McConnell v. Comm'r

T.C. Memo. 2008-167

UNITED STATES TAX COURT

NORMAN J. AND PAULA A. MCCONNELL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 13063-06. Filed July 14, 2008.

R determined that Ps are liable for additions to
tax pursuant to secs. 6653(a)(1) and (2) and 6661(a),
I.R.C., for their 1983 taxable year.

Held: Ps are liable for the additions to tax.

Anthony V. Diosdi and Anita Steburg, for petitioners.

Andrew R. Moore, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHERRY, Judge: This case is before the Court on a petition

for redetermination of an affected items notice of deficiency in
 - 2 -

which respondent determined that petitioners are liable for the

following additions to tax:

Additions to Tax
Year Sec. 6653(a)(1) Sec. 6653(a)(2) Sec. 6661(a)
1
1983 $855.70 $4,148.25
1
50 percent of the interest due on a deficiency of
$17,114.

Unless otherwise indicated, section references are to the

Internal Revenue Code, as amended and in effect for the taxable

year at issue. The issues for decision are whether petitioners

are liable for each of the additions to tax.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts and the accompanying exhibits are hereby incorporated by

reference into our findings. At the time they filed their

petition, petitioners resided in California.

Petitioner Norman J. McConnell (Mr. McConnell) has a

master’s degree in business from the University of San Francisco.

In 1983 he was vice president and sales manager of California

Printing, a printing company in San Francisco, California.

That same year petitioners’ neighbor and family friend, Army

General Paul Vallely,1 advised petitioners to invest in a limited

partnership called Contra Costa Jojoba Research Partners (CCJRP),

1
General Vallely’s name is misspelled “Vallily” in the trial
transcript and in petitioners’ brief.
 - 3 -

which was involved in the growing of jojoba beans. General

Vallely informed petitioners that there was a small tax benefit

associated with an investment in CCJRP. During 1983 petitioners

acquired 20 units in CCJRP for $55,000, or $2,750 per unit. They

paid $22,000 upon closing and signed a promissory note for the

remaining $33,000.

Petitioners were provided copies of a “Certificate and

Agreement of Limited Partnership”, “Research and Development

Agreement”, and “License Agreement” pertaining to their interest

in CCJRP. They did not provide those documents to an attorney or

accountant for review. In addition to their investment in CCJRP,

petitioners invested in stocks, mutual funds, options, and other

partnerships.

In 1983, the taxable year at issue, CCJRP filed with the

Internal Revenue Service and provided to petitioners a Schedule

K-1, Partner’s Share of Income, Credits, Deductions, Etc., in

which CCJRP allocated to petitioners an ordinary loss of $50,000.

In turn, petitioners on their 1983 joint Form 1040, U.S.

Individual Income Tax Return, claimed an ordinary loss relating

to their interest in CCJRP of $50,000 as a deduction in computing

their total income. Ed Klein (Mr. Klein), a professional tax
 - 4 -

preparer, prepared petitioners’ 1983 joint Federal income tax

return.2

On May 30, 1989, respondent sent petitioners a notice of

final partnership administrative adjustment (FPAA) issued to

CCJRP for the 1983 taxable year. On July 13, 1989, a petition in

the name of CCJRP, Charles B. Toepfer, Tax Matters Partner, was

filed with the Court at docket No. 17323-89. On January 28,

1994, the parties filed a stipulation to be bound by the result

in Utah Jojoba I Research v. Commissioner (Utah Jojoba I), a case

docketed at No. 7619-90.

The Court issued an opinion in Utah Jojoba I on January 5,

1998, in which it held that the partnership at issue in that case

was not entitled to deduct its losses for research and

development expenditures. See Utah Jojoba I Research v.

Commissioner, T.C. Memo. 1998-6. On April 11, 2005, the Court

entered a decision against CCJRP upholding as correct the

partnership item adjustments as determined and set forth in the

FPAA for, among other years, CCJRP’s 1983 taxable year. That

decision was not appealed.

On April 10, 2006, respondent issued the aforementioned

notice of deficiency. Petitioners then filed a timely petition

2
Ed Klein’s last name is misspelled “Klien” throughout
petitioner’s brief and reply brief.
 - 5 -

with this Court. A trial was held on May 16, 2007, in San

Francisco, California.

OPINION

I. Statute of Limitations

In general, section 6501(a) provides that the amount of any

tax imposed shall be assessed within 3 years after the return was

filed. However, with respect to partnership and affected items,

section 6229(a) provides that the period for assessing tax shall

not expire before the date which is 3 years after the later of:

(1) The date on which the partnership return for such taxable

year was filed, or (2) the last day for filing such return for

such year.3 Section 6501(a) is a true statute of limitations;

section 6229(a) is not. See Rhone-Poulenc Surfactants &

Specialties, L.P. v. Commissioner, 114 T.C. 533, 542 (2000)

(“Section 6229 provides a minimum period of time for the

assessment of any tax attributable to partnership items (or

affected items) notwithstanding the period provided for in

section 6501, which is ordinarily the maximum period for the

assessment of any tax.”); see also G-5 Inv. Pship. v.

Commissioner, 128 T.C. 186, 189-190 (2007) (“Section 6229 is not

a stand-alone statute of limitations but can extend the section

3
The additions to tax at issue are affected items, as
defined in sec. 6231(a)(5), that require partner-level
determinations but are subject to sec. 6229(a). See Ruggiero v.
Commissioner, T.C. Memo. 2001-162.
 - 6 -

6501 period of limitations with respect to the tax attributable

to partnership items or affected items.”).

Section 6229(d) provides that the mailing of an FPAA

suspends the running of both 3-year periods--the section 6501(a)

period and the section 6229(a) period. See Rhone-Poulenc

Surfactants & Specialties, L.P. v. Commissioner, supra at 542

(holding that “section 6229 extends the section 6501 period with

respect to tax attributable to partnership items or affected

items”); id. at 555 (“Interpreting ‘the period specified in

subsection (a)’ in section 6229(d) as referring only to the

minimum period for making assessments would produce additional

anomalous results.”).4 The suspension is for the period during

4
To the best of our knowledge, the Court of Appeals for the
Ninth Circuit, to which an appeal lies in this case absent
stipulation to the contrary, has not ruled on this issue. The
two Courts of Appeals that have considered this issue--the Court
of Appeals for the D.C. Circuit and the Court of Appeals for the
Federal Circuit--have endorsed our decision in Rhone-Poulenc
Surfactants & Specialties, L.P. v. Commissioner, 114 T.C. 533
(2000). See AD Global Fund, LLC v. United States, 481 F.3d 1351,
1354 (Fed. Cir. 2007) (“Reading § 6229(a) together with § 6501,
we conclude that § 6229(a) unambiguously sets forth a minimum
period for assessments of partnership items that may extend the
regular statute of limitations in § 6501.”); Andantech L.L.C. v.
Commissioner, 331 F.3d 972, 976 (D.C. Cir. 2003) (“Applying those
standards to the record before us, we first affirm the Tax
Court’s interpretation of two sections of the Internal Revenue
Code, 26 U.S.C. §§ 6501; 6229(a), to allow for an extension of
the period in which the IRS may properly assess items
attributable to a partnership.”), affg. in part and remanding in
part T.C. Memo. 2002-97; id. at 977 (“The language of § 6501
plainly refers to all the assessments made pursuant to the
chapter, and specifically notes that § 6229 may be used to extend
the period in case of partnership items.”).
 - 7 -

which an action for judicial review of the FPAA may be brought

(and, if an action is brought, until the decision of the court

has become final) and for 1 year thereafter. See sec. 6229(d);

Ruggiero v. Commissioner, T.C. Memo. 2001-162. A statute of

limitations defense relating to the issuance of an FPAA must be

raised during the partnership-level proceeding and cannot be

raised at the partner-level proceeding. See Crowell v.

Commissioner, 102 T.C. 683, 693 (1994); see also Davenport

Recycling Associates v. Commissioner, 220 F.3d 1255, 1260-1261

(11th Cir. 2000), affg. T.C. Memo. 1998-347; Chimblo v.

Commissioner, 177 F.3d 119, 125-126 (2d Cir. 1999), affg. T.C.

Memo. 1997-535; Kaplan v. United States, 133 F.3d 469, 473 (7th

Cir. 1998).

Petitioners argue that because respondent issued the FPAA

more than 3 years after the date on which CCJRP’s 1983

partnership return was due to be filed, there can be no

proceedings to adjust petitioners’ income or losses reported on

their 1983 joint Federal income tax return. Petitioners rely

primarily on dissenting opinions in Rhone-Poulenc Surfactants &

Specialties, L.P. v. Commissioner, supra, for the proposition

that section 6229(d) should not suspend the section 6501

limitations period. Respondent cites Crowell v. Commissioner,

supra, and asserts that petitioners cannot raise the issue of
 - 8 -

whether the FPAA was issued within the limitations period in this

partner-level proceeding.

We agree with respondent that whether the FPAA was issued to

CCJRP within the applicable period in section 6229(a) is not now

at issue. Petitioners conveniently ignore that a statute of

limitations defense predicated on facts relating to the issuance

of an FPAA must be raised at the partnership level.5 See Crowell

v. Commissioner, supra at 693 (“We conclude that the statute of

limitations defense as it pertains to the FPAA for 1983 should

have been prosecuted within the context of a partnership level

proceeding and is not properly before us in this proceeding.”);

see also Davenport Recycling Associates v. Commissioner, supra at

1260-1261; Chimblo v. Commissioner, supra at 125-126; Kaplan v.

United States, supra at 473. Consequently, we look only to

whether the notice of deficiency issued to petitioners in April

2006 was timely.

In April 2005 the Court entered a decision against CCJRP

upholding as correct the partnership item adjustments as

determined and set forth in the FPAA for CCJRP’s 1983, 1984, and

1985 taxable years. That decision was not appealed. Because a

5
Rhone-Poulenc Surfactants & Specialties, L.P. v.
Commissioner, supra, involved a partnership-level proceeding.
Thus, even assuming arguendo that the Court could be persuaded to
overrule that Opinion and adopt the dissenters’ position in that
case, this case, which involves a partner-level proceeding, would
be an improper vehicle for doing so.
 - 9 -

decision becomes final 90 days after it is entered if it is not

appealed, the Court’s decision became final in July 2005. See

secs. 7481(a)(1), 7483. Because the limitations period in this

case expired in July 2006, 1 year and 90 days after the Court’s

April 2005 decision was entered, the notice of deficiency mailed

to petitioners in April 2006 was timely.

II. Additions to Tax Under Section 6653(a)(1) and (2)

Section 6653(a)(1) and (2) imposes additions to tax if any

part of any underpayment of tax is due to negligence or disregard

of rules and regulations.6 For the purposes of this statute,

negligence is defined as a “‘lack of due care or failure to do

what a reasonable and ordinarily prudent person would do under

the circumstances.’” Neely v. Commissioner, 85 T.C. 934, 947

(1985) (quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th

Cir. 1967), affg. in part and remanding in part 43 T.C. 168

(1964) and T.C. Memo. 1964-299).

The Court of Appeals for the Ninth Circuit, to which an

appeal would ordinarily lie in this case, has held that a

determination as to negligence for purposes of sections 6653(a)

6
Those additions to tax are for: (1) An amount equal to 5
percent of the underpayment and (2) an amount equal to 50 percent
of the interest payable under sec. 6601 with respect to the
portion of the underpayment which is attributable to negligence.
That interest on which the penalty is computed is the interest
for the period beginning on the last date prescribed by law for
payment of such underpayment (without consideration of any
extension) and ending on the date of the assessment of the tax.
Sec. 6653(a)(1) and (2).
 - 10 -

and 6661(a) in a case involving a deduction for loss that results

from an investment “depends upon both the legitimacy of the

underlying investment, and due care in the claiming of the

deduction.” Sacks v. Commissioner, 82 F.3d 918, 920 (9th Cir.

1996), affg. T.C. Memo. 1994-217.

Petitioners contend that they were not negligent because

they were unfamiliar with tax law, made full disclosure to their

tax preparer, Mr. Klein, and exercised ordinary business care and

prudence. Regarding petitioners’ investment in CCJRP, respondent

argues that petitioners were not reasonable because they:

(1) Relied on General Vallely, a promoter of CCJRP, who had no

apparent expertise in jojoba farming, (2) did not undertake a

meaningful investigation of jojoba farming before investing in

CCJRP, and (3) sought no independent advice before investing in

CCJRP. With respect to petitioners’ asserted reliance on Mr.

Klein, respondent argues that the record is devoid of evidence

that Mr. Klein was provided with the agreements pertaining to

petitioners’ investment in CCJRP or that he conducted any

research into the nature of that investment.

As explained below, although reasonable reliance on

professional advice may serve as a defense to the additions to

tax for negligence, see United States v. Boyle, 469 U.S. 241, 251

(1985), petitioners have not demonstrated that they acted with
 - 11 -

due care with respect to their investment in CCJRP and subsequent

deduction claimed in 1983 for a loss relating to that investment.

CCJRP’s underlying activity lacked legitimacy, as we decided

in Utah Jojoba I. See Utah Jojoba I Research v. Commissioner,

T.C. Memo. 1998-6 (“we hold that Utah I was not actively involved

in a trade or business and also lacked a realistic prospect of

entering a trade or business”); see also Welch v. Commissioner,

T.C. Memo. 2002-39. Petitioners, at least one of whom was a

well-educated individual and a sophisticated investor and neither

of whom had any background or expertise in jojoba farming,

invested in CCJRP solely upon the advice of General Vallely, a

promoter of CCJRP, without first conducting their own research or

seeking independent advice regarding the risks and tax

implications of that investment.7 See LaVerne v. Commissioner,

94 T.C. 637, 652 (1990) (“The failure of petitioners to look

beyond the promotional materials supplied by the salespeople or

to consult independent advisors on so complex a matter as the

proposed investments in the Barbados partnerships is unreasonable

and is not in keeping with the standard of the ordinarily prudent

person.”), affd. without published opinion 956 F.2d 274 (9th Cir.

7
At trial Mr. McConnell testified that in 1983 General
Vallely was a “retired army general”. The Court believes that
General Vallely retired from the U.S. Army in 1991 as a Major
General. In any event, General Vallely had a military
background. There is no evidence that he was qualified to
provide investment advice.
 - 12 -

1992), affd. without published opinion sub nom. Cowles v.

Commissioner, 949 F.2d 401 (10th Cir. 1991).8

Nor does the fact that a professional tax preparer prepared

petitioners’ 1983 joint Federal income tax return shield them

from liability for the section 6653(a)(1) and (2) additions to

tax. There is no evidence in the record that Mr. Klein was a

competent tax professional or that Mr. Klein did anything more

than transfer the losses from the Schedule K-1 provided by CCJRP

onto petitioners’ return. Moreover, Mr. McConnell expected a tax

benefit associated with his investment in CCJRP not on the advice

of a tax professional but on the advice of General Vallely, who

had no demonstrated tax expertise.

In the end, the record is devoid of evidence that a fully

informed, competent tax professional advised petitioners

8
We note that this case is distinguishable from Kantor v.
Commissioner, 998 F.2d 1514 (9th Cir. 1993), affg. in part and
revg. in part T.C. Memo. 1990-380. In Kantor the Court of
Appeals for the Ninth Circuit reversed this Court’s affirmance of
the imposition of a sec. 6653(a) addition to tax on the basis
that the experience and involvement of the general partner and
the lack of warning signs could reasonably have led investors to
believe that they were entitled to deductions in light of the
undeveloped state of the law regarding sec. 174. The Court of
Appeals explained that the Supreme Court’s decision in Snow v.
Commissioner, 416 U.S. 500 (1974), left unclear the extent to
which research must be “in connection with” a trade or business
for purposes of qualifying for an immediate deduction under sec.
174. See, e.g., Nilsen v. Commissioner, T.C. Memo. 2001-163.
Unlike the partnership in Kantor, CCJRP was neither engaged in a
trade or business nor conducting research and development, either
directly or indirectly. See Utah Jojoba I Research v.
Commissioner, T.C. Memo. 1998-6.
 - 13 -

regarding the propriety of their claimed $50,000 deduction in

1983 for losses relating to their investment in CCJRP. That is

particularly troublesome considering that petitioners invested

$22,000 in CCJRP in 1983 and that same year claimed a $50,000

deduction for a loss relating to that investment.9 Under the

circumstances, petitioners acted with a lack of due care in

claiming as a deduction on their 1983 joint Federal income tax

return an ordinary loss of $50,000 relating to their interest in

CCJRP. Consequently, petitioners are liable for the section

6653(a)(1) and (2) additions to tax.

III. Addition to Tax Under Section 6661(a)

Section 6661(a) provides for an addition to tax of 25

percent of the amount of any underpayment attributable to a

substantial understatement.10 There is a “substantial

understatement” of income tax for any taxable year where the

amount of the understatement exceeds the greater of: (1) 10

percent of the tax required to be shown on the return for the

taxable year or (2) $5,000. Sec. 6661(b)(1). However, the

amount of the understatement is reduced to the extent

9
Although petitioners also signed a promissory note for
$33,000, there is no evidence as to whether they ever made
payments on that note.
10
In 1983 sec. 6661(a) provided for a 10-percent addition to
tax. The amount of the sec. 6661(a) addition to tax was later
increased to 25 percent for additions to tax assessed after Oct.
21, 1986. Omnibus Budget Reconciliation Act of 1986, Pub. L.
99-509, sec. 8002, 100 Stat. 1951.
 - 14 -

attributable to an item: (1) For which there is or was

substantial authority for the taxpayer’s treatment thereof or (2)

with respect to which the relevant facts were adequately

disclosed on the taxpayer’s return or an attached statement. See

sec. 6661(b)(2)(B).11

Petitioners raise a number of arguments regarding the

section 6661(a) addition to tax. First, they argue that applying

a 25-percent rate versus the 10-percent rate that was in the

statute in 1983 violates the Due Process Clause of the Fifth

Amendment to the Constitution.12 Next, they contend that

respondent’s failure to waive the section 6661(a) addition to tax

constitutes an abuse of discretion in light of the fact that

petitioners were motivated to invest in CCJRP by the hysteria

surrounding alternative energy during the energy crisis of the

11
Where the understatement at issue is attributable to a tax
shelter, adequate disclosure is inconsequential; and in addition
to substantial authority, the taxpayer must demonstrate a
reasonable belief that the tax treatment claimed was more likely
than not proper. Sec. 6661(b)(2)(C). Because the result would
be the same whether or not we label CCJRP a tax shelter, we will
analyze petitioners’ entitlement to a reduction of the sec.
6661(a) addition to tax as though CCJRP were not a tax shelter.
12
Although petitioners acknowledge the Court of Appeals for
the Ninth Circuit’s decision in Licari v. Commissioner, 946 F.2d
690 (9th Cir. 1991), affg. T.C. Memo. 1990-4, they contend that
this case is distinguishable from Licari because the facts and
circumstances of this case make the retroactive application of
the increased rate “so harsh and oppressive as to transgress
constitutional limitations.” They rely primarily on the fact
that more than 22 years passed between the filing of their 1983
tax return and the issuance of the notice of deficiency.
 - 15 -

late 1970s and early 1980s. Finally, they assert that they are

not liable for the section 6661(a) addition to tax because in

investing in CCJRP and claiming the subsequent deduction for a

loss related to that investment, they were acting in reasonable

reliance on the advice of General Vallely and Mr. Klein.

Responding to petitioners’ first argument, respondent

contends that the Court of Appeals for the Ninth Circuit, in

Licari v. Commissioner, 946 F.2d 690 (9th Cir. 1991), affg. T.C.

Memo. 1990-4, found that the retroactive increase of the section

6661(a) addition to tax rate does not violate the Due Process

Clause. In response to petitioners’ waiver argument, respondent

asserts that there is no evidence that petitioners ever requested

a waiver and that the Court therefore has no basis to review

respondent’s determination for abuse of discretion. Finally,

with respect to petitioners’ argument regarding reasonable

reliance, respondent asserts that any such claim is negated by

petitioners’ admitted failure to supply Mr. Klein with all of the

documentation relating to their investment in CCJRP. As

explained below, we agree with respondent in all relevant

respects.

The facts underlying the Court of Appeals’ decision in

Licari are not distinguishable from the facts of petitioners’

case in any meaningful way. Petitioners place great significance

on the fact that the April 2006 notice of deficiency was issued
 - 16 -

to them more than 22 years after they filed their 1983 tax

return. However, the long time between the filing of their 1983

tax return and the issuance of that notice of deficiency bears no

relationship to the period of retroactivity of the increased

section 6661(a) addition to tax rate now at issue. That is

because the retroactivity of the increased section 6661(a)

addition to tax is measured from when the change in law occurred,

not from when the notice of deficiency was issued. Section

6661(a) was amended in 1986, making it retroactive for 3 years,

not 22 years, in petitioners’ case. Because the earliest taxable

year at issue in Licari was 1982, the period of retroactivity in

this case, which involves petitioners’ 1983 taxable year, is even

shorter than the period of retroactivity at issue in Licari.

While retroactive changes in tax laws may be inequitable or

represent poor tax policy, we are unpersuaded by petitioners’

constitutional due process contention.

Because petitioners neither have sought nor were denied a

waiver of the section 6661(a) addition to tax, we cannot find

that respondent abused his discretion in failing to waive the

addition to tax. See Dugow v. Commissioner, T.C. Memo. 1993-401,

affd. without published opinion 64 F.3d 666 (9th Cir. 1995); see

also McCoy Enters. Inc. v. Commissioner, 58 F.3d 557, 563-564

(10th Cir. 1995), affg. T.C. Memo. 1992-693. Moreover, in light

of our earlier conclusions regarding petitioners’ lack of due
 - 17 -

care with respect to their 1983 deduction, petitioners have not

demonstrated that they satisfied the reasonable cause and good

faith tests necessary to obtain a waiver. See Finazzo v.

Commissioner, T.C. Memo. 2002-56 (“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”.); see also sec. 1.6661-6, Income Tax Regs.

Finally, although section 6661(b)(2)(B) does allow for the

reduction of an understatement under the circumstances described

above, see supra p. 14, petitioners do not meet the criteria for

such a reduction.

Petitioners do not argue that they possessed substantial

authority for claiming the loss on their 1983 Federal income tax

return, and they have not demonstrated that they adequately

disclosed the facts relevant to their investment in CCJRP on

their 1983 Federal income tax return or on an attached statement.

Rev. Proc. 83-21, 1983-1 C.B. 680, 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. Notwithstanding the inapplicability of

Rev. Proc. 83-21, supra, a taxpayer may make adequate disclosure

if the taxpayer provides sufficient information on the return to

enable the Commissioner to identify the potential controversy

involved. See Schirmer v. Commissioner, 89 T.C. 277, 285-286
 - 18 -

(1987). However, “Merely claiming the loss, without further

explanation,” as petitioners did, was insufficient to alert

respondent to the controversial nature of the partnership loss

claimed on the tax return. See Robnett v. Commissioner, T.C.

Memo. 2001-17. In addition, petitioners did not attach any

statement to their 1983 return. As a result, the Court sustains

the imposition of a section 6661(a) addition to tax.

The Court has considered all of petitioners’ contentions,

arguments, requests, and statements. To the extent not discussed

herein, we conclude that they are meritless, moot, or irrelevant.

To reflect the foregoing,

Decision will be entered

for respondent.