MEMORANDUM FINDINGS OF FACT AND OPINION
THORNTON, Judge: Respondent determined the following deficiencies, additions to tax, and penalties with respect to petitioners' Federal income tax liabilities:
Additions to Tax and Penalties
______________________________
Sec. Sec. Sec.
Year Deficiency 6653(a)(1)(A) 6653(a)(1)(B) * 6662(a) **/
____ __________ _____________ _____________ _______
1987 $ 5,766 $ 288 50% of the ---
interest due
on $ 4,446
1988 4,272 214 --- ---
1989 14,766 --- --- $ 2,477
The issues for decision are:
1. Whether Hillside Farm Co. (Hillside Farm), a putative business trust established by petitioners, should be disregarded for Federal income tax purposes because it lacks economic substance. We hold that it should.
2. Whether petitioners are liable for additions to tax for negligence pursuant to section 6653(a), for taxable years 1987 and 1988, and an accuracy-related penalty pursuant to section 6662(a) for taxable year 1989. 1 We hold that they are.
FINDINGS OF FACT
The parties have stipulated some of the facts, which are so found. The stipulated facts and associated exhibits are incorporated by this reference.
Leon and Ione Zachman were married until her death in 1989. Leon Zachman is the representative of the Estate of Ione Zachman. Unless otherwise indicated, "petitioner" hereinafter refers to Leon Zachman, and "petitioners" refers to Leon Zachman and Ione Zachman. Petitioner resided in Rogers, Minnesota, when the petition was filed.
Petitioners have farmed in the Rogers area since 1949. Prior to 1983, petitioners' farm was held in Shady Elms Farm, a trust promoted by Lowell Anderson. 2 On January 26, 1983, petitioners transferred their farm real property to another trust, Walnut Leaf. In 1983, petitioner attended a meeting with other farmers to hear a presentation by James Noske and Norb Stelton about utilizing business trusts. On September 8, 1983, petitioners executed bills of sale, purporting to transfer their farm equipment and livestock to Hillside Farm. On the same date, in their capacities as trustees of Walnut Leaf, petitioners deeded their interests in the farm real property to Maplewood Co. (Maplewood). On October 4, 1983, petitioners executed a bill of sale whereby for the stated consideration of "One dollar and other good and valuable consideration" they transferred to Maplewood two life insurance policies and an extensive assortment of personal property, including furniture, china, lamps, home appliances, a popcorn pumper, and a "Blue Madonna picture".
Hillside Farm and Maplewood both purport to be business trusts formed pursuant to Minnesota law. The named trustees of each of these trusts are Parnell, Inc. (Parnell) and Armageddon, Inc. (Armageddon), nonprofit corporations organized under the laws of South Dakota. These corporations are also the named trustees for numerous other business trusts.
The Declaration of Trust of Hillside Farm (the Declaration of Trust), dated April 25, 1983, recites that it is made between Parnell and Armageddon, "herein referred to as Trustees, for the purpose of enabling the Trustees to hold and manage the trust estate and to carry on business as hereinafter provided." The Declaration of Trust further provides in pertinent part:
ARTICLE III. SHARES
SECTION 1. The beneficial interest in this trust shall
be divided into shares without par value. Upon unanimous
approval of the Board of Trustees, shares may be sold or
exchanged for such consideration, and on such terms, as the
Trustees deem proper. All shares shall be evidenced by
trust certificates of which [sic] shall be signed by each of
the Trustees.
SECTION 2. The certificates shall entitle owners
thereof to participate proportionately in all dividends and
other distributions of income or principal as the Trustees
may, from time to time, in their absolute discretion,
declare and pay out; provided that, upon the termination of
the trust, the Trustees shall distribute all of the property
and accrued income to the certificate holders of record in
proportion that the number of shares they own bears to the
total number of shares issued and outstanding.
SECTION 3. Any Trustee hereunder may acquire, hold and
dispose of shares in this Trust to the same extent and in
the same way as if he were not a Trustee and without
affecting in any way his status or power as such.
SECTION 4. No shares shall be issued in addition to
those originally specified herein except as replacements for
other certificate holders as authorized by this Declaration.
The total number of shares outstanding shall not exceed 100
(one hundred) in number.
SECTION 5. Transfers of shares shall be made only on the
books of the business trust and the old certificate properly
endorsed shall be surrendered and canceled before a new
certificate is issued, provided that, no transfer shall be
effective until approved by unanimous vote of the Board of
Trustees.
* * * * * * *
SECTION 7. The rights of trust certificate holders and
other persons becoming entitled to shares of the trust shall be
subject to all terms and conditions of this Declaration of
Trust. The shares shall not be personal property, and the
ownership thereof shall not give any person any legal or
equitable title in or to the trust property or any part thereof,
but shall only entitle the owners of shares to their
proportionate shares of dividends and distributions as herein
provided. No shareholders shall have any rights to manage or
control the property, affairs, or business of the trust, or any
power to control Trustees in these respects. No shareholder
shall have any right to a partition of the trust property or to
an accounting during the continuance of the trust. No part of
the trust property or the income therefrom shall be liable for
the debts of any trust certificate holder and no certificate
holder shall have any power to sell, assign, transfer, encumber,
or in any manner to anticipate or dispose of his shares or the
income produced thereby, prior to the actual distribution in
fact, by the Trustee to said certificate holder.
SECTION 8. The death, insolvency or incapacity of any trust
certificate holder shall not operate to terminate or dissolve
the trust or affect its continuity * * *. If any certificate
holder hereunder dies, becomes insolvent or is placed under any
legal incapacity before the termination of this trust, his
shares shall become null and void and shall immediately revert
to the Board of Trustees, who shall thereupon name a replacement
beneficiary or beneficiaries and issue a new certificate or
certificates as provided in this Declaration.
ARTICLE IV. BOARD OF TRUSTEES
SECTION 1. The business and property of the business
trust shall be managed by Board of Trustees, who shall be the
persons named in the Declaration of Trust, who shall serve until
their successors are duly qualified. In the event of the death,
incapacity, resignation or retirement of any Trustee, a
successor Trustee shall be appointed by the remaining Trustee or
SECTION 3. The Trustees shall hold, in the trust name,
legal and equitable title to all property, real and
personal, and shall have absolute and exclusive power and
control over the management and conduct of the business of
the trust free from any right of control of any of the
certificate holders. The Trustees may hold, manage and
dispose of the property and business of the trust in the
same manner as if they were absolute proprietors thereof,
subject only to the specific limitations herein contained.
The Trustees shall have the power, without limitation, to
purchase or otherwise acquire property, and to sell,
exchange, lease, mortgage, pledge or in any manner dispose,
encumber, improve or deal with the property of the trust,
real or personal, or any part thereof, or any interest
therein, on such terms and for such consideration as they
deem proper. * * *
The Declaration of Trust, as well as various minutes for the board meetings of its trustees, bears the signatures of Cheryl A. Foshaug, president of Armageddon, and Marti Inman, president of Parnell. Neither Foshaug nor Inman has ever met petitioners or heard of Hillside Farm. Neither ever managed Hillside Farm. They each signed various papers, including blank or incomplete pages, at the request of James or Joan Noske. Foshaug often neither read nor understood the pieces of paper she signed. As president of Parnell, Inman took no action other than as directed by James or Joan Noske. 3
The minutes for the Hillside Farm trustees' meeting dated September 8, 1983, signed by Foshaug and Inman, indicate that the trustees appointed Daniel Strohmeier as manager of Hillside Farm, with authority to oversee the business operations of the trust and to issue checks to pay general operating expenses. 4 If Strohmeier ever conducted business related to Hillside Farm, it was at the direction and under the control of James or Joan Noske.
Sometime in 1987 or 1988, John B. Ellering became president of Armageddon and Parnell, and replaced Strohmeier as manager of Hillside Farm. 5
Petitioners had no official titles or offices in Hillside Farm, Armageddon, or Parnell. Initially, petitioners received all 100 trust shares in Hillside Farm. On December 29, 1983, petitioners surrendered their original 100 shares in Hillside Farm, each receiving 20 new shares. The remaining 60 shares purportedly were transferred to BBCA, Inc. (BBCA), an organization purporting to be a church. 6 The president of BBCA was Joan Noske.
Several years before the creation of Hillside Farm, petitioner had curtailed his work on the farm because of health problems. During the years at issue, his work on the farm consisted largely of riding a tractor or baling hay no more than a few times a week. Ione Zachman did not participate in the farm work, apart from growing her own garden. Both before and after the creation of Hillside Farm, petitioners' sons, Dale and Paul, performed most of the farm work. Dale made most of the farming decisions. Dale and Paul each received weekly wages for their labors.
All the gross receipts from petitioners' farming operation were sent to Joan Noske at a post office box in Cold Springs, Minnesota. Joan Noske generally made provision out of "Hillside Farm" funds for paying farm expenses, as well as certain of petitioners' personal expenses, including insurance, medical bills, income taxes, and property taxes on petitioners' residence.
During the years at issue, Joan Noske did all the bookkeeping for Hillside Farm. She prepared the Federal income tax returns for Hillside Farm and at least 20 other trusts that name Armageddon and Parnell as trustees. She also prepared petitioners' Federal income tax returns for the years in issue. At least twice a year, petitioners received ledgers from Joan Noske which accounted for funds purportedly received and disbursed by Hillside Farm during the years at issue. The disbursements included $ 125 per month to Joan Noske for her bookkeeping services.
On November 16, 1985, the U.S. District Court for the District of Minnesota entered a Final Judgment of Permanent Injunction as to James and Joan Noske, finding that they had engaged in conduct subject to penalty under section 6700 and enjoining them from organizing, assisting, selling, or otherwise promoting business trusts as abusive tax shelters. As part of the judgment, the Noskes were ordered to supply respondent's District Director with the names and addresses of all purchasers of the 186 business trusts on file with the Minnesota Secretary of State which list Armageddon and Parnell as corporate trustees. Subsequently, the Noskes identified Hillside Farm and Maplewood as being among the business trusts involved in the injunction action.
In September 1995, Joan and James Noske were convicted of, among other things, conspiracy to defraud the United States by impeding the Internal Revenue Service, and conspiracy to evade Federal income taxes. The convictions were based on the Noskes' participation in a scheme to assist their clients in reducing or avoiding Federal income taxes by forming business trusts which named Armageddon and Parnell as trustees. It was further determined that the Noskes participated in a scheme whereby their clients would transfer all of their income-producing property to the business trusts and then issue 60 percent of their trust shares to BBCA, thus effectively evading the assessment and payment of 60 percent of their clients' Federal income tax liability.
Hillside Farm filed Federal income tax returns for 1987 through 1989 reporting Schedule F income from petitioners' farming operation. During the years at issue, Hillside Farm reported that 40 percent of its net income was distributed to petitioners. 7 The trust itself paid no taxes.
Respondent determined that petitioners are taxable on Hillside Farm's gross income because the creation of Hillside Farm and the subsequent transfer of petitioners' assets thereto was a sham transaction lacking in economic substance, because petitioners have improperly attempted to assign their income to Hillside Farm, and because petitioners are taxable on the trust income under the grantor trust rules in sections 671 through 678.
OPINION
If the creation of a trust has no real economic effect and alters no cognizable economic relationships, it will be disregarded for Federal income tax purposes; our guidepost is the economic substance of the transaction. See Zmuda v. Commissioner, 79 T.C. 714, 719 (1982), affd. 731 F.2d 1417 (9th Cir. 1984); Markosian v. Commissioner, 73 T.C. 1235, 1241 (1980). This rule applies even if the trust is recognized pursuant to State law as a business trust or other form of jural entity. See Zmuda v. Commissioner, supra.8
Whether a trust lacks economic substance is a question of fact. See Paulson v. Commissioner, 992 F.2d 789, 790 (8th Cir. 1993), affg. per curiam T.C. Memo 1991-508. Relevant factors include whether the taxpayer's relationship as grantor to the property differed materially before and after the trust's formation, whether the trust had an independent trustee, whether an economic interest passed to other beneficiaries of the trust, and whether the taxpayer felt bound by any restrictions imposed by the trust or by the law of trusts. See Markosian v. Commissioner, supra 73 T.C. at 1243-1245; Muhich v. Commissioner, T.C. Memo 1999-192. The burden of proof is on petitioners. See Rule 142.
The evidence clearly establishes that Hillside Farm lacked economic substance and was merely a paper entity created for the primary purpose of reducing petitioners' Federal income tax. Petitioners' relationship to their property did not differ materially before and after the creation of Hillside Farm. Although petitioners purported to transfer all their income-producing personal property to Hillside Farm, in reality they retained dominion and control over it, with their sons providing most of the labor in return for weekly wages.
The record does not establish that Parnell and Armageddon were independent trustees or that they performed any significant duties or exercised any significant control or power over the farm. Contrary to the terms of Article IV, Section 3, of the Declaration of Trust, Parnell and Armageddon did not have "absolute and exclusive power and control over the management and conduct of the business". Petitioners concede that Inman and Foshaug were strangers to Hillside Farm and were nothing more than figurehead presidents of the corporate trustees, merely signing documents, often blank or incomplete, at the instigation of the Noskes. The use of strangers as signers of organizational documents and the absence of any meaningful role by nominal trustees in the operation of the trust are evidence that the purported trust lacks economic substance. See Para Techs. Trust v. Commissioner, T.C. Memo 1994-366, affd. without published opinion sub nom. Anderson v. Commissioner, 106 F.3d 406 (9th Cir. 1997), and cases cited therein.
Petitioners also concede that Strohmeier served no meaningful function as "manager" of Hillside Farm. Similarly, there is no evidence that Strohmeier's successor, Ellering, served any meaningful function as manager of Hillside Farm. 9 In fact, there is no evidence that Hillside Farm ever conducted any business at all. 10
Upon the alleged creation of Hillside Farm, no economic interest passed to any beneficiary other than petitioners. Nor does the record establish that the subsequent purported transfer to BBCA of 60 percent of petitioners' shares in Hillside Farm was a valid conveyance of petitioners' economic interests. To the contrary, at trial petitioner vigorously asserted that he never knowingly authorized or intended any such transfer of shares to BBCA. Similarly, on brief petitioners argue that "there were no valid transfers to BBCA".
Petitioners argue that Hillside Farm was created for estate-planning purposes to keep the farm together in the family. It is unclear, however, how the establishment of Hillside Farm would accomplish any such objective. Under Article III, Section 8 of the Declaration of Trust, if any trust certificate holder dies before termination of the trust, his shares become "null and void and shall immediately revert to the Board of Trustees, who shall thereupon name a replacement beneficiary or beneficiaries". Accordingly, the creation of Hillside Farm would have provided petitioners no assurance that the farm would remain in their family. To the contrary, under the terms of the Declaration of Trust, absolute power over the disposition of the farm property, either during their lives or upon the death of either petitioner, would have resided with Parnell and Armageddon. In any event, the expectancy of an estate- planning advantage does not establish entitlement to an income tax advantage. See Prindle Intl. Marketing, UBO v. Commissioner, T.C. Memo 1998-164. 11
Contending that they received only a share of the Hillside Farm income, petitioners argue that they should be taxed only on the share they actually received. 12 It is axiomatic, however, that taxation is concerned with "actual command over the property taxed -- the actual benefit for which the tax is paid" and that the transfer of formal legal title will not operate to "shift the incidence of taxation attributable to ownership of property where the transferor continues to retain significant control over the property transferred." Frank Lyon Co. v. United States, 435 U.S. 561, 573, 55 L. Ed. 2d 550, 98 S. Ct. 1291 (1978); see Sundance Ranches, Inc. v. Commissioner, T.C. Memo 1988-535, affd. without published opinion (9th Cir. 1990). Petitioners clearly retained sufficient power and control over the farm to be properly treated as the recipients of the income for tax purposes. Cf. Commissioner v. Sunnen, 333 U.S. 591, 604, 92 L. Ed. 898, 68 S. Ct. 715 (1948); Hutcherson v. Commissioner, T.C. Memo 1984-165.
In light of our holdings on these issues, we need not reach respondent's alternative argument that petitioners should be taxed on the Hillside Farm income under the grantor trust rules. Additions to Tax and Penalties
Respondent determined that petitioners are liable for additions to tax under section 6653(a) for taxable years 1987 and 1988, and an accuracy-related penalty under section 6662 for taxable year 1989. Section 6653(a)(1)(A) imposes an addition to tax equal to 5 percent of the underpayment if any part of the underpayment is attributable to negligence. Section 6653(a)(1)(B) imposes an addition to tax equal to 50 percent of the interest payable on the portion of the underpayment attributable to negligence. Section 6662(a) imposes a 20-percent penalty on any portion of an underpayment that is attributable to negligence. Negligence is the lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the same circumstances. See Neely v. Commissioner, 85 T.C. 934 (1985). Petitioners have the burden of proving that respondent's determinations are incorrect. See Rule 142(a); Bixby v. Commissioner, 58 T.C. 757, 791-792 (1972).
Petitioners argue only that because there is no underpayment of tax, there is no amount upon which to compute additions to tax or penalties. We have sustained respondent's determination that petitioners understated their Federal income tax liability for taxable years 1987, 1988, and 1989. Accordingly, petitioners' argument must fail.
Petitioners have not established that they used reasonable care in ascertaining their income tax liability for these years. They have not shown that they reasonably relied on a competent professional adviser independent of those persons who were involved in marketing these abusive trusts. We sustain respondent's determinations on this issue.
To reflect the foregoing,