T.C. Memo. 2002-56
UNITED STATES TAX COURT
ANTHONY N. AND MARIE M. FINAZZO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5727-00. Filed February 27, 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 $618 $12,355 $3,089
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 equates the amount of this addition to tax with
the amount of the deficiency in income tax (see infra,
subdivision “I” of the Findings of Fact). Prior to trial,
respondent amended his answer to claim an increased
addition to tax pursuant to sec. 6214(a). The increase,
in the amount of $17,877, is purely computational in
nature.
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 a concession by petitioners,1 the issues for decision
are as follows:
(1) Whether petitioners are liable for additions to tax
under section 6653(a)(1) and (2) for negligence or intentional
disregard of rules or regulations. We hold that petitioners are
liable for such additions.
(2) Whether petitioners are liable for the addition to tax
under section 6661 for substantial understatement of tax
liability. We hold that petitioners are liable for such
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).
- 3 -
addition.
The foregoing two issues relate to the participation of
Anthony N. Finazzo (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.
Petitioners resided in Fontana, California, at the time that
their petition was filed with the Court.
A. Petitioners’ Background and Experience
Petitioner graduated in 1953 from Chaffey Junior College in
Ontario, California, with an associate of arts degree. He then
attended the University of California at Los Angeles for 1 year
where he took basic courses in business administration, including
accounting, economics, and investing. Petitioner never took
courses in either Federal or State taxation, nor did he ever take
courses related to either farming or agriculture.
Petitioner is a successful businessman. Prior to 1983,
petitioner served for 11 years as chairman of the board of
directors of Fontana First National Bank; he also served as
branch manager for several other financial institutions. In
1983, the taxable year in issue, petitioner was the general
manager and 25-percent owner of Midway Honda-GMC Inc., a highly
- 4 -
profitable automobile and truck dealership. In July 1983,
petitioner sold his ownership interest in the dealership and
later became executive vice president of Monitor Dynamics, a
corporation specializing in electronic security systems for both
civilian and military use.
During the year in issue, petitioner Marie M. Finazzo was
employed by the Fontana Unified School District as secretary for
the budget commission.
In 1983, petitioner was financially well off and
sophisticated. For that year, he received compensation from
Midway Honda-GMC, Inc. in the amount of $170,085, gain from the
sale of stock in the dealership in the amount of $245,160, and
interest in the amount of $8,445. In addition, petitioner had
equity interests in: (1) A partnership known as Fontana Bancorp
Development; (2) a partnership known as Carousel Video; (3) San
Nicholas Research, Ltd. (see infra “C” through “F”); and (4) an S
corporation known as Classic Touch, Inc., that manufactured
convertible tops for automobiles in Palm Springs, California.
B. Petitioner’s Friend and Associate William G. Kellen
William G. Kellen (Mr. Kellen) was petitioner’s close
personal friend and business associate.
Mr. Kellen was a general partner and tax matters partner of
four limited jojoba partnerships: Utah Jojoba Research, Ltd.
(Utah Jojoba); Blythe Jojoba I Research, Ltd. (Blythe Jojoba I);
- 5 -
Blythe Jojoba II Research, Ltd. (Blythe Jojoba II); and Desert
Center Jojoba Research, Ltd. (Desert Center Jojoba). Each of
these partnerships was similar, if not identical, to San Nicholas
Research, Ltd., described infra in “C” through “F”.
Prior to 1982, Mr. Kellen did not have any experience in
growing jojoba, nor did he have any experience in either the
research or development of jojoba. Prior to 1982, Mr. Kellen’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.
In 1983, Mr. Kellen was actively engaged in the practice of
law, specializing in the formation of financial institutions such
as banks, savings and loan associations, and thrift and loan
associations. Mr. Kellen did not have any expertise in
accounting or tax matters, nor did he ever attempt to render
advice on those subjects.
C. Petitioner’s Investment in San Nicholas Research, Ltd.
Petitioner was introduced to jojoba in the fall of 1983 by
Mr. Kellen, who provided petitioner with a copy of a private
placement memorandum dated October 10, 1983 (see infra “D” and
“F”) for San Nicholas Research, Ltd. (San Nicholas or the
partnership). Thereafter, on December 29, 1983, petitioner
signed a subscription agreement and purchased 10 limited
- 6 -
partnership units (a 7.8-percentage interest) in San Nicholas.2
The general partner and tax matters partner of San Nicholas
was Alfred M. Clancy, an individual whom petitioner did not know,
nor whom he had ever met, at the time that he invested in San
Nicholas.
Petitioner purchased the partnership units pursuant to the
aforementioned private placement memorandum. Petitioner paid
$2,790 per limited partnership unit, or a total of $27,900, for
his 10 units in San Nicholas. Of this amount, $1,140 per unit,
or $11,400 for 10 units, was paid in cash. The balance, $1,650
per unit or $16,500 for 10 units, was payable pursuant to a 10-
year promissory note.3
Prior to investing in San Nicholas, petitioner did not have
any expertise in either farming or agriculture in general or
jojoba in particular, nor did petitioner have any expertise in
the area of research and development.
2
The parties stipulated that petitioners acquired the
partnership interest in San Nicholas. However, at trial, the
parties proceeded as if petitioner himself was the only one who
had acquired the partnership interest. Our findings of fact
reflect the approach taken by the parties at trial. We hasten to
add that if we had taken the other approach, our decision in this
case would not have been different in any regard. We also hasten
to add that petitioners expressly declined to raise any issue
under sec. 6015.
3
The note, which was recourse in form, contemplated
payments of interest only for the first 5 years. As matters
actually transpired, in 1989, the limited partners were given the
option of paying a steeply discounted percentage of the principal
in cash. Petitioner elected this option.
- 7 -
Prior to investing in San Nicholas, petitioner did not
consult any expert in either farming or agriculture or jojoba,
nor did petitioner consult any expert in research and
development.
Prior to investing in San Nicholas, petitioner did not
consult any attorney or accountant.4
Prior to investing in San Nicholas, petitioner did not visit
the plantation site, nor did he know where it was located.
Petitioner was influenced to invest in San Nicholas by the
fact that Mr. Kellen, his friend and business associate, had done
so.5 Indeed, prior to investing, petitioner spoke with no
individual other than Mr. Kellen. Petitioner was also influenced
to invest by his belief that an investment in San Nicholas
offered tax benefits.
4
Although Mr. Kellen was an attorney, he never rendered any legal
advice to petitioner concerning either San Nicholas or the
advisability of investing therein. Indeed, petitioner never
consulted Mr. Kellen in his capacity as an attorney; rather,
petitioner consulted Mr. Kellen solely as a friend and business
associate.
In addition, although petitioner may have shown the private
placement memorandum dated Oct. 10, 1983, see infra “D” and “F”,
to his accountant and return preparer Lloyd Maryanov, see infra
“G”, petitioner only did so after investing in San Nicholas.
5
Mr. Kellen’s investment in San Nicholas also culminated in a
case in this Court. See Kellen v. Commissioner, T.C. Memo. 2002-
19; see also Utah Jojoba I Research v. Commissioner, T.C. Memo.
1998-6, discussed infra in subdivision “I” of the Findings of
Fact, regarding Mr. Kellen’s involvement in another jojoba
partnership.
- 8 -
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
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.[6]
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.
6
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, subdivision “I” of the Findings of Fact.
- 9 -
(U.S. Agri) as a party to the contract and the R&D contractor
thereunder. The license agreement identified U.S. Agri as a
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. Mr. Kellen 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.
Mr. Pace and Mr. Kellen were close personal friends and
business associates for a number of years before the formation of
San Nicholas in late 1983. In contrast, neither in 1983 nor at
any other time relevant to this case did petitioner ever meet Mr.
Pace.
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
- 10 -
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.
* * * * * * *
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
- 11 -
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 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,
- 12 -
cashflow, and taxable income or loss. Investors were warned,
however, that those projections, which had been prepared 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. Petitioners’ Accountant and Return Preparer Lloyd Maryanov
Lloyd Maryanov (Mr. Maryanov), a certified public accountant
and a named partner in the accounting firm of Maryanov, Madsen,
Gordon & Campbell of Palm Springs, California, prepared
petitioners’ income tax return for 1983. In preparing
petitioners’ return, Mr. Maryanov relied on the Schedule K-1 given
to him by petitioner. See infra “H”.
H. Petitioners’ 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 $24,710 for the year.
Petitioners timely filed a joint Federal income tax return,
Form 1040, for 1983. Petitioners attached to their return page 2
of Schedule E, Supplemental Income and Loss, and claimed thereon a
loss from San Nicholas in the amount of $24,710. Petitioners then
offset this loss against their other income. See supra “A”.
I. Jojoba Partnership Litigation
San Nicholas was examined by the Internal Revenue Service,
- 13 -
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.7 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
commenced by Mr. Kellen 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,8 Mr. Kellen, 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 Commissioner’s
7
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. 324. 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).
8
At least 18 docketed cases were bound by stipulation to
the outcome of Utah Jojoba I Research v. Commissioner, docket No.
7619-90.
- 14 -
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.9 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).10
Thereafter, the Commissioner assessed a deficiency in petitioners’
income tax for 1983 in the amount of $12,355 and mailed a so-
called affected items notice of deficiency to petitioners
9
In other words, in order to decrease the limited partners’
cost of investing in the jojoba partnerships, large upfront
deductions were manufactured from expenditures that were actually
capital contributions.
10
All Rule references are to the Tax Court Rules of
Practice and Procedure.
- 15 -
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,
T.C. Memo. 1998-6.
At trial, petitioners’ witness, Mr. Kellen, testified that
the jojoba partnerships failed because of the Internal Revenue
Service. At a previous trial, Mr. Kellen testified that “the
collapse, basically, of the tax incentive for doing jojoba”
contributed to the partnerships’ failure. Id.
- 16 -
OPINION
We have decided many jojoba cases involving additions to tax
for negligence and substantial understatement of tax liability.11
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 petitioners are
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. Petitioners bear the burden of proof
to show that they are not liable for these additions to tax.12
11
See, e.g., Kellen v. Commissioner, T.C. Memo. 2002-19;
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.
12
It must be acknowledged that respondent bears the burden
of proof to show that petitioners are liable for the increase in
the addition to tax under sec. 6653(a)(2). Rule 142(a); see
supra, p. 2, table, note 2. However, in the present case, the
increase is purely computational in nature, and respondent has
convincingly demonstrated the proper amount of the addition to
tax. Accordingly, our analysis proceeds on the basis that
(continued...)
- 17 -
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. 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).13
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
12
(...continued)
petitioners bear the burden of proof regarding their liability
for this addition to tax. In any event, we would resolve this
issue for respondent based on a preponderance of the evidence.
13
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 petitioners’
income tax return for 1983 commenced well before July 22, 1998.
- 18 -
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 investment, and 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
- 19 -
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
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
- 20 -
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 respect to any
technology that was to be developed by U.S. Agri. Id.
Notwithstanding the foregoing, petitioners contend that
petitioner’s investment in San Nicholas was motivated solely by
the potential to earn a profit. Petitioners also contend that,
taking into account petitioner’s experiences as a successful
businessman and the nature of petitioner’s investment, petitioner
exercised the due care that a reasonable and ordinarily prudent
person would have exercised under like circumstances. Finally,
petitioners contend that reliance on Mr. Kellen, Mr. Pace, a
professor at the University of California, and Mr. Maryanov should
absolve petitioners of liability for negligence in this case. For
the following reasons, we disagree with petitioners’ 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
- 21 -
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 Kellen v. Commissioner, T.C. Memo. 2002-19; 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; Fawson v. Commissioner, T.C.
Memo. 2000-195. Any experienced attorney capable of reading and
understanding the subject documents should have understood the
legal ramifications of the licensing agreement's canceling the R&D
agreement. Petitioner failed to consult an attorney and, further,
failed to carefully scrutinize the offering himself.
Second, we are unable to accept uncritically petitioners’
contention that petitioner invested in San Nicholas solely to earn
a profit.14 Rather, at the time that petitioner signed the
14
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.
(continued...)
- 22 -
subscription agreement, he believed that his investment in San
Nicholas offered tax benefits, and his decision to invest was
influenced, in part, by that belief.
Third, we do not think that petitioner, 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 petitioners’ contention that petitioner
reasonably relied on the offering memorandum. The short answer to
this contention is that petitioner either did not read the
offering memorandum in its entirety or chose to ignore portions
thereof. See Goldman v. Commissioner, supra at 407-408, 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.15
The offering memorandum was replete with caveats and warnings
regarding the business and tax risks associated with an investment
14
(...continued)
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).
15
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”.
- 23 -
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 distribution system for
jojoba, and the highly speculative nature of the investment.
Petitioner ignored these warnings, reasoning that “for the amount
of investment that I made here, I didn’t think it was necessary to
go hire an attorney to find out if this was * * * legitimate”.16
16
In the alternative, petitioners assert that petitioner
did in fact consult an attorney; i.e., Mr. Kellen. However,
there is simply nothing in the record to suggest that petitioner
ever questioned Mr. Kellen concerning the details of San Nicholas
or that petitioner ever compensated Mr. Kellen for whatever
advice may have been rendered. More to the point, the record is
clear that petitioner consulted Mr. Kellen not as an attorney but
rather as a close personal friend and business associate.
- 24 -
On brief, petitioners painstakingly attempt to dissect
portions of the offering memorandum in an attempt to show that
petitioner carefully perused what he calls a “business plan”.
Petitioners’ 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 sophisticated businessman such as petitioner.17
Fourth, petitioners contend that reliance on Mr. Kellen, Mr.
Pace, a professor at the University of California, and Mr.
Maryanov should absolve petitioners of liability for negligence in
this case. We disagree that any such reliance was reasonable;
rather, the record demonstrates that petitioners failed to obtain
competent, independent, professional advice before investing in
San Nicholas.
Petitioners contend that petitioner reasonably relied on
advice from Mr. Kellen. In this regard petitioners argue that Mr.
Kellen was qualified as an expert in jojoba and that he (i.e., Mr.
Kellen) conducted an extensive “analysis” of San Nicholas.
However, the record establishes that Mr. Kellen only became
17
We find it curious that petitioners would emphasize
petitioner’s significant business experience as evidence of due
care. To the contrary, petitioner’s significant business
experience should have caused petitioner to delve deeper into the
nature of his investment.
- 25 -
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
Kellen v. Commissioner, T.C. Memo. 2002-19; see also Freytag v.
Commissioner, 89 T.C. at 888. Further, we have found that Mr.
Kellen’s “analysis” of San Nicholas was not based on anything
other than the projections set forth in the offering memorandum.
Kellen v. Commissioner, supra; see Tokarski v. Commissioner, 87
T.C. 74, 77 (1986).
The record also establishes that Mr. Kellen was the general
partner and tax matters partner of four other jojoba partnerships,
including Utah Jojoba. See supra “B”. Mr. Kellen was also the
close personal friend and business associate of Mr. Pace, the
president (and a director) of U.S. Agri, which was the R&D
contractor and licensee of San Nicholas and other jojoba
partnerships. Indeed, at one time, Mr. Kellen was also a director
of U.S. Agri. Accordingly, any advice that Mr. Kellen may have
given can be analogized to that of an insider or 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
- 26 -
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 Mr.
Kellen may have given was nothing more than a generalized
affirmation to invest in jojoba. Indeed, at trial, petitioner
testified as follows:
Bill was probably a major influence on our investment
with jojoba. You know, Bill was very excited about it
and, you know, he talked to us like a Dutch uncle, you
might say. He was very, very high on the jojoba
investment.
Petitioners also contend that petitioner reasonably relied on
advice from Mr. Pace. The short answer to this contention is that
at no time relevant to this case did petitioner ever meet Mr.
Pace. But if what petitioners mean is that petitioner relied on a
videotape in which Mr. Pace appeared, see supra note 15, then
suffice it to say that reliance on a promotional videotape
produced by the sole contractor (here, U.S. Agri) of the promoter
does not constitute due care, see, e.g., Addington v.
Commissioner, 205 F.3d at 59 (“It is unreasonable for taxpayers to
rely on the advice of someone who they know has a conflict of
interest.”).
Petitioners also contend that petitioner reasonably relied on
advice from a professor at the University of California at
Riverside, a Dr. Yermanos, an individual whom petitioners regard
- 27 -
as an expert in jojoba.18 Yet the record demonstrates that
petitioner never spoke with this individual.19 At best, petitioner
merely visited the university and “looked at some of the
documentations that Dr. Yermanos had prepared” regarding the
jojoba plant. In short, there is simply nothing in the record to
indicate that this individual provided any advice to petitioner
that would absolve petitioners from liability for the additions to
tax for negligence.
Petitioners contend that petitioner reasonably relied on
advice from Mr. Maryanov concerning the proper tax treatment of
the partnership loss at the time that their 1983 tax return was to
be filed. However, this individual did not testify at trial, so
we do not know first hand what knowledge or experience he may have
had regarding either jojoba or the deductibility of R&D expenses,
what advice he may have given, or on what basis any such advice
may have been rendered. The record establishes only that Mr.
Maryanov prepared petitioners’ tax return, relying on the Schedule
18
We note that this individual did not testify at trial, so
we know essentially nothing about him. We also note that no
mention is made of a “Dr. Yermanos” in Utah Jojoba I Research v.
Commissioner, T.C. Memo. 1998-6.
19
Although Mr. Kellen may have spoken to this individual,
there is nothing in the record to even suggest that this
individual knew about the existence of San Nicholas, much less
the details regarding the promotion.
- 28 -
K-1 that petitioner had received from San Nicholas.20
Finally, petitioners rely 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.
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
20
Although petitioner testified that he provided Mr.
Maryanov with a copy of the offering memorandum, there is nothing
in the record to indicate whether Mr. Maryanov either read or
considered it before he prepared petitioners’ 1983 tax return.
In addition, even though, as petitioner testified, Mr. Maryanov
may have been “involved with some jojoba growers in the Palm
Springs area”, there is nothing in the record to indicate that
Mr. Maryanov was knowledgeable about the nontax aspects of the
San Nicholas promotion. See Barlow v. Commissioner, T.C. Memo.
2000-339 (“A taxpayer may not reasonably rely on the advice of an
accountant who knows nothing about the nontax business aspects of
the contemplated venture.”).
- 29 -
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 instant case.
Petitioners’ reliance on the cited case is misplaced.
In view of the foregoing, we hold that petitioners are 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 petitioners are
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
addition to tax of 25 percent of the amount of any underpayment
attributable to a substantial understatement of income tax.
Petitioners bear the burden of proving that they are not liable
for the addition to tax. Monahan v. Commissioner, 109 T.C. 235,
257 (1997); Kellen v. Commissioner, T.C. Memo. 2002-19; Mueller v.
Commissioner, T.C. Memo. 2001-178.21
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
21
See supra note 13.
- 30 -
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 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).
Petitioners appear to concede that there was a substantial
understatement of income tax within the meaning of section
- 31 -
6661(a).22 Petitioners do not contend, however, that there was
substantial authority supporting the deduction of the partnership
loss that they claimed on their return. Nor do petitioners
contend that there was adequate disclosure of the facts related to
that loss. Rather, petitioners contend that they 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).
There is nothing in the record to suggest that petitioners
ever requested that respondent waive the addition to tax under
section 6661(a). Indeed, petitioners do not even allege that they
requested such a waiver. For that reason alone, petitioners are
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; Kellen v. Commissioner, T.C. Memo. 2002-19;
22
We note that the understatement of tax on which
respondent determined the addition to tax is $12,355. The amount
required to be shown as tax on petitioners’ return is $103,069.
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).
- 32 -
Klieger v. Commissioner, T.C. Memo. 1992-734; sec. 1.6661-6,
Income Tax Regs.
Even if petitioners had requested a waiver under section
6661(c), the record demonstrates that they failed to act
reasonably and in good faith in deducting the claimed loss from
San Nicholas. Petitioner’s limited discussions with Mr. Kellen, a
promoter of other, similar jojoba partnerships and a close
personal friend and business associate of U.S. Agri’s president,
are insufficient to demonstrate reasonable cause and good faith.
Similarly, petitioners’ failure to establish the extent of any tax
advice received, as well as the basis on which such advice may
have been rendered, is further evidence of petitioners’ lack of
reasonable cause and good faith. See DePlano v. Commissioner,
T.C. Memo. 1998-303.
In view of the foregoing, we hold that petitioners are liable
for the addition to tax under section 6661(a) for substantial
understatement of tax liability. Respondent’s determination is
sustained.
- 33 -
III. Conclusion
To reflect our disposition of the disputed issues, as well as
petitioners’ concession, see supra note 1,
Decision will be entered
for respondent as to the
additions to tax under sections
6653(a)(1) and 6661 as
determined in the notice of
deficiency and as to the
addition to tax under section
6653(a)(2) as claimed in the
amended answer.