Harvey v. Commissioner

T.C. Memo. 2001-16

UNITED STATES TAX COURT

MICHAEL G. HARVEY AND PENNY B. HARVEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9527-99. Filed January 25, 2001.

Joel N. Crouch and Sarah Q. Qureshi, for petitioners.

Rodney J. Bartlett, for respondent.

MEMORANDUM OPINION

DINAN, Special Trial Judge: Respondent determined that

petitioner was liable for the following additions to tax for

taxable year 1982: $452.25 under section 6653(a)(1), 50 percent

of the interest due on a $9,045 deficiency under section

6653(a)(2), and $2,261.25 under section 6661. Unless otherwise
 - 2 -

indicated, section references are to the Internal Revenue Code in

effect for the year in issue.

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

liable for additions to tax for negligence under section 6653(a),

and (2) whether petitioners are liable for the addition to tax

for a substantial understatement under section 6661. The issues

in this case concern the participation of petitioner husband (Mr.

Harvey or petitioner) as a limited partner in Yuma Mesa Jojoba,

Ltd. (“Yuma Mesa” or “the partnership”).1

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

The stipulations of fact and the attached exhibits are

incorporated herein by this reference. Petitioners resided in

Norman, Oklahoma, on the date the petition was filed in this

case.

1
The underlying deficiency in this case is based upon a
computational adjustment made by respondent in accordance with
partnership level adjustments. Those adjustments were upheld by
this Court in Cactus Wren Jojoba, Ltd. v. Commissioner, T.C.
Memo. 1997-504. In that case, this Court reviewed respondent’s
determinations with respect to Yuma Mesa and a related
partnership. We held that the partnerships did not directly or
indirectly engage in research or experimentation and that the
partnerships lacked a realistic prospect of entering into a trade
or business. In upholding respondent’s disallowance of
$1,298,031 in research and experimental expenditures claimed by
Yuma Mesa, we described the research and development agreement
entered into by the partnership as “mere window dressing,
designed and entered into solely to decrease the cost of
participation in the jojoba farming venture for the limited
partners through the mechanism of a large upfront deduction for
expenditures that in actuality were capital contributions.” Id.
 - 3 -

Mr. Harvey currently teaches international business and

conducts research at the University of Oklahoma. He has received

a bachelor’s degree in business administration (marketing), a

master’s degree in business administration, a second master’s

degree in marketing research, and a doctorate in marketing and

international sociology. However, he has no tax background, and

his accounting background is limited to two accounting classes.

His teaching and writing encompass neither accounting nor tax.

Petitioner wife (Ms. Harvey) has received a bachelor’s degree in

secondary education.

Beginning in 1967, Mr. Harvey was involved in the formation

and operation of a business that reconditioned and then sold

trucks. He ran the business for a period of 2-1/2 years, after

which time he became a minority shareholder until the business

was terminated in 1982.

During 1982, the year in issue, Mr. Harvey was a professor

of international marketing at Southern Methodist University, he

was the sole proprietor of a consulting business which generated

$86,766 in gross receipts and a $71,091 profit, and he was the

sole proprietor of a trucking business (separate from the

business discussed above) which generated $83,157 in gross

receipts and a $19,610 loss.

Mr. Harvey’s introduction to jojoba occurred about 1970

through 1972 through discussions he had with two neighbors.
 - 4 -

These neighbors happened to be doctoral students of archaeology

and anthropology who were conducting research related to the

history of jojoba. Mr. Harvey was reacquainted with jojoba in

1982 by Marlin Peterson. Mr. Peterson, a certified public

accountant, is petitioners’ accountant and has prepared their tax

returns since around 1974. When Mr. Harvey and Mr. Peterson

first discussed jojoba in November 1982, Mr. Peterson was in the

planning stages of the jojoba investment. Mr. Harvey discussed

the investment with Mr. Peterson when Mr. Harvey met with him and

another of his clients at a lunch which was both social and for

the purpose of discussing tax matters. After meeting with Mr.

Peterson, Mr. Harvey met with Rick Avery, president of Anderson-

Clayton Food Company. Mr. Avery had access to research which had

been conducted relating to potential uses of jojoba in the food

industry. Mr. Harvey learned from this meeting that the

insufficient supply of jojoba was at least in part prohibiting

its use in food products. Mr. Harvey then discussed jojoba with

a health food store owner, who provided him with materials

relating to jojoba’s properties and uses.

Mr. Harvey also obtained, and carefully reviewed, a copy of

the private placement memorandum distributed by the promoters of

Yuma Mesa. According to this document, the partnership was

organized “to engage in research and development and, thereafter,

participate in the marketing of the products of the jojoba
 - 5 -

plant.” Interests in the partnership were offered for $12,245

each, payable by cash of $3,571 and a 4-year promissory note of

$8,674 bearing 10 percent annual interest.

Yuma Mesa was organized as a limited partnership, with two

co-general partners. The general partners, G. Dennis Sullivan

and William Woodburn, were lawyers; the private placement

memorandum listed no experience of either outside the legal

field. Yuma Mesa was to enter into a “Research and Development

Agreement” with Hilltop Plantations, Inc. (Hilltop), which would

in turn enter into a farming subcontract with its wholly owned

subsidiary, Mesa Plantations, Inc. (Mesa). Hilltop was then to

enter into an “Experimental Agricultural Lease” with Hilltop

Ventures, a general partnership with identical ownership as

Hilltop. This lease was to be assigned to Mesa upon completion

of the research and development. Finally, Hilltop was to enter

into a “Research and Development Management Agreement” with

Agricultural Investments, Inc., which was to be the “manager” of

the project.

Hilltop (as well as Mesa and Hilltop Ventures) was

controlled by four individuals. These individuals were Raymond

H. Meinke (president, director, and shareholder), Keith A. Damer

(vice president, secretary, director, and shareholder), Mr.

Peterson (vice president, treasurer, director, and shareholder),

and Cecil R. Almand (shareholder). The three officer/directors
 - 6 -

of Hilltop were all listed as certified public accountants with

expertise in the tax field. The private placement memorandum

listed no experience of any of the officer/directors or

shareholders which is relevant to the farming of jojoba.

The private placement memorandum contained language

specifically alerting investors to the planned deduction of the

“research and development” costs, as well as other tax risks

involved in making an investment in the partnership. The

document also contained an opinion letter stating that the

research and development agreement contained therein met the

requirements of section 174. Potential investors were required

to provide information concerning any previous experience in tax

shelter investments, and the subscription agreement required

investors to initial a statement that the investor had been

advised to consult with an attorney concerning the tax

consequences of the investment.

Several weeks after meeting with Mr. Peterson, Mr. Harvey

decided to invest in the partnership. Mr. Harvey made his

investment because he felt he had insider knowledge concerning

jojoba and because he thought demand for the product was

sufficient to meet a larger supply. Petitioner did not research

the possible yield per acre of a jojoba plantation, did not

analyze production costs, did not independently investigate the

available markets or means of transporting the jojoba to
 - 7 -

purchasers, and did not make any financial projections regarding

the product.

Petitioner purchased two interests in Yuma Mesa. On

December 30, 1982, he executed a subscription agreement, a

promissory note in the amount of $17,348, and a partnership

agreement. Petitioner subsequently was issued a Schedule K-1 by

the partnership which reflected a $23,174 ordinary loss for

taxable year 1982.

On their joint Federal income tax return for 1982,

petitioners reported the following amounts of income and losses:

Wages (University) $43,978
Interest 984
Business (Consulting) 71,091
Business (Trucking) (19,610)
Royalties 2,878
Yuma Mesa partnership (23,174)
S corporation (79)
Total income 76,068

In the years following his investment in 1982, petitioner

received and reviewed financial statements and progress reports.

The reports were semiannual or quarterly, and discussed the

progress or problems at the sites. At one point, petitioner

traveled to the plantation in Yuma, where he spent approximately

1½ days. While there, he spoke with individuals involved in the

project to ascertain the progress being made and the outlook for

the jojoba development. The partnership failed in 1987.

The private placement memorandum provided projections of

estimated cash expenditures and tax savings associated with
 - 8 -

investments in the partnership. These projections, adjusted to

two interests, together with petitioner’s actual cash

expenditures, are as follow:

Cash Expenditures Tax Savings
Year Projected Actual Projected

1982 $9,782 $8,439 $11,998
1983 5,280 5,186 764
1984 5,280 5,186 572
1985 5,280 5,186 360
1986 2,640 3,888 152
28,262 27,885 13,846

Petitioners’ claimed loss from Yuma Mesa for taxable year

1982 was disallowed in the computational adjustment which was

made pursuant to the partnership level proceedings, resulting in

a $9,045 deficiency. Respondent issued petitioners a statutory

notice of deficiency determining additions to tax under sections

6653(a)(1), 6653(a)(2), and 6661, in the respective amounts of

$452.25, 50 percent of the interest due on a $9,045 deficiency,

and $2,261.25.

The first issue for decision is whether petitioners are

liable for additions to tax for negligence under section

6653(a)(1) and (2). Section 6653(a)(1) imposes an addition to

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

the underpayment is attributable to negligence or intentional

disregard of rules or regulations. Section 6653(a)(2) provides

for a further addition to tax equal to 50 percent of the interest
 - 9 -

due on the portion of the underpayment attributable to negligence

or intentional disregard of rules or regulations.

Negligence is defined as “lack of due care or failure to do

what a reasonable and prudent person would do under similar

circumstances.” Anderson v. Commissioner, 62 F.3d 1266, 1271

(10th Cir. 1995), affg. T.C. Memo. 1993-607. Petitioners argue

that Mr. Harvey was not negligent because he relied on the advice

of a professional, Mr. Peterson. Reliance on professional advice

may be a defense to the negligence penalties. See id. The

advice must be from competent and independent parties, not from

the promoters of the investment. See LaVerne v. Commissioner, 94

T.C. 637, 652 (1990), affd. without published opinion sub nom.

Cowles v. Commissioner, 949 F.2d 401 (10th Cir. 1991), affd.

without published opinion 956 F.2d 274 (9th Cir. 1992); Rybak v.

Commissioner, 91 T.C. 524, 565 (1988). We hold that petitioner’s

reliance on any advice2 from Mr. Peterson was not reasonable

because it was not from an independent source. As such, this

reliance cannot be a defense to negligence.

2
The advice petitioner received from Mr. Peterson was
apparently only in the context of Mr. Peterson’s preparation of
petitioners’ tax return. Mr. Harvey testified that he never
discussed the tax implications of the investment with Mr.
Peterson.
 - 10 -

Petitioners argue that reliance on an adviser who is a

promoter may be reasonable under precedents from the Court of

Appeals for the Tenth Circuit, to which appeal lies in this case.

The first case petitioners cite is Anderson v. Commissioner,

supra. In Anderson, the taxpayer relied on both an investment

adviser and an accountant in making his investment. The court

found that reliance on the investment adviser, who received a

commission for selling the investment to the taxpayer, was

reasonable under the circumstances of the case. However, the

court stressed that the investment adviser was not affiliated

with the corporation which had entered into the agreement with

the taxpayers. On the contrary, the adviser was an independent

insurance agent and registered securities dealer who presumably

would have received a commission on any investment he sold to the

taxpayer. See id. at 1271.

The second case petitioners cite is the unpublished opinion

of Gilmore & Wilson Constr. Co. v. Commissioner, 166 F.3d 1221,

83 AFTR 2d 99-457, 99-1 USTC par. 50,186 (10th Cir. 1999), affg.

Estate of Hogard v. Commissioner, T.C. Memo. 1997-174.3 In that

3
Gilmore & Wilson Constr. Co. is an unpublished opinion of
the Court of Appeals for the Tenth Circuit. Although unpublished
decisions generally are not binding precedent in the Tenth
Circuit and citation thereto is disfavored, that court allows
citation to such a decision where “(1) it has persuasive value
with respect to a material issue that has not been addressed in a
published opinion; and (2) it would assist the court in its
disposition.” 10th Cir. Rule 36.3. Gilmore & Wilson Constr. Co.
(continued...)
 - 11 -
case, the taxpayers relied upon their accountant for investment

advice. Following Anderson, the court noted that the fact that

the accountant was entitled to receive compensation for the

taxpayers’ investment does not make that advice per se

unreasonable: “the mere fact that * * *[the adviser] received

compensation for taxpayers’ reliance on his advice does not turn

him into a promoter whose advice cannot be considered

independent.” Gilmore & Wilson Constr. Co. v. Commissioner,

supra. As in Anderson, the court noted that the accountant was

not in any way affiliated with the partnerships related to the

investment (other than a personal investment in one of them).

In the case at hand, unlike Anderson and Gilmore & Wilson

Constr. Co., Mr. Peterson was involved in Yuma Mesa from the

planning stages through its operation. He was a promoter of the

partnership and was an officer and director of the corporation

which entered into the research and development agreement with

it. Mr. Peterson falls far outside the role of an adviser who

simply received commissions from independent entities upon the

3
(...continued)
was discussed by the Court of Appeals for the Tenth Circuit in
accordance with its rule 36.3 in Thompson v. United States, 223
F.3d 1206, 1210 n.7 (l0th Cir. 2000), which was decided after the
briefs were filed in this case. The court in Thompson, however,
addressed “the more limited question of whether a reliance
instruction was warranted”; i.e., whether the district court
abused its discretion in instructing the jury that reliance on a
professional was a defense to the negligence penalties. Id. at
1210.
 - 12 -
sale of an investment. Rather, he was integrally involved in the

partnership, and consequently petitioners’ reliance on any advice

from him was not reasonable.

We are convinced that petitioner intended to make an actual

investment in Yuma Mesa and not merely derive a tax benefit

therefrom. Petitioner, for example, performed some investigation

into the potential of jojoba prior to investment, monitored the

investment after it was made, and made payments to the

partnership in an amount greater than the tax benefits expected

to be derived. We nevertheless find that petitioner was

negligent within the meaning of section 6653(a) with respect to

taxable year 1982. First, despite petitioner’s substantial

business background in both academia and the business world, he

did not make any financial projections for the investment, and he

did little to investigate the investment beyond a limited inquiry

into the uses of and possible demand for jojoba. Second,

petitioner participated in an investment which was organized and

promoted by tax lawyers, and which involved warnings in the

private placement memorandum concerning tax risks and the need to

obtain legal advice. In addition, petitioner claimed a $23,174

ordinary loss for 1982, despite the fact that he had invested

only $9,782 in cash in the partnership via a subscription

agreement dated December 30, 1982; such a disproportionate and

accelerated loss should also have alerted petitioner to the need
 - 13 -
for outside advice regarding the propriety of its deduction.

Despite these warnings, petitioner was not concerned with the tax

risks, and consequently neither personally investigated the tax

implications of the investment nor sought outside legal advice

related to them. Instead, he relied on Mr. Peterson’s treatment

of the loss when it came time to complete petitioners’ tax

return.

Because we hold that petitioner was negligent and that

petitioners’ reliance upon Mr. Peterson was not reasonable, we

uphold respondent’s determination that petitioners are liable for

the section 6653(a)(1) and (2) additions to tax for negligence.

The second issue for decision is whether petitioners are

liable for the addition to tax under section 6661 for a

substantial understatement of tax. Section 6661(a), as amended

by the Omnibus Budget Reconciliation Act of 1986, Pub. L. 99-509,

sec. 8002, 100 Stat. 1951, provides for an addition to tax of 25

percent of the amount of any underpayment attributable to a

substantial understatement of income tax for the taxable year. A

substantial understatement of income tax exists if the amount of

the understatement exceeds the greater of 10 percent of the tax

required to be shown on the return, or $5,000. See sec.

6661(b)(1)(A). Generally, the amount of an understatement is

reduced by the portion of the understatement which the taxpayer

shows is attributable to either (1) the tax treatment of any item
 - 14 -
for which there was substantial authority, or (2) the tax

treatment of any item with respect to which the relevant facts

were adequately disclosed on the return. See sec. 6661(b)(2)(B).

If an understatement is attributable to a tax shelter item,

however, different standards apply. First, in addition to

showing the existence of substantial authority, a taxpayer must

show that he reasonably believed that the tax treatment claimed

was more likely than not proper. See sec. 6661(b)(2)(C)(i)(II).

Second, disclosure, whether or not adequate, will not reduce the

amount of the understatement. See sec. 6661(b)(2)(C)(i)(I).4

Petitioners do not argue that they had substantial authority

for claiming the loss, nor do they argue that there was adequate

disclosure on the return. We find that the record does not

establish the presence of either. The only argument petitioners

make is that they acted with reasonable cause and in good faith

in claiming the loss.

Section 6661(c) provides the Secretary with the discretion

to waive the section 6661(a) addition to tax if the taxpayer

shows he acted with reasonable cause and in good faith. We

review the Secretary’s failure to waive the addition to tax for

4
Respondent argues in his brief that “petitioners’ claimed
loss for 1982 was clearly a tax shelter item,” despite the fact
that the notice of deficiency stated that the underpayment “is
attributable to non-tax shelter items.” As a result of our
findings we need not decide whether the tax shelter provisions
are applicable in this case.
 - 15 -
abuse of discretion. See McCoy Enterprises, Inc. v.

Commissioner, 58 F.3d 557, 562-563 (10th Cir. 1995) affg. T.C.

Memo. 1992-693. Nothing in the record indicates petitioners

requested a waiver for good faith and reasonable cause under

section 6661(c). In the absence of such a request, we cannot

review respondent’s determination for an abuse of discretion.

See id.

Because petitioners have not established either that they

had substantial authority for their treatment of the partnership

loss or that they adequately disclosed the relevant facts of that

treatment, we uphold respondent’s determination on this issue.

To reflect the foregoing,

Decision will be entered

for respondent.