DAVIS v. COMMISSIONER

T.C. Summary Opinion 2001-151

UNITED STATES TAX COURT

MICHAEL E. AND JOHANNA S. DAVIS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 17837-99S. Filed September 25, 2001.

Johanna S. Davis, pro se.

Timothy S. Sinnott, for respondent.

COUVILLION, Special Trial Judge: This case was heard

pursuant to section 7463 of the Internal Revenue Code in effect

at the time the petition was filed.1 The decision to be entered

is not reviewable by any other court, and this opinion should not

be cited as authority.

1
Unless otherwise indicated, subsequent 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.
 - 2 -

Respondent determined that petitioners were liable for the

following additions to tax for the years 1982, 1983, 1984, and

1985:

Additions to Tax
Year Sec. 6653(a)(1) Sec. 6653(a)(2)

1982 $250 *
1983 25 **
1984 15 ***
1985 17 ****

* Fifty percent of the interest due on $5,000.
** Fifty percent of the interest due on $298.
*** Fifty percent of the interest due on $294.
**** Fifty percent of the interest due on $427.

The issue for decision is whether, for 1982 through 1985,

petitioners are liable for the additions to tax shown above

relating to their participation as a limited partner in a

partnership known as Jojoba Research Partners, Hawaii (Jojoba

Hawaii 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 petition was filed, petitioners'

legal residence was Colorado Springs, Colorado.

Petitioner husband is a salesman in the telecommunications

industry, and petitioner wife is a homemaker. During the years

at issue, petitioner husband worked in the telecommunications

industry, and petitioner wife worked as an administrative
 - 3 -

assistant and office manager for various employers. Petitioner

wife's father, Ralph S. Matsuda (Mr. Matsuda), worked in the

financial services and products industry during the years at

issue and was petitioners' financial adviser. During 1982, Mr.

Matsuda introduced petitioners to Jojoba Hawaii, which was being

promoted as an agricultural research and development partnership.

Jojoba Hawaii was the first agricultural type investment

opportunity that had been proposed by Mr. Matsuda to petitioners.

He provided petitioners with a fairly voluminous private

placement memorandum2 (the offering), which described the

proposed investment and the activities to be conducted through

Jojoba Hawaii. Petitioner wife perused the document but could

not recall whether petitioner husband examined the document.3

Petitioners did not consult an attorney, an accountant, or any

independent expert knowledgeable in the field of agriculture and,

in particular, jojoba production and the economic potential

thereof. Petitioners, nevertheless, invested in Jojoba Hawaii.

On their joint 1982 Federal income tax return, petitioners

reported wages of $77,665 from petitioner husband's employment

with Mark Telephone and $24,426 from petitioner wife's employment

with Applied Materials, Inc. Petitioners also reported interest

2
The private placement memorandum consisted of some 47
pages, plus eight exhibits, and a table of contents.
3
Petitioner husband did not appear at trial.
 - 4 -

income of $1,788, taxable dividend income of $182, a State income

tax refund of $605, and taxable pension income of $2,100.

Petitioners deducted a net loss from Jojoba Hawaii of $12,971,

which they reported on Schedule E, Supplemental Income Schedule,

as a partnership loss. Thus, petitioners reported total income

of $93,795 and a tax liability of $13,959.

On their joint 1983 Federal income tax return, petitioners,

in the same fashion, reported wages of $45,989 from petitioner

husband's employment and $29,145 from petitioner wife's

employment. Petitioners also reported interest income of $2,224,

a State income tax refund of $1,803, and a Schedule E net loss

from Jojoba Hawaii of $1,017. Thus, petitioners reported total

income of $78,144 and a tax liability of $7,515.

On their joint 1984 Federal income tax return, petitioners

likewise reported wages of $52,086 from petitioner husband's

employment, $30,145 from petitioner wife's employment, interest

income of $879, a loss on Schedule C, Profit or (Loss) From

Business or Profession, of $15,767 from a commercial fishing

activity, a Schedule F, Farm Income and Expenses, net farm loss

of $1,650, and a Schedule E loss from Jojoba Hawaii of $1,205.

Thus, petitioners reported total income of $64,488 and a tax

liability of $3,757.

On their joint 1985 Federal income tax return, petitioners

similarly reported wages of $57,059 from petitioner husband's
 - 5 -

employment, $31,417 from petitioner wife's employment, interest

income of $952, a State income tax refund of $1,490, a loss of

$3,468 from the commercial fishing activity, "other gains" of

$237, a net farm loss of $1,890, other income of $4,685, and a

net loss from Jojoba Hawaii of $1,205. Thus, petitioners

reported total income of $89,277 and a tax liability of $8,704.

Jojoba Hawaii 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. A decision was thereafter entered in

Utah Jojoba I Research v. Commissioner, T.C. Memo. 1998-6, which

involved a similar jojoba investment program.4 In the decided

case, this Court held that the partnerships5 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 the Commissioner'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

4
The tax matters partner of Jojoba Hawaii signed a
stipulation to be bound by the outcome of Utah Jojoba I Research
v. Commissioner, T.C. Memo. 1998-6.
5
Eighteen docketed cases were bound by stipulation by
the outcome of Utah Jojoba I Research v. Commissioner, supra.
 - 6 -

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 Jojoba Hawaii's TEFRA proceeding, and its

agreement to be bound, petitioners were assessed tax deficiencies

of $5,000 for 1982, $508 for 1983, $294 for 1984, and $346 for

1985, plus interest. Subsequently, respondent issued notices of

deficiency to petitioners for 1982 through 1985 for affected

items determining that petitioners are liable for the additions

to tax for negligence under section 6653(a)(1) and (2). These

additions to tax are the subject of the instant case.

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
 - 7 -

determinations in the notices of deficiency are presumed correct,

and petitioners must establish otherwise. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933); cf. sec. 7491(c).6

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. 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. 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. Henry Schwartz

6
The Internal Revenue Service Restructuring & Reform Act
of 1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726, added
sec. 7491(c), which places the burden of production on 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, nor is there evidence, that their examination
commenced after July 22, 1998, or that sec. 7491 is applicable in
this case.
 - 8 -

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

"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. Id.

The facts pertinent to the instant case relating to the

structure, formation, and operation of Jojoba Hawaii are as

discussed in Utah Jojoba I Research v. Commissioner, supra, with

the exception of a few specific dates and dollar amounts. Jojoba
 - 9 -

Hawaii 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 October

28, 1982, provided for a maximum capitalization of $741,000

consisting of 260 limited partnership units at $2,850 per unit.

Each unit required a cash downpayment of $1,000 and a promissory

note in the principal amount of $1,850, requiring 12 semiannual

interest payments of $92.50 during the first 6 years and 40

quarterly payments of $73.70 for the following 10 years. The

promissory note contained 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 portion of which, but for

tax-advantaged investments, would be subject to a Federal income

tax rate of 50 percent.

Petitioners' investment was for one limited partnership

unit, which required an initial downpayment of $1,000 and

execution of a promissory note for $1,850. Petitioners were to

make 12 semiannual "interest only" payments for the first 6 years

and quarterly principal and interest payments for the following

10 years until the note was fully paid. The record is unclear as
 - 10 -

to the total amount petitioners actually paid in connection with

their partnership interest.

The offering identified Mr. Matsuda, who was petitioner

wife's father and a promoter of the partnership, as the general

partner of Jojoba Hawaii and U.S. Agri as the contractor for the

R & D program under an R & D agreement. Additionally, a license

agreement between Jojoba Hawaii and U.S. Agri granted U.S. Agri

the exclusive right to utilize technology developed for Jojoba

Hawaii for 40 years in exchange for a royalty of 85 percent of

gross sales of all products produced. The offering included

copies of both the R & D agreement and the license agreement.

Following close examination of these documents, as well as

various other items of evidence, this Court held in Utah Jojoba I

Research v. Commissioner, T.C. Memo. 1998-6, that 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
 - 11 -

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 Jojoba

Hawaii was motivated primarily by the potential to earn a profit

but admit that the promise of tax deductions played a role in

their decision. Petitioners contend further that their reliance

on the advice of petitioner wife's father, Mr. Matsuda, should

absolve them of liability for the negligence penalty in this

case. Petitioners also argue that, taking into account their

experience and the nature of the investment in Jojoba Hawaii,

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 Jojoba Hawaii

was evident from the face of the very documents included in the

offering. A reading of these documents illustrated that the

partnership would not be engaged, either directly or indirectly,

in the conduct of any research or experimentation, but, rather,

the partnership was merely a passive investor seeking royalty

returns pursuant to the licensing agreement.7 Any experienced

7
Indeed, as noted previously, the offering stated that
(continued...)
 - 12 -

attorney capable of reading and understanding the subject

documents should have understood the legal ramifications of the

contents thereof. However, petitioners never consulted an

attorney in connection with this investment, nor did they

carefully scrutinize the offering themselves. Moreover,

petitioners failed to consult an experienced tax accountant

regarding the proper deductibility of research and development

expenses.

Secondly, in making their investment in Jojoba Hawaii

petitioners relied solely on the advice of Mr. Matsuda, who was

their financial adviser, as well as petitioner wife's father and

a promoter for the partnership. Mr. Matsuda did not appear at

trial, and the details in this record surrounding his advice to

petitioners about Jojoba Hawaii are scant. The record is devoid

of any evidence to show that Mr. Matsuda conducted any

independent research or consulted any type of agricultural or

jojoba plant expert about the activity. The record indicates

that Mr. Matsuda relied solely on the representations made in the

offering in rendering his advice to petitioners.

Moreover, the record lacks evidence to show whether Mr.

Matsuda had any previous experience with the deductibility of

7
(...continued)
the general partner had no previous experience with Jojoba beans
and was relying on U.S. Agri to develop technology and plant
cultivars.
 - 13 -

research and development expenses at the time he advised

petitioners about Jojoba Hawaii. These types of expenses would

have allowed petitioners certain tax benefits above and beyond

what would have been provided by an ordinary business deduction.

There is no evidence in the record to suggest that Mr. Matsuda

conducted 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.

There is also no evidence in the record to suggest that

petitioners ever questioned Mr. Matsuda 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.

Matsuda to explain the Jojoba Hawaii investment to them, which

would seem particularly important given the fact that petitioners

clearly did not carefully scrutinize the offering themselves.

The facts here 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. * * *
 - 14 -

Similarly, petitioners here acted on their enthusiasm for the

potential uses of jojoba and for the tax benefits offered by the

investment. The evidence suggests that the nature of the advice

given by Mr. Matsuda 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. Matsuda had the expertise and knowledge of the

pertinent facts to provide informed advice on the investment in

Jojoba Hawaii. See Freytag v. Commissioner, 89 T.C. at 888.

Accordingly, petitioners failed to establish that their reliance

on the advice of Mr. Matsuda was reasonable or in good faith.

See Glassley v. Commissioner, supra.

Mr. Matsuda had no background or expertise in the areas of

agriculture or jojoba plants. More importantly, because Mr.

Matsuda had a personal profit motive in selling this investment

to clients, of which petitioners were aware, he had a conflict of

interest in advising petitioners to purchase the limited

partnership interests. The advice petitioners purportedly

received from Mr. Matsuda fails as a defense to negligence due to

his lack of 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.

Matsuda was unreasonable under the circumstances.
 - 15 -

Outside of Mr. Matsuda, petitioners made no other inquiry

into the viability of the partnership's proposed research and

operations. The Court finds it notable that the offering listed

at least 15 potential uses of jojoba nuts; yet, petitioners

failed to explore the plausibility of any of those potential

uses. Some of the potential uses listed in the offering were

various lubricants for high-speed or high-temperature machinery,

cosmetics, shampoos and soaps, sunscreens, pharmaceuticals,

cooking oils, disinfectants, polishing waxes, corrosion

inhibitors, candles, animal feed supplements, and fertilizer.

Petitioners' failure to investigate independently any of the

enumerated potential uses of jojoba plants was unreasonable under

the circumstances.

Petitioners had no legal or agricultural background or

training; yet, they consulted no one in these fields of endeavor

prior to investing in Jojoba Hawaii. Petitioners appear to argue

that they felt no need to consult an appropriate expert or

experts to examine the substance of the investment because they

were relying on the advice of Mr. Matsuda, petitioner wife's

father. To the contrary, the Court believes that, at a minimum,

petitioners should have contacted an attorney to review the

offering and provide legal advice surrounding the partnership. A

reasonable and ordinarily prudent investor under the

circumstances would have consulted an attorney. Also a
 - 16 -

reasonable and ordinarily prudent investor under the

circumstances would have consulted a tax adviser about the

propriety of deducting research and development expenses.

Additionally, the Court does not believe that petitioners would

have experienced a great degree of difficulty 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.

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, supra. 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
 - 17 -

involved with the investment and the highly speculative nature of

the commercial viability of jojoba production. The offering

clearly stated on page 8 that the general partner "has no

previous 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 Contract". Such statements

should have raised some degree of suspicion in the mind of a

reasonable and ordinarily prudent investor, even one lacking any

legal, tax, or agricultural background. However, petitioners did

not carefully read the offering, nor did they make any effort to

have the investment explained to them prior to investing in

Jojoba Hawaii.

The Court is mindful that the Court of Appeals for the Ninth

Circuit (Ninth Circuit) 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 business for purposes of qualifying for an immediate

deduction under section 174. However, here, the partnership was
 - 18 -

neither engaged in a trade or business nor conducting research

and development, either directly or indirectly. Additionally,

the offering made clear that the general partner, Mr. Matsuda,

had no experience in jojoba research and development. Also, it

is apparent from the evidence presented that Mr. Matsuda 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.

To the extent the Court has failed to address an argument of

petitioners herein, the Court concludes such argument is without

merit.

Reviewed and adopted as the report of the Small Tax Case

Division.

Decision will be entered

for respondent.