The opinion
T.C. Memo. 2000-184
UNITED STATES TAX COURT
DANIEL L. AND INGRID N. CARROLL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 19403-89. Filed June 23, 2000.
David G. Ebert, for petitioners.
Lori J. Balboni, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
DAWSON, Judge: This case was assigned to Special Trial
Judge Robert N. Armen, Jr., pursuant to the provisions of section
7443A(b)(5) of the Internal Revenue Code in effect at the time of
assignment and Rules 180, 181, and 183.1 The Court agrees with
1
Unless otherwise indicated, all subsequent section
(continued...)
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and adopts the opinion of the Special Trial Judge, which is set
forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
ARMEN, Special Trial Judge: Respondent determined a
deficiency with respect to petitioners' Federal income tax for
1981 in the amount of $26,639, as well as additions to tax under
section 6659 in the amount of $7,992, under section 6653(a)(1) in
the amount of $1,344, and under section 6653(a)(2) in the amount
of 50 percent of the portion of the underpayment that is
attributable to negligence. Respondent also determined that
petitioners are liable for additional interest under section
6621(c) for interest on the entire underpayment to be computed at
120 percent of the rate otherwise applicable under section
6621(a).
The issues for decision are as follows:
(1) Whether petitioners are entitled to a partnership loss
and investment and energy credits flowing from the Sentinel EPE
recycler leasing program entered into by Clearwater Group. We
hold that they are not.
(...continued)
references are to the Internal Revenue Code in effect for the
taxable year in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
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(2) 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 they are.
(3) Whether petitioners are liable for the addition to tax
under section 6659 for an underpayment of tax attributable to a
valuation overstatement. We hold that they are.
(4) Whether petitioners are liable for additional interest
under section 6621(c). We hold that they are.
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
Garden City, New York, at the time that their petition was filed
with the Court.
A. The Recycling Transactions
This case is a part of the Plastics Recycling group of
cases. In particular, the deficiency, additions to tax, and the
additional interest arise from the disallowance of losses,
investment credits, and energy credits claimed by petitioners
with respect to the Clearwater Group partnership (Clearwater).
For a detailed discussion of the transactions involved in
the Plastics Recycling group of cases, see Provizer v.
Commissioner, T.C. Memo. 1992-177, affd. per curiam without
published opinion 996 F.2d 1216 (6th Cir. 1993). The underlying
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transactions involving the Sentinel recycling machines
(recyclers) in petitioners’ case are identical to the
transactions in Provizer, and, with the exception of certain
facts that we regard as having minimal significance, petitioners
have stipulated substantially the same facts concerning the
underlying transactions that were described in Provizer v.
Commissioner, supra.
In transactions described in the Provizer case and
stipulated by the parties herein, Packaging Industries of
Hyannis, Massachusetts (PI), manufactured and sold2 six Sentinel
EPE3 recyclers to ECI Corporation (ECI) for $981,000 each. PI
manufactures thermoplastic and other types of packaging
machinery, as well as energy saving devices. PI holds itself out
as the world’s largest manufacturer of blister packaging
machinery and as fabricating the industry’s widest line of
thermoforming machinery. EPE recyclers are batch type machines
designed to convert expanded low density polyethylene foam into a
densified form called “popcorn” that can be further processed to
produce resin pellets suitable for some uses in the plastics
industry.
2
Terms such as sale, lease, license, and sublicense, as
well as their derivatives, are used for convenience only and do
not imply that the particular transaction was in fact a sale,
lease, license, or sublicense.
3
EPE stands for expanded polyethylene.
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The sales of the recyclers from PI to ECI were financed with
nonrecourse notes. Approximately 7 percent of the sales price of
the recyclers sold by PI to ECI was paid in cash, with the
remainder financed through a 12-year nonrecourse note requiring
equal monthly installments of $100,917, including annual interest
at 19.8 percent with the first payment due 7 months after
closing. ECI’s purchase was subject to Clearwater’s leasing
agreement and FMEC’s licensing agreement as set out below.
In the second part of the transaction, ECI resold the
recyclers to F&G Corporation (F&G) for $1,162,667 each, of which
less than about 7 percent was paid in cash. The balance was
paid by a 12-year partial recourse note requiring equal monthly
installments of $100,917, including annual interest at 15.4
percent. 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, 90 percent, was paid in full. The
first payment on the note was due 7 months after the closing.
F&G’s purchase was subject to Clearwater’s agreement to
enter into a lease with F&G and was subject to FMEC’s agreement
to enter into the license as set out below.
In the third part of the transaction, F&G leased the
recyclers to Clearwater for 12 years, a lease term equal to 150
percent of the class life of the assets. Under the lease, the
monthly rental payment was $100,917, with an initial amount of
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$605,500 to be prepaid at the closing as rental for the first 6
months.
In the fourth step of the transaction, Clearwater licensed
the recyclers to First Massachusetts Equipment Corp. (FMEC) for
12 years at a guaranteed minimum royalty of $100,917 per month
beginning with the seventh month of the license plus a prepaid
nonrefundable $20,500 advance royalty. After the recyclers were
placed in service, the license required additional royalty
payments based on a percentage of profits that might be realized
on the sale or use of the resin pellets produced by the
recyclers.
In the fifth step of the transaction, FMEC sublicensed the
recyclers back to PI, the manufacturer, on a month-to-month basis
for a royalty of $100,917 per month. The sublicense to PI was
subject to most of the terms of the license from Clearwater to
FMEC.
In the final step of the transaction, PI was to sublicense
the recyclers to end-users who would use the recyclers to do the
actual converting of their low density thermoplastic foam or
film. The terms of the sublicense generally required the end-
user to pay PI 100 percent of the recycled foam in exchange for a
payment from FMEC based on the quality and amount of recycled
scrap. PI was to control and be responsible for placing the
recyclers with end-users and for arranging to collect or dispose
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of the product of the recyclers. Service and installation costs
were to be borne by the end-user. End-users were also required
to use their best efforts to recycle 220 pounds an hour for 16
hours per week. Only PI was to service or repair the recyclers.
No arm's-length negotiations for the price of the Sentinel
EPE recyclers took place among PI, ECI, and F&G. All of the
monthly payments required among the entities in the above
transactions offset each other. These transactions occurred
simultaneously.
Clearwater leased Sentinel EPE recyclers from F&G and
licensed those recyclers to FMEC. For convenience, we refer to
the series of transactions among PI, ECI, F&G, Clearwater, and
FMEC as the Clearwater transactions.
By private placement memorandum dated November 17, 1981,
Clearwater offered subscriptions for 16 limited partnership units
at $50,000 per unit. The limited partners owned 99 percent of
Clearwater, and the general partner, Samuel L. Winer, owned the
remaining 1 percent. Each limited partner was required to have a
minimum net worth, exclusive of his principal home, furnishings,
and automobiles, in the amount of $200,000 per limited
partnership unit. In addition, each partner was required to have
enough income during the 1981 taxable year to place the limited
partner in an income tax bracket of at least 50 percent.
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In addition to the Clearwater transactions, a number of
other limited partnerships entered into transactions similar to
the Clearwater transactions.
B. Individuals Involved
Samuel L. Winer (Winer) was the general partner of
Clearwater and paid $1,000 for a 1-percent interest in all items
of income, gain, deduction, loss, and credit arising from the
operations of Clearwater. Winer received $60,000 out of the
proceeds of the Clearwater group private offerings as
compensation for his services.
In 1981 Richard Roberts (Roberts) was a businessman and the
general partner in a number of limited partnerships that leased
EPE recyclers. Roberts was also the general partner in a number
of other limited partnerships that leased and licensed Sentinel
recyclers. He also was a 9-percent shareholder in F&G, the
corporation that leased the recyclers to Clearwater. From 1982
through 1985, Roberts and Raymond Grant (Grant) were in the
business of promoting tax sheltered investments. Grant was an
investment banker, attorney, accountant, and the president and
100-percent owner of ECI. Roberts and Grant together were
general partners in other partnerships. Prior to the Clearwater
transactions, Roberts and Grant were clients of the accounting
firm H.W. Freedman & Co. (Freedman & Co.).
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Harris W. Freedman (Freedman), a certified public accountant
and the named partner in Freedman & Co., was the president and
chairman of the board of F&G. Freedman was experienced with
leveraged leasing, and he owned 94 percent of a Sentinel EPE
recycler.
Freedman & Co. prepared the tax returns for ECI, F&G, and
Clearwater. Although Freedman & Co. did not prepare the initial
financial projections included in the offering memorandum,
Freedman did review the financial projections and made
suggestions as to both format and substance.
Freedman & Co. also provided tax services to John D. Bambara
(Bambara). Bambara was the 100-percent owner of FMEC, as well as
its president, treasurer, clerk, and director. Bambara was also
the president of PI and a member of its board of directors. He,
his wife, and his daughter also owned directly or indirectly 100
percent of the stock of PI.
Elliot I. Miller (Miller) was the corporate counsel to PI.
In 1981, Miller was also a shareholder of F&G. Miller
represented Grant personally and Grant’s clients who invested in
other programs that Grant promoted. Miller was also an
acquaintance of Winer.
John Y. Taggert (Taggert) was a well-known tax attorney and
an adjunct professor at the New York University Law School.
Taggert had been acquainted with Miller for about 15 years prior
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to 1981. Miller recommended that Roberts employ Taggert and his
firm as counsel to the general partner of Hyannis Recycling
Associates, the initial plastics recycling partnership. Taggert
and other members of his firm, Windels, Marx, Davies & Ives
(WMDI), prepared private offering memoranda, tax opinions, and
other legal documents for Clearwater and over 15 other plastics
recycling partnerships. Taggert acquired a 6.66-percent interest
in a second-tier Plastics Recycling partnership but only after
his representation of Clearwater and other recycling partnerships
had ended.
Robert Gottsegen (Gottsegen) was a businessman active in the
plastics industry and a long-time business associate of Bambara.
Miller represented Gottsegen and Bambara in several business
transactions.
C. The Private Offering Memorandum
Clearwater distributed to potential limited partners a
private placement memorandum dated November 17, 1981. The
offering memorandum listed significant business and tax risk
factors associated with an investment in Clearwater.
Specifically, the offering memorandum stated: (1) There was a
substantial likelihood of audit by the Internal Revenue Service
(IRS), and the purchase price paid by F&G to ECI probably would
be challenged as being in excess of fair market value; (2) the
partnership had no prior operating history; (3) the general
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partner had no prior experience in marketing recycling or similar
equipment; (4) the limited partners would have no control over
the conduct of the partnership's business; (5) there was no
established market for the Sentinel recyclers; (6) 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) certain potential
conflicts of interest existed. The private offering memorandum
also informed investors that the business of the partnership
would be conducted in accordance with six simultaneous
transactions.
The private offering memorandum stated that the projected
tax benefits for the initial year of investment for an investor
contributing $50,000 would be investment credits and energy
credits in the aggregate amount of $86,328, plus deductions in
the amount of $39,399.
The offering memorandum also included a discussion of the
tax aspects of the transactions and a tax opinion prepared by
WMDI concerning the tax issues involved in the Plastics Recycling
Program.
Also included in the offering memorandum were the reports of
the “F&G evaluators", Samuel Z. Burstein (Burstein) and Stanley
Ulanoff (Ulanoff).
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At the time Ulanoff prepared the report, he was a professor
of marketing at Baruch College. Ulanoff is also the author of
numerous books on technical and marketing subjects. His report
covered the marketing value and potential of the recyclers and
expressed the conclusion that the sales price paid by F&G for the
recyclers and the rental payment made by Clearwater were fair and
reasonable. His conclusion allegedly was based on his personal
observation of the Sentinel EPE recycler prototype during a visit
to PI, discussions with PI employees, the needs of the plastics
industry, and his analysis of the economic projections provided
in the offering memorandum.
Burstein was an associate professor of mathematics at New
York University. Allegedly based on his visit to PI, discussions
with PI personnel, an evaluation of the technical value of the
recycler, the recycler's history of performance, and information
concerning the use of recycled polyethylene as a raw material,
Burstein concluded that the Sentinel EPE recycler was capable of
recycling on a continuous basis.
The offering memorandum represented that the Sentinel
recyclers were unique machines. However, they were not. Several
machines capable of densifying low density materials were already
on the market in 1981. Other plastics recycling machines
available at that time ranged in price from $20,000 to $200,000,
including the Foremost “Densilator", the Nelmor/Weiss
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Densification System (Regenolux), the Buss-Condux Plastcompactor,
and the Cumberland Granulator. See Provizer v. Commissioner,
T.C. Memo. 1992-177, and the discussion regarding expert
testimony, infra.
D. Expert Testimony
The parties did not agree on the value of the Sentinel EPE
recyclers, and petitioners did not stipulate to be bound by the
value of the Sentinel EPE recyclers that we found in Provizer v.
Commissioner, supra.
At trial, petitioners did not offer expert testimony
regarding the value of the recyclers. In contrast, respondent
offered expert testimony from Steven Grossman (Grossman) and
Richard S. Lindstrom (Lindstrom).
1. Grossman
Grossman is a professor in the Plastics Engineering
Department at the University of Massachusetts at Lowell. He has
a bachelor of science degree in chemistry from the University of
Connecticut and a doctorate degree in polymer science and
engineering from the University of Massachusetts. He also has
more than 15 years of experience in the plastics industry,
including more than 4 years of experience as a research and
development scientist at the Upjohn Company in its Polymer
Research Group.
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Grossman is also a partner in the law firm of Hayes,
Soloway, Hennessey, Grossman & Hage, P.C., which firm practices
in the area of intellectual property, including patents,
trademarks, copyrights, and trade secret protection.
Grossman's reports concerning the value of the Sentinel EPE
recyclers discuss the limited market for the recycled plastic
material. Grossman concluded that these recyclers were unlikely
to be successful products because of the absence of any new
technology, the absence of a continuous source of suitable scrap,
and the absence of any established market. Grossman suggested
that a reasonable comparison of the products available in the
polyethylene industry in 1981 with the Sentinel EPE recyclers
reveals that the recyclers had very little commercial value and
were similar to comparable products available on the market in
component form. For these reasons, Grossman opined that the
Sentinel EPE recyclers did not justify the “one-of-a-kind"
pricetag that they carried.
Specifically, Grossman reported that there were several
machines on the market as early as 1981 that were functionally
equivalent to, and significantly less expensive than, the
Sentinel EPE recyclers. These machines included: (1) The Japan
Repro recycler, available in 1981 for $53,000; (2) the Buss-
Condux Plastcompactor, available before 1981 for $75,000; (3)
Foremost Machine Builders' “Densilator", available from 1978-1981
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for $20,000; and (4) the Midland Ross Extruder, available in 1980
and 1981 for $120,000. Grossman observed that all of these
machines were “widely available".
Grossman's opinion regarding the Sentinel EPE recycler was
based on the descriptions of such recycler as set forth in the
writings of other professionals. Grossman neither tested nor
examined the Sentinel EPE recycler.
Finally, Grossman reported on the relationship between the
plastics industry and the petrochemical industry. Grossman noted
that although the development of the petrochemical industry is a
contributing factor in the growth of the plastics industry, the
two industries have a “remarkable degree of independence".
Grossman observed that the “oil crisis" in 1973 triggered “dire"
predictions about the future of plastics that had not been
fulfilled in 1981. Grossman stated that the cost of a plastic
product depends, in large part, on technology and the price of
alternative materials. Grossman's studies concluded that a 300-
percent increase in oil prices results in a 30-40 percent
increase in the cost of plastic.
Grossman did not specifically value the Sentinel EPE
recycler. However, as previously stated, Grossman concluded that
existing technology was available that provided equivalent
capability of recycling polyethylene.
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2. Lindstrom
Lindstrom graduated from the Massachusetts Institute of
Technology with a bachelor's degree in chemical engineering.
From 1956 until 1989, Lindstrom worked for Arthur D. Little,
Inc., in the areas of process and product evaluation and
improvement and new product development, with special emphasis on
plastics, elastomers, and fibers. At the time of trial,
Lindstrom continued to pursue these areas as a consultant.
In his report, Lindstrom determined that in 1981 several
different types of equipment capable of recycling expanded
polyethylene were available and priced at approximately $50,000.
Lindstrom found that, on the basis of his research, “there were
available in 1981 commercial units that could be purchased for
$50,000 or less that were totally equal to the Sentinel EPE
recycler in function, product quality, and capacity."
Lindstrom examined the Buss-Condux Plastcompactor and the
Regenolux. Lindstrom found that these machines were functionally
equivalent to the Sentinel EPE recycler and were available in the
years and at the prices reported by Grossman, detailed supra.
Lindstrom also reported that various equipment companies, such as
the Cumberland Engineering Division of John Brown Plastics
Machinery, were willing to provide customized recycling programs
to companies at a minimum cost of $50,000.
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Lindstrom found that in “average-use situations" the
Sentinel EPE recycler could process 200 pounds of plastic per
hour.
Lindstrom observed a Sentinel EPE recycler in operation at
PI, and he was allowed to take photographs of it and examine its
blueprints. Based on his observations and study, Lindstrom
estimated that the manufacturing cost of the Sentinel EPE
recycler was approximately $20,000. Lindstrom concluded that the
market value of the Sentinel EPE recycler did not exceed $50,000.
Lindstrom also reported that information was available in
1981 regarding state-of-the-art foamed plastic recycling
machines. Lindstrom described several approaches that might have
been taken by a layman of average intelligence to obtain such
information, even in a small town library.
E. Petitioners and Their Introduction to Clearwater
Petitioners acquired a 1.547-percent interest in Clearwater
in 1981 for $12,500.
Petitioner husband (petitioner) has a bachelor of science
degree in chemical engineering. During college, petitioner was
employed during 2 summers by the Scott Paper Company. There, he
became familiar with batch type paper pulp machines used to
process wood chips or recycled paper or cardboard into pulp.
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Petitioner also has a J.D. degree. While in law school,
petitioner was employed by a patent attorney and conducted
numerous patent searches.
Petitioner was an associate, and subsequently a partner, of
the law firm of Shea and Gould from 1966 until 1989. Petitioner
wife (Mrs. Carroll) was not employed outside the home.
Petitioner was introduced to Clearwater and its general
partner, Winer, by Mr. Hirschfield, a partner at Shea & Gould.
Petitioner read the offering memorandum and the reports contained
therein and discussed the investment with other partners at his
firm, including Alan Parker, the senior tax attorney at the firm,
who were investing, or considering investing, in the Plastics
Recycling Program.
Petitioners had no knowledge concerning the plastics
industry and/or plastics recycling. Petitioners did not see a
Sentinel EPE recycler prior to their investment in Clearwater nor
did they do a patent search on the EPE recyclers. Rather,
petitioner was aware that the promoters had not applied for a
patent for the recyclers but concluded it was because they wanted
to keep their invention a trade secret. Petitioner relied almost
exclusively on the Clearwater offering memorandum (and the
reports of Burstein, Ulanoff and WMDI, contained therein) and
Petitioner’s assessment of those reports as accurate. Petitioner
considered the caveats and warnings contained in the Clearwater
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memorandum but concluded that for the most part they were boiler-
plate and overstated, included only to protect the promoters.
Petitioners never made any profit from their investment in
Clearwater. Petitioners did not contact the general partner,
Winer, at any time after their investment to inquire why the
investment did not generate the profits projected.
The projected tax benefits for the initial year of
investment described in Clearwater’s offering memorandum greatly
exceeded petitioners’ investment in Clearwater. In fact, the tax
benefits actually claimed by petitioners on their tax return for
the initial year of investment in Clearwater greatly exceeded
their investment in the partnership. For 1981, petitioners
claimed a loss of $9,995 as their distributive share of
Clearwater’s losses for the year, and they claimed an investment
tax credit in the amount of $11,542 and an energy tax credit in
the amount of $10,785.
In the notice of deficiency, respondent disallowed all the
claimed deductions and credits relating to petitioners’
Clearwater investment.
F. Ultimate Finding of Fact
At all relevant times, the fair market value of the Sentinel
EPE recyclers did not exceed $50,000 per machine.
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OPINION
We have decided many Plastics Recycling cases. The majority
of these cases presented issues regarding additions to tax for
negligence and valuation overstatement. See Greene v.
Commissioner, T.C. Memo. 1997-296; Kaliban v. Commissioner, T.C.
Memo. 1997-271; Sann v. Commissioner, T.C. Memo. 1997-259 n.13
(and cases cited therein), affd. Addington v. Commissioner, 205
F.3d 54 (2d Cir. 2000). We found the taxpayers liable for the
addition to tax for valuation overstatement in all of those cases
and liable for the additions to tax for negligence in the
overwhelming majority of those cases. In a limited number of
cases, the taxpayers also contested the underlying deficiency
arising from the disallowance of the losses and various credits
with respect to their Plastics Recycling investment. We
sustained the Commissioner on the issue of the underlying
deficiency in every one of those cases.
In Provizer v. Commissioner, T.C. Memo. 1992-177, the test
case for the Plastics Recycling group of cases, this Court: (1)
Found that each Sentinel EPE recycler had a fair market value not
in excess of $50,000; (2) held that the Clearwater transaction
was a sham because it lacked economic substance and a business
purpose; (3) sustained the additions to tax for negligence under
section 6653(a)(1) and (2); (4) sustained the addition to tax for
valuation overstatement under section 6659 because the
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underpayment of taxes was directly related to the overvaluation
of the Sentinel EPE recyclers; and (5) held that losses and
credits claimed with respect to the Clearwater Group were
attributable to tax-motivated transactions within the meaning of
section 6621(c). In reaching the conclusion that the transaction
lacked business purpose, this Court relied heavily upon the
overvaluation of the Sentinel EPE recyclers.
In the notice of deficiency, respondent disallowed all of
the claimed deductions and credits relating to petitioners’
Clearwater investment. Respondent’s determination is
presumptively correct, and petitioners bear the burden of proving
otherwise. See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503
U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S.
435, 440 (1934).
Issue 1. The Underlying Deficiency
Respondent determined that the integrated series of
transactions involved in the Plastics Recycling Program, of which
Clearwater was a part, was an economic sham. Petitioners must
therefore prove otherwise in order to prevail.
There is a complete failure by petitioners to prove that the
Plastics Recycling Program in which Clearwater participated was
not an economic sham. As in Provizer v. Commissioner, supra, we
rely heavily on the fact that the Sentinel EPE machines were
highly overvalued, an issue with respect to which petitioners
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bear the burden of proof but on which they provided no expert or
other persuasive testimony. In this regard they rely simply on
the Clearwater offering memorandum and ineffective cross-
examination of respondent’s expert witnesses to establish the
value of the Sentinel EPE recyclers.
Similarly, petitioners failed to introduce persuasive
evidence on pertinent factors to establish the economics of the
transaction, such as the presence of arm's-length price
negotiations, see Helba v. Commissioner, 87 T.C. 983, 1005-1007
(1986), affd. 860 F.2d 1075 (3d Cir. 1988); the relationship
between the sales price and fair market value, see Zirker v.
Commissioner, 87 T.C. 970, 976 (1986); the structure of the
financing, see Helba v. Commissioner, supra at 1007-1011; the
degree of adherence to contractual terms, see id. at 1011; and
the reasonableness of the income projections, see Rice's Toyota
World, Inc. v. Commissioner, 81 T.C. 184, 204-207 (1983), revd.
in part and remanded on other issues 752 F.2d 89 (1985).
Petitioners contend that although they stipulated
substantially the same facts concerning the underlying
transactions that were described in Provizer v. Commissioner,
supra, they did not agree to be bound by any findings or
conclusions in Provizer. Although we do not hold petitioners to
the Provizer decision as a matter of stipulation, there is
nothing in this record to persuade us to reach a different
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conclusion. Rather, there is ample evidence on the record in the
present case to establish independently that the series of
Plastics Recycling transactions, of which petitioners’ Clearwater
transaction was a part, constituted an economic sham. However,
because petitioners have provided no further evidence nor any
novel contention with respect to the underlying deficiency not
previously considered in Provizer, we shall not revisit that
opinion. Accordingly, we sustain respondent’s determination for
substantially identical reasons as in Provizer.
Issue 2. Section 6653(a)(1) and (2) Negligence
Respondent determined that petitioners are liable for
additions to tax under section 6653(a)(1) and (2) with respect to
the underpayment attributable to petitioners’ investment in
Clearwater. Petitioners have the burden of proof to show that
they were not negligent. See Addington v. Commissioner, 205 F.3d
54 (2d Cir. 2000), affg. Sann v. Commissioner, T.C. Memo. 1997-
259; Goldman v. Commissioner, 39 F.3d 402, 407 (2d Cir. 1994),
affg. T.C. Memo. 1993-480; Luman v. Commissioner, 79 T.C. 846,
860-861 (1982); Bixby v. Commissioner, 58 T.C. 757, 791-792
(1972).
Section 6653(a)(1) and (2) imposes additions to tax if any
part of the underpayment of tax is due to negligence or
intentional disregard of rules or regulations. Negligence is
defined as the failure to exercise the due care that a reasonable
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and ordinarily prudent person would exercise under the
circumstances. See Neely v. Commissioner, 85 T.C. 934, 947
(1985). The pertinent question is whether a particular
taxpayer's actions are reasonable in light of the taxpayer's
experience, the nature of the investment, and the taxpayer's
actions in connection with the transactions. See Henry Schwartz
Corp. v. Commissioner, 60 T.C. 728, 740 (1973). In this regard,
the determination of negligence is highly factual. “When
considering the negligence addition, we evaluate the particular
facts of each case, judging the relative sophistication of the
taxpayers as well as the manner in which the taxpayers approached
their investment." Turner v. Commissioner, T.C. Memo. 1995-363.
Petitioners claimed operating losses and investment and
energy tax credits relying almost exclusively on representations
in the Clearwater offering memorandum. Petitioners did not hire
an independent industry expert to evaluate the profitability of
their investment, nor did they employ an accountant to verify the
correctness of the position on their tax return.
Petitioners contend that because of petitioner’s background
in chemical engineering and patent law, he possessed sufficient
expertise to evaluate the Clearwater transaction, making it
unnecessary to hire an expert to do the same. Petitioners claim
that petitioner drew on his background to conclude that the EPE
recyclers were unique (based on the purportedly unique blade
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angle design of the EPE recyclers and the purportedly unique
chemical process used to recycle the material) and warranted the
$1,162,667 price tag.
Although petitioner may have been more familiar with
chemical processes because of his college degree--or with machine
designs because of his limited patent law experience–-than the
average investor, it is clear that he did not have adequate
plastics industry knowledge to evaluate the investment. See
Addington v. Commissioner, supra. Petitioner did not have any
expertise in plastics recycling or evaluation of machinery,
including plastics recycling equipment, to evaluate competently
the profitability of the Clearwater transaction.
We have found that the EPE recyclers did not have a fair
market value of more than $50,000 and that the recyclers did not
have any unique features warranting their exorbitant pricetag.
By simply relying on petitioner’s limited knowledge and
experience, without independent research or consultation,
petitioners never made an adequate effort to learn that the EPE
recyclers were highly overvalued or the true nature of the
transaction as a sham.
There is also no indication that petitioners invested the
necessary time to gain the requisite expertise to evaluate their
investment. Petitioners claim that petitioner discussed the
investment with several partners in his firm, the majority of
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whom were also investing in Clearwater or related plastics
partnerships. We have not been convinced that these were any
more than half-hearted inquiries, or that any of these other
individuals were qualified to opine on the profitability of the
transaction. See id.
Petitioners also assert that because of petitioner’s
background, it was reasonable for them to rely simply on the
Clearwater offering memorandum, including the reports of
Burstein, Ulanoff, and the tax opinion prepared by WMDI.
Petitioners claim that petitioner was sufficiently knowledgeable
to decipher those reports and to find their conclusions
reasonable. Petitioners contend that after reading those
reports, petitioner concluded that the reports were accurate, and
that there was nothing more an independent expert, or independent
research, could tell petitioners that was not already in these
reports.
We think it unreasonable for an educated and sophisticated
investor, such as petitioner, to conclude that an independent
expert cannot evaluate a deal more objectively than the
individuals retained by insiders to draft the offering memorandum
and the tax opinions contained therein. “It is unreasonable for
taxpayers to rely on the advice of someone who they should know
has a conflict of interest.” Id. at 59; see Goldman v.
Commissioner, 39 F.3d at 408; LaVerne v. Commissioner, 94 T.C.
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637, 652-653 (1990), affd. without published opinion 956 F.2d 274
(9th Cir. 1992), affd. in part without published opinion sub nom.
Cowles v. Commissioner, 949 F.2d 401 (10th Cir. 1991).
It is also clear that petitioners could not reasonably rely
on the advice of the Plastics Recycling promoters with respect to
the substantive merits or the tax treatment of items in
connection with their investment in Clearwater. See Patin v.
Commissioner, 88 T.C. 1086, 1131 (1987), affd. without published
opinion 865 F.2d 1264 (5th Cir. 1989), affd. sub nom. Gomberg v.
Commissioner, 868 F.2d 865 (6th Cir. 1989), affd. sub nom. Skeen
v. Commissioner, 864 F.2d 93 (9th Cir. 1989), affd. per curiam
without published opinion sub nom. Hatheway v. Commissioner, 856
F.2d 186 (4th Cir. 1988); Kleiger v. Commissioner, T.C. Memo.
1992-734. Advice from such individuals “is better classified as
sales promotion". Vojticek v. Commissioner, T.C. Memo. 1995-444.
Petitioners also claim that their decision to invest was
greatly influenced by the nature of the transaction, guaranteeing
them a profit based on “conservative” assumptions regarding the
price of resin and minimal output by the recyclers. Based on
these assumptions, petitioners claim to have concluded that the
circular nature of the transaction in fact guaranteed them a
profit. In this regard, petitioners claim that the circuitous
nature of the transaction did not alarm them because petitioner
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concluded that the Clearwater transaction was set up to satisfy
the safe harbor leasing rules.
Petitioners’ contention is completely circular and flawed.
Petitioners reached the conclusion that the Clearwater
transaction virtually guaranteed them a profit based on
assumptions contained in the Clearwater offering memorandum.
Petitioners did not perform adequate research nor obtain advice
from an independent expert regarding the price of resins, the
quality of the resin processed by the EPE recyclers, or the
quality of the EPE recyclers. What is more, petitioners’
argument completely ignores any fair market value consideration.
The standard for measuring fair market value is the price at
which the property would change hands between a hypothetical
willing buyer and seller, neither being under any compulsion to
buy or sell and both having reasonable knowledge of the relevant
facts. See United States v. Cartwright, 411 U.S. 546, 551
(1973). We have held that the fair market value of the Sentinel
EPE recyclers did not exceed $50,000.
If petitioners had made any reasonable effort to determine
the fair market value of the recyclers, they would have
determined, as we have found, that the recyclers’ pricetage of
$1,162,667 was grossly inflated.4 At that point, petitioners
4
There were many factors to indicate that the Sentinel
(continued...)
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would have become skeptical of the manner in which payments for
the recycler were to be made through a complex series of
offsetting payments. Petitioners would also have inquired why
the partnership would be willing to “invest” in machines at far
in excess of their fair market value when it could invest in
other much less expensive machines performing virtually the same
functions as the EPE recyclers. Inquiry may also have spurred
petitioners to take more seriously the tax and business warnings
in the offering memorandum which, for the most part, petitioners
cavalierly dismissed as overly cautious and boilerplate.
Petitioners claim that petitioner closely studied the
Clearwater offering memorandum and was aware of the nature of the
transaction. What petitioner should have realized, or what an
independent expert would have told him, is that the Sentinel EPE
recyclers were not offered to the general public, and therefore
the $1,162,667 pricetag did not result from traditional supply
and demand pricing. See Provizer v. Commissioner, T.C. Memo.
4
(...continued)
recyclers were highly overvalued. For example, the Sentinel
recyclers were not unique. Respondent's experts identified other
machines that were not only functionally equivalent to the
Sentinel recyclers but that were also significantly less
expensive. We have found that information regarding comparable,
less expensive recyclers was widely available. If a potential
purchaser, especially a sophisticated one, had conducted a due
diligence investigation into the Sentinel EPE recyclers, such
potential purchaser should have learned that comparable, less
expensive equipment existed and that the Sentinel EPE recyclers
were overvalued.
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1992-177. Rather, the promoters were free to assign arbitrarily
a value to the recyclers to be used for the Plastics Recycling
transactions.
The circular nature of the transaction offered an
opportunity for abuse. With the exception of a minimal
downpayment for the machines, the majority of the purchase price
was in the form of a series of offsetting payments realized only
through bookkeeping entries, there being no disincentive for the
promoters to exaggerate the value of the recyclers. To the
contrary, the high price of the machines assured high tax write-
offs and was sure to attract investors for that very reason.
In fact, we are convinced that petitioners’ investment in
Clearwater was purely tax driven. The Clearwater offering
memorandum emphasized projected tax savings. For the year in
issue, for each $50,000 invested, the purchaser was projected to
receive $86,328 in investment and energy tax credits and $39,399
in tax deductions. Petitioners claimed a reduction of taxes in
the year of investment of over twice the amount of their
investment. “A reasonably prudent person would have asked a
qualified tax adviser if this windfall were not too good to be
true.” Provizer v. Commissioner, supra; see McCrary v.
Commissioner, 92 T.C. 827 (1989). Petitioners did not act
reasonably in claiming those benefits on their tax return without
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making further inquiry and intentionally disregarded rules and
regulations.
In view of his sophistication and educational background,
petitioner should have been able to determine that the Sentinel
EPE recyclers were not unique, that they were not worth the
amount ascribed to them, and that Clearwater lacked economic
substance and had no potential for profit. Taking all of the
above factors into consideration, we think it is more likely than
not that petitioners invested in Clearwater in an effort to
generate tax benefits, rather than to make a profit. Therefore,
under the circumstances of this case, petitioners failed to
exercise due care in claiming loss deductions and tax credits
with respect to Clearwater.
Upon consideration of the entire record, we hold that
petitioners are liable for the additions to tax for negligence
under section 6653(a)(1) and (2). Respondent is sustained on
this issue.
Issue 3. Section 6659 Valuation Overstatement
Petitioners also contest the addition to tax for valuation
overstatement under section 6659.
A value claimed on a return that exceeds the correct value
by 150 percent or more constitutes a valuation overstatement.
See sec. 6659(c). The Sentinel EPE recyclers were valued at
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$1,162,667 each, but they did not, as we have found, have a value
exceeding $50,000 per machine.
Although petitioners declined to stipulate the value of the
Sentinel recyclers at issue, petitioners presented no probative
evidence by way of expert testimony or otherwise to contradict
the conclusions reached by respondent's experts. The record is
devoid of any evidence indicating that petitioners conducted a
meaningful investigation to value the Sentinel recyclers. We
have extensively considered the value of the Sentinel EPE
recycler and have concluded as an ultimate fact that the
recyclers did not have a fair market value in excess of $50,000.
See Provizer v. Commissioner, T.C. Memo. 1992-177. Having so
concluded, it follows that there was a valuation overstatement
under section 6659.
In view of the foregoing, we sustain respondent's
determination that petitioners are liable for the addition to tax
for valuation overstatement under section 6659.
Issue (4) Section 6621(c) Additional Interest
Respondent determined that petitioners are liable for
additional interest with respect to the underpayment attributable
to petitioners’ investment in Clearwater.
Section 6621(c), formerly section 6621(d), provides for an
increased rate of interest if the underpayment of tax exceeds
$1,000 and is attributable to a tax-motivated transaction as
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defined in section 6621(c)(3). The increased rate of interest is
effective only with respect to interest accruing after December
31, 1984, notwithstanding that the transaction was entered into
before that date. See Solowiejczyk v. Commissioner, 85 T.C. 552
(1985), affd. per curiam without published opinion 795 F.2d 1005
(2d Cir. 1986); Provizer v. Commissioner, supra.
As we held in Provizer, a tax-motivated transaction
includes any sham or fraudulent transaction. See sec.
6621(c)(3)(A)(v). We have held that the Plastics Recycling
Program to which petitioners’ 1981 underpayment is attributable
was a sham transaction. The tax-motivated increased rate of
interest is therefore clearly applicable. Accordingly, we
sustain respondent’s determination on this issue.5
Petitioners have made other arguments that we have
considered in reaching our decision. To the extent that we have
not discussed these arguments, we find them to be without merit.
To reflect our disposition of the disputed issues,
Decision will be entered
for respondent.
5
We note that a tax-motivated transaction also includes
any valuation overstatement within the meaning of sec. 6659(c).
See sec. 6621(c)(3)(A)(i). It is apparent that there was such a
valuation overstatement in the present case. See the discussion
supra, under Issue (3), regarding sec. 6659. Accordingly,
respondent's determination could also be sustained on this
alternative basis.