# T.C. Memo. 2017-21 8

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## Record

- **Collection:** Agency decision
- **Document type:** Agency decision

## Text

CT

T.C. Memo. 2017-21 8

UNITED STATES TAX COURT

ROBERT E. SMITH, III AND ANGELA K. SMITH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 21707-15.

Filed November 6, 2017.

George W. Connelly, Jr., for petitioners.
M. Kathryn Bellis and Yvette Nunez, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Respondent issued a notice of deficiency determining a
$623,795 income tax deficiency and a $124,759 accuracy-related penalty under
section 6662(a) for petitioners' 2009 tax year.¹ During 2009 petitioners

¹Unless otherwise indicated, all Rule references are to the Tax Court Rules
(continued...)

SERVED Nov 06 2017

-2[*2] transferred their personal assets of cash and marketable securities to a wholly
owned S corporation, which in turn transferred the assets to a family limited
partnership. Petitioners dissolved the S corporation and received the partnership
interest in the dissolution of the S corporation. Through this structure and the
transfer of their personal assets, petitioners claimed an ordinary loss deduction on
the liquidating distribution by using a substantially discounted value for the assets
held by the partnership. Petitioners have conceded that to the extent they are
entitled to a loss deduction for 2009, it should be characterized as a short-term
capital loss.
After concessions the issues for consideration are whether petitioners:
(1) are entitled to deduct a short-term capital loss for 2009 relating to the
dissolution of the S corporation and (2) are liable for a section 6662(a) accuracyrelated penalty for 2009. For the reasons stated herein, we decide both issues for
respondent.

¹(...continued)
of Practice and Procedure, and all section references are to the Internal Revenue
Code (Code) in effect for the year at issue. All amounts are rounded to the nearest

dollar.

-3[*3]

FINDINGS OF FACT
At the time petitioners timely filed their petition, they resided in Texas.2

Mr. Smith worked for National Coupling Co., Inc. (National Coupling), for 36
years, retiring in 2009, the year at issue, and owned 3,000 shares of its stock,
representing an approximately 0.5828% ownership. National Coupling
manufactured pneumatic and hydraulic subsea couplings and valves. Mr. Smith
was the company's vice president and the manager at its manufacturing facility.
He was in charge of manufacturing, engineering, intellectual property work, and
trademarks. Mr. Smith is an inventor with over 400 patents issued or in
prosecution at the time of trial. Most of Mr. Smith's inventions relate to subsea
hydraulic couplings and pneumatic couplings from his employment with National
Coupling. One of his inventions was used to fix the space shuttle rocket boosters
after the Challenger disaster. He won a Texas Inventor of the Year Award from
the Texas State Bar Association in 2008. Petitioners have been married for over
50 years. Mrs. Smith is a homemaker. Both Mr. and Mrs. Smith graduated from
high school and have taken some college courses.

2The parties' stipulation of facts with accompanying exhibits is incorporated
herein by this reference.

-4[*4]

In June 2009 National Coupling was sold and Mr. Smith retired. Mr. Smith

received a $600,000 bonus, $248,246 from the sale of his stock, and $181,170
from the surrender of two company-sponsored life insurance policies. In total he
received employee compensation, including the bonus, of $664,007 in 2009. After
the sale he began to provide consulting services to National Coupling under a twoyear contract and received $37,800 under that contract in 2009. During his
employment at National Coupling Mr. Smith had worked on a sprinkler device for
home sprinkler systems that would automatically apply fertilizer or insecticide.
He had worked on the sprinkler device in 2005 or 2006, and a patent application
was filed with the U.S. Patent and Trademark Office (USPTO) in 2006. Patent
applications were also filed in Canada and the United Kingdom. The U.S. patent
was issued in 2014, and the Canadian patent was issued in October 2009. The
record does not establish the date of the U.K. patent. Documents relating to the
sale of National Coupling did not grant Mr. Smith the right to the sprinkler device
patent. However, Mr. Smith believed that he would retain the patent rights to the
sprinkler device after the sale.

-5[*5] I.

Tax Strategy
As a result of the National Coupling sale and Mr. Smith's retirement,

petitioners' financial adviser recommended that they obtain estate planning advice
and referred them to Richard Shanks of the Shanks Law Firm (Shanks Firm), now
known as Shanks & Hauser. The financial adviser had referred other clients to
Mr. Shanks, an experienced attorney and a certified public accountant. He has an
undergraduate accounting degree from the University of Texas and a law degree
from the University of Texas Law School. His practice focuses on estate planning,
probate, tax planning, and tax return preparation, and he works mostly with
entrepreneurs and executives. Petitioners met with Mr. Shanks on June 23, 2009.
He prepared various estate planning documents for them, including wills and
medical directives. Mr. Shanks also recommended a tax planning strategy
intended to mitigate the effect on petitioners' tax liability of Mr. Smith's
compensation from National Coupling. The tax structure involved the
organization of an S corporation and the formation of a family limited partnership.
Under the structure, petitioners would transfer their cash and marketable securities
to a wholly owned S corporation that would then transfer the assets to a family
limited partnership. Mr. Shanks explained to petitioners that the family limited
partnership would provide asset protection. The S corporation would own the

-6[*6] limited partnership, and the partnership would hold petitioners' cash and
marketable securities. As part of the structure, petitioners would organize and
dissolve the S corporation within the same tax year. The S corporation would
distribute the partnership interest to the shareholders upon dissolution. Mr.
Shanks would determine the fair market value of the distributed partnership
interest using large discounts for lack of marketability and lack of control,
generating a tax loss upon the dissolution of the S corporation. The
S corporation's dissolution and the distribution of the partnership interest were
both necessary to generate the tax loss. A third entity in the planning structure
was a revocable management trust that would hold the general partnership interest.
Mr. Shanks advised that the tax structure could generate either a capital or an
ordinary loss deduction on the basis of the business purpose of the S corporation.
He had implemented similar structures for 10 to 15 other clients between 1999 and

2009.
On July 9, 2009, petitioners organized RACR Ventures, Inc. (Ventures), an

S corporation, formed RACR Partnership, Ltd. (RACR Partnership), a family
limited partnership, and created the Smith Management Trust (Smith Trust), a

revocable management trust (collectively, RACR structure). Petitioners each
owned 50% of Ventures. Mr. Smith was its president and treasurer, and Mrs.

-7[*7] Smith was the vice president and secretary. Both were directors. Ventures
owned a 98% limited partnership interest in RACR Partnership. Initially each
petitioner was a 1% general partner. Petitioners transferred their general
partnership interests to the Smith Trust. Petitioners were cotrustees and
beneficiaries of the Smith Trust. From the outset petitioners understood that
Ventures would not hold any assets, Ventures would immediately transfer its
assets to RACR Partnership, and they would dissolve Ventures by the end of 2009
to accomplish their tax mitigation plan. Petitioners understood that Ventures was
the vehicle they would use to minimize their 2009 income tax liability.
Petitioners' handwritten notes from their meeting with Mr. Shanks in June 2009
identified the RACR structure as a vehicle to minimize tax for 2009. Email
communications between petitioners and the Shanks Firm in July and August 2009
acknowledge a "liquidation" in 2009, Ventures "goes away" in 2009, and they
"will form a new corp next year".
II.

Transfer of Assets
On August 3, 2009, petitioners made a series of transfers of cash and

marketable securities from three personal accounts at Merrill Lynch to three newly
opened accounts of Ventures at Merrill Lynch (Ventures accounts) and then to

-8[*8] three newly opened accounts of RACR Partnership at Merrill Lynch (RACR
Partnership accounts) as follows:
Account No.

Cash

Securities

1

$804,911

$362,095

2

65,069

513,557

3

766

70,554

Total

870,746

946,206

Petitioners transferred a total of $1,816,952 in cash and marketable
securities to RACR Partnership via Ventures in the above transfers. On August 5,
2009, petitioners made additional nominal cash transfers to two Ventures
accounts, and Ventures in turn transferred the cash to two RACR Partnership

accounts the next day. By August 5, 2009, most of petitioners' assets were held
by RACR Partnership. Subsequently the RACR Partnership transferred a nominal
amount of cash to Ventures to pay account fees. On August 31 and November 18,
2009, petitioners transferred additional nominal amounts of cash from their
personal account at Merrill Lynch to a Ventures account and then to an RACR
Partnership account at Merrill Lynch. As of the end of August, September,
October, and November 2009, Ventures' three accounts had zero balances.

-9[*9] On August 12, 2009, RACR Partnership distributed $100,000 to petitioners
to purchase long-term care insurance that Mr. Shanks had recommended as part of
their estate planning. Mrs. Smith recorded the $100,000 as a loan to petitioners,
but Mr. Shanks treated the transfer as a distribution. In August 2009 RACR

Partnership also extended a line of credit to petitioners for $500,000. Mr. Shanks
suggested the line of credit as a means for petitioners to have access to RACR
Partnership's assets to pay their living expenses if necessary. Petitioners signed a
line of credit note on August 9, 2009, payable to RACR Partnership with a
$500,000 principal and a 2.8% interest rate payable at maturity on July 31, 2018.
Petitioners did not withdraw any money from the line of credit and ultimately
canceled it in 2014.
In August 2009 petitioners opened accounts in the names of Ventures and
RACR Partnership at Morgan Stanley Smith Barney (Smith Barney) and

authorized the transfer of assets held in a personal account at Smith Barney to
Ventures and authorized the transfer of those assets from Ventures to RACR
Partnership. On November 3, 2009, petitioners transferred $57,037 in securities
from a personal account at Smith Barney to a newly opened account for Ventures
at Smith Barney. The next day Ventures transferred the securities to a newly
opened account for RACR Partnership at Smith Barney. Smith Barney recorded

- 10 [*10] the transfers in journal entries as effective September 30, 2009. After the
transfer petitioners' and Ventures' Smith Barney accounts had zero balances. On
November 18, 2009, petitioners transferred nominal amounts of cash from two
personal accounts at Merrill Lynch to two Ventures accounts at Merrill Lynch, and
Ventures transferred the cash to two RACR Partnership accounts at Merrill Lynch
the next day. During 2009 petitioners transferred a total of $1,881,737 in cash and
marketable securities to Ventures, and Ventures transferred a net amount of
$1,881,467 to RACR Partnership. Petitioners transferred a net amount of
$1,781,467 to RACR Partnership via Ventures, taking into account the $100,000
distribution from RACR Partnership to them for the long-term care insurance.

Ventures did not have any business activities during 2009. It did not have a bank
account, did not issue stock certificates, did not keep minutes of meetings, and did
not follow corporate formalities.
III.

Dissolution of Ventures
On November 18, 2009, petitioners met with Mr. Shanks and began to

dissolve Ventures, effective December 31, 2009. On December 10, 2009,
petitioners filed required documents with the Texas secretary of state to end
Ventures' corporate existence, indicating that they had organized Ventures to
pursue business opportunities and were dissolving the corporation to reduce

- 11 [*11] overhead expenses because they had not found any profitable opportunities.
The Shanks Firm prepared the legal documents required to dissolve Ventures. In
the dissolution Ventures transferred a 49% limited partnership interest in RACR

Partnership to each petitioner, effective December 10, 2009. Petitioners
transferred 1% limited partnership interests to two trusts in the names of each of
their two sons (children's trusts), effective December 31, 2009. As of the end of
2009 RACR Partnership was owned as follows: the Smith Trust owned a 2%
general partnership interest, petitioners each owned a 48% limited partnership
interest, and the children's trusts owned 1% limited partnership interests.
IV.

Legal Fees
Mr. Shanks generally charged a flat fee for his legal services. He charged

petitioners a flat fee of $23,200 for services relating to their will and relevant
estate planning documents and the RACR structure. Petitioners paid the fee in
two installments of $10,000 and $13,200 at the initial meeting on June 23, 2009,
and on July 9, 2009, respectively. Mr. Shanks did not charge petitioners an
additional fee for Ventures' dissolution in November 2009. He submitted an
invoice dated January 2, 2010, to petitioners for legal services relating to
Ventures' dissolution showing a fee of zero.

- 12 [*12] V. Tax Returns and Reporting Position
The Shanks Firm prepared the 2009 returns for petitioners, Ventures, and
RACR Partnership for $3,050. In August 2009 Mrs. Smith met with petitioners'
former accountant and return preparer. She provided relevant documents relating

to the RACR structure to the accountant. After meeting with the former
accountant, Mrs. Smith asked Mr. Shanks to answer the accountant's questions
concerning the RACR structure. Petitioners understood that their former

accountant did not feel comfortable preparing the necessary returns for the RACR
structure. Petitioners did not consult any other tax professionals regarding the
RACR structure or their 2009 income tax.
Ventures filed an initial and final corporate tax return for 2009. Ventures

reported gross receipts of $1,120,675 and cost of goods sold of $1,870,527,
resulting in an ordinary loss of $749,852. It reported the values of the 49% limited
partnership interests in RACR Partnership distributed to petitioners as gross
receipts. To calculate the values of the distributed partnership interests, the
Shanks Firm used the cash and the value of the securities that petitioners had
transferred to RACR Partnership via Ventures and applied a 40% discount for lack
of marketability and lack of control. Mr. Shanks used a 40% discount on the basis

- 13 [*13] of his research of discounts allowed in reported court opinions. Ventures'
reported gross receipts for 2009 were calculated as follows:3
Item

Amount

Cash and marketable securities

$1,805,090

Note payable

$100,000

Total assets

$1,905,090

98% of total assets

$1,867,791

Adjustment for 40% discount
for partnership interests

Gross receipts

60%
$1,120,675

To calculate cost of goods sold of $1,870,527, the Shanks Firm used
petitioners' alleged bases in the cash and marketable securities that they had
transferred to Ventures and then to RACR Partnership. Mr. Shanks intended that

the cost of goods sold would equal petitioners' bases in Ventures. The parties
have stipulated that petitioners had a total basis of $1,833,558 in Ventures. Mr.
Shanks had Ventures report the values of the distributed partnership interests as
gross receipts and report petitioners' alleged total basis in Ventures as the cost of
goods sold because the RACR tax strategy was intended to produce an ordinary

3We note that the value of a 98% partnership interest would be $1,866,988
using the above amounts, and a 40% discount would result in gross receipts of

$1,120,193.

- 14 [*14] loss to offset Mr. Smith's compensation from National Coupling.
Petitioners reported the loss on the distribution of the RACR Partnership interests
as an ordinary loss. Ventures did not have any gross receipts for 2009 or any cost
of goods sold. Ventures reported property distributions of $1,115,479, including
$1,120,675 in gross receipts less certain deductions.
On two separate forms filed with the Internal Revenue Service (IRS)
Ventures' business activity was reported as trading or management. On its 2009
return RACR Partnership's business activity was reported as investment. RACR
Partnership's 2009 return did not report any gross receipts, sales, deductions, or
business income or loss. RACR Partnership reported nominal amounts of interest
income, dividends, and net short-term and long-term capital gains that passed
through to Ventures.
On their 2009 joint return petitioners reported income of $849,422 from

National Coupling, including $664,007 in compensation, $37,800 in consulting
fees, and $181,170 in capital gain from two company-sponsored life insurance
policies. Petitioners have conceded that the $181,170 received upon the surrender
of the two life insurance policies was ordinary income. Petitioners claimed an
ordinary loss deduction of $749,852 from Ventures. In the notice of deficiency
respondent disallowed the $1,870,527 adjustment for cost of goods sold from

- 15 [*15] Ventures as reported on petitioners' joint return and increased petitioners'
ordinary income by the reported gross receipts of $1,120,675 and, in the
alternative, determined that Ventures had gross receipts of zero, resulting in a
disallowance of petitioners' claimed ordinary loss deduction. Respondent
advanced the alternative argument at trial.

OPINION
Respondent contends that petitioners are not entitled to deduct the 2009 loss
upon the dissolution of Ventures because the RACR structure lacked economic
substance, or in the alternative, the loss deduction did not meet the section 165
requirements for a bona fide loss incurred in a trade or business or a transaction
entered into for profit. He further argues that if petitioners are entitled to the 2009
loss deduction, they understated the fair market value of the partnership interests
distributed by Ventures. Each party presented expert testimony on the fair market
value of RACR Partnership upon Ventures' dissolution. We find that the RACR
structure lacked economic substance and accordingly do not address respondent's
two alternative arguments.
I.

Economic Substance Doctrine
Taxpayers generally are free to structure their business transactions as they

wish even if motivated in part by a desire to reduce taxes. Gregory v. Helvering,

- 16 [*16] 293 U.S. 465, 469 (1935). The economic substance doctrine, however,
permits a court to disregard a transaction--even one that formally complies with
the Code--for Federal income tax purposes if it has no effect other than generating
an income tax loss. See Knetsch v. United States, 364 U.S. 361 (1960). Whether
a transaction has economic substance is a factual determination. United States v.

Cumberland Pub. Serv. Co., 338 U.S. 451, 456 (1950). The taxpayer bears the
burden of proving that a transaction has economic substance. Coltec Indus., Inc.

v. United States, 454 F.3d 1340, 1355-1356 & n.15 (Fed. Cir. 2006).
An appeal in this case would lie to the Court of Appeals for the Fifth
Circuit. Accordingly, we follow the law of that circuit with respect to its
interpretation of the economic substance doctrine. See Golsen v. Commissioner,

54 T.C. 742 (1970), aff d, 445 F.2d 985 (10th Cir. 1971). The Court of Appeals
for the Fifth Circuit has interpreted the economic substance doctrine as a
conjunctive "multi-factor test". Klamath Strategic Inv. Fund ex rel. St. Croix

Ventures v. United States, 568 F.3d 537, 544 (5th Cir. 2009). In Klamath, the
Court of Appeals stated that a transaction will be respected for tax purposes only
if: (1) it has economic substance compelled by business or regulatory realities,
(2) it is imbued with tax-independent considerations, and (3) it is not shaped
totally by tax-avoidance features. Thus, a transaction must exhibit an objective

- 17 [*17] economic reality, a subjectively genuine business purpose, and some
motivation other than tax avoidance. Southgate Master Fund, L.L.C. ex rel.

Montgomery Capital Advisors LLC v. United States, 659 F.3d 466, 480 (5th Cir.
2011). Failure to meet any one of these three factors renders the transaction void
for tax purposes. Klamath, 568 F.3d at 544. While Klamath phrases the economic
substance doctrine as a conjunctive, three-factor test, the Court of Appeals for the
Fifth Circuit has recognized that "there is near-total overlap between the latter two
factors. To say that a transaction is shaped totally by tax-avoidance features is, in
essence, to say that the transaction is imbued solely with tax-dependent
considerations." Southgate Master Fund, 659 F.3d at 480 & n.40.
Petitioners claim that they organized Ventures as part of the RACR
structure to manufacture and sell the sprinkler device after Mr. Smith received the
patent. They claim that they transferred their personal assets to Ventures to
finance the start of this new business enterprise. Ventures immediately transferred
the assets to RACR Partnership purportedly for asset protection purposes, but,
according to petitioners, the funds would have been available to Ventures once it
started to manufacture the sprinkler device. According to petitioners, they
dissolved Ventures four months later because of unforeseeable circumstances:
(1) the patent had not been issued and (2) Mr. Smith was busy with his consulting

- 18 [*18] work. We find that petitioners' claims with respect to their purpose for
organizing and dissolving Ventures in 2009 are not credible. Ventures and the
RACR structure fail to meet all three prongs of the economic substance doctrine as
set forth by the Court of Appeals for the Fifth Circuit.
A.

Objective Economic Reality Inquiry

For purposes of the objective economic inquiry, a transaction lacks
economic substance if it does not "vary ,3 control ,3 or change the flow of economic
benefits." R at 481 (quoting Klamath, 568 F.3d at 543). The objective economic
inquiry asks whether the transaction affected the taxpayer's financial position in
any way, i.e., whether the transaction "either caused real dollars to meaningfully
change hands or created a realistic possibility that they would do so." R at 481 &
n.41. A circular flow of funds among related entities does not indicate a
substantive economic transaction for tax purposes. Merryman v. Commissioner,

873 F.2d 879, 882 (5th Cir. 1989), § T.C. Memo. 1988-72.
The RACR structure failed to alter petitioners' economic position in any
way that affected objective economic reality. The RACR structure was a circular
flow of funds among related entities used to generate an artificial tax loss to offset
petitioners' 2009 income. Petitioners transferred a substantial portion of their
personal assets to a wholly owned S corporation, Ventures, which in turn

- 19 [*19] transferred the assets to RACR Partnership in exchange for a 98%
partnership interest. In accordance with petitioners' prearranged tax scheme,
Ventures dissolved and distributed a 49% partnership interest to each petitioner.
Petitioners controlled RACR Partnership. It held only their personal assets, and
they received those assets back in the liquidating distribution of the partnership
interest. They generated a loss by valuing the combined 98% distributed
partnership interests using a substantial discount for a lack of control and a lack of
marketability. They had constant control over the assets. While the form of
ownership of the cash and securities changed, the substance did not. The RACR
structure and the dissolution of Ventures did not affect petitioners' financial
position and did not cause real dollars to meaningfully change hands. Moreover,
petitioners understood from the time they implemented the RACR structure that
they would not lose control over their personal assets. Petitioners intended from
the beginning to dissolve Ventures by the end of 2009 and, as discussed below,
never intended that it would manufacture the sprinkler device. Accordingly, we
find that the RACR structure and Ventures' dissolution lacked objective economic
reality and failed to satisfy the first prong of the economic substance doctrine as
set forth by the Court of Appeals for the Fifth Circuit. Failure to satisfy any one
prong of the multifactor test established by the Court of Appeals causes the

- 20 [*20] transaction to lack economic substance. Nevertheless, we will address the
remaining two factors of the economic substance doctrine as interpreted by the

Court of Appeals for the Fifth Circuit.
B.

Subjective Purpose Inquiry

The second and third Klamath factors, while enumerated separately, overlap
and derive from an inquiry into the taxpayer's purpose--whether the taxpayer had
a subjectively genuine business purpose or some motivation other than tax
avoidance. Southgate Master Fund, 659 F.3d at 481. Accordingly we address the
two factors together. Taxpayers are not prohibited from seeking tax benefits in
conjunction with seeking profits for their businesses. R Taxpayers who act with
mixed motives of profits and tax benefits can satisfy the subjective test. R at
481-482. However, for the subjective purpose inquiry, tax-avoidance
considerations cannot be the taxpayer's sole purpose for entering into a
transaction. Salty Brine I, Ltd. v. United States, 761 F.3d 484, 495 (5th Cir.

2014). The fact that a taxpayer enters into a transaction primarily to obtain tax
benefits does not necessarily invalidate the transaction under the subjective
purpose inquiry. Compaq Comput. Corp. & Subs. v. Commissioner, 277 F.3d 778,

786 (5th Cir. 2001), rev'g 113 T.C. 214 (1999).

- 21 [*21] Petitioners claim that they organized Ventures to manufacture the sprinkler
device but changed their minds because the patent had not been issued by the end
of 2009 and Mr. Smith was busy with his consulting work. The record is not clear
as to whether Mr. Smith owned a right to the sprinkler device patent.4 Even if we
assume that Mr. Smith had the right to the sprinkler device patent, we do not find
petitioners' claims that they organized Ventures to manufacture the sprinkler
device to be credible. First, Mr. Smith's testimony relating to the Canadian and
U.S. patents conflicts with the record. He testified the Canadian patent was issued
before the National Coupling sale, but documents in the record show that it was
issued in October 2009. Mr. Smith also testified that on the basis of his
experience he expected that the USPTO would issue the sprinkler device patent
shortly after the Canadian patent's issuance. Thus, according to his testimony he
should have expected the U.S. patent to be issued shortly after October 2009.
However, petitioners began to dissolve Ventures only one month later. Mr. Smith
is an experienced businessman familiar with patent procedure. The U.S. patent
application was submitted in 2006. By the end of 2009 he had already waited
three years for the patent. In the light of these inconsistencies, we do not find Mr.
4Petitioners assert that Mr. Smith was to receive the patent rights in the
National Coupling sale but did not because of an oversight by the attorneys
involved in the sale. Petitioners allege that this mistake was corrected in 2010.

- 22 [*22] Smith's testimony that he intended to manufacture the sprinkler device
through Ventures to be credible. Nor do we believe that petitioners decided to
dissolve Ventures because the USPTO had not issued the sprinkler device patent
by November 2009. Rather, we find that petitioners never intended to operate
Ventures as a manufacturing business. They intended from the beginning of the
RACR structure to organize and dissolve Ventures within the same year to
generate a tax loss to minimize their 2009 income tax liability.
Documents in the record establish that it was petitioners' intent when they
implemented the RACR structure to organize and dissolve Ventures within the
same year. These documents include handwritten notes from their initial meeting
with Mr. Shanks that refer to an S corporation as the "vehicle to minimize tax
event this year" and statements made in August 2009 that Ventures "goes away" in
2009 and they "will form a new corp next year". Additional inconsistencies in the
record include the identification of Venture's activity on IRS forms as trading and
management and not the alleged purpose of manufacturing, a reference by an
employee of the Shanks Firm to a "liquidation" in July 2009 when asked about the
preparation of the 2009 tax returns, and Mr. Smith's testimony stating an incorrect

date for when the Canadian patent was issued. Petitioners tried to explain away
each of these inconsistencies, but we do not find their explanations credible. The

- 23 [*23] record establishes that petitioners had a prearranged plan to organize and
dissolve Ventures within the same year to achieve their tax-avoidance strategy.
Petitioners did not have a genuine business purpose for Ventures or the RACR
structure. They organized Ventures and implemented the RACR structure solely
for tax-motivated reasons.
Irrespective of whether Mr. Smith owned the patent rights, we do not
believe that Ventures was organized to manufacture the sprinkler device.
Ventures existed for only four months and did not conduct any business activities.
It did not have any assets, offices, facilities, employees, or expenses. It did not
hold any funds to use for business operations because it transferred petitioners'
cash and marketable securities to RACR Partnership on the same day or within
one day of the initial transfers to it. The Ventures accounts had zero balances as
of the end of August through November 2009. Ventures did not follow corporate
formalities. Petitioners used the RACR structure to transfer their personal assets
to RACR Partnership and added Ventures as a conduit for the sole purpose of
creating an artificial tax loss by claiming a substantial discount on the value of
their personal cash and securities by holding the assets through a partnership.
Petitioners claim that they did not discuss the tax consequences of the
RACR structure or the dissolution of Ventures with Mr. Shanks and did not learn

- 24 [*24] about the loss until the 2009 returns had been prepared. They contend that
they did not discuss the tax consequences when they implemented the RACR
structure in June 2009. They also claim that they did not discuss the tax impact of
dissolving and liquidating Ventures when they made the decision to liquidate in
November 2009. We find that these claims are not credible and contradict the
record. Petitioners' handwritten notes from their initial meeting with Mr. Shanks

referred to an S corporation as a tax-mitigation device. An email from an
employee of the Shanks Firm dated July 25, 2009, refers to a liquidation. In an
email dated August 5, 2009, Mrs. Smith stated Ventures "goes away after 2009.
Will there be another corporation beginning in 2010?", and Mr. Shanks responded
in an email dated August 6, 2009: "We will form a new corp next year." These
emails show that Mrs. Smith knew that Ventures' dissolution was part of the
RACR structure from the beginning and they had not changed their minds.

Petitioners' attempts to explain these inconsistencies are without merit. The
$23,200 flat fee for the RACR structure included a fee for Mr. Shanks' services to
dissolve Ventures. Petitioners paid the entire fee when they retained Mr. Shanks
and he implemented the RACR strategy. Mr. Shanks did not charge an additional
fee to dissolve Ventures and submitted an invoice to petitioners showing a fee of
zero. Mr. Shanks had other clients organize and dissolve S corporations within

- 25 [*25] the same year to achieve tax benefits, although he sought to blame the
S corporations' dissolutions on the 2009 economy.
Petitioners knew from the outset that Ventures would not operate a
manufacturing business. They never intended to manufacture the sprinkler device
through Ventures. They planned from the beginning to dissolve Ventures before
the end of 2009 to create an artificial tax loss to offset their 2009 income tax.
They also knew despite their arguments to the contrary that the RACR structure
would generate a loss. Mr. Shanks designed the tax structure to include the
application of a substantial discount on the value of petitioners' personal assets
used in the strategy, and thereby the structure would produce a loss even if the
marketable securities increased in value during Ventures' short existence.
Petitioners could have accomplished their alleged estate planning goal of asset
protection through the limited partnership framework without first transferring

their personal assets to Ventures. Ventures was organized for the sole purpose of
tax avoidance. Accordingly, we find that Ventures lacked economic substance,
and petitioners are not entitled to deduct any loss for 2009 relating to Ventures or
the RACR structure.

- 26 [*26] II.

Section 6662(a) Accuracy-Related Penalty

Respondent determined that petitioners are liable for a section 6662(a)
accuracy-related penalty for 2009. Section 6662(a) and (b)(1) and (2) imposes a
penalty equal to 20% of the amount of any underpayment of tax that is attributable
to (1) negligence or disregard of rules or regulations or (2) a substantial
understatement of income tax. The term "negligence" includes any failure to make
a reasonable attempt to comply with the provisions of the Code, and "disregard"
includes any careless, reckless, or intentional disregard of rules and regulations.
Sec. 6662(c). For individual taxpayers, an understatement is substantial if it
exceeds the greater of 10% of the amount of tax required to be shown on the return
or $5,000. Sec. 6662(d)(1)(A). By claiming the ordinary loss deduction on the
liquidating distribution of RACR Partnership interests, petitioners understated the
tax required to be shown on their 2009 joint return by more than 10%, which was
more than $5,000.5 Accordingly, they are liable for the section 6662(a) penalty

5Respondent has conceded any accuracy-related penalty with respect to the
portion of petitioners' underpayment attributable to the mischaracterization of the
proceeds from the two life insurance policies as capital gain because National
Coupling incorrectly reported the life insurance proceeds as capital gain on
petitioners' Schedule K-1, Shareholder's Share of Income, Deductions, Credits,
etc.

- 27 [*27] with respect to this portion of the underpayment unless they establish a
defense of reasonable cause.
Section 6664(c)(1) provides an exception to the section 6662(a) penalty
where the taxpayers demonstrate that they acted with reasonable cause and in good
faith with respect to the underpayment. We determine whether a taxpayer acted
with reasonable cause and in good faith on a case-by-case basis, taking into
account all pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax
Regs. Once the Commissioner presents a prima facie case that a penalty should
apply, the taxpayers have the burden to prove that they acted with reasonable

cause and in good faith. Higbee v. Commissioner, 116 T.C. 438, 446-449 (2001).
A taxpayer's reliance on the advice of a tax professional may constitute reasonable
cause and good faith. United States v. Boyle, 469 U.S. 241, 250 (1985). The
advice must be based on all pertinent facts and circumstances and the law as it
relates to those facts and circumstances and must not be based on any
unreasonable factual or legal assumptions. Sec. 1.6664-4(c)(1), Income Tax Regs.
We have summarized the requirements of reasonable reliance on professional
advice as follows: (1) the taxpayer reasonably believed that the professional was a
competent tax adviser with sufficient expertise to justify reliance, (2) the taxpayer
provided necessary and accurate information to the adviser, and (3) the taxpayer

- 28 [*28] actually relied in good faith on the adviser's judgment. Neonatology

Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), M, 299 F.3d 221
(3d Cir. 2002). A taxpayer's education and business experience are relevant to the
determination of whether the taxpayer acted with reasonable reliance on an adviser
and in good faith. Sec. 1.6664-4(c)(1), Income Tax Regs. The most important
factor is the extent of the taxpayer's effort to assess his or her proper tax liability.
IA para. (b). Due care does not require that the taxpayer challenge his or her
attorney's advice or independently investigate its propriety. Streber v.

Commissioner, 138 F.3d 216, 219 (5th Cir. 1998), rev'g T.C. Memo. 1995-601.
The question of whether petitioners' reliance on Mr. Shanks was reasonable
is a difficult one. Petitioners went to Mr. Shanks upon the recommendation of
their financial adviser for estate planning advice because Mr. Smith was retiring.
Mr. Shanks was a qualified attorney and a competent adviser and had the
necessary and accurate information to provide his tax advice. Up to this point
petitioners' reliance on Mr. Shanks was reasonable. However, we have found that
petitioners never intended to conduct any business activities through Ventures.
They understood, early in the process, that Ventures would be organized and
dissolved in 2009 but continued to represent, even at trial, that Ventures had a
business purpose. This is not acting in good faith. They knew from the beginning

- 29 [*29] that Ventures would not last past 2009, it did not have a genuine business
purpose, and its sole purpose was tax avoidance. That knowledge alone negates a
reliance defense.
Petitioners knew that the purpose of the RACR structure was to minimize
their 2009 income tax. Their handwritten notes from their first meeting with Mr.

Shanks referred to an S corporation as the vehicle to minimize the tax event in
2009. Mrs. Smith emailed the Shanks Firm in August 2009 and sought to confirm

that Ventures would dissolve by the end of 2009. Petitioners knew from the time
they implemented the RACR structure that Ventures' sole purpose was to avoid
income tax on Mr. Smith's bonus from the National Coupling sale. They knew
that Ventures would never manufacture the sprinkler device. Even if Mr. Smith
owned the patent rights as he claims, petitioners had no intent to keep Ventures in
existence until the patent was issued but dissolved it after only four months. Yet
they continued to perpetuate their tax-avoidance scheme through their testimony at
trial that we have found not to be credible or reliable. Nor do we find credible
petitioners' attempts to explain away multiple inconsistencies in the record.
Petitioners did not act with reasonable reliance on a professional or act in good
faith. Accordingly, we find that petitioners are liable for the section 6662(a)
penalty.

- 30 [*30] In reaching our holding, we have considered all arguments made, and, to the
extent not mentioned above, we conclude that they are moot, irrelevant, or without
merit.

Decision will be entered under
Rule 155.

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Ac76f46bd3a0e8fcb. Public record. Not legal advice.