T.C. Memo. 2009-90



                      UNITED STATES TAX COURT



                  LARRY D. KLAAS, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

  LARRY D. KLAAS, LISA G. KLAAS, and APEX INSURANCE COMPANY, AN
    ANGUILLA BRITISH WEST INDIES CORPORATION, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 16774-06, 19803-06.     Filed April 29, 2009.



     David E. Ross II, for petitioners.

     Richard W. Kennedy and Kirk M. Paxson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:   These consolidated cases are before the Court

for determination of the tax consequences of the sale of a

recreational vehicle park in 2001.     Respondent determined that

petitioners Larry D. Klaas and Lisa G. Klaas are subject to tax
                                - 2 -

on the sale of the recreational vehicle (RV) park as Mr. Klaas

was the sole shareholder of the passthrough entities that held

title to the property.

     Respondent determined deficiencies in Federal income tax and

penalties for 2000 and 2001 against petitioners Larry D. Klaas

and Lisa G. Klaas (petitioners Klaas or petitioners) and

determined a Federal income tax deficiency and penalty against

Mr. Klaas for 2002 as follows:1

                                        Penalties
     Year        Deficiency     Sec. 6663      Sec. 6662(a)

     2000           $54,989        ---           $10,998
     2001         2,241,548     $1,681,161          ---
     2002           216,933        ---            43,387

For 2001 respondent determined in the alternative to the fraud

penalty that petitioners are liable for a section 6662(a)

accuracy-related penalty.

     Respondent has conceded the deficiency and penalty against

petitioners for 2000.    Mrs. Klaas is a party herein only because

she filed joint income tax returns with Mr. Klaas for 2001 and

2002.    Respondent has not argued the fraud penalty against Mrs.

Klaas for 2001, and we find that respondent has conceded the

fraud penalty against Mrs. Klaas.




     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code), and all Rule references are to
the Tax Court Rules of Practice and Procedure. Amounts are
rounded to the nearest dollar.
                               - 3 -

     As a protective measure respondent issued a notice of

deficiency to Apex Insurance Co. (Apex) for 2001 which determined

that Apex is subject to tax on the sale of the recreational

vehicle park in the event that we find that petitioners Klaas are

not subject to tax on the sale of the recreational vehicle park.

For 2001 respondent determined against Apex a Federal income tax

deficiency of $2,720,000, a section 6651(a)(1) addition to tax of

$680,000, a section 6651(a)(2) addition to tax to be determined

on the basis of the entire deficiency, and a section 6654

estimated tax penalty of $115,749.

     As a protective measure respondent also issued a notice of

deficiency to Mr. Klaas for 2002 in the event that we find that

he is not subject to tax on the sale of the recreational vehicle

park in 2001.   For 2002 respondent determined on the basis of a

purported shareholder loan that Mr. Klaas received a constructive

dividend from Apex of $678,689.    Respondent also determined a

Federal income tax deficiency of $216,933 and a section 6662(a)

accuracy-related penalty of $43,387 against Mr. Klaas.

                         FINDINGS OF FACT

     The stipulation of facts and the accompanying exhibits are

incorporated by this reference.    Mr. Klaas resided in Wyoming at

the time of filing his petition.    Mrs. Klaas resided in

Washington at the time of filing her petition.    Apex is an

insurance company organized under the laws of Anguilla British
                               - 4 -

West Indies, and its place of business and registered office were

in Utah at the time its petition was filed.

     Mr. Klaas is engaged in the development and management of

recreational vehicle parks throughout the United States.     Mr.

Klaas has sold four RV parks for a profit after making repairs to

the properties, including the RV park at issue, the Silver Spur

RV park (Silver Spur) in Mesa, Arizona.   Mr. Klaas continued to

own and manage other RV parks after selling Silver Spur.     In 1999

Mr. Klaas owned Silver Spur through Klaas Development, Inc.

(KDI), an S corporation.   At that time Mrs. Klaas held an

interest in KDI.   In mid-2000 Ms. Klaas disposed of all her

shares in KDI.   By the beginning of 2001, the year of the sale,

Mr. Klaas was KDI’s sole shareholder.   Before Mr. Klaas became

involved in the purchase and management of Silver Spur, he was

engaged in diverse lines of work, including accounting for 8

months following college, importing bicycles, selling airplanes,

running a family farm for 7 years, and working as a real estate

broker.

     In early 1999 Mr. Klaas sought tax planning and investment

advice from Merrill Scott Associates (MSA) regarding his

ownership of Silver Spur RV park.   In an April 12, 1999, letter

to MSA, Mr. Klaas indicated that he anticipated refinancing

Silver Spur and reinvesting the equity into other business
                                 - 5 -

ventures.2    He estimated the value of Silver Spur at $6 to $6.5

million.     Mr. Klaas specifically expressed an interest in

investing in a New Zealand mortgage company.      Mr. Klaas

understood that real estate loans in New Zealand earned high

interest rates and New Zealand imposed a low tax rate on interest

income earned by foreign investors.      He stated that he wanted to

form “an entity somewhere that would not have to pay US taxes”.

The letter also indicated Mr. Klaas’s intent to purchase real

property in the United States using the equity from Silver Spur.

In the April 12, 1999, letter Mr. Klaas asked MSA for advice

concerning the creation of an offshore entity for his investment

in the New Zealand mortgage company, how to structure ownership

of future U.S. real estate purchases, and how to structure

ownership of an experimental aircraft.      On July 6, 1999, MSA

presented a proposal to Mr. Klaas for a financial master plan

that outlined the formation of multiple foreign entities and U.S.

entities for tax planning purposes.      Mr. Klaas executed an

engagement letter with MSA in November 1999.      At that time Mr.

Klaas informed MSA that he had decided not to pursue the New


     2
      The parties stipulated that the Apr. 12, 1999, letter
stated that Mr. Klaas anticipated selling Silver Spur RV park for
approximately $6 to $6.5 million. However, the letter did not
say a sale was anticipated. The letter stated because of trading
restrictions, “I think I’ll just keep the Mesa park, refinance it
every 5-7 years to pull out equity”. The Court may set aside a
stipulation that is clearly contrary to the facts disclosed by
the record. See Jasionowski v. Commissioner, 

, 318
(1976).
                               - 6 -

Zealand mortgage company investment and intended to invest all

his equity from Silver Spur RV park in U.S. real property.    Mr.

Klaas also informed MSA of his plan to refinance Silver Spur RV

park and indicated that it then had a market value of $8 million.

     In December 1999 Mr. Klaas refinanced Silver Spur RV park to

receive approximately $1 million in equity from the property.      On

December 8, 1999, KDI conveyed title to Silver Spur RV park to

Silver Spur Holdings, L.L.C., on account of a bank requirement

for the refinancing.   Silver Spur Holdings was incorporated on

November 19, 1999, and KDI was its sole shareholder.   Silver Spur

Holding is a disregarded entity for Federal tax purposes.    See

sec. 301.7701-3(b), Proced. & Admin. Regs.    On December 30, 1999,

Silver Spur Holdings received an offer from Cal-Am Properties,

Inc. (Cal-Am), to purchase Silver Spur RV park for $8 million.

At that time Mr. Klaas discussed Silver Spur with MSA the

creation of another entity to act as the seller of Silver Spur RV

park although details of the plan are not clear from the record.

Mr. Klaas also discussed with MSA the use of a deferred annuity

to delay tax on the sale.   Mr. Klaas expressed concerns to MSA

about his Arizona State tax liability from the sale of Silver

Spur RV park.   Because of these concerns, Mr. Klaas changed his

legal residence to the State of Washington.

     In February 2000 Mr. Klaas informed MSA that he did not want

to implement the financial master plan as it related to the sale
                               - 7 -

of Silver Spur RV park because of Federal and State tax concerns

that the plan did not adequately address.   Mr. Klaas also stated

that he understood from his communications with MSA that there

was “no real tax advantage from foreign entities investing in US

real estate”.   Mr. Klaas continued to negotiate with Cal-Am over

the sale of Silver Spur into March 2000, but Mr. Klaas ultimately

decided not to sell the property.   MSA has since been enjoined

from any sales activities, and a receiver was appointed to

distribute its assets to defrauded investors.

     In April 2001 Mr. Klaas again refinanced Silver Spur to

obtain approximately $1 million in equity from the property.    On

July 17, 2001, Cal-Am made a second offer to purchase Silver Spur

from Silver Spur Holdings for $7.75 million.    Mr. Klaas engaged

in negotiations including the purchase price.   In July 2001 Mr.

Klaas made a counteroffer for $8 million and also changed the

seller to include “an entity to be formed”.    Mr. Klaas sought to

delay the sale for tax planning purposes.   On July 19, 2001, Mr.

Klaas sent an email to Cal-Am that requested a delay in the sale

of Silver Spur for 6 months because of estate planning and a need

to get his “ducks in a row”, which Mr. Klaas explained to mean

time to set up a foreign captive insurance company as the owner

of Silver Spur to minimize U.S. taxes on the sale.
                                - 8 -

     Before receiving this second offer from Cal-Am, Mr. Klaas

had sought tax planning and investment advice from Cornerstone

Strategic Advisors (Cornerstone).    Mr. Klaas had previously

worked with the two principals of Cornerstone--Roger Fuller, a

certified public accountant, and Michael Bishop, a tax attorney,

when they worked for MSA.    Mr. Bishop and Mr. Fuller left MSA in

2000 to form Cornerstone.    Mr. Bishop and Mr. Fuller recommended

forming a foreign captive insurance company that would qualify

for tax-exempt status under section 501(c)(15) as the owner of

Silver Spur to avoid U.S. tax on a sale.    Cornerstone had also

recommended foreign captive insurance companies as a tax planning

device to other clients.    Mr. Fuller and Mr. Bishop explained to

Mr. Klaas the tax advantages of the insurance company and the

ability to self-insure.    Mr. Klaas was interested in self-

insurance for an experimental turbine engine aircraft that he was

having built.   Mr. Klaas could not obtain insurance to pilot the

airplane because he did not have sufficient flight experience.

     On October 8, 2001, Mr. Klaas incorporated Apex under the

laws of the Cook Islands, as a controlled foreign corporation

within the meaning of section 957(a).    Mr. Klaas is the sole

shareholder of Apex.   On that same date Mr. Klaas executed an

agreement and plan of merger on behalf of KDI and Apex.    Pursuant

to the plan of merger, KDI was to merge into Apex with Apex

surviving in a transaction intended to qualify as a
                                - 9 -

reorganization under section 368(a)(1)(A) (an “A” reorganization)

and KDI would cease to exist.   Under the plan of merger Mr. Klaas

would transfer all of his shares in KDI to Apex, the KDI shares

would be canceled, and Mr. Klaas would receive newly issued

shares of Apex.   The plan of merger contemplated that the merger

would occur on October 15, 2001, if the parties had satisfied all

conditions to the merger by that date.   The plan of merger stated

that the merger would become effective upon the filing of the

merger documents.   The plan of merger permitted the parties to

terminate the agreement at any time before the effective date by

mutual consent or by unilateral action of either party if the

merger was not consummated on or before December 31, 2001.    KDI

and Apex filed the merger documents with the State of Washington

on March 1, 2002.

     On November 14, 2001, Silver Spur was sold for $8 million

with Silver Spur Holdings listed as the seller to Norton Karno

(Mr. Karno).   Cal-Am assigned its contractual right to purchase

Silver Spur to Mr. Karno shortly before the sale.   Cornerstone

was not involved in the negotiations for the sale of Silver Spur.

After payment of the mortgage of approximately $5 million and

closing costs, the proceeds were deposited into KDI’s bank

account.   Later that month KDI wired approximately $3 million in

proceeds to Apex.   The legal documents prepared in connection

with the sale list Silver Spur Holdings as the transferor,
                               - 10 -

seller, grantor, or titleholder and were signed by Mr. Klaas as

president of KDI, Silver Spur Holdings’ sole member.      The

documents include:    A master final settlement statement, a

general warranty deed, a nonforeign certification, a Form 1099

certification, a bill of sale, and an owner’s affidavit and

indemnity.    None of the documents lists Apex as a shareholder of

KDI.    Mr. Klaas as president of KDI executed a document, under

penalties of perjury, labeled “Non-Foreign Certification” that

states the transferor was not a foreign person, a foreign

corporation, or foreign estate as defined by the Code.      The

purpose of the certification is to inform the transferee that

withholding is not required under section 1445(a), which requires

10-percent withholding of the amount realized on the sale of U.S.

real property by a foreign person.      See sec. 1.1445-2(b)(2),

Income Tax Regs.    The certification provided KDI’s taxpayer

identification number as the transferor.

       Apex became licensed as an insurance company on November 14,

2001.    Cornerstone assisted with obtaining a corporate charter

and insurance license for Apex.    Mr. Klaas has been the sole

employee of Apex since its inception.      Upon receiving its

license, Apex engaged Sovereign Insurance Management L.L.C.

(Sovereign), an entity related to Cornerstone, to provide

insurance management services.    On December 15, 2001, Sovereign

executed three income replacement policies for unrelated persons
                                - 11 -

on Apex’s behalf with gross annual premiums of $350,000.      On that

same date Apex entered into a reinsurance agreement with

Sovereign or a related entity for the three policies, thereby

reducing Apex’s potential liability from $925,371 to $64,853.      As

a result of the reinsurance agreement, $325,000 of the $350,000

on account of the gross premiums shown on Apex’s 2001 return was

ceded to the reinsurance company, reducing Apex’s net premium

income to $25,000.   Apex reported the ceded insurance premiums as

an expense on its 2001 return.    Apex’s general ledger for 2001

listed accounts receivable of $350,000 on account of the gross

premiums from the three policies, recorded as “unearned policy

premiums”.

     Apex did not receive payment for the $25,000 in net premiums

from the three income replacement policies.    Nor does the record

establish that Sovereign received payment for any amount of the

premiums on these policies.   Mr. Klaas terminated Apex’s

relationship with Sovereign in 2002 because he was dissatisfied

with its management services.    Upon termination of Apex’s

relationship with Sovereign, Apex received a refund of its

management fees of $70,000, which included a $25,000 credit for

the uncollected premiums.

     Apex did not issue any insurance policies in 2002 and did

not renew the three income replacement policies from 2001.

Apex’s general ledger for 2002 continued to show $350,000 in
                               - 12 -

accounts receivable from the three income replacement policies

from 2001.   In late December 2003 Apex issued two insurance

policies each with a 1-year term:   An aviation liability policy

to Winchester Management, Inc., wholly owned by Mr. Klaas, to

insure an experimental aircraft to be piloted by Mr. Klaas, with

an $8,400 annual premium, and a professional liability policy for

cosmetic medicine and laser treatment (med-spa policy), with a

$5,000 annual premium, issued to a day spa in California that

performed botox injections and other cosmetic applications.     In

2004 Apex reissued the aviation and med-spa policies and issued

four additional policies:   A life policy on Mr. Klaas with a

$5,000 annual premium, a medical malpractice policy with a

$15,000 annual premium to a doctor who lost his hospital

privileges and was unable to obtain insurance from other

insurance companies, a health policy to Mr. Klaas with a $5,000

annual premium, and a legal services policy to Mr. Klaas with a

$1,000 annual premium.   In 2005 Apex reissued five policies from

2004 (with the exception of the med-spa policy) with the same

annual premiums and issued a pollution policy with a $12,000

premium to a company of which Mr. Klaas owned 50 percent.    Apex

reinsured all of the policies issued in 2004 and 2005 to reduce

its risk under the policies.
                                - 13 -

       The annual premiums from the above policies are as follows:

                          No. of Self-                    Premiums
             Total No.     Insurance            Annual    From Self-
Year        of Policies     Policies           Premiums   Insurance

2001             3              0              $25,000       -0-
2002             0              0                 -0-        -0-
2003             2              1               13,400    $ 8,400
2004             6              4               29,400     14,400
2005             6              5               36,400     21,400

       No evidence of the receipt of the annual premiums listed

above was presented at trial.    Apex reported program service

revenue on Form 990, Return of Organization Exempt From Income

Tax, as follows:

                 Year                Revenue

                 2001                $350,000
                 2002                   8,700
                 2003                  25,000
                 2004                  26,000
                 2005                  92,250
                 2006                  97,033

       Apex did not issue any insurance policies in 2002 but

reported program service revenue.    During 2005, 2006, and 2007

Apex acted as a reinsurer of policies insured by other insurance

providers through a pooling of insurance arrangement and earned

revenue through this arrangement that accounts for the revenue

reported in excess of the premiums from the above policies issued

by Apex.    The record does not contain evidence of the policies

Apex independently issued, if any, in 2006 and 2007.

       Since its inception Apex has sought niche markets within the

insurance industry where other insurers would not provide
                               - 14 -

coverage.   However, Apex quickly abandoned these niche markets or

did not pursue them because of the costs and risks of the

policies.   For example, in 2003 Sovereign pursued nursing home

insurance on Apex’s behalf because few insurers would provide

insurance to nursing homes.   Similarly, Mr. Klaas thought that

Apex found a profitable niche in the med-spa business.     After

Apex issued the first policy in December 2003, two other spa

owners contacted Apex about insurance.   Mr. Klaas inquired about

obtaining an insurance license in California.    However, he

decided to abandon med-spa insurance after he learned of the

expense associated with obtaining an insurance license in

California and a $250,000 lawsuit was filed against the first

policy holder.   After its decision not to pursue the med-spa

industry niche, Apex unsuccessfully sought to partner with

another insurance company to write medical malpractice policies

so that Apex could avoid State insurance licensing requirements.

     In 2006 Apex began to pursue aviation insurance for

experimental airplanes, like the one piloted by Mr. Klaas, as a

potential niche market.   Apex negotiated a joint venture with

Prime Insurance Co. (Prime) to write these policies.    Mr. Klaas

anticipated Apex’s receiving a 5-percent commission on any

policies issued by Prime.   Prime issued one policy for a $25,000

premium.    The policy holder filed a claim within 3 months of the

policy’s issuance.   Apex did not pay any portion of the claim
                              - 15 -

because Apex never finalized its agreement with Prime.

Thereafter, Apex’s relationship with Prime became contentious,

and the parties terminated the relationship.

     From 2001 to 2007 Apex engaged five different insurance

management companies.   Mr. Klaas became dissatisfied with the

management companies because of their inability to establish a

profitable insurance business for Apex.   Three of the management

companies prepared business plans for Apex:    (1) Sovereign

prepared the first plan, dated October 8, 2001; (2) David Ross,

the attorney representing petitioners in this proceeding,

prepared the second plan in either 2003 or 2004; and (3) Altas

Insurance Management prepared the third plan in connection with

Apex’s move to Anguilla in September 2005.

     From its inception, Apex’s business plan was for a

substantial portion of its business to be self-insurance.      Apex’s

business Spur plan dated October 8, 2001, stated:

     Annuity, Property & Casualty, Directors & Officers,
     Loss of Income, Life and Business Interruption products
     shall be issued to and/or for the benefit of Apex
     principal, Lawrence Klaas, his associates and outside
     third parties pursuant to private (not public)
     transactions. At least thirty (30%) of the business
     written will occur to outside third parties.

Apex planned to rely on outside consulting firms for services,

including underwriting and marketing.   The business plan also

projected net premium income for 2001 of $320,000 and for 2002 of
                               - 16 -

$350,000.   The business plan listed paid-in capital of $100,000

and did not list any capital surplus.

     In a May 8, 2002, letter, Mr. Bishop for Sovereign explained

to Mr. Klaas the conditions and tax consequences of forming and

maintaining an offshore insurance company.    The letter explained

that Apex’s investment income is not subject to tax but that any

tax benefits are subject to Mr. Klaas’s intent to operate “a real

insurance company; the tax benefits are merely incentives that

Congress has provided to form and operate bona fide insurance

companies.”    The letter also advised Apex on the need for a

substantial part of Apex’s premium to originate from unrelated

third parties.

     On July 2, 2002, KDI filed a final short-year return for

2001 for the period ending October 15, 2001, on Form 1120S, U.S.

Income Tax Return for an S Corporation.    The return indicated

that the boards of directors of Apex and KDI approved the plan of

merger on October 8, 2001.    The return did not report the sale of

Silver Spur.    The return reported the merger of KDI with and into

Apex on October 15, 2001, and listed KDI stock as the assets

transferred from the acquired company in exchange for Apex stock.

Mr. Klaas did not report the sale of Silver Spur on his 2001

individual return.

      On June 17, 2002, Apex filed an election under section

953(d) to be treated as a U.S. domestic insurance company for the
                               - 17 -

2001 tax year.    The election listed Apex’s gross underwriting

income and gross investment income in the respective amounts of

$350,000 and $4,780,877, for the period from October 7 to

December 31, 2001.    The election annualized gross income for 2001

to $22,011,462 for purposes of the U.S. asset test described in

Notice 89-79, 1989-2 C.B. 392.

     On August 6, 2002, Apex submitted Form 1024, Application for

Recognition of Exemption Under Section 501(a), to be recognized

as a tax-exempt entity as described in section 501(c)(15).      On

Form 1024, Apex stated its intent to sell property and casualty

insurance.    On October 15, 2002, Apex filed Form 990 reporting

the sale of Silver Spur and reporting total revenues of

$5,130,877.    Apex claimed that the sale of Silver Spur was not

subject to tax because Apex is a tax-exempt insurance company

under section 501(c)(15).    In May 2003 Mr. Ross provided a legal

opinion that Apex qualified as a tax-exempt captive insurance

company under section 501(c)(15).

     On October 25, 2005, respondent issued a final determination

that Apex did not qualify for tax-exempt status under section

501(c)(15).    The final determination letter states that Apex did

not qualify as an insurance company for 2003 and 2004.    The

heading of the letter identifies the years at issue as “2001 et

seq.” and the form required to be filed as Form 1120, U.S.

Corporation Income Tax Return, but the body of the letter does
                                - 18 -

not indicate whether Apex qualified for tax-exempt status for

2001 and 2002.     The letter further states that Apex must file

returns on the form and for the years listed above.     The body of

the letter does not mention Form 1120.     The Internal Revenue

Service has not granted tax-exempt status to Apex for any year at

issue.   Petitioners concede that Apex was not an insurance

company for 2003 but dispute respondent’s determination for 2001,

2002, and 2004.

     In 2002, the year following the sale of Silver Spur, Apex

lent $678,689 to Mr. Klaas from the proceeds from the sale of

Silver Spur.   Mr. Klaas used the loan in part to purchase a

personal residence.     Mr. Klaas executed a note on the property

with a 4.5-percent interest rate and a maturity date of December

31, 2004.   He also executed a deed of trust to secure the note

filed with the county recorder approximately 7 months later.       Mr.

Klaas sold the residence on April 18, 2003, and repaid the loan

as follows:    $10,000 on April 18, 2003, and $551,469.34 on April

28, 2003.

                                OPINION

     The issue for decision is the tax consequences of the sale

of Silver Spur.3    Respondent contends that the facts show that

     3
      Respondent based the Federal income tax deficiency for 2001
on capital gain on the sale of Silver Spur equal to the $8
million realized without a reduction for the basis in Silver
Spur. The petition assigned error to respondent’s failure to
account for the basis of Silver Spur as reported on KDI’s tax
                                                   (continued...)
                               - 19 -

Mr. Klaas remained KDI’s sole shareholder at the time of the

sale, that Mr. Klaas did not contribute his KDI stock to Apex

before the sale, and that a merger of the two entities did not

occur before the sale.    Accordingly, respondent contends that on

the facts of the transactions petitioners Klaas are subject to

tax on the sale.    In the alternative, respondent relies on

substance over form principles, including the sham transaction

and the step-transaction doctrines, to argue that Mr. Klaas

should be taxed on the sale of Silver Spur in the event we find

that a merger or a contribution occurred before the sale.

Respondent also presents alternative theories for taxing Mr.

Klaas on the gain from the sale of Silver Spur that are based on

section 367, relating to the denial of nonrecognition treatment

for transfers from a domestic to a foreign corporation, and on

section 269, relating to the disallowance rules for tax-motivated

corporate transactions.    If the Court determines that petitioners

Klaas are not subject to tax on the sale of Silver Spur, we must

determine whether Apex is subject to tax on the sale.

I.   Ownership of KDI at the Time of Sale

     The first issue is which entity owned Silver Spur at the

time of the sale.    Respondent argues that the merger between KDI


     3
      (...continued)
returns. Petitioners contend that Silver Spur had a cost basis
after depreciation of $3,226,231. The parties attached basis and
depreciation information to the stipulation of facts. Respondent
did not address this issue at trial or on brief.
                                - 20 -

and Apex did not become effective until the filing of the

articles of merger with the State of Washington on March 1, 2002,

over 3 months after the sale.    Thus, respondent argues that Mr.

Klaas remained the sole shareholder of KDI at the time of sale.

Respondent seeks to tax Mr. Klaas on the basis of the following

chain of ownership:   Silver Spur was sold by Silver Spur

Holdings, a disregarded entity wholly owned by KDI, an S

corporation wholly owned by Mr. Klaas.    Petitioners do not

contest the effective date of the merger argued by respondent or

argue that the merger occurred before the sale.    Instead,

petitioners argue:    (1) The Court should not consider

respondent’s effective date argument because it is a new issue

being raised for the first time on brief, and (2) Mr. Klaas made

a capital contribution of his KDI stock to Apex on October 8,

2001, the date Apex was incorporated.    Petitioners appear to

argue that the contribution was a separate transaction from the

merger and occurred before the merger.

     A party may not raise a new issue on brief where

consideration of the issue would surprise or prejudice the

opposing party.   See Smalley v. Commissioner, 

, 456

(2001); 508 Clinton St. Corp. v. Commissioner, 

, 353

n.2 (1987); Gordon v. Commissioner, 

, 331 n.16 (1985).

In his opening statement, respondent contended that the sale of

Silver Spur occurred before the merger.    Respondent’s trial
                              - 21 -

position contradicted his pretrial memorandum, which indicated

his assent to an October 8, 2001, merger date.   Respondent’s

pretrial memorandum stated that Mr. Klaas transferred all his KDI

shares to Apex in exchange for Apex stock on October 8, 2001.

Nevertheless, the parties did not stipulate the merger date.

Moreover, respondent’s position in his pretrial memorandum is

inconsistent with petitioners’ position that Mr. Klaas

transferred the KDI stock in a capital contribution and not in

the merger transaction.   In the petition, petitioners assigned

error to respondent’s determination that Apex and KDI entered

into a merger transaction and alleged that Mr. Klaas contributed

his KDI stock to Apex in a transaction separate from the merger,

relying on substance over form principles.   Under petitioners’

argument, they would have to establish whether Mr. Klaas

transferred the KDI stock in a capital contribution or in the

merger transaction and when he transferred the KDI stock.

Petitioners should have known that the date of the merger

relative to the date of the sale was at issue.

     Regardless of which theory respondent relies on, the issue

is which entity owned Silver Spur on the date of sale.   The issue

as presented by petitioners under their contribution theory is

essentially the same issue presented under respondent’s effective

date argument--whether Mr. Klaas owned KDI at the time of the

sale.   Petitioners are not required to introduce any additional
                              - 22 -

or different evidence as their own argument depends on who was

the ultimate owner of Silver Spur at the time of the sale.     Nor

have petitioners suggested that the record contains insufficient

facts to permit us to decide the effective date of the merger or

to consider respondent’s argument.     Even if respondent’s

effective date argument is a new issue, it should not surprise or

prejudice petitioners.

     Petitioners have not taken a position as to when the merger

occurred.   Petitioners would have difficulty arguing that the

merger occurred before the sale.   Under the terms of the merger

plan, KDI ceased to exist upon the merger, and Apex was the

surviving entity.   Under Washington State law, when a merger

takes effect, the target corporation merges into the surviving

corporation and the separate existence of the target ceases, and

the title to all real estate owned by the target is vested in the

surviving corporation.   Wash. Rev. Code Ann. sec.

23B.11.060(1)(a) and (b) (West 1994).     If the merger had occurred

before the date of the sale, KDI would have ceased to exist, Apex

would have been the surviving entity, and Apex should have been

listed in the sale documents as the seller, not KDI.     All the

sale documents for Silver Spur show KDI as the signatory on the

sale and thus still in existence at the time of the sale.     A

finding that the merger occurred before the sale of Silver Spur

would be inconsistent with petitioners’ reporting of the sale
                               - 23 -

because KDI would not have existed after the merger.      On brief

petitioners acknowledge that the merger did not take place until

after the sale, stating:   “At the time of the sale KDI was Silver

Spur RV park’s sole member.”   Petitioners’ position on brief is

inconsistent with KDI’s 2001 short-year return, which reported

that the merger occurred on October 15, 2001.

     Petitioners do not take a position as to whether the merger

occurred before or after the sale.      Instead, petitioners argue

that Mr. Klaas’s contribution of his KDI stock to Apex was

separate from the plan of merger.    The record does not establish

that Mr. Klaas made a capital contribution of his KDI stock to

Apex before the sale of Silver Spur.      The stipulation of facts

contains a stipulation that is contrary to petitioners’ assertion

that Mr. Klaas transferred his KDI stock to Apex through a

capital contribution and not through the merger transaction.      The

parties stipulated that “Mr. Klaas transferred all of his shares

in KDI to Apex pursuant to the Plan of Merger, below.      When it

incorporated, Mr. Klaas funded KDI with a capital contribution of

$4,777,399.”4

     The stipulation does not indicate whether Apex was funded

with a contribution of KDI stock or from the proceeds from the

sale of Silver Spur by KDI.    Generally, a stipulation of fact is

treated as a conclusive admission by the parties and is binding



     4
      It appears that the stipulation contains an error and
should refer to Mr. Klaas’s funding of Apex.
                              - 24 -

on the parties.   Rule 91(e); Stamos v. Commissioner, 

, 1455 (1986).   We may modify or set aside a stipulation that

is clearly contrary to facts in the record.     Jasionowski v.

Commissioner, 

, 318 (1976).     The Court will not allow

a party to qualify, change, or contradict a stipulation except

where justice requires.   Rule 91(e).   There is no documentation

or fact in the record except for Mr. Klaas’s self-serving

testimony to establish a contribution of the KDI stock to Apex

independent from the merger documents.    Petitioners are bound by

the stipulation that Mr. Klaas transferred his KDI stock to Apex

pursuant to the plan of merger.   Petitioners cannot argue that

Mr. Klaas contributed his KDI stock to Apex before the merger

occurred.5

     Although petitioners have not taken a position as to when

the merger occurred, petitioners’ position relies on KDI’s

existence at the time of the sale.     Thus, petitioners implicitly

acknowledge that the merger occurred after the sale; otherwise

KDI would have not existed at the time of the sale.    Moreover,

Washington State law supports respondent’s position that the



     5
      Respondent contends that under petitioners’ contribution
argument Mr. Klaas would also be taxable on the gain from his KDI
stock at the time of the alleged contribution to a foreign
corporation under sec. 367(a), resulting in double taxation at
the corporate and shareholder levels. Because respondent views
Apex as a foreign corporation without a valid sec. 953(d)
election to be treated as a domestic corporation, respondent
argues that the nonrecognition rules of sec. 351 would not apply.
                               - 25 -

merger occurred upon the filing of the articles of merger on

March 1, 2002, after the sale of Silver Spur.   Washington State

law provides that the surviving entity in a merger must file

articles of merger with the secretary of state.   Wash. Rev. Code

Ann. secs. 23B.11.090 (West Supp. 2009), 23B.11.050 (West 1994).

The plan of merger defined the effective time of the merger as

the date of the filing of the articles of merger with the State.

Washington State law recognizes the parties’ right to abandon an

authorized merger at any time before the filing of the articles

of merger in accordance with the procedure set forth in the plan

of merger.   Wash. Rev. Code Ann. sec. 23B.11.030(9) (West 1994).

The plan of merger between Apex and KDI permitted the termination

of the plan of merger under certain circumstances at any time

before the effective time.   Thus, the merger between Apex and KDI

could have been abandoned after the sale of Silver Spur and was

not final at the time of the sale.

     Finally, we note that Mr. Klaas chose to structure the

transaction between KDI and the newly created Apex as a merger

without any documentation that he planned to make his capital

contribution of his KDI stock to Apex independent and separate

from the merger transaction.   Taxpayers are entitled to arrange

and conduct their affairs and structure their transactions to

minimize any adverse tax implications.   Gregory v. Helvering, 

, 469 (1935).   Once having done so, taxpayers are
                                - 26 -

generally bound by the form of the transaction they chose and

cannot disregard the chosen form when confronted with adverse tax

consequences.     Commissioner v. Natl. Alfalfa Dehydrating &

Milling Co., 

, 149 (1974); Legg v. Commissioner, 

, 169 (1971), affd. per curiam 

 (9th Cir.

1974).   There is nothing in the record except Mr. Klaas’s self-

serving testimony to suggest that the plan of merger did not

properly reflect the transactions between KDI and Apex.    The

parties structured the transaction in the form of a merger and

executed the plan of merger to effect this result.

     We find on the record and the stipulation of facts that Mr.

Klaas did not contribute the KDI stock to Apex before the sale of

Silver Spur.    We find on the basis of petitioners’ contribution

argument and the reporting of the sale documents that petitioners

have conceded that the merger did not occur until after the sale

of Silver Spur.    Thus, Mr. Klaas remained KDI’s sole shareholder

at the time of the sale and is subject to tax on the gain from

the sale.

     Because petitioners Klaas are liable for tax on the gain

from the sale of Silver Spur, respondent concedes the adjustments

against Apex for 2001 and the adjustments against Mr. Klaas for

2002.
                               - 27 -

II.    Respondent’s Alternative Arguments

       As an alternative argument, respondent argues that Mr. Klaas

should be directly taxed on the gain from Silver Spur under

either the sham transaction or the step transaction doctrine in

the event we find that a merger or contribution occurred before

the sale.    Respondent further argues that Mr. Klaas is subject to

tax on the sale of Silver Spur under section 367 or section 269.

Since we find as a matter of fact that Mr. Klaas remained KDI’s

sole shareholder at the time of the sale, we do not need to

decide these issues.

III.    Fraud Penalty Under Section 6663

       Section 6663 imposes an addition to tax equal to 75 percent

of any underpayment attributable to fraud.    Respondent contends

that Mr. Klaas is liable for the section 6663 fraud penalty for

2001 on account of his failure to report the gain from the sale

of Silver Spur.    Respondent bears the burden of proving fraud by

clear and convincing evidence.    See sec. 7454(a); Rule 142(b);

Rowlee v. Commissioner, 

, 1123 (1983).    Fraud is an

intentional wrongdoing with the purpose of evading taxes believed

to be owing.    See Neely v. Commissioner, 

, 947 (1985).

To establish fraud, respondent must prove (1) an underpayment

exists, and (2) Mr. Klaas intended to evade taxes known to be

owing by conduct intended to conceal, mislead, or otherwise

prevent the collection of taxes.    See Parks v. Commissioner, 94
                               - 28 -

T.C. 654, 660-661 (1990).    We have found above that Mr. Klaas is

taxable on the sale of Silver Spur as the sole shareholder of

KDI.    He did not pay Federal income tax on the gain from the

sale.    Therefore, he underpaid his tax for 2001.

       The existence of fraud is a question of fact to be resolved

upon consideration of the entire record.     DiLeo v. Commissioner,

, 874 (1991), affd. 

 (2d Cir. 1992).     Since

direct evidence of fraud is rarely available, fraud may be proved

by circumstantial evidence and reasonable inferences from the

facts.    Petzoldt v. Commissioner, 

, 699 (1989).

Courts have developed a nonexclusive list of factors or “badges

of fraud” that demonstrate fraudulent intent.     Niedringhaus v.

Commissioner, 

, 211 (1992).     These badges of fraud

include:    (1) Understatement of income; (2) inadequate records;

(3) failure to file tax returns; (4) implausible or inconsistent

explanations of behavior; (5) concealment of income or assets;

(6) failure to cooperate with tax authorities; (7) filing false

documents; (8) failure to make estimated tax payments; (9)

dealing in cash; (10) engaging in illegal activities; and (11)

engaging in a pattern of behavior that indicates an intent to

mislead.    Vogt v. Commissioner, T.C. Memo. 2007-209.   No single

factor is necessarily sufficient to establish fraud; however, a

combination of several of these factors may constitute persuasive

evidence of fraud.    Niedringhaus v. Commissioner, supra at 211.
                               - 29 -

       Respondent argues that Mr. Klaas sought advice from tax

shelter promoters and considered various tax shelter products

before deciding to form a foreign insurance company to conceal

the gain on the sale of Silver Spur.    Respondent alleges that Mr.

Klaas established Apex to reduce his U.S. tax liability from the

sale of Silver Spur but still had access to the sale proceeds for

his personal benefit as evidence by a purported loan in 2002.

Respondent further alleges that Mr. Klaas concealed the

transactions at issue by failing to report the gain on his

individual return or KDI’s return, even though he listed KDI as

the selling entity.

       Through his reliance on the stipulation of facts, respondent

misstates the purpose of Mr. Klaas’s first seeking advice from

MSA.    Mr. Klaas did not initiate a relationship with MSA for

advice on tax products to shelter the gain from the sale of

Silver Spur.    The April 12, 1999, letter does not state that Mr.

Klaas anticipated selling Silver Spur.    In fact, the letter

states the opposite, that he intended to keep the property and

pull out equity to invest in other investment opportunities.      Mr.

Klaas sought MSA’s advice on these other investment

opportunities.    Mr. Klaas sought tax planning advice from MSA

regarding the sale of Silver Spur in December 1999 after

receiving an unsolicited offer to purchase the property.    Mr.

Klaas decided not to pursue any of MSA’s tax planning advice.
                                - 30 -

After making that decision, Mr. Klaas continued to negotiate the

sale.     After Mr. Klaas received a second unsolicited offer in

July 2001, he sought advice from Mr. Bishop and Mr. Fuller, then

principals of Cornerstone, who recommended a foreign insurance

company.     Mr. Klaas delayed the sale of Silver Spur so that he

would have time to implement the tax planning strategies.

Although these actions establish that Mr. Klaas sought to

minimize his tax liability from the sale, none constitutes fraud.

     Clearly, Mr. Klaas was concerned about minimizing both his

Federal and State tax liabilities from the sale of Silver Spur

and discussed various ways to reduce his tax liabilities with his

tax advisers.     Mr. Klaas acknowledged that one reason he formed

Apex was to minimize U.S. tax on the sale.     Taxpayers are

generally allowed to arrange their affairs and to structure their

transactions to minimize any adverse tax consequences so long as

the transactions have economic effect apart from their tax

benefits.    See Gregory v. Helvering, 293 U.S. at 469; Zmuda v.

Commissioner, 

, 1421 (9th Cir. 1984), affg. 

 (1982).     Mr. Klaas failed to structure the transactions in a

manner that reflected economic reality.     Although Mr. Klaas’s

dealings with MSA demonstrate that he wanted to minimize taxes,

they do not support a finding of fraud.

        The 2002 loan from Apex to Mr. Klaas is not evidence of

fraud as respondent alleges.     Respondent contends that the loan
                              - 31 -

was part of a prearranged plan to take money out of Apex.

Respondent has not established that the loan was part of a

prearranged plan in which Mr. Klaas would have access to the sale

proceeds for his personal benefit.     Mr. Klaas credibly testified

that he decided to use Apex’s capital to repay his mortgage

because Apex earned a low interest rate on its capital reserves.

Mr. Klaas signed a note with a 4.5-percent interest rate and

repaid the loan in 2003 when he sold the residence.

     Respondent also contends that Mr. Klaas concealed the gain

by failing to report the sale on his individual return or KDI’s

return.   Mr. Klaas’s failure to report the gain from the sale on

his individual or KDI’s return is not sufficient proof of fraud

for the Court to sustain the section 6663 fraud penalty.

Although the failure includes an element of concealment, Apex

reported the sale on its Form 990.     In addition, KDI reported the

merger with Apex on its 2001 short-year return and attached the

merger documents to the return.   Apex’s continued use of Form

990, instead of Form 1120, after respondent’s determination that

Apex did not qualify for tax-exempt status is not evidence of

fraud, as respondent alleges, because Apex may challenge that

determination.

      Finally, respondent contends that Mr. Klaas made false and

inconsistent statements including:     (1) The execution of a listed

transaction check sheet (the check sheet) dated November 1, 2004;
                               - 32 -

(2) the nonforeign status certification; and (3) Apex’s section

953(d) election.    We do not believe Mr. Klaas’s submission of any

of these documents constitutes fraud with an intent to conceal

income.    The check sheet included as prohibited transactions

“Transactions that shifted income to related companies purported

to be insurance companies that are subject to little or no U.S.

federal income tax.”    Although the overly broad description used

in the check sheet would arguably apply to Apex, the listed

transaction identified by respondent--producer-owned reinsurance

companies--does not apply to Apex.      Notice 2002-70, 2002-2 C.B.

765.    Moreover, the Internal Revenue Service eliminated such

reinsurance arrangements from the list of listed transactions on

September 24, 2004, before Mr. Klaas signed the check sheet.     See

Notice 2004-67, 2004-2 C.B. 600.    Accordingly, we find that the

check sheet is not evidence of fraud.

       In the nonforeign certification Mr. Klaas claimed that KDI,

a domestic entity, was the seller, thereby avoiding the 10-

percent withholding requirement of section 1445(a) on the sale of

U.S. real property by a foreign entity.      However, petitioners now

take an inconsistent position, claiming that Apex was the seller.

While the position taken on the nonforeign certification is

questionable, it does not establish fraud.

       As further evidence of fraud, respondent contends that Apex

improperly annualized the gain from the sale of Silver Spur for
                              - 33 -

purposes of its section 953(d) election, inflating its 2001

income to over $22 million to artificially enhance Apex’s

reserves and to mislead respondent into believing that Apex was

maintaining an insurance business.     Apex also incorrectly

calculated its annual gross underwriting income for 2001 by

failing to reduce its gross premiums by $325,000 for the premiums

it ceded for reinsuring the three income replacement policies.

See Notice 89-79, supra, 1989-2 C.B. at 393 (defining gross

income as gross premiums written less return premiums and

premiums paid for reinsurance).   Although Apex may have made

mistakes on its section 953(d) election statement, these mistakes

do not constitute fraud.   The question of whether Apex overstated

its reserves does not affect the determination of which party was

the seller of Silver Spur.   Moreover, the incorrect calculations

may be contrary to petitioners’ interests; for example, the

election reported annual underwriting income that would

disqualify Apex from tax-exempt status.     See sec. 501(c)(15)(A).

The section 953(d) election is not evidence of Mr. Klaas’s

fraudulent intent to evade taxes on the sale of Silver Spur.

     Respondent has not proven by clear and convincing evidence

that Mr. Klaas’s failure to report the sale of Silver Spur was

fraudulent with the intent to evade taxes.     Mr. Klaas engaged in

aggressive tax planning to minimize his taxes on the sale of

Silver Spur.   However, his actions do not constitute fraud.    Mr.
                                - 34 -

Klaas’s limited experience as an accountant, where he prepared

simple individual tax returns for 8 months following college,

does not prove that he acted with fraudulent intent.       We find

that Mr. Klaas is not liable for the section 6663 fraud penalty

for 2001.

IV.   Negligence Penalty Under Section 6662(a)

      As an alternative to the fraud penalty, respondent

determined that petitioners are liable for a section 6662(a)

accuracy-related penalty for 2001 on account of their failure to

report the gain on the sale of Silver Spur.      Section 6662(a) and

(b)(1) and (2) imposes a 20-percent penalty on an underpayment of

tax that results from negligence or disregard of rules and

regulations or from a substantial understatement of income tax.

Negligence is defined as any failure to make a reasonable attempt

to comply with the provisions of the Code.    Sec. 1.6662-3(b)(1),

Income Tax Regs.   An understatement of income tax is substantial

if it exceeds the greater of 10 percent of the tax required to be

shown on the return or $5,000.    Sec. 6662(d)(1)(A).

      The section 6662 penalty is inapplicable to the extent the

taxpayer had reasonable cause for the underpayment and the

taxpayer acted in good faith.    Sec. 6664(c)(1).    The

determination of whether the taxpayer acted with reasonable cause

and in good faith is made on a case-by-case basis, taking into

account the relevant facts and circumstances.       Sec. 1.6664-
                                - 35 -

4(b)(1), Income Tax Regs.     The extent of the taxpayer’s efforts

to assess the proper tax liability is generally the most

important factor.   Id.    Good faith reliance on professional

advice concerning tax laws may be a defense to negligence

penalties.    United States v. Boyle, 

, 250-251 (1985);

see also sec. 1.6664-4(b)(1), Income Tax Regs.    Reliance on

professional advice is not an absolute defense to negligence, but

a factor to be considered.     Freytag v. Commissioner, 

,

888 (1987), affd. 

 (5th Cir. 1990), affd. 

 (1991).

     Petitioners contend that they are not liable for the section

6662(a) penalty because Mr. Klaas reasonably and in good faith

relied on the advice of tax professionals in forming Apex.

Despite the advice received from tax professionals, petitioners

have not demonstrated that they acted with due care in reporting

the sale of Silver Spur.    Mr. Klaas engaged in aggressive tax

planning to minimize his taxes on the sale of Silver Spur.       Mr.

Klaas was aware of the potential risks associated with an

offshore insurance company and nevertheless chose to structure

the transactions in this matter.    Mr. Klaas maintains that he

intended to operate Apex as a profitable insurance business.

However, he made no serious effort to achieve that result in the

years following Apex’s inception.    Mr. Klaas claimed that he

pursued niche markets within the insurance industry.    However,
                              - 36 -

his actions show that he was not willing to accept the risks

associated with the insurance business as he abandoned the market

once an insurance claim was filed.

     Furthermore, Mr. Klaas negotiated the sale of Silver Spur

and executed the sales documents which listed KDI as the selling

entity.   As an experienced and successful businessman, Mr. Klaas

should have been aware that the sale documents did not comport

with the plan of merger because KDI would cease to exist when the

merger occurred.   Mr. Klaas should have also known that the

articles of merger were not filed until after the sale.    Mr.

Klaas did not rely on professionals to negotiate the sale of

Silver Spur or prepare the sale documents.    We find that the

underpayment is attributable to negligence.    Accordingly,

petitioners are liable for the section 6662(a) and (b)(1)

accuracy-related penalty for 2001.

     To reflect the foregoing,


                                      Decision will be entered for

                                 petitioner in docket No. 16774-06.

                                      Decision will be entered under

                                 Rule 155 in docket No. 19803-06.