Kerman v. Comm'r

T.C. Memo. 2011-54

UNITED STATES TAX COURT

MARK AND LUCY KERMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 15894-06. Filed March 8, 2011.

Scott R. Cox and Brennan S. Cox, for petitioners.

Mark D. Eblen and Dessa J. Baker-Inman, for respondent.

MEMORANDUM OPINION

GOEKE, Judge: During 2000 Mark and Lucy Kerman sold 132,897

shares of Kenmark Optical, Inc. (Kenmark) stock, generating gain

and leaving them facing a contingent tax liability. Petitioners

entered into a Custom Adjustable Rate Debt Structure (CARDS)

transaction in order to reduce their tax liability. The CARDS

transaction generated a loss reported on petitioners’ 2000 Form
 - 2 -

1040, U.S. Individual Income Tax Return. Respondent’s notice of

deficiency determination would disallow the loss and impose a 40-

percent penalty under section 6662.1 For the reasons stated

herein, we find that petitioners are not entitled to the claimed

loss and are liable for the penalty.

Background

The stipulations of fact and the accompanying exhibits are

incorporated herein by this reference. Petitioners resided in

Kentucky at the time of filing their petition.

1. Kenmark

Kenmark was founded in 1972 by Mark Kerman (Mr. Kerman), who

was in charge of Kenmark from its inception through 2001.

Kenmark imports eyeglass frames from the Far East, Italy, and

France and sells them to retailers, optometrists, and opticians

throughout the United States and abroad. During its first

several years of existence Kenmark had sales of approximately $2

million. In 1990 sales increased to about $20 million, and by

2000 sales were approximately $35 million. At the time of trial,

sales were about $45 million. For 2000 Kenmark was an S

corporation. Its profits flowed through to its shareholders,

including Mr. Kerman, with his share of the profits shown on his

Schedule E, Supplemental Income and Loss. Before 2000 Mr. Kerman

1
All section references are to the Internal Revenue Code,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
 - 3 -

was CEO of Kenmark and owned 100 percent of its stock.

Additionally, Mr. Kerman was paid $780,000 as compensation and

$450,000 in rents by Kenmark. During 2000 Mr. Kerman sold 27

percent of his stock to an employee stock ownership plan of

Kenmark for $6 million and recognized gain of $5.4 million.

Facing large contingent tax liabilities as a result of this gain,

Mr. Kerman sought ways to offset the gain. One possible solution

was a CARDS transaction.

2. Introduction to CARDS

Petitioners participated in a CARDS transaction in 2000.

The transaction was developed by Chenery Associates, Inc.

(Chenery), a promoter.

A. Chenery Associates, Inc.

Chenery was incorporated in 1993. Roy Hahn (Mr. Hahn) was a

principal at Chenery. Chenery developed and promoted tax

shelters, working with different investment banks in New York

to implement its transactions. Chenery developed and implemented

numerous CARDS transactions, including the CARDS transaction at

issue, and received fees for each. A portion of the fees was

used to pay the third parties involved in the specific CARDS

transaction and their counsel.

B. Bruce Cohen and Craig Stone

Bruce Cohen (Mr. Cohen) and Mr. Kerman have been good

friends for 25 years. Mr. Cohen learned about the CARDS
 - 4 -

transaction at a seminar which taught ways to avoid tax. At one

of the tax seminars, Mr. Cohen met Craig Stone (Mr. Stone), an

employee at Chenery, where Mr. Stone was giving a presentation

about CARDS transactions. Knowing that Mr. Kerman had recently

sold stock and needed some tax help, Mr. Cohen told him about the

CARDS transactions and introduced Mr. Stone to Mr. Kerman.

C. Decision To Enter Into a CARDS Transaction

On or about December 21, 2000, petitioners entered into a

CARDS transaction.

4. The CARDS Transaction in General

A CARDS transaction has three phases: (1) The loan

origination phase; (2) the loan assumption phase; and (3) the

operational phase. In general, three parties are required to

carry out a CARDS transaction: (1) A bank; (2) a borrower; and

(3) an assuming party.

A. Loan Origination Phase

During the loan origination phase, the bank agrees to lend

funds to the borrower. The borrower is a Delaware limited

liability company with two members, both of whom are United

Kingdom citizens to ensure that there are no U.S. income tax

effects at the borrower level. The bank requires the borrower to

be capitalized in an amount equal to 3 percent of the funds to be

borrowed.
 - 5 -

The loan is typically for 30 years, with principal due after

30 years but interest due annually. The credit agreement

memorializing the loan imposes restrictions on how the loan

proceeds can be used. Collateralization requirements imposed

by the bank require the borrower to use the loan proceeds to

acquire highly stable items such as Government bonds or highly

rated commercial paper. After initially collateralizing the loan

with high-value, stable assets such as Treasury bonds or

promissory notes from the bank, the borrower can substitute

collateral and gain access to the loan proceeds. In effect, the

loan proceeds are initially used to purchase high-value items to

serve as collateral for the loan until an item of equally high

value can be swapped for the purchased items. This swapping of

collateral purportedly frees some of the loan proceeds to be used

for investment purposes as the borrowers see fit. However, the

decision to swap collateral is not left to the discretion of the

borrower. The bank ultimately decides whether and on what terms

a certain asset or security can be used as collateral.

B. Loan Assumption Phase

The second phase is the loan assumption phase--when the

assuming party would assume a portion of the loan on behalf of

the borrower. The assuming party would receive only a portion of

the loan proceeds but would agree to become jointly and severally

liable for the entire amount of the original loan to the
 - 6 -

borrower.2 The assuming party would assume a portion of the loan

equal to the present value of the principal amount due in 30

years.

C. Operational Phase

The operational phase consists of periodic “reset dates”.

Each reset date allows the borrower to exchange collateral, with

corresponding adjustments of the interest rate and of the term

until the next reset date. The decision to swap collateral or

adjust the interest rate at a reset date is left to the

discretion of the bank. If new collateral is proposed, it often

results in a change of loan terms to reflect any adjustments to

the amount of risk the parties face.

The purported purpose behind a CARDS transaction was to

provide investment financing. A CARDS participant would enter

into the CARDS transaction and use the assumed portion of the

loan proceeds to make an investment. The investment property

would then be swapped as collateral. In theory, the investment

would be successful if the rate of return on the investment

property exceeded the costs of entering into the CARDS

transaction.

2
For instance, suppose the amount of the original loan from
the bank to the borrower was $10 million. The assuming party
would assume a portion, $1 million, of the loan. The $1 million
would be transferred from the borrower to the assuming party, and
in exchange the assuming party would become jointly and severally
liable for the entire $10 million loan.
 - 7 -

5. Mr. Kerman and Third Parties

A. Bayerische Hypo-und Vereinsbank AG

Bayerische Hypo-und Vereinsbank AG (HVB) acted as the lender

in the CARDS transaction at issue.

B. Colindale

Colindale Financial Trading, L.L.C. (Colindale), was a

special-purpose limited liability company with Elizabeth A.D.

Sylvester and Michael Sherry, citizens and residents of the

United Kingdom, as its members (the members). Colindale was

formed solely for petitioners’ CARDS transaction, acting as the

borrower. Colindale was capitalized via a note receivable from

the members in the amount of £102,145. The note receivable was

Colindale’s only asset listed on its balance sheet on December

20, 2000.

6. The CARDS Transaction at Issue

A. Origination

On December 5, 2000, Colindale entered into a Credit

Agreement with HVB Structured Finance (HVB) as its agent whereby

HVB purportedly extended a Custom Adjustable Rate Debt loan (the

loan) to Colindale in the amount of €5,700,000 with a stated 30-

year term. The Credit Agreement provided that Colindale was

required to give HVB its notice of borrowing at least 2 business

days before the transaction. The loan term was divided into

annual interest periods with the exception of the first interest
 - 8 -

period, which extended from December 5, 2000, until January 5,

2001, and of the second interest period, which extended from the

end of the first interest period to December 5, 2001. Under the

terms of the loan, HVB could adjust the interest rate annually.

For the first interest period, the interest rate was set at the

London Interbank Offered Rate (LIBOR) plus 50 basis points, or

5.51875 percent. The Credit Agreement provided that the loan

could be prepaid by the borrower, without premium or penalty, on

the last day of any interest period, excluding the first. The

interest rate on the loan during the second interest period,

ending December 5, 2001, was 5.5188 percent.

On December 5, 2000, Colindale issued a notice of borrowing

that stated Colindale’s commitment to borrow €5,700,000 and

requested that the proceeds of the borrowing be credited to

Colindale’s euro account ending in 4501 (Colindale’s euro

account). The notice of borrowing provided that the loan

proceeds were to be credited to an account ending in 4501

“maintained at the offices of * * * [HVB].” Colindale’s

obligation to repay the loan was documented by a promissory note

issued by Colindale to HVB for €5,700,000, due on December 5,

2030. On December 5, 2000, HVB credited to Colindale €5,700,000

in Colindale’s euro account.

On December 5, 2000, Colindale entered into a Master Pledge

and Security Agreement (MPSA) that pledged to HVB all of
 - 9 -

Colindale’s holdings at HVB and their proceeds as collateral for

the loan. The MPSA provided that if the loan was in default, HVB

had the right to take possession of, hold, collect, sell, lease,

deliver, grant options to purchase or otherwise retain,

liquidate, or dispose of all or any portion of Colindale’s

pledged collateral and apply any proceeds from the foregoing to

expenses incurred in retaking, holding, collecting, or

liquidating Colindale’s pledged collateral as well as to the

payment of amounts due under the Credit Agreement and/or other

loan documents. On December 5, 2000, Colindale entered into a

Deposit Account Pledge in favor of HVB. Chenery deposited €2,375

into HVB for credit to Colindale’s balance. On December 22,

2000, Colindale purchased an HVB time deposit in the amount of

€4,847,375, maturing on December 5, 2001, at a rate of 5.01875

percent. Colindale’s HVB time deposit paid a rate that was 50

basis points less than the loan rate.

B. Assumption by the Members

On December 21, 2000, Colindale entered into an Assumption

Agreement with petitioners which provided that petitioners became

jointly and severally liable for Colindale’s obligations under

the Credit Agreement and promissory note, which included

repayment of the loan principal of €5,700,000. On December 21,

2000, petitioners entered into an Assuming Party Master Pledge

and Security Agreement (the Assuming Party MPSA) that pledged to
 - 10 -

HVB as collateral all of petitioners’ holdings at HVB and their

proceeds.

If the loan was in default, HVB had the right to take

possession of, hold, collect, sell, lease, deliver, grant

options to purchase or otherwise retain, liquidate, or dispose of

all or any portion of petitioners’ pledged collateral and apply

any proceeds from the foregoing to expenses incurred in retaking,

holding, collecting, or liquidating petitioners’ pledged

collateral as well as to the payment of amounts due under the

Credit Agreement and/or other loan documents. The pledged

collateral was held at HVB under a dollar pledge HVB pooled

account with a number ending in 4502, and in a euro pledge HVB

pooled account with a number ending in 4501. Sylvie DeMetrio, an

employee of HVB, stated that HVB did not need an account for each

purchaser of the CARDS transaction, only a customer number not

associated with any account, and that HVB would instead use “one

retail account under [Financial Engineering] which will act as an

omnibus account running the money through for the clients.”

Petitioners’ customer number at HVB was 310875.

The assuming party MPSA provided that petitioners could

request to substitute other collateral in place of the pledged

collateral, but only at HVB’s discretion. If HVB were to release

a portion of the loan proceeds, the assuming party MPSA required
 - 11 -

that petitioners execute and deliver a deposit account pledge and

a securities account control agreement.

On December 21, 2000, Colindale and petitioners entered into

a purchase agreement whereby Colindale sold to petitioners 15

percent, or €855,000, of Colindale’s HVB deposit that had been

pledged as collateral. The purchase agreement provided that

petitioners would be jointly and severally liable for all

obligations under the loan not covered by Colindale’s collateral.

Colindale and petitioners agreed that Colindale would be

responsible for interest payments on the loan and petitioners

would be responsible for all other amounts due under the terms of

the loan to the extent not covered by seller collateral. If

Colindale did not pay the interest, petitioners had to pay the

interest. Colindale could have sold some of the collateral to

make the interest payments. Petitioners would have to make up

the shortfall in the collateral. If Colindale did not make the

interest payments, petitioners waived their right of contribution

against Colindale. Petitioners agreed to waive their right of

contribution against Colindale because the CARDS promoters told

them to do so. However, the waiver did not prevent petitioners

from obtaining reimbursement from Colindale’s collateral if

Colindale violated the payment arrangement. Section 5.3(f) of

the Purchase Agreement provided that Colindale would not request

the release or withdrawal of any collateral without petitioners’
 - 12 -

prior written consent. Petitioners did not waive their right of

contribution against Colindale for any breach of section 5.3(f)

of the purchase agreement.

The Purchase Agreement provided that Colindale’s collateral

would be applied first to interest payments, then to the seller’s

profit, then to the discharge of credit obligations under the

loan other than principal, and lastly to the payment of loan

principal.

On December 20, 2000, Kenmark wired $500,000 to HVB. That

amount was credited to petitioners in an HVB pooled account with

a number ending in 4502. On December 20, 2000, Kenmark debited

its account payable to petitioners in the amount of $500,000.

HVB debited €855,000 from Colindale’s balance and credited it to

petitioners’ balance in an HVB pooled account with a number

ending in 4301.

The CARDS promoters instructed petitioners to sell the euro

on the date they wanted the tax loss. On December 22, 2000,

petitioners exchanged €346,666 of the €855,000 for $312,000.3 On

December 27, 2000, petitioners told HVB to sell “100% of the

Euros in my account (€855,000)” before the close of business on

December 27, 2000. HVB had already exchanged for $312,000, on

3
On Dec. 22, 2000, petitioners entered into a forward
exchange contract to exchange $880,600 for €925,000 on Dec. 5,
2001. The forward contract was in the amount necessary to pay
off petitioners’ 15-percent portion of the loan.
 - 13 -

December 22, 2000, €346,666.67 of the euro credited to

petitioners’ balance before they told HVB to do so. On December

27, 2000, petitioners exchanged €508,333 of the €855,000 for

$472,749.69. Petitioners were credited with a total of $784,750

from their foreign currency exchanges. As a result of the

conversion, petitioners claimed an ordinary loss of $4,250,000

for the taxable year 2000.

On Form 4797, Sales of Business Property, of their 2000

Federal tax return, petitioners claimed a $4,251,389 loss from

the sale of foreign currency. On January 3, 2001, Mr. Hahn of

Chenery wired $48,356 to HVB. That amount was credited to

petitioners’ balance in an HVB pooled account with a number

ending in 4502. The amounts credited to petitioners’ balances in

the HVB pooled accounts were used to purchase three different

time deposits, each of which had a maturity date of December 5,

2001. On December 22, 2000, petitioners purchased the first time

deposit (time deposit 1) in the amount of $811,624, with an

interest rate of 6.0 percent and a maturity date of December 5,

2001.

On January 2, 2001, petitioners purchased the second time

deposit (time deposit 2) in the amount of $431,009 with an

interest rate of 5.9425 percent and a maturity date of December

5, 2001. On January 3, 2001, petitioners purchased a third time

deposit (time deposit 3) in the amount of $48,356 with an
 - 14 -

interest rate of 5.78875 percent and a maturity date of December

5, 2001. During the year 2001, time deposits 1 and 2 were in

Financial Engineering’s U.S. dollar account with a number ending

in 4502 (HVB’s USD account). On June 12, 2001, time deposit 2 in

the amount of $431,009 plus accrued interest of $11,454.57

(totaling $442,463.57) was credited to petitioners in HVB’s USD

account. On June 13, 2001, $300,000 of the proceeds of time

deposit 2 was wired from HVB to Chenery in partial payment of

Chenery’s fees due from petitioners.

On August 30, 2001, petitioners sent a letter to HVB

and Colindale stating their intention to “pay-off (and thereby

terminate)” the loan on December 5, 2001. On October 31, 2001,

time deposit 1 in the amount of $811,624, plus accrued interest

of $42,339.72 for a total of $853,963.72, was credited to

petitioners’ balance in HVB’s USD account. In October 2001

petitioners executed a “Control Agreement” between Kerman

Investments, L.L.C., and HVB for a Salomon Smith Barney (SSB)

account with a number ending in 6627 and in the name of HVB

“Secured Party F/B/O Kerman Investments, LLC.” Sylvie DeMetrio

informed petitioners’ attorneys that to use their portion of the

loan as operating capital for Kenmark, petitioners would have to

provide firm collateral to guarantee the proceeds, such as a

letter of credit from a major bank, a certificate of deposit, or

other safe collateral acceptable to HVB.
 - 15 -

As of August 30, 2001, HVB notified petitioners’ attorney

that it would not be cost effective for petitioners to extend the

CARDS loan past December 5, 2001, because the bank would exercise

its right under the Credit Agreement to increase the spread on

the loan to an unfavorably high rate. On October 31, 2001, after

petitioners had given HVB notice of their intent to terminate the

loan, HVB transferred $400,000 of petitioners’ balance to SSB

account No. 6627. By way of the Control Agreement, HVB

controlled the $400,000 transferred to SSB account No. 6627.

Pursuant to the Control Agreement, SSB account No. 6627 had to be

a “cash securities account” meaning petitioners could invest only

in cash, cash equivalents, or qualified municipal bonds, which

were certain AAA-rated bonds. Petitioners had to obtain HVB’s

prior written consent to make any other investments.

Petitioners could not withdraw any of the proceeds from SSB

account No. 6627 unless they replaced those proceeds with cash,

cash equivalents, or qualified municipal bonds of equal value.

If petitioners wanted to replace the proceeds with marketable

securities, they had to obtain HVB’s prior written consent.

Petitioners stated that the $400,000 transferred from HVB to SSB

account No. 6627 in the name of Kerman Investments, L.L.C., was a

payment of fees to the CARDS promoters. The $400,000 transferred

from HVB to SSB account No. 6627 could not have been a payment of

fees to the CARDS promoters. After HVB wired the $400,000 to SSB
 - 16 -

account No. 6627, the remaining $453,963.72 was immediately

deposited back to time deposit 1. Petitioners could not withdraw

or transfer any of the $400,000 from SSB account No. 6627.

On November 13, 2001, HVB issued a mandatory prepayment

election notice to petitioners which stated that the outstanding

principal amount of the loan, plus accrued interest, would be due

on December 5, 2001. On November 20, 2001, Sylvie DeMetrio

emailed petitioners’ attorneys that the payoff of petitioners’

portion of the loan was “not an early unwind, this is a scheduled

reset and the bank has simply opted not to continue with the

facility as it stands. There have been no special circumstances

surrounding the unwind of this transaction.”

On December 5, 2001, petitioners’ time deposit 3 at HVB

matured. Because of the $400,000 wire from HVB to Kerman

Investments, L.L.C., petitioners had a shortfall of $184,798.92

to unwind the CARDS transaction. On December 4, 2001,

petitioners wired $184,798.92 from an account titled HVB “Secured

Party F/B/O Kerman Investments, LLC,” with a number ending in

6627 to HVB. All of the $400,000 withdrawn from HVB remained in

SSB account No. 6627 until $184,798.92 was transferred back to

HVB on December 4, 2001. The remaining funds stayed in SSB

account No. 6627 until withdrawn on January 9, 2002, which is

after the loan was repaid on December 5, 2001. On December 5,

2001, the forward contract matured and settled, causing $880,600
 - 17 -

in HVB’s USD account to be exchanged for €925,000, which was

credited to petitioners’ balance in an HVB pooled account with a

number ending in 4501. The actual amount required to pay off

petitioners’ 15-percent portion of the loan was €924,906.27.

On December 5, 2001, HVB debited petitioners’ €924,906.27

balance in the account with a number ending in 4501 and credited

this amount to Colindale. On December 5, 2001, Colindale paid

€6,018,937.76 from its euro account in repayment of the CARDS

loan, which comprised €5,700,000 of principal and €318,937.76 of

interest. Of the €6,018,937.76, petitioners provided

€924,906.27, which was credited into Colindale’s euro account on

December 5, 2001. After the payoff of petitioners’ portion of

the loan, HVB held $581.91 of petitioners’ funds.

On December 24, 2001, HVB wired $581.91 to SSB account

No. 6627, which was in the name of HVB “Secured Party F/B/O

Kerman Investments, LLC”. On January 2, 2002, Michael Shields

(Mr. Shields), chief financial officer of Kenmark during 2000,

faxed to Steve Goodman (Mr. Goodman), petitioners’ attorney,

their Termination Agreement, dated December 12, 2001, for their

CARDS transaction, and asked Mr. Goodman to review the agreement

and let him know whether he approved of it. Petitioners did not

sign the Termination Agreement until after January 1, 2002. On

January 8, 2002, HVB sent notice to SSB terminating the Control
 - 18 -

Agreement for Kerman Investments, L.L.C.’s SSB account No. 6627,

thereby releasing this account from collateralization. On

January 9, 2002, petitioners transferred $581.91 from SSB account

No. 6627 to an SSB account with a number ending in 1627 in the

name of Kerman Investments, L.L.C. On January 9, 2002,

petitioners transferred $216,182.62 from SSB account No. 6627 to

the SSB account with a number ending in 1627. That amount was

the balance of account No. 6627.

Colindale’s members signed a Unanimous Written Consent to

dissolve Colindale as of July 25, 2002. On July 31, 2002,

Colindale filed a Certificate of Cancellation with the Delaware

secretary of state’s office because Colindale had no assets and

ceased transacting business.

Discussion

I. Burden of Proof

Tax deductions are a matter of legislative grace, and a

taxpayer has the burden of proving that he is entitled to the

deductions claimed. Rule 142(a)(1); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934). The burden of proof on

factual issues that affect a taxpayer’s liability for tax may be

shifted to the Commissioner where the “taxpayer introduces

credible evidence with respect to * * * such issue.” Sec.
 - 19 -

7491(a)(1). Petitioners have failed to establish that they have

satisfied the requirements of section 7491(a)(2). On the record

before us, we find that the burden of proof does not shift to

respondent under section 7491(a).

II. Economic Substance Doctrine

“The legal right of a taxpayer to decrease the amount of

what otherwise would be his taxes, or altogether avoid them, by

means which the law permits, cannot be doubted.” Gregory v.

Helvering, 293 U.S. 465, 469 (1935). However, even if a

transaction is in formal compliance with Internal Revenue Code

provisions, a deduction will be disallowed if the transaction is

an economic sham. Am. Elec. Power Co. v. United States, 326 F.3d

737, 741 (6th Cir. 2003).

The parties have not formally stipulated where an appeal of

this case would lie. Both petitioners and respondent focus on

caselaw of the Sixth Circuit in their posttrial briefs. The

Court of Appeals for the Sixth Circuit has stated: “‘The proper

standard in determining if a transaction is a sham is whether the

transaction has any practicable economic effects other than the

creation of income tax losses.’” Dow Chem. Co. v. United States,

435 F.3d 594, 599 (6th Cir. 2006) (quoting Rose v. Commissioner,

868 F.2d 851, 853 (6th Cir. 1989), affg. 88 T.C. 386 (1987)).

“[W]hen ‘it is patent that there [is] nothing of substance to be

realized by [the taxpayer] from [a] transaction beyond a tax
 - 20 -

deduction,’ the deduction is not allowed despite the

transaction’s formal compliance with Code provisions.” Am. Elec.

Power Co. v. United States, supra at 741 (quoting Knetsch v.

United States, 364 U.S. 361, 366 (1960)). “If the transaction

has economic substance, ‘the question becomes whether the

taxpayer was motivated by profit to participate in the

transaction.’” Dow Chem. Co. v. United States, supra at 599

(quoting Illes v. Commissioner, 982 F.2d 163, 165 (6th Cir.

1992), affg. T.C. Memo. 1991-449). “‘If, however, the court

determines that the transaction is a sham, the entire transaction

is disallowed for federal tax purposes,’” id., and no subjective

inquiry into the taxpayer’s motivation is made, id. at 599. A

court “will not inquire into whether a transaction’s primary

objective was for the production of income or to make a profit,

until it determines that the transaction is bona fide and not a

sham.” Rose v. Commissioner, supra at 853.

III. Petitioners’ Arguments

Petitioners argue that the CARDS transaction had economic

substance and was entered into to provide flexible cash reserves

and lending opportunities to fund Kenmark. Petitioners contend

that the CARDS transaction was a bona fide transaction that was

specifically designed to create a synthetic, 30-year coupon

lending facility.
 - 21 -

According to petitioners, the CARDS transaction generated

income and had economic substance separate and distinct from the

economic benefit derived from a tax deduction in the form of

$63,194 earned on the amounts held by HVB Bank and the off-

balance-sheet financing provided to Kenmark from the CARDS loan.

Lastly, petitioners argue that they are entitled to claim

the loss because they acquired property subject to a loan by

paying consideration and assuming liability for the loan.

Petitioners contend that because they purchased the assets, part

of the consideration they gave was their assumption of the loan,

for which they became jointly and severally liable and thus at

risk for the repayment of the entire amount of the loan. Upon

the sale of the foreign currency, the basis of which was the

entire loan, petitioners generated an ordinary loss valued at the

difference between the value of the currency purchased and the

entire loan. The loss from the exchange and sale of the loan

assets was a foreign currency loss under section 988 because it

was an acquisition of a “nonfunctional” currency. Consequently,

petitioners are entitled to claim an ordinary loss calculated as

the difference between the basis of the euro-currency deposit and

its value.
 - 22 -

IV. Respondent’s Arguments

Respondent first argues that the CARDS transaction lacked

economic substance and had no practical effect other than the

creation of income tax losses because: (1) No economic

outlay to create basis occurred; and (2) the claimed loss was not

incurred in a trade or business or in a transaction entered into

for profit.

Respondent claims that petitioners’ CARDS transaction was

almost identical to the one in Country Pine Fin., L.L.C. v.

Commissioner, T.C. Memo. 2009-251. In Country Pine Finance,

losses were disallowed in a CARDS transaction funded by another

bank because the CARDS transaction “lacked economic substance”.

In the opinion the Court determined that the transaction lacked

economic substance because it “consisted of prearranged steps

entered into to generate a tax loss; the loan proceeds were never

at risk and the transaction giving rise to the tax loss was

cashflow negative.”

Similar to Country Pine Finance, all of the proceeds

remained as security at the bank for the sole source of repayment

of the loan and therefore the bank bore no risk. Petitioners

purchased a foreign exchange forward contract that allowed them

to convert bank time deposits, denominated in dollars, back into

euro, a year after the loan was initiated. Like Country Pine

Finance, less than a year after the bank and the L.L.C. entered
 - 23 -

into the credit agreement, the bank informed the other parties

that it was no longer willing to maintain the loan. All of the

borrowed funds were paid back out of the pledged collateral, and

all amounts lent by the bank were guaranteed by collateral

purchased from the bank with the loan proceeds. Additionally,

the promoter in this transaction is the same as in Country Pine

Finance.

Respondent argues that even if petitioners believed that the

CARDS transaction was a sensible method to provide financing for

Kenmark, that belief would not save the transaction because they

have failed the subjective inquiry, as they were not motivated by

profit to participate in the CARDS transaction. The steps in the

CARDS transaction were part of a single transaction designed to

create an inflated basis and corresponding tax loss without any

economic outlay or loss.

Next, respondent argues that petitioners were never at risk

because all of the proceeds remained as security at the bank for

the sole source of repayment of the loan and, therefore, they

bore no risk. Respondent argues that the bank required the

entire loan to be fully collateralized, and the loan was

collateralized by the funds from the loan itself in a pooled

account containing the proceeds of other CARDS transactions.

Petitioners invested their portion of the loan in HVB time

deposits which had a stated interest rate slightly higher than
 - 24 -

that of the loan, but actually a lower effective interest rate.

Petitioners knew that the largest portion of the loan,

Colindale’s portion, would remain at the bank as collateral and

that they were not at risk for it.

V. Analysis

A. Objective Analysis

We begin by analyzing the objective profit potential of the

transaction giving rise to the claimed tax loss. The transaction

giving rise to the loss was the swap of €5,700,000 for $750,000

as part of the cross-currency swap. Petitioners claimed a basis

totaling $5 million in the euro and the promissory note. As a

result of this inflated basis, petitioners claimed losses

totaling $4,251,389.4

There were no independent third parties to this transaction.

Chenery was the initial promoter of CARDS. HVB was one of at

least two banks Chenery used for the approximately 60 CARDS

transactions it sold. Like the L.L.C. in Country Pine Finance,

Colindale’s sole purpose was effecting the CARDS transaction and

it dissolved less than a year after the transaction ended. The

fees paid to accommodating parties in connection with CARDS were

based upon the amount of the loan and tax loss created and

dependent upon the assumption of the loan. The CARDS transaction

4
Included in this amount is $1,389 for amortization fees.
 - 25 -

consisted of prearranged steps entered into to generate a tax

loss; the loan proceeds were never at risk.

Further, Kenmark never received any of the loan proceeds.

Kenmark actually paid $500,000 on petitioners’ behalf to HVB for

their CARDS transaction. The terms of the National City Bank

loan were much more favorable than those of the loan. In 2000

and 2001 the interest rate on the National City Bank loan was

prime minus one-half percent, instead of the LIBOR plus 50 basis

points, which was the rate on the loan. The interest on the

National City Bank loan was tax deductible for Kenmark. The

interest on the loan was to be paid with Colindale’s collateral,

and petitioners had to replenish the collateral and therefore

were effectively making the interest payments. However, they

could not deduct those interest payments. No investment-banking

fee was charged for Kenmark’s National City Bank loan, and

Kenmark actually had access to those loan proceeds and could use

them in its operations. There was no requirement that the

proceeds from the National City Bank loan be left on deposit with

the bank. Additionally, Mr. Shields testified that in 2000,

Kenmark was routinely able to get credit on favorable terms.

This is supported by the fact that interest on Kenmark’s loan was

at the rate of prime minus one-half percent for 2000 and 2001,

which equaled a loan rate of 9 percent as of August 31, 2000.
 - 26 -

A. Lawrence Kolbe (Dr. Kolbe), a financial economist,

testified that the CARDS transaction resulted in a negative net

present value to petitioners of €555,000 on the borrowing of

€855,000. This negative net present value is created by the loan

itself and would be a material drag on any investment undertaken

by petitioners. Dr. Kolbe calculated that the cost of capital

for the loan was approximately 5.51875 percent but that

petitioners expected to pay interest at a rate of just under 70

percentage points above the market rate. Because petitioners

were effectively making the annual interest payments on the CARDS

loan, Dr. Kolbe testified that the total after-tax interest

expense on the loan was more than twice that of a normal loan.

He testified that regardless of what investment might have been

made with petitioners’ portion of the loan proceeds, the

additional interest expense would greatly reduce the

profitability of that investment relative to proceeds of a normal

loan. According to Dr. Kolbe, the longer the loan remained

outstanding, the worse the economic outcome for petitioners.

Petitioners’ obligation to repay the principal in 30 years was a

liability with a value approximately twice as large as the amount

HVB credited them for accepting it. The CARDS transaction did

not provide petitioners with a reasonable possibility of profit.

Kevin Gibbs (Mr. Gibbs), petitioners’ certified public
 - 27 -

accountant, admitted that petitioners did not make a profit on

the CARDS transaction.

Further, the interest rate paid on petitioners’ time

deposits at HVB was actually less than the loan rate. HVB

effectively paid petitioners a euro rate of about 2.1 percent,

not a dollar rate of about 6 percent, on their dollar time

deposits. Because HVB paid lower interest rates on petitioners’

deposits than it charged on the loan, leaving the loan proceeds

in the Bank guaranteed a loss to them on their portion of the

proceeds. Dr. Kolbe testified that a normal loan would be a much

less costly way to finance whatever investments petitioners had

in mind. He determined that putting aside the tax deduction, the

economically rational course of action is to not undertake the

CARDS transaction at all and to end it as soon as possible. The

loan makes no economic sense as a source of financing.

The fact that HVB could permit substitution of collateral

does not save this transaction from being a sham. While HVB

could allow substitution of collateral, petitioners had no right

to substitute collateral. They had only the right to request

that collateral be substituted, and HVB, in its sole discretion,

could consent or refuse the substitution.

Colindale’s sole purpose was effecting the CARDS

transaction, and it dissolved less than a year after the

transaction ended. Even if the other parties had been
 - 28 -

independent, the CARDS transaction would have had no practicable

economic effect on them. HVB issued the loan to Colindale, and

the proceeds were invested in HVB time deposits. Colindale never

received the loan proceeds; the proceeds stayed at HVB.

Petitioners did not receive the assets upon purchase. Rather,

the assets remained in the possession of the bank, and, even

before petitioners’ instruction to do so, HVB converted the

assets to dollars. The dollars were used to purchase HVB time

deposits which remained at HVB. Petitioners never had access to

the loan proceeds. The proceeds remained in the possession of

HVB. Petitioners entered into the forward contract, which

protected them from any foreign currency risk. At all times, HVB

had sole dominion and control over the loan proceeds. After 1

year, the proceeds, which never left the bank, were used to repay

the loan. The only economic consequence of this transaction was

petitioners’ $4,251,389 tax deduction, which created a tax

benefit of $1,248,876, the amount of the deficiency here.

Colindale was immune from any offsetting gain because of the

members’ foreign citizenship.

The CARDS transaction was designed to offset petitioners’

long-term capital gain income from their sale of the Kenmark

stock in 2000. HVB kept a spreadsheet of assuming parties and

the amounts of their desired losses. This spreadsheet shows that

the amount of the loss, before fees, petitioners reported on
 - 29 -

their 2000 income tax return is the amount of loss petitioners

desired. The amounts reported on petitioners’ 2000 return do not

match the realities of the CARDS transaction but instead work to

create a loss in the exact amount petitioners desired. Although

they were credited with $784,750 when they exchanged the

€855,000, petitioners’ 2000 return reports an amount realized of

$750,000 in foreign currency. This lower basis creates an even

larger loss of $4,250,000. In fact, petitioners did not tell Mr.

Gibbs, their return preparer, the actual amounts from the CARDS

transaction. Instead, Mr. Gibbs relied on the promotional

materials provided by Chenery to determine the amounts to be

reported on petitioners’ 2000 tax return.

B. Subjective Analysis

The claimed loss is also disallowed because the members did

not have a nontax business purpose for entering into the CARDS

transaction. Although the members testified that the decision

was made to secure financing for future Kenmark investments, that

testimony is not credible. There is substantial evidence that

the decision to enter into the CARDS transaction was solely tax

motivated.

Mr. Cohen, a longtime friend of Mr. Kerman and one of his

financial advisers, introduced him to Mr. Hahn and Mr. Stone of

Chenery, the CARDS promoters. Mr. Cohen learned about the CARDS

transaction while attending a meeting discussing ways to avoid
 - 30 -

paying taxes and knew that Mr. Kerman was interested in a way to

eliminate his large income tax liability from selling his Kenmark

stock. Mr. Cohen’s gross fee from Chenery for Mr. Kerman’s CARDS

transaction was 10 percent of Chenery’s fee, or $50,000. Mr.

Cohen testified that before the CARDS transaction, Mr. Kerman had

considered another tax shelter called the “basis boost” to

mitigate petitioners’ tax liability. He also testified that Mr.

Kerman’s interest in the CARDS transaction had nothing to do with

Kenmark or its operating needs but was based solely on reducing

petitioners’ tax liability from their sale of the Kenmark stock.

Another of petitioners’ stated business purposes for the

CARDS transaction was to borrow euro at a low rate to conduct

business in Europe and to serve as “a low risk hedge to overseas

transactions.” Contrary to the stated intent, petitioners

exchanged the euro for dollars almost as soon as they were

credited to them.

Dr. Kolbe testified that if petitioners’ business purpose

was to borrow euro, petitioners’ conversion of the euro to

dollars was wasteful because of the implicit fee to HVB for the

forward contract to convert the dollars back to euro at the end

of the loan. He stated that the forward contract locked in

petitioners’ interest rate on its part of the loan in euro, not

dollars. Dr. Kolbe determined that the conversion of the euro to

dollars, plus the purchase of the forward contract, had the
 - 31 -

economic effect of immediately converting petitioners’ just-

converted dollar loan proceeds back into euro. Mr. Kerman

testified that he thought he was assuming the loan to purchase

euro and that his expected profit on the CARDS transaction was to

be based on currency fluctuation. However, the euro were

exchanged for dollars almost as soon as they were credited to

him, and petitioners had no income from currency fluctuation in

connection with their CARDS transaction.

Before entering into the CARDS transaction, petitioners

did not prepare or have prepared for them a business plan, risk

analysis, profitability projection, or financial projection.

Mr. Kerman stated that they instead relied on the business plan,

risk analysis, profitability projection, and financial projection

in the CARDS promotional materials. However, the promotional

materials contain none of these. Petitioners believed that the

interest rate on the loan was approximately 3 percent, but

admitted that they were never able to determine the loan’s

actual interest rate. If petitioners did not know the

interest rate on the loan, absent the tax loss, they could not

have determined how the CARDS transaction could be profitable.

Mr. Kerman testified that neither he nor his financial

advisers, legal advisers, or accounting advisers ever prepared

business plans or profitability projections because only large

companies did “those types of things”. Without this information,
 - 32 -

Mr. Kerman could not have determined how he could generate a

return on the assets that exceeded the all-in cost of borrowing.

Mr. Kerman developed Kenmark into a successful, multimillion-

dollar business and that he did so without the use of a business

plan or a profitability projection is not credible.

Mr. Kerman testified that he understood that he was assuming

a $5 million loan but did not know whose loan he was assuming or

the identity of the original borrower. Mr. Kerman never heard of

Colindale or met either of the members or any of its

representatives. Therefore, he is claiming to have been willing

to assume a $5 million liability of a newly formed entity owned

by strangers. Petitioners stated that the reason they required

Colindale to represent that neither it nor the members or its

manager had a permanent establishment in the United States was

that the CARDS promoters told them to do so.

Petitioners did not take notes during meetings with the

CARDS promoters. They did not read the CARDS transaction

documents but merely signed the signature pages and had them

faxed from Mr. Goodman’s office. Because they did not read the

transaction documents, Mr. Kerman testified that he did not know

that the proceeds of the loan had to remain at HVB or that he

waived his right of subrogation against Colindale.

As new clients of HVB, petitioners had to be approved by the

bank as clients before they could proceed with the CARDS
 - 33 -

transaction. There is no evidence of any negotiations between

petitioners and Colindale as to the terms of the loan or which

party would make the principal or interest payments. The CARDS

promoters were responsible for structuring the financing

arrangements of the CARDS transaction, including arranging a

source of funds and negotiating with the funding institution the

terms and conditions of the funding.

Another business purpose alleged by petitioners was to

provide working capital for Kenmark while keeping the debt off

Kenmark’s books. This business purpose is not credible. Mr.

Shields, chief financial officer of Kenmark, testified that

Kenmark had almost reached its credit limit with National City

Bank in the years immediately preceding the CARDS transaction and

needed additional resources for a new Vera Wang line of eyewear

that the company was considering adding. According to Mr.

Shields, for the first year of the Vera Wang contract Kenmark

expected to spend $500,000 to $1 million on advertising and

$200,000 to $1 million for the product itself.

Contrary to Mr. Shields’ and Mr. Kerman’s testimony, Kenmark

had a line of credit with National City Bank that was more than

sufficient to cover the expected costs of adding the Vera Wang

line. As of August 31, 2000, Kenmark had drawn only $4,725,000

of its $12 million line of credit with National City Bank.

Kenmark’s loan balance increased an additional $1,450,000 to
 - 34 -

$6,175,000 on August 31, 2001, and an additional $1,325,000, to

$7,500,000, a year later. The additional borrowing demonstrates

that Kenmark had ready access to working capital from its bank.

Further, petitioners personally guaranteed Kenmark’s $12 million

line of credit with their $12 million net worth, so Kenmark could

have drawn the entire $12 million had it needed funds. If

Kenmark really could not have obtained additional financing from

National City Bank, petitioners could have sought other means of

financing. However, there is no evidence that they explored

other financing options for Kenmark during 2000 and 2001.

There is no evidence in the record of how Colindale could

have used the loan proceeds to pursue any investment program that

would be expected to generate a profit. HVB did not face any of

the traditional risks associated with lending, including

interest-rate risk, credit/default risk, foreign exchange risk,

and liquidity risk because the CARDS loan proceeds remained

either in HVB or under its control.

C. Country Pine Finance

In Country Pine Finance, L.L.C. v. Commissioner, T.C. Memo.

2009-251, losses were disallowed in a CARDS transaction funded by

another bank because the CARDS transaction “lacked economic

substance”. In the opinion of the Court, the transaction lacked

economic substance because it “consisted of prearranged steps

entered into to generate a tax loss; the loan proceeds were never
 - 35 -

at risk and the transaction giving rise to the tax loss was

cashflow negative.”

Petitioners’ CARDS transaction is almost identical to the

transaction in Country Pine Finance. Both CARDS transactions had

no practical economic effect other than the creation of income

tax losses for petitioners. Petitioners recognized a large

gain, in the approximate amount of $5.4 million, on the sale of

Kenmark stock and sought ways to offset that gain. The CARDS

transaction was developed by Chenery and involved a special-

purpose limited liability company, Colindale, acting as the

borrower. Colindale was formed solely for the CARDS transaction

and had the same members as did Fairlop Trading in Country Pine

Finance, United Kingdom citizens and residents Elizabeth A.D.

Sylvester and Michael Sherry.

Like Country Pine Finance, the bank and the L.L.C. entered

into a credit agreement whereby Colindale was required to pledge

collateral in order to borrow from HVB. Like Country Pine

Finance, petitioners exchanged their portion of the loan

proceeds, euro, for dollars and completed the exchange within

days of signing the assumption agreement. Like Country Pine

Finance, less than a year after the bank and the L.L.C. entered

into the credit agreement, the bank informed the other parties

that it was no longer willing to maintain the loan. Like Country

Pine Finance, Colindale’s sole purpose was effecting the CARDS
 - 36 -

transaction and dissolving less than a year after the transaction

ended. The fees paid to accommodating parties in connection with

CARDS were not standard banking or financial fees but were based

upon the amount of the loan and tax loss created and dependent

upon the assumption of the loan. Like Country Pine Finance,

petitioners claimed a tax basis in 100 percent of the loan, here

$5 million, a sale price of $750,000, and a loss of $4,251,389,

which included $1,389 in amortized transaction costs. The CARDS

transaction lacked economic substance. Petitioners did not have

a nontax business purpose for entering into the CARDS

transaction. Because we find that the CARDS transaction lacked

economic substance, it is disregarded for tax purposes and

petitioners’ claimed loss is disallowed.

VI. Accuracy-Related Penalty

Under section 6662(a) and (b), a taxpayer may be liable for

a penalty of 20 percent on the portion of an underpayment which

is attributable to, among other things, a substantial

understatement of income tax, a substantial valuation

misstatement, or negligence or disregard of rules or regulations.

The term “negligence” includes any failure to make a reasonable

attempt to comply with the provisions of internal revenue laws.

Sec. 6662(c). The term “disregard” includes any careless,

reckless, or intentional disregard. Id.
 - 37 -

A substantial understatement of income tax exists if the

amount of the understatement exceeds the greater of 10 percent of

the tax required to be shown on the return, or $5,000. Sec.

6662(d)(1)(A). The term “understatement” means the excess of the

amount of tax required to be shown on the return for the taxable

year over the amount of tax imposed which is shown on the return,

reduced by any rebate. Sec. 6662(d)(2)(A). The amount of the

“understatement” is reduced by that portion of the understatement

which is attributable to: (1) The tax treatment of any item if

there is or was substantial authority for such treatment; or (2)

any item if the relevant facts affecting the item’s tax treatment

are adequately disclosed in the return or, in a statement

attached to the return, and there is a reasonable basis for the

tax treatment of such item by the taxpayer. Sec. 6662(d)(2)(B).

However, this reduction does not apply to any item

attributable to a “tax shelter”, which is defined as a

partnership or other entity, any investment plan or arrangement,

or any other plan or arrangement if a significant purpose of such

partnership, entity, plan, or arrangement is the avoidance or

evasion of Federal income tax. Sec. 6662(d)(2)(C). There is a

substantial valuation misstatement if, among other things, the

value or adjusted basis of any property claimed on any return is

200 percent or more of the amount determined to be the correct

amount of such value or adjusted basis. Sec. 6662(e)(1)(A). If
 - 38 -

the value or adjusted basis of any property claimed on a return

is 400 percent or more of the amount determined to be the correct

amount of such value or adjusted basis, the valuation

misstatement constitutes a “gross valuation [misstatement]”.

Sec. 6662(h)(2)(A). If there is a gross valuation misstatement,

then the 20-percent penalty under section 6662(a) is increased to

40 percent. Sec. 6662(h)(1) and (2)(A); Palm Canyon X Invs., LLC

v. Commissioner, T.C. Memo. 2009-288.

One of the circumstances in which a valuation misstatement

may exist occurs when a taxpayer’s claimed basis is disallowed

for lack of economic substance. Illes v. Commissioner, 982 F.2d

163 (6th Cir. 1992); New Phoenix Sunrise Corp. & Subs. v.

Commissioner, 132 T.C. 161 (2009), affd. without published

opinion 106 AFTR 2d 2010-7116, 2010-2 USTC par. 50,740 (6th Cir.

2010). In the Court of Appeals for the Sixth Circuit, where a

transaction is disallowed for lack of economic substance and the

artifice of the transaction was constructed on the foundation of

the overvaluation of assets, the valuation overstatement penalty

applies. See Illes v. Commissioner, supra at 167.

The accuracy-related penalty may not be imposed with

respect to an underpayment if the taxpayer’s actions regarding

it can be justified by reasonable cause and the taxpayer acted

in good faith. Sec. 6664(c)(1). Reasonable cause and good

faith are determined on a case-by-case basis, taking into
 - 39 -

account all pertinent facts and circumstances. New Phoenix

Sunrise Corp. & Subs. v. Commissioner, supra at 192; sec. 1.6664-

4(b)(1), Income Tax Regs. The most important factor

in determining reasonable cause and good faith is the extent of

the taxpayer’s effort to assess his proper tax liability.

Kolbeck v. Commissioner, T.C. Memo. 2005-253; sec. 1.6664-

4(b)(1), Income Tax Regs.

One application of the exception is to a taxpayer’s

reasonable reliance in good faith on the advice of an independent

professional adviser as to the tax treatment of an item. Menard,

Inc. v. Commissioner, T.C. Memo. 2004-207 (citing United States

v. Boyle, 469 U.S. 241, 250 (1985)), revd. on other grounds 560

F.3d 620 (7th Cir. 2009)); sec. 1.6664-4(b)(1), Income Tax Regs.

A taxpayer must show that: (1) The adviser was a competent

professional who had sufficient expertise to justify the

taxpayer’s reliance on him; (2) the taxpayer provided necessary

and accurate information to the adviser; and (3) the taxpayer

actually relied in good faith on the adviser’s judgment. Menard,

Inc. v. Commissioner, supra (citing Sklar, Greenstein & Scheer,

P.C. v. Commissioner, 113 T.C. 135, 144-45 (1999)).

The advice must not be based on unreasonable factual or

legal assumptions (including assumptions as to future events)

and must not unreasonably rely on the representations,

statements, findings, or agreements of the taxpayer or any other
 - 40 -

person. For example, the advice must not be based upon a

representation or assumption which the taxpayer knows, or has

reason to know, is unlikely to be true, such as an inaccurate

representation or assumption as to the taxpayer’s purposes for

entering into a transaction or for structuring a transaction in

a particular manner. Sec. 1.6664-4(c)(1)(ii), Income Tax Regs.

“A taxpayer is not reasonable * * * in relying on an adviser

burdened with an inherent conflict of interest about which the

taxpayer knew or should have known.” Am. Boat Co., LLC v. United

States, 583 F.3d 471, 481-482 (7th Cir. 2009) (citing Neonatology

Associates., P.A. v. Commissioner, 299 F.3d 221, 234 (3d Cir.

2002), affg. 115 T.C. 43 (2000), Chamberlain v. Commissioner, 66

F.3d 729, 732-733 (5th Cir. 1995), affg. in part and revg. in

part T.C. Memo. 1994-228, Pasternak v. Commissioner, 990 F.2d

893, 902 (6th Cir. 1993), affg. Donahue v. Commissioner, T.C.

Memo. 1991-181, and Carroll v. LeBoeuf, Lamb, Greene & MacRae,

LLP, 623 F. Supp. 2d 504, 511 (S.D.N.Y. 2009)).

“[W]hen an adviser profits considerably from his

participation in the tax shelter, such as where he is compensated

through a percentage of the taxes actually sheltered, a taxpayer

is much less reasonable in relying on any advice the adviser may

provide.” Am. Boat Co., LLC v. United States, supra at 482.

“‘In order for reliance on professional tax advice to be

reasonable * * * the advice must generally be from a competent
 - 41 -

and independent advisor unburdened with a conflict of interest

and not from promoters of the investment.’” New Phoenix Sunrise

Corp. & Subs. v. Commissioner, supra at 193 (quoting Mortensen v.

Commissioner, 440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo.

2004-279).

Reliance on the professional advice of a tax shelter

promoter is unreasonable when the advice would seem to a

reasonable person to be “too good to be true”. Edwards v.

Commissioner, T.C. Memo. 2002-169 (citing Pasternak v.

Commissioner, supra at 903, Elliott v. Commissioner, 90 T.C. 960,

974 (1988), affd. without published opinion 899 F.2d 18 (9th Cir.

1990), and Gale v. Commissioner, T.C. Memo. 2002-54, affd. 119

Fed. Appx. 293 (D.C. Cir. 2005)).

Petitioners reviewed the CARDS promotional materials, all of

which focus on the tax consequences of the transaction. The

materials describe the steps of a CARDS transaction exactly as

petitioners’ transaction was executed and included a statement

that the “Lender is the custodian of and receives a security

interest in the collateral.” The materials also state that the

transaction can be structured to generate ordinary or capital

losses and that “if ordinary losses are desired, the borrowing is

denominated in a non-United States currency.” The promotional

materials warn that the IRS might challenge the transaction, and

that “the tax law requires taxpayers to possess a business
 - 42 -

purpose and a transaction to have economic substance to be

respected for federal income tax purposes.”

IRS Notice 2000-44, 2000-2 C.B. 255, which is included in

the CARDS promotional materials, contains the statement that tax

losses from transactions similar to CARDS that are designed to

produce noneconomic tax losses by artificially overstating basis

are not allowable as deductions for Federal income tax purposes.

The materials also alert potential assuming parties that the IRS

may determine that the CARDS transaction results in an unintended

tax benefit to the assuming party. Petitioners understood that

they were an assuming party. The promotional materials also

state that an assuming party includes the entire face amount of

the loan proceeds in its tax basis and that the value of the loan

proceeds is only 15 percent of the loan. The materials further

explain that a tax loss of approximately 85 percent of the loan

results when the foreign currency is converted into United States

dollars and that “the taxpayer claims a tax loss * * * even

though the taxpayer has incurred no corresponding economic loss.”

The materials contain the caveat that the existence of a nontax

business purpose is a requirement for participating in the

transaction and that the tax treatment assumes that the investor

expects to earn a return on the use of the loan proceeds in

excess of the all-in cost of the loan.
 - 43 -

Petitioners knew, or should have known, that any advice they

received from Chenery or anyone associated with Chenery was not

independent because Chenery stood to benefit from the promotion

of the CARDS transaction. They came into contact with Chenery

and its associates because petitioners were looking for a way to

mitigate their large capital gain and considering tax savings

strategies due to the sale of the Kenmark shares. Chenery was

responsible for structuring the financing arrangements of

petitioners’ CARDS transaction including arranging a source of

funds; negotiating with the funding institution, HVB, the terms

and conditions of the funding; and providing a tax opinion.

Chenery received a $500,000 fee based on the amount of the loss

generated for petitioners. Any advice from Chenery or any of its

associates was burdened with an inherent conflict of interest.

Petitioners did not read any of the CARDS transaction

documents but provided them to Mr. Shields to review. Although

they claimed to have relied on advice from Mr. Gibbs and Louis T.

Roth & Co., the accounting firm, neither provided them with a

written tax opinion for the CARDS transaction. Petitioners could

not have reasonably relied upon any other advice given by Mr.

Gibbs as they did not provide necessary and accurate information

to him. This is evidenced by the fact that Mr. Gibbs did not

know the most basic facts about petitioners’ CARDS transaction,

such as the amount of U.S. dollars petitioners were credited with
 - 44 -

when the €855,000 was exchanged. Instead of fully disclosing the

facts concerning the CARDS transaction to Mr. Gibbs, Mr. Kerman

testified that he did not know but assumed that Mr. Gibbs saw the

CARDS transaction documents. Mr. Gibbs evidently relied on the

promotional materials and a tax opinion prepared by Brown & Wood,

a law firm, in completing petitioners’ 2000 income tax return and

in advising petitioners.

Mr. Kerman also testified that he was not sure but assumed

that Mr. Goodman saw the CARDS promotional materials. It

appears that Mr. Goodman did see the CARDS materials, because

he asked Mr. Stone some questions about the transaction. Mr.

Goodman gave petitioners no written opinion with respect to

petitioners’ CARDS transaction. Petitioners estimated that they

paid fees to Mr. Goodman in an amount between $10,000 and $15,000

to review the transaction but did not provide copies of Mr.

Goodman’s bills.

Petitioners also could not have reasonably relied upon the

tax opinion provided by R.J. Ruble (Mr. Ruble), a partner with

Brown & Wood. Before petitioners entered into the CARDS

transaction, Mr. Hahn and Mr. Stone assured them that they would

receive a tax opinion from Brown & Wood that would ensure they

would not be liable for tax penalties if the CARDS transaction

was determined to be an invalid tax shelter. Petitioners knew

that Mr. Ruble and Brown & Wood were working together with the
 - 45 -

CARDS promoters. They also knew, or should have known, that the

Brown & Wood opinion was not independent advice and that Mr.

Ruble had an inherent conflict of interest.

Mr. Hahn and Mr. Stone also promised petitioners that they

would receive benefits from the CARDS transaction when filing

their tax returns. Petitioners relied on the representation of

the CARDS promoters that the CARDS transaction would earn a

return on investment that exceeded the $500,000 cost of the

transaction and that it was a sound business transaction with tax

advantages. Petitioners assumed they could earn a profit on

their portion of the loan proceeds. While Mr. Shields testified

that he spoke with Mr. Ruble and Mr. Goodman about several of the

CARDS transaction documents, he admitted that they merely

discussed that the various documents were consistent with the

transaction as presented to him and to petitioners. Mr. Shields

never testified that he spoke with either Mr. Ruble or Mr.

Goodman about the tax treatment of the CARDS transaction.

The tax opinion states that Chenery is the arranger of the

CARDS transaction, developed the structure, identified the LLC

and its members, negotiated the credit facility with the bank,

arranged for the transaction’s documentation, and presented

completed financing to petitioners for evaluation and assumption.

The tax opinion discloses that Chenery would receive an

investment banking fee from petitioners and that Colindale would
 - 46 -

receive a fee for incurring the loan. The final version of Brown

& Wood’s tax opinion was identical to the draft provided to

petitioners by the CARDS promoters before the transaction.

Consequently, they must have known that the CARDS transaction was

not unique to their situation but was instead a transaction for

taxpayers seeking tax losses.

Further, Mr. Kerman admitted that he did not select Brown

& Wood as the law firm to provide the tax opinion and that he

had met neither Mr. Ruble nor any attorney at Brown & Wood.

There is no evidence showing that petitioners had an engagement

letter with, directly paid any fees to, or ever spoke to anyone

at Brown & Wood. Although the Credit Agreement and the Purchase

Agreement clearly state that Brown & Wood was Colindale’s legal

counsel in connection with petitioners’ CARDS transaction, Mr.

Kerman denied knowing that fact.

The Brown & Wood tax opinion contains several misstatements,

and petitioners admitted that the representations in the tax

opinion are false and fraudulent. It states that the assets were

released to petitioners when they purchased them and that they

provided substitute collateral. As discussed above, petitioners

never received any of the loan proceeds and never substituted

collateral. Additionally, the tax opinion states that

petitioners sold the assets on December 28, 2000, even though

they actually exchanged portions of the euro on December 22 and
 - 47 -

27, 2000. The tax opinion states that petitioners represented

that they had reviewed the transaction summary in the tax opinion

and that it was “accurate and complete”. However, Mr. Kerman

testified that he never reviewed the transaction summary.

Mr. Kerman represented that he reasonably believed that the

assets, or the proceeds from the sale, could be used to generate

a return that would exceed “by more than a de minimis amount the

all-in cost of borrowing”, including fees and costs paid to third

parties “and without regard to Federal income taxes”. However,

as discussed above, he had no purpose to use the loan proceeds,

so this representation is false. Petitioners also represented

that every transaction described in the tax opinion actually

occurred, when it is obvious from the record that the actual

CARDS transaction differed from that represented. The tax

opinion concludes with a statement that Brown & Wood did not

independently verify the representations and documents for the

CARDS transaction; and if they were inaccurate in any material

respect, the tax opinion could not be relied upon.

Petitioners did not read the Brown & Wood tax opinion.

Petitioners cannot rely on an opinion that they knew, or should

have known, came from a law firm with an inherent conflict of

interest and that contained blatantly false representations.

Lucy Kerman has a college degree in physical therapy. Mr.

Kerman founded Kenmark in 1972 and developed it into a successful
 - 48 -

business. He was in charge of Kenmark from its inception through

2001, was its chairman and CEO in 2000, and is currently its

chairman of the board. In 2000 Kenmark’s sales were

approximately $34 million. Petitioners became multimillionaires

as a result of Mr. Kerman’s efforts with Kenmark and had a net

worth of $12.66 million as of November 30, 2000.

In general, Mr. Kerman testified that he had no knowledge

or understanding of the CARDS transaction. He did not read,

review, or remember the documents executed as part of the CARDS

transaction. He was either not familiar with or had only a

superficial recollection of Mr. Hahn, Chenery, Colindale, and

HVB and its affiliates. As Mr. Cohen testified, it is obvious

that Mr. Kerman was motivated by the tax aspects of the CARDS

transaction. To believe Mr. Kerman’s story, one must believe

that he paid over $600,000 in fees and costs to receive

“financing” of $784,750. As a capable businessman and prudent

investor, Mr. Kerman knew or should have known that the CARDS

transaction was just too good to be true.

We find petitioners are liable for the 40-percent gross

valuation misstatement penalty. The correct cost basis of the

foreign currency credited to petitioners’ balance is $784,750,

not $5 million as reported on petitioners’ 2000 income tax
 - 49 -

return.5 Therefore, the basis misstatement satisfies the gross

valuation [misstatement] threshold pursuant to section

6662(h)(1).

VII. Conclusion

The CARDS transaction lacked economic substance and stood no

chance of earning a profit. The members did not have a nontax

business purpose for entering into the CARDS transaction.

Because we find that the CARDS transaction lacked economic

substance, it is disregarded for tax purposes and petitioners’

claimed loss is disallowed. Petitioners have failed to establish

reasonable cause for the gross misstatement in the value of the

basis of the foreign currency used in the CARDS transaction.

To reflect the foregoing,

Decision will be entered

for respondent.

5
Going from $784,750 to $5 million is a 530 percent
increase.