# UNITED STATES TAX COURT > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Ae1e6837e3d7564dc ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text T.C. Memo. 1999-101 UNITED STATES TAX COURT JERRY AND PATRICIA A. DIXON, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent* Docket Nos. 9382-83, 17646-83, 4201-84, 7323-84, 15907-84, 20119-84, 40159-84, 22783-85, 30010-85, 30979-85, 29643-86, 35608-86, 19464-92, 621-94, 7205-94, 9532-94, 17992-95, 17993-95. Filed March 30, 1999. 1 Cases of the following petitioners are consolidated herewith: Ronald L. Alverson and Mattie L. Alverson, docket No. 17646-83; Hoyt W. and Barbara D. Young, docket Nos. 4201-84, 22783-85, 30010-85; Anthony E. and Carol A. Eggers, docket No. 7323-84; Robert L. and Carolyn S. DuFresne, docket Nos. 15907-84, 30979-85; John L. and Terry E. Huber, docket No. 20119-84; Terry D. and Gloria K. Owens, docket No. 40159-84; Richard and Fidella Hongsermeier, docket No. 29643-86; Norman W. and Barbara L. Adair, docket No. 35608-86; Willis F. McComas, II and Marie D. McComas, docket No. 19464-92; Wesley Armand and Sherry Lynn Cacia Baughman, docket No. 621-94; Joe A. and JoAnne Rinaldi, docket No. 7205-94; Norman A. and Irene Cerasoli, docket No. 9532-94; Stanley C. and Sharon A. Titcomb, docket No. 1799295; Richard B. and Donna G. Rogers, docket No. 17993-95. * This opinion supplements our previously filed Memorandum Findings of Fact and Opinion in Dixon v. Commissioner, T.C. Memo. 1991-614, vacated and remanded per curiam sub nom. DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994). - 2 In Dixon v. Commissioner, T.C. Memo. 1991-614, vacated and remanded per curiam sub nom. DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994), following a trial of 14 docketed test cases of eight Ps, the Court sustained R's disallowance of interest deductions claimed by Ps in various tax shelter programs promoted by K. After the Court entered decisions against the test case Ps in accordance with its opinion, R moved to vacate the decisions entered in three test cases (T, C, and X). R alleged that, before the trial of the test cases, R's trial attorney and District Counsel had entered into contingent settlement agreements with T and C that had not been disclosed to the Court or to the other test case Ps or their counsel. R asked the Court to conduct an evidentiary hearing to determine whether the undisclosed agreements with T and C had affected the trial of the test cases or the opinion of the Court. The Court granted R's motions to vacate the decisions entered in the T and C cases, entered revised decisions in the T and C cases consistent with R's prior agreements with T and C, denied R's motion to vacate the decision in the X case, and denied R's request for an evidentiary hearing on the ground that the testimony, stipulated facts, and exhibits relating to the T and C cases had no material effect on the Court's opinion as it related to the remaining test case Ps. On appeal, the Court of Appeals for the Ninth Circuit vacated the decisions in the remaining test cases and remanded them to this Court with directions "to conduct an evidentiary hearing to determine the full extent of the admitted wrong done by the government trial lawyers." DuFresne v. Commissioner, supra at 107. The Court of Appeals, citing Arizona v. Fulminante, 499 U.S. 279, 309 (1991), directed the Court to consider "whether the extent of misconduct rises to the level of a structural defect voiding the judgment as fundamentally unfair, or whether, despite the government's misconduct, the judgment can be upheld as harmless error." Id. Further, the Court of Appeals directed this Court to consider on the merits all motions of intervention filed by affected parties. See id. This Court ordered that the cases of 10 nontest case Ps, the majority of whom had previously signed piggyback agreements, be consolidated with the remaining test cases for purposes of the evidentiary hearing. Three groups of Ps participated in all subsequent phases of the evidentiary hearing. - 3 Ps argue (under various theories) that the Court's decisions in the remaining test cases should not be reinstated, or, in the alternative, that the piggyback agreements are not enforceable. R counters that the decisions in the remaining test cases should be reinstated on the ground that Ps were not prejudiced by the Government misconduct in the trial of the test cases and that the piggyback agreements remain in force. Held: The Government misconduct in the trial of the test cases did not result in a structural defect in the trial. Held further: The Government misconduct in the trial of the test cases resulted in harmless error. Held further: The Government misconduct in the trial of the test cases does not provide any other basis for invalidating the Court's decisions in the remaining test cases or for setting aside the piggyback agreements. Held further: As a sanction against R, program participants who have not been the subject of a final determination are not liable for time-sensitive additions to tax for negligence under secs. 6653(a)(2) and 6653(a)(1)(B), I.R.C., or increased interest under sec. 6621(c), I.R.C. Joe Alfred Izen, Jr., counsel for petitioners in docket Nos. 9382-83, 4201-84, 15907-84, 40159-84, 22783-85, 30010-85, 3097985, 29643-86, and 35608-86. Robert Alan Jones, counsel for petitioners in docket Nos. 17646-83, 19464-92, 621-94, and 9532-94. Robert Patrick Sticht, counsel for petitioners in docket Nos. 7323-84, 20119-84, 7205-94, 17992-95, and 17993-95. Mary Elizabeth Wynne, Steven A. Wilson, Andrew J. Gottlieb, Milton J. Carter, Jr., Robert E. Casey, and Richard S. Goldstein, for respondent. - 4 CONTENTS Page Introduction....................................................9 FINDINGS OF FACT...............................................15 I. Kersting Tax Shelter Programs and Related Matters........15 A. The Pike Case............................................15 B. Kersting Criminal Investigation..........................16 C. Assessments of Kersting Promoter Penalties...............18 D. Kersting Notice of Deficiency............................19 II. Notices of Deficiency Issued to Kersting Program Participants ............................................20 A. Form of Notices of Deficiency............................20 B. Thompson Notices of Deficiency...........................21 C. Cravens Notices of Deficiency............................23 D. Alexander Notices of Deficiency..........................24 1. 1974 and 1975.........................................25 2. 1976 and 1977.........................................26 E. Validity of Notices of Deficiency........................27 F. Errors in Notices of Deficiency..........................27 III. Commencement of Kersting Project ........................28 A. Tax Shelter Projects and Test Case Procedures............28 1. Overview..............................................28 2. National Office Tax Shelter Branch Functions..........30 B. Petitions for Redetermination............................31 C. Brian J. Seery...........................................32 D. Respondent's Counsel.....................................33 1. Kenneth W. McWade.....................................33 2. William A. Sims.......................................34 E. Adoption of Test Case Procedures in Kersting Project.....34 1. The Honolulu Session (June 1985)......................34 2. Test Case Procedure...................................35 3. Test Case Array.......................................38 IV. The Maui Session (February 1987).........................42 A. Trial Notices............................................42 B. Piggyback Agreements.....................................44 C. Mr. Seery's Withdrawals as Counsel.......................48 1. The Thompsons.........................................49 2. The Test Cases........................................50 D. Entries of Appearance by Chicoine and Hallett............51 E. Evidentiary Issues.......................................54 1. The Maui Session......................................54 2. Dixon I Opinion.......................................55 V. Kersting Disputes With Program Participants..............55 A. The Thompsons............................................56 - 5 1. The Bauspar Program...................................56 2. Deterioration of Thompson/Kersting Relationship.......57 B. The Alexander Dispute....................................67 C. Collection Actions.......................................72 1. Steve Hane............................................72 2. Carl Mott, George Vermef, and Robert Peterson.........73 VI. Settlements..............................................74 A. Internal Revenue Service Policy..........................74 1. National Office Position..............................74 2. Regional Counsel......................................76 B. Official Kersting Project Settlement Offer (7-Percent Reduction of Deficiency or Out-of-Pocket Expenses).......77 C. Deviations From Official Project Settlement Offer........78 1. Modified 7-Percent Settlement Offer...................78 2. 20-Percent Settlement Offer...........................80 3. Negotiations for 50-Percent Settlement Offer..........82 4. Revival of 20-Percent Settlement Offer................84 D. The Thompson Settlement..................................92 1. Initial Thompson Settlement Agreement.................92 2. First Revision of Thompson Settlement.................94 3. Second Revision of Thompson Settlement................98 E. The Cravens Settlement..................................100 F. The Alexander Understanding.............................106 G. The Kozak Decision......................................115 VII. Pretrial Developments...................................116 A. The Kersting Deposition--Postponed (January 1987).......116 B. John Doe Summons/Assessments of Promoter Penalties......118 C. Chicoine and Hallett's Withdrawal as Counsel............120 D. Mr. Izen's Entry of Appearance..........................120 E. The Kersting Deposition (October 1988)..................121 VIII. Trial of Test Cases (January 1989)......................123 A. Mr. Cravens.............................................124 B. Mr. Thompson............................................126 C. Mr. Kersting............................................129 D. Mr. Alexander...........................................130 E. Mr. DeCastro............................................133 F. Comfort Letters.........................................133 G. Mr. Izen's Introduction of Evidence of Collection Litigation..............................................135 IX. Posttrial Developments..................................137 A. First Thompson Refund...................................137 B. Mr. Izen's Motion To Reopen Record......................141 C. Dixon II Opinion........................................142 D. Disclosure of Thompson Settlement.......................143 E. Disclosure of Cravens Settlement........................152 F. Respondent's Motions To Vacate..........................155 - 6 G. Attempted Discovery by Counsel for Nontest Case Petitioners.............................................156 H. Closing of Thompson Cases/Further Refunds...............156 I. Closing of Cravens Cases................................160 PROCEDURAL HISTORY OF EVIDENTIARY HEARING.....................162 I. Developments Before Evidentiary Hearing.................162 A. Referral of Thompson and Cravens Settlements to Office of Inspector General....................................162 B. Revival of 7-Percent Settlement Offer...................165 C. Disciplinary Actions....................................165 D. Indictment of Mr. Izen..................................166 E. Pretrial Conference (July 1995).........................167 F. Pretrial Conference (January 1996)......................168 G. Denial of Respondent's Motion To Disqualify Mr. Izen....168 H. Mr. DeCastro's Withdrawal...............................170 I. Discovery of Alexander Decisions and Referral to Office of Inspector General.............................170 J. Mr. Izen's Motion To Compel Production of Documents and Issuance of Protective Orders.......................171 K. Burden of Proof and Rule 145 Order......................173 II. The Evidentiary Hearing.................................175 A. Testimony...............................................176 1. Mr. Cravens......................................... 176 2. Mr. Thompson.........................................178 3. Mr. Alexander........................................179 4. Mr. McWade...........................................180 5. Mr. Sims.............................................182 6. Mr. DeCastro.........................................183 7. Mr. Izen.............................................184 B. Mr. Sticht's Allegations of Potential Witness Intimidation............................................186 C. Mr. Bradt's June 12, 1996, Letter to Mr. Kersting.......187 D. Denial of Mr. Izen's Motion To Refer Thompson and Cravens Settlements and Alexander Agreement to Department of Justice (Public Integrity Section)........189 III. Developments Following Initial Evidentiary Hearing......189 A. Denial of Respondent's Motion for Further Hearing Regarding Potential Witness Intimidation................189 B. Supplemental Evidentiary Hearing (August 18, 1997)......192 C. Denial of Mr. Izen's Motion To Compel Production of Documents...............................................194 D. Denial of Mr. Sticht's Motion To Reopen Record..........195 E. Denial of Mr. Izen's Motion To Take Judicial Notice.....196 F. Denial of Mr. Sticht's Motions for Release From Piggyback Agreements....................................198 G. Reports Regarding the Court's Protective Orders.........199 - 7 ULTIMATE FINDINGS OF FACT.....................................200 OPINION.......................................................202 I. Burden of Proof.........................................203 II. Structural Defect.......................................211 A. Case Law................................................211 B. Arguments...............................................215 C. Summary of Government Misconduct........................218 D. Discussion..............................................225 III. Harmless Error Analysis.................................233 A. Review of Dixon II......................................236 1. Mr. Kersting's Lack of Credibility...................237 2. Sham Analysis........................................238 3. Lack of Genuine Debt/Waltz of Funds..................240 i. Subscription Interest...........................241 ii. Primary Loans...................................242 iii. Leverage Loans..................................244 4. Collection Litigation................................244 5. CAT-FIT Plan.........................................245 6. Additions to Tax.....................................247 i. Negligence......................................247 ii. Late Filing.....................................247 iii. Substantial Understatement......................247 iv. Increased Interest..............................248 B. Discussion..............................................249 1. Mr. Cravens.........................................249 i. Sham Analysis...................................251 ii. Lack of Genuine Debt/Waltz of Funds.............254 2. Mr. Thompson.........................................255 i. Sham Analysis...................................257 ii. Lack of Genuine Debt/Waltz of Funds.............258 iii. Additions to Tax................................262 3. Mr. Alexander........................................264 4. Summary..............................................266 IV. V. Fraud, Misrepresentation, and Misconduct................267 VI. Fraud on the Court......................................271 A. Case Law Survey.........................................271 B. Discussion..............................................281 Mr. Izen's Allegations That Mr. DeCastro Was a "Mole"...283 VII. Enforceability of Piggyback Agreements..................284 A. Principles of Contract Law..............................285 B. Discussion..............................................290 1. Benefit of the Bargain...............................290 2. Mr. Seery's Purported Conflict of Interest...........294 - 8 3. Rejection of Mr. Izen's Argument for Entry of Decision On the Basis of Thompson Decisions..........296 VIII. Mary Carter Agreements..................................296 IX. Mr. Sticht's Motion To Sever Case and for Entry of Decision or Alternatively To Sever Case and Set for Trial ..................................................300 X. Protective Orders.......................................302 XI. Sanctions...............................................305 Conclusion....................................................307 SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION BEGHE, Judge: Eight of these consolidated cases--with five petitioners represented by Joe Alfred Izen, Jr. (Mr. Izen),--are test cases before the Court on remand from the Court of Appeals for the Ninth Circuit in DuFresne v. Commissioner, 26 F.3d 105 (9th Cir. 1994), vacating and remanding per curiam Dixon v. Commissioner, T.C. Memo. 1991-614. The other 10 consolidated cases--with petitioners in one case represented by Mr. Izen and the other petitioners represented by Robert Alan Jones (Mr. Jones) and Robert Patrick Sticht (Mr. Sticht)--are nontest cases that have been added to the consolidated group in order to effectuate the direction of the Court of Appeals "to consider on the merits all motions of intervention filed by parties affected by this case." Id. at 107. Unless otherwise indicated, section references are to the Internal Revenue Code, as amended, and Rule references are to the Tax Court Rules of Practice and Procedure. - 9 Introduction These consolidated cases are part of a group of more than 1,300 remaining cases--more than 500 cases have settled--arising from respondent's disallowance of interest deductions claimed by participants in various tax shelter programs promoted by Henry F.K. Kersting (Mr. Kersting). The Kersting group of cases (hereinafter the Kersting project) was assigned to Judge William A. Goffe (Judge Goffe) for disposition. By agreement of the parties and the Court, the merits of the Kersting programs were to be litigated in a consolidated trial of 14 docketed cases of eight petitioners that had been designated as "test cases". The vast majority of the remaining Kersting project petitioners signed stipulations to be bound (sometimes referred to herein as piggyback agreements) in which they agreed with respondent that their cases would be resolved in accordance with the Court's opinion in the test cases. Before the trial of the test cases, some test case petitioners argued that a 1981 search of Mr. Kersting's office had been illegal, that materials seized during the search should be suppressed in the test case proceedings, and that the burden of proof and burden of going forward with evidence should be shifted to respondent. In Dixon v. Commissioner, 90 T.C. 237 (1988) (Dixon I), the Court held, in an opinion by Judge Goffe, that the petitioners had failed to establish standing to contest the Kersting search and seizure. - 10 Judge Goffe held the trial of the test cases in Honolulu, Hawaii, during January 1989. The majority of the test case petitioners were represented at trial by Mr. Izen. However, test case petitioners John R. and Maydee L. Thompson (docket Nos. 19321-83, 31236-84, and 30965-85) were represented at trial by Luis C. DeCastro (Mr. DeCastro), and test case petitioners John R. and E. Maria Cravens (docket Nos. 16900-83 and 15135-84) appeared pro sese. Following the trial of the test cases, the Court issued its memorandum opinion in Dixon v. Commissioner, T.C. Memo. 1991-614, 62 T.C.M. (CCH) 1440, 1991 T.C.M. (RIA) par. 91,614 (Dixon II), sustaining virtually all of respondent's determinations in each of the test cases, and entered decisions against the test case petitioners in accordance with its opinion. On March 13, 1992, the Court entered the following decisions in the Thompson and Cravens cases: John R. and Maydee L. Thompson Year Deficiency Sec. 6651(a) Additions to Tax Sec. Sec. 6653(a) 6653(a)(1) 1979 1980 1981 $18,161.00 24,838.00 36,294.52 ----$4,934.32 $908 ----- ----$1,958.28 Sec. 6653(a)(2) ----50 percent of the interest due on the deficiency John R. and E. Maria Cravens Year Deficiency Additions to Tax Sec. 6653(a) 1979 1980 $4,508.00 5,893.45 $225.40 294.67 - 11 On June 9, 1992, respondent filed motions for leave to file motions to vacate the decisions entered against the Thompsons, the Cravenses, and another test case petitioner, Ralph J. Rina (Mr. Rina), docket No. 17640-83. Respondent's motions to vacate alleged that, before the trial of the test cases, respondent's trial attorney, Kenneth W. McWade (Mr. McWade), and his supervisor, Honolulu District Counsel William A. Sims (Mr. Sims), had entered into contingent settlement agreements with the Thompsons and the Cravenses that had not been disclosed to the Court or to the other test case petitioners or their counsel. Respondent asked the Court to conduct an evidentiary hearing to determine whether the undisclosed agreements with the Thompsons and the Cravenses had affected the trial of the test cases or the opinion of the Court. On June 22, 1992, Judge Goffe granted respondent's motions to vacate filed in the Thompson and Cravens cases, vacated the decisions entered in those cases, ordered the parties to file agreed decisions with the Court, or otherwise move as appropriate, and denied respondent's request for an evidentiary hearing. By order dated June 22, 1992, Judge Goffe also denied respondent's motion to vacate the decision entered against Mr. Rina, on the ground that the testimony, stipulated facts, and exhibits relating to the Thompson and Cravens cases had no material effect on the Court's Dixon II opinion as it related to Mr. Rina. - 12 On July 22, 1992, the test case petitioners represented by Mr. Izen filed a motion for reconsideration of the Court's order denying respondent's motion to vacate the decision in the Rina case. By order dated August 4, 1992, Judge Goffe denied petitioners' motion for reconsideration. In August 1992, the Court entered revised decisions in the Thompson and Cravens cases consistent with Mr. McWade's prior agreements with the taxpayers in those cases. Specifically, the Court entered the following decisions in the Thompson and Cravens cases: John R. and Maydee L. Thompson Year Deficiency Additions to Tax 1979 1980 1981 --$15,000 15,000 ------- John R. and E. Maria Cravens Year Deficiency Additions to Tax 1979 1980 $3,606.40 6,175.76 ----- The decisions entered in the Thompson and Cravens cases are now final.2 2 Mr. Izen and Mr. Sticht filed separate motions with the Court to intervene in the Thompson and Cravens cases. The Court denied these motions to intervene. Although Mr. Izen and Mr. Sticht filed separate appeals in the Thompson and Cravens cases with various courts, including the Courts of Appeals for the Second, Ninth, and Tenth Circuits, all appeals in the Thompson and Cravens cases eventually were dismissed. In an unpublished opinion filed June 15, 1994, the Court of Appeals for the Ninth Circuit stated: (continued...) - 13 Because of Judge Goffe's termination, on September 30, 1992, of his recall status as a Senior Judge of the Court, all cases in the Kersting project group were reassigned to Judge Renato Beghe. The other test case petitioners, including Mr. Rina, appealed the decisions entered in their cases to the Court of Appeals for the Ninth Circuit. On appeal, those petitioners argued that the trial of the test cases had been tainted by the Thompson and Cravens settlement agreements. The response of the Court of Appeals was to vacate the decisions in the remaining test cases and remand them to this Court with directions "to conduct an evidentiary hearing to determine the full extent of the admitted wrong done by the government trial lawyers." DuFresne v. Commissioner, 26 F.3d at 107. The Court of Appeals, citing Arizona v. Fulminante, 499 U.S. 279, 309 (1991), directed the Court to consider "whether the extent of misconduct rises to the level of a structural defect voiding the judgment as fundamentally unfair, or whether, despite the government's misconduct, the judgment can be upheld as harmless error." DuFresne v. Commissioner, supra at 107. 2 Further, the Court of (...continued) The Tax Court's August 25 and 26, 1992 decisions entering settlement in the Cravens and Thompson cases, respectively, are final. 26 U.S.C. § 7481(a)(1); Fed. R. App. P. 13. The Tax Court lacks jurisdiction to vacate those decisions. Billingsley v. CIR, 868 F.2d 1081, 1084 (9th Cir. 1989). Because there is no case remaining in which the taxpayers can intervene, this appeal is moot. [Adair v. Commissioner, No. 92-70812, 26 F.3d 129 (9th Cir. 1994).] - 14 Appeals directed this Court to consider on the merits all motions See id.3 of intervention filed by parties affected by Dixon II. On February 2, 1995, respondent filed a Motion for an Evidentiary Hearing. On September 14, 1995, the Court granted respondent's motion. To effectuate the direction of the Court of Appeals regarding intervention, the Court ordered that the cases of 10 nontest case petitioners, the majority of whom had previously signed piggyback agreements, be consolidated with the remaining test cases for purposes of the evidentiary hearing.4 As a result, three groups of petitioners have participated in all subsequent phases of the evidentiary hearing: Test case and nontest case petitioners represented by Mr. Izen; nontest case petitioners represented by Mr. Jones; and nontest case petitioners represented by Mr. Sticht.5 The positions taken by 3 The appellate panel in DuFresne v. Commissioner, 26 F.3d 105, 107 (9th Cir. 1994), vacating and remanding per curiam Dixon v. Commissioner, T.C. Memo. 1991-614, 62 T.C.M. (CCH) 1440, 1991 T.C.M. (RIA) par. 91,614 (Dixon II), issued an order stating that the panel would retain jurisdiction over any subsequent appeal. 4 On June 13, 1995, test case petitioner Mr. Rina conceded his case in full, resulting in entry of a stipulated decision in docket No. 17640-83 that was identical with the decision originally entered in that case on the basis of the Court's opinion in Dixon II. 5 The group of cases that were consolidated for purposes of the evidentiary hearing initially included the case of William D. and Karen S. Booth, docket No. 28950-88, in which Declan J. O'Donnell (Mr. O'Donnell) had entered his appearance. However, at the start of the evidentiary hearing, the Court granted Mr. O'Donnell's motion to sever the Booth case from the cases consolidated for the evidentiary hearing. Mr. O'Donnell argued that, in light of the theory underlying a Motion for Summary Judgment that he had filed on behalf of the Booths, they had no (continued...) - 15 the various groups of petitioners during these proceedings have not been consistent in all respects and in some respects the positions of counsel--primarily Messrs. Izen and Sticht--have become adversarial.6 Following pretrial conferences on the record in Los Angeles on July 17, 1995, and January 16, 1996, the evidentiary hearing was held at special trial sessions of the Court conducted in Los Angeles on May 13 to 30 and June 10 to 26, 1996, and August 18, 1997. In the interest of chronology and as an aid to understanding this opinion, the procedural history of the evidentiary hearing comes after the Court's detailed findings of fact and before the ultimate findings of fact. FINDINGS OF FACT I. Kersting Tax Shelter Programs and Related Matters A. The Pike Case Mr. Kersting began promoting tax shelter programs in Hawaii in the early 1970's. Mr. Kersting's early tax shelter programs included an "Auto-Leasing Plan" and an "Acceptance Corporation Plan." Those plans generally required participants to purchase 5 (...continued) need to participate in the evidentiary hearing. In Gridley v. Commissioner, T.C. Memo. 1997-210, the Court rejected the argument, raised in the Booths' Motion for Summary Judgment, that Kersting petitioners who signed stipulations to be bound to Dixon II were entitled to entry of decisions in their cases consistent with the decision entered by the Court in the Thompson case at docket No. 19321-83. 6 See infra pp. 168-169, 171-172, and 187-188. - 16 stock in a subchapter S leasing corporation or an acceptance corporation and/or enter into a subscription agreement to purchase stock, all in connection with loans to the participants by various entities created by Mr. Kersting. The plans were primarily designed to generate income tax deductions for interest that the participants purportedly paid to the Kersting entities on the loans. The Commissioner determined that participants in Mr. Kersting's auto-leasing and acceptance corporation plans were not entitled to deduct: (1) "Interest" that participants claimed to have paid on either the Auto-Leasing stock purchase or leverage loans; (2) the participants' pro rata shares of losses or investment credits from the auto leasing companies; and (3) "interest" that participants claimed to have paid either on the acceptance corporation stock purchase or stock subscription loans. In Pike v. Commissioner, 78 T.C. 822 (1982), affd. without published opinion 732 F.2d 164 (9th Cir. 1984), this Court sustained the Commissioner's disallowances of all deductions for interest, losses, and credits claimed by participants in Mr. Kersting's early programs. B. Kersting Criminal Investigation While the Pike litigation was underway, Mr. Kersting continued to promote additional tax shelter programs, which came to be known as the stock purchase plan, the stock subscription plan, the leasing company plan, and the CAT-FIT plan. The - 17 Court's opinion in Dixon II describes the mechanics of these programs in detail.7 On January 22, 1981, following an undercover criminal investigation, the Internal Revenue Service searched Mr. Kersting's offices in Hawaii pursuant to a search warrant issued by the U.S. District Court for the District of Hawaii. Seventy-seven boxes and two filing cabinets of records were seized from Mr. Kersting's office, including lists identifying, by name and address, approximately 1,800 participants in Mr. Kersting's programs, and schedules of the interest purportedly paid by each participant to one or more Kersting companies during the taxable years 1977, 1978, and 1979. On January 24, 1981, Mr. Kersting wrote a form letter to the participants of his programs, one of his many "Dear Friend" letters, stating that he had been entrapped by an undercover Internal Revenue Service special agent into creating a backdated "tax deduction" of $21,600.8 By letter dated February 15, 1981, Mr. Kersting provided participants in his programs with "tax reporting notices", presumably for the 1980 tax year, and encouraged them to "take full advantage of the deductions 7 The Kersting programs involved a number of corporations (hereinafter Kersting corporations). Mr. Kersting served as both a director and president of most of these corporations and also sometimes owned stock. For those corporations in which he served as president during the years in issue, he had exclusive management authority. 8 The record in these cases contains no fewer than 38 "Dear Friend" letters. - 18 reported to you." Mr. Kersting further informed participants that the Internal Revenue Service had "accomplished only a temporary disruption of our operations" and that his office was "back to almost normal workings". All records seized in the January 22, 1981, search were returned to Mr. Kersting by 1987. In January 1983, Mr. Kersting filed suit in the U.S. District Court for the District of Hawaii (docket No. CV-83-0018MP) against the United States, the Internal Revenue Service, and certain Internal Revenue Service agents alleging, inter alia, that the January 1981 search was illegal and that the defendants had abused the grand jury process by shopping for a favorable grand jury, by violating grand jury secrecy, and by using the grand jury as a civil investigation tool. Through a number of unpublished orders, the District Court and the Court of Appeals for the Ninth Circuit rejected Mr. Kersting's claims. See Kersting v. United States, 865 F. Supp. 669, 674-675 (D. Haw. 1994). C. Assessments of Kersting Promoter Penalties Mr. Kersting's tax shelter activities did not lead to an indictment. However, in October 1989, the Commissioner assessed promoter penalties of $1,545,201 and $2,330,000 against Mr. Kersting, pursuant to sections 6700 and 6701, respectively, for the years 1982 through 1988.9 9 The District Court for the Sec. 6700 provides for imposition of a penalty of a percentage of the gross income derived from promoting an abusive tax shelter, and sec. 6701 provides for imposition of a penalty (continued...) - 19 District of Hawaii sustained the Commissioner's assessments. See Kersting v. United States, Civil Nos. 90-00304, 91-00747, 9200593 (D. Haw., Sept. 30, 1994). Mr. Kersting's appeal of that decision to the Court of Appeals for the Ninth Circuit, docket No. 94-16942, was argued and submitted on May 8, 1996, but subsequently withdrawn from submission (with an opportunity for supplemental briefing) until after this Court issues its opinion in these consolidated cases. D. Kersting Notice of Deficiency The Commissioner sent Mr. Kersting a notice of deficiency determining deficiencies in and additions to his Federal income taxes for the taxable years 1982 through 1988. The deficiencies were based upon the Commissioner's determination that cash payments of so-called leverage loan interest received by Kersting corporations, which were characterized by the District Court in the promoter penalty cases as "alter egos" of Mr. Kersting, and which the Court's Dixon II opinion characterized as fees paid to Mr. Kersting by program participants in exchange for tax deductions, were includable in Mr. Kersting's gross income. Mr. Kersting filed a timely petition for redetermination with this Court (assigned docket No. 7448-96), and the case was tried at a Honolulu special trial session that commenced January 27, 1999. 9 (...continued) of $1,000 (per incident) upon a person who knowingly aids or assists another in understating his tax liability. - 20 II. Notices of Deficiency Issued to Kersting Program Participants In 1982, respondent began to issue notices of deficiency to Kersting program participants, disallowing interest deductions claimed with respect to the stock purchase plan, the stock subscription plan, the leasing company plan, and the CAT-FIT plan for a number of taxable years. A. Form of Notices of Deficiency The notices of deficiency issued by respondent to many Kersting program participants used a common format, stating in pertinent part as follows: EXPLANATION OF ADJUSTMENTS 1. It is determined that the following amounts claimed on your income tax return as interest deductions are not allowable: Amount $--------- Purported Payee[10] Any entity owned, associated with, or controlled, either directly or indirectly, by Henry Kersting This disallowance is based on the determination that the transactions giving rise to the claimed interest deduction are shams. This disallowance is further based upon your failure to establish that the above amounts were paid or properly accrued, or that the transactions purportedly generating the claimed amounts resulted either in any bona fide indebtedness or in any enforceable and bona fide obligation to pay compensation for use or forbearance of money on indebtedness within the meaning of I.R.C. Section 163. Furthermore, if it is established that any portion of the above disallowed "interest" is a properly 10 In some instances, respondent's notices of deficiency listed specific Kersting corporations under "Purported Payee". - 21 allowable deduction, it is further determined that such interest constitutes interest in investment indebtedness and deduction of such amounts is limited under the provisions of I.R.C. 163(d). Further, and in support of a portion of the determined deficiency, if you establish that you are entitled to the above-mentioned interest deduction, it is determined that you improperly failed to report the income resulting from the same transaction. 2. It is determined that part of the underpayment of tax for the taxable year ____ is due to your negligent of [sic] intentional disregard of the rules and regulations. Consequently, the 5 percent addition to the tax is charged for ____ as provided by Section 6653(a) of the Internal Revenue Code. B. Thompson Notices of Deficiency John R. Thompson (Mr. Thompson) was a pilot with Continental Airlines from 1946 until his retirement in October 1982. Mr. Thompson became aware of Mr. Kersting's programs through a conversation with another pilot, Michael Provan (Mr. Provan), who had solicited other pilots to participate in Mr. Kersting's programs.11 The Thompsons began participating in Mr. Kersting's programs in 1977.12 In addition to their participation in 11 Mr. Provan, who was at one time the president of one of the Kersting companies, eventually became an adversary of Mr. Kersting. See infra p. 66. 12 Although the Thompsons participated in one of Mr. Kersting's programs during 1977, the Thompsons did not claim any Kersting-related interest deductions on their 1977 return because their accountant-return preparer refused to include them on the return. The record suggests that the Thompsons' 1978 tax return was prepared by Phil Scheff (an accountant recommended by Mr. Kersting) and that the Thompsons claimed Kersting program interest deductions on their return for that year. The Thompsons experienced audit problems with their 1978 tax return that were (continued...) - 22 certain programs that were the subject of this Court's opinion in Dixon II, the Thompsons, along with some 40 other investors, including Mr. Provan, participated in a transaction arranged by Mr. Kersting in early 1978 to acquire First Savings and Loan Association of Hawaii (First Savings). The Thompsons filed joint Federal income tax returns for 1979, 1980, and 1981 in which they claimed interest deductions attributable to their participation in certain Kersting programs. On May 5, 1983, June 13, 1984, and May 31, 1985, respondent mailed notices of deficiency to the Thompsons determining deficiencies in and additions to their Federal income taxes for the taxable years 1979, 1980, and 1981, as follows: Deficiency Sec. 6651(a) Additions to Tax Sec. Sec. 6653(a) 6653(a)(1) 1979 $18,161.00 1980 24,838.00 1981 36,294.52 ----$4,934.32 $908 ----- Year ----$1,958.28 Sec. 6653(a)(2) ----50 percent of the interest due on the deficiency Respondent further determined that the Thompsons were liable for increased interest for 1981 pursuant to section 6621(d).13 The 12 (...continued) due, in part, to their failure to attach to the return a Form W-2 showing the amount of tax that Continental Airlines had withheld from Mr. Thompson's wages. In early to mid-1986, the Thompsons' counsel, Samuel M. Huestis, negotiated a settlement of their tax liability for 1978. The record does not disclose the terms of the settlement. 13 Sec. 6621(d) was redesignated sec. 6621(c) by sec. 1511(c)(1)(A)-(C) of the Tax Reform Act of 1986 (TRA), Pub. L. 99-514, 100 Stat. 2744. We will hereinafter refer to the (continued...) - 23 Thompsons filed timely joint petitions for redetermination of the above-described deficiencies. C. Cravens Notices of Deficiency John R. Cravens was a pilot with American Airlines during 1979 and 1980. Mr. Cravens became aware of Mr. Kersting's programs through conversations with other pilots. The Cravenses filed joint Federal income tax returns for 1979 and 1980 in which they claimed interest deductions attributable to their participation in certain Kersting programs. On April 15, 1983, and March 20, 1984, respondent mailed notices of deficiency to the Cravenses determining deficiencies in and additions to their Federal income taxes for the taxable years 1979 and 1980, as follows: Year Deficiency Additions to Tax Sec. 6653(a) 1979 1980 $4,508.00 19,251.70 $225.40 962.59 The notice of deficiency issued to the Cravenses for 1979, while disallowing interest deductions of $9,810, included a credit for personal exemptions of $4,000, resulting in a net adjustment of $5,810. The notice of deficiency issued to the Cravenses for 1980 included disallowed interest deductions of $19,620 and, as an alternative to the disallowance of such interest, the inclusion of $18,000 in unreported dividend income from a Kersting controlled entity known as Candace Acceptance Corp. 13 (...continued) provision as sec. 6621(c). - 24 (Candace). The notice of deficiency issued to the Cravenses for 1980 also included the disallowance of two personal exemptions claimed for the Cravenses' children. The Cravenses filed timely joint petitions for redetermination contesting the abovedescribed notices of deficiency. The Cravenses' reporting position was unique among the test case petitioners insofar as the Cravenses had adjusted (reduced) their tax basis in their Candace stock by the amount of a "nontaxable distribution" from Candace in 1980. Having reduced the basis of their Candace stock, the Cravenses reported a capital gain of $7,200 on their 1980 tax return after surrendering the stock to Mr. Kersting in exchange for cancellation and return of the note evidencing their primary loan.14 D. Alexander Notices of Deficiency Denis Alexander (Mr. Alexander) is a broker and investor who first met Mr. Kersting in Los Angeles in the early 1960's. Mr. Alexander lent money to Mr. Kersting's subchapter S leasing corporations in the 1970's, participated in the acquisition of First Savings, and participated in some of the Kersting programs at issue in Dixon II. 14 Although the Cravenses' reporting position was unique insofar as they had reported a capital gain in a taxable year in dispute before the Court, we note that test case petitioners Robert L. and Carolyn S. DuFresne had also reported a capital gain (albeit in a year subsequent to the years in dispute) upon the surrender of stock in Charter Financial Corp. to Mr. Kersting. Like the Cravenses', the DuFresnes' capital gain was attributable to their reduction of the tax basis of their stock as opposed to an increase in its value. - 25 1. 1974 and 1975 Mr. Alexander and his wife, Freida, filed joint Federal income tax returns for the taxable years 1974, 1975, 1976, and 1977. Following an examination of their returns for 1974 and 1975, the Alexanders conceded certain adjustments proposed by respondent, resulting in agreed assessments of $2,133 and $811 for 1974 and 1975, respectively.15 However, because the Alexanders declined to agree to other proposed adjustments, respondent, on November 29, 1979, issued a notice of deficiency determining deficiencies of $4,891.83 and $40,760.38, respectively, in their Federal income taxes for 1974 and 1975. Respondent's deficiency determinations against the Alexanders for 1974 and 1975 were based, in part, on disallowance of interest deductions of $2,917 and $46,500, respectively, attributable to their participation in Kersting programs for those taxable years. Additional adjustments included disallowance of an $18,500 capital loss claimed by the Alexanders for 1974 on a sale of stock in Mendocino Financial Corp. and respondent's determination that they had failed to report a $59,080 capital gain for 1975 from a sale of real estate to the Cadillac Drive Apartments partnership. 15 The Alexanders were represented during the audit by their accountant, Gilbert Matsumoto (Mr. Matsumoto). Mr. Matsumoto had served as the accountant for some of Mr. Kersting's subchapter S leasing corporations, and Mr. Kersting had recommended that program participants use Mr. Matsumoto, among others, to prepare their tax returns. - 26 On February 28, 1980, the Alexanders filed a timely petition with the Court, assigned docket No. 2758-80, contesting the notice of deficiency for 1974 and 1975. 2. 1976 and 1977 Respondent also examined the Alexanders' joint income tax returns for 1976 and 1977. On April 17, 1986, respondent issued the Alexanders a notice of deficiency determining deficiencies in and additions to their 1976 and 1977 Federal income taxes, as follows: Year Deficiency Additions to Tax Sec. 6653(a) 1976 1977 $3,596 876 $180 44 Respondent also determined that the Alexanders were liable for increased interest for 1976 pursuant to section 6621(c). The deficiencies that respondent determined against the Alexanders for 1976 and 1977 resulted, in part, from respondent's disallowance of interest deductions of $8,665 and $12,993, respectively, attributable to their participation in Kersting programs for those years. Respondent also disallowed a $5,149 partnership loss claimed by the Alexanders for 1976 on their investment in the Avista Epsilon and Sarbonne partnership. On July 21, 1986, the Alexanders filed a petition through Mr. Kersting's office, assigned docket No. 30413-86, contesting the notice of deficiency for 1976 and 1977. - 27 E. Validity of Notices of Deficiency In Dixon II, the Court considered and rejected arguments by the test case petitioners represented by Mr. Izen that the notices of deficiency issued to them were invalid under Scar v. Commissioner, 814 F.2d 1363 (9th Cir. 1987), revg. 81 T.C. 855 (1983). After the evidentiary hearing in these proceedings, the Court rejected the Scar argument advanced by Mr. Jones on behalf of a Kersting participant who had settled his case before the trial of the test cases in Dixon II. See Richards v. Commissioner, T.C. Memo. 1997-149, supplemented by T.C. Memo. 1997-299, affd. without published opinion 165 F.3d 917 (9th Cir. 1998).16 F. Errors in Notices of Deficiency Although this Court rejected the argument that notices of deficiency issued to Kersting program participants were invalid, it is evident that some notices of deficiency issued to Kersting program participants did contain errors. For instance, in Richards v. Commissioner, supra, it appears that respondent overstated the deficiency using an excessive tax rate of 70 percent. In addition, the petition filed in the Richards case included an allegation that respondent disallowed interest 16 Although Luis C. DeCastro had negotiated the settlement on behalf of Mr. and Mrs. Richards, he did not participate in the filing or prosecution of Mr. Jones' motion to vacate the decision entered in their case. - 28 deductions in excess of Kersting interest deductions that the Richardses actually claimed.17 Similarly, as observed in the Court's Dixon II opinion, respondent's alternative determinations in the notice of deficiency issued to the Cravenses overstated their deficiency for 1980. The Court ordered that the Cravenses' deficiency for 1980 be reduced to account for: (1) The elimination of respondent's alternative determination that the Cravenses failed to report $18,000 in dividends paid by Candace; and (2) respondent's failure to eliminate the capital gain of $7,200 reported by the Cravenses for 1980 on the disposition of their Candace stock. III. Commencement of Kersting Project A. Tax Shelter Projects and Test Case Procedures 1. Overview The large volume of cases generated by the Commissioner's disallowances of deductions claimed by taxpayers participating in large tax shelter programs during the late 1970's and early 1980's created the largest inventory of cases ever docketed in the Tax Court. Among the responses of the Internal Revenue Service and the Tax Court were the development of procedures that 17 Test case petitioners Terry D. and Gloria K. Owens alleged in their petition that respondent disallowed legitimate interest deductions in their notice of deficiency. However, it appears that the allegation was not pursued by or on behalf of the Owenses, inasmuch as the decision entered by the Court in their case, following the issuance of the Court's opinion in Dixon II, was consistent with the deficiency determined by respondent. - 29 were intended to streamline the litigation process, economize on the use of administrative and judicial resources, and reduce the costs incurred by taxpayers in resolving disputes over tax shelter adjustments. The Internal Revenue Service, Office of Chief Counsel, created the Tax Shelter Branch in the National Office to oversee tax shelter litigation across the country and to organize individual tax shelter projects. Concurrently, the Tax Court began working with the Internal Revenue Service and private parties in tax shelter cases to create what became known as the test case procedure; i.e., the selection of representative or test cases from a particular tax shelter project for a single trial on the merits. See, e.g., Drobny v. Commissioner, T.C. Memo. 1995-209 (citing H. Conf. Rept. 98-861, at 985-986 (1984), 1984-3 C.B. (Vol. 2) 1, 239-240), affd. 113 F.3d 670 (7th Cir. 1997). The test case procedure is intended to streamline the litigation process. To this end, taxpayers who are not selected as test cases are encouraged to execute a piggyback agreement; i.e., a stipulation to be bound by the outcome of the test cases. As a practical matter, the effectiveness of the test case procedure depends in large part upon the agreement of the taxpayers not selected as test cases to be bound by the outcome of the test cases. Normally, taxpayers in a tax shelter project who decline or otherwise fail to sign a piggyback agreement will either have their cases set for trial with the test cases or, after the trial of the test cases, will be ordered to show cause - 30 why their case should not be decided the same way as the test cases. See, e.g., Krause v. Commissioner, 99 T.C. 132 (1992), affd. sub nom. Hildebrand v. Commissioner, 28 F.3d 1024 (10th Cir. 1994); Acierno v. Commissioner, T.C. Memo. 1997-441; Karlsson v. Commissioner, T.C. Memo. 1997-432. Using the order to show cause procedure to dispose of nontest cases in a tax shelter project is more cumbersome and consumes more time and judicial, administrative, and private party resources than using piggyback agreements. As discussed in greater detail below, the Court used the test case procedure in the Kersting project; the vast majority of the Kersting project participants signed piggyback agreements. 2. See infra pp. 34-41. National Office Tax Shelter Branch Functions The Tax Shelter Branch, established by the Office of Chief Counsel in the National Office, was given the responsibilities of coordinating the examination, appeals, and litigation functions and of overseeing tax shelter projects from the National Office perspective. The Tax Shelter Branch provided advice and prepared material for use by the field in tax shelter cases, reviewed legal briefs, monitored the status of tax shelter case inventory, and prepared reports for Internal Revenue Service executives. The Tax Shelter Branch monitored tax shelter projects by reviewing and extracting information from quarterly tax shelter reports that were required to be submitted by the project attorney; i.e., the District Counsel trial attorney with primary responsibility for the project. Each project attorney was - 31 required to submit a quarterly tax shelter report providing an update on the status of the project, including a summary of the current project settlement offer and any recent court action affecting the project. One of the goals of the tax shelter program was consistent treatment of similarly situated taxpayers. The Tax Shelter Branch monitored settlement offers in similar tax shelter projects for disparities and tried to determine whether the project settlement offers should be similar. However, actual supervisory responsibility in a tax shelter project was left primarily in the Regional Counsel and District Counsel offices to which the project was assigned. B. Petitions for Redetermination In or around June 1982, Mr. Kersting facilitated the filing of petitions with the Tax Court by Kersting program participants. In letters issued in June and July 1982, Mr. Kersting informed Kersting program participants that a joint petition was being prepared on behalf of a large group of taxpayers. On July 12, 1982, Lu N. Nevels, Jr., filed a consolidated Tax Court petition, assigned docket No. 17445-82, on behalf of 60 Kersting program participants.18 18 Lu N. Nevels, Jr., had represented the test case taxpayers in Pike v. Commissioner, 78 T.C. 822 (1982), affd. without published opinion 732 F.2d 164 (9th Cir. 1984). For an example of the problems created by using one petition on behalf of so many different petitioners, see Aaronson v. Commissioner, T.C. Memo. 1985-131, involving the Hongsermeier petitioners in what is now docket No. 29643-86. See infra p. 38. - 32 C. Brian J. Seery In early 1982, Brian J. Seery (Mr. Seery) began assisting Kersting program participants with issues arising from the audit of their income tax returns. On April 14, 1982, Mr. Kersting issued a letter to Kersting program participants informing them that they soon would receive a letter from the Commissioner proposing to disallow their Kersting program interest deductions. Mr. Kersting advised program participants that they should not remit any amount to the Internal Revenue Service until their liability was determined in court. On February 15, 1983, Mr. Kersting issued a letter to Kersting program participants stating in pertinent part: "I trust that you have placed the tax retrievals which we have accomplished for you over the years into profitable investments and that you are receiving a reasonable rate of return. You will not lose any ground if your funds earn at least a return equal to the interest charges imposed by the IRS from time to time." On March 1, 1985, Mr. Kersting issued a letter to Kersting program participants stating that he had retained Mr. Seery to represent them in the Tax Court at no charge to the individual petitioners.19 The letter requested that each Kersting program participant provide written authorization for Mr. Seery's 19 Initially, Mr. Kersting or the entities that he controlled paid the legal fees associated with the Tax Court litigation. Later, however, some Kersting program participants began paying $100 per month to a legal defense fund managed by Mr. Kersting. - 33 representation. In a letter to program participants dated August 11, 1986, Mr. Kersting recommended that program participants not attempt to resolve their cases on their own and instead rely on counsel that he had hired. Mr. Seery subsequently entered his appearance in the Tax Court on behalf of several hundred Kersting petitioners, including the Thompsons and the Cravenses. Mr. Seery's compensation for legal services rendered to Kersting program participants was always paid by one of the corporations controlled by Mr. Kersting. D. Respondent's Counsel 1. Kenneth W. McWade In 1970, Mr. McWade began his career as a trial attorney with the Office of Chief Counsel. Mr. McWade's duties with the Office of Chief Counsel included litigating tax cases. In January 1982, Mr. McWade transferred from respondent's District Counsel office in Seattle, Washington, to respondent's District Counsel office in Honolulu, Hawaii. Mr. McWade initially assisted with the Pike group of cases. On or about July 1, 1984, the Kersting project was officially established in the Honolulu Appeals Office, and Mr. McWade was appointed to serve as the project attorney. Wally Kobayashi was appointed to serve as the key Appeals officer for the Kersting project. By late 1986, Mr. McWade had litigated 40 to 50 Tax Court cases. However, Mr. McWade had never litigated any cases that were part of a tax shelter project. - 34 2. William A. Sims In 1972, Mr. Sims began his career with the Office of Chief Counsel, General Litigation Division, National Office. Except for a 6-month assignment doing Tax Court work, Mr. Sims handled general litigation matters concerning collection, bankruptcy, and tax liens. Mr. Sims eventually became Assistant Director of the General Litigation Division in the National Office. In February 1986, Mr. Sims was appointed District Counsel for Honolulu, Hawaii. Before his appointment as District Counsel, Mr. Sims had never worked on a tax shelter project in any capacity. E. Adoption of Test Case Procedures in Kersting Project 1. The Honolulu Session (June 1985) The Court set for trial the cases of approximately 375 Kersting program participants at a Tax Court session scheduled to commence on June 10, 1985, in Honolulu, Hawaii (the June 1985 session). Before the June 1985 session, Mr. McWade and Mr. Seery agreed to use the test case procedure in the Kersting project. During the June 1985 session, Mr. McWade and Mr. Seery discussed the use of the test case procedure with Judge Goffe during a chambers conference. During the conference, Mr. Seery informed Judge Goffe that, although he was representing petitioners who were Kersting program participants, he was being paid by Mr. Kersting. Judge Goffe indicated that he saw no conflict of interest as long as Mr. Seery had not participated in the - 35 planning or promotion of the Kersting programs. See Rule 24(f).20 Consistent with counsels' agreement to use the test case procedure in the Kersting project, Judge Goffe granted the parties' joint motions to continue the cases called at the June 1985 session. At the same time, the parties began filing piggyback agreements (discussed in greater detail below), which they did in the vast majority of the Kersting project cases. Mr. Seery reported the results of the June 1985 proceedings to Mr. Kersting and kept him abreast of developments. Mr. Seery relied upon Mr. Kersting to distribute correspondence from Mr. Seery to petitioners in the Kersting project. 2. Test Case Procedure Mr. McWade and Mr. Seery agreed to select test cases that would be representative of all the Kersting programs for all years in dispute, including the taxable years 1975 through 1983. At the time that Mr. Seery selected his test cases, he assumed that the test case petitioners would bear the burden of proof at trial. In selecting test cases, Mr. Seery was not concerned with whether a case involved other tax issues. Mr. Seery was simply looking for cases "where someone did everything right." 20 Rule 24(f), which became effective on July 1, 1990, see 93 T.C. 857, addresses conflicts of interest in Tax Court litigation. Rule 24(f) was redesignated Rule 24(g) effective Aug. 1, 1998. See 109 T.C. 542. - 36 Mr. Seery selected two or three test cases, including the Cravenses and the Hongsermeiers. In an effort to find the best cases for trial from petitioners' point of view, Mr. Seery selected test cases by reference to the manner in which the taxpayers had reported the transactions. Mr. Seery selected test cases that he thought he could win, but, as he testified at the evidentiary hearing, he had difficulty identifying such cases in addition to the Cravenses and the Hongsermeiers.21 Mr. Kersting and Mr. Cravens discussed having Mr. Cravens' case serve as a test case. Mr. Kersting told Mr. Cravens that Mr. Seery wanted to use him as a test case because, unlike other Kersting program participants, the Cravenses had reported a capital gain when they surrendered their stock in the Kersting holding company in conjunction with the annual termination of the Kersting program. The Cravenses' reporting position was consistent with Mr. Kersting's advice to program participants that distributions by Kersting holding companies used by program participants to pay the principal amount of leverage loans were tax-free returns of capital rather than taxable dividends. Mr. Seery viewed the Cravens cases as "unique" in this respect. Mr. Cravens believed that he had a choice whether his case would serve as a test case. 21 When Mr. Cravens agreed to have his Mr. Seery's testimony: "I was having trouble selecting cases beyond those two that I thought would be good vehicles for that." - 37 case serve as a test case, he did so without condition. He believed that he would win his case because he had correctly reported his tax liabilities, as reduced by reason of his participation in the Kersting programs. Mr. Seery selected the Hongsermeier case because it was his impression that the Hongsermeiers had used their own funds to pay the principal of a Kersting leverage loan, rather than using a "nontaxable distribution" from a Kersting holding company.22 Mr. Seery also selected the Hongsermeiers because they had participated in the CAT-FIT program, which Mr. Seery viewed as the strongest Kersting program from the standpoint of sustaining the interest deductions claimed. Mr. McWade analyzed between 400 and 500 project cases; he selected test cases that he thought would be representative of all Kersting programs for all years in dispute. Mr. McWade selected "clean" cases; i.e., cases that did not include issues other than Kersting interest deductions. Mr. McWade tried to avoid cases that were unique or atypical of the Kersting programs. Although Mr. McWade selected at least five of the test cases, he could not recall the specific cases that he selected. In June 1986, Mr. McWade and Mr. Seery agreed on the dockets that were to serve as the test cases. 22 By letter dated June 10, Mr. Seery's impression was not quite right. The Court found in Dixon II that the Hongsermeiers were unique insofar as they paid $250 per month out-of-pocket (rather than use the proceeds from a leverage loan) to satisfy the interest due on a CAT-FIT primary loan. See Dixon II, 62 T.C.M. (CCH) at 1480, 1991 T.C.M. (RIA), at 91-3023. - 38 1986, Mr. McWade notified Judge Goffe that he and Mr. Seery had selected the following 14 dockets to serve as test cases with respect to the Kersting project: Case Name Dixon v. Commissioner Cravens v. Commissioner Rina v. Commissioner Thompson v. Commissioner Young v. Commissioner Cravens v. Commissioner DuFresne v. Commissioner Thompson v. Commissioner Owens v. Commissioner Young v. Commissioner Young v. Commissioner Thompson v. Commissioner DuFresne v. Commissioner Hongsermeier v. Commissioner Docket No. 9382-83 16900-83 17640-83 19321-83 4201-84 15135-84 15907-84 31236-84 40159-84 22783-85 30010-85 30965-85 30979-85 1 29643-86 1 By order dated Aug. 13, 1986, the Court severed the Hongsermeiers from docket No. 17445-82 (the Aaronson consolidated petition filed by Mr. Nevels) and assigned them new docket No. 29643-86. See supra note 18 and accompanying text. With the exception of the Cravens case assigned docket No. 16900-83, and the Hongsermeier case assigned docket No. 17445-82, each of the test case petitioners had filed pro se petitions. By August 1986, Mr. Seery had entered his appearance in each of the test cases with the exception of the Young cases assigned docket Nos. 4201-84, 22783-85, and 30010-85, the DuFresne case assigned docket No. 30979-85, and the Thompson case assigned docket No. 30965-85. 3. Test Case Array The test case petitioners had participated in Kersting programs during the taxable years 1975 through 1983 as follows: - 39 Taxable Year 1975 Program Petitioner(s) CAT-FIT MAURIER LEASING1 NORWICK 20/20 Owens Owens Owens Taxable Year 1976 Program Petitioner(s) UNIVERSAL LEASING FORBES 30/30 Owens Owens Taxable Year 1977 Program Petitioner(s) CAT-FIT ESCON LEASING FARGO 30/30 NORWICK 20/20 Dixon Dixon Dixon Owens Taxable Year 1978 Program Petitioner(s) CAT-FIT CAT-FIT UNIVERSAL LEASING ESCON LEASING ESCON LEASING MAHALO 30/30 MAHALO 60/60 Hongsermeier Dixon Hongsermeier Dixon Hongsermeier Owens Dixon Taxable Year 1979 Program Petitioner(s) CAT-FIT CAT-FIT UNIVERSAL LEASING ANSETH LEASING ANSETH LEASING ESCON LEASING ESCON LEASING ESCON LEASING CANDACE 60/60 CANDACE 60/60 CANDACE 60/60 Hongsermeier Dixon Hongsermeier Rina Young Hongsermeier Dixon Thompson Dixon Cravens Rina - 40 CANDACE 60/60 CANDACE 60/60 CHARTER 80,000 CHARTER 120,000 INVESTORS 80,000 INVESTORS 120,000 Thompson Young Rina Young Rina Young Taxable Year 1980 Program Petitioner(s) CAT-FIT CAT-FIT CAT-FIT ANSETH LEASING ANSETH LEASING ANSETH LEASING ESCON LEASING ESCON LEASING ESCON LEASING CANDACE 60/60 CANDACE 60/60 DELTA 40/40 DELTA 60/60 DELTA 60/60 DELTA 60/60 DELTA 60/60 DELTA 60/60 DELTA 60/60 CHARTER 40,000 CHARTER 80,000 CHARTER 120,000 CHARTER 120,000 CHARTER 120,000 CHARTER 120,000 INVESTORS 80,000 INVESTORS 80,000 INVESTORS 80,000 INVESTORS 120,000 INVESTORS 120,000 Dixon DuFresne Hongsermeier Hongsermeier Rina Young Dixon Hongsermeier Thompson Cravens Rina Hongsermeier Cravens Dixon DuFresne Rina Thompson Young Rina Rina Dixon DuFresne Thompson Young DuFresne Rina Thompson Dixon Young Taxable Year 1981 Program Petitioner(s) ANSETH LEASING ESCON LEASING DELTA 60/60 CHARTER 120,000 CHARTER 120,000 CHARTER 120,000 Young Dixon Young Dixon DuFresne Young - 41 INVESTORS 80,000 INVESTORS 120,000 INVESTORS 120,000 DuFresne Dixon Young Taxable Year 1982 Program Petitioner(s) ANSETH LEASING CHARTER 120,000 CHARTER 120,000 INVESTORS 80,000 INVESTORS 120,000 Young DuFresne Young DuFresne Young Taxable Year 1983 Program Petitioner(s) ANSETH LEASING CHARTER 120,000 INVESTORS 80,000 Young DuFresne DuFresne 1 Maurier Leasing, a subch. S leasing program, was considered by the Court in Pike v. Commissioner, 78 T.C. 822 (1982). The notice of deficiency issued to the Thompsons for the taxable year 1981 states in pertinent part: "Based on examination information from the 1978, 1979, and 1980 returns, the investment interest is generated from the interest deduction tax shelter. The purported payees cannot be identified from the 1981 income tax return filed by the taxpayers." Respondent has not been able to identify specifically the Kersting programs that the Thompsons participated in during 1981. However, the record suggests that, in addition to the Kersting programs that the Thompsons participated in during 1979 and 1980, the Thompsons participated in the Anseth Leasing Program during 1981. If the Thompson and Cravens cases had been removed from the test case array, there would have been no reduction in coverage - 42 of the test cases. In other words, each program in which the Thompsons and Cravenses participated during the years in issue was also a program before the Court in which one or more of the other test case petitioners had participated. IV. The Maui Session (February 1987) After Messrs. Seery and McWade had selected the test cases, they initiated settlement negotiations and began to prepare the test cases for trial.23 Their trial preparations included work on a proposed stipulation of facts and an attempt to take Mr. Kersting's deposition. During this period (June 1986 or thereabout), Mr. Seery and Mr. Kersting's attorney, L.T. Bradt (Mr. Bradt), discussed using the 1981 search of Mr. Kersting's office as a basis for filing a motion to shift the burden of proof to respondent in the test cases. A. Trial Notices By letter dated July 30, 1986, Judge Goffe informed Messrs. Seery and McWade that the test cases would be set for trial during a special session of the Court commencing on February 9, 1987, in Wailuku, Maui, Hawaii (the Maui session). Judge Goffe's letter also informed Messrs. Seery and McWade that he intended to notify each Kersting petitioner who had not filed a piggyback agreement that his or her case would be set for trial during the Maui session. 23 Settlement negotiations between Mr. McWade and Mr. Seery are discussed in greater detail infra pp. 78-80. - 43 In August 1986, the Court issued orders setting the 14 test cases for trial during the Maui session. By letter dated August 5, 1986, Judge Goffe informed all Kersting petitioners who had not already executed piggyback agreements that their cases would be set for trial at the Maui session unless they executed piggyback agreements by September 29, 1986. Judge Goffe's letter states as follows: August 5, 1986 Dkt # Dear _______________: Your case involves matters concerning promotions by Henry Kersting. Cases with issues identical to the issues in your case have been set for trial on February 9, 1987, at the courtroom of the Circuit Court for the Second Circuit in Wailuku, Maui, Hawaii. In order to conserve the time and expense of the taxpayers, the government and the Court, all of the cases with identical issues will be tried at one time unless the parties agree in advance, in writing, to be bound by the outcome of the cases set for trial. In most of the pending cases, the parties have so agreed to be bound. You should contact at your earliest convenience the lawyer for the government in the Kersting cases if you decide to agree to be bound. He is Mr. Kenneth McWade, PJKK Federal Building, Room 3304, Box 50089, 300 Ala Moana Boulevard, Honolulu, Hawaii 96850. His telephone number is (808) 546-7333. If, however, you do not wish to be bound, you should advise my office promptly, in writing at the above address, in order that your case may be set for trial on February 9, 1987. In either event, you must advise Mr. McWade or me by September 29, 1986. If you fail to advise Mr. McWade by September 29, 1986, that you wish to be bound and have executed a stipulation to be bound by that time and if you fail to advise me by September 29, 1986, that you wish to have your case set for trial, it will automatically be set for trial on February 9, 1987. If your case is set for - 44 trial and you do not appear for trial, your case will likely be dismissed and you will be required to pay all of the income tax which the government contends you owe, plus interest thereon as provided by law. William A. Goffe Judge In November 1986, the Court issued orders notifying Kersting petitioners who had not filed piggyback agreements that their cases were set for trial at the Maui session. As additional Kersting project cases were docketed and identified, the Court issued orders setting them for trial at the Maui session, subject to being stricken if the parties executed a piggyback agreement. B. Piggyback Agreements As early as June 1985, Kersting program participants had begun executing piggyback agreements (1985 piggyback agreements),24 drafted by Messrs. McWade and Seery, that stated as follows: Stipulation of Settlement for Tax Shelter Adjustments With respect to all adjustments in respondent's notice of deficiency relating to the Kersting interest deduction tax shelter(s), the parties stipulate to the following terms of settlement: 1. The term Kersting programs refers to interest expense deductions or other related deductions associated with various programs promoted by Henry Kersting. 2. The Kersting program deduction adjustments shall be redetermined on the same basis that the same program adjustments are resolved with respect to taxpayers trying the same program adjustments at the 24 Before 1987, there was no uniform format for piggyback agreements. In 1987 or early 1988, respondent's Tax Shelter Branch issued a standard form of piggyback agreement. - 45 June 10, 1985 session of the Court in Honolulu, Hawaii, or such session as these cases may be adjourned or continued to by the Court (hereinafter "TRIED CASE"). 3. All issues involving the Kersting programs shall be resolved as if the petitioner(s) in this case is the same as the taxpayers in the TRIED CASE; 4. A decision shall be submitted in this case when the decision in the TRIED CASE is entered; 5. Following entry of the decision in this case, petitioner(s) consents to the assessment and collection of the deficiencies, attributable to the adjustments formulated by reference to the Tax Court's opinion, notwithstanding the restrictions contained in I.R.C. § 6213(a); 6. The petitioner(s) in this case will testify or provide information in any case involving the same tax shelter adjustments, if subpoenaed; and 7. The petitioner(s) in this case consents to the disclosure of all tax returns and tax return information for the purpose of respondent's discovering or submitting evidence in any case involving the same Kersting shelter adjustments. The parties agree to this stipulation of settlement. Piggyback agreements executed by Kersting program participants after 1985 differed from those executed in 1985. particular, post-1985 piggyback agreements stated as follows: Stipulation of Settlement for Tax Shelter Adjustments With respect to all adjustments in respondent's notice of deficiency relating to the Kersting interest deduction tax shelter(s), the parties stipulate to the following terms of settlement: 1. The Kersting interest deduction tax shelter adjustments shall be redetermined on the same basis that the same tax shelter adjustments are resolved with respect to taxpayers trying the same shelter adjustments at the February 9, 1987 session of the Court in Wailuku, Maui, Hawaii, or such session as In - 46 these cases may be adjourned or continued to by the Court (hereinafter "TRIED CASE"). 2. All issues involving the Kersting interest deduction tax shelter(s) shall be resolved as if the petitioner(s) in this case is the same as the taxpayers in the TRIED CASE; 3. A decision shall be submitted in this case when the decision in the TRIED CASE becomes final under I.R.C. § 7481; 4. Following entry of the decision in this case, petitioner(s) consent to the assessment and collection of the deficiencies, attributable to the adjustments formulated by reference to the Tax Court's opinion, notwithstanding the restrictions contained in I.R.C. § 6213(a); 5. The petitioner(s) in this case will testify or provide information in any case involving the same tax shelter adjustments, if subpoenaed; and 6. The petitioner(s) in this case consents to the disclosure of all tax returns and tax return information for the purpose of respondent's discovering or submitting evidence in any case involving the same shelter adjustments. 7. If the Court determines the I.R.C. § 6621(d) penalties are applicable in the test case controlling petitioner's(s') case, then the petitioner(s) concedes that I.R.C. § 6621(d) is applicable to any underpayment of tax determined in their case(s) attributable to the Kersting interest deduction tax shelter(s), if such underpayment exceeds $1,000.00 in any one taxable year. 8. With respect to adjustments in respondent's notice of deficiency relating to additions to the tax under I.R.C. § 6653(a), the parties agree to the following: (a) Respondent concedes that the petitioner(s) are not liable for additions to tax under I.R.C. § 6653(a) or § 6653(a)(1) or § 6653(a)(2) for any year prior to the taxable year 1982. The parties agree to this stipulation of settlement. - 47 - In sum, whereas paragraph 4 of the 1985 piggyback agreements states that a decision will be entered in the piggyback case following entry of decision in the test cases, paragraph 3 of the post-1985 piggyback agreements states that a decision will be entered in the piggyback case once the decision in the test cases becomes final.25 210. See Gridley v. Commissioner, T.C. Memo. 1997- Unlike 1985 piggyback agreements, post-1985 piggyback agreements state (at paragraph 7) that petitioners agree to be bound to the Court's holding in the test cases respecting the applicability of increased interest under section 6621(c) on any underpayment of tax of more than $1,000. Further, while 1985 piggyback agreements make no reference to additions to tax, post1985 piggyback agreements state (at paragraph 8) that petitioners are not liable for additions to tax for negligence for any year before the taxable year 1982.26 25 Despite this distinction, respondent did not move for entry of decision--upon entry of decisions in the Kersting test cases in early 1992--in any of the cases in which Kersting petitioners had executed the 1985 version of the piggyback agreement. Respondent has taken the position that no decisions should be entered in any of the piggyback cases until the decisions in the test cases become final. Cf. Abatti v. Commissioner, 859 F.2d 115 (9th Cir. 1988), affg. 86 T.C. 1319 (1986). 26 Although the record does not reveal why post-1985 piggyback agreements limit respondent's concession of additions to tax for negligence to taxable years before 1982, a plausible explanation for selecting 1982 as the line of demarcation would be that the Tax Court had released its opinion in Pike v. Commissioner, 78 T.C. 822 (1982), in May 1982, putting taxpayers on notice for 1982 and later taxable years that Mr. Kersting's programs did not generate legitimate interest deductions. - 48 When Messrs. McWade and Seery drafted the piggyback agreements, Mr. Seery did not consider the possibility that a test case might be settled.27 Nontest case petitioners Ronald L. and Mattie E. Alverson (docket No. 17646-83) executed their piggyback agreement in June 1985. Nontest case petitioners Anthony E. and Carol A. Eggers (docket No. 7323-84), John L. and Terry E. Huber (docket No. 20119-84), Stanley C. and Sharon A. Titcomb (docket No. 1799295), and Richard B. and Donna G. Rogers (docket No. 17993-95) executed piggyback agreements in late November 1986. Nontest case petitioners Norman W. and Barbara L. Adair (docket No. 35608-86) executed their piggyback agreement in March 1987. Nontest case petitioners Willis F. McComas, II and Marie D. McComas (docket No. 19464-92), Wesley Armand and Sherry Lynn Cacia Baughman (docket No. 621-94), Joe A. and JoAnne Rinaldi (docket No. 7205-94), and Norman A. and Irene Cerasoli (docket No. 9532-94) did not execute piggyback agreements for their cases on these dockets. C. Mr. Seery's Withdrawals as Counsel During late 1986 and early 1987, and shortly before the Maui session, Mr. Seery began to withdraw as counsel in the Kersting cases in the circumstances described below. 27 A piggyback agreement that binds the piggyback case to the outcome of the test case, whether by litigation or settlement, is not unprecedented. See, e.g., Fisher v. Commissioner, T.C. Memo. 1994-434. - 49 1. The Thompsons In 1985, the Thompsons had retained Samuel M. Huestis (Mr. Huestis) to prepare an estate plan for them. Eventually, the scope of Mr. Huestis' representation was extended to include settlement of the Thompsons' 1978 tax liabilities and their dispute with Mr. Kersting, as described infra pp. 56-67. One result of that dispute was Mr. Huestis' letter of September 10, 1986, to Mr. Seery, notifying him that the Thompsons were seeking substitute counsel and requesting the Thompson files. On September 15, 1986, Mr. Seery sent the Thompson files to Mr. Huestis and informed him that the Thompsons were test case petitioners. Mr. Seery indicated that he was withdrawing as the Thompsons' counsel in the Tax Court. On October 28, 1986, Mr. Huestis wrote to Mr. Seery to express dissatisfaction with the sufficiency of the Thompsons' files and to warn Mr. Seery that his earlier representation of the Thompsons, while he was also apparently representing Mr. Kersting, could be viewed as a conflict of interest and lead to an action for "professional negligence". On October 31, 1986, Mr. Seery filed motions to withdraw as counsel in the Thompsons' cases.28 The Court granted Mr. Seery's motions in November 1986. 28 Mr. Seery had entered his appearance only in the Thompson cases assigned docket Nos. 19321-83 and 31236-84, not docket No. 30965-85. - 50 In the interim, Mr. Huestis assisted the Thompsons in locating and interviewing Mr. DeCastro to serve as their counsel in the Tax Court.29 On November 15, 1986, Mr. Thompson and Mr. DeCastro's associate, Phillip Hoskins, executed a retainer agreement under which Mr. Thompson agreed to pay Mr. DeCastro $5,000 for his effort to negotiate a settlement of the Thompson tax cases. The agreement provided that the retainer fee was limited to settlement negotiations and did not include preparation for or representation at trial. In early January 1987, Mr. DeCastro filed an entry of appearance in the Thompson cases. 2. The Test Cases On November 7, 1986, Mr. Seery filed a motion to change the place of trial of the test cases from Maui to Honolulu. Mr. Seery asserted that a trial in Maui would be inconvenient and a hardship to Mr. Kersting, who lived and operated a business in Honolulu. Mr. Seery's motion included the statement that 4. Mr. Kersting is providing the financial support for the litigation of this and the related cases and the additional expense involved in transporting witnesses and staff to Wailuku as well as paying for accommodations for the staff while in Wailuku is a great financial burden to him. On November 14, 1986, the Court issued an order denying Mr. Seery's motion to change the place of trial. 29 In so doing, Mr. Huestis had initially referred the Thompsons to a law firm, Loeb & Loeb, in Los Angeles, California. The Loeb firm declined to represent the Thompsons because of the short time to prepare for the Maui session and the incompleteness of the Thompson files. - 51 the Court noted that the motion "implies that * * * [Mr. Seery] represents not only petitioners but also Henry Kersting, the promoter of the tax shelters which are the subject of this litigation." The Court went on to observe that, if Mr. Seery were representing both Mr. Kersting and petitioners, the dual representation would constitute a conflict of interest. The Court attached to the order copies of several authorities concerning conflicts of interest, including Adams v. Commissioner, 85 T.C. 359 (1985). Mr. Seery subsequently filed motions to withdraw as counsel in the Kersting project cases (both test cases and nontest cases), citing concerns about a possible conflict of interest. The Court granted Mr. Seery's motions. By letter dated December 12, 1986, Mr. Kersting informed Kersting program participants that Judge Goffe had "inferred" that Mr. Seery might have a conflict of interest. Although Mr. Kersting denied that he was represented by Mr. Seery, he stated that he and Mr. Seery had decided that it would be prudent for Mr. Seery to withdraw as counsel. Mr. Kersting further stated that substitute counsel had been retained to represent test case and nontest case petitioners alike. D. Entries of Appearance by Chicoine and Hallett Following Mr. Seery's withdrawal, Mr. Bradt recommended that Mr. Kersting hire Mr. Izen to serve as counsel for the test - 52 cases.30 However, Mr. Kersting, with his son-in-law, an attorney, Roger Moseley (Mr. Moseley), contacted Robert J. Chicoine (Mr. Chicoine) and Darrell D. Hallett (Mr. Hallett) (collectively Chicoine and Hallett), to determine whether they would represent the test case petitioners at the Maui session. On November 22, 1986, Mr. Kersting sent Mr. Hallett a letter describing the Kersting programs. Shortly thereafter, Mr. Kersting interviewed Mr. Hallett in Hawaii. On December 9, 1986, Chicoine and Hallett reached an agreement with Mr. Kersting to represent the test case petitioners (other than the Thompsons). On December 12, 1986, Mr. Kersting wrote to Kersting program participants informing them that Mr. Seery had withdrawn as counsel and that Chicoine and Hallett had been retained. At the same time, either Mr. Kersting or Chicoine and Hallett informed the test case petitioners that they would have to provide Chicoine and Hallett with written authorization to enter appearances in their cases. Although Mr. Seery sent Chicoine and Hallett his files for the test cases, most of the documents that Mr. Seery had intended to use at trial remained in Mr. Kersting's possession. By letter dated December 19, 1986, Chicoine and Hallett reminded Mr. Kersting that they needed all documents in the possession of Mr. Kersting and Mr. Seery that pertained to the Kersting programs in dispute in the Tax Court. 30 to 1981. Mr. Bradt and Mr. Izen had been law partners from 1978 - 53 By letter dated January 7, 1987, Chicoine and Hallett outlined the conditions underlying their agreement with Mr. Kersting to represent the test case petitioners in the Tax Court. Chicoine and Hallett's letter states in pertinent part: Our representation is conditioned upon the following however: 1. We will represent only the individuals selected as test cases and who request us to do so. We are not representing or acting on behalf of any other taxpayers or litigants who have invested in various companies in which you are affiliated and who have stipulated to be bound by the outcome of the litigation or desire legal advice with respect to whether they should accept the Internal Revenue Service's settlement proposal. 2. All parties understand and agree that under the circumstances, the Petitioners involved in the test cases who have expressly authorized us to represent them will be our clients and that we do not represent you individually, although you have agreed with those Petitioners that you will pay the legal fees to defer [sic] the costs of their defense. We will discuss the fee arrangement with each of the Petitioners in the test cases and their perception of any possible conflict of interest which we would require that they waive. 3. It is understood that there will be no restrictions on the advice which we may provide to our clients and after review of the relevant facts and documents, we are free to propose such settlements as we may deem appropriate. We need not proceed with trial in any situation if which we consider our position to be indefensible or frivolous. In early January 1987, Messrs. Chicoine and Hallett filed entries of appearance as counsel in each of the test cases other than the Thompson and Cravens cases. As discussed in greater detail infra pp. 100-106, at the time of Mr. Seery's withdrawal from the Cravens cases, - 54 Mr. Cravens and Mr. McWade had agreed to a settlement of the Cravens cases. After reaching an agreement with Mr. McWade, Mr. Cravens did not authorize Chicoine and Hallett to enter an appearance in his cases. E. Evidentiary Issues After undertaking to represent the test case petitioners, Chicoine and Hallett decided to challenge their deficiency notices on the ground that the search of Mr. Kersting's office in January 1981 had been illegal. Chicoine and Hallett thereupon filed motions for leave to file amendments to the petitions and lodged the amendments with the Court. The amendments included arguments that the materials seized by the Internal Revenue Service during the search of Mr. Kersting's office should be suppressed at trial of the test cases and that the burden of proof and burden of going forward with evidence should be shifted to respondent. On January 14, 1987, the Court granted Chicoine and Hallett's motions for leave to file amendments to the petitions and subsequently directed respondent to file answers to the petitions as amended. 1. The Maui Session Although the test cases were originally scheduled for trial at the Maui session, the trial was delayed by the need to use the Maui session to receive testimony and evidence on the evidentiary issues raised by Chicoine and Hallett. Mr. McWade and Henry E. O'Neill (Mr. O'Neill), another trial attorney assigned to the Honolulu District Counsel Office, - 55 appeared on behalf of respondent at the Maui session. Mr. DeCastro appeared at the Maui session on behalf of the Thompsons. The Cravenses did not appear at the Maui session. Following the Maui session, the Court ordered respondent and petitioners, by May 18 and June 17, 1987, respectively, to file opening and reply briefs addressing the evidentiary issues raised by Chicoine and Hallett. On motions by the parties, the Court extended the dates for the filing of opening and reply briefs to June 8 and August 10, 1987, respectively. 2. Dixon I Opinion On February 11, 1988, the Court issued its Dixon I opinion rejecting Chicoine and Hallett's evidentiary arguments. Specifically, the Court held that petitioners had failed to establish standing to contest the Kersting search. Dixon v. Commissioner, 90 T.C. 237 (1988). By order dated July 1, 1988, the Court set the test cases for trial in San Diego, California, on January 9, 1989. By order dated October 24, 1988, the Court granted Mr. Izen's motion to reconsider and set the test cases for trial in Honolulu, Hawaii, on January 9, 1989. V. Kersting Disputes With Program Participants Before the trial of the test cases, Mr. Kersting had disputes, summarized below, with the Thompsons and the Alexanders. - 56 A. The Thompsons 1. The Bauspar Program On August 13, 1979, the Thompsons purchased a condominium unit in Wahiawa, Hawaii (the Wahiawa property), from Pacific Universal Corp. (not a Kersting company). On April 24, 1981, the Thompsons entered a Kersting program known as Bauspar--not one of the Kersting programs in dispute at the trial of the test cases-to effect the payoff of seller-provided financing on the Wahiawa property. The Thompsons executed a first mortgage and promissory note reflecting a loan from Bauspar, Inc. (Bauspar), in the principal amount of $80,000. The Thompsons agreed to repay the $80,000 Bauspar loan, with interest at 7 percent per year, through monthly payments of principal and interest of $532.24 for a 10-year period, followed by a balloon payment of $69,182.47.31 In conjunction with the Bauspar loan, the Thompsons agreed to purchase $80,000 worth of Bauspar stock. The Thompsons borrowed $80,000 to purchase the Bauspar stock from another Kersting company, Paragon Investments, Inc. (Paragon), at an annual interest rate of 18 percent. The Thompsons further agreed to participate in a "savings program" by depositing $1,200 per month into an account with Citizen's Financial, Inc. (Citizen's Financial), another Kersting company. On August 12, 1982, the Thompsons agreed to sell the Wahiawa property to Kevin and Ada Shea for $122,500 by an "Agreement of 31 It appears that the Thompsons actually made monthly payments of $535 to Bauspar. - 57 Sale" under which the Thompsons apparently took back a purchase money mortgage on the property. The Thompsons continued to participate in the Bauspar program until 1986 when the Sheas decided to sell the Wahiawa property to a third party. On January 30, 1985, Mr. Kersting sent Mr. Thompson a schedule listing the interest payments that Mr. Thompson had made during 1984 as follows: Payee Amount Bauspar, Inc. Paragon Investments, Inc. Citizens Financial, Inc. $6,420.00 9,611.04 14,400.00 Upon sale of the Wahiawa property by the Sheas in 1986, Bauspar received a check in the amount of $75,511.74 in satisfaction of the principal amount remaining due on the Thompsons' loan from Bauspar. 2. Deterioration of Thompson/Kersting Relationship While working on the Thompsons' estate plan, Mr. Huestis asked Mr. Kersting for an accounting of the Thompsons' investments in Kersting programs. By letter dated March 3, 1986, Mr. Kersting responded by providing Mr. Huestis a summary list of the Kersting programs that the Thompsons had participated in during 1977, 1978, 1979, 1980, and 1981. By letter dated March 12, 1986, Mr. Huestis informed Mr. Kersting that the Thompsons wished to terminate their participation in all Kersting programs and obtain a complete accounting of their investments. Mr. Huestis also requested that all future communications - 58 regarding the matter be directed to Mr. Huestis rather than to the Thompsons. By letter dated March 17, 1986, Mr. Kersting complained to Mr. Huestis about his "assertive approach" and said he would continue to communicate directly with the Thompsons. By letter dated March 17, 1986, Mr. Kersting wrote to Mr. Thompson, confirmed that he would terminate Mr. Thompson's programs, and inquired whether Mr. Thompson still had any stock certificates issued in connection with his participation in Kersting programs. Mr. Kersting's letter also states that Mr. Thompson would incur tax liability for capital gains that would be realized upon the termination of his accounts in the Kersting programs. On March 21, 1986, Mr. Huestis again wrote to Mr. Kersting, stating that the Thompsons were disappointed with Mr. Kersting's failure to respond to their requests or to assist them with the tax problems arising from their participation in his programs. By letter to the Thompsons dated March 25, 1986, Mr. Kersting confirmed that he would liquidate their investments, as discussed with Mr. Thompson in a recent telephone conversation. Mr. Kersting requested that Mr. Thompson endorse all relevant stock certificates and return them to Mr. Kersting so that the proceeds from the sale of stock represented by such certificates could be used to retire Mr. Thompson's debts to Kersting companies. By letter dated March 31, 1986, Mr. Kersting wrote to Mr. Thompson and admitted that he was having difficulty - 59 reconciling Mr. Thompson's Bauspar account because Earl LeMond, Mr. Kersting's son-in-law and the manager of the Bauspar program, did not keep reliable records. Nonetheless, Mr. Kersting prepared an accounting of Mr. Thompson's Bauspar account indicating that Mr. Thompson had paid $90,769.72 under the program and had received nontaxable dividends of $27,000 and Federal tax and State income tax savings (presumably from interest deductions) of $36,307.79 and $9,000, respectively. Mr. Kersting further indicated that, in light of Mr. Thompson's apparent dissatisfaction, he would waive the normal requirement that the Bauspar program run for a 10-year period, allow Mr. Thompson to terminate the program prematurely, and pay Mr. Thompson $27,000 reflecting 3 years of "equity build-up" in the program. On the basis of his accounting, Mr. Kersting concluded that Mr. Thompson would realize a net gain of $8,538.07 from the Bauspar program. Mr. Kersting advised Mr. Thompson to check his accounting carefully, and that, if necessary, Mr. Kersting would make adjustments in Mr. Thompson's favor to avoid a legal dispute. On March 31, 1986, Mr. Kersting wrote a second letter to Mr. Thompson stating that the Thompsons owed a total of $11,844 to Avalon Acceptance Corp., Aztec Acceptance Corp., Mahalo Acceptance Corp., Lombard Acceptance Corp., and Candace, for interest due on leverage notes during 1983 and 1984. Mr. Kersting's letter states in pertinent part: - 60 I will assume that you will take the position that you should not be paying interest on notes which produced deductions which you might not have used. While this, of course, would not go well with a bank or Credit Union (they would charge you interest whether you use the deductions or not) I am willing to make adjustments to your advantage. To get that underway I suggest that you tell us which of the deductions were claimed by you in 1983 and 1984. * * * * * * * To keep the spirit of accommodation alive and to remove all elements of dissatisfaction we are quite willing to lean over into your direction. It has troubled me considerably that of all people you would be displeased with our services. On May 6, 1986, Mr. Thompson wrote to Mr. Kersting requesting a full accounting for his participation in the Bauspar program. Mr. Thompson informed Mr. Kersting that the property subject to the Bauspar mortgage had been sold. Mr. Thompson also said that he was reminding Mr. Kersting that, upon his retirement in 1982, he had asked to terminate his participation in the programs for which Mr. Kersting was now seeking interest payments for leverage loans. Beginning in June 1986, Mr. Thompson stopped making the $1,200 monthly deposits to Citizens Financial as required under the Bauspar program. At the same time, Mr. Thompson ignored Mr. Kersting's written requests to explain his failure to make the deposits. Further, on June 23, 1986, at the suggestion of Mr. Huestis, the Thompsons retained John A. Chanin (Mr. Chanin), an attorney practicing in Honolulu, to assist them in their dispute with Mr. Kersting. Mr. Chanin assigned the matter to his associate, Keith Y. Yamada (Mr. Yamada). - 61 On August 1, 1986, Mr. Yamada spoke with Mr. Kersting by telephone and requested a detailed accounting of the amounts that the Thompsons had paid to Bauspar and Citizen's Financial, as well as a status report on the promissory notes executed by the Thompsons in favor of Bauspar, Signet Financial, Inc., and Paragon. Following the telephone call from Mr. Yamada, Mr. Kersting called Mr. Thompson. During this conversation, Mr. Thompson reminded Mr. Kersting that the Wahiawa property had been sold. Mr. Kersting stated that he would provide Mr. Chanin with copies of the documents relating to Mr. Thompson's participation in the Bauspar program as soon as Mr. Thompson provided Mr. Kersting with a written authorization to release them. By letter dated August 23, 1986, Mr. Kersting notified the Thompsons that he had turned their file over to Mr. Moseley for collection and that he sensed that litigation was imminent. Mr. Kersting's letter states in pertinent part: Since the odds, however, are in favor of imminent litigation I consider it to be my obligation to point out to you the consequences: The day after you have allowed your attorneys to file suit I will declare all notes which you have executed to our companies in default and begin collection proceedings. We will make an effort to collect from you not only the $11,844.00 of interest on promissory notes of which we have sent you billings several times we will also file suit to collect the principal of all notes which we hold. The aggregate sum is well in excess of $250,000.00, as you know. I will also ask you to return to us the $40,000.00 we advanced to you after the First Savings debacle. We will start collection proceedings on the $75,000.00 - 62 note which you executed in favor of FEDERATED FINANCE COMPANY to facilitate the acquisition of your stock in First Savings & Loan Ass. We will ask you to pay a pre-payment penalty on your mortgage on the house in Wahiawa. We will NOT arrange for you a capital gain in your BAUSPAR HOLDINGS INC. stock which I had considered-even though not due you because of premature withdrawal from the Plan--and we will NOT render assistance in saving you capital gains taxes on the re-capture of basis in your stock holdings. We will NOT provide legal assistance free of cost to you any longer in US Tax Court proceedings. You will have to retain your own attorney to make an appearance for you on February 9/1987 in US Tax Court. By letter dated August 24, 1986, Mr. Kersting notified Mr. Seery that he expected to be in litigation with the Thompsons and directed Mr. Seery not to "render any services, at our expense," to the Thompsons. By letter dated August 28, 1986, Mr. Huestis notified Mr. Moseley that he represented the Thompsons in connection with their Kersting transactions and the pending Tax Court litigation. Mr. Huestis advised Mr. Moseley to direct all future communications regarding the Thompsons to Mr. Chanin.32 By letter dated September 5, 1986, Mr. Kersting again notified Mr. Seery of his dispute with the Thompsons and the likelihood of litigation. Mr. Kersting included a copy of Mr. Huestis' August 28, 1986, letter to Mr. Moseley. 32 As previously mentioned, this was around the time that Mr. Seery began the process of withdrawing as counsel for the Thompsons, following Mr. Huestis' notification to Mr. Seery that the Thompsons were in the process of retaining substitute counsel. - 63 Mr. Kersting told Mr. Seery that he considered it "mandatory" that the Thompsons be removed as test case petitioners. On September 24, 1986, Mr. Kersting again wrote to Mr. Seery, reminding him of the need to remove the Thompsons from the list of test cases. During this period, Mr. Thompson began talking with other Kersting program participants about filing a class action lawsuit against Mr. Kersting. On January 1, 1987, Mr. Kersting wrote to Bill Witthorne, a Kersting program participant, requesting help in dealing with Mr. Thompson. Mr. Kersting's letter states in pertinent part: Yet, I consider it important that someone would bring home to Jack the dangers of the action he has in mind. He has been hoodwinked by the attorneys out in California and I think he is blind to the ramifications. Can you think of anyone in California who is close to Jack and willing to talk to him? That same day Mr. Kersting wrote to Benness M. Richards, another Kersting program participant, stating in pertinent part: We have been unsuccessful over the last six months or so to convince Jack that he will be better off with the legal representation provided by us. Neither has anyone be [sic] able to bring home to him that the IRS does NOT make him a better deal than offered to all the other Petitioners. On March 10, 1987, Mr. DeCastro and Mr. Huestis informed Mr. Thompson that Mr. Kersting would not return the Thompsons' promissory notes. Mr. DeCastro indicated that he wanted to discuss the possible involvement of his firm in bringing legal action against Mr. Kersting. On April 10, 1987, Mr. Thompson wrote a letter to other Kersting program participants, saying that Mr. Kersting had - 64 deceived him. In his letter, Mr. Thompson said that he had gone to Mr. Kersting to reduce his tax liabilities but that he now believed the cost to him would be great because the Internal Revenue Service was challenging Mr. Kersting's programs. Mr. Thompson suggested that the biggest worry for Kersting program participants was Mr. Kersting's "ultimate weapon", the promissory notes. Mr. Thompson enclosed a copy of a letter that he had received from Mr. Kersting as an example of what the others might face.33 Mr. Thompson informed the other participants that, although Mr. Kersting had promised to cancel all promissory notes in exchange for the surrender of the Kersting company stock that was purchased with the proceeds of the primary loan, Mr. Thompson had tried to surrender his Kersting company stock but Mr. Kersting had refused to cancel Mr. Thompson's promissory notes. Mr. Thompson indicated that he no longer trusted Mr. Kersting, and that he had retained Mr. DeCastro. By letter dated May 5, 1987, Mr. Yamada advised Mr. Thompson that a lawsuit against Mr. Kersting would have merit, and that a class action lawsuit should be considered. Around this time, Mr. DeCastro had proposed to file suit on behalf of the Thompsons against Mr. Kersting in Federal District Court. 33 Although the Court's copy of Mr. Thompson's Apr. 10, 1987, letter does not include a copy of a letter from Mr. Kersting, we assume that Mr. Thompson circulated Mr. Kersting's letter of Aug. 23, 1986. - 65 On May 26, 1987, Mr. Huestis called Mr. DeCastro and learned that, after Mr. Kersting had obtained a copy of Mr. Thompson's April 10, 1987 letter, Mr. Moseley had written to Mr. DeCastro on behalf of Mr. Kersting and proposed a settlement of the Kersting/Thompson dispute. During a later meeting that day with Mr. Thompson, Mr. Huestis agreed to contact another lawyer in Honolulu, Charles R. Kozak (Mr. Kozak), to discuss whether Mr. Kozak might represent the Thompsons in a lawsuit against Mr. Kersting. On May 27, 1987, Mr. Huestis contacted Mr. Kozak on behalf of the Thompsons. Mr. Kozak informed Mr. Huestis that he had represented two other Kersting participants (David L. Bigelow34 34 David L. Bigelow and Patricia L. Bigelow had participated in the CAT-FIT program during the taxable years 1975 and 1976. In Bigelow v. Commissioner, T.C. Summary 1983-6 (docket No. 3147-78S), the Court held that the Bigelows were entitled to interest deductions that they had claimed under the CAT-FIT program, partly on the basis of evidence that the Bigelows had successfully sued a related Kersting finance company in State court. Because the Bigelows' case was tried under the small tax case procedure, the case was not subject to appeal and is not treated as precedent for any other case. See sec. 7463(b). Mr. Kozak had represented Mr. Bigelow in a lawsuit against Mr. Kersting for payment of the "equity build-up" in a mortgage funding program (presumably Bauspar) following Mr. Bigelow's termination of the program. Mr. Bigelow won the suit and collected damages. According to Mr. Kozak, Mr. Bigelow had prevailed by virtue of Mr. Kersting's promise not to enforce notes that Mr. Bigelow had signed in connection with his participation in other Kersting programs. Mr. Bigelow used Mr. Kersting's written promise that he would not enforce promissory notes to prevent Mr. Kersting from asserting the principal on the notes as a defense or offset to Mr. Bigelow's claim to the equity buildup in the mortgage funding program. - 66 and Michael Provan35) and that he knew the Kersting programs and how to locate Mr. Kersting's assets.36 On June 2, 1987, Mr. Huestis agreed to send a copy of the Thompson file to Mr. Kozak. On the same date, Mr. Huestis notified Mr. Yamada that the Thompsons did not plan to retain the Chanin firm to bring suit against Mr. Kersting. Messrs. Bigelow, Provan, and Thompson all asked Mr. Kozak to investigate the filing of a lawsuit against Mr. Kersting. On August 6, 1987, Mr. Kozak wrote to Mr. Thompson and suggested that there was a good chance of obtaining a large judgment against Mr. Kersting through a class action lawsuit, but that collection of any such judgment would be uncertain. In addition, Mr. Kozak's letter states in pertinent part: As you know, Kersting is now embroiled with the IRS on behalf of his clients. I recently had a conference with Ken McWade, local counsel for the IRS. He tells me the trial of these cases will be no sooner than late Spring 1988. I suspect 12-18 months is a more realistic date. Also McWade stated he is 100% sure Kersting will be unable to show any "purposive" function of his corporations other than to avoid taxes. Several witnesses including yourself are available to McWade to prove Kersting never had any intention of enforcing the notes he had his clients execute. Also, I am suspicious that Kersting's representation that his 35 Mr. Kozak had represented Mr. Provan when he had been sued as a director of First Savings. The representation ended with a settlement with the company that provided First Savings' officers and directors liability insurance. Mr. Kozak did not represent Mr. Provan in any tax controversies with the Internal Revenue Service related to the Kersting programs. 36 As discussed in greater detail, infra pp. 115-116, Mr. Kozak and his wife, Susan K. Kozak, had participated in one or more of the Kersting programs that were the subject of this Court's opinion in Pike v. Commissioner, 78 T.C. 822 (1982). - 67 companies are making loans, leasing cars and factoring accounts in any meaningful business sense is without any merit. Further, I believe we will find that Kersting did not do many of the "house keeping" accounting and legal matters which needed to be done to qualify his schemes before the IRS, even if there was an arguable business purpose position for his schemes under the tax code. In my estimation, those clients of Kersting who continue to be represented by Kersting's lawyers are headed towards a nightmare. Interest continues to mount on the taxes due. By the time the pilots finally get a decision from the tax court, they will be in terrible financial condition. Of course, they will still have to pay the tax since bankruptcy will not terminate their tax liability. Those who are smart enough should disassociate themselves from Kersting's lawyers now, obtain their own counsel, offer their testimony as part of their negotiations with the IRS and buy out as cheap as they can now! There is no evidence in the record that the Thompsons have ever filed a lawsuit against Mr. Kersting or that Mr. Kersting has ever filed a lawsuit against the Thompsons. There is no documentation in the record to support Mr. Thompson's statement to Mr. Kersting in 1986 that in 1982 he had asked Mr. Kersting to terminate Mr. Thompson's participation in the Kersting programs. B. The Alexander Dispute As previously mentioned, Mr. Alexander first met Mr. Kersting in Los Angeles in the early 1960's. In the mid- 1970's, Mr. Alexander lent over $100,000 to Mr. Kersting to assist him in the acquisition of Cosmopolitan Financial Corp. Mr. Alexander's creditor's interest in Cosmopolitan evolved into a stock interest in Charter Financial. Mr. Alexander also lent - 68 $80,000 to Mr. Kersting's subchapter S leasing corporations in the 1970's. In 1977, Mr. Alexander, a minority shareholder of First Savings, met with Mr. Kersting to discuss the possible acquisition of the company. Mr. Alexander participated in the acquisition of First Savings and added to his First Savings stock holdings in the process. Mr. Alexander participated in certain Kersting programs at issue in Dixon II during the taxable years 1974 through 1977. In 1980, Mr. Alexander brought suit against Mr. Kersting in Hawaii State court seeking the repayment or return of approximately $450,000 that Mr. Alexander claimed he had lent to or invested with Mr. Kersting. Mr. Kozak initially represented Mr. Alexander in this litigation. Mr. Kersting and/or his companies eventually filed counterclaims in excess of $4 million against Mr. Alexander. Mr. Moseley represented Mr. Kersting in the Alexander litigation. In March 1982, Mr. Alexander received a telephone call from Internal Revenue Service Special Agents George Scott and Mike Duncan, who were interested in questioning Mr. Alexander regarding Mr. Kersting's various programs. The record does not reflect whether Mr. Alexander ever agreed to be questioned by the agents. The Alexander/Kersting litigation eventually was submitted to arbitration during a week-long proceeding in July 1987. During the arbitration proceeding, Mr. Kersting discovered that - 69 Messrs. Alexander, Kozak, and Matsumoto had contacted Mr. McWade to discuss whether the Government would pay a finder's fee for information pertaining to Mr. Kersting's programs. Mr. Alexander's discussions with Mr. McWade on the subject of a finder's fee are discussed in greater detail, infra pp. 106115. In a letter dated July 24, 1987, Mr. Kersting brought his dispute with Alexander to the attention of Chicoine and Hallett, stating as follows: Dear Darrell: I have spent the better part of this week in arbitration hearings concerning a case whereby we are attempting to accomplish an offset of debt owed us by a Mr. Denis Alexander against certain obligations we have to him. The matter has been going on for more than six years and has become sheer agony. During the course of the proceedings, however, certain matters came to the surface which will become apparent to you as you will read the enclosed material. The material will disclose a conspiracy between McWade, DEnis [sic] Alexander, an accountant by the name of Gilbert Matsumoto and an attorney by the name of Charles Kozak. Here are some short facts to illuminate the case: DEnis [sic] Alexander was a long-time friend going back more than 25 years, until we locked horns over the debt referred to above. Gilbert Matsumoto is an accountant who was for years the tax preparer for our Finance Company in Aiea, Federated Finance Company, and for about 10 to 14 of our clients which we had referred to him. He had given me an opinion with respect to the viability of the SubChapter S concept which we employed in the mid-70s for our Leasing Companies. He, in fact, did the filing of SubChapter S qualification forms for us with the IRS in Fresno, Calif. and did some of the Tax Returns. I - 70 adapted the SubChapter S principles on the strength of his advise [sic]. Charles Kozak is an attorney here in town who was at one time a shareholder in one of our SubChapter S Leasing Companies and also a participant in other programs. He did some legal work for us in the mid-70s in chasing a dead-beat by the name of Feliciano and he obtained judgement for us. He became an adversary after he had made no lease payments on a car which we had leased to him which compelled us to repossess the car. He was delinquent by more than one year. He has stirret [sic] up trouble for me ever since. These three characters now conspired with McWade to initiate criminal proceedings again against me and, as you will read, already discussed among themselves how to divide the "finders fee" (more precisely the Judas ducats) which they expected to receive from IRS. As we took Alexanders [sic] testimony this week it became apparent to Kozak that he had acted unethically and he read a statement into the records that "he had advised his client (Alexander) not to engage in reporting me to the IRS in order to extract from me a settlement of his claims" which, of course, is self-defeating since he was an active participant in the scheme. I have reason to believe that all of this led nowhere. If even entrapment and subsequent raid on our premises did not yield the evidence for the CID characters to take me out of circulation the Kozak / Alexander / Matsumoto / McWade conspiracy had no prospect of success. More than a year has gone by since these rats tried to make money by setting me up for execution. I will assume that this incident will become a piece of the mosaic which should be made known to the US Tax Court Judge in support of my contention that IRS and it's [sic] representatives have conspired to ruin my business and inflict harm on me personally, one way or another. Following the arbitration hearing, Mr. Moseley filed a complaint with the Supreme Court of the State of Hawaii, Office of Disciplinary Counsel (HODC), accusing Mr. Kozak of conflict of interest and of attempting to extort money from Mr. Kersting in a civil suit. On March 17, 1988, Mr. Kozak submitted a written - 71 response to the HODC in response to Mr. Moseley's complaint. Mr. Kozak alleged that he had been offered inducements by the Internal Revenue Service in exchange for his cooperation in an Internal Revenue Service investigation of Mr. Kersting, suggested that HODC should contact Mr. McWade, denied that he used the threat of Internal Revenue Service litigation against Mr. Kersting, and denied any conflict of interest. On April 12, 1988, Mr. Kozak wrote another letter to HODC stating that the Internal Revenue Service had agreed to pay Mr. Kozak and Mr. Alexander for their cooperation in an Internal Revenue Service investigation of Mr. Kersting. At the evidentiary hearing in this proceeding, Mr. Kozak testified that his statements to HODC that the Internal Revenue Service had agreed to pay him for cooperation in an investigation of Mr. Kersting were false. On July 12, 1988, the arbitrator released his Arbitration Decision and Award denying all claims and counterclaims between Messrs. Alexander and Kersting.37 The arbitrator's decision 37 Following the issuance of the arbitration decision, the Alexanders claimed a net operating loss (NOL) on their 1988 tax return in the amount of $321,000 identified as amounts "expended for the purpose of starting new businesses deemed to be unretrievable by the American Arbitration Association". The Alexanders later claimed an NOL in the amount of $360,260 on their 1990 tax return and an NOL carryforward of $201,955 and a loss "due to fraud" in the amount of $129,000 on their 1991 tax return. The Alexanders' 1991 tax return included the following statement: The loss was $450,000. $321,000 was claimed on the 1988 returns. $129,000 was not claimed because (continued...) - 72 turned largely on the lack of credibility of both parties. The record does not reflect the outcome of Mr. Kersting's complaint filed with HODC against Mr. Kozak. C. Collection Actions In Dixon II, the Court described Mr. Kersting's 1980 dunning letter to more than 30 program participants and several lawsuits brought during the period 1983-86 in the names of Kersting corporations against Kersting program participants to collect amounts purportedly due on promissory notes. See Dixon II, 62 T.C.M. (CCH) at 1466-1467, 1505-1506, 1991 T.C.M. (RIA), at 913007 to 91-3008, 91-3048 to 91-3050. Summarized below are the Court's findings and conclusions in Dixon II regarding the collection lawsuits. 1. Steve Hane In 1983, a Kersting company, Atlas Funding, commenced an action on a $30,000 renewal primary note for a stock subscription plan against Kersting program participant Steve Hane. The Court noted that the Hane litigation was the only example in the record 37 (...continued) recovery was expected in the future. In 1991 the assets on which the recovery was anticipated disappeared because the corporation was absorbed and ceased to exist. Upon examination of the Alexanders' returns for 1990 and 1991, the Commissioner disallowed the claimed NOL's and fraud loss. After the Alexanders agreed to these adjustments, the Commissioner issued a notice of deficiency to the Alexanders determining accuracy-related penalties attributable in part to the disallowed losses. In Alexander v. Commissioner, T.C. Summary 1997-80 (docket No. 8948-95S), the Court sustained the Commissioner's determinations. - 73 of litigation on a primary note. The Court concluded that the evidence of the Hane litigation was inconsequential because of the lack of any testimony about the matter and the fact that Atlas Funding dismissed the action voluntarily after obtaining a default judgment. 2. Carl Mott, George Vermef, and Robert Peterson In Dixon II, the Court found that Kersting corporations pursued collection lawsuits in 1985-86 on leverage loans against Kersting program participants Carl Mott, George Vermef, and Robert Peterson. The Court noted that while Carl Mott had been sued only for interest on leverage loans, Messrs. Vermef and Peterson had been sued for both interest and principal on leverage loans. The Court found that there was no explanation in the record how Messrs. Vermef and Peterson could have owed principal on leverage loans that would be consistent with the way the Kersting programs were intended to operate nor with the way that they apparently actually operated. Further, the Court found that the judgments entered against Mr. Vermef were vacated after the parties agreed to settle the cases and that a default judgment entered against Mr. Peterson later was set aside on Mr. Peterson's motion. The Court summarized its conclusions regarding collection activities and litigation as follows: Five Kersting corporations commenced actions against Carl Mott based upon a year of unpaid interest on 15 leverage notes, but the principal amounts of the notes were not in issue. The record is replete with copies of checks, drawn on personal bank accounts other than Liberty Bank or Hawaii National Bank, that petitioners used to pay interest on leverage notes. - 74 Respondent does not dispute that Kersting insisted on these interest payments, but maintains that to the extent th [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Ae1e6837e3d7564dc. Public record. Not legal advice.