Judges: Chiechi
Attorneys: George W. Connelly, Jr. , Linda S. Paine , and Pamela E. Powers , for petitioners. Christopher A. Fisher and Richard S. Bloom , for respondent.
Filed: Apr. 15, 2009
Latest Update: Nov. 21, 2020
Summary: T.C. Memo. 2009-80 UNITED STATES TAX COURT PETER ACKERMAN AND JOANNE LEEDOM-ACKERMAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 13947-06, 26400-06. Filed April 15, 2009. George W. Connelly, Jr., Linda S. Paine, and Pamela E. Powers, for petitioners. Christopher A. Fisher and Richard S. Bloom, for respondent. Table of Contents FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . 4 Background . . . . . . . . . . . . . . . . . . . . . . . . . 5 Peter Ackerman .
Summary: T.C. Memo. 2009-80 UNITED STATES TAX COURT PETER ACKERMAN AND JOANNE LEEDOM-ACKERMAN, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 13947-06, 26400-06. Filed April 15, 2009. George W. Connelly, Jr., Linda S. Paine, and Pamela E. Powers, for petitioners. Christopher A. Fisher and Richard S. Bloom, for respondent. Table of Contents FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . 4 Background . . . . . . . . . . . . . . . . . . . . . . . . . 5 Peter Ackerman . ..
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T.C. Memo. 2009-80
UNITED STATES TAX COURT
PETER ACKERMAN AND JOANNE LEEDOM-ACKERMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 13947-06, 26400-06. Filed April 15, 2009.
George W. Connelly, Jr., Linda S. Paine, and Pamela E.
Powers, for petitioners.
Christopher A. Fisher and Richard S. Bloom, for respondent.
Table of Contents
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . 4
Background . . . . . . . . . . . . . . . . . . . . . . . . . 5
Peter Ackerman . . . . . . . . . . . . . . . . . . . . . 5
Perry Lerner . . . . . . . . . . . . . . . . . . . . . . 7
Don Ackerman . . . . . . . . . . . . . . . . . . . . . . 8
Jason Ackerman . . . . . . . . . . . . . . . . . . . . . 8
Jeffrey Deutschman . . . . . . . . . . . . . . . . . . . 9
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Somerville S Trust and Certain
Other Entities That It Owned . . . . . . . . . . 9
Deena Patriarca . . . . . . . . . . . . . . . . . . . 11
Rockport Advisors . . . . . . . . . . . . . . . . . . 11
Crown Capital . . . . . . . . . . . . . . . . . . . . 13
Petitioners’ Tax Returns . . . . . . . . . . . . . . . 15
Notices of Deficiency . . . . . . . . . . . . . . . . 16
Claimed Business Expense Deductions . . . . . . . . . . . . 16
Claimed Deduction for the
Protection of Business Reputation . . . . . . . . . . . 32
Funds Advanced to ECC . . . . . . . . . . . . . . . . 33
Book and Tax Treatment of the $7,850,000 of
Advanced Funds by Somerville and by Santa Monica . 37
Claimed Losses With Respect to ISI . . . . . . . . . . . . 40
Claimed Theft Loss Deduction . . . . . . . . . . . . . . . 42
Accuracy-Related Penalty Under Section 6662(a) . . . . . . 49
OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Burden of Proof . . . . . . . . . . . . . . . . . . . . . . . 54
Evaluation of Evidence on Which Petitioners Rely . . . . . 56
Testimonial Evidence . . . . . . . . . . . . . . . . . 56
Mr. Ackerman’s Testimony . . . . . . . . . . . . 57
Mr. Lerner’s Testimony . . . . . . . . . . . . . 57
Don Ackerman’s Testimony . . . . . . . . . . . . 57
Jason Ackerman’s Testimony . . . . . . . . . . . 58
Mr. Deutschman’s Testimony . . . . . . . . . . . 58
Ms. Patriarca’s Testimony . . . . . . . . . . . . 58
Mr. Braddock’s Testimony . . . . . . . . . . . . 59
Mr. Levinton’s Testimony . . . . . . . . . . . . 59
Documentary Evidence . . . . . . . . . . . . . . . . . 59
Claimed Business Expense Deductions . . . . . . . . . . . . 60
Petitioners’ Cost Company or Agency Argument . . . . . 61
Petitioners’ Compensation Argument . . . . . . . . . . 71
Claimed Deduction for the
Protection of Business Reputation . . . . . . . . . . . 88
Claimed Losses With Respect to ISI . . . . . . . . . . . . 96
Claimed Theft Loss Deduction . . . . . . . . . . . . . . . 104
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Accuracy-Related Penalty Under Section 6662(a) . . . . . . 108
APPENDIX A . . . . . . . . . . . . . . . . . . . . . . . . 117
APPENDIX B . . . . . . . . . . . . . . . . . . . . . . . . 119
MEMORANDUM FINDINGS OF FACT AND OPINION
CHIECHI, Judge: Respondent determined the following defi-
ciencies in, an addition under section 6651(a)(1)1 to, and
accuracy-related penalties under section 6662(a) on petitioners’
Federal income tax (tax):
Addition to Tax Accuracy-Related Penalty
Year Deficiency Under Sec. 6651(a)(1) Under Sec. 6662(a)
1997 $1,022,612 -- --
1998 163,350 -- --
2000 657,877 -- --
2002 771,330 $20,959.40 $154,266.00
2004 206,239 -- 41,247.80
The issues remaining for decision are:2
(1) Are petitioners entitled for each of their taxable years
1997, 1998, 2000, 2002, and 2004 to deduct certain claimed
business expenses under section 162(a)? We hold that they are
not.
1
All section references are to the Internal Revenue Code in
effect for the years at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
2
Issues (2), (3), and (4) set forth below are affirmative
issues that petitioners raised in the pleadings and that do not
relate to any determinations in the notices of deficiency.
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(2) Are petitioners entitled for their taxable year 1997 to
deduct under section 162(a) certain funds that they claim peti-
tioner Peter Ackerman advanced to a certain corporation in order
to protect his business reputation? We hold that they are not.
(3) Is a certain loss with respect to a company in which
petitioner Peter Ackerman indirectly owned an interest a passive
activity loss within the meaning of section 469(a) for each of
petitioners’ taxable years 1998 and 2000? We hold that it is.
(4) Are petitioners entitled for their taxable year 2002 to
deduct a claimed theft loss under section 165(a)? We hold that
they are not.
(5) Are petitioners liable for each of their taxable years
2002 and 2004 for the accuracy-related penalty under section
6662(a)? We hold that they are.
FINDINGS OF FACT3
Some of the facts have been stipulated and are so found
except as stated below.
Petitioners resided in Washington, D.C., at the time they
filed the petition in each of these cases.
3
We found the record in these cases to have been not well
developed, inconclusive, and/or not reliable in many respects,
including certain material respects. Although the gaps in the
record are substantial in many instances, and therefore our
findings of fact are incomplete and/or disconnected in those
instances, we have not undertaken to note every instance in which
the record does not contain reliable evidence that would have
enabled us to find all the facts relevant to our deciding the
issues presented.
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Background
Peter Ackerman
Petitioner Peter Ackerman (Mr. Ackerman) received a bache-
lor’s degree from Colgate University and a master’s degree in law
and diplomacy and a Ph.D. degree from the Fletcher School of Law
and Diplomacy of Tufts University (Fletcher School).
From the mid-1970s until January 1990, Drexel Burnham
Lambert (Drexel) employed Mr. Ackerman in various positions.4
The first position that Mr. Ackerman held at Drexel was assistant
to the president. From 1978 to 1989, Mr. Ackerman was in charge
of Drexel’s so-called special projects group. As head of that
group, Mr. Ackerman worked on, inter alia, the restructuring and
the financing of various businesses. Drexel received various
types of fees, equity interests, and investment opportunities in
connection with its special projects work.
In early 1990, Mr. Ackerman moved to London, England (Lon-
don), where he became a visiting scholar at the International
Institute for Strategic Studies, a premier think tank that
concentrated on issues relating to international security.
While living in London, Mr. Ackerman registered with English
authorities as a person undertaking a business and formed, owned
4
While at Drexel, Mr. Ackerman worked on, inter alia, the
restructuring of Penn Central Railroad and Resorts International
and the formation and the financing of a company for the purpose
of taking over a certain other company that operated supermar-
kets.
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with petitioner Joanne Leedom-Ackerman (Ms. Ackerman), and served
as the director of a company known as Rockport Capital Limited.
The principal activity of that company was providing certain
consulting services.
From 1990 to 1992, Ms. Ackerman owned a company known as
Rockport Consultants, Inc. (Rockport Consultants), that was
incorporated as a Delaware corporation on September 5, 1990, and
that filed an election to be taxed as an S corporation on or
about January 1, 1991. Rockport Consultants was engaged in the
business of providing certain consulting services. While resid-
ing in London, Mr. Ackerman served as the director of Rockport
Consultants and acted on behalf of that company in providing
certain consulting services. The consulting services that
Rockport Consultants provided included certain consulting ser-
vices provided to Saatchi & Saatchi Company Plc. (Saatchi &
Saatchi) with respect to, inter alia, its financing and its
capital structure. In exchange for those services, Rockport
Consultants received from Saatchi & Saatchi fees of more than $5
million.
On or about January 3, 1992, Rockport Consultants changed
its name to Rockport Financial, Inc. (Rockport Financial).
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During each of Rockport Financial’s taxable years 1992, 1993, and
1994, Ms. Ackerman was its sole stockholder.5
At the end of 1995, Mr. Ackerman left London and returned to
the United States. Thereafter, as discussed in more detail
below, Mr. Ackerman became interested in and explored various
investment opportunities.
During each of the years 1997, 1998, 2000, 2002, and 2004,
the years at issue, Mr. Ackerman devoted 40 to 50 percent of his
time to social and charitable causes. For example, Mr. Ackerman
served on the respective boards of CARE and Freedom House and as
chairman of the Fletcher School.
Perry Lerner
While Mr. Ackerman was living in London, he met Perry Lerner
(Mr. Lerner). Mr. Lerner received a bachelor’s degree from
Claremont McKenna College and a law degree from Harvard Univer-
sity. From approximately 1980 to 1996, Mr. Lerner practiced law
as a tax attorney with the law firm of O’Melveny & Myers, LLP
(O’Melveny & Myers). In that capacity, Mr. Lerner represented
Mr. Ackerman with respect to various legal matters. Around 1996,
Mr. Lerner resigned from O’Melveny & Myers in order to provide
certain legal services for Mr. Ackerman on a full-time basis.
5
As discussed below, on or about Apr. 15, 1996, Rockport
Financial changed its name to Rockport Capital, Inc. (Rockport
Capital).
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In February 1996, Mr. Lerner formed Rockport Advisors, Inc.
(Rockport Advisors). In January 1997, he formed Crown Capital
Group, Inc. (Crown Capital). As discussed in more detail below,
Mr. Lerner used Rockport Advisors and Crown Capital in order to
provide certain services with respect to certain investment
opportunities that Mr. Ackerman wanted to explore and/or pursue.
Don Ackerman
Don Ackerman is the older brother of Mr. Ackerman. From
around 1965 to around the end of 1997, Don Ackerman managed the
business operations of Economy Color Card, Inc. (ECC), a supplier
of wallpaper sample books and sample cards for paint, rugs, and
wood pieces.
Jason Ackerman
Jason Ackerman is the son of Don Ackerman and the nephew of
Mr. Ackerman. Jason Ackerman received an undergraduate degree in
economics and business management from Boston University.
Beginning around 1990, Jason Ackerman worked as an investment
banker (1) for about a year at Drexel and (2) for about seven
years at Donaldson Lufkin Jenrette. While serving as an invest-
ment banker, Jason Ackerman worked on several business deals that
involved the formation of companies for the purpose of taking
over certain other companies that operated supermarkets.
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Jeffrey Deutschman
Jeffrey Deutschman (Mr. Deutschman) received a bachelor’s
degree in history and economics from Columbia University and a
master’s degree in business administration from the Graduate
School of Management of the University of California, Los An-
geles. From 1981 through 1997, Mr. Deutschman worked for or was
a partner in various private equity firms.
Mr. Deutschman first met Mr. Ackerman in 1981 while Mr.
Ackerman was working for Drexel. At that time, Mr. Deutschman
had been working for a private equity firm for which Drexel had
been interested in financing an acquisition.
Somerville S Trust and Certain
Other Entities That It Owned
During each of the years at issue, Mr. Ackerman was treated
as the owner of Somerville S Trust, a so-called grantor trust
under section 671. For all relevant taxable years of petition-
ers, all of the income, deductions, and credits of Somerville S
Trust were includible in the computation of their taxable income
and credits. During each of the years at issue, Mr. Lerner was
the trustee of Somerville S Trust and was fully empowered to
transfer or invest its assets.
On or about April 15, 1996, Rockport Financial changed its
name to Rockport Capital. During each of the years at issue,
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Somerville S Trust was the sole stockholder of Rockport Capital.6
Pursuant to a limited liability company agreement dated
December 10, 1996, Rockport Capital and Mr. Lerner formed Santa
Monica Pictures, LLC (Santa Monica). Since its formation, Santa
Monica has been subject to the unified partnership provisions of
sections 6221 through 6234. On December 11, 1996, Somerville S
Trust became a member of, and received a 99.882-percent profits
interest in, Santa Monica. During 1997 and thereafter, the
members of Santa Monica were Somerville S Trust, Rockport Capi-
tal, and Mr. Lerner.
Pursuant to a limited liability company agreement dated
December 15, 1997, Somerville S Trust formed Somerville, LLC
(Somerville). From its formation until December 29, 1997,
Somerville S Trust was the sole member of Somerville. On Decem-
ber 29, 1997, Somerville S Trust contributed its interest in
Somerville to Santa Monica, and Santa Monica became, and has
remained, the sole member of Somerville.7
6
The record does not disclose when or how Somerville S Trust
acquired its interest in Rockport Capital.
7
Somerville was a “disregarded” entity under secs. 301.7701-
2(a) and 301.7701-3(a) and (b)(1)(ii), Proced. & Admin. Regs.,
and was not required to file a tax return for any of the years at
issue. Nonetheless, as discussed in more detail below, it
prepared Form 1065, U.S. Return of Partnership Income (Form
1065), for each of those years.
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Deena Patriarca
From 1984 until February 1990, Drexel employed Deena
Patriarca (Ms. Patriarca) as an assistant to Mr. Ackerman.
Shortly thereafter, Rockport Capital or one of its predecessors
employed her.8 During each of the years at issue, Ms. Patriarca
handled (1) the bookkeeping, accounting, payroll, and similar
functions for Rockport Capital and (2) the bookkeeping for
Somerville S Trust.
Rockport Advisors
As discussed above, in February 1996, Mr. Lerner formed
Rockport Advisors, which was located in Washington, D.C.9 During
8
For several months after Ms. Patriarca left Drexel, she
provided certain unidentified services for Mr. Ackerman in his
personal capacity.
9
The record is very sparse as to the activities of Rockport
Advisors during each of the years at issue. The record, however,
does establish that (1) as of Aug. 25, 1995, Somerville S Trust
was a member of, and had agreed to make capital contributions
totaling $100 million to, Cumberland Investment Partners, LLC
(Cumberland Investment), (2) the purpose of Cumberland Investment
was to invest in securities and other similar investments, and
(3) on Mar. 1, 1996, Rockport Advisors agreed to provide certain
unidentified administrative services to Cumberland Investment.
The record also establishes that on Mar. 1, 1996, Rockport
Advisors and two individuals entered into an employment agreement
(Rockport Advisors employment agreement) under which Rockport
Advisors was to, and did, employ those two individuals (two
Rockport Advisors employees). That agreement provided that
Somerville S Trust was to “bear the costs of the services per-
formed by * * * [the two Rockport Advisors employees] on behalf
of Rockport Advisors.” The Rockport Advisors employment agree-
ment further provided the following mechanism by which Somerville
S Trust was to recoup those costs:
(continued...)
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each of the years at issue, Mr. Lerner was the sole owner of
Rockport Advisors. At all relevant times, Rockport Advisors
maintained books and records, had employees, and generated
income.
Rockport Advisors filed Form 1120, U.S. Corporation Income
Tax Return (Form 1120), for each of its taxable years 1997, 1998,
and 2000.10 In each of those returns, Rockport Advisors showed
its business activity as “ADVISORY SERVICES” and its product or
service as “CONSULTING”.
In Form 1120 for its taxable year 1997, Rockport Advisors
reported total income of $1,600,196, total deductions of
$1,909,634, and a loss of $309,438. In Form 1120 for its taxable
year 1998, Rockport Advisors reported total income of $951,395,
total deductions of $1,144,857, and a loss of $193,462. In Form
9
(...continued)
To allow Somerville [S Trust] to recoup these costs,
* * * [the two Rockport Advisors employees were to]
cause to be paid to Somerville [S Trust] 25% of any
performance-based fees * * * [they] receive in the
future while * * * employed by Rockport Advisors from
clients other than Cumberland [Investment], until
Somerville [S Trust] has received an amount equal to
the unrecovered balance in its “Recoupment Account.”
* * *
The record further establishes that in 2000 and 2001 the two
Rockport Advisors employees caused $60,000 and $100,031.73,
respectively, to be paid to Rockport Advisors in order for
Somerville S Trust to recoup the costs that it had incurred with
respect to the services performed by them.
10
The record does not disclose whether Rockport Advisors
filed Form 1120 for any of the other taxable years at issue.
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1120 for its taxable year 2000, Rockport Advisors reported total
income of $1,296,676, total deductions of $1,239,039, and taxable
income of $57,637.
Crown Capital
As discussed above, in January 1997, Mr. Lerner formed Crown
Capital, which was located in New York City. On or about January
1, 1998, Crown Capital filed an election to be taxed as an S
corporation. At all relevant times, Mr. Lerner owned 49 percent
and petitioners’ nephew Jason Ackerman owned 51 percent of Crown
Capital. Crown Capital never issued any of its stock to Mr.
Ackerman.
At all relevant times, Crown Capital maintained books and
records, had employees, and generated income.11 As discussed
below, during at least certain of the years at issue, Crown
Capital provided certain services, including “consultation,
advice and direct management assistance * * * with respect to
operations, strategic planning, [and] financing”, to certain
companies in which Mr. Ackerman indirectly invested. In exchange
for those services, those companies agreed to pay certain manage-
ment fees to Crown Capital.
11
From 1997 until early 2002, Sheila Innes, an employee of
Crown Capital, maintained Crown Capital’s books and records.
Around early 2002, Crown Capital began winding down its business
operations and shipped its books and records to Ms. Patriarca.
- 14 -
Mr. Ackerman, whose reputation in finance far exceeded the
respective reputations of the employees of Crown Capital, was
involved in the hiring of Crown Capital’s employees in that he
told Crown Capital whom to hire or consented to its hiring of
certain employees. By the end of 1997, Crown Capital had about
15 employees, including Mr. Lerner, Jason Ackerman, and Don
Ackerman.12 In 1998, Mr. Deutschman joined Crown Capital and
served as its managing director. It was Mr. Deutschman’s under-
standing that Crown Capital was established to provide certain
services regarding the various companies in which Mr. Ackerman
invested or intended to invest.
Mr. Lerner, Jason Ackerman, and Mr. Deutschman were the key
employees of Crown Capital. Mr. Ackerman negotiated the respec-
tive salaries that Crown Capital was to pay to those key employ-
ees.
Crown Capital filed Form 1120 for its taxable year 1997 and
Form 1120S, U.S. Income Tax Return for an S Corporation (Form
1120S), for each of its taxable years 1998 and 2000.13 In each
12
The record does not disclose when Don Ackerman began
working for Crown Capital. We presume that shortly after Don
Ackerman stopped managing the operations of ECC, which was
sometime around the end of 1997, he began working for Crown
Capital.
13
The record does not disclose whether Crown Capital filed
Form 1120S for any of the other taxable years at issue.
- 15 -
of those returns, Crown Capital showed its business activity as
“CONSULTING” and its product or service as “INVESTMENT ADVICE”.
In Form 1120 for its taxable year 1997, Crown Capital
reported total income of $1,754,632, total deductions of
$1,735,293, and taxable income of $19,339. In Form 1120S for its
taxable year 1998, Crown Capital reported total income of
$5,649,920, total deductions of $5,549,062, and “Ordinary income
* * * from trade or business activities” of $100,858. In Form
1120S for its taxable year 2000, Crown Capital reported total
income of $6,509,302, total deductions of $6,194,276, and “Ordi-
nary income * * * from trade or business activities” of $315,026.
Petitioners’ Tax Returns
Petitioners jointly filed Form 1040, U.S. Individual Income
Tax Return (joint return), for each of their taxable years 1997,
1998, 2000, 2002, and 2004.
Petitioners included Schedule C, Profit or Loss From Busi-
ness (Schedule C), as part of the 1997 joint return (1997 Sched-
ule C), the 1998 joint return (1998 Schedule C), the 2000 joint
return (2000 Schedule C), the 2002 joint return (2002 Schedule
C), and the 2004 joint return (2004 Schedule C). In each of
those schedules, petitioners showed the “Principal business or
profession, including product or service” as “INVESTMENTS AND
BANKING” and the “Business name” as “PETER ACKERMAN”.
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Petitioners also included Schedule E, Supplemental Income
and Loss (Schedule E), as part of the 1997 joint return, the 1998
joint return, the 2000 joint return, the 2002 joint return, and
the 2004 joint return. In each of those schedules, petitioners
reported, inter alia, Somerville S Trust’s allocable share of any
income or loss, including any dividend income, from each of the
limited liability companies in which that trust directly or
indirectly invested.14
Notices of Deficiency
On April 26, 2006, respondent issued to petitioners a notice
of deficiency with respect to their taxable years 1997, 1998, and
2000 (notice for 1997, 1998, and 2000). On November 17, 2006,
respondent issued to petitioners a notice of deficiency with
respect to their taxable years 2002 and 2004 (notice for 2002 and
2004).
Claimed Business Expense Deductions
During the years at issue, various individuals and companies
sought Mr. Ackerman’s advice with respect to certain projects
that those individuals and companies were considering. Mr.
14
For convenience, instead of referring to what was reported
by petitioners as Somerville S Trust’s allocable share of any
income or loss, including any dividend income, from each of the
limited liability companies in which that trust directly or
indirectly invested, we shall generally refer only to the tax
reporting by those limited liability companies which are involved
in certain of the issues presented and in which Somerville S
Trust was a direct or indirect investor.
- 17 -
Ackerman and Crown Capital’s key employees (namely, Mr. Lerner,
Jason Ackerman, and Mr. Deutschman) examined each of those pro-
jects in order to determine whether it was a project that Mr.
Ackerman wanted to pursue. Mr. Ackerman and Crown Capital’s key
employees (namely, Mr. Lerner, Jason Ackerman, and Mr.
Deutschman) examined a total of about six to ten potential pro-
jects for every project that Mr. Ackerman decided to pursue. It
was Mr. Ackerman who determined which employees of Crown Capital
were to work on the projects that he wanted to pursue.
During the years at issue, Mr. Ackerman pursued at least
five major projects (major projects).15 As discussed in more
detail below, each of those projects pertained to a company in
which Mr. Ackerman indirectly made a substantial investment.16 As
part of its business, Crown Capital (1) provided certain due
15
Except for a project that pertained to a company that
purchased cellular phone spectrum licenses and that was facing
financial difficulty, the record does not disclose the number or
the nature of any projects, other than the five major projects,
that Mr. Ackerman may have explored and/or pursued during the
years at issue.
16
Mr. Ackerman did not directly own an interest in any of
the companies to which the major projects pertained. Instead, as
discussed in more detail below, Mr. Ackerman invested in each of
those companies through one or more entities in which he directly
or indirectly owned a substantial interest, such as Somerville S
Trust, Somerville, and Santa Monica. Although Mr. Ackerman did
not directly own an interest in any of the companies to which the
major projects pertained, in discussing those projects, we shall
sometimes for convenience not describe Mr. Ackerman’s investments
and ownership interests in those companies as indirect invest-
ments and indirect ownership interests.
- 18 -
diligence services in connection with the major projects and
(2) monitored the progress of Mr. Ackerman’s respective invest-
ments in the companies to which those projects pertained.
Mr. Ackerman maintained no books and records with respect to
the projects that he pursued during the years at issue. Nor did
he have any employees or lease agreements with respect to those
projects.
One major project that Mr. Ackerman pursued involved the
financing of a resort theater business. On a date not disclosed
by the record, Mr. Lerner introduced Mr. Ackerman to an individ-
ual (resort theater developer) who had been in the process of
acquiring a small chain of movie theaters located in certain
resort areas and who had been having difficulty financing those
acquisitions.
On February 18, 1999, Santa Monica, virtually all of which
Mr. Ackerman owned indirectly, invested $14 million in Resort
Theaters of America, Inc. (Resort Theaters), in exchange for a
100-percent ownership interest in Resort Theaters. On the same
date, Crown Capital entered into a management services agreement
with Resort Theaters (Resort Theaters management service agree-
ment). Pursuant to that agreement, in exchange for certain fees
to be paid by Resort Theaters to Crown Capital, Crown Capital was
to provide to Resort Theaters certain management services, in-
cluding “consultation, advice and direct management assistance to
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* * * [Resort Theaters] with respect to operations, strategic
planning, financing and other aspects of the business of [Resort
Theaters]”.
On certain dates not disclosed by the record, Crown Capital
and Mr. Ackerman assisted the resort theater developer in obtain-
ing certain financing for Resort Theaters.17
The business operations of Resort Theaters were ultimately
unsuccessful, and it did not pay to Crown Capital any of the fees
required by the Resort Theaters management service agreement.
Santa Monica reported in Form 1065 for its taxable year 2000
a long-term capital loss of $14 million with respect to its
investment in Resort Theaters.18
Another major project that Mr. Ackerman pursued involved the
formation of an investment management company. Mr. Ackerman
learned of that project through Jay Regan (Mr. Regan), whom Mr.
Ackerman had known for many years.
On a date not disclosed by the record in or shortly before
1999, Mr. Regan introduced Mr. Ackerman to Marek Fludzinski (Mr.
17
The record does not disclose whether Mr. Ackerman assisted
Resort Theaters in obtaining financing before or after Santa
Monica invested in that company.
18
In Form 1065 for its taxable year 2000, Santa Monica
reported with respect to its investment in Resort Theaters that
(1) it had acquired its interest in Resort Theaters on Feb. 18,
1999; (2) its basis in that interest was $14 million; and (3) it
had sold that interest on Dec. 31, 2000. In that form, Santa
Monica made no entry in the column headed “Sales price” with
respect to the interest in Resort Theaters that it reported it
had sold.
- 20 -
Fludzinski). Mr. Fludzinski had been managing a fund for a large
investment partnership and wanted to leave that partnership in
order to start his own investment management business. From 1999
to 2000, Mr. Ackerman assisted Mr. Fludzinski in an undisclosed
manner in forming Thales Fund Management, LLC (Thales Fund Man-
agement), which was to be the manager of an investment company
called Thales Fund, LP (Thales Fund). Mr. Ackerman asked Mr.
Lerner to provide assistance with respect to certain of the legal
matters pertaining to the formation of Thales Fund Management.
On a date not disclosed by the record, Mr. Ackerman and Mr. Regan
made investments of $30 million and $20 million, respectively,
with respect to the project involving the creation of Thales Fund
Management.19
Another major project that Mr. Ackerman pursued involved
starting a towel manufacturing business in Mexico for Davidson
Cotton Holding Corp. (Davidson Cotton). Mr. Ackerman
19
The record does not establish what ultimately happened to
the investment of $30 million that Mr. Ackerman made with respect
to the project involving the creation of Thales Fund Management.
Nor does the record establish the specific entity or entities in
which or through which Mr. Ackerman made that investment.
However, Somerville reported in Form 1065 distributive shares of
taxable income generated by the operations of (1) Thales Fund
Management and Thales Capital, LLC (Thales Capital), for each of
Somerville’s taxable years 1999 through 2004 and (2) Thales Fund,
for each of Somerville’s taxable years 1999, 2000, 2002, and
2004. We presume from Somerville’s Form 1065 for each of its
taxable years 1999 through 2004 that Mr. Ackerman made his
investment of $30 million through Somerville.
- 21 -
learned of that project through his brother Don Ackerman shortly
after Don Ackerman began working for Crown Capital.
On December 3, 1999, Mr. Ackerman invested in Davidson
Cotton.20 On the same date, Crown Capital entered into a manage-
ment services agreement with Davidson Cotton (Davidson Cotton
management services agreement). Pursuant to that agreement, in
exchange for certain fees to be paid by Davidson Cotton to Crown
Capital, Crown Capital was to provide to Davidson Cotton certain
“executive management services, including consultation, advice
and direct management assistance * * * with respect to opera-
tions, strategic planning, financing and other aspects of the
business of” Davidson Cotton.
On certain dates not disclosed by the record, the key em-
ployees of Crown Capital (namely, Mr. Lerner, Jason Ackerman, and
Mr. Deutschman) and Mr. Ackerman assisted Davidson Cotton in
starting a towel manufacturing business in Mexico. The business
operations of Davidson Cotton were ultimately unsuccessful, and
the company was liquidated. Davidson Cotton was able to pay to
Crown Capital only a portion of the fees required by the Davidson
Cotton management services agreement.21
20
Our detailed findings of fact with respect to Mr.
Ackerman’s investment in Davidson Cotton are set forth in the
attached appendix A, which is incorporated herein.
21
The record does not disclose what ultimately happened to
Mr. Ackerman’s investment in Davidson Cotton.
- 22 -
Another major project that Mr. Ackerman pursued involved
assisting a company known as Equity Marketing, Inc. (Equity
Marketing),22 in making certain unidentified acquisitions. In
early 2000, Equity Marketing, through one of Mr. Ackerman’s
former colleagues at Drexel, approached Mr. Ackerman and asked
him to make an investment in the company and to provide advice
with respect to the acquisitions that Equity Marketing was seek-
ing to make. Mr. Ackerman asked Jason Ackerman, Mr. Deutschman,
and Mr. Lerner to perform certain due diligence services in order
to determine whether Equity Marketing was a company in which Mr.
Ackerman should invest.
Sometime before March 22, 2000, Mr. Ackerman decided to
invest in Equity Marketing through Somerville, and on that date
Mr. Ackerman made that investment (discussed in more detail
below). From 2000 to 2008, Mr. Ackerman provided certain advice
to Equity Marketing regarding the acquisitions that it was seek-
ing to make.
On March 22, 2000, Somerville formed Crown Acquisition
Partners, LLC (Crown Acquisition Partners). On March 29, 2000,
Crown Acquisition Partners entered into a securities purchase
agreement (Equity Marketing securities purchase agreement) with
Equity Marketing. That agreement provided that on March 29,
2000, Equity Marketing was to sell to Crown Acquisition for
22
Equity Marketing was a marketing/advertising agency lo-
cated in Los Angeles, Cal.
- 23 -
$11,900,000 (1) certain shares of series A preferred stock in
Equity Marketing, (2) certain warrants to purchase certain shares
of series B preferred stock in Equity Marketing, and (3) certain
warrants to purchase certain shares of series C preferred stock
in Equity Marketing. The Equity Marketing securities purchase
agreement also provided that “as soon as practicable” Equity
Marketing was to sell to Crown Acquisition Partners for
$13,100,000 (1) certain additional shares of series A preferred
stock in Equity Marketing, (2) certain warrants to purchase
certain additional shares of series B preferred stock in Equity
Marketing, and (3) certain warrants to purchase certain addi-
tional shares of series C preferred stock in Equity Marketing.
As part of its agreement to sell to Crown Acquisition Part-
ners certain shares of stock in Equity Marketing and certain
warrants to purchase certain other shares of stock in Equity
Marketing, Equity Marketing agreed to pay to Crown Acquisition
Partners, or any of its affiliates, including Crown Capital, a
total commitment fee of $1,250,000 in 20 quarterly installments
of $62,500. As required by the Equity Marketing securities
purchase agreement, from June 30, 2000, to March 31, 2005, Equity
Marketing paid to Crown Capital that $1,250,000 commitment fee in
20 quarterly installments of $62,500.
On April 28, 2000, Crown Acquisition Partners changed its
name to Crown Emak Partners, LLC (Crown Emak Partners). On a
- 24 -
date not disclosed by the record, Somerville contributed its
interest in Crown Emak Partners to Crown Emak Investments, LLC
(Crown Emak Investments).23 As of June 13, 2000, the members of
Crown Emak Investments were Somerville, Crown Emak Holdings, LLC
(Crown Emak Holdings), and J. Rothschild Nominees (Guernsey)
Limited.24
Crown Emak Investments issued to Somerville Schedule K-1,
Partner’s Share of Income, Credits, Deductions, etc. (Schedule K-
1), for each of Somerville’s taxable years 2000 through 2006.
Each of those schedules showed dividend income paid by Equity
23
As of June 13, 2000, the members of Crown Emak Partners
were Crown Emak Investments, Allen Ba (Mr. Ba), Chris Calise (Mr.
Calise), and Ken Squire (Mr. Squire). Mr. Ba, Mr. Calise, and
Mr. Squire were employed by Crown Capital when they became
members of Crown Emak Partners. Crown Emak Investments, which
was the managing member of Crown Emak Partners, owned a 99.31-
percent interest in Crown Emak Partners, which it had received in
exchange for its contribution to Crown Emak Partners of
$24,828,541.
24
Somerville owned a 79.96-percent interest in Crown Emak
Investments, which it had received in exchange for its contribu-
tion to Crown Emak Investments of $8,090,000 and its interest in
Crown Emak Partners valued at $11,900,000. Crown Emak Holdings
owned a .04-percent interest in Crown Emak Investments, which it
had received in exchange for its contribution to Crown Emak
Investments of $10,000. J. Rothschild Nominees (Guernsey)
Limited owned the remaining 20-percent interest in Crown Emak
Investments, which it had received in exchange for its contribu-
tion to Crown Emak Investments of $5 million.
As of July 17, 2003, the members of Crown Emak Holdings were
Somerville, Jason Ackerman, Mr. Deutschman, Mr. Lerner, Mr.
Squire, Michael Leraris (Mr. Leraris), Suneel Kaji (Mr. Kaji),
and J. Rothschild Nominees (Guernsey) Limited. Jason Ackerman,
Mr. Deutschman, Mr. Lerner, Mr. Squire, Mr. Leraris, and Mr. Kaji
were employees of Crown Capital when they became members of Crown
Emak Holdings.
- 25 -
Marketing to Crown Emak Partners with respect to the preferred
stock that Crown Emak Partners had acquired pursuant to the
Equity Marketing securities purchase agreement. That dividend
income was the only income reported in the Schedule K-1 that
Crown Emak Investments issued to Somerville for each of
Somerville’s taxable years 2001 through 2004.25
Crown Emak Holdings issued to Somerville Schedule K-1 for
each of Somerville’s taxable years 2000 through 2006. Each of
those schedules showed dividend income paid by Equity Marketing
to Crown Emak Partners with respect to the preferred stock that
Crown Emak Partners had acquired pursuant to the Equity Marketing
securities purchase agreement.26
Another major project that Mr. Ackerman pursued involved
starting an Internet grocery business. The initial concept of
25
The respective Schedules K-1 that Crown Emak Investments
issued to Somerville for Somerville’s taxable years 2001 through
2004 are part of the record. The respective Schedules K-1 that
Crown Emak Investments issued to Somerville for Somerville’s
taxable years 2000, 2005, and 2006 are not part of the record.
Thus, we do not know whether there was any income reported in any
of those schedules other than the dividend income paid by Equity
Marketing to Crown Emak Partners with respect to the preferred
stock that Crown Emak Partners had acquired pursuant to the
Equity Marketing securities purchase agreement.
26
The respective Schedules K-1 that Crown Emak Holdings
issued to Somerville for Somerville’s taxable years 2000 through
2006 are not part of the record. Thus, we do not know whether
there was any income reported in any of those schedules other
than the dividend income paid by Equity Marketing to Crown Emak
Partners with respect to the preferred stock that Crown Emak
Partners had acquired pursuant to the Equity Marketing securities
purchase agreement.
- 26 -
that business originated with Jason Ackerman. Beginning around
1999, Mr. Ackerman, Crown Capital under the leadership of Jason
Ackerman, and Joe Fedele, a supermarket executive hired by Mr.
Ackerman and Crown Capital, spent approximately two years in
creating a business plan for an Internet grocery business.
Around 2000, Mr. Ackerman, Crown Capital, and/or Joe Fedele
formed Fresh Direct Holdings, Inc. (Fresh Direct), to operate
that business.
From the formation of Fresh Direct until early 2006, Mr.
Ackerman served as chairman of the board of directors of Fresh
Direct. In early 2006, Mr. Ackerman resigned as chairman of that
board but continued to serve as a member thereof.27
On a date not disclosed by the record, Mr. Ackerman invested
in Fresh Direct by purchasing 83 percent of the shares of stock
in that corporation for a penny a share. Thereafter, Mr.
Ackerman contributed at least certain of those shares to Crown
Fresh Direct, LLC (Crown Fresh Direct), that had been formed by
Somerville on March 1, 2000.28
27
In 2006, Rick Braddock (Mr. Braddock) became the chairman
of the board of directors of Fresh Direct. On a date not dis-
closed by the record before the date on which Mr. Braddock became
the chairman of that board, he had invested in, and entered into
an agreement to provide certain consulting services to, Fresh
Direct.
28
Our detailed findings of fact with respect to the owner-
ship of Crown Fresh Direct and certain other related entities are
set forth in the attached appendix B, which is incorporated
herein.
- 27 -
On a date not disclosed by the record before September 2002,
C. Gregory Earls (Mr. Earls), a well-known businessman in Wash-
ington, D.C., whom Mr. Ackerman had known since 1995 or 1996,29
informed Mr. Ackerman that he had certain clients that would be
interested in investing in Fresh Direct. Thereafter, Mr. Earls
and Mr. Ackerman each attempted to raise funds for that corpora-
tion. Mr. Ackerman successfully raised a substantial amount of
funds for Fresh Direct. Mr. Earls advised Mr. Ackerman to place
those funds in an escrow account in the name of Mr. Earls, which
Mr. Ackerman did. (We shall refer to the funds that Mr. Ackerman
raised for Fresh Direct and placed into that escrow account as
the Fresh Direct investor funds in escrow.)
On April 12, 2000, Crown Capital and Fresh Direct entered
into a management services agreement (Fresh Direct management
services agreement), and on April 29, 2003, they entered into an
amended and restated management services agreement (Fresh Direct
amended management services agreement). Pursuant to those agree-
ments, Crown Capital was to provide to Fresh Direct
advisory and consulting services in relation to the
affairs of * * * [Fresh Direct] in connection with
strategic financial planning, and other services, in-
cluding, without limitation, advisory and consulting
services relating to the selection, supervision and
retention of independent auditors, the selection, re-
tention and supervision of outside legal counsel, and
the selection, retention and supervision of investment
bankers or other financial advisors or consultants.
29
Mr. Ackerman met Mr. Earls when Mr. Ackerman’s son was in
the same class at Harvard University as Mr. Earls’s daughter.
- 28 -
In exchange for the services that Crown Capital provided to Fresh
Direct, Fresh Direct paid to Crown Capital the fees required by
the Fresh Direct management services agreement and the Fresh
Direct amended management services agreement.
During each of the years at issue, Mr. Ackerman, through
Somerville S Trust, made payments to Crown Capital of the funds
that Crown Capital requested in order to assist it in carrying on
its business activities.30 The total amount of payments that Mr.
Ackerman made to Crown Capital during each of those years was:
Year Total Payment
1
1997 $1,954,632
1998 7,300,000
2
2000 6,687,520
3
2002 2,254,747
2004 1,000,000
1
Of the $1,954,632 that Mr. Ackerman paid to Crown Capital
during 1997, $200,000 pertained to a failed attempt to establish
an insurance company.
2
Of the $6,687,520 that Mr. Ackerman paid to Crown Capital
during 2000, $1,827,418 pertained to certain unidentified aban-
doned projects.
3
Of the $2,254,747 that Mr. Ackerman paid to Crown Capital
during 2002, $663,520 pertained to certain unidentified abandoned
projects.
The practice that Crown Capital followed in requesting funds
from Mr. Ackerman was to send an invoice for the funds requested
to Ms. Patriarca, who, as discussed above, handled the bookkeep-
30
The record does not establish how Crown Capital treated
for book and tax purposes the payments that Mr. Ackerman made to
it during each of the years at issue.
- 29 -
ing for Somerville S Trust.31 After obtaining Mr. Ackerman’s
approval, Ms. Patriarca had the funds requested sent to Crown
Capital.
During each of petitioners’ taxable years 1997, 1998, 2000,
and 2002, Mr. Ackerman made payments to Rockport Advisors of
certain funds that it requested.32 The total amount of payments
that Mr. Ackerman paid to Rockport Advisors during each of those
years was:33
Year Total Payment
1997 $587,500
1998 950,000
2000 1,235,876
2002 500,000
During each of the years at issue, Mr. Ackerman did not
provide advisory services with respect to the major projects in
31
The invoices that Crown Capital sent to Ms. Patriarca are
not part of the record.
32
The record not establish how Rockport Advisors treated for
book and tax purposes the payments that Mr. Ackerman made to it
during each of petitioners’ taxable years 1997, 1998, and 2002.
However, we note that the amount of “Gross receipts or sales”
that Rockport Advisors reported in its Form 1120 for its taxable
year 1998 is equal to the total amount of the payments that Mr.
Ackerman made to Rockport Advisors during that year. As for
petitioners’ taxable year 2000, Rockport Advisors booked the
total amount of the payments that Mr. Ackerman made to it during
that year as “ADVISORY FEE INCOME”, and Rockport Advisors re-
ported that amount as “Gross receipts or sales” in its Form 1120
for that year.
33
The record does not disclose any other information regard-
ing Mr. Ackerman’s payments to Rockport Advisors during 1997,
1998, 2000, and 2002. Nor does the record disclose whether Mr.
Ackerman made any payments to Rockport Advisors during petition-
ers’ taxable year 2004.
- 30 -
exchange for a fee or a commission or with the purpose of selling
his interests in the respective companies involved in those
projects in the ordinary course of any business of his. Nor did
Mr. Ackerman provide advisory services with respect to the major
projects during any of those years in exchange for any other
compensation other than the normal investor’s return.
As discussed above, in petitioners’ Schedule C for each of
the years at issue, petitioners showed the “Principal business or
profession, including product or service” as “INVESTMENTS AND
BANKING” and the “Business name” as “PETER ACKERMAN”. Mr.
Ackerman maintained no books and records with respect to the
activity reflected in each of those schedules.
In the 1997 Schedule C, petitioners reported no income in
part I and claimed $2,752,132 as “Other expenses” in part II
consisting of payments of (1) $1,954,632 to Crown Capital,
(2) $587,500 to Rockport Advisors, and (3) $210,000 to Nevada
Media Partners. In that schedule, petitioners claimed a net loss
of $2,752,132. In determining the taxable income reported in the
1997 joint return, petitioners deducted that net loss.
In the 1998 Schedule C, petitioners reported no income in
part I and claimed $8,250,000 as “Other expenses” in part II
consisting of payments of (1) $7,300,000 to Crown Capital and
(2) $950,000 to Rockport Advisors. In that schedule, petitioners
claimed a net loss of $8,250,000. In determining the taxable
- 31 -
income reported in the 1998 joint return, petitioners deducted
that net loss.
In the 2000 Schedule C, petitioners reported no income in
part I and claimed $7,973,649 as “Other expenses” in part II
consisting of (1) $50,253 of expenses for a book that Mr.
Ackerman had coauthored on nonviolent resistance34 (Mr. Ackerman’s
book on nonviolent resistance) and (2) payments of
(a) $6,687,520 to Crown Capital and (b) $1,235,876 to Rockport
Advisors. In that schedule, petitioners claimed a net loss of
$7,973,649. In determining the taxable income reported in the
2000 joint return, petitioners deducted that net loss.
In the 2002 Schedule C, petitioners reported no income in
part I and claimed $2,754,747 as “Other expenses” in part II
consisting of payments of (1) $2,254,747 to Crown Capital and
(2) $500,000 to Rockport Advisors. In that schedule, petitioners
reported a net loss of $2,754,747. In determining the taxable
income reported in the 2002 joint return, petitioners deducted
that net loss.
In the 2004 Schedule C, petitioners reported no income in
part I and claimed $1 million as “Other expenses” in part II
consisting of a payment of that amount to Crown Capital. In that
schedule, petitioners reported a net loss of $1 million. In
34
The $50,253 of expenses pertaining to Mr. Ackerman’s book
on nonviolent resistance consisted of expenses for certain
research and publicity and an unidentified “book purchase”.
- 32 -
determining the taxable income reported in the 2004 joint return,
petitioners deducted that net loss.
In the notice for 1997, 1998, and 2000 and the notice for
2002 and 2004 (collectively, the notices), respondent determined
that (1) the “Other expenses” that petitioners claimed in Sched-
ule C “are not attributable to an active trade or business under
IRC Section 162”, (2) those expenses are deductible as “expenses
related to the production or collection of income under IRC
Section 212 subject to the 2 percent floor for miscellaneous
deductions”, and (3) therefore petitioners should have reported
those expenses in Schedule A--Itemized Deductions (Schedule A)
instead of Schedule C.35
Claimed Deduction for the
Protection of Business Reputation
In 1918, the maternal grandfather of Don Ackerman and of Mr.
Ackerman started a business that was the predecessor of ECC. In
1964, the father of Don Ackerman and of Mr. Ackerman incorporated
ECC, a supplier of wallpaper sample books and sample cards for
paint, rugs, and wood pieces. Around 1965, when the grandfather,
the father, and the uncle of Don Ackerman and of Mr. Ackerman
35
With respect to the payment of $210,000 to Nevada Media
Partners that petitioners deducted in the 1997 Schedule C, the
parties agree that that payment constituted a capital expendi-
ture. They further agree that that $210,000 should not have been
deducted in the 1997 Schedule C but should have been included as
part of Somerville S Trust’s basis in its interest in Santa
Monica.
- 33 -
developed certain health problems, Don Ackerman took over the
management of ECC.
Funds Advanced to ECC
During the early 1990s, ECC operated a successful business.
It generated annual revenue of approximately $25 million and had
approximately 1,500 employees. By 1997, at a time when Don
Ackerman and Jason Ackerman owned ECC,36 that company faced dire
financial circumstances that were due in large part to a reduced
need for wallpaper sample books.
On a date in 1997 not disclosed by the record before May 7,
Don Ackerman approached his brother Mr. Ackerman and informed him
that ECC was unable to meet its payroll obligations, that ECC
and/or Don Ackerman had accrued a substantial amount of bank
debt, and that ECC and Don Ackerman might have to commence a
bankruptcy proceeding.
Mr. Ackerman, who was not a stockholder, guarantor, em-
ployee, or officer of ECC, decided to advance certain funds to
ECC. On the dates indicated, Mr. Ackerman, through Somerville S
Trust, advanced to ECC the following amounts totaling $7,850,000
($7,850,000 of advanced funds):37
36
The record does not disclose when Don Ackerman and Jason
Ackerman acquired their respective stock interests in ECC.
37
Although Mr. Ackerman advanced a total of $7,850,000 to
ECC through Somerville S Trust, in discussing Mr. Ackerman’s
advancing those funds, we shall sometimes for convenience not
(continued...)
- 34 -
Date Amount
5/7/1997 $1,000,000
6/3/1997 1,000,000
7/2/1997 1,000,000
7/30/1997 2,400,000
8/29/1997 500,000
9/26/1997 500,000
10/28/1997 600,000
11/6/1997 100,000
11/21/1997 750,000
ECC never repaid the funds that Mr. Ackerman advanced to it.
Around the time in 1997 Mr. Ackerman had decided to advance,
and was advancing, $7,850,000 to ECC, a decision had been made to
form International Service Investors, LLC (ISI), International
Service Group, LLC (ISG), and International Service Group Hold-
ings, LLC (ISGH),38 in order to continue the operations of ECC in
modified form.39 Around the same time, Mr. Ackerman also decided
37
(...continued)
indicate that Mr. Ackerman advanced those funds through
Somerville S Trust.
38
ISI, ISG, and ISGH were formed on the following dates:
Entity Date of Formation
ISI 8/27/1997
ISG 8/29/1997
ISGH 11/1/1997
39
The parties generally refer to ISI, ISG, and ISGH as the
“International Group”. In describing the activities of the
International Group in their stipulation of facts, the parties do
not make clear whether each of the three companies making up the
International Group engaged in those activities. It appears from
the record that ISG was the only company engaged in manufacturing
(continued...)
- 35 -
to make, and was making, through Somerville an investment of
$18,050,000 in the International Group by investing that amount
in ISI.40 Those funds enabled ISI and the other companies making
up the International Group to conduct their operations.
As of December 31, 1997, Somerville owned a 98-percent
interest, ECC owned a 1-percent interest, and New Cumberland
Corporation, Inc. (New Cumberland),41 owned a 1-percent interest
in ISI. In exchange for the 1-percent interest in ISI that ECC
owned as of December 31, 1997, ECC contributed all of its assets
(discussed below) totaling $15,190,903, but none of its liabili-
ties, to ISI.42 As of December 31, 1997, ISI owned a 1-percent
interest and ISGH, in which ISI owned a 75-percent interest,43
owned a 99-percent interest in ISG.
39
(...continued)
operations. When referring to one or more of the companies
making up the group that the parties refer to as the “Interna-
tional Group”, we shall sometimes for convenience use the termi-
nology that the parties use.
40
The record does not disclose the specific date in 1997 on
which Somerville invested $18,050,000 in ISI.
41
At all relevant times, Don Ackerman owned New Cumberland.
42
As of Dec. 31, 1997, ISI was the sole stockholder of ECC.
The record does not disclose how, or the specific date on which,
ISI acquired its stock interest in ECC.
43
As of Dec. 31, 1997, Jason Ackerman and Mr. Deutschman
each owned a 7-percent interest, New Cumberland owned a 3.75-
percent interest, and Crown Capital owned a 7.25-percent interest
in ISGH.
- 36 -
Included in the assets that ECC contributed to ISI were a
substantial, but undisclosed, amount of cash, substantial amounts
of inventory, certain accounts receivable, certain intangible
assets in the form of customer relationships, certain employee
relationships, certain leasehold interests, and substantial
amounts of machinery and equipment that ECC had used in the
production of sample cards and packaging projects. The assets
that ECC contributed to ISI assisted the International Group in
continuing the operations of ECC in modified form.
After the International Group was formed and received from
Mr. Ackerman, through Somerville, over $18 million and from ECC
over $15 million of assets, the International Group made certain
fundamental changes to ECC’s business model and continued ECC’s
business in modified form. For example, the International Group
engaged in the manufacture of Pokemon cards and the business of
creating packaging for various companies.
From at least 1998 through 2003, Mr. Deutschman managed the
day-to-day business operations of the International Group from
the International Group’s offices in New Jersey. At all relevant
times, the International Group carried out its operations in New
Jersey, New York City, Texas, and/or Mexico. In 1999, at least
certain of the manufacturing operations of the International
Group were moved from New Jersey to Mexico.
- 37 -
Book and Tax Treatment of the $7,850,000 of
Advanced Funds by Somerville and by Santa Monica
At the direction of Mr. Lerner, Somerville S Trust booked
the $7,850,000 of advanced funds as a loan from Somerville S
Trust to ECC. Consistent with Somerville S Trust’s treatment of
the $7,850,000 of advanced funds in its books, ECC booked those
funds as a loan from Somerville S Trust to ECC. In Schedule L,
Balance Sheets per Books (Schedule L), of Form 1120 for each of
its taxable years ended November 30, 1998 (1998 Schedule L), and
November 30, 1999, ECC included the $7,850,000 of advanced funds
as part of its “Other liabilities”.44 In Schedule M-1, Reconcili-
ation of Income (Loss) per Books With Income per Return, of Form
1120 for its taxable year ended November 30, 2000, ECC included
the $7,850,000 of advanced funds as book income from the “CANCEL-
LATION OF DEBT”.
On December 16, 1997, Somerville S Trust contributed to
Somerville a loan receivable (contributed loan receivable) with
respect to the $7,850,000 of advanced funds. Somerville S
Trust’s basis in its interest in Somerville included the value of
that loan receivable, and the contributed loan receivable was
among the assets held by Somerville when Somerville S Trust
contributed its interest in Somerville to Santa Monica on Decem-
ber 29, 1997.
44
In the 1998 Schedule L, ECC incorrectly identified the
amount of the ECC funds as $7,750,000, instead of $7,850,000.
- 38 -
In Schedule L of Form 1065 that it prepared, but did not
file,45 for each of its taxable years 1997, 1998, and 1999,
Somerville included the contributed loan receivable as part of
its “Other current assets”. In Form 1065 that it prepared, but
did not file, for its taxable year 2000, Somerville claimed an
“Ordinary * * * (loss) from trade or business activities” of
$9,171,171 (Somerville’s claimed 2000 ordinary loss). In calcu-
lating that loss, Somerville deducted a bad debt of $7,850,000
with respect to the contributed loan receivable.
On July 2, 2001, Santa Monica, which owned all of
Somerville, filed Form 1065 for its taxable year 2000. In that
form, Santa Monica claimed an “Ordinary * * * (loss) from trade
or business activities” of $10,344,426 (Santa Monica’s claimed
2000 ordinary loss). That ordinary loss that Santa Monica claim-
ed included Somerville’s claimed 2000 ordinary loss.46 Santa
Monica’s claimed 2000 ordinary loss was allocated as follows:
99.88 percent to Somerville S Trust, .059 percent to Rockport
45
See supra note 7.
46
The parties stipulated that Santa Monica’s claimed 2000
ordinary loss included “an ordinary loss in the amount of
$91,171,171 from Somerville LLC.” That stipulation is clearly
contrary to the facts that we have found are established by the
record, and we shall disregard it. See Cal-Maine Foods, Inc. v.
Commissioner, 93 T.C. 181, 195 (1989). The record establishes,
and we have found, that Santa Monica’s claimed 2000 ordinary loss
included Somerville’s claimed 2000 ordinary loss of only
$9,171,171.
- 39 -
Capital, and .059 percent to Perry Lerner.47 In Schedule E of
their 2000 joint return, petitioners reported Somerville S
Trust’s and Rockport Capital’s respective allocable shares of
Santa Monica’s claimed 2000 ordinary loss.48
On or about August 8, 2005, petitioners and respondent
executed Form 872, Consent to Extend the Time to Assess Tax (Form
872), in which they consented to extend to December 31, 2006, the
time within which to assess petitioners’ tax for their taxable
year 2000. That Form 872 did not provide that it applied to any
tax of petitioners attributable to the partnership items of Santa
Monica.
Santa Monica did not execute Form 872-P, Consent to Extend
the Time to Assess Tax Attributable to Partnership Items, with
respect to its taxable year 2000.
In the second amended petition at docket No. 13947-06,
petitioners alleged as an affirmative issue that the $7,850,000
of advanced funds is deductible under section 162(a) for peti-
tioners’ taxable year 1997.
47
Before 2000, Santa Monica, Somerville, and petitioners did
not claim any deductions with respect to the $7,850,000 of
advanced funds.
48
The record does not disclose whether Mr. Lerner reported
in his tax return for his taxable year 2000 his allocable share
of Santa Monica’s claimed 2000 ordinary loss.
- 40 -
Claimed Losses With Respect to ISI
From around early 1998 through 2003, Mr. Deutschman, who
lived in New York City, had a leadership role in each of the
companies (i.e., ISI, ISG, and ISGH) that made up the Interna-
tional Group.49 During each of those years, Mr. Deutschman spent
more than 500 hours managing the day-to-day business operations
of the International Group. Mr. Deutschman performed his manage-
ment activities with respect to the business operations of the
International Group from the International Group’s offices in New
Jersey. No person spent more time managing the business opera-
tions of the International Group than Mr. Deutschman.
During at least 1998 and 2000, Don Ackerman and Jason
Ackerman also provided certain unidentified management services
to the International Group.
Mr. Ackerman, who during the years at issue lived in Wash-
ington, D.C., was not an employee or officer of any of the compa-
nies that made up the International Group, did not receive any
wages from any of those companies, and did not maintain a log
documenting the amount of time that he devoted to any of those
companies.
During 1998 through 2000, Mr. Ackerman communicated on
various occasions with Mr. Deutschman regarding various matters,
49
For example, from 1998 through 2003, Mr. Deutschman served
as president of ISI.
- 41 -
including the business operations and finances of the Interna-
tional Group and various other investments of Mr. Ackerman. Mr.
Deutschman sent Mr. Ackerman at least one memorandum dated July
9, 1999, regarding the business operations of the International
Group that served as a basis for discussions between the two of
them.
During 1998 through 2000, Mr. Ackerman spent at least one or
two days in certain weeks in New York City. During that period,
he also visited New Jersey where his mother and his brother Don
Ackerman lived. While in New York City, Mr. Ackerman spent time
on various matters, including matters relating to certain of the
major projects in which Crown Capital was involved and certain
charitable activities relating to CARE. While in New Jersey, Mr.
Ackerman, inter alia, occasionally visited Mr. Deutschman where
Mr. Deutschman managed the operations of the International Group.
ISI issued to Somerville Schedule K-1 with respect to each
of Somerville’s taxable years 1998 (1998 ISI Schedule K-1 issued
to Somerville) and 2000 (2000 ISI Schedule K-1 issued to
Somerville). In the 1998 ISI Schedule K-1 issued to Somerville,
ISI showed an “Ordinary * * * (loss) from trade or business
activities” of $6,983,996 (1998 ISI loss). In the 2000 ISI
Schedule K-1 issued to Somerville, ISI showed an “Ordinary * * *
(loss) from trade or business activities” of $1,771,427 (2000 ISI
loss).
- 42 -
In the 1998 joint return and the 2000 joint return, peti-
tioners treated Mr. Ackerman’s allocable portions of the respec-
tive 1998 ISI loss and 2000 ISI loss as passive activity losses.
In the second amended petition at docket No. 13947-06, petition-
ers alleged as an affirmative issue that the “losses deducted by
Petitioners as passive losses [with respect to ISI] should be
allowed as active because Mr. Ackerman materially participated in
this business activity throughout the years of the deductions.”
Claimed Theft Loss Deduction
Around 1996 or 1997, Mr. Earls approached Mr. Ackerman with
a proposal to invest in U.S. Technologies, Inc. (U.S. Technolo-
gies), a publicly traded Delaware corporation that used prison
labor to manufacture a variety of products. Mr. Ackerman be-
lieved that such an investment would be profitable.
On June 22, 1998, USV Partners, LLC (USV), was formed for
the purpose of acquiring and holding shares of preferred and
common stock of U.S. Technologies. At all relevant times, Mr.
Earls was the sole director, officer, and employee of USV and
controlled all of its funds.
Pursuant to various subscription agreements, from July 10,
1998, through August 27, 2001, Mr. Ackerman, through Somerville S
Trust, invested funds totaling $4,467,610 in USV. Pursuant to
those agreements, those invested funds were to be used by USV to
purchase shares of common and/or preferred stock in U.S. Technol-
- 43 -
ogies.50 On March 4, 2002, USV distributed to Somerville S Trust
18,759,879 shares of common stock in U.S. Technologies.
Around September 2002, Mr. Ackerman asked Mr. Earls to
return to him the Fresh Direct investor funds in escrow (dis-
cussed above). Mr. Earls was unable to do so because he had
removed from escrow at least certain of those funds. Mr.
Ackerman gave Mr. Earls a deadline by which he had to return to
him the full amount of the Fresh Direct investor funds in escrow.
Mr. Earls borrowed a certain amount of money and returned to Mr.
Ackerman the full amount of those funds by the deadline that Mr.
Ackerman set.
When Mr. Ackerman learned that Mr. Earls had removed from
escrow certain of the Fresh Direct investor funds in escrow, Mr.
Ackerman began to question whether Mr. Earls had properly handled
the funds that Mr. Ackerman, through Somerville S Trust, had
invested in USV. On a date not disclosed by the record before
December 9, 2002, Mr. Ackerman learned that Mr. Earls had used
for his own personal benefit certain of the funds that Mr.
Ackerman, through Somerville S Trust, and other members of USV
had invested in USV. Shortly thereafter, Mr. Ackerman informed a
50
On a date not disclosed by the record, Mr. Lerner also
invested certain funds in USV. Like the funds that Mr. Ackerman,
through Somerville S Trust, invested in USV, the funds that Mr.
Lerner invested in USV were to be used by USV to purchase shares
of common and/or preferred stock in U.S. Technologies.
- 44 -
district attorney in New York51 of Mr. Earls’s conduct with re-
spect to those funds.
On December 9, 2002, in an effort to recover damages of
approximately $5,953,000, Somerville S Trust and certain other
persons who owned interests in USV filed a complaint (December 9,
2002 complaint) in the United States District Court for the
District of Maryland (U.S. District Court for Maryland) against
David Ferreira (Mr. Ferreira) and Ferreira & Isbell, LLC
(Ferreira & Isbell). (We shall refer to that civil action as the
Ferreira litigation.) In the December 9, 2002 complaint, the
plaintiffs in the Ferreira litigation alleged, inter alia, that
the defendants identified in that complaint had “negligently and
recklessly failed to exercise due care in performing their review
of USV’s general ledgers and trial balances, in making any ad-
justments thereto, and in performing other accounting services
for USV.”
On December 18, 2002, criminal complaints were filed against
Mr. Earls in the United States District Court for the Southern
District of New York. Thereafter, on March 24, 2003, Mr. Earls,
who was accused of stealing $13 million of $20 million that had
been invested in USV, was indicted in that court on one count of
51
The record does not disclose which district attorney’s
office in New York Mr. Ackerman informed of Mr. Earls’s conduct
with respect to the funds that Mr. Ackerman, through Somerville S
Trust, and other members of USV had invested in USV.
- 45 -
securities fraud, 19 counts of wire fraud, and two counts of mail
fraud.
On June 17, 2003, Mr. Ackerman executed a formal engagement
letter for representation by the law firm of Jenner & Block, LLC
(Jenner & Block), in connection with the Ferreira litigation and
certain other litigation against Mr. Earls in the Superior Court
of the District of Columbia.
On August 19, 2003, Somerville S Trust entered into three
respective securities and purchase agreements with (1) Mr.
Lerner, (2) WS Investments, LP (WS Investments), and (3) certain
family trusts that were established for the benefit of certain
members of Mr. Ackerman’s family (Ackerman family trusts).52
Pursuant to the securities and purchase agreement entered into by
Somerville S Trust and Mr. Lerner, that trust was to acquire from
Mr. Lerner for a total purchase price of $150,000 (1) any member-
ship interests in USV and shares of stock in U.S. Technologies
that Mr. Lerner owned and (2) any claims that Mr. Lerner had
against Mr. Earls or any of Mr. Earls’s affiliates with respect
to any fraudulent conduct of Mr. Earls concerning those member-
ship interests and shares of stock. Pursuant to the securities
and purchase agreement entered into by Somerville S Trust and WS
52
On a date not disclosed by the record before Mr.
Ackerman’s discovery of Mr. Earls’s conduct with respect to the
funds invested in USV, Somerville S Trust had transferred as
gifts small portions of its USV membership interest to the
Ackerman family trusts.
- 46 -
Investments, that trust was to acquire from WS Investments for a
total purchase price of $200,000 (1) any membership interests in
USV and shares of stock in U.S. Technologies that WS Investments
owned and (2) any claims that WS Investments had against Mr.
Earls or any of Mr. Earls’s affiliates with respect to any fraud-
ulent conduct of Mr. Earls concerning those membership interests
and shares of stock. Pursuant to the securities and purchase
agreement entered into by Somerville S Trust and the Ackerman
family trusts, Somerville S Trust was to acquire from those
family trusts for a total purchase price of $50,000 (1) any
membership interests in USV and shares of stock in U.S. Technolo-
gies that the Ackerman family trusts owned and (2) any claims
that the Ackerman family trusts had against Mr. Earls or any of
Mr. Earls’s affiliates with respect to any fraudulent conduct of
Mr. Earls concerning those membership interests and shares of
stock.
On August 21, 2003, in an effort to recover damages of at
least $5,952,860, Somerville S Trust, which was represented by
Jenner & Block, filed a complaint (August 21, 2003 complaint) in
the United States District Court for the District of Columbia
(U.S. District Court for the District of Columbia) against, inter
alia, Mr. Earls, USV Partners, and U.S. Technologies. The claims
set forth in the August 21, 2003 complaint included the claims
that were assigned to Somerville S Trust by Mr. Lerner, WS In-
- 47 -
vestments, and the Ackerman family trusts pursuant to the respec-
tive securities and purchase agreements described above.
Somerville S Trust alleged in that complaint, inter alia, that
Mr. Earls had “devised and implemented a fraudulent investment
scheme by which he embezzled and misappropriated funds from
investors for his own personal benefit.”
On November 26, 2003, the parties involved in the Ferreira
litigation filed a stipulation of dismissal in the U.S. District
Court for Maryland.
By letter dated March 19, 2004, Jenner & Block sent Mr.
Ackerman a check in the amount of $1,882.73, which had been
recovered from a personal bank account of Mr. Earls. In that
letter, Jenner & Block advised Mr. Ackerman that “We have re-
cently served additional subpoenas and attachment orders on
various banks where Earls had or has accounts”.
On April 23, 2004, Mr. Earls was convicted on all 22 counts
on which he had been indicted on March 24, 2003, and was sen-
tenced to prison for ten years.
By letter dated January 11, 2005, Jenner & Block sent Mr.
Ackerman a check in the amount of $772.86, which had been recov-
ered from another personal bank account of Mr. Earls. In that
letter, Jenner & Block advised Mr. Ackerman of the difficulties
and prohibitive costs of recovering any more funds from that
account.
- 48 -
On a date not disclosed by the record, Somerville S Trust
received a memorandum dated February 14, 2005, that had been sent
to the common shareholders of U.S. Technologies by an individual
named Adam Joseph (Mr. Joseph).53 Mr. Joseph concluded in that
memorandum: “Given the outstanding liabilities of the company
and the illiquid state of the remaining investment portfolio, I
am not optimistic that * * * [U.S. Technologies] shareholders
will realize value.”
On May 26, 2005, Somerville S Trust filed a motion to dis-
miss the August 21, 2003 complaint against Mr. Earls, USV Part-
ners, and U.S. Technologies.54 On June 6, 2005, the U.S. District
Court for the District of Columbia granted that motion.
From around 2002 through 2005, petitioners paid more than
$2.2 million in legal and investigative fees pursuing recovery of
any losses sustained as a result of any fraudulent conduct of Mr.
Earls with respect to the funds invested in USV.
In the 2002 joint return, petitioners claimed a long-term
capital loss of $4,467,610 with respect to the funds that Mr.
Ackerman, through Somerville S Trust, invested in USV. In the
53
The record does not disclose any other information regard-
ing Mr. Joseph.
54
As discussed above, Somerville S Trust alleged in the
August 21, 2003 complaint, inter alia, that Mr. Earls had “de-
vised and implemented a fraudulent investment scheme by which he
embezzled and misappropriated funds from investors for his own
personal benefit.”
- 49 -
2004 joint return, petitioners again claimed a long-term capital
loss in the same amount with respect to that investment.
In the notice for 2002 and 2004, respondent did not make any
determinations regarding the long-term capital loss of $4,467,610
that petitioners claimed in both the 2002 joint return and the
2004 joint return with respect to the funds that Mr. Ackerman,
through Somerville S Trust, invested in USV. In the amended
petition at docket No. 26400-06, petitioners acknowledged that
they are not entitled to deduct that long-term capital loss for
both of their taxable years 2002 and 2004. In that amended
petition, petitioners further alleged as an affirmative issue
that the long-term capital loss that they claimed in both the
2002 joint return and the 2004 joint return with respect to the
funds that Mr. Ackerman, through Somerville S Trust, invested in
USV is “deductible as a theft loss” for their taxable year 2002.
Accuracy-Related Penalty Under Section 6662(a)
Joseph Miller (Mr. Miller) prepared petitioners’ joint
return for each of the years at issue. Ms. Patriarca was respon-
sible for sending to Mr. Miller certain records and schedules
that were pertinent to the preparation of each of those returns.
Grant Thornton, LLP (Grant Thornton), prepared the respec-
tive tax returns of Somerville, Santa Monica, and Crown Capital
for each of the years at issue.
- 50 -
In February 2001, respondent began an examination of peti-
tioners’ taxable years 1997, 1998, and 2000 (examination of 1997,
1998, and 2000). The only issue involved in that examination was
whether the “Other expenses” that petitioners claimed in Schedule
C for each of their taxable years 1997, 1998, and 2000 should
have been claimed in Schedule A instead of Schedule C.
Howard Levinton (Mr. Levinton), an accountant who has been
employed by Grant Thornton since 1987, represented petitioners
with respect to the examination of their taxable years 1997,
1998, and 2000. Mr. Levinton presented to respondent’s revenue
agent (revenue agent) who was assigned to that examination cer-
tain information that that agent requested.
During the examination of 1997, 1998, and 2000, Mr. Levinton
also presented to the revenue agent an amended joint return for
petitioners’ taxable year 1999 (1999 amended joint return). In
that amended return, petitioners claimed a refund of $1,857,106.
Petitioners included Schedule C as part of the 1999 amended joint
return (1999 Schedule C). In that schedule, petitioners showed
the “Principal business or profession, including product or
service” as “INVESTMENTS AND BANKING” and the “Business name” as
“PETER ACKERMAN”. In the 1999 Schedule C, petitioners made no
entries in the section entitled “Income” and claimed “Other
expenses” of $9,694,269 consisting of “INVESTMENT ADVISORY FEES”
of that amount. Petitioners explained in the 1999 amended joint
- 51 -
return that “TAXPAYERS INCORRECTLY DEDUCTED INVESTMENT ADVISORY
FEES AS AN ITEMIZED DEDUCTION RATHER THAN DEDUCTING THEM AS A
TRADE OR BUSINESS EXPENSE ON SCHEDULE C.”55
Around September 2002, respondent issued to petitioners a
30-day letter with respect to their taxable years 1997, 1998, and
2000 (respondent’s 30-day letter). In October 2002, Mr.
Levinton, on petitioners’ behalf, appealed to respondent’s Ap-
peals Office (Appeals Office) the adjustments proposed in that
letter (petitioners’ appeal). Mr. Levinton continued to repre-
sent petitioners throughout that appeal process.
Around early 2005, over a year after petitioners filed the
2002 joint return on November 21, 2003, Mr. Levinton informed Mr.
Lerner of respondent’s position with respect to petitioners’
claimed Schedule C expenses for 1997, 1998, and 2000. Sometime
thereafter in 2005, Mr. Levinton asked Mr. Lerner to accompany
Mr. Levinton to a conference with the Appeals Office (Appeals
Office conference) regarding the adjustments proposed in respon-
dent’s 30-day letter with respect to those years.56
55
In view of respondent’s position on the claimed Schedule C
deductions that are at issue in these cases, we presume that
respondent did not approve the refund that petitioners claimed in
the 1999 amended joint return.
56
The Appeals Office conference that Mr. Levinton asked Mr.
Lerner to attend was rescheduled from a date in 2005 not dis-
closed by the record to a date in December 2005 not disclosed by
the record.
- 52 -
Mr. Ackerman had discussions with Mr. Levinton and Mr.
Lerner regarding the propriety of petitioners’ claimed Schedule C
deductions. Mr. Ackerman had those discussions (1) with Mr.
Levinton on a date not disclosed by the record after respondent
began the examination of 1997, 1998, and 2000 but before peti-
tioners filed the 2002 joint return and (2) with Mr. Lerner57 on a
date in 2005 not disclosed by the record after Mr. Levinton
informed him about respondent’s position with respect to peti-
tioners’ claimed Schedule C deductions for 1997, 1998, and 2000
and over a year after petitioners filed the 2002 joint return.
When Mr. Ackerman discussed the propriety of petitioners’
claimed Schedule C deductions with Mr. Levinton and Mr. Lerner,
he informed them that the expenses for which petitioners claimed
those deductions were “for my business” and “Basically to create
business, to create revenue”. Based upon what Mr. Ackerman told
them, Mr. Levinton and Mr. Lerner advised Mr. Ackerman that they
believed that petitioners’ claimed Schedule C deductions were
proper.
In December 2005, the Appeals Office held the Appeals Office
conference with Mr. Levinton and Mr. Lerner regarding the adjust-
57
It is not clear from the record whether Mr. Levinton was
present at the discussions that Mr. Ackerman had with Mr. Lerner
regarding the propriety of petitioners’ claimed Schedule C
deductions.
- 53 -
ments proposed in respondent’s 30-day letter with respect to
petitioners’ taxable years 1997, 1998, and 2000.
At a time not disclosed by the record before November 17,
2006, respondent began an examination of petitioners’ taxable
years 2002 and 2004. Neither Mr. Levinton nor Mr. Lerner was
involved in that examination.
As discussed above, in the notice for 1997, 1998, and 2000
and the notice for 2002 and 2004, respondent determined (1) that
petitioners’ claimed Schedule C expenses “are not attributable to
an active trade or business under IRC Section 162”, (2) that
those expenses are deductible under section 212 subject to the 2-
percent floor imposed by section 67(a), and (3) that therefore
petitioners should have reported those expenses in Schedule A
instead of Schedule C. In the notice for 2002 and 2004, respon-
dent also determined that petitioners are liable for each of
their taxable years 2002 and 2004 for the accuracy-related pen-
alty under section 6662(a).58 The respective accuracy-related
penalties under section 6662(a) that respondent determined for
petitioners’ taxable years 2002 and 2004 are imposed on respec-
tive underpayments for those years that are attributable solely
to respondent’s disallowance of petitioners’ respective Schedule
58
In the notice for 1997, 1998, and 2000, respondent did not
determine that petitioners are liable for the accuracy-related
penalty under sec. 6662(a).
- 54 -
C deductions claimed in the 2002 joint return and the 2004 joint
return.
OPINION
Burden of Proof
Petitioners do not dispute that they bear the burden of
proof with respect to (1) the affirmative issues that they raised
in the pleadings and that remain at issue and (2) the determina-
tions in the notice for 2002 and 2004 to impose the accuracy-
related penalty. Nor do petitioners dispute that they bear the
burden of proof with respect to the determinations in the notices
to disallow their claimed Schedule C deductions. See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Petition-
ers argue, however, that the burden of proof with respect to the
determinations to disallow those claimed deductions shifts to
respondent under section 7491(a).
In order for the burden of proof to shift to the Commis-
sioner of Internal Revenue under section 7491(a), the taxpayer
must (1) provide credible evidence with respect to any factual
issue relevant to determining the tax liability of the taxpayer
and (2) comply with the applicable requirements of section
7491(a)(2). Although section 7491(a) does not define the term
“credible evidence”, the legislative history of the statute does.
The legislative history of section 7491(a) states in pertinent
part:
- 55 -
Credible evidence is the quality of evidence which,
after critical analysis, the court would find suffi-
cient upon which to base a decision on the issue if no
contrary evidence were submitted (without regard to the
judicial presumption of IRS correctness). * * * The
introduction of evidence will not meet this standard if
the court is not convinced that it is worthy of belief.
* * *
H. Conf. Rept. 105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-
995.
In support of their argument that the burden of proof shifts
to respondent under section 7491(a) with respect to the determi-
nations in the notices to disallow their claimed Schedule C
deductions, petitioners assert:
The extensive testimony of Mr. Ackerman and others
about his Schedule C activity certainly constitutes
“credible evidence” with respect to all pertinent fac-
tual issues. No expense was challenged for lack of
substantiation or failure to maintain records. * * *
Accordingly, the burden of proof on this issue should
shift to respondent. * * *
Respondent counters that
Petitioners rely heavily on the testimony of petitioner
and related individuals, much of which was overly
broad, vague, misleading, and uncorroborated by any
documentary evidence. This testimony does not consti-
tute credible evidence under section 7491(a)(1). * * *
Furthermore, section 7491(a)(2) specifies certain re-
quirements that must be met before section 7491(a)(1)
can apply. Specifically, the taxpayer must have main-
tained all records required by the Internal Revenue
Code. I.R.C. § 7491(a)(2)(B). * * * Petitioner did not
maintain any books or records with respect to his
Schedule C activity. * * *
As discussed below, there are material factual issues rele-
vant to determining whether petitioners are entitled under sec-
- 56 -
tion 162(a) to their claimed Schedule C deductions as to which
they have not introduced credible evidence within the meaning of
section 7491(a)(1).59
On the record before us, we find that the burden of proof
does not shift to respondent under section 7491(a) with respect
to any factual issues that pertain to the Schedule C deductions
that petitioners are claiming for each of the years at issue.
Evaluation of Evidence on Which Petitioners Rely
Petitioners rely on certain testimonial evidence and certain
documentary evidence in order to satisfy their burden of proof
with respect to each of the issues presented.
Testimonial Evidence
The testimonial evidence on which petitioners rely is the
respective testimonies of Mr. Ackerman, Mr. Lerner, Jason
Ackerman, Don Ackerman, Mr. Deutschman, Mr. Levinton, Mr.
Braddock, and Ms. Patriarca.
59
Assuming arguendo that petitioners had introduced credible
evidence within the meaning of sec. 7491(a)(1) with respect to
the factual issues relevant to determining whether petitioners
are entitled under sec. 162(a) to their claimed Schedule C
deductions, the burden of proof with respect to that issue
nonetheless would not shift to respondent under sec. 7491(a)(1).
That is because we have found that Mr. Ackerman maintained no
books and records with respect to the activity reflected in
petitioners’ Schedule C for each of the years at issue. See sec.
7491(a)(2)(B).
- 57 -
Mr. Ackerman’s Testimony
We found the testimony of Mr. Ackerman to be in certain
material respects general, conclusory, vague, ambiguous, confus-
ing, questionable, self-serving, and/or evasive. We shall not
rely on Mr. Ackerman’s testimony to establish petitioners’ re-
spective positions on the various issues to which that testimony
pertained.
Mr. Lerner’s Testimony
We found the testimony of Mr. Lerner to be in certain mate-
rial respects vague, ambiguous, questionable, and/or serving the
interests of his longtime associate Mr. Ackerman, who retained
Mr. Lerner to provide certain legal services for him and who
played a significant role in enabling Mr. Lerner to be employed
by Crown Capital. We shall not rely on Mr. Lerner’s testimony to
establish petitioners’ respective positions on the various issues
to which that testimony pertained.
Don Ackerman’s Testimony
We found the testimony of Don Ackerman to be in certain
material respects general, conclusory, vague, ambiguous, ques-
tionable, and/or serving the interests of his brother Mr.
Ackerman, who played a significant role in enabling Don Ackerman
to be employed by Crown Capital after the business of ECC that
Don Ackerman was managing began facing dire financial circum-
- 58 -
stances.60 We shall not rely on Don Ackerman’s testimony to
establish petitioners’ respective positions on the various issues
to which that testimony pertained.
Jason Ackerman’s Testimony
We found the testimony of Jason Ackerman to be in certain
material respects vague, ambiguous, questionable, and/or serving
the interests of his uncle and longtime associate Mr. Ackerman,
who played a significant role in enabling Jason Ackerman to be
employed by Crown Capital. We shall not rely on Jason Ackerman’s
testimony to establish petitioners’ respective positions on the
various issues to which that testimony pertained.
Mr. Deutschman’s Testimony
We found the testimony of Mr. Deutschman to be in certain
material respects vague, ambiguous, questionable, and/or serving
the interests of his longtime associate Mr. Ackerman, who played
a significant role in enabling Mr. Deutschman to be employed by
Crown Capital. We shall not rely on that testimony to establish
petitioners’ respective positions on the various issues to which
that testimony pertained.
Ms. Patriarca’s Testimony
We generally found the testimony of Ms. Patriarca to be
credible. However, that testimony, together with other reliable
60
See supra note 12.
- 59 -
evidence in the record, did not enable us to sustain petitioners’
position on any of the issues to which that testimony pertained.
Mr. Braddock’s Testimony
We generally found the testimony of Mr. Braddock to be
credible. However, that testimony, together with other reliable
evidence in the record, did not enable us to sustain petitioners’
position on the issue to which that testimony pertained.
Mr. Levinton’s Testimony
We found the testimony of Mr. Levinton to be questionable in
certain material respects. We shall not rely on Mr. Levinton’s
testimony to establish petitioners’ respective positions on the
various issues to which that testimony pertained.
Documentary Evidence
The documentary evidence on which petitioners rely includes,
inter alia, the notices, the respective tax returns of petition-
ers and certain entities that petitioners directly or indirectly
owned, certain written agreements,61 certain travel itineraries of
Mr. Ackerman, and certain newspaper articles regarding Mr. Earls.
Although the documentary evidence on which petitioners rely is
voluminous, that documentary evidence, together with the reliable
61
The written agreements on which petitioners rely include,
inter alia, the Equity Marketing securities purchase agreement
and certain management service agreements entered into between
Crown Capital and each of certain corporations in which Mr.
Ackerman invested.
- 60 -
testimonial evidence in the record, did not enable us to sustain
petitioners’ position on any of the issues presented.
Claimed Business Expense Deductions
It is petitioners’ position that the claimed Schedule C
expenses that remain at issue are deductible under section
162(a).62 In support of that position, petitioners argue that Mr.
Ackerman incurred those expenses in carrying on the business of
advising companies about their finances and management.63
It is respondent’s position that the claimed Schedule C
expenses that remain at issue are deductible under section 212(1)
and that therefore those expenses are subject to the 2-percent
floor imposed by section 67(a). In support of that position,
respondent argues that Mr. Ackerman incurred the claimed Schedule
62
Virtually all of the expenses that petitioners claimed in
Schedule C for each of their taxable years 1997, 1998, 2000,
2002, and 2004 and that remain at issue, see supra note 35,
consist of payments that Mr. Ackerman made during each of those
years to Rockport Advisors and/or Crown Capital. The only
expenses that remain at issue and that do not consist of payments
to Rockport Advisors and/or Crown Capital are $50,253 of expenses
for Mr. Ackerman’s book on nonviolent resistance that petitioners
claimed in the 2000 Schedule C. See supra note 34. The parties
agree, and we have found, that petitioners paid $50,253 of
expenses for that book. However, petitioners make no argument as
to why they are entitled for their taxable year 2000 to deduct
those expenses under sec. 162(a). We conclude that petitioners
have abandoned that argument.
63
For convenience, we shall sometimes refer to Mr.
Ackerman’s claimed business of advising companies about their
finances and management as the alleged business of providing
advisory services.
- 61 -
C expenses that remain at issue as an investor and not in carry-
ing on a trade or business within the meaning of section 162(a).
Section 162(a) generally allows a deduction for ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business. Section 212(1) allows an
individual a deduction for ordinary and necessary expenses paid
or incurred during the taxable year for the production or collec-
tion of income.
In support of their claim that during each of the years at
issue Mr. Ackerman was engaged in the business of advising compa-
nies about their finances and management, petitioners presented
evidence with respect to the major projects64 and advance what we
understand to be two arguments.65 We address each of those argu-
ments below.
Petitioners’ Cost Company or Agency Argument
As we understand it, petitioners are arguing that during
each of the years at issue Rockport Advisors and/or Crown Capital
were cost companies and/or agents of Mr. Ackerman. Consequently,
64
See supra note 15. The record does not disclose what
portion of petitioners’ claimed Schedule C deductions for each of
the years at issue that remains at issue pertained to the major
projects.
65
We found petitioners’ arguments on brief in support of
their position that during each of the years at issue Mr.
Ackerman was engaged in the business of providing advisory
services and that therefore the claimed Schedule C expenses are
deductible under sec. 162(a) to be confusing. We state our
understanding of those arguments.
- 62 -
according to petitioners, they are entitled for each of the years
at issue to deduct under section 162(a) the respective payments
that Mr. Ackerman made during each of those years to Rockport
Advisors and/or Crown Capital. It is not clear from petitioners’
briefs whether petitioners are arguing (1) that during each of
the years at issue Rockport Advisors and/or Crown Capital were
cost companies of Mr. Ackerman and that therefore those companies
were his agents or (2) that during each of those years Rockport
Advisors and/or Crown Capital were Mr. Ackerman’s agents regard-
less of whether they were cost companies of Mr. Ackerman. On the
record before us, we reject both arguments.
We turn first to whether, as petitioners appear to be argu-
ing, Rockport Advisors and/or Crown Capital were cost companies
of Mr. Ackerman and that therefore those companies were his
agents during each of the years at issue. In support of that
argument, petitioners rely on Revenue Ruling 56-542, 1956-2 C.B.
327 (Revenue Ruling 56-542). In that ruling, the Internal Reve-
nue Service (Service) concluded that the stockholders of a cap-
tive mining company (mining company) that had been established as
a cost company were entitled to certain depletion deductions
under section 611 of the Internal Revenue Code of 1954.
In Revenue Ruling 77-1, 1977-1 C.B. 161 (Revenue Ruling 77-
1), the Service revoked Revenue Ruling 56-542. As a result,
petitioners’ reliance on Revenue Ruling 56-542 is misplaced. In
- 63 -
Revenue Ruling 77-1, the Service concluded that “all corporations
operating as cost companies” within the meaning of Revenue Ruling
56-542 “will be treated as separate taxpayers and will be re-
quired to compute their own income, deductions, credits and tax
liabilities.” Rev. Rul. 77-1, 1977-1 C.B. at 161.
Even if the Service had not revoked Revenue Ruling 56-542 in
Revenue Ruling 77-1, we nonetheless would, and do, conclude that
petitioners’ reliance on Revenue Ruling 56-542 is misplaced.
That is because the facts that we have found on the record before
us are materially distinguishable from the facts involved in
Revenue Ruling 56-542. Revenue Ruling 56-542 described the facts
involved therein as follows:
Certain manufacturing corporations, which require for
their normal operations several grades and several
kinds of ore, unite and join with other manufacturers
in an arrangement for the acquisition, by fee or lease,
of mining property and for the exploration, development
and operation of such property. The manufacturers
organize a corporation to own and operate the property,
subscribe to the corporation’s capital stock, and ad-
vance all funds needed both for capital and operative
purposes. The mining company, referred to as a ‘cost
company,’ executes a contract with its stockholding
manufacturing corporations. The contract provides
essentially that the participants, each in proportion
to its stock ownership, shall advance all funds, both
capital and operative, necessary for the mining company
to operate and shall share in the same proportion in
the ore produced. Under an agreement signed with its
stockholding manufacturing corporations, the mining
company will not sell any ore and will have no net
income. Its operations, as well as the disposition of
the products mined, will at all times be under the
control of the participants.
- 64 -
Thus, the basic issue for consideration is whether
the economic interest in the ore thus being produced,
with the resultant right to claim depletion, is in the
captive mining company or its stockholding corpora-
tions.
Rev. Rul. 56-542, 1956-2 C.B. at 327.
In concluding in Revenue Ruling 56-542 that the stockholders
of the mining company involved therein were entitled to certain
depletion deductions under section 611 of the Internal Revenue
Code of 1954, the Service indicated that the mining company must
“file a corporate return showing no income and no deductions on
its face, but containing schedules showing the gross income and
deductions allocable” to its stockholders.
Although during each of the years at issue Mr. Ackerman made
certain payments to Rockport Advisors and/or Crown Capital, Mr.
Ackerman was not a stockholder of those entities. Moreover,
Rockport Advisors and Crown Capital did not file tax returns as
cost companies described in Revenue Ruling 56-542 in which they
claimed no income and no deductions. Instead, (1) Rockport
Advisors filed Form 1120 for each of its taxable years 1997,
1998, and 200066 in which it reported income and deductions that
were attributable to its business activities, and (2) Crown
Capital filed Form 1120 for its taxable year 1997 and Form 1120S
66
See supra note 10.
- 65 -
for each of its taxable years 1998 and 200067 in which it reported
income and deductions that were attributable to its business
activities.68
On the record before us, we find that petitioners have
failed to carry their burden of establishing that during each of
the years at issue Rockport Advisors and/or Crown Capital were
cost companies of Mr. Ackerman.
We turn now to whether, as petitioners appear to be arguing,
Rockport Advisors and/or Crown Capital were Mr. Ackerman’s agents
during each of the years at issue regardless of whether they were
cost companies of Mr. Ackerman. Petitioners state: “A taxpayer
may deduct payments for business expenses made by * * * his agent
on his behalf.”69 In support of that statement, petitioners cite,
67
See supra note 13.
68
Petitioners also rely on Kenco Rests., Inc. v. Commis-
sioner, T.C. Memo. 1998-342, affd. 206 F.3d 588 (6th Cir. 2000),
for the proposition that the “concept of centralizing costs for
several projects in one entity still exists.” Petitioners’
reliance on that case is misplaced. Unlike the instant case,
Kenco Rests., Inc. involved the reallocation under sec. 482 of
deductions claimed by commonly controlled corporations, one of
which had been established as a “cost company” that provided
management and administrative support services to the remaining
commonly controlled corporations there involved. Moreover, the
“cost company” involved in Kenco Rests., Inc. is materially
distinguishable from the cost company described in Rev. Rul. 56-
542, 1956-2 C.B. 327.
69
However, in these cases petitioners did not claim as
Schedule C deductions the respective expenses that Rockport
Advisors and/or Crown Capital incurred during each of the years
at issue. Instead, petitioners claimed as Schedule C deductions
(continued...)
- 66 -
inter alia, Commissioner v. Bollinger, 485 U.S. 340 (1988), in
which the Supreme Court of the United States (Supreme Court)
discussed and applied the four indicia and two requirements of
corporate agency (discussed below).70 Although petitioners cite
Bollinger, they do not analyze and apply those indicia and re-
quirements to Rockport Advisors and to Crown Capital.71
Before turning to Commissioner v. Bollinger, supra, we shall
consider Natl. Carbide Corp. v. Commissioner, 336 U.S. 422
(1949), the seminal case of the Supreme Court addressing how to
determine the existence of a corporate agency. In addressing
69
(...continued)
in the joint return for each of the years at issue certain
payments that Mr. Ackerman made during each of those years to
Rockport Advisors and/or Crown Capital, and Rockport Advisors
and/or Crown Capital claimed as deductions in their respective
tax returns the respective expenses that they incurred during
each of those years.
70
In support of their statement that “A taxpayer may deduct
payments for business expenses made by * * * his agent on his
behalf”, petitioners also cite, inter alia, N.Y. Guandong Fin.,
Inc. v. Commissioner, T.C. Memo. 2008-62. In that case, we
discussed and applied the four indicia and two requirements of
corporate agency that the Supreme Court discussed and applied in
Commissioner v. Bollinger, 485 U.S. 340, 346-347 (1988). We
concluded in N.Y. Guandong Fin., Inc., that the facts therein did
not establish the existence of a corporate agency.
71
In advancing what appears to be petitioners’ argument that
Rockport Advisors and/or Crown Capital were cost companies of Mr.
Ackerman and that therefore those companies were his agents
during each of the years at issue, petitioners claim that “Crown
[Capital] operated for the account of Mr. Ackerman”. If the
record had established that “Crown [Capital] operated for the
account of Mr. Ackerman”, which we find it does not, as discussed
below, that alleged fact would have been an indicium of agency.
- 67 -
that issue, the Supreme Court set forth the following four indi-
cia and two requirements that are to be considered in making such
a determination:
Whether the corporation operates in the name and for
the account of the principal, binds the principal by
its actions, transmits money received to the principal,
and whether receipt of income is attributable to the
services of employees of the principal and to assets
belonging to the principal are some of the relevant
considerations in determining whether a true agency
exists. If the corporation is a true agent, its rela-
tions with its principal must not be dependent upon the
fact that it is owned by the principal, if such is the
case. Its business purpose must be the carrying on of
the normal duties of an agent. * * * [Fn. refs. omit-
ted.]
Id. at 437. (The above-quoted indicia and requirements of corpo-
rate agency are commonly referred to, and we shall refer to them,
as the six National Carbide factors.) In Natl. Carbide Corp.,
the Supreme Court applied the six National Carbide factors and
concluded that the facts therein did not establish the existence
of a corporate agency.
In Commissioner v. Bollinger, supra, the Supreme Court again
addressed how to determine whether a corporate agency exists. In
addressing that issue, the Supreme Court restated the six Na-
tional Carbide factors, id. at 346-347, and observed that those
factors are designed to ensure “the genuineness of the agency
relationship”, id. at 349. According to the Supreme Court,
the genuineness of the agency relationship is ad-
equately assured * * * when the fact that the corpora-
tion is acting as agent for its shareholders with re-
spect to a particular asset is set forth in a written
- 68 -
agreement at the time the asset is acquired, the corpo-
ration functions as agent and not principal with re-
spect to the asset for all purposes, and the corpora-
tion is held out as the agent and not principal in all
dealings with third parties relating to the asset.
* * *
Id. at 349-350. In Bollinger, the Supreme Court concluded that
the facts therein established “the genuineness of the agency
relationship”. Id.
In order to determine whether Rockport Advisors and/or Crown
Capital were Mr. Ackerman’s agents during each of the years at
issue, we shall apply and analyze the six National Carbide fac-
tors. We turn first to Rockport Advisors. As discussed above,
the record is very sparse as to the activities of Rockport Advi-
sors during each of the years at issue,72 including 1997, 1998,
2000, and 2002, the only years in which Mr. Ackerman made certain
payments to that company that petitioners claimed as expenses in
their respective Schedules C for those years.73 We note initially
that the requirement included as one of the six National Carbide
factors that the corporation’s “relations with its principal must
not be dependent upon the fact that it is owned by the princi-
pal”, Natl. Carbide Corp. v. Commissioner, supra at 437, is
irrelevant to our resolving whether Rockport Advisors was Mr.
Ackerman’s agent during each of petitioners’ taxable years 1997,
72
See supra note 9.
73
See supra note 33.
- 69 -
1998, 2000, and 2002. That is because the parties do not dispute
that during each of those years Mr. Ackerman did not have an
ownership interest in Rockport Advisors. See Shenker v. Commis-
sioner, 804 F.2d 109, 113 (8th Cir. 1986), affg. T.C. Memo. 1985-
301.
With respect to the remaining five National Carbide factors,
on the record before us, we find that petitioners have failed to
carry their burden of establishing that during each of their
taxable years 1997, 1998, 2000, and 2002 (1) Rockport Advisors
acted in the name, and for the account, of Mr. Ackerman; (2)
Rockport Advisors bound Mr. Ackerman by its actions; (3) Rockport
Advisors transmitted money received to Mr. Ackerman; (4) the
receipt of income by Rockport Advisors was attributable to the
services of the employees of Mr. Ackerman and the assets belong-
ing to Mr. Ackerman; or (5) the business purpose of Rockport
Advisors was the carrying on of the normal duties of an agent.
On the record before us, we find that petitioners have
failed to carry their burden of establishing that during each of
petitioners’ taxable years 1997, 1998, 2000, and 2002 Rockport
Advisors was Mr. Ackerman’s agent.
We turn now to Crown Capital. We note initially that, as
was true with respect to Rockport Advisors, the requirement
included as one of the six National Carbide factors that the
corporation’s “relations with its principal must not be dependent
- 70 -
upon the fact that it is owned by the principal”, Natl. Carbide
Corp. v. Commissioner, 336 U.S. at 437, is irrelevant to our
resolving whether Crown Capital was Mr. Ackerman’s agent during
each of the years at issue. That is because the parties do not
dispute that during each of those years Mr. Ackerman did not have
an ownership interest in Crown Capital. See Shenker v. Commis-
sioner, supra at 113.
With respect to the remaining five National Carbide factors,
on the record before us, we find that petitioners have failed to
carry their burden of establishing that during each of the years
at issue (1) Crown Capital acted in the name, and for the ac-
count, of Mr. Ackerman;74 (2) Crown Capital bound Mr. Ackerman by
its actions; (3) Crown Capital transmitted money received to Mr.
Ackerman; (4) the receipt of income by Crown Capital was attrib-
utable to the services of the employees of Mr. Ackerman and the
assets belonging to Mr. Ackerman;75 or (5) the business purpose of
Crown Capital was the carrying on of the normal duties of an
agent.76
74
See supra note 71.
75
Although Mr. Ackerman paid Crown Capital the funds that it
requested in order to assist it in carrying on its business
activities, after he did, those funds became the funds of Crown
Capital and no longer belonged to Mr. Ackerman.
76
Moreover, on the record before us, we find that petition-
ers did not establish the following facts that would have been
helpful in ensuring “the genuineness of the [claimed] agency
(continued...)
- 71 -
On the record before us, we find that petitioners have
failed to carry their burden of establishing that during each of
the years at issue Crown Capital was Mr. Ackerman’s agent.
Petitioners’ Compensation Argument
As we understand it, petitioners are arguing that during
each of the years at issue Mr. Ackerman received compensation
other than the normal investor’s return for the advisory services
that he provided during each of those years with respect to the
major projects. Consequently, according to petitioners, under
applicable caselaw, during each of the years at issue Mr.
Ackerman was engaged in a trade or business of providing advisory
services within the meaning of section 162(a). The principal
case on which petitioners rely to support that argument is Giblin
v. Commissioner, 227 F.2d 692 (5th Cir. 1955), revg. T.C. Memo.
76
(...continued)
relationship”, Commissioner v. Bollinger, 485 U.S. at 349,
between Crown Capital and Mr. Ackerman: (1) There was a written
agreement that set forth that Crown Capital was an agent of Mr.
Ackerman during any of the years at issue; (2) Crown Capital
functioned for any purpose as an agent with respect to the major
projects that he pursued during those years; and (3) Crown
Capital was held out as an agent of Mr. Ackerman in all dealings
with third parties relating to those projects during those years.
To the contrary, we have found that during the years at issue
Crown Capital, in its own name, entered into various management
service agreements with the respective companies involved in
certain of the projects that Mr. Ackerman pursued. Pursuant to
those agreements, in exchange for certain fees to be paid by
those respective companies to Crown Capital, Crown Capital was to
provide certain services to them.
- 72 -
1954-186.77 According to petitioners, “Mr. Ackerman’s business
was not dissimilar [to that of the taxpayer in Giblin], as he
helped people create and structure transactions.” What petition-
ers fail to understand or choose to ignore is that the fact that
Mr. Ackerman may have “helped people create and structure trans-
actions” in providing advisory services during the years at issue
with respect to the major projects is not determinative of
whether for each of those years he was engaged in a trade or
business of providing those services within the meaning of sec-
tion 162(a).
In Giblin v. Commissioner, supra, the United States Court of
Appeals for the Fifth Circuit (Court of Appeals for the Fifth
Circuit) addressed whether the taxpayer “was regularly engaged in
the business of seeking out business opportunities, promoting,
organizing and financing them, contributing to them substantially
50% of his time and energy and then disposing of them either at a
profit or loss”. The Court of Appeals for the Fifth Circuit held
that the taxpayer was engaged in that business. In so holding,
that Court relied on, inter alia, Foss v. Commissioner, 75 F.2d
77
Petitioners also rely on certain other cases to establish
that during each of the years at issue Mr. Ackerman was engaged
in a trade or business of providing advisory services within the
meaning of sec. 162(a). We have carefully considered each of
those other cases. We find all of them to be materially distin-
guishable from the instant cases and petitioners’ reliance on
them to be misplaced.
- 73 -
326 (1st Cir. 1935), and Sage v. Commissioner, 15 T.C. 299
(1950). Giblin v. Commissioner, supra at 696.
In Whipple v. Commissioner, 373 U.S. 193, 203 n.10 (1963),
which the Supreme Court decided after Giblin, the Supreme Court
expressly disapproved of any statements and holdings in Foss and
Sage that were contrary to its statements and holdings in
Whipple. In Whipple, the Supreme Court addressed whether a
taxpayer who had furnished regular services to several corpora-
tions in which he was an investor was engaged in an independent
trade or business. The Supreme Court held that “Absent substan-
tial additional evidence, furnishing management and other ser-
vices to corporations for a reward not different from that flow-
ing to an investor in those corporations is not a trade or busi-
ness”. Id. at 203 (fn. ref. omitted). In so holding, the Su-
preme Court stated:
Devoting one’s time and energies to the affairs of
a corporation is not of itself, and without more, a
trade or business of the person so engaged. Though
such activities may produce income, profit or gain in
the form of dividends or enhancement in the value of an
investment, this return is distinctive to the process
of investing and is generated by the successful opera-
tion of the corporation’s business as distinguished
from the trade or business of the taxpayer himself.
When the only return is that of an investor, the tax-
payer has not satisfied his burden of demonstrating
that he is engaged in a trade or business since invest-
ing is not a trade or business and the return to the
taxpayer, though substantially the product of his ser-
vices, legally arises not from his own trade or busi-
ness but from that of the corporation. Even if the
taxpayer demonstrates an independent trade or business
of his own, care must be taken to distinguish bad debt
- 74 -
losses arising from his own business and those actually
arising from activities peculiar to an investor con-
cerned with, and participating in, the conduct of the
corporate business.
If full-time service to one corporation does not
alone amount to a trade or business, which it does not,
it is difficult to understand how the same service to
many corporations would suffice. To be sure, the pres-
ence of more than one corporation might lend support to
a finding that the taxpayer was engaged in a regular
course of promoting corporations for a fee or commis-
sion, * * * or for a profit on their sale, see Giblin
v. Commissioner, 227 F.2d 692 * * *, but in such cases
there is compensation other than the normal investor’s
return, income received directly for his own services
rather than indirectly through the corporate enterprise
* * *
Id. at 202-203.
Although, as quoted above, the Supreme Court in Whipple
cited Giblin v. Commissioner, 227 F.2d 692 (5th Cir. 1955), it
cited Giblin only for the narrow proposition that “the presence
of more than one corporation might lend support to a finding that
the taxpayer was engaged in a regular course of promoting corpo-
rations * * * for a profit on their sale”. Whipple v. Commis-
sioner, supra at 202-203. In citing Giblin for that narrow
proposition, the Supreme Court emphasized that in order to con-
clude that a taxpayer is engaged in a trade or business “there
* * * [must be] compensation other than the normal investor’s
return, income received directly for * * * [the taxpayer’s] own
services rather than indirectly through the corporate enter-
prise”. Id. We must read Giblin in a manner that is consistent
- 75 -
with Whipple. We did so in Deely v. Commissioner, 73 T.C. 1081
(1980), a case that petitioners do not cite.
In Deely, we addressed whether a taxpayer who had organized
and financed 26 companies was engaged in the trade or business of
promoting, organizing, financing, and/or dealing in corporations.
We held in Deely that the taxpayer was not engaged in that trade
or business. Id. at 1096. In so holding, we stated:
In order to establish a business separate from
that of his corporations, * * * [the taxpayer] must
show that the compensation he seeks from his activities
is other than the normal investor’s return and that
income received is directly for his services rather
than indirectly through the successful operation of the
corporate enterprise. Whipple v. Commissioner, supra
at 203.
* * * [The taxpayer] contends that he was in the
separate business of promoting, organizing, financing,
and/or dealing in corporations. It seems clear from
Whipple that to qualify such activities as a separate
business they must be conducted for a fee or commission
or with the immediate purpose of selling the corpora-
tions at a profit in the ordinary course of that busi-
ness. * * * There is no evidence in this case that
* * * [the taxpayer] received any fees or commissions
for organizing, financing, or promotional activities;
instead, he usually invested or took an equity interest
in the entities that he organized, promoted, or fi-
nanced. * * *
Id. at 1093.
In reaching our holding in Deely v. Commissioner, supra at
1093, we considered Giblin v. Commissioner, supra. We concluded
in Deely that in order to come within the holding in Giblin a
taxpayer must show that the taxpayer organized the entities in
which the taxpayer invested “with a view to a quick and profit-
- 76 -
able sale after each business had become established, rather than
with a view to long-range investment gains.”78 Id.
In contrast to the taxpayer in Giblin v. Commissioner,
supra, petitioners do not claim, and presented no evidence, let
alone credible evidence, see sec. 7491(a), establishing, that
during each of the years at issue Mr. Ackerman provided advisory
services pertaining to the finances and management of the respec-
tive companies involved in the major projects with the purpose of
selling his respective interests in those companies at a profit
in the ordinary course of his alleged business of providing those
services.79 We find Giblin to be materially distinguishable from
the instant cases and petitioners’ reliance on that case to be
misplaced.
On the record before us, we find that petitioners have
failed to carry their burden of establishing that during each of
the years at issue Mr. Ackerman provided advisory services with
respect to the major projects with the purpose of selling his
78
We observed in Deely v. Commissioner, 73 T.C. 1081, 1093
n.11 (1980), that “it would appear that Giblin v. Commissioner,
227 F.2d 692 (5th Cir. 1955), has been sapped of some of its
vitality by the opinions of the Fifth Circuit in Bodzy v. Commis-
sioner,
321 F.2d 331 (5th Cir. 1963); and United States v. Byck,
325 F.2d 551 (5th Cir. 1963).”
79
Indeed, on the record before us, we find that petitioners
have failed to establish that Mr. Ackerman sold any of his
respective interests in the companies involved in the major
projects in the ordinary course of his alleged business of
providing advisory services.
- 77 -
interests in the respective companies involved in those projects
at a profit in the ordinary course of his alleged business of
providing those services.80 See Whipple v. Commissioner, 373 U.S.
at 202-203; Deely v. Commissioner, supra at 1093; cf. Giblin v.
Commissioner, supra.
We shall address now whether during each of the years at
issue Mr. Ackerman provided advisory services with respect to
each of the major projects in exchange for a fee or a commission
or any other compensation other than the normal investor’s re-
turn. See Whipple v. Commissioner, supra at 202-203; Deely v.
Commissioner, supra at 1093.
With respect to the major project pertaining to Equity
Marketing (Equity Marketing project), petitioners claim that Mr.
Ackerman received a fee in exchange for the advisory services
that he provided with respect to that project.81 To support that
claim, petitioners rely on the testimony of Mr. Ackerman on which
we are unwilling to rely to establish petitioners’ position with
respect to their claimed Schedule C deductions. In this regard,
80
See supra note 79.
81
Petitioners reported no income, let alone income from the
Equity Marketing project, in Schedule C for each of the years at
issue. Moreover, petitioners do not claim, and the record does
not establish, that they reported in any other part of their
joint returns for any of the years at issue the fee that peti-
tioners claim Mr. Ackerman received in exchange for the advisory
services that he provided with respect to the Equity Marketing
project.
- 78 -
Mr. Ackerman testified that he received a fee in exchange for the
advisory services that he provided with respect to the Equity
Marketing project. Our understanding is that the fee to which
Mr. Ackerman referred in his testimony is the commitment fee that
Equity Marketing agreed to pay to Crown Acquisition Partners, or
any of its affiliates, as part of Equity Marketing’s agreement to
sell to Crown Acquisition Partners certain shares of its stock
and certain warrants to purchase certain other shares of its
stock. There is no reliable evidence in the record establishing
that Equity Marketing was required to, and did, pay the commit-
ment fee required in the Equity Marketing securities purchase
agreement in exchange for any advisory services that Mr. Ackerman
provided to Equity Marketing. We have found that that commitment
fee was required to be paid to Crown Acquisition Partners or one
of its affiliates as part of Equity Marketing’s agreement to sell
to Crown Acquisition Partners certain shares of its stock and
certain warrants to purchase certain other shares of its stock
and that it was paid to Crown Capital, one of Crown Acquisition
Partners’ affiliates. That commitment fee was not required to
be, and was not, paid to Mr. Ackerman.82
82
The record does not establish, and petitioners do not even
claim, that they reported in any of their joint returns for the
years at issue the commitment fee required in the Equity Market-
ing securities purchase agreement. See supra note 81.
- 79 -
Petitioners claim not only that Mr. Ackerman received a fee
in exchange for the advisory services that he provided with
respect to the Equity Marketing project, but also that he re-
ceived dividends in exchange for those services. The parties do
not dispute that petitioners received, and reported in their
joint return for each of their taxable years 2000 through 2006,
certain dividend income from Equity Marketing that had flowed
through, inter alia, Somerville. However, that fact does not
support petitioners’ position that Mr. Ackerman received compen-
sation other than the normal investor’s return in exchange for
the advisory services that he provided with respect to the Equity
Marketing project. The receipt of dividends is “distinctive to
the process of investing and is generated by the successful
operation of the corporation’s business as distinguished from the
trade or business of the taxpayer”. Whipple v. Commissioner,
supra at 202.
On the record before us, we find that petitioners did not
introduce credible evidence, see sec. 7491(a)(1), and have failed
to carry their burden of, establishing that Mr. Ackerman provided
advisory services with respect to the Equity Marketing project in
exchange for a fee or a commission or any other compensation
other than the normal investor’s return.
With respect to the major project pertaining to Thales Fund
Management (Thales project), petitioners claim that Mr. Ackerman
- 80 -
received as compensation other than the normal investor’s return
certain equity interests in Thales Fund Management and/or one of
its related entities in exchange for the advisory services that
he provided with respect to that project. To support that claim,
petitioners rely on the respective testimonies of Mr. Ackerman
and Mr. Lerner on which we are unwilling to rely to establish
petitioners’ position with respect to their claimed Schedule C
deductions. Although we have found that Mr. Ackerman indirectly
owned certain equity interests in Thales Fund Management, Thales
Capital, and Thales Fund, on the record before us, we find that
petitioners have failed to carry their burden of establishing
that Mr. Ackerman received those respective equity interests as
compensation other than the normal investor’s return for the
advisory services that he provided with respect to the Thales
project.83
83
Petitioners reported no income, let alone income from the
Thales project, in Schedule C for each of the years at issue.
Nonetheless, petitioners argue that “Amounts received for ser-
vices for Thales Fund Management were reported [by petitioners]
through Somerville”. In advancing that argument, petitioners
point to the fact that Somerville reported in its Form 1065 its
respective distributive shares of taxable income that were
generated by the respective operations of (1) Thales Fund Manage-
ment and Thales Capital for each of Somerville’s taxable years
1999 through 2004 and (2) Thales Fund for each of Somerville’s
taxable years 1999, 2000, 2002, and 2004. Those respective
distributive shares of taxable income that were generated by the
respective operations of Thales Fund Management, Thales Capital,
and Thales Fund did not represent compensation for Mr. Ackerman’s
advisory services.
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On the record before us, we find that petitioners did not
introduce credible evidence, see sec. 7491(a)(1), and have failed
to carry their burden of, establishing that Mr. Ackerman provided
advisory services with respect to the Thales project in exchange
for a fee or a commission or any other compensation other than
the normal investor’s return.
With respect to the major project pertaining to Fresh Direct
(Fresh Direct project), petitioners claim that Mr. Ackerman
received as compensation other than the normal investor’s return
certain “‘free’ equity” in exchange for the advisory services
that he provided with respect to that project.84 To support that
claim, petitioners rely on the respective testimonies of Mr.
Ackerman and Jason Ackerman on which we are unwilling to rely to
establish petitioners’ position with respect to their claimed
Schedule C deductions. In this regard, Mr. Ackerman testified at
trial that (1) in exchange for the advisory services that he
provided to Fresh Direct, he was able to purchase 83 percent of
the stock of that company for the nominal amount of a penny a
share, (2) the value of each of those shares eventually rose to
84
Petitioners reported no income, let alone income from the
Fresh Direct project, in Schedule C for each of the years at
issue. Moreover, petitioners do not claim, and the record does
not establish, that they reported in any of the joint returns for
the years at issue any income, let alone income in the form of
compensation other than the normal investor’s return, from the
Fresh Direct project.
- 82 -
$2, and (3) therefore he received “free equity” in Fresh Direct
that had a value of $135 million.
Mr. Ackerman’s testimony that, in exchange for the advisory
services that he provided to Fresh Direct, he was able to pur-
chase 83 percent of the stock of Fresh Direct for the nominal
amount of a penny a share is apparently based on the assumption
that the stock of Fresh Direct was worth more than a penny a
share at the time Mr. Ackerman purchased 83 percent of that
stock--an alleged fact that we are unable to find on the record
before us. Mr. Ackerman’s testimony that the value of the shares
of stock of Fresh Direct that he purchased for a penny a share
eventually rose to $2 a share and that therefore he received
“free equity” in Fresh Direct valued at $135 million is appar-
ently based on the assumption that any increase in the value of
the Fresh Direct stock that he purchased establishes that he
received compensation other than the normal investor’s return for
the advisory services that he provided with respect to the Fresh
Direct project–-a conclusion that is contrary to Whipple v.
Commissioner, 373 U.S. 193 (1963). Any enhancement in the value
of the Fresh Direct shares that Mr. Ackerman purchased “is dis-
tinctive to the process of investing and is generated by the
successful operation of the corporation’s [Fresh Direct’s] busi-
ness as distinguished from the trade or business of the taxpayer
[Mr. Ackerman] himself.” Id. at 202.
- 83 -
On the record before us, we find that petitioners did not
introduce credible evidence, see sec. 7491(a)(1), and have failed
to carry their burden of, establishing that Mr. Ackerman provided
advisory services with respect to the Fresh Direct project in
exchange for a fee or a commission or any other compensation
other than the normal investor’s return.
With respect to the major project pertaining to Resort
Theaters (Resort Theaters project), petitioners claim that Mr.
Ackerman received as compensation other than the normal inves-
tor’s return certain “equity compensation” in Resort Theaters in
exchange for the advisory services that he provided with respect
to that project.85 To support that claim, petitioners rely on the
testimony of Mr. Lerner on which we are unwilling to rely to
establish petitioners’ position with respect to their claimed
Schedule C deductions. We have found (1) that on February 18,
1999, Santa Monica, virtually all of which Mr. Ackerman owned
indirectly, invested $14 million in Resort Theaters in return for
which Santa Monica received a 100-percent ownership interest in
Resort Theaters and (2) that Santa Monica reported in Form 1065
for its taxable year 2000 a long-term capital loss of $14 million
85
Petitioners reported no income, let alone income from the
Resort Theaters project, in Schedule C for each of the years at
issue. Moreover, petitioners do not claim, and the record does
not establish, that they reported in any of the joint returns for
the years at issue any income, let alone income in the form of
compensation other than the normal investor’s return, from the
Resort Theaters project.
- 84 -
with respect to its investment in Resort Theaters. On the record
before us, we find that petitioners have failed to carry their
burden of establishing that Mr. Ackerman received that indirect
equity interest in Resort Theaters as compensation other than the
normal investor’s return for the advisory services that he pro-
vided with respect to the Resort Theaters project.
On the record before us, we find that petitioners did not
introduce credible evidence, see sec. 7491(a)(1), and have failed
to carry their burden of, establishing that Mr. Ackerman provided
advisory services with respect to the Resort Theaters project in
exchange for a fee or a commission or any other compensation
other than the normal investor’s return.
With respect to the major project pertaining to Davidson
Cotton (Davidson Cotton project), petitioners claim that Mr.
Ackerman received as compensation other than the normal inves-
tor’s return what he characterized at trial as an “override” in
exchange for the advisory services that he provided with respect
to that project.86 To support that claim, petitioners rely on the
testimony of Mr. Ackerman on which we are unwilling to rely to
establish petitioners’ position with respect to their claimed
86
Petitioners reported no income, let alone income from the
Davidson Cotton project, in Schedule C for each of the years at
issue. Moreover, petitioners do not claim, and the record does
not establish, that they reported in any of the joint returns for
the years at issue any income, let alone income in the form of
compensation other than the normal investor’s return, from the
Davidson Cotton project.
- 85 -
Schedule C deductions. We understand the ordinary meaning of the
term “override”. However, we do not understand the meaning or
the nature of the “override” to which Mr. Ackerman referred in
his testimony.87 We have found (1) that on December 3, 1999,
Somerville, virtually all of which Mr. Ackerman owned indirectly,
invested $15 million in Crown Davidson Partners and (2) that on
the same date Crown Davidson Partners acquired 15,000 shares of
preferred stock in Davidson Cotton.88 On the record before us, we
find that petitioners have failed to carry their burden of estab-
lishing that Mr. Ackerman received compensation other than the
normal investor’s return for the advisory services that he pro-
vided with respect to the Davidson Cotton project.
87
Mr. Ackerman testified as follows with respect to the so-
called override:
And we negotiated, we went to Jacob Rothschild and
basically negotiated an investment that he would come
in on on which we negotiated an override and with an
other Mexican investor where we negotiated an override.
Now what I mean by we, * * * I meant Jeff
Deutschman, Jason [Ackerman], and Perry [Lerner], and
me as well, as a participant in the overrides we would
get from these other people.
For example, with Jacob Rothschild, we negotiated
a 20 percent override. The relationship, each of the
other three —- Perry, Jason and Jeff –- received three
and a third percent of that override, of that 20 per-
cent; I received ten percent of that override.
88
See appendix A.
- 86 -
On the record before us, we find that petitioners did not
introduce credible evidence, see sec. 7491(a)(1), and have failed
to carry their burden of, establishing that Mr. Ackerman provided
advisory services with respect to the Davidson Cotton project in
exchange for a fee or a commission or any other compensation
other than the normal investor’s return.
On the record before us, we find that petitioners have
failed to carry their burden of establishing that Mr. Ackerman
provided advisory services with respect to the major projects in
exchange for a fee or a commission or any other compensation
other than the normal investor’s return. See Whipple v. Commis-
sioner, 373 U.S. at 202-203; Deely v. Commissioner, 73 T.C. at
1093.
It appears from the record before us, including the respec-
tive testimonies of Mr. Ackerman and Mr. Deutschman, that during
the years at issue Mr. Ackerman provided advisory services with
respect to the major projects as part of an investment strategy
designed to determine whether to make investments in the respec-
tive companies involved in those projects and how to enhance the
value of any such investments made.89 By way of illustration, Mr.
89
It was petitioners themselves who described Mr. Ackerman’s
“Principal business or profession, including product or service”
in their Schedule C for each of the years at issue as “INVEST-
MENTS AND BANKING”. Petitioners do not claim, and the record
does not establish, that Mr. Ackerman was engaged in the business
of banking during any of the years at issue.
- 87 -
Ackerman testified with respect to the Equity Marketing project
that Equity Marketing
came to me and asked me to make an equity investment
and to also provide direct advice for them in the ac-
quisition process.
What I then did was went to Jason [Ackerman],
* * * [Mr. Deutschman] and * * * [Mr. Lerner] and said
would you do the due diligence to see whether, number
one, we had an investment that was of interest to us;
and then to see more importantly as [to] whether we
could add value from an advisory point of view in terms
of their negotiating strategy.
By way of further illustration, Mr. Deutschman, the managing
director of Crown Capital, testified with respect to Mr.
Ackerman’s relationship with Crown Capital90 that “Crown Capital
was a private equity investment business set up to acquire con-
trol of middle-market companies or perhaps the seed, the growth
plans, of companies that exhibited attractive grown [sic] oppor-
tunities for the benefit of primarily Peter Ackerman.” According
to Mr. Deutschman, “The people in New York [i.e., the employees
of Crown Capital] were responsible for doing diligence, doing a
lot of detail work, reporting back to the managing directors and
Peter [Ackerman] as to the progress in various investments”.
Based upon our examination of the entire record before us,
we find that petitioners have failed to carry their burden of
establishing that during each of the years at issue Mr. Ackerman
90
Crown Capital was the recipient of substantially or virtu-
ally all of the payments that petitioners claimed in Schedule C
for each of the years at issue.
- 88 -
was carrying on a trade or business of advising companies about
their finances and management within the meaning of section
162(a). On that record, we further find that petitioners have
failed to carry their burden of establishing that they are enti-
tled for each of those years to deduct under section 162(a) the
Schedule C expenses that petitioners are claiming.
Claimed Deduction for the
Protection of Business Reputation
It is petitioners’ position that they are entitled for their
taxable year 1997 to deduct under section 162(a) the $7,850,000
that Mr. Ackerman, through Somerville S Trust, advanced to ECC
and that was booked by both Somerville S Trust and ECC as a loan.
In support of that position, petitioners argue (1) that the
$7,850,000 that Mr. Ackerman advanced to ECC did not constitute a
loan and (2) that Mr. Ackerman’s primary motive in advancing
those funds to ECC was to protect his business reputation.
It is respondent’s position that petitioners are not enti-
tled for their taxable year 1997 to deduct under section 162(a)
the $7,850,000 that Mr. Ackerman, through Somerville S Trust,
advanced to ECC. In support of that position, respondent argues
that the transfer of those funds constituted a loan from
Somerville S Trust to ECC. Respondent further argues:
It is clear that the transfers in question were
part of a substantial capital investment by Somerville
S Trust in the International Group. The transfers were
contemporaneous with the formation in 1997 of the indi-
vidual members of the International Group. Economy
- 89 -
Color Card was acquired by ISI in 1997, and its assets
and operations were absorbed into the International
Group. Not only did the International Group carry on
the business of Economy Color Card, it also sought to
develop new areas of business. Clearly the transfers
were part of a larger investment in the International
Group. * * *[91]
We need not resolve the parties’ dispute over whether for
tax purposes the $7,850,000 that Mr. Ackerman advanced to ECC
constituted a loan from Somerville S Trust to ECC. That is
because, even if we were to find, as petitioners contend, that
that transfer did not constitute a loan, any such finding would
not affect our ultimate finding with respect to the deductibility
under section 162(a) of the $7,850,000 of advanced funds.
Petitioners acknowledge that generally a taxpayer may not
deduct the expenses paid on behalf of another. See Welch v.
Helvering, 290 U.S. 111 (1933). Petitioners nonetheless argue
that they are entitled to deduct under section 162(a) the
$7,850,000 of advanced funds because Mr. Ackerman’s primary
motive in advancing those funds was to protect his business
reputation and not to acquire any capital asset or protect an
investment. In support of that argument, petitioners rely on,
inter alia, Allen v. Commissioner,
283 F.2d 785 (7th Cir. 1960),
91
Respondent argues in the alternative that petitioners are
“barred by * * * the TEFRA partnership provisions” from claiming
a deduction with respect to the $7,850,000 of advanced funds for
their taxable year 1997. See infra note 96.
- 90 -
affg. in part and revg. in part T.C. Memo. 1959-227, and Lohrke
v. Commissioner, 48 T.C. 679 (1967) (discussed below).
Although it is not altogether clear, petitioners appear to
be arguing that the business reputation that Mr. Ackerman was
seeking to protect was his reputation in his alleged business of
advising companies about their finances and management. We have
found that petitioners have failed to carry their burden of
establishing that during any of the taxable years at issue,
including 1997 for which petitioners are claiming a deduction
with respect to the $7,850,000 of advanced funds, Mr. Ackerman
was carrying on a trade or business of advising companies about
their finances and management within the meaning of section
162(a).
Assuming arguendo that petitioners had carried their burden
of establishing that during their taxable year 1997 Mr. Ackerman
was carrying on a trade or business of advising companies about
their finances and management within the meaning of section
162(a), on the instant record, we nonetheless would, and do
below, reject petitioners’ contention that Mr. Ackerman, through
Somerville S Trust, advanced $7,850,000 to ECC in order to pro-
tect his reputation in that alleged business.
In deciding whether petitioners are entitled for their
taxable year 1997 to deduct under section 162(a) the $7,850,000
of advanced funds, we must determine whether Mr. Ackerman’s
- 91 -
primary motive in advancing those funds to ECC was to protect his
reputation in his alleged business of providing advisory ser-
vices. See Capital Video Corp. v. Commissioner, 311 F.3d 458,
464 (1st Cir. 2002), affg. T.C. Memo. 2002-40; Lohrke v. Commis-
sioner, supra.
In support of their claim that Mr. Ackerman’s primary motive
in advancing $7,850,000 to ECC was to protect his reputation in
his alleged business of providing advisory services, petitioners
rely on the respective testimonies of Mr. Ackerman, Jason
Ackerman, Don Ackerman, and Mr. Lerner on which we are unwilling
to rely to establish petitioners’ position with respect to their
claimed deduction under section 162(a) of the $7,850,000 of
advanced funds. They also rely on the testimony of Mr. Braddock.
Mr. Braddock testified that he knew nothing about the busi-
ness of ECC. Mr. Braddock also testified that he was not even
aware at the time in 1997 Mr. Ackerman made advances totaling
$7,850,000 to ECC that Mr. Ackerman was making those advances.
Mr. Braddock thus could not have known at that time, and he did
not testify about, why Mr. Ackerman advanced a total of
$7,850,000 to ECC. We are unable to find from Mr. Braddock’s
testimony that Mr. Ackerman’s primary motive in advancing those
funds to ECC was to protect Mr. Ackerman’s reputation in his
alleged business of providing advisory services.
- 92 -
We turn now to Allen v. Commissioner, supra, and Lohrke v.
Commissioner, supra, on which, inter alia, petitioners rely to
support their position that they are entitled to deduct under
section 162(a) the $7,850,000 of advanced funds.92
In Allen v. Commissioner, supra, the United States Court of
Appeals for the Seventh Circuit (Court of Appeals for the Seventh
Circuit) addressed whether the president (Mr. Allen) of a corpo-
ration (Tucson corporation), who was a stockholder of that corpo-
ration, was entitled to deduct as an ordinary and necessary
business expense $10,000 ($10,000 of Tucson funds) that he had
advanced to that corporation so that it could make certain pay-
ments to its creditors. That court held that Mr. Allen was
entitled to do so. Id. at 791. In so holding, the Court of
Appeals for the Seventh Circuit examined Mr. Allen’s purpose in
advancing those funds. Id. at 790. That court found that Mr.
Allen advanced the $10,000 of Tucson funds “to protect the repu-
tation and credit standing” of his sole proprietorship. Id. In
making that finding, the Court of Appeals for the Seventh Circuit
noted that the Tucson corporation was in the process of liquidat-
ing when Mr. Allen advanced $10,000 to it and that “The condition
92
Petitioners also rely on certain other cases to establish
that they are entitled to deduct under sec. 162(a) the $7,850,000
of advanced funds. We have carefully considered each of those
other cases. We find all of them to be materially distinguish-
able from the case at docket No. 13947-06 and petitioners’
reliance on them to be misplaced.
- 93 -
of the [Tucson] corporation and its business belie any intention
of making an investment in the corporation or its business.”93
Id. That Court further reasoned that
the record demonstrates, as taxpayer testified and
contends, he made the payment to protect the reputation
and credit standing of his Milwaukee business opera-
tion, a highly successful venture. Default and bank-
ruptcy of the Tucson corporation under his presidency
and management could but reflect adversely on the busi-
ness reputation of taxpayer’s similar Milwaukee enter-
prise as a sole proprietor. * * *
Id.
In Lohrke v. Commissioner, 48 T.C. 679 (1967), the Tax Court
of the United States, a predecessor of this Court, addressed
whether a taxpayer (Mr. Lohrke), who owned a substantial interest
in a corporation (Textiles), was entitled to deduct as an ordi-
nary and necessary business expense a payment (Textiles payment)
that he had made to a customer of that corporation. That Court
held that Mr. Lohrke was entitled to do so. Id. at 689. In so
holding, the Tax Court of the United States examined Mr. Lohrke’s
purpose in making the Textiles payment. Id. at 688-689. That
93
The Court of Appeals for the Seventh Circuit further held
in Allen v. Commissioner, 283 F.2d 785, 791 (7th Cir. 1960),
affg. in part and revg. in part T.C. Memo. 1959-227, that Mr.
Allen was not entitled to deduct as ordinary and necessary
business expenses certain other payments that he had advanced to
the Tucson corporation before it was in the process of liquidat-
ing. The Court of Appeals for the Seventh Circuit held that
those payments, which were advanced as working capital, did not
“bear the requisite relationship to the taxpayer’s business to
qualify them for treatment as other than capital losses or non-
business losses”. Id.
- 94 -
Court found that Mr. Lohrke’s ultimate purpose in making that
payment was to protect or promote his own business, and not to
keep Textiles in existence. Id. at 689. The Tax Court of the
United States found in Lohrke:
We are inclined to believe that the [taxpayer’s]
* * * primary motive was the protection of his licens-
ing business. That business was providing him with a
substantial income, and therefore, we can believe him
when he says that he acted to protect that business.
On the contrary, Textiles was unprofitable, and the
prospects were that it would remain so. Thus, we think
that the most likely explanation is that he acted to
protect his profitable individual business.
Id. at 689.
We find the respective facts in Allen v. Commissioner, 283
F.2d 785 (7th Cir. 1960), and Lohrke v. Commissioner, supra, to
be materially distinguishable from the facts before us and peti-
tioners’ reliance on those cases to be misplaced. Unlike the
respective facts in Allen and Lohrke, here, around the time in
1997 Mr. Ackerman had decided to advance, and was advancing,
$7,850,000 to ECC, a decision had been made to form the Interna-
tional Group94 in order to continue ECC’s operations in modified
form. In addition, unlike the respective facts in Allen and
Lohrke, around the time in 1997 Mr. Ackerman had decided to
advance, and was advancing, $7,850,000 to ECC, he also decided to
make, and was making, through Somerville an investment of
94
The International Group consisted of ISI, ISG, and ISGH.
See supra note 39.
- 95 -
$18,050,000 in the International Group by investing that amount
in ISI.95
On the record before us, we find that petitioners have
failed to carry their burden of establishing that Mr. Ackerman’s
primary motive in advancing $7,850,000 to ECC was to protect his
reputation in his alleged business of providing advisory ser-
vices. It appears from that record that Mr. Ackerman’s primary
motive in advancing those funds to ECC was to protect the invest-
ment that he intended to, and did, make in the International
Group, a group of companies formed in order to continue ECC’s
operations in modified form.
Based upon our examination of the entire record before us,
we find that petitioners have failed to carry their burden of
establishing that they are entitled for their taxable year 1997
95
ECC was also an investor in ISI. ECC contributed to ISI
over $15 million of assets, including a substantial amount of
cash, in return for which it received a 1-percent interest in
ISI. Included in the assets that ECC contributed to ISI were
substantial amounts of inventory, certain accounts receivable,
certain intangible assets in the form of customer relationships,
certain employee relationships, certain leasehold interests, and
substantial amounts of machinery and equipment that were used in
the production of sample cards and packaging projects. Those
assets, along with the substantial amount of cash that ECC
contributed to ISI, assisted the International Group in continu-
ing the operations of ECC in modified form. The record does not
disclose how ECC, a company facing dire financial circumstances
in 1997, had a substantial amount of cash to contribute to ISI or
whether the cash that ECC contributed to ISI consisted of a
portion of the $7,850,000 that Mr. Ackerman had advanced to ECC.
- 96 -
to deduct under section 162(a) the $7,850,000 that Mr. Ackerman,
through Somerville S Trust, advanced to ECC.96
Claimed Losses With Respect to ISI
It is petitioners’ position that Mr. Ackerman’s allocable
portions of the respective 1998 ISI loss and 2000 ISI loss are
not passive activity losses within the meaning of section 469(a).
That is because, according to petitioners, Mr. Ackerman should be
treated as having materially participated in ISI’s business
during each of petitioners’ taxable years 1998 and 2000.97
96
Respondent argues in the alternative, see supra note 91,
that petitioners are “barred by * * * the TEFRA partnership
provisions” from claiming a deduction with respect to the
$7,850,000 of advanced funds for their taxable year 1997. In
this regard, Santa Monica, which owned Somerville during each of
the years at issue and which was subject to the provisions of
secs. 6221 through 6234 for each of those years, included in Form
1065 for its taxable year 2000 the bad debt deduction of
$7,850,000 that Somerville claimed with respect to those funds in
Form 1065 that it prepared for its taxable year 2000 but did not
file because it was a disregarded entity. See supra note 7.
During each of the years at issue, Mr. Ackerman owned virtually
all of Santa Monica through Somerville S Trust. Pursuant to sec.
6222(a), petitioners reported in Schedule E of their 2000 joint
return Somerville S Trust’s allocable share of Santa Monica’s
claimed 2000 ordinary loss, which included Somerville’s claimed
bad debt deduction of $7,850,000. Petitioners now want to
deviate from not only the bad debt tax treatment that Santa
Monica, as the owner of Somerville, claimed for the $7,850,000 of
advanced funds but also the year (i.e., 2000) for which Santa
Monica claimed that treatment. Petitioners here claim a deduc-
tion for their taxable year 1997 for the $7,850,000 of advanced
funds as an ordinary and necessary business expense under sec.
162(a). Sec. 6222(a) does not allow them to do so.
97
The parties do not dispute that if Mr. Ackerman materially
participated in the business of ISI during each of petitioners’
taxable years 1998 and 2000, petitioners are entitled (1) for
(continued...)
- 97 -
Pursuant to section 469(a), a passive activity loss of an
individual for the taxable year is generally not allowed as a
deduction for that year.98 For this purpose, the passive activity
loss for the taxable year is generally the amount, if any, by
which the passive activity deductions for the taxable year exceed
the passive activity gross income for such year. Sec. 469(d)(1).
As pertinent here, section 469(c)(1) defines the term “passive
activity” to include any activity which involves the conduct of
any trade or business and in which the taxpayer does not materi-
ally participate. For purposes of section 469(c)(1)(A), the term
“trade or business” is defined in section 469(c)(6) to include
any activity in connection with a trade or business or any activ-
ity with respect to which expenses are allowable as a deduction
under section 212.
Section 469(h)(1) provides that generally an individual is
to be treated as materially participating in an activity only if
such individual is involved in the operations of the activity on
a basis that is regular, continuous, and substantial. Congress
expressly authorized the Secretary of the Treasury to prescribe
regulations as may be necessary or appropriate to carry out the
97
(...continued)
their taxable year 1998 to deduct Mr. Ackerman’s allocable
portion of the 1998 ISI loss and (2) for petitioners’ taxable
year 2000 to deduct his allocable portion of the 2000 ISI loss.
98
A disallowed passive activity loss for a taxable year is
generally treated as a deduction allocable to a passive activity
for the next year. Sec. 469(b).
- 98 -
provisions of section 469, including regulations that specify
“what constitutes * * * material participation”. Sec. 469(l)(1).
Both temporary and final regulations relating to the meaning
of the terms “participation” and “material participation” have
been promulgated under section 469. With respect to the term
“participation”, final regulations issued under section 469
provide that generally
any work done by an individual (without regard to the
capacity in which the individual does the work) in
connection with an activity in which the individual
owns an interest at the time the work is done shall be
treated for purposes of this section as participation
of the individual in the activity.
Sec. 1.469-5(f)(1), Income Tax Regs. Temporary regulations
issued under section 469 provide certain exceptions to that
definition of participation. As pertinent here, section 1.469-
5T(f)(2)(ii)(A), Temporary Income Tax Regs., 53 Fed. Reg. 5727
(Feb. 25, 1988), provides that work done by an individual in such
individual’s capacity as an investor in an activity is not to be
treated as participation by the individual in the activity unless
the individual is involved in the day-to-day management or opera-
tions of the activity. For this purpose, work done by an indi-
vidual in such individual’s capacity as an investor in an activ-
ity includes:
(1) Studying and reviewing financial statements or
reports on operations of the activity;
- 99 -
(2) Preparing or compiling summaries or analyses
of the finances or operations of the activity for the
individual’s own use; and
(3) Monitoring the finances or operations of the
activity in a non-managerial capacity.
Sec. 1.469-5T(f)(2)(ii)(B), Temporary Income Tax Regs., 53 Fed.
Reg. 5727 (Feb. 25, 1988).
As pertinent here, temporary regulations relating to when a
taxpayer is to be treated as “materially participating” in an
activity for purposes of section 469(h)(1) provide that in gen-
eral
an individual shall be treated, for purposes of section
469 and the regulations thereunder, as materially par-
ticipating in an activity for the taxable year if and
only if--
(1) The individual participates in the activity
for more than 500 hours during such year * * *
Sec. 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725
(Feb. 25, 1988).
As also pertinent here, section 1.469-5T(f)(4), Temporary
Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), provides
that
The extent of an individual’s participation in an ac-
tivity may be established by any reasonable means.
Contemporaneous daily time reports, logs, or similar
documents are not required if the extent of such par-
ticipation may be established by other reasonable
means. Reasonable means for purposes of this paragraph
may include but are not limited to the identification
of services performed over a period of time and the
approximate number of hours spent performing such ser-
vices during such period, based on appointment books,
calendars, or narrative summaries.
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According to petitioners, Mr. Ackerman should be treated for
each of their taxable years 1998 and 2000 as having materially
participated in ISI’s business within the meaning of section
469(h)(1) because he participated in ISI’s business for more than
500 hours during each of those years and therefore satisfies
section 1.469-5T(a)(1), Temporary Income Tax Regs., supra.99
Respondent counters (1) that any “participation” by Mr. Ackerman
in ISI’s activities was performed in his capacity as an investor
and (2) that petitioners have failed to carry their burden of
establishing that during each of their taxable years 1998 and
2000 Mr. Ackerman participated in ISI’s business for more than
500 hours. We need not address respondent’s contention that any
“participation” by Mr. Ackerman in ISI’s activities was performed
in his capacity as an investor. That is because, assuming
arguendo that we were to agree with petitioners that the work
done by Mr. Ackerman with respect to ISI’s activities was not
done in his capacity as an investor, we nonetheless would, and do
below, find that petitioners have failed to carry their burden of
establishing that during each of their taxable years 1998 and
2000 Mr. Ackerman participated in ISI’s business for more than
500 hours.
99
Petitioners do not rely on any of the other provisions in
sec. 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725-
5726 (Feb. 25, 1988), in support of their position that Mr.
Ackerman should be treated as having materially participated in
ISI’s business within the meaning of sec. 469(h)(1).
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In support of their position under section 1.469-5T(a)(1),
Temporary Income Tax Regs., supra, petitioners rely principally
on the respective testimonies of Mr. Ackerman,100 Mr. Deutschman,
and Don Ackerman on which we are unwilling to rely to establish
petitioners’ position with respect to whether Mr. Ackerman’s
allocable portions of the respective 1998 ISI loss and 2000 ISI
loss are passive activity losses within the meaning of section
469(a). Although we are unwilling to rely on Mr. Deutschman’s
testimony to establish that position of petitioners, we have
found based on, inter alia, his testimony that during 1998
through 2000 Mr. Ackerman communicated on various occasions with
Mr. Deutschman regarding various matters, including the business
operations and finances of the International Group and various
other investments of Mr. Ackerman. However, we have not found
any reliable evidence in the record establishing the amount of
time that Mr. Ackerman spent during each of the years 1998 and
2000 communicating with Mr. Deutschman on matters relating to the
International Group.
We have also found based on, inter alia, Mr. Deutschman’s
testimony that during 1998 through 2000 Mr. Ackerman spent at
100
The lack of knowledge that Mr. Ackerman exhibited at trial
regarding the affairs of the International Group, which consisted
of ISI, ISG, and ISGH, belies his claimed participation in ISI’s
business. For example, Mr. Ackerman was unable to answer certain
questions at trial regarding the affairs of the International
Group, including whether the International Group’s production
facility had been moved and whether the International Group
conducted any operations in New York City.
- 102 -
least one or two days in certain weeks in New York City and that
during that period he also visited New Jersey where his mother
and his brother Don Ackerman lived. We have further found on the
record before us (1) that while in New York City Mr. Ackerman
spent time on various matters, including matters relating to
certain of the major projects in which Crown Capital was involved
and certain charitable activities relating to CARE, and (2) that
while in New Jersey Mr. Ackerman occasionally visited Mr.
Deutschman where Mr. Deutschman managed the operations of the
International Group. However, we have not found any reliable
evidence in the record establishing the amount of time, if any,
that Mr. Ackerman spent during each of the years 1998 and 2000 in
New York and/or New Jersey on matters relating to the Interna-
tional Group.
In support of their position under section 1.469-5T(a)(1),
Temporary Income Tax Regs., supra, petitioners also rely on the
following documentary evidence: (1) A memorandum dated July 9,
1999, from Mr. Deutschman to Mr. Ackerman and Jason Ackerman
(1999 memorandum) that addresses (a) ISG’s expected cashflow for
the six-month period July through December 1999, (b) a review of
ISG’s then current operations in Mexico, (c) certain adjustments
that were to be made with respect to a deal in which ISG was
involved, and (d) a preliminary forecast of ISG’s operations for
2000; (2) a printed copy of an e-mail dated July 15, 1999, from
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Mr. Deutschman to Mr. Ackerman (1999 e-mail), which sets forth
the amount of funding that ISG needed for July and August 1999
and to which was attached a schedule of legal fees that ISG and
certain “related entities”101 incurred at the end of 1998 and in
1999; and (3) certain travel itineraries of Mr. Ackerman (Mr.
Ackerman’s itineraries) covering the periods April 28, 1998,
through June 24, 1999, and September 27 through December 5, 2001.
With respect to the 1999 memorandum, that document estab-
lishes that Mr. Ackerman was involved in certain matters relating
to the business operations of the International Group. However,
the 1999 memorandum does not establish the amount of time that
Mr. Ackerman spent during each of the years 1998 and 2000 on
matters relating to the International Group.
With respect to the 1999 e-mail and the attachment thereto,
those documents establish that Mr. Deutschman informed Mr.
Ackerman that ISG and/or certain of its related entities needed
funding and/or had incurred certain legal fees. However, the
1999 e-mail and the attachment thereto do not establish the
amount of time that Mr. Ackerman spent during each of the years
1998 and 2000 on matters relating to the International Group.
With respect to Mr. Ackerman’s itineraries covering the
periods April 28, 1998, through June 24, 1999, and September 27
through December 5, 2001, those itineraries establish that during
101
The record does not disclose the related entities of ISG
to which the 1999 e-mail was referring.
- 104 -
those two periods Mr. Ackerman was scheduled to take certain
trips to New York City and/or New Jersey. However, those itiner-
aries do not establish that on any of those trips Mr. Ackerman
spent time during each of the years 1998 and 2000 on matters
relating to the International Group, let alone the amount of time
that Mr. Ackerman might have spent during each of those years on
any such matters.
Based upon our examination of the entire record before us,
we find that petitioners have failed to carry their burden of
establishing that for each of their taxable years 1998 and 2000
Mr. Ackerman participated in ISI’s business for more than 500
hours and that therefore he should be treated as having materi-
ally participated in ISI’s business under section 1.469-5T(a)(1),
Temporary Income Tax Regs., supra. On that record, we further
find that petitioners have failed to carry their burden of estab-
lishing that Mr. Ackerman’s allocable portions of the respective
1998 ISI loss and 2000 ISI loss are not passive activity losses
within the meaning of section 469(a).
Claimed Theft Loss Deduction
It is petitioners’ position that they are entitled for their
taxable year 2002 to deduct under section 165(a) a theft loss
with respect to the $4,467,610 that Mr. Ackerman, through
Somerville S Trust, invested in USV (claimed theft loss). In
support of that position, petitioners argue that the actions of
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Mr. Earls with respect to that investment constitute theft under
the law of the District of Columbia (D.C. law) and that as of the
end of their taxable year 2002 there was no reasonable prospect
of recovery with respect to the loss resulting from that theft.
As pertinent here, section 165(a) allows a deduction for any
theft loss sustained during the taxable year that is not compen-
sated for by insurance or otherwise. See sec. 165(c)(3). A
theft loss is sustained during the taxable year in which the
taxpayer discovers it. Sec. 165(e). However,
if in the year of discovery there exists a claim for
reimbursement with respect to which there is a reason-
able prospect of recovery, no portion of the loss with
respect to which reimbursement may be received is sus-
tained, for purposes of section 165, until the taxable
year in which it can be ascertained with reasonable
certainty whether or not such reimbursement will be
received.
Sec. 1.165-1(d)(3), Income Tax Regs. As this Court concluded in
Viehweq v. Commissioner, 90 T.C. 1248, 1255-1256 (1988), “If in
the year of the discovery of the loss there exists a claim for
reimbursement with respect to which there is a reasonable pros-
pect of recovery, then there is no closed and completed transac-
tion fixed by identifiable events and thus no deductible loss.”
A reasonable prospect of recovery exists when the taxpayer
has a bona fide claim for recoupment and there is a substantial
possibility that such claim will be decided favorably for the
taxpayer. Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795,
811 (1974), affd.
521 F.2d 786 (4th Cir. 1975). Whether a rea-
- 106 -
sonable prospect of recovery exists is determined as of the end
of the taxable year for which the deduction is claimed. Id.
Petitioners argue, and respondent does not dispute, that
D.C. law determines whether the actions of Mr. Earls with respect
to the $4,467,610 that Mr. Ackerman, through Somerville S Trust,
invested in USV constitute theft. Petitioners and respondent
disagree over whether those actions constitute theft under D.C.
law. We need not resolve that disagreement. That is because,
assuming arguendo that we were to find that the actions of Mr.
Earls with respect to the $4,467,610 that Mr. Ackerman, through
Somerville S Trust, invested in USV constituted theft under D.C.
law, on the instant record, we nonetheless would, and do below,
reject petitioners’ position that they are entitled for their
taxable year 2002 to a deduction under section 165 with respect
to the claimed theft loss.
We have found that Mr. Ackerman became aware of the claimed
theft loss in 2002 and that on December 9, 2002, in an effort to
recover damages of approximately $5,953,000 with respect to that
loss, Somerville S Trust and certain other parties filed a law-
suit in the U.S. District Court for Maryland against Mr. Ferreira
and Ferreira & Isbell. Somerville S Trust pursued that lawsuit
until November 26, 2003, when the parties involved in the
Ferreira litigation filed a stipulation of dismissal. We have
also found that on August 21, 2003, in an effort to recover
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damages of at least $5,952,860 with respect to the claimed theft
loss, Somerville S Trust filed a lawsuit in the U.S. District
Court for the District of Columbia against, inter alia, Mr.
Earls, USV Partners, and U.S. Technologies. The pendency of the
above-described lawsuits to recover the claimed theft loss gives
rise to an inference that as of the end of their taxable year
2002 Somerville S Trust had a claim for reimbursement that pro-
vided a reasonable prospect of recovery with respect to that
claimed loss.102 See Dawn v. Commissioner, 675 F.2d 1077, 1078
(9th Cir. 1982), affg. T.C. Memo. 1979-479; Gale v. Commissioner,
41 T.C. 269, 276 (1963).
Based upon our examination of the entire record before us,
we find that petitioners have failed to carry their burden of
establishing that as of the end of 2002 there was no reasonable
prospect of recovery of the $4,467,610 that Mr. Ackerman, through
102
Somerville S Trust did not file the lawsuit in the U.S.
District Court for the District of Columbia against, inter alia,
Mr. Earls, USV Partners, and U.S. Technologies until Aug. 21,
2003. However, that fact does not negate the inference that as
of the end of their taxable year 2002 Somerville S Trust had a
claim for reimbursement that provided a reasonable prospect of
recovery with respect to the claimed theft loss. See Dawn v.
Commissioner, 675 F.2d 1077, 1078 (9th Cir. 1982), affg. T.C.
Memo. 1979-479; Natl. Home Prods., Inc. v. Commissioner,
71 T.C.
501, 523, 525-526 (1979). Moreover, on the record before us, we
are unable to find that the lawsuits that Somerville S Trust
filed on Dec. 9, 2002, and Aug. 21, 2003, were “‘specious,
speculative, or wholly without merit’”. Gale v. Commissioner,
41
T.C. 269, 274 (1963) (quoting Estate of Scofield v. Commissioner,
266 F.2d 154, 159 (6th Cir. 1959), revg. on this issue
25 T.C.
774 (1956)).
- 108 -
Somerville S Trust, invested in USV. On that record, we further
find that petitioners have failed to carry their burden of estab-
lishing that they are entitled for their taxable year 2002 to
deduct under section 165(a) the claimed theft loss.
Accuracy-Related Penalty Under Section 6662(a)
In the notice for 2002 and 2004, respondent determined that
petitioners are liable for each of those years for the accuracy-
related penalty under section 6662(a). According to respondent,
petitioners are liable for those penalties because of substantial
understatements of tax under section 6662(b)(2) that are attrib-
utable solely to the respective Schedule C deductions claimed in
the 2002 joint return and the 2004 joint return.
Section 6662(a) imposes an accuracy-related penalty equal to
20 percent of the underpayment of tax attributable to, inter
alia, a substantial understatement of tax, sec. 6662(b)(2). An
understatement is equal to the excess of the amount of tax re-
quired to be shown in the tax return over the amount of tax shown
in the tax return, sec. 6662(d)(2)(A), and is substantial in the
case of an individual if it exceeds the greater of 10 percent of
the tax required to be shown or $5,000, sec. 6662(d)(1)(A).
The amount of the understatement is to be reduced to the
extent that it is attributable to, inter alia, the tax treatment
of an item for which there is or was substantial authority. See
sec. 6662(d)(2)(B)(i). In order to satisfy the substantial
- 109 -
authority standard of section 6662(d)(2)(B)(i), petitioners must
show that the weight of authorities supporting their tax return
is substantial in relation to those supporting a contrary posi-
tion. See Antonides v. Commissioner, 91 T.C. 686, 702 (1988),
affd.
893 F.2d 656 (4th Cir. 1990). That standard is not so
stringent that a taxpayer’s treatment must be one that is ulti-
mately upheld in litigation or that has a greater than 50-percent
likelihood of being sustained in litigation. Sec. 1.6662-
4(d)(2), Income Tax Regs. A taxpayer may have substantial au-
thority for a position even where it is supported only by a well-
reasoned construction of the pertinent statutory provision as
applied to the relevant facts. See sec. 1.6662-4(d)(3)(ii),
Income Tax Regs. There may be substantial authority for more
than one position with respect to the same item. Sec. 1.6662-
4(d)(3)(i), Income Tax Regs.
The accuracy-related penalty under section 6662(a) does not
apply to any portion of an underpayment if it is shown that there
was reasonable cause for, and that the taxpayer acted in good
faith with respect to, such portion. Sec. 6664(c)(1). The
determination of whether the taxpayer acted with reasonable cause
and in good faith depends on the pertinent facts and circum-
stances, including the taxpayer’s efforts to assess such tax-
payer’s proper tax liability, the knowledge and experience of the
taxpayer, and the reliance on the advice of a professional, such
- 110 -
as an accountant. Sec. 1.6664-4(b)(1), Income Tax Regs. Reli-
ance on the advice of a professional does not necessarily demon-
strate reasonable cause and good faith unless, under all the
circumstances, such reliance was reasonable and the taxpayer
acted in good faith. Id. In this connection, a taxpayer must
demonstrate that the taxpayer’s reliance on the advice of a
professional concerning substantive tax law was objectively
reasonable. Goldman v. Commissioner, 39 F.3d 402, 408 (2d Cir.
1994), affg. T.C. Memo. 1993-480. A taxpayer’s reliance on the
advice of a professional will be objectively reasonable only if
the taxpayer has provided necessary and accurate information to
the professional. Neonatology Associates, P.A. v. Commissioner,
115 T.C. 43, 99 (2000), affd.
299 F.3d 221 (3d Cir. 2002); see
also Ma-Tran Corp. v. Commissioner,
70 T.C. 158, 173 (1978).
Petitioners argue that they are not liable for each of their
taxable years 2002 and 2004 for the accuracy-related penalty
under section 6662(a) because respondent has failed to “introduce
some evidence that it was appropriate to assert” that penalty.
As we understand it, petitioners are arguing that respondent has
not satisfied respondent’s burden of production under section
7491(c) with respect to those accuracy-related penalties. On the
record before us, we reject that argument.
- 111 -
To meet respondent’s burden of production under section
7491(c), respondent must come forward with sufficient evidence
showing that it is appropriate to impose the accuracy-related
penalty under section 6662(a) for each of petitioners’ taxable
years 2002 and 2004. See Higbee v. Commissioner, 116 T.C. 438,
446 (2001). The accuracy-related penalty that respondent deter-
mined for each of petitioners’ taxable years 2002 and 2004 is
imposed on an underpayment of tax for each of those years that is
attributable to a substantial understatement of tax resulting
from respondent’s disallowance of petitioners’ claimed Schedule C
deductions, which we have sustained. On the record before us, we
find that respondent has satisfied respondent’s burden of produc-
tion under section 7491(c) with respect to the accuracy-related
penalty under section 6662(a) that respondent determined for each
of petitioners’ taxable years 2002 and 2004.
Although respondent bears, and has satisfied, the burden of
production with respect to the accuracy-related penalties at
issue, respondent “need not introduce evidence regarding reason-
able cause, substantial authority, or similar provisions. * * *
the taxpayer bears the burden of proof with regard to those
issues.” Higbee v. Commissioner, supra at 446. As discussed
above, petitioners do not dispute that they bear the burden of
proof with respect to the accuracy-related penalty under section
6662(a) that respondent determined for each of their taxable
- 112 -
years 2002 and 2004. Instead, petitioners argue that they are
not liable for each of those years for that penalty because
(1) there was substantial authority to support their tax return
position with respect to their respective claimed Schedule C
deductions for 2002 and 2004 (petitioners’ substantial authority
argument), and (2) they acted with reasonable cause and in good
faith in taking that position (petitioners’ reasonable cause
argument).
We turn first to petitioners’ substantial authority argu-
ment. It is petitioners’ position that they had substantial
authority for their respective claimed Schedule C deductions in
the 2002 joint return and the 2004 joint return that respondent
disallowed, thereby resulting in a substantial understatement of
tax for each of those years. According to petitioners, they
claimed those Schedule C deductions because during each of peti-
tioners’ taxable years 2002 and 2004 Mr. Ackerman was engaged in
a trade or business of providing advisory services within the
meaning of section 162(a). The principal authorities on which
petitioners rely to establish their claim about Mr. Ackerman’s
alleged business are Revenue Ruling 56-542 and Giblin v. Commis-
sioner, 227 F.2d 692 (5th Cir. 1955). We found those authorities
to be materially distinguishable from the instant cases and
- 113 -
petitioners’ reliance on those authorities to be misplaced.103 On
the record before us, we reject petitioners’ substantial author-
ity argument.
We turn now to petitioners’ reasonable cause argument. As
we understand it, it is petitioners’ position that they acted
with reasonable cause and in good faith in claiming the respec-
tive Schedule C deductions in the 2002 joint return and the 2004
joint return because they relied on Mr. Levinton and Mr. Lerner
in claiming those deductions.104
Mr. Ackerman’s own testimony undermines petitioners’ reason-
able cause argument. The trial transcript reflects that the
following exchange took place between petitioners’ counsel and
Mr. Ackerman on direct examination:
Q Mr., Ackerman, are there ever situations, and
I’m talking the period 1997 through 2004, where tax
reporting issues come to your attention before a tax
return is filed? Do you remember any situations?
A No.
Q Well, how about the deduction of the Schedule
C business expenses for 2002 and 2004?
A I’m sorry. I was told that that was at is-
sue.
103
We also found the other cases on which petitioners rely to
establish that during each of the years at issue Mr. Ackerman was
engaged in a trade or business of providing advisory services
within the meaning of sec. 162(a) to be materially distinguish-
able from the instant cases and petitioners’ reliance on those
other cases to be misplaced. See supra note 77.
104
Mr. Miller prepared the 2002 joint return and the 2004
joint return.
- 114 -
Q Okay. * * * Why did you understand or what
were you told in terms of it being at issue?
A Mr. Levinton and Mr. Lerner said that they
were told that certain of my expenses for the busi-
nesses that I was in would not be accepted for a deduc-
tion.
Q Okay. And what did you and they discuss
about them, if anything?
A Well, frankly, I was incredulous because how
could they not be since I was in the business, so I
asked them, I reaffirmed, what is your opinion about
these appropriate deductions for my business, and they
said absolutely.
Q And was this a conversation you had with
respect to both returns, the 2002 and the 2004?
A It was a conceptual discussion about how
these expenses which continued during those periods of
time should be handled.
Q But my question more specifically is do you
recall that discussion with them with respect to both
your 2002 and 2004 returns?
A Only upon learning that these deductions
would not be allowed.
Q Okay.
A But this issue basically existed before then
because of a dispute over Schedule C and Schedule A,
and it’s the same issue, and I went to my accountants
and I went to my lawyers and I said, am I accounting
for these things properly? They said, well, what did
you spend it for? Basically to create business, to
create revenue, to create the things that I’ve
described. They said, well, these are Schedule C de-
ductions plain and simple.
Q And this is Mr. Howard Levinton and Mr. Perry
Lerner?
A Yes. [Reproduced literally.]
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Except for the above-quoted testimony of Mr. Ackerman about
what he told Mr. Levinton and Mr. Lerner, there is no evidence in
the record establishing what Mr. Ackerman told Mr. Levinton and
Mr. Lerner when he discussed with them the propriety of petition-
ers’ claimed Schedule C deductions. On the record before us, we
find that petitioners have failed to carry their burden of estab-
lishing that Mr. Ackerman provided necessary and accurate infor-
mation to Mr. Levinton and Mr. Lerner regarding petitioners’
claimed Schedule C deductions. On that record, we further find
that petitioners have failed to carry their burden of establish-
ing that Mr. Ackerman reasonably relied on the advice of Mr.
Levinton and Mr. Lerner in claiming the respective Schedule C
deductions in the 2002 joint return105 and the 2004 joint return.
See Neonatology Associates, P.A. v. Commissioner, 115 T.C. at 99;
Ma-Tran Corp. v. Commissioner, 70 T.C. at 173.
On the record before us, we find that petitioners have
failed to carry their burden of establishing that there was
reasonable cause for, and that they acted in good faith with
respect to, the underpayment for each of their taxable years 2002
105
Indeed, on the record before us, we find that petitioners
could not have relied on any advice of Mr. Lerner in deducting
the claimed Schedule C deductions in petitioners’ 2002 joint
return. That is because Mr. Lerner testified, and we have found,
that he did not even become aware of respondent’s position with
respect to the respective claimed Schedule C deductions for 1997,
1998, and 2000 until around early 2005, which was more than a
year after petitioners filed the 2002 joint return on Nov. 21,
2003.
- 116 -
and 2004 that is attributable to petitioners’ claimed Schedule C
deductions.
Based upon our examination of the entire record before us,
we find that there is a substantial understatement of tax for
each of petitioners’ taxable years 2002 and 2004. On that re-
cord, we further find that petitioners have failed to carry their
burden of establishing that they are not liable for each of their
taxable years 2002 and 2004 for the accuracy-related penalty
under section 6662(a).
We have considered all of the contentions and arguments of
the parties that are not discussed herein, and we find them to be
without merit, irrelevant, and/or moot.
To reflect the foregoing, the concessions of respondent, and
the concession of petitioners,106
Decisions will be entered
under Rule 155.
106
See supra note 35 describing the concession by both
respondent and petitioners with respect to the payment of
$210,000 to Nevada Media Partners that petitioners deducted in
the 1997 Schedule C and that respondent disallowed in the notice
for 1997, 1998, and 2000.
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APPENDIX A
On November 17, 1999, Somerville, virtually all of which Mr.
Ackerman owned indirectly, formed Crown Davidson Partners, LLC
(Crown Davidson Partners). On December 3, 1999, (1) Somerville
invested $15 million in Crown Davidson Partners and (2) Crown
Davidson Partners acquired 15,000 shares of preferred stock of
Davidson Cotton.
On June 14, 2000, Somerville contributed its interest in
Crown Davidson Partners, as well as $4,990,000, to Crown Davidson
Investments, LLC (Crown Davidson Investments),107 in return for
which Somerville received a 62.47-percent interest in Crown
Davidson Investments. As of June 13, 2000, Crown Davidson In-
vestments owned a 99.8-percent interest and Kevin Gay owned a .2-
percent interest in Crown Davidson Partners.108
As of June 13, 2000, Crown Davidson Holdings, LLC (Crown
Davidson Holdings), owned a .03-percent interest, GARD Invest-
ments, Inc., owned a 25-percent interest, and J. Rothschild
107
The record does not establish the percentage interest that
Somerville owned in Crown Davidson Partners and contributed to
Crown Davidson Investments; nor does it establish the date on
which Somerville acquired that interest. It is not clear from
the record whether Somerville acquired the percentage interest
that it owned in Crown Davidson Partners and contributed to Crown
Davidson Investments in exchange for the $15 million that it
invested in Crown Davidson Partners.
108
As of June 13, 2000, Crown Davidson Investments was the
“managing member” of Crown Davidson Partners.
- 118 -
Nominees (Guernsey) Limited owned a 12.5-percent interest in
Crown Davidson Investments.
As of June 13, 2000, the members of Crown Davidson Holdings
were Crown Davidson Management, LLC (Crown Davidson Manage-
ment),109 and GARD Investments.110
109
The record does not disclose the identities of the members
of Crown Davidson Management. The record does establish that, as
of June 13, 2000, Mr. Deutschman served as the manager of that
entity.
110
The record does not disclose the respective percentages of
Crown Davidson Holdings that Crown Davidson Management and GARD
Investments owned.
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APPENDIX B
On dates not disclosed by the record after the formation of
Crown Fresh Direct, Somerville acquired an interest in Crown
Fresh Direct. Thereafter, Somerville contributed that interest
to Crown Fresh Direct Investments, LLC (Crown Fresh Direct In-
vestments).111
As of April 29, 2003, the following owned the percentage
interests listed in Crown Fresh Direct:112
Owner Percentage Interest
Crown Fresh Direct Investments 98.1836
Mr. Ba .1534
Mr. Calise .3835
Mr. Squire .8959
Judith Leedom Tyrer .0890
L-A & A Gift Trust for the .1473
Benefit of Nathanael Leedom
Ackerman
L-A & A Gift Trust for the .1473
Benefit of Elliot Leedom
Ackerman
As of April 29, 2003, Crown Fresh Direct II, LLC (Crown
Fresh Direct II), owned a 100-percent interest in Crown Fresh
Direct Investments.113
111
The record does not disclose the percentage of Crown Fresh
Direct that Somerville acquired and contributed to Crown Fresh
Direct Investments.
112
As of Apr. 29, 2003, Crown Fresh Direct Investments was
the “managing member” of Crown Fresh Direct.
113
As of Apr. 29, 2003, Crown Fresh Direct Management, LLC
(Crown Fresh Direct Management), was the “managing member” of
Crown Fresh Direct Investments.
- 120 -
As of April 29, 2003, Somerville owned a 100-percent inter-
est in Crown Fresh Direct II.114
As of April 29, 2003, the following owned the percentage
interests listed in Crown Fresh Direct Management:
Owner Percentage Interest
Mr. Deutschman 66.6
Mr. Lerner 25.9
Mr. Squire 2.5
Mr. Leraris 2.5
Mr. Kaji 2.5
114
As of Apr. 29, 2003, Somerville was the “managing member”
of Crown Fresh Direct II. As of that date, Jason Ackerman was
also a member of Crown Fresh Direct II.
