Ferraro v. Commissioner

T.C. Memo. 1999-324

UNITED STATES TAX COURT

JOSEPH AND SUSAN L. FERRARO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2762-89. Filed September 27, 1999.

Joseph Ferraro, pro se.

John Mikalchus and Maureen O'Brien, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

DAWSON, Judge: This case was assigned to Special Trial

Judge Robert N. Armen, Jr., pursuant to Rules 180, 181, and 183.1

1
All Rule references are to the Tax Court Rules of
Practice and Procedure, and all section references are to the
Internal Revenue Code in effect for the taxable year in issue.
All amounts are rounded to the nearest dollar.
 - 2 -

The Court agrees with and adopts the opinion of the Special Trial

Judge, which is set forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

ARMEN, Special Trial Judge: Respondent determined a

deficiency, additions to tax, and additional interest with

respect to petitioners' Federal income tax for the taxable year

1981 in the amounts shown below:

Additions Additions Additions Additional
to Tax to tax to tax Interest
Sec. Sec. Sec. Sec.
Deficiency 6653(a)(1)1 6653(a)(2)1 6659 6621(c)
2 3
$28,169 $1,408 $8,451

1
The references in the notice of deficiency are to
sec. 6653(a)(1)(A) and sec. 6653(a)(1)(B),
respectively. For the year in issue, the references
should have been to sec. 6653(a)(1) and sec.
6653(a)(2), respectively. However, there is no
substantive difference between sec. 6653(a)(1) and sec.
6653(a)(1)(A) and between sec. 6653(a)(2) and sec.
6653(a)(1)(B).
2
50 percent of the portion of the underpayment
that is attributable to negligence.
3
Interest on the entire underpayment to be
computed at 120 percent of the rate otherwise
applicable under sec. 6621(a).
 - 3 -

After a concession by petitioners,2 the issues remaining for

decision are as follows:

(1) Whether petitioners are entitled to a partnership loss

deduction and investment and energy tax credits flowing from the

Sentinel EPE recycler leasing program entered into by the

Clearwater Group. We hold that they are not.

(2) Whether petitioners are liable for additions to tax

under section 6653(a)(1) and (2) for negligence or intentional

disregard of rules or regulations. We hold that they are.

(3) Whether petitioners are liable for additional interest

under section 6621(c). We hold that they are.

FINDINGS OF FACT

Some of the facts have been stipulated, and they are so

found.3 The stipulated facts and the attached exhibits are

incorporated herein by this reference. Petitioners resided in

White Plains, New York, at the time that their petition was filed

with the Court.

2
Petitioners concede that the Sentinel EPE recyclers that
are involved in this case were overvalued. Petitioners therefore
also concede that they are liable for the addition to tax for
overvaluation under sec. 6659 if we hold that they are liable for
the underlying deficiency.
3
Petitioners objected to many of the stipulated facts on
the ground of relevancy. We have considered petitioners'
objections, and they are overruled.
 - 4 -

A. The Recycling Transactions

This case is part of the Plastics Recycling group of cases.

In particular, the deficiency, additions to tax, and additional

interest arise from the disallowance of a partnership loss

deduction and investment and energy tax credits claimed by

petitioners with respect to petitioner husband's (petitioner)

investment in a partnership known as the Clearwater Group

(Clearwater). Clearwater was one of a large number of plastics

recycling partnerships. On its 1981 partnership return,

Clearwater listed licensing as its principal business and

recycling equipment as its principal product.

For a detailed discussion of the transactions involved in

the Plastics Recycling group of cases, and specifically

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

affd. per curiam without published opinion 996 F.2d 1216 (6th

Cir. 1993). The transactions in this case are identical to the

transactions discussed in Provizer as they involve the same

partnership and the same Sentinel EPE recyclers that were

involved in Provizer. Further, with the exception of certain

facts that we regard as having minimal significance, petitioners

have stipulated substantially the same facts concerning the

underlying transactions that were described in Provizer.

However, petitioners were not parties to Provizer and do not

agree to be bound by the decision therein.
 - 5 -

In a series of simultaneous transactions discussed in more

detail in the Provizer case, Packaging Industries of Hyannis,

Massachusetts (PI) manufactured and sold4 six Sentinel EPE

recyclers to ECI Corporation (ECI Corp.) for $981,000 each. PI

manufactures thermoplastic and other types of packaging

machinery, as well as energy saving devices. PI held itself out

as one of the world's largest manufacturers of blister packaging

machinery and fabricated a wide line of thermoforming machinery,

including highly specialized disposable medical and food

packaging systems. The Sentinel EPE recyclers were designed by

PI to process low-density polyethylene foam scrap. The recycling

process for polyethylene foam scrap consists of four steps and

results in the formation of a milky-white uniform pellet of

resin, but only if appropriate plastic scrap is collected and fed

into the recyclers.

ECI Corp. in turn resold the Sentinel EPE recyclers to F&G

Corporation (F&G Corp.) for $1,162,667 each. F&G Corp. then

leased them to Clearwater, which licensed them to FMEC

Corporation (FMEC Corp.), which sublicensed them back to PI.

4
Terms such as "sale", "lease", and "license", as well as
their derivatives, are used solely for convenience, and their use
in this opinion should not be understood to imply that the
transactions described herein constitute leases, sales, or
licenses for Federal tax purposes.
 - 6 -

Approximately 7 percent of the sale price of the Sentinel

EPE recyclers sold by PI to ECI Corp. was paid in cash, with the

balance financed through a 12-year nonrecourse note requiring

equal monthly installments of $100,917, including annual interest

of 19.8 percent. ECI Corp.'s purchase was subject to

Clearwater's leasing agreement and FMEC Corp.'s licensing

agreement.

Similarly, approximately 7 percent of the sale price of the

Sentinel EPE recyclers sold by ECI Corp. to F&G Corp. was paid in

cash, with the remainder financed through a 12-year, 90-percent

nonrecourse note requiring equal monthly installments of

$100,917, including annual interest at 15.4 percent. The 10-

percent recourse portion of the note was payable only after the

90-percent nonrecourse portion was satisfied.

F&G Corp.'s purchase was subject to Clearwater's agreement

to enter into a lease with F&G Corp. and was also subject to FMEC

Corp.'s agreement to enter into a license agreement with

Clearwater.

Clearwater's lease from F&G Corp. was for a term of 12

years, a lease term equal to 150 percent of the class life of the

Sentinel EPE recyclers. The lease required monthly rental

payments of $100,917.

Clearwater's license to FMEC Corp. was for a term of 12

years at a guaranteed minimum royalty of $100,917 per month.
 - 7 -

After the Sentinel EPE recyclers were placed in service, the

license required additional royalty payments based on a

percentage of profits that might be realized on the sale or use

of the resin pellets produced by the Sentinel EPE recyclers.

FMEC Corp.'s sublicense to PI, the manufacturer, was on a

month-to-month basis for a royalty of $100,917 per month. The

sublicense to PI was subject to most of the terms of the license

from Clearwater to FMEC Corp.

No arm's-length negotiations for the price of the Sentinel

EPE recyclers took place among PI, ECI Corp., F&G Corp.,

Clearwater, and FMEC Corp. All of the monthly payments required

among the entities in the above transactions offset each other,

and the transactions occurred simultaneously. For convenience,

we refer to the series of transactions among PI, ECI Corp., F&G

Corp., Clearwater, and FMEC Corp. as the Clearwater transactions.

PI allegedly sublicensed the Sentinel EPE recyclers to

entities that would use the recyclers to recycle plastic scrap.

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

100 percent of the recycled scrap in exchange for a payment from

FMEC Corp. based on the quality and amount of recycled scrap.

End- users were also required to use their best efforts to

recycle 220 pounds per hour for 16 hours per week. Profits could

then allegedly be made by lessees, such as Clearwater, in the

form of royalties calculated as the sale price of the resin
 - 8 -

pellets (or their fair market value if used by the sublicensee),

less the sum of (1) the scrap recycling fee paid to converters

(estimated at 15 cents per pound) and (2) an allowance to

sublicensees for transporting and further processing the recycled

material (also estimated at 15 cents per pound).

In addition to the Clearwater transactions, a number of

other limited partnerships entered into transactions similar to

the Clearwater transactions involving Sentinel EPE recyclers.

B. Individuals Involved

Samuel L. Winer (Winer) is an investor, investment banker,

and consultant. Winer was the general partner of Clearwater and

paid $1,000 for a 1-percent interest in all items of income,

gain, deduction, loss, and credit arising from the operations of

Clearwater. For his services, Winer received $60,000 from the

proceeds of the Clearwater private placement offering.

Richard Roberts (Roberts) was the general partner in a

number of limited partnerships that leased Sentinel EPE

recyclers. Roberts was also a 9-percent shareholder in F&G

Corp., the corporation that leased the recyclers to Clearwater.

From 1982 through 1985, Roberts and Raymond Grant (Grant)

were in the business of promoting tax-sheltered investments.

Grant was the president and 100-percent owner of ECI Corp.

Roberts and Grant together were general partners in other

partnerships. Before the Clearwater transactions, Roberts and
 - 9 -

Grant were clients of the accounting firm H.W. Freedman & Co.

(Freedman & Co.).

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

and the name partner in Freedman & Co., was the president and

chairman of the board of F&G Corp. Freedman was experienced with

leveraged leasing, and he owned 94 percent of a Sentinel EPE

recycler.

Freedman & Co. prepared the tax returns for ECI Corp., F&G

Corp., and Clearwater. It also provided tax services to John D.

Bambara (Bambara). Bambara was the 100-percent owner of FMEC

Corp., as well as its president, treasurer, clerk, and director.

Bambara was also the president of PI and a member of its board of

directors. He, his wife, and his daughter also owned (directly

or indirectly) 100 percent of the stock of PI. Bambara purchased

one Sentinel EPE recycler.

Anthony Giovannone (Giovannone) was the executive vice

president of PI and a member of its board of directors.

Giovannone purchased a 15-percent interest in a Sentinel EPE

recycler. Elliot I. Miller (Miller) was the corporate counsel to

PI. In 1981, Miller was also a shareholder of F&G Corp.

John Y. Taggert (Taggert) was a well-known tax attorney and

an adjunct professor at the New York University Law School.

Taggert had been acquainted with Miller for about 15 years before

1981. Miller recommended that Roberts employ Taggert and his
 - 10 -

firm as counsel. Taggert and other members of his firm prepared

private offering memoranda, tax opinions, and other legal

documents for Clearwater.

Robert Gottsegen (Gottsegen) was a businessman active in the

plastics industry and a longtime business associate of Bambara.

C. The Private Offering Memorandum

Clearwater distributed to potential limited partners a

private offering memorandum. The offering memorandum informed

investors that the business of Clearwater would be conducted in

accordance with the six simultaneous transactions described

above. The offering memorandum also listed significant business

and tax risk factors associated with an investment in Clearwater.

Specifically, the offering memorandum stated: (1) There was

a substantial likelihood of audit by the Internal Revenue

Service, and the purchase price paid by F&G Corp. to ECI Corp.

would probably be challenged as being in excess of fair market

value; (2) the partnership had no prior operating history; (3)

the general partner had no prior experience in marketing

recycling or similar equipment; (4) the limited partners would

have no control over the conduct of the partnership's business;

(5) there was no established market for the Sentinel EPE

recyclers; (6) there were no assurances that market prices for

virgin resin would remain at their current costs per pound or

that the recycled pellets would be as marketable as virgin
 - 11 -

pellets; and (7) certain potential conflicts of interest existed.

In addition, the private offering memorandum included a provision

stating:

The offer and sale of units is being made in
reliance upon exemptions from registration under
Federal and state securities laws. However, neither
the Securities and Exchange Commission nor any other
Federal or state government agency or self-regulatory
body has approved or disapproved the securities offered
hereby or passed upon the accuracy or adequacy of this
memorandum.

The private offering memorandum for Clearwater also stated

that each limited partner should have a minimum net worth

(exclusive of his principal home, furnishings, and automobiles)

in the amount of $200,000 per limited partnership unit. In

addition, each partner was required to have enough income during

1981 to place the limited partner in at least the 50-percent

income tax bracket. The private offering memorandum also stated

that the projected tax benefits for the initial year of

investment for an investor contributing $50,000 would be

investment and energy tax credits in the aggregate amount of

$86,328, plus partnership loss deductions in the amount of

$39,399.

Reports by Samuel Z. Burstein (Burstein) and Stanley Ulanoff

(Ulanoff), the "F&G evaluators", were included in the private

offering memorandum. As indicated in their reports, neither

Burstein nor Ulanoff was an expert in plastics or plastics
 - 12 -

recycling, and both relied on information provided by PI and

other parties related to the transaction in providing their

reports. Both individuals were paid a fee each time their

reports were included as part of a private offering memorandum of

a plastics recycling partnership.

Burstein is a professor of mathematics at New York

University. Burstein's report concluded that the Sentinel EPE

recyclers were capable of continuous recycling. Ulanoff is a

professor of marketing at Baruch College and has written numerous

books on marketing subjects. His report covered the marketing

value and potential of the Sentinel EPE recyclers and expressed

the conclusion that the sale price paid by F&G Corp. for the

recyclers was fair and reasonable. Ulanoff's report stated that

his conclusions were based on his personal observation of the

Sentinel EPE recycler prototype during a visit to PI, discussions

with PI employees, the needs of the plastics industry, and his

analysis of the economic projection provided in the offering

memorandum.

The offering memorandum represented that the Sentinel EPE

recyclers were unique machines. However, they were not. Several

machines capable of densifying low-density materials were already

on the market in 1981. Other plastics recycling machines

available at that time ranged in price from $20,000 to $200,000,

including the Foremost "Densilator", the Nelmor/Weiss
 - 13 -

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

and the Cumberland Granulator. See Provizer v. Commissioner,

T.C. Memo. 1992-177, and the discussion regarding expert

testimony, infra. At the time of the closing of the Clearwater

transactions on December 21, 1981, there was no established

market for leasing or operating the Sentinel EPE recyclers.

D. Expert Testimony

Although petitioners conceded the overvaluation of the

Sentinel EPE recyclers, the parties did not agree on the

recyclers' value, and petitioners did not stipulate to be bound

by the value of the recyclers that we found in Provizer.

At trial, petitioners did not offer expert testimony

regarding the value of the Sentinel EPE recyclers. In contrast,

respondent offered expert testimony from Steven Grossman

(Grossman) and Richard S. Lindstrom (Lindstrom).

1. Grossman

Grossman is a professor in the Plastics Engineering

Department at the University of Massachusetts at Lowell. He has

a bachelor of science degree in chemistry from the University of

Connecticut and a doctorate in polymer science and engineering

from the University of Massachusetts. He also has more than 15

years of experience in the plastics industry, including more than

4 years of experience as a research and development scientist at

the Upjohn Company in its Polymer Research Group.
 - 14 -

Grossman is also a partner in the law firm of Hayes,

Soloway, Hennessey, Grossman & Hage, P.C., which practices in the

area of intellectual property, including patents, trademarks,

copyrights, and trade secret protection.

Grossman's report concerning the value of the Sentinel EPE

recycler discusses the limited market for the recycled plastics

material. Grossman concluded that the Sentinel EPE recycler was

unlikely to be a successful product because of the absence of any

new technology, the absence of a continuous source of suitable

scrap, and the absence of any established market. Grossman

suggested that a reasonable comparison of the products available

in the polyethylene industry in 1981 with the Sentinel EPE

recycler reveals that the Sentinel EPE recycler had very little

commercial value and was similar to comparable products available

on the market in component form. For these reasons, Grossman

opined that the Sentinel EPE recycler did not justify the "one-

of-a-kind" pricetag that it carried.

Specifically, Grossman reported that there were several

machines on the market as early as 1981 that were functionally

equivalent to, and significantly less expensive than, the

Sentinel EPE recycler. These machines included: (1) The Buss-

Condux Plastcompactor, available before 1981 for $75,000; (2)

Foremost Machine Builders' "Densilator", available from 1978-81

for $20,000; and (3) the Midland Ross Extruder, available in 1980
 - 15 -

and 1981 for $120,000. Grossman observed that all of these

machines were "widely available".

Grossman's opinion regarding the Sentinel EPE recycler was

based on the descriptions of it in the writings of other

professionals. Grossman neither tested nor examined the Sentinel

EPE recycler.

Grossman reported on the relationship between the plastics

industry and the petrochemical industry. Grossman noted that

although the development of the petrochemical industry is a

contributing factor in the growth of the plastics industry, the

two industries have a "remarkable degree of independence".

Grossman observed that the "oil crisis" in 1973 triggered "dire"

predictions about the future of plastics that had not been

fulfilled in 1981. Grossman stated that the cost of a plastic

product depends, in large part, on technology and the price of

alternative materials. Grossman's studies concluded that a 300-

percent increase in oil prices would result in a 30-40 percent

increase in the cost of plastic.

Finally, Grossman reported that by 1981 the plastics

industry had established that the success and value of any

recycler was to be judged by the properties of the materials it

produced. The private offering memorandum failed to consider the

resulting material properties of the plastics that were recycled

by the operation of the Sentinel EPE recycler. Grossman
 - 16 -

concluded, therefore, that the applications and markets based on

the recycled pellets were never seriously contemplated.

Grossman did not specifically value the Sentinel EPE

recycler. However, as previously stated, Grossman concluded that

existing technology provided equivalent capability for recycling

polyethylene. Moreover, Grossman reported that information

regarding the status of recycling in the plastics industry in

1981 was already well documented. Grossman reported further that

an individual investor would have had little or no difficulty in

confirming the invalidity of the claims in the private offering

memorandum and, in particular, the claims of Ulanoff and Burstein

suggesting that the Sentinel EPE recycler was unique.

2. Lindstrom

Lindstrom graduated from the Massachusetts Institute of

Technology with a bachelor's degree in chemical engineering.

From 1956 until 1989, Lindstrom worked for Arthur D. Little,

Inc., in the areas of process and product evaluation and

improvement and new product development, with special emphasis on

plastics, elastomers, and fibers. At the time of trial,

Lindstrom continued to pursue these areas as a consultant.

In his report, Lindstrom determined that in 1981 several

different types of equipment capable of recycling expanded

polyethylene were available and priced at approximately $50,000.

Lindstrom found that, on the basis of his research, "there were
 - 17 -

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."

Lindstrom examined the Buss-Condux Plastcompactor and the

Regenolux. Lindstrom found that these machines were functionally

equivalent to the Sentinel EPE recycler and were available in the

years and at the prices reported by Grossman, detailed supra.

Lindstrom also reported that various equipment companies, such as

the Cumberland Engineering Division of John Brown Plastics

Machinery, were willing to provide customized recycling programs

to companies at a minimum cost of $50,000.

Lindstrom found that in "average-use situations" the

Sentinel EPE recycler could process 200 pounds of plastic per

hour.

Lindstrom observed a Sentinel EPE recycler in operation at

PI, and he was allowed to take photographs of it and examine its

blueprints. Based on his observations and study, Lindstrom

estimated that the manufacturing cost of the Sentinel EPE

recycler was approximately $20,000. Lindstrom concluded that the

market value of the Sentinel EPE recycler did not exceed $50,000.

Lindstrom also reported that information was available in

1981 regarding state-of-the-art foamed plastic recycling

machines. Lindstrom described several approaches that might have
 - 18 -

been taken by a layman of average intelligence to obtain such

information, even in a small town library.

E. Petitioner and His Introduction to Clearwater

Petitioner acquired one-fourth of a limited partnership unit

in Clearwater in 1981 for $12,500. As a result, petitioner owned

a 1.547-percent interest in the profits, losses, and capital of

Clearwater during that year.

Petitioner received a bachelor of arts degree in English

literature from Fordham University in 1966 and a J.D. with honors

from Harvard University in 1969. Petitioner has no formal

education in plastics recycling or plastics material. During the

year in issue, petitioner was a partner in the law firm of Shea &

Gould. During that year, petitioner wife was employed as a

college instructor.

While in school, petitioner was employed during three

summers by Consolidated Molded Plastics Company (Consolidated).

Consolidated was in the business of making various industrial and

consumer molded plastic products. Petitioner was a machine

operator and assisted in operating two types of molding machines;

specifically, an injection-molding machine and a phenolic-molding

machine. During his summer employment, petitioner learned that

both the injection-molding machine and the phenolic-molding

machine produce plastic scrap as a byproduct. Petitioner also

learned that depending on the type of process used to mold the
 - 19 -

plastic, the plastic scrap may or may not be recyclable.

Finally, petitioner learned that certain plastic products could

be made only from virgin plastic resins, whereas other products

could be made from recycled plastic resins. Consolidated did not

use expanded polyethylene foam in its operations.

Shortly after graduating from law school, petitioner

represented the Society of the Plastics Industry (SPI) against

the City of New York regarding the imposition of a 2-cent tax on

every plastic container sold in the city. The New York Supreme

Court held the tax provision to be unconstitutional and ultra

vires to the city council, and the decision was affirmed by the

New York Appellate Division. For a 10-year period starting in

1975, petitioner represented British Petroleum Company (BP) in an

antitrust suit and a contract arbitration.

Petitioner became involved in Clearwater in 1981 after being

introduced to Winer by Stuart Hirshfield (Hirshfield), a partner

in his law firm. Hirshfield had previously invested in an

equipment leasing transaction in which Winer was a general

partner. Petitioner did not see a Sentinel EPE recycler before

investing in Clearwater. Petitioner never made a profit in any

year from his investment in Clearwater.

On their 1981 return, petitioners claimed a net Schedule E

partnership loss of $10,002 from the Clearwater investment.

Further, petitioners claimed investment and energy tax credits
 - 20 -

from the Clearwater investment in the total amount of $22,303.

The tax credits were based on valuing a Sentinel EPE recycler at

$1,162,667. The Schedule E partnership loss and the investment

and energy tax credits served to reduce petitioners' income tax

liability on their 1981 return by $28,169, an amount more than

twice their $12,500 investment in Clearwater.

In the notice of deficiency, respondent disallowed the

Schedule E partnership loss and the investment and energy tax

credits claimed by petitioners on their 1981 return with respect

to the Clearwater investment.

ULTIMATE FINDING OF FACT

At all relevant times, the fair market value of the Sentinel

EPE recyclers did not exceed $50,000 per machine.

OPINION

We have decided many Plastics Recycling cases. Most of

these cases, like the present case, presented issues regarding

additions to tax for negligence and valuation overstatement. See

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

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

Memo. 1997-259 n.13 (and cases cited therein). We found the

taxpayers liable for the addition to tax for valuation

overstatement in all of those cases and liable for the additions

to tax for negligence in all but two of those cases. In a

limited number of cases, the taxpayers also contested the
 - 21 -

underlying deficiency arising from the disallowance of the

partnership losses and various tax credits with respect to their

plastics recycling investment. We sustained the Commissioner on

the issue of the underlying deficiency in every one of those

cases.

In Provizer v. Commissioner, T.C. Memo. 1992-177, the test

case for the Plastics Recycling group of cases, this Court: (1)

Found that each Sentinel EPE recycler had a fair market value not

over $50,000; (2) held that the transaction, which was virtually

identical to the transactions in the present case, was a sham

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

sustained the additions to tax for negligence under section

6653(a)(1) and (2); (4) sustained the addition to tax for

valuation overstatement under section 6659 because the

underpayment of taxes was directly related to the overvaluation

of the Sentinel EPE recyclers; and (5) held that the partnership

losses and tax credits claimed with respect to Clearwater Group

were attributable to tax-motivated transactions within the

meaning of section 6621(c). In reaching the conclusion that the

transaction lacked business purpose, this Court relied heavily on

an objective criterion; namely, the overvaluation of the Sentinel

EPE recyclers.
 - 22 -

Issue 1. The Underlying Deficiency for 1981

Petitioners contend that they are not liable for the

underlying deficiency for 1981 with respect to their investment

in Clearwater. They assert that petitioner's investment in

Clearwater and petitioner's professed belief that the Clearwater

transactions were economically sound were not dependent on the

valuation of the Sentinel EPE recyclers. They contend that

because of the offsetting structure of the transaction (under

which Clearwater did not purchase the equipment but leased it,

and under which Clearwater licensed the equipment to FMEC Corp.

in exchange for a guaranteed annual royalty that was sufficient

to pay the annual rent required of Clearwater) the gross

overvaluation of the EPE recyclers was immaterial. They

conclude, therefore, that petitioner's investment in Clearwater

was not an economic sham.

Petitioners also assert that given information available at

the time of the transactions, i.e., without the benefit of

hindsight, the Clearwater transactions were not an economic sham.

As already mentioned, petitioners have stipulated

substantially the same facts concerning the underlying

transactions as we found in Provizer v. Commissioner, supra.

Further, all of petitioners' contentions were addressed in

Provizer, the test case for the Plastics Recycling group of

cases. Specifically, we considered whether, without the benefit
 - 23 -

of hindsight, investment in Clearwater was an economic sham. In

deciding that the Clearwater transactions were an economic sham,

we stated: "We do not consider whether, in light of hindsight,

the taxpayer made a wise investment, but rather whether he made

any bona fide investment at all or merely purchased tax

deductions."

We went on to consider in detail whether the taxpayer had

made a bona fide investment in Clearwater, and we concluded that

the transactions were a sham, lacking economic substance, in

light of certain objective factors including: (1) The manner in

which the transactions were structured; (2) the lack of arm's-

length dealings; and (3) the discrepancy between the fair market

value and purchase price on which the pass-throughs were based.

In this case, there is a complete failure by petitioners to

prove that the Clearwater transactions were not the circular

transactions found to be an economic sham in Provizer.

Petitioners have not established, or indeed attempted to

establish, that any of the objective criteria considered in

Provizer were in any manner different in their case. Cf. McCrary

v. Commissioner, 92 T.C. 827 (1989); Rose v. Commissioner, 88

T.C. 386 (1987), affd. 868 F.2d 851 (6th Cir. 1989). Neither

have petitioners provided any further evidence or any novel
 - 24 -

contention with respect to the underlying deficiency not

previously considered in Provizer.5

The record in the present case regarding the Clearwater

transactions plainly supports respondent's determination

regarding the underlying deficiency. Petitioners have conceded

overvaluation of the Sentinel EPE recyclers. The overvaluation

of the Sentinel EPE recyclers was integral to our holding in

Provizer, and the overvaluation in this case is inseparable from

petitioners' claimed tax benefits. In fact, the overvaluation is

the principal ground for the disallowance of petitioners' claimed

tax benefits. Cf. McCrary v. Commissioner, supra at 859; Zenkel

v. Commissioner, T.C. Memo. 1996-398.

We will therefore not revisit our decision in Provizer and

reconsider whether the Plastics Recycling leasing program in

which Clearwater participated was an economic sham. As in

Provizer, we rely heavily on the fact that the Sentinel EPE

recyclers were highly overvalued. On the basis of the same

objective criteria and for the reasons discussed in detail in

Provizer, we hold meritless the contention that the offsetting

nature of the various steps of the Clearwater transactions made

5
As previously mentioned, for a detailed discussion of the
facts and the applicable law in the substantially identical case,
see Provizer v. Commissioner, T.C. Memo. 1992-177, affd. per
curiam without published opinion 996 F.2d 1216 (6th Cir. 1993).
 - 25 -

the investment economically sound as to petitioner.6 We

therefore sustain respondent's determination regarding the

underlying deficiency.

Issue 2. Section 6653(a)(1) and (2) Negligence

Respondent determined that petitioners are liable for

additions to tax under section 6653(a)(1) and (2) with respect to

the underpayment attributable to petitioners' investment in

Clearwater. Respondent contends that it was not reasonable for

petitioner to invest in Clearwater without conducting an

independent investigation as to whether the transactions were an

economic sham, or more importantly, for petitioners to claim tax

benefits from such investment relying simply on the Clearwater

private offering memorandum.

6
Petitioners imply that we should adopt a subjective test,
i.e., consider factors listed in sec. 1.183-2(b), Income Tax
Regs., in deciding whether the Clearwater transactions were an
economic sham. In this regard, petitioners contend that the
investment in Clearwater was made with a "reasonable objective"
of making a profit, thus negating the conclusion that the
Clearwater transactions were an economic sham. We disagree. On
the basis of the record in this case, the contention that
petitioner entered into the Clearwater transactions with a
reasonable objective of making a profit is meritless. However,
in deciding whether the Clearwater transactions were an economic
sham, we find it unnecessary to discuss in any detail the factors
that lead us to conclude that petitioner did not invest in
Clearwater with the reasonable objective of making a profit. Cf.
McCrary v. Commissioner, 92 T.C. 827 (1989). For a discussion of
the professed reasonableness of petitioner's expectation of
making a profit from the Clearwater transactions, see Issue 2,
infra, where we decide whether petitioners are liable for the
additions to tax under sec. 6653(a)(1) and (2) for negligence or
intentional disregard of rules or regulations.
 - 26 -

Petitioners have not alleged any facts to prove that

petitioner conducted an independent investigation to determine

whether the Clearwater transactions were an economic sham before

investing in the partnership or before claiming tax benefits

based on highly overvalued machinery. However, petitioners

contend that in light of the totality of the circumstances, the

limited nature of petitioner's investigation of the Clearwater

investment and the claiming of tax benefits therefrom were

reasonable. Petitioners refer to petitioner's summer employment

at Consolidated and his representation of SPI and BP after

graduation from law school. They conclude that in light of

petitioner's background, it was reasonable to simply rely on the

Clearwater private offering memorandum (and specifically on the

reports of Burstein and Ulanoff) and on alleged discussions with

Shea & Gould's tax partner.7 We disagree. Rather, we hold that

petitioner, a highly educated and sophisticated individual with a

very limited background in plastics, failed to exercise the due

care required under the circumstances of this case.

Section 6653(a)(1) and (2) imposes additions to tax if any

part of the underpayment of tax is due to negligence or

intentional disregard of rules or regulations. Negligence is

defined as the failure to exercise the due care that a reasonable

7
See infra note 8.
 - 27 -

and ordinarily prudent person would exercise under the

circumstances. See Neely v. Commissioner, 85 T.C. 934, 947

(1985). The pertinent question is whether a particular

taxpayer's actions are reasonable in light of the taxpayer's

experience, the nature of the investment, and the taxpayer's

actions in connection with the transactions. See Henry Schwartz

Corp. v. Commissioner, 60 T.C. 728, 740 (1973). In this regard,

the determination of negligence is highly factual. "When

considering the negligence addition, we evaluate the particular

facts of each case, judging the relative sophistication of the

taxpayers as well as the manner in which the taxpayers approached

their investment." Turner v. Commissioner, T.C. Memo. 1995-363.

Petitioners have the burden of proving error in respondent's

determination of the additions to tax for negligence. See Rule

142(a); Luman v. Commissioner, 79 T.C. 846, 860-861 (1982); Bixby

v. Commissioner, 58 T.C. 757, 791-792 (1972).

A. Petitioner's Experience

We start with the contention that petitioner was not

negligent because, on the basis of his summer employment at

Consolidated and his representation of SPI and BP after

graduating from law school, he reasonably expected to make a

profit from the Clearwater investment. In this regard,

petitioner claims that from personal experience, he appreciated

the economic desirability of effective recycling equipment and
 - 28 -

was knowledgeable about the supply and price movements of

petroleum products. Based on these factors, petitioner claims

that he reasonably expected to make a profit from his investment

in Clearwater and was therefore not negligent.

We fail to see how petitioner's limited experience with

plastics and plastics recycling, together with his professed

knowledge about the desirability of "effective" recycling

equipment, made it reasonable for him to invest in a partnership

designed to produce tax benefits. Although petitioner's limited

experience with plastics and plastic scrap, and his professed

awareness about the economic desirability of effective recycling

equipment, may have provided some motivation to consider the

Clearwater investment, petitioner should have thereafter

reasonably investigated his prospective investment.

There were many factors that should have alerted petitioner

to conduct an independent investigation of the Clearwater

investment. The transactions were structured in a manner such

that, with the exception of a minimal downpayment for the

Sentinel EPE recyclers, most of the purchase price was in the

form of a series of offsetting payments realized only through

bookkeeping entries. The purported price tags had nothing to do

with traditional principles of supply and demand pricing because

the Sentinel EPE recyclers were never offered on the open market,

and there is no evidence that anyone ever intended to offer them
 - 29 -

on the open market. See Provizer v. Commissioner, T.C. Memo.

1992-177. The lack of arm's-length negotiations in the open

market and the exorbitant cost of each Sentinel EPE recycler,

$1,162,667, should have caused petitioner to investigate the

investment independently.

We have found that an independent investigation would have

revealed the true nature of the Clearwater transactions as an

economic sham. Many factors were present to indicate that the

Sentinel EPE recyclers were highly overvalued. For instance, the

Sentinel EPE recyclers were not unique. Respondent's experts

identified other machines that were not only functionally

equivalent to the Sentinel EPE recyclers but were also

significantly less expensive. Information regarding comparable,

less expensive recyclers was widely available. If a potential

purchaser, especially a sophisticated individual such as

petitioner, had conducted a due diligence investigation of the

Sentinel EPE recyclers, such a potential purchaser would have

learned that comparable, less expensive equipment existed. Such

an investor would have concluded that the structure of the

Clearwater transactions, set up to take advantage of tax benefits

involving grossly overvalued equipment, constituted a sham.

In particular, petitioner was well positioned to recognize

the Clearwater transactions as an economic sham. Petitioner was

a sophisticated and well-educated attorney. Petitioner testified
 - 30 -

that he was aware of the varying degrees of recyclability of

plastic scrap depending on the process used by a manufacturer to

mold plastic into a particular product. Petitioner was also

aware of the varying qualities of resin pellets made from

recycled plastic scrap depending on the "effectiveness" of the

recycling equipment. Yet petitioner did very little to

investigate his investment in a partnership formed to lease

Sentinel EPE recyclers at the exorbitant cost of $1,162,667 each

to ensure that they were in fact "effective" in producing

marketable resin pellets. The record clearly indicates that if

it were not for the promised tax benefits, a sophisticated

individual such as petitioner would not have invested in a

partnership that leased Sentinel EPE recyclers at 20 times their

value. We are convinced that petitioner would not have invested

in Clearwater were it not for the prospect of the sizable tax

benefits that the investment in Clearwater offered.

Petitioners next present us with the so-called oil crisis

argument. They assert that while representing BP, petitioner

learned about the so-called oil crisis and the likelihood that

the price of plastic would increase in future years because

plastic is an oil derivative. According to petitioners, it was

therefore reasonable to conclude that the Clearwater investment

would be profitable.
 - 31 -

Petitioners' so-called oil crisis argument has been made in

more than 20 of the Plastics Recycling cases. See, e.g.,

Provizer v. Commissioner, supra; Merino v. Commissioner, T.C.

Memo. 1997-385; Singer v. Commissioner, T.C. Memo. 1997-325; Sann

v. Commissioner, T.C. Memo. 1997-259. We have found this

argument to be unpersuasive in every one of those cases.

Petitioners' argument is no different in any substantive manner,

nor is their argument based on any legal authority not previously

considered in those cases. We will not revisit the oil crisis

argument. We therefore hold that the so-called oil crisis did

not provide a reasonable basis for petitioners to conclude that

the Clearwater investment would be profitable.

B. Reliance on the Private Offering Memorandum

We next address the contention that petitioner reasonably

relied on the Clearwater private offering memorandum, and

specifically on the reports of Burstein and Ulanoff, in making

the Clearwater investment and claiming the tax benefits

therefrom.8

8
Petitioners also claim that petitioner relied on the
advice of Shea & Gould's tax partner, Alan Parker (Parker).
However, petitioners failed to present any evidence in this
regard other than petitioner's own testimony. We do not find
petitioner's self-serving testimony sufficient or particularly
reliable in this regard. See Tokarski v. Commissioner, 87 T.C.
74, 77 (1986); Hawkins v. Commissioner, T.C. Memo. 1993-517,
affd. without published opinion 66 F.3d 325 (6th Cir. 1995).
Regardless, the record does not demonstrate: (1) Whether Parker
(continued...)
 - 32 -

Under some circumstances, a taxpayer may avoid liability for

negligence because of the taxpayer's reasonable reliance on a

competent professional adviser. See United States v. Boyle, 469

U.S. 241, 250-251 (1985); Freytag v. Commissioner, 89 T.C. 849,

888 (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; rather it is a

factor to be considered. See Freytag v. Commissioner, supra.

Petitioners claim that petitioner relied on representations

by Burstein and Ulanoff regarding the uniqueness of the Sentinel

EPE recyclers. However, petitioner did not independently obtain

these individuals' advice but rather received their reports as

part of the promotional material that he received from

Clearwater. Burstein and Ulanoff were paid to promote the

Plastics Recycling leasing programs and, in particular, the

Clearwater investment. Reliance on representations by insiders,

8
(...continued)
possessed the requisite expertise and knowledge of the pertinent
facts regarding the Clearwater transactions to provide informed
advice on the claimed partnership losses and tax credits, see
David v. Commissioner, 43 F.3d 788, 789-790 (2d Cir. 1995), affg.
per curiam T.C. Memo. 1993-621; Goldman v. Commissioner, 39 F.3d
402 (2d Cir. 1994), affg. T.C. Memo. 1993-480; Freytag v.
Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th
Cir. 1990), affd. 501 U.S. 868 (1991); or (2) what advice Parker
rendered with respect to either the profitability of the
transaction or the claiming of tax benefits therefrom, see also
Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165
(1946), affd. 162 F.2d 513 (10th Cir. 1947).
 - 33 -

promoters, or offering materials has been held to be an

inadequate defense to negligence. See Goldman v. Commissioner,

39 F.3d 402 (2d Cir. 1994), affg. T.C. Memo. 1993-480; LaVerne v.

Commissioner, 94 T.C. 637, 652-653 (1990), affd. without

published opinion 956 F.2d 274 (9th Cir. 1992), affd. in part

without published opinion sub nom. Cowles v. Commissioner, 949

F.2d 401 (10th Cir. 1991).

What is more, the record demonstrates that petitioner either

did not thoroughly review the offering memorandum or chose to

ignore certain portions thereof. The offering memorandum

included numerous caveats and warnings regarding the business

risks of the Clearwater transactions (including the general

partner's lack of experience in marketing recycling or similar

equipment and the lack of an established market for the

recyclers) and the risks involved in claiming tax benefits

therefrom. It also included a statement that "each offeree

should consult his own professional advisors as to legal, tax,

accounting and other matters relating to any purchase by him of

units". Therefore, even the offering memorandum warned

petitioner that he should not rely on Burstein or Ulanoff for

either business or tax advice. A careful consideration of the

offering memorandum, especially the discussion of high writeoffs

and the risk of audit, would have alerted a prudent investor to

question the nature of the promised tax benefits. We certainly
 - 34 -

expect no less from a well-educated and sophisticated individual

such as petitioner.

More importantly, it was not reasonable for petitioner to

claim tax benefits from his investment in Clearwater on the basis

of reliance on reports contained in the private offering

memorandum. We have long held as a general rule that a taxpayer

may not reasonably rely on the advice of the promoter of a tax

shelter with respect to the substantive merits or the tax

treatment of items in connection with that program. See Patin v.

Commissioner, 88 T.C. 1086, 1131 (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. per curiam

without published opinion sub nom. Hatheway v. Commissioner, 856

F.2d 186 (4th Cir. 1988); Klieger v. Commissioner, T.C. Memo.

1992-734. Such advice "is better classified as sales promotion".

Vojticek v. Commissioner, T.C. Memo. 1995-444.

Petitioners contend that it was reasonable for petitioner

not to look beyond the offering memorandum but to accept its

representations at face value because Federal and State

securities laws discourage false or misleading statements. We

find no merit in petitioners' argument.

First, in light of petitioner's educational background and

professional experience, we are not convinced that he would have
 - 35 -

been so naive if the Clearwater investment had not been driven by

the promise of large tax benefits. Second, there is no

explanation why the many caveats and warnings regarding the tax

and business risk factors detailed in the offering memorandum did

not alert petitioner to investigate the Clearwater investment in

more detail. The Clearwater private offering memorandum

contained cautionary language that was directed to the investor.

Petitioners have presented no reason for us to doubt that the

cautionary language meant what it said.

We therefore are not convinced of petitioner's professed

faith in the representations in the offering memorandum, which

was allegedly based on the concept that the securities laws

discourage false and misleading statements. Regardless of

whether petitioners have a cause of action under Federal or State

securities laws against Clearwater or any of its promoters,

petitioners were not relieved of the duty to conduct an

independent investigation of their investment before claiming tax

benefits therefrom. Under these circumstances, petitioner's

failure to look beyond the private offering memorandum and the

representations by Burstein and Ulanoff was unreasonable and not

in keeping with the standard of the ordinarily prudent person.

See Triemstra v. Commissioner, T.C. Memo. 1995-581; see also

LaVerne v. Commissioner, supra; Marine v. Commissioner, 92 T.C.
 - 36 -

958 (1989), affd. without published opinion 921 F.2d 280 (9th

Cir. 1991).

Thus, it was not reasonable for petitioners to claim

substantial tax credits and a partnership loss on the basis of

reports contained in the Clearwater private offering memorandum;

and, there is no indication that petitioners obtained

professional advice from an individual with the requisite

expertise and knowledge of the pertinent facts to provide

informed advice regarding the claimed partnership loss and tax

credits. Cf. David v. Commissioner, 43 F.3d 788, 789-790 (2d

Cir. 1995), affg. per curiam T.C. Memo. 1993-621; Goldman v.

Commissioner, 39 F.3d 402 (2d Cir. 1994); Freytag v.

Commissioner, 89 T.C. 849 (1987). Therefore, petitioners did not

act reasonably in claiming tax benefits relating to the

Clearwater investment.

C. Conclusion Regarding Negligence

In view of petitioner's sophistication, petitioner knew or

should have known that the Sentinel EPE recyclers were not

unique, that they were not worth more than $50,000 each, and that

Clearwater lacked economic substance and had no potential for

profit. Therefore, under the circumstances of this case,

petitioners failed to exercise due care in claiming a partnership

loss deduction and substantial tax credits with respect to

Clearwater. Taking all of the above factors into consideration,
 - 37 -

we think it is more likely than not that petitioner invested in

Clearwater in an effort to generate tax benefits, rather than to

make a profit.

Upon consideration of the entire record, we hold that

petitioners are liable for the additions to tax for negligence

under section 6653(a)(1) and (2). Respondent is therefore

sustained on this issue.

Issue 3. Section 6621(c) Additional Interest

Respondent determined that petitioners are liable for

additional interest with respect to the underpayment attributable

to the Clearwater investment.

Section 6621(c), formerly section 6621(d), provides for an

increased rate of interest if the underpayment of tax exceeds

$1,000 and is attributable to a tax-motivated transaction as

defined in section 6621(c)(3). The increased rate of interest is

effective only with respect to interest accruing after December

31, 1984, notwithstanding that the transaction was entered into

before that date. See Solowiejczyk v. Commissioner, 85 T.C. 552

(1985), affd. per curiam without published opinion 795 F.2d 1005

(2d Cir. 1986); Provizer v. Commissioner, T.C. Memo. 1992-177.

A tax-motivated transaction includes any valuation

overstatement within the meaning of section 6659(c). See sec.

6621(c)(3)(A)(i). Petitioners have conceded that there was such

a valuation overstatement in the present case. In addition, we
 - 38 -

have held that the Clearwater transactions to which petitioners'

1981 underpayment is attributable were a sham. A tax-motivated

transaction includes any sham or fraudulent transaction. See

sec. 6621(c)(3)(A)(v); Provizer v. Commissioner, supra. Finally,

the grounds for the disallowance of petitioners' claimed tax

benefits was largely the overvaluation of the Sentinel EPE

recyclers. Cf. McCrary v. Commissioner, 92 T.C. at 857-860.

Under these circumstances, the increased rate of interest is

therefore clearly applicable. Accordingly, we sustain respondent

on this issue.

Petitioners have made other arguments that we have

considered in reaching our decision. To the extent that we have

not discussed these arguments, we find them to be without merit.

To reflect our disposition of the disputed issues, as well

as petitioners' concession,

Decision will be entered

for respondent.