UNITED STATES TAX COURT

FILES

T.C. Memo. 1998-231

UNITED STATES TAX COURT

STEPHEN D. PODD, ET AL.,1 Petitioners y.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 20225-93, 20226-93,

20227-93, 20228-93,

20229-93,

6209-94,

62 0-94,

6211-94,

6212-94,

6213-94,

6214-94.

Filed June 30, 1998.

Kevin M. Flynn and Julian W. Dority, for petitioners.

John Aletta, Elise Frost Alair, and Bradford A. Johnson, for

respondent.

¹

The following cases are consolidated herewith for purposes

of trial, briefing, and opinion: Victor I. Podd, docket No.

20226-93; Victor T. Podd, docket No. 20227-93; Powertex, Inc.,

docket No. 20228-93; Powertex, Inc., docket No. 20229-93;

Powertex, Inc., docket No. 6209-94; Victor T. Podd, docket No.

6210-94; Victor I. Podd, docket No. 6211-94; Stephen D. Podd,

docket No. 6212-94; Julia Podd, docket No. 62s13-94; and Powertex,

Inc., docket No.

6214-94.

SERVED

JUN 3 0 1996

- 3 Respondent determined deficiencies in, and additions to,

Powertex, Inc.'s withholding tax as follows:

Powertex, Inc., docket Nos. 20229-93, 6209-94:

Tax

Year

Ended

Deficiency

5/31/85

5/31/86

5/31/88

5/31/89

5/31/90

5/31/87

Additions to Tax Under Section

6653 (a) (1) (A)

6653 (a) (1) (B)

6651

6653 (a)

$412,425

$103,776.50

-

$20,621.25

2

167

41,510.60 $103,106.25

48,206

487,975

245,882

12,454

-

$2,410.30

-

-

-

4,981.60

50,106.90

24,588

-

-

-

-

-

6656

136

6661

Penalties

Sec. 6662 (a)

-

-

-

12,051.50

$100,213.80

49,176

¹50 percent of the interest due on the deficiency.

Pursuant to amended answers, respondent asserts increased

deficiencies, additions to tax, and penalties in petitioners'

Federal income taxes. 2

2

The increased deficiencies result from respondent's

assertion of additional constructive dividends to the individual

petitioners which, correspondingly, results in increased

additions to tax and penalties. Specifically, respondent amended

his answers to assert that certain payments deducted as

management fees paid by Powertex, Inc. to Powertex Plus

International, Inc. resulted in constructive dividends. The

amendments to answer assert such constructive dividends against

several of the individual petitioners in addition to those

against whom constructive dividends were determined in the

notices of deficiency. The amendments to answer also raise an

alternative argument that if these payments are not constructive

dividends, they should be characterized as compensation income to

the individual petitioners.

Respondent also amended his answers with respect to certain

royalty payments that respondent determined were not ordinary and

necessary business expenses pursuant to sec. 162.

In the notices

of deficiency, respondent's alternative position was that the

royalty rate should be adjusted, pursuant to sec. 482, to 5

percent. By way of amended answers, respondent asserts that the

appropriate royalty rate pursuant to sec. 482 should be O

percent. Correspondingly, respondent amended his answers to

increase the constructive dividends asserted against several of

the individual petitioners.

Respondent bears the burden of proof with respect to the

increased deficiencies, additions to tax, and penalties pleaded

in the amended answers. Rule 142(a).

In light of our holdings

with regard to the issues raised in the amended answers, however,

the location of the burden of proof is immaterial.

- 5 -

the segments following our general findings of fact discusses one of

the separate issues set forth above and sets forth our findings of

fact and opinion concerning the respective issue.

I.

General Findings of Fact

Some of the facts have been stipulated for trial pursuant to

Rule 91.

The stipulations of facts are incorporated herein by

reference, and they are found accordingly.

At the time its petition was filed, in the instant case,

Powertex, Inc.

(Powertex) was a New York corporation.

Powertex's

principal corporate office was located at Rouses Point, New York.

At the time they filed their petitions in the instant case,

petitioners Victor T. and Julia Podd resided in Mount Royal, Quebec,

Canada; petitioner Stephen D. Podd resided in North Hero, Vermont;

and petitioner Victor I. Podd resided in Boca Raton, Florida.

A.

Founding of Powertex

Powertex was incorporated under the laws of the state of

Vermont in 1977 by petitioner Victor T. Podd (Mr. Podd), his wife

petitioner Julia Podd (Mrs. Podd), and his brother Alexander Podd.

The original name of the corporation was Powerstrap, Inc., which was

subsequently changed to Powertex Corporation, Inc., in 1979 and

finally to Powertex, Inc., in 1984.

to be a packaging manufacturer.

Powertex was initially formed

Powertex began its business

operations in Alburg, Vermont, on property owned by Mr. Podd.

In

1984, Powertex expanded its business from the Alburg facility to a

new manufacturing plant in Rouses Point, New York.

Powertex currently manufacturers three principal types of

intermodal container liner systems.

B.

The Hideliner

One of Powertex's earliest products consisted of an intermodal

container liner system known as the hideliner.

During the 1970's,

Mr. Podd became acquainted with several employees of Sea-Land

Service, Inc.,

(Sea-Land), a company engaged in the commercial

transportation business.

packed in salt.

Sea-Land shipped raw green animal hides

The hides released contaminating fluids which,

combined with the salt, had a caustic effect on the containers in

which they were shipped.

In response to this problem, Mr. Podd

developed the hideliner (also known as the powerliner) to be used

for shipping raw green animal hides.

Essentially, the hideliner consists of a base sheet of foam

material and a top cover sheet of polymeric material which is bonded

to the base sheet, and which extends over at least a portion of the

walls of the container.

As designed, it constitutes a liquid

impervious liner useful in the transportation of raw animal skins.

Mr. Podd filed a patent application for the hideliner with the

U.S. Patent and Trademark Office on August 1, 1978.

On February 5,

1980, the U.S. Patent and Trademark Office issued United States

Patent No. 4,186,845

(the '845 patent) covering the hideliner

invention.

On May 21, 1980, Mr. Podd licensed to Powertex the exclusive

right to manufacture, market, and sell the hideliner.

The terms of

the agreement granted Powertex an exclusive 6-year license in

- 9 -

1982, a dispute developed between Insta-Bulk, Sea-Land, and Tri-Wall

concerning whether Insta-Bulk was manufacturing and selling liners

which infringed upon the Sea Bulk patents.

During 1982, Insta-Bulk

filed a request for declaratory judgment with the United States

District Court in New York alleging that the Sea Bulk patents were

invalid and unenforceable and that it was not infringing upon the

Sea Bulk patents.

Sea-Land and Tri-Wall counterclaimed for damages

resulting from Insta-Bulk's alleged disclosure of Tri-Wall's trade

secrets and for infringement of the Sea Bulk patents by Insta-Bulk.

Sea-Land eventually became dissatisfied with Tri-Wall's

performance and therefore terminated its license agreement during or

around May 1983.

On May 5, 1983, Powertex entered into an exclusive

license agreement with Sea-Land for use of the Sea Bulk patents

(Sea-Land license agreement).

The Sea-Land license agreement

required, for all Sea Bulk liners sold within the ocean container

industry, that Powertex pay Sea-Land a royalty of 10 percent of net

sales of Sea Bulk liners, and expend a minimum of 10 percent of net

sales of Sea Bulk liners for the purpose of marketing, advertising,

and promotion of Sea Bulk liners.

For Sea Bulk liners sold outside

the ocean container industry, Powertex was required to pay Sea-Land

a royalty of $10 for every Sea Bulk liner sold, and to expend $10

for each unit sold for the purpose of research and development of

markets outside of the ocean container industry.

The Sea-Land

license agreement was amended on January 17, 1985, to provide that

Powertex would pay royalties quarterly at the rate of 10 percent for

the first 5,000 Sea Bulk liners sold, 7 ½ percent for the next

- 11 -

Manager), and Tracy Sommer (an engineer at Amoco) to observe a test

loading of a Sea Bulk liner at General Electric, a Powertex

customer, in Selkirk, New York.

After witnessing the demonstration,

the Amoco personnel determined that the Sea Bulk liner was not

acceptable for shipping PTA, due to the 2 to 3 hour loading time,

which needed to be shortened to approximately 15 minutes.

Additionally, Amoco needed a liner that was moisture sensitive and

utilized a center discharge opening in order to be compatible with

their customers' unloading equipment.

A short time later, Amoco

employees visited another Powertex customer in New Orleans to

witness another loading demonstration.

Initial testing of the Sea Bulk liner supplied by Powertex

began in late 1985 and early 1986 at Amoco's Cooper River plant.

The Powertex plant at Rouses Point, New York, manufactured the test

liner.

Mr. Podd worked closely with Mr. Rakar, Mr. Sommer, and Mr.

Hall in testing and modifying the liner in order to meet Amoco's

needs.

Initially, the Sea Bulk liner was modified by providing a

center discharge opening in order to fit the unloading equipment of

Amoco's customers.

The liner was inadequate for unloading PTA,

however, due to its poor flow characteristics, which resulted in the

product's gathering in the corners and tearing of the liner when

discharging.

In order to remedy the problem, Amoco hired

contractors to install wooden triangles in the rear corners of the

container by nailing them to the bracing attached to the container

walls and floor.

- 13 -

resulting in total loss of the PTA shipment.

During July and August

of 1986, several modified liners supplied by Powertex were loaded

with PTA and shipped to Amoco's customers in Hong Kong and Taiwan.

Those liners also failed to unload properly, however, because

several hundred pounds of PTA remained inside the container.

In response to such problems, the liner was modified by (1)

changing the angles of the triangles to allow the PTA to more easily

flow out upon unloading;

(2) removing the front bulkhead and

replacing it with a wooden nailing strip laminated to the liner;

(3)

adding "shake-out straps" to assist in removing the PTA; and (4)

separating the liner from the bulkhead, thereby allowing the

triangles to function without tearing the liner when the PTA was

unloaded.

Mr. Sommer and other Amoco engineers worked closely with

Powertex in determining the proper size and shape of the triangles.

On October 16, 1986, Mr. Podd filed a patent application with

the U.S. Patent and Trademark Office for an intermodal container

liner system, the key features of which include a prefabricated,

collapsible bulkhead that is easily installed in an intermodal

container.

Another important feature is the provision for hinged,

triangular corner members designed to funnel the cargo towards a

center discharge opening, thus preventing the product from gathering

in the corners of the container upon unloading.

During late 1986, Amoco increased its purchases of the modified

liner as the initial testing had been completed.

During November

1986, Powertex shipped liners to Amoco's Belgium plant for testing.

Amoco was not satisfied with those liners because they employed

- 15 -

During 1990, the Podds incorporated Powertex South Carolina

(Powertex SC) in Moncks Corner, South Carolina, which began

manufacturing liners for Amoco's Cooper River plant in April of

1990.

Eventually, Powertex SC came to sell 50 percent of the liners

it manufactured to customers throughout the world.

Powertex SC did

not pay any royalties to the Podds or Powertex for its sale of the

Amoco liners.

On September 27, 1988, Mr. Podd filed a patent application with

the U.S. Patent and Trademark Office for certain improvements on the

October 16, 1986, application.

Although Amoco made several

suggestions and requests during the developmental stages of the

liner system, Amoco did not assert any ownership rights in the

invention.

On January 24, 1989, and December 5, 1989, United States

Patent numbers 4,799,607 and 4,884,722, respectively,

(the Amoco

patents) were issued to Mr. Podd by the U.S. Patent and Trademark

Office for the invention.

Subsequently, Powertex filed applications in several countries

for foreign counterpart patents concerning the Amoco liner, listing

Mr. Podd as the inventor.4

Several foreign counterpart patents were

subsequently published as a result of the applications.

Powertex paid the legal expenses and filing fees for both the

U.S. and foreign counterpart patents concerning the Amoco liner.

4

Petitioners contend that applications for foreign

counterpart patents were filed by Powertex because at that time

Canada was not a signatory to the Patent Cooperation Treaty, and,

therefore, Mr. Podd could not file for such patents, but

Powertex, a United States corporation, could.

On

- 17 -

Fiscal

Year

Percentage of

Total Sales

1986

1987

1988

1989

1990

.

<1

40

69

68

60

Sales of Amoco liners contributed to significantly increased profits

for Powertex, as shown below:

-

Fiscal

Year

Net Taxable

Income

1985

1986

1987

1988

1989

1990

$1,290,536

1,351,033

1,701,787

4,335,176

6,739',962

7,174,522

During February 1988, Mr. Podd discussed with his accountant,

Ronald R. Plante of Peat Marwick, the possibility of licensing the

Amoco patents to Powertex.

The discussion was motivated in part by

the increasing amounts of taxable income that Powertex was expected

to earn from the increased sales of Amoco liners.

In May 1989, at

the end of Powertex's fiscal year, Mr. Podd and Mr. Plante again

discussed licensing the Amoco patents to Powertex and set the

royalty rate at 15 percent of net sales of Amoco liners.

Powertex did not make any royalty payments for use of the Amoco

patents during the fiscal years ending May 31, 1986, through May 31,

1988.

On its Federal corporate income tax returns for the fiscal

years ending May 31, 1989, and May 31, 1990, Powertex reported

paying royalties of $686,034 and $531,082, respectively.

On May 30,

1989, and May 30, 1990,- Powertex issued checks to Mr. Podd in the

- 19 -

exchange for the right to use the Amoco patents.

The agreement's

term was 6 years, commencing June 1, 1988, and renewable by Powertex

if it sold at least 5,000 Amoco liners in fiscal year 1993.

The

agreement further provided:

Podd hereby grants to Powertex, for the full term of

this Agreement and any extension thereof, the sole and

exclusive right and license to manufacture, market and

sell AMOCO STYLE units and any and all other devices,

methods and processes covered by the patents and patent

applications listed in the attached Exhibit A. Said right

and license shall be world-wide in scope and shall include

the right to use and enjoy said patent rights and permit

others to use and enjoy said patent rights, including the

marketing and sale of AMOCO STYLE units for uses outside

of the ocean container industry.

Under the agreement, the Podds also granted a license to

Powertex for the exclusive worldwide right to use the trademark

"POWERLINER" in connection with products covered by the licensed

patents without an additional royalty.

Powertex also agreed to assume financial responsibility to the

extent of $50,000 per year, commencing on June 1, 1988, for costs

incurred by the Podds or Powertex in defending and litigating patent

infringement claims.

The agreement provided that it would be

construed and governed by New York Law.

identify the patents covered.

The agreement failed to

The only reference to specific

patents was contained in the following clause:

(c)

Powertex may terminate this Agreement as of the

tenth day following the sending of a notice of such

termination to Podd if any court of competent jurisdiction

of last resort shall render a final adjudication holding

that the AMOCO STYLE United Stated [sic] Patents

4,799,607 and 4,884,722) are invalid.

(numbers

- 21 -

purpose designated.

.

Alternatively, respondent determined that Mr.

Podd did not engage in the Amoco patent transactions between himself

and Powertex at arm's length, and, accordingly, respondent made

adjustments pursuant to section 482.

Respondent initially

determined an alternative adjustment under section 482 using a 5percent royalty rate, resulting in a disallowance of royalty

expenses claimed for the years ending May 31, 1989, and May 31,

1990, in the amounts of $457,356 and $318,649, respectively.

Respondent's answer was amended to assert an arm's-length royalty

rate pursuant to section 482 of 0 percent.

2.

The Experts' Positions

a.

Respondent's Experts

i.

Joel E. Lutzker

Mr. Lutzker received his B.A. in physics from New York

University and his J.D. from New York University School of Law.

He

has been active in the fields of patents, trademarks, and copyrights

for 20 years and is currently a partner in the intellectual property

law firm of Amster, Rothstein & Ebenstein.

Mr. Lutzker's reports examined the ownership of the Amoco

patents and their validity and enforceability.

Mr. Lutzker began by

examining several different theories under which Powertex could be

found to have an ownership interest in the patents.

He explained

that under the "corporate opportunity" doctrine, the fiduciary

responsibility of a corporate officer to act in the corporation's

best interests could create an obligation to assign a patent.

Such

an obligation could also arise under the "alter ego" theory where

- 23 the U.S. Patent and Trademark Office; i.e., where the applicant

breaches the duty of candor and good faith by failing to disclose

all material information concerning the patentability of the

invention.

After examining the circumstances surrounding the issuance of

the Amoco patents, Mr. Lutzker concluded that there was "strong

evidence" that both patents were unenforceable due to Mr. Podd's

failure to disclose material prior art to the U.S. Patent and

Trademark Office.

He further concluded that a "strong argument"

could be made that both patents were invalid because certain prior

art renders each claim of the patents obvious.

ii.

Robert Goldscheider

Mr. Goldscheider received his B.S. in economics from Columbia

University in 1951 and his J.D. from Harvard Law School in 1954.

He

has more than 35 years of experience in the licensing field and is a

frequent lecturer on problems involving the transfer and

commercialization of technology.

Mr. Goldscheider's expert report and his rebuttal report were

limited to the issue of a reasonable royalty rate for a license of

the Amoco patents.

He indicated that the issues of "patentability

and enforceability" of the patents were outside the scope of his

expertise and that he would therefore rely on Mr. Lutzker's reports

as to those issues.

Essentially, Mr. Goldscheider adopted Mr. Lutzker's conclusions

that the Amoco patents were invalid and unenforceable and that

Powertex owned or at least had shop rights in such patents.

He

- 25 -

patent rights to an invention until those rights are transferred.

He stated that there are several exceptions to the general rule,

including an express or implied contract to assign patent rights,

the "hired to invent" doctrine, the "corporate opportunity"

doctrine, the "alter ego" theory, and the "shop right" doctrine.

Professor Chisum examined the legal framework underpinning each

of the exceptions to the general rule.

He determined that none of

the exceptions apply to give Powertex an ownership interest in the

Amoco patents.

Accordingly, Professor Chisum concluded that Mr.

Podd has been the legal and equitable owner of the Amoco patents at

all times and that any rights Powertex has in those patents derive

solely from the Tri-Podd license agreement.

ii.

Gayle Parker

Mr. Parker received his B.S. in industrial engineering from

Lafayette College in 1956 and his J.D. from George Washington

University in 1960.

From 1956 to 1957, he worked as a patent

examiner in the U.S. Patent and Trademark Office.

From 1958 to

1979, he was the Director of Licensing and patent counsel for the

National Aeronautics and Space Administration Headquarters.

Since

1979, he has been the president of Technology Licensing Corporation

and "of counsel" to a patent law firm, Larson & Taylor, in

Arlington, Virginia.

Mr. Parker's expert report and his rebuttal report were limited

to examining the reasonableness of the royalties paid pursuant to

the Tri-Podd license agreement.

Mr. Parker began by analyzing the

relevant factors identified in section 1.482-2(d)(2)(iii),

Income

- 27 -

percent of the anticipated profits to the licensor.

Mr. Parker

noted, however, that such percentage can be negotiated upward or

downward, and, because Mr. Podd brought a "strong arsenal of assets"

to the licensing negotiations, he could demand a royalty rate which

would entitle him to 50 to 75 percent of the anticipated profits.

Mr. Parker used such an allocation of profits to determine that Mr.

Podd was entitled to royalties in the range of 15.3 to 23.0 percent

and that a royalty rate in the range of 12.5 to 15 percent is

"definitely reasonable."

In using the allocation of profits to

determine a reasonable royalty rate, however, Mr. Parker used

actual, rather than projected, sales data in his calculations.

iii.

George M. Thomas

Mr. Thomas received his B.S. in mechanical engineering from the

University of South Carolina in 1957 and his L.L.B. from the

American University Law School in 1964.

From 1960 to 1964, he

worked as a patent examiner in the United States Patent Office in

Washington, D.C.

Since 1964, he has been continuously engaged in

the practice of patent, trademark, and copyright law.

He is

currently the senior partner in the firm of Thomas, Kayden,

Horstemeyer & Risley in Atlanta, Georgia.

Mr. Thomas prepared two expert witness reports (first and

supplemental) which addressed the validity and enforceability of the

Amoco patents, and the reasonableness of the royalties paid pursuant

to the Tri-Podd license agreement.

Mr. Thomas began his analysis of the validity of the Amoco

patents by noting that patent applications are subject to a rigorous

- 29 -

would be in an arm's-length transaction.

He then determined that a

higher royalty rate was justified under the Tri-Podd license

agreement because the rights granted therein did not restrict sales

to a single customer and because of the provision including all

improvement patents developed by the Podds.

Rather than analyzing the relevant factors identified in

section 1.482-2(d)(2)(iii), Income Tax Regs., Mr. Thomas next

proceeded to analyze 15 factors set forth in Georgia-Pacific Corp.

v. U.S. Plywood Corp., 318 F.Supp. 1116, 1120 (S.D.N.Y. 1970),

modified 446 F.2d 295 (2d Cir. 1971), which dealt with determination

of the amount of a reasonable royalty to be paid by an infringer to

the patent holder.

Based on his analysis of such factors, he

concluded that Mr. Podd could command a royalty in an arm's-length

transaction of "greater than the 11% royalty for the restricted

license of Insta-Bulk, probably 15%".

OPINION

1.

Analysis of Arm's-Length Royalties for Use of

Intangibles

a.

Section 482 in General

- 31 -

Commissioner's section 482 determination must be sustained absent a

showing that he has abused his discretion.

Commissioner, 85 T.C. 754, 787

1988).

Paccar, Inc. v.

(1985), affd. 849 F.2d 393

(9th Cir.

Consequently, the taxpayer bears the heavier than normal

burden of proving that the Commissioner's section·482 allocations

are arbitrary, capricious, or unreasonable.7

Commissioner, 489 F.2d 957, 960

Your Host, Inc. v.

(2d Cir. 1973), affg. 58 T.C. 10, 23

(1972); Seagate Tech., Inc. & Consol. Subs. v. Commissioner, supra

at 164; G.D. Searle & Co. v. Commissioner,

88 T.C.

252,

359

(1987).

Whether the Commissioner's discretion has been exceeded is a

question of fact.

American Terrazzo Strip Co., Inc. v.

Commissioner, 56 T.C. 961, 971 (1971).

In reviewing the

reasonableness of the Commissioner's allocation under section 482,

we focus on the reasonableness of the result, not the details of the

methodology employed.

Bausch & Lomb, Inc. v. Commissioner, supra at

582; see also Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 372

F.2d 990,

997

(1967).

In addition to proving that the deficiencies set forth in the

notice of deficiency are arbitrary, capricious, or unreasonable, the

taxpayer has the burden of proving satisfaction of the arm's-length

standard.

See Sundstrand Corp. v. Commissioner, supra at 354.

In the instant case, petitioners thus bear the burden of

proving that re.spondent's downward adjustment of the royalty

rate, pursuant to sec. 482, to 5 percent in the notices of

deficiency is arbitrary, capr1clous, or unreasonable. Because

respondent amended his answers to assert that the appropriate

royalty rate, pursuant to sec. 482, should be O percent, the

burden of proving that the royalty rate should be adjusted below

5 percent rests with respondent. Rule 142(a); see also supra

note 2.

- 33 consideration where an adequately similar transaction is absent

are:S

(a) The prevailing rates in the same industry or for

similar property,

(b) The offers of competing transferors or the bids of

competing transferees,

(c) The terms of the transfer, including limitations on

the geographic area covered and the exclusive or nonexclusive

character of any rights granted,

(d) The uniqueness of the property and the period for

which it is likely to remain unique,

(e) The degree and duration of protection afforded to the

property under the laws of the relevant countries,

Sec. 1.482-2(d), Income Tax Regs., was effectively

superseded by sec. 1.482-4T, Temporary Income Tax Regs., 58 Fed.

Reg. 5263, 5287 (Jan. 21, 1993), generally effective for taxable

years beginning after April 21, 1993.

Additionally, sec. 482 was amended, for tax years beginning

after Dec. 31, 1986, by the addition of the following sentence at

the end thereof:

"In the case of any transfer (or license) of

intangible property (within the meaning of section 936(h)(3) (B)),

the income with respect to such transfer or license shall be

commensurate with the income attributable to the intangible."

Tax Reform Act of 1986, Pub. L. 99-514, sec. 1231(e)(1), 100

Stat. 2085, 2562-2563. The effect of the amendment to sec. 482

is that we may consider the actual profits realized by the

transferee through its use of the intangible property. H. Rept.

99-426, 425

(1985),

1986-3 C.B.

(Vol. 2)

425

("The committee does

not intend, however, that the inquiry as to the appropriate

compensation for the intangible be limited to the question of

whether it was appropriate considering only the facts in

existence at the time of the transfer. The committee intends

that consideration also be given the actual profit experience

realized as a consequence of the transfer.")

The statutory amendment to sec. 482 is apparently in

conflict with sec. 1.482-2(d)(2)(iii)(g), Income Tax Regs., which

provides that only the prospective profits to be realized by the

transferee through its use of the property may be considered in

the determination of the amount of an arm's-length consideration

(i.e., without consideration of subsequent actual profits). See

Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 601 (1989)

("Unlike both respondent and petitioners' experts, we find little

relevance in B&L Ireland's actual results of operations during

1981 and 1982.

Such information would not have been available in

1980 to a potential licensee negotiating a license agreement

which was entered on January 1, 1981."), affd. 933 F.2d 1084 (2d

Cir. 1991).

- 35 establish an arm's-length royalty rate.

License fees negotiated in

settlement of litigation may not be indicative of a true arm'slength royalty rate because of the incentive to avoid high

litigation costs.

See Rude v. Westcott,

130 U.S. 152, 164

Panduit Corp v. Stahlin Bros. Fibre Works,

n.11

(6th Cir. 1978).

(1889);

Inc., 575 F.2d 1152, 1164

Consequently, we find that the

Powertex/Insta-Bulk license agreement covering the Amoco liner was

not a "sufficiently similar transaction" as contemplated by section

1.482-2(d)(2)(ii), Income Tax Regs.

Having found that the record does not contain a sufficiently

similar transaction involving an unrelated party, we must attempt to

construct an arm's-length royalty.

In doing so, we look to the

relevant factors identified by section 1.482-2(d)(2)(iii), Income

Tax Regs.

We are not completely satisfied with the methodology employed

or the results reached by either party.

We conclude that petitioner

has shown that the royalty rate advanced by respondent is

unreasonably low and therefore is arbitrary, capricious, and

unreasonable.

Seagate Tech., Inc. & Consol. Subs. v. Commissioner,

supra; Sundstrand Corp. v. Commissioner, supra. .On the other hand,

we believe that the royalty rate advocated by petitioner is

unreasonably high for the property involved in this case.

evaluated all of the arguments raised by the parties.

We have

In reaching

our conclusion, we draw on the record as a whole to determine the

royalty rate at which we believe unrelated parties, under the facts

and circumstances of the instant case, would have arrived for the

- 37 -

we noted above, however, the fact that this license was granted in

settlement of litigation prevented it from being a sufficiently

similar transaction for purposes of section 1.482-2(d)(2)(ii),

Income Tax Regs.

Additionally, we are puzzled as to his decision to

examine the factors found in Georgia-Pacific Corp. v. U.S. Plywood

Corp., 318 F. Supp. at 1120, instead of those enumerated in section

1.482-2(d)(2)(iii), Income Tax Regs.

Although some of the Georgia-

Pacific Corp. factors are similar to those listed in the regulation,

several are not.

For example, the Georgia-Pacific Corp. factors

include the derivative effect of selling the patented product in

promoting sales of other products of the licensee and opinions from

expert witnesses, factors which are not included in the regulation.

Finally, Mr. Thomas' basic approach was to rely on the

Powertex/Insta-Bulk settlement license of the Amoco patents as

evidence of a "clearly arm's-length transaction."

He then pointed

to the advantages inherent in the Tri-Podd license agreement as

justifying a royalty of "greater than * * * 11% * * * probably 15%",

with no effort to quantify the effect of the asserted advantages.

As to Mr. Goldscheider, his entire opinion is grounded on Mr.

Lutzker's opinion that the Amoco patents are invalid, unenforceable,

and owned by Powertex.

He made no attempt to evaluate the relevant

factors identified in section 1.482-2(d)(2)(iii), Income Tax Regs.,

and his reports added little to what was provided by Mr. Lutzker.

Moreover, we found Mr. Goldscheider's demeanor at the trial to take

away from his credibility, as he acted more like an advocate, rather

- 39 -

included quantity discounts which could reduce the royalty first to

7 ½ percent and then to 5 percent, and finally for a flat 5 percent

for all sales after September 30, 1985.11

Powertex sublicensed the

Sea Bulk patents to Insta-Bulk in an agreement providing for 18-

percent royalties in the first year and 20 percent thereafter.

The

agreement was later amended to provide for royalties at a 13-percent

rate,. effective January 1, 1989.

Accordingly, by 1989, the Sea Bulk patents were being licensed

at royalty rates of 5 percent and 13 percent.

We believe that this

range of royalties circumscribes the appropriate royalty rate to be

paid for use of the Amoco patents as well.

Petitioners describe the Amoco patents as being superior to the

Sea Bulk patents, and therefore capable of commanding higher royalty

rates.

We believe, however, that the Amoco patents can best be

described as more specialized and designed for a particular use,

whereas the Sea Bulk patents were intended for more general usage.

Petitioners also point to the substantial increase in profits

of Powertex that resulted from sales of the Amoco liners as a factor

to justify a high royalty rate.

Although we agree that the Amoco

patents were an important factor in generating those profits, we

believe that they were not the only catalyst.

During 1987, Amoco

chose Powertex as its sole source of intermodal container liners, in

part because they had developed a good working relationship and

¹¹

Mr. Parker, petitioner's expert, ignored the provision in

the agreement requiring Powertex to also pay 10 percent of net

sales for the purpose of marketing, advertising, and promotion

when he evaluated the royalties payable by Powertex for use of

the Sea Bulk patents. We do likewise.

- 41 the amount·it is willing to pay."), affd. without published opinion

691 F.2d 508

(9th Cir. 1982).

We believe that an evaluation of the foregoing factors results

in a royalty towards the middle of the 5- to 13-percent range we

identified above.

Using our best judgement, and evaluating the

record as a whole, we conclude that a royalty of 9 percent of net

sales of Amoco liners is a reasonable arm's-length consideration

pursuant to section 482 for the intangibles in issue.12

III.

Issue 2: Whether Consulting Fees Paid by Powertex to

Special Commodities Services, Inc. Are Ordinary and Necessary

Business Expenses Deductible Under Section 162

FINDINGS OF FACT

From 1983 through 1992, James L. Clark (Mr. Clark) was employed

by Sea-Land as its Director of Corporate Terminal Operations and

Director of Special Commodities Services.

His responsibilities

included managing the license agreement between Powertex and SeaLand, and providing technical support, marketing assistance, and

advice for assisting Sea-Land's customers in using Sea Bulk liners.

Pursuant to the license agreement between Sea-Land and Powertex, Mr.

Clark was responsible for providing technical advice and marketing

12

Respondent also disallowed the royalty expense deductions

claimed by Powertex under sec. 162 on the grounds that they were

not ordinary and necessary business expenses, on the grounds that

Powertex actually owned, or at least had shop rights in, the

Amoco patents.

In light of our holding that a royalty of 9

percent constitutes an arm's-length consideration pursuant to

sec. 482, such a royalty is deductible pursuant to sec. 162 as

well.

See R.T. French Co. v. Commissioner, 60 T.C. 836, 849

(1973) (the arm's-length test commonly associated with sec. 482

is equally applicable in ascertaining the ordinary and necessary

character of a payment to a related party that is deducted under

sec.

162(a)).

4

- 43 license) through consultations with Powertex during and

subsequent to the negotiations between Powertex and Sea

Land * * *

WHEREAS Powertex and SCS, Inc. believe it to be in

their mutual best interests for Powertex to continue to

receive marketing and technical advice on the manufacture,

marketing and sales of Sea Bulk units * * *

*

*

*

*

*

*

*

Powertex hereby grants to SCS, Inc. for the full term

of Powertex's exclusive licensing agreement with Sea Land

Service on the SEA-BULK units and any extension thereof,

this Consulting Agreement to utilize SCS, Inc.'s,

technical expertise in the manufacturing, marketing and

sale of the SEA BULK units throughout the world.

The

042

agreement provided that notices to SCS should be sent to Mr.

Clark's condominium located at 580 Patten Avenue, Unit #39, Long

Branch, New Jersey 07740.

Mr. Clark did not purchase the

condominium until April 6, 1984.

Pursuant to the agreement, Powertex was required to pay SCS a

"commission" of 2 ½ percent of net sales of Sea Bulk liners by

Powertex and its sublicensee, Insta-Bulk.

Beginning with the

quarter ending September 30, 1987, through February 25, 1992, the

"commission" was increased to 3 ½ percent of net sales of Sea Bulk

liners, and, for sales by Insta-Bulk, the commission remained at 2 ½

percent.

During the period from mid-1985 through February 25, 1992,

Powertex paid approximately $927,451 to SCS pursuant to the

agreement.

On October 26, 1995, Sea-Land filed a lawsuit in the Superior

Court of New Jersey against Mr. Clark, Mary J. Clark, SCS, Powertex,

and Mr. Podd, based on claims of fraud, commercial bribery,

conspiracy, and breach of fiduciary duties in order to recover the

payments made to SCS.

The suit sought damages and demanded that SCS

- 45 respondent's hesitancy to pursue a section 162(c)(2) argument is due

to the fact that respondent would bear the burden of proving, by

clear and convincing evidence, that the payments were illegal and

that the other requirements for disallowance under section 162(c)(2)

are satisfied.

Brizell v. Commissioner, 93 T.C. 151, 161 (1989);

sec. 1.162-18(b)(4), Income Tax Regs.

In any event, in the instant

case, we need not examine the legality of the payments to SCS.

Deductions are a matter of legislative grace, and a taxpayer

seeking a deduction must meet every condition that Congress has

imposed for entitlement to the deduction claimed.

Co. v. Helvering, 292 U.S. 435, 440

(1934).

New Colonial Ice

To qualify as an

allowable deduction under section 162(a) an item must (1) be paid or

incurred during the taxable year;

or business;

(3) be an expense;

be an ordinary expense.

(2) be for carrying on any trade

(4) be a necessary expense; and (5)

Commissioner v. Lincoln Sav. & Loan

Association, 403 U.S. 345, 352 (1971).

Whether an expenditure is

ordinary and necessary is a question of fact to be decided on the

basis of all of the facts and circumstances.

Heininger, 320 U.S. 467, 475

431, 431

Commissioner v.

(1943); Hearn v. Commissioner,

309 F.2d

(9th Cir. 1962), affg. 36 T.C. 672 (1961); Brizell v.

Commissioner, supra at 156.

In general, an expense is ordinary if it is considered "normal,

usual, or customary" in the context of the particular business out

of which it arose.

Deputy v. Du Pont, 308 U.S. 488, 495-496

(1940).

An expense is necessary if it is "appropriate and helpful" to the

- 47 -

1972), affg. on this issue and revg. on another issue 51 T.C. 337,

343-344 (1968).

It appears that Mr. Clark could have been

subpoenaed by either petitioners or respondent.

Accordingly, we

draw no inference from the fact that neither party subpoenaed Mr.

Clark.

Nonetheless, several aspects of the relationship between

Powertex, SCS, and Mr. Clark cause us to scrutinize the

relationships between them.

During 1983, Mr. Clark negotiated and

executed the license agreement between Powertex and Sea-Land.

During 1983, he also authorized Sea-Land to give free freight to

Powertex for shipment of its liners.

Mr. Clark also incorporated

SCS in 1983 and entered into the "consulting agreement" between SCS

and Powertex.

The "consulting agreement" provides that SCS will

provide "technical expertise in the manufacturing, marketing and

sale of the Sea Bulk units".

Mr. Podd, however, admitted that Mr.

Clark had no experience in the liner industry and that his expertise

was in the refrigerated container industry.

Mr. Clark left Sea-Land during 1992, and, within 3 months, the

free freight arrangement for shipment of Powertex liners was

terminated by Sea-Land.

The Sea-Land lawsuit filed in 1995

describes the payments required by the "consulting agreement" as

bribes or kickbacks and contends that all of Mr. Clark's activities

with regard to Powertex were undertaken in his capacity as an

employee of Sea-Land.

A deduction for a kickback has been allowed

when the payments were not shown by the Commissioner to be illegal

and the taxpayer established that the payments were ordinary and

- 49 -

IV.

Issue 3: Whether Amounts Deducted by Powertex as Management

Fees Paid to Powertex Plus International, Inc. Are Reasonable

Payments for Services Rendered

FINDINGS OF FACT

During the years 1977 through 1990, the Podds and Mrs. Podd

were Canadian citizens.

From 1977 through 1983, the Podds and Mrs.

Podd did not hold any immigration status or visa with the United

States.

During 1977, the Immigration and Naturalization Service

(INS) detained Mr. Podd while he was crossing the United

States/Canadian border and questioned him about his immigration

status and right to work in the United States.

On September 19, 1977, Powertex Plus International, Inc.

(Plus)

was incorporated in Canada by Mr. Podd, originally under the name

Powerweb Corporation, Ltd.

Petitioners' law firm advised Mr. Podd

to incorporate and receive wages from Plus in Canada because of the

prohibition against a Canadian citizen's working in the United

States without a visa.

During the years 1983 through 1990, Mr. Podd owned 28 percent

of the outstanding stock of Plus, and Mrs. Podd, Stephen, and

¹³(...continued)

to give free freight to Powertex for the shipment of liners to

Powertex customers, the free freight arrangement was terminated

shortly after Mr. Clark retired from Sea-Land, and thereafter

Sea-Land filed suit to recover the payments from Powertex to SCS,

the most plausible explanation for the payments is that they were

kickbacks to Mr. Clark.

Petitioners have obvious reasons for not

contending that the payments were kickbacks, and respondent, as

noted, may have been reluctant to characterize the payments as

illegal kickbacks due to the burden of proof provision in sec.

162(c)(2).

In any event, we are left with a less than adequate

record concerning the SCS payments, and it is petitioners' burden

to prove that such payments were ordinary and necessary business

expenses.

- 51 Fiscal Year

Ending

Amount

May 31,

May 31,

May 31,

May 31,

May 31,

May 31,

May 31,

$120,000

125,000

125,000

175,000

250,000

250,000

250,000

1984

1985

1986

1987

1988

1989

1990

During the years 1983 through 1990, Plus' place of business was

located at 255 Beverley Avenue, Montreal, Quebec, Canada, which was

also used as a residence by Mr. Podd, Mrs. Podd, and Stephen during

such years.

Additionally, Powertex deducted expenses for an office

maintained at the 255 Beverly Avenue address on its Federal

corporate income tax returns for the fiscal years ending May 31,

1984, through May 31, 1990.

During the same period, however,

Powertex also maintained offices at the Rouses Point facility for

use by the Podds and Mrs. Podd.

During the fiscal years ending May 31, 1989 and 1990, Powertex

claimed depreciation deductions on its Federal corporate income tax

returns for a desk, chair, and other standard office furniture

located at 255 Beverly Avenue.

Powertex also paid the Podds'

worldwide travel and entertainment expenses.

Plus paid the

following wages in Canadian dollars:

Year

Mr. Podd

Mrs. Podd

Victor, Jr.

Stephen

1988

1989

1990

$70,000

61,525

100,000

$60,000

61,525

100,000

$35,000

49,215

25,000

$35,000

49,215

25,000

OPINION

In the notices of deficiency, respondent adjusted the income of

Powertex by disallowing the deductions claimed for management fees

- 53 -

performed, and not the label put on them by the payor and the payee.

Estate of Boyd v. Commissioner, 76 T.C. at 658 (and cases cited

therein).

Petitioners bear the burden of proving what portion of

the fees is allocable to deductible expenses.

Id.

Petitioners argue that the amounts labeled as management fees

paid from Powertex to Plus are deductible under section 162 as

ordinary and necessary business expenses.

Petitioners contend that

Plus provided substantial, regular, and valuable management

services.

Mr. Podd testified that Plus provided Powertex services

in the nature of "general guidance" and "direction".

More

specifically, it was Mr. Podd's uncontroverted testimony that Plus

reviewed sales invoices and entertained customers of Powertex.

Respondent contends that the fees paid to Plus are not

deductible because they lacked a business purpose and because Plus

was merely a holding company which failed to provide any significant

services to Powertex.

Respondent does not argue that the management fee payments were

not reasonable.

At trial, petitioners offered credible testimony

that significant services were provided to Powertex through Plus.

On the record before us, we hold that the payments made by Powertex

to Plus as management fees during the years in issue were for

services actually rendered and that, therefore, they are deductible

under section 162.

- 55 -

also determined that Victor, Jr. and Stephen each received $250,000

of constructive dividend income for 1988 and 1989.

OPINION

A dividend is a distribution of property by a corporation to

its shareholders out of its earnings and profits.

Sec. 316(a).

Dividends are taxable as ordinary income to shareholders to the

extent of the earnings and profits of the corporation.

Sec. 316.

A

dividend need not be formally declared or even intended by the

corporation.

Noble v. Commissioner, 368 F.2d 439, 442 (9th Cir.

1966), affg. T.C. Memo. 1965-84; Commissioner v. Makransky, 321 F.2d

598

(3d Cir. 1963), affg. 36 T.C. 446

277 F.2d 879

(1961); Sachs v. Commissioner,

(8th Cir. 1960), affg. 32 T.C. 815

(1959).

Additionally, the distribution need not be made to a shareholder,

but only for the shareholder's personal benefit.

Cirelli v.

Commissioner, 82 T.C. 335, 351 (1984); Edgar v. Commissioner, 56

T.C. 717 (1971).

The determination of whether a constructive

dividend has occurred is a question of fact which depends on each

case.

Hardin v. United States, 461 F.2d 865

(5th Cir.

1972).

The only argument petitioners advance with respect to the

royalty payments is that the full amount of such payments is

deductible as an ordinary and necessary business expense and

therefore cannot be a constructive dividend.

As discussed supra, we

have found that the appropriate royalty rate for the patents

licensed pursuant to the Tri-Podd license agreement is 9 percent.

To the extent that royalty payments were made in excess of 9

percent, such amounts are not ordinary and necessary business

- 57 -

Ms. Cohen eventually began dating and were married on August 16,

1991.

During 1990, Victor, Jr. conducted business for Powertex in

Florida by contacting and meeting with its Florida customers.

Victor, Jr. utilized a phone, desk, and fax machine located in Ms.

Cohen's apartment for conducting Powertex business.

Victor, Jr.

also utilized an automobile owned by Powertex while in Florida

during 1990.

On March 26, 1990, Powertex purchased mobile telephone

service for Victor, Jr.'s use at Ms. Cohen's apartment.

During or

around May of 1990, Victor, Jr. transported a boat that he owned

with Stephen from Rouses Point, New York to Fort Lauderdale,

Florida, docking it at the marina servicing Ms. Cohen's apartment.

In the insurance policy covering the boat, Victor, Jr. listed Ms.

Cohen's apartment as his address and the address where the boat is

normally kept.

On August 22, 1990, Victor, Jr. obtained a driver's license

issued by the State of Florida.

listed as his address.

Again, Ms. Cohen's apartment is

During 1990, Victor, Jr. incurred charges on

his credit card for 160 days in Florida and for 55 days in other

locations in the United States.

For the 1990 taxable year, Victor, Jr. filed a Canadian

resident income tax return.

For the 1991 taxable year, Victor, Jr.

claimed that he was a United States resident for income tax purposes

and resided in Fort Lauderdale, Florida.

.

During 1990, Victor, Jr. also held a Quebec driver's license

and belonged to a health club in Montreal.

He owned two automobiles

- 59 -

Accordingly, because Victor, Jr. held a valid green card during

1990, he generally would be treated as a resident alien of the

United States with respect to that year.

If, for income tax

purposes, Canada also considered Victor, Jr. to be a resident of

that country for 1990, he potentially would be subject to double

taxation.

The United States-Canada income tax treaty (the treaty),

however, provides a method for alleviating such potential.¹³

The

treaty provides a series of so-called "tie-breaker" rules for

determining residence where an individual qualifies as a resident of

both countries, as follows:

2. Where by reason of the provisions of paragraph 1 an

individual is a resident of both Contracting States, then his

status shall be determined as follows:

(a) He shall be deemed to be a resident of the

Contracting State in which he has a permanent home

available to him; if he has a permanent home available to

him in both States or in neither State, he shall be deemed

to be a resident of the Contracting State with which his

personal and economic relations are closer (centre of

vital interests);

(b) If the Contracting State in which he has his

centre of vital interests cannot be determined, he shall

¹³

United States income tax treaties are on equal footing with

domestic law in that both are "the supreme Law of the Land".

U.S. Const. art. VI, cl. 2; see also sec. 894(a) ("The provisions

of this title shall be applied to any taxpayer with due regard to

any treaty obligation of the United States which applies to such

taxpayer."); sec. 7852(d)(1) ("For purposes of determining the

relationship between a provision of a treaty and any law of the

United States affecting revenue, neither the treaty nor the law

shall have preferential status by reason of its being a treaty or

law.")

If a treaty conflicts with a Federal law, the later in time

will prevail.

Chae Chan Ping v. United States, 130 U.S. 581, 600

(1889); Whitney v. Robertson,

124 U.S. 190,

194

(1888); see also

Lindsey v. Commissioner, 98 T.C. 672, 676 (1992), affd. without

published opinion 15 F.3d 1160

(D.C. Cir. 1994).

- 61 -

Canada.

Neither party, however, has introduced any evidence of the

Canadian law concerning residence.

In the absence of any evidence

regarding the Canadian law for determining residence for income tax

purposes, we conclude that Victor, Jr. was not a Canadian resident

for income tax purposes in 1990.

T.C. 1045, 1053 (1980)

See MacLean v. Commissioner, 73

(petitioner not considered a resident of the

United Kingdom where he failed to cite any United Kingdom statutory

or case law authority); Afshar v. Commissioner, T.C. Memo. 1981-241

("where neither party has offered any material with respect to the

applicable foreign law, we need not take judicial notice of such

law"), affd. without published opinion 692 F.2d 751 (4th Cir. 1982).

Accordingly, the "tie-breaker" rules of the treaty are inapplicable.

Consequently, we hold that Victor, Jr. is a resident of the United

States for 1990 pursuant to section 7701(b)(1) (A)(i).

VII.

Issue 6:

Additions to Tax and Penalties

FINDINGS OF FACT

Respondent determined additions to tax for negligence under

section 6653(a)(1)(A) and (B), additions to tax for negligence under

section 6653(a)(1), additions to tax for substantial understatements

under section 6661(a), and accuracy-related penalties for negligence

or substantial understatements under section 6662(a).

Respondent

also determined additions to tax for failure to file tax returns

under section 6651(a)(1) and additions to tax for failure to make

deposit of taxes under section 6656.

- 63 -

with reasonable cause and in good faith depends upon the pertinent

facts and circumstances.

2.

Sec. 1.6664-4(b)(1), Income Tax Regs.

Substantial Understatement

Section 6661 imposes an addition to tax in an amount equal to

25 percent of the underpayment of income tax if the underpayment is

attributable to a substantial understatement.

Section 6661 applies

to tax returns with a due date prior to January 1, 1990.

Section

6661 was repealed with regard to returns having a due date after

December 31, 1989, and recodified in section 6662.

Section 6662(a)

and 03)(2) imposes a penalty in an amount equal to 20 percent of the

portion of underpayment which is attributable to any substantial

understatement of income tax.

For purposes of sections 6661 and 6662(a), an understatement is

substantial if it exceeds the greater of 10 percent of the correct

tax or $5,000 or, in the case of a corporate taxpayer, $10,000.

Secs.

6661(b) (1) (A)

and (B) ,

6662 (d) (1) (A)

and (B) .

The term

"understatement" is defined as the excess of the amount of tax

required to be shown on the return for the taxable year over the

amount of tax shown on the return for the taxable year reduced by

any rebate.

Secs. 6661(b)(2), 6662(d)(2)(A).

In calculating

understatements, items for which there was substantial authority or

adequate disclosure are not to be considered.

6661(b)(2) (B)(i)

3.

and (ii),

6662(d)(2)(B)(i)

and

Secs.

(ii).

Failure To File Tax Return

Section 6651(a)(1) provides for an addition to tax of 5 percent

of the tax required to be shown on the return for each month or

a

- 65 The individual petitioners were Canadian citizens unfamiliar

with the U.S. tax system.

They sought assistance from a certified

public accountant in the United States in order to comply with the

provisions of the Internal Revenue Code.

The accountant for the

individual petitioners and Powertex, Ronald R. Plante, a C.P.A. with

Peat Marwick, testified as to his role in the preparation of

petitioners' tax returns.

Mr. Plante had a longstanding

professional association with Powertex and the individual

petitioners, which began around 1977 or 1978.

Mr. Plante credibly

testified that petitioners sought his advice in order to fulfill

their tax obligations in the United States.

It is well documented

in the record that petitioners relied upon the advice of Mr. Plante.

It is obvious that Mr. Plante possessed sufficient expertise in

the field of tax law, and we believe that, with the exception of the

issue concerning the deduction claimed by Powertex for consulting

fees paid to SCS, petitioners provided him with the necessary and

relevant information to prepare their tax returns.

After a careful

review of the record, we hold that, based on all the facts and

circumstances, except as to the SCS consulting fees issue,

petitioners reasonably relied in good faith on the advice of Mr.

Plante and are therefore not liable for the penalties and additions

to tax as determined by respondent.

As to the SCS consulting fees issue, we hold that petitioners

have not met the requirements of the reasonable cause exception that

are necessary to avoid imposition of the section 6662(a) accuracyrelated penalty.

If a taxpayer relies reasonably and in good faith