Melnik v. Comm'r

T.C. Memo. 2006-25

UNITED STATES TAX COURT

ZALMAN MELNIK AND LEA MELNIK, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

MOSHE M. MELNIK, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent

Docket Nos. 13392-01, 13395-01. Filed February 15, 2006.

George W. Connelly, Jr., and Lawrence Sherlock, for

petitioners.

W. Lance Stodghill, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

MARVEL, Judge: In these consolidated cases, respondent

determined the following deficiencies and penalties in

petitioners’ Federal income taxes:
 - 2 -

Docket No. 13392-01
Zalman Melnik and Lea Melnik:
Accuracy-
related penalty
Year Deficiency Sec. 6662(a)1

1997 $731,083 $146,217

Docket No. 13395-01
Moshe M. Melnik:
Accuracy-
related penalty
Year Deficiency Sec. 6662(a)

1997 $1,015,157 $203,031

The issues for decision2 are:

(1) Whether petitioners carried their burden of proving

their sale of HouTex Metals Co. (HouTex) stock to Clend

Investments Holding, Ltd. (Clend)--a foreign company owned by two

Bermuda trusts established for petitioners’ benefit--in exchange

for private annuities, was not a sham transaction lacking

economic substance;

1
All section references are to the Internal Revenue Code in
effect for the year in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Monetary amounts are
rounded to the nearest dollar.
2
Respondent asserted a second alternative position in the
notices of deficiency. Respondent determined “that due to the
transfer of appreciated stock of HouTex Metals, Inc., in 1996, a
35% excise tax is applicable on the value of the stock
transferred reduced by the present value of the annuity received
that is associated with this transfer for the 1996 taxable year
in accordance with Internal Revenue Code Section 1491.” We do
not have jurisdiction over the excise tax imposed by sec. 1491.
Freedman v. Commissioner, 71 T.C. 564 (1979).
 - 3 -

(2) whether, in the alternative, petitioners carried their

burden of proving that the income from petitioners’ respective

trusts is not attributable to petitioners under the grantor trust

rules; and

(3) whether petitioners are liable for the section 6662(a)

accuracy-related penalties determined by respondent.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. We

incorporate the stipulated facts into our findings by this

reference.

Background

Zalman Melnik and Lea Melnik (Lea) were married and resided

in Houston, Texas, when they filed their petition. Moshe Melnik

also resided in Houston, Texas, when he filed his petition.

Hereinafter, we refer to these consolidated cases as this case.

Zalman and Moshe Melnik3 (the Melniks) are brothers who grew

up in Israel. In 1974, Moshe Melnik moved to Canada, where he

attended college and received a degree in mechanical engineering.

Moshe Melnik then worked in Canada as an engineer for a scrap

metal company before moving to the United States in 1978 or 1979.

In 1979, Moshe Melnik and his wife at the time, Barbara

Melnik, formed HouTex, a scrap metal dealer involved in the

3
Petitioner Moshe Melnik is sometimes referred to as “Mike
Melnik”, and petitioner Zalman Melnik is sometimes referred to as
“Sol Melnik” in the record in this case.
 - 4 -

processing, recycling, and marketing of scrap metal. Moshe and

Barbara Melnik each received 5,000 shares of stock in HouTex and

were the sole shareholders.

In 1980, Zalman Melnik, who had worked in the construction

business in Israel, moved to the United States to help his

brother set up the scrap metal business. Zalman Melnik was

responsible for the internal operations at HouTex, while Moshe

Melnik was involved in the sales operation and customer

solicitation. In January 1981, Zalman Melnik received 7,000

shares of HouTex stock, and Moshe Melnik received an additional

3,000 shares.

In April 1996, Moshe and Barbara Melnik divorced.4 After a

contentious battle over the valuation of their HouTex stock,

Moshe and Barbara Melnik ultimately agreed that the fair market

value of their 65-percent interest was $1,970,000.5 Moshe Melnik

received Barbara Melnik’s HouTex stock pursuant to their property

settlement agreement.

After the divorce was final, Moshe Melnik sold some of his

HouTex shares to Zalman Melnik. Following the sale, Moshe Melnik

4
During the divorce proceedings, Moshe Melnik’s insurance
agent advised him to set up a trust, but he did not do so at that
time.
5
The appraised value included a 20-percent discount for lack
of marketability.
 - 5 -

owned 58 percent and Zalman Melnik owned 42 percent of the 20,000

issued and outstanding HouTex shares.

HouTex Sale Negotiations and Annuity Agreement Discussions

During the 1980s, Moshe Melnik approached a company called

Commercial Metals about the possibility of selling HouTex.

Commercial Metals was not interested, however, in operating a

scrap metal business.

In the 1990s, an individual named Larry White proposed a $2

million purchase price for HouTex. The Melniks rejected the

proposal when they learned that a large portion of the purchase

price would be paid in promissory notes.

After his 1996 divorce, Moshe Melnik again considered

selling HouTex and getting out of the scrap metal business.

Sometime in 1996, Moshe Melnik attended a scrap dealer convention

in Las Vegas, where he heard about companies that were “rolling

up” small scrap metal companies into larger, publicly traded

companies. After the convention, on a date that does not appear

in the record, Ben Jennings, the chairman of the board of

directors and chief development officer for Metal Management,

Inc. (MMI), contacted Moshe Melnik. MMI was engaged in the

business of dismantling, processing, marketing, brokering, and

recycling both ferrous and nonferrous metals. After preliminary

discussions, on a date that does not appear in the record, Mr.

Jennings came to Houston to evaluate HouTex, and initially he
 - 6 -

proposed a purchase price in excess of $8 million, of which 90

percent would be paid in stock and the remaining 10 percent in

cash.

Moshe Melnik, who was surprised at the amount of the MMI

proposal, was interested in the proposal and sought legal advice

regarding it from Larry Pennoni, an attorney whom he had met when

Larry White had offered to purchase HouTex in the 1990s. Mr.

Pennoni practiced in the areas of tax, international tax, and

corporate mergers and acquisitions. Moshe Melnik and HouTex’s

accountant, Margie Reedy, met with Mr. Pennoni on a date that

does not appear in the record to discuss the proposed sale of

HouTex. Moshe Melnik wanted advice from Mr. Pennoni on the risks

to himself and to Zalman Melnik if MMI acquired HouTex.

On dates that do not appear in the record, Mr. Pennoni met

with the Melniks and discussed with them the risks of being sued

by Barbara Melnik, whether the original HouTex valuation would be

respected in such a suit, and how to prove that any offer to

purchase HouTex was received after Moshe and Barbara Melnik’s

property settlement agreement. Mr. Pennoni outlined the tax

aspects of a merger agreement and discussed with the Melniks

various planning scenarios that might be used in connection with

the sale of HouTex stock. The scenarios that Mr. Pennoni

explained included setting up trusts for Moshe Melnik’s children

and gifting HouTex stock to them or putting the stock in a trust,
 - 7 -

a foreign trust, a foreign corporation, or an Alaska trust. Mr.

Pennoni explained to Moshe Melnik the advantages and

disadvantages of each scenario.

After Mr. Pennoni had reviewed the alternatives with the

Melniks, the Melniks, on a date that does not appear in the

record, chose a transaction in which they would sell part of

their HouTex stock to a foreign corporation owned by foreign

trusts in exchange for annuities. The Melniks were concerned,

however, that their money would not be secure in a foreign

corporation owned by foreign trusts. Mr. Pennoni had dealt with

three trust companies in the past. From those, he selected the

Bermuda Trust Co. (Bermuda Trust), a subsidiary of the Bank of

Bermuda, to set up the transaction.6

Mr. Pennoni also suggested that the Melniks obtain a second

legal opinion about using foreign trusts. He referred the

Melniks to Carlos Kepke, an attorney who formerly practiced with

Mr. Pennoni’s firm and who also utilized foreign trusts in

planning transactions. Moshe Melnik testified that Mr. Kepke

assured him that foreign trusts were safe and that the Melniks

would receive their annuity payments.

6
To allay the Melniks’ concerns about using foreign trusts,
Mr. Pennoni introduced the Melniks at some point to David
Richardson, a Bermuda Trust trust officer.
 - 8 -

Formation of the Rashi and Rambam Trusts

On a date that does not appear in the record but was

sometime before the sale of their HouTex stock, the Melniks

decided to enter into the private annuity transaction that Mr.

Pennoni had suggested. At the Melniks’ request, Moshe Taub, an

Israeli citizen, agreed to establish trusts for their benefit.

Mr. Taub had served with Zalman Melnik in the Israeli Army and

was an old and trusted friend of the Melniks.

On a date that does not appear in the record,7 Mr. Taub

executed two trust indentures, dated November 4, 1996, that

established the Rashi and Rambam Trusts and appointed Bermuda

Trust as trustee.8 The initial corpus of each trust consisted of

$10,000.9 The trust indentures provided that Bermuda Trust had

“sole and absolute discretion” to make distributions of any or

all of the trust income or corpus to any one or more of the

beneficiaries.

7
The trust indentures are dated Nov. 4, 1996. However, in a
letter to William Maycock, a Bermuda Trust trust manager, dated
Oct. 14, 1996, Mr. Pennoni sent to Mr. Maycock trust indentures
that had already been signed by Mr. Taub.
8
Although the trust indentures are dated Nov. 4, 1996, Mr.
Maycock signed the trust indentures on behalf of the trustee
sometime between Nov. 20 and Nov. 22, 1996.
9
On Oct. 8, 1996, Mr. Taub’s bank in Israel issued two
$10,000 checks to fund the Rashi and Rambam Trusts. On Oct. 14,
1996, Mr. Pennoni mailed the checks to Mr. Maycock. However, the
checks were not credited to (and presumably not deposited into)
trust accounts until Jan. 23, 1997, although Bermuda Trust, on
Nov. 22, 1996, acknowledged receiving the checks.
 - 9 -

The named beneficiaries of the Rashi Trust were:

[Mr. Taub], Zalman Melnik, the Descendants of any of
the foregoing individuals, including, without
limitation, [the names and ages of Mr. Melnik’s
children are omitted], the Spouses of any of the
foregoing individuals, and any organization qualifying
as a charitable organization according to the laws of
Israel, Bermuda, or the United States of America.
* * *

Additionally, the Rashi Trust beneficiaries included, in general,

any other trusts that exist for the benefit of the named

beneficiaries. The Rambam Trust contained identical provisions

naming its beneficiaries but, in place of Zalman Melnik and his

children, substituted Moshe Melnik and his children. These

beneficial interests were not fixed or definable interests with

respect to all or any portion of the trusts.

The trust indentures appointed the Melniks to serve as trust

protectors of their respective trusts. As trust protectors, the

Melniks had the right to replace Bermuda Trust, with or without

cause, with an independent corporate trustee. The successor

trustee could not be a corporation in which a beneficiary

(including Mr. Taub) or a trust protector held a direct or

indirect economic interest greater than 1 percent.

In addition, the Melniks’ respective trust indentures

granted them “special testamentary limited powers of appointment”

over the trusts. Pursuant to these powers of appointment, the

Melniks were authorized to (1) direct outright all or any part of

the income and/or principal to any person or to any entity or (2)
 - 10 -

direct Bermuda Trust to retain and hold any amounts in a separate

trust. The Melniks’ respective trust indentures further provided

that when the Melniks die, subject to the terms of effectively

exercised powers of appointment, Bermuda Trust must divide the

remaining portions of their respective trusts into separate

shares for the Melniks’ children or their children’s

descendants.10

Acquisition of Clend by the Trusts and the Stock Purchase
Agreements

As part of the overall transaction, Mr. Pennoni planned for

the trusts to acquire a company with which the Melniks would

exchange a portion of their HouTex stock for a deferred private

annuity. No earlier than in November 1996,11 the Rashi and

Rambam Trusts acquired Clend, a British Virgin Islands holding

10
The sixth page of the Rashi Trust indenture as it appears
in the record is incomplete. The missing section contains the
first few sentences directing the division of the remaining
portion of the Rashi Trust after Zalman Melnik’s death. Though
we can conclude from the seventh page of the trust indenture that
Zalman Melnik’s children or their descendants were to receive
separate shares, we cannot conclude whether his spouse was also
allocated a share.
11
Again, the exact date does not appear in the record. On
Nov. 22, 1996, “Further to instructions received earlier today
from Mr. Bob Colvin of Chamberlin Hrdlicka”, Ethlyn George, a
trust administrator at Arawak Trust, faxed a copy of inaugural
minutes for Clend that appointed Mr. Maycock a director. On Dec.
12, 1996, Ms. George faxed to Mr. Maycock a resolution of Clend’s
directors dated Nov. 7, 1996, that authorized him to sign the
Nov. 8, 1996, stock purchase agreements.
 - 11 -

company.12 Clend had been incorporated by Arawak Trust Co.

(Arawak) on March 3, 1995, and had conducted no business before

it was acquired by the Rashi and Rambam Trusts. Clend’s

memorandum of association provided for authorized capital of 500

shares of $1 par value stock.

On a date that does not appear in the record,13 Clend

entered into separate stock purchase agreements14 with Moshe

Melnik and Zalman and Lea Melnik to purchase 75 percent of the

outstanding shares in HouTex in exchange for private annuities.

The stock purchase agreements provided that Clend’s obligation to

pay the annuities was an unconditional and unsecured personal

liability and that the Melniks and Lea unconditionally waived all

12
The record contains no exhibits confirming that the trusts
purchased Clend or specifying how and when the acquisition
occurred. However, by letter dated Dec. 5, 1996, Arawak Trust
Co. forwarded copies of Clend’s organizational documents to Mr.
Colvin, an attorney in Mr. Pennoni’s office.
13
The stock purchase agreements do not show when they were
executed. They show only the date on which they became
effective.
14
Mr. Pennoni had prepared the stock purchase agreements and
determined the purchase price for the HouTex stock. Mr. Pennoni
relied upon Mr. Colvin to calculate the annuity payments. Mr.
Colvin consulted the Treasury regulations guidelines for
computing the annuity payments and computed the annuity payments
to be made under the annuity contract using approximately $6
million as the fair market value of 75 percent of the outstanding
HouTex stock. The valuation of the HouTex stock appears to have
been based on the acquisition price offered by MMI and not on the
appraisals prepared in connection with Moshe Melnik’s divorce
case.
 - 12 -

liens against Clend’s property, including the HouTex stock.15

The stock purchase agreements were signed by the Melniks and Lea

and by William Maycock, a Bermuda Trust trust manager, as

director of Clend16 “to be effective as of” November 8, 1996.

However, as of November 8, 1996, Clend had not yet held its first

shareholders’ or directors’ meeting, had not yet appointed Mr.

Maycock as a director, and had no assets to fund the purchase of

the HouTex shares.17 Clend did not participate in any

negotiations regarding the terms of the stock purchase agreement,

including any negotiations regarding the consideration to be paid

for the HouTex stock it was allegedly purchasing.

On or about November 22, 1996, Clend held its first board of

directors meeting. The minutes of that meeting purport to show

that Mr. Maycock and Stanley Wright were appointed directors of

Clend at that meeting.18 The minutes also purport to show that,

15
Clend had no other assets when it entered into the stock
purchase agreements with the Melniks and Lea.
16
Although Mr. Maycock was not formally appointed a director
of Clend until Nov. 22, 1996, or later in a resolution backdated
to Nov. 7, 1996, Arawak authorized Mr. Maycock to sign the stock
purchase agreements on behalf of Clend. That resolution was
forwarded to Mr. Maycock on Dec. 12, 1996, so it is likely that
Mr. Maycock was not authorized to sign and did not sign the
resolution until on or after Dec. 12, 1996.
17
It is also probable that, on Nov. 8, 1996, the Rashi and
Rambam Trusts had not yet acquired Clend.
18
The minutes of the first board of directors meeting at
which Mr. Maycock and Mr. Wright were allegedly appointed
(continued...)
 - 13 -

at that meeting, Clend issued 500 shares in bearer form, as

follows: 210 shares, representing 42 percent of its outstanding

shares, in the form of Share Certificate No. 1 and the remaining

290 shares, representing 58 percent of the outstanding shares, in

the form of Share Certificate No. 2. Moshe Melnik’s trust was

credited with 290 shares and Zalman Melnik’s trust was credited

with 210 shares of Clend’s stock in the records maintained by

Bermuda Trust.

Pursuant to the stock purchase agreement, on a date that

does not appear in the record but which could not have been any

earlier than November 22, 1996,19 Moshe Melnik transferred 8,700

of his 11,600 HouTex shares to Clend in exchange for an annuity

to commence on January 1, 2008, when he attained the age of 57,

with quarterly payments of $226,401, payable until his death.

The HouTex shares that Moshe Melnik transferred to Clend pursuant

to the stock purchase agreement were valued at $3,480,000 for

purposes of computing the annuity amount.

18
(...continued)
directors were apparently revised sometime after Dec. 12, 1996,
“to give effect to the appointment to” Mr. Maycock and Mr.
Wright. However, the copy of minutes in the record does not
indicate on its face that the minutes were revised on a later
date.
19
Mr. Pennoni delivered the stock purchase agreements and
related stock certificates reflecting the sale of stock to Clend
to Mr. Maycock by courier on Dec. 2, 1996.
 - 14 -

Pursuant to the stock purchase agreement, on a date that

does not appear in the record but which could not have been any

earlier that November 22, 1996, Zalman Melnik transferred 6,300

of his 8,400 HouTex shares to Clend in exchange for an annuity to

commence on January 1, 2006, when he attained the age of 57, with

quarterly payments of $129,114, payable until the death of both

Zalman and Lea Melnik. The HouTex shares that Zalman Melnik

transferred to Clend were valued at $2,520,000 for purposes of

computing the annuity amount.

After the Melniks transferred their HouTex stock to Clend,

Moshe Melnik retained a 14.5-percent ownership interest in

HouTex, and Zalman Melnik retained a 10.5-percent ownership

interest in HouTex. After the transfer, Clend owned 15,000 of

the 20,000 outstanding HouTex shares, representing a 75-percent

ownership interest in HouTex.

HouTex Merger

Sometime during 1996, Moshe Melnik and Mr. Jennings of MMI

negotiated the sale of HouTex. As a result of those

negotiations, HouTex and MMI entered into a merger agreement,

executed on December 10, 1996, and a first amendment to the

merger agreement dated as of December 10, 1996. The agreement

specified that the transaction would close before the end of 1996

unless the parties agreed to extend the closing to a later date.

The merger was dependent upon MMI’s ability to secure $37 million
 - 15 -

in financing before April 30, 1997. To effectuate the

transaction, MMI organized MTLM Merger, Inc. (MTLM), as a wholly

owned subsidiary and capitalized the subsidiary with MMI common

stock. MTLM was then to be merged into HouTex, with HouTex’s

being the surviving corporation.

On or about January 7, 1997,20 the acquisition closed, and

MMI paid the following consideration in cash, promissory notes,

and unregistered MMI common stock and warrants in exchange for

all the outstanding shares in HouTex:

MMI MMI Promissory
Shareholder Cash stock warrants notes
1 2
Moshe Melnik $435,000 $168,381 $93,960 $960,055
3 4
Zalman Melnik 315,000 121,930 68,040 695,213
5 6
Clend -0- 1,058,690 108,000 5,000,000
Total 750,000 1,349,001 270,000 6,655,268
1
59,289 shares of MMI at $2.84 per share
2
87,000 MMI warrants at $1.08 per warrant
3
42,933 shares of MMI at $2.84 per share
4
63,000 MMI warrants at $1.08 per warrant
5
372,778 shares of MMI at $2.84 per share
6
100,000 MMI warrants at $1.08 per warrant

The total consideration that the HouTex shareholders received in

exchange for their shares was $9,024,269.21 Individually, Clend,

20
The parties stipulated that the acquisition closed on
Jan. 7, 1997. However, various documents associated with the
closing are dated Jan. 3, 1997.
21
The values of the MMI shares and warrants that were used
to report the transactions for Federal income tax reporting
purposes were based on an appraisal by Howard Frazier Barker
Elliott, Inc., as of Jan. 7, 1997.
 - 16 -

Moshe Melnik, and Zalman Melnik received consideration totaling

$6,166,690, $1,657,396, and $1,200,183, respectively.

On or about April 15, 1997, Clend exercised Category 2

conversion rights to acquire an additional 182,482 shares of MMI

for $1 million. The purchase price was offset against MMI’s

obligation to Clend under the promissory note. On or about May

21, 1997, Clend exercised warrants to acquire 180,000 shares of

MMI for $720,000. The purchase price was again offset against

MMI’s obligation to Clend under the promissory note. On or about

June 3, 1997, MMI wired to Clend $3,388,907 representing the

principal balance and interest due under the promissory note.

In June 1997,22 MMI delivered the MMI warrants and stock to

Clend.

Clend’s Investments

On or about May 21, 1997,23 the Melniks met Mr. Maycock for

the first time at a meeting arranged and attended by Mr. Pennoni.

In a letter dated May 28, 1997, Mr. Maycock issued instructions

22
According to Clend’s “Company Account Statement” for 1999,
the Bank of Bermuda received 735,260 shares of MMI stock
registered in nominee name (Gerlack & Co.) on or before Jan. 5,
1999. On or before Jan. 15, 1999, the MMI shares were delivered
to Warburg Dillon Read LLC, with offices in New York, N.Y. From
Aug. 18, 1999, through Oct. 1, 1999, Bermuda Trust sold or
arranged the sale of 727,360 shares of Clend’s MMI stock for
approximately $930,000.
23
In a letter dated May 28, 1997, which was a Wednesday, Mr.
Maycock wrote to Mr. Pennoni acknowledging that he was introduced
to the Melniks in Mr. Pennoni’s offices on the preceding
Wednesday.
 - 17 -

regarding registering the MMI stock and wiring the proceeds from

the payoff of Clend’s promissory note. In the May 28, 1997,

letter, Mr. Maycock also explained that different investment

proposals were being prepared for the approximately $3.4 million

to be received in satisfaction of Clend’s promissory note, and

the proposals would be forwarded to Mr. Pennoni and the Melniks

for their review.

By letter dated July 1, 1997, Mr. Maycock wrote to Mr.

Pennoni to summarize certain discussions at a meeting which Moshe

Melnik, Mr. Pennoni, and representatives of the Bank of Bermuda’s

investment department attended. In that letter, Mr. Maycock

stated as follows:24

The meeting allowed Mike to learn of alternative
strategies which could be adapted for the deployment of
funds totalling initially US $3.4 million and for their
diversification pursuant to the sale of some of the
shares of Metal Management Inc. upon the removal of the
holding restrictions in March of next year. Based on
the conclusions of that meeting it was agreed that
three investment proposals would be prepared with
different risk profiles i.e., ultra-conservative,
conservative and moderate. As you know, they were
hand-delivered to Mike at the Princess Hotel prior to
his departure.

Once the proposals have been reviewed by him and his
brother, Sol, may I suggest that he get into contact
with Fern who now has responsibility for the
administration of the affairs of Clend and the trusts.
She will in turn arrange with Joel for the funds to be

24
References in the July 1, 1997, letter to “Mike” are to
Moshe Melnik. References to “Sol” are to Zalman Melnik.
References to “Fern” and to “Joel” are to Fern Inglefield and
Joel Schaefer of the Bank of Bermuda’s investment department.
 - 18 -

deployed as required and at the same time arrange for
our Bank’s investment group to be appointed as the
investment manager.

Copies of the three proposals are not in the record, and the

record does not disclose what actions, if any, the Melniks and

Mr. Pennoni took to review and comment upon the proposals.

In August 1999,25 Moshe Melnik left MMI’s board of directors

and began pursuing ventures in real estate. Later that year,

Moshe Melnik approached the Bank of Bermuda regarding an

investment property in Houston. In response to the Bank of

Bermuda’s request for additional information on the property and

its potential as an investment, Moshe Melnik sent maps of the

area, as well as information regarding the owner, and explained

that a rail system would be built next to the property. At some

point,26 Clend formed and capitalized a separate company, Tapuz,

Ltd. (Tapuz), to acquire the property (the Tapuz property) for

approximately $1.38 million.27 The funds used by Clend to make

the capital contribution were apparently advanced by the Bank of

25
On Nov. 20, 2000, MMI and its affiliates filed for ch. 11
bankruptcy protection. However, over a period from Aug. 18 to
Oct. 1, 1999, Clend had sold 727,360 shares of its MMI stock for
approximately $930,000, so it is not clear from the record in
this case how the bankruptcy impacted petitioners and Clend.
26
From the account statements in the record, it appears that
Clend capitalized Tapuz in approximately April 2000.
27
The record does not contain any documentation regarding
the acquisition of the Tapuz property, although petitioners
testified that Tapuz purchased the property.
 - 19 -

Bermuda, but the financing mechanism is not explained in the

record.28 The Tapuz property was subsequently condemned,

however, when the new rail line was rerouted through it. At the

time of trial, Tapuz allegedly still owned the property, which

remained the subject of the condemnation proceeding.

Sometime during 1999, Moshe Melnik approached Bermuda Trust

about appointing Goldman Sachs as an investment adviser for any

U.S. investments. Moshe Melnik had set up a personal cash

management account at Goldman Sachs, and, when his adviser

discovered that the Melniks had sold HouTex, his adviser

suggested that Moshe Melnik invest the proceeds of the sale with

Goldman Sachs. Bermuda Trust informed Moshe Melnik that it could

not appoint Goldman Sachs because Bermuda Trust had its own

trading division, conducted its own deals, and did not let anyone

else invest money for which it was responsible. However, in

1997, Bermuda Trust had prepared three investment proposals

28
Clend transferred approximately $1.38 million to
capitalize Tapuz. The funds were apparently advanced by the Bank
of Bermuda pursuant to a “credit facility” that is referenced but
not explained in the record. Clend’s transfer of funds resulted
in a deficit account balance in Clend’s company account of
approximately $888,500, as of May 3, 2000. By Dec. 31, 2000, the
deficit account balance in Clend’s company account had cost Clend
over $53,000 in overdraft charges and had increased to $1,284,523
as a result of the $900,000 in loans to the Melniks. Sometime
before Nov. 2, 2001, the Bank of Bermuda made a demand for Clend
to repay its “credit facility” by Nov. 2, 2001. When the
requested repayment did not occur, the Bank of Bermuda liquidated
investments in Clend’s investment account to cover the deficit.
The investments were liquidated over a period from November 2001
to January 2002.
 - 20 -

reflecting different levels of risk, had presented them to the

Melniks, and apparently had permitted the Melniks to choose which

proposal they preferred.

The $900,000 Loan From Clend to the Melniks

The Melniks investigated other potential real estate

investments in Houston during 1999 and 2000. In 2000, they

became involved with a Mr. Jacobs and with Mr. Jennings in an

attempt to purchase a downtown Houston property for approximately

$2.3 million. When Mr. Jacobs and Mr. Jennings were unable to

secure financing for the transaction, they dropped out. Moshe

Melnik attempted to obtain a loan from Whitney Bank in Houston,

but Whitney Bank was only willing to lend him $750,000. Moshe

Melnik then found two other partners and approached the Bank of

Bermuda about purchasing the property. Instead of the Bank of

Bermuda investing directly in the property, Bermuda Trust

apparently agreed to have Clend make a loan. In approximately

October 2000, Clend made two short-term loans to the Melniks

totaling $900,00029 bearing an interest rate of 8.22 percent in

29
A “Summary of Financial Position (unaudited) As at
December 31, 2001”, and Clend’s account records reflect that
Clend made two loans of $450,000 each to Sol and Moshe Melnik on
Oct. 27, 2000. According to the summary, the loans bore an
interest rate of 10 percent per annum and were for a term of 5
years. However, the summary conflicts with the promissory notes
in the record. The promissory notes are dated as of Oct. 27,
2000, and reflect 1-year term loans of $378,000 to Sol Melnik and
of $522,000 to Moshe Melnik bearing an interest rate of 8.22
percent compounded annually. The promissory notes do not
(continued...)
 - 21 -

exchange for promissory notes dated as of October 27, 2000. The

promissory notes required the Melniks to repay the loans on or

before October 27, 2001.

The Melniks did not meet the repayment deadline. In January

2002, Bermuda Trust contacted the Melniks to determine whether

they anticipated repaying the $900,000 in loans or whether they

wanted the loans to be treated as trust distributions. Bermuda

Trust strongly recommended that if the Melniks could not repay

the loans and interest in full immediately, they should obtain

tax advice before proceeding. At the time of trial, the loans

from Clend had not been repaid, canceled, or treated as

distributions to petitioners.

As of December 31, 2001, Clend had the following assets:

(1) The stock in Tapuz, which owned the Tapuz property, with a

book value of $1,380,000, (2) $900,000 in promissory notes due

from the Melniks, and (3) approximately $54,000 in cash.

Preparation of Petitioners’ Tax Returns

In anticipation of filing their 1997 Federal income tax

returns, the Melniks, on the recommendation of Mr. Pennoni,

changed their accountant. Adrian Hernandez, a certified public

accountant recommended by Mr. Pennoni, prepared the Melniks’ 1997

29
(...continued)
indicate when the notes were executed or who prepared them.
 - 22 -

income tax returns. Mr. Hernandez relied upon information

furnished by Mr. Pennoni regarding the sale of HouTex stock when

preparing the Melniks’ 1997 returns.

On his 1997 Federal income tax return, Moshe Melnik reported

$1,608,515 as a long-term capital gain from the sale of his 2,900

shares of HouTex. The sales proceeds reported by Moshe Melnik on

his 1997 return were $29,000 less than the total consideration

received.30

On their 1997 joint Federal income tax return, Zalman and

Lea Melnik reported $1,179,183 as a long-term capital gain from

the sale of Zalman Melnik’s 2,100 shares of HouTex. The sales

proceeds reported were $21,000 less than the total consideration

received.31

Respondent’s Determinations

In notices of deficiency dated August 24, 2001, respondent

determined that the Melniks’ sale of their HouTex stock to Clend

was a sham transaction lacking economic substance. Pursuant to

this theory, respondent determined that Zalman Melnik and Lea

should recognize additional capital gain of $2,611,010, and Moshe

30
The sale price that Moshe Melnik reported as a long-term
capital gain on his 1997 return reflected a mathematical error in
the amount of $19,881. The mathematical error and the $29,000
underreporting of the total consideration received were taken
into account in respondent’s notice of deficiency.
31
The $21,000 underreporting of the total consideration
received was taken into account in respondent’s notice of
deficiency.
 - 23 -

Melnik should recognize additional capital gain of $3,625,560.

In the alternative, respondent determined that petitioners’

“capital gains are increased because the * * * [Rashi and Rambam]

trusts which * * * [petitioners] state own the stock of * * *

[Clend] are grantor trusts whose income is taxable to * * *

[them] individually either as direct capital gains or Subpart F

income taxable as ordinary income.” Respondent also determined

that, with respect to either position, petitioners are liable for

section 6662(a) accuracy-related penalties.

OPINION

I. The Private Annuity Transactions’ Economic Substance

A. The Economic Substance Doctrine in General

A taxpayer has the legal right to structure transactions in

a manner that minimizes or avoids taxes by any means the law

allows. Gregory v. Helvering, 293 U.S. 465, 469 (1935). Even

so, if the “form employed for doing business or carrying out the

challenged tax event is unreal or a sham”, the Government may

“disregard the effect of the fiction as best serves the purposes

of the tax statute.” Higgens v. Smith, 308 U.S. 473, 477 (1940).

In Frank Lyon Co. v. United States, 435 U.S. 561, 583-584

(1978), the United States Supreme Court identified the

circumstances under which the the Commissioner must respect a

transaction for Federal tax purposes. It stated that

where * * * there is a genuine multiple-party
transaction with economic substance which is compelled
 - 24 -

or encouraged by business or regulatory realities, is
imbued with tax-independent considerations, and is not
shaped solely by tax-avoidance features that have
meaningless labels attached, the Government should
honor the allocation of rights and duties effectuated
by the parties. * * *

After the Supreme Court issued its opinion in Frank Lyon

Co., several Courts of Appeals reduced the Frank Lyon Co.

formulation to a multipart test. However, the Courts of Appeals

do not agree whether the various parts are merely factors in

deciding whether a transaction is a sham for tax purposes or are

the exclusive elements for determining whether a transaction

meets the Frank Lyon Co. formulation. In Rice’s Toyota World,

Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985), affg. in

part, revg. in part and remanding 81 T.C. 184 (1983), the Court

of Appeals for the Fourth Circuit held that Frank Lyon Co.

requires the use of a two-part inquiry to ascertain whether a

transaction has economic substance or is a sham that will not be

recognized for tax purposes. It articulated the inquiry as

follows:

To treat a transaction as a sham, the court must find
that the taxpayer was motivated by no business purposes
other than obtaining tax benefits in entering the
transaction, and that the transaction has no economic
substance because no reasonable possibility of a profit
exists. [Id.]

In contrast, in ACM Pship. v. Commissioner, 157 F.3d 231, 247 (3d

Cir. 1998), affg. in part, revg. in part, dismissing in part and

remanding T.C. Memo. 1997-115, the Court of Appeals for the Third
 - 25 -

Circuit treated the business purpose and reasonable possibility

of profit prongs as factors to be considered in determining

whether a transaction is a sham for tax purposes, stating that

these distinct aspects of the economic sham inquiry do
not constitute discrete prongs of a “rigid two-step
analysis,” but rather represent related factors both of
which inform the analysis of whether the transaction
had sufficient substance, apart from its tax
consequences, to be respected for tax purposes. * * *
[Id.]

See also James v. Commissioner, 899 F.2d 905, 908-909 (10th Cir.

1990), affg. 87 T.C. 905 (1986).

This case is appealable, barring a stipulation to the

contrary, to the Court of Appeals for the Fifth Circuit. In

Compaq Computer Corp. & Subs. v. Commissioner, 277 F.3d 778 (5th

Cir. 2001), revg. 113 T.C. 214 (1999), the Court of Appeals

declined to decide whether business purpose and the reasonable

possibility of profit were the exclusive elements of a Frank Lyon

Co. inquiry or simply factors to be considered in a Frank Lyon

Co. inquiry, because it concluded that the transaction at issue

there had both a realistic possibility of generating a profit and

a business purpose. Nevertheless, Compaq Computer Corp. confirms

that the Frank Lyon Co. formulation is controlling. A

transaction will not be respected for Federal tax purposes if it

lacks a business purpose and a reasonable possibility of

generating a profit independent of tax considerations.
 - 26 -

B. The Parties’ Contentions

Respondent contends that the formation of the Rashi and

Rambam Trusts and the Melniks’ subsequent transfer of their

HouTex stock to Clend in exchange for private annuities lacked

economic substance. According to respondent, we should (1)

disregard the annuity transactions as sham transactions lacking

economic substance and treat the entire proceeds from the HouTex

merger as petitioners’ income or (2) recharacterize the private

annuity transactions as transfers in trust with retained income

interests.

Petitioners maintain that the trusts and Clend were not

shams and that the private annuity transactions had economic

substance. Petitioners bear the burden of proof. Rule

142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).32

C. The Sufficiency of the Record in General

As the party with the burden of proof in this case,

petitioners bear the ultimate burden of persuasion; i.e., the

risk of nonpersuasion, as well as the initial burden of

production. See, e.g., Gerling Intl. Ins. Co. v. Commissioner,

86 T.C. 468, 476 n.5 (1986). In order to satisfy their initial

burden of production, petitioners were required to introduce

evidence sufficient, if believed, to demonstrate by a

32
In the stipulation of facts, petitioners conceded that
sec. 7491(a) does not apply to shift the burden of proof to
respondent.
 - 27 -

preponderance of the evidence that respondent’s determination is

excessive; i.e., erroneous, and/or arbitrary; i.e., “without

rational foundation”. Helvering v. Taylor, 293 U.S. 507, 514-515

(1935); see also Pittman v. Commissioner, 100 F.3d 1308, 1317

(7th Cir. 1996), affg. T.C. Memo. 1995-243; Page v. Commissioner,

58 F.3d 1342, 1347-1348 (8th Cir. 1995), affg. T.C. Memo. 1993-

398. If petitioners fail to satisfy their initial burden of

production, the burden of production does not shift to

respondent, petitioners do not satisfy their burden of

persuasion, and we must uphold respondent’s determination.

Helvering v. Taylor, supra at 514-515; Berkery v. Commissioner,

91 T.C. 179, 186 (1988), affd. without published opinion 872 F.2d

411 (3d Cir. 1989).

Petitioners attempted to satisfy their initial burden of

production and their ultimate burden of persuasion by calling

only three witnesses--Zalman Melnik, Moshe Melnik, and Lawrence

Pennoni. Zalman and Moshe Melnik are petitioners seeking to

convince us that the annuity transactions at issue in this case

should be respected for Federal income tax purposes. Mr. Pennoni

is the attorney who planned and implemented the transactions.

Petitioners did not call any witness to testify on behalf of MMI,

the firm that acquired HouTex, regarding the timing and substance

of the negotiations, nor did they call any witness to testify on

behalf of Bermuda Trust, the Rashi and Rambam Trusts, or Clend.
 - 28 -

The resulting record reeks of self-interest and is riddled with

imprecision and inconsistencies that petitioners do not explain.

The record fails to establish the dates when certain relevant

events took place, is lacking in credible evidence that the

annuity transactions had economic substance independent of tax

considerations, and is woefully inadequate to demonstrate that

respondent’s determination was wrong.

The inadequacies permeate every aspect of the record. We

shall review in detail some of the problems with the record

presented by petitioners and our reasons for concluding that

petitioners’ evidence is not worthy of belief and is not

sufficient to demonstrate that respondent’s determination was in

error.

1. Failure To Prove Relevant Dates

Petitioners contend that the establishment of the foreign

trusts and Clend, the sale of HouTex stock to Clend in exchange

for private annuities, and the sale and merger of HouTex were

bona fide business transactions that were motivated by a business

purpose and imbued with economic substance independent of tax

considerations. However, the record fails to disclose the dates

when important steps of these transactions took place, making it

difficult, if not impossible, for us to evaluate the legitimacy

of petitioners’ contentions.
 - 29 -

The record does not establish the following relevant dates:

a. The dates on which Moshe Melnik met Mr. Jennings in

Houston and received MMI’s initial proposal to acquire HouTex;

b. The date on which Moshe Melnik first met with Mr.

Pennoni;

c. The dates of subsequent meetings with Mr. Pennoni;

d. The date on which the Melniks decided to engage in a

transaction involving foreign trusts and a foreign corporation;

e. The date on which the foreign trusts acquired Clend;

f. The date on which the Melniks transferred their HouTex

shares to Clend; and

g. The date on which the Melniks and MMI reached an

agreement in principle regarding the acquisition of HouTex.

Although the vagueness of the chronology in the record

facilitates petitioners’ arguments that MMI’s acquisition of

HouTex was negotiated over a period of months and was not

finalized until after Clend had purchased 75 percent of HouTex’s

stock and that petitioners did not continue to exercise de facto

control over the assets ostensibly owned by Clend and the foreign

trusts, the lack of precise dates is a defect in the record that

impairs our review of the transactions. It is also a defect that

petitioners could easily have remedied but did not. It is well

established that the failure of a party to introduce evidence

which, if true, would be favorable to him, gives rise to the
 - 30 -

presumption that the evidence would be unfavorable if produced.

Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165

(1946), affd. 162 F.2d 513 (10th Cir. 1947).

2. Backdating and “Effective As of” Dating of
Documents

Petitioners have admitted that one of the critical documents

in the record was backdated. Although petitioners explain the

backdating as a matter of convenience, the fact that any

backdating occurred suggests a willingness to manipulate the

relevant chronology in a way that does not enhance the

credibility of petitioners’ evidence.

At least one document was revised after the effective date,

but the fact of the revision is not disclosed on the face of the

document. It also appears that several key documents were not

prepared and dated contemporaneously. For example, the

promissory notes dated as of October 27, 2000, that purported to

formalize the loans the Melniks obtained from Clend were probably

not executed on the dates indicated and conflict with records

maintained by Bermuda Trust. Many of the critical documents

reflect “effective as of” dating and do not reveal when they were

executed.

The “effective as of” dating and backdating of relevant

documents impede our review of the substance of the transactions

involving the foreign trusts and Clend and lead us to conclude

that the chronology reflected by those documents is not credible.
 - 31 -

3. Suspicious Timing

The timing of certain actions raises questions regarding the

accuracy of testimony given by the three witnesses in this case.

Although each of the three witnesses claimed that the creation of

the foreign entities and the sale of 75 percent of HouTex’s stock

to Clend was motivated by nontax business reasons, the timing of

the creation of the foreign trusts, the acquisition of Clend, and

the deposit of Mr. Taub’s checks to fund the foreign trusts in

relationship to the sale of HouTex stock to MMI casts doubt on

that testimony. On October 8, 1996, Mr. Taub’s bank in Israel

issued two checks for $10,000 each to fund the foreign trusts.

The two checks were mailed to Bermuda Trust on October 14, 1996,

but were not credited to (or presumably deposited into) trust

accounts until January 23, 1997. The deal with MMI apparently

closed on or about January 7, 1997, because MMI transferred

approximately $9 million in cash, warrants, and notes to or for

the benefit of the Melniks and Clend at that time.33 These facts

permit an inference that Mr. Taub’s checks intentionally were not

deposited by Bermuda Trust until after the MMI deal had closed.

That inference is not consistent with petitioners’ argument that

the formation of the foreign entities was separate from, and

33
The MMI stock and warrants were placed in escrow at
closing.
 - 32 -

preceded, the negotiation and consummation of the private annuity

and MMI transactions.

The proximity of certain key events, particularly in

combination with petitioners’ failure to prove the precise date

of some of the events, is also telling. Petitioners did not

introduce evidence to prove the exact date when the foreign

trusts acquired Clend. Petitioners would have us believe that,

sometime before November 8, 1996, the trusts had acquired Clend,

had elected Mr. Maycock a director, and had authorized Mr.

Maycock to execute the stock purchase agreements dated November

8, 1996, on behalf of Clend. As of November 8, 1996, however,

Clend had not yet held its first directors’ or shareholders’

meetings (the first meeting of directors was not held until

November 22, 1996), it had no director who was authorized to act

on its behalf in executing the stock purchase agreements, and it

had no assets with which to fund the purchase of the HouTex

shares. Clend’s shareholders, the foreign trusts, had not yet

been funded and would not be funded until Mr. Taub’s checks were

deposited and credited to trust accounts on or about January 23,

1997.34 The true chronology, incomplete though it is, suggests

that documents were executed to create the misleading impression

that the foreign entities were formed and functioning before the

34
Until the checks were deposited and cashed, Mr. Taub could
have stopped payment on the checks, thereby preventing the checks
from being cashed and used to fund the trusts.
 - 33 -

stock purchase agreements establishing the Melniks’ right to

private annuity payments were executed.35

4. Negotiations and Preparation of Documents

Petitioners admit that Clend did not participate in the

negotiations with MMI. Only Moshe Melnik participated in the

negotiations. Petitioners argue that Moshe Melnik represented

the interests of all HouTex shareholders in the negotiations, but

that claim rings hollow in the absence of any credible evidence

in the record that representatives of Bermuda Trust authorized

the representation, participated in the negotiations, or made any

attempt to ascertain the value of the HouTex shares that Bermuda

Trust allegedly held as a fiduciary.36

The record confirms that Mr. Pennoni prepared the relevant

documents without any meaningful input from Bermuda Trust, and

35
In fact, Moshe Melnik testified that the formation of the
foreign trust was delayed until he knew he had a deal with MMI.
36
In a letter to Mr. Pennoni dated Nov. 22, 1996, Mr.
Maycock wrote as follows: “It was agreed in our telephone
conversation that you would provide details relating to the
planning purposes for the trust, information on the formation of
the underlying BVI company, Clend Investment Holdings Ltd, to be
put in place and the nature and value of the stock transaction to
be conducted by and through that company.” In a followup letter
to Mr. Pennoni dated Dec. 2, 1996, Mr. Maycock stated the
following: “Various details relating to the planning purposes of
the trusts and for the underlying company were requested in that
letter and I know (sic) look forward to receiving same together
with the additional items to complete our compliance
requirements.” Mr. Maycock inserted a postscript indicating that
“I have subsequently spoken to you concerning the planning tenets
of the trust.”
 - 34 -

that a lawyer in Mr. Pennoni’s firm calculated the value of the

annuities under Mr. Pennoni’s direction. And, although

petitioners did not testify to this fact, the record supports a

conclusion that the valuation of the HouTex stock and the amount

of the annuity reflected in the stock purchase agreements

prepared by Mr. Pennoni were based on the acquisition price to be

paid by MMI for the HouTex stock.37 In fact, the record supports

a conclusion that the stock purchase agreements and related

documents were prepared at a time when the approximate

acquisition price of the HouTex stock that MMI would eventually

pay was already known to Mr. Pennoni and to petitioners.

37
Mr. Pennoni testified that he negotiated with Mr.
Richardson regarding the amount that Clend agreed to pay under
the annuity contracts in exchange for the HouTex stock and that
Mr. Richardson was Clend’s initial director. Mr. Pennoni also
testified that the valuation of the HouTex stock was based on the
two appraisals that were prepared in the divorce case. We do not
accept this testimony as credible. The correspondence in the
record establishes that Bermuda Trust had little involvement in
structuring the annuity transactions, including the amount of
the private annuities to be paid by Clend, and did not even
receive any detailed explanation of the purpose of the foreign
entities until approximately December 1996, after Clend had
entered into the stock purchase agreements. The relevant
documents do not contain any indication that Mr. Richardson
negotiated any aspect of the annuity transactions or the MMI
transaction. The relevant documents also do not support Mr.
Pennoni’s testimony that Mr. Richardson was Clend’s initial
director. The valuation of the HouTex stock for purposes of the
annuity transactions appears to have been based on the
acquisition price for HouTex proposed by MMI rather than the
appraisals prepared for the divorce case.
 - 35 -

5. Testimony Regarding Business Purpose

Each of the three witnesses testified regarding the alleged

business purposes for the creation of the foreign entities and

the sale of HouTex stock to Clend. According to the witnesses,

the business purposes were to prevent Moshe’s ex-wife, Barbara,

from challenging the valuation of her HouTex stock in the divorce

proceeding, to address the long-held concerns of Moshe and Zalman

Melnik resulting from the fact that HouTex did not have a

retirement plan, and to protect the proceeds of the HouTex stock

sale from claims under warranties the Melniks would have to give

to MMI.

The testimony regarding business purposes was not convincing

or credible. The Melniks offered no evidence, other than their

own self-serving testimony, that they had had any concern

regarding their retirement before the MMI proposal was made. If

their testimony were true, we would have expected to see evidence

establishing that they had engaged in retirement planning in the

past or that HouTex had investigated the possibility of

establishing a retirement plan before the MMI proposal was made.

No such evidence was offered, leading us to conclude that the

Melniks’ concern about retirement arose only when the Melniks

were faced with the prospect of a substantial windfall resulting

from the MMI proposal.
 - 36 -

The testimony regarding Moshe Melnik’s concern about

possible litigation with his ex-wife also fails to convince us

that the structure selected by the Melniks had a legitimate

business purpose, independent of tax considerations. Even if the

testimony were true, the testimony does not establish a business

purpose for the use of foreign entities. At best, it indicates

that Moshe Melnik had a personal reason for placing a portion of

the proceeds in an entity that his ex-wife could not easily

access, but such motivation hardly qualifies as a business

purpose for the structure that the Melniks chose for the sale of

their HouTex stock.

The other reason offered by the Melniks and Mr. Pennoni for

the use of foreign entities is the concern about liability

resulting from warranties given to MMI in connection with its

acquisition of HouTex. We do not accept their testimony as

credible. We do not believe that MMI would have entered into the

transaction to acquire HouTex stock from a foreign entity if

there had been any realistic chance that the warranties MMI had

negotiated would be rendered unenforceable by the Melniks’ use of

the foreign entity. In fact, MMI stock and warrants to which the

Melniks and Clend were entitled under the acquisition agreement

were held in escrow after the HouTex acquisition closed to ensure

that their contractual obligations to MMI were fulfilled.
 - 37 -

The record regarding the business purpose for the use of the

foreign entities is unsatisfying and unconvincing for the reasons

summarized above. The record is also unconvincing and not

credible because none of the witnesses ever admitted that tax

considerations played any role in their decision to use the

foreign entities. The tax savings that resulted from the use of

the foreign entities were considerable, yet none of the witnesses

acknowledged this reality when they attempted at trial to justify

the use of the foreign entities. The only acknowledgment offered

with respect to the tax consequences was in the form of testimony

by Mr. Pennoni, who stated that taxes would eventually be paid by

the Melniks when they received their respective annuity payments.

The record, however, raises substantial questions regarding

whether Clend will ever be in a position to pay the annuities in

question. Assets that should have been invested and managed to

ensure, to the fullest extent reasonably possible, that the

annuities would actually be paid, were instead made available to

the Melniks through loans and directed real estate investments

that, as of the date of trial, were either in default or in

litigation.38

38
As of the trial date, the defaulted loans made to the
Melniks had not been treated by Clend as distributions to the
foreign trusts and by the trusts as distributions to the Melniks,
even though Bermuda Trust had warned the Melniks that the unpaid
loans might be treated as trust distributions.
 - 38 -

6. Role of Clend

Neither the Melniks nor Mr. Pennoni offered any testimony

regarding the business purpose for, or the role of, Clend, and

the record fails to establish that Clend was acquired for reasons

other than tax avoidance.

This Court has decided a number of cases involving foreign

trusts and/or private annuity transactions involving foreign

trusts. See, e.g., Weigl v. Commissioner, 84 T.C. 1192 (1985);

Estate of Fabric v. Commissioner, 83 T.C. 932 (1984); Benson v.

Commissioner, 80 T.C. 789 (1983); Stern v. Commissioner, 77 T.C.

614 (1981), revd. 747 F.2d 555, 558 (9th Cir. 1984); LaFargue v.

Commissioner, 73 T.C. 40 (1979), affd. in part and revd. in part

689 F.2d 845 (9th Cir. 1982); Lazarus v. Commissioner, 58 T.C.

854, 864 (1972) (The principle of substance over form is

“peculiarly applicable to annuities and trusts because they are

easily susceptible of manipulation so as to create illusion.”),

affd. 513 F.2d 824 (9th Cir. 1975); Bixby v. Commissioner, 58

T.C. 757, 789 (1972); Archbishop Samuel Trust v. Commissioner, 36

T.C. 641 (1961), affd. sub nom. Samuel v. Commissioner, 306 F.2d

682 (1st Cir. 1962); Waegemann v. Commissioner, T.C. Memo. 1993-

632. Except for Estate of Fabric v. Commissioner, supra, and

Benson v. Commissioner, supra, in which we were required, under

the rule of Golsen v. Commissioner, 54 T.C. 742, 757 (1970),

affd. 445 F.2d 985 (10th Cir. 1971), to follow adverse precedent
 - 39 -

decided by the Court of Appeals for the Ninth Circuit, we have

held in each of the enumerated cases either that the underlying

transactions and/or entities lacked economic substance or were

shams, that the private annuity transaction was really a transfer

in trust with a retained income interest, or that the taxpayer

was the grantor of the foreign trusts.

None of the above-cited cases involved an obligation to make

annuity payments by a foreign corporation owned by foreign

trusts. Interposing a foreign corporation between the annuitant

and the foreign trust enabled petitioners to argue that the

private annuity/foreign trust cases are distinguishable from the

facts of this case and are not controlling.

The injection of Clend into the transaction planning in this

case also enabled petitioners to argue that other Code sections

designed to circumvent foreign entity tax planning do not apply.

For example, section 679 provides that, subject to certain

exceptions, a United States person39 who directly or indirectly

transfers property to a foreign trust shall be treated as the

owner of the trust if there is a United States beneficiary of any

portion of the trust. Because the Melniks transferred 75 percent

of their HouTex stock to a foreign corporation and not to the

39
Sec. 7701(a)(30) defines a U.S. person as a citizen or
resident of the United States. The Melniks were U.S. persons
within the meaning of sec. 7701(a)(30) and were beneficiaries of
their respective foreign trusts.
 - 40 -

foreign trusts, section 679 does not apply unless we conclude

that the transfer to Clend was, in substance, an indirect

transfer to the foreign trusts.40

Although respondent argues that section 679 allows us to

conclude that Clend must be disregarded, we need not reach this

issue. The record raises serious doubt regarding whether the

foreign trusts had actually acquired Clend before Clend allegedly

executed the stock purchase agreements with the Melniks.

Moreover, the record suggests that, after Clend was acquired, it

functioned primarily as a conduit in connection with the sale of

the HouTex stock and the investment of the resulting proceeds.

In Commissioner v. Court Holding Co., 324 U.S. 331, 334

(1945), the Supreme Court of the United States held that the sale

of an apartment building by a corporation’s shareholders was, in

substance, a sale by the corporation. The Supreme Court

explained its holding as follows:

The incidence of taxation depends upon the substance of
a transaction. The tax consequences which arise from
gains from a sale of property are not finally to be
determined solely by the means employed to transfer
legal title. Rather, the transaction must be viewed as
a whole, and each step, from the commencement of

40
Sec. 1.679-3(f), Income Tax Regs., which applies to
transfers after Aug. 7, 2000, see sec. 1.679-7, Income Tax Regs.,
provides that, if a U.S. person is a related person (such as a
grantor or beneficiary) to a foreign trust, then any property
transferred from the U.S. person to an entity in which the
foreign trust holds an ownership interest is treated as a
transfer by the U.S. person to the foreign trust followed by a
transfer from the foreign trust to the entity owned by the
foreign trust.
 - 41 -

negotiations to the consummation of the sale, is
relevant. A sale by one person cannot be transformed
for tax purposes into a sale by another by using the
latter as a conduit through which to pass title. To
permit the true nature of a transaction to be disguised
by mere formalisms, which exist solely to alter tax
liabilities, would seriously impair the effective
administration of the tax policies of Congress. [Id.;
fn. ref. omitted.]

See also Robino, Inc. Pension Trust v. Commissioner, 894 F.2d 342

(9th Cir. 1990) (holding that pension trust beneficiaries’ sale

of real estate to their pension trusts, which immediately resold

the property, was in substance a sale by the beneficiaries),

affg. T.C. Memo. 1987-468.

Like the corporation in Court Holding Co., Clend functioned

as a conduit in the sale of HouTex. It did not participate in

the negotiations with MMI or in the valuation of the HouTex stock

it ostensibly owned. After the acquisition of HouTex by MMI,

Clend functioned primarily as the repository of the sale

proceeds, most of which were used to make loans to the Melniks or

to purchase real estate at the Melniks’ request.

The lack of evidence regarding Clend’s business purpose,

coupled with its apparent role as a conduit and its usefulness in

obfuscating the pertinent legal analysis, leads us to conclude

that respondent properly disregarded Clend in determining that

petitioners should be taxed on the gain from the sale of HouTex’s

stock.
 - 42 -

7. Petitioners’ Relationship to Mr. Taub

Moshe Melnik testified that Mr. Taub established and funded

the foreign trusts because he is a close friend of the Melniks.

Although Mr. Taub did not testify, we have no reason to doubt the

truthfulness of Mr. Melnik’s testimony regarding his friendship

with Mr. Taub. In response to the Court’s question, however, Mr.

Melnik also testified that Mr. Taub used $20,000 of his own money

to set up the foreign trusts simply because Mr. Melnik asked him

to do so and that Mr. Melnik did not offer or promise anything in

return for Mr. Taub’s generosity. After reviewing the trust

declarations, we have substantial doubt about the veracity of Mr.

Melnik’s testimony regarding the absence of a quid pro quo.

Each of the trust declarations contains a provision

designating Mr. Taub a beneficiary of the trust. Mr. Melnik did

not mention this provision at trial or explain why Mr. Taub was a

beneficiary of the Melniks’ foreign trusts. Absent an

explanation, the beneficiary designations in the trust

declarations cast doubt on Mr. Melnik’s testimony. Mr. Pennoni,

who drafted the trust declarations, obviously anticipated that a

distribution might be made to Mr. Taub at some point in the

future, or he would not have included Mr. Taub as one of the

trust beneficiaries. Mr. Taub did not testify regarding any

conversations that he may have had with the Melniks and Mr.

Pennoni, and the witnesses who did testify failed to explain the
 - 43 -

beneficiary designation. Unexplained, the designation of Mr.

Taub as a beneficiary of the foreign trusts raises the

possibility that the money paid by Mr. Taub to establish the

trusts could be repaid to Mr. Taub at a future date out of trust

principal or income.

8. Missing Documents

Relevant documents that might have helped to answer some of

the questions left open by the record in this case were not

introduced into evidence by petitioners. Those documents

included the three investment proposals regarding the Clend

investment strategy, parts of Clend’s account records including

documentation of the “credit facility” provided by Bermuda Trust

to Clend, and documents (including correspondence) relating to

the negotiation and consummation of Tapuz’s real estate

transaction.

9. Lack of Arm’s-Length Dealings

In this case, the Melniks transferred 75 percent of HouTex’s

stock, worth millions of dollars, to an unknown and unfunded

foreign entity without obtaining any security interest or

guaranty whatsoever. We must ask why. The answer that we glean

from the record is not favorable to petitioners.

Although the record in this case is not clear, it appears

that the Melniks agreed to transfer their HouTex stock to a

foreign corporation owned by foreign trusts without investigating
 - 44 -

Bermuda Trust and the persons who would manage the foreign

corporation. Petitioners relied on the representations of Mr.

Pennoni as their “due diligence” regarding the annuity

transaction and did not require any security interest or guaranty

in connection with the transfer of stock.

In the years following the sale of petitioners’ and Clend’s

HouTex stock, the Melniks sought and obtained from Clend/Bermuda

Trust at least two unsecured loans, totaling $900,000, to

purchase real estate in the United States. The Melniks defaulted

on the loans, but no action had been taken by the Melniks or by

Clend or Bermuda Trust to remedy the default as of the date of

trial. The Melniks also prevailed upon Bermuda Trust, the

trustee of the foreign trusts and the entity in control of Clend,

to arrange for Clend to form a subsidiary to purchase real estate

that the Melniks wanted to acquire in the United States.

Proceeds from the HouTex stock sale were used to make investments

that were sold to cover the $1,380,000 purchase price.

As of December 31, 2001, Clend’s assets consisted of the

$900,000 loan receivable owed by the Melniks, the real estate

acquired by Clend’s subsidiary for $1,380,000, and approximately

$54,000 in cash. Of the total cash ($3,388,907) paid to Clend by

MMI in 1997, $2,200,000 or 65 percent has been used to acquire

real estate in the United States either at the Melniks’ request

or to enable the Melniks to purchase real estate directly.
 - 45 -

Proceeds of $930,000 from the sale of MMI stock in 1999 were also

dissipated. Some of the cash was used to pay substantial fees,

and the remainder, with the exception of approximately $54,000,

was apparently used to make investments primarily in U.S. stocks

that were sold, often at a substantial loss, to cover the overage

in Clend’s account resulting from the $900,000 loans to the

Melniks.

The record demonstrates that Clend functioned primarily as a

conduit and that neither the Melniks, Clend, nor Bermuda Trust

acted with the kind of restraint that one would expect to see

from participants in a legitimate annuity transaction. Although

Clend had a substantial annuity obligation to fund, Clend and

Bermuda Trust used substantial portions of Clend’s assets to make

unsecured loans and high-risk real estate investments in the

United States at the Melniks’ request. In reality, the Melniks

treated Clend’s assets as a personal bank account and line of

credit.41 Such transactions support a conclusion that the

Melniks had access to, and indirect control over, Clend’s

assets42 in a manner that is inconsistent with the Melniks’ paper

status as creditors/annuitants.

41
During trial, Moshe Melnik referred to the assets held by
his foreign trust and by Clend as “my money.”
42
In the Form 8-K that MMI filed with the Securities and
Exchange Commission regarding the acquisition of HouTex, MMI
stated that the Melniks indirectly controlled Clend.
 - 46 -

In Samuel v. Commissioner, 306 F.2d at 687, the Court of

Appeals for the First Circuit summarized the essential substance

of a true annuity transaction as follows:

Inherent in the concept of an annuity is a transfer of
cash or property from one party to another in return
for a promise to pay a specific periodic sum for a
stipulated time interval. As such, an annuity contract
gives rise to a debtor-creditor relationship between
the transferee and transferor. * * * [O]nce the
annuitant has transferred the cash or property to the
obligor and has received his contractual right to
periodic payments, he is unconcerned with the ultimate
disposition of the property transferred once it is in
the obligor’s hands. * * *

In this case, the Melniks treated the stock sale proceeds that

should have been invested to preserve and ensure Clend’s ability

to pay the annuities as a personal line of credit, which they

used freely to finance real estate investments in the United

States. They did not act like annuitants whose only claim was to

periodic payments beginning sometime in the future. Although

Bermuda Trust purported to be an independent trustee of the

foreign trusts that owned and controlled Clend, the entity

obligated to make the annuity payments, Bermuda Trust not only

gave the Melniks virtually unlimited access to Clend’s assets but

failed to take action when the Melniks defaulted on the $900,000

loans.

All of the facts summarized above undermine the credibility

of petitioners’ case43 and contribute to our conclusion that

43
Petitioners argue that, because respondent did not call
(continued...)
 - 47 -

petitioners’ evidence in many material respects is not sufficient

to satisfy either their initial burden of production or their

ultimate burden of persuasion. Because petitioners have failed

to convince us that respondent’s determination was erroneous, we

sustain respondent’s determination that the annuity transactions

lacked economic substance.

Because we sustain respondent’s determination, we need not

and do not decide the alternative issues raised by respondent.

We turn instead to respondent’s contention that petitioners are

liable for the accuracy-related penalty under section 6662.

II. Petitioners’ Liability for Section 6662 Penalty

Respondent contends that petitioners are liable for the

accuracy-related penalty under section 6662 on alternate grounds:

(1) The underpayment of tax was attributable to negligence or

disregard of rules and regulations within the meaning of section

6662(b)(1), and (2) there was a substantial underpayment of

income tax within the meaning of section 6662(b)(2).

43
(...continued)
any witnesses to dispute petitioners’ version of the facts, we
are required to accept petitioners’ evidence without question.
Petitioners are mistaken. In order to satisfy their initial
burden of production and their ultimate burden of persuasion,
petitioners were required to produce evidence that was credible.
If petitioners’ evidence is not credible or if petitioners’
evidence is not convincing enough to satisfy us that respondent’s
determination is erroneous, petitioners are not entitled to a
decision in their favor.
 - 48 -

Section 6662(a) authorizes a 20-percent penalty to be

imposed on the portion of an underpayment of income tax

attributable to negligence or disregard of rules or regulations.

Sec. 6662(b)(1). Negligence “includes any failure to make a

reasonable attempt to comply with the provisions of * * * [the

Internal Revenue Code]”. Sec. 6662(c); see also Neely v.

Commissioner, 85 T.C. 934, 947 (1985) (stating that negligence is

the lack of due care or failure to do what a reasonable person

would do under the circumstances).

Section 6662(a) also authorizes the 20-percent penalty to be

imposed if there is a substantial understatement of income tax.

Sec. 6662(b)(2). A substantial understatement of income tax with

respect to an individual taxpayer exists if, for any taxable

year, the amount of the understatement for the taxable year

exceeds the greater of 10 percent of the tax required to be shown

on the return for the taxable year or $5,000, whichever is

greater. Sec. 6662(d)(1)(A).

Respondent bears the initial burden of production with

respect to petitioners’ liability for the section 6662 penalty,

in that respondent must first produce sufficient evidence to

establish that the imposition of the section 6662 penalty is

appropriate. Sec. 7491(c). If respondent satisfies his initial

burden of production, the burden of producing evidence to refute

respondent’s evidence and to establish that petitioners are not
 - 49 -

liable for the section 6662 penalty shifts to petitioners.

Higbee v. Commissioner, 116 T.C. 438, 447 (2001).

We have previously held that a taxpayer’s adoption of a

“flagrant tax avoidance scheme” repeatedly rejected by the courts

is patently negligent. Wesenberg v. Commissioner, 69 T.C. 1005,

1015 (1978); see also Gouveia v. Commissioner, T.C. Memo. 2004-

256; Hanson v. Commissioner, T.C. Memo. 1981-675, affd. 696 F.2d

1232 (9th Cir. 1983). However, as petitioners point out, the

implementation of a private annuity transaction using foreign

entities has not been consistently rejected by the courts.

Although this Court has subjected such transactions to strict

scrutiny and has upheld only a few, the Court of Appeals for the

Ninth Circuit has reversed this Court in several cases involving

private annuity transactions, holding that, on the facts of those

cases, the transactions had sufficient economic substance to be

respected for Federal income tax purposes. See Stern v.

Commissioner, 77 T.C. 614 (1981), revd. 747 F.2d 555, 558 (9th

Cir. 1984); LaFargue v. Commissioner, 73 T.C. 40 (1979), affd. in

part and revd. in part 689 F.2d 845 (9th Cir. 1982).

With this background in mind, we are unable to conclude that

a private annuity transaction using foreign entities is a

flagrant tax avoidance scheme that is per se negligent. Instead,

we look to the evidence introduced by the parties to determine

whether petitioners are liable for the section 6662 penalty.
 - 50 -

Petitioners contend that they were not negligent in using

the private annuity transaction recommended and implemented by

Mr. Pennoni. Petitioners also argue that, even if we conclude

they were negligent, petitioners relied upon the advice of an

experienced tax professional who had full knowledge of the

relevant facts in entering into the private annuity transaction

and that they qualify for relief from the penalty under section

6664(c).

Section 6664(c)(1) provides that “No penalty shall be

imposed under this part with respect to any portion of an

underpayment if it is shown that there was a reasonable cause for

such portion and that the taxpayer acted in good faith with

respect to such portion.” The record consisted solely of a

substantial number of stipulated exhibits and the testimony of

three witnesses called by petitioners. The three witnesses

testified, among other things, that the private annuity

transactions were planned and implemented by Mr. Pennoni, who

assured petitioners that the transactions were legitimate and

were entitled to respect under Federal income tax law. The

exhibits reflect the planning and implementation of the private

annuity transactions and, on their faces, do not support a

conclusion that petitioners’ decision to enter into the

transactions was per se negligent.
 - 51 -

The uncontroverted record establishes that petitioners

relied on Mr. Pennoni, who was the driving force behind the

planning of the annuity transactions and who assured petitioners

that there was a reasonable basis for the income tax reporting of

the private annuity transactions and the HouTex stock sale.

We conclude that, under the circumstances, petitioners’

reliance on Mr. Pennoni was reasonable, that petitioners had

reasonable cause for the underpayment, and that petitioners acted

in good faith with respect to the underpayment within the meaning

of section 6664(c)(1). Consequently, we hold that petitioners

are not liable for the section 6662 accuracy-related penalty.

III. Other Arguments

We have considered the remaining arguments of both parties

for results contrary to those expressed herein, and we conclude

that those arguments, to the extent not discussed above, are

without merit or that it is not necessary to reach those

arguments.

To reflect the foregoing,

Decisions will be entered

under Rule 155.