Merino v. Commissioner

T.C. Memo. 1997-385

UNITED STATES TAX COURT

DONALD N. AND ROSEMARIE F. MERINO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14555-85. Filed August 21, 1997.

Bernard S. Mark and Richard S. Kestenbaum, for petitioners.

Barry J. Laterman and Paul Colleran, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

DAWSON, Judge: This case was assigned to Special Trial

Judge Norman H. Wolfe pursuant to the provisions of section

7443A(b)(4) and Rules 180, 181, and 183. All section references

are to the Internal Revenue Code in effect for the tax years in
 - 2 -

issue, unless otherwise indicated. All Rule references are to

the Tax Court Rules of Practice and Procedure. The Court agrees

with and adopts the opinion of the Special Trial Judge, which is

set forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

WOLFE, Special Trial Judge: This case is part of the

Plastics Recycling group of cases. For a detailed discussion of

the transactions involved in the Plastics Recycling cases, see

Provizer v. Commissioner, T.C. Memo. 1992-177, affd. without

published opinion 996 F.2d 1216 (6th Cir. 1993). The facts of

the underlying transactions and the Sentinel recyclers in this

case are substantially identical to those considered in Provizer.

In a notice of deficiency dated April 9, 1985, respondent

determined deficiencies in petitioners' joint Federal income

taxes for the years 1978, 1979, 1980, and 1981 in the respective

amounts of $505, $12,647.87, $4,503, and $32,463. Respondent

also determined that interest on the deficiencies accruing after

December 31, 1984, would be calculated at 120 percent of the

statutory rate under section 6621(c).1

1
The deficiency notice refers to sec. 6621(d). This section
was redesignated as sec. 6621(c) by sec. 1511(c)(1)(A) of the Tax
Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, 2744 and
repealed by sec. 7721(b) of the Omnibus Budget Reconciliation Act
of 1989 (OBRA 1989), Pub. L. 101-239, 103 Stat. 2106, 2399,
effective for tax returns due after Dec. 31, 1989, OBRA 1989 sec.
7721(d), 103 Stat. 2400. The repeal does not affect the instant
case. For simplicity, we refer to this section as sec. 6621(c).
The annual rate of interest under sec. 6621(c) for interest
(continued...)
 - 3 -

In a first amendment to answer, respondent asserted

additions to tax for negligence for the years 1978, 1979, and

1980 under section 6653(a) in the respective amounts of $25,

$632, and $239,2 and for 1981 under section 6653(a)(1) in the

amount of $1,582, and under section 6653(a)(2) in the amount of

50 percent of the interest due on $31,645. Respondent also

asserted an addition to tax for 1981 under section 6659 for

valuation overstatement in the amount of $6,645.

The parties filed a Stipulation of Settled Issues concerning

the adjustments relating to petitioners' participation in the

Plastics Recycling Program. The stipulation provides:

1. Petitioners are not entitled to any deductions,
losses, investment credits, business energy investment
credits or any other tax benefits claimed on their tax
returns as a result of their participation in the
Plastics Recycling Program.

2. The underpayments in income tax attributable to
petitioners' participation in the Plastics Recycling
Program are substantial underpayments attributable to
tax motivated transactions, subject to the increased
rate of interest established under I.R.C. §6621(c),
formerly section 6621(d).

3. This stipulation resolves all issues that relate to
the items claimed on petitioners' tax returns resulting
from their participation in the Plastics Recycling
Program, with the exception of petitioners' potential
liability for additions to the tax for valuation

1
(...continued)
accruing after Dec. 31, 1984, equals 120 percent of the interest
payable under sec. 6601 with respect to any substantial
underpayment attributable to tax-motivated transactions.
2
The deficiencies for 1978, 1979, and 1980 derived from
disallowed credit carrybacks from 1981.
 - 4 -

overstatements under I.R.C. §6659 and for negligence
under the applicable provisions of Section 6653(a).

4. With respect to the issue of the addition to the
tax under I.R.C. §6659, the petitioners do not intend
to contest the value of the Sentinel Recycler or the
existence of a valuation overstatement on the
petitioners' returns; however, petitioners preserve
their right to contest the issue of whether I.R.C.
§6659 is applicable under the facts and circumstances
of this case.

The issues remaining in this case are: (1) Whether

petitioners are liable for the additions to tax for negligence

under section 6653(a) for the years 1978, 1979, and 1980, and

under section 6653(a)(1) and (2) for 1981; and (2) whether

petitioners are liable for the addition to tax under section 6659

for underpayment of tax attributable to a valuation overstatement

for 1981.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulated facts and attached exhibits are incorporated

herein by this reference.

A. The Plastics Recycling Transactions

This case concerns petitioners' investment in Northeast

Resource Recovery Associates (Northeast), a limited partnership

that leased seven Sentinel expanded polyethylene (EPE) recyclers.

The transactions involving the Sentinel EPE recyclers leased by

Northeast are substantially identical to those in the Clearwater

Group limited partnership (Clearwater), the partnership

considered in Provizer v. Commissioner, supra. Petitioners have
 - 5 -

stipulated substantially the same facts concerning the underlying

transactions as we found in the Provizer case.

In transactions closely resembling those in the Provizer

case, Packaging Industries, Inc. (PI), manufactured and sold

seven Sentinel EPE recyclers to ECI Corp. for $981,000 each. ECI

Corp., in turn, resold the recyclers to F & G Corp. for

$1,162,666 each. F & G Corp. then leased the recyclers to

Northeast, which licensed the recyclers to FMEC Corp., which

sublicensed them back to PI. The sales of the recyclers from PI

to ECI Corp. were financed with nonrecourse notes. Approximately

7.5 percent of the sales price of the recyclers sold by ECI Corp.

to F & G Corp. was paid in cash with the remainder financed

through notes. These notes provided that 10 percent of the notes

were recourse but that the recourse portion of the notes was only

due after the nonrecourse portion, 90 percent, was paid in full.

All of the monthly payments required among the entities in

the above transactions offset each other. These transactions

were done simultaneously. Although the recyclers were sold and

leased for the above amounts under the structure of simultaneous

transactions, the fair market value of a Sentinel EPE recycler in

1981 was not in excess of $50,000.

PI allegedly sublicensed the recyclers to entities that

would use them to recycle plastic scrap. The sublicense

agreements provided that the end-users would transfer to PI 100

percent of the recycled scrap in exchange for a payment from FMEC
 - 6 -

Corp. based on the quality and amount of recycled scrap. Neither

PI nor the end-users carried out the terms of the sublicense

faithfully. In practice, those terms regularly were ignored.

Both Clearwater and Northeast leased Sentinel EPE recyclers

from F & G Corp. and licensed those recyclers to FMEC Corp.

Apart from leasing and licensing seven recyclers instead of six,

the underlying transactions involving Northeast do not differ in

any substantive respect from the Clearwater transactions

considered in the Provizer case.

For convenience, we refer to the series of transactions

among PI, ECI Corp., F & G Corp., Northeast, FMEC Corp., and PI

as the Northeast transactions. In addition to the Northeast

transactions, a number of other limited partnerships entered into

transactions similar to the Northeast transactions, also

involving Sentinel EPE recyclers and Sentinel expanded

polystyrene (EPS) recyclers. We refer to these collectively as

the Plastics Recycling transactions.

B. Northeast Resource Recovery Associates

Northeast is a New York limited partnership that closed on

October 7, 1981. Richard Roberts (Roberts) is the general

partner of Northeast.

A private placement memorandum for Northeast was distributed

to potential limited partners. Reports by F & G Corp.'s

evaluators, Dr. Stanley M. Ulanoff (Ulanoff), a marketing

consultant, and Dr. Samuel Z. Burstein (Burstein), a mathematics
 - 7 -

professor, were appended to the offering memorandum. Ulanoff

owns a 1.27-percent interest in Plymouth Equipment Associates and

a 4.37-percent interest in Taylor Recycling Associates. Burstein

owns a 2.605-percent interest in Empire Associates and a 5.82-

percent interest in Jefferson Recycling Associates. Like

Northeast, Plymouth Equipment Associates, Taylor Recycling

Associates, Empire Associates, and Jefferson Recycling Associates

are partnerships that leased Sentinel recyclers. Burstein also

was a client and business associate of Elliot I. Miller (Miller),

the corporate counsel to PI.

The Northeast offering memorandum states that the general

partner will receive fees from Northeast in the amount of

$25,000. The offering memorandum further states that the general

partner "may retain as additional compensation all amounts not

paid as sales commissions or offeree representative fees".

According to the offering memorandum, it was anticipated that 10

percent of the proceeds from the offering--$95,000--would be

allocated to the payment of sales commissions and offeree

representative fees. Roberts therefore was to receive a minimum

of $25,000 and up to $120,000 from Northeast.

The offering memorandum lists significant business and tax

risk factors associated with an investment in Northeast.

Specifically, the offering memorandum states: (1) There is a

substantial likelihood of audit by the Internal Revenue Service

(IRS), and the purchase price paid by F & G Corp. to ECI Corp.
 - 8 -

probably will be challenged as being in excess of fair market

value;3 (2) Northeast has no prior operating history; (3) the

general partner has no prior experience in marketing recycling or

similar equipment; (4) the limited partners have no control over

the conduct of Northeast's business; (5) there is no established

market for the Sentinel EPE recyclers; (6) there are no

assurances that market prices for virgin resin will remain at

their current costs per pound or that the recycled pellets will

be as marketable as virgin pellets; and (7) certain potential

conflicts of interest exist.

The Sentinel EPE recycler had a "nuts and bolts", or

manufacturing, cost of $18,000. It was a simple batch type

machine designed to grind expanded polyethylene foam and film

into a densified form called "popcorn" that could be further

processed to produce resin pellets suitable for some uses in the

plastics industry. The Sentinel EPE recycler was incapable of

recycling low density polyethylene by itself and had to be used

in connection with grinders, extruders, and pelletizers.

Operation of the Sentinel EPE recycler was performed by low wage

factory help with minimal training. The Sentinel EPE recyclers

3
The offering memorandum notes that "Such purchase price is
the basis for computing the regular investment and energy tax
credits to be claimed by the Partnership" and that "if a
challenge by the [Internal Revenue] Service with respect to the
fair market value of the Sentinel Recyclers * * * were
successfully made, all or part of the regular investment and
energy tax credits * * * would be lost."
 - 9 -

were placed with end-users that did not have sufficient amounts

of scrap ever to pay off the notes on the machines. There is no

evidence that FMEC Corp. ever made payments to end-users although

on occasion PI made some payments for scrap produced by end-

users.

Although the offering memorandum represented that the

Sentinel EPE recycler was a unique machine, it was not.

Specially designed systems for densifying polyethylene and

polystyrene were commercially available prior to 1981 from such

companies as Cumberland Engineering Division of John Brown

Plastics Machinery and the NRM Corp. Ranging in price from

$20,000 to $200,000, other plastics recycling machines available

during 1981 included the Foremost Densilator, Nelmor/Weiss

Densification System (Regenolux), Buss-Condux Plastcompactor, and

Cumberland Granulator. See Provizer v. Commissioner, T.C. Memo.

1992-177. The Regenolux, for example, was fully capable of

recycling expanded polyethylene or polystyrene, and worked better

than either the Sentinel EPE or EPS recycler. It sold for

$38,000 in 1981.

C. Richard Roberts

Roberts is a businessman and the general partner in

Northeast and many other limited partnerships that leased and

licensed Sentinel EPE recyclers. He also is a 9-percent

shareholder in F & G Corp., the corporation that leased the

recyclers to Northeast. From 1982 through 1985, Roberts
 - 10 -

maintained the following office address with Raymond Grant

(Grant), the sole owner and president of ECI Corp.:

Grant/Roberts
Investment Banking
Tax Sheltered Investments
745 Fifth Avenue, Suite 410
New York, New York 10022

Grant was instrumental in the hiring of Ulanoff as an evaluator

of the Plastics Recycling transactions. The two had met on a

cruise. Roberts and Grant together have been general partners in

other investments.

Prior to the Northeast transactions, Roberts and Grant were

clients of the accounting firm H. W. Freedman & Co. (Freedman &

Co.). Harris W. Freedman (Freedman), a certified public

accountant (C.P.A.) and the named partner in Freedman & Co., was

the president and chairman of the board of F & G Corp. He also

owned 94 percent of a Sentinel EPE recycler. Freedman & Co.

prepared the partnership returns for ECI Corp., F & G Corp., and

Northeast. It also provided tax services to John D. Bambara

(Bambara). Bambara is the 100-percent owner of FMEC Corp., as

well as its president, treasurer, clerk, and director. He, his

wife, and his daughter also owned directly or indirectly 100

percent of the stock of PI.

D. Petitioners and Their Introduction to Northeast Resource
Recovery Associates

Petitioners resided in Tenafly, New Jersey, at the time

their petition was filed. Hereafter, reference to petitioner in

the singular denotes Donald N. Merino.
 - 11 -

Petitioner earned a master's degree in industrial

engineering in 1963 and a Ph.D. in managerial economics in 1975.

He has been a licensed professional engineer in industrial

engineering and has been a member of the American Institute of

Industrial Engineers, the American Society of Mechanical

Engineers, and the National Society of Professional Engineers.

Petitioner's professional experience includes employment with

Standard Brands, Exxon Corp., Mobil Corp. (Mobil), and the

Celanese Corp. (Celanese). At Mobil, petitioner worked as a

financial analyst, a project manager for distribution facilities,

and as a senior consultant for marketing and distribution in

Mobil's international division. In the latter capacity he was

employed in analysis of the economics of the oil business.

Petitioner left Mobil after 10 years and in 1974 joined Celanese,

where he remained employed through the tax years in issue.

Petitioner started at Celanese as manager of the

hydrocarbons planning group of the company, which was the largest

merchant buyer of ethylene in the United States. Celanese's

primary business concerned hydrocarbons--plastics, chemicals, and

fibers. According to petitioner, at one point Celanese was the

100th largest corporation in the United States and had revenues

of approximately $4 billion. Celanese subscribed to services

provided by nearly every major forecasting entity, including

Arthur D. Little, Inc., the Stanford Research Institute, and Data

Resources, Inc. It budgeted approximately $500,000 annually for
 - 12 -

consultants and purchased a broad range of reports. Celanese

also subscribed to numerous magazines and trade publications such

as Chemical Reporter, Modern Plastics, Plastics World, and

Plastics Technology. In 1975 or 1976, Celanese participated in a

series of conferences presented by the Department of Energy (DOE)

in connection with the National Energy Policy Plan. When the DOE

published one of the periodic updates of the National Energy

Policy Plan concerning energy projections in July 1981, Celanese

held internal seminars analyzing the report and circulated

internal reports commenting on its conclusions.

As manager of the hydrocarbons planning group at Celanese,

petitioner forecasted prices for crude oil, ethylene, and related

products, and helped establish a purchasing pattern for ethylene

and propylene. Subsequent positions held by petitioner included

director of the Celanese Chemical Co.; worldwide director of

chemicals, plastics, and specialties for Celanese; corporate

director of new business development; director of the quality

program; and director of strategic business development.

Petitioner was at various times responsible for "the planning and

economics of" plastics, petrochemicals, chemicals, and capital

expenditures; and new business ventures. In two of his

positions, petitioner had responsibilities related to the

budgeting and appropriation of funds for new materials and

equipment such as extruders and machinery to manufacture

plastics.
 - 13 -

In 1981, through a nominee, petitioner acquired a 24-percent

interest in two limited partnership units in Northeast for

$24,000.4 As a result of petitioner's investment in Northeast,

on their 1981 return petitioners claimed an operating loss in the

amount of $19,526.16, and investment tax and business energy

credits totaling $22,431.29.5 Petitioners carried back a total

of $18,279 in unused business energy credits to their 1978, 1979,

and 1980 returns.6 Respondent disallowed petitioners' claimed

operating loss and credits related to Northeast in full.

Petitioner learned of the Plastics Recycling transactions

and Northeast from a personal friend Norman Lewis (Lewis), who

was a C.P.A. Lewis was considering the Plastics Recycling

transactions for some of his clients, and he asked petitioner to

examine the proposal. Petitioner agreed to do so, and Lewis sent

him the offering materials for Northeast and another Plastics

Recycling partnership. Before and after reviewing the offering

materials, petitioner spoke to Roberts. Petitioner questioned

whether PI was "a real company" and whether it had a "real

4
Petitioner's nominee was Norman Lewis (Lewis). Lewis
acquired a 10.421050-percent interest in Northeast for $100,000.
Petitioners therefore indirectly owned an approximately 2.5
percent interest in Northeast (24 percent x 10.421050 percent =
2.5 percent).
5
Petitioners' interest in Northeast generated $20,355 in
investment tax credits and $20,355 in business energy credits.
However, their business energy credit was subject to limitation
in the amount of $2,326.
6
The record does not reveal the respective amounts of the
claimed carrybacks to petitioners' 1978, 1979, and 1980 returns.
 - 14 -

machine". Petitioner told Roberts: "If you have a demonstration

of this, and I'm going to do this, I certainly understand the

economics. I understand what you're trying to do, but I want to

see it working." He explained: "I would never invest in

anything unless I saw it".

Roberts suggested that petitioner visit the PI plant in

Hyannis, Massachusetts, and arranged a date for him to visit. PI

was located near a house on Cape Cod where petitioners vacationed

at the time. At PI, petitioner spent the first "hour to two

hours" in Bambara's office discussing and examining samples of

plastics products made by PI. Bambara "asked [petitioner] to

sign a secrecy agreement, and sort of twisted [his] arm a little

bit about nondisclosure, and things like that." After signing

the agreement, petitioner was allowed to tour the plant.

Petitioner recalled that the PI representatives "were a little

uncomfortable that somebody that knew plastics technology and

plastics economics was going to visit the plant" and "were very

reluctant to give me any information." According to petitioner,

the PI representatives refused to give petitioner any of the

information that he asked for, such as company records,

purportedly because petitioner was there to perform due diligence

and was not an investor.

Petitioner viewed a demonstration of the machine, which he

recalled as follows:

What they did was they took the plastic scrap that
they were manufacturing * * * [and] ran it through one
 - 15 -

of the machines, made the popcorn material. Had a very
small-barrelled extruder. They ran it through the
extruder.
And they took the pellets that came out of the
extruder and they put it back in the process, which was
very difficult to do, by the way, because they used
cyclone feeding.
So, getting the pellets back in the process wasn't
easy.

Petitioner observed at the demonstration: "It worked. You know,

on the scale that they gave, everything worked."

Attorneys from the law firm of Windels, Marx, Davies & Ives

(WMDI) visited the PI plant on the same day as petitioner. WMDI

prepared the offering memorandum, tax opinion, and other legal

documents for all of the 1981 Plastics Recycling partnerships,

including Northeast. During a lunch break, petitioner asked the

attorneys some questions about the legal aspects of the venture,

such as whether the transactions qualified for the recently

enacted safe-harbor leasing provisions of section 168(f).

Petitioner "knew that the government was not happy with"

nonrecourse leveraged lease transactions, and he considered the

Northeast transaction to be "a classic leveraged lease deal."

After lunch petitioner questioned Bambara, particularly with

respect to factors bearing on the price of resin, which he

purportedly considered "the crucial part of the economics of this

deal". Petitioner understood that PI purchased resin at "a

volume discount", but Bambara did not indicate the amount of the

discount. Petitioner also learned that because PI received resin

shipments by truck instead of rail, it paid a penalty that
 - 16 -

petitioner estimated at "about a 4-cent per pound penalty". In

addition, PI was not in a good location; trucks had difficulty

getting in and out, especially during the summer, and therefore

it also paid a "location differential" that petitioner estimated

at several cents per pound.

Petitioner also questioned Bambara about the sources of PI's

recyclable scrap. Petitioner testified that in his view "it's

difficult to make money in plastics recycling. You need to have

enough product in terms of the volume." Petitioner understood

from Bambara that PI's customers purchased plastic foam from an

average of 3 to 5 suppliers. Consequently, petitioner reasoned,

"if the machines went to those suppliers, it was not only PI's

volume that could supply those machines, but also two or three or

four other suppliers could supply that". Petitioner also

understood from Bambara that PI had been working on the machine

for "a long time" and had been using it in practice. To confirm

this claim, petitioner allegedly spoke to one of his Cape Cod

neighbors who worked in PI's machine shop in Hyannis. Petitioner

claims that he understood from his neighbor that PI first began

working on the Sentinel EPE recycler under a prior president at

PI, and that it had been using the machine in practice.

Petitioner recalled being satisfied that the Sentinel EPE

recycler was unique because it recycled 1- to 2-pound low density

polyethylene foam. He recalled:

I was surprised that they could do this, the 1- to
2-pound. I read pretty much all the literature.
 - 17 -

* * * [I]f somebody else had had a machine that
did 1- to 2-pound low density polyethylene foam, you
would have seen an article in one of the, you know,
whatever, Modern Plastics, or Technology, whatever.

Petitioner stated that he was familiar with the Foremost

Densilator, Regenolux, Buss-Condux Plastcompactor, and Cumberland

Granulator. He attended a number of plastics shows and "pretty

much all those companies advertised their goods to" Celanese.

Also, Celanese had a technical laboratory where it "had pretty

much just about every plastics machine, grinder, [and] piece of

equipment that you can imagine to test for their customers",

including "basically" all the machines mentioned. Petitioner

asserted that he questioned the testing facility personnel about

PI's reputation, the Sentinel EPE recycler, and other machines.

Petitioner used the projections in the Northeast offering

memorandum to run "a series of sort of back of the envelope

calculations to see whether or not the business made any sense

from an economic standpoint." He described the Northeast

transaction as "basically a closed loop deal", which "is very

important to the economics of this". Petitioner analyzed the

economics from both a full equity basis and a cash basis. In so

doing, he did not give any consideration to the manufacturing

costs of the recycler. Petitioner explained:

Manufacturing costs, per se, of this particular
item is only a small part of the economics. In this
particular case, I didn't really think it had much
relevance to the decision.
 - 18 -

Petitioner claims that after analyzing the projections on an

equity and cash basis, he concluded that the economics of the

transaction made sense.

Petitioner explained his consideration of the fair market

value of the Sentinel EPE recycler as follows:

When I looked at the price of the machine and the
business deal, I looked at it as a business deal. From
a business perspective, * * * it's not just the price
of the machine. It's really the price of the business
deal, of which the machine is one part of it.

* * * * * * *

So, when you looked at it, you didn't look at it
to see whether or not it costs $50,000 or $100,000 to
build the machine. You looked to see whether or not
the overall economics justified that kind of investment
and made sense.
So it was really a systems, or a group look at the
whole thing.

When asked for his assessment of the fair market value of the

machine, petitioner replied: "As part of the overall system, it

was worth the million dollars that was in the prospectus."

However, petitioner claimed that he could not properly place a

value on the Sentinel EPE recycler if considered in isolation

from "the overall system".

Price difficulties arose soon after petitioner invested in

Northeast. He recalled that even though the price of crude oil

continued to rise during the latter part of 1981 and into the

next year, the price of low density polyethylene actually

decreased. Petitioner visited PI to inquire about the machines

during his summer vacation trips to Cape Cod, but became "very
 - 19 -

discouraged after about maybe a year and a half or 2 years into

this deal". He "gave up after that point because then it really

became apparent that the price of crude [oil] was really

declining." Petitioners never made a profit in any year from

their participation in Northeast.

OPINION

We have decided a large number of the Plastics Recycling

group of cases. Provizer v. Commissioner, T.C. Memo. 1992-177,

affd. without published opinion 996 F.2d 1216 (6th Cir. 1993),

concerned the substance of the partnership transaction and also

the additions to tax. See also Singer v. Commissioner, T.C.

Memo. 1997-325; Gottsegen v. Commissioner, T.C. Memo. 1997-314;

Greene v. Commissioner, T.C. Memo. 1997-296; Kaliban v.

Commissioner, T.C. Memo. 1997-271; Sann v. Commissioner, T.C.

Memo. 1997-259 (and cases cited therein). The majority of these

cases, like the present case, raised issues regarding additions

to tax for negligence and valuation overstatement. We have found

the taxpayers liable for such additions to tax in all but one of

the opinions to date on these issues.

In Provizer v. Commissioner, supra, a test case for the

Plastics Recycling group of cases, this Court (1) found that each

Sentinel EPE recycler had a fair market value not in excess of

$50,000, (2) held that the Clearwater transaction was a sham

because it lacked economic substance and a business purpose, (3)

upheld the section 6659 addition to tax for valuation
 - 20 -

overstatement since the underpayment of taxes was directly

related to the overstatement of the value of the Sentinel EPE

recyclers, and (4) held that losses and credits claimed with

respect to Clearwater were attributable to tax-motivated

transactions within the meaning of section 6621(c). In reaching

the conclusion that the Clearwater transaction lacked economic

substance and a business purpose, this Court relied heavily upon

the overvaluation of the Sentinel EPE recyclers.

Although petitioners have not agreed to be bound by

Provizer, they have stipulated that their investment in the

Sentinel EPE recyclers in this case is similar to the investment

described in Provizer v. Commissioner, supra. The underlying

transactions in this case, and the Sentinel EPE recyclers

purportedly leased by Northeast, are the same type of

transactions and same type of machines considered in Provizer v.

Commissioner, supra.

Based on the entire record in this case, including the

extensive stipulations, testimony of respondent's experts, and

petitioner's testimony, we hold that the Northeast transaction

was a sham and lacked economic substance. In reaching this

conclusion, we rely heavily upon the overvaluation of the

Sentinel EPE recyclers. Respondent is sustained on the question

of the underlying deficiencies. We note that petitioners have

explicitly conceded this issue in the stipulation of facts and

stipulation of settled issues filed shortly before trial. The
 - 21 -

record plainly supports respondent's determinations regardless of

such concession. For a detailed discussion of the facts and the

applicable law in a substantially identical case, see Provizer v.

Commissioner, supra.

A. Section 6653(a)--Negligence

Respondent asserted the additions to tax for negligence

under section 6653(a)(1) and (2) for 1981, and under section

6653(a) for the years 1978, 1979, and 1980, in an amended answer.

Because these additions to tax were raised for the first time in

an amended answer, respondent has the burden of proof. Rule

142(a); Vecchio v. Commissioner, 103 T.C. 170, 196 (1994); Bagby

v. Commissioner, 102 T.C. 596, 612 (1994).

Section 6653(a) for 1978, 1979, and 1980, and section

6653(a)(1) for 1981, impose an addition to tax equal to 5 percent

of the underpayment if any part of an underpayment of tax is due

to negligence or intentional disregard of rules or regulations.

Section 6653(a)(2) for 1981 imposes an addition to tax equal to

50 percent of the interest payable with respect to the portion of

the underpayment attributable to negligence or intentional

disregard of rules or regulations.

Negligence is defined as the failure to exercise the due

care that a reasonable and ordinarily prudent person would employ

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

(1985). The question is whether a particular taxpayer's actions

in connection with the transactions were reasonable in light of
 - 22 -

his experience and the nature of the investment or business. See

Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 740 (1973).

When considering the negligence addition to tax, we evaluate the

particular facts of each case, judging the relative

sophistication of the taxpayers, as well as the manner in which

they approached their investment. McPike v. Commissioner, T.C.

Memo. 1996-46. Compare Spears v. Commissioner, T.C. Memo. 1996-

341 with Zidanich v. Commissioner, T.C. Memo. 1995-382.

Petitioners contend that they were reasonable in claiming

deductions and credits with respect to Northeast. They maintain

that petitioner "conducted a good faith investigation of the

Northeast transaction and did not merely rely on the offering

memorandum or other materials supplied by the investment vendor."

Petitioners further assert that they reasonably expected to make

a profit from Northeast because plastic is an oil derivative and

the United States was experiencing a so-called oil crisis during

the latter 1970's and early 1980's.

Petitioner's educational background and professional

experience should have enabled him to make a reasonable and

informed assessment of the Sentinel EPE recycler and the

Northeast transaction. His own testimony is that he reviewed the

offering memorandum repeatedly; visited PI and viewed a

demonstration of the machine; spoke with members of WMDI,

Roberts, Bambara, and Celanese personnel; and analyzed the

economics of the transaction. However, the record in this case,
 - 23 -

particularly the basic sham nature of the transaction, undermines

critical aspects of petitioner's testimony and analysis and does

not support the conclusions he purportedly reached with respect

to the Sentinel EPE recycler and the Northeast transaction.

1. Petitioner's Investigation of the Transaction Was
Inadequate

The Northeast offering memorandum warned: (1) Northeast had

no prior operating history; (2) management of Northeast's

business was dependent upon the general partner, who had no prior

experience in marketing recycling or similar equipment; (3) the

general partner had other business commitments that required a

substantial portion of his time; (4) the general partner was

required to devote only such time to Northeast as he, in his

absolute discretion, deemed necessary; (5) the limited partners

had no control over the conduct of Northeast's business; and (6)

there was no established market for the Sentinel EPE recyclers.

In addition, PI faced added costs because it shipped resin by

truck instead of rail, and because PI was in an inconvenient

location with high costs for supplies.

To some extent these added costs were offset by a volume

discount PI purportedly received on its resin purchases.

However, Bambara did not tell petitioner the amount of the

discount, nor, for that matter, did he tell petitioner how much

PI paid in added costs as a "location differential". The PI

representatives refused to provide petitioner with any of the

records or information that he requested, ostensibly because he
 - 24 -

"was doing due diligence and * * * was not an investor."

Petitioner testified that he did not find this refusal odd. Yet

petitioner was visiting PI as a potential investor; Roberts

arranged for his visit because petitioner "would never invest in

anything unless [he] saw it." Moreover, petitioner had signed a

secrecy agreement, and the offering memorandum disclosed that PI

did not intend to seek patent protection. Petitioner knew from

experience that "it's difficult to make money in plastics

recycling," even for a preeminent corporation such as Celanese.

The business risk factors listed in the offering memorandum, PI's

high costs, petitioner's knowledge of the basic difficulty in

making money in plastics recycling, and the uncooperative

attitude of the PI personnel in simply refusing to furnish any

information concerning corporate finance or actual operating

costs should have raised serious questions in petitioner's mind

about the financial and economic viability of Northeast.

2. Petitioner Failed To Show That the Sentinel EPE Recycler
was Unique

Petitioner claims that he concluded that the Sentinel EPE

recycler was unique because it could recycle 1-to-2 pound density

polyethylene. He testified:

At that time--this is August of 1981--I was not
aware, and neither were any of the people I talked to
aware of any machines that [recycled] low density
[polyethylene] down in the 1 and 2 pound range.

* * * * * * *
 - 25 -

I specifically asked people who were knowledgeable
in the area whether they knew of anybody in that area,
that anybody had produced. And, the answer was no.
So I felt that from a technology standpoint that
[PI] had worked on something unique.

Petitioner acknowledged that he was familiar with other plastics

recycling machines, such as the Foremost Densilator, Buss/Condux

Plastcompactor, Cumberland Granulator, and the Regenolux.

Nonetheless, he contends that he understood from Celanese

personnel that there was no recycler comparable to the Sentinel

EPE recycler, and that he was unaware of any advertisements or

articles pertaining to any comparable machines in any of the

plastics industry trade journals.

However, respondent's expert witnesses, Richard S. Lindstrom

(Lindstrom) and Steven Grossman (Grossman), testified otherwise.

Lindstrom, who consulted in plastics and plastics equipment at

Arthur D. Little, Inc. from 1956 until 1989, testified that

"there were available in 1981 commercial units that could be

purchased for $50,000 or less that were totally equal to the

Sentinel EPE Recycler in function, product quality, and

capacity." Grossman, who has a Ph.D. in Polymer Science and

Engineering and was at the time a professor of Plastics

Engineering at the University of Massachusetts-Lowell, testified

that the Sentinel EPE recycler "represented no new technology to

the plastics recycling industry at the time of its offering", and

that comparable and "more efficient technology was available to

recycle film/foam polyethylene scrap." See Gottsegen v.
 - 26 -

Commissioner, T.C. Memo. 1997-314; Provizer v. Commissioner, T.C.

Memo. 1992-177. Consistent with this expert testimony,

petitioners stipulated that information published prior to the

Plastics Recycling transactions indicated that several machines

capable of densifying low density materials were already on the

market in 1981. Moreover, the Northeast offering memorandum

disclosed that FMEC could encounter significant competition, and

that PI did "not intend to apply for a patent for protection

against appropriation and use by others." Consequently, any

unique capabilities of the Sentinel EPE recycler were subject to

appropriation, and any competitive advantage derived therefrom

would likely have been short lived. As an experienced business

executive, petitioner knew or should have known that in the

absence of patent protection, even if PI's machine had possessed

advantageous design capabilities, those capabilities would soon

have been incorporated into the designs of competitors if the

characteristics of the PI machine had been of significant

commercial value.

The offering memorandum also disclosed that "competition

could adversely affect the amount of Additional Rent which the

[recyclers] are anticipated to produce". This admission

undermines petitioner's argument for a purported fair market

value for the machine based upon a projected stream of royalty

income. See Provizer v. Commissioner, supra. In his testimony,
 - 27 -

petitioner did not directly address this matter of competition

affecting the allegedly anticipated flow of income.

3. Petitioner's Argument Concerning Valuation of the
Recycler Erroneously Requires Acceptance of a Sham Transaction as
Though It Were Valid

With respect to the fair market value of the recycler,

petitioner claims that he did not view the investment as a

purchase of the machines standing alone, and that he did not

"look at it to see whether or not it costs $50,000 or $100,000 to

build the machine." Instead, he "looked to see whether or not

the overall economics justified that kind of investment and made

sense." Petitioner asserted that the Sentinel EPE recycler could

not be valued in isolation from the Northeast transactions, but

within the context of said transactions, he concluded that it was

worth $1,162,666.

However, as petitioners stipulated, the fair market value of

a Sentinel EPE recycler was not in excess of $50,000 in 1981.

Respondent's expert Lindstrom testified that prices of

commercially available machines that were similar to the Sentinel

EPE recycler were in the range of $50,000 in 1981. An example of

a machine "that provided equivalent capability of recycling

polyethylene and polystyrene film and foam waste", according to

respondent's expert Grossman, was the Foremost Densilator, which

had been available since 1978 and sold for approximately $20,000

in 1981. Petitioner testified that he was familiar with the

Foremost Densilator, as well as other plastics recycling
 - 28 -

machines. In view of the gross disparity in the prices of such

other machines and the Sentinel EPE recycler, petitioner's

purported valuation estimate was not reasonable.

Petitioner's testimony to the effect that the Sentinel EPE

recycler was worth $1,162,666, within the context of the

artificial Northeast transactions, is specious. Petitioner's

refusal to value the EPE recycler by itself and his insistence on

valuing it only as part of an "overall system" amounts to

considering the sham transaction as though it were a valid

transaction. In his calculations of value, petitioner allows an

investment credit of 20 percent of $1,162,666 and allows

depreciation on the basis of the same inflated value. He treats

the nonrecourse loans as though they were enforceable loans. In

his discussion, he ignores all possibility of competition from

users of machines purchased for $50,000 or less. In short,

petitioner's valuation of the "overall system" is based on an

artificial inflation of values in isolation from real-world

prices or influences. As the rapid collapse of the sham

transaction demonstrated, the EPE machines were grossly

overvalued by comparison with similar machinery.

4. The Carmagnola Reports

In support of the reasonableness of his valuation estimate,

petitioner submitted into evidence preliminary reports prepared

for respondent by Ernest D. Carmagnola (Carmagnola), the

president of Professional Plastic Associates. Carmagnola had
 - 29 -

been retained by the IRS in 1984 to evaluate the Sentinel EPE and

EPS recyclers in light of what he described as "the fantastic

values placed on the [recyclers] by the owners." Based on

limited information available to him at that time, Carmagnola

preliminarily estimated that the value of the Sentinel EPE

recycler was $250,000. However, after additional information

became available to him, Carmagnola concluded in a signed

affidavit, dated March 16, 1993, that the machines actually had a

fair market value of not more than $50,000 each in the fall of

1981.

We accord no weight to the Carmagnola reports submitted by

petitioners. The projected valuations therein were based on

inadequate information, research, and investigation, and were

subsequently rejected and discredited by their author. In one

preliminary report, Carmagnola states that he has "a serious

concern of actual profit" of a Sentinel EPE recycler and that to

determine whether the machines actually could be profitable, he

required additional information from PI. Carmagnola also

indicates that in preparing the report, he did not have

information available concerning research and development costs

of the machines and that he estimated those costs in his

valuations of the machines.

Respondent rejected the Carmagnola reports and considered

them unsatisfactory for any purpose, and there is no indication

in the record that respondent used them as a basis for any
 - 30 -

determinations in the notice of deficiency. Even so, counsel for

petitioners obtained copies of these reports and urge that they

support the reasonableness of the value reported on petitioners'

1981 return. Not surprisingly, counsel for petitioners did not

call Carmagnola to testify in this case, but preferred instead to

rely solely upon his preliminary ill-founded valuation estimates.

(Carmagnola has not been called to testify in any of the Plastics

Recycling cases before us.) The Carmagnola reports were a part

of the record considered by this Court and reviewed by the Court

of Appeals for the Sixth Circuit in the Provizer case, where we

held the taxpayers negligent. We find in this case, as we have

found previously, that the reports prepared by Carmagnola are

unreliable and of no consequence.

5. The Oil Pricing Argument

Petitioner testified that he reasonably expected to make an

economic profit from Northeast and that speculation regarding

crude oil prices "was the critical factor" in his decision to

invest. He indicated that the price of plastic is directly

proportional to the price of crude oil, and that when he invested

in Northeast, the prevailing opinion in both the public and

private sectors was that, due to the so-called oil crisis, the

price of crude oil was going to increase significantly. As

evidence of such speculation, petitioners placed into the record

several articles from Modern Plastics, dated April 1980, May

1981, and August 1981, and an energy projections report from the
 - 31 -

DOE, published in July 1981. The prefatory overview to the DOE

report, however, cautioned about "the tremendous uncertainties

underlying energy projections" and warned "that [the] projections

[in the report] do not constitute any sort of blueprint for the

future." Reflective of such uncertainties, the April 1980 Modern

Plastics article contemplated resin price hikes, while the May

1981 article predicted a leveling of prices, market disruptions,

and an industrywide shakeout.

In contrast to petitioner's testimony, respondent's expert

Grossman explained that the price of plastics materials is not

directly proportional to the price of oil. In his report,

Grossman stated that less than 10 percent of crude oil is

utilized for making plastics materials and that studies have

shown that "a 300% increase in crude oil prices results in only a

30 to 40% increase in the cost of plastics products." An even

greater disparity was reported in the May 1981 article from

Modern Plastics, which stated: "A rule-of thumb unproven by

cost-accounting but apparent from price history is that with

every $1/barrel hike for Saudi marker crude, the per-pound price

of ethylene increases by about half a cent." (Emphasis added.)

Indeed, petitioner recalled that during the latter part of 1981

and for some months thereafter, while the price of crude oil

rose, the price of low density polyethylene actually decreased.

Petitioners' reliance on Krause v. Commissioner, 99 T.C. 132

(1992), affd. sub nom. Hildebrand v. Commissioner, 28 F.3d 1024
 - 32 -

(10th Cir. 1994), and Rousseau v. United States, 71A AFTR 2d 93-

4294, 91-1 USTC par. 50,252 (E.D. La. 1991), is misplaced. In

the Krause case, the taxpayers invested in limited partnerships

whose investment objectives concerned enhanced oil recovery (EOR)

technology. The Krause opinion states that during the late

1970's and early 1980's, the Federal Government adopted specific

programs to aid research and development of EOR technology. In

holding that the taxpayers in the Krause case were not liable for

the negligence additions to tax, this Court noted that one of the

Government's expert witnesses acknowledged that "investors may

have been significantly and reasonably influenced by the energy

price hysteria that existed in the late 1970's and early 1980's

to invest in EOR technology." Krause v. Commissioner, supra at

177. Similarly, in Rousseau v. United States, supra, the

District Court rejected the negligence additions to tax because,

inter alia, the property underlying the investment was equipment

capable of producing ethanol, which was widely considered at that

time to be a viable fuel alternative to oil, and its potential

for profit was apparent.

In the present case, however, as explained by respondent's

expert Grossman (and the May 1981 Modern Plastics article

submitted by petitioners), the price of plastics materials is not

directly proportional to the price of oil. The Krause and

Rousseau cases involved ventures in which the so-called oil

crisis provided a reasonable basis for the respective taxpayers'
 - 33 -

decisions to invest. EOR was in the forefront of national policy

and the media during the late 1970's and 1980's, and ethanol was

widely considered to be a viable fuel alternative to oil. In

contrast, there is no showing in the record of this case that the

so-called energy crisis would provide a reasonable basis for

petitioners' investing in recycling of polyethylene, particularly

in the machinery here in question. Accordingly, we do not

consider petitioners' arguments with respect to the Krause and

Rousseau cases applicable.

Petitioners also cite a number of cases in which courts

rejected the negligence additions to tax because the taxpayers

reasonably relied upon offering materials and/or qualified expert

advice. Mollen v. United States, 72 AFTR 2d 93-6443, 93-2 USTC

par. 50,585 (D. Ariz. 1993); Brifman v. Commissioner, T.C. Memo.

1992-375; Gralnek v. Commissioner, T.C. Memo. 1989-433; Butler v.

Commissioner, T.C. Memo. 1985-613. However, we are not convinced

that petitioner placed a great deal of reliance on the offering

materials. The record shows that petitioner did not give due

consideration to many of the caveats and warnings contained in

the offering memorandum, particularly the business risk factors

and PI's express disregard for patent protection. With respect

to expert advice, petitioner's own testimony is the only account

in the record regarding any discussions he had with others, and

he did not adequately relate the substance of any advice he may

have received. The record does not convince us that petitioner
 - 34 -

reasonably relied upon the offering memorandum or any expert

advice. Accordingly, we consider petitioners' reliance on the

Mollen, Brifman, Gralnek, and Butler cases misplaced.

6. Conclusion

In view of petitioner's educational background and extensive

experience in plastics and the nature and extent of his

investigation, he learned or should have learned that the

Sentinel EPE recycler was not unique and not worth in excess of

$50,000, and that Northeast lacked economic substance and had no

potential for profit. Petitioner's self-serving testimony to the

contrary is not credible, and this Court is not required to

accept it as true. Wood v. Commissioner, 338 F.2d 602, 605 (9th

Cir. 1964), affg. 41 T.C. 593 (1964); Niedringhaus v.

Commissioner, 99 T.C. 202, 212 (1992); Tokarski v. Commissioner,

87 T.C. 74, 77 (1986); Snyder v. Commissioner, T.C. Memo. 1995-

285; Sacks v. Commissioner, T.C. Memo. 1994-217, affd. 82 F.3d

918 (9th Cir. 1996). In contrast, the reports of respondent's

experts Lindstrom and Grossman, which reach opposite conclusions

from petitioner's, are reasonable and persuasive, and the

testimony of these experts is supported by other portions of the

record. See Gottsegen v. Commissioner, T.C. Memo. 1997-314;

Provizer v. Commissioner, T.C. Memo. 1992-177.

Under the circumstances of this case, petitioners failed to

exercise due care in claiming a large loss deduction and tax

credits with respect to Northeast on their Federal income tax
 - 35 -

returns for the years 1978, 1979, 1980, and 1981. The direct

reductions claimed on petitioners' tax returns for those years,

from the investment tax credits alone, equaled 170 percent of

their cash investment. Therefore, like the taxpayers in Provizer

v. Commissioner, supra, "except for a few weeks at the beginning,

petitioners never had any money in the * * * [Northeast

transaction]." The record shows that petitioner was on notice

that the Northeast transaction was a sham transaction primarily

intended to generate tax benefits, and that his decision to

invest was tax driven, not economically driven. See Zfass v.

Commissioner, 118 F.3d 184 (4th Cir. 1997), affg. T.C. Memo.

1996-167. We hold, upon consideration of the entire record, that

petitioners are liable for the negligence additions to tax under

section 6653(a) for 1978, 1979, and 1980, and under section

6653(a)(1) and (2) for 1981. Respondent is sustained on this

issue.

B. Section 6659--Valuation Overstatement

In the amended answer, respondent asserted that petitioners

were liable for the section 6659 addition to tax on the portion

of their underpayment attributable to valuation overstatement.

Because the section 6659 addition to tax was raised for the first

time in the amended answer, respondent has the burden of proof.

Rule 142(a); Vecchio v. Commissioner, 103 T.C. at 196; Bagby v.

Commissioner, 102 T.C. at 612.
 - 36 -

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).

Petitioners claimed tax benefits, including investment tax

credits and business energy credits, based on a purported value

of $1,162,666 for each Sentinel EPE recycler. Petitioners

concede that the fair market value of a Sentinel EPE recycler in

1981 was not in excess of $50,000. Therefore, if disallowance of

petitioners' claimed tax benefits is attributable to such

valuation overstatement, petitioners are liable for the section

6659 addition to tax at the rate of 30 percent of the

underpayment of tax attributable to the tax benefits claimed with

respect to Northeast.

Petitioners contend that respondent erroneously failed to

waive the section 6659 addition to tax. Section 6659(e)

authorizes respondent to waive all or part of the addition to tax

for valuation overstatement if taxpayers establish that there was

a reasonable basis for the adjusted bases or valuations claimed

on the returns and that such claims were made in good faith.
 - 37 -

Respondent's refusal to waive a section 6659 addition to tax is

reviewable by this Court for abuse of discretion. Krause v.

Commissioner, 99 T.C. at 179. Abuse of discretion has been found

in situations where respondent's refusal to exercise such

discretion is arbitrary, capricious, or unreasonable. See

Mailman v. Commissioner, 91 T.C. 1079 (1988); Estate of Gardner

v. Commissioner, 82 T.C. 989 (1984); Haught v. Commissioner, T.C.

Memo. 1993-58.

We note initially that there is no showing in the record

that petitioners timely requested a waiver. We are reluctant to

find that respondent abused any discretion in this case when

respondent was not timely requested to exercise it and there is

no direct evidence of any abuse of administrative discretion.

Haught v. Commissioner, supra; cf. Wynn v. Commissioner, T.C.

Memo. 1995-609; Klieger v. Commissioner, T.C. Memo. 1992-734.

However, we do not decide this issue solely on petitioners'

failure timely to request a waiver but instead, we have

considered the issue on its merits. Petitioners urge that

petitioner "did all that one could reasonably be expected to do"

in deciding on the valuation claimed on their 1981 tax return.

However, as we explained above in finding petitioners liable for

the negligence additions to tax, petitioner's purported

conclusion with respect to the fair market value of the Sentinel

EPE recycler was not reasonable. In view of his extensive

knowledge and experience in plastics, and the resources readily
 - 38 -

available to him, petitioner learned or should have learned that

the Sentinel EPE recycler was not worth in excess of $50,000 in

1981.

In support of their contention that they acted reasonably,

petitioners cite Mauerman v. Commissioner, 22 F.3d 1001 (10th

Cir. 1994), revg. T.C. Memo. 1993-23, and Rousseau v. United

States, 71A AFTR 2d 93-4294, 91-1 USTC par. 50,252 (E.D. La.

1991). However, we consider the Mauerman case and the Rousseau

case (for the same reasons discussed supra) distinguishable. In

Mauerman, the Court of Appeals for the Tenth Circuit held that

the Commissioner had abused discretion for not waiving a section

6661 addition to tax. Like section 6659, a section 6661 addition

to tax may be waived by the Commissioner if the taxpayer

demonstrates that there was reasonable cause for his underpayment

and that he acted in good faith. Sec. 6661(c). The taxpayer in

Mauerman reasonably relied upon independent attorneys and

accountants for advice as to whether payments were properly

deductible or capitalized. In the present case, however, the

record fails to establish that petitioner reasonably relied upon

any independent, expert advice. None of the persons that

petitioner purportedly spoke with testified in this case, and

petitioner's self-serving testimony is unpersuasive.

Consequently, we consider petitioners' reliance on the Mauerman

and Rousseau cases inapplicable.
 - 39 -

For the same reasons that we held petitioners negligent,

supra, we hold that petitioners did not have a reasonable basis

for the adjusted basis or valuation claimed on their tax return

with respect to the investment in Northeast. The record in this

case does not establish an abuse of discretion on the part of

respondent but supports respondent's position. We hold that

respondent's refusal to waive the section 6659 addition to tax in

this case is not an abuse of discretion. Petitioners are liable

for the section 6659 addition to tax at the rate of 30 percent of

the underpayment of tax attributable to the disallowed tax

benefits. Respondent is sustained on this issue.

Decision will be entered

under Rule 155.