Memo. 1972-133.

We recognize that imposing the burden of proof on respondent

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

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

Thompsons was not a result of the Thompson settlement.

In other

circumstances, when a taxpayer has the burden of proving the

negative of a proposition, such as proving the nonreceipt of

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

Commissioner to produce at least some substantive evidence

linking the taxpayer to the income-producing activity.

Weimerskirch v. Commissioner, 596 F.2d 358, 361

See

(9th.Cir. 1979)

(respondent must offer "some foundational support" of the receipt

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

Accordingly, in the

matter at hand, it is appropriate to require petitioners to

43Petitioners have filed a motion, as supplemented by a

later motion, asking the Court to assign the burden of proof to

respondent on 22 specified issues;.in so doing, petitioners aver

that they do not seek a general allocation of the burden of proof

to respondent.

Respondent has objeçted to these motions, quoting

Kluger v. Commissioner, 83 T.C. 309, 310 n.1 (1984), for the

proposition that the Court "has never, in any context, invoked

such a sanction". Our action in Dixon III in shifting the

ge-neral burden of proof and persuasion to respondent in that

phase of these proceedings belies respondent's objections. We

have c·oncluded that no useful purpose would be served by

addressing petitioners' motions on an issue-by-issue basis.

Suffice to say we have assigned the·burden of proof and

persuasion to respondent on each issue of fact that bears on the

scope and terms of the Thompson settlement.

- 83 produce at least some substantive evidence indicating that

asserted benefits to the Thompsons are the result of the Thompson

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

to prove the contrary.

In this regard, it is appropriate for

petitioners to rely upon circumstantial evidence, although here,

as in other contexts, "'mere suspicion or speculation does not

rise to the level of sufficient evidence'".

See United States v.

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

(quoting United

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

Finally, we believe the factual issues regarding the

operative terms and scope of the Thompson settlement, now that

the existence and overall significance of the misconduct have

been determined, do not present policy considerations that

require a heightened standard of proof, such as the requirement

of "clear and convincing" proof of fraud imposed by our Rule

142(b)

in deficiency cases, that we applied in Dixon III against

respondent in an earlier phase of these proceedings.

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

burden is a "preponderance" of the evidence, the traditional

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

law thereunder."

This is the same.standard to which we and

"Petitioners have not sought to allocate the burden of

proof to respondent on the ultimate question of whether the

Thomson settlement is characterized as a 20-percent reduction in

deficiencies, plus the payment of the Thompsons' legal fees, or

(continued...)

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

general·tax liability, and we believe that this is the

appropriate standard to apply to respondent in this phase of the

proceedings.

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

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

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

II.

Defining and Applying the Thompson Settlement

Overview

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

the Court of Appeals reminded us that its opinion may be

consulted to ascertain what was intended by the mandates.

Dixon V, the Court of Appeals described the basis of the "secret.

settlement agreements" with the Thompsons and the Cravenses as

follows:

"A condition of their settlements required Thompson and

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

Thompson, McWade agreed to have Thompson's tax deficiencies

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

$60,000."

Dixon v. Commissioner, 316 F.3d at 1044; fn. ref.

"(...continued)

as a 62-percent reduction. See Part C, infra. We observe that

the significant evidentiary facts on this issue are not in

dispute, so that the burden of proof does not enter into what we

see as a problem of legal characterization.

Therefore, the

question does not arise whether we should employ some heightened

standard of proof,· such as "strong proof" or "clear and

convincing" proof, that might otherwise arise when a party to a

transaction seeks to disregard the form employed. Our resolution

of this issue does not depend on the allocation or standard of

the burden of proof.

- 85 omitted.

The Court of Appeals further described the Thompson

settlement as a "vehicle for paying Thompson's attorney's fees",

notwithstanding McWade's testimony that the settlement "was

attributable to a separate transaction."

Id. at 1045."

The opinion of the Court of Appeals displays its

understanding that the Thompson settlement was a covert

transaction, a "secret settlement agreement" that "was a vehicle"

to provide the Thompsons with advantages--including payment of

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

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

above those offered to other taxpayers.

Thus, while our sanction

should put the other affected taxpayers in the position of having

received the benefits the Thompsons received, those benefits

should be fairly traceable to the sanctionable conduct of

respondent's counsel, McWade and Sims.

As we informed the

parties in an order dated February 28, 2005:

"The reference to a "separate transaction" is to the

Thompsons' participation in the Bauspar program.

In his brief to

the Court of Appeals, Izen explained that McWade and Sims had

misled this Court by "denying that the Thompsons [sic] settlement

was a vehicle for paying DeCastro's legal fees for representing

the Thompsons at the trial of the test cases, [and] by testifying

that the Thompsons [sic] settlement was attributable to the

Thompsons' participation in the Bauspar program."

Additionally,

as we observed in Dixon III, "Mr. McWade testified that the

Thompsons' settlement was revised in the summer of 1989 in order

to dispose of the Bauspar issue. Mr. McWade denied that .the

Thompsons' settlement was revised to provide a means for the

Thompsons to pay Mr. DeCastro's attorney's fees."

- 86 The mere fact that the Thompsons received a tax benefit

is insufficient to enable the Court to conclude that

the benefit was part of the settlement. With respect

to each item, it is also necessary to show, ori find it

appropriate to assume, that respondent's counsel played

an enabling or facilitating role in procuring or.

assuring the benefit to the Thompsons.

Areas of Agreement

The parties' stipulation of settled issues, in addition to

delineating the beneficiaries of the Court of Appeals' mandates,

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

relief to which those beneficiaries are entitled:

The "burnout" element of the Thompson

settlement is as follows:

(a)

for taxpayers with 2-3 taxable. years

before the court, the first year's

deficiencies·are shifted forward and

combined with the deficiencies in the

. second year then reduced in accord with

the Ninth Circuit's mandate; and

(b)

for taxpayers with 4 or more taxable

years before the court, the first year's

deficiencies are shifted forward to the

second year and the second year's

deficiencies are shifted forward and

combined with the deficiencies in the

third year, after which all deficiencies

are reduced in accord with -the Ninth

Circuit's mandate.

4. No petitioner will incur any penalties

stemming from such petitioners's [sic) Kersting

deficiencies. .

- 87 We incorporate the foregoing stipulations in the relief we

announce today."

As for the deficiencies themselves, petitioners and

respondent have agreed that the originally determined Kersting

deficiencies should be reduced in proportion to the monetary

benefit the Thompsons received as a result of the new agreement

between McWade and DeCastro.

As petitioners explain: "To

determine a percentage reduction of aggregate deficiencies

requires a numerator and denominator, the numerator being the

amount the Thompsons actually paid under the settlement and the

denominator being the amount they would have paid absent the

settlement."47

We agree, with the initial caveat that, inasmuch

as the parties address both interest and Kersting-related

penalties elsewhere, we. disregard those items in determining what

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

denominator).

"We do not adopt all aspects of the parties' stipulation of

settled issues.

See infra note 67.

47Actually, the resulting percentage would represent the

proportion of proposed deficiencies that affected taxpayers would

be required to pay.

To obtain the "percentage reduction" it will

be necessary to subtract the percentage so found.from 100

percent.

- 88 C.

Starting Point:

The Thompsons' Settlement

of Proposed Deficiencies for 1979-1981

Respondent's Position

Respondent's characterization of the Thompsons'

settlement

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

dated May 28, 2003, has remained constant throughout the

proceedings on remand from Dixon V.

Respondent maintains,

"from

a substantive standpoint", that the Thompsons' settlement of

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

deficiencies"" plus "payment of the Thompsons' attorney's fees

incurred with respect to the actual trial of the test cases

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

1991-614

(Dixon II)."

In other words, respondent maintains that

the settlement fraction numerator--"the amount the Thompsons

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

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

respondent's view, the settlement should not reflect the

additional $33,000 reduction in tax plus the accompanying

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

1989 and $32,250 in February 1993" that were signed over to

DeCastro, nor the interest refunds on the resulting overpayments

"More accurately, 20.55 percent (from $79,294 to $63,000).

"Respondent applied the remaining $750 to the Thompsons'

1988 tax year.

- 89 that funded an additional fee payment to Decastro later in 1993

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

Respondent argues that, because none of the other

petitioners (test case or nontest case)

incurred attorney's fees

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

those petitioners would receive an economic windfall if we were.

to use the actual 62-percent reduction in the Thompsons' 19791981 deficiencies as the starting point for our remedy.

Respondent reasons that the 62-percent characterization would

provide a benefit to petitioners (the reduction in their proposed

deficiencies by an additional 42 percent) that·the Thompsons did

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

of the resulting refunds to DeCastro as payment for legal

services that conferred no discernible benefit to them.

Respondent further argues that the relatively small portion of

the refunds of tax and interest ultimately retained by the

Thompsons

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

insignificant by the fact that the Thompsons reported almóst

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

from the IRS in 1993 on which they paid tax.5°

In sum,

respondent argues, the sweetener embodied in the final settlement

so Respondent overlooks the fact that the refunds of

$33,966.68 of taxable interest income reported by the Thompsons

for 1993 were substantially exceeded by the $51,000 deduction for

legal fees claimed by and allowed to them for tha't year.

- 90 that was achieved by increasing the deficiency reduction

percentage from 20 percent to 62 percent in effect should be

. disregarded because the refunds generated thereby purchased

nothing of value and provided at most a de minimis increase in

the Thompsons' net worth."

Petitioners' Position

In sharp contrast, petitioners view the Thompsons'

settlement of their 1979-1981 deficiencies stri.ctly in terms of

the percentage reduction in the total amount of tax the Thompsons

were required to pay.

Thus, petitioners maintain that the

starting point for determining the percentage reduction in

deficiencies to which they are entitled is 62.17 percent,

representing the final total reduction of the Thompsons' proposed

defic·iencies for the years at issue .from $79,294 to $30,000.

In addition to their argument that the form of·the

Thompsons' settlement of their 1979-1981 deficiencies (62.17percent reduction) provides the starting point for determining

the appropriate sanction in these cases, petitioners dispute

respondent's assertion that the payment of DeCastro's fees was

"A more nuanced adoption and application of respondent's

argument might arrive at some percentage between 20 percent and

62 percent by increasing the 20 percent to reflect the amount of

the refunds actually retained by the Thompsons or the amount they

expected or were expected to retain after their endorsement over

to DeCastro of the first two refunds.

Neither side has advanced

such an argument.

- 91 one of the substantive elements of that settlement.

Petitioners

urge that the evidence does not support a finding that the

Thompsons' use of the refunds generated by the final reduction in

deficiencies was restricted in any way.

They point to some

inconsistencies in the estimate of total fees that DeCastro had

given to McWade, as well as DeCastro's initial reluctance to

acknowledge that respondent had arranged to pay his fees.

Accordingly, petitioners argue that the substance of the

Thompsons' settlement of their 1979-1981 deficiencies did not

depart from the form in which respondent provided it--that is,· a

reduction of 62.17 percent in the deficiencies originally

determined for those years.

Analysis

As a threshold matter, we do not believe that the

inconsistencies perceived by petitioners outweigh the direct and

circumstantial evidence that, in substance, the Thompsons'

settlement of their 1979-1981 deficiencies was, in the words of

the Court of Appeals, a "vehicle for paying Thompson's attorneys'

fees".

The preponderance of the evidence shows that, when they

made their final deal, McWade and DeCastro intended that the

refunds generated by the final reduction of the Thompsons'

deficiencies would go to DeCastro in payment of his fees.

The

fact that the Thompsons endorsed the first two refunds--two

checks totaling $62,225--directly to DeCastro's law firm confirms

- 92 that intention.

In a telephone call with Bakutes on June 10,

1992, DeCastro himself conceded that the refunds were intended as

a means of paying his fees.

Although we recognize that the payment of DeCastro's fees

was an essential element of the Thompsons' settlement of their

1979-1981 deficiencies, it does not follow that respondent's

characterization of that settlement·(20-percent reduction in

deficiencies plus payment of attorney's fees) must prevail.

From

a practical standpoint, respondent overlooks the fact that the

refunds generated by the ·reduction in deficiencies exceeded the

legal fees they were intended to defray.

More importantly,

inasmuch as the Court of Appeals has taken us to task for twice

failing "to equitably resolve" a situation in which respondent's

attorneys committed fraud on the court, we believe respondent

should be held to the form of the new settlement.

That is, we do

not think it appropriate to define the Thompsons' settlement of

their 1979-1981 deficiencies only by reference to its asserted

substance, which would require respondent to reduce the proposed

deficiencies of the affected taxpayers by only 20 percent (this

would be the practical effect, because, although respondent would

.also be required to reimburse the affected taxpayers for

attorney's fees, none of the affected taxpayers paid any such

- 93 fees).52

We instead think it appropriate to hold respondent to

the form of the transaction adopted by his misbehaving attorneys,

i.e., the reduction of the Thompsons' 1979-1981 deficiencies by

62.17 percent., without regard to the fact that the Thompsons used

the bulk of the refunds generated thereby to pay DeCastro's fees.

We recognize that, in the usúal case,

it is taxpayers who

are held to the form of the transaction they have adopted; once a

party has chosen to organize his affairs in a certain fashion,

"he must accept the tax consequences of his choice, whether

contemplated or not * * * and may not enjoy the benefit of some

other route he might have chosen to follow but did not."

Commissioner v. Natl. Alfalfa Dehydrating & Milling Co.,

134,

149 (1974).

417 U.S.

On the other hand, respondent generally may

disregard the taxpayer's form, and, if that form is "unreal or a

sham may sustain or disregard the effect of the fiction as best

serves the purposes of the tax statute."

U.S. 473,

477

(1940).

Higgins v. Smith,

308

We also recognize that, in these cases,

the traditional roles of petitioner and respondent have been

reversed.

Requiring respondent to assume the procedural posture

of a taxpayer does not necessarily prohibit respondent from

asserting substance over form.

We have in mind the following

52The attorney's fees incurred by petitioners for which

respondent may be liable relate to further proceedings required

by the misconduct of respondent's attorneys and are in no way .

analogous to the Thompsons' fees to DeCastro for his

representation in the original trial in Dixon II. ·

- 94 comment of Judge Wisdom:

"The taxpayer too.has a right to assert

the priority of substance--at least in a case where his tax

repor.ting and actions show an honest and consistent respect for

the substance of a transaction."

Weinert v. Commissioner, 294

F.2d 750, 755 (5th Cir. 1961), affg. 31 T.C. 918 (1959).53

Our difficulty with respondent's assertion of the "priority

of substance" arises from the failure of respondent's actions to

show "an honest and consistent respect for the substance of [the]

transaction."

Here, respondent, through his former attorneys,

did not shöw respect for the substance of the transaction.

McWade and Sims tried to hide the settlement from their

supervisors,

from the other parties, and' from the Court.

As we

have seen, and the Court of Appeals has noted, Dixon v.

Commissioner, 316 F.3d 1044 n.5, when Thompson was about to

reveal his settlement in open court, McWade immediately steered

him to another subject.

Nor did respondent's attorneys manifest

a consistent respect for the substance of the transaction.

substance, the Thompsons' settlement of their 1979-1981

deficiencies was a vehicle for payment of their attorney's fees,

but respondent, again through his former attorneys who

perpetrated the fraud, characterized it as a refund of taxes to

the Thompsons that was solely attributable to Bauspar.

53 See Smith, "Substance over Form: A Taxpayer's Right to

Assert the Priority of Substance", 44 Tax Law. 137, 142 (1990).

- 95 We therefore reject respondent's assertion of substance over.

form.

We shall instead apply to respondent the nondisavowal

principle of Commissioner v. Natl. Alfalfa Dehydrating & Millin

Co., supra at 149, that a party who has chosen to organize his

affairs in a certain fashion "must accept the tax consequences of

his choice, whether contemplated or not * * * and may not enjoy

the benefit of some other route he might have chosen to follow

but did not."

We believe the settlement of the Thompsons' 1979-

1981 deficiencies must be applied by giving effect to their

receipt of the entire amount of the refunds, rather than by

disregarding such receipt as a mere formality in the process of

what was, in substance, respondent's manipulation of the tax

administrative process to use the Thompsons as a conduit.to pay

DeCastro's fees.

We are not content to rest our conclusion solely by invoking

the nondisavowal principle to hold respondent to the form of the

transaction.

To do so might give rise to the implication that we

have disregarded the substance of the transaction.

If we did no

more than disregard the substance of the Thompson settlement by

upholding its form, respondent might well impeach our conclusion

by arguing that we thereby would have disregarded the mandate of

the Court of Appeals for the Ninth Circuit to put all petitioners

"in the same position as provided in the Thompson settlement".

- 96 We therefore push the analysis fur-ther by observing that our

conclusion accords with principles of Federal income taxation

developed by the Supreme Court in analogous situations..

Specifically, our treatment of the Thompson settlement ·is

analogous to the treatment of taxpayers who are held to havereceived gross income, even though that income was paid directly

to a third party.

Petitioners cite Old Colony Trust Co. v.

Commissioner, 279 U.S. 716 (1929), in which the Supreme Court

held that an employer's payment of its employees' income taxes

should be recognized as a taxable payment of additional

compensation to the employee."

Our conclusion is supported by the recent decision of the

Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005).

There, Mr. Banks settled an employment discrimination suit for

$464,000 and, pursuant to a contingent fee arrangement, paid his

attorneys $150,000 of that amount.

The Supreme Coùrt held that

the $150,000 fee amount was includable in the gross income of. Mr.

Banks, notwithstanding his preexisting obligation to pay

"We note that the Thompsons did not report as gross income

the first refund of $30,000, presumably because it was a refund

of tax they had previously paid. Moreover, they did not claim

that amount as a deduction under sec. 212(3) when they endorsed

the check for that amount to DeCastro, as a partial payment on

account of his legal fees. Although their failure to claim the

deduction operated as a tax detriment to the Thompsons, there is

no evidence that th-eir forbearance was in any way related to the

deal with McWade.

- 97 approximately one-third of his total recovery to his lawyers.

We read the Supreme Court's opinion in Banks as confirming and

applying the general principle that the portion of a settlement

that is dedicated to the payment of the plaintiff's attorney's

contingent fee·is still regarded as received by the plaintiff

even though he is not expected or entitled to retain it.

Our conclusion is guided also by the fact that the Court of

Appeals has specifically directed us to provide the equivalent of

the Thompson settlement as a sanction against respondent.

We do

not believe that the Court of Appeals contemplated the

application of this aspect of the Thompson settlement in the way

that respondent urges, that is, as a 20-percent reduction in

proposed deficiencies, together with the hollow requirement that

respondent reimburse the many other affected petitioners for

attorney's fees that in fact they never incurred.

If we did so,

"We note that in Kenseth v. Commissioner, 114 T.C. 399

(2000), affd. 259 F.3d 881 (7th Cir. 2001), a majority of this

Court upheld respondent's contention that the taxpayers were

chargeable with the receipt of gross income on the portion of a

settlement that was úsed to pay their attorney under a contingent

fee arrangement.

In Kenseth, the taxable year was 1993, the

taxable year for which, in the matter at hand, respondent

contends that we should disregard as a formality the Thompsons'

receipt of the second refund they used to pay their attorney.

We observe that our hewing to the form of the transaction as

generating refunds of tax and interest to the Thompsons obviates

any argument by petitioners that the Thompsons received a tax

benefit in not being required to report as gross income the

receipt of the. refund of tax that enabled them to make their

first installment payment of DeCastro's attorney's fees.

- 98 we wóuld not be applying the equivalent of the Thompsons' 19791981 settlement; instead we would be.applying·essentially the

same 20-percent reduction settlement that McWade extended to

other taxpayers, .including other clients of Chicoine and Hallett

and DeCastro, the monetary benefit of which respondent would have

been content to allow the Thompsons to retain.

We believe the

modest deficiency reduction percentage urged by respondent would

not provide an appropriate sanction for misconduct that the'Court

of Appeals has held to be a fraud on this Court.

To adopt

respondent's view would be to ignore the financial terms and

effects of the final settlement that was sweetened for the

illicit purpose of creating the fund from which DeCastro's trial

fees could be paid.

We conclude that the Court of Appeals intended that the

Thompsons' "secret agreement" with respect to 1979-1981, to the

extent it reflected the reduction of deficiencies to $30,000 for

those years, is to be applied as a reduction of 62.17 percent in

the Kersting deficiencies of the affected taxpayers, rather than

the 20-percent reduction urged by respondent, or some

intermediate percentage based upon the actual or expected amounts.

of the refunds to be retained by the Thompsons after payment of

DeCastro's fees.

See supra note 51.

In terms of the "settlement

fraction" discussed above, we begin with a numerator of $30,000

(the total 1979-1981 tax deficiency the Thompsons paid) and a

- 99 denominator of $79,294 (the 1979-1981 tax deficiencies the

Thompsons would have paid absent the settlement).

Other Benefits Relating to the Thompsons'

1981 Tax Year

Elimination of the Thompsons' Late

Filing (Non-Kersting) Addition for 1981

Petitioners maintain that the denominator of the settlement

fraction should be increased by $4,934.32, representing the late

filing addition in the Thompsons' statutory notice for 1981 that

they would have had to pay absent the settlement of their 1979-

1981 tax years.

We disagree.

Respondent's proposed application

of non-Kersting penalties and additions was specific to

individual taxpayers, unlike the Kersting-related deficiencies

and additions for which all affected taxpayers are liable.

For

that reason, we believe it is appropriate to.limit the benefit of

this aspect of the Thompson settlement (relief from liability for

non-Kersting additions) to those affected taxpayers who, like the

Thompsons, were subject to non-Kersting additions.

We therefore

deal with this aspect of the Thompson settlement separately from

our determination of the percentage reduction in Kersting

deficiencies that will apply to all affected taxpayers.

infra Part II.G.1.

See

- 100 2.

Respondent's Failure To Address the

Bauspar Issue in the Thompsons' Statutory

Notice for 1981

As discussed above, the Thompsons began.participating in the

Bauspar program in 1981.

Respondent's notice of deficiency with

respect to the Thompsöns' 1981 tax year did not disallow the

$8,000 claimed by the Thompsons on their 1981 return as home

mortgage interest, interest that was probably attributable to the

Bauspar program.

By August 1985, when the Thompsons filed their

petition in this Court for 1981, respondent was generally

precluded from revising the statutory notice to include the

Bauspar issue.

See sec. 6212(c)(1).

Because that cutoff date

predates the Thompsons' retention of DeCastro by more than a

year, respondent's failurë to include the Bauspar issue in the

statutory notice for 1981 could not have been part of the secret

settlement agreement between. DeCastro and McWade."

Benefits to the Thompsons Relating to Years

Other Than 1979-1981

In General

Respondent maintains that the only years covered by the

Thompson settlement were the Thompsons' 1979-1981 taxable years

before the Court in this proceeding.

Petitioners, on the other

"Respondent presumably could have raised the Bauspar issue

later by seeking leave.to amend his answer in the Thompsons' 1981

Tax Court case.

See sec. 6214(a); Rule 41(a); Rule 142(a)

(shifting the burden of proof to the Commissioner with respect to

the increased deficiency). For reasons discussed infra in Part

II.E.4., we need not concern ourselves with that possibility.

- 101 hand, maintain that the Thompson settlement covered a number of

years between 1979 and 1993, thereby increasing the percentage

reduction in Kersting deficiencies to which they are entitled to

79.95 percent."

They base this percentage on their calculation

that, absent the settlement, the amount of taxes the Thompsons

would have paid respondent for the taxable years 1979-1983, 198687, and 1993 was $143,894.10, while the amount they actually paid

was $28,894.87 ($30,000 reduced by $1,105.13 that respondent

maintains Mr. Thompson improperly received as reimbursement for

his travel to Hawaii to testify in the Dixon II trial).

examine various suspect benefits below."

"In a separate brief, petitioners' counsel Sticht argues

for a "cashflow" approach to the calculation of the reduction

percentage, which would bring the initial reduction percentage to

86.8 percent of petitioners' aggregate deficiencies, additions,

and interest. Without closely following the mechanics of

Sticht's calculation, we.reject the cashflow approach out of

hand.

It completely disregards the time value of money

principles that underlie our Preliminary Comments.

See text

accompanying notes 38, 39, and 40, supra.

We also note that, in the course of the evidentiary hearing

required by the Dixon V mandates, petitioners' counsel O'Donnell

and Jones filed motions for summary judgment of "100-percent

discount" as a sanction. We denied the motions and the motions

for reconsideration of our denials because of numerous

outstanding issues of material fact. With the completion of the

evi~dentiary.hearing and issuance of our opinion herein, we now

regard petitioners' motions to characterize the Thompson

settlement as a 100-percent reduction in the Kersting-related

deficiencies as having been denied on the merits.

"We note that petitioners do not question the settlement of

the Thompsons' 1978 tax year, which was apparently the first year

for which the Thompsons claimed Kersting deductions.

In any

(continued...)

- 102 2.

The Thompsons' Escape From Kerstino

Liability with Respect to 1982

As discussed earlier, the Thompsons claimed Kersting (and

probably Bauspar) deductions on their 1982 return.sufficient to

reduce their adjusted gross income of $99,364 to $4,336.

Respondent took no action with respect to that return, and the

generally applicable 3-year period of limitations for the

Thompsons' 1982 tax year expired in May 1986.

Given the fact

that the Thompsons did not retain DeCastro until November 1986,

respondent's failure to act on the Thompsons' 1982.return before

the expiration of the 3-year period of limitations could not have

been part of the secret settlement agreement between DeCastro and

McWade.

Petitioners nevertheless maintain that the Thompsons' escape

from Kersting liability with respect to 1982 is attributable to

the DeCastro/McWade agreement.

In support of that argument, they

point to DeCastro's August 3, 1989 letter to McWade, which

states: "We have agreed that the total taxes due for all the open

years are $15,000 for 1980 and $15,000 for 1981." (Emphasis

added.)

Petitioners then argue that the Thompsons'

1982 tax year

was still fair game at that time because Mr. Thompson's fraud

rendered the statute of limitations inapplicable pursuant to

58(...continued)

event, that settlement was consummated in early to mid-1986,

before DeCastro came on the scene.

- 103 section 6501(c)(1).

They argue that Mr. Thompson was liable for

fraud because he had claimed Kersting deductions even though he

believed he wouldn't have to pay the notes.

Petitioners' arguments are farfetched.

are serious business.

Allegations of fraud

The grounds for asserting civil fraud were

succinctly explained in Webb v. Commissioner, 394 F.2d 366, 377

(5th Cir. 1968)

(quoting Carter v. Campbell, 264 F.2d 930,

935-936 (5th Cir. 1959)), affg. T.C. Memo. 1966-81:

"Fraud implies bad faith, intentional wrongdoing and a

sinister motive. It is never imputed or presumed and

the court should not sustain findings of fraud upon

circumstances which at most create only suspicion.

* * * Negligence, whether slight or great, is not

equivalent to the fraud with intent to evade tax

named in the statute. The fraud meant is actual,

intentional wrongdoing, and the intent required is the

specific purpose to evade a tax believed to be owing.

Mere negligence does not establish either.

* * * "

We amplified these requirements in Fields v. Commissioner, T.C.

Memo. 2002-320:

To succeed in the instant case, respondent must

show that he had a reasonable basis for believing that

he could prove his allegation of petitioner's fraud by

clear and convincing evidence.

See, e.g., Rutana v.

Commissioner, 88 T.C. 1329, 1337-1338 (1987). More

particularly, he must show that he had a reasonable

basis for believing that he could prove by clear and

convincing evidence that petitioner willfully intended

to evade a tax she believed to be owing.

In Fields, where we found that respondent lacked a reasonable

basis for asserting fraud, we awarded attorney's fees to the

petitioner under section 7.430.

T.C. Memo. 2004-272.