Fawson v. Commissioner

T.C. Memo. 2000-195

UNITED STATES TAX COURT

NORMAN H. FAWSON AND MARY JANE B. FAWSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7705-99. Filed June 28, 2000.

Bruce E. Babcock, for petitioners.

Richard W. Kennedy, for respondent.

MEMORANDUM OPINION

DEAN, Special Trial Judge: Respondent issued a notice of

deficiency to petitioners for taxable year 1982. In the notice,

respondent determined that petitioners were liable for additions

to tax for negligence pursuant to section 6653(a)(1)1 of $509.75

and pursuant to section 6653(a)(2) for 50 percent of the interest

1
Unless otherwise indicated, all 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 -

due on $10,195. Respondent also determined an addition to tax of

$2,548.75 for a substantial understatement of tax under section

6661.

Petitioners did not contest and have conceded the addition

to tax for a substantial understatement. The issue for decision

is whether petitioners are liable for the additions to tax for

negligence pursuant to section 6653(a)(1) and (2) with respect to

the loss from their investment in the Utah Jojoba I Research

partnership claimed on their 1982 Federal income tax return.

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

The stipulation of facts and the attached exhibits are

incorporated herein by reference. Petitioners resided in St.

George, Utah, at the time their petition was filed.

Background

Norman Fawson (petitioner) has a degree in genetics and a

medical degree from the University of Utah. He practices family

medicine with a medical group in St. George, Utah. He grew up on

a farm, and in 1979 he purchased approximately 15 acres and

started an apple orchard.

In 1982 petitioners’ financial planner/investment counselor,

Elroy Jones (Mr. Jones), recommended that petitioners invest in

the Utah Jojoba I Research partnership (the partnership). Over

the previous 2 or 3 years, Mr. Jones had set up an investment

plan for petitioners’ retirement, and petitioners had purchased
 - 3 -

one or two investments through Mr. Jones. As an officer of and

participant in the retirement plan sponsored by his medical

partnership (the retirement plan), petitioner also had

participated in other investments recommended and sold by

Mr. Jones.

The partnership was promoted by the CFS Corp. (CFS), through

which petitioners and the retirement plan had made several

investments. CFS was highly recommended by the attorney who

oversaw the retirement plan. Petitioners also had made

investments in real estate limited partnerships through this

attorney.

Petitioners discussed the partnership investment opportunity

with Mr. Jones. In addition to information provided by Mr.

Jones, petitioner had discovered, while investigating drip

irrigation for his apple orchard, that farmers in Israel were

already researching jojoba as an alternative source to sperm

whale oil and had already started jojoba plantations. Petitioner

also read what he could find at the library to become acquainted

with jojoba.

Mr. Jones gave petitioners a private placement memorandum

which they read and discussed with him. One of the features of

the investment was that it would generate substantial tax

deductions. The promotional materials petitioners reviewed

indicated that there were tax risks associated with the
 - 4 -

investment. Petitioners felt reassured about the tax risks after

talking with Mr. Jones. They also were reassured after talking

with someone from CFS. Petitioners did not explain the substance

of the reassuring statements made by Mr. Jones or by CFS.

Petitioners did not discuss the investment with an attorney.

Although petitioner does not recall whether he had their

accountant review the private placement offering before making

the investment, petitioners did discuss the partnership with him

after making the investment.

On their joint 1982 Federal income tax return, petitioners

reported wages from petitioner’s medical practice of $123,455 and

losses of $20,919 from the Utah Jojoba I Research partnership.

The partnership was audited and a Notice of Final Partnership

Administrative Adjustment was issued to the partnership. The

partnership initiated a TEFRA proceeding to contest the matter.

The matter was resolved by Utah Jojoba I Research v.

Commissioner, T.C. Memo. 1998-6, which found that the activities

of the partnership did not constitute a trade or business and

that the agreements between the partnership and U.S. Agri

Research & Development Corp. (U.S. Agri) had been designed and

entered into solely to provide a mechanism to disguise the

capital contributions of limited partners as currently deductible

expenditures.
 - 5 -

As a result of the partnership’s TEFRA proceeding,

petitioners were assessed a tax liability of $10,195, along with

interest. Respondent issued a notice of deficiency for affected

items determining that petitioners are liable for additions to

tax for negligence pursuant to section 6653(a)(1) and (2) and for

a substantial understatement addition to tax pursuant to section

6661. Petitioners timely filed a petition seeking a

redetermination of the negligence additions to tax.

Discussion

Section 6653(a)(1) imposes an addition to tax in an amount

equal to 5 percent of an underpayment of tax if any part of the

underpayment is due to negligence or intentional disregard of

rules or regulations. Section 6653(a)(2) imposes another

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

due on the portion of the underpayment attributable to negligence

or intentional disregard of rules or regulations.

Respondent’s determinations, contained in the notice of

deficiency, are presumed correct, and petitioners must establish

otherwise. See Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933); cf. sec. 7491(c).2 Respondent maintains that

2
The Internal Revenue Service Restructuring & Reform Act
of 1998, Pub. L. 105-206, sec. 3001, 112 Stat. 685, 726, added
sec. 7491(c), which shifts the burden of proof to the Secretary
with respect to a taxpayer’s liability for penalties and
additions to tax in court proceedings arising in connection with
examinations commencing after July 22, 1998. Petitioners do not
(continued...)
 - 6 -

petitioners’ underpayment was due to negligence. Petitioners,

therefore, have the burden of proving they were not negligent in

deducting their share of the partnership’s losses. See Estate of

Mason v. Commissioner, 64 T.C. 651, 663 (1975), affd. 566 F.2d 2

(6th Cir. 1977); Bixby v. Commissioner, 58 T.C. 757, 791 (1972);

Anderson v. Commissioner, T.C. Memo. 1993-607, affd. 62 F.3d 1266

(10th Cir. 1995).

Negligence is defined as the failure to exercise the due

care that a reasonable and ordinarily prudent person would

exercise under like circumstances. See Anderson v. Commissioner,

62 F.3d 1266, 1271 (10th Cir. 1995), affg. T.C. Memo. 1993-607;

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

Commissioner, T.C. Memo. 1996-206. The focus of our inquiry is

on the reasonableness of the taxpayer’s actions in light of his

experience and the nature of the investment. See Henry Schwartz

Corp. v. Commissioner, 60 T.C. 728, 740 (1973); Greene v.

Commissioner, T.C. Memo. 1998-101, affd. without published

opinion 187 F.3d 629 (4th Cir. 1999); Glassley v. Commissioner,

supra; Turner v. Commissioner, T.C. Memo. 1995-363. Whether a

taxpayer is negligent in claiming a tax deduction “depends upon

both the legitimacy of the underlying investment, and due care in

the claiming of the deduction.” Sacks v. Commissioner, 82 F.3d

2
(...continued)
contend that their examination commenced after July 22, 1998, or
that sec. 7491 is applicable to them.
 - 7 -

918, 920 (9th Cir. 1996), affg. T.C. Memo. 1994-217; see Greene

v. Commissioner, supra.

A taxpayer may avoid liability for negligence penalties

under some circumstances if the taxpayer reasonably relied on

competent professional advice. See Freytag v. Commissioner, 89

T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd.

on other issue 501 U.S. 868 (1991). Such reliance, however, is

“not an absolute defense to negligence, but rather a factor to be

considered.” Id. For reliance on professional advice to excuse

a taxpayer from the negligence additions to tax, the taxpayer

must show that the professional adviser had the expertise and

knowledge of the pertinent facts to provide informed advice on

the subject matter. See id.

The record does not establish the exact nature of the

underlying partnership investment in this case. No prospectus or

private placement memorandum was produced, few facts on the exact

nature of the investment were stipulated, and no witnesses other

than petitioner testified at trial. Nevertheless, a fair reading

of the stipulation of facts and the briefs of the parties shows

that they agree that the underlying facts of the partnership

operations are as discussed in Utah Jojoba I Research v.
 - 8 -

Commissioner, T.C. Memo. 1998-6.3 See Greene v. Commissioner,

supra. It is petitioners’ burden, in any event, to establish the

context in which their deductions were taken. See Rule 142(a);

Welch v. Helvering, 290 U.S. at 115; Bixby v. Commissioner, 58

T.C. 757, 791 (1972).

In Utah Jojoba I Research v. Commissioner, supra, we found

that the partnership was organized on December 27, 1982, as a

limited partnership with a described purpose of conducting

research and development (R&D) involving the jojoba plant. CFS

prepared the private placement memorandum (the offering) dated

November 10, 1982, and an R&D agreement and licensing agreement

executed on December 31, 1982. The partnership was formed with

subscriptions for 247 units for a total capitalization of

$2,094,560.

The offering identified William G. Kellen as the general

partner and characterized him as having “no previous experience”

with respect to jojoba beans. The offering also indicated that

3
Although the parties disagree as to what was apparent
from the partnership’s promotional materials, they have
stipulated that the Court found in Utah Jojoba I Research v.
Commissioner, T.C. Memo. 1998-6, that the activities of the
partnership did not constitute a trade or business and that the
research and development and licensing agreements entered into by
the partnership had been designed and entered into solely to
provide a mechanism to disguise the capital contributions of
limited partners as currently deductible expenditures. In their
brief, petitioners request a finding of fact that the Court’s
decision found that the activities of the partnership did not
constitute a trade or business.
 - 9 -

U.S. Agri was the contractor selected to carry out the R&D

program under an R&D agreement. The offering included the R&D

agreement and the license agreement.

The partnership entered into the exclusive R&D agreement

with U.S. Agri on December 31, 1982. The license agreement

between the partnership and U.S. Agri was executed concurrently

with the R&D agreement, granting U.S. Agri the exclusive right to

utilize technology developed for the partnership for 40 years in

exchange for a royalty of 85 percent of all products produced.

The R&D agreement, according to its terms, expired upon the

partnership’s execution of the license agreement. Because the

two agreements were executed concurrently, amounts paid to U.S.

Agri by the partnership were not paid pursuant to a valid R&D

agreement but were passive investments. The partnership never

engaged in research or experimentation either directly or

indirectly.

We noted that Mr. Kellen exhibited a lack of concern about

the details of the partnership’s operations. He hastily signed

the R&D agreement and licensing agreement prepared by CFS and

admitted he did not read the offering until preparing the case

for trial. Mr. Kellen also never took any legal action to

enforce promissory notes signed by limited partners who had

purchased subscriptions in the partnership and defaulted.

We found in Utah Jojoba I Research v. Commissioner, supra,
 - 10 -

that U.S. Agri’s attempts to farm jojoba commercially did not

constitute research and development. We concluded that the R&D

agreement was designed and entered into solely to decrease the

cost of participation in the jojoba farming venture for the

limited partners through large up-front deductions for

expenditures that were in reality capital contributions. We

further found that the partnership was not involved in a trade or

business and had no realistic prospect of entering into a trade

or business with regard to any technology that was supposed to be

developed by U.S. Agri. On these bases, we determined that the

partnership was not entitled to a claimed loss of $1,304,819,

including $1,298,627 claimed as qualified research and

experimental expenditures under section 174.

Petitioners contend that they invested in the partnership

and claimed losses arising out of the partnership in a good faith

belief that the partnership had the potential to earn a profit.

They contend they exercised the due care of reasonable and

ordinarily prudent persons under the circumstances, taking into

account their experience and the nature of the investment. They

further argue that at the time they claimed the deductions at

issue the law relating to the deductibility of research and

development expenses under section 174 was still unclear and that

there were no warning signs that they would not be entitled to

the claimed deduction. We, however, do not find that the
 - 11 -

evidence supports the conclusion that petitioners acted

reasonably under the circumstances.

In contrast to many of the cases decided by this Court

involving tax shelters in which the impropriety of partnership

deductions could be discerned only by an investigation of the

partnership’s actual operations, the problem with Utah Jojoba I

Research was apparent from the documents included in the offering

prepared by CFS. Both the R&D agreement and the licensing

agreement were included in the offering. An experienced attorney

capable of reading and understanding these documents should have

understood the legal ramification of the licensing agreement

canceling the R&D agreement. With the concurrent execution of

the two agreements, the partnership was not engaging, even

indirectly, in any research or experimentation. Instead, the

partnership was merely a passive investor seeking royalty returns

pursuant to the licensing agreement.

Rather than seeking professional legal and tax advice,4

petitioners relied solely on their reading of the offering, their

discussions with Mr. Jones, who was selling the investment, their

discussion with someone from CFS, which was promoting the

investment, and petitioner’s reading about jojoba. The record

4
Petitioner testified that he discussed the investment
with his accountant “at least after the investment was made”. He
did not indicate, however, what information he shared with the
accountant or the exact nature of any advice he received.
 - 12 -

provides no information about Mr. Jones’ background and

expertise, other than that he helped petitioners prepare their

retirement plan. Although petitioner testified he felt reassured

about any tax risks after talking with Mr. Jones and someone from

CFS, he did not elaborate on what he was told or why he felt

reassured.

Petitioners were not naive investors and should have

recognized the need for independent professional advice. See

LaVerne v. Commissioner, 94 T.C. 637, 652 (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); Glassley v. Commissioner, T.C. Memo.

1996-206. Petitioner apparently recognized the necessity of such

advice in connection with the investments of his medical group’s

retirement plan. He and his medical partners hired an attorney

to oversee the retirement plan’s investments. In the case at

hand, however, petitioners relied on the assurances of Mr. Jones

even though petitioner testified he was not clear about the

“legalese” in the offering and that the offering had put him on

notice of tax risks.

Furthermore, petitioners should have had reason to question

Mr. Jones’ representations. Petitioner testified that Mr. Jones

had indicated that he had met with Mr. Kellen, the partnership’s

general partner, and that Mr. Kellen had significant experience
 - 13 -

in the research and development of jojoba. In contrast, the

offering, which petitioner testified he read, characterized Mr.

Kellen as having no experience in the research and development of

jojoba.

Petitioner seemingly contends that his experience with

farming and his reading about jojoba gave him confidence in the

viability of his investment in the partnership, yet he presented

no evidence that he actually applied any of his knowledge through

an investigation of the partnership. If anything, petitioner’s

knowledge should have prompted him to inquire into the

operational aspects of the partnership and into the nature of the

“research” U.S. Agri was to conduct under the terms of the R&D

agreement. The record provides no evidence that petitioner ever

visited the jojoba plantation or inquired into U.S. Agri’s

ability to conduct research. If petitioner had investigated the

nature of the purported research U.S. Agri was to conduct, he

likely would have discovered that it amounted to nothing more

than farming activity. With petitioner’s farming background and

his professed interest in jojoba, we find it difficult to believe

he would have relied solely on the promoter’s investigation if he

viewed the partnership as a long-term investment.5

Petitioners’ contention that they were not negligent in

5
We note that petitioner went to Israel to investigate
drip irrigation for his own apple orchard.
 - 14 -

claiming losses associated with the partnership because the

limits of section 174 on the deductibility of research or

experimental expenditures had not been sufficiently developed in

1982 is without merit. Petitioners cite Kantor v. Commissioner,

998 F.2d 1514 (9th Cir. 1993), affg. in part and revg. in part

T.C. Memo. 1990-380, in support of their proposition. In Kantor,

the Court of Appeals for the Ninth Circuit concluded that the

experience and involvement of the general partner and the lack of

warning signs could have reasonably led investors to believe they

were entitled to deductions in light of the undeveloped state of

the law regarding section 174.

As explained by the Court of Appeals, the Supreme Court’s

decision in Snow v. Commissioner, 416 U.S. 500 (1974), left

unclear the extent to which research must be “in connection with”

a trade or business for purposes of qualifying for an immediate

deduction under section 174. In the present case, however, not

only was the partnership not engaged in a trade or business, it

was not conducting, directly or indirectly, any research or

development.

Petitioners’ investment in the partnership is further

distinguishable from the taxpayers’ investment in Kantor v.

Commissioner, supra. The general partner of Utah Jojoba I

Research was not experienced in jojoba research and development,

and he had minimal involvement in the partnership. Petitioners
 - 15 -

should have recognized additional warning signs including the

offering’s warnings of tax risks involved with the investment and

the terms of the licensing agreement which canceled the R&D

agreement.

Petitioners did not exercise the due care of reasonable and

ordinarily prudent persons under the circumstances. Accordingly,

we hold that petitioners are liable for the negligence additions

to tax imposed by the provisions of section 6653(a)(1) and (2).

To reflect the foregoing,

Decision will be entered

for respondent.