Todd v. Comm'r

T.C. Memo. 2011-123

UNITED STATES TAX COURT

FREDERICK D. TODD, II AND LINDA D. TODD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 26378-06. Filed June 6, 2011.

David B. Shiner and Sanjay Shivpuri, for petitioners.

Angela B. Friedman, Jason W. Anderson, and David S. Weiner,

for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HAINES, Judge: After concessions, the issues for decision

are: (1) Whether petitioner Frederick D. Todd II (petitioner)

received a taxable distribution of $400,000 from United Employee

Benefit Fund (UEBF) in 2002; (2) alternatively, if petitioner did

not receive a taxable distribution from UEBF in 2002, whether
 -2-

petitioner received $412,973 of discharge of indebtedness income

in 2003; (3) whether petitioners are liable for an addition to

tax under section 6651(a)(1) for 2003; and (4) whether

petitioners are liable for a section 6662 penalty for 2002 or

2003.1

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

The stipulations of facts and the exhibits attached thereto are

incorporated herein by this reference. At the time they filed

their petition, petitioners resided in Texas.

FINDINGS OF FACT

Petitioner was a practicing neurosurgeon employed by

Frederick D. Todd, II, M.D., P.A. (corporation), a Texas

corporation of which petitioner was the sole shareholder,

director, and president. The corporation also employed a few

individuals who worked with petitioner.

On August 18, 1995, petitioner signed an application on

behalf of the corporation to become a member of the American

Workers Master Contract Group (AWMCG), authorizing AWMCG to

represent the corporation in negotiations with the National

Production Workers Union Local 707 (Local 707), the union

representing the corporation’s employees. The corporation agreed

1
Unless otherwise indicated, section references are to the
Internal Revenue Code (Code) as amended and in effect for the
years in issue. Rule references are to the Tax Court Rules of
Practice and Procedure. Amounts are rounded down to the nearest
dollar.
 -3-

to provide eligible employees with a death benefit only (DBO)

plan organized through the American Workers Benefit Fund (AWBF),

a welfare benefit fund established between AWMCG and Local 707.

The agreement provided that upon a covered employee’s death,

AWBF would provide the employee’s designated beneficiary with an

amount equal to eight times the employee’s annual income up to $6

million. However, AWBF’s obligation to pay a death benefit

ceased if the corporation’s covered employee was voluntarily or

involuntarily terminated or retired; if the corporation ceased

making contributions; or if the master contract between the union

and the master contract group was not renewed. As an eligible

employee of the corporation, petitioner enrolled in the DBO plan,

designating petitioner Linda D. Todd as the beneficiary of the $6

million death benefit. A few of petitioner’s fellow eligible

employees also participated in the DBO plan.

On September 5, 1995, petitioner submitted an application

for life insurance to Southland Life Insurance Co. (Southland) on

behalf of AWBF. On November 15, 1995, Southland issued a $6

million universal life insurance policy (policy No. 5160) on

petitioner’s life to AWBF. The annual premium on policy No. 5160

was approximately $100,000. The policy was owned solely by AWBF

to provide insurance to fund the death benefit owed by AWBF to

petitioner’s wife if petitioner died. The corporation made

yearly contributions to AWBF on behalf of petitioner and his
 -4-

fellow covered employees and deducted those payments under

section 419A(f)(5). Upon receipt of the corporation’s yearly

contribution, AWBF paid the premium on policy No. 5160.

On July 21, 1999, petitioner submitted another application

for life insurance to Southland. On October 1, 1999, Southland

issued a $6 million indexed universal life insurance policy

(policy No. 8889) on petitioner’s life that required an annual

premium of approximately $100,000. On December 3, 1999,

petitioner transferred ownership of policy No. 8889 to AWBF. On

January 28, 2000, AWBF rolled policy No. 5160, which had an

accumulation value of $315,773, into policy No. 8889 pursuant to

section 1035, resulting in a single $6 million policy on

petitioner’s life.

On December 18, 2000, AWBF merged into United Employees

Benefit Fund (UEBF). UEBF was a welfare benefit fund established

between Professional Workers Master Contract Group and the Union

of Needletrades, Industrial and Textile Employees, Local 2411

(Local 2411), to provide a DBO plan to eligible employees of

participating employers. Before November 2001 petitioner’s

corporation made yearly contributions to AWBF on behalf of

petitioner and his fellow covered employees and deducted those

payments as contributions to AWBF. After receiving notice of the

transfer of the insurance policies on the lives of the

corporation’s employees from AWBF to UEBF on November 15, 2001,
 -5-

the corporation made contributions to UEBF, which paid the

premiums on the Southland life insurance policies held on the

lives of petitioner and his covered employees.

Under article 8 of the UEBF Trust Agreement (trust

agreement), the employer and employee trustees had discretionary

authority to make loans to a plan participant on a

nondiscriminatory basis.2 Upon an application and written

evidence of an emergency or serious financial hardship from the

eligible employee, the trustees could make a loan up to the

amount of the present value of the death benefit.3 David Fensler

was a certified employee benefit specialist and was the employer

trustee and administrator of both UEBF and AWBF. James Skonicki

was the employee trustee of UEBF from before 1998 through 2002.

On May 20, 2002, Southland notified petitioner’s insurance agent

that the maximum available distribution from policy No. 8889 was

$400,000 and that any greater distribution would cause the policy

to lapse. On July 11, 2002, petitioner submitted to UEBF an

application for a loan of $400,000 for “unexpected housing

costs”.

2
The loan requirements of AWBF and UEBF were the same.
3
The present value of the death benefit was to be
actuarially computed using an assumed interest rate of 8 percent
and an assumed mortality of age 75.
 -6-

Upon receipt of petitioner’s loan application, Mr. Fensler

recommended to Mr. Skonicki that the loan4 to petitioner be

approved. Neither Mr. Fensler nor Mr. Skonicki made further

inquiries into the hardship claimed by petitioner. On August 26,

2002, Mr. Fensler submitted a policy loan request to Southland

requesting a loan of $400,000 on policy No. 8889. However, after

receiving the loan check, Mr. Fensler decided that the 4.76-

percent interest rate charged by Southland on the loan made the

choice of a partial surrender from policy No. 8889 a better

prospect.5 On August 30, 2002, petitioner agreed to a

distribution, which would reduce the face value of policy No.

8889 to $5,600,000. On September 18, 2002, Southland reissued a

check for $400,000 to UEBF representing the distribution from

policy No. 8889. Upon receipt of the funds from Southland, UEBF

issued a check for $400,000 to petitioner on September 25, 2002.

On October 25, 2002, the corporation made its annual contribution

to UEBF for petitioner’s DBO plan, and on January 7, 2003, UEBF

4
Our reference to the transaction as a loan is made for ease
of discussion. This reference is not dispositive of the status
of the transaction, and the determination of whether the
transaction between petitioner and UEBF is a valid debt for tax
purposes is the subject of discussion below.
5
The midterm applicable Federal rate, applicable to loans
with terms of 3 to 9 years, was 3.75 percent for loans
originating in September 2002. See sec. 1274(d); Rev. Rul. 2002-
53, 2002-2 C.B. 427. The long-term applicable Federal rate for
loans originating in September 2002 was 5.23 percent. Rev. Rul.
2002-53, 2002-2 C.B. at 428.
 -7-

made a premium payment to Southland on policy No. 8889. After

2003, however, petitioner’s corporation stopped making its annual

contributions to UEBF on behalf of petitioner’s DBO plan, and

UEBF ceased premium payments on policy No. 8889.

The trust agreement provided that a loan from UEBF had to be

secured by a pledge of the actuarially determined present value

of the eligible employee’s death benefit and evidenced by an

executed promissory note that provided for payments at least

quarterly. The trust agreement also required that the loan bear

a reasonable rate of interest, taking into account the interest

rates charged by persons in the business of lending money for

loans which would be made under similar circumstances.

Six months after the $400,000 check was delivered to

petitioner, and after Mr. Fensler provided an amortization

schedule, on March 21, 2003, petitioner signed a promissory note

to UEBF in the amount of $400,000. The stated interest on the

note was 1 percent, and the note provided that petitioner make

quarterly installment payments of $20,527 beginning on November

1, 2002, and continuing until the note was paid.

The note and the trust agreement also included an

alternative means of repayment, referred to by petitioners as a

“dual repayment mechanism”. In the absence of quarterly payments

by petitioner, the dual repayment mechanism allowed UEBF to

deduct the outstanding loan balance from any payment or
 -8-

distribution due from UEBF to the participant or his beneficiary.

According to UEBF, the dual repayment mechanism prevented a

participant from defaulting on his obligation to repay the loan

while any payments or distributions were due to the participant

under the terms of the agreement. At the end of 2002 and 2003,

petitioner owed a principal balance of $400,000. As of the date

of trial, petitioner had not made any payments on the note, and

UEBF had taken no action to collect on the note.

The trust agreement required that UEBF hire an auditor to

conduct a certified audit and issue an opinion as to the UEBF

financial statements. An accounting firm conducted a certified

audit and, despite the dual repayment mechanism and its purported

protection against default, determined that the purported loan to

petitioner was in default because of the nonreceipt of payments.

For the taxable years 2002 and 2003, the auditor required UEBF to

report the loan as uncollectible or in default in 2002 and 2003

on Schedules G of Forms 5500, Annual Return/Report of Employee

Benefit Plan. UEBF and its trustees issued a statement

expressing disagreement with the auditor, explaining that the

dual repayment mechanism prevented the loan from entering default

under the terms of the trust agreement and UEBF’s policies and

procedures. The statement likewise explained that the loan was

not in default or uncollectible because petitioner’s death
 -9-

benefit owed by UEBF under the DBO plan would provide the

necessary collateral for the payment of the promissory note.

On July 5, 2005, petitioners filed delinquent 2002 and 2003

Federal income tax returns. On September 21, 2006, respondent

issued a notice determining deficiencies for 2002 and 2003 of

$65,237 and $16,719, respectively, together with section 6662(a)

penalties of $13,047 and $3,344, respectively. The deficiencies

were based primarily on unreported dividends from life insurance

contributions made on petitioner’s behalf by the corporation and

denial of petitioners’ claimed charitable contribution

deductions. Petitioners filed a petition with the Tax Court for

2002 and 2003 on December 21, 2006.

In preparation for trial, respondent discovered petitioner

had received a $400,000 distribution from UEBF in 2002. Arguing

that the distribution was taxable upon receipt, respondent filed

an amendment to answer and asserted an increased deficiency for

2002 of $224,269 and an increased penalty under section 6662(a)

of $44,854. Respondent alternatively argued that if the $400,000

distribution was a valid loan, the indebtedness was discharged in

2003 and resulted in a deficiency for 2003 of $165,596 and a

penalty under section 6662(a) of $33,139. Respondent also

asserted an addition to tax under section 6651(a)(1) of $29,184

for 2003 but none for 2002.
 -10-

OPINION

I. Burden of Proof

As a general rule the taxpayer bears the burden of proving

that the Commissioner’s determinations set forth in a notice of

deficiency are erroneous. Rule 142(a)(1); Welch v. Helvering,

290 U.S. 111 (1933). However, the Commissioner has the burden of

proof as to any new issue or increased deficiency. Rule

142(a)(1). Respondent concedes that he bears the burden of proof

because the only issues to be decided were raised in the

amendment to answer.

II. Loan or Plan Distribution

The parties agree that petitioner received $400,000 from

UEBF on September 25, 2002. Petitioners maintain that the

distribution was a loan which petitioner intended to repay.

Respondent argues that the distribution from UEBF to petitioner

was taxable income. The parties agree that UEBF did not

distribute the funds in satisfaction of its obligation to

petitioner’s beneficiaries under the DBO plan.

Section 61(a) provides the following broad definition of the

term “gross income”: “Except as otherwise provided in this

subtitle, gross income means all income from whatever source

derived”. Exclusions from gross income must be narrowly

construed. Commissioner v. Schleier, 515 U.S. 323, 328 (1995).

One such exclusion excepts the receipt of loan proceeds from
 -11-

gross income because the temporary economic benefit of income is

offset by a corresponding obligation to repay. United States v.

Rochelle, 384 F.2d 748, 751 (5th Cir. 1967); Dennis v.

Commissioner, T.C. Memo. 1997-275. However, for genuine

indebtedness to be present there must be both good-faith intent

on the part of the borrower to repay the debt and good-faith

intent by the lender to enforce payment of the debt. Estate of

Chism v. Commissioner, 322 F.2d 956, 960 (9th Cir. 1963), affg.

Chism Ice Cream Co. v. Commissioner, T.C. Memo. 1962-6; Wright v.

Commissioner, T.C. Memo. 1992-60.

The U.S. Court of Appeals for the Fifth Circuit, to which an

appeal in this case would lie absent a stipulation otherwise,

has held that whether a transaction constitutes a loan for income

tax purposes is a factual question involving several

considerations, and a distinguishing characteristic of a loan is

the intention of the parties that the money advanced be repaid.

Moore v. United States, 412 F.2d 974, 978 (5th Cir. 1969).

Important factors considered by courts in finding a bona fide

debt are whether: (1) The promise to repay was evidenced by a

note or other instrument; (2) interest was charged; (3) a fixed

schedule for repayments was established; (4) collateral was given

to secure payment; (5) repayments were made; (6) the borrower had

a reasonable prospect of repaying the loan, and whether the

lender had sufficient funds to advance the loan; and (7) the
 -12-

parties conducted themselves as if the transaction was a loan.

See Goldstein v. Commissioner, T.C. Memo. 1980-273 (and cases

cited therein). We address each factor in turn.

A. Whether the Promise To Repay Was Evidenced by a Note or
Other Instrument

A note or other instrument is indicative of a debtor-

creditor relationship. Teymourian v. Commissioner, T.C. Memo.

2005-232. However, an instrument will be given little weight

when the form of the instrument fails to correspond with the

substance of the transaction. Provost v. Commissioner, T.C.

Memo. 2000-177.

On September 25, 2002, UEBF issued a $400,000 check to

petitioner. Six months later, on March 21, 2003, petitioner

signed a promissory note to UEBF for a loan of $400,000. Despite

the requirements within the trust agreement, the parties failed

to contemporaneously memorialize the indebtedness when the money

was distributed to petitioner. Moreover, the record further

reflects that neither petitioner nor UEBF adhered to the terms of

the promissory note or the trust agreement that governed the

transaction. UEBF failed to charge a market rate of interest,

petitioner did not make quarterly payments as required under the

promissory note, and UEBF did not attempt to collect the amount

owed or any portion thereof after petitioner defaulted.

For the foregoing reasons, the Court finds that neither

petitioner nor UEBF strictly complied with the terms of the loan
 -13-

agreement or the promissory note. Thus, the Court gives the

promissory note little weight. This factor indicates the parties

did not intend to establish a debtor-creditor relationship at the

time the funds were advanced.

B. Whether Interest Was Charged

The payment of interest indicates the existence of a bona

fide loan. Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir.

2000), affg. T.C. Memo. 1998-121; Teymourian v. Commissioner,

supra; Morrison v. Commissioner, T.C. Memo. 2005-53. The trust

agreement provided that a reasonable rate of interest should be

charged, taking into account the interest rates charged by

persons in the business of lending money under similar

circumstances. Southland charged a rate of 4.76 percent on a

similar loan, and petitioner acknowledges that the 1-percent

interest rate charged on the promissory note was lower than the

market rate. The failure of UEBF and petitioner to agree to a

reasonable market rate of interest as dictated by the trust

agreement indicates the parties did not intend to establish a

debtor-creditor relationship at the time the funds were advanced.

C. Whether a Fixed Schedule for Repayment Was Established

A fixed schedule for repayment is indicative of a bona fide

loan. Welch v. Commissioner, supra at 1231; Teymourian v.

Commissioner, supra. Evidence that a creditor did not intend to

enforce payment or was indifferent to the exact time an advance
 -14-

was repaid indicates a bona fide loan did not exist. Gooding

Amusement Co. v. Commissioner, 23 T.C. 408, 418-419 (1954), affd.

236 F.2d 159 (6th Cir. 1956); Provost v. Commissioner, supra.

According to the promissory note, petitioner was to make

quarterly installment payments of $20,527 beginning on November

1, 2002, and continuing until the note was fully paid. Three

months after the first payment was due, UEBF provided petitioner

with an amortization schedule reflecting quarterly payments that

should have been paid beginning on November 1, 2002. Almost 4

months after the first payment was due, the parties finally

executed the promissory note. Petitioner did not make any

payments to UEBF, and UEBF never attempted to collect the amount

owed after each default. This factor indicates the parties did

not intend to establish a debtor-creditor relationship at the

time the funds were advanced.

D. Whether Collateral Was Given To Secure Payment

Respondent argues that petitioner provided no collateral

because he did not own or have any rights in the Southland

insurance policies purchased on his life. AWBF secured the

potential death benefit obligation by purchasing policy No. 5160

from Southland. On July 21, 1999, petitioner purchased his own

policy from Southland, policy No. 8889. However, on December 3,

1999, petitioner transferred ownership of policy No. 8889 to

AWBF, which rolled the balance of policy No. 5160 into policy No.
 -15-

8889. After the merger of AWBF and UEBF in 2000, policy No. 8889

became the property of UEBF. At the time of the purported loan,

petitioner did not own the policy, had no access to the cash

value of the policy, and had no rights to the proceeds from the

policy. Thus, respondent correctly states that the policy cannot

be treated as collateral for petitioner’s purported loan.

In response, petitioners claim that the death benefit owed

to them by UEBF under the DBO plan, and not the Southland

insurance policies, provided the necessary collateral for the

payment of the promissory note. Petitioners argue that when

combined with the death benefit owed by UEBF, the dual repayment

mechanism served as collateral since any balance remaining on the

loan at the time of petitioner’s death would reduce the death

benefit payable by UEBF to his beneficiaries. Thus, petitioner

claims he provided the necessary collateral despite making no

payments or relinquishing control over any property in favor of

UEBF.

In our analysis below we find the dual repayment mechanism

does not serve as a valid repayment method for purposes of

classifying the distribution to petitioners as a bona fide loan.

However, the mechanism could serve as security between the

parties for the promissory note. For example, if petitioner died

having met all conditions precedent entitling him to death

benefits, UEBF would receive $5,600,000 from Southland and would
 -16-

be obligated to pay $6 million to petitioner’s beneficiary. The

dual repayment mechanism agreed to by petitioners provides

security and allows UEBF to deduct the $400,000 distribution from

the death benefit obligation. This factor indicates the parties

possible intent to establish a debtor-creditor relationship at

the time the funds were advanced.

E. Whether Repayments Were Made

Repayment is an indication that a loan is bona fide. Haber

v. Commissioner, 52 T.C. 255, 266 (1969), affd. 422 F.2d 198 (5th

Cir. 1970). Although petitioner signed a promissory note

obligating him to make quarterly payments beginning in November

2002, as of the date of trial petitioner had not made any

payments toward the purported loan. Petitioners argue that the

dual repayment mechanism serves as a valid method of repayment.

For a valid debt to exist for tax purposes, there must exist

an unconditional obligation to repay. Midkiff v. Commissioner,

96 T.C. 724, 734-735 (1991) (“Indebtedness is ‘an existing,

unconditional, and legally enforceable obligation for the payment

of a principal sum.’”, affd. sub nom. Noguchi v. Commissioner,

992 F.2d 226 (9th Cir. 1993) (quoting Howlett v. Commissioner, 56

T.C. 951, 960 (1971))). If a repayment mechanism is too

contingent and indefinite, the alternative payment method is not

recognized. Zappo v. Commissioner, 81 T.C. 77, 87-88 (1983).
 -17-

Despite petitioners’ characterization of the transaction and

the dual repayment mechanism, there are significant conditions

precedent to petitioners’ receipt of a death benefit under the

DBO plan from UEBF. If the corporation ceased participation in

the UEBF plan, if the covered employee was voluntarily or

involuntarily terminated or retired, or if the master contract

group and Local 2411 failed to renew their agreement, then UEBF

was not required to pay any benefits. Thus, even if petitioner

had rights to a death benefit, the rights were contingent because

if any of the foregoing conditions were present at the time of

his death, his beneficiaries would not receive benefits from

UEBF. Because the purported benefits were contingent upon

multiple future events, petitioner cannot reasonably rely on the

death benefit as an alternative payment method to show that the

loan would be unconditionally repaid. This factor indicates the

parties did not intend to establish a debtor-creditor

relationship at the time the funds were advanced.

F. Whether the Borrower Had a Reasonable Prospect
of Repaying the Loan and Whether the Lender Had
Sufficient Funds To Advance the Loan

This factor is best determined by looking to whether there

was “a reasonable expectation of repayment in light of the

economic realities of the situation” at the time the funds were

advanced. Fisher v. Commissioner, 54 T.C. 905, 909-910 (1970).

A reasonable prospect of repayment at the time the funds were
 -18-

advanced indicates the existence of a bona fide loan. Welch v.

Commissioner, 204 F.3d at 1231.

Petitioner earned a substantial living as a neurosurgeon,

and there was a reasonable prospect of petitioner’s repaying the

purported loan. This factor favors the existence of a debtor-

creditor relationship between the parties.

G. Whether the Parties Conducted Themselves as if the
Transaction Were a Loan

The conduct of the parties may be sufficient to indicate the

existence of a loan. Baird v. Commissioner, 25 T.C. 387, 395

(1955); Teymourian v. Commissioner, T.C. Memo. 2005-232; Morrison

v. Commissioner, T.C. Memo. 2005-53.

Petitioners produced little evidence showing UEBF and

petitioner conducted themselves in a manner indicating that

UEBF’s distribution of $400,000 to petitioner was a loan.

Although petitioner executed a loan application and a promissory

note, neither party strictly abided by their terms. First,

petitioner failed to provide any written evidence of the

unexpected housing costs that necessitated the loan application,

and UEBF made no further inquiry into the hardship. Second, the

interest rate was below market, petitioner failed to make any

quarterly payments as required under the promissory note, and

UEBF never attempted collection. Third, the promissory note was

not executed for almost 6 months after the funds were advanced.

Lastly, petitioner’s corporation ceased making contributions to
 -19-

UEBF to fund petitioner’s death benefit shortly after petitioner

received the $400,000 distribution from UEBF.

This factor indicates the parties did not intend to

establish a debtor-creditor relationship at the time the funds

were advanced.

H. Conclusion

In accordance with our analysis above, respondent has met

his burden of proving that the distribution of $400,000 did not

constitute a bona fide loan. On this record, the Court holds

that petitioners improperly failed to report as income the

$400,000 UEBF distributed to petitioner in 2002. Because of our

findings herein, it is unnecessary to address the parties’

arguments regarding a discharge of indebtedness by UEBF or the

year in which it occurred.

III. Penalties and Additions to Tax

A. Addition to Tax Under Section 6651(a)(1)

Section 6651(a)(1) imposes an addition to tax in the case of

any failure to timely file a Federal income tax return unless it

is shown that such failure is due to reasonable cause and not

willful neglect. A showing of reasonable cause requires

petitioners to demonstrate they exercised ordinary business care

and prudence and nevertheless were unable to file the return by

the due date. Sec. 301.6651-1(c)(1), Proced. & Admin. Regs.

Petitioners filed their returns for 2002 and 2003 on July 5,
 -20-

2005. Respondent did not assert a section 6651(a)(1) addition to

tax for 2002. The amount of the section 6651(a)(1) addition to

tax is a computational matter based on the amount of tax due. To

the extent respondent bears the burden of proving an increased

section 6651(a)(1) addition to tax, respondent has met this

burden if petitioners’ concessions result in an increased

deficiency for 2003. See sec. 7491(c); Higbee v. Commissioner,

116 T.C. 438, 446-447 (2001); Howard v. Commissioner, T.C. Memo.

2005-144.

Petitioners admit that they did not have reasonable cause

for their failure to timely file and failed to argue that the

addition should not apply. Accordingly, we conclude that

petitioners are liable for an addition to tax under section

6651(a)(1) for 2003 in an amount to be determined in the Rule 155

computation.

B. Accuracy-Related Penalty Under Section 6662

Petitioners contest the imposition of an accuracy-related

penalty for 2002.6 Section 6662(a) and (b)(1) and (2) imposes a

20-percent accuracy-related penalty upon any underpayment of

Federal income tax attributable to a taxpayer’s negligence or

disregard of rules or regulations, or substantial understatement

6
Because of the parties’ concessions and our holding that
petitioners improperly failed to report the $400,000 distribution
as income in 2002, we find it unnecessary to address respondent’s
alternative position regarding the imposition of the accuracy-
related penalty for 2003 or petitioners’ response thereto.
 -21-

of income tax. Section 6662(c) defines negligence as including

any failure to make a reasonable attempt to comply with the

provisions of the Code and defines disregard as any careless,

reckless, or intentional disregard. Disregard of rules or

regulations is careless if the taxpayer does not exercise

reasonable diligence to determine the correctness of a tax return

position that is contrary to the rule or regulation. Sec.

1.6662-3(b)(2), Income Tax Regs. Disregard of rules or

regulations is reckless if the taxpayer makes little or no effort

to determine whether a rule or regulation exists. Id. An

understatement is substantial if it exceeds the greater of 10

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

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

Under section 7491(c), the Commissioner bears the burden of

production with respect to penalties and must come forward with

sufficient evidence indicating that it is appropriate to impose

penalties. Higbee v. Commissioner, supra at 446-447. Once

respondent meets his burden of production, petitioners bear the

burden of proof as to substantial authority, reasonable cause, or

similar provisions. Id. In an amendment to answer, respondent

asserted an increased penalty based on the asserted increased

deficiency for each year at issue. To the extent respondent

bears the burden of proof for the increased 2002 penalty, we find
 -22-

that respondent has met that burden. See Bhattacharyya v.

Commissioner, T.C. Memo. 2007-19; Howard v. Commissioner, supra.

Respondent has proved that petitioners improperly excluded

from income in 2002 the $400,000 distribution from UEBF, which

exceeds both 10 percent of the tax required to be shown on the

return and $5,000. Respondent has also shown that petitioners

negligently disregarded rules and regulations by failing to make

a reasonable attempt to ascertain the correctness of the

treatment of the distribution. Petitioners arranged for a

distribution from the policy, accepted funds, and made no attempt

to make payments on the purported loan, thus defaulting.

Moreover, petitioner provided no evidence that he discussed his

failure to meet the terms of his purported loan with his tax

return preparer or made any attempt to determine the correct

treatment of his failure to report any income associated with the

distribution on his income tax return. This evidence is

sufficient to indicate that it is appropriate to impose a penalty

under section 6662(a) for 2002, except to any portion of the

underpayment as to which petitioners acted with reasonable cause

and in good faith. See sec. 6664(c)(1); Higbee v. Commissioner,

supra at 448. The decision as to whether a taxpayer acted with

reasonable cause and in good faith is made on a case-by-case

basis, taking into account all of the pertinent facts and

circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
 -23-

Reliance on professional advice may constitute reasonable

cause and good faith if, under all the circumstances, such

reliance was reasonable and the taxpayer acted in good faith.

Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d

1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991); sec. 1.6664-

4(b)(1), Income Tax Regs. However, the taxpayer cannot avoid the

penalty merely by having a professional adviser read a summary of

the transaction and offer advice that assumes the facts presented

are true. See Novinger v. Commissioner, T.C. Memo. 1991-289.

Moreover, the professional’s advice must be based on all

pertinent facts and circumstances; and, if the adviser is not

versed in the nontax factors, mere reliance on the tax adviser

may not suffice. See Addington v. United States, 205 F.3d 54, 58

(2d Cir. 2000); Collins v. Commissioner, 857 F.2d 1383, 1386 (9th

Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-217;

Freytag v. Commissioner, supra at 888, 889.

For a taxpayer’s reliance on advice to be sufficiently

reasonable so as to negate possible liability for the accuracy-

related penalty, the Court has stated that a taxpayer must

satisfy a three-prong test by showing: (1) The adviser was a

competent professional who had sufficient expertise to justify

reliance; (2) the taxpayer provided the adviser with the

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

relied in good faith on the adviser’s judgment. Neonatology
 -24-

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

299 F.3d 221 (3d Cir. 2002).

Petitioners claim that they relied on the tax advice of

Jeffrey Oerke, C.P.A., who prepared their 2002 return, and thus

reasonable cause exists. However, there is no evidence that Mr.

Oerke had any particular expertise in employee benefit plans or

that petitioners thought he had such expertise. Furthermore,

petitioners failed to show that they provided Mr. Oerke with all

the necessary and accurate information to properly prepare their

returns or evaluate the purported loan. Petitioner testified

that although he provided Mr. Oerke with a copy of the promissory

note, he was unsure whether Mr. Oerke received any documents

related to the DBO benefit plan. Finally, the record indicates

that petitioner did not seek or receive an opinion from Mr. Oerke

regarding the validity of the purported loan transaction.

Instead, Mr. Oerke merely prepared petitioners’ income tax return

for 2002 from the documents petitioners provided. As we have

stated, reliance on the mere fact that a certified public

accountant has prepared a tax return does not mean that he or she

opined on any or all of the items reported herein. Id. at 100.

For all of the foregoing reasons, petitioners are precluded from

now arguing that they relied on the tax advice of Mr. Oerke.

We conclude that petitioners’ underpayment for 2002 was the

result of their substantial understatement of income tax and
 -25-

their negligence and disregard of rules or regulations under

section 6662. We also conclude that petitioners are not entitled

to the reasonable cause and good faith defense under section 6664

because they did not rely on their accountant. Thus, we find

that petitioners are liable for the accuracy-related penalty for

2002 pursuant to section 6662 in an amount to be determined in

the Rule 155 computation. We do not impose a section 6662

penalty for 2003.

The Court, in reaching its holdings, has considered all

arguments made, and, to the extent not mentioned, concludes that

they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.