Hansen v. Comm'r

T.C. Memo. 2004-269

UNITED STATES TAX COURT

GARY D. AND JOHNEAN F. HANSEN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 25191-96. Filed November 24, 2004.

Wendy S. Pearson, Terri A. Merriam, and Jennifer A. Gellner,

for petitioners.

Nhi T. Luu-Sanders, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GOLDBERG, Special Trial Judge: Respondent determined that

petitioners are liable for a section 6662(a) accuracy-related

penalty of $1,545 for the taxable year 1991. Unless otherwise

indicated, section references are to the Internal Revenue Code in

- 2 -

effect for the year in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.

The sole issue for decision is whether petitioners are

liable for the section 6662(a) accuracy-related penalty for

negligence or disregard of rules or regulations in the year in

issue.

FINDINGS OF FACT

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

The first, second, third, and fourth stipulations of facts and

the attached exhibits (excluding those withdrawn at trial) are

incorporated herein by this reference. Petitioners resided in

Kennewick, Washington, on the date the petition was filed in this

case.

I. Walter J. Hoyt III and the Hoyt Partnerships

The accuracy-related penalty at issue in this case arises

from an adjustment of a partnership item on petitioners’ 1991

Federal income tax return. This adjustment is the result of

petitioners’ involvement in certain partnerships organized and

promoted by Walter J. Hoyt III (Mr. Hoyt).

Mr. Hoyt’s father was a prominent breeder of Shorthorn

cattle, one of the three major breeds of cattle in the United

States. In order to expand his business and attract investors,

Mr. Hoyt’s father had started organizing and promoting cattle

breeding partnerships by the late 1960s. Before and after his

- 3 -

father’s death in early 1972, Mr. Hoyt and other members of the

Hoyt family were extensively involved in organizing and operating

numerous cattle breeding partnerships. From about 1971 through

1998, Mr. Hoyt organized, promoted to thousands of investors, and

operated as a general partner more than 100 cattle breeding

partnerships. Mr. Hoyt also organized and operated sheep

breeding partnerships in essentially the same fashion as the

cattle breeding partnerships (collectively the “investor

partnerships” or “Hoyt partnerships”). Each of the investor

partnerships was marketed and promoted in the same manner.

Beginning in 1983, and until removed by this Court due to a

criminal conviction, Mr. Hoyt was the tax matters partner of each

of the investor partnerships that are subject to the provisions

of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA),

Pub. L. 97-248, 96 Stat. 324. As the general partner managing

each partnership, Mr. Hoyt was responsible for and directed the

preparation of the tax returns of each partnership, and he

typically signed and filed each return. Mr. Hoyt also operated

tax return preparation companies, variously called “Tax Office of

W.J. Hoyt Sons”, “Agri-Tax”, and “Laguna Tax Service”, that

prepared most of the investors’ individual tax returns during the

years of their investments. Petitioners’ 1991 return was

prepared in this manner and was signed by Mr. Hoyt. From

approximately 1980 through 1997, Mr. Hoyt was a licensed enrolled

- 4 -

agent, and as such he represented many of the investor-partners

before the Internal Revenue Service (IRS) before he was disbarred

as enrolled agent in 1998.

Beginning in February 1993, respondent generally froze and

stopped issuing income tax refunds to partners in the investor

partnerships. The IRS issued prefiling notices to the investor-

partners advising them that, starting with the 1992 taxable year,

the IRS would disallow the tax benefits that the partners claimed

on their individual returns from the investor partnerships, and

the IRS would not issue any tax refunds these partners might

claim attributable to such partnership tax benefits.

Also beginning in 1993, an increasing number of investor-

partners were becoming disgruntled with Mr. Hoyt and the Hoyt

organization. Many partners stopped making their partnership

payments and withdrew from their partnerships, due in part to

respondent’s tax enforcement. Mr. Hoyt urged the partners to

support and remain loyal to the organization in challenging the

IRS’s actions. The Hoyt organization warned that partners who

stopped making their partnership payments and withdrew from their

partnerships would be reported to the IRS as having substantial

debt relief income, and that they would have to deal with the IRS

on their own.

On June 5, 1997, a bankruptcy court entered an order for

relief, in effect finding that W.J. Hoyt Sons Management Company

- 5 -

and W.J. Hoyt Sons MLP were both bankrupt. In these bankruptcy

cases, the U.S. Trustee moved in 1997 to have the bankruptcy

court substantively consolidate all assets and liabilities of

almost all Hoyt organization entities and the many Hoyt investor

partnerships. This consolidation included all the investor

partnerships. On November 13, 1998, the bankruptcy court entered

its Judgment for Substantive Consolidation, consolidating all the

above-mentioned entities for bankruptcy purposes. The trustee

then sold off what livestock the Hoyt organization owned or

managed on behalf of the investor partnerships.

Mr. Hoyt and others were indicted for certain Federal

crimes, and a trial was conducted in the U.S. District Court for

the District of Oregon. The District Court described Mr. Hoyt’s

actions as “the most egregious white collar crime committed in

the history of the State of Oregon.” Mr. Hoyt was found guilty

on all counts, and as part of his sentence in the criminal case

he was required to pay restitution in the amount of $102 million.

This amount represented the total amount that the United States

determined, using Hoyt organization records, was paid to the Hoyt

organization from 1982 through 1998 by investor-partners in

various investor partnerships.

- 6 -

II. Petitioners and Their Investment

Petitioner wife (Ms. Hansen) is a high school graduate and a

licensed respiratory care practitioner. Petitioner husband (Mr.

Hansen) has a college education, with a bachelor of science

degree in civil engineering and architecture. During the year in

issue, Ms. Hansen was employed as a respiratory therapist, and

Mr. Hansen was employed as a civil engineer. At the time they

invested in the Hoyt partnerships, petitioners’ investment-

related experience comprised the purchase of their residence, the

purchase of a term life insurance policy and Government bonds,

the use of savings accounts, and Mr. Hansen’s investments in his

employment-related retirement account. Petitioners did not have

any prior experience with farming or cattle.

Petitioners first heard about the Hoyt partnerships from Mr.

Hansen’s co-workers in 1986. At the suggestion of one of these

co-workers, who was himself an investor in a Hoyt partnership,

petitioners attended an informational session about the

partnerships at the Red Lion Hotel in Pasco, Washington, in the

latter part of 1986. Mr. Hoyt and others involved in the Hoyt

organization attended the session, where a presentation was given

concerning the nature of the Hoyt partnerships and how they were

being marketed as a retirement investment. While at this

session, petitioners discussed the Hoyt partnerships with

individuals who had already made investments in the partnerships.

- 7 -

Petitioners first invested in the Hoyt partnerships in late

1986. Prior to investing, petitioners received promotional

material prepared by the Hoyt organization. Petitioners relied

on these promotional materials which, in general, provided

rationales for why the partnerships were good investments and why

the purported tax savings were legitimate. One document on which

petitioners relied, entitled “Hoyt and Sons -- The 1,000 lb. Tax

Shelter”, provided information concerning the Hoyt investment

partnerships and how they purportedly would provide profits to

investors over time. The document emphasized that the primary

return on an investment in a Hoyt partnership would be from tax

savings, but that the U.S. Congress had enacted the tax laws to

encourage investment in partnerships such as those promoted by

Mr. Hoyt. The document stated that an “investment in cattle [is

arranged] so the cash required to keep it going is only about

seventy five percent” of an investor’s tax savings, while the

other twenty-five percent of the tax savings is “a thirty percent

return on investment.” This arrangement purportedly provided

protection to investors: “If the cows do die and the sky falls

in, you have still made a return on the investment, and no matter

what happens you are always better off than if you paid taxes.”

After an explanation of the tax benefits, the document asked:

“Now, can you feel good about not paying taxes, and feeling like

- 8 -

you were not, somehow, abusing the system, or doing something illegal?”

A section of the “1,000 lb. Tax Shelter” document that was

devoted to a discussion of audits by the IRS stated that the

partnerships would be “branded an ‘abuse’ by the Internal Revenue

Service and will be subject to automatic” and “constant audit”.

Statements in the document compared the IRS to children, stating

that IRS employees did not have the “proper experience and

training” and “working knowledge of concepts required by the

Internal Revenue Code” to evaluate the partnerships. In a

section of the document titled “Tax Aspects”, the following

“warning” was given:

Out here, tax accountants don’t read brands, and our cowboys

don’t read tax law. If you don’t have a tax man who knows

you well enough to give you specific personal advice as to

whether or not you belong in the cattle business, stay out.

The cattle business today cannot be separated from tax law

any more than cattle can be separated from grass and water.

Don’t have anything to do with any aspect of the cattle

business without thorough tax advice, and don’t waste much

time trying to learn tax law from an Offering Circular.

Despite this warning, the document spent numerous pages

explaining the tax benefits of investing in a Hoyt partnership

and explaining why investors should trust only Mr. Hoyt’s

organization to prepare their individual tax returns:

It is the recommendation of the General Partner, as outlined

in the private placement offering circular, that a

prospective Partner seek independent advice and counsel

concerning this investment. * * * The Limited Partners

should then authorize the Tax Office of W.J. Hoyt Sons to

prepare their personal returns. * * * Then you have an

- 9 -

affiliate of the Partnership preparing all personal and

Partnership returns and controlling all audit activity with

the Internal Revenue Service. * * * Then, all Partners are

able to benefit from the concept of “Circle the Wagons,” and

no individual Partner can be isolated and have his tax

losses disallowed because of the incompetence or lack of

knowledge of a tax preparer who is not familiar with the

law, regulations, format, procedures, and operations

concerning the Partnership that are required to protect the

Limited Partners from Internal Revenue audits. * * * If a

Partner needs more or less Partnership loss any year, it is

arranged quickly within the office, without the Partner

having to pay a higher fee while an outside preparer spends

more time to make the arrangements.

Finally, the document warned that there remained a chance that “A

change in tax law or an audit and disallowance by the IRS could

take away all or part of the tax benefits, plus the possibility

of having to pay back the tax savings, with penalties and

interest.”

At the time that she initially made the investment in 1986,

and through the year in issue, Ms. Hansen believed that she owned

cattle through the investment and that the investment would

produce a profit and provide retirement income.1 She also

believed the Hoyt promotional materials insofar as they stated

that Congress passed tax laws intending to promote the

subsidization of the cattle industry and that investing in a Hoyt

partnership was therefore “socially desirable”. Before investing

in the Hoyt partnerships, petitioners did not consult with anyone

1

Because Mr. Hansen did not testify at trial, there is no

evidence in the record with respect to his understanding of the

nature of the Hoyt investment.

- 10 -

other than members of the Hoyt organization and investors in Hoyt

partnerships--such as other cattle ranchers, independent

investment consultants, or independent tax advisers--concerning

either the partnerships or the tax claims made by the

partnerships.

Petitioners signed a number of documents in connection with

their investment in the Hoyt partnerships; those documents that

appear in the record are summarized as follows. On December 17,

1986, both petitioners signed a document titled “Instructions to

the Managing General Partner”.2 This document stated in relevant

part:

(1) You [Mr. Hoyt] have the authority to sign my

[petitioners’] name to full recourse Promissory Notes used

for the purchase of breeding cattle to be held as an

investment by the above Limited Partnership [Shorthorn

Genetic Engineering 1986], purchased from HOYT & SONS

RANCHES, an Oregon Partnership, in Burns, Oregon, but only

on notes that were made for the purchase of Registered

Shorthorn Breeding Cattle from HOYT & SONS RANCHES.

(2) You must inform me of the amount of Partnership

liabilities I have personally assumed in order to increase

my tax basis and qualify for income tax deductions. I

understand I can refuse, at the end of any year, to obligate

myself to any additional liability and reserve the right to

notify you in writing that I refuse to incur any additional

personal liability through my ownership in the above named

Partnership.

2

Petitioners initially invested in the Hoyt partnerships in

1986. However, the partnership in which they initially invested

was “rescinded”, forcing petitioners to change their investment

to a different partnership in 1987. It is unclear why the

partnership was rescinded; Ms. Hansen believes it was because

“the tax laws changed and so they had to do things a little

differently.”

- 11 -

* * * * * * *

(6) I am a General Partner and a Limited Partner (for tax

purposes only) because I have personally assumed Partnership

liabilities (a Limited Partner does not personally assume

Partnership liabilities).

(7) Because I have the right to increase or decrease

(including down to zero) the amount of cash I contribute to

the Partnership each year, you may charge my capital account

nine percent (9%) interest on the amount of unpaid required

contributions not paid until liquidation and distribution of

all Partnership assets. The total cash I contribute during

the first five years of the Partnership’s life, divided by

$2,500.00, must be the total number of units I will own.

* * * * * * *

(9) By the sixth year the Partnership is in business, it

must begin selling raised breeding cattle to pay the

installment payments on cattle purchase notes.

When Ms. Hansen signed documents such as these, Ms. Hansen

believed that petitioners would be required to repay the

promissory notes.

On January 17, 1987, Mr. Hansen signed a form titled

“Instructions to Hoyt and Sons Ranches -- Acknowledgement of

Appointment of Power of Attorney”. This form provided:

(1) I have given Walter J. Hoyt III the irrevocable

authority to sign my name to a Certificate of Assumption of

Primary Liability Form as part of a transfer on a full

recourse Promissory Note in the amount of $175,000, that

will become part of a transfer of debt agreement between me,

the Partnership known as Durham Genetic Engineering 1986

Ltd., and HOYT & SONS RANCHES, said note having been

delivered to HOYT & SONS RANCHES to pay for breeding cattle

purchased from HOYT & SONS RANCHES, an Oregon Partnership,

in Burns, Oregon, which are to be held as breeding cattle by

the above named Partnership. This authorizes Mr. Hoyt to

sign my name on the notes that were made for the purchase of

Registered Durham Breeding cattle from HOYT & SONS RANCHES,

- 12 -

and no other purpose. I understand I will owe this amount

directly to HOYT & SONS RANCHES, and not to my partnership.

* * * * * * *

(4) My goal is that the value of my share of the cattle

owned by the Partnership, in which you have a secured party

interest, must never fall below the amount for which I am

personally liable. If the value of my cattle does fall

below the amount of my loan, and you become aware of that,

you must so notify me within thirty days in order that I may

make a damage claim to W.J. Hoyt Sons Management Company for

possible default on the Share-Crop Operating Agreement,

and/or the cattle fertility warranties.

Also on January 17, 1987, Mr. Hansen signed a document titled

“Instructions to the Managing General Partner and and [sic]

Acknowledgement of Certain Agreements”. The provisions of this

document are similar to those in the above-described documents,

and they include a grant of authority to Mr. Hoyt to sign a “full

recourse Promissory Note” in the amount $175,000 with respect to

a partnership known as Durham Genetic Engineering 1986-4 Ltd. On

March 15, 1989, Ms. Hansen signed a “Bull Reservation Form”,

purporting to reserve two bulls for petitioners to contribute to

the partnership Timeshare Breeding Service, J.V., in exchange for

a payment of $2,000. Finally, on or around February 22, 1990,

both petitioners signed a “Promissory Note” and “Security

Agreement”, in which petitioners agreed to pay “Timeshare

Breeding Service Joint Venture 89" the amount of $3,500, plus

interest of 10 percent. The note provided for 10 payments of

$350 to be made monthly.

- 13 -

Petitioners were involved in a variety of different cattle

breeding partnerships from 1987 through 1996, including Shorthorn

Genetic Engineering 1986-B, Hoyt and Sons Trucking, Timeshare

Breeding Services, and Timeshare Breeding Services 1989-1.

During the year in issue, petitioners were involved with the

partnerships known as Durham Shorthorn Breed Syndicate 1987-A,

J.V. (DSBS 87-A) and Durham Shorthorn Breed Syndicate 1987-C,

J.V. (DSBS 87-C). Ms. Hansen believed that the Hoyt

organization’s frequent changing of their partnership investments

was the result of tax law changes rather than problems with the

underlying business operations.

Although petitioners did not personally visit or otherwise

independently investigate the cattle ranching operations prior to

their investment, in 1990 and again in 1993 petitioners

participated in “ranch tours”. These tours were annual events

where partners met one another, toured Hoyt-related ranches, and

talked with people involved in the Hoyt organization. When

visiting the ranches, Ms. Hansen did not know which cattle

belonged to any given partnership, or whether the herds were

segregated in any manner. Beginning sometime in either 1989 or

the early 1990s, petitioners also attended a number of monthly

meetings of Hoyt partners that were held near petitioners’ home.

Various guest speakers were invited to these meetings, and

members of the Hoyt organization would also attend on occasion.

- 14 -

In 1989, petitioners received from the Hoyt organization a

copy of this Court’s opinion in Bales v. Commissioner, T.C. Memo.

1989-568. Mr. Hoyt touted the Bales opinion as proof that the

Hoyt partnerships were legal, and that the IRS was incorrect in

challenging their tax claims. Petitioners read the opinion, and

Ms. Hansen believed that “It set a precedent for the ability to

be able to use this business to be able to recap depreciation and

losses through tax writeoffs.” Despite the fact that neither

petitioners nor their partnerships were involved as parties in

the Bales case, Ms. Hansen believed that the opinion meant “that

the things that needed to be understood that weren’t previously

were now understood, that is was a legal operation and that

nothing was wrong” with respect to the tax benefits being derived

from the Hoyt partnerships.

Petitioners made substantial cash payments to the Hoyt

organization during the years 1987 through 1997. In a summary of

such payments prepared by petitioners, they estimate that the

total amount of these payments exceeds $100,000. These payments

included the remittance of their tax refunds, the payment of

quarterly and monthly installments on their promissory notes,

special “assessments” imposed by the partnerships, and

contributions to purported individual retirement account plans

maintained by the Hoyt organization. Petitioners have not

received any of their contributions back from the Hoyt

- 15 -

organization. Before and after the year in issue, petitioners

received numerous documents purporting to show both the

legitimacy of the Hoyt partnerships and the legality of the tax

claims being made by the Hoyt organization. The Hoyt

organization also portrayed employees of the IRS as incompetent

and claimed that they were engaging in unjust harassment of Hoyt

investors. Petitioners trusted these documents and believed and

relied upon what the Hoyt organization told them.

III. Petitioners’ Federal Tax Claims

On petitioners’ original joint Federal income tax returns

for the years 1984 and 1985, they reported adjusted gross income

of $39,315 and $52,048, respectively. After petitioners invested

in the Hoyt partnerships in 1986, they filed a Form 1045,

Application for Tentative Refund, on which they claimed tentative

refunds for the years 1984 and 1985, based upon a claimed net

operating loss (NOL) carryback of $79,171 from 1987. This form

reflects originally-reported tax liabilities for these years of

$6,299 and $8,886, respectively, and tax liabilities of zero in

both years after applying the claimed NOL carryback. Petitioners

reported the following on their joint Federal income tax returns

in the respective taxable years:

- 16 -

1987 1988 1989 1990

Income1 $65,750 $59,281 $61,239 $63,388

Partnership losses 142,950 28,972 37,249 41,470

Tax liability -0- 2,344 1,902 1,466

1

Includes taxable income from wages, interest, and

dividends.

The Form 1045 and each of the returns from 1987 through 1990 were

prepared by an individual affiliated with the Hoyt organization.

By letter dated April 25, 1989, respondent notified

petitioners that one of their Hoyt partnerships was under review.

This letter stated in relevant part:

Our information indicates that you were a partner in the

above partnership [DSBS 87-C] during the above tax year

[1988]. Based upon our review of the partnership’s tax

shelter activities, we have apprised the Tax Matters Partner

that we believe the purported tax shelter deductions and/or

credits are not allowable and, if claimed, we plan to

examine the return and disallow the deductions and/or

credits. The Internal Revenue Code provides, in appropriate

cases, for the application [of various penalties].

In January 1992, respondent mailed Hoyt investors, including

petitioners, a letter regarding the application of section 469

(relating to passive activity loss limitations). That same

month, Mr. Hoyt mailed a letter to investors, including

petitioners, setting forth arguments that Hoyt investors

materially participated in their investments within the meaning

of section 469. In this letter, Mr. Hoyt stated that

respondent’s assertions in the preceding letter were incorrect,

and that the investors should do what was necessary to

participate in their investment at least 100 or 500 hours per

- 17 -

year, depending upon the circumstances, in order to meet the

section 469 requirements. Mr. Hoyt stated that the time

investors spent in recruiting new investors, as well as “reading

and thinking about these letters”, would count toward the

material participation hourly requirements. Finally, in this

letter Mr. Hoyt emphasized that “The position of your partnership

is that it is not a tax shelter”, because tax shelters “are never

recognized for Federal income tax purposes.” By letter dated

February 11, 1992, respondent mailed petitioners a notice

stating:

In Mr. Hoyt’s letter misleading and/or inaccurate

premises were made which may directly affect you and your

decision-making process in filing your 1991 individual tax

return.

First, a “tax shelter” is not necessarily synonymous

with a “sham” investment. Low income housing credits, your

personal residence, and real estate rentals are examples of

tax shelters. It is an oversimplification to state tax

shelters are never recognized for Federal income tax

purposes.

The letter stated that I failed to include number seven

of the regulations which addresses the facts and

circumstances test. Enclosed is the exact wording of this

test, Regulation 1.469-5T(a)(7), and example #8 which refers

to this regulation. Also enclosed is paragraph (b) that is

referred to in paragraph (a)(7). Section 1402 noted in

paragraph (b) defines income subject to self-employment tax.

In the past, and currently, Mr. Hoyt has used Revenue

Rulings 56-496, 57-58, and 64-32 as authorities for

investors having met the material participation requirement.

These rulings and the court cases he has cited are prior to

the enactment of section 469 and all refer to section 1402.

Please note in (b)(2) that meeting the material

participation requirement of Section 1402 is specifically

excluded from being taken into account for having met the

material participation requirement of section 469 in using

the facts and circumstances test of (a)(7).

- 18 -

Whether a person meets the material participation

requirement of section 469 is a factual determination. The

Reg. 1.469-5T(f)(2)(ii) defines investors’ activities that

are not considered in meeting the hourly requirement.

Simply signing a statement or making an election are not a

means in meeting the requirement. Although Section 469 may

not have existed at the time of your initial investment, it

is law that investors have to address in claiming investment

losses today. Contrary to Mr. Hoyt’s statement, time spent

reading and thinking about this issue should not be

considered as material participation hours for 1992.

If this letter is somewhat confusing or you are

questioning the accuracy of this letter, I recommend you

consider having an independent accountant or attorney review

this matter with you.

Petitioners also received several notices informing them that

respondent was beginning an examination of various partnerships

in which petitioners had been involved. Petitioners received

such notices dated June 19, 1989, June 26, 1989, August 13, 1990,

January 28, 1991, February 19, 1991, May 13, 1991, February 3,

1992, and February 18, 1992. Finally, petitioners had been

notified by respondent by letter dated December 9, 1988, that

their 1987 individual income tax return had been selected for

examination prior to issuance of the requested refund; the refund

was subsequently issued on February 20, 1989.

In June 1992, petitioners completed their joint Federal

income tax return for their taxable year 1991. They reported the

following items of income and loss on this return:

- 19 -

Wage income $72,690

Interest income 110

Rental property loss (2,534)

DSBS 87-A loss (27,170)

DSBS 87-C loss (32,306)

Farm income 8,681

Total income 19,471

The losses from DSBS 87-A and DSBS 87-C were reported on

Schedules K-1, Partner’s Share of Income, Credits, Deductions,

Etc., issued to both petitioners by the partnerships for the

partnerships’ taxable years ending in 1991. Although it appears

from the return that the farming income is related to

petitioners’ Hoyt investment, it is unclear how this amount of

income was calculated or earned. Petitioners reported a total

tax liability of $799 for 1991. Attached to the return was a

“Material Participation Statement”. On this statement,

petitioners averred that they spent 114 hours during 1991 working

in various Hoyt-related activities. The 1991 return was signed

by Mr. Hoyt as the return preparer on June 19, 1992, it was

signed by petitioners on June 27, 1992, and it was stamped

“Received” by respondent on July 23, 1992.

Starting with the Form 1045 and the 1987 return, and

continuing through the 1991 return, Mr. Hoyt or a member of the

Hoyt organization prepared petitioners’ tax forms. Upon signing

the returns, Ms. Hansen did not know how the Hoyt-related items

were derived; she knew only that Mr. Hoyt or a member of his

organization had entered the items on the Schedules K-1 and on

- 20 -

the returns, and she assumed the items were therefore correct.

Petitioners did not have the returns reviewed by an accountant or

anyone else outside the Hoyt organization prior to signing them.

The section 6662(a) accuracy-related penalty in this case is

derived solely from the loss that petitioners claimed in 1991

with respect to DSBS 87-C. Respondent issued a Notice of Final

Partnership Administrative Adjustment (FPAA) to petitioners with

respect to DSBS 87-C that reflected the disallowance of various

deductions claimed on the partnership return for its taxable year

ending in 1991. Because a timely petition to this Court was not

filed in response to the FPAA issued for DSBS 87-C, respondent

made a computational adjustment assessment against petitioners

with respect to the FPAA. The computational adjustment of

$40,892 changed petitioners’ claimed DSBS 87-C loss of $32,306 to

income of $8,586, increasing petitioners’ tax liability by

$7,724, from $799 to $8,523.3 In the notice of deficiency

underlying this case, respondent determined that petitioners are

liable for the section 6662(a) accuracy-related penalty for

negligence or disregard of rules or regulations with respect to

the entire amount of the underpayment resulting from the DSBS 87-

C computational adjustment.

3

The amount of the farm income reported by petitioners on

their 1991 return was not changed by respondent pursuant to the

computational adjustment assessment, presumably because the farm

income was not a partnership item.

- 21 -

OPINION

I. Evidentiary Issues

As a preliminary matter, we address evidentiary issues

raised by the parties in the stipulations of facts. Petitioners

and respondent reserved objections to a number of the exhibits

and paragraphs contained in the stipulations, all on the grounds

of relevancy. We address here those objections that were not

withdrawn by the parties at trial. Federal Rule of Evidence 4024

provides the general rule that all relevant evidence is

admissible, while evidence which is not relevant is not

admissible. Federal Rule of Evidence 401 provides that

“‘Relevant evidence’ means evidence having any tendency to make

the existence of any fact that is of consequence to the

determination of the action more probable or less probable than

it would be without the evidence.” While certain of the exhibits

and stipulated facts are given little to no weight in our finding

of ultimate facts in this case, we hold that the exhibits and

stipulated facts meet the threshold definition of “relevant

evidence” under Federal Rule of Evidence 401, and that the

exhibits and stipulated facts therefore are admissible under

Federal Rule of Evidence 402. Accordingly, to the extent that

4

The Federal Rules of Evidence are applicable in this Court

pursuant to sec. 7453 and Rule 143(a).

- 22 -

the Court did not overrule the relevancy objections at trial, we

do so here.

II. The Section 6662(a) Accuracy-Related Penalty

Section 6662(a) imposes an addition to tax of 20 percent on

the portion of an underpayment attributable to any one of various

factors, one of which is “negligence or disregard of rules or

regulations”. Sec. 6662(a) and (b)(1). “Negligence” includes

any failure to make a reasonable attempt to comply with the

provisions of the Internal Revenue Code, and “disregard of rules

or regulations” includes any careless, reckless, or intentional

disregard. Sec. 6662(c). The regulations under section 6662

provide that negligence is strongly indicated where:

A taxpayer fails to make a reasonable attempt to ascertain

the correctness of a deduction, credit or exclusion on a

return which would seem to a reasonable and prudent person

to be “too good to be true” under the circumstances * * * .

Sec. 1.6662-3(b)(1)(ii), Income Tax Regs.

Negligence is defined as the “‘lack of due care or failure

to do what a reasonable or 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 on another

ground 43 T.C. 168 (1964)); see Allen v. Commissioner, 925 F.2d

348, 353 (9th Cir. 1991), affg. 92 T.C. 1 (1989). Negligence is

determined by testing a taxpayer’s conduct against that of a

reasonable, prudent person. Zmuda v. Commissioner, 731 F.2d

- 23 -

1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982). Courts

generally look both to the underlying investment and to the

taxpayer’s position taken on the return in evaluating whether a

taxpayer was negligent. Sacks v. Commissioner, 82 F.3d 918, 920

(9th Cir. 1996), affg. T.C. Memo. 1994-217. When an investment

has such obviously suspect tax claims as to put a reasonable

taxpayer under a duty of inquiry, a good faith investigation of

the underlying viability, financial structure, and economics of

the investment is required. Roberson v. Commissioner, T.C. Memo.

1996-335, affd. without published opinion 142 F.3d 435 (6th Cir.

1998) (citing LaVerne v. Commissioner, 94 T.C. 637, 652-653

(1990), affd. without published opinion sub nom. Cowles v.

Commissioner, 949 F.2d 401 (10th Cir. 1991), affd. without

published opinion 956 F.2d 274 (9th Cir. 1992); Horn v.

Commissioner, 90 T.C. 908, 942 (1988)).

The Commissioner’s decision to impose the negligence penalty

is presumptively correct.5 Rule 142(a); Collins v. Commissioner,

857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister v.

Commissioner, T.C. Memo. 1987-217; Hansen v. Commissioner, 820

F.2d 1464, 1469 (9th Cir. 1987). A taxpayer has the burden of

5

While sec. 7491 shifts the burden of production and/or

burden of proof to the Commissioner in certain circumstances,

this section is not applicable in this case because respondent’s

examination of petitioners’ return did not commence after July

22, 1998. See Internal Revenue Service Restructuring and Reform

Act of 1998, Pub. L. 105-206, sec. 3001(c), 112 Stat. 727.

- 24 -

proving that respondent’s determination is erroneous and that he

did what a reasonably prudent person would have done under the

circumstances. See Rule 142(a); Hansen v. Commissioner, supra;

Hall v. Commissioner, 729 F.2d 632, 635 (9th Cir. 1984), affg.

T.C. Memo. 1982-337; Bixby v. Commissioner, 58 T.C. 757, 791

(1972).

III. Application of the Negligence Standard

Although petitioners had no experience in farming or

ranching, and petitioners did not consult any independent

investment advisers, petitioners made the decision to invest in a

cattle ranching activity as a means to provide for their

retirement. As part of their initial investment in the Hoyt

partnerships, petitioners provided Mr. Hoyt with the authority to

sign promissory notes on their behalf in an amount of at least

$175,000. Ms. Hansen, and presumably Mr. Hansen, believed that

petitioners would be personally liable on these promissory notes

in the event that a problem arose causing there to be

insufficient value in the cattle to cover the amount of the

notes. Nevertheless, petitioners placed their trust entirely

with the promoters of the investment, and they did not

investigate either the legitimacy of the partnerships or the

implications of the promissory notes. We conclude that

petitioners were negligent in signing the promissory notes and in

entering into the investment.

- 25 -

In the years 1987 through 1991, petitioners used the Hoyt

investment to report a total Federal income tax liability of

$6,511 on income totaling $322,458. In addition, petitioners

filed the Form 1045 which purportedly reduced their combined 1984

and 1985 Federal income liabilities from $15,165 to zero.

Petitioners claimed these tax benefits based solely on the advice

that they received from the promoters of the investment and from

other Hoyt investors. Furthermore, the promotional materials

that petitioners received had clearly indicated that there were

substantial tax risks in making an investment. Nevertheless,

petitioners did not investigate the tax claims being made by the

Hoyt organization with anyone outside the organization.

When it came time to prepare petitioners’ tax returns and

claim the losses being reported by the Hoyt partnerships,

petitioners relied on the very people who were receiving the bulk

of the tax savings generated by the claims. Thus, the same

individuals who sold petitioners an interest in the Hoyt

partnerships and who ran the purported ranching operations also

prepared the partnerships’ tax returns, prepared petitioners’ tax

returns, and received from petitioners most of the tax savings

that resulted from the positions taken on petitioners’ returns.

With respect to 1991, the year in issue in this case,

petitioners claimed that they incurred $59,476 in losses from the

Hoyt partnerships. Ms. Hansen did not know, and there is no

- 26 -

evidence that Mr. Hansen knew, how these losses were derived; she

knew only that the Hoyt organization had reported the amounts on

the Schedules K-1 and on petitioners’ tax return. Petitioners

claimed these losses despite the fact that respondent had been

warning petitioners, at least since December 1988, that there

were potential problems with the tax claims being made on both

the partnership returns and on petitioners’ returns. Prior to

signing their 1991 return, petitioners had received at least 11

separate letters from respondent alerting petitioners to

suspected problems or alerting petitioners to reviews that had

been commenced with respect to various Hoyt partnerships in which

they were involved. Despite these letters, petitioners did not

further investigate the partnership losses, such as by consulting

an independent tax adviser, before claiming the losses as

deductions on their 1991 return. We conclude that petitioners

were negligent in 1991 in claiming the Hoyt partnership loss at

issue in this case; namely, the $32,306 loss from DSBS 87-C.

IV. Alleged Defenses to the Accuracy-Related Penalty

Section 6664(c)(1) provides that the section 6662(a)

accuracy-related penalty is not imposed “with respect to any

portion of an underpayment if it is shown that there was a

reasonable cause for such portion and that the taxpayer acted in

good faith with respect to such portion.” “The determination of

whether a taxpayer acted with reasonable cause and in good faith

- 27 -

is made on a case-by-case basis, taking into account all

pertinent facts and circumstances.” Sec. 1.6664-4(b)(1), Income

Tax Regs. The extent of the taxpayer’s effort to ascertain his

proper tax liability is generally the most important factor. Id.

A. Reliance on the Hoyt Organization and Hoyt Partners

Petitioners first argue that they should escape the

negligence penalty because they relied in good faith on various

individuals with respect to the Hoyt investment: Mr. Hoyt and

other members of the Hoyt organization, tax professionals hired

by the Hoyt organization, and other Hoyt investor-partners.

Good faith reliance on professional advice concerning tax

laws may be a defense to the negligence penalties. United States

v. Boyle, 469 U.S. 241, 250-251 (1985); see also sec. 1.6664-

4(b)(1), Income Tax Regs. However, “Reliance on professional

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

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

89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990),

affd. 501 U.S. 868 (1991). In order to be considered as such,

the reliance must be reasonable. Id. To be objectively

reasonable, the advice generally must be from competent and

independent parties unburdened with an inherent conflict of

interest, not from the promoters of the investment. Goldman v.

Commissioner, 39 F.3d 402, 408 (2d Cir. 1994), affg. T.C. Memo.

1993-480; LaVerne v. Commissioner, 94 T.C. at 652; Rybak v.

- 28 -

Commissioner, 91 T.C. 524, 565 (1988); Edwards v. Commissioner,

T.C. Memo. 2002-169.

It is clear in this case that the advice petitioners

received, if any, concerning the partnership loss deduction that

resulted in the underlying deficiency was not objectively

reasonable. First, we note that petitioners have not established

that they received any advice at all concerning the deduction.

Although petitioners relied on Mr. Hoyt and his organization to

prepare the return, Ms. Hansen’s testimony and the other evidence

in the record does not suggest that petitioners directly

questioned Mr. Hoyt or his organization about the nature of the

tax claims. When petitioners signed the return, they did not

question or seek advice from anyone concerning the large

partnership loss at issue. Nevertheless, assuming arguendo that

petitioners did receive advice from Mr. Hoyt or someone within

his organization, any such advice that they received is in no

manner objectively reasonable. Mr. Hoyt and his organization

created and promoted the partnership, they completed petitioners’

tax return, and they stood to profit from doing so. For

petitioners to trust Mr. Hoyt or members of his organization for

tax advice and/or to prepare their returns under these

circumstances was inherently unreasonable.

In addition to relying on members of the Hoyt organization

itself, petitioners argue that they relied on tax professionals

- 29 -

hired by the Hoyt organization and on other Hoyt investors.

Petitioners, however, have established only that they believed

that the Hoyt organization and the other partners had consulted

with tax professionals. Petitioners have not established in what

manner they personally relied upon any such professionals, or

even the details of what advice the professionals provided that

would be applicable to petitioners’ situation with respect to the

year in issue. Furthermore, because all of these individuals

were affiliated with the Hoyt organization, it would have been

objectively unreasonable for petitioners to rely upon them in

claiming the tax benefits advertised by that very organization.

B. Deception and Fraud by Mr. Hoyt

Petitioners next argue that they should not be liable for

the negligence penalty because they were defrauded and otherwise

deceived by Mr. Hoyt with respect to their investment in the Hoyt

partnerships. In this regard, petitioners first argue that the

doctrine of judicial estoppel bars application of the negligence

penalty because the U.S. Government successfully prosecuted Mr.

Hoyt for, in general terms, defrauding petitioners.

Judicial estoppel is a doctrine that prevents parties in

subsequent judicial proceedings from asserting positions

contradictory to those they previously have affirmatively

persuaded a court to accept. United States ex rel. Am. Bank v.

C.I.T. Constr., Inc., 944 F.2d 253, 258-259 (5th Cir. 1991);

- 30 -

Edwards v. Aetna Life Ins. Co., 690 F.2d 595, 598-599 (6th Cir.

1982). Both this Court and the Court of Appeals for the Ninth

Circuit, to which appeal in this case lies, have accepted the

doctrine of judicial estoppel. See Helfand v. Gerson, 105 F.3d

530 (9th Cir. 1997); Huddleston v. Commissioner, 100 T.C. 17, 28-

29 (1993).

The doctrine of judicial estoppel focuses on the

relationship between a party and the courts, and it seeks to

protect the integrity of the judicial process by preventing a

party from successfully asserting one position before a court and

thereafter asserting a completely contradictory position before

the same or another court merely because it is now in that

party’s interest to do so. Edwards v. Aetna Life Ins. Co., supra

at 599; Huddleston v. Commissioner, supra at 26. Whether or not

to apply the doctrine is within the sound discretion of the

court, but it should be applied with caution in order “to avoid

impinging on the truth-seeking function of the court because the

doctrine precludes a contradictory position without examining the

truth of either statement.” Daugharty v. Commissioner, T.C.

Memo. 1997-349 (quoting Teledyne Indus., Inc. v. NLRB, 911 F.2d

1214, 1218 (6th Cir. 1990)), affd. without published opinion 158

F.3d 588 (11th Cir. 1998)).

Judicial estoppel generally requires acceptance by a court

of the prior position and does not require privity or detrimental

- 31 -

reliance of the party seeking to invoke the doctrine. Huddleston

v. Commissioner, supra at 26. Acceptance by a court does not

require that the party being estopped prevailed in the prior

proceeding with regard to the ultimate matter in dispute, but

rather only that a particular position or argument asserted by

the party in the prior proceeding was accepted by the court. Id.

Respondent’s position in this case is in no manner

contradictory to the position taken by the United States in the

criminal conviction of Mr. Hoyt. See, e.g., Goldman v.

Commissioner, 39 F.3d 402, 408 (2d Cir. 1994) (taxpayer-

appellants’ argument that an investment partnership “constituted

a fraud on the IRS, as found by a civil jury * * * and by the tax

court * * * cannot justify appellants’ own failure to exercise

reasonable care in claiming the losses derived from their

investment”), affg. T.C. Memo. 1993-480. To the contrary, this

Court has sustained a finding of negligence with respect to

investors who had been victims of deception by tax shelter

promoters. For example, in Klieger v. Commissioner, T.C. Memo.

1992-734, this Court held that taxpayers in a situation similar

to that of petitioners were negligent. In Klieger, we addressed

taxpayers’ involvement in certain investments that were sham

transactions that lacked economic substance:

Petitioners are taxpayers of modest means who were

euchred by Graham, a typical shifty promoter. Graham sold

petitioners worthless investments by giving spurious tax

advice that induced them to reduce their withholding and

- 32 -

turn their excess pay over to Graham as initial payments to

acquire interests in “investment programs” that did not

produce any economic return and apparently never had any

prospects of doing so. Graham purported to fulfill his

prophecies about the tax treatment of the Programs by

preparing petitioners’ tax returns and claiming deductions

and credits that have been disallowed in full, with

resulting deficiencies* * *.

* * * * * * *

When a tax shelter is a sham devoid of economic

substance and a taxpayer relies solely on the tax shelter

promoter to prepare his income tax return or advise him how

to prepare the return with respect to the items attributable

to the shelter that the promoter has sold him, it will be

difficult for the taxpayer to carry his burden of proving

that he acted reasonably or prudently. Although a tax

shelter participant, as a taxpayer, has a duty to use

reasonable care in reporting his tax liability, the promoter

who prepares the participant’s tax return can be expected to

report large tax deductions and credits to show a relatively

low amount of tax due, and thereby fulfill the prophecies

incorporated in his sales pitch.

We conclude that there are no grounds for application of judicial

estoppel in the present case.

In a vein similar to their judicial estoppel argument,

petitioners further argue that Mr. Hoyt’s deception resulted in

an “honest mistake of fact” by petitioners when they entered into

their investment. More specifically, petitioners assert that

they had insufficient information concerning the losses and that

“all tangible evidence available to the Hoyt partners supported

Jay Hoyt’s statements.”

Reasonable cause and good faith under section 6664(c)(1) may

be indicated where there is “an honest misunderstanding of fact

or law that is reasonable in light of all the facts and

- 33 -

circumstances, including the experience, knowledge, and education

of the taxpayer.” Sec. 1.6664-4(b)(1), Income Tax Regs.

However, “reasonable cause and good faith is not necessarily

indicated by reliance on facts that, unknown to the taxpayer, are

incorrect.” Id.

For the reasons discussed above in applying the negligence

standard, whether or not petitioners had a “mistake of fact” does

not alter our conclusion that petitioners’ actions in relation to

their investment and the tax claims were objectively

unreasonable. Furthermore, and again for the reasons discussed

above, petitioners’ failure to investigate further--beyond what

was made available to them by Mr. Hoyt and his organization--was

also not an objectively reasonable course of action.

C. Petitioners’ Investigation

Petitioners further argue that they had reasonable cause for

the underpayment because they made a reasonable investigation

into the partnership, taking into account the level of their

sophistication. Petitioners assert that this investigation

yielded no indication of wrongdoing by Mr. Hoyt, and petitioners

further assert that an “average taxpayer was unable to discover

Hoyt’s fraud”. As we have held, petitioners’ investigation into

the partnership went no further than members of the Hoyt

organization and other Hoyt partner-investors. Relying on these

individuals as a source of objective information concerning the

- 34 -

partnerships was not reasonable. Furthermore, even assuming that

an “average taxpayer” would have been unable to discover any

wrongdoing, petitioners were nevertheless negligent in not

further investigating the partnership and/or seeking independent

advice concerning it.

D. The Bales Opinion

Petitioners next argue that they had reasonable cause for

the underpayment because of this Court’s opinion in Bales v.

Commissioner, T.C. Memo. 1989-568.6 The Bales case involved

deficiencies asserted against various investors in several

different cattle partnerships marketed by Mr. Hoyt. This Court

found in favor of the investors on several issues, stating that

“the transaction in issue should be respected for Federal income

tax purposes.” Bales involved different investors, different

partnerships, different taxable years, and different issues than

those underlying the present case.

6

Petitioners also argue that the opinion in Bales v.

Commissioner, T.C. Memo. 1989-568, provided “substantial

authority for the positions taken on petitioners’ 1991 income tax

return.” There is no explicit “substantial authority” exception

to the sec. 6662(a) accuracy-related penalty for negligence.

Hillman v. Commissioner, T.C. Memo. 1999-255 n.14 (citing Wheeler

v. Commissioner, T.C. Memo. 1999-56). While petitioners refer to

the “reasonable basis” exception to the negligence penalty, set

forth in sec. 1.6662-3(b)(3), Income Tax Regs., they do not

specifically argue that the exception applies in this case.

Nevertheless, we note that the record does not establish that

petitioners had a reasonable basis for claiming the partnership

loss at issue in this case.

- 35 -

First, petitioners argue they relied on Bales in claiming

the deduction for the partnership loss. Without further

addressing the applicability of Bales to petitioners’ situation,

we find that petitioners have not established that they relied on

Bales in this manner. The record shows that petitioners relied

instead on the interpretation of Bales provided by Mr. Hoyt and

his organization, who repeatedly claimed that Bales was proof

that the partnerships and the tax positions were legitimate. We

have already found that petitioners’ reliance on Mr. Hoyt and his

organization was objectively unreasonable and, as such, not a

defense to the negligence penalty. Accepting Mr. Hoyt’s

assurances that Bales was a wholesale affirmation of his

partnerships and his tax claims was no less unreasonable.

Second, petitioners argue that, because this Court was

unable to uncover the fraud or deception by Mr. Hoyt in Bales,

petitioners as individual taxpayers were in no position to

evaluate the legitimacy of their partnership or the tax benefits

claimed with respect thereto. This argument employs the Bales

case as a red herring: The Bales case involved different

investors, different partnerships, different taxable years, and

different issues. Furthermore, adopting petitioners’ position

would imply that taxpayers should have been given carte blanche

to invest in partnerships promoted by Mr. Hoyt, merely because

Mr. Hoyt had previously engaged in activities which withstood one

- 36 -

type of challenge by the Commissioner, no matter how illegitimate

the partnerships had become or how unreasonable the taxpayers

were in making investments therein and claiming the tax benefits

that Mr. Hoyt promised would ensue.

E. Fairness Considerations

Petitioners’ final arguments concerning application of the

accuracy-related penalty are in essence arguments that imposition

of the penalty would be unfair or unjust in this case.

Petitioners argue that “The application of penalties in the

present case does not comport with the underlying purpose of

penalties.” To this effect, petitioners argue that, in this

case,

the problem was not Petitioners’ disregard of the tax laws,

but was Jay Hoyt’s fraud and deception. Petitioners did not

engage in noncompliant behavior, instead they were the

victims of a complex fraud that it took Respondent years to

completely unravel.

Petitioners made a good faith effort to comply with the tax

laws and punishing them by imposing penalties does not

encourage voluntary compliance, but instead has the opposite

effect of the appearance of unfairness by punishing the

victim. Indeed, penalties are improper for any investor in

the Hoyt partnerships on a policy basis alone. [Fn. ref.

omitted.]

We are mindful of the fact that petitioners were victims of Mr.

Hoyt’s fraudulent actions. Petitioners ultimately lost the bulk

of the tax savings that they received, which they had remitted to

Mr. Hoyt as part of their investment, and which they never

received back. Nevertheless, petitioners believed that this

- 37 -

money was being used for their own personal benefit--at the time

that they claimed the tax savings, they believed that they would

eventually benefit from them. Petitioners also lost a

substantial amount of out-of-pocket cash which they paid to Mr.

Hoyt in the years preceding and following the year in issue. In

fact, some of the later payments were made in response to not-so-

thinly-veiled threats by Mr. Hoyt of retaliatory action if

petitioners failed to remit the payments. However, this does not

alter our conclusion that petitioners were negligent with respect

to entering the Hoyt investment, and that they were negligent

with respect to the positions that they took on their 1991 tax

return. Despite Mr. Hoyt’s actions, the positions taken on the

1991 return signed by petitioners were ultimately the positions

of petitioners, not of Mr. Hoyt.

V. Conclusion

Upon the basis of the record before the Court, we conclude

that petitioners’ actions in relation to the Hoyt investment

constituted a lack of due care and a failure to do what

reasonable or ordinarily prudent persons would do under the

circumstances. First, petitioners entered into an investment,

allegedly involving at least $175,000 of personal debt, without

investigating its legitimacy. Second, and foremost, petitioners

trusted individuals who told them that they effectively could

escape paying Federal income taxes for a number of years--

- 38 -

petitioners reported a combined tax liability of $6,511 on

$413,821 of income over 7 taxable years--based solely upon the

advice of the individuals promoting the tax shelter. Our

conclusion is reinforced by the fact that petitioners received

multiple warnings from respondent, including one as late as

February 1992, warnings that petitioners ignored. We find that

petitioners were negligent with respect to entering the Hoyt

investment, and that they were negligent with respect to claiming

the DSBS 87-C loss on their return.

To reflect the foregoing,

Decision will be entered

for respondent.