Kowalchuk v. Commissioner

T.C. Memo. 2000-153

UNITED STATES TAX COURT

STEPHEN KOWALCHUK, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 1434-95. Filed May 5, 2000.

Stephen Kowalchuk, pro se.

Louise R. Forbes, for respondent.

MEMORANDUM OPINION

POWELL, Special Trial Judge: Respondent determined that

petitioner is liable for additions to tax under sections

6653(a)(1) and 6659 in the respective amounts of $199 and $844

for the taxable year 1982.1 In addition, respondent also

determined that petitioner is liable for the addition to tax

under section 6653(a)(2) in the amount of 50 percent of the

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

interest due on a $3,987 deficiency for 1982. The issues are

whether petitioner is liable for these additions to tax.

Petitioner resided in Boca Raton, Florida, at the time he filed

the petition in this case.

The facts may be summarized as follows.

A. Background

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

For a detailed discussion of the transactions involved in the

Plastics Recycling group of cases, see Provizer v. Commissioner,

T.C. Memo. 1992-177, affd. without published opinion 996 F.2d

1216 (6th Cir. 1993). It is stipulated that the underlying

transactions involving the Sentinel Recyclers in the present case

are substantially identical to the transactions in Provizer v.

Commissioner, supra. The facts concerning the transactions as

found in Provizer v. Commissioner, supra, are as follows.

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

six Sentinel Recyclers to Ethynol Cogeneration, Inc. (ECI), for

$981,000 each. ECI, in turn, resold the recyclers to F&G

Equipment Corp. (F&G Corp.) for $1,162,666 each. F&G Corp.

leased the recyclers to the Clearwater Group partnership, which

then licensed the recyclers to First Massachusetts Equipment

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

sublicensed the recyclers to entities (the end-users), which

would use them to recycle plastic scrap. The sublicense
 - 3 -

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

percent of the recycled scrap in exchange for payment from FMEC

based on the quality and amount of recycled scrap. All of the

foregoing transactions were executed simultaneously.

The sale of the recyclers from PI to ECI was financed with

nonrecourse notes. Approximately 7 percent of the sales price of

the recyclers sold by ECI to F&G Corp. was paid in cash, and the

remainder was financed through notes. The notes provided that 10

percent of the amount thereof was recourse but that the recourse

portion was due only after the nonrecourse portion had been paid

in full. All of the monthly payments required among the entities

in the above transactions offset each other.

In Provizer v. Commissioner, supra, we found that the market

value of a Sentinel Recycler in 1981 did not exceed $50,000 and

that the nuts and bolts, or manufacturing, cost was $18,000.

Other recycling machines were commercially available during the

years in issue in Provizer v. Commissioner, supra.

B. Petitioner’s Introduction to Plastics Recycling

Petitioner is a civil engineer by training, and during 1982

he was a self-employed real estate broker. A personal friend and

business associate, Ira Sullivan (Mr. Sullivan), gave petitioner

a prospectus for SAB Recycling Associates (SAB), a limited

partnership, formed “to exploit steam chest molded expanded

polystyrene recycling equipment (the ‘Sentinel EPS Recyclers’).”
 - 4 -

SAB purported to lease four recyclers manufactured by PI. The

prospectus stated that the projected tax benefits for a $50,000

investor were investment and energy tax credits in the amount of

$81,529 and tax deductions in the amount of $38,768 in the year

of the investment.

In reading the prospectus petitioner noticed that Samuel Z.

Burstein2 had written a favorable analysis of the recyclers

manufactured by PI. Petitioner had known Mr. Burstein in college

and considered him to have “a fabulous reputation.” Petitioner,

however, did not contact Mr. Burstein.

Petitioner has no knowledge concerning the plastics

industry and/or plastics recycling. Petitioner never saw one of

the recyclers and did not understand how the machinery worked.

He essentially relied on Mr. Sullivan, but, as far as petitioner

knew, Mr. Sullivan had no knowledge of how the process worked.

Petitioner also relied on John Masak (Mr. Masak), but Mr. Masak

had no experience in plastics recycling. In reading the

prospectus, petitioner noticed that PI had no experience in

manufacturing and operating plastics recyclers. When there was

no financial return from the partnership, petitioner never

contacted the general partner to find out why the investment did

not generate the profits projected in the prospectus. Even

2
In the transcript, this name is spelled Bernstein; in the
prospectus, however, the name is spelled Burstein.
 - 5 -

though he was a engineer by training, petitioner did no research

with respect to whether there were comparable recyclers and what

were the value of the machines.

C. Petitioner’s Interest in SAB and the Tax Returns

In 1982, petitioner invested $5,500 in Overview Associates

(Overview), a partnership, which in turn had a 19.974705-percent

interest in SAB. On its 1982 partnership return, SAB reported

that each of the four recyclers had a basis of $1,750,000 and

that its bases for the purposes of the investment and business

energy tax credits were $7 million. In Provizer v. Commissioner,

supra, we found that of the $7 million only 7 percent was paid in

cash. Overview, the second tier-partnership, reported its

aliquot share of the tax credits and deductions. On his 1982

Federal income tax return, petitioner claimed an ordinary loss of

$4,298 and reported a $44,841 basis eligible for the investment

tax credit upon which an investment tax credit of $2,814 was

claimed by petitioner.

SAB was a so-called TEFRA partnership to which the

provisions of sections 6221 through 6233 apply. On August 18,

1993, this Court entered a decision in SAB Recycling Associates

1982 v. Commissioner, docket No. 4504-92. Based on the decision

in that case, respondent issued a notice of deficiency for so-

called affected items to petitioner for the additions to tax
 - 6 -

under section 6653(a) for negligence and the valuation

overstatement addition to tax under section 6659.

Discussion

This case is one of many cases involving additions to tax

resulting from the plastics recycling scheme. See, e.g.,

Grelsamer v. Commissioner, T.C. Memo. 1996-399, affd. without

published opinion sub nom. Morgan v. Commissioner, 138 F.3d 957

(11th Cir. 1998). Except for a few cases that involved

exceptional circumstances, the Court has upheld the imposition of

the additions to tax. See Grelsamer v. Commissioner, supra at

n.2. This case is similar to the many cases that have fallen on

the other side of the line.

A. Section 6653(a)--Negligence

In a notice of deficiency for 1982 respondent determined

that petitioner is liable for the additions to tax for negligence

under section 6653(a)(1) and (2). Petitioner has the burden of

proving that respondent's determinations of these additions to

tax are erroneous. See Rule 142(a); Goldman v. Commissioner, 39

F.3d 402, 407 (2d Cir. 1994), affg. T.C. Memo. 1993-480; Luman v.

Commissioner, 79 T.C. 846, 860-861 (1982).

Section 6653(a)(1) imposes 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) imposes an addition to tax equal
 - 7 -

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

of the underpayment attributable to the negligence or intentional

disregard of rules or regulations.

Negligence is defined as the failure to exercise the due

care that a “reasonable and prudent” person would employ under

the circumstances. Goldman v. Commissioner, supra at 407; Neely

v. Commissioner, 85 T.C. 934, 947 (1985).

In Provizer v. Commissioner, supra, this Court found that

each Sentinel Recycler had a fair market value not in excess of

$50,000 and that the Clearwater Group transaction was a sham

because it lacked economic substance and a business purpose. In

reaching the conclusion that the transaction lacked economic

substance and a business purpose, this Court relied heavily upon

the overvaluation of the Sentinel Recycler. It is stipulated

that the SAB transactions are substantially similar, and

petitioner, therefore, agrees that the same flaws existed with

SAB.

Petitioner essentially contends that the additions to tax

for negligence should not apply because he was not a

sophisticated investor. Petitioner may not be a sophisticated

investor, but, even if a taxpayer is an unsophisticated investor,

that taxpayer is not relieved of the requirement to use ordinary

care and prudence. The pertinent facts here are that petitioner
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put $5,500 into a scheme that promised for the first year $3,5873

in tax credits and $4,298 in ordinary deductions and reduced his

income tax liability to zero.4 As far as this record indicates,

petitioner made this investment without the slightest notion of

how the recyclers, in which he had indirectly invested, worked.

Furthermore, as courts have frequently noted, during this period

there was extensive publicity concerning questionable tax

shelters. See, e.g., Freytag v. Commissioner, 89 T.C. 849, 888

(1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868

(1991).

These facts require a “reasonable and prudent” person at

least to seek advice from persons who have knowledge concerning

the investment. The only people with whom petitioner spoke

concerning SAB were Messrs. Sullivan and Masak, and it is agreed

that they had no such expertise. Petitioner, therefore, cannot

deflect his own culpability onto other shoulders.

We also reject petitioner’s argument that the small amount

of his investment militated against seeking further information

because of the costs that would have been involved. Having

claimed bogus tax deductions and credits, he must bear

responsibility for his actions. The long and short of the matter

3
Petitioner’s 1982 income was such that he claimed only a
credit in the amount of $2,814; the unused portion of the credit,
however, may have been carried back or forward. See sec. 46(b).
4
Petitioner did have a liability for self-employment taxes.
 - 9 -

is that petitioner did not use reasonable and prudent care in

investing in and claiming the deductions and credits from this

scheme. Respondent’s determinations as to the additions to tax

under section 6653(a) are sustained.

B. Section 6659--Valuation Overstatement

Under section 6659 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 the

property claimed on a return equals or exceeds 150 percent of the

amount determined to be the correct amount. See sec. 6659(c).

If the claimed valuation exceeds 250 percent of the correct

value, the addition is equal to 30 percent of the underpayment.

See sec. 6659(b).

In the notice of deficiency, respondent determined that

petitioner is liable for the section 6659 addition to tax on the

portion of his underpayment attributable to valuation

overstatement. Petitioner has the burden of proving that

respondent's determination of the section 6659 addition to tax is

erroneous. See Rule 142(a); Luman v. Commissioner, supra at 860-

861.

Petitioner received tax benefits, including investment and

business energy tax credits, based on a purported value of
 - 10 -

$1,750,000 for each recycler. Petitioner concedes that the fair

market value of a recycler in 1982 was not in excess of $50,000.

Therefore, if petitioner’s underpayment of tax is attributable to

such valuation overstatement, petitioner is 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 the partnership.

Except for his petition, petitioner makes no argument

concerning the section 6659 addition to tax. It is clear that

the underpayment of tax resulted directly from the grossly

overstated value of the recycling machinery. Respondent’s

determination with respect to the section 6659 addition to tax is

sustained.

Decision will be entered

for respondent.