PUBLISHED
`
`UNITED STATES COURT OF APPEALS
`FOR THE FOURTH CIRCUIT
`
`
`No. 18-2277
`
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`ESTATE OF ARTHUR E. KECHIJIAN, DECEASED; SUSAN P. KECHIJIAN,
`individually and as co-executor; SCOTT E. HOEHN, co-executor,
`
` Petitioners – Appellants,
`
`v.
`
`COMMISSIONER OF INTERNAL REVENUE,
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` Respondent – Appellee.
`
`
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`
`
`
`
`
`No. 18-2402
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`LARRY E. AUSTIN; BELINDA AUSTIN,
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` Petitioners – Appellants,
`
`v.
`
`COMMISSIONER OF INTERNAL REVENUE SERVICE,
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` Respondent - Appellee.
`
`
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`Appeals from the United States Tax Court. (Tax Ct. Nos. 8967-10; 8966-10)
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`
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`
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`Submitted: May 8, 2020
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`Decided: June 23, 2020
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`
`UNITED STATES COURT OF APPEALS
`FOR THE FOURTH CIRCUIT
`
`
`No. 18-2277
`
`
`ESTATE OF ARTHUR E. KECHIJIAN, DECEASED; SUSAN P. KECHIJIAN,
`individually and as co-executor; SCOTT E. HOEHN, co-executor,
`
` Petitioners – Appellants,
`
`v.
`
`COMMISSIONER OF INTERNAL REVENUE,
`
` Respondent – Appellee.
`
`
`
`
`
`
`
`
`No. 18-2402
`
`
`LARRY E. AUSTIN; BELINDA AUSTIN,
`
` Petitioners – Appellants,
`
`v.
`
`COMMISSIONER OF INTERNAL REVENUE SERVICE,
`
` Respondent - Appellee.
`
`
`
`Appeals from the United States Tax Court. (Tax Ct. Nos. 8967-10; 8966-10)
`
`
`
`
`
`
`
`
`
`
`Submitted: May 8, 2020
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`Decided: June 23, 2020
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`
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`Before WILKINSON, NIEMEYER, and KING, Circuit Judges.
`
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`Affirmed by published opinion. Judge Wilkinson wrote the opinion, in which Judge
`Niemeyer and Judge King joined.
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`
`
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`Lynn F. Chandler, Stephanie C. Daniel, Lucas D. Garber, SHUMAKER, LOOP &
`KENDRICK, LLP, Charlotte, North Carolina, for Appellants. Richard E. Zuckerman,
`Principal Deputy Assistant Attorney General, Richard Farber, Jennifer M. Rubin, Tax
`Division, UNITED STATES DEPARTMENT OF JUSTICE, Washington, D.C., for
`Appellee.
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`2
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`WILKINSON, Circuit Judge:
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`This case concerns the federal income tax consequences arising from a complex set
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`of business transactions orchestrated by petitioners Arthur Kechijian and Larry Austin.1
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`The IRS Commissioner maintains that petitioners substantially underreported their taxable
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`income for the 2004 tax year. After a trial, the Tax Court agreed. It held that petitioners
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`had failed to report approximately $41.2 million of compensation income that they realized
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`when certain restricted stockholdings that they owned became substantially vested in
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`January 2004. The Tax Court also upheld the Commissioner’s decision to impose
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`accuracy-related penalties for negligence and substantial understatement of tax liability,
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`and it denied petitioners’ post-trial attempt to offset their underreported income with
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`various net operating loss carrybacks. Petitioners challenge each of these holdings. After
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`careful review of the record, we find no error in the Tax Court’s rulings and accordingly
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`affirm its judgment. Petitioners cannot be allowed to proceed on any assumption that the
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`sheer complexity of their corporate transactions will assist them in the evasion of their
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`appropriate tax liability.
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`I.
`
`A.
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`Petitioners were partners in the distressed debt loan portfolio business for
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`approximately fifteen years, beginning in 1990. At the most basic level, petitioners’
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`1 Arthur Kechijian died in 2013; his estate was substituted as a party petitioner on
`October 23, 2013. Petitioners’ wives, Belinda Austin and Susan Kechijian, are also parties
`to this action by virtue of having filed joint federal income tax returns with their husbands.
`3
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`
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`business entailed raising funds from outside investors to finance the acquisition of
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`distressed debt from financial institutions and government agencies. Corporate entities
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`controlled by petitioners would then own and service that debt. Each man brought a
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`different set of skills to their partnership. Austin performed “front-end work,” such as
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`acquiring loan portfolios, conducting due diligence on potential acquisitions, formulating
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`bid strategies, performing cashflow analyses, and maintaining investor relationships. On
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`the other hand, Kechijian performed “back-end work,” including servicing the loan
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`portfolios, collection activities, human resources, and other back-office operations.
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`In 1998, petitioners reorganized their business. Prior to that year, petitioners were
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`the owners and operators of a group of corporations and limited liability companies
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`(“LLCs”) known as the “UMLIC entities.” Petitioners decided to consolidate the separate
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`UMLIC entities into a single holding company known as UMLIC Consolidated, Inc. (the
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`“UMLIC S-Corp.”). UMLIC S-Corp. was a North Carolina corporation for which
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`petitioners elected so-called “S corporation status.” The goals of this restructuring were
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`threefold: (1) allowing assets to be moved more efficiently between the various entities;
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`(2) reducing the number of tax and financial filings the businesses were required to make;
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`and (3) achieving substantial tax benefits.
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`To effectuate the contemplated reorganization, petitioners executed a series of
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`transactions relevant to the instant case. First, each man transferred the entirety of his
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`shareholdings in the UMLIC entities, each valued at $142,566, to UMLIC S-Corp. in return
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`for 47,500 shares of UMLIC S-Corp. common stock. Simultaneously, petitioners executed
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`two collateral agreements, the Restricted Stock Agreement (“RSA”) and the Employment
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`4
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`Agreement (“EA”). Taken together, these agreements provided that either petitioner would
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`lose at least 50% of the value of his UMLIC S-Corp. stock if he voluntarily terminated his
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`employment with the company before January 1, 2004. This five-year “earnout” period
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`was designed to incentivize petitioners to continue working for UMLIC S-Corp. so that the
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`new company would benefit from their diverse skill sets.
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`The ownership of UMLIC S-Corp. was further divided over the next few years. In
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`December 1998, petitioners created an employee stock ownership plan (“ESOP”) for
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`UMLIC S-Corp. The ESOP purchased 5,000 shares of UMLIC S-Corp. common stock at
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`a price of $500,000. In August 1999, petitioners each transferred 24,500 shares of their
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`UMLIC S-Corp. stock to two new, irrevocable trusts established for the benefit of their
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`families. These shares remained subject to the RSA and EA. Thus, as of August 1999,
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`petitioners, their trusts, and the ESOP were the only shareholders of UMLIC S-Corp.
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`As alluded to above, petitioners had an additional, non-business motive for creating
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`this elaborate corporate shareholding structure, namely the deferral of federal income tax
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`on the profits of UMLIC S-Corp. Four background principles are necessary to understand
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`this intricate scheme. First, I.R.C. § 83 applies where property, including stock, is
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`transferred to a taxpayer “in connection with the performance of services.” At the
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`taxpayer’s election, he may defer tax inclusion of any gains from such a transfer until the
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`first taxable year in which his rights in the property “are not subject to a substantial risk of
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`forfeiture,” 26 U.S.C. § 83(a), i.e., when his rights become “substantially vested,” 26
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`C.F.R. § 1.83-1. Importantly, such rights “are subject to a substantial risk of forfeiture
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`if . . . [they] are conditioned upon the future performance of substantial services by any
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`5
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`
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`individual.” 26 U.S.C. § 83(c)(1). Second, under the Internal Revenue Code (“IRC”), an
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`S corporation does not itself pay income taxes; rather, it passes any income or losses it
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`makes through to its outstanding shareholders who must then report the same on their
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`individual income tax returns. Third, restricted stock in an S corporation “that is issued in
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`connection with the performance of services . . . and that is substantially nonvested . . . is
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`not treated as outstanding stock of the corporation” for tax purposes. 26 C.F.R. § 1.1361-
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`1(b)(3). As such, profits or losses of an S corporation will not flow through to a holder of
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`non-vested stock and need not be included on the holder’s individual income tax returns.
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`Fourth, an ESOP is a tax-exempt entity.
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`In combination, these principles allowed petitioners to avoid reporting any income
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`from UMLIC S-Corp. on their federal tax returns from 2000 to 2003, despite the fact that
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`the company was profitable during that period. The Tax Court aptly summarized the
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`functioning of this scheme: “[petitioners] took the position that their stock (and that owned
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`by their grantor trusts) was subject to a ‘substantial risk of forfeiture’ and was thus
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`‘substantially nonvested’ . . . . Because the 95,000 shares owned by petitioners and their
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`grantor trusts were deemed to be ‘non-outstanding,’ UMLIC S-Corp. for tax years 2000–
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`2003 allocated 100% of its income, losses, deductions, and other tax items to the ESOP.
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`Consistently with the company’s reporting, neither petitioner reported any flow-through
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`items from UMLIC S-Corp. on the joint return he filed with his spouse for 2000, 2001,
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`2002, or 2003. And because the ESOP was a tax-exempt entity, it likewise reported no
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`taxable income from UMLIC S-Corp. for 2000–2003.” Austin v. Comm’r, T.C. Memo.
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`
`
`6
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`
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`2017-69, at *14–15. In other words, between 2000–2003, no one paid any federal income
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`tax on UMLIC S-Corp.’s profits.
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`In late 2003, petitioners again undertook to restructure their business operations.
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`This second reorganization was undertaken for two purposes. First, petitioners hoped to
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`attract greater outside investment from hedge funds and private equity firms, which they
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`felt would be difficult while the business continued to operate as an S corporation. Second,
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`Congress had amended the tax laws to close the loophole by which petitioners had avoided
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`reporting taxable income on the earnings of UMLIC S-Corp. As such, the existing
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`structure would cease to provide tax benefits as of January 1, 2005.
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`To effectuate this restructuring, petitioners formed UMLIC Holdings, LLC
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`(“Holdings”), a Delaware limited liability corporation in which petitioners each held a 50%
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`interest. In November 2003, Holdings purchased all of UMLIC S-Corp.’s operating assets
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`in exchange for a $190 million interest-bearing promissory note and the assumption of
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`various liabilities. Though UMLIC S-Corp. realized $174.6 million of capital gain on this
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`sale, it allocated the entirety of that gain to the tax-exempt ESOP, which, according to
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`petitioners, was still the only outstanding shareholder of UMLIC S-Corp.
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`On January 1, 2004, the restrictions imposed by the RSA and EA on petitioners’
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`UMLIC S-Corp. stock lapsed and their shares became fully vested. At this point, the fair
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`market value of the shares held by each petitioner and his respective trust was
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`approximately $45.9 million. But petitioners did not hold these shares for long. On March
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`30, 2004, petitioners entered into identical “surrender” and “subscription” agreements with
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`UMLIC S-Corp. (the “Surrender Transactions”). Pursuant to the Surrender Transactions,
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`7
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`petitioners purported to (1) return the entirety of their newly vested shares to UMLIC S-
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`Corp. and (2) simultaneously repurchase 47,500 identical shares from UMLIC S-Corp. in
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`exchange for a $41.5 million promissory note. On their 2004 income tax returns,
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`petitioners reported $4.5 million in compensation income from this series of transactions,
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`which represented the difference between the fair market value of the new UMLIC S-Corp.
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`shares and the price paid to purchase those shares, i.e., the $41.5 million promissory notes.
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`On June 22, 2004, UMLIC S-Corp. redeemed the 5,000 shares owned by the ESOP
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`at a price of approximately $10.4 million. At that point, UMLIC S-Corp. became entirely
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`owned by petitioners and their trusts. It continued to operate in this manner until the
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`petitioners’ business failed during the 2008 financial crisis.
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`B.
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`The IRS examined petitioners’ income tax returns for the years 2000–2004. In the
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`course of its investigation, the IRS concluded that petitioners had underreported their tax
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`liability and significantly underpaid tax over that five-year period. Consequently, on
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`January 15, 2010, the IRS issued timely notices of deficiency to petitioners. As relevant
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`here, the IRS asserted that: (1) petitioners’ stock in UMLIC S-Corp. was substantially
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`vested upon receipt in 1998, such that petitioners were required to report their pro rata
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`shares of the company’s income each year; and (2) even if the stock did not substantially
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`vest until the RSA restrictions lapsed in January 2004, petitioners should have reported the
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`fair market value of that stock as taxable income in 2004, notwithstanding their purported
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`“surrender” of the shares. The IRS also assessed accuracy-related penalties for negligence
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`and substantial understatement of tax liability for all five years. Petitioners disputed the
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`8
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`IRS’s findings and sought redetermination in the Tax Court. Their case eventually
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`proceeded to trial in 2015.
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`
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`The Tax Court resolved the first issue in petitioners’ favor. Specifically, it held that
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`petitioners’ UMLIC S-Corp. stock remained subject to a substantial risk of forfeiture until
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`the RSA restrictions lapsed. See Austin, T.C. Memo. 2017-69, at *28. And because
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`petitioners’ shares were not substantially vested between 2000–2003, they were not
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`required to report the company’s income on their individual returns during that period.
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`
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`But petitioners did not get off scot-free. The Tax Court agreed with the IRS that
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`“[s]ection 83(a)(1) requires that the [fair market value] of stock be treated as compensation
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`income to the shareholder at the first time the stock becomes substantially vested.” Austin,
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`T.C. Memo. 2017-69, at *38–39 (internal quotation marks omitted). As such, when
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`petitioners’ stock vested on January 1, 2004, they each “received taxable compensation in
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`excess of $45 million at that time” and could not “unring this bell by subsequent actions
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`with respect to the stock, whether that action consisted of sale to a third party or surrender
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`to the corporation.” Id. at *39. Likewise, the Tax Court concluded that both the Surrender
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`Transactions and the promissory notes delivered to UMLIC S-Corp. as part of those
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`Transactions were “palpably lacking in economic substance” and should be disregarded in
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`calculating tax liability. Ibid. This because, according to the Tax Court, the Transactions
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`were undertaken for no purpose other than avoiding tax liability and had no reasonable
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`possibility of generating an economic profit. Id. at *39–41. Thus, the Tax Court held that
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`petitioners each were required to include compensation income of approximately $45.7
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`9
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`million for tax year 2004,2 and it upheld the Commissioner’s decision to impose accuracy
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`penalties for that year. See id. at *44–48.
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`The Tax Court then ordered the parties to file computations under Tax Court Rule
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`155 regarding the exact tax liability owed by petitioners. As relevant here, in filing their
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`computations, petitioners asserted that they had sustained various net operating losses
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`(“NOLs”) in taxable year 2008 and that they had permissibly carried back those losses to
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`taxable year 2003. They further maintained that they should now be permitted to carry
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`those NOLs forward to taxable year 2004 to offset some of the tax liability resulting from
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`the Tax Court’s decision. The Tax Court rejected this argument on the grounds that “[a]n
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`NOL carryback or carryforward claim is a new issue that cannot be raised for the first time
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`in a Rule 155 proceeding.” J.A. 1578.
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`
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`Finally, on August 28, 2018, the Tax Court issued an order setting the Austins’
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`deficiency in 2004 income tax due at $1,665,619, J.A. 1641, and the Kechijians’ at
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`$1,835,130, J.A. 1639. The court also imposed accuracy-related penalties on the Austins
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`in the amount of $333 thousand, J.A. 1642, and on the Kechijians in the amount of $367
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`thousand, J.A. 1640. This appeal followed.
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`2 The Tax Court arrived at this figure by subtracting petitioners’ basis in their
`UMLIC S-Corp. shares, which was $142,566, from the fair market value of those shares
`on January 1, 2004, which was $45,857,434. Austin, T.C. Memo. 2017-69, at *37.
`Because petitioners reported $4.5 million of income on their UMLIC S-Corp. shares in
`2004, the total amount of income that they each failed to report was $41,214,868. Id. at
`*44.
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`
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`10
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`II.
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`
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`Petitioners challenge two aspects of the Tax Court’s decision: (1) that the court erred
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`in holding that petitioners each realized and were required to report $45.7 million of taxable
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`income when their UMLIC S-Corp. stock substantially vested in taxable year 2004 and (2)
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`that the court erred in upholding the accuracy-related penalties imposed by the
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`Commissioner.
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`We review the Tax Court’s decisions “on the same basis as decisions in civil bench
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`trials in United States district courts,” that is “[q]uestions of law are reviewed de novo, and
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`findings of fact for clear error.” Baxter v. Comm’r, 910 F.3d 150, 156 (4th Cir. 2018).
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`A.
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`
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`Petitioners argue that they were not required to report the $45.7 million in gain that
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`they realized when their UMLIC S-Corp. shares vested. In reaching its contrary holding,
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`the Tax Court noted that a taxpayer realizes compensation income “at the first time” that
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`restricted stock transferred pursuant to I.R.C. § 83 becomes substantially vested, which, in
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`this case, occurred on January 1, 2004. Austin v. Comm’r, T.C. Memo. 2017-69, at *39–
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`40 (2017); see also 26 U.S.C. § 83(a)(1). Petitioners do not seriously contest this point.
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`See Petitioners’ Opening Br. 15 (acknowledging that petitioners “were in constructive
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`receipt of compensation income on January 1, 2004 when [their shares] became available
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`to them without substantial restrictions”). Instead, they maintain that the subsequent
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`Surrender Transactions effectively negated or reversed their receipt of this compensation,
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`such that they were not required to include it in their gross income. For the reasons that
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`follow, we disagree.
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`11
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`1.
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`
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`It is a well-settled principle of tax law that compensation is included in the taxable
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`income of the person who earned it, notwithstanding any assignment or transfer of that
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`compensation to a third party. See Lucas v. Earl, 281 U.S. 111, 114–15 (1930). Thus, the
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`mere fact that petitioners purported to return their vested shares back to UMLIC S-Corp.
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`has no effect on their individual tax liability. Likely aware of this fundamental rule,
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`petitioners advance a slightly different argument premised on the tax rescission doctrine.3
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`Specifically, they maintain that the Surrender Transactions effectuated a complete
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`rescission of their contractual agreements with UMLIC S-Corp., and because that
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`rescission occurred in the same year as petitioners’ receipt of compensation income under
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`those agreements, that income should be disregarded for federal income tax purposes.
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`We do not see it. The Surrender Transactions did not restore petitioners “to the
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`relative positions that they would have occupied had no contract been made,” which is a
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`fundamental requirement for application of the rescission doctrine. Rev. Rul. 80-58, 1980-
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`1 C.B. 181, 181; Hutcheson v. Comm’r, 71 T.C.M. (CCH) 2425, at *4 (1996) (“For the
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`rescission to be effective, both buyer and seller must be put back in their original
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`positions.”); see also Reeves v. United States, 173 F. Supp. 779, 781 (M.D. Ala. 1959). Put
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`simply, if you can’t restore, you can’t rescind. The contracts at issue here were for personal
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`services, namely the five years of services performed by petitioners on behalf of UMLIC
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`3 The parties dispute whether petitioners have waived any argument based on the
`rescission doctrine. We need not resolve this question because, as discussed below, we find
`that petitioners’ rescission arguments are unavailing even if properly presented.
`12
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`S-Corp. When a personal services contract has actually been performed, it is essentially
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`impossible for the individual who rendered the services to be “returned” to his position ex
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`ante. See Jasper L. Cummings, Circular Cash Flows and the Federal Income Tax, 64 Tax
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`Law. 535, 602 (2011) (noting that “compensation arrangements are not well suited” to
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`analysis under the tax rescission doctrine “because the employee cannot usually give back
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`his or her performance”). What is more, as part of the underlying contracts, petitioners
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`transferred the entirety of their interests in the UMLIC entities to UMLIC S-Corp., but they
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`did not receive those assets back in the Surrender Transactions. See J.A. 1109–11. As
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`such, the Surrender Transactions are completely unlike the prototypical instance of
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`rescission, in which all property that changes hands is returned to its original owner. See
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`Rev. Rul. 80-58, 1980-1 C.B. 181.
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`In attempting to fit the square peg of the Surrender Transactions into the round hole
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`of the rescission doctrine, petitioners point to a line of authorities suggesting that
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`compensation is not taxable to an employee if returned to his employer in the year it was
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`received. See, e.g., Russel v. Comm’r, 35 B.T.A. 602 (1937). But those precedents are
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`inapposite here. As the Tax Court has clarified, they stand only for the limited proposition
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`that returned compensation may not be taxable income where “the original salary
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`agreements . . . [were] subject to modification by the taxpayers and their employers and
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`not absolute.” Jones v. Comm’r, 82 T.C. 586, 591 (1984). There is no indication that
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`petitioners’ compensation agreements with UMLIC S-Corp. were open-ended in the sense
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`contemplated by those cases, and petitioners’ belated attempt to modify those agreements
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`via the Surrender Transactions could not affect their tax liability. See Leicht v. Comm’r,
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`13
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`137 F.2d 433, 435 (8th Cir. 1943) (“[I]t is not given to a taxpayer to lift the federal tax-
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`hand from income, which he has once received in absolute right, by an attempt thereafter
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`to alter its legal status through modification of the agreement out of which it arose.”).
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`2.
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`In any event, even if the Surrender Transactions could somehow be seen as
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`rescinding petitioners’ employment and compensation agreements with UMLIC S-Corp.,
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`we agree with the Tax Court’s conclusion that those transactions were totally devoid of
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`economic substance and must be disregarded for federal income tax purposes.
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`
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`The economic substance doctrine effectuates the Supreme Court’s command that
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`the tax effect of a transaction should be based on “the objective economic realities of [the]
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`transaction rather than . . . the particular form the parties employed.” Frank Lyon Co. v.
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`United States, 435 U.S. 561, 573 (1978). The doctrine permits the IRS to “ignore for tax
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`purposes any sham transaction, i.e., a transaction designed to create tax benefits rather than
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`to serve a legitimate business purpose.” Hines v. United States, 912 F.2d 736, 739 (4th
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`Cir. 1990). We employ a two-prong test to determine if a given transaction should be
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`disregarded pursuant to the doctrine. “To treat a transaction as a sham, the court must find
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`[1] that the taxpayer was motivated by no business purposes other than obtaining tax
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`benefits in entering the transaction, and [2] that the transaction has no economic substance
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`because no reasonable possibility of profit exists.” Rice’s Toyota World, Inc. v. Comm’r,
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`752 F.2d 89, 91 (4th Cir. 1985). The first prong of the test is subjective, and the second is
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`objective; nevertheless, while we “examine both the subjective motivations of the taxpayer
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`and the objective reasonableness of the investment, in both instances our inquiry is directed
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`14
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`
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`to the same question: whether the transaction contained economic substance aside from the
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`tax consequences.” Black & Decker Corp. v. United States, 436 F.3d 431, 441 (4th Cir.
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`2006) (internal quotation marks omitted). Whether a particular transaction was a sham is
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`a question of fact that we review only for clear error. Rice’s Toyota World, Inc., 752 F.2d
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`at 92.
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`Application of the foregoing principles to the instant case reveals that the Surrender
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`Transactions were indeed nothing more than a sham to avoid tax liability and were rightly
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`disregarded by the Tax Court.
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`Petitioners’ own admissions satisfy the first prong of the economic substance test.
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`At trial, petitioners proffered only one business purpose for the Surrender Transactions—
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`relieving UMLIC S-Corp. from the burden of withholding and paying payroll and
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`employment taxes attributable to the $92 million of compensation income realized by
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`petitioners when their restricted stock vested. See J.A. 1295–96. But as the Tax Court
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`noted, “[t]hat is in itself a tax-avoidance purpose,” and “by admitting that [they] sought to
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`avoid payment of employment taxes, [petitioners] in effect admitted that they sought to
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`avoid payment of income taxes, because the former would not be payable unless the latter
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`were payable also.” Austin, T.C. Memo. 2017-69, at *40–41.
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`Surprisingly, petitioners double down on their position in this appeal. They
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`candidly acknowledge that the only reason they executed the Surrender Transactions was
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`to enable UMLIC S-Corp. to avoid withholding and remitting approximately $33 million
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`in state and federal payroll and income taxes. Petitioners maintain that this course of action
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`was necessary to ensure UMLIC S-Corp.’s continued viability as a going concern. This is
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`15
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`
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`because, according to petitioners, UMLIC S-Corp. did not have enough cash on hand to
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`cover its tax withholding obligations, an assertion that the Tax Court found to be
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`unsupported by the evidence at trial. See Austin, T.C. Memo. 2017-69, at *40 n.13. But
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`even if that were true, it does nothing to change the fact that the sole purpose for the
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`Surrender Transactions was the avoidance of tax obligations, both those of UMLIC S-Corp.
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`and, by extension, those of petitioners. Under our case law, that is enough to satisfy the
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`first prong of the economic substance test. See Friedman v. Comm’r, 869 F.2d 785, 792
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`(4th Cir. 1989) (noting that the first prong “requires a showing that the only purpose for
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`entering into the transaction was the tax consequences”).
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`
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`The second prong of the economic substance test is likewise met here. As the Tax
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`Court found, it is inconceivable that either petitioner “could envision a reasonable
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`possibility of profit by surrendering, for no consideration, stock worth $45.8 million.”
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`Austin, T.C. Memo. 2017-69, at *41. The fact that petitioners each gave UMLIC S-Corp.
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`a $41.5 million promissory note as part of the Surrender Transactions only bolsters this
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`conclusion, as “no rational person would incur indebtedness of $41.5 million to acquire
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`stock that he already owned free and clear.” Ibid. On the record before us, we cannot say
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`that these findings were anything but sound.
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`
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`Petitioners’ final argument regarding economic substance is based on the
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`promissory notes that they conveyed in exchange for the newly issued UMLIC S-Corp.
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`stock. On petitioners’ telling, because those notes constituted recourse debt, they had
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`independent economic substance such that their value should have been added to
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`petitioners’ basis in their UMLIC S-Corp. shares. This basis increase would have caused
`
`
`
`16
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`
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`them to realize only $4.2 million in taxable income when those shares vested, rather than
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`the $45.7 million found by the Tax Court.
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`Again, we must disagree. For starters, we concur with the Tax Court’s finding that
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`that the notes lacked economic substance and should be disregarded for tax purposes
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`because they were issued by petitioners to a company owned and controlled by petitioners.
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`In other words, petitioners effectively issued the notes to themselves. See Austin, T.C.
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`Memo. 2017-69, at *41. But there is an additional problem with their argument. As
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`petitioners themselves point out, the notes were “used to purchase stock in UMLIC.”
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`Petitioners’ Reply Br. 11 (emphasis added). Thus, even if the notes had economic
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`substance, their value would be included in petitioners’ basis for the new UMLIC stock
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`that they purchased in March 2004, not the original UMLIC stock that they acquired in
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`1998. See 26 U.S.C. § 1012(a) (defining “basis of property” as “the cost of such property”).
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`Thus, the notes could not possibly offset any of the taxable income petitioners realized
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`when the original shares vested in January 2004.
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`B.
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`Petitioners also take issue with the Tax Court’s decision affirming the
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`Commissioner’s imposition of accuracy-related penalties.
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`I.R.C. § 6662 provides for the imposition of a 20% penalty on “any portion of an
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`underpayment of tax” that is attributable to, inter alia, “[n]egligence or disregard of rules
`
`or regulations” or “[a]ny substantial understatement of income tax.” 26 U.S.C. § 6662(a),
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`(b)(1), (b)(2). But “[n]o penalty shall be imposed under section 6662 . . . with respect to
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`any portion of an underpayment if it is shown that there was a reasonable cause for such
`
`
`
`17
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`
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`portion and that the taxpayer acted in good faith with respect to such portion.” 26 U.S.C.
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`§ 6664(c)(1). In determining whether a taxpayer acted with reasonable cause and good
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`faith, we consider “all the pertinent facts and circumstances,” but “[g]enerally the most
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`important factor is the extent of the taxpayer’s effort to assess [his] proper tax liability.”
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`Treas. Reg. § 1.6664-4(b)(1). Whether a taxpayer acted with reasonable cause and in good
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`faith is a question of fact, thus we review the Tax Court’s findings on this score only for
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`clear error. Baxter, 910 F.3d at 165 (citing Antonides v. Comm’r, 893 F.2d 656, 659 (4th
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`Cir. 1990)).
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`The Tax Court held that each petitioner’s failure to report $41.2 million of income
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`on his UMLIC S-Corp. stock was attributable to negligence and amounted to a substantial
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`understatement of tax. Austin, T.C. Memo. 2017-69, at *45. Petitioners do not contest this
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`conclusion. Rather, they maintain that they should not have been subject to accuracy-
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`related penalties because they had reasonable cause for the tax position they took with
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`respect to the Surrender Transactions, they acted in good faith, and the issues presented in
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`this case are novel.
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`We disagree. For starters, as the Tax Court pointed out, petitioners have presented
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`neither evidence nor legal authority to suggest that they made any effort to accurately
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`assess their 2004 tax liability. See Austin, T.C. Memo. 2017-69, at *46–47. They did not
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`obtain or rely on the opinion of a tax professional in adopting their position regarding the
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`tax effect of the Surrender Transactions. Moreover, petitioners structured the Transactions
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`with the specific purpose of evading tax liability on the compensation income that even
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`petitioners admit they realized at the moment their shares substantially vested. And they
`
`
`
`18
`
`
`
`can point to no legal authority suggesting that the Surrender Transactions were anything
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`other than a sham designed to avoid taxes that should be disregarded. In sum, we agree
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`with the Tax Court’s finding that “[p]etitioners’ overall conduct shows that they were fully
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`aware of the tax consequences of their stock’s becoming substantially vested,” and their
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`efforts to escape that liability did not rest on an “honest misunderstanding of fact or law
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`that was reasonable under all the circumstances.” Austin, T.C. Memo. 2017-69, at *47
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`(internal quotation marks omitted). As such, petitioners have failed to establish a defense
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`of reasonable cause and good faith.
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`
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`Petitioners’ argument that the tax law issues in this case are novel does nothing to
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`change our conclusion. For one thing, we have never recognized novelty as a stand-alone
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`defense to the imposition of accuracy-related penalties. See Baxter, 910 F.3d at 168. More
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`importantly, there is nothing novel about the legal issues presented by or doctrines applied
`
`in this case. That the law prohibits a taxpayer from avoiding tax liability by means of a
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`sham transaction is a rule almost as old as the federal income tax system. See, e.g., Gregory
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`v. Helvering, 293 U.S. 465, 468–70 (1935); see also Baxter, 910 F.3d at 168 (rejecting a
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`similar novelty argument on the grounds that “it [is] well-established that transactions
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`lacking economic substance must be disregarded for tax purposes”). There is no reason
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`that petitioners, sophisticated businessmen who were clearly cognizant of the tax
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`consequences of their actions, could have reasonably expected that the Surrender
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`Transactions would be exempted from this longstanding rule. See Treas. Reg. § 1.6664-
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`4(b)(1) (noting that “the experience, knowledge, and education of the tax
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