Connell v. Commissioner

T.C. Memo. 1996-349

UNITED STATES TAX COURT

JAMES L. AND PATRICIA A. CONNELL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4924-93. Filed July 31, 1996.

James L. Connell, pro se.

Andrew M. Winkler, for respondent.

MEMORANDUM OPINION

FAY, Judge: This case was assigned to Special Trial Judge

D. Irvin Couvillion pursuant to section 7443A(b)(4)1 and Rules

180, 181, and 183. The Court agrees with and adopts the opinion

of the Special Trial Judge which is set forth below.

1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years at issue. All Rule
references are to the Tax Court Rules of Practice and Procedure.
 - 2 -

OPINION OF THE SPECIAL TRIAL JUDGE

COUVILLION, Special Trial Judge: Respondent determined

deficiencies in petitioners' Federal income taxes and additions

to tax with respect to the following tax years:

Additions to Tax
Sec. Sec. Sec. Sec. Sec.
Year Deficiency 6653(a) 6653(a)(1) 6653(a)(2) 6659(a) 6661(a)

1980 $ 2,822 $141 -- -- $ 847 --
1983 14,045 -- $702 * 3,092 $ 900
1984 13,485 -- 674 * 2,072 1,491

* 50 percent of the interest due on the deficiency.

Respondent also determined that petitioners were liable for

the increased rate of interest under section 6621(c), for each of

the taxable years at issue.

Prior to trial, respondent filed a motion for leave to file

an amended answer to claim an increased deficiency in tax for the

year 1980. The deficiency for 1980 arises from the carryback of

an investment tax credit by petitioners for the year 1983. On

their 1983 income tax return, petitioners reported an investment

tax credit of $17,924.08 from their investment in a partnership

discussed later in this opinion. Petitioners utilized $15,101.95

of the investment tax credit on their 1983 return and carried

back the unused credit to their 1980 tax year. Petitioners

received a tentative refund of $2,822 for their 1980 tax year,

and that is the amount of deficiency in tax set out in the notice

of deficiency for 1980. Later, respondent's Service Center noted
 - 3 -

that petitioners had erroneously calculated their tax liability

for 1983 using the tax rates applicable to married individuals

filing separately, when instead petitioners were entitled to the

rates for married individuals filing jointly. The Service Center

recomputed petitioners' 1983 tax, which reduced their tax

liability for that year by the amount of $4,654. This correction

resulted in an increase in the carryback of the investment credit

to the 1980 tax year in the amount of $4,546 and a carryforward

of $108 of the credit to 1981. The amounts of $4,546 and $108

were thereafter paid to petitioners as tentative refunds. In the

notice of deficiency, respondent failed to include the $4,546

tentative refund for 1980 as part of the deficiency in tax for

1980, and the amended answer sought an increase in the deficiency

in tax for that year from $2,822 to $7,368 to reflect the

subsequent tentative refund for that year and to correspondingly

increase the additions to tax to $368 and $2,120, respectively,

under sections 6653(a) and 6659(a), and the increased interest

under section 6621(c). The Court granted respondent's motion.2

The issues for decision are: (1) Whether petitioners are

entitled to claimed losses and investment tax credits with

respect to James L. Connell's (petitioner) investment in 1983 in

2
Since petitioners' 1981 tax year is not before the Court,
the increased deficiency claimed by respondent does not include
the tentative refund of $108, which was paid to petitioners as a
carryforward of the credit to 1981.
 - 4 -

the Barrister Equipment Associates Series 162 limited partnership

(Series 162); (2) whether petitioners are liable for the

additions to tax for negligence under sections 6653(a) and

6653(a)(1) and (2); (3) whether petitioners are liable for the

additions to tax for valuation overstatements under section

6659(a); (4) whether petitioners are liable for the additions to

tax for substantial understatements of income tax under section

6661(a) for the taxable years 1983 and 1984; and (5) whether

petitioners are liable for the increased rate of interest under

section 6621(c) for each of the years at issue.

These issues arise from petitioner's investment as a limited

partner in Series 162. During 1983 and 1984, Series 162's

principal place of business was in Rockville Centre, New York.

Series 162 was one of approximately 95 limited partnerships

organized in 1983 and 1984 that have been referred to as the

Barrister Equipment Associates partnerships (the Barrister

partnerships). This case is part of a national litigation

project initiated by respondent involving the Barrister

partnerships. The facts of this case are very similar to those

considered by this Court in Barrister Equipment Associates Series

#115 v. Commissioner, T.C. Memo. 1994-205. The facts in this

case are also essentially the same as those considered in In re

MDL-731-Tax Refund Litigation v. United States, 989 F.2d 1290 (2d

Cir. 1993). Accordingly, in this case, the Court will summarize
 - 5 -

the findings of facts to the extent necessary to address the

issues identified above. For a more detailed explanation of the

Barrister partnerships, see the cases cited above.

Some of the facts were stipulated, and those facts, with the

annexed exhibits, are so found and are incorporated herein by

reference. At the time the petition was filed, petitioners'

legal residence was Santa Rosa, California.

The promoter of the Barrister partnerships, and of the

transactions involved herein, was an individual named Irving

Cohen (Cohen). Cohen organized and controlled an entity named

Universal Publishing Resources Ltd. (Universal).3 At Cohen's

request, in 1981, Paul F. Belloff (Belloff) and Robert Gold

(Gold) formed Barrister Associates (Barrister), a New York

general partnership. Belloff and Gold each held a 50-percent

interest in Barrister.

Between 1981 and 1983, Barrister organized and was the

general partner of the Barrister partnerships. Barrister

organized 35 limited partnerships in 1982, collectively named the

Barrister Equipment Associates Series 80 through 114, and 300.

In 1983, Barrister organized 60 limited partnerships,

collectively named the Barrister Equipment Associates Series 115

3
The Madison Library, Inc. (Madison), a corporation, was
owned, directly or indirectly, for the benefit of Cohen's
children. In the 1980's Madison formed a subsidiary, Geoffrey
Townsend, Ltd. (Townsend). Universal was a subsidiary of
Townsend, and Cohen was Universal's president.
 - 6 -

through 175, 201, and 302 (the 1983 partnerships). Series 162

was one of the Barrister partnerships organized in 1983.

Barrister was the general partner and tax matters partner of

Series 162.4

All of the Barrister partnerships were similar to each

other, having all been organized to acquire and exploit literary

and computer program properties (properties), which were

purchased or leased, directly or indirectly, from corporations

owned or controlled by Cohen. With respect to Series 162,

Universal acquired the properties from several publishers and

then leased these properties to Series 162.

On behalf of Series 162, Cohen arranged to have "services

contractors" publish, distribute, and sell the products to be

produced with the properties Universal leased to Series 162. In

most cases, the services contractors were affiliates of the

publishers of the books or the computer programs. For example,

Confucion Press, Inc., a subsidiary of the publisher, Richard

Gallen & Co., Inc., was expected to serve as a services

4
Series 162 is subject to the unified audit and litigation
procedures of secs. 6221-6233. Those provisions, sometimes
referred to as the TEFRA procedures, were enacted as part of the
Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L.
97-248, sec. 402(a), 96 Stat. 648, and provide a method for
adjusting partnership items in one unified partnership
proceeding, rather than in separate proceedings with the
partners. Maxwell v. Commissioner, 87 T.C. 783, 787 (1986); H.
Conf. Rept. 97-760, at 600, 604 (1982), 1982-2 C.B. 600, 662,
664.
 - 7 -

contractor for three of the properties that Universal would lease

to Series 162.

The limited partnership interests in Series 162 were sold by

Chadwick Investor Services, Inc. (Chadwick), a corporation owned

by Belloff, Gold, and Ronald Cohen (no relationship to Irving

Cohen). As compensation for selling the limited partnership

interests in Series 162, Chadwick received a commission of 10

percent of the cash invested by the limited partners. Chadwick,

in turn, paid a commission to its independent sales

representatives.

During 1983, petitioner became involved in selling, as an

independent sales representative, limited partnership interests

in the 1983 Barrister partnerships, including Series 162.5 As a

result of those sales, petitioner received commissions during

1983 from Universal, Chadwick, and Townsend totaling $55,375.

During 1984, petitioner received commissions from Parliament

Securities, Inc.,6 Universal, and Carrington Associates, an

affiliate of Universal's, totaling $66,650.

In December 1983, petitioner acquired a 4.8781 percent

limited partnership interest in Series 162 for $25,000, paying

5
Prior to 1983, petitioner had been a salesman for 25 years.
Among the products previously sold by petitioner were mutual
funds and life insurance. Petitioner has a college degree in
business.
6
In 1984, Chadwick changed its name to Parliament Securities,
Inc.
 - 8 -

$12,500 in cash, and executing a promissory note for the

remainder, which note was paid by petitioner a year later.7

Prior to investing in Series 162, petitioner received an offering

memorandum and a brochure that summarized the offering.

Petitioner did not study these documents prior to his investment,

because, as an independent sales representative, he had studied

similar documents for other 1983 Barrister partnerships "with a

fine-toothed comb" and found that all of the partnerships were

"cookie cutter", i.e., basically the same. Furthermore, the

specific book properties purchased by Series 162 were not of

importance to petitioner.

For tax years 1983 and 1984, Series 162 reported partnership

losses of $210,789 and $285,234, and investment tax credits of

$4,593,000 and $1,770,000, respectively. On their 1983 and 1984

Federal income tax returns (returns), petitioners claimed their

4.8781 percent distributive share of these losses and investment

tax credits from Series 162. More specifically, petitioners

claimed partnership losses of $10,283 and $15,757 and investment

tax credits of $10,447 and $6,907 for 1983 and 1984,

respectively. In addition, petitioners claimed a tentative

7
The private placement memorandum (offering memorandum) of
Series 162, dated Dec. 19, 1983, indicates that the limited
partnership interests in Series 162 would be offered in 10 units
of $50,000 each, for a total of $500,000 to the partnership.
Although the record is not clear, petitioner apparently purchased
a half-unit, since his limited partnership interest cost $25,000.
 - 9 -

refund of $7,368 on their 1980 return for an unused investment

tax credit carryback from the 1983 tax year.

On September 5, 1989, respondent issued notices of final

partnership administrative adjustment to Barrister with respect

to the partnership returns filed by Series 162 for 1983 and 1984.

The tax matters partner of Series 162 petitioned this Court in

the case of Anderson Equip. Associates v. Commissioner, docket

No. 27745-89. A stipulated decision in that case was entered on

February 17, 1995.

Petitioners were not subject to the TEFRA proceeding because

they had previously filed, on February 28, 1992, a petition in

bankruptcy under chapter 7 in the U.S. Bankruptcy Court, Northern

District of California. Pursuant to section 6231(c)(2) and the

regulations thereunder, partnership items of a partner named as

the debtor in a bankruptcy proceeding shall be treated as

nonpartnership items as of the date the petition naming the

partner as debtor is filed in bankruptcy. Sec. 301.6231(c)-

7T(a), Temporary Proced. & Admin. Regs., 52 Fed. Reg. 6793

(Mar. 5, 1987). The effect of the conversion is to remove the

partner from the partnership proceeding and subject the converted

items to deficiency procedures applicable to the partner's

individual tax case. Computer Programs Lambda, Ltd. v.

Commissioner, 89 T.C. 198, 203 (1987).
 - 10 -

After the order of discharge in petitioners' bankruptcy

proceeding was entered on July 7, 1992, respondent issued a

notice of deficiency to petitioners on February 13, 1993. In the

notice of deficiency, respondent disallowed the partnership

losses and investment tax credits claimed by petitioners on their

1983 and 1984 returns and determined the additions to tax and

increased rate of interest under section 6621(c).

The Commissioner's determinations in a notice of deficiency

are presumed correct, and the taxpayer bears the burden of

proving that those determinations are erroneous. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). This burden of

proof extends as well to the additions to tax and the increased

rate of interest. Rule 142(a); Bixby v. Commissioner, 58 T.C.

757, 791 (1972). However, with respect to respondent's amended

answer, relating to an increase in the deficiency in tax for the

year 1980 and correspondent increases in the additions to tax and

increased interest, the burden of proof is on respondent, since

the claim by respondent constitutes "new matter". Rule 142(a).

The record reflects that respondent met that burden in that

petitioners' income tax return for 1983 erroneously reflected a

tax computation for married persons filing separately when in

fact the computation should have been based on rates for married

persons filing jointly, and by petitioner's acknowledgment of
 - 11 -

having subsequently received the tentative refund of the

investment credit carryback of $4,546 to the year 1980.

In the notice of deficiency, respondent disallowed the

losses and credits claimed by petitioners on their 1983 and 1984

returns, determining that Series 162 was not an activity engaged

in for profit and was devoid of economic substance.

In general, a transaction is effective for income tax

purposes only if its economic substance is consonant with its

intended tax effects. Frank Lyon Co. v. United States, 435 U.S.

561, 573 (1978); Knetsch v. United States, 364 U.S. 361, 365-366

(1960); Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966),

affg. 44 T.C. 284 (1965). In evaluating whether a transaction

possesses economic substance, the Court looks to objective

factors that indicate whether the taxpayer acquired an equity

interest in the property, and whether the taxpayer had a

realistic potential for profit. Levy v. Commissioner, 91 T.C.

838, 856 (1988); Cherin v. Commissioner, 89 T.C. 986, 993 (1987);

Packard v. Commissioner, 85 T.C. 397, 417 (1985).

The Court applied these objective factors in Barrister

Equipment Associates Series #115 v. Commissioner, T.C. Memo.

1994-205, the test case in this Court for the litigation project

involving the Barrister partnerships. In that case, this Court

held that the transactions involving Barrister partnerships

Series 115 (Series 115) lacked economic substance and were shams.
 - 12 -

Respondent determined the deficiencies against petitioners

on the premise that the facts and transactions involved in this

case are essentially the same as those in Barrister Equipment

Associates Series #115 v. Commissioner, supra. Although

petitioner's investment in Series 162 was not exactly the same as

the investments in Series 115, petitioner acknowledged, at trial,

that the facts surrounding, and the transactions involving,

Series 115 and Series 162 were basically the same, and that,

essentially, the partnerships were all "cookie-cutter".

Petitioners presented no evidence to show that petitioner's

investment in this case differed in a material manner from those

in Series 115. Accordingly, the Court finds that the holding in

Barrister Equipment Associates Series #115 v. Commissioner,

supra, is controlling and, therefore, is applicable to this case.

See Simmons v. Union News Co., 341 F.2d 531, 533 (6th Cir. 1965);

see also Leishman v. Radio Condenser Co., 167 F.2d 890 (9th Cir.

1948). The Court, therefore, finds that the transactions

involving Series 162 lacked economic substance. Accordingly,

respondent is sustained as to the deficiencies in tax.

Respondent determined that petitioners are liable for

additions to tax for negligence for the taxable years in issue.

Section 6653(a) for 1980 and section 6653(a)(1) for 1983 and 1984

impose an addition to tax if any portion of an underpayment is

due to negligence or intentional disregard of rules or
 - 13 -

regulations. For 1983 and 1984, section 6653(a)(2) imposes an

addition to tax in an amount equal to 50 percent of the interest

due on the portion of the underpayment attributable to

negligence. Negligence is defined as the failure to exercise due

care that a reasonable and ordinarily prudent person would employ

under the circumstances. Neely v. Commissioner, 85 T.C. 934, 947

(1985).

With respect to the issue of negligence, petitioners are

required to prove that their actions in connection with Series

162 were reasonable in light of their experience and the nature

of the investment. See Henry Schwartz Corp. v. Commissioner, 60

T.C. 728, 740 (1973). Within this framework, petitioners may

prevail if they reasonably relied on competent professional

advice. Freytag v. Commissioner, 89 T.C. 849 (1987), affd. 904

F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991). However,

"Reliance on professional advice, standing alone, is not an

absolute defense to negligence, but rather a factor to be

considered." Id. at 888. Furthermore, the Court has rejected

pleas of reliance when neither the taxpayer nor the advisers

purportedly relied upon by the taxpayer knew anything about the

nontax business aspects of the contemplated venture. Beck v.

Commissioner, 85 T.C. 557 (1985); Flowers v. Commissioner, 80

T.C. 914 (1983); Steerman v. Commissioner, T.C. Memo. 1993-447.
 - 14 -

At trial, petitioner stated that, in 1983, at the

recruitment meeting for the Barrister partnerships' independent

sales representatives, the presentation by the partnership

promoters originally did not pass petitioner's "sniff test".

Petitioner was skeptical as to whether the Barrister partnerships

had economic substance. However, after speaking with numerous

certified public accountants (C.P.A.'s), attorneys, and other tax

professionals, petitioner became convinced that the partnerships

were not shams. He decided to become an independent sales

representative and, eventually, an investor in Series 162.

Petitioner stated that, in making this decision, he did not focus

on the cash flow projections of the partnerships because the

C.P.A.'s made these computations for petitioner, and he accepted

their responses.

Prior to petitioner's involvement in the Barrister

partnerships, he had never been involved in book publishing.

Petitioner has a college degree in business and, for

approximately 25 years, was a salesman. The fact that petitioner

did not have knowledge of the book publishing industry did not

concern him because he felt that Cohen, as well as the services

contractors, had a great deal of experience in the industry.

However, petitioner did not consult with these individuals or

anyone else in the publishing business about the economic
 - 15 -

substance of Series 162 or any other of the Barrister

partnerships.

Petitioner solely relied on the advice of the C.P.A.'s,

attorneys, and other tax professionals in determining whether to

invest in Series 162. At trial, petitioner acknowledged that

none of these individuals were knowledgeable about the book

publishing industry. The advice of these individuals appears,

from the record, to have been strictly about the tax aspects of

the venture. As stated above, this Court has rejected pleas of

reliance when neither the taxpayer nor the advisers purportedly

relied on by the taxpayer knew anything about the nontax business

aspects of the contemplated venture. Beck v. Commissioner, 85

T.C. 557 (1985); Flowers v. Commissioner, 80 T.C. 914 (1983);

Steerman v. Commissioner, T.C. Memo. 1993-447. Such is the case

here. Petitioners have failed to persuade the Court that their

actions in connection with their investment in Series 162 were

reasonable in light of their experience and the nature of their

investment. Petitioner acknowledged at trial that, based on the

presentation of the promoters at the recruitment meeting in 1983,

he was not satisfied about the merits of the promotion and was

skeptical that the Barrister partnerships had economic substance.

Petitioner was not only an investor, but he was also a promoter

of investments in the partnerships from which he derived

substantial sales commissions. He made no independent
 - 16 -

investigations of the merits of the investment programs he

promoted with persons knowledgeable about the book publishing

business. Petitioner's role as promoter, coupled with his

initial skepticism, placed him in the situation where he should

have done more than merely rely on discussions with individuals

who had no knowledge of the nontax aspects of the investment. On

this record, the Court holds that petitioners are liable for the

additions to tax for negligence for the years at issue.

Respondent is sustained on this issue.

Respondent determined that petitioners are liable for the

additions to tax for valuation overstatements under section

6659(a) on the underpayments of their Federal income taxes for

the years at issue attributable to the investment tax credits

claimed with respect to Series 162.

A graduated addition to tax is imposed when an individual

has an underpayment of tax that equals or exceeds $1,000 and is

attributable to a valuation overstatement. Sec. 6659(a), (d). A

valuation overstatement exists if the fair market value (or

adjusted basis) of property claimed on a return equals or exceeds

150 percent of the amount determined to be the correct amount.

Sec. 6659(c). If the claimed valuation exceeds 250 percent of

the correct value, the addition is equal to 30 percent of the

underpayment. Sec. 6659(b). In this case, respondent determined

that the overstatement percentage in petitioner's investment in
 - 17 -

Series 162 was over 1,000 percent and accordingly applied the 30-

percent rate.

As stated above, petitioners bear the burden of proving that

respondent's determination on this issue in the notice of

deficiency is erroneous. Rule 142(a); Bixby v. Commissioner, 58

T.C. 757, 791 (1972). Petitioners failed to present any evidence

to show that respondent's determination under section 6659(a) was

erroneous. Accordingly, respondent is sustained on this issue.

Section 6661(a) imposes an addition to tax equal to 25

percent of the amount attributable to a substantial

understatement of income tax. An understatement is substantial

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

shown on the return or $5,000. Sec. 6661(b)(1)(A).8

Petitioners failed to present any evidence to prove that

they should not be held liable for the additions to tax under

section 6661(a). Rule 142(a); Bixby v. Commissioner, supra.

Accordingly, respondent is sustained on this issue.

With respect to the increased rate of interest determined by

respondent, section 6621(c) provides for an increased rate of

interest with respect to any underpayment in excess of $1,000

that is "attributable to one or more tax motivated transactions".

8
An understatement will be reduced to the extent that it is:
(1) Based on substantial authority, or (2) adequately disclosed
in the return or in a statement attached to the return. Sec.
6661(b)(2)(B). Petitioners have failed to prove that either of
these situations existed in this case.
 - 18 -

Sec. 6621(c)(1) and (2). The increased rate of interest applies

to interest accruing after December 31, 1984. See DeMartino v.

Commissioner, 88 T.C. 583, 589 (1987), affd. 862 F.2d 400 (2d

Cir. 1988), affd. without published opinion sub nom. McDonnell v.

Commissioner, 862 F.2d 308 (3d Cir. 1988) (the increased rate of

interest applies to interest accruing after December 31, 1984,

even though the transaction in question was entered into before

the date of enactment of section 6621(c)). Respondent determined

that petitioners were liable for the increased interest because

the underpayments for the taxable years at issue were

attributable to tax-motivated transactions.

Section 6621(c)(3)(A)(v) provides that the term "tax-

motivated transaction" includes "any sham or fraudulent

transaction." Economic shams, or transactions that lack economic

substance, fall within the ambit of section 6621(c)(3)(A)(v).

Patin v. Commissioner, 88 T.C. 1086, 1128-1129 (1987), affd.

without published opinion 865 F.2d 1264 (5th Cir. 1989), affd.

sub nom. Gomberg v. Commissioner, 868 F.2d 865 (6th Cir. 1989),

affd. sub nom. Skeen v. Commissioner, 864 F.2d 93 (9th Cir.

1989), affd. without published opinion sub nom. Hatheway v.

Commissioner, 856 F.2d 186 (4th Cir. 1988). The Court has

concluded that Series 162 was an economic sham. Accordingly,

respondent's determination that petitioners were liable for the
 - 19 -

increased rate of interest under section 6621(c) with respect to

the deficiencies for 1980, 1983, and 1984 is sustained.

To reflect the foregoing,

Decision will be entered

for respondent.