HENN v. COMMISSIONER

T.C. Memo. 2002-261

UNITED STATES TAX COURT

CARL L. HENN AND EUGENIA T. HENN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9895-00. Filed October 9, 2002.

E. Martin Davidoff, for petitioners.

Rodney J. Bartlett and Timothy S. Sinnott, for respondent.

MEMORANDUM OPINION

DINAN, Special Trial Judge: Respondent determined that

petitioners are liable for additions to tax for taxable year 1982

under section 6653(a)(1) and (2) in the respective amounts of

$256 and 50 percent of the interest due on a $5,124 deficiency.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the year in issue, and all
 - 2 -

Rule references are to the Tax Court Rules of Practice and

Procedure.

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

liable for the additions to tax for negligence under section

6653(a), as determined by respondent in the notice of deficiency;

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

a substantial understatement of tax under section 6661(a), as

asserted by respondent in his answer to the amended petition.1

Background

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

The stipulations of fact and those attached exhibits which were

admitted into evidence are incorporated herein by this reference.

Petitioners resided in New Brunswick, New Jersey, on the date the

petition was filed in this case.

Petitioner husband (petitioner) earned an undergraduate

business degree from Northwestern University, an M.B.A. from

Harvard Business School, and a master of arts degree in

international economic relations from George Washington

1
In the petition, petitioners argued that (1) the notice of
deficiency was issued “beyond the Statute of Limitations”; (2)
the notice “is invalid due to the fact that the Commissioner
failed to make a determination” after an examination of facts
particular to petitioners’ case; and (3) the Commissioner failed
to allow petitioners “their appeal rights within the Internal
Revenue Service”. Petitioners concede the first issue.
Petitioners did not address the remaining issues in their briefs,
and we therefore consider them to have been abandoned and need
not address them here.
 - 3 -

University. He also attended an advanced management program at

Harvard following the completion of his degree there, as well as

postgraduate courses in economics at the University of California

at Berkeley. Petitioner’s primary career path was in the United

States Navy. Among other duties, petitioner was responsible for

various budgetary, financial, and accounting matters, and spent

time as an instructor in management, economics, and international

affairs at the Industrial College of the Armed Forces. After

retiring from the Navy and from a subsequent financially related

career at American Standard, petitioner began working for E.F.

Hutton in 1982. While there, he participated in a 3-month

investment training course for brokers. He earned certification

as a certified financial planner, and was licensed by

approximately 10 insurance companies for work related to

annuities and life insurance products.

Around 1980, while petitioner was employed by American

Standard, he learned of jojoba as an investment opportunity. In

the following years, petitioner learned more about jojoba by word

of mouth and by reading articles concerning it. Near or prior to

the time petitioner joined E.F. Hutton in 1982, he invested in

Jojoba Research Partners of Newport Beach, California (“the

partnership”). A colleague had recommended petitioner contact

the partnership’s general partner, Robert E. Cole. Petitioner

discussed the partnership with Mr. Cole on several occasions via
 - 4 -

telephone, but he did not discuss it with anyone other than those

who recommended the investment and those who were involved with

it. The partnership was formed on December 20, 1982. At this

time, petitioner had investments in stocks, bonds, mutual funds,

real estate, and other partnership ventures.

Petitioner received and read a private placement memorandum,

dated April 1, 1982, relating to his investment in the

partnership. Prefatory material in the memorandum contained the

following caveats:

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.

* * * * * * *

NO REPRESENTATIONS OR WARRANTIES OF ANY KIND ARE
INTENDED OR SHOULD BE INFERRED WITH RESPECT TO THE ECONOMIC
RETURN OR TAX ADVANTAGES WHICH MAY ACCRUE TO THE INVESTORS
IN THE UNITS.

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

In a section entitled “Use of Proceeds”, an estimation of various

expenditures, the memorandum stated that approximately 95 percent

of the capital contributions from the partners would be allocated

to the research and development contract (regardless of the total

amount of the contributions). The only other expenses were to be

organizational costs and commissions. One of the “risk factors”

listed for the investment contained the following discussion:
 - 5 -

Federal Income Tax Consequences: An investment in the
Units involves material tax risks, some of which are set
forth below. Each prospective investor is urged to consult
his own tax advisor with respect to complex federal (as well
as state and local) income tax consequences of such an
investment.
* * * * * * *

(c) Validity of Tax Deductions and Allocations.

The partnership will claim all deductions for
federal income tax purposes which it reasonably
believes it is entitled to claim. There can be no
assurance that these deductions may not be contested or
disallowed by the Service * * * . Such areas of
challenge may include * * * expenditures under the R &
D contract * * * .

* * * * * * *

The Service is presently vigorously auditing
partnerships, scrutinizing in particular certain
claimed tax deductions. * * * Counsel’s opinion is
rendered as of the date hereof based upon the
representations of the General Partner * * * . Counsel
shall not review the Partnership’s tax returns. * * *

(d) Deductibility of Research and Experimental
Expenditures.

The General Partner anticipates that a substantial
portion of the capital contributions of the Limited
Partners to the Partnership will be used for research
and experimental expenditures of the type generally
covered by Section 174 of the Code. However,
prospective investors should be aware that there is
little published authority dealing with the specific
types of expenditures which will qualify as research or
experimental expenditures within the meaning of Section
174, and most of the expenditures contemplated by the
Partnership have not been the subject of any prior
cases or administrative determinations.

There are various theories under which such deductions
might be disallowed or required to be deferred. * * * No
ruling by the Service has been or will be sought regarding
deductibility of the proposed expenditures under Section 174
of the Code.
 - 6 -

A section entitled “Tax Aspects” contains the following

information concerning a legal opinion from outside counsel

obtained by the general partner:

The General Partner has received an opinion of counsel
concerning certain of the tax aspects of this investment.
The opinion * * * is available from the General Partner.
Since the tax applications of an investment in the
Partnership vary for each investor, neither the Partnership,
the General Partner, nor counsel assumes any responsibility
for tax consequences of this transaction to an investor.
* * *The respective investors are urged to consult their own
tax advisers with respect to the tax implications of this
investment. * * * Counsel has concluded:

* * * * * * *

(4) * * * The deductions which may be available to
the partnership under Section 174 (Research and
Development) of the Internal Revenue Code are dependent
upon the acceptance by the Internal Revenue Service or
the courts of the Partnership’s characterization of the
transaction as a payment of research and development
fees to the Contractor.

Finally, the investor subscription agreement required a

subscriber upon purchase of an interest to aver that:

He understands that an investment in the Partnership is
speculative and involves a high degree of risk, there is no
assurance as to the tax treatment of items of Partnership
income, gain, loss, deductions of credit and it may not be
possible for him to liquidate his investment in the
Partnership.

Petitioner purchased five units in the partnership for cash

of $5,000 and a promissory note of $9,500. Petitioner made this

investment in 1982 prior to the formation of the partnership on

December 20, 1982. On their 1982 joint Federal income tax

return, petitioners claimed a loss of $13,847 with respect to
 - 7 -

this investment, in accordance with the Schedule K-1, Partner’s

Share of Income, Credits, Deductions, etc., which the partnership

had provided to petitioner. Petitioners did not consult with any

attorney or accountant with tax expertise prior to filing their

return and they filed the return without the assistance of a

return preparer, relying on the return preparation instructions

provided by the Internal Revenue Service.

As the result of partnership level proceedings concerning

Jojoba Research Partners, this Court ultimately entered a

decision disallowing in full the partnership’s claimed ordinary

loss of $678,439 for taxable year 1982. This decision was based

upon a stipulation by the partnership and the Commissioner to be

bound by the outcome of the case in which this Court rendered our

opinion in Utah Jojoba I Research v. Commissioner, T.C. Memo.

1998-6. In that case, we found that the Utah Jojoba I Research

partnership (“Utah I”) was not entitled to a section 174(a)

research or experimental expense deduction (or a section 162(a)

trade or business expense deduction) because (a) Utah I did not

directly or indirectly engage in research or experimentation, and

(b) the activities of Utah I did not constitute a trade or

business, nor was there a realistic prospect of Utah I ever

entering into a trade or business. Id.

Following the entry of the decision concerning the

partnership, respondent adjusted petitioners’ 1982 return by
 - 8 -

disallowing their claimed share of the partnership loss, $13,847.

Respondent determined that the amount of tax required to be shown

on petitioners’ return was $16,137 and that there was a

deficiency of $5,124 for that year.

In the statutory notice of deficiency which provides the

basis for our jurisdiction in this case, respondent determined

that petitioners are liable for additions to tax for 1982 under

section 6653(a)(1) and (2) in the respective amounts of $256 and

50 percent of the interest due on the $5,124 deficiency. Prior

to issuing the notice of deficiency, respondent did not make

inquiries of petitioners concerning the proposed adjustments, nor

did respondent provide petitioners with an opportunity for an

administrative appeal.

In his answer, respondent has asserted that petitioners also

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

substantial understatement of tax.

Discussion

Burden of Proof

Prior to trial, petitioners moved to shift the burden of

production in this case pursuant to section 7491(c). The motion

was denied. In their brief, petitioners argue that respondent

bears the burden of proof with respect to the negligence issue

because respondent’s determination in the notice of deficiency

was determined “in an arbitrary manner.” We need not revisit the
 - 9 -

statutory argument or address the assertion that respondent’s

determination was arbitrary: Who bears the burden of proof is

immaterial because the record is sufficient to decide this case

on the basis of a preponderance of the evidence. See, e.g.,

Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 210 n.16

(1998). We note, however, that respondent does bear the burden

of proof with respect to the substantial understatement addition

to tax because it was asserted for the first time in his answer.

Rule 142(a).

Negligence

Section 6653(a)(1) imposes an addition to tax equal to 5

percent of the underpayment of tax if any part of the

underpayment is attributable to negligence or intentional

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

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

due on the portion of the underpayment attributable to negligence

or intentional disregard of rules or regulations. Negligence is

defined to include “any failure to reasonably comply with the Tax

Code, including the lack of due care or the failure to do what a

reasonable or ordinarily prudent person would do under the

circumstances.” Merino v. Commissioner, 196 F.3d 147, 154 (3d

Cir. 1999) (quoting Heasley v. Commissioner, 902 F.2d 380, 383

(5th Cir. 1990)), affg. T.C. Memo. 1997-385.
 - 10 -

The private placement memorandum contained numerous warnings

regarding the tax risks involved with the investment. After

making the investment regardless of these risks, petitioners

claimed a $13,847 ordinary loss for 1982, despite the fact that

petitioner had only recently invested just $5,000 in cash in the

partnership. This disproportionate and accelerated loss--along

with the resulting substantial tax savings--should have been

further warning to petitioners for the need to obtain outside

advice regarding the propriety of the deduction. Despite these

warnings, petitioners did not seek such advice or conduct any

other type of inquiry into the propriety of the deduction.

Instead, when it came time to complete their tax return, they

relied on the Schedule K-1 given to them by the partnership in

claiming a loss in an amount nearly triple that of their cash

investment.2 Taking into account petitioner’s extensive

background and ability to judge the merits of the investment as a

whole, it was negligent to have claimed this loss as a deduction

based only on the Schedule K-1 and without further inquiry.

2
Petitioners argue that the instructions for Schedules K-1
provided by the Internal Revenue Service required them to report
the loss. The instructions state that the individual taxpayer
“must treat partnership items * * * consistent with the way the
partnership treated the items on its filed return.” The
instructions have further provisions dealing with errors on
Schedules K-1 as well as with the filing of statements to explain
inconsistencies between the partnership’s return and the
taxpayer’s return. We find to be unreasonable any belief by
petitioners that they were required by law to mechanically deduct
a loss which was improper.
 - 11 -

Petitioners argue that they were not negligent under the

standard set forth by the Fifth Circuit Court of Appeals in

Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), revg. T.C.

Memo. 1988-408. In Heasley, the court found that the taxpayers--

who were moderate-income, blue-collar investors with little prior

investment experience--were to be held to a lower standard of due

care when evaluating whether they were negligent in making an

investment. Petitioners do not merit such a lower standard. On

the contrary, petitioner’s excellent business education and

extensive financial experience requires a higher standard. See

Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 740 (1973);

Harvey v. Commissioner, T.C. Memo. 2001-16. Consequently,

Heasley is not applicable to the case at hand.3

Petitioners cite several cases4 for the proposition that

taxpayers cannot be negligent where the relevant legal issue was

“unsettled” or “reasonably debatable”. Petitioners, however, did

not receive substantive advice concerning the deduction from

anyone independent of the investment, nor did they conduct their

own investigation into the propriety of the deduction. Indeed,

3
Likewise inapplicable is this Court’s opinion in Dyckman v.
Commissioner, T.C. Memo. 1999-79, to which petitioners cite,
regarding the standard to be applied for taxpayers with a
“complete lack of sophistication in investment matters.”
4
Everson v. United States, 108 F.3d 234 (9th Cir. 1997);
Foster v. Commissioner, 756 F.2d 1430 (9th Cir. 1985), affg. in
part and vacating in part 80 T.C. 34 (1983); Hummer v.
Commissioner, T.C. Memo. 1988-528.
 - 12 -

there is no indication that petitioners ever were aware of the

nature of the purportedly uncertain legal issues involved.

Petitioners may not rely upon a “lack of warning” as a defense to

negligence where no reasonable investigation was ever made, and

where they were repeatedly warned of the relevant risks in the

private placement memorandum. Christensen v. Commissioner, T.C.

Memo. 2001-185; Robnett v. Commissioner, T.C. Memo. 2001-17.

Finally, petitioners argue that they were not negligent

because they relied on advice contained in the legal opinion

referenced in the private placement memorandum.5 Reasonable

reliance on professional advice may be a defense to the

negligence additions to tax. 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). The advice must be from competent and

independent parties, not from the promoters of the investment.

LaVerne v. Commissioner, 94 T.C. 637, 652 (1990), affd. without

published opinion sub nom. Cowles v. Commissioner, 949 F.2d 401

(10th Cir. 1991), affd. without published opinion 956 F.2d 274

(9th Cir. 1992); Rybak v. Commissioner, 91 T.C. 524, 565 (1988).

According to the private placement memorandum’s summary of

the letter upon which petitioners claim reliance, the letter

5
No copy of the opinion letter appears in the record, and
petitioners have not established that they ever received such a
letter.
 - 13 -

stated only the following as counsel’s opinion concerning a

section 174 deduction:

The deductions which may be available to the partnership
under Section 174 (Research and Development) of the Internal
Revenue Code are dependent upon the acceptance by the
Internal Revenue Service or the courts of the Partnership’s
characterization of the transaction as a payment of research
and development fees to the Contractor.

It appears that counsel in fact expressed no opinion concerning

the propriety of the deduction, but instead merely stated that

the partnership would take the deduction. Although it may have

been reasonable if petitioners had overlooked certain minor

details in the summary of the letter, petitioners should have

been alerted to the importance of this claimed deduction: The

memorandum clearly stated that approximately 95 percent of the

capital contributed to the partnership would be immediately

expended under the research and development contracts. Among the

various cautionary statements in the memorandum was a discussion

concerning the risks involved in the partnership’s claiming a

deduction with respect to this expense, and the memorandum also

specifically stated that no ruling would be requested by the

partnership from the Internal Revenue Service regarding this

issue.

As support for a reliance defense, petitioners cite the

unpublished opinion of the Court of Appeals for the Ninth Circuit

in Balboa Energy Fund 1981 v. Commissioner, 85 F.3d 634 (9th Cir.

1996), affg. in part and revg. in part sub nom. without published
 - 14 -

opinion Osterhout v. Commissioner, T.C. Memo. 1993-251. In that

case, the court found that it was reasonable for the taxpayers to

have relied upon a tax opinion contained in a placement

memorandum, stating: “Absent some evidence that would tell a

prospective investor that the opinion of a reputable CPA or law

firm should be suspect, we find such reliance to be reasonable

under the circumstances.” Id. Because petitioners’ purported

reliance does not even rest upon an expressed opinion concerning

a critical issue, Balboa Energy Fund 1981 is inapposite to the

present case. Furthermore, considering petitioner’s extensive

experience and the numerous statements found in the private

placement memorandum advising petitioners to consult outside

counsel, any reliance by petitioners on the opinion letter would

nevertheless have been unreasonable under the circumstances of

this case.

We sustain respondent’s determination that petitioners are

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

negligence.

Substantial Understatement

As a preliminary matter, petitioners argue that respondent’s

assertion of the substantial understatement addition to tax is

not timely. However, the parties agree--and the record supports

the finding--that the notice of deficiency was issued prior to

the running of the applicable period of limitations. See sec.
 - 15 -

6229(a), (d). Once this Court has jurisdiction pursuant to a

timely issued notice of deficiency, our jurisdiction allows us to

redetermine the correct amount of the deficiency and any

additions to tax--even in an amount greater than that determined

in the notice of deficiency--so long as the Secretary asserts a

claim for the increase at or before the hearing of the case.

Secs. 6213(a), 6214(a). Because respondent asserted a claim for

the increased amount of the section 6661(a) addition to tax prior

to trial, this Court has jurisdiction to redetermine the correct

amount thereof. Sec. 6214(a).

Section 6661(a), as amended by the Omnibus Budget

Reconciliation Act of 1986, Pub. L. 99-509, sec. 8002, 100 Stat.

1951, provides for an addition to tax of 25 percent of the amount

of any underpayment attributable to a substantial understatement

of income tax for the taxable year. A substantial understatement

of income tax exists if the amount of the understatement exceeds

the greater of 10 percent of the tax required to be shown on the

return, or $5,000. Sec. 6661(b)(1)(A). Generally, the amount of

an understatement is reduced by the portion of the understatement

which the taxpayer shows is attributable to either (1) the tax

treatment of any item 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. Sec.

6661(b)(2)(B). If an understatement is attributable to a tax
 - 16 -

shelter item, however, different standards apply. First, in

addition to showing the existence of substantial authority, a

taxpayer must show that he reasonably believed that the tax

treatment claimed was more likely than not proper. 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).6

The understatement of tax of $5,124 on petitioners’ return

is greater than $5,000 and is greater than 10 percent of the tax

required to be shown on the return, or $1,614. Consequently, it

is a substantial understatement of tax. Sec. 6661(b)(1)(A).

Petitioners first argue that there was substantial authority

for claiming the loss. Substantial authority exists when “the

weight of authorities supporting the treatment is substantial in

relation to the weight of the authorities supporting contrary

positions.” Sec. 1.6661-3(b)(1), Income Tax Regs. Petitioners

argue that at the time they claimed the loss no authority existed

indicating that deducting the loss was improper. Lack of

authority, however, necessarily cannot provide the substantial

authority required under the statute and regulations. See, e.g.,

Hunt v. Commissioner, T.C. Memo. 2001-15; Robnett v.

Commissioner, T.C. Memo. 2001-17. Petitioners also point to the

6
As a result of our findings, discussed below, we need not
decide whether the tax shelter provisions are applicable in this
case.
 - 17 -

tax opinion letter referenced in the private placement

memorandum. However, the memorandum, and presumably the letter

itself, did not refer to any specific authority for deducting the

loss based on the research and experimental expense deduction.

Adequate disclosure, another defense to the substantial

understatement addition to tax, may be made either in a statement

attached to the return or on the return itself if in accordance

with the requirements of Rev. Proc. 83-21, 1983-1 C.B. 680. Sec.

1.6661-4(b), (c), Income Tax Regs. Petitioners did not attach

such a statement to their 1982 return. Rev. Proc. 83-21,

applicable to tax returns filed in 1983, lists information which

is deemed sufficient disclosure with respect to certain items,

none of which are involved in this case. If disclosure is not

made in compliance with the regulations or the revenue procedure,

adequate disclosure on the return may still be satisfied if

sufficient information is provided to enable the Commissioner to

identify the potential controversy involved. Schirmer v.

Commissioner, 89 T.C. 277, 285-286 (1987). Merely claiming the

loss without further explanation, as petitioners did in this

case, was not sufficient to alert respondent to the controversial

section 174 deduction of which the partnership loss consisted.

See, e.g., Hunt v. Commissioner, supra; Robnett v. Commissioner,

supra.
 - 18 -

Finally, petitioners argue that they acted with reasonable

cause and in good faith in claiming the loss. Section 6661(c)

provides the Secretary with the discretion to waive the section

6661(a) addition to tax if the taxpayer shows he acted with

reasonable cause and in good faith. Generally, we review the

Secretary’s failure to waive the addition to tax for abuse of

discretion. Martin Ice Cream Co. v. Commissioner, 110 T.C. 189,

235 (1998). The most important factor in determining whether a

taxpayer acted with reasonable cause and in good faith generally

is “the extent of the taxpayer’s effort to assess the taxpayer’s

proper tax liability under the law.” Sec. 1.6661-6(b), Income

Tax Regs. For the same reasons we found petitioners to be

negligent in claiming the reported loss as a deduction, we find

petitioners also lacked reasonable cause for doing so.

Consequently, petitioners are not entitled to a waiver under

section 6661(c), and they are liable for the addition to tax

under section 6661(a) for a substantial understatement of tax.7

7
Respondent stated in his answer that this addition to tax
was in the amount of $512.40. As respondent argued in his pre-
trial memorandum and orally at trial, this amount is incorrect.
The correct computation under the provisions of section 6661(a)
results in an addition to tax of $1,281.
 - 19 -

To reflect the foregoing,

Decision will be entered for

respondent for the increased

additions to tax.