Corporations couldn't rely on employee-tax professional to avoid the accuracy-related penalty

Seven W. Enterprises, Inc. & Subsidiaries and Highland Supply Corporation & Subsidiaries, (2011) 136 TC No. 26

The Tax Court has concluded that corporations that engaged an independent consultant to prepare their returns could rely on his

advice as a tax professional to avoid the accuracy-related penalty under Code Sec. 6662(a) and Code Sec. 6662(b)(2) . However,

when those corporations employed that individual as their vice president to prepare their returns, they no longer had reasonable

cause to avoid the penalty.

Background. Under Code Sec. 6662(a) and Code Sec. 6662(b)(2) , a 20% penalty applies for any substantial underpayment of income

tax. The accuracy-related penalty under Code Sec. 6662(a) doesn't apply, however, to any portion of an underpayment if a taxpayer

shows that there was reasonable cause for it, and that the taxpayer acted in good faith with respect to that portion. ( Code Sec.

6664(c)(1) , Reg. § 1.6664-4(a) ) In determining reasonable cause, pertinent facts and circumstances include the taxpayer's

efforts to assess his proper tax liability, the taxpayer's knowledge and experience and the reliance on the advice of a

professional in determining whether the taxpayer acted with reasonable cause and in good faith. ( Reg. § 1.6664-4(b)(1) )

Facts. William Mues, a certified public accountant, worked as a consultant from February 2001 until March 2002 for Seven W.

Enterprises, Inc. (7W) and Highland Supply Corporation (HSC)—(collectively, the Corporations), two closely held businesses

controlled by the Weder family. 7W and HSC, were each the parent of a group of corporations which filed a consolidated Federal

income tax returns, 7W Group and HSC Group, respectively. Mues, who had previously been employed by the Corporations beginning in

1990 until resigning in January 2001, provided his consulting services from February 2001 until March 2002 as an independent

contractor under an agreement with the Corporations and was not subject to the Corporations' supervision or direction.

During this period, Mues prepared 7W Group's 2000 tax return and HSC Group's 2001 tax return. In March 2002, the Corporations

hired Mues as their vice president of taxes. In this position, Mues prepared and signed, on the Corporations' behalf, 7W Group's

2001, 2002, and 2003 tax returns and HSC Group's 2002, 2003, and 2004 tax returns. In 2000 through 2004, Mues incorrectly

concluded that the Corporations weren't liable for personal holding company taxes and, as a result, understated their tax

liabilities for those years.

IRS issued 7W Group a notice of deficiency relating to 2000 through 2003 and HSC Group a notice of deficiency relating to 2003 and

2004. IRS determined, and the Corporations agreed, that incorrect reporting of personal holding company tax on their returns for

the years in issue resulted in substantial tax understatements. In addition, IRS contended that the Corporations were liable for

accuracy-related penalties.

In response, the Corporations argued that the accuracy-related penalty was inapplicable. They maintained that they had reasonable

cause for their underpayments and acted in good faith. Alternatively, they contended that they reasonably relied on the advice of

Mues in 2000 when he served as a consultant and in 2001 through 2004 when he served as vice president of taxes.

Court's conclusion. The Tax Court held that under Reg. § 1.6664-4(b)(1) and Reg. § 1.6664-4(c)(1) , 7W Group wasn't liable for an

accuracy-related penalty relating to 2000 because it reasonably relied on Mues to prepare its tax return. Mues signed 7W Group's

2000 return as a paid preparer and the consulting agreement specifically provided that he wasn't subject to 7W Group's

supervision. 7W Group provided Mues, an experienced and knowledgeable tax professional, with all of the relevant information

necessary to prepare the return and relied in good faith on Mues to accurately and correctly prepare its 2000 return.

However, the Tax Court disagreed with the Corporations' contention that they exercised ordinary business care and prudence on

their 2001 through 2004 returns. Further, the Court found that Mues didn't qualify as “a person, other than the taxpayer,” under

Reg. § 1.6664-4(c)(2) , for the returns which he signed on behalf of the Corporations. The Court reasoned that a corporation can

act only through its officers. The Corporations authorized Mues to act as both the vice president of taxes and the taxpayer.

Unlike the 2000 return, which Mues signed as a paid preparer, the 2001 through 2004 returns were signed by Mues on the

Corporations' behalf. Thus, the Corporations didn't have reasonable cause for the 2001 through 2004 underpayments, and they were

liable for accuracy-related penalties for those years.

6662; 6664; 7491.

SEVEN W. ENTERPRISES, INC. and SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent HIGHLAND SUPPLY

CORPORATION and SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information:
Code Sec(s): 6662; 6664; 7491
Docket: Docket Nos. 13594-08, 13595-08.
Date Issued: 06/7/2011
Judge: Opinion by FOLEY
HEADNOTE

XX.

Reference(s): Code Sec. 6662 ; Code Sec. 6664 ; Code Sec. 7491

Syllabus

Official Tax Court Syllabus

From February 2001 until March 2002, M worked as a consultant for P1 and P2 (collectively, Ps). During this period, M prepared

P1's 2000 tax return and P2's 2001 tax return. In March 2002, Ps hired M as their vice president of taxes. As Ps' vice president

of taxes, M prepared and signed, on behalf of Ps, P1's 2001, 2002, and 2003 tax returns and P2's 2002, 2003, and 2004 tax returns.

In 2000 through 2004, Ps incorrectly concluded that they were not liable for personal holding company taxes and, as a result,

understated their tax liabilities relating to those years.

R issued P1 a notice of deficiency relating to 2000 through 2003 and P2 a notice of deficiency relating to 2003 and 2004. In the

notices, R determined that Ps were liable for accuracy-related penalties. Ps contend that they had reasonable cause for their

underpayments and acted in good faith. Alternatively, Ps contend that they reasonably relied on the advice of M in 2000 when M

served as a consultant and in 2001 through 2004 when he served as vice president of taxes. 1. Held: Pursuant to   sec. 1.6664-4

(b)(1) and (c)(1), Income Tax Regs., P1 is not liable for an accuracy-related penalty relating to 2000 because it reasonably

relied on M to prepare its tax return. 2. Held, further, M does not qualify as “a person, other than the taxpayer”, pursuant to  

sec. 1.6664-4(c)(2), Income Tax Regs., with respect to the returns which he signed on behalf of Ps, and therefore the

aforementioned regulation is not applicable to Ps' underpayments of taxes relating to 2001 through 2004. 3. Held, further, Ps are

liable for accuracy- related penalties relating to 2001 through 2004.

Patrick B. Mathis, William J. Niehoff, and Philip D.

Counsel

Speicher, for petitioners.
James M. Cascino, David B. Flassing, and William G. Merkle, for respondent.

Opinion by FOLEY

The issue for decision is whether petitioners are liable for   section 6662(a) 1 accuracy-related penalties relating to tax years

ending in 2000, 2001, 2002, 2003, and 2004 (years in issue). 2

FINDINGS OF FACT

The Weder family controlled two closely held businesses: Highland Supply Corporation (HSC) and Seven W. Enterprises, Inc. (7W).

HSC was the parent of a group of corporations (collectively, HSC Group), which filed a consolidated Federal income tax return and

manufactured floral, packaging, and industrial wire products. HSC Group included Highland Southern Wire, Inc., and Weder

Investment, Inc. (WI). 3 7W, a corporation principally engaged in leasing nonresidential buildings, was the parent of a group of

entities (collectively, 7W Group), which filed a consolidated Federal income tax return. 7W owned an 89- percent interest in Weder

Agricultural Limited (WAL), a limited partnership.

In 1990, HSC Group and 7W Group (collectively, petitioners) hired William Mues, a certified public accountant, to serve as their

tax manager. Mues had experience relating to personal holding company tax matters and had previously worked at Deloitte Haskins &

Sells, preparing tax returns for individuals, corporations, partnerships, and trusts, and at Peabody Coal Co., preparing

consolidated returns. In 1991, petitioners promoted Mues to vice president of taxes. While employed by petitioners, Mues drafted

documents, performed general legal work, and prepared returns for petitioners and petitioners' shareholders. Petitioners provided

Mues with full access to all resources necessary to handle petitioners' tax matters (i.e., access to corporate and accounting

personnel, corporate records, research databases, and outside professionals). In addition, petitioners authorized Mues to sign, on

their behalf, Internal Revenue Service (IRS) documents.

On December 12, 1995, Southpac Trust International, Inc., as trustee of the Family Trust (STI), an entity unrelated to

petitioners, executed a $4,062,000 interest-bearing promissory note (the promissory note) for the benefit of HSC. In 1996, HSC

assigned the promissory note to WI.

In 1997, the IRS began auditing HSC Group's 1995 return and eventually expanded the audit to include HSC Group's 1996 and 1997

returns. On April 2, 1999, the IRS and HSC Group reached a settlement with respect to the audit relating to HSC Group's 1995,

1996, and 1997 returns. The agreed adjustments were in excess of $2.2 million and included the disallowance of more than $450,000

of deductions relating to HSC's president's personal expenses. These adjustments were set forth on Form CG-4549, Income Tax

Examination Changes, which required HSC Group's signature. Mues signed his name on the line labeled “Signature of Taxpayer”. The

IRS and petitioners also reached settlements relating to HSC Group's and 7W Group's 1998 and 1999 returns. HSC Group had recurring

adjustments relating to research and development expenses.

While an employee of petitioners and prior to 2001, Mues obtained a master's degree in business administration and began law

school as a part-time student. In January 2001, Mues resigned as vice president of taxes and continued his legal studies as a

full-time student. After resigning, Mues, pursuant to an agreement, provided petitioners with consulting services concerning tax

matters and was not subject to petitioners' supervision or direction. As a consultant, Mues prepared 7W Group's 2000 return and

HSC Group's 2001 return. In March 2002, after Mues completed law school, petitioners hired him to serve as their vice president of

taxes. In accordance with his responsibilities, Mues prepared and signed, on behalf of petitioners, 7W Group's 2001, 2002, and

2003 returns and HSC Group's 2002, 2003, and 2004 returns.

With respect to the years in issue, Mues incorrectly characterized petitioners' income and concluded that petitioners were not

liable for personal holding company taxes. The personal holding company tax is a penalty tax on undistributed income and is

designed to discourage individuals from using closely held corporations to defer taxation on dividends, interest, rents, and other

forms of passive income. See   secs. 541,   543; Fulman v. United States,  434 U.S. 528, 530-531 [41 AFTR 2d 78-698] (1978); H.

Rept. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B. (Part 2) 554, 562-563; S. Rept. 558, 73d Cong., 2d Sess. (1934), 1939-1 C.B

(Part 2) 586, 596-598. On HSC Group's 2003 and 2004 returns, Mues incorrectly concluded that interest income, relating to the

promissory note held by WI, was income from a source within HSC Group and that WI was not liable for the personal holding company

tax. As a result, HSC Group, whose consolidated return included WI, understated its 2003 and 2004 tax liabilities. On 7W Group's

2000, 2001, 2002, and 2003 returns, Mues made a similar mistake with respect to interest income received by WAL. During 2000,

2001, 2002, and 2003, WAL received interest income relating to an installment note issued by an entity outside 7W Group, and each

year 7W, in determining its income, took into account a portion of that interest income equal to 7W's distributive share. For

purposes of calculating the personal holding company tax, however, Mues did not take this income into account. In addition, Mues

misapplied the personal holding company tax rules relating to rental income and, in doing so, incorrectly concluded that 7W's

rental income was not subject to the personal holding company tax. As a result, 7W Group understated its 2000 through 2003 tax

liabilities.

On March 7, 2008, respondent issued 7W Group a notice of deficiency relating to 2000, 2001, 2002, and 2003 and HSC Group a notice

of deficiency relating to 2003 and 2004 (collectively, notices). In the notices, respondent determined that petitioners were

liable for   section 6662(a) accuracy-related penalties. On June 4, 2008, petitioners, whose principal place of business was

Highland, Illinois, timely filed petitions with the Court seeking redetermination of the penalties set forth in the notices.

OPINION

  Section 6662(a) and   (b)(2) imposes a 20-percent penalty on the portion of an underpayment of tax attributable to any

substantial understatement of income tax. The parties agree that petitioners' incorrect reporting of personal holding company tax

on their returns relating to the years in issue resulted in substantial understatements of income tax as defined in section See  

sec. 7491(c); Higbee v. Commissioner,   116 T.C. 438, 6662(d). 446-447 (2001).   Section 6664(c)(1), however, provides that no

penalty shall be imposed if a taxpayer demonstrates that there was reasonable cause for the underpayment and that the taxpayer

acted in good faith. See also   sec. 7491(c); Higbee v. Commissioner, supra. The determination of whether a taxpayer acted with

reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer's efforts to assess his or her

proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor.   Sec.

1.6664-4(b)(1), Income Tax Regs. I. 7W Group's 2000 Return With respect to its 2000 return, 7W Group contends that it is entitled

to relief from the accuracy-related penalty because it relied in good faith on the advice of Mues, an independent, competent tax

advisor. Indeed, when he prepared 7W Group's 2000 return, Mues, having resigned from his position as petitioners' vice president

of taxes, was working for petitioners pursuant to a consulting agreement. Respondent emphasizes that Mues continued to perform the

same activities before and after his resignation; requests, in essence, that we ignore the consulting agreement; and urges us to

hold that Mues was not sufficiently independent for petitioners to avail themselves of relief pursuant to   section 6664(c).

We reject respondent's contention. Mues resigned, signed a valid consulting agreement, and served as petitioners' independent

contractor. See Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 322-325 (1992); Weber v. Commissioner,   103 T.C. 378, 387-390

(1994) (delineating factors to be considered when determining an employment relationship between parties), affd.   60 F.3d 1104

[76 AFTR 2d 95-5782] (4th Cir. 1995). In addition, Mues signed 7W Group's 2000 return as a paid preparer and the consulting

agreement specifically provided that he was not subject to petitioners' supervision. 7W Group provided Mues, an experienced and

knowledgeable tax professional, with all of the relevant information necessary to prepare the return and relied, in good faith, on

Mues to accurately and correctly prepare 7W Group's 2000 return. Therefore, it was reasonable for 7W Group to rely on Mues to

prepare its 2000 return. See   sec. 6664(c); Montgomery v. Commissioner,   127 T.C. 43, 67 (2006) (stating that it is reasonable

to rely on an advisor's professional judgment if the taxpayer “selects a competent tax adviser and supplies him or her with all

relevant information” and that “a taxpayer who seeks the advice of an adviser does not have to challenge the adviser's

conclusions, seek a second opinion, or try to check the advice by reviewing the tax code himself or herself.” (citing United

States v. Boyle,   469 U.S. 241, 250-251 [55 AFTR 2d 85-1535] (1985)));   ,   sec. 1.6664-4(b)(1), (c)(1), Income Tax Regs.

Accordingly, 7W Group is not liable for the   section 6662(a) accuracy-related penalty relating to 2000.

II. Petitioners' 2001 Through 2004 Returns Petitioners contend that they exercised ordinary business care and prudence relating to

their 2001 through 2004 returns. We disagree. It is unclear whether petitioners' myriad of mistakes was the result of confusion,

inattention to detail, or pure laziness, but we are convinced that petitioners and Mues failed to exercise the requisite due care.

See United States v. Boyle, supra at 250-251; Neonatology Associates, P.A. v. Commissioner,   115 T.C. 43, 98 (2000), affd.   299

F.3d 221 [90 AFTR 2d 2002-5442] (3d Cir. 2002).

Petitioners are sophisticated taxpayers. See Campbell v. Commissioner,   134 T.C. 20, 33 (2010);   sec. 1.6664-4(b)(1), Income Tax

Regs. Indeed, Mues was a well-educated and experienced tax professional with full access to petitioners' records and personnel.

Petitioners readily acknowledge that Mues was familiar with the personal holding company tax rules, yet emphasize that these rules

are complex and that Mues' mistakes were reasonable. The personal holding company tax rules certainly are complex, but Mues failed

to apply some of the most basic provisions of those rules. In fact, Mues conceded that in applying the   section 543(a)(2) test he

“truncated the test” and “misapplied the second prong”. He simply did not read the entire test. Moreover, he did not understand or

do the requisite work to ascertain the basic facts relating to petitioners' income items. For example, the applicability of the

personal holding company tax rules to HSC Group (or any member of the affiliated group) depended in part on the determination of

whether income items were from inside or outside the affiliated group. See   sec. 542(b). Mues failed to recognize that STI (i.e.,

the debtor on the note held by WI) was an entity outside the HSC Group. Mues was petitioners' vice president of taxes both when

the note was executed and when it was assigned. Furthermore, Mues testified that he knew at the time he prepared HSC Group's

returns that the note's debtor was outside the group, yet he inexplicably treated the interest income as if it was derived from

within HSC Group and not subject to the personal holding company tax. When asked by the Court whether this was reasonable, Mues

stated: “it seemed reasonable at the time. It seems less reasonable now in hindsight.” Petitioners' repeated audit adjustments

relating to multiple IRS audits coupled with Mues' experience, expertise, and education further bolster our conclusion that

petitioners failed to exercise ordinary business care and prudence as to the See Cobb v. Commissioner,   77 T.C. 1096, 1101-

disputed items. 1102 (1981), affd. without published opinion 680 F.2d 1388 (5th Cir. 1982).

Petitioners further contend that the accuracy-related penalties should not apply because they relied on the advice of Mues—a

competent tax advisor. Again, we disagree. As previously discussed, good-faith reliance on the advice of an independent, competent

tax advisor may constitute reasonable cause and good faith.   ,   Sec. 1.6664-4(b)(1), (c)(1), Income Tax Regs.; see also

Neonatology Associates, P.A. v. Commissioner, supra at 98. The right to rely on professional tax advice, however, is subject to

certain restrictions. See United States v. Boyle, supra at 250-251;   ,   sec. 1.6664-4(b), (c), Income Tax Regs. Pursuant to  

section 1.6664-4(c)(2), Income Tax Regs., “advice” is “any communication *** setting forth the analysis or conclusion of a person,

other than the taxpayer”. (Emphasis added.) Petitioners contend that, pursuant to   section 7701(a)(1) and   (14), the definition

of a “taxpayer” is limited to petitioners (i.e., the persons subject to the tax) and does not include Mues—petitioners' employee.

A corporation can act (e.g., sign the corporation's return) only through its officers. See   sec. 6062; DiLeo v. Commissioner,  

96 T.C. 858, 875 (1991), affd.   959 F.2d 16 [69 AFTR 2d 92-998] (2d Cir. 1992). Petitioners authorized Mues to act as both the

vice president of taxes and the taxpayer. Indeed, unlike the 2000 return, which Mues signed as a paid preparer, the 2001 through

2004 returns were signed by Mues on petitioners' behalf. Simply put, Mues does not qualify as “a person, other than the taxpayer”

with respect to the returns which he signed on behalf of the taxpayer (i.e., petitioners). Thus, petitioners did not have

reasonable cause for the 2001 through 2004 underpayments. 4 See   sec. 1.6664-4(b) and (c), Income Tax Regs. We need not, and do

not, opine as to whether reliance on an in- house professional tax advisor may establish reasonable cause in other circumstances.

Contentions we have not addressed are irrelevant, moot, or meritless.

To reflect the foregoing,

Appropriate decisions will be entered.

1
  Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the

years in issue.
2
  The years in issue are the tax years ending Dec. 31, 2000, 2001, 2002, and 2003 with respect to 7W Group and the tax years

ending Apr. 30, 2003 and 2004 with respect to HSC Group.
3
  WI is wholly owned by Highland Southern Wire, Inc., which is wholly owned by HSC.
4
  We note that petitioners, citing several regulations, contend that respondent's position is contrary to regulations providing

that reasonable cause includes reliance on the advice of “house counsel”. The cited regulations simply are not applicable.   Secs.

53.4941(a)-1(b)(6),   53.4945-1(a)(2)(vi),  53.4955-1(b)(7), and 53.4958-1(d)(4)(iii)(A), Foundation Excise Tax Regs., relate to

prohibited transactions and the application of excise taxes.   Sec. 1.856-7(c)(2)(iii), Income Tax Regs., relates to the

determination of whether an entity qualifies, pursuant to   sec. 856(c), as a real estate investment trust. These regulations are

distinguishable because they explicitly provide that legal counsel includes “house counsel” and that the advice of counsel must be

in a “reasoned written opinion”. Furthermore, while   sec. 1.6664-4, Income Tax Regs., provides a standard for determining whether

a taxpayer has acted in good faith, the cited regulations relate to whether a taxpayer has acted willfully.



Nield Montgomery, et ux. v. Commissioner, 127 TC 43, Code Sec(s) 83.

NIELD AND LINDA MONTGOMERY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information: [pg. 43] 127 T.C. No. 3
Code Sec(s): 83
Docket: Dkt. No. 633-05.
Date Issued: 08/28/2006 .
Judge: Opinion by Haines, J.
Tax Year(s): Year 2000.
Disposition: Decision for Taxpayers in part and for Commissioner in part.
HEADNOTE

1. Transfers of restricted property—incentive stock options—substantial risk of forfeiture—Securities Exchange Act. IRS properly

determined that communications corp. founder/ex-pres.'s rights in ISO shares weren't on exercise subject to substantial risk of

forfeiture within meaning of Code Sec. 83(c) : taxpayer's argument that such risk existed because he was insider subject to

liability and potential disgorgement under 1934 SEA §16(b) was flawed. Regardless of taxpayer's dubious insider sta tus, there was

clearly no risk of §16(b) liability because he didn't sell any shares within operative rules' 6-month period, as measured from

last acquisition/grant date. And his attempt to take his transactions outside those rules, re-characterizing them as

“discretionary transactions,” was erroneous since for SEA purposes, discretionary transactions were defined as those going to

fund-switching transactions effected within contributory employee benefit plans, which didn't happen here.

Reference(s): ¶ 835.02(5) Code Sec. 83

2. Incentive stock options—treatment and qualification—holding periods; disqualifying dispositions; computations. IRS properly

determined that aggregate FMV of stock with respect to which communications corp. founder/ex-pres. held ISOs exceeded Code Sec.

422(d) 's $100,000 limitation: taxpayer's objection to IRS's computation, arguing that computation should have included only those

shares not subject to disqualifying disposition, was belied by statute's plain language and statutory scheme, indicating that all

shares are taken into account.

Reference(s): ¶ 4225.01 Code Sec. 422 ; Code Sec. 421

3. Alternative minimum taxable income—computations—transfers of restricted property—incentive stock options—capital losses—

alternative tax net operating losses—carrybacks. IRS properly determined that Code Sec. 1211 and Code Sec. 1212 regular tax

capital loss limitations applied to AMTI calculation and forbid communications corp. founder/ex- pres.'s claim for ISO-related

excess AMT loss: application of loss rules was consistent with earlier case law and established principles, under which regular

tax rules generally apply in AMT context absent explicit exception; and fact that IRS had not included Code Sec. 1211 in Form 6251

instructions for some years was irrelevant. Also, ATNOL wasn't available since ATNOL was defined by reference to allowable Code

Sec. 172 NOL and computed without/excluding excess AMT capital loss.

Reference(s): ¶ 565.01(5) ; ¶ 12,115.01(10) ; ¶ 565.01(10) Code Sec. 55 ; Code Sec. 56 ; Code Sec. 1211 ; Code Sec. 1212 ; Code

Sec. 172

4. Accuracy-related substantial understatement penalties—burden of proof and production—reasonable cause—reliance on professional.

Accuracy-related substantial understatement penalties weren't upheld against communications corp. founder/ex-pres. and wife for

year they improperly reported tax consequences of incentive stock options transactions: although IRS satisfied its burden of

production with proof taxpayers had substantial understatement, they showed reasonable cause therefor by their reliance on

accounting firm to which they gave all relevant information necessary to prepare return reflecting what were complex issues that

had not been previously litigated as of their return date.

Reference(s): ¶ 66,625.01(3) ; ¶ 74,915.03(10) Code Sec. 6662 ; Code Sec. 7491

Syllabus

Official Tax Court Syllabus

 P-H, president and CEO of MGC Communications, Inc. (MGC), received incentive stock options (ISOs) from MGC between April 1996 and

March 1999. In November 1999, P-H resigned as president and CEO of MGC and entered into an employment contract with MGC which

included provisions accelerating the vesting dates of his ISOs. In early 2000, P-H exercised many of his ISOs. P-H subsequently

sold shares of MGC stock in 2000 and 2001 at prices above and below the exercise prices that he paid for the shares.
Ps filed a joint Federal income tax return for 2000 reporting total tax of $2,831,360, including alternative minimum tax (AMT). Ps

subsequently submitted to R an amended return for 2000 in which they claimed (1) they were not subject to AMT, and (2) [pg. 44]

they overpaid their taxes. R rejected Ps' claimed overpayment and issued to Ps a notice of deficiency for 2000. R determined Ps

failed to report wages, capital gains, and additional alternative minimum taxable income (AMTI) arising from the exercise of P-H's

ISOs.
Held: P-H's rights to the MGC shares he acquired upon the exercise of his ISOs were not subject to a substantial risk of

forfeiture within the meaning of   sec. 83, I.R.C., and   sec. 16(b) of the Securities Exchange Act of 1934. Held, further: R's

determinations Ps failed to report wages, capital gains, and AMTI arising from the exercise of P-H's ISOs are sustained in that

(1) R properly applied the $100,000 annual limit imposed on ISOs under   sec. 422(d), I.R.C., (2) Ps are not entitled to carry

back capital losses to 2000, and (3) Ps are not entitled to carry back alternative tax net operating losses to 2000. Held,

further: Ps are not liable for an accuracy-related penalty for 2000 under   sec. 6662(b)(2), I.R.C.
Counsel

Duncan C. Turner and Brian G. Isaacson, for petitioners.
Kirk M. Paxson, Julie L. Payne, and William C. Schmidt, for respondent.

HAINES, Judge

Respondent determined a deficiency of $417,601 in petitioners' Federal income tax for 2000 and an accuracy-related penalty of

$83,520 under   section 6662(b). 1 All references to petitioner in the singular are to petitioner Nield Montgomery.

After concessions, 2 the issues remaining for decision are:

1. Whether petitioner's rights in shares of stock acquired upon the exercise of incentive stock options (ISOs) in 2000 were

subject to a substantial risk of forfeiture within the meaning of   section 83(c)(3) and   section 16(b) of the Securities

Exchange Act of 1934) 3 (the Exchange Act). We hold petitioner's rights were not subject to a substantial risk of forfeiture.

2. Whether respondent properly determined that petitioner's options exceeded the $100,000 annual limit imposed on ISOs under  

section 422(d). We hold respondent correctly applied   section 422(d) in this case. [pg. 45]

3. Whether petitioners may carry back capital losses to reduce the amount of their alternative minimum taxable income for 2000. We

hold they may not.

4. Whether petitioners may carry back alternative tax net operating losses to reduce the amount of their alternative minimum

taxable income for 2000. We hold they may not.

5. Whether petitioners are liable for an accuracy-related penalty under   section 6662(b)(2) for 2000. We hold petitioners are not

liable for the accuracy-related penalty under   section 6662(b).

FINDINGS OF FACT

Some facts have been stipulated and are so found. The parties' stipulations of facts, with attached exhibits, are incorporated

herein by this reference. At the time the petition was filed, petitioners (husband and wife) resided in Las Vegas, Nevada.

A. MGC Communications, Inc.

In 1995, petitioner cofounded NevTEL, Inc., subsequently renamed MGC Communications Inc. (MGC), 4 to engage in the business of

providing local telephone service in Nevada. Petitioner served as MGC's president and chief executive officer from 1995 to

November 1999. During the period in question, MGC's common stock was publicly traded on the NASDAQ market system, and MGC was

subject to the reporting requirements of the Exchange Act.

MGC shares were subject to a 6-for-10 reverse stock split in May 1998 and a 3-for-2 stock split in August 2000. Unless otherwise

indicated, all data (including tables) set forth below reflect these stock splits.

1. MGC Communications, Inc. Stock Option Plan

In 1996, MGC adopted the MGC Communications, Inc. Stock Option Plan (the MGC stock option plan) which provided in pertinent part:

(1) The plan would be administered by a committee of no fewer than two “disinterested persons” (the committee), who would be

appointed by MGC's board of directors (MGC board) from its membership or, in the absence of [pg. 46] such appointments, by the

entire MGC board; (2) the committee would have the sole discretion to (a) select the persons to be granted options, (b) determine

the number of shares subject to each option, (c) determine the duration of the exercise period for any option, (d) determine that

options may only be exercised in installments, and (e) impose other terms and conditions on each option as the committee in its

sole discretion deemed advisable. The MGC stock option plan expressly contemplated that the committee would grant to MGC employees

ISOs within the meaning of   sections 421 and   422.

2. Petitioner's Incentive Stock Options

On April 1, 1996, September 4, 1998, and March 1, 1999, petitioner executed a series of share option agreements under which he was

granted ISOs from MGC. Each of the share option agreements stated that if petitioner were considered an “insider” subject to  

section 16(b) of the Exchange Act, petitioner “shall be restricted from selling any Option Shares acquired by him through exercise

of the Options or any portion thereof during the six (6) month period following the date of grant of the Option.” Table 1 sets

forth the dates on which petitioner's ISOs were granted and the number of MGC shares petitioner was entitled to purchase under

each ISO.

     Table 1
     -------
                  Grant          Grant date          Shares
                  -----          ----------          ------
                    1              4/1/96            540,000
                    2              9/4/98             22,500
                    3              9/4/98             45,000
                    4              3/1/99             15,000
                    5              3/1/99             22,500
Petitioner's ISOs provided for exercise prices, i.e., the price petitioner would pay for each MGC share, ranging from $0.55 to

$5.33. Petitioner's ISOs originally were scheduled to vest on various dates between 1997 and 2003.

Petitioner was not granted any additional MGC stock options after March 1, 1999. During the period in question, petitioners owned

less than 10 percent of the total combined voting power of all classes of MGC's stock. [pg. 47]

Petitioner unilaterally determined the specific terms and conditions of the ISOs that he received under the share option

agreements. The MGC board did not appoint a committee to administer the MGC stock option plan, and the MGC board did not play any

role in consummating the share option agreements described above.

B. Petitioner's 1999 Employment Agreement With MGC

On November 1, 1999, petitioner entered into a comprehensive agreement with MGC governing his employment status with MGC and his

ISOs (the 1999 employment agreement). Pursuant to the 1999 employment agreement: (1) Petitioner resigned as president, chief

executive officer, and director of MGC, and he resigned as an officer and director of MGC's subsidiaries; (2) petitioner agreed to

assist MGC's new chief executive officer “in order to provide for a smooth transition for the Company”; (3) MGC agreed to make a

lump-sum payment of $360,000 to petitioner; (4) MGC and petitioner agreed to accelerate the vesting dates of petitioner's ISOs;

and (5) petitioner and MGC agreed that petitioner would continue to be employed by MGC through April 1, 2001, for the purpose of

providing advice regarding regulatory developments, testimony at legal, regulatory, and administrative proceedings as necessary,

and other mutually agreed duties.

After November 1, 1999, MGC never requested petitioner to prepare any formal reports for the company, and petitioner did not

prepare any formal reports for MGC.

Table 2 sets forth (1) the fair market value of MGC shares as of the dates petitioner's ISOs were granted, and (2) the total fair

market value of all shares as to which petitioner's ISOs were exercisable for the first time during each of the years 1997 to 2001

(taking into account the ac celerated vesting schedule that MGC and petitioner agreed to on November 1, 1999):

Table 2
-------

Year ISO
first
exercisable        FMV of MGC shares as of ISO grant date
-----------   ------------------------------------------------    Total
              Grant 1   Grant 2   Grant 3    Grant 4   Grant 5     FMV
              -------   -------   -------    -------   -------   --------
   1997       $60,000      --        --         --        --     $ 60,000
   1998        60,000      --        --         --        --       60,000
   1999        60,000   $96,000   $240,000   $20,298      --      416,298
   2000        60,000    24,000      --       20,298   $91,350    195,648
   2001        60,000      --        --       20,304      --       80,304
[pg. 48]
C. Petitioner's SEC Filings

In February 2000, petitioner filed with the Securities and Exchange Commission (SEC) a Form 5, Annual Statement Of Changes In

Beneficial Ownership of Securities, in which he reported owning 736,500 shares of MGC common stock and options to purchase 430,000

additional shares of MGC common stock. 5 A cover letter accompanying petitioner's Form 5 stated that the report would be

petitioner's last because he was no longer subject to the reporting requirements of   section 16(a) of the Exchange Act.

Petitioner did not file any further Forms 5 with the SEC.

During 2000 and 2001, petitioner remained in contact with certain MGC executive officers and was privy to material, non-public

information regarding MGC's operations and financial matters.

D. Petitioner's Acquisitions and Dispositions of MGC Shares

Table 3 sets forth the ISOs that petitioner exercised, identified by grant, exercise date, numbers of MGC shares acquired, total

exercise price, and total fair market value (FMV) of the MGC shares acquired as of each exercise date:

Table 3
-------

Grant      Exercise date    Shares acquired    Exercise price        FMV
-----      -------------    ---------------    --------------        ---
  1           1/11/00           324,000           $179,982       $10,773,000
  2           1/11/00            18,000             96,000           598,500
  3           1/11/00            45,000            240,000         1,496,250
  4           1/11/00             5,000             20,300           166,250
  4            3/9/00             5,000             20,300           237,050
  5            3/9/00            22,500             91,350         1,066,725
  1           3/29/00           108,000             59,994         4,733,640
Petitioner subsequently disposed of a number of the MGC shares he had acquired upon the exercise of his ISOs (as described in

Table 3 above). In particular, on May 4, 2000, petitioner transferred 2,250 shares of MGC stock by way of a gift. In addition,

petitioner sold a number of MGC shares during 2000 and 2001, as set forth in the following table: [pg. 49]

Table 4
-------

                                                         Gain or loss
                                                      (Difference between
                                                      exercise price and
Grant    Sale date    Shares sold    Sale proceeds      sales proceeds)
-----    ---------    -----------    -------------      ---------------
  1       9/29/00       175,000       $1,480,729          $1,383,517
  1       12/8/00        50,000          209,991             182,216
  1      12/20/00        42,000          140,121             116,790
  1      12/20/00        13,000           43,371              36,149
  1      12/21/00        41,750          151,486             128,294
  2      12/21/00         9,750           35,377             (16,623)
  2      12/21/00         8,250           29,934             (14,066)
  3      12/21/00        10,250           37,191             (17,475)
  3      12/28/00         6,000           28,947              (3,053)
  3      12/29/00        19,000           82,196             (93,037)
  3       3/13/01         5,000           19,122              (7,544)
  3       3/14/01         4,740           18,297              (7,036)
  4       3/14/01           250              963                 (52)
  4       3/15/01         4,750           18,215              (1,070)
  4       3/15/01           998            3,827                (225)
  4       3/15/01         4,002           15,346                (902)
  5       3/14/01           250              963                 (52)
  5       3/16/01        10,000           39,496              (1,104)
  5       3/19/01         5,000           19,278              (1,022)
  5       3/20/01         7,500           27,275              (2,160)
Petitioners have never been in the trade or business of trading stocks. Petitioners held their MGC shares for investment purposes

and not as traders or dealers.

MGC never requested that petitioner disgorge any profits from his sales of MGC shares, petitioner was never sued by MGC or one of

its shareholders pursuant to   section 16(b) of the Exchange Act, and petitioner never paid over to MGC any part of the proceeds

from his sales of MGC common stock.

E. Petitioners' Tax Return and Amended Return

On or about October 18, 2001, petitioners filed a joint Federal income tax return for the taxable year 2000 reporting total tax of

$2,831,360 (including AMT described below). Petitioners reported total payments of $2,636,723, leaving a balance due of $196,006

(including an estimated tax penalty of $1,369). Petitioners submitted Form 6251, Alternative Minimum Tax—Individuals, with their

tax return for 2000. On Form 6251, line 10, petitioners reported $3,988,180 of alternative minimum tax income (arising from the

exercise of petitioner's ISOs) in excess of regular taxable income, a total of $10,665,935 of alternative minimum taxable income

(AMTI), and AMT of $526,679. Petitioners' tax return was pre-[pg. 50] pared and signed by a tax return preparer employed at

Deloitte & Touche LLP.

Petitioners failed to remit the full amount of tax due with their tax return. Respondent accepted petitioners' tax return as filed

and assessed the tax reported therein, as well as statutory interest and a late-payment penalty.

Respondent issued to petitioners a Final Notice of Intent to Levy and Notice of Your Right to a Hearing with regard to their

unpaid taxes for 2000. Petitioners submitted to respondent an amended return for 2000 and a request for an administrative hearing

under   section 6330. In their amended return, petitioners claimed that they overstated the amount of tax due on their original

return, and they claimed they were due a refund of $519,087. Contrary to their original return, petitioners submitted a Form 6251

with their amended return in which they reported $850,534 of alternative minimum taxable income in excess of regular taxable

income, a total of $7,148,666 of AMTI, and zero AMT.

Respondent declined to consider petitioners' refund claim and issued to petitioners a Notice of Determination Concerning

Collections Actions for 2000. Petitioners filed a petition for lien or levy action with the Court at docket No. 16864-02L. Upon

review of the matter, the Court remanded the collection case to respondent's Office of Appeals for consideration of petitioners'

amended return. During the remand, respondent audited petitioners' original and amended returns and issued to petitioners a

Supplemental Notice of Determination under   section 6330 and a notice of deficiency under   section 6213(a). 6

In the notice of deficiency, respondent determined (1) petitioners failed to report the correct amount of wages and capital gains

arising from the exercise of petitioner's ISOs, (2) petitioners were not entitled to certain itemized deductions, (3) petitioners

were liable for AMT in excess of that reported on their original return, and (4) petitioners were liable for an accuracy- related

penalty. Specifically, respondent determined that petitioners' correct tax liability for 2000 totaled $3,248,961—a sum comprising

regular tax of $2,511,949 and [pg. 51] AMT of $737,012. Petitioners filed a petition for redetermination in this case challenging

the notice of deficiency.

At the conclusion of the trial in this case, the Court directed the parties to file seriatim briefs. After petitioners filed their

opening brief, respondent filed an answering brief and a motion for leave to file amended answer seeking an increased deficiency

and an increased accuracy-related penalty to conform the pleadings to testimony offered by petitioner at trial. Respondent

asserted that petitioner's trial testimony demonstrated that petitioner's options were not ISOs as defined in   section 422(b).

Respondent's motion was denied by Order dated May 10, 2006. Under the following analysis, petitioner's options are treated as ISOs

(consistent with respondent's position in the notice of deficiency).

OPINION

I. Taxation of Stock Options

A. Incentive Stock Options

Generally, under   section 421(a), a taxpayer is not required to recognize income upon the grant or exercise of an ISO. 7  

Section 422(a) provides that   section 421(a) shall apply with respect to the transfer of a share of stock to a taxpayer pursuant

to the exercise of an ISO if (1) no disposition of such share is made by the individual within 2 years from the date of the

granting of the option nor within 1 year after the transfer of the share to the individual, and (2) the taxpayer remains an

employee of the corporation granting the option (or of a parent or subsidiary corporation of such corporation) during the period

beginning on the date the option was granted and ending on the day 3 months before the date the option was exercised. Any gain or

loss on a sale of shares [pg. 52] acquired pursuant to the exercise of an ISO that are held for the periods prescribed in  

section 422(a)(1) generally will qualify as a capital gain or loss.   Secs. 1001,   1221,   1222.

  Section 421(b) provides that if a taxpayer disposes of any shares of stock acquired pursuant to the exercise of an ISO before

the expiration of the holding periods prescribed in   section 422(a)(1), the taxpayer shall recognize an increase in income in the

taxable year in which such disqualifying disposition occurs. 8   Section 422(c)(2) provides in pertinent part that if a taxpayer

disposes of any shares of stock acquired pursuant to the exercise of an ISO before the expiration of the holding periods required

in   section 422(a)(1), and such disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized

to such individual, the amount includable in the taxpayer's gross income shall not exceed the excess (if any) of the amount

realized on such sale or exchange over the adjusted basis of such shares.

  Section 422(d) imposes an annual limit on options that qualify as ISOs.   Section 422(d) provides:

  SEC. 422(d). $100,000 Per Year Limitation.—

(1) In general.—To the extent that the aggregate fair market value of stock with respect to which incentive stock options

(determined without regard to this subsection) are exercisable for the 1st time by any individual during any calendar year (under

all plans of the individual's employer corporation and its parent and subsidiary corporations) exceeds $100,000, such options

shall be treated as options which are not incentive stock options.
(2) Ordering rule.—Paragraph (1) shall be applied by taking options into account in the order in which they were granted.
(3) Determination of fair market value.—For purposes of paragraph (1), the fair market value of any stock shall be determined as

of the time the option with respect to such stock is granted.
In sum, when the aggregate fair market value of stock that a taxpayer may acquire pursuant to ISOs that are exercisable for the

first time during any taxable year exceeds $100,000, such options shall be treated as nonqualified stock options (NSOs) under  

section 83 (as discussed in detail below). [pg. 53]

B. Alternative Minimum Tax

1. In General

The Internal Revenue Code imposes upon taxpayers an AMT in addition to all other taxes imposed by subtitle A.   Sec. 55(a).

Although a taxpayer exercising an ISO may defer recognition of income for regular tax purposes, the taxpayer nevertheless may

incur AMT liability. See   sec. 56(b)(3). The AMT is imposed upon the taxpayer's AMTI, which is an income base broader than that

applicable for regular tax purposes. Allen v. Commissioner,   118 T.C. 1, 5 (2002); see also H. Conf. Rept. 99-841 (Vol. II), at

II-249, II-264 (1986), 1986-3 C.B. (Vol. 4) 1, 249, 264. AMTI is defined as the taxable income of a taxpayer for the taxable year,

determined with adjustments provided in   sections 56 and   58, and increased by the amount of items of tax preference described

in   section 57.   Sec. 55(b)(2).

For purposes of computing a taxpayer's AMTI,   section 56(b)(3) provides that   section 421 shall not apply to the transfer of

stock acquired pursuant to the exercise of an ISO as defined by   section 422. Therefore, under the AMT, the spread between the

exercise price and the fair market value of the shares of stock on the date an ISO is exercised is treated as an item of

adjustment and is included in the computation of AMTI. See   sec. 56(b)(3);  sec. 1.83-7(a), Income Tax Regs.; see also Speltz v.

Commissioner,   124 T.C. 165, 178-179 (2005), affd.   454 F.3d 782 [98 AFTR 2d 2006-5364] (8th Cir. 2006). Insofar as   section

56(b)(3) provides that   section 421 shall not apply to the exercise of an ISO,   section 83 is applicable to the exercise of an

ISO inasmuch as the exclusion for ISOs set forth in   section 83(e)(1) is negated. 9

2.   Section 83

  Section 83(a) provides in pertinent part that if property is transferred to a taxpayer in connection with the performance of

services (i.e., stock transferred to a taxpayer upon the exercise of a stock option), the excess of the fair market value of the

stock (measured as of the first time the taxpayer's [pg. 54] rights in the stock are not subject to a substantial risk of

forfeiture) over the amount, if any, paid for the stock (the exercise price) shall be included in the taxpayer's gross income in

the first taxable year in which the taxpayer's rights in the stock are not subject to a substantial risk of forfeiture. See Tanner

v. Commissioner,   117 T.C. 237, 242 (2001), affd. 65 Fed. Appx. 508   [91 AFTR 2d 2003-1842] (5th Cir. 2003);   sec. 1.83-7(a),

Income Tax Regs. As mentioned above, the combined application of various provisions of   sections 55,   56, and   83, requires

that, upon the exercise of an ISO, such income be included in the computation of AMTI.

  Section 83(c) contains special rules related to recognition of income under   section 83(a).   Section 83(c)(3) provides that a

taxpayer's rights in property (stock) are subject to a substantial risk of forfeiture and are not transferable so long as the sale

of the stock at a profit could subject the taxpayer to suit under   section 16(b) of the Exchange Act.

3. AMT Impact on Basis

As a result of the unique treatment of the exercise of ISOs under the AMT regime, a taxpayer normally will have two different

bases in the same shares of stock. The taxpayer's regular tax basis is the exercise price or cost basis. See   sec. 1012. However,

for AMT purposes,   section 56(b)(3) provides that the adjusted basis of any stock acquired by the exercise of an ISO “shall be

determined on the basis of the treatment prescribed by this paragraph.” In other words, a taxpayer's adjusted AMT basis equals the

exercise or cost basis in the shares increased by the amount of income included in AMTI. See  secs. 55(b)(2),   56(b)(3),   83(a).

The following example illustrates the general operation of the ISO basis rules. Assume a taxpayer is granted an ISO giving him the

right to purchase 100 shares of ABC, Inc., common stock at $1 per share. The taxpayer exercises the ISO at a time when ABC, Inc.

common stock is trading at $10 per share and the taxpayer's rights in such shares are freely transferrable. Under this example,

the taxpayer's basis for regular tax purposes is $100—the total exercise price or cost incurred by the taxpayer to purchase the

100 shares of stock. On the other hand, the taxpayer's adjusted basis solely for AMT purposes is $1,000—an amount that comprises

the tax-[pg. 55] payer's $100 cost basis plus the $900 bargain purchase element of the transaction that is included in the

computation of the taxpayer's AMT liability.

The anomaly in the ISO basis rules may create inequitable results when a taxpayer has incurred AMT liability upon the exercise of

an ISO in one taxable year, only to have the shares of stock decrease in value the following year. In this situation, the AMT

imposed on the bargain purchase element of the ISO results in a payment of tax on income the taxpayer may never actually receive.

II. The Parties' Positions

A. Respondent's Determinations

Respondent determined that the aggregate fair market value of the stock with respect to which petitioner held ISOs that were first

exercisable in 1999 and 2000 exceeded the $100,000 limitation imposed under   section 422(d). In connection with this

determination, respondent asserts that the aggregate value of stock that a taxpayer may acquire pursuant to ISOs during a taxable

year is computed for purposes of the $100,000 limitation of   section 422(d) without taking into account any disqualifying

dispositions; i.e., transfers or sales of stock prior to the expiration of the holding periods required under   section 422(a)(1).

Taking into account the effects of   section 422(d) and petitioner's disqualifying dispositions of MGC shares, respondent

determined that petitioners failed to report gross income (wages and capital gains) subject to regular tax, and they failed to

compute properly their AMT for 2000.

B. Petitioners' Contentions

Petitioners first contend they were not obliged to recognize any income related to the shares of stock petitioner acquired upon

the exercise of his ISOs during the taxable year 2000 because petitioner's rights in the MGC shares in question were subject to a

substantial risk of forfeiture during 2000. Specifically, petitioner maintains he was a statutory insider of MGC throughout 2000,

and he could have been sued by MGC or another MGC shareholder under   section 16(b) of the Exchange Act and forced to disgorge the

profits he realized when he sold his MGC shares. See   sec. 83(c)(3). [pg. 56]

In the alternative, petitioners assert they incurred capital losses or alternative tax net operating losses (ATNOLs) in years

subsequent to the taxable year 2000, and such losses may be carried back to reduce their AMTI for 2000. Petitioners contend that

for AMT purposes (1) capital losses are not subject to the $3,000 limitation imposed under   section 1211, and (2) imposing a

$3,000 limitation on the amount of capital losses petitioners may report would defeat Congress's intent to tax only the economic

gain received by a taxpayer.

III. Whether Petitioner's Rights in his MGC Shares Were Subject to a Substantial Risk of Forfeiture Within the Meaning of  

Section 83(c)(3)

  Section 16(a) of the Exchange Act requires the principal stock holders of any class of equity security registered under  

section 12 of the Exchange Act, and the directors and officers of the issuer of such securities (hereinafter insiders), to file

periodic statements with the SEC disclosing the amount of equity securities such insider owns, and purchases and sales made by

such insider, during the reporting period.   Section 16(b) of the Exchange Act provides in pertinent part:

(b) For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director,

or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and

purchase, of any equity security of such issuer (other than an exempted security) or a security- based swap agreement (as defined

in   section 206B of the Gramm-Leach- Bliley Act) involving any such equity security within any period of less than six months,

unless such security or security- based swap agreement was acquired in good faith in connection with a debt previously contracted,

shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or

officer in entering into such transaction of holding the security or security-based swap agreement purchased or of not

repurchasing the security or security-based swap agreement sold for a period exceeding six months.
The remainder of   section 16(b) provides that an issuer or any shareholder of the issuer may bring suit against an insider to

recover any profit realized by the insider on any purchase and sale, or any sale and purchase, of any equity security of such

issuer within any period of less than 6 months.

  Section 16(b), the so-called short-swing profit recovery provision, is a prophylactic and strict liability measure [pg. 57]

“under which an insider's short-swing profits can be recovered regardless of whether the insider actually was in possession of

material, non-public information.” Ownership Reports and Trading By Officers, Directors and Principal Security Holders (Ownership

Reports), Exchange Act Release No. 34-28869, 56 Fed. Reg. 7242, 7243 (Feb. 21, 1991); see Levy v. Sterling Holding Co., LLC, 314

F.3d 106, 109-111 (3d Cir. 2002); Magma Power Co. v. Dow Chem. Co., 136 F.3d 316, 320 (2d Cir. 1998).  Section 16(b) applies to

transactions involving derivative securities such as stock options. At Home Corp. v. Cox Commcns. Inc., 446 F.3d 403 (2d Cir.

2006); Magma Power Co. v. Dow Chem. Co., supra at 321; SEC rule 16a-1(c) and (d), 17 C.F.R.   sec. 240.16a-1(c) and (d) (2006).

The elements of a claim under   section 16(b) of the Exchange Act are “(1) a purchase and (2) a sale of securities (3) by an

officer or director of the issuer or by a shareholder who owns more than ten percent of any one class of the issuer's securities

(4) within a six-month period.” Gwozdzinsky v. Zell/Chilmark Fund, L.P., 156 F.3d 305, 308 (2d Cir. 1998).

The parties disagree whether petitioner was an insider subject to liability under   section 16(b) of the Exchange Act during 2000.

Respondent points out that, after petitioner's resignation as an officer and director of MGC in 1999, petitioner no longer filed

Form 4, Statement of Changes in Beneficial Ownership, or Form 5, Statement of Changes in Beneficial Ownership of Securities, with

the SEC, he was not a 10-percent shareholder, and he apparently no longer considered himself an insider subject to the reporting

requirements of   section 16(a) of the Exchange Act. Re spondent also points out that no lawsuit was ever filed against petitioner

seeking disgorgement of the profits he realized when he sold MGC shares during 2000 and 2001. Petitioner counters that he remained

an insider at MGC during 2000 and 2001 as an adviser to MGC's executives. Although we are doubtful petitioner was an insider

subject to liability under   section 16(b) of the Exchange Act during 2000, we need not decide the point. Assuming arguendo that

petitioner was an insider within the meaning of   section 16(b) of the Exchange Act, we conclude that petitioner was not subject

to a substantial risk of forfeiture during the taxable year 2000 because he exercised his ISOs and acquired shares of MGC stock at

a point in [pg. 58] time outside of the 6-month period which would give rise to a lawsuit under   section 16(b) of the Exchange

Act.

It is well settled that it is the acquisition (grant) of a stock option (as opposed to the exercise of a stock option) that is

deemed to be a purchase of a security for purposes of the 6-month short-swing profit recovery provision under   section 16(b) of

the Exchange Act. 10 See Magma Power Co. v. Dow Chem. Co., supra at 321-322. The SEC made this point indelibly clear when it

adopted the regulatory framework governing insider transactions involving derivative securities in 1991. The SEC stated in

pertinent part:

The functional equivalence of derivative securities and their underlying equity securities for   section 16 purposes requires that

the acquisition of the derivative security be deemed the significant event, not the exercise. *** The Rules correspondingly

recognize that, for purposes of the abuses addressed by   section 16, the exercise of a derivative security, much like the

conversion of a convertible security, essentially changes the form of beneficial ownership from indirect to direct. Since the

exercise represents neither the acquisition nor the disposition of a right affording the opportunity to profit, it should not be

an event that is matched against another transaction in the equity securities for purposes of   section 16(b) short-swing profit

recovery. [Emphases added; fn. ref. omitted.]
Ownership Reports, supra, 56 Fed. Reg. at 7248-7249. The SEC went on to state that “to avoid short-swing profit recovery, a grant

of an employee stock option by an issuer, absent an exemption, must occur at least six months before or after a sale of the equity

security or any derivative security relating to the equity security.” Id., 56 Fed. Reg. at 7251 n.120; see   sec. 16(b) of the

Exchange Act (last sentence authorizes the SEC to adopt rules and regulations exempting transactions as not comprehended within

the purpose of the provision).

In Tanner v. Commissioner,   117 T.C. 237, 239 (2001), affd. 65 Fed. Appx. 508 (5th Cir. 2003), this Court held that the 6-month

period under which an insider is subject to liability [pg. 59] under   section 16(b) of the Exchange Act begins on the date that a

stock option is granted. In Tanner v. Commissioner, supra, the taxpayer, an officer, director, and owner of approximately 65

percent of an issuer's stock, was granted an NSO in July 1993 to purchase up to 182,000 of the issuer's shares at an exercise

price of 75 cents per share. The taxpayer exercised the NSO in September 1994, and the Commissioner determined the taxpayer was

obliged to report compensation income on his return for 1994 pursuant to   section 83. The taxpayer challenged the Commissioner's

determination and asserted he was not obliged to report compensation income in 1994 because he had signed a lockup agreement which

purportedly extended for 2 years the period under which he would he would remain liable under   section 16(b) of the Exchange Act.

We rejected the taxpayer's arguments and held (1) the 6-month period under   section 16(b) of the Exchange Act began to run in

July 1993 when the taxpayer was granted the NSO in question, (2) the 6- month period was not extended by the 2-year lockup

agreement, and (3) the 6-month period expired long before the taxpayer exercised the NSO in September 1994. Id. at 244-246.

Petitioner contends the Court's holding in Tanner v. Commissioner, supra, is not controlling in this case. Petitioner testified at

trial that the MGC stock option plan was not administered by the MGC Board nor by a committee as contemplated under the plan, and

he unilaterally granted the ISOs in question to himself. Consistent with these points, petitioner maintains (1) he obtained his

ISOs pursuant to a “discretionary transaction” within the meaning of SEC rule 16b-3(b)(1), 17 C.F.R.   sec. 240.16b-3(b)(1)

(2006); (2) his ISOs were not exempt from the application of   section 16(b) of the Exchange Act; and (3) because he failed to

report to the SEC that he exercised the ISOs, and subsequently sold some of the shares so acquired, he remained liable under

section 16(b) of the Exchange Act until approximately June 2003.

Petitioner's reliance on the discretionary transaction provisions contained in SEC rule 16b-3 is misplaced. A discretionary

transaction is defined in SEC rule 16b-3(b)(1) as a transaction pursuant to an employee benefit plan that (1) is at the volition

of a plan participant; (2) is not made in connection with the participant's death, disability, retirement, or termination of

employment; (3) is not required to be [pg. 60] made available to a plan participant pursuant to the Internal Revenue Code; and (4)

results in either an intraplan transfer involving an issuer equity securities fund, or a cash distribution funded by a volitional

disposition of an issuer equity security. SEC rule 16b-3(f) provides that a discretionary transaction shall be exempt from  

section 16(b) of the Exchange Act only if an election effecting an acquisition (or disposition) is made at least 6 months

following the date of the most recent disposition (or acquisition), as the case may be.

A review of the SEC's release adopting SEC rule 16b-3 reveals the exemption for discretionary transactions was targeted at

opportunities for abuse arising from so- called fund-switching transactions effected within contributory employee benefit plans.

In particular, the SEC stated in pertinent part:

Many contributory employee benefit plans permit a participant to choose one of several funds in which to invest (e.g., an issuer

stock fund, a bond fund, or a money market fund). Plan participants typically are given the opportunity to engage in 'fund-

switching' transactions, permitting the transfer of assets from one fund to another, at periodic intervals. Plan participants also

commonly have the right to withdraw their investments in cash from a fund containing equity securities of the issuer. Fund-

switching transactions involving an issuer equity securities fund and cash distributions from these funds may present

opportunities for abuse because the investment decision is similar to that involved in a market transaction. Moreover, the plan

may buy and sell issuer equity securities in the market in order to effect these transactions, so that the real party on the other

side of the transaction is not the issuer but instead a market participant. [Fn. ref. omitted.]
Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange Act Release No. 34-37260, 61 Fed.

Reg. 30376, 30379 (June 14, 1996).

Although petitioner exercised discretion in granting ISOs to himself, in exercising the ISOs, and in disposing of the underlying

shares, petitioner's activities were not undertaken under the auspices of an employee benefit plan as contemplated under SEC rule

16b-3, nor did his activities result in an intrafund transfer or a cash distribution from a plan. Accordingly, we conclude the

discretionary transaction provisions are not relevant to the question whether petitioner was subject to a suit under   section 16

(b) of the Exchange Act during 2000. [pg. 61]

The period during which petitioner was subject to liability under   section 16(b) of the Exchange Act is directly addressed in SEC

rule 16b-3(d)(3) and SEC rule 16(b)-6(a) and (b), 17 C.F.R.   sec. 240.16b-6(a) and (b) (2006), which apply specifically to

derivative securities. Read together, these regulations provide that (1) the establishment of a call equivalent posi tion (grant

of a stock option) shall be deemed a purchase of the underlying security for purposes of   section 16(b) of the Exchange Act, (2)

the acquisition of underlying securities at a fixed price upon the exercise of a call equivalent position shall be exempt from the

operation of   section 16(b) of the Exchange Act, and (3) if 6 months elapse between the acquisition of a derivative security and

the disposition of the derivative security or its underlying equity security, the transaction is exempt from the operation of  

section 16(b) of the Exchange Act. Inasmuch as petitioner did not sell any MGC shares within 6 months of March 1999—the last date

MGC granted petitioner an ISO—we conclude petitioner qualified for the exemption set forth in SEC rule 16b-3(d)(3). Consequently,

we hold petitioner was not subject to a suit under  section 16(b) of the Exchange Act during 2000.

We would reach the same conclusion even if some technical impediment precluded petitioner's ISOs from qualifying for exemption

under SEC rule 16b. That rule merely provides exemptions or a “safe-harbor” from the applicability of   section 16(b) of the

Exchange Act—it does not impose affirmative liability. As previously discussed, because petitioner's ISOs were granted between

April 1996 and March 1999, the 6-month period during which petitioner would have been subject to suit under   section 16(b) of the

Exchange Act expired in September 1999, several months before petitioner exercised his ISOs in 2000. Petitioner simply has not

persuaded us that his liability under   section 16(b) of the Exchange Act extended beyond September 1999. Because petitioner was

not subject to a suit under   section 16(b) of the Exchange Act during 2000, we conclude petitioner's rights in his MGC shares

were not subject to a substantial risk of forfeiture within the meaning of   section 83(c). 11[pg. 62]

IV. Whether Respondent Correctly Applied the $100,000 Annual Limit on ISOs Imposed Under  Section 422(d)

  Section 422(d) provides stock options will be subject to taxation as NSOs under   section 83 if the aggregate fair market value

of stock a taxpayer may acquire pursuant to ISOs that are exercisable for the first time during any taxable year exceeds $100,000.

  Section 421(b) provides that if the transfer of a share of stock to a taxpayer pursuant to the exercise of an option would

otherwise meet the requirements of   section 422(a), except there is a failure to meet a holding period requirement, any increase

in the income of the taxpayer or deduction from income of his employer corporation shall be recognized in the taxable year in

which such disposition occurs.

The fair market value of the MGC shares petitioner was entitled to purchase under his ISOs, measured as of the dates petitioner's

ISOs were granted and which were first exercisable in 1999 and 2000, exceeded $100,000. The parties also agree that during 2000

and 2001, petitioner engaged in disqualifying dispositions of MGC shares that he acquired upon exercising his ISOs.

Respondent determined that the value of the MGC shares petitioner could acquire pursuant to his ISOs exceeded the $100,000 limit

imposed under  section 422(d) by $316,298 and $95,648 for 1999 and 2000, respectively. 12 Petitioners contend, without citation to

any authority or any meaningful discussion, that respondent erroneously applied   section 422(d). As we understand petitioners'

position, they assert the $100,000 limitation is only applied to shares that are not subject to a subsequent disqualifying

disposition during the same taxable year in which the shares were acquired. We disagree.

  Section 422(b), summarized supra note 7, sets forth the definition of the term “in centive stock option”.   Section 422(b) [pg.

63] does not impose a holding period requirement on shares of stock acquired pursuant to the exercise of an ISO, nor does it

cross-reference   section 422(a)(1) or otherwise exclude shares which are later subject to disqualifying dispositions. Equally

important, although   section 422(a) provides the general rule that   section 421(a) shall apply with respect to the transfer of a

share of stock to an individual pursuant to an exercise of an ISO if, among other requirements, certain holding periods are

satisfied under   section 422(a)(1),   section 422(a) does not state that a violation of the holding period requirement will cause

the option to fail to qualify as an ISO. Along the same lines, although   section 421(b) describes the tax effects if a taxpayer

receives shares of stock pursuant to the exercise of an option which would meet the requirements of   section 422(a), except for a

failure to meet any of the holding period requirements of   section 422(a)(1),   section 421(b) does not state that the option is

not to be considered an ISO. In contrast,   section 422(d) unambiguously states that options exceeding the $100,000 limitation

“shall be treated as options which are not incentive stock options.”

In the absence of any language in the controlling statutory provisions suggesting a disqualifying disposition of stock will cause

the related option to be treated as something other than an ISO, we reject petitioners' argument on this point. We sustain

respondent's interpretation and application of the $100,000 limit imposed under   section 422(d) in this case.

V. Whether Petitioners May Reduce Their AMTI in 2000 by AMT Capital Losses Realized in 2001

Capital Losses Under Regular Tax and Alternative Minimum Tax

Sales of securities generally are subject to the capital gain and loss provisions.   Section 165(f) provides that capital losses

are permitted only to the extent allowed in   sections 1211 and   1212.

Under   section 1212(b), a noncorporate taxpayer is required to offset capital losses against capital gains for a particular

taxable year. If aggregate capital losses exceed aggregate capital gains for a taxable year, up to $3,000 of the excess may be

deducted against ordinary income. 13   Sec. 1212(b). A noncorporate taxpayer may carry forward unrecognized cap-[pg. 64] ital

losses to subsequent taxable years, but it does not allow such unrecognized capital losses to be carried back to prior taxable

years.   Sec. 1212(b). The Internal Revenue Code does not explicitly address the treatment of capital losses for AMT purposes. See

  secs. 55-59 (and accompanying regulations).

Petitioners are not securities dealers, and they held their MGC shares strictly as investors. There is no dispute the MGC shares

in question are capital assets under   section 1221. The record also shows petitioner sold MGC shares in 2001 and that he realized

capital losses as a result. 14 However, the capital loss limitations of   sections 1211(b) and   1212(b) restricted petitioners'

ability to deduct these regular capital losses. 15

Petitioners also realized AMT capital losses in 2001 taking into account petitioner's adjusted AMT basis in his MGC shares.

Petitioners contend that they may carry back these AMT capital losses to reduce their AMTI in 2000. Petitioners argue the capital

loss limitations of   sections 1211 and   1212 do not apply to bar the carryback of AMT capital losses for purposes of calculating

AMTI. We disagree.

In Merlo v. Commissioner,   126 T.C. 205, 211-212 (2006), on appeal to the U.S. Court of Appeals for the Fifth Circuit, the Court

recently rejected the argument that the capital loss limitations of   sections 1211 and   1212 do not apply for purposes of

calculating a taxpayer's AMTI. In so holding, we cited   section 1.55-1(a), Income Tax Regs., which states in pertinent part that,

except as otherwise provided: “[A]ll Internal Revenue Code provisions that apply in determining the regular taxable income of a

taxpayer also apply in determining the alternative minimum taxable income of the taxpayer.” In the absence of any statute,

regulation, or other published guidance which purports to change the treatment of capital losses for AMT purposes, we held the

capital loss limitations of   sections 1211 and   1212 apply in calculating a taxpayer's AMTI. Id. at 212.

Like the taxpayer in Merlo v. Commissioner, supra, petitioners argue the instructions to lines 9 and 10 of Form 6251 for 2000 do

not mention   section 1211, and, therefore, [pg. 65]   section 1211 does not apply for purposes of calculating petitioners' AMTI.

Petitioners' reliance on these instructions is misplaced. It is settled law that taxpayers cannot rely on Internal Revenue Service

instructions to justify a reporting position otherwise inconsistent with controlling statutory provisions. Johnson v.

Commissioner,   620 F.2d 153, 155 [45 AFTR 2d 80-1149] (7th Cir. 1980), affg.   T.C. Memo. [sic, 1978] 978-426; Graham v.

Commissioner,   T.C. Memo. 1995-114 [1995 RIA TC Memo ¶95,114]; Jones v. Commissioner,   T.C. Memo. 1993-358 [1993 RIA TC Memo

¶93,358].

Consistent with Merlo v. Commissioner, supra, we conclude petitioners may not carry back their AMT capital losses to reduce their

AMTI in 2000. See Spitz v. Commissioner,   T.C. Memo. 2006-168 [TC Memo 2006-168].

VI. Whether Petitioners May Carry Back Net Operating Losses and Alternative Tax Net Operating Losses To Reduce Their AMTI for 2000

In a further attempt to carry back their AMT capital losses, petitioners assert their AMT capital losses entitle them to an ATNOL

deduction under  section 56. This, too, is an argument the Court rejected in Merlo v. Commissioner, supra.

A taxpayer normally may carry back a net operating loss (NOL) to the 2 taxable years preceding the loss, then forward to each of

the 20 taxable years following the loss. 16   Sec. 172(b)(1)(A).   Section 172(c) defines an NOL as “the excess of the deductions

allowed by this chapter over the gross income”, as modified under   section 172(d). In the case of a noncorporate taxpayer, the

amount deductible on account of capital losses shall not exceed the amount includable on account of capital gains.   Sec. 172(d)

(2)(A);   sec. 1.172-3(a)(2), Income Tax Regs. Consequently, the effect of  section 172(d)(2)(A) is that net capital losses are

excluded from the NOL computation. See, e.g., Parekh v. Commissioner,   T.C. Memo. 1998-151 [1998 RIA TC Memo ¶98,151]. In Merlo

v. Commissioner, supra, we stated in pertinent part:

For AMT purposes,   section 56(a)(4) provides that an ATNOL deduction shall be allowed in lieu of an NOL deduction under   section

172. An ATNOL deduction is defined as the NOL deduction allowable under   section 172 and is computed by taking into consideration

all the adjustments to [pg. 66] taxable income under   sections 56 and   58 and all the preference items under   section 57 (but

only to the extent that the preference items increased the NOL for the year for regular tax purposes).   Sec. 56(d)(1).
Petitioner's net regular capital loss is excluded from computing his NOL deduction. See   sec. 172(c), (d)(2)(A);   sec. 1.172-3

(a)(2), Income Tax Regs. For AMT purposes, petitioner's ATNOL is the same as his NOL, taking into consideration all the

adjustments to his taxable income under   sections 56,   57, and   58. See   ,   sec. 56(a)(4), (d)(1). No adjustments under those

sections modify the exclusion of net capital losses from the NOL computation under   section 172(d)(2)(A). Therefore, petitioner's

AMT capital loss is excluded for purposes of calculating his ATNOL deduction. As a result, petitioner's AMT capital loss realized

in 2001 does not create an ATNOL that can be carried back to 2000 under   sections 56 and   172(b).
Merlo v. Commissioner, supra at 212-213 (fn. ref. omitted).

Consistent with Merlo v. Commissioner, supra, we hold petitioners may not claim an ATNOL carryback to reduce their AMTI for 2000.

See Spitz v. Commissioner, supra.

VII. Whether Petitioners Are Liable for a Substantial Understatement Penalty Under   Section 6662(b)(2)

Respondent determined petitioners are liable for a substantial understatement penalty under   section 6662(b)(2). 17 Petitioners

assert (1) respondent's determination is invalid because respondent did not consider “standardized exception criteria” before

imposing the penalty, and (2) the penalty is inapplicable because petitioners acted in good faith and reasonably relied upon tax

professionals to prepare their tax return for 2000.

While the Commissioner bears the initial burden of production as to the accuracy-related penalty and must come forward with

sufficient evidence showing it is appropriate to impose the penalty, the taxpayer bears the burden of proof as to any exception to

the accuracy-related penalty. See   sec. 7491(c); Rule 142(a); Higbee v. Commissioner,   116 T.C. 438, 446-447 (2001). One such

exception to the accuracy-related penalty applies to any portion of an underpayment if the taxpayer can prove there was reasonable

cause for the taxpayer's position and the taxpayer acted in good faith with respect to that portion.   Sec. 6664(c)(1);   sec.

1.6664-4(b), Income Tax Regs. The determination of whether a taxpayer [pg. 67] acted with reasonable cause and in good faith

depends on the pertinent facts and circumstances, including the taxpayer's efforts to assess his or her proper tax liability, the

knowledge and experience of the taxpayer, and the reliance on the advice of a professional.   Sec. 1.6664-4(b)(1), Income Tax

Regs. When a taxpayer selects a competent tax adviser and supplies him or her with all relevant information, it is consistent with

ordinary business care and prudence to rely upon the adviser's professional judgment as to the taxpayer's tax obligations. United

States v. Boyle,   469 U.S. 241, 250-251 [55 AFTR 2d 85-1535] (1985). Moreover, a taxpayer who seeks the advice of an adviser does

not have to challenge the adviser's conclusions, seek a second opinion, or try to check the advice by reviewing the tax code

himself or herself. Id.

Petitioners received professional assistance in preparing their 2000 tax return. The return was prepared and signed by a

representative of Deloitte & Touche, and we are satisfied from a review of the return petitioners supplied the return preparer

with all relevant information. We likewise conclude petitioners relied on their return preparer to accurately and properly prepare

their return for 2000. We find nothing in the record to indicate it was unreasonable for petitioners to accept the advice of their

return preparer. Our holding sustaining respondent's determinations on the substantive issues in dispute does not, in and of

itself, require holding for respondent on the penalty. See Hitchins v. Commissioner,   103 T.C. 711, 719-720 (1994) (“Indeed, we

have specifically refused to impose *** [a penalty] where it appeared that the issue was one not previously considered by the

Court and the statutory language was not entirely clear.”). Considering that the complex issues underlying the deficiency in this

case had yet to be litigated at the time petitioners filed their return for 2000, we are persuaded petitioners had reasonable

cause and acted in good faith in reporting their stock option transactions. See, e.g., Williams v. Commissioner,   123 T.C. 144

(2004) (declining to impose a penalty involving an issue of first impression and the interrelationship between complex tax and

bankruptcy laws). Consequently, we hold petitioners are not liable for an accuracy- related penalty under   section 6662(b)(2) for

2000. [pg. 68]

To reflect the foregoing,

Decision will be entered pursuant to Rule 155.

1
  Unless otherwise indicated, section references are to the Internal Revenue Code, as amended, and Rule references are to the Tax

Court Rules of Practice and Procedure.
2
  The parties filed a stipulation of settled issues in which they agreed to the amounts of deductions petitioners are entitled to

claim for charitable contributions made during 2000.
3
  The Securities Exchange Act of 1934, ch. 404,   sec. 16(b), 48 Stat. 896, codified at 15 U.S.C. sec. 78p(b) (2000). For

convenience, all citations are to sections of the Securities Exchange Act of 1934.
4
  Although MGC Communications, Inc., was subsequently renamed Mpower Communications, Inc., we shall refer to the corporation as

MGC.
5
  Adjusted for MGC's August 2000 stock split, petitioner held options to purchase 645,000 shares of MGC common stock. See supra

Table 1.
6
  Petitioners' collection review case at docket No. 16864-02L was stayed pending the disposition of the instant case.
7
     Sec. 422(b) defines an incentive stock option (ISO) in pertinent part as an option granted to a taxpayer by an employer

corporation (or a parent or subsidiary corporation) to purchase stock of any such corporation but only if (1) the option is

granted pursuant to a plan which is approved by the stockholders of the granting corporation, (2) such option is granted within

the earlier of 10 years from the date such plan is adopted or approved by the stockholders, (3) such option is not exercisable

after 10 years from the date such option is granted, (4) the option price is not less than the fair market value of the stock at

the time such option is granted, (5) such option is not transferrable by the taxpayer other than by will or the laws of descent

and distribution and is exercisable during the taxpayer's lifetime only by the taxpayer, and (6) such taxpayer, at the time the

option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock

of the employer corporation or of its parent or subsidiary corporation.
8
     Sec. 424(c) provides that the term “disposition” as related to shares of stock acquired pursuant to the exercise of an ISO

generally means “a sale, exchange, gift, or a transfer of legal title”.
9
     Sec. 56(b)(3) further provides, however, that   sec. 422(c)(2) shall apply “in any case where the disposition and the

inclusion for *** this part are within the same taxable year and such section shall not apply in any other case.”
10
  For the sake of completeness, we observe the exercise of a stock option is treated as a purchase of the underlying security for

purposes of the insider reporting provisions under   section 16(a) of the Exchange Act. SEC rule 16a-1(b), 17 C.F.R.   sec.

240.16a-1(b) (2006) defines a “call equivalent position” as “a derivative security position that increases in value as the value

of the underlying equity increases, including, but not limited to, a long convertible security, a long call option, and a short

put option position.” SEC rule 16a-4(b), 17 C.F.R.   sec. 240.16a-4(b) (2006), provides that the exercise of a call equivalent

position shall be reported on Form 4 and treated for reporting purposes as (1) a purchase of the underlying security and (2) a

closing of the derivative security position.
11
  Petitioner contends   sec. 1.83-3(j)(1), Income Tax Regs., is invalid insofar as the regulation fails to acknowledge that the

period during which an insider may remain subject to suit under   sec. 16(b) of the Exchange Act may extend beyond the normal 6-

month period specified in that provision. Because we have rejected petitioner's argument that the period he was subject to a suit

under   sec. 16(b) of the Exchange Act extended beyond the 6-month period beginning with the dates his ISOs were granted, we need

not address petitioner's challenge to the validity of   sec. 1.83-3(j)(1), Income Tax Regs.
12
  Respondent determined the following shares were not eligible to be treated as having been transferred to petitioner pursuant to

ISOs: (1) 10,499 of the 22,500 shares that were the subject of option grant No. 2 dated Sept. 4, 1998; (2) all of the 45,000

shares that were the subject of option grant No. 3 dated Sept. 4, 1998; (3) 6,057 of the 15,000 shares that were the subject of

option grant No. 4 dated Mar. 1, 1999; and (4) all of the 22,500 shares that were the subject of option grant No. 5 dated Mar. 1,

1999.
13
  For married individuals filing separately, $3,000 is reduced to $1,500.   Sec. 1211(b)(1). If the excess of capital losses over

capital gains is less than $3,000 (or $1,500), then only that excess may be deducted.   Sec. 1211(b)(2).
14
  To avoid confusion between petitioner's capital losses, we shall refer to his capital losses for regular tax purposes as his

“regular capital losses”, and we shall refer to his capital loss for AMT purposes as his “AMT capital loss”.
15
  The effect of the capital loss limitations of   secs. 1211(b) and   1212(b) for regular tax purposes is not in issue and thus,

is not discussed in detail.
16
  In the case of NOLs incurred in 2001 or 2002,   sec. 172(b)(1)(H) creates a 5-year carryback. Petitioners argue they are

entitled to relief from the 5-year carryback. However, because we conclude infra that petitioners are not entitled to an ATNOL,

petitioners' argument is moot.
17
  There is a substantial understatement of tax if the amount of the understatement exceeds the greater of either 10 percent of the

tax required to be shown on the return, or $5,000.   ,   Sec. 6662(a), (b)(1) and (2), (d)(1)(A);   sec. 1.6662-4(a) and (b)(1),

Income Tax Regs. This threshold is satisfied in the instant case.


www.irstaxattorney.com 888-712-7690

.S. v. MAGGERT, Cite as 107 AFTR 2d 2011-XXXX, 05/31/2011

---

UNITED STATES OF AMERICA, Plaintiff-Appellee, v. MARK S. MAGGERT, Defendant-Appellant.

Case Information:

Code Sec(s):
Court Name:	IN THE UNITED STATES COURT OF APPEALS FOR THE ELEVENTH CIRCUIT,
Docket No.:	No. 10-14112 Non-Argument Calendar; D.C. Docket No. 5:09-cr-00044-WTH-GRJ-1,
Date Decided:	05/31/2011.
Disposition:

HEADNOTE

.
Reference(s):

OPINION

IN THE UNITED STATES COURT OF APPEALS FOR THE ELEVENTH CIRCUIT,
Appeal from the United States District Court for the Middle District of Florida
Before HULL, MARCUS and FAY, Circuit Judges.
Judge: PER CURIAM:
[DO NOT PUBLISH]
After a jury trial, Mark S. Maggert appeals his convictions and sentences for attempted tax evasion, in violation of 26 U.S.C. § 7201. After review, we affirm.

I. BACKGROUND FACTS

A. Offense Conduct

Maggert, a dentist, worked for several dental offices as an independent contractor. In 1998, Maggert and his wife attended a seminar by American Rights Litigators (“ARL”) and Eddie Kahn at which they were told they did not have to pay federal income tax. Maggert relayed this information to his accountant, who counseled Maggert against ARL's advice and ended their professional relationship when Maggert persisted. Maggert dissolved his professional association, Mark S. Maggert, D.D.S., P.A., and, from 1998 to 2005, did not file a federal tax return or pay federal income tax.
Beginning in 2002, Maggert instructed the accountants for the dental offices where he worked to make his paychecks payable to Total Business Systems, LLC, a Florida corporation, or to Mark's Word of Faith International, a Nevada corporation. The accountants complied and issued Form 1099s, using the corporate identification numbers for these organizations rather than Maggert's social security number. Maggert deposited the paychecks into accounts he opened in these organization's names and withdrew money from the accounts on a regular basis (over $40,000 in 2002, over $52,000 in 2003, $178,000 in 2004 and $128,000 in 2005, for a total of $398,600).
The articles of organization for Total Business Systems, LLC identified the managing member as Geneva Holdings, Inc., in Australia and the registered agent as Ronald Saltzer. The articles of organization were signed by Saltzer and Alan R. Horne, the “Director” of Geneva Holdings, Inc. Saltzer admitted that he knew nothing about Total Business Systems, LLC or Geneva Holdings, Inc., and had never met Maggert or Horne. Saltzer had agreed to act as the registered agent and sign the articles of incorporation in exchange for a meal provided by Eddie Kahn.
The articles of incorporation for Mark's Word of Faith International listed Maggert as the “Presiding Patriarch (Overseer).” Maggert's wife signed the articles of incorporation as a witness and “Scribe.” Maggert's wife admitted there was no such religious organization and that Maggert was not a spiritual leader or priest. ¹
Additionally, Maggert gave powers of attorney to two individuals associated with ARL, Bryan Malatesta, a certified public accountant, and Milton Baxley, an attorney. A former ARL employee testified that although she had seen Malatesta and Baxley at ARL once or twice between 1998 and 2003, they were never with clients and did not have office space at ARL.

B. Criminal Investigation

Michael Anderson, a special agent with the IRS Criminal Investigation Division, participated in an investigation of ARL and executed a search warrant at ARL's Florida business location. According to Agent Anderson, ARL maintained records for its “clients,” but did not have any tax accounting software or the documents a CPA would need to represent someone before the IRS. None of ARL's records indicated that either CPA Malatesta or attorney Baxley maintained a professional relationship with ARL's clients. Instead, ARL paid Malatesta and Baxley solely for the use of their names. ARL's correspondence sent to the IRS was generated by ARL employees.
From 1999 to 2005, the IRS sent Defendant Maggert letters advising him of his federal tax obligations, warning him of possible criminal sanctions and attempting to set up appointments to meet with Maggert. Through ARL, Maggert sent the IRS correspondence, often stamped with the signature of CPA Malatesta or attorney Baxley. That correspondence asserted that Maggert had no obligation to file a federal income tax return or pay federal income taxes and that the IRS did not have the authority to investigate or determine Maggert's tax liability.
Based on financial information from its investigation, the IRS computed Maggert's taxable income for the years 2002 to 2005 and calculated that Maggert owed the following federal income taxes: at least $51,538 in 2002; at least $50,316 in 2003; at least $101,570 in 2004 and at least $90,464 in 2005.

C. Trial Date Continued

A federal grand jury indicted Maggert on four counts of attempt to evade and defeat the federal income tax for the years 2002 through 2005. At his September 28, 2009 initial appearance, Maggert stated he planned to obtain counsel. When Maggert appeared without counsel at his October 16, 2009 arraignment, the district court gave Maggert two more weeks to find counsel.
At an October 30, 2009 hearing, Maggert still had not obtained counsel and indicated he wished to represent himself. The district court gave Maggert appropriate warnings about his decision and found that Maggert's decision to proceed pro se was knowing and voluntary. The district court appointed standby counsel that same day.
The district court originally set trial for January 11, 2010, but granted Maggert a 60-day continuance to hire counsel and prepare a defense. The district court reset trial for March 15, 2010. The district court warned Maggert that: (1) the trial date was firm, (2) no additional continuances would be granted and (3) if Maggert was unable to obtain counsel, he would be expected to proceed pro se on that date with the aid of standby counsel.
On March 15, 2010, Maggert failed to appear at trial. Standby counsel advised the court she had no contact with Maggert prior to trial. With the jury panel standing by, the district court issued a warrant for Maggert's arrest and recessed while the U.S. Marshal Service located Maggert that day.

D. Trial

Later that day, the parties selected a jury and gave opening statements. The next day, the government called its first witness, an IRS custodian of records. After the government finished its direct examination, Maggert informed the court that he wanted standby counsel to conduct cross-examination. The district court advised Maggert that he could either represent himself or standby counsel could represent him, but not both. After a short recess, Maggert decided to have standby counsel represent him.
Standby counsel then moved for a mistrial and for a continuance to allow her to consult with experts and prepare to defend Maggert. The district court denied both requests, and the trial recommenced. The jury convicted Maggert on all counts.

E. Sentencing

The presentence investigation report (“PSI”): (1) calculated Maggert's base offense level as 20, pursuant to U.S.S.G.  §§ 2T1.1(a)(1) and 2T4.1(H), based on a loss amount of more than $400,000 but less than $1 million; and (2) recommended a two-level sophisticated means enhancement, pursuant to U.S.S.G.  § 2T1.1(b)(2), because Maggert had attempted to hide assets or transactions from the IRS through the use of fictitious entities. With a total offense level of 22 and a criminal history category of II, the PSI recommended an advisory guidelines range of 46 to 57 months' imprisonment.
Maggert objected to, inter alia, the sophisticated means enhancement. Maggert argued that his use of corporate entities could not be considered “sophisticated” because he did not file fraudulent tax returns and the IRS easily determined his income from 1099s his employers issued and subpoened bank records.
At the sentencing hearing, the district court overruled Maggert's objection and applied the sophisticated means enhancement. The district court adopted the PSI's guidelines calculations and advisory guidelines range of 46 to 57 months. After considering the 18 U.S.C. § 3553(a) factors, the district court imposed a 42-month sentence. Maggert appealed.

II. DISCUSSION

A. Denial of Motion for Continuance

Maggert argues that the district court should have granted his request for a continuance on the second day of trial when his standby counsel began representing him. ² “Under certain circumstances, denial of a motion for continuance of trial may vitiate the effect of” the Sixth Amendment's right to counsel to such an extent that it results in a due process violation. United States v. Valladares, 544 F.3d 1257, 1262 (11th Cir. 2008). “To prevail on such a claim, a defendant must show that the denial of the motion for continuance was an abuse of discretion which resulted in specific substantial prejudice” by identifying “relevant, non-cumulative evidence that would have been presented if [the defendant's] request for a continuance had been granted.” Id. (quotation marks omitted).
Maggert has not shown an abuse of discretion resulting in specific substantial prejudice. The district court gave Maggert a two-month continuance (January 11 to March 15) and almost six months (September 28 to March 15) to prepare for trial or find counsel. Standby counsel was available for most of that time, but Maggert did not seek her assistance. When the district court granted Maggert's first continuance request, it warned Maggert that the new trial date was firm and no further continuances would be granted. Maggert let the trial begin without raising any concern and did not ask standby counsel to take over until the second day of trial.
More importantly, the record reflects that once standby counsel took over, she was able to cross-examine witnesses, object to evidence and offer objections to the jury instructions. And, Maggert has not pointed to any relevant, non-cumulative evidence he would have presented if his second continuance request had been granted. Under these circumstances, we find no abuse of discretion and no due process violation. ³

B. Jury Instruction on Elements of Attempted Tax Evasion

For the first time on appeal, Maggert contends the district court did not properly instruct the jury on the elements of a  § 7201 offense for attempted tax evasion.
At trial, the district court instructed the jury that the defendant could be found guilty of attempted tax evasion “only if all of the following facts are proved beyond a reasonable doubt: first, that the defendant owed substantial income tax upon income that was not declared in a tax return for the year in question and, second, that the defendant knowingly and willfully attempted to evade or defeat such tax.” The district court further instructed that “[t]he word “attempted” contemplates that the defendant had knowledge and an understanding that during the particular tax year involved he had income which was taxable and which he was required by law to report but that he, nevertheless, tried or endeavored -- that is, attempted -- to evade or defeat the tax or a substantial portion of the tax on that income by willfully failing to report all of the income which he knew he had during that year.”
Maggert argues, and the government concedes, that the district court omitted from its instruction that it was necessary to find an affirmative act of attempted evasion. See United States v. Kaiser,  893 F.2d 1300, 1305 [65 AFTR 2d 90-721] (11th Cir. 1999) (“The elements of tax evasion under  § 7201 are: (1) willfulness; (2) existence of a tax deficiency; and (3) an affirmative act constituting an evasion or attempted evasion of the tax.”). ⁴Because Maggert did not object to the jury instruction in the district court, however, our review is for plain error only. United States v. Felts, 579 F.3d 1341, 1343 (11th Cir. 2009). “Jury instructions will not be reversed for plain error unless the charge, considered as a whole, is so clearly erroneous as to result in a likelihood of a grave miscarriage of justice, or the error seriously affects the fairness, integrity, or public reputation of judicial proceedings.” United States v. Starke, 62 F.3d 1374, 1381 (11th Cir. 1995) (quotation marks omitted). The challenged jury instruction must “be a plainly incorrect statement of the law” and “probably responsible for an incorrect verdict, leading to substantial injustice,” such that it misled the jury or left the jury to speculate as to an essential point of law. United States v. Prather, 205 F.3d 1265, 1271 (11th Cir. 2000).
Maggert has not shown plain error. First, it is not clear under our precedent whether the district court's instruction even misstated the law. Although the district court's instruction did not explicitly state that an affirmative act of evasion was an element of the offense, the instruction as a whole conveyed to the jury that it was required to find that Maggert tried to evade paying income taxes by willfully failing to report that income on a tax return. This Circuit has not directly addressed whether the willful failure to report taxable income constitutes an affirmative act of evasion, and at least one former Fifth Circuit case suggests that it does. See United States v. Buckley,  586 F.2d 498, 504 [43 AFTR 2d 79-761] (5th Cir. 1978) (“Where one of the affirmative acts of evasion relied upon by the government in proving attempted tax evasion under the  Section 7201 is the failure to file an income tax return, failure to file [under  Section 7203] is a lesser included offense ....”). ⁵ Thus, the district court's instruction was not a plainly incorrect statement of the law.
Second, there was overwhelming evidence that Maggert committed numerous affirmative acts of evasion—creating two corporate entities, opening bank accounts in the name of those corporate entities, instructing his employers to issue his paychecks to those corporate entities, depositing those paychecks into the corporate entities' bank accounts and then withdrawing money from those accounts on a regular basis. Accordingly, we cannot say the district court's instruction on the elements of the attempted tax evasion was probably responsible for an incorrect verdict.

C. Jury Instruction on Good Faith Reliance on a Professional

Maggert also challenges the district court's refusal to give his requested jury instruction on good faith reliance on professional advice. ⁶ A defendant has a right to have the jury instructed on his theory of defense if there is “any foundation in the evidence.” United States v. Ruiz, 59 F.3d 1151, 1154 (11th Cir. 1995). Even under this extremely low evidentiary burden, however, the instruction must have “some basis in the evidence.” United States v. Hedges, 912 F.3d 1397, 1405 (11th Cir. 1990). A district court's refusal to give a requested jury instruction is reversible error if “(1) the requested instruction was substantively correct, (2) the court's charge to the jury did not cover the gist of the instruction, and (3) the failure to give the instruction substantially impaired the defendant's ability to present an effective defense.” United States v. Culver, 598 F.3d 740, 751 (11th Cir.), cert. denied, 131 S. Ct. 336 (2010).
The good faith reliance defense seeks to “refute the government's proof that the defendant intended to commit the offense.” United States v. Kottwitz, 614 F.3d 1241, 1271 [106 AFTR 2d 2010-5929] (11th Cir.), modified in part on rehearing by  627 F.3d 1383 [106 AFTR 2d 2010-7436] (11th Cir. 2010) (quotation marks omitted). To establish the defense, the defendant must show that he “(1) fully disclosed all relevant facts to the expert and (2) relied in good faith on the expert's advice.” Id.
Here, there was no evidence in the record that Maggert even spoke to Malatesta, Baxley or any other tax professional, much less sought and relied upon their advice. There also was no evidence that Maggert provided Malatesta, Baxley or any other tax professional at ARL the kind of information needed to furnish professional tax advice. The only evidence in the record indicated that Malatesta and Baxley did not maintain an office at ARL or meet with ARL's clients and were merely paid for the use of their names. Under the circumstances, the district court's refusal to give the requested good faith reliance instruction was not an abuse of discretion. ⁷

D. Sophisticated Means Enhancement

Under the advisory guidelines, the defendant's offense level is increased by two levels if the tax evasion offense used “sophisticated means.” U.S.S.G.  § 2T1.1(b)(2). The commentary defines “sophisticated means” as “especially complex or especially intricate offense conduct pertaining to the execution or concealment of an offense” and gives as an example hiding assets through the use of fictitious entities or corporate shells. U.S.S.G.  § 2T1.1, cmt. n.4.⁸
Here, the district court's application of the sophisticated means enhancement was not clear error. To facilitate his tax evasion scheme, Maggert set up two fictitious entities and used them to try to hide his income. Such conduct falls squarely within  § 2T1.1's definition of sophisticated means. That Maggert did not file a tax return and that the IRS ultimately was able to glean Maggert's true earnings from Form 1099s submitted by his employers has no bearing on whether his use of those corporate entities qualified under the advisory guidelines as sophisticated means. ⁹
For all of these reasons, we affirm Maggert's convictions and sentences.
AFFIRMED.

---

¹
  In 2004, Maggert formed a Nevada corporation also called Total Business Systems LLC. The articles of incorporation listed “Mark S. Maggert, DDS” with a Las Vegas address as the “manager.” A separate list of initial members also identified Maggert's wife as a manager and Mark's Word of Faith International as a member.

---

²
  Maggert's brief lists the denial of his motion for a mistrial in its statement of the issues, but fails to develop any argument regarding this issue. Therefore, we do not address the issue on appeal. See United States v. Jernigan, 341 F.3d 1273, 1283 n.8 (11th Cir. 2003) (explaining that an issue was abandoned where the defendant's brief made only “passing references” to the issue).

---

³
  To the extent Maggert argues that his trial counsel was ineffective, we decline to address this issue on direct appeal. See United States v. Bender, 290 F.3d 1279, 1284 (11th Cir. 2002) (explaining that generally we do not consider ineffective assistance of counsel claims on direct appeal where the district court did not address the claim and develop the factual record).

---

⁴
  The district court modified the Eleventh Circuit's Pattern Jury Instruction for tax evasion, which states the elements of the offense as: (1) the defendant owed substantial income tax in addition to the amount declared on the defendant's return, (2) the defendant knew when he filed his return that he owed the substantial amount of income tax, and (3) the defendant intended to evade paying the taxes he knew he was required to pay. 11th Cir. Pattern Jury Instruction 107.1. In other words, Pattern Jury Instruction 107.1 applies when the defendant filed a tax return that under-reported his taxable income, which in and of itself would constitute an affirmative act. See United States v. Uscinski,  369 F.3d 1243, 1247 [93 AFTR 2d 2004-2252] (11th Cir. 2004) (explaining that when the tax evasion involves the filing of a fraudulent tax return, the offense is complete upon filing of the return). Here, because Maggert did not file a tax return at all, the district court omitted any reference to the filing of a tax return.

---

⁵
  Decisions of the former Fifth Circuit on or before September 30, 1981 are binding precedent in the Eleventh Circuit. Bonner v. City of Prichard, 661 F.2d 1206, 1209 (11th Cir. 1981) (en banc).

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⁶
  “We review a district court's refusal to give a requested jury instruction for abuse of discretion.” United States v. Svete, 556 F.3d 1157, 1161 (11th Cir. 2009) (en banc).

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⁷
  Although the district court refused to instruct the jury on good faith reliance on a professional, it did instruct the jury that a defendant's good faith was a valid defense because good faith “is inconsistent with the element of willfulness which is an essential part of the charge.”

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⁸
  We review a district court's determination that a defendant used sophisticated means to accomplish tax evasion for clear error. United States v. Clarke, 562 F.3d 1158, 1165 [103 AFTR 2d 2009-1349] (11th Cir. 2009).

---

⁹
  On appeal, Maggert does not raise any other procedural sentencing error or argue that his ultimate sentence is substantively unreasonable.

  

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U.S. v. POOLE, Cite as 107 AFTR 2d 2011-2163, 05/11/2011 , Code Sec(s) 7206

UNITED STATES OF AMERICA, PLAINTIFF-APPELLEE v. Joseph POOLE, DEFENDANT-APPELLANT.
Case Information:

Code Sec(s): 7206
Court Name: U.S. Court of Appeals, Fourth Circuit,
Docket No.: No. 09-5128,
Date Decided: 05/11/2011.
Prior History: District Court, (2009, DC MD)   104 AFTR 2d 2009-5753, affirmed.
Disposition: Decision for Govt.
HEADNOTE

1. Tax crimes—assisting false returns preparation—evidence. Accountant's conviction for assisting in false returns preparation was affirmed: although erroneous and implicating accountant's constitutional rights, district court's improper references at discrete points during trial to accountant's clients/married couple's guilty pleas was merely trial vs. structural error and ultimately harmless when considering overwhelming evidence that accountant deliberately avoided learning that clients' returns contained materially false representations. His arguments to contrary or attempts to attack court's credibility determination regarding IRS agent/expert witness were rejected. Alternate argument that evidence was insufficient to show willfulness was also rejected when considering foregoing evidence and other indications of accountant's deliberate ignorance and willful blindness. Evidence included that he ignored significant discrepancies in clients' accounting and admitted knowing that clients were using co. credit cards for personal expenses.

Reference(s): ¶ 72,065.01(10) Code Sec. 7206

2. Tax crimes—conspiracy to defraud IRS. This issue wasn't discussed on appeal.

Reference(s): ¶ 73,447.507(35)

OPINION

ARGUED: Gregory Wayne Gardner, LAW OFFICES OF GREGORY W. GARDNER, PLLC, Washington, D.C., for Appellant. Jonathan Biran, OFFICE OF THE UNITED STATES ATTORNEY, Baltimore, Maryland, for Appellee. ON BRIEF: Kenneth E. McPherson, Riverdale, Maryland, for Appellant. Rod J. Rosenstein, United States Attorney, Stephen M. Schenning, Assistant United States Attorney, OFFICE OF THE UNITED STATES ATTORNEY, Baltimore, Maryland, for Appellee.

UNITED STATES COURT OF APPEALS FOR THE FOURTH CIRCUIT,

Appeal from the United States District Court for the District of Maryland, at Baltimore. Richard D. Bennett, District Judge. (1:08-cr-00098-RDB-2)

Before KING, DAVIS, and KEENAN, Circuit Judges.

OPINION

Judge: KEENAN, Circuit Judge:

PUBLISHED

Affirmed by published opinion. Judge Keenan wrote the opinion, in which Judge King and Judge Davis joined.

Joseph Poole appeals from a judgment entered after a bench trial, in which the district court found him guilty of four counts of aiding in the preparation of false tax returns in violation of 26 U.S.C.   § 7206(2). To obtain these convictions under   § 7206(2), the government was required to prove that Poole willfully aided, assisted, or otherwise caused the preparation of a tax return that was fraudulent or false with regard to a material matter. See United States v. Hayes,   322 F.3d 792, 797 [91 AFTR 2d 2003-1324] (4th Cir. 2003); United States v. Aramony,   88 F.3d 1369, 1382 [78 AFTR 2d 96-5738] (4th Cir. 1996).

Poole makes three principal arguments in his challenge to his convictions: 1) the district court unlawfully based its verdict on the guilty pleas of his co-defendants, which were not evidence in the case, thereby depriving Poole of his due process right to a fair trial; 2) the district court improperly credited testimony by the government's key witness that Poole contends was false; and 3) the evidence was insufficient to prove that Poole knew that the tax returns he prepared were fraudulent, and that he acted willfully in violation of   § 7206(2). We conclude that these arguments are without merit, and we affirm the district court's judgment.

I.

Between 1998 and 2003, Poole worked as an accountant for Bay Area Accounting & Management, an accounting firm owned by Poole's wife. In his capacity as an accountant, Poole provided accounting services to Fidelity Home [pg. 2011-2164] Mortgage Corporation (Fidelity Home), a mortgage brokerage firm with headquarters located in Baltimore, Maryland. Stilianos Mavroulis was the sole shareholder of Fidelity Home, and his son, Kyriakos Mavroulis, was the supervisor of the company's accounting department.

During the years in question, Poole prepared various financial documents for Fidelity Home. These documents included year-end financial statements and informational tax returns that were filed with the Internal Revenue Service (IRS). Poole also prepared personal financial statements for Stilianos Mavroulis, and joint income tax returns for Stilianos Mavroulis and his wife.

In 2003, the IRS received information from a former employee of Fidelity Home that Stilianos Mavroulis may have been filing fraudulent income tax returns. Following an investigation by the IRS, a federal grand jury returned an indictment charging Stilianos Mavroulis, Kyriakos Mavroulis (collectively, the Mavroulises), and Poole with conspiracy to defraud the United States, in violation of 18 U.S.C. § 371. The Mavroulises also were charged with filing fraudulent tax returns, in violation of 26 U.S.C.   § 7206(1). The indictment separately charged Poole with four counts of aiding and assisting in the preparation of false tax returns, in violation of   § 7206(2).

On the defendants' motion, the district court severed the trial of the Mavroulises from the proceedings against Poole. Stilianos Mavroulis later pleaded guilty to one count of filing false tax returns, and Kyriakos Mavroulis pleaded guilty under a superseding indictment to one count of willfully failing to file an income tax return, in violation of 26 U.S.C.   § 7203. In a separate proceeding before the same district court judge, Poole entered a plea of not guilty.

The case proceeded to a bench trial, in which the government sought to prove that Poole conspired with Stilianos Mavroulis (Mavroulis) in preparing false income tax returns that materially underreported Mavroulis's taxable income from Fidelity Home. The district court acquitted Poole of the conspiracy charge, but found him guilty of the four counts of aiding in the preparation of false tax returns. Poole later filed motions for a judgment of acquittal under Federal Rule of Criminal Procedure 29, and for a new trial pursuant to Rule 33. The district court denied these motions, and sentenced Poole on the four counts to a total term of two years' imprisonment and to one year of supervised release.

II.

A.

[1] We first consider Poole's argument that the district court erroneously based its judgment on the Mavroulises' guilty pleas, which were not admitted into evidence. Poole relies primarily on three references that the district court made to the pleas during the trial and in the court's memorandum opinion.

We consider these statements by the district court in the context in which they were made. During the government's case-in-chief, the district court interrupted Poole's counsel as he cross-examined the government's key witness, IRS Agent Richard Wallace. The district court suggested that Poole's counsel spend less time eliciting from Agent Wallace the details of the tax returns at issue, stating:

I just want to make sure we stay focused on what the issues are. Stanley Mavroulis has pled guilty. Kirk Mavroulis has pled guilty .... The issue is the knowledge and intent of Mr. Poole with respect to whether he knowingly aided and abetted the filing of false tax returns and whether or not he engaged in a conspiracy. And so to the extent we're going to spend a great deal of time trying to justify the particular tax returns, it's fine up to — it's certainly important in terms of the understanding that someone has when they're looking at the return. But my point is that the Mavroulises are not on trial here right now and the issue is not the matter of the legitimacy of all these tax returns. [They] pled guilty to tax offenses with respect to these returns . So I'm just trying to make sure we stay focused.... I'm not trying to limit [the cross-examination] in terms of ... attacking or trying to support and justify all the tax returns. But ... if you want to try to establish that all these returns were perfectly legitimate and that no wrong doing was undertaken, then that's certainly contrary to what I've got in these other co-defendant cases. (emphases added.)
The second statement by the court occurred after the government rested its case and Poole filed a motion for a judgment of acquittal. During a hearing on that motion, counsel for Poole argued that although the government had presented a strong case against Mavroulis, there was insufficient evidence to support a conviction of Poole. The district court interjected, suggesting that counsel did not need to evaluate the strength of the government's case against Mavroulis because he had “already pled guilty.”

The third reference relied on by Poole occurred in footnote three of the district court's [pg. 2011-2165] memorandum opinion. There, the district court stated that to the extent Poole claimed that the tax returns at issue did not violate federal tax laws, that defense was “belied” by Agent Wallace's testimony and “by the simple fact that Stilianos Mavroulis had pled guilty on the advice of his attorneys to four separate counts of filing tax returns in violation of 26 U.S.C.   § 7206(1).” The district court made a substantially similar statement when it announced its verdict in open court. 1

Poole asserts that these statements by the district court demonstrate that the district court “prejudged” the issue of the falsity of the tax returns and the willful nature of Poole's conduct, thereby effectively relieving the government of its burden to prove these elements of   § 7206(2) beyond a reasonable doubt and denying Poole his due process right to a fair trial. 2 As an example of this alleged bias, Poole argues that the district court mistakenly thought that Mavroulis pleaded guilty to four counts of tax fraud, and was influenced by that factual error in finding Poole guilty “by association” of four counts of aiding in the preparation of false tax returns.

B.

Before we consider the merits of these arguments, we must resolve the parties' dispute regarding the proper standard for our appellate review. At the outset, we observe that the district court's comments constitute error, because the court apparently gave some consideration to matters that were not in evidence in the case. When a district court commits an evidentiary error, even one that implicates a defendant's constitutional rights, we ordinarily review that error for harmlessness. Chapman v. California, 386 U.S. 18, 24 (1967); Bauberger v. Haynes, 632 F.3d 100, 104 (4th Cir. 2011). Poole maintains, however, that harmless error review is inappropriate in this case. He contends that the district court's repeated references to the Mavroulises' guilty pleas demonstrate that the error in this case affected the entire course of his trial, from beginning to end, depriving him of his due process right to a fair trial. Thus, Poole asserts, the district court's alleged reliance on the pleas, which were not admitted into evidence, constitutes “structural” error, requiring automatic reversal of his conviction of the four charges.

To warrant such automatic reversal as “structural” error, however, an error must implicate a defendant's constitutional rights and affect the very framework in which a trial proceeds. See Neder v. United States,   527 U.S. 1, 8–9 [83 AFTR 2d 99-2668] (1999); Arizona v. Fulminante, 499 U.S. 279, 310 (1991); United States v. Higgs, 353 F.3d 281, 304–305 (4th Cir. 2003); United States v. Curbelo, 343 F.3d 273, 278, 285 (4th Cir. 2003); United States v. Blevins, 960 F.2d 1252, 1262 (4th Cir. 1992). The Supreme Court has described structural errors as “defects in the constitution of the trial mechanism [that] defy analysis by “harmless-error” standards,” because those defects are “necessarily unquantifiable and indeterminate.” Sullivan v. Louisiana, 508 U.S. 275, 281–82 (1993) (quoting Fulminante, 499 U.S. at 309)); Curbelo, 343 F.3d at 278, 285.

The Supreme Court has found structural error in only a very limited class of cases involving errors that affect constitutional rights and that are so intrinsically harmful to the proceeding that the errors render the trial an unreliable vehicle for determining innocence or guilt. See Tumey v. Ohio, 273 U.S. 510, 535 (1927) (biased trial judge); Vasquez v. Hillery, 474 U.S. 254, 263–64 (1986) (racial discrimination in selection of grand jury); McKaskle v. Wiggins, 465 U.S. 168, 177 (1984) (denial of self-representation at trial); Sullivan, 508 U.S. at 281–82 (defective reasonable-doubt instruction). Thus, the vast majority of constitutional errors are not structural, but are “trial errors” that are subject to harmless error review.

We explained the difference between structural and trial errors in United States v. Blevins, a case involving a jury trial. In that case, the district court allowed the introduction into evidence of guilty pleas entered by non-testifying codefendants. 960 F.2d at 1261. On appeal, this Court assumed that the defendant timely objected to this evidence and concluded that although the district court's error was of “constitutional dimension,” it was not a structural error, because the error did not affect the “entire conduct of the trial from beginning to end.” Id. at 1262. We held instead that the district court's improper admission of the guilty pleas into evidence was a “trial error” subject to harmless error review, because the error “occurred during the presentation of the case to the jury [and could] be quantitatively assessed in the context of other evidence presented in order to determine whether [the admission] was harmless beyond a reasonable doubt.” Id. [pg. 2011-2166]

We will assume, without deciding, that the district court's repeated references to the guilty pleas implicated Poole's constitutional rights. Nevertheless, we hold that the district court's error is a classic example of a trial error subject to harmless error review. The effect of the district court's statements about the Mavroulises' guilty pleas, which occurred at various discrete times during the presentation of the case and in the court's memorandum opinion, can be measured against the other evidence that was properly admitted during the trial. See id. at 1262. Thus, we disagree with Poole's contentions that the cumulative effect of the error renders it “structural” in nature, and that the repetition of the remarks demonstrates bias on the part of the district court. The repetition of this error does not change its fundamental nature, because we can still evaluate its impact along with the properly admitted evidence in the case. See id. at 1263.

C.

Having rejected Poole's claim of structural error, we apply harmless error review to the district court's several references to the guilty pleas by the Mavroulises. Id. at 1262. Accordingly, we determine whether the impact of the references to those pleas was harmless beyond a reasonable doubt, such that it is clear that a rational fact finder would have found Poole guilty absent the error. Chapman, 386 U.S. at 24.

Relying on our prior decisions involving jury trials, Poole contends that the district court's references to the Mavroulises' guilty pleas were presumptively prejudicial. These decisions, however, are inapposite to the consideration of such error in the context of a bench trial. As we explained in Blevins, when a defendant is tried by a jury, there are two dangers inherent in a jury being permitted to consider a guilty plea of a co-defendant who does not testify. A defendant in such a case cannot probe the motivations for the guilty plea through cross-examination, and a reviewing court cannot be certain that a conviction rests on an assessment of the defendant's own culpability rather than the disposition of the charges against the co-defendant. Blevins, 960 F.2d at 1260.

In contrast, when a district court finds a defendant guilty after a bench trial, appellate courts generally presume that the conviction rested only on admissible evidence. See United States v. Smith, 390 F.2d 420, 422 n.2 (4th Cir. 1968) (ordinary presumption in non-jury cases is that trial judge relied only on the evidence that properly was admitted); United States v. Cardenas, 9 F.3d 1139, 1156 (5th Cir. 1993) (judge, sitting as a trier of fact, is presumed to have rested decision only on admissible evidence and to have disregarded inadmissible evidence). Moreover, in the present case, the district court addressed Poole's challenge to footnote three of the memorandum opinion during post-trial proceedings and expressly disavowed any reliance on Mavroulis's plea, stating that “[the] plea had no effect at all” on the court's judgment. (emphasis added.)

In the post-trial proceedings, the district court further explained that its judgment rested solely on the government's “overwhelming” evidence that the tax forms prepared by Poole failed to report portions of Mavroulis's taxable income. The district court also stated that it rejected Poole's defense that he was merely incompetent, rather than willful, and found that Poole deliberately avoided learning that the financial records provided to him by the Mavroulises were materially false.

We agree with the district court's characterization of the evidence in this case as “overwhelming.” As discussed in greater detail below, the various financial documents prepared by Poole contained large discrepancies, supporting a conclusion that Poole deliberately avoided learning of materially false representations in Mavroulis's income tax returns. For example, in 2001, Poole prepared both an informational tax return for Fidelity Home indicating that the business paid $120,000 in compensation to Mavroulis, and a personal income tax return for Mavroulis that resulted in Mavroulis receiving an “earned income tax credit,” a credit available to individuals earning low wages. Therefore, based on our review of the record, including the district court's explanation of the bases for its judgment, we conclude that the district court's various references to the Mavroulises' guilty pleas did not contribute to the verdict and, accordingly, were harmless beyond a reasonable doubt. See Chapman, 386 U.S. at 24; see also Eplus Tech., Inc. v. Aboud, 313 F.3d 166, 178 (4th Cir. 2002).

III.

We next address Poole's claim that the district court erred in crediting certain “objectively flawed” testimony by Agent Wallace, who was qualified by the district court as an expert witness in forensic accounting and income tax computation. Poole maintains that Agent Wallace did not understand “passive-loss” rules for related-party transactions, and that he failed to consider the impact of certain deductions on the calculation of Mavroulis's personal tax liability. Based on these al [pg. 2011-2167] leged mistakes, Poole contends that Agent Wallace's testimony was too unreliable to be considered as evidence of Poole's guilt.

Practically speaking, however, Poole asks us to accept his own calculations of Mavroulis's tax liability in place of the numbers and conclusions drawn by Agent Wallace. We decline Poole's request, because it effectively asks us to reverse a credibility determination by the district court and to reweigh the evidence presented at trial.

In qualifying Agent Wallace as an expert witness, the district court determined that his testimony was the product of reliable principles and methods. See Fed. R. Evid. 702. Moreover, any purported factual mistakes by Agent Wallace or alleged weaknesses in his methodology were subject to cross-examination at trial. Based on the questions posed by Poole's counsel on cross-examination, the district court was aware of the asserted problems regarding Agent Wallace's testimony, and nonetheless accepted that testimony as credible and reliable. We defer to this credibility determination by the district court. United States v. Abu Ali, 528 F.3d 210, 232 (4th Cir. 2008); see United States v. Murray, 65 F.3d 1161, 1169 (4th Cir. 1995).

IV.

Poole next argues that the government failed to prove that he acted willfully, and with knowledge that the tax forms he prepared contained materially false information. 3 We consider this argument under an established standard of review. In examining the sufficiency of the evidence supporting a conviction, an appellate court must affirm the district court's judgment if “any rational trier of fact could have found the essential elements of the crime beyond a reasonable doubt.” United States v. Madrigal-Valadez, 561 F.3d 370, 374 (4th Cir. 2009) (quoting Jackson v. Virginia, 443 U.S. 307, 319 (1979)). This standard is met when there is “substantial evidence” in the record, viewed in the light most favorable to the government, to support the district court's judgment. Id.

Generally, in criminal prosecutions, the government elects to establish a defendant's guilty knowledge by either of two different means. The government may show that a defendant actually was aware of a particular fact or circumstance, or that the defendant knew of a high probability that a fact or circumstance existed and deliberately sought to avoid confirming that suspicion. See United States v. Ruhe, 191 F.3d 376, 384 (4th Cir. 1999); United States v. Abbas, 74 F.3d 506, 513 (4th Cir. 1996).

Under this second method of proof, in a criminal tax prosecution, evidence establishing a defendant's “willful blindness” constitutes proof of his subjective state of mind, thereby satisfying the scienter requirement of knowledge. United States v. Stadmauer,   620 F.3d 238, 235 [106 AFTR 2d 2010-6206] (3d Cir. 2010); United States v. Bussey,   942 F.2d 1241, 1246 [68 AFTR 2d 91-5405] (8th Cir. 1991). Thus, in a criminal tax prosecution, when the evidence supports an inference that a defendant was subjectively aware of a high probability of the existence of a tax liability, and purposefully avoided learning the facts pointing to such liability, the trier of fact may find that the defendant exhibited “willful blindness” satisfying the scienter requirement of knowledge. United States v. Anthony,   545 F.3d 60, 64 [102 AFTR 2d 2008-6745] (1st Cir. 2008); United States v. Wisenbaker,   14 F.3d 1022, 1027 [73 AFTR 2d 94-1309] (5th Cir. 1994); United States v. Hauert,   40 F.3d 197, 203 [74 AFTR 2d 94-7004] n.7 (7th Cir. 1994); Bussey, 942 F.2d at 1246.

The rationale supporting the principle of “willful blindness” is that intentional ignorance and actual knowledge are equally culpable under the law. See Stadmauer,   620 F.2d at 255 [45 AFTR 2d 80-1791]; United States v. Jewell, 532 F.2d 697, 700 (9th Cir. 1975). Intentional ignorance reflects a state of mind that extends beyond any form of mere negligence, or even recklessness. United States v. Guay, 108 F.3d 545, 551 (4th Cir. 1997) (“This circuit approves willful blindness instructions when the jury is not permitted to infer guilty knowledge from a mere showing of careless disregard or mistake.”); see also United States v. Wertz-Ruiz, 228 F.3d 250, 255 (3d Cir. 2000); Wisenbaker, 14 F.3d at 1027.

Poole asserts that the government failed to prove either actual or constructive knowledge in the present case. He maintains that the evidence demonstrated that he reasonably relied on the financial data provided by the Mavroulises, and that this reliance insulated him from criminal liability for the four offenses at issue. After reviewing the extensive evidence before us, we disagree with Poole's arguments.

The evidence at trial showed that in 1998, Poole instructed the Mavroulises regarding the proper use of a computer software program for [pg. 2011-2168] bookkeeping. Poole testified that, as part of this training, he advised the Mavroulises to classify any withdrawals of funds from Fidelity Home for personal use as “shareholder draws,” to indicate funds withdrawn by an owner with accumulated equity in the business. 4 Thereafter, according to Poole, he generally relied on the Mavroulises and their staff to record and properly classify the income and expenses of the business, including any withdrawals of funds from Fidelity Home by the Mavroulises for their personal use.

Agent Wallace testified, however, that in practice, the tax returns prepared by Poole from 1999 to 2003 so greatly underreported Mavroulis's taxable income that Mavroulis owed an additional $476,000 in federal income taxes for those tax years. According to Agent Wallace, over the tax years in question, Mavroulis withdrew more than $1,000,000 from Fidelity Home accounts for personal use. These funds were used to make school tuition payments for Mavroulis's children, to pay company credit card bills that included personal purchases, to make personal insurance payments, and to fund a personal “E-Trade” account. Agent Wallace also testified that in 2003, the sum of $98,000 was transferred to Fidelity Promotions, LLC, a music production company owned by Mavroulis and his wife. Agent Wallace explained that this payment to Fidelity Promotions was not an expense incurred by Fidelity Home and, therefore, the amount of the transferred funds should have been listed on Mavroulis's tax return as taxable personal income. Additionally, Agent Wallace testified that the “shareholder draws” shown on the ledger account included withdrawals to compensate certain of Mavroulis's children who performed work for Fidelity Home but were not listed on the company's payroll.

Agent Wallace testified that in calculating Fidelity Home's tax liability, Poole incorrectly deducted many of these personal expenses as business expenses. These improper deductions had the effect of reducing the income of Fidelity Home, which otherwise would have “passed through” to Mavroulis creating a personal tax liability. Further, according to Agent Wallace, Poole was required to treat personal expenses, which were classified by Fidelity Home as “shareholder draws,” as taxable capital gains distributions to Mavroulis who at that time had a negative tax basis in the corporation.

Poole conceded that he knew when he prepared Fidelity Home's informational tax returns that Mavroulis was using company credit cards for personal expenses and taking “shareholder draws” from Fidelity Home. However, Poole also testified that he mistakenly thought that in taking “shareholder draws” Mavroulis merely was recouping $20,000,000 in equity, which Poole thought Mavroulis retained in Fidelity Home because Mavroulis personally had guaranteed certain lines of credit for Fidelity Home in that amount. Poole further stated that he did not review Fidelity Home's ledger accounts to ensure that its accounting staff were properly classifying individual transactions.

Poole also testified that at the time he prepared the tax returns in question, he applied partnership rules for calculating Mavroulis's tax basis in Fidelity Home when he should have applied rules applicable to Subchapter S corporations. According to Poole, he did not learn of this mistake until an IRS agent brought the matter to his attention.

Agent Wallace testified that on the 2001 income tax return prepared by Poole for Fidelity Home, the company claimed a deduction of $120,000 for officer compensation. This deduction reduced the corporation's profits by $120,000 and, in turn, reduced the corporate income that should have “passed through” to Mavroulis. As noted above, however, in that same year, Poole prepared a Form 1040 personal income tax return for Mavroulis that failed to include the $120,000 as income and that, in fact, resulted in Mavroulis receiving an “earned income tax credit.” Poole testified at trial that the omission of the $120,000 from Mavroulis's personal income tax return was a “regrettabl[e] mistake.”

Poole prepared all the financial forms at issue. He had access to all the financial data recorded and classified by the Fidelity Home staff. Considering the evidence described above, we hold that a reasonable trier of fact could conclude that Poole purposefully “closed his eyes to” large accounting discrepancies, which strongly indicated that the tax forms he prepared during the years in question contained materially false financial information. Accordingly, we affirm Poole's convictions on the four counts of tax fraud because they are supported by substantial evidence. See Madrigal-Valadez, 561 F.3d at 374. [pg. 2011-2169]

V.

In conclusion, we hold that the district court's erroneous references to the unadmitted guilty pleas of his co-defendants constituted harmless error. We also hold that the district court did not err in its consideration of Agent Wallace's testimony, and that the evidence was sufficient to support Poole's conviction. Accordingly, we affirm the district court's judgment.

AFFIRMED

1
  We observe that the district court also referenced the guilty pleas by the Mavroulises in reciting the procedural history of the case in its memorandum opinion.
2
  Poole contemporaneously objected through his post-trial motions to footnote three of the memorandum opinion. Although he did not challenge specifically the district court's oral remarks about the Mavroulises' pleas until this appeal, we conclude for purposes of the appeal that his objections are preserved because the issue of the district court's reliance on the pleas was plainly before the district court.
3
  In his statement of the issues presented, Poole assigns error to the district court “applying the concept of “willful blindness” to satisfy the mens rea element necessary to find ... Poole guilty.” The remainder of Poole's opening brief, however, contains a more general challenge to the sufficiency of the evidence supporting the district court's findings of knowledge and willfulness in this case. We consider Poole's argument as developed in his brief.
4
  Fidelity Home is a “Subchapter S” corporation. Such corporations, authorized under 26 U.S.C.                                      §§ 1361–79, are not required to pay federal income taxes. 26 U.S.C.   § 1363. Instead, shareholders of the corporation report their pro rata share of the corporation's income and losses on their personal income tax returns, and are assessed tax based on their individual income tax rates. See 26 U.S.C.   § 1366. Subchapter S corporations report corporate income, losses, deductions, and credits to the IRS using Form 1120S.
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Lloyd T. Asbury v. Commissioner, TC Memo 2011-107 , Code Sec(s) 61; 67; 165; 301; 316; 6651; 6654.

LLOYD T. ASBURY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information:
Code Sec(s): 61; 67; 165; 301; 316; 6651; 6654
Docket: Docket No. 18443-05.
Date Issued: 05/23/2011
Judge: Opinion by GOEKE
HEADNOTE

XX.

Reference(s): Code Sec. 61 ; Code Sec. 67 ; Code Sec. 165 ; Code Sec. 301 ; Code Sec. 316 ; Code Sec. 6651 ; Code Sec. 6654

Syllabus

Official Tax Court Syllabus

Counsel

Lloyd T. Asbury, pro se.
Miriam C. Dillard, for respondent.

Opinion by GOEKE

MEMORANDUM FINDINGS OF FACT AND OPINION

Respondent determined the following income tax deficiencies and additions to tax under   sections 6651(f) 1 and (a)(2) and 6654 for the years 1997 through 2002:

Additions to Tax Year Deficiency   Sec. 6651(f)   Sec. 6651(a)(2)   Sec. 6654 1 2 1997 $66,397 $48,138 $16,599 -0- 1998 117,590 85,253 29,398 $5,381 1999 88,408 64,096 22,102 4,279 2000 101,846 73,838 25,462 5,440 2001 82,410 59,747 20,603 3,293 2002 66,358 48,110 33,179 2,217

Petitioner, a decorated military hero, was a successful tax lawyer during the years in question whose life unraveled as the result of a gambling problem. The present case is, it is hoped, the last chapter in the resulting series of negative repercussions to petitioner.

After concessions made, 2 the issues for decision are:

(1) Whether petitioner failed to report dividends from his incorporated law practice for tax years 1997 through 2002. We hold that he did;

(2) whether petitioner is entitled to additional itemized deductions. We hold that he is;

(3) whether petitioner is liable for the addition to tax under   section 6651(f) for failure to file returns for 1997 through 2002. We hold that he is;

(4) whether petitioner is liable for the addition to tax under   section 6651(a)(2) for 1997 through 2002 for failure to pay. We hold that he is; and

(5) whether petitioner is liable for the addition to tax under   section 6654 for failure to make estimated payments for tax years 1998 through 2002. We hold that he is.

FINDINGS OF FACT

Petitioner resided in Florida when the petition was filed. Petitioner graduated from the United States Military Academy at West Point in June 1963 and began an illustrious military career that lasted more than 10 years. He received, among other decorations, the Silver Star and the Purple Heart for service in Vietnam.

A.      Postmilitary Legal Career
Petitioner obtained several postgraduate degrees after serving in Vietnam. In May 1971 he completed a master's program in Paris, France, through Middlebury College. Petitioner was subsequently assigned to serve on the staff and faculty at West Point. During this assignment petitioner earned an M.B.A. in accounting and taxation at Fairleigh Dickinson University. In April 1976 petitioner resigned from the Army and entered law school at the University of Florida. In 1978 he completed his law degree and was admitted to the Florida Bar and began practicing in Jacksonville, Florida. Petitioner was admitted to practice before this Court in 1979.

Petitioner had immediate success as an attorney. His practice focused on taxation, estates, trusts, probate, and corporate law. He served as chairman of the Tax Section of the Jacksonville Bar Association in 1984 and 1985. After working for several years with a partner, he opened a solo practice in 1986.

Petitioner's financial troubles began after he started his solo practice. He developed relationships with several clients who traveled regularly to Las Vegas to gamble. Petitioner began traveling every 6 weeks for gambling junkets. As substantial gambling losses accrued, petitioner's gambling habits affected other business decisions. Petitioner relied on credit to cover his gambling losses, pursued high-risk investments, and mismanaged client funds.

During the years at issue, petitioner maintained four bank accounts at First Guaranty Bank. He maintained a personal account under the name Lloyd T. Asbury or Elizabeth F. Asbury, his then wife. 3 He also maintained an operating account, a payroll account, and a client trust account for the law firm under the name Lloyd T. Asbury Attorney at Law PA. Petitioner also maintained two investment accounts at Paine Webber: One in the name of Lloyd T. Asbury Revocable Trust, FBO, and the other in the names of Elizabeth F. Asbury and Lloyd T. Asbury, JTWROS.

Petitioner regularly commingled client trust account funds with funds from other law firm accounts. He did not keep a separate file for each client transaction, and he did not reconcile accounts as required by the Florida Bar. He frequently shifted funds between his law firm accounts and personal accounts.

Petitioner was the only person with control over the law firm's client trust account. In 2001 the Florida Bar Association investigated petitioner's records relating to funds held in trust for his clients. Petitioner was unable to provide proper records to the Florida Bar, and his membership was suspended in November 2001. Petitioner resigned from the Florida Bar in January 2003.

On September 14, 2004, petitioner pleaded guilty to one count of the first degree felony of grand theft under Fla. Stat. Ann. sec. 812.014(2)(a)1., in connection with the mismanagement of client funds. On December 17, 2004, he was sentenced to 5 years' incarceration, 10 years' probation, 1,000 hours of community service, and a restitution payment of $357,000 to his clients. On March 2, 2005, petitioner began his period of incarceration; on March 11, 2009, he was released. B. IRS Adjustments On June 30, 2005, respondent issued a notice of deficiency to petitioner for tax years 1997 through 2002 while petitioner was still incarcerated. Petitioner neither filed individual Federal income tax returns for 1997 through 2002 nor made any estimated tax payments. In addition, petitioner failed to file corporate Federal income tax returns for his corporation Lloyd T. Asbury Attorney at Law PA for the years 1998 through 2002. 4 Respondent prepared substitutes for returns (SFRs) under   section 6020(b) for tax years 1997 through 2002. Respondent determined that petitioner failed to report the following dividends from the law firm:

Dividends

Year

1997 $203,333

1998 330,367

1999 256,165

2000 273,341

2001 239,152

2002 166,541

Petitioner also received income from interest; from dividends received from sources other than the law firm; from an S corporation in which he was a shareholder; from a distribution from his pension account; and from gambling winnings.

Respondent summoned petitioner's personal bank records and the bank records from his law practice in determining his income. Respondent used the specific-item method to compute this income. Respondent counted as income the amounts of checks that were written to petitioner and deposited into his personal bank account, from his law firm's client trust account, or from his law firm's operating account. Respondent also included as income payments made to petitioner's family members, payments made on an obligation relating to petitioner's personal residence, and income reported by third-party payors. Most of petitioner's income is from checks written directly to him. Respondent refers to the income petitioner received from his law practice and through other sources as constructive dividends.

On October 3, 2005, petitioner timely petitioned this Court for redetermination of the deficiencies and additions to tax for the taxable years 1997 through 2002.

OPINION

Petitioner bears the burden of proving by a preponderance of evidence that respondent's income tax deficiency determinations in the notice of deficiency are incorrect. See   sec. 7491(c); Rule 142(a)(1); Welch v. Helvering,   290 U.S. 111, 115 [12 AFTR 1456] (1933).

Petitioner acknowledged that he failed to file tax returns and to pay taxes, including estimated taxes, for the years at issue. He filed requests for extensions of time to file tax returns for years 1997 through 2000 without payment, except for tax years 1998 and 2000 when he made a payment of $100 for each year. He stipulated that he received dividends from his law practice and from other sources for the years at issue. He stipulated that he earned interest income for all years at issue and received a premature distribution from his pension account for 1998. Finally, petitioner stipulated that he received income from an S corporation from 2000 through 2002 and from gambling winnings in 1999, 2000, and 2002. Nevertheless, petitioner argues that he lacked the intent to evade taxes.

Petitioner also contests the inclusion in income of certain amounts he deposited into and then withdrew from his law firm's client trust and operating accounts. Although petitioner admits that he wrongly deposited the funds into his law firm accounts, he argues that the funds originated from nontaxable sources. Petitioner testified to the specific instances where he alleges respondent wrongly included in income money from different sources. Respondent counters that petitioner has failed to introduce any credible evidence to support his argument that receipts from nontaxable sources were included in income.

I. Constructive Dividends Respondent asserts that constructive dividend income should be imputed to petitioner for amounts both from his law practice and from other sources for the years 1997 through 2002.

A constructive dividend arises when a corporation confers an economic benefit upon a shareholder without expectation of repayment if the corporation has sufficient earnings and profits. Loftin & Woodard, Inc. v. United States,   577 F.2d 1206, 1214 [42 AFTR 2d 78-5637] (5th Cir. 1978); Crosby v. United States,   496 F.2d 1384, 1388 [34 AFTR 2d 74-5371] (5th Cir. 1974); Truesdell v. Commissioner,   89 T.C. 1280, 1295 (1987). Corporate payments to a shareholder which confer personal benefits on the shareholder may constitute constructive dividends whether or not dividends are formally declared. Noble v. Commissioner,   368 F.2d 439, 442 [18 AFTR 2d 5982] (9th Cir. 1966), affg.   T.C. Memo. 1965-84 [¶65,084 PH Memo TC].

The evidence in this record clearly establishes that petitioner did not separate his personal transactions and expenses from those of his law firm. He paid personal expenses with corporate checks.

Through examinations conducted by the examining agent, in which petitioner's personal bank records and bank records for petitioner's law firm were summoned, the examining agent identified checks that were written directly to petitioner or payments made for his benefit from the bank accounts of the law firm. In addition, the examining agent was able to trace checks written directly to petitioner from his law practice into his personal bank accounts.

Consequently, we find that petitioner received constructive dividends regarding the transactions described herein and thus those dividends constitute gross income to him.

II. Transactions at Issue We will consider the deposits petitioner argues originated from nontaxable sources and the withdrawals he argues were not for his personal benefit.

A. Mortgage Payments At trial petitioner argued that respondent wrongly included income mortgage payments made from his law firm operating account. Petitioner has failed to produce any credible evidence that the payments made for his residence during tax years 1997, 1998, 1999, and 2000 were not for his personal benefit. Accordingly, petitioner has not met his burden, and respondent's determination is sustained.

B. Merrill Lynch

Petitioner argued that respondent wrongly included in income withdrawals from an investment account with Merrill Lynch. After petitioner's father's death in 1996, the account stood in the joint names of petitioner and petitioner's brother. Petitioner testified that neither he nor his brother removed funds for personal use, but for certain purposes including the care of their mother. Petitioner testified that he was his mother's caretaker before his brother retired and lived with her. Petitioner identified three withdrawals from the Merrill Lynch account, all dated August 11, 2000, of $5,000, $10,000, and $35,000.

Petitioner's Merrill Lynch account statements support his testimony that on August 11, 2000, he wrote one check to Lloyd T. Asbury PA of $5,000, and two checks to Lloyd T. Asbury PA Trust Account of $10,000 and $35,000. The firm's operating account records indicate that a deposit of $5,000 5 was made on August 11, 2000. The firm's client trust account records indicate that deposits of $10,000 and $35,000 were made on August 11, 2000. 6

Petitioner's testimony contradicts earlier statements that his mother did not own the securities held in the Merrill Lynch account. Petitioner filed a petition in this Court on behalf of his mother in response to a notice of deficiency issued to her. In the petition, his mother alleged that she did not own the securities in the Merrill Lynch account. At trial of the present case petitioner did not establish who owned the securities or how the funds were used to care for his mother. Accordingly, petitioner has not met his burden, and respondent's determinations with respect to the Merrill Lynch transactions are sustained.

      C.      Check Held for Petitioner's Wife
Petitioner contests the inclusion in income of a check for $68,512.81 from his firm's client trust account issued to his then wife. Petitioner explained that his then wife and two of her sisters, Ruth Loot and Barbara Milacki, each received a check for $68,512.81 as part of a distribution from an estate passed on to them through their mother. Petitioner's wife and her sisters placed these moneys in the firm's client trust account for the purpose of reserving funds for their mother's care. The firm's client trust account later issued three checks, each made payable to three payees; namely, his then wife and her sisters.

Petitioner's firm's client trust account records show copies of three checks each made out to Mrs. Asbury and her two sisters, Ms. Loot and Ms. Milacki, of $68,512.81. These amounts were debited from his account on July 17, 1998. Although petitioner did not identify the date when the funds were originally deposited into his account, we find his testimony regarding these funds credible. Accordingly, the total amount of these checks will be subtracted from respondent's adjustment for 1998.

D. Checks Held for Son and Daughter-in-Law Petitioner also contests the inclusion in income of funds from the client trust account used to fund two checks issued to Jennifer E. and Thomas Asbury, his daughter-in-law and son, while they were in the process of selling their condominium and purchasing a home. Petitioner testified that he deposited his son's funds into the firm's client trust account to hold on his son's behalf, but stresses that he was not the recipient of the funds. First, he cites a check written to Gibraltar Title Services for $40,013.90 representing the closing costs for the purchase of his son and daughter-in-law's home. Petitioner's firm's client trust account records show a copy of a check made payable to Gibraltar Title Services in this exact amount which was debited from the firm's account on May 24, 2000.

Next, petitioner cites a check written on June 8, 2000, for $1,000. Petitioner's law firm's client trust account records show a copy of a check made payable to his son and daughter-in- law debited from his trust account on June 13, 2000, for the same amount. Petitioner testified that this check was issued in order to cover a binder fee when his son and daughter-in-law were trying to sell their condominium.

Petitioner failed to produce any evidence verifying that he deposited his son's funds into his client trust account for safekeeping. Therefore, we find he has not proven that deposits to the account were not his income. Respondent's determination is sustained.

E. Loan From Ms. Baum Petitioner testified that he received a loan of $104,622.88 in July 2001 from Georgia Baum. Ms. Baum held an account at Invest Financial Corp. Ms. Baum's records show that she issued to the law firm's client trust account a check for $104,620.88 on July 24, 2001. The firm's trust account records show a copy of a check indicating that a deposit of $104,620.88 was credited to this account on July 25, 2001. Accordingly, we find petitioner's testimony concerning this transaction credible, and thus he has met his burden. The inclusion of this deposit in petitioner's income is in error.

F. Loan From Mr. Arbogast Petitioner cites two loans from Gordon Arbogast of $80,000 on February 28, 2002, and another of $25,000 on May 23, 2002.

Petitioner could not produce any evidence to trace the transactions between Mr. Arbogast and himself. His account records do not correspond with his testimony and cannot be verified. Thus, he has not met his burden, and we sustain respondent's determination for these transactions.

      G.      Loan From Mr. Edleberg
Petitioner cites a loan from J.W. Edleberg of $60,000 in 2002. However, petitioner could not produce any evidence to trace the transactions between Mr. Edleberg and himself. His account records do not correspond with his testimony and cannot be verified. Thus, petitioner has not met his burden, and we sustain respondent's determination for this transaction.

H. Loan From Ms. Smith Petitioner cites a loan from Della Smith of $50,000 on March 1, 2002. However, petitioner could not produce any evidence to trace the transactions between Ms. Smith and himself. His account records do not correspond with his testimony and cannot be verified. Thus, petitioner has not met his burden, and we sustain respondent's determination for this transaction.

I. Moving Stipend From the City of Jacksonville Petitioner cites a check from the city of Jacksonville paid to him as a moving stipend following the city's condemnation of his leased office building. Petitioner testified that it was deposited into the firm's operating account on April 18, 2002. The firm's operating account records do reflect a deposit of $10,000 on April 18, 2002. The records include a deposit slip but do not include a copy of the check or identify the payor. As a result, petitioner has not met his burden to show this amount was not income in 2002, and we sustain respondent's determination.

III. Additional Deductions   Section 165(d) permits a taxpayer to deduct losses from wagering transactions “only to the extent of the gains from such transactions.” The taxpayer bears the burden of proving entitlement to such a deduction. Schooler v. Commissioner,   68 T.C. 867, 869 (1977); see INDOPCO, Inc. v. Commissioner,   503 U.S. 79, 84 [69 AFTR 2d 92-694] (1992).

For all years at issue, respondent allowed the standard deduction. However, for years 1999, 2000, and 2002 respondent adjusted petitioner's income for gambling winnings, and for years 1999 and 2002 his gambling winnings exceeded the standard deduction. Petitioner's personal life and professional life were devastated by his gambling addiction, and his gambling losses were substantial. We hold that petitioner proved he sustained gambling losses and is entitled to additional itemized deductions for gambling losses for tax years 1999 and 2002 up to the amount of his gambling winnings in those years.

IV. Additions to Tax

1.   Section 6651(a)(2)—Failure To Pay   Section 6651(a)(2) imposes an addition to tax for failure to timely pay the amount of tax shown on a taxpayer's Federal income tax return. Cabirac v. Commissioner,   120 T.C. 163, 170 (2003).

Petitioner did not file valid returns for the years 1997 through 2002. Where the taxpayer did not file a valid return, the Commissioner, to satisfy his burden of production for the   section 6651(a)(2) addition to tax, must introduce evidence that he prepared SFRs. Respondent prepared SFRs under   section 6020(b) for the years in issue. SFRs made by the Secretary under   section 6020(b) are treated as the returns filed by the taxpayer for purposes of determining whether the   section 6651(a)(2) addition to tax applies.   Sec. 6651(g)(2); Wheeler v. Commissioner,   127 T.C. 200, 208-209 (2006), affd.   521 F.3d 1289 [101 AFTR 2d 2008-1696] (10th Cir. 2008). Thus, respondent has established SFRs were prepared and we sustain respondent's determination of the failure to pay additions to tax pursuant to   section 6651(a)(2).

2.   Section 6651(f)—Failure To File   Section 6651(f) imposes an addition to tax of up to 75 percent of the amount of tax required to be shown on the return when the failure to file a Federal income tax return timely is due to fraud.

In ascertaining whether petitioner's failure to file was fraudulent under   section 6651(f), the Court considers the same elements that are considered in imposing the fraud penalty under   section 6663 and former   section 6653(b). Those two elements of fraud are: (1) The existence of an underpayment, and (2) fraudulent intent with respect to some portion of the underpayment. In a case involving fraud, the Commissioner bears the burden of establishing fraud by “clear and convincing evidence”.   Sec. 7454(a); Rule 142(b); Korecky v. Commissioner,   781 F.2d 1566, 1568 [57 AFTR 2d 86-839] (11th Cir. 1986), affg.   T.C. Memo. 1985-63 [¶85,063 PH Memo TC]; Clayton v. Commissioner,   102 T.C. 632, 653 (1994); Petzoldt v. Commissioner,   92 T.C. 661, 699 (1989).

Fraud is not to be imputed or presumed but rather must be established by some independent evidence of fraudulent intent. Beaver v. Commissioner,   55 T.C. 85, 92 (1970); Otsuki v. Commissioner,   53 T.C. 96, 106 (1969). Fraud may be established by surveying the taxpayer's entire course of conduct and drawing reasonable inferences therefrom. Spies v. United States,   317 U.S. 492, 499 [30 AFTR 378] (1943); Korecky v. Commissioner, supra at 1568.

Courts have relied on long-recognized badges of fraud in deciding whether to sustain the Commissioner's determinations with respect to the addition to tax for fraud. Although no single factor may be necessarily sufficient to establish fraud, the existence of several indicia may be persuasive circumstantial evidence of fraud. Spies v. United States, supra at 499-500; Conti v. Commissioner,   39 F.3d 658, 662 [74 AFTR 2d 94-6867] (6th Cir. 1994), affg.  99 T.C. 370 (1992) and   T.C. Memo. 1992-616 [1992 RIA TC Memo ¶92,616]; Bradford v. Commissioner,   796 F.2d 303, 307-308 [58 AFTR 2d 86-5532] (9th Cir. 1986), affg.   T.C. Memo. 1984-601 [¶84,601 PH Memo TC]; Niedringhaus v. Commissioner,   99 T.C. 202, 211 (1992).

We find some of those badges of fraud to be present in this case. They include: Understatement of income; awareness of obligation to file returns, report income, and pay taxes; failure to make estimated tax payments; and engaging in illegal activity.

Petitioner failed to report substantial amounts of income from his law and tax practice for 6 years. This Court has held that “consistent understatements of income in substantial amounts over a number of years by knowledgeable taxpayers, standing alone, are persuasive evidence of fraudulent intent to evade Otsuki v. Commissioner, supra at 108. Moreover, on this taxes.” record we are satisfied that petitioner, with his status as a practicing tax attorney, was aware of his obligation to report income and to pay taxes on this income.

The record also demonstrates that petitioner failed to file returns for both himself and his law practice (with exception of a 1997 corporate return filed during the examination process) for the 6 consecutive years at issue.

Also, petitioner did conceal income and assets for the years at issue. Petitioner testified that he had used “my PA trust account illegally as, essentially as, a checking account. I would put funds in. I would take funds out.” In addition, he testified “Did I fail to reveal or try to conceal assets? I mean, the record is here. *** it's *** more than what should have went through these accounts. *** deposits were made, checks were written. There's no question about that.”

In addition, petitioner failed to make any estimated tax payments or have any Federal income tax withheld with respect to his individual income tax liabilities for the years at issue. Petitioner's only payments for the years at issue are two $100 payments—one for tax year 1998 and the other for tax year 2000. In addition, during the years at issue petitioner failed to timely pay employment taxes for the employees of his law practice.

Petitioner did engage in illegal activity. Petitioner was convicted of grand theft of client funds during or near the years at issue, sentenced to 5 years in prison, and ordered to pay $350,000 in restitution.

Petitioner's actions demonstrate a majority of the indicia of fraud considered by this Court. Respondent has met his burden of proof by providing clear and convincing evidence that petitioner not only established a pattern of failing to file income tax returns, but he also created trusts designed to conceal his income, thereby knowingly attempting to evade taxes. Thus, respondent has shown that at least some portion of the underpayment for each of the years in issue was due to fraud. Moreover, petitioner did not demonstrate that any portion of the underpayment was not attributable to fraud.

Further, the Court allowed petitioner the opportunity at the conclusion of trial to file a motion to reopen the record in the event he could provide additional documentation to support his position regarding the items he disputes. Petitioner failed to provide any further documentation in his defense. Therefore, petitioner has failed to show that any additional portions of respondent's determinations are incorrect. Accordingly, the Court finds that petitioner is liable for an addition to tax under   section 6651(f) for each of the years 1997 through 2002.

3.   Section 6654—Failure To Make Estimated Tax Payments   Section 6654(a) imposes an addition to tax on an underpayment of estimated income tax. A taxpayer generally has an obligation to pay estimated income tax for a particular year only if he has a “required annual payment” for that year.  Sec. 6654(d). The required annual payment is equal to the lesser of: (1) 90 percent of the tax shown on the individual's return for that year (or if no return is filed, 90 percent of the tax for such year), or (2) 100 percent of the tax shown on the return if the taxpayer filed a return for the immediately preceding tax   Sec. 6654(d)(1)(B); Wheeler v. Commissioner, 127 T.C. at year. 210-211.

Because petitioner failed to file an individual Federal income tax return for any of the years at issue, the required payment is 90 percent of the tax due for each of the years 1998 through 2002. Petitioner failed to make any estimated tax payments or to have any Federal income tax withheld with respect to his individual income tax liabilities for the years at issue. Petitioner's only payments for any of the years at issue are two $100 payments—one for tax year 1998 and the other for tax year 2000.

Because the amounts as determined by respondent exceed the payments made, petitioner is liable for the addition to tax for failure to pay estimated tax under   section 6654(a) for each of the years 1998 through 2002. 7

V. Conclusion Despite his personal struggles and recent efforts to overcome these challenges, petitioner cannot escape his obligation to timely file and pay taxes. Petitioner's experience as an attorney made him acutely aware of his obligation to accurately report income and submit the required tax filings and payments. His background as a licensed attorney also gave him precise knowledge concerning the consequences of his failure to file. His failure to make any effort to comply with known tax obligations over a period of 6 years is substantial and does not result from any good-faith misunderstanding. We find his failures to file returns fraudulent as to the income tax underpayments we have found previously.

Consequently, we conclude that (1) petitioner is liable for deficiencies for the tax years 1997 through 2000; (2) petitioner is liable for additions to tax for fraudulent failure to file under   section 6651(f) and for failure to pay under   section 6651(a)(2) for the tax years 1997 through 2002, and (3) petitioner is liable for additions to tax for failure to pay estimated tax under   section 6654(a) for the years 1998 through 2002.

To reflect the foregoing and concessions by the parties,

Decision will be entered under Rule 155.

1
  Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
1
  Amounts are rounded to the nearest dollar.
2
  Petitioner conceded the following issues: (1) Failure to report dividends from sources other than his law practice for tax years 1997 through 2002; (2) failure to report interest income for tax years 1997 through 2002; (3) failure to report a premature taxable distribution from his pension account for tax year 1998; (4) failure to report income from Columbia Plantation Co., an S corporation in which he was a shareholder for tax years 2000 through 2002; (5) failure to report gambling winnings for tax years 1999, 2000, and 2002.
2
  Petitioner conceded the following issues: (1) Failure to report dividends from sources other than his law practice for tax years 1997 through 2002; (2) failure to report interest income for tax years 1997 through 2002; (3) failure to report a premature taxable distribution from his pension account for tax year 1998; (4) failure to report income from Columbia Plantation Co., an S corporation in which he was a shareholder for tax years 2000 through 2002; (5) failure to report gambling winnings for tax years 1999, 2000, and 2002.
3
  Petitioner and his wife divorced subsequently.
4
  Petitioner filed a corporate return for 1997 sometime in April 2002.
5
  The deposit slip reflects a returned item charge of $5. The total deposit was $5,005.
6
  The deposit slips also include returned item charges of $5. The total deposit amounts were $10,005 and $35,005.
7
  Respondent concedes the addition to tax for failure to make estimated tax payments for the tax year 1997.
 


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