Henry v. Commissioner

T.C. Memo. 1997-86

UNITED STATES TAX COURT

JOE E. HENRY AND CAROLYN J. HENRY, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4347-89. Filed February 19, 1997.

Andrew M. Wolov, for petitioners.

David G. Hendricks and Osmun R. Latrobe, for respondent.

MEMORANDUM OPINION

DAWSON, Judge: This case was assigned to Special Trial

Judge Lewis R. Carluzzo pursuant to section 7443A(b)(4) and Rules

180, 181, and 183. All section references are to the Internal

Revenue Code in effect for the years in issue. All Rule

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references are to the Tax Court Rules of Practice and Procedure.

The Court agrees with and adopts the Special Trial Judge's

opinion, which is set forth below.

OPINION OF THE SPECIAL TRIAL JUDGE

CARLUZZO, Special Trial Judge: Respondent determined

deficiencies and additions to tax in petitioners' 1979, 1980,

1981, and 1982 Federal income taxes as follows:

Additions to Tax

Sec. Sec. Sec. Sec.

Year Deficiency 6653(a) 6653(a)(1) 6653(a)(2) 6659

1979 $15,738.00 $ 786.90 --- --- $ 4,721.40

1980 22,950.00 1,147.50 --- --- 6,885.00

1981 12,645.00 --- $ 632.25 1 3,793.50

1982 53,453.70 --- 2,672.69 1 16,036.11

1 50 percent of the interest due on the deficiency.

In addition, respondent determined that interest accruing after

December 31, 1984, on the deficiency for each year would be

calculated in accordance with section 6621(c).

This case is part of the Plastics Recycling group of cases.

For a detailed discussion of the transactions involved in the

Plastics Recycling cases, see Provizer v. Commissioner, T.C.

Memo. 1992-177, affd. without published opinion 996 F.2d 1216

(6th Cir. 1993).

Consistent with the resolution of some of the disputed

issues in Provizer, the parties filed a Stipulation of Settled

Issues concerning the adjustments related to petitioners'

participation in the Plastics Recycling Program. The stipulation

provides:

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1. Petitioners are not entitled to any deductions,

losses, investment credits, business energy investment

credits or any other tax benefits claimed on their tax

returns for the taxable years in issue as a result of

their participation in the Plastics Recycling Program.

2. The petitioners are liable for the additions to tax

pursuant to I.R.C. section 6659 as set forth in the

notice of deficiency.

3. The underpayments in income tax attributable to

petitioners' participation in the Plastics Recycling

Program are substantial underpayments attributable to

tax motivated transactions, subject to the increased

rate of interest established under I.R.C. section

6621(c) as set forth in the notice of deficiency.

The issue remaining for decision is whether petitioners are

liable for the additions to tax for negligence under section

6653(a) for 1979 and 1980 and under section 6653(a)(1) and (2)

for 1981 and 1982.

Background

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

found. At the time of the filing of the petition, petitioners

resided in Tulsa, Oklahoma. References to petitioner are to Joe

E. Henry.

The details of petitioner's educational background have not

been provided. He attended college for at least 1 year and took

some accounting courses. He also took various seminars and

courses relating to his profession at unspecified locations and

times. As of the date of trial, petitioner had been employed in

various capacities in manufacturing industries for over 40 years.

In the 1970's he was employed as the general manager of several

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manufacturing companies and during this period petitioner became

familiar with plastic injection molding machines. In 1975,

petitioner was hired by Ramsey Winch Co. (Ramsey) as the vice

president of operations. At Ramsey, petitioner acquired

expertise in manufacturing winches. He negotiated Ramsey's

acquisition of the Auto Frame Co., and thereafter was employed as

president of both companies. Petitioner continued his employment

with Ramsey at least through the date of trial.

Neither the educational nor employment histories of Carolyn

J. Henry have been placed in the record. The parties stipulated

that she was a "housewife" during 1982.

Petitioners' Federal income tax returns for the years in

issue and presumably the relevant Forms 1045 were prepared by

William L. Storey (Storey). Petitioners have been clients of

Storey, who was a certified public accountant, since the late

1960's. Storey received a bachelor of science degree in Business

Administration with a major in accounting from the University of

Arkansas. Storey retired in 1989 after practicing as a certified

public accountant for 35 years. While in practice, Storey

provided general financial advice to his clients and specialized

in the preparation of Federal income tax returns and financial

statements.

Between 1970 and 1986, Storey occasionally reviewed tax

shelter investments for his clients. In the fall of 1981, Storey

learned about the Sunbelt Group partnership (Sunbelt) after

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contacting Samuel Winer (Winer) in connection with a matter

involving a client. Sunbelt is a limited partnership which

purportedly engaged in licensing Sentinel expanded polyethylene

(EPE) recyclers manufactured by Packaging Industries of Hyannis,

Massachusetts (PI). Winer was an investment banker and financial

consultant with offices in Clearwater, Florida. During his

conversation with Winer, Storey became interested in investing in

Sunbelt and asked Winer to send him an offering memorandum.

Aside from being the general partner of Sunbelt, Winer was also

an investor in the project and the general partner in a number of

other plastics recycling limited partnerships including

Clearwater, Poly Reclamation Associates, Southeast Recovery

Associates, and Esplanade Associates. For his services to

Sunbelt, Winer received $60,000 out of the proceeds of the

Sunbelt private offering.

After receiving the offering memorandum,1 Storey read it

thoroughly twice and read portions of it five times. He

considered the offering memorandum to be well prepared, at least

as compared to others that he had read. Storey was skeptical of

representations made in the offering memorandum regarding cash

flow, revenue projections, and tax benefits. He contacted John

Taggart (Taggart) and Elliot Miller (Miller) regarding the tax

1

The offering memorandum for Sunbelt was not made a part

of the record. Instead, the parties stipulated to the offering

memorandum for Clearwater. We assume that the offering memoranda

for Sunbelt and Clearwater are substantially identical.

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benefits; however, the substance of these conversations is not

disclosed in the record. Taggart and other members of the law

firm of Windels, Marx, Davies and Ives prepared the offering

memorandum, tax opinion, and other legal documents for the

initial Plastics Recycling partnership, Clearwater, and 16 other

Plastics Recycling partnerships, including Sunbelt. Taggart was

the head of the tax department of Windels, Marx, Davies and Ives

and taught tax law as an adjunct professor at New York University

(NYU) Law School. Taggart had previously been employed by the

U.S. Treasury Department and as a full-time faculty member of NYU

Law School. Taggart owned a 6.66-percent interest in a second-

tier Plastics Recycling partnership. Miller was a practicing

attorney who specialized in tax matters. Miller was employed as

corporate counsel to PI for 29 years and at all times relevant to

this case. Storey tentatively decided to invest in Sunbelt for

various reasons, including its "attractive" tax benefits.

In December 1981, Storey went to Hyannis, Massachusetts, to

visit PI's facilities. While in Hyannis, Storey spent 7 hours at

PI where he toured PI's facilities and observed a demonstration

of a recycler. While at PI's facilities, Storey observed the

presence of security officers and the use of personnel name tags.

During this visit, Storey met John D. Bambara (Bambara) and

Anthony Giovannone (Giovannone). Bambara is the president of PI

and member of its board of directors. Bambara is also the

president, treasurer, clerk, and director of FMEC Corp., as well

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as 100-percent owner of its stock. Giovannone is executive vice

president of PI and a member of its board of directors.

Giovannone and Bambara advised Storey that the recycler was

unique because no other machine on the market could recycle

plastic. To support their statements, they referred Storey to

the marketing report of Stanley Ulanoff, a marketing consultant

with an interest in two recycling partnerships. The marketing

report was appended to the offering memorandum.

When Storey questioned Bambara about the price of the

recycler, Bambara stated that the recycler was unique and that,

if he were to sell the recycler, he would not sell it for less

than the price in the offering memorandum. However, Storey was

still skeptical about its cost because in his words:

I am not an engineer and it is hard for me to say what

it cost to produce something like that and I couldn't

see the inside of the machine. But I -- it just didn't

look like the cost to produce one would be anything

like the price that was put on them but the value of it

is not the cost to produce it.

I was somewhat at a loss regarding this. * * *

In December 1981, Storey went to Clearwater, Florida, to

meet Winer. Storey and Winer discussed Sunbelt; however, the

substance of any conversation between them is unknown. In

October 1982, Storey traveled to Hyannis with Bill Stewart

(Stewart) to observe a demonstration of another recycler. During

this trip, Storey and Stewart agreed to split the commissions

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related to Stewart's clients who subsequently invested in

Sunbelt.

Storey considered contacting an independent engineer for

advice regarding the recycler, but he did not know how or where

to locate someone knowledgeable in plastics. Despite his visits

to Hyannis and review of the offering memorandum, Storey did not

know the names of specific companies that would lease the

recyclers, whether the use of the recycler would be profitable

for any company, or the operating history of the recycler.

Storey spent about 100 hours on an "investigation" of

Sunbelt. He kept track of the time he devoted to this

"investigation" through the use of time sheets and memoranda

regarding his telephone conversations. Storey billed the time

directly related to petitioner's investment in Sunbelt to

petitioner at one rate, and Storey allocated a portion of the

other time, which was general in nature with respect to the

investment, to petitioner at a different rate. Storey believed

he would recoup the expenses related to his "investigation"

through commissions from Sunbelt and the fees he charged clients.

Storey recommended Sunbelt to at least five of his clients

including petitioners. For each investment, Storey was entitled

to receive, and on some occasions did receive, a commission of 10

percent of their investment. Although Storey was entitled to

receive a commission of $5,000 related to petitioners' investment

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in Sunbelt, he instructed Winer to pay the commission to

petitioners.

When he recommended Sunbelt to petitioner, Storey advised

petitioner that he was planning to invest in Sunbelt, described

his "investigation" into Sunbelt, and provided him with the

offering memorandum for Sunbelt. Storey also advised petitioner

to read the offering memorandum to determine for himself whether

an investment in Sunbelt would result in an economic return.

Petitioner thoroughly reviewed the offering memorandum. During

this review, petitioner noticed that the offering memorandum

advised the potential investor to closely review the offering

memorandum to be satisfied as to the feasibility of the

investment and that the investment would generate the advertised

tax credits.

The offering memorandum allocates 10 percent of the proceeds

from each offering to the payment of sales commissions and

offeree representative fees. In addition, the offering

memorandum lists significant business and tax risks associated

with an investment in Sunbelt including: (1) A substantial

likelihood of an audit by the Internal Revenue Service (IRS) and

that the purchase price paid by F&G Corp. to ECI Corp. would

probably be challenged as being in excess of fair market value;

(2) that Sunbelt had no prior operating history; (3) that Winer

had no prior experience in marketing, recycling, or similar

equipment; (4) that the limited partners had no control over the

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conduct of Sunbelt's business; (5) that there was no established

market for the recyclers; (6) that there were no assurances that

market prices for virgin resin would remain at their current

costs per pound or that the recycled pellets would be as

marketable as virgin pellets; and (7) that certain potential

conflicts of interest existed.

Because petitioner was surprised at the price of the

recycler, petitioner and Storey discussed its value in relation

to Ulanoff's marketing opinion in the offering memorandum.

Because petitioner was also surprised at the tax benefits, he and

Storey discussed the kind and amount of deductions generated by

an investment in Sunbelt. During these discussions, petitioner

did not ask Storey to seek an expert opinion regarding the value

of the recycler. Petitioner never inquired about specific

details of the operation of the recyclers or the viability of the

recycler to end-users. Petitioners knew that Storey did not have

a background in plastics, but did not personally investigate

Sunbelt or PI.

During 1982, petitioners invested $50,000 in Sunbelt and in

return acquired a 6.19-percent limited partnership interest in

Sunbelt. On their 1982 Federal income tax return, petitioners

claimed a loss of $40,073 related to their investment in Sunbelt.

Petitioners also claimed an investment tax credit of $44,211 and

a business energy investment tax credit of $43,181. Petitioners

used $34,447 of these credits in 1982 and carried back unused

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credits to 1979, 1980, and 1981 in the amounts of $15,738,

$22,950, and $12,645, respectively.

In the notice of deficiency, respondent disallowed all items

of income, loss, deductions, and credits related to Sunbelt, and

increased petitioners' income accordingly for 1982. Respondent

also disallowed the investment tax credit carry backs for 1979,

1980, and 1981, and allowed an investment tax credit of $1,230

for 1982. In addition, respondent determined that, for each

year, petitioners were liable for the additions to tax under

section 6653 for negligence, section 6659 for valuation

overstatement, and section 6621(c) for increased interest. As

previously noted, petitioners now dispute only respondent's

determinations relating to the imposition of the addition to tax

for negligence.

Petitioners have stipulated substantially the same facts

concerning the underlying transactions as we found in Provizer v.

Commissioner, T.C. Memo. 1992-177, with the exception of certain

facts concerning the Provizers, the expert opinions, and other

matters that we consider of minimal significance. Those facts

may be summarized as follows. In 1981, PI manufactured and sold

six Sentinel EPE Recyclers to ECI Corp. for $981,000 each. ECI

Corp., in turn, resold the recyclers to F&G Corp. for $1,162,666

each. F&G Corp. then leased the recyclers to Clearwater, which

licensed the recyclers to FMEC Corp., which sublicensed them back

to PI. The sales of the recyclers from PI to ECI Corp. were

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financed with nonrecourse notes. Approximately 7 percent of the

sales price of the recyclers sold by ECI Corp. to F&G Corp. was

paid in cash with the remainder financed through notes. These

notes provided that 10 percent of the notes were recourse but

that the recourse portion of the notes was due only after the

nonrecourse portion was paid in full. The fair market value of a

Sentinel EPE Recycler in 1981 was not in excess of $50,000, and

the nuts and bolts, or manufacturing cost, was $18,000. Other

recycling machines were commercially available during the years

in issue including the Buss-Condux Plastcompactor, Nelmor/Weiss

Densification System (Regenolux), Cumberland Granulators, and

Foremost Densilator. Information regarding these other machines

was readily available. PI allegedly sublicensed the recyclers to

entities that would use them to recycle plastic scrap. The

sublicense agreements provided that the end-users would transfer

to PI 100 percent of the recycled scrap in exchange for payment

from FMEC Corp. based on the quality and amount of recycled

scrap.

Like Clearwater, Sunbelt leased Sentinel EPE Recyclers from

F&G Corp. and, as prearranged, licensed those recyclers to FMEC

Corp. The significant transactions of Sunbelt differ from the

underlying transactions in Provizer v. Commissioner, supra, only

in the following respects: (1) The entity that leased the

machines from F&G Corp. and licensed them to FMEC Corp; and (2)

the number of machines sold, leased, licensed, and sublicensed.

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In Provizer, a test case for the Plastics Recycling group of

cases, this Court found that each Sentinel EPE recycler had a

fair market value not in excess of $50,000; (2) held that the

transaction, which is almost identical to the transactions in

this case, was a sham because it lacked economic substance and a

business purpose; (3) upheld the sections 6653(a)(1) and (2)

additions to tax for negligence; (4) upheld the section 6659

addition to tax for valuation overstatement since the

underpayment of taxes was directly related to the overstatement

of the value of the Sentinel EPE recyclers; and (5) held that

losses and credits claimed with respect to Clearwater were

attributable to tax-motivated transactions within the meaning of

section 6621(c). In reaching the conclusion that the transaction

lacked economic substance and a business purpose, this Court

relied heavily upon the overvaluation of the Sentinel EPE

recyclers.

The value of the Sentinel recyclers was misrepresented in

Sunbelt's promotional materials. Petitioners never took any

legal action against anyone connected with Sunbelt or PI.

Petitioners never took any legal action against Storey in

connection with the recommendations or advice he provided to them

regarding Sunbelt.

Discussion

Section 6653(a) for 1979 and 1980 and section 6653(a)(1) for

1981 and 1982 impose an addition to tax equal to 5 percent of the

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underpayment if any part of any underpayment in tax is due to

negligence or disregard of rules or regulations. Section

6653(a)(2) imposes an addition to tax equal to 50 percent of the

interest payable with respect to the portion of the underpayment

attributable to negligence or disregard of rules or regulations.

Petitioners bear the burden of proof to show that any

underpayment was not due to negligence. Rule 142(a); Bixby v.

Commissioner, 58 T.C. 757, 791-792 (1972).

We have decided numerous Plastics Recycling cases and, to

date, have found the taxpayers liable for such additions to tax

in all but one of the opinions. See Friedman v. Commissioner,

T.C. Memo. 1996-558 and cases cited therein.

Negligence is defined as the failure to exercise the due

care that a reasonable and ordinarily prudent person would employ

under the circumstances. Neely v. Commissioner, 85 T.C. 934, 947

(1985). The question is whether a particular taxpayer's actions

in connection with the transactions were reasonable in light of

his or her experience and the nature of the investment or

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

(1973). When considering the negligence addition to tax, we

evaluate the particular facts of each case, judging the relative

sophistication of the taxpayers, as well as the manner in which

they approached their investment. McPike v. Commissioner, T.C.

Memo. 1996-46. Compare Spears v. Commissioner, T.C. Memo. 1996-

341 with Zidanich v. Commissioner, T.C. Memo. 1995-382.

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Petitioners contend that they were not negligent because

they reasonably relied in good faith upon the advice of a

qualified, independent adviser, to whom they made full

disclosure. In addition, petitioners contend that they were not

negligent because they reasonably expected to make a profit from

their investment in Sunbelt. Respondent, on the other hand,

contends that petitioners were negligent because their reliance

on Storey was not reasonable and they failed to investigate the

investment.

Under some circumstances a taxpayer may avoid liability for

the additions to tax under sections 6653(a)(1) and (2) if

reasonable reliance on a competent professional adviser is shown.

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. 501 U.S. 868 (1991). Reliance on professional

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

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

supra. For reliance on professional advice to excuse a taxpayer

from the negligence additions to tax, the taxpayer must show that

the professional had the expertise and knowledge of the pertinent

facts to provide informed advice on the subject matter. 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 (2d Cir.

1994), affg. T.C. Memo. 1993-480; Freytag v. Commissioner, supra.

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Reliance on representations by insiders, promoters, or

offering materials has been held an inadequate defense to

negligence. Goldman v. Commissioner, supra; LaVerne v.

Commissioner, 94 T.C. 637, 652-653 (1990), affd. without

published opinion 956 F.2d 274 (9th Cir. 1992), affd. without

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

(10th Cir. 1991). Pleas of reliance have been rejected when

neither the taxpayer nor the advisers purportedly relied upon by

the taxpayer knew anything about the nontax business aspects of

the contemplated venture. Freytag v. Commissioner, supra; Beck

v. Commissioner, 85 T.C. 557 (1985).

The offering memorandum contains a description of various

business and tax risks associated with an investment in Sunbelt.

Despite a review of the offering memorandum and skepticism of its

contents, Storey made no effort to verify the information in the

offering memorandum beyond visiting PI's facilities and

contacting Miller, Bambara, Taggart, Giovannone, and Winer, all

of whom are insiders and promoters associated with Sunbelt.

Despite his lack of knowledge regarding the recycler, the target

market for the recycler, and the technical aspects of the

transactions, Storey did not contact an expert in plastics

recycling or engineering or recommend that petitioner do so.

Although Storey visited the PI plant in Hyannis, toured the

facility, and observed a demonstration of the recycler, he was

not qualified to analyze or assess the machines on display or the

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facility. Storey made no adequate investigation into the value

of the recycler, although, an investigation would have revealed

the existence of other plastics recycling machines available in

1981 and 1982 ranging in price from $20,000 to $200,000. See

Provizer v. Commissioner, T.C. Memo. 1992-177. Despite his lack

of special qualifications and professional skills in plastics

engineering, recycling, or materials, Storey made no effort to

contact or consult with anyone who possessed such qualifications.

Given Storey's background and experience, he undoubtedly was

aware that the tax benefits outlined in the offering memorandum

and claimed by petitioners depended in large part on the value of

the recycling machines. Nevertheless, having no knowledge or

background regarding the value of the machines, he did nothing

sufficient to verify the representations made in the promotional

materials and by individuals associated with the promotion. As

we view the matter, Storey's trips to inspect the machine and the

other aspects of this "investigation" were essentially

superficial. In effect, he relied not upon the information he

gathered through his own investigation, but upon representations

made by Sunbelt's promotional materials and promoters.

Taking the above into consideration, petitioners' reliance

upon Storey was not reasonable. A taxpayer may rely upon his

adviser's expertise, in this case financial planning and tax

advice, but it is not reasonable to rely upon an adviser

regarding matters outside his field of expertise or with respect

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to facts which he does not verify, in this case the value of the

recycler. Skeen v. Commissioner, 864 F.2d 93 (9th Cir. 1989),

affg. Patin v. Commissioner, 88 T.C. 1086 (1987).

Moreover, Storey was not an independent adviser since he was

entitled to receive compensation from Sunbelt for petitioners'

investment. Although Storey refunded the commission to

petitioners, because he was paid to sell the investment, his

advice was suspect.

Petitioners contend that they read the offering memorandum

and questioned Storey regarding its contents. The extent of

petitioners' review of the offering memorandum is unclear;

however, a review of those materials would have indicated the

numerous business and tax risks associated with an investment.

The preface to the offering memorandum warned the potential

investor not to consider its contents as expert advice and to

seek advice from the investors' own advisers. The offering

memorandum also clearly stated that the transactions involved

significant tax risks and that in all likelihood the IRS would

challenge the validity of the transactions and the purported

value of the recycling machines. The "business risks" section of

the offering memorandum warned that there was no history for

Sunbelt and that there was no established market for the

recyclers or pellets produced therefrom. Petitioner failed to

carefully consider the offering memorandum and to take into

account its warnings. Statements regarding the business and tax

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risks and the warnings placed on the front page of the offering

memorandum would have alerted a prudent and reasonable investor

to the questionable nature of the promised deductions and

credits. See Collins v. Commissioner, 857 F.2d 1383, 1386 (9th

Cir. 1988), affg. T.C. Memo. 1987-217.

Petitioners' contention that they reasonably relied upon

Storey's advice is further undermined by petitioner's background

in manufacturing. In view of petitioner's success in various

manufacturing businesses, we find it difficult to accept the

proposition that he did not know or have reason to know that the

value of the Sentinel machine was grossly overstated.

In addition, petitioners contend that the investment was

reasonable because they expected to make a profit. We find that

petitioners' profit motive is not dispositive of the issue here

in dispute. Whether or not petitioners intended to profit from

their investment in Sunbelt, they failed to exercise due care in

claiming tax benefits from that investment. Their subjective

intent does not excuse them from the consequences of claiming

deductions and credits to which under the circumstances they were

clearly not entitled. See Klieger v. Commissioner, T.C. Memo.

1992-734.

We have considered and find unpersuasive petitioners'

arguments comparing this case with other cases that were resolved

in the taxpayers' favor with respect to the negligence addition

to tax.

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Petitioners failed to exercise due care in claiming the

deductions and tax credits relating to their investment in

Sunbelt. We find that they did not reasonably rely upon Storey

or in good faith investigate the aspect of the investment that

generated the "attractive" tax benefits--the value of the

Sentinel recycler. Therefore, we hold that petitioners are

liable for the negligence additions to tax under the provisions

of section 6653(a) for 1979 and 1980 and section 6653(a)(1) and

(a)(2) for 1981 and 1982.

To reflect the foregoing, and to ensure that the

Stipulation of Settled Issues is properly taken into account,

Decision will be

entered under Rule 155.