WB Acquisition, Inc. v. Comm'r

T.C. Memo. 2011-36

UNITED STATES TAX COURT

WB ACQUISITION, INC. & SUBSIDIARY, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 26187-06, 29106-07, Filed February 8, 2011.
5039-08.

Ernest S. Ryder, Richard V. Vermazen, Lauren A. Rinsky, and

John W. Sunnen, for petitioners.

Monica D. Gingras and Mistala G. Merchant, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HAINES, Judge: These cases are before the Court

consolidated for purposes of trial, briefing, and opinion. WB

1
Cases of the following petitioners are consolidated
herewith: WB Partners f.k.a. WB Acquisition Partners, DJB
Holding Corporation, Tax Matters Partner, docket No. 29106-07;
and WB Acquisition, Inc., docket No. 5039-08.
 -2-

Acquisition, Inc., & Subsidiary petitioned the Court for

redetermination of the following Federal income tax deficiencies

and penalties:

Penalty
Year Deficiency Sec. 6662
2002 $987,222 $197,444
2003 3,543,011 708,602
2004 226,162 45,232
2005 131,302 26,260

The tax matters partner of WB Partners separately petitioned the

Court for readjustment of final partnership administrative

adjustments with respect to 2003, 2004, and 2005. WB

Acquisition, Inc., and Watkins Contracting, Inc., filed

consolidated tax returns for taxable years 2002-2005.

The issues for decision after concessions2 are:

1. Whether Watkins Contracting, Inc., and WB Partners

conducted the environmental remediation of the San Diego Naval

Training Center as a joint venture for Federal tax purposes

during taxable years 2002-2004;

2. whether the proceeds of a covenant not to compete and

interest income resulting from the 2003 sale of Watkins

2
On brief respondent conceded that: (1) A refund check for
$326,574 erroneously issued by respondent to Watkins Contracting,
Inc., was returned and does not constitute income to Watkins
Contracting, Inc., in 2005; (2) WB Partners, DJB Holding
Corporation, GSW Holding Corporation, the DJB Holding Corporation
ESOP, and the GSW Holding Corporation ESOP are not shams for tax
purposes; (3) DJB Holding Corporation and GSW Holding Corporation
are the true partners of WB Partners; and (4) petitioners have
substantiated the net operating loss (NOL) of $563,485 of Watkins
Contracting, Inc., generated in 2000 and used in 2002 and 2003.
 -3-

Contracting, Inc.’s assets were properly included in the income

of WB Partners in 2003 and 2004;

3. whether an NOL claimed by Watkins Contracting, Inc., as

a carryforward from 2001 to 2003 was substantiated; and

4. whether WB Acquisition, Inc., & Subsidiary are liable

for section 6662(a) penalties.3

FINDINGS OF FACT

I. History of WCI

Daren J. Barone (Barone) and Gregory S. Watkins (Watkins)

began their careers in the business of specialty contracting,

environmental remediation, and demolition in Hawaii in the early

1980s. Soon after, they expanded into the asbestos removal

trade. In the early 1990s, Barone and Watkins returned to their

hometown of San Diego, where Watkins worked for his father’s

company, Watkins & Son, a business specializing in asbestos

removal. In late 1991 or early 1992 Barone joined Watkins & Son

as an employee. Together with Watkins’ father, Barone and

Watkins ran the company until Watkins’ father retired in the mid-

1990s. Barone and Watkins subsequently purchased Watkins’

father’s interest in the company and renamed it Watkins

Contracting, Inc. (WCI).

3
Unless otherwise indicated, all section references are to
the Internal Revenue Code of 1986, as amended, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
Amounts are rounded to the nearest dollar.
 -4-

Barone and Watkins operated WCI until 1997, when they sold

the stock of the company to REXX Environmental Corp. (REXX) for

cash and stock. Barone testified that he encouraged Watkins to

sell WCI in part because of the personal liability associated

with the business, which required Barone and Watkins to obtain

performance bonds and sign indemnity agreements to guarantee the

completion of certain projects. The sale relieved Barone and

Watkins from any such personal guaranties.

In connection with the sale, REXX hired Barone and Watkins

as employees to manage WCI. Under REXX, Barone managed employees

and accounts, handled financing, and developed business.

Similarly, Watkins bid jobs, managed construction, and oversaw

field work.

By 1999 REXX encountered financial difficulties in its

operation of WCI. These financial difficulties significantly

impaired WCI’s ability to bond future projects. REXX’s

executives refused to execute personal indemnities and guaranties

for WCI to bond its projects and began looking to sell the

company. Under these circumstances, REXX’s executives turned to

Barone and Watkins to sign personal guaranties for WCI to bond

projects. In exchange for their personal guaranties, REXX

offered Barone and Watkins a percentage of profits from WCI

projects.
 -5-

During this time a profitable opportunity arose for WCI to

perform remediation work for the U.S. Navy in San Diego in a job

known as the IDIQ project. Because of WCI’s financial position,

however, REXX was unable to secure the bonding on the IDIQ

project without personal guaranties for the completion of the

project. Consequently, an agreement was reached with REXX for

Barone and Watkins to personally guarantee the bond for the IDIQ

project. In exchange for their personal guaranties, the

agreement entitled Barone and Watkins to 66.66 percent of the

profits from the IDIQ project.

As WCI’s financial problems mounted, REXX became more eager

to sell the company and approached Barone and Watkins to gauge

their interest in reacquiring WCI. Barone and Watkins initially

were hesitant about a potential deal because they were concerned

with a number of liability issues surrounding WCI. Nonetheless,

Barone and Watkins eventually offered to purchase the stock of

WCI for approximately one-third of the price they had received

for it just 2 years earlier. As a condition of their offer,

Barone and Watkins required the sale to be structured in a way

that would limit their personal exposure.

To address this concern, Barone met with Ernest S. Ryder

(Ryder), an attorney, to discuss asset protection vehicles for

the purchase and subsequent ownership of WCI. Barone and Watkins

had a laundry list of concerns they wanted to address before
 -6-

moving forward, including: (1) Personal protection from

creditors; (2) layers of liability protection to operate WCI; (3)

the ability to invest both together and separately, depending on

the risks involved in each project; (4) creating qualified

retirement plans; and (5) avoiding probate. Barone and Watkins

ultimately contracted the services of Ryder to design a structure

to meet their concerns.

The structure designed by Ryder began with forming a

corporate owner of WCI, WB Acquisitions, Inc. (Acquisitions).

Acquisitions is a C corporation wholly owned by a partnership, WB

Partners. The partnership had two equal S corporation partners,

DJB Holding Corporation (DJB) and GSW Holding Corporation (GSW).

DJB and GSW are wholly owned by the DJB Holding Corporation ESOP

(DJB ESOP) and the GSW Holding Corporation ESOP (GSW ESOP),

respectively, each of which is an employee stock ownership plan.

Barone is the lone participant in the DJB ESOP, and Watkins is

the lone participant in the GSW ESOP. This structure is

reflected in the following diagram:
 -7-

Barone & Watkins Entities
 -8-

This structure addressed each of Barone’s and Watkins’

concerns. Acquisitions served as a corporate owner of WCI to

protect Barone and Watkins from the risks of personal liability.

WB Partners was a vehicle that allowed Barone and Watkins to

invest together on projects unrelated to the environmental

remediation and construction work performed by WCI.4 DJB and GSW

were corporate vehicles which allowed Barone and Watkins to

invest individually5 and added another layer of protection from

personal liability. Finally, the DJB ESOP and the GSW ESOP

provided Barone and Watkins with qualified retirement plans. On

June 10, 1999, Barone and Watkins finalized the purchase of the

stock of WCI from REXX, and on September 19, 2000, Barone and

Watkins assigned their ownership interests in WCI to

Acquisitions.

II. The Services of Barone and Watkins

In connection with the purchase from REXX and with the

formation of the above-described structure, Barone and Watkins

entered into employment agreements with their respective

corporations, DJB and GSW, to provide construction management,

indemnity, and financing services full time. Several relevant

4
Since its formation, WB Partners has invested in at least
20 business ventures, including investments in a publishing
company, a medical center, a hotel in Florida, condominiums in
Las Vegas, and other properties in California.
5
At trial, Barone testified that he was more willing to take
risks and that DJB allowed him to make investments that Watkins
could not stomach.
 -9-

provisions describe Barone’s and Watkins’ responsibilities

pursuant to their employment agreements. Section 1.1.4 of each

employment agreement provides for the services of Barone and

Watkins to include any and all services related to the present or

future business of DJB, GSW, WCI, any related entity, and any

party that may acquire an interest in any of the above-listed

entities. Section 1.3 of each employment agreement is a

noncompetition provision, preventing Barone and Watkins from

engaging in any business activity which is, or could become,

competitive with or adverse to any of the above-listed entities.

Finally, section 2.2 of each employment agreement requires Barone

and Watkins to provide their services exclusively for the benefit

of DJB and GSW.

DJB and GSW each hold a 50-percent partnership interest in

WB Partners. Pursuant to section 1.6 of the WB Partners

partnership agreement, which provides that DJB and GSW controlled

the exclusive rights to the services of Barone and Watkins, the S

corporations contributed such services to the partnership as

necessary to manage and conduct its business.

Despite the exclusivity clauses of their employment

agreements, Barone and Watkins performed services for WCI without

the permission of DJB, GSW, or WB Partners. Barone testified

that he continued to perform the same services he had performed

for WCI while it was controlled by REXX after Barone and Watkins
 -10-

repurchased the stock of WCI. Those services included managing

employees and accounts, handling financing, and developing

business. Further, Watkins testified that he “bid and got and

oversaw” nearly three-quarters of WCI’s projects.

III. The NTC Joint Venture

A. The NTC Project

In late 1999 or early 2000, the city of San Diego solicited

bids for a redevelopment project at the San Diego Naval Training

Center (the NTC project). This project required extensive

environmental remediation work, including the removal of

asbestos, lead-based paint, and contaminated soil from close to

200 buildings. The city of San Diego ultimately chose the Corky

McMillin Cos. (McMillin) as the master developer of the project.

McMillin then hired the Harper-Nielsen-Dillingham Joint Venture

(Harper) as the construction manager to oversee the demolition

and remediation of the NTC project. Harper does not perform this

type of work on its own, however, so on September 29, 2000,

Harper entered into an agreement with WCI for the performance of

the demolition and environmental remediation work of the NTC

project (the subcontract agreement). Pursuant to the subcontract

agreement, WCI was to receive $17,001,073.

WCI’s willingness to undertake the demolition and

remediation work of the NTC project came with risk. The NTC

project required the demolition of and removal of all hazardous
 -11-

materials from close to 200 buildings covering a space

approximately 1 mile long and three-quarters of a mile wide. To

secure the subcontract agreement, McMillin and Harper required

WCI to submit a lump-sum bid. A lump-sum bid would force WCI to

take on the risk of unexpected costs, a risk that was prevalent

in the NTC project because no clearly defined scope of work was

provided to Harper and WCI during the bidding process. WCI

reviewed prints and conducted an investigation of the NTC project

site before bidding. Nonetheless, the project posed significant

construction and environmental risks, including unknown amounts

of asbestos, lead-based paints, and other items.

As part of the bidding process for the NTC project, the city

of San Diego required a developer to put up a bond and sign an

indemnity agreement to guaranty completion of the job. Both

McMillin and Harper refused to guarantee the work, forcing WCI to

assume the risk as part of its subcontract bid. Both Barone and

Watkins testified that signing a $17 million bond was scary; it

was far and away the largest personal guaranty they had ever

contemplated. Barone and Watkins were specifically concerned

that with WCI’s financial difficulties under REXX, creditors from

other projects might be able to reach the cashflow of the NTC

project. Accordingly, each testified that taking on that kind of

risk required taking steps to make sure the cashflow from the NTC

project was protected.
 -12-

B. The NTC Joint Venture Agreement

To address their concerns Barone decided that WCI would

participate in the NTC project through a joint venture. On

September 20, 2000, WCI and WB Partners executed an agreement

(the NTC joint venture agreement) to form a joint venture for the

purpose of completing the NTC project (the NTC joint venture).

Pursuant to section 4.4 of the NTC joint venture agreement, 30

percent of the profits from the NTC joint venture were allocated

to WCI and 70 percent to WB Partners. The ownership structure of

the NTC joint venture is reflected in the following diagram:
 -13-

The NTC joint venture
 -14-

Section 2.1.1 of the NTC joint venture agreement describes the

obligations of WCI in the NTC joint venture, providing:

2.1.2 Obligations and Responsibilities of WCI. The
proposal shall provide that WCI shall have responsibility
for management and performance of the Subcontract Work in
connection with the Project, with full authority to make
decisions regarding the performance of said Subcontract
work.

Similarly, section 2.1.2 of the NTC joint venture agreement

describes the obligations and responsibilities of WB Partners in

the NTC joint venture, providing:

2.1.2 Obligations and Responsibilities of WB. The proposal
shall provide that WB shall have responsibility for
providing Indemnity and Financing Services to WCI so that
WCI has the financial capability to perform the Subcontract
work.

Section 3.1 of the NTC joint venture agreement further provides

that WB Partners agrees to assist WCI with any additional

information and data reasonably required throughout the proposal

process.

Several other provisions of the NTC joint venture agreement

are relevant to our discussion. As discussed above, section 4.4

of the NTC joint venture agreement allocates 30 percent of the

profits from the NTC joint venture to WCI and 70 percent to WB

Partners. According to Barone and Watkins, this profit split was

based on their agreement with REXX for the IDIQ project. Because

REXX paid Barone and Watkins 66.66 percent of the profits from

the IDIQ project in an arm’s-length transaction, Barone and

Watkins reasoned WB Partners was entitled to 70 percent of the
 -15-

profits from the NTC project for providing similar financial

services. According to Barone and Watkins, the profit split was

designed to prevent the 70 percent of profits allocated to WB

Partners from being exposed to the reach of WCI’s creditors.

Next, section 4.2 of the NTC joint venture agreement

protects WCI from incurring a loss on the NTC project, providing:

4.2 Reimbursement of WCI Costs and Expenses. WCI shall be
entitled to reimbursement from the NTC joint venture Account
of all Direct Costs incurred by WCI in connection with the
Subcontract Work, plus Five Percent (5%) of all such Direct
Costs. As herein, “Direct Costs” shall mean all direct
costs and expenses reasonably incurred by WCI in connection
with the Subcontract Work, but excluding therefore any
indirect costs, including without limitation, overhead and
general administrative expenses as determined in accordance
with Federal government cost accounting standards. WCI
shall, on a monthly basis, submit to the Joint Venture an
invoice for Direct Costs incurred, plus Five Percent (5%) of
such costs.

Further, section 4.1 of the NTC joint venture agreement provides

that payments from the NTC project may be made directly to WCI

and requires such payments to be deposited in a bank account in

the name of the NTC joint venture. Finally, section 5.1 of the

NTC joint venture agreement requires the NTC joint venture to

maintain books and records and to file income tax returns.

Despite the NTC joint venture agreement, the Subcontract

agreement with Harper was not amended to replace WCI with the NTC

joint venture. Moreover, only WCI, and not the NTC joint

venture, had the proper contracting licenses to perform the

physical work required by the NTC project.
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C. Conduct of the NTC joint venture

Once the NTC joint venture was formed, it applied for,

obtained, and used its own employer identification number. This

employer identification number was used to open up the NTC joint

venture bank account. In addition to bank records, the NTC joint

venture prepared its own income statements, work in progress

schedules, and other financials.

On September 20, 2000, a general indemnity agreement was

executed by and between the member companies of the American

International Group (including, among others, the American

Fidelity Co., the Insurance Co. of the State of Pennsylvania and

the Commerce and Industry Co. of Canada) (together referred to as

AIG), as the surety, and Barone, Watkins, WCI, WB Partners, DJB,

GSW, and the NTC joint venture as the indemnitors. On January 2,

2002, an additional indemnity agreement was issued naming the

Greenwich Insurance Co. as the surety in connection with any

bonds issued on behalf of WCI, WB Partners, DJB, GSW, and the NTC

joint venture (together, the September 20, 2000, and January 2,

2002, agreements are hereinafter referred to as the indemnity

agreements). The indemnity agreements require the indemnitors to

exonerate the surety for any costs incurred by reason of, among

other things, the execution of a bond.

On October 18, 2000, a payment and performance bond was

issued by the Insurance Co. of the State of Pennsylvania, as
 -17-

surety, in the amount of $17,829,279, with WCI as the principal

and Harper as the obligee. On January 22, 2001, a replacement

bond was issued in the amount of $17,001,072 to change the bond

amount and to add McMillin as a dual obligee with Harper

(together, the October 18, 2000, and January 22, 2001, bonds are

hereinafter referred to as the NTC bond). The NTC bond required

the Insurance Co. of the State of Pennsylvania to complete the

NTC project if WCI were to default on the subcontract agreement.

Consistent with the subcontract agreement, Harper paid WCI,

and not the NTC joint venture or WB Partners, for the work

performed on the NTC project. In fact, Brad Humphrey, the

project manager at Harper, testified that he was not familiar

with WB Partners. In contrast, Krispin Rosner (Rosner), a

certified public accountant (C.P.A.) working for the accounting

firm of Milloy Rosner & Brown (MRB), was familiar with the NTC

joint venture, WCI, and WB Partners. Rosner testified that MRB

calculated the profits from the NTC joint venture and accounted

for those profits on the tax returns of each of the joint

venturers. Rosner further testified that MRB did not file a tax

return for the NTC joint venture. On brief, petitioners contend

that MRB treated the NTC joint venture as jointly controlled

operations under generally accepted accounting principles (GAAP),

and therefore it had no need to file its own tax return.
 -18-

By September 30, 2002, WCI had billed Harper $14,100,332.

At that time, the NTC joint venture had incurred costs related to

the NTC project of $5,822,738, resulting in a profit of

$8,277,599. Pursuant to the NTC joint venture agreement, WB

Partners was entitled to 70 percent of the profits, or

$5,714,319. However, Barone and Watkins instituted a profit cap,

limiting WB Partners’ allocation to $4,172,000, or 50.4 percent

of the NTC joint venture profits. Barone and Watkins were the

only persons involved in determining the profit split. On

February 2, 2004, Harper certified the completion of the NTC

project.

IV. Sale of WCI to Kuranda

On April 18, 2003, WCI entered into an asset purchase

agreement with Kuranda Capital, LP (Kuranda), for the sale of

substantially all of the assets of WCI (the asset purchase

agreement). The final purchase price for the assets was

$5,423,091, paid with $4,923,091 in cash and a $500,000 note

payable to Watkins. In connection with the asset purchase

agreement, Barone, Watkins, WB Partners, DJB, GSW, and WCI

entered into a noncompetition agreement for the benefit of

Kuranda (the noncompetition agreement). Exhibit B to the asset

purchase agreement allocates $3,400,000 of the purchase price to

the noncompetition agreement.
 -19-

Section 1 of the noncompetition agreement prohibits Barone,

Watkins, WB Partners, DJB, GSW, and WCI from engaging in

“Competing Services” or from working for another company engaging

in such services. For purposes of the noncompetition agreement,

“Competing Services” is defined as any:

(i) service that has been provided, performed or offered by
or on behalf of * * * [WCI] (or any predecessor of * * *
[WCI]) at any time on or prior to the date of this
Noncompetition Agreement that involves or relates to
asbestos, mold, and lead abatement in residential,
commercial and government properties; (ii) service that is
substantially the same as, is based upon or competes in any
material respect with any service referred to in clause
“(i)” of this sentence.

Further, recital D of the noncompetition agreement provides that

WB Partners, through DJB’s and GSW’s exclusive employment

agreements, controls the services of Barone and Watkins,

including the right to enforce observation of the noncompetition

requirements by each.

Pursuant to the $500,000 note, Kuranda agreed to pay Watkins

the principal of the note plus interest at an annual rate of 10

percent. The proceeds of the noncompetition agreement and

interest paid on the $500,000 note were included as income by WB

Partners in its 2003 and 2004 Federal partnership income tax

returns.

V. Net Operating Loss

On its 2000 and 2001 Federal income tax returns, WCI claimed

NOLs of $563,485 and $1,311,524, respectively. In 2002 WCI used
 -20-

$443,077 of the NOL generated in 2000. In 2003, according to

WCI’s Federal income tax return, WCI used a balance of $159,593

from the NOL generated in 2000 and the entire $1,311,524

generated in 2001, for a total NOL deduction of $1,471,117.

Petitioners claim that the NOL generated in 2001 comprises

in part the following: (1) An adjustment on Schedule M-1, Book

to Tax Reconciliation, of $214,960; (2) professional fees of

$243,199; and (3) cost of goods sold of $526,998. Rosner

testified that the Schedule M-1 adjustment is an accounting

adjustment made to reduce book income because WCI had reported an

excess of book income when it was owned by REXX. Rosner further

testified that the Schedule M-1 adjustment was the result of

WCI’s overstating its profits on three jobs in 2000. Next,

petitioners provided canceled checks and the testimony of Rosner

with respect to the legal and professional fees of $243,199.

Finally, petitioners provided the general ledger of WCI with

respect to the $526,998 attributable to cost of goods sold.

VI. Notices of Deficiency

On September 29, 2006, and November 27, 2007, respondent

issued notices of deficiency to Acquisitions for the 2002 and

2003-2005 tax years, respectively.6 On September 14 and November

21, 2007, respondent issued notices of final partnership

administrative adjustment (the FPAAs) to WB Partners for the 2003

6
As discussed above, Acquisitions filed a consolidated tax
return with WCI for taxable years 2002-2005.
 -21-

and 2004-2005 tax years, respectively. Petitioners timely filed

their petitions in this Court. The principal place of business

of Acquisitions, WCI, and WB Partners is in California.

OPINION

I. Burden of Proof

The Commissioner’s determinations in the notice of

deficiency are generally presumed correct, and the taxpayers bear

the burden of proving them incorrect. See Rule 142(a)(1). In

respect of any new matter pleaded in the answer, however, the

Commissioner bears the burden of proof. Id. Here, because the

issue was raised only in respondent’s amended answer, respondent

bears the burden of proof with respect to whether the NTC joint

venture was a joint venture for Federal tax purposes in 2002,

resulting in an assignment of income in 2002 from WCI to WB

Partners. Petitioners do not argue that the burden of proof

shifts to respondent pursuant to section 7491(a) for any other

issue or year, nor have they shown that the threshold

requirements of section 7491(a) have been met for any of the

other determinations at issue. Accordingly, the burden remains

on petitioners with respect to all other issues to prove that

respondent’s determination of deficiencies in income tax is

erroneous.
 -22-

II. The NTC joint venture

In United States v. Basye, 410 U.S. 441, 450 (1973), the

Supreme Court reiterated the longstanding principle that income

is taxed to the person who earns it, stating: “The principle of

Lucas v. Earl, [281 U.S. 111, 115 (1930),] that he who earns

income may not avoid taxation through anticipatory arrangements

no matter how clever or subtle, has been repeatedly invoked by

this Court and stands today as a cornerstone of our graduated

income tax system.” For a more recent formulation of this

principle, see Commissioner v. Banks, 543 U.S. 426 (2005),

which held that a contingent-fee agreement should be viewed as an

anticipatory assignment to the attorney of a portion of the

client’s income from any litigation recovery. The entity earning

income “cannot avoid taxation by entering into a contractual

arrangement whereby that income is diverted to some other person

or entity.” United States v. Basye, supra at 449. We must

determine whether the NTC Joint Agreement created a legitimate

joint venture between WCI and WB Partners or was merely a vehicle

to divert income from the NTC project to WB Partners and away

from WCI.

Whether there is a partnership for tax purposes is a matter

of Federal, not local, law. Commissioner v. Tower, 327 U.S.

280, 287-288 (1946); Estate of Kahn v. Commissioner, 499 F.2d

1186, 1189 (2d Cir. 1974), affg. Grober v. Commissioner, T.C.
 -23-

Memo. 1972-240; Beck Chem. Equip. Corp. v. Commissioner, 27 T.C.

840, 849 (1957); Comtek Expositions, Inc., v. Commissioner, T.C.

Memo. 2003-135, affd. 99 Fed. Appx. 343 (2d Cir. 2004). “[T]he

term ‘partnership’ includes a syndicate, group, pool, joint

venture or other unincorporated organization through or by means

of which any business, financial operation, or venture is carried

on, and which is not * * * a corporation or a trust or estate.”

Secs. 761(a), 7701(a)(2). The principles applied to determine

whether there is a partnership for Federal tax purposes are

equally applicable to determine whether there is a joint venture

for Federal tax purposes. Sierra Club, Inc. v. Commissioner, 103

T.C. 307, 323 (1994), affd. in part and revd. in part on other

grounds 86 F.3d 1526 (9th Cir. 1996); Luna v. Commissioner, 42

T.C. 1067, 1077 (1964); Beck Chem. Equip. Corp. v. Commissioner,

supra at 848-849.

The required inquiry for determining the existence of a

partnership for Federal income tax purposes is whether the

parties “really and truly intended to join together for the

purpose of carrying on business and sharing in the profits or

losses or both.” Commissioner v. Tower, supra at 287. Their

intention is a matter of fact, “to be determined from testimony

disclosed by their ‘agreement, considered as a whole, and by

their conduct in execution of its provisions.’” Id. (quoting

Drennen v. London Assurance Co., 113 U.S. 51, 56 (1885)).
 -24-

In Commissioner v. Culbertson, 337 U.S. 733, 742 (1949), the

Supreme Court elaborated on this standard and stated that there

is a partnership for Federal tax purposes when

considering all the facts--the agreement, the conduct of the
parties in execution of its provisions, their statements,
the testimony of disinterested persons, the relationship of
the parties, their respective abilities and capital
contributions, the actual control of income and the purposes
for which it is used, and any other facts throwing light on
their true intent--the parties in good faith and acting with
a business purpose intended to join together in the present
conduct of the enterprise. * * *

In Luna v. Commissioner, supra at 1077-1078, this Court

distilled the principles mentioned in Commissioner v. Tower,

supra, and Commissioner v. Culbertson, supra, to set forth the

following factors as relevant in evaluating whether parties

intend to create a partnership for Federal income tax purposes

(the Luna factors):

The agreement of the parties and their conduct in
executing its terms; the contributions, if any, which
each party has made to the venture; the parties’ control
over income and capital and the right of each to make
withdrawals; whether each party was a principal and
coproprietor, sharing a mutual proprietary interest in the
net profits and having an obligation to share losses, or
whether one party was the agent or employee of the other,
receiving for his services contingent compensation in the
form of a percentage of income; whether business was
conducted in the joint names of the parties; whether the
parties filed Federal partnership returns or otherwise
represented to respondent or to persons with whom they dealt
that they were joint venturers; whether separate books of
account were maintained for the venture; and whether the
parties exercised mutual control over and assumed mutual
responsibilities for the enterprise.

See also Estate of Kahn v. Commissioner, supra at 1189.
 -25-

None of the Luna factors is conclusive of the existence of a

partnership. Burde v. Commissioner, 352 F.2d 995, 1002 (2d Cir.

1965), affg. 43 T.C. 252 (1964); McDougal v. Commissioner, 62

T.C. 720, 725 (1974). We apply each Luna factor to the facts of

these cases to determine whether WCI and WB Partners engaged in a

joint venture during the taxable periods at issue.

1. The Agreement of the Parties and Their Conduct in
Executing Its Terms

The NTC joint venture agreement sets forth the terms of the

NTC joint venture. However, the existence of a written agreement

is not determinative of whether a joint venture existed between

WCI and WB Partners. See Sierra Club, Inc. v. Commissioner,

supra at 324; Comtek Expositions, Inc. v. Commissioner, supra.

It is well established that the tax consequences of transactions

are governed by substance rather than form. Frank Lyon Co. v.

United States, 435 U.S. 561, 573 (1978).

The NTC joint venture agreement describes the anticipated

conduct of, and relationship between, WCI and WB Partners in the

NTC joint venture. The NTC joint venture agreement includes,

among other things, terms governing each joint venturer’s

participation in the preparation and submission of the proposal

for the NTC project, obligations and responsibilities to the NTC

joint venture, the receipt, allocation and distribution of

profits, and the NTC joint venture’s financial and tax reporting

obligations.
 -26-

Petitioners argue that WCI and WB Partners substantially

complied with the terms of the NTC joint venture agreement. In

at least three instances, however, WCI and WB Partners acted

outside the plain language of the agreement. Most notably,

Barone testified that because the NTC project was more profitable

than expected, the NTC joint venture capped WB Partners’ profits

and awarded WCI approximately $1,600,000 more than it was

entitled to pursuant to the NTC joint venture agreement. This

additional allocation resulted in an actual allocation of profits

between WCI and WB Partners of 49.6 and 50.4 percent,

respectively. Respondent contends that the profit cap is a

significant change from the 70 percent of profits allocated to WB

Partners in section 4.4 of the NTC joint venture agreement.

The NTC joint venture agreement does not include a provision

permitting WCI and WB Partners to institute a profit cap for

either party. Further, although WCI and WB Partners had the

right to amend the NTC joint venture agreement, there is no

evidence of such an amendment. Accordingly, WCI and WB Partners

did not comply with the terms of the NTC joint venture agreement

with respect to the profit allocation.

In addition to the profit cap, respondent argues that the

NTC joint venture failed to file a Federal income tax return as

required pursuant to section 5.1 of the NTC joint venture

agreement. Petitioners argue that MRB treated the NTC joint
 -27-

venture as jointly controlled operations under GAAP using a

method where each joint venturer included its share of the NTC

joint venture profits in its income and its share of the NTC

joint venture assets on its balance sheets.

MRB’s treatment of the NTC joint venture pursuant to GAAP is

not determinative as to whether the NTC joint venture must file a

Federal income tax return. The treatment of an item for

financial accounting purposes does not always mesh with its

treatment for Federal tax purposes. Thor Power Tool Co. v.

Commissioner, 439 U.S. 522, 531 (1979); see also Hamilton Indus.,

Inc. v. Commissioner, 97 T.C. 120, 128 (1991); UFE, Inc. v.

Commissioner, 92 T.C. 1314, 1321 (1989); Sandor v. Commissioner,

62 T.C. 469, 477 (1974), affd. 536 F.2d 874 (9th Cir. 1976).

Further, MRB’s treatment of the NTC joint venture pursuant to

GAAP does not affect whether WCI and WB Partners executed the

terms of the NTC joint venture agreement. Accordingly, the NTC

joint venture’s failure to file a Federal income tax return is a

substantive deviation from the NTC joint venture agreement.

The first Luna factor weighs against finding a joint venture

between WCI and WB Partners. WCI and WB Partners failed to

comply with the terms of the NTC joint venture agreement with

respect to the allocation of profits and tax return filing

requirements. We find this failure to comply to be a significant

deviation from the NTC joint venture agreement.
 -28-

2. The Contributions, If Any, Which Each Party Has Made to
the Venture

We have held that both parties do not have to be active

participants to a venture, so long as there is an intent to form

a business together. 70 Acre Recognition Equip. Pship. v.

Commissioner, T.C. Memo. 1996-547. Nonetheless, both parties to

the common enterprise must contribute elements necessary to the

business. See Beck Chem. Equip. Corp. v. Commissioner, 27 T.C.

at 852; Wheeler v. Commissioner, T.C. Memo. 1978-208.

The Supreme Court has indicated that the services or

capital contributions of a partner need not meet an objective

standard. See Commissioner v. Culbertson, 337 U.S. at 742-743.

The Court further stated:

If, upon a consideration of all the facts, it is found that
the partners joined together in good faith to conduct a
business, having agreed that the services or capital to be
contributed presently by each is of such value to the
partnership that the contributor should participate in the
distribution of profits, that is sufficient. * * *

Id. at 744-745. Accordingly, the Tax Court may not substitute

its judgment for that of the parties in determining the value of

their contributions. Id.

Petitioners and respondent agree that WCI made significant

contributions to the NTC joint venture. Respondent contends,

however, that WB Partners failed to contribute to and was

therefore unnecessary to the NTC joint venture. WB Partners’

obligations and responsibilities to the NTC joint venture are set
 -29-

forth in section 2.1.2 of the NTC joint venture agreement, which

provides:

2.1.2 Obligations and Responsibilities of WB. The proposal
shall provide that WB shall have responsibility for
providing Indemnity and Financing Services to WCI so that
WCI has the financial capability to perform the subcontract
work.

Petitioners argue that WB Partners fulfilled its obligations to

the NTC joint venture by contributing its rights to the financing

capabilities and bonding guaranty services of Barone and Watkins,

which were essential to the NTC joint venture. Additionally,

petitioners argue that WCI would not have been able to obtain the

NTC bond without WB Partners’ financial guaranties, which were

necessary to securing the NTC project.

Petitioners argue that because WB Partners is a legitimate

entity, its contributions to the NTC joint venture must be

respected pursuant to Forman v. Commissioner, 199 F.2d 881 (9th

Cir. 1952), vacating a Memorandum Opinion of this Court. In

Forman, the court held a partnership between a husband and wife

to be valid. In finding the partnership to be valid, the court

observed that not all business relationships between a husband

and wife are shams for tax purposes and that a court must respect

the valuable contributions of a wife where the facts dictate.

Petitioners urge us to adopt this policy in the context of

related entities.
 -30-

We conclude that Forman is not dispositive of the issue.

The question is not whether WB Partners is capable of a valuable

contribution, but rather, whether it made a valuable

contribution. In other words, what was the value of WB Partners’

contribution to the joint venture?

Petitioners argue that WB Partners made significant

contributions to the NTC joint venture by providing the financial

services and expertise of Barone and Watkins, as well as

providing the financial resources necessary to obtaining the NTC

bond. We first analyze the value of the financial services and

expertise of Barone and Watkins.

As discussed above, we may not substitute our judgment for

the judgment of petitioners in determining the value of the

services WB Partners contributed to the NTC joint venture.

Nonetheless, we must determine whether WB Partners contributed

the financial services of Barone and Watkins in good faith for

purposes of conducting a business. Respondent argues that WCI

was entitled to the services and expertise of Barone and Watkins

because of their roles as WCI corporate officers. Accordingly,

respondent contends that WB Partners furnished nothing of value

to WCI apart from services which WCI could have engaged directly

had the NTC joint venture not been created.

The rights to the services and expertise of Barone and

Watkins were ostensibly contributed to WB Partners from DJB and
 -31-

GSW pursuant to section 1.6 of the WB Partners partnership

agreement. DJB and GSW held exclusive rights to the financing,

construction management, and indemnity services of Barone and

Watkins pursuant to section 2.2 of their respective employment

agreements. If we are to respect these agreements, Barone and

Watkins were contractually forbidden from providing these

services to WCI in their roles as corporate officers. As

discussed above, however, it is well established that the tax

consequences of transactions are governed by substance rather

than form. Frank Lyon Co. v. United States, 435 U.S. at 573.

Accordingly, we must determine whether Barone and Watkins

conducted themselves in a manner consistent with their respective

employment agreements with DJB and GSW.

Throughout the NTC project, WCI had other projects in

progress, projects that did not involve WB Partners, DJB, or GSW.

In discussing contracts outside the NTC project at trial, Watkins

testified that he “bid and got and oversaw three quarters of the

rest of them.” In doing so, Watkins regularly conducted

activities as an officer of WCI that he was contractually

obligated to exclusively provide to GSW. Further, Barone

testified that while WCI was owned by REXX, his responsibilities

included “anything from managing employees to handling finance to

business development.” He described these duties to include

managing projects. After WCI was repurchased from REXX, Barone
 -32-

testified that his duties remained the same as CEO of WCI, where

he mostly oversaw the NTC project but managed other projects as

well. Accordingly, the exclusivity clause of the employment

agreements did not prevent Barone and Watkins from providing

allegedly restricted services in their capacity as officers of

WCI. Because Barone and Watkins failed to respect the language

of the exclusivity clauses of the employment agreements, we do

the same, and we find that WB Partners’ contribution of the

services of Barone and Watkins to the NTC joint venture was not

necessary for the purpose of conducting the NTC project.

Next, petitioners argue that WB Partners contributed its

financial guaranties to the NTC joint venture. In determining

the value of this contribution, petitioners rely on the agreement

among Barone, Watkins, and REXX for Barone and Watkins’ personal

guaranties to secure the bond for the IDIQ project. In return

for their guaranties Barone and Watkins were given 66.66 percent

of the profits from the project. Petitioners claim that this

agreement was used as a model to value WB Partners’ interest in

the NTC joint venture.

Petitioners argue that WCI could not have obtained the NTC

bond without WB Partners’ financial guaranties. Petitioners

overlook, however, that the NTC bond was issued on the basis of

the combined net worth and financial guaranties of each of WCI,

WB Partners, Barone, Watkins, DJB, and GSW. In doing so,
 -33-

petitioners ignore the reality of WB Partners’ contribution. The

NTC joint venture was not necessary for WB Partners’ financial

guaranty, nor was it necessary for WCI to obtain the NTC bond.

WB Partners was a required indemnitor under the indemnity

agreements because WB Partners was related to WCI, not because WB

Partners provided any unique value to the NTC joint venture.

Accordingly, no different from those of Barone, Watkins, DJB, and

GSW, WB Partners’ financial guaranties were not intertwined with

its participation in the NTC joint venture. This is a

significant distinction from the agreement among Barone, Watkins,

and REXX for the guaranties provided in the IDIQ project. The

guaranties of Barone and Watkins required compensation from REXX.

Further, despite requiring the financial guaranties of

Barone, Watkins, DJB, and GSW to obtain the NTC bond, WCI did not

enter into a joint venture agreement with anyone but WB Partners.

Neither Barone, Watkins, DJB, nor GSW was entitled to a portion

of the profits from the NTC joint venture in exchange for making

contributions identical to that of WB Partners. Petitioners do

not explain why the financial guaranties of these other parties

were valueless while WB Partners’ guaranties entitled it to a

significant portion of the NTC joint venture profits. This

arrangement is not indicative of an arm’s-length negotiation

between uncontrolled parties.
 -34-

The contributions of WB Partners to the NTC joint venture

were of little value to the NTC project. Accordingly, this Luna

factor weighs against the finding that WB Partners and WCI

engaged in a joint venture.

3. The Parties’ Control Over Income and Capital and the
Right of Each To Make Withdrawals

WCI entered into the contract for the NTC project with

Harper and was entitled to all payments from the job. Pursuant

to the NTC joint venture agreement, however, WCI was required to

deposit the funds received from Harper into the NTC joint venture

bank account. Petitioners posit that Barone and Watkins wore two

hats in dealing with the income and capital received from the NTC

joint venture. Specifically, petitioners argue that Barone and

Watkins wore one hat to represent the best interests of WCI and

another hat to represent the independent and often competing

interests of WB Partners. Accordingly, petitioners argue that

Barone and Watkins, on behalf of both WCI and WB Partners,

exercised control over the income and capital and the right of

each entity to make withdrawals.

Throughout their arguments, petitioners set forth this

theory that Barone and Watkins wore two hats in negotiations and

transactions affecting related entities under their control. For

the Court to respect this theory requires evidence that decisions

affecting WCI and WB Partners were conducted at arm’s length. We

cannot reconcile the profit cap with petitioners’ two hat theory.
 -35-

Petitioners contend that it was decided to cap WB Partners’

share of the profits because the NTC joint venture was more

profitable than expected. Without further explanation,

petitioners describe this as a “valid business reason.” This

justification is not sufficient. Pursuant to the NTC joint

venture agreement, WB Partners was entitled to 70 percent of the

profits from the NTC joint venture. Petitioners have not

presented any legitimate reason why WB Partners would forfeit its

contractual right to 19.6 percent of the NTC joint venture

profits. Such a forfeiture is not indicative of the conduct of

unrelated parties in an arm’s-length agreement.7

Accordingly, WCI and WB Partners did not exercise control

over the income and capital of the NTC joint venture in a manner

commensurate with their joint venture interests. This Luna

factor weighs against a finding that WB Partners and WCI engaged

in a joint venture.

7
Petitioners argue that the profit cap is evidence that the
NTC joint venture was not entered into for tax purposes.
Petitioners contend that had they been motivated by tax concerns,
they would not have allocated an additional $1,600,000 to WCI,
subjecting that amount to an increased net tax. We decline to
speculate as to the intent of WCI and WB Partners in instituting
the profit cap. The end result was a forfeiture of income in a
manner that fails to represent an arm’s-length transaction.
 -36-

4. Whether Each Party Was a Principal and Coproprietor,
Sharing a Mutual Proprietary Interest in the Net
Profits and Having an Obligation To Share Losses, or
Whether One Party Was the Agent or Employee of the
Other, Receiving for His Services Contingent
Compensation in the Form of a Percentage of Income

Since its inception WB Partners has filed financials and tax

returns and has engaged in investment activities outside of the

NTC joint venture. WB Partners is not a sham for tax purposes.

Petitioners argue that Barone and Watkins, on behalf of WB

Partners, contributed indemnity and financing services to the NTC

joint venture; that WCI contributed environmental remediation,

construction, and licensing services; and that section 4.4 of the

NTC joint venture agreement allocates the net profit of the NTC

joint venture between WCI and WB Partners accordingly. However,

as discussed above, a profit cap was instituted to limit the

profit share of WB Partners. This profit cap is more indicative

of a contingent compensation arrangement than a mutual

proprietary interest.

Further, WCI does not have an obligation to share pro rata

in the NTC joint venture losses. Section 4.2 of the NTC joint

venture agreement provides:

4.2 Reimbursement of WCI Costs and Expenses. WCI shall be
entitled to reimbursement from the NTC joint venture Account
of all Direct Costs incurred by WCI in connection with the
subcontract Work, plus Five Percent (5%) of all such Direct
Costs. As herein, “Direct Costs” shall mean all direct
costs and expenses reasonably incurred by WCI in connection
with the subcontract Work, but excluding therefore any
indirect costs, including without limitation, overhead and
general administrative expenses as determined in accordance
 -37-

with Federal government cost accounting standards. WCI
shall, on a monthly basis, submit to the Joint Venture an
invoice for Direct Costs incurred, plus Five Percent (5%) of
such costs.

Petitioners concede that pursuant to this provision, any

possibility of loss to WCI on the NTC project was virtually

eliminated (i.e., it was guaranteed reimbursement of direct costs

plus 5 percent). Petitioners argue, however, that WCI’s

obligation on the NTC bond left it at risk to the extent of its

net worth. We do not find this risk relevant to the inquiry.

WCI agreed to the NTC bond and the indemnity agreements as an

entity separate from the NTC joint venture. Accordingly, any

resulting risk is an independent business obligation, and not a

risk resulting from WCI’s participation in the NTC joint venture.

WCI and WB Partners did not share in the profits of the NTC

joint venture in a manner consistent with a mutual proprietary

interest. Further, WCI did not share pro rata in the losses from

the NTC joint venture. Accordingly, this Luna factor weighs

against the finding that WB Partners and WCI engaged in a joint

venture.

5. Whether Business Was Conducted in the Joint Names of
the Parties

The evidence with respect to this Luna factor is mixed.

WCI, not the NTC joint venture, entered into the subcontract

agreement. WCI billed Harper, and Harper made payments directly

to WCI. Further, WCI is the principal on the NTC bond, not the
 -38-

NTC joint venture. On the other hand, the NTC joint venture

applied for, obtained, and used its own employer identification

number. The NTC joint venture also (1) used its employer

identification number to open the NTC joint venture bank

account,(2) signed the indemnity agreements, and (3) conducted

business as a joint venture with the MRB accounting firm.

Accordingly, this Luna factor is neutral with respect to

whether WCI and WB Partners engaged in a joint venture.

6. Whether the Parties Filed Federal Partnership Returns
or Otherwise Represented to Respondent or to Persons
With Whom They Dealt That They Were Joint Venturers

The NTC joint venture did not file a Federal partnership

income tax return as required by the NTC joint venture agreement.

Further, WCI did not represent itself as a member of the NTC

joint venture in its negotiations, agreement, and dealings with

Harper. At trial, Humphrey, Harper’s primary representative on

the NTC project, testified that he was not aware of WB Partners.

In many other respects, WCI and WB Partners represented

themselves as joint venturers. As discussed above, the NTC joint

venture used its own employer identification number, opened a

bank account, and signed the indemnity agreements. In doing so,

WCI and WB Partners represented themselves as joint venturers to,

among others, AIG, the Greenwich Insurance Group, the Insurance

Co. of the State of Pennsylvania, and Wells Fargo Bank.
 -39-

The NTC joint venture did not file a Federal income tax

return; however, in certain instances it was represented to third

parties as a joint venture between WCI and WB Partners.

Accordingly, this Luna factor is neutral with respect to whether

WCI and WB Partners engaged in a joint venture.

7. Whether Separate Books of Account Were Maintained for
the Venture

The NTC joint venture maintained separate books for the NTC

joint venture bank account. Further, the NTC joint venture

created separate income statements. Other documents, such as

work-in-progress reports, were created in the name of the NTC

joint venture. These documents were labeled as documents of the

NTC joint venture; however, they were prepared by WCI employees.

Further, no other books of account that may normally be expected

in the operation of a business were maintained for the NTC joint

venture. Accordingly, this Luna factor is neutral with respect

to whether WCI and WB Partners engaged in a joint venture.

8. Whether the Parties Exercised Mutual Control Over and
Assumed Mutual Responsibilities for the Enterprise

Petitioners once again set forth the theory that Barone and

Watkins wore two hats in representing both WCI and WB Partners in

the mutual control of the NTC joint venture. As discussed above,

this theory requires evidence of arm’s-length dealings between

the two entities. Absent evidence of a reasonable business

purpose to justify a forfeiture, the Court does not believe that
 -40-

WB Partners exercised mutual control over the NTC joint venture

when WB Partners conceded a significant portion of the profits it

was entitled to pursuant to the NTC joint venture agreement.

Petitioners have failed to present such a business purpose.

Accordingly, this Luna factor weighs against a finding that WB

Partners and WCI engaged in a joint venture.

Five of the eight Luna factors weigh against a finding of a

joint venture and three Luna factors are neutral. Applying the

various Luna factors, with no one factor being conclusive, we

hold there was no joint venture between WCI and WB Partners

during the taxable periods at issue.

We reach the same conclusion using the overall intent

approach set forth in Commissioner v. Culbertson, 337 U.S. 733

(1949). WCI conducted all of the business of the NTC joint

venture throughout the NTC project. As discussed above, WB

Partners did not contribute anything of substance to the NTC

joint venture. Considering all the facts and circumstances and

in accordance with our analysis of the Luna factors, we find that

WCI and WB Partners did not intend to join together in the

conduct of a joint venture.8 As a result, respondent has met his

8
Petitioners spent significant time throughout these cases
discussing the benefits of the NTC joint venture in isolating WB
Partners’ allocation of profits from the NTC project from WCI’s
other creditors. Petitioners argue that this nontax business
purpose supports the economic substance of the NTC joint venture
and is evidence of the parties’ intent to join together. Having
already held that WCI and WB Partners did not conduct a joint
(continued...)
 -41-

burden of proof for 2002 and petitioners have failed to meet

their burden of proof for 2003 and 2004. Accordingly, we sustain

respondent’s determinations with regard to the NTC joint venture

for 2002-2004.

III. Sale of WCI

On April 18, 2003, WCI entered into an asset purchase

agreement for the sale of substantially all of the assets of WCI

to Kuranda for $5,423,091. The parties allocated $3,400,000 of

the purchase price to the noncompetition agreement. The proceeds

of the noncompetition agreement and interest paid on the $500,000

note were included as income by WB Partners on its 2003 Federal

partnership income tax return. Respondent contends that the

assets sold belonged to WCI and, therefore, the proceeds of the

noncompetition agreement and interest paid on the $500,000 note

should be properly included as income to WCI, not WB Partners.

Petitioners argue that the exclusive services of Barone and

Watkins belonged to DJB and GSW through their respective

employment agreements and that those rights were contributed by

DJB and GSW to WB Partners. Petitioners therefore contend that

because WB Partners controlled the exclusive rights to the

services of Barone and Watkins and because without those services

8
(...continued)
venture, we need not decide whether the NTC joint venture had
economic substance. Insofar as the NTC joint venture isolated WB
Partners’ share of the NTC project profits from WCI’s creditors,
this result does not reflect an intent of the parties to join
together to conduct a business.
 -42-

it would be impossible for an entity controlled by Barone and

Watkins to compete with Kuranda, the proceeds of the

noncompetition agreement were properly included in the income of

WB Partners.

Petitioners rely on section 1.1.4 and 1.3 of the employment

agreements, which was added by amendment on December 3, 2002.

Section 1.1.4 of each employment agreement provides that the

exclusive service provided by Barone and Watkins include any and

all services related to the present or future business of DJB,

GSW, WB Partners, WCI, the NTC joint venture, or any party that

acquires an interest in any of the above-listed entities.

Section 1.3 is a noncompetition provision which prevents Barone

and Watkins from engaging in any business activity which is, or

could become, competitive with or adverse to the above-listed

entities. Petitioners further rely on recital D of the

noncompetition agreement, which provides that WB Partners,

through DJB’s and GSW’s exclusive employment agreements, controls

the services of Barone and Watkins, including the rights to

enforce observation of the noncompetition requirements by each.

Petitioners argue that this provision is evidence that Kuranda

recognized that the rights to these services belonged to WB

Partners.

In our discussion of the Luna factors we held that WB

Partners did not contribute the services of Barone and Watkins to
 -43-

the NTC joint venture because WCI was able to engage those

services from Barone and Watkins in their capacities as corporate

officers. In doing so, we analyzed substance over form to

determine that Barone and Watkins did not conduct themselves

consistently with the exclusivity clauses of their respective

employment agreements. This substance over form analysis is

equally applicable to determine whether WB Partners properly

included the proceeds of the noncompetition agreement in its 2003

gross income.

The noncompetition agreement prevents Barone and Watkins and

any related entity from participating in “Competing Services.”

The noncompetition agreement defines “Competing Services” as any:

(i) service that has been provided, performed or offered by
or on behalf of * * * [WCI] (or any predecessor of * * *
[WCI]) at any time on or prior to the date of this
Noncompetition Agreement that involves or relates to
asbestos, mold, and lead abatement in residential,
commercial and government properties; (ii) service that is
substantially the same as, is based upon or competes in any
material respect with any service referred to in clause
“(i)” of this sentence.

According to the subcontract agreement and the testimony of

Humphrey, Barone, and Watkins, the physical work of the NTC

project was performed by WCI. WCI had the proper licenses and

permits to perform the necessary construction and excavation

work, not WB Partners, DJB, GSW, or the NTC joint venture.

Petitioners describe WB Partners, DJB, and GSW as investment

vehicles, not businesses engaged in performing services. Except
 -44-

for WCI, nothing in the record suggests that any of the entities

controlled by Barone and Watkins performed services involving or

related to “asbestos, mold, and lead abatement in residential,

commercial and government properties”. Despite the language of

the employment agreements, the asset purchase agreement, and the

noncompetition agreement, in reality WCI was the only entity

involved that actively conducted the “Competing Services.”

Accordingly, WCI, and not WB Partners, owned the rights to the

future performance of such services, and we sustain respondent’s

determination with respect to the noncompetition agreement.

As discussed above, WB Partners recognized interest income

on its 2003 and 2004 partnership Federal income tax returns for

interest paid by Kuranda on the $500,000 note. Respondent

contends that because the proceeds of the noncompetition

agreement properly belonged to WCI, any interest on the $500,000

note is interest income to WCI. Having sustained respondent’s

determination with respect to the noncompetition agreement, we

further sustain respondent’s determination that interest paid on

the $500,000 note must be included as interest income to WCI, and

not WB Partners, in 2003 and 2004.

Finally, respondent contends that because WCI must recognize

income from the proceeds of the noncompetition agreement and

interest income from the $500,000 note, it is entitled to related

deductions claimed by WB Partners. We agree. Accordingly, we
 -45-

sustain respondent’s determination with respect to deductions

related to the noncompetition agreement and $500,000 note.

IV. NOL

Petitioners bear the burden of establishing both the

existence and amounts of NOL carrybacks and carryforwards. See

Rule 142(a); Keith v. Commissioner, 115 T.C. 605, 621 (2000); Lee

v. Commissioner, T.C. Memo. 2006-70. Taxpayers are required to

maintain records sufficient to establish the amounts of allowable

deductions and to enable the Commissioner to determine the

correct tax liability. Sec. 6001; Shea v. Commissioner, 112 T.C.

183, 186 (1999). If a factual basis exists to do so, the Court

may in some contexts approximate an allowable expense, bearing

heavily against the taxpayer who failed to maintain adequate

records. Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir.

1930); see sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed.

Reg. 46014 (Nov. 6, 1985). However, in order for the Court to

estimate the amount of an expense, the Court must have some basis

upon which an estimate may be made. Vanicek v. Commissioner, 85

T.C. 731, 742-743 (1985). Without such a basis, any allowance

would amount to unguided largesse. Williams v. United States,

245 F.2d 559, 560-561 (5th Cir. 1957).

In 2000 and 2001 WCI claimed NOLs of $563,485 and

$1,311,424, respectively. In 2002 WCI used $443,077 of the NOL

generated in 2000. In 2003, according to WCI’s Federal income
 -46-

tax return, WCI used a balance of $159,593 from the NOL generated

in 2000 and the entire $1,311,424 generated in 2001, for a total

NOL deduction of $1,471,117. Respondent conceded that

petitioners have substantiated the $563,485 NOL generated in

2000.

As a preliminary matter, respondent argues in his reply

brief for the first time that WCI miscalculated its NOL carryover

from 2002, resulting in double counting in both 2002 and 2003 of

a portion of the NOL generated in 2000. Respondent concedes that

this issue has not been raised previously; however, respondent

argues that pursuant to Rule 41(b)(1) an issue may be tried even

if the issue was not raised in the pleadings. Rule 41(b)(1)

provides that in appropriate circumstances, an issue that was not

expressly pleaded, but was tried by express or implied consent of

the parties, may be treated in all respects as if raised in the

pleadings. LeFever v. Commissioner, 103 T.C. 525, 538-539

(1994), affd. 100 F.3d 778 (10th Cir. 1996). This Court, in

deciding whether to apply the principle of implied consent, has

considered whether the consent results in unfair surprise or

prejudice to the consenting party and prevents that party from

presenting evidence that might have been introduced if the issue

had been timely raised. See Krist v. Commissioner, T.C. Memo.

2001-140; McGee v. Commissioner, T.C. Memo. 2000-308.
 -47-

WCI’s 2002 Federal income tax return shows that WCI used

$443,077 of the $563,485 NOL generated in 2000. This would leave

a carryover of the NOL generated in 2000 of $120,408. However,

on its 2003 Federal income tax return, WCI claimed a carryover

NOL from 2000 of $159,593. Accordingly, respondent argues that

WCI overstated the carryover from the NOL generated in 2000 by

$39,185. The only explanation for this discrepancy on the record

is found in the workpapers of MRB, which describe the $39,185 as

a “contribution * * * [carryover] converted into an NOL”.

Because respondent raised this issue for the first time in his

reply brief and because the record provides a possible

explanation for the discrepancy, we find that petitioners would

be unfairly prejudiced if we were to consider this issue without

petitioners’ having the opportunity to respond. Accordingly, we

do not find implied consent pursuant to Rule 41(b)(1), and the

Court will not consider whether WCI overstated the carryover by

$39,185.

Next, respondent contends that petitioners have failed to

substantiate the $1,311,424 NOL generated in 2001 and used in

2003. Petitioners have presented evidence with respect to three

items making up a portion of the NOL generated in 2001: (1) An

adjustment on Schedule M-1 of $214,960; (2) professional fees of

$243,199; and (3) cost of goods sold of $526,998. These items

combined make up $985,157 of the $1,311,424 NOL claimed.
 -48-

Petitioners argue that respondent asked for information to

substantiate the NOL deductions during the examination process.

Petitioners contend that respondent has challenged only the three

items above and conceded the balance. There is no evidence on

the record to support this assertion.

Petitioners’ evidence respecting the $1,311,424 NOL

generated in 2001 is confined to the three items listed above.

Accordingly, before examining the weight of that evidence, we

find that petitioners have failed to substantiate the remaining

$326,267 of the NOL generated in 2001, and we sustain

respondent’s determination with regard to this remainder.

Petitioners claim to have substantiated a $214,960 Schedule

M-1 adjustment. At trial, petitioners’ C.P.A. Rosner testified

that the Schedule M-1 adjustment is an accounting adjustment made

to reduce book income because WCI had reported an excess of book

income when it was owned by REXX. Rosner further testified that

the Schedule M-1 adjustment was the result of WCI’s overstating

its profits on three jobs in 2000. Petitioners did not describe

the three jobs for which WCI overstated profits in 2000.

Further, petitioners failed to explain how it was determined that

profits in 2000 were overstated or provide any documentation to

evidence this determination. Accordingly, petitioners have

failed to meet their burden of proof, and we sustain respondent’s

determination with regard to the Schedule M-1 adjustment.
 -49-

Petitioners provided canceled checks and the testimony of

Rosner to substantiate legal and professional fees of $243,199.

Respondent argues that because the canceled checks do not include

memo lines describing the nature of the work provided,

petitioners have failed to substantiate that the amounts were

paid for ordinary and necessary business expenses. We disagree

with respondent. The parties have stipulated that the canceled

checks reflect amounts paid by WCI to various law firms or other

entities providing legal services, and Rosner testified to his

discussions with the revenue agent with respect to legal and

professional fees during examination. Further, the legal and

professional fees were consistent with similar expenses claimed

by WCI in 2000, 2002, and 2003. Accordingly, we find that WCI is

entitled to $243,199 of the NOL attributable to legal and

professional fees.

Finally, petitioners provided the general ledger of WCI as

evidence of the $526,998 attributable to cost of goods sold.

Petitioners have not provided receipts, invoices, canceled

checks, or any other evidence to prove the nature of these

expenses or whether such expenses were paid. Accordingly,

petitioners have failed to meet their burden of proof, and we

sustain respondent’s determination with regard to the cost of

goods sold.
 -50-

V. Section 6662(a) Penalty

Section 6662(a) and (b)(2) imposes an accuracy-related

penalty upon any underpayment of tax resulting from a substantial

understatement of income tax. The penalty is equal to 20 percent

of the portion of any underpayment attributable to a substantial

understatement of income tax. Id. An understatement is

“substantial” if it exceeds the greater of: (1) 10 percent of

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

or (2) $5,000 ($10,000 in the case of a corporation). Sec.

6662(d)(1). Section 6662(a) and (b)(1) also imposes a penalty

equal to 20 percent of the amount of an underpayment attributable

to negligence or disregard of rules or regulations. Negligence

includes any failure to make a reasonable attempt to comply with

the provisions of the Internal Revenue Code, including any

failure to maintain adequate books and records or to substantiate

items properly. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax

Regs.

Respondent has the burden of production with respect to the

accuracy-related penalty. To meet this burden, respondent must

produce sufficient evidence indicating that it is appropriate to

impose the penalty. See Higbee v. Commissioner, 116 T.C. 438,

446 (2001). Once respondent meets this burden of production,

petitioners have the burden of proving that respondent’s

determination is incorrect. See Rule 142(a); Higbee v.
 -51-

Commissioner, supra at 446-447. Petitioners’ underpayments of

tax resulting from our determinations exceed $5,000 for each year

in issue. Further, petitioners’ failure to produce records

substantiating their claimed NOL deductions supports the

imposition of the accuracy-related penalty for negligence with

respect to those deductions for the years at issue.

An accuracy-related penalty is not imposed on any portion of

the underpayment as to which the taxpayer acted with reasonable

cause and in good faith. Sec. 6664(c)(1). A taxpayer may be

able to demonstrate reasonable cause and good faith (and thereby

escape the accuracy-related penalty of section 6662) by showing

its reliance on professional advice. See sec. 1.6664-4(b)(1),

Income Tax Regs. However, reliance on professional advice is not

an absolute defense to the section 6662(a) penalty. Freytag v.

Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th

Cir. 1990), affd. 501 U.S. 868 (1991). A taxpayer asserting

reliance on professional advice must prove: (1) That his adviser

was a competent professional with sufficient expertise to justify

reliance; (2) that the taxpayer provided the adviser necessary

and accurate information; and (3) that the taxpayer actually

relied in good faith on the adviser’s judgment. See Neonatology

Associates, P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd.

299 F.3d 221 (3d Cir. 2002). As a defense to the penalty,

petitioners bear the burden of proving that they acted with
 -52-

reasonable cause and in good faith. See Higbee v. Commissioner,

supra at 446.

Petitioners argue that they relied on Rosner, as a tax

specialist, to determine the tax treatment of the transactions at

issue.9 Petitioners contend that they have established Rosner as

a professional with the requisite expertise, he was provided

necessary and accurate information, and they relied on him in

good faith. We disagree.

Petitioners have failed to set forth any evidence that

Rosner was provided with all the necessary and accurate

information. In fact, Rosner testified that he was not involved

in any discussions about the structure of the transactions at

issue and that he merely prepared financial statements and

returns based on the information he was provided. Accordingly,

petitioners have failed to show reasonable cause or any other

basis for reducing the penalties, and we find them liable for the

section 6662 penalty for the years at issue as commensurate with

the concessions and our holding. See id.

In reaching our holdings herein, we have considered all

arguments made, and, to the extent not mentioned above, we

conclude they are moot, irrelevant, or without merit.

9
Petitioners do not argue that they relied on the
professional advice of Ryder despite his role in structuring the
entities controlled by Barone and Watkins.
 -53-

To reflect the foregoing,

Decisions will be entered

under Rule 155.