KELLEN v. COMMISSIONER

T.C. Memo. 2002-19

UNITED STATES TAX COURT

WILLIAM G. AND DEBRA C. KELLEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5429-00. Filed January 22, 2002.

Robert S. Schriebman and Patrick E. McGinnis, for

petitioners.

Timothy S. Sinnott, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

ARMEN, Special Trial Judge: In a so-called affected items

notice of deficiency, respondent determined additions to tax to

petitioners’ Federal income tax for the year and in the amounts

as shown below:
 - 2 -

Additions to tax
Sec.1 Sec. Sec.
3
Year 6653(a)(1) 6653(a)(2) 6661
2
1983 $685.50 $29,095.94 $3,427.50

1
Throughout this opinion and unless otherwise
indicated, all section references are to the Internal
Revenue Code in effect for the taxable year in issue.
2
The first page of the notice of deficiency
mistakenly shows this amount as the sum of the additions
to tax under sec. 6653(a)(1) and (2), i.e., $29,781.
3
The first page of the notice of deficiency
mistakenly references sec. 6662(d), which section is the
successor to sec. 6661 and is applicable for returns the
due date for which (determined without regard to
extensions) is after December 31, 1989. See Omnibus
Budget Reconciliation Act of 1989, Pub. L. 101-239, sec.
7721(a), (c)(2), (d), 103 Stat. 2395-2400.

After concessions by the parties,1 the issues for decision

are as follows:

(1) Whether petitioner William G. Kellen (petitioner) is

liable for additions to tax under section 6653(a)(1) and (2) for

negligence or intentional disregard of rules or regulations. We

hold that petitioner is liable for such additions.

(2) Whether petitioner is liable for the addition to tax

under section 6661 for substantial understatement of tax

1
Petitioners concede that the notice of deficiency is
valid. Cf. Scar v. Commissioner, 814 F.2d 1363 (9th Cir. 1987),
revg. 81 T.C. 855 (1983).
Respondent concedes, and petitioner William G. Kellen does
not dispute, that pursuant to sec. 6015, petitioner Debra C.
Kellen is entitled to relief from joint and several liability for
the additions to tax.
 - 3 -

liability. We hold that petitioner is liable for such addition.

The foregoing two issues relate to the participation of

petitioner as a limited partner in a jojoba partnership known as

San Nicholas Research, Ltd.

FINDINGS OF FACT

Some of the facts have been stipulated, and they are so

found. The stipulated facts and attached exhibits are

incorporated herein by this reference.

Petitioner resided in Cora, Wyoming, at the time that his

petition was filed with the Court.

A. Petitioner’s Education and Experience

Petitioner is a highly educated individual. In 1964, he

graduated from Loyola University of Los Angeles with a bachelor

of science degree in civil engineering, specializing in water

systems. Ten years later, in 1974, he received a law degree from

Western State College of Law in Fullerton, California.

Since 1964, petitioner has practiced engineering in both the

public and private sectors. Since 1974, he has practiced law in

the private sector.

Petitioner also has experience related to farming. In 1974,

he formed a company known as the Great American Hay Company that

grew hay in Desert Center, California. In 1975, he and certain

friends and investors purchased property known as Brown’s Farm

that grew citrus, alfalfa, and row crops.
 - 4 -

In 1983, the taxable year in issue, petitioner was actively

engaged in the practice of law, although he also served as a

consulting engineer and was involved in farming.2 Petitioner

maintained a law office in Riverside, California, and he

specialized in the formation of financial institutions, such as

banks, savings and loan associations, and thrift and loan

associations. Petitioner formed more than 23 financial

institutions in southern California.

Neither in 1983 nor at any other time relevant to this case

did petitioner have any expertise in accounting or tax matters,

nor did he ever attempt to render advice on those subjects.

In 1983, petitioner was financially well-off and

sophisticated. For that year, he earned a net profit of $122,464

from his law practice, and he derived capital gains from stock

transactions in the net amount of $115,5083 and interest in the

amount of $21,747. In addition, petitioner had equity interests

in: (1) An equipment rental proprietorship, (2) a partnership

known as Fontana Bancorp Development, (3) five jojoba

partnerships, see pp. 5-6, and (4) an S corporation known as

2
Any income that petitioner may have earned in 1983 from
consulting as an engineer or from farming was minimal.
3
In one instance, petitioner parlayed a $5,000 investment
in Corona Bancorp in June 1982 into a $98,508 sale in Dec. 1983.
 - 5 -

Vancouver Coors, Inc.4

B. Petitioner’s Initial Involvement in Jojoba Partnerships

In late 1982, petitioner became the general partner and tax

matters partner of four limited partnerships: Utah Jojoba

Research, Ltd. (Utah Jojoba); Blythe Jojoba I Research, Ltd.

(Blythe Jojoba I); Blythe Jojoba II Research, Ltd. (Blythe Jojoba

II); and Desert Center Jojoba Research, Ltd. (Desert Center

Jojoba).5 Each of these partnerships was similar, if not

identical, to San Nicholas Research, Ltd., described infra pp.

5-11.

Prior to 1982, petitioner did not have any experience in

growing jojoba, nor did he have any experience in either the

research or development of jojoba. Prior to that time,

petitioner’s knowledge concerning jojoba was limited to articles

that he had read in various magazines and a general familiarity

with the existence of an experimental jojoba plantation located

at the University of California at Riverside.

4
At trial, petitioner testified that he became a general
partner in Coordinated Financial Services (CFS) of Salt Lake
City, Utah “in the latter part of 1982.” The record is not clear
whether petitioner continued to be a partner in CFS in 1983. CFS
is described in Utah Jojoba I Research v. Commissioner, T.C.
Memo. 1998-6; see infra pp. 12-14.
5
Petitioner also became a limited partner in Desert Center
Jojoba.
 - 6 -

C. Petitioner’s Investment in San Nicholas Research, Ltd.

In late 1983, petitioner signed a subscription agreement and

purchased 15 limited partnership units (an 11.719-percentage

interest) in San Nicholas Research, Ltd. (San Nicholas or the

partnership).6 Petitioner purchased the partnership units

pursuant to a private placement memorandum dated October 10,

1983. See infra pp. 6-8, 8-11.

Petitioner paid $2,790 per limited partnership unit, or a

total of $41,850, for his 15 units in San Nicholas. Of this

amount, $1,140 per unit, or $17,100 for 15 units, was paid in

cash. The balance, $1,650 per unit or $24,750 for 15 units, was

payable pursuant to a 10-year promissory note.7

At the time that he signed the subscription agreement,

petitioner believed that his investment in San Nicholas offered

tax benefits, and his decision to invest was influenced by that

belief.

D. Putative Nature of San Nicholas’ Business

According to the private placement memorandum dated October

10, 1983 (the offering memorandum), San Nicholas was formed in

6
The general partner and tax matters partner of San
Nicholas was Alfred M. Clancy, an individual whom petitioner did
not know at the time that he invested in San Nicholas.
7
The note, which was recourse in form, contemplated
payments of interest only for the first 5 years. As matters
actually transpired, in the late 1980s, the limited partners were
given the option of paying a discounted percentage of the
principal in cash. Petitioner elected this option.
 - 7 -

order “to undertake a comprehensive research and development

program on the plant Simmondsia Chinesis (Jojoba).” The offering

memorandum described how this program was to be carried out:

The Partnership will enter into a research and
development contract * * * with U.S. Agri Research and
Development Corp. (the “R & D Contractor”), who will
conduct the experiments in various test sites * * * as
well as its laboratory or greenhouse facilities that it
in its sole discretion deems advisable. In addition,
the R & D Contract sets forth that a site in the
vicinity of Desert Center and Blythe, California of
from 30-50 acres will be delineated as the applied
research site upon which all technology and improved
cultivars developed on behalf of the Partnership during
the term of the contract will be placed “in field.”
The Partnership will also have the right but not be
obligated to enter into a License Agreement * * * to
license to U.S. Agri Research and Development Corp. all
technology developed on behalf of the Partnership for a
period of forty (40) years and receive therefrom an
amount equal to 85% of the products produced from the
developed technology.[8]

Copies of the research and development (R&D) contract and

the license agreement referred to in the preceding paragraph were

attached as exhibits to the offering memorandum. The R&D

contract identified U.S. Agri Research and Development Corp.

(U.S. Agri) as a party to the contract and the R&D contractor

thereunder. The license agreement identified U.S. Agri as a

8
Although San Nicholas may not have been obligated to
enter into a license agreement with U.S. Agri Research and
Development Corp., it was a foregone conclusion that it would do
so. Indeed, the research and development (R&D) contract and the
license agreement were executed concurrently. Notably, execution
of the license agreement by San Nicholas served to automatically
terminate the R&D contract pursuant to the terms of the latter
contract. See infra pp. 19-20.
 - 8 -

party to the contract and the licensee thereunder.

E. U.S. Agri and Eugene Pace

As previously indicated, the offering memorandum identified

U.S. Agri as the R&D contractor under the R&D contract and as the

licensee under the license agreement. U.S. Agri was also the R&D

contractor and the licensee for Utah Jojoba, Blythe Jojoba I,

Blythe Jojoba II, and Desert Center Jojoba.

The president of U.S. Agri was Eugene Pace (Mr. Pace), who

was also a member of its board of directors. Petitioner also

served as a member of U.S. Agri’s board until he became general

partner of Utah Jojoba, Blythe Jojoba I, Blythe Jojoba II, and

Desert Center Jojoba in late 1982.

At the time that petitioner invested in San Nicholas, he and

Mr. Pace had been personal friends and business associates for a

number of years.

F. Cautionary Language in the San Nicholas Offering Memorandum

The face of the offering memorandum warned, in block

letters, that “THIS OFFERING INVOLVES A HIGH DEGREE OF RISK”.

The offering memorandum also included the following cautionary

language in block letters:

PROSPECTIVE INVESTORS ARE CAUTIONED NOT TO CONSTRUE
THIS MEMORANDUM OR ANY PRIOR OR SUBSEQUENT
COMMUNICATIONS AS CONSTITUTING LEGAL OR TAX ADVICE.
* * * INVESTORS ARE URGED TO CONSULT THEIR OWN COUNSEL
AS TO ALL MATTERS CONCERNING THIS INVESTMENT.

* * * * * * *
 - 9 -

THERE IS NO PUBLIC OR OTHER MARKET FOR THE UNITS, NOR
WILL SUCH MARKET DEVELOP.

* * * * * * *

THE PURCHASE OF SUCH UNITS DESCRIBED IN THIS MEMORANDUM
INVOLVES A HIGH DEGREE OF RISK (SEE “RISK FACTORS”) AND
SHOULD BE CONSIDERED ONLY BY PERSONS WHO CAN AFFORD THE
TOTAL LOSS OF THEIR INVESTMENT.

* * * * * * *

EACH PURCHASER OF THE UNITS HEREIN SHOULD AND IS
EXPECTED TO CONSULT WITH HIS OWN TAX ADVISOR AS TO THE
TAX ASPECTS.

In addition, the offering memorandum limited the sale of

partnership units to investors with a net worth (exclusive of

home, furnishings, and automobiles) of at least $150,000, or

investors whose net worth was at least $50,000 (exclusive of

home, furnishings, and automobiles) and who anticipated that, for

the taxable year of the investment, they would have gross income

of at least $65,000 or taxable income, a portion of which, but

for tax-advantaged investments, would be subject to Federal

income tax at a marginal rate of 50 percent.

The offering memorandum included a section entitled “Risk

Factors”, which was the single longest section. It began with a

general warning:

The purchase of the interests offered hereby involves
various risk factors. Investment in the Partnership
* * * involves an extremely high degree of risk.
Investors should consider carefully the various risk
factors set forth in this and other portions of this
Memorandum. Investment in the Partnership is suitable
only for persons of substantial financial means who
 - 10 -

will not require liquidity in the investment.
Investors must be prepared for the possible loss of
their entire investment.

The offering memorandum then proceeded to discuss a number

of specific, and significant, risk factors associated with an

investment in San Nicholas. Among those risks, the offering

memorandum warned: (1) Research and development risks were so

great that an investment in San Nicholas should be considered

“highly speculative”; (2) the general partner had no previous

experience in dealing in jojoba; (3) there was no structured

market or distribution system for jojoba; (4) there were no

facilities dedicated to the processing of jojoba; (5) commercial

applications of jojoba are not extensive; (6) the general partner

had not conducted any market analysis or similar studies; (7)

there was no assurance of any increase in marketing or production

facilities or in the demand for jojoba; (8) in the absence of any

such increase, the production of jojoba might be unprofitable,

regardless of any technology that might be developed by the R&D

contractor; and (9) there was the likelihood of audit by the

Internal Revenue Service. Indeed, the discussion concerning the

tax risks associated with an investment in San Nicholas

constituted half of the section on “Risk Factors”.

The offering memorandum also included projections of

revenue, cashflow, and taxable income or loss. Investors were

warned, however, that those projections, which had been prepared
 - 11 -

for the general partner, had not been audited and that they

should not be relied on to indicate the actual results that might

be attained.

G. Petitioner’s Friend and Associate E.T. Jacobs

E.T. Jacobs (Mr. Jacobs), a former IRS agent and examination

manager, was a certified public accountant in private practice.

He was also one of petitioner’s friends and business associates.

In or about 1982, Mr. Jacobs became involved in the farming

of jojoba in Desert Center, California. Mr. Jacobs sold limited

partnership interests in a number of jojoba partnerships.

H. Petitioner’s 1983 Schedule K-1 and Income Tax Return

Petitioner received a Schedule K-1, Partner’s Share of

Income, Credits, Deductions, Etc., from San Nicholas for 1983.

The Schedule K-1 reported that petitioner’s distributive share of

partnership loss from San Nicholas was $37,064 for that year.

Petitioner timely filed a Federal income tax return (Form

1040) for 1983.9 Petitioner attached to his return page 2 of

Schedule E (Supplemental Income Schedule) and claimed thereon a

loss from San Nicholas in the amount of $37,064. Petitioner then

offset this loss against his other income. See supra p. 4.

I. Jojoba Partnership Litigation

San Nicholas was examined by the Internal Revenue Service,

9
The return was prepared by David Macher, a certified
public accountant in Riverside, California.
 - 12 -

and a notice of final partnership administrative adjustment

(FPAA) was ultimately issued to the partnership. In December

1991, Alfred M. Clancy (Mr. Clancy), the general partner and tax

matters partner of San Nicholas, commenced a TEFRA partnership

proceeding in this Court.10 Subsequently, in November 1993, Mr.

Clancy and the Commissioner agreed to be bound by the decision to

be entered in Utah Jojoba I Research v. Commissioner, docket No.

7619-90, a TEFRA partnership proceeding involving Utah Jojoba

that had previously been commenced by petitioner in his capacity

as tax matters partner of that partnership.

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

6, the Court made detailed findings of fact related to the jojoba

limited partnerships,11 petitioner, U.S. Agri, and Mr. Pace. The

Court described the R&D contract between the partnerships and

U.S. Agri as “mere window dressing” and 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 the

10
The TEFRA partnership proceeding was assigned docket No.
29994-91. TEFRA stands for the Tax Equity and Fiscal
Responsibility Act of 1982, Pub. L. 97-248, 96 Stat. 648. See
secs. 6221-6232; N.C.F. Energy Partners v. Commissioner, 89 T.C.
741, 744 (1987); Maxwell v. Commissioner, 87 T.C. 783, 789
(1986).
11
At least 18 docketed cases were bound by stipulation to
the outcome of Utah Jojoba I Research v. Commissioner, docket No.
7619-90.
 - 13 -

Commissioner’s disallowance of research and experimental

expenditures, the Court concluded that the agreements between the

partnerships and the R&D contractor (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.12 The Court stated that the activities of the

partnerships were “another example of efforts by promoters and

investors in the early 1980s 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.

In November 1998, Mr. Clancy, acting in his capacity as tax

matters partner of San Nicholas, consented to entry of decision

against the partnership. Subsequently, in December 1998, the

Court entered decision against San Nicholas pursuant to the

Commissioner’s Motion for Entry of Decision under Rule 248(a).13

Thereafter, the Commissioner assessed a deficiency in

petitioner’s income tax for 1983 in the amount of $13,710 and

mailed a so-called affected items notice of deficiency to

12
In other words, in order to decrease the limited
partners’ cost of investing in the jojoba partnerships, large up-
front deductions were manufactured from expenditures that were
actually capital contributions.
13
All Rule references are to the Tax Court Rules of
Practice and Procedure.
 - 14 -

petitioner determining additions to tax for negligence and

substantial understatement of tax liability. See sec. 6230(a);

N.C.F. Energy Partners v. Commissioner, 89 T.C. 741, 744 (1987);

Maxwell v. Commissioner, 87 T.C. 783, 792 n.9 (1986). It is

those additions to tax that are in issue in the present case.

J. Epilogue: Demise of the Jojoba Partnerships

The jojoba partnerships proved to be financial failures. In

October 1991, some 30 to 40 jojoba partnerships under contract

with U.S. Agri were consolidated into one large limited

partnership, Jojoba Plantation Ltd. Sometime thereafter, Jojoba

Plantation Ltd. filed a petition in bankruptcy under chapter 7 of

the Bankruptcy Act. See Utah Jojoba I Research v. Commissioner,

supra.

At trial, petitioner testified that the jojoba partnerships

failed because of the Internal Revenue Service.14 At a previous

trial, petitioner testified that “the collapse, basically, of the

tax incentive for doing jojoba” contributed to the partnerships’

failure. See id.

14
Petitioner’s sole third-party witness suggested a
different reason: That no commercially viable method of
harvesting jojoba was ever developed.
 - 15 -

OPINION

We have decided many jojoba cases involving additions to tax

for negligence and substantial understatement of tax liability.15

We have found the taxpayers liable for additions to tax for

negligence in all of those cases; likewise, we have found the

taxpayers liable for the addition to tax for substantial

understatement of tax liability in all of those cases that have

presented that issue.

I. Section 6653(a)(1) and (2) Negligence

The first issue for decision is whether petitioner is liable

for additions to tax under section 6653(a)(1) and (2) with

respect to the underpayment of tax attributable to petitioner’s

investment in San Nicholas. Petitioner has the burden of proof

to show that he is not liable for these additions to tax. See

Addington v. Commissioner, 205 F.3d 54, 58 (2d Cir. 2000), affg.

Sann v. Commissioner, T.C. Memo. 1997-259; Bixby v. Commissioner,

58 T.C. 757, 791-792 (1972); Anderson v. Commissioner, T.C. Memo.

15
See, e.g., Lopez v. Commissioner, T.C. Memo. 2001-278;
Christensen v. Commissioner, T.C. Memo. 2001-185; Serfustini v.
Commissioner, T.C. Memo. 2001-183; Carmena v. Commissioner, T.C.
Memo. 2001-177; Nilsen v. Commissioner, T.C. Memo. 2001-163;
Ruggiero v. Commissioner, T.C. Memo. 2001-162; Robnett v.
Commissioner, T.C. Memo. 2001-17; Harvey v. Commissioner, T.C.
Memo. 2001-16; Hunt v. Commissioner, T.C. Memo. 2001-15; Fawson
v. Commissioner, T.C. Memo. 2000-195; Downs v. Commissioner, T.C.
Memo. 2000-155; Glassley v. Commissioner, T.C. Memo. 1996-206;
Stankevich v. Commissioner, T.C. Memo. 1992-458.
 - 16 -

1993-607, affd. 62 F.3d 1266 (10th Cir. 1995). See generally Rule

142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992);

Welch v. Helvering, 290 U.S. 111, 115 (1933).16

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

equal to 5 percent of the 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.

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). The focus of

inquiry is the reasonableness of the taxpayer’s actions in light

of the taxpayer’s experience and the nature of the investment.

See Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 740

(1973); see also Sacks v. Commissioner, 82 F.3d 918, 920 (9th Cir.

1996) (whether a taxpayer is negligent in claiming a tax

deduction “depends upon both the legitimacy of the underlying

16
Cf. sec. 7491(c), effective for court proceedings
arising in connection with examinations commencing after July 22,
1998. In the present case, the examination of petitioner’s
income tax return for 1983 commenced well before July 22, 1998.
 - 17 -

investment, and the due care in the claiming of the deduction.”),

affg. T.C. Memo. 1994-217; Turner v. Commissioner, T.C. Memo.

1995-363. In this regard, the determination of negligence is

highly factual.

Under some circumstances, a taxpayer may avoid liability for

negligence if reasonable reliance on a competent professional

adviser is shown. See United States v. Boyle, 469 U.S. 241, 250-

251 (1985); Freytag v. Commissioner, 89 T.C. 849, 888 (1987),

affd. 904 F.2d 1011 (5th Cir. 1990), affd. on another issue 501

U.S. 868 (1991). However, reliance on professional advice,

standing alone, is not an absolute defense to negligence, but

rather a factor to be considered. See Freytag v. Commissioner,

supra. For reliance on professional advice to excuse a taxpayer

from negligence, the taxpayer must show that the professional had

the requisite expertise, as well as knowledge of the pertinent

facts, to provide informed advice on the subject matter. See

David v. Commissioner, 43 F.3d 788, 789-790 (2d Cir. 1995), affg.

T.C. Memo. 1993-621; Goldman v. Commissioner, 39 F.3d 402, 407

(2d Cir. 1994), affg. T.C. Memo. 1993-480; Freytag v.

Commissioner, supra.

The facts pertinent to the present case relating to the

structure, formation, and operation of San Nicholas are as found

above and as discussed in Utah Jojoba I Research v. Commissioner,

T.C. Memo. 1998-6. The offering memorandum identified U.S. Agri
 - 18 -

as the contractor under the R&D contract. In addition, a license

agreement between San Nicholas and U.S. Agri granted U.S. Agri

the exclusive right to use all technology developed for the

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

of the products produced from such technology. The R&D contract

and the license agreement were executed concurrently.

According to its terms, the R&D contract expired upon the

partnership’s execution of the license agreement. Because the

two contracts were executed concurrently, amounts paid by the

partnership to U.S. Agri were not paid pursuant to a valid R&D

contract but rather were passive investments in a farming venture

under which the investors’ return, if any, was to be in the form

of royalties pursuant to the license agreement. Thus, as the

Court held in Utah Jojoba I Research v. Commissioner, supra, the

partnership was never engaged in research or experimentation,

either directly or indirectly. Moreover, the Court found that

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

constitute R&D, thereby concluding that the R&D contract was

designed and entered into solely to decrease the limited

partners’ cost of investing in an jojoba partnership through

large, upfront deductions for expenditures that were actually

capital contributions. The Court further concluded that the

partnership was not involved in a trade or business and had no

realistic prospect of entering into a trade or business with
 - 19 -

respect to any technology that was to be developed by U.S. Agri.

Id.

Notwithstanding the foregoing, petitioner contends that his

investment in San Nicholas was motivated solely by the potential

to earn a profit. Petitioner also contends that, taking into

account his experiences as a farmer and engineer and the nature

of his investment, he exercised the due care that a reasonable

and ordinarily prudent person would have exercised under like

circumstances. Finally, petitioner contends that reliance on Mr.

Pace, Mr. Jacobs, and a professor at the University of California

should absolve him of liability for negligence in this case. For

the following reasons, we disagree with petitioner’s contentions.

First, the principal flaw in the structure of San Nicholas

was evident from an examination of the R&D contract and the

license agreement. Both of these documents were a part of the

offering memorandum. A reading of the R&D contract and the

license agreement demonstrates that the license agreement

canceled, or rendered ineffective, the R&D contract because of

the concurrent execution of the two documents. Accordingly, San

Nicholas was never engaged in, either directly or indirectly, any

research or experimentation. Rather, San Nicholas was merely a

passive investor seeking royalty returns pursuant to the license

agreement. See Lopez v. Commissioner, T.C. Memo. 2001-278;

Christensen v. Commissioner, T.C. Memo. 2001-185; Serfustini v.
 - 20 -

Commissioner, T.C. Memo. 2001-183; Carmena v. Commissioner, T.C.

Memo. 2001-177; Nilsen v. Commissioner, T.C. Memo. 2001-163;

Fawson v. Commissioner, T.C. Memo. 2000-195. Petitioner, an

experienced attorney, should have understood the legal

ramifications of the license agreement canceling the R&D

contract.

Second, we are unable to accept uncritically petitioner’s

contention that he invested in San Nicholas solely to earn a

profit.17 Rather, at the time that he signed the subscription

agreement, petitioner believed that his investment in San

Nicholas offered tax benefits, and his decision to invest was

influenced by that belief.

Third, we do not think that petitioner, a well-educated and

successful attorney and a sophisticated investor, exercised due

care at the time that he signed the subscription agreement. In

this regard we are again unable to accept uncritically

petitioner’s contention that he reasonably relied on the offering

memorandum. The short answer to this contention is that

17
It is the duty of the Court to listen to testimony,
observe the demeanor of witnesses, weigh the evidence, and
determine what to believe. The Court is not required to accept
testimony at face value, and the Court may discount a party’s
self-interested testimony and place reliance on other evidence
that is believed to be more reliable. See Christensen v.
Commissioner, 786 F.2d 1382, 1383-1384 (9th Cir. 1986), affg. in
part and remanding in part T.C. Memo. 1984-197; Niedringhaus v.
Commissioner, 99 T.C. 202, 212 (1992); Duralia v. Commissioner,
T.C. Memo. 1994-269; see also Tokarski v. Commissioner, 87 T.C.
74, 77 (1986).
 - 21 -

petitioner either did not read the offering memorandum in its

entirety or chose to ignore portions thereof. See Goldman v.

Commissioner, 39 F.3d 402, 407-408 (2d Cir. 1994), affg. T.C.

Memo. 1993-480, holding that the taxpayer’s reliance on offering

materials was not reasonable; see also Pasternak v. Commissioner,

990 F.2d 893, 903 (6th Cir. 1993), affg. Donahue v. Commissioner,

T.C. Memo. 1991-181, holding that claims that are probably “too

good to be true” should be investigated by a reasonably prudent

person.18

The offering memorandum was replete with caveats and

warnings regarding the business and tax risks associated with an

investment in San Nicholas. The cover page cautioned that “THIS

OFFERING INVOLVES A HIGH DEGREE OF RISK” and warned prospective

investors “NOT TO CONSTRUE THIS MEMORANDUM OR ANY PRIOR OR

SUBSEQUENT COMMUNICATIONS AS CONSTITUTING LEGAL OR TAX ADVICE.”

Potential inventors were urged “TO CONSULT THEIR OWN COUNSEL AS

TO ALL MATTERS CONCERNING THIS INVESTMENT” and were advised “TO

CONSULT WITH [THEIR] OWN TAX ADVISOR AS TO THE TAX ASPECTS.” The

single longest section of the offering memorandum was devoted to

“risk factors” and warned of numerous risks, specifically

including tax risks, the lack of a structured market and

18
In the present case, the parties stipulated to a
promotional videotape produced by U.S. Agri that described jojoba
as “liquid gold” and “the industrial crop of the future”, which
would be cultivated in “some of the most hostile land anywhere”.
 - 22 -

distribution system for jojoba, and the highly speculative nature

of the investment. Petitioner ignored these warnings.

On brief, petitioner painstakingly dissects portions of the

offering memorandum in an attempt to show that he carefully

perused what he calls a “business plan”. Petitioner’s piecemeal

approach to the offering memorandum ignores the existence of the

strong cautionary language. A careful review of the offering

memorandum, especially the portion discussing the tax risks,

would have caused a prudent investor to question the propriety of

the tax benefits. We would certainly expect no less from a well-

educated and sophisticated individual such as petitioner.

Petitioner contends that he also conducted his own analysis

of San Nicholas prior to investing. However, there is no

persuasive evidence that petitioner’s “analysis” was based on

anything other than the projections set forth in the offering

memorandum. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Investors were warned, however, that those projections had been

prepared for the general partner, had not been audited, and

should not be relied on. There is nothing in the record to

persuade us that petitioner’s “projections” were ever audited or

examined by any disinterested third party. Any reliance on those

projections was unreasonable.

Petitioner contends that his experience with farming and his

reading about jojoba gave him confidence in the viability of his
 - 23 -

investment in San Nicholas. Yet, petitioner’s experience and his

knowledge should have led him to inquire into both the

operational aspects of the partnership and the nature of the

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

contract.19 See Fawson v. Commissioner, T.C. Memo. 2000-195.

Although petitioner claims to have visited the jojoba sites

about once a month, the primary purpose of these visits was to

“see how the plants were growing” and that proper watering and

weeding methods were being utilized. However, there is no

persuasive evidence in the record to demonstrate that petitioner,

either as a limited partner in San Nicholas or as the general

partner and tax matters partner of four other jojoba

partnerships, visited the jojoba sites in order to determine

whether research or development was being conducted. If

petitioner had visited the jojoba sites for that purpose, he

would have quickly discovered that U.S. Agri was engaged in

19
We find it curious that petitioner would choose to
emphasize his experience when the record clearly demonstrates
that prior to 1982, he did not have any experience in growing
jojoba, nor did he have any experience in either the research or
development of jojoba. Petitioner’s experience first came in
late 1982, when he became the general partner and tax matters
partner of Utah Jojoba, Blythe Jojoba I, Blythe Jojoba II, and
Desert Center Jojoba.
We find it equally curious that petitioner would choose to
emphasize his knowledge when the record demonstrates that prior
to 1982, his knowledge was limited to articles that he had read
in various magazines and a general familiarity with the existence
of an experimental jojoba plantation located at the University of
California at Riverside.
 - 24 -

nothing more than a farming activity. See Fawson v.

Commissioner, supra. Petitioner should have realized that in the

absence of any research and development, there could be no

deduction for research and experimental expenditures under

section 174.

Fourth, petitioner contends that in deciding to invest in

San Nicholas, he reasonably relied on advice from Mr. Pace, Mr.

Jacobs, and a professor at the University of California. For

reasons that we shall discuss, we disagree that any such reliance

was reasonable.

Petitioner contends that he reasonably relied on advice from

Mr. Pace. At the time of trial, Mr. Pace was deceased;

accordingly, we do not know first hand what knowledge he may have

had or what advice he may have given.20 The record does establish

that Mr. Pace was the president of U.S. Agri and a member of its

board of directors. Petitioner, who for a period of time was

also a member of U.S. Agri’s board, obviously knew that Mr. Pace

was an interested party and that Mr. Pace had a conflict of

interest. Thus, whatever advice petitioner may have received

from Mr. Pace fails as a defense to negligence because of Mr.

Pace’s lack of competence to give such advice and the clear

presence of a conflict of interest. See Rybak v. Commissioner,

20
In Utah Jojoba I Research v. Commissioner, T.C. Memo.
1998-6, the Court found that before 1983, Mr. Pace had only
limited knowledge of, and minimal background in, jojoba.
 - 25 -

91 T.C. 524, 565 (1988).

Petitioner also contends that he reasonably relied on advice

from Mr. Jacobs. At the time of trial, Mr. Jacobs was deceased;

accordingly, we do not know first hand what knowledge he may have

had or what advice he may have given. The record does establish

that Mr. Jacobs only became involved in the farming of jojoba in

or about 1982, so his experience was limited, and there is

nothing to suggest that he was knowledgeable about research and

development of jojoba. See Freytag v. Commissioner, 89 T.C. at

888. The record also establishes that Mr. Jacobs was involved in

the sale of limited partnership interests in a number of jojoba

partnerships. Accordingly, any advice that he may have given can

be analogized to that of a promoter, which advice is inherently

suspect. E.g., Addington v. Commissioner, 205 F.3d at 59;

Pasternak v. Commissioner, 990 F.2d at 903.

In Glassley v. Commissioner, T.C. Memo. 1996-206, we 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” * * *.

The record in the present case suggests that whatever advice may

have been given by Mr. Jacobs was nothing more than a generalized

affirmation to invest in jojoba. Indeed, at trial, petitioner

testified that Mr. Jacobs was “very high on the investments in
 - 26 -

jojoba, and I–-and that was the primary reason I invested in it.”

Petitioner also contends that he reasonably relied on advice

from a professor at the University of California at Riverside, a

Dr. Yermanos. This individual did not testify at trial, so we do

not know first hand what advice he may have given or on what

basis such advice may have been rendered.21 However, the record

suggests that petitioner never compensated Dr. Yermanos for his

time and that Dr. Yermanos may have merely opined on whether the

jojoba industry as a whole could become profitable.22 There is

nothing in the record to suggest that petitioner ever discussed

the details of San Nicholas with Dr. Yermanos or that Dr.

Yermanos even knew about the existence of that partnership. In

short, petitioner’s testimony concerning Dr. Yermanos is too

amorphous for us to conclude that whatever advice Dr. Yermanos

may have provided was sufficiently informed to absolve petitioner

from liability for the additions to tax for negligence.

Finally, petitioner relies heavily on Krause v.

Commissioner, 99 T.C. 132 (1992), affd. sub nom. Hildebrand v.

Commissioner, 28 F.3d 1024 (10th Cir. 1994). That case, however,

is distinguishable on its facts.

21
We note that no mention is made of a Dr. Yermanos in Utah
Jojoba I Research v. Commissioner, T.C. Memo. 1998-6.
22
Remarkably, Dr. Yermanos apparently admitted to
petitioner that he, i.e., Dr. Yermanos, had not been successful
in convincing anyone to enter the field of jojoba.
 - 27 -

In Krause v. Commissioner, supra, we held for the taxpayers

on the issue of negligence. We did so in the context of oil

recovery technology based on special or unusual circumstances

related to the energy and oil crisis of the late 1970s and early

1980s:

In evaluating the imposition of the additions to tax
in this case, and in light of the above facts
(encouraging investments in and the development of
tertiary oil recovery methods such as [enhanced oil
recovery] technology), we are somewhat understanding of
the individual investments that were made in * * *
Partnerships. In the context of the hysteria relating
to the energy crisis, the oil price increases of the
late 1970s, the industry and the governmental interest
in [enhanced oil recovery] technology, the heavy and
sophisticated promotion of these investments * * * we
conclude that petitioners are not liable for the
additions to tax and the additional interest element
for negligence under sections 6653(a), 6653(a)(1) and
(2). [Id. at 178.]

None of the circumstances that were determinative in Krause

v. Commissioner, supra, are present in the case at bar.

Petitioner’s reliance on the cited case is misplaced.

In view of the foregoing, we hold that petitioner is liable

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

negligence. Respondent’s determination is sustained.

II. Section 6661(a) Substantial Understatement of Tax Liability

The second issue for decision is whether petitioner is

liable for an addition to tax under section 6661(a). That

section, as amended by the Omnibus Budget Reconciliation Act of

1986, Pub. L. 99-509, sec. 8002, 100 Stat. 1951, provides for an
 - 28 -

addition to tax of 25 percent of the amount of any underpayment

attributable to a substantial understatement of income tax.

Petitioner bears the burden of proving that he is not liable for

the addition to tax. Monahan v. Commissioner, 109 T.C. 235, 257

(1997); Mueller v. Commissioner, T.C. Memo. 2001-178.23

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. 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).

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. 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. Sec.

1.6661-4(b) and (c), Income Tax Regs.

If an understatement is attributable to a tax shelter item,

then different standards apply. First, in addition to showing

23
See supra note 16.
 - 29 -

the existence of substantial authority, a taxpayer must show that

he or she reasonably believed that the tax treatment claimed was

more likely than not the proper treatment. Sec.

6661(b)(2)(C)(i)(II). Second, disclosure, whether or not

adequate, will not reduce the amount of the understatement. Sec.

6661(b)(2)(C)(i)(I).

Petitioner appears to concede that there was a substantial

understatement of tax within the meaning of section 6661(a).24

Petitioner does not contend, however, that there was substantial

authority supporting the deduction of the partnership loss that

he claimed on his return, nor does petitioner contend that there

was adequate disclosure of the facts related to that loss.

Rather, petitioner contends that he should be absolved of

liability for the addition to tax by virtue of section 6661(c).

Section 6661(c) vests the Commissioner with discretion to

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

shows that he or she acted with reasonable cause and in good

faith. The Commissioner’s failure to waive the addition to tax

is reviewed by this Court for abuse of discretion. Martin Ice

Cream Co. v. Commissioner, 110 T.C. 189, 235 (1998).

24
We note that the understatement of tax on which
respondent determined the addition to tax is $13,710. The amount
required to be shown as tax on petitioner’s return is $41,080.
The understatement is therefore “substantial” because it exceeds
the greater of 10 percent of the amount required to be shown on
the return, or $5,000. Sec. 6661(a).
 - 30 -

There is nothing in the record to suggest that petitioner

ever requested that respondent waive the addition to tax under

section 6661(a). Indeed, petitioner does not even allege that he

requested such a waiver. For that reason alone, petitioner is

not entitled to relief from liability. See McCoy Enters., Inc.

v. Commissioner, 58 F.3d 557, 563-564 (10th Cir. 1995), affg. T.C.

Memo. 1992-693; Klieger v. Commissioner, T.C. Memo. 1992-734;

sec. 1.6661-6, Income Tax Regs.

Even if petitioner had requested a waiver under section

6661(c), the record demonstrates that he failed to act reasonably

and in good faith in deducting his claimed loss from San

Nicholas. As general partner and tax matters partner of four

other jojoba partnerships, specifically including Utah Jojoba,

petitioner was aware, or should have been aware, that San

Nicholas was not engaged in the research and development of

jojoba. Accordingly, petitioner knew, or should have known, that

in the absence of any research and development, there could be no

deduction for research and experimental expenditures under

section 174.

In view of the foregoing, we hold that petitioner is liable

for the addition to tax under section 6661(a) for substantial

understatement of tax liability. Respondent’s determination is

sustained.

III. Conclusion
 - 31 -

To reflect our disposition of the disputed issues, as well

as the parties’ concessions, see supra note 1,

Decision will be entered

for petitioner Debra C. Kellen

and for respondent as to

petitioner William G. Kellen.