Bruce W. Lemay v. Commissioner

T.C. Memo. 2020-59

UNITED STATES TAX COURT

BRUCE W. LEMAY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 19356-15L. Filed May 14, 2020.

Bruce W. Lemay, pro se.

Rachael J. Zepeda, Derek S. Pratt, Alicia E. Elliott, and Trisha S. Farrow,

for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

NEGA, Judge: This case is before the Court on a petition for review of a

Notice of Determination Concerning Collection Action(s) Under Section(s) 6320
 -2-

[*2] and/or 6330 (notice of determination).1 After concessions by the parties,2 the

primary issue for decision is whether petitioner is liable for penalties totaling

$46,984, $74,694, and $59,398 under section 6700 for tax years 2008, 2009, and

2010, respectively (years at issue).

FINDINGS OF FACT

Some of the facts are stipulated and are so found. The stipulation of facts

and the attached exhibits are incorporated herein by this reference. Petitioner,

Bruce W. Lemay, resided in Kansas when the petition was filed. This case was

consolidated for trial along with the case of Davison v. Commissioner, docket No.

14765-15L. Our opinion in Davison may be found at T.C. Memo. 2020-58.

I. Background

Petitioner graduated from Boston College in 1973, where he earned a

bachelor’s degree in English. From 1981 to 1996 petitioner was a corporate

executive in the insurance industry, primarily working in the fields of property and

1
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years at issue. All monetary amounts are rounded
to the nearest dollar.
2
Respondent and petitioner proceeded as if the question of petitioner’s
underlying liability is appropriately before this Court, with the primary issue for
decision being whether petitioner is liable for promoter penalties under sec. 6700.
Since both parties proceeded as though the underlying liability is in dispute, we
will follow their lead.
 -3-

[*3] liability insurance. Petitioner first made the acquaintance of Allen Davison in

a professional setting. They became friends, and have maintained that friendship

since the early nineties.

It was while working in the insurance industry that petitioner first came to

learn of “tool plans”.3 A former colleague had requested petitioner’s assistance in

calculating, or otherwise determining, how an employer’s participation in a tool

plan affected that employer’s worker’s compensation insurance premiums.

Petitioner responded that he was unfamiliar with tool plans, but he researched this

issue and found that an employer’s participation in a tool plan had no effect on the

calculation of an employer’s worker’s compensation premiums. Petitioner

reported these findings to his former colleague.

While researching tool plans petitioner discovered a tool plan company

called ProCheck and began to foster a relationship with its president. Petitioner

and ProCheck’s president discussed tool plans generally, as well as their tax

aspects. The president of ProCheck offered petitioner the opportunity to join

ProCheck. Petitioner sought the advice of Mr. Davison, as petitioner held

reservations about ProCheck’s operations and the purported benefits its tool plans

3
“Tool plans” generally attempt to operate to recharacterize a portion of an
employee’s wages as reimbursement or rental expenses reflecting the cost of the
employee’s tools.
 -4-

[*4] offered. After being apprised of the details of ProCheck, Mr. Davison

validated petitioner’s concerns, and advised him to decline ProCheck’s offer.

Although petitioner declined the offer to join ProCheck, petitioner and the

president of ProCheck agreed to form a new company that would promote tool

plans, so long as such plans were reviewed and approved by Mr. Davison and his

employer, Grant Thornton.

II. Organization of CMS

On September 29, 1999, petitioner, along with the president of ProCheck

and two other individuals affiliated with ProCheck, organized Cash Management

Systems (CMS), an S corporation, in the State of Virginia. Petitioner at all

relevant times sat on that company’s board of directors. From 1999 through the

summer of 2002 petitioner served as the president of CMS. After 2002 petitioner

served as executive vice president of CMS.

Shortly after organization, CMS formally engaged Mr. Davison, and

through him Grant Thornton, to consult with and advise CMS with respect to the

tax benefits of its proposed tool plans. Mr. Davison managed the CMS client

account for Grant Thornton. Mr. Davison’s first task was to review the proposed

tool plans’ compliance with law.
 -5-

[*5] III. Development of the Tool Program

CMS had three different tool plans in its Tool Program: (1) the existing tool

plan, (2) the new tool plan, and (3) the tool use plan. CMS planned to operate the

tool plans in sequence in order to maximize the lifetime tax savings for both the

employees and employers enrolled in its plans. In addition to the tool plans and

payroll administration, CMS would offer legal research and free audit

representation as part of an overall employee benefits package. The tool plans,

administrative support, and audit representation collectively constituted the Tool

Program.

CMS designed its tool plans to allow both employers and employees to

claim substantial tax savings by bifurcating an employee’s base pay into a taxable

labor portion and a nontaxable portion for tool reimbursement or use. This

bifurcation was based upon a proprietary formula.4 The CMS Tool Program

purported to offer tax savings by limiting Federal income tax withholding,

employment taxes, or both, depending on the tool plan.5 The maximum tool

4
Despite the fact that CMS marketed its proprietary formula as a selling
point of the tool program, petitioner was unaware of how the formula was
determined at all relevant times.
5
We use the term “employment taxes” to refer to taxes under the Federal
Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act. See
(continued...)
 -6-

[*6] reimbursement or use pay per pay period was 35% of the participating

employees wages. CMS made money from fees charged for administering the tool

plans. Upon enrolling both an employer and its employees, CMS administered the

enrolled employer’s payroll and issued associated statements to participating

employees. Through those associated statements, CMS kept employers and client-

employees abreast of the claimed tax savings from CMS tool plans.

A. The Existing Tool Plan

Under the existing tool plan, an employer recharacterized a portion of each

employee’s base pay as a reimbursement to that employee for the cost of tools

acquired by that employee before enrolling in the plan. The employees were

reimbursed in amounts reflecting the acquisition costs of their tools, rather than

the replacement costs or fair market value costs, before enrollment in the existing

tool plan.6 CMS calculated the appropriate tax withholdings for each employer’s

labor pay, but not tool pay, and remitted this information to the employer. The

5
(...continued)
Weber v. Commissioner, 138 T.C. 348, 357 (2012); Stevens Techs., Inc. v.
Commissioner, T.C. Memo. 2014-13, at *27-*29; Otto’s E-Z Clean Enters., Inc. v.
Commissioner, T.C. Memo. 2008-54, slip op. at 2 n.2.
6
CMS determined the cost of an employee’s tool inventory by reference to
an estimate of what the employee had originally paid for those tools rather than the
current replacement costs.
 -7-

[*7] employer withheld the necessary taxes for the labor pay portion, but no taxes

would be withheld for the tool portions determined by CMS. CMS claimed that

the existing tool plan was an accountable plan under section 62, whereby

reimbursement paid to employees for the cost of their own tools used on a job was

not considered wages for employment tax purposes.

B. The New Tool Plan

The new tool plan also recharacterized a portion of each employee’s base

pay as a nontaxable reimbursement. The only meaningful difference between the

existing tool plan and the new tool plan was that, under the new tool plan,

employees were reimbursed only for tools purchased after their enrollment.

Otherwise, the bifurcation of an employee’s base pay operated in an identical

manner. The new tool plan also purported to be an accountable plan under

section 62.

C. The Tool Use Plan

Once an employee was treated as reimbursed for the cost of his or her tool

inventory by way of the existing and/or new tool plan, CMS transitioned the

client-employee to the tool use plan. CMS offered the tool use plan as a method to

allow an employee to charge his or her employer a fee for the rental of his or her

tools used during the daily course of his or her labor. Similarly to the other plans,
 -8-

[*8] the employee’s base wages were recharacterized into a taxable portion for

labor and a tax-exempt portion for rental fees. CMS did not claim the tool use

plan was an accountable plan, thus rental fees paid under the plan were subject to

Federal income taxation. CMS did claim, however, that the rental fees paid

pursuant to the tool use plan fell outside the employment tax definition of wages

and thereby reduced the employment tax liability of the employer and the

employee. The tool use plan was available to any employee enrolled in the CMS

Tool Program, including those treated as fully reimbursed for the stated value of

their tools under the existing or new tool plan, or any employee who was treated as

having fully depreciated the cost of his or her tools before enrollment in the plan.

CMS calculated the tool usage amount for each participating employee and

reported the amount to his or her employer so that the employee could be paid

accordingly. CMS issued a Form 1099-MISC, Miscellaneous Income, to each

client-employee for tool pay received under the use plan. All payments to those

employees came from their employer directly, and they would also receive a Form

W-2, Wage and Tax Statement, from their employer reflecting their labor pay.

IV. Initial Review of the Tool Plans

Mr. Davison agreed to review the tool plans and their proposed

administration. Mr. Davison advised that securing a private letter ruling from the
 -9-

[*9] Internal Revenue Service (IRS) was critical to ensure the viability of the tool

plans. In order to better understand the prospects of securing a favorable private

letter ruling, petitioner and Mr. Davison sought the advice and counsel of Tom

Ochsenschlager, a partner at Grant Thornton’s national tax office in Washington,

D.C. Petitioner and Mr. Davison provided Mr. Ochsenschlager with relevant

information on CMS and the tool plans it intended to offer.

Through a series of communications occurring in November 1999, Mr.

Ochsenschlager informed petitioner and Mr. Davison that there was little chance

of securing a favorable private letter ruling from the IRS with respect to the CMS

tool plans. Mr. Ochsenschlager spoke with attorneys from the IRS and advised

petitioner and Mr. Davison that the IRS believed that the tool plans failed to

comply with the law applicable to accountable plans. Mr. Ochsenschlager stated

that the tool plans allowed for reimbursements to employees in amounts exceeding

their out-of-pocket expenses, contravening the statutory requirements for

accountable plans. Further, Mr. Ochsenschlager indicated that the IRS believed

the tool use plan lacked economic substance, that there was limited legal authority

supporting tool reimbursement plans generally, and that the IRS had an interest in

litigating against taxpayers promoting tool reimbursement plans such as those

proposed by CMS.
 - 10 -

[*10] Petitioner and Mr. Davison subsequently met to determine how best to bring

the CMS Tool Program to market in the light of Mr. Ochsenschlager’s concerns.

To that end, on December 2, 1999, petitioner and Mr. Davison met and developed

the following plan of action: (1) CMS would aggressively proceed in marketing

its three separate tool plans; (2) Mr. Davison would draw up a document on behalf

of Grant Thornton endorsing the Tool Program (Grant Thornton’s justification

paper); (3) Mr. Davison, along with petitioner, would be included in marketing the

tool plans to targeted clients; (4) Mr. Davison would train Mike East, an employee

of petitioner’s wholly owned S corporation, Xell Enterprises, Inc. (Xell), on the

tax aspects of the Tool Program, and Mr. East would then train CMS’ sales agents

on the tax aspects of the Tool Program; and (5) training dates for sales agents,

dates for commencing sales calls, and the establishment of sales targets would be

set.

During that meeting petitioner and Mr. Davison agreed that the new tool

plan and the existing tool plan would be promoted as accountable plans but that

the tool use plan was not an accountable plan and payments made thereunder

would instead be properly characterized as incidental rental payments. Petitioner

and Mr. Davison also agreed that Grant Thornton’s justification paper should

serve to clearly establish that the only risk of enrolling in the new tool plan and the
 - 11 -

[*11] tool use plan was payment of additional tax and that neither plan carried the

risk of penalties or prosecution. Mr. Davison was aware that the existing tool plan

was aggressive and bore the risk of penalties, and this awareness led him to omit

the existing tool plan from Grant Thornton’s justification paper. Nevertheless,

petitioner and Mr. Davison resolved to aggressively market the existing tool plan.

In a letter dated December 6, 1999, petitioner wrote to an associate at Grant

Thornton who assisted Mr. Davison with CMS matters generally. In that letter, for

purposes of memorializing his meeting with Mr. Davison, petitioner offered

specific instructions about what information he wanted included in Grant

Thornton’s justification paper. Petitioner requested that Grant Thornton’s

justification paper address the tax regulations and cases that demonstrated the

validity and compliance of the new tool plan with accountable plan rules.

Additionally, petitioner requested that Grant Thornton’s justification paper

document the tax cases and regulations supporting the position that payments

under the tool use plan were not subject to employment taxes. Further, petitioner

requested that Grant Thornton refrain from discussing the existing tool plan in its

justification paper but suggested that its risks be discussed with prospective clients

in person.
 - 12 -

[*12] Mr. Davison wrote and finalized Grant Thornton’s justification paper dated

February 12, 2000, and delivered it to CMS. Grant Thornton’s justification paper

did not address the existing tool plan but discussed only the new tool plan and the

tool use plan. Grant Thornton’s justification paper concluded that the new tool

plan qualified as an accountable plan and was therefore exempt from employment

taxes and that the potential for a penalty imposed under section 6672 was limited.

The paper also concluded that payments to employees under the tool use plan

would be unlikely to withstand IRS scrutiny for an accountable plan but that there

was a “long line of authority” that such payments should be treated as exempt

from self-employment tax. The paper further concluded that if the IRS audited

returns of an employer enrolled in the tool use plan and payments made thereunder

were recharacterized as wages, the consequence would be possible examination,

collection, and submission of employment taxes and interest.

Mr. Davison also drafted an executive summary of Grant Thornton’s

justification paper for distribution to clients and potential clients of CMS. He

drafted the executive summary because CMS advised him that its clients likely did

not want to read the full opinion but would prefer an abridged version. The

executive summary concluded that the “reimbursement plan for the cost of the

employee’s tools qualifies as an accountable plan under [section] 62(a)(2)(A).”
 - 13 -

[*13] That summary also concluded that “there is a long line of authority leading

to the conclusion that the usage payments under CMS’ plan should be treated as

other income not subject to the self-employment tax.”

In both Grant Thornton’s justification paper and Mr. Davison’s executive

summary, Mr. Davison emphasized that the legal positions taken on the Tool

Program were supported by “substantial authority”. Mr. Davison’s executive

summary did not include a definition of “substantial authority” or discuss the

likelihood that the plans would fail under IRS scrutiny. Neither Grant Thornton’s

justification paper nor the executive summary emphasized that the legal positions

taken in connection with the purported tax benefits available under the Tool

Program were supported by “substantial authority” as the term was understood by

petitioner and Mr. Davison--that the tool plans had a 33.5% chance of

withstanding an IRS attack. Further, Mr. Davison’s executive summary did not

address or express confidence in the lawfulness of the existing tool plan, despite

the fact that CMS marketed its three tool plans simultaneously. Grant Thornton’s

justification paper and Mr. Davison’s executive summary were distributed to

clients and potential clients of CMS.

Following CMS’ receipt of Grant Thornton’s justification paper, petitioner

determined that the tool plans were ready to market and delivered a presentation to
 - 14 -

[*14] the CMS board of directors indicating as much. The CMS board of

directors, on which petitioner sat, approved the tool plans, sales strategy, and

marketing materials developed by petitioner and Mr. Davison. CMS began

marketing and administering the tool plans immediately thereafter.

V. Marketing the Tool Plans

A. Xell Enterprises, Inc., and Its Relationship With CMS

CMS used third-party agents to market and sell its tool plans, rather than

directly executing sales itself. Petitioner organized Xell in the State of Kansas on

April 26, 1999. At all relevant times, petitioner was the sole shareholder and

president of Xell. Petitioner originally formed Xell for the purpose of operating

his own sales-consulting business. After CMS was organized, however, Xell’s

primary purpose became marketing and selling CMS’ tool plans.

From 1999 through 2010 petitioner oversaw the marketing and sales of

CMS’ tool plans in his capacity as president and owner of Xell. Petitioner’s duties

for Xell consisted of managing and training sales agents,7 coordinating and

7
From 1999 to 2009, Xell also hired independent contractors to serve as
sales agents to identify potential clients and pitch CMS’ tool plans. CMS would
pay Xell sales commissions for enrolling clients, and Xell would remit a
percentage of those commissions to the independent contractors responsible for
procuring the enrollments. Further, independent contractors would continue to
earn a portion of the commissions CMS paid to Xell so long as clients they
(continued...)
 - 15 -

[*15] participating in Xell’s sales pitches, and closing deals with prospective

clients. In his capacity as president of CMS, petitioner’s duties blended with those

performed in his capacity as Xell’s sole shareholder and president in that he

directed and participated in the marketing and sales of the Tool Program. More

specifically, with CMS, petitioner coordinated, developed, and managed the

marketing aspects of CMS’ tool program. Petitioner continued to direct the

marketing aspects of the tool program in his capacity as the owner and president of

Xell while also serving as executive vice president of CMS. Throughout CMS’

existence, Xell and petitioner were responsible for procuring all but a few of

CMS’ clients.

CMS described Xell as its “National Distribution Organization” in its

marketing materials. CMS’ marketing materials also indicated that Xell’s officers

were representative of CMS’ leadership and integral to the strength of its

operations. Xell and CMS shared a web-domain from 2003 to 2011, and

petitioner was directly involved in the decision to combine the web-domains.

CMS had knowledge of all meetings Xell’s sales agents and petitioner had with

prospective clients. With Xell, petitioner incurred substantial expenses marketing

7
(...continued)
enrolled continued to generate revenue for CMS by remaining in the Tool
Program.
 - 16 -

[*16] CMS’ Tool Program and CMS often reimbursed petitioner for such

expenses. When petitioner’s role at CMS changed from president to executive

vice president, CMS’ board of directors passed a resolution declaring that CMS

would grant petitioner additional CMS stock if Xell achieved certain sales

milestones, thereby tying his incentive compensation at CMS to his performance

with Xell.

Xell’s primary source of income was sales commissions paid by CMS. In

2009, 99% of Xell’s income came from CMS commissions and 97% of the

commissions paid by CMS during that year were paid to Xell. For 2010, 96% of

all commissions paid by CMS were paid to Xell, and 96% of Xell’s income was

from CMS commissions.

B. The Sales Pitch

Because the tool plans aimed to provide tax savings to employers and

employees, CMS needed both parties to enroll in the Tool Program. The first step

in the CMS strategy was to enroll employers whose employees were required to

furnish their own tools. In general this meant marketing to employers in the

heating, ventilation, and air conditioning industry, as well as the automotive and

trucking industries. Once CMS successfully enrolled an employer (client-
 - 17 -

[*17] employer), the next step was to enroll that employer’s employees (client-

employees).

1. Employers

The sales process would typically begin when sales agents, who were

trained and managed by petitioner, identified a potential client-employer. Once a

potential client-employer was identified, petitioner or a sales agent would meet

with the client-employer and deliver a presentation on the Tool Program. During

the presentation, petitioner and the sales agents relied on the marketing strategy

and materials that petitioner developed alongside Mr. Davison. CMS relied on the

legal positions Mr. Davison expressed in Grant Thornton’s justification paper to

develop its marketing materials.

CMS’ marketing materials included a slide show and informational flyers

that provided an overview of the purported tax savings of CMS’ three plans. As a

general matter, these materials emphasized the Tool Program’s compliance with

relevant laws.8 The materials specifically claimed that Grant Thornton’s support

of the program virtually eliminated any tax liability or risk of penalties, that CMS

8
At a presentation to a potential client in 2008, petitioner advertised that
CMS’ “unequaled experience has resulted in the successful examination of our
program.” At the time this statement was made, the IRS had not completed an
audit of any of CMS’ clients’ returns.
 - 18 -

[*18] maintained full compliance with IRS guidelines, and that CMS

reimbursement plans met the accountable plan requirements under section 62.

These materials broadly described the tool plans as a “no net cost” employee

benefit that funded an increase in employee take-home pay, while also boosting an

employer’s bottom line. The marketing materials failed to clarify to potential

clients how petitioner’s positions on the purported tax benefits available under the

Tool Program were supported by “substantial authority” and what exactly that

term meant.

Petitioner routinely provided potential clients with additional marketing

materials to assuage concerns regarding the legality of the purported tax benefits

available under the Tool Program. Such materials included Grant Thornton’s

justification paper. Other materials included, such as the executive summaries and

“comparisons” drafted by Mr. Davison, further represented that Grant Thornton

had determined that the new tool plan and the tool use plan complied with

applicable law, and that the tax benefits purported to flow therefrom were

supported by substantial authority.

The materials petitioner provided to potential clients represented that the

CMS tool plans and proprietary formulas had been “tested and accepted”,

undergone “successful examination”, and found to comply with all “tax
 - 19 -

[*19] requirements”. Further, these materials emphasized that Grant Thornton

would represent CMS’ clients during audit at no cost. If prospective or current

clients had questions, Mr. Davison was available to speak with them. Mr. Davison

did in fact speak with prospective clients on the tax aspects of the Tool Program,

and these conversations often resulted in client enrollment.

2. Employees

Although an employee’s participation in the tool plan was voluntary, the

employee’s attendance at a CMS or Xell sales presentation was mandatory.

Petitioner pressured client-employers to maximize employee participation in

enrollment on the grounds that it would foster a better employee and employer

relationship and promote greater savings for the employer. When the Tool

Program was met with concern or skepticism by employees, petitioner often

recommended a one-on-one meeting with them to explain “why their fear is not

accurate.” During such meetings, petitioner or a sales agent aimed to provide the

concerned employee with a “more accurate insight” into the program and its

benefits.

The marketing materials directed toward the prospective client-employees

also emphasized that the tool plans offered an increase in an employee’s take-

home pay. The decision to enroll in the full suite of tool plans was presented as
 - 20 -

[*20] simple as the decision to pick up a $20 bill on the ground. These marketing

materials, however, did not disclose the level of risk involved with participating in

a CMS plan. Petitioner instructed client-employees who received conflicting

advice from an independent tax adviser regarding the Tool Program’s legal

compliance to contact CMS in order to resolve any discrepancies.

C. Postenrollment Procedure

After enrolling, a client-employer executed an account agreement and

authorization to debit with CMS to pay CMS fees for its administration of the Tool

Program. CMS would then coordinate with the client-employer to establish a

timeline for enrolling employees and implementing the tool program thereafter.

Once a timeline was set, CMS would turn its attention to marketing the Tool

Program to the employees.

Although employees could enroll in one or more of the three tool plans,

approximately 90% of all client-employees enrolled in all three. If a client-

employee enrolled in all three tool plans, the first step was the completion of an

enrollment form for submission to CMS. The enrollment form included a chart

organized by different categories of tools with corresponding spaces for the client-

employee to fill in the acquisition costs of all the tools he or she owned at the time

of enrollment. Client-employees were encouraged to include as many tools as
 - 21 -

[*21] possible in determining the total acquisition costs of their tools, even if some

of those tools were not required for their employment with the client-employer.

CMS explicitly instructed client-employees not to state the replacement

costs or the fair market values of their tools on the enrollment form. If employees

did not have records of the acquisition costs of their tools, they were instructed to

estimate the original costs and write those amounts on the enrollment form. The

enrollment forms instructed client-employees to enter these estimated costs under

a space for “miscellaneous” tools, without listing each separate tool or its cost.

The enrollment forms also instructed client-employees to answer a yes or no

question as to whether they had depreciated or expensed any of their tools, and, if

so, how much in total. Until 2007 client-employees were not formally required to

provide receipts supporting the acquisition costs stated on the enrollment forms or

to list the dates they purchased their tools. In 2007 CMS asked prospective clients

and current clients to provide receipts along with their tool inventories; however,

CMS did not enforce this requirement. The marketing materials emphasized the

importance of accurate record substantiation in accordance with the accountable

plan rules. However, no one from CMS or Xell was responsible for verifying that

the stated acquisition costs for an employee’s tools were, in fact, accurate.
 - 22 -

[*22] The sum total of the client-employee’s acquisition costs for the tool

inventory was tracked as the employee’s base for reimbursement for the duration

of his or her enrollment in the existing tool plan. Under the existing tool plan

CMS characterized a fixed percentage of each client-employee’s gross wages in

each pay period as a partial reimbursement for the value of his or her tool

inventory and paid that amount each pay period until the client-employee was

fully reimbursed for the tool inventory. CMS’ practice of encouraging client-

employees to list as many tools as possible had the effect of greatly inflating the

employees’ bases for reimbursement and therefore increased both the purported

tax savings and the fees received by CMS.

CMS operated the new tool plan in a manner similar to the existing tool

plan. Under the new tool plan, when a client-employee purchased a new tool, he

or she would report the purchase and cost to CMS, and that tool and its value

would be added to the client-employee’s tool inventory and treated as reimbursed

in the same manner as the preexisting tool inventory.

Once a client-employee was reimbursed for the cost of his or her tool

inventory, CMS would transition the client-employee to the tool use plan. Under

that plan CMS categorized a portion of the client-employee’s base pay as tool
 - 23 -

[*23] rental fees, in a proportion determined by applying a CMS-developed

formula against the total value of the client-employee’s tool inventory.

VI. Professional Advice Regarding the Tool Program and Marketing Materials

A. Crowe Chizek

After Mr. Ochsenschlager of Grant Thornton’s national office concluded

that there was little to no chance of securing a favorable IRS private letter ruling

with respect to the Tool Program, petitioner and Mr. Davison actively sought a

second opinion. Petitioner contacted to the accounting firm Crowe Chizek

(Crowe) to inquire about CMS’ prospects of securing a favorable private letter

ruling. Petitioner provided Crowe with a copy of Grant Thornton’s justification

paper for Crowe’s evaluation.

On October 9, 2000, Robert Zwiers of Crowe wrote a letter (Crowe opinion)

to petitioner with Crowe’s analysis of Grant Thornton’s justification paper. Grant

Thornton’s justification paper did not include an analysis of the existing tool plan.

Accordingly, the Crowe opinion did not discuss the existing tool plan. The Crowe

opinion stated that Grant Thornton’s justification paper provided insufficient

information for Crowe to determine whether the new tool plan met the

requirements for an accountable plan. The Crowe opinion also stated that the IRS

had recently withdrawn a private letter ruling where it has concluded that
 - 24 -

[*24] payments made under an accountable plan were not subject to Federal

employment taxes. The Crowe opinion stated that it was possible that the

conclusion reached in that private letter ruling could apply to the new tool plan.

As to the tool use plan the Crowe opinion stated that “there does not appear to be

any authority for * * * [Mr. Davison and petitioner’s] conclusion” that payments

made thereunder were not subject to Federal employment taxes. Further, the

Crowe opinion stated that there was no support for treating payments to

employees, in their capacity as employees, as exempt from Federal employment

taxes unless made under an accountable plan. The Crowe opinion concluded there

appeared to be little support, if any, for the position that payments under the tool

use plan should be exempt from Federal employment taxes.

Petitioner did not accept the advice in the Crowe opinion. Rather, he asked

Mr. Davison to draft a response to the Crowe opinion on behalf of Grant Thornton

in which he disputed that advice. In a letter dated November 1, 2000, Mr. Davison

responded to the Crowe opinion and sent the response to petitioner. Mr.

Davison’s letter concluded that the Crowe opinion incorrectly stated that there was

insufficient information to determine whether the requirements of an accountable

plan were met in the New Tool Plan. Mr. Davison also concluded that, although

there was not any caselaw specifically addressing usage payments under a plan
 - 25 -

[*25] similar to the Tool Use Plan, the use plan was in compliance with all

relevant law. Petitioner and Mr. Davison’s support of the Tool Program was

unaffected by the Crowe opinion. CMS made no changes to the Tool Program

after receiving the Crowe opinion.

B. McDermott Will & Emery

Petitioner also contacted the law firm of McDermott, Will & Emery

(McDermott) regarding the Tool Program. In addition to the new tool plan and the

tool use plan, petitioner sought McDermott’s opinion on the existing tool plan,

which was not addressed in Grant Thornton’s justification paper. McDermott sent

petitioner a memorandum dated June 1, 2001, written by tax attorneys David

Fuller and Janine Cook.

In that memorandum, McDermott stated that tool reimbursement plans were

the subject of increased scrutiny because the IRS had placed employer

reimbursement programs on its Priority Guidance Plan. McDermott’s

memorandum warned that the existing tool plan would likely fail the accountable

plan requirements. McDermott explained that the IRS would not allow CMS to

reimburse client-employees for expenses incurred before the employees’ current

employment. McDermott advised that the new tool plan was “the strongest

component of the * * * [Tool Program] under the accountable plan rules,” but also
 - 26 -

[*26] noted that aspects of that plan needed to be modified in order to comply with

accountable plan rules. Specifically, the new tool plan would likely run afoul of

the business connection component of the accountable plan rules if CMS operated

a plan in which a client-employer paid the same weekly amount whether or not the

employee incurred business expenses.

McDermott confirmed Mr. Davison’s conclusion that the tool use plan

would probably fail the accountable plan requirements. McDermott concluded if

the tool use plan failed the accountable plan rules, there was no support for the

position that payments made under the tool use plan were exempt from Federal

employment taxes. McDermott also warned petitioner that operating the three tool

plans in tandem greatly increased the risk of losing in an IRS audit. This is

because “an independent party bargaining at arm’s length would not agree to both

pay for buying the * * * [employee’s tools and equipment] and then pay for using

the * * * [tools and equipment], unless the latter payment was only intended to

cover maintenance and related continuing costs.”

McDermott offered a number of recommendations for bringing the Tool

Program into legal compliance. McDermott recommendations included, but were

not limited to, the following: (1) that CMS offer only the combined Tool Plans

where expense reimbursements would be for the value of the use of tools and
 - 27 -

[*27] equipment attributable to ongoing maintenance, insurance and inventorying

costs; (2) that CMS enforce a salary reduction if the employee failed to incur or

substantiate tool expenses for any given payroll period; (3) that, for the existing

tool plan, CMS ensure all eligible expenses were incurred within a year; (4) that

expenses had not been incurred in the capacity of independent contractor and had

not been previously reimbursed, deducted, or depreciated; and (5) that expenses

have been incurred for tools that will be used to perform services for the employer.

After petitioner received McDermott’s memorandum, petitioner and Mr.

Davison scheduled a meeting with the McDermott attorneys who had drafted it.

Before that meeting petitioner sent Mr. Davison an email asking how CMS ought

to modify the existing tool plan in the light of the fact that McDermott’s

memorandum cited a private letter ruling in which the IRS had disallowed

reimbursement of the acquisition costs of tools purchased before an employee’s

tenure with his or her current employer. Despite petitioner’s knowledge that

McDermott recommended changes be made to the existing tool plan to bring it

into compliance, CMS made no changes to the Tool Program as a result of

McDermott’s memorandum.
 - 28 -

[*28] C. Grant Thornton’s Disavowal of CMS and the Tool Program

On April 15, 2001, Mr. Davison gave Grant Thornton his resignation letter,

effective October 15, 2001. Mr. Davison left Grant Thornton to pursue another

full-time job with the National Association of Independent Truckers, which

offered him a more flexible work schedule. Mr. Davison continued to work with

and on behalf of CMS after leaving Grant Thornton.

In a letter received by petitioner dated June 26, 2002, Grant Thornton

demanded that CMS stop using Grant Thornton’s name in marketing the Tool

Program. The letter was written by Robert P. Scales, associate general counsel for

Grant Thornton. In that letter Mr. Scales also advised that CMS did not have

permission to distribute copies of correspondence and memoranda from Grant

Thornton for purposes of marketing the Tool Program. Further, Mr. Scales

insisted that CMS clarify with its existing and potential clients that Grant

Thornton did not endorse the Tool Program.

Petitioner responded to Grant Thornton with a letter dated July 22, 2002.

Petitioner wrote the letter in order to salvage the relationship between Grant

Thornton and CMS. In petitioner’s letter he defended CMS’ use of Grant

Thornton’s name in its marketing materials on the ground that the positions CMS

had taken regarding the new tool plan and the tool use plan were made with the
 - 29 -

[*29] knowledge and agreement of Mr. Davison and Mr. Ochsenschlager.9

Petitioner requested that Grant Thornton provide updated feedback on the tool

plans, or alternatives to bring CMS’ positions current.

Grant Thornton responded to petitioner in a letter dated August 15, 2002,

reiterating that no position or alternative argument could be made to support the

tool use plan. Grant Thornton clarified that a reimbursement plan is either

accountable and thereby exempt from employment taxes or nonaccountable and

subject to both income and employment taxes. Grant Thornton again advised that

CMS stop marketing the tool use plan as a general matter and demanded that CMS

stop using marketing materials with Grant Thornton’s name on them. Further,

Grant Thornton advised that Rev. Rul. 2002-35, 2002-1 C.B. 1067, effectively

9
Mr. Ochsenschlager repudiated petitioner’s assertion that the positions
CMS had taken regarding the tool program were made with his knowledge and
agreement. Mr. Ochsenschlager recalled that his “conclusion was negative” with
respect to the new tool plan and the tool use plan. Mr. Ochsenschlager
commented that, on both occasions when he had met with Mr. Davison and
petitioner to discuss the Tool Program, he expressed no optimism that the tool use
plan would pass muster with the IRS. Mr. Ochsenschlager stated that the new tool
plan could probably be supported if it essentially expensed small tool purchases,
but he regarded the tool use plan as the “bread and butter of CMS.”
 - 30 -

[*30] rendered moot Mr. Davison’s argument that a tool reimbursement plan may

be nonaccountable and nonetheless avoid employment taxes.10

Following receipt of Grant Thornton’s letter dated August 15, 2002,

petitioner understood that CMS no longer had the support of Grant Thornton.

Despite petitioner’s knowledge that clients enrolled in the Tool Program under the

assumption that it was supported by Grant Thornton, CMS failed to notify any of

its client-employers or client-employees that Grant Thornton no longer supported

the Tool Program. Although CMS’ relationship with Grant Thornton terminated

in 2002, some clients that enrolled before that time continued to believe that Grant

Thornton was responsible for their audit defense until as late as 2011.

D. Mr. Davison’s Response to Grant Thornton’s Disavowal

In response to Grant Thornton’s disavowal of its relationship with CMS,

petitioner requested that Mr. Davison draft a series of memoranda in support of the

Tool Program. First, Mr. Davison drafted a memorandum dated July 24, 2002,

10
Rev. Rul. 2002-35, 2002-1 C.B. 1067, dealt with pipeline welders and
equipment mechanics. The mechanics were employees who also provided
equipment to the employer, and they received a separate payment for use of the
equipment. The ruling held that the payments were subject to both income and
employment taxes. The ruling also stated in pertinent part that “[i]f an
arrangement does not satisfy one or more of * * * [the accountable plan]
requirements,” all of the amounts paid under the arrangement would be paid under
a nonaccountable plan. Id., 2002-1 C.B. at 1068.
 - 31 -

[*31] concluding that a number of tax theories supported the conclusion that the

existing tool plan met the business connection requirement of the accountable plan

rules. Mr. Davison also stated that client-employees ought to be allowed

deductions for the costs of any existing tools used on the job and that such

expenses constituted ordinary and necessary business expenses. Mr. Davison

reasoned that employees entered into a new business with respect to their existing

tool inventory by enrolling in the CMS Tool Program and that this conversion

opened the doorway to ordinary and necessary business deductions with respect to

the costs of those tools. Mr. Davison understood that client-employees might have

purchased their tools several years before participating in the existing tool plan.

Further, Mr. Davison understood that client-employees did not hold themselves

out as being in a new or different trade or business by virtue of their enrollment in

the CMS Tool Program.

Mr. Davison’s memorandum dated July 24,2002, did not address whether

tools unnecessary for a job, or tools used outside of work, were eligible for

reimbursement under the accountable plan rules. Mr. Davison knew that an

employee’s expense incurred for an unnecessary tool “murkies the water” as to

whether it qualifies as an ordinary and necessary business expense. Petitioner
 - 32 -

[*32] promoted Mr. Davison’s memorandum dated July 24, 2002, in selling the

Tool Program.

Mr. Davison also drafted a memorandum dated October 10, 2002, which did

not discuss the existing tool plan. This memorandum concluded that “substantial

authority” supported the new tool plan’s qualification as an accountable plan. Mr.

Davison’s opinion defined “substantial authority” as a 33.5% chance of prevailing

if returns were examined by the IRS. This memorandum also concluded that

payments made under the tool use plan were not subject to self-employment or

payroll taxes, but it did not directly conclude that substantial authority existed for

this position. Mr. Davison reasoned that since the client-employee was not in the

trade or business of renting tools or equipment, rental payments made under the

use plan were not subject to self-employment tax.

Mr. Davison created an executive summary of his memorandum dated

October 10, 2002, on November 22, 2002. Mr. Davison was asked to draft this

executive summary for marketing purposes, and CMS did in fact use it for

marketing purposes.

In the executive summary dated November 22, 2002, the existing tool plan

is mentioned only once. Mr. Davison wrote: “[A] variation of * * * [the new tool]

plan may allow employees to substantiate the cost of their existing tools when they
 - 33 -

[*33] initially enroll in the plan to take advantage of tax benefits of reimbursement

for existing tools without income tax or employment taxes.” Further, Mr. Davison

asserted that both the new tool plan and the tool use plan were supported by

“substantial authority”, and that in the event of an audit, CMS would provide audit

support at no cost. In direct contrast with Grant Thornton’s reading of Rev. Rul.

2002-35, supra, Mr. Davison did not believe that the ruling dictated that

reimbursement plans must qualify as accountable plans in order for payments

made thereunder to avoid employment taxes.11 Petitioner used this executive

summary to help sell the tool plan and to train CMS and Xell sales agents in

marketing the Tool Program.

E. KPMG’s Opinion on the Tool Program

Following Grant Thornton’s disavowal of the Tool Program, petitioner

sought to bolster the reputation of CMS and the Tool Program by obtaining

support from another independent tax firm. Petitioner also wanted another

11
Mr. Davison concluded that the technical underpinnings of the CMS tool
usage program plan were not addressed by Rev. Rul. 2002-35, supra. He then
concluded that the IRS tacitly acknowledged that payments for use of property
might constitute rent. He grounded these conclusions on his reading of a 2001
field service advice, FSA 200127004, which he read to allow for usage payments
separate from the employment relationship that are not considered wages for
employment tax purposes, regardless of whether such payments were made under
an accountable plan.
 - 34 -

[*34] opinion on the likelihood of obtaining a favorable IRS private letter ruling.

To that end, petitioner contacted KPMG’s Wichita office (KPMG) and requested

its opinion of Mr. Davison’s memorandum dated October 10, 2002. On April 3,

2003, CMS received KPMG’s opinion on the Tool Program. There was no

discussion of the existing tool plan in KPMG’s opinion.

KPMG advised petitioner that the tool use plan failed the accountable plan

rules and advised that Rev. Rul. 2002-35, supra, did not permit alternate

characterizations of payments made to employees. Accordingly, KPMG advised

that payments made to employees be characterized as wages for services rendered,

accountable plan reimbursements, or nonaccountable plan reimbursements.

Further, KPMG stated that nonaccountable plan payments were treated as

additional wages, and employee payments not made under an accountable plan

were subject to income taxation and employment taxation. KPMG noted that there

was no direct or indirect support for bifurcating wages plan as contemplated under

the tool use plan.

KPMG concluded that the new tool plan appeared to meet the requirements

of an accountable plan but noted that each employer should be encouraged to

adopt formal, written personnel policies providing conditions for reimbursement

consistent with the accountable plan requirements. The record does not reflect
 - 35 -

[*35] CMS’ having encouraged its clients to do this. Further, no changes were

made to the Tool Program in the light of KPMG’s opinion and CMS did not

distribute it to clients.

F. Further Opinions by Mr. Davison and Second Try With McDermott

In 2005 petitioner requested that Mr. Davison write another opinion for

CMS, as well as an executive summary of that opinion, in the light of Rev. Rul.

2005-52, 2005-2 C.B. 423. That ruling concluded that tool allowances paid to

employees were not paid under an accountable plan because the substantiation and

return of excess requirements were not met. Further, the ruling concluded that all

tool allowance payments under the arrangement must be included in the

employees’ gross income and reported on the employees’ Forms W-2 and are

subject to withholding and payment of Federal employment taxes. Id., 2005-2,

C.B. at 425. Mr. Davison drafted the requested opinion dated September 14,

2005, and a related executive summary. This opinion, like earlier opinions written

by Mr. Davison, did not address the existing tool plan or the valuation formula

provided by CMS. Petitioner used this opinion to help sell the CMS tool plans.

The September 14, 2005, opinion and its executive summary stated that

there was “substantial authority” to conclude that reimbursement for tools

acquired after enrollment, i.e., the new tool plan, would be nontaxable. As with
 - 36 -

[*36] prior opinions written by Mr. Davison, “substantial authority” meant a

33.5% chance that the plan would survive IRS scrutiny. With respect to the tool

use plan, Mr. Davison again concluded that payments made to technicians for the

use of their tools were not subject to self-employment or payroll taxes. Mr.

Davison rejected KPMG’s position that Rev. Rul. 2002-35, supra, precluded

nontaxable status for usage payments made under a plan that failed to comply with

the accountable plan rules, and he instead asserted that Rev. Rul. 2002-35, supra,

opened alternative characterizations such as that promoted under CMS’ use plan.

Mr. Davison’s opinion and executive summary explained that, under Rev.

Rul. 2005-52, supra, “employers using accountable plans to reimburse employees

for the cost of providing tools must substantiate the expenses reimbursed and, to

the extent the plan provides payments before expenses are incurred, the plan must

require that the employee return amounts in excess of the substantiated expenses.”

Mr. Davison understood this to mean that “the ruling clarifies that an accountable

plan may not use estimates to substantiate the amount of the expenses.” This

negated the viability of CMS’ existing tool plan; however, Mr. Davison’s

memorandum and executive summary did not address this concern. Mr. Davison’s

executive summary did not address the risks of using the three tool plans in

conjunction. Further, in the executive summary Mr. Davison reiterated the
 - 37 -

[*37] conclusions and rationale used in prior opinions, despite new rulings and

legal advice that invalidated these positions.

Petitioner once again sought to obtain a favorable independent opinion

regarding the tool plans’ legal compliance law, and he contacted McDermott. On

December 16, 2005, CMS received another opinion from McDermott, which

warned CMS as follows:

We believe you should anticipate an audit of a client in which the IRS
will challenge the nontaxable “accountable plan” treatment of the
reimbursements for both current and new inventory, subjecting all
such payments to income and FICA taxes on the basis that the
reimbursements are amounts that would be paid anyway (i.e., as a
usage payment), thus violating the accountable plan regulations. The
IRS is unlikely to respect the reimbursement arrangement nor to
recognize the usage payment as separate from the compensation for
services, subjecting the usage payment to FICA taxes as well.

The McDermott opinion advised that Rev. Rul. 2005-52, supra, “makes it

even harder for prospective CMS clients to rely upon the positions being asserted

by CMS.” McDermott explained that the revenue ruling required tool allowance

payments to be included in gross income and reported as wages subject to

withholding and employment taxes if the arrangement did not require

substantiation and return of excess payments, as required under the accountable

plan rules. McDermott noted that CMS’ reimbursement program appeared

“almost indistinguishable” from the program discussed in the revenue ruling
 - 38 -

[*38] notwithstanding CMS’ proprietary calculations. Petitioner did not distribute

this opinion to clients or potential clients. Petitioner and CMS made no changes

to the tool program as a result of this opinion.

Mr. Davison wrote another opinion in support of the Tool Program dated

July 1, 2007. Petitioner did not use this opinion primarily for the purpose of

selling the Tool Program, because CMS and Xell were not selling the Tool

Program at that point. Nevertheless, the opinion was distributed to existing

clients, and Mr. Davison wrote it with the understanding that it would be used to

market the Tool Program. Mr. Davison addressed the existing tool plan in his

July 1, 2007, opinion. He concluded that “substantial authority” supported the

position that reimbursements for tools acquired before and after the initiation of

CMS’ tool reimbursement plan were nontaxable under the accountable plan rules.

Around October 2007 CMS made its first substantive change to the tool

program. At that time, CMS began to require receipts for purposes of

substantiating payments made under the reimbursement plans. Although this was

a change to the Tool Program that appeared to be required in the light of Rev. Rul.

2005-52, supra, and was advised by McDermott in its 2005 memorandum, CMS

waited over two years to make this change. CMS did not discontinue the existing

tool plan for those already enrolled and made no other substantive changes to the
 - 39 -

[*39] Tool Program. Therefore, those already enrolled in the existing tool plan

did not have to provide receipts.

Mr. Davison wrote one more memorandum to CMS dated November 28,

2007, in response to a Chief Counsel Advice (CCA) in which the IRS announced

increased audit attention would be paid to tool reimbursement plans, such as those

administered by CMS. Mr. Davison described the recent CCA as follows:

This CCA raises some serious concerns regarding the CMS existing
tool plan * * * I am concerned that CMS clients need to acknowledge
and understand a “substantial authority” conclusion only avoids tax
penalties; not actual tax and interest. At this point, I am not ready to
recommend a Draconian approach of suspending the existing tool
plan and seeking a legislative remedy, but it should be in the back of
our collective minds.

Mr. Davison knew that CMS did not attempt to verify client-employees’

statements regarding the costs, business use, depreciation, and prior

reimbursements for their tools. He recommended that CMS start requiring client-

employees to reimburse their employers for excess reimbursements. Mr. Davison

acknowledged that the existing tool plan was the “Achilles heel” of the Tool

Program and that no matter what CMS did to change the existing tool plan, it

might not be enough to bring it into compliance. Despite repeated advice to the

contrary, Mr. Davison stated his confidence that the tool use plan would pass IRS
 - 40 -

[*40] muster and complied with the relevant rules and regulations. As to the new

tool plan, Mr. Davison stated it should easily pass IRS muster.

On August 22, 2008, petitioner emailed Mr. Davison and the other CMS

board members indicating that a client of CMS had notified petitioner that the IRS

issued a coordinated paper dated July 2, 2008, in which it concluded that the tool

and equipment plans it had seen to date failed to meet the accountable plan

requirements. Petitioner subsequently forwarded to Mr. Davison and other CMS

board members an article published in the August 22, 2008, issue of Payroll

Currently entitled “Tool Plan Payments Must Be Included in Employees’ Gross

Income, IRS Says”, which discussed the IRS coordinated paper referenced in the

email dated August 22, 2008. That article ultimately concluded that “the routine

reimbursement of unsubstantiated expenses and the practice of recharacterizing

wages as reimbursements until the employee’s tool inventory value is zeroed out,

only to reinstate the original wage amount at that point, ‘evidence a pattern of

abuse of the accountable plan rules.’”

VII. Client Audits, Injunction, and Penalties

A. Client Audits and Injunctions Against CMS, Petitioner, and Davison

Several CMS clients’ returns were audited by the IRS in connection with

their participation in the CMS Tool Program beginning in 2008. In total 24 CMS
 - 41 -

[*41] client-employers had returns audited by the IRS. Petitioner received calls

from many of these clients regarding audit representation, and petitioner provided

these clients with a protest letter drafted by Mr. Davison defending the CMS tool

plans. Each of CMS’ clients whose returns were audited was required to remit

additional employment taxes. The total resulting tax due was $4,591,106.

In February 2008 the United States initiated an action against Mr. Davison

to enjoin him from promoting tax shelters. Petitioner was aware of the suit when

it was initiated. CMS took no action against Mr. Davison on the basis of the

injunction action. Petitioner continued to distribute protest letters prepared by Mr.

Davison to CMS clients with returns under audit. Petitioner failed to notify CMS

clients that Mr. Davison was being sued for the promotion of tax shelters.

On May 11, 2010, the U.S. District Court for the Western District of

Missouri found that Mr. Davison had “routinely falsely and fraudulently advised

clients that his tax arrangements were legal.” The District Court concluded that

Mr. Davison’s “record establishes that this cycle will continue unless he is barred

from providing tax advice without significant restraint.” Therefore, the District

Court enjoined Mr. Davison from organizing, establishing, promoting, selling, or

offering for sale or helping to organize, establish, promote, sell, or offer for sale
 - 42 -

[*42] any tax plan. As a result of the injunction, Mr. Davison’s C.P.A. licenses

were suspended in 2011.

The District Court required Mr. Davison to provide a copy of its order

within 60 days to each client for whom petitioner had provided any type of tax-

related advice within the last five years. Mr. Davison did not provide a copy of

the injunction to any of CMS’ client-employers or client-employees. Mr. Davison

did notify CMS and petitioner of the injunction. Nevertheless, CMS continued to

distribute protest letters prepared by Mr. Davison to CMS clients with return under

audit. Petitioner did not notify CMS clients that Mr. Davison was sued for the

promotion of tax shelters. On December 17, 2010, Mr. Davison was officially

suspended indefinitely from representing anyone in front of the IRS; however,

CMS continued to distribute an unsigned version of Mr. Davison’s protest letter to

its clients.

B. Section 6700 Penalty Examination

In 2008 the IRS opened a section 6700 penalty examination against CMS,

petitioner, and Mr. Davison regarding the Tool Program. The matter was assigned

to an IRS revenue agent (RA). The RA concluded that CMS and its principals,

including petitioner, made a number of false or fraudulent statements concerning

the Tool Program, that petitioner knew or had a reason to know these statements
 - 43 -

[*43] were false or fraudulent, and that these statements had a substantial impact

on the decision-making process of the clients and caused them to avoid the

payment of employment taxes. Therefore, in accordance with section 6700, the

RA determined that the IRS should assess penalties against CMS, petitioner, and

Mr. Davison.

To calculate the penalties against petitioner, the RA reviewed CMS’ client

list. CMS had 91 client-employers for whom it was administering a tool plan

during the period between January 1, 2006, and December 31, 2008. Of those 91

clients, only 63 were still participating as of the end of 2008. The RA identified

CMS’ gross receipts for each tax year at issue. For 2008 CMS earned gross

receipts of $587,298.12 For 2009 CMS earned gross receipts of $933,674. For

2010 CMS earned gross receipts of $742,473. The RA then multiplied these

amount by petitioner’s ownership of shares in CMS, 16%, for tax years 2008,

2009, and 2010. The RA then multiplied petitioner’s proportionate share of the

gross receipts by 50% as required by section 6700(a).

The RA prepared and submitted for supervisory approval Forms 8278,

Assessment and Abatement of Miscellaneous Civil Penalties, dated January 23,

12
For 2008 the RA included only half the gross receipts in the penalty base
to be conservative.
 - 44 -

[*44] 2014, for the years at issue. The RA’s immediate supervisor signed and

dated the Forms 8278 on March 26, 2014. On June 24, 2014, respondent assessed

penalties against petitioner pursuant to section 6700 for tax years ending

December 31, 2008, 2009, and 2010, of $46,984, $74,694, and $59,398,

respectively. On that same day, respondent issued petitioner Notice CP15, Notice

of Penalty Charge, for each of the tax years at issue formally communicating to

petitioner for the first time respondent’s determination of those penalties. On July

15, 2014, petitioner submitted Forms 6118, Claim for Refund of Tax Return

Preparer and Promoter Penalties, to respondent for the years at issue.

Petitioner paid $150 toward his penalty liability for each of the years at

issue in conjunction with his submission of the Forms 6118.13 Respondent had not

acted on petitioner’s Form 6118 by the time the notice of determination was issued

on July 2, 2015.

Before respondent concluded the section 6700 penalty examination,

petitioner and the U.S. Department of Justice agreed that petitioner would execute

a stipulated order for permanent injunction under sections 7402, 7407, and 7408.

This stipulated order was signed by petitioner on January 4, 2013, and was filed

13
The Notice CP15 stated consistently with sec. 6703(c)(1) that petitioner
could pay not less than 15% of the penalty and file a claim for refund on Form
6118 for the amount paid within 30 days after the date of the Notice CP15.
 - 45 -

[*45] on January 14, 2013, with the District Court in which the injunction action

was pending. This stipulated order enjoined petitioner from further promoting

unlawful tool reimbursement, tool rental, or tool use tax avoidance schemes that

could implicate sections 6700 and 6701. The stipulated order also enjoined

petitioner from advising customers that the tool reimbursement and tool

reimbursement plans, or any other similar plan, are consistent with the internal

revenue laws. Petitioner also executed the same stipulated order on behalf of Xell,

which was signed by petitioner on January 4, 2013, and filed on January 14, 2013.

Petitioner, along with Mr. Davison, executed the same stipulated order on behalf

of CMS, which was signed on January 4, 2013, and filed on January 15, 2013.

VIII. CDP Process

On October 27, 2014, respondent sent petitioner a Final Notice of Intent to

Levy and Notice of Your Right to a Hearing (levy notice) with respect to

petitioner’s unpaid section 6700 penalties for the tax years at issue. Petitioner

timely submitted a Form 12153, Request for a Collection Due Process or

Equivalent Hearing, dated November 20, 2014 (CDP request 1), in response to his

receipt of the levy notice. Petitioner submitted a document with his CDP

request 1, titled “Explanation of Taxpayer Position”, dated November 20, 2014.

In this document, petitioner explained that “he ha[d] paid tax and filed Forms 6118
 - 46 -

[*46] seeking refunds of the tax paid,” and that he “directs * * * [respondent] to

suspend all collection activities when * * * [his] claim for a refund in a section

6700 case is pending.”

While petitioner’s CDP levy hearing was pending, respondent issued a

Notice of Federal Tax Lien Filing and Your Right to a Hearing Under Section

6320 (lien notice) dated December 9, 2014, to petitioner for the tax years at issue.

Petitioner timely submitted a second Form 12153, dated January 9, 2015 (CDP

request 2), in response to the lien notice. Petitioner also submitted a document

with CDP request 2, titled “Explanation of Taxpayer Position”, dated January 9,

2015. In this document petitioner reiterated that “he ha[d] paid tax and filed

Forms 6118 seeking refunds of the tax paid” and that he “directs * * *

[respondent] to suspend all collection activities when * * * [his] claim for a refund

in a section 6700 case is pending.”

Petitioner’s CDP request 1 and CDP request 2 were assigned to a settlement

officer (SO) with no prior involvement with the liabilities at issue. On February 2,

2015, the SO sent petitioner an appointment letter scheduling a face-to-face CDP

hearing for February 19, 2015, requesting that petitioner provide the SO with a

completed Form 433-A, Collection Information Statement for Wage Earners and

Self-Employed Individuals. At petitioner’s request the CDP hearing was
 - 47 -

[*47] rescheduled to February 20, 2015. Petitioner and the SO held a face-to-face

CDP hearing on February 20, 2015, at the Kansas City Appeals Office.

The SO sent petitioner a letter dated March, 27, 2015, scheduling a second

face-to-face CDP conference for April 10, 2015, and requesting that petitioner

provide the SO with a completed Form 433-A. At petitioner’s request, the second

CDP hearing was rescheduled to April 13, 2015, and was held on that date at the

Kansas City Appeals Office.

During the February 20, 2015, CDP hearing, petitioner told the SO that he

“wanted his day in court” regarding the underlying liabilities for the promoter

penalties. The SO explained to petitioner that petitioner’s refund claim appeared

invalid because petitioner failed to pay 15% of the penalty, but he notified

petitioner that he would inquire into the status of the refund.14 Petitioner did not

raise any collection alternatives or submit any of the financial information

requested by the SO. Petitioner raised no other issues during the February 20,

2015, CDP hearing. During the April 13, 2015, CDP hearing, petitioner reiterated

that the underlying liability was flawed. Petitioner again stated his desire to

dispute the underlying liability for the promoter penalty in court, and that he was

14
The SO had no jurisdiction over the refund claim, but was making this
statement as an expression of his opinion on the matter.
 - 48 -

[*48] not interested in collection alternatives at that time. At the time of the CDP

hearings, respondent had not ruled on petitioner’s Form 6118 claim for refund.

Further, petitioner had not filed suit in District Court regarding his claims for

refund, despite the expiration of the six-month period without a decision on those

refund claims by respondent.

On July 2, 2015, the Appeals Office issued a notice of determination

sustaining the levy notice and the lien notice. The notice of determination

indicated that respondent could not move forward with the collection action while

petitioner’s claims were under consideration, or during any subsequent litigation

related to denial of those claims. The suspension of the levy action does not

invalidate the issuance of the levy notice. Further, the filing of the lien notice by

respondent is not similarly restricted under section 6703.

On July 30, 2015, petitioner timely filed a petition with this Court.

OPINION

I. Standard of Review

Sections 6320 and 6330 require the Commissioner to notify a taxpayer if he

has filed a lien or intends to levy on that taxpayer’s property. The notice must

inform the taxpayer of his or her right to a CDP hearing regarding the filing of a

lien or the proposed collection action. Secs. 6330(a), 6320(a). In a CDP hearing
 - 49 -

[*49] taxpayers may raise any relevant issue or request the consideration of a

collection alternative. Sec. 6330(c)(2)(A). Taxpayers may not challenge the

underlying tax liability unless they did not receive a statutory notice of deficiency

or otherwise have an opportunity to dispute the liability. Sec. 6330(c)(2)(B).

Once the Commissioner issues a notice of determination at the conclusion of the

CDP hearing, the taxpayer may seek judicial review by timely filing a petition

with this Court. Sec. 6330(d).

When the underlying tax liability is properly at issue, we review that

determination de novo. Sego v. Commissioner, 114 T.C. 604, 610 (2000). In the

instant case, the underlying liabilities are the section 6700 penalties imposed on

petitioner for promoting abusive tax shelters. This Court has jurisdiction to

review the Commissioner’s determination when the underlying tax liabilities stem

from section 6700 penalties. Gardner v. Commissioner, 145 T.C. 161, 174 (2015),

aff’d, 704 F. App’x 720 (9th Cir. 2017). Section 6700 penalties are not subject to

deficiency procedures. Sec. 6703(b). Respondent concedes that petitioner did not

have an opportunity to dispute his liabilities for the section 6700 penalties with the

Appeals Office before his administrative CDP hearing. Further, the parties

proceeded as if petitioner’s underlying liabilities were appropriately challenged
 - 50 -

[*50] and properly at issue in this case. We follow the lead of the parties and

review de novo the question of petitioner’s liabilities under section 6700.

II. Section 6700 Penalty

A. Burden of Proof

Section 6700 penalties are subject to the procedural rules of section 6703.

Section 6703(a) provides that the Secretary bears the burden of proving a

taxpayer’s liability with respect to penalties assessed under section 6700.

Although this Court has not decided the appropriate standard of proof in

determining liability for section 6700 penalties, this Court in Gardner v.

Commissioner, 145 T.C. at 175 n.10, cited a Court of Appeals for the Ninth

Circuit decision affirming a District Court’s application of the preponderance of

the evidence standard in a section 6700 case. Additionally, the Court of Appeals

for the Tenth Circuit applied the preponderance of the evidence standard in a case

for injunctive relief under section 7408 based on a violation of section 6700.

United States v. Hartshorn, 751 F.3d 1194, 1198 (10th Cir. 2014). We will follow

the Court of Appeals for the Tenth Circuit, the likely appellate venue, and apply a
 - 51 -

[*51] preponderance of the evidence standard. See Golsen v. Commissioner, 54

T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971).15

B. Elements and Application

To satisfy the burden of proof with respect to section 6700, respondent must

prove by a preponderance of the evidence that petitioner: (1) organized (or

assisted in the organization of) or participated (directly or indirectly) in the sale of

an interest in an investment plan or arrangement, or any other plan or arrangement;

and (2) made material statements concerning the “tax benefits”16 to be derived

from that plan or arrangement that petitioner knew or had reason to know were

false. See sec. 6700(a). We address these requirements in turn.

15
This Court has applied a preponderance of the evidence standard with
respect to analogous penalty contexts, such as penalties assessed under sec.
6702(a) when taxpayers file frivolous returns. See O’Brien v. Commissioner, T.C.
Memo. 2012-326. Additionally, a number of Federal courts have specifically held
that preponderance of the evidence is the appropriate standard of proof under secs.
6700 and 6701. See United States v. Estate Pres. Servs., 202 F.3d 1093, 1098 (9th
Cir. 2000); Barr v. United States, 67 F.3d 469, 469 (11th Cir. 1995).
16
For purposes of sec. 6700, “statements concerning the tax benefits” means:
“a statement with respect to the allowability of any deduction or credit, the
excludability of any income, or the securing of any other tax benefit by reason of
holding an interest in the entity or participating in the plan or arrangement”. Sec.
6700(a)(2)(A).
 - 52 -

[*52] 1. Organization and Sale of a Plan or Arrangement

Petitioner contends that he did not sell a plan or arrangement to avoid taxes.

Petitioner does not refer to specific evidence in support of this contention but

asserts that the record on the whole supports this position.

Section 6700 does not define the terms “investment plan or arrangement” or

“any other plan or arrangement.” Further, there are no regulations defining what

conduct constitutes the organization of an entity, plan, or arrangement described in

section 6700(a)(1)(A). Nevertheless, Federal caselaw on this issue instructs that a

“plan or arrangement” under section 6700 should be defined broadly and that the

“sale of a plan or arrangement” component of section 6700 “is satisfied simply by

‘selling an illegal method by which to avoid paying taxes.’” See United States v.

Stover, 650 F.3d 1099, 1107 (8th Cir. 2011) (quoting United States v. Benson, 561

F.3d 718, 722 (7th Cir. 2009)). For purposes of section 6700, “any ‘plan or

arrangement’ having some connection to taxes can serve as a ‘tax shelter’ and will

be an ‘abusive’ tax shelter if the * * * [promoter] makes the requisite false or

fraudulent statements concerning the tax benefits of participation.” United States

v. Raymond, 228 F.3d 804, 811 (7th Cir. 2000). Federal courts have found that

engaging in a broad range of marketing activities constitutes participation in the

sale of any interest in an entity, plan, or arrangement, for purposes of section 6700.
 - 53 -

[*53] See id.; see also United States v. Kaun, 827 F.2d 1144, 1149-1150 (7th Cir.

1987).

We conclude that respondent has demonstrated that the CMS Tool Program

is a plan or other arrangement under section 6700 and that petitioner organized

and assisted in the sale of that plan or arrangement. To those ends, evidence

shows, and we find, that CMS marketed and sold the Tool Program as a multistep

benefit plan through which employers and employees could avoid paying taxes

and that petitioner was a primary and indispensable figure in the plan’s

organization and sale. The Tool Program consisted of three different tool plans:

(1) the existing tool plan, (2) the new tool plan, and (3) the tool use plan. CMS

operated the tool plans in sequence, thereby attempting to maximize the purported

lifetime tax savings for enrolled employees and employers. In addition to the tool

plans and payroll administration, CMS promised to offer legal research and free

audit representation as part of an overall employee benefits package. CMS

charged fees for administering the tool plans. All CMS’ claims that the Tool

Program offered a legal avenue to achieve tax savings were unsupported by law.

Further, all of the independent tax professionals with whom petitioner and Mr.

Davison consulted rejected the position that the Tool Program provided its

enrollees a means to achieve legal tax savings. We find that CMS administered a
 - 54 -

[*54] benefits program, the Tool Program, that had as its primary purpose the

reduction in Federal income and employment taxes. Therefore, the Tool Program

constituted a plan or arrangement under section 6700. See Kaun, 827 F.2d at

1149-1150; see also United States v. Zanfei, No. 04 C 2703, 2006 WL 2861051,

at *8 (N.D. Ill. Sept. 29, 2006).

We also find that respondent has shown that petitioner was an organizer and

seller of a plan or arrangement under section 6700. CMS existed solely to market

and operate the Tool Program. Petitioner was a founding member of CMS and at

all relevant times sat on its board of directors. Petitioner served as president of

CMS from 1999 to 2002, and as executive vice president of CMS thereafter.

Further, at all relevant times, petitioner, in his capacity as sole shareholder and

president of Xell, oversaw the marketing and sales of the CMS tool plans. Xell

was responsible for securing the majority of CMS’ clients and revenues.

Petitioner’s duties with Xell consisted of managing and training sales agents,

coordinating and participating in sales pitches, and closing deals with prospective

clients. Petitioner’s core duties with CMS and Xell were indistinguishable, and in

both capacities he directly participated in the marketing and sales of the CMS Tool

Program. Ultimately, petitioner was instrumental in organizing and facilitating the

sales of the CMS Tool Program.
 - 55 -

[*55] 2. Petitioner’s Material Statements He Knew or Had Reason To
Know Were False

As relevant here, the section 6700 penalty applies when the organizer (or

assistant thereto), or seller of a subject plan (or assistant thereto), makes or causes

to be made any statement with respect to tax benefits arising from participation in

such a plan that (a) is material and (b) he or she “knows or has reason to know is

false”. See sec. 6700(a). Statements covered by section 6700 include factual

matters that are relevant to the availability of tax benefits and those directly

addressing the availability of tax benefits. See Stover, 650 F.3d at 1108.

Unqualified statements concerning the tax benefits of a subject plan have been

found to be false or fraudulent statements under section 6700. See United States

v. Gleason, 432 F.3d 678, 683-684 (6th Cir. 2005). The question of materiality

does not require proof that anyone actually relied on the misrepresentations or lies

of the promoter. Gardner v. Commissioner, 145 T.C. at 176. Rather, a statement

is material if it would have a substantial impact on the decision-making process of

a reasonably prudent investor or concerns matters relevant to the availability of a

tax benefit. See United States v. Campbell, 897 F.2d 1317, 1320 (5th Cir. 1990).

The question of whether an alleged promoter’s statements were knowingly

false, or whether he or she had reason to know the same, requires an evaluation of
 - 56 -

[*56] what a reasonable person in his or her position would have discovered. See

id. at 1321-1322. To determine whether an alleged promoter knew or had reason

to know the statements he or she made were false, Federal courts have considered:

(1) the extent to which he or she relied on knowledgeable professionals, (2) his or

her sophistication and education, and (3) his or her familiarity with tax matters.

United States v. Estate Pres. Servs., 202 F.3d 1093, 1103 (9th Cir. 2000); see

Kaun, 827 F.2d at 1149. Further, if an alleged promoter knew his or her

statements contradicted settled law or were contrary to express IRS guidance, he

or she would be is treated as if he or she had a reason to know that such statements

might be and probably were false. See Stover, 650 F.3d at 1110. Additionally,

omission of material facts weighs as heavily making false material statements. See

id. at 1109-1111; see also Hartshorn, 751 F.3d at 1202 (Court of Appeals for the

Tenth Circuit applying section 6700 in the context of an injunction under section

7408 used the reasonable person test).

Petitioner does not specifically dispute that he made material statements

regarding the tax benefits of the Tool Program. However, he contends that he did

not make any material statements that he knew or had a reason to know were false

regarding the tax benefits of the Tool Program. Petitioner argues that he relied on

the advice of highly respected tax professionals in organizing and marketing the
 - 57 -

[*57] Tool Program. For support, petitioner points out that he relied on Mr.

Davison’s tax advice in creating and marketing the Tool Program, particularly

Grant Thornton’s justification paper. Petitioner asserts that the record shows he

was transparent with prospective clients regarding the risks incident to the Tool

Program, specifically that the tool plans would likely be unsuccessful on an IRS

audit.

a. Material False Statements About the Existing Tool
Plan’s Compliance With the Accountable Plan Rules

Respondent argues that petitioner made material false statements concerning

the tax benefits of the Tool Program. Specifically, respondent contends that

petitioner stated falsely that reimbursement payments made under the existing tool

plan were nontaxable under the accountable plan rules. Further, respondent

contends that such statements would have a substantial impact on a reasonably

prudent investor’s decision-making process because such statements include

matters relevant to the availability of a tax benefit. See Campbell, 897 F.2d at

1320; see also Stover, 650 F.3d at 1111 (“[Stover] promised to reduce his client’s

taxable income by hundreds of thousands of dollars. Any such promise would

have had a substantial impact on the decision making process of a reasonably

prudent investor.”). We agree with respondent and find that the CMS Tool
 - 58 -

[*58] Program’s existing tool plan did not qualify as an accountable plan and that

statements made by petitioner to the contrary while marketing the tool program

were material and false.

Under section 62(a)(2)(A), an employee can deduct certain business

expenses incurred in connection with the performance of services for an employer

under a reimbursement or other expense allowance arrangement. If these expenses

are reimbursed by the employer pursuant to an “accountable plan”, then the

reimbursed amount is excluded from gross income and is not considered wages or

other compensation. Sec. 1.62-2(c)(4), Income Tax Regs. Thus, expenses

reimbursed pursuant to an accountable plan would be exempt from withholding

and payment of employment taxes. See id. However, if the reimbursement is not

made under an accountable plan, then the amount of the reimbursement is treated

as wages and is included in the employee’s taxable income. Id. subpara. (5)

To qualify as an accountable plan, the plan must: (1) have a business

connection, (2) require substantiation of expenses, and (3) require the return to the

employer of amounts exceeding the employee’s actual expenses. Id. paras. (c),

(d), (e), and (f). A reimbursed employee expense can be “in connection with” the

performance of services as an employee, and excludable from gross income under

the accountable plan rules, only if it is incurred by an employee on behalf of the
 - 59 -

[*59] employer that provides the reimbursement. Id. para. (d)(1).

Reimbursements for expenses incurred before an employee’s employment with his

or her current employer are not incurred by an employee in the course of his or her

current employment, and would thus fail the business connection requirement.

See Biehl v. Commissioner, 118 T.C. 467, 478 (2002), aff’d, 351 F.3d 982 (9th

Cir. 2003).

At all relevant times, the existing tool plan was marketed as an accountable

plan. Promotional materials created by petitioner emphasized the existing tool

plan’s compliance with the laws and regulations on accountable plans. Although

an employer’s employees had the option of enrolling in one or more of the three

Tool Plans, approximately 90% of all client-employees enrolled in the existing

tool plan. A client-employee was required to fill out an enrollment form as the

first step toward full participation in the existing tool plan. On the enrollment

form, the client-employee listed the acquisition cost of all his or her tools,

including tools acquired before employment and tools unnecessary for the job.

Employees were instructed to, and did in fact, include on their enrollment forms

the acquisition costs of tools unrelated to their work or purchased in years before

their current employment. This practice is directly inconsistent with the business

connection requirement of the accountable plan rules. See sec. 1.62-2(d)(1),
 - 60 -

[*60] Income Tax Regs.; see also Biehl v. Commissioner, 351 F.3d at 986-987

(stating that in order to meet the business connection requirement, reimbursed

expenses must be incurred during the course of employment). Therefore, the

existing tool plan did not meet the business connection requirement of the

accountable plan rules.

Further, to properly substantiate expenses, employees must submit

information to the employer sufficient to identify the specific nature of each

expense and to conclude that the expense is attributable to the employer’s business

activities. Sec. 1.62-2(e)(3), Income Tax Regs. Each of the elements of an

expenditure or use must be substantiated to the payor. Namyst v. Commissioner,

T.C. Memo. 2004-263, slip op. at 4, aff’d, 435 F.3d 910 (8th Cir. 2006); sec. 1.62-

2(e)(3), Income Tax Regs. In accordance with section 1.62-2(e)(3), Income Tax

Regs., if an employee is not required to substantiate an expense to the payor for

reimbursement, then the reimbursement arrangement is not an accountable plan.

Further, if an employee merely aggregates expenses into broad categories, or

reports individual expenses through the use of vague nondescriptive terms (such

as “miscellaneous business expenses”), the substantiation requirement is not

satisfied. Id.
 - 61 -

[*61] In determining the total acquisition cost of a client-employee’s tools, CMS

instructed client-employees to list as many tools as possible, even unnecessary or

previously acquired tools. If the employee did not have records of the acquisition

costs of their tools, the employee was instructed to estimate the original costs and

write that amount on the enrollment form. Client-employees were not required to

provide either receipts supporting the acquisition costs stated on their enrollment

forms or to list the dates they purchased their tools. Although petitioner claimed

CMS formally changed this rule in 2007 to require receipts, CMS did not demand

receipts from its current or future clients.

Although CMS and Xell’s marketing materials emphasized the importance

of accurate record substantiation in accordance with the accountable plan rules, no

one from CMS or Xell verified that the stated acquisition costs for the tools were

accurate or that a given tool was needed for the job. Further, the enrollment form

did not require the client-employee to list the cost of each separate tool but instead

directed the client-employee to categorize the tool costs into broad categories,

such as a “miscellaneous” category. These behaviors are directly inconsistent with

the substantiation requirement of the accountable plan rules. See sec. 1.62-2(e)(3),

Income Tax Regs.
 - 62 -

[*62] Because the existing tool plan did not meet the business connection

requirement or the substantiation requirement, it is not an accountable plan. False

statements under section 6700 include representations that a plan qualifies for

special tax treatment when the plan does not comply with the law. See Koresko v.

United States, 123 F. Supp. 3d 654, 682-689 (E.D. Pa. 2015). The marketing

materials created and used by petitioner and sales agents included statements that

the existing tool plan was in compliance with the law on accountable plans.

Therefore, petitioner made and caused sales agents of CMS and Xell to make false

statements concerning the availability of tax benefits under the Tool Program.

Further, because statements concerning whether the existing tool plan qualified as

an accountable plan are statements directly relevant to the availability of a tax

benefit, such statements are material. See Campbell, 897 F.2d at 1320.17

Therefore, petitioner made material false statements concerning the availability of

tax benefits under the Tool Program with respect to the existing tool plan’s

qualification as an accountable plan.

17
Respondent has shownThe record establishes that petitioner failed the
business connection and substantiation requirements of the accountable plan rules.
Consequently, we need not address whether he failed the excess receipts
requirement.
 - 63 -

[*63] b. False Statements About the Tax Benefits of the
Tool Use Plan

Promotional materials created and used by petitioner and CMS’ sales agents

marketed the tool use plan as a method to allow a client-employee to charge his or

her employer a nontaxable fee for the rental of the employee’s tools during the

daily course of the employee’s labor. Petitioner and Mr. Davison knew that the

tool use plan failed the accountable plan requirements and did not attempt to

market the tool use plan as an accountable plan. Instead, CMS claimed that the

rental fees paid under the tool use plan fell outside the employment tax definition

of wages, and payments made thereunder, from the employer’s point of view, were

not subject to the employment tax. Marketing materials erroneously claimed that

relevant law supported the tool use plan.

Despite claims in CMS’ promotional materials that payments made under

the tool use plan were nontaxable, petitioner was repeatedly instructed by

independent tax professionals that there was no authority for the conclusion that

such payments were not subject to Federal employment taxes. Further, petitioner

was aware that the IRS in Rev. Rul. 2002-35, supra, instructed that if a plan or

arrangement does not satisfy one or more of the accountable plan requirements, all

amounts paid under that arrangement are paid under a nonaccountable plan and
 - 64 -

[*64] taxed as wages. Petitioner and Mr. Davison were repeatedly made aware of

this guidance but persisted in marketing the tool use plan as resulting in

nontaxable payments. Petitioner used Mr. Davison’s legal opinions in promoting

the tool use plan despite the fact that all of the other tax practitioners with whom

he consulted completely disagreed with Mr. Davison and advised petitioner to stop

marketing the tool use plan as resulting in nontaxable payments.

Ultimately, petitioner’s marketing materials claimed the tool use plan was

supported by law, but the evidence in the record does not support that claim.

Petitioner failed to instruct client-employers and client-employees as to the risks

that the tool use plan would fail in an audit by the IRS. Statements are false when

assertions are not qualified and customers are not notified that following the

advice could subject them to IRS scrutiny. Stover, 650 F.3d at 1109-1110.

Petitioner was repeatedly instructed as to the risks associated with enrollment in

the tool use plan but failed to inform prospective and current clients of that risk.

Therefore, petitioner made false statements as to the tax benefits incident to

participation in the tool use plan, and by extension, the Tool Program. See id.

Such claims were material because they concerned the availability of tax benefits

under the Tool Program. See Campbell, 897 F.2d at 1320.
 - 65 -

[*65] c. Petitioner’s False Statements Concerning the Risks of
Enrolling in the Tool Program

Statements are false when promoters fail to qualify assertions about the

availability of tax benefits and notify clients that following the statements could

subject them to IRS scrutiny. See Stover, 650 F.3d at 1109-1110. Courts have

repeatedly held that a tax promoter’s failure to advise his clients of the

requirements to qualify for a tax benefit qualify as a false statement. See Gleason,

432 F.3d at 682-683; Estate Pres. Servs., 202 F.3d at 1101.

Although petitioner and Mr. Davison believed there was a mere 33.5%

chance that the new tool plan and tool use plan would succeed in an audit by the

IRS, they marketed the Tool Program as if there were minimal risks in enrollment.

For example, petitioner did not mention that tool reimbursement plans were being

closely scrutinized by the IRS when he discussed the Tool Program with current

and prospective clients. Instead, the marketing materials emphasized that the tool

plans offered an increase in an employee’s take-home pay. Further, the decision to

enroll in the full suite of tool plans was presented as simple as the decision to pick

up a $20 bill on the ground. Executive summaries drafted by Mr. Davison

represented that Grant Thornton had determined that the new tool plan and the tool

use plan complied with applicable law and that the tax benefits purported to flow
 - 66 -

[*66] therefrom were supported by “substantial authority”. The summaries did not

disclose that Grant Thornton, KPMG, McDermott, and Crowe rejected the position

that there was legal authority supporting the tool use plan and the new tool plan as

administered by CMS. These executive summaries also failed to address the

lawfulness of the existing tool plan, despite the fact that CMS marketed all three

plans simultaneously. Petitioner and Mr. Davison aggressively marketed the

existing tool plan despite their common understanding that this plan carried a risk

of penalties and was an aggressive tax planning tactic.

Petitioner’s failure to emphasize the IRS’ heightened scrutiny toward tool

reimbursement plans was a failure to inform the clients that following his advice

could subject them to IRS scrutiny. See Stover, 650 F.3d at 1109-1110. Further,

petitioner did not truthfully disclose the availability of tax benefits under the Tool

Program generally, particularly benefits available under the existing tool plan. See

id. Together, these omissions constitute the promulgation of additional false

statements concerning the tax benefits available under the Tool Program. See id.;

Gleason, 432 F.3d at 682-683; see also Estate Pres. Servs., 202 F.3d at 1101. Such

statements are material precisely because they concern the availability of tax

benefits under the Tool Program. See Campbell, 897 F.2d at 1320.
 - 67 -

[*67] d. Petitioner’s Knowledge That His Material Statements
About the Tax Benefits of the Tool Program Were False

Petitioner argues that he did not violate section 6700 because he did not

know or have reason to know that he made material false statements concerning

the tax benefits of the Tool Program. Petitioner contends that he lacks tax and

legal expertise. Petitioner argues that he relied on the tax guidance of Mr.

Davison.

Respondent contends that petitioner is not entitled to rely on Mr. Davison’s

advice because Mr. Davison was not an independent tax adviser and was a

copromoter and a necessary element of the Tool Program’s commercial success.

In support of this position, respondent directs our attention to Estate Pres. Servs.,

where the Court of Appeals for the Ninth Circuit held that a promoter had not

relied on professional advice when he chose to ignore those who were skeptical as

to the legality of his statements and to take the advice of only those who

unquestioningly agreed to further the scheme. Estate Pres. Servs., 202 F.3d at

1103. The record indicates that Mr. Davison was not an independent tax adviser,

but instead was intimately involved in the development of the CMS Tool Program.

Mr. Davison sat on the CMS board of directors and was held out as the tax expert

behind the Tool Program. Mr. Davison was specifically assigned the task of
 - 68 -

[*68] mollifying skeptical client-employees’ concerns about the legality of the

Tool Program. Petitioner understood that Mr. Davison’s “substantial authority”

opinions meant the new tool plan and the tool use plan stood only a 33.5% chance

of success on audit. Petitioner failed to adequately communicate this to potential

client-employers and client-employees. During the IRS audits of CMS’ clients’

returns, petitioner provided copies of Mr. Davison’s protest letter, despite

petitioner’s knowledge that Mr. Davison was enjoined from promoting tax

shelters.

Additionally, petitioner was aware of guidance issued by the IRS indicating

increased audit attention to tool reimbursement plans such as those marketed and

administered by CMS. Petitioner was repeatedly advised by independent tax

practitioners, including Crowe, Grant Thornton, KPMG, and McDermott of the

risks that the tool plans would fail to pass muster if returns were examined by the

IRS. Crowe, Grant Thornton, KPMG, and McDermott informed petitioner that

there was no legal authority for the tool use plan. Instead of relying on the advice

of impartial tax professionals, petitioner chose to follow Mr. Davison’s advice.

Courts have found that the “know or reason to know standard” means what

a reasonable person in the taxpayer’s subjective position would have discovered.

See Campbell, 897 F.2d at 1321-1322. We look at (1) the extent to which the
 - 69 -

[*69] taxpayer relied on knowledgeable professionals, (2) the taxpayer’s

sophistication and education, and (3) the taxpayer’s familiarity with tax matters.

Estate Pres. Servs., 202 F.3d at 1103. A taxpayer has reason to know that

statements may be and probably are false when those statements contradict settled

law or are contrary to express IRS guidance. Stover, 650 F.3d at 1110.

It is clear that petitioner was aware of IRS guidance relevant to the legality

of the Tool Program. Further, petitioner was aware that no knowledgeable

professional with whom he consulted agreed with Mr. Davison’s position

regarding the tool program. Instead of relying on these knowledgeable

professionals, petitioner completely ignored their advice and made no changes to

the tool program as a result of their recommendations. Further, petitioner knew

that Mr. Davison believed each of the tool plans would probably fail IRS

examination, which results in the denial of the tax benefits under the Tool

Program. Thus, petitioner was aware that these programs were not devoid of risk,

which was how he presented the plans to potential clients. Petitioner helped

design the Tool Program along with Mr. Davison, and regularly discussed the tax

advice he received with the firms that issued it, as well as with Mr. Davison. To

claim petitioner had no tax knowledge would mean he ingested no tax information

during the years spent designing, marketing, discussing the Tool Program--a
 - 70 -

[*70] program whose value depends entirely on the purported tax benefit it

delivered to the customer. Ultimately, we agree with respondent that petitioner

knew or should have known that his material statements regarding the tax benefits

available under the tool program were false.

III. Supervisory Approval and Amount of Penalties

Respondent bears the burden of production with respect to petitioner’s

liability for section 6700 penalties. See sec. 7491(c). As part of that burden,

respondent must show that the written supervisory approval requirement of section

6751(b)(1) was timely complied with. See Graev v. Commissioner, 149 T.C. 485,

493 (2017), supplementing and overruling in part 147 T.C. 460 (2016); see also

Clay v. Commissioner, 152 T.C. 223, 249 (2019). On the record before us we find

that respondent has met his burden of production. The RA’s immediate supervisor

personally approved the initial determination of the section 6700 penalties

assessed against petitioner on March 26, 2014, by signing the Forms 8278 for each

of the years at issue. The penalties assessed were first communicated to petitioner

by way of a Notice CP15, dated June 23, 2014, for each of the years at issue.

Thus, written supervisory approval for the penalties was given before the first

formal communication of the penalties to petitioner. Belair Woods, LLC v.
 - 71 -

[*71] Commissioner, 154 T.C. __, __ (slip op. at 23) (Jan. 6, 2020); see also Clay

v. Commissioner, 152 T.C. at 246-250.

Section 6700(a) provides that for any promoter who makes or causes to be

made any material false statements relating to tax benefits, the amount of the

penalty shall be equal to 50% of the gross income the promoter derived therefrom.

Thus, the penalty is appropriately calculated as 50% of the gross income petitioner

derived from selling, or participating in selling, the Tool Program.18 Respondent

assessed section 6700 penalties against petitioner in the total amount of $181,076.

In determining the section 6700 penalty for each of the tax years at issue, the RA

identified CMS’ gross receipts and then multiplied that amount by 16%,

petitioner’s proportionate share of the gross receipts. The RA then multiplied

petitioner’s proportionate share of CMS’ gross receipts by 50% for each of the tax

years at issue.

18
Penalties under sec. 6700 are not assessed for discrete taxable years, but
for conduct and transactions that occur over one or more taxable years, not on an
annual basis. Planned Invs., Inc. v. United States, 881 F.2d 340, 344 (6th Cir.
1989). In Gardner v. Commissioner, 145 T.C. 161, 182 (2015), aff’d, 704 F.
App’x 720 (9th Cir. 2017), this Court expressly agreed with the reasoning in
Planned Investments, concluding that the sec. 6700 penalty is not necessarily tied
to activities or amounts earned in a particular tax year and can be based on
activities and amounts earned in other years.
 - 72 -

[*72] For 2008 CMS earned gross receipts of $587,298.19 For 2009 the RA

identified CMS’ gross receipts as $933,674. For 2010 the RA identified CMS’

gross receipts as $742,473. The RA then multiplied these amount by petitioner’s

ownership of shares in CMS, 16%, for tax years 2008, 2009, and 2010. The RA

then multiplied petitioner’s proportionate share of the gross receipts by 50% as

required by section 6700(a). Respondent determined penalties against petitioner

pursuant to section 6700 for tax years ending December 31, 2008, 2009, and 2010,

of $46,984, $74,694, and $59,398, respectively.20 The penalties were

appropriately assessed, accurately calculated, and respondent followed all

administrative procedures.

IV. Remaining CDP Issues

When the Court conducts a de novo review of an underlying liability, we

review all determinations not involving the underlying liability for abuse of

19
For 2008 the RA included only half the gross receipts in the penalty base
for purposes of being conservative.
20
Ultimately, respondent used a rather conservative formula for calculating
the base amount for petitioner’s penalties. Petitioner was the sole shareholder of
Xell at all times, and nearly all of Xell’s income was derived from selling the Tool
Program. There is no clear reason why the gross income derived from
participating in the sale of the CMS Tool Program should not include income
petitioner derived from Xell. See In re Tax Refund Litig., 766 F. Supp. 1248,
1258 (E.D.N.Y. 1991).
 - 73 -

[*73] discretion. Craig v. Commissioner, 119 T.C. 252, 260 (2002). An action

constitutes an abuse of discretion if it is arbitrary, capricious, or without sound

basis in fact or law. Giamelli v. Commissioner, 129 T.C. 107, 111 (2007). This

review is to ensure that the Appeals Office verified that the Commissioner

complied with the requirements of all applicable law and administrative

procedure, considered all relevant issues raised by the taxpayer, and considered

whether the proposed collection action balances the need for the efficient

collection of tax with the taxpayer’s legitimate concern that the collection action

be no more intrusive than necessary.21 See sec. 6330(c)(3).

The notice of determination sustained the collection action, with the caveat

that collection may not proceed until petitioner’s refund claim was closed. The

only issue that petitioner raised during his CDP hearing was his underlying

liability. The SO addressed this issue. Further, the SO verified that the

assessment of the section 6700 penalty was timely and that petitioner received all

appropriate notices in this respect. Accordingly, petitioner does not allege, and we

21
Petitioner did not request a collection alternative and failed to present
necessary financial information for the SO to consider. See sec.
6330(c)(2)(A)(iii). The record shows the SO verified that the requirements of
applicable law and administrative procedure were followed.
 - 74 -

[*74] do not hold, that the SO abused his discretion in arriving at any of these

determinations.

V. Conclusion

We have considered all the other arguments of the parties, and to the extent

not discussed above, find those arguments to be irrelevant, moot, or without merit.

To reflect the foregoing,

Decision will be entered

for respondent.