Friday, July 29, 2011

From The Boston Tax Institute

Boston Tax Alert 2011-41, 2011-42, 2011-43


Lu Gauthier of The Boston Tax Institute has given me permission to republish his newsletter. The BTI newsletter is a regular feature of this blog now, although I have been a little irregular in putting them up. Be sure to check out the BTI catalog for great CPE value.



On 07/26/11, the United States Court of Appeals for the First Circuit affirmed the decision of the United States Tax Court in Recovery Group, Inc. v. Commissioner holding that a covenant not to compete, which was entered into in connection with the redemption of the stock interest of a 23% shareholder, was an amortizable section 197 intangible which had to be amortized over 15 years instead of over its one year term. The opinion states "According, we hold that, pursuant to this section, a 'section 197 intangible' includes any covenant not to compete entered into in connection with the acquisition of any shares--substantial or not--of stock in a corporation that is engaged in a trade or business." Note the reference to ANY shares! As you may recall, although the S corporation lost on this issue in the Tax Court, it was able to avoid the 20% taxpayer accuracy-related penalty on the built-in gains tax that resulted from the increase in its taxable income as a result of this decision based on reliance on professional advice.


I also noticed this case and put up the full-text on this site and did a commentary on it on my Forbes blog.
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In a recent regular decision, Stephen G. Woodsum v. Comm., 136 TC No. 29 (06/13/11), the Tax Court upheld a 20% taxpayer accuracy-related penalty of $104,295 with respect to a $3.4M omission of an amount reported on Form 1099-MISC. The 1099 was scanned into the preparer's records for use in preparing the taxpayer's 2006 return. Although the taxpayer claimed to have relied on professional advice a la U.S. v. Boyle in order to avoid the penalty, the court concluded that in this case no advice was rendered--the preparers simply had made an error of omission, and the taxpayer should have caught it in his review of the return but did not. Perhaps if the results of the scanned information returns had been tied back to the original paper 1099s more carefully, this problem may not have arisen. This and other recent case law developments will be discussed in detail in our seminar on Current Tax Developments/New Tax Legislation on 08/17 in Waltham.

I had noticed this one but had trouble making much out of it.  Something tells me somebody else might end up paying that penalty.
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On 07/19/11, MA DOR issued a working draft of Directive 11-XX - Seven-Month Extension for Combined Reporting Filers which reads in part as follows:



Effective for tax years beginning on or after January 1, 2010, a taxpayer corporation that is a member of a combined group and that must report income derived from the activities of that group in a combined report ("combined reporting filer") may receive an extension of seven months, in lieu of the six-month extension allowed to corporate excise filers under G.L. c 62C, § 19, to file its combined report upon the combined group's request for this extension. The seven-month extension also applies to the non-income measure filing required from any member of the combined group if the member has the same tax year as the combined group. For the tax year beginning on or after January 1, 2010 but before January 1, 2011, a combined reporting filer that has previously requested a six-month extension will be granted an extension of an additional month, for a total of seven months. Pending further instructions, these taxpayers need take no further action to obtain the additional month extension for the 2010 tax year.



This and other topics will be discussed in detail in our 1-day seminar entitled MA Combined Reporting on 08/16 in Waltham.

Wednesday, July 27, 2011

Covenant Not To Compete

RECOVERY GROUP, INC., ET AL. v. COMM., Cite as 108 AFTR 2d 2011-XXXX, 07/26/2011




RECOVERY GROUP, INC., ET AL., Petitioners, Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.

Case Information:

Code Sec(s):

Court Name: United States Court of Appeals For the First Circuit,

Docket No.: No. 10-1886,

Date Decided: 07/26/2011.

Disposition:



HEADNOTE

.



Reference(s):



OPINION

Peter L. Banis, with whom Banis, O'Sullivan & McMahon, LLP, was on brief for petitioners.



Damon W. Taaffe, Attorney, Tax Division, Department of Justice, with whom John A. DiCicco, Acting Assistant Attorney General, and Thomas J. Clark, Attorney, were on brief for respondent.



United States Court of Appeals For the First Circuit,



APPEAL FROM THE JUDGMENT OF THE UNITED STATES TAX COURT



Before Torruella, Circuit Judge, Souter, * Associate Justice, and Boudin, Circuit Judge.



Judge: TORRUELLA, Circuit Judge.



The present appeal requires us to determine whether a covenant not to compete, entered into in connection with the acquisition of a portion of the stock of a corporation that is engaged in a trade or business, is considered a “ section 197 intangible,” within the meaning of I.R.C. § 197(d)(1)(E), regardless of whether the portion of stock acquired constitutes at least a “substantial portion” of such corporation's total stock. For the reasons stated below, we answer in the affirmative.



Petitioners-Appellants Recovery Group, Inc. (“Recovery Group”) and thirteen individuals who held shares in said corporation appeal the United States Tax Court's decision in Recovery Group, Inc. v. Comm'r of Internal Revenue, T.C. Memo 2010-76 [TC Memo 2010-76], 99 T.C.M. (CCH) 1324 (U.S. Tax Ct. Apr. 15, 2010), which found in favor of respondent Commissioner of Internal Revenue (the “Commissioner”) concerning the correctness of certain income tax deficiencies assessed by the United States Internal Revenue Service (the “IRS”) against the appellants. 1 These deficiencies resulted from the finding that a certain covenant not to compete -- entered into by Recovery Group in connection with the redemption of 23% of the shares of a former shareholder -- constituted a “ section 197 intangible,” and, consequently, that Recovery Group had to amortize the payments it made under such covenant not to compete over the fifteen-year period prescribed by I.R.C. § 197(a), and not over the duration of the covenant, as Recovery Group had reported in its corresponding income tax returns. Because we find that the aforementioned covenant not to compete was an “amortizable section 197 intangible,” we affirm.



I. Facts and Procedural History

The relevant facts in this appeal are not in dispute. During the tax years in question, Recovery Group was an “S corporation” 2 that engaged in the business of providing consulting and management services to insolvent companies.



In 2002, James Edgerly -- one of Recovery Group's founders, employees and minority shareholders -- informed its president that he wished to leave the company and to have the company buy out his shares, which represented 23% of Recovery Group's outstanding stock. As a result of the subsequent negotiations, Mr. Edgerly entered into a buyout agreement whereby Recovery Group agreed to redeem all of Mr. Edgerly's shares for a price of $255,908. In addition, Mr. Edgerly entered into a “noncompetition and nonsolicitation agreement” that prohibited Mr. Edgerly from, inter alia, engaging in competitive activities from July 31, 2002 through July 31, 2003. The amount paid by Recovery Group to Mr. Edgerly for this covenant not to compete (the “Covenant”) amounted to $400,000, which was comparable to Mr. Edgerly's annual earnings.



In its corresponding income tax returns, Recovery Group claimed deductions for its payments under the Covenant by amortizing such payments over the twelve-month duration of the Covenant. Thus, because that twelve-month term straddled the two tax years 2002 and 2003, Recovery Group allocated the $400,000 over those two years.



After a subsequent investigation, the IRS determined that the Covenant was an amortizable section 197 intangible, amortizable by Recovery Group over fifteen years (beginning with the month of acquisition) and not over the duration of the Covenant, as had been reported by Recovery Group in its corresponding income tax returns. Consequently, the IRS partially disallowed Recovery Group's deductions for the cost of the Covenant, allowing amortization deductions of only $11,111 for 2002 and $26,667 for 2003, and disallowing $155,552 for 2002 and $206,667 for 2003. This disallowance increased Recovery Group's net income for each year, and thus each shareholder's share of Recovery Group's income. Accordingly, the IRS issued notices of deficiency to both Recovery Group and its shareholders. 3



Recovery Group and its shareholders filed timely petitions in the tax court, alleging that the Covenant was not considered a “ section 197 intangible,” and, consequently, that it was not subject to I.R.C. § 197's fifteen-year amortization period, but rather that it was amortizable over its one-year duration. Specifically, Recovery Group alleged that, in order for a covenant not to compete to be considered a “ section 197 intangible” under I.R.C. § 197(d)(1)(E), the covenant must be entered into in connection with the acquisition of either the totality of such corporation's stock or a substantial portion of such corporation's total stock. The tax court rejected Recovery Group's interpretation of I.R.C. § 197 and found in favor of the Commissioner, concluding that § 197(d)(1)(E)'s substantiality requirement only applied to asset acquisitions and not to stock acquisitions, and, consequently, that a covenant not to compete entered into in connection with the acquisition of any corporate stock, even if not “substantial,” was considered a “ section 197 intangible” amortizable over fifteen years. The tax court also opined, in the alternative, that even if the aforementioned conclusion was incorrect and I.R.C. § 197(d)(1)(E)'s substantiality requirement indeed applied to stock acquisitions, Recovery Group's claim nonetheless failed because the court found the stock redemption in question (23% of Recovery Group's total stock) to be a “substantial portion” of the company's stock. This appeal ensued. 4



II. Standard of Review

We review de novo the tax court's legal conclusions, including its interpretation of the Internal Revenue Code. Drake v. Comm'r, 511 F.3d 65, 68 [100 AFTR 2d 2007-7113] (1st Cir. 2007).



III. Discussion

On appeal, Recovery Group contests the tax court's decision on the tax deficiencies by challenging the court's interpretation of I.R.C. § 197. 5 Specifically, Recovery Group avers that the tax court erred by concluding that the Covenant is a “ section 197 intangible” within the meaning of I.R.C. § 197(d)(1)(E).



In interpreting the meaning of I.R.C. § 197(d)(1)(E), we begin our analysis with the statutory text and determine whether the same is plain and unambiguous. See Carcieri v. Salazar, 555 U.S. 379, 129 S.Ct. 1058, 1063 (2009). In so doing, we accord the statutory text “its ordinary meaning by reference to the “specific context in which that language is used, and the broader context of the statute as a whole.”” Mullane v. Chambers, 333 F.3d 322, 330 (1st Cir. 2003) (quoting Robinson v. Shell Oil Co., 519 U.S. 337, 341 (1997)). If the statutory language is plain and unambiguous, we “must apply the statute according to its terms,” Carcieri, 129 S.Ct. at 1063–64, except in unusual cases where, for example, doing so would bring about absurd results. See In re Hill, 562 F.3d 29, 32 (1st Cir. 2009). “If the statute is ambiguous, we look beyond the text to the legislative history in order to determine congressional intent.” United States v. Vidal-Reyes, 562 F.3d 43, 50–51 (1st Cir. 2009) (internal quotation marks omitted). “A statute is ambiguous only if it admits of more than one reasonable interpretation.” Id. at 51 (internal quotation marks omitted).



We begin our discussion by providing a brief background of I.R.C. § 197 and then turn to sketching both the Commissioner's construction of I.R.C. § 197, which was adopted by the tax court as its primary holding, and Recovery Group's interpretation.



A. Background

Section 197 entitles taxpayers to claim “an amortization deduction with respect to any amortizable section 197 intangible.” 26 U.S.C. § 197(a). The cost of an “amortizable section 197 intangible” must be amortized “ratably over the 15-year period beginning with the month in which such intangible was acquired.” Id. No other depreciation or amortization deduction is allowed with respect to any “amortizable section 197 intangible.” Id. at § 197(b). On the other hand, intangible assets not classified as “amortizable section 197 intangible[s]” are not within the purview of I.R.C. § 197 and are not subject to this section's mandatory fifteen-year amortization period. Rather, depreciation and amortization for such non- section 197 intangible assets may be allowed under the rules of other code provisions, such as I.R.C. § 167, provided the asset complies with the requirements set forth therein.



B. Relevant Statutory Language

Section 197(d)(1)(E) defines the term “ section 197 intangible” as including, among other things, “any covenant not to compete ... entered into in connection with an acquisition (directly or indirectly) of an interest in a trade or business or substantial portion thereof.” Recovery Group does not contest that, under I.R.C. § 197(d)(1)(E), a redemption of stock is considered an indirect acquisition of an interest in a trade or business. See Frontier Chevrolet Co. v. Comm'r, 329 F.3d 1131, 1132 [91 AFTR 2d 2003-2338] (9th Cir. 2003). Rather, the parties' dispute over the construction of this section deals primarily with the antecedent of the word “thereof” and the definition of “an interest.”



The tax court held and the Commissioner asserts that the phrase “an interest in a trade or business” refers to a portion -- all or a part -- of an ownership interest in a trade or business, and that the phrase “trade or business” is the antecedent of the word “thereof.” Thus, the tax court essentially read I.R.C. § 197(d)(1)(E) as follows: “the term “ section 197 intangible” means ... any covenant not to compete ... entered into in connection with an acquisition ... of [(1)] an interest in a trade or business or [(2)] [a] substantial portion [of a trade or business].” It is noteworthy that, under this interpretation, the question of whether an acquisition is “substantial” arises only where the acquisition is “of a trade or business” (i.e., of assets constituting a trade or business), and not where the acquisition is of “an interest” (i.e., a stock or partnership ownership interest) in a trade or business. In other words, under this reading, a covenant not to compete executed in connection with a stock acquisition of any size -- substantial or not -- would be considered a “ section 197 intangible.” Meanwhile, in the context of asset acquisitions, a covenant not to compete would only be considered a “ section 197 intangible” insofar as it is entered into in connection with the acquisition of all or a substantial portion of assets constituting a trade or business. Accordingly, the tax court held that “15-year amortization is required when a covenant is entered into in connection with an acquisition of either an interest (i.e., an entire or fractional stock interest) in a trade or business or assets constituting a substantial portion of a trade or business.” Recovery Group, Inc., T.C. Memo 2010-76 [TC Memo 2010-76].



Recovery Group, on the other hand, argues that the words “an interest in a trade or business” refer to “the entire interest in a trade or business,” and that the phrase “an interest in a trade or business” is the antecedent of the word “thereof.” Accordingly, Recovery Group maintains that I.R.C. § 197(d)(1)(E) should be construed as follows: “the term “ section 197 intangible” means ... any covenant not to compete ... entered into in connection with an acquisition ... of [(1)] [the entire] interest in a trade or business or [(2)] [a] substantial portion [of an interest in a trade or business].” Recovery Group further alleges that the phrase “an interest in a trade or business” should be read to include both assets constituting a trade or business and stock in a corporation that is engaged in a trade or business. 6 Thus, under this interpretation, section 197's fifteen-year amortization would apply to covenants issued in connection with a stock acquisition only insofar as the covenantee 7 acquires at least a “substantial portion” of stock in a corporation that is engaged in a trade or business. In other words, under this reading of I.R.C. § 197(d)(1)(E), the question of whether an acquisition is “substantial” would arise both in stock and asset acquisitions.



As an initial matter, we note that Recovery Group's construction of I.R.C. § 197(d)(1)(E) makes a portion of the statutory language seem redundant, and thus fails to give effect to the entire statute. See In re Baylis, 313 F.3d 9, 20 (1st Cir. 2002) (“In construing a statute we are obliged to give effect, if possible, to every word Congress used.” (quoting Reiter v. Sonotone Corp., 442 U.S. 330, 339 (1979))). Specifically, if, as Recovery Group alleges, the textual definition of a section 197 intangible includes a covenant not to compete entered into in connection with, (1) the entire interest in a trade or business or (2) a substantial portion of an interest in a trade or business, then the first category may be considered redundant because any acquisition falling under “(1)” would presumably also satisfy the second category. Nevertheless, this weakness, by itself, is not sufficient in the present case to discard Recovery Group's interpretation as unreasonable or to dispel the ambiguity that otherwise arises from the statutory language. See Lamie v. United States Tr., 540 U.S. 526, 536 (2004) (noting that “[a court's] preference for avoiding surplusage constructions is not absolute”). Rather, we find that the relevant statutory language is ambiguous, as both the Commissioner's and Recovery Group's interpretations of the same are reasonable within the context of the statute. 8 Accordingly, we proceed to analyze the statute's legislative history in order to determine congressional intent. See Vidal-Reyes, 562 F.3d at 50–51.



C. Purpose and Legislative History

Prior to the enactment of I.R.C. § 197, as part of the Revenue Reconciliation Act of 1993 (Pub. L. No. 103-66, 107 Stat. 312), taxpayers were not allowed an amortization deduction with respect to goodwill, but were allowed an amortization deduction for intangible assets that had limited useful lives that could be determined with reasonable accuracy. See Newark Morning Ledger Co. v. United States, 507 U.S. 546, 548 [71 AFTR 2d 93-1380] n.1 (1993) (citing 26 C.F.R. § 1.167(a)-3 (1992)). As a result, taxpayers and the IRS engaged in voluminous litigation concerning the identification of amortizable intangible assets and their useful lives. 9



The legislative history of I.R.C. § 197 identified the following three types of disputes arising between taxpayers and the IRS: “(1) whether an amortizable intangible asset exists; (2) in the case of an acquisition of a trade or business, the portion of the purchase price that is allocable to an amortizable intangible asset; and (3) the proper method and period for recovering the cost of an amortizable intangible asset.” H.R. Rep. No. 103-111, at 760 (1993).



The legislative history referred to the “severe backlog of cases in audit and litigation [as] a matter of great concern,” and made explicitly clear that “[t]he purpose of [ I.R.C. § 197] [was] to simplify the law regarding the amortization of intangibles.” Id. at 777. 10 The Committee “believed that much of the controversy that [arose] under [pre-section-197] law with respect to acquired intangible assets could be eliminated by specifying a single method and period for recovering the cost of most acquired intangible assets and by treating acquired goodwill and going concern value as amortizable intangible assets.” Id. at 760. Accordingly, the bill required the cost of most acquired intangible assets, including goodwill and going concern value, to be amortized ratably over a fixed fifteen-year period. Id. 11 In reaching this simplified approach, the Committee recognized that certain acquired intangible assets -- to which I.R.C. § 197 applied -- would have useful lives that would not coincide with the fifteen-year amortization period prescribed by the statute. Id.



In the particular case of a covenant not to compete, Congress made I.R.C. § 197 applicable only where the covenant was entered into in connection with an acquisition of an interest in a trade or business or substantial portion thereof. 12 26 U.S.C. § 197(d)(1)(E). This category was included in I.R.C. § 197 because of the immense volume of litigation regarding the value properly assignable to covenants not to compete. See generally Annette Nellen, BNA Tax Management Portfolio 533-3rd: Amortization of Intangibles § III.B.10.



In the context of asset acquisitions, if I.R.C. § 197(d)(1)(E) had not been included, a buyer of assets constituting a trade or business would have had a significant tax-motivated incentive to allocate as covenant cost -- and amortize over the covenant's useful life -- what was in fact purchase price attributable to section 197 intangibles (such as goodwill and going concern), which are amortizable over a fifteen-year period pursuant to I.R.C. § 197. 13 This incentive would have inevitably given rise to much litigation, since the value of goodwill and going concern is notoriously difficult to determine, see Sanders v. Jackson, 209 F.3d 998, 1003 (7th Cir. 2000) (noting that “due to its transitory nature, goodwill is extremely difficult to quantify and value with any certainty”), thus allowing for much latitude and uncertainty in the allocation of amounts between the covenant and these intangibles. Section 197 attempts to eliminate this incentive and avoid litigation by applying to the covenant not to compete the same fifteen-year amortization period and rules applicable to section 197 intangibles (such as goodwill and going concern) transferred under the sale of the business, thereby making it less relevant for a buyer of a business whether a payment to the seller is classified as covenant consideration or goodwill purchase price. However, because goodwill and going concern are presumably only transferred where at least a substantial portion of assets constituting a trade or business is sold, the opportunity to classify as covenant consideration what is in fact goodwill purchase price is generally not present where a covenant is entered into in connection with the acquisition of less than a substantial portion of assets constituting a trade or business. This explains why, in the context of asset acquisitions, Congress made I.R.C. § 197(d)(1)(E) applicable only where the covenant not to compete was entered into in connection with the acquisition of at least a substantial portion of assets constituting a trade or business.



In the context of stock acquisitions, however, the uncertainty -- and consequently the possibility for much litigation between taxpayers and the IRS -- caused by the inherent difficulty in valuing goodwill and going concern is generally present even where the purchased stock does not constitute a substantial portion of the corporation's total stock. This is due to the fact that goodwill and going concern generally constitute an essential component of the value of each share of corporate stock, as each share of stock reflects a proportionate allotment of the value of the corporation's goodwill and going concern. See, e.g., Home Sav. Bank v. City of Des Moines, 205 U.S. 503, 512 (1907) (noting that goodwill was an essential component of the value of the shares of a bank); Charter Wire, Inc. v. United States, 309 F.2d 878, 879 [10 AFTR 2d 6030] (7th Cir. 1962) (“The stock included the good will value of the enterprise.”); Young v. Seaboard Corp., 360 F. Supp. 490, 497 (D. Utah 1973) (noting that the market value of the shares of a corporation “included the going concern and good will value of the corporation”). Accordingly, especially in the case of non-publicly held corporations, 14 the valuation of shares of corporate stock can become quite complex and uncertain. See Dugan v. Dugan, 457 A.2d 1, 6 (N.J. 1983) (“There are probably few assets whose valuation imposes as difficult, intricate and sophisticated a task as interests in close corporations. They cannot be realistically evaluated by a simplistic approach which is based solely on book value, which fails to deal with the realities of the good will concept ....”). As discussed below, concerns over the voluminous amount of litigation between taxpayers and the IRS, brought in part by this uncertainty in the valuation of corporate stock, directly influenced the solution crafted by Congress in I.R.C. § 197(d)(1)(E).



If I.R.C. § 197(d)(1)(E) had not applied to a covenant not to compete entered into in connection with the acquisition of a corporation's stock, a buyer of such stock would have had a very significant incentive to allocate to the cost of the covenant what was in fact stock purchase price, because the ostensible cost of the covenant would presumably be amortized and deducted over its usually short useful life, while amounts allocated to the stock's purchase price would not be deductible and would simply form part of the buyer's basis in the stock, presumably to be recovered only after the buyer subsequently disposed of such stock and a capital gain/loss was computed on such disposition. See generally, Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts ¶ 46.1 (RIA 2011). This powerful incentive for the stock buyer-covenantee to overstate the cost of the covenant and to understate the price of the stock, combined with the opportunity for massaging the numbers provided by the aforementioned uncertainty inherent in determining the value of the stock, would create fertile ground for substantial litigation between taxpayers and the IRS. Section 197 addresses this situation by decreasing the stock buyer-covenantee's tax-motivated incentive to overstate the cost of the covenant. Specifically, I.R.C. § 197 imposes a fifteen-year amortization period to covenants not to compete entered into in connection with the acquisition of stock in a corporation that is engaged in a trade or business. H.R. Rep. No. 103-111, at 764 (1993). This rule reduces the tax benefit that a stock buyer-covenantee would presumably have otherwise derived from an overstatement of the covenant's cost (i.e., it precludes the taxpayer from amortizing and deducting the covenant over its usually short useful life).



In light of the foregoing, we now analyze the crux of this case: whether Congress intended I.R.C. § 197(d)(1)(E) to apply to any stock acquisition or only those stock acquisitions considered “substantial.”



D. Analysis

We disagree with Recovery Group's contention that, in the context of stock acquisitions, I.R.C. § 197(d)(1)(E) only applies to acquisitions considered at least “substantial.”



As previously mentioned, I.R.C. § 197(d)(1)(E) illustrates Congress' recognition that the difficulty and uncertainty in the valuation of corporate stock, combined with the rule allowing taxpayers to deduct and amortize covenants not to compete over their usually short useful lives, provided too much of an incentive for stock buyers, who entered into a covenant not to compete in connection with the acquisition of such stock, to overstate the cost of the covenant and understate the price of the stock. Congress thus attempted, under I.R.C. § 197, to reduce this incentive and simplify the law regarding amortization of intangibles, by decreasing the tax benefit related to such covenants; more specifically, it required that they all be amortized over a fifteen-year period, instead of their usually short useful lives.



Furthermore, it is important to note that these concerns -- influencing Congress to include stock acquisitions in I.R.C. § 197(d)(1)(E) -- are present both where the taxpayer acquires a substantial and a less than substantial portion of a corporation's stock. That is, the fact that a taxpayer acquires a non-substantial portion of corporate stock -- as opposed to a substantial portion -- does not make the value of such stock any less difficult to quantify, because the goodwill and going concern components are still present even where a non-substantial portion of stock is transferred. Accordingly, a taxpayer who enters into and pays for a covenant not to compete (as the covenantee) -- in connection with the acquisition of a non-substantial portion of corporate stock -- generally has the same opportunity, for purposes of overstating the cost of the covenant and understating the value of the stock, as compared to a taxpayer who instead acquires a substantial portion of stock. Thus, Congress' concerns and purposes behind the enactment of I.R.C. § 197(d)(1)(E) strongly suggest that Congress intended that the section be made applicable to covenants entered into in connection with the acquisition of any shares of corporate stock, regardless of whether they constitute a substantial portion of the corporation's total stock.



The situation is different, however, in the case of asset acquisitions, because a transfer of assets, which do not constitute a substantial portion of a trade or business, presumably does not encompass the transfer of goodwill or going concern, and, consequently, does not pose the same difficult valuation issues as a transfer of assets constituting a substantial portion of a trade or business, the value of which presumably includes goodwill and going concern. This difference explains why Congress chose different tax treatments for (1) covenants executed in connection with the acquisition of at least a substantial portion of assets constituting a trade or business, as opposed to (2) covenants executed in connection with the acquisition of less than a substantial portion of assets constituting a trade or business. Specifically, as both parties assert, in this context, Congress made I.R.C. § 197(d)(1)(E) applicable only to covenants not to compete entered into in connection with the acquisition of at least a substantial portion of assets constituting a trade or business. As previously explained, however, the reason for this difference in tax treatment is not present in the context of stock acquisitions.



Based on the above, we agree with the tax court and the IRS in that I.R.C. § 197(d)(1)(E) should be construed as follows: “the term “ section 197 intangible” means ... any covenant not to compete ... entered into in connection with an acquisition ... of [(1)] an interest in a trade or business or [(2)] [a] substantial portion [of assets constituting a trade or business].” Accordingly, we hold that, pursuant to this section, a “ section 197 intangible” includes any covenant not to compete entered into in connection with the acquisition of any shares -- substantial or not -- of stock in a corporation that is engaged in a trade or business.



We find that this interpretation comports better with the purposes of I.R.C. § 197 and responds to Congress' reiterated intentions of simplifying the law regarding the amortization of intangibles and reducing the voluminous amount of litigation that has characterized this area. Based on the legislative history, we doubt Congress chose to spur a new wave of litigation in this area by unnecessarily requiring taxpayers and the IRS to litigate what may constitute a “substantial portion” of corporate stock.



Having found that I.R.C. § 197(d)(1)(E) applies to covenants not to compete entered into in connection with the acquisition of any shares of corporate stock, we conclude in the instant case that the Covenant, which was entered into by Recovery Group in connection with the redemption (i.e., indirect acquisition) of 23% of its stock, was a “ section 197 intangible.” Moreover, because Recovery Group does not allege that any exception applies, we conclude that the Covenant was an “amortizable section 197 intangible” subject to the fifteen-year amortization period prescribed under I.R.C. § 197(a). We therefore affirm the tax court's decision as to the tax deficiencies in question.



IV. Conclusion

For the reasons stated, we conclude that the Covenant was an “amortizable section 197 intangible” subject to the fifteen-year amortization period set forth under I.R.C. § 197(a). Accordingly, we affirm the tax court's determination regarding the tax deficiencies disputed in this appeal.



Affirmed.

*





The Hon. David H. Souter, Associate Justice (Ret.) of the Supreme Court of the United States, sitting by designation.

1



The tax court, however, ruled against respondent Commissioner of Internal Revenue regarding the application of certain accuracy-related penalties. The Commissioner did not appeal this ruling.

2



Subchapter S of the Internal Revenue Code, I.R.C. §§ 1361 et seq., permits small business corporations meeting the criteria set forth in the statute to elect to be taxed as “pass through” entities in a manner similar to partnerships, rather than corporations. 26 U.S.C. § 1362(a).

3



If an eligible corporation makes an election under I.R.C. § 1362(a) to be treated as an “S corporation” for income tax purposes, as Recovery Group did for the tax years here in question, the corporation's income is generally not taxed at the corporate level, but rather is passed through (and taxed) to its shareholders. As an exception to this rule, however, an S corporation itself is liable for tax under I.R.C. § 1374(a) on its “net recognized built-in gain,” if any. In the instant case, the IRS's disallowance of the deductions claimed by Recovery Group gave rise to such a gain. Thus, the IRS also issued a notice of deficiency to Recovery Group.

4



We have jurisdiction to hear this appeal, pursuant to I.R.C. § 7482.

5



All appellants, including Recovery Group, join in raising the same arguments on appeal.

6



Recovery Group supports its interpretation -- that “interest in a trade or business” is the operative phrase working as the antecedent of the word “thereof” -- by citing a sentence in the legislative history that states as follows: “For [purposes of I.R.C. § 197], an interest in a trade or business includes not only the assets of a trade or business, but also stock in a corporation that is engaged in a trade or business or an interest in a partnership that is engaged in a trade or business.” H.R. Rep. No. 103-111, at 764 (1993). However, as discussed in the following section, a comprehensive analysis of the congressional concerns and purposes manifested in the legislative history of I.R.C. § 197 makes clear that Recovery Group's reading of the statute is incorrect.

7



A “covenantee” is the “person to whom a promise by covenant is made; one entitled to the benefit of a covenant.” Black's Law Dictionary 421 (9th ed. 2009). In the present case, Recovery Group was the covenantee under the Covenant.

8



As counsel for the respondent-appellee understatedly conceded during oral arguments for this appeal, the statutory language here in question “is not a model of clarity.”

9



In 1993, the IRS estimated that $14.4 billion in proposed adjustments relating to intangible amortization cases were in various levels of the audit and litigation process. Sheppard, IRS Official Discusses Settlement of Intangible Cases, Tax Analysts, Tax Notes Today, 93 TNT 204-1, October 4, 1993.

10



In the American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418, which extended the rules of I.R.C. § 197 to acquisitions of sports franchises, Congress had an opportunity to reiterate the purposes served by I.R.C. § 197. Notably, the legislative history of this act referred to disputes over the amortizable life of intangible assets as “an unproductive use of economic resources.” H.R. Rep. No. 108-548, pt. 1 (2004).

11



Although this portion of the legislative history provided for a fourteen-year amortization period, the bill was later modified to reflect a fifteen-year amortization period. See H.R. Rep. No. 103-213 (1993).

12



Other covenants not to compete are not governed by I.R.C. § 197 and may be amortized over their useful lives, provided they satisfy the requirements of I.R.C. § 167 and its regulations. See generally David L. Cameron & Thomas Kittle-kamp, Federal Income Taxation of Intellectual Properties & Intangible Assets ¶ 8.03[2][b], at 8 (RIA 2011).

13



This incentive would have been balanced only by the stock seller-covenantor's preference for allocating purchase price to the assets sold (instead of the covenant), because he presumably would receive capital gain treatment (generally taxed at preferential rates) for his gain on the sale of the assets and would receive ordinary gain treatment for the consideration received under the covenant. See Muskat v. United States, 554 F.3d 183, 188 [103 AFTR 2d 2009-666] (1st Cir. 2009).

14



The valuation of shares in publicly traded corporations is not as complex as in non-publicly traded corporations, because, in the case of the former, one can determine their value based on the market price of the stock. See Dugan v. Dugan, 457 A.2d 1, 5 (N.J. 1983) (citing G. Catlett & N. Olson, Accounting for Goodwill 14 (1968)).

Innocent Spouse Case

William G. Pearce v. Commissioner, TC Summary Opinion 2011-98




WILLIAM GERARD PEARCE, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent .

Case Information: Code Sec(s):

Docket: Docket No. 6053-09S.

Date Issued: 07/26/2011

Judge: Opinion by HAINES

Reference(s): Code Sec. 6015





Syllabus

Official Tax Court Syllabus

PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b),THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.



Counsel

William Gerard Pearce, pro se.

John R. Bampfield, for respondent.



Opinion by HAINES



This case was heard pursuant to the provisions of section 7463 of the Internal Revenue Code in effect when the petition was filed. 1 Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.



This proceeding was commenced under section 6015 for review of respondent's determination that petitioner is not entitled to relief from joint and several liability with respect to an understatement of Federal income tax reported on a joint Federal income tax return filed for 2004.



Background

The parties' stipulation of facts and supplemental stipulation of facts and the attached exhibits are incorporated herein by this reference. Petitioner resided in Tennessee when he filed his petition.



On August 23, 2006, respondent received petitioner and his former spouse's 2004 joint income tax return (the joint return). On Schedule A, Itemized Deductions, petitioner and his former spouse claimed a deduction of $27,200 for State and local income taxes paid. As a result, petitioner and his former spouse claimed a refund of $4,379. Petitioner's reported wages in 2004 were $27,200, the exact amount also reported as State and local income taxes paid. Petitioner's former spouse prepared the joint return. Petitioner did not review the joint return, and neither petitioner nor his former spouse signed it.



On September 15, 2006, respondent sent petitioner and his former spouse a letter informing them that the joint return was not signed and a declaration requiring their signatures was needed to remedy their initial failure to sign. The declaration stated:



Under penalties of perjury, I declare that I have examined the return (including any accompanying schedules and statements) referred to in this letter and, to the best of my knowledge and belief, it is true, correct, and complete. Petitioner and his former spouse signed the declaration, but petitioner again did not examine the joint return before signing. Petitioner was aware at the time he signed the declaration that Tennessee did not have a State income tax.



Petitioner unsuccessfully attempted to contact the Internal Revenue Service (IRS) to ask when a refund check for 2004 would arrive. On October 27, 2006, respondent issued a refund check for $4,379 to petitioner and his former spouse. Despite petitioner's former spouse's request that the refund check be sent to her mother's home, it was sent to the home petitioner and his former spouse shared in 2006. Petitioner did not receive the refund check. However, on November 10, 2006, petitioner's former spouse deposited the refund check in their joint bank account. Petitioner's former spouse used the proceeds of the refund check for her benefit in small increments throughout November and December 2006. Petitioner believed the joint bank account was an “empty account” during that time because petitioner and his former spouse were working through mediation in their divorce proceedings. On July 16, 2008, the Circuit Court of Tennessee for the 30th Judicial District of Memphis issued a final decree of divorce between petitioner and his former spouse.



On December 17, 2007, respondent issued Form 4549, Income Tax Examination Changes, disallowing the $27,200 State and local income tax deduction. Respondent further issued a notice of deficiency on February 11, 2008, determining a deficiency in income tax against petitioner and his former spouse of $2,670. On February 27, 2008, petitioner signed Form 8857, Request for Innocent Spouse Relief, requesting relief from the deficiency.



On December 11, 2008, respondent issued a final Appeals determination letter denying petitioner's request for relief from joint and several liability. Petitioner filed a timely petition with this Court challenging respondent's determination.



Discussion

Generally, when a husband and wife file a joint Federal income tax return, they are jointly and severally liable for the full amount of the tax. Sec. 6013(d)(3); Butler v. Commissioner, 114 T.C. 276, 282 (2000). However, a spouse may qualify for relief from joint and several liability under section 6015(b), (c), or (f) if various requirements are met. Petitioner contends he qualifies for full relief from joint liability under section 6015(b) and (c), and if not, that he is entitled to equitable relief under section 6015(f). A. Relief From Joint and Several Liability Under Section 6015(b) Section 6015(b)(1) authorizes the Commissioner to grant relief from joint and several liability for tax (including interest, penalties, and other amounts) if the taxpayer requesting relief satisfies each of the following five requirements of subparagraphs (A) through (E):



(A) a joint return has been made for a taxable year;



(B) on such return there is an understatement of tax attributable to erroneous items of one individual filing the joint return;



(C) the other individual filing the joint return establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement;



(D) taking into account all the facts and circumstances, it is inequitable to hold the other individual liable for the deficiency in tax for such taxable year attributable to such understatement; and



(E) the other individual elects (in such form as the Secretary may prescribe) the benefits of this subsection not later than the date which is 2 years after the date the Secretary has begun collection activities with respect to the individual making the election *** The requesting spouse bears the burden of proving that he satisfies each of these five requirements. See Rule 142(a); Jonson v. Commissioner, 118 T.C. 106, 113 (2002), affd. 353 F.3d 1181 [93 AFTR 2d 2004-323] (10th Cir. 2003). If the requesting spouse fails to meet any one of the five requirements, he fails to qualify for relief. Alt v. Commissioner, 119 T.C. 306, 313 (2002), affd. 101 Fed. Appx. 34 [93 AFTR 2d 2004-2561] (6th Cir. 2004). Respondent does not dispute that petitioner satisfies two requirements of section 6015(b)(1); namely, those regarding the filing of a joint return and making a timely election under section 6015(b)(1)(A) and (E), respectively. Thus, we must consider whether petitioner satisfies the remaining three requirements of section 6015(b)(1).



The first requirement, in section 6015(b)(1)(B), is that an understatement of tax be attributable to erroneous items of the other person filing the joint return. The joint return claimed a deduction for $27,200 of State and local income tax that was not due or paid. This deduction was for the exact amount petitioner reported as wages in 2004. Accordingly, the deduction is attributable to him. Further, petitioner signed the declaration stating under penalties of perjury that he had examined the joint return and to the best of his knowledge and belief it was true, correct, and complete. Because each of the five requirements of the statute must be satisfied for relief, petitioner is not eligible for relief from joint and several liability under section 6015(b)(1) and we need not consider the other requirements. B. Relief From Joint and Several Liability Under Section 6015(c) Petitioner further claims eligibility for relief under section 6015(c). Under section 6015(c), if the requesting spouse is no longer married to, or is legally separated from, the spouse with whom he filed the joint return, the requesting spouse may elect to limit his liability to the deficiency properly allocable to him. As discussed above, the $27,200 State and local income tax deduction is allocable to petitioner. Accordingly, petitioner is not eligible for relief from joint and several liability under section 6015(c). C. Relief From Joint and Several Liability Under Section 6015(f) Relief may be granted from joint and several liability under section 6015(f) if "(1) taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either); and (2) relief is not available to such individual under subsection (b) or (c)”. This Court has jurisdiction to determine whether a taxpayer is entitled to equitable relief under section 6015(f). Sec. 6015(e)(1)(A); see also Farmer v. Commissioner, T.C. Memo. 2007-74 [TC Memo 2007-74]. Our determination is made in a trial de novo. Porter v. Commissioner, 130 T.C. 115, 117 (2008).



The Commissioner prescribed procedures in Rev. Proc. 2003- 61, 2003-2 C.B. 296, that IRS personnel must use to determine whether a requesting spouse qualifies for relief under section 6015(f). According to Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297-298, a requesting spouse must satisfy seven conditions (threshold conditions) before the Commissioner will consider a request for relief under section 6015(f). The threshold conditions of this section are stated in the conjunctive, and each condition must be satisfied for the spouse The to be eligible for relief under section 6015(f). Id. parties do not dispute that the first six threshold conditions have been satisfied. 2



The final threshold condition, as set forth in Rev. Proc. 2003-61, sec. 4.01(7), 2003-2 C.B. at 297-298, is that the income tax liability from which the requesting spouse seeks relief must be attributable to an item of the nonrequesting spouse, unless one of four enumerated exceptions applies. 3 As discussed above, the deduction of $27,200 for State and local income taxes is attributable to petitioner. Petitioner does not qualify for any of the enumerated exceptions. Accordingly,



(5) the nonrequesting spouse not transfer disqualifying assets to the requesting spouse; and (6) the requesting spouse not file or fail to file the return with fraudulent intent. Rev. Proc. 2003- 61, sec. 4.01, 2003-2 C.B. 296, 297. petitioner has failed to meet the threshold conditions for consideration for relief from joint and several liability pursuant to section 6015(f).



In reaching these holdings, the Court has considered all arguments made and, to the extent not mentioned, concludes that they are moot, irrelevant, or without merit.



To reflect the foregoing, Decision will be entered for respondent.

1





Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and Rule references are to the Tax Court Rules of Practice and Procedure. Amounts are rounded to the nearest dollar.

2



The first six threshold conditions require that: (1) The requesting spouse file a joint return for the year at issue; (2) relief not be available under sec. 6015(b) or (c); (3) the requesting spouse apply for relief no later than 2 years after the date of the IRS' first collection activity after July 22, 1998, with respect to the requesting spouse; (4) no assets be transferred between the spouses as part of a fraudulent scheme;

3



The four exceptions are: (1) Attribution due solely to the operation of community property law; (2) nominal ownership; (3) misappropriation of funds; and (4) abuse not amounting to duress. Id. sec. 4.01(7), 2003-2 C.B. at 297-298

Tuesday, July 26, 2011

ESOP Deal

Jonathan S. Landow, et ux. v. Commissioner, TC Memo 2011-177 , Code Sec(s) 1033; 1042.




JONATHAN S. AND TRACY A. LANDOW, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .

Case Information: Code Sec(s): 1033; 1042

Docket: Docket Nos. 15506-09, 20206-09.

Date Issued: 07/25/2011

Judge: Opinion by CHIECHI





HEADNOTE

XX.



Reference(s): Code Sec. 1033 ; Code Sec. 1042



Syllabus

Official Tax Court Syllabus

Counsel

David D. Aughtry and Hale E. Sheppard, for petitioners.

Jennifer K. Martwick, for respondent.



Opinion by CHIECHI



MEMORANDUM FINDINGS OF FACT AND OPINION

Respondent determined the following defi- ciencies in, additions under section 6651(a)(1) 1 to, and accuracy-related penalties under section 6662(a) on petitioners' Federal income tax (tax):



Addition to Accuracy-Related

Tax Under Penalty

Year Deficiency Sec. 6651(a)(1) Under Sec. 6662(a)

2003 $4,318,104.00 -- $863,620.80

2004 749.00 -- --

2005 93,009.45 $3,962.45 18,601.89

2006 89,040.00 -- 17,808.00

2007 211,976.00 16,300.70 42,395.20

The issues remaining for decision are: 2

(1) Did a certain transaction in 2003 between petitioner

Jonathan S. Landow and Derivium Capital, LLC, constitute a loan

or a sale of securities? We hold that that transaction was a

sale of securities by petitioner Jonathan S. Landow.

(2) In the light of our holding with respect to issue 1, are

petitioners required to recognize under section 1042(e) any gain

realized on the sale of securities by petitioner Jonathan S.

Landow described in that issue? We hold that they are.

(3) In the light of our holdings with respect to issues 1

and 2, are petitioners entitled to defer under section 1033 any

gain realized on the sale of securities by petitioner Jonathan S.

Landow described in issue 1? We hold that they are not.

FINDINGS OF FACT

All of the facts in these cases, which the parties submitted under Rule 122, have been stipulated by the parties and are so found. 3



Petitioners resided in New York at the time they filed the petitions in these cases.



In 1994, petitioner Jonathan S. Landow (Mr. Landow) orga- nized New York Medical, Inc. (NY Medical), under the laws of Delaware. Mr. Landow has developed NY Medical into a successful provider of medical services.



Around early 2000, Mr. Landow was considering diversifying his personal assets and simultaneously rewarding employees of NY Medical through the establishment of an employee stock ownership plan (ESOP). In May 2000, Mr. Landow contacted Irwin Selinger of Corporate Solutions Group, LLC (CSG), an affiliate of American Express Corporate Services, to assist him in establishing an ESOP for NY Medical. Around July 25, 2000, NY Medical and CSG exe- cuted an agreement (ESOP advisory agreement) pursuant to which CSG was to provide certain services to NY Medical, including establishing and implementing an ESOP, financing that ESOP's purchase of certain stock of NY Medical from Mr. Landow, and aiding Mr. Landow to defer under section 1042 any gain that he realized on his sale of that stock. On a date not established by the record, NY Medical established the New York Medical, Inc., Employee Stock Ownership Trust (NY Medical ESOP) that was to be effective on January 1, 2000.



At a time not established by the record between July and November 2000, NY Medical and Mr. Landow decided to engage in a so-called seller-financed ESOP transaction with leveraged quali- fied replacement property (QRP), as defined in section 1042. After that decision and pursuant to the ESOP advisory agreement, CSG solicited on behalf of NY Medical certain information from various financial institutions regarding the terms on which those financial institutions would lend NY Medical the funds necessary to purchase certain stock of that company from Mr. Landow. At a time not established by the record, NY Medical decided to obtain financing for that purchase from Citibank, N.A. (Citibank).



On November 30, 2000, NY Medical, Mr. Landow, and Citibank executed a letter agreement (Citibank letter agreement), and NY Medical executed a demand note (Citibank demand note) payable to Citibank. Pursuant to that letter agreement, Citibank agreed to lend NY Medical $15 million, which was the amount payable under that demand note. The Citibank letter agreement provided in pertinent part:



As a condition to our [Citibank] making funds available to NY Med[ical], NY Med[ical] shall use the proceeds to immediately make a $15,000,000 loan to the ESOT [the NY Medical ESOP] (the “ESOT Loan”). The ESOT shall use the proceeds of the ESOT Loan to purchase the stock of NY Med[ical] from Landow. Landow shall use the proceeds of the sale of the stock to make a loan to NY Med[ical] (the “Sub Loan”). NY Med[ical] shall use the proceeds of the Sub Loan to repay our advance [of $15 million] under the Note. The proceeds shall be advanced to each party under the Blocked Account Agree- ments [4] referred to above. This letter shall serve as an instruction letter from each party to us to advance the funds from each of the Blocked Accounts to fund the ESOT Loan, the Stock purchase and the Sub Loan. NY Med[ical] hereby instructs us to debit the Blocked Account maintained on behalf of NY Med[ical] and apply the amounts therein to repay the advance under the Note. 2. The Customer [Mr. Landow] has opened the Pledged Account and will cause to be deposited therein and will maintain therein cash from time to time. The Customer hereby pledges to the Bank, and grants to the Bank a lien, mortgage and security interest in, all cash or other assets deposited from time to time in the Pledged Account. At any time amounts are due and payable to the Bank with respect to the obligations of the Customer to the Bank, including the obligations under Customer's guaranty of the $15,000,000 Demand Note of the New York Medical, Inc. to the Bank dated as of the date hereof (the “Obligations”), whether prior to or during the occurrence of a default or Event of Default and whether or not Bank has made any demand or the Obligations have matured, the Bank may, at its discretion, may [sic] appropriate and apply the funds in the Pledged Account to the payment of the Obliga- tions. The Bank shall have sole dominion and control over the Pledged Account. *** Pursuant to the Citibank letter agreement, on November 30, 2000, (1) Citibank lent NY Medical $15 million, (2) NY Medical used the proceeds of that loan in order to lend the NY Medical ESOP $15 million, (3) the NY Medical ESOP used those proceeds to purchase from Mr. Landow 450,000 shares of NY Medical's stock for $15 million, (4) Mr. Landow used those proceeds to lend NY Medical $15 million, and (5) NY Medical used the proceeds of that loan to pay Citibank $15 million in full satisfaction of its obligation under the Citibank demand note. After the above- described transactions were effected, Mr. Landow (1) did not retain any cash from his sale of certain stock of NY Medical to the NY Medical ESOP and (2) held a note of NY Medical in the amount of $15 million evidencing his loan to that company.



After the sale of certain of Mr. Landow's stock of NY Medical to the NY Medical ESOP, Mr. Landow sought to purchase certain QRP in order to defer under section 1042 recognition of any gain that he had realized on the sale of that stock. Be- cause, as discussed above, Mr. Landow did not retain any cash from his sale of certain stock of NY Medical to the NY Medical ESOP, he was unable to buy that QRP without borrowing the funds to do so. Citibank offered to extend Mr. Landow a line of credit not exceeding $12 million in order to facilitate Mr. Landow's purchase of certain QRP.



On November 1, 2000, NY Medical, Mr. Landow, and Citibank executed a document titled “REVOLVING CREDIT NOTE (Multiple Advances)” (revolving credit note). Pursuant to that note, Citibank made available to Mr. Landow a line of credit not exceeding $12 million (Citibank line of credit), which was a recourse loan and on which Mr. Landow was allowed to draw during the period November 1, 2000, to October 31, 2001. Pursuant to the revolving credit note, in the event of Mr. Landow's default under that note Citibank retained “all of the rights and remedies provided to it (i) under the Loan Documents, (ii) under applica- ble laws, and (iii) as a secured party by the Uniform Commercial Code in effect in New York State at that time.” The revolving credit note also required Mr. Landow to maintain a minimum net worth of not less than $30 million.



The revolving credit note permitted Mr. Landow to choose at the time he drew against the line of credit thereunder one of two alternative methods of calculating interest: (1) An interest rate that was one percentage point greater than the LIBOR rate as defined in that note 5 or (2) an interest rate that was one and one-half percentage points less than the base rate as defined in that note. 6



On November 1, 2000, Mr. Landow executed a document titled “General Hypothecation Agreement” (hypothecation agreement). Pursuant to that agreement, Mr. Landow pledged as security for the Citibank line of credit certain rights to the QRP that he intended to purchase with the loan proceeds that he borrowed against that line of credit. In this regard, the hypothecation agreement provided in pertinent part:



I. That, as security for all indebtedness and other liabilities of the undersigned [Mr. Landow] *** pursuant to the Revolving Credit Note dated the date hereof *** (the “Note”), together with all obliga- tions of the undersigned hereunder or under any other document or agreement executed and delivered by the undersigned in connection with the Note and this Agree- ment (the “Obligations”), the Lender [Citibank] shall have and is hereby given a lien upon and a security interest in any and all property in which the under- signed at any time has rights and which at any time has been delivered, transferred, pledged, mortgaged or assigned to, or deposited in or credited to an account with, the Lender, or any third party(ies) acting in its behalf or designated by it, including, but not limited to, Pledged Collateral (as herein defined) [7] contained



The undersigned [Mr. Landow] will maintain at all times in the Pledged Account assets acceptable to the Lender [Citibank], consisting of Eligible Floating Rate Notes, Eligible CP [commercial paper] and other marketable securities, cash and cash equivalents. Such Eligible



(continued...) in the Pledged Account (as herein defined), [8] or other- wise at any time is in the possession or under the control or recorded on the books of or has been trans- ferred to the Lender, or any third party(ies) acting in its behalf or designated by it, whether expressly as collateral or for safekeeping or for any other or different purpose, *** and in any and all property in which the undersigned at any time has rights and in which at any time a security interest has been trans- ferred to the Lender. Stock dividends and the distri- butions on account of any stock or other securities subject to the terms and provisions hereof, including FRN Interest (as herein defined) [9] shall be deemed an increment thereto and if not received directly by the Lender shall be delivered immediately to it by the undersigned in form for transfer. ***



III. That, in addition to its rights and inter- ests as herein set forth, the Lender may, at its option at any time(s) following the occurrence of an Event of Default and with notice to the undersigned, appropriate and apply to the payment or reduction, either in whole or in part, of the amount owing on any one or more of the Obligations, whether or not then due, any and all moneys now or hereafter with the Lender, any affiliate of the Lender or any third party acting in its behalf or designated by it, on deposit or otherwise to the credit of or belonging to the undersigned, it being understood and agreed that the Lender shall not be obligated to assert or enforce any rights, liens or security interests hereunder or to take any action in reference thereto, and that the Lender may in its discretion at any time(s) relinquish its rights as to particular property or in any instance without thereby affecting or invalidating its rights hereunder as to any other property hereinbefore referred to or in any similar or other circumstance. ***



VII. That the Lender may, at its option and without obligation to do so, transfer to or register in the name of its nominee(s), including any “clearing corporation” or “custodian bank” as defined in the Uniform Commercial Code in effect in New York State and any nominee(s) thereof, all or any part of the afore- mentioned property and it may do so before or after the maturity of any of the Obligations and with or without notice to the undersigned.



VIII. That the Lender may assign or otherwise transfer all or any of the Obligations, and may deliver all or any of the property to the transferee(s), who shall thereupon become vested with all the powers and rights in respect thereof given to the Lender herein or otherwise and the Lender shall thereafter be forever relieved and fully discharged from any liability or responsibility with respect thereto, all without preju- dice to the retention by the Lender of all rights and powers not so transferred. Furthermore that the Lender may, in connection with any such assignment, transfer or delivery, disclose to the assignee or transferee or proposed assignee or proposed transferee any informa- tion relating to the undersigned furnished to the Lender by or on behalf of the undersigned, provided, that, prior to any such disclosure, the assignee or transferee or proposed assignee or proposed transferee shall agree to preserve the confidentiality of any confidential information related to the undersigned received by it from the Lender. ***



XV. That the following additional terms and conditions are as set forth below: ***



(g) Minimum Collateral Value. The undersigned shall comply with the following minimum collateral value requirements. ***



(iii) If at any time the undersigned has not satisfied the obligation to deposit additional Pledged Collateral or repay the Obligations as required in the event of an FRN Facility Margin Call, such occurrence shall be deemed an Event of Default, and the Lender shall have the immediate right, without notice or other action *** to exercise any or all of the remedies available to the Lender under this Agreement or other- wise, including the right to immediately sell the Pledged Collateral.



On November 1, 2000, NY Medical executed a document titled “GENERAL SECURITY AGREEMENT”. Pursuant to that agreement, NY Medical granted to Citibank a security interest in all of NY Medical's assets as collateral for its obligations under the revolving credit note.



Between November 2, 2000, and November 29, 2001, Mr. Landow purchased as QRP the following floating rate notes (FRNs) 10 at a total cost of $15 million:



Date of Principal Date of Purchase Amount Issuer Maturity 11/2/2000 $3,094,000 Proctor & Gamble 8/15/2050 11/2/2000 3,000,000 E.I. Dupont 12/27/2039 6/20/2001 3,000,000 Merck & Co. 12/27/2040 9/17/2001 3,000,000 United Parcel Service 6/21/2051 11/13/2001 1,500,000 Minnesota Mining 12/21/2041 11/29/2001 1,156,000 Minnesota Mining 12/21/2041 11/29/2001 250,000 E.I. Dupont 10/9/2041 (We shall refer collectively to the FRNs that Mr. Landow pur- chased between November 2, 2000, and November 29, 2001, as the FRN portfolio.) During December 2001, Mr. Landow received proposals from certain financial institutions, including Citibank and J.P. Morgan Chase, in which those institutions proposed to make available to Mr. Landow a line of credit not exceeding $13.5 million.



On February 11, 2002, Mr. Landow and petitioner Tracy A. Landow (Ms. Landow) executed the following documents that amended the revolving credit note and the hypothecation agreement: (1) A document titled “Amended and Restated REVOLVING CREDIT NOTE (Multiple Advances)” (amended revolving credit note) and (2) a document titled “Amended and Restated General Hypothecation Agreement” (amended hypothecation agreement).



The amended revolving credit note amended the revolving credit note by (1) increasing to $13.5 million the line of credit that Citibank was to make available to Mr. Landow (Citibank increased line of credit), (2) substituting Ms. Landow for NY Medical as a borrower under that note, and (3) reducing to $15 million the minimum net worth that petitioners were to maintain. In all other material respects, the amended revolving credit note was identical to the revolving credit note.



The amended hypothecation agreement did not make any mate- rial amendments to the portions of the hypothecation agreement quoted above. The only amendments that the amended hypothecation agreement made to the terms of that hypothecation agreement were to (1) increase to $13.5 million the line of credit that Citibank was to make available to Mr. Landow, (2) add reference to Ms. Landow as a borrower on the amended revolving credit note, and (3) delete from the definition of the term “Pledged Collateral” the references in the hypothecation agreement to “Eligible CP”. (We shall refer to the transactions by which Citibank extended the Citibank line of credit and the Citibank increased line of credit, Mr. Landow drew upon those lines of credit to purchase the FRNs, and he pledged as collateral those FRNs as the Citibank transaction.) As of December 31, 2002, the end of petitioners' taxable year 2002, Mr. Landow met the requirements of section 1042 with respect to his sale of certain stock of NY Medical to the NY Medical ESOP. As a result, Mr. Landow was not required to recognize any of the gain that he realized on that sale.



In proposing a line of credit to Mr. Landow, Citibank informed him that the use of FRNs as QRP would achieve a result known as “zero-cost borrowing”, 11 which was Mr. Landow's objec- tive. However, Citibank failed to provide such zero-cost borrow- ing during 2001 and 2002. As a result, Mr. Landow did not meet his objective of zero-cost borrowing and therefore Mr. Landow retained CSG on June 12, 2002, in order to assist him in negoti- ating with a different lender a new loan of $13.5 million that would replace the Citibank increased line of credit.



From June to August 2002, Mr. Landow negotiated with Morgan Stanley Dean Witter & Co. (Morgan Stanley) regarding that com- pany's refinancing the Citibank increased line of credit. On June 17, 2002, Morgan Stanley sent Mr. Landow a letter in which it proposed providing him with a so-called margin loan of $13.5 million at an interest rate equal to the three-month London interbank offered rate plus 35 basis points. 12 In that letter, Morgan Stanley also indicated that, as security for such a loan, it would require Mr. Landow to deposit with Morgan Stanley not only the FRN portfolio but also $5 million of additional assets. 12 A basis point is equal to 0.01 percent.



On July 10, 2002, Morgan Stanley sent Mr. Landow a second letter in which it changed to its so-called cost-of-funds index rate the interest rate that it would set for any margin loan that it agreed to make to him. 13 In that letter, Morgan Stanley also proposed charging Mr. Landow a management fee of 1.25 percent of the $5 million of assets that that company required as additional security for any $13.5 million margin loan that it made to him.



Around August 2002, CSG informed Mr. Landow about Derivium Capital, LLC (Derivium). Sometime later in 2002, Mr. Landow conducted certain research into Derivium and its founder, Charles Cathcart (Mr. Cathcart). As part of that research, Mr. Landow read numerous articles and other materials about Derivium and Mr. Cathcart as well as certain marketing materials that Derivium had prepared. In addition, Mr. Landow engaged certain independ- ent financial advisors and legal advisors to assist him in evaluating Derivium and any transactions that it might propose to him.



On August 19, 2002, Derivium prepared a separate document titled “ESOP QRP LOAN—INDICATIVE FRN LOAN TERM SHEET” (proposed loan term sheet) 14 with respect to each of Mr. Landow's FRNs. 15 In each of those documents, Derivium proposed to lend Mr. Landow on a nonrecourse basis 90 percent of the face value of the FRN to which the document pertained at a net interest rate calculated by reference to either the one-month London interbank offered rate or the three-month London interbank offered rate and taking into account interest paid on that FRN. Each of the proposed loan term sheets proposed prohibiting (1) Derivium from calling before maturity the loan to which each such sheet pertained unless Mr. Landow was in default on that loan and (2) Mr. Landow from prepaying before maturity the principal of that loan. The respective proposed loan term sheets set forth the terms of the proposed loans as ranging from 27 to 38 years and required annual net interest payments on those loans (i.e., the respective amounts, if any, that Mr. Landow was to pay after taking into account the respective interest payments under the FRNs) that ranged from $1,207.50 to $15,098.72 depending on the respective face values of the FRNs.



On August 29, 2002, Derivium sent Mr. Landow certain infor- mation with respect to the loans that Derivium proposed to make to him (proposed Derivium loans), including a document titled “MASTER AGREEMENT TO PROVIDE FINANCING AND CUSTODIAL SERVICES” and a separate schedule A with respect to each of his FRNs. Each of those schedules contained information that was materially identical to the information contained in the respective proposed loan term sheets that Derivium had prepared with respect to those FRNs.



On September 20, 2002, Derivium sent Mr. Landow certain sample documents, including sample documents titled (1) “MASTER



AGREEMENT TO PROVIDE FINANCING AND CUSTODIAL SERVICES",

(2) “SCHEDULE A-1 PROPERTY DESCRIPTION AND LOAN TERMS”, and (3) “SCHEDULE D DISCLOSURE ACKNOWLEDGEMENT AND BROKER/BANK INDEMNIFICATION".



From September 23 to 26, 2002, Derivium sent Mr. Landow revised versions of certain of the documents that it had sent to him on August 29, 2002. Those revised versions of those docu- ments did not materially differ from the documents that Derivium had sent to Mr. Landow on August 29, 2002.



At Mr. Landow's request, around January 16, 2003, Derivium sent him revised versions of respective schedules A, numbered A-1 through A-6, with respect to the six loans for which his FRNs were to serve as collateral (revised proposed schedules A). 16 Each of those schedules provided that Mr. Landow was permitted to pay before maturity the principal of the loan to which each such schedule pertained but only under limited conditions.



On a date not disclosed by the record between January 16 and March 7, 2003, Mr. Landow requested from Derivium additional revisions to certain of the documents that Derivium had sent to him with respect to the proposed Derivium loans. 17 On March 7, 2003, Mr. Cathcart sent to Mr. Landow a letter responding to that request. That letter stated in pertinent part:



To address the concern about what would happen in a bankruptcy setting, we have the following suggested language that we have added in another case: “DC and the Lender acknowledge that the Collateral is the asset of the Client and is not subject to the claims of any creditors of DC or the Lender.” Please let us know if that would accomplish the intended need. For the pre-payment provision, the Lender can agree to pre-payment at five-year windows, with one-year advance notice and a penalty of 6.0%. Please let us know if that accomplishes the need in that area.



Around April 9, 2003, Mr. Landow executed the following documents with respect to the proposed Derivium loans: (1) A document titled “MASTER AGREEMENT TO PROVIDE FINANCING AND CUSTODIAL SERVICES” (Derivium master agreement), (2) respective schedules A, numbered A-1 through A-6, with respect to the six loans for which his FRNs were to serve as collateral titled “FRN PROPERTY DESCRIPTION AND LOAN TERMS” (Derivium schedules A), 18 and (3) a document titled “SCHEDULE D FRN DISCLOSURE ACKNOWLEDGE- MENT AND BROKER/BANK INDEMNIFICATION” (Derivium schedule D). 19 (We shall refer collectively to the Derivium master agreement, the Derivium schedules A, and the Derivium schedule D as the Derivium transaction documents.) The Derivium master agreement and the Derivium schedules A were also executed by Derivium and Bancroft Ventures Ltd. (Bancroft), a company which was located in the Isle of Man and which was the entity that served as the lender under the Derivium transaction.



The Derivium master agreement provided in pertinent part:



This Agreement is made for the purpose of engaging DC [Derivium] to provide or arrange financing(s) and to provide custodial services to the Client [Mr. Landow], with respect to certain properties and assets (”Proper- ties”) to be pledged as security, the details of which financing and Properties are to be set out in loan term sheets and attached hereto as Schedule(s) A (”Sched- ule(s) A”). *** 3. FUNDING OF LOAN The contemplated Loan(s) will be funded according to the terms identified in one or more term sheets, which will be labeled as Schedule A, indi- vidually numbered and signed by both parties, and, on signing, considered a part of and merged into this Master Agreement. The Client understands that by transferring securities as collateral to DC and under the terms of the Agreement, the Cli- ent gives DC and/or its assigns, the right, with- out requirement of notice to or consent of the Client, to assign, transfer, pledge, repledge, hypothecate, rehypothecate, lend, encumber, short sell, and/or sell outright some or all of the securities during the period covered by the loan. The Client understands that DC and/or its assigns have the right to receive and retain the benefits from any such transactions and that the Client is not entitled to these benefits during the term of a loan. The Client agrees to assist the relevant entities in completing all requisite documents that may be necessary to accomplish such trans- fers. 4. RETURN OF CLIENT COLLATERAL DC agrees to return, at the end of the loan term, the same collateral (or cash equivalent if the Client's collateral securities have reached their maturity date or the collateral has been called by the issuer), as set out and defined in Schedule(s) A attached hereto, upon the Client satisfying in full all outstanding loan balances, including all outstanding net interest payments due, if any, and/or all late payment penalties due, if any. 5. REGISTRATION AND SUBCUSTODIANS DC may place the Client Assets i) with any domes- tic or foreign depository or clearing corporation or system that provides handling, clearing or safekeeping services; ii) with the issuer of a security in non-certificate form; iii) with any domestic or foreign bank or depository as subcustodian; and DC will pay the fees and ex- penses of the foregoing entities. Each of the Derivium schedules A provided in pertinent part: 3. Anticipated Loan Amount: 90% of the face value *** 4. Interest Rate: Loan interest rate (LIR) will be indexed to [1 or] 3 month [as the case may be] $US LIBOR (”LIBOR”) *** 5. Interest Interest on the collateral will be Payments: received by the Lender and applied against interest due on the Loan, with the result that net interest due per dollar on the Loan will be determined by the *** Annual Net Interest Rate Formula *** The *** formula reduces to the Annual Net Interest Payment/Loan Amount. *** 6. Late Payment A late fee of 5% of the Quarterly Penalty: Net Interest Payment due will be assessed for any Net Interest Pay- ment past due by 30 days or more and will be payable within 60 days of the Net Interest Payment due date. 7. Default: Borrower will be considered in default if any Quarterly Net Inter- est Payment or late payment penalty is past due by 90 days or more. *** 10. Prepayment: Except as provided for in Paragraph 14, prepayment of the Loan can be made on any date which is a five- year anniversary date of this Loan, provided DC is noticed of this election at least one year prior to a five-year anniversary date and a pre-payment fee of 6.0% of the Loan amount has been paid to DC or the Lender at the time of said elec- tion. 11. Margin Requirement: None, beyond initial collateral. 12. Non-Callable: Loan cannot be called by Lender before maturity as long as Borrower is not considered in Default. If Borrower is in Default, the Loan may be called by Lender at Lender's discretion. 13. Non-Recourse: Non-recourse to Borrower, recourse against the Collateral only. 14. Creditor DC and the Lender acknowledge that Claims: the Collateral is the asset of the Client and is not subject to the claims of any creditors of DC or the Lender. Should any creditor of DC or the Lender contest the owner- ship of the Collateral in any court or similar proceeding, DC shall provide immediate notice to the Client and Client shall have the right to prepay the Loan (without any fee) and recover the Collateral provided that the benefit of any transaction entered into by DC or the Lender shall be held by the Client for DC's or the Lender's benefit and such benefit shall be the only compensation due to DC or the Lender. The respective Derivium schedules A also provided as follows:



Annual Net

Loan Term Interest

Schedule No. (in years) Payment Due

A-1 28 $921.25

A-2 28 9,480.00

A-3 36 11,055.00

A-4 37 9,480.00

A-5 38 9,322.56

A-6 27 11,556.09

The Derivium schedule D provided in pertinent part:



The Client understands that by transferring securities as collateral to DC and under the terms of the Agree- ment, the Client gives DC the right, without notice to the Client, to transfer, pledge, repledge, hypothecate, rehypothecate, lend, short sell, and/or sell outright some or all of the securities during the period covered by the loan. The Client understands that DC has the right to receive and retain the benefits from any such transactions and that the Client is not entitled to these benefits during the term of a loan. On repayment of a loan in full by the Client, including all out- standing net interest payments due, if any, and/or all late payment payment [sic] penalties due, if any, DC has the obligation to return to the Client the same collateral (or cash equivalent if the Client's collat- eral securities have reached their maturity date or the collateral has been called by the issuer), as set out and defined in Schedule(s) A attached hereto.



None of the Derivium transaction documents required Mr. Landow to make any payments against the principal of the loans before maturity of those loans.



On April 14, 2003, Derivium executed a document titled “LETTER OF AGREEMENT” as a supplement to the Derivium transaction documents (Derivium letter agreement). That agreement provided that Bancroft was to make certain payments and credits to Mr. Landow to compensate him for (1) the accrued interest on each of his FRNs that remained unpaid on the date of the closing of each of the loans that Bancroft made to him and (2) the interest that Wachovia Securities (Wachovia) was to charge him on certain margin debt associated with the FRN portfolio between the time that he transferred from Citibank to Wachovia that portfolio and that margin debt and the time that he transferred to Bancroft's account with Wachovia that portfolio and that margin debt. Pursuant to the Derivium letter agreement, on May 5, 2003, Bancroft sent Mr. Landow a check in the amount of $4,846.41 as compensation for the interest that Wachovia charged him.



On April 14, 2003, Mr. Landow sent Wachovia a letter in which he gave it instructions with respect to his FRN portfolio and certain transactions that he anticipated undertaking. That letter stated in pertinent part:



Landow will deposit into the Account [a certain account that Mr. Landow maintained at Wachovia] on April 16, 2003 the floating rate notes (”FRNs”) described below [the FRN portfolio] ***



Simultaneously with the receipt of an aggregate of $13.5 million *** hereinafter defined as “Total Loan Proceeds Due” from Bancroft Ventures Limited (”Bancroft”), you are irrevocably authorized and uncon- ditionally instructed to transfer and deliver (in essence, a delivery vs. payment transaction) the above- described FRNs [the FRN portfolio] from the Account to Bancroft ***



Pursuant to the Derivium loan documents, on April 15, 2003, Mr. Landow instructed Citibank to transfer the FRN portfolio from a certain account that he maintained at Citibank to a certain account that he maintained at Wachovia. Around the same date, Citibank complied with those instructions and transferred the FRN portfolio to Wachovia.



On April 21, 2003, Mr. Landow executed certain documents authorizing Wachovia to transfer each of Mr. Landow's FRNs from his account at Wachovia to a certain account that Bancroft maintained at Wachovia. On the same date, Bancroft sold each of those FRNs. 20 Bancroft realized net sales proceeds of $14,257,180.88 from the sale of the FRN portfolio. At the time Bancroft sold the FRN portfolio, Mr. Landow was not aware of that sale and did not become aware that Bancroft had sold the FRN portfolio until some time after 2003.



On April 22, 2003, Derivium sent Mr. Landow a facsimile. In that facsimile, Derivium informed Mr. Landow (1) that Bancroft had completed certain “hedging transactions” with respect to the FRN portfolio, (2) that the total of the six loans that Bancroft was to make to him was $13.5 million, and (3) that those loans were to close and the proceeds were to be transferred to Mr. Landow on April 24, 2003.



On April 24, 2003, Bancroft transferred to Mr. Landow $13.5 million. (We shall refer collectively to the transactions in which Mr. Landow transferred the FRN portfolio to Bancroft and Bancroft transferred to Mr. Landow $13.5 million in cash as the Derivium transaction.) On the same date, Derivium sent Mr. Landow a facsimile in which it informed him that each of the six loans had closed and that the proceeds of those loans totaling $13.5 million had been transferred to his account at Wachovia. On April 24, 2003, Derivium sent Mr. Landow a second facsimile. Derivium included with that facsimile two documents titled “VALUATION CONFIRMATION” and “ACTIVITY CONFIRMATION” (activity confirmation documents), respectively, with respect to each of the FRNs that Bancroft had sold on April 21, 2003. The respec- tive activity confirmation documents listed the principal amounts of the six loans and the total value of the collateral (i.e., the FRNs) transferred to Bancroft with respect to those loans.



After the Derivium transaction was effected, Mr. Landow used a portion of the proceeds that he received as part of that transaction to repay the outstanding balance on the Citibank increased line of credit of $13.5 million.



From around July 2003 through around April 2005, Bancroft sent Mr. Landow the following with respect to each of the six loans that it made pursuant to the Derivium transaction docu- ments: (1) Quarterly account statements reflecting the interest accrued on the loan, any credits arising from interest accrued on the FRN that served as collateral for the loan, and the net amount of interest due from Mr. Landow for each of the calendar quarters ended June 30 and September 30, 2003, March 31, June 30, September 30, and December 31, 2004, and March 31, 2005 and (2) yearend account statements reflecting interest payments that Mr. Landow made during each of the calendar years 2003 and 2004. From around October 2003 through August 2005, Mr. Landow paid Bancroft for each calendar quarter for which he received an account statement, except the quarter ended June 30, 2003, 21 net interest of $12,953.72.



At a time during 2004 not established by the record, peti- tioners filed Form 1040, U.S. Individual Income Tax Return (Form 1040), for their taxable year 2003 (2003 joint return). In that return, petitioners claimed, inter alia, a deduction of $167,159 for investment interest paid, including investment interest paid to Citibank and Bancroft of $120,083 and $35,587, respectively. Petitioners attached to the 2003 joint return Schedule D, Capital Gains and Losses (Schedule D), for their taxable year 2003 (2003 Schedule D). In that schedule, petitioners reported for their taxable year 2003 a net short-term capital loss of $1,147,323 consisting of total short-term capital gains of $201,773 and a short-term capital loss carryover from their taxable year 2002 of $1,349,096. In the 2003 Schedule D, petitioners also reported for their taxable year 2003 a net long-term capital loss of $130,290 consisting of a long-term capital loss of $2,187 and a long-term capital loss carryover from their taxable year 2002 of $128,103. Petitioners claimed in the 2003 joint return a capital loss of $3,000 and carried forward the remainder of the loss reported in the 2003 Schedule D (i.e., $1,274,613) to their taxable years 2004, 2005, 2006, and 2007. Petitioners did not report in the 2003 Schedule D or anywhere else in the 2003 joint return any gain with respect to the Derivium transaction.



At a time during 2005 not established by the record, peti- tioners filed Form 1040 for their taxable year 2004 (2004 joint return). In that return, petitioners claimed, inter alia, a deduction of $45,278 for investment interest paid during that year. 22 Petitioners attached to the 2004 joint return Schedule D for their taxable year 2004 (2004 Schedule D). In that schedule, petitioners reported for their taxable year 2004 a net short-term capital loss of $1,120,292 consisting of total short-term capital gains of $24,031 and a short-term capital loss carryover from their taxable year 2003 of $1,144,323. In the 2004 Schedule D, petitioners also reported for their taxable year 2004 a net long- term capital loss of $215,987 consisting of total long-term capital losses of $85,697 and a long-term capital loss carryover from their taxable year 2003 of $130,290. Petitioners claimed in the 2004 joint return a capital loss of $3,000 and carried forward the remainder of the loss reported in the 2004 Schedule D (i.e., $1,333,279) to their taxable years 2005, 2006, and 2007. Petitioners did not report in the 2004 Schedule D or anywhere else in the 2004 joint return any gain with respect to the Derivium transaction.



On August 18, 2005, Bancroft sent Mr. Landow a letter in which it informed him that “Optech Limited (`Optech') has ac- quired your Floating Rate Loan(s) from Bancroft Ventures Limited (`Bancroft') and Optech is now the lender of record for your transaction(s).” That letter also informed Mr. Landow that interest payments due on the six loans, including interest due for the calendar quarter ended June 30, 2005, were to be paid to Optech Ltd. (Optech).



From around August 2005 to around April 2007, Optech sent Mr. Landow the following with respect to each of the six loans that Bancroft had made pursuant to the Derivium transaction documents: (1) Quarterly account statements reflecting the interest accrued on the loan, any credits arising from interest accrued on the FRN that served as the collateral for the loan, and the net amount of interest due from Mr. Landow for each of the calendar quarters ended June 30, September 30, and December 31, 2005, March 31, June 30, September 30, and December 31, 2006, and March 31, 2007, and (2) yearend account statements reflecting interest payments that Mr. Landow made during each of the calen- dar years 2005 and 2006. From around August 2005 to around September 2007, Optech sent to Mr. Landow with respect to each of the six loans that Bancroft had made to him an invoice for interest due on the loan for each of the calendar quarters ended June 30, 2005, through September 30, 2007.



Around July 18, 2005, Mr. Landow engaged John W. Moscow (Mr. Moscow), an attorney with the law firm of Rosner, Moscow & Napierala, LLP. Mr. Landow engaged Mr. Moscow to investigate the status of Bancroft and of the FRN portfolio that Mr. Landow had transferred to Bancroft pursuant to the Derivium transaction documents.



On September 19, 2005, Mr. Landow sent Optech a letter in which he requested that Optech provide him with documentation evidencing that Optech had acquired the FRN portfolio from Bancroft and where Optech was holding that portfolio. Mr. Landow did not receive any response from Optech. On each of September 21 and October 25, 2005, and April 13, 2006, Mr. Landow contacted Optech and restated his request that Optech provide him with documentation evidencing that Optech had acquired the FRN portfo- lio from Bancroft and where Optech was holding that portfolio. Mr. Landow did not receive any response from Optech.



Mr. Moscow sent Mr. Cathcart, Derivium's founder, separate letters on November 29, 2005 (November 29, 2005 letter), and December 1, 2005 (December 1, 2005 letter), that were addressed to different places regarding the Derivium transaction and certain concerns of Mr. Landow about that transaction. 23 Those letters stated in pertinent part:



You have been the subject of a recent article in Forbes magazine, as has Derivium Capital LLC and Bancroft Ventures Ltd (IOM). My client, Dr. Landow, is concerned about the custody and control of his securi- ties [the FRN portfolio] *** . As you know he negoti- ated a contract different from that proposed to others, and he has every expectation that you will return his securities to him. The sentence in the Forbes article that you sold the stock is therefore extremely disturb- ing.



We have not received any notice pursuant to para- graph 14 of the Schedule A-4 FRN Property Description and Loan Terms. [24] Given your contractual obligation to return the securities and the absence of such notice it is our expectation that you are in a position to return the securities when obligated to do so.



Because Mr. Landow was unable to confirm that Optech had acquired the FRN portfolio from Bancroft, around March 2006 he opened a bank account with Long Island Commercial Bank in the name of “Jonathan S. Landow FBO Accrued Interest Charges for Floating Rate Note Portfolio” (interest escrow account). In March 2006, Mr. Landow deposited into the interest escrow account $51,814.88, which equaled four quarterly interest payments of $12,953.72 on the six loans that Bancroft had made pursuant to the Derivium transaction documents. Thereafter, and until April 2009, Mr. Landow deposited into the interest escrow account all quarterly interest payments due on the six loans that Bancroft had made pursuant to the Derivium transaction documents.



At a time during 2006 not established by the record, peti- tioners filed Form 1040 for their taxable year 2005 (2005 joint return). In that return, petitioners claimed, inter alia, a deduction of $109,906 for investment interest paid during that year, including $51,815 that Mr. Landow paid to “BANCROFT & SUCCESSOR” during that year. 25 Petitioners attached to the 2005 joint return Schedule D for their taxable year 2005 (2005 Sched- ule D). In that schedule, petitioners reported for their taxable year 2005 a net short-term capital loss of $991,991 consisting of total short-term capital gains of $125,301 and a short-term capital loss carryover from their taxable year 2004 of $1,117,292. In the 2005 Schedule D, petitioners also reported for their taxable year 2005 a net long-term capital loss of $99,628 consisting of total long-term capital gains of $116,359 and a long-term capital loss carryover from their taxable year 2004 of $215,987. Petitioners claimed in the 2005 joint return a capital loss of $3,000 and carried forward the remainder of the loss reported in the 2005 Schedule D (i.e., $1,088,619) to their taxable years 2006 and 2007. Petitioners did not report in the 2005 Schedule D or anywhere else in the 2005 joint return any gain with respect to the Derivium transaction.



At a time during 2007 not established by the record, peti- tioners filed Form 1040 for their taxable year 2006 (2006 joint return). In that return, petitioners claimed, inter alia, a deduction of $55,040 for investment interest paid during that year, including $38,860 that Mr. Landow paid with respect to “FRN NOTES” during that year. 26 Petitioners attached to the 2006 joint return Schedule D for their taxable year 2006 (2006 Sched- ule D). In that schedule, petitioners reported for their taxable year 2006 a net short-term capital loss of $1,082,140 consisting of total short-term capital losses of $93,149 and a short-term capital loss carryover from their taxable year 2005 of $988,991. In the 2006 Schedule D, petitioners also reported for their taxable year 2006 a net long-term capital gain of $378,116 consisting of total long-term capital gains of $477,744 and a long-term capital loss carryover from their taxable year 2005 of $99,628. Petitioners claimed in the 2006 joint return a capital loss of $3,000 and carried forward the remainder of the loss reported in the 2006 Schedule D (i.e., $701,024) to their taxable year 2007. Petitioners did not report in the 2006 Schedule D or anywhere else in the 2006 joint return any gain with respect to the Derivium transaction.



At a time during 2008 not established by the record, peti- tioners filed Form 1040 for their taxable year 2007 (2007 joint return). In that return, petitioners claimed, inter alia, a deduction of $144,122 for investment interest paid during that year, including $51,815 that Mr. Landow paid with respect to “FRN NOTES” during that year. 27 Petitioners attached to the 2007 joint return Schedule D for their taxable year 2007 (2007 Sched- ule D). In that schedule, petitioners reported for their taxable year 2007 a net short-term capital gain of $2,522,746 consisting of total short-term capital gains of $3,226,770 and a short-term capital loss carryover from their taxable year 2006 of $704,024. In the 2007 Schedule D, petitioners also reported for their taxable year 2007 a net long-term capital gain of $312,942 consisting of only long-term capital gains. Petitioners reported in the 2007 joint return a capital gain of $2,835,688 consisting of the net short-term capital gain and the net long-term capital gain that they reported in the 2007 Schedule D. Petitioners did not report in the 2007 Schedule D or anywhere else in the 2007 joint return any gain with respect to the Derivium transaction.



On March 31, 2009, respondent issued to petitioners a notice of deficiency (2003-2004 notice) with respect to petitioners' taxable years 2003 and 2004. In that notice, respondent deter- mined, inter alia, that the Derivium transaction constituted a sale by Mr. Landow of the FRN portfolio with respect to which petitioners are required to recognize a capital gain of $13.5 million. 28



On July 6, 2009, respondent issued to petitioners a notice of deficiency with respect to petitioners' taxable years 2005, 2006, and 2007 (2005-2007 notice). In that notice, respondent determined, inter alia, to reduce the respective capital loss carryovers that petitioners had reported in their 2005 joint return, their 2006 joint return, and their 2007 joint return. That determination was based on respondent's determination in the 2003-2004 notice that the Derivium transaction constituted a sale in 2003 by Mr. Landow of the FRN portfolio and that petitioners are required to recognize a capital gain of $13.5 million for As discussed supra note 28, the short- their taxable year 2003. term loss carryover and the long-term loss carryover that peti- tioners claimed in the 2003 Schedule D were used to offset a portion of the gain that respondent determined resulted from the Derivium transaction. As a result, the capital loss carryover that petitioners claimed in their 2003 joint return was not available to carry forward to any of their taxable years after 2003.



As of around May 2010, Mr. Landow had not paid any of the $13.5 million principal of the six loans that Bancroft had made to him pursuant to the Derivium transaction documents. 28 (...continued) tioners are entitled for their taxable year 2004 to the $3,000 deduction for capital losses that they claimed in their 2004 joint return.



OPINION

Petitioners bear the burden of proving that respondent's determination in the 2003-2004 notice that the Derivium transac- tion constitutes a sale in 2003 by Mr. Landow of the FRN portfo- lio is erroneous. 29 See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 [12 AFTR 1456] (1933).



Shortly before the parties filed their respective opening briefs, we decided Calloway v. Commissioner, 135 T.C. 26 (2010). We held on the basis of the facts presented there that a transac- tion between the taxpayer and Derivium in which the taxpayer transferred to Derivium purportedly as collateral certain securi- ties and Derivium purportedly lent the taxpayer an amount equal to 90 percent of the fair market value of those securities constituted the taxpayer's sale of those securities, and not a loan to the taxpayer of that amount. In reaching that holding, we found that the taxpayer (1) transferred to Derivium legal title to certain securities that he owned, (2) gave Derivium the right to sell those securities at any time and without notice to the transferor and to retain any and all benefits from any such sale, and (3) left the taxpayer with at best an option to repur- chase the securities at the end of the term of the purported loan in question. Id. at 34-36.



In resolving the issue presented in Calloway, we relied on various facts relating to the Derivium transaction at issue in that case, including the following: (1) The taxpayer transferred to Derivium under the agreements that he executed the securities that he owned and gave it an unrestricted right to sell those securities and retain all benefits from any such sale; 30 (2) the purported loan was nonrecourse; (3) except for the securities that the taxpayer transferred to Derivium purportedly as collat- eral for the purported loan there were no margin requirements;



(4) the taxpayer was entitled to credit against the interest that accrued on the purported loan from Derivium any dividends paid on the securities that he transferred to that company; and "[Petitioner] understands that by transferring securi- ties as collateral to *** [Derivium] and under the terms of the *** [master agreement], *** [peti- tioner] gives *** [Derivium] the right, without notice to *** [petitioner], to transfer, pledge, repledge, hypothecate, rehypothecate, lend, short sell,



and/or sell outright some or all of the securities during the period covered by the loan. * * * [Peti-

tioner] understands that *** [Derivium] has the right to receive and retain the benefits from any such trans- actions and that *** [petitioner] is not entitled to these benefits during the term of a loan. *** [Empha- sis added.]" [Bracketed insertions, asterisks, and emphasis in Calloway.]

(5) Derivium did not require the taxpayer to make any payment of the principal of the purported loan before maturity. Calloway v. Commissioner, supra at 29, 34-36.



The facts listed above on which we relied in Calloway are present in the instant cases. In the Derivium transaction at issue here: (1) Mr. Landow transferred to Bancroft under the Derivium transaction documents the FRNs that he owned and gave it an unrestricted right to sell those FRNs and to retain all benefits from any such sale; 31 (2) each of the six loans that Bancroft made to Mr. Landow pursuant to the Derivium transaction documents were nonrecourse loans; (3) except for the FRNs that Mr. Landow transferred to Derivium as collateral for the loans that Bancroft made to him there were to be no margin require- ments; (4) under each of the Derivium schedules A Mr. Landow was entitled to credit against the interest accrued on each loan the interest accrued on each FRN that he transferred to Derivium; 32 and (5) Derivium and Bancroft did not require Mr. Landow to make any payments of the principal of any of the six loans before maturity.



Petitioners do not dispute that the facts listed above relating to the Derivium transaction at issue here are materially indistinguishable from the facts listed above relating to the Derivium transaction at issue in Calloway v. Commissioner, supra. Petitioners argue, however, that there are certain other facts in the present cases that make the Derivium transaction at issue here materially distinguishable from the Derivium transaction at issue in Calloway. Therefore, petitioners maintain, Calloway does not control the resolution of whether the Derivium transac- tion at issue here constitutes a sale by Mr. Landow of his FRN portfolio. 33



Petitioners point out that in the Derivium transaction at issue here, unlike in the Derivium transaction at issue in Calloway, (1) Mr. Landow did not enter into the Derivium transac- tion for the purpose of minimizing his risk of loss with respect to the FRN portfolio and monetizing the value of that portfolio without paying tax on the proceeds; (2) at all times petitioners treated the Derivium transaction as a loan; and (3) Mr. Landow “never surrendered his FRNs to Derivium or its affiliates, and has taken significant steps to locate and recover the FRNs” in contrast to the taxpayer in Calloway who “voluntarily surrendered his collateral at the expiration of the three-year loan term”. 34



Petitioners are correct that none of the above-listed facts were present in Calloway v. Commissioner, 135 T.C. 26 (2010). However, those facts were present in Shao v. Commissioner, T.C. Memo. 2010-189 [TC Memo 2010-189], and/or Kurata v. Commissioner, T.C. Memo. 2011- 64 [TC Memo 2011-64], 35 two cases in which we held that Calloway was controlling and that the respective transactions at issue in those cases constituted sales of securities by the respective taxpayers, and not loans to those respective taxpayers. 36



In Shao v. Commissioner, supra, there was no evidence that the taxpayer entered into the transaction for the purpose of monetizing her securities without paying tax on the proceeds. Id. In fact, the taxpayer in Shao entered into the Derivium transaction at issue in that case in order to replace a certain margin account that she had maintained with a certain financial institution. Id. Moreover, the taxpayer in Shao treated her transaction as a loan at all times and did not “voluntarily surrender” at the end of the term of her purported loan the securities that she had transferred to Derivium as purported collateral for that purported loan. Id. Although the taxpayer in Shao, like any other nonrecourse borrower, had the right to “walk away” from the purported loan at the conclusion of the three-year term of that purported loan, she chose to pay a significant renewal fee in order to extend the term of the Despite the foregoing factual differences purported loan. Id. from Calloway v. Commissioner, supra, we held in Shao that Calloway was controlling and that the Derivium transaction at issue in Shao constituted a sale of securities by the taxpayer, and not a loan to the taxpayer by Derivium. Shao v. Commis- sioner, supra.



In Kurata v. Commissioner, supra, there also was no evidence that the taxpayers entered into the Derivium transaction at issue there for the purpose of monetizing their securities without paying tax on the proceeds. Id. Moreover, the taxpayers in Kurata treated the transaction as a loan during the term of that purported loan and reported gain from the sale of the securities when they chose to surrender those securities at the conclusion of the three-year term of the purported loan. Id. Despite these factual differences from Calloway, we held in Kurata that Calloway was controlling and that the Derivium transaction at issue in Kurata constituted a sale of securities by the taxpay- ers, and not a loan to the taxpayers by Derivium. Kurata v. Commissioner, supra.



Petitioners also point to certain other facts that they contend make the Derivium transaction at issue here materially distinguishable from the Derivium transaction at issue in Calloway , including the following: (1) Mr. Landow retained the ability to prepay the loan principal under the Derivium transac- tion documents and (2) those documents provided that the FRN portfolio continued to be an asset of Mr. Landow. 37



With respect to the provision in the Derivium transaction documents involved here that gave Mr. Landow the right to prepay the loan principal, which the taxpayer in Calloway did not have, that right of Mr. Landow was extremely limited. He had the right to prepay the loan principal only once every five years and only after having given Derivium and Bancroft one-year advance notice. The purported loan at issue in Calloway was for a term of three years, Calloway v. Commissioner, supra, which was two years less than the earliest point at which Mr. Landow was able to prepay the principal of his loan. Moreover, another condition to Mr. Landow's ability to prepay the loan principal was the requirement that he pay at the time he gave the required notice a fee of 6 percent of the loan principal, which equaled $810,000—a signifi- cant disincentive to Mr. Landow's exercising his prepayment right.



With respect to the provision in the Derivium transaction documents that the FRN portfolio was to remain the asset of Mr. Landow, we find that provision to be meaningless. This is evidenced by the fact that on the same date on which Mr. Landow transferred the FRNs to Bancroft, Bancroft sold those FRNs, which it was expressly allowed to do in those documents, and used 90 percent of the sale proceeds to make the six loans in question to Mr. Landow.



Based upon our examination of the entire record before us, we find that the Derivium transaction at issue here is not materially distinguishable from the Derivium transaction at issue in Calloway v. Commissioner, supra. On that record, we further find that Calloway is controlling in these cases. On the record before us, we find that the Derivium transaction constitutes a sale by Mr. Landow of the FRN portfolio to Bancroft, and not a loan by Bancroft to Mr. Landow that was collateralized by that portfolio.



We turn now to petitioners' argument that if we were to find, as we have, that the Derivium transaction at issue here constitutes a sale by Mr. Landow of the FRNs, they would not be required under section 1042(e) to recognize any gain that Mr. Landow realized as a result of that sale. That is because, according to petitioners, gain under that section is recognized only where the taxpayer disposes of qualified replacement prop- erty (i.e., the FRN portfolio), and Mr. Landow did not dispose of the FRN portfolio; Derivium did.



Petitioners' argument misreads our Opinion in Calloway v. Commissioner, 135 T.C. 26 (2010). In Calloway, an important fact was that Derivium sold the taxpayer's stock immediately after the Id. at 34-36, 38-39. That taxpayer transferred it to Derivium. fact, combined with other facts, led us to hold in Calloway that the taxpayer sold his stock when he transferred it to Derivium. Id. at 39. We did not hold in Calloway, as petitioners suggest, that Derivium's immediate sale of the taxpayer's stock consti- tuted the sale with respect to which the taxpayer was subject to tax. Id. In making their argument under section 1042(e), petitioners are focusing on the wrong transaction, namely, Bancroft's immediate sale of the FRNs. The transaction on which we must focus to address petitioners' argument under section 1042(e) is Mr. Landow's disposition by sale of the FRNs to Bancroft.



On the record before us, we have found that Mr. Landow sold the FRN portfolio when he transferred that portfolio to Bancroft pursuant to the Derivium transaction documents. On that record, we further find that petitioners are required under section 1042(e) to recognize for their taxable year 2003 any gain that Mr. Landow realized as a result of that sale.



Petitioners also argue that if we were to find, as we have, that the Derivium transaction constitutes a sale by Mr. Landow of the FRNs, that sale would constitute a theft and therefore an involuntary conversion under section 1033(a). 38 Consequently, 38



Sec. 1033(a) provides in pertinent part:



SEC. 1033. INVOLUNTARY CONVERSIONS.

(a) General Rule.—If property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted— *** (2) Conversion into money.—Into money or into property not similar or related in service or use to the converted property, the gain (if any) shall be recognized except to the extent hereinaf- ter provided in this paragraph: (A) Nonrecognition of gain.—If the taxpayer during the period specified in sub- paragraph (B), for the purpose of replacing the property so converted, purchases other property similar or related in service or use to the property so converted, or purchases stock in the acquisition of control of a corporation owning such other property, at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion (regard- less of whether such amount is received in one or more taxable years) exceeds the cost of such other property or such stock. Such election shall be made at such time and in such manner as the Secretary may by regula- tions prescribe. * * * according to petitioners, they are entitled to purchase replace- ment property as required by section 1033(a)(2)(A) and thereby defer under section 1033(a) any gain that Mr. Landow realized as a result of that sale.



In Wheeler v. Commissioner, 58 T.C. 459 (1972), we explained the scope and the purpose of section 1033 as follows:



Congress clearly intended to extend the benefits of section 1033 *** only to public takings and casualty- like conversions, and the limitation of its benefits to involuntary conversions—i.e., those “wholly beyond the control of the one whose property has been taken”— reflects that intent. Id. at 463 (quoting Dear Publ. & Radio, Inc. v. Commissioner, 274 F.2d 656, 660 [5 AFTR 2d 746] (3d Cir. 1960), affg. 31 T.C. 1168 (1959)).



Mr. Landow voluntarily entered into the Derivium transaction in which he transferred to Bancroft the FRN portfolio in exchange for $13.5 million in cash and gave Bancroft the right, inter alia, to sell the FRN portfolio without notice to him and to retain the proceeds of that sale.



On the record before us, we find that Mr. Landow's sale of the FRN portfolio to Bancroft in exchange for $13.5 million in cash does not constitute an involuntary conversion, as defined in section 1033. On that record, we further find that petitioners are not entitled to defer under that section any gain that Mr. Landow realized as a result of that sale. 39



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 and the concessions of the parties,



Decisions will be entered under Rule 155.

1





All section references are to the Internal Revenue Code in effect at all relevant times. All Rule references are to the Tax Court Rules of Practice and Procedure.

3



The parties reserved objections based on relevancy to certain of the stipulated facts. We need not and shall not address those respective objections. That is because we have not relied on any of the facts to which the parties reserved those objections in resolving the issues presented.

5



The revolving credit note defined the term “LIBOR rate” as the interest rate that Citibank's London office offered to prime banks in the London interbank market.

6



The revolving credit note defined the term “base rate” as the interest rate that Citibank periodically published as its base rate.

10



A floating rate note is a debt instrument with a variable interest rate that is determined on the basis of a certain benchmark (e.g., the yield for U.S. Treasury bills). The inter- est rate on an FRN is adjusted periodically to reflect any changes in the relevant benchmark.

11



Zero-cost borrowing was possible, according to Citibank, because the interest that Mr. Landow earned on the FRNs would entirely offset the periodic interest that Citibank charged on any line of credit that it made available to him.

12





12





13



Morgan Stanley's cost-of-funds index rate was calculated by using certain short-term interest rate indices.

14



Our use of terms like “loan”, “lend”, “collateral”, “bor- row”, “maturity”, and “interest” when describing the proposed transaction and the actual transaction between Mr. Landow and Derivium is for convenience only. Our use of any such terms is not intended to imply, and does not imply, that the transaction at issue between Mr. Landow and Derivium constitutes a loan for tax purposes.

15



Although we have found that Mr. Landow purchased seven FRNs, he purchased on different dates in November 2001 two FRNs issued by Minnesota Mining, both with maturity dates of Dec. 21, 2041. In making its proposals to Mr. Landow, Derivium treated and referred to those two FRNs as one FRN, and for convenience we shall refer to those two FRNs as one FRN. As discussed below, Derivium proposed to make only one loan to Mr. Landow with respect to the two FRNs issued by Minnesota Mining and separate loans with respect to the remaining five FRNs that Mr. Landow purchased, or a total of six loans.

16



The respective revised proposed schedules A, numbered A-1 through A-6, pertained to the respective loans for which the following FRNs were to serve as collateral:

Schedule No. FRN

A-1 E.I. Dupont maturing 10/9/2041

A-2 United Parcel Service maturing 6/21/2051

A-3 E.I. Dupont maturing 12/27/2039

A-4 Merck & Co. maturing 12/27/2040

A-5 Minnesota Mining maturing 12/21/2041

A-6 Proctor & Gamble maturing 8/15/2050



17



The record does not contain any letter or other communica- tion by which Mr. Landow requested certain revisions to certain of the documents that Derivium had sent him.

18



Each of the Derivium schedules A, numbered A-1 through A- 6, pertained to the same loan and FRN as the revised proposed schedule A with the same number. See supra note 16.

19



At no time before Apr. 9, 2003, the date on which Mr. Landow and Derivium entered into the transaction at issue, did Derivium request or require that Mr. Landow complete a loan application or that he provide any personal financial informa- tion.

90





20



Bancroft's sale of each of the FRNs was to settle on Apr. 24, 2003.

21



For the calendar quarter ended June 30, 2003, the interest that accrued on the FRN portfolio during that quarter was greater than the interest that accrued during that quarter on the six loans that Bancroft had made to Mr. Landow. As a result, on July 14, 2003, Bancroft paid Mr. Landow the difference between those amounts.

22



Petitioners netted the interest that accrued on Mr. Landow's FRNs against the interest that accrued on the six loans that Bancroft had made to him and included the difference in the investment interest for which they claimed a deduction in the 2004 joint return.

23



The record does not establish whether Mr. Cathcart sent Mr. Landow or Mr. Moscow any response to the November 29, 2005 letter or the December 1, 2005 letter.

25



Petitioners netted the interest that accrued on Mr. Landow's FRNs against the interest that accrued on the six loans that Bancroft had made to him and included the difference in the investment interest for which they claimed a deduction in the 2005 joint return.

26



Petitioners netted the interest that accrued on Mr. Landow's FRNs against the interest that accrued on the six loans that Bancroft had made to him and included the difference in the investment interest for which they claimed a deduction in the 2006 joint return.

27



Petitioners netted the interest that accrued on Mr. Landow's FRNs against the interest that accrued on the six loans that Bancroft had made to him and included the difference in the investment interest for which they claimed a deduction in the 2007 joint return.

28



Because of respondent's determination with respect to the Derivium transaction, respondent further determined in the 2003- 2004 notice to use the short-term loss carryover and the long- term loss carryover that petitioners claimed in the 2003 Schedule D to offset a portion of the gain that respondent determined resulted from the Derivium transaction. As a result, the capital loss carryforward of $1,274,613 that petitioners claimed in their 2003 joint return was reduced to zero and was not available to carry forward to their taxable years 2004, 2005, 2006, and 2007. However, because, as discussed above, petitioners reported in the 2004 Schedule D long-term capital losses for their taxable year 2004 in excess of short-term capital gains for that year, peti-

28





29



As discussed above, our resolution of the issues presented by respondent's determination in the 2003-2004 notice that the Derivium transaction constitutes a sale in 2003 by Mr. Landow of the FRN portfolio resolves the issues presented by respondent's determinations in the 2005-2007 notice. See supra notes 2 and 28.

30



In Calloway v. Commissioner, 135 T.C. 26, 29 (2010), the agreement between the taxpayer and Derivium provided in pertinent part:

31



The Derivium master agreement that Mr. Landow executed provided in pertinent part:



The Client [Mr. Landow] understands that by transfer- ring securities as collateral to DC [Derivium] and under the terms of the Agreement, the Client gives DC and/or its assigns, the right, without requirement of notice to or consent of the Client, to assign, trans- fer, pledge, repledge, hypothecate, rehypothecate, lend, encumber, short sell, and/or sell outright some or all of the securities during the period covered by the loan. The Client understands that DC and/or its assigns have the right to receive and retain the bene- fits from any such transactions and that the Client is not entitled to these benefits during the term of a loan.

32



We do not find it material that in the present cases Mr. Landow was required by the Derivium transaction documents to pay quarterly to Bancroft the net difference between the interest accrued on each of the six loans that Bancroft made to him pursuant to those documents and the interest accrued on each of the FRNs that he transferred to Bancroft, whereas in Calloway v. Commissioner, supra at 29, the taxpayer was required to pay interest only at the end of the three-year loan term.

33



Petitioners also contend that the Derivium transaction is materially indistinguishable from the Citibank transaction which respondent acknowledges constituted a loan by Citibank to Mr. Landow that was collateralized by the FRN portfolio. Because of respondent's acknowledgment that the Citibank transaction consti- tuted a loan to Mr. Landow and because petitioners maintain that the Citibank transaction and the Derivium transaction are materi- ally the same, petitioners assert (1) that the Derivium transac- tion constitutes six loans by Bancroft to Mr. Landow that were collateralized by the FRN portfolio or (2) that the Citibank transaction constituted a sale in 2000 by Mr. Landow of the FRN portfolio. On the record before us, we reject petitioners' contentions. On that record, we find the Citibank transaction to be materially distinguishable from the Derivium transaction.

34



With respect to the third alleged difference between these cases and Calloway v. Commissioner, supra, it appears that petitioners are contending that Mr. Landow did not abandon his obligations under the Derivium transaction documents and there- fore did not allow Bancroft to retain the FRNs that he trans- ferred to it. However, the six loans that Bancroft made to Mr. Landow had terms ranging from 27 to 38 years, and none of those loans had reached maturity as of the time that the parties submitted these cases under Rule 122. More importantly, because those six loans were nonrecourse loans, Mr. Landow, like any other nonrecourse borrower, had the right to “walk away” from his obligations to repay those loans and to allow the lender to retain the FRNs that he had transferred to it.

35



We decided Shao v. Commissioner, T.C. Memo. 2010-189 [TC Memo 2010-189], and Kurata v. Commissioner, T.C. Memo. 2011-64 [TC Memo 2011-64], on the same day or after the day the parties filed their respective reply briefs.

36



On brief, petitioners cite repeatedly the concurring opinion of Judge Holmes in Calloway v. Commissioner, 135 T.C. at 53, as support for certain of their arguments. We note that Judge Holmes was the author of our opinion in Shao v. Commis- sioner, supra, which held Calloway to be controlling.

37



As noted supra note 35, we decided Shao v. Commissioner, supra , and Kurata v. Commissioner, supra, on the same day or after the day the parties filed their respective reply briefs. If those two cases had been released before the parties filed their respective briefs, we presume that petitioners would have pointed out that the facts listed below were not present in those cases.

38





38





39



In the light of our finding that petitioners are not