Gustashaw v. Comm'r

T.C. Memo. 2011-195

UNITED STATES TAX COURT

WILLIAM E. GUSTASHAW, JR. AND NANCY D. GUSTASHAW, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 19668-06. Filed August 11, 2011.

Held: Ps, who concede deficiencies in tax
attributable to PH’s participation in a Custom
Adjustable Rate Debt Structure (CARDS) transaction, are
liable for accuracy-related penalties for gross
valuation misstatements or, for 1 year, negligence, on
account of resulting underpayments in tax.

William P. Gregory, for petitioners.

Stephen R. Takeuchi and Robert W. Dillard, for respondent.
 - 2 -

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: By notice of deficiency (the notice),

respondent determined deficiencies in, and accuracy-related

penalties with respect to, petitioners’ Federal income tax as

follows:1

Penalty
Year Deficiency Sec. 6662(a)

2000 $3,188,225 $1,275,290
2001 159,775 31,955
2002 85,648 17,130
2003 4,492 898

By amendment to answer to amended petition, respondent increased

by $31,955 and $17,130 the accuracy-related penalties he had

determined for 2001 and 2002, respectively, for total section

6662(a) penalties for those years of $63,910 and $34,260,

respectively. Taking into account both parties’ concessions,2

the only issue for decision is whether petitioners are liable for

the accuracy-related penalties of $1,275,290, $63,910, $34,260,

1
Unless otherwise stated, section references are to the
Internal Revenue Code in effect for the years in issue and all
Rule references are to the Tax Court Rules of Practice and
Procedure. We round all amounts to the nearest dollar.
2
In the answer to amended petition, respondent asserted an
increased deficiency and a corresponding increased sec. 6662
penalty for 2001, should the Court ultimately disregard
respondent’s 2000 deficiency determination. Petitioners
subsequently conceded the deficiencies for all of the years in
issue. As a result, respondent conceded the increased deficiency
and accuracy-related penalty claims for 2001 asserted in the
answer to amended petition.
 - 3 -

and $898 for 2000, 2001, 2002, and 2003, respectively (the years

in issue).

FINDINGS OF FACT

Introduction

Some facts are stipulated and are so found. The stipulation

of facts, the supplemental stipulation of facts, the second

supplemental stipulation of facts, and the third supplemental

stipulation of facts, with accompanying exhibits, are

incorporated herein by this reference.

At the time they filed the petition, petitioners lived in

Florida.

Background

William and Nancy Gustashaw married in 1971. Two years

later, Mr. Gustashaw (sometimes, petitioner3) graduated from

Gannon University with a bachelor of science degree in industrial

management. While pursuing his degree, he took various business

management courses, including courses in managerial cost

accounting and the principles of accounting.

From 1973 to 1993, petitioner held management positions with

various companies in the food and beverage industry. In 1994, he

3
The accuracy-related penalty at issue arose from a
transaction entered into by Mr. Gustashaw and reported on
petitioners’ 2000 joint Federal income tax return. The parties’
arguments, therefore, focus on Mr. Gustashaw’s evaluation and
reporting of the transaction for Federal income tax purposes.
Accordingly, hereafter, when referring to him alone, we sometimes
refer to Mr. Gustashaw as petitioner.
 - 4 -

entered the pharmaceutical industry, joining Merck Medco Managed

Care (Merck Medco) as vice president of operations, responsible

for large-scale prescription processing in a mail-order pharmacy,

before being promoted to vice president and general manager

responsible for all operations of two of its mail-order

pharmacies. During his employ by Merck Medco, he received stock

options.

Petitioner’s Retirement Plans

Petitioner wished to retire at the age of 50. In 1995, at

the age of 45, he began to plan for his retirement. He expected

to exercise the majority of his Merck Medco stock options in

1999, or 2000, and, although he had handled almost all of his and

Mrs. Gustashaw’s investment decisions throughout their marriage,

petitioner sought a financial planner to determine whether the

stock option exercise would generate enough income to fund their

retirement.

Petitioner and Mrs. Gustashaw hired Ralph Maulorico (Mr.

Maulorico), a financial planner at New England Financial. In

1996, upon Mr. Maulorico’s recommendation, petitioner exercised

some of his stock options, selling the acquired stock and

investing the proceeds in mutual funds.

For all years during their marriage, until 2000, Mr.

Gustashaw prepared petitioners’ joint Federal income tax returns.

In 1997, however, petitioners decided to hire a tax accountant
 - 5 -

(initially, only to review petitioners’ returns, which Mr.

Gustashaw would continue to prepare). Mr. Maulorico recommended

his college friend, William Gable (Mr. Gable). Mr. Gable is an

enrolled agent and an accountant, although not a certified public

accountant. He owns an accounting practice in Florida and

received both an undergraduate and a master’s degree in

accounting, the latter with a specialty in taxation, at LaCrosse

University. Mr. Gable reviewed petitioners’ self-prepared joint

returns for 1997-99 before they filed them.

The CARDS Transaction

In 1999, Merck Medco underwent a reorganization and offered

petitioner the option to retire early. He accepted and retired

that same year. In 2000, petitioner exercised his remaining

Merck Medco stock options and sold the acquired stock, generating

$8,077,376 of income.

That same year, Mr. Maulorico learned of the Custom

Adjustable Rate Debt (sometimes, Custom Adjustable Rate Debt

Structure; hereafter, without distinction, CARDS) transaction

from a colleague and suggested it to petitioner as a possible

investment opportunity because of what he thought to be both its

profit potential and its ability to shelter the 2000 stock option

exercise income. Chenery Associates, Inc. (Chenery), promoted
 - 6 -

and arranged the CARDS transaction. Petitioner consulted with

Roy Hahn (Mr. Hahn), a certified public accountant and the

founder of Chenery, to learn more about the transaction.

The transaction works as follows.4 A newly formed Delaware

limited liability company (L.L.C.), owned 100 percent by

nonresident alien individuals, enters into a credit agreement

with a European financial institution (bank) under which the bank

extends to the L.L.C. a loan for a term of 30 years with interest

payments (but not principal payments) due, generally, annually.

The loan may be denominated in either U.S. or European currency

(i.e., dollars or euro). The interest rate is set at the London

Interbank Offered Rate (LIBOR) plus 50 basis points for the first

interest period and reset annually. The bank deposits the loan

proceeds directly into the L.L.C.’s account at the bank.

The L.L.C. invests 85 percent of the deposited proceeds in

Government bonds and uses the remaining 15 percent to make a

short-term time deposit, all of which the L.L.C. pledges as

collateral for the loan. To withdraw the loan proceeds, the

4
We provide only a summary description of the CARDS
transaction herein because it is virtually identical to the
transaction more fully described in Kerman v. Commissioner, T.C.
Memo. 2011-54.
 - 7 -

L.L.C. must provide substitute collateral, which it could do, at

the bank’s discretion,5 at each annual interest reset date.

If the bank chooses not to maintain the loan for the

upcoming interest period, its rejection constitutes delivery to

the L.L.C. of a “Mandatory Prepayment Election Notice”, which

requires repayment of the loan at the end of the current interest

period. The L.L.C. may repay the loan at any time after the

first year.

Upon the short-term time deposit’s maturity, the L.L.C. and

the taxpayer involved (the taxpayer) enter into an agreement

whereby the L.L.C. transfers the deposit’s proceeds, representing

15 percent of the entire loan amount, to the taxpayer in exchange

for his assumption of joint and several liability for the

L.L.C.’s obligations to the bank, including repayment of the

entire loan. The L.L.C. and the taxpayer agree that, as between

them, the taxpayer would repay the unpaid principal amount6 of

the loan at maturity and the L.L.C. would retain all interest

obligations.

The deposit’s proceeds (the taxpayer’s portion of the loan

proceeds) are credited to his deposit account maintained at the

5
The L.L.C. could also request, at that time, a change to
the loan terms, such as to amount or maturity.
6
The amount due would equal the present value of the loan’s
principal amount, which amounts to 15 percent of the loan
principal.
 - 8 -

bank. Once transferred from the L.L.C.’s pledged account, the

proceeds no longer collateralize 15 percent of the loan, which

requires the taxpayer to pledge to the bank, as collateral, all

of his holdings at the bank, including the deposit account

holding his portion of the loan proceeds.

The taxpayer may, at the bank’s discretion, withdraw his

portion of the loan proceeds after providing substitute

collateral on at least a dollar-for-dollar basis. At each annual

interest reset date, the L.L.C. may allow the taxpayer to

purchase additional portions of the loan proceeds, up to the full

principal amount of the loan.7

According to Mr. Hahn, upon converting his portion of the

euro-denominated loan into dollars or selling the Government

securities in the market, the taxpayer would generate a permanent

tax loss of approximately 85 percent of the entire loan amount

(the loan from the bank to the L.L.C.). Mr. Hahn further

explained that the taxpayer’s only out-of-pocket expense for the

entire transaction is an investment banking fee, equal to a

percentage of the entire loan amount, payable to Chenery to

arrange the transaction.

7
In addition, petitioner believed that upon the loan’s
maturity, the taxpayer could pay the unpaid principal amount of
the loan in either dollars or euro.
 - 9 -

Petitioner’s Investigation of the CARDS Transaction

As discussions with Mr. Hahn progressed, petitioner became

interested in the transaction because he understood that it gave

him: (1) The potential to generate a tax loss in the first year

sufficient to eliminate petitioners’ entire 2000 joint tax

liability, (2) access to a large pool of funds, not usually

available to individuals, for investment over a 30-year period,

and (3) the ability to leverage the euro against the dollar after

the first year by drawing down a euro-denominated loan and

repaying the loan in dollars if the euro was valued lower than

the dollar at maturity.

In June 2000, petitioner met with Mr. Maulorico and Mr.

Gable to discuss the transaction and review the CARDS executive

summary, a program overview prepared by Mr. Hahn. After the

meeting, Mr. Maulorico “anecdotally” reviewed the transaction’s

economics and concluded that, on the basis of past Standard &

Poor compound annual returns, it would be profitable to finance

long-term investments with the CARDS transaction’s line of

credit, promising petitioner that he could make “16 percent on

your [petitioner’s] money”. Mr. Maulorico did not accompany his

conclusions with a written analysis. Petitioner did not contact

other banks to see whether they offered a similar credit

arrangement.
 - 10 -

Mr. Gable, meanwhile, asked Mr. Hahn about obtaining a tax

opinion letter regarding the transaction’s Federal income tax

consequences. Mr. Gable had felt uncomfortable opining on the

transaction’s tax ramifications, specifically whether the

transaction would indeed generate a permanent tax loss, as

assured by Mr. Hahn, because the transaction invoked provisions

of the Internal Revenue Code with which he was unfamiliar.

Having been asked to prepare petitioners’ 2000 joint Federal tax

return, Mr. Gable refused to prepare, and take a permanent loss

tax position on, the return without a tax opinion letter

supporting the position.

Mr. Hahn offered to provide to petitioner a model tax

opinion letter from the law firm of Brown & Wood LLP (Brown &

Wood). Chenery had retained Brown & Wood to produce a tax

opinion letter when it first developed the CARDS transaction, and

the law firm “stood available” to write tax opinion letters for

future CARDS participants.

Mr. Gable informed petitioner of Mr. Hahn’s offer, stating

that a tax opinion letter from a major law firm, such as Brown &

Wood, concluding that the CARDS transaction would more likely

than not withstand an Internal Revenue Service (IRS) examination

would protect petitioner from substantial tax penalties if the

transaction was ultimately disregarded for Federal tax purposes.

Petitioner asked to see a model tax opinion letter.
 - 11 -

Chenery provided the model tax opinion letter shortly

thereafter, and petitioner met with Mr. Maulorico and Mr. Gable

to review its conclusions. The letter, which assumed that the

loan would be denominated in euro, stated that the CARDS

transaction “has not been before a court of law addressing the

issues addressed herein”. It concluded, however, that on the

basis of authority in analogous contexts, it is more likely than

not that: (1) The transaction (the transfer of the euro-

denominated deposit proceeds to the CARDS participant

(participant) in exchange for his assumption of the L.L.C.’s

obligations to the bank) would constitute a sale of the foreign

currency (assets) by the L.L.C. to the participant, (2) the

participant’s tax basis in the assets would equal the principal

amount of the loan (the amount of the L.L.C.’s liability to the

bank that the participant assumed) plus the amount of cash and

the fair market value of any other consideration paid, (3) any

gain or loss recognized upon the assets’ disposition would be

characterized as ordinary gain or loss under section 988, and (4)

the participant would recognize no income upon the L.L.C.’s

repayment of the loan to the bank.

Despite the fact that the model tax opinion letter was

provided by the transaction’s promoter, Mr. Gable viewed it as an

“honest opinion of the viability of this transaction” because

Brown & Wood was a reputable and “major law firm”. At Mr.
 - 12 -

Gable’s insistence, petitioner requested that Brown & Wood

provide him with a formal tax opinion letter. Because he viewed

a second formal tax opinion letter as superfluous, and

considering the substantial cost of obtaining it, Mr. Gable

advised petitioner against obtaining such a letter from a second

tax professional. Petitioner heeded that advice, in part because

of Mr. Gable’s statement that Brown & Wood had “expertise in this

area of foreign transactions”.

Petitioner was aware that the transaction’s tax

ramifications were untested, but he did not seek either a ruling

from the IRS on the tax consequences or an opinion regarding the

legality, not merely the tax consequences, of the transaction.

Instead, he relied on the “credibility” of Mr. Hahn and Brown &

Wood, as reported to him by Mr. Gable and Mr. Maulorico.

On July 6, 2000, petitioner asked Mr. Gable, among other

things, to: (1) Determine petitioners’ estimated 2000 tax

liability, including the income from the Merck Medco stock

options exercise, (2) prepare a CARDS investment schedule to

create a loss sufficient to offset petitioners’ 1998, 1999, and

2000 tax liabilities, (3) prepare a schedule of rates of return,

using reasonable return assumptions, to offset the program’s cost

and any interest charged by the IRS if generated deductions were

disallowed, and (4) complete the program’s after-tax cost using

reasonable rates of return if generated deductions were
 - 13 -

disallowed because of the transaction’s untested tax

ramifications.

Mr. Gable’s report, dated August 18, 2000, examined the

requested scenarios using exclusively information provided by Mr.

Hahn. The report assumed that the CARDS transaction would

terminate, prompting the loan’s repayment, on April 30, 2004, a

date outside the period of limitations for examination of

petitioners’ 2000 joint Federal income tax return. In

calculating the earnings generated on tax refunds, Mr. Gable

assumed that all tax refunds would be received by June 30, 2001.

Petitioner’s CARDS Participation

Petitioner sent a letter to Chenery, dated October 5, 2000,

agreeing to pay it an $800,000 investment banking fee and

enclosed a $10,000 downpayment towards the fee, the balance of

which was to be paid upon the loan’s termination.

Notwithstanding the $10,000 payment, petitioner remained under no

obligation to participate in the CARDS transaction.

After receiving petitioner’s letter, Chenery arranged the

CARDS facility, identifying Bayerische Hypo- und Vereinsbank AG

(HVB), a German bank, as lender and Osterley Financial Trading

LLC (Osterley), a newly formed Delaware L.L.C. wholly owned by

two nonresident alien individuals, as the initial borrower.

On December 5, 2000, HVB entered into an agreement with

Osterley whereby it extended a €12,900,000 loan to Osterley under
 - 14 -

the earlier described terms. Petitioner received a letter from

HVB, dated December 21, 2000, confirming his interest in assuming

joint and several liability for the euro-denominated loan to

Osterley. The letter stated that HVB “makes no guarantee or

representation whatsoever as to the expected performance or

results of the Transaction (including the legal, tax, financial

or accounting consequences thereof)” and that petitioner

represents that he has been “independently advised by” his own

legal counsel and will comply with the Federal internal revenue

laws.

On December 21, 2000, petitioner executed the documents to

participate in the transaction. He read the documents before

signing them but did not fully understand them. Petitioner did

not have an attorney review the documents before executing them,

assuming most of the language to be boilerplate and the documents

merely to formalize his discussions with Mr. Hahn. Petitioner

considered the transaction legitimate, believing that Brown &

Wood and HVB, a reputable law firm and a major bank,

respectively, would not engage in illegitimate transactions.

Neither Mr. Gable nor Mr. Maulorico reviewed the transaction

documents. The transaction documents did not provide a euro-

dollar conversion opportunity during the first year, and the

purchase agreement between petitioner and Osterley stated that
 - 15 -

Brown & Wood acted as U.S. counsel to Osterley in the

transaction.

On December 22, 2000, HVB released as collateral under the

loan €1,577,778 of petitioner’s €1,935,000 portion of the loan’s

proceeds, which petitioner converted to $1,448,400. On December

27, 2000, HVB released the remaining portion, €357,222, which

petitioner converted to $332,216 on December 29, 2000. Although

released, the money remained in petitioner’s account at HVB.

Petitioner received Brown & Wood’s formal tax opinion

letter, dated December 31, 2000, and signed by “Brown & Wood

LLP”, which arrived at the same “more likely than not”

conclusions as the model tax opinion letter. He did not

compensate Brown & Wood for either tax opinion letter; Chenery

paid the law firm out of the $800,000 fee owed to it by

petitioner. Petitioner did not know how much Brown & Wood was

ultimately paid for its services.

Mr. Gable reviewed the formal tax opinion letter and read

the cited Internal Revenue Code sections but did not

independently consider whether they, or the cited caselaw,

supported the opinion letter’s conclusions because he did not

doubt that they were correct.

Wishing to access the loan proceeds (which he had converted

from euro to dollars), on April 2, 2001, petitioner pledged

substitute collateral, and HVB wired out of his HVB account a
 - 16 -

portion of the previously released loan proceeds. The value of

the collateral soon became deficient, however, and, upon HVB’s

request, petitioner pledged additional substitute collateral to

cover the shortfall.

On November 13, 2001, HVB issued to petitioner a Mandatory

Prepayment Election Notice, notifying him that the bank was

calling in the loan and the entire outstanding principal amount

of the loan, including any interest accrued, would be due and

payable as of December 5, 2001. Mr. Maulorico asked Mr. Hahn

whether another bank would provide the same credit arrangement;

all banks declined. On December 17, 2001, the CARDS transaction

was terminated, with all debts satisfied.

Petitioners’ Joint Federal Income Tax Returns for 2000, 2001,
2002, and 2003

Petitioners filed a joint Form 1040, U.S. Individual Income

Tax Return, for tax year 2000. Mr. Gable prepared the tax return

and reviewed it with petitioners. Form 4797, Sales of Business

Property, attached to the Form 1040, reported the CARDS

transaction generally in the following terms: On December 5,

2000, petitioners acquired property in a foreign currency

transaction pursuant to section 988 at a cost or other basis of
 - 17 -

$11,739,258,8 and they sold it, on December 21, 2000, for

$1,800,934,9 generating an ordinary loss of $9,938,324. Mr.

Gable relied on Mr. Hahn to calculate the amounts reported on

Form 4797.

The claimed ordinary loss offset all of petitioners’

reported income for 2000, resulting in $1,784,462 of negative

adjusted gross income. Petitioners claimed net operating loss

carryforward deductions related to the CARDS transaction of

$1,231,106, $785,986, and $498,860 on their joint 2001, 2002, and

2003 Forms 1040, respectively.

Respondent’s Examination

Respondent examined petitioners’ joint Forms 1040 for the

years in issue. He disallowed the $9,938,324 loss claimed on the

2000 tax return on the grounds, among other, that petitioners

failed to establish the claimed $11,739,258 basis and that the

transaction lacked economic substance, “was entered into for the

primary purpose of tax avoidance, and/or was prearranged and

predetermined.” Respondent also disallowed the 2001, 2002, and

2003 claimed net operating loss carryforward deductions because

of his adjustments to petitioners’ 2000 return. Finally,

8
The reported amount represents the U.S. dollar equivalent
of the €12,900,000 loan.
9
The reported amount represents the U.S. dollar equivalent
of Mr. Gustashaw’s collateralized 15-percent share.
 - 18 -

respondent determined an accuracy-related penalty under section

6662(a) for each year in issue.

HVB’s Fraudulent Behavior

On February 13, 2006, HVB entered into a deferred

prosecution agreement with the U.S. Government in which it

admitted that it participated in several tax shelter

transactions, including CARDS, between 1996 and 2002 and that the

CARDS transactions involved purported 30-year loans, when all

parties, including the borrowers, knew that the transactions

would be unwound in approximately 1 year so as to generate false

tax benefits for the participants. HVB acknowledged that the

transactions, therefore, had no purpose other than to generate

tax benefits for the participants. HVB further admitted that it

engaged in activities with others, including Brown & Wood,

“related to the CARDS tax shelter with the intention of

defrauding the United States.”

Before trial, and in the light of HVB’s admissions in the

deferred prosecution agreement, petitioners conceded the

deficiencies in income tax for all years in issue, leaving only

the applicability of the accuracy-related penalty at issue. At

trial, Mr. Gustashaw admitted that petitioners did not suffer a

$9,938,324 economic loss associated with the $9,938,324 tax loss

claimed on their 2000 Form 1040.
 - 19 -

OPINION

I. Imposition of the Accuracy-Related Penalty

A. Introduction

Section 6662(a) imposes an accuracy-related penalty of 20

percent of the portion of an underpayment of tax attributable to,

among other things, negligence or disregard of rules or

regulations (without distinction, negligence), any substantial

understatement of income tax, or any substantial valuation

misstatement. Sec. 6662(a) and (b)(1)-(3). In the case of a

gross valuation misstatement, the penalty is increased from 20

percent to 40 percent. Sec. 6662(h)(1). The accuracy-related

penalty, however, does not apply to any part of an underpayment

if it is shown that the taxpayer acted with reasonable cause and

in good faith. Sec. 6664(c)(1).

The Commissioner bears the burden of production with respect

to penalties. See sec. 7491(c). To meet this burden, he must

produce evidence regarding the appropriateness of imposing the

penalty. Higbee v. Commissioner, 116 T.C. 438, 446 (2001);

Raeber v. Commissioner, T.C. Memo. 2011-39. The taxpayer’s

concessions may be taken into account to meet this burden. Oria

v. Commissioner, T.C. Memo. 2007-226. Once the Commissioner

carries his burden, the burden of proof remains with the

taxpayer, “including the burden of proving that the penalties are

inappropriate because of reasonable cause.” Kaufman v.
 - 20 -

Commissioner, 136 T.C. ___, ___ (2011) (slip op. at 47). The

Commissioner, however, bears the burden of proof with respect to

any increased penalty asserted in an amendment to answer. Rule

142(a).

Respondent determined the accuracy-related penalty,

alternatively, upon all three of the above-referenced grounds for

the years in issue. On brief, however, respondent states that he

determined an accuracy-related penalty with respect to 2003 only

on the ground of negligence. We construe that as a concession of

other grounds for the penalty for 2003. See Rule 151(e)(4) and

(5).

Only one accuracy-related penalty may be applied with

respect to any given portion of an underpayment, even if that

portion is subject to the penalty on more than one of the grounds

set out in section 6662(b). Sec. 1.6662-2(c), Income Tax Regs.

B. Valuation Misstatement Penalty

As stated above, section 6662(a) and (b)(3) imposes a

penalty of 20 percent of the portion of an underpayment of tax

attributable to a substantial valuation misstatement. A

substantial valuation misstatement exists if the value, or

adjusted basis, of any property claimed on a tax return is “200

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

of such valuation or adjusted basis”. Sec. 6662(e)(1)(A). If

the valuation misstatement is 400 percent or more of the correct
 - 21 -

amount, a gross valuation misstatement exists and the 20-percent

penalty increases to 40 percent. Sec. 6662(h)(1) and (2)(A)(i).

“The value or adjusted basis claimed on a return of any property

with a correct value or adjusted basis of zero is considered to

be 400 percent or more of the correct amount.” Sec. 1.6662-5(g),

Income Tax Regs. No penalty, however, is imposed unless the

portion of the underpayment attributable to the valuation

misstatement exceeds $5,000. Sec. 6662(e)(2).

Respondent argues that petitioners are liable for the 40-

percent gross valuation misstatement penalty for taxable year

2000 because petitioners’ claimed $9,938,324 loss resulted from

reporting an $11,739,258 basis on their tax return, rather than

the correct basis amount of zero. Respondent asserts that the

underpayment resulting from the disallowed loss is, therefore,

attributable to an overstatement of basis of 400 percent or more

of the correct amount. In addition, he argues that the 40-

percent penalty applies to the carryover of the loss attributable

to the gross valuation misstatement to 2001 and 2002. See sec.

1.6662-5(c)(1), Income Tax Regs.

Petitioners argue that the valuation misstatement penalty is

inapplicable as a matter of law because respondent’s disallowance

of their claimed loss in 2000 was attributable not to an

overvaluation but rather to the CARDS transaction’s lack of

economic substance and, therefore, its nonexistence. Petitioners
 - 22 -

assert that, as a result of HVB’s fraudulent conduct, the

transaction, in effect, never occurred. They argue that the

disallowance, therefore, could not be attributable to an

overvaluation of an asset because the asset never existed. In

support of their argument, petitioners rely primarily on Keller

v. Commissioner, 556 F.3d 1056 (9th Cir. 2009), affg. in part and

revg. in part T.C. Memo. 2006-131, and Klamath Strategic Inv.

Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Tex. 2007),

affd. 568 F.3d 537 (5th Cir. 2009).

We have previously held the valuation misstatement penalty

applicable where a transaction lacks economic substance and the

underpayment results from disallowed deductions, credits, or

losses computed with overvalued bases. See, e.g., Zirker v.

Commissioner, 87 T.C. 970 (1986) (finding that section 6659, the

predecessor of section 6662(a), applies where the transaction

lacked economic substance and the underpayment was due to the

disallowed deductions and credits caused by a finding of a zero

adjusted basis). Indeed, in deciding cases factually similar to

the instant case that were appealable to Courts of Appeals other

than those for the Ninth and Fifth Circuits, we have expressly

distinguished the reasoning of both Klamath and Gainer v.

Commissioner, 893 F.2d 225 (9th Cir. 1990), affg. T.C. Memo.

1988-416, upon which Keller relies. See Palm Canyon X Invs., LLC

v. Commissioner, T.C. Memo. 2009-288 (finding Gainer
 - 23 -

distinguishable because “[i]n Gainer, the court disallowed the

claimed tax benefits on grounds independent from any alleged

valuation misstatement” whereas in the case before the Court, the

claimed inflated basis in the partnership interest directly

contributed to the decision to disregard the transaction on

economic substance grounds); LKF X Invs., LLC v. Commissioner,

T.C. Memo. 2009-192, affd. in part and revd. in part without

published opinion 106 AFTR 2d 2010-5003, 2010-1 USTC par. 50,488

(D.C. Cir. 2010); Panice v. Commissioner, T.C. Memo. 2007-110.

Petitioners offer no reason for us to deviate from our

position, and we are not inclined to do so. Accordingly, we find

the valuation misstatement penalty applicable in the instant

case. We note that our holding is consistent with the views of

many of the Courts of Appeals that have addressed this issue.

See, e.g., Zfass v. Commissioner, 118 F.3d 184 (4th Cir. 1997),

affg. T.C. Memo. 1996-167; Illes v. Commissioner, 982 F.2d 163

(6th Cir. 1992), affg. T.C. Memo. 1991-449; Gilman v.

Commissioner, 933 F.2d 143 (2d Cir. 1991), affg. T.C. Memo. 1989-

684; Massengill v. Commissioner, 876 F.2d 616 (8th Cir. 1989),

affg. T.C. Memo. 1988-427.

With respect to the section 6662(h) penalty, respondent

bears the burden of production for 2000 and, because he asserted

the augmented penalty under section 6662(h) for 2001 and 2002 in

the amendment to answer, the burdens of production and proof for
 - 24 -

the augmented penalty for 2001 and 2002. We find that respondent

has satisfied those burdens. On Form 4797, petitioners reported

a basis of $11,739,258 in an asset that they purportedly later

sold, resulting in a claimed $9,938,324 loss from the

transaction. In the notice, respondent determined a basis of

zero, which petitioners effectively accepted as accurate in

conceding all of the deficiencies in tax. The basis claimed on

the return exceeds the correct basis by 400 percent or more. The

underpayments determined for 2000, 2001, and 2002, each exceeding

the $5,000 requirement of section 6662(e)(2) and caused by the

disallowed loss and related carryover deductions, result directly

from this overstatement. See, e.g., Zirker v. Commissioner,

supra.

Accordingly, petitioners are liable for the 40-percent

accuracy-related penalty under section 6662(h) for tax years

2000, 2001, and 2002 unless they meet the section 6664(c)

exception for reasonable cause and good faith. Because of

section 1.6662-2(c), Income Tax Regs., we need not address the

applicability of the penalty upon the grounds of substantial

understatement of income tax or negligence for 2000, 2001, and

2002.

C. Negligence Penalty

Respondent contends that, for 2003, petitioners are liable

for the 20-percent accuracy-related penalty under section 6662(a)
 - 25 -

and (b)(1) because the 2003 underpayment resulting from the

disallowed net operating loss carryover deduction was due to

negligence.

Negligence is defined as a “lack of due care or the failure

to do what a reasonable and ordinarily prudent person would do

under the circumstances”. Viralam v. Commissioner, 136 T.C. __,

___ (2011) (slip op. at 38). Negligence is strongly indicated

where “[a] taxpayer fails to make a reasonable attempt to

ascertain the correctness of a deduction, credit or exclusion on

a return which would seem to a reasonable and prudent person to

be ‘too good to be true’ under the circumstances”. Sec. 1.6662-

3(b)(1)(ii), Income Tax Regs.

A return position is not negligent, however, if it is

reasonably based on certain enumerated authorities and is not a

merely arguable or colorable claim. Sec. 1.6662-3(b)(1), (3),

Income Tax Regs. Conclusions reached in opinion letters written

by tax professionals are not considered authority, although

“authorities underlying such expressions of opinion where

applicable to the facts of a particular case” may provide

reasonable basis for an item’s tax treatment. Sec. 1.6662-

4(d)(3)(iii), Income Tax Regs.

Petitioners conceded that they improperly claimed the net

operating loss carryover deduction on their joint 2003 Form 1040.

Their concession is sufficient for us to conclude that respondent
 - 26 -

has carried his burden of production. A reasonable and

ordinarily prudent person would have considered as “too good to

be true” a carryover deduction generated from a previously

claimed $9,938,324 tax loss when he did not suffer an associated

economic loss and invested only $800,000 in the transaction. As

such, he would have conducted a thorough investigation before

claiming the deduction on his tax return.

Petitioners, however, failed to do so. Mr. Gustashaw is

college educated, has over 20 years of investment experience, and

has competently prepared petitioners’ joint Federal tax returns

without the involvement of a tax professional for more than 20

years. Despite this experience, he did not attempt to understand

the mechanics of the CARDS transaction, executed the transaction

documents without reading them and without an attorney’s review,

and, although aware of the transaction’s untested tax

ramifications, declined to seek a ruling from the IRS. Further,

he did not question the claimed carryover loss amount even though

he knew that he did not suffer an associated economic loss. Such

a “too good to be true” transaction required greater scrutiny.

See, e.g., Viralam v. Commissioner, supra at __ (slip op. at 38-

39).

Petitioners argue that they were not negligent because the

legal authorities underlying the Brown & Wood tax opinion letter

provided a reasonable basis for claiming the 2000 loss and thus
 - 27 -

provided a reasonable basis for claiming, on their 2003 tax

return, the related carryover deduction. See sec. 1.6662-

3(b)(1), Income Tax Regs. We disagree. The tax opinion letter

addresses the tax consequences of four independent transactions

and presumes that the CARDS transaction is the amalgamation of

these separate transactions. In reaching its four conclusions,

the opinion letter cites authorities of the type set forth in

section 1.6662-4(d)(3)(iii), Income Tax Regs. See sec. 1.6662-

3(b)(3), Income Tax Regs. Although, piecemeal, the cited

authorities support each individual conclusion, the authorities

present factual situations that do not adequately describe the

CARDS transaction as a whole. See sec. 1.6662-4(d)(3)(ii),

Income Tax Regs. (“The weight accorded an authority depends on

its relevance * * * . For example, a case or revenue ruling

having some facts in common with the tax treatment at issue is

not particularly relevant if the authority is materially

distinguishable on its facts”). We, therefore, cannot conclude

that petitioners had a reasonable basis for claiming the net

operating loss carryover deduction on their joint 2003 Form 1040.

Petitioners also assert that they were not negligent because

they made a reasonable attempt to ascertain the correctness of

the carryover deduction, a deduction that they seem to argue

would not seem to a reasonable and prudent person to be “too good

to be true”. They argue that Mr. Gable did not find the
 - 28 -

transaction’s tax benefits to be unusual and that he provided

them with examples of similar tax-leveraged investments.

Regardless of the accuracy of those statements, as stated supra

we cannot conclude that petitioners made a reasonable attempt to

ascertain the correctness of the 2003 carryover deduction.

Accordingly, we find that, barring reasonable cause and good

faith, petitioners are liable for the 20-percent accuracy-related

penalty for negligence for tax year 2003.

D. Section 6664(c) Reasonable Cause Defense

A taxpayer may avoid the section 6662(a) penalty by showing

that he acted with reasonable cause and in good faith. Sec.

6664(c)(1). Reasonable cause requires that the taxpayer have

exercised ordinary business care and prudence as to the disputed

item. United States v. Boyle, 469 U.S. 241, 246 (1985). That

determination is made on a case-by-case basis, taking into

account all pertinent facts and circumstances, including the

taxpayer’s knowledge and experience. Racine v. Commissioner,

T.C. Memo. 2006-162, affd. 493 F.3d 777 (7th Cir. 2007); sec.

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

A taxpayer may demonstrate reasonable cause through the good

faith reliance on the advice of an independent professional, such

as a tax adviser, lawyer, or accountant, as to the item’s tax

treatment. United States v. Boyle, supra at 251; Canal Corp. &

Subs. v. Commissioner, 135 T.C. 199, 218 (2010). To prevail, the
 - 29 -

taxpayer must show that he: (1) Selected a competent adviser

with sufficient expertise to justify reliance, (2) supplied the

adviser with necessary and accurate information, and (3) actually

relied in good faith on the adviser’s judgment. 106 Ltd. v.

Commissioner, 136 T.C. 67, 77 (2011) (citing Neonatology

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

299 F.3d 221 (3d Cir. 2002)). Reliance is unreasonable, however,

if the adviser is a promoter of the transaction or suffers from

“an inherent conflict of interest that the taxpayer knew or

should have known about.” Neonatology Associates, P.A. v.

Commissioner, supra at 98.

Petitioners assert that Mr. Gustashaw reasonably, and in

good faith, relied upon the advice of: (1) Mr. Gable as to Brown

& Wood’s reputation in the legal community, the quality of its

tax opinion letter, and the protection that the letter would

provide against the possible imposition of penalties; (2) Mr.

Maulorico as to the investment potential of the CARDS

transaction; and (3) Brown & Wood’s tax opinion letter.

The only tax advice petitioner sought concerning the CARDS

transaction was from Brown & Wood, as neither Mr. Gable nor Mr.

Maulorico opined on the tax issues involved. On brief,

petitioners’ arguments focus on Mr. Gustashaw’s lack of knowledge

of Brown & Wood’s subsequently exposed conflict of interest in

advising him.
 - 30 -

We find that petitioners’ reliance on Brown & Wood’s tax

opinion letter was unreasonable because they should have known

about the law firm’s inherent conflict of interest. Chenery, the

promoter of CARDS, both referred Brown & Wood to Mr. Gustashaw

and supplied him with the law firm’s model tax opinion letter,

which described a CARDS transaction that was not unique to Mr.

Gustashaw’s situation. Petitioners proffered no evidence that

Mr. Gustashaw had an engagement letter with Brown & Wood, spoke

to any attorney at the law firm, or directly compensated Brown &

Wood for either tax opinion letter. On the facts presented,

petitioners could not have reasonably believed that Brown & Wood

was an independent adviser. See, e.g., Van Scoten v.

Commissioner, 439 F.3d 1243, 1253 (10th Cir. 2006) (“Regardless

of their level of sophistication, it was unreasonable for * * *

[the taxpayers] to rely on tax professionals that they did not

personally consult with, explain their unique situation to, or

receive formal advice from.”), affg. T.C. Memo. 2004-275.

Petitioners have not carried their burden of proving that

they acted with reasonable cause and in good faith in reporting

the loss and related net operating loss carryover deductions on

their joint Forms 1040 for the years in issue.
 - 31 -

II. Conclusion

Petitioners are liable for the section 6662(a) penalty as

applied to the underpayments of tax redetermined herein.

Decision will be entered

for respondent.