T.C. Memo. 2001-163
UNITED STATES TAX COURT
RICHARD E. & ELIZABETH S. NILSEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 17295-99, 17296-99. Filed July 3, 2001.
Jerome L. Blut, for petitioners.
Timothy S. Sinnott, for respondent.
MEMORANDUM OPINION
COUVILLION, Special Trial Judge: In these consolidated
cases, respondent determined that petitioners were liable for the
following additions to tax for the years 1982 and 1983:1
1
Unless otherwise indicated, all section references are
to the Internal Revenue Code in effect for the years at issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
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Additions to Tax
Year Sec. 6653(a)(1) Sec. 6653(a)(2) Sec. 6661
1982 $443 * $2,215
1983 10 ** –--
* Fifty percent of the interest due on $8,858.
** Fifty percent of the interest due on $201.
The issues for decision are: (1) Whether, for 1982 and
1983, petitioners are liable for the additions to tax under
section 6653(a)(1) and (2) for negligence, and (2) whether, for
1982, petitioners are liable for the addition to tax under
section 6661 for a substantial understatement of tax. The issues
in these cases relate to the participation of Richard E. Nilsen
(petitioner) as a limited partner in a partnership known as
Blythe Jojoba II Research, Ltd. (Blythe II or the partnership).
Some of the facts were stipulated, and those facts, with the
annexed exhibits, are so found and are incorporated herein by
reference. At the time the petitions were filed, petitioners'
legal residence was Henderson, Nevada.
Petitioner is a medical doctor specializing in family
practice medicine. Petitioner has been practicing family
medicine in Las Vegas, Nevada, since 1964. During 1963 or 1964,
when petitioner was a medical intern, he became acquainted with a
financial adviser named Gary Sheets (Mr. Sheets). At that time,
Mr. Sheets began advising petitioner on various financial matters
and introduced petitioner to numerous investment opportunities.
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Between the years 1964 and 1982, petitioner invested money with
Mr. Sheets approximately two or three times per year. Petitioner
experienced a favorable rate of financial success with Mr.
Sheets' investment suggestions, which consisted primarily of real
estate investments such as land development.
During 1982, Mr. Sheets approached petitioner about
investing in Blythe II, which was being promoted as an
agricultural research and development partnership. Blythe II was
the first agricultural type investment opportunity that had been
proposed by Mr. Sheets for consideration by petitioner. Mr.
Sheets provided petitioner with a fairly voluminous private
placement memorandum2 (the offering), which described the
proposed investment in, and the activities to be conducted
through, Blythe II. Petitioner admittedly only scanned the
document and did not carefully read each page. Instead,
petitioner passed along the offering to his certified public
accountant, Gary Mathis (Mr. Mathis), who routinely reviewed
petitioner's other investment opportunities. After perusing the
offering, Mr. Mathis advised petitioner that Blythe II appeared
to be a reasonable investment opportunity and that petitioner
should be entitled to deductions for research and development
costs, as well as other partnership expenses.
2
The private placement memorandum consisted of some 47
pages, plus 8 exhibits, and a table of contents.
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Petitioner also contacted Jack Huntington (Mr. Huntington),
who operated Huntington Jewelers in Las Vegas, to inquire about
the use of jojoba bean oil in the jewelry and watch industry.
According to the offering, one of the potential uses for oil
extracted from jojoba beans was a substitute for sperm whale oil,
which had been banned from importation into the United States in
the early 1970's. Mr. Huntington advised petitioner that there
was some concern among those in the watch industry about the
availability of sperm whale oil as a lubricant and the prospects
for any viable substitute. Petitioner did not consult an
attorney or any independent expert in the area of agriculture or
jojoba plants regarding whether jojoba oil could be a viable or
competitive substitute for sperm whale oil. Petitioners,
nevertheless, invested in Blythe II.
On their joint 1982 Federal income tax return, petitioners
reported wages of $105,100 from petitioner's medical practice and
a loss of $20,933 from Blythe II. Including the loss reported
from Blythe II, petitioners reported total net losses from
various partnerships of $54,575 for 1982. Thus, petitioners
reported an adjusted gross income of $51,576 and a total tax
liability of $3,181.3
3
During May 1985, petitioners filed an amended return
for 1982 reporting an increase in adjusted gross income of
$17,265 due to the disallowance of another partnership loss
(continued...)
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On their joint 1983 Federal income tax return, petitioners
reported wages of $86,000 from petitioner's medical practice and
a loss of $1,006 from Blythe II. Including the loss reported
from Blythe II, petitioners reported total net losses from
various partnerships of $33,680 for 1983. Thus, petitioners
reported an adjusted gross income of $71,351 and a total tax
liability of $9,133.4
Blythe II was audited by the Internal Revenue Service and a
Notice of Final Partnership Administrative Adjustment was issued
to the partnership. The partnership initiated a TEFRA proceeding
in this Court, and a decision was entered in Utah Jojoba I
Research v. Commissioner, T.C. Memo. 1998-6, which involved a
similar jojoba investment program.5 In the decided case, this
Court held that the partnerships6 did not directly or indirectly
3
(...continued)
claimed on their original 1982 return. On the amended return,
petitioners reported a total tax liability of $8,617.
4
During December 1987, petitioners filed an amended
return for 1983 reporting an increase in adjusted gross income of
$6,132 due to respondent's disqualification of a pension and
profit-sharing plan to which petitioner made contributions during
1983. On the amended return, petitioners reported a total tax
liability of $10,360.
5
The tax matters partner of Blythe II signed a
stipulation to be bound by the outcome of Utah Jojoba I Research
v. Commissioner, T.C. Memo. 1998-6.
6
Eighteen docketed cases were bound by stipulation by
the outcome of Utah Jojoba I Research v. Commissioner, supra.
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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 research and
experimental expenditures, the Court found that the agreements
between the partnerships and the proposed research and
development contractor, 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. The Court stated
that the activities of the partnerships were "another example of
efforts by promoters and investors in the early 1980's to reduce
the cost of commencing and engaging in the farming of jojoba by
claiming, inaccurately, that capital expenditures in jojoba
plantations might be treated as research or experimental
expenditures for purposes of claiming deductions under section
174." Id.
As a result of Blythe II's TEFRA proceeding, petitioners
were assessed tax deficiencies of $8,858 for 1982 and $201 for
1983, plus interest. Subsequently, respondent issued notices of
deficiency to petitioners for 1982 and 1983 for affected items
determining that petitioners are liable for the additions to tax
for negligence under section 6653(a)(1) and (2) and a substantial
understatement of tax under section 6661 for 1982. These
additions to tax are the subject of the instant cases.
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The first issue is whether petitioners are liable for the
additions to tax for negligence under section 6653(a)(1) and (2)
for both years at issue. 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 in a 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).7 Respondent determined that
petitioners’ underpayments were 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);
7
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
contend that their examination commenced after July 22, 1998, or
that sec. 7491 is applicable in these cases.
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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 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.
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
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"not an absolute defense to negligence, but rather a factor to be
considered." Id. For reliance on professional advice to relieve
a taxpayer from the negligence addition 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 facts pertinent to the instant cases, relating to the
structure, formation, and operation of Blythe II, are as
discussed in Utah Jojoba I Research v. Commissioner, T.C. Memo.
1998-6, with the exception of a few specific dates and dollar
amounts. Blythe II was organized in December 1982, as a limited
partnership for the described purpose of conducting research and
development (R & D) involving the jojoba plant. The offering,
dated November 30, 1982, provided for a maximum capitalization of
$2,968,000 consisting of 350 limited partnership units at $8,480
per unit. Each unit required a cash downpayment of $2,500 and a
noninterest-bearing promissory note in the principal amount of
$5,980 payable in 10 annual installments with an acceleration
provision in the event of default. The offering was limited to
investors with a net worth (exclusive of home, furnishings, and
automobiles) of $150,000, or investors whose net worth was
$50,000 (exclusive of home, furnishings, and automobiles) and who
anticipated that, for the taxable year of the investment they
would have gross income equal to $65,000, or taxable income, a
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portion of which, but for tax-advantaged investments, would be
subject to a Federal income tax rate of 50 percent.
Petitioners' investment was for four limited partnership
units, which required an initial downpayment of $10,000 and
execution of a promissory note for $23,920. Petitioners paid
$2,600 each year from 1983 through 1985 and $2,100 per year from
1986 through 1991 on the promissory note. In 1992, petitioners
made a final payment of $3,520.
The offering identified William Kellen (Mr. Kellen) as the
general partner and U.S. Agri as the contractor for the R & D
program under an R & D agreement. Additionally, a license
agreement between Blythe II and U.S. Agri granted U.S. Agri the
exclusive right to utilize technology developed for Blythe II for
40 years in exchange for a royalty of 85 percent of all products
produced. The offering included copies of both the R & D
agreement and the license agreement.8 The R & D agreement was
executed concurrently with the license agreement.
8
In the instant cases, the Blythe II offering is
included in evidence as a stipulated exhibit; however, the
stipulated exhibit contains an incomplete copy of the R & D
agreement that was attached to the original offering. To the
extent that relevant facts are omitted due to the incomplete copy
of the R & D agreement (or other incomplete pieces of evidence)
in the instant cases, the Court must rely on findings of fact in
Utah Jojoba I Research v. Commissioner, T.C. Memo. 1998-6, to
which the partners of Blythe II agreed to be bound. It is
petitioners' burden to establish the context in which their
deductions were taken. See Rule 142(a); Welch v. Helvering, 290
U.S. 111, 115; Bixby v. Commissioner, 58 T.C. 757, 791 (1972).
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According to its terms, the R & D agreement expired upon the
partnership's execution of the license agreement. Since the two
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 in a farming venture under which the
investors' return, if any, was to be in the form of a royalty
pursuant to the licensing agreement. Thus, as this Court held in
Utah Jojoba I Research v. Commissioner, supra, the partnership
was never engaged in research or experimentation either directly
or indirectly. Moreover, this Court found in Utah Jojoba I
Research v. Commissioner, supra, that U.S. Agri's attempts to
farm jojoba commercially did not constitute research and
development, thereby concluding 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 actually capital contributions. The Court concluded further
that the partnership was not involved in a trade or business and
had no realistic prospect of entering into a trade or business
with respect to any technology that was to be developed by U.S.
Agri.
Petitioners here contend that their investment in Blythe II
was motivated solely by the potential to earn a profit.
Petitioners contend further that their reliance on the advice of
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their certified public accountant, Mr. Mathis, should absolve
them of liability for the negligence penalty in these cases.
Petitioners also argue that, taking into account their experience
and the nature of the investment in Blythe II, they exercised the
due care that a reasonable and ordinarily prudent person would
have exercised under like circumstances. For the reasons set
forth below, the Court does not agree with petitioners'
contentions.
First, the principal flaw in the structure of Blythe II was
evident from the face of the very documents included in the
offering. A reading of the R & D agreement and licensing
agreement, both of which were included as part of the offering,
plainly shows that the licensing agreement canceled or rendered
ineffective the R & D agreement because of the concurrent
execution of the two documents. Thus, the partnership was never
engaged, either directly or indirectly, in the conduct of any
research or experimentation. Rather, the partnership was merely
a passive investor seeking royalty returns pursuant to the
licensing agreement. Any experienced attorney capable of reading
and understanding the subject documents should have understood
the legal ramifications of the licensing agreement canceling out
the R & D agreement. However, petitioners never consulted an
attorney in connection with this investment, nor did they
thoroughly read the offering themselves.
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Secondly, in making their investment in Blythe II,
petitioners relied on the advice of their certified public
accountant, Mr. Mathis, Mr. Sheets, who was a promoter for the
partnership, and petitioner's brief conversation with a local
jeweler about the prospects for the use of jojoba bean oil in the
watch and jewelry industry. Mr. Mathis, admittedly, made only a
cursory review of the offering and advised petitioners that,
based on what he had read in the offering, there was some basis
for the investment, there would be some tax advantages, and the
investment had, "at least, some potential". Mr. Mathis testified
that the subject tax deductions appeared reasonable to him
because they were "one for one" deductions rather than the
"multiple write-off kind of investments that were floating around
at that time." Mr. Mathis did not give petitioners a written
opinion about the investment, nor did he conduct any independent
research or consult any type of agricultural or jojoba plant
expert about the investment. Instead, he relied solely on the
representations made in the offering.
Moreover, when questioned by this Court, Mr. Mathis admitted
that, at the time he advised petitioners about Blythe II, he had
rarely been presented with a question concerning research and
development expenses, and he realized that such expenses would
have allowed petitioners certain tax benefits above and beyond
what would have been provided by an ordinary business deduction.
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Despite his relative inexperience with the deductibility of
research and development expenses, however, Mr. Mathis failed to
conduct any independent investigation to determine whether the
specific research and development proposed to be conducted by or
on behalf of the partnership would have qualified for deductions
under section 174. It is also notable that Mr. Mathis had no
educational background or experience in the area of agricultural
pursuits.
There is no evidence in the record to suggest that
petitioners ever questioned Mr. Mathis about the facts and/or
legal analysis upon which he based his recommendations. Further,
the record is devoid of any evidence that petitioners asked Mr.
Mathis to explain the Blythe II investment to them, particularly
those portions of the offering that they had opted not to read or
apparently were unable to understand.
The facts in these cases are similar to those in Glassley v.
Commissioner, T.C. Memo. 1996-206, in which this Court found that
the taxpayers:
acted on their fascination with the idea of
participating in a jojoba farming venture and their
satisfaction with tax benefits of expensing their
investments, which were clear to them from the
promoter’s presentation. They passed the offering
circular by their accountants for a "glance" * * *.
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Similarly, petitioners in these cases acted on their enthusiasm
for the potential uses of jojoba and acted with knowledge of the
tax benefits of making the investment. The evidence in this
record suggests that the nature of the advice given by Mr. Mathis
was highly generalized and based primarily on a mere cursory
review of the offering rather than on independent knowledge,
research, or analysis. Petitioners failed to show that Mr.
Mathis had the expertise and knowledge of the pertinent facts to
provide informed advice on the investment in Blythe II. See
Freytag v. Commissioner, 89 T.C. at 888. Accordingly,
petitioners failed to establish that their reliance on the advice
of Mr. Mathis was reasonable or in good faith. See Glassley v.
Commissioner, supra.
The Court next examines petitioners' reliance on the advice
of Mr. Sheets. Mr. Sheets had no background or expertise in the
areas of agriculture or jojoba plants. In fact, nearly all of
the previous investments recommended to petitioners by Mr. Sheets
had been real estate investments, and Blythe II was the first
investment of an agricultural nature advocated by him. Also,
because Mr. Sheets was a salesperson for this investment, he had
a personal profit motive, and thus a conflict of interest, in
advising petitioners to purchase the limited partnership
interests. The advice petitioners allegedly received from Mr.
Sheets fails as a defense to negligence due to his lack of
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competence to give such advice and the clear presence of a
conflict of interest. See Rybak v. Commissioner, 91 T.C. 524,
565 (1988). Petitioners' reliance on the advice of Mr. Sheets
was unreasonable under the circumstances.
Outside of Mr. Mathis and Mr. Sheets, petitioner's sole
inquiry into the viability of this partnership's operations was
his contact with a jeweler, Mr. Huntington, who advised
petitioner that there were concerns in the watch industry about
the lack of availability of sperm whale oil as a lubricant and
the prospects for any viable substitute for this oil. The Court
finds it notable that the offering listed at least fifteen
"potential uses of jojoba nuts", only one of which was a
lubricant substitute for sperm whale oil; yet, petitioners chose
to explore only one of those potential uses by contacting a local
jeweler. Some other potential uses listed in the offering were
cosmetics, shampoos and soaps, sunscreens, pharmaceuticals,
cooking oils, disinfectants, polishing waxes, corrosion
inhibitors, candles, animal feed supplements, and fertilizer.
Being a physician, it seems logical that petitioner would have
had some access to information about the use of jojoba in the
pharmaceutical arena; however, petitioner failed to pursue this
possibility. Petitioners' failure to investigate any of the
other enumerated potential uses of jojoba plants was unreasonable
under the circumstances.
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Petitioners had no legal or agricultural background or
training; yet, they consulted no source of such information prior
to investing more than $30,000 in Blythe II. Petitioners contend
that, based on the amount of money they were investing in Blythe
II, they couldn't justify spending additional funds to research
the partnership and its proposed activities. Petitioners argue
further that they didn't know where or how to find an appropriate
expert to examine the investment. On the contrary, the Court
believes that, at a minimum, petitioners could have contacted an
attorney to review the offering, provide legal advice surrounding
the partnership, and explain the legal ramifications of the
licensing agreement canceling out the R & D agreement. A
reasonable and ordinarily prudent investor under the
circumstances would have consulted an attorney.
Additionally, the Court does not believe that petitioners
would have experienced a great degree of difficulty or incurred a
great deal of expense in contacting the agricultural department
of a nearby college or university or going to another reliable
source to inquire about the research and development of jojoba
plants and their potential commercial usage, if any. Again, a
reasonable and ordinarily prudent investor would have at least
attempted to make this type of inquiry under the circumstances.9
9
In Utah Jojoba I Research v. Commissioner, T.C. Memo. 1998-
(continued...)
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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. In fact, the offering cautioned that prospective
investors should not "construe this memorandum or any prior or
subsequent communications as constituting legal or tax advice"
and urged investors to "consult their own counsel as to all
matters concerning this investment." The offering was replete
with statements, including the cover page statement that "THIS
OFFERING INVOLVES A HIGH DEGREE OF RISK", warning of tax risks
involved with the investment and the highly speculative nature of
the commercial viability of the jojoba plant. The offering
contained inconsistent information, such as the statement on page
9 that the general partner "has limited experience in dealing in
Jojoba beans and is mainly relying on the R & D Contractor to
develop technology and plant cultivars over the term of the R & D
Agreement", contrasted with the statement on page 34 that the
9
(...continued)
6, the Court noted that there were experimental jojoba
plantations located at the University of California at Riverside,
California, of which the general partner of Blythe II, Mr.
Kellen, was aware.
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general partner "pioneered the development of the Blythe Airport
as an alfalfa ranch and jojoba farming in Desert Center" and was
"familiar with the development of jojoba, citrus, vineyards,
alfalfa and asparagus." Such inconsistencies should have raised
a healthy suspicion in the mind of a reasonable and ordinarily
prudent investor, even one lacking any legal, tax, or
agricultural background. However, petitioner testified that,
prior to investing some $33,000 in Blythe II, he did not even
bother to read the entire offering, nor did he make an effort to
obtain a reasonable understanding of those portions that he did
read. Moreover, petitioners failed to monitor the progress of
their investment after purchasing the limited partnership
interests.
The Court is mindful that the Court of Appeals for the Ninth
Circuit (Ninth Circuit), the court to which appeals in these
cases would lie, has held that experience and involvement of the
general partner and the lack of warning signs could reasonably
lead investors to believe they were entitled to deductions in
light of the undeveloped state of the law regarding section 174.
See Kantor v. Commissioner, 998 F.2d 1514 (9th Cir. 1993), affg.
in part and revg. in part T.C. Memo. 1990-380. In its holding,
the Ninth Circuit explained that 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
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business for purposes of qualifying for an immediate deduction
under section 174. However, in the instant cases, the
partnership was neither engaged in a trade or business nor
conducting research and development, either directly or
indirectly. Additionally, the experience in jojoba research and
development of the general partner of Blythe II, Mr. Kellen, was
questionable, at best, as evidenced by conflicting statements in
the offering. Also, it is apparent from the evidence presented
in these cases that Mr. Kellen had minimal involvement in the
partnership. Petitioners are precluded from relying upon a "lack
of warning" as a defense to negligence when there is no evidence
that a reasonable investigation was ever made, and the offering
materials contained many warnings of the tax risks associated
with the investment.
On this record, the Court finds that petitioners did not
exercise the due care of reasonable and ordinarily prudent
persons under the circumstances. Consequently, the Court holds
that petitioners are liable for the negligence additions to tax
under section 6653(a)(1) and (2) for each of the years at issue.
Respondent is sustained on this issue.
The second issue is whether petitioners are liable for the
addition to tax under section 6661(a) for a substantial
understatement of tax for 1982. Section 6661(a), as amended by
the Omnibus Budget Reconciliation Act of 1986, Pub. L. 99-509,
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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 that the taxpayer
shows is attributable to either (1) the tax treatment of any item
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).
Substantial authority exists when "the weight of the
authorities supporting the treatment is substantial in relation
to the weight of authorities supporting contrary positions."
Sec. 1.6661-3(b)(1), Income Tax Regs. Petitioners appear to
argue that no authority, other than section 174 itself, existed
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at the time they claimed the relevant loss. However, their
reliance on section 174, standing alone, does not provide the
substantial authority required under section 6661 and
accompanying regulations. Petitioners have failed to show that
substantial authority existed for the tax treatment of the Blythe
II loss on their 1982 return.
Adequate disclosure of the tax treatment of a particular
item may be made either in a statement attached to the return, or
on the return itself, if it is in accordance with the
requirements of Rev. Proc. 83-21, 1983-1 C.B. 680. See sec.
1.6661-4(b) and (c), Income Tax Regs. The record indicates that
petitioners did not attach a statement to their 1982 return
disclosing the specific facts surrounding their Blythe II loss
deduction. Rev. Proc. 83-21, supra, applicable to tax returns
filed in 1983, lists information that would be deemed sufficient
disclosure if listed on the return itself, without the necessity
of attaching an additional statement to the return. However,
none of the specific tax items referenced in Rev. Proc. 83-21 are
relevant to the instant cases. If disclosure is not made in
compliance with the regulations or the revenue procedure,
adequate disclosure on the return may still be satisfied if
sufficient information is provided to enable respondent to
identify the potential controversy involved. See Schirmer v.
Commissioner, 89 T.C. 277, 285-286 (1987). Petitioners appear to
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argue that the Blythe II deduction was clearly indicated on their
1982 return. However, a mere claiming of the loss, without
further explanation, is not sufficient to alert respondent to the
controversial section 174 deduction of which the partnership loss
consisted. Petitioners have failed to show that the relevant
facts pertaining to their Blythe II loss deduction were
adequately disclosed on their 1982 return.10
Finally, 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.
This Court reviews for abuse of discretion the Secretary’s
failure to waive the addition to tax. See Martin Ice Cream Co.
v. Commissioner, 110 T.C. 189, 235 (1998). Petitioners argue
that they acted in good faith and reasonably relied upon the
advice of Mr. Mathis in claiming the relevant loss. However,
nothing in the record indicates that petitioners requested a
waiver for good faith and reasonable cause under section 6661(c).
In the absence of such a request, this Court cannot review
respondent’s determination for an abuse of discretion. See id.
In any event, petitioners have not shown that they met the tests
of reasonable cause and good faith.
10
As noted earlier, even if an adequate disclosure had
been made on the return, such disclosure would not reduce the
amount of the understatement attributable to a tax shelter item.
- 24 -
Petitioners have failed to prove that they had substantial
authority for their treatment of the partnership loss and that
they adequately disclosed the relevant facts of that treatment.
The understatement upon which the addition to tax was imposed was
$8,858. The understatement is substantial because it exceeds the
greater of $5,000 or 10 percent of the amount required to be
shown on the return.11 On this record, the Court holds that
petitioners are liable for the addition to tax under section
6661(a) for a substantial understatement of tax for 1982.
Respondent is sustained on this issue.
Finally, to the extent the Court has failed to address an
argument of petitioners herein, the Court concludes such argument
is without merit.
Decisions will be entered
for respondent.
11
The amount required to be shown on the return was
$17,475, 10 percent of which equals $1,747.50.