Venture Capitalist Argues Against Liability for Taxes, Penalties

The evidence in the case consists of a First Stipulation of Facts, a First Supplemental Stipulation of Facts, and a Second Supplemental Stipulation of Facts, with attendant exhibits; additional exhibits introduced during trial; and the testimony of witnesses. In this brief, the Stipulation of Facts, trial exhibits, and trial transcripts will be cited as "First Stip.", "Ex.", and "Tr.", respectively.

Following the trial, the Court ordered that the parties file opening briefs on or before October 8, 2013, and reply briefs on or before December 6, 2013. Due to the federal government shutdown from October 1, 2013 through October 16, these dates were extended to November 8, 2013 for the opening briefs and January 14, 2014 for the reply briefs.

2. Although not mentioned in the Notice, respondent also has argued that petitioner is subject to taxation on income from the assets of Boiler Riffle under the investor control doctrine first articulated in Rev. Rul. 77-85.

3. In addition, the Notice alleges that petitioner is liable for a 20 percent penalty under I.R.C. § 6662 on the grounds that any alleged underpayment of tax is attributable to negligence or disregard of the rules and regulations, and/or a substantial understatement of income tax. Petitioner denies that there is any underpayment, negligence, or understatement of tax, and denies that he is liable for the penalties asserted in the Notice.

4. Further, petitioner has raised the issue of whether the burden of proof should be shifted to respondent pursuant to I.R.C. § 7491.

1. Petitioner is Jeffrey T. Webber, an individual, calendar-year taxpayer (hereinafter "petitioner"). First Stip. at ¶ 1.

2. Petitioner timely filed his Federal income tax returns for 2006 and 2007, the tax years at issue in this case. First Stip. at ¶¶ 7-8; Exs. 1-J, 2-J.

3. Respondent timely mailed the Notice to petitioner relating to the 2006 and 2007 tax years on March 22, 2011. First Stip. at ¶ 9; Ex. 3-J.

A. Petitioner's Background and Expertise in Private Equity

4. Petitioner received his bachelor's degree from Yale University and attended (but did not complete) Stanford University's MBA program. Petitioner dropped out of business school to start his own technology consulting firm, which he later sold at a profit. Tr. at 442, 444.

5. In 1977, petitioner went to work for the strategic planning team of McKinsey & Company. Tr. at 596-97.

6. After leaving McKinsey, between 1980 and 2003, petitioner served as the founding partner of New Venture Consultants, Inc., and then R.B. Webber & Company, which provided strategic planning consulting services to technology companies. Tr. at 376.

7. Petitioner, a venture capitalist well-known for his expertise in strategic planning and technology, is the founder and manager of a series of private equity funds that specialize in providing "seed capital" to start-up technology companies. First Stip. at ¶ 3; Tr. at 444-45, 446-47, 494, 574-75, 596-97.

8. Specifically, petitioner founded five venture capital funds, The Entrepreneurs Fund ("TEF I"), The Entrepreneurs Fund II ("TEF II"), the Entrepreneurs Fund III ("TEF III"), the Entrepreneurs Fund IV ("TEF IV"), and The Entrepreneurs Growth Fund ("TEGF") (the "venture capital funds"). First Stip. at ¶ 2; Exs. 85-J, 86-J, 87-J, 88-J; Tr. at 447, 575-75.

9. Each of these venture capital funds has a general partner, which is a partnership, and petitioner is the managing director of that partnership. First Stip. at ¶ 2; Tr. at 448, 451.

10. Petitioner and his venture capital funds invest primarily in technology companies because that is petitioner's area of expertise. Tr. at 446-47, 456.

11. During the past ten years, petitioner's venture capital funds have outperformed the industry by 400-500%. Tr. at 450.

12. Petitioner and his venture capital funds frequently invest through syndicates, i.e., a group of investors, who can be individuals or funds, in order to spread the risk of investing in new companies. Tr. at 172-73, 203-206, 208, 201-11, 445-56, 542.

13. A syndicate partnership is not a formal legal partnership, but merely a group of investors in a company. Tr. at 624-26.

14. Petitioner has served on over one hundred boards of directors, Tr. at 454, including the following entities: Accept Software (October 2005-October 2012); Attensity Corp. (December 2002-August 2003); Borderware Technologies, Inc. (July 2004-July 2009); JackNyfe, Inc. (October 2007-present); Lignup Inc. (September 2004-late 2008); Nextalk Inc. (July 2007-present); Prevarex Inc. (December 2007-June 2009); PTRx Media LLC (July 2005-August 2011); Soasta Inc. (March 2006-present); Techtribenetworks Inc. (approximately January 2006-March 2009); Vizible Corporation (January 2003-March 2009); Webify Solutions (October 2002-August 2006). First Stip. at ¶ 150.

15. Prior to December 31, 2007, petitioner either directly invested in or was a partner in a partnership that invested in the following companies: Accept Software, Attensity Corp., Borderware Technologies, Inc., DTL Plum Investments, LLC, JackNyfe Inc., Lignup Inc., Links Mark Multimedia, Inc., Lunamira Inc., Milphworld Inc., Nextalk Inc., Prevarex Inc., Promoter Neurosciences LLC, PTRx Inc., Push Media LLC, RJ Research Inc., Reactrix Systems, Inc., Renaissance 2.0 Media, Inc., Signature Investments RBN, Soasta Inc., Techtribenetworks, Inc., Vizible Corporation, Weldunn Restaurant Group, Inc., Medstory, Inc., and Webify Solutions. First Stip. at ¶¶ 115-138.

16. Prior to December 31, 2007, petitioner's IRA invested in the following companies: Accept Software, Lignup Inc., Weldunn Restaurant Group Inc., Vizible Corporation, Soasta, Inc., PTRx Inc., and Borderware Technologies, Inc. First Stip. at ¶¶ 139-146.

17. Petitioner has two children, who in 1999, were five years old and two years old. Also, in 1999, petitioner was married. Tr. at 457-58.

18. In 1999, petitioner had a net worth in excess of $20 million, and his wife was privately wealthy. Tr. at 62-64.

19. William D. Lipkind was and is petitioner's trusts and estate and general tax attorney. First Stip. at ¶ 13.

20. Petitioner also had another estate and tax attorney, David Herbst, who prepared petitioner's will and assisted him with a standard life insurance policy. Tr. at 458.

B. The Trusts

21. Petitioner established a series of three grantor trusts for the benefit of his minor children: The Jeffrey T. Webber 1999 Alaska Trust (the "Alaska Trust"), The Chalk Hill Trust (the "Chalk Hill Trust"), and The Jeffrey T. Webber Delaware Trust (the "Delaware Trust") (collectively, the "Trusts"). Exs. 5-J, 40-J, 44-J; Tr. at 53, 61-62, 461, 607.

22. The Trusts were estate planning tools, i.e., the intent was that the assets held in trust would not be included in petitioner's gross estate when he died. Tr. 56.

23. The Trusts were grantor trusts and irrevocable life insurance trusts, both common estate-planning vehicles. Tr. at 55-56, 60-61.

24. Mr. Lipkind and other members of his firm drafted the Trust documents, and petitioner worked with Mr. Lipkind and his staff to assign beneficiaries. Tr. at 463, 683-85.

25. Mr. Lipkind recommended that petitioner be a discretionary beneficiary of the Trusts in order to achieve grantor trust status. Tr. at 59, 722-24.

26. There was no intention for there to be any distributions to petitioner from the Trusts, and the only reason that he was named as a discretionary beneficiary was to secure grantor trust status. Tr. at 62, 723-24.

27. Although petitioner was listed as a discretionary beneficiary, the Trustee could only make a distribution to petitioner if deemed necessary after considering petitioner's income and other assets. Ex. 5-J (JTW0022836); Tr. at 62.

28. Mr. Lipkind advised petitioner that although he was listed as a discretionary beneficiary, he should not expect to receive any distributions from the Trusts, and that because the Trusts were irrevocable, he could not get back any contributions that he might make. Tr. at 62, 64, 481, 487-88.

29. Petitioner has never requested or received any distributions from the Trusts. Tr. at 65, 74, 76, 483.

30. On March 24, 1999, petitioner established the Alaska Trust, a grantor trust for federal income tax purposes. First Stip. at ¶¶ 20, 21; Ex. 5-J; Tr. at 62.

31. The Trustees and the Independent Trustees of the Alaska Trust were Mr. Lipkind and the Alaska Trust Company, and the beneficiaries were petitioner's children, petitioner's brother, and petitioner's brother's children. First Stip. at ¶¶ 22, 23, 24; Ex. 5-J (JTW 0022824, 2286, 2287).

32. Alaska Trusts are common in estate planning, and Mr. Lipkind recommended that petitioner form the Alaska Trust because Alaska permitted self-settled spendthrift trusts, and Mr. Lipkind wanted the Trust to be a grantor trust. Tr. at 58-60.

33. Mr. Lipkind also recommended Alaska as the situs of the Trust because Alaska did not have income tax, and he was concerned that if the trust was formed in California, where petitioner resided, the income would be subject to state income tax, and the trust would be taxed upon petitioner's death. Tr. at 60.

34. In 1999, petitioner contributed $700,000 to the Alaska Trust, which the Trustee of the Alaska Trust, for the benefit of the Trust, used to purchase two "Flexible Premium Restricted Lifetime Benefit Variable Life Insurance Policies," Policy 99-47 and Policy 99-048 (the "Policies."). First Stip. at ¶ 37; Exs. 15-J, 82-J (JTW0022893, 22890); Tr. at 66, 465, 468.

35. Petitioner timely filed a gift tax return reporting the $700,000 gift that he made to the Alaska Trust to purchase the Policies. Ex. 82-J (JTW0022893, 22890); Tr. at 81-82, 466.

36. On September 2, 2003, the Trustees of the Alaska Trust established the Chalk Hill Trust, a foreign grantor trust. First Stip. at ¶ 79; Ex. 40-J.

37. Petitioner was the grantor of the Chalk Hill Trust, the Trustee was Oceanic Bank and Trust Limited, the United States Protector was William D. Lipkind, and the Foreign Protector was The Overseas Oversight Group LLC Isle of Man. First Stip. at ¶¶ 82-88; Ex. 40-J.

38. On October 9, 2003, the Alaska Trust assigned the Trust assets, including the Policies, to the Chalk Hill Trust. First Stip. at ¶¶ 79-81; Exs. 41-J, 42-J; Tr. at 75.

39. Petitioner transferred the Policies to the Chalk Hill Trust because he wanted additional credit protection for the Trust for the benefit of his children. Tr. at 70-71.

40. Petitioner was concerned about credit protection in 2003 because his company, R.B. Webber, was going out of business after petitioner personally guaranteed an expensive lease for it. Petitioner also was concerned that unhappy investors would sue him personally to recover their losses after the "dot-com bubble" had burst. Also during this time period, petitioner was in the process of getting a divorce, and was suffering from clinical depression. Tr. at 70-71, 476.

41. Petitioner did not move any of his personal assets offshore, but only requested that the Trustees transfer the Trust assets that were for the benefit of his children. Tr. at 72, 477-78.

42. Mr. Lipkind advised petitioner that he did not think it was necessary to move the trust assets offshore for credit protection, it would be more expensive to do so, and there were tax disadvantages to the Trust because upon petitioner's death, there would be a taxable event that would not occur if the Trust was a domestic trust. Tr. at 73-74, 479.

43. Nevertheless, because petitioner was concerned about protecting the Trust from creditors, he requested that the Trust assets be transferred offshore. Tr. at 74.

44. Petitioner filed a timely Form 3520 Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts reporting the Chalk Hill Trust to the Service. First Stip. at ¶ 89; Ex. 43-J; Tr. at 479.

45. On February 14, 2008, the Trustee of the Chalk Hill Trust established the Delaware Trust. First Stip. at ¶ 90; Ex. 44-J.

46. As soon as petitioner believed that the credit risks had passed, the Trust assets, including the Policies, were transferred back to the United States to the Delaware Trust. First Stip. at ¶¶ 90-91; Ex. 45-J; Tr. at 75, 77, 480.

47. Petitioner was the grantor of the Delaware Trust, the Trustee was Christiana Bank and Trust Company, the Investment Advisor was William Lipkind, and the beneficiaries were the petitioner's children. First Stip. at ¶¶ 92-94; Ex. 45-J.

48. On March 6, 2008, the Chalk Hill Trust assigned the Policies to the Delaware Trust. First Stip. at ¶¶ 90-91; Ex. 45-J; Tr. at 77.

C. The 1999 Transfers of Stock to the Alaska Trust

49. One of the objects of the estate plan formulated by Mr. Lipkind was to get as many assets into the Trust as possible, particularly, assets with a current low value but which had the potential to explode in value. Tr. at 83-84, 475.

50. Accordingly, on the advice of Mr. Lipkind, after the Policies were issued, petitioner sold his shares of stock in three companies (Commerce One, Persistence, and Sagent) to the 1999 Fund and the 1999 Second Fund, Bahamian entities owned by Lighthouse Capital Insurance in support of the Policies. Tr. at 84, 85-86, 88-89, 108, 470-71, 475.

51. The purchase price of the stock was the fair market value at the time of the transaction, and this price was substantially confirmed by an appraisal at a later date. Tr. 91-92, 471.

52. Petitioner protectively disclosed the sale of the stock on his 1999 gift tax return, Ex. 82-J (JTW00022900); Tr. at 95, 471-72, and the Service has never challenged the purchase price of the stock, Tr. at 96.

53. After purchasing the stock from petitioner, the Lighthouse entities sold the shares at a profit, and used the proceeds to make other investments. Tr. at 97.

D. Lighthouse Capital Insurance Company

54. Lighthouse Capital Insurance Company ("Lighthouse") is a Cayman Islands Class B Unlimited life insurance company established on November 19, 1996 and is licensed and regulated by the Cayman Islands Monetary Authority. Exs. 6-J, 7-J, 38-J.

55. Lighthouse is licensed under Cayman Islands law to issue variable life insurance and variable annuity policies. First Stip. at ¶ 25; Exs. 6-J, 7-J, 8-J; Tr. at 269-70.

56. Lighthouse was originally formed to be a subsidiary of the Bank of Bermuda, but the bank went through structural changes and the project was never completed. Instead, Colin Muirhead an executive at Bank of Bermuda, left the bank and founded Lighthouse on his own. Subsequently, Mr. Muirhead sold approximately fifty-percent of his interests in Lighthouse to a subsidiary of a large Dutch global private bank and to Fortis, one of the world's largest global insurance conglomerates. Ex. 8-J (JTW0018021-25); Tr. at 253-55.

57. Petitioner has no direct or indirect ownership interest in Lighthouse. Exs. 8-J (JTW0018021-25), 83-J (JTW0018576).

58. Lighthouse issues variable life insurance and annuity policies on a global basis, and, as of 2011, had over $1 billion of in-force insurance and annuity policies. Ex. 8-J.

59. Lighthouse is managed by Aon Insurance Managers, which is a wholly-owned subsidiary of Aon, PLC. Aon, PLC is a United Kingdom company with headquarters in London, and it has an employee base of over 65,000 people, working at over 500 offices, in more than 120 countries. Ex. 9-J.

60. Aon PLC is responsible for Lighthouse's day-to-day operations, recordkeeping, compliance, annual audits, and reviews by the Cayman Monetary Authority and Cayman Island Insurance Commissioner. Ex. 8-J; Tr. at 267-68.

61. Lighthouse has received annual certificates of good standing from the Cayman Island Monetary Authority which is necessary for having an insurance license, and requires a full annual review. First Stip. at ¶¶ 30, 31; Exs. 7-J (JTW0018020), 10-J, 11-J, 12-J; Tr. at 268.

62. Lighthouse's financial statements are audited on a regular basis, as required by Cayman law. Tr. at 270.

63. Since 1999, KPMG has been Lighthouse's outside auditor. First Stip. at ¶ 35; Exs. 8-J, 10-J, 11-J, 13-J (P000441-451); Tr. at 270.

64. Lighthouse reinsures mortality risk with Hannover Reckversicherungs-AG ("Hannover Re"), one of the top reinsurers in the world in terms of size, capacity, and expertise with an annual gross premium of approximately €13.8 Billion. First Stip. at ¶ 36; Exs. 8-J, 14-J, 20-J, 22-J, 23-J; Tr. at 270-71, 314-15.

65. Reinsurance is common in the life insurance industry, and Lighthouse reinsures most of its mortality risk in order to spread the risk through a large pool. Tr. at 315, 438.

66. Lighthouse generally reinsures all but approximately $10,000 of risk, and reinsures virtually all risk for elderly insured. Even where it reinsures mortality risk, Lighthouse remains primarily liable to the policyholder. Tr. at 315, 435, 438.

67. Lighthouse hired the independent actuarial firm of Avon Consulting Group ("Avon"), a United States licensed consulting actuary to provide written determinations regarding Lighthouse's compliance with I.R.C. §§ 7702 and 7702A. Tr. at 322-23; Ex. 16-J.

68. James A. Walker, Jr., formerly a partner at Powell Goldstein Frazer & Murphy in Atlanta, Georgia, and now at Walker & Associates, Tr. at 245, is outside general counsel for Lighthouse, along with Brian T. Casey from Locke Lord, LLP and Maples and Calder in Cayman Islands. Tr. at 251.

69. In 1999, Lighthouse issued approximately 75-100 life insurance policies. Tr. at 288-89.

70. From 2006-2007, Lighthouse had approximately 200 life insurance policies in force. Tr. at 377-78.

71. The global premiums paid to Lighthouse in 1999 were between $50 to $75 million and the total outstanding face value of its policies was between $250 to $300 million. Tr. at 305.

72. Before issuing a policy, Lighthouse conducts detailed underwriting analysis, including conducting medical tests and collecting financial data to determine the insurance capacity of the potential insured. Tr. at 298.

73. Where the policyholder is not the insured, Lighthouse performs due diligence regarding the source of funds and the structure of any entities, and requires that there be an appropriate insurable interest, such as a familial or business relationship with the policyholder. Tr. at 299.

74. Mr. Lipkind introduced petitioner to Lighthouse, and petitioner had no relationship with Lighthouse other than that the Trusts, of which he was the grantor, purchased and maintained the Policies. Tr. at 84, 485, 609.

75. Mr. Lipkind recommended Lighthouse to petitioner after conducting due diligence about the company and learning that Lighthouse's general counsel was in the United States, it had certified financials, was managed by Aon, and had its primary reinsurance treaty with Hannover Re. Ex. 21-J; Tr. at 85-86.

E. The Lighthouse Policies

76. As noted above, on Mr. Lipkind's recommendation, the Trustee of the Alaska Trust, for the benefit of the Trust, purchased two "Flexible Premium Restricted Lifetime Benefit Variable Life Insurance Policies," Policy 99-047 and Policy 99-48 (the "Policies"). First Stip. at ¶ 37; Ex. 15-J; Tr. at 66, 77, 468.

77. The Policies were "life insurance contracts" within the meaning of I.R.C. § 7702 and were compliant with I.R.C. § 7702A. Ex. 16-J; Tr. 77, 274, 301, 305-07, 310, 322-26, 331.

78. The Alaska Trust paid $735,046 in aggregate premiums for the two Policies. First Stip. at ¶ 40; Ex. 18-J (P000390-395).

79. The $735,046 in aggregate premiums paid to Lighthouse for the two Policies represented less than 1% of the insurance premiums received by Lighthouse with respect to pure mortality risk. Tr. at 305.

80. Policy 99-047 insured the life of Mabel Jordan, who was 78 years old at the time the policy was issued in 1999. First Stip. at ¶ 46; Tr. at 468.

81. Mabel Jordan was petitioner's now ex-wife's step-grandmother. First Stip. at ¶ 46; Tr. at 468. Petitioner chose her as an insured because he wanted one of the insured to be on his wife's side of the family. Tr. at 468-69.

82. Ms. Jordan died on November 23, 2012, at age 92. First Stip. at ¶ 46; Tr. at 67, 470.

83. The policy insuring Ms. Jordan had a minimum guaranteed death benefit of $2,720,000. Exs. 15-J (JTW0018071), 16-J (P000452); Tr. at 304, 306.

84. Policy 99-048 insured the life of Olette Sublette, petitioner's aunt, who is still alive. First Stip. at ¶ 47; Tr. at 68, 470. Ms. Sublette was 77 years old when the Trust purchased the Policy. First Stip. at ¶ 47.

85. The Policy insuring Ms. Sublette had a minimum guaranteed death benefit of $2,720,000. Exs. 15-J (JTW0018083), 16-J (P000456); Tr. at 301, 306.

86. Lighthouse conducted a detailed underwriting process with respect to the issuance of the Policies. Exs. 19-J (see policy applications), 20-J. The Policies' underwriting documents were subsequently reviewed and approved by Hannover Re. Ex. 20-J; Tr. at 297.

87. The face values of the Policies, the $2.720,000 each for Ms. Jordan and Ms. Sublette, was a guaranteed minimum death benefit, which would be payable no matter how the segregated accounts performed, as long as the Policies were in force. Ex. 15-J (JTW0018067, 180671, 180679, 180683); Tr. at 304, 327-28, 438-40.

88. If the investments in the segregated accounts performed well, the death benefit would be the larger of the value of the assets in the segregated accounts or the guaranteed minimum death benefit. Ex. 15-J (JTW0018067, 180671, 180679, 180683); Tr. at 438-40.

89. The Policies permitted the policyholder to add additional premiums to the Policies up to $350,000 per year for five years. Ex. 15-J (JTW00018064, 00018071, JTW00018083); Tr. at 306.

90. With variable universal policies, such as the Policies here, the policyholder has the choice of how much premium to pay and when to make the payment, up to the annual and aggregate limits imposed by the Internal Revenue Code. Tr. at 307.

91. The Policies require that Lighthouse establish a "Separate Account" pursuant to Section 7(6)(c) of the Cayman Islands Insurance Law of 1979 to reserve for and fund benefits provided for under the Policies. The Separate Account is comprised of all Policy reserve assets. First Stip. at ¶ 51.

92. All premiums, reduced by Lighthouse charges, are deposited into the Separate Account. Ex. 15-J (JTW0018064-66, 180876-79).

93. Lighthouse is the owner of all Separate Account assets. Ex. 15-J (JTW0018065, 18077).

94. The Lighthouse policyholder has no legal, equitable, direct, indirect, or other interest in any investment items held in or belonging to the Separate Account. Id.

95. The Lighthouse policyholder has no voting rights with respect to the Separate Account or any assets held therein. Id.

96. The Policies define "Separate Account Value" as the sum of the fair market value of the assets belonging to the Separate Account. Ex. 15-J (JTW0018063, 18075).

97. The Policies define "Account Value" as equal to "the sum of the Separate Account Value and the Loan Account Balance." Ex. 15-J (JTW0018063, 18075).

98. The Policies define "Cash Value" as the "Cash Surrender Value." "Cash Surrender Value" is defined as equal to "the lesser of (i) the Account Value, or (ii) the sum of the Premiums paid under the Policy less the value all prior partial surrenders made from the Policy." Ex. 15-J (JTW00018063, 18075).

99. The total Cash Surrender Value of both Policies is $385,046, the total of premiums paid. Exs. 18-J, 24-J (P 000365-66, P000368-69). Thus the Trusts could not borrow from Lighthouse an amount exceeding the Policies' aggregate Cash Surrender Value of $385,046. Ex. 15-J (JTW 0018069, 18081).

100. The Policies may be surrendered at any time, but the maximum amount payable upon surrender is the Cash Surrender Value, reduced by existing loan balance. Ex. 15-J (JTW 0018069, 18081).

101. The Policies' maximum surrender value was the aggregate Cash Surrender Value of $385,046, and the only way to increase the Cash Surrender Value was for the policyholder to make additional premium payments. Ex. 15-J (JTW 0018069, 18081); Tr. at 317-18.

102. The Policies were restricted "Type III" policies because the Cash Surrender Value was limited to the amount of premiums paid by the policyholder. Ex. 15-J; Tr. at 80-81, 233-34, 316.

103. Lighthouse has never violated the cash value restriction of any one of its policies including the Policies at issue here. Tr. at 318-19.

F. Administrative and Mortality Charges for the Policies

104. The Policies were "in force" so long as the mortality and administrative charges were paid. Tr. at 328.

105. On receiving the initial premiums in 1999, Lighthouse debited the first year policy charges from the premiums. These charges were the mortality expense and administrative charges, which were computed annually. Tr. at 420.

106. The investment portion of the premium is allocated to the segregated fund, and on an annual basis, Lighthouse debited the amounts due for mortality and administrative charges from the segregated account to a general account. Tr. at 329, 421.

107. If there was not enough premium or sufficient assets within the segregated account reserves to cover these charges, the Trusts could add more premiums, otherwise the Policies would lapse. Ex. 15-J (JTW0018068, 18080); Tr. at 308, 329-30.

108. Although additional premiums paid would be part of the Cash Surrender Value, Ex. 15-J (JTW0018063, 18075); Tr. at 330, when the segregated account was debited to pay the mortality or administrative charges, these amounts were not included in the Cash Surrender Value as premiums paid because they were internal reserve deductions from funds that belong to Lighthouse, not to the policyholder. Tr. at 330-31, 432, 434.

109. In June 2006, Boiler Riffle made two transfers to Lighthouse totaling $130,000 (one transfer of $65,000 and a second transfer of $65,000) for payment of annual policy mortality and expenses charges due for the Policies. First Stip. at ¶ 67; Exs. 22-J, 36-J (JTW0023356), 37-J (JTW0001497); Tr. at 358-62, 421-24.

110. Each of the $65,000 transfers was comprised of an annual insurance premium for mortality risk of $2,670 and administrative charges of $62,330. Ex. 39-J; Tr. at 359-62.

111. In September 2007, Boiler Riffle made two transfers to Lighthouse totaling $161,500 (one transfer of $81,000 and a second transfer of $81,500) for the payment of annual policy mortality and expense charges due for the Policies. Exs. 38-J, 39-J.

112. The $81,000 transfer was comprised of an annual insurance premium for mortality risk of $3,480, and administrative charges of $77,520, and the $81,500 transfer was comprised of an annual insurance premium for mortality risk of $3,480 and administrative charges of $78,020. Tr. at 359-62.

G. The Separate Accounts

113. As noted above, the Policies require that Lighthouse establish "Separate Accounts" to reserve for and fund the Policies. First Stip. at ¶ 51.

114. The Separate Accounts satisfied the diversification requirements of I.R.C. § 817(h). Ex. 15-J (JTW 0018066, 18078); Tr. at 331-33.

115. The Separate Accounts are comprised of reserve assets, including but not limited to the Lighthouse Nineteen Ninety-Nine Fund, LDC ("1999 Fund"), the Lighthouse Second Nineteen Ninety-Nine Fund, LDC ("1999 2nd Fund"), Philtap Holdings, Ltd. ("Philtap"), and Boiler Riffle Investments Ltd. ("Boiler Riffle"). First Stip. at ¶ 59.

116. The 1999 Fund and the 1999 2nd Fund are Bahamian limited duration companies formed by Lighthouse as part of the separate account reserves to fund its obligations under the Policies. First Stip. at ¶ 60; Ex. 26-J.

117. On May 17, 2002, Boiler Riffle was incorporated in the Commonwealth of the Bahamas as an International Business Company. First Stip. at ¶ 64; Exs. 29-J, 30-J.

118. Similar to the 1999 Fund and the 1999 2nd Fund, Boiler Riffle is an insurance dedicated investment fund owned by Lighthouse's segregated accounts to fund its obligations under the Policies. Tr. at 341.

119. Since its inception, Boiler Riffle has been wholly-owned by Lighthouse and is associated with the segregated asset accounts of the two Policies. Ex. 32-J; Tr. at 98.

120. Petitioner has no direct or indirect ownership interest in Boiler Riffle. Ex. 83-J (JTW0018576); Tr. at 452.

121. Petitioner has never been a member or director of Boiler Riffle. First Stip. at ¶¶ 65-68, 71; Ex. 32-J.

122. Petitioner has never had signatory authority over Boiler Riffle's financial accounts. First Stip. at ¶ 69; Ex. 30-J.

H. The Investment Manager

123. The Policies required Lighthouse to contract with a qualified independent third-party investment manager to manage the assets in the Separate Accounts. Ex. 15-J (JTW0018065); Tr. at 121, 252, 334.

124. Leopold Joseph (Bahamas) Ltd. (now the Bank of Butterfield) entered into the initial Investment Management Agreement for the Policies. First Stip. at ¶¶ 12, 39; Exs. 4-J, 17-J; Tr. at 336.

125. The Bank of Butterfield was the Investment Manager of the Separate Accounts for the Policies, including Boiler Riffle, from January 1, 2006 through November 6, 2007. First Stip. at ¶ 53.

126. Experta Trust Company (Bahamas) ("Experta") was the Investment Manager of the Separate Accounts, including Boiler Riffle, from November 7, 2007 through December 31, 2007. First Stip. at ¶ 59.

127. Neither petitioner nor the Trusts was a party to the Investment Management Agreement. Ex. 17-J.

128. The Investment Manager acts solely on behalf of Lighthouse to manage the Policies' Separate Accounts. Ex. 17-J; Tr. at 337.

129. The Lighthouse Investment Management Agreement permits the Investment Manager to consider investment recommendations from the policyholder, as well as third parties, but a policyholder does not have the contractual authority to direct investments, and thus cannot commit Lighthouse to purchase any particular asset or direct it to do so. Ex. 17-J (P000397); Tr. at 373-74, 382, 385.

130. The Investment Management Agreement is a discretionary investment contract, Ex. 17-J; Tr. at 337, but this discretion is limited by I.R.C. § 817(h)'s diversification requirements, Lighthouse's due diligence requirements, and other operational restrictions. Ex. 17-J; Tr. at 338-39.

131. The Investment Management Agreement provides that Lighthouse reserves the right to (i) reject any investment selected by the Investment Manager and (ii) remove and replace the Investment Manager at any point in time. Ex. 17-J.

132. The Investment Manager must vet any non-publicly traded security with due diligence regarding the company's financial compliance, valuation, financial exposure, reputational exposure, and other factors. Tr. at 252, 339.

133. The Investment Manager's due diligence includes review of financial statements, business plans, websites, audit reports, and other information. Tr. at 403-404.

134. Lighthouse's Investment Manager also is required to perform "know your client" anti-terrorism and anti-money laundering due diligence before making any investment. Tr. at 400-403.

135. Lighthouse requires adequate due diligence and strong investment performance in order to be compliant with all applicable laws and regulations, and to avoid liability for financial mismanagement. Tr. at 436.

136. The policyholder sets the overall investment strategies, and the Investment Manager builds within those parameters. The specific strategies for the Policies here were growth stock, with 100% of the portfolio allocated to "high risk" investments. This was intended to be a high risk investment portfolio that would include private equity investment opportunities. Ex. 19-J (P000526-527, 550-552); Tr. at 383, 415.

137. The investment strategy also allowed for fixed income, which includes promissory notes and cash, investments in real estate, and any other ventures that the Investment Manager believes meet the investment goals. Ex. 17-J; Tr. at 340, 395, 418-19.

I. Petitioner's Recommendations to the Lighthouse Investment Manager

138. Petitioner offered Boiler Riffle the opportunity to be a syndicate partner in various investments in the same manner that he offered those opportunities to other third parties. Through Mr. Lipkind, petitioner recommended these opportunities to the Investment Manager. Tr. at 111-12, 120, 242, 454, 627.

139. Petitioner did not have the power to direct the Investment Manager to make any investments, and in fact, neither petitioner nor Mr. Lipkind acting on his behalf, ever demanded or directed the Investment Manager to make any investment. Ex. 15-J (JTW0018065); Tr. at 113, 119, 204-05, 494-95, 632.

140. Petitioner had no direct communication with Boiler Riffle or Lighthouse or the Investment Managers. Ex. 83-J (JTW0018576); Tr. at 120, 485, 486-88, 495, 559, 609-10, 661.

141. Mr. Lipkind insulated petitioner from any communications with the Investment Manager to avoid even the appearance of any sub rosa understanding between petitioner and Lighthouse. Tr. at 118, 136, 153-55, 162-63, 209, 485-86.

142. Petitioner's recommendations were highly valued by the Investment Manager and others because of his success as a venture capitalist and entrepreneur. Tr. at 186-87.

143. Before making any investment on behalf of his venture capital funds or himself, petitioner conducted his own due diligence and received due diligence and information about potential investments from others. Because petitioner also provided consulting services and actively managed some of the companies in which his venture capital funds invested, he had proprietary information about these companies. Based on this information, petitioner decided whether to invest or to recommend an investment in a particular company. Tr. at 449-50, 577-78, 577-78 585-85, 593-95.

144. Mr. Lipkind sometimes assisted the Investment Manager by answering questions regarding transactional documents and by providing additional information about the potential investments. Tr. at 120-22, 498-99.

145. On behalf of the Investment Manager, Mr. Lipkind sometimes passed along questions regarding potential investments or a company's performance to petitioner. Tr. at 498-99.

150. Susan Chang, petitioner's personal bookkeeper, First Stip. at ¶ 15; Tr. at 455, also passed on information and provided assistance to Boiler Riffle's Investment Managers, Tr. at 669-70, 881-82, communicated with Mr. Lipkind to determine whether Boiler Riffle was interested in investments, and had some contact with the companies themselves related to administrative issues, such as wire transfer instructions, Tr. at 885-86.

151. Ms. Chang received Boiler Riffle's financial statements from Mr. Lipkind and created a spreadsheet to keep track of Boiler Riffle's investments. First Stip. at ¶ 104; Ex. 54-J; Tr. at 888-89.

152. Most, but not all, of petitioner's recommendations were implemented by the Investment Manager. Tr. at 120.

153. There were instances where the Investment Manager did not accept petitioner's recommendations. Ex. 78-J; Tr. at 221-22, 499, 502, 505.

154. For example, petitioner recommended that Boiler Riffle invest in a company called Safeview, but the Investment Manager declined after conducting its own due diligence. Ex. 467-J.

155. The Investment Manager did not accept petitioner's recommendation to make an equity investment in a company called "Milphworld" because of concern about reputational risk, Tr. at 507-08, but did accept petitioner's recommendation to purchase convertible promissory notes from petitioner in 2007 and also directly from Milphworld. Exs. 35-J (P 000783, 000803), 66-J; Tr. at 657-58.

156. The Investment Manager may have rejected other recommendations of petitioner, such as investments with Lehman Brothers, Goldman Sachs, and Credit Suisse. Tr. at 509-10, 665-66.

157. In several instances, petitioner invested in a company, either through his venture capital fund, other entities, or individually, that Boiler Riffle did not invest in either because these investment opportunities were not offered to the Investment Manager or because the Investment Manager declined the recommendation. Ex. 78-J; Tr. at 505.

158. Although petitioner recommended all of the initial equity investments made by Boiler Riffle, Boiler Riffle could have made decisions on "follow-on" or "pro rata" investments without petitioner's input. Tr. at 650-51, 660-61.

159. Ordinarily, when an investment is made in a start-up company, the investors enter into an agreement that when the company does its next round of financing, the original investors will have a guaranteed opportunity to invest in order to maintain their "pro rata" share of the company. Tr. at 511-12.

160. If an investor declines to make a further investment to maintain its pro rata share, that pro rata share may be offered to other syndicate investors. Tr. at 514-55.

161. An investor would only be offered a "pro rata", i.e., the opportunity to invest in a later series financing in a company to avoid dilution, if that investor had already invested in the company. Tr. at 511-12. Accordingly, references in communications to Boiler Riffle being offered a "pro rata" share, necessarily mean that Boiler Riffle already owned shares in that company. Tr. at 211, 258, 512; see e.g., Ex. 554-J (referring to Boiler Riffle taking its pro rata share).

162. In addition, with respect to the debt instruments in Boiler's Riffle portfolio, if Boiler Riffle was already an investor, it would have been offered an opportunity to participate in a promissory note offered by the company, and petitioner would not necessarily have had any input. Tr. at 658-59.

163. For example, although petitioner recommended Boiler Riffle's initial equity investment in Accept Software, he does not believe that he recommended that Boiler Riffle enter into a promissory note with Accept Software. Ex. 35-J (P000858); Tr. at 658-60.

J. Webify Solutions, Inc.

164. Petitioner and two other venture capitalists invested the initial seed money to start Webify Solutions, Inc. ("Webify"), a Delaware corporation. First Stip. at ¶ 99; Tr. at 516-17.

165. Petitioner served on the Board of Directors of Webify from October 2002 through August 2006 and was a shareholder. First Stip. at ¶ 112; Tr. at 517-18, 673.

166. After petitioner recused himself, the Webify Board of Directors approved the issuance of the stock warrants to petitioner and also approved the transfer of those warrants to Boiler Riffle. Exs. 48-J, 49-J, 50-J; Tr. at 518, 673-75.

167. Petitioner recommended that Boiler Riffle purchase the Webify warrants from him, and Mr. Lipkind conveyed this recommendation to the Investment Manager. Tr. at 679-80.

168. Petitioner did not negotiate the purchase of the Webify warrants by Boiler Riffle. Tr. at 679, 683.

169. On March 31, 2003, petitioner sold his Webify stock warrants to Boiler Riffle for $.05/share, for a total of $3,085, and reported the sale of the warrants on his timely-filed 2003 gift and income tax returns. Exs. 50-J, 51-J, 53-J; Tr. at 522-24.

170. The $3,085 sale price was confirmed by a valuation, entitled "Fair Market Value Analysis of Certain Warrants in Webify Solutions, Inc. As of March 31, 2003," issued by Applied Economics Corporate Finance and Business Valuation, dated April 22, 2003, which was attached to petitioner's timely-filed 2003 gift tax return. Exs. 51-J, 52-J.

171. Petitioner also recommended that Boiler Riffle purchase stock in Webify. Tr. at 134.

172. On September 19, 2002, Boiler Riffle loaned Webify $250,000 in exchange for a promissory note that was convertible into equity of Webify. Ex. 55-J. Boiler Riffle subsequently converted the promissory note plus accrued interest into Webify Series A Preferred Stock. Ex. 56-J.

173. On April 23, 2004, Boiler Riffle exercised its option and purchased 250,000 shares of common stock of Webify for $12,500. Ex. 56-J.

174. On June 30, 2003, Boiler Riffle loaned Webify $100,000 in exchange for a promissory note that was convertible into equity of Webify. Ex. 57-J. Boiler Riffle subsequently converted the promissory note plus accrued interest into Webify Series B Preferred Stock. Ex. 58-J.

175. In March of 2005, Boiler Riffle loaned Webify $62,500 in exchange for a promissory note that was convertible into equity of Webify. Ex. 59-J. Boiler Riffle subsequently converted the promissory note plus accrued interest into Webify Series C Preferred Stock. Ex. 60-J.

176. On May 26, 2005, Boiler Riffle purchased additional Webify Series C Preferred Stock for $401,937.66. Ex. 60-J.

177. Boiler Riffle's aggregate basis in its Webify stock was $838,574. Exs. 34-J (JTW0015895-96, 15937), 35-J (P000802).

178. On July 31, 2006, IBM entered into an agreement to purchase the stock of Webify from Boiler Riffle for $2,730,987.11, which was paid to Boiler Riffle in 2006 and 2007. First Stip. at ¶ 114; Ex. 62-J.

179. Petitioner had no control over Webify's decision to sell its stock to IBM. Tr. at 237-38.

K. William D. Lipkind

180. Mr. Lipkind is a founding member of his law firm, Lampf, Lipkind, Prupis & Petigrow, and has specialized in taxation and estate planning throughout most of his legal career. Tr. at 48-50.

181. Mr. Lipkind received his B.A. from Cornell University, his J.D. from Harvard University, and his LL.M. in taxation from New York University. Tr. at 47.

182. Mr. Lipkind only charged petitioner for his billable time at his normal hourly rate, and sometimes reduced his bill. Tr. at 148, 463.

183. Mr. Lipkind did not receive a bonus or any other remuneration from petitioner, other than his normal hourly rate, and did not receive any remuneration from Lighthouse, Boiler Riffle, or the Investment Managers. Tr. at 148, 197-98, 322, 463.

184. Before advising petitioner on the estate planning described above, Mr. Lipkind reviewed all applicable Revenue Rulings, Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1985), and other judicial opinions, the Internal Revenue Code, and Treasury Regulations. Tr. at 77-78, 126, 157-58.

185. Mr. Lipkind also reviewed legal opinions issued to Lighthouse by Powell Goldstein, Lighthouse's United States counsel (the "Powell Goldstein Opinions"). Exs. 782-P, 783-P, 785-P; Tr. at 124, 281, 278, 413-14. Lighthouse also received tax opinions from Brian Casey, then of Morris Manning & Martin, and John Daticus of Rogers & Wells. Each of these opinions was shared with Mr. Lipkind. Tr. at 284-286.

186. James A. Walker, Jr., who is now outside general counsel for Lighthouse, Tr. at 248, was the author of the Powell Goldstein Opinions during his time as a partner at that firm. Tr. at 246-47.

187. Lighthouse requested that Mr. Walker provide the Powell Goldstein Opinions because Lighthouse wanted to consider the United States tax consequences of policies issued to United States clients, and to assist United States counsel in advising their individual clients. Tr. at 271-74, 286, 368-69.

188. Mr. Walker has represented Lighthouse since its inception and has been intimately involved in Lighthouse's creation and the legal aspects of its policies, procedures, and operations. Tr. at 247-48.

189. Mr. Lipkind had extensive discussions with Mr. Walker about the structure and tax aspects of the Policies. Tr. at 321.

190. After studying the legal authorities in depth, Mr. Lipkind advised petitioner that he did not believe that there was any legal validity to the application of the investor control doctrine to the Policies because petitioner was not in constructive receipt of the Policies' assets. Tr. at 116, 133-34, 557.

191. Mr. Lipkind advised petitioner that the risk of the estate plan was that the Service would challenge the transaction on the basis of the investor control doctrine, but that in his opinion, there was no legal basis for the application of investor control doctrine because there was no constructive receipt of the Policies' assets. Tr. at 80.

192. Mr. Lipkind did not provide a written legal opinion himself because he did not think it was necessary since he was certain of his advice based on the existing authorities. Tr. at 152, 199.

193. Mr. Lipkind and petitioner first met in California and when Mr. Lipkind outlined the estate plan, petitioner's previous tax and estate attorney, David Herbst, was present. Petitioner discussed Mr. Lipkind's estate plan with Mr. Herbst, who agreed with Mr. Lipkind's advice. Tr. at 459, 461, 557.

194. Mr. Lipkind requested that petitioner and Mr. Herbst sign confidentiality agreements before Mr. Lipkind described his estate plan because he did not want Mr. Herbst to get the benefit of his intellectual capital, Exs. 496-J, 497-J; Tr. at 177-78, but Mr. Lipkind never sought to enforce the agreements, which only applied to the first meeting and not to the estate plan. Tr. at 177-78, 459-60.

195. Mr. Lipkind was not a "promoter" of any tax avoidance transaction. Tr. at 147.

196. Mr. Lipkind's wife owns a life insurance policy issued by Lighthouse. The segregated account supporting her policy is Daintree, a Bahamian Corporation. Tr. at 113, 194-95, 605.

197. From time to time, Mr. Lipkind asked petitioner whether he or Daintree could participate in an investment or whether he could share petitioner's recommendation with others, and from time to time, petitioner agreed. Tr. at 111-12, 605.

198. Accordingly, petitioner invited Mr. Lipkind, Daintree, and Mr. Lipkind's clients, GES and Twin Falls, to invest in some companies recommended by petitioner. Tr. at 195, 605.

199. GES did not own a Lighthouse policy. Tr. at 196-97.

200. Twin Falls was a Bahamian corporation that was owned by Lighthouse as the separate account for a Lighthouse insurance policy owned by a trust formed by another client of Mr. Lipkind. Tr. at 171, 196-97.

L. Petitioner's Cooperation During the Audit

201. Throughout the audit, petitioner fully complied and cooperated with all reasonable requests by respondent for documents and information.

202. Petitioner was completely cooperative with all aspects of the audit. Tr. at 503, 562-63, 565, 569.

203. Petitioner directed his staff to produce everything that the Service asked for "as fast as you can -- whatever they want, get it," Tr. at 562, hired extra staff for copying records, Tr. at 561-62, gave his employees paid time off while they were interviewed by the Service, Tr. at 563-64, and was interviewed by several representatives of the Service, including Revenue Agent Michael Parisi. Tr. 564-65.

204. During the audit, Revenue Agent Parisi requested that petitioner file Forms 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) for Boiler Riffle for the 2005-2007 tax years. Ex. 33-J.

205. On May 28, 2009, petitioner's counsel provided a written statement with substantiating records to the Revenue Agent that petitioner had no obligation to file a Form 5471 because 100% of the shares of Boiler Riffle was owned by Lighthouse, and petitioner had no legal or beneficial ownership interest in Boiler Riffle. Id.

206. Petitioner's attorneys moved to quash an administrative summons issued to Ms. Chang because the Revenue Agent had made false statements to third parties that petitioner was under criminal investigation, and had engaged in other misconduct, including referring to petitioner as a "crook." Tr. at 566-70.

2. Lighthouse is not a sham. Lighthouse is a bona fide and fully-regulated Cayman Islands insurance company that conducts substantial operations for hundreds of customers, including petitioner, and petitioner has no direct or indirect financial interest in Lighthouse.

3. The Lighthouse Policies are not shams but are bona fide life insurance policies compliant with the Internal Revenue Code, including I.R.C. §§ 817(h), 7702, and 7702A, as well as Cayman Islands law.

4. The Lighthouse Policies have economic substance, as they shift substantial risk from the policyholder to Lighthouse by guaranteeing a minimum death benefit.

5. The step transaction doctrine does not apply, as there is no series of inter-related steps that can be collapsed into a single transaction that has any income tax consequence to petitioner.

6. The investor control doctrine does not apply because petitioner is not in constructive receipt of the underlying assets of Boiler Riffle. Under the Service's prior articulation of the investor control test, see Rev. Rul. 77-85, Rev. Rul. 80-274, Rev. Rul. 81-225, Rev. Rul. 81-255, Rev. Rul. 82-54, and Rev. Rul. 2003-92, as well as Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1985), for there to be investor control, the taxpayer must have significant incidents of ownership with respect to the assets of the separate account and be in constructive receipt of the income attributable to those assets.

7. Petitioner is not in constructive receipt of the assets of the Separate Accounts because there are substantial restrictions on his access to those assets. The Cash Surrender Value restrictions in the Policies prohibit petitioner (through the Trusts) from accessing the assets of the Separate Accounts, including Boiler Riffle, through loan or surrender, beyond the amount of premiums paid. Because petitioner does not have unrestricted access to the assets of Boiler Riffle, petitioner is not in constructive receipt of those assets.

8. Even if the investor control doctrine could be satisfied merely by an investor's ability to direct the investments, which it cannot, petitioner did not have any such ability. Rather, both under the contractual terms of the Policies and the actual practice of the Investment Manager, petitioner could not and did not control the investments of Boiler Riffle and Lighthouse.

9. The Subpart F rules of the Internal Revenue Code do not apply to petitioner because Lighthouse, and not the Chalk Hill Trust, was the owner of the Policies during the tax years at issue. In any event, if the investor control doctrine applied here, petitioner would be treated as owning the underlying assets of Boiler Riffle, and not Boiler Riffle itself.

10. If petitioner were taxable on the income of Boiler Riffle, which he is not, the income from the sale of Webify should be characterized as long-term capital gain and petitioner should be given credit for Boiler Riffle's cost basis in the Webify stock.

11. Respondent has waived any challenge to the valuation of the Webify stock warrants that petitioner sold to Boiler Riffle in 2003, and has failed to present any evidence undermining the contemporaneous and reasonable appraisal that petitioner submitted with his timely-filed 2003 gift tax return.

12. Petitioner should not be taxed on the transfers from Boiler Riffle to Lighthouse for mortality and administrative charges because these charges were not paid on behalf of the Trusts, and would be deductible business expenses in any event. Alternatively, if petitioner is deemed to be the owner of Boiler Riffle, payments from Boiler Riffle to Lighthouse would not be income to petitioner.

13. Petitioner is not liable for penalties for negligence and substantial understatements of income tax for taxable years 2006 and 2007 under I.R.C. § 6662, because there are no underpayments of income tax on petitioner's income tax returns; petitioner was not negligent in the preparation of his returns; there was a reasonable basis and substantial authority for the positions reported on the returns; and petitioner acted with reasonable cause and in good faith with respect to his returns.

The burden of proof is generally on the taxpayer in a Tax Court case. Rule 142(a), Tax Court's Rules of Practice and Procedure. Under Section 7491 of the Code, however, the burden of proof shifts to respondent:

The taxpayer must also comply with the Code's substantiation requirements and cooperate with reasonable requests by respondent for documents and information. See generally Higbee, 116 T.C. at 440-441. Whether the taxpayer has cooperated with a reasonable request is a "facts and circumstances analysis" undertaken in each case. Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 166-67 (D. Conn. 2004), aff'd 150 Fed. Appx. 40 (2d Cir. 2005). The testimony of witnesses and the thousands of pages of exhibits introduced at trial establish that petitioner satisfied the substantiation requirements of the Code.

Petitioner also maintained records and cooperated with all reasonable requests by respondent for documents and information during the audit. Petitioner testified that he was completely cooperative, Tr. at 503, 562-63, 565, 569, and that he directed his staff to produce everything that the Service asked for "as fast as you can -- whatever they want, get it," Tr. at 562, he hired extra staff for copying records, Tr. at 561-62, he gave his employees paid time off while they were interviewed by the Service, Tr. at 563-64, and was interviewed by several representatives of the Service, including Agent Parisi, Tr. 564-65. Because respondent did not call Agent Parisi to testify on this point, the only inference we can draw is that he would have corroborated petitioner's testimony that petitioner fully cooperated with all reasonable requests for information and documents.

Any argument by respondent that petitioner was not cooperative because his counsel made a motion to quash the summons of his bookkeeper, Susan Chang, should be rejected. In certain cases, the cooperation requirement has been interpreted to mean that the burden of proof does not shift where the Service was forced to issue a summons. See, e.g., AMC Trust v. Comm'r, T.C. Memo. 2005-180. The taxpayer, however, will not be foreclosed from I.R.C. § 7491 where there was a legitimate reason for his or her actions. For example, in Kohler v. Comm'r, T.C. Memo. 2006-152, the taxpayer did not produce documents summoned by the Service, but instead filed a motion to quash the summons on the ground that some of the documents sought by the Service were irrelevant, sealed, or contained sensitive business information. The Tax Court found that the taxpayers had legitimate concerns about providing confidential and proprietary business information that they believed to be irrelevant, and that the taxpayers' conduct "did not require a finding that the taxpayer failed to cooperate with respondent." Id.

Here, as petitioner testified, his attorneys made a motion to quash the administrative summons because the Revenue Agent had stated to third parties that petitioner was under criminal investigation. Tr. at 566-67. Had petitioner, in fact, been under criminal investigation, the administrative summons of Ms. Chang would have been improper under I.R.C. § 7602(d).

Petitioner's alternative basis for the motion was that, if he was not under criminal investigation (which, he was not), Agent Parisi had committed misconduct by telling third parties that he was under criminal investigation and referring to petitioner as a "crook." Tr. at 567-70. Even though Revenue Agent Parisi was in the courtroom, respondent did not call him to refute these allegations. The inference that must be drawn is that Revenue Agent Parisi did, in fact, commit misconduct during the audit of petitioner. These were valid bases for petitioner's counsel to move to quash the administrative summons, and petitioner should not be deemed uncooperative for having initiated that proceeding, particularly where petitioner instructed Ms. Chang and others to be completely cooperative with the Service during the audit. Tr. at 562-563.

Because petitioner produced credible evidence supporting his positions in this case, complied with the substantiation requirements, and cooperated with all reasonable requests for information and documents, the burden of proof shifts to respondent in this case.

The burden shifting has particular significance with respect to many factual issues in this case, including whether Lighthouse and the Policies are shams or have economic substance, whether petitioner actually controlled the investments of Boiler Riffle, Boiler Riffle's basis in Webify, and other issues. See e.g., Murphy v. Comm'r, T.C. Memo. 2006-243 (where there are "evidentiary gaps," the Court should find against the party who has the burden of proof).

Respondent's position in the Notice was that Lighthouse and Boiler Riffle are shams, lack economic substance, and that the estate planning here was "arranged in a series of predetermined interrelated steps toward the goal of moving taxable funds offshore to avoid federal income tax." Ex. 3-J.

Because respondent presented no evidence at trial and made no additional arguments on this point that were not merely versions of the investor control doctrine, we primarily rely on the arguments in petitioner's pre-trial memorandum, see Pet. Mem. at 17-19, but will address a few additional points here.

With respect to the allegation that Lighthouse or the Policies were a sham, the record evidence should put this to rest. The unrefuted evidence is that the Policies were bona fide and valid life insurance policies under the Internal Revenue Code. Although respondent has refused to concede the issue, he has agreed to "assume" that the life insurance policies meet the requirements of Cayman law and the Internal Revenue Code, Tr. at 25, 39, 40.

To begin with, petitioner has no direct or indirect ownership or financial interest in Lighthouse, Exs. 8-J (JTW 0018021-25), 83-J (JTW0018576), and Lighthouse cannot possibly be viewed as petitioner's alter ego or captive to him or in any way acting under his control, either directly or indirectly.

Lighthouse was owned by Colin Muirhead and Meespierson Cayman, Ltd., a subsidiary of a large Dutch global private bank, and Fortis, one of the world's largest global insurance conglomerates, Ex. 8-J (JTW0018021-25); Tr. at 253-55. Lighthouse is licensed and regulated by the Cayman Islands Monetary Authority, Exs. 6-J, 7-J, 38-J, and has received annual certificates of good standing from the Cayman Island Monetary Authority, First Stip. at ¶¶ 30, 31; Exs. 7-J (JTW0018020), 10-J, 11-J, 12-J; Tr. at 268. Lighthouse issues variable life insurance and annuity policies on a global basis, and, as of 2011, had over $1 billion of in-force insurance and annuity policies. Ex. 8-J. Moreover, Lighthouse is managed by Aon Insurance Managers, which is a wholly-owned subsidiary of Aon, PLC. Ex. 9-J.

Lighthouse's financial statements are audited on a regular basis, as required by Cayman law, Tr. at 270, and since 1999, KPMG has been Lighthouse's outside auditor, First Stip. at ¶ 35; Exs. 8-J, 10-J, 11-J, 13-J (P000441-451); Tr. at 270. Lighthouse reinsures mortality risk with Hannover Re, one of the top reinsurers in the world in terms of size, capacity, and expertise with an annual gross premium of approximately € 13.8 Billion. First Stip. at ¶ 36; Exs. 8-J, 14-J, 20-J, 22-J, 23-J; Tr. at 270-71, 314-15.

Lighthouse's compliance with I.R.C. §§ 7702 and 7702A is verified by Avon. Ex. 16-J; Tr. 322-23. Lighthouse also has reputable and knowledgeable outside counsel, including Mr. Walker, whose expertise and commitment to compliance was apparent from his testimony at trial, Brian T. Casey from Locke Lord, LLP, and Maples and Calder. Tr. at 251. There can be no doubt that Lighthouse is not a sham.

The evidence at trial also unequivocally establishes that the Policies, like all Policies issued by Lighthouse, are legitimate, bona fide life insurance policies, and not sham transactions. Before issuing a policy, Lighthouse conducts detailed underwriting analysis and all proper and necessary due diligence. Tr. at 299. Lighthouse conducted a detailed underwriting process with respect to the issuance of the Policies. Exs. 19-J (see policy applications), 20-J. The Policies' underwriting documents were subsequently reviewed and approved by Hannover Re, which reinsured the Policies' mortality risk. Ex. 20-J; Tr. at 297. That the underwriting was legitimate and that the Policies were not shams is further illustrated in the correspondence related to reducing the $5,000,000 amount of insurance originally requested for Mabel Jordan, Ex. 20-J; Tr. at 300-301, and requiring further medical information for Ms. Sublette after she received ambiguous results from her mammogram, Ex. 20-J; Tr. at 302.

Most importantly, the Policies are not a sham or lack economic substance, as there has been a substantial change in economic position and clear risk shifting and risk distribution with respect to the Policies. The Trusts paid premiums of $735,046 for the two Policies, which, as long as they were in force, would pay a total guaranteed minimum death benefit of $5.4 million, regardless of how the Separate Accounts performed. Ex. 15-J (JTW0018067, 180671, 180679, 180683); Tr. at 304, 327-28, 438-40. This is a substantial and significant shifting of mortality risk and distribution of risk, making the Policies bona fide life insurance. See e.g., Helvering v. Le Gierse, 312 U.S. 531, 539 (1941) ("[h]istorically and commonly insurance involves risk-shifting and risk-distributing."); see also Clougherty Packing Co. v. Comm'r, 811 F.2d 1297, 1300 (9th Cir. 1987).

The only case that respondent cites relating to insurance is Child v. Comm'r, T.C. Memo 2010-58; Pretrial Memorandum for Respondent ("Resp. Mem.") at 44. Child holds that the test for whether an insurance arrangement has economic substance is whether there was risk shifting and risk distribution. Here, respondent does not allege that the Policies lack risk shifting or risk distribution, and all of the evidence demonstrates that these requirements are met, and therefore the "sham" argument must fail.

B. The Lighthouse Policies Have Economic Substance

Respondent's arguments related to the economic substance doctrine fail for the same reason. As noted above, petitioner has established that the Policies are bona fide life insurance policies, and respondent did not offer any evidence that indicates that the Policies lack economic substance. Instead, respondent stated that he was willing to assume that the Policies were valid insurance policies under Cayman insurance law and the Internal Revenue Code. Tr. at 25, 39, 40.

Nevertheless, in its pre-trial memorandum, respondent argued that the Policies lack economic substance. Resp. Mem. at 45-47. Respondent begins that discussion by citing to economic substance cases such as Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978), and Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352 (Fed. Cir. 2006), none of which relate to insurance contracts. Respondent does not cite one case in which an insurance policy that involved real risk shifting and risk distribution was found to lack economic substance. As noted above, Child is the only insurance case that respondent cites.

The court's analysis in Child is premised on the notion that real insurance involves risk shifting and risk distribution. T.C. Memo 2010-58 (citing Helvering v. Le Gierse, 312 U.S. 531, 539 (1941)). The Tax Court held that the insurance contract at issue lacked economic substance because there was no risk shifting and distribution. Id. Here, the evidence shows uncontroverted risk shift and risk distribution; accordingly, the Policies have economic substance.

C. The Step Transaction Doctrine Does Not Apply

Respondent attempts to collapse the following four steps into one transaction: (i) petitioner forms the Alaska Trust; (ii) the Trust purchases the Policies; (iii) the death benefit of Policies are paid to beneficiaries of the Trust (which is not technically correct as the death benefit is payable to the Trust, and the Trustee has limited discretion to make a distribution to the Trust's beneficiaries); and (iv) petitioner directed investments with respect to the separate account. S ee Resp. Mem. at 47-48.

Any argument based on this series of steps fails. First, step (iv) has no relationship to the other steps. Second, steps (i) through (iii) are true of every life insurance contract that is purchased by a life insurance trust. Third, step (iii) (the death of the insured) had not occurred in the tax years at issue. And, finally, what is most peculiar about respondent's step transaction argument is that even if these four steps were collapsed into a single step, there is no reason why this would result in taxation to petitioner.

Respondent claims "[t]he end result of the steps in petitioner's transaction is that he controlled the assets in the Separate Accounts whose value determined the death benefits that would be paid to him and his children." Resp. Mem. at 48. It is clear that the "step transaction" doctrine is nothing more than another iteration of respondent's investor control doctrine, which, as discussed below, does not apply here.

All of respondent's arguments at trial and in his pre-trial memorandum collapse into the position that petitioner should be treated as the owner of the assets of Boiler Riffle under the doctrine of investor control. Respondent seems to be taking the position in this case that a policyholder's mere direction of investments makes it the owner for federal income tax purposes.

This is simply not a correct interpretation of the law of investor control. As is explained in Christoffersen, and the Service's own Revenue Rulings, which are discussed at length in Petitioner's Pre-Trial Memorandum, see Pet. Mem. at 21-46, there must be some other significant indicia of ownership of the underlying assets such that the policyholder is in constructive receipt. Here, there are no such incidents of ownership. Rather, the Cash Surrender Value restriction prohibits petitioner from access to any policy assets beyond the premiums paid by the Trusts.

A. Petitioner Does Not Own Boiler Riffle

As provided in the Policies, the Trust had no right to any asset in the Separate Accounts, and the Separate Accounts belonged to Lighthouse. Ex. 15-J (JTW0018065, 18077). The Policies expressly state that the Lighthouse policyholder has no legal, equitable, direct, indirect, or other interest in any investment items held in or belonging to the Separate Accounts. Id. Since its inception, Boiler Riffle has been wholly-owned by Lighthouse and is associated with the segregated asset accounts of the two Policies. Ex. 32-J; Tr. at 98. Petitioner has no direct or indirect ownership interest in Boiler Riffle. Ex. 83-J (JTW0018576); Tr. at 452.

Respondent argues that despite all other evidence to the contrary, petitioner was, in fact, the owner of Boiler Riffle, on the basis of Ex. 27-J, a memorandum written by Butterfield Bank referring to petitioner as the "ultimate beneficial owner of Boiler Riffle." Respondent misconstrues the import of this document, which was created as part of Butterfield's "know your customer compliance." In that context, "beneficial owner" is a term of art that merely means the original source of the funds for the transaction. Tr. at 343-44.

Respondent's primary argument in this case is that petitioner should be taxed on the income of Boiler Riffle because he directed its investments, i.e., he instructed the Investment Manager to make particular investments on behalf of the Policies. There is no authority for this argument. Rather, the investor control doctrine, as it has been articulated in Rev. Rul. 77-85 and its progeny,² and in Christoffersen v. United States, 749 F.2d 513 (8th Cir. 1985), look to whether the taxpayer had incidents of ownership over the assets such that he is in constructive receipt of the income of the underlying investments.

The Cash Surrender Value restrictions of the Policies, which respondent has completely and repeatedly ignored, is the fatal flaw in respondent's position: the Trust had no right to the assets owned by the Lighthouse Policies except to the sum of the premiums paid, and, as a result, the Trust is not in constructive receipt of cash or other property, either as a loan or a distribution, exceeding that sum. The terms of the Policies are unambiguous that no matter what the gain is on the underlying investments, petitioner cannot access these funds beyond the premiums paid through surrender or loan. See Ex. 15-J (JTW 0018063, 18075); Tr. at 316. The Cash Surrender Value restriction is a contractual provision of the Policies, and has never been violated by Lighthouse for any policyholder, including the Trusts. Tr. at 318-19. As noted by Mr. Walker, these Policies were "designed to build maximum death benefit, not to build lifetime access." Tr. at 318.

Because petitioner (through the Trusts) had no access to the policy assets themselves or the income generated from those assets, but could only either cash out or borrow the amounts paid in premiums, he was not in constructive receipt of Boiler Riffle's assets. Although petitioner disputes that he directed the investments of Boiler Riffle, even if he did direct them, this would not be sufficient to treat him or the Trusts as the owner of the assets for income tax purposes.

Moreover, it is Lighthouse, and not the Trusts, that bears the entire investment risk. The Policies' minimum death benefits, which exceeded the amounts paid in premium by six-fold, was guaranteed to the Trust upon the deaths of the insured regardless of how the investments of the Separate Accounts performed. See Ex. 15-J (JTW0018067, 180671, 180679, 180683); Tr. at 304, 327-28, 438-40. This is a major difference between the Policies here and the annuity contracts in Christoffersen, in which the court found that the investor bore the entire investment risk. 749 F.2d at 515.

Respondent has not yet addressed whether the Policies here, which are subject to the Cash Surrender Value restrictions described above and have a guaranteed minimum death benefit, are distinguishable from the Revenue Rulings and Christoffersen. In those decisions, the taxpayer had access to the income of the underlying assets and the investment risk remained with the taxpayers. First, in Rev. Rul. 77-85 and 80-274, the holder of an annuity policy had the right to make a full or partial cash surrender at any time. Next, in Rev. Rul. 81-225, which considered whether owners' annuity policies invested in mutual funds available to the general public should be taxed on the inside build-up of those policies, the Service expanded the investor control doctrine somewhat, but again made clear that other incidents of ownership, such as the right to surrender the contract for cash, were required for a finding of investor control.

In Christoffersen, the only judicial opinion that has, to date, upheld the investor control doctrine, the Court defined investor control as requiring constructive receipt of the policy assets. 749 F.2d at 515-16. Indeed, in Christoffersen, the taxpayers had the ability to withdraw the value of the policy's separate account, and the Court found that although the taxpayers chose to reinvest the separate account income, they were in constructive receipt of that income because they could have withdrawn it at any time. Id. at 516 (citing Treas. Reg. § 1.451-2(a)).

In his pretrial memorandum, respondent attempts to downplay the importance of constructive receipt to the holding of Christoffersen, and suggests that the decision was based on the taxpayer's ability to direct the investment of premium payment into particular mutual funds. Resp. Mem. at 26-27. This is simply not the case, as can be seen from the appellate brief filed by respondent in that case, respondent argued that the taxpayers were in constructive receipt of the assets of the annuity account because they bore the entire investment risk, and they had the right to receive the accumulated value of the contract in cash at any time and to make cash withdrawals at any time while still keeping the contract in force. See Brief of Appellant, Christoffersen v. United States, 84-1420-NI (8th Cir.) (filed June 18, 1984) (annexed hereto as Pet. Mem. Ex. A), at I, 4-5, 7-17. It is disingenuous for respondent to suggest that the decision in Christoffersen, which is the only legal authority on the issue at hand, was not based on constructive receipt.

In later Revenue Rulings, Rev. Rul. 82-54 and Rev. Rul. 2003-92, which are grounded in Rev. Rul. 77-85 and 80-274 and Christoffersen, the Service considered other aspects of investor control, but, of course, never abandoned the requirement that the taxpayer have significant incidents of ownership and constructive receipt over the policy's account assets. In Rev. Rul. 2003-92, although the focus was on whether the investments were available to the general public, the Service noted that the taxpayer possessed other significant incidents of ownership, including the right to surrender the annuity contract in part or in full for cash or to convert it into an annuity stream at any time.

There is simply no authority for respondent's position that a taxpayer's selection of the investments supporting a life insurance policy satisfies the investor control doctrine. By attempting to apply the Revenue Rulings to petitioner, who does not have significant incidents of ownership over Boiler Riffle's assets or constructive receipt of its income, respondent is essentially saying that whenever a person is able to direct another's investments, those investments are treated as belonging to him or her for income tax purposes. This position is inconsistent with the bedrock notions of constructive receipt that underlie the Internal Revenue Code. See e.g., Comm'r v. Sunnen, 333 U.S. 591, 604-05 (1948) ("The crucial question remains whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes."); Helvering v. Clifford, 309 U.S. 331, 336 (1940) (finding ownership for income tax purposes where "the benefits directly or indirectly retained blend so imperceptibly with the normal concepts of full ownership.").

Petitioner should not be taxed on the inside build-up of the assets of the Separate Accounts, including Boiler Riffle, where he could not access the funds and bears none of the investment risk, and thus has never been in constructive receipt. Without constructive receipt, there is simply no basis for taxing petitioner on the income of Boiler Riffle.

B. Petitioner Did Not Control the Investment Decisions of Boiler Riffle

This is the one issue that is genuinely in dispute in this case: Despite the contractual language of the Policies, did petitioner, in fact, direct the investments of the Separate Accounts? As explained above, it is unnecessary to address this question, because the ability to direct investments, standing alone, is not sufficient indicia of ownership to render petitioner the owner of Boiler Riffle or its assets.

In any event, the record evidence establishes that petitioner did not and could not direct the investments of the Separate Accounts, including Boiler Riffle. As stated in the Policies:

Respondent's primary tactic at trial was to introduce various email communications to show that petitioner was directing Boiler Riffle's investments. In the exhibit that respondent referred to as "say[ing] it all in terms of ownership," Tr. at 35, Mr. Lipkind states: "At the end of the day, Daintree is my wallet as BR is Jeff's", Ex. 687-J. Mr. Lipkind testified that this email, which was addressed to an employee at Accept Software, a company that Boiler Riffle and Daintree had invested in, was a "slap-off emotional response," after he had become exasperated by the employee's inaccurate analysis of the pro rata shares available to Daintree and Boiler Riffle. Tr. at 114-15.

Another example, Ex. 586-J, is an email related to an investment in Medstory, Inc., in which petitioner stated "we will not be participating in any downstream financing." Tr. at 705-06. Petitioner explained that the "we" referred to petitioner's venture capital funds, and that he meant to convey that he was not recommending that Boiler Riffle participate. Tr. at 705-707. However, it was the Investment Manager's decision whether they wanted to participate or not, and petitioner did not direct that decision. Tr. at 706. It certainly would not be unreasonable for the Investment Manger to want to know whether petitioner, whose venture capital funds also had invested in Medstory, was planning to invest more funds based on petitioner's first-hand knowledge of Medstory's prospects.

In another email highlighted by respondent at trial, Ex. 161-J, Susan Chang stated, "per Jeff Webber, Boiler Riffle Investment, Ltd. will be investing $144,000 and his IRA zero in this August 11 closing." Petitioner was not copied on this email, which was addressed to the attorney for Accept Software, Han Le, see Tr. at 883, and not even to the Investment Manager. This is nothing more than Ms. Chang providing administrative assistance to Accept Software and Boiler Riffle, and is not evidence that petitioner controlled the Investment Manager's investment decisions.

The Court indicated on several occasions during the trial that it did not intend to give much weight to the "shorthand" and "loose language" used in emails, see e.g., Tr. at 482, 709, 927-28. Accordingly, we are not providing an analysis of most of the emails referenced at trial, and certainly not the thousands of emails introduced into evidence. If, despite the Court's admonition, respondent attempts to argue that certain emails are probative evidence of "investor control," petitioner will address any such allegations on Reply. However, there are numerous emails that support petitioner's position that he did not direct or control Boiler Riffle.

For example, Mr. Lipkind sent an email to Ms. Chang and petitioner complaining "[c]an't they understand that Jeff is not Boiler Riffle?" Ex. 134-J (P001264). On another occasion, Ms. Chang emailed Mr. Lipkind asking him to obtain authorization from Bank of Butterfield for an agreement because "we have no authority to do so on behalf of Boiler Riffle." Ex. 492-J. In May 12, 2005, before the 2006 and 2007 tax years at issue, Mr. Lipkind wrote a letter to petitioner's business partner stating unequivocally that "Jeff does not own Boiler Riffle nor does he have any right or authority to make investment decision on its behalf." Ex. 91-J. Similarly, in a September 20, 2006 email to his business partner and employees of his venture capital funds, petitioner described his limited relationship with Boiler Riffle as follows:

The evidence in the record also indicates that the Investment Advisor did as much due diligence as possible with respect to investments in start-up companies, which, by definition, have no historical data to review. The only diligence that could be performed for start-up companies was what was done by the Investment Manager: obtaining the available transactional documents and business plans and learning about the ideas and the people running the company.

Mr. Lipkind testified that when providing a recommendation to the Investment Manager he would send the legal documents, the business plan, and any financial information that existed. Tr. at 122. Mr. Walker confirmed that his onsite audit of the Investment Manager showed that the due diligence involved review of the business plans, available financial information, and information about the people running the company. Tr. at 403. Moreover, as was true with petitioner's own investments, the venture capital funds and the syndicate partners relied on petitioner's judgment, which was highly valued because of his industry expertise and successful track record. The Investment Manager was no different than the hundreds of limited partners and syndicate partners who trusted petitioner's judgment.

Respondent may argue that the investments in Post Ranch Inn and Longboard Winery were an exercise of investor control because they were somehow more personal to petitioner. This is simply not the case. First, there is no evidence that any of Boiler Riffle's investments in those ventures personally benefited petitioner. Second, both of these investments were permitted by the Investment Management Agreement and were within the investment parameters established when the Policies were purchased. And, third, the evidence at trial with respect to these investments indicates that the Investment Manager had sufficient information upon which to make an independent investment decision.

Petitioner recommended that Boiler Riffle invest in Post Ranch Inn, a luxury hotel in Big Sur, California because he believed that it was a very promising investment opportunity. Tr. at 217-18, 698-700. Before forwarding the recommendation to Mr. Lipkind to pass on to the Investment Manager, petitioner read the offering memo and discussed the investment with the developer, whom he knew personally. Tr. at 701-02. In 2006, Philtap Holdings, Ltd. ("Philtap") was established as a Separate Account by Butterfield Bank at Lighthouse's direction in order to make the $250,000 investment in Post Ranch Inn. Exs. 27-J, 28-J. There is nothing about this investment that suggests any inappropriate exercise of control by petitioner.

Similarly, petitioner recommended that Boiler Riffle invest in Longboard Winery. Exs. 67-J, 68-J, and 69-J; Tr. at 690-91. In order to accomplish this, an entity known as Signature Investments, RBN ("Signature"), of which petitioner was the president, was formed, and Boiler Riffle made a series of loans to Signature, which were invested in Longboard Winery. First Stip. at ¶¶ 151-55; Exs. 35-J (P000783), 67-J, 68-J, 69-J; Tr. at 697. Again, there is no evidence that petitioner personally benefited from this investment or that he improperly directed the Investment Manager.

C. Petitioner's Status as a Discretionary Beneficiary of the Trusts Does Not Render Him the Owner of the Assets of Boiler Riffle or Taxable on Boiler Riffle's Income

The Service appears to be taking the position that because petitioner was a discretionary beneficiary of the Chalk Hill Trust, he had investor control over its assets, including the assets owned by Lighthouse in support of the Policies. In this vein, the Court directed counsel to clarify the Trusts' status as grantor trusts for federal income tax purposes. See Tr. at 913.

The Court's analysis should focus exclusively on whether the Trusts, as owners of the Policies, exercised investor control with respect to the assets of the segregated accounts. If the Trust would have had investor control with respect to the assets of the segregated accounts (for example, if the Cash Surrender Value restriction did not exist), the Trust would recognize income or loss with respect to the assets of the segregated account, and such income would be attributable to petitioner under the grantor trust rules. See I.R.C. §§ 671, 677.

In any event, it was never intended that petitioner have access to the Trusts' assets. As petitioner and Mr. Lipkind testified at trial, it was important to the estate planning that the Trusts be grantor trusts. Tr. at 59, 62, 722-24. The standards for distribution made it virtually impossible for petitioner to ever personally benefit. Tr. at 64, 118. And, indeed, through 2007, petitioner never requested or received any distributions or loans from the Trusts.

The Service also seems to suggest that there was something nefarious about the selection of two elderly relatives as the insured. This was not done for any improper purpose, but as Mr. Lipkind and petitioner both testified, part of the estate plan was to fund the Trust for petitioner's minor children while petitioner was still alive. Tr. at 68-69, 469-70.³

D. The Ability to Pledge the Policies Is Not an Incident of Ownership of the Separate Account Assets

The Court asked the parties to address whether the Trust has the unilateral ability to pledge the Policies as collateral for a loan, and, if so, whether such ability should be taken into account in the investor control analysis. Tr. at 915-917. The Policies directly address this question, stating:

Lighthouse's express consent is required in order for the Policies to be assigned as collateral to secure a loan. Even if the Trust could pledge the Policies as loan collateral without Lighthouse's affirmative consent (which it cannot) the Trust should still not be viewed as having access to the appreciation of the separate account assets for two independent reasons.

First, for there to be constructive receipt, a taxpayer must be able to draw upon income during a taxable year, without substantial limitations or restrictions. See Treas. Reg. § 1.451-2(a); Christoffersen, 749 F.2d at 515-16. Even if the Trust had the ability to monetize the inside build-up of the Separate Account assets through a third-party loan, the Trust would be required to pay interest on this loan, which is a substantial restriction barring the application of the constructive receipt doctrine.

In Rutland v. Comm'r, T.C. Memo 1977-8, under the terms of a contractual arrangement with a vendor, the taxpayer was permitted to draw upon funds during the current taxable year that would not otherwise be earned by the taxpayer until the following year. In order to receive this advance, the taxpayer was required to pay the vendor interest at a rate that was only one half of a percent above the prime rate. The Tax Court held that the doctrine of constructive receipt did not apply because "[i]n our view we should not effectively say that an individual with ample funds should be required to draw amounts available if he pays interest at on half of one percent above the prime rate . . . To say that petitioners turned their backs on income unrestrictedly available to them would in effect be stating that they were required to take available funds at an interest rate above the prime rate, regardless of their need for funds." Id.⁴

Similarly, in United States v. Steck, 295 F.2d 682, 684 (10^th Cir. 1961), the court held that the doctrine of constructive receipt did not apply where the taxpayer, by accepting a deposit, would have had to give up his claim for interest on the amount due to him. Likewise, in Revenue Ruling 73-220, 1973-1 C.B. 297, the Service stated that a taxpayer was not in constructive receipt of interest accrued on a certificate of deposit that would be forfeited upon a premature withdrawal, again because giving up the right to receive interest was viewed as a substantial limitation to receiving the funds.

Here too, even if the Trust could pledge the Policies as collateral for a loan, it nevertheless would not be in constructive receipt of the Policies' assets, as it would have to pay interest to the third-party lender.⁵

Second, a commercial third-party lender would disregard the death benefit when determining the value of the Policies for purposes of collateral because there would be a significant risk that the Trust would not have the funds to repay the loan as the underlying investments assets are illiquid, highly speculative, and subject to significant value depreciation at any point in time.

E. The Payment of Policy Charges Is Not An Incident of Ownership of the Separate Account Assets

The Court asked petitioner to discuss whether the fact that payments for the annual policy charges are made from the Policies' separate accounts to keep the Policies in force should be considered an incident of ownership of the Separate Account assets by the Trust. Tr. at 919-922. The answer to this question is "no" for two independent reasons.

First, the annual Policy charges are the exclusive obligation of the Separate Accounts, which are owned by Lighthouse, and not the obligation of the Trusts. See Ex. 15-J (JTW0018068, 108080). The Policies explicitly provide that mortality, investment, and administrative charges "shall be borne by the Separate Account." Id. The Policies further provide that "[i]n the event that funds in the Separate Account are insufficient to satisfy the [applicable charges], the Policy will lapse, and Cash Surrender Value less the Loan Account Balance determined as of the date of the lapse shall be returned to the Policy owner." Id. If the Separate Account assets are not sufficient to cover the charges, the policyholder could contribute additional premium to the Separate Account to prevent the Policies from lapsing, but this decision would be (i) completely at the discretion of the policyholder and (ii) subject to the premium contribution limit contained in the Policies. Ex. 15-J (JTW 0018064, 18071).

Thus, the fact that the Trust may contribute additional premium to keep the Policies in force is an option, not an obligation. The fact that there may be sufficient investment assets so that the Trust does not have to decide whether to pay additional premiums is not an incident of ownership, nor constructive receipt of the Separate Account assets, but simply a feature of owning a universal life insurance policy. Put differently, the fact that a policyholder does not have to pay a premium where there are sufficient assets in the separate account indicates ownership of the Policies, not the separate account assets. This is in contrast to the notions of constructive receipt articulated in the Revenue Rulings and Christoffersen, where the policyholders had full access to the assets of the separate account to use in any way they chose.

As noted above, the investor control doctrine relies on constructive receipt. An item of income is treated as constructively received by a taxpayer only if "it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given." Treas. Reg. § 1.451-2(a). Here, it cannot be said that the Separate Account assets have been set aside in a manner such that the Trust can draw upon them "at any time" merely because the Trust is not required to decide whether to contribute additional premium.

Second, if the Separate Account assets were not sufficient to keep the Policies in force, it is almost certain that the policyholder would allow the policy to lapse. To keep the Policies in force if the Separate Account assets were depleted would require the Trusts to pay the annual cost of insurance for the full mortality risk. Universal life policies, including variable life, are built on the premise of positive returns over time that build the policy's internal reserve and decrease the retention/reinsurance portion of the policy. If that assumption proves false because of poor investment performance, the cost to maintain the policy would grow rapidly in the later years of the insured lifetime, making it economically prohibitive. In such a situation, it would make no sense for the policyholder to continue to pay more premium into the policy.

Finally, it is worth noting that the Code treats payments for mortality charges and administrative fees as not being a benefit to the policyholder. Section 72 of the Code governs taxation of amounts paid under an annuity or life insurance contract. Certain expenses incurred by the insurance company, such as mortality charges and contract administration fees are treated as "contract expenses" and not as an amount received under the contract.

This ambiguity also exists in respondent's pretrial memorandum, which separately discusses the investor control doctrine and certain rules relating to grantor trusts and CFC's. See Resp. Mem. at 24-32 (arguing that the investor control doctrine applies); id. at 32-33 (arguing that Boiler Riffle is a CFC); and id. at 33-36 (attempting to calculate Boiler Riffle's purported subpart F income).

The Court questioned respondent about this ambiguity at the start of the trial and during closing arguments. See Tr. at 41, 954. During opening statements, respondent made the following statement: "constructive receipt, which Petitioner focused on in her opening, is a doctrine that applies to the cash method of accounting and is not relevant to determine when a U.S. shareholder of a . . . CFC . . . has to pick up its Subpart F income. It has no relevance." Tr. at 42.

Later, in response to the Court's questioning about whether the Cash Value Restriction distinguishes this case from the Revenue Rulings, Tr. at 950, respondent stated "[i]t has nothing to do with constructive receipt. Constructive receipt is irrelevant to the Subpart F rules." Tr. at 952.

Respondent finally put his whole CFC/Subpart F theory together in closing argument, as follows:

Based upon these statements, it appears that respondent is invoking the CFC/subpart F regime because he erroneously believes that the CFC/Subpart F regime somehow sidesteps the investor control doctrine's requirement of constructive receipt. Respondent's attempt to apply the CFC regime in this fashion is tautological. Respondent admits that the only way the Trust could be treated as owning Boiler Riffle is with the application of the investor control doctrine (in respondent's words, "[t]he way we are coming at it is. . . does the policyholder, which is Chalk Hill Trust, or the insurance company Lighthouse, own the assets of the separate accounts? We thought that that's the threshold issue that investor control addresses." Id.). Thus, if the investor control doctrine does not apply (which it cannot in the absence of constructive receipt), Lighthouse is indisputably the legal owner of Boiler Riffle, and Boiler Riffle is not a CFC. If Boiler Riffle is not a CFC, the CFC rules cannot be used to solve for the constructive receipt element of the investor control doctrine.

As the Court remarked, "my instinct tells me . . . that it would be surprising if . . . the government could be relieved of the obligation to show this indicia of ownership solely because things are offshore." Tr. at 965. There is no rationale for respondent's position that merely because Boiler Riffle was an offshore corporation, petitioner received deemed distributions even though he did not own or control Boiler Riffle.

Moreover, respondent is attempting to argue that if the investor control doctrine applies, petitioner should be treated as owning Boiler Riffle itself, and not the underlying assets. This is simply not correct. First, Christoffersen and each of the Revenue Rulings are uniform in their holdings that where the investor control doctrine applies, the policyholder is viewed as owning the underlying investments over which he or she had investor control. For example, Revenue Ruling 81-225 held that where the policyholder exercised investor control, he was treated as the owner of the mutual fund shares (i.e., the actual underlying investment assets).

Similarly, in Christoffersen, the court concluded that "[t]he Christoffersens have surrendered few of the rights of ownership or control over the assets of the sub-account [and therefore] . . . the Christoffersens, and not Pacific Fidelity, owned the assets of the sub-account." Id. (emphasis added). And, in fact, respondent took the position in the Christoffersen appeal that the taxpayers should be taxed on the dividend income from the shares of the mutual funds, and the not vehicle that held these investments. See Pet. Mem. Ex. A at v, 13-15. Respondent has not provided any rationale for taking a different position in this case.

Accordingly, if the Court were to conclude that petitioner's recommendations to purchase investment assets were sufficient to implicate the investor control doctrine, it should apply with respect to underlying investments over which petitioner had investor control.

Treating the underlying assets as the source of taxable income would be the correct result, as there is no evidence that petitioner exercised any control over Boiler Riffle or that Boiler Riffle was established at petitioner's direction. Rather, Lighthouse formed Boiler Riffle as provided in the Policies, and petitioner has never had any ownership interest in Boiler Riffle. Exs. 15-J (JTW0018065, 18077), 32-J, 83-J (JTW0018576); Tr. at 98, 452. Respondent's entire case relies on petitioner making recommendations with respect to Boiler Riffle's underlying investment assets, and thus, if the investor control doctrine applied, it should apply to those underlying investment assets.

Further, as the Court noted at trial, there is a "possible fairness problem" raised by respondent's position. During opening statements, the Court asked respondent "[w]hat would happen on your theory -- assuming the Service applied was consistent over time, in later years -- if Boiler Riffle insurance policies had large losses?" Tr. at 43. Respondent contended that petitioner would not be able to benefit from those losses, Tr. at 44, presumably because United States shareholders of a CFC cannot utilize the CFC's losses, as I.R.C. § 954(c)(1)(B) only provides for the inclusion of the CFC net gains. This problem does not exist if petitioner is treated as the owner of the underlying investments, as opposed to Boiler Riffle itself.

Respondent's alternate CFC theory is that petitioner, or the Trust, owns Boiler Riffle because the Trust owns the Policies, and the Policies own Boiler Riffle. See Resp. Mem. at 32-22. This argument, which is based on a single document prepared by Bank of Butterfield, defies common sense. At trial, respondent referred to Ex. 32-J, which is a register of the members of Boiler Riffle that identifies these members as the two Policies. This document does not make the Policies the owners of Boiler Riffle. As succinctly stated by Mr. Lipkind, "a policy is a contract . . . . contracts don't own anything." Tr. at 98; see also Tr. at 342 (testimony of James Walker that reference to policies as owners of Boiler Riffle was "sloppy, simple shorthand."). Rather, as is plain from all of the evidence, Lighthouse owns Boiler Riffle.

The Court asked the parties to consider whether the Policies differed in any way from a standard form of variable life insurance. Tr. at 932. The Court stated that while it was convinced that there was a "real life" insurance element to the Policies, Tr. at 931, it questioned whether the Policies could be bifurcated into two parts: (i) a life insurance contract; and (ii) an investment fund owned by the Trust. Tr. at 932. In the Court's words, the question is whether "there are any respects in which this version of the variable life insurance transaction departs from what we might call industry norms for variable life insurance?" Tr. at 933. The answer to this question is unequivocally, "no."

The Lighthouse Policies have two distinct components: (i) a minimum death benefit for which cost of insurance is paid annually; and (ii) a pool of investment assets (which the Court analogized to a "fund"), both of which are payable upon the death of the insured. Lighthouse has mortality risk with respect to the first component, but not with respect to second component, as it will pay to the Trust the fair market value of the pool of investment assets upon the death of the insured. This is true of almost every commercially-available variable life insurance policy, as contemplated by Congress when it enacted I.R.C. § 7702.

Prior to the enactment of I.R.C. § 7702, the Code did not contain a definition of "life insurance." The common law definition of life insurance for federal income tax purposes was established by the Supreme Court in Helvering v. Le Gierse, 312 U.S. 531 (1941), which held that a life insurance contract must provide mortality risk shifting and risk distribution. The magnitude of the mortality risk shift required by Le Gierse was not material,⁶ and this permitted taxpayers to purchase insurance policies that had extremely low death benefits, so that the overwhelming majority of premium paid was credited to the investment component of the policy, as opposed to cost of insurance. Congress viewed these policies as "investment-oriented products that maximize the advantages of the deferral provided in the Code." H.R. Rep. No. 432, 98th Cong., 1st Sess., Vol. 1, 102. The enactment of I.R.C. § 7702 was Congress' response to the tax-favored treatment of life insurance policies that were overly investment-oriented. Id. Section 7702's definition of "life insurance" thus explicitly excludes policies that have a disproportionately large cash value component.

Under I.R.C. § 7702, a policy is treated as a life insurance contract if it satisfies either the (i) cash value accumulation test; or the (ii) guideline premium/cash value corridor test. See Pet. Mem. at 23-25. Both tests are designed to limit the investment component of life insurance contracts that receive preferential tax treatment. The cash value of a policy that does not satisfy I.R.C. § 7702 is treated as a taxable investment fund. H.R. Rep. No. 861, 98th Cong., 2d Sess. 1074-76 (1984).

Respondent has acknowledged, at least for purposes of this case, that the Policies meet the life insurance contract definition of I.R.C. § 7702. It therefore follows that the Policies should receive the tax preferential treatment intended by Congress in enacting I.R.C. § 7702. See, e.g., In re Tyler, 2004 WL 903826, at *2 (Bkrtcy. D.N.H. April 21, 2004) (if variable life insurance policy satisfies the requirements of I.R.C. § 7702, "the cash build up of earnings accumulates tax free, loans are considered debt and not a taxable event and there are no tax penalties associated with withdrawals.").

After the enactment of I.R.C. § 7702, Congress continued to be interested in aspects of the investment component of life insurance not addressed by I.R.C. § 7702, which led to the enactment of I.R.C. § 7702A in 1988. The bill that enacted I.R.C. § 7702A directed Treasury to study "the effectiveness of the revised tax treatment of life insurance and annuity contracts in preventing the sale of life insurance primarily for investment purposes." Senate Committee Report to 1988 enactment of Section 7702A. P.L. 100-647, 1032 Stat. 3342 (Nov. 10, 1988). This history shows that Congress was well aware that life insurance contracts compliant with I.R.C. §§ 7702 and 7702A still offered the opportunity to defer investment income, but nonetheless declined to further limit the deferral.

Returning to the Court's question, it is readily apparent from examining the publicly-available promotional materials of commercial issuers of variable life insurance that the Lighthouse Policies do not depart from the industry norms. See Tr. at 933. First, the court in In re Tyler, 2004 WL 903826 (Bkrtcy. D.N.H. April 21, 2004), provides the following common understanding and definition of a variable life insurance policy, which is echoed in the various descriptions published by life insurance companies:

Other life insurance companies describe their variable life insurance products in similar terms, as can be seen from excerpts from the following promotional materials:

Similar descriptions of variable life insurance can be found in financial publications. For example, an article by Kiplinger states that:

A useful illustration is the standard private placement variable life insurance policy from the Zurich American life Insurance Company. See Pet. Mem. Ex. B(7). This example is of a $1,000,000 single premium policy with a death benefit of $4,210,780 insuring a 55 year-old female. Breaking the Zurich policy down into the standard variable life policy formula, the separate account at issue is $1,000,000 (less policy charges), and the guaranteed minimum death benefit is $4,210,780. The difference between the two is $3,210,780, which is the initial "net amount at risk" of mortality coverage imbedded within the policy. This means that if the insured dies shortly after the issuance of the policy, the beneficiary would receive $4,210,780 as an income tax-free death benefit under I.R.C. § 101(a)(1). Internally, $1,000,000 of this death benefit would be separate account policy reserves, and $3,210,780, or 76% of the death benefit, would be mortality risk born by Zurich and/or its reinsurer.

If the insured dies at age 75, the result changes dramatically. According to Zurich's projections, the separate account policy reserves will have grown at a rate of 10% per year. This means that after twenty years, the separate account reserves would be $6,130,064, the death benefit would have grown to $6,559,168, and the mortality risk would have fallen to $429,104, such that only approximately 6% of the total death benefit would be born by Zurich and/or its reinsurer.

As can be seen by this example, Zurich is counting on the segregated account policy reserves to cover virtually all of the death benefit obligation. This is true for all other variable life insurance policies, including the Lighthouse Policies at issue here.

Comparing the Lighthouse Policies to the Zurich policy described above also illustrates how the Lighthouse Policies are similar to standard forms of variable life insurance. Lighthouse Policy No. 99-047 (Mabel Jordan) had an initial premium of $350,000 with a guaranteed minimum death benefit of $2,720,000. If Ms. Jordan had died the day after the policy was issued, $350,000 of this death benefit would be separate account policy reserves, and $2,370,000, or 77% of the death benefit, would be mortality risk born by Lighthouse and/or Hannover Re. This is very similar to the Zurich policy.

Looking forward, had Ms. Jordan died in 2006, based on the Separate Account's performance up to that point, the death benefit increased to $6,421,290, the separate account reserves increased to $6,357,713, and the mortality risk had dropped to $63,577. See Ex. 22-J. Accordingly, in 2006, based on these calculations, less than 1% of the total death benefit would have been be born by Lighthouse and/or Hannover Re. The only difference between the Zurich example and the Lighthouse Policies is that the Separate Account performed extremely well. Zurich and the other insurance companies undoubtedly would like to see similar investment performance for their own policyholders.

The above examples demonstrate that the Lighthouse Policies, like other standard commercial forms of variable life insurance, have significant fund investment components that in no way relate to mortality risk,⁷ but are nevertheless treated as part of the life insurance contract for federal income tax purposes. By focusing on the dual nature of variable life insurance, the Court appears to be troubled by the tax-preferred treatment of life insurance products with significant investment component separate from the mortality risk component. Under I.R.C. § 7702, however, the two components are not treated separately, but are, collectively, one tax-free death benefit. It is for Congress to enact legislation curtailing the tax benefits of variable life insurance, and not for the Court to divest the Lighthouse Policies of those benefits.

The only evidence of the value of the Webify warrants is the valuation attached to petitioner's 2003 Gift Tax Return which states that the value is $3,085, the amount reported by petitioner. Respondent has neither challenged the methodology or accuracy of this valuation nor offered an alternative valuation. And, the only testimony regarding the value of the warrants was from petitioner's former business partner, who testified that Webify's value increased in 2004, when IBM first expressed interest in acquiring it, Tr. at 860-61, well after the 2003 transfer of the warrants to Boiler Riffle.

In any case, respondent waived any challenge to the valuation of the Webify warrants. The capital gain from the sale of the warrants was reported on petitioner's 2003 income tax return, see Ex. 53-J, and was never challenged by the Service. Petitioner also protectively disclosed his sale of the Webify warrants to Boiler Riffle on his 2003 gift tax return. Ex. 51-J; Tr. at 523-24. The $3,085 sale price for the warrants was determined by an independent appraisal, which was attached to the gift tax return. Ex. 52-J; Tr. 519-20. Because the transfer was adequately disclosed, any challenge to the valuation must have been made within three or six years of the filing of the gift tax return. See Treas. Reg. § 301.6501(c)-1(f). Here, the gift tax return was filed on April 14, 2004, and the Notice issued on March 22, 2011, thereby making any challenge to the valuation untimely, regardless of whether a six-year or three-year statute of limitations for assessment applies.

If the Court finds that petitioner should be taxed on Boiler Riffle's income, which it should not, the capital gain should be reduced by Boiler's Riffle's basis in Webify stock. The Court indicated it intends to find that Boiler Riffle's basis in Webify stock was the amount reported on the Bank of Butterfield financial statements. Exs. 35-J (P 000802), 34-J (JTW 0015895-96, 15937); Tr. at 903. Since respondent has not conceded the issue, however, we will briefly address it.

The Bank of Butterfield financial statements containing the record of Boiler Riffle's purchases of Webify stock are reliable evidence of basis. These statements were professionally prepared and both sides relied on them and treated them as credible and reliable throughout the case. Exs. 34-J, 35-J; Tr. at 903. Respondent appears to be relying on these financial statements to establish the amount of the gross proceeds from the sale of Boiler Riffle's stock to IBM, since there is no other evidence in the record. Respondent also relied on these financial statements to establish various other facts in the record, see e.g. Tr. at 637, 641, 644-46, 650-53, 653-56, 660-61. Respondent cannot articulate any rationale for treating these statements as reliable when they are helpful to respondent, but unreliable when they are helpful to petitioner.

Mr. Walker, who developed Lighthouse's procedures for ensuring accurate financial statements, Tr. at 349, testified about those procedures, establishing that these financial statements are accurate and reliable:

When asked about the level of accuracy in the financial statements from this process of review and verification, Mr. Walker testified that: "They should pick up anything. Missing a dollar is important as missing $100,000. . . . [t]here should never be any money missing, any money not accounted for, really to the nickel. That's what the systems and processes are there for." Tr. at 351-52.

Petitioner also produced the following exhibits, stipulated to be authentic by respondent, which are consistent with the information in the Bank of Butterfield financial statements. See Exs. 55-J ($250,000 Subordinated Convertible Promissory Note); 56-J (Series A Preferred Stock Purchase Agreement); 57-J ($100,000 Note Purchase Agreement); 58-J (Series B Preferred Stock Purchase Agreement); 59-J ($62,500 Subordinated Convertible Promissory Note); 60-J (Series C Preferred Stock Purchase Agreement).

Moreover, the witnesses at trial agreed to the common sense notion that Boiler Riffle could not have obtained the Webify stock without paying for it, thus refuting respondent's position that Boiler Riffle's basis was zero. For example, Mr. Lipkind testified that it was "inconceivable" that Boiler Riffle did not pay for its Webify stock. Tr. at 137. Mr. Lipkind's testimony was based on his personal knowledge of the offering documents and the prices stated therein, and that Webify had independent counsel who would have insisted on performance of the various purchase agreements. Tr. at 138. Petitioner, who himself was on the Webify Board of Directors from October 2002 through August 2006, First Stip. at ¶ 112, also testified that it would have been "impossible" for Boiler Riffle not to have paid for its Webify stock at the same price as every other investor. Tr. at 547-48.

Although a taxpayer must establish the cost basis for the purpose of determining gain or loss on a sale of property, Cullins v. Comm'r, 24 T.C. 322, 328 (1955), the Tax Court may apply the "Cohan" rule to estimate a taxpayer's basis in an asset at the time of transfer. Cohan v. Comm'r, 39 F.2d 540 (2d Cir. 1930); Group Admin. Premium Servs., Inc. v. Comm'r, T.C. Memo. 1996-451. In order for the Court to estimate basis, the taxpayer must provide some "reasonable evidentiary basis" for the estimation. Group Admin. Premium Servs., T.C. Memo. 1996-451 (citing Polyak v. Comm'r, 94 T.C. 337, 345 (1990); Vanicek v. Comm'r, 85 T.C. 731, 743 (1985)).

Here, the evidence at trial has established the exact amount that Boiler Riffle paid for its Webify stock. The explanation of Boiler Riffle's purchases contained in the Statement of Facts and the accompanying documents, along with the Boiler Riffle financial statement, establish that Boiler Riffle's basis was $838,574.59. Exs. 35-J (P 000802), 34-J (JTW 0015895-96, 15937). This evidence more than satisfies the Cohan rule cited above, and provides a reasonable evidentiary basis for the Court to find that Boiler Riffle's basis in Webify was $838,485, making the gain on the sale $1,892,412 ($2,730,987.11 less cost of $838,574.59), as opposed to the $2,730,987.11 gain stated in the Notice.

B. Gain on the Sale of Webify Stock Should Be Characterized as Long-Term Capital Gain and Not a Dividend

If the Court rules that petitioner exercised investor control of the Policies' underlying investment assets (which it should not), not only should petitioner be given credit for Boiler Riffle's basis in Webify, but the character of the gain resulting from the sale of the Webify stock should be long-term capital gain. The Notice characterizes the gross proceeds from the sale of the Webify stock sale as a dividend, which is taxed as ordinary income. Exhibit 3-J (JTW 0015201). Respondent attempts to justify this characterization by arguing that Boiler Riffle is a controlled foreign corporation, and therefore all its Subpart F income is treated as a deemed distribution to the Trust, which results in ordinary income. See Resp. Mem. at 33-36. As discussed above, however, under Christoffersen and the applicable Revenue Rulings, where the investor control doctrine applies, the policyholder is treated as the owner of the underlying investment assets. Accordingly, if the investor control doctrine applied here, the Trust would be viewed as having sold the Webify stock after holding it for more than a year, and therefore recognizing a long-term capital gain.

Nevertheless, if the Court were to hold that the investor control doctrine applies, and that petitioner should be treated as owning Boiler Riffle's underlying assets, a payment from Boiler Riffle for the benefit of petitioner would be equivalent to petitioner paying business expenses from his own bank account.

Finally, even if the distributions were income to petitioner (which they are not), he would be entitled to an offsetting deduction for the majority of the expenses. Petitioner is in the business of making private equity investments, and the management fees would thus be deductible under I.R.C. § 162. See Achiro v. Comm'r, 77 T.C. 881, 903 (1981) ("[a]mong the items deductible as business expenses under section 162(a) are management expenses").

A. There Was No Understatement of Tax and Petitioner Was Not Negligent

An underpayment is defined as the difference between a taxpayer's correct tax liability, and the total tax shown on the return plus amounts not so shown but previously assessed or collected, less any rebates previously made. I.R.C. § 6664(a). For all of the reasons discussed in this brief and petitioner's pre-trial memorandum, petitioner has no underpayments on his income tax returns for 2006 and 2007, and therefore cannot be held liable for penalties for negligence or substantial understatements of tax for those years.

B. Petitioner's Return Positions Had a Reasonable Basis and Were Supported by Substantial Authority

Even if the Court were to consider penalties in this case, and petitioner respectfully submits that it should not because there were no underpayments, petitioner should not be liable for either the negligence or substantial understatement penalties. Negligence includes the failure to make a reasonable attempt to comply with the Code or to exercise reasonable care in the preparation of a tax return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1); Matthews v. Comm'r, 92 T.C. 351, 362-363 (1989); Neely v. Comm'r, 85 T.C. 934, 937 (1985).

Under I.R.C. § 6662(d)(2)(B)(i), the amount of any understatement of tax is reduced by that portion of the understatement that is attributable to the tax treatment of an item for which there is or was substantial authority. See also Treas. Reg. § 1.6662-4(d)(1). Treas. Reg. § 1.6662-4(d)(2) defines substantial authority as an objective standard involving an analysis of the law and an application of the law to the relevant facts. There is substantial authority for the tax treatment of an item if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. Treas. Reg. § 1.6662-4(d)(3)(i).

Under Treas. Reg. § 1.6662-3(b)(1), a return position that has a "reasonable basis" is not attributable to negligence. Treas. Reg. § 1.6662-3(b)(3) provides that a return position meets the reasonable basis requirement if it is reasonably based on one or more of the authorities listed in Treas. Reg. § 1.6662-4(d)(3)(iii), even though the position may not satisfy the "substantial authority" standard.

The legal authorities and the factual discussion presented in Points II through VIII, supra, and in petitioner's pre-trial memorandum, prove beyond any doubt that petitioner acted in a reasonable and prudent manner in preparing his income tax returns and in reporting his income, and that petitioner had a reasonable basis for the positions taken on his tax returns. These same arguments establish that there was and is substantial authority for the tax treatment of the items reported on petitioner's tax returns. Consequently, petitioner is not liable for penalties for substantial understatements of income tax. See I.R.C. § 6662(d)(2)(B)(i); Treas. Reg. §§ 1.6662-3(b)(1), (b)(3), 1.6662-4(d)(1).

C. Petitioner Acted Reasonably and In Good Faith

If the Court were to find an underpayment and that petitioner's other defenses to the penalties do not apply (i.e., reasonable basis and substantial authority), petitioner still would not be liable for penalties because he acted with reasonable cause and in good faith within the meaning of I.R.C. § 6664(c)(1).

Section 6664(c)(1) provides that penalties for negligence and substantial understatement of income tax do not apply to underpayments if there is reasonable cause and the taxpayer acted in good faith. See also Treas. Reg. § 1.6664-4(a). Reasonable cause requires that the taxpayer exercised ordinary business care with respect to the tax items in issue. See United States v. Boyle, 469 U.S. 241 (1985); see also Hatfried, Inc. v. Comm'r, 162 F.2d 628, 631-632 (3d Cir. 1947); Estate of Young v. Comm'r, 110 T.C. 297, 317 (1998).

Mr. Lipkind also reviewed and considered the Powell Goldstein Opinions authored by Mr. Walker, see Exs. 782-P, 783-P, and 785-P, and had extensive discussions with him, Tr. at 124, 281, 278. Mr. Walker described his discussions with Mr. Lipkind as follows:

Respondent's attempt to characterize Mr. Lipkind as a promoter upon whom petitioner could not reasonably rely fell flat. It is the case that taxpayers cannot reasonably rely on the advice of a "promoter." See Tigers Eye Trading, LLC v. Comm'r, T.C. Memo. 2009-121 (collecting cases). The Tax Court has held that "where the transaction involved is the same tax shelter offered to numerous parties," a "promoter" is defined as an "adviser who participated in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction.'" Blum v. Comm'r, 103 T.C.M. (CCH) 1099 (T.C. 2012) (quoting 106 Ltd. v. Comm'r, 136 T.C. 67, 79 (2011), aff'd, 684 F.3d 84 (D.C. Cir. 2012) (quoting Tigers Eye Trading, T.C. Memo. 2009-121))).

This definition should not apply because the transaction at issue in the present case is not a "cookie cutter" tax shelter offered to numerous parties like those considered in Blum and similar cases. Despite respondent's insinuations in pre-trial submissions, see Resp. Mem. at 55; Respondent's Motion to Compel Compliance with Subpoena Duces Tecum, at 7-8, there was no evidence that numerous other clients of Mr. Lipkind engaged in the same or similar estate plans. Rather, the evidence was that just one other client set up a trust that purchased a Lighthouse Policy, and that Mr. Lipkind's wife directly owned a Lighthouse insurance policy. Tr. at 113, 194-97, 605.

Because there is no evidence that Mr. Lipkind marketed the estate plan to numerous other parties, whether Mr. Lipkind was a competent advisor or a promoter is determined under the following test, which considers whether the advisor:

Each of these factors establishes that Mr. Lipkind is a competent advisor and not a promoter. First, although Mr. Lipkind was introduced to petitioner in 1999 in order to develop an estate plan to benefit his children, Mr. Lipkind has maintained a continuous attorney-client relationship with petitioner, and has advised him on the transactions with the Trusts, the formation of the subsequent trusts and the property assignments, and his firm prepared petitioner's gift tax returns and handled all communications with Lighthouse.

Second, there is no evidence that Mr. Lipkind gave unsolicited advice regarding the transactions he recommended to petitioner. Petitioner sought out Mr. Lipkind because he wanted estate planning advice. Respondent called a witness⁸ who had met with Mr. Lipkind at petitioner's suggestion in early 2000. Although this witness was purportedly called for the purpose of establishing that Mr. Lipkind was promoting a tax avoidance scheme, the witness candidly admitted that he did not think that Mr. Lipkind was suggesting anything illegal or improper, but merely that the estate planning techniques that Mr. Lipkind described were complex and that he did not understand them. Tr. at 800-801, 842-43. Ironically, the witness complained that Mr. Lipkind did not provide him with any handouts or flowcharts, Tr. at 801, one of the hallmarks of a promoted tax shelter, see e.g. Long Term Capital Holdings, LL v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004) (power point presentation to potential investors); Gerdau Macsteel v. Comm'r, 139 T.C. 67 (2012) (cash flow analysis and transaction checklist given to investors).

Next, there was no evidence that Mr. Lipkind advised outside of his normal area of expertise or that he took any action outside of his regular course of conduct. Respondent may attempt to argue that Mr. Lipkind's request that petitioner and his counsel, Mr. Herbst, sign a confidentiality agreement is somehow significant. The evidence at trial indicated that Mr. Lipkind requested the agreement because he had developed estate planning techniques that he did not want to give away. Mr. Lipkind never sought to enforce the agreement, which by its terms, only applied to the meeting and did not require petitioner to keep the underlying transactions confidential. Exs. 496-J, 497-J; Tr. at 177-79.

Finally, Mr. Lipkind had no stake in petitioner's estate planning other than his normal hourly rate. Tr. at 463. Mr. Lipkind received no other remuneration or other benefit from petitioner, Lighthouse, Boiler Riffle, or the Investment Manager. Tr. at 148, 197-98, 322, 463.

In sum, the evidence overwhelmingly established that Mr. Lipkind is a competent and qualified advisor upon whom petitioner reasonably relied for tax advice.

In the present case, petitioner reviewed the information provided by Mr. Lipkind and discussed the legal issues with him, but he did not ask for a formal legal opinion because he trusted Mr. Lipkind and believed his analysis was correct, and knew that Mr. Lipkind had received the Powell Goldstein Opinions. Tr. at 729-31. The lack of a written opinion does not diminish petitioner's good faith and reasonable reliance on Mr. Lipkind's reasonable and competent advice.

Although these disclosures may not have been on Form 8275, they fully apprised the Service of the transactions between petitioner and the Trusts, and the existence of the Lighthouse Policies. Further, these disclosures demonstrate that petitioner acted with reasonable cause and in good faith.

The gift and income tax disclosures show that petitioner was attempting to be transparent with the Service by consistently disclosing information about the Trust and the Lighthouse Policies. As Mr. Lipkind testified, even though he believed that the tax reporting was correct, he "bent over backwards to disclose" the transactions to the Service. Tr. at 209.

Based on all of the foregoing arguments, petitioner is not liable for penalties for negligence and/or substantial understatements of income tax under I.R.C. § 6662.

Dated: New York, New York

² As explained in petitioner's pretrial memorandum, Revenue Rulings are not binding on the Court, and are only persuasive to the extent that they are persuasive and consistent with the Commissioner's position over time. See Pet. Mem. at 28-29; Taproot Admin. Serv., Inc. v. Comm'r, 133 T.C. 202, 208-10 (2009), aff'd, 679 F.3d 1109 (9th Cir. 2012).

³ Apparently intending to establish that the life expectancy for petitioner's insured relatives was short, respondent offered into evidence Exhibit 779-R, the United States Social Security Administration's Life Expectancy Tables, published in 2002. These tables, however, contain information about the general population and do not reflect the life insurance underwriting performed by Lighthouse, which takes into consideration not just the age of the insured, but specific information about their health and lifestyle. Tr. at 312-13.

⁴ Even if a third party would lend money using the Policies as collateral, it is likely that the loan would be regarded as a non-conforming loan and subject to a significantly higher rate of interest.

⁵ Although Steck and Rev. Rul. 73-220 involve taxpayers who would be giving up the right to interest instead of paying interest, in Rutland, the Tax Court noted that "a true distinction cannot be drawn between a situation where a taxpayer who must surrender his right to interest in order to take an amount available to him and a taxpayer who must pay substantial interest in order to take that amount." T.C. Memo 1977-8.

⁶See Andrew D. Pike, "Reflections on the Meaning of Life: An Analysis of Section 7702 and the Taxation of Cash Value Life Insurance," 43 Tax. L. Rev. 491, 494 (1988).

⁷ The commercial issuers of variable life insurance generally publish the funds in which their policyholders may invest. A quick glance at these funds will leave no doubt that the typical I.R.C. § 7702-compliant variable life insurance policy is intended to be an investment vehicle. See Pet. Mem. Ex. C, which includes listings of mutual fund investment options offered by various commercial issuers of variable life insurance and annuities.

⁸ Because this witness' testimony was sealed by the Court, we do not identify him by name.